Appropriate structure for handling crisis management by Rosa Mara Lastra

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Appropriate structure for handling crisis
management by Rosa María Lastra

• Professor of International Financial and Monetary
  Law
• Queen Mary University of London
• Joint FMG CCLS Conference
• London, 30 January 2008

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Introduction A tale of greed and fear

• The trigger of the current financial crisis was
  the US Sub-prime mortgage market crisis.
• The major casualty so far in the UK has been
  Northern Rock, a classic banking crisis triggered
  by liquidity problems.
• The banking industry is inherently fragile and
  vulnerable to crises. The resolution of banking
  crises is always problematic, since often gains
  are privatised and losses are socialised (Martin
  Wolf).
• Who is to blame for the current troubles in the
  financial World? Some would say that the
  mis-pricing of risk (Greenspan put) is the causa
  remota. Others would point to macro-economic
  imbalances. The focus of this conference is not
  to discuss how and why the crisis came about, but
  rather to analyse the regulatory response to the
  crisis. My presentation deals with the
  appropriate structure for handling crisis
  management. To this end I will discuss
• The scope of bank crisis management
• Structure in the UK - The tripartite arrangement
• Role of the Bank of England (central banking
  role)
• Role of the FSA (role of regulators and
  supervisors)
• Role of HMT (fiscal authority role of
  politicians)
• Cross-border considerations at the European level
  and internationally.

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Scope of bank crisis management

• Bank crisis management at the national level
  comprises an array of official and private
  responses.
• Any structural review ought to take into account
  this multi-faceted reality it is not possible to
  reform one part of the structure without
  considering the others. As regards the official
  responses, when confronted with failed or failing
  banks, public authorities have at their disposal
• (1) The lender of last resort role of the
  central bank
• (2) Deposit insurance schemes
• (3) Government policies of implicit protection
  of depositors, banks (the too-big-to-fail
  doctrine) or the payment system
• (4) Insolvency laws (lex specialis vs lex
  generalis)
• (5) Prompt corrective action and preventive
  mesasures (PCA formal rules and other forms of
  prompt corrective action).

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The UK structure the Tripartite Arrangement

• The Tripartite arrangement does not deal with all
  the aspects of bank crises management. It deals
  with (1) ELA and (3).
• The Tripartite arrangement is a good structure to
  respond to the problems of transferring
  supervision from the central bank (Bank of
  England) to a separate supervisory agency (FSA),
  while keeping the Treasury involved. However,
  the wisdom of separating the monetary and
  supervisory responsibility of the central bank
  remains a matter of controversy. This is a key
  structural issue. Given that supervision is a
  key instrument in the maintenance of financial
  stability, depriving the central bank of this
  instrument, makes the pursuit of the goal of
  financial stability more difficult.
• Why did the Tripartite arrangement fail in
  Northern Rock? Lack of effective and timely
  communication, apparent lack of a clear
  leadership structure, uncertainties surrounding
  the resolution procedures (questions of EU law,
  timing etc), an ill-designed deposit insurance
  system.... It needs reform.

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UK reform proposals

• It is anticipated that the FSA will be given new
  powers and that the tripartite arrangement will
  be reformed (FT Interview with the Chancellor, 3
  January 2008). The UK Government is also looking
  at insolvency law and considering improvements
  in the compensation scheme. The Government plans
  to introduce new legislation in May.
• However, the HC Treasury Select Committee in its
  recently published report (26 January 2008) The
  Run on the Rock suggests that the Bank of
  England should be given new powers. It recommends
  that a single authority akin to the US FDIC -
  be created (the Deputy Governor of the Bank of
  England and Head of Financial Stability and a
  corresponding Office) with powers for handling
  failing banks (ch. 5) and the Deposit Insurance
  Fund (Ch.6).

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Resolution procedures and deposit insurance in
the UK

• DEPOSIT INSURANCE - Northern Rock exposed the
  deficiencies in the structure of deposit
  insurance in the UK. A credible deposit
  insurance system requires inter alia prompt
  payment of depositors and a reasonable amount of
  coverage (neither too meagre to be non-credible
  nor too generous to incur into moral hazard
  incentives). The Financial Services Compensation
  Scheme was set up under the Financial Services
  and Markets Act 2000 (FSMA) as the UKs
  compensation fund of last resort for customers of
  financial services according to the Directives on
  Deposit Guarantee Schemes and Investor
  Compensation Schemes. FSCS has no real powers
  as opposed to FDIC in the US insurer, supervisor
  and receiver of failed or failing institutions.
• RESOLUTION PROCEDURES - Northern Rock exposed
  the deficiencies of the UK regime to deal with
  banks in distress. With regard to bank
  resolution procedures, prevalence should be given
  to prompt resolution and market solutions, while
  maintaining access to critical banking functions
  in a crisis. Shareholders should bear losses. The
  Treasury Select Committee (January 2008 Report)
  recommends a special resolution regime.
• PRE-INSOLVENCY PHASE - The efficiency of bank
  insolvency law and procedures would be greatly
  enhanced - in terms of minimising cost to
  taxpayers - by the adoption of a system of a
  formal system of prompt corrective action (akin
  to FDICIA), linking the intensity of supervision
  to the level of capitalization. The Treasury
  Select Committee sees great merit in the adoption
  of PCA

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Cross-border considerations the European
dimension

• The appropriate structure to handle crisis
  management cannot ignore cross-border issues.
  Though regulation and supervision remain
  nationally based, financial markets have grown
  international, and hence the structure at the EU
  and international level must be reformed, too.
• Though the ECB has so far successfully provided
  liquidity to the market (in recent months) to
  alleviate the credit squeeze, the structure for
  managing and resolving a cross-border financial
  crisis in the EU is, in my opinion,
  inappropriate.
• Cross-border crisis management in Europe presents
  additional challenges for policy-makers and
  regulators, because of
• European Monetary Union. The ECB has no European
  fiscal counter-part, which means that the
  relevant fiscal authorities are by definition at
  the national level.
• Supervision remains at the national level -
  process of financial integration, the single
  market in financial services - the trilemma
• The patchy and scattered legal framework
• The complex European Financial architecture

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The trilemma of financial supervision (Thygesen
Schoenmaker)

• Stable financial system

National financial supervision
Integrated financial market
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A patchy and scattered legal framework

• Primary Law article 105 EC Treaty and Articles
  18 and 25 ESCB Statute LOLR rules on state aid
  - Articles 87-89 EC Treaty.
• Secondary law (pursuant to Art 47 (2) EC Treaty)
• Directive 2006/48/EC of the European Parliament
  and of the Council relating to the taking up and
  pursuit of the business of credit institutions
  (Recast Banking Directive).
• Dir 2006/49/EC, Capital Requirements Directive
  Directive 2003/6/EC, Market Abuse Directive.
• Dir 2002/87/EC, Financial Conglomerates
  Directive
• Directive 2001/24/EC on the reorganisation and
  winding up of credit institutions.
• Directive 2004/39/EC on markets in financial
  instruments (MiFID)
• Dir 94/19/EC,Deposit-Guarantee Schemes
  Directive.
• Dir 97/9/EC, Investor Compensation Schemes Dir.
  
• MoUs (non-legally binding arrangements) 2001,
  2003, 2005

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Reform in the EU recent proposals

• ECOFIN conclusions October 2007 calling for an
  enhancement of the arrangements for financial
  stability in the EU (co-operation (?) and review
  of the tools for crisis prevention, management
  and resolution 2007-9)
• To revise the Winding Up Directive - Public
  consultation on the reorganization and winding up
  of credit institutions by the EU Commission
  (http//ec.europa.eu/internal_market/bank/windingu
  p/index_en.htm lthttp//ec.europa.eu/internal_marke
  t/bank/windingup/index_en.htm
• To clarify the Deposit Guarantee Directive
• ECOFIN conclusions December 2007 calling for a
  review of the Lamfalussy framework (half-baked
  solution?)
• Towards a single regulator????

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Cross-border considerations the international
dimension

• The IMF surveillance function (akin to
  supervision at the national level) ought to be
  strengthened to detect incipient financial
  tensions and vulnerabilities in international
  capital markets.
• New rules (regulation) are needed to deal with
  cross-border bank insolvency. The Basel Committee
  has established a working group (December 2007)
  to study the resolution of cross-border banks.
• The cross-border dimension was echoed in an
  article (Ways to Fix the Worlds Financial
  System) by Gordon Brown published in FT 25 Jan
  2008 As financial markets become increasingly
  interlinked, countries must ensure they have
  robust and effective cross-border crisis
  management arrangementsThe IMF should be at the
  heart of this reformwith clearer
  responsibilities for financial stability.

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Concluding observations

• Protection justifies regulation (preventive
  regulation) and supervision.
• The financial system has become very
  complicated.
• Complexity frustrates accountability
• Time is of the essence in any rescue operation.
  Central bank lending over an extended period of
  time is typically an indication of insolvency not
  of illiquidity.
• As the Chancellor stated with regard to the
  handling of the NR crisis (p. 80 of 2008 Jan
  report, The run on the Rock) in his appearance
  in front of the Treasury Select Committee
• What you need is a legal framework
• This framework providing clarity,
  predictability and certainty has a national
  dimension, but also a European and an
  international dimension