Már Guðmundsson: Managing capital flows in a financially integrated
area - lessons from the Icelandic financial crisis
Remarks by Mr Már Guðmundsson, Governor of the Central Bank of Iceland, at a conference
organised by the International Monetary Fund, Bank of Estonia and Sveriges Riksbank on
Nordic-Baltic financial linkages and challenges, Tallinn, 13 December 2013.
* * *
Accompanying charts can be found at the end of the speech.
I would like to thank Eesti Bank, Sveriges Riksbank, and the IMF for inviting me to speak at
this most interesting event.
In my remarks, I will focus on those aspects of the Icelandic financial crisis that are most
closely associated with the topic of this session, which is financial integration. I will draw out
some salient features of that story and then link them to several lessons that might be of
more general relevance.
In the autumn of 2008, two separate but interrelated sub-stories of the recent Icelandic
financial and economic saga converged in a tragic grand finale. These are:
1. Iceland's boom-bust cycle and problems with macroeconomic management in small,
open, and financially integrated economies. This is a story that has played out many
times around the globe, and many of its elements have been seen before in Iceland.
2. The rise and fall of three cross-border banks operating on the basis of EU legislation
(the European "passport"). This story was much more unique, as it involved the first
banking crisis in Europe since the EU single market was formed in the early 1990s.
Let me briefly discuss each of these in turn, in order to set the stage for the policy
discussions.
First, the macroeconomic boom-bust story. All the usual suspects were present: very strong
capital inflows fuelling a credit and asset price boom that subsequently turned into a bubble
at the same time as the economy overheated and an unsustainable external position
developed, as could be seen in a double-digit current account deficit. And macroeconomic
and prudential policies were not up to the task.
At the deepest level, this part of the story was related to three factors:
1. The complications that tend to arise with macroeconomic management as very
small, open economies become more and more financially integrated;
2. The specific conditions of ample and cheap credit at the global level;
3. And major policy mistakes in Iceland, both of the type that would be deemed to be
such in any book (such as giving an already overheated economy a demand
stimulus), and those more closely related to the orthodoxy prevailing at the time:
freely floating exchange rates, interest rate policy focusing mainly on low inflation in
terms of goods and services, and good micro-supervision; and let the markets do
the rest.
The first factor is perhaps of interest here. The process runs as follows: Domestic interest
rates at the longer end of the maturity spectrum tend to become more closely correlated with
the global rate, or the rate of the largest trading partner, and less correlated with the
domestic policy rate. This means that monetary transmission tends to go increasingly
through the exchange rate channel, which is only a problem, however, if the exchange rate
behaves badly. Unfortunately, there is a lot of evidence to suggest that it does. Uncovered
interest rate parity (UIP) does not hold except over long horizons. Interest rate differentials
give rise to widespread carry trading, which is by nature a bet against UIP. Exchange rates
thus diverge from fundamentals for protracted periods, followed by sharp corrections. So the
exchange rate often seems to be as much a source of shocks and instability as a tool for
adjustment and stabilisation. Ultimately, these cycles can take the boom-bust form and, in
extreme cases, can result in serious financial instability or crisis. The research on this
phenomenon is still ongoing, but there is a lot of evidence to suggest that the problem would
not disappear even if macroeconomic policies in the traditional sense were perfect.
This process was important in the Icelandic episode. The capital inflows were driven by the
traditional push and pull factors. But when a benign upturn originally driven by FDI in the
energy-intensive sector turned into overheating, and fiscal and other demand levers pulled
by the Government were either insufficiently used or pulling in the other direction, monetary
policy was overburdened and the increased interest rate differential that resulted pulled in
further capital and carry trade positions.
Let me now turn to the banking part of the story. Before the collapse, the banking system had
expanded very rapidly, growing in just five years from a combined balance sheet of less than
2 times GDP at the end of 2003 to 10 times GDP. Most of this expansion was cross-border,
and a significant part of it was really off-border, having little to do with Iceland, as both
financing and investment took place abroad. Around two-thirds of the balance sheet of the
three cross-border banks was denominated in foreign currency. As is typical for banks, the
FX part of the balance sheet had a significant maturity mismatch. However, there was no
safety net of the type that we have in a national setting to back it up. This turned out to be the
fatal flaw in the whole setup, although we now know that these banks were also
undercapitalised, which might have done them in at a later stage. But so were several
European banks that were considered solid at the time - and some of them are still around!
In the panic that gripped global financial markets after the collapse of Lehman Brothers,
Iceland's big banks were faced with a wholesale run on their foreign currency liabilities and
were therefore heading towards a default on those liabilities in the absence of LOLR
assistance in foreign currency. However, given their size, it was impossible for the Icelandic
authorities to provide such assistance on their own.
Given the lack of international cooperation, the Icelandic authorities were forced to consider
radical solutions. Although they were probably not articulated fully at the time, these solutions
entailed several goals: preserving a functioning domestic payment system, ring-fencing the
sovereign in the case of bank failures, limiting the socialisation of private sector losses, and
creating the conditions for the reconstruction of a domestic banking system.
In essence, the adopted solution saved the domestic operations of the banking system and
let the international part to go into a resolution process. The new banks were created by
carving the domestic assets and liabilities out of the old, failing banks. The new banking
system amounted to 1.7 times GDP.
To a significant degree, these measures were successful in keeping the domestic payment
system and basic banking services up and running, which was a key factor in dampening the
effect of the banks' failure on the economy.
There were two key elements to the policy response during the autumn of 2008. The first
was crisis management vis-à-vis the failing banks, which I have just mentioned. The second
was the economic programme developed by the Icelandic authorities in co-operation with the
IMF. The programme had three key goals: stabilisation of the exchange rate, fiscal
sustainability, and reconstruction of the financial sector. Comprehensive capital controls were
an important element in the programme, but their rationale was to help to stabilise the
exchange rate in a situation where the currency had fallen more than 50% in 2008, where
foreign króna positions that were a legacy of carry trade and capital inflows amounted to
around 40% of GDP, and where a large fiscal deficit that had to be financed in the domestic
market had developed. The capital controls therefore gave monetary policy more scope to
help stabilise and turn around the real economy once inflation came down. Subsequently,
they shielded the eocnomy from the financial spillover effects of the crisis in the eurozone.
But the problem is that they are still in place, over five years after the climax of Iceland ́s
financial crisis. The reason is that Iceland is still facing a balance of payments crisis that is a
legacy of former capital inflows and the unwinding of these big cross-border banks. There
are three elements to this, as is described in this slide: contractual foreign debt payments in
the next few years, well in excess of reasonable expectations of the size of the current
account surplus; offshore krónur, a legacy of the carry trade, which still amount to 20% of
GDP; and potential króna payments, from the old banks to foreign residents, amounting to
another 25% of GDP.
We can see from the Icelandic case, and indeed many others, that although financial
integration can offer many benefits to small, open economies, it also potentially entails
significant risks that can turn into a nightmare if left unchecked. In Iceland's case, it was a
pretty dramatic. What are the lessons, then? In the interest of time, I will briefly mention a
select few.
The first issue that I would like to mention is the need to monitor closely both net capital flows
that immediately affect the economy - especially credit growth, asset prices, and domestic
demand - and the developments of gross external assets and liabilities that might not affect
the economy until risks materialise and banks are undergoing the transformation from being
international in life to being national in death. During the financial crisis, there have been
numerous cases of vulnerabilities in gross positions coming home to roost, such as the
dollar-denominated parts of European banks' balance sheets. In Iceland and similar cases
there is also a statistical issue here that needs to be acknowledged: the distinction between
flows that actually entered or left the country at the time and those that were simply flowing
offshore in both directions but were booked through the Icelandic headquarters and thus
recorded in the country's BP and IIP.
The second lesson relates to the EU framework for cross-border banking, which clearly
facilitated the cross- and off-border expansion of the Icelandic banks through the so-called
European passport. It was and is deeply flawed.
The basic problem is that the freedoms are not matched by public action and frameworks at
the EU and EEA level. Bank size relative to country size was assumed to be a matter of no
concern, and FX risk was largely ignored. Based on the Icelandic experience, a banking
union makes perfect sense, but only fully for the eurozone, and even then it has to include all
three elements - common supervision, resolution, and deposit insurance - in order to break
the deadly embrace of banks and sovereigns. In the interim, I think small countries,
especially those with their own currencies, will have to impose their own prudential measures
in order to defend themselves against the risks they face.
The third lesson relates to the structure of the financial sector in small, open economies in
the absence of robust and credible international or regional safety nets. To my mind,
international financial centres cannot be located in such countries without some ex ante
mechanism that at least partly insulates the domestic economy from the risks involved. In
some sense, this is what Iceland did in the nick of time in early October 2008. Furthermore,
in very small, open economies with their own currency, like Iceland, the international
activities of domestic banks and FX risks on their balance sheets must be limited and
regulated. In this context, we have been thinking about the prudential regime that must be in
place in Iceland when we have lifted capital controls and Icelandic banks are again free to
use their European passporting rights. We will have more stringent restrictions on
permissible currency mismatches than in the past, also taking into account positions of
unhedged households and companies, but more importantly, we will, through some
combination of LCR- and NSFR-type ratios in foreign exchange, put strict limits on
FX maturity mismatches. The combination of these and other measures will make it
impossible for the banking system to attain the size and cross-border reach it had before the
crisis. The big question is whether it will be deemed compatible with the EEA Agreement.
More generally, I think the distinction between macroprudential measures and capital
controls can be more complex than many make it out to be.
The fourth lesson is on capital flows: Deal with the inflows if you want to avoid the risk of
having to introduce comprehensive capital controls on outflows, which can work as in Iceland
but have increasingly negative side effects on the economy. The measures that can be taken
to deal with the inflows include adopting correctly aligned macroeconomic and
macroprudential policies, leaning into the wind by buying part of the inflows into foreign
exchange reserves, and even in extreme cases, deploying selective capital inflow
management tools.
The final lesson from all of this is that if we are going to reap the benefits of financial
globalisation, we must make it safer.
BIS central bankers' speeches 5