Iceland's meltdown is teaching lessons

  • Article by: OMAR R. VALDIMARSSON , Bloomberg News
  • Updated: August 3, 2012 - 9:11 PM

After nearly going bankrupt, Iceland is taking steps to limit the ability of banks to make high-risk, government-backed investments.

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A Landsbankinn HF bank branch in Reykjavik, Iceland. Landsbankinn and two other banks in Iceland would have their operations broken up under reform efforts after a 2008 economic collapse.

Photo: Arnaldur Halldorsson, Bloomberg

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REYKJAVIK, ICELAND

Iceland was brought to the brink of bankruptcy when its biggest banks failed four years ago. Now, the site of the world's most spectacular financial collapse is becoming a pioneer in banking reform.

"We've been burned by this, and that's why we have to look very closely at what we need to do to prevent it happening again," Economy Minister Steingrimur Sigfusson said in an interview. "Icelanders are more interested in taking greater steps than small steps when it comes to regulating banking."

His party, the junior member in Prime Minister Johanna Sigurdardottir's coalition, has submitted a motion to parliament to stop banks using state-backed deposits to finance risky investments. The move puts Iceland on course to become the first Western nation since the global financial crisis hit five years ago to force banking conglomerates to split their business.

It's a proposal that's gaining traction elsewhere. Even Sandy Weill, whose 1998 creation of New York-based Citigroup triggered the Gramm-Leach-Bliley Act that paved the way for financial behemoths, now says investment banks should be separated from deposit-taking banks. Opponents including JPMorgan Chase & Co. Chief Executive Jamie Dimon say diverse businesses are needed to spread risk across divisions and stay competitive.

The Icelandic lawmaker who presented the motion, Alfheidur Ingadottir, says the best way to stop banks creating asset bubbles is to pass laws akin to the 1933 Glass-Steagall Act, which separated commercial and investment banking in the U.S. for more than six decades.

The law would force Arion Bank, Landsbankinn and Islandsbanki -- state-engineered successors to the banks that failed -- to break up their operations. Investment banking now makes up less than 5 percent of business at the banks, whose deposits are backed by the Icelandic state. Before the crisis, the ratio was as high as 33 percent at Iceland's biggest lender, said David Stefansson, an economist at Arion.

Sigfusson, whose ministry oversees the financial industry, wants a "partial, or even complete, separation of commercial and investment banking," he said. "It's a way to prevent the riskier parts of banking being mixed with regular day-to-day banking and shouldered by regular customers or taxpayers," he said.

Support in banking industry

The government has found support inside Iceland's banking industry. The head of the island's biggest investment bank says breaking up financial conglomerates is the most effective crisis prevention tool and one that would have prevented the nation's meltdown.

"Giving banks too much of a free ride with deposits -- money they don't need to repay if something goes wrong -- isn't such a great idea," Straumur Investment Bank Chief Executive Petur Einarsson said.

Einarsson says Europe should look to Iceland to get a sense of how much damage an overgrown banking system can wreak.

"Europe is today feeling the pain of the same disease Iceland caught in 2008," he said. "The changes that need to be made should benefit the depositors and businesses served by these financial institutions, rather than the institutions themselves."

The excesses of Kaupthing Bank, Glitnir Bank and Landsbanki Islands proved ruinous for Iceland's economy. The banks grew to about 10 times the nation's total economic output before defaulting on $85 billion in 2008, forcing the government to impose capital controls and to resort to an international bailout.

Kaupthing's balance sheet ballooned by a factor of 85 between 2000 and 2007 to peak at 5.3 trillion kronur ($44 billion), compared with Iceland's gross domestic product last year of $13.5 billion. The bank, Iceland's biggest before it was put under state control in October 2008, opened offices in Luxembourg, New York and Dubai. Its size and complexity relative to the economy made proper risk analysis difficult.

Red flags were missed

The financial regulator also missed the red flags. Iceland's three biggest banks all had capital adequacy ratios of more than 10 percent of their risk-weighted assets as of the end of June 2008, the Financial Supervisory Authority said in August the same year. All three lenders passed FSA stress tests in a report published two months before they failed.

In the years that followed the banks' collapse, Iceland's unemployment rate jumped nine-fold and the economy was thrust into a recession. An 80 percent plunge in the krona against the euro offshore sent inflation soaring to 19 percent. That bloated the debt burdens of a household sector paying down inflation-linked mortgages.

Now, the government wants to ensure that the new banks are never again allowed to grow big enough to wreak such havoc. Preventing financial conglomerates from dwarfing the economy is key, according to Ingadottir.

"Running a commercial bank isn't really compatible with running an investment bank, especially in regards to financial risk management," she said.

Iceland's economic reforms since the end of 2008 have so far proved successful. The economy will outgrow the euro area this year and next, the International Monetary Fund estimates. Iceland's krona has appreciated 14 percent against the euro since March, making it the best-performing emerging-market currency in the period. The krona was little changed Friday at 147.67 per euro.

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