Global banking relationship needs revision

The ongoing debate over “too-big-to-fail” banks is often framed from the perspective of the “home country” — that is, countries with advanced economies, where the largest financial institutions with global operations are headquartered. Limited consideration is given to the implications of their failure on countries that “host” those institutions.

Many emerging market economies play “host” to these global giants, either in the form of locally incorporated subsidiaries or via a foreign branch license.

From a policy standpoint, there is an important legal difference between local subsidiaries and the local branches of foreign banks.

The former is a separately capitalized legal entity owned by the parent bank, while the latter is
an appendage of the parent bank with no separate capital or liquidity of its own.

If given the choice, nearly all foreign banking institutions would prefer to operate outside their home turf under a foreign branch model — all else being equal — due to cost savings and the realization of economies of scale (e.g. no separate capital requirements for foreign branch operations and no need to maintain a separate board of directors, shared information systems with the parent bank etc.).

From the host country’s perspective, the foreign model raises a range of troubling policy issues that center on the fundamental question of fairness.

In short, host authorities that oversee foreign bank branches have limited powers to supervise or influence the risk profile of the parent bank, yet they remain responsible for the liabilities (like depositors and creditors) of the local operation if the parent bank fails.

This problematic relationship is accentuated if the foreign branch operations, because of their size, are considered “systemic” to the host country’s financial system; in the event of the parent bank’s demise financial instability and damage to the local economy could result.

With this background, there is an urgent need for the G20, together with international organizations, to accelerate the development of an equitable cross-border resolution mechanism that recognizes the unequal nature of “home” and “host” authorities regarding the oversight of foreign bank branches. While it is encouraging that the IMF and the Basel Committee on Banking Supervision have flagged cross-border resolution as a high priority item, reform efforts to date have focused primarily on improved information sharing between home and host authorities.

While the issues are complex, two critical questions must be addressed as part of an equitable system of burden sharing.

First, to what degree should home country authorities be expected to backstop retail deposits in foreign bank branches that are protected under a local deposit guarantee (e.g. any amounts or premiums the foreign branch has paid into a local deposit insurance fund) if the parent bank were to fail?

Second, can home authorities ensure that host country creditors — that are not subject to the deposit guarantee — be treated on a level playing field with the home country’s non-insured creditors in the event of the liquidation of the parent bank’s assets?

In exchange, host authorities could be expected to relinquish their rights to the local assets of foreign branches in order to facilitate an orderly cross-border resolution.

The absence of an equitable international solution may compel host authorities to pursue a range of unilateral actions — such as the imposition of financial and structural constraints — to protect their national interests, including measures that may hamper effective cross-border resolutions or that could result in higher costs and inefficiencies for global banks at a time when they are looked at to support the nascent worldwide economic recovery.

The near failure of systemically important firms during the depths of the financial crisis exposed long-standing weaknesses in the cross-border resolution framework, including the troublesome nature of “home” and “host” relationships. The stakes for host jurisdictions — and the global banking system — are too high to continue with “business as usual”.

If the international community fails to reach a compromise, the foreign bank branch model may become a relic of the past.

Muliaman Hadad is a deputy governor at Bank Indonesia and S. Raihan Zamil is an advisor at Bank Indonesia.