Lessons from a Financial System Collapse: Iceland 2008 and Its - - PowerPoint PPT Presentation

Lecture by Dr. Murray J. Bryant Professor Emeritus Western University, Canada

Lessons from a Financial System Collapse: Iceland 2008 and Its Aftermath

Iceland: Facts and Figures

• Population

340,000 and is almost entirely urban

• Economy export drivers in 2017: tourism, fishing and

aluminum

• Homogeneous population: Celtic and Norwegian
• European Economic Association since 1994, along with

Luxembourg, Norway and Switzerland

• Legal System – Civil law based on Danish civil law
• Workforce participation: male 82%, female 79%
• Happiness index – 4th in the world, New Zealand is 8th

Source: CIA Country Fact Book, 2017

Economic Factors

• Smallest country in the world to have it own currency – the króna
• Flexible exchange rate
• Substantial liberalization since 2000
• Weak prudential regulation and supervision
• Severe fiscal imbalances
• Imprudent monetary policy
• Some systemic financial instability

Source: Mishkin and Herbertsson, 2006

Problems of Small Economies

(as observed from 2000-2008)

• Media is not independent

RUV government owned TV channel, other media outlets owned by Baugur Group (largest holding company and biggest borrower from Glitnir and other banks)

• In 2008, the Governor of the Central Bank of Iceland was a

former Prime Minister, who lead deregulation

• Government closely tied as promoters of the bank
• Strong interplay between regulators and those regulated

What Happened in Iceland October 2008?

• The entire financial system of Iceland collapsed – 97%
• GDP $12 billion (US), bank failures $180 Billion (US)

‒ Bronze medal winner after Lehman Brothers and Washington

Mutual

• The Iceland króna collapsed, all trade in forex cancelled

for about four months, except for N1 and oil—necessary for the fishing industry

• Scale is notable—all households directly affected, disaster

was 15X the economy, in contrast TARP (ignoring other effects) was about 3% of US economy

Causes of the Collapse

The main cause of the failure

• f the banks was rapid

growth of credit and their size at their collapse.

• How?
• Why?
• What implication did this

have on bank operation?

• Why didn’t anybody stop

them?

• What can we learn?

How Did The Collapse Happen?

• Rapid growth in the banking system (see following slide)
• Holding company loans examined on a transaction basis

not a systemic basis

• Information asymmetry
• Owners were often the largest borrowers
• Landsbanki and Björgólfsson, Kaupthing Exista and Tchenguiz
• The banks were too large for the country
• The internet based savings accounts launched in 2005

were assumed by borrowers (incorrectly) to be covered by the government—moral hazard

20-FOLD GROWTH IN SIZE IN 7 YEARS

20-fold Growth in Size in 7 Years

Year-end Asset and Liability Values (million ISK), sum of the three largest Icelandic banks

Total assets at year-end Change in assets Asset growth rate % Firm acquired during the year Asset value change due to ISK revaluation “Organic Growth”1 Organic growth rate % 2002 1,450,751 2004 2,946,494 1,495,743 103.1 797,609

• 50,882

749,016 51.6 2005 5,418,521 2,472,027 83.9 726,316

• 202,822

1,948,533 66.1 2006 8,474,660 3,056,139 56.4 1,068,092 1,988,047 36.7 2007 11,353,801 2,879,141 34.0 58,339

• 231,263

3,052,065 36.0 20082 14,436,884 3,083,083 27.2 3,301,994

• 218,911
• 1.9

1 “Organic growth” is the ISK-denominated growth in assets at the banks and their subsidiaries, not related to acquisitions. 2 2008 numbers as of June.

Source: SIC report, Vol. 7, Ch. 21, pg. 91 and Flannery (2009) SIC report, Vol. 9.

THE OWNERS WERE BORROWERS

2006 and its Effects

The largest borrowers of the three banks, largely Icelandic entrepreneurs were also large borrowers in the UK, Denmark, Luxembourg and Germany. Credit tightened, in 2006, they refinanced in Iceland (doubling down) as credit tightened in Europe and banks there required many of their largest customers to reduce exposure. Associated impact was the need to grow debt— traditional forms unobtainable, so borrowed from

• verseas depositors

How were the banks able to grow so quickly?

• Access to loans and depositors through international

lenders

• Rating agencies only examined national debt (very low).
• Hreidar Mar and Kaupthing 2006, bought Singer Friedland

paid 35x earnings, borrowed $500m US.

• Weak supervision by the regulator – examined

transactions, not system effects. Too many lawyers.

• With the refinancing of loans in 2006, Edge and Icesaver,

high yield internet-based savings account – rise in króna, moral hazard, depositors felt safe!

• Locals borrowed in low cost loans—CHF Fr, and J¥ on

mortgage loans, but high risk if ISK fell

October 2008

• Collapse of system, Glitnir nationalized on September 28.

October 6, emergency law, FME takes control and priority given only to domestic deposits

• Government imposed capital controls October 2008 –

lasted until 2011—hedge funds purchased debt of the banks

• IMF monies secured, plus even Faroe Islands assisted
• Stock market lost 90% of its value
• All households affected
• Severe economic depression

The Icelandic Central Bank

• Central Bank’s legal responsibility is to

ensure financial stability

• Central Bank’s concerns of the stability
• f the banking system increased

substantially by Nov. 2007

‒ The bank never formally nor informally

communicated to the government the necessary reaction to the prevalent threat

• f a collapse
• Did the Central Bank find itself without

the legal means to intervene?

‒ Then it should have communicated that

fact formally to the government

• Roman or Greek interpretation of

the law?

Source: SIC’s presentation April 12, 2010

Why didn’t anybody stop them?

• Monitored only domestic liquid

assets until end of 2007

• Relaxed reserve requirements
• Open FX balance allowed instead of

increasing equity requirements

• Other unused tools:
• Tighter collateral rules
• Dynamic provisioning
• Maturity mismatch regulations
• Threaten to retrieve their bank license

unless assets were sold or headquarters moved abroad when the role of lender of last resort could not be fulfilled

Special Investigation Commission

Exceptional Powers

• Search premises
• Seize evidence
• Subpoena witnesses
• Criminal behavior to be referred to the Special

Prosecutor

• Reported to parliament, not the government
• Members—a judge, the parliamentary
• mbudsperson, and an economist

The Special Investigation Commission

The Special Investigation Commission (SIC) was set up December 2008

• To seek the truth behind the events leading to and the

causes of the downfall of the Icelandic banks in October 2008 and related events

‒ Was it mistakes? ‒ Was it negligence? ‒ Who was responsible?

Report released April 2010

Special Prosecutor set up in early 2009

• 208 cases
• 60 prosecutions and indictments
• Bankers and even a civil servant went to prison;

all senior managers of all three banks!

• Even the Prime Minister was charged and

prosecuted with negligence, but acquitted on more serious charges

Domestic deposits Domestic good assets Domestic bad assets Foreign assets Other liabilities

Capital

Domestic good assets Domestic deposits

Capital

Bond Domestic bad assets Foreign assets Other liabilities

State injection

Old bank’s stake in new bank and bond Old bank’s balance sheet Bank’s balance sheet Discounted assets New bank’s balance sheet Discounted foreign assets and some domestic assets Assets Liabilities

Separation of Assets and Liabilities from Old Banks to New Banks Source: Benediktsdóttir et al. (2017).

RESOLUTION COMMITTEES AND STRUCTURAL CHANGES

Return of Trust?

• Small economy, everyone was affected
• Small economy, everyone blamed each other
• The SIC and the Special prosecutor were

designed to bring order to chaos

• Foreign denominated mortgages held to be

illegal by the Supreme Court of Iceland

• Multiple governments – 5 since 2008
• Our book, Return of Trust? Most authors in the

book suggest that trust is a work in progress

What Has Happened Since 2008?

• Massive growth in tourism (air, cruise ships)
• Now 27 carriers up from one in 2007
• New governance rules for all organizations >50
• Enhanced regulation
• Risk in króna
• Risk of overbuilding, environmental damage

Evolution of the annual number of foreign visitors to Iceland, as compared to the growth of the resident population

Closing Thoughts

Áfrann med smjörid :Carry on Dugnadur :It will be ok – similar to Kiwi “she’ll be right” Nenna :Can’t be bothered Gluggavedur :Window weather Dragsúgur :Wind that comes through the window

Closing Thoughts Really

• Regulation matters
• Governance matters
• Ethics matters
• Growth needs to be carefully

managed not just economically but be aware of unintended consequences.