Working Paper: CEPR ID: DP9664
Authors: Fridrik Mar Baldursson; Richard Portes
Abstract: We examine the evolution of the Icelandic banking sector in its macroeconomic environment. The story culminates in the crisis of October 2008, when all three major banks in Iceland collapsed in three successive days. The country is still struggling to cope with the consequences. The paper follows on our report of autumn 2007. The macroeconomic boom that peaked in 2007 led to severe imbalances. The banks had expanded at a rapid pace and reported healthy profits, capital ratios and liquidity until their collapse. An official report (SIC, 2010) has, however, exposed severe weaknesses in the banks? assets and governance. The Icelandic Financial Services Authority (FSA) clearly knew little of the magnitude of large, single exposures and lending to the banks? owners, although they strongly maintained otherwise in autumn 2007. Neither the FSA nor the Central Bank of Iceland (CBI) saw the systemic risks created by lending to owners and related parties, which increased greatly from September 2007.With the financial turmoil that began in August 2007, the banks? access to capital markets was curtailed. They then gambled on resurrection, expanding their balance sheets and refinancing the investments of their owners and other big borrowers, while they should have been deleveraging and securing their liquidity positions in foreign currency. The banks also prevented their share prices from collapsing by purchases of their own shares in the stock market, offloading accumulated shares in private deals, usually financed by themselves. All this went on apparently unnoticed by regulators. The Icelandic banks did not buy toxic securities ? but together, they administered their own potent mix of systemic poison.Only a month before the collapse of October 2008 the banks all reported strong liquidity positions. These reports were misleading, but we also show how financing unravelled over the course of a few days, and collapse became inevitable. The rapid evaporation of liquidity and market funding is one of the key lessons of the story.Whereas the United States, the United Kingdom and other countries had the resources to bail out their irresponsible and illiquid banks, Iceland did not, and it received little foreign help or even sympathy. Iceland?s response to the crisis, with its heterodox policies and aid from the IMF, has been relatively successful.
Keywords: banking crisis; carry trade; currency crisis; financial crisis of 2008; icelandic banks; liquidity
JEL Codes: E44; E52; E63; F31; F32; F65; G01; G15; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Banks' rapid expansion (G21) | Systemic vulnerabilities (F65) |
| Risky lending practices (G21) | Systemic vulnerabilities (F65) |
| Lack of regulatory insight (L51) | Financial crisis (G01) |
| Lack of regulatory insight into banks' lending practices (G21) | Financial crisis (G01) |
| Failure to assess systemic risks (F65) | Failure to intervene (H84) |
| Failure to intervene (H84) | Financial crisis (G01) |
| Gambling for resurrection (H27) | Financial crisis (G01) |
| Lack of transparency (D82) | Financial crisis (G01) |
| Concealment of true financial conditions (G33) | Financial crisis (G01) |
| Absence of regulatory oversight (G18) | Financial crisis (G01) |
| Moral hazard from owners' involvement (G32) | Financial crisis (G01) |