financia'13 case study

7/29/2019 Financia'13 Case Study

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ICELAND CASE STUDY

For the greater part of this decade, Iceland has been ranked as the best place in the world to

live. However, in 2008 Iceland was devastated by a liquidity crisis that arose from the globalfinancial crisis. Over the preceding five years, Icelands banks transformed into huge

financial entities, controlling amounts of money far greater than the countrys own wealth.

Iceland was a state in turmoil; the countrys first ever riots forced the resignation of the

government which oversaw the unchecked growth of Icelandic banks.

HISTORY

Iceland started to form about 20 million years ago from a series of volcanic eruptions on the

Mid-Atlantic Ridge. The Iceland hotspot is likely partly responsible for the island's creation

and continued existence. Iceland remained for a long time one of the world's last largerislands uninhabited by humans.

Throughout the 19th century, the country's climate continued to grow worse, resulting in

mass emigration to the New World, particularly Manitoba in Canada. However, a new

national consciousness was revived in Iceland, inspired by romantic nationalist ideas from

continental Europe.

INTRODUCTION

Throughout the 19th century, the country's climate continued to grow worse, resulting in

mass emigration to the New World, particularly Manitoba in Canada. However, a new

national consciousness was revived in Iceland, inspired by romantic nationalist ideas from

continental Europe. This revival was spearheaded by the Fjlnismenn, a group of Danish-

educated Icelandic intellectuals. An independence movement developed under the leadership

of a lawyer named Jon Sigurdsson. In 1843 a new Althing was founded as a consultative

assembly. It claimed continuity with the Althing of the Icelandic Commonwealth, which had

remained for centuries as a judicial body and been abolished in 1800.

In 1874, a thousand years after the first acknowledged settlement, Denmark granted Iceland a

constitution and home rule, which again was expanded in 1904. The constitution was revisedin 1903, and a minister for Icelandic affairs, residing in Reykjavk, was made responsible to

the Althing, the first of whom was Hannes Hafstein. The Act of Union, a December 1, 1918,

agreement with Denmark, recognized Iceland as a fully sovereign statethe Kingdom of

Iceland - joined with Denmark in a personal union with the Danish king. Iceland established

its own flag, declared its neutrality and asked Denmark to represent its foreign affairs and

defense interests. The Act would be up for revision in 1940 and could be revoked three years

later if agreement was not reached.

These principles of partial sovereignty were exercised in the Swedish-Icelandic Declaration

regarding mutual protection of trade marks in Sweden and Iceland, exchanged at Copenhagenon March 23, 1921. Even though the declaration was signed in Copenhagen and with the


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approval of the Danish government, it was drawn in Swedish and Icelandic only, without the

Danish language being represented.

The culture of Iceland is rich and varied as well as being known for its literary heritage which

stems from authors from the 12th to 14th centuries. Other Icelandic traditional arts include

weaving, silver smiting, and wood carving. The Reykjavk area has several professional

theatres, a symphony orchestra, an opera, and a large amount of art galleries, bookstores,

cinemas, and museums. There are also four active folk dance ensembles in Iceland. Iceland's

literacy rate is among the highest in the world, and a love of literature, art, chess, and other

intellectual pursuits is widespread.

ICELANDS BANKING CRISIS

During one week in early October 2008, Icelands banking system went into meltdown,

threatening to suck the entire nation down with it. Global banks were reeling from post-

Lehman aftershocks and towards the end of September; Icelands three largest banks

Glitnir, Landsbanki and Kaupthing experienced a run on their foreign currency liabilities.

Given their high leverage, they quickly collapsed. The entire banking system accounted for

almost 900 per cent or a staggering 10 times Icelands GDP

These three banks represented 85 per cent of Icelands banking sector. At first, the

government drew up a plan to nationalize the first bank to show major fissures. However, the

transfer of assets never went through and in hindsight, this was probably Icelands salvation.

Following the Icelandic banking system liberalization of 2003, these banks had grown

rapidly, both domestically and internationally (through acquisitions). Capital inflows fed

strong domestic demand, and easy access to borrowing led to bubbles in Icelands property

and equity markets.

It turned out that at the time of the banks collapse, the banking system accounted for almost

900 per cent, or a staggering 10 times Icelands GDP. This compared to 237 per cen t of GDP

in France (BNP Paribas, CrditAgricole and SocGen), 101 per cent in Italy (Unicredit and

Intesa), 337 per cent in the UK (RBS, Barclays and HSBC) and merely 56 per cent for the top

five banks in the US.

The initial reaction of the credit rating agencies was to downgrade the sovereign debt.Standard & Poor had rated Iceland AA until April 2008, downgrading to BBB+ as news

broke out. Moodys even had them at AAA until May 2008. With the banks collapse,

Iceland was first downgraded to A1, then to BAA1 as the crisis developed. Iceland is

currently rated BBB- and BAA3 respectively.

The consumer prices ballooned due to higher prices on import prices. A staggering 75 per

cent of households had borrowed in foreign currency at a time when they believed it was

cheap to do so, and three-fourths of these borrowings were indexed to the price level.

The problem was way too large for Iceland to handle, leading the sovereign to seek the helpof the International Monetary FUND (IMF) and its Nordic neighbours. In November 2008 the


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International Monetary FUND (IMF)approved a Stand-By Arrangement (SBA) of SDR 1.4

billion (Special Drawing Rights). Denmark, Sweden, Finland, Norway, Poland and the Faroes

pitched in with financial assurance equivalent to another $2.75 billion.

The main objectives were to preserve the functioning of the domestic payment system; to

limit the absorption of private-sector losses by the public sector; and to keep some kind of

domestic banking system functioning and going forward. The government extended a

guarantee on all deposits to domestic depositors. Guaranteeing liabilities owed to overseas

creditors was never an option it would have ruined the country. The banks did not have any

government shareholding, and to all intents and purposes the whole issue was considered a

private-sector default.

Iceland was heading into a recession when lightning struck, and the meltdown pushed it

further in the dark, with the economy contracting by more than 10 per cent in the following

two years. However, the same currency devaluation reduced state spending and capital

controls helped kick start the economy which grew by 4.5 per cent in Q1 2012.

The Icelandic Central Bank approached the Bank of England in March 2008 for assistance to

support its currency as confidence in its heavily-indebted banking system began to ebb away.

Following sharp inflation in the Icelandic krna during 2008, the three major banks in

Iceland, Glitnir, Landsbanki and Kaupthing were placed under government control. A

subsidiary of Landsbanki, Icesave, which operated in the UK and the Netherlands, was

declared insolvent, putting the savings of thousands of UK and Dutch customers at risk. It

also transpired that over 70 local authorities in the UK held more than 550 million of cash in

Icelandic banks. In response to statements that the accounts of UK depositors would not be

guaranteed, the British governments seized assets of the banks and of the Icelandic

government.

On 28 October 2008, Iceland's central bank raised its interest rate to 18 per cent to fight

inflation.

Following negotiations with the IMF, a package of $4.6 billion was agreed on 19 November,

with the IMF loaning $2.1 billion and another $2.5 billion in loans and currency swaps from

Norway, Sweden, Finland and Denmark. In addition, Poland has offered to lend $200 million

and the Faroe Islands have offered 300 million Danish kroner ($50 million, about 3 per cent

of Faroese GDP).The Icelandic government also reported that Russia has offered $300

million. The next day, Germany, the Netherlands and the United Kingdom announced a joint

loan of $6.3 billion (5 billion), related to the deposit insurance dispute. (Dollar values are

US dollars.)

In 2001, banks were deregulated in Iceland. This set the stage for banks to upload debts when

foreign companies were accumulated. The crisis unfolded when banks were unable to

refinance their debts. It is estimated that the three major banks held foreign debt in excess of

50 billion, or about 160,000 per Icelandic resident, compared with Iceland's gross domestic

product of 8.5 billion.


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As early as March 2008, the cost of private deposit insurance for deposits in Landsbanki and

Kaupthing was already far higher (68% of the sum deposited) than for other European

banks. Households took on a large amount of debt, equivalent to 213% of disposable income,

which led to inflation. This inflation was exacerbated by the practice of the Central Bank of

Iceland issuing liquidity loans to banks on the basis of newly-issued, uncovered bondseffectively, printing money on demand.

In response to the rise in prices, 14% in the twelve months to September 2008, compared

with a target of 2.5% the Central Bank of Iceland has held interest rates high (15.5%). As

with many banks around the world, the Icelandic banks found it increasingly difficult to roll

over their loans in the interbank market, their creditors insisting on payment while no other

banks were willing to make fresh loans. In such a situation, a bank would normally have to

ask for a loan from the central bank as the lender of last resort.

The situation was made worse by the fact that Icesave was operating as a branch of

Landsbanki, rather than as a legally independent subsidiary. It was completely dependent on

the Central Bank of Iceland for emergency loans of liquidity, and could not turn to the Bank

of England for help. However the plan which was never implemented would have forced the

Icelandic banks to cut interest rates or stop taking new deposits, and might even have sparked

the sort of bank run it was designed to prevent.

The current economic climate in the country has affected many Icelandic businesses and

citizens. With the creation of NiLandsbanki, the new organization which replaces the old

Landsbanki, around 300 employees will lose their jobs due to a radical restructuring of the

organization which is intended to minimize the bank's international operations. Similar joblosses are expected at Glitnir and Kaupthing. The job losses can be compared with the 2,136

registered unemployed and 495 advertised vacancies in Iceland at the end of August 2008.

The national airline Iceland air has noticed a significant slump in domestic demand for

flights. However, the airline states that year-on-year international demand is up from last year

(2007). Morgunblai, an Icelandic newspaper had also cut some of the jobs and merging

parts of its operations with the media corporation 365. The newspaper 24 stundir has ceased

publication due to the crisis, resulting in the loss of 20 jobs.

Importers are particularly hard hit, with the government restricting foreign currency toessential products such as food, medicines and oil. The 400 million loan from the central

banks of Denmark and Norway is sufficient to pay for a month's imports, although on 15

October there was still a "temporary delay" which affected "all payments to and from the

country".

The assets of Icelandic pension funds are, according to one expert, expected to shrink by 15

25%.Iceland's GDP is expected to shrink by 10% as a result of the crisis, putting Iceland on

measures in an economic depression. Inflation may climb as high as 75% by the end of the

year (2008).


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Unemployment had more than tripled by late November 2008, with over 7000 registered

jobseekers. As 80% of household debt is indexed and another 13% denominated in foreign

currencies, debt payment is going to be more costly.


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EXHIBITS

CHANGE IN GDP RATIO


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BALANCE OF TRADE

Central Bank of Iceland, Statistics (2009)


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PPP RATIO

Icelands crisis and recession were severe, but imbalances have unwound partially . Thecollapse of the entire financial system in 2008 led to a deep recession, as Icelands pre-crisis

boom turned to a bus, investment and consumption fell to record lowlevels as a share ofGDP. Depreciation and the sharp decline in domestic demand led to a partial unwinding ofmacroeconomic imbalancesthe underlying current account swung into surplus and inflationdeclined.


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Questions

1. In your opinion, what led to the crisis in Iceland? Was it avoidable? How

could it have been avoided?2. Why did Icelandic banks run into trouble in the financial crisis, and what

has this meant for the depositors?3. What, in your opinion, are the lessons in Financial Stability for India

from the Iceland crisis?4. Should Iceland apply for the membership in the European Union or not?

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