Chapter 4: the Luxembourg financial centre and the international financial crisis.
Luxembourg is a major European and international financial centre. The growth of these activities has been crucial to the country's economic and social development over recent decades (OECD, 2008a): the financial sector accounted for 29% of GDP in 2008, 12% of employment and around one-fifth of total tax revenues, a share well above that in any other OECD country. The Luxembourg financial centre plays an important role in the Europe's financial system, both in terms of channelling funding to international banks and in asset management activities.
The global financial crisis had a strong impact on the Luxembourg financial centre. As elsewhere, banks and money market funds came under pressure as funding conditions in the interbank market became difficult. Balance sheets contracted significantly. Two major cross-border banks with large local subsidiaries required direct government intervention by local and home governments, and three relatively small foreign-owned institutions were put into administration. The overall value of assets under management fell sharply as stock markets plummeted. World financial markets have now recovered since the worst days of the crisis and market conditions have eased. Although the overall impact on the financial sector may be more limited than anticipated, activity in the financial centre is lower than before the crisis. Employment in the financial sector has contracted modestly to date and tax revenues are lower.
Looking ahead, the crisis is likely to have a lasting effect on Luxembourg as the financial industry evolves and the regulatory system is strengthened. In addition, a new EU directive on investment funds (UCITS IV) will have a large impact on asset management activities. The crisis exposed some of the risks in the international banking system and, given its role in the economy as whole, it is important that Luxembourg continues to strengthen financial regulation and supervision in the light of this experience.
The financial crisis had a strong impact on Luxembourg
While the proximate causes of the international financial crisis lay outside Luxembourg, the turning of the credit cycle had a significant impact on its financial centre. The crisis has its origins in a pronounced global credit cycle created by a combination of inappropriate monetary policy settings, financial innovation and regulatory failings (Ahrend et al., 2008). As the cycle turned, asset prices collapsed and credit spreads increased in many markets (Figure 4.1). In particular, in the wake of the sub-prime crisis and then the bankruptcy of the investment bank Lehman Brothers, banks and financial institutions became very reluctant to lend to each other. This led to severe financial stress and higher funding costs for banks. Policy action was taken at the European and international level to guarantee bank deposits and other liabilities and recapitalise banks (OECD, 2009). In addition, changes in the scope of monetary policy operations by the ECB have increased the volume of monetary operations by around two-thirds from their pre-crisis level, as well as lengthening the maturity of credit on offer. These measures contributed to stabilising the financial system and are now being withdrawn. However, financial conditions remain tighter than prior to the turning of the cycle. This has affected Luxembourg through a reduction in activity and tensions in the interbank market, a fall in the value of assets under management and the wider impact of these developments on the local economy.
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The interbank market was at the centre of the storm
Pressures on the banking system and tensions in interbank markets had a large effect in the Luxembourg financial centre, given its specialisation in intermediating interbank funding between different institutions and its provision to international banks in other countries. Tensions in the interbank market from the summer of 2007 led to increased demand for funding and interbank operations in Luxembourg, given that liquidity in the market as a whole was in short supply, and interbank loans from Luxembourg banks continued to rise from mid-2007 to autumn 2008. This changed dramatically following the collapse of Lehman Brothers as banks' willingness to lend dried up: loans to other euro area monetary and financial institutions (MFI) are now more than 25% lower than the peak and there has also been a sharp reduction in lending to non-euro area residents (much of which is interbank business). These developments largely account for an overall contraction in bank balance sheets of around 17% in 2009 compared with the previous year (Figure 4.2). This represents a sharp turnaround in balance sheet developments compared with average annual growth of close to 7% in the five years up to 2007.
Severe difficulties during the crisis in a number of specific institutions required intervention by the authorities. Two large cross-border institutions (Dexia and Fortis) came under critical pressure and public support was required (Box 4.1). However, government support in the form of guarantees and capital was more limited than in many other OECD countries, both relative to the size of the financial system and GDP (OECD, 2009). Nevertheless, the rescue of Fortis involved a government recapitalisation equivalent to more than 6% of GDP. In addition, three relatively small subsidiaries of Icelandic banks were put into administration by the financial supervisor. All these problems had substantial cross-border elements. Nevertheless, their resolution was achieved relatively smoothly and contagion to other institutions in the financial centre was avoided.
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Box 4.1. The resolution of difficulties at specific institutions during the crisis Fortis is a major cross-border European financial group and had total group assets of around EUR 800 billion before the crisis. Originating from the merger of Belgian and Dutch insurance companies, the group purchased Banque Generale du Luxembourg (BGL) in 2000. BGL was the third largest bank in Luxembourg with close links to the local economy. In 2007, the assets of the BGL-Fortis subsidiary were around EUR 50 billion (135% of Luxembourg's GDP). Following Fortis' takeover of ABN Amro in 2007, it sought to raise more capital. Doubts emerged about its solvency during 2008 as the international banking crisis unfolded and investors began rapidly to lose confidence in its viability. Between 28 September and 5 October 2008, the French, Belgian and Luxembourg authorities put in place a number of rescue measures. Fortis' Dutch operations were eventually taken over by the Netherlands government. The Belgian government provided extensive liquidity support to the remaining entity, of which 75% was sold to BNP Paribas and the rest held by the Belgian state. In December 2008, a subordinated loan from the Luxembourg government of EUR 2.5 billion (6.4% of GDP) was converted into equity. Following further operations, Luxembourg now holds one-third of the capital of BGL with the rest owned by BNP Paribas. The government intends to divest itself of this stake in the coming years. The Dexia group arose from cross-holdings of three banks in Belgium, France and Luxembourg (Banque Internationale a Luxembourg, BIL) with BIL ultimately almost entirely owned by the group. Dexia was active in financing local authorities, commercial and private banking. The group had assets of around EUR 600 billion prior to the crisis with BIEs assets close to EUR 60 billion (around 160% of Luxembourg's annual GDP). The Dexia group was heavily exposed to the sub-prime crisis through a US subsidiary, recording losses of EUR 3.3 billion for 2008. This led to increasing pressure from financial markets, which was augmented by fears of contagion from the difficulties at Fortis. In the autumn of 2008, EUR 6 billion of additional capital was injected by the Belgian and French states. Luxembourg committed EUR 376 million of further capital. Furthermore, a state-guarantee of up to EUR 150 billion was provided jointly by the three states, the Luxembourg share amounting to 3% of the total (EUR 4.5 billion). Three Icelandic bank established subsidiaries in Luxembourg prior to the crisis (Glitnir Bank, Kaupthing and Landsbanki). Much of their business was conducted outside Luxembourg. In early October 2008 and with mounting problems in their parent companies, the Luxembourg financial supervisor placed these banks into administration using a special procedure in place for banks. This resulted in claims on the deposit insurance scheme of around EUR 300 million (0.7% of GDP). This may be repaid as the firms are wound up and investors in these banks are likely to recover much of their losses.
After several years of high and sustained earnings, the profitability and financial position of banks has weakened significantly as a result of the crisis. For the Luxembourg banking sector as a whole, profits net of provisions collapsed in 2008 compared with the previous year (Figure 4.3). This was almost entirely due to the sharp rise in debt provisioning and depreciation, largely attributable to mark-to-market losses on banks' securities portfolios. With the subsequent market recovery, 40% of these losses had been recouped by the end of September 2009. Income from commissions and "other income", which is linked to stock market trends, also declined sharply as markets fell. These effects were partly offset by higher net interest margins, reflecting high market interest rates relative to the cost of funds for banks. As a key role of banks in Luxembourg is to redistribute liquidity on the interbank market, they were well placed to profit from the rate differentials. For 2009, profits increased as provisions on mark-to-market losses were smaller and other income increased significantly. However, profits remained below their pre-crisis levels and may be squeezed in the coming years if net interest margins narrow as policy rates are raised.
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The investment fund industry is recovering
The balance sheet of the investment funds industry contracted significantly as asset prices tumbled. The net value of their holdings fell by a quarter during 2008, compared to only 8% during the 2001-03 "dot com" crisis. The reduction in assets under management was largely due to falling prices, although there were large net outflows of funds at the end of 2008. While the net inflows from clients over 2008-09 were much weaker than before (Figure 4.4), the value of assets under management has increased again and stood at the end of 2009 at just below 13% of the peak value.
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The crisis in the financial system has affected the wider economy
The financial crisis has had an impact on the wider Luxembourg economy, although the effect on the real economy has been less severe than in some other countries and limited relative to the scale of the crisis and the size of the sector. The sharp slowdown in financial sector activity directly explains about half of the overall peak-to-trough drop in GDP, and somewhat more if related activities such as business services are taken into account. However, Luxembourg suffered much less than other small OECD countries with large financial sectors, such as Iceland and Ireland, owing to the nature of its financial activities. Banking activities in Luxembourg are based around intermediation of liquidity rather than structured instruments or proprietary trading, and mostly relate to the foreign rather than the domestic market. Only a small share of overall banking activities involves the supply of credit to the domestic economy. This configuration is reflected in high foreign ownership (Figure 4.5), which also reduces the wealth effects of banking difficulties on the local economy. 76% of the assets of resident banks are held by the subsidiaries of foreign-owned banks with a further 19% in the branches of international institutions, leaving only a small share in the hands of Luxembourg-based banks. Recovery in the financial sector explains much of the pick-up in activity since the third quarter of 2009, as well as stronger exports.
There is no evidence of a material credit crunch in the domestic economy, although the growth of overall credit to Luxembourg residents has slowed significantly. Credit to the resident household sector has actually continued to expand during the crisis, albeit at a much slower pace, and lending to domestic non-financial corporations was only marginally lower in the year to February 2010. The Banque Centrale du Luxembourg Bank Lending Survey shows a moderate tightening in corporate credit standard compared with the euro area at large, while credit standards applied to household loans have only tightened marginally.
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Despite the drop in growth, employment in the financial sector has fallen only modestly. The number of jobs in banking has been cut by around 3% since its peak, and employment in asset management activities is only slightly lower (Figure 4.6). Many of the job losses in banking are due to institutions closing down their presence in Luxembourg and so may be permanent. Following the "dot com" crisis, bank jobs continued to decline for a couple of years and developments to date appear similar. This could mean that the overall fall may be somewhat greater than seen so far. By contrast, employment in asset management has stagnated over the past year rather than fallen. Over time, asset management has come to account for around one third of employment in the financial sector, although this partly reflects widening of the definition of "financial sector professionals". The recent weakness is in contrast to the experience after the "dot corn" crisis, when investment funds continued to expand their workforce which may suggest that this slowdown is having more severe consequences for employment.
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The downturn in the financial sector has had a large impact on government revenues. Taxes from this sector have yielded around a fifth of total receipts in recent years (OECD, 2008a). Taxes paid by banks fell by two-thirds in 2008, reducing their yield to less than 1% of GDP, well below the level in recent years and by even more compared with the 1990s (Figure 4.7). This drop reflects the exceptional jump in provisioning and the exercise of the option under accounting rules to activate future tax charges during a year when the company has suffered losses. The full effect of the crisis on tax revenues will only become apparent after a certain delay, as corporate profits and corporation taxes are only finally determined after couple of years. The tax on investment fund subscriptions, an annual tax on the value of assets under management, is the other major source of revenue from the financial sector. It has become increasingly important as asset management sector has grown substantially. With lower equity prices, revenue from this source fell by about a fifth in 2008 and will decline again sharply in 2009. A partial recovery is likely in 2010. Overall, the loss of tax revenue from the financial sector appears more severe than during the crisis of 2001-02. (1)
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The international banking sector is highly specialised and large relative to the economy
Luxembourg is a major financial centre specialised in interbank liquidity operations, alongside asset management activities (Table 4.1). These activities are linked through various channels. As an international banking centre, Luxembourg is a location for pooling and transferring liquidity between different financial actors. Liquidity comes from three major sources: loans from international banks with excess funding provide around 45% of funding, with the remainder mostly provided by deposits and by money market mutual funds. Intra-group lending, by which local entities provide funding to parents in other countries, plays an important role. Although the financial centre is highly specialised in these activities for international banks, Luxembourg-resident monetary financial institutions (MFIs) are relatively small in the context of the euro area, and account for around 3% of overall assets and less than 7% of loans to other euro area MFIs.
The management of banking group liquidity leads to a concentration of risks
Luxembourg's resident banking sector is better capitalised than the EU average and more profitable (Table 4.2). This reflects its role in channelling liquidity through subsidiaries and branches to the major international banking groups that have a need for funds in excess of their own deposit base. These subsidiaries typically have much lower leverage than their parent companies (IMF, 2009). Interbank lending accounts for over half of credit in Luxembourg compared with only 28% for the euro area as a whole (Figure 4.8). This is part of a growing trend toward centralisation of liquidity management within international banking groups (Basel Committee on Banking Supervision, 2006). The rationales for centralisation are the optimisation of financing costs for the group as a whole, diversification of financing sources, the underlying dispersion of funds across different entities, and other practical aspects of how financial transactions are structured. The acute crisis of confidence in the interbank market in 2007 and 2008 showed some of the advantages of this approach with some parent banks relying heavily on funding from the Luxembourg banking centre.
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Large intragroup exposures imply a high concentration of risks of local entities. Funding obtained by Luxembourg subsidiaries and branches is channelled to parts of the same groups located in different countries. Intra-group assets accounted for almost 40% of Luxembourg bank assets in 2007 with exposure for some individual institutions likely to be far higher (Figure 4.9). As they are typically in surplus, these local entities of international banks are exposed to large risks on their assets, which are concentrated on a small number of counterparties from the same group (Rychtarik, 2009). Local entities are vulnerable to problems at other institutions in the same group through two channels of contagion:
* The local entity's direct exposure to the wider banking group. This exposure is often very large for assets with short-term maturities.
* Any information about the group can be taken as providing new information on the local entity, which may have negative consequences on depositors' and investors' confidence. Given imperfect information, this form of contagion may also arise from unfounded expectations about difficulties at subsidiaries.
It is hard to judge the size of these effects, not least because support from the group can also provide protection to the local entity in other circumstances. Contagion has, however, tended to spread from subsidiaries to the group, A study of contagion effects focusing on large banking groups from 1999 to 2003 did not find any clear evidence that subsidiaries of banking groups are more vulnerable than banks that are less integrated into a group (Derviz and Podpiera, 2007). Exposures to the intra-group capital market are not in themselves riskier than those on the external market. While the risk for the Luxembourg entities that had difficulties stemmed from the group, underlying problems at Dexia and Fortis were a mixture of group and local pressures.
The high concentration of assets on a single, foreign, parent banking group, nevertheless remains an important source of risk for the Luxembourg banking sector. In prudential matters, the European "large exposures" rule calls for preserving banks against default by a counterparty or group of counterparties in the wake of exceptional events, by limiting the concentration of exposures. As in many other countries, Luxembourg's regulators have used the possibility of excluding short-term intra-group and interbank exposures from this rule. (2) Given the current architecture of the international system, this approach could not be changed without fundamentally calling into question the way global capital markets are structured.
Regulation of banking liquidity is being strengthened to reduce risks
The inherent risks raised by the role of Luxembourg subsidiaries in the wider banking system mean that liquidity regulation is particularly important. Internationally, policies in this area prior to the crisis were less sophisticated and comprehensive than in other areas, such as capital adequacy. In the European Union, the regulatory framework left a comparatively wide role to national regulation in liquidity management. The Luxembourg regime was essentially to require maintaining liquid assets at 30% of liabilities and did not take into account off-balance-sheet positions. Following banking liquidity problems during the financial crisis, the European Committee of Banking Supervisors (CEBS-BCBS) has issued recommendations for new procedures (CEBS, 2009). Accordingly, banks should maintain adequate liquidity reserves composed of cash and liquid assets to deal with a liquidity crisis. The results of stress tests should also be reported to the supervisory authorities. These recommendations are further designed to ensure close co-operation among supervisors of cross-border banking groups to improve understanding of the liquidity risk profile of such groups.
Luxembourg is implementing the reinforced liquidity rules. The Financial Sector Supervisory Commission (CSSF) and the central bank have instituted a new qualitative liquidity regime, intended to transpose the CEBS recommendations on liquidity risk) These go further than the European rules in stipulating that, for financial institutions that are branches or subsidiaries, taking into account liquidity risks at the level of the group will not be enough. Luxembourg entities must have their own capacity to manage local liquidity risks, to conduct stress tests covering the liquidity risks of the Luxembourg institution, and to manage situations of liquidity crisis. In addition, the CSSF reserves the right to restrict intra-group transactions that are deemed contrary to the principle of sound and prudent management of liquidity risk for institutions in Luxembourg. It is commendable that this application exceeds the simple recommendations of the CEBS and in effect provides Luxembourg with stronger regulatory and supervisory requirements in these areas.
To strengthen regulation in a quantitative sense, the CEBS has proposed two ratios to measure liquidity risk (CEBS, 2009). These can be used as guides in constituting liquidity cushions: the short-term ratio (30-day Liquidity Coverage Ratio) calls for the stock of highly liquid assets to be 100% or more of net cash outflows; and the medium-term ratio (Net Stable Funding Ratio) is a relationship between stable funding available and stable funding needs over a period of one year. In principle, these rules are intended to be applied to an entire banking group on a consolidated basis, but the CEBS encourages the authorities to implement them for each member of a group so as not to discriminate between domestic banks and members of international groups. The CSSF is preparing proposals in this area in the light of the evolving international and European debate. These should be designed to align Luxembourg's standards with best international practices, taking into account the specific features of the Luxembourg banking system and avoiding excessive risk taking by local entities.
Large financial institutions present significant risks for a small economy
The financial sector balance sheet is exceptionally large relative to the size of the local economy (Figure 4.10). While some other OECD countries with large bank balance sheets relative to GDP have experienced serious difficulties, Luxembourg's experience during the crisis has been less difficult, although substantial fiscal resources were called upon. As discussed above, the largely international activities and foreign ownership of Luxembourg's financial institutions protected the local economy. In addition, the role of these institutions in providing credit to the domestic economy is limited and the overall level of indebtedness of the real economy is fairly low, despite increases during the past decade. Nevertheless, the large size of many financial activities does have important implications and carries risks for the local economy.
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Governments in OECD countries put in place substantial support for banking sectors threatened by the financial crisis. Measures included guarantees of bank liabilities, unconventional monetary policy operations, reinforced deposit insurance arrangements and bank recapitalisation (OECD, 2009). As outlined above, Luxembourg has been involved in these measures for a number of cross-border institutions. These interventions can be justified in the interest of financial stability. However, they are undesirable in the sense that they encourage moral hazard: banks have incentives to take excessive risks if they know that the state will intervene when losses are large. Stronger regulation will be therefore necessary to offset the increase in moral hazard in the global financial system.
Only a handful of resident financial institutions have strong links to Luxembourg's non-financial sector or to domestically-focused financial institutions. Furthermore, with the exception of the state-owned Banque et Caisse d'epargne de l'Etat (BCEE), these banks are largely foreign-owned. Any losses therefore would not be borne by Luxembourg taxpayers. This illustrates a fundamental difference between Luxembourg's situation and that of Iceland and Ireland. The eventual rescue of Luxembourg entities of international banks therefore predominantly relies on the budgetary resources of other countries. Whether this occurs is a matter for the authorities in banks' home countries. Most of the major banking groups in Luxembourg are likely to be considered systemic at their home countries, as they retain very significant assets, employment and activity (Houben et al., 2008), and are therefore likely to be rescued. During the crisis, this is what occurred as the Belgian, Dutch and French governments took the lead in supporting their home institutions that had a presence in Luxembourg. However, there can be a problem if the government of the parent company has limited resources, as occurred with the Icelandic subsidiaries.
Problems in Luxembourg could still arise, if a systemically large institution was not rescued by its home government and it was too large for the Luxembourg authorities to support. The massive scale of bank balance sheets relative to the size of the local economy means that Luxembourg could provide only limited support. Each of around 25 resident banks has local assets larger than Luxembourg's annual GDP and aggregated local assets are almost 35 times greater than annual GDP. Although at present it is not explicitly backed by the state, the deposit guarantee scheme also has large potential liabilities relative to GDP. While failure of individual banking institutions might have few direct effects on the real economy, the consequences of such failures could be serious for others within the international financial centre such as other banks or money market mutual funds (Box 4.2). This does not appear to have been a problem to date, although the crisis has underlined these issues. One solution might be for Luxembourg to negotiate burden sharing agreements with home countries of large banks (IMF, 2009), although it is difficult to envisage circumstances under which other countries would agree to provide such support. By participating in the rescue of Dexia and Fortis, Luxembourg has signalled its willingness and ability to contribute to such operations when there is a link to its wider domestic economy.
Box 4.2. Money market mutual funds in Luxembourg The money market fund (MMF) industry in Luxembourg is the second largest in Europe with more than a quarter of total European MMF assets under management. MMFs play an important role in channelling liquidity into the European money markets, mainly from the non-banking corporations to banks. They account for more than a quarter of the overall liabilities of resident banks, while deposits and securities issued by banks across the world amount to around two-thirds of Luxembourg MMFs total assets. From the investor's point of view, MMFs are a close substitute for bank deposits, but they have the advantage of providing credit diversification compared with placing deposits in a single bank. However, in the European Union, retail MMFs are typically not insured, in contrast to bank deposits. Because of their size and systemic importance, risks associated with MMFs have repercussions for the Luxembourg and European banking sectors. Indeed, pressure on MMFs domiciled in Luxembourg mounted during the period of highest turbulence in financial markets in October 2008. In the face of increased volatility of spreads, uncertainty and drying up of international money markets, fears of failure to meet the maximum possible redemptions ("breaking the buck") could have led to a run on the funds. While this was avoided, several MMFs had to be assisted by their sponsoring banks with short-term loans to finance redemptions. Unlike banks and in contrast to the practice in the United States, European MMFs do not have direct access to central bank liquidity facilities. While the government of Luxembourg made statements of support to domestically domiciled MMFs, the country did not have financial means to provide guarantees as MMF assets were nine times larger than GDP. Nevertheless, the pressures eased and MMFs recorded renewed inflows in the following months. While the MMF industry in Luxembourg showed resilience facing the immediate threats of the financial crisis, there are important indirect implications. Firstly, in the aftermath of the crisis, there is much stronger international recognition of the importance of liquidity in prudential regulation and supervision, as reflected in emerging Basel Committee proposals. The treatment of MMFs in these proposals might imply very different prospects for the industry, which contributes around 2% of Luxembourg GDP (CSSF, 2009). In particular, the failure to recognise MMFs as highly liquid assets could lead to replacing MMFs with other financial instruments in European money markets with a smaller role for Luxembourg. Secondly, there is a widely articulated need for a more precise European definition of MMFs and greater transparency about portfolios and eligible investments, which could also change the landscape in the industry. Thirdly, the inability to provide the guarantees at a level comparable with other financial centres may represent a competitive disadvantage of the MMF industry in Luxembourg.
There is a specific resolution procedure for banks and deposit insurance has been strengthened
Compared with many other countries, Luxembourg has an efficient bank resolution process that should help to reduce moral hazard as well as ensuring swift resolution of banking problems. There is a special regime for banks to suspend payments in case of distress. This has served it well during the crisis and contributed to the smooth resolution of the problems with the Icelandic banks. The first-best solution for bank failures is to have efficient mechanisms to avoid or manage them. This requires effective mechanisms to wind down failed banks that minimise uncertainty and disruption in the financial system. This can reduce the need for government support through an established path into bankruptcy, rather than a slow and undefined process. Many OECD countries have paid a high price for not having had such institutions prior to the crisis.
Deposit guarantee schemes can smooth bank resolution and help avoid bank panics by reducing or eliminating the incentive to withdraw funds, if they are perceived to provide a credible guarantee. In Luxembourg, the guarantee was increased during the crisis from EUR 20 000 to EUR 100 000, in line with EU policy, and there are no copayments. Payout is currently expected to require several months, which may not always provide sufficient reassurance. Many depositors in Luxembourg have high net wealth and large deposits: although their sophistication may increase their sensitivity to perceived financial distress at their bank, they may have a more limited motive to withdraw when fearing temporary loss of access to their liquid assets. However, for small retail depositors it can be more important that funds can be released rapidly. To enhance credibility, the pay-out time should be reduced to a few days for the insured portion of deposits, beyond the requirements of the current EU directive. Operational arrangements should be put in place to ensure that this can be achieved. A reform of the deposit guarantee scheme is currently underway and will be finalised once new EU requirements have been established.
Ex ante funding of deposit insurance would add to the soundness and credibility of the scheme. It is currently financed by an ex post system underwritten by the banks. Prior to the crisis, accumulated reserves in the fund amounted to EUR 900 million with additional cover from bank provisions for potential liabilities. The winding up of the Icelandic banks led to a claim on the fund of around EUR 300 million. Given the concentration of the banking sector, most of the contributions to the fund would be expected to come from a small number of large banks. Risk-based premia would help ensure that ex ante funding does not distort incentives.
Ensuring more effective regulation and supervision of international banking groups is crucial
Given its large financial centre, international and cross-border regulation are especially important to the financial stability of Luxembourg. International agreements, such as the Basel Accords, provide a framework, while EU directives lay out the basic regulatory set-up (Lawson, Barnes and Sollie, 2009). EU directives impose a number of requirements in terms of regulations, although there are many areas where individual member states may apply stricter standards. The 2006 Capital Requirements Directive (CRD) had close to a hundred options that national jurisdictions could apply more strictly, although it can be difficult to apply tougher standards given Europe's integrated financial markets and the consequent competitive pressures and regulatory arbitrage. The EU framework sets out regulatory requirements in the main areas such as capital requirements, accounting standards, large exposures and deposit guarantee schemes. An important risk is that the exceptions to this framework lead to inconsistencies in the integration of capital markets in Europe, as well as a bias towards the minimum standards. Luxembourg should continue to play its part in international efforts to strengthen financial regulation in the aftermath of the crisis to make the financial system more stable and reduce moral hazard. However, its role is necessarily limited given the small size of its financial system and the EU competences in the area.
The application of regulatory standards and effective supervision of large, complex international banking groups is complicated because it necessarily involves the "home- host" principle and a number of supervisors in other jurisdictions (Box 4.3). The first-best approach to aligning supervisory incentives for cross-border banks and ensuring full sharing of relevant information would be to create a single European regulator for large international banks (OECD, 2008b). Given that this approach has not been adopted, the challenge is to ensure that the current system of supervisors and the measures proposed in the de Larosiere report (European Commission, 2009) are implemented effectively. These increase the power of home country regulators, require the creation of supervisory colleges for large international banks, and strengthen the role of CEBS to co-ordinate and harmonise the operation of the supervisory colleges.
Box 4.3. Banking regulation and supervision in the European Union The second banking directive came into force in 1993 and introduced the "EU Banking Passport". This is based on minimal harmonisation, mutual recognition and the principle of home country control for the branches of European banking groups licensed in a member country. By contrast, subsidiaries remain entirely subject to the domestic supervisory rules of the host country. The host supervisory authority has jurisdiction over the branches only as far it relates to maintaining financial sector stability and providing assistance in case of a liquidity crisis. The "Lamfalussy" process was set up in 2004 to improve institutional co-ordination for the supervision of international banking and insurance groups. At the first level, the Commission, the European Council and Parliament draw up proposed directives. At the second level, technical committees for implementing these directives are set up. At the third level, there are three European committees of supervisors which are responsible for co-ordination and for advising the national supervisory authorities in securities, banking and insurance. At the fourth level, the European Commission is responsible for overseeing the transposition of directives into national legislation. The de Larosiere report (European Commission, 2009) found the "embryonic" agreements developed by the third-level committees ineffective, citing a lack of frankness, mutual confidence and co-operation among national supervisors. New EU legislation is intended to strengthen the role of these institutions, upgraded to the status of authorities, and their powers over how colleges of cross-border supervisors are configured and operate. Under the auspices of the Financial Stability Forum, colleges of supervisors are being created for all, not just EU, systemically important international banking groups and 20 are now in place.
Cross-border supervision is of particular relevance to Luxembourg as the host of so many large international banks. As discussed, Luxembourg has already been involved with two significant cross-border banking crises (the rescue of Dexia and Fortis) as well as the failure of the local subsidiaries of the Icelandic banks. In the former, it appears that the Luxembourg authorities had insufficient information to assess the scale of the risks at the group level ahead of time, and therefore had an imperfect appreciation of the risks facing the resident entities. For the Icelandic banks, similar problems were compounded by the fact that most of the business of the Luxembourg subsidiaries was being carried out in third countries. The CSSF is already a member of a large number of colleges of supervisors and its staff attends a large number of related meetings. It will be important for Luxembourg to ensure that the CSSF is able to engage fully with the complicated process of international co- ordination and that the new model of EU cross-border supervision is made to work.
Supervisory resources in Luxembourg have steadily increased and appear adequate. Although the banks themselves have the primary responsibility in managing risks, the crisis has underlined the importance of effective supervision. Compared with other European countries with big financial centres, the means available to the Luxembourg CSSF appear adequate, although exact comparison is difficult (Figure 4.11). Compared with banking assets, supervisory budgetary and human resources appear to be relatively high. However, if the asset management industry is included, supervisory resources are more limited, although fund management activities are in some sense less risky than banking. The CSSF's resources have been growing significantly in recent years and faster than the volume of assets. From 1999 when it was created in its current form to 2008, its staff increased by a factor of almost 2.5 while banks' assets increased by a factor of 1.5 and the number of investment funds by 2. Additional staff has been hired following the crisis, including significant numbers of experts from the private sector, and on-site inspections have increased. Statistical reporting has been upgraded with the implementation of new reporting forms. The main challenge now is for the supervisor to become more effective, and ensuring it has sufficient capacity to build up its own independent assessment of the key risks facing the institutions and their interaction in the market.
Overall responsibility for financial stability is split between the CSSF and the central bank with no institutional mechanisms to ensure a coherent approach to the financial market as a whole. While the CSSF is the main financial supervisor, the central bank (Banque Centrale du Luxembourg, BCL) has responsibility for macroprudential supervision and was given a new mandate to supervise liquidity in October 2008. Given the highly integrated way the financial centre in Luxembourg operates, this split of responsibilities for overlapping areas may make effective supervision more difficult. While the two institutions co-operate, there are no formal mechanisms linking them and there is no memorandum of understanding or related procedures. This creates the risk that relevant information is not fully shared between institutions, both statistical data and softer information picked up through on-site inspections and contacts with the market. Furthermore, it may be more difficult to build a picture of the overall functioning of the market in terms of both microprudential developments in individual institutions and macroprudential issues in the market and the economy more widely. It is important that supervisors can be held accountable for maintaining financial stability: this is more difficult when responsibility for related activities is shared between institutions. A number of OECD countries have sought to resolve these tensions by creating a single integrated regulator. This solution may be particularly relevant to small countries, where the absolute size of institutions is necessarily limited. A common objection to bringing together financial supervisors and central banking functions is the risk of weakening the focus of monetary policy on inflation, but this does not apply to euro area countries. There is, however, a cost of institutional change which must be taken into account. Nevertheless, other countries, such as Ireland, have moved increasingly towards integrated supervision. At the minimum, co-operation between the BCL and the CSSF should be institutionalised. While it is neither necessary nor sufficient condition for effective supervision, merging the two institutions into a single institution covering supervision of the entire financial sector could contribute to enhance effective supervision.
[FIGURE 4.11 OMITTED]
Asset and wealth management activities face new challenges
Luxembourg is the second most important international centre for investment funds, second only to the United States and just ahead of France. It has a share of almost 30% of assets under management in Europe (Figure 4.12). Together with that of Ireland, Luxembourg's fund industry centres on fund domiciliation and distribution of fund shares. Luxembourg has 75% of the European market for the cross-border distribution of funds according to the number of authorisations. In particular, its share of cross-border funds covered by the European passport is extremely high (Figure 4.13). This gives the centre a powerful first-mover advantage as these markets continue to develop. While funds are domiciled in Luxembourg, active management activities are very limited. Survey evidence suggests that the management of 70% of the funds is subcontracted, compared with an average of 55% for the European Union as a whole (ZEW, 2006).
[FIGURE 4.12 OMITTED]
Changes in the legal environment and financial developments during the crisis and in the coming years will have a significant impact on Luxembourg. It is not clear whether the net impact of the changes will be positive or negative. In terms of prudential regulation, asset management activities are inherently less risky than banking, because there is not the same leverage or mismatch in positions. Nevertheless, effective regulation is an important part of maintaining the integrity of the market and Luxembourg's competitive position. The UCITS IV directive, published in November 2009, will have a major effect on the investment funds industry in Luxembourg (Box 4.4). This could be comparable in scale to the UCITS I directive in 1985, which sparked the growth of the funds sector in Luxembourg (OECD, 2008a).
[FIGURE 4.13 OMITTED]
Box 4.4. The UCITS IV Directive The UCITS IV Directive makes far-reaching amendments to the first directive on investment funds. In particular, it introduces six significant changes: 1. It institutes a "European Management Company Passport" (MCP), which will allow fund management companies to conduct in other member states the activities for which they are licensed at home. Funds domiciled in one country will not have to be monitored by a local management company but can rely instead on a depositary bank. This measure broadens the choice of geographic location for investment fund services. 2. The "master-feeder" structure is authorised throughout the European Union. The feeder funds can be adapted to meet different demands and can invest the bulk of their assets in a master fund. 3. A harmonised legal regime is instituted for cross-border mergers of investment funds and their components. This will encourage the merger of small funds to create big cross- border funds. 4. A new disclosure document for investors, "Key Investor Information", replaces the current simplified prospectus. This document will summarise investment objectives, performance history, costs borne by the investor, and the risk profile. 5. The notification procedure that must be followed before units of a fund can be distributed in another European country will be simplified and streamlined. The home country regulator will have ten days to transmit the registration file to the host country regulator. This measure will improve the functioning of the "common passport". 6. There will be better cross-border co-operation among European regulators.
Regulatory changes will increase competition in the industry
The new directive is expected to foster consolidation and rationalisation of the funds industry in Europe. Notwithstanding earlier directives, the European funds market remains segmented. Contrary to many other economic sectors which are dominated by a few big firms, the asset management industry is still rather fragmented with a great many relatively small funds. Indeed, the average size of European funds of all types is less than one-sixth that of American funds. Among the obstacles to integration of the European market, the key constraints include lengthy procedures for registering funds in another country, discriminatory taxation, national regulatory differences, and the characteristics of existing distribution channels (Heinemann, 2002). UGITS IV will help reduce these barriers and permit significant economies of scale and scope in the industry (Latzko, 1999; Ang and Wuh Lin, 2001). Studies have detailed the costs in the funds' production chain by analysing the fees charged for asset management, administration, transfer, custody, audit and distribution (CRA, 2006; Lipper-Fitzrovia, 2006). In general, costs (measured by total expenses as a percentage of the value of assets under management) appear to be inversely related to the size of the fund. Fund service providers suggest that average accounting costs for a large fund (more than EUR 250 million) are proportionately less than a quarter of those for a medium-sized fund (EUR 70 million), although the high costs of small funds could also be linked to performance (Chen et al., 2004).
Luxembourg is likely to benefit from the expected shift to more cross-border master funds. The Luxembourg investment funds industry is highly specialised in funds that are distributed throughout Europe and would be directly concerned by rationalisation and concentration as a result of UGITS IV. The fall-off in revenues from funds management during the 2007-09 financial crisis is an additional factor in favour of rationalisation. Moreover, the UCITS IV directive calls for the creation of a "master-feeder" cross-border funds structure. The "feeder" fund is generally domiciled in the investor's country to accommodate local market characteristics or taxation differences, and invests most of its assets in "master" funds that can centralise their management and administration. The Luxembourg market, which accounts for the vast majority of existing cross-border funds, would seem to be well positioned in terms of the structures and capabilities to serve as the domicile for "master" funds. The tax aspect of "master-feeder" funds has not been clearly established and would seem to be a crucial element in the strategy of fund managers (KPMG and RBC-Dexia, 2009). Rationalisation in the industry that would lower costs for investors may have some negative impact on the volume of activities in Luxembourg.
The efforts to adapt to the new investor protection rules, as well as the specialisation in the management and distribution of UCITS funds, could help to attract more of these activities to Luxembourg. The new provisions governing investor information pursuant to the MIFID directives, which have been applicable to banks since 2007, are being introduced to cover areas such as internal controls, investor information, and transparency in the fees charged by the management companies. These requirements will significantly increase entry costs for new fund managers. This should foster centralisation of these functions. Like some other European countries, Luxembourg already requires domiciled management companies to observe MIFID or comparable provisions. (4)
The UCITS IV directive may also change the outsourcing strategy followed by management companies. For companies that have adopted significant "delegation" of their activities to service providers, the new requirements for publishing fees and retrocessions may reduce the multiplication of service providers and intermediaries. Survey evidence suggests that taxation (including VAT, taxes on management fees and transfer price for cross-border groups) is the most important factor in locational decisions, followed by supervisory conditions, and the presence of an existing infrastructure and expertise (KPMG and RBC-Dexia, 2009). It is unclear whether possible changes in the pattern of outsourcing and its location will increase the share of value-added of activities carried out in Luxembourg.
The role of depositary banks need clarification
The crisis revealed deficiencies in the legal framework governing depositary banks. Depositary banks play a crucial role in support of fund management, assuring "safekeeping" for securities and supporting the sound management of the funds. Regulation of these institutions is not covered by the European passport under the UCITS IV directive and will remain a responsibility of the state where an investment fund is registered. Given the size of assets under management, this is a sizeable activity for the Luxembourg financial sector. Issues concerning depositary banks have arisen during the current crisis in relation to the collapse of the Madoff scheme and of the Lehman Brothers investment bank. These involve the clarification of the legal liability of funds depositaries and some features of the current Luxembourg legislation (Bon and Vilret-Huot, 2009). Luxembourg law makes it clear that the depositary is responsible for safekeeping of the assets and for overseeing certain transactions conducted by funds. The deposit contract assumes that the depositary keeps the securities, oversees them and returns them at the request of the depositor. Observance of these obligations could well be compromised, in particular with respect to oversight, in those very frequent cases where assets circulate among sub-depositaries (Riassetto, 2009).
Luxembourg should consider measures to clarify the legal framework in this field, even if legal separation would impose administrative costs, in order to keep the market functioning properly and to minimise the risks to Luxembourg's reputation as a financial centre. The EU directives have always called for "organic" separation between the fund management functions and the depositary bank function (safekeeping and control over the functioning of the fund) to prevent conflicts of interest. Some other countries prohibit any ownership link between the manager and the depositary.
New specialised funds are being created
In recent years, Luxembourg has tried to develop alternative and specialised funds, alongside the more established investment vehicles. Following the earlier pattern of creating an attractive legal framework for certain activities, two instruments have been put in place. The Societe d'Investissement en Capital a Risque (SICAR) functions as an investment fund, but with no restrictions on its portfolio or its investment policy. This allows private equity investments within a regulated framework. This is intended to compete with London's strong position in this market. More recently, a framework for Specialised Investment Funds (fonds d'investissement specialists) was established, anticipating the forthcoming European directive on alternative funds management,s These funds are aimed at professional managers and have fewer restrictions than conventional investment funds. However, both of these types of investment are regulated and so can take investments from standard funds. They may also offer legal and tax advantages. Since 2007 and despite the financial crisis, around 700 special investment funds have been set up under these provisions. Luxembourg's ability to attract these activities may be strengthened by the crisis as poorly-regulated offshore financial centres now seem less attractive. However, it is unlikely that the higher value-added parts of these activities will be carried out in Luxembourg, given the past experience with more conventional funds, and service providers will need to adapt to this new potential source of demand. A draft EU directive on Alternative Investment Fund Managers could have important implications for how these special fund management activities develop in Luxembourg in the future.
Wealth management is being challenged by international tax and regulatory changes
Wealth management and private banking are significant features of the Luxembourg financial sector. Some estimates suggest that Luxembourg could be the third largest international centre for wealth management, behind Switzerland and the Caribbean, and ahead of the Channel Islands,a although there is no official definition of these activities. They developed since the early 1980s, supported by banking secrecy, and tax policies in the neighbouring countries (OECD, 2008a). The industry is supported by laws allowing the establishment of specialised companies, and structures that are highly attractive to financial companies. This industry employs somewhere between 6 000 and 7 000 people directly.
The wealth management industry is facing challenging times in the face of changes in its customer base and the international regulatory and tax environment. In 2009, Luxembourg withdrew its long-standing reservations on the exchange of information "foreseeably relevant for tax purposes" under the OECD Model Tax Convention and has since concluded and ratified 22 amendments to bilateral taxation treaties (Box 4.5). This marks a prompt and serious implementation of the new information exchange regime. It is uncertain to what extent banking secrecy has influenced the decision to make deposits in Luxembourg in the past, and the impact on the industry is therefore difficult to evaluate. For the moment, it seems that the effects have been limited. However, there is persistent European and international pressure to reform the international tax system further. The impact of the EU withholding tax, which will increase to 35% in July 2011, should be carefully evaluated against the alternative regime of automatic exchange information for tax purposes.
Box 4.5. Luxembourg and information exchange for tax purposes Co-operation in international taxation is important to avoid double taxation and tax evasion. Article 26 of the 2004 OECD Model Tax Convention with respect to Taxes on Income and on Capital requires contracting states to "exchange such information as is foreseeably relevant, including bank and fiduciary information" for the assessment and administration of the taxes of the other Party. Four OECD countries, Austria, Belgium, Luxembourg and Switzerland, entered reservations to this Article and had not included it in their tax treaties. On 13 March 2009, Luxembourg and the three other OECD countries withdrew their reservations to Article 26. Luxembourg has since concluded 22 agreements (new treaties or Protocols to existing treaties) to include information sharing on request as set out by the Article. As a result, Luxembourg has been moved up in the category of jurisdictions which have substantially implemented the OECD standard, as reflected in the progress report issued by the OECD Secretary General. Luxembourg is also a member of the Global Forum on Transparency and Exchange of information for Tax Purposes which will assess the implementation of the standard by member jurisdictions. At the EU level, the Savings Directive of 2000 that was implemented from July 2005 sets out automatic exchange of information for tax purposes as an ultimate objective. This would require that tax authorities automatically exchange files with the tax details of each other's residents. Austria, Belgium and Luxembourg have opted during a transitional period to apply an alternative withholding tax option. Tax is withheld at source unless the payee proves that tax should not be withheld. The rate of the withholding tax started at 15% but increased to 20% from July 2008 and will rise to 35% in July 2011. Belgium will move to automatic information exchange when the withholding tax reaches 35%. Box 4.6. Summary recommendations on the stability and development of the financial sector The main policy actions to strengthen financial regulation need to be taken at European and international level, notably through the implementation of such initiatives as the ECOFIN Financial Turmoil and Financial Stability Roadmaps. As a major international financial centre, Luxembourg can play a constructive role in these developments. In addition, some measures should be taken at a national level to safeguard against risks and ensure the sustainability of the sector: * Implement the CSSF circular and BCL regulations on liquidity risk with the emphasis on stand-alone liquidity and introduce new quantitative regulations in line with international best practice. * Ensure that supervisory practice and information gathering evolve in line with international best practice and requirements. The recruitment of additional specialist staff should continue. * Participate fully in the development of cross-border supervisory colleges, from which Luxembourg has a great to deal to gain in terms of understanding the risks of local institutions. * Strengthen co-operation between the CSSF and the BCL through the creation of institutional arrangements clearly setting out the responsibilities and requirements for the two institutions. Consideration would be given to creating a single integrated financial supervisor by merging the CSSF and the central bank. * Clarify the requirements on custodian banks. Custodial institutions should be under separate ownership from asset management activities. * Reduce the pay-out time of the deposit insurance scheme to a few days. Proposals to fund the scheme on an ex ante basis using risk-based premia should be implemented. * The OECD welcomes Luxembourg's withdrawal of its objections to Article 26 on information sharing for tax purposes and encourages it to continue to implement this decision rapidly. * Ensure that competitive conditions favour the continued development of the financial system through framework conditions, such as improved transport links and housing supply, greater competition to reduce costs in the local economy and improved educational outcomes to provide a local workforce better equipped to participate in financial sector activities.
Private banking is a mature industry in Luxembourg and the growth perspectives of this sector may be limited, even if the market around the world has strong growth potential. This is due to changes in the international regulatory environment and the nature of the local industry. One constraint is that Luxembourg has been oriented towards relatively mature European markets rather than emerging economies. In 2009, half of private banking assets were in cash or fixed-income products, where activities have lower value-added and management margins are relatively thin. However, private banks in Luxembourg have sought to develop a broader range of products for family office and wealth management and efforts are under way to diversify the client base by attracting high net worth individuals from emerging markets, in particular from the Middle East, the Far East and Latin America.
Luxembourg relies on two types of entities to attract more sophisticated wealth management activities. There are 76 000 of these entities domiciled: 50 000 are structured as Societe de participations financieres (SOPARFI) and the remainder as Societe de gestion de patrimoine familial (SPF). The annual volume of funds flowing through these specialised financial entities may exceed EUR 100 million. The SPF entities replace the widely-used "Holding 29" entities and offer a favourable tax regime, (7) with their activities limited to holding equity interests in other companies and reserved to individuals. The SOPARFI is a fully taxable resident corporation that can take advantage of double-taxation treaties and of the European Union parent-subsidiary directive,s In addition, the proposed EU Directive on Alternative Investment Fund Managers (AIFMs) could create new opportunities for Luxembourg's financial centre in terms of wealth management and investment vehicles.
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(1.) The insurance share in tax revenues was up strongly in 2008, primarily due to the reinsurance sector, which accounts for 81% of taxes paid by the sector. One large reinsurance concern transferred all its European activities to Luxembourg, boosting taxes from EUR 38 million in 2007 to EUR 269 million in 2008.
(2.) Pierre, G. (2008), "Pourquoi une revision de la Capital Requirement Directive ?", Le Mensuel AGEFI, Luxembourg, October.
(3.) Circulaire CSSF 09/403 May 2009, "Saine gestion du risque de liquidite--Modification de la circulaire CSSF 07/301" and Banque Centrale du Luxembourg, "Reglement de la Banque centrale du Luxembourg 2009/N[degrees]4 du 29 avril 2009 relatif a la surveillance de la liquidite".
(4.) Luxembourg: law of 13 July 2007.
(5.) The law of February 2007 on "specialised investment funds" replaces the law of 19 July 1991 on institutional UCIs.
(6.) Boston Consulting Group.
(7.) No taxation of dividends paid to non-residents, no municipal business tax, and annual wealth tax and subscription tax of 0.25%. As a counterbalance to this favourable tax regime FSPs are excluded from the scope of double-taxation treaties and are ineligible for the common tax regime between parent corporations and their subsidiaries in the European Union.
(8.) As a fully taxable corporation, it can take advantage of double-taxation treaties and the parentdaughter directive, provided it confines its activities to the holding and disposal of shares. This common tax regime between the parent company and its subsidiary means that dividends paid by a corporation, resident or not, are under certain conditions tax-free in Luxembourg, where the parent corporation (the SOPARFI) is domiciled. Provided these conditions are met, there is no withholding of tax on the income distributed by the SOPARFI, and this structure is widely used as a tax optimisation strategy for international groups and wealth managers. The capital of the SOPARFI may be represented by nominal or bearer shares.
Table 4.1. Balance sheets of main Luxembourg financial institutions EUR billion 2007 2008 2009 Banks Assets 920 930 790 Loans 650 680 560 Interbank loans 460 470 370 Of which: Intragroup 330 370 n.a. Securities 220 200 190 Of which: Claims on banks 100 090 090 Other assets 050 050 040 Liabilities 920 930 800 Deposits 300 280 250 Debts 450 490 390 Of which: Owed to banks 440 480 370 Other 170 160 160 Investment funds Assets 2 060 1 560 1 840 Of which: Money market funds 250 340 320 Loans 060 110 050 Of which: Interbank loans 060 110 050 Securities 190 230 260 Of which: Claims on banks 110 150 150 Other 000 000 010 Memorandum items: GDP 037 039 037 Central bank assets 060 100 080 Of which: Claims on banks 030 040 020 Source: Banque centrale du Luxembourg and Commission de surveillance du secteur financier. Table 4.2. Banking sector indicators Per cent EU average Luxembourg (large domestic banks) Solvency Tier 1 ratio 12.74 8.02 Overall solvency ratio 15.14 11.44 Distribution < 8% 0 0.54 8-10% 10.24 20.19 10-12% 8.78 38.58 12-14% 19.69 20.13 > 14% 51.29 20.5 Average risk weights 26.26 39.85 for credit risk Profitability Operating profit (share of 0.65 0.4 assets) Provisions and depreciation -0.56 -0.53 (share of assets) Return on equity 1.07 -5.71 Liquidity Cash, trading and available 20.01 32.54 for sale ratio Interbank market dependency 42.86 12.85 ratio Funding base stability ratio 38.88 51.01 Source: ECB, EU Banking Stability, August 2009. Figure 4.8. Share of interbank lending Average 1999-2009 Euro area Interbank assets 28% Other assets 72% Luxembourg Interbank assets 51% Other assets 49% Source: Banque centrale de Luxembourg and Commission de surveillance du secteur financier. Note: Table made from pie chart.