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Central Bank of Iceland The financial crisis in Iceland Causes, consequences, policy responses and Central Bank of Iceland The financial crisis in Iceland Causes, consequences, policy responses and recovery Már Gudmundsson Central Bank of Iceland Adam Smith Seminars, Paris November 10, 2009

Prologue Prologue

The financial crisis in Iceland The major banks collapsed following Lehman’s fall … The financial crisis in Iceland The major banks collapsed following Lehman’s fall …

The financial crisis in Iceland … as FX funding dried up and a run The financial crisis in Iceland … as FX funding dried up and a run on the banks’ short-term liabilities escalated swiftly

The financial crisis in Iceland … in a situation where limited capacity existed to The financial crisis in Iceland … in a situation where limited capacity existed to replace private FX funding with public lending The chart above gives a simplified summary of the balance sheets of the non-financial private sector , financial institutions, the public sector, and non-residents, illustrating total assets and liabilities for each sector as of September 2008.

International comparison The largest banking system to go through a crisis … International comparison The largest banking system to go through a crisis …

International comparison …with the most indebted private sector … International comparison …with the most indebted private sector …

International comparison …and widespread foreign-currency borrowing International comparison …and widespread foreign-currency borrowing

Two partly independent stories Iceland’s domestic boom-and-bust cycle … Two partly independent stories Iceland’s domestic boom-and-bust cycle …

Two partly independent stories … and the rise and fall of Iceland’s cross-border banks Two partly independent stories … and the rise and fall of Iceland’s cross-border banks

Large macroeconomic repercussions Reflected in a large drop in the exchange rate Large macroeconomic repercussions Reflected in a large drop in the exchange rate

Large macroeconomic repercussions Asset destruction Large macroeconomic repercussions Asset destruction

Large macroeconomic repercussions Challenging government debt situation Large macroeconomic repercussions Challenging government debt situation

Large macroeconomic repercussions Drop in output Large macroeconomic repercussions Drop in output

Large macroeconomic repercussions Rise in unemployment and high inflation • Large macroeconomic repercussions Rise in unemployment and high inflation •

The build-up The build-up

Build-up of domestic imbalances Started as a positive FDI shock Build-up of domestic imbalances Started as a positive FDI shock

Build-up of domestic imbalances Credit boom following privatisation and restructuring Build-up of domestic imbalances Credit boom following privatisation and restructuring

Build-up of domestic imbalances Fuelling asset price bubbles Build-up of domestic imbalances Fuelling asset price bubbles

Build-up of domestic imbalances Wide interest rate differential encouraged carry trade Build-up of domestic imbalances Wide interest rate differential encouraged carry trade

Build-up of domestic imbalances Iceland’s economy was vulnerable to the global crisis Build-up of domestic imbalances Iceland’s economy was vulnerable to the global crisis

Expansion of the cross-border banks Privatisation, consolidation and expansion … Expansion of the cross-border banks Privatisation, consolidation and expansion …

Expansion of the cross-border banks … extremely rapid expansion Expansion of the cross-border banks … extremely rapid expansion

Relatively big and geographically dispersed • • Total assets around 200 b. $ 11 Relatively big and geographically dispersed • • Total assets around 200 b. $ 11 times Iceland’s GDP before the collapse 41% of total assets in foreign subsidiaries 60% of total lending to non-residents and 60% of income from foreign sources • Over 2/3 of total lending in terms of foreign currency • Around 2/3 of deposits in foreign currency

Expansion of the cross-border banks The EEA framework • Iceland became a member of Expansion of the cross-border banks The EEA framework • Iceland became a member of the EEA in 1994 • Free movement of capital • European “passport” for financial institutions headquartered in any country within the area • Common legal and regulatory framework … • … but the safety net (eg deposit insurance and LOLR) and crisis management and resolution remained largely national • There was a inbuilt vulnerability/risk in this setup, especially for small countries outside the euro area

The crisis The crisis

The crisis Distrust in Icelandic banks and their lack of FX funding led to The crisis Distrust in Icelandic banks and their lack of FX funding led to the break down of the main channel for inflows …

The crisis … causing a large depreciation of the currency and rapidly increasing inflation The crisis … causing a large depreciation of the currency and rapidly increasing inflation

The crisis Private consumption lost momentum as real wages, confidence and credit all contracted The crisis Private consumption lost momentum as real wages, confidence and credit all contracted

The crisis As the global crisis deepened and reached its climax • • 7/9 The crisis As the global crisis deepened and reached its climax • • 7/9 2008: Fannie Mae and Freddie Mack taken into conservatorship 15/9 2008: Lehman Brothers files for Chapter 11 bankruptcy 16/9 2008: A large US money market “breaks the buck”, support given to AIG 18/9 2008: Coordinated central bank measures to address US dollar funding squeeze, the other Nordic CB participated but not the Central Bank of Iceland • 25/9 2008: Glitnir asks for FX emergency loan

The crisis … the Icelandic banks’ collapse • 29/9 2008: Glitnir takeover announced (€ The crisis … the Icelandic banks’ collapse • 29/9 2008: Glitnir takeover announced (€ 600 million), bank failures in Europe and US, and US House of Representative rejects TARP • 30/9 2008: Sovereign and bank downgrading followed by widespread margin calls and closing of credit lines – domestic domino effects. In Ireland a wide-reaching guarantee is given to bank debt • 6/10 2008: Emergency laws in Iceland • 7/10 2008: Glitnir and Landsbanki intervened by FME • 8/10 2008: Freezing of Icelandic assets in the UK and takeover of Kaupthing’s Singer &Friedlander • 8/10 2008: System-wide responses by central banks and governments, increased international coordination • 9/10 2008: Kaupthing intervened by FME

Expansion of the cross-border banks Some key metrics as of June 30, 2008 Kaupthing Expansion of the cross-border banks Some key metrics as of June 30, 2008 Kaupthing Landsbanki Glitnir 11. 2% 10. 3% 11. 2% Tier 1 ratio 9. 3% 8. 2% 8. 0% Leverage ratio 15. 1 20. 0 19. 3 Equity/tangible assets 5. 2% 4. 0% 3. 6% 5 y 5 y 3. 2 y 32. 3% 72. 4% 20. 8% 1. 95 1. 74 1. 52 CAD ratio Bond maturity Deposits/funding Liquidity ratio

Why did the banks then fail? • • • Big foreign currency balance sheets Why did the banks then fail? • • • Big foreign currency balance sheets with a significant maturity mismatch but without a lender-of-last resort (LOLR) Size relative to the home base (country and currency) Fatal flaws in the EU financial architecture

Triggers and contributing factors: l The international financial crisis l Flaws in business models Triggers and contributing factors: l The international financial crisis l Flaws in business models and risk management l Iceland’s big macroeconomic imbalances l Domino vulnerabilities in Iceland’s financial sector (eg cross-ownership, connected lending, large exposures across institutions) l Bad governance and accounting? l Non-cooperative crisis management across interested jurisdictions

The crisis Systemic European event • Event of systemic proportions in parts of Europe The crisis Systemic European event • Event of systemic proportions in parts of Europe • Failure of private and public risk management policies in Iceland • Failure of the EU framework for cross-border banking • Figures as an example in major reports • Will affect the shape of a future framework for the regulation and supervision of cross-border banks • Also a key example of the problems with cross-currency liquidity management during the crisis - lack of CB liquidity provision and ELA facilities in terms of foreign currency

The crisis The banks’ collapse deepened the economic recession that was already in the The crisis The banks’ collapse deepened the economic recession that was already in the charts

The policy responses The policy responses

The policy responses IMF program • • A two year Stand-by Arrangement was initiated The policy responses IMF program • • A two year Stand-by Arrangement was initiated in November 2008 External financing from IMF, the Nordic countries, Poland others Extensive technical assistance First revision delayed but was completed in October 2009

The policy responses Key features of the IMF program 1. Exchange rate stability – The policy responses Key features of the IMF program 1. Exchange rate stability – Monetary policy’s contribution is to protect vulnerable balance sheets while their restructuring takes place – Unconventional measures: capital controls and FX interventions – FX reserves build-up

Monetary stance has been relaxed but still too tight for the domestic economy Monetary stance has been relaxed but still too tight for the domestic economy

The policy responses Key features of the IMF program 2. Bank resurrection and debt The policy responses Key features of the IMF program 2. Bank resurrection and debt restructuring – Approximately 90% of the banking system collapsed, markets seized up and private sector debt and payment problems increased – Bank restructuring has been delayed but important milestones have been reached – The conditions ripe for private sector debt restructuring

The policy responses Key features of the IMF program 3. Public debt sustainability – The policy responses Key features of the IMF program 3. Public debt sustainability – Debt sustainability analysis – Plan for government finances and decisive action on that front – Multilateral and bilateral loans

Exchange rate developments The ISK remains weak but has stabilised… Exchange rate developments The ISK remains weak but has stabilised…

Exchange rate developments … despite declining interventions by the Central Bank Exchange rate developments … despite declining interventions by the Central Bank

The prospects for recovery The prospects for recovery

The prospects for recovery The contraction seems to be bottoming out The prospects for recovery The contraction seems to be bottoming out

The prospects for recovery The economy’s flexibility has provided support The prospects for recovery The economy’s flexibility has provided support

The prospects for recovery The economy’s flexibility has provided support The prospects for recovery The economy’s flexibility has provided support

An underlying current account deficit is turning into a surplus An underlying current account deficit is turning into a surplus

The economy will begin to recover in the beginning of next year The economy will begin to recover in the beginning of next year

Longer term prospects • Iceland´s longer term prospects are underpinned by the strong resource Longer term prospects • Iceland´s longer term prospects are underpinned by the strong resource base and human capital • The degree and mode of integration with the rest of the world is also under consideration • There are probably more than one or two alternatives • Iceland has now applied for EU membership