Entranced by banking

Jon Danielsson, Gylfi Zoega, 9 February 2009

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Iceland underwent a systemic crisis in October last year, the only developed economy to do so in recent decades. The fate of Iceland is sometimes taken as an indication of what might happen to other countries with an outsized financial sector, such as the UK. However, the main factors in Iceland’s downfall can be explained by its unique history, inappropriate policy responses, and weaknesses in EU banking regulations, conspiring to make a perfect storm, unlikely to happen elsewhere. Our study of the Icelandic collapse, available here, provides the details.

Historical background

Traditionally, the Icelandic economy was more regulated and politicised than economies in most other Western countries. Economic management was more based on discretion than rules, with tight connections between private sector firms and political parties. The banking system was politicised with access to capital based on nepotism and political connections.

Government control over the economy has reduced over time, with key events being the joining of the European Free Trade Association and then the European Economic Area in the early 1990s. The latter meant that Iceland got extensive access to European markets and adopted European regulations.

Iceland did however retain to some extent its discretionary approach to economic management, and its key institutions, such that the Central Bank and the financial regulator remained weaker than in most of its European counterparts.

Betting on banking

The Icelanders decided a few years ago that their economic future lay in banking and privatised and deregulated their banking system. The banks passed into the hands of individuals with little experience of modern banking, while supervision remained weak.

The role models were easy to find, other small countries, such as Luxembourg and Switzerland have done quite well out of banking. What the Icelanders forgot was that those countries have centuries worth of experience running banks and the associated infrastructure, while Iceland has less than a decade.

The banks passed into the hands of individuals with extensive business interests. The result was a system of cross holdings, with liquidity needs being met within the group. The banks retained tight connections to the political superstructure.

The banks, with strong government support, proceeded to take advantage of ample capital in international markets to fuel high degrees of leverage and exponential growth, eventually growing 10 fold in just over four years to a size of about ten times the economy.

Iceland’s institutional structure lagged behind developments in the banking sector. Neither the Central Bank nor the financial regulator developed the necessary infrastructure, nor did they receive the necessary independence and backup from the authorities to fulfil their duties adequately. This is manifested by the fact that while the assets of the banking system grew 900% as a fraction of GDP from 2003 to 2007, contributions to the financial regulator only grew by 47%.

It is now clear that the government at the time committed a classic mistake in deregulation, allowing the financial sector to undertake high-risk activities without adequate regulatory structure.

The hedge fund in the North Atlantic

The growth in the banking system affected the entire economy, with many firms and even households adopting their business model of extreme leverage driving asset acquisitions.
The country decided to stake its economic future on international banking, with all of the inherent risks ignored. It did not have institutional structure to adequately supervise the banking system nor develop the ability to provide lending of last resort services.

Iceland was in effect turned into a hedge fund sitting in the middle of the North Atlantic. It is not like the country was poor and needed high risk activities to grow. Iceland was already an affluent economy and had reached the income per capita levels of Germany, France and the UK in year 2000 before the banking sector expanded.

Unstable banking system

The three main Icelandic banks were tightly interconnected. They did business with many of the same firms, were all dependent to a varying extent on the same macroeconomy, and where perceived by international capital markets as being highly related.

A difficulty in one bank directly affected confidence in the other banks, affecting access to liquidity, and perhaps triggering bank runs. The three banks accounted for about 85% of Iceland’s financial system and there was no doubt that their failure would have catastrophic effects for the Icelandic economy.

Eventually, their hubris caught up with them. The banks started having problems borrowing in wholesale markets, and decided that opening up high interest savings accounts in the UK and elsewhere in Europe was a good idea. The Icelandic banks, with government permission, used European savers to provide the liquidity they could not obtain from the better-informed banking system.

Unheeded warnings

There were ample warnings that something was amiss. In addition to papers and interviews with local economists, a natural starting point is a critical report from the Danske bank 2006 . Aliber in May 2008 described Iceland’s banking expansion as the most rapid in the history of banking, and predicted the banks’ imminent demise. Buiter and Sibert 2008 focused on the banks’ liquidity problems caused by the absence of a credible lender of last resort.

By contrast, official reports were more favourable. The financial stability report of the Central Bank of Iceland in (April, 2008) indicated that the economy was in a good state.
The Icelandic Chamber of Commerce commissioned two reports, combining local economists with international celebrities to write reports that painted the Icelandic economy and its banking system in favourable terms, see Herbertsson and Mishkin (2006) and Baldursson and Porters (2007). While documenting the strengths of the Icelandic economy was a worthwhile task and necessary for the maintenance of confidence in its banking system, such reports may have blinded policy makers to the coming storm.

Regulatory capture

The instability of the banking system appears to have caused little concerns from the authorities. Why this is the case is unclear. After all, both the financial regulator and the Central Bank had or should have had ample information on the stability of the banks as well as the legal ability and obligation to prevent destabilising banking.

The best explanation seems to be regulatory capture. This went as far as the financial regulator even participating in the Landsbanki’s marketing of internet accounts in the Netherlands only a few months before its collapse when it should have been clear that the bank was likely to fail.

If banks are too big to save, failure is a self-fulfilling prophecy

In this global crisis, the strength of a bank’s balance sheet is of little consequence. What matters is the explicit or implicit guarantee provided by the state to the banks to back up their assets and provide liquidity. Therefore, the size of the state relative to the size of the banks becomes a crucial factor. If the banks become too big to save, their failure becomes a self-fulfilling prophecy.

The reasons for the failure of the Icelandic banks are in many ways similar to the difficulties experienced by many financial institutions globally, such as the seemingly unlimited access to cheap capital, excessive risk-taking, and lax standards of risk management.

The crucial difference is scale. While many countries have their share of troubled banks, in those cases the problems are confined to only a segment of their banking system, in economies were the overall assets of the banks are much smaller relative to GDP. In those countries the government has adequate resources to contain the fallout from individual bank failures.

Ultimately this implies that the blame for bank failures lies at home rather than internationally. We suspect that even if the world had not entered into a serious financial crisis, the Icelandic banks would have failed.

Government’s response - gambling for resurrection

Given the ample warnings the government had of the pending difficulties in the banking system its apparent lack of concern is surprising. Surely the regulator and the Central Bank knew what was happening.

The only public information we have has the Central Bank and the financial regulator blaming each other, with the government claiming not to have been informed, and blaming the global economy. We do not find his convincing. Such a catastrophic pending failure had to have been discussed by the entire Cabinet.

We therefore cannot escape the feeling that the board and directors of the Central Bank and the financial services authority, along with senior officials there knew what was happening. Similarly, all government ministers, along with senior bureaucrats in the ministries of finance, commerce, foreign affairs, and office of the prime minister had to have known.

Still the government failed to act. It could have at any point taken decisions that would have alleviated the eventual outcome. If the Government had acted prudently the economy would have been left in a much better shape.

By not addressing the pending failure of the banking system, perhaps in the hope that the instability would disappear, we cannot escape the feeling that the Icelandic authorities gambled for resurrection, and failed.

Weaknesses in European banking regulations

Iceland’s collapse also exposes fault lines in the EEA/EU approach to banking supervision. Regulations are Europe wide, with supervision in the hands of the home regulator, which can be problematic in the case of cross-border banking if the host supervisor does not have the necessary information and responsibilities or does not cooperate adequately with the home supervisor.

Within the EU/EEA regulations are mostly pan-European, but supervision (enforcement) is national. This may lead to problems where authorities in one country see that other countries have the same regulations, and implicitly assume supervision is the same. Politically it is (currently) impossible to implement Europe wide supervision.

A good example of problems that may arise is the high interest savings accounts, Icesave, set up across Europe by Landsbanki, when it was having difficulties obtaining funds in wholesale markets. According to European Union laws, the home regulator is in charge of supervision and offers deposit insurance of at least €20,887, but the host supervisor may offer more, as is the case in the UK.

After the run on Northern Rock, the UK government announced that no individual UK deposit holder would lose money in the case of bankruptcy. At the very least, this provided an implicit guarantee to Icesave depositors. In this case it would have been essential that the UK FSA also exercised supervisory duties. It is unclear to what extent this was done.
In addition, in the EU/EEA, deposit insurance is provided by a national insurance fund paid for by banks. It is unclear what is supposed to happen if the national insurance fund is not sufficient.

The authorisation of the opening of cross-border savings accounts of the magnitude and risk of Icesave represents a serious failure in the decision-making process by the supervisors in Iceland and the host countries, the UK and the Netherlands and/or in EU/EEA regulations.

The supervisors in all three countries should have recognised the dangers and acted to prevent the rapid expansion of Icesave. Ultimately supervision failed. The notion that a country of 300,000 inhabitants could assume the responsibility of providing deposit insurance of the magnitude of Icesave is absurd.

We suspect this also casts light on another failure of cross-border banking supervision in Europe. Host supervisors generally only observed the part of the banks operating in their country, not the overall picture. Some of the Icelandic banks had extensive operations of various types both within Europe and outside.

Unless an individual national supervisor has a clear picture of those operations it is difficult to exercise adequate supervision. The Icelandic regulator may have been the only supervisor that had the complete picture. If so, the only supervisor who had the necessary information failed.

Conclusion

The Icelandic economy crashed because the financial system was deregulated and privatised without adequate supervision; there was insufficient institutional knowledge, both within the banking system and within the government on how to run and regulate a modern banking system; and the government failed to recognise the systemic risk of having such a large banking system.

Ultimately, when the banks were heading for failure the government opted for gambling for resurrection rather than closing the banks down. The government’s gamble failed and Iceland as a consequence suffered a systemic crisis.

Bibliography

Aliber, Robert (2008), “Monetary turbulence and the Icelandic economy”, lecture, University of Iceland, 5 May 2008 .
Baldursson and Porters (2007), “The Internationalisation of Iceland’s Financial Sector,” The Iceland Chamber of Commerce.
Danielsson, Jon (2008), “The first casualty of the crisis: Iceland,” VoxEU, 12 November.
Danielsson, Jon and Gylfi Zoega (2009) “The collapse of a country”, www.RiskResearch.org.
Danske Bank (2006), titled “Iceland: Geyser Crisis”.
Central Bank of Iceland (2008), Financial stability report, 25 April
Herbertsson, Tryggvi and Frederic S. Mishkin (2006), “Financial Stability in Iceland,”
Zoega, Gylfi (2008), “Icelandic turbulence: A spending spree ends,” VoxEU, 9 April.
Zoega, Gylfi (2008), “Iceland faces the music,” VoxEU, 27 November.


1 The author of the report comments on it in the FT on October 8th 2008, “As a result I had to go to Reykjavik back then and got a pretty hot reception. The Prime Minister publicly denounced our research piece, and banks issued denials. … In essence two years ago all these problems were in the open. Yet Icelandic authorities have not acted and the banks were not reined in (enough).”

 

Topics: Financial markets
Tags: global crisis, Iceland

Director of the ESRC funded Systemic Risk Centre, London School of Economics

Reader in Economics, Birkbeck College