Monetary and financial issues

Economic Survey of Iceland 2009: The financial and economic crisis

 

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The following OECD assessment and recommendations summarise chapter 1 of the Economic Survey of Iceland published on 2 September 2009.

 

Contents

 

 

Iceland has plunged into its deepest economic recession in decades after succumbing to a widespread financing crisis and a collapse of domestic demand. The meltdown of Icelandic banks unfolded against the backdrop of faltering global capital markets, which reached a climax in September 2008 with the failure of Lehman Brothers. By the fourth quarter of last year, almost all OECD countries were experiencing sharp declines in real GDP and world trade was plummeting. After years of rapid expansion, the economic situation in Iceland also turned for the worse when the country’s three main banks collapsed, capital markets seized up and financial relations with foreign countries were shut down. While Iceland is in part a victim of the international crisis, its severe plight largely results from a recent history of ineffective bank supervision, exceptionally aggressive banks and inadequate macroeconomic policies. The government has devised a medium-term adjustment programme to restore policy credibility and economic growth, which is being implemented in the context of an IMF Stand By Arrangement. The origins of Iceland’s severe banking and macroeconomic difficulties and policies for a sustainable recovery are discussed in this Economic Survey.


The collapse of Iceland’s three main banks caused a deep crisis

A banking crisis of extreme severity is unfolding in Iceland. After five years of brisk expansion, the country’s three main banks, representing 85% of the banking system, all collapsed during the same week in October 2008. The failure of Iceland’s banks was not an isolated event: in most other OECD countries, banks also came under severe stress following the sudden meltdown of global capital markets. But Icelandic banks were particularly vulnerable to such a shock because their very aggressive strategies had exposed them to massive equity market risk, and they had relied heavily on precarious sources of funding. Upon their failure, the three banks were put into receivership and new banks were formed to enable the domestic payment system to continue to function smoothly. Complex negotiations between the new banks and the creditors of the old banks were needed to reach a final settlement. With hindsight, it appears that the Icelandic financial supervisory authorities had become overwhelmed by the complexity of the national banking system, and had been unable to stop their expansion. In addition, there was a lack of a macro prudential framework that would have reacted to unsustainable developments in credit, leverage and risk. By the end, the size of the banks far exceeded the limited capacity of the Icelandic authorities to rescue them. Although the size of the banking sector has been reduced substantially, there is still a need to rethink the regulatory and supervisory framework.


The recession is set to be deeper than in most other OECD countries

A direct consequence of the crisis is that Iceland has entered a deep recession. The economy had already started to weaken in the first half of 2008 and, following the failure of the banks, the contraction in all components of domestic demand deepened markedly. The retrenchment of domestic demand is already much greater than in other OECD countries. Deep cuts in employment and working time were made, pushing up the unemployment rate sharply from 2.5% in the third quarter of 2008 to 7.1% by the first quarter of 2009. A sharp drop in the exchange rate of the króna caused inflation to soar initially, although it had slowed to 11.6% by May 2009 as the effects of the depreciation eased and depressed economic conditions weighed on firms’ pricing power. Wages have adjusted quickly to the crisis, falling by 6¾ per cent in real terms in the year to April 2009, with the fall being much more marked in the private– than the public sector. On the basis of announced macroeconomic policies (see below), the OECD projects a deep recession this year, with GDP shrinking by around 7%, and a gradual recovery beginning next year assuming that large energy related projects get underway as planned. The unemployment rate is projected to rise to a peak of 10% in 2010 while inflation should fall to around 2½ per cent.


A Stand By Arrangement was agreed with the IMF

Faced with an unprecedented crisis, the Icelandic authorities turned to the IMF for help and agreed to a programme supported by a Stand By Arrangement. In the near term, the programme seeks to prevent a further sharp depreciation of the króna to reduce the risk of adverse balance-sheet effects, which arise notably from the high shares of foreign-exchange denominated and inflation-indexed debt in the economy. To this end, the programme foresees a tight monetary policy to make króna assets more attractive and exchange controls to be maintained on the capital account. Beyond this immediate goal, the programme seeks to restore the smooth operation of the banking system. It also calls for strong fiscal consolidation to ensure medium-term sustainability. The Stand By Arrangement envisages access to official financing, from the IMF and other sources, of about US$ 5 billion.


Iceland’s banks pursued highly risky strategies that doomed them

The financial collapse largely results from the banks’ risky strategies. After the completion of banking privatization in 2003, the new owners set the banks on a path of international expansion and greater risk taking. Global financial market conditions were favourable at the time, enabling the banks to finance their expansion cheaply, mainly through wholesale markets. They grew quickly, increasing their consolidated assets to the equivalent of 880% of Icelandic GDP by the end of 2007, a very large amount by any standard. As they expanded, the banks increasingly made loans to a few Icelandic investment companies, typically controlled by the main shareholders of the banks, which were taking equity stakes in foreign firms. To finance these loans, the banks borrowed in foreign capital markets, increasing Iceland’s net external debt by 142 percentage points of GDP over the four years to end 2007. This strategy indirectly exposed the banks to equity market risk. In the wake of the global financial meltdown in September 2008, fear about the solvency of the three Icelandic banks became widespread, effectively shutting them off from the wholesale markets and preventing the refinancing of maturing obligations. As the banks were far too big to be recapitalised by the government, the Financial Supervisory Authority (FME) had no choice but to place them all into receivership.



Ratio of bank assets to GDP(1)

1. Assets of domestically registered banks as at December - excludes assets of foreign subsidiaries.
2. Consolidated assets of the three largest banks - includes foreign subsidiaries'assets.
3. Data for the assets of domestically registered banks (excluding foreign subsidiaries'assets) are only available from July 2007.
Source:   Central Banks of the countries shown.

 


International investment position

End of year, as per cent of GDP

1. Net external debt is residents' debt claims or non-residents'debt claims on residents.
2. Net external equity is residents'equity assets (i.e., foreign direct investment and portfolio investments in shares) abroad net of non-residents' equity assets in Iceland.
3. The international Investment Position (IIP) is the sum of net external debt and net external equity asset positions.
Source:   Central Bank of Iceland, Monetary Bulletin, 2009-2.


To restrain the build-up of systemic risks, macro- and micro-prudential supervision must interact

The expansion of the banks entailed a major build up of systemic risk in Iceland’s financial system – all of them had significant exposures to the same risk factors: reduced liquidity in global bond markets, a decline in equity markets and exchange-rate depreciation. In addition to these risks, domestic bank lending underpinned an asset price boom in Iceland, increasing risks further. Finally, the banks grew to be too big for the Iceland government to rescue. Banking in these circumstances became very dangerous when the global financial crisis deepened. To restrain the build-up of systemic risks in the future, macro-prudential supervision needs a legal basis to restrain bank behaviour, such as through countercyclical capital adequacy requirements. To implement this reform effectively, it may be necessary to merge the Central Bank of Iceland, the macro-prudential supervisor, and the FME, the micro prudential supervisor, or at least bring them under the same administrative umbrella (as in Finland and Ireland), as planned.


Bank supervisors need to lay down tougher rules and apply them more strictly

Although it will take some time to fully understand the causes of the financial crisis, some light was shed by studies commissioned by the authorities. The report of the former Finnish supervisor, Mr. Jännäri, notes that the first big mistake made was to allow local investor groups (with major expansion plans) to gain controlling stakes in the banks when they were privatised. The FME was not satisfied with this decision, which it considers to have been political, but acquiesced after lengthy deliberations. The report also points to a variety of practices that would have been considered elsewhere as inconsistent with basic banking regulation. Although banks seemed well capitalised, evidence suggests the capital was of poor quality, sometimes coming from connected parties. The banks had large exposures to investment groups and to each other (via shareholdings), implying a high degree of common vulnerability. While banking regulations were largely transposed from the European Union, Iceland’s supervisors were unable to keep up with the complexity and size of the system as it grew rapidly and applied rules in an excessively legalistic manner. In the future, Iceland’s supervisors should not allow the banking sector to become so complex and so large that they cannot effectively fulfil their supervisory duties. Also, bank supervisors should lay down tougher rules and, subsequently, apply stricter practice on large exposures, connected lending and quality of owners, using discretionary best judgement when necessary.


The Depositors’ and Investors’ Guarantee Fund needs to be reformed

An important cross-border banking issue raised by the financial crisis was that national deposit guarantee systems may not have enough resources to honour the minimum EU deposit guarantee obligations. The government was obliged to stand behind Iceland’s Depositors’ and Investors’ Guarantee Fund (DIGF) to enable it to meet these obligations, thus exposing Icelandic taxpayers to a large cost. While this issue goes beyond Iceland and would involve reforms of EU wide practices, the Icelandic authorities should review and improve the deposit guarantee system, closely following the developments within the EU, to protect the taxpayer from new large costs.


Economic recovery requires restoring the smooth functioning of the banking system

Following the banking collapse, the authorities decided to create three new banks by transferring the domestic deposits and claims on residents previously held by the old banks, thus effectively separating domestic from foreign operations. While this preserved the functioning of the domestic payment system, the new banks have no capital and there is considerable uncertainty about the value of their assets and liabilities. Once the compensation instruments between the new and old banks have been issued, the government will recapitalise the new banks, which will enable them to provide more normal financial intermediation services. To eliminate uncertainties about the strength of the balance sheets of the new banks, the government should move low-quality domestic assets into an asset management company, which will dispose them over time. In addition, there is evidence that the banks remain oversized for the Icelandic markets, thus weakening their profitability. The banks should be streamlined to make them profitable, including by merger if necessary (provided that this does not undermine competition in banking services). All of these measures would help to prepare the banks for full privatisation within the next few years. To facilitate privatisation, foreign direct investment into the Icelandic banking system should be encouraged. Other small countries, such as New Zealand, have found that having a banking system that consists almost entirely of well run fully-owned subsidiaries of foreign banks works well and has been particularly advantageous during this period of global financial turmoil.
 

How to obtain this publication

 

The complete edition of the Economic Survey of Iceland is available from:

 

The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.

 

Additional information

For further information please contact the Iceland Desk at the OECD Economics Department at eco.survey@oecd.org.

The OECD Secretariat's report was prepared by David Carey and Andrea De Michelis under the supervision of Patrick Lenain. Research assistance was provided by Roselyn Jamin.

 

 

 

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