The future of cross-border banking

Dirk Schoenmaker 25 October 2011

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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 US is required to keep matching assets in US, while having a US dollar shortage at home. The same tends to happen within Europe. When a Dutch bank is collecting deposits via the Internet in Spain, the local supervisor starts asking for matching assets in Spain. Local holdings of liquidity and capital are suboptimal (Allen et al 2011). The Internal Market in Banking is being reversed.

What does theory say?

The financial trilemma indicates that the three objectives of financial stability, cross-border banking, and national financial supervision are not compatible (Schoenmaker 2011). 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.

What are the facts?

De Haan et al (forthcoming) examine the developments of large banks in the aftermath of the first financial crisis. They select the 60 largest banks on the basis of Tier 1 capital, as reported in the Top 1,000 world banks rankings by The Banker. The dataset is divided into three samples of top European banks, top American banks, and top Asian banks.

Table 1 reports the geographical segmentation of these banks for the years 2006 to 2009. European banks are the most international, with close to 50% of business abroad. This may be due to the integrated European banking market. But even when looking at their business outside the region, European banks are the most international – 25% of their business is in the rest of the world. American banks are catching up; their business in the rest of the world rose from 14% in 2006 to 21% in 2009. So, the European and American banks have maintained their international outlook throughout the 2007-09 financial crisis.

The picture is very different for the Asian-Pacific banks. They used to have a very domestic orientation, which was reinforced over the last several years. Business in the rest of the world declined from 13% in 2006 to 8% in 2009. Although the Asian-Pacific banks are least affected by the US-originated financial crisis, they seem to be retrenching from the international scene. The composition of the top Asian-Pacific banks is shifting from the major Japanese banks to the major Chinese banks, which have an even stronger domestic orientation than Japanese ones.

Table 1. Development of international banking by continent, 2006-09

 

2006

2007

2008

2009

Continent

h

R

w

h

r

w

h

R

w

h

r

w

Europe

52

23

25

52

22

25

51

21

28

52

22

26

Americas

78

8

14

75

10

15

73

9

18

72

7

21

Asia-Pacific

82

5

13

83

6

11

82

7

11

85

7

8

Notes: Share of business in home country (h), rest of region (r) and rest of world (w) of the top banks by continent. The shares add up to 100%.

Source: De Haan et al (forthcoming).

While European and American banks have maintained their international business after the first financial crisis, more recent anecdotal evidence of the ongoing second financial crisis indicates that supervisors are forcing banks to maintain local holdings of liquidity and capital. What are the costs of maintaining separate capital and liquidity buffers at national standalone subsidiaries? In a first study on this topic, Cerutti et al (2010) simulate the potential capital needs of 25 major European cross-border banking groups resulting from a credit shock affecting their affiliates in central, eastern, and southern Europe. The simulations show that under ring-fencing (standalone subsidiaries) sample banks’ aggregate capital needs are 1.5 to three times higher than in the case of no ring-fencing.

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:

  • Supervision: The European Banking Authority must get the cross-border banks under its supervisory wings. Supervision would then move from a national mandate (with loose coordination) to a European mandate.

  • Lender of last resort: The European Central Bank is operating as the de facto lender of last resort for the European banking system.

  • Deposit insurance: Deposit insurance for cross-border banks should be based on a European footing.

  • Resolution: A European resolution authority should be established to resolve troubled cross-border banks. Ex ante burden-sharing rules are needed to raise the required funds for resolving cross-border banks (Goodhart and Schoenmaker 2009).

As suggested by Allen et al (2011), 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.

References

Allen, F, T Beck, E Carletti, P Lane, D Schoenmaker and W Wagner (2011), Cross-Border Banking in Europe: Implications for Financial Stability and Macroeconomic Policies, CEPR eReport. London: Centre for Economic Policy Research.

Cerutti, E, A Ilyina, Y Makarova, and C Schmieder (2010), “Bankers Without Borders? Implications of Ring-fencing for European Cross-Border Banks,”IMF Working Paper 10/247.

De Haan, J, S Oosterloo, and D Schoenmaker (forthcoming), Financial Markets and Institutions: A European Text, 2nd Edition, Cambridge: Cambridge University Press.

Goodhart, C and D Schoenmaker (2009), “Fiscal Burden Sharing in Cross-Border Banking Crises”, International Journal of Central Banking 5, 141-165.

Grosse, R and LG Goldberg (1991), “Foreign bank activity in the United States: An analysis by country of origin”, Journal of Banking & Finance 15, 1092–1112.

Obstfeld, M (2011), “International Liquidity: The Fiscal Dimension”, NBER Working Paper No. 17379.

Schoenmaker, D (2011), “The Financial Trilemma”, Economics Letters 111, 57-59.

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Topics:  International finance

Tags:  decoupling, cross-border banking