Government failures in iceland entranced by banking

Historical background

Traditionally, the Icelandic economy was more regulated and politicised than economies generally in most other Western countries. Economic management was more predicated on discretion than rules, with tight connections between private sector firms and political parties. The bank operating system was politicised with usage of capital predicated on nepotism and political connections.

Government control over the economy has reduced as time passes, with key events being the joining of the European Free Trade Association and the European Economic Area in the first 1990s. The latter meant that Iceland got extensive usage of European markets and adopted European regulations.

Iceland did however retain somewhat its discretionary method of economic management, and its own key institutions, in a way that the Central Bank and the financial regulator remained weaker than generally in most of its European counterparts.

Betting on banking

The Icelanders decided a couple of years ago that their economic future lay in banking and privatised and deregulated their bank operating system. The banks passed in to the hands of people with little connection with modern banking, while supervision remained weak.

The role models were no problem finding, other small countries, such as for example Luxembourg and Switzerland did quite nicely out of banking. What the Icelanders forgot was that those countries have centuries worth of experience running banks and the associated infrastructure, while Iceland has significantly less than a decade.

The banks passed in to the hands of people with extensive business interests. The effect was something of cross holdings, with liquidity needs being met within the group. The banks retained tight connections to the political superstructure.

The banks, with strong government support, proceeded to benefit from ample capital in international markets to fuel high examples of leverage and exponential growth, eventually growing 10 fold in only over four years to a size around ten times the economy.

Iceland’s institutional structure lagged behind developments in the banking sector. Neither the Central Bank nor the financial regulator developed the required infrastructure, nor did they have the necessary independence and backup from the authorities to fulfil their duties adequately. That is manifested by the actual fact that as the assets of the bank operating system grew 900% as a fraction of GDP from 2003 to 2007, contributions to the financial regulator only grew by 47%.

It really is now clear that the federal government at that time committed a classic mistake in deregulation, allowing the financial sector to attempt high-risk activities without adequate regulatory structure.

The hedge fund in the North Atlantic

The growth in the bank operating system affected the complete economy, with many firms and even households adopting their business design of extreme leverage driving asset acquisitions.
The united states made a decision to stake its economic future on international banking, challenging inherent risks ignored. It didn’t have institutional structure to adequately supervise the bank operating system nor develop the opportunity to provide lending of final resort services.

Iceland was in place converted into a hedge fund sitting in the center of the North Atlantic. It isn’t just like the country was poor and needed risky activities to grow. Iceland had been an affluent economy and had reached the income per capita degrees of Germany, France and the united kingdom in year 2000 prior to the banking sector expanded.

Unstable bank operating system

The three main Icelandic banks were tightly interconnected. They did business with lots of the same firms, were all dependent to a varying extent on a single macroeconomy, and where perceived by international capital markets to be highly related.

A difficulty in a single bank directly affected confidence in the other banks, affecting usage of liquidity, as well as perhaps triggering bank runs. The three banks accounted for approximately 85% of Iceland’s economic climate and there was without doubt that their failure could have catastrophic effects for the Icelandic economy.

Eventually, their hubris swept up with them. The banks started having troubles borrowing in wholesale markets, and decided that checking high interest savings accounts in the united kingdom and elsewhere in Europe was an excellent idea. The Icelandic banks, with government permission, used European savers to supply the liquidity they cannot obtain from the better-informed bank operating system.

Unheeded warnings

There have been ample warnings that something was amiss. Furthermore to papers and interviews with local economists, an all natural starting point is a crucial report from the Danske bank 2006 . Aliber in-may 2008 described Iceland’s banking expansion as the utmost rapid in the annals of banking, and predicted the banks’ imminent demise. Buiter and Sibert 2008 centered on the banks’ liquidity problems due to the lack of a credible lender of final resort.

In comparison, official reports were more favourable. The financial stability report of the Central Bank of Iceland in (April, 2008) indicated that the economy was in an excellent state.
The Icelandic Chamber of Commerce commissioned two reports, combining local economists with international celebrities to create reports that painted the Icelandic economy and its own bank operating system in favourable terms, see Herbertsson and Mishkin (2006) and Baldursson and Porters (2007). While documenting the strengths of the Icelandic economy was an advisable task and essential for the maintenance of confidence in its bank operating system, such reports may have blinded policy makers to the coming storm.

Regulatory capture

The instability of the bank operating system seems to have caused little concerns from the authorities. Why it is the case is unclear. In the end, both financial regulator and the Central Bank had or must have had ample information on the stability of the banks in addition to the legal ability and obligation to avoid destabilising banking.

The very best explanation is apparently regulatory capture. This went so far as the financial regulator even taking part in the Landsbanki’s marketing of internet accounts in holland just a few months before its collapse when it will have already been clear that the lender was more likely to fail.

If banks are too large to save lots of, failure is a self-fulfilling prophecy

In this global crisis, the effectiveness of a bank’s balance sheet is of little consequence. What counts may be the explicit or implicit guarantee supplied by the state to the banks to back up their assets and offer liquidity. Therefore, how big is the state in accordance with how big is the banks becomes an essential factor. If the banks become too large to save lots of, their failure becomes a self-fulfilling prophecy.

The reason why for the failure of the Icelandic banks are in lots of ways like the difficulties experienced by many finance institutions globally, like the seemingly unlimited usage of cheap capital, excessive risk-taking, and lax standards of risk management.

The key difference is scale. Even though many countries have their share of troubled banks, in those cases the issues are confined to only a segment of their bank operating system, in economies were the entire assets of the banks are much smaller in accordance with GDP. In those countries the federal government has adequate resources to support the fallout from individual bank failures.

Ultimately therefore that the blame for bank failures lies in the home instead of internationally. We suspect that even if the world hadn’t entered right into a serious financial meltdown, the Icelandic banks could have failed.

Government’s response – gambling for resurrection

Given the ample warnings the federal government had of the pending difficulties in the bank operating system its apparent insufficient concern is surprising. Surely the regulator and the Central Bank knew that which was happening.

The only public information we’ve gets the Central Bank and the financial regulator blaming one another, with the federal government claiming not to have already been informed, and blaming the global economy. We usually do not find his convincing. Such a catastrophic pending failure needed been discussed by the complete Cabinet.

We therefore cannot escape the sensation that the board and directors of the Central Bank and the financial services authority, along with senior officials there knew that which was happening. Similarly, all government ministers, along with senior bureaucrats in the ministries of finance, commerce, foreign affairs, and office of the prime minister needed known.

Still the federal government failed to act. It might have at any point taken decisions that could have alleviated the eventual outcome. If the federal government had acted prudently the economy could have been left in a far greater shape.

By not addressing the pending failure of the bank operating system, perhaps in the hope that the instability would disappear, we can not escape the sensation that the Icelandic authorities gambled for resurrection, and failed.

Weaknesses in European banking regulations

Iceland’s collapse also exposes fault lines in the EEA/EU method of banking supervision. Regulations are Europe wide, with supervision in the hands of the house regulator, that may be problematic regarding cross-border banking if the host supervisor doesn’t have the required information and responsibilities or will not cooperate adequately with the house supervisor.

Within the EU/EEA regulations are mostly pan-European, but supervision (enforcement) is national. This might result in problems where authorities in a single country see that other countries have the same regulations, and implicitly assume supervision may be the same. Politically it really is (currently) impossible to implement Europe wide supervision.

Among issues that may arise may be the high interest savings accounts, Icesave, setup across Europe by Landsbanki, when it had been struggling obtaining funds in wholesale markets. According to EU laws, the house regulator manages supervision and will be offering deposit insurance of at least €20,887, however the host supervisor may offer more, as may be the case in the united kingdom.

After the operate on Northern Rock, the united kingdom government announced that no individual UK deposit holder would lose cash regarding bankruptcy. At the minimum, this provided an implicit guarantee to Icesave depositors. In cases like this it would have already been essential that the united kingdom FSA also exercised supervisory duties. It really is unclear from what extent this is done.
Furthermore, in the EU/EEA, deposit insurance is supplied by a national insurance fund payed for by banks. It really is unclear what is likely to happen if the national insurance fund isn’t sufficient.

The authorisation of the opening of cross-border savings accounts of the magnitude and threat of Icesave represents a significant failure in the decision-making process by the supervisors in Iceland and the host countries, the united kingdom and holland and/or in EU/EEA regulations.

The supervisors in every three countries must have recognised the dangers and acted to avoid the rapid expansion of Icesave. Ultimately supervision failed. The idea a country of 300,000 inhabitants could assume the duty of providing deposit insurance of the magnitude of Icesave is absurd.

We suspect this also casts light on another failure of cross-border banking supervision in Europe. Host supervisors generally only observed the area of the banks operating within their country, not the entire picture. A number of the Icelandic banks had extensive operations of varied types both within Europe and outside.

Unless a person national supervisor includes a clear picture of these operations it really is difficult to exercise adequate supervision. The Icelandic regulator might have been the only supervisor that had the entire picture. If so, the only supervisor who had the required information failed.

Conclusion

The Icelandic economy crashed as the economic climate was deregulated and privatised without adequate supervision; there is insufficient institutional knowledge, both within the bank operating system and within the federal government on how best to run and regulate today’s banking system; and the federal government didn’t recognise the systemic threat of having such a big banking system.

Ultimately, when the banks were at risk of failure the government chosen gambling for resurrection instead of closing the banks down. The government’s gamble failed and Iceland as a result suffered a systemic crisis.

Bibliography

Aliber, Robert (2008), “Monetary turbulence and the Icelandic economy”, lecture, University of Iceland, 5 May 2008 .
Baldursson and Porters (2007), “The Internationalisation of Iceland’s Financial Sector,” The Iceland Chamber of Commerce.
Danielsson, Jon (2008), “The first casualty of the crisis: Iceland,” VoxEU, 12 November.
Danielsson, Jon and Gylfi Zoega (2009) “The collapse of a country”, www.RiskResearch.org.
Danske Bank (2006), titled “Iceland: Geyser Crisis”.
Central Bank of Iceland (2008), Financial stability report, 25 April
Herbertsson, Tryggvi and Frederic S. Mishkin (2006), “Financial Stability in Iceland,”
Zoega, Gylfi (2008), “Icelandic turbulence: A spending spree ends,” VoxEU, 9 April.
Zoega, Gylfi (2008), “Iceland faces the music,” VoxEU, 27 November.

1 The writer of the report comments onto it in the FT on October 8th 2008, “Consequently I had to visit Reykjavik in the past and got a fairly hot reception. The Prime Minister publicly denounced our research piece, and banks issued denials. … Essentially two years ago each one of these problems were on view. Yet Icelandic authorities have not acted and the banks weren’t reined in (enough).”

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