Iceland shows challenges of cross-border regulation

Thanks to cross-border passporting, Icesave became a high-profile online brand in the UK. But when its parent Landsbanki collapsed in October 2008, Icesave depositors found they were not covered under any country’s deposit guarantee scheme. The UK government reluctantly stepped in and has been arguing with the Icelandic government over who should pick up the tab ever since.

Those difficulties will be returning to policy-makers’ minds following the EU’s stress-tests in July 2011. Two of the banks that failed the tests, Greece’s Eurobank and Austria’s Volksbank, have widespread operations in central and eastern Europe. Several of the near-miss banks in Greece and Portugal are also cross-border players.

Following the Icesave debacle, the new orthodoxy that emerged was that each national regulator should ask foreign banks to incorporate full subsidiaries in each country, with local capital and liquidity resources. When Austria’s Raiffeisen bought the 300 branches of Eurobank’s Polish operation Polbank in early 2011, part of the deal with the Polish regulator was that Polbank’s branch licence would be upgraded to a full subsidiary licence.

However, the experience of depositors in another Landsbanki operation suggests subsidiarisation alone is not enough. Landsbanki Guernsey was a locally incorporated subsidiary. But when the parent bank failed, this meant that Guernsey retail depositors – many of them inherited from Cheshire Building Society, whose Guernsey operations Landsbanki bought in 2006 to acquire a local licence – had no priority recourse to the parent bank’s assets.

Instead, they had to rely on the performance of the assets held by Landsbanki Guernsey. These mainly consisted of loans made to the parent bank and other Landsbanki subsidiaries. Those loans were simply thrown into the insolvency pot with other wholesale creditors, leaving Guernsey depositors at the back of the queue for recoveries.

To be fair to the Guernsey regulators, they had pressured the local Landsbanki subsidiary to diversify its assets months before the collapse, but too late to avoid losses for depositors. Supervisors will need to ensure that local subsidiaries of foreign banks are genuinely engaged in local lending, not just conduits heavily exposed to the parent bank. Healthy retail banking still needs to be a national activity, even in a single European market.