The lesson from Iceland’s recovery: let banks go bust

The sovereign debt crises around the world rumble on. If it isn’t the UK and other European countries being downgraded or threatened with downgrades by credit rating agencies, then it’s the latest twists in the Greek saga.

You’d be forgiven for thinking that it’s all doom and gloom in the bond markets.

However, some countries are having their credit ratings raised. Fitch has just upgraded Icelandic debt to BBB-. This means that all three major agencies, (the other two being Standard & Poor’s and Moody’s) consider Icelandic debt to be investment grade once again. It costs nearly the same amount to insure Belgian debt against default as it does that of Iceland’s government.

And it’s not just markets and rating agencies who are happy – Iceland’s unemployment is only 7.2%, and GDP growth is expected to come in at 2.4% this year. That’s a lot stronger than anything forecast for the UK or the rest of Europe.

So what went right for Iceland? And what can we learn from its experience?

How Iceland’s problems started

From 2003 to 2008, Iceland went on a debt-fuelled buying spree. Iceland’s major banks began borrowing from international lenders on a huge scale to finance asset purchases. The population followed suit, borrowing from low interest-rate countries like Japan to bet on domestic assets (the carry trade).

While prices remained high, the banks made big profits, and a booming property market allowed ordinary people to borrow even more. At the peak of the debt bubble, the top three banks owed lenders debts equivalent to six times Iceland’s GDP.

Even rising interest rates could not halt the cycle, as foreign lenders piled in to take advantage of a strong currency and high-yielding Icelandic debt.

The warning signs were apparent for a good while even before the credit crunch kicked in. However, the party finally came to an end in October 2008 when the international financial crisis hit asset prices. The country’s over-levered banks were forced into bankruptcy.

What Iceland did

Governments around the world bailed out their financial sectors. The US government bought stakes in key banks and lent them money. Britain nationalised RBS, assuming all its debts. Ireland guaranteed all the debts of its six largest banks.

However, Iceland took a different tack. The government declared that it would only save domestic bank account holders – everyone else would have to fight over the remaining assets.

It also refused to pay foreign governments for the cost of compensating retail depositors in foreign subsidiaries of Iceland’s banks. Although a deal that would have paid the debts, over a longer schedule, was nearly agreed twice, it finally collapse due to public opposition.

Meanwhile, instead of trying to prop up its currency, Iceland let the value of the krona more than halve. It also imposed capital controls to prevent money leaving the country.

What happened

Make no mistake: Iceland still took a big hit. From the peak in the third quarter of 2007 to the trough in the second quarter of 2010, the economy shrank by 14.3%. The fall in the value of the krona pushed inflation up to nearly 19%.

The collapse of the banks decimated domestic stock markets. On 17 August 2007 the stock market peaked at 8,238. By 13 March 2009 – just over 18 months later – it reached a low of 379.93;  a fall of more than 95%.

The decision not to compensate British and Dutch regulators for bailing out investors turned Iceland into an international pariah. The UK used anti-terror laws to freeze the assets of the Icelandic central bank. And Iceland may end up having to pay up anyway, if it loses an European Economic Area case against it.

That all sounds appalling. And most Icelanders would probably tell you that it was. But it’s only when you compare Iceland’s plight to what happened to other countries that you realise that things could have been much worse – particularly given the sheer scale of its banking bubble.

Cutting real wages through inflation meant that unemployment peaked at an annual rate of 7.6% in 2010 – lower than any of the peripheral European countries, for example. And after the initial plunge, the Icelandic economy has started to grow strongly again:  GDP has grown by 6.9% since the second quarter of 2010.

On top of that, the decision not to bail out the banks has meant that debt/GDP levels peaked at an acceptable 100% of GDP, and are set to fall. By contrast, the Greek bail-out deal is hoping to achieve a debt-to-GDP ratio of 120% by 2020 – and that’s the best-case scenario.

The lessons for Europe

Iceland’s problems were closer to those of Ireland than those of Greece: the explosion of an outsized financial sector  rather than a chronic inability to balance revenue and spending in the context of a fixed currency.

However, there are two key lessons that the rest of us, and those two countries in particular, can learn from Iceland. To avoid having banks drag them into bankruptcy, governments should focus on saving depositors only – not other bank creditors. That’s the lesson for Ireland.

As for Greece, Iceland’s experience suggests that devaluation and capital controls may be the least painful solution to an economic contraction.

None of this is easy or painless, as the Icelanders could tell you. And it doesn’t alter the fact that the best way to avoid a bust is to avoid having an unsustainable boom in the first place. Unfortunately, that’s a lesson that none of us seems able to learn.

  • Jon

    Tentatively agree with the premise, however let us not forget a few things:

    – Iceland went ugly early; as such it had (at that time) a reasonably healthy list of sources of replacement capital. Those countries at the back of the queue will find the cupboards are bare

    – Iceland was/is relatively small and, crucially, unconnected.

    – Due to devaluation from a stable 80-90ISK to EUR from 2000 through 2007 (so much for a boom) to a now ‘stable’ 160ISK, Icelanders have lost half of their overseas purchasing power

    – Icelanders have further lost over 25% of internal purchasing power in the past 3 years due to inflation alone

    The last two are not dissimilar to the conditions in the UK.

  • Boris MacDonut

    Fundamental mistake Matthew. Iceland is physically the size of a typical country, but has only 280,000 people .That puts it on a par with Bournemouth or Warrington.
    Such a place should never have had a banking industry to speak of and certainly should not allow it’s relatively wealthy people to be hijacked to provide the collateral for a series of poorly run hedge funds.
    Iceland has fish and thermal power,only one of which it can sell abroad. When they tried to buy up the UK High Street most people said how rich and clever they were. Reality bit them rather hard. Luckily Iceland does not carry 3 million unemployed.

  • Dave A

    It is not reasonable to look at the actions of this one small country as being representative of what could or would happen to a much larger entity loke Ireland , Greece , the UK or Europe .
    Iceland has benifited from there action in isolation but if there policy had been adopted by any or all of the major economies it would have made the current situation look like nirvana

  • John M

    Maybe the comparison is not a fair one, but why was Government panicked into supporting incompetent and insolvent banks such as RBS and Lloyds. They should have been put into Administration, profitable parts sold or refloated, loss making parts closed. No company or Country is too big to fail; its just that we have politicians with limited vision. Much easier to kick the can down the road.

  • Engineer

    John M is right, the banks should have gone together with the bad overpaid management. Small depositors should have been saved. We would now have been well on the road to a working bank system rather than a bunch of speculators.

  • alex

    @4, firstly Lloyds was a managed and well financed English bank before it was bounced into a deal with HBoS by a Scottish prime minister who realising the loss of 50,000 jobs north of the border would spell the end of Labour in Scottland was panicked into bailing out two failed Scottish banks at enourmous cost to the UK. The rescue of RBS and HBoS was entirely political.

    Did Labour feel the need to ride to the rescue of Natwest when it fell from grace in the late 90’s…… they glowingly approved it’s purchase by RBS who fired thousands of English staff and moved the hq to Scotland.

  • Peter Jenkins

    It is purely logical to let bad businesses go to the wall. Small depositors can be saved and other profitable banks and new ones could take up mortgages etc. I was totally horrified that the three main parties in the UK and the press all thought that saving RBS and other Northern Banks was a good idea. As Engineer says; we would have a working bank system now and our government would not be quite so bankrupt as it is at present. Yes, there would have been a huge shock but the only way would have been up!!!

  • SteveH

    @ John M Maybe the comparison is not a fair one, but why was Government panicked into supporting incompetent and insolvent banks such as RBS and Lloyds.

    My recollection is that they were rightly panicked, because otherwise they would have gone bust (the next day!), taking many businesses and people with them. I certainly agree they didn’t do a great job, and others did better here and there (Holland scrapped all directors bonuses for example), but still.

    My solution is – if a bank goes broke then so do the directors, no arguments about fault, it’s just a risk they will have to take. Thus concentrating minds. Fred Goodwin would have been just fine and dandy if RBS had folded, so the silly risks with short term silly bonuses would still have paid off from his point of view.

  • alex

    @8, neither Lloyds, Barclays nor HSBC would have gone bust, they were/are well run and funded, infact Barclays took advantage of a weekened Lehmans to buy a huge chunk of it’s buisness at rock bottom prices.

    RBS, and HBoS were badly run, overstetched banks which should have been allowed to go bust but weren’t because they were both Scottish and the job losses following their breakup would have annihilated Labour in Scotland and cost them any chance of ever being re-elected as Governors of the UK.

  • SteveH

    Well I cedrtainly think it was right to deal with it which would protect ordinary people’s savings, people who’d just sold their house, business bank accounts with the payroll ready to run etc? Is there anyone here who actually has an informed take on a better way?

  • Boris MacDonut

    #6 & #9 Alex. Nonsense. Lloyds was an accident waiting to happen. An abysmally overstaffed and feet of clay finance house. How come they are in for 5 times as big a PPI payout as RBS? Because it was run by incompetents and wide boys.

  • Mark

    I support hanging the criminal thieving bankers, and the politicians who helped them, starting with the thief Gordon Brown.