| Was the Icesave fiasco avoidable? | | | | Communication between regulators |
| Introduction | | | | In the European Directive on Financial Stability a home |
| This article analyses both the risk management | | | | country is obliged to contact the host country in |
| aspects that were known to all market participants | | | | question in case of known deficiencies. Strangely |
| and the risk management regulatory framework | | | | enough, on request of the DNB to provide more |
| which existed prior to the Icesave approval by the | | | | explanation about the explosive growth of Icelandic |
| DNB in May 2009. The aim of this analysis is to | | | | banks and liquidity problems, the FME (Icelandic |
| attempt to understand whether regulators and the | | | | supervisor) replied in August 2008 as following: ".. |
| DNB in particular exhausted all their means and | | | | Landsbanki's business is healthy, capital levels are |
| analysed thoroughly all information available at the | | | | strong and it performs well in various stress-tests |
| time of the granting of banking permission to Icesave | | | | that the FME applies." [2]. |
| in the Netherlands. | | | | Role of the supervisors in analyzing the market |
| At the time of the implosion of Icesave the bank | | | | trends |
| had more than 100,000 accounts and more than 1, 7B | | | | In the Basel document regulating liquidity |
| Euro deposited money, but according to Landsbanki's | | | | management it was clearly stated that to protect |
| plans before the Icesave launch it expected to take | | | | local entities supervisors have a duty to help ensure |
| only about 400-500 M Euro by the end of 2008. It | | | | the resilience of entities within their jurisdiction to |
| looks like the DNB could do little to prevent the | | | | protect local depositors.[3] |
| explosive growth of Icesave in the first few months | | | | In the later document issued in September 2008 and |
| of its operations. | | | | named "Principles for Sound |
| Recently a report requested by the Dutch Parliament | | | | Liquidity Risk Management and Supervision" there is |
| was published by two academics, DeMoor-Van Vugt | | | | more clear description of the role of supervisors with |
| and Du Perron from the University of Amsterdam. | | | | an emphasis on the comprehensive assessment of a |
| The report presented all events leading to the | | | | bank's overall liquidity risk management framework by |
| nationalisation of Landsbanki (the mother bank of | | | | the monitoring of a combination of internal reports, |
| Icesave) in chronological sequence, and analysed the | | | | prudential reports and market information. The |
| actions of regulators both in the Netherlands and | | | | market information was a missing link in the analysis |
| Iceland related to the granting of banking permission | | | | of Landsbanki. The main European and Dutch banks |
| to Icesave. The report was mainly focused on the | | | | had already withdrawn from Iceland by the end of |
| legal aspects of granting the banking license, with | | | | 2007 as more reports came in indicating that the |
| analysis of the European Passport regime and the | | | | Icelandic economy and banks grew very fast and the |
| home/host country model. | | | | bubble might burst very soon. The Swap rate of |
| By granting the permit, Icesave was included in Dutch | | | | Icelandic banks and specifically Landsbanki were very |
| Deposit Guarantee scheme, although the home | | | | high in the interbank market. This means that |
| country (Iceland) was responsible for regulating the | | | | counterparties have less trust with these banks than |
| Landsbanki group. The Icelandic regulator primarily | | | | with other banks. It worth mentioning that the Swap |
| looked into the Group level reports, which were | | | | rate of Landsbanki was very high, (see a graph in the |
| periodically submitted and showed solid liquidity | | | | attachment). |
| buffers and withstood stringent stress tests. | | | | So consequently the market knew that something |
| The fact that the DNB granted the license provided | | | | was wrong with the Icelandic banks, but supervisors |
| the quality image to the bank. The authors stress | | | | it seems were unaware or seemingly ignored the |
| that the DNB did not have the legal tools to prevent | | | | market behaviour. |
| the granting of the license, but if it had been handled | | | | Challenges in Liquidity Risk Management and Key Risk |
| less favorably and more time spent analysing and | | | | indicators |
| asking tough questions, the whole disaster may have | | | | In certain circumstances, firms may also face |
| been prevented. | | | | challenges in transferring funds and securities across |
| The most important recommendation of the report is | | | | borders and currencies, especially on a same-day |
| that the European regulations should be substantially | | | | basis. For example, institutions operating centralised |
| revised, to prevent a situation where a country bears | | | | liquidity management may be dependent on foreign |
| the risk of failure of a financial institution (via a | | | | exchange (FX) swap markets. |
| deposit protection scheme), but has little power in | | | | For example, if the liquidity reserve of a bank in for |
| regulating such institution. | | | | instance NL is transferred within a cross-border group |
| The difference between Foreign Branch versus | | | | to Iceland where the local entity faces a liquidity |
| subsidiary explained | | | | shock but the transfer fails to resolve the problem |
| A branch of a foreign bank is obligated to follow the | | | | within the group, the local entity in NL is likely to |
| regulations of both the home and host countries. | | | | come under severe pressure and will have no liquidity |
| Because the foreign branch banks' loan limits are | | | | buffer to prevent failure. In that event, depositors in |
| based on the parent bank's capital, foreign banks can | | | | NL are in a potentially worse position than before the |
| provide more loans than subsidiary banks. That was | | | | transfer. If however the transfer succeeds in |
| probably the main reason why Icesave has been | | | | stemming the problem, and there is no reputational |
| launched as a branch and not a subsidiary. | | | | contagion, then depositors in Iceland would be better |
| The risk management framework prior the granting | | | | off and those in NL no worse off. |
| of a banking license to Icesave operations in the | | | | A bank also should design a set of key risk indicators |
| Netherlands | | | | or KRI's to identify the emergence of increased risk |
| Now let's move on from the legal to the Risk | | | | or vulnerabilities in its liquidity risk position or potential |
| management framework which existed before the | | | | funding needs. Such early warning indicators should |
| time of granting the banking license to Icesave. | | | | identify any negative trend and cause an assessment |
| Liquidity regimes are nationally based according to the | | | | and potential response by management in order to |
| principle of "host" country responsibility (although in | | | | mitigate the bank's exposure to the emerging risk. |
| some cases, the task, though not the responsibility, | | | | Early warning indicators can be qualitative or |
| of supervision of branches is delegated to the home | | | | quantitative in nature and may include but are not |
| supervisor). | | | | limited to:o rapid asset growth, especially when |
| The risk assessment method used by the DNB called | | | | funded with potentially volatile liabilitieso growing |
| FIRM, which is kind of a scoring cards model. On the | | | | concentrations in assets or liabilitieso increases in |
| basis of the FIRM score the DNB sets the risk profile | | | | currency mismatcheso a decrease of weighted |
| of an institution, which can lead either to a light or | | | | average maturity of liabilitieso repeated incidents of |
| heavy supervisory regime. A branch office of a EU | | | | positions approaching or breaching internal or |
| bank has a very small risk profile according to this | | | | regulatory limitso negative trends or heightened risk |
| model because it can request funds from the mother | | | | associated with a particular product line, such as rising |
| bank in the EU[1]. | | | | delinquencieso significant deterioration in the bank's |
| According to this method the DNB supervises on | | | | earnings, asset quality, and overall financial conditiono |
| liquidity and integrity risks, which were both assessed | | | | negative publicityo a credit rating downgradeo stock |
| as limited. By that time, February- May 2008, the | | | | price declines or rising debt costso widening debt or |
| Basel II requirements already had to be implemented | | | | credit-default-swap spreadso rising wholesale or retail |
| and Landsbanki was informed about the | | | | funding costso counterparties that begin requesting |
| requirements. | | | | or request additional collateral for credit exposures or |
| Let's have a look now at the liquidity risk of | | | | that resist entering into new transactionso |
| Landsbanki at that time. | | | | correspondent banks that eliminate or decrease their |
| The original Basel II accord did not include liquidity | | | | credit lineso increasing retail deposit outflows |
| requirements and a document named "Liquidity | | | | increasing redemptions of CDs before maturityo |
| Risk:Management and Supervisory Challenges" dated | | | | difficulty accessing longer-term fundingo difficulty |
| February 2008 was the main source in defining the | | | | placing short-term liabilities (eg commercial paper). |
| liquidity risk framework. | | | | In my opinion many of these KRI's were in red during |
| In that document the following elements were | | | | the approval period in first half of 2008. |
| highlighted: liquidity policies, stress tests, scenario | | | | On December 17, 2009, the Basel Committee on |
| analyses, contingency funding plans, setting of limits, | | | | Banking Supervision (BCBS) issued two consultative |
| reporting requirements and public disclosure | | | | documents intended to apply lessons of the financial |
| It is worth mentioning that one important | | | | crisis to strengthen bank capital and liquidity |
| differentiating factor across regimes is the extent to | | | | frameworks while harmonising cross-border |
| which supervisors prescribe detailed limits on the | | | | supervisory approaches. The central purpose for |
| liquidity risk and insurance that banks should hold. This | | | | these revisions is to emphasise the holding of |
| is in contrast to an approach that relies more on | | | | higher-quality capital and widen the pool of risks it is |
| reviewing and strengthening banks' internal risk | | | | to support. |
| management systems, methods and reports. | | | | Conclusion. |
| The core sentence is: the application of liquidity | | | | It is certain that that the Icelandic authorities bear |
| regimes on a local management or legal entity basis | | | | responsibility for the Icesave collapse, but also so do |
| requires that each legal entity be sufficiently robust | | | | the Dutch and UK authorities for allowing Icesave to |
| with regard to external shocks. This may require a | | | | operate in their markets without adequate regulation |
| pool of liquid assets to be held locally, or for each | | | | and supervision of its operations or an appreciation of |
| entity to have independent access to contingent | | | | the consequences of a collapse (notwithstanding the |
| liquidity lines. | | | | European passport rules that allowed Icesave to |
| This pool has been requested by the DNB from | | | | operate in those markets). |
| Landsbanki but only just before the Landsbanki | | | | The actual CDS spreads, the Basel II working rules |
| collapsed (September 2008). | | | | on risk management that prescribes the DNB to do |
| Diversity in liquidity regimes | | | | an integrated risk assessment, including Landsbanki |
| Liquidity regimes are affected by policy choices made | | | | and the FX exchange risk, the problems with the |
| by national authorities relating to the desired resilience | | | | loans of Icelandic banks with the Luxemburg Central |
| of banks to liquidity stress. Factors include those | | | | Bank, the different 'warning' reports on Icelandic |
| nationally determined such as insolvency regimes, | | | | banking by market participants and the lack of |
| deposit insurance guarantees, and central bank credit | | | | reserves in the Icelandic Central Bank were all |
| and collateral policies, including intraday, standing | | | | reasons enough to at least take more than a formal |
| facility, or emergency liquidity assistance | | | | procedural approach during granting the banking |
| arrangements, as well as the structure of the banking | | | | license to Icesave. |
| sector itself. | | | | |