ECONOMICS:The earlier Asian crisis made Singapore and Hong Kong more cautious – and more protected from meltdown, writes PAT McARDLE

A RECENT International Monetary Fund (IMF) paper* looked at what makes economies with large banking systems vulnerable to a crisis.

The countries examined were Hong Kong, Iceland, Ireland, Singapore and Switzerland. It is worth considering because Irish commentators frequently look at things from a domestic perspective only.

Bank strategies varied considerably from country to country. Icelandic and Irish banks sought to generate profits through rapid expansion. Between 2003 and 2007 their average loan growth rates were 61 per cent and 25 per cent respectively.

In a paper last year, Central Bank governor Patrick Honohan noted that an annual real growth rate of 20 per cent is often used as a trigger in assessing bank risk.

The only solace here for the Financial Regulator is that its Icelandic counterpart was in a much deeper slumber.

By contrast, loan growth in Asia and Switzerland averaged less than 10 per cent. Major British banks were mostly between 20 per cent and 30 per cent, ie, not very different from their Irish counterparts (see table).

Some banks became dependent on wholesale funding, frequently foreign. While access to foreign funding was a problem for Icelandic and Irish banks, the concerns were triggered by deteriorating assets. Both had overextended their loan books to companies and property markets respectively, according to the paper.

The two big Swiss investment banks were the most highly leveraged, followed by Ireland and then Iceland, with Asia at the other end of the scale.

Icelandic and Irish banks also had weaker liquidity buffers – their loan-to-deposit ratios were the highest and their liquid asset ratios were the lowest of the five countries examined.

In general, Asian banks produced acceptable returns from a diversified deposit base while keeping relatively large capital and liquidity cushions.

Swiss banks sought higher returns by taking on leverage via investment banking that relied on wholesale funding, which exposed them to risk, as did their investments in toxic US property-related assets. Iceland and, to a lesser extent, Ireland both went for broke on more traditional-type lending.

Bank governance also mattered. Swiss bank UBS had a decentralised structure that relied heavily on external (ie, ratings agency) endorsements of credit quality when warehousing and packaging collateralised debt obligations. Credit Suisse hedged more effectively and exited the US property market early.

The IMF concluded that the Icelandic authorities had insufficient supervisory and regulatory experience and lacked the instruments to effectively oversee complex bank ownership structures.

The IMF was kinder to the Irish, merely observing that the expansion was supported by UK-style principles-based regulation. This ignores the fact that US-style rules-based regulation produced an outcome that is arguably worse in the case of the subprime debacle.

Swiss regulators were criticised for their over-reliance on banks’ risk models and for failing to take proper account of, legally but not morally, separate off-balance sheet vehicles, which were frequently undercapitalised.

Asian regulators were praised for measures such as a stringent 70 per cent cap on loan-to-value ratios (LTVs), whereas the Irish authorities assigned higher risk weights “to mortgages with LTVs above 80 per cent only in May 2006”. Asian capital ratios were also higher and better composed.

The crisis rapidly exposed the strong links between bank and sovereign risk. Reflecting their underlying vulnerabilities, global turbulence affected Iceland first, then Ireland and Switzerland.

The paper devotes little or no attention to the causes of the global turbulence, which undoubtedly exacerbated a weak underlying situation in several of the countries examined. If the US subprime issue was the rocket that launched the global crisis, the Lehman collapse was the booster that drove it into outer space.

The rapid collapse of the Icelandic banking system forced the government to give unlimited support to depositors, initially largely confined to domestic deposits. This, in turn, sparked a major row with Britain and the Netherlands, where Icelandic banks had taken huge deposits at high interest rates, a dispute which is not yet fully settled.

A potential funding run on Irish banks after Lehman collapsed was quelled by an extensive guarantee on bank deposits and debt, which transferred the risks to the State.

By rapidly dealing with UBS’s troubled assets, the Swiss authorities partially insulated the government from bank risks even though it had to rescue a major bank.

The IMF says this reconfirms past experience that early and well-designed intervention – the Swiss speedily created a “bad bank” – generally lowers the fiscal cost while limiting moral hazard by ensuring that troubled banks pay a significant proportion of the eventual costs.

There is no mention of the long delay in setting up the National Asset Management Agency but we now know that no action could have saved Anglo Irish Bank or Irish Nationwide.

The overall conclusion is that the fiscal costs are likely to remain a lasting legacy of the crisis in Iceland and Ireland, but the costs to the Asian economies and, strikingly, Switzerland are modest.

Swiss banks expanded slowly but got caught when the two large banks “bought into the unsustainable US bubble”.

Though Hong Kong and Singapore already had large banking systems, their rate of expansion after 2001 was significantly below Iceland and Ireland and, for that matter, below the euro zone and the US. Foreign debt remained constrained and the regulators helped by tightening lending standards for property loans. The earlier Asian crisis had made banks and regulators cautious.

It appears that the lessons from the current crisis are the best guarantee against a repeat performance.

*Cross-Cutting Themes in Economies with Large Banking Systems, IMF, April 16th, 2010