‘Banking policy could include limiting of balance sheets’

Patrick Honohan: National authorities are the victims.

Macroprudential policy for the banking system in the future could include measures to prevent expansion of banks’ balance sheets beyond a certain scale, said the governor of the Central Bank, Patrick Honohan.

This would then “put the onus on authorities to determine what is the optimal size and structure of the country’s financial sector — not an enviable task”.

Mr Hohohan was speaking in Reykjavik at a conference organised by the Central Bank of Iceland. He noted that if a country has an underdeveloped banking system relative to the size of the economy, this situation will constrain economic growth. However, if a country’s banking system grows disproportionately to the size of GDP, then this can pose different and far greater challenges.

“When it was famously observed that large banks, though international in life, are national in death, what was meant was that it will be national fiscal authorities and the local customers that are the victims in case of a failing international bank,” said Mr Honohan.

Domestic banks can access vast amounts of foreign funding because the markets take a view that there is an implicit guarantee of this capital in the event of a bank collapse. However, domestic banks that can tap international wholesale funding can have the effect of over heating domestic property markets and propping up, “the finances of an overspending fiscal authority, creating extensive pockets of domestic over-indebtedness whose deleveraging destabilises economic activity.”

Mr Honohan cited as examples three countries that suffered banking crises: Iceland, Ireland, and Cyprus.

In Iceland, domestic deposits and assets were carved out of failing banks and put in new banks. These failing banks, which mostly had foreign liabilities, were liquidated, which limited the impact on the sovereign.

In Ireland, the domestic banks had accumulated huge amounts of foreign liabilities that were covered by a state guarantee, which stretched the fiscal capacity of the Government.

In Cyprus, deposits had grown to 3.5 times GDP. In this instance, depositors were bailed in, which underlined the need for European legislation in bank resolutions, said Mr Honohan.

“If large banking systems with access to foreign finance become involved in providing credit to the local economy, they have the capacity to rapidly destabilise it,” said Mr Honohan. “Furthermore, it will be difficult or impossible for the national fiscal authorities to deal with the failure of such a bank if it is providing important payment or transactions balance services to the domestic economy.

“Of course, these considerations are directed to the situation of a small country with a large banking system. More generally, the interpenetration of banking systems has been seen as an important contributor to limiting uncompetitive practices in terms of price and improving provision of services. The degree of segmentation of international finance along national borders seen in the course of this crisis is surely an over-reaction which should, and will, be reversed.”


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