Iceland’s banking collapse is the biggest, relative to the size of an economy, that any country has ever suffered. There are lessons to be learnt beyond its shores

AP

ATOP a hill near Reykjavik's old harbour is a bronze statue of Ingolfur Arnarson, the first Nordic settler of inhospitable Iceland. It overlooks a bunker-like building: the central bank, headed by David Oddsson, a man who more than 1,100 years later has shown similar survival skills. Before chairing the central bank's board of governors, Mr Oddsson was prime minister for more than 13 years, a record, during which time Iceland became one of the richest countries in the world. For years he was Iceland's most popular politician, privatising most of the banking system with a Thatcherite zeal and floating the currency, the krona.

But the collapse of the krona and nationalisation of the country's three largest banks in early October, which forced the country to secure help from the IMF, have left Iceland's economic miracle and Mr Oddsson's reputation in tatters. For weeks, protesters have gathered in Reykjavik's main square each Saturday calling for his removal from office. On the chilly afternoon of December 1st a few hundred of them, shouting “David out, David out”, gathered at the Arnarson statue and marched down the hill to the central bank. In the lobby, they were met by riot police, who eventually defused the situation.

Such protests are almost unheard of: the only previous mass demonstrations to shake the country, against NATO membership, took place in 1949. But the economic crisis has exposed deep fissures in the nation of 300,000 people. In the same building the next day, Mr Oddsson barely smiles when he tells The Economist, “They say that the only way to get to paradise without dying is to be governor of a central bank. This has not been true in Iceland.”

So far, such protests are the most tangible evidence of the troubles besetting Icelandic society. The landscape bears scars too. From the central bank, the view of snow-dusted Mount Esja across the estuary is blocked by a half-finished grey edifice, sprawled like a dead whale across the harbour-front. This was to have been Iceland's most spectacular building, crowning 15 years of economic growth: a concert hall facing out to the North Atlantic, covered in glass prisms imported from China meant to resemble glaciers and lava. But since the collapse of the bank that led the funding, construction has almost ground to a halt.

Likewise, blocks of half-built luxury flats stand half-finished along the waterfront. Instead of glass prisms, Icelanders are looking forward to a different Chinese cargo in the dying weeks of the year: fireworks. They set off more per person each new year than any other country in the world. Such is the demand that the Chinese manufacturers are making a special loan to Icelanders to buy them, according to a local newspaper.

Almost no other private creditor is lending them anything; Iceland has turned instead to the IMF. In November the fund agreed to a $2.1 billion two-year standby programme, which was supplemented by promises from Nordic countries and Poland, as well as Britain, the Netherlands and Germany. The package will be worth $10.2 billion in total—more than half of Iceland's GDP.

The IMF calls the collapse of the banks the biggest banking failure in history relative to the size of an economy. In 2007 Iceland's three main banks made loans equivalent to about nine times the size of the booming economy, up from about 200% of GDP after privatisation in 2003 (see chart 1). Only about one-fifth of those loans were in kronur; interest rates on these were punitively high. Ordinary citizens instead borrowed from their banks in cheaper currencies such as yen and Swiss francs to buy even the most modest homes and cars.

But after the banks collapsed in early October, the currency slumped and domestic interest rates rose sharply (see chart 2). Exchange controls imposed in the heat of the crisis have severely restricted access to hard currency. Initially, there were fears for the payments system. But after an initial panic, credit and debit cards appear to work normally again; Reykjavik's stores are filled with Christmas shoppers, and restaurants still serve up expensive delicacies such as grilled whale.

But people are mostly living on borrowed time as well as borrowed money. The IMF programme forecasts that the economy will contract by 9.6% next year. Many workers have been laid off but, thanks to Iceland's labour laws, they have three months' notice, so the impact is not yet being fully felt. Many young Icelanders, who have never known unemployment, are expected to lose their jobs as businesses shut down. Vilhjalmur Egilsson, head of the Confederation of Icelandic Employers, the main business organisation, says that “corporate Iceland is technically bankrupt” because of its foreign debts. It is unable to refinance loans because the new capital controls mean all credit to the country has dried up.

With unemployment rising, citizens talk openly about defaulting on their home and car loans (those flashy Range Rovers are now known dryly as “Game Overs”). Principal payments on local-currency mortgages are indexed to inflation, which is expected to be 20% this year. Because of this and their foreign-currency exposure, many households' debts have doubled in krona terms. Sirry Hjaltested, a pre-school teacher who joins in the Saturday protests, says that her grocery bills have gone up by half in a few months. She blames the country's reckless bankers for the ruin of the economy. “If I met a banker,” she says, “I'd kick his ass so hard, my shoes would be stuck inside.”

The scale of what confronts Ms Hjaltested and other Icelanders is only just becoming clear. According to the IMF, the failure of the banks may cost taxpayers more than 80% of GDP. Relative to the economy's size, that would be about 20 times what the Swedish government paid to rescue its banks in the early 1990s. It would be several times the cost of Japan's banking crisis a decade ago.

Abroad, there are also stark lessons from Iceland's woes. There may also be important consequences for cross-border banking regulation all over Europe. Iceland's tale exemplifies why central banks around the world are spraying liquidity at the financial system to keep banks in business. When liquidity vanishes, banks quickly become insolvent. When that happens to foreign-currency loans and deposits, the central bank's abilities as lender of last resort are tested, and Iceland shows how quickly a small country with a thinly traded currency can fail that test.

Iceland was uniquely overextended, but other countries, too, have big banking industries relative to the size of their economies supported by lots of borrowing. Britain is one. Willem Buiter of the London School of Economics, who prepared a report on Iceland earlier this year that gave warning of the risk of disaster, asked in a recent, widely discussed blog whether London could be “Reykjavik-on-Thames”.

A geyser under London

The balance-sheet of Britain's banking system, at 450% of GDP, was half the (relative) size of Iceland's at the end of last year. But that is still high. Like Iceland, Britain does not have a global reserve currency, such as the dollar or the euro, to draw on if it needs to act as lender of last resort. Its net foreign-exchange exposure is nil, but Iceland was in a similar position, and its banks have not been able to liquidate foreign assets to cover their foreign debts.

Mr Buiter acknowledges that Britain has access to currency swap lines from the world's biggest central banks, which would help it prevent a run on the banks. But he argues that the cost of this insurance will make London less competitive as a global financial centre. He thinks this makes a good case for Britain to adopt the euro. Among larger European countries, he says, the British government's exposure to its banking sector is by far the highest. “Switzerland, Denmark and Sweden are in a similar pickle,” he adds.

Iceland found, to its peril, that its access to the leading currencies was not as sure as it had hoped. In fact, as troubles mounted, it succeeded only in securing swap lines worth €1.5 billion ($2.3 billion) from three Nordic central banks in May, hardly enough to prevent a run on its banks. The Federal Reserve, the European Central Bank (ECB) and the Bank of England all rejected Iceland's requests, stating, according to the Central Bank of Iceland, that the Icelandic financial system was too large relative to the size of the economy for plausible swap lines to be effective. They also wanted Iceland to talk to the IMF, which the authorities appear to have done only half-heartedly at first.

Why were the foreigners so tight-fisted? A big problem was the increasingly rickety business model of Iceland's two largest banks, Landsbanki and Kaupthing Bank. Because Iceland is so small, the banks could attract only paltry sums in domestic deposits, which made them overly reliant on international capital markets. But in 2006, in what one of their chief executives describes as a stroke of genius, they hit upon the idea of creating internet accounts to attract foreign deposits, using the cost savings from online banking to offer higher interest rates to savers. Their strategy was so successful that soon they were sucking deposits away from bricks-and-mortar banks across Europe.

Financial officials in several countries say it became clear early this year that these online banks might pose a systemic threat across the region. Landsbanki, for example, had used Iceland's membership of the European Economic Area (which gives countries access to the European single market without having to join the European Union) to develop its online banking presence. Under the EEA's “passport” system, it could set up bank branches abroad that were supervised from Reykjavik, notably its internet operations in Britain and the Netherlands, called Icesave.

But as Icesave grew, European authorities realised that Iceland's coffers were far too small to provide deposit insurance to savers, and that its central bank lacked reserves to act as a credible lender of last resort in the case of a run. The British authorities pressed Landsbanki to create a subsidiary in London that would be supervised by British banking authorities, as its compatriot, Kaupthing, had done. It never did. When Landsbanki collapsed in October, the country ended up owing $8.2 billion to foreign internet depositors of its banks, an amount almost half the size of Iceland's entire economy.

At the time, other big cross-border banks, such as Fortis, a Benelux bank, and Dexia, a Belgo-Dutch bank, were in deep trouble, and there were growing concerns among European officials that a country could be overwhelmed if it was home to a big international bank that failed. Landsbanki made this fear into reality. Partly as a result of the Iceland fiasco, the British government has written to the European Commission seeking urgent consideration of improvements to legislation of cross-border banking in the EEA, including better ways of protecting depositors in branches of foreign banks.

Forever in your debt

In Iceland there are still many misgivings about repaying the huge debts incurred, as there are about other aspects of the IMF programme. A report in Morgunbladid, a national newspaper, claimed that relative to Iceland's size, the debt to Icesave depositors is bigger than the reparations demanded of Germany by the Treaty of Versailles. Mr Egilsson of the employers' confederation has written to the IMF's local boss in Iceland urging him to scrap what he describes as ruinous capital controls.

In his unassuming whitewashed offices near the central bank, Geir Haarde, the prime minister, appears sympathetic to some of these concerns. “There is still a lot of legal argumentation saying we should not pay” the debt to Icesave depositors, he says, though he stresses that his government has agreed to reimburse them.

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Oddsson loses his grip

He suggests that the government also thought long and hard before turning to the IMF. Already the country is chafing under interest rates that were pushed up by six percentage points to 18% during talks with the fund. “The interest-rate policy is probably the most difficult part for Icelanders to accept and understand,” he says. He hopes that rates will start to fall quite quickly early next year, but knows the IMF is concerned about a premature relaxation of monetary policy. “We will need to do it in a very careful way. [But] we have had high interest rates here for a long time and people are tired of them.”

The status of the nationalised banks is another sore point. After being seized by the government (Kaupthing was given an unhelpful shove into bankruptcy when the British government put its London subsidiary into administration), they have defaulted on their huge international liabilities. These have been placed into “old banks”, while local-currency deposits and loans are in “new banks” that are meant to restore a semblance of normality to Iceland's financial system. However, even the new banks have written off about 50% of their loans, implying that they do not expect that portion to be repaid. With interest rates as high as they are, and principal payments indexed to inflation, Jon Jonsson, an Icelandic international banker, says the solvency of even the new banks remains in doubt.

Mr Haarde says one possible solution is to hand the banks over to their biggest foreign creditors. Talks are under way with some, such as Germany's Bayerische Landesbank, he says. (On December 1st the German bank announced huge job cuts and said it would receive about €30 billion of state support, partly because of its losses in Iceland. It is not keen to take over an Icelandic bank.)

The key to stabilising Iceland will be the currency, and here the responsibility falls most heavily on Mr Oddsson. In recent days the krona has shot up in value against the euro, partly because the central bank has eased the controls on inflows of foreign exchange. But capital outflows are still restricted and there are growing fears among business people that the capital controls will drive the last vestiges of foreign investment out of Iceland.

It is also clear, however, that lifting the controls too quickly may lead to huge capital flight. Mr Oddsson makes little attempt to conceal his disquiet over these matters. Capital controls are “not a line taken from the Bible,” he says. “They were the recommendation of the IMF. It was the government's call and after it was done we supported it.” That hardly amounts to a ringing endorsement.

The currency is also where the politics of the crisis are likely to prove most troublesome. It is not just left-wing agitators who blame Mr Oddsson for the crisis. (Ever the politician, he expresses sympathy, saying the protests “describe a huge disappointment of the people”.) He has regularly tussled with members of the country's business elite and the large parts of the media that are owned by Baugur, Iceland's most prominent international firm. In an impassioned speech to Iceland's Chamber of Commerce last month, he urged the police to investigate the activities of bank executives. One Icelandic firm had debts of 1 trillion kronur ($5.3 billion) to the three big domestic banks, more than all the banks' equity combined, he said. “The Central Bank of Iceland should probably place dead last on the list of those in need of investigation,” he declared.

The bankers, in turn, blame him for almost everything, especially the blundered rescue of Glitnir, the smallest of the three banks, in late September, which turned a private-banking crisis into a sovereign-debt one. He has been criticised for his handling of the overvaluation of the krona, which caused all manner of unhealthy speculation. He is also accused of overlooking the inadequacy of the central bank's lender-of-last-resort facility.

An answer across the sea

Whatever the merits of these arguments, the blame game complicates a debate which some consider crucial to Iceland's attempts to escape from its crisis: a move towards adopting a hard currency, specifically the euro. The nationalistic Mr Oddsson, who has spent his working life in Reykjavik, is thought to be against this. (He dismisses the euro zone as a “Shangri-La”.) Iceland's international business people, buoyed by the arguments of academics such as Mr Buiter, believe that the crisis has exposed the dangers of relying on a small, fragile currency.

It would not be an easy decision. Iceland has kept out of the EU, not least to safeguard its cod-fishing quotas. The ECB has made clear that Iceland cannot adopt the euro unless it joins the EU first, which might take years. Some academics suggest unilateral “euroisation”, as Montenegro has done. This could be done with as little as €100m to replace notes in circulation, a fraction of Iceland's €3 billion of international reserves. But such a unilateral step runs the risk of antagonising the EU. And it might not stop capital flight.

The Independence Party, which Mr Oddsson long led, has brought forward its national convention to January to discuss these matters, but it is divided on the issue. With the krona on life support, cool heads will be needed to stop the debate splitting the country. Mr Jonsson, the banker, believes the euro question could be as significant, in its way, as Iceland's decision to adopt Christianity and throw out its pagan gods 1,000 years ago. If the krona finally goes the way of the pagans, there is a good chance that Mr Oddsson will go with it.