Risk Management

National Trust

The United States and Britain outline plans for dealing with failing cross-border banks.
Economist StaffDecember 18, 2012

“Phew,” says a senior bank regulator, leaning back in his chair, when asked how he would cope with the collapse of a big global bank. “It’s a daunting task.” On December 10 the Bank of England (BoE) and America’s Federal Deposit Insurance Corporation (FDIC) took a step towards making it a little less daunting when they outlined plans to work together were any of their large global banks to implode.

The most important element of the strategy is that big cross-border banks should be “resolved,” or cleaned up, from the top down, meaning by the authority in their home countries. A second is that these banks be forced to hold enough unsecured debt at the top of their corporate structures to allow the authorities to impose losses on bondholders, a process known as “bail-in.”

The logic of both positions is compelling. In a normal bankruptcy authorities in different places try to grab assets in their own jurisdictions to pay off local creditors, often felling perfectly sound subsidiaries. That happened after the collapse of Lehman Brothers.

Even so, the top-down resolution process proposed by the BoE and the FDIC may be difficult to achieve in practice. Regulators in all of the countries where a tottering bank operates would have to trust that they would be treated fairly by the bank’s home-country regulator — in other words, that if the clock were wound back, American regulators would make sure that Lehman’s foreign creditors were treated the same as domestic ones.

Trust is difficult to achieve even when regulators are committed to working together. Transatlantic harmony evaporated as cash flowed out of Lehman’s London operations in 2008. Paul Tucker, the BoE’s deputy governor, said this week that British authorities were ready in principle to let American regulators resolve U.S. banks with big London operations; such public assurances were noticeably absent on the other side of the Atlantic. Britain and the U.S. account for a big chunk of the world’s largest banks (see chart). But other regulators matter too. Places like Switzerland want to cut adrift the foreign subsidiaries of big Swiss banks to protect the domestic banking system.

Two things may help to strengthen cross-border trust. The first is if banks were forced to create local subsidiaries with their own capital and liquidity buffers. Daniel Tarullo, a governor of the Federal Reserve, argued recently for tougher regulation of foreign banks in America, saying that some governments didn’t seem likely to backstop their firms. This would make it easier for regulators to pick apart failing banks, but also make them less inclined to seize assets at the first sign of trouble. That in turn could allow more time for a top-down resolution.

A second is the proposal for banks to hold more unsecured “bail-in” debt at the top of their corporate pyramids. Big chunks of this debt could provide a cushion to absorb losses throughout the organization, including those in foreign subsidiaries. Regulators would not face a choice between creditors at home and abroad.

Such reforms are not without their costs. More bail-in debt would drive up the price of banks’ own funding, and thus of providing credit to businesses and people. Greater subsidiarization would increase costs for banks, trap capital, and make them less profitable. Yet the alternatives are worse: a further balkanization of finance as countries close their doors to foreign financial institutions, and the continuation of banks that are too big to fail. “I don’t care whether resolution plans work in practice,” says Simon Gleeson, a lawyer at Clifford Chance. “What’s important is that they work in theory … what matters is getting to a stage where it is widely accepted that banks can fail.” By that measure the new plan is a step in the right direction.

© The Economist Newspaper Limited, London (December 15, 2012)