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In many ways, Iceland fits this bill. Membership in the European Economic Area in 1994 provided access to EU markets and a level playing field. Privatisation of the banking system in the late 1990s and early this decade created the incentives and the dynamism. Then, the country’s banks embarked on an international expansion that was partly designed to follow Icelandic firms in their own outreach. This has now created a situation where three-quarters of the total lending of the largest commercial bank groups is to non-residents. This episode raises an interesting question that has to my knowledge not been given a satisfactory answer: what determines which countries become predominantly home countries and which become predominantly host countries? Why is Iceland a home country but New Zealand and the Baltic countries, to name a few examples, host countries? I leave the question with you, but I suspect that accidents of history might have as much to do with it as current assessment of economic efficiency.
The challenges for prudential authorities created by the internationalisation of banking are many. First, internationally active banks are more complex, as you know better than most, requiring more sophisticated resources from supervisory authorities. Second, in the absence of global or regional supervisors, internationalisation of banking requires information, views and local knowledge to be shared between supervisors in different jurisdictions, in particular between home and host authorities. Third, crisis management and resolution will necessarily involve several jurisdictions, with all the complexities and tensions over burden-sharing that this implies. Fourth, emergency liquidity assistance will be complicated or even impossible for central banks to deliver when internationally active banks face liquidity problems in currencies other than that of their home country. Iceland is a case in point.
The fundamental problem is of course that there is a mismatch between the international scope of banking institutions and the national scope of the frameworks for banking supervision and crisis management. The home-host principle is designed to meet these challenges, at least partly. However, it is currently being strained in several respects. Let me mention three examples:
First, banks might be systemically important in the host country but not in the home country, leading to differences in perspectives on the importance of supervision or at the time of stress. An example of that are many countries in central and eastern Europe.
Second, internationally active banks might be engaging in activities in host countries that are risky in terms of the macrofinancial stability in those countries, but where the risks are not sufficiently large to threaten the stability of the institutions concerned. An example is the foreign currency lending of some major European banks to unhedged borrowers in central and eastern Europe.
Finally, shocks to the operations of institutions in host countries might have systemic effects on the banking system in the home country, if the host country operations are sufficiently large. An extreme example of that is the Icelandic banking system. However, the other side of that coin is that the banking system in Iceland is more resilient to domestic macroeconomic shocks as its relative exposure to the domestic economy is much less than it used to be.
The setting-up of supra-national (that is global or regional) supervisors requires political will and initiative that is hard to muster. Although there has been some discussion about setting up such a supervisor for internationally active banks at the EU level, it is in the best of cases some time off. However, that does not mean that progress is not being made. On the contrary, policymakers have been dealing with these issues through various other means. Let me mention few examples. First, international standard setting has aimed at co-ordination and harmonisation of rules and supervisory practices. Second, Basel II has set up a common regulatory infrastructure which further reinforces cross-border harmonisation and co-ordination among supervisors. Third, at the level of the European Union there are significant efforts taking place, including joint crisis management exercises. Fourth, as you know very well, the most important supervisors for major global banks get together to discuss supervisory strategy. For example, I could mention the close collaboration of supervisors in the Nordic countries on the supervision of Nordea.
Monetary policy
My final topic is how financial globalisation is affecting monetary policy, especially among small and medium-sized countries that operate open capital accounts and flexible exchange rates.
Although sometimes forgotten when discussing the current plight of countries like New Zealand or Iceland, we know from theory that full financial globalisation will result in real returns on financial assets with similar maturity and risk being equalised across countries. For the small open economy that is unable to affect global financial conditions, this means that monetary policy will not be able to influence domestic real interest rates. Its ability to affect domestic demand through the interest rate channel would then disappear. That still leaves the exchange rate channel, which is sufficient for monetary policy to hit any inflation target in the medium to long run and potentially retain some countercyclical force in the short run, provided of course that monetary authorities do not try to fix the exchange rate.
These results are of course not new. Nobel Laureate Bob Mundell demonstrated in a series of articles in the early 1960s that for the small open economy with free and frictionless capital movements, monetary policy working only through the exchange rate would be a powerful stabilisation tool when the exchange rate floats but totally ineffective when it is fixed. The reverse would hold for fiscal policy.
We are still some way from this state of affairs, although a few small open mature economies might be getting closer. However, in order to know where we are heading, even if we might never completely get there, it might be interesting to speculate on what would happen to monetary policy if globalisation, both real and financial, were to run its full course.
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