Már Guðmundsson: Iceland's crisis and recovery and the crisis in the
eurozone
Address by Mr Már Guðmundsson, Governor of the Central Bank of Iceland, in an
international panel of bank governors on the European financial crisis and the Israeli
economy, the Eli Hurvitz Conference on Economy and Society, Masada, Israel,
28 June 2012.
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Almost 90% of Iceland's financial sector collapsed in the first week of October 2008, after its
three private cross-border banks failed. In the panic that gripped global financial markets
after the collapse of Lehman Brothers, these banks, like so many internationally active banks
around the world, 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
lender-of-lastresort assistance in terms of foreign currency. However, given the size of the balance sheets
involved (10 times GDP overall, with over two-thirds in foreign currency), it was impossible
for the Icelandic authorities to provide this assistance on their own. Had the government
made a full-scale attempt to save the banks, it would have been at serious risk of defaulting
itself. The Icelandic banks' failures were large by any criteria: the largest of them places 4th
on the world list of corporate failures, and the three Icelandic banks combined rank 2nd, after
Lehman. It was thus an event of systemic proportion in parts of Europe.
At that point, Iceland was already on its way into a recession after an unsustainable boom
and serious overheating during 2005-2007 and a currency crisis in the first half of 2008. The
banking collapse and the associated wealth loss and further currency depreciation only made
the recession worse.
Over the course of that autumn, two separate but interrelated sub-stories of the recent
Icelandic saga were converging 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.
2. The rise and fall of three cross-border banks operating on the basis of EU legislation
(the European "passport").
Let us look a little bit closer at the second story. In just five years' time, the Icelandic banking
system expanded from a combined balance sheet of under 2 times GDP at the end of 2003
to almost 10 times GDP in mid-2008. Most of this expansion was cross-border, and a great
deal of it had very little to do with Iceland, as both financing and investment took place
abroad.
There were indeed important domestic factors behind this expansion. One was the
privatisation of the Icelandic banking system in the early 2000s, which was carried out in a
manner that placed the country's largest banks into the hands of risk-loving investment
bankers and the ill-founded promotion of "financial centre Iceland". On the other hand, it is
hard to imagine that this scenario could have played out as it did without the worldwide glut
of cheap credit in the years before the global financial crisis and Iceland's position as a party
to the EEA Agreement, which provides for a legal and regulatory framework based on
European Union Directives, including free movement of capital and provision of financial
services. The underlying principles are those of home licensing for operation throughout the
EEA and a level playing field for competition, where size and location are not supposed to
matter. This European "Passport" enabled the Icelandic banks to operate throughout the
EEA, including through branches in other EEA countries.
We know now that there were and are deep flaws in this framework: flaws that are important
elements in the current eurozone crisis. A key issue here is the dichotomy between
European passport rights, on the one hand, and national supervision, national deposit
insurance, and national crisis management and resolution regimes, on the other. This is what
recent proposals of a banking union are supposed to deal with. But then, for EEA countries
outside the euro area, this framework entails potentially enormous foreign currency liquidity
risk in the banking system that is not covered by a lender-of-last-resort (LOLR). This was a
key element in the Icelandic banking crisis and must be addressed in future reforms of the
system.
Let me now say a few words about Iceland's crisis and recovery. The shocks hitting Iceland
in 2008 were mitigated by the policy response, which had two focal points. First, immediate
crisis management was based on several key goals: keeping domestic payment systems up
and running, preserving common citizens' access to their deposits, and ring-fencing the
sovereign against the failing private banks. The tools used were to declare all deposits in
Iceland safe and to carve domestic banks (1.7 times GDP) out of the failing banks. Second,
Iceland went on a programme with the IMF, which had three main goals: stabilising the
exchange rate, achieving fiscal sustainability, and rebuilding a sound, domestically oriented
financial sector. Comprehensive capital controls were a key element in the programme.
The recession that followed was the deepest in post-war history, with GDP falling by 12%
from peak to trough and unemployment soaring from around 2% pre-crisis to a peak of
8-9%. The exchange rate fell by over 50% in 2008, taking the real rate to around 30% below
its long-term historical average. That helped turn the huge current account deficit around to
an underlying surplus but wreaked havoc on domestic demand and balance sheets, as 2⁄3 of
corporate debt and 20% of household debt was in foreign currency, and an additional 3⁄4 of
household debt was indexed to the price level. But the policy measures were successful in
turning the situation around: the exchange rate stabilised in 2009, fiscal consolidation
progressed from 2010 onwards, growth resumed in the second half of 2010, the sovereign
regained foreign capital market access in summer 2011, and the new banks were profitable
and well capitalised. On the other hand, private sector debt restructuring has proven more
time-consuming than originally hoped, and lifting the capital controls is a challenging task.
According to the latest figures, Iceland's growth rate is 4.5% and the unemployment rate has
fallen to the 51⁄2-6% range.
What lessons can be drawn from this story?
1. Excessive and volatile capital flows played an important role in Iceland's crisis, and
the capital controls and the underlying balance of payments problem are a legacy of
that.
2. To a significant degree, the euro area crisis is also a capital flow - balance of
payments problem.
3. The framework for cross-border banking in the EU is deeply flawed. Either there will
be a regression of financial globalisation at the EU level, or the freedoms must be
matched by public frameworks and policies.
4. In the absence of international or EU-wide reforms, small, open economies like
Iceland might have to take action to protect themselves, such as restricting the
international activities of home banks and placing much more stringent prudential
limits on foreign currency maturity mismatches and foreign currency lending.
5. An independent flexible currency is a double-edged sword. In Iceland's case, it was
both part of the problem and part of the solution.
6. We need to think of ways to protect the sovereign from failing banks. Bailing out
bondholders is probably not always the best policy.
7. Finally, some elements of the so-called "Icelandic model" merit further consideration
as regards wider applicability: allowing banks to fail, using the exchange rate as a
tool for adjustment, and using capital controls as a tool for stabilisation. But we need
to avoid hype and over-simplification. Some of what Iceland did was due to a lack of
other options, and the cost-benefit analysis of allowing banks to fail or imposing
capital controls might look quite different in larger countries or countries with
different connections with the rest of the world.