SIFIs and States

Today an enormous global civilization rests upon a jury-rigged financial frame rife with moral hazards, perverse incentives, and unintended consequences. This article, SIFIs and States, forthcoming in the Texas International Law Journal, addresses one aspect of that fragile structure. It argues for basic reform in the international management of financial institutions in distress, with a special emphasis on SIFIs (Systemically Important Financial Institutions). The goal is to examine public institutional arrangements for resolution of financial institutions in the midst of a crisis, rather than the substantive rules governing the resolution process. The proposition central to this article is that the resolution of major financial institutions in serious distress will generally require substantial infusions of public money, at least temporarily. The home jurisdiction for a given financial institution must furnish the bulk of the public funds necessary for the successful resolution of its financial distress. The positive effect is that other jurisdictions may be likely to acquiesce in the leadership of the funding jurisdiction in exchange for acceptance of that financial responsibility. On the other hand, acceptance of the funding obligation would have profound consequences for the state as well as the institution, because the default of a SIFI may threaten the financial stability of that state. Until the crisis of 2007-2008, all that was implicit and unexamined in the political process; to a large extent it remains so.

The challenge of multinational regulation exists for both the preventative and the resolution mechanisms in the regulatory process, although in different ways. While much progress has been made in the effort to prevent the failure of international financial institutions, the ex ante regulatory process is notoriously subject to capture and fatigue, a lesson reinforced by the crisis of 2007-2008. This history makes imperative careful preparation for resolution of these financial institutions where the preventative process fails; that is, damage control.

There are three possible structures of international financial crisis management—national, supranational, or multinational. A multinational structure is at present the only workable solution to crisis management. That solution raises difficult questions of coordination among independent and self-interested sovereigns who are adapting only slowly to dramatic changes in global economics and the multinationalization of economic power. Effective coordination of each institution’s financial distress will be achieved only through agreements made in advance that include assigning one jurisdiction the role of primer inter pares at the center of the coordinated effort. That jurisdiction must be the one with the primary responsibility for funding.

Adoption of the structure just described for resolution would have other possible implications. In that structure, the state with the authority for resolution should also be the primary prudential regulator for that institution for two reasons. First, to some extent the need for resolution represents a failure of prudential regulation and the jurisdiction responsible for funding and managing resolution therefore has a great incentive to regulate responsibly. In addition, ex ante regulation can include requirements that will be helpful in the event of financial distress, connections that the jurisdiction with resolution authority is most likely to see and enforce. Generally the home country of a bank has that primary regulatory position today, but that central regulation is mixed with a great deal of local regulation by countries that host an institution’s branches and subsidiaries. This localization is inevitable in the current system in which a host country bears much of the financial risk of failure of a guest institution. It will be less necessary and less appropriate if the primary financial responsibility and regulatory authority for the guest institution is established in the home country in advance of any crisis. Success or failure of such a system may depend upon advance commitments as to both financial responsibility and regulatory deference and that commitment is unlikely unless it is multinational.

A second likely consequence of the structure proposed here would be a requirement that the financial risks created in a host country by a guest institution be limited to those that its home country is financially able to bear. That requirement will have the effect of disqualifying smaller economies as home countries for global banks. Indeed, even the largest economies may be too small to bear the risk of failure of the largest banks, suggesting a reduction in the size of those banks that may or may not be politically plausible.

The full article can be downloaded here.