Transcript As of 30 June 2008 Official Less “weak” capital

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.
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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