Recapitalization Of International Banks
Companies / Credit Crisis Bailouts Mar 02, 2013 - 12:30 PM GMTBy: Submissions
Mandeep Chadha writes: Cross Border Economic-Political Relations & Risk to International Banks
Global economy is witnessing an integrated banking system is emerging with a small group of large across developed countries' banks the spanning respective national banking markets: As Garrett, Mahadeva and Sviridzenka noted. This raises the issue of the appropriate international level of body to monitor and manage financial stability. Financial stability is currently managed at respective national levels. In particular, the fiscal competence to deal with banking crises is a responsibility of national governments. However, the recent wave of recession starting in the western economy, as travelled and affected the global economy at large. The risk management is required to manage the recession and make the global economy turn back to the growth path.
At the individual financial organization level, the measure of transparency of trades, fraud detection and risk management will only be successful if there is technology and resource handshake not only between the global financial institutes but economic-political relations also across the countries of financial operations.
When one financial market witness stress, it is expanded to not only local markets, the financial risk threatens the international financial organizations at broader level. It may increase manifold if the organization is also exposed imperfect international co-ordination. There exists a systemic risk among the network of international banking groups arises Multinational banks tend to determine and mitigate risk in an international environment. It is not an easy task. It tends to be affected by many financial, global and political equations between the countries.
The fiscal costs of resolving a banking crisis can be large. Risk varies per the cross-border social-economic-political relations. Though these factors are paid heed to by the risk analyst, yet looking at the polarization of global powers, it is imperative to not to ignore them. These may not be key factors for managing risk in practical view of the scenario, and demands careful evaluation in order to curtail the risk.
Recapitalization of international banks
Recapitalization of banks will be efficient if social benefits of preserving systemic stability exceed the cost of recapitalization. In any national setting, the implementation of an optimal policy is relatively straight and clear. While in a multi-national financial setting, an organization can be confronted with possible coordination challenges.
Say in an international organization model, it has been observed by economists that even after burden sharing negotiations lead to an under provision of recapitalizations. Like Scandinavia and Japan faced a severe banking crisis in the 1990s. The Scandinavian crisis amounted to a fiscal cost of 8 percent of GDP. The prolonged Japanese crisis added up to a total fiscal cost of 20 percent of GDP.
National authorities (central banks and finance ministries) have a mandate for financial stability in their national financial system. They may be reluctant to provide liquidity or solvency support for solving problems in other European Union (EU) countries, and thus not take into account cross-border externalities caused by financial institutions under their jurisdiction (Schoenmaker and Oosterloo 2005).
Financial Problems of One Country Affecting Others
Financial challenges of one country cast ill-affect on the financial system of other countries through different channels:
- The first type of contagion risk occurs when the financial shock causes some financial institution’s failure. This is referred as the first-round effect of financial contagion where financial problems spread throughout institution and to its foreign branches & subsidiaries. Thus, in countries where the financial system is dominated by foreign banking groups, the consequences of these first-round effects can be significant.
- The second type of contagion risk is the risk of failure of a financial institution being transmitted to other institutions because of explicit financial linkages between these financial institutions; which is referred to as the second-round effect of financial contagion; see also De Bandt and Hartmann (2002). What is the impact of these cross- border externalities on the economy? This partial financial system break down results in constrained credit capacity. The economic effects of credit contraction in a country can be of serious national or international concern. We have witnessed first and second type of financial contagion due to the 2008 economic recession in US.
The only measure to check the second type of contagion risk is coordination between the international economies where there is risk for second-round effect. However, there are only a few international arrangements for crisis management through recapitalization in case of such cross-border externalities.
Model of Cross-Border Recapitalizations
The fiscal costs of resolving a banking crisis can be large. Scandinavia and Japan, for example, experienced a severe banking crisis in the 1990s. While the Scandinavian crisis amounted to a fiscal cost of 8 percent of GDP, the long, drawn-out Japanese crisis added up to a total fiscal cost of 20 percent of GDP. There are also broader, real, costs to the welfare of the economy. Hoggarth, Reis, and Saporta (2002) find that the cumulative output losses incurred during crisis periods are roughly 15–20 percent of GDP.
The fiscal costs of resolving a banking crisis can be large. In a worldwide sample of forty banking crisis episodes, Honohan and Klingebiel (2003) find that governments spent on average 13 per- cent of national GDP to clean up the financial system. To clarify our position, the preferred route to solving a banking failure is a private- sector solution. The use of public money should only be considered when the social benefits (in the form of preventing a wider banking crisis) exceed the costs of recapitalization via taxpayers’ money. The issue at stake in today's financial and investment banking context is that not only national, but also cross-border, externalities should be taken into account in the process of decision making.
In a multinational setting, the costs of such recapitalization can be shared between countries. Freixas shows in a model that ex post negotiations on burden sharing lead to an under-provision of recapitalizations. Countries have an incentive to understate their share of the problem in order to have a smaller share in the costs. This leaves the largest country, almost always the home country, with the decision whether to shoulder the costs on its own or to let the bank close and possibly be liquidated. Freixas labels this mechanism, which reflects the current arrangements, as improvised cooperation.
Ex Ante Burden-Sharing Mechanisms
There are different ex ante burden-sharing mechanisms to overcome the coordination failure.
- The first is a general mechanism where the institution is being financed collectively by the participating countries (generic burden sharing). The first mechanism general fund could be financed directly by the participating countries, which would pay their relative share (e.g., based on GDP) in the fund. The main advantage of this system is that the cost of recapitalization is smoothed over countries. There are, however, serious problems with this approach, not least that there is little (political) enthusiasm for cross-border fiscal transfers.
- The second relates the burden to the location of the assets of the bank to be recapitalized (specific burden sharing). The working of the two mechanisms is calibrated with data on large cross-border banks. Because the costs and benefits are better aligned in the specific scheme, it is better able to overcome the coordination failure. In this mechanism, only countries in which the problem bank is conducting business, contribute to the burden sharing. A country’s contribution is being related to the percentage of the problem faced by the financial institution. Thus, the cross-border transfers are largely avoided.
Both mechanisms are subject to a catch, none of the countries sign up for burden sharing, nevertheless profit from burden sharing, as the stability of the financial system is for public good.
Bibliography:
Wikipedia.com
Garrett, R., Mahadeva, L. and Sviridzenka, K. (2011) ‘Mapping systemic risk in the international banking network’, Bank of England Working Paper No. 413, London: Bank of England.
By Mandeep Chadha
Mandeep Chadha, the Global Operations IT Financial Lead, Assistant Vice President at UBS (USA). As finance and IT actuary, I have worked with global financial banking leaders across USA, UK, Europe and Asia. My responsibilities involve: In the realms of investment management, to have better risk management and transparency in the financial system for the global investment banks.
Copyright © 2013 Mandeep Chadha - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.
© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.
