Oct. 19 (Bloomberg) -- Federal Reserve Bank of Boston President Eric Rosengren said the European debt crisis underscores that regulators must address the “significant challenges” that remain in the global banking system to end the need for public rescues of financial firms.
“Once again, governments have started to intervene to mitigate global banking problems, which in turn may stress the debt burden of those governments, and could ultimately undermine the credit ratings of some countries,” Rosengren said in the text of remarks in Boston today. “It is apparent that the financial intermediaries encompass some vulnerabilities for the world financial system and the global economy.”
Spanish, Italian and Greek bonds fell yesterday on concern that the euro region is struggling to contain a crisis that threatens to trigger another global slump, as banks faced with rising defaults lack the capital to absorb a shock in sovereign debt. Moody’s Investors Service yesterday cut Spain’s credit rating for the third time since June 2010 as European Union leaders worked on plans to quell the crisis.
“Three years after the failure of Lehman Brothers, there remain significant impediments to avoiding the need for government intervention to protect large financial intermediaries,” Rosengren said. “So it is critical that we focus on strengthening the financial architecture, so that the struggles of one institution or a group of them no longer poses risks to the broader global economy.”
‘Too Big to Save’
When banks become too big relative to the economies of their home countries, they “could essentially be ‘too big to save’” because of the amount of capital required to rescue them, Rosengren said. For example, Ireland has gone from being a nation with a low proportion of debt relative to its gross domestic product, to having a high ratio because of the emergency funds it provided to its banks, he said.
The reliance of some large financial institutions on so- called wholesale funding, such as commercial paper, can also lead to a “fairly sudden liquidity crisis,” Rosengren said. “This situation is quite prevalent among many large European banks.”
U.S. prime money-market funds cut their exposure to euro- zone bank deposits and commercial paper, or short-term IOUs, to $214 billion in August from $391 billion at the end of last year, according to JPMorgan Chase & Co. data.
“If we are to avoid future crises and the need for extraordinary government intervention in crises, then the issue of over-reliance on wholesale funding will need to be addressed,” Rosengren said.
Countries that are only willing to provide support to the domestic operations of their banks can also cause other nations to be “adversely affected,” Rosengren said. “It is exactly these concerns that have caused some countries to require that all branches of foreign banks operating within their borders be supported by capital.” That would likely lead to a more stable funding base, including a reliance on deposits and longer-term borrowing, yet would also come “at a cost” to the parent of the subsidiary, he said.
In addition, regulators need to address “the challenge of resolving a failing international institution,” as illustrated by the litigation over Lehman Brothers Holdings Inc.’s bankruptcy three years after its collapse, Rosengren said.
Regulators also need a more “proactive approach to retaining capital” within banks as the use of taxpayer funds to support the financial system “should not manifest itself in paying scarce funds to equity holders,” Rosengren said.
“Using easily observable financial triggers, such as very substantial declines in a firm’s stock price, to pause share repurchases and dividends would provide no additional information about the institution’s financial strength -- but would allow it to build up capital during times of stress.”
--Editors: Gail DeGeorge, Christopher Wellisz
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