þriðjudagur, mars 31, 2009


Karlo Jännäri, former bank regulator of Finland, was invited last fall to Iceland to draft a report on the Icelandic financial sector and the causes of the banking collapse of October 2008. That report was published yesterday. The report gives some excellent (and very readable) history on the development of the Icelandic crisis, and the steps taken to mitigate problem areas like ICESAVE before they exploded. This report is the first time I have read detailed discussion of the steps taken by the Icelandic authorities to mitigate the banking crisis before it hit, and I found this very enlightening. The report then goes into more detailed discussion of issues affecting the banking system, such as credit risk, liquidity management, and FX risk.

A few paragraphs from the section discussing the history of the crisis jumped out at me:

[CBI = Icelandic Central Bank, Seðlabanki Íslands
FME = Financial Supervisory Authority, Fjármálaeftirlitið
HFF = Housing Finance Fund, Íbúalánasjóður]

Privatization: The privatisation process of the banking system at the beginning of this decade was another milestone in this development. This is also where the first potentially “wrong decisions” or mistakes were made. Instead of spreading ownership among several institutional investors and private households, with no one holding a controlling interest, as was the original intention, the government then in power decided in 2002 to allow one investor group, Samson, to have a de facto controlling interest of 45% in Landsbanki, then the country’s largest bank. This was largely a political decision. The FME, for instance, was dissatisfied with the result and, in early 2003, gave its approval to the holding by Samson only after lengthy deliberations. The same applied to the acquisition of Búnadarbanki by the “S-group” when that bank was privatised. Some efforts were made to have reputed foreign financial institutions invest in the Icelandic banking system, but with limited success. This is not surprising, as the Icelandic financial market was (and to a large degree, still is) difficult for foreign financial professionals to assess because of the high degree of indexation, the role of the HFF, the small currency and market size, and the volatility of the economy. Even so, it appears that at least one reputable bank was showing interest in entering the Icelandic market, but it was turned down in the end, probably for protectionist reasons.

The Boom: At the time, the global financial market was flush with liquidity; moreover, due to historically low real interest rates, funds were readily available for the international expansion of the Icelandic banks, as investors were hungry for higher returns. The Icelandic banks also enjoyed favourable ratings from the international rating agencies, which greatly facilitated their access to the international bond markets. At the same time, the domestic economy overheated due to lax monetary and fiscal policies. Large-scale aluminium and power projects, large salary and wage increases combined with a reduction in both direct and indirect taxes led to a boost in domestic demand that resulted in wide current account deficits. At the same time, the HFF started to relax conditions in the mortgage market in order to increase its market share, and the banks joined in to compete aggressively in this rapidly growing market. In many cases, loan-to-value ratios neared 100%, and because real estate prices rose at unprecedented rates, households used the opportunity to raise money by using their homes as collateral to fund their consumption spree. This led to high household indebtedness. Firms also expanded by borrowing.

Ineffective Interest Rates: Most mortgages remain in ISK and are indexed, as are term deposits. In my opinion, this state of affairs renders the CBI’s interest rate policy rather toothless, as the Central Bank’s interest rate decisions affect only a small portion of the domestic money and capital markets. Contrary to traditional theory, increases in ISK interest rates accelerated the boom in consumption due to increased inflows of capital through so-called carry trade and Glacier bonds (Eurobonds denominated in ISK). It should be noted, however, that the CBI strongly disagrees with the above analysis, and admittedly, economists have widely differing views on this.

Foreign Loans: Households normally have no way to hedge against foreign exchange risks; therefore, lending to them in foreign currencies is not very prudent from a risk point of view. This is why there are restrictions on such lending in many countries. This might have been advisable in Iceland also, although the EEA and EU legal framework would have made it difficult to enforce such rules.

Rules Meant to be Thwarted: The banking community and the business community at large had a tendency to consider the letter rather than the spirit of the law as setting the boundaries for their actions. Here they were helped by a fair number of diligent legal advisors and international financial consultants. Complicated legal structures and webs of holding companies were established to circumvent many of the restrictions in banking and company law.

Global Context: When judging the reasons for the Icelandic banking crisis and the events leading to it, one should not forget the international setting in which it happened and which made it possible. It would not have been possible without the overall laxity in the global financial markets and the bubbles it produced, which were bound to burst at some point in time. When greed gave way to fear and the bubbles started bursting, there was no way the Icelandic banks could have been saved. This is not to say that Icelandic banks were innocent victims of the circumstances. They made the gravest mistakes themselves by going along with the global euphoria and forgetting that conquering the world is not possible without a strong home base and own resources. The nation, up to its highest echelons, supported and admired the banks, and many are still in a state of denial regarding their own part in this tragedy. The CBI and the FME tried to raise words of caution, but it was too little and too late, and it is doubtful whether they could have stopped these developments even if they had had the power to do it.

The report ends with recommendations, including:
  • Solve the problem of inflation-indexed loans
  • Reduce or eliminate the influence of HFF
  • Decrease the number of government ministries involved in regulating the financial market
  • Create a credit reporting agency to score creditworthiness and overall exposure of individuals and businesses
  • Give more discretion to the FME
  • Actively cooperate with other international banking regulators and central banks
You can read a PDF of the report here.


Anonymous Biskupinn said...

Thanks for the great summary!

Interestingly, the more I learn about this situation, the more I realise how much left I have yet to learn.


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