The causes of the icelandic banking crisis

Since 2006 the Icelandic economy has been under scrutiny by the international financial community essentially because of the country’s large current account deficit (16% of the GDP) and of its very fast growing banking sector. Two years later, the latter would determine what is now known as the Icelandic banking crisis.

Buiter and Sibert (2008), in an early study commissioned by the Icelandic Central Bank at the beginning of 2008, “prophetically” pointed out the main weaknesses of the Icelandic financial system that would lead to the economic breakdown of the country the following summer. According to the authors, the causes of the “meltdown” were straightforward even at that time: “The fundamental reason was that Iceland was the most extreme example in the world of a very small country, with its own currency, and with an internationally active and internationally exposed financial sector that is very large relative to its GDP and relative to its fiscal capacity” (Buiter and Sibert, 2008).

Iceland, with its 300,000 inhabitants, is, in fact, the smallest country with an independent monetary policy. Its economy is essentially constituted of three well developed sectors: the Fishery, Aluminum and Financial sectors. The latter has grown at an increasing pace following the 2001 sector deregulation, in which the three domestic commercial banks were privatized. According to Portes, Baldurssonand Ólafsson (2007), at the end of 2006 Iceland emerged as: “Exceptionally open in finance: external assets 395% of GDP, external liabilities 517% of GDP” (moreover, total assets were already worth 800% of the GDP).

In 2008 the three major banks reported assets worth almost eleven times the Ministry of Finance’s estimate of the 2007 GDP. What is more, by then the banks had acquired an international profile and were very large, which meant that in order to finance their assets they had to increasingly rely on funding from abroad. The result was that at the beginning of 2008 roughly half of Landsbanki’s assets and two-thirds of the assets of Glitnir and Kaupthing were located outside of Iceland (Buiter and Sibert, 2008).

This trend contributed to exposing the Icelandic banks to the same funding issue that forced the much larger (Lehman Brothers, Merrill Lynch, etc.) investment banks out of the market: a liquidity mismatch problem. Similarly to the American banks, they held assets with a long maturity and were funded by short-term liabilities (large stakes of which were foreign currency denominated). However, the peculiarity of the Icelandic case was the banks’ inability to prevent a run on their foreign denominated liabilities, given that the Icelandic central bank could not be an effective lender of last resort. Icelandic authorities, differently from their British and American counterparts, had too few foreign exchange resources compared with the short-term foreign-currency liabilities of the banks (Buiter and Sibert, 2008).

Before the crisis hit the country, Portes, Baldursson and Ólafsson (2007) had already pointed out that Icelandic banks carried a significantly higher risk premium with respect to their Nordic peers and argued that this could reflect either the market’s lack of information, or that the markets were actually putting “a country risk premium on the banks”. This perception was reflected also in the price of Credit Default Swaps, which started increasing in 2006 and then soared in 2008 (see fig. 1). Credit Default Swaps, by measuring the cost to get insured against the default of a debtor, provided operators with a rough measure of the insolvency risk the market attached to the three banks. Overall, this financial information had two effects: on one hand, it generated in the market the perception of the increasing riskiness of the three banks and, at the same time, contributed to actually increasing the likelihood of their becoming insolvent by increasing their funding costs.

     Fig. 1 The evolution of CDS spreads

Source: Buiter and Sibert (2008) on data from the Icelandic Central Bank. The figure compares the trend of CDS prices for the three Icelandic banks with the itraxx, the European benchmark for credit risk in the financial sector. The evident steady increase in the cost creditors had to face to insure against the default of the banks, stresses the sensible risk the market perceived on the three institutions (perhaps, some argue, on the country).

The crisis unfolded when, in the context of the unraveling global financial crises, Icelandic banks became unable to refinance their debts, not because of a traditional bank run, but because creditors would not roll over their loans. At the wholesale level, one of the reasons for this was  the freezing up of the interbank credit market, induced by the banks’ perception of higher counterparty risk following the failure of several financial institutions and the lack of transparency regarding the real value of the assets held by the financial institutions.

Indeed, the likelihood of this event taking place had been reckoned by previous surveys of the Icelandic economy (Miskin and Herbertsson, 2006) as the major risk factor to which the Icelandic banking system was exposed. The argument went as follows: since Iceland is a small player in international financial markets it is highly sensible to variations in financial flows which would heavily affect both asset prices and the value of the krona. According to Kallestrup (2008) in Iceland, foreign exchange volatility was likely to have a greater impact than it would have had in a larger country, due to the fact that the Icelandic economy is very small and open. The author argued that Consumers’ and businesses’ sizable debt in foreign currency made exchange rate volatility in Iceland more costly and could reduce the effectiveness of the exchange rate’s response to external shocks.

Within this framework, Miskin and Herbertsson (2006) suggested that a potential negative outcome could have been triggered in particular by the creation of a self-fulfilling prophecy. Hence that operators fearing the collapse of the value of domestic assets (stocks, currency etc.), would immediately pull their assets out of the country, thus contributing and/or determining the actual meltdown of the economy. Although the authors considered this outcome unlikely, given the quality of Icelandic economic institutions, and the unlikelihood of a major credit event, they also pointed out that such risk could be independent of the economic fundamentals of the country. What happened soon after somehow demonstrated this.

Furthermore, the confessed inability by the Central bank to tackle the effects of a global financial crisis (based on its actual foreign currency reserves) further increased, once the crisis actually took place, capital flights and speculators’ short selling Icelandic assets. In this respect the peg established by the Central bank in an attempt to prevent the krona from further depreciating was totally ineffective: indeed, it did not last more than a day.