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Towards an International Framework for Cross Border Resolution, Remarks by John Lipsky, First Deputy Managing Director, International Monetary Fund, at the ECB and its Watchers Conference XII
July 9, 2010
As prepared for delivery
It is both an honor and a great pleasure for me to participate today in the twelfth “ECB and its Watchers Conference.” I would like to congratulate the ECB and the Centre for Financial Studies for launching and sustaining this unique event. The frank and open dialogue it creates between senior ECB officials, academic experts and financial sector representatives makes this event especially valuable. It is very gratifying that this annual conference—that was first created by Otmar Issing and Axel Weber—is being carried on in such an excellent fashion by President Trichet and his colleagues, working with Volker Wieland. While today I am representing the International Monetary Fund, I had the opportunity to participate in some earlier Conferences from the financial sector side.
The challenge of agreeing on a set of improved financial regulations naturally and reasonably has absorbed much attention and international effort in the past 18 months, and the recent Toronto Leaders' Summit also called for new progress on improving supervision. However, as this audience understands well, even under an optimal system of supervision and regulation, some financial institutions will fail. In this context, there is another issue that deserves renewed attention, and that I would like to address today, regarding how we can better prepare to deal with the insolvency of a systemically important financial institution that operates in multiple national jurisdictions.
The recent crisis has shown that the lack of an agreed protocol to deal with such an occurrence potentially could threaten global financial stability. The officials that are working together through the Financial Stability Board and standard-setting bodies, including the Basel Committee on Banking Supervision, to finalize a package of proposed regulatory reforms in time for the November G20 Leaders Summit in Seoul recognize the potential value of an international resolution mechanism. However, there is no prospect of an agreement on this issue anytime soon, and certainly not by the Summit. The reason for this isn’t a lack of will or interest, but because creating an agreed resolution mechanism for cross-border institutions has no clear precedent and will involve difficult choices. Inevitably, this process will take time.
The issue of maintaining financial and economic stability is central to the mandate of the IMF. Thus, my specialist colleagues in our Monetary and Capital Markets and Legal Departments have been working on alternative approaches to the issue of cross-border resolution, responding among other things to a request from the G-20. Last week, our Executive Board discussed a framework staff has developed that could help to deal with cross-border failures. It is quite novel and would represent an important step forward.
I would like to take this opportunity to share with you its principal features. We hope that the ideas it contains represent a positive contribution to the ongoing discussion, and we look forward to collaborating with our partners in the FSB to take forward the effort to develop a resolution mechanism for cross-border financial institutions.
Cross-Border Resolution: The Nature of the Problem
I will begin by laying out the problem. Large international financial groups play an important role in helping to channel capital and financial services across national borders. There is no doubt that these institutions supported the strong global growth that preceded the recent crisis. As we have seen, however, problems in these institutions also can undermine global financial stability. If one of these institutions is in risk of insolvency, the entire system will feel the consequences.
Thus, systemic stability could be enhanced through an agreement on a method for dealing effectively and in an orderly fashion with the insolvency of a large international bank or financial group. Such a mechanism would facilitate rapid and preemptive action while at the same time preserving financial stability. A key issue in designing the mechanism is to create a framework that allows for the prompt resolution of a failing firm, and that allocates the cost of resolution fairly and predictably to shareholders and creditors. There has been a clear agreement—most recently affirmed at the Toronto Summit—that public funds should not be used for such purposes, but rather that the costs of resolution should be borne by the financial system itself.
The recent financial crisis has demonstrated that the existing framework for addressing these cases is inadequate. Even when faced with a purely domestic insolvency, many countries lacked effective legal frameworks through which to resolve failing institutions in a manner that preserves financial stability and minimizes the cost to the public.
These problems increase dramatically when the authorities are faced with the insolvency of a large international financial institution or group. As has been noted widely, major financial firms today live globally but die locally. Notwithstanding their global reach, the failure of large international financial institutions remains subject to multiple national legal frameworks, with no effective template for international cooperation. It was the highly leveraged purchase of ABN Amro by a set of international purchasers that caused the problems at the RBS and Fortis groups and ultimately led to their nationalizations. While in the United Kingdom this resulted in a relatively simple if potentially costly exercise, in the case of Fortis it was complicated by national interests coming to the fore even between jurisdictions whose financial regulators have a long tradition of co-operation and whose legal frameworks are considerably harmonized. As a result, the Fortis group was resolved along national lines in a protracted process.
Thus, the basic mismatch between global institutions and national frameworks already has led to serious problems. When a large international institution has fallen into difficulty, the authorities have had to choose between two unattractive options: either providing public funding—perhaps very large funding—to support the institutions, including through an arranged acquisition; or relying on an insolvency regime that is ill-equipped to efficiently restructure financial institutions in an efficient and orderly manner. Too often, as we have seen recently, national authorities have felt compelled to use public funds to ensure the survival of an institution, often in a manner that implied increased moral hazard. Indeed, recent experience demonstrates that the more interconnected and integrated international financial institutions and groups have become, the more disruptive and value-destroying uncoordinated local resolution actions are likely to be.
Lehman Brothers represents the most prominent recent case in point. When Lehman filed for bankruptcy protection in the United States, it had over 200 principal subsidiaries and participated in over 100 payment and settlement systems across the globe. Despite main proceedings in the United States and the United Kingdom, insolvency officials in numerous other jurisdictions are engaged in winding down various international components of Lehman Brothers with little or no coordination. The separate insolvency proceedings and the complex intra-group structure of Lehman have impeded the return of segregated client money deposited by Lehman’s UK-based broker dealer with a German affiliate which itself entered an insolvency moratorium.
Clearly, there must be a better way. One potential solution would be a multilateral treaty that would obligate countries to participate in a coordinated international resolution process, possibly under the jurisdiction of an international tribunal. While there are examples of such treaties in some areas of international relations, this approach simply does not appear to be a feasible option at this time, as few countries appear ready to agree to the implied surrender of national sovereignty. Only among formally-integrated groups of countries – such as the European Union – might national governments be prepared to consider such an approach.
A more radical alternative would be the de-globalization of financial institutions. If the legal and regulatory frameworks for dealing with financial institutions are national in scope, some might argue, financial institutions themselves also should be national in scope. In fact, many respected observers have called in the wake of the recent crisis for reducing the size, scope and complexity of existing systemically-important institutions. However, it is even more widely held that such an approach would create significant efficiency costs while reducing access to global capital just when the benefits of capital mobility have been clearly recognized, most notably in dynamic emerging economies. It seems to me that in fact there exists broad consensus support for efforts to improve the global system, rather than to repress it.
A Proposed Framework
In the view of my Fund staff colleagues and myself, the most realistic approach regarding cross-border resolution is one that focuses on enhancing co-ordination among national authorities. We would envisage establishing an international framework under which countries would agree to cooperate with each other if certain conditions are met. The establishment of such a framework may involve changes to legislation at the national level that would enable such cooperation to take place, and by design it .would apply among countries that meet certain core standards. Our suggested approach would create an incentive for countries to cooperate and a mechanism for doing so, but it would not create a binding treaty obligation. Nevertheless, given the potential gains to all sides from a resolution process that limits the risks from and maximizes the potential value of a failing financial institution, we see a substantial increase in international cooperation in this area as highly feasible.
Any framework for cross-border resolution needs to recognize a fundamental reality: when faced with the potential failure of a large international financial institution, national authorities will be willing to cooperate fully only if they trust each other. That trust generally will be built on three pillars: i) that the relevant authorities all maintain high standards of regulation and supervision; ii) that they have the tools within their national regimes to deal effectively with insolvent institutions at an early stage; and, iii) that they have developed effective working relations with each other that demonstrate that they are capable of cooperating effectively.
The framework we have in mind would be built upon these principles, and it would consist of four principal elements:
• First, countries would amend their domestic legislation to permit their own authorities to cooperate in an international resolution whenever they view such cooperation as being consistent with the interests of creditors and financial stability.
• Second, participating countries would adhere to “core coordination standards” that ensure that their national supervisory and insolvency frameworks are sufficiently robust.
• Third, they would agree on the criteria and parameters that would guide the burden sharing process among the members of the coordination framework.
• Finally, they would agree on procedures for coordinating resolution measures across borders, including the cross-border recognition of measures taken in other countries.
I would like to provide you with a bit more detail on each of these four elements.
First, the commitment to cooperate. A basic problem with many national regimes is that the authorities often are effectively precluded from cooperating in an international resolution exercise. For example, in liquidating the local branch of a foreign bank, some countries require their authorities to ring-fence the local assets of the branch for the benefit of local creditors and, in this manner, effectively prevent participation in a broader international process. Under our approach, national legislation would be amended to remove these obstacles. Moreover, it would call for national authorities to cooperate with other countries in the framework, but only when they believed such cooperation to be consistent with the interests of creditors and supportive of financial stability. A jurisdiction will be willing to defer to another only if it is clear that local creditors will be treated equitably and will receive at least what they would have received had the entity been liquidated on a strictly national basis.
Second, core coordination standards. Meeting core coordination standards would represent a precondition for cooperation. Adherence to such standards would ensure that countries’ bank supervisory and insolvency regimes are sufficiently robust and are harmonized in key areas. In particular, countries bank insolvency regimes would need to treat domestic and foreign creditors in a nondiscriminatory manner. Moreover, resolution regimes would include minimum standards that ensure that the authorities have the necessary resolution tools to deal effectively with an insolvent financial institution at an early stage of its difficulties.
In particular, the rules would enable the participating authorities to:
• unilaterally restructure the various claims of an institution;
• conclude mergers and acquisitions without shareholder consent;
• transfer assets and liabilities to other institutions, including a bridge bank, without third party consent;
• provide bridging financing; and
• assume public ownership on a temporary basis.
Third, burden sharing. Let me be clear: the final cost of resolution should be borne by private stakeholders and not by public funds. In a systemic crisis, however, up-front and temporary funding by public authorities may be necessary. Prefunded resolution schemes represent one potentially attractive option for dealing with cases of cross-border failure. The IMF report on this topic, prepared at the request of the G20 Leaders for their recent Toronto Summit suggested a “Financial Stability Contribution” to be levied against a risk-adjusted base and linked to funding a credible and effective resolution mechanism. In its recent Communication, the European Commission advocated the creation of resolution funds that are segregated from general revenue and that would be funded ex ante by bank levies. Such resolution funds can enhance confidence that any direct resolution costs would be borne by private stakeholders.
If we are clear on where the burden ultimately should fall between the private and public sectors, we also need to be clear on burden sharing across countries. We envisage that countries could agree on principles to guide burden sharing that would be applied on an institution-by-institution basis. These principles could reflect features such as the relative systemic importance of the group across jurisdictions, the relative contribution from deposit guarantee schemes or resolution funds and the relative distribution of losses across jurisdictions.
Crucially, our approach would encourage specificity while recognizing that agreement on burden sharing is complex, inevitably will depend on individual circumstances and in many cases will be difficult to achieve. However, burden sharing agreements ideally would be reached for individual financial groups before or at the very least soon after they experience difficulties. This is a role for Recovery and Resolution Plans or “living wills”, an aspect that is being addressed by supervisors working under the direction of CEBS, to encourage common understanding between authorities. If successful, these could help authorities in the principal jurisdictions of each financial group develop and agree criteria and parameters, such as the relative contribution of resolution and deposit insurance funds, that would help guide negotiations in any specific case.
Finally, procedures would be agreed and enshrined in national legislation to facilitate coordination in individual cases. To some degree, these rules could draw on the great progress that has been made in recent years in the field of cross-border corporate insolvency. The adoption of such a framework would represent an important step forward in promoting international cooperation but it would differ from a formal treaty framework in at least one important respect. While it is true that the implementation of this framework may require changes to national legislation in some countries, it would not give rise to a binding legal obligation between countries to cooperate. As such, it would not imply the surrender of national sovereignty that would be implicit in a formal treaty.
The Case of the European Union
We believe that this framework could be applied among a wide range of countries, including those whose economies are not closely integrated. We envisage an incremental approach under which a few countries – perhaps representing the principal financial centers – would first cooperate on this basis with other countries joining the framework over time.
We recognize, however, that more closely integrated countries may wish to go further. This is the especially the case for the European Union. My IMF colleagues and I welcome the continuing work in the EU to ensure the adoption of harmonized resolution tools among its Member State authorities. As the Commission wrote in its May 26 Communication on Bank Resolution Funds, it seeks to ensure that the authorities have common tools that can be used in a coordinated manner to allow prompt and legally robust action in the event of major banking failures, with the aim of ensuring that orderly failure is a credible option for any bank, irrespective of size or complexity. The Commission aims to adopt a detailed road map to achieve this in October. We have maintained a close dialogue with the Commission on these issues, including through a detailed contribution by IMF staff to the Commission’s public consultation on crisis management. And we look forward to continuing this productive dialogue. One common objective should be that the EU’s tools and coordination standards are similar to and compatible with a global approach, such as the one I am describing today.
Moreover, as the IMF's Managing Director outlined in a March 19 speech in Brussels, we think that the EU needs an integrated framework, including the creation of a European Resolution Authority (ERA). This ERA would be armed with the mandate and tools to deal cost-effectively with cross-border bank failures. In our view, the EU’s objective of establishing a single financial market, its institutional possibilities, its close economic and financial integration, and the steps it has taken already toward more integrated cross-border crisis management and resolution make such an integrated resolution framework feasible and desirable. It offers the best perspectives for efficient crisis management and resolution and for safeguarding the interests of all member states in crisis situations.
Developing such a European Resolution Authority is a formidable challenge and the EU is not yet fully committed to such a course of action. The Commission accepts that an integrated framework is desirable, but sees this as a second step after the harmonization of national frameworks and intends to revisit the matter in 2014. The European Parliament, by contrast, is seeking agreement on an integrated crisis management and resolution framework for large cross-border banks as part of the package of supervisory reforms that is still being negotiated. Inevitably, Member States hold a range of views. At the Fund, we understand the Commission’s desire for a step-by-step approach, given the complexity of the matter. However, we think that the European Parliament is right to insist on a fundamental solution for the challenge of integrating supervisory arrangements and integrating crisis management and resolution. If I may suggest a compromise: why not accept the European Parliament’s position on principle, but agree on a step-by-step implementation that allows adequate time to work out all the difficult details? This would also have the important advantage of allowing time to ensure consistency with the evolving global arrangements.
Conclusion
Improving national resolution templates remains an important task for each and every jurisdiction, but national templates will not by themselves be sufficient to address the basic challenge of bolstering international financial stability. Despite the extreme stress that the international financial system has suffered, our best response is not to dismantle this system, but to focus on achieving greater resilience, greater clarity of approach, and greater commonality of goals.
The proposed framework I have discussed here attempts to identify an achievable and reasonable way forward to address the continuing cross border resolution problem. There are challenges – and I do not seek to minimize how great some of the obstacles may be. It will not be easy to agree on all the principles I have discussed, and nor will it be straightforward to assess whether these same principles have been satisfied. As rational as we believe our approach to be, we understand that in the crucible of an unfolding crisis, it will need calm determination to follow through on the principles, agreements and procedures of the enhanced coordination approach. With the elements that we propose, however, the prospect of more effective and value-preserving international resolution will be one step closer.
As I stated at the outset; my Fund colleagues and I look forward to working in the context of the FSB and the standard-setting bodies to make real progress on this critical challenge.
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