Do not depend on Otherland to apply the rules

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The best answer would be more Europe – an effective pan-European regulator and a single Europe-wide scheme for protecting depositors.

Lord Turner, chairman of the Financial Services Authority, recently said we needed either “more Europe or less Europe” in banking regulation. This enigmatic remark is important.

The common market for financial services in Europe allows businesses to operate freely across borders. A bank from Homeland can operate in Otherland as a branch. It either sets up an office in Otherland or, through a subsidiary, establishes a distinct but wholly owned Otherlandic bank. One of the two large failed Icelandic banks, Landsbanki , had a UK branch while the other, Kaupthing , owned a UK subsidiary.

The single European market needs to be reconciled with regulation and deposit protection. Branches are regulated by Homeland, and Homeland is required to protect all European depositors of the Homelandic bank (home country regulation). The subsidiary will be licensed and regulated in Otherland, and savers can seek protection there (host country regulation).

Both systems failed. Neither Icelandic bank should have ever been allowed to attract large inflows of funds from British savers by offering improbably high rates. Long before these banks failed, the credit default swap market signalled red alerts.

The Icelandic regulator lacked both the competence and the will to act. The UK regulator did not restrain Kaupthing, presumably because the accounts of the UK subsidiary seemed to show a sound position. When Landsbanki failed, the resources of the Icelandic deposit protection scheme were insufficient. The UK then inexcusably but understandably used anti-terrorist legislation to freeze Landsbanki’s UK assets. The UK also took control of Kaupthing UK, which led to the immediate failure of the parent. There was no politically feasible alternative.

The resulting bills will be shared among Icelandic taxpayers, UK taxpayers, and other UK banks and building societies, and are likely to run into billions of pounds. These Icelandic banks were minnows among global financial institutions and had significant operations in only a few countries. The incident should be treated as a wake-up call. We have no adequate measures to deal with a major international banking failure. What would have happened if the struggling Royal Bank of Scotland, whose principal retail operation is the English NatWest bank, had been headquartered in an independent Scotland? It is only necessary to frame the question to want to go to great lengths not to have to answer it.

Home country regulation makes every member of the EU dependent on the skills of the weakest regulator among its 27 members (although Iceland is not an EU member, like Norway and Switzerland it is treated as if it is for many purposes, including this, because of its membership of the European Economic Area). Host country regulation is inadequate because the host does not have enough control over large financial institutions based elsewhere.

The best answer would be more Europe – an effective pan-European regulator and a single Europe-wide scheme for protecting depositors. But this will not happen. If there cannot be more Europe, there should be less. Countries should insist that global institutions seeking retail deposits within their borders should operate narrowly, with a limited range of activities and sufficient liquid assets in the country to support most or all of the deposits they secure. Some states will certainly wish to continue to allow universal banking. But if institutions are to undertake cross-border retail activities they should establish narrow banking subsidiaries with reliable firewalls that would safeguard the interests of small savers in the event of failure of the parent institution.

This will not happen either. The likely outcome of present discussions is that everyone will agree they will regulate better and that there should be more co-operation between national regulators. This might prevent anything like the Icelandic problem occurring again. It is more likely that the tooth fairy will agree to provide compensation for future bank failures.

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