Barrage of regulations undermines clarity on cross-border bank resolution

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For all the rhetoric about the importance of international cooperation in banking oversight, a lack of trust, regulatory fragmentation and a complex pipeline of divergent policy measures, particularly at the national level, are preventing the creation of a workable cross-border bank resolution system, observers warn.

Cross-border bank resolution requires an unprecedented level of international regulatory harmonization. But such cooperation, the law and politics are still determined by the nation state. In the US, for example, Dodd-Frank requires FBOs – foreign banking organizations – to create separately capitalized holding companies, subject to US regulatory oversight, to house all US bank and non-bank subsidiaries. The measure is designed to protect the US, but shows little trust in foreign regulators.

EU internal market and services commissioner Michel Barnier responded with a letter to Federal Reserve chairman Ben Bernanke that made it clear the move risked triggering tit-for-tat measures. Clearly this runs contrary to the spirit of international coordination that is supposed to characterize cross-border bank resolution regulation; indeed, it reeks of global regulatory fragmentation.

The US is not alone in this. Switzerland has explicitly indicated it will pull up the drawbridge if one of its big banks gets in trouble. The Swiss Financial Market Supervisory Authority (Finma) said bail-in legislation should prevent assets held abroad from being separated. It is only being explicit about an aspiration that applies to many other countries.

Although the International Organization of Security Commissions, the Financial Stability Board and other bodies have taken steps to coordinate the rules, it will be hard to break this mindset in the absence of a world government.

“It is complicated because there is no functioning model people can look to,” says Nicolas Veron, senior fellow at think-tank Bruegel. “It means fragmentation is the default option. People see the value of international coordination, but it is hard to actually do it.”

This lack of trust is fuelled by the different approaches countries have taken to strengthen their banking systems, and resolve the conundrum of too-big-to-fail banks. The UK has its retail ring-fencing model, the US has the Volcker Rule restricting the ability of banks to trade certain speculative instruments and a host of different responses are found across continental Europe. Each approach is suited to the country championing it, but looks less applicable elsewhere. Retail ring-fencing, for example, is unlikely to find favour in Germany, where the universal banking model is deeply ingrained.

Although the merits of each approach can be debated, the fact that countries have taken different approaches to structure their banking systems leads to questions about equivalence, says Jonathan Herbst, partner at Norton Rose Fulbright. While each country will defend regulatory efforts to restructure domestic banking systems to reduce sovereign liability, politicians are often non-committal about the approaches being taken elsewhere for obvious diplomatic reasons. However, eventually they will have to come off the fence if progress is to be made in cross-border bank resolution, given that the exercise, at its heart, explicitly delineates systemic risks and liabilities, he adds.

But even – or especially – in Europe, there is no consensus on cross-border resolution. At the end of last year, policymakers had ostensibly been gunning for some sort of banking union. The market agrees this should help break the negative sovereign-bank feedback loop. “Successful banking union needs a single deposit protection scheme and a single resolution authority if we are to avoid the issues that arose with Cyprus,” says Giles Williams, financial services partner at KPMG. “Events in Cyprus demonstrate how important this will be.”

However, after a meeting between French and German leaders, there appears to be a dilution of banking union plans in favour of more national discretion. That might not be without merit. Foreign regulators are likely to be less familiar with the intricacies of a national banking system and domestic economies, and might apply a foreign cultural mindset to its problems, says Williams. This could be a recipe for a host of unintended consequences, he says.

Still, the European Central Bank disagrees with Germany. Benoît Coeuré, member of the executive board of the ECB, cited a single resolution mechanism (SRM) and single resolution authority as fundamental prerequisites to such a union. Financed by an industry-funded single resolution fund, “it would enable prompt and coordinated resolution action, specifically where cross-border banks are concerned,” he said in a recent speech.

Meanwhile, Andrea Enria, chairman of the European Banking Authority, described the creation of a comprehensive and credible framework for the SRM as “the greatest challenge” the regulator faced. An SRM that only covered countries joining the Single Supervisory Mechanism, as is likely, would likely exacerbate segmentation according to the divergent underlying safety nets cross-border banks rely on, he warned.

Nevertheless, investors in large banks can take comfort in the push to boost the amount of loss-absorbing capital banks set aside before liquidation. In other words, the best form of bank resolution mechanism is one that prevents failure in the first place. While banks have been busy deleveraging, there has also been significant issuance of tier 1 equity and convertible bonds such as CoCos, to strengthen balance sheets.

But even here, there is still some debate around CoCos. One question is whether issuance should come at the parent level, allowing capital to be deployed anywhere it is needed within an organization, or from individual subsidiaries, reinforcing the organization’s internal ring-fencing.

Part of the problem is that CoCos remain untested in a crisis situation. There is no clear answer regarding which option works best – or even whether the securities will be effective at all. It may be that the triggering of the equity conversion itself fuels panic and undermines confidence in the bank, says Veron. Whether this will outweigh the capital benefits of the conversion to equity will only be known when they are tested in a crisis, he says.

What is true of CoCos is true of global regulatory efforts generally. The world is unrecognizable from the days before 2008, and rules on banking have already been dramatically overhauled and tightened. Yet if another Lehman event were to occur now, while things would certainly unfold differently, the end result wouldn't necessarily be any different.

But if Lehman illustrated the scale of the problem of too-big-to-fail banks, it is sobering to consider that the concentration at the top of global finance has only increased in the past five years.

In sum, the US and the UK have boosted cooperation on the resolution of systemically important banks and financial institutions have taken meaningful strides to hike their capital and liquidity buffers, a move regulators hope will reduce bank failures. However, mistrust between regulators and the enormous complexity of new rules, which are still in their infancy, blight the bid for a harmonized framework to resolve cross-border banks in an ex-ante fashion. If anything, the events in recent years have taught market players that ex-post solutions are more realistic. 

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