Are the Risks of an International Banking Crisis Increasing

First, let us restate our definition. An international banking crisis is the international transmission of financial problems that, without policy intervention, would have threatened the stability of the banking system and the operation of the payments system in a number of different countries. On this definition, events that come even close to being classified as international banking crises have been extremely rare. Over the past century there has been Credit Anstalt, Herstatt, and the problems of Sovereign Debt lending, and none of these can really be categorized as a fully fledged international banking crisis.

Moreover, on balance we can argue that, the globalization of banking notwithstanding, the risks of an international banking crisis in the early part of the twenty-first century have diminished rather than increased, relative to the situation in the second half of the twentieth century. Our argument runs as follows. First we consider again, and in turn, the main forces underlying banking crises previously discussed in this section, establishing that the risks of bank crisis, domestic or international, have diminished. Second, we consider whether increased international exposure has increased the risk of a domestic crisis transmitting internationally and becoming international. We find that it has not.

Macroeconomic policy making, especially monetary policy, is now much more stable than was the case a decade or more ago. The shift towards greater independence of central banks in the industrial world, together with the widespread adoption of inflation targeting, is a profound change. The UK is a prime example of the acceptance of monetary discipline, beginning with the espousal of monetarist policies by the Conservative government of Margaret Thatcher in the early 1980s and culminating in the 1997 decision by the Labour government of Tony Blair to give the Bank of England operational independence in monetary policy.

For some of the more inflation-prone countries of southern Europe, monetary policy discipline has been attained by an alternative route, through the creation of the euro and the substitution of politically independent European Central Bank monetary policy in place of a more politically controlled domestic monetary policy. This is not to say that no financial problems lie ahead. Again the UK provides a good example, where the control of inflation and consequent lowering of interest rates during the 1980s was followed by an asset price and consumption boom. Some countries within the eurozone, including Portugal and Ireland, have experienced similar asset price and consumption booms in the late 1990s, and the possibility of them. But these cases are to a large extent problems of transition from a regime of high and variable to low and stable inflation. Once the new regime is widely understood and accepted, the acceptance of monetary discipline promises to bring about greater banking sector stability in all the developed countries, making the possibility of an international banking crisis even more remote.

Internal controls and the external governance of banks have also, generally, improved over recent years. In France, Italy, Greece and elsewhere there have been major programmes of bank privatization. At a global level there have been improvements in risk management as a response to the experience of portfolio losses and of loan default. Virtually all investment banks now use 'value at risk' modelling to monitor their exposure to market risk. While value at risk is not an exact measure, it is a good deal better than having no measure of risk exposure at all. Commercial banks in Scandinavia, France, the US, the UK and elsewhere now generally operate much tighter controls over all their credit exposures than was customary a decade ago.

Experience of exchange rate problems such as in the European ERM in 1992 and 1993, or in South East Asia in 1997, has reinforced the point that pegged exchange rates are not sustainable in a regime of capital mobility. Thus in all the major countries the choice has been made between either permanent exchange rate fix (in the eurozone) or a floating exchange rate. In consequence banks are either less exposed to foreign exchange risk, or the foreign exchange risks are so obvious that they have to be almost entirely hedged.

A number of developments have also strengthened both domestic and international payments systems, and come close to removing the possibility of an international or even domestic payments breakdown. Most large value payment systems, including the euro TARGET system linking the payment systems of the euro area, now operate on a real time gross settlement basis. This development, not without cost because someone has to provide liquidity, removes the threat that the failure of a single institution could cripple payments activity. Where systems still operate on a net basis, for example, the New York CHAPS, stringent operating standards are now applied, again effectively removing the possiblity of a systemic crisis. In the foreign exchange markets the introduction, early in 2002, of continuous linked settlement will further reduce systemic risk. While central bankers on the Bank for International Settlements committee on payment and settlement systems remain vigilant, it can be fairly safely asserted that a Herstatt crisis could only happen in today's payment systems if some cataclysm were first to wipe out the majority of the world's financial institutions. Nowadays payments breakdown might be a consequence of, but could not be a contributory cause to, an international banking crisis.

It is thus clear that all these principal factors, macroeconomic, structural and international financial arrangements have shifted so as to reduce (although not eliminate) the risk of banking crises. Still, it might be argued, increased international exposure may have increased the risk of an international banking crisis, even if the risks of domestic banking problems have receded. We can make a number of points to refute this position.

First, globalization of the banking industry has not in fact proceeded very far in commercial banking. With the exception of a handful of institutions with substantial international corporate and trade finance business (including Citigroup, HSBC, Deutsche Bank, Barclays and ABN-AMRO), commercial banking exposures remain overwhelmingly domestic. This is true even within the euro area, where cross-border banking activity is still relatively unimportant. This fact means that the risk of a domestic banking crisis remains relatively high (because many institutions have considerable exposure to their own country) but that the threat of a bank failure leading to the collapse of banking systems and payment mechanisms in several countries is very low.

Second, were commercial banking exposures to become international, as may well happen in the euro area over the next few years once a genuine single market in financial services is established, there will be two offsetting impacts. While international transmission of bank difficulties will have increased, bank portfolios will be increasingly diversified. In the event of much greater globalization of commercial banking, and with country and industry risks unchanged, the probability of an individual bank failure occurring is greatly diminished. In such a situation a banking crisis if it occurs will be international simply because banking systems have become international. But the likelihood of crisis is greatly diminished.

Third, as commercial banking becomes a truly international activity, it will be accompanied by increased international banking competition and, most importantly, a growing international market for the control of banks via mergers and acquisitions. Provided governments do not seek to protect their own local institutions, this will in turn promote better governance and improved standards of risk management and internal control, since a clear focus on profitability and appropriate risk-adjusted returns to shareholders will be the only effective defence against acquisition. Where acquisition does take place it will generally result in a transfer of better practice into the target bank.

Internationalization has proceeded rapidly in global investment banking. Here the nature of risk is entirely different from that in commercial banking. Investment banks' exposure to market risks is now tightly controlled. What the major investment banks face instead are substantial business risks, especially the very real possibility at this point in time of a worldwide decline in securities issuance and trading. But suppose there were a serious collapse of these businesses, with ensuing problems of overcapacity and the need for contraction and even liquidation of major international investment banking operations. This would no more be an international banking crisis than would be a collapse in the market for steel or motor cars. Nowadays, with investment banking activity income shifted so substantially from trading to fee-based issuance and market making, there would not be a direct impact on the pricing and liquidity of financial assets. And contraction or liquidation of the investment banking sector does not threaten bank depositors, payments activity, or the integrity of the financial system. Such developments would not qualify as an international banking crisis.

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