On February 2, 1930, the Icelandic parliament, the Althing, convened an emergency night session to determine the fate of the nation’s sole private bank. The most obvious sign of trouble was the long lines of depositors who had been trying to withdraw their money from the bank, but the crisis was also being exacerbated by international creditors, who had lost their confidence in the institution and were now refusing to extend any new credit. The bank’s management was imploring the government to guarantee all its deposits and foreign obligations; otherwise, the bank would be doomed to close the following day and would go into default.
Despite the unrelenting bad news, the Althing was reluctant to act. Although the bank bore the name Islandsbanki—the bank of Iceland—it was wholly a foreign-owned concern. Turn-of-the-century Danish investors had offered to found a bank—Iceland’s first real financial connection to the outside world—on the condition that they be granted the privilege of printing the legal tender for Iceland: that is, they sought to establish a central bank with commercial interests. The government, which had long complained about the difficulty of attracting foreign investments to that outermost corner of Europe where Iceland was located, accepted the arrangement. Now, barely three decades later, the onset of the Great Depression had brought Islandsbanki to its knees.
The legislators debated Islandsbanki’s fate until dawn. Why, asked the bank’s opponents, should Icelandic citizens pay the debts of foreign speculators who, out of greed, had leveraged the country abroad and taken on excessive risk? Was it not true that the speculators had caused hyperinflation through the excessive printing of money and turned the country upside down with excessive lending that led to a housing bust? The default of the bank would also relieve the country of the foreign debt the foreign speculators had accumulated as well as setting the country free from foreign domination. On the other side, supporters pointed out that Islandsbanki had enabled a modernized economy by financing the mechanization of the fishing fleet. They reminded the chamber that the bank held a wealth of Icelandic deposits and was therefore a lifeline for many companies that would follow it into default; should these interests renege on foreign wholesale loans, they would damage the country’s credit beyond repair, perhaps for decades to come.
The debate took on the familiar form of isolationists against internationalists and in the end the former won the argument. The Althing refused to extend any guarantee to the bank, and its customers rushed on closed doors the next morning. As the news spread, the Icelandic government was soon receiving telegrams—from Hambros bank of England, Privatbanken in Denmark, and the Danish ministry of finance, the bank’s primary creditors—which warned that the country would be excommunicated from the international financial community if the decision was upheld. The political bickering continued for several weeks, but ultimately the Althing gave in to the pressure, nationalized Islandsbanki, and turned its foreign debts into equity. It did manage to keep representatives of the creditors off the board of the new entity.
The equity was paid out during World War II, when the Icelandic fishing sector hit upon a new bonanza selling fish to Britain and no foreign creditors lost a dime. But nevertheless the damage was done. Although the other bank in Iceland, the state-owned Landsbanki, was able to keep a credit line open to Hambros bank, Iceland had effectively been locked out of the international credit market; its new, state-controlled banking system developed behind a shield of capital controls. The fateful night in February 1930 marked the birth of a banking order that would endure in Iceland until the end of the century. All efforts to understand the Icelandic banks today must begin at the moment when Islandsbanki was taken down.
What may seem outlandish to twenty-first-century sensibilities—namely, allowing a foreign private bank to act simultaneously in Iceland’s national and commercial interests—was not considered unwise in 1900. Iceland was still a part of the Danish state, and it was not uncommon for central banks to be privately held; the Bank of England was a contemporary example. Some argued at the time that private parties would exercise more responsibility over a printing press than would kings and governments. What was more, the entire world operated on the gold standard, and the new Icelandic bank was obliged to insure all its note issues with gold. Most critical, though, was the fact that Icelanders longed for foreign investment and financing to kick-start their economy, which was considered the laggard of Scandinavia.
In the nineteenth century, Iceland had been served by a single, state-owned bank—Landsbanki—and 24 savings and loan funds. Landsbanki’s management had been deeply conservative. Mortgages accounted for approximately 50 percent of the bank’s loan portfolio, and the loan-to-value rate was set at a maximum of 50 percent. Danish treasuries were the second largest portion of the portfolio. The interest rate margin was a slim 1 percent, and the bank fixed rates were 3.15 percent on deposits and 4.15 percent on outgoing loans. Landsbanki also supplied funds to the savings and loan institutions, which served in the fashion of retail branches for the bank, providing small consumer credit loans. At its founding in 1886, Landsbanki was granted the right to issue a fixed amount of monetary notes. Although it was allowed to keep outstanding note issues in circulation after Islandsbanki was established, Landsbanki’s operations remained primarily commercial.
When Islandsbanki opened its office in 1904, the effect was nothing short of revolutionary. The bank’s equity, wholesale financing from the Danish financial community, and freshly printed notes did indeed give a jolt to the slumbering Icelandic economy. Its credit policy was strongly pro-business, with much higher interest rates and lower collateral requirements than Landsbanki’s. Having spent years starved for foreign capital, Iceland was suddenly awash with fresh funds, and bank credit tripled in just three years. Investments in the fishing sector soon increased Icelandic export revenues by 110 percent. The country would come to enjoy a 15-year economic boom.
However, Islandsbanki’s arrival had benefits beyond new foreign capital: it also marked the birth of deposit banking and money multiplication via the banks. In 1900, about 70 percent of Icelandic savings were kept at home, where it sat idle while the underdeveloped economy was begging for funds. Thus, Islandsbanki’s aggressive entrance set in motion the use of banking accounts as both store of value and medium of exchange, which is the basis of modern financial intermediation. This meant that, while initially Islandsbanki’s credit expansion was financed by foreign loans and bond issues abroad, it could be maintained by domestic deposits as people brought their money to the bank. By 1910 the Icelandic savers had by and large brought their funds to the banks and only about 20 to 30 percent of the country’s savings was kept at home in money notes and gold coins. The checkbook became the instrument of choice for making payments. To the present day, Islandsbanki’s emergence remains an outstanding example of how advances in financial services can enable the industrialization of an entire country.
The core clientele of Islandsbanki were businesses involved in the fishing sector, but about 50 percent of the bank’s loan portfolio was represented by collateral in trawlers, processing facilities, or inventories. Initially, most of these fishing clients were Danish, and many were quite large enterprises compared with the size of the bank. For example, the purchase price of a single trawler might be worth 3 or 4 percent of Islandsbanki’s equity, and most fishing companies would operate more than one trawler. The loan portfolio of the bank, therefore, was always highly concentrated, not only on one sector but also on individual businesses. As a result, trouble for a single company easily could spell trouble for Islandsbanki itself. For example, after a decade of decent profits and generous dividends, the bank lost about 25 percent of its equity when a single fishing company went into bankruptcy in 1914. Fortunately, food prices rose steeply in Europe with the outbreak of World War I, and the bank not only recovered its losses but reaped immense profits throughout the war; by the time of the armistice in 1918, its stock price had nearly doubled.
As a rule, gold convertibility was suspended by the central banks of Europe during the war, giving them a free hand with the printing press; Islandsbanki was no exception, which meant that by 1914 it was churning out what its critics called excessive amounts of money notes. By 1919, the outstanding money note issues had increased by a factor of seven and prices in Iceland had more than quadrupled. Despite high wartime inflation, the government insisted on making the Icelandic krona (ISK) trade at par with its Danish counterpart, as these two currencies were both functioning as a legal tender alongside each other in Iceland. This shout of national pride, however, was premature. When Europe went into recession in 1920, fish prices fell sharply and Islandsbanki, still de facto the central bank, faced a balance of payments crisis as exports no longer covered the importing needs of the country. With its foreign liquid reserves hemorrhaging, the bank obtained a loan from the Danish ministry of finance to meet the capital outflow. In 1921, the Icelandic government also secured a loan from the Hambros bank of England, although at a high spread. Fortunately for the fledgling sovereign government, the recession was brief, and rising fish prices and a devaluation of the ISK set the country and its central bank on solid footing again.
Nevertheless, the sharp, short-lived recession had inflicted political damage on Islandsbanki’s reputation. The Icelandic government, which had hurried to concentrate its sovereign rights while riding the war boom, was also compromised. Nationalistic leaders, who claimed that the nation could thrive without Danish oversight, had their eyes blackened when the country was forced to go begging for a loan, and again when the ISK lost parity with the Danish krona. The ability and willingness of Islandsbanki—still a Danish private bank—to act as guardian of the capital account was questioned. The bank was accused of abusing its exclusive right to print the national currency in order to create profits for its foreign shareholders, and, in the process, creating hyperinflation and national indebtedness.
The question of whether Islandsbanki as a foreign private bank was fit to serve as the central bank of a newly independent country was now relevant. The bank’s note-issuing privileges extended to 1933, but by 1921 the Althing was intent on drafting a new central banking arrangement, one that either shifted the money-issuing rights to Landsbanki or founded an entirely new entity.
These financial upheavals corresponded to uncomfortable social transformations. Having slept through the nineteenth century, Iceland was now modernizing and shifting toward urbanization at extraordinary speed. The rural areas were emptying out and their residents were converging in port towns. In 1900, roughly 10 percent of the population lived in Reykjavik; by 1930 the number was 40 percent. Many Icelanders feared that their national identity was being lost, as the population morphed from an independent agrarian society to a mindless urban proletariat. In the popular mind, the owners of fishing trawlers were seen as predatory, reckless nouveau riche, who dominated the country in between its regular bankruptcies. The “Grimsby trash”—so named because their trawlers often made harbor in the British port of the same name—were excoriated for their conspicuous spending and large Reykjavik villas, which contrasted starkly with the poverty of the majority of the population. Furthermore, building the country’s future on fishing, just one volatile sector at the mercy of foreign commodity markets, was seen as unhealthy by many. Lastly, there were worries that the hard-won independence was in name only since the country was still dominated by foreign commercial interests from Denmark and elsewhere.
After two decades of internationalism and almost unbroken economic progress and urbanization the Icelandic public swung to the side of the isolationists. In the 1920s the so-called Progressive party was voted into power. The party combined agrarian interests with Icelandic patriotism and cultural values and was to a large extent a youth movement. In the coming years the Danish-educated, free market-orientated and internationalist elite in Reykjavik was swept aside.
In this hostile climate, the Althing finally granted exclusive rights to print the national currency to Landsbanki in 1928. Islandsbanki was to repurchase its outstanding note issues in equal installments until its contract expired in 1933. This required the bank either to find a new funding base to replace the note issues or to gradually shrink its balance sheet. Increasing deposits was problematic, now that Landsbanki alone owned the government’s guarantee and new wholesale funding was not forthcoming from Denmark. There was no longer any margin for error for the Islandsbanki’s management.
The blows continued to fall on Islandsbanki and the “Grimsby trash” in 1929. At the onset of the Great Depression, two large fishing companies went bankrupt, wiping out a considerable amount of the bank’s equity. In October, Islandsbanki solicited the acting central bank—Landsbanki—for liquidity assistance, via purchase of its bond issue, to finance the scheduled note withdrawal for that year. Landsbanki was, of course, also a commercial bank and in direct competition with Islandsbanki; although obligated to finance note withdrawals it refused, on the grounds that liquidity had already been extended by previous loans to Islandsbanki. Since the central bank was also vulnerable in the growing international crisis, it was hardly keen on risking its own solvency by bailing out its main competitor.
On January 20, 1930, Landsbanki pressed the situation by refusing to extend another bill it had bought earlier from Islandsbanki. The news quickly passed to the streets, and the run on Islandsbanki deposits began. On February 1, the ministry of finance granted Islandsbanki a small emergency loan. The following day, the bank’s board sent a petition to the Althing, stating that without a state guarantee on deposits and more emergency funding, the bank could not open on the next morning. This was the petition that was ultimately rejected in the night session of February 2, leading to Islandsbanki’s immediate closure.
After the Althing’s reversal and the subsequent nationalization, Islandsbanki reopened on April 11 as Utvegsbanki (the bank of fisheries). The new bank had a 20 percent equity ratio and was owned jointly by the Icelandic state, the Danish finance ministry, Privatbanken in Denmark, and Hambros bank in Britain. The Icelandic state maintained control of the board, and all the creditors recovered their principal during World War II.
THE BIRTH OF A NEW BANKING STRUCTURE
Iceland had lost most of its access to foreign financial markets when it moved to separate from Denmark in 1918 and became a sovereign entity with a very short credit history. Once Islandsbanki was nationalized, there was only narrow, remaining access to foreign financing through the Hambros bank in London. As the Great Depression set in, Landsbanki found itself in exactly the same tight spot that Islandsbanki had occupied in 1920, supporting an overvalued currency while export revenues collapsed. This time no help was sought from Denmark and the gates to the international financial community remained closed. In 1931, Landsbanki petitioned the Althing for capital controls, which were instantly enacted, and which remained in place until 1994.
A third state entity, Bunadarbanki (the Agricultural Bank), was founded in 1930 at the behest of the Progressive party. Afterward, all three prongs of the banking system operated under the same proprietary capacity in state ownership. Representatives of each political party had seats on the banks’ boards, and each bank appointed three governors with political connections, even retired members of parliament. The banks’ integration into the political structure ensured consensus and continuity, yet kept their operations above political conflicts. In 1961 a new central bank was founded under the same political governing structure. Dozens of small regional savings and loan funds provided retail services outside the three commercial banks, but they had little overall bearing on the financial market.
With capital controls in place and the absence of any foreign financing, it was nearly impossible for any private party to challenge the dominance of the state banking structure. However, in the postwar period, a number of corporate interest groups became deeply unhappy with the credit practices of the state-owned banks, which reflected political priorities. With the continued development of the Icelandic economy, these interest groups had a growing political clout, which they used to break into the banking market and acquire their “fair” share of the savings pool. In 1953, a bank of industry (Idnadarbankinn) was founded, and in 1961, a bank of commerce (Verslunarbankinn). In 1971, employing the same methods, the labor unions opened the people’s bank (Althydubankinn).
These new banks broke into the sector by opening new branches, which led to a “branch war.” Since interest rates were fixed by the government, the upstarts could compete only by opening more and more branches that were close to the retail customer. As a result, the state-owned banks began to lose market share, and the country became overbanked. In 1990, Iceland had the greatest proportion of bank employees to the total workforce of any Scandinavian country, a circumstance comparable to that of Switzerland.
In 1985, Utvegsbanki lost over 80 percent of its equity as the result of a single bankruptcy of a shipping company and was taken into intensive care by the government. By 1988, the three private banks had mustered enough clout to acquire Utvegsbanki and merge into a single bank, which opened for business on January 2, 1989. This new entity reached back six decades and named itself Islandsbanki (later renamed Glitnir).
THE BANKING DEVELOPMENT OF ICELAND
Banking development has a universal logic, although the characteristics and developmental pace of different financial systems vary. History matters when we evaluate banking systems, since their final outcome has a path dependency. In the case of Iceland, the firebrand entrance and demise of Islandsbanki are key to understanding how its banking sector developed in a way fundamentally different from those of other Western countries.
According to a landmark article by Victoria Chick entitled “The Evolution of the Banking System,” published in 1986 in Économies et Sociétés banking development can be divided into six stages, which are based on the UK’s development:
Stage 1. Pure financial intermediation
An institution, firm, or individual lends out surplus savings to someone in need of funding. There is no money multiplier.
Stage 2. Fractional reserve banking—deposits used as money
Banks offer liquidity insurance to their customers by accepting their deposits, while allowing instantaneous access and interest rate payments. The law of large numbers then allows the bank to minimize liquidity risk to the extent that the deposits can be transformed into long-term, large and risky loans.
Stage 3. Interbank lending
Liquidity is efficiently distributed across the financial markets.
Stage 4. Lender of last resort facility
An actor armed with the power of money printing is able to offer insurance against systematic liquidity shocks.
Stage 5. Liability management
Banks seek lending opportunities and then matching funds. Liabilities are simply managed with new deposit creation, interbank lending, or wholesale funding to fit growth of bank assets.
Stage 6. Securitization
Banks turn existing loans into marketable securities and develop the provision of financial services in securities markets. They turn away from lending, and favor derivative products and offthebalancesheet profit opportunities.
Iceland was stuck at stage one until the dawn of the twentieth century. Until then, its market, entirely dependent on Denmark, was small and backward. As long as the Danish financial community saw no gain in integrating with Icelandic markets, it continued to neglect them. It was not until 1904 that the number of Danish businessmen in Iceland reached critical mass and formed a client base for Islandsbanki, which thrust the nation onto stage two.
Progress toward stages three and four might have been gradual and smooth had Iceland remained a Danish concern and gold insurance continued to back up its printed notes. But after sovereignty was granted, Iceland no longer had a clear lender of last resort; it was forced to beg at the door of Denmark’s ministry of finance when recession destabilized the financial system.
Seeking aid from a former master was intolerable to the nascent state, and trusting a foreign, private bank with its printing press seemed reckless. But without easy access to foreign financial markets or the foresight to separate central bank functions from commercial banking, the Icelandic banking system virtually was without a lender of last resort in the 1920s. Thus, the 1930 assault on Islandsbanki led to a near-complete government takeover of the financial system supported by capital controls, and a 50-year pause in Iceland’s financial development.
Iceland belatedly entered stage three when an official interbank market was founded in 1980. Not until Islandsbanki’s 1989 resurrection would the nation again have a large, private commercial bank. Stage five was not attained until the late 1990s, when the financial markets were liberalized.
Being decades behind its neighbors, Iceland had no sophisticated banking tradition to build upon. Its state-owned banks had operated like any other government bureaucracies, with tight political controls that allowed only the most basic commercial banking activities under the protection of market barriers. They faced competition on a very narrow spectrum from small, corporatist banks. With no liquidity distribution from an interbank market, there was little room for an active capital market before 1989.
Once it was liberalized, the financial sector broke out of the political cage, and the older generation of bankers was brushed aside abruptly by a hungry new free market orientated and internationalist generation. Most of these people were born in the years between 1966 and 1976, and they had grown up with antipathy for politics and regulation. They adopted the American-style investment-brokerage banking model that came to dominate the Icelandic banking sector at the turn of the twenty-first century. At the time, few saw a dangerous parallel to the 1920s, when the sector last had lacked a clearly defined lender of last resort.
However, this sudden generational shift did not occur at the governmental level, which sustained a system in which hierarchy and political connections superseded merit and public disclosure and transparency were uncommon. The central bank clung to the antiquated system of political boards and governors, and never hired new talent from the surging financial sector. The divide between the dynamic and international private sector and the stagnant, introspective public sector became ever larger as the financial sector fast-forwarded into the twenty-first century.
Iceland never completed the sixth, securitization stage of banking development. Its banks never really handled subprime loans, collateralized debt obligations (CDOs), or other advanced market tools, with the exception of Kaupthing, which had a small asset managing company in structured credit (New Bond Street Asset Management). However, the U.S.-structured credit industry would exert a heavy influence over their funding.
Iceland’s approach to banking was far more cautious than that of any other Western European nation during the twentieth century, and the excessive governmental controls kept its financial system immature. Once it was embroiled in the worldwide investment bubble that grew in the late 1990s, the lack of institutional memory allowed all participants, bankers and government officials alike, fundamentally to underestimate systemic risk.
In the modern day, the presence of one aggressive international investment bank would have been a tremendous benefit to Iceland. But once its entire financial system was put in this high gear, there was trouble in store (to better understand what happened, try to imagine all the major banking operations in the United States being run by broker-dealers). Had Iceland’s banks been examined independently, they would not have looked so different from any other bank in Europe. But looking at them in the aggregate, crowded onto a tiny island dependent on foreign wholesale funding, they would form an outsized systematic risk for the country.
Unfortunately, the 60 years that Icelandic banks spent behind bars were sufficient to expunge all memories, and Iceland was due for a repeat of disaster—on a far grander scale.