How Icelandic Banks Funded their Risky Business Models
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.
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 Collateralized Debt Obligations (CDO) issues.
Foreign Wholesale and Retail Deposits
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.
Short-term Collateralized Loans
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).