Iceland's Banking Crisis: The Meltdown of an Interventionist Financial System

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Icelandic Prime 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.

Regrettably, 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!

What analysts 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.

The policy 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.

Maturity Mismatching and Artificial Booms

Iceland’s crisis 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.

Figure 1: Funding gap: Big Three Banks (in million krna) Source: Kaupthing, 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.

Considering 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).

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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 maturity mismatching.

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.

The ultimate 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.

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July 9, 2009