Uncertainties that exist regarding the level of capital and liquidity available at the local level when a crisis happens that involves a cross-border banking group (Figure 1) tend to lead the supervisors of the foreign branches and subsidiaries of an international bank (“host supervisors”) to adopt various forms of ring-fencing measures: increased capital buffers or Pillar 2 requirements for subsidiaries, and application at the local level of specific capital or liquidity requirements.
In my view, these ring-fencing practices represent an obstacle to the emergence of truly cross-border banking groups even within the EU banking union, where all banks are subject to the single supervision of the European central bank, because they hinder the effectiveness of the allocation of capital and liquidity within banking groups and therefore reduce economies of scale. They also constitute an obstacle to financial stability because banking groups are less able to diversify their risks.
But at the same time, because these practices mostly reflect legitimate concerns from host supervisors, the only way to remove the former is to address the latter. In this regard, practical solutions have to be worked out and implemented to increase the confidence of supervisors in the ability of cross-border banking groups to withstand a possible crisis without involving public finances at the national level.
At least within the European Union, credible cross-border guarantees provided by EU parent banks to their subsidiaries, based on EU law and enforced by EU supervisors, are in my view the most credible option to increase trust between supervisors in the short term while we continue working on the completion of the banking union. Outside the banking union, continuous dialogue aimed at reciprocal recognition of recovery and resolution measures should help to limit ex ante ring-fencing.
- Faced with uncertainties regarding the level of capital and liquidity at the local level if a crisis hits, supervisors tend to implement different ring-fencing measures.
The role and responsibilities of national supervisors in the event of a crisis involving a cross-border banking group is a strong explanatory factor.
Ring-fencing practices by national supervisors generally have the same root causes in different jurisdictions and economic areas. A host supervisor anticipates that the parent company of a banking group headquartered in a third country might decide to repatriate liquidity and capital located in the host jurisdiction if the group faces some difficulty. If the host supervisor is not confident enough that the local subsidiary will not suffer a liquidity shortage and retains enough loss-absorbing capacities, it will set ex ante requirements to ensure that a minimum level of capital and liquidity is readily available at the national level if a crisis occurs.
Similar decisions are also taken by host resolution supervisors when there is a doubt over the effective implementation of a single-point-of-entry (SPOE) strategy for a banking group – for instance, due to the lack of explicit liquidity support for subsidiaries. For banking groups implementing an SPOE strategy, subsidiaries stay out of resolution, and their losses need to be moved up to the resolution entity (i.e., the parent company). This could cause concern for the host resolution authority over the allocation of loss-absorbing and recapitalization capacities within the banking group.
These ex ante ring-fencing practices can be easily explained. National supervisors can still be responsible for addressing a cross-border banking crisis – even when considering the recent progress toward implementation of the new international standards, which have not yet been tested in a severe international case.
Various kinds of ring-fencing practices hinder the ability of banking groups to freely move capital and liquidity across borders.
There are various ways to maintain the desired level of capital or of liquidity at the local level. Some approaches, such as those in the EU, involve activating macroprudential tools, including the systemic risk buffer and other systemically important institution (O-SII) buffers, in order to address potential microprudential risks. Higher buffer requirements lead to an increase in the total amount of capital held at the level of the subsidiary. A similar outcome in the European Union could be achieved through the minimum requirement for own funds and eligible liabilities top-up.
A national resolution supervisor can increase the amount of eligible liabilities required from a subsidiary of third-country banks in addition to the decisions of the home supervisor regarding the international total loss-absorbing capacity (TLAC )standard.
In regard to banking groups operating cross-border, some national supervisors may tend to impose the creation of a subsidiary instead of a branch due to the greater control they have over this type of legal entity. This leads to additional constraints for banking groups.
International banking groups operating with a significant footprint in different economic areas may also be affected when it comes to TLAC. Decisions on the level of internal TLAC are one example: There has been an international tendency to progressively set a higher level of required internal TLAC (from 75% to 90% of an otherwise applicable external TLAC requirement, for instance), which leads to increased ring-fencing of capital and recapitalization resources.
Decisions to increase the level of required internal TLAC can be explained by the fact that some host supervisors believe that loss-absorbing capital and recapitalization resources could be easily repatriated by the parent company in the event of a crisis or, worse, not deployed from the parent to the local operations in the host jurisdiction where they may be needed.
The level of Pillar 2 requirements for subsidiaries represents a key “lever” for host supervisors: These requirements can be especially high for subsidiaries when taking into account their risk profile. In some extreme cases, Pillar 2 requirements for subsidiaries can even be higher than for the parent company. The relative flexibility to set Pillar 2 requirements allows host supervisors to maintain more capital at the level of the subsidiary, which decreases the flexibility of allocation of capital within the banking group.
All in all, ring-fencing is not a uniform measure but covers a wide array of approaches, depending on the situation of each banking group and on the perception that host supervisors may have of the risks.
Beyond this diversity, one must look at the effect these measures have on the proper allocation of capital where banks, through their role of intermediates, have a critical role to play for the economy. It is therefore important to work out ways to address the root causes of the issue under consideration here, with the aim of removing the unjustified constraints that may weigh on banks while fully reassuring host supervisors.
- Because these ring-fencing practices lead to suboptimal allocation of capital and liquidity for cross-border banking groups, practical solutions must be worked out.
A suboptimal situation for cross-border banking groups hinders economic efficiency and financial stability.
The post-crisis era increased fragmentation of the banking markets; this may be seen as inefficient from an economic perspective but is also suboptimal in terms of bank resolution and crisis response. Because of ring-fencing, resources available in resolution are fragmented and less fungible; contrary to the purpose of the SPOE model, a banking group cannot rely on the possibility of easily moving capital and liquidity resources across borders.
From a multiple-points-of-entry (MPOE) perspective, the ex ante freezing of assets diminishes the capacity to generate diversification and group support. Furthermore, groups are less resilient to idiosyncratic shocks if they are exposed to only a few domestic markets, and one should note that private risk-sharing remains low in the EU compared with the United States.
A more integrated global banking sector would allow for more efficient financing of all the economies through better matching between savings and investment needs across different markets as well as economies of scale in the collection and allocation of savings.
Ring-fencing practices constitute an obstacle to economic efficiency and financial stability because they do not allow banking groups to progress toward resource- and risk-sharing: Capital and liquidity remain trapped at the national level.
Banking groups therefore do not have the flexibility that is required to operate across borders. They are also less keen to set up and develop new subsidiaries because they know that this could significantly increase their cost of doing business. Ring-fencing practices also do not allow banking groups to build up an efficient internal capital market through which the business units in different countries compete to access the limited resources of the group (capital, liquidity, leverage).
Improving the ability of banking groups to do business across borders would allow for a more efficient allocation of savings and investment.
Possible solutions to limit ring-fencing practices in the banking union include the use of credible guarantees between parent banks and their subsidiaries.
Reducing ring-fencing practices in the banking system represents an achievable goal over the medium term, but it requires significant effort on different fronts. At the international level, progress may be slower than inside the European Union, but we should be able at least to preserve the advantages of a common international framework and encourage reciprocal recognition to counter further fragmentation.
At the EU level, some progress is already underway stemming from the ongoing discussions on the banking package at the European Council and the European Parliament. We like the idea that the European Union should be seen as a single jurisdiction in calculating an alternative global systemically important bank score. This will tend to reduce the cost of doing business across borders inside of the EU. Limiting Pillar 2 to microprudential risks is also a positive result even if, in our view, the macroprudential powers given to national supervisors can still lead to ring-fencing because of the flexibility given to host supervisors on the levels of Single Resolution Board (SRB) and O-SII buffers for subsidiaries.
Other progress includes the introduction of cross-border capital waivers by the European Parliament. This idea goes in the right direction but should take into account the legitimate concerns of host supervisors. On the risk-reducing front, the recent initiative of the European Commission to tackle the nonperforming loans issue also constitutes a step in the right direction because it might be seen as a prerequisite for more risk-sharing in the banking union.
However, much remains to be done. We believe that the key issue is to develop credible guarantees provided by EU parent banks to their subsidiaries, based on EU law, and enforced by EU supervisors. This will allow increasing the level of confidence of host supervision and resolution supervisors. These guarantees should include ex ante arrangements to upstream losses. They have to be robust and enforceable by EU supervisors. Resolution and supervisory supervisors in the different countries should work in cooperation to design the adequate guarantee mechanisms for each specific banking group. These guarantees should address the question of group support for subsidiaries during going-concern and not only during resolution. They could be adjusted regularly depending on the evolution of the risk profile of the banking group.
These credible EU guarantees would allow lower prudential constraints aimed at subsidiaries. At the banking union level, the creation of the SRB allowed former host countries that are now members of the Union to believe that we should focus on effective guarantee mechanisms for cross-border banking groups as a first step, and then build on the trust.
At the global level, other critical steps could be taken in order to improve the situation for cross-border banking groups. A more significant involvement of the host countries in the ex ante management of cross-border banking groups’ recovery and resolution plans would allow for an increased level of trust between supervisors. This dialogue should happen before the next banking or financial crisis arrives, in particular covering early intervention phases and recovery planning in order to build up confidence between jurisdictions before a crisis erupts.
In this context, we should encourage reciprocity among all those jurisdictions that share the global international framework because one can start from the assumption that if the regulations are broadly equivalent, efficient coordination for its implementation could allow each jurisdiction to avoid a “race to fragmentation” if it is confident that ultimately its own measures could be effectively recognized.
Conclusion
Ring-fencing appears to be the symptom of a deep problem, which results from several causes. Those who recognize the value of an international framework know they need to work out solutions to deal with these issues. The solutions mentioned in this article suggest in broad terms possible ways forward. Further work will be needed to make solutions implementable. To go live, strong political support will be essential. The benefits that can be expected from a better allocation of capital and liquidity across countries leads to the hope that this effort eventually will prevail.
Author Bio:
Edouard Fernandez-Bollo
After post-graduate studies at the Ecole Normale Supérieure de Saint-Cloud, Section Humanities and Social Sciences, and experiences in different branches of the French civil service, Edouard Fernandez-Bollo joined the Banque de France, the French central bank, in 1988. He has occupied different posts related to banking regulation and licensing, European harmonization, and banking resolution issues. After 2000, he was in charge of the legal secretariat of the Commission bancaire, the French supervisory authority, and of its anti-money laundering policy unit. In 2004, he became its General Counsel, and in 2008, its Deputy General Secretary. Since 2007, he has chaired the Basel Committee Expert group on work related to anti-money laundering efforts and combating the financing of terrorism. From 2010 to 2013, he was Deputy General Secretary of the new Autorité de contrôle prudentiel, the integrated French prudential supervisor. Since January 2014, he has been Secretary General of the Autorité de contrôle prudentiel et de resolution, and of the Basel Committee on Banking Supervision. Since 2015, he is a management board member of the European Banking Authority.
