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Jean-Claude Trichet |
Last week, Jean-Claude Trichet, the President of the European Central Bank (ECB), blocked a proposal from European Union member states where, in the interests of systemic risk across the EU, they would bail out a failed bank. The EU’s Economic and Financial Affairs Council (Ecofin) had put forward plans for publicly funded rescue operations of failed banks within the EU but this has been effectively killed off by a mixture of EU non-interventionism and the failure on how to manage and fund any such rescue operations. Will this have Basel II implications?
In a Financial Times report, Mr Trichet is reported to have argued that any publicly funded rescue operation would send the wrong signals to the markets and could lead to investment assumptions that national bodies would automatically step in to bail out any large financial institution that got into trouble. He was also reported to have the support of Mervyn King, the Governor of the Bank of England. Separately the finance ministers of Britain and Germany opposed any agreement on the basis of it being impossible to determine who would pay if a crisis in one or more organisation who would foot the bill if a systemic crisis hit more than one country. Ministers at the Ecofin meeting agreed to improve cooperation and crisis planning but decided against any plans for sharing the costs of a publicly funded life boat.
This raises a question in the calculation of regulatory capital reserves of any large financial institution. The Basel II advanced capital models are based on the assumption that, ultimately, large financial institutions with significant retail investments and deposits will not be allowed to fail as part of a systemic crisis. Alan Greenspan, in 1996, said "… nor should we require individual banks to hold capital in amounts sufficient to fully protect against those rare systemic events which, in any event, may render standard probability evaluation moot. The management of systemic risk is properly the job of central banks. Individual banks should not be required to hold capital against the possibility of overall financial breakdown. Indeed central banks, by their existence, appropriately offer a form of catastrophe insurance to banks against such events…".
Basel II capital models have since been based on the above assumption and have excluded holding capital against systemic risk. Is this now to change? Should the models be reviewed to hold more risk capital?
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