ESSA

ESSA

The Icelandic pandemic


William Johnson

By

April 28th, 2014


How one small country experienced history’s largest systematic banking collapse


Upon hearing the word ‘Iceland’ many thoughts come to the minds of foreigners. The exclusive department stores, the stunningly beautiful people and possibly even the torrential weather. But one commonly held stereotype, that Iceland possesses a highly efficient and profitable banking system, has continued to overshadow all others in the Western world. Until quite recently this may have been true. But looks can be deceptive because it was in fact Iceland, populated by just 325,671, that experienced history’s largest systematic banking collapse between 2007-2009.

Our perception of Iceland is still of financial security and confidence, but why is this? As the Global Financial Crises spread its contagion throughout the turmoil of 2007-2009, the world’s attention remained fixed unequivocally upon the United States. But little attention was diverted to examining how the smaller states and countries were travelling in the midst of the worst economic period since the Great Depression. Before the crisis, Iceland boasted highly rated financial institutions (all three central banks carried an AAA credit rating) and one of the world’s highest GDP per capita rates by the mid-2000s (AUD$65,566 in 2007). When Icelandic banks collapsed at the end of 2008 however, unemployment tripled in 6 months with many people losing their life savings and GDP per capita falling to just AUD$38,037. This is how it happened.

From the early 1990s to the mid 2000s the Icelandic government initiated an aggressive program of financial decentralisation and privatisation. First and foremost, the country’s there largest banks – Glitnir, Landsbanki and Kaupthing – were privatised, giving these entities not only higher profits but also operational freedom. The actions they took were the most crucial trigger to the crises. In the proceeding six months alarming hyper-expansion occurred with these banks borrowing over $120 million (theee times the size of the economy). They used substantial wholesale funding to finance their entry into the local mortgage market and acquire foreign financial firms, primarily in Britain and Scandinavia. In fact, according to Richard Portes, professor of economics at London Business School, two-thirds of the Icelandic bank’s financing came from domestic sources and one-third from abroad. But as wholesale funding markets seized in late 2007, the banks started to collapse under a mountain of foreign debt. By October 2008 all three of Iceland’s central banks were forced to file for bankruptcy.

From bad to worse

As unemployment spiked and growth plummeted Iceland’s government had no choice but to shut down the internally crumbling stock market. And in September 2008 they did exactly that. The last major bank Kauputhing was taken over by the government. Trading of the currency krona was pulled to a halt with foreign banks no longer willing to take it, even at painfully discounted rates. With a major fall of the exchange rate Iceland could no longer pay for imports.

This economic turmoil was part of a complex global financial crisis and was by no means an isolated event. It is therefore naive to assume that the deregulators were the only ones responsible for the financial mess. Eight months prior to the crises, for instance, American accounting firm KPMG audited Iceland’s banks and found no problems and in fact gave them the top credit rating. Along with many other Icelandic economic advisors, Prime Minister Sigmundur Davíð Gunnlaugsson reflected in distress, “There [was] a very real danger… that the Icelandic economy, in the worst case, could be sucked with the banks into the whirlpool and the result could have been national bankruptcy”. A $5.1bn sovereign debt package was initiated to help finance budget deficits and the creation of new domestic banks. Comprising of the bailout package was $2.1bn from the IMF and the remaining $3bn from a group of Nordic countries.

Whilst Iceland’s situation may have been dire, its actions to combat it have been met with much appraisal. In fact there is probably more material focusing on the positive actions taken rather than the actual crises itself. In addition to the implementation of effectively tight monetary policy and fiscal policy, emergency laws were passed that allowed the Icelandic Financial Regulatory Authority (FSA) to take over operations of illiquid banks. Despite the fact that the recent financial crisis has hit Iceland hard, the economy is still strong and resilient.

At the present

Even at the time of writing, Icelandic lending to consumers and businesses has slowed to just a fraction of what it was before the crisis. Iceland may of come a long way from the dark pits of the crises but today stands as an example of the dangers deregulation. Even with these steps, the economy shrank 16 percent over the next year, and the unemployment rate rose to nearly 10 percent, from around 2 percent.

Thus far, Iceland has been hit particularly hard by this unprecedented financial storm due to the large size of the banking sector in comparison to the overall economy.

 

 

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

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