Banks just too big to fail? Iceland shows otherwise

By Yalman Onaran

Decision to let banks go under looks smarter by the day, in contrast to Ireland's costly bailout, reports Yalman Onaran.

On his second day as head of Iceland's third-largest bank, Arni Tomasson faced a crisis: the firm that regulators had asked him to run was out of cash.

It was October 8, 2008, at the height of the global financial meltdown and Iceland's bank assets in Britain had been frozen. Customers flocked to branches of Tomasson's Glitnir Banki to withdraw money, even though the Government had guaranteed their deposits. By the end of the day, the vaults were empty, says Tomasson, recalling the drama.

The only way Glitnir and other lenders could avoid a panic the next morning was to get more cash, which they were having trouble doing. A container of crisp kronur sat on the tarmac at Reykjavik's airport awaiting payment.

The British company that printed the bills, De La Rue, was demanding sterling, and the central bank couldn't access its British account.

"Everybody was panicked - depositors, creditors, banks around the world," Tomasson says.

But Tomasson got the cash he needed that night after the central bank managed to open an emergency line of credit with a European lender. Now he's sitting in an office in Reykjavik, handling about US$24 billion ($32 billion) of claims by creditors as life in Iceland's capital returns to normal.

Unlike other nations, including the US and Ireland, which injected billions of dollars of capital into their financial institutions to keep them afloat, Iceland placed its biggest lenders in receivership. It chose not to protect creditors of the country's banks, whose assets had ballooned to US$209 billion, 11 times gross domestic product.

The crisis almost sank the country. The krona lost 58 per cent of its value by the end of November 2008, inflation reached 19 per cent in January 2009, GDP fell 7 per cent that year and the Prime Minister resigned after nationwide protests.

But with the economy projected to grow 3 per cent this year, Iceland's decision to let the banks fail is looking smart.

"Iceland did the right thing by making sure its payment systems continued to function while creditors, not the taxpayers, shouldered the losses of banks," says Nobel laureate Joseph Stiglitz, an economics professor at Columbia University in New York. "Ireland's done all the wrong things, on the other hand. That's probably the worst model."

Ireland guaranteed all the liabilities of its banks when they ran into trouble and has been injecting capital - €46 billion so far - to prop them up. That brought the country to the brink of ruin, forcing it to accept a rescue package from the European Union in December.

Ireland's banks had more than 10 times the assets of Iceland's lenders, making their collapse more dangerous for the European financial system. Ireland also couldn't devalue its currency because it is part of the euro zone. Still, countries with larger banking systems can follow Iceland's example, says Adriaan van der Knaap, a managing director at UBS.

"It wouldn't upset the financial system," says Van der Knaap, who has advised Iceland's bank resolution committees. "Even Irish banks aren't too big to fail."

Under an emergency act of Iceland's parliament on October 6, 2008, the assets and liabilities of the three biggest banks - Kaupthing, Landsbanki Islands and Glitnir - were divided based on whether they were originated at home or abroad. The act created three new banks that were given the deposits and loans made to Icelandic companies and consumers. Resolution committees were set up to manage and liquidate what the old banks were left with: the overseas borrowing and lending that fuelled a sevenfold increase in assets from 2000 to 2008.

"If we'd guaranteed all the banks' liabilities, we'd be in the same situation as Ireland," says Iceland's Minister of Economic Affairs, Arni Pall Arnason. Today, Iceland is recovering. The three new banks had combined profits of US$309 million in the first nine months of last year. The economy grew for the first time in two years in the third quarter, by 1.2 per cent, and inflation is down to 1.8 per cent. Stores in Reykjavik were filled with Christmas shoppers in early December and bank branches were crowded with customers.

Iceland's banking boom began in 2001, after the US Federal Reserve began cutting interest rates, pumping cheap money into the global economy. The next year Iceland sold its majority stakes in two banks. The new owners, along with those of Glitnir, which was already in private hands, expanded lending at home and overseas.

Banking's share of national output almost doubled to 9 per cent, while that of fishing, the traditional backbone of Iceland's economy, halved to 4 per cent.

More homes were built from 2004 to 2008 than in the entire previous decade, fuelled by a Government decision in 2003 to lower down payments on mortgages to 10 per cent from 30 per cent.

The 367 Range Rovers sold in Iceland in 2007 exceeded the number in Denmark and Sweden, which combined have almost 50 times Iceland's population of 318,000.

The banks were particularly aggressive in Britain. Many of the borrowers had insufficient or low-quality collateral, according to investigations launched by the Icelandic Government since the crisis.

Loans were also made to companies in which bank executives and owners had stakes or which were controlled by their friends, according to dozens of lawsuits initiated by regulators and resolution committees. Gunnar Andersen, director-general of Iceland's Financial Supervisory Authority, says that before his arrival in April 2009, the agency was understaffed and failed to see the red flags being raised as the banks grew through risky lending. So did auditors and credit-rating firms. Moody's Investors Service gave the Icelandic banks its fourth-highest rating of Aa3 in 2007, Andersen says.

The three banks had become the largest companies in Iceland, creating thousands of well-paid positions, says former central bank chairman David Oddsson, who oversaw the privatisation of Iceland's state-owned lenders when he was Prime Minister. "Nobody wanted to listen when the party was on."

It was Oddsson's decision not to build up the central bank's foreign currency reserves from 2005 to 2008 that made a bailout impossible. "They were collecting debt at such a fast pace, it would be stupid for us to build a mountain they could lean on if they failed," Oddsson says.

After the three lenders were seized by regulators, the Government negotiated with the creditors, almost all outside the country.

Glitnir's 8500 creditors and Kaupthing's 28,000 expect to get about 30 cents on the dollar for their claims, based on secondary-market prices of the banks' debt and asset valuations by the resolution committees. Claims against the three banks add up to US$107 billion and it may take years to resolve them in court, even after the resolution committees finish their work.

At Kaupthing's offices, housed on the seventh floor of a building with floor-to-ceiling windows overlooking the Atlantic Ocean, a half-dozen asset managers huddle over computer monitors watching market prices for stocks and bonds the bank owns. They and their counterparts at Landsbanki and Glitnir are in no hurry to sell.

"Creditors are telling us not to hurry, not to do fire sales," says Tomasson, the Glitnir resolution committee chairman.

At the headquarters of one of the new banks, Arion, chief executive Hoskuldur Olafsson talks about the challenges facing the new bank. Those include restructuring thousands of consumer loans, mortgages and debts of small Icelandic companies.

While the bank got the loans from Kaupthing at steep discounts - in some cases for nothing - it has to work with borrowers to make sure they can pay back, Olafsson says. "Asset values and income in Iceland have gone down a lot, so people just can't pay," he says.

Creditors have an interest in seeing the new banks succeed. They stand to recover more if they can be sold for a good price to strategic investors or in a public offering. Glitnir aims to do so in three years; Kaupthing is shooting for five.

While the shattered trust of the public may take years to rebuild, there aren't any alternatives for Icelanders, who have kept their deposits at the new banks.

"I lost all confidence in the banks, but where else can we go?" says Jon Birgir Valsson, a customer at an Islandsbanki branch in downtown Reykjavik.

Rebuilding the confidence of international investors may take longer. Iceland's banks won't be able to access international markets until political and financial uncertainties are removed.

Those include an agreement reached with Britain and the Netherlands, which has to be approved by President Olafur Grimsson. The head of state has said he'll decide this month whether to put the issue to a referendum again. Voters rejected a previous arrangement last year that forced a higher interest rate on Iceland.

Birna Einarsdottir, chief executive of another of the new banks, Islandsbanki, agrees that settlement of these issues and completion of debt restructuring is required before the Government and the banks can access international capital markets again.

"In the beginning, banks and other financial institutions in Europe were telling us, 'Never again will we lend to you'," Einarsdottir says. "Then it was 10 years, then five. Now they say they might soon be ready to lend again."

This time, her bank won't use foreign funds to go on a lending binge.

"We will only focus on areas where we can bring on the nation's expertise, such as fishing and geothermal energy," says Einarsdottir. "We will grow cautiously."

Economy Minister Arnason acknowledges that the nation got into banking without the right infrastructure or knowhow. Still, he doesn't think Icelanders have to go back to fishing now that they've proven themselves inept at finance.

His Government needs to find work for the 2000 highly educated finance-sector employees who lost their jobs, he says. Arnason will have a better chance of keeping his countrymen home if Iceland can resume growth as predicted. It would also help prove his predecessors were right to let the country's banks fail: Ireland, which rescued its financial institutions, is on the way to shrinking for a fourth consecutive year.

- BLOOMBERG

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