Governance of International Banking: The Financial Trilemma

By Dirk Schoenmaker

International banking is at the cross-roads. Are we heading for the decentralised banking model, by which banks are split in national subsidiaries supervised by national supervisors? Or can we maintain the integrated business model for international banks? In a new book on Governance of International Banking, published by Oxford University Press, the author Dirk Schoenmaker explores the trade-offs between internationally active banks and national supervision.


The Global Financial Crisis has shown that the international financial system is vulnerable to breakdown. The financial trilemma demonstrates that financial stability, international banking and national financial supervision cannot be combined. National supervisors force international banks to keep local liquidity pools and capital buffers, which cannot be transferred. This national approach is a very costly solution to the trilemma. Governance of International Banking advocates an alternative solution to keep international banking alive. The central element is an international coordinated approach to supervision and resolution of international banks. International financial institutions, like the Bank for International Settlements and the International Monetary Fund, should take on a supervisory role of global systemic banks, broadening their mission for monetary stability to one that includes monetary and financial stability. At the European level, the European Central Bank is currently assuming the financial stability mandate for the European banking system.

The Global Financial Crisis has shown that the international financial system is vulnerable to breakdown. The financial trilemma demonstrates that financial stability, international banking and national financial supervision cannot be combined.

The financial trilemma

The financial trilemma states that policy-makers have to choose two out of the three policy objectives: 1) financial stability, 2) international banking, and 3) national financial policies. The outcome of the financial trilemma is crystal clear. Financial authorities need to operate over the same terrain as banks, if one wants to maintain financial stability. So, the public domain will need to assert itself on the global banks, which underpin the wider global financial system (giving up the 3rd objective). Alternatively, national regulators will need to require the current global banks to turn their banking group into a string of nationally licensed stand-alone-subsidiaries (giving up the 2nd objective). The model of the financial trilemma, developed in a new book on Governance of International Banking1, has laid the theoretical foundation for this strong conclusion. The game of cooperation between national supervisors is basically an application of the prisoner’s dilemma. By putting their own self-interest first, supervisors cannot reach the cooperative equilibrium. The handling of international bank failures during the Global Financial Crisis confirms this non-cooperative behaviour in practice.


Global reform is deficient

Reform of global governance, guided by the Group of Twenty (G20) and executed by the Financial Stability Board (FSB), has so far focused on soft law solutions. Regulators adopt a consensual approach towards the setting of international standards. For day-to-day supervision, home and host supervisors of global banks work together in supervisory colleges. For crisis management, home and host authorities cooperate in crisis management groups. This approach is underpinned by legally non-binding Memoranda of Understanding (MoUs), buttressed by peer reviews of each other’s supervisory system.

The central thesis in the new book is that such voluntary cooperation is bound to break down, in particular in crisis times when cooperation is most needed. The explanation is that financial stakes are high and national governments, which are accountable to their national parliament, only take care of the domestic effects of an international bank failure. But how important and how international are these global banks? Empirical evidence shows that internationalisation is still strong, though global de-leveraging is outpacing domestic deleveraging in the aftermath of the Global Financial Crisis. Half of the top 60 world banks have more than 25 percent of their asset base abroad. So, cross-border externalities are substantial and cannot be ignored. Recognising the importance of global banks, the FSB has developed a list of 28 so-called G-SIBs (global systemically important banks). All large and global banks – defined as total assets exceeding $1 trillion and foreign assets more than 25 percent of total assets – are on the FSB list.

Half of the top 60 world banks have more than 25 percent of their asset base abroad. So, cross-border externalities are substantial and cannot be ignored.

Global banks support the move to a supranational approach for banking supervision and resolution, because they fear the alternative of national subsidiaries with separate liquidity pools and capital buffers, which is very costly. These local liquidity and capital holdings will be trapped in the national subsidiaries, as the national supervisors want to keep these extra safety valves at the national level, in particular when a crisis hits and liquidity and capital should be directed to where most needed. It feels like not being able to use the firemen and water resources of a neighbouring village, when the village’s fire brigade is fighting a raging fire.

But the politicians are in charge of global governance and not the private sector. The dominant approach in the leading economies, notably the US and China, is national. The US applies a territorial approach, which puts domestic interests first in a bankruptcy. By contrast, Europe favours a universal approach, under which all depositors (and creditors) get equal treatment. Moreover, Europe is exploring a Banking Union in response to the ongoing sovereign and banking crisis in Europe. There are important parallels between the vulnerability – in the form of cross-border externalities – of the European banking system and the global banking system.

The ultimate driver for global governance of the global financial system may come from the corporate sector and citizens. Multinational companies produce and trade on a global scale. To operate on a global scale, these multinationals need the services of globally operating banks that can execute cross-border payments efficiently and pool local balances – held in various currencies – centrally at the end of the day. Citizens enjoy the benefits of a wide choice of domestic and foreign products and services, at low prices. Furthermore, global travel and global consumption may foster a transnational identity on top of a strong national identity. That may, in turn, provide a fertile ground for developing an international approach towards governance. The result is then a multi-layered approach towards governance, whereby most economic issues are dealt with at the national level and some at the European, or wider global levels. However, some observers have a more sceptical view. Dani Rodrik, for example, argues that the nation state remains the only game in town, when it comes to global governance.


Global governance is needed

How would a system of global governance look? While policy-makers tend to embrace evolutionary methods, a piecemeal approach may make things worse. The combination of an international supervisor (whether European or global) of banks with national resolution of bank failures distorts incentives. What is the incentive for the international supervisor, other than reputation, to put in sufficient effort, if somebody else pays the bill in case of failure? That is why Charles Goodhart and I have always stressed in our joint work that supervision and resolution should be at the same level. The guiding principle for decision-making on crisis management is “he who pays the piper calls the tune”.

The combination of an international supervisor (whether European or global) of banks with national resolution of bank failures distorts incentives.

The endgame of resolution sets the incentives for ex ante supervision. In that light, I apply a backward-solving approach, illustrated by the backward arrow for the fiscal backstop in Figure 1. The design of global governance thus starts with mobilising the funds for resolution, the so-called fiscal backstop. At the European level, the European Stability Mechanism (ESM) is fulfilling the role of the European crisis fund for countries and is now on the verge of expanding that role to banks.

A European governance system may therefore consist of the following building blocks: the European Commission (EC) as European rule-maker, the European Central Bank (ECB) as European supervisor and lender of last resort, a new European Deposit Insurance and Resolution Authority (EDIRA), and the ESM as fiscal backstop (see Figure 1). The European Deposit Insurance and Resolution Authority will be the new player in this governance system. To minimise the cost for taxpayers and maximise private sector involvement, this new Authority should build a deposit insurance fund, funded by risk-based premiums levied on the European banks. Only after that fund is exhausted would the European Deposit Insurance and Resolution Authority have access to the ESM.

Moving to the global level, the International Monetary Fund (IMF) is the international financial institution with resources for crisis management (Figure 1). The IMF would broaden its global support from sovereign countries to global banks and thus become the International Resolution Authority for global banks. The IMF already has the governance arrangements in place for involvement of, and accountability to, the ministers of finance who provide the resources to the IMF.



While many observers would also give the role of international supervisor of global banks to the IMF, I argue for the Bank for International Settlements (BIS) for two reasons. First, supervisory independence, one of the core principles for effective banking supervision, would be violated. As ministries of finance play a dominant role in the governance of the IMF (which is much needed for the decision-making on spending public resources for crisis support to countries or banks), the IMF cannot act independently from government. Second, the functions of supervision and resolution should be separated. Supervisors have a tendency towards forbearance hoping for better times, while resolution authorities aim for timely intervention to minimise the costs.

The BIS has required a strong reputation in international policy-making, as host to multiple international committees, notably the Basel Committee on Banking Supervision. But a major overhaul would be needed. First, the BIS has no supervisory capacity. It would need to expand its staff resources. Next, the BIS is currently a cosy central bankers’ club. It will need to beef up its governance, moving to appropriate accountability mechanisms, including the appointment of the BIS head by the G20. Finally, the Financial Stability Board (FSB) – also under the political guidance of the G20 would remain the international body for driving the international policy agenda and international rulemaking.


Addressing moral hazard

The main objection towards global governance is moral hazard. International safety nets would induce excessive risk-taking by the institutions or countries that enjoy the protection. That objection needs to be addressed. The international policy agenda, after the Global Financial Crisis, has already substantially strengthened the capital framework. That is much needed. The FSB is also implementing a capital surcharge for G-SIBs. Moreover, the authorities need to ensure that a resolution plan is in place for the G-SIBs. That would facilitate an orderly wind-down and make it possible to (partly) liquidate non-systemic parts of a global bank.

Such extra capital charges and resolution plans should be in place for all banks under global supervision. The capital surcharge is only foreseen for the risk-weighted capital ratio (capital divided by risk-weighted assets) of global banks. I argue to increase the leverage ratio (capital divided by total assets) accordingly. That would strengthen the supervisory lever on risk-taking and unbridled expansion of the balance sheet by large banks.

In sum, the remit of the ESM in Europe and the IMF in the world would be expanded from international monetary stability to international monetary and financial stability. That is in line with the current trend at national central banks, which are now moving beyond their narrow monetary mandates. The role of the ESM and the IMF would be broadened from global support for sovereign countries to global support for global banks, recognising the key role of these banks in the global financial system. If and when these fiscal backstops are in place, the supervision can also be lifted to the ECB for the European banks and, perhaps later, to the BIS for the truly global banks. That would make the global financial system a safer place.

About the Author

Dirk Schoenmakeris Dean of the Duisenberg School of Finance and Professor of Finance, Banking and Insurance at the VU University Amsterdam. He has widely published on international banking and financial stability, including a new book on ‘Governance of International Banking’ and a textbook on ‘Financial Markets and Institutions: A European Perspective’. He is a member of the Advisory Scientific Committee of the European Systemic Risk Board, the new authority for macro-prudential policy at the European Central Bank. He is a consultant for the IMF, the OECD and the European Commission.


1. Schoenmaker, D. (2013). Governance of International Banking: The Financial Trilemma. New York: Oxford University Press.


The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.