Management of financial crises in cross-border banks.

• Author: Borchgrevink, Henrik
• Position: Industry Overview

Financial integration in Europe is increasing. The emergence of large, cross-border banks poses new challenges to the authorities. The management of financial crises in such banks will involve a number of authorities in many countries. Conflicts of interest between the authorities in different countries may hinder effective crisis solutions. Crisis management agreements between supervisory authorities and central banks aim to clarify the division of responsibilities and facilitate the exchange of relevant information. The Nordic central bank governors signed an agreement in 2003. This article provides an overview of developments and discusses the challenges facing the authorities.

1 Introduction

Banks are subject to specific supervision and regulation by the authorities because financial crises in the banking sector can have substantial repercussions on the real economy. Nonetheless, crises may occur. The responsibility for resolving a financial crisis in a bank lies primarily with the bank itself. Owners and management are responsible for ensuring that the bank does not end tip in a critical financial situation and they also have the main responsibility for managing any crises that might arise. Experience of earlier banking crises shows, however, that the authorities must also have contingency arrangements in place for coping with crises.

The emergence of large, cross-border banks poses new challenges to the authorities. If a large cross-border bank should experience a serious financial crisis, central banks, supervisory authorities, deposit guarantee funds and political authorities in several countries will be involved. The current division of roles and responsibilities between the authorities has not, however, been adjusted to accommodate the extensive activity of cross-border banks in host countries, whether through a subsidiary or a branch. (2) Conflicts of interest may therefore arise between the authorities in different countries.

We begin this article by providing a short summary of developments in the banking sector in Europe. Section 3 focuses on the challenges facing the authorities with regard to managing financial crises in cross-border banks, including conflicts of interest. In Section 4, we discuss the work that has been done internationally to clarify the division of roles and responsibilities in relation to supervision and crisis management in cross-border banks. Finally, Section 5 describes some of the proposed solutions to the conflicts of interest that can arise in a crisis situation. A key question is the extent and content of the home country's responsibility for crisis management. For a cross-border bank organised in a branch structure, the responsibility lies with the relevant home country. For banks organised in a subsidiary structure, the formal responsibility lies with the host-country authorities. A number of factors suggest, however, that the responsibility for crisis management for banks in a subsidiary structure should also lie with the parent bank's home country authorities. Irrespective of the way responsibilities are assigned, the authorities should focus on avoiding crises, strengthening market discipline and ensuring that banks themselves take responsibility for resolving financial crises.

2. Developments towards cross-border banks in Europe (3)

   Legislation for financial markets and financial institutions in the EU has been designed to promote a common market. The introduction of a common currency has expanded the basis for a common financial market in Europe. Integration has progressed furthest in the foreign exchange, capital and money markets, cf. ECB (2004), and has been more modest in banking, particularly in the retail segment, see EU (2004). There has been considerable consolidation in the banking sector, primarily by establishing large, national entities.

   There is, however, a growing trend towards cross-border banking groups in Europe. A number of studies have shown that there are substantial efficiency gains in connection with the establishment of foreign banks; see Clarke, Cull, Peria and Sanchez (2001). In the EU, there is strong political pressure to lay the basis for more cross-border enterprises in general, including the financial sector. New rules for establishing European Companies (Societas Europaea) will facilitate cross-border mergers and the cross-border relocation of company headquarters in the EEA area. Large, cross-border banks have already been established in the Nordic, Baltic and Benelux countries.

   In the regulation of cross-border banks, it is important to distinguish between subsidiary banks and branches. This distinction has important consequences with regard to the prevention and management of problems in cross-border banks. Subsidiary banks are separate, independent legal entities and are subject to supervision in the country where they operate--in the same way as other national banks. The parent bank is similarly subject to supervision in its home country, and the home country is also responsible for consolidated supervision of the group. (4) Branches are not independent legal entities. Branch and parent company are one and the same legal entity. The responsibility of host-country supervisory authorities for the supervision of foreign branches is therefore limited. The responsibility for resolving a financial crisis in the bank will lie with the authorities in the parent bank's home country.

   Even though the regulatory framework for banks in the EU provides for cross-border establishment using branches, the subsidiary structure continues to dominate. Dermine (2003) gives a number of reasons for this:

   * The parent bank limits its exposure to the subsidiary bank.

   * The subsidiary bank maintains a local connection.

   * The bank maintains its membership in the national deposit guarantee scheme.

   * There may be tax reasons for maintaining a subsidiary bank structure.

   At the same time, centralisation in these cross-border banks is increasing. Thus, although subsidiary banks are formally maintained as independent companies, management of these banks is often centralised across global business segments, with global risk management and control (see the Basel Committee (1999)).

3. Which authorities are responsible for cross-border banks?

   The division of responsibilities between the authorities in different countries for subsidiary banks and branches of foreign banks has not really been adjusted to accommodate large cross-border banks. (5) Table 1 provides an overview of the "traditional" perception of the division of responsibilities between the relevant authorities for a cross-border bank. (6)

   The traditional view is that the host-country authorities are responsible for subsidiary banks, while responsibility for branches is divided between host-country and home-country authorities. It has been pointed out, however, that it would be natural for the home country's authorities to take broader responsibility for a global group with subsidiary banks or branches in a number of countries, including responsibility for those areas traditionally regarded as the host country's responsibility. Specifically, it could be argued that extraordinary liquidity support for a wholly foreign-owned subsidiary bank or branch should not be the responsibility of the host country's central bank. On the other hand, the host country's central bank will be responsible for financial stability in that country and it will therefore clearly have a keen interest in the crisis management of a large cross-border bank, especially if the bank is systemically important.

   At present, no authorities are required to take into account the effects on other countries of a crisis in a large cross-border bank. The host country does not control crisis management in branches of foreign banks, while the home country normally focuses on problems in the domestic market without taking into account the adverse effects in the host countries of a bankruptcy. However, if the bank is organised in a subsidiary structure, the host countries will be in control of crisis management in subsidiary banks in the host country and might seek to isolate the subsidiary banks from the rest of the group, so-called "ring-fencing". This may hinder a joint solution that might have been better overall.

   Table 2 presents a simple, schematic overview of home countries' and host countries' views on support in the event of a financial crisis in a cross-border bank--depending on the size of the bank.

   If the bank in question is a large bank both in the home and host countries (1), the authorities in both countries will be interested in minimising the adverse affects of a crisis. This may make it easier to find a joint crisis management solution. (7) If on the other hand, the bank is small in the one country and large in the other (2 and 3), it may be more difficult to come to an agreement as to who should provide liquidity support or capital in a crisis. If the parent bank is very large relative to the home-country banking market and economy, the home-country authorities will be particularly interested in finding a coordinated solution--because they will not alone be able to raise the necessary funds to keep the bank in operation.

   3.1 Subsidiary banks

   As shown in Table 1, it is usually assumed that the host-country authorities have "home-country responsibility" for all banks established in the country, including subsidiary banks of foreign banks. A banking group with subsidiary banks in several countries therefore has to relate to many different authorities. This may result in overlapping areas of authority and give rise to potential conflict in a crisis management situation involving a cross-border bank. Crisis management in a bank with subsidiaries in other countries becomes even more complicated when these banks do not function as independent...