FINANCIAL STABILITY IN ICELAND

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FINANCIAL STABILITY IN ICELAND FREDERIC S.
MISHKIN GRADUATE SCHOOL OF BUSINESS, COLUMBIA
UNIVERSITY TRYGGVI T. HERBERTSSON INSTITUTE OF
ECONOMIC STUDIES, UNIVERSITY OF
ICELAND PPRESENTATION AT THE SCANDINAVIA HOUSE,
NEW YORK MAY 3 2006
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INTRODUCTION

• BECAUSE OF HIGH VOLATILITY IN FINANCIAL MARKETS
  ICELAND HAS BEEN RECEIVING A LOT OF ATTENTION
  LATELY
• AFTER A NEGATIVE REPORT BY FITCH RATINGS THE
  CURRENCY (ISK) AND THE STOCK MARKET FELL
• MARKET ANALYSTS HAVE BEEN RAISING CONCERNS ABOUT
  ICELAND'S FUTURE STABILITY WORRYING THAT
  ICELAND MIGHT GO DOWN THE ROUTE OF THAILAND AND
  TURKEY TOWARD FINANCIAL MELTDOWN
• OUR REPORT PROVIDES A FRAMEWORK TO THINK MORE
  SENSIBLY ABOUT ICELAND'S POTENTIAL FOR FINANCIAL
  FRAGILITY
• 1. UNIQUENESS OF ICELAND'S ECONOMY
• 2. ANALYSIS OF HOW FINANCIAL INSTABILITY OCCURS

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THE PLOT

• 1. OVERVIEW OF THE ICELANDIC ECONOMY
• 1.1 UNIQUE IN SIZE
• 1.2 ADVANCED COUNTRY WITH EXCELLENT INSTITUTIONS
• 1.3 STRONG FISCAL POSITION
• 1.4 UNIQUENESS OF THE FINANCIAL SECTOR
• 2. UNDERSTANDING FINANCIAL INSTABILITY
• 2.1 WHAT IS FINANCIAL INSTABILITY
• 2.2 WHAT CAUSES FINANCIAL INSTABILITY TO OCCUR?
• 2.3 ROUTES TO FINANCIAL INSTABILITY
• 3. IS ICELAND GOING DOWN TRADITIONAL ROUTES TO
  FINANCIAL INSTABILITY
• 3.1 FINANCIAL LIBERALIZATION WITH WEAK PRUDENTIAL
  REGULATION AND SUPERVISION?
• 3.2 SEVERE FISCAL IMBALANCES?
• 3.3 IMPRUDENT MONETARY POLICY?
• 3.4 BUT WHAT ABOUT THE CURRENT ACCOUNT DEFICIT?

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THE PLOT

• 4. ARE THERE OTHER FINANCIAL STABILITY CONCERNS?
• 4.1 COULD BANK REFINANCING BE A PROBLEM?
• 4.2 COULD RAPID CREDIT GROWTH OF BANKS BE A
  PROBLEM?
• 4.3 IS THE FINANCIAL SUPERVISORY AUTHORITY
  MONITORING RISK SUFFICIENTLY?
• 4.4 COULD THERE BE MULTIPLE EQUILIBRIA?
• 5. CONCLUSIONS AND POLICY
• RECOMMENDATIONS
• 5.1 MICROECONOMIC POLICIES
• 5.2 MACROECONOMIC POLICIES

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OVERVIEW
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UNIQUE IN SIZE

• SMALLEST COUNTRY IN THE WORLD WITH ITS OWN
  CURRENCY AND FLEXIBLE EXCHANGE RATE
• CURRENT ACCOUNT DEFICIT VERY HIGH CURRENTLY, BUT
  HISTORY SHOWS THAT THE ECONOMY AND CURRENT
  ACCOUNT ADJUST RAPIDLY
• FLEXIBLE ECONOMY

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UNIQUE IN SIZE

• CURRENT ACCOUNT IS MORE VOLATILE IN SMALL
  COUNTRIES SO IT HAS TO BE INTERPRETED DIFFERENTLY
• CURRENT ACCOUNT DEFICIT COULD BE OPTIMAL
• LARGE, LUMPY INVESTMENTS FOR SMALL ECONOMY RESULT
  IN LARGE CA DEFICIT
• EXCHANGE RATE UNUSUALLY FAVORABLE, OPTIMAL FOR
  HOUSEHOLDS TO BORROW TO FINANCE CONSUMPTION OF
  IMPORTED GOODS (CONSUMPTION SMOOTHING)

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ADVANCED COUNTRY WITH EXCELLENT INSTITUTIONS

• ONE OF THE RICHEST COUNTRIES IN WORLD (5 IN PPP
  TERMS)
• INSTITUTIONAL RANKINGS
• 5 FOR ECONOMIC FREEDOM
• 1 FOR LOW CORRUPTION
• 4 FOR COMPETITVENESS
• 1 FOR FREEDOM OF THE PRESS

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STRONG FISCAL POSITION

• CURRENTLY HAS LARGE BUDGET SURPLUS
• NET DEBT OF CENTRAL GOVERNMENT ALMOST ZERO
• PENSION SYSTEM IS FULLY FUNDED AND AGE STRUCTURE
  OF POPULATION IS FAVORABLE
• BOTTOM LINE U.S., JAPAN AND EUROPE WOULD LOVE TO
  BE IN ICELAND'S SHOES

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STRONG FISCAL POSITION
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STRONG FISCAL POSITION

• HOWEVER, EXTERNAL DEBT HAS GROWN DRAMATICALLY IN
  RECENT YEARS

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UNIQUENESS OF FINANCIAL SECTOR

• FINANCIAL SECTOR WAS HIGHLY REPRESSED UNTIL 1980S
  WHEN FINANCIAL LIBERALIZATION STARTED
• LIBERALIZATION ESSENTIALLY COMPLETE BY 1995
  (PRIVATIZATION SOMEWHAT LATER
• BANKING SYSTEM TRANSFORMS FROM DOMESTIC LENDER TO
  INTERNATIONAL FINANCIAL INTERMEDIARIES
• IN LAST FIVE YEARS!!!
• ICELAND MOVES TOWARD BECOMING LIKE HONG KONG,
  NETHERLANDS, SWITZERLAND AS INTERNATIONAL
  FINANCIAL CENTER (BUT ON A SMALLER SCALE)

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UNIQUENESS OF FINANCIAL SECTOR
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UNIQUENESS OF FINANCIAL SECTOR
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FINANCIAL INSTABILITY
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UNDERSTANDING FINANCIAL INSTABILITY

• WHAT IS FINANCIAL INSTABILITY?
• FINANCIAL INSTABILITY OCCURS WHEN THERE IS A
  DISRUPTION TO FINANCIAL MARKETS IN WHICH
  ASYMMETRIC INFORMATION AND HENCE ADVERSE
  SELECTION AND MORAL HAZARD PROBLEMS BECOME MUCH
  WORSE, SO THAT FINANCIAL MARKETS ARE UNABLE TO
  EFFICIENTLY CHANNEL FUNDS TO THOSE WHO HAVE THE
  MOST PRODUCTIVE INVESTMENT OPPORTUNITIES.

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WHAT CAUSES IT TO OCCUR?

• DETERIORATION IN BANK BALANCE SHEETS
• BANKS ARE SPECIAL BECAUSE THEY SOLVE ASYMMETRIC
  INFO PROBLEMS, SO IF THEIR LENDING IS IMPAIRED BY
  WEAK BALANCE SHEETS, OVERALL LENDING DECLINES AND
  ECONOMY CONTRACTS
• IF THE DETERIORATION IS SEVERE ENOUGH BANK PANICS
  CAN OCCUR, WITH EVEN SHARPER CONTRACTION IN
  ECONOMIC ACTIVITY
• DETERIORATION IN NON-FINANCIAL BALANCE SHEETS
• NET WORTH DECLINES gt LESS COLLATERAL TO SOLVE
• ADVERSE SELECTION PROBLEM gt LENDING DOWN
• NET WORTH DECLINES gt FIRM HAS LESS AT STAKE
• gt MORAL HAZARD INCENTIVES TO TAKE RISK
• INCREASES gt LENDING DOWN

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WHAT CAUSES IT TO OCCUR?

• CURRENCY CRISES
• WITH FOREIGN CURRENCY DEBT, LIABILITY
  DOLLARIZATION
• DEPRECIATION RAISES VALUE OF LIABILITIES IN
  DOMESTIC CURRENCY gt BALANCE SHEETS DETERIORATE
  gt ADVERSE SELECTION AND MORAL HAZARD INCREASE gt
  LENDING DOWN
• HOWEVER, ONLY HAPPENS FOR FIRMS WHOSE ASSETS ARE
  VALUED IN DOMESTIC CURRENCY
• HOWEVER IF ASSETS VALUED IN FOREIGN CURRENCY,
  THEN DEPRECIATION RAISES ASSET VALUE IN DOMESTIC
  CURRENCY TO OFFSET RISE IN VALUE OF LIABILITIES
• I.E., LIABILITY DOLLARIZATION IS HEDGED (EITHER
  NATURALLY OR WITH DERIVATIVES)

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WHAT CAUSES IT TO OCCUR?

• FLOATING FX REGIME LESS LIKELY TO LEAD TO
  INSTABILITY THAN PEGGED REGIME
• 1. FX RISK APPARENT SO FIRMS AND BANKS MORE
  LIKELY TO HEDGE
• 2. CHANGE IN EXCHANGE RATE LESS NON-LINEAR
• 3. LIABILITY DOLLARIZATION LESS LIKELY
• FLOATING FX REGIME LESS LIKELY TO LEAD TO
  INSTABILITY THAN PEGGED REGIME, STANLEY FISCHER
• EACH OF THE MAJOR INTERNATIONAL CAPITAL
  MARKET-RELATED CRISES SINCE 1994-MEXICO IN
• 1994, THAILAND, INDONESIA AND KOREA IN 1997,
  RUSSIA AND BRAZIL IN 1998, AND ARGENTINA AND
• TURKEY IN 2000- HAS IN SOME WAY INVOLVED A FIXED
  OR PEGGED EXCHANGE RATE REGIME. AT THE
• SAME TIME, COUNTRIES THAT DID NOT HAVE PEGGED
  RATES - AMONG THEM SOUTH AFRICA, ISRAEL IN 1998,
  MEXICO IN 1998 - AVOIDED CRISES OF THE TYPE THAT
  AFFLICTED EMERGING MARKET COUNTRIES WITH PEGGED
  RATES.

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ICELAND AND FINANCIAL INSTABILITY
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ROUTES TO FINANCIAL INSTABILITY

• 1. FINANCIAL LIBERALIZATION WITH WEAK PRUDENTIAL
  REGULATION AND SUPERVISION
• BANKS GO ON LENDING SPREE gt BAD LOANS gt BANK'S
  BALANCE SHEETS DETERIORATE gt BANK LENDING DOWN
  gt INVESTMENT AND ECONOMY CONTRACT
• DETERIORATION IN BANK BALANCE SHEETS TRIGGERS
  CURRENCY CRISIS GOVERNMENT CAN'T DEFEND CURRENCY
  BY RAISING INTEREST RATES BECAUSE WILL DO FURTHER
  DAMAGE TO BANKS ONCE MARKETS REALIZE THIS,
  SPECULATORS PILE ON AND ATTACK CURRENCY
• CURRENCY CRISIS gt DESTRUCTION OF FIRMS BALANCE
  SHEETS IF LIABILITY DOLLARIZATION gt ADVERSE
  SELECTION AND MORAL HAZARD RISE gt LENDING FALLS
  AND ECONOMY CONTRACTS
• SOLUTION TO PROBLEM IS GOOD PRUDENTIAL REGULATION
  AND SUPERVISION
• IN COUNTRIES WITH WEAK INSTITUTIONAL ENVIRONMENT
  (CORRUPTION, UNFREE PRESS) POWERFUL BUSINEES
  INTERESTS MAKE SURE IT DOESN'T HAPPEN.
• SEE MISHKIN THE NEXT GREAT GLOBALIZATION HOW
  DISADVANTAGED NATIONS CAN HARNESS THEIR FINANCIAL
  SYSTEMS TO GET RICH (PUP FALL 2006)

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ROUTES TO FINANCIAL INSTABILITY

• IS ICELAND GOING DOWN THIS ROUTE?
• NO

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ROUTES TO FINANCIAL INSTABILITY

• PROBLEMS WITH FINANCIAL LIBERALIZATION USUALLY
  COME WITHIN 5 YEARS ICELAND COMPLETED IT OVER
  TEN YEARS AGO
• STRONG INSTITUTIONAL ENVIRONMENT IN ICELAND
  SUGGESTS PRUDENTIAL REGULATION AND SUPERVISION IS
  OF HIGH QUALITY
• STRESS TESTS INDICATE BANK CAPITAL IS SUFFICIENT
• FOREIGN DENOMINATED DEBT IS TO FOREIGN FIRMS OR
  DOMESTIC FIRMS WHOSE CASH FLOW IS DENOMINATED IN
  FOREIGN CURRENCY
• HOUSEHOLDS DO NOT HAVE FOREIGN DENOMINATED DEBT
  AND DEBT SERVICE RATIOS ARE NOT ABOVE LEVEL IN
  2000

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ROUTES TO FINANCIAL INSTABILITY

• 2. SEVERE FISCAL IMBALANCES
• FISCAL IMBALANCES LEAD TO PLACING OF GOVERNMENT
  DEBT ON BANKS BALANCE SHEETS (ARGENTINA) WHEN
  CONCERNS ABOUT DEFAULT OCCUR, VALUE OF GOVT DEBT
  FALLS gt DETERIORATION IN BANK BALANCE SHEETS gt
  FINANCIAL INSTABILITY
• PROSPECT OF GOVT DEFAULT gt PEOPLE PULL MONEY OUT
  OF COUNTRY gt CURRENCY CRISIS gt DETERIORATION OF
  BALANCE SHEETS gt FINANCIAL INSTABILITY

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ROUTES TO FINANCIAL INSTABILITY

• IS ICELAND GOING DOWN THIS ROUTE?
• NO
• ICELAND HAS A VERY STRONG FISCAL POSITION

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ROUTES TO FINANCIAL INSTABILITY

• 3. IMPRUDENT MONETARY POLICY
• BAD MONETARY POLICY LEADS TO INFLATION AND
  UNHEDGED LIABILITY DOLLARIZATION THAT MAKES
  FINANCIAL SYSTEM MORE FRAGILE
• WEAKENING OF CENTRAL BANK CREDIBILITY LEADS TO
  DEPRECIATION OF CURRENCY gt DETERIORATION OF
  BALANCE SHEETS gt FINANCIAL INSTABILITY (ANOTHER
  PART OF ARGENTINA STORY)

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ROUTES TO FINANCIAL INSTABILITY

• IS ICELAND GOING DOWN THIS ROUTE?
• NO

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ROUTES TO FINANCIAL INSTABILITY

• INFLATION TARGETING HAS WORKED WELL AND CENTRAL
  BANK OF ICELAND HAS HIGH CREDIBILITY. AFTER
  INITIAL PERIOD OF HIGH INFLATION IN 2001-2002,
  INFLATION HAS BEEN LOW, PARTICULARLY IF HOUSING
  IS TAKEN OUT FROM INFLATION MEASURE

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ROUTES TO FINANCIAL INSTABILITY

• BUT WHAT ABOUT THE LARGE CURRENT ACCOUNT DEFICIT?
• THEORY OF FINANCIAL CRISES DOES NOT GIVE THEM
  PROMINENT ROLE RATHER DEEPER FUNDAMENTALS DRIVE
  FINANCIAL INSTABILITY
• CA DEFICITS AND COUNTERPART OF LARGE CAPITAL
  INFLOWS CAN LEAD TO LENDING BOOM THAT PRECIPATE
  FINANCIAL INSTABILITY, BUT THIS HAS NOT BEEN A
  PROBLEM IN ICELAND WHERE LARGE CURRENT ACCOUNT
  DEFICITS HAVE BEEN REVERSED WITH
• LITTLE STRESS ON FINANCIAL SYSTEM

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ROUTES TO FINANCIAL INSTABILITY

• BOTTOM LINE
• ICELAND IS NOT LIKE THAILAND OR ANY OTHER
  EMERGING MARKET COUNTRY THAT HAS EXPERIENCED A
  FINANCIAL CRISIS

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ARE THERE OTHER CONCERNS?
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ARE THERE OTHER CONCERNS?

• 1. COULD BANK REFINANCING BE A PROBLEM
• ICELAND'S BANKS HAVE HAD SOME TROUBLE LATELY
  REFINANCING
• REFINANCING PROBLEMS REFLECTED IN CDS SPREADS
• BANKS ARE LIQUID AND HAVE CREDIT LINES, BUT THERE
  IS A RISK FROM REFINANCING PROBLEMS
• HIGHLY UNLIKELY THAT ICELAND'S BANKS WILL BE THE
  NEXT CREDIT EVENT!

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ARE THERE OTHER CONCERNS?

• 2. COULD RAPID GROWTH OF BANKS BE A PROBLEM?
• COULD LEAD TO DETERIORATION OF BANK BALANCE
  SHEETS IF THEY HAVE NOT DEVELOPED ORGANIZATIONAL
  CAPITAL TO HANDLE NEW BUSINESS
• SITUATION IN ICELAND IS UNPRECEDENTED MOVEMENT
  TO INTERNATIONAL BANKING CENTER IN 5 YEARS MAKES
  THESE CONCERNS LEGITIMATE - INCREASED INVESTMENT
  BANKING ACTIVITIES HAVE MADE BANKS LESS
  TRANSPARENT
• BANKS ARE BEGINNING TO DEAL WITH THIS PROBLEM

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ARE THERE OTHER CONCERNS?

• 3. IS THE FINANCIAL SUPERVISORY AUTHORITY
  MONITORING RISK SUFFICIENTLY?
• IS THE FSA ABLE TO MANAGE UNPRECEDENTED
  TRANSITION OF BANKS TO INTERNATIONAL FINANCIAL
  INTERMEDIARIES?
• FSA IS WELL AWARE OF PROBLEM LATEST ANNUAL
  REPORT
• ON THE OTHER HAND, THE RAPID GROWTH IN THEIR
  FOREIGN OPERATIONS, ESPECIALLY IN ACQUIRING
  EXISTING FINANCIAL ENTERPRISES, MEANS NEW RISKS
  AND CALLS FOR MORE COMPLEX AND MORE ROBUST RISK
  MANAGEMENT THAN BEFORE.

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ARE THERE OTHER CONCERNS?

• 4. COULD THERE BE MULTIPLE EQUILIBRIA?
• UNIQUE SMALL SIZE OF ICELAND MAKES IT VULNERABLE
  BECAUSE ONLY SMALL SHIFT IN INTERNATIONAL
  PORTFOLIO FLOWS WOULD HAVE A HUGE IMPACT ON
  ICELAND AND LEAD TO SELF FUFILLING PROPHECY OF
  FINANCIAL MELTDOWN EVEN THOUGH FUNDAMENTALS DON'T
  WARRANT IT
• HOWEVER, THEORY OF MULTIPLE EQUILIBRIA INDICATES
  BAD EQUILIBRIUM MUCH MORE LIKELY TO OCCUR WHEN
  FUNDAMENTALS ARE WEAK
• FUNDAMENTALS IN ICELAND ARE STRONG

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POLICY RECOMMENDATIONS
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CONCLUSIONS POLICY RECOMMENDATIONS

• POSSIBILITY OF MULTIPLE EQUILIBRIA WHICH COULD DO
  SERIOUS DAMAGE TO ICELAND'S ECONOMY SUGGESTS NEED
  FOR POLICIES TO BOLSTER CONFIDENCE
• TWO TYPES OF POLICIES
• MICRO
• MACRO

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CONCLUSIONS POLICY RECOMMENDATIONS

• 1. FINANCIAL SUPERVISION MIGHT BE MORE EFFECTIVE
  IF IT WAS CONSOLIDATED INSIDE THE CENTRAL BANK OF
  ICELAND.
• GOOD REASONS TO HAVE PRUDENTIAL SUPERVISION IN
  CENTRAL BANK
• CBS NEED INFO TO DO LENDER-OF-LAST-RESORT
  PROPERLY
• GOODFRIEND AND KING (1988), MISHKIN (1992) AND
  BERNANKE (2005) MAKE THIS ARGUMENT
• ICELAND HAS ADDITIONAL REASON BECAUSE OF SMALL
  SIZE
• TINY POPULATION MEANS IT IS HARD TO FIND ENOUGH
  INDIVIDUALS WITH EXPERTISE IN PRUDENTIAL
• SUPERVISION
• DANGER OF SPREADING EXPERTISE TOO THIN IF
  PRUDENTIAL SUPERVISION IS IN TWO PLACES
• CB ALREADY HAS TO WORRY ABOUT SYSTEMIC RISKS AND
  ISSUES FINANCIAL STABILITY REPORT (PUBLISHED
  TOWMORROW)
• MAKES SENSE TO PUT SUPERVISION UNDER ONE ROOF AT
  THE CB

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CONCLUSIONS POLICY RECOMMENDATIONS

• 2. ICELAND'S COMMERCIAL BANKS SHOULD BE
  ENCOURAGED AND SHOULD ALSO SEE THAT IT IS IN
  THEIR BEST INTEREST TO DISCLOSE MORE INFORMATION
  ABOUT THEIR ACTIVITIES.
• WHEN FUNDAMENTALS ARE SOUND, DISCLOSURE MAKES BAD
  SELF-FULFILLING PROPHECY LESS LIKELY

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CONCLUSIONS POLICY RECOMMENDATIONS

• 3. THE CENTRAL BANK OF ICELAND SHOULD CHANGE THE
  MEASURE THAT IT USES FOR ITS INFLATION TARGET TO
  MINIMIZE THE INFLUENCE OF HOUSING PRICE
  FLUCTUATIONS.
• MONETARY THEORY SUGGESTS THAT CB SHOULD TARGET ON
  INFLATION MEASURES THAT ARE MOSTLY COMPRISED OF
  PRICES THAT ARE STICKY, AND SO EXCLUDE ASSET
  PRICES SUCH AS HOUSING, BUT WHICH CAN TAKE
  ACCOUNT OF THE IMPUTED RENTS
• FROM THESE ASSETS THIS HELPS STABILIZE OUTPUT
  FLUCTUATIONS
• CPI MEASURE IN ICELAND A PARTICULAR PROBLEM
  BECAUSE IT MAKES CB LOOK LIKE IT HAS NOT BEEN
  DOING A GOOD JOB WHEN IT HAS - CREATES
  UNWARRANTED CREDIBILITY PROBLEMS

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CONCLUSIONS POLICY RECOMMENDATIONS

• 4. THE GOVERNMENT SHOULD IMPLEMENT A FORMAL
  FISCAL POLICY RULE IN ORDER TO DAMPEN THE
  ICELANDIC BUSINESS CYCLE TO SUPPORT MONETARY
  POLICY BETTER
• FISCAL RULE THAT MAKES ICELAND'S FISCAL POLICY
  LESS PROCYCICAL WOULD HELP DAMPEN CURRENT ACCOUNT
  SWINGS AND BUSINESS CYCLE FLUCTUATIONS
• HAS WORKED WELL IN CHILE

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CONCLUSIONS

• THE FOUR RECOMMENDATIONS, WHICH ARE BY NO MEANS
  EXHAUSTIVE, WOULD INCREASE STABILITY OF ICELAND'S
  ECONOMY AND LOWER PROBABILITY OF MULTIPLE
  EQUILIBRIA
• BOTTOM LINE LIKELIHOOD OF FINANCIAL MELTDOWN IS
  VERY LOW