This problem was significantly mitigated with the FX swap lines that the US Fed negotiated with the ECB and other major central banks, especially after these became uncapped in some cases. But the problem was not confined to currency pairs involving the US dollar, and a similar kind of dynamic played out for smaller currencies in Europe vis-à-vis the euro, especially where banking systems had significant short-term foreign refinancing needs, or what can also be called rollover risk in terms of foreign currency. In some cases, FX swap lines were granted vis-à-vis the dollar, the euro and the yen, and in some cases not. Where swap lines were granted, it helped. And for some of the smaller players, it might not have mattered terribly much which of the major international currencies they hooked on to in this sense, especially after the uncapped swap lines had been established. What we observed during this peak of the crisis was thus a run on cross-border banking operations. We know how to solve such problems domestically by letting central banks lend to markets and/or institutions through their almost unlimited short-run capacity to expand their domestic balance sheet. However, when it comes to foreign currency, a central bank’s capacity to help banks to refinance the foreign liquidity denied them on the market is limited by the size of its reserves or the willingness of its big neighbours to help. This is what did the Icelandic banks in.
In their Consultancy Study, KPMG/Barents identified this as an important issue as the banking sector becomes more competitive and the level of risk possibly increases. They also considered that the current arrangements, which give priority to small depositors, did not appear to have sufficiently raised the crisis of confidence threshold to avoid bank runs. They therefore recommended that the issue of deposit protection should be looked at again. This we have done in the form of a new consultancy study by Arthur Andersen that was completed in July of this year. This has looked at various options for deposit protection, including maintenance of the status quo at one extreme and the introduction of an explicit scheme for deposit insurance at the other. Such schemes are increasingly being introduced around the world and are advocated by a number of international standard setting bodies. The drawbacks of deposit insurance are however well known, including the risk of increased systemic instability due to moral hazard. The costs of such a scheme would also need to be carefully considered. This is a controversial issue that will need to be fully debated. Subject to views of Exco, it is our intention to undertake a consultation on the various options for deposit protection at the beginning of October. If it is eventually decided to introduce one of these options, further consultation would then be required on the detailed arrangements. Risk-based supervision Of course, the best thing would be for the safety net not to be actually used.