Thorvaldur GylfasonJoint Vienna Institute/IMF Institute

August 24–September 4, 2009

Begin in Ghana 1904

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

DuringGovernment actionsOld bank/new bank approach

AfterTen lessons from crisis IMF-supported programProspects

For decades, the government owned the banks Political leaders sat side by side on bank boards,

representing essentially bankrupt economic interests and dividing the spoils (“Socialism of the Devil”Socialism of the Devil”) With negative real interest rates and an overvalued

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

sever those connections, but did not fully succeed 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

Banks were sold both at once at low prices No serious attempt was made to attract foreign

buyers of banks as was done in the Baltics Unlike Nordic and Baltic countries, there is as yet

no foreign competition in Icelandic banking More concentration of industry than among Nordics Oligopoly is the rule in European banking

Market share of EU’s five largest banks is over 50% EU’s competition policy is important

Iceland: three banks had 85% market share Interest spread is a rough indicator of oligopoly

Interest rate spread Interest rate spread between lending and deposit rates Net interest margin Net interest margin (interest received less interest paid)

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, but didn’t Central Bank Central Bank ought to have constrained them

through reserve requirements, but didn’t Financial Supervision Authority Financial Supervision Authority ought to have

applied more stringent stress tests, appropriate to local conditions, but didn’t

Besides, several documented earlier episodes of bank problems – scandals, really – when banks were state-owned were covered up No culture of 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,

among other things, long-term housing loans at home at unprecedentedly low rates An element of sub-prime lending involved? Yes, clearly

Loan pushers from the banks were in full swing Extensive insider lending without adequate collateral

has begun to come to light William Black: The Best Way to Rob a Bank Is to Own One The Best Way to Rob a Bank Is to Own One (2005)

Banks became international 2007: derived half their earnings from abroad

31 subsidiaries in 21 countries (October 2007)

“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 took on excessive riskSo, if one fell, others were likely to fall as well 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

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

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

Inflation target

-40

-35

-30

-25

-20

-15

-10

-5

0

5

Beyond our means, yes, big time:

Investment (housing, hydro-

projects) Consumption (jeeps, jets, Elton

John)

Mid-2008

End 2008

Net External Debt (% of GDP)*Net External Debt (% of GDP)*

*Excluding risk capital

Mid-2008

End 2008

International Investment Position (% of GDP)*International Investment Position (% of GDP)*

*Including risk capital

Mid-2008

End 2008

Mid-2008

End 2008

Three-month Rule

Giudotti-Greenspan Rule

Mid-2008

End 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

126

179

US per capita GDP is USD 42KUSD 42K

Iceland has long been a high-exchange-rate place, for several reasons High inflation is conducive to overvaluation Mounting foreign debts, partly due to high inflation Pervasive farm support, also support for fisheries

Symptom: Expensive hamburgers (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 of “glacier bonds” outstanding,

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

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 in 2008, and then fall back to square one just before the crash, taking the OMIX15 (Iceland’s stock market index) up and then back down with them Banks accounted for 50% of OMIX15

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

OMIX15 index fell

from its peak by

97%

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 reserves and to rein in the banks

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 Anne Sibert, London Prof. Daniel Gros, Brussels Prof. Robert Wade, London

IMF issued a

polite warning

against

“staggering”

credit expansion,

could have said

more

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 let rating agencies be paid by the Do not let rating agencies be paid by the banksbanks

Fundamental conflict of interest Also, prevent accountants from cooking the books

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

Work in progress

Asymmetric information

Moral hazard

United States 1871-2003 France 1821-2003

Perhaps bank regulation during

Great Depression also helped

stabilize GDP

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; learned this from Thailand 1997

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 May violate law against breach of trust

7.7. Erect firewalls between banking and Erect firewalls between banking and politicspolitics

For reasons discussed before8.8. When things go wrong, hold those When things go wrong, hold those

responsible accountable by law, or at least responsible accountable by law, or at least try to uncover the truth: Do not cover uptry to uncover the truth: Do not cover up

In Iceland, there have been 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

Public has a need and right to know National Transport Safety Board investigates every

civil-aviation crash in America

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

The structure can

withstand the

removal of the

top layer unless

the financial ruin

seriously weakens the

fundamentals, as

may have occurred in

Iceland

A financial crisis typically wipes out only a small fraction of national wealthEvidence from post-1945 crises

Equity prices fall by a half over 6 years Real estate prices fall by a third over 4 years Unemployment up by 7%, recovers within 4

years GDP contracts by 9%, recovers within 4 years

Iceland crisis 2008 is similar except... ... Equity prices fell by 97% ... Financial damage amounts to multiple of

Iceland’s annual GDP because foreign creditors of banks stand to lose up to five times GDP from the collapse, in addition to losses suffered by foreign depositors and other clients abroad and at home

Carmen M. Reinhart and Kenneth Rogoff:This Time is Different: Eight Centuries of Financial Folly (2009)

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 as a general rule that banking and politics are not a good mixbanking and politics 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

Two-year stand-by arrangement IMF provides $2.1 billion, with $0.8 billion up

front and the rest in eight equal installments subject to quarterly reviews Exceptional access to Fund resources, amounting to

1,190% of Iceland's quota Second installment, scheduled for February 2009,

remains to be made due to delays in implementation Fund money covers 42% of total financing gap

of $5 billion during 2008-2010 Remaining $2.9 billion is provided by

Denmark, Finland, Norway, and Sweden (conditional) Russia (conditional, but conditions not yet made

public) Poland (unconditional) Faroe Islands (unconditional)

Fund needs to listen to

concerns of other

creditors

Monetary restraintCentral Bank policy rate of 18% (since cut to 12%)

Transparent bank restructuring (took too long) Floating exchange rate

Supported by strict but temporary capital controlstemporary capital controls Fiscal space 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 2009with uncertain asset recovery

% 2009 2010 2011

2012

2013

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

66 7 5 4 3

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

160160 147 136 118 101

Source: IMF, November 2008

* % per year

** % of labor force

*** public and private, % of GDP

Will be 9%

Will be 200% or more, perhaps 240%, but exact division of extra debt between public and private debt is not yet known

IMF remains optimistic, perhaps too optimistic Two views

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

equivalent to 80% of GDP, then reduced their claim by half Victors also took land, reducing Germany by more than 10% Claim was not paid in full, was settled peacefully in 1932

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 120% 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; yet, population shrank in 2009

Successful recovery rests on two pillars Must effectively implement IMF program and

supplement it with further reforms Announcement in July 2009 of intention to apply for EU

and EMU membership will, it is hoped, send encouraging signal to international community

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 took to the streets, banging their pots and pans, producing change of government, new elections, …

What next? Continuation and success of IMF program depends,

inter alia, on Iceland’s ability to implement the program and to satisfy demands made by the program’s cosponsors for the settling of certain controversial claims Conditionality is no longer the sole prerogative of the IMF Other creditors also have a say

By applying for EU membership, Iceland has indicated its readiness to share its sovereignty with other EU members as required by rules of the game

EU membership will ultimately be decided in a national referendum when terms of accession have been laid down through negotiations