Patrick Honohan: Vulnerability of small countries with big banking
sectors - macroprudential lessons from recent experience
Address by Mr Patrick Honohan, Governor of the Central Bank of Ireland, to a conference,
organised by the Central Bank of Iceland, Reykjavík, 28 November 2013.
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Related charts are available here.
It is not only in Iceland and Ireland that the failure of big banking sectors has had a
devastating effect on entire economies, though they do provide the most spectacular
examples. What macroprudential lessons can be learnt from recent experience about
vulnerability of small countries with big banking sectors?
1. The Issue
In the age of cloud computing, the actual location of a bank is less unambiguous than it was
in the past, but sufficient legal clarity still exists to determine the relevance of national
jurisdiction. Indeed, location decisions of banks as providers of international banking services
on cross-border banking have been considered a matter for the industrial policy of several
countries (trying to become financial centres). Especially in such cases, there is a need for
national macroprudential policies to ensure that the overall national policy mix adequately
copes with the risks presented by banking location.
To be sure, having an undeveloped or repressed banking system - one that is small relative
to the size of the economy - is in itself a restraint on growth. Comparing across countries,
the positive relationship between banking depth and economic growth seems to hold at least
until the bank-to-GDP ratio gets to about 100 per cent or so. But beyond that, there is little
evidence of a growth-enhancing function for having a large banking system per se. And rapid
growth in a banking system's credit to the domestic economy has been long-known as a risk
factor for financial instability.
I would like to propose three perspectives on the macroprudential risks that are presented.
First: lending and the problem of credit bubbles; second: funding and what I will refer to as
the "financial shield" phenomenon; third: exchange rate policy and its complex interaction
with banking internationalisation.
When it was famously observed that large banks, though international in life, are national in
death, what was meant was that it will be national fiscal authorities and the local customers
that are the victims in case of a failing international bank.
But a bank in an international banking centre may not have the same experience. It may not
lend much to the domestic economy, it may not source its funding from the domestic
economy, it may do all of its business in foreign exchange. In short, it may be a bank whose
main connection to the economy is the processing and booking of exported banking services.
All-in-all, chances are that the fiscal authorities in the host country will not be interested in
providing bail-out to the uninsured creditors of such a bank if it were to fail. In death, as in
life, it will remain largely offshore. This is the situation that characterises classic offshore
banking.
Nevertheless, much of today's international banking involves deeper interactions between
the banks and the national economy, and as such entails macroprudential risks.
Lending
Take lending. This is the most familiar source of leakage of international finance into the
domestic economy. With such easy access to foreign funding, internationally connected
banks have time and again pumped-up the domestic property market or propped-up the
finances of an overspending fiscal authority, creating extensive pockets of domestic
overindebtedness whose deleveraging destabilises economic activity. The result is often the
insolvency not only of those who borrowed, but of others whose business model is
undermined by the subsequent recession induced by the need for deleveraging. This pattern
is familiar and it is now uncontroversial to declare that preventing this pattern emerging calls
for macroprudential policy measures to stifle demonstrably excessively credit growth.
Funding
On the funding side, what I have to say may not be quite as standard. What we can notice
from many highly-banked economies is the fact that the banks cannot be readily partitioned
into those catering to the domestic market and those operating an exclusively export service
business. This happens when local banks start to tap foreign funding to meet a local demand
for funds, or to get into international lending themselves. By taking foreign funding onto a
balance sheet already strongly funded by the transactions balances and other core liquid
assets of the economy, a domestically significant bank implicitly increases the risk for the
domestic fund providers. But the foreign fund providers will feel protected by being pooled
with domestic depositors. The domestic fund providers can thus be thought of as a sort of
domestic financial shield potentially taken hostage by the foreign funders. After all, if the
bank fails and if the national fiscal authorities then decide that the domestic funders should
be bailed-out, the national authorities will find it difficult to discriminate against the foreign
funders. They may therefore prefer to bail them out also in order to avoid damaging the
residents. Bear in mind that it is not just the transactions balances of domestic households
and firms that may be at stake, but also their payments services. (Banking systems are what
give payment finality to domestic economic transactions).
Since the banks and their foreign funders are aware of this shielding property, it serves to
lower the bank's cost of funding overall. In this way, the indirect access of borrowers to
foreign funds is increased by having such funds routed through the domestic banking
system.
But beyond a certain point - easily reached with the size of modern banking systems - the
losses of a failing bank will exceed the fiscal capacity of the host economy. The controversial
re-emergence of capital controls, including exchange controls on inward payments is one of
the macroprudential tools that have recently been advocated by some as a potential solution
to this problem.
Exchange rate policy
Exchange rate policy also comes into play in a variety of ways (though I will not spend too
much time on that topic here). Most international banking works in just a handful of major
currencies, with the result that any country with a large banking system is either using one of
these currencies itself or has to face the challenges of managing exchange rate risk on those
transactions in which the international banking system interacts with the domestic economy.
Low interest rates in the international currency tempt borrowers into assuming foreign
exchange risks they may have no capacity to manage or absorb. If the authorities choose to
peg their currency in order to limit this risk, they may simply be altering the risk profile:
increasing the probabilities both of no change in the currency (in the normal course of
affairs), and of a large discrete change in the exchange rate should the peg have to be
abandoned.
2. Country examples
Good examples of these aspects come from several small countries caught up in the present
crisis. Let's consider Cyprus, Iceland and Ireland. By the mid-2000s their banking systems
had grown to a multiple of GDP (Figure 1); each was tested by the current or previous crises.
Iceland
The Iceland case is one where public sector borrowing was not a major driver of the crisis.
Instead the banks, while based in Iceland, suddenly (in the period 2003-7) became heavily
involved in financing non-Icelandic ventures of Icelandic-controlled entities, and other foreign
borrowers, as well as fuelling a domestic property boom. Claims on corporate borrowers
jumped to over 300 per cent of GDP by 2007, while claims on households also jumped, but
to the more moderate level of just over 100 per cent of GDP (Annual growth rate of corporate
lending reached the startling figure of over 60 per cent at one stage, whereas for household
debt it was only a bit less dramatic, peaking at about 30 per cent - IMF Staff report August
2008). The growth in the activity of the Icelandic banks was extraordinary: little more than
100 per cent of GDP in 2004, the consolidated total assets of the three main banks reached
about 10 times that by end-2007.
The Icelandic króna has not been a very stable currency over the years. The Iceland banks
funded their expansion substantially in foreign currency and much of their domestic lending
was indexed to FX or to inflation.
The banks sourced their funding in different ways as the boom progressed and as different
sources became reluctant to increase their Icelandic exposure. Because of this segmentation
- bonds, syndicated loans, deposits mobilised in retail markets in the UK and Netherlands -
the bulk of the funding came in ways which were more easily separable from the domestic
depositor than in the other countries examined here.
And indeed, separated they were. Icelandic deposits (and assets) were carved out of the
failing banks and moved to new banks, leaving the bulk of the banking system to be
liquidated (Figure 2). Because some of the deposits were placed in branches of one of the
Icelandic banks (not a subsidiary) the Icelandic deposit guarantee fund would have been
liable to pay, but was unable to do so. Following litigated disputes, the EFTA court
adjudicated that, because of the extraordinary circumstances, the Government of Iceland did
not have to meet this potentially costly charge. Creditor expectations, that non-discrimination
clauses in the EEA agreement would be effective in protecting the foreign depositors, were
also dashed in this 2013 court adjudication.
While the Icelandic customers of the banks were far from insulated from the collapse,
suffering as they did from protracted exchange controls and currency depreciation (to speak
only of the problems of depositors), they did much better than the foreign creditors. After the
claims of the UK and Netherlands deposit guarantee system are met from the liquidation, it
seems there may be relatively little left for other creditors.
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What the Iceland case exemplifies is a situation where the international and domestic
funders were sufficiently separable to disable the "financial shield" mechanism (of which I
have been speaking) and prevent it from protecting the foreign funders from bail-in at the
expense of the domestic economy. This separation somewhat moderated the fiscal and
domestic macro-financial impact of the collapse.
Ireland
That Ireland's banking system had total assets approaching nine times GDP in 2008 is a
headline fact which tends to mislead. Four different categories of bank can be identified in
this total figure (Figure 3). First - making up about 44 per cent of the total - were the locally
controlled banks which serviced the domestic economy. Second, a further 12 per cent, were
subsidiaries and branches of foreign controlled concerns dealing with the domestic economy.
Third, accounting for a further 19 per cent, were foreign-owned concerns which provided
mainly export services (not much connected to the domestic borrowers or funders) and which
failed as a result of the subprime crisis. Fourth, the remaining foreign-owned concerns also
using Ireland as an export base and which remain solid.
Although the first three categories all got into trouble and had to be rescued, only the first
category was implicated in the fiscal cost to the Irish Government, as it did not guarantee the
other categories. The shareholders of the second category and foreign fiscal authorities of
the parent entities of the third category bailed-out creditors of those entities. The financial
shield mechanism insulated only those foreigners who were creditors of the nationally
controlled banks. Lesson: the presence of strong foreign parents can reduce or eliminate the
financial shield problem for the national authorities.
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The large Irish banking system was structured in such a way as to partially - but only
partially - ringfence the international part from the domestic. The part that was not ringfenced
was still big enough to cause great damage. The wider destabilisation of the Irish economy,
including the boom and bust in property prices which has left a large section of the
household sector under stress of over-indebtedness, was created by the first two categories
of bank (and especially their ability to source foreign funding), but not by the third or fourth
category.
Cyprus
Cyprus (Figure 4) is a case where the foreign depositors were embedded in the domestic
system, but when it failed, the shield I have been speaking of did not in the end protect them.
Instead in each of the two main banks, creditors suffered equally, whether domestic or
foreign. The rate of growth in the scale of the Cyprus banking system was not as rapid as in
Iceland or even Ireland, but total deposits had reached 31⁄2 times GDP by the end. As in
Ireland, exchange rate movements were not an issue insofar as the euro is the national
currency.
For Cyprus, the classification "resident" is sometimes challenged, but taking it at face value
we find that loans to residents in Cyprus at 74% of the total, exceeded residents' share of
deposits at 62%. The difference meant that residents borrowed more than €10 billion more
than they deposited with the banks - about 60 per cent of GDP. Thus, while the banking
system in Cyprus has been considerably exposed to other countries, notably Greece (both
restructured Government bonds and problem loans reportedly associated in particular with
Laiki Bank), it is neither a situation where foreign funds have been employed in net terms to
fund the domestic fiscal authorities, nor to fund a domestic property bubble on the scale that
occurred in Ireland. Instead, the scale of foreign funding enabled the main banks to become
exposed to Greek official debt and to make loans of doubtful quality to Cypriot, Greek and
other borrowers, which resulted in losses that promised to demand recapitalisation on a
scale unaffordable by the Cypriot State. While the mechanism adopted for bailing-in the bank
creditors (and certainly some of the earlier proposed mechanisms) in order to boost the
capital position of the banks can be criticised - and certainly underlines how welcome is the
European legislation on bank resolution, now in advanced stage of negotiation - there are
also lessons for macroprudential regulation.
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The fact that the most affected banks in Cyprus have also been the main retail and payments
banks for the national economy has resulted in broad economic disruption, including the
introduction of exchange and payments controls, and haircuts on transactions balances of
companies. Here the "domestic financial shield" mechanism has been ineffective in
protecting the foreign depositors, but was itself broken in the collapse.
3. Concluding remarks
By avoiding the melange of export banking with the domestic banking sector, some of the
macrostability risks of having a large banking sector doing international business can be
reduced. Fiscal resources will not be stressed and the domestic economy will not be
destabilised by an export banking sector if its funding and lending is largely focused on the
rest of the world.
Without such separation, extremely prudent and active management is needed to avoid
trouble in systems with large banking sectors. One can even imagine devising
macroprudential policies to be put in place to prevent expansion of banks' balance sheets
beyond a certain scale, putting the onus on authorities to determine what is the optimal size
and structure of the country's financial sector - not an enviable task.
If large banking systems with access to foreign finance become involved in providing credit to
the local economy they have the capacity to rapidly destabilise it. Furthermore, it will be
difficult or impossible for the national fiscal authorities to deal with the failure of such a bank,
if it is providing systemically important payment or transactions balance services to the
domestic economy.
Of course, these considerations are directed to the situation of a small country with a large
banking system. More generally, the interpenetration of banking systems has been seen as
an important contributor to limiting uncompetitive practices in terms of price and improving
provision of services. The degree of segmentation of international finance along national
borders that has been seen in the course of this crisis is surely an over-reaction which
should, and will in time, be reversed.