Cross-border stability framework: Lessons from the global financial crisis Jerzy Pruski

1. Cross-border stability framework: Lessons from the global financial crisis Jerzy Pruski BFG 15th Anniversary Conference Warszawa, 21 May 2010 1

2. Domestic financial stability framework Completeness & efficiency of the system 2

3. Low effectiveness of existing crisis management tools Global financial crisis 2007 – 2010 / response options Private sector solutions Bailout/nationalization Standard bankruptcy proceedings Very limited Broadly used Very limited Scope Examples • Important M&A • Bear Stearns (JP Morgan) • Merrill Lynch (BoA) • Negative examples: • ABN Amro (RBS, Santander • and Fortis) TARP, AIG, CitiGroup, RBS, Lloyds TSB, Northern Rock, Fortis, Dexia, KBC, AIB, Commerzbank, Hypo Real Estate Available only for small banks. Not resorted to after the collapse of Lehman Brothers for fear of systemic risk Standard legislation • Ineffective: • need for quick decisions • inadequate for specific • circumstances Significant changes required Fiscal burden of financial turmoil must to be drastically limited 3

4. Robust domestic stability network as prerequisite for effective cross-border safety net • Regulations • Rescue function (temporary) Ministry of Finance MoF DGS Rescue function: to be extended & implemented Central Bank • Liquidity Financial Services Authority strong & complete domestic financial stability system • Regulations • Supervision Deposit Guarantee Scheme ? Special resolution regimes: to be implemented • Pay-box • Rescue function Periodic financial crises remain inevitable in a market economy even despite strong domestic stability network 4

5. Need for effective rescue and resolution functions Complete toolkit of instruments a pre-condition for effective crisis management Rescue Resolution Change of ownership required No change of ownership Private sector solution not available Bailout/Temporary nationalisation Private sector solutions Bank restructuring or capital injection Rescue activities not justified Moral hazard Tools to support M&As Assistance for existing shareholders Special receivership powers Authority for Purchase and Assumption Orderly liquidation Rescue function (capital injection and/or liquidity support) Insurance Pay-box function 5

6. Resolution function Sell the whole bank Receivership Cost and systemic risk assessment Failed Bank Quick decision Sell asset pools Liquidate assets FDIC Sell deposits & branches Coverage for insured deposits (DGS) Alternative model Insured deposit pay-out • Reduction of: • systemic risk • amount of required funds • moral hazard 6

7. Significance of special resolution regimes Fiscal and stability costs* Advantages *based on Čihák & Nier (2009) • Reduction of systemic risk of default • Transfer of control to regulators • Reduction of fiscal cost • Costs transferred to existing shareholders • Reduction of moral hazard • Better market discipline (Indirect costs) „Bailout” Fiscal costs Ordinary resolutions Disorderly bankruptcy (Direct costs) Special resolution Stability costs Systemic financial stability impact 7

8. Cross-border interconnectedness Additional risks and challenges 8

9. Cross-border interconnectedness Global economy cross- border dimensions Broad range of benefits of globalisation • Insufficient information • Crisis contagion Increased risk of crisis & Extraordinary challenge for crisis management 9

10. Cross-border risk management • Cross-border banking groups imply: • enormous complications for financial safety net • modifications in the toolkit of stability instruments and new regulatory authorities Domestic market risk External risk Microprudential Default risk Country 1 Macroprudential Country 2 Bank 11 Cross-border dimensions Bank 21 Bank 12 Prevention instruments Bank 2 Bank 1 Bank 22 Bank 13 Crisis management Bank 14 interbank links 10

11. Cross-border connections Risk monitoring limitations Limitations Systemic risk Identification of systemically important institutions requires access to data on entire cross-border network Total picture of the risk is not visible from the perspective of a single country Source - IMF • In addition to a local component, the risk imposed on domestic banks depends • on external foreign risk, which is only partially visible 11

12. Limiting the risk of crisis Available solutions for mitigation of cross-border crisis risk Robust domestic safety net Harmonization + cooperation Integrated solutions Effective domestic financial stability system Mostly non-binding Some decisions are transferred to international level Pending construction Difficult to implement • Involves the issue of individual state independence • legal aspect – different legal rules • burden sharing aspect 12

13. European Union Financial stability system enhancement 13

14. Existing cross-border stability framework in the EU • monetary policy • stabilization policy European ECB Euro Area Regulations ESRB, EBA not authorized to impose fiscal cost New solutions Union • Crucial importance however still: • non-binding • limited efficiency Harmonisation Crucially important but remain: Coordination Urgent need for new and rigorously enforced fiscal rules 14

15. Proposed cross-border stability framework European stability framework legs behind domestic standards Fragmented Non-binding Lack of funds Currently discussed solutions Basel III • Limitations and barriers • lack of ex-ante burden sharing • non – existant legal framework for transfer of assets • legal differences • lack of common bankruptcy law ESF European Stability Fund ERA European Resolution Agency EDGS European DGS IES Integrated European Supervisor EMF European Monetary Fund 15

16. Risk of overregulation Sources of global financial crisis Macroprudential Microprudential Macroeconomics European Systemic Risk Board New regulations Theory and practice of macroeconomic policy essentially unchanged • selective scope • (only banking sector) • - effectiveness not fully proved • incomplete cost-benefit analysis • limited territorial scale • limiting the scale of operations - focus on stability of consumer prices - not oriented to asset prices and monetary aggregates - fiscal policy - FX regime Remains to be tested Risk of overregulation • Outstanding: • fiscal problems • global imbalances • asset bubbles 16

17. Risk of suboptimal policy mix Monetary policy Fiscal policy Supervisory and regulatory policy Low interest rates and monetary easing despite improvement of economic situation Recently reached deficit and debt levels force budgetary restraint Focus on new regulation rather than more effective supervision Banking regulations Restrict the range and scope of banking activity Counter-cyclical measures Pro-cyclical measures Pro-cyclical measures • The risk of inconsistent monetary – regulatory policy mix • The entire burden of emerging from the crisis rests on monetary policy with successively • lowerinterest rates and a familiar potential for future assets bubbles 17