Iceland offers lessons for small countries and financial centres
By Ásgeir Jónsson
The Icelandic financial crisis was very similar to the Asian crisis of 1998, or at least the part concerning the currency crisis. On both occasions you had countries that were initially favoured by international investors and received very large sums of foreign investment, which to a large extent was short-term carry trade position. Then when the international liquidity crisis began, foreign capital took flight. In 2008, the Icelandic krona (ISK) lost 50% of its value before capital controls were enacted in October of 2008.
In a way, the Icelandic crisis of 2008 and the Asian crisis of 1998 are the classical cases of economic reforms leading to both boom and bust, as the ready availability of cheap foreign credit created a boom in consumer spending and in the real estate sectors that eventually proved unsustainable. However, the banking aspect of the Icelandic crisis is in many ways unique and offers lessons regarding the risk involved in regional financial integration, the hazards of cross border banking and the fragility of financial centres that are not supported by big currencies or large taxation power of a national state.
In 1994 Iceland, a nation of 300,000 inhabitants, became part of the European common market. Successful economic reforms, political stability and the prudent use of natural resources then landed the country a AAA rating in 2003. The high credit rating and open access to the European financial markets gave the Icelandic financial sector a market lead that gave rise to a very large growth in international banking. By 2007 Iceland seemed on its way to become an international financial centre with banking assets totalling 10 times GDP.
However, even though a part of the European common market, Iceland was not a part of the European political framework, neither with the European Union itself nor through a currency union with the Euro. Its banks operated internationally and were funded by foreign currencies, which meant that the Central Bank of Iceland could not serve as a lender of last resort for the Icelandic banking system since printing more kronur would be of little or no use for banks that needed hard currency; in fact, money printing on the behalf of the central bank would just create a currency crisis as people would want to convert their ISK holdings into foreign currencies. Moreover, the small Icelandic state did not have the taxing power to stage a bailout of its oversized banking system the way that the US or UK did.
Since Iceland was not a member of the EU, it was not included in any European political safety net and did not have access to a credit line from Europe. After the collapse of Lehman Brothers in September 2008 and the ensuing money market meltdown on both sides of the Atlantic, investors at home and abroad suddenly lost confidence in the Icelandic financial sector, which was wiped out in just one week in one colossal bank run.
The situation was made worse by the fact the British government, out of fear that money would be transferred out of the UK to Iceland, invoked anti-terrorist legislation against Icelandic banks to freeze their assets. Thus the Icelandic Central Bank popped on the governmental list of terrorist threats along with Al Qaeda and North Korea, destroying the Icelandic system of payments in and out of the country. In just one week about 95% of Iceland’s financial system collapsed.
The situation has taught us several things:
1) There is a saying that “international banks are international in life, but in death they become domestic”. Financial centres have to be supported by either a strong currency or a large state. Iceland was in many ways an extreme case; nevertheless, even a traditionally strong centre such as Switzerland is now facing problems supporting its financial system since the country is also relatively small compared with the banks that are headquartered there. The sensible approach for small countries is to do like Luxembourg: invite foreign banks to operate in the country but forbid any international bank from having its headquarters there. Thus it is clear that the state does not have the obligation to bail out an over-sized banking system.
2) Systematic risk is always underestimated. Iceland’s three banks were each considered too big to fail and thus were assumed to have an implicit state guarantee, thereby giving them the same credit rating as the Icelandic state. This analysis assumed that in a crisis situation, perhaps only one bank would fail; but, of course, in the financial crisis all three got into trouble, creating a situation that was just too much for the state. In general, every state has to think very carefully of not letting any bank reaching the size of becoming too-big-to-fail.
3) Financial integration without some kind of political framework of cooperation concerning lending of last resort and bank bailouts is very hazardous. The resolution of financial crisis is always a political task, and as banks get more international the need for cross-border cooperation increases.
4) Bank regulation should focus much more on liquidity and currency risk.
Ásgeir Jónsson is the chief economist of Iceland’s Arion Bank and the author of Why Iceland? How one of the World’s Smallest Countries Became the Meltdown’s Biggest Casualty.
