Introduction
Situated between the North Atlantic and Arctic Ocean, Iceland is one of the Nordic countries falling into the European continent. The population of the country is 321,000 and the total area of the country is 40,000 sq. mile. Iceland is the least densely populated country in Europe. The capital city of Iceland is Reykjavik which is also the north most capital city in the world. In 2008 when a global financial meltdown started in US after the bankruptcy of Lehman Brothers, Icelandic economy was hurt badly by the crisis. This resulted in the whole banking sector of Iceland going bankrupt. This financial crisis also created lot of political unrest. If we compare the % of financial impact the nations have gone through compared to their GDP’s the Iceland’s financial crisis was the worst in the history. This essay will discuss about the banking sector of Iceland before the crisis, how the financial crisis happened, what the reasons of crisis were and what measures were taken to bring the economy back to normal.
Icelandic Banks before the Crisis
Iceland is an open economy and in 2001 Icelandic banking sector was deregulated (O'brien 2013). This opened a door for the Icelandic banks to go outside Iceland for business and growth. The main three banks at that time in Iceland were Glitnir, Landsbanki and Kaupthing. Kaupthing was the largest among the three banks. Icelandic economy was considered to be a stable economy and the GDP growth rate of Iceland was one of the highest in Europe at that time. The main contributor to the GDP for Iceland was fishing. The average GDP growth was near 4-5%. After the banking sector was deregulated, private banks went outside the country to improve its business. Private Banks like Glitnir, Lansbanki and Kaupthing first started expanding into other Nordic countries (O'brien 2013). The branches of those banks in other Nordic countries like Norway, Sweden started offering higher rates for deposit than any other bank. As the Iceland economy was stable many people started putting their money into Icelandic banks for better savings account rate. In second phase the banks also started expanding their operation into UK, Netherlands, Luxemburg, Germany and Switzerland. Landsbanki opened a separate entity called Icesave in UK and Netherlands offering a special rate to the depositors (Finkle 2013). This further improved the financial base of the banks. Furthermore, this increased the monetary base of Iceland exponentially causing the inflation to go high. Inflation rate went above 10% by 2006. The Central Bank was forced to increase the lending rate. This allowed the private banks to offer even higher rates to its customers. However, the amount of deposits the Icelandic banks were getting became unmanageable. The volume of money the banks were receiving could not be backed by Iceland Central Bank as the amount was much higher than the whole Icelandic economy. The banks started defaulting on payments starting 2007 and in the subsequent months it became even worse.
The Banking Crisis of Iceland
After the failure of Lehman Brothers in early 2008, it was clear that Icelandic banks were under distress. The branches of Icelandic banks in UK and Netherland saw many people withdrawing their money from the banks making matters worse for the banks. These banks were then forced to announce a freeze on many of their overseas branches. In later part of September, 2008 Glitnir was the first bank to have announced bankruptcy and it was taken under receiving. Financial Supervisory Authority handed over the bank’s assets to the receivers. On 7th October, 2008 Landsbanki was also handed over to the receivers for the liquidation and deposit payment process. Only 2 days later the biggest bank of Iceland, Kaupthing announced bankruptcy and FME announced receivership for Kaupthing as well. The debt amount for those three banks was about €50 billion, almost 6 times the value of the GDP of Iceland which was €8.5 billion at that time (O'brien 2013). The assets which came under receiving were more than 11 times the size of the Icelandic GDP of 2007. The debt was so mammoth that everyone thought that Iceland as a nation would go bankrupt. In such scenarios the last resort is the central banks. However, the central banks capacity was so small compared to the total debt that it was impossible for the banks to repay the debt without serious currency devaluation. The first step that was taken by the Icelandic government was to create three separate domestic entities of the existing banks Glitnir, Lansbanki and Kaupthing and nationalize those banks. Additionally, the government decided to use the existing assets to pay the savings On the other hand, after protecting the payments of the Icelanders, the government left the remaining of the banks in the hands of receivers for foreign investors and depositors. This created a political stir in the Eurozone. As UK was the main investor outside Iceland along with Netherlands in Icesave and Icelandic bonds, they felt cheated. In fact UK filed a lawsuit against the Icesave as per the anti-terrorist law. This created a political unrest between the two countries resulting in the resignation of Prime Minister Geir Haarde in January, 2008 (O'brien 2013). The next Left-Green government came under pressure from the Eurozone and finally said that they would try to repay some of the depositors based on priority. Based on that promise, International Monetary fund gave a loan of $2 billion to Iceland as a recovery loan to boost the economy. Germany also provided a loan of $1 billion to Iceland. However, a loan of $4 billion was offered by UK and Netherlands to Iceland mainly with the clause that the foreign depositors would be paid back their money as soon as possible but this loan was never accepted by the Icelandic government. Iceland economy started coming back to normal from early 2010. The currency was devaluated by over 50% from what it was back in 2007 and the inflation rate was still high in 2010 (Bloomberg 2012). Iceland still continues to enforce strict capital controls to bring back the economy to its hey days. However, foreign investors have lost confidence in Iceland and it will take time before Iceland regains the confidence of foreign investors.
Causes of Banking Crisis
There are several reasons why the banking crisis happened in Iceland. Since 2001, Iceland banking sector was made open by the government. Within a span of 8 years Icelandic stock market rose 900% and its banking sector expanded into overseas locations (Bloomberg 2012). Because of the expansion of the banks and the stock market doing very well, a slew of foreign investors showed interest in Icelandic economy. They started investing into Icelandic companies, especially into Icelandic banks. The banks were promising rates much higher than the Eurozone banks. It made perfect business sense for the investors to invest the money in a place where the return on investment was higher. This soon created a lot of wealth for Icelanders. Many Icelanders became so rich that they even started acquiring companies like Woolworths, West Ham United outside Iceland. Even ordinary investors were enthusiastic about the economic growth and they started investing their savings into complex and sophisticated financial instruments like foreign currency denominated loans and mortgages. These types of financial instruments were even not available in some of the Eurozone countries. These loans were marked to the interest rate differential between Iceland and other countries to incentivize borrowing. This is generally not a problem for a big economy and often this marks a long term financial growth. However, because of the small size of the country bankers and the regulators of the Iceland economy were a close knit group. In fact during the growth years the post of both Prime Minister and Central Bank Chairman were held by David Oddsson (Lynam 2013). This type of situation is ideal for corrupt and biased financial practices. Although the level of corruption that happened was never established but no action was taken from the Central Bank when the total foreign denominated debt for the three largest banks, Kaupthing, Lansbanki and Glitner, grew more than eight times than the gross domestic product of the country. The domestic business for the banks was far smaller than the foreign bases of the banks. Because of this repaid growth between 2003 and 2007 these banks acquired an impressive amount of deposits but they could not invest that money into quality loans which would give secure returns. In fact during that time due to rapid growth the quality of loans received a hit, making the banks more susceptible to the risk of a loan default. Till 2004, the majority of the borrowers were from the Icelandic household market. However, between 2006-2007 majority of the borrowers were foreign investors. Almost, 40% of the total borrowings were by the foreign investors. However, beginning 2007 a good many banks in US and Europe were facing the liquidity crunch and that forced some of the investors to direct their investment towards Icelandic banks. In fact, the amount of foreign deposits skyrocketed between 2007 and 2008 in the banks. Between the end of 2007 and early 2008 the deposit grew by 120% (Bowers 2013). The Krona was seeing depreciation steadily due to high inflation and after the collapse of Lehman brothers in September, 2008 the three giant Icelandic banks were unable to repay the short term loans as lot of leans started defaulting. To increase the liquidity of the banks in Iceland, Kaupthing, Lansbanki and Glitner planned to take out money from its foreign subsidiaries but at the same time UK passed an anti-terrorism legislation and froze all assets of the Iceland banks. UK legislation cited that it was trying to protect the deposits of its 300,000 customers of Icelandic banks. At the same time offshore accounts of some Icelandic banks were also frozen in Luxemburg, Switzerland and Norway. This created huge cash starved situation for the Icelandic banks forcing the banks to go to the government and declare bankruptcy.
Secondly, while all these were happening the inflation was on a rise and the Krona was on a free fall, the Central Bank of Iceland did nothing to mend the situation. It was so engrossed in the economic boom of Iceland that it totally ignored that the financial burden on the economy was growing beyond control. In fact the Central Bank actually kept the lending rate high during 2008 to encourage investment. The lending rate was kept at 18% even during 2008 to attract investments (Lynam 2013). If the Central Bank would have realized the problem early and kept the rates low then the investment in Icelandic banks would have been much less and perhaps the problem could have been avoided.
Measures Taken
We can say that the Icelandic economy is on its recovery. It was not an easy journey. Starting 2008 fourth quarter, Iceland has seen 10 straight quarters of declining GDP followed by 8 straight quarters of steady GDP growth (Lynam 2013). There are natural ingredients in the soil of Iceland which have made the Icelanders tough from within. However, to get out of a bad financial crisis being tough is not enough. Iceland needed to take some critical decisions to come out of the crisis. There was lot of problems surfacing in October, 2008 for the Iceland government. First of all, the banks had a huge credit crunch. Secondly, European nations like Netherlands and UK had frozen all assets of Icelandic banks. Thirdly, the whole world was seeing a deep financial crisis so there were not many countries which could help Iceland. Finally, the Icelandic people were facing the fear of losing their savings which they have invested in Kaupthing, Lansbanki and Glitner.
The first thing to have been done by the Icelandic government immediately after the banking crisis was to nationalize the banking sector and make them totally domestic so that the banking system for Icelandic families and businesses did not get affected by the crisis. NBI was set up as a nationalized entity from Landsbanki. Nyi Glitner was set up as a nationalized bank from Glitner and Nyja Kaupthing was also created as a nationalized bank (Bloomberg 2012). The assets of all those banks were used for domestic banking purpose and were used to pay the Icelandic depositors and creditors after the crisis. Foreign Investors and depositors were given less priority and were put under liquidation and receiving. This move shrunk the banking system of Iceland to a very small size but manageable by the Central Bank of Iceland.
Secondly, the government stopped all foreign currency related deals. Exporters needed to inform the Central Bank before involving in any foreign currency related deals and transactions (Lynam 2013). The Central Bank of Iceland offered exchange rates between Krona and Euro during 2008 and 2009. However, slowly it opened the economy for export and Krona currency dealing. Once the domestic situation and businesses stabilized Iceland government again opened the economy partially for foreign trade and export. This move made Krona less volatile in the currency market since 2010.
Thirdly, the government of Iceland saw that a lot of Icelanders have taken foreign currency backed mortgage loans for their houses. Krona was steady against Euro before the crisis but after the crisis and due to high level of inflation Krona depreciated so massively that some of the repayments of houses almost doubled. Some people who had taken index backed loans suffered badly when the index crashed (Bloomberg 2012). Therefore, the Icelandic government relaxed the housing loan rate and provided some incentives so that the house owners could get relieved of the financial burden.
Iceland government was also seeing a huge gap in revenue and expenditure. To bridge that gap it took some harsh austerity measures. The tax rate was hiked to cover up some of the expenses. Iceland government also made massive cuts in its budgets (Lynam 2013). The government of Iceland was pressed hard by the foreign investors in the Icelandic banks to repay their investment after the liquidation of those banks. In fact, the government of United Kingdom demanded almost $4 billion repayment from the Icesave accounts (Finkle 2013). The Prime Minister of Iceland on several occasions was forced by the international bodies to sign contract that Iceland would repay the amount but he refused the payment. This strategy of refusal ultimately helped the domestic economy of Iceland to come back to normal state within 3-4 years of the crisis. Now that Iceland economy is showing steady growth rate, Iceland government has started the process of payment to the foreign customers. Among the three banks Landsbanki banks customers with priority claims are being paid in 2013 (Lynam 2013).
Alternative Measures that Could Have Been Taken
The common tactics when a big financial institution goes down is to provide support. In many countries we have seen that when the financial institutions go into financial crisis, the governments of those countries provide support to the companies so that they can bounce back. Governments generally provide support to financial institutions as hard earned savings of lot of ordinary people are at stake (Clinch 2013). For example, when Royal Bank of Scotland (RBS) showed signs of financial distress, the UK government provided financial aid to RBS which gave them short term support helping RBS turn its operation around quickly. Similarly the US government provided aid to the Bank of America during the time of financial distress. Iceland could have done the same. However, it was impossible for the Iceland Central Bank to provide the money needed by the Iceland banks. The total debts of those banks were $50 billion, almost 8 times more than the GDP (Bowers 2013). Iceland also refused the help from UK and Netherlands. If they would have accepted the loans offered by those countries then probably Kaupthing, Lansbanki and Glitner could have survived. In that case the large number of foreign investors who suffered probably would have got something back from their investments. It is highly debatable which action was better for whom but certainly there were few other options.
Conclusion
Iceland is a big island between North Atlantic and Arctic Ocean. The country has a small population. Iceland has seen one of the worst financial crises of our generation between 2008 and 2011. Kaupthing, Lansbanki and Glitner were the three biggest banks of Iceland. Before the 2008 crisis these three banks expanded their operation beyond the boundaries of Iceland. With the help of a booming economy, high inflation rate and high lending rate of the Central Bank, these three banks started offering savings account rates which were highest in the Eurozone and among the Nordic countries. This helped attract many investors and soon a banking boom followed in Iceland. Banks started getting huge investment from foreign investors. Especially the biggest foreign investor base came from United Kingdom and Netherlands. In 2008, after Lehman Brothers collapsed, all three Iceland banks went to receiving. Iceland government immediately created domestic nationalized banks from the domestic assets of those three banks to protect the investments of the Icelanders. The Icelandic government put the foreign investors’ payments in receiving. Through measures like capital controls, IMF bailout package and austerity measures Iceland is able to come out of the crisis. Iceland is showing signs of recovery from 2011 onwards. The economy is growing at a healthy rate of 5.5% for the last 3 years. Hopefully the worst crisis for Iceland is over and the country will only see better days in future.
Work Cited
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