Transcript The Icelandic banking crisis and what to do About it

The Icelandic Banking
Crisis
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.
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.
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 …
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.
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.
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.
This is not a typical insurance market

You do not have to have an insurable interest in 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.
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.
CDS rates
Beginning of 2007
Landsbanki: 18
Kaupthing: 27
Glitnir: 24
Late Mar/early Apr 2008 Landsbanki: 850
peaks
Kaupthing: 1140
Glitnir: 1026
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 longterm foreign-currency rating of the
Republic of Iceland from “A+” to “A”.
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.
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)
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.
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
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.
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.
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.
If there had been a run on foreign-currency
liabilities, Iceland had no foreign-currency lender of
last resort
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
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
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?
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 Antiterrorism Act of 2001 to freeze the assets
of of Landsbanki in the United Kingdom.
 Nationalisation plans fortunately
abandoned, Glitnir followed on 8 Oct.
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.
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.
IMF Loan

On 19 Nov the IMF approved a two-year StandBy 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.
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.
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.
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.
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.
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.

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.
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 Jón Ásgeir
Jóhannesson, was accused of looting it to prop up his
struggling business empire.
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.
A UK regulatory failure?
 Under
the attractive nuisance doctrine a
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 …
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.”

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.”
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.
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.
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?
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.
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.
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.
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.
GDP Growth (% change)
Annual Inflation
Unemployment
Government Debt (% GDP)
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.
Who else should we be worried
about?





Switzerland has a bank-asset-to-GDP ratio of
seven percent, down from over nine percent in
2006.
Swiss banks were among the most leveraged in
the world.
They had significant exposure to the US subprime mortgage market.
Swiss authorities reacted faster than Icelandic
ones.
There was a perception that the world would
have more anxious to help save Swiss banks.
Some before-the-crisis total bank
asset to GDP ratios
12
8
4
0
Iceland
Switzerland
Belgium Netherlands
UK
Overbanked

I have used overbanked to refer to a situation
where the banking sector is too large.
 More typically, it refers to a scenario where there
are too many banks and each is too small to
earn a satisfactory rate of return.
 Currently, in countries where the banking sector
is too large it is because just a few banks grew
rapidly.
What can be done to keep banks
from becoming too big?

The G-30 have suggested that larger banks
should be restricted from certain activities and
should be subject to greater supervision and
regulation.
 But regulators and supervisors tend to be
captured by the industry that they tend and the
bankers always seem to be a step ahead of their
minders.
 Willem Buiter’s suggestion, endorsed by the UK
FSA: Tax size. Make the minimum allowable
ratio of capital to assets increasing in bank size.
A country can be too small to
have its own currency

Iceland has ministries of business affairs,
communications, science, culture, environment,
finance, fisheries, agriculture, foreign affairs,
health, industry, tourism, justice, ecclesiastical
affairs, social affairs, social security: if they can
outsource monetary policy, maybe this is a good
idea!
 Difficult to find qualified senior officials
 Heavy burdens placed on senior officials
The multi-talented David Oddson

Appointed chairman
of the board of
directors of the
Icelandic central bank
in October 2005
Experience:
Theatre director
X
Comedy radio
show director
X
Political
commentator
X
Foreign minister
X
Prime minister
X
Economist
Since 1990, 33 new countries
have formed
 Many
are very small
 East Timor, Kosovo, Macedonia, Marshall
Islands, Montenegro, Namibia, Palau and
Slovenia, for example, all have
populations near or below 2 million
The Icesave dispute
 Icesave
accounts were internet savings
accounts offered by British and Dutch
branches of Landsbanki.
 They were available in Britain form Oct
2006; in the Netherlands from May 2008.
 They offered attractive interest rates.
The British rushed to invest
 Households,
charities, local authorities,
even the UK Audit Commission.
 About 6 billion pounds was invested.
What would happen to
deposits?
 When
Landsbanki failed the government
of Iceland announced that all deposits in
Iceland would be covered.
 Foreign deposits were in limbo.
 Uncertain of the Icelandic intent to replay
Alistair Darling froze the assets of
Landsbanki.
Iceland’s obligation
 Iceland
was supposed (it is said) to cover
about 20,000 euros per account.
 Iceland was a member of the UK’s
Financial Services Compensation Scheme
which originally guaranteed deposits up to
35,000 pounds, but it increased the limit to
50,000 just before Landsbanki failed.
 The Labour government was playing
reverse Robin Hood.
Was Iceland liable?
 Iceland
is a member of the European
Economic Area.
 The relevant legislation is the EU’s
Directive 94/19/EC which the EEA has
adopted.
 A directive is a mandate that specifies a
result, leaving the method up to the
national authorities.
The Directive
 Countries
must set up a deposit-guarantee
scheme.
 A branch located outside of the home
country is supervised and regulated by the
home office’s authorities.
 Retail deposits were protected up to
20,000 euros at the time.
The Directive
 The
government is not required to insure
deposits: only to set up a scheme.
 The scheme is supposed to have sufficient
resources.
 A government guarantee is not sufficient.
 In the introduction it is said that the
sovereign is not liable if it sets up a
scheme.