The Collapse of the Icelandic Banking System Finance Essay

In the transition from a small-scale, low risk deposit money banking system to a universal international banking system oriented toward high-risk leveraged investments and depending heavily on foreign wholesale financing was accomplished in less than a decade. The three leading banks, Glitner, Kaupthing, and Landsbanki, were among the fastest growing financial institutions in the world (Eggertsson and Herbertsson, 2009). As the domestic economy had grown and stock prices had soared, the three banks’ assets had expanded from “100 percent GDP in 2004 to 923 percent at end 2007” (IMF,2008) which is almost ten times the country’s GDP. Early October 2008, the Icelandic economic euphoria was crushed by the three large banks’ failures, bringing down the financial system, creating an economic crisis, social and political chaos. The purpose of this Report is to respond to the issue as a regulator for banks, on the collapse of the Icelandic banking system by Identifying the main causes of the collapse of the banks. Recommending prudential regulations which will protect the community from such devastating bank failures in the future. The failure towards the three large banks, effectively taken over the government placed a burden of debt on citizens. II. Main causes of the collapse of the banks Growth of Banks and size at the time of collapse The main explanation on the collapse of the three large banks, Glitner, Kaupthing, and Landsbanki is highly due to the rapid expansion and their subsequent size when they fell in October 2008. Internal growth of the bank was due to the increase in loan portfolios, averaged of nearly 50% from the beginning of 2004 until their collapse (Althingi,chapter2,2009); commonly associated with poor quality loans as a result of poor underwriting, record keeping, management and supervision (Flannery,2009). The quality of the loan portfolios were eroded under these circumstances as such large-scale and high risk growth were not compatible with the long-term interests of solid banks where there were strong incentives for growth within the banks. Foreign operations of the banks rocketed and a change in the nature of the banks’ activities were also seen as investment banking gained importance as part of their operations. An opening of global debt financing further drove the growth of the banks. The banks received high credit ratings; inherited from the county’s sovereign debt rating on the sound position of the state and expectations.

They also had access to the markets in Europe due to the European Economic Area Agreement (EEA), to participate in a European Union’s single market without a conventional EU membership. Such big growth in lending by the banks will cause their asset portfolio to develop into a very high-risk one (Jimenez,2006). As the liquidity crisis started in 2007, foreign deposits and short term securitised funding became the main source of funding for the three banks and these type of financing were very sensitive to market conditions. A run on the collateralised loans was as detrimental as a run on foreign deposit accounts. The likelihood of run therefore increases, both on deposits and other means of funding. At the time of the collapse, repayment schedule of outstanding bond issues and collateral loans were burdensome due to the enormous growth throughout the decade. Weak equity As a result of the abundance of supply of credit with low interest rates in the international markets, the banks were able to borrow more money at low interest rates and passed in on to its customers. The economic resources that the banks had were invested into its own shares and were known as “weak equity”. It consisted of loans with collaterals and forward contract on own shares. It was reported that these three banks have financed themselves with 300 billion of Iceland Kro na (IKR) of their own shares in mid-2008(Althingi, chapter21, 2009). Hence, the bank capital ratios did not reflect in the real ability of the banks in withstanding losses if it were to happen. Leveraging of the bank’s owners The owners of the large three banks were amongst the biggest borrowers (Althingi, chapter21 ,2009). As owners, they had easy access to the loans and received substantial facilities though banks’ subsidiaries that operated money market funds. The largest debtors of Glitner, Kaupthing and Landsbanki were also the principal owners of the banks. The operations of the banks were in many ways characterised by their maximising of the benefit of majority shareholders, who held the reins in the bank, rather than by running reliable banks with the interests of all shareholders in mind and to showing due responsibilities towards creditors. There is a conflict of interest between the operation of the banks and operation of other companies owned by the same owners.

When in the late 2007 and 2008, where the banks began to experience funding problems, it seemed that the boundaries between the interests of the banks and the interests of their biggest shareholders were often unclear and the banks were seen to put more emphasis on backing up their owners instead. (Moore, 2010). The privatisation of the banks were owned and controlled by three groups of investors who used the banks to extend their balance sheet, and not by running the bank reliably and responsibly towards the interests of all shareholders. Concentration of risks Risk diversification is vital in the operation of the banks. As the banks are heavy indebted, it is therefore important for their portfolio of assets to be widely spread. As the largest debtors of the three banks are also the principal owner of the banks, there is a high risk such that the performance of the bank is dependent upon the performance of the group. It is too much risk for a bank to handle as the group falls and in the event when more loans is given, proven to be harmful to the depositors and creditors if they default. There was the exposure of more than one related party which accumulated within individual banks in the country and also between banks as there were groups of interrelated borrowers within all the banks. As a consequence, systemic risk exposure became significant to the loan portfolios of the banks. The loan of the groups amounted up to 5.5 billion EUR, 11% of all the loans and about an aggregated equity of 53%.( Althingi, chapter21 ,2009) This significant systemic risk does not only affect one of the banks if it fails but all three banks. III. Recommendations on prudential regulations to protect community from future bank failures Keeping up in pace with the monitoring on financial institutions As the banks pursued rapid international growth and domestic expansion, it is vital that FSA is able to keep up to date with the rapid growth of the banks and be well equipped with technical expertise and the equipment necessary to produce high quality comprehensive surveys of the position in the development of individual financial institutions. It was clearly seen from the FSA’s budget up to 2006 that it was insufficient for it to keep pace with the growth ( Althingi, chapter 2,2009) and hence unable to fulfil its tasks properly.

Vast expert knowledge is required on the operations of banks, economics, accounting, and legislation, especially for country has minimal experience in the financial industry. The Depositors’ and Investors’ Guarantee Fund (DIGF) needed strong surveillance under the FSA as an insufficient sum and the potential losses to foreign depositors will lead to serious problems. In closely monitoring the financial institutions and its activities, prompt actions should be exercised when growth is too rapid to reduce the size of the balance sheets of the banks, where the banking system will become far too big in relative to the size of the economy. Contingency plans There should be a stricter regulation into the systemic risk management on the capital reserve in the financial institution and also a compulsory contingency plan as to withstand a financial shock within the company. These contingency plans are to be clear and realistic. A strict act on minimum equity capital of banks should also be placed on these institutions. In the event of the failure in 2008, the rules were based on the “so-called” Basel II standards and provide that the capital base of banks should always extend more than 8% of the risk base. However, during the time where the financial system tumbled, capital ratios did not reflect the real strength as it own shares that risks exposure through direct collaterals and forward contracts on their own shares( Althingi, chapter21 ,2009) More sectors to identify specific risks It is important that there is compulsory of university degree, extensive knowledge and experience in financial market in hiring competent staff. With the resources and expertise, the organisational structured can be changed to incorporate groups of experts from different units who examine specific risks (including market risks) across sectors (Jännäri,K. ,2009). A department for solvency and capital adequacy, department of credit and market risks can be introduced on top of the current four units.

This can lessen the danger of compartmentalisation of the supervisory authority along the industry lines and allow regulators to concentrate on its own supervisory tasks. Maximise the amount of shares that can be owned by the debtor, Cross-ownerships Supervision in cross-ownerships has to be tighter and rules more stringent. The fact that banks were financing purchases of their own banks’ shares by their owners and other clients poses a large indirect risks in each other’s shares (Jännäri,K. ,2009). This is especially true for a small economy. Cross-ownership is hard to avoid in the absence of a comprehensive regulatory and supervisory framework. Therefore close supervision is vital in the case of any methods used to boost their capital adequacy artificially. IV Conclusion In the wake of a flawed process of privatisation, together with insufficient experience in the financial industry; the rapid growth of the three banks, Glitner, Kaupthing, and Landsbanki in a short period of time was deemed only possible by applying weak underwriting standards, loans to large holding companies and relying on “weak equity”. The fall of these three banks resulted in some of the biggest bankruptcies ever. Preliminary estimates indicate that creditors might have lost around 70 billion dollars in the crisis (Eggertsson and Herbertsson, 2009)and about roughly $330,000 for every Icelandic man, woman and child (Lewis,2009). The failure and the collapse of these banks as a result of these iniquities have caused a significant burden to the Icelandic citizens. A change in the organisational structure of the prudential regulations is to be implemented, in order to prevent and protect the community from such devastating bank failures in the future. Aliber,R.,2008, Monetary Turbulence and the Icelandic Economy, University of Iceland, June 20, 2008. https://www.hi.is/files/skjol/icelandlecutre-May-2008.pdf Althingi,2009, Chapter 2: Summary of the Report’s Main Conclusions, Report of the Special Investigation Committee to the Icelandic Parliament Althingi,2009, Chapter 21: Summary of the Report’s Main Conclusions, Report of the Special Investigation Committee to the Icelandic Parliament Buiter,W.,2008, The Icelandic banking crisis and what to do about it: The lender of last resort theory of optimal currency areas, Centre for Economic Policy Research, Policy insight No. 26., October 2008. https://www.cepr.org/pubs/PolicyInsights/PolicyInsight26.pdf Eggertsson,T. and Herbertsson,T. 2009, System Failure in Iceland and the 2008 Global Financial Crisis, University of Iceland & University of Reykjavik, June 10, 2009. Flannery,M. 2009, Iceland’s Failed Banks : A Post-Mortem, University of Florida, November 9, 2009. International Monetary Fund, 2008, Iceland: Financial System Stability Assessment-Update, December 2008. Jännäri,K., 2009, “Report on Banking Regulation and Supervision in Iceland: past, present and future”, March 30, 2009. https://www.island.is/media/frettir/KaarloJannari%20_2009_%20Final.pdf Jimenez,G., J. Saurina,2006, Credit Cycles, Credit Risk, and Prudential Regulation. “International Journal of Central Banking 2, February 2006, pages 65-98. Lewis, Michael, 2009, Wall Street on the Tundra, Vanity Fair Magazine, April 1, 2009. Moore,J.,2010, Iceland was ‘negligent’ over banking collapse, The independent, April 13, 2010. https://www.independent.co.uk/news/business/analysis-and-features/iceland-was-negligent-over-banking-collapse-1943153.html

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