A further look at the Banks

The Icelandic economy began major expansion back in 2003. Its GDP growth rate was on average above 4 percent and in some cases exceeding it twice as much as in the case of 2004 and 2005. This can be seen from the graph below.

 Source: http://bilbo.economicoutlook.net/blog/?p=7161

When the Iceland Economy collapsed in 2007/08, everything went downhill from there. The Icelandic currency; the Krona (ISK) was devalued by over 35% and they were forced to seek help from the International Monetary Fund (IMF) for a 2.1 billion dollar loan bailout. It is agreed by many economists that the Icelandic financial crisis was cause greatly by the rapid expansion of its three largest Banks.

The Role the Banks played

The Icelandic banking system was extremely large and growing in comparison to the economy. The balance sheets of these banks were up to approximately 10 times larger than the Icelandic economy as can be seen in the figure below,(Vidar Ingason, 2012) . It is these large banks that inevitably contributed to the eventual downfall of the Icelandic economy. The Mortgage and Lending portfolio of these large banks were so huge that the Financial Supervisory Authority (FSA) could not keep up with this rapid expansion to properly deal with the amounting high risk that these banks were engaging in.

Furthermore, it is argued that the privatisation of these banks in late 1998 to 2002 contributed to their rapid growth, reckless behavior and speculative trading. Prior to 1998, the Government  owned Iceland's three largest banks namely;  Glitnir, Kaupthing  and Landsbanki Banks. The new domestic owners of these banks had no previous experience in running a bank and incidentally, they were also some of the largest borrowers of these institutions. Therefore, they had much easier access to credit and there was little to be done to stop them from using these funds at their careless disposal.

To add fuel to their reckless behavior, the period of privitisation  was coupled with deregulation. This allowed the banks to become even larger by mergers and acquisitions  taking place in early 2000's. Furthermore, since the population of Iceland is only 320,000 persons, with such rapid growth of these banks, they soon outgrew the economy of Iceland and in order to continue growing at the rate they currently were at, these three large banks had to look at international markets for financial opportunities. In so doing, these banks were in a way transformed from traditional domestic banks to international investment banks. This give rise for the banks' increasing risk appetites and to make matters worse, higher rewards for such risk taking, so long as the returns were substantial. The banks created an international presence all over northern Europe with the purchase of smaller subsidiaries in Luxembourg  Denmark  and Norway for example. Large amounts of foreign debt was incurred in order to finance their expansion. as much as over 700% of GDP as seen in the graph below.

Source: http://www.debtonation.org/2009/05/iceland-%E2%80%93-a-country-of-proud-indebted-people/

The banks and their investment subsidiaries began investing in large companies in the United Kingdom and Europe. Companies such as Debenhams,  House of Fraser, Karen Millen, Hamleys and All Saints, (Ivester, Wilson, 2010).  The banks even went further as in with their largest shareholders, to allow persons to purchase their shares by extension of credit to these individuals by the banks themselves. This in effect caused the shares to be overvalued and inflated since credit was being extended quite easily for the purchase of shares. As a result, the credit ratings of these three banks went to triple A since its share prices went skyrocketing. With such high credit ratings, this allowed the banks to go even further and get involved in even more risky speculative trading. 

In summary of the banks' changing financial positions, Richard Portes, a professor of economics at London Business School, quoted that  “two-thirds of their financing came from domestic sources and one-third from abroad. More recently, until the crisis hit, that ratio was reversed.” Basically, the Icelandic debt crisis emerged from the substancial amounts of foreign debt piled up on the banks balance sheets. These banks rose from being domestic players to international financial intermediaries within the space of less than 10 years.  Their rapid growth, risky behavior and accumulation of excess foreign debt was what lead to the eventual failure of the economy and the banks themselves.