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### Box 1 — Is There an “Optimal Size” of the Financial Sector?
- Theoretical trade-offs and policy framing:
  - Benefits of an efficient financial sector: producing information; pooling savings and allocating capital; managing, intermediating and allocating risks; monitoring businesses; easing external financing constraints facing firms.
  - Optimal size arises where these benefits outweigh: costs of diverting resources from other sectors, and financial stability risks.
  - Crisis lesson: rapid financial sector growth can reflect unsustainable asset booms rather than improved intermediation.
  - Policy response emphasized two elements:
    - create a safety net to minimize the costs of a crisis; and
    - use domestic regulation to minimize resulting moral hazard.
  - For internationally active financial centers there is an additional trade-off:
    - international banking boosts GDP and incomes but the accumulation of external liabilities by banks adds external and fiscal risks for the sovereign;
    - these externalities can be offset via tighter regulation of banks, additional external and fiscal buffers, and burden sharing agreements with other countries.

- Key vulnerabilities for economies with large banking sectors:
  - Three characteristics that increase crisis vulnerability:
    - (i) a significant cross-border dimension to its banks;
    - (ii) limited fiscal resources; and
    - (iii) issues a (non-reserve) currency or adopts a reserve currency as its legal tender.
  - Vulnerability mechanisms:
    - external retail or wholesale depositors can create a funding crisis; and/or shocks can lower liquidity of assets relative to foreign liabilities;
    - the sovereign may be unable to guarantee (foreign currency) liquidity needs of a large banking sector;
    - liquidity crises can quickly morph into solvency crises, bringing into question fiscal capacity to recapitalize banks;
    - expansion of banking, securitization, and a “shadow” banking system created less transparent ways for banks to expand operations.

- Empirical contrasts (illustrative outcomes):
  - Iceland: suffered a banking collapse.
  - Ireland: avoided a financial collapse but faces a significant increase in costs of government borrowing as debt is projected to rise rapidly.
  - Switzerland: intervened in one of its two major banks; fiscal consequences more modest.
  - Hong Kong SAR and Singapore: emerged largely unscathed.
  - Offsets that mattered: private sector regulation, public sector prudence, and international cooperation (or their absence).

- Bank growth dynamics and business models:
  - Icelandic bank assets rose to over eight times GDP by 2007 — a striking six times the 2001 ratio — and foreign debt shot up even faster.
  - Hong Kong SAR and Singapore already had large banking systems in 2001 (bank assets of some 470 and 780 percent of GDP, respectively); subsequent growth rates of these ratios were significantly below Iceland and Ireland.
  - LCFIs dominated assets and external borrowing/lending in sample economies: the largest three banks represented over half of assets in all sample countries except Singapore and Ireland.
  - Business-model groupings and vulnerabilities:
    - Icelandic and Irish banks: rapid expansion of loan portfolios at home and/or abroad; Icelandic banks much more dependent on foreign wholesale funding than Irish banks.
    - Large Asian banks (Hong Kong SAR, Singapore): diversified deposit base, relatively large capital and liquidity cushions, exposures mainly to rest of Asia.
    - Swiss LCFIs: expansion driven by investment banking and cross-border investments (notably to the United States), higher leverage and reliance on wholesale funding.

### Box 2 — Asset quality, profitability, capital adequacy, liquidity (2001–07)
- Asset expansion and composition:
  - Assets of Icelandic and Irish banks expanded much faster than loan books of banks in Hong Kong SAR and Singapore; by end-2007 Icelandic bank assets were equally split between domestic and foreign operations (branches and subsidiaries, principally in the Nordic countries and in the U.K.).
  - Swiss bank asset growth driven mainly by cross-border investments (notably to the United States).
  - Loan growth 2003–2007 (average): Iceland and Ireland materially higher than Singapore and Hong Kong SAR (local banks).
- Profitability and trading income:
  - Profitability indicators for Icelandic and Irish banks tended to be higher but more volatile.
  - Icelandic banks derived roughly 20 percent of income from trading; in Irish banks trading income never exceeded 5 percent.
  - Asian banks’ trading income contribution was less than 10 percent; local banks in Hong Kong SAR had better ROEs than banks in Singapore.
- Capital buffers (TCE ratios):
  - Local Asian banks had the largest tangible common equity (TCE) ratios: local banks in Hong Kong SAR had an average TCE ratio of 8 percent, while the Swiss banks had an average TCE ratio of only 2 percent.
- Leverage:
  - LCFIs following the investment banking model (e.g., UBS, Credit Suisse) had the highest (rising) leverage ratios during 2001–07; Asian banks and Icelandic banks had fairly low (stable) leverage ratios; Irish banks were intermediate.
- Funding strategies and wholesale funding dependence:
  - Icelandic banks relied heavily on wholesale funding: at over 70 percent, their share of wholesale funding in total liabilities was comparable only to that of investment banks in the sample.
  - For HSBC and Standard Chartered, wholesale funding accounted for 20–30 percent of total financing against an average of around 15 percent for local Hong Kong SAR banks.
- Liquidity buffers and loan-to-deposit ratios:
  - Icelandic and Irish banks had the highest loan-to-deposit ratios and the lowest liquid asset ratios (share of liquid assets in total assets) in the sample; local banks in Hong Kong SAR were at the opposite end.
- Nonperforming assets and loan-loss reserves:
  - NPAs (as share of total loans) for European banks picked up more sharply after the onset of the crisis than for Asian banks; NPAs rose sharply in 2007–08 while loan-loss reserves ratios remained flat.

### Governance, regulation, supervisory differences and ownership structures
- Governance and internal risk management differences affected how much LCFIs stretched balance sheets:
  - Rating-agency analyses suggested UBS had a decentralized structure and reliance on external credit assessments and agency ratings, use of monoline insurance, and autonomy for Dillon Read Capital Management; Credit Suisse used more effective hedging strategies and exited the U.S. property market relatively early.
- Financial liberalization and light-touch regulation catalyzed growth in some cases:
  - Icelandic banks, privatized in 2002, pursued aggressive lending and foreign asset acquisitions amid insufficient supervisory experience and lack of instruments to oversee complex ownership, connected lending, and large exposures.
  - Ireland’s expansion followed euro area membership and was supported by U.K.-style principles-based regulation.
- Inadequate regulation for investment banking exposures:
  - UBS and Credit Suisse took on large, highly leveraged exposures both on- and off-balance sheet; Swiss supervisors appear to have relied heavily on banks’ risk models; off-balance sheet entities were legally separate yet markets assumed reputational support (“moral recourse”).
- Tighter prudential supervision likely helped contain credit expansion in Hong Kong SAR and Singapore:
  - LTV caps and property measures: Hong Kong SAR imposed a 70 percent cap on loan-to-value (LTV) ratios for property loans; LTV caps were also in place in Singapore, China, Korea, and Malaysia. By contrast, Irish authorities introduced a requirement for Irish banks to assign higher risk weights to mortgage loans with LTV above 80 percent only in May 2006.
  - Capital composition and higher minimums: Singapore required banks to maintain capital adequacy ratios of 10 percent and Tier 1 ratios of at least 6 percent, two percentage points above minimum standards set by the Basel Committee. Asian banks exhibited higher ratios of tangible common equity to Tier 1 capital.
- Ownership structures of foreign operations and fiscal implications:
  - Choice between foreign subsidiaries and branches largely reflected bank business decisions (existing business/franchise, Greenfield investments), tax, and regulatory considerations rather than lender-of-last-resort concerns.
  - Fiscal implications differ: subsidiaries are independently capitalized and under host country supervision; home regulators are typically responsible for branches (particularly in Europe), affecting potential home-country fiscal liabilities during crises.

*Italic: Source — Box 1 and Box 2 content from the supplied IMF chapter/section.*

### 12. In the European Economic Area (EEA) — Branch passporting, macro environment, and macro indicators
- Branch passporting and organizational choices:
  - The passport system put branches clearly under the jurisdiction of the home country and may have made it easier for banks to choose branch structures.
  - U.K. regulators felt passport provisions factored into the decision to accept IceSave as a branch in 2006. IceSave was used by Landsbanki to replace “hot money” wholesale funds with “hot deposits” attracted via high internet deposit rates.
  - By contrast, Swiss banks’ U.S. broker-dealers used for investment banking operations had to be independently capitalized subsidiaries, helping to cushion the blow to Swiss taxpayers when the crisis hit.

- Macroeconomic environment and private sector imbalances:
  - Cross-border banking activities increased sensitivity to external shocks, especially from the United States and the United Kingdom.
  - Private sector macroeconomic imbalances built in Iceland and, to a much lesser extent, Ireland: expanding bank balance sheets, domestic credit booms, real estate bubbles, significant increases in household and corporate debt, and rising current account deficits.
  - Switzerland, Singapore, and Hong Kong SAR: ran current account surpluses, remained net external creditors, had stable private sector debt ratios.
  - Even though land prices started to rise in Hong Kong SAR and Singapore after 2006, private sector credit as a percent of GDP was still lower in 2007 than in 2001.

- Key macroeconomic and policy stance indicators (preserve exact figures)
  - Fiscal Balance/GDP (end-2007) (%) — Iceland: 5.4; Ireland: 0.2; Switzerland: 0.9; Singapore: 12.4; Hong Kong SAR: 7.7
  - Fiscal Balance/GDP (end-2009) (E) (%) — Iceland: -14.4; Ireland: -11.8; Switzerland: -0.5; Singapore: 1.5; Hong Kong SAR: -0.9
  - Reserves/GDP (Beginning 2007) (%) — Iceland: 12.8; Switzerland: 16; Singapore: 98; Hong Kong SAR: 70.1; (Ireland: ...)
  - Reserves/GDP (End-2009) (%) — Iceland: 42; Switzerland: 26; Singapore: 117; Hong Kong SAR: 121.4; (Ireland: ...)
  - Net IIP (end-2007, % of GDP) — Iceland: -127.2; Ireland: -16.5; Switzerland: 139; Singapore: 100.5; Hong Kong SAR: 252

- Additional EEA notes:
  - The Asian economies built up fiscal and external buffers to cover large short-term debts; Hong Kong SAR’s 30 percent coverage of gross short-term external debt before the crisis was within standard prudential norms.
  - In Iceland and (to a lesser extent) Ireland, bubble-related revenues obscured weaknesses in underlying fiscal positions; the Fund sharply revised downwards the estimated structural fiscal position after the crisis.
  - Irish banks’ access to European Central Bank operations (as part of the Euro area) shielded them from serious liquidity risks.
  - Switzerland ran significant structural fiscal surpluses but maintained limited foreign exchange reserves and a floating exchange rate regime (as did Iceland).

### Box 3 — Cross-Border Spillovers: scenarios, sample, data, and key results
- Scenarios analyzed:
  - (1) Credit shock: initial default may trigger additional rounds of defaults.
  - (2) Credit and liquidity shock: each credit shock compounded by a liquidity shock (unable to roll over funding, triggering fire sales).
- Sample and data:
  - Sample: economies with large financial systems covered in the paper (Belgium, Netherlands, Ireland, and Switzerland); three other developed financial systems (Austria, Spain, Sweden); systemically significant large financial systems (France, Germany, United Kingdom, and the United States).
  - Data: BIS consolidated banking statistics reported on an immediate borrower basis (IBB) supplemented with Bankscope capital data; simulations based on figures at end-2006, 2007, and 2008 and averages over these years.

- Key results (exact figures preserved)
  - Under the credit shock scenario:
    - An initial hypothetical failure of French and German banks would lead to average losses of 30.8 and 45.6 percent of capital, with Switzerland and Belgium most affected.
    - The hypothetical Dutch failure would produce a projected capital loss to Belgian banks of 72.4 percent of their initial capital.
  - Under the credit and liquidity shock scenario:
    - The impact of the liquidity squeeze increases the systemic role of Netherlands, France, and Germany.
    - The default of Netherlands would induce one hypothetical default (Box Table 3).
    - For France and Germany, induced failures rise to nine and two, respectively, under the credit and liquidity shock (from zero and one in the credit shock scenario).
    - On average, the hypothetical default of the Dutch, French, and German financial systems would lead to losses of 7.3, 54, and 7 percent of the total capital (Box Table 3).
    - Compared to the credit shock, the combined credit and liquidity shock significantly increases the impact of Switzerland on the U.S.

- Selected simulation metrics (preserve table figures as reported)
  - Table 1: Simulation Results under Credit Shock Scenario — Hazard Rate / Failed Capital / Induced Failures / Absolute Hazard / Contagion Rounds (selected entries)
    - Belgium2.5800220
    - Netherlands4.7300220
    - Switzerland2.6600220
    - Ireland3.1800220
    - France10.4800220
    - Germany5.8211220
    - UK54.0092110
    - USA100.0010200
  - Table 3: Simulation Results under Credit and Liquidity Shock Scenario — (selected entries)
    - Belgium2.5800440
    - Netherlands7.3011330
    - Switzerland2.6600330
    - Ireland3.1800330
    - France54.0093220
    - Germany6.9921330
    - UK54.0092220
    - USA100.0010200
  - Table 2: Credit Shock Scenario - Post Simulation Capital Impairment (in percent of pre-shock capital) — example row averages (Trigger Country averages):
    - Average  -104.2 -88.6 -193.3 -50.7 -49.0 -34.9 -74.1 -73.9 -167.5 -27.0 -1.5
  - Table 4: Credit and Liquidity Shock Scenario - Post Simulation Capital Impairment (in percent of pre-shock capital) — example row averages (Trigger Country averages):
    - Average  -164.5 -141.6 -251.7 -111.0 -98.6 -77.0 -121.0 -89.2 -258.1 -56.5 -17.9

### Fund surveillance, crisis impact, and policy response
- Fund surveillance and assessment:
  - Fund surveillance generally recognized growing macroeconomic imbalances but underestimated inward and outward spillovers.
  - The need to enhance bank supervision in Iceland and Ireland was highlighted but not forcefully enough; the impact of asset bubbles was underestimated.
  - Bank stress tests in Ireland and Iceland (conducted by the authorities) and in Switzerland were sanguine compared to outcomes.
  - For Hong Kong SAR and Singapore, prudent macroeconomic policies were praised, though links to the banking sector were not emphasized. Except in Switzerland, external spillovers received limited attention.

- How bank risks shifted to the government — crisis impact (country highlights):
  - Iceland:
    - Post-Lehman turbulence shut Icelandic banks out of bond and foreign exchange swap markets.
    - After Glitnir was unable to fund a foreign payment due in October 2008, an agreement provided the bank with new equity amounting to €600 million (23 percent of reserves) from the Central Bank, and a Fund program was rapidly arranged.
  - Ireland:
    - Irish banks’ access to wholesale funding came under growing scrutiny as asset quality concerns mounted.
    - Projected loan losses rose with the bursting of domestic and U.K. housing bubbles; capital eroded as provisions exceeded operating incomes.
  - Switzerland:
    - Affected mainly through international exposures of UBS and, to a lesser extent, Credit Suisse; stability concerns centered on significant write-downs and credit losses on largely dollar-denominated “toxic assets.”
  - Hong Kong SAR and Singapore:
    - Banking systems were relatively resilient; aside from a short-lived and minor bank run in Hong Kong SAR, main impacts were through domestic and global slowdown and contraction in the asset management industry.

- Sovereign risk and cross-border resolution:
  - The lack of effective cross-border resolution mechanisms increased sovereign risks for countries with large banking systems.
  - Absence of cross-border frameworks led to ad hoc and inefficient solutions (e.g., Fortis was split on national, rather than business, lines).

- Macroeconomic policies and financial measures:
  - Rapid global monetary easing supported bank profitability as financial conditions normalized: Swiss National Bank guided policy interest rates to zero; Hong Kong SAR, Ireland, and Singapore imported lower interest rates through their exchange rate arrangements.
  - Switzerland intervened to stem upward pressures on the franc from safe-haven flows (first intervention since 1995).
  - European sample countries implemented rapid and forceful financial policies; resulting large (actual and contingent) fiscal claims limited the attractiveness of direct fiscal stimulus. Ireland tightened fiscal policy in 2009.
  - By contrast, Asian economies provided significant fiscal support from 2008; in Singapore the package amounted to some 8 percent of GDP.

- Summary of Financial Support Measures (as presented)
  - Iceland: Extension of retail deposit insurance ✓; Debt Guarantees ✓; Liquidity Support (intern’l) ✓; Liquidity Support (domestic) ✓; Capital Injections ✓; Asset Purchases/Swaps ✓; Capital Controls ✓
  - Ireland: Extension of retail deposit insurance ✓; Debt Guarantees ✓; Liquidity Support (intern’l) ✓; Liquidity Support (domestic) ✓; Capital Injections ✓; Asset Purchases/Swaps ✓; Capital Controls NO
  - Switzerland: Extension of retail deposit insurance ✓; Debt Guarantees NO; Liquidity Support (intern’l) ✓; Liquidity Support (domestic) NO; Capital Injections ✓; Asset Purchases/Swaps ✓; Capital Controls NO
  - Singapore: Extension of retail deposit insurance ✓; Debt Guarantees NO; Liquidity Support (intern’l) ✓; Liquidity Support (domestic) ✓; Capital Injections NO; Asset Purchases/Swaps NO; Capital Controls NO
  - Hong Kong SAR: Extension of retail deposit insurance ✓; Debt Guarantees NO; Liquidity Support (intern’l) NO; Liquidity Support (domestic) ✓; Capital Injections NO; Asset Purchases/Swaps NO; Capital Controls NO

### Box 4 — Benelux cross-border resolution lessons
- Consolidation into LCFIs and international banking networks (ABN Amro, Fortis, Dexia, KBC, ING) complicated crisis management.
- The absence of explicit burden-sharing and cross-border resolution arrangements complicated interventions; Fortis was split along geographical lines, increasing costs.
- Dexia’s governments agreed to a plan that preserved the group; different outcomes illustrate the importance of prearranged burden-sharing.
- EU competition policy is the main platform for coordinating cross-border resolution in Europe, with plans for a more structured and binding approach in the future.
- Resulting structural change: Benelux banks retrenched to core domestic retail franchises (“back-to-basics banking”).
- Policy implication: sensible international burden-sharing arrangements should be negotiated so costs from cross-border resolution can be fairly shared among stakeholders within financially integrated areas such as the EU.

### 22. Differing types of government support for large banking systems over the crisis
- How government support shifted risk between banks and sovereigns:
  - Three broad forms:
    - Protection of liabilities to prevent bank runs (extending deposit insurance, providing guarantees of other types of liabilities).
    - Support for impaired assets to shore up bank solvency (capital injections and asset purchases/swaps).
    - Provision of external liquidity by foreign central banks.
  - Estimated probabilities (Figure 5) show how CDS events in banks (sovereigns) could lead to events in sovereigns (banks); interpretation for Singapore and Hong Kong SAR CDS is cautious due to limited liquidity in those contracts.

- Country case evidence on types of support and observed outcomes:
  - Iceland:
    - Rapid collapse of the Icelandic financial system (all three major banks were intervened) focused attention on sovereign liability for foreign depositors.
    - Retail liabilities in foreign subsidiaries were paid by host governments; the Icelandic government proposed unlimited support for depositors in domestic branches but only limited support for branches in the EEA, triggering an unresolved dispute with the United Kingdom and the Netherlands.
  - Ireland:
    - Risks of a wholesale funding run after Lehman were quelled via a guarantee on deposits and debt, transferring risks to the sovereign.
    - The guarantee covered retail and wholesale deposits, as well as senior debts, of major banks.
    - CDS spreads on several Irish banks and the sovereign became highly connected until plans to recapitalize three banks in December 2008 and public discussion from February 2009 on creating a bad bank; a bad bank scheme was announced in April 2009. Bank and sovereign risks remained elevated and strongly correlated.
  - Switzerland:
    - Rapid resolution of UBS’s troubled assets (a “bad bank” funded by the central bank and backed by a Fed swap line for dollar liquidity) partially insulated the sovereign.
    - Early and well-designed intervention on bank assets generally lowered fiscal cost and limited moral hazard by ensuring troubled banks pay a significant proportion of eventual costs.
  - Hong Kong SAR:
    - A large transfer of risk from banks to the government first occurred in early 2008 after Bear Stearns’ collapse but then subsided.
    - Another transfer occurred after a blanket guarantee of retail deposits and a contingency facility for bank capital; the link has remained elevated.
  - Singapore:
    - Transfers of risk from banks to the government occurred after upward shifts in risk perception (e.g., after Bear Stearns’ rescue in 2008) and after announcing a blanket guarantee of retail deposits.
    - Impact was mitigated by a subsequent swap line with the Federal Reserve, though market concerns over the bank–sovereign link rose over time.

- International links, liquidity support, and scale effects:
  - Contagion and international linkages:
    - Contagion risks from banks and sovereigns in the sample to major foreign LCFIs rose significantly in mid-2007 as international liquidity became constrained.
    - Sovereign-to-sovereign spillovers rose more slowly, plateauing after the Lehman collapse.
    - These international risks are highest from the larger (Switzerland) and less risky (Hong Kong SAR, and Singapore) banking systems in the sample.
  - Central bank balance-sheet and liquidity support facts:
    - Iceland negotiated swap arrangements with the Nordic countries worth some 12 percent of GDP before its banking system collapsed.
    - Switzerland used nearly $40 billion (some 10 percent of GDP and 8 percent of M3) of the dollar swap line to finance the Stabilization Fund that bought bad UBS assets and recapitalized the bank; the Stabilization Fund was refinanced by the central bank from February 2009 onwards by issuing dollar denominated bills to local banks.
    - Irish banks obtained large amounts of liquidity support from the ECB: liquidity support from ECB repo operations intermediated through the Central Bank of Ireland’s balance sheet peaked in mid-2009 at more than 80 percent of GDP, with well over half going to domestic banks or foreign banks with domestic operations.
    - By 2007, Hong Kong SAR and Singapore had built foreign currency buffers of around the size of GDP.
  - Relative fiscal costs:
    - The crisis is projected to generate a major rise in public debt in Iceland and (to a lesser extent) Ireland (see Figure 3).
    - Costs to the Asian economies and Switzerland are projected to be much more modest, reflecting sound non-financial balance sheets and swift, well-designed resolution of UBS’s problem assets.

- Explaining divergent outcomes: Asian resilience vs. European fragility:
  - Share-price performance between Lehman bankruptcy and March 2009 trough:
    - Typical major European financial institution share prices fell by 80 percent (in U.S. dollars).
    - Singapore banks fell by 50 percent.
    - Hong Kong SAR banks fell by 33 percent.
  - Three broad explanations proposed for stronger performance of Asian banks:
    - Operated in a high-saving and fast-growing region.
    - More tightly supervised and regulated.
    - Strong internal management.

- Evidence on supervision, liquidity, and behavior:
  - Supervisory approach:
    - Hong Kong SAR and Singapore supervisors were more “hands-on,” actively monitoring internal management and limiting leverage in specific markets.
    - Regulators in Hong Kong SAR and Singapore subjected banks to strict liquidity requirements: minimum monthly average liquidity ratios of 25, and 16 percent respectively.
  - Private sector behavior:
    - Corporates and households in Hong Kong SAR and Singapore gradually rebuilt balance sheets after the Asia crisis and kept cautious borrowing attitudes.
  - Macroeconomic buffers:
    - Fiscal surpluses and large foreign currency buffers supported market confidence.
  - Internal bank management:
    - Global banks with Asian roots (HSBC and Standard Chartered) headquartered in London were subject to “light touch” U.K. home regulation but exhibited conservative internal management and diversified retail deposit bases.
  - Funding structure differences:
    - Asian local banks maintained considerably higher liquid assets than European counterparts and had widely dispersed retail deposit bases, reducing reliance on wholesale funding.
    - Swiss banks developed significant currency funding gaps in expanding U.S. dollar trading (over 10 percent of assets by mid-2006 according to BIS calculations).

- Policy lessons and recommended directions forward:
  - Systemic scale, safeguards, and international coordination:
    - The crisis underlined fiscal vulnerabilities of countries with large banking systems: in 1990, the world’s ten largest banks had an average balance sheet size of 14 percent of their home countries’ GDP; this rose to an average of 92 percent by 2007.
    - An effective global resolution regime and binding international burden sharing mechanism would define and likely diversify the risks of a large banking sector, lower moral hazard, and enhance market discipline; Fund staff are preparing a paper on cross-border bank resolution building on the Basel Committee’s Cross-Border Bank Resolution Group’s recommendations (March 2010).
    - Absent progress on burden sharing, territorial risks must be internalized via tighter regulation and prudent macroeconomic policies, ideally backstopped by international cooperation.
  - Micro- and macro-prudential policy measures:
    - Liquidity is the first line of defense in a world with recurrent wholesale funding runs — maintained liquidity buffers reduced reliance on wholesale funding for Asian banks.
    - Tight supervision and regulation can reduce potential fiscal support demands:
      - More robust supervisory approaches—pro-active engagement, understanding individual bank risk profiles—appear meritorious.
      - Stronger regulation: Swiss requirements for the two large banks to hold twice the internationally agreed minimum regulatory capital are an example.
      - Taxes and levies could be used to shrink the banking sector (area of active Fund staff work).
  - Structural and organizational measures:
    - Encouraging subsidiarization relative to branches can lower fiscal risks for host countries, though it does not eliminate the need for coordinated supervision and burden sharing; subsidiarization may “trap” capital and liquidity, fragment markets, and reduce cross-border flows (ongoing Fund work).
    - The size of the banking sector needs to match the resources of the home regulator; limited fiscal resources constrain the credible supervisory umbrella.
  - Crisis-resolution design:
    - Swift and well-designed actions to resolve bad assets of troubled institutions can help decouple sovereign from bank risk.
    - Protection of liabilities (deposits, debt) may be necessary to stem runs but generally increases the bank–sovereign link; asset-focused interventions can lower long-term fiscal costs by restoring healthier bank balance sheets.

### 40. Strong external and fiscal buffers as a macro backstop
- Role of external and fiscal buffers:
  - Hong Kong SAR and Singapore, with less flexible exchange rate regimes, entered the crisis with levels of foreign reserves within usual prudential norms given their high levels of short-term debt.
  - The reserve coverage of Switzerland (which did, however, have a solid overall external position) and of Iceland (which did not) was lower, partly reflecting their floating exchange rates.
  - Building stronger external buffers does not necessarily imply reserve accumulation.
  - All the economies considered in this paper entered the crisis with reasonably low public debt levels. However, in the cases of Iceland and Ireland apparently healthy fiscal positions masked underlying structural weaknesses.

- Liquidity support and swap arrangements:
  - The swap lines extended by the U.S. Fed to several economies, as well as liquidity support from the ECB and the Swiss National Bank, alleviated market pressures.
  - Countries with large banking systems may want to pursue such agreements more durably.

- Supervisory cooperation and burden sharing:
  - International supervisory cooperation can significantly mitigate market pressures especially if burden sharing arrangements are clear.
  - Cross-border supervisory colleges are helpful when supervisors from home and host countries can meaningfully exchange information.
  - These colleges will be of most value if they can help in agreeing enforceable burden sharing arrangements to avert abrupt losses in cooperation like those experienced in the Benelux region after the crisis hit.

- Financial system growth and macro implications (summary):
  - Banking system assets of Iceland, and to a lesser extent Ireland, grew rapidly, both as a ratio to GDP and relative to the labor force—from the lowest to the highest ratios in the sample (growth referenced to Avg. 2003–07).
  - Sharp increases in banking systems’ assets were accompanied by increases in external bank debt liabilities, which were a significant source of asset acquisition.
  - Bank assets were very high both relative to tax revenue and to international reserves. Singapore reserve coverage was notably better than in other countries.
  - Iceland, and to a much lesser extent Ireland, ran current account deficits financed in part by the banking systems and accompanied by domestic credit booms.
  - The credit booms resulted in unsustainable house price growth, construction activity, and deteriorating competitiveness.
  - Fiscal positions in Iceland, and to a lesser extent Ireland, looked comfortable, but masked reliance on unsustainable boom-related fiscal revenues, and pro-cyclical fiscal policies.

- LCFIs and banking structure (sample observations):
  - Iceland’s largest commercial banks (Kaupthing, Glitnir, Landsbanki) exhibited very large foreign exposures and high wholesale and short-term funding reliance (2003-07 averages).
  - Swiss banks (UBS, Credit Suisse) had substantial foreign revenue shares in 2007 and significant international footprints.
  - Hong Kong SAR and Singapore banks emphasized more liquid balance sheets, with relatively less reliance on short-term and wholesale funding compared with several European LCFIs.

- Bank flows, current account, external financing patterns:
  - The banking system provided net external inflows into Iceland, and to a lesser extent Ireland, thereby financing current account deficits and domestic credit expansion.
  - Switzerland and Singapore ran current account surpluses and their banking systems produced net external outflows.
  - In Hong Kong SAR, banking system external flows oscillated around zero while the economy overall ran a current account surplus.

- Domestic transfer of risk: banks to sovereigns:
  - The analysis presents sovereign vs. bank CDS dynamics and conditional probabilities of distress (methodology by Miguel Segoviano and references listed in the source).
  - Policy announcements (bank guarantees, recapitalizations, purchase of bad assets, swap lines, receiverships, establishment of stabilization funds, increases to deposit insurance, liquidity lines) are shown to coincide with changes in sovereign and bank CDS spreads and estimated conditional distress probabilities across countries.
  - Examples of policy actions:
    - Ireland: Blanket bank liability guarantee; Purchase of bad assets (NAMA); Recapitalization of major banks.
    - Iceland: Unlimited deposit guarantee for domestic banks; Swap lines with Norway, Denmark & Sweden; Receivership of three major banks.
    - Switzerland: Establishment of stabilization fund; Plans announced to increase deposit insurance.
    - Hong Kong SAR: Unlimited bank liability guarantee through 2010; Liquidity line with China’s central bank.
    - Singapore: Unlimited deposit insurance through 2010; Swap line with the US Fed.

- Comparative insights across regions and bank types:
  - Asian banks (Hong Kong SAR, Singapore) had higher RoAs, were less leveraged, maintained higher capital ratios that were better composed, and placed greater emphasis on liquid balance sheets with less reliance on short-term and wholesale funding.
  - Two “hybrid-Asian” banks—HSBC and Standard Chartered—resembled Hong Kong SAR and Singapore banks in terms of lower leverage and higher RoAs, but were less capitalized relative to Hong Kong SAR and Singapore banks and more similar to U.K. banks on balance-sheet liquidity while maintaining an Asian-style funding structure.

*Italic: Source: IMF staff report excerpt (chapter/section provided).*

### Box 1: Is There an Optimal Size of the Financial Sector? ........................................................ 3

### Box 1: Is There an ―Optimal Size‖ of the Financial Sector?

### Theoretical trade-offs and policy framing
- Benefits of an efficient financial sector:  
  - producing information; pooling savings and allocating capital; managing, intermediating and allocating risks; monitoring businesses; easing external financing constraints facing firms.  
- Optimal size arises where these benefits outweigh:  
  - costs of diverting resources from other sectors, and financial stability risks.  
- Crisis lesson: rapid financial sector growth can reflect unsustainable asset booms rather than improved intermediation.  
- Policy response emphasized two elements:  
  - create a safety net to minimize the costs of a crisis; and  
  - use domestic regulation to minimize resulting moral hazard.  
- For internationally active financial centers there is an additional trade-off:  
  - international banking boosts GDP and incomes but the accumulation of external liabilities by banks adds external and fiscal risks for the sovereign;  
  - these externalities can be offset via tighter regulation of banks, additional external and fiscal buffers, and burden sharing agreements with other countries.

### Key vulnerabilities identified for economies with large banking sectors
- Three characteristics that increase crisis vulnerability:  
  - (i) a significant cross-border dimension to its banks;  
  - (ii) limited fiscal resources; and  
  - (iii) issues a (non-reserve) currency or adopts a reserve currency as its legal tender.  
- Vulnerability mechanisms:  
  - external retail or wholesale depositors can create a funding crisis; and/or shocks can lower liquidity of assets relative to foreign liabilities;  
  - the sovereign may be unable to guarantee (foreign currency) liquidity needs of a large banking sector;  
  - liquidity crises can quickly morph into solvency crises, bringing into question fiscal capacity to recapitalize banks;  
  - expansion of banking, securitization, and a ―shadow‖ banking system created less transparent ways for banks to expand operations.

### Empirical contrasts across sample economies (illustrative outcomes)
- Diverse crisis outcomes despite common feature of large banking systems:  
  - Iceland: suffered a banking collapse.  
  - Ireland: avoided a financial collapse but faces a significant increase in costs of government borrowing as debt is projected to rise rapidly.  
  - Switzerland: intervened in one of its two major banks; fiscal consequences more modest.  
  - Hong Kong SAR and Singapore: emerged largely unscathed.  
- Offsets that mattered: private sector regulation, public sector prudence, and international cooperation (or their absence).

### Bank growth dynamics and business models
- Rapid bank growth driving and being driven by domestic bubbles led to growing international activities, rising leverage and macro risks. Examples and magnitudes:  
  - Icelandic bank assets rose to over eight times GDP by 2007 — a striking six times the 2001 ratio — and foreign debt shot up even faster.  
  - Hong Kong SAR and Singapore already had large banking systems in 2001 (bank assets of some 470 and 780 percent of GDP, respectively); subsequent growth rates of these ratios were significantly below Iceland and Ireland.  
- LCFIs (large complex financial institutions) dominated assets and external borrowing/lending in sample economies: the largest three banks represented over half of assets in all sample countries except Singapore and Ireland.
- Business-model groupings and vulnerabilities:  
  - Icelandic and Irish banks: rapid expansion of loan portfolios at home and/or abroad; Icelandic banks much more dependent on foreign wholesale funding than Irish banks.  
  - Large Asian banks (Hong Kong SAR, Singapore): diversified deposit base, relatively large capital and liquidity cushions, exposures mainly to rest of Asia.  
  - Swiss LCFIs: expansion driven by investment banking and cross-border investments (notably to the United States), higher leverage and reliance on wholesale funding.

### Box 2 findings — Asset quality, profitability, capital adequacy, liquidity (2001–07)
- Asset expansion and composition:  
  - Assets of Icelandic and Irish banks expanded much faster than loan books of banks in Hong Kong SAR and Singapore; by end-2007 Icelandic bank assets were equally split between domestic and foreign operations (branches and subsidiaries, principally in the Nordic countries and in the U.K.).  
  - Swiss bank asset growth driven mainly by cross-border investments (notably to the United States).  
  - Loan growth 2003–2007 (average): Iceland and Ireland materially higher than Singapore and Hong Kong SAR (local banks).  
- Profitability and trading income:  
  - Profitability indicators for Icelandic and Irish banks tended to be higher but more volatile. Icelandic banks derived roughly 20 percent of income from trading; in Irish banks trading income never exceeded 5 percent. Asian banks’ trading income contribution was less than 10 percent; local banks in Hong Kong SAR had better ROEs than banks in Singapore.  
- Capital buffers (TCE ratios):  
  - Local Asian banks had the largest tangible common equity (TCE) ratios: local banks in Hong Kong SAR had an average TCE ratio of 8 percent, while the Swiss banks had an average TCE ratio of only 2 percent.  
- Leverage:  
  - LCFIs following the investment banking model (e.g., UBS, Credit Suisse) had the highest (rising) leverage ratios during 2001–07; Asian banks and Icelandic banks had fairly low (stable) leverage ratios; Irish banks were intermediate.  
- Funding strategies and wholesale funding dependence:  
  - Icelandic banks relied heavily on wholesale funding: at over 70 percent, their share of wholesale funding in total liabilities was comparable only to that of investment banks in the sample.  
  - For HSBC and Standard Chartered, wholesale funding accounted for 20–30 percent of total financing against an average of around 15 percent for local Hong Kong SAR banks.  
- Liquidity buffers and loan-to-deposit ratios:  
  - Icelandic and Irish banks had the highest loan-to-deposit ratios and the lowest liquid asset ratios (share of liquid assets in total assets) in the sample; local banks in Hong Kong SAR were at the opposite end.  
- Nonperforming assets and loan-loss reserves:  
  - NPAs (as share of total loans) for European banks picked up more sharply after the onset of the crisis than for Asian banks; NPAs rose sharply in 2007–08 while loan-loss reserves ratios remained flat.

### Governance, regulation, and supervisory differences
- Governance and internal risk management differences affected how much LCFIs stretched balance sheets:  
  - Rating-agency analyses suggested UBS had a decentralized structure and reliance on external credit assessments and agency ratings, use of monoline insurance, and autonomy for Dillon Read Capital Management; Credit Suisse used more effective hedging strategies and exited the U.S. property market relatively early.  
- Financial liberalization and light-touch regulation catalyzed growth in some cases:  
  - Icelandic banks, privatized in 2002, pursued aggressive lending and foreign asset acquisitions amid insufficient supervisory experience and lack of instruments to oversee complex ownership, connected lending, and large exposures.  
  - Ireland’s expansion followed euro area membership and was supported by U.K.-style principles-based regulation.  
- Inadequate regulation for investment banking exposures:  
  - UBS and Credit Suisse took on large, highly leveraged exposures both on- and off-balance sheet; Swiss supervisors appear to have relied heavily on banks’ risk models; off-balance sheet entities were legally separate yet markets assumed reputational support (―moral recourse‖).  
- Tighter prudential supervision likely helped contain credit expansion in Hong Kong SAR and Singapore: examples include:  
  - LTV caps and property measures: Hong Kong SAR imposed a 70 percent cap on loan-to-value (LTV) ratios for property loans; LTV caps were also in place in Singapore, China, Korea, and Malaysia. By contrast, Irish authorities introduced a requirement for Irish banks to assign higher risk weights to mortgage loans with LTV above 80 percent only in May 2006.  
  - Capital composition and higher minimums: Singapore required banks to maintain capital adequacy ratios of 10 percent and Tier 1 ratios of at least 6 percent, two percentage points above minimum standards set by the Basel Committee. Asian banks exhibited higher ratios of tangible common equity to Tier 1 capital.

### Ownership structures of foreign operations and fiscal implications
- Choice between foreign subsidiaries and branches largely reflected bank business decisions (existing business/franchise, Greenfield investments), tax, and regulatory considerations rather than lender-of-last-resort concerns.  
- Fiscal implications differ: subsidiaries are independently capitalized and under host country supervision; home regulators are typically responsible for branches (particularly in Europe), affecting potential home-country fiscal liabilities during crises.

*Italic: Source — Box 1 and Box 2 content from the supplied IMF chapter/section.*

### 12. In the European Economic Area (EEA, comprising EU and most EFTA members)

### 12. In the European Economic Area (EEA, comprising EU and most EFTA members)

### Branch passporting and organizational choices
- The passport system put branches clearly under the jurisdiction of the home country and may have made it easier for banks to choose branch structures.
- U.K. regulators felt passport provisions factored into the decision to accept IceSave as a branch in 2006. IceSave was used by Landsbanki to replace ―hot money‖ wholesale funds with ―hot deposits‖ attracted via high internet deposit rates (other authorities, however, have argued the U.K. could have blocked the application).
- By contrast, Swiss banks’ U.S. broker-dealers used for investment banking operations had to be independently capitalized subsidiaries, helping to cushion the blow to Swiss taxpayers when the crisis hit.

### Macroeconomic environment and private sector imbalances
- Cross-border banking activities increased sensitivity to external shocks, especially from the United States and the United Kingdom; feedback onto money centers or between sample economies was limited except for a combined Swiss credit and liquidity shock which had some impact on the United States.
- Private sector macroeconomic imbalances built in Iceland and, to a much lesser extent, Ireland: expanding bank balance sheets, domestic credit booms, real estate bubbles, significant increases in household and corporate debt, and rising current account deficits.
- By contrast, Switzerland, Singapore, and Hong Kong SAR:
  - ran current account surpluses,
  - remained net external creditors,
  - had stable private sector debt ratios.
- Even though land prices started to rise in Hong Kong SAR and Singapore after 2006, private sector credit as a percent of GDP was still lower in 2007 than in 2001.

Key macroeconomic and policy stance indicators (preserve exact figures)
- Fiscal Balance/GDP (end-2007) (%) — Iceland: 5.4; Ireland: 0.2; Switzerland: 0.9; Singapore: 12.4; Hong Kong SAR: 7.7
- Fiscal Balance/GDP (end-2009) (E) (%) — Iceland: -14.4; Ireland: -11.8; Switzerland: -0.5; Singapore: 1.5; Hong Kong SAR: -0.9
- Reserves/GDP (Beginning 2007) (%) — Iceland: 12.8; Switzerland: 16; Singapore: 98; Hong Kong SAR: 70.1; (Ireland: ...)
- Reserves/GDP (End-2009) (%) — Iceland: 42; Switzerland: 26; Singapore: 117; Hong Kong SAR: 121.4; (Ireland: ...)
- Net IIP (end-2007, % of GDP) — Iceland: -127.2; Ireland: -16.5; Switzerland: 139; Singapore: 100.5; Hong Kong SAR: 252

- The Asian economies (Hong Kong SAR and Singapore) built up fiscal and external buffers to cover large short-term debts; Hong Kong SAR’s 30 percent coverage of gross short-term external debt before the crisis was within standard prudential norms.
- In Iceland and (to a lesser extent) Ireland, bubble-related revenues obscured weaknesses in underlying fiscal positions; the Fund sharply revised downwards the estimated structural fiscal position after the crisis.
- Irish banks’ access to European Central Bank operations (as part of the Euro area) shielded them from serious liquidity risks.
- Switzerland ran significant structural fiscal surpluses but maintained limited foreign exchange reserves and a floating exchange rate regime (as did Iceland).

### Box 3 — Cross-Border Spillovers: scenarios, sample, data, and key results
- Scenarios analyzed:
  - (1) Credit shock: initial default may trigger additional rounds of defaults.
  - (2) Credit and liquidity shock: each credit shock compounded by a liquidity shock (unable to roll over funding, triggering fire sales).
- Sample: economies with large financial systems covered in the paper (Belgium, Netherlands, Ireland, and Switzerland); three other developed financial systems (Austria, Spain, Sweden); systemically significant large financial systems (France, Germany, United Kingdom, and the United States).
- Data: BIS consolidated banking statistics reported on an immediate borrower basis (IBB) supplemented with Bankscope capital data; simulations based on figures at end-2006, 2007, and 2008 and averages over these years.

Key results (exact figures preserved)
- Under the credit shock scenario:
  - An initial hypothetical failure of French and German banks would lead to average losses of 30.8 and 45.6 percent of capital, with Switzerland and Belgium most affected.
  - The hypothetical Dutch failure would produce a projected capital loss to Belgian banks of 72.4 percent of their initial capital.
- Under the credit and liquidity shock scenario:
  - The impact of the liquidity squeeze increases the systemic role of Netherlands, France, and Germany.
  - The default of Netherlands would induce one hypothetical default (Box Table 3).
  - For France and Germany, induced failures rise to nine and two, respectively, under the credit and liquidity shock (from zero and one in the credit shock scenario).
  - On average, the hypothetical default of the Dutch, French, and German financial systems would lead to losses of 7.3, 54, and 7 percent of the total capital (Box Table 3).
  - Compared to the credit shock, the combined credit and liquidity shock significantly increases the impact of Switzerland on the U.S.

Selected simulation metrics (preserve table figures as reported)
- Table 1: Simulation Results under Credit Shock Scenario — Hazard Rate / Failed Capital / Induced Failures / Absolute Hazard / Contagion Rounds (selected entries)
  - Belgium2.5800220
  - Netherlands4.7300220
  - Switzerland2.6600220
  - Ireland3.1800220
  - France10.4800220
  - Germany5.8211220
  - UK54.0092110
  - USA100.0010200
- Table 3: Simulation Results under Credit and Liquidity Shock Scenario — (selected entries)
  - Belgium2.5800440
  - Netherlands7.3011330
  - Switzerland2.6600330
  - Ireland3.1800330
  - France54.0093220
  - Germany6.9921330
  - UK54.0092220
  - USA100.0010200
- Table 2: Credit Shock Scenario - Post Simulation Capital Impairment (in percent of pre-shock capital) — example row averages (Trigger Country averages):
  - Average  -104.2 -88.6 -193.3 -50.7 -49.0 -34.9 -74.1 -73.9 -167.5 -27.0 -1.5
- Table 4: Credit and Liquidity Shock Scenario - Post Simulation Capital Impairment (in percent of pre-shock capital) — example row averages (Trigger Country averages):
  - Average  -164.5 -141.6 -251.7 -111.0 -98.6 -77.0 -121.0 -89.2 -258.1 -56.5 -17.9

### Fund surveillance and assessment of imbalances and spillovers
- Fund surveillance generally recognized growing macroeconomic imbalances but underestimated inward and outward spillovers.
- The need to enhance bank supervision in Iceland and Ireland was highlighted but not forcefully enough; the impact of asset bubbles was underestimated.
- Bank stress tests in Ireland and Iceland (conducted by the authorities) and in Switzerland were sanguine compared to outcomes.
- For Hong Kong SAR and Singapore, prudent macroeconomic policies were praised, though links to the banking sector were not emphasized. Except in Switzerland, external spillovers received limited attention.

### How bank risks shifted to the government during the crisis — crisis impact and policy response
Crisis impact (country-specific highlights)
- Iceland:
  - Post-Lehman turbulence shut Icelandic banks out of bond and foreign exchange swap markets.
  - After Glitnir was unable to fund a foreign payment due in October 2008, an agreement provided the bank with new equity amounting to €600 million (23 percent of reserves) from the Central Bank, and a Fund program was rapidly arranged.
- Ireland:
  - Irish banks’ access to wholesale funding came under growing scrutiny as asset quality concerns mounted.
  - Projected loan losses rose with the bursting of domestic and U.K. housing bubbles; capital eroded as provisions exceeded operating incomes.
- Switzerland:
  - Affected mainly through international exposures of UBS and, to a lesser extent, Credit Suisse; stability concerns centered on significant write-downs and credit losses on largely dollar-denominated ―toxic assets.‖
- Hong Kong SAR and Singapore:
  - Banking systems were relatively resilient; aside from a short-lived and minor bank run in Hong Kong SAR, main impacts were through domestic and global slowdown and contraction in the asset management industry.

Sovereign risk and cross-border resolution
- The lack of effective cross-border resolution mechanisms increased sovereign risks for countries with large banking systems.
- Absence of cross-border frameworks led to ad hoc and inefficient solutions (e.g., Fortis was split on national, rather than business, lines).

Macroeconomic policies and financial measures
- Rapid global monetary easing supported bank profitability as financial conditions normalized: Swiss National Bank guided policy interest rates to zero; Hong Kong SAR, Ireland, and Singapore imported lower interest rates through their exchange rate arrangements.
- Switzerland intervened to stem upward pressures on the franc from safe-haven flows (first intervention since 1995).
- European sample countries implemented rapid and forceful financial policies; resulting large (actual and contingent) fiscal claims limited the attractiveness of direct fiscal stimulus. Ireland tightened fiscal policy in 2009.
- By contrast, Asian economies provided significant fiscal support from 2008; in Singapore the package amounted to some 8 percent of GDP.

Summary of Financial Support Measures (as presented)
- Iceland: Extension of retail deposit insurance ✓; Debt Guarantees ✓; Liquidity Support (intern’l) ✓; Liquidity Support (domestic) ✓; Capital Injections ✓; Asset Purchases/Swaps ✓; Capital Controls ✓
- Ireland: Extension of retail deposit insurance ✓; Debt Guarantees ✓; Liquidity Support (intern’l) ✓; Liquidity Support (domestic) ✓; Capital Injections ✓; Asset Purchases/Swaps ✓; Capital Controls NO
- Switzerland: Extension of retail deposit insurance ✓; Debt Guarantees NO; Liquidity Support (intern’l) ✓; Liquidity Support (domestic) NO; Capital Injections ✓; Asset Purchases/Swaps ✓; Capital Controls NO
- Singapore: Extension of retail deposit insurance ✓; Debt Guarantees NO; Liquidity Support (intern’l) ✓; Liquidity Support (domestic) ✓; Capital Injections NO; Asset Purchases/Swaps NO; Capital Controls NO
- Hong Kong SAR: Extension of retail deposit insurance ✓; Debt Guarantees NO; Liquidity Support (intern’l) NO; Liquidity Support (domestic) ✓; Capital Injections NO; Asset Purchases/Swaps NO; Capital Controls NO

### Box 4 — The Case of the Benelux Region: cross-border resolution lessons
- Benelux saw consolidation into large complex financial institutions (LCFIs) and international banking networks (ABN Amro, Fortis, Dexia, KBC, ING).
- The absence of explicit burden-sharing and cross-border resolution arrangements complicated interventions; Fortis was split along geographical lines, increasing costs.
- Dexia’s governments agreed to a plan that preserved the group; different outcomes illustrate the importance of prearranged burden-sharing.
- EU competition policy is the main platform for coordinating cross-border resolution in Europe, with plans for a more structured and binding approach in the future.
- Resulting structural change: Benelux banks retrenched to core domestic retail franchises (―back-to-basics banking‖).
- Policy implication: sensible international burden-sharing arrangements should be negotiated so costs from cross-border resolution can be fairly shared among stakeholders within financially integrated areas such as the EU.

*Source: IMF staff report excerpt (chapter/section provided).*

### 22. Differing types of government support for large banking systems over the crisis

### 22. Differing types of government support for large banking systems over the crisis

### How government support shifted risk between banks and sovereigns
- Government support took three broad forms, each shifting risk differently:
  - Protection of liabilities to prevent bank runs (marked in red): extending deposit insurance, providing guarantees of other types of liabilities.
  - Support for impaired assets to shore up bank solvency (marked in blue): capital injections and asset purchases/swaps.
  - Provision of external liquidity by foreign central banks (marked in green).
- Estimated probabilities (Figure 5) show how CDS events in banks (sovereigns) could lead to events in sovereigns (banks); interpretation for Singapore and Hong Kong SAR CDS is cautious due to limited liquidity in those contracts.

### Country case evidence on types of support and observed outcomes
- Iceland
  - Rapid collapse of the Icelandic financial system (all three major banks were intervened) focused attention on sovereign liability for foreign depositors.
  - Retail liabilities in foreign subsidiaries were paid by host governments; the Icelandic government proposed unlimited support for depositors in domestic branches but only limited support for branches in the EEA, triggering an unresolved dispute with the United Kingdom and the Netherlands.
- Ireland
  - Risks of a wholesale funding run after Lehman were quelled via a guarantee on deposits and debt, transferring risks to the sovereign.
  - The guarantee covered retail and wholesale deposits, as well as senior debts, of major banks.
  - CDS spreads on several Irish banks and the sovereign became highly connected until plans to recapitalize three banks in December 2008 and public discussion from February 2009 on creating a bad bank; a bad bank scheme was announced in April 2009. Bank and sovereign risks remained elevated and strongly correlated.
- Switzerland
  - Rapid resolution of UBS’s troubled assets (a “bad bank” funded by the central bank and backed by a Fed swap line for dollar liquidity) partially insulated the sovereign.
  - Early and well-designed intervention on bank assets generally lowered fiscal cost and limited moral hazard by ensuring troubled banks pay a significant proportion of eventual costs.
- Hong Kong SAR
  - A large transfer of risk from banks to the government first occurred in early 2008 after Bear Stearns’ collapse but then subsided.
  - Another transfer occurred after a blanket guarantee of retail deposits and a contingency facility for bank capital; the link has remained elevated.
- Singapore
  - Transfers of risk from banks to the government occurred after upward shifts in risk perception (e.g., after Bear Stearns’ rescue in 2008) and after announcing a blanket guarantee of retail deposits.
  - Impact was mitigated by a subsequent swap line with the Federal Reserve, though market concerns over the bank–sovereign link rose over time.

### International links, liquidity support, and scale effects
- Contagion and international linkages
  - Contagion risks from banks and sovereigns in the sample to major foreign LCFIs rose significantly in mid-2007 as international liquidity became constrained.
  - Sovereign-to-sovereign spillovers rose more slowly, plateauing after the Lehman collapse.
  - These international risks are highest from the larger (Switzerland) and less risky (Hong Kong SAR, and Singapore) banking systems in the sample.
- Central bank balance-sheet and liquidity support facts
  - Iceland negotiated swap arrangements with the Nordic countries worth some 12 percent of GDP before its banking system collapsed.
  - Switzerland used nearly $40 billion (some 10 percent of GDP and 8 percent of M3) of the dollar swap line to finance the Stabilization Fund that bought bad UBS assets and recapitalized the bank; the Stabilization Fund was refinanced by the central bank from February 2009 onwards by issuing dollar denominated bills to local banks.
  - Irish banks obtained large amounts of liquidity support from the ECB: liquidity support from ECB repo operations intermediated through the Central Bank of Ireland’s balance sheet peaked in mid-2009 at more than 80 percent of GDP, with well over half going to domestic banks or foreign banks with domestic operations.
  - By 2007, Hong Kong SAR and Singapore had built foreign currency buffers of around the size of GDP.
- Relative fiscal costs
  - The crisis is projected to generate a major rise in public debt in Iceland and (to a lesser extent) Ireland (see Figure 3).
  - Costs to the Asian economies and Switzerland are projected to be much more modest, reflecting sound non-financial balance sheets and swift, well-designed resolution of UBS’s problem assets.

### Explaining divergent outcomes: Asian resilience vs. European fragility
- Share-price performance between Lehman bankruptcy and March 2009 trough:
  - Typical major European financial institution share prices fell by 80 percent (in U.S. dollars).
  - Singapore banks fell by 50 percent.
  - Hong Kong SAR banks fell by 33 percent.
- Three broad explanations proposed for stronger performance of Asian banks:
  - Operated in a high-saving and fast-growing region.
  - More tightly supervised and regulated.
  - Strong internal management.
- Evidence on supervision, liquidity, and behavior
  - Supervisory approach:
    - Hong Kong SAR and Singapore supervisors were more “hands-on,” actively monitoring internal management and limiting leverage in specific markets.
    - Regulators in Hong Kong SAR and Singapore subjected banks to strict liquidity requirements: minimum monthly average liquidity ratios of 25, and 16 percent respectively.
  - Private sector behavior:
    - Corporates and households in Hong Kong SAR and Singapore gradually rebuilt balance sheets after the Asia crisis and kept cautious borrowing attitudes.
  - Macroeconomic buffers:
    - Fiscal surpluses and large foreign currency buffers supported market confidence.
  - Internal bank management:
    - Global banks with Asian roots (HSBC and Standard Chartered) headquartered in London were subject to “light touch” U.K. home regulation but exhibited conservative internal management and diversified retail deposit bases.
  - Funding structure differences:
    - Asian local banks maintained considerably higher liquid assets than European counterparts and had widely dispersed retail deposit bases, reducing reliance on wholesale funding.
    - Swiss banks developed significant currency funding gaps in expanding U.S. dollar trading (over 10 percent of assets by mid-2006 according to BIS calculations).

### Policy lessons and recommended directions forward
- Systemic scale, safeguards, and international coordination
  - The crisis underlined fiscal vulnerabilities of countries with large banking systems: in 1990, the world’s ten largest banks had an average balance sheet size of 14 percent of their home countries’ GDP; this rose to an average of 92 percent by 2007.
  - An effective global resolution regime and binding international burden sharing mechanism would define and likely diversify the risks of a large banking sector, lower moral hazard, and enhance market discipline; Fund staff are preparing a paper on cross-border bank resolution building on the Basel Committee’s Cross-Border Bank Resolution Group’s recommendations (March 2010).
  - Absent progress on burden sharing, territorial risks must be internalized via tighter regulation and prudent macroeconomic policies, ideally backstopped by international cooperation.
- Micro- and macro-prudential policy measures
  - Liquidity is the first line of defense in a world with recurrent wholesale funding runs — maintained liquidity buffers reduced reliance on wholesale funding for Asian banks.
  - Tight supervision and regulation can reduce potential fiscal support demands:
    - More robust supervisory approaches—pro-active engagement, understanding individual bank risk profiles—appear meritorious.
    - Stronger regulation: Swiss requirements for the two large banks to hold twice the internationally agreed minimum regulatory capital are an example.
    - Taxes and levies could be used to shrink the banking sector (area of active Fund staff work).
  - Structural and organizational measures:
    - Encouraging subsidiarization relative to branches can lower fiscal risks for host countries, though it does not eliminate the need for coordinated supervision and burden sharing; subsidiarization may “trap” capital and liquidity, fragment markets, and reduce cross-border flows (ongoing Fund work).
    - The size of the banking sector needs to match the resources of the home regulator; limited fiscal resources constrain the credible supervisory umbrella.
  - Crisis-resolution design:
    - Swift and well-designed actions to resolve bad assets of troubled institutions can help decouple sovereign from bank risk.
    - Protection of liabilities (deposits, debt) may be necessary to stem runs but generally increases the bank–sovereign link; asset-focused interventions can lower long-term fiscal costs by restoring healthier bank balance sheets.

*Source: _041610 - 22. Differing types of government support for large banking systems over the crisis*

### 40. Strong external and fiscal buffers can provide a macroeconomic backstop to tight

### 40. Strong external and fiscal buffers can provide a macroeconomic backstop to tight

### Role of external and fiscal buffers
- Hong Kong SAR and Singapore, with less flexible exchange rate regimes, entered the crisis with levels of foreign reserves within usual prudential norms given their high levels of short-term debt.
- The reserve coverage of Switzerland (which did, however, have a solid overall external position) and of Iceland (which did not) was lower, partly reflecting their floating exchange rates.
- Building stronger external buffers does not necessarily imply reserve accumulation.
- All the economies considered in this paper entered the crisis with reasonably low public debt levels. However, in the cases of Iceland and Ireland apparently healthy fiscal positions masked underlying structural weaknesses.

### Liquidity support and swap arrangements
- The swap lines extended by the U.S. Fed to several economies, as well as liquidity support from the ECB and the Swiss National Bank, alleviated market pressures.
- Countries with large banking systems may want to pursue such agreements more durably.

### Supervisory cooperation and burden sharing
- International supervisory cooperation can significantly mitigate market pressures especially if burden sharing arrangements are clear.
- Cross-border supervisory colleges are helpful when supervisors from home and host countries can meaningfully exchange information.
- These colleges will be of most value if they can help in agreeing enforceable burden sharing arrangements to avert abrupt losses in cooperation like those experienced in the Benelux region after the crisis hit.

### Financial system growth and macroeconomic implications (summary of findings)
- Banking system assets of Iceland, and to a lesser extent Ireland, grew rapidly, both as a ratio to GDP and relative to the labor force—from the lowest to the highest ratios in the sample (growth referenced to Avg. 2003–07).
- Sharp increases in banking systems’ assets were accompanied by increases in external bank debt liabilities, which were a significant source of asset acquisition.
- Bank assets were very high both relative to tax revenue and to international reserves. Singapore reserve coverage was notably better than in other countries.
- Iceland, and to a much lesser extent Ireland, ran current account deficits financed in part by the banking systems and accompanied by domestic credit booms.
- The credit booms resulted in unsutainable house price growth, construction activity, and deteriorating competitiveness.
- Fiscal positions in Iceland, and to a lesser extent Ireland, looked comfortable, but masked reliance on unsustainable boom-related fiscal revenues, and pro-cyclical fiscal policies.

### Large Complex Financial Institutions (LCFIs) and banking structure (sample observations)
- The report catalogs LCFI and large-bank metrics (2003–07 averages) across Ireland, Iceland, Switzerland, Hong Kong SAR, and Singapore, including measures such as LCFI Assets (2003-07 avg), Loan Growth (2003-07 avg), Loan-to-Deposit Ratio (2003-07 avg), Wholesale Funding (2003-07 avg), Short-term borrowing (2003-07 avg), and Foreign Revenues (2007).
- In Iceland, the largest commercial banks listed (Kaupthing, Glitnir, Landsbanki) exhibited very large foreign exposures and high wholesale and short-term funding reliance (2003-07 averages).
- Swiss banks (UBS, Credit Suisse) had substantial foreign revenue shares in 2007 and significant international footprints.
- Hong Kong SAR and Singapore banks emphasized more liquid balance sheets, with relatively less reliance on short-term and wholesale funding compared with several European LCFIs.

### Bank flows, current account, and external financing patterns
- The banking system provided net external inflows into Iceland, and to a lesser extent Ireland, thereby financing current account deficits and domestic credit expansion.
- Both Switzerland and Singapore ran current account surpluses and their banking systems produced net external outflows.
- In Hong Kong SAR, banking system external flows oscillated around zero while the economy overall ran a current account surplus.

### Domestic transfer of risk: banks to sovereigns
- The analysis presents sovereign vs. bank CDS dynamics and conditional probabilities of distress (methodology by Miguel Segoviano and references listed in the source).
- Policy announcements (bank guarantees, recapitalizations, purchase of bad assets, swap lines, receiverships, establishment of stabilization funds, increases to deposit insurance, liquidity lines) are shown to coincide with changes in sovereign and bank CDS spreads and estimated conditional distress probabilities across countries (Switzerland, Ireland, Iceland, Hong Kong SAR, Singapore).
- Examples of specific policy actions noted in the sample:
  - Ireland: Blanket bank liability guarantee; Purchase of bad assets (NAMA); Recapitalization of major banks.
  - Iceland: Unlimited deposit guarantee for domestic banks; Swap lines with Norway, Denmark & Sweden; Receivership of three major banks.
  - Switzerland: Establishment of stabilization fund; Plans announced to increase deposit insurance.
  - Hong Kong SAR: Unlimited bank liability guarantee through 2010; Liquidity line with China’s central bank.
  - Singapore: Unlimited deposit insurance through 2010; Swap line with the US Fed.

### Comparative insights across regions and bank types
- Asian banks (Hong Kong SAR, Singapore) had higher RoAs, were less leveraged, maintained higher capital ratios that were better composed, and placed greater emphasis on liquid balance sheets with less reliance on short-term and wholesale funding.
- Two “hybrid-Asian” banks—HSBC and Standard Chartered—resembled Hong Kong SAR and Singapore banks in terms of lower leverage and higher RoAs, but were less capitalized relative to Hong Kong SAR and Singapore banks and more similar to U.K. banks on balance-sheet liquidity while maintaining an Asian-style funding structure.

*Source: IMF staff analysis and country data (figures and tables referenced are averages and series as reported in the chapter, including Avg. 2003–07 and 2007 datapoints).*

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