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Minister Geir Haarde’s resignation on January 23rd of this year
marked the first political casualty of the current financial crisis.
While the Icelandic situation has received scant attention relative
to other calamities reverberating through the world’s financial
markets, the source of Iceland’s woes can be found in many of the
same locales. Unfortunately, while the events affecting Iceland’s
populace have been severe, the country’s diminutive size –
approximately 320,000 residents – has made it a target all
too easy to miss. However, the repercussions on both the country’s
native Icelanders as well as global financial markets give reason
to dedicate serious attention to the causes, and cures, of this
unfortunate and wholly avoidable event.
the current focus on the causes of the crisis continually misidentifies
its true source, resulting in prescribed cures that fall short of
the necessary actions. Peter Gumbel writing for the December 4th,
2008, edition of Fortune reckons previous Prime Minister
Davíð Oddsson’s free-market reforms during his 1991–2004
years in office are what ultimately gave rise to the bust. Likewise,
the IMF’s mission chief sent to Iceland to survey the nature of
the problem, Poul Thomsen, recently commented in an interview that
the root problem in Iceland was an unregulated environment that
allowed an oversized banking system to develop. Indeed, the post-privatization
banking experienced in Iceland resulted in a banking sector that
saw assets increase to over 1,400% of GDP!
and authors commonly miss is the reason the banking sector could
expand so rapidly. Indeed, as we shall see, the incentive structure
of the Icelandic economy was manipulated through government guarantees,
artificially low interest rates, and monetary spigots opened wide,
allowing liquidity to be flushed through the economy. In addition,
Iceland’s homeowners were offered tantalizingly low interest rates
through the "Housing Financing Fund" (HFF), a state agency
that enjoyed explicit government guarantees on its debt, resulting
in reduced interest charges for homeowners. Interestingly, while
the Fund’s merely implicitly guaranteed American counterparts
– Freddie Mac and Fannie Mae – have been the center of
much controversy, the HFF has remained relatively unscathed.
prescriptions in the wake of the crisis have called for more interventions,
which will prove to exacerbate the situation if placed into effect.
Only by gaining a true understanding of the unsustainable and artificial
nature of the boom of the past decade may we arrive at effective
solutions to navigate the bust that engulfs the country.
Mismatching and Artificial Booms
shares a common bond with those that have infected other developed
economies recently: all have banking systems heavily engaged in
the practice of maturity mismatching. In other words, Icelandic
banks issued short-term liabilities in order to invest in long-term
assets, as can be seen in figure 1, which presents the funding gaps
(i.e., liabilities less assets) of a given maturity for the three
largest Icelandic banks – Kaupthing, Glitnir, and Landsbanki.
1: Funding gap: Big Three Banks (in million krna)
Glitnir, Landsbanki: 2008 annual reports
Thus, the banking
system had to continuously roll over (renew) their short-term liabilities
until their long-term assets fully matured. If an event arose whereby
Icelandic banks failed to find new borrowers to continue rolling
over their liabilities, they could face a liquidity crisis and,
more importantly, spark the collapse of the Icelandic financial
system; recent events have borne out this exact scenario.
these recent events, the question that immediately comes to mind
is, why did Icelandic banks engage in such a risky practice in the
first place? First of all, maturity mismatching can turn out to
be a very profitable business, involving a basic interest arbitrage.
Normally, long-term interest rates are higher than their corresponding
short-term rates. A bank may then profit the difference – the
spread between short- and long-term rates – through these transactions.
Yet, while maturity mismatching can turn out to be profitable, it
is very risky as the short-term debts require continual reinvestment
(i.e., a continual "rollover" must occur).
As in other
countries, Icelandic banks enjoyed guarantees by the government
to bail them out should their bets on the market turn erroneous.
However, while this guarantee is merely implicit in most developed
economies, the CBI committed to it explicitly. The Central Bank
of Iceland effectively functioned as the "roller-over of last
resort," providing fresh short-term debt as the market required
it. Indeed, the three main Icelandic banks – Kaupthing, Glitnir,
and Landsbanki – were so big in comparison to the GDP that
they could regard themselves as too big to fail. This led to moral-hazard
problems: If we have rollover problems threatening our solvency,
someone – be it the government or the central bank – will
come to help us, lest a detrimental shock reverberate through the
financial community. The result of this explicit guarantee was excessive
The most obvious
effect of this undertaking is that it represents a financially unsound
practice and may lead to banking-system instability. However, another
even more important effect of excessive levels of maturity-mismatched
loans is that it leads to distortions in the real economy by distorting
the capital structure, as demonstrated by Austrian business-cycle
theory. By expanding credit, banks create demand deposits (zero
maturity) in order to invest in loans issued to the public (longer-term
maturity). A similar maturity mismatch occurred, as we shall see,
when Icelandic banks borrowed in (mainly international) wholesale
markets (via short-term interbank loans and repurchase agreements,
asset-backed commercial paper, etc.) in order to investment in long-term
loans, such as commercial and residential mortgages.
problem with maturity mismatching is that there are insufficient
savings available to finish the artificially high number of projects
undertaken. Lenders have only saved for 3 months (i.e., the term
of the commercial paper) or not saved at all (i.e., the term of
the deposit), and not for 30 or 40 years (i.e., the term of the
mortgage or capital project). Maturity mismatching deceives both
investors and entrepreneurs about the available amount of real long-term
savings. Hence, by borrowing short and lending long, long-term interest
rates are artificially reduced. Entrepreneurs think that more long-term
savings are available than really exist and accordingly engage in
malinvestments that must be liquidated, once it becomes obvious
that there are not enough real savings to sustain them to completion.