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Abstract
The Icelandic financial collapse, which occurred in the fall of 2008, is without precedent. Never before in modern history has an entire financial system of a developed country collapsed so dramatically. This paper describes the country's path towards financial liberalisation and the economic background that lead to an initially flourishing banking sector. In doing so, the paper elaborates on the economic oversights that were made during the financial build-up of the country and how such mistakes contributed to the crash. The focus is thus on identifying the main factors that contributed to the financial collapse and on drawing conclusions about how these missteps could have been avoided. Also summarised are the mistakes that followed in the attempted rescue phase after the disaster had struck. The paper discusses these issues from a general perspective to provide an overview of the pitfalls that any fast growing market may be exposed to. It concludes that the economic collapse was primarily home-brewed and a consequence of an unbound, risk-seeking banking sector and ineffective (or non-existent) actions of the Icelandic authorities.
Acknowledgements
The authors would like to thank Sigridur Benediktsdottir, Rene Kallestrup, Herdis Steingrimsdottir, two anonymous referees and the editors for helpful comments. Any errors or omissions are the responsibility of the authors alone. The paper reflects only the views, explicitly stated or implied, of the authors.
Notes
1Kaminsky/Reinhart, ‘Twin Crises’ (1999).
2Demirgüç-Kunt/Detragiache, ‘Financial liberalization’ (1999).
3IMF, ‘Iceland’ (2005, 2006, 2007). OECD, ‘Policy Brief’ (2005, 2006, 2008). Thomas, ‘Icelandic Banks’ (2006). Christensen/Valgreen, ‘Iceland’ (2006). Fitch, ‘Iceland’ (2006).
4Mishkin/Herbertsson, ‘Financial Stability’ (2006). Portes/Baldursson, ‘Internationalisation’ (2007).
5Buiter/Sibert, ‘Crisis’ (2008).
6Gros, ‘Iceland’ (2008). Gylfason, ‘Events’ (2008).
7Danielsson/Zoega, ‘Collapse’ (2009).
8Special Investigation Commission (SIC), Addragandi (2010).
9Danielsson/Zoega, ‘Collapse’ (2009).
10Gudmundsson et al., ‘Exchange Rate Policy’ (2000).
11A press release with the details of these sales can be found on the website of the Ministry of Industry, Energy and Tourism: http://www.idnadarraduneyti.is/frettir/frettabref/nr/1043.
12Wade/Sigurgeirsdottir, ‘Meltdown’ (2011), 60.
13Gylfason, ‘Events’ (2008), 1. Gylfason et al., Nordics in Global Crisis (2010), 146.
14SIC, Addragandi (2010).
15SIC, Addragandi (2010), ch. 6.3, 267. David Oddsson, then prime minister, and Halldor Asgrimsson, then foreign minister, led the Independence Party and the Progressive Party, respectively. The quote is based on authors’ own translation.
16SIC, Addragandi (2010), ch. 6.3, 263.
17SIC, Addragandi (2010), ch. 6.6, 300–02.
18Stiglitz, ‘Policy’ (2001).
19Taylor, ‘Housing’ (2007).
20Growth rates of the banks are authors’ calculations based on data from annual accounts of Glitnir, Kaupthing and Landsbanki (and its predecessors), GDP and consumer price data from Statistics Iceland (www.statice.com) and exchange rate data from the Central Bank.
21Organic growth of a bank refers to increased lending and securities investments of the bank as opposed to external growth where the bank grows by purchasing another firm or bank.
22Fitch, ‘Iceland’ (2006).
23Thomas, ‘Icelandic Banks’ (2006). Christensen/Valgreen, ‘Iceland’ (2006).
24Aliber/Zoega, Preludes (2011), ch. 2.
25CDS-spread data are obtained from the Special Investigation Commission, Addragandi (2010), ch. 4, Fig. 9.
26SIC, Addragandi (2010), ch. 21.2.
27Solttila/Vihriälä, ‘Finnish Banks' Problem Assets’ (1994). Jiménez/Saurina, ‘Credit’ (2006).
28Between 2002 and 2007, foreign loans rose from less than 7% to 39% of total loans of the Icelandic banks, not including the foreign subsidiaries of the banks (Central Bank of Iceland, www.sedlabanki.is).
29Note that the data collectors do not classify bank loans into mortgages until mid-year of 2007.
30All numbers in this paragraph are authors’ calculations based on data from The Central Bank of Iceland (www.sedlabanki.is, see ‘Statistics’), Statistics Iceland (www.statice.is) and Registers Iceland (www.skra.is).
31Gylfason et al., Nordics in Global Crisis (2010).
32Government Offices of Iceland, ‘Government’ (2010).
33OECD, ‘Policy Brief’ (2006, 2008). IMF, ‘Iceland’ (2007).
34Monetary Bulletin, ‘Vidauki’ (2003).
35Monetary Bulletin, Peningamal (2004). OECD, ‘Policy Brief’ (2005, 2006, 2008). IMF, ‘Iceland’ (2005, 2006, 2007).
36Asbjornsson/Jonsson, ‘Market’ (2007).
37Monetary Bulletin, ‘Markets’ (2007).
38Mishkin/Herbertsson, ‘Financial Stability’ (2006), 45, note that the ‘rule of thumb is that a 10% lasting depreciation increases inflation by 3.5% and debt service approximately in the same proportion’.
39Calvo et al., ‘Empirics’ (2004).
40Note that an increase in the exchange rate index indicates a depreciation of the krona. Also, as a result of capital controls, two krona markets arose – namely the on-shore and off-share markets. The depreciation of the krona in the off-shore market was even more dramatic than the one depicted in .
41Although the Central Bank objective was inflation targeting, the exchange rate is an important factor in the inflation rate (as in any small, open economy). Therefore it would have been justifiable to use the foreign exchange reserves to dampen exchange rate fluctuations.
42Moody's, ‘Banking’ (2006), 2.
43Information on bond issuance and repayment schedules in this section is taken from the SIC, Addragandi (2010), ch. 7.
44Usually around or above 12%, based on information from the annual accounts of the banks. See detailed information on Basel II at the website of the Bank for International Settlements, http://www.bis.org/publ/bcbsca.htm and http://www.bis.org/publ/bcbs128b.pdf
45Annual reports of the three big banks for 2003 and 2007.
46SIC, Addragandi (2010), ch. 9.6.
47Examples of such cross-financing methods date as far back as 2001, when Kaupthing placed just under 5% of its shares into a separate legal entity, controlled by one of the other banks, Landsbanki. Kaupthing and Landsbanki then went on to make contracts insuring that all financial risk because of the stocks would indeed still be borne by Kaupthing, Special Investigation Commission, Addragandi (2010), ch. 9. These transactions therefore caused Kaupthing to underreport its own stock ownership.
48SIC, Addragandi (2010), ch. 9.6.
49Aliber, ‘Turbulence’ (2008).
50Special Investigation Commission, Addragandi (2010), ch. 8.
51To prevent large concentrations of credit risks, there were rules limiting credit exposure to a group of connected lenders to 25% of a bank's regulatory capital. However, as discussed later in Section 4.3, these rules were not sufficiently enforced by the regulatory authorities and the definition of connected lenders seems to have been open to interpretation.
52SIC, Addragandi (2010), ch.14.
53La Porta et al., ‘Lending’ (2003). Charumilind et al., ‘Lending’ (2006). Laeven, ‘Lending’ (2001).
54SIC, Addragandi (2010), ch.12.
55The quote is taken from a loan application submitted before Kaupthing's Board Credit Committee, May 29. The quote was made available in the report provided by the SIC, Addragandi (2010), ch. 9.6, 21.
56The TED spread is the difference between the USD London interbank offered rate (LIBOR) rate and US Treasury bill rate.
57Brunnermeier, ‘Deciphering’ (2009).
58CDS refers to Credit Default Swap and is a form of insurance that protects the lender if a borrower of capital defaults on his/her loan. Thus, it can also be taken as a probability measure of bankruptcy.
59CDS-spread data are obtained from the SIC, Addragandi (2010), ch.7, Fig. 23.
60A currency swap market is an interbank market where one bank lends to another bank in one currency and borrows from that bank in a different currency. A currency swap can also be thought of as a bilateral contract that combines a spot contract and a forward contract, i.e. one party buys an exchange rate spot and sells it forward, leaving only the interest rate component of the forward contract.
61Data obtained from the website of the Central Bank of Iceland and the European Central Bank.
62Baba et al. ‘Spillover’ (2008) describe how covered interest parity (CIP) should force the interest rates implied by currency swap agreements towards the cash rate. The cash rate they consider is the LIBOR rate, which in normal times is close to the policy rate, the Fed funds rate.
63Authors’ calculations based on data from The Central Bank of Iceland (www.sedlabanki.is, see ‘Statistics’).
64Buiter/Sibert, ‘Crisis’ (2008).
65Gylfason et al., Nordics in Global Crisis (2010), 138.
66Wade/Sigurgeirsdottir, ‘Meltdown’ (2011), 66.
67SIC, Addragandi (2010), ch. 5.2 & 19.6.1.
68SIC, Addragandi (2010), ch.19.
69SIC, Addragandi (2010), ch. 19.4.4.
70SIC, Addragandi (2010), ch.16.10.3.
71Jonsson, speech given on January 10 (2008).
72SIC, Addragandi (2010), ch. 16.10.4, 160.
73SIC, Addragandi (2010), ch. 21.4.3.
74Demirgüç-Kunt/Detragiache, ‘Financial liberalization’ (1999).
75Mishkin/Herbertsson, ‘Financial Stability’ (2006).
76Portes/Baldursson, ‘Internationalisation’ (2007).
77Transparency International, Transparency (2003).
78Danielsson/Zoega, ‘Collapse’ (2009).
79SIC, Addragandi (2010), ch. 21.3.2.
80SIC, Addragandi (2010), ch. 4.5.4.
81Buiter/Sibert, ‘Crisis’ (2008).
82SIC, Addragandi (2010), ch. 4.5.5.
83Based on authors’ calculations.
84Mishkin/Herbertsson, ‘Financial Stability’ (2006). SIC, Addragandi (2010), ch. 16.13 & 21.5.5.
85SIC, Addragandi (2010), ch. 16.
86Gylfason et al., Nordics in Global Crisis (2010).
87SIC, Addragandi (2010), ch. 16.13.
88SIC, Addragandi (2010), ch. 16.10.2, 157.
89SIC, Addragandi (2010), ch. 16, 162.
90Wade/Sigurgeirsdottir, ‘Meltdown’ (2011).
91Gylfaon et al., Nordics in Global Crisis (2010), 148, argue that the banks could, e.g., have been constrained through special taxation, but add that this was not well received within the government since ‘you do not tax your friends, especially not when they fund your party directly and indirectly’. They also name two examples of institutes that were discontinued once they did not follow the party line. First, the National Economic Institute, which was set up to offer impartial economic counsel, was disbanded on the grounds that the continuously optimistic economic departments of the banks could fill the gap. Also, the Competition authority was abolished and reincarnated under new management after having raided the offices of oil companies (that were later found guilty of illegal price collusion).
92Wade/Sigurgeirsdottir, ‘Meltdown’ (2011).
93Christensen/Valgreen, ‘Iceland’ (2006), 1.
94Mishkin/Herbertsson, ‘Financial Stability’ (2006). Portes/Baldursson, ‘Internationalisation’ (2007).
95Wade/Sigurgeirsdottir, ‘Meltdown’ (2011).
96Buiter/Sibert, ‘Crisis’ (2008).
97Aliber/Zoega, Preludes (2011), 21.