07 October 2009

Goldschmidt: Too big to fail? Maintaining a single market and fairness between bigger versus smaller EU members

A proper resolution mechanism should not discriminate against banks from smaller states: There is a basic contradiction between an EU single market for banking services and a Member State-based “resolution mechanism”.

There is broad agreement that the current financial crisis was able to develop in part because the existing fragmented regulatory framework proved incapable of detecting in time the excess credit risks that pervaded the system which, in turn, were significantly magnified by the degree of leverage financing risk assets.

There is further consensus that governments and monetary authorities had no choice but to intervene to prevent the overall collapse of the financial system that would have lead to a total economic breakdown and social chaos. From this latter consideration was derived the definition of “too big to fail” applied to institutions described as “systemically” important. This concept had, however, already contaminated the system since many years fuelling the appetite for risk beyond all reasonable limits.

 

If one analyses this phenomenon more closely one comes to the conclusion that there are three main mechanisms through which an institution can acquire “systemic” relevance and in proposing remedies, it is important to distinguish between them. They are not however mutually exclusive.

 

The first and more traditional criterion is based on the “connectivity” of financial markets by which the failure of an important intermediary can, through a domino effect, cause other institutions, otherwise perfectly healthy, to fail bringing down the whole system. This syndrome was emblematically demonstrated when the already fragile interbank market completely seized up after the failure of Lehman Brothers forcing central banks around the world to provide quasi unlimited access to liquidity and governments to provide direct support or guarantees so that banks could obtain adequate funding.

 

In light of the global nature of financial markets, remedies to prevent reoccurrence of events leading to market seizure must clearly be taken at supra national level through implementation of common standards, for instance by requiring clearing and settlement of cash transactions through secure platforms and appropriate collateralisation mechanisms of all transactions involving a credit exposure between regulated financial institutions. A year ago, I had suggested the creation of such an EU wide mechanism for the interbank market involving the intermediation of the EIB ensuring a uniform approach rather than the patchwork of individual Member State initiatives which will make the coordination of “exit” strategies more complicated. Bringing the CDS market within such a regulatory framework is another significant improvement being considered. The United States Congress is currently considering extending the scope of such measures to a significant part of the 530 trillion dollar derivatives market.

 

The second criterion derives from the unacceptable direct consequences of a default by a major institution. The most striking example was provided by the US Government which was forced to formalise its implicit guarantee over the USD 6 trillion of Fannie Mae and Freddy Mac debt to placate, in particular, overseas investors and prevent a run on the US currency a few weeks prior to the Lehman debacle. Another example was the rescue of AIG, a focal point in the unregulated CDS market.

 

The third criterion is related to the intrinsic importance of an institution, and more specifically to the total of its balance sheet in relation to the size of the economy of the country in which it is incorporated. This particular aspect was in evidence in Belgium where the Government found itself in the very uncomfortable position of having to rescue quasi simultaneously 4 major institutions whose size – cumulatively – exceeded 500% of Belgian GNP.

 

By intervening rapidly and decisively – as did other governments - the Belgian Government was able to stabilise the system and avoid the contamination of the global markets in the process. Its task was greatly facilitated by Belgium’s membership in EMU which gave access to the support of the ECB (this was also true in dealing with the Irish banking crisis). However, the risk assumed by Belgium as a whole was patently unsustainable and therefore unacceptable. This is the main reason why, quite appropriately, the Belgian Government sold very rapidly a majority stake in its “unsolicited” Fortis Bank holding to BNP-Paribas, decision which should leave no room for hindsight criticisms by disgruntled shareholders. 

 

This latter criterion poses, however, a fundamental political problem at EU level: if for prudential reasons, one concludes that the size of a systemic financial institution must be limited as a function of the size of their home country economy (which seems reasonable as long as each Member State remains solely responsible for supervision within its own borders), then there appears immediately a serious competition problem. Indeed, “small” countries will be automatically restricted to “small” banks giving an unfair competitive advantage to banks incorporated in the larger European Member States capable of operating trans-nationally. Such an outcome contravenes both the rules and spirit of the single market which is based on a “level playing field”. To illustrate these difficulties, one has only to question how the proposed European Systemic Risk Council could express its views impartially if it has to discriminate between institutions and make recommendations in part on the basis of the size of the economy of the home country.

 

The question of a resolution mechanism for troubled institutions must be at the heart of dealing with the “too big to fail” question. To gain broad acceptance some basic principles should be observed:  first and foremost, the question of moral hazard must be addressed squarely so as to remove as far as possible the feeling of impunity for excessive risk taking that played such a central role in the current crisis. This problem should be addressed simultaneously from different angles:

 

·         A comprehensive regulatory framework covering key operating parameters such as leverage, capital ratios, diversification of risks, etc.  It should be completed by compliance with a set of mandatory governance rules regarding, for example, the responsibilities of corporate officers, executive compensation, disclosure and transparency of financial information.

 

·         A significant strengthening of “enforcement powers” and a harmonisation of sanctions at EU level to avoid “judiciary arbitrage”.

 

·         The obligation to implement structural reforms at corporate level ensuring the insulation of certain activities presenting either higher risks or involving potential conflicts of interest.

 

·         The obligation to submit to regulators and to update an indicative “resolution plan” detailing measures to be implemented to mitigate systemic risk aspects.

 

·         The clear disclosure of the risks assumed by:

 

Shareholders: A request for Government support connected with a rescue operation would entail suspension of their rights until such time as the taxpayer was no longer at risk and had been fully compensated for the intervention. The request could emanate either from the company itself or the regulator responsible.

 

Counterparties: they should require adequate collateral, obtain insurance cover or, failing to do so, be prepared to assume a share in the losses in case of resolution.        

 

Depositors: only banks participating in a recognised government guarantee scheme would provide depositor protection. To be recognised, the banks should adhere to a strict code of conduct concerning the characteristics of products offered to depositors (level of interest rates – risks involved). As a quid pro quo for benefitting from a deposit guarantee, depositors should waive contractually any impediment to the communication of information legally requested by public authorities concerning their accounts. This proposal would also deter fraud and fight effectively unfair competition by “tax havens”.

 

In his recent testimony to the American Senate Finance Committee, Federal Reserve Bank Chairman Bernanke recommended an approach to implementing a “resolution mechanism” that included a “significant degree of pain” for shareholders and counterparts of an institution facing liquidation as being the most effective way of reducing moral hazard and, consequently, the likelihood of having to resort to the implementation of such procedures.

 

Such an approach has the great merit of addressing concerns expressed by those who fear that “excessive regulation” could inhibit institutions in delivering the financial services that the economy relies upon to prosper. The adequate mix of sensible regulation and “shared responsibility” between debtor and creditor should provide the necessary incentive to manage risk in a responsible fashion.

 

 

 

 

Conclusion:

 

The arguments developed here above for dealing with the “too big to fail” question should be sufficient reason on their own for requiring a single EU wide regulatory framework. Unfortunately, a common EU “resolution mechanism” (including burden sharing) remains outside the competence of the new Financial Authorities proposed in the latest Commission proposals on regulatory reform. Reliance on “enhanced cooperation” will be manifestly insufficient to address seriously this problem.

 

On the contrary, this gaping hole in the proposed reforms has all the necessary ingredients to lead to a confrontation between the big five (UK, France, Germany, Italy and Spain) on the one side and many of the 22 other Member States on the other. The biggest danger lies in the 5 large Member States using the excuse of the intergovernmental approach prevailing at G20 level to justify maintaining a similar stance at EU level. In the long run, failing to speak with one voice is bound to weaken significantly the EU’s bargaining power in establishing new global standards of financial regulation and supervision while commensurately reinforcing the hand of the United States and its Anglo-Saxon followers.

 

Coming to an appropriate agreement on this subject at EU level will provide an excellent test of the good faith of politicians and their desire to make substantial progress in future crisis prevention.

 

 

A proper resolution mechanism should not discriminate against banks from smaller states: There is a basic contradiction between an EU single market for banking services and a Member State based “resolution mechanism”. Smaller member States will be at a competitive disadvantage violating both the spirit and the letter of EU competition rules. This adds a strong argument to the case for going further towards EU wide Regulation and Supervision than is envisaged by the de Larosière Report endorsed by the latest Commission legislative proposals.

© Paul Goldschmidt