The Icelandic Banking Crisis

1
The Icelandic Banking Crisis

• Friðrik Már Baldursson
• Reykjavik University

2
The Icelandic banking crisis in brief

• Began in August 2007 with onset of the
  international (subprime) crisis
• Wholesale funding dried up due to perception of
  increased risk
• A vicious spiral began where Icelandic banks,
  with balance sheets on the order of 10 times GDP,
  were perceived as too large for the government to
  back up
• Yet, the expectiation built up rightly so
  that Iceland would bear large costs were the
  banks to fail
• Perception of risk exacerbated by macroeconomic
  imbalances
• Culminated in complete evaporation of liquidity
  after Lehman failure September 15 Landsbanki and
  Glitnir hit especially hard
• Kaupthing then failed after UK government seized
  KSF
• All major banks went down October 7-9 2008
• To prevent a complete collapse of the Icelandic
  economy the government stepped in and
  nationalised the domestic part of the banking
  sector
• Iceland is still in serious financial crisis
  although some improvements can be seen

3
Macroeconomic background
4
Big macroeconomic boom from 2004-2007 driven by

• Big investment projects
• Privatisation of banks (1999-2003)
• Major impact on credit growth, incomes, and
  wealth
• Banks entered the housing market in 2004,
  competing agressively with the governments HFF
• Financed foreign investments of Icelandic
  entrepreneurs
• Grew increasingly large out of proportion to
  the countrys economy
• Procyclical fiscal policy
• Rising asset prices and private expenditure
• Serious overheating despite restrictive monetary
  policy

5
Fiscal policy was procyclical and monetary policy
ineffective

• Why procyclical fiscal policy?
• Big surplus (5-6 of GDP) too tempting for
  politicians
• Promises to cut taxes were made and stood by
  in 2003 elections.
• Public expenditure boomed in runup to 2007
  elections
• Monetary policy was ineffective (and may have
  been destabilising) due to
• Widespread indexation and fixed terms on housing
  loans
• Pervasive euroisation
• Carry trade foreign investment in ISK assets

6
(No Transcript)
7
(No Transcript)
8
International investment position, of GDP
9
Turning point August 15 2007. Banks faced
progressively worse terms in capital markets
Kaupthings CDS spread (5 year senior debt)
10
ISK grew increasingly volatileVolatility of
selected currencies against Euro
11
ISK began depreciating steadily from December
2007 onwards along with contagion of banks terms
to sovereign debtExchange rate (TWI) and CDS
spread of Icelands sovereign debt
12
IMF Global Financial Stability Report, April 2009
13
The Banks
14
The banks Glitnir, Landsbanki, Kaupthing

• Banks privatized 1998-2003
• Used low international interest rates, ample
  liquidity and low degree of perceived risk to
  expand internationally. Fast!
• Total assets about 1 GDP at end 2000
• Total assets about 10 times GDP at end 2007
• Relative sizes Kaupthing 46 , Landsbanki
  Glitnir each about 27
• After expansion, majority of activity and income
  international
• Loans in Iceland 41 of total (GLB 48, LAIS
  53, KB 30)
• Important for domestic economy
• Financial services, excluding insurance about
  8 of GDP (2007)
• Total no of employees in 3 large banks about
  8,000, in Iceland about 4,000. Approx. 2 of
  domestic labor force
• Big taxpayers

15
The banks appeared to perform quite well compared
to peers despite their fast growth

• Deposit ratios strong, market funding maturities
  relatively long, overall, and core profitability
  high
• Despite high capital adequacy ratios with which
  they counterbalanced high equity exposure
• Negligible exposure to US subprime market,
  structured finance products, related financial
  vehicles
• FSA stress tests indicated they could withstand
  quite extreme movements in market variables
  specific to Iceland

16
Half-year results 2008 were remarkably good,
considering the circumstances

• Managed to maintain high return on equity
• Helped by depreciation of ISK and higher
  inflation in Iceland
• Capital ratios still comparatively high
• LAIS 10.3, GLB KB 11.2
• Provisions rising
• Liquidity appeared in order for next 4 quarters
• Landsbanki and Kaupthing had both built up
  substantial retail deposits Landsbanki mainly
  in branches, Kaupthing mainly in subsidiaries
• Glitnir in the tightest position, but seen to
  have best loan portfolio
• Kaupthing had no major payments due until May
  2009
• Still, it was clear that if markets would not
  open up there would be trouble in early 2009,
  especially for Glitnir and Landsbanki

17
September is the cruellest month ...

• After Lehman collapse (Sept 15) interbank
  markets dried up completely and liqudity position
  of Icelandic banks especially Glitnir and
  Landsbanki became much worse
• Glitnir asked for a 600 MEUR emergency loan from
  Central Bank after Landesbank shut off a loan
  line (inadvertently caused by CBI)
• When intended nationalisation of Glitnir was
  announced (Sept. 29) rating agencies downgraded
  sovereign and bank debt
• As loan covenants kicked in following downgrade
  this led to further deterioration of liquidity
• Depreciating ISK caused margin calls from ECB
  Icelandic collateral no longer covered repo loans
• On Friday Oct. 3 all three banks were in need for
  emergency funding
• Too big to save, although Kaupthing, which had a
  good chance of surviving until KSF was seized by
  UK, did get a loan from CBI (500 M EUR) with
  Danish FIH bank as collateral
• In any case, currency reserves were much too small

18
Emergency legislation

• Passed on Monday Oct. 6 after intense work over
  prev. weekend
• Allowing the Icelandic Financial Regulatory
  Authority (FME) to take over operations of
  illliquid banks
• Powers to suspend payments in order to safeguard
  value and protect depositors
• Powers to establish new banks to overtake
  domestic deposit obligations and assets from
  failing banks
• FME asumed control of all three banks in the same
  week
• Each bank placed under an administrative
  committee
• New (state owned) banks
• Take on deposits at domestic branches
• Take on domestic assets (loans)
• Difference between domestic assets and
  liabilities at fair value paid to old banks
  (valuation done by Deloitte and vouched by Oliver
  Wyman)

19
The CDS spread of Iceland tells the story
20
The banks were too large for Iceland

• Refinancing of foreign market debt amounted to
  approximately 100 bn ISK each month on average
  on the order of 1 GDP each year
• Deposits at foreign branches (i.e. not
  subsidiaries hence guaranteed by Iceland) were
  also on the order of 1 GDP
• Even if single large exposures were within
  regulatory limits they were in some cases
  (Baugur) extremely large in terms of GDP
• Currency reserves were about 200 bn ISK approx.
  2 months refinancing need of wholesale debt
• Government was not a credible lender of last
  resort
• Still, the CBI tried to act as one (see next
  slide) - at peak, repo loans at Central Bank
  amounted to 30 of GDP and 400 of CBI equity
• Losses on uncovered bank bonds held as collateral
  biggest cause of post-crash fiscal debt

21
Central collateral loans (GDP in 2008 1465
billion ISK)
22
Exchange rate dynamics and financial euroisation
23
Vicious spiral Liquidity crisis currency
crisis banking crisis

• From August 2007, banks in liqudity squeeze -
  regarded as risky by markets
• Lack of credible lender of last resort
• Fast growth inbreeding (seen as implying bad
  loan quality)
• Macro imbalances in Iceland
• Borrowing in foreign currency (financial
  euroisation)
• Banks in need of liquidity in foreign currency
• ECB provided liqudity in EUR against ISK
  collateral
• CBI provided liquidity in ISK against ISK
  collateral
• Banks converted ISK into foreign currency
• ISK depreciated
• Loan quality deteriorated (due to financial
  euroisation)
• Asset markets plummeted (stock market, housing)
  further damaging loan quality
• Inflation rapidly up (ditto ,due to indexation)
• In September 2008 CBI belatedly tried to shore up
  krona by increasing currency reserves
  inadvertently shutting off a loan line to Glitnir
  - Glitnir in trouble
• Margin calls from ECB (ISK collateral no longer
  covered EUR loans) and breached covenants
• Banking crisis

24
Destabilising exchange rate dynamics

• Vicious spiral ended in collapse of the banking
  system
• An important reason borrowing in foreign
  currency (financial euroisation)
• During the boom foreign inflows and a
  strengthening krona fuelled the fire
• During the liquidity crisis (August 2007 Sept
  2008) the weakening krona wreaked havoc on
  balance sheets and confidence
• Now, after the crash, many (maybe most) firms and
  some households in Iceland are technically
  bankrupt, i.e. with negative equity
• Positive correlation between asset markets and
  ISK destabilising - exacerbated both upswing and
  downturn
• The downwards spiral went all the way
• Stock market almost completely wiped out
• Ditto corporate bond market
• Devastating effects on firms, homes and pension
  funds

25
Correlations exchange rate and share
prices(Holds up even after controlling for
foreign stock prices)
26
Financial euroisation in Iceland

• Pervasive external and internal on the
  liability side (outside financial sector)
• Banks hedged their position
• But borrowing by homes and non-tradable sectors
  created balance sheet risks which materialised
  as the krona collapsed
• This, in turn, led to credit risk which was
  probably an important underlying factor for the
  liquidity crisis that hit Icelandic banks after
  the onset of the subprime crisis (August 2007)

27
Source CBI Monthly Economic Indicators
28
Share of foreign currency in banks domestic
lending
29
Why did foreign currency become so pervasive on
liability side?

• Fluctuations in ISK notwithstanding, real
  exchange rate has been fairly stable over the
  medium term
• Due to fast passthrough, the central bank had a
  semi-official exchange rate target wanted to
  maintain a stable exchange rate
• Virtually the only functioning channel for
  monetary policy
• Exchange rate supported by high interest rate
• High interest rate differential approximately
  10 was too tempting for firms and homes even
  those that were not hedged
• So they borrowed in foreign currency often
  low-yielding (yen, CHF)
• A form of carry trade
• CBIs attempts to support the ISK reinforced this
  development

30
(No Transcript)
31
Higher policy rate had limited impact on
long-term interest rates, but encouraged
borrowing in foreign currency and attracted carry
trade
32
Short vs. long rates in Iceland3 year moving
correlation between monthly changes
33
Carry trade was an important driver in exchange
rate developments
34
In the end undone by banks market
termsExchange rate, interest rate differential,
CDS spread
35
Concluding thoughts on the crisis

• Icelandic banks were solvent according to
  regulatory standards yet they collapsed in a
  crisis of liquidity
• Vicious spiral size of banks vs. size of
  Iceland reinforced by macroeconomic imbalances
  in Iceland and agressive growth of banks
• Could it have been avoided? With some degree of
  hindsight
• Should have been clear late 2007/early 2008 that
  the financial crisis would not come to a quick
  resolution
• A decisive process of deleveraging of Iceland -
  sale of assets or transfer of bank headquarters
  should have been started
• Ownership structure was probably important in
  preventing holding companies and management
  would have realised huge losses
• Coventants were also important in stopping
  deleveraging (Jännäri, March 2009)
• The rapid buildup of Icesave/Edge branch accounts
  especially from early 2008 should have rung
  regulatory alarm bells
• Again covenants were a serious stumbling block
  (Jännäri, March 2009)

36
The aftermath
37
IMF agreement in November

• Objective strengthen currency reserves and
  support exchange rate
• IMF and others lend 5 bn USD to strengthen
  currency reserves
• Concomitant package of measures designed to
  gurantee repayment
• Banking review and revision
• Public sectorfiscal consolidation
• Monetary policy and foreign exchange extreme
  tightening
• Large increase in public deficit and debt
  inevitable, albeit from a low level
• Fiscal deficit is not financed by IMF related
  loans (almost all the IMF loan is sitting in an
  account at the US Fed) so considerable fiscal
  tightening needed over next 3-4 years (cumulative
  12 of GDP)
• Monetary policy extremely tight (policy rate
  started at 18, now down to 15.5), especially in
  light of low inflation expectations
• Foreign exchange restricted due to an overhang
  of ISK denominated debt to the tune of 40 of GDP

38
Expected macro developments (IMF/MoF)

• V-shaped recession bottoming out in 2010 strong
  growth from 2011
• Unemployment peaking 2010 at 8.5
• Inflation is now 11.9 (12 m lagging) and is
  projected to decline rapidly to 2.5 towards the
  end of 2009
• Almost 15 drop in real disposable income in 2009
• Considerable surplus on current account
• This forecast was based on a more positive
  international development than now envisaged
• Micro policies working homes and viable firms
  quickly and efficiently out of bankruptcy an
  extremely important premise

39
Fiscal position

• Perception (at least internationally) seems to be
  that the state of Iceland nationalised the banks
  as a whole and took on all the debts of the banks
  the CDS spread is still hovering around 9
• Paul Krugman Weve seen one advanced country
  Iceland essentially go bankrupt. (April 14,
  2009)
• This is misleading
• The private financial sector in Iceland was
  essentially bankrupted although there are some
  small survivors. However, the Icelandic Treasury
  has not defaulted and there is no intention or
  prospect of that happening.
• Treasury had little gross debt and zero net debt
  prior to the crisis
• Will now be higly indebted gross debt probably
  close to 80 at the end of 2009
• Loss due to Icesave guarantees (41 of GDP), loss
  on collateral loans (19), 2009 deficit (10)
• Uncertainty about net debt depends to large
  extent on how much sales of bank assets will
  fetch may end up at about 30 of GDP
• A serious blow for the people of Iceland a
  setback of some years in living standards, but
  still manageable

40
Some challenges for incoming government

• Get fiscal situation under control with (growth
  supportive) tax policy and reduction in
  expenditure
• Get banking system up and running again
• Implement efficient bankruptcy procedures in
  order for homes and viable firms that become
  bankrupt to get quickly on their feet again
• Establish an efficient and credible monetary
  policy
• Open up the currency market and lift restrictions
  on capital mobility
• Convince international markets that Iceland is on
  a sustainable path to recovery

41
Nobody is convinced yetTrade weighted exchange
rate index
42
Thanks for listening!

• Recommended reading Kaarlo Jännäri , Report on
  Banking Regulation and Supervision in Iceland
  Past, Present and Future, March 2009 (contains,
  inter alia, an insider informed account of the
  events leading up to the October crash)