I have described above how national authorities, with the aim of maintaining credit flows, have responded to the financial crisis through a series of measures in support of financial institutions. We next turn to the question of how these support measures give rise to cross-border effects. This question is important for two reasons. First, the cross-border effects of national policy measures im- ply that there is a divergence between policy behaviour which optimizes nar- row national interests and optimal policy behaviour. Thus, there are advantages related to international coordination. We will return to this topic in the next section when I consider the actual policy behaviour of policy makers during the crisis. Secondly, and more broadly, the cross-border effects mean that the different kinds of national policy intervention will affect international rela- tions, with implications for relations between national governments.
Effects on Policy goals in Foreign Countries
An important cross-border effect arises because, due to financial companies’
cross-border activities, national intervention affects the welfare of non-resi-
dents as well as residents. A distinction can be made between three channels through which the welfare of non-residents is affected.
First, if, in order not to disrupt credit flows, national authorities choose to support a bank with cross-border activities, this means that access to credit is maintained not only for residents but also for non-resident businesses and households who borrow from the bank in question. Thus, measures which sup- port credit by keeping financial companies afloat, also work to the benefit of foreign residents by maintaining their supply of credit too.
As a second channel, national guarantees on the debt obligations incurred by financial companies will prevent losses not only among domestic residents who are supplying finance to the company in question (in terms of deposits, direct loans, and/or by investing in bonds issued by the financial company) but also among the foreign investors who are contributing to the financing of the company. Thus, national guarantee schemes and other measures which make it possible for financial companies to honour debt obligations work also to the advantage of creditors who are resident in foreign countries.
Finally, as a third mechanism through which national intervention works to increase the welfare of foreign residents, the ownership of financial compa- nies, especially large companies, is often dispersed among national and foreign owners. This means that national policy interventions that in some way sup- port the survival of a financial company with its existing ownership structure, also work to the benefit of its foreign owners.
If policy-makers display self-oriented behaviour – that is, if they wish only to maximise the interests of their national constituencies – they will, in their choice of intervention, try to restrict the positive effects of the intervention which fall on foreign residents. One possibility is outright discrimination against foreigners, for example, by issuing guarantees only to domestic resi- dents. An indirect discrimination can be achieved if guarantees are provided only for those types of funding that are typically supplied by residents. The authorities may, for example, guarantee only bank deposits which are often supplied by national residents while not guaranteeing those types of finance, such as bonds issued by banks or loans raised through the wholesale markets, that are raised through markets in which a large proportion of lenders are for- eigners.
Self-oriented national authorities can further try to maintain the beneficial
effects within the domestic jurisdiction by imposing conditions on the recipi- ent financial companies. One possibility is to require that, in return for sup- port, financial companies should maintain lending in the national jurisdiction.
The maintenance of such national credit flows will be achieved at the cost of lower lending in other countries.
In the case of foreign ownership, self-oriented national authorities would be particularly inclined to choose intervention that destroys value for the owners of the companies. Governments may, for example, nationalise a foreign-owned company, offering low or no compensation to the owners. One possibility is to write down the value of shares to zero.
Cross-border Effects on the Effectiveness of Instruments
A further cross-border effect arises because the effect of policy measures to attract finance depends on which measures are implemented in other coun- tries. If, for example, public support is given to national financial companies to improve their capacity to attract funding, e.g. through public guarantees on funding, less funding will be available for financial companies from other countries. Similarly, the government’s injection of capital into financial compa- nies improves the capacity of the recipient companies to raise finance relative to companies which do not receive such support.
Thus, national policy measures which improve the capacity of firms to raise finance detract from the ability of other firms to attract finance, including firms from foreign jurisdictions. In the absence of international coordination, one possible outcome is competition among national governments to attract funding for their respective financial companies. The winners in such a com- petition would tend to be those governments that are able to offer the best protection, probably strong governments in countries with strong institutional frameworks.
Effects on National Competitiveness
Government intervention in support of distressed financial companies gives a competitive advantage to the national financial sector. Government inter- vention will make it possible for the country’s financial sector to obtain fund- ing at a lower cost than financial companies in countries that lack such public support. Furthermore, government intervention to support national financial
firms increases the confidence among financial clients that the company will continue to exist, and thus the confidence to engage in long-term customer relationships with the financial company concerned. These positive effects on the competitive position of national financial companies will be important especially for countries with large financial sectors relative to the size of the country, making a country particularly dependent on the jobs created through the financial sector.
Cross-border Effects of Insolvency Proceedings
Different national procedures exist for dealing with debtors who are experienc- ing difficulties in honouring debt obligations. In Denmark, for example, there is a procedure for borrowers to suspend debt payments for a brief period while attempts to restructure the company take place. Debtors, who are insolvent, undergo a procedure of bankruptcy which usually leads to the company’s disso- lution. In the United States, the Chapter 11 insolvency procedure can be used by firms which are likely to survive after a debt restructuring has taken place.
While negotiating with its creditors, the firm can suspend debt payments but is otherwise free to continue operations.
The legal procedures for dealing with situations where borrowers are unable to fulfil debt obligations, affect the allocation of losses between borrowers and lenders. Thus, in the United States where businesses can apply for a Chapter 11 procedure, borrowers will be in a stronger position and will thus be better positioned to make the lender agree to a debt restructuring which reduces the burden of repayment, to the detriment of creditors. Under this procedure, it may be expected that a larger proportion of losses will fall on the creditors, while the debtors will get away with easier terms.
National authorities can reduce the burden on borrowers by changing in- solvency proceedings. Such changes have cross-border consequences insofar as a proportion of lenders are foreign, e.g. where there is a large proportion of foreign banks in the banking sector. In this case, by changing the procedure for debt repayments, national authorities can shift the burden on to foreign lend- ers. In light of this possibility to shift the debt burden, one might expect self- oriented national authorities to alleviate the debt burden for debtors especially in countries with a large presence of foreign banks and in particular during a financial crisis in which the debt burden has grown to an unsustainable level.
Cross-border Effects of Schemes for Debt Relief
Through government schemes that provide support for debtors, debtors’ ability to repay can be improved. In the United States, the Obama Administration has implemented a special program (Making Home Affordable) that gives public support to the repayment of residential mortgage debt when certain conditions are met. Self-oriented national governments would be less willing to use public debt relief schemes as a means to ease the debt burden of borrowers when a high proportion of lenders are foreign. Thus, when there are a large number of foreign lenders, government debt relief schemes may benefit them in particular.