Gordon Kerr’s second address this year at the European Parliament was at a meeting of the European Enterprise Institute. The meeting was chaired by Diego Feio MEP and the meeting organised by Christopher Pichonnier. The platform was shared with Tryggvi Thor Herbertsson (MP, Iceland) and Rok Spruk, a Lithuania based economist. This speech was originally published on 4 March 2010.

1. Introduction

Mr Feio, Mr Pichonnier, ladies and gentlemen, thankyou for inviting me to address you today. We are here to explain and hopefully start to resolve the Icelandic banking collapse.

By way of brief personal introduction I am a banker. In my 29 year career I have experienced several banking crises. In the early 80’s I worked on Paris Club restructurings for Latin American sovereign defaulters.

Later in the 80’s I travelled frequently to the US in connection with the Savings and Loan crisis. In the early 90’s I worked mainly in Stockholm on mortgage backed transactions during the Swedish banking collapse.

A few years later I designed instruments that would in turn play a small but significant role in precipitating the collapse of the Western banking system. These instruments were called synthetic capital structures. They created the appearance of an increase in capital on bank balance sheets when in reality the economic risk and return positions of the banks concerned were essentially the same after the transactions as before.

I am a member of the Advisory Board of a London based banking educational charity – The Cobden Centre, and I work for a small investment banking firm in London.

My message to you today is simple. There is nothing specific about the way the Icelandic authorities managed its economy or its banking system that caused this massive failure. The root of the problem lies within the very essence of the banking system itself. Iceland, as a very small country with an aggressive banking industry, was just at the tipping point when the system itself failed, and has therefore suffered to a disproportionately greater extent than others.

2. Were the Western Governments correct to bail out the banks?

Imagine the feeling of going to see a doctor with a puzzling medical condition, having both legs amputated, and three months later experiencing a recurrence of the symptoms. You are admitted to hospital again, but this time the doctor who greets you post examination is far more sombre.

He explains that you have had a pancreatic tumour all along. Had it been correctly diagnosed on first consultation the tumour would have been annulled, but now it is out of control and certain to kill you.

This, I believe, is a fair parallel with the way in which banks in the UK and many other European countries have been rescued. I believe the bailouts are having the opposite effect to that which was intended. They are not helping to re-stimulate lending to small and medium sized businesses – the engines of these economies.

A smarter observer than I has compared the UK solution to the actions of an alcoholic, accepting with equanimity inevitable long term pain as the consequence of his inability to resist the temptation of one more short term, fuzzy high.

There is a danger that solutions presently proposed could accidentally cut the legs off Iceland and condemn its economy to years of stasis, instead of helping to cure its crippled banking condition.

Let us look now at the banking system itself. The legal rules which allow banks to gamble depositors’ demand funds on long term investments have simply created a liquidity pyramid scheme which, enhanced by various other banking developments, have boosted a variety of assets to unsustainable price levels that cannot be supported by the wealth of the relevant underlying economy. Iceland, being both part of this system and a tiny country with its own currency, simply sits at the pinnacle of this Western banking system crisis.

3. Iceland and the Global Collapse.

I urge you to resist the temptation of embracing the political exculpation of ‘global credit crunch’. Although the crisis was truly global this simple linguistic term seeks if anything to discourage serious analysis of what went wrong.

Many papers and speeches I have read are good quality diarised timelines of events in Iceland, without presenting credible cures or accurate analyses of the cause.

Iceland’s collapse was clearly related to the global failure, but each country does not necessarily need a global solution. Indeed, whenever I hear of a problem that can only be solved by global accord I cannot avoid the conclusion that such a problem is being expressed as intractable. The climate change issue is but one other example of a problem looking for a global solution.

Before addressing Iceland’s unique challenges, may I present some of the “banking developments” to which I referred earlier. I am about to set out just some of the features of permitted banking activity which have combined to create an unsustainable pyramid of asset prices which Western liquidity may struggle to support.

Most of the features I am about to describe do not appear on the radar screen of the press or blissfully ignorant politicians. For brevity I will set out only five such features:

a) The circular effect whereby asset prices are inflated merely by the creation of loans provided by banks to finance the purchase of such assets. I have many times witnessed competitive bidding wars between two purchasers wherein the independent valuer has simply up valued the assets each time one side or the other’s bank has issued a larger loan offer. It is essentially the case that the size of the loan determines the asset price, not the other way around. Therefore it is impossible to divorce the independent valuation of assets from the quantity of debt which banks are willing to issue against the assets.

b) Under EU fractional reserve regulations banks are required to maintain a minimum of say 8% “fraction” of their exposures as capital. Since the bulk of European banks are shareholder owned, market forces virtually compel them to push fractional reserve regulation to the limit. It is very difficult for the CEO of a major bank to keep his job if he is not fully leveraged in supposedly stable market conditions.

c) The absurd accounting regime that encourages banks to transfer as much exposure as possible into derivative format. The derivatives accounting regime presents two important benefits to banks: 1) the front ending of multi year’s hoped for income as Day 1 “profit”, and 2) the ability of a bank to leverage its capital not 12 times (the reciprocal of the 8% basic capital ratio) but up to 200 times (the reciprocal of 1/16 of the basic capital ratio). The 200 times leverage rule has historically been the starting point for calculating the capital to be reserved against derivative exposures, and now, under Basel 2 rules, this higher level of leverage is permitted against any AAA rated assets even in non-derivative format provided the bank concerned is regarded as sufficiently sophisticated).

I have a second confession to make. I was involved in designing the early forms of credit derivatives. I have written articles about this activity on the Cobden Centre website and I am grateful to its founder, Toby Baxendale, for inviting me to write about this. Let me clarify for the record one frequently confused point. The motivation behind the emergence of credit derivatives was not the enabling of banks to distribute loans to non-banks. That activity was operating perfectly well before the advent of credit derivatives via other financial instruments.

The overriding motive behind the emergence of credit derivatives was in the accounting rules. Credit derivatives allow banks to book multi-year profits, subject to supposedly conservative reserves, before they have been realised or earned in a sense that would satisfy an accountant in any industry other than banking.

d) I referred earlier to the liquidity pyramid that results from the legal relationship between banks and depositors. Depositors’ money belongs in law to the bank, not depositors. The EU seems aware of this concern and some proposed new regulations talk about inhibiting banks’ future ability to mismatch the maturities of assets and liabilities. This mismatching has, I believe, been a major contributor to the crisis in a very simple way:

Person ‘A’ deposits £100 of cash into his instant-access bank account and receives a promise to return the cash on demand.

The bank retains a small reserve (say £3), and lends out £97 to Person ‘B’.

Person B purchases £97 worth of goods from person C who in turn redeposits the money in the bank.

Both ‘A’ and ‘C’ both have a claim to instant access on this money.

In three steps, the bank has turned £100 into £197 of useable money.

e) The use of the ECB discount window to finance banks purchase of assets post crisis. There has, in the last 10 months, been a gradual rise in the prices of large volumes of the very type of banking assets that many UK commentators have termed “alphabet soup”. Less kind commentators have termed some of these assets a “Liverpudlian Stew” – a rather unpleasant menu item, even by British culinary standards. It is in essence an attempt to present undigestible left over food as attractively as possible. (On behalf of Liverpool may I thank the EU for ordaining it as European City of Culture in 2008).

These price rises seem inconsistent with present reduced liquidity within the banking system. The only explanation I can reach is that some financial institutions have been able to fund their purchases of such assets via the central bank discounting windows such as the ECB itself. Banks are then, as rational players in a regulated industry, motivated to make money by the monetisation of unrealised future profits by entering into synthetic arrangements on these same assets. If true this effect will dash all our hopes that we may be coming out of the crisis.

4. ICELAND

Let us look at Iceland more specifically. The root of the problem lay not in the failure of Iceland’s specific regulators or its national regulation system per se, but in the simple combination of three factors:

i. Its small size and status as a country; ii. Its banks seeking aggressive growth; iii. Its acceptance of the Western bank regulatory regime.

The scale of the problem measured against Iceland’s GDP was simply incredible. The country effectively staked its economic future on international banking, raising capital internationally and lending it out in highly leveraged packages relying on rating agencies and more experienced capital markets arrangers.

The deposit base which lay at the root of the banks’ efforts to prop up the pyramid should have collapsed before the problems became quite so bad, but thanks to Iceland’s status as a sovereign state and international conventions whereby one country’s banks can be “passported” to raise deposits in another, Iceland’s banks succeeded in raising considerable sums of demand deposits from other countries’ savers, in particular the UK and the Netherlands. Those savers looked only to their own national regulators who, under passporting rules, in capital markets parlance simply “wrapped” the Icelandic Central Bank.’’

Ironically the taxpayers of countries such as the UK and Netherlands in effect wrote credit default protection on Iceland, and now, having been called on this protection, seek to exercise rights of subrogation against the Icelandic taxpaying citizenry. But if the Icelandic people did not understand what was going on, are these actions not akin to luring the demented old lady next door into leaving you her house in her will and thereby disinheriting her children?

Icelanders who had saved in its major banks, supervised by its national regulators, were effectively performing the function of a junior mezzanine investor (ie just above the shareholders) in the capital structure of a typical “alphabet soup” investment whose fragility was almost impossible for the ordinary taxpayer to understand.

And so, the pyramid inflated further until September 29 2008. On that date Glitnir, on seeing its credit lines withdrawn following the collapse of Lehman, knew it was unable to raise funds to satisfy a €750 million payment due on October 15th and approached the Central Bank of Iceland for an emergency loan. The loan request was turned down and instead Glitnir was forced to accept €600m from the central bank in return for a 75% stake. Its shareholders were practically wiped out[i].

Iceland therefore suffered like no other country, and at a rapacious rate. At less than 6% of GDP, government debt was tiny at the beginning of 2008. Under an FRB system that mirrored that of all major European countries its banking system was quickly destroyed and its people burdened with unimaginable levels of debt.

5. What Should Iceland Do?

We have just heard from Dr. Tryggvi Thor Herbertsson MP that there is great doubt as to whether it will join the Euro. Even if the Eurozone states can fund the PIGS and other bailouts presently planned, should Iceland ask for an EU bailout?

The short term appeal is obvious, is the longer term outlook as rosy? What of the concerns of abandonment of control over fiscal and monetary policy? Are these measures consistent with the Icelandic character and way of doing things?

Let us consider Greece very briefly. The calm 2 weeks ago when the Greek bailout was announced has been replaced by concern. The austerity measures the EU would impose will be as unpopular in Iceland as they are in Greece.

There is clearly a gulf between the positions of the bailor and the bailee. As I prepare this speech I read in February 25th Daily Telegraph the following report by Ambrose Evans Pritchard:

“Hans-Werner Sinn, head of Germany’s IFO economic institute, said Athens was holding Euroland to ransom, threatening to set off mayhem if there is no bail-out. “Greece should never have entered the euro zone because they did not qualify and they are now blackmailing other European countries via the euro. It’s not for the EU to help Greece. We have an institution that is very experienced in bailing-out activities: the IMF,” he said.

Otmar Issing, former doyen of the European Central Bank, echoed this view in Germany’s Bundestag last Wednesday, warning that a Greek rescue would “open the floodgates” for serial bail-outs and destroy EMU discipline. “The crisis is made in Greece. It is the result of bad policy, not outside forces like an earthquake.” “

Does this rhetoric imply that life under the EU will be much better for Icelanders? That is clearly a decision for Iceland’s Government and people.

If Iceland joins the EU then I would urge the EU to reform its own regulatory regime fundamentally to protect Iceland from further catastrophe. Relying on rating agencies as the basis of regulation, rather than markets, makes little sense.

It is not impossible to devise a fractional reserve regulatory system that will work if its practitioners are expert bankers and fully appraised of everything that its banks are engaged in post reform. But this is fraught with risks.

A far easier solution for Iceland is to make one simple law change. Grant depositors title to their deposits, stipulate that the state and taxpayers will never again bail out the banks, and allow free market forces to create a safe and transparent banking system. A ban on the maturity mismatching of assets, combined with a clear policy of NOT bailing out the banks in future, will enable free markets to flourish.

Do not blame the bankers, they were merely acting like rational capitalist players in a wrongly regulated system. If we are to allocate blame then look to yourselves right here in the Brussels Parliament. It is you rulemakers who have made the mistakes. You should have worked this out.

6. Conclusion

The way forward for Iceland should be to look to itself. Tryggvi, your people have a powerful sense of identity. You have a wonderful natural economy, a well educated population and a well documented strength of character. You can fix your problems yourselves, but maybe with a little help from my firm! The detail of implementation needs to be set in the context of modern banking. A restructured banking system as proposed today would ensure:

1) Depositors could NEVER AGAIN lose their money;

2) Credit would resume flowing from savers to entrepreneurs;

3) The reopening of the international capital markets to Iceland

Without these measures I fear it will be back to the operating theatre in a year or two, with little prospect of a speedy recovery.

Mr Feio, Mr Pichonnier, ladies and gentlemen, thank you for your time.

END

Gordon Kerr – March 2nd 2010

EU Parliament, Brussels

Further Reading