Ingimundur Friðriksson: The banking crisis in Iceland in 2008
Paper by Mr Ingimundur Friðriksson, Governor of the Central Bank of Iceland, prepared for a
seminar which was scheduled to be held at the Bank of Finland, 6 February 2009. The
author was unable to attend.
* * *
Iceland has been hit extraordinarily hard by the financial crisis that has swept across the
globe. The rapid growth of the country's financial system in the past few years rendered it
much more vulnerable to global developments than it would otherwise have been. In my talk
today, I would like to trace in broad terms various aspects of the runup to the Icelandic
banking crisis, particularly from the point of view of the Central Bank. It will not be a complete
picture.
After Iceland's banks were fully privatised early this century, they began expanding at a rapid
pace, with the primary focus of that growth outside Iceland. They acquired financial
companies in other countries, opened branches, and expanded their international business
from their headquarters in Reykjavík. This rapid growth was facilitated by Iceland's
membership in the European Economic Area (EEA) through which the country had created
for its financial system a regulatory framework that was rooted in the directives adopted by
the European Union. Among other things, this meant that operating licences granted to
Icelandic financial companies extended not only to Iceland but to all other EEA states. For
example, they were permitted to operate branches anywhere in the EEA. The European
regulatory framework gave the Icelandic banks the same operational flexibility all over the
EEA as they enjoyed in Iceland. They had the same rights and responsibilities as banks in all
of the other EEA states. The Icelandic Financial Supervisory Authority based its operations
on European law, regulations, and procedures, and was given good marks by rating
agencies and the International Monetary Fund.
But the regulatory environment was by no means the sole factor allowing the banks to
expand to the degree that they did. During the early years of the 21st century, the situation
on the global financial markets was highly unusual. The supply of credit was virtually
inexhaustible and interest rates lower than they had been in a hundred years. Financial
markets were hungry for bonds, including those issued by Iceland's banks, which were a
welcome addition to many of the structured securities that became so popular. The banks
were thoroughly scrutinised by international rating agencies and their favourable credit
ratings greatly facilitated the banks' foray into the bond market. The banks became a vital
link in the national economy, their expansion and that of other Icelandic companies garnered
widespread support, they offered handsome salaries, and they paid the Treasury sizeable
tax revenues, directly and indirectly.
The banks attracted international attention late in 2005 and early in 2006. The market
became more wary of them, their CDS spreads began rising toward the end of 2005, and
they received more probing and critical coverage by the media and others than they were
accustomed to. The criticism was wide ranging, targeting the banks' growth pace, risk
appetite, low deposit ratios and high dependence on borrowed funds, as well as cross
ownership, lack of transparency, and so on. Until that time, the banks had increasingly been
active in the global bond market, with ever larger debt issues.
In February 2006, Iceland's Prime Ministry, Ministry of Finance, Ministry of Business Affairs,
Financial Supervisory Authority, and Central Bank concluded a collaboration agreement
centring on financial stability and contingency measures. The government then established
an advisory group on the basis of this agreement.
The Icelandic banks sought to respond in various ways to the criticism levelled at them. They
greatly enhanced their information disclosure to the global marketplace, thus improving
transparency in their operations. They sought to reduce cross-ownership, improve their
liquidity position and capital ratios, and took the first steps toward increasing the share of
deposits on the liabilities side of their balance sheets. They were strongly encouraged to do
so by rating agencies and numerous foreign financial analysts, among others. Landsbanki
launched its Icesave deposit accounts in the United Kingdom toward the end of 2006. The
banks also sought out new credit markets for example in the US which was wide open at the
time for issuers with favourable credit ratings.
Because they took this action, the Icelandic banks were perhaps better prepared than they
would otherwise have been for the sudden changes that took place in the global financial
Financial Stability
markets in mid-2007. In this context, I wish to cite the Central Bank's 2007
report, which appeared in April that year. It contained the following statement: "The Central
Bank underlines that global market conditions can take a sudden turn for the worse and it is
important to be on the alert and prepared for such a contingency." The report goes on to say:
"The current episode of ample liquidity and lower interest rates which has been ideal for
riskseeking investors may change unexpectedly. Short-term interest rates have been rising in
most markets recently and capital costs are no longer so favourable." With this warning, the
Central Bank was merely stating what should have been obvious, at least to those engaged
in banking. The time had come to prepare for a change in the economic and financial
climate. In the global arena, it had been stressed time and time again that risk premia were
far too low, risk was not correctly priced, and that change would come.
One of the side effects of the dramatic developments in the global financial markets starting
in mid-2007 was the sharp rise in risk aversion among investors and the rapidly shrinking
supply of credit. CDS spreads began rising, including those of Icelandic banks. Around
midAugust 2007, Kaupthing Bank announced its intention to acquire the Dutch bank NIBC,
which was roughly two thirds its size. Kaupthing's CDS spreads widened as a result, as the
proposed acquisition would have increased its need for re-financing in the years to follow.
Global market conditions continued to deteriorate throughout 2007: share prices plummeted,
access to credit became much more limited, and interbank business transactions more
complicated at best. CDS spreads widened, including those of all the Icelandic banks. Many
clung to the hope that conditions would improve in early 2008. That hope proved fruitless.
Market conditions continued to deteriorate, and the supply of credit became tighter than ever.
The Icelandic banks' CDS spreads rose to very high levels.
As I have mentioned, the banks began to increase their deposit business after the
experience of early 2006 by offering favourable premiums. Retail deposits in branches and
subsidiaries abroad grew quickly and soon became an important source of funding for two of
the banks, particularly in 2007 and early 2008. But the bond markets remained virtually
closed to them as the year 2008 progressed.
Financial Stability
At the beginning of May 2008, the Central Bank published its annual
report, which included a detailed analysis of the state of and prospects for the financial
system. The report pointed out vulnerabilities but also identified elements that tended to
strengthen the system. The title of the Central Bank's analysis was: "Current conditions test
the banks' resilience." The report stated that the system was considered broadly sound but
that contingency measures were needed. The chief risk factors were a vulnerable foreign
exchange market and limited access to capital, which represented a short-term risk. For the
longer term, vulnerabilities centred rather on the effects of higher cost of capital and the risk
of erosion of asset quality. The report included a detailed analysis of the quality of the banks'
loan portfolios. Although the conclusion was that the banks were well prepared to face rising
defaults and loan losses at that time, particular attention was drawn to the fact that the
previous year had seen increases in the ratio of large exposures to capital and in the
proportion of holding companies among borrowers. The report emphasised that there was
good reason to scrutinise this development closely. The Central Bank had actually noted this
in earlier publications as well. For the near term, the banks' most critical task was to
guarantee access to foreign credit and reduce their borrowing requirement. Furthermore,
confidence among investors and depositors was of vital importance. It was deemed unlikely
that conditions in the international markets would improve to any dramatic extent in the near
future, and when they did, investors would undoubtedly demonstrate more caution and
conservatism than they had previously. In addition to this, the report shed light on the banks'
very large re-financing needs in the next few years: They would need to re-finance 35 billion
euros in foreign bonds through 2012, including 17 billion in 2009 and 2010.
Some critics have maintained that, in the May 2008 issue of Financial Stability, the Central
Bank contradicted its own knowledge of the state of the banks - or even that it did not know
any better. This is untrue. The report examined in a transparent manner the financial
system's weaknesses, as well as its strengths. The developments in the global arena since
the spring of 2008 rendered the risks mentioned in Financial Stability far more serious than
was foreseen.
In its monetary policy statement in July 2008, the Board of Governors said inter alia that
"Iceland's commercial banks play an important role in maintaining confidence in the financial
system. Under the current global financial market conditions, they must protect their liquidity
and capital position, seek all possible ways to reduce their need for foreign credit, and adapt
the scope of their operations to dramatically changed circumstances."
Throughout 2008, the Central Bank of Iceland focused increasing attention on the
developments and operational outlook at the nation's financial institutions - particularly its
large banks. Among other things, it monitored their liquidity much more closely and
frequently than is stipulated in the Bank's rules on liquidity requirements, and considerably
more than had been customary. The Central Bank met with leaders from the large
commercial banks and reviewed various aspects of their operations, requesting information
on and explanations of the developments in certain areas, such as liquidity, funding, changes
in lending and deposits, asset sales, etc. The banks were urged to show restraint and
downsize, and to follow that up, the Central Bank specifically collected information from them
on their downsizing efforts. They realised, of course, that they were in a tight position, and
they responded by selling assets and discontinuing selected activities in a number of
countries, among other things. Kaupthing Bank's decision to abandon its plans to acquire
NIBC in the Netherlands was very important in this regard, not just for Kaupthing itself but for
all of the banks. The Central Bank supported all of these actions wholeheartedly; however, it
did not have the statutory authority power to force the banks to change their conduct.
It is known that the Central Bank expressed its growing concern over the position of the
banks during meetings with governmental authorities. Early last year, the Central Bank's
concern centred not least on the banks' large near-term refinancing requirement for the
coming years, which I have already mentioned, and the opinion, expressed by leaders of a
number of international banks, that the global credit crunch was unlikely to ease in the
foreseeable future. The Central Bank feared that credit markets could remain closed to
Icelandic banks for some time to come. Although various explanations have been given for
the swift rise in the Icelandic banks' CDS spreads, first in early 2008 and again that summer,
it is perhaps possible to claim that the most important explanation lay in growing scepticism
about the banks' ability to obtain the medium-term funding they needed for refinancing
purposes.
In late 2006, the Central Bank had doubled its foreign exchange reserves through an
international Treasury bond issue the proceeds of which were deposited with the Central
Bank. Early in 2008 it began preparing to fortify its reserves still further, as is explained in a
memorandum published on the Central Bank's website in October 2008.2 Raising the foreign
reserves was deemed important in order to bolster confidence in the Icelandic financial
system and thus to facilitate its adjustment to a new reality. Currency swap agreements with
three Nordic central banks were announced in May 2008 and renewed towards the end of
the year. No other central banks apart from the Nordic ones were prepared to lend their
support in 2008, in spite of the Central Bank's requests and in spite of the public declarations
from the international community, including the Financial Stability Forum, about the necessity
for consultation and co-operation, not least among central banks, including the establishment
of swap lines.
As mentioned, the Icelandic banks significantly increased their presence in the retail deposit
market abroad, beginning in late 2006. Actually, they were so confident about their success
that, at meetings held over the course of 2008, some of their leaders voiced the expectation
that it should be easy for them to fund all of their outstanding bonds and other debt for the
coming years through deposit business in Europe. However, through discussions with
governors and other representatives from central banks abroad, the Board of Governors of
the Central Bank of Iceland had become aware of growing opposition to the Icelandic banks'
accumulation of deposits. No doubt this opposition stemmed from many factors, among them
the fact that banks in those same parts of Europe felt the pressure of the sudden competition
and communicated their concerns to their authorities. Another cause was the fact that the
accumulation of deposits in foreign subsidiaries increased the potential obligations of the
deposit insurance schemes in the countries of operation. A third factor may have been
concerns that the relatively high interest rates offered by the Icelandic banks might reflect
underlying weakness. A fourth consideration was the concern about the Icelandic deposit
insurance scheme with respect to deposits in foreign bank branches. It was clear, however,
that the Icelandic system fulfilled the requirements set forth in European directives, which
stipulate that the government must ensure that such a deposit insurance scheme is
established but do not address the issue of government responsibility for the scheme's
commitments, and certainly not in the event of a system-wide shock. Official European
documents corroborate this.
Some declared outright that the Icelandic banks would be prevented from receiving deposits
or that they would be forbidden to receive further deposits in the countries where they were
already established. There were examples of demands that the banks reduce their deposits,
in spite of the provisions in EU directives on financial companies' equal right to conduct
business anywhere within the European Economic Area. In this case national interests
outweighed pan- European commitments. As a result, it appeared as though the banks'
plans to meet their funding needs through retail deposits would be, at best, difficult to carry
out. The Board of Governors of the Central Bank explained the foreign authorities' attitudes
towards this deposit accumulation to the leaders of the Icelandic banks and informed them
that they would be faced with strong and swiftly mounting opposition.
The Central Bank of Iceland was unequivocally of the opinion that the banks' foreign deposits
should be held in subsidiaries rather than branches and that Landsbanki's deposit business
in London should be transferred to a subsidiary of the bank. The preparation for this transfer
began early in 2008, and the Central Bank was informed soon thereafter of what was needed
to make the change and how long it would take. Judging from discussions with senior
executives at Landsbanki, the Central Bank assumed that the process had begun that spring.
In July, it was revealed that this was not the case. Although the Central Bank's position on
the matter was clear, it did not have the power to force changes or make demands.
Moreover, other Icelandic authorities also had limited legal power in this respect under the
legislation then in force which was and is based on EU Directives.
As I have mentioned, the Central Bank of Iceland kept close watch on the liquidity of the
Icelandic banks throughout 2008, both by compiling data regularly and by meeting with
senior executives in the banks. Among other things, the Central Bank tracked the banks'
liquidity virtually on a daily basis and kept abreast of their refinancing efforts and asset sales.
It was common knowledge that one of the banks, Glitnir, had a large foreign loan payment
coming up in mid-October. Unlike the other banks, Glitnir had not been active in creating a
presence in the retail deposit market abroad, having chosen instead to bolster liquidity by
selling assets. In mid-September, the Board of Governors of the Central Bank met with the
Glitnir management and reviewed the bank's liquidity outlook once again. At that time, the
prospects for funding the October payment were good, and according to information
presented to the Central Bank, Glitnir would be able to cover that payment with an asset sale
that was virtually complete. It was then that American investment bank Lehman Brothers
collapsed, starting a tremor that would shake financial markets all over the globe.
In its Quarterly Review in December 2008, the Bank for International Settlements went so far
as to say that, after the failure of Lehman Brothers, the global financial markets "seized up
and entered a new and deeper state of crisis.(...) With credit and money markets essentially
frozen and equity prices plummeting, banks and other financial firms saw their access to
funding eroded and their capital shrink owing to accumulating mark to market losses." The
Lehman bankruptcy had triggered a widespread crisis of confidence.
Among other repercussions of the Lehman Brothers collapse, the above-mentioned virtually
completed sale of Glitnir assets did not materialise. This kicked off the well-known chain of
events. Glitnir turned to the Central Bank for assistance. Not only was the bank unsuccessful
in its attempt to sell assets, it was unable to renew a bank loan that it had expected to extend
without any difficulty. Ultimately, the Government decided that the Treasury should acquire a
majority holding in Glitnir, but before that could be finalised, the bank collapsed.
In early October, there was substantial pressure on Landsbanki's deposit accounts in
London, and the British Financial Services Authority (FSA) steadily tightened the demands it
made on the bank. Landsbanki's liquidity difficulties became insurmountable, and it was clear
that rescuing the bank would not represent prudent use of the Central Bank's foreign
exchange reserves. The amounts involved were simply too large. By this time, only
Kaupthing remained of the three large banks. In view of the prospects for Kaupthing's
liquidity, the bank was deemed likely to survive the storm. On the basis of that assumption,
the Central Bank, after consulting the Government, granted Kaupthing a collateralized
fourday loan that should have sufficed - as things stood then. Subsequent events in London
changed that, however, including the FSA ́s action against the Kaupthing subsidiary.
The three leading commercial banks, representing about 85% of total banking assets, all
collapsed. The Icelandic Financial Supervisory Authority took over their operations on the
basis of newly adopted legislation, and they were divided into two entities, the new banks
and the old. I will not expound on that process here, except to say that top priority was given
to the maintenance of smooth payment intermediation and uninterrupted banking operations,
and that efforts in that regard were successful in spite of measures such as the "freezing
order" imposed on Landsbanki by the British authorities under the Anti-Terrorism, Crime and
Security Act - a freezing order that originally extended as well to the Icelandic government,
Central Bank, and Financial Supervisory Authority, among others. In fact, in the
circumstances, the relative ease with which banking operations and payment intermediation
continued to function bordered on the miraculous.
The International Monetary Fund conducted an FSAP appraisal of the Icelandic financial
system during the summer of 2008. The resulting staff report can be found on the Fund's
website. Another report, which was submitted to the Fund's Executive Board in connection
with the Icelandic government's November 2008 request for a Stand-By Arrangement,
includes the following statement:
"Iceland's overstretched, over-leveraged banking system was ill-positioned to cope with
the global financial turmoil. The Icelandic banking sector experienced a dramatic
expansion in just a few years, funded by cheap foreign financing, which allowed it to
boost its assets from 100 to almost 900 percent of GDP between 2004 and end-2007.
This expansion made the Icelandic banking system one of the largest in the world in
relation to GDP. As global conditions deteriorated in early 2008, banks' CDS spreads
rose to unprecedented levels. In response, banks slowed lending growth, enhanced
liquidity buffers, reduced costs, and started a process of downsizing non-core
operations and laying off staff. But their ability to deleverage was limited by the global
risk aversion. A recent FSAP update and Article IV Consultation conducted in June
2008 pointed to several risks that were mounting throughout 2008: (i) liquidity and
funding risks, associated with the banks' reliance on market funding and their large
funding needs over the short run; (ii) credit and market risks, resulting from foreign
currency, equity exposures, and high indebtedness of domestic borrowers, as well as
collateralized lending, connected lending, and large exposures; (iii) operational risks,
associated with the banks' rapid expansion in recent years; and (iv) quality of capital
risks, related to complex ownership structures. In this light, the Staff Report concluded
that "if risks were to materialize in full, Iceland could face severe financial strains."
Despite the authorities' attempts to prepare for contingencies earlier in the year, the
crisis brought down the three main banks within a week. In May 2008, the central bank
entered into swap agreements with other Nordic central banks, in an effort to secure
liquid foreign exchange should the need arise. In September, the government borrowed
300 million Euro to further boost reserves. At the same time, the central bank had been
increasing liquidity provision, easing rules on eligible collateral (including by accepting
uncovered bonds from banks) and reducing reserve requirements. But renewed global
pressures in late September led to a swift loss of investor confidence in the Icelandic
economy and financial system, and a massive depreciation of the króna. The three
main banks could not secure payments for their due obligations, and the government
decided to promptly intervene rather than to continue what was considered to be an
eventually unsustainable process of supporting the three banks."
As I have already mentioned, the Central Bank responded to developments and prospects in
2008 by monitoring the banks' liquidity even more frequently and maintaining close contact
with them. In addition, the Bank's contingency committee had been mobilised and worked
continuously from the fall of 2007 onward. The advisory committee from the Prime Minister's
Office, Ministry of Finance, Ministry of Business Affairs, Financial Supervisory Authority, and
Central Bank met frequently and exchanged information. The committee prepared
contingency plans and had a legislative bill drafted - the bill that later became the emergency
legislation passed in early October.
It is obvious that the banks had become too large in relation to the Icelandic economy. They
took advantage of a liberal regulatory environment, good credit ratings, and the unusually
advantageous conditions on the global markets and expanded their operations at a rapid
pace. The European regulatory framework made this possible. In many ways their activities
resembled those of banks in other countries. Under normal market conditions, this posed no
immediate problem. The banks could have funded their operations even under sub-optimal
market conditions. Many were of the opinion that the Central Bank should build up very large
foreign exchange reserves, even up to a multiple of GDP, in order to back up the financial
system. Given the current account deficit on the balance of payments, this would only have
been possible with massive foreign borrowing. It would never have transpired, for the simple
reason that the Icelandic government would have been unable to borrow such a large
amount. Its credit ratings would not have tolerated it, and lenders would have been difficult to
find.
As I have touched on, the banks responded to mounting difficulties in various ways.
Kaupthing, for example, abandoned its plans to acquire the Dutch bank NIBC. All of the
banks sold assets and discontinued various non-core operations; however, as the IMF
mentioned in the previously cited Staff Report, it was not a seller's market. In addition, the
banks all reduced their lending and laid off staff. Meetings held last summer with the banks'
leaders revealed, among other things, that some of them were making vigorous attempts to
attract foreign investors, those with retail deposit collection in foreign branches were aiming
to transfer the deposits held in those branches to subsidiaries within a few months, and some
were even considering moving their headquarters out of Iceland which the Central Bank did
not object to.
As pressures in the global liquidity markets intensified, much like banks in other parts of the
world, the Icelandic banks turned to the Central Bank for funding, as many banks abroad
have done. The Central Bank of Iceland expanded its liquidity facilities, as did its foreign
counterparts. Iceland's banks obtained funding both from their own Central Bank and,
through their foreign subsidiaries, from the European Central Bank (ECB), from which they
sought liquidity in euros. As other banks, they became heavily dependent on ready access to
liquidity facilities. However, the Central Bank of Iceland could not provide liquidity in
currencies other than the Icelandic króna, and until recently most other central banks only
provided loans in their own currency. All over the globe, central banks and other authorities
fought to rescue banks and other financial companies, resorting to increasingly
unconventional measures in the process. In spite of these attempts, financial companies of
all sizes have gone bankrupt, while others have been rescued - at least temporarily -
through massive government assistance or guarantees. At this point, banks are almost
entirely dependent on central bank liquidity facilities, and the interbank markets are more or
less non-functional because of the utter lack of confidence. The balance sheets of the world's
largest central banks have grown significantly since the end of last summer, with some
expanding many times over.
For several years, the Central Bank of Iceland's rules on liquidity facilities have been largely
modelled on those of the ECB. I say largely because for quite a while the Icelandic rules
were rather more stringent than those in Europe - that is, the Central Bank of Iceland set
stricter requirements concerning eligibility of collateral. Facilities in the Central Bank of
Iceland resembled those in the ECB's jurisdiction; the collateral accepted was similar, and so
on. This applied, among other things, to bonds issued by banks. Last year, steps were taken
to align the Icelandic rules more closely with those in Europe in order to increase access to
liquidity.
In 2008, the European Central Bank responded sharply to what it considered excessive
borrowing from the ECB by Icelandic banks through subsidiaries in EMU countries. The
loans concerned had been taken in compliance with the ECB's rules on liquidity facilities for
financial undertakings in EMU countries, but the ECB demanded that the Icelandic banks
repay, quite quickly, a large share of the facilities of which they had availed themselves in
good faith. Those repayments were funded at least partially with deposit accumulation in
foreign branches. Early in October, two Icelandic banks received sizeable margin calls from
the ECB. The ECB demanded that they be met immediately, which would have driven the
banks to collapse. The news of these margin calls spread widely. For reasons that were not
explained, the ECB withdrew the margin calls at the last moment, in spite of the fact that the
Central Bank of Iceland had been informed that such decisions by the ECB were irrevocable.
In retrospect, perhaps the safest way to prevent the collapse of the Icelandic banks would
have been, at the outset, to place more stringent limits on their operations than were placed
on financial institutions in other EEA states; in other words, to deny them the rights conferred
by the EEA Agreement. Had this been done, Iceland would not have been a full participant in
the internal market of the European Union. I will leave it to others to answer the question of
whether political support would have been forthcoming for the imposition of such restrictions
on the banks at that time. On the other hand, in view of recent developments, it is obvious
that the banks took advantage of extremely favourable conditions to expand more rapidly
than was sustainable for the long term as things developed. Because of their relative size,
the Icelandic banks were more vulnerable than many other businesses even to moderately
adverse developments, not to mention the catastrophic events that have shaken the global
financial environment in the past year. The question of when it would have been right to
intervene - and how - is extremely difficult to answer, however. No one has perfect foresight.
Many lessons will doubtless be learned from the experience of the past few years, including
lessons about capital and liquidity requirements, concentration of financial company
ownership, financial links between owners and financial companies, and financial companies'
ownership of other businesses, to name a few. But those lessons are outside the scope of
my talk today.
Conditions in the global financial system are at their worst since the Great Depression,
particularly after the collapse of Lehman Brothers. It is virtually an unprecedented crisis.
Perhaps it is possible to say after the fact that the fall of Lehman sealed the fate of Iceland's
banks. Once Lehman had failed, nothing could have saved them. Assets had become almost
impossible to sell due to the crisis of confidence and the global credit squeeze the Icelandic
banks faced a much harsher operating environment and could expect that strict limitations
would be placed on their foreign deposit business - if it were not stopped entirely.
Government authorities in other countries consulted with one another more and more
frequently on these issues.
Early in October, the Icelandic Parliament passed emergency legislation authorising the
Financial Supervisory Authority to take over the banks' operations. The authorities had no
choice but to act on that authorisation immediately, take over the three large banks, and
divide their operations into two parts, the old banks and the new. The new banks, which are
owned by the government, took over domestic banking activities, while foreign operations
remained within the old banks, which have been granted a moratorium on payment. The
government's response in October was guided by the overriding aim of guaranteeing
continued domestic banking operations and domestic and cross-border payment
intermediation under extraordinarily difficult circumstances.
Following the collapse of the banks, the Icelandic government negotiated a Stand-By Facility
from the International Monetary Fund on the