Thorvaldur Gylfason

Agriculture and fisheries: 21% of GDP

Share of

fisheriesfisheries fell

from 16% to

7% Share of

servicesservices rose

from 54% to

68% Share of

bankingbanking rose

from 5% to

8%

BeforeBackground and history

DuringWhat the government didOld bank/new bank approach

AfterTen lessons from crisis IMF program and prospects

For decades, government owned the banks In 1930s, leaders of two main political parties sat

side by side on the board of Landsbanki, each representing essentially bankrupt economic interests that went on to divide the spoils (“Socialism of the Socialism of the Devil”Devil”) One of them sat there until the day he died in 1964,

despite serving as prime minister on five occasions Until late 1990s, bank directors and governing

boards were political players, with few exceptions With negative real interest rates and an overvalued

króna, bankers exercised significant power Privatization 1998-2003 ought to have aimed to

sever those connections, but did not fully succeed

Before

Two largest banks were sold in part to well-connected individuals with close ties to the two governing parties (“within calling distance”) The two parties maintained their operatives on the

banks’ governing boards Both banks were sold both at once at prices

deemed modest by the National Audit Office No serious attempt was made to attract foreign

buyers of banks as was done in the Baltics Unlike the Nordics and the Baltics, there is as yet

no foreign competition in Icelandic banking More concentration of industry than among Nordics Large spreads between lending and deposit rates

See my History and context

Iceland’s privatization of its state banks 1998-2003 was mismanaged in ways that contributed to collapse and to weak restraints on bank growth GovernmentGovernment ought to have constrained the banks

through taxes Central Bank Central Bank ought to have constrained them

through reserve requirements Financial Supervision Authority Financial Supervision Authority ought to have

applied more stringent stress tests, appropriate to local conditions

Besides, several earlier episodes of bank problems when banks were state-owned were covered up No accountability

Once freed from government control, the banks kicked up their heels like cows in spring Unprecedented borrowing and lending spree Borrowed short abroad at low interest to make long-

term housing loans at home at unprecedentedly low rates Some loans with variable interest rates after a five-

year grace period, to be renegotiated in 2009 An element of sub-prime lending involved? Perhaps

Banks became international 2007: derived half their earnings from foreign

operations 31 subsidiaries in 21 countries (October 2007) Net interest income: 50%-60% of total (2008, Q1-Q2) Net fee and commission income: 30%-40% of total High return on equity, capital adequacy 10%-11% Deposit/loans ratios 40%-60%, aimed to raise them

“A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.” (J.M. Keynes). Icelandic banks copied each other’s business

model, and possibly took on excessive risk

“Daring ideas are like chessmen moved forward. They may be beaten, but they may start a winning game.” (J.W. Goethe) Icelandic banks faced an insignificant home

market, so their choice was essentially to “evolve or die”

Source: Union Bank of Switzerland, December 2007

How did they grow?

Barclays: 100% of Britain’s GDP

Deutsche Bank: 80% of

Germany’s GDP

Source: Union Bank of Switzerland

Mid-2008

Mid-2008

Mid-2008

Mid-2008

Beyond our means, yes, big time:

Investment (housing, hydro-

projects) Consumption (jeeps, jets, Elton

John)

Mid-2008Net External Debt (% of GDP)Net External Debt (% of GDP)

Mid-2008International Investment Position (% of GDP)International Investment Position (% of GDP)

Mid-2008

Three-month Rule

Giudotti-Greenspan Rule

Mid-2008

ISK per USDISK per USD

ISK per EURISK per EUR

Inevitable correction, and overdue

At 2007 exchange rate, recorded

per capita GDP in 2008 would be

USD 70KUSD 70K At pre-crash exchange rate, USD USD

44K44K At post-crash exchange rate, USD USD

35K35K

127

169

Iceland has long been a high-exchange-rate place, for several reasons High inflation Mounting foreign debts Pervasive farm support, also for fisheries High domestic prices of tradable goods (Big Mac

index) Recently, also, carry trade (Ms. Watanabi of

Tokyo) How? Borrow in, say, yen at low interest, buy

krónur, place proceeds in high-interest accounts Pre-crash amount outstanding, due within year:

20% of GDP Needed to be refinanced, this proved impossible Put further downward pressure on króna

See my Skating on thin ice?

Mid-2008

Rapid expansion of money and credit

did not produce commensurate

inflation like in the past because of

imported labor from EEA and

increased flexibility

Even so, inflation was bound to

rise

Mid-2008

Closer Look at 2004-2008 (% per year)Closer Look at 2004-2008 (% per year)

Inflation target

Stock market rose by a factor of 9 from 2001 to 200744% average annual increase six years in a

row World record

Clearly a bubble, and hence unsustainable Even before bank collapse, stock market fell by

more than 50% from 2007 Real estate prices rose by a factor of 2.5

from 2001 to 200811% per year on averageLed to construction boom

Count the cranes! (Professor Robert Aliber)Also, a bubble, unsustainableAccident waiting to happen

Three largest banks (Kaupthing, Glitnir, Landsbanki) saw their stock prices double, and then fall back to square one just before the crash, taking the OMIX15 up and then back down with themBanks accounted for 50% of OMIX15

CDS spreads for the banks rose to stratospheric heights (26 October 2008) Glitnir: 1600Kaupthing: 1500Landsbanki: 1200

For comparison, Barclays: 200

Thin market, some

said, so not

relevant Not justified

by numbers

either, others

claimed

End of September 2008: Collapse First, Glitnir collapsed

Glitnir asked Central Bank for $600 million loan to meet due date 15 days later as foreign credit line had closed; Central Bank refused

Within a week, Landsbanki and Kaupthing also collapsed The three accounted for 85% of the banking system

Government put all three banks into administration Their shares became worthless overnight New bank/old bank approach

New state banks took over deposits and provided domestic banking services, injected new capital into them, also into Central Bank

Old private banks were left with their dodgy assets and foreign debts

Resolution committees were appointed to liquidate old banks In effect, temporary renationalization

Based on Nordic solution, worked well in crisis of 1988-1993

Plan is to reprivatize the new banks, e.g., by exchanging their debts for equity, inviting foreign ownership

during

Were all observers caught by surprise? No For years, some domestic observers had

warned against Excessive credit expansion Excessive credit expansion of banks and

inflation Danger of banking crisis Danger of banking crisis because Central Bank

neglected to build up foreign exchange reserves

Danger of currency collapseDanger of currency collapse because the króna was clearly overvalued

Several foreign observers also spoke out Prof. Robert Aliber, Chicago Prof. Willem Buiter and Ann Sibert, London Prof. Daniel Gros, Brussels Prof. Robert Wade, London

1. 1. Need legal protection against predatory Need legal protection against predatory lendinglending

Like laws against quack doctors, same logicPatients know less about health problems than

doctors, so we have legal protection against medical malpractice

Same applies to some bank customers vs. bankers, especially in connection with complex financial deals

2. 2. Do not allow rating agencies to be paid Do not allow rating agencies to be paid by the banksby the banks

Fundamental conflict of interest

3. 3. Need more effective regulation of banks Need more effective regulation of banks and other financial institutionsand other financial institutions

Work in progress

after

4. 4. Read the warning signalsRead the warning signalsThree rules, or stories

The Aliber RuleCount the cranes

The Giudotti-Greenspan RuleDo not allow gross foreign reserves held by the

Central Bank to fall below the short-term foreign debts of commercial banks

Failure to respect the Giudotti-Greenspan Rule amounts to an open invitation to speculators to stage an attack on the currency

The Overvaluation RuleSooner or later, an overvalued currency will fall

5. 5. Do not let banks outgrow Central Bank’s Do not let banks outgrow Central Bank’s ability to stand behind them as lender – ability to stand behind them as lender – or borrower – of last resortor borrower – of last resort

6. 6. Do not allow banks to operate branches Do not allow banks to operate branches abroad rather than subsidiaries, thus abroad rather than subsidiaries, thus exposing domestic deposit insurance exposing domestic deposit insurance schemes to foreign obligationsschemes to foreign obligations

Without having been told about it, Iceland suddenly found itself held responsible for the moneys kept in Landsbanki by 300.000 British depositors, and more in the Netherlands and Germany

7. 7. Erect firewalls between banking and politicsErect firewalls between banking and politics Iceland’s privatization of its state banks 1998-

2003 was mismanaged in ways that contributed to collapse and to weak restraints on bank growth GovernmentGovernment ought to have constrained the banks

through taxes Central Bank Central Bank ought to have constrained them through

reserve requirements Financial Supervision Authority Financial Supervision Authority ought to have applied

more stringent stress tests, appropriate to local conditions

Besides, several earlier episodes of bank problems when banks were state-owned were covered up No accountability

8. 8. When things go wrong, hold those When things go wrong, hold those responsible accountable by law, or at responsible accountable by law, or at least try to uncover the truth: Do not least try to uncover the truth: Do not cover upcover up

In Iceland, there are now vocal demands for an International Commission of Enquiry, a Truth and Reconciliation Committee of sorts

If history is not correctly recorded if only for learning purposes, it is more likely to repeat itself with dire consequences

9. 9. When banks collapse and assets are When banks collapse and assets are wiped out, protect the real economy by a wiped out, protect the real economy by a massive monetary or fiscal stimulusmassive monetary or fiscal stimulus

Think outside the box: put old religion about monetary restraint and fiscal prudence on ice

Always remember: a financial crisis, painful though it may be, typically wipes out only a small fraction of national wealth Physical capital (typically 3 or 4 times GDP) and

human capital (typically 5 or 6 times physical capital) dwarf financial capital (typically less than GDP)

So, financial capital typically constitutes one fifteenth or one twenty-fifth of total national wealth, or less

10. 10. Do not jump to conclusions and do not Do not jump to conclusions and do not throw out the baby with the bathwaterthrow out the baby with the bathwater

Since the collapse of communism, a mixed mixed market economymarket economy has been the only game in town

To many, the current financial crisis has dealt a severe blow to the prestige of free markets and liberalism, with banks having to be propped up temporarily by governments, even nationalized

Even so, it remains true that banking and banking and politics are not a good mixpolitics are not a good mix

But private banks clearly need proper proper regulation regulation because of their ability to inflict severe damage on innocent bystandersinnocent bystanders

Time line of events (various sources) April 2008: British Prime Minister advises

Icelandic Prime Minister to seek IMF assistance Spring and summer 2008: Nordic Central Banks

advise Icelandic Central Bank to go to IMF Summer 2008: ECB and US Fed make same

recommendation, and exclude Iceland from currency swap agreements with other Nordic Central Banks

October 2008: After collapse, Iceland seeks “new friend” in Russia, but deal does not materialize

November 2008: IMF program, six months too late, with help from Nordics, Faroes, Poland, and Russia

Monetary restraintCentral Bank policy rate of 18%

Floating exchange rateSupported by strict but temporary capital controlstemporary capital controls

Transparent bank restructuring Fiscal respite in 2009, with government

budget deficit of 14% of GDPFiscal restraint kicks in from 2010 onward

Cut spending from 55% of GDP in 2009 to 43% in 2013 Raise revenue from 42% in 2009 to 45% in 2013 Retrenchment equivalent to 15% of GDP in 4 years;

tough Different from Asian programs 10 years ago

IMF now tolerates capital controls, fiscal respite

% of GDP Gross cost Net cost

New banks 26 26

Central bank 10 10

Foreign depositors*

47 19

Total 83 55

* Estimated asset recovery equivalent to 28% of GDP

Source: IMF, November 2008

Numbers are subject to considerable uncertainty

% of GDP 2008 2009 Difference

Public debt 29 109 80*

Foreign debt 670 160 -510**

*Fiscal cost of cleanup in 2009

**Private debt write-off in 2009

with uncertain asset recovery

% 2009 2010 2011

2012

2013

GDP growth* -10 0 4 4 4Unemployment**

6 7 5 4 3

Inflation* 14 3 2 2 2Foreign debt***

160 147 136 118 101

Source: IMF, November 2008

* % per year

** % of labor force

*** % of GDP

IMF is optimistic, perhaps too optimistic Two views

PessimistsPessimists warn that the debt burden threatens to match that which the allies imposed on Germany at VersaillesVersailles after World War I, with predictable economic and political consequences

OptimistsOptimists emphasize that the Faroe Islands Faroe Islands emerged from their deep financial crisis in early 1990s with an external debt to Denmark equivalent to 140% of GDP, and were able to repay with interest within 6-8 years Long-term loss to Faroes despite recovery in other

respects Net emigration of about 10% of population This Iceland must avoid

Successful recovery rests on two pillarsMust effectively implement IMF program and

supplement it with further reforms Announcement of intention to apply for EU and EMU

membership would send encouraging signal to international community; this may occur soon

Must also uncover the causes of the collapse, including massive failure of policy and institutions Iceland needs an international Commission of Enquiry Rather, Parliament decided to appoint its own

domestic Investigative Committee, risking a deepening crisis of confidence if the committee fails to convince the public

People have taken to the streets