by
Tryggvi Thor Herbertsson,
Professor of Economics, Reykjavík University
December 27th 2008
AbstractThis is a dramatic title but after all this is a dramatic story. The total collapse of a country’s financial system and in the wake its currency is no small matter. This is the story of the Icelandic banking crisis: An unprecedented event that
occurred in Iceland the last days of September and the first of October 2008. At the time of writing, it looks as this is going to be the most costly financial crisis for a sovereign industrialized country ever. The estimated direct cost that the public will be responsible for is today estimated to be around 85% of the
country’s GDP. This short paper gives an account of the events the lead to the collapse, discusses how it was handled,and what the future holds for the country.
Keywords: Financial Crisis, IcelandI. IntroductionThe two single biggest mistakes in current financial crisis were to let Lehman
Brothers and the Icelandic system banks go under. September 15 2008 will mark
a similar event for World financial markets as September 11 2001 for World
peace. History will view the decision of the Federal Reserve System not to save
Lehman at least as big a mistake as the Fed not providing enough liquidity for the
American economy at the onset of the Great Depression. The decision of the
international financial system to starve Iceland of funds is a mistake of similar
magnitude.
The event of September 15 resulted in absolute mistrust in the financial
community - almost all funding lines of the Icelandic banks were cut and they
were faced with severe funding problems. The usual route - to use the central
bank as a lender-of-last-resort - was not possible as the needs of the banking
system dwarfed the capabilities of the Central Bank of Iceland (CBI). The
reserves amounted to about half the country’s GDP but the banks’ balance sheet
was about ten times GDP. There was a total systemic failure and the three
largest banks were taken over by the Icelandic authorities. The crisis lead to a
complete deterioration of the country’s capital account and a full-fledged currency
crisis. Moreover, the event triggered a complete mistrust in emerging market
economies around the World and a renewed role for the IMF. Following the fall of
Iceland, Hungary, Ukraine, Serbia, and other countries applied for help from the
IMF.
Direct costs for the Icelandic taxpayer associated with the demise of the banks
are estimated, at the time of writing, to be around 85% of the country’s GDP. This
cost estimate includes the equity injected into the new banks, about 30% of GDP.
Cost in terms of lost output remains to be seen but the first estimate of the IMF is
that GDP might contract by 10%. For comparison, it was estimated that the total
cost of the most expensive financial crisis to date, the crisis in Indonesia in late
1990’s, was around 40% of GDP and a little over 10% in Finland in the early
1990’s.
This short paper is organized in the following manner. First it gives a brief
background on the developments that lead to the collapse of the Icelandic banks.
Secondly the takeover process is described. Thirdly some policy mistakes that
lead to the result are identified and finally the outlook for Iceland is discussed.
II. BackgroundFor Iceland It all began by reports published by Royal Bank of Scotland and
Dresdner Kleinwort Wasserstein late November 2005. The focus shifted to
Iceland and people in the market started to pay attention to how leveraged the
financial system of the country was. Stories of participants shorting the Icelandic
banks, companies, and even the currency began to surface. CDS spreads
started to widen.
In the coming months and especially in March 2006 Iceland was the talk of the
town. Research departments of all major banks paid disproportional attention to
Iceland and issued reports on the country’s financial system - the bloodier the
better.
In March 2006 CDS spreads shot to 110 bp and Iceland was generally viewed as
a risky place in the wholesale market. In May I and Rick Mishkin published a
report on Iceland concluding that this was a misconception, as the country was
fundamentally in a very good state and that generally the outlook was good.
However, we warned that there was a probability of multiple equilibria incidences.
We concluded by saying that we believed that if our policy recommendations
were followed, confidence of the international financial community in the Icelandic
economy would be regained. But we did not foresee the current international
financial crisis that eventually toppled the banks.
Yet another report was published in the summer of 2006, now by Morgan
Stanley. The tone was much more positive and they concluded by saying that
after reviewing our report, they were confident that there was almost no danger
of a financial crisis in Iceland and recommended investors to invest in Tier I
capital of the banks.
The Icelandic banks used this mini-crisis to get their act somewhat together.
Cross-holdings were reviewed and some dissolved, the funding structure was
changed, transparency increased, and much more emphasis put on deposits as
a source of funding. Late autumn 2006 Landsbanki introduced the infamous
IceSave internet accounts in their London branch and later Kaupthing their Edge
accounts in a subsidiary. The system slowly gained confidence and continued
growing. The rating agencies complemented Landsbanki for their internet
accounts and the market rewarded the bank with the lowest CDS spreads of the
three banks.
The current crisis is marked by events surrounding the fall of the Bear Stearns
hedge funds in the summer of 2007. Wholesale funding became gradually more
difficult. Finally at the start of this year, Iceland was more or less closed off from the wholesale market. As a reaction even more focus was put on deposits and
old private placement contacts were renewed. The funding situation became
grimmer for the banks.
III. The CollapseCurrent events in Iceland started with a 600 million euro equity injection by the
CBI into Glitnir, the third largest bank of the country on Sunday the 29th of
September. The week before credit lines had been cancelled as a consequence
of the fall of Lehman Brothers. Glitnir was scheduled to meet a 750 million euro
payment on the 15th of October and with the dry-up of liquidity they saw no other
way than to go to the CBI and take out an emergency loan in order to meet the
upcoming maturity. The plan provided by the CBI was that instead of the loan the
CBI would inject 600 million Euros into the bank and in exchange get 75% of the
equity of the bank. Shareholders would practically be wiped out. The following
morning the share price of Glitnir fell by 75% in matter of minutes. At the same
time the value of the (unlisted) holding company Stoðir that owned the biggest
share in the bank fell even more dramatically. The next day Stoðir applied for a
moratorium. Majority of Glitnir’s stocks had been pledged in Kaupthing and
Landsbanki and with the fall of Glitnir’s stock prices stockholders were subject to
margin calls, which they could not meet. The collateral became practically
worthless. It became apparent in the following days that liquidity in the country
was fast disappearing and that the situation with Glitnir was deteriorating. Also
the domino effect from the fall in the banks stocks was emerging. Slowly it
emerged that more had to be done as the grave situation with Glitnir was starting
to affect the other banks, especially Landsbanki.
The following days a plan emerged on how to take the banks over one-by-one if
needed. It was apparent that the CBI could not come to the rescue as the size of
the banks was absolutely disproportional to the capabilities of the sovereign. It
was decided a blanked guarantee should be given to depositors in local banks
and that depositors should come first in line as claimants on the assets of the
banks. Unlike the Nordic countries, which provided a blanket guarantee to the
creditors in their crisis in the 1990s, Iceland only guaranteed deposits. The
Icelandic banks have now defaulted on their senior debt. Emergency laws giving
similar powers to the financial supervisor as the FDIC has in the US were ratified
the following Monday and Glitnir was taken over the following night, Landsbanki
two days later and, finally, Kaupthing on Friday after the UK had used their
terrorist act to freeze all assets of Landsbanki in the UK.
Figure 1 depicts a stylized schematic representation of the plan that was followed
in the takeover process.
In the first phase various ministries and the Icelandic Financial Supervisory
Authority (FME) drew out the plan on how to take over the banks. This included
writing up the legal framework and organizing the architecture of the new system.
The second phase was to execute the plan which was the responsibility of the
FME. The third phase was to value the assets, which was the responsibility of an
Oversight Committee, one for each bank, appointed by the FME. The fourth is to
sell assets that had to be sold quickly in order for their value not to deteriorate.
And the fifth phase was to restructure the banks financially which is obviously the
responsibility of the new banks. A sixth phase can possibly be added - reprivatization of the banks but no such decision has been taken yet.
In each case a new bank was formed and all deposits directly guaranteed by the
sovereign transferred there, see Figure 2. A preliminary evaluation of the assets
was carried out and assets amounting to deposits moved to the new banks. The
state finally injected capital into the new banks supporting a CAD ratio of 10%.
What remained in the old banks were all assets that had not been moved to the
new banks, a bond issued by the new banks for the assets they took over, and
claims of creditors (such as deposits in branches outside of Iceland and claims of
bondholders).
The capital contribution of the Icelandic government amounted to 380 billion ISK
or almost 30% of GDP. The new system is about three times the country’s GDP
compared to almost ten times before the crisis, now fully financed in ISK.
IV. The Sources of the Collapse
This decade has been unusually favorable to Iceland. The liberalization of the
economy has made the country the fifth richest of the member countries of the
OECD living standards next to non according to the UN. Output, consumption,
and investment, both FDI and domestic, grew rapidly the last decade. At the
same time public finances were in a very good shape. Taxes were lowered and
the economy flourished. As a matter of fact government debt was almost nonexistent
at the onset of the crisis, less than 7% of GDP. Also implicit debt was
none-existent with pension wealth amounting to almost 1.5 times GDP and a
very favorable demographic composition of the population. There was no
unemployment and almost 10% of the labor force were migrant workers, mostly
from Eastern Europe. Favorable fundamentals justified optimism. Iceland was the
”Nordic tiger”.
The Icelandic banking system was more or less government owned until the turn
of the century. It was a simple depositary system with a balance sheet
approximately amounting to the country’s GDP. The loan portfolio was mostly
domestic, fairly low risk, and credit losses were small. However, Iceland had
already deregulated its financial market at the time of privatization being a
member of the European Economic Area and by adopting the European
Financial Directive in the early 1990s.
After privatization of the banks, the flow of foreign credit increased rapidly.
Domestic liquidity fuelled an investment boom and later an asset price bubble.
International creditors were willing and able to lend what seemed like limitless
amounts to Iceland. Housing prices rose dramatically with easier excess to
capital and the stock market boomed. It could be said in retrospect that a Ponzigame
was played in the stock market. One could start with a certain amount, buy
stocks, pledge the stock in the bank and use the money to buy more stocks and
thereby increasing the price, pledge the increase and buy more stocks, etc. This
pumped up the stock market and created a bubble.
Monetary policy was changed from a fixed exchange regime in 2001 to a floating
exchange rate and inflation targeting. The first 3-4 years this new policy fared
well. However, because of the carry game that both households and firms played
they were more or less immune to hikes in the policy rate and in fact the higher
the rate more you gained on the carry trade. Monetary policy soon became
almost impotent. The exchange rate was targeted to keep import prices at bay,
which encouraged further international investors, firms, and households in the
carry game, fueling increased demand and an illusionary wealth effect. The
sustained strong exchange rate helped to maintain investor confidence and
created an illusion of low exchange rate risk in foreign currency borrowing. Both
households and firms borrowed heavily in foreign currency, which became a
major problem when the ISK started to depreciate.
This policy turned out to be almost deadly for the monetary regime as inflation
targeting is non-linear. When the policy rate is sufficiently close to, for lack of a
better word, World interest rate the monetary transmission mechanism works
fine. As the policy rate moves further away its effects on demand diminish in a
small open economy as the carry trade sets in, the currency appreciates, and
demand increases because of illusionary wealth effects. Moreover, the targeted
price index included an asset price - housing prices - and there was a structural
change in funding of housing that lead to rapid increases in housing prices and
consequently inflation. The banks started to lend foreign currency dominated
mortgage loans to households. The current account started to deteriorate and the
deficit became monumental - peaking at over 20% of GDP.
Gradually the banking system turned from being a fairly simple depositary
system to full fledge international financial intermediation, with its operations all
over the World. The banking system was, however, not supervised prudently
enough. The banks, the FME and to some extent the CBI did not have the
knowledge to understand fully the systemic risks that had built up in the system.
The focus was too much on CAD‘s and formalities but not on systemic risk and
funding. One of the policy measures put forth by Mishkin and myself in our report
was to consolidate the financial stability mandate of the Central Bank and the
banking supervisory functions of the FME in the Central Bank and thereby put
more emphasis on actual risks but not only on regulation. Also, in a country of
only 320 thousand inhabitants there must be economies of scale in overseeing
the financial system. Not following this advice lead to the same mistake as we
saw in the Northern Rock incidence in the UK - a detachment of lender-of-lastresort
and supervision responsibilities.
After the 2006 incident the Icelandic banks did react in an encouraging manner
but they should have done more. In retrospect it was obvious that the system
was far too big for the currency. The banks were too myopic and risk seeking.
Funding the leverage game of Icelandic and foreign entrepreneurs turned out be
very risky. The banks might possibly have understood their own risk but they
hardly understood the systemic risk their collected action imposed on Iceland.
The banks should have deleveraged and de-risked and they should have been
required to do so. In less than eight years the balance sheet of the banks had
grown from one times the country’s GDP to almost ten times. With the fall of
Lehman Brothers and the size of Iceland’s financial system the banks had almost
no chance of surviving. Investor confidence in Iceland was none.
V. Conclusions
So what is the future for Iceland? The request of the UK government to
compensate depositors in the IceSave internet accounts far beyond what the
European Deposit Insurance Directive requires amounts many times German
reparations under the Versailles agreement, in relative terms. It could be the
straw that would break the camel’s back. Further, it is not at all clear if small
states like Iceland can have their own independent currency in a new World
order. It could be done if the country would go back to basics. Where exports
would equal imports and capital movements were restricted and the financial
system would be a simple domestic depositary system. But that is not a future
that can be offered to young people who need opportunities, opportunities that
only free markets can offer. Therefore the route is possibly to join our neighbors
in Europe - join the European Union and adopt the Euro. That way Iceland would
give away the flexibility that comes with an independent currency but would gain
the stability that comes with a credible fixed exchange rate instead.
On a more positive note, unlike most other countries that have survived a
financial collapse, the fundamentals are strong in Iceland. The export industries,
fisheries, heavy industries, energy, and tourism, are in a healthy state. The
country has abundant human capital and favorable demographics. Public
finances are more or less in order, although the crisis will put a burden on
Icelandic taxpayers in the near future. And after all, there are positives about
reducing an oversized financial system to a more manageable size in only one
week.
What Iceland has to worry about is unjust redistribution of wealth, corruption, and
crony capitalism during the restructuring of the system. The experience of
Finland in the 1990s in terms of redistribution of wealth was not good. The
outcome still is a matter of controversy. Lots of good assets, such as big chunks
of Nokia, where sold to foreigners at distressed prices. Also the chaos that
surrounds transformations on this scale gives rise to corruption. Therefore it is of
paramount importance to keep the process transparent and to have as much
independent advice as possible. By doing so the soil for corruption cannot be
cultivated as easily.
The story of the first decade of the century for Iceland is a story of broken
promises. Not only to the Icelandic population who were lead to believe that the
country would become the next international financial centre, but also to the
creditors who expect to lose colossal amounts of money on the Icelandic
adventure.
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