Chapter 6
The Reincarnation of Iceland’s Banks
When Iceland’s authorities seized the country’s three main banks in October 2008, they struggled at first to keep things running. The banks’ creditors, depositors, banks in other countries, clearing agencies—everybody panicked. They didn’t know what it meant for a country’s whole banking system to collapse (the three accounted for 87 percent of the nation’s financial assets). “Nobody wanted to work with an Icelandic bank,” says one of the bank executives appointed by the authorities after the takeover. The overseas assets of the banks were frozen in several countries, the United Kingdom going as far as using antiterrorist laws to do so. Even though the Icelandic government had issued a guarantee on domestic deposits, people flocked to ATMs to withdraw money. Arni Tomasson, who was asked to oversee one of the banks, remembers how he scrambled to find cash to fill up the ATMs after a rash of withdrawals spurred by a delayed public announcement on the banks’ situation. “We were all trying to make sure life could go on as normal, that people could use their credit cards, get their salaries, companies could transfer money,” Tomasson says.
Despite all the difficulties and panic, Tomasson and others managed to keep the banks functioning. And within two weeks, the government announced it was setting up new banks with clean balance sheets, leaving the troubled assets and losses with the old banks. Resolution committees would sift through those and deal with the claims of the creditors while the new banks could move on with their regular business.
The panic about Iceland’s banks, whose assets had grown to 11 times the national economy, started at the same time as Ireland’s lenders. After Lehman Brothers’ bankruptcy on September 15, both countries’ banks ran into funding problems because they had overreached, and the world knew that. On September 29, when the Irish government decided to guarantee all its banks’ liabilities, Iceland decided to buy a 75 percent stake in the country’s third biggest lender. However, a week later, when troubles spread to the other two banks, Iceland went exactly in the opposite direction of its oceanic neighbor 900 miles to the southeast. The government pushed through parliament an emergency law that gave it powers to seize the banks, restructure them, and guarantee only domestic deposits. So while one island’s banks were kept alive as zombies for two more years before they brought down the whole country with them, the neighboring island’s troubled banks were allowed to die. Their reincarnations emerged quickly as smaller, more focused, and cleaned-up versions of their former selves to support Iceland’s economic recovery.
To be fair, in addition to the similarities between their situations, Ireland and Iceland had several key differences that cannot be overlooked. Iceland wasn’t part of the Eurozone and had an independent currency that it could devalue when trouble struck. Even with their overgrown size, Iceland’s banking sector was about one-third the size of the Irish domestic banks (Ireland didn’t rescue the subsidiaries of foreign lenders domiciled in Dublin). Therefore, the losses faced by the creditors of the Icelandic institutions were more manageable. Yet these weren’t impediments to Ireland taking a similar path to Iceland when their banks ran into trouble. The devaluation of the Icelandic currency, the krona, didn’t solve that island’s problems overnight whereas Ireland has been cutting wages, increasing taxes, and implementing other measures that are mimicking the outcome of a devalued currency. Europe’s banks, pension funds, and insurance companies could handle the default of Irish banks just as they handled Icelandic losses. “Ireland’s banks were not too big to fail either,” says Adriaan van der Knaap, a UBS managing director who advises governments on bank restructuring.
The Land of Fire and Ice Catches Fire
Iceland is known as the land of fire and ice because some of Europe’s largest glaciers rub elbows with the continent’s largest volcanoes on the same island. Separated from the nearest land mass by the rough seas of the North Atlantic Ocean, in perpetual darkness for half the year (well, you do get a few hours of dusk in the middle of the day), and most of it uninhabited due to ice or fire, Iceland’s population lingers around 300,000, give or take a few thousand depending on that year’s migration trend. The story of how this island caught financial fire is in a lot of ways similar to its distant neighbor, Ireland: free money sloshing around the world in the early 2000s, the meteoric rise of its banks binging on that money, and a housing boom supported by the first two.
Just as the U.S. Federal Reserve started cutting interest rates after the dot-com bubble burst and the European Central Bank (ECB) followed suit, Iceland sold its majority stakes in the two largest banks in 2002. A year later, the government lowered how much down payment home buyers had to make, allowing 90 percent loan-to-value ratio in purchases. So the newly privatized banks, along with the third bank already in private hands, started feasting on the cheap loans from the German, French, and British banks to manage a sevenfold increase in their assets between 2000 and 2008 (Figure 6.1). Banking’s share of national output almost doubled to 9 percent, whereas that of fishing, the traditional backbone of Iceland’s economy, was halved to 4 percent. The profit of the number-one bank, Kaupthing, surged 100-fold to almost $1 billion. With 80 percent home ownership and 2 percent unemployment, the Icelandic people were pretty well off even before the bonanza started. They still gorged on the cheap credit, expanding the size of their homes and their cars, buying second or third homes. More homes were built from 2004 to 2008 than in the entire previous decade, while prices almost doubled.1
Figure 6.1 Iceland’s fast-growing banks dwarfed their nation. Here, annual gross domestic product is compared to the total assets of the nation’s commercial banks. 2008 data is midyear figure to show the peak before the banks’ collapse later that year.
SOURCES: Financial Supervisory Authority (Iceland), Statistics Iceland.
And yet the small island’s already wealthy population wasn’t enough to satisfy the appetites of the growing banks. So they turned overseas, making loans to property developers in England and the United States, and companies in Denmark and Norway. Kaupthing’s lending outside Iceland reached three-fourths of its loan book. So how could a small island’s internationally unknown banks grab market share from those countries’ powerful, much bigger banks? They were either lending to firms that the local banks had passed up or to Icelandic businessmen who went on a buying spree on the continent. The acquisitions abroad were at high prices and fully funded by debt, which made them riskier and easier to go sour when the global economy turned downward, according to Gunnar T. Andersen, head of the country’s banking regulator. “Excessive risk-taking, greed and ambition were always three steps ahead of capability,” says Andersen, who was appointed after the collapse. The agency he took over was underfunded and understaffed to properly supervise the incredibly fast growing financial institutions, Andersen adds.
There was also a lot of related lending, to directors of the banks and their companies. British entrepreneur Robert Tchenguiz—who indirectly owned the biggest stake in Kaupthing—and firms with ties to him accounted for a quarter of the bank’s loans. Tchenguiz and his brother were arrested briefly in March 2011 in connection with a fraud investigation the UK authorities are conducting. The Tchenguiz brothers claim they have done nothing illegal.2 The companies with weak collateral and the Icelandic consumers who overreached because of the mistaken belief they were richer as their currency appreciated were the “subprime borrowers” of Iceland’s banks, says Magnus Arni Skulason, founder of Reykjavik Economics, a consulting firm. The banks established subsidiaries in other European countries, even collected deposits from some (the United Kingdom, Netherlands, Germany) by offering higher rates to savers. Those overseas operations escaped the attention of banking supervisors on the island, Andersen says. They weren’t on the radar screens of UK or Dutch regulators either.
The Unheeded Fire Alarm
There were a few warnings in late 2005 and early 2006 about the dangerous path the country’s banks were on. David Oddsson, the longest serving prime minister of the country, became the central-bank governor in October 2005. Two months later, he relayed his concerns about the banks’ surging growth to government leaders, he says. The three banks—Kaupthing was followed closely by number-two Landsbanki Islands and number-three Glitnir—had become the largest companies in the country, created thousands of well-paying jobs, took charge of the top trade associations, and were paying the biggest chunk of the taxes, Oddsson says. “So nobody wanted to listen when the party was on,” he says. After recognizing the threat, Oddsson could build the central bank’s foreign currency reserves to prepare for a possible bailout of the lenders, but he claims to have chosen not to do so because “it would be stupid” to rescue them. Oddsson jacked up interest rates to slow down the housing and consumption frenzy fueled by the lending, but the banks got around that by making loans in foreign currency, for which they could charge less because they were borrowing it at a lower rate from German banks. Oddsson may have woken up to the dangers of the growing banks, but he wasn’t as innocent as it sounds either. As prime minister until 2004, he led the privatization of the two largest banks. A series of articles in the Frettabladid newspaper at the time reported that Oddsson and his finance minister Geir Haarde manipulated the sales process so their close supporters would get the largest stakes.3 Haarde was the prime minister Oddsson was alerting about the banks a few years later.
Another warning came from Fitch Ratings, which placed the country’s credit rating on negative watch in February 2006, followed by analyst reports raising concern on the Icelandic banks. While those increased the banks’ borrowing costs in European markets, they turned to the United States, where money was still cheap and nobody really paid attention to what was included in a collateralized debt obligation as long as it was rated high investment grade. So Icelandic bank debt was packaged into collateralized debt obligations (CDOs), sold in the United States, and gave the banks new sources of funding to continue their frenzy.4 And again, nobody heeded the warnings.
Whether Oddsson had acted intentionally or not, by the time the banks blew up, the country didn’t have the means to rescue them. The central bank didn’t have the foreign currency to back their liabilities, and not being part of the Eurozone, there was no ECB to turn to either. So when the banks couldn’t roll over their debt at the end of September 2008, the government had to let them fail. They’d gotten too big to save while other countries such as the United States and Ireland rushed to the aid of their too-big-to-fail banks. With the emergency act passed by Parliament on October 6, the government seized the three top lenders. Their assets and liabilities were split based on whether they were originated at home or abroad. The three new banks, also created by the legislation, were given the domestic deposits and loans made to Icelandic companies and consumers. Resolution committees were set up to manage and liquidate what the old banks were left with: the overseas borrowing and lending. As a result, German lenders, such as Dekabank, the asset management firm of the savings banks, were left holding the bag along with London-based hedge funds, European pension funds, and other creditors.
Devaluation No Panacea
When Iceland’s housing/banking bubble burst, the overvalued currency came tumbling down, losing 58 percent of its value in two months after the banks’ seizure. Inflation spiked to 19 percent a few months later.5 That led to a serious economic recession and a surge in unemployment. Although the devaluation of the currency made Iceland’s exports more competitive in world markets, there was too much consumer and corporate debt that was denominated in foreign currencies, so the drop in krona’s value made those balloon and led to a surge of bankruptcies. What devaluation has done in Iceland almost overnight—cut the wealth of the island’s population by half —austerity measures in the EU periphery countries are trying to do slowly through tax increases, benefit reductions, and government job cuts. Still, being swift and less politically controversial doesn’t make a currency devaluation any less painful. And it doesn’t create a sharp economic recovery just like that either. “Having an independent currency you can devalue is a double-edged sword,” says Árni Páll Árnason, Iceland’s minister of economic affairs. “Of course it helped exports but it also hurt households. Wealth is cut; purchasing power is reduced. These have hampered recovery. It’s hard to generate growth when you have excessive debt levels for households and corporations.” To cushion the krona’s drop, the government also implemented capital controls, restricting the outflow of foreign currency deposits and investments in the country. Those still haven’t been lifted completely, though they’ve been eased. That also makes foreign investors edgy about reinvesting in Iceland and the new banks less able to manage their currency risks.
Even with the 58 percent devaluation, the economic devastation in Iceland has been less harsh than in Ireland. Unemployment rose to only 8 percent, about half of Ireland’s 15 percent. While both countries’ economies contracted by about 10 percent since the crisis, the International Monetary Fund (IMF) expects Iceland to grow by 2.3 percent in 2011, but another year of stagnation is forecast in Ireland. Of course, the most striking part of the differences in the two islands’ experiences result from their opposing treatments of the failing banks. Ireland’s debt is already almost 100 percent of gross domestic product (GDP) and expected to go up to 120 whereas Iceland’s peaked at 85 and is declining (Figure 6.2).6 Also, the figures for Ireland don’t include the toxic assets taken on by the bad bank the government set up because it’s technically majority owned by private investors. Because it’s thinly capitalized, the losses from the bad bank will also fall on the shoulders of the Irish taxpayer at the end. Meanwhile, the Icelandic taxpayer is immune from the bad banks’ losses. Almost everyone in Iceland sighs in relief looking at Ireland. “There’s no bottom to banks’ losses,” says Economy Minister Árnason. Höskuldur Ólafsson, who runs Arion Banki, one of the new banks, says not guaranteeing the failed lenders’ liabilities saved Iceland. “Our future isn’t as bleak because our public debt isn’t as high,” he says.
Figure 6.2 Comparison of Ireland’s and Iceland’s economic contractions, rising debt, and unemployment levels. 2011 economic growth based on IMF estimates; 2011 unemployment figures as of first quarter for Iceland and as of May for Ireland; 2011 Ireland debt estimate by the Irish government, no estimate available for Iceland.
SOURCES: OECD, National Treasury Management Agency (Ireland), Statistics Iceland, Central Statistics Office Ireland, International Monetary Fund.
Good Bank–Bad Bank, Sort of …
Because Iceland wanted to separate its bust banks’ overseas adventures from their homeland activities, the split of assets and liabilities wasn’t in the tradition of good bank-bad bank exactly. There were plenty of toxic loans, including Iceland-style subprime mortgages, made at home that ended up on the new banks’ balance sheets. But they were transferred from the old banks with serious haircuts depending on the likelihood of repayment, sometimes at zero valuations. So even though the new banks have been involved in a nationwide restructuring effort to improve recovery, they have had enough of a margin on the valuations to offer companies or homeowners reductions on their principal. That’s what has been missing from the Irish or U.S. experiences, which has prevented the housing markets from recovering. Because zombie banks cannot afford to make reductions on their bad loans, the clearing of the housing glut is delayed while the zombies try to earn enough to cover such losses. “Iceland cleaned out its banks; we decided to spread it over time,” says Alan Dukes, the new chairman of Anglo Irish bank tasked with winding down the first lender to go bust in Ireland.
The managements of the new Icelandic banks completed the restructuring of corporate loans on their books in 2010 and were hoping to finish the process with thousands of home and consumer loans in 2011 though the IMF has indicated the process is going more slowly than expected.7 Still, the new banks—Arion Banki, Islandsbanki, and NBI—made a combined profit of $600 million in 2010.8 The profitability of the banks is important because the goal is to sell them in three to five years. Arion and Islandsbanki are owned by the creditors to the old banks, who will get the upshot of their improving prospects through better sale prices. NBI has a promissory note to the creditors, whose value will increase if the bank does well. The banks are hoping to return to international capital markets to borrow again as well, to diversify their sources of funding and make them more appealing to potential buyers. The prospects of that are also improving as the country’s economy improves, along with the banks’ profits. “In the beginning, banks and other financial institutions in Europe were telling us, ‘Never again will we lend to you,’ ” says Islandsbanki CEO Birna Einarsdóttir. “Then it was 10 years, then 5. Now they say they might soon be ready to lend again.”
One thing that has clouded the picture for the banks and the country’s credit worthiness has been an international dispute over the payment of deposits collected by one of the old banks overseas. Although they all enticed deposits (mostly through online banking) in other countries, the biggest operation was by Landsbanki, which ended up hoarding about $5 billion from British and Dutch savers under the online scheme Icesave.
The Icesave Saga
The TV commercials for Icesave boasted of the savings accounts’ transparency (because it paid high interest rates without any conditions attached) without ever explaining how it was possible that it could pay such higher rates. When Iceland’s emergency act in October 2008 didn’t include overseas deposits in the government’s guarantee, the United Kingdom and Netherlands took it upon themselves to pay the depositors in their own countries and then demanded full payment from the Icelandic state. Iceland agreed to pay the $5 billion back, but the independent president, Olafur Ragnar Grimsson, who has very little power except rejecting legislation and demanding a referendum, did so twice regarding the payments to the United Kingdom and Netherlands. Both times the people voted down the proposed payback, even though the second time around the government had negotiated very easy payments spread over 35 years. Those campaigning against the payments have argued that it’s not the debt of the nation but of private banks that had private owners and creditors.9
The government of Iceland has been hoping all along to cover the payments to the other two countries through the liquidation of Landsbanki’s assets. German banks and other creditors have been disputing the legality of the 2008 emergency act, which had put all deposits ahead of other liabilities in the hierarchy of payments during the resolution process. They have been arguing that they loaned to Landsbanki long before the act changed the payment order and that deposits should be in line like everybody else. In April 2011, Icelandic courts sided with the government, upholding the emergency law’s hierarchy. If the appeals court upholds the lower courts’ decision to allow depositors to remain on top of the payments from the liquidation, UK and Dutch governments would be first in line to get their money back from the estate of Landsbanki. That would cover the Icesave payments in full. Other investors would pretty much get nothing then. If they all share the proceeds from asset sales, then the ratio would be roughly 30 percent recovery for all. That’s close to the recovery rate for the other two banks.10
The Icesave saga points to a crucial weakness in global banking: the lack of rules on cross-border resolution. So it’s not only the Eurozone countries that haven’t thought of how to regulate their banks as the financial system integrated and more lenders did more business across borders. The world’s banks have gone increasingly international in the last two decades, but regulation and oversight have lagged far behind. While regulators worldwide have paid lip service to cooperation, they were pretty much unaware of their home-country banks’ operations in other countries or operations of other countries’ banks in their own territory. As was the case with Ireland’s international banking center, everybody thought somebody else was taking care of the oversight. So when the Icelandic banks blew up and their activities in other European countries had to be wound down, too, there were no mechanisms to do it in an orderly fashion, and every country grabbed what it could. Since the 2008 global financial crisis, there has been more discussion of a cross-border scheme though efforts to create one have been fruitless so far.11
The unresolved dispute over Icesave slowed Iceland’s efforts to regain its credibility in financial markets. The government had to delay plans to sell international bonds. The court decisions in favor of the government on the priority of deposits in the liquidation process eased the concerns to a great extent because it will allow the resolution committees of the old banks to pay England and the Netherlands through the liquidation of assets. In June 2011, Iceland managed to sell its first international bond since the crisis. The $1 billion bond sale was oversubscribed, investors seeking to buy twice as much as what was being offered for sale.12
Reincarnation and Recovery
Clearly, Iceland’s path hasn’t been that smooth since 2008. Yet the land of fire and ice has done several things correctly, which are now easing its return to normalcy. First, it didn’t convert the private debts of its banks to public as Ireland did. The creditors of the banks—German lenders as well as other European investors—have thus shared the costs of the gamble that went wrong, along with the Icelandic people. That has also spared Iceland the incredible debt burden that has made Ireland’s sovereign solvency questionable. So Iceland could start its economic recovery whereas the periphery countries cannot due to the debt overhang, says Desmond Lachman, a scholar at the American Enterprise Institute for Public Policy Research in Washington. Iceland’s currency has recouped some of its losses; inflation has come down to 3 percent and economic growth has resumed slowly.
Second, it didn’t prop up the failed banks and allow them to live as zombies. The full clean-up of the balance sheets, through a mixture of good bank-bad bank split, serious write-downs and debt restructurings, have made the new banks viable, profitable, and able to stand on their own feet without any government support. They can be sold soon whereas the half-completed cleanup of German or Irish zombies renders their sale impossible. “New Icelandic banks are clean while most European banks aren’t still,” says UBS’s Van der Knaap, who has advised Iceland’s banks in their restructuring efforts. Van der Knaap suspects the resistance to letting banks fail in the rest of Europe is over concern that banks’ borrowing costs would rise considerably going forward if bondholders are burned. But perhaps their borrowing costs have been too low, not taking the risks into account properly, and perhaps they should go up to reflect the risks—such as lending billions to land developers during a housing boom.
Ireland and Iceland have both suffered in the last few years. The biggest fear of the politicians on both islands is how much outward migration that suffering may cause. Both nations have a history of such outflows and are worried about losing their best educated, talented people when times get tough. Net migration has been over 40,000 from Ireland in 2009–2010, the biggest since the 1980s. Iceland has seen some 7,000 people leave in that period. Having a much smaller population, Iceland’s outward migration accounts for 2 percent while Ireland’s is half that.13 Yet, Iceland’s slowed in 2010 while Ireland’s picked up pace, another sign of the diverging paths of the two countries’ future prospects. The return of Iceland to international capital markets in mid-2011 put it ahead of Ireland by several years too. Nobel laureate Joseph Stiglitz says the opposing approaches the two took to treating their zombies is the key to the divergence now. “Iceland is a success story,” he says. “It has managed to turn the worst crisis to recovery.”
Notes
1. Statistics Iceland database; The Financial Supervisory Authority (of Iceland), Annual Report 2009; Magnus Arni Skulason, “Global Housing Markets in the Light of a Global Banking Crisis—Case Study: The Boom and Burst of the Icelandic Housing Market,” public Lecture at Lehigh University, October 19, 2010.
2. Páll Hreinsson, Tryggvi Gunnarsson, Sigrídur Benediktsdóttir, “Report of the Special Investigative Commission,” Presented to Icelandic parliament, April 12, 2010; Brooke Masters and Daniel Thomas, “Tchenguizes Arrested in Kaupthing Probe,” Financial Times, March 9, 2011.
3. Iceland Review Online, “Privatization of Banks Draws Heavy Fire,” Daily News from Icelandic Newspapers, May 31, 2005.
4. Hreinsson, Gunnarsson, and Benediktsdóttir, “Report of the Special Investigative Commission.”
5. Statistics Iceland database.
6. Central Statistics Office Ireland database; Statistics Iceland; Government Debt Management Office, Iceland; International Monetary Fund, World Economic Outlook database; National Treasury Management Agency, “PCAR and Bank Restructuring to Rebuild Confidence in Ireland,” slide presentation, April 2011.
7. International Monetary Fund, “Statement by the IMF Mission to Iceland,” press release No. 11/163, May 5, 2011.
8. Arion banki, “Consolidated Financial Statements for the Year 2010,” March 2, 2011; Landsbankinn (NBI hf.) “Consolidated Financial Statements 2010,” March 31, 2011; Islandsbanki, “Annual Report 2010,” March 29, 2011.
9. “Iceland Rejects Repayment Deal Again,” The Independent, April 10, 2011; InDefence. “Icesave: We Demand a Reasonable Icesave Agreement to Avoid National Bankruptcy,” slide presentation, February 2010.
10. Landsbanki Islands hf, “Financial Information 2010,” March 2, 2011.
11. Yalman Onaran, “Banks Get One-Year Reprieve as G-20 Told to Wait for Measures,” Bloomberg News, November 12, 2010.
12. Iceland Review Online, “Iceland Court: Icesave Deposits Are Priority Claims.,” Daily News from Icelandic Newspapers, April 28, 2011; Omar R. Valdimarsson, “Iceland May Shelve Eurobonds as President Blocks Depositor Bill,” Bloomberg News, February 21, 2011; Ministry of Finance (Iceland), “Iceland Issues USD 1 Billion Bond—A Milestone Says Finance Minister,” press release, June 9, 2011.
13. Statistics Iceland and Central Statistics Office Ireland databases.