While it is true that the Icelandic banks grew very rapidly after privatization of Glitnir in 1990, and Kaupthing and Landsbanki in 2003, the problem with this explanation is that in 2008 there were some European countries with banking sectors just as large on a relative basis.
Leaving aside offshore financial centers like Jersey, Guernsey and the Isle of Man, in 2008 the ratio of short-term bank liabilities to GDP was, for example, 260 percent in Switzerland and 211 percent in Iceland. In 2012 total assets of the Scottish banking sector were more than 12 times the GDP of Scotland, whereas at the end of 2007, total assets of the Icelandic banking sector were about nine times the GDP of Iceland.
Swiss banks did not collapse in 2008, because they were given liquidity support by the Swiss government, with crucial dollar swap deals between the U.S. Federal Reserve and the Swiss National Bank running up to $466 billion in aggregate.
Without these swap deals, the Swiss banks would have probably gone under, even if the Swiss National Bank produces a widely accepted currency, the Swiss franc.
Scottish banks did not collapse, because they were bailed out by the U.K. government with taxpayers’ money, supplemented by immense dollar swap deals between the Bank of England and the U.S. Fed. In both cases, the banking sectors could rely on external help.
In the mid-2000s Iceland’s banks were heavily funded in the interbank dollar and euro markets, but after 2006 funding shifted to retail deposits, not least from branches in the U.K.
In early 2008, the Central Bank of Iceland, the CBI, had sought currency swap deals with the Bank of England, the U.S. Fed and the European Central Bank, but had been refused by all of them. In other words, the Icelandic banks were not too big; it was Iceland which was too small, on its own, just as Switzerland and Scotland would have been, if they had been on their own.
There were three main reasons for the rapid growth of Icelandic banks between 2003 and 2008. First, the center-right governments of David Oddsson, prime minister from 1991 to 2004, had liberalized and stabilized the economy, with the result that Iceland’s credit ratings had gone up significantly.
The owners and managers of the newly-privatized banks benefitted much from Iceland’s good reputation. They suddenly found themselves being able to borrow cheaply in international financial markets. In addition, Oddsson’s first government had in 1994 opened up the economy by joining the European Economic Area, EEA – comprising all EU countries in addition to Iceland, Norway and Liechtenstein – after which the banks could legally operate anywhere in Europe.
It also meant that the EEA regulatory framework applied to the Icelandic financial market. Therefore, another common explanation for the Icelandic bank collapse does not make much sense: that the financial sector was under-regulated. The Icelandic banking sector was regulated in the same way as its counterparts in other European countries.
Moreover, even if the Icelandic Financial Supervisory Authority had had more staff and even if it had interpreted and implemented financial regulations more severely, the indisputable fact is that the Icelandic bankers found willing customers in other countries, both depositors and other creditors, including well-established, large banks.
A third reason, perhaps more speculative, was that a culture of entrepreneurship, individual initiative and risk-taking had developed in Iceland in the 1990s and early 2000s. While Swedish bankers were for example somewhat risk-averse after the 1991–92 Swedish banking crisis, the relatively young Icelandic bankers had not known any setbacks or big defeats. In this, they were not much different from bankers in, say, Scotland and Switzerland.
The managers of Glitnir, Kaupthing and Landsbanki were aggressive, but hardly more reckless than their colleagues at RBS, UBS and some other big European banks. While the large relative size of the Icelandic banking sector and the aggressive risk-taking of the bankers certainly made this particular banking sector vulnerable in an international liquidity crisis, these are not adequate explanations of the collapse.
Rather, they are descriptions of the situation before the collapse, and even tautologies: the Icelandic banking sector collapsed because it was collapsible. The reason why the Icelandic banking sector collapsed while its Scottish and Swiss counterparts survived, was that three decisions made abroad entered into and greatly affected an already precarious situation.
First, Iceland, unlike Scotland and Switzerland, was unable to obtain currency liquidity. The CBI could print kronur, but it could not print dollars, euros or pounds.
While earlier unsuccessful attempts by the CBI to make currency swap deals had been kept strictly confidential, the death knell for the Icelandic banks really sounded on Sept. 24, 2008, when the U.S. Fed announced massive dollar swap deals with the central banks of Sweden, Denmark and Norway, with the CBI being conspicuously absent. Suspicion in the international financial markets turned into certainty: Iceland was being left out in the cold. Credit lines were cancelled; a run started on the banks, slowly gaining momentum.
Oddsson, now CBI governor, tried several times to make dollar swap deals with the U.S. Fed, first in the spring of 2008, then again on June 6, on Sept. 24, and yet again, urgently, on Oct. 2, explaining to Timothy Geithner, then president of the Federal Reserve Bank of New York, how important it was for Iceland not to be seen as being left on its own limited devices. He was turned down each time: Iceland’s banking sector was too big, he was told; it was unsustainable.
In addition, British banks under Icelandic ownership – Landsbanki’s Heritable Bank and Kaupthing’s KSF, Kaupthing Singer & Friedlander – were excluded from the immense liquidity support scheme for British banks in October 2008.
When Kaupthing managers approached British authorities asking to participate in the scheme, they were bluntly told: “Those funds are not for you.” Instead, the British authorities closed the two banks and put them into administration.
Thirdly, in the midst of the crisis, the U.K. government invoked an anti-terrorism law against Iceland, briefly against both the CBI and the IFSA, and for a longer period against Landsbanki. For a while, Landsbanki could be seen on a special list at the U.K. Treasury website with the Taliban, Al-Qaida and the governments of Sudan and North Korea.
While the stated purpose of invoking the law was to prevent illegal asset transfers from the U.K. to Iceland, this measure had an immediate and extremely negative impact on the credit and credibility of Icelandic institutions and enterprises and made impossible any further rescue attempts.
It should be added that no illegal transfers from the U.K. to Iceland, either at Landsbanki or Kaupthing, have been discovered, despite accusations to that effect from British government ministers.
Surprised and shocked by the sudden meltdown of the Icelandic banks at the end of September 2008, bankers, politicians and officials discussed possible options. CBI Governor Oddsson felt that the most important goal in such a serious situation was to prevent the default of the sovereign. The second most important objective was to maintain a functioning system of payments, both within the country and internationally. Then, depositors had to be protected.
The interests of bank shareholders and creditors were of less concern. His proposal was, in other words, to “ring-fence” the economy. Others believed for a while that the government might be able to rescue some of the banks. Experts from JP Morgan, invited to Iceland by the CBI, managed however to convince the government that it was essential to “ring-fence” the economy, nationalize the banks and split them up between a domestic part which government would temporarily operate and an international part which would be put into resolution.
Parliament passed the so-called Emergency Act on Oct. 6, 2008, giving the authorities necessary powers and also making deposits priority claims on the bank estates. In the law all deposits were included, also in foreign branches of Icelandic banks.
At the same time as the Emergency Act was passed, government ministers announced publicly that all domestic deposits were guaranteed. But the British authorities chose to misinterpret this, claiming that the government had discriminated by law between Icelandic and British depositors, whereas the public announcement of a government guarantee of domestic deposits had no legal force and was similar to such announcements in other European countries.
Why was Iceland left out in the cold? One possible answer is bad luck. If the financial crisis had hit Iceland later, at the same time as other European countries, then perhaps the British authorities would not have moved so brutally against it.
Another possible answer is lack of information. Authorities in the U.S. and Europe did not seem to realize that despite the aggressiveness of the bankers, the Icelandic economy was basically sound: The state was debtless; the fisheries were well managed and profitable; ample resources of energy existed; the pension funds were strong. A third answer was that Iceland was expendable. It had lost the strategic importance it had had for the U.S. and the U.K. in World War II and in the Cold War.
It did not seem to matter that Iceland had long been an ally of the Anglo-Saxon powers (unlike Switzerland), a founding member of NATO and even a member of the “coalition of the willing” during the 2003 Iraq War. On the basis of the second and third answer, it may be suggested that one failure that can indeed be blamed on the Icelandic government of the time was not to have cultivated closer ties with the U.S. and the U.K.
A fourth answer was that the aggressive Icelandic bankers, operating online accounts which were cheap to run so they could offer high interest rates, were seen as upstarts, outsiders, irritants, by British banks and building societies competing with them for deposits. Moreover, some Icelandic businessmen were regarded as gamblers and adventurers rather than real entrepreneurs.
There was, however, a difference between the attitude of the U.S. authorities that took little if any interest in Iceland, and the U.K. authorities that were sometimes outright hostile to Iceland, as is evident from Chancellor Alistair Darling’s account of the financial crisis.
Perhaps a political motive for showing that small economies can hardly survive on their own can be deduced from his almost gleeful comment: “Iceland, along with Ireland, was part of what Scotland’s nationalist first minister, Alex Salmond, liked to refer to as an ‘arc of prosperity,’ to which he yearned to attach Scotland.
It was now an arc of insolvency. Chancellor Darling and Prime Minister Gordon Brown were both from Scotland where the nationalists had formed a government in 2007, posing a real political threat to the Labour Party.
One of the unionists’ main planks in the campaign before the Scottish referendum on independence in 2014 was that Scotland could have shared the fate of Iceland if it had not been helped out by its powerful southern neighbor.
It is also an interesting question whether the Icelandic bank collapse was inevitable.
Another way of putting it is to ask whether the Icelandic banks were all insolvent. A complete answer is impossible to give, because the system broke down and many bank assets were sold at a much lower price than they would have carried in more normal times. The downfall of the banks was therefore a self-fulfilling prophecy.
However, it is worthwhile considering what would have happened if the three crucial decisions entering into the precarious situation in Iceland – which the Icelandic bankers had certainly created themselves with their rapid expansion – had been different. If the U.S. Fed had announced a dollar swap deal with the CBI of, say, $7.5 billion, even as late as Oct. 2, 2008, then probably the cancellation of many credit lines and the run on the banks would not have taken place.
The CBI and the government would have had the powers and the means to pursue the “Swedish Way” which was to nationalize the banks and to split them up into a “good” domestic part continuing to operate and a “bad” international part to be put into resolution. Shareholders in the banks would have lost some or even all the value of their shares, and foreign creditors, except depositors, would have lost some of the value of their claims.
However, possibly, if such a deal between the Fed and the CBI would have been made, politicians close to the bankers might have been tempted to pursue the “Irish Way” and to issue wide-ranging government guarantees, an unwise move in the circumstances. Moreover, if the British government had rescued Heritable Bank and KSF at the same time as all other banks in the U.K., then the two banks would have stayed open and eventually would have been sold, thus reducing creditors’ losses.
These banks were essentially sound. The recovery rate for preferential creditors was 100 percent in both banks, and it seems that it will be about 95 percent for other creditors in Heritable Bank and about 85 percent in KSF. The recovery rate of their parent companies in Iceland may be lower. According to one estimate it will be 28 percent for Kaupthing, 42 percent for Glitnir and 51 percent for Landsbanki. However, the average recovery rate for failed banks in the U.S. is about 25 percent, which suggests that at least one or two of the Icelandic banks were sound.
Thirdly, the dispute between the U.K. and Iceland about deposits in the Landsbanki branch in London would have been avoided. The U.K. government unilaterally paid out, presented the bill afterwards to the Icelandic government and started a dispute in which deals were made between the U.K. and Iceland, under pressure from the IMF, and turned down in two Icelandic referenda. The dispute only ended when the EFTA Court concluded in 2013 that the U.K. claim was without merit.
Fourthly, if the anti-terrorism law had not been invoked, then it would have been much easier for Iceland to tackle the problems it faced in late 2008.
It was certainly a grave crisis, which could only be overcome with great difficulties, but this crisis did not have to turn into a collapse.