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The Crisis in Retrospect

Wade et al. (2012) have argued convincingly that one cannot understand the lead up to and the reasons for the collapse of the Icelandic banking system without taking what may be best termed a political economy approach. The rapid growth of the banking system, the inadequate regulation, and the reckless loans to the owners of the banks were all the result of a flawed privatization process that was designed to benefit the extremely small elite who had links with the political parties. See Johnsen (2014 , Chap. 5) for a discussion of just how flawed the privatization process was.

However, Gissurarson (2013), who, it should be noted, had served on the supervisory board of the CBI from 2001-2009, attempts to place the blame for the collapse of the Icelandic banking system on the general collapse of the international banking system in the wake of the subprime crisis. This overlooks the evidence that the Icelandic banks would probably have collapsed, irrespective of the unfolding of the crisis. While it is not possible to be definitive, Flannery (2009) concludes that “one is left with the strong suspicion that some or all of the banks were insolvent [by October 2008]—and hence the market’s unwillingness to lend was rational” (p. 106). The Icelandic mini-crisis of 2006, for example, occurred even before the subprime crisis. While Gissurarson (2013) points out that a large banking system is not unsustainable in a small country, for example, Ireland, Luxembourg and Switzerland, he overlooks the fact that the lost two countries have a long experience of international banking. Moreover, the situation of Iceland differs in one significant respect from the other three countries. In Luxembourg, the banks’ assets largely belong to the branches of foreign banks and, as such, the banks’ deposits are guaranteed by their respective foreign countries. In Ireland, for example, this applies to about 40 percent of the banks’ assets. The Swiss banking system is much larger, but it is so interconnected with the international financial system that there would almost certainly be a worldwide response if any of its banks were in any danger of failing (the reason why this did not happen to the Icelandic banks is discussed below). These banking systems did not have an explosive growth over three or four years for which the regulatory institutions were unprepared and which they did nothing to address. The Iceland financial system was indeed “overbanked and undersized” in the words of Sibert (2011), an assertion which Gissurarson disputes.

It is also unconvincing to lay the blame for the crisis on “the systematic error in the legal and regulatory framework for the European financial common market” (Gissurarson 2013, p. 7). The problem here lay with the failure of the Icelandic institutions such as the FME, the CBI and the government effectively to implement these regulations. It is also disingenuous to blame the customers. “If the Icelandic banks were reckless, were their foreign customers not reckless as well?”, Gissurarson (2013, p. 7) rhetorically asks. However, the whole point of the banking regulatary framework is to overcome the problem of asymmetric information. The banks are able to apply due diligence to the issue of loans and the credit worthiness of borrowers (whether or not they actually do so is another matter). Individual investors do not have the resources or information to undertake a detailed assessment of a financial institution’s financial stability. That is the whole reason for the regulatory framework. This is, namely, to ensure that banks act prudentially on behalf of the investors and the government, who ultimately provides the depositors’ guarantees. It was here that the FME and the CBI proved totally inadequate to the task, and the credit rating agencies for a short period got it (nearly) right. Moreover, Gissurarson (op. cit.) attributes much of the blame for the collapse to the fact that “the Icelandic banking sector was only unsustainable because in its hour of need nobody was willing to help” (p. 7), whereas other countries received help from the US Federal Reserve Bank, inter alia. It is sufficient to quote the SIC (2010) on this:

After the G10 Summit of the central bank governors in Basel on 4 May 2008, it became clear that neither a currency swap with the agreement with the Bank of England nor the other central banks, with the exception of the Danish, Norwegian and Swedish ones was on offer to the CBI. In a letter to the Investigation Committee, Stefan Ingves, Governor of the Central Bank of Sweden, makes it clear that unclear ownership, along with the banks’ rapid balance sheet growth had led to a dangerous situation and that the Icelandic government did neither seem fully to grasp nor understand how to deal with it. (p. 15)

The Bank of England was likewise so concerned with the fragility of the Icelandic banks that it also refrained from even discussing a swap, but merely gave advice that the size of the banking system should be reduced. So Gissurarsons (2013) argument that the whole crisis primarily was due to the lack of diligence of the largely foreign investors in the banks and the inexcusable failure of the other central banks to rescue the Icelandic banks is not a compelling one.

Nor can the banks’ actions as the crisis unfurled be considered to be ‘gambling for resurrection’, as Baldursson and Portes (2013) assert. Gambling for resurrection is where a bank or financial institution gets into serious financial difficulties and makes risky loans which will, if successful, bring a high return and rescue the bank, but the probability of this occurring is extremely low. Black (2014a and b) argues that the banks engaged in reckless behaviour from the time of their privatization, acting solely in the interests of the few large shareholders, as evidenced by the SIC (2010). The banks’ behaviour was not ‘gambling for resurrection’, but rather ‘looting’ in Akerlof and Romer’s (1993) sense of the term or engaging in ‘accounting control fraud’ (Black 2014a).

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