Már Guðmundsson: Cross-border banking - where do we stand?
Speech by Mr Már Guðmundsson, Governor of the Central Bank of Iceland, at the Eleventh
Asia-Pacific High Level Meeting on Banking Supervision, Manila, 11 February 2015.
* * *
Chairmen and distinguished participants,
I would like to begin by thanking the organisers for inviting me to address this impressive
meeting. I spoke in this forum in Tokyo in 2009. The title of my presentation then was The
collapse of Iceland's cross-border banks: lessons for regulation, supervision and crisis
management. The experience of the financial crisis in Iceland was then fresh in our minds,
and it was considered to be both an extreme and an interesting case. But now, after other
cases have been better analysed and after the banking and sovereign debt crisis in the euro
area, it is clearer that although there was a significant domestic element in the financial and
economic crisis in Iceland, the cross-border banking crisis aspect was to a significant degree
an extreme manifestation of a global problem. That is partly why I want to take a more global
perspective here today than I did in 2009 and ask where we stand with cross-border banking.
To gain a clearer perspective on the big risks in recent forms of cross-border banking, it is
useful to remind ourselves that fractional banking, with the associated maturity
transformation, is inherently very risky. In national settings we learnt through trial and error
over long periods how to design a safety net around the banking system in order to mitigate
it ́s inherent instability. The Bank of England was at the forefront in learning how bank runs
could be contained through lending against collateral to banks that were presumed to be
solvent.1 Deposit insurance was introduced later, both as an additional mitigating device
against runs and as a consumer protection device.
In order to operate this system, it was necessary to have an assessment of the state of
health of the banks. It was also necessary to mitigate the moral hazard introduced by the
safety net. Thus banking supervision initially emerged mostly as part of central banking,
although the legal powers were initially often on a weak foundation.2 Finally, bank resolution
schemes were needed to efficiently clean up any mess that might occasionally be made and
limit contagion from individual bank failures to the system as whole.
In many advanced countries, this system worked so well that the memory of bank runs had
faded. Perhaps this is why, when I last saw the musical about Mary Poppins in a theatre, the
scene with the bank run was omitted! Banks could still fail, of course, because of capital
erosion, and even entire banking systems could do so, as in the Nordic banking crises in the
late 1980s and early 1990s. But the liquidity risks inherent in fractional banking were mostly
contained.
It was an important causal element of the financial crisis that part of the financial sector had
escaped this safety net. This applied in particular to cross-border banking. Let me take two
examples to illustrate this.
First, the euro area as a whole had a more or less balanced current account position during
the build-up to the financial crisis. A fact that drew less attention at the time, however, was
that European banks had built up huge USD-denominated balance sheets that had
mismatches, especially in terms of maturity. This became a major problem when there was a
run on the dollar-denominated bank liabilities of non-US international banks post-Lehman.3
Second, the Icelandic banking system expanded very rapidly prior to the crisis, growing in
just five years from a combined balance sheet of less than 2 times GDP (at the end of 2003)
to almost 10 times GDP (in mid-2008). Most of this expansion was cross-border, and a
significant part of it was really off-border, having very little to do with Iceland, as both
financing and investment took place abroad.
This was facilitated by two factors: first, Iceland's membership in the European Economic
Area (EU + Iceland, Lichtenstein, and Norway), which gave banks headquartered anywhere
in the region the right to operate throughout the region, and second, the prevailing global
conditions of abundant, cheap credit.
Just before their failure, the Icelandic banks had foreign currency balance sheets amounting
to almost 7.5 times Iceland's GDP, with a significant maturity mismatch between assets and
liabilities. In comparison, the Central Bank of Iceland's foreign reserves amounted to 21% of
GDP.4
These and other examples I could mention were accidents waiting to happen. And happen
they did in the autumn of 2008, when, during the panic that gripped markets after the
collapse of Lehman Brothers, there was a full-scale run on cross-border banks' foreign
currency liabilities. What prevented the ensuing international dollar shortage from triggering a
widespread failure of internationally active non-US banks to deliver on their foreign currency
payments were major LOLR operations in foreign currency, using countries' reserves and,
more importantly, US dollar swap lines granted to central banks around the globe on a large
scale.
Strictly speaking, a currency swap between two central banks is a symmetric agreement. In
most cases, however, it is the central bank providing the reserve currency in excess demand
at the time that is the party putting real money on the table. When the swap is used to lend to
banks in the receiving country, that country's central bank bears the counterparty risk. But
from a liquidity standpoint, the foreign central banks were intermediaries of the Federal
Reserve's global liquidity operations. And so the LOLR function at the national level was
replicated at the global level.5
Does this mean that we have a solution to the problem of mitigating the extra risks in
crossborder banking compared to national banking? Unfortunately not. First of all, there are big
question marks over central bank swaps as permanent and widespread tools of crisis
prevention and management, as I will come back to later in my speech. Second, the failures
3
This case is described in Ingo Fender and Patrick McGuire, "European banks' U.S. dollar funding pressures".
BIS Quarterly Review (June 2010): 57-64.
4
Guðmundsson and Thorgeirsson describe the case of the Icelandic banks and draw lessons for cross-border
banking: Már Guðmundsson and Thorsteinn Thorgeirsson. "The Fault Lines in Cross-Border Banking:
Lessons from the Icelandic Case". SUERF Studies 05/2010, European Money and Finance Forum (2010).
Baldursson and Portes give a recent assessment of the rise and fall of the Icelandic banks: Friðrik M
Baldursson and Richard Portes (2013), "Gambling for resurrection in Iceland: the rise and fall of the banks",
CEPR Discussion Paper 9664, September.
5
Fleming and Klagge describe the Federal Reserve's foreign exchange swap lines: Michael J. Fleming, and
Nicholas J. Klagges. "The Federal Reserve's Foreign Exchange Swap Lines. Federal Reserve Bank of New
York: Current Issues in Economics and Finance", 16, 4 (2010). Allen and Moessner analyse the important role
of the US Dollar surplus in the policy response to the crisis and compare it to the policy response during the
Great Depression: William A Allen and Richard Moessner (2010), "Options for meeting the demand for
international liquidity during financial crises", BIS Quarterly Review, September 2010, http://www.bis.org/.
of the safety net and the associated moral hazard-mitigating mechanism in cross-border
banking applied across the board to regulation, supervision, LOLR, deposit insurance, and
crisis management and resolution.
The adjustment that needs to take place after the crisis in order to make cross-border
banking safer is clear in principle: the market action and the public framework in the form of
the safety net and other arrangements has to be better aligned. Again, in principle, this can
take place through two channels: through retrenchment of cross-border banking so that
national safety nets of big countries are more sufficient, or through international expansion of
safety nets. There was significant retrenchment during and immediately after the crisis, and it
was unavoidable and necessary at that point in time.6
There are significant benefits to be derived from financial globalisation, including
crossborder banking, so we will have to hope that extending public frameworks through
international and regional co-operation will be an important part of the story. Here progress is
uneven and occurs on three tracks: national, regional, and global.
Policy initiatives taken at the national level after the crisis have partly made banking safer by
contributing to the retrenchment of cross-border banking. In the absence of credible
multilateral safety nets, countries will have to take unilateral action to reduce the risks they
face. In my country, we have taken action to limit the FX liquidity risk of our banks by
imposing limits on the size and composition of their FX balance sheets. Thus we have a
specific liquidity coverage ratio in FX, as does Sweden. We have also introduced a specific
net stable funding ration in FX, which at present goes one year out but might be extended
further as we make the system safer in anticipation of lifting capital controls.7
There has been major progress within the EU through the implementation of a banking
union. Again, the biggest strides have been taken in the realm of supervision, but a greatly
improved resolution framework is also in the process of being introduced. A common deposit
insurance system is not yet on the agenda, however. That might be an impediment to further
banking integration and potentially a source of vulnerability. EU members outside the euro
area can opt into banking union. This introduces the possibility of deep banking integration
without a LOLR, which is a risky combination, as we have seen. That risk could of course be
mitigated through uncapped central bank swaps and mutual acceptance of collateral, but as
far as I can see, there is as yet no formal framework for this.
In this connection, I note with interest the plans in this region to progress with regional
banking integration by, for instance, the ASEAN. The benefits will be substantial, but we
need to be mindful of the risks and learn from the European experience. As I see it, banking
integration without a monetary union or alternative arrangements for FX liquidity provision is
potentially very risky. That said, recent events have shown that a monetary union without a
banking union is also risky.
At the global level, there has been some progress on the framework for supervision,
crossborder crisis management, and resolution of cross-border banks through the work of the
Financial Stability Board (FSB). The progress on resolution through aligning national
resolution regimes to the FSB Key Attributes of Effective Resolution Regimes is still limited,
however, and the risk of non-cooperative and disorderly resolution is still high if the system
should experience significant stress. This is a complex area and in many ways more difficult
than cross-border cooperation of supervisors.8 To illustrate the issued involved, let us briefly
review the resolution of the Icelandic cross-border banks.9
Given the lack of international cooperation, the Icelandic authorities were forced to consider
radical solutions in order to preserve the domestic payment system and basic banking
services. In doing so, it had to take into account that these were private banks and
socialising their losses carried the risk of bankrupting the government.
In essence, the adopted solution saved the domestic operations of the banking system by
creating new banks, which was done by carving a big part of the domestic assets and
liabilities out of the old, failing banks. The new banking system amounted to 1.7 times GDP.
The rest - and much bigger part - went into a resolution process, where it largely remains,
pending a solution that would make it possible for Iceland to lift its comprehensive controls
on capital outflows, but that is another story.
In order to reverse the ongoing run on domestic deposits, a declaration was made that all
deposits in Iceland were safe and all deposits in Icelandic-headquartered banks were given
priority over other unsecured claims. This distinction made between domestic deposits and
foreign currency deposits in the banks' foreign branches added fuel to the fire of the
socalled Icesave dispute about the settlement of deposit guarantees in the Dutch and British
branches of one of the banks. But guaranteeing those deposits would never have been
credible and might have bankrupted the Government had it been attempted. The deposits in
question were in foreign currencies and amounted to 111⁄2 billion euros - far in excess of
Iceland's FX reserves, which amounted to 21⁄2 billion euros. And the sovereign was
completely closed off from foreign capital markets at that point. Furthermore, in economic
terms, given that these deposits were used to a significant degree to finance illiquid assets in
outside Iceland, such a payment, if it had been possible, would have amounted to a net
transfer of resources from Iceland to other countries - where the United Kingdom would have
been prominent - at a time when Iceland was going through its deepest financial and
economic crisis in the post-war period! That made no sense. Finally, it should be noted that
the deposit preference introduced before the banks failed is securing full recovery to all
deposits if we discount the time value of money, which so far has been low during the
postcrisis period.
This case clearly highlights the link that must exist between the LOLR function and deposit
insurance, which, in the absence of clear prior arrangements for currency swaps or other
such mechanisms, must be predominantly in the same currency in order to work. The EU
framework for this was therefore deeply flawed, as has been recognised in the discussions
about a banking union.
You can see from this that the key characteristics of crisis management and bank resolution
in Iceland during the crisis were that share-holders lost all their equity, unsecured bond
holders were bailed in, vital infrastructure elements of the domestic banking system were
preserved and deposit were given preference over other unsecured claims. It seems in many
ways a standard approach today, but it was not always well received at the time.
Finally, I would like to briefly discuss an important unresolved part of the story: the future of
central bank swaps of the type initiated between the US Fed and several other central banks
around the globe during the crisis10. It should be noted, however, that there are several other
arrangements around the globe which, with time and modifications, could become partial
substitutes for these swaps. Examples of this are the multilateralisation of the Chiang Mai
Initiative in this part of the world, swap lines among BRIC countries, and the bilateral swap
network of the People's Bank of China. But as they are currently constructed, these are not
well suited to large-scale and speedy provision of liquidity in reserve currencies more or less
directly to internationally active banks.
In the absence of almost total retrenchment in international banking - except in cases
involving countries issuing reserve currencies and with strong fiscal capacity - the problem
these swap lines were meant to address will not go away. The past few years have seen
lively discussion of whether it is desirable and feasible to anchor the swaps more firmly in the
international monetary system, through clearer and more transparent access criteria and a
multilateral governance mechanism.
Clearly, there are arguments for such institutionalisation, but I sense that this might be
premature and that we should allow the discussion to evolve further. Those who oppose
constraining central bank discretion in this area present important arguments. The most
compelling are those based on the analogy with liquidity provision and LOLR in a national
setting, where flexibility, speed, and large scale can be essential. This argues in favour of
giving central banks a major role in the arrangements. Less compelling are arguments based
on moral hazard, which would apply equally to domestic arrangements.
What seems clear is that even greatly enhanced IMF facilities are not close substitutes for
swap lines among central banks. First, the swap lines are there to provide short-term
collateralised FX liquidity to banks, whereas IMF facilities are uncollateralised longer-term
lending to sovereigns and are intended primarily to mitigate balance of payments problems.
Norway and the euro area were offered USD swaps without prior balance of payments
disequilibrium and the euro area, at least, badly needed it. Second, IMF facilities generally
cannot match the swap lines in terms of speed of delivery, as the decision processes at the
IMF are unavoidably more cumbersome. At present, the IMF's maximum lending capacity is
just over a trillion US dollars. At their peak in early December 2008, the USD swaps
amounted to over USD 580 billion, after having increased very rapidly to that level in a matter
of a few weeks11. If needed, the total could have risen much higher because the swaps had
been uncapped vis-à-vis key central banks, which also mattered greatly in terms of
signalling. If the IMF or any other international organisation is to be able to provide a credible
alternative to the swaps, it must be able to expand its balance sheet speedily and on a large
scale when the need arises. In short, it would have to function like a global central bank. This
is not likely to be in the cards in the near future.
So where do we stand regarding cross-border banking? In some sense, we are in the middle
of a strong river. Some want to go back, as they do not find it safe to continue - perhaps
because they are not offered a helping hand - and given the choices currently available, it
could be better for them to stay on the other side. Others are banding together to hold hands
and wade across. And still others are strong enough to go it on their own. It will be interesting
to see how this story plays out in coming years.
Thank you very much!