Protecting the financial system from cross-border contagion

In brief

Written by Partner Matthew McLennan and Senior Associate David Harris

In the aftermath of the global financial crisis, governments and regulators have been busy identifying ways to better protect the financial system from future shocks. Among these are measures for arming financial regulators with a more comprehensive 'crisis management toolkit'. Of particular concern are authorised deposit-taking institutions (ADIs) that operate across borders, giving rise to the risk that distress in one large financial institution in one country could quickly spread throughout the global system. Existing laws have focused on the protection of individual creditors of such institutions. Proposed reforms would see a shift in focus to protecting the health of the financial system as a whole. 

Protecting Australian interests in a global crisis

Australia's Banking Act 1959 (Cth) contains a predictable, if protectionist, approach to resolving priority claims in the event of a foreign ADI facing financial distress. Section 11F stipulates that:

If a foreign ADI (whether in or outside Australia) suspends payment or becomes unable to meet its obligations, the assets of the ADI in Australia are to be available to meet the ADI's liabilities in Australia in priority to all other liabilities of the ADI.

This differs from the default position under the model law for cross-border insolvency. Under the model law, an insolvent multinational ADI would be wound up in its 'centre of main interests' (often its head office and central business location outside Australia). All its assets would be pooled together and then distributed on a pro-rated (rather than priority) basis among all creditors by a single liquidator, leaving Australian creditors to receive cents in the dollar for their claims (and leaving Australian shareholders and deposit-holders in a far less certain position). Section 11F is a departure from the model law.

A protection without sufficient power to implement it?

However, a difficulty with giving effect to section 11F for the benefit of Australian creditors is that the Australian Prudential Regulation Authority (APRA) at present lacks the power to appoint a statutory manager to control the business of an Australian branch of a foreign ADI. This presents a potential problem if the foreign parent is taking insufficient action to protect Australian creditors (or is taking action contrary to Australian interests, such as seeking to remove assets from Australia). There is also some ambiguity in the current legislation concerning APRA's ability to apply to the courts to wind up a foreign ADI's Australian business. Accordingly, unless the Banking Act is amended to address these issues, APRA may not have sufficient power to ensure that the Australian assets of a foreign ADI are made available to meet the ADI's Australian liabilities in priority to all of its foreign liabilities.

These deficiencies were picked up in the Commonwealth Treasury's comprehensive September 2012 consultation paper, titled Strengthening APRA's Crisis Management Powers, and in the final report of the Financial System Inquiry (FSI). A key line of defence against the contagion risk referred to earlier is the power of the prudential regulator, APRA, to intervene during a crisis (or better yet, before a crisis develops) to ensure an orderly resolution of the distressed entity. To strengthen these powers, Treasury proposed amendments to the Banking Act that would:

• give APRA the power to appoint a statutory manager to the Australian business of a foreign ADI;
• give APRA the power to facilitate the compulsory or voluntary transfer of business from a distressed Australian branch of a foreign ADI to a bridging entity to assist in the cross-border resolution of the ADI;
• clarify APRA's powers to apply for the winding-up of a foreign ADI's Australian business; and
• more generally, encourage APRA to carry out further work in relation to pre-planning for resolution, including developing plans for specific entities, which may extend to stress-testing to identify systemic risks.

The FSI gave these proposals its strong support.

Shifting the focus

Treasury's proposals mark a shift in focus. Rather than relying on section 11F of the Banking Act to give priority to individual Australian creditors after a foreign ADI encounters financial difficulty, the proposals would see APRA intervene earlier and address potential issues with an entity before it became distressed. Where APRA exercised its powers in a time of crisis to appoint a statutory manager or wind up the Australian business of a foreign ADI, the focus would be on protecting the financial system as a whole and avoiding contagion from a distressed entity, rather than just protecting the entity's individual creditors in Australia.

The industry will need to wait a little longer to see which, if any, of the proposals are pushed forward, and the precise form that any regulatory changes will take. The FSI final report supported the proposals but recommended, given the time elapsed since the Treasury consultation paper, that further consideration of stakeholder views, regulatory assessment and compliance cost assessment be undertaken, along with a consideration of international developments in the last two years.

In the meantime, Treasury's consultation paper had identified two particular risk areas that would be a focus of further discussion:

• Treasury is mindful not to discourage participation in the Australian market by foreign banks. The risk is that, if the regulatory burden is too high and the consequences of a crisis too severe, foreign ADIs may either avoid the Australian market altogether, or adopt alternative structures that are harder to manage in the event of a crisis.
• Faced with a crisis and the possibility that APRA would appoint a statutory manager or apply to wind up the Australian business to protect the Australian assets, there is a heightened risk of unscrupulous (or desperate) foreign ADIs rapidly stripping the assets of the Australian branch and avoiding constructive dialogue with APRA in the lead-up to a crisis.

These risks should be fully considered in the next round of consultation. The consultation process should also focus on the effects of increased regulation on the industry outside times of crisis. Although the FSI's final report asserts that 'many of the proposed powers would have a limited regulatory burden in normal times', this would of course depend on how APRA would exercise any new powers in practice.