Icelandic Financial Crisis

What is the Background?

Iceland’s top 3 banks adopted an aggressive acquisition spree causing banking assets to skyrocket from EUR18bn to EUR124bn (12x domestic GDP at the time). In 2006, spooked bond investors sent credit spreads soaring and credit default swaps spreads suffered under concern on the bank’s increased reliance on wholesale funding. In 2007, retail banks grew their deposit base by 93% by luring foreign savers with attractive pricing (rates as high as 7%). By 2007, outstanding depositor and wholesale external debt of the 3 banks totalled over EUR95bn.

What were the initial responses?

In response to overheating markets, in November 2007, the Icelandic central bank had raised interest rates a further 45bps to 13.75%.

On 29 Sept 2008, Glitnir was the first Icelandic bank to be nationalised, followed swiftly by Landsbanki and Kaupthing. By early October, domestic operations and deposits were ring-fenced by the Icelandic Government whilst foreign depositors were left to the devices of their respective countries.

Who was to blame?

The Icelandic Central Bank was focused primarily on controlling inflation and a weakening ISK. They were neglecting its role as bank supervisor and regulator.

In the Sedlabanki’s Financial Stability Report (2008) – it concluded that the Icelandic financial system was well prepared and able to withstand potential shocks to the economy. This was a clear oversight from the Central Bank. Similarly, the Central Bank failed as a lender of last resort.

The Central Bank was hostile and instead placed blame on authorities in the UK, Northern Europe and elsewhere for not stepping up financial aid to the new ‘global’ institutions. As Icelandic authorities did not have the resources to rescue banks, the lack of international assistance is also to blame.

Retail banks had severe weaknesses in areas such as asset quality and governance, in addition to their business model and risk management. Also, it was the bank's difficulties in refinancing their foreign assets that catalysed the crash.

What were the effects of the Financial Crisis?

1. Domestic equities plummeted by over 90%
2. The ISK fell by over 60%
3. Inflation soared
4. GDP dropped by over 10% in real terms
5. Unemployment peaked over 9%

Most banks, companies and homes were left bankrupt.  Also, at the time of the collapse, outstanding liabilities totalled over EUR90bn in wholesale and deposit funding.

How did they recover?

The Icelandic Government was forced to go to the IMF for a EUR4bn loan. Since this, Iceland has managed to make a significant recovery due to tourism.