After 5 years of the highest growth in the OECD area Iceland is facing the consequences of trying to build an international banking empire on the back of an economy of roughly 300.000 people with the smallest free floating currency in the world and an industry based primarily on fishing and aluminium smelting. The financial crisis in Iceland and the collapse of the economy was triggered by external factors – the international credit crunch – that had its origins in the subprime crises in the United States. Due to its high level of exposure to cyclicality in the international financial system, Iceland has been hit hardest of all OECD countries. The reasons for Iceland’s crises are however both economic and political. The origins can be traced in the final analysis to politics, or rather to the failure of the political system and Iceland’s political culture.
The Icelandic economy is the smallest within the OECD, generating GDP of €14.5 billion in 2007. This is little more than 1/1000 of the US economy, 1/20 of the Danish economy, and 1/3 of the economy of Luxembourg. GNI per capita measured in terms of Purchasing Power Parities (PPP) amounted to 34 thousand US dollars in 2007, the twenty-second highest in the world and the fifteenth highest among the OECD countries. In comparison with the Nordic countries, Iceland’s GNI per capita is lower, but somewhat above the EU average. Historically, this prosperity has largely been built on Iceland’s comparative advantages in abundant marine and energy resources. More recently the main driver of economic growth has been services, in particular the financial services sector.
The domestically driven, foreign-funded boom lifted real output by over 25 percent during 2003–2007. Iceland allowed a highly oversized banking system to develop—a banking system that outstripped the ability of the government to act as a lender of last resort when troubles began in international financial markets. Three large banking groups dominated the domestic financial system (Glitnir, Kaupthing and Landsbanki). After the privatization of the banking sector was completed in 2003, the banks increased their assets from slightly more than 100 percent of GDP to being worth close to 1,000 percent of GDP.
By the end of 2007 over 50 percent of the banks’ assets were held abroad in branches and subsidiaries, principally in the Nordic countries and the U.K. This expansion was funded in global wholesale markets, allowing banks to overcome resource constraints at home but doubling their foreign debt. This dependence on wholesale market funding became a source of concern when the global turbulence in mid-2007 started and credit default swap spreads began to increase sharply.
The worsening of the global liquidity crises created unforeseen and ignored challenges that the banks were unable to overcome on their own. In particular:
- Liquidity ratios were comparatively high, but obviously not high enough to refinance short-term debt. Access to Central Bank loan facilities was therefore crucial for survival when international credit markets seized up. Those facilities were non-existent. Reduction or lack of such access required changes in the banks liquidity management strategy. Attempts at change were too little too late.
- Capital levels were above minimum levels, but below the average of the previous five years and did not provide adequate buffers as the crises deepened and market uncertainties about the strength of the banks increased.
- Foreign debt maturities of the financial sector were relatively short – concentrated in the period 2008–2010. They created funding risks as outstanding facilities would mature in a context of limited market funding and perceived counterparty risk.
- Asset quality concerns increased in the light of a slowdown in economic growth in Iceland and host countries, higher inflation, exchange rate pressure and a restricted supply of credit. Non-performing loans were rising and the banks were exposed to market risk through their securities holdings and collateralized lending.
When credit on the international market dried up the combination of these factors created the collapse of the Icelandic economy. In less than a week the three banks collapsed, the krona’s (Icelandic currency) value dropped by more than 70 percent and the stock market lost more than 80 percent of its value.
The astronomical growth of the banks took place in the absence of a solid legal, regulatory and supervisory framework. The Central Bank, the Government and the Financial Supervisory Authority failed to act and plan for worst case scenarios. The Central Bank did not build up foreign currency reserves to counterbalance short-term foreign liabilities of the banks, an incredible policy choice in a liquidity crisis. It was done in the name of independent monetary policy that aimed to keep the Icelandic krona stable (and highly overvalued) and fight skyrocketing inflation. It led to the highest interest rates in the OECD area, around 17%. It can be argued that had the Central Bank asked for IMF assistance last summer the worst could have been averted. It also remains to be explained why the Icesave accounts of Landsbanki in the UK were not transformed into a UK subsidiary as the UK government had requested. The dispute over deposit guarantees regarding these accounts held up an agreement with the IMF for weeks. The reasons for these policy failures have to be sought in politics.
Political / Cultural factors
The structural reforms previously mentioned aimed to increase the role of market forces through privatization, deregulation and integration into the world economy. This process was accelerated by the need to align the Icelandic legislative and regulatory framework to that prevailing in the European Union when Iceland became one of the founding members of the EEA in 1994. It integrated Iceland into EU’s internal market, making the free flow of people, capital, and goods and services a reality.
These reforms brought Iceland many benefits. The problem was, and still is, that Iceland’s political culture and the legacy of heavy state intervention in the economy had created a dangerous nexus of politics and business, exemplified by the adoption of the individually transferable quota system in fisheries. Its adoption was completed in 1990, before the economic liberalization policies were introduced. In essence the political elite decided to give selected fishing vessel owners fishing rights within the Icelandic Exclusive Economic Zone, a de facto ownership of a public good, free of charge. The stated aim was to increase efficiency and make the fishing companies stakeholders in the management and sustainable development of fishing stocks (that aim was reached, but could have been reached as well with a more equitable system). It also made a select group of people, the fishing vessel owners and their political sponsors fabulously rich. All political parties took part in this greatest wealth transfer in the history of Iceland and every political party got a cut. It was not an unforeseen consequence. It was clear from the beginning that this would be the result and the political elite got away with it.
The privatization of banks and state-owned companies was supposed to put an end to the cozy relationship between politics and business and make the division transparent and permanent. The government failed in that task, very much like the Russian government in the 90’s. The most valuable assets, primarily the banks, were handed over under market value to a small number of politically connected insiders who did not have much experience of running banks. The original aim of selling state assets to a diverse group of small investors and encouraging foreign access to the process was abandoned. That was a political decision with fatal economic consequences down the road.
It is not surprising that the political elite repeated the politicized fishing quota allocations when the most valuable state assets, the banks, were privatized starting this century. There are many similarities between the privatization of natural resources and state assets in Russia and Iceland. The privatized banks in Iceland were quick to buy media assets and use their ownership to create a favorable media environment and fight battles against critics and competitors. Both countries suffered from the same lack of an efficient regulatory and supervisory framework and democratic deficiencies. The Icelandic civil service has for a long time suffered from nepotism and political allocation of jobs. It has led to high level of incompetence. Talent and merit have not been the guiding principles in the civil service, except on paper. To demonstrate the danger of the high level incompetence is the misunderstanding that seems to have taken place between the Finance Ministers of Iceland and the Finance Minister of the UK. It led the UK to apply Anti-Terrorist legislation to Landsbanki and delivered the final blow to the Icelandic banks. Another example is the announcement by the Central Bank governor of a USD 5 billion loan from Russia, which turned out to be a misunderstanding. The credibility of the Icelandic civil service and political system plunged to new lows.
Iceland’s incomplete democracy has failed to create an effective division of power. Executive power has dominated legislative and judiciary power. Checks and balances have been weak. It is interesting to note that no verdict in the judicial system went against the state until the mid-90’s and is still a rare occurrence. In a mature democracy a former prime minister, lawyer by education, could not have had himself appointed as the head of the Central Bank without Parliament raising objections and without media criticism; that a veterinarian would become the Minister of Finance; that political leaders and their associates could enrich themselves through their own policies.
It is a telling fact of Iceland’s political culture and democratic deficit that neither the government, individual ministers or the Central Bank governor have resigned despite public pressure. They have also refused to assume responsibility for the greatest economic catastrophe in the history of the republic. 10 weeks after the collapse no official enquiry has been launched into the crash. The idea of an independent investigation led by foreigner specialist has been brushed aside. The government intends to investigate itself.
Causal relationships are difficult to establish in the social sciences, but an attempt can be made. The failure of introducing effective regulatory and supervisory frameworks led to an unsustainable expansion of the Icelandic banking system. The banking system’s failure to self-regulate can be traced to the lack of experience (and human nature; greed) of those put in charge of the banks (Iceland has not centuries old traditions of banking like Switzerland and Luxembourg). That structural weakness was increased by the failure of the privatization process when political connections became the unofficial guiding principles. That political interference was made possible by weak institutions, a relatively weak civil society and the precedence of the fisheries quota system that emboldened the political elite. The institutional weakness can be traced to an immature democracy with a history of heavy state intervention in the economy. That legacy made political appointments and nepotism possible and contributed to the incompetence of the civil service, making attempts at regulation and supervision still more futile. Nepotism is in many ways inevitable in a small society and has demographic roots, but a political culture that has failed to incorporate accountability as an ethic is not capable of regeneration when a systemic collapse takes place. That is in the final analysis a moral problem.