Iceland is a small country with a population of about 300,000. Its economy is not considered to be significant enough to make headlines in the world financial news. However, in 2009, all this changed and Iceland became a talking point for economic experts all over the world. The way Iceland was handling its finances became a talking point in developed countries like the United States and the United Kingdom!
Iceland was getting all this attention because the unique policy that it had adopted while dealing with its recent financial crisis. Like many other countries in the world, the economy of Iceland was plunged into a recession by the irresponsible and risky behaviour of its banks. However, unlike other countries, Iceland decided that there was no need for the taxpayer to pick up the bill.
The Icelandic crisis of 2009, therefore, became important because it was the first time that the supposedly “too big to fail” banks were allowed to collapse while the government stood by watching as a mere spectator. This gave wind to the argument that developed countries like America and UK must also follow the same path.
The surprising fact is that contrary to popular opinion, all hell did not break loose in Iceland. The economy of Iceland has been steadily growing after the crisis. In this article, we will have a closer look at this historic crisis in a bit more detail.
Like the banks in the United States and Europe, the banks in Iceland had started taking excessive risks during the first few years of the new century. At first, these risky investments seemed to be paying off, and Icelandic banks were basking in the laurels of the unprecedented profits that they were recording.
The increasing profits created a kind of mania around the banking sector. The government of Iceland also became needlessly confident on the strength of its banking system and regulations were relaxed. The result was massive credit creation by the banks. The banking system grew so large that at one point the assets of the banking system i.e. the loans that are due to them became 1400% of the Gross Domestic Product.
This massive credit creation was the result of loose monetary policies of the central bank of Iceland. The interest rates were kept at near zero levels for many years. It seemed like the central bank in Iceland were simply aping the policies of the western central banks without giving any consideration to the applicability of these policies to the local market.
Concentration of Credit
Not only was an unprecedented amount of credit being created by the banks, but this credit was also being channelled to just two sectors viz. construction and mining. The influx of such a huge amount of credit in such a short period created asset bubbles in these markets. The prices of houses rose by a factor of three during the period.
The government was also complicit in creating this homeownership boom. In fact, the Icelandic government had created special agencies which provided an explicit guarantee on all the housing debt being issued by the banks. This obviously created a situation of moral hazard. Banks did not have any incentive to be careful with whom they give money to since even if the loans did go bad, the government would bear the loss!
Maturity Mismatch and the Collapse
Icelandic banks had grown extremely greedy. As a result, they started taking excessive risks like funding long-term loan assets with short-term deposit liabilities. The idea was to gain an interest rate arbitrage. The interest rate to be paid on short-term liabilities is much smaller than the interest to be gained on making a long term loan. Hence the banks seemed to be making money by using the term mismatch to their advantage.
However, maturity mismatch has always been a major risk in the banking system. Long term loans can only be funded by short-term deposits if the deposits are rolled over multiple times. Therefore if one deposit matures, another one must immediately be available to take its place and keep the system stable.
The Icelandic banks were able to rollover the short maturity deposits several times when the going was good. However, the subprime crisis of 2008 had adverse effects in Iceland as well. As a result, banks were not able to roll over their deposits. This ended up in banks not being able to meet their reserve requirements triggering the Icelandic crash of 2009.
Forex Crisis and Starvation!
The central bank and the guarantees that it had issued to protect its member banks crashed as a result of the crisis. Runs on banks were common and became an everyday affair. The central banks bankruptcy also resulted in a foreign exchange crisis. The people of Iceland would have been starving had it not been for the international aid that was received in the form of food items. The bankrupt Iceland government quickly got its act together and instituted policies that fiercely protected the scarce foreign exchange because it was required to buy food and other essential commodities from the international market.
The distortion caused by the fake rise in the banking industry had destroyed the fishing industry which had earlier been the mainstay of the local economy. The fishing sector, however, seems to have recovered from this backlash and once again appears to be slowly but steadily guiding the Icelandic economy to prosperity.