Deutsche Bank Research

Small country, oversized financial sector: Really intolerable?

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In the wake of the crisis in Cyprus, several (large country) European politicians have opined that a large financial sector was an unacceptable business model for a small country. It is now asked whether especially Malta and Luxembourg, whose banking sectors (at 7.9x GDP and 21.7x GDP, respectively) are even larger than Cyprus’ (7.2xGDP), will be forced to shrink theirs.

Leave aside that concentration always creates vulnerabilities, whether in finance, electronics (Finland), or oil (Norway). Also leave aside that these comments reveal that EMU politicians still do not accept (understand?) the idea of a true banking union, in which national GDP would no longer be the reference point, as potential systemic risk would be shared by all banking union members. Simple comparisons with Cyprus ignore important differences: in Malta, international banks, accounting for some 5xGDP, have little or no linkage to the domestic economy, limiting contingent liabilities of the Maltese government. The economy is also more diversified than either Cyprus or Luxembourg. In Luxembourg, most of the value-added in the financial industry (25% of GDP) actually comes from asset management with AuM of 50xGDP that obviously do not create liabilities for the state. As regards on-b/s business, inter-bank and cross-border (mainly intra-group) exposures account for about 3/4 of Luxembourg-based banks’ loans. Hence, effective cross-border supervision and resolution regimes would be more helpful for Luxembourg than generalising statements. Will the debate on «business models» continue nonetheless? You bet!

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Published with kind permission of Deutsche Bank Research.

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