Iceland’s Financial Crisis

1. Iceland’s Financial Crisis TMA Europe Conference 2010 J. Eric IvesterSkadden, Arps, Slate, Meagher & Flom LLPDaniel C. McElhinneyEpiq Systems TMA Europe Conference 2010June 11, 2010Berlin, Germany

2. Events Leading up to Iceland’s Financial Crisis The events leading up to Iceland’s crisis can be divided into three broad periods. Deregulation Crisis/Default 1990 2000 2010 Increasing Inflation and Debt Load

3. 1991-2004: Radical Deregulation Commencing with new government in 1991, Iceland embarked on significant economic reform program. Key changes in fiscal policy included a significant reduction in government spending, reductions in corporate and personal income taxes and privitasation of industry Banks, which had been closely controlled by the state, were privatized by the end of the 1990s. Further liberalization and reform occurred in conjunction with Iceland’s efforts to join the European Economic Area.

4. A Lack of Oversight In part because of the rapid deregulation and explosive growth of the banks, parties that would ordinarily provide informative criticism or impose restraints on the banks failed to do so: Board Members >> Many were new members lacking equivalent banking experience prior to privatization. Shareholders >> It appears that each of the banks was controlled by a groups of related shareholders affiliated with key management figures. Media >> The domestic media responded negatively to any foreign criticism of the banking system. Government >> All parties in the government of Iceland have been criticised for failing to properly monitor and act to restrain the expansion of the banking industry.

5. Growth (and Fall) of the OMX Iceland 15 Index With deregulation and an increase in foreign investment, Icelandic stocks rose. Source: Public domain image

6. Increasing Debt Load and Inflation Banks racked up liabilities equal to ten times the country’s GDP. In 2005 alone, the banks issued €14 billion in new debt securities. Household debt rose to 200% of the average disposable family income, which lead to increasing inflation. To combat inflation, the central bank raised interest rates to 15%, when most European countries’ rates hovered at 5%. The high rate led to a large demand for Icelandic króna, driving the price of the currency up. By 2007, The Economist ranked the króna the most overvalued currency in the world. The banks relied heavily on wholesale funding, which is very susceptible to market fluctuations. When they could no longer rely on wholesale funding, they turned to retail deposits. “Someone called it bumblebee economics: scientifically, aerodynamically, you cannot figure out how it flies, but it does, and very nicely, too.” -Dagur Eggertsson, former mayor of Reykjavik, quoted in The Guardian, May 2008.

7. Other Countries Step In Investors from other countries, attracted by the high interest rate, began placing deposits in local branches of Icelandic banks. In the United Kingdom, a branch of Landsbanki called Icesave took in over £4 billion in deposits. Because Icesave was operated as a branch of Landsbanki, it could not rely on the Central Bank of England for assistance in the event of a liquidity crisis, nor could it rely on the modest reserves of the Central Bank of Iceland.

8. Insider Control/Foreign Investment Entities funded by the Icelandic banks invested heavily in foreign business. In England, these “Viking Raiders” bought stakes in numerous high-end retailers and West Ham United Football Club. Investigations by the Special Investigation Commission and the complaint recently filed by the Winding-Up Board of Glitnir hf. indicate many of these “Raiders” owned shares in the Icelandic banks from which they were borrowing. Evidence suggests that in the second half of 2007 lending to these “Raiders” increased significantly at a time when other banks were restricting lending standards in response to the initial stages of the global credit crisis. The Special Investigation Commission concluded that controlling shareholders and related entities enjoyed easy access to funding from the banks they controlled, often circumventing internal procedures designed to mitigate risk associated with concentration of lending to a single entity or related group. The Glitnir complaint alleges $2.0 billion in funds were loaned to insiders improperly.

9. Creditors Come Calling As the credit markets dried up, Icelandic banks were less able to finance their loans through the interbank markets. Usually, a bank unable to cover its deposits or other obligations would turn to the central bank or the government for a loan. However, because the debt was so much larger than the entire Icelandic economy, neither the Icelandic government nor the central bank could guarantee the debt. In addition, much of the debt was held in foreign currency – and the Central Bank of Iceland had not increased foreign currency reserves sufficient to offer a bailout. “The huge measures introduced by the US authorities to rescue their banking system represent just under 5 per cent of the US GDP. The total economic debt of the Icelandic banks, however, is many times the GDP of Iceland.” -Former Prime Minister Geir Haarde

10. The Bank Failures and Government Response In September of 2008, the Icelandic government announced a plan to purchase a 75% stake in the Icelandic bank Glitnir, which had a $750 million loan coming due in mid-October. This plan never came to fruition, as the bank was taken into receivership by the Icelandic Financial Supervisory Authority (FME) before stockholders could approve it. Shortly after, the FME placed Landsbanki into receivership as well. Source: Public domain image

11. The British Reaction and Asset Freeze The UK, whose citizens had placed large deposits in Landsbanki via its Icesave branch, used an anti-terrorism law to freeze the assets of Landsbanki in the UK. The asset freeze and use of anti-terrorism laws caused an uproar in Iceland, with thousands of Icelanders signing a petition later delivered to Parliament. The UK also moved all deposits in a UK subsidiary of Kaupthing Bank – the last of Iceland’s three major banks – into ING Bank, causing the Icelandic bank to be put into receivership by the FME in Iceland. A referendum that would have established an Icelandic government guarantee on the foreign liabilities was defeated in March 2010. 98% of the votes were “no” votes.

12. International Response The International Monetary Fund provided Iceland with a $2.1 billion loan. Other Nordic countries offered currency swaps for Icelandic Krona, representing a total of approximately €1.5 billion. Iceland draws the IMF loan over time. The latest installment was approved in April 2010.

13. Consequences of the Crisis: Financial The value of the Krona became, and remains, volatile against the dollar and the Euro. Value Against the Euro Value Against the US Dollar Source: Google Finance

14. Consequences of the Crisis: Financial (Cont.) The Icelandic government has split each of the three large banks into “old” and “new” entities, and transferred the old deposits into the new banks. These “new” banks, owned by the government, hold the deposits of Iceland’s citizens, which the government guaranteed. Iceland’s government also infused the “new” banks with capital. During the height of the crisis, Iceland’s sovereign debt rating was downgraded to BBB-

15. Consequences of the Crisis: Iceland’s Citizens GDP growth is expected to be near zero in 2010. Iceland’s pension system, which was previously very well-capitalized, has been predicted by some experts to decrease in value by 15-25%. Unemployment is expected to reach 10%. Data Source: Statistics Iceland

16. Consequences of the Crisis: Political High-level ministers, including the Prime Minister, resigned from the Icelandic parliament, and a new government committed to addressing the crisis was elected in 2009. The new government narrowly voted to apply for European Union membership in July 2009. Iceland’s government has set a date of 2012 for a possible referendum on joining the EU, though support has dwindled since the crisis.

17. Lessons Learned A banking system with no actual ability to resort to a central bank for emergency loans risks a liquidity crisis. Such a crisis is exacerbated when vast amounts of debt are held by local banks in foreign currency. Unexpected external factors can have serious domestic consequences, e.g.: Worldwide credit crisis deprives banks of short-term liquidity. UK asset freeze Resort to a strong central bank is important in staving off a liquidity crisis. A central bank should hold foreign reserves at least sufficient to cover short-term liabilities. Investors should be wary of interest rates that seem too good to be true. Risk Management Officers should be in place at institutions to oversee questionable investments. Critical oversight – by board members, public shareholders, media, and government – is crucial to avoid asset bubbles and liquidity crises.

18. Sources Consulted BBC News. “Crisis Claims Iceland Cabinet.” 26 January 2009. BBC News. “Iceland Moves Toward Joining EU.” 16 July 2009. Central Bank of Iceland. “Republic of Ireland’s Sovereign Credit Rating.” Accessed 2 June 2010. Available at http://www.sedlabanki.is/?PageID=789. CIA World Factbook Entry: Iceland. Accessed 2 June 2010. Available at https://www.cia.gov/library/publications/the-world-factbook/geos/ic.html. Danielsson, Jon. “The first casualty of the crisis: Iceland.” VoxEU. 12 Nov 2008. Eggertsson, Thrainn and Herbertsson, Tryggvi Thor. “System Failure in Iceland and the 2008 Global Financial Crisis.” Paper Presented at the 13th Annual Conference of ISNIE, June 18-20, 2009. IMF Press Release No.10/156. “IMF Completes Second Review Under Stand-By Arrangement for Iceland.” April 16, 2010. Jackson, Robert. “The Big Chill.” Financial Times. 15 November 2008. "Kreppanomics." The Economist. 9 October 2008. Landler, Mark. “3 Nordic Banks Help Prop Up Currency.” New York Times. 17 May 2008. Statistics Iceland. Referendum Results. Accessed 2 June 2010. Available at http://www.statice.is/Pages/2465. Wade, Robert. “Iceland as Icarus.” 52 Challenge 5, May-June 2009. Ward, Andrew. “Seeds of Iceland crisis sown years before crash.” Financial Times. 12 April 2010.