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Iceland and the Financial Crisis - Origins, consequences, lessons -


Iceland and the Financial Crisis - Origins, consequences, lessons - Presentation by the INAO 26 February 2010 Topics What has happened in Iceland? – PowerPoint PPT presentation

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Title: Iceland and the Financial Crisis - Origins, consequences, lessons -

Iceland and the Financial Crisis - Origins,
consequences, lessons -
  • Presentation by the INAO
  • 26 February 2010

  • What has happened in Iceland?
  • How the crisis originated and evolved
  • What measures were taken
  • How the INAO was affected
  • Challenges and lessons learned

What has happened?
  • After enjoying a rapid growth for a number of
    years Icelands economy took a sharp turn to the
    worse in 2008 that culminated in October when the
    Icelandic banking system collapsed.
  • These events correlated with international
    developments (booming economies followed by a
    financial crisis).
  • But they had more serious consequences in Iceland
    due to its (relatively) huge banking sector (10x
    GDP), its reliance on foreign trade (40 of GDP),
    foreign currency denominated debts, and other

  • Economic and fiscal consequences
  • GDP decreased in real terms by 6 between 2008
    and 2009. Predictions for 3-4 further decline in
    GDP in 2010
  • Inflation peaked to 12 in 2008 and 2009 (16 in
    2009 without the housing component). Predicted to
    be 6 in 2010
  • The value if the ISK has decreased 50 against
    the euro in two years. The ISK is predicted to
    remain weak
  • Unemployment has risen from 2,3 in 2007 to 7,2
    in 2009. Even higher rates are projected for 2010
  • Central government budget deficit has gone from
    0 to 14 of GDB
  • Gross government debts likely to exceed 100 of
  • Source Statistics Iceland, Central Bank of

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How the crisis originated and evolved
  • A worldwide financial crisis started in 2007,
    caused by a number of factors, e.g.
  • Easy availability of low-interest loan capital
    during the 2000s.
  • Resulted in classical asset and loan bubbles in
    many countries.
  • Complicated by financial products that made
    valuations/risks difficult to determine
    (sub-prime lending, derivatives, etc.) while
    incentive pay-schemes awarded short term profits
    and risk-taking appetite.
  • Worldwide banking operations linked economies
    together making booms and depressions global
    instead of local.

  • In Iceland
  • Deregulation of financial markets in the 1990s
    (after Iceland joined the EEA).
  • Privatization of banks in yearly 2000s.
  • Icelandic business and banks invested heavily
    abroad, often by leveraged buyouts. Stock market
    prices in Iceland quadrupled in 5 years.
  • Huge govenment sponsored investment projects were
    launched during the 2000s (hydro-energy and
    aluminum smelting plants).

  • In Iceland (cont.)
  • Changes to the housing loan system resulted in
    higher loan-to-value ratios and greater
    competition. Real estate prices doubled in 5
  • Lowering of tax ratios while increasing public
    expenditures (made everyone happy!)
  • The CBI gradually increased its interest rates in
    order to stem inflation (its monetary policy
    based on inflation targets)
  • Resulted in (1) businesses and homes seeking
    foreign loans, and (2) carry-trade as never seen
  • Is inflation really always a bad thing?

  • In Iceland (cont.)
  • Homes increased their expenditures, partly paying
    for by higher incomes but also by loans.
  • A shortage in the work-force was met with foreign
    workers (proportion of foreign citizens living in
    Iceland increased from 3,5 in 2003 to 7,6 in

How the crisis evolved
  • In early 2006 there was an Icelandic
    mini-banking crisis when CDS spreads increased
    and the banks were unable to seek funds for a
  • Bankers and the government agreed there was a
    lack of understanding about the Icelandic banks
    business model.
  • Report by economist F. Mishkin at Columbia
    University was commissioned by the Chamber of
    Commerce to assure investors everything was safe
    and sound.
  • Icelandic banks started to issue bonds in new
    markets (the Americas, Asia) and especially
    offering high-interest deposits through their
    branches and subsidiaries in Europe.
  • Confidence was bolstered when the assault had
    been halted.
  • During 2007 financial markets were starting to
    panic because of sub-prime lending, dubious CDOs,
    etc. and it became increasingly difficult and
    expensive to obtain capital. In March 2008 the
    investment bank Bear Stearns collapsed. Funding
    for the Icelandic banks again dried up as their
    CDS rose to new levels.
  • At the same time the ISK started to decline
    sharply as investors became increasingly worried.
  • The Icelandic banks had to depend on short time
    funds from the ECB and CBI. The CBI sought in
    wane to assure reserve funds.
  • After the Lehman Brothers collapse in September
    2008 it became obvious one or more of the
    Icelandic banks would become illiquid and
    default. One bank (Glitnir) sought assistance
    from the CBI.
  • At the beginning of October the three largest
    banks collapsed. The banking system had become
    too large to save. Events surrounding their
    collapse are still somewhat unclear with a lot of
    the blame game still going on.

  • Kaarlo Jännäris Report on Banking Regulation and
    Supervision in Iceland (March 2009)
  • The collapse of the Icelandic banking sector
    resulted from a combination of several factors
  • Bad banking
  • Bad policies
  • Bad luck
  • http//

  • Bad banking
  • The owners and managers of banks adopted an
    aggressive policy of rapid international growth
    based on high leverage and investment in growth
    areas that turned into bubbles.
  • In the euphoric stage of rapid growth, risk
    controls and contingency plans were considered a
    nuisance, and the quality of the banks assets
    and the collateral used to protect them did not
    withstand the pressure when the prevailing
    emotion in the overheated global financial market
    turned from greed to fear.
  • Icelands government and central bank were unable
    to support the overgrown banking sector in its
    difficulties. The banks had grown too big for

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  • Bad policies
  • The money and financial market in Iceland is
    highly indexed or foreign exchange-based. As a
    result, the CBIs monetary policy only affects a
    small fraction of the financial system. The high
    degree of foreign currency denominated lending
    domestically also made the economy susceptible to
    fluctuations in the external value of the
    Icelandic króna.
  • During the boom years, macroeconomic policies in
    general were too lax and accommodating. The CBIs
    foreign exchange reserves could not grow in
    tandem with the economys overall dependency on
    international developments. In addition, the
    CBIs human resources may have been too small for
    a country with a freely floating currency and a
    large banking system that was more international
    than domestic but was nonetheless viewed by
    foreigners as Icelandic.

  • Bad policies (cont.)
  • The FME Icelands financial regulator, was too
    small to supervise a complex banking system like
    that in Iceland. The powers of the supervisors
    were too limited, and the Nordic tradition of
    jurisprudence did not allow much leeway into
    discretion. The tycoons of the financial system
    could circumvent the underlying purpose of the
    regulations by sticking to the letter of the law
    with the help of diligent lawyers and complicated
    corporate structures.
  • The supervisors were too timid and lacked legal
    authority in their efforts to intervene in these
    developments, but the overall national pride in
    the success of the banks would probably have made
    it futile even to try while the going was good
    and success followed success.

  • Bad luck
  • Since the Great Depression of the 1930s, the
    modern world has not seen a financial global
    crisis like the one we are experiencing right
    now. In these circumstances, the efforts of the
    Icelandic banks to retrench in late 2007 and 2008
    were rather futile. Finally, the collapse of
    Lehman Brothers on September 15, 2008 struck the
    final blow to the ability of the Icelandic banks
    and the authorities to save the system.
  • There might just might have been a
    possibility for the Icelandic banks to survive if
    the almost total freezing of the international
    financial markets had not taken place and
    confidence in Iceland had not been lost. Even in
    that case, they probably would have needed
    government support to maintain their solvency, as
    credit losses would have risen due to the
    deterioration of their loan portfolios.
  • Now that the blaming game continues at high speed
    in Iceland, it is perhaps beneficial to bear in
    mind that most, if not all, Icelandic players in
    this game must also look in the mirror. Placing
    the blame solely on external circumstances is not

Anything new under the Sun?
  • The causes of the Nordic banking crises
  • Bad banking
  • Inadequate market discipline
  • Weak banking regulation and supervision,
  • Inadequate macro policies, including having to
    deal with financial liberalization.
  • Stefan Ingves, at a seminar on the Nordic
    banking crises hosted by Kredittilsynet, in Oslo
    in September 2002.
  • http//

What measures were taken
  • The government introduced an emergency
    legislation enabling the financial regulator
    (FME) to take over control of the banks and the
    establishment of new banks.
  • The idea was to ringfence domestic bank
  • This was mostly successful but authorities seem
    to have misjudged reactions by foreign creditors
    and esp. foreign governments.
  • Iceland was forced to seek assistance from the
    IMF and the Nordic countries, the first Western
    European country to do so since 1976. This move
    was hugely unpopular by many even if IMF has been
    rather soft on Iceland (except maybe the
    Icesave settlement).
  • Capital controls were introduced in November 2009
    as a temporarily measures but still remain in
    force with no obvious escape plan.

  • Issues related to deposit insurance guarantees
    stemming from Landsbankis operations in the UK
    and the Netherlands (Icesave accounts) have been
    difficult to resolve. Repeated discussions have
    yet to result in a final agreement. This also has
    become a hotly debated political issue (with
    parties changing agendas depending on if they are
    in government or it the opposition).
  • Inquiries and criminal investigations are taking
    place. Widespread distrust by the general public
    towards politicians and bankers.
  • A challenging task ahead to preserve the
    integrity and trust in the legal system (foreign
    creditors unhappy and accuse the government of
  • High expectations by the public towards the
    government to solve their problems. (But would
    this be a crisis if they were easily solved?)
  • Classical counter-depression measures with
    deficit spending not possible or appropiate.
  • No political consensus on the way ahead when it
    comes to EU membership, monetary policy and other
    major issues!

  • Restoring the banking system
  • New banks were established to take over domestic
    operations. Only domestic deposits and assets
    were transferred to them.
  • Settlement between the new and old banks has
    taken a lot longer than expected (valuation and
  • Eventually the old banks took over two the new
    banks (will be operated as subsidiaries) while
    the government retains ownership of the largest
  • Bankrupcy laws were changed to accomotate for a
    continuing but limited operations of the old
  • Dissatisfaction from many creditors of the old
    banks. Resolution committee have been criticized
    for lack of accountability (Who do they really
    represent? Conficts of interests. Lack of
    trans-parency). A legal minefield concerning ex
    post facto laws and discrimination.
  • Smaller banks (SL) are still being restored.

  • Measures to assist the banks debtors (business
    and homes)
  • Many debtors have loans denominated in foreign
    currencies (there are some doubts on the legality
    of such lending).
  • The government has repeatedly put a moratorium on
    foreclosures and introduced new legal measures
    than can be used instead of bankruptcy in some
    cases (greiðsluaðlögun skuldsanering).
  • Banks are offering extensions of loans, giving
    discounts on remaining balance if loans are
    transformed into ISK, etc.
  • Banks are also heavily involved in the financial
    restructuring of businesses. Widespread distrust
    by the public and in the media on how things are
    being handled following the crash (e.g. about
    ownership and competition). The banks and the
    government have not been successful in creating
    trust about the way things are handled.

Dont be careless!
  • Your are just starting, Göran Persson said in a
    speech at the University of Iceland yesterday
    Dec 10, 2008 while on a short visit by
    invitation of the Associations of Investors.
    Persson discussed the banking crisis in Sweden in
    the 90 and what Iceland could learn from
    Swedens experience. The government of Iceland
    needs to show strong fiscal discipline and cut
    the deficit.
  • I did so and ended up as one of the most hated
    politicians in Sweden for a number of year, but
    it was worth it, as the other option was worse,
    Persson said.
  • You have no time to loose. Some people say
    restructuring the public finances should be
    delayed until next year. I think the IMF shares
    that opinion. But why loose a year? Why wait?
    Persson asked.
  • Morgundbladid, December 11, 2008.
  • http//

Almost a year later
  • At yesterdays conference Nov 11, 2009, the
    government was also criticized by its financial
    advisor, Mats Josefsson.
  • It appears that the restoration of the economy
    is not being prioritized by the government these
    days. Lack of political decision-making is the
    main hindrance in the restoration of the
    Icelandic economy, he said .
  • He also told that the main weakness in the
    governments restructuring was than no single
    entity was responsible for decision making.
    Actions need to be coordinated and in order to
    create more trust a single entity should be
    responsible to give information to the public and
    to creditors.
  • Iceland Review
  • http//

How the INAO was affected
  • New tasks
  • Participating in the audit of the new banks while
    they remain in goverment ownership (only
  • Giving opinions on budget proposals
  • More frequent monitoring of the budget execution
  • New audit tasks in financial management, mergers,
    procurments, hiring practices etc.
  • A role in monitoring fiscal affairs of
  • All while cutting costs by 10 due to lesser

Challenges and lessons learned
  • A the macro level
  • A sound economic policy (fiscal and monetary) is
    important also during good times. A strong fiscal
    discipline is always needed.
  • Managing a floating exchange rate, inflation
    targets and interest rates is difficult (and even
    dangerous) esp. in a small open economy (has been
    called the impossible triad).
  • The CBI should never forget the mantra We are
    the lender of last resort! when considering the
    size of the banking and financial system.

  • At the micro level
  • Sensible rules and regulations on financial
    markets should be adopted and enforced with
    zero-tolerance and not in an overly legalistic
    way. Still, regulation has its limits and is not
    a cure for everything. There is always a danger
    of regulatory capture and laxness, esp. when
    everyone has forgotten the last crisis!
  • Warning signals should never be taken lightly
    and/or defensively. The most convenient
    explanations are not necessarily the right ones.
    Always make sure you consider the worst possible
    outcomes and decide if you are willing to face
  • In a small society there are often too close
    relationships leading to conflicts of interests.
    The pool of talents may also be too limited.
    These issues should always be treated as problems
    and for example met with the help of outside
    experts and advisors.

  • The Role of the SAI
  • In preventing crisis (maybe a little optimistic!)
  • Make sure there is reliable information
  • Make sure regulators are doing their job
  • Make sure there is enough risk awareness
  • In coping with crisis (more realistic)
  • Make sure limited funds are spent wisely
  • Government operations and projects need to be
  • Modern methods applied to help with decision
    makings (appraisal techinques, cost-benefit,
    cost-effectiveness analysis, value for money
    audits, etc.)
  • Report on progress, point out areas that need
    actions, create trust by closely monitoring all