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International trade and multinational business operations have traditionally been facilitated by international banks. The client-pull hypothesis (Grosse and Goldberg 1991) argues that a bank’s international clientele provide an incentive for internationalisation by that bank, since the financial system of the foreign country might lack the sophistication desired by the bank’s clientele.
Following the financial crises, the international business model of banks is under pressure. Governments’ rescue operations were performed on a national basis in the first financial crisis of 2007-09. US TARP funds were, for example, only available for US-headquartered banks. European banks with significant operations in the US were not eligible. By the same token, European banks were supported by their respective home governments. In the case of truly cross-border banks, such as Fortis, the banks were split and resolved on national lines.
The supervisory response to this national fiscal backstop has been to reinforce supervisors’ national mandates, while paying lip service to international cooperation with non-binding Memoranda of Understanding (MoUs). In the second financial crisis starting in 2010, banks are required by their supervisors to match their assets and liabilities on national lines. So a French bank with liabilities in the USis required to keep matching assets in US, while having a US dollar shortage at home. The same tends to happen within Europe.
The financial trilemma indicates that the three objectives of financial stability, cross-border banking, and national financial supervision are not compatible. One has to give. The trilemma makes clear that policymakers have to make a choice on cross-border banking. While we were slowly evolving towards European financial supervision with the establishment of the new European Supervisory Authorities and the European Systemic Risk Board, the financial crisis has thrown us back towards national supervision.
The way forward
If policymakers seek to enhance global banking, then the international community must provide a higher and better-coordinated level of fiscal support than it has in the past (Obstfeld 2011). Capital or loans to troubled financial institutions (as well as sovereign countries) imply a credit risk that ultimately must be lodged somewhere. Expanded international lending facilities, including an expanded IMF, cannot remain unconditionally solvent absent an expanded level of fiscal backup.
The same point obviously applies to the European framework. If policymakers want to preserve the Internal Market in Banking, then the institutional framework must be improved along the following lines:
The latter two functions can be combined within some kind of European equivalent of the FDIC. The EU would then get a European deposit insurance fund with resolution powers. The fund would be fed through regular risk-based deposit insurance premiums with a fiscal backstop of national governments based on a precommitted burden sharing key.