Iceland Crisis Case Study

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Introduction

           In the history of finance, they have never been a developed country that experienced a collapse of the banking sector like Iceland. According to Sigurjonsson & Mixa, 2011, October 2008 is a year that Iceland and the finance industry will always remember; it was when three banks Glitnir, Kaupthing and Landsbanki which were the largest in Iceland were taken into receivership; they had $182 billion in assets. The three banks had started as local commercial banks and had grown to international commercial banks; the growth was attributed by rights to operate within EU countries border that was granted in 1993 and the privatization in 2003. The privatization in Iceland was carried out differently since the other countries privatized their institutions but still had some foreign ownership; this was not the case in Iceland. In 2006 an information crisis hit the banks, and this was just the beginning of the end of the growth in the Iceland banking sector. The banks also bought assets that were higher than the country’s gross domestic product; this made the sector very vulnerable since they had leveraged their capital base. 

           Moreover, in 2007 after some issues with the US housing credit market, some liquidity difficulties arose that led to the intervention by Iceland Central bank, which merely provided some relief. The Lehman Brothers fell in September 2008, and while it had no direct effect on the Iceland banks, it indirectly did; the liquid resources disappeared, international money markets froze, and assets could not be traded. Glitnir bank was the first to ask help from the Iceland Central bank, and it was taken over on October 6, Landsbanki also went to receivership after failing to meet its obligations, and on October 9 Kaupthing too went into receivership. Surprisingly, the three banks some weeks past had passed the stress test, which did not account for currency or liquidity vulnerability conducted by the Financial Supervisory Authority(FSA). The FSA had been bought by the banks to maintain an imbalance of skills and knowledge in the bank’s favor; this made it weak and decreased their control over the banks, which encouraged risk-taking (Sigurjonsson & Mixa, 2011). The discussion below will shed light on the crisis with an emphasis on the policy surrounding the issue, policy responses and implications, recovery from the crisis, and the lessons learned from the crisis.

Causes of the Crises

           According to Wade & Sigurgeirsdottir, 2012, the crises happened in 2008, but the signs of impending danger were evident from 2006, big banks were having problems raising money in the short term money markets, Iceland’s current account deficit was one of the highest in the world having increased to 20% in 2006 from 5% in 2003. The country’s stock market also increased nine times between 2001 and 2007, and the three banks were operating beyond the country’s central bank, which could be their last resort lender. A mini-crisis was seen where the business defaults rose, liabilities of banks in foreign currencies rose, and the krona fell; the IMF wrote an alarming report. The crisis was blushed off with only the central bank taking a loan to increase the foreign exchange reserves.

           According to Thorhallsson & Kirby, 2012, the most prominent finance crises in history, is said to have been resulted by various factors. First, the financial exposure was said to be greater than average this has been necessitated by the country having an extensive banking system and high leverage in the private sector while also having large inflows of capital. According to an analysis carried out by the head of the Iceland Desk in the Economics Department of the OECD, he claimed that banks foreign branches and domestic operation lacked last-resort lending. Also, he added that as the crisis continued to develop, the depression of the currency continues to worsen the negative equity positions for the banks. The main problem, according to him, was that the banks were suffering from a liquidity problem because they were insolvent suspicions since the banks had been struggling with wholesale funding in 2006. By mid-2007, their funding had been closed.

            In addition, it was concluded that the Icelands bank’s supervisors were unable to keep up with the size and complexity of the system as it continued to grow fast while legislatively applying rules. The lack of expertise and the small size of Iceland’s state of bureaucracy and political favoritism is said to have instigated the collapse. Also, it was fueled by nationalistic rhetoric, as concluded by the Working Group on Ethics. Moreover, the Iceland authorities had no place to result too for assistance because, in spring 2008, they had been required to put pressure on Iceland’s banks so that they could reduce their balance sheets; unfortunately, they never complied. The privatization of Iceland banks, their expansion to other countries, together with the accumulated borrowing to finance the foreign businesses, is said to have attributed to the crises. Later, it was discovered that the privatization was mishandled; this is because the banks were taken over by the governing parties, and they lacked the experience to run international systems, and their plan was to convent the banks to being investment banks.

           Moreover, bad banking is another reason that was said to have led to the collapse of Iceland’s banking sector. According to Sigurthorsson, 2012, the bank managers and owners adopted a policy that was aggressive and was based on high investment and leverage in growth areas that later become bubbles. The abundant credit led to the incorporation of policies that offered to lend to companies and customers. Unfortunately, most of these abundant credits were used in high-risk investments both abroad and in Iceland, where the floundered of these investments resulted in losses for the clients. This notion of bad banking can be termed as a violation of the bank’s duties to the shareholders and society.

Macroeconomic Policies Surrounding the Crises 

           They were various policies that surrounded the Iceland Crises. Fiscal and monetary policies, fiscal policies are used to promote long-term growth, while monetary policies contain inflation. One of the objectives of fiscal policy is the lowering of taxes to increase the labor supply and investment. The government lowered taxes to 18%in 2001 and 15%in 2008; the income tax was also reduced by 1%in each of the 3 years that preceded the crisis, in 2007, the value-added tax was lowered, and the property taxes abolished. However, the boom in the financial sector, import duties, and increased wages led to increased tax revenues, which helped in paying the government debt and increased the spending of the government. 

           Additionally, the monetary policy helped contain domestic expansion. The central bank, which is guided by a framework targeting inflation, became independent in 2001, and it has raised interest rates from 5.3% in 2003 to 15.55 in 2008 just months before the crises. The central bank lost control of the supply of money when the Iceland banks resulted in using the wholesale funds to finance the expansion and charging the customers the foreign interest rates on loans. However, the central bank placed no effort in solving the liquidity crises that cause crises. The monetary policy deficiencies were evident when the exchange rate linked loans that had foreign rates of interest were visible; this weakness resulted in the central bank raising the interest prior to the crises to try to curb the pressures from the domestic demand. According to Sibert & Buiter, 2011, to respond to the rising and falling exchange rates, the central bank raised the interest rates to counter depreciation and not lowering them to counter appreciations. The monetary policy interest rates were emasculated because most of the country’s domestic currency lending of the credit system was linked to the CPI. The half of non-exchange linked loans, domestic currency loan s of the depository monetary banks and mortgages were linked to the CPI; this meant that the interest rate for the policy was not viable.

Effects of the Crises

           According to Thorhallsson & Kirby, 2012, following the collapse of the three biggest banks that had 85% of the financial sector, their assets were 10 times the country’s GDP; the effects were disastrous. The country’s GDP decreased by 6.8%, and this had never been witnessed since the measurement was put into place in 1948, and the country’s debt rose to 96% of the GDP in 2020 from 28% of the GDP in 2007. The state, which was almost to achieve full employment, plummeted into unprecedented unemployment, and the real wages decreased with 8% in 2008 and 10%in 2009. Unfortunately, the debt burden on firms and households that had borrowed in foreign currency increased as the currency depreciated; this currency depreciation also increased inflation. The imported goods prices increased with that of food prices increased by 40%. The country also experienced tense relations with other countries; the United Kingdom demanded that the Iceland government reimburse its citizens in full by trying to seize the bank’s assets had been held in Britain by relying on the anti-terrorist rules.

           In addition, most of the country’s businesses declared bankruptcy, while the Iceland citizens who had borrowed from the international marker were immersed into debt. The government that had hardly been in office for a year was broken after the coalition failed. Other elections were conducted after the protest by the people who were frustrated by the sinking economy.

Policy response

           Some policies to revert the effects of the crises were suggested. One scholar suggested that it would have been advantageous for Iceland if they had joined the euro. The reason is that by being a member of the Eurozone, this would have increased the trade with the rest of the members, increasing the economic gains from trade, this would have reduced the domestic rates of interests (Thorhallsson & Kirby, 2012). Additionally, the capital intensity of production and labor productivity would have been increased. When the IMF was called, it offered a loan of $2.1 billion to stabilize the currency, and it supported the decision by the government of not transferring the bank liability to the taxpayers by allowing the banks to bust and supported the capital controls suggested by the government. Also, it is supported the Dutch and British governments’ requirement that Iceland should honor its obligations and repay them for the bailout.

However, Iceland, in various cases, encountered problems while trying to handle the crises. While attempting to seek external financial help, but it received some resistance, the EU declined the request by Iceland to provide a framework to settle the disputes. Also, the United Kingdom tried to enact its legislation on terrorism to try to seize the Iceland bank assets in Britain to settle and payback the citizens who had invested in the bank. The International Monetary Fund(IMF) was not able to offer its help until after a year since part of the rescue package fund was the Nordic loans, and they refused to lend it to Iceland until the Ice-save issue had been resolved with Netherlands and Britain. Unfortunately, after a year, the IMF was unable to help since the Ice-save had been referred to a popular referendum by the president; it was rejected even after a new deal was enacted (Thorhallsson & Kirby, 2012).

Resolving the Crises

           To resolve the crises that were taking a toll on the Iceland economy, various factors facilitated the shifting; the flexibility of the exchange rate shifted the demand to domestic production from imports, which boosted the exports. Also, the losses that had been witnessed during the surge because of competitiveness helped reverse the depreciation of the currency. The labor market flexibility helped in the real exchange rate adjustment despite its supply shocks not being correlated with those from the euro area (Thorhallsson & Kirby, 2012). Additionally, on October 6, 2008, an Emergency Act was put into action. The act required the Financial Supervisory Authority to break up the three large commercial banks to two separate entities, an old bank for international activities and a new bank to cater for all domestic financial activities (Guðmundsson, 2016). The act also stated that bank deposits were going to be given a priority over any other bank claims, and the government issues a pledge that provided all bank deposits with a guarantee; this helped prevent any panic in the financial market. To make sure the new banks could cope with any economic issues, they were recapitalized with high capital ratios. The loan portfolios that had been moved to the new banks had been revalued on fair value so that if the recovery period took longer, there was a safety margin. Banking activity, too, was focused on repairing the balance sheet and restructuring the debts. Secondly, capital controls were introduced in November 2008, and all capital account transactions were abolished to avoid any financial assets that were being held by foreign investors from exiting the market. The control imposed had also received support from the IMF, which Iceland had entered with in the Stand-By Arrangement.

           According to Guðmundsson, 2016, results from the measures that were put into place past the crises are evident. While the restructuring initiative has lowered the household debt, it has been slower in the household sector because of the household lending with non-bank financial institutions and loan composition differences. The profitability of banks has continued to be strong, which is contrary to the expectations. The shift from imports to domestic production has facilitated the export growth, which explains the 7% fall in GDP, and the unemployment that rose with an 8% after crises with the construction and import service sectors being affected has declined. A shift in the relative prices had been witnessed and was attributed to the Iceland currency devaluation during the crisis and the increases revenues from exports resulting from the increased tourism industry. The capital controls that were enacted after the crises still remain where the financial transactions across borders are prohibited; this has raised concern that the financial capital locked may result in asset bubbles.

           Additionally, the Ice save debt that had led to IMF holding its loan after the crises is bo longer an issue today. After the bill presented by the British and Dutch governments being rejected twice and even required a new constitution but the Supreme Court Invalidated the decision. The Ice cave case was then forwarded to the EFTA Courts, but luckily, Iceland has continually recovered its assets that, when sold, will almost cover the whole principal (Wade & Sigurgeirsdottir, 2012).

Lessons Learnt from the Crises

           The Iceland crises, while it affected the country, the results were not as disastrous since the devaluation of the currency gave the country some advantages; despite the effects of the crises they are still some lessons that can be learned from the crises. First is that any losses made in the financial sector are a past mistake, and a bad investment made possible hence should be exposed for future ramifications. In the Iceland case, if they had approached and addressed the crisis as required by the IMF in the 2006 report, the crises could have been avoided. Secondly, some adjustments are made possible by currency depreciation, while others are only achieved by price adjustments; this was witnessed with the Iceland currency that ensured the country recovered quickly. Lastly, some policies, while being put into place to control the capital flows they also have effects; in our case, the capital controls put by Iceland have cost the country 1% of the GDP, and they will still be in effect for the next three years.

Conclusion

           Iceland’s economy before the crises was in a boom period, with the country almost achieving full employment. Unfortunately, the greed of a few people and lack of experience plunged the country in a crisis that, while they are trying to recover from its effects, will forever be felt. While the county seems to be recovering from the aftermath of the crises, it is unfortunate that if they had adhered to the IMF report, the crises could not have seen the light of the dead. Luckily, for the country, the depreciation of the currency gave them an advantage and have aided its recovery, also while the control imposed are affecting the GDP, they helped to increase export revenues by focusing on domestic production after abolishing imports. The crises that happened in Iceland can be referenced by all countries while setting the financial sector crises since the stem of the problem in Iceland was the lack of liquidity, which is regulated by the set rules and can be avoided if measures are put to place.

References

Guðmundsson, B. (2016). Financialisation and financial crisis in Iceland. European Journal Of Economics And Economic Policies: Intervention, 13(3), 292-322. https://doi.org/10.4337/ejeep.2016.03.05Sibert, A., & Buiter, W. (2011). The Icelandic banking crisis and what to do about it: The lender of last resort theory of optimal currency areas [Ebook] (pp. 4-42). Palgrave Macmillan. Retrieved April 5 2020, from https://notendur.hi.is/ajonsson/kennsla2008/iceland%5B1%5D.pdf.

Sigurjonsson, T., & Mixa, M. (2011). Learning from the “worst behaved”: Iceland’s financial crisis and the Nordic comparison. Thunderbird International Business Review, 53(2), 209-223. https://doi.org/10.1002/tie.20402Sigurthorsson, D. (2012). The Icelandic Banking Crisis: A Reason to Rethink CSR?. Journal Of Business Ethics, 111(2), 147-156. https://doi.org/10.1007/s10551-012-1207-8

Thorhallsson, B., & Kirby, P. (2012). Financial Crises in Iceland and Ireland: Does European Union and Euro Membership Matter?. JCMS: Journal Of Common Market Studies, 50(5), 801-818. https://doi.org/10.1111/j.1468-5965.2012.02258.x Wade, R., & Sigurgeirsdottir, S. (2012). Iceland’s rise, fall, stabilisation and beyond. Cambridge Journal Of Economics, 36(1), 127-144. https://doi.org/10.1093/cje/ber038