Shifting regulatory responsibility away from international bodies and putting it into national hands is threatening the globalised nature of banking. The banking community should instead be concentrating on broadening and strengthening the remit of international supervisors.

We are quietly heading for the deglobalisation of banking, as national banking supervisors take steps to carve big banks into separate national subsidiaries, with their own liquidity and capital requirements. But there are alternative solutions to keep international banking alive.

The global financial crisis has shown that the international financial system is vulnerable to breakdown. The financial trilemma – which states that financial stability, financial integration and national financial policies are incompatible – demonstrates that financial stability, international banking and national financial supervision cannot be combined. National supervisors force international banks to keep local liquidity pools and capital buffers, which cannot be transferred.

The latest spat on the protectionism front is the proposal of the Federal Reserve to require foreign banks to ring-fence their US operations into separately capitalised and regulated subsidiaries. Similarly, the UK’s Financial Services Authority, shortly before it was dismantled, consulted on a subsidiary requirement for US and Australian banks. These latter banks are subject to national depositor preference, leaving foreign depositors in the cold.

A costly solution

The costs of the national approach can be big, as national subsidiaries need to maintain separate liquidity pools and capital buffers. Take the example of a pan-European bank: national supervisors force the bank to keep extra liquidity buffers up to €20bn in the different countries in which it operates. With an opportunity cost of 1%, the annual cost amounts to €200m.

Another example involves a group of 25 European banks. Applying a shock in the form of a gross domestic product drop of 2% and an interest rate rise of 2%, these banks need an additional €45bn in capital with ring-fencing. Without such ring-fencing, the banks need only €20bn in extra capital. The national approach is thus a very costly solution to the trilemma.

There is an alternative solution to keep international banking alive. The central element is an international coordinated approach to supervision and resolution of international banks. Reform of global governance, guided by the G-20 and executed by the Financial Stability Board, has so far focused on soft law solutions. Regulators adopt a consensual approach towards the setting of international standards. For day-to-day supervision, home and host supervisors of global banks work together in supervisory colleges. For crisis management, home and host authorities co-operate in crisis management groups. This approach is underpinned by legally non-binding memoranda of understanding, buttressed by peer reviews of each others' supervisory system.

My central thesis is that such voluntary co-operation is bound to break down, in particular in crisis times when co-operation is most needed. The explanation is that financial stakes are high and national governments, which are accountable to their national parliament, only take care of the domestic effects of an international bank failure. But how would a system of binding global governance look?

Backwards thinking

The endgame of resolution sets the incentives for ex ante supervision. In that light, I apply a backward-solving approach. The design of global governance thus starts with mobilising the funds for resolution, the so-called fiscal backstop. At the European level, the European Stability Mechanism (ESM) is fulfilling the role of the European crisis fund for countries and is now on the verge of expanding that role to banks. A European governance system may thus consist of the European Central Bank (ECB) for supervision, a new European Resolution Authority for resolution, and the ESM as fiscal backstop.

Moving to the global level, the International Monetary Fund (IMF) is the international financial institution with resources for crisis management. The IMF would broaden its global support from sovereign countries to global banks and thus become the international resolution authority for global banks. The IMF already has the governance arrangements in place for involvement of, and accountability to, the ministers of finance who provide the resources to the IMF.

As the functions of supervision and resolution should be separated, we need another institution for supervision. I propose the Bank for International Settlements (BIS) as the international supervisor of global banks. The BIS has acquired a strong reputation in international policy-making, as host to multiple international committees, notably the Basel Committee on Banking Supervision. But a major overhaul would be needed. Similar to the ECB, the BIS would need to build up a supervisory capacity and expand its staff resources.

Summing up, international financial institutions such as the BIS and the IMF should take on a supervisory role of global systemic banks, broadening their mission for monetary stability to one that includes monetary and financial stability. At the European level, the ECB is currently assuming the financial stability mandate for the European banking system.

Dirk Schoenmaker is dean of the Duisenberg School of Finance and professor of finance, banking and insurance at the VU University Amsterdam, and the author of Governance of International Banking: The Financial Trilemma.

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