Chapter

VII International Aspects of Official Support for Banks

Author(s):
G. Johnson, and Richard Abrams
Published Date:
March 1983
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Viewed from an international perspective, deposit insurance plays a relatively minor role in bolstering the confidence of depositors. There are also a number of gaps in coverage by lenders of last resort, in terms of both providing support to individual banks and providing liquidity to the international banking system.20 The nature of these gaps is the subject of the remainder of this paper.

Deposit Insurance

A major feature of the safety nets for most domestic banking systems is deposit insurance. Table 6 summarizes the systems in force in a number of industrial countries, many of which have been installed only recently. In some banking systems, such as that of the United States, deposit insurance has virtually eliminated the danger that fears for the safety of deposits could prompt panicky withdrawals by small depositors. With a limit in the United States of $100,000 for each nonbank depositor in any one bank, all but the wealthiest individuals and large businesses can easily arrange their deposits in order to have complete coverage. Some two thirds of bank liabilities in the United States are covered by deposit insurance. Deposit insurance in other systems is more narrowly focused on protecting the small depositor, as opposed to protecting banks from panicky withdrawals. Limits of coverage may be lower, corporations may be excluded, and in some cases the depositor must bear some fraction of any loss. The importance of deposit insurance in domestic safety nets thus varies substantially from system to system. It plays a particularly important role in systems like that of the United States, with its large network of small, independent banks.

Table 6.Bank Deposit Insurance Schemes in Selected Industrial Countries
Country1Date of

Establishment
Organizational

Status2
Funding3Nonbank

Deposits

Covered4
Limits of

Coverage per

Depositor
Membership Required
Belgium5JointPoolAll6, 7Variable, case by caseYes
Canada1967OfficialPoolAll domestic currency8Can$20,000Yes
France1979PrivateUnfundedAll domestic currencyF 200,000Yes
Germany, Fed. Rep. of1976PrivatePoolAll7, 930% of bank’s stated equity capitalNo
Italy
Japan1971JointSmall poolAll domestic currency6, 9¥ 3,000,000Yes
Luxembourg
Netherlands1979JointUnfundedAll but company depositsf. 30,000No
SwitzerlandUnder considerationPoolAll100% up to Sw F 20,000

75% Sw F 20,000–30,000

50% Sw F 50,000–75,000
Yes10
United Kingdom1982OfficialSmall poolAll domestic currency75% up to £10,000Yes10
United States1933OfficialPoolAllUS$100,000No11
Sources: Various official; and Dale (1982).

Countries listed are the industrial countries whose banks are active in the international capital markets.

Schemes organized by banks in most cases were undertaken at the initiative of the authorities.

Unfunded schemes are supported by guarantees from the participating banks. Pools often include similar protection. In the United States, for example, the Federal Deposit Insurance Corporation has a credit line with the Treasury.

Liabilities to other banks are usually not covered. Coverage is usually limited to banking entities located within the country. In some cases, certain types of deposit are not covered (e.g., “bons de caisse” in France, certificates of deposit in the United Kingdom).

No formal system in effect, but the Rediscount and Guarantee Institute provides financial support to troubled banks, with further support available since 1975 from a supplementary special intervention reserve.

Excludes domestic branches of foreign banks.

Pay-off discretionary.

Also covers interbank deposits.

Includes foreign branches of domestic banks.

Except for foreign banks with equivalent coverage from home country.

However, U.S. branches of foreign banks doing retail business and, by state law, banks in all but three states must be members.

Sources: Various official; and Dale (1982).

Countries listed are the industrial countries whose banks are active in the international capital markets.

Schemes organized by banks in most cases were undertaken at the initiative of the authorities.

Unfunded schemes are supported by guarantees from the participating banks. Pools often include similar protection. In the United States, for example, the Federal Deposit Insurance Corporation has a credit line with the Treasury.

Liabilities to other banks are usually not covered. Coverage is usually limited to banking entities located within the country. In some cases, certain types of deposit are not covered (e.g., “bons de caisse” in France, certificates of deposit in the United Kingdom).

No formal system in effect, but the Rediscount and Guarantee Institute provides financial support to troubled banks, with further support available since 1975 from a supplementary special intervention reserve.

Excludes domestic branches of foreign banks.

Pay-off discretionary.

Also covers interbank deposits.

Includes foreign branches of domestic banks.

Except for foreign banks with equivalent coverage from home country.

However, U.S. branches of foreign banks doing retail business and, by state law, banks in all but three states must be members.

This automatic underpinning for confidence of depositors in many domestic banking systems is largely absent in international banking. While deposit insurance systems do not, by and large, make any distinction between domestic and international depositors, the fact that limits of coverage are low relative to the size of international deposits means that only a small fraction of international deposits is covered. The exclusion of interbank deposits by most systems further reduces the importance of deposit insurance.

Financial Support for International Banks

To help prevent the problems of individual banks from affecting the rest of their domestic banking systems, official agencies provide liquidity support for banks in difficulty. In many banking systems, a certain amount of official support is available almost automatically through, for example, central bank discount windows. Beyond that, however, the extent to which the national authorities are prepared to assist a financial institution is left vague—purposely so, on grounds of moral hazard.21 Generally, however, they indicate their intention to intervene when they judge it to be necessary, and confidence in their capacity to do so has been generated by the success of their past interventions.

This system of support for domestic banks extends to their international transactions, although various complexities can arise. In the case of the Franklin National Bank, for example, the Federal Reserve Bank of New York, which initially provided its support in U.S. dollars, was faced with the fact that holders of foreign exchange were not prepared to sell to the Franklin National Bank for fear that they would not receive payment. Eventually, the U.S. Federal Reserve undertook to purchase foreign exchange on behalf of the Franklin National Bank to permit the latter to meet its obligations.22

By the same token, the system of support extends virtually automatically to the foreign branches of domestic banks, since for most legal purposes the parent bank is fully responsible for meeting the obligations of the branch.23 In effect, therefore, the parent bank authorities have the ultimate responsibility. The national authorities in that case could normally count on the cooperation of the host country’s authorities, particularly with respect to liabilities in the host country currency. The Franklin National Bank was the first case in which the U.S. discount window was used to cover outflows at foreign branches, and in that case the Bank of England helped the U.S. authorities to perfect the assets of the bank’s London branch, which was needed to secure the advances they had made to the bank.

The situation of subsidiaries is less clear. While the parent bank does not, in general, have formal legal responsibilities, it could normally be expected to support the subsidiary in order to preserve confidence in itself. Where subsidiaries have confirmed lines of credit with the parent (a common practice), the parent’s obligation would be automatic to that extent. Beyond these considerations is the issue of the moral responsibility of the parent.

The bank failures of 1974, particularly that of the Israel-British Bank, focused attention on the question of moral responsibility. The U.K. authorities pressed for international understandings based on the British practice, under which the parents of a closely held subsidiary are virtually required to take responsibility for its obligations. In the case of the Israel-British Bank, the Bank of England argued that it had no responsibility as lender of last resort for a British subsidiary of a foreign bank, though in an eventual compromise with the Israeli banking authorities the Bank of England contributed to the pool of assets created by merging the resources of the subsidiary with those of the Israeli parent. In the fall of 1974, the Bank of England asked for “comfort letters” from the owners of consortium banks and the foreign parents of U.K. subsidiaries, asking them to acknowledge their “moral responsibility,” defined as “responsibility to support those investments beyond the narrow limits laid down by laws of limited liability and, above all, as responsibility to protect depositors with those banks.”

Another means of reinforcing the idea of parental responsibility, adopted in Luxembourg, is to require subsidiaries to bear the name of the parent.

Lenders of last resort in other countries have not, in general, acknowledged that they incur any obligations as a result of comfort letters or other understandings between the host country authorities and banks. (In 1976, however, the U.S. Federal Reserve Board indicated that, in deciding on approval of applications by U.S. banks to open foreign subsidiaries, it would take into account the possibility that the parent could be requested to provide support beyond its original commitment.) Thus, even more than in the case of supervisory responsibility, there is ambiguity about the obligations of lenders of last resort with respect to foreign subsidiaries. In this case, as supervisors are quick to point out, there is not even a concordat.24 Nonetheless, informal understandings appear to be evolving in this area. As in the case of supervision, the responsibility appears increasingly to be placed on the authorities of the parent banks. While some ambiguities remain (witness the recent dispute over support for Banco Ambrosiano Holding in Luxembourg), by and large, when both the subsidiary and the parent are located in industrial countries, the banking authorities in the two countries can be expected to arrive at a satisfactory division of their responsibilities as lenders of last resort. The complexity of ownership of consortium banks, however, might give rise to operational problems in the event of difficulty.

Other banking entities might not be so reliably supported. Particularly in question would be the status of subsidiaries of banks based outside the industrial countries, as the parent authority might lack the ability and willingness to provide support. The status of subsidiaries operating in some offshore centers might also be in question, as there would be neither a local lender of last resort nor, perhaps, a strong understanding on the moral obligations of the parent bank and its authorities. Such banks are in a sense on the fringes of the system, and it is unlikely that failure of a few of them would, in itself, lead to major problems for banks in general. Nonetheless, a residual uncertainty will remain until such banks are firmly brought under the wing of a reliable lender of last resort.

Resolution of Bank Failures

As with their role in providing financial support, the role of lenders of last resort in winding up the affairs of failing banks has special features when international aspects are involved. Even more than in domestic banking, an orderly conclusion of the affairs of failing international banks is important to minimize both the direct financial burden placed on bank creditors and the inevitable shock to the confidence of depositors caused by failures.

After the failures of the 1930s, no failures of major international banks took place until 1974. Lenders of last resort, which inevitably play a major role in winding up the affairs of failing banks, thus did not have their capabilities tested. The contrasting experiences of the Franklin National Bank and Bankhaus I.D. Herstatt in 1974 provide a number of examples of the special aspects of failures of international banks. A difference in viewpoint at that time between the U.S. authorities and those in the Federal Republic of Germany accounts for much of the contrast.25 The U.S. Federal Reserve intervened early to manage the Franklin National Bank crisis, while the Deutsche Bundesbank argued in the case of Bankhaus I.D. Herstatt that it should not help banks whose problems resulted from illegal activities. Such differences in philosophy apparently still exist among lenders of last resort, but some common lessons about the need for orderly action seem to have been drawn from those experiences.

Despite the fact that the Franklin National Bank was much larger than Bankhaus I.D. Herstatt, the international repercussions of its failure seem to have been less. A major reason is that the U.S. authorities took special action to keep the Franklin National Bank operating and to ensure that the bank met its immediate commitments, in contrast to the abrupt closure of Bankhaus I.D. Herstatt. The fact that not even spot foreign exchange transactions were completed in the latter case meant that, for a time, most banks other than the largest international banks had difficulty in dealing in foreign exchange. While the Franklin National Bank’s demise may also have contributed to the general loss of confidence in the health of the international banking system at the time, the orderly way in which it was handled was a positive factor. Since then, a number of banking systems have adopted new techniques for dealing with bank failures.

A major question for international confidence is the treatment accorded to foreign creditors in the event of bank failures. Certain actions taken by the U.S. authorities following the failure of the United States National Bank of San Diego in 1973 had left foreign banks uncertain about their situation, and part of the rapidity with which foreign creditors withdrew their funds from the Franklin National Bank may have reflected that experience. In any case, the Federal Deposit Insurance Corporation acted throughout to ensure that foreign creditors would receive no less favorable treatment than domestic creditors. More recently, when the First Pennsylvania Bank was in difficulty, the U.S. Federal Reserve’s public statement of support was reportedly aimed at preventing foreign creditors of other regional U.S. banks from withdrawing their funds.

This approach contrasts with the initial reaction of the German authorities to the failure of Bankhaus I.D. Herstatt, which created some concern abroad that foreign creditors might not receive equitable treatment. Eventually, however, in what has been characterized as “essentially a political solution,” the bank’s foreign creditors in fact received a higher percentage of their claims than did most domestic creditors (Spero, 1980).

International supervisory groups—the European Community’s Contact Group and the Basle Committee—have come to play an important indirect role in dealing with problems of failing banks by providing informal networks through which supervisors can consult each other about the problems of particular banks. This sort of consultative process has begun to be extended to the offshore centers through the establishment of a group of offshore supervisors.

Some problems of coordination still remain, as evidenced by the failure of Banco Ambrosiano, discussed in Section II. A recent example involving a bank outside the industrial countries was the failure of Argentina’s Banco Intercambio Regional. When the Argentine authorities declined to accept responsibility for claims on the bank’s New York branch on grounds that they lacked the authority to do so, the New York State Banking Department took possession of the branch, which had the resources to pay off its own creditors. This action raises awkward questions about conflicting interpretations of the role of lender of last resort, with New York State authorities going against the normal practice of considering the branch an integral part of the parent and seemingly asserting that Argentina had an obligation to protect all foreign creditors. There may also have been concern that the Argentine authorities were not in a position to assure equitable treatment of the creditors of the branch if its assets were left under the parent’s control. Perhaps such action would not have been taken in the case of an institution whose supervisors were in closer contact with the U.S. authorities.

Lenders of Last Resort and System-Wide Liquidity

In domestic banking systems, lenders of last resort provide resources in one way or another to the banking system as a whole to preserve liquidity in the face of deposit withdrawals. Such actions can prevent undesirable changes in the money supply and in the value of bank assets by preventing a rise in interest rates and, through their general macroeconomic effects, by supporting the ability of bank debtors to be able to repay their debts. The decline in the confidence of depositors is thus arrested.

When international banking is involved, however, implementation of such a policy might encounter balance of payments constraints, particularly if foreign depositors were less easily reassured than domestic depositors. Hence comes the emphasis, noted previously, on the need for fair treatment of foreign creditors of failing banks. Insofar as the funds withdrawn were reinvested in other instruments in the same country, no capital outflow would result, but in practice some net outflow would be likely. If the drain was very large, the lender of last resort might decide to restrict its banks’ repayment of foreign obligations, whether booked domestically or abroad.26

It thus is important that a lender of last resort faced with balance of payments difficulties resulting from banking problems be able to obtain balance of payments support. The Basle Committee has considered ways in which central banks could cooperate in providing financial support to troubled banks. The major official statement in this area appeared in a communiqué following the September 1974 monthly meeting of the Central Bank Governors of the Group of Ten and Switzerland:

  • The Governors . . . had an exchange of views on the problem of the lender of last resort in the Euro-markets. They recognized that it would not be practical to lay down in advance detailed rules and procedures for the provision of temporary liquidity. But they were satisfied that means are available for that purpose and will be used if and when necessary.

This statement, which has been reaffirmed on a number of occasions, was designed to provide assurance of the availability of liquidity to deal with system-wide banking disturbances. It clearly was not intended to imply agreement on the provision of liquidity to individual banks, nor did it address the question of how to ensure a continued flow of international finance through banks. It is the possibility of an interruption of that flow that gives rise to questions about an international “lender of last resort”—not for banks, but for borrowers who have lost their access to bank lending.

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