Resolution of international banks: Can smaller countries cope?

• Author: Dirk Schoenmaker
• Published date: 01 March 2018
• DOI: http://doi.org/10.1111/infi.12123
• Date: 01 March 2018

DOI: 10.1111/infi.12123

ORIGINAL ARTICLE

Resolution of international banks: Can smaller

countries cope?

Dirk Schoenmaker

Rotterdam School of Management,

Erasmus University, Rotterdam, The

Netherlands

Correspondence

Dirk Schoenmaker, Rotterdam School of

Management, Erasmus University,

Burgemeester Oudlaan 50, 3062 PA

Rotterdam, The Netherlands.

Email: schoenmaker@rsm.nl

Abstract

The stability of a banking system ultimately depends on the

strength and credibility of the fiscal backstop. While large

countries can still afford to resolve large global banks on

their own, small and medium-sized countries face a policy

choice. This paper investigates the impact of resolution on

banking structure. The financial trilemma model suggests

that smaller countries can either conduct joint supervision

and resolution of their global banks (based on single point of

entry resolution) or reduce the size of their global banks and

move to separate resolution of these banks' national

subsidiaries (based on multiple point of entry resolution).

Euro-area countries are heading for joint resolution based

on burden sharing, while the United Kingdom and

Switzerland have implemented policies to downsize their

banks.

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INTRODUCTION

The Great Financial Crisis (GFC) of 2007–2009 highlighted that ‘financial institutions may be global

in life, but they are national in death’(Huertas, 2009, p. 6). National authorities were thus on their own

to resolve the respective national parts of those global banks that were failing or under severe pressure.

While there have been reforms to strengthen the governance of the international banking system, they

have not succeeded in addressing this coordination failure in the resolution of international banks

between national authorities.

A key element of the reform is a new resolution framework setting out the responsibilities of

authorities to resolve failing financial institutions in an orderly manner, by protecting critical functions

and without exposing the taxpayer to the risk of loss. For this purpose, the Financial Stability Board

(FSB, 2014) has introduced key principles for the resolution of international banks. Although these

principles encourage cooperation between national resolution authorities, they are non-binding

International Finance. 2018;21:39–54. wileyonlinelibrary.com/journal/infi © 2017 John Wiley & Sons Ltd

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(Riles, 2014). As we witnessed during the GFC, as well as in earlier crises, authorities put non-binding

agreements (like Memoranda of Understanding) aside in the heat of the moment when large sums are at

stake.

There is a new literature emerging on resolution models for international banks, which applies

game theory to analyse the cooperation between national authorities (Bolton & Oehmke, 2016; Faia &

Weder di Mauro, 2016; Schoenmaker, 2013). A key insight is that a banking crisis can be considered as

a rare event (one-shot game) with high financial stakes. The repeated game solution is thus not

applicable to the non-cooperative equilibrium.

Bolton and Oehmke (2016) and Faia an d Weder di Mauro (2016) analyse the tw o main

resolution models for globa l banks. Under single point of ent ry (SPE) resolution, a global ba nk is

recapitalized at the level of a si ngle bank holding company th at owns banking subsidiarie s in

multiple jurisdictions. The r esolution losses are first allocated to the equity (and bond) ho lders of the

parent holding and the authoritie s have statutory power to execute res olution at the parent holding.

The underlying idea is that an y remaining losses are shared a cross countries. Goodhart and

Schoenmaker (2009) claim that on ly ex ante binding burden sh aring agreements between

governments can solve the coor dination failure. Faia and Wede r di Mauro (2016) label this solu tion

as cooperative SPE, which gen erally minimizes losses sin ce authorities internali ze cross-country

spillovers and is thus more cos t-efficient.

By contrast, under multiple point of entry (MPE) resolution, separate resolutions are performed in

each country (if necessary) with funds from national subsidiaries. The resolution losses are first

allocated to the equity (and bond) holders of national subsidiaries. The host country has statutory power

of resolution of national subsidiaries. Bolton and Oehmke (2016) show that MPE resolution is more

applicable to decentralized global banks. The main contribution of Bolton and Oehmke (2016) and Faia

and Weder di Mauro (2016) is to analyse the impact of the chosen resolution regime on the

organizational form of banks. SPE is more inducive to centralized banks, while MPE leads to

decentralized banks.

The contribution of this paper is to analyse the impact of the choice of resolution model on the

structure of the banking system in a country. In my setting, authorities first choose to cooperate in

resolution by providing a joint fiscal backstop under a binding burden sharing agreement, or not.

Burden sharing (or loss allocation) facilitates joint supervision and cooperative SPE resolution.

Without burden sharing, the home country has to carry the full burden of a possible bank

recapitalization under SPE. But the fiscal capacity of the home country can be limited, which

subsequently puts the SPE model into question for banks headquartered in these countries.

The paper develops a method to assess the potential fiscal costs for a country required to support its

banking system. I apply this method to countries that are home to global systemic banks

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and find that

small and medium-sized countries cannot provide a credible fiscal backstop to large global banks. My

hypothesis is that these countries can only maintain global banks if they organize a joint fiscal backstop

through burden sharing. The empirical estimates suggest that medium-sized countries without burden

sharing have started a policy-driven process of downsizing their banks, while countries with burden

sharing have been able to preserve their banks. My method is helpful to explain the impact of resolution

(cooperation or the lack of it) on banking structure.

The paper is organized as follows. Section 2 discusses the need for a fiscal backstop and provides

some estimates for the required size of the backstop. Section 3 analyses the (in)stability of international

banking and derives three outcomes for international coordination and banking structure. I argue that

burden sharing is the most stable, albeit politically most difficult, outcome. Next, section 4 provides

empirical evidence on these different outcomes. Finally, section 5 discusses policy implications and

concludes.

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