MASTER THESIS (final draft)
INTERNATIONAL BUSINESS & MANAGEMENT
Information asymmetry and financial stability in the
Dutch and Icelandic banking sector
Student: L.A. de Vries Student number: 1547054
Mail: lutsendevries@gmail.com / l.a.de.vries.3@student.rug.nl Supervisor: drs. H.C. Stek
Co-supervisor: mr. drs. H.A. Ritsema April 2011
ABSTRACT:
Keywords: Iceland, Netherlands, Banking Crisis, Financial Stability, Information Asymmetry, Deposit Insurance, Banking Regulation, Banking Supervision.
In past research of the current financial crisis, the information asymmetry aspect did not receive a lot of attention, while research shows its utter importance. Moreover, previous methods to show information asymmetries prove to be inadequate.
TABLE OF CONTENTS
ABSTRACT: ... 2
TABLE OF CONTENTS... 3
1. INTRODUCTION... 4
1.1.SCOPE OF RESEARCH... 4
1.2.RELEVANCE AND PURPOSE OF RESEARCH... 4
1.3.RESEARCH QUESTIONS AND MOTIVATION OF RESEARCH QUESTIONS... 8
1.4.OUTLINE... 9
2. THEORETICAL BACKGROUND... 10
2.1.THE BASIS OF THE INFORMATION ASYMMETRY LITERATURE... 10
2.2.INFORMATION ASYMMETRY IN THE FINANCIAL AND BANKING SECTOR... 11
2.3.EVIDENCE AND APPLICATION OF INFORMATION ASYMMETRY... 12
2.4.MEASURING INFORMATION ASYMMETRY... 12
2.5.LIMITING INFORMATION ASYMMETRY IN THE BANKING SECTOR... 13
2.5.1.DEPOSIT INSURANCE SYSTEMS... 14
2.5.2.REGULATION AND SUPERVISION IN THE BANKING SECTOR... 20
2.5.2.1.REGULATION... 21
2.5.2.2.BANK SUPERVISION... 22
2.6.MEASURING FINANCIAL STABILITY... 23
2.7.CONCEPTUAL MODEL... 23
3. RESEARCH METHODOLOGY... 24
3.1.GENERAL... 24
3.2.THE INFORMATION ASYMMETRY PREVENTION FRAMEWORK... 25
3.2.1.DEPOSIT INSURANCE SCHEMES: METHODOLOGY AND DATA COLLECTION... 25
3.2.2BANKING REGULATION: METHODOLOGY AND DATA COLLECTION... 26
3.2.3.BANKING SUPERVISION: METHODOLOGY AND DATA COLLECTION... 26
3.3.INDICATORS FOR FINANCIAL STABILITY: METHODOLOGY AND DATA COLLECTION... 27
4. DATA AND FINDINGS ... 27
4.1.GENERAL... 27
4.2.THE INFORMATION ASYMMETRY PREVENTION FRAMEWORK: DATA AND FINDINGS... 27
4.2.1.1.DEPOSIT INSURANCE SCHEMES: DATA AND FINDINGS... 27
4.2.1.2.DEPOSIT INSURANCE SCHEMES:ICELAND AND THE NETHERLANDS COMPARED... 29
4.2.2.1BANKING REGULATION: DATA AND FINDINGS... 29
4.2.2.2.BANKING REGULATION IN ICELAND AND THE NETHERLANDS COMPARED... 33
4.2.3.1BANKING SUPERVISION: DATA AND FINDINGS... 33
4.2.3.2.BANKING SUPERVISION IN ICELAND: DATA AND FINDINGS... 33
4.2.3.3.BANKING SUPERVISION IN THE NETHERLANDS: DATA AND FINDINGS... 35
4.2.3.4.BANKING SUPERVISION IN ICELAND AND THE NETHERLANDS COMPARED... 36
4.3.FINANCIAL STABILITY INDICATORS: DATA AND FINDINGS... 37
4.3.1.FINANCIAL STABILITY IN ICELAND: DATA AND FINDINGS... 37
4.3.2.FINANCIAL STABILITY IN THE NETHERLANDS: DATA AND FINDINGS... 39
4.3.3.FINANCIAL STABILITY IN ICELAND AND THE NETHERLANDS COMPARED... 41
5. CONCLUSIONS AND DISCUSSION, LIMITATIONS AND RECOMMENDATIONS ... 43
5.1.CONCLUSIONS AND DISCUSSION... 43
5.2.LIMITATIONS... 46
5.3.RECOMMENDATIONS... 47
REFERENCES... 49
1. INTRODUCTION
1.1. Scope of research
In the recent history, we have seen increasing turbulence on the different financial markets of the world. There are numerous studies on causes of this turbulence on financial markets and on causes of crises in general (see among others Mishkin, 1991, 1996, 2006; Demirgüç-Kunt, and Detragiache, 1998; Eichengreen and Carlos, 2000; Felton and Reinhart, 2008; Reinhart and Rogoff, 2009). One theory, on which this thesis will focus, is the asymmetric information theory. According to Mishkin (1991, 1996, 2006) one of the contributing factors to financial instability is information asymmetry in financial markets:
Financial instability occurs when there is a disruption to financial markets in which asymmetric information and hence adverse selection and moral hazard problems become much worse, so that financial markets are unable to channel funds efficiently to those with the most productive investment opportunities.1
Why asymmetric information? The reason the research focuses on asymmetric information
in this thesis are the large potential effects of information asymmetry. Gorton and Metrick (2009) show us that financial markets sometimes just stop functioning in their research on the repo market in 2007 – 2009. Furthermore, in his seminal paper on information asymmetry, Akerlof (1970) has shown us that a complete collapse of trade is a theoretical possibility in economies with asymmetric information.
Asymmetric information in the current crisis. Back to current turbulence on the different
financial markets around the world, we see that there is little research related to the role of information asymmetry in this crisis, despite the importance of the subject outlined previously. Research is limited to focused research on the role of information asymmetry in separate fields such as syndicates, stock markets and finance (see among others: Sufi 2007, Lambert 2009). Research related to financial instability and asymmetry of information limits mostly to research on emerging markets (Mishkin 1996) and past crises (Mishkin 1991). Thus the role of information asymmetry in the 2008 financial crisis as well as information asymmetry in established (non-emerging) markets remains uncovered in research until now.
1.2. Relevance and purpose of research
In a 2006 research on financial stability in Iceland, Mishkin and Herbertsson argue that financial regulation and prudential supervision in Iceland is ‘of high quality’ and ’generally strong’, with an economy that ‘has adjusted to financial liberalisation’, and where ‘it is unlikely that there are serious problems with safety and soundness in the banking system’ and where ‘the likelihood of a financial meltdown is low’. Two years after the publication of this research, we have seen that emergency measures had to be taken for Icelands three largest banks (Kaupthing, Landsbanki and Glitnir) to safe them from bankruptcy and the Icelandic economy is in a severe economic recession. Although Mishkin and Herbertsson concluded in their research that information asymmetry would not cause severe problems in the Icelandic banking sector, it obviously did after the publication of the report. Therefore in this research, I want to analyse how information asymmetries are reduced and thus how this affects financial stability.
Purpose. The purpose of this research is to show how the authorities try to reduce information
asymmetry in their banking sector, in order to reduce financial instability. In this research, focus lies on two countries, Iceland and the Netherlands. The first choice to focus solely on two countries is partly given by Demirgüc-Kunt and Detriache (1998), who emphasise the need to research banking crises more in depth in smaller country sets. Their research is on the determinants of banking crises, of which information asymmetry is one. The choice is also practical, as a research involving more countries would be too time consuming for the scope of this thesis. The argumentation for the second choice, for the countries Netherlands and Iceland, is two sided. On the one hand the countries are very comparable, both being relatively small open economies in Europe2 with a relatively large banking sector. On the other side, and this is much more important, these banking sectors and economies differ quite significantly.
Iceland. Iceland’s banking sector is very rapidly liberalised after financial reforms in
the 1990s. These liberalisations gave way to investments bankers to run the three main banks in Iceland, which collapsed in 2008 (Jännari 2009). Also outside Iceland these banks grew aggressively, illustrated by the growth of bank assets in per cent of GDP: in 2000 this was approximately 100 %, in 2008 this was grown to eleven (!) times GDP.
Netherlands. In the last decades, the Dutch banking sector consolidated more and
more (Garcia and Prast 2003), and the emphasis moved to consumer protection, all with the
purpose of creating a common European financial market, in which the small depositor could trust the banking system and in which investors had the possibility to transfer funds and capital freely across the borders within the Common European Market.
The differences between Iceland and the Netherlands are also seen clearly when we briefly compare the effects of the crisis in the two countries.
Table 1: Development in macro-economic variables
Iceland The Netherlands EU27
Inflation rate 2007 / 2008 / 2009 3,6% / 12,6% / 16,3% 1,6% / 2,1% / 1% 2,3% / 3,7% / 1% ∆GDP 2009 -6,5% -4% -4,2% Unemployment 2007 / 2008 / 2009 2,0% / 3,0% / 7,6% 3,2% / 2,7% / 3,4% 7,2% / 7,1% / 9,0% Source: Eurostat (2010)
As can be seen, inflationary pressures do affect the Icelandic economy drastically, as rates have quadrupled over the last 3 years. Note that all this is contrary to what is going on in the Netherlands and the rest of Europe, where inflation tends to decline. Also GDP growth reduction is much more pronounced in 2009 in Iceland than in the rest of Europe or the Netherlands. Even though unemployment figures have increased dramatically in Iceland, they are still under the level of the European Union. The Netherlands can be seen to perform rather well under these crisis conditions when we look at the employment market.
Relevance. This research is in the first place relevant for academic purposes as it proposes a
views of named ‘early theorists’, elements to reduce information asymmetry are distilled, after which information and data from these elements are used from more recent projects researching banking crises, regulation and supervision. Combining data indicating these different elements together into one research has not yet been done before, as research before focused on separate elements of information asymmetry reduction, thus treating deposit insurance, banking regulation and supervision et cetera separately. Combination of this data helps academia to grasp the asymmetric information problem in a country entirely, instead of just focusing on one element of asymmetric information reduction.
In the second place, relevance is found in comparing two countries with a different background, one being heavily liberalised from the 1990s (Iceland) and one already being established as a country with a rather liberal and stable financial sector (Netherlands), thus entering the crisis from a more stable perspective (Jännari 2009 and Garcia and Prast 2003). These two different backgrounds allow us to see how information asymmetries influence financial stability in different settings, one being rather turbulent and one being more stable. As we have seen in the figures above, Iceland suffered much more from the crisis than the Netherlands. This is in line with literature, as Ranciere et al (2006) argue that after financial liberalisation, as occurred in Iceland, crises are more likely to occur. This thesis shows what role information asymmetries play in the development of this crisis.
For policy-makers in the banking sector, relevance of this research is found in the comparison of measures to counter asymmetric information across countries. Moreover, effectiveness of these measures can be evaluated, as also an analysis is made of certain macro-economic indicators which are used to show the impact financial instability had on the country’s economies. These macro-economic indicators will also be extracted from the ‘banking-crisis literature’ named above.
seen as an indicator of effectiveness of the policies administered by the Dutch and Icelandic authorities to reduce information asymmetry.
First step in the research process thus will be to show the ways in which information asymmetry is reduced in order to prevent financial instability. Second step in the process is to compare the countries under research on financial stability indicators to see how they are impacted by the crisis, and thus to evaluate the working of these information asymmetry reduction measures.
1.3. Research questions and motivation of research questions
The main research question that will guide this research is the following:
How do the Icelandic and Dutch authorities deal with information asymmetry in their respective banking sectors and how do these methods affect financial stability?
This main research question is the question that will be answered in the conclusion of the research. This research question will be supported by the following subquestions, guiding the research:
1. What elements can be discerned in policies to limit information asymmetry?
Ad 1: First we will look how information asymmetry can be limited. The answer to this
subquestion will show us in what ways information asymmetry can be limited according to the relevant academic literature, what are the most common methods to do this and how these methods are evaluated in the literature.
2. How is information asymmetry limited in the Icelandic banking sector? 3. How is information asymmetry limited in the Dutch banking sector?
Ad 2 and 3: When we have discerned various elements to reduce information asymmetry,
these elements will be applied to the Dutch and Icelandic banking sector. In this way we can gather data on the information asymmetry prevention framework in the banking sectors of Iceland and the Netherlands.
4. What differences do we see in the application of information asymmetry limitation policies when we compare application in the Dutch and Icelandic banking sector?
Ad 4: After we have seen in the previous two questions how information asymmetry is limited
Ad 5: Then, to be able to show how financial stability developed in the years under research,
we look into the literature to see what variables indicate financial stability.
6. What idea do these variables (Q5) give us of financial (in)stability in the Icelandic banking sector?
7. What idea do these variables (Q5) give us of financial (in)stability in the Dutch banking sector?
Ad 6 and 7: Then, using the variables from question 5, we analyse financial stability in the
banking sectors of Iceland and the Netherlands. Comparing these differences, we will be able to see what effect the information asymmetry prevention policies have in Iceland and the Netherlands.
8. If we see differences, can we say that information asymmetry is limited better in the one banking sector compared to the other?
Ad 8: Finally, combining the answers from the various subquestions, we will be able to say
where financial stability suffered most and thus where information asymmetry has been prevented better, in Iceland or the Netherlands.
1.4. Outline
2. THEORETICAL BACKGROUND
In this theoretical background, first an analysis will be made of the literature around the concept of information asymmetry to inform and familiarise the reader with this concept and the use of it. In this section will also be elaborated on the relationship between crises and information asymmetry and the concept of information asymmetry more specifically in the financial and banking sector.
Then, the theoretical background will close with the question how information asymmetry can be limited as much as possible in order to avoid financial instability. As we will see in this theoretical background, (roughly) information asymmetry can be limited using deposit insurance schemes, proper banking regulation and decent banking supervision, thus: first, elements of comparison will be found in the sphere of deposit insurance schemes. Second, bank regulation will be discussed, followed by an analysis of supervision in the banking sector.
Last question to the literature will be what variables can be used to measure financial stability.
2.1. The basis of the information asymmetry literature
In his 1970 paper, titled ‘the market for ‘lemons’’, Akerlof describes the basis of the information asymmetry problem: the seller of the product (in Akerlofs essay a used car) knows much more about the product than the buyer, leading to a disadvantage for the buyer. More extremely, the buyer will buy a lemon (jargon for a bad car), for the price of a good car, because due to his informational disadvantage he will not know the car he bought is a lemon. The author then zooms out to the entire market: if this happens on a larger scale, eventually the market will only consist of lemons: low quality cars for a high price.
In extension to this, Rothschild and Stiglitz (1976) describe in their paper on the insurance market, that imperfect information has significant effects on competitive markets, where equilibria were hard to attain in their model that incorporated imperfect information on the insurance market. In an entirely different field of research, labour markets, Michael Spence (1973 and 1974), describes the information asymmetry problem at the job market: the prospective employee knows exactly what he is capable of, but for the prospective employer this is hard to verify.
reveal this information to its counterparty, screening occurs when the uninformed party induces the informed party to reveal more information (Mankiw, 2009).
Now that we have treated the development of the basic information asymmetry literature over the years, let us now turn to information asymmetry in the financial and banking sector. Here we will also find evidence that information asymmetry leads to financial instability and it is explained how this happens using the concepts moral hazard and adverse selection.
2.2. Information asymmetry in the financial and banking sector
If we take a leap towards the problems of asymmetric information in the financial and banking sector, and more specifically in relation to financial crises, additional literature is found. In several publications (a.o. 1991, 1996, 2006), Mishkin argues that one of the factors causing financial instability and worsening banking crises and panics is asymmetric information. Mishkin argues that problems arising from asymmetric information are twofold:
Adverse selection. The first type of problem caused by asymmetric information is so called
adverse selection: this type of problem is briefly defined by Mishkin as ‘the party who is most eager to engage in a transaction is the one most likely to produce an undesirable (adverse) outcome for you. Someone who knows that she is not going to pay you back will be the most eager to get a loan from you.‘ (Mishkin 2006, p.26). The adverse selection problem occurs before a transaction is closed.
Moral hazard. After the transaction occurs, a second problem, the moral hazard problem,
arises. This is the risk or hazard that arises after the loan has been made: the investor might suddenly decide not to make the save investment he promised to make, but to go to the casino with the money he borrowed to make a much more risky investment. This moral hazard problem is also confirmed by McCoy (2007). This problem can also be classified as the principal agent problem: the principal and agent might 1) have conflicting interests, desires or goals and 2) the attitude towards risk of the principal and the agent might differ tremendously (Eisenhardt 1989).
The above authors argue that these problems exist always in transactions. Mishkin (2006), argues that these problems worsen in crisis situations, in turn worsening these same crisis situations, resulting in a downward spiral.
the research of Mishkin in the financial and banking sector, the asymmetric information theorem also holds in other sectors than in banking. The section ends with a figure giving an overview of asymmetric information literature.
2.3. Evidence and application of information asymmetry
In their 2002 paper on the work of Akerlof, Spence and Stiglitz, three Swedish authors seek for further evidence and applications of the information asymmetry hypothesis (Löfgren, Persson and Weibull 2002). They find among others applications in the IT-sector, where lower quality IT-firms tend to be overvalued on the stock market, eventually leading to a burst in the IT-bubble (Myers and Majluf 1984), and in the labour sector – remember where the research of Spence started - (Riley 1979, Bedard 2001). That the majority of research trying to confirm the existence of information asymmetry is older, can be explained by the fact that currently signalling and screening eliminate many information asymmetry effects (Löfgren, Persson and Weibul 2002).
In figure 1 below, an overview is given of the relevant information asymmetry literature:
Figure 1: The Concept of Information Asymmetry (author, 2010)
2.4. Measuring information asymmetry
As stated, it is argued in the literature that information asymmetry is less visible nowadays because of signalling and screening possibilities which have improved tremendously over the last years (Löfgren, Persson and Weibul 2002).
The Concept Of Information Asymmetry In Development
Akerlof (1970) ‘The Market for ‘Lemons’’
Rothschild & Stiglitz (1976) IA in insurance
Spence (1973,1974), Riley (1979), Bedard (2001) IA in Job Market
Mishkin (1996), McCoy (2007)
IA in Financial Sector, leading to Moral Hazard and Adverse
Although in their essays on the theoretical side of information asymmetry a tremendous amount of important work has been done (and awarded with a Nobel Prize in 2001), they deal to a lesser extent with the actual measurement of asymmetric information in markets. The foundation of this body of research can be found in Bagehot (1971). He argues that the bid-ask spread (the difference between the bid price on the market and the bid-ask price) increases when informed trading increases. In this sense, informed trading means trading with one party being ‘informed’, having more information, at the expense of the counterparty. Thus, a higher bid-ask spread can be seen as a proxy for higher information asymmetry in the market. Other authors confirm this view of the bid-ask spread as proxy for information asymmetry (Copeland and Galai 1983), and base their analysis on the view that the bid-ask spread is a purely informational phenomenon, arguing that the difference between ask and bid price increases when more information is available (Glosten and Milgrom 1985). Also in more recent researches, the bid-ask spread is used as measure of information asymmetry (Kanagaretman, Lobo and Whalen 2007, Bhat 2009).
Note that these theories are about measuring information asymmetry on markets, for example stock markets. We cannot use these measures of information asymmetry in our research, because if we would for example use the bid-ask spread of shares of stock listed banks, we would have a proxy of information asymmetry in the market in which shares of banks are traded, and not a proxy of information asymmetry in the banking sector as a whole.
2.5. Limiting information asymmetry in the banking sector
We started this theoretical background by explaining what information asymmetry is and that it leads to financial instability through moral hazard and adverse selection. Thus authorities try to limit information asymmetry as much as possible in their banking sectors in order to reduce the chance financial instability occurs. Now, how do we reduce the problems related with asymmetric information as much as possible and thus reduce the chances to financial instability? Which solutions does the literature suggest in order to limit information asymmetry in the banking sector as much as possible?
his 1996 paper, Mishkin also lists the most common forms of bank regulation and supervision in order to reduce the risks associated with asymmetric information. These are:
- Safety nets for depositors
- Restrictions on bank asset holdings and capital requirements - Chartering banks and examining banks
- Disclosure requirements - Prompt corrective action
- Resources of regulators/supervisory authorities
On a more micro, enterprise based level, in a research on corporate governance and asymmetry of information, Kanagaretman, Loben and Whalen (2007) find evidence for the hypothesis that information asymmetry is lower in companies where good corporate governance is in place.
We will now look deeper into the elements of, as Spence and Stiglitz call them ‘screening and signalling’ which are used to limit moral hazard and adverse selection in the banking sector.
2.5.1. Deposit insurance systems
In the literature, depositor safety nets are found as one way to reduce risk taking, improve banking discipline and reduce the information asymmetry problem (Diamond and Dybvig 1986, Mishkin 1996, Martinez Peria and Schmukler 2001, Gropp and Vesala 2004, Demirgüc-Kunt, Kane and Laeven 2008). On the other hand, there is also literature criticizing the disciplining role of deposit insurance schemes, but most of these studies use regional and not federal United States data, which limits generalization possibilities to other financial markets (Hoelscher, Tayor and Klueh 2006). Concerning generosity of deposit insurance schemes, Demirgüc-Kunt et al. (2002) as well as Barth, Caprio and Levine (2006) suggest that higher generosity of a deposit insurance scheme is positively related to financial instability. Roughly, the most important choices which have to be made in designing a deposit insurance scheme are listed below:
1. implicit or explicit deposit insurance 2. foreign currency coverage
3. interbank deposit coverage 4. coinsurance
7. compulsory or voluntary membership
We will now look deeper into these criteria, to fully understand what elements can be discerned and are important in deposit insurance schemes. These elements will later be used to see how Iceland and the Netherlands reduce information asymmetry in their banking sectors.
Implicit versus explicit deposit insurance. Differences between implicit and explicit deposit
To illustrate the distribution of implicit and explicit insurance schemes around the world, see the map above in which grey indicates explicit insurance and white depicts implicit insurance (Demirgüc-Kunt, Karacaovali and Laeven 2005).
It has to be noted that an explicit system gives various advantages: it encourages good governance and discipline from the sides of owners, managers and creditors. Moreover, it makes that risk premiums can be required from banks by the public, thus restraining, or at least warnings customers of banks against excessive risk taking reflected in the risk premiums (Garcia 2000).
between deposit insurance and moral hazard: because deposit insurance shifts the loss risk from the depositor to the provider of deposit insurance. Santos (2000) argues that these moral hazard risks can be mitigated by using risk-related insurance premiums and capital structure regulation. The latter measures will be treated more extensively in the section about regulation and supervision. With regard to risk-related insurance premiums, it appears that this might be less desirable than it seems, because it induces cross-subsidisation of inefficient banks by more efficient banks (Freixas and Rochet 1995).
Despite the above mentioned critics on the functioning on deposit insurance systems – please note that most critical sounds are in the field of deposit insurance systems in poorly developed economies – we can see that an the adoption of explicit deposit insurance has been rising tremendously towards the end of the last century, especially in Asia, Europe, Middle East and the Americas (Garcia 2000). From IMF data, we can see that this rise continues worldwide in the 21st century, as can be seen in the table below.
Table 2: Deposit Insurance around the world
1995 2000 2005 Number of Deposit Insurance Systems around the world 47 67 87
Source: Garcia (2000) and IMF Statistics
Foreign currency coverage. If we look at the aforementioned database, we can see that in the
Table 3: Interbank and foreign currency deposits in deposit insurance systems
Interbank deposits. As the asymmetric information problem between banks is not considered
very urgent (the classic asymmetric information problem supposedly arises between two unequal contracting parties), in most countries interbank deposits are not covered under the deposit insurance scheme. Another reason for not including interbank deposits is that this would increase moral hazard: with interbank deposits insured, banks do not have an incentive to monitor their colleagues as carefully as necessary.
Coinsurance. Coinsurance can be scheduled under the caption ‘measures to limit moral
hazard’, as it makes the depositor a party in the deposit insurance contract: part of the loss is not returned to the depositor but has to be borne by the depositor himself. In other words, coverage is less then 100 per cent of the value of the deposit (Hoelscher, Taylor and Kluhe 2006). The direct aim of the coinsurance mechanism is to lead the depositor into more prudent bank choices in their deposit decision (Demirgüc-Kunt, Kane and Laeven 2008). In the literature is indicated that a system of coinsurance gives the signal that a country is willing to control moral hazard - by making the depositor personally liable for part of his deposit outstanding - in its banking sector (Nenovsky and Dimitrova 2008). Although econometric evidence pointing towards favourability of coinsurance exists, the share of countries using coinsurance declined slightly in the first years of the century (Hoelscher, Taylor and Kluhe 2006).
Coverage per deposit versus coverage per depositor. The policy maker can choose whether to
refunded the deposit coverage limits times the number of accounts he has outstanding. Over the past years, there has been a shift from per deposit coverage to per depositor coverage. Reasons can be found in the line of argument above: per deposit coverage would basically extend coverage to the unlimited. Note that in most cases it is still possible to extend coverage above the limit by spreading funds over deposits in different banks. This is perfectly illustrated by the cartoon on the left. A translation is found in the footnote3.
Ways of funding. There are different ways of funding the deposit insurance scheme in a
country. Choices have to be made with regard to funding ex ante or ex post, establishing a permanent fund, private or public sourcing and the (non) existence of an obligation to be part of the deposit insurance system.
The first choice to be made is funding the scheme ex post or ex ante. In the literature ex post funding is criticised among others because it would offer lower coverage than ex ante funding (Garcia 2000). Additional criticism of ex post funding lies in that at the time the arrangements are needed, balance sheets of bank have already deteriorated, possibly due to poor economic conditions, leading to a procyclical effect: banks in bad weather have to help the depositors of other banks in bad weather, causing balance sheets to deteriorate even further (Hoelscher, Taylor and Klueh 2006).
For ex post funding, advantages are also found in the literature: because banks know they will have to pay in case another bank will collapse, the system encourages monitoring of each other’s activities (Hoelscher, Taylor and Klueh 2006). It is also said to be less expensive in the long run, because no funds have to be managed in times there are no bank collapses, thus
reducing administrative and management cost (International Association of Deposit Insurers 2009).
In principle, ex ante funding gains more enthusiasm in the literature: it is said to enhance public confidence, to be more equitable (as also ‘falling’ institutions paid for the depositors which have to be compensated), to be anti-cyclical (as funds are gathered in ‘better times’) and gives the ability to charge a risk adjusted premium to reduce moral hazard (Garcia 2000, Hoelscher, Taylor and Klueh 2006, International Association of Deposit Insurers 2009). The result of this praise is that in the period 1995-2004 the share of pre-funded systems around the world rose from 72 per cent to 84 per cent, being an overwhelming majority. However, also serious criticism is found with regard to ex ante funding: risk taking would be increased because 1) banks know that there are provisions for insolvency resolution, 2) institutions might see the funds invested in a pre-funded foundation as sunk cost, giving less incentive to engage in active monitoring and 3) in less transparent environments, corrupt officials might simply use part of the funds meant for deposit insurance for other purposes (Demirgüc-Kunt and Kane 2002, Hoelscher, Taylor and Klueh 2006).
Then, the choice has to be made whether the scheme will be privately or publicly funded. The majority (99%) of deposit insurance schemes follow the way of private or joint funding: funding privately banks themselves have to allocate funds to compensate depositors as member institutions to the deposit insurance scheme (Demirgüc-Kunt, Kane and Laeven 2008).
2.5.2. Regulation and supervision in the banking sector
If we look deeper into the literature on information asymmetry and ask the question what more can be done to reduce information asymmetry, we see that banking regulation and supervision also play a prominent role (Spence 1974, Rothschild and Stiglitz 1976, Diamond and Dybvig 1986, Mishkin 1996). Regulation plays an important role in the banking sector, and is in times of turbulence often subject to change. Also in a European context it is argued that prudential regulation is a legitimate way to protect ‘uninformed’ investors (Dermine 2000).Regulation in the banking sector also includes the way in which the banking sector is supervised.
compare regulation and supervision across countries, and in later papers the authors also do recommendations in terms of ‘best practices’. The most important elements which can be discerned in regulation and supervision are the following according to this research.
- restrictions in banking activities - entry requirements
- capital requirements - official supervisory power
- private monitoring and information disclosure rules 2.5.2.1. Regulation
The elements on which the two banking sectors will be compared from a regulation perspective are outlined below.
Entry requirements. With entry requirements for a bank is meant the obligations which a
potential new bank has to fulfil in order to obtain a licence from the Central Bank4.
Examples of these entry requirements are: - capital entry requirements
- amount of licences required before entry - financial projections for the first three years
- background experience of future directors/managers - strictness in denial / approval of licences
Capital requirements. We can see that the minimum capital ratio that is required by the first
Basel regulations is 8% (Dewatripont and Tirole 1993). Further theoretical justifications of the use of minimum capital ratios are given by Miles (1999). In his paper he proves that it is also possible to introduce capital requirements without reducing the level of intermediation by the banks under capital regulations. Also Santos (2000) argues for minimum capital levels to reduce excessive risk taking behaviour by undercapitalised banks. However, he adds to this that increasing capital standards does reduce the risk of bank failure, but that it also reduces deposits due to the imperfect substitutability of capital and deposits.
Liquidity and diversification requirements. From the literature we know that diversification
requirements are negatively related to financial instability in the banking sector, and that this effect is larger in smaller economies (Barth, Caprio and Levine, 2001). Thus more diversification reduces the changes to financial instability in smaller economies.
Restrictions in banking activities. With restrictions in banking activities, we find in the
literature that restrictions on activities might reduce moral hazard, because a very broad range of activities gives banks many more possibilities to engage in riskier behaviour (Boyd, Chang and Smith 1998). Moreover, accepting unlimited expansion of banks lead to extremely large financial conglomerates whose operations may be impossible to monitor for supervisors (Camdessus 1997).
2.5.2.2. Bank Supervision
When we speak of bank supervision, and comparability of bank supervision across countries, we have to look for standardised elements in bank supervision. These can be found in the Basel Core Principles for Effective Supervision. Research shows that adherence to these core principles does positively affect banking sector performance and improves bank soundness (Podpiera 2004, Demirgüç-Kunt et al 2008). Literature also suggests that the Basel Core Principle assessment ‘is crucial for forming an overall opinion on a countries financial sector health’ (Evanoff and Kauffman 2005, p. 72).
The first Basel framework (1988) consisted of 25 core principles in the following areas: - objectives, autonomy, powers and resources
- licensing and structure
- prudential regulations and requirements - methods of ongoing supervision
- information requirements - remedial measures and exit - cross-border banking.
Figure 2: Basel II (author 2011)
2.6. Measuring financial stability
If we look into the literature to find measures of financial stability this appears hard, because there is not one definition of financial stability, nor for its counterpart financial instability. We will focus on factors from the literature causing financial instability, as these factors can be used to show the development from financial stability to financial instability. Research has been done in what causes banking and currency crises, how crises develop and what indicates in the eve of crises a coming crisis (Demirgüc-Kunt and Detriache 1998, Kaminsky et al 1998, Hardy and Pasarbazioglu, 1998). The first authors argue that the major indicators for financial instability are:
- GDP growth: the emergence of banking crises is often related to lower GDP growth - Interest rates: the emergence of banking crises is often related to excessively high
interest rates
- Inflation: high inflation is also often related to the emergence of banking crises.
These indicators are, among others, also confirmed by Kaminsky et al (1998). The current account balance and external debt did not count as proper indicators shows this research.
2.7. Conceptual model
Then, in order to show relationships between the concepts we have introduced in this theoretical background, let us turn to a basic conceptual model in which these relationships will be made clear.
Minimum Capital Requirements
Supervisory
Figure 3: conceptual model (author 2011)
As we see, the first concept is information asymmetry (1). We have seen in the review of literature above that information asymmetry in the banking sector leads to moral hazard and adverse selection. Thus, this concept is positively related to moral hazard (2a) and adverse selection (2b) in the model: when information asymmetry increases, moral hazard and adverse selection also increase. Then, literature has shown us that an increase in moral hazard and adverse selection decreases financial stability, as depicted in the figure by the arrow between boxes 2a and 2b on the one side and box 3 on the other side, indicating a negative relationship. Finally, box 4 shows us that information asymmetry can be reduced by the methods named in the literature. When the use of these methods increase, information asymmetry decreases, moral hazard and adverse selection decreases and financial stability does not decrease.
3. RESEARCH METHODOLOGY
3.1. General
In the theoretical background above, we have seen that actually measuring information asymmetry in the banking sector is not possible. In previous researches on information asymmetry and financial stability, such as Mishkin and Mishkin and Herbertsson (1999 and 2006), worsening information asymmetry is argued mainly to come from increasing uncertainty caused by deterioration of balance sheets in financial firms. In Mishkins research elements to limit information asymmetry are used to evaluate the role of information asymmetry in crises, but not enough: we have seen in the introduction to this thesis that for the case of Iceland financial stability did decrease tremendously, and thus an environment in which information asymmetries could grow was shaped, although research showed that this meltdown was not to be expected (Mishkin and Herbertsson 2006).
(1) Information asymmetry
(2a) Moral hazard
(2b) Adverse selection (3) Financial stability + +
-(4) Signalling and screening, monitoring, deposit insurance, regulation, supervision et cetera
-
-3.2. The information asymmetry prevention framework
Recalling from the theoretical background the urged need for screening and signalling (Spence 1974 and Rothschild and Stiglitz 1976), we therefore in this thesis propose a method which looks deeper into ways to limit information asymmetry and use these ways as method of comparison between the Icelandic and Dutch banking sector. These elements from the asymmetric information literature have been combined into a framework displayed below:
Figure 4: The Information Asymmetry Prevention Framework (author, 2011)
To measure the elements named above, we have to look for objective keystones which form the foundation for these elements. These keystones can then be measured and function as element of comparison between Iceland and the Netherlands. Below per element is shown how this is done. In most instances, data is drawn from secondary sources, that is existing research. First, from the literature appeared what information is needed, and then this information is gathered from these sources. So on the level of information asymmetry measurement, data triangulation is used. This method ensures a more enhanced validity of the concept of information asymmetry (Eisenhardt and Graebner 2007).
3.2.1. Deposit Insurance Schemes: methodology and data collection
In the theoretical background, we have seen that deposit insurance schemes consist of various building blocks which among others give an idea of the effectiveness of these schemes. Pro’s and contra’s of these building blocks have been discussed in the theoretical background, and these elements will now be used as measure of comparison of the deposit insurance schemes in Iceland and the Netherlands. This will be done on the basis of the database provided by Demirgüc-Kunt, Kane and Laeven (2005). This database has been compiled of data from 181 countries regarding their deposit insurance system and can be considered the most extensive dataset on the subject available. The dataset has been compiled from country sources, interviews with officials of deposit insurances institutions and central banks and survey data of other researches, such as that of Barth, Caprio and Levine (2005). Using data from this
Information Asymmetry Prevention Framework
Deposit Insurance Schemes
database ensures reliability of the comparison, as for the data both for the Netherlands and Iceland the same data gathering method is used, as well as the same surveys et cetera.
3.2.2 Banking regulation: methodology and data collection
When it comes to banking regulation, also different important keystones have to be identified, after which these keystones can be used as elements of comparison between Iceland and the Netherlands. In the theoretical background various important elements have been discerned. These elements will be used to compare regulation in the banking sector between Iceland and the Netherlands. Data for this comparison will be extracted from the World Bank database which was compiled by Barth, Caprio and Levine (2001 and 2008) for their research on banking regulation. The basis of this database lies in surveys distributed to national bank regulatory authorities. Just as the case in the database from which data for the comparison of deposit insurance schemes is drawn, this research covers a large magnitude of countries (107), ensuring comparability by the use of standardised results.
3.2.3. Banking supervision: methodology and data collection
Turning now to banking supervision, we also need a method to objectively be able to compare the banking sectors of Iceland and the Netherlands. From the theoretical background, we have seen that the Basel Principles for Effective Banking Supervision provide us with such a method of comparison. In the literature we find that the Basel Core Principles provide us with a unique source of information about the quality of banking supervision in a country (Demirgüc-Kunt et al 2006). Now, where do we find information on compliance to these core principles?
3.3. Indicators for financial stability: methodology and data collection
To be able to compare financial stability in the Netherlands and Iceland, we have denoted 3 indicators of financial stability, which will be used to on the one hand show us the development in financial (in)stability, and on the other hand to give us the opportunity to compare financial stability between Iceland and the Netherlands. Can be said that one country remained financially more stable than the other? And later in the research: can we conclude that information asymmetry is managed better in one country than in the other?
In order to find the indicators for financial stability introduced in the theoretical background, we use data from three sources. In the first place, data from the Central Banks of Iceland and the Netherlands is used. Because these central banks often report to the IMF, the Fund is also used as source for the data. Finally, the European Union statistics base, Eurostat is used.
4. DATA AND FINDINGS
4.1. General
Now that we have in the previous section seen what elements will be used to compare information asymmetry reduction measures in the Dutch and Icelandic banking sector, in this section these elements will be analysed. This will be done in the same sequence as in the previous section: first the data found in the information asymmetry prevention framework will be analysed, followed by an analysis of financial stability in both countries.
4.2. The information asymmetry prevention framework: data and findings
4.2.1.1. Deposit insurance schemes: data and findings
Implicit versus explicit deposit insurance. Both in the Netherlands and Iceland an explicit
for a member of the European Economic Association to establish an explicit deposit insurance scheme.
Foreign currency coverage. Contrary to the global developments as reviewed in the
theoretical background, we can see that in Iceland as well as in the Netherlands foreign currency deposits are covered in their deposit insurance schemes. This is in line with European developments in deposit insurance schemes (Hoelscher, Taylor and Kueh 2006).
Interbank deposits. Also in line with European developments, we can see that both Iceland
and the Netherlands exclude interbank deposits in their deposit insurance schemes. This is less apparent in the rest of the world, but as said, in Europe it is.
Coinsurance. Although allowed under European legislation, and found favourable in the
academic literature, both in Iceland and the Netherlands a system of coinsurance does not exist.
Coverage per deposit versus coverage per depositor. Both in Iceland and the Netherlands,
coverage is found per depositor, meaning that deposits are insured under the deposit insurance scheme up to a maximum per depositor, independent of how many deposits the depositor has outstanding.
Way of funding. Iceland is a typical example of a country using a purely private funding
scheme funded ex ante. Under the Act no 98/1999 (basically the Icelandic implementation act of the European Union Directive 94/19/EC), a Depositors’ and Investors’ Guarantee Fund has been established5. Note that this is a private non-profit foundation. It has been divided into
two legally separate departments, a Deposit Department and a Securities Department. Total assets of the Deposit Department of the Fund have to be a minimum of 1% of total guaranteed deposits, and the total assets of the Securities Department have to be minimal 100 million ISK6. Membership of this deposit insurance system is compulsory for commercial banks,
savings banks, companies providing investment services and other parties involved in securities trading pursuant by law (www.tryggingsarsjodur.is). In a 2001 report, the IMF
concluded that the deposit insurance foundation established in this way, could exhaust rather quickly in times of financial turbulence (IMF 2001). In the case of Iceland, problems arose with the ex ante funding scheme. Deposits from foreign sources increased rapidly, and as a consequence, the Fund could not cope with this, resulting in assets of only 0,5 per cent of deposits in October 2008 (Jännäri 2009). Remember that the minimum requirement of the Fund is 1 per cent of total deposits
In the Netherlands the deposit insurance scheme is organised differently. Under the supervision of the Dutch National Bank, payments are made to depositors. Membership of the deposit insurance scheme is compulsory for banks operating under a licence of the Dutch National Bank. Depositors with a current account, savings account and special savings account are offered protection under the system. Funding takes place ex post, and will be according to the pro rata principle (banks have to make a contribution related to their size). In 2004, the IMF recommended that the Netherlands should move a scheme that is pre-funded to some degree at least, and recommended the introduction of risk-based premia (IMF 2004).
4.2.1.2. Deposit Insurance schemes: Iceland and the Netherlands compared Table 4: Elements in deposit insurance compared
Iceland Netherlands
1. Implicit / Explicit Explicit Explicit 2. Foreign currencies Covered Covered 3. Interbank deposits Uncovered Uncovered 4. Coinsurance Not included Not included
5. Coverage Per depositor Per depositor
6. Funding Ex ante Ex post
Looking at the comparison table above, we can see that only in the funding of the deposit insurance scheme significant differences can be found between Iceland and the Netherlands when it comes to deposit insurance. We will now turn to the data and findings in banking regulation.
4.2.2.1 Banking regulation: data and findings
Restrictions in banking activities. Over the years 1998-2006 a global trend can be seen
2008). Comparing Iceland and the Netherlands in this trend, we can see in the graph (appendix A) that the restrictiveness in the latter remains unchanged, but that Iceland did move in the opposite direction: restrictions on banking activities were eased. Probably the source of this decrease in stringency can be found in the limitation of restrictions of real estate investments for banks, as this was the main difference in restrictions with the Dutch system compared to Icelandic bank activities in 1998 (Database Barth, Caprio and Levine 2008). It has to be noted that restrictions in the Netherlands were less in the 1998 starting point of research than restrictions in Iceland. The nature of the restrictions other than real estate investment is comparable: in both countries banks can engage in securities and insurance activities and can own voting shares in non-financial firms, albeit with some restrictions in Iceland. Note however, that both countries can be considered rather liberal in this category: in 1998, in only 15 per cent of the countries unrestricted access to real estate was available (Barth, Caprio and Levine 2001b).
Entry requirements. As pointed out in the theoretical background, with regard to entry
requirements, different elements can be discerned. With entry requirements for a bank is meant the obligations which a potential new bank has to fulfil in order to obtain a licence from the Central Bank7. The most important entry requirements have been highlighted in the
theoretical background and will be discussed below.
Main differences in the way of licensing between Iceland and the Netherlands can be found in the number of licences required: for every activity a licence is required (commercial banking, securities trading et cetera), whereas in the Netherlands, all banking activities are categorised under the same licence (Barth, Caprio and Levine 2008). At this point thus, Iceland can be considered stricter.
With regard to entry capital requirements, we see some similarities: for domestic banks, subsidiaries of foreign banks and branches of foreign banks the minimum entry capital requirement is €5 million, or the Iceland krónur equivalent. However, in the Netherlands some less strict capital requirements exist for intermediaries in securities trading (€2,5 million), and banks whose sole function is the electronic distribution of money (€1 million).
In the latter cases being domestic or foreign is irrelevant. Again Iceland can be considered stricter in their entry requirements, making less exceptions to their rules.
Other legal requirements that have to be submitted before a bank licence can be issued are named in the table below.
Table 5: Requirements before a bank licence can be issued
Legal requirements: Iceland Netherlands
1. Draft bylaws? Yes Yes
2. Intended organization chart? Yes Yes 3. Financial projections for first three years? Yes Yes 4. Financial information on main potential
shareholders?
Yes Yes
5. Background/experience of future directors? Yes Yes 6. Background/experience of future managers? Yes No 7. Sources of funds to be disbursed in the
capitalization of new bank?
Yes Yes
8. Market differentiation intended for the new
bank? Yes Yes
Source: Barth, Caprio and Levine (2008)
Line 6 is the only line that differs between the Netherlands and Iceland: whereas Iceland has to file the background and experience of prospective managers and directors, the Netherlands only have to file this for the future directors of the bank. A peculiarity is, that in the 2003 version of the database, the background/experience of future managers had to be enclosed.
Capital requirements. When we look at capital requirements, we can see that both countries
A combined index of the extent of regulatory requirements regarding the capital of banks and the stringency of capital regulations indicate that from 1998 to 2005 regulations and stringency of regulations has become stricter in Iceland (Barth, Caprio and Levine 2008). For the same index, the situation in the Netherlands remained unchanged.
Liquidity and diversification requirements. In both countries there are not many obligations
or limitations for the banks with regard to liquidity and diversification requirements. Banks are free to lend and borrow over sectoral, geographical and country borders. Restrictions can be found in this regard when we look at the possibility to hold reserves: this is not allowed in foreign denominated currencies or other instruments.
Table 6: Liquidity and diversification requirements
Element of liq./div. requirements Iceland 2005 The Netherlands 2005 What percent of the commercial banking
system’s assets is foreign-currency denominated?
27% 18,5%
What percent of the commercial banking system’s liabilities is foreign-currency denominated?
40% 28,7%
What percent of the commercial banking system’s assets is in central government bonds or other government or central bank securities?
0,6% 10,3%
What percent of the commercial banking system’s assets is funded with deposits? (data from 2003)
30% 68%
What percent of the commercial banking system’s assets is funded with insured deposits?
(data from 2003)
30% 46,4%
Source: Barth, Caprio and Levine (2008)
than the euro, which is obviously in use by far more countries. A not unimportant implication of this high degree of funds in this high number of foreign currency denominated assets and liabilities on the balance sheets is the high exposure to exchange rate risk. Also the relative amount of government bonds or securities outstanding varies hugely: Iceland’s numbers are only a fraction of the Dutch numbers. A possible explanation can be that the government of a relatively small economy and country like Iceland does not need as much funding as the Dutch government.
4.2.2.2. Banking regulation in Iceland and the Netherlands compared
Table 7: Banking regulation compared
Iceland Netherlands 1. Restrictions in banking activities Converged, now comparable
2. Entry requirements Stricter Less strict
3. Capital entry requirements Stricter Less strict
4. Licence requirements Comparable
5. Capital requirements Comparable
6. Liquidity and diversification requirements Comparable
When we briefly summarise the data and findings above in table 6 we can say that in most cases banking regulation is comparable between Iceland and the Netherlands, or has become comparable over the last years. Only in entry requirements, the Icelandic banking sector is more strict than the Netherlands. Note that in the discussion of liquidity and diversification requirements, important differences were observed, indicating that much more freedom is taken in Iceland than in the Netherlands in the banking sector.
4.2.3.1 Banking supervision: data and findings
Now that we have seen how the most important elements of banking regulation are structured in Iceland and the Netherlands, we will now turn to the supervision of this regulation. How is the regulatory framework supervised? How are actors in the banking sector supervised?
4.2.3.2. Banking supervision in Iceland: data and findings
of Business Affairs (Jännäri 2009). In 2001, 2003 and 2008, the International Monetary Fund did a series of assessments of the Icelandic Financial System. The timeframe in which these assessments were conducted can be seen as rather interesting, as consolidated assets of the three main banks rose from 100 per cent of GDP in 2004 to 923 (!) per cent of GDP in 2007 (IMF 2008). Compare this to the Netherlands, with in 2003 bank assets amounting to 320 per cent of GDP. This giant leap was accompanied by firm internationalisation: almost 50 per cent of these banks assets were held abroad (IMF 2008). When we look at the 2001 Financial System Stability Assessment of the International Monetary Fund, we can shortly summarise the most important points from this assessment:
- the general legal and accounting framework, as well as adherence to accounting principles is sound
- relevant EU-directives have been implemented into national legislation
- the regime is compliant or largely compliant with 20 out of 25 Basel Core Principles on banking supervision8. Shortcomings are in the fields of:
o lack of legal supervising power
o no stringent rules on classification and provisioning of loans
o no stringent rules for the classification and monitoring of connected lending o no stringent rules for the recognition of country and transfer risk
o legal protection of civil servants in the FSA
- the supervising authority is understaffed, which explains part of the shortcomings. This is also confirmed by Jännäri (2009).
- looking at the institutional features of the Icelandic system, instability in crisis situations might arise due to: high interconnectedness, deficiencies in supervisory, regulatory and prudential frameworks and increased competition due to foreign entry - stress tests indicated that the financial system was vulnerable to market risk and credit
risk
In follow-up Financial System Stability Assessments in 2003 and 2008, the IMF found that things had improved sincerely (IMF 2003 and 2008):
- the FSA budget had increased by almost 50 per cent, which made it possible to increase personnel by 30 per cent. Furthermore, the FSA became more active in
training staff, interfering, issuing legislation et cetera (2003). The supervisory framework has been improved and capacity has been enhanced, but the bank resolution framework should be strengthened (2008). Moreover, Jännäri (2009) finds that the EU-directive on Financial Conglomerates was not implemented until September 2008, thus handicapping the FSA’s ability to oversee complex financial structures. Especially with the rapid growth, consolidation and internationalisation in the banking sector, this remark appears rather relevant
- the adoption of an inflation targeting framework has reduced potential instability of the system (2003)
- stress tests suggest the banking system is resilient and the reported financial indicators are above the minimum requirements (2008). However, stress tests should be conducted under more severe conditions9
- in 2006 the Basel II framework was implemented, ensuring confirmation to international banking standards.
From the database of Barth, Caprio and Levine (2008), also an index measuring Official Supervisory powers has been compiled. In this index, the authors recognise an increase in the Official Supervisory Powers in Iceland in the time period 1998 to 2006. Thus, these numbers confirm the research done by the IMF.
4.2.3.3. Banking supervision in the Netherlands: data and findings
In the Netherlands, prudential supervision of the banking sector is concentrated in the Dutch Central Bank (DNB)10. This centrally funded authority is also responsible for broader system
stability and macro prudential supervision (IMF 2004). The 2004 IMF Financial System Stability Assessment evaluated the Dutch banking supervision rather positively, and concluded that Dutch banking supervision complies for a very high degree with the Basel Core Principles (IMF 2004):
- the Dutch financial sector is dominated by a small number of international Large and Complex Financial Institutions (LCFIs), bringing some complications into the sector:
o supervision becomes complex
9 The IMF mentions that tests should be conducted that ‘envision a sharper deterioration in credit quality’ (IMF 2008, p.9).
o there is the risk of moral hazard when these institutions become ‘too big to fail’
- on the other hand
o increased size makes that more diversification is possible
o close supervision and cooperation with foreign authorities of DNB mitigates these complications mentioned above
- overall, supervision is well balanced between onsite and offsite supervision, making the Dutch banking system effective. The mix between on and offsite supervision could be a bit more structured.
- the DNB’s international and global supervision is effective, well-staffed and comprehensive
- the financial supervision legislation is restructured in 2005, with an improved
supervisory system as a result , being more cross-sectoral, efficient and adaptable. This reform in the financial system has been taken as an example for other countries. The main feature is that it assigns two authorities who function cross sectorally: the DNB for the macro- as well as micro prudential supervision and soundness of financial institutions and the Authority for Financial Markets (AFM) for enhancing orderly and fair market practices and conduct-of-business supervision (IMF 2004b).11
4.2.3.4. Banking supervision in Iceland and the Netherlands compared Table 8: Banking supervision compared
Iceland Netherlands
Compliance to Basel Core Principles Improvement needed Well
Legal framework Sound Sound
Staffing Understaffed Well staffed
Number of supervising authorities 1 2
In the short summarising table above, we can see that in the field of banking supervision, Dutch supervision can be judged to be more effective and proficient. In compliance to the Basel Core Principles, the Icelandic authorities do miss points in rather important aspects of supervision, whereas in Dutch supervision this compliance does not rise problems. Also in
staffing of the supervisory authorities, Iceland cannot be positively evaluated, whereas the Dutch authorities can be judged as well staffed. The number of authorities does not necessarily indicate that Dutch authorities are better in supervising – the more is not always the better -, but this recent task division has been judged by the IMF as ‘best practice’.
4.3. Financial stability indicators: data and findings
As announced, as financial stability indicators three indicators will be used: interest rates, inflation and GDP growth. These indicators will be used to give us an idea of the development of financial stability during the crisis in Iceland and the Netherlands, and more important, to be able to compare financial stability across these two countries.
4.3.1. Financial stability in Iceland: data and findings
If we look at the first indicator in Iceland, GDP growth, we see in graph 1 below that in the before the crisis, in 2005, starting point for the graph, GDP grows year after year, but only until 2007, after which a large decrease in GDP growth can be seen, this decrease continues until 2010, where GDP growth is still negative.
Graph 1: Average GDP growth rate in Iceland
-8 -6 -4 -2 0 2 4 6 8 10 2005 2006 2007 2008 2009 2010 Year Pe r c e n t
Average GDP growth rate
Source: Iceland Statistics (2011)
inflation rate in the eurozone is 2 per cent. Thus, Icelandic values are only at a level which is twice as high as a minimum during this period.
Graph 2: Changes in consumer price index in Iceland
0 2 4 6 8 10 12 14 2005 2006 2007 2008 2009 2010 Year Pe r c e n t
Changes in consumer price index in Iceland
Source: Iceland Statistics (2011)
Graph 3: Nominal interest rate, % per year in Iceland 0 1 2 3 4 5 6 7 2005 2006 2007 2008 2009 Year Pe r c e n t
Nominal interest, % per year
Source: Iceland Statistics (2011)
4.3.2. Financial stability in the Netherlands: data and findings
Then now we will review financial stability in the Netherlands using the same indicators as we have done in Iceland. In graph 4 below, GDP growth can be seen.
Graph 4: Average GDP growth in the Netherlands
-5 -4 -3 -2 -1 0 1 2 3 4 5 2005 2006 2007 2008 2009 Year Pe r c e n t
Average GDP growth in the Netherlands
Source: Central Statistics Bureau (2011)
Graph 5: Changes in consumer price index in the Netherlands 0,00 0,50 1,00 1,50 2,00 2,50 2005 2006 2007 2008 2009 Year Pe r c e n t
Changes in consumer price index in the Netherlands
Source: IMF Statistics (2011)
Then, we have a look at the price index in the Netherlands in graph 5 above. As also noted before when we reviewed the data from Iceland, in the eurozone a recommended maximum inflation of 2 per cent exists. In the Dutch graph below, we see that in the 2005 – 2007 period, this maximum is nicely kept, although in 2008 prices have risen more than 2 per cent compared to 2007. In 2009 we see a rebound in price rises, as prices only have risen 1 per cent compared to the year before. Overall, we can say inflation in the Netherlands, especially in the first 2 years of the chosen period, has remained rather stable.
Graph 6: nominal interest rate, % per year in the Netherlands
0 0,5 1 1,5 2 2,5 3 3,5 4 4,5 5 2005 2006 2007 2008 2009 2010 Year Pe r c e n t
Nominal interest, % per year
Source: Dutch Central Bank (2011)
sudden, as the decrease is larger than the increase in the two years before 2009. In the chosen period interest rates are moving, but in a limited bandwidth of only 1,5 per cent. Note that due to low inflation, real interest rates remain positive during this period.
4.3.3. Financial stability in Iceland and the Netherlands compared
We have now seen how the chosen indicators behave in the economies of Iceland and the Netherlands separately. In this section the indicators will be compared directly to be able to say whether for specific indicators one economy is more stable than the other.
Graph 7: Average GDP growth compared
-8 -6 -4 -2 0 2 4 6 8 10 2005 2006 2007 2008 2009 2010 Year P e r cen t
Average GDP growth rate in Iceland
Average GDP growth in the Netherlands
Source: Central Statistics Bureau and Iceland Statistics (2011)
Graph 8: Changes in consumer price index in Iceland 0,00 2,00 4,00 6,00 8,00 10,00 12,00 14,00 2005 2006 2007 2008 2009 Year P e r cen t
Changes in consumer price index in the Netherlands Changes in consumer price index in Iceland
Source: IMF Statistics and Iceland Statistics (2011)
Then turning to a comparison of the price level in both countries, we can see more or less the same peculiarities as in the GDP growth comparison: in Iceland the inflationary spread is much larger, and drops and booms are much more extreme than in the Netherlands (see Graph 8 above). On average, we can also see that price levels in Iceland increase much more than in the Netherlands. Moreover, growth in inflation in Iceland lies in all years at a percentage which double the Dutch numbers.
Graph 9: nominal interest rate, % per year compared
0 1 2 3 4 5 6 7 2005 2006 2007 2008 2009 Year Pe r c e n t
Nominal interest rate, % per year, in Iceland Nominal interest, % per year in the Netherlands
Source: Iceland Statistics and Dutch Central Bank (2011)
