Before leaving the topic of crisis management and resolution in the case of the Icelandic banks, I would like to say a few words about deposit guarantees. Why did the Government give a verbal blanket guarantee only for domestic deposits and not the deposits in the banks’ foreign branches? After all, this distinction probably added fuel to the fire of the so-called Icesave dispute about the settlement of deposit guarantees in Landsbanki’s Dutch and British branches. The short answer is that such a guarantee would never have been credible. As a result, it would not have stopped the run on these deposits and, if attempted, might have bankrupted the Government. At the time, the Central Bank of Iceland’s FX reserves amounted to 2½ billion euros, while the foreign currency deposits in Landsbanki’s Dutch and British branches totalled 11½ billion euros and payment of the EU minimum deposit insurance would have required 4½ billion euros. In economic terms, given that these deposits were used to a significant degree to finance illiquid assets in these same countries, such a payment would have amounted to a net transfer of resources from Iceland to these countries at a time when Iceland was going through its deepest financial and economic crisis in the post-war period! That made no sense, and the only solution was for the governments concerned to pay out the insurance in their own currency with the aim of settling later with Iceland.
The financial crisis revealed major fault lines in cross-border banking, the most important being large foreign currency balance sheets with significant maturity mismatches but with limited lender of last resort facilities in foreign currency. The nature and magnitude of this phenomenon were not well understood before the crisis.2 Maturity mismatches are, of course, the bread and butter of modern banking, although they make banks vulnerable to runs. In the case of solvent institutions, we have known theoretically since Thornton (1802) – and probably over a century, as a practical policy – how to deal with that vulnerability in a domestic setting: with central bank lender-of-last-resort (LOLR) operations, later complemented by deposit insurance. In the current setting, it is far from guaranteed that this process can be replicated at the international level. Of course, in normal times and with developed capital markets, banks can use foreign exchange swap markets to convert domestic liquidity into foreign exchange liquidity swiftly and relatively cheaply. However, this process broke down almost completely during the global run on cross-border non-US bank liabilities in the immediate aftermath of the Lehman collapse. In a situation like this, the home central bank’s ability to assist banks in acquiring the foreign liquidity denied them on the market and thus avoid a failure to deliver on their foreign currency payments, is limited by the size of its reserves or the willingness of the central bank issuing the international currency in question to help.