Early in 2008, Anne Sibert and I were asked by the Icelandic bank Landsbanki (now in receivership) to write a paper on the causes of the financial problems faced by Iceland and its banks, and on the available policy options. We sent the paper to the bank towards the end of April 2008. On July 11, 2008, we presented a slightly updated version of the paper in Reykjavik in front of an audience of economists from the central bank, the ministry of finance the private sector the academic community. A link to that paper can be found here.
Because our Icelandic interlocutors considered the paper to be too market sensitive, we agreed not to put it in the public domain. Now that all three formerly internationally active Icelandic banks – Glitnir, Landsbanki and Kaupthing - have gone into receivership, there is no reason not to circulate the paper more widely, as some of its lessons have wider relevance.
Our main point was that Iceland’s banking sector, and indeed Iceland, had an unsustainable business model. The country could retain its internationally active banking sector, but that would require it to give up its own currency, the Icelandic kroner, and to seek membership of the European Union to become a full member of the Economic and Monetary Union and adopt the euro as its currency. Alternatively, it could retain its currency, in which case it would have to move its internationally active banking sector abroad. It could not have an internationally active banking sector and retain its own currency.
There is no such thing as a safe bank, even if its assets are sound, in the sense that they would cover all obligations if held to maturity. Any highly leveraged entity that borrows short and lends long and illiquid is vulnerable to a speculative attack (run). A withdrawal of deposits, refusal to renew credit or inability to sell assets could force a bank into insolvency even if its assets were good, provided they could be held to maturity.
A viable bankings system therefore requires a central bank that can act as lender of last resort (to offer support against funding illiquidity) and market maker of last resort (to offer support against market illiquidity of its assets).
A viable lender of last resort and market maker of last resort has to be able to provide ample liquidity in the currency to which the banks it wants to support are exposed. If the bulk of the banks’ short-term liabilities are domestic-currency-denominated, the central bank can always act as lender of last resort (LLR) and market maker of last resort (MMLR), although the price of doing so may be excessive inflation.
Excessive inflation will result from central bank domestic-currency LLR and MMLR operations, if the banks have a fundamental solvency problem (a solvency gap even if the assets could be held to maturity) rather than just a liquidty problem. In that case, the LLR and MMLR task can be fulfilled without excessive inflation only if the fiscal authorities can recapitalise the banks.
When a large part of the short-maturity liabilities of the banking system are denominated in foreign currency, as was the case in Iceland, the central bank can act as foreign currency LLR and MMLR only to the limit of its foreign exchange reserves and its ability to borrow foreign exchange, through swaps with other central banks, credit lines or whatever.
The ability of the central bank to borrow foreign exchange is ultimately limited by the ability of the sovereign to borrow foreign exchange. That in turn is limited by the ability of the sovereign to make (1) an internal fiscal transfer (now and in the future) from domestic households and firms to the state and (2) an external transfer of resources (now and in the future) to its foreign creditors.
The internal transfer requires higher taxes or lower public spending. The external transfer requires primary external surpluses (surpluses in the current account excluding net foreign investment income). That in turn requires a depreciation of the real exchange rate and probably a worsening of the external terms of trade.
Both the internal transfer and the external transfer are painful and politically unpopular. The question then becomes whether it was credible that Iceland’s government would be able and willing to put the domestic economy through the wringer required to guarantee the servicing of the external debt.
The paper considered a range of alternative ways of collateralising external borrowing by the Icelandic authorities, that might not involve large-scale unemployment and excess capacity. Securitising Iceland’s future revenues from hydro and geo-thermal power generation seemed an attractive option to us. At the moment, Iceland exports electric power only indirectly, embodied in aluminium that is smelted and refined there. The scale of these operations is about to increase. In addition, it may soon become technogically feasible and economically viable to export power directly, via cable, to Scotland.
For whatever reason, Iceland’s government was unable or unwilling to raise the external resources to defend its banks. All three formerly internationally active banks are now in receivership. The government is buying some of the domestic banking assets to safeguard the domestic payments, clearing and settlement systems. As regards the creditors, many of whom are foreign, including 82 UK local government councils, they are on their own. They can join the cue of unsecured creditors and wait to see what, if anything, they get back from the sale of the assets of the banks. This is as it should be.
How would membership of the euro area have made a difference? It would not have made any difference if the problem of the banks had been one of fundamental insolvency – if the hold-to-maturity value of the assets was insufficient to cover its obligations. But if the problem were only one of illiquidity causing a non-fundamental insolvency because the assets of the banks could be realised in the short run only at fire-sale prices, then membership of the eurozone would have permitted the banks to survive. Many of the illiquid assets of the three banks could have been used as collateral at the discount window of the Eurosystem or in Eurosystem repos. Because the euro is a global reserve currency, there would not have been no appreciable effect on the external value of the euro from the LLR and MMLR operations of the Eurosystem in support of the Icelandic banks.
None of this would have done any good if the Icelandic banks’ problem had been one of fundamental insolvency rather than illiquidity creating the risk of non-fundamental insolvency. Even in the euro area, Iceland would have had the unavoidable problems faced by any small country with a large banking system (gross assets and liabilities 900 percent of annual GDP). The fundamental solvency gap of the banks could be too large to be manageable for the national fiscal authority. Only international aid, or fiscal risk insurance and fiscal burden sharing would help a country whose banking system’s solvency gap exceeded the fiscal capacity of the national authorities. But if, as the Icelandic banks, the Icelandic authorities and such experts as Professor Richard Portes argued, the Icelandic banks are fundamentally sound, then membership of the euro area would have prevented the collapse we have just witnessed.
There are obvious lessons here for other small countries with large, internationally exposed banking sectors and their own currencies. In Europe, Switzerland, Denmark, Sweden and even the UK come to mind. He who has ears to hear, let him hear.