Understanding the role of banks in cross-border finance has become an urgent priority. The recent Global Financial Crisis and ongoing European crisis have shown the importance of creating the necessary regulatory and macroeconomic conditions for a Single European Banking Market to function properly in good and in tough times. Together with five other economists (Franklin Allen, Elena Carletti, Philip Lane, Dirk Schoenmaker and Wolf Wagner) I have published a CEPR policy report  that analyzes key aspects of cross-border banking and derives policy recommendations from a European perspective. We argue that for Europe to reap the important diversification and efficiency benefits from cross-border banking, while reducing the risks stemming from large cross-border banks, reforms in micro- and macro-prudential regulation and macroeconomic policies are needed.
The benefits and risks of cross-border banking have been extensively analyzed and discussed by researchers and policy makers alike. The main stability benefits stem from diversification gains; in spite of the Spanish housing crisis, Spain’s large banks remain relatively solid, given the profitability of their Latin American subsidiaries. Similarly, foreign banks can help reduce funding risks for domestic firms if domestic banks run into problems. However, the costs might outweigh the diversification benefits if outward or inward bank investment is too concentrated. Based on several new metrics, we find that the structure of the large banking centers in the EU tends to be well balanced. However, problems are identified for the Central and Eastern European countries which are highly dependent on a few West European banks, and the Nordic and Baltic region which are relatively interwoven without much diversification. At the system-level, we find that the EU, in contrast to other regions, is poorly diversified and is overexposed to the United States.
What role did cross-border banking play in the recent crisis? We argue that while cross-border banks were the face of the crisis, they were not the underlying cause. The rise of cross-border banks was part of a broader set of trends in the financial systems of the developed world, which also included consolidation, increasingly volatile yet cheaper wholesale funding, and a lengthening of the intermediation chain; trends that were not accompanied by the necessary regulatory adjustments. While the failure of cross-border banks dominated the headlines, there were at least as many small or even local banks failing. We argue that the crisis has been exacerbated by an inadequate response from regulators – stemming from a misalignment of regulatory incentives and a lack of an appropriate resolution framework on both the national and supra-national levels. The failure of the Belgian-Dutch-Luxembourgian Fortis bank is telling – first the resolution had to be nationalized, i.e. the bank had to split into national fragments, which then had to be nationalized, in the absence of a reasonable resolution framework.
We also examine the rationale for macro-prudential regulation. We argue that the increasing importance of cross-border banks – not only in terms of their sheer size but also because of systemic interdependencies and hence the systemic risks they pose – suggests that banking issues should be taken into account when dealing with macroeconomic problems. This requires a partial reversal from strict inflation targeting – the dominant paradigm for monetary policy prior to the crisis – as it does not take into account financial stability issues, even though financial stability is an important prerequisite for effective monetary policy. We also argue that cross-border banks are particularly prone to various important sources of systemic risk, which require macro-prudential regulation to address them. One such risk is that in times of crisis, the prices of assets may no longer reflect fundamental values. This is particularly problematic when institutions have to adhere to mark-to-market accounting.
Policy recommendations for sustainable cross-border banking
Based on the analysis in the report we derive some key policy recommendations. We argue that these recommendations should focus on solutions at the European – rather than the national level. This is because the only real alternative is to require cross-border banks to organize themselves as a string of national stand-alone subsidiaries, which foregoes the significant benefits of having a Single Market in the EU. The following showcase some of the key recommendations:
1. Applying macro-prudential tools to prevent bubbles
Different forms of macro-prudential regulation may be used to prevent bubbles. An example is limits on loan-to-value ratios that would be lowered as property prices increase at a faster pace. A further example is with Basel III which introduces a countercyclical capital charge that increases when the economy is in an upswing (credit growth to GDP is above trend) and decreases in the downswing. These tools are applied at the country level, as asset price bubbles tend to be country specific, while at the same time they should be monitored at the EU level. Macro-prudential rules can thus have a critical role as a complementary policy tool to monetary policy instruments, that) cannot take account of local boom-and-bust cycles, especially in the Euro area
2. Risk-weights for sovereign debt
It has become clear that government debt, even of OECD countries, is far from risk-free. Banking regulation should recognise this. One way to do this is to assign risk weights and diversification requirements on sovereign debt. This would force investors to more appropriately price sovereign risk.
3. Bankruptcy regime for countries
One solution to the problem of sovereign default, is a bankruptcy mechanism that would limit the need for a bail-out. This would remove a great deal of uncertainty (as we are currently observing with Greece), and reduce moral hazard risk, especially if the process could be expedited; an efficiency improvement both ex-ante and ex-post. One way that such a mechanism could work, is for the country to declare it cannot fully meet its debt obligations. This would be verified by a team from the IMF, ECB and the European Commission, that would then assist in designing the optimal repayment plan. A high priority for this element of the proposed European Stability Mechanism (ESM) is to establish this bankruptcy mechanism in a transparent and predictable fashion.
4. Eliminating tax deductibility of debt
Minimum capital is needed to foster sound banking, but equity is perceived to be more costly than debt. One of the reasons why capital is privately more costly, is that in many countries debt interest is tax deductible at the corporate level but dividends are not. The removal of tax deductibility across all sectors can go some way towards reducing the incentive to use debt rather than equity in financial institutions. Obviously, it would not be enough to reduce a second bias (which can explain the much higher leverage ratios in finance than in other sectors), which is the regulatory safety net benefit.
5. Compatible bank resolution regimes including contingent capital
Reforms of bank resolution regimes at the national level are critical to avoid corner solutions observed in the last crisis, such as costly and moral hazard inducing bail-outs, or lengthy and disruptive liquidations. Therefore, in the aftermath of the crises, many countries are in the process of introducing special resolution regimes to allow for orderly and swift decision making. These national regimes should be compatible in order to facilitate the resolution of cross-border banks. These reforms however, should also align incentives better. Shareholders and unsecured debtholders should share in losses to a larger extent than they currently do. One mechanism that could achieve this would be the issuance of convertible debt that could be converted into equity in the event of a crisis. These so-called CoCos have two main advantages. First, it is not necessary for banks to raise capital in difficult times as it would already be available. Second, contingent capital allows sharing losses with debtholders. This would also have a disciplinary effect and induce bank managers to behave more prudently.
6. European-level deposit insurance and bank resolution framework
The credibility of current deposit insurance arrangements based on the home country principle for cross-border banks is in question, as the case of Iceland has shown. A European deposit insurance fund would address this lack of credibility and would also reinforce the notion that cross-border banks should be resolved at the European level. While different institutional solutions are possible, a European-level framework for deposit insurance and bank resolution is critical in order to enable swift and effective intervention into failing cross-border banks, reduce uncertainty and strengthen market discipline. Depending on the choice of resolution authority (supervisor or central bank), the new European Banking Authority (EBA) or the European Central Bank (ECB) can be given this central power in the college of resolution authorities.
7. Resolution framework on a bank group level with ex ante burden-sharing agreements
Resolution plans for cross-border banks should be developed ex ante rather than ad hoc to allow for an orderly winding down of (parts of) a large systemic financial institution. As large financial institutions have multiple legal entities, interconnected through intercompany loans, it is most cost effective to resolve a failing bank at the group level. This can imply a split-up of the group, sale of parts to other financial institutions and liquidation of other parts. In this context, ex ante burden-sharing arrangements should be agreed upon to overcome coordination failure between governments in the moment of failure and ineffective ad hoc solutions. By agreeing ex ante on a burden-sharing key, authorities are faced only with the decision to intervene or not.
Many of the recommendations are politically ambitious. But they are critical for reaping the benefits of cross-border banking in a sustainable manner. Progress has been made along some but not all dimensions.