The Fault Lines in Cross-Border Banking: Lessons from the Icelandic Case

Abstract

This paper discusses the fault lines in cross-border banking, both at the global level and at the European Union/European Economic Area (EU/EEA) level, using the case of the three Icelandic cross-border banks as an example. Cross-currency liquidity risk built up prior to the crisis, especially maturity mismatches in foreign currency. This risk tended to be grossly underestimated at the time. There was a run on banks’ FX liabilities after the collapse of Lehman Brothers in September 2008. The Icelandic banks were highly vulnerable to such a run and lacked a credible lender of last resort (LOLR) in terms of foreign currency. The crisis also exposed serious flaws in the EU and EEA framework for cross-border banking, including deposit insurance. One of the main lessons of the Icelandic experience is that sizeable cross-border banking operations in small countries with their own currency come with very significant risks. The Icelandic experience suggests that further reforms are needed for cross-border banking activities in the Single Market, where the key issue is to match the European passport for banks with pan- European supervision, deposit insurance and LOLR. Domestic banks could remain in the domestic system.