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Seminar Paper, 2012
15 Pages, Grade: 2,3
II. Economic Crisis in Iceland 2008 - ongoing
II.1. History of Iceland
II.2. Evaluation of the Banking Sector
II.3. Collapse of the Banking Sector
II.4. Steps done to solve the Economic Crisis
During the current financial crisis which started in the year 2007 with the bust of the American housing market and peaked with the collapse of Lehman Brothers we observe that many countries face difficulties with their domestic banking system. For instance Germany had problems with several Landesbanken, the Hypo Real Estate (HRE) and with Commerzbank or the United States struggled with the collapse of Merrill Lynch and Bear Stearns leading to an enforced merger with Bank of America and JP Morgan Chase respectively. In other countries problems in the banking system were more dramatic. After rumors in the United Kingdom about a collapse of Northern Rock people went immediately to the branches to withdraw their deposits. The picture spread the world when people waited outside in a queue of a branch of Northern Rock to get inside. To prevent a domestic bank run in the United Kingdom the government nationalized several financial institutions such as Royal Bank of Scotland; afterwards holding a stake of 95% in this particular institution. Nowadays Spain faces a huge banking crisis after the bust of the Iberian housing bubble. But what is the problem of having a banking crisis?
The effect of banking crisis on the growth of a country is significant. Business sectors that are more dependent on external finance grow less than business sectors which are more independent to lending. The economic downturn which often occurs together with a banking crisis and bank distress leads to a cut back of lending from banks to the real sector. In extraordinary bad times the effect of reduced lending might be accelerated if banks experience liquidity and solvency problems. There is a real cost of a banking crisis (Dell’Ariccia, Detragiache, Rajan, 2006, page 107). Banks take an important role in an economy. Since banks actively transform maturity in the economy, in particular transforming short-term deposits into long-term loans, a panic in the financial system is very risky for banks. If a bank-run occurs in which many depositors withdraw their money at the same time and force banks to sell their assets under pressure to get sufficient liquidity to pay out deposits they might get into solvency difficulties. Therefore confidence in the financial system is very important for an economy. Banking crisis are major amplifiers of recessions and countries have more difficulties to solve a financial crisis than escaping a long history of sovereign debt crisis. On average a country spends more time in the status of sovereign default than in a financial crisis. For a country it is easier to delay negotiations about its debt with foreign creditors than leaving a banking crisis unsolved due to its negative effects on investment and trade (Reinhart & Rogoff, 2009, p. 147).
As the dangers of banking crisis are briefly shown we need to examine the reasons causing banking crisis. From the data we observe that periods of high international capital mobility have repeatedly produced international banking crisis. An increase of capital inflow often occurs after a liberalization of the financial sector. Financial liberalization has an independent negative effect on the stability of the banking sector. Financial liberalization often takes place together with inadequate regulation and lack of supervision of the financial system (Reinhart & Rogoff, 2009). Huge capital inflow often provokes a boom in the equity and credit market. After studying data of the housing market of all banking crisis in advanced economies after World War II it is striking that a boom in real housing prices in the run-up to a crisis is followed by a marked decline in the year of the crisis and subsequent years. Banking crisis tend to occur either at the peak of a boom in real housing prices or right after the bust. In emerging markets an increase of capital inflow leads often to a credit boom in the country and many times ends in a financial crisis (Reinhart & Rogoff, 2009, page 158-159). When the bubbles bust and a financial crisis occurs mostly governments experience a sharp decline in tax revenues due to the following recession. The response to a financial crisis is often very similar. Governments tend to do a bailout of the banking sector and a fiscal stimulus package to restore the economy. These expenditures together with the decline of tax revenues need to be covered by additional government debt. If the stock of debt is indexed to equal 100 at the time of the crisis, the average experience is one in which the real stock of debt rises to 186 three years after the crisis (Reinhart & Rogoff, 2009, page 170).
The characteristics of the European debt crisis suggest that this crisis is not so much different than preceding crisis. But there is no strict definition when a country faces a debt crisis and when not. According to the Maastricht criteria member states of the European Union must not have a higher government debt to GDP ratio of 60%. Still, if a country violates the ratio it is not automatically in a debt crisis as seen in Germany for instance. One other measurement might be the country ratings of major agency such as Moody’s or Standard & Poor’s. Another could be the spread between a government bond interest rate and a “safe haven” government bond interest rate such as the US or Germany. But without any strict definition provided from institutions like the IMF market forces have to decide when a country is on the way to a sovereign debt crisis. Usually that can be observed in an increase of interest rates for debt of this government and a lack of interest to purchase government debt in the primary market.
The first country that collapsed during the ongoing financial crisis was Iceland. After the failure of the financial system Iceland nationalized its biggest banks and afterwards concluded an agreement with the IMF on an economic stabilization program. Why did the Icelandic financial system collapsed? What can we learn from it for the future? That are the questions I will try to answer in this paper. In the beginning I will present the brief history of the pre-crisis major events in Iceland. Then I will examine the Icelandic banking sector more in depth and show why the sector collapsed in the end. The emphasis will be on the development of the asset- and housing market. When the financial system finally collapsed several steps were taken by the Icelandic government to restore the domestic economy. I will give an overview of the IMF program and about the monetary policy in Iceland after the collapse. Finally I will try to answer the questions stated above and show what we might learn of the recent crisis in Iceland for the future. My research is mostly based on publications by the Central Bank of Iceland, by the Organisation for Economic Co-operation and Development (OECD) and on articles written my economists concerning banking crisis and sovereign debt crisis. Books written by Joseph Stiglitz about the recent crisis gave me some insights for my conclusion.
Iceland is the second biggest insular state in Europe and residence for approximately 300,000 people. Iceland is localized between Greenland and the United Kingdom. It is abundant with marine resources and energy resources due to its regenerative power production. Power is produced only with hydro energy and geothermal energy. When Iceland started to capitalize its abundant factor power several power intensive industries settled down in Iceland such as one of the world’s biggest corporation in producing aluminum, Alcoa. The economy of Iceland is predominantly based on the export of marine products and the indirect export of energy through the production of metals.
With the beginning of the current century another sector experienced a high growth rate, the financial service sector. In the past the financial sector was highly regulated with the three biggest banks owned by the Icelandic government. In the year 1994 Iceland joined the European Economic Area (EEA) which allowed Icelandic banks to open branches in the European Union. In the late 1990s the Icelandic government started to privatize the domestic banking sector. In the year 2004 Iceland’s commercial banks started to lend actively in the domestic mortgage market. Before that time the Housing Financing Fund (HFF), a government institution, was the only major player in that market. After the privatization and a further deregulation of the banking sector several commercial banks expanded operations to the United Kingdom, Europe and the United States. Therefore the banks opened branches in these countries. The three biggest banks were Glitnir, Landsbanki and Kaupthing. After a rapid and functional expansion of these three banks suddenly the subprime crisis started in the year 2007. The business model of the Icelandic banks started to crack and in October 2008 Iceland’s Financial Supervisory Authority took control of Landsbanki, Glitnir and Kaupthing. Just one month later Iceland closed an agreement with the IMF on an economic stabilization program.
With the IMF program Iceland is working onto get back on track. In the year 2011 Iceland returned to international capital markets and issued a new government bond denominated in USD and maturing in 2016.
In this chapter I will examine the banking sector of Iceland more in depth. Therefore I will show some characteristics of the banking sector that might explain why it was so vulnerable to financial turmoil of the subprime crisis.
The global expansion of Icelandic banks started with the privatization of the Icelandic financial sector and the deregulation in the late 1990s. When Iceland joined the EEA Icelandic banks were allowed to open branches in countries of the European Union and other countries who are members of the EEA.
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