Macroprudential Regulatory Policies: The New Road To Financial Stability?

The New Road to Financial Stability?

Stijn Claessens, Douglas D Evanoff, George G Kaufman, Laura E Kodres

• Publisher: WSPC
• Year: 2011
• Print ISBN: 9789814360661
• eBook ISBN: 9789814405157
• Topic: Biological Sciences
• Subtopic: Science General
• Index: Biological Sciences

This book is a collection of papers presented in the conference held at the Federal Reserve Bank of Chicago in September 2010, that examines the role of macroprudential regulation in the financial industry. Shocked by the experience of the last few years, many argue that the more traditional microprudential regulatory tools are inadequate to create a safe and stable financial system. The microprudential paradigm relies on the presumption that the financial system as a whole can be made safe by ensuring individual financial institutions are made safe. This ignores interconnections and externalities, whereby the actions of one financial institution or events in financial markets can lead to spillover effects that adversely affect general market conditions, other financial institutions, and ultimately the economy as a whole. Instead, it is argued, there is a need for both microprudential approaches to regulate individual institutions and macroprudential approaches to manage the overall financial system risks.

Conference participants discussed macroprudential regulation and related issues, including: What are the theoretical motivations for macroprudential regulation? How would it interact with other regulatory and macroeconomic policies, especially monetary policy? What would be the specific macroprudential tools? Who should have control over the macroprudential tools? How should a macroprudential regulator be structured? Where should it be housed? How can macroprudential policies be structured across national borders? What role, if any, can market discipline play in supporting macroprudential objectives?

Concentrating on public policy issues, the conference featured keynote addresses by influential past and present public policy figures including: Paul Volcker, Chairman of the US President's Economic Recovery Advisory Board and former Chairman of the Federal Reserve System; Tommaso Padoa-Schioppa, Chairman, Promontory Financial Group Europe and Former Chairman of the Basel Committee on Banking Supervision; Jaime Caruana, General Manager of the Bank for International Settlements and Former Chairman of the Basel Committee on Banking Supervision; and Charles Taylor, Director of the Pew Charitable Trust Financial Reform Project and Former Executive Director of the Group of Thirty.

Contents:

• Special Addresses:
  • Protecting the Stability of Global Financial Markets (Paul A Volcker)
  • Global Macroprudential Regulation (Tommaso Padoa-Schioppa)
  • The Challenge of Taking Macroprudential Decisions: Who Will Press Which Button(s)? (Jaime Caruana)
  • Macroprudential Regulation and Evolution: Looking at the Financial System Through Darwin's Glasses (Charles Taylor)
• Why Macroprudential Policies are Needed:
  • Lessons from American Bank Supervision from the Nineteenth Century to the Great Depression (Eugene N White)
• Coordination with Other Policies:
  • Cross-Border Coordination of Macroprudential Policies (Attila Csajbók and Júlia Király)
  • Macroprudential Policy: Central Banking Reconsidered (Jean-Pierre Landau)
  • Macroprudential Policy and Monetary Policy: Some Lessons from the Euro Area (Domenico Giannone, Michele Lenza, Huw Pill, and Lucrezia Reichlin)
  • Commentary on Macroprudential and Other Policies (E Philip Davis)
• Components of Macroprudential Regulation:
  • Measuring Systemic Risk (Viral V Acharya)
  • Systemic Risk in Bankruptcy Exceptions, Natural Candidates for Liquidity Charges (Enrico Perotti)
  • Working Macroprudential Tools (Jesús Saurina)
• Structuring Macroprudential Regulation:
  • On the Governance of Macroprudential Policies (Erlend W Nier)
  • Some Implications of Systemic Risk and the Design of Regulatory Architecture (Marco Espinosa-Vega, Juan Solé, Charles Kahn and Rafael Matta)
• Cross-Border Issues:
  • The Last Frontier: Protecting Critical Functions Across Borders (Eva H G Hüpkes)
  • Cross-Border Crisis Management: Can Harmonization Create Harmony If the Orchestra Is Dissonant? (Grégory Nguyen and Peter Praet)
  • Regulation and Competition in EU Banking: Before, During, and After the Crisis (André Sapir)
• Market Discipline:
  • Cycle-Proof Market Discipline and Macroprudential Regulation (Luc Laeven)
  • Curbing Risk on Wall Street (Oliver Hart and Luigi Zingales)
  • What Role, If Any, Can Market Discipline Play in Supporting Macroprudential Policy? (María J Nieto)
• Policy Panel: Where to from Here?:
  • Macroprudential Regulatory Policies: The New Road to Financial Stability (William R White)
  • Beyond Regulatory Challenge: The New Public Policy Paradigm (Tarisa Wataganase)
  • Challenges for Macroprudential Supervision (Randall Kroszner)
  • Macroprudential Regulation, Financial Stability, and Capital Flows (José De Gregorio)

Readership: Undergraduate and graduate students as well as researchers in international finance, central banks and financial regulators.

VI. CROSS-BORDER ISSUES

15

THE LAST FRONTIER:
PROTECTING CRITICAL
FUNCTIONS ACROSS BORDERS

Eva H. G. Hüpkes*
Financial Stability Board

Introduction

One of the lessons of the financial crisis is the need for an effective mechanism to wind down large and complex globally active financial institutions in a rapid and orderly manner. During the crisis, authorities in many jurisdictions were confronted with a binary choice: One option was to let the firm enter the applicable bankruptcy or resolution procedures and risk a Lehman-style disorderly failure resulting in market chaos with runs on similarly situated institutions; the other option was to use massive amounts of taxpayers’ money in an attempt to avoid the institution defaulting on its obligations and causing havoc among counterparties and in the financial system more generally.

The latter “rescue” option is not only costly in fiscal terms, it also creates moral hazard. It distorts competition by providing an unpriced state guarantee to institutions that are perceived to be “too big to fail,” and it sows the seeds of future crises by dulling the incentive to monitor and manage risks. For these reasons it is important to search for a third option that would allow the resolution of an institution in an orderly manner and without systemic disruptions while imposing losses on shareholders and creditors.

Save functions, not institutions

A paper presented at the Federal Reserve Bank of Chicago’s Bank Structure Conference in September 2004 proposed a functional approach to the resolution of financial institutions.¹ The objective of the functional approach is to integrate regulation and resolution regimes into one coherent whole. Regulatory action, ex ante or ex post, needs to ensure that systemically important functions can be insulated from a problem imperilling the viability of the institution and continue to be performed in case their provider fails. If this is achieved, authorities can effectively reduce the expectation that large international firms will be bailed out in their entirety and limit moral hazard. There are different approaches to ensuring continuity of critical functions and insulating them from failure. The choice of the measure will depend on the nature of the function. Certain key infrastructure functions may be insulated ex ante from other risk taking activities.² If a financial institution operates certain proximate infrastructure-type functions (e.g., custodial or clearing and settlement services) or material economic functions, it may be possible to resolve the institution in a manner that would ensure the continued operation of the essential functions while the institution’s other (non-essential) activities are being wound up.

The objectives of an effective resolution regime — minimizing contagion, containing the social costs associated with financial panic and ensuring the continuity of critical functions for the financial system³ — are widely accepted.⁴ Corporate bankruptcy procedures are primarily aimed at protecting individual stakeholders’ interests and not well suited for dealing with financial failures.⁵ They are essentially a micro-measure that seeks to maximize individual creditors’ interests, but may result in fire sales with detrimental effects on other market participants. They were not designed to take account of externalities and the costs that the failure of a financial institution could impose on the broader economy. Typical corporate bankruptcy procedures result in stays that block creditors’ access to funds. A financial institution, if subject to a stay, is not able to conduct financial transactions, to make and receive payments, and to engage in hedging strategies. The lengthy process of initiating a bankruptcy process, negotiating a reorganization or liquidation plan, and obtaining court approval is lethal for a financial institution that lives or dies on the trust of financial markets.

Just as regulation needs to have a macro-prudential dimension, wind-down processes need to take into account systemic considerations. Bankruptcy actions that seek to maximize the residual value of the individual firm for all of the firm’s stakeholders, may have unintended and possibly adverse systemic consequences for the wider market place.

The Basel Committee’s Cross-border Bank Resolution Group (CBRG) set out the requirements and key features of special resolution regimes in its ten recommendations of March 2010 that were endorsed by the G-20 leaders at the Toronto Summit.⁶ They include processes to intervene early and place a financial institution under temporary public control or administration, with powers to take any other actions necessary to restructure or wind down the financial institution’s operations, including the powers to operate the financial institution, repudiate or continue contracts, and sell assets.⁷ The Financial Stability Board (FSB) is undertaking further work to identify those key attributes of resolution regimes that are critical for resolving LCFIs.⁸

There are three types of powers that are particularly important for ensuring continuity of systemically important functions:

• First, resolution authorities should be able to establish a temporary bridge company to take over certain essential business operations of the failing institution in order to continue operating these functions. What is left behind will be placed into liquidation or receivership.⁹ To ensure the continued seamless operation of the bridge company, authorities should have in place adequate funding arrangements.¹⁰ This resolution measure is essential when a private sector solution (e.g., sale or merger) cannot be arranged immediately to ensure continuity of the essential business activities.

• Second, in order to transfer operations into a bridge company while placing the residual firm in receivership or liquidation, resolution authorities need to have the power to transfer assets and liabilities, including deposit liabilities, customer property and the ownership of shares, notwithstanding any otherwise applicable requirements of consent by counterparties or shareholders.¹¹

• Third, resolution authorities should have the power to “cherry pick” and transfer only those essential financial contracts, assets and liabilities (those that preserve franchise value and are essential for the continuity of certain critical functions in the financial system) and not the ones that can be wound down without cost to society as a whole. This requires powers to alter counterparties’ rights, including powers to suspend temporarily the exercise of counterparties’ contractual early termination rights, subject to appropriate safeguards and legal protections.¹²

Achievements to date

Parliaments in a number of important jurisdictions have demonstrated the willingness and ability to implement significant changes in national laws and regulatory structures. It is unlikely that they would have been prepared to make such sweeping changes in the absence of the financial crisis. The most noteworthy reforms are:

• In the US, the Dodd-Frank Act now enables the FDIC to apply the resolution tools that it has used effectively to resolve individual retail deposit banks,¹³ to a far wider range of financial institutions.¹⁴ This includes, among other things, powers to enforce or repudiate financial contracts and transfer assets and liabilities of the failing company to either a third-party acquirer or to one or more specially chartered bridge financial companies.¹⁵ The Dodd-Frank Act reaffirms the principle that all similarly situated claimants be treated in a similar manner. The FDIC can exceptionally differentiate between creditors within the same class, and even treat junior creditors better than senior creditors, if it determines that it is necessary to “maximize the value or minimize losses upon the sale or other disposition of assets or deemed essential to implementation of the receivership or any bridge financial company,”¹⁶ subject to the condition that no claimant receives less than “the amount that the claimant would have received if the FDIC had not been appointed receiver and the institution had been liquidated under Chapter 7 of the Bankruptcy Code.”¹⁷

• In the UK, the Banking Act of 2009 provides the UK authorities with powers to transfer all or part of a bank to a private sector purchaser or to a bridge bank, which would be set up as a subsidiary of the Bank of England.¹⁸ The UK Special Resolution Regime contains a number of explicit safeguards designed to protect creditors in case of partial transfers. A compensation mechanism ensures that creditors left in a residual company will be no worse off than they would have been in the liquidation of the bank.

• Switzerland already introduced a special resolution regime for banks and securities firms in 2004. A recent amendment to the Banking Act would further strengthen individual elements of the framework, by introducing a bridge bank authority and strengthening the legal basis for the conversion of debt into equity (debt-equity swap). The special resolution regime, which so far has applied to banks and securities dealers, will also apply, with certain amendments, to insurance undertakings.

• In Germany, the recent Restructuring Act of December 9, 2010 provides Germany’s Federal Financial Supervisory Authority with a range of new resolution powers, including the powers to segregate the systemically relevant parts of a bank’s business and to transfer them to a bridge bank.¹⁹ Financial contracts may not be terminated on the occasion of a transfer order.²⁰

• In Canada, Parliament amended the financial institution restructuring provisions of the Canada Deposit Insurance Corporation Act (CDIC Act) in March 2008. These amendments allow the CDIC, acting as a receiver, to assign assets and liabilities of a financial institution, including financial contracts, to a bridge institution.²¹

• The European Parliament in its resolution of July 2010 asked the European Commission to prepare legislative proposals relating to an EU crisis-management framework. The Parliament recommended that the framework have a common minimum set of rules that provide, among other things, for powers to “trigger separation of stand-alone modules” from an institution, to transfer assets and liabilities to other institutions and to create a bridge bank to ensure that core functions can continue to operate.²²

A number of other jurisdictions are also considering or are in the process of implementing similar reforms of their bank resolution.²³

The challenge

As important as the new powers are, they remain national in scope. There has been no experience with how they would be used if a large and complex financial institution active in multiple jurisdictions and with assets spread across many countries needed to be wound down. There are three major potential hurdles to the use of these new national resolution powers to wind down such an institution:

• The first is the complexity of globally active LCFIs;

• The second is that the new powers are national in scope, but the institutions are global in reach; and

• The third is that invoking the powers could trigger adverse market reactions and cause contagion rather than containment.

How to Achieve an Efficient and Equitable Cross-Border Solution

When it comes to preserving critical functions in a cross-border context, the key question is under what authority and law these functions could be preserved. Generally, more than one authority or court will assert jurisdiction over all or part of a firm’s operations. The applicable law and competent authority will be determined by a range of factors, including the locus of incorporation, the location of assets, liabilities and collateral, the domicile of the counterparties, the design and governing law of the financial contracts to which the financial institution is party.²⁴ These criteria also determine how creditors will be treated in a resolution and what recoveries they can expect.²⁵ And they affect the incentives of market participants, who may choose to relocate or to structure their operations differently in response to those incentives.

Conflicts in law and conflicts among national authorities in asserting jurisdiction are likely to arise as regards the control of the institution’s assets and affairs in different jurisdictions, the choice of the resolution methods and the distribution of that value, including priorities in distributions where available value does not permit full recovery by all parties.

Legal theory in the area of transnational bankruptcy law distinguishes three broad conceptual approaches to resolve these conflicts: territorialism, universalism, and contractualism. None exist in a pure form, and there is considerable debate about which will or should guide the development of resolution regimes for globally active financial firms.²⁶ Delineating the key features of these three approaches helps to determine the ones that are needed in a framework for the cross-border resolution of LCFIs.

• In territorialism, there are multiple proceedings in a variety of jurisdictions. Territorialism permits each jurisdiction to take control of operations and administer assets within its borders according to its own local laws.²⁷ It stresses state sovereignty and respects the differences between national legal regimes and policies. Territorialism is the approach that commands the resolution of many non-financial firms and is the prevailing approach under which bank insolvencies are resolved.²⁸ As a result, many countries require sufficient assets to be held where they can be ring fenced in the event of a bankruptcy.²⁹

• In universalism, a single forum is responsible for adjudicating all the legal issues arising from the insolvency of an internationally active firm, irrespective of the location of the counterparties or the assets. It is based in the idea that all or nearly all transactions and stakeholders should be treated identically with respect to their legal rights and duties as they relate to an insolvent entity.³⁰ A single authority can take a global view and bind all stakeholders of the entity and exercise control over all assets, both within and outside of its jurisdiction. It determines when to “pull the trigger” and decides on resolution measures (whether to restructure or to liquidate). Host jurisdictions will be constrained in taking action and heavily reliant on timely and effective action by the lead authority.

• In contractualism, or “bargained bankruptcy,” the parties concerned (the firm and its counterparties) decide ex ante which forum(s) will adjudicate and what law will be applied in the event of insolvency. Contractualism respects the rights of the stakeholders (or at least those with the strongest bargaining power) to determine their fate and reduces the risk of arbitrary and unpredictable outcomes and conflicts of laws.

Each approach has attractions:

• Territoriality respects sovereignty and permits each jurisdiction to promote the public interest within its own domain.

• Universality respects the unity of a business entity and would make it possible to preserve operations that span national borders.

• Contractualism promotes market-efficient outcomes by reducing uncertainties about what regime will be applied.

But none of these approaches are well-suited to resolving a large and complex globally active financial institution and to preserving its critical functions:

• It is very difficult for national authorities to ensure continuity of functions performed by multiple entities located in multiple jurisdictions under any one of thes...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Preface
• Acknowledgements
• Contents
• I: Special Addresses
• II: Why Macroprudential Policies Are Needed
• III: Coordination with Other Policies
• IV: Components of Macroprudential Regulation
• V: Structuring Macroprudential Regulation
• VI: Cross-Border Issues
• VII: Market Discipline
• VIII: Policy Panel: Where to from Here?
• Agenda
• Index