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Dealing with Financial Crises by C.A.E.
Goodhart Financial Markets Group, London School
of Economics (A) Will greater financial
integration lead to more, or less,
stability? More diversity, less concentration
makes financial intermediaries more robust,
(example Canadian vs US banks in Great
Depression). Can, however, be partially
achieved by product innovation without location
expansion, e.g. securitisation, Credit Default
Swaps, etc. Only used by a relatively few banks
in Europe as yet.
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More linkages brings strength in response to
small/medium shocks, but can widen scale/scope of
big shocks, (Allen and Gale). Centralisation of
operations (in institutions/markets) can bring
efficiency economies, but need to protect against
monopoly, especially when run by public sector
bodies, and against break-down (terrorism,
natural disaster). Greater robustness of
financial integrated system may be subject to
test from greater procyclicality of Basel II,
plus IAS 39, and mark to market.
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(B) Can we forestall a banking crisis? A
commonly expressed hope is that a move to Prompt
Corrective Action (PCA) via Structured Early
Intervention and Resolution (SEIR) could nip
crises in the bud before they led to insolvency
and losses. But the core strength of that
approach lies, in my view, not so much in the
particular merits of the measure of capital, (the
leverage ratio), as in the legal support for a
ladder of sanctions, culminating in the ability
to force a banks re-organisation by
recapitalisation, merger or closure once it
becomes seriously undercapitalised, but before it
becomes insolvent.
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FSAs do not, in general, have such legal rights
to force actions/closure on bank shareholders in
Europe. By its nature the Basel Committee on
Banking Supervision (BCBS) has been unwilling to
consider international harmonisation of sanctions
and banking laws, including bankruptcy laws. Is
a call for PCA/SEIR in Europe likely to be of
only limited benefit, unless accompanying legal
support structure can be put in place? Also note
the much slower speed of deposit insurance pay
out in Europe than in the USA (3 months plus vs
next working day!). Anyhow many crises can be
triggered by a shock causing a jump in asset
values (e.g. Oct 1987, 9/11, October 1998). In
many cases crisis not preceded by gently
declining CARs.
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(C) How to handle a cross-border crisis? So we
have to accept that there could be (low
probability) cross-border crises involving
significant loss, beyond that which can be met by
shareholders and subordinated debt holders. In
a cross-border integrated banking system both the
location and the responsibility for the loss may
be difficult to determine. Moreover, the desire
to recapitalise and/or merge the bank may differ
between home and host countries. Particular
position of US banks with separate entity
bankruptcy laws. Particular position of
euro-zone banks with a common federal euro
currency, but national fiscal competences.
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Ex post negotiations on national fiscal
recapitalisation, undertaken by politicians with
domestic constituencies, likely to be rancorous
and long-drawn-out. Recipe for
disaster. European insurance. Perhaps, but (1)
early years, (2) need for ultimate public
guarantee (Eisenbeis on US State Insurance
failures). Ex ante burden sharing, (example
Nuclear disaster) needs Treaty to avoid
re-negotiation. While nice idea in principle,
Treaty involves cost in time, etc. Any ex ante
burden sharing scheme probably will entail
winners/losers, (e.g. UK). So nothing will be
done until after the first major cross-border
crisis in Europe.