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, reykjavik, 28 november 2013. * * * 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

##sing 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. bis central bankers ’ speeches bis central bankers ’ speeches bis central bankers ’ speeches