TMA Europe
Conference 2010
Iceland’s Financial Crisis
J. Eric Ivester
Skadden, Arps, Slate, Meagher & Flom LLP
Daniel C. McElhinney
Epiq Systems
TMA Europe Conference
2010
June 11, 2010
Berlin, Germany
TMA Europe
Conference 2010
Events Leading up to Iceland’s Financial Crisis
The events leading up to Iceland’s crisis can be
divided into three broad periods.
Deregulation
1990
Crisis/Default
2000
2010
Increasing Inflation and Debt
Load
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1991-2004: Radical Deregulation
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• 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.
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A Lack of Oversight
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• 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.
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Growth (and Fall) of the OMX Iceland 15 Index
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With deregulation and an increase in foreign investment, Icelandic stocks rose.
Source: Public domain image
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Increasing Debt Load and Inflation
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“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.
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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.
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Other Countries Step In
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• 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.
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Insider Control/Foreign Investment
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Conference 2010
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.
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Creditors Come Calling
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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.
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“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
June 11, 2010
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The Bank Failures and Government Response
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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
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The British Reaction and Asset Freeze
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• 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.
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International Response
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• 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.
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Consequences of the Crisis: Financial
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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
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Consequences of the Crisis: Financial (Cont.)
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• 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-
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Consequences of the Crisis: Iceland’s Citizens
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• GDP growth is expected to be near zero in 2010.
• Iceland’s pension system, which was previously very wellcapitalized, has been predicted by some experts to decrease in
value by 15-25%.
• Unemployment is expected to reach 10%.
15
10
5
0
-5
-10
Unemployment
GDP Growth
2005
2006
2007
2008
2009
2010
Year
Data Source: Statistics Iceland
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Consequences of the Crisis: Political
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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.
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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 shortterm liquidity.
– UK asset freeze
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Conference 2010
• 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.
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Sources Consulted
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Conference 2010
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.
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