Lessons from Iceland's financial crisis

The 2008–2009 Icelandic financial crisis illustrates how an interconnected global financial system can threaten the very existence of a small economy with an outsized financial sector. The crisis was triggered off by the collapse of all three of the country's major banks following their difficulties in refinancing their short-term debt. In late September 2008, the government stepped in and partly nationalised Glitnir, the third-largest bank. Having tried to bail out one bank, the government soon had to take care of the two others, Landsbanki and Kaupthing. Relative to the size of its economy, Iceland’s banking collapse was the largest suffered by any country in economic history.
The financial crisis had serious consequences for the Icelandic economy. The national currency fell sharply in value. Foreign currency transactions were suspended for weeks. The market capitalisation of the Icelandic stock exchange dropped by more than 90%. The nation's gross domestic product decreased by 5.5% in real terms in the first six months of 2009. The standard of living in the country came down dramatically.Looking back, the collapse of Iceland’s banks, was not a sudden development. After a set back in 2006, when the main banks struggled to finance themselves, the banks had been trying to shift to safer policies. The banks had attempted to attract foreign deposits to back their assets abroad. On the other hand, the central bank had been raising interest rates to try to cool the economy. In the end, however, thanks to the frozen credit markets, the banks were unable to roll over their debts.

Various factors contributed to Iceland’s fall. One of them was the monetary policy pursued by the country’s central bank. High interest rates encouraged domestic firms and households to borrow in foreign currency, and also attracted currency speculators. This brought large inflows of foreign currency, leading to sharp exchange rate increases, giving the Icelanders an illusion of wealth. The speculators and borrowers profited from the interest rate difference between Iceland and abroad as well as the exchange rate appreciation. All this fuelled both economic growth and inflation, prompting the central bank to raise interest rates further. The end result was a bubble caused by the interaction between domestic interest rates and foreign currency inflows.

Before the crisis, the Icelandic banks had foreign assets worth around 10 times the Icelandic GDP. This was a clear sign that the financial sector had assumed monumental proportions. Yet in normal circumstances, this was not a cause for worry. Indeed, the Icelandic banks were better capitalized and with a lower exposure to high risk assets than many of their European counterparts. But in this crisis, the strength of a bank's balance sheet was of little consequence. What mattered was the explicit or implicit guarantee provided by the state to the banks to back up their assets and provide liquidity. The size of the state relative to the size of the banks became the crucial factor. Going by this criterion, the government was in no position to guarantee the banks.

The Icelandic authorities failed to show leadership. They did not communicate appropriately with their international counterparts, leading to an atmosphere of mistrust. At the same time, Iceland failed to receive support from Britain when the Scandinavian nation badly needed the support. The UK authorities seemed to have overreacted, using antiterrorist laws to take over Icelandic assets, and causing the bankruptcy of the remaining Icelandic bank.

To conclude, the original cause of the Icelandic crisis was a combination of inappropriate monetary policy and an outsized banking system. Throughout 2008, the Icelandic currency had been falling due to the currency speculators running for shelter. But the extreme global financial uncertainty, the mishandling of the crisis by the Icelandic authorities and the overreaction of the UK authorities served as the tipping points. In conclusion, we must appreciate that Iceland was done in as much by its policy failures as by the interconnectedness of the global financial system.
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