Deficiencies in VAR based estimates of risk
1.3 Global finance without global government: faultlines in regulatory approach
The developments described above raise important questions about appropriate future approaches to regulating capital, liquidity, bank-like institutions, credit rating agencies and remuneration, which are relevant to all banks across the world – irrespective of whether they operate entirely within national markets or on a cross-border basis. But they also raise issues specific to the operation of cross-border banks.
The origins of the crisis were to a significant degree global. Some of them (e.g. rapid mortgage credit extension and property price bubbles) were more prevalent in the English-speaking
countries, but there were also other property markets, such as Spain which showed similar rapid growth. And the purchase of securitised credit assets was widely spread across the world, with some German banks big purchasers, for instance.
But the crisis also followed a period of significant globalisation of banking activities, both wholesale and retail. Major European investment banks, such as UBS and Deutsche bank, expanded extensively in both London and New York, and major US investment banks developed much larger London operations and extensive networks throughout the world. UK banks like Barclays, RBS and HSBC significantly expanded their US operations. In addition there was a significant extension of cross-border retail activity, particularly in Europe – with, for instance, the Icelandic and Irish banks and ING being active gatherers of retail deposits in the UK, either through physical branches or online.
The crisis revealed fault lines in the global regulation and supervision of some of these cross- border firms, which raise fundamental issues about the appropriate future approach. The essence of the problem – as the Governor of the Bank of England, Mervyn King has put it – is that global banking institutions are global in life, but national in death. That is, when crises occur, it is national central banks which have to provide lender-of-last-resort (LOLR) support and national governments that provide fiscal support, and that if there is a failure, bankruptcy procedures are national and it matters with which specific legal entity a creditor has their claim.
The failures of Lehmans and Landsbanki threw these fault lines into sharp relief:
1.3(i) Lehman Brothers and the future approach to global wholesale banks
Lehman Brothers collapsed in September 2008, following a loss of market confidence in the firm’s solvency, arising from its overexposure to troubled asset classes – in particular, mortgage-backed securities and commercial real estate.
In the past the FSA’s regulatory approach to large cross-border wholesale banks and investment banks, in line with that of most other regulators, assumed that primary responsibility for ensuring prudential soundness lies with the home country supervisor (though with extensive information sharing between home and host supervisors). It also assumed that it is appropriate for firms to gain efficiency benefits from global approaches to managing liquidity, allowing significant flexibility in the use of legal entities to book transactions across border, and to move liquidity between legal entities.
The failure of Lehman Brothers demonstrated, however, that decisions about fiscal and central bank support for the rescue of a major bank are ultimately made by home country national authorities focusing on national rather than global considerations. It also illustrated that separate legal entities and nationally specific bankruptcy procedures have major implications for creditors.
To address these problems in the future requires some combination of:
• More international cooperation in ongoing supervision through, for instance, colleges of
supervisors. And more intense international cooperation and coordination in crisis management.
• An increased use of host country powers to require strongly capitalised local subsidiaries, ring- fenced liquidity and restrictions on intra-group exposures and flows.
The balance between these options, the inherent limits to what can be achieved, and the possible implications for cost efficiency and international capital flows, are discussed in Section 2.2 (vii) and 2.10 (i).
1.3 (ii) Landsbanki and the European single market: the need for major reform
The lessons arising from the Icelandic banking crisis are summarised in the box overleaf (Box 1C).
The essential points are that:
• European Union single market rules require that banks which are recognised by their home country supervisors as sound have a right to operate as branches in other member states; and
• that, as a result depositors in one country (or the government) can be vulnerable to the failure of banks in another country if the home country concerned lacks the supervisory resources to ensure bank solvency, or the fiscal resources to fund bank rescue, and if the deposit insurance cover is low and unfunded.
These current rules and arrangements are untenable for the future and must be changed through some combination of:
• more European coordination in regulation, supervision and deposit insurance; and
• more host country national powers in regulating and supervising the branches of banks based in other member states.
Section 2.10 (ii) discusses these alternative ways forward.
BOX 1C: LESSONS FROM THE ICELANDIC BANKING CRISIS
The collapse of Landsbanki HF in October 2008 raises important issues relating to the appropriate regulation of bank branches within the European single market and appropriate approaches to deposit insurance.
Landsbanki operated in the UK as a branch, raising retail internet deposits under the Icesave brand.
It had around £4.5 billion of retail deposits outstanding at the time of failure. These deposits were legally covered by the Icelandic deposit insurance scheme up to a value of €20,887. In addition, they were covered on a top-up basis by the UK Financial Services Compensation Scheme (FSCS), to which Landsbanki had chosen to opt in. As a top-up member, Landsbanki would have been liable to meet a share of the costs in the event of the default of another bank covered by the UK scheme.
The Icelandic government indicated that it would not be in a position to meet the liabilities of the Icelandic deposit insurance scheme immediately, and is currently discussing the terms of a loan from the UK to allow it to meet those liabilities. In addition, there were £800 million of retail deposits which, because above £50,000, were covered neither by the Icelandic scheme nor by the FSCS top up. The UK government concluded that these deposits should be protected to underpin depositor confidence in the banking system. The total initial costs of retail depositor protection arising from the collapse of
Landsbanki’s UK branch have therefore been met by a combination of the UK government and the FSCS.
Landsbanki’s UK branch was not subject to full prudential supervision by the FSA. This is because European Union single market rules – which cover Iceland as a member of the European Economic Area (EEA) – allow banks in one country to operate as branches in another, with the supervision of solvency and of whole bank liquidity resting with the home country supervisor (this right is known as
‘pass-porting’). The FSA, as host country supervisor, had only limited powers relating to the supervision of local liquidity.
The insolvency of Landsbanki therefore illustrates a weakness in the current European approach to a single market in retail banking. Depositors in one country (or their government) are vulnerable to the failure of banks in another country if the home country concerned lacks the supervisory resources to ensure bank solvency, or the fiscal resources or willingness to fund bank rescue, and if the deposit insurance cover is low and unfunded.
The approach to bank branch passporting rights, at least as they apply to branches conducting retail business, therefore requires review. Options for change could include:
Increased home country power:
• The restriction of branch passporting rights and the requirement that retail deposit gathering be conducted through fully capitalised subsidiaries supervised by the host country regulator.
• Host countries’ supervisory powers to conduct a whole bank assessment and to refuse local branches the right to operate if not satisfied.
Increased European coordination:
• European-wide processes to assess the effectiveness of home country supervision of those banks wanting to conduct retail business in other member countries.
• Cross-European requirements for pre-funded and ring-fenced deposit insurance, combined with more overt warnings to customers of the limits of deposit insurance.
The relative merits of these different approaches are discussed in Section 2.10