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Iceland and the Financial Crisis- Origins, consequences, lessons -

Presentation by the INAO

26 February 2010

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Topics

• What has happened in Iceland?

• How the crisis originated and evolved

• What measures were taken

• How the INAO was affected

• Challenges and lessons learned

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What has happened?

• After enjoying a rapid growth for a number of years Iceland’s economy took a sharp turn to the worse in 2008 that culminated in October when the Icelandic banking system collapsed.

• These events correlated with international developments (booming economies followed by a financial crisis).

• But they had more serious consequences in Iceland due to its (relatively) huge banking sector (10x GDP), its reliance on foreign trade (40% of GDP), foreign currency denominated debts, and other factors.

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• Economic and fiscal consequences– GDP decreased in real terms by 6% between 2008 and 2009.

Predictions for 3-4% further decline in GDP in 2010– Inflation peaked to 12% in 2008 and 2009 (16% in 2009 without

the housing component). Predicted to be 6% in 2010– The value if the ISK has decreased 50% against the euro in two

years. The ISK is predicted to remain weak– Unemployment has risen from 2,3% in 2007 to 7,2% in 2009.

Even higher rates are projected for 2010– Central government budget deficit has gone from 0% to 14% of

GDB– Gross government debts likely to exceed 100% of GDP.

Source: Statistics Iceland, Central Bank of Iceland

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Consumer Price Index

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How the crisisoriginated and evolved

• A worldwide financial crisis started in 2007, caused by a number of factors, e.g.– Easy availability of low-interest loan capital during the 2000s.– Resulted in classical asset and loan bubbles in many countries.– Complicated by financial products that made valuations/risks

difficult to determine (sub-prime lending, derivatives, etc.) while incentive pay-schemes awarded short term profits and risk-taking appetite.

– Worldwide banking operations linked economies together making booms and depressions global instead of local.

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• In Iceland– Deregulation of financial markets in the 1990s (after

Iceland joined the EEA).– Privatization of banks in yearly 2000s.– Icelandic business and banks invested heavily

abroad, often by leveraged buyouts. Stock market prices in Iceland quadrupled in 5 years.

– Huge govenment sponsored investment projects were launched during the 2000s (hydro-energy and aluminum smelting plants).

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• In Iceland (cont.)– Changes to the housing loan system resulted in

higher loan-to-value ratios and greater competition. Real estate prices doubled in 5 years.

– Lowering of tax ratios while increasing public expenditures (made everyone happy!)

– The CBI gradually increased its interest rates in order to stem inflation (its monetary policy based on inflation targets)

• Resulted in (1) businesses and homes seeking foreign loans, and (2) carry-trade as never seen before.

• Is inflation really always a bad thing?

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• In Iceland (cont.)– Homes increased their expenditures, partly paying for

by higher incomes but also by loans.– A shortage in the work-force was met with foreign

workers (proportion of foreign citizens living in Iceland increased from 3,5% in 2003 to 7,6% in 2009).

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How the crisis evolved• In early 2006 there was an Icelandic “mini-banking crisis” when CDS spreads increased

and the banks were unable to seek funds for a while.– Bankers and the government agreed there was a lack of understanding about the Icelandic

banks’ business model.– Report by economist F. Mishkin at Columbia University was commissioned by the Chamber of

Commerce to assure investors everything was safe and sound.– Icelandic banks started to issue bonds in new markets (the Americas, Asia) and especially

offering high-interest deposits through their branches and subsidiaries in Europe.– Confidence was bolstered when the “assault had been halted”.

• During 2007 financial markets were starting to panic because of sub-prime lending, dubious CDOs, etc. and it became increasingly difficult and expensive to obtain capital. In March 2008 the investment bank Bear Stearns collapsed. Funding for the Icelandic banks again dried up as their CDS rose to new levels.

• At the same time the ISK started to decline sharply as investors became increasingly worried.

• The Icelandic banks had to depend on short time funds from the ECB and CBI. The CBI sought in wane to assure reserve funds.

• After the Lehman Brothers’ collapse in September 2008 it became obvious one or more of the Icelandic banks would become illiquid and default. One bank (Glitnir) sought assistance from the CBI.

• At the beginning of October the three largest banks collapsed. The banking system had become too large to save. Events surrounding their collapse are still somewhat unclear with a lot of the blame game still going on.

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• Kaarlo Jännäri’s Report on Banking Regulation and Supervision in Iceland (March 2009):– The collapse of the Icelandic banking sector resulted

from a combination of several factors:• Bad banking• Bad policies• Bad luck

http://eng.forsaetisraduneyti.is/media/frettir/KaarloJannari__2009.pdf

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• Bad banking– The owners and managers of banks adopted an aggressive policy of

rapid international growth based on high leverage and investment in growth areas that turned into bubbles.

– In the euphoric stage of rapid growth, risk controls and contingency plans were considered a nuisance, and the quality of the banks’ assets and the collateral used to protect them did not withstand the pressure when the prevailing emotion in the overheated global financial market turned from greed to fear.

– Iceland’s government and central bank were unable to support the overgrown banking sector in its difficulties. The banks had grown too big for Iceland.

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Banking system running loose!Banking assets, GDP and CBI FX reserves

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• Bad policies– The money and financial market in Iceland is highly indexed or

foreign exchange-based. As a result, the CBI’s monetary policy only affects a small fraction of the financial system. The high degree of foreign currency denominated lending domestically also made the economy susceptible to fluctuations in the external value of the Icelandic króna.

– During the boom years, macroeconomic policies in general were too lax and accommodating. The CBI’s foreign exchange reserves could not grow in tandem with the economy’s overall dependency on international developments. In addition, the CBI’s human resources may have been too small for a country with a freely floating currency and a large banking system that was more international than domestic but was nonetheless viewed by foreigners as Icelandic.

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• Bad policies (cont.)– The FME [Iceland’s financial regulator], was too small to supervise a

complex banking system like that in Iceland. The powers of the supervisors were too limited, and the Nordic tradition of jurisprudence did not allow much leeway into discretion. The tycoons of the financial system could circumvent the underlying purpose of the regulations by sticking to the letter of the law with the help of diligent lawyers and complicated corporate structures.

– The supervisors were too timid and lacked legal authority in their efforts to intervene in these developments, but the overall national pride in the success of the banks would probably have made it futile even to try while the going was good and success followed success.

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• Bad luck– Since the Great Depression of the 1930s, the modern world has not seen a

financial global crisis like the one we are experiencing right now. In these circumstances, the efforts of the Icelandic banks to retrench in late 2007 and 2008 were rather futile. Finally, the collapse of Lehman Brothers on September 15, 2008 struck the final blow to the ability of the Icelandic banks and the authorities to save the system.

– There might – just might – have been a possibility for the Icelandic banks to survive if the almost total freezing of the international financial markets had not taken place and confidence in Iceland had not been lost. Even in that case, they probably would have needed government support to maintain their solvency, as credit losses would have risen due to the deterioration of their loan portfolios.

– Now that the blaming game continues at high speed in Iceland, it is perhaps beneficial to bear in mind that most, if not all, Icelandic players in this game must also look in the mirror. Placing the blame solely on external circumstances is not appropriate.

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Anything new under the Sun?

• The causes of the Nordic banking crises– Bad banking– Inadequate market discipline– Weak banking regulation and supervision,– Inadequate macro policies, including having

to deal with financial liberalization.

Stefan Ingves, at a seminar on the Nordic banking crises hosted by Kredittilsynet, in Oslo in September 2002.

http://www.imf.org/external/np/speeches/2002/091102.htm

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What measures were taken

• The government introduced an “emergency legislation” enabling the financial regulator (FME) to take over control of the banks and the establishment of new banks.

• The idea was to “ringfence” domestic bank operations.• This was mostly successful but authorities seem to have misjudged

reactions by foreign creditors and esp. foreign governments.• Iceland was forced to seek assistance from the IMF and the Nordic

countries, the first Western European country to do so since 1976. This move was hugely unpopular by many even if IMF has been rather “soft” on Iceland (except maybe the Icesave settlement).

• Capital controls were introduced in November 2009 as a temporarily measures but still remain in force with no obvious escape plan.

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• Issues related to deposit insurance guarantees stemming from Landsbanki’s operations in the UK and the Netherlands (Icesave accounts) have been difficult to resolve. Repeated discussions have yet to result in a final agreement. This also has become a hotly debated political issue (with parties changing agendas depending on if they are in government or it the opposition).

• Inquiries and criminal investigations are taking place. Widespread distrust by the general public towards politicians and bankers.

• A challenging task ahead to preserve the integrity and trust in the legal system (foreign creditors unhappy and accuse the government of discrimination).

• High expectations by the public towards the government to “solve their problems”. (But would this be a crisis if they were easily solved?)

• Classical counter-depression measures with deficit spending not possible or appropiate.

• No political consensus on the way ahead when it comes to EU membership, monetary policy and other major issues!

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• Restoring the banking system– New banks were established to take over domestic operations.

Only domestic deposits and assets were transferred to them.– Settlement between the new and old banks has taken a lot

longer than expected (valuation and negociations).– Eventually the old banks took over two the new banks (will be

operated as subsidiaries) while the government retains ownership of the largest bank.

– Bankrupcy laws were changed to accomotate for a continuing but limited operations of the old banks.

– Dissatisfaction from many creditors of the old banks. Resolution committee have been criticized for lack of accountability (Who do they really represent? Conficts of interests. Lack of trans-parency). A legal minefield concerning “ex post facto” laws and discrimination.

– Smaller banks (S&L) are still being restored.

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• Measures to assist the bank’s debtors (business and homes)– Many debtors have loans denominated in foreign currencies

(there are some doubts on the legality of such lending).– The government has repeatedly put a moratorium on

foreclosures and introduced new legal measures than can be used instead of bankruptcy in some cases (greiðsluaðlögun = skuldsanering).

– Banks are offering extensions of loans, giving discounts on remaining balance if loans are transformed into ISK, etc.

– Banks are also heavily involved in the financial restructuring of businesses. Widespread distrust by the public and in the media on how things are being handled following the crash (e.g. about ownership and competition). The banks and the government have not been successful in creating trust about the way things are handled.

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Don’t be careless!• “Your are just starting,“ Göran Persson said in a speech at the University of

Iceland yesterday [Dec 10, 2008] while on a short visit by invitation of the Associations of Investors. Persson discussed the banking crisis in Sweden in the 90’ and what Iceland could learn from Sweden’s experience. The government of Iceland needs to show strong fiscal discipline and cut the deficit.”

• “I did so and ended up as one of the most hated politicians in Sweden for a number of year, but it was worth it, as the other option was worse,” Persson said.

• “You have no time to loose. Some people say restructuring the public finances should be delayed until next year. I think the IMF shares that opinion. But why loose a year? Why wait?” Persson asked.

Morgundbladid, December 11, 2008.http://www.mbl.is/mm/gagnasafn/grein.html?grein_id=1259648

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Almost a year later

• At yesterday’s conference [Nov 11, 2009], the government was also criticized by its financial advisor, Mats Josefsson.

• “It appears that the restoration of the economy is not being prioritized by the government these days. Lack of political decision-making is the main hindrance in the restoration of the Icelandic economy,” he said […]”.

• He also told that the main weakness in the government’s restructuring was than no single entity was responsible for decision making. Actions need to be coordinated and in order to create more trust a single entity should be responsible to give information to the public and to creditors.

Iceland Review

http://icelandreview.com/icelandreview/search/news/Default.asp?ew_0_a_id=351875

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How the INAO was affected

• New tasks– Participating in the audit of the new banks while they

remain in goverment ownership (only temporarily)– Giving opinions on budget proposals– More frequent monitoring of the budget execution– New audit tasks in financial management, mergers,

procurments, hiring practices etc.– A role in monitoring fiscal affairs of municipalities?– All while cutting costs by 10% due to lesser

appropriations!

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Challenges and lessons learned

• A the macro level– A sound economic policy (fiscal and monetary) is

important also during good times. A strong fiscal discipline is always needed.

– Managing a floating exchange rate, inflation targets and interest rates is difficult (and even dangerous) esp. in a small open economy (has been called “the impossible triad”).

– The CBI should never forget the mantra: “We are the lender of last resort!” when considering the size of the banking and financial system.

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• At the micro level– Sensible rules and regulations on financial markets should be adopted

and enforced with zero-tolerance and not in an overly legalistic way. Still, regulation has its limits and is not a cure for everything. There is always a danger of regulatory capture and laxness, esp. when everyone has forgotten the last crisis!

– Warning signals should never be taken lightly and/or defensively. The most convenient explanations are not necessarily the right ones. Always make sure you consider the worst possible outcomes and decide if you are willing to face them.

– In a small society there are often too close relationships leading to conflicts of interests. The pool of talents may also be too limited. These issues should always be treated as problems and for example met with the help of outside experts and advisors.

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• The Role of the SAI– In preventing crisis (maybe a little optimistic!)

• Make sure there is reliable information• Make sure regulators are doing their job• Make sure there is enough risk awareness

– In coping with crisis (more realistic)• Make sure limited funds are spent wisely

– Government operations and projects need to be prioritized– Modern methods applied to help with decision makings

(appraisal techinques, cost-benefit, cost-effectiveness analysis, value for money audits, etc.)

– Report on progress, point out areas that need actions, create trust by closely monitoring all actions.