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

Domestic financial stability framework Completeness & efficiency of the system 2

Low effectiveness of existing crisis management tools 3 Global financial crisis 2007 – 2010 / response options Standard legislation Ineffective: - need for quick decisions - inadequate for specific circumstances Private sector solutionsBailout/nationalizationStandard bankruptcy proceedings 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 Scope Very limited Broadly used Significant changes required Fiscal burden of financial turmoil must to be drastically limited

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

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

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

Significance of special resolution regimes Advantages 1.Reduction of systemic risk of default 2.Transfer of control to regulators 2.Reduction of fiscal cost 3.Costs transferred to existing shareholders 5.Reduction of moral hazard 6.Better market discipline 7 Fiscal and stability costs* *based on Čihák & Nier (2009) Fiscal costs Stability costs Systemic financial stability impact Special resolution Disorderly bankruptcy „Bailout” Ordinary resolutions (Direct costs) (Indirect costs)

Cross-border interconnectedness Additional risks and challenges 8

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

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

Cross-border connections Risk monitoring limitations 11 Systemic risk Limitations 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 In addition to a local component, the risk imposed on domestic banks depends on external foreign risk, which is only partially visible Source - IMF

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

European Union Financial stability system enhancement 13

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

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

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

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