The year 2008 saw the collapse of the three largest banks in Iceland. Relative to the size of the economy this was the largest banking failure in the world.

The purpose of this tutorial is to discuss the details of the case, how it happened, the warning signals, and other case details.
<h2>Triple Crisis in Iceland</h2>
Iceland's economy was plagued by three crisis simultaneously, namely, Banking Crisis, Currency Crisis, and Public Debt Crisis. The extent of these crises was so huge that it leads to the collapse of the three largest banks in Iceland.

Let's discuss the extent of these crises:
<h3>Banking Crisis</h3>
The three banks being discussed are Kaupthing, Landsbanki and Glitnir. These banks mainly focused on Iceland, UK, Denmark, and Norway but had branches in more than 20 countries.

In March 2008, the book assets of these three banks stood at more than 1000% of the country's GDP.

The collapse of these three banks accounted for 85% of their banking system. As the crisis widened, all three banks had to write-down a high number of assets, the asset values fell and by October 2008, the values had fallen to 300% of GDP.

The percentage of non-performing loans for significantly high compared to others financial crises.
<h3>Currency Crisis</h3>
During 2008 the value of Icelandic krona declined significantly. This happened because of the market pressure to sell krona denominated assets. The free floating exchange rate collapsed.

This significantly affected the economy that depended on imports. Also affected were entities with foreign currency denominated loans.

For this reason IMF, as a part of their rescue package, recommended to stabilize exchange rates at a higher level.

In the off sure market, the drop in exchange rate was even bigger.
<h3>Public Debt Crisis</h3>
During this period the public sector debt increased substantially. This was attributed to the cost or rebuilding the banking system and  the large fiscal deficit.

Given these three crises, the crisis in Iceland can be called a triple crisis.

Triple Crisis in Iceland

Like in every financial crisis, even the Icelandic Financial Crisis provided many early warning indicators and cues, which if acted upon at the right time could have avoided or atleast reduced the extent of the losses.

Let’s look at the key early warning indicators:

<strong>1. Size of the balance sheets compared to the size of the economy.</strong>

The rate at which the balance sheets of the top banks in Iceland grew was actually worrying. In 2003, the banks assets were about 100% of GDP. However, by March 2008, the assets had grown to 100% of the country’s GDP.

The growth was attributed to organic growth as well as acquisitions. Both these sources can expose the institutions to different risks. In acquisition, the risk is that you over-pay for the assets. In organic growth, the risk is that asset quality suffers because of poor underwriting and lower lending standards.

Compared to its Nordic peers, the Icelandic banks were actually earning more than their overseas competitors.    Since the Icelandic banks relied heavily on more expensive wholesale funding, its high earnings were achieved at higher costs.

The two more related warning signals were: very low reported loan problems and a growing reliance on shares to collateralize their loans.

<strong>2. Private sector credit boom</strong>

There was a rapid expansion of credit to the private sector, which also contributed to the expansion of banks. This is an indication of deteriorating asset quality.

<strong> 3. Rise in Stock Prices and Housing Prices</strong>

With the expansion of credit to private sector, the funds were invested in the stock markets and real estate.

This leveraged stock purchase lead to the rise in stock markets. The benchmark stock index rose 500% from 2003 to 2007.

Similarly, the real estate prices rose by 80%.

The risk with such highly leveraged buying is then when the markets return to normal, the asset values will become negative, the value of collateral will fall because people will be forced to sell their assets in distress conditions.

<strong>4. Appreciation in real-exchange rate</strong>

Even though in the year 2008, the value of krona declined significantly, in the years leading to the crisis, the real exchange rate appreciated. As the real-exchange rate of krona appreciated, their domestic businesses became incompetent.

<strong>5. Persistent Current Account Deficit</strong>

The increased consumption and strong currency contributed to the increased demand for foreign goods.

The current account deficit for Iceland was about 20% of GDP. Their net external debt was the second highest in world.

For NIIP, the net international investment position, for Iceland was -131% of GDP. NIIP = total external assets - total external liabilities).

As per macroeconomic theory, if a country has large negative NIIP, it will experience currency depreciation, so that it can generate trade surplus to pay interest on external liabilities. For Iceland, if currency depreciated, it would increase the cost of servicing debt that held loans indexed to foreign currency.

<strong>6. High Short-term External Debt</strong>

Iceland had very high short-term external debt. It includes deposits in foreign branches and loans. Since the bank has to rollover the short-term debt, it exposes banks to funding risk.

<strong>7. Mini-crisis in early 2006</strong>

Iceland also faces a min-crisis in the early 2006, which was triggered by two reports in February, 2006 by Fitch. This should have been seen as an early warning signal about the stability of the banking system.

Early Warning Indicators in Icelandic Financial Crisis

Before the financial crisis began, even though all the warning signals were there, the top three Icelandic banks were able to underplay their true riskiness. Moody's had assigned high credit ratings to all these banks.

Moody's ratings consider both quantitative and qualitative factors. Let's take a look at the reasoning behind Moody's ratings.

<strong>Quantitative Factors</strong>

Moody's quantitative indicators are based on five factors, namely, asset quality, profitability, total capital, liquidity, and efficiency.

When you look at the fundamentals of these Icelandic banks from the perspective of these factors, they look quit favorable. However, that was not really the case.

The asset quality factor was based on loan loss reserves and did not capture the deterioration in the asset quality. Also, the loan loss reserves were inadequate which inflated the profits. The total capital projected was way above the truth because their asset prices were overvalued. It also did not account for weak capital (purchase of their own stock by the bank).  Liquidity was based on the bank's own estimation. It did not even account for the liquidity dry up in the market during the crisis. Partly, there was problem with the rating methodology, and partly it was the over-reliance on the figures supplied by the banks themselves.
<h2>Qualitative Factors</h2>
Moody's qualitative assessment was based on four factors: franchise value, regulatory environment, operating environment, and risk positioning. The first three factors were assessed with moderate score, while the risk position was given a low score.

How Icelandic Banks Underplayed their True Riskiness?

In this article we will take a look the asset composition of the Icelandic banks and the concentration risk in the system.

There are several factors that contribute to the deteriorating asset quality of the banks. This includes:
<ul>
	<li>Expansion of loans to corporate and housing sector.</li>
	<li>Loans denominated in foreign currency (vulnerability to depreciation in krona)</li>
	<li>Heavy exposure to domestic equities</li>
	<li>Weak corporate governance</li>
	<li>High concentration in loan portfolio</li>
</ul>
Let’s take a closer look at their assets.
<h2>Loans to Corporates</h2>
<ul>
	<li>Corporate loans amounted to 83% of their total loan portfolio. This was driven by their reliance on the simple Standardized approach to measuring risk-weighted assets rather than developing their own internal rating-based model.</li>
</ul>
<ul>
	<li>The Icelandic banks also expanded outside of Iceland to diversify their loan portfolio. By 2008, the loans outside of Iceland increased to 2/3 of total loans. Due to fierce competition, they could not charge a higher risk premium in other countries.</li>
</ul>
<ul>
	<li>The banks were also lending for stock purchases, where they accepted domestic stocks as collateral. This exposed the banks to market liquidity risk.</li>
</ul>
<ul>
	<li>Since the Inflation in Iceland was very high, there was an incentive for Icelandic companies to finance through low-interest foreign currencies. Almost 75% of bank loans to corporates were foreign exchange linked. This was an indirect credit risk for the Icelandic banks because even though the banks’ foreign currency exposure was fully hedged, the customers were left with open foreign currency exposure. Customers were dependent on krona earnings to repay debt and interest denominated in foreign currency. So, if krona depreciated, the customers won’t be able to pay the now huge amounts in foreign currency.</li>
</ul>
<h2>Loans to Households</h2>
<ul>
	<li>Loans to households represented a small portion of the banks’ loan portfolio.</li>
	<li>Banks underpriced risk as they were competing with the state-supported HF fund.</li>
	<li>To make their offerings attractive, they softened their criteria for extending loans, for example, attractive loan-to-value ratios.</li>
	<li>Banks also promoted low-interest foreign currency loans. This lead to a sharp increase in foreign currency linked loans (causing indirect credit risk for banks).</li>
	<li>The fall in real estate prices was not however a main reason behind the banking crisis.</li>
</ul>
<h2>Large Trading Assets</h2>
<ul>
	<li>The banks had a large trading portfolio comprising bonds and equity holdings (small portion).</li>
</ul>
<ul>
	<li>Banks are required to market their portfolio to market (MTM). When the stock markets were rising, the trading income was reflected in strong profits. However, during the crisis, when the asset prices fell, this income couldn’t be sustained.</li>
</ul>
<h2>Poor Governance and Leveraged Bank Owners</h2>
<ul>
	<li>The Icelandic banks had a relatively high concentration of exposure to large borrowers and connected parties and the top 20 borrowers representing between 250% to 300% of Tier I capital.</li>
</ul>
<ul>
	<li>The controlling shares in the banks were owned by highly leveraged interconnected companies.</li>
</ul>

Icelandic Banks: Asset Composition and Quality of Banks’ Balance Sheets

Even after the mini-crisis in 2006, the Icelandic banks were able to fund themselves.

The banks had three primary funding sources:

1. Issuance of commercial paper and bonds

2. Foreign wholesale and retail deposits

3. Loans, including bilateral and syndicated loans, and money market lines from relationship banks.

Let's look at each of these sources in more detail.
<h2>Unsecured Securities</h2>
Before the crisis, banks borrowed in foreign security markets at low credit spreads. These were unsecured bond issuances having maturity of 3-5 years.

After the crisis, the European debt securities markets became difficult to access. So, they shifted to US debt securities market. In the US markets, the Icelandic banks' securities were attractive as securities underlying the <a title="Collateralized Debt Obligations (CDOs) and Synthetic CDOs" href="https://financetrain.com/collateralized-debt-obligations-cdos-and-synthetic-cdos/">Collateralized Debt Obligations (CDO)</a> issues.
<h2>Foreign Wholesale and Retail Deposits</h2>
Before the 2006 crisis, the deposits were about 20% of banks' total liabilities, and loan-to-deposit ratio was 3 implying high dependency on market funding.

To increase their deposits, they expanded to European markets and deposits in their subsidiaries and branches abroad became an important funding source. Their deposits rose to 30% of liabilities and loan-to-deposit ratio fell to 2.

The banks offered both wholesale and retail deposits.
<h2>Short-term Collateralized Loans</h2>
After the onset of global financial crisis, repurchase agreements (collateralized loans) became a significant funding source. By September 2008, the collateralized loans from outside Iceland amounted to 70% of Iceland's GDP. The securities secured under loans were the banks' foreign bonds and Icelandic securities. They also had multiple lines of credit from relationship banks.

One problem here was that central banks accepted dubious capital to provide these loans. The rules prevent banks from posting their own debt as collateral (Central bank of Luxembourg). The three banks circumvented this rule by posting each other’s collateral at the CBL. This process is known as issuing ‘love letters’. However, CBL later restricted this type of funding. This, however, continued in other places such as Central Bank of Ireland (CBI).

&nbsp;

How Icelandic Banks Funded their Risky Business Models

Icelandic Financial Crisis and Banking Collapse

This frontmatter description will appear below the title

COURSE

Icelandic Financial Crisis and Banking Collapse

LESSONS