Iceland's banking saga

Ásgeir Jónsson is Assistant Professor of Economics at the University of Iceland and the author of "Why Iceland?: How One of the World's Smallest Countries Became the Meltdown's Biggest Casualty." He previously worked as Chief Economist at Iceland's Kaupthing bank.

This day is also remembered as the day the UK authorities invoked an article of a terrorist legislation to freeze Icelandic banking assets as well as forcing two Icelandic-owned British banks into bankruptcy, which in turn brought Kaupthing, the last of the Icelandic banks, to its knees. With this invokement the Central Bank of Iceland became listed as a terrorist entity, along with al Qaeda and Hezbollah and others, which instantly shut Iceland off from the international payment system.

The events on this dark Thursday were, however, only the final blow. The trigger was the Lehman default on September 15. The watershed moment came nine days later when the US Fed granted all Nordic countries an overdraft facility, except Iceland. This was interpreted as a clear sign that no outside assistance was forthcoming and was the death knell for the Icelandic banks that had assets 10 times the national output and no lender of last resort in the hard currencies with which it was financed. The currency market instantly collapsed and the fumbled attempts by Icelandic authorities to nationalize one of the banks a few days later only made matters worse. By the time the UK authorities made their move against Iceland, the country had completely lost the confidence of the outside world and its banks were doomed.

Iceland collapsed because its banks had become too-big-to-save but more importantly the country itself was too-small-to-save with no systematic impact on any other country, save perhaps for Britain. It is now clear that many other European countries were close to the brink that fateful autumn. The drastic actions in Britain were driven by the fear that the run on Icelandic online accounts would spread into the wider financial system. The British banking system is about 4.5 times the national output and just a stone's throw away from being too-big-to-save, just like the Icelandic system.

Good fortune?

Now, five years later, this disaster is increasingly seen as a slice of good fortune, since the Icelandic taxpayer was spared the impact of nationalizing private banking debts that a conventional bailout would have entailed. Facing the collapse, Iceland took force majeure right to divide each bank into two parts: a foreign bank that went into receivership and a domestic bank whose deposit base was guaranteed by Reykjavik. In the process, the banking system shrunk by 80 percent. The Icelandic banks are now solely financed with domestic deposits and, after restructuring, have 25 percent equity ratios. The Icelandic sovereign is also fully solvent with about 80 percent debt to GDP ratio.

In hindsight, the failure of Iceland was more than anything the failure of the European universal bank model, which is withering away slowly but painfully on the continent. Western Europe stands out in the world with oversized, bond-financed banking systems. The sheer size of European banks and dependence on whole-sale financing will cause the crisis to be much more deeply-rooted than is commonly thought.

Furthermore, if it had not been for the tremendous printing power of the common currency, which has provided liquidity support for oversized banks of the Eurozone, a significant number of European countries would have already been forced to downsize their banking system using measures similar to those in Iceland. The first signs of Europe going "Icelandic" can be seen from the Cyprus bail-in, which imposed losses on large deposit holders.

Fundamental flaws

The simple fact is that the European banking funding model is fundamentally broken since it has become both uncompetitive and unattainable without a government life support. The only way forward are Anglo-American style reforms where banks are retail-focused but corporate entities obtain direct market financing. The main risk now for Europe is financial repression, as seen in Japan, where losses are not acknowledged, banks become ossified, new loans disappear and economic growth stagnates.

These past five years have brought the Icelanders some vindication of the scorn that was initially poured upon them. After the collapse, British authorities enacted financial sanctions against Iceland, with the support of Iceland's traditional Scandinavian allies, to demand a government guarantee for the Icesave online accounts offered by Landsbanki. After this demand had been rejected twice in a national referendum in Iceland, the case was taken to the European Court where it was dismissed.

Happy ending?

Similarly, all fraud investigations launched in Britain against the Icelandic banks have been dropped. It is also open to dispute whether the asset quality of the Icelandic banks was any worse than the average European counterpart since, despite everything, the overall recovery rate from their estates will probably be in the neighborhood of 60-70 percent. The two Icelandic-owned British banks, Kaupthing Singer&Friedlander and Heritable bank, which were forced into receivership on October 8th 2008, have estimated asset recovery in excess of 90 percent.

However, it is still uncertain whether the Icelandic saga will have a happy ending. As part of the reconstruction efforts, capital controls were implemented, which have virtually unplugged the country from the world economy. Therefore, a 40-50 percent currency depreciation in 2008, which should have significantly boosted Iceland's competitive position, has not yet led to a significant increase in exports and economic recovery is slow.

As time goes by, the deadweight loss from the controls accumulates and the corporate sector is further drawn away into autarchy. The controls were implemented under the auspices of the IMF and were supposed to be a short-term measure. Five years on and two years after Iceland graduated from the IMF program, the country still lacks a credible plan to abolish the controls. On October 8, 2008, the world closed in on the Icelanders and there they still remain.