Framework for cross-border banking needs repair: Expert

Iceland is one country which came out of the crisis after a huge financial implosion by allowing some private banks to default and by hugely depreciating its currency. Mar Gudmundsson, the central bank governor of the Bank of Iceland, gives his views on what central bankers should concentrate on.

According to Gudmundsson, fiscal sustainability is key. He added that cross-border banking is retrenching around the world. The framework for cross-border banking in Europe is deeply floored and that needs to be fixed.

He further said, "In terms of crisis management, we need to focus on what it is that we want to preserve. It is not banks, but the kind of the infrastructure that is inside the banks, the payment system and the access of the common man to his or her deposits."

Below is the edited transcript of the interview. Also watch the accompanying videos.

Q: Your country stands out across several in the world as an example of having successfully pulled itself out of the Lehman crisis. What would you say were the key lessons? Some people believe it is because you had a floating exchange rate and because you allowed you banks to default?

A: There is some truth in both of those statements but they have to be nuanced. First of all, we did not bailout our banks because it was totally impossible for us to do so. The banks had a balance sheet that was 10 times GDP and if we had attempted to save those banks as they were, we would have bankrupted the country in the process. It is impractical because these banks were operating to a very large degree abroad and their balance sheet was the amount denominated in foreign currencies and you can print your own currency, you can lend banks in your own currency, but when it comes to all the currencies you cannot exit to a very limited degree. So what we did is that we allowed these banks to fail.

We protected the domestic depositors and created new banks. Around the domestic deposits and the domestic payment system, this was not on good bank-bad bank bid but the new bank-old bank bid. So that helped a lot because it avoided us from making a big mistake. The currency also helped up to a point because the currency was both partly the solution and the part of the problem because we had a 50% depreciation in the course of 2008 and that was more or less needed to stimulate the export sector.

It created a lot of problems with households and corporations because many of those had debt denominated either directly or indirectly in foreign currencies, and then households had debt that were intact to the price level, and when the currency fell as much as this, the price levels dropped. So it created an internal debt pressure. But over time, it changed the 25% current account deficit that we have in 2006-07 into an underlying surplus and has helped up to a point but we got too much of the medicine than you can take.

Q: Allowing banks to default, now I understand, you didn't allow depositors to suffer, but you allowed bondholders and equity holders to lose. Is this a lesson in Greece? Is that the only way to force on private bondholders a larger haircut? Is that the best solution for indebted European sovereigns?

A: Of course, this was not the sovereign. The sovereign did not default and nobody took a haircut on government bonds. So the credit on the sovereign was kept intact. This was a private sector default. One has to be careful in drawing too many conclusions vis-à-vis the rest of the world.

I think there are some, because there was no other sensible way or action, so to speak. Iceland is an island. People cannot take money and put it in their cars and drive out as they can in Greece, so it might be somewhat more complicated in these other cases. So I think it is a bit premature. But in general, I think the underlying principle is that you should try everything in order to protect the tax payer from their private bankers. So if banks are at the point of failing, then consider them failing - that might not be as bad as you think.

Q: After a QE2, there are hints of a QE3 from the United States. The long-term refinance arrangement by the ECB is also amounting to some kind of a quantitative easing. What do you think will be the impact for countries like yours and mine and the rest of the world? There are so many euros and dollars floating and maybe more of other currencies. Are you seeing a period of sustained inflation? What does the rest of 2012-13 look like?

A: No, I don't think we are at that point where we see a period of sustained inflation. Countries might have to take action themselves if there are spillover effects that undermine the equilibrium in the countries concerned. So as there is in my country, we have capital controls on outflows. So we are not affected to the same degree. Now India has some capital controls as well, so that is yield through some effect but in the limit. If you tend to insulate yourself from such effects, you need to allow your exchange rate to move to some degree. So that is the lesson. I think that these countries are taking the monetary policy actions based on domestic considerations. So that is how it is, that is how it has always been, and so long as we don't change the international monetary system, we will have to live with that.

Q: One final question to you for those who are observing Iceland from the outside. What is your key lesson or what would be your key takeaway of the events of the last three years? What should central bankers concentrate as their single important objective?

A: I think that the key lesson is to transcend central banking because fiscal policy was very important in this whole process. Iceland was one of those countries that on the surface had the fiscal house in order when the crisis struck with very low debt levels, a surplus etc.

But now, we know that in underlying terms if you took the boom away, we always had a financial sector where the policy wasn't strong enough. So I think that one lesson for the future is that don't be afraid of big surpluses in good times because bad times will surely come. Secondly, especially for small countries, even if you are in a recession, you need a medium-term consolidation plan for fiscal deficit and for a fiscal situation, which we got.

We allowed automatic surpluses to work in 2009 and then we have been on a consolidation plan and we felt that we would not have a CDS around 300. We would not have tapped the US market last year and we would not be out of the woods in the same way as we are in spite of the short-term negative demand effects. So, fiscal sustainability is key. The second lesson is the one regarding banks, and first of all, the framework. This crisis, not only in case write-downs but more generally it is, to my mind, a crisis of cross-border banking. Now cross-border banking is retrenching around the world.

The framework for cross-border banking in Europe is deeply floored and we need to fix that. Thirdly, in terms of crisis management, we need to focus on what it is that we want to preserve. It is not banks, but the kind of the infrastructure that is inside the banks, the payment system and the access of the common man to his or her deposits.