A solution to financial instability: Ring-fence Cross-Border Financial Institutions
Josef Ackermann, Chief Executive of Deutsche Bank and chairman of the Institute of International Finance, writes in the FT (2009): “There is a danger that changes in the regulatory environment will, by accident or design, lead to a refragmentation of markets. .. Consequently, we should not seek answers in the perceived safety of nation-based structures, but rather establish effective processes for cross-border crisis management”. According to Dr. Ackermann, the inability to reach binding cross border standards and insolvency system is likely to lead domestic regulators to abandon trust in home/host regulatory arrangements, and encourage financial institutions to contract to their home turf. Shall we listen to Dr. Ackermann’s self interested recommendations? No.
In fact, the international community has achieved little in its quest to improve cross-border insolvency since the start of the global financial crisis. The existing arrangements, in which cross-border operations are covered solely by the financial stability arrangements of the home country, are unsustainable. When a large company with global operations seeks Chapter 11 protection, it can spawn numerous legal proceedings with different rules in different countries. However, there is no official code that brings them together. In such cases, the threat of bankruptcy is not credible: the private and social costs are simply too prohibitive. In April 2008, the Financial Stability Forum (FSF) issued a Report on principles for cross-border cooperation on crisis management. A careful read of the report leads to the conclusion that the entire set of recommendations is based on voluntary cooperation. The assumption that countries will ignore self-interest in cross border financial crises is ludicrous. The report does not recognize that self-interest will guide the countries, and therefore will not be willing to adopt the principles in a real crisis and does not offer any binding implementation roadmap. Until the cross border insolvency issue is addressed, it will be impossible to reach a binding global financial order.
Witness as well the legislative paralysis in the US and the debate regarding the future of financial regulation in the UK between the Conservative Party and the Labour party. Speaking on the eve of the G20 summit in London, German Chancellor Angela Merkel said bluntly what everyone knows - “International policy is, for all the friendship and commonality, always also about representing the interests of one’s own country.” (Merkel, New York Times, March 30th, 2009). Ultimately, the financial centers will do what is beneficial to maintain their hegemony as financial centers and “regulation light” will be the norm again. Therefore, we should not wait for answers in effective processes for cross-border crisis management and an internationally consistent intervention and resolution scheme for complex global financial institutions from self interested financial centers and self interested To Large to Fail Financial Institutions (TLFFI). The rest of the G-20 countries could take steps to regulate the global financial system, without waiting for the financial centers to join the process.
What is the solution for the rest of the world in this impasse? I propose that large, internationally active financial institutions- that are too big to fail or too interconnected to fail- should be reduced to holding companies of national operations that are organized as stand-alone units in the respective countries. Such a structure would reduce the risks to financial stability by creating domestic financial institutions subject to local jurisdictions in the respective markets. Once other countries demonstrate commitment to achieve some stability, the UK and the U.S. can be brought on board to discuss and accept the detailed arrangement of a new financial order.
A further advantage is that domestic pools of liquidity and capital will prevent short term destabilizing capital flows. According to Bank for International Settlements (BIS 2009 ) (http://www.bis.org/statistics/rppb0907.htm) data cross-border lending had slumped to $29.4 trillion at the end of March, down from $35.8 trillion at the end of March 2008 (distorted by the strength of the U.S. dollar). However, a lending contraction of over $6 trillion (16.75%) in the year to the end of March 2009 is the worst contraction for at least 30 years. Dani Rodrik has long questioned the benefits of capital account liberalization “Global finance, to work well and safely, requires institutions similarly global in scope. The chance that these global institutions can be created is, well, nil—at least in our time” (http://rodrik.typepad.com/dani_rodriks_weblog/2007/06/martin_wolf_mak.html). Rodrik (1998) (Rodrik, Dani. 1998. “Who Needs Capital Account Convertibility?” Princeton Essays in International Finance 207, 55-65) empirical analysis finds no correlation between the openness of countries’ capital accounts and the amount they invest or the rate at which they grow. Since the publication of Rodrik’s article, evidence has mounted in support of the view that capital account liberalization has no impact on investment, growth, or any other real variable with significant welfare implications. For example, in his survey of the research on capital account liberalization, Eichengreen (2001) (Eichengreen, Barry. 2001. “Capital Account Liberalization: What Do Cross-Country Studies Tell Us?” The World Bank Economic Review, 16(3), 341-365) concludes that the literature finds, at best, ambiguous evidence that liberalization has any impact on growth. Kose, Prasad, Rogoff and Wei (2006 ( http://ssrn.com/abstract=934448) conclude in a more nuanced paper that critical reading of the recent empirical literature lends some qualified support to the view that developing countries can benefit from financial globalization, but with many nuances. For instance, Tong and Wei (2009) (http://www.imf.org/external/pubs/cat/longres.cfm?sk=23141.0) study whether capital flows affect the degree of credit crunch faced by a country's manufacturing firms during the 2007-09 crises. They find that the volume of capital flows has no significant effect on the severity of the credit crunch. However, the composition of capital flows matters: pre-crisis exposure to non-FDI capital inflows worsens the credit crunch, while exposure to FDI alleviates the liquidity constraint.
In conclusion, while direct investment and portfolio equity can be beneficial, and therefore countries should normally discourage short term international bank lending. This lending is prone to boom-and-bust cycles and generates financial crashes with painful economic consequences equivalent to “playing Russian roulette with bullets in all the chambers”. In this context, domestic regulators could further mandate domestic subsidiaries of foreign banks to maintain prudential norms related to local currency lending as a percentage of local currency funding, as well as a foreign currency foreign assets as a percentage of foreign currency funding, and thereby preventing sloshing short tem capital inflows. Banks and domestic regulators would be able to manage their risk, capital and liquidity on a country basis, without relying on ineffective division of labor between home and host regulators.