Download Icelandic banks 2008 in context

Thorvaldur Gylfason
 Before

Background and history
 During


What the government did
Old bank/new bank approach
 After


Ten lessons from crisis
IMF program and prospects

For decades, government owned the banks
In 1930s, leaders of two main political parties sat side
by side on the board of Landsbanki, each representing
essentially bankrupt economic interests that went on to
divide the spoils (“Socialism of the Devil”)
 One of them sat there until the day he died in 1964,
despite serving as prime minister on five occasions
 Until late 1990s, bank directors and governing boards
were political players, with few exceptions
 With negative real interest rates and an overvalued
króna, bankers exercised significant power


Privatization 1998-2003 ought to have aimed to
sever those connections, but did not fully succeed

Two largest banks were sold in part to wellconnected individuals with close ties to the two
governing parties (“within calling distance”)

The two parties maintained their operatives on the
banks’ governing boards
Both banks were sold both at once at prices
deemed modest by the National Audit Office
 No serious attempt was made to attract foreign
buyers of banks as was done in the Baltics
 Unlike the Nordics and the Baltics, there is as
yet no foreign competition in Icelandic banking

More concentration of industry than among Nordics
 Large spreads between lending and deposit rates


Iceland’s privatization of its state banks 1998-2003
was mismanaged in ways that contributed to
collapse and to weak restraints on bank growth
Government ought to have constrained the banks
through taxes
 Central Bank ought to have constrained them through
reserve requirements
 Financial Supervision Authority ought to have applied
more stringent stress tests, appropriate to local
conditions


Besides, several earlier episodes of bank problems
when banks were state-owned were covered up

No accountability

Once freed from government control, the banks
kicked up their heels like cows in spring
Unprecedented borrowing and lending spree
 Borrowed short abroad at low interest to make long-term
housing loans at home at unprecedentedly low rates
 Some loans with variable interest rates after a five-year
grace period, to be renegotiated in 2009
 An element of sub-prime lending involved? Perhaps


Banks became international

2007: derived half their earnings from foreign operations
 31 subsidiaries in 21 countries (October 2007)
 Net interest income: 50%-60% of total (2008, Q1-Q2)
 Net fee and commission income: 30%-40% of total
 High return on equity, capital adequacy 10%-11%
 Deposit/loans ratios 40%-60%, aimed to raise them

“A sound banker, alas, is not one who foresees
danger and avoids it, but one who, when he is
ruined, is ruined in a conventional way along
with his fellows, so that no one can really blame
him.” (J.M. Keynes).


Icelandic banks copied each other’s business model,
and possibly took on excessive risk
“Daring ideas are like chessmen moved forward.
They may be beaten, but they may start a
winning game.” (J.W. Goethe)

Icelandic banks faced an insignificant home market,
so their choice was essentially to “evolve or die”
Source: Union Bank of Switzerland, December 2007
Source: Union Bank of Switzerland
10
9
8
7
6
5
4
3
2
1
0
Switzerland
Iceland
Net External Debt (% of GDP)
700
350
300
600
250
500
200
400
100
300
200
100
0
150
50
0
2004
2005
2007
2007
2008
International Investment Position (% of GDP)
0
-20
-40
-60
-80
-100
-120
-140
-160
-180
2004
2005
2007
2007
2008
% of short-term debt
140
120
100
80
60
40
20
0
Icelandic krónur (ISK)
0
20
40
60
80
100
120
140
160
 Iceland
has long been a high-exchange-rate
place, for several reasons





High inflation
Mounting foreign debts
Pervasive farm support, also for fisheries
High domestic prices of tradable goods (Big Mac
index)
Recently, also, carry trade (Ms. Watanabi of Tokyo)
 How?
Borrow in, say, yen at low interest, buy
krónur, place proceeds in high-interest accounts



Pre-crash amount outstanding, due within year: 20%
of GDP
Needed to be refinanced, this proved impossible
Put further downward pressure on króna
Closer Look at 2004-2008 (% per year)
14
12
10
8
6
4
2
0
2004
2005
2007
2007
2008
 Stock
market rose by a factor of 9 from 2001
to 2007

44% average annual increase six years in a row


World record
Clearly a bubble, and hence unsustainable

Even before bank collapse, stock market fell by more
than 50% from 2007
 Real
estate prices rose by a factor of 2.5
from 2001 to 2008


11% per year on average
Led to construction boom



Count the cranes! (Professor Robert Aliber)
Also, a bubble, unsustainable
Accident waiting to happen
 Three
largest banks (Kaupthing, Glitnir,
Landsbanki) saw their stock prices double,
and then fall back to square one just before
the crash, taking the OMIX15 up and then
back down with them

Banks accounted for 50% of OMIX15
 CDS
spreads for the banks rose to
stratospheric heights (26 October 2008)



Glitnir: 1600
Kaupthing: 1500
Landsbanki: 1200

For comparison, Barclays: 200

End of September 2008: Collapse

First, Glitnir collapsed


Within a week, Landsbanki and Kaupthing also collapsed


The three accounted for 85% of the banking system
Government put all three banks into administration


Their shares became worthless overnight
New bank/old bank approach




Glitnir asked Central Bank for $600 million loan to meet due date 15
days later as foreign credit line had closed; Central Bank refused
New state banks took over deposits and provided domestic banking
services, injected new capital into them, also into Central Bank
Old private banks were left with their dodgy assets and foreign debts
Resolution committees were appointed to liquidate old banks
In effect, temporary renationalization


Based on Nordic solution, worked well in crisis of 1988-1993
Plan is to reprivatize the new banks, e.g., by exchanging
their debts for equity, inviting foreign ownership
 Were
all observers caught by surprise? No
 For years, some domestic observers had
warned against



Excessive credit expansion of banks and inflation
Danger of banking crisis because Central Bank
neglected to build up foreign exchange reserves
Danger of currency collapse because the króna
was clearly overvalued
 Several




foreign observers also spoke out
Prof. Robert Aliber, Chicago
Prof. Willem Buiter and Ann Sibert, London
Prof. Daniel Gros, Brussels
Prof. Robert Wade, London
1. Need legal protection against predatory
lending

Like laws against quack doctors, same logic


Patients know less about health problems than doctors,
so we have legal protection against medical malpractice
Same applies to some bank customers vs. bankers,
especially in connection with complex financial deals
2. Do not allow rating agencies to be paid by the
banks

Fundamental conflict of interest
3. Need more effective regulation of banks and
other financial institutions

Work in progress
4. Read the warning signals

Three rules, or stories



The Aliber Rule
 Count the cranes
The Giudotti-Greenspan Rule
 Do not allow gross foreign reserves held by the Central
Bank to fall below the short-term foreign debts of
commercial banks
 Failure to respect the Giudotti-Greenspan Rule amounts
to an open invitation to speculators to stage an attack
on the currency
The Overvaluation Rule
 Sooner or later, an overvalued currency will fall
5. Do not let banks outgrow Central Bank’s
ability to stand behind them as lender – or
borrower – of last resort
6. Do not allow banks to operate branches
abroad rather than subsidiaries, thus
exposing domestic deposit insurance schemes
to foreign obligations

Without having been told about it, Iceland
suddenly found itself held responsible for the
moneys kept in Landsbanki by 300.000 British
depositors, and more in the Netherlands and
Germany
7. Erect firewalls between banking and politics

Iceland’s privatization of its state banks 1998-2003
was mismanaged in ways that contributed to
collapse and to weak restraints on bank growth




Government ought to have constrained the banks
through taxes
Central Bank ought to have constrained them through
reserve requirements
Financial Supervision Authority ought to have applied
more stringent stress tests, appropriate to local
conditions
Besides, several earlier episodes of bank problems
when banks were state-owned were covered up

No accountability
8. When things go wrong, hold those responsible
accountable by law, or at least try to uncover
the truth: Do not cover up


In Iceland, there are now vocal demands for an
International Commission of Enquiry, a Truth and
Reconciliation Committee of sorts
If history is not correctly recorded if only for
learning purposes, it is more likely to repeat itself
with dire consequences
9. When banks collapse and assets are wiped out,
protect the real economy by a massive
monetary or fiscal stimulus


Think outside the box: put old religion about
monetary restraint and fiscal prudence on ice
Always remember: a financial crisis, painful though
it may be, typically wipes out only a small fraction
of national wealth


Physical capital (typically 3 or 4 times GDP) and human
capital (typically 5 or 6 times physical capital) dwarf
financial capital (typically less than GDP)
So, financial capital typically constitutes one fifteenth or
one twenty-fifth of total national wealth, or less
10. Do not jump to conclusions and do not
throw out the baby with the bathwater




Since the collapse of communism, a mixed
market economy has been the only game in town
To many, the current financial crisis has dealt a
severe blow to the prestige of free markets and
liberalism, with banks having to be propped up
temporarily by governments, even nationalized
Even so, it remains true that banking and politics
are not a good mix
But private banks clearly need proper regulation
because of their ability to inflict severe damage
on innocent bystanders
 Time





line of events (various sources)
April 2008: British Prime Minister advises Icelandic
Prime Minister to seek IMF assistance
Spring and summer 2008: Nordic Central Banks
advise Icelandic Central Bank to go to IMF
Summer 2008: ECB and US Fed make same
recommendation, and exclude Iceland from
currency swap agreements with other Nordic
Central Banks
October 2008: After collapse, Iceland seeks “new
friend” in Russia, but deal does not materialize
November 2008: IMF program, six months too late,
with help from Nordics, Faroes, Poland, and Russia
 Monetary

Central Bank policy rate of 18%
 Floating

restraint
exchange rate
Supported by strict but temporary capital controls
 Transparent
bank restructuring
 Fiscal respite in 2009, with government budget
deficit of 14% of GDP

Fiscal restraint kicks in from 2010 onward



Cut spending from 55% of GDP in 2009 to 43% in 2013
Raise revenue from 42% in 2009 to 45% in 2013
Retrenchment equivalent to 15% of GDP in 4 years; tough
 Different

from Asian programs 10 years ago
IMF now tolerates capital controls, fiscal respite
% of GDP
New banks
Central bank
Foreign depositors*
Total
Gross cost
26
10
47
Net cost
26
10
19
83
55
* Estimated asset recovery equivalent to 28% of GDP
Numbers are subject to considerable uncertainty
Source: IMF, November 2008
% of GDP
Public debt
Foreign debt
2008
29
670
2009
109
160
Difference
80*
-510**
*Fiscal cost of cleanup in 2009
**Private debt write-off in 2009
with uncertain asset recovery
%
2009
GDP growth*
-10
Unemployment**
6
Inflation*
14
Foreign debt***
160
2010
0
7
3
147
2011 2012 2013
4
4
4
5
4
3
2
2
2
136
118
101
* % per year
** % of labor force
*** % of GDP
Source: IMF, November 2008
IMF is optimistic, perhaps too optimistic
 Two views

Pessimists warn that the debt burden threatens to
match that which the allies imposed on Germany at
Versailles after World War I, with predictable economic
and political consequences
 Optimists emphasize that the Faroe Islands emerged
from their deep financial crisis in early 1990s with an
external debt to Denmark equivalent to 140% of GDP,
and were able to repay with interest within 6-8 years


Long-term loss to Faroes despite recovery in other respects
 Net emigration of about 10% of population
 This Iceland must avoid
 Successful

Must effectively implement IMF program and
supplement it with further reforms


recovery rests on two pillars
Announcement of intention to apply for EU and EMU
membership would send encouraging signal to
international community; this may occur soon
Must also uncover the causes of the collapse,
including massive failure of policy and institutions



Iceland needs an international Commission of Enquiry
Rather, Parliament decided to appoint its own domestic
Investigative Committee, risking a deepening crisis of
confidence if the committee fails to convince the public
People have taken to the streets