One exam done. So I was reading up on capital controls and a lot of people seem to make the Cyprus-Iceland analogy, which got me thinking about how Icelandic banks used to issue ‘love letters’ to each other. The ‘love letter’ was debt issued by the banks. Then they swapped that debt with other banks, and then used it as collateral for central bank liquidity. Here’s Anne Sibert:
Surprisingly, it was not just the Central Bank of Iceland that was willing to make loans against love letters – the Eurosystem was as well. Between the start of February and the end of April 2008, subsidiaries of the three large Icelandic banks, Kaupthing, Glitnir and Landsbanki, increased their borrowing from the Central Bank of Luxembourg by €2.5 billion. A significant amount of their collateral was in the form of love letters (Hreinsson et al. 2009, p44). It is questionable whether Icelandic bank debt should have been acceptable as collateral in the Eurosystem for any borrower. Given their inter-linkages, the Icelandic banks’ fortunes were far too highly correlated for one Icelandic bank’s debt to be satisfactory collateral against another Icelandic bank’s borrowing.
By late April 2008, the ECB had become concerned about its loans to Icelandic banks and on 25 April, the ECB President, Jean-Claude Trichet, phoned Icelandic central bank governor Davíð Oddsson and demanded a meeting with Icelandic banks and monetary and regulatory authorities (Hreinsson et al. 2009, p44). As a result, an informal agreement was made in Luxembourg on 28th and 29th April to limit the use of love letters as collateral. This proved ineffective. By the end of June, loans to the Icelandic banks had risen sharply to €4.5 billion. At the end of July, the Central Bank of Luxembourg finally prohibited the further use of love letters altogether and lending to Icelandic banks fell back to around €3.5 billion. In the autumn of 2008, five counterparties defaulted on their Eurosystem loans and three of these were subsidiaries of the large Icelandic banks (European Central Bank 2009).
From the ‘Causes of the Collapse of the Icelandic Banks‘ chapter from the Report of the Special Investigation Commission, we have the following tidbit from what happened there (p. 45):
The problem now was not only the unprotected „love letters“ being put forth as collateral for the loans at the ECB but also the currency swap agreements that were in force inside of the asset backed securities. It is clear that the Icelandic banks had angered the governors of the Central Bank of Luxembourg and the European Central Bank. At the end of July the three banks were in fact prohibited from using each others securities as collateral for loans from the European Central Bank which was effective. In general, the conduct of the Icelandic banks which has been described here, can be thought to have played a part in the fact that Iceland became eliminated from the scene of European Central Banks, but this, in return, made it more difficult for the CBI and the Icelandic government to raise liquid funds, see a more detailed discussion later in this chapter.
Also we have these graphs:
Which leads us to this announcement from the ECB:
On 20 March 2013 the Governing Council adopted Decision ECB/2013/6 on the rules concerning the use as collateral for Eurosystem monetary policy operations of own-use uncovered government-guaranteed bank bonds. Under this Decision, from 1 March 2015, the use of such bonds issued by the counterparty using them or an entity closely linked to that counterparty as collateral in Eurosystem monetary policy operations will be prevented. The Governing Council also decided to amend the rules on the use of uncovered government-guaranteed bank bonds for the period ending on 28 February 2015. To this end, the Governing Council adopted Guideline ECB/2013/4 on additional temporary measures relating to Eurosystem refinancing operations and eligibility of collateral and amending Guideline ECB/2007/9 (recast), the provisions of which encompass several existing legal acts on temporary measures. Finally, in order to clarify the overall framework, the Governing Council adopted Decision ECB/2013/5 repealing Decisions ECB/2011/4, ECB/2011/10, ECB/2012/32 and ECB/2012/34.
So everything is fine until March 1, 2015. This is — it seems to me — some housekeeping post-financial crisis. In the case of Cyprus, this bit is relevant from the original press release:
As a result, the national central banks of the Eurosystem will now only be allowed to reject eligible uncovered government-guaranteed bank bonds as collateral if they have been issued by the counterparty itself and do not comply with the Eurosystem’s minimum credit rating threshold.
Unlimited liquidity in other words, unless the ECB decide to go all nuclear again.
[And no — this is not a perfect analogy, but it’s kind of interesting since there are a few similarities. Don’t over-interpret it.]