Lessons from a Financial System Collapse: Iceland 2008 and Its Aftermath Lecture by Dr. Murray J. Bryant Professor Emeritus Western University, Canada
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 – 4 th in the world, New Zealand is 8 th 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 of 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 Firm Asset value Total Asset acquired change due Organic assets at Change in growth rate during the to ISK “Organic growth rate year-end assets % year revaluation Growth” 1 % 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 0 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 2008 2 14,436,884 3,083,083 27.2 0 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 overseas 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 Why didn’t anybody stop Central Bank them? • Monitored only domestic liquid • Central Bank’s legal responsibility is to assets until end of 2007 ensure financial stability • Relaxed reserve requirements • Central Bank’s concerns of the stability of the banking system increased • Open FX balance allowed instead of substantially by Nov. 2007 increasing equity requirements ‒ The bank never formally nor informally • Other unused tools: communicated to the government the • Tighter collateral rules necessary reaction to the prevalent threat • Dynamic provisioning of a collapse • Maturity mismatch regulations • Did the Central Bank find itself without the legal means to intervene? • Threaten to retrieve their bank license unless assets were sold or ‒ Then it should have communicated that headquarters moved abroad when the fact formally to the government role of lender of last resort could not • Roman or Greek interpretation of be fulfilled the law? Source: SIC’s presentation April 12, 2010
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 ombudsperson, 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
Bank’s balance sheet Assets Liabilities Domestic Domestic Discounted assets deposits good assets Other Domestic liabilities bad assets Foreign assets Capital Discounted foreign New bank’s balance sheet Old bank’s balance sheet assets and some domestic assets Domestic Domestic bad assets deposits Other Domestic liabilities good assets Foreign Bond assets Capital State injection Old bank’s stake in new bank and bond 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 Evolution of the annual number of foreign visitors to Iceland, as compared to the growth of the resident population New governance rules for all organizations >50 Enhanced regulation Risk in króna Risk of overbuilding, environmental damage
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.
Recommend
More recommend
