The Icelandic Banking Crisis

1. The Icelandic Banking Crisis

2. It is 2006 … • A one-time Reykjavik grocer has already bought up a large part of London’s Oxford Street and is about to buy the House of Fraser. He has become the major shareholder of a large Icelandic bank and will soon have a 145-foot yacht and a £20 million private jet.

3. The Collapse of Iceland’s Banks: The predictable end of a non-viable business model • In early 2008 the Icelandic bank Landsbanki asked Willem Buiter and myself to write a paper on the causes of the financial problems faced by Icelandic banks and the possible policy options for the banks and the Icelandic authorities. • We prepared a report in April and in July we presented a slightly revised version in Reykjavik to an audience of economists from the central bank, the ministry of finance, the private sector and academics. • Landsbanki considered our report to be too market sensitive to be put into the public domain and we agreed to keep it confidential. • But, the worst possible outcome occurred; Landsbanki was placed in receivership. We published our results.

4. Iceland, appeared to be a wealthy country with • High quality economic institutions, governance and policy making • Sustainable public finances • Flexible markets • A first-rate labour force But, there were warning signs early in the spring of 2008 that not all was well …

5. Credit Default Swap market • A CDS is a credit derivative instrument where one party makes periodic payments to another party in return for that other party making a payment if the underlying instrument defaults. • The underlying instrument might be corporate debt, an emerging market bond, or a mortgage-backed security.

6. CDS spread • The spread of a CDS is the annual amount that must be paid over the length of a contract expressed as a percentage of the notional amount. • Suppose that the CDS spread is 100 basis points. A basis point is 1/100 of a percentage point. So, an investor buying 10 million euros worth of protection would pay one percent of 10 million euros, or 100,000 euros. • Thus, the spread is related to the perceived probability of default.

7. History • Credit default swaps were introduced by JP Morgan in 1997. • By mid-2007 the market had a notional value of $45 trillion, twice that of the US stock market.

8. This is not a typical insurance market • You do not have to have an insurable interestin the underlying security: you do not have to own it or even to suffer a loss if there is a default! • Typically in insurance markets, you do need an insurable interest. • For example, the UK Life Assurance Act of 1774 makes it illegal to buy life insurance on someone else’s life unless you are economically dependent upon them. • This ensures that the transaction is insurance and not gambling. It also protects against some obvious moral hazard problems! • See Willem’s 16 Mar 2009 Financial Times blog for more on this.

9. The market is also unregulated • No one is ensuring that buyers of risk actually have the necessary funds • As a result, spreads reflect the risk that the buyer of the risk might not be able to fulfill his obligations.

10. CDS rates

11. In addition, • The FX swap market became disfunctional in March 2008. • On 1 April 2008, Fitch put the three banks on Rating Watch Negative • On 17 Apr 2008 S & P’s lowered the long-term foreign-currency rating of the Republic of Iceland from “A+” to “A”.

12. What was going on? • There was nothing obviously wrong with the three large Icelandic banks. • They were not believed to be significantly exposed to the US sub-prime mortgage market. • They were not as leveraged as many other European banks.

13. What economists had to say: • Later Federal Reserve Board member Ric Mishkin and his co-author Tryggvi Herbertsson said that “financial fragility is not high and the likelihood of financial meltdown is very low.” (May 2006) • LBS Professor Richard Portes and his two Icelandic coauthors studied the banks and concluded, “The internationalisation of the Icelandic financial sector is a remarkable success story that markets should better acknowledge.” (Nov. 2007)

14. Banks are vulnerable to runs • The canonical liquidity crisis is a bank run: if each depositor believes that all other depositors are going to withdraw their assets then each depositor’s rational response is to withdraw his own. The outcome – a bank run – validates the depositors’ beliefs: it is individually rational, but socially disastrous.

15. New Style Bank Runs • For highly leveraged institutions that fund themselves mainly in the wholesale capital markets, an analogous event is possible . • in the belief that other creditors will be unwilling to roll over or to extend new their loans to a borrower whose obligations are maturing, each creditor finds it optimal to refuse to roll over his own loans or to extend new loans to the borrower. • As with a classic bank run, this scenario can occur even when the assets of the bank are believed to be sound, if only they could be held to maturity

16. The credit crisis made things worse • Bank costs increased, raising the likelihood that any bank would become insolvent. • By coordinating market beliefs about Icelandic and other banks it made bank runs based solely on self-fulfilling expectations, rather than fundamentals, more likely. • It made it more difficult for banks to insure themselves against runs.

17. What can governments do to protect its banks? • As long as its banks’ deposits and short-term liabilities are denominated in domestic currency, a government can always issue enough currency to avert a run. • If the government is credible, the run is likely to be averted. If the bank is fundamentally sound, it repays its loan (at a penalty rate). The government makes a profit. • There is no consequent inflation; the fiscal situation is improved. • If the bank turns out to be insolvent, either the attempted rescue is inflationary or the taxpayers foot the bill.

18. But … • The Icelandic banker sector had assets and liabilities that dwarfed Icelandic GDP. • In Q1 2008, total assets of the three main banks were almost eleven times estimated 2007 GDP. • Only about 21 percent of the assets and 15 percent of the liabilities were denominated in kronur.

19. If there had been a run on foreign-currency liabilities, Iceland had no foreign-currency lender of last resort

20. The central bank was stunningly candid: • “Critics have asserted that Icelandic banks have grown too large. This might be true if a major crisis were imminent and the Icelandic government were forced to resolve a critical situation affecting banking operations both in Iceland and abroad.” Financial Stability May 2008

21. Iceland was small and vulnerable • Rumours were that traders from a now defunct investment bank met in the bar of the 101 Hotel in Reykjavik and planned a crisis, using ‘trash and trade’ strategies: shorting the króna or the stock or debt of one or more of the Icelandic banks, while spreading unfavourable rumours

22. Some of what happened after • On 15 Sep 2008 Lehman Brothers sought Chapter 11 bankruptcy protection. • Glitnir had a sizable amount of debt set to mature in mid October. It was unable to raise the money to pay the debt and the Icelandic authorities lacked the foreign exchange to make Glitnir a sizable enough loan. • On 29 Sep it was announced that the bank would be nationalised. • Question for thought: If a domestic company defaults, is this a good time to nationalise it?

23. Landsbanki was next • On 3 Oct British depositors staged a run on their Icesave accounts in Landsbanki. • On 7 Oct Landsbanki was placed in receivership. • The UK government invoked the Anti-terrorism Act of 2001 to freeze the assets of of Landsbanki in the United Kingdom. • Nationalisation plans fortunately abandoned, Glitnir followed on 8 Oct.

24. And then Kaupthing … • After what must have been an acrimonious discussion with the Icelandic authorities, the British authorities seized the assets of Kaupthing’s UK subsidiary and transferred them to the Dutch bank, ING. • This ensured the collapse of Kaupthing on 9 Oct. • Kaupthing might have been saved but for the UK government.

25. The exchange rate • On 6 Oct the government attempted to peg the króna at 131 kronur to the euro. • On 8 Oct the peg was abandoned and by 9 Oct the exchange rate had fallen to 340. The demise of the last of the three big Icelandic banks on that day caused trade to collapse. Capital controls were introduced. • On 28 Oct the central bank raised its policy rate to 18 percent and, following this, a small amount of commercial trade in the króna outside Iceland recommenced. The exchange rate was 240.

27. IMF Loan • On 19 Nov the IMF approved a two-year Stand-By Arrangement of about $2.1 billion for Iceland. About $827 was available right away and the rest in eight equal tranches, subject to quarterly reviews. • The IMF said that it is essential that the government not take on the losses of the banks, other than paying guaranteed deposits. Iceland agreed and was saved from the fate of Ireland and Spain.

28. Icelandic Economy • “Economic developments are shrouded in uncertainty at present … ” (central bank) • It was feared that Icelandic GDP might contract by ten percent in 2009. • And that private domestic consumption would probably fall by about 25 percent in 2009.

29. Could Iceland have been saved? • We estimated that they would have needed $10 billion to stave off a collapse. • This would only have been worth it if the crisis is a liquidity crisis and not a solvency crisis. • Iceland had $2.6 billion in reserves and $2.3 billion in Nordic swap lines. It could have tried to set up swap lines with the US, the UK and the ECB. It could have borrowed from the markets using its energy resources as collateral. It could have gone to the IMF: the IMF had about $200 billion to lend and was desperate for borrowers.

30. Iceland should have joined the EMU • Its banks would have been protected from liquidity crises; the ECB would be the lender of last resort. • Making monetary policy in Iceland is way too difficult. It is not possible both to target the price level and ensure a stable exchange rate. • Smaller transactions costs and households would no longer need to be foreign exchange speculators.

31. Should Iceland have had a reserve fund? • The assets would have had to be held in the most liquid possible form. • By effectively undoing the maturity- and liquidity transformation of the banking sector, this large investment in liquid assets would have destroyed the social profitability of Iceland’s international banking activities.

32. Were the banks solvent? • Richard Portes (FT, 13 Oct 2008) says, “Lilke fellow Icelandic banks Landsbanki and Kaupthing, Glitnir was solvent. All posted good first-half results, all had healthy capital adequacy ratios, and their dependence on market funding was no greater than their peers’. None held any toxic securities.” • This is likely to be optimistic! But, we still are not completely sure. But, it did not matter.

33. We never had any idea. • We read their financial statements carefully, but they don’t contain enough information to tell. • We suspect that the Icelandic supervisors were not sure.

34. It does appear they were criminal • Half of the banks’ loans were to holding companies: many associated with the banks or their owners. • The banks supposedly made loans to friends and employees so that they could buy shares. The shares were then the collateral. Supposedly the loans were written off just before the collapse. • Glitner’s owner, the one-time grocer JónÁsgeirJóhannesson, was accused of looting it to prop up his struggling business empire.

35. Mistakes the UK made • The thuggish behaviour of the UK government: demonstrating that it cannot be trusted not to misuse anti-terrorism legislation. (Obviously just warming up to go after the Opposition … ) • The willingness of households, the government, even the Cat Protection League, to put their savings into the banks of a small far away country that they have made no effort to learn anything about.

36. A UK regulatory failure? • Under the attractive nuisance doctrinea home owner may be held liable if a child drown in his unfenced swimming pool. • The UK government should have warned against risky investments. • To the Icelandic banks, the British public was like an unfenced and lovely blue swimming pool on a hot day …

37. And, it wasn’t just the Cats Protection league … • “In autumn 2008, five counterparties defaulted on refinancing operations undertaken by the Eurosystem, namely Lehman Brothers Bankhaus AG, three subsidiaries of Icelandic banks, and Indover NL.” • “The total nominal value of the Eurosystems claims on these credit institutions amounted to some E10.3 billion at end-2008. The monetary policy operations in question were executed on behalf of the Eurosystem by three NCBs, namely the Deutsche Bundesbank, the Banque centrale du Luxembourg and de Nederlandsche Bank.”

38. I’d rather they’d said it was a horrible mistake … • “The Governing Council has confirmed that the monetary policy operations in question were carried out by these NCBs in full compliance with the Eurosystem's rules and procedures, and that these NCBs had taken all the necessary precautions, in full consultation with the ECB and the other NCBs, to maximise the recovery of funds from the collateral held.”

39. What collateral did they give the ECB? • "The counterparties in question submitted eligible collateral in compliance with the Eurosystem's rules and procedures. This collateral, is of limited liquidity under the present exceptional market conditions and some of the ABSs need to be restructured in order to allow for efficient recovery. Under current market conditions, it is difficult to assess when the eventual resolution will be achieved by the Eurosystem.” • We don’t know how the ECB valued their collateral: it won’t tell us.

40. Love Letters • It was a common practice in Iceland for two banks to swap their debt securities with each other and for each to use the other’s debt as collateral in their borrowing from the central bank of Iceland. This type of collateral was called a love letter.

41. And it wasn’t just Sedlabanki • Between the start of February and the end of April 2008 subsidiaries of the three large Icelandic banks increased their borrowing from the Central Bank of Luxembourg by 2.5 billion euros and a significant part of this was done using love letters as collateral. • Was this reasonable collateral?

42. Trichet gets worried • On 25 Apr the ECB president phoned the president of the Icelandic central bank and demands a meeting. • As a result an informal agreement was made to limit the use of love letters. • By the end of June loans to Icelandic banks had risen to 4.5 billion euros.

43. Landsbanki has a new idea • On 30 Jun the CBL said that only 25 percent of collateral could be love letters and that banks had to phase this out altogether. • Landsbanki had a way around this. • At the end of July lending to Icelandic banks is still 3.5 billion euros. • In the autumn of 2008 the Icelandic banks defaulted on their loans to the Eurosystem.

44. The European Parliament is curious • In Mar 2009 an member asks Trichet at a formal dialogue about the default and Icelandic loans. • Trichet: “I don’t know the details – you are very well informed; you are better informed than I am. I have to say, at the moment – but I have no doubt that the Luxembourg bank is complying precisely with the requirements imposed by its position as a member of the Eurosystem and is applying the Eurosystem rules to the banks that submit eligible collateral to it.

45. What Iceland did right • Iceland did not accept liability for the losses of private banks. • The banking system has been downsized and recapitalised. It is now twice the size of GDP. • The IMF arrangement expired on 31 Aug 2011; it was judged a success.

46. GDP Growth (% change)

47. Annual Inflation

48. Unemployment

49. Government Debt (% GDP)

50. Lesson for All: A country can be OVERBANKED • It is highly undesirable for a small country to have both its own currency and a large, internationally exposed banking sector. • A country that is a member of the euro zone will be protected from liquidity problems, but may not have the capacity to recapitalise the banking system in the event of a solvency crisis.