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28 November 2013

Band of Iceland/Guðmundsson: The financial crisis in Iceland – What are the lessons five years later?


Guðmundsson spoke on the development of the financial crisis in Iceland, and the lessons learned from it. He warned that the EU framework for cross-border banking was - and still is - deeply flawed.

It is well known that almost 90 per cent of Iceland’s banking sector failed in the first week of October 2008. What is probably less well known is that at that point, Iceland was already on its way into a recession after an unsustainable boom and serious overheating during 2005–2007 and a currency crisis in the first half of 2008. That autumn, two separate but interrelated sub-stories of the recent Icelandic saga converged in a tragic grand finale. These are (1) Iceland’s boom-bust cycle and problems with macroeconomic management in small, open, and financially integrated economies and (2) the rise and fall of three cross-border banks operating on the basis of EU legislation (the European "passport"). The combined balance sheet of these banks was 10 times Iceland’s GDP.

Before the collapse, the banking system had expanded very rapidly, growing in just five years from a combined balance sheet of less than 2 times GDP at the end of 2003 to the aforementioned 10 times GDP. Most of this expansion was cross-border, and a significant part of it was really off-border, having little to do with Iceland, as both financing and investment took place abroad. As is typical for banks, the FX part of the balance sheet had a significant maturity mismatch. However, there was no safety net of the type that we have in a national setting to back it up.

Given the lack of international cooperation, the Icelandic authorities were forced to consider radical solutions to preserve a functioning domestic payment system, ring-fence the sovereign in the case of bank failures, limit the socialisation of private sector losses, and create the conditions for the reconstruction of a domestic banking system. The adopted solution saved the domestic operations of the banking system and let the international part to go into a resolution process. The new banks were created by carving the domestic assets and liabilities out of the old, failing banks. The new banking system amounted to 1.7 times GDP.

I would like to mention selected lessons that I think can be drawn from this experience:

  1. Dealing with failing big banks in small countries: Guaranteeing the entire banking system in Iceland’s case would probably have resulted in sovereign default and the bankruptcy of the country. In general, taking such a step with big banks in small countries is risky, especially if a significant part of their balance sheets are in foreign currencies.
  2. Dealing with volatile capital flows: Deal with the inflows if you want to avoid having to take drastic measures to deal with the outflows. That includes adopting correctly aligned macroeconomic and macroprudential policies, leaning into the wind by buying part of the inflows into foreign exchange reserves and, in the limit, deploying selective capital inflow management tools.
  3. The design of the financial sector in small, open economies: The financial sector has to be smaller than it has been in countries like Iceland, and international activities must be restricted as long as such countries are not part of a credible multilateral safety net.
  4. The EU framework for cross-border banking: It was very much this framework that facilitated the cross- and off-border expansion of the Icelandic banks through the so-called European passport. It was and is deeply flawed, and it contributed in a significant way to both the Icelandic banking crisis and the crisis in the eurozone.

Full speech



© BIS - Bank for International Settlements


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