Could the collapse of Icelandic bank Icesave in the Netherlands have been avoided?
Could the Icesave fiasco have been avoided?
This article analyzes both the aspects of risk management that were known to all market participants and the regulatory framework for risk management that existed prior to the approval of Icesave by the DNB in May 2009. The purpose of this analysis is to try to to find out whether the regulators and DNB in particular have exhausted all their resources and thoroughly analyzed all available information at the time of granting banking authorization to Icesave in the Netherlands.
At the time of Icesave’s collapse, the bank had more than 100,000 accounts and more than EUR 1.7 billion in deposited money, but according to Landsbanki’s plans before the launch of Icesave, it was expected to take only about EUR 400-500 million by the end of 2008. It appears that DNB can do little to prevent Icesave’s explosive growth in its first few months of operation.
Recently, a report requested by the Dutch parliament was published by two scientists, DeMoor-Van Vugt and Du Perron of the University of Amsterdam. The report presents all events leading to the nationalization of Landsbanki (Icesave’s parent bank) in chronological order and analyzes the actions of regulators in both the Netherlands and Iceland related to the granting of Icesave’s banking authorization. The report was mainly focused on the legal aspects of the granting of a banking licence, with an analysis of the European passport regime and the country/host model.
With the granting of the permit, Icesave was included in the Dutch deposit guarantee scheme, although the country of origin (Iceland) was responsible for the regulation of the Landsbanki group. The Icelandic regulator looked primarily at group-level reports, which were periodically submitted and showed solid liquidity buffers and withstood rigorous stress tests.
The fact that DNB granted the license ensured the quality image of the bank. The authors emphasize that the DNB did not have the legal tools to prevent the license from being issued, but if it had been treated less favorably and more time had been spent analyzing and asking difficult questions, the entire disaster may have been averted.
The most important recommendation in the report is that European regulations need to be substantially revised to prevent a situation where a country bears the risk of failure of a financial institution (through a deposit protection scheme) but has little power to regulate such institution.
The difference between a foreign branch and a subsidiary is explained
A branch of a foreign bank is required to comply with the regulations of both the home country and the host country. Because foreign branch banks’ loan limits are based on the parent bank’s capital, foreign banks can lend more than subsidiary banks. This was probably the main reason why Icesave started as a branch rather than a subsidiary.
The risk management framework prior to the granting of a banking license to Icesave’s operations in the Netherlands
Let us now move from the legal to the risk management framework that existed prior to the granting of the banking license to Icesave.
Liquidity regimes are nationally based in accordance with the principle of ‘host’ country responsibility (although in some cases the task, but not the responsibility, of supervising branches is delegated to the home supervisor).
The risk assessment method used by DNB is called FIRM, which is something like a dot-map model. Based on the FIRM result, the DNB determines the risk profile of an institution, which may lead to a light or heavy supervisory regime. An EU bank branch has a very low risk profile under this model as it can request funds from the EU parent bank.
Under this method, DNB supervises liquidity and integrity risks that are assessed as limited. At that time, February-May 2008, the Basel II requirements had already to be met and Landsbanki was informed of the requirements.
Let us now look at Landsbanki’s liquidity risk at that time.
The original Basel II accord did not include liquidity requirements, and a February 2008 document called “Liquidity Risk: Challenges for Management and Supervision” was the main source in defining the liquidity risk framework.
The following elements were highlighted in this document: liquidity policies, stress tests, scenario analyses, contingency funding plans, setting limits, reporting requirements and public disclosure
It is worth mentioning that one important differentiating factor between the regimes is the extent to which supervisors prescribe detailed limits on the liquidity risk and insurance that banks must hold. This is in contrast to an approach that relies more on reviewing and strengthening banks’ internal risk management systems, methods and reports.
The main sentence is: applying local management or legal entity liquidity regimes requires each legal entity to be sufficiently stable with respect to external shocks. This may require a pool of liquid assets to be held locally or for each entity to have independent access to contingent liquidity lines.
This pool was requested by DNB from Landsbanki, but just before Landsbanki collapsed (September 2008).
Diversity in liquidity regimes
Liquidity regimes are influenced by policy choices made by national authorities regarding the desired resilience of banks to liquidity stress. Factors include nationally determined insolvency regimes, deposit insurance guarantees and central bank lending and collateral policies, including intraday agreements, standing facilities or emergency liquidity arrangements, and the structure of the banking sector itself.
Communication between regulators
In the European Financial Stability Directive, the home country is obliged to contact the host country in question in case of known deficiencies. Strangely enough, when asked by DNB to provide more explanation about Icelandic banks’ explosive growth and liquidity problems, FME (the Icelandic supervisory authority) responded in August 2008 as follows: “..Landsbanki’s business is healthy, capital levels are strong and it performs well in various stress tests that FME applies.” .
Role of supervisors in analyzing market trends
The Basel document governing liquidity management made it clear that to protect domestic entities, supervisors have a duty to help ensure the soundness of entities within their jurisdiction to protect domestic depositors.
In the later paper, released in September 2008 and called “Principles of Sound
Liquidity risk management and supervision” has a clearer description of the role of supervisors with an emphasis on the overall assessment of the bank’s overall liquidity risk management framework by monitoring a combination of internal reports, prudential reports and market information. Market information was lacking unit in Landsbanki’s analysis. Major European and Dutch banks had already pulled out of Iceland by the end of 2007 as more reports emerged indicating that the Icelandic economy and banks were growing very fast and the bubble could burst very soon. The swap rate of the Icelandic banks and in particular Landsbanki was very high in the interbank market. This means that counterparties have less confidence in these banks than in other banks. It is worth mentioning that the swap rate of Landsbanki was very high (see attached graphic).
Therefore, the market knew that something was wrong with Icelandic banks, but the supervisors seemed to be unaware or seemingly ignored the market behavior.
Challenges in liquidity risk management and key risk indicators
Under certain circumstances, businesses may also face challenges in transferring funds and securities across borders and currencies, particularly on a same-day basis. For example, institutions operating centralized liquidity management may be dependent on foreign exchange (FX) swap markets.
For example, if the liquidity reserve of a bank in, say, the Netherlands is transferred within a cross-border group to Iceland, where the local entity faces a liquidity shock, but the transfer fails to resolve the problem within the group, the local entity in the Netherlands is likely to be subject to under severe pressure and will have no liquidity buffer to prevent failure. In this case, depositors in the Netherlands are potentially worse off than before the transfer. However, if the transfer succeeds in stopping the problem and there is no reputational contagion, then depositors in Iceland will be better off and those in the Netherlands no worse off.
The bank must also develop a set of key risk indicators, or KRIs, to identify the emergence of increased risk or vulnerabilities in its liquidity risk position or potential funding needs. Such early warning indicators should identify any negative trend and trigger an assessment and potential response by management to mitigate the bank’s exposure to emerging risk.
Early warning indicators can be qualitative or quantitative in nature and may include, but are not limited to:
o rapid asset growth, especially when financed with potentially volatile liabilities
o increasing concentration in assets or liabilities
o increase in currency mismatches
o decrease in the weighted average maturity of liabilities
o repeated incidents of positions approaching or violating internal or regulatory limits
o negative trends or increased risk associated with a particular product line, such as increasing delinquencies
o significant deterioration of the bank’s revenues, asset quality and overall financial condition
o negative publicity
oa credit rating downgrade
o falling stock prices or rising debt costs
o Widening debt swap or credit default spreads
o rising wholesale or retail financing costs
o counterparties that start to require or request additional collateral for credit exposures or that oppose the conclusion of new transactions
o correspondent banks that eliminate or reduce their credit lines
o increase in retail deposit outflows increase in pre-maturity CD redemptions
o difficult access to long-term financing
o difficulties in placing short-term liabilities (eg commercial securities).
In my opinion, many of these KRIs were in the red during the approval period in the first half of 2008.
On 17 December 2009, the Basel Committee on Banking Supervision (BCBS) issued two advisory papers designed to apply the lessons of the financial crisis to strengthening bank capital and liquidity frameworks while harmonizing cross-border supervisory approaches. The main purpose of these revisions is to emphasize the holding of higher quality capital and to expand the range of risks it must support.
It is certain that the Icelandic authorities are responsible for the collapse of Icesave, but also the authorities in the Netherlands and the UK for allowing Icesave to operate in their markets without proper regulation and supervision of its operations or assessment of the consequences of the collapse ( regardless of European passporting rules that allow Icesave to operate in these markets).
The actual CDS spreads, the Basel II working rules for risk management, which prescribe DNB to make an integrated risk assessment, including Landsbanki and currency risk, the Icelandic banks’ loan problems with the central bank of Luxembourg, the various “warning The reports on Icelandic banking by market participants and the lack of reserves at the Icelandic Central Bank were reasons enough to at least take a more than formal procedural approach in granting Icesave’s banking license.
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Written by Boris Agranovich
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