Why Iceland?

6 ideas

1. Banking system outgrew its lender of last resort

   The three Icelandic banks grew to roughly ten times Iceland's GDP, far beyond what the central bank and state could backstop in a run. Because the banks' liabilities sat largely in foreign currency, the Central Bank of Iceland could not print its way to rescuing them, so the collapse was a structural mismatch between bank size and sovereign capacity, not only a failure of individual bank management. This is the author's framing, and as Kaupthing's chief economist he has an interest in stressing systemic over firm-level causes.

2. Wholesale funding dependence as hidden fragility

   The banks financed rapid expansion by borrowing on international bond and interbank markets instead of from a stable deposit base. When global credit markets froze in 2007–2008, they could not roll over their short-term debt, and assets that looked healthy on paper could not be sold quickly enough to meet maturing obligations.

3. Small currency, big balance sheet trap

   A country with a tiny floating currency can join global capital markets, but its banks then carry large foreign-currency exposures its own currency cannot defend. Carry-trade inflows attracted by high domestic interest rates inflated the króna, and when they reversed the currency collapsed, which in turn raised the domestic burden of foreign-denominated debts.

4. Collapse triggered by foreign policy decisions

   The author argues that actions by other governments sharply accelerated the failure. The main examples he gives are the UK's use of anti-terrorism legislation to freeze Icelandic bank assets and its moves against Kaupthing's British subsidiary. On this view, cross-border contagion and a loss of confidence among authorities abroad turned a severe liquidity crunch into an outright collapse of the system, a reading that puts less weight on the banks' own conduct.

5. Deposit guarantees stranded across borders

   Online savings accounts such as Icesave collected deposits from foreign savers through branches, which left Iceland's small deposit insurance scheme on the hook for liabilities far larger than it could pay. Under the EU passporting regime, host countries had little supervisory control while the home country had little fiscal capacity, so responsibility fell into the gap between the two.

6. Privatization to boom in a decade

   Iceland's state-owned banks were privatized around 2003. Newly liberalized and ambitious management then expanded them aggressively through acquisitions abroad, backed by strong credit ratings and easy global money. In just a few years a traditional fishing economy came to host an internationally scaled financial sector, which shows how quickly deregulation and cheap funding can turn an economy's risk profile upside down.

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