During one week in early October 2008, Iceland’s banking system went into meltdown, threatening to suck the entire nation down with it. Global banks were reeling from post-Lehman aftershocks and towards the end of September, Iceland’s three largest banks – Glitnir, Landsbanki and Kaupthing – experienced a run on their foreign currency liabilities. Given their high leverage, they quickly collapsed.
The banking system accounted for almost 900 per cent or a staggering 10 times Iceland’s GDP- Vincent Micallef
These three banks represented 85 per cent of Iceland’s banking sector. At first, the government drew up a plan to nationalise the first bank to show major fissures. However, the transfer of assets never went through and in hindsight, this was probably Iceland’s salvation.
Following the Icelandic banking system liberalisation of 2003, these banks had grown rapidly, both domestically and internationally (through acquisitions). Capital inflows fed strong domestic demand, and easy access to borrowing led to bubbles in Iceland’s property and equity markets.
It turned out that at the time of the banks’ collapse, the banking system accounted for almost 900 per cent, or a staggering 10 times Iceland’s GDP. This compared to 237 per cent of GDP in France (BNP Paribas, Crédit Agricole and SocGen), 101 per cent in Italy (Unicredit and Intesa), 337 per cent in the UK (RBS, Barclays and HSBC) and merely 56 per cent for the top five banks in the US (figures for 2010).
The foreign currency held in the balance sheets of the Icelandic trio was more than 20 times Sedlabanki’s (the Central Bank of Iceland) foreign reserves.
The initial reaction of the credit rating agencies was to downgrade the sovereign debt. Standard & Poor’s had rated Iceland AA until April 2008, downgrading to BBB+ as news broke out. Moody’s even had them at Aaa until May 2008. With the banks’ collapse, Iceland was first downgraded to A1, then to Baa1 as the crisis developed. Iceland is currently rated BBB- and Baa3 respectively.
The króna, already down 35 per cent January to September 2008, slid 38 per cent further by the end of 2008. With it, consumer prices ballooned due to higher prices on import prices. A staggering 75 per cent of households had borrowed in foreign currency at a time when they believed it was cheap to do so, and three-fourths of these borrowings were indexed to the price level, further exacerbating CPI and inflation issues. In the middle of all this, Sedlabanki first attempted and then abandoned plans to peg the króna to the euro, and by October 9, 2008, introduced restrictions on the purchase of foreign currency within Iceland to avoid additional pressure on the exchange rate.
The problem was way too large for Iceland to handle, leading the sovereign to seek the help of the IMF and its Nordic neighbours. In November 2008 the IMF approved a Stand-By Arrangement (SBA) of SDR 1.4 billion (Special Drawing Rights, today equivalent to US$2.16 billion). Denmark, Sweden, Finland, Norway, Poland and the Faroes pitched in with financial assurance equivalent to another $2.75 billion.
Following the collapse of the banking system, the authorities set in place measures to ringfence domestic stakeholders so as to preserve the financial system. The main objectives were to preserve the functioning of the domestic payment system; to limit the absorption of private-sector losses by the public sector; and to keep some kind of domestic banking system functioning and going forward. The government extended a guarantee on all deposits to domestic depositors, mainly denominated in Icelandic kronur, to reduce the probable effects of bank runs. Guaranteeing liabilities owed to overseas creditors was never an option – it would have ruined the country. The banks did not have any government shareholding, and to all intents and purposes the whole issue was considered a private-sector default.
Iceland was heading into a recession when lightning struck, and the meltdown pushed it further in the dark, with the economy contracting by more than 10 per cent in the following two years. However, the same currency devaluation, reduced state spending (keeping welfare payments stable) and capital controls helped kickstart the economy which grew by 4.5 per cent in Q1 2012.
Total assets of today’s three major commercial banks – NBI (today referred to as Nýi Landsbanki); Arion Bank (formerly Kaupthing) and Islandsbanki (formerly Glitnir) declined to circa 190% of GDP by end 2010. Furthermore, recapitalising the banking system cost Iceland 20 per cent of GDP – half the 40 per cent that IMF’s SBA had requested in 2008.
Last May, Iceland successfully returned to the international capital markets by raising $1 billion through the issuance of a 10-year USD bond yielding six per cent. At the time of writing, this same bond is trading on a yield of 4.65 per cent.
Curmi & Partners Ltd are members of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business. This article is the author’s objective and independent opinion. It is based on public information and should not be viewed as investment advice in any manner. The value of investments may fall as well as rise and past performance is no guarantee of future performance.
Mr Micallef is an executive director at Curmi and Partners Ltd.