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The fault lines in cross-border banking: lessons from the Iceland case Már Gudmundsson Governor, Central Bank of Iceland BIS-FSI-IMF Meeting on the Emerging Framework for Financial Regulation and Monetary Policy Washington, DC, 23 April 2010 Outline of the presentation • Setting the stage: foreign currency liquidity risk and the run on cross-border banking • The case of the Icelandic banks • Some reflections on the lessons and the reform agenda 2 Foreign currency liquidity risk • Risk underestimated before the crisis • Cross-border banking with maturity mismatch in terms of foreign currency • Often not sufficiently regulated or backed by capital or lender of last resort (LOLR) • Well documented in several BIS studies and an excellent recent CGFS report 3 Intense materialisation post-Lehman • Run on cross-border banking: – Intense deleveraging and transfer of funds to the US – Freezing of interbank funding markets and dysfunctional FX swap markets • From banking crisis to country crisis: – Iceland, Hungary, Ukraine, Pakistan, etc. • Retreat from cross-border banking: – Cross-border lending down 15% since early 2008 – Talk of de-globalisation, shrinking back to the domestic base, and fragmentation through standalone subsidiaries 4 Near-term responses • Use of FX reserves • Geographic extension of LOLR through swap agreements • IMF to the rescue 5 The case of the Icelandic banks 6 The recent Icelandic saga Two separate but interrelated stories: 1. Iceland’s boom-bust cycle and problems with macroeconomic management in small, open, and financially integrated economies 2. The rise and fall of three cross-border banks on the basis of EU legislation (the European “passport”) The two converged in a tragic grand finale in early October 2008, when Iceland’s three commercial banks failed and were placed in special resolution regimes. 7 The European Economic Area • Iceland became a member of the EEA in 1994 • Free movement of capital • European “passport” for financial institutions headquartered in any country within the area • Common legal and regulatory framework … • … but the safety net (e.g., deposit insurance and LOLR) and crisis management and resolution remained largely national • There was a built-in vulnerability/risk in this setup, especially for small countries outside the euro area 8 Consolidation and privatisation • The Icelandic banks began consolidating in the 1990s. • They were gradually privatised from the late 1990s, a process largely completed in 2003. • Based on the EU “ passport,” Icelandic banks grew very rapidly by expanding their activities abroad, for the most part by acquiring financial institutions in other countries, opening up bank branches, and stepping up foreign operations. 9 Rapid expansion of the banks 10 Small countries, big banks Banking Assets to GDP, % 1000% 2001 900% 2007 800% 700% 600% 500% 400% 300% 200% 100% 0% Iceland Ireland Hong Kong SAR Singapore Switzerland Source: IMF: Cross-Cutting Themes in Economies with Large Banking Systems 11 Geographic dispersion • 41% of total assets in foreign subsidiaries • 60% of total lending to non-residents and 60% of income from foreign sources • Over 2/3 of total lending and deposits in foreign currency • Kaupthing – operated in 13 jurisdictions: Austria, Belgium, Denmark, Dubai, Finland, Germany, the Isle of Man, Luxembourg, Norway, Qatar, Sweden, Switzerland, and the UK. 12 Not outliers in terms of capitalisation 13 Somewhat weaker in terms of liquidity But there were hidden vulnerabilities Official Less “weak” capital CAD ratio 11% 7% Tier 1 ratio 9% 5% Equity/tangible assets 6% 3% Leverage ratio 16 31 Bond maturity Liquidity ratio 5y 1.7 5y 1.7 As of 30 June 2008 “Weak” capital is bank equity financed by lending from the banks themselves. Icelandic banks had the largest foreign currency liabilities in relative terms Banking External Debt Liabilities to GDP, % 700% 600% 2001 500% 2007 400% 300% 200% 100% 0% Iceland Ireland Hong Kong SAR Singapore Switzerland 16 Building defences • It was clear by early 2008 that the banks were in dire straits and faced massive rollover risk in terms of foreign currency liabilities. • Authorities tried to negotiate swap lines, declined by ECB, BoE and Fed (told to go to the IMF) but negotiated € 1.5 m with Nordic countries in May. • In May 2008, Parliament approved substantial foreign borrowing to boost FX reserves (€ 5 m, mostly unused). 17 FX liquidity available to the Central Bank was dwarfed by the banks’ FX liabilities Foreign currency liabilities of banks and CB forex reserves september 2008 800% 700% 600% 750% GDP 500% 400% 300% CB forex reserves: 21% GDP 200% CB swaps and credit lines: 14% GDP 100% 0% Foreign currency liabilities of the banks CB forex liquidity 18 The banking collapse • The three cross-border banks all failed during the first full week of October 2008. • Almost 90% of Iceland’s financial sector collapsed. • Large by any criteria: Kaupthing, at USD 20 bn, ranks 4th in the world in corporate failures; Iceland’s 3 banks combined come in 2nd, after Lehman. • Event of systemic proportions in parts of Europe 19 Causes? • Most of the usual suspects of the international financial crisis were at play... • ..but also specific vulnerabilities of “weak” capital, interconnectedness and a rapidly souring loan book. • Key vulnerabilities and the immediate causes of demise were large foreign currency liabilities with a maturity mismatch and disproportionate size relative to home base. • Non-cooperation and bad crisis management across interested jurisdictions made things worse. 20 Some reflections on the lessons and the reform agenda 21 Key lessons not fully understood • Most reports focus on supervisory failure and the associated home host responsibilities. • This is only part of the story. • The failure of the Icelandic banks was also rooted in key design flaws in the EU/EEA framework for cross-border banking: – European passport but national supervision, deposit insurance, crisis management and resolution – Regulatory framework largely ignored foreign currency liquidity risk ... – ...and country size. 22 EU reform agenda • Key proposals (e.g., De Larosière) do not go far enough and do not measure up to the Icelandic experience. • We need to move towards EU supervision, deposit insurance, crisis management and resolution regimes for cross-border banks. • Specific risk for and of EU/EEA countries outside the euro area must be addressed. • Should banks from such countries (especially the small ones) have the same “passport” rights and/or capital charges as banks inside the euro area? 23 Deposit insurance • The EEA/EU framework for deposit insurance was put to the test and found seriously lacking. • The framework violated the insurance principle of pooling and ignored the difference between insuring in one’s own currency and that of others. • Unclear regulation has also proved unhelpful in a dispute between Iceland and the UK and Netherlands concerning the reimbursement of Icesave deposits in branches of Landsbanki. 24 The global issues • Retrenchment and de-globalisation? • Separately capitalised subsidiaries? • Global extension of LOLR: FX swap lines or global FX liquidity pool? Who will have access? • Truly international banks only based in a handful of countries? • Let us hope we can address this situation successfully, as the benefits of financial globalisation are substantial. 25