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THE ICELANDIC BANKING CRISIS OF 2008-2011
A SHORT TRAILER TO THE ICELANDIC CRISIS

The Icelandic Banking Crisis was one of the most surprising and dramatic events of the 2008 international financial and economic crisis. The collapse of the three largest banks of the country (Kaupthing, Landsbanki, and Glitnir) went onto severely undermine the nation’s economy. Not only it led to inflation followed by severe depression in the economy, but it also caused much political unrest in the economy as well. In accordance with the size of the economy, this crisis was the third-worst financial crisis in a country after the US and the Lehman Brothers. This issue rose to prominence the first time when the then Prime Minister, Minister Geir Haarde officially announced the country’s bankruptcy in October 2008. The collapse of the three banks was followed by their difficulties in refinancing the short-term debts given out and were forced to run only on the deposits in the UK and in the Netherlands. 

    It was not only this collapse but a combination of various other factors starting from the early 2000s to the mid which finally built up to this crisis. The deregulation of the banking sector encouraged the banks to rapidly expand in the overseas market, easily accessible credit policies, and rapid economic growth due to a boom in the domestic construction are some of the factors which also built up to this crisis. On the eve of the global financial crisis of 2008, Iceland’s banking sector was the largest of any country in relation to its GDP (SIGRÍÐUR BENEDIKTSDÓTTIR, 2017). So, the crisis that followed came as a surprise to many due to Iceland’s unprecedented growth before the crisis and then the downfall. This crisis has been mentioned to be a noteworthy lesson for the future in fighting a banking crisis. Apart from this, the Icelandic crisis forms a great case study on the costs of a financial crisis. The GDP declined 10% and the disposable income declined by 20%. Iceland’s recovery from the same, with the use of accurate policy measures, have also been strong. Falling a victim to massive outflows of cash and an unnatural ending too short term debt due to the Lehman Brothers, Iceland became the world’s first country to succumb to the global crisis. Iceland failed to repay its loans back to the US and the UK when they asked for returns due to them tightening their own credit and as such was linked to the subsequent decline in the global financial market.

PRE-CRISIS GROWTH

The three largest banks in Ireland, namely the Kaupthing, Landsbanki, and Glitnir accounted for over 95% of the country’s banking system and grew from 100% of the country’s GDP to become 900% of the GDP within a span of 10 years from 1998-2008. This happened because of the favorable conditions for finance globally which reduced the cost of credit along with the liberalization of the country’s financial sector which encouraged them to expand in Europe rapidly. This growth has often been called up as evidence of the unsustainability of the banking sector of the country.

                    The above graph shows that the growth in the economic sector began in 1998 but major growth was observed only from 2005. This growth is regarded as unstable as it was found that a large part of the equity of these banks was self- funded and hence was called to be fictional. The privatization of the banking sector along with abundant global liquidity led to transform Iceland from a fringe investment opportunity to that of mainstream investment. Apart from this, the economy also boomed due to a four-year investment project in a hydroelectric dam followed by a mega smelter project. The banks then started to collect deposits from abroad offering a higher interest rate than the foreigners could get at their homes, which made the banks grow about 10 times the size of the country’s economy.

EVENTS THAT LED TO THE CRISIS

                    Now, with abundant cash in hand, the banks (liberalized and privatized), went onto an uncontrollable and unaccounted buying spree buying foreign real estate assets, companies, and even sports teams. The unsustainability of the banking sector came from the fact that while these banks were paying an exorbitantly high rate of interest (about 15%) to the depositors, at the same time, they were also paying high prices to acquire assets abroad. The banks were undergoing, in a way, The Winner’s Curse as propounded by Richard H. Thaler.

                  Shortly, afterward, came the default of the Lehman Brothers which led to an end to short term lending. Adding to this, as the global crisis began to unfold, investors started deeming the Icelandic banks to be very risky. As the liquidity began to tighten up in 2007, these banks funded themselves through collateralized borrowing from the Central Bank as well as the European Central Bank. Due to the practice of the CBI issuing loans to these banks against uncovered bonds and printing money on demand, inflation rose in the country. But these borrowings were channeled disproportionately towards the companies and the firms having strong connections to the owners of these banks. According to rule, only 25% of the banks’ own assets could be transferred to third parties which had also been bent heavily in the case of the three banks aforementioned. In the case of Glitnir, these transfers even rose to a high of 90%. This happened in these banks as the owners had disproportionate access to the funds. Lending to insiders weakened these banks due to tunneling and looting. As the trust in the banks failed to result in a depletion in the value of the Icelandic currency (krona), the banks found it extremely difficult to get back their short-term debts. Due to the huge size of the banks as compared to the economy of the country, even the Central bank, the Seðlabanki Islands, failed to act as the lender of last resort to these big commercial banks which further lead to the reduction in the faith in the Icelandic banking system. As the banks failed and books were opened, it was highlighted that the banks were majorly funded by themselves and loans from each other signaling that the banking sector had very little equity of its own since its privatization. In addition to this, all the banks lent extensively to buy its own shares before the crisis became rough. On their failure, these loans became worthless and gave the depositors a thought as if the equity had never been there as a buffer against any losses. Upon the crisis, the banks were increasingly operating in foreign currencies for which they lacked a credible lender of last resort. Also, the banks loaned out this foreign currency to Icelandic households many of which had neither assets nor income in foreign currency.

When the Icelandic Crisis took a serious turn, there was an economic upswing in the economy i.e. the interest rate was raised higher and higher by the CBI to fight rising inflation. Following this, as the interest rate differentials became high, the capital inflow bonanza further threatened a major crisis ahead. The major factors behind high inflation were that the value of krona in the international market kept falling, the prices of goods were still rising and there were even uncertain effects on wage agreements and labor costs.

As the liquidity crisis struck, it became harder for the Icelandic Banks to secure foreign credit funding, the banks started to collapse, and as a result, the krona started to fall. Glitnir was nationalized in an attempt to stabilize the financial sector but this effort by the government did not seem to be credible for the international market given the size of the banking system and the krona. The capital was being called off. Share prices began to fall freely as well as bonds as now both the domestic and foreign investors feared the future of the banking sector. The share prices of the banks’ even fell, liquidity lines became rigid, margin calls were started to come in for the collateralized borrowings and the banks lost liquidity of foreign assets. 

RESTRUCTURING OF THE ECONOMY

Considering the size of the Icelandic banking system once it failed, the recovery from the crisis was expected to be a long and strict one. On the contrary, the recovery was not the costliest in terms of output cost even though the crisis was largest in relation to the banking system with respect to the GDP. There was a major restructuring of the banking sector. Loans to the firms and households were now transferred to the newly established banks at a discount of 60%, with equity being injected to these banks through monetary policy measures by the government. The Monetary Policy Committee (MPC) voted to lower the interest rates, thereby resulting in the appreciation of krona in weighted terms. According to the IS-LM, decreasing interest rates will lead to an increase in the supply in the economy, which will help to curb depression and ultimately leading to a rightwards shift in the LM curve. Iceland’s decision to devalue the krona during the global crisis proved to be effective in the recovery from the global crisis.

                    The refinancing was done by equity injections and subordinated loans. The government adopted aggressive debt restructuring with the help of newly established banks. Since, the crisis occurred mainly due to the liberalization and privatization of the banking sector, not only monetary, but fiscal reforms were to play a major role in the healing of the economy. The government opted for increasing the tax rates and removing the pre imposed cuts on tax during the boom period. This led to an increase in the personal tax and restoring the VAT to levels before the boom period. These planned fiscal measures helped the government to curb its expenditures. Since taxation has increased, the IS curve would result in a leftward shift. The outstanding debt was significantly reduced when the CBI declared most of the foreign currency loans given by the banks before the crisis to be illegal. Individuals were given access to pension saving plans in order to repay the principal loan amounts. Foreign creditors like the IMF helped to write down the loans by the collapsed banks. The recovery is termed to be one of the costliest in terms of fiscal policy measures. The CBI holding company was established to calculate the assets that the CBI and the government treasury took over during the crisis. The CBI repossessed the assets of the collapsed banks in exchange for their collateralized loans as well this company included the outlays from small banks. The most important fiscal revenue earned for the recovery was by the stability contribution by the creditors of the failed banks which amounted to almost 18.2% of the GDP. The State reclaimed ownership of the old banks as well as owned 99% of the newly established banks. Rules and regulations were tightened and the role of a lender of last resort in foreign currencies was killed. Under the fiscal policy measures, the major one was the debt relief program for the households. During the crisis, capital control was established which, along with the IMF, leading to a steady stabilization of the krona by restricting capital movements. Connectivity with foreign banks and finance increased at a slow, carefully supervised pace and only that for large Icelandic banks. On achieving stability, capital controls were completely lifted in 2016-17.

                        Source:- World Bank Indicators, World Bank.

Though this Icelandic crisis has been termed as a surprise more often, it can be noted that features of this crisis also correspond to some of the theories propounded famously throughout economic literature. The surprise might have arisen due to the lack of theories of banking and finance that could give explanations about the potential risks and possibility of a crisis. 

References

(n.d.). Retrieved from https://www.ukessays.com/essays/economics/effects-of-the-financial-crisis-on-iceland-economics-essay.php

(n.d.). Retrieved from databank.worldbank.org: https://databank.worldbank.org/source/world-development-indicators#

Centonze, A. (2011). Case Study: Iceland's Financial Meltdown. Journal of                  Financial Education,  37(1/2), 131-166. Retrieved August 2, 2020, from www.jstor.org/stable/41948662

SIGRÍÐUR BENEDIKTSDÓTTIR, G. B. (2017). The Rise, Fall, and Resurrection of Iceland: A Postmortem Analysis of the 2008 Financial Crisis. Brookings Papers on Economic Activity,, 191-281.

Sigurthorsson, D. (2012). The Icelandic Banking Crisis: A Reason to Rethink CSR? Journal Of Business Ethics, 147-156.

The miraculous story of Iceland. (n.d.). Retrieved from www.washingtonpost.com: https://www.washingtonpost.com/news/wonk/wp/2015/06/17/the-miraculous-story-of-iceland/