Multinational banks are a crucial piece of the puzzle in the flurry of proposals for European financial reform. The size and cross-border operations of these institutions are seen by some as amplifying the effects of wrong management choices and practices and making the current crisis more systemic. That has cast doubts on the viability of this business model in the post-crisis world.
Debate persists as to whether the problem is multinational banking per se or the mismatch between the extent of multinational banks’ cross-border financial activities and the national scope of the supervisory rules. Our view is that such banks have still a very important role to play in the integration of the European financial market and that the supervision mismatch is the key problem. Understanding why also provides useful insights to strengthen recent reform proposals like those of the de Larosière Group or of the Turner Review.
Specifically, we believe that a comprehensive reform of financial market supervision also requires a new regulation for European banking groups that defines the responsibilities and powers of the parent company, its subsidiaries, and branches.
The value of multinational banks
Why are multinational banks important? One reason is the extent of their role in European banking. The median share of assets of foreign subsidiaries in European countries was 14.4% in 2007 (ECB, “Financial Integration in Europe”, April 2008). It is much larger in Eastern European countries. But this is a bit of a circular argument. While cross-border activities grew very quickly in the last decade, they could retrench behind national borders at equal speed if this business model were no longer viable. National rescue packages have added pressure in this direction, responding to the concerns of national electorates rather than to those of good global citizens.
A second argument is what large banks keep telling financial investors – synergies, economies of scales, risk diversification, etc. We now know that this is true for some activities (e.g. investment banking), but we also know that the costs of integration might be larger than these benefits, particularly in the short term.
A third and most fundamental reason is that carrying out multinational banking, with branches and subsidiaries in foreign countries, is nearly the only way to achieve financial integration of non-tradable retail activities in the single European financial market. Essentially, banks open or buy foreign operations to acquire shares in markets they cannot serve through exports. According to the ECB, retail banking is the area where financial market integration has not yet been fully achieved in Europe.
The interesting twist of this last argument is that, with multinational banks, financial integration does not typically take place through external market transactions, as for example in the market for securities, but, rather, through their internal capital market, which channels funds across their global operations. This can be a good thing, for example, when it overcomes information asymmetries that hinder efficient capital allocation in external markets.
The need for regulation
However, the crisis has shown that some banks have been poor managers of their risks and capital allocation. How then could we rely on internal capital markets for an efficient and stable global allocation of capital in banking? We need good rules and adequate supervision.
The current regulatory and supervisory framework in Europe is wholly inadequate. Based on the principle of a minimum set of uniform banking regulations, mutual recognition, and the single banking license scheme, it in fact involves multiple regulatory jurisdictions and regulators. National laws often differ significantly and even conflict across countries. They mostly protect the interest of each company and its shareholders, neglecting the perspective of the group as a whole. This hinders the functioning of the internal capital market, limiting asset and liquidity transferability, exchanges of information within the group, and the ability of the parent company to carry out a centralised risk management.
The fragmentation of supervisory power also prevents an adequate supervision of cross-border activities. Colleges of supervisors are too weak and have too limited powers to effectively oversee such activities. Banking crisis are assessed mainly at the national level, and remedial actions are almost exclusively defined at the country level. The cross-border externalities and the negative spillovers resulting from individual supervisory decisions are not given due consideration.
For these reasons, the de Larosiére Group’s proposal to move towards a European System of Banking Supervision would be a fundamental step towards an adequate regulatory framework for cross-border banks. But, in our view, the proposals in the report leave unspecified two related but crucial issues that urgently need to be addressed.
Allocating responsibility and neutrality
The first one is the distribution of responsibilities and binding powers between the supervisors of a multinational bank even within the European System of Banking Supervision. The second one is the lack of neutrality of present rules with respect to the organisation of cross-border activities into branches and subsidiaries.
The de Larosiéres Group’s report envisages a legally binding mediation role for the new European authorities to solve disputes between national supervisors. However, the few cross-border interventions carried out during the crisis have shown that any coordinated scheme of cross-border supervision is bound to fail unless responsibilities are clearly allocated among supervisors. In turn, this can happen only if regulation is neutral with respect to the organisation of multinational banks’ foreign activities into branches and subsidiaries. At present, branches and subsidiaries work within different regulatory frameworks. Branches follow the single banking licence schemes and are under the supervision of their home authorities. Subsidiaries are independent companies, supervised by domestic authorities.
The too-big-to-save problem is a useful illustration of how the combination of a muddled allocation of responsibilities among supervisors and non-neutral regulations can be a source of serious concerns when a crisis erupts.
Take the case of Iceland. The operations of Icelandic banks in the UK were carried out by branches. For this reason British depositors in principle were guaranteed by the Icelandic deposit guarantee fund. Had they been carried out through subsidiaries, depositors would have been protected by a British scheme. This geographic mismatch in regulation paradoxically means that, at present, foreign banks in any European country may be subject to different sets of rules and their clients face different levels of protection. And, like the British clients of Icelandic banks, they are often unaware victims of the too-big-to-save syndrome.
Yet, defining an adequate and consistent division of tasks and responsibilities between home and host supervisors and clear burden-sharing rules will be pretty difficult, unless governments establish a new regulatory framework for European banking groups. This is an essential step that has thus far been absent from the main regulatory proposals. A substantive regulation would harmonise risk-management rules, define responsibilities and powers of the parent company, subsidiaries, and branches, taking into account due protection to minorities and creditors. It would be better suited to our purposes than a directive, as it would set uniform rules, directly applicable in all Member States, without the risk of distortions and fragmentation due to differences in adoption (such as “gold plating”).
Full harmonisation could be achieved by common implementing measures provided by a level two regulation, following the Lamfalussy structure.
The new regulatory framework would apply to cross-border banks with at least one branch or a subsidiary in a Member State other than that of the parent company’s incorporation. The group would be given full recognition upon the following conditions:
- the group structure is firmly established;
- a coherent overall policy for the whole group is in place;
- benefits and burdens are appropriately distributed within the group so that a balance is maintained.
Provided that these conditions are met and no insolvency procedure is pending, the regulation would allow asset and liquidity transfers from and to the parent company and between subsidiaries, on an arms-length basis, under the coordination of the parent company. For these purposes, the parent company should have power over its subsidiaries for the group’s responsibilities towards the competent supervisory authorities.
The clear allocation of powers and responsibilities to the parent company could facilitate the allocation of supervisory competences to the European System of Banking Supervision.
Several commentators in search of light at the end of the tunnel have reverted to Chinese, in which the word “crisis” is composed of two characters, one meaning “danger” and the other “opportunity”. Combining a full reform of multinational banking supervision with a substantive regulation of banking groups would certainly provide a new opportunity for the orderly and stable completion of the European single financial market.
Note: This column is the outcome of discussions that the authors had within the Forum on Financial Cross-border Groups organised by Unicredit Group. The views expressed herein are only the authors’ and do not necessarily reflect those of Unicredit or other participants in the Forum. The full report produced by the forum, ‘Cross Border banking in Europe: What Regulation and Supervision?’ can be retrieved from www.unicreditgroup.eu