2nd April 2014

Regulatory cooperation is needed to make further progress on too big to fail

Written by Adam Cull, the BBA’s Senior Director (Financial Policy and Operations)

The International Monetary Fund (IMF) attracted a lot of attention yesterday morning following its estimate that UK banks benefit from a “too important to fail’ advantage of £15-£70 billion.

The report argues that some progress is being made to end “too big to fail” but more international coordination is required to fully resolve the issue and to address tensions between home and host countries.

The IMF’s report is based on three models that evaluate the extent of support banks receive based on the assumption they won’t be allowed to fail.

Simply analysing the differences between the spreads on bonds issued by large banks and other institutions was found to have shortcomings. However, two other models – a contingent claims analysis using CDS spreads and a ratings based approach – provide a broadly consistent picture. They reveal that “subsidies have declined from their crisis peaks but remain substantial, especially in Europe (meaning the Eurozone).”

There has been some good progress on this issue, driven by:

  • Requiring banks to hold more capital and liquidity (Basel III/CRDIV)
  • Increasing loss absorbency and ensuring shareholders and creditors meet the costs of failure through resolution and bail-in (BRRD)
  • Structural reforms such as Vickers, Volcker & Liikanen.

The paper considers what more could be done and suggests two thematic approaches: further measures to reduce the probability of failure and greater international coordination.

The first of these is the subject of on-going work coordinated by the G20’s Financial Stability Board (FSB). The FSB leadership met in London yesterday where they announced plans to present ideas for how to enhance loss absorbing capacity when a bank has gone into resolution (gone concern) and develop a better framework for cross-border recognition of resolution actions at the G20 summit in Brisbane. The UK is ahead of its international peers in both of these areas.

Achieving greater international coordination is a trickier proposition. The IMF says that it is “essential to prevent regulatory arbitrage and make cross-border resolution effective”, but expressed general disappointment at current efforts. For instance, in areas such as structural reform the IMF found that “countries have adopted policies without much coordination” and goes as far as to suggest that “local initiatives may end up being mutually destructive”.

Many within the industry share the IMF’s concerns. Interestingly, however, Federal Reserve Governor Daniel Tarullo used a recent speech at Harvard to argue that “firms cross borders in ways their regulators do not” and that policymakers “cannot ignore this fact” and pretend that they have global oversight.

Tarullo insisted that he supported more genuine cooperation among supervisory authorities and the FSB’s work programme on resolution. However, collaboration was framed against a need for “more tangible safeguards in host countries” – such as the new US prudential requirements for the larger Foreign Banking Organisations.

His comments reflect an underlying tension blocking progress on this issue. Regulators differ in their roles as “home” and “host” countries and on the division of responsibility for oversight of cross-border groups – the “global in life but local in death” problem.

Supervisors need to start trusting each other if they are to take a holistic view of the groups they supervise and work together to achieve more effective and efficient outcomes.

As the IMF paper notes, reducing the scale and scope of banks results in both economic costs and complex policy challenges. Both should act to incentivise cooperation over local solutions. Likewise, for resolution to be credible, authorities must coordinate and cooperate when a bank fails. This credibility will remove the assumption that governments will be forced to rescue failing banks, reducing further any perceived support that makes banks “too big to fail”.

The challenge is to build this trust and through it credibility that governments can allow banks to fail.

One part of the solution lies in “colleges of supervisors”, forums commonly used to coordinate the supervision of international groups. The Basel Committee is already consulting on how to enhance the effectiveness of colleges and embed them in the on-going supervision of groups, all necessary prerequisites for building trust. The BBA has long supported the concept of colleges and will be providing the Basel Committee with detailed comments later this month.