Lessons from the financial crisis for cross-border banking

1. Lessons from the financial crisis for cross-border banking Már Gudmundsson Governor, Central Bank of Iceland SUERF/BWG Conference and Special OeNB East Jour Fixe “Contagion and Spillovers – New Insights from the Crisis” Vienna, February 12 2010

2. Outline of the presentation The run on cross-border banking The case of the Icelandic banks The lessons The reform agenda Conclusions

3. The run on cross-border banking

4. Some stylised facts Ebbs and flows of cross-border banking linked to economic cycles in advanced countries and financial crisis more generally Retreat from cross-border banking during the latest financial crisis (BIS international banking statistics)

5. Claim growth linked to crises US recessions Financial crises Highest YoY growth in 20 years!

6. European versus US banks • European banks borrowed dollars from other banks (probably mostly US) and accumulated US-dollar denominated claims on non-banks • European banks were therefore vulnerable to the drying up of US-dollar wholesale markets as occurred during the turmoil • US banks borrowed from non-banks

7. Post Lehman: international bank run • Intense deleveraging and transfer of funds to the US • Freezing of inter-bank funding markets • Run on cross-border banking operations • FX swap markets dysfunctional

8. Global dollar liquidity shortage: FX swap spreads 1 Spread between three-month FX swap-implied dollar rate and the three-month Libor; the FX swap implied dollar rate is the implied cost of raising US dollars via FX swaps using the funding currency. Sources: Bloomberg; BIS calculations. • 12 Dec 2007: USD swap lines introduced • 18 Sept 2008: major expansion of USD swap lines • 13 Oct 2008: swap lines uncaped for some major central banks

9. From banking crisis to country crisis Several countries under pressure with banking and currency crisis interacting FX swap arrangements Use of FX reserves IMF rescue packages (Iceland, Hungary, Ukraine, Pakistan, etc)

10. Retreat from cross-border banking

11. The crisis and international banking • Concerns in host countries: • Withdrawal of cross-border lending • Reduced activity of foreign bank’s subsidiaries or branches • Concerns in home countries: • Risks in cross-border operations • Retrenchment to home base or • collapse – Iceland’s extreme case

12. The case of the Icelandic banks

13. The recent Icelandic saga Two separate, but interrelated stories: Iceland´s boom-burst cycle and problems with macroeconomic management in small open and financially integrated economies The rise and fall of three cross-border banks on the basis of EU legislation (the European “passport”) The two came together in a tragic grand finale in early October 2008 when the three banks failed and were put into special resolution regimes.

14. 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 (eg deposit insurance and LOLR) and crisis management and resolution remained largely national There was a inbuilt vulnerability/risk in this setup, especially for small countries outside the euro area

15. Consolidation and privatisation The Icelandic banks entered into a process of consolidation in the 1990s. They were also gradually privatized from the late 1990s; a process largely completed in 2003. Based on the “EU Passport,” the Icelandic banks proceeded to grow 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 their foreign operations.

16. Extremely rapid expansion

17. Relatively big and geographically dispersed Total assets around 200 b.$ or 11 times Iceland’s GDP before the collapse 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 of deposits in terms of foreign currency Kaupthing – in 13 jurisdictions: Austria, Belgium, Denmark, Dubai, Finland, Germany, the Isle of Man, Luxembourg, Norway, Qatar, Sweden, Switzerland and the UK.

20. Some key metrics as of June 30, 2008

21. Capital adequacy and funding duration for some selected banks in March 2008 Source: the Riksbank and Bloomberg

22. Why did the banks then fail? Big foreign currency balance sheets with a significant maturity mismatch but without a lender-of-last resort (LOLR) Size relative to the home base (country and currency) Fatal flaws in the EU financial architecture Domino vulnerabilities in Iceland’s financial sector (eg cross-ownership, connected lending, large exposures across institutions) Flaws in business models, risk management, governance and accounting Non-cooperative crisis management across interested jurisdictions

23. Building defences Clear by early 2008 that the banks were in dire straits The main concern was the closure of foreign funding markets, associated rollover risk and an absence of a credible LOR in terms of forex Authorities tried to negotiate swap lines, declined by ECB, BoE and Fed (told to go to the IMF) but 1.5 m € with Nordic countries in May Parliament approved in May a big forex borrowing to boost forex reserves (5 m €; mostly unused)

24. Disorderly and hostile cross-border crisis management Lack of information sharing and co-operation across affected juristictions Early sale of “good” assets at firesale prices => recovery ratio for bond holders will be reduced UK authorities froze and ringfenced assets Further research will throw light on the UK decision to close Singer & Friedland that brought down Kaupthing – however, LOR loan in Sweden

25. Securing continued banking operations • Fundamental need to ensure continued banking operations in the country and prevent chaos: • Emergency Act: FSA got broad based intervention rights; deposits got higher priority than other unsecured claims; parliamentary approval of governmental capital injections • Icelandic FSA (FME) intervened in the three banks, at the requests of the banks’ boards • Statement from the Government that all deposits in Iceland were guaranteed • The banks’ assets were 10xGDP and in the absence of international cooperation, a forced down-sizing was the only option

26. Systemic European event Event of systemic proportions in parts of Europe Failure of private and public risk management policies in Iceland Failure of the EU framework for cross-border banking Figures as an example in major reports Will affect the shape of a future framework for the regulation and supervision of cross-border banks Also a key example of the problems with cross-currency liquidity management during the crisis - lack of CB liquidity provision and ELA facilities in terms of foreign currency

27. The lessons

28. Some (preliminary) lessons • The risks in cross-border banking were underestimated, especially the cross-currency part – see BIS research (Packer, McCauley, McGuire et al) • The crisis had a significant element of a run on cross-border banking: • Drying up of foreign currency funding, fx swap markets and the dollar shortage • In Iceland´s case a partial run on deposits in foreign branches and subsidiaries also contributed • Sizeable cross-border banking operations in small countries with their own currency are too risky

29. What will happen to cross-border banking? Retrenchment and de-globalisation? Separately capitalised subsidiaries? System of FX swap lines? FX liquidity pool to provide insurance against a run on cross-border banking (as we have domestically through CB liquidity provisions and LOLR)? Truly international banks only based in a handful of countries?

30. The reform agenda

31. G20 National authorities should establish supervisory colleges for each of the largest global financial institutions (in progress) FSF Principles for Cross-border Cooperation on Crisis Management (published in April 2009) Cross-border Bank Resolution Group reported to BCBS in September 2009 on improving bank resolution mechanisms and their application across borders BCBS/IADI Core Principles for Effective Deposit Insurance Systems issued in March 2009 for public consultation

32. Turner Review in the UK Global finance without global government: fault lines in the regulation of cross-border banks Problems with the EU architecture A new European institution to regulate and oversee the supervision of cross-border banks Increase national powers to require subsidiarisation or to limit retail deposit taking Reform of European deposit insurance – pre-funded resources

33. De Larosiére report Deposit guarantee systems in EU should be harmonised and preferably pre-funded Review existing powers of host countries in respect of branches European Systemic Risk Council and European System of Financial Supervisors Colleges of supervisors for all major cross-border institutions Burden-sharing not resolved

34. Assessment Key proposals (eg De Larosiére and Turner reports) do not go far enough and do not measure up to the Icelandic experience (seen wrongly as mostly a supervisory failure, which it was only partly) We need to go 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 need to be addressed – the lender-of-last-resort issue in a cross-border, cross-currency setting

35. Deposit insurance The EEA/EU framework for deposit insurance was put to the test and found seriously lacking Unclear regulation has proved unhelpful in a dispute between Iceland and the UK and Netherlands around the payment of Icesave deposits in the branches of Landsbanki The EEA framework violated the principle of matching international private action with international public measures and the insurance principle of pooling EEA active banks need EEA wide deposit insurance

36. Conclusions

37. Conclusions I • The financial crisis had an element of a run on cross-border banking and has resulted in a significant retrenchment • The case of the Icelandic banks clearly demonstrates the following: • There is a limit to the size of banks relative to the size of the currency area and/or country resources • The EEA framework for cross-border banking is flawed • “Banks are global in live, but national in death”.

38. Conclusions II Both the global and the European frameworks for the operation of cross-border banks needs reforming The alternative is de-globalisation of finance Let us hope it is the former!