Cross-Border Banking in Europe: Implications for Financial Stability and Macroeconomic Policies

Understanding the role of banks in cross-border finance has become an urgent priority after the recent crisis where they played a central role. This report argues that policy reforms in micro- and macro-prudential regulation and macroeconomic policies are needed for Europe to reap the important diversification and efficiency benefits from cross-border banking, while reducing the risks stemming from large cross-border banks. Cross-border banks have played a central role in the dynamics of the global crisis of 2007-2009. This report argues, however, that multinational banks have been the face, but not necessarily the cause of the crisis and neither have they exacerbated it. In Western Europe, it was rather regulatory failure to deal with large cross-border banks in an efficient way that deepened the crisis, while there is increasing evidence that in the central and eastern European countries foreign banks helped mitigate the impact of the crisis rather than exacerbated it. This report argues that the benefits of cross-border banking are likely to outweigh any potential stability costs. Regulators should therefore focus on encouraging forms of cross-border banking that are both balanced and not excessive to avoid undue risk concentrations and dependencies, both on the country-level and the EU-level. In addition, macro-prudential and monetary and fiscal policies have to be adjusted to take into account the repercussions of cross-border banking for asset price and credit booms, currency and maturity mismatches and contagion. Sensible macroeconomic policy making is no longer possible without explicitly taking into account the feedback loop with the financial system. This report takes the view that the efficiency gains of a common European Banking Market outweigh the costs and policies should therefore be adjusted to reap these gains while reducing the risks stemming from cross-border banking. Among the recommendations are (i) the introduction of macro-prudential regulations at the national level, but monitored on the European level, (ii) introduction of risk weights for sovereign debt and a bankruptcy regime as part of the European policy framework, (iii) the elimination of tax deductibility of debt to reduce the incentives towards high leverage in banking, (iv) compatible bank resolution frameworks with contingent capital on the national level, and (v) a European-level deposit insurance scheme and a bank-group level resolution framework with ex-ante burden sharing agreements for large cross-border banks.