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Introduction Iceland enacted different public policies in order to deregulate its banking sector at the beginning of 1990, culminating in a privatization of its banking industry in 2002. From the years 2002 to the beginnings of 2008, the banking sector of Iceland experienced an exponential leveraged growth as a result of its privatization. At the end of 2008, Iceland suffered one of the worst financial crises that the world has ever seen. This paper will show how public policy towards the deregulation and privatization of the banking industry in Iceland affected its financial markets. First, I will summarize the public policies of the banking sector of Iceland and its financial stance prior the deregulation and privatization policies of 2000. Second, I will outline the deregulation and privatization policies and the reasons why they were instituted. Third, I will provide a screenshot of how Icelands financial markets developed under the new public policies from 2000 to 2008. Fourth, I will describe the financial crisis of Iceland at the end 2008, which is attributed to the institution of the public policies towards the deregulation and privatization of the banking sector, and its impact to its national and the global financial markets. Finally, I will show how the government of Iceland was forced to nationalize its banks again. The public policies that prompted the deregulation of the banking industry of Iceland allowed its banks to acquire immense leveraged capital to run its operations which, in consequence, culminated in an unprecedented financial crisis that had both national and international consequences. Pre-2000 Icelands Public Policy towards its Financial Markets Iceland always conducted a protective approach of its public policy towards the national and international activities of the banking sector prior to the year 1990. For example, as


explained by Benediktsdottir et al, Before the liberalization of Icelands credit markets in the 1990s, nominal interest rates were set by the central bank which was controlled by the government, and real interest rates were kept negative until the late1980s (2010). An additional example of how protective was Iceland towards its financial sector is the policy towards the rationalization of the capital of its banks. The laws were enacted in 1931 and remained constant until 1994.i With the protective approach towards its public policy, Icelands economy experienced an annual growth of 2.6% on average throughout the 20th century, allowing it to become one of the richest societies in the world (Benediktsdottir, Danielsson, & Zoega, 2010).ii As a result of protective public policies from the years 1930 to 1990, the banking sector of Iceland was heavily regulated and politicized.iii Landsbanki, Kaupping and Glitnir were the 3 major banks of Iceland, which were state owned and operated, in the most part, only with capital from Icelands economic sectorsiv with little exposure to international markets.v In the international organizations arena, Iceland was only affiliated with institutions that were not intrusive to its national policies. Iceland was a founding member of the International Monetary Fund (IMF), one of the original members of the Organization for Economic Cooperation and Development (OECD) and part of the European Bank for Reconstruction and Development (EBRD).vi In the late 1980s, Iceland started to change its policies in order to engage in a marketbased framework.vii In the mid 1990s, Iceland joined the World Trade Organization (WTO) and the European Economic Area Agreement (EEAA). Structural changes were necessary to join these NGOs. Icelands public policies were enacted in order to move away from government


intervention in markets towards creating a more competitive environment (OECD, 1998 ). The medium-term objective of the government in the financial area was to achieve open to external financial influences and advantages (OECD, 1998 ). As a result, between the years 1990 and 2000, Iceland underwent a period of financial liberalization and deregulation that included central bank reforms, the development of securities markets and a stock exchange, and the liberalization of capital movements in and out of Iceland (Centonze, 2011). Some examples of the changes and additions in public policy that affected directly the financial sector in Iceland were the liberalization of capital movements in 1990, new foreign exchange legislation in 1992, new legislation on foreign direct investment was passed in 1996, and the abolition of liquidity ratios imposed on commercial and savings banks by the end of 1999.viii In Addition, in the 199O's, a number of Icelandic banks consolidated by merging together, and expanded their operations domestically by merging with investment banks, insurance companies and securities firms (Centonze, 2011). For the first time, global policy influenced Icelands public policy decisions, specially, with the deregulation of its financial industry. Jonsson (2009) explains that Icelandic law had kept investment banking separate from retail banking, in the spirit of the United States GlassSteagall Act.ix But once it entered the European Economic Area, the country also adopted EU banking legislation, which essentially allowed the same institutions to accept retail deposits while being engaged in investment banking activities. In turn, banks in Iceland were building a framework to become universal banks. When Iceland became a member of the EEA Treaty, it adopted the EUs directives into Icelandic law.x As explained by Benediktsdottir et al, some of the changes made when Iceland


adopted the EUs directives into law were increased authorization to invest in non-financial businesses, increased authorization to extend credit to directors, increased authorization to invest in real estate and real estate companies, increased authorization to lend money to buy own shares, reduced requirements concerning the operating structure of securities companies, increased authorization to operate insurance companies, and increased authorization for ownership in other credit institutions. It is important to mention that the directives posed by the EU did not prevent member states from maintaining or setting stricter rules in relation to the credit institutions in the home country as long as they satisfied the main objectives required by the provisions of the EU and the EEA Treaty (Benediktsdottir, Danielsson, & Zoega, 2010). But Iceland policy makers chose not to impose strict regulations to the new directives for they were aiming to increase Icelands competitiveness in the international arena. In consequence, these structural changes of Icelands policies were the beginning of a privatization and deregulation era which sought more exposure to international financial markets and more growth. The Privatization and Deregulation of the Banking Sector In the early 2000s, Iceland continued the liberalization of its economy. Capital markets were established, capital controls abolished and the commercial banks privatized (Benediktsdottir, Danielsson, & Zoega, 2010). Icelands government allowed the privatization of two of the largest, state owned, commercial banks, the Landsbanki and the Buraoarbanki.xi Also, FBA, an investment credit fund, was privatized and merged with Glitnir Bank to become the third largest bank of the country.xii The reforms that culminated in the privatization and the deregulation of the banking sector of Iceland were enacted under the Conservative Independence


Party administration in 1991.xiii Centonze (2011) explains that Iceland rapidly became a marketbased economy similar to those found in the European Union, with a growing entrepreneurial class that led to the launch of biotechnology and software companies, foreign mergers and acquisitions and, perhaps most importantly, the exponential development of the country's financial system. Moreover, several factors and policies accounted for the unprecedented expansion and success of the privatization of the banks in Iceland between the early 2000s until 2005. First, the global and local economic environment was strong in the early 2000s. Productivity, real GDP, income, equity and real estate values were growing.xiv Centonze explains that the combination of high liquidity and low interest rates created favorable conditions for the expansion of financial markets under the mentioned favorable economic conditions (2011). Second, due to the policies towards the liberalization of financial markets and capital movements, Iceland could enjoy the benefits of looking for new, bigger business opportunities overseas while having virtually no competition in the local arena (Centonze, 2011). Third, the privatized banks were sold to individuals who were related or affiliated with the two parties in power, which gave little incentive for policy makers to enact laws that limited the progress of the banks. xv Fourth, by 2003, the participation of governmental institutions in the financial market was limited primarily to mortgage lending through institutions such as the Housing Financing Fund (Centonze, 2011). Initially, the outcomes of the public policy changes towards deregulation and privatization, which expanded the banking sector, were critical to the global banking activities of Iceland, which permanently affected its financial markets landscape. With the liberalization of capitals, Iceland could finally adopt an external, global oriented market focus. Consequently, Icelands banking sector benefited in two ways. Banks had more opportunities to participate in


acquisitions and branch expansions in foreign countries, which in turn, would bring more capital and customers to the entities. Icelandic banks' foreign acquisitions included other banks, securities companies and other financial service firms abroad totaling approximately ISK904.2 billion ($15.85 billion) over the 1995-2005 period.xvi Diversification was in focus and Icelandic banks began to offer financial services to other European countries. For instance, Landsbanki created the Icesave, which was a deposit program for the European market. Icesave offered an easy-access, on-line savings account for international customers. Centonze says that by late 2008, Landsbanki had over 300,000 Icesave depositors in their UK branches with deposits of more than ISK702 billion ($6.55 billion), and over 125,000 depositors in their Netherlands branches with deposits of approximately ISK289 billion ($2.45055 billion). The idea was to extend Icesave to more countries in Europe through online banking. In addition, the exposure to international markets allowed local customers from Iceland to fund their foreign ventures without the need of looking for a foreign source of capital. The objective of foreign expansion, as Centonze explains, was part of the banks' efforts to go beyond the limited market opportunities of a small country, and to diversify their income stream, depositor and investor bases; thereby, decreasing risk and extending growth opportunities (2011). Screenshot of Icelands Financial Markets from 2000 to 2008 The aggressive growth through foreign acquisition, investment and branch extension that resulted after the deregulation of the banking industry enabled Icelandic banks to extend their operations to many other countries and to exponentially increase their activities in the local arena.xvii Jonsson (2009) explains that once equity constraints were minimized and friendly foreign wholesale markets became available, the three banks (the then privatized Landsbanki, Buraoarbanki and Glitnir), rapidly began to expand their lending. The local economy


experienced a total change. Corporate debt, measured as the ratio of Icelands GDP, doubled from 2000 to 2003.xviii The loan-to-deposit ratio of the Icelandic banks stood between 20 and 30 percent, and the majority of their new lending to corporations was done in foreign currency. xix Net foreign debt of the banks went from 33 percent of GDP to 55 percent.xx As stated by Jonsson, by 2003, the median Icelandic corporation had attained the debt equity ratio of 150 to 200 percent; by contrast, a comparable company in Scandinavia maintained a leverage ratio of about 50 percent (2009). Therefore, the public policies that transformed the financial sectors of Iceland brought a wave of foreign debt and leverage to its economy. In consequence, the banking sector deregulation and the policy of openness towards global markets allowed Icelands banks to acquire its capital through the European bond market. Credit ratings agencies gave an AAAxxi credit rate to Icelands which allow them to acquire capital at competitive rates. Benediktsdottir et al (2010) explains that in the two-year period 2004-2005, the three biggest banks borrowed around 21 billion EUR in foreign debt securities markets, or about two times Icelands annual GDP at the time and at very favorable interest rates.xxii The banks managed to borrow this much because they were commercial banks with a high CAD ratioxxiii domiciled in a country where the sovereign had a good credit rating (JNSSON, 2009). Icelands enormous access to financial capitals with favorable rates came to a halt in 2006. As stated by Benediktsdottir et al, except for ten years between 1945 and 1955, Iceland's current accountxxiv was always in a low deficit, at around 10% of GDP. The deficits began to increase in the early 2000's and reached 25.5% of GDP in 2006. Jonsonn (2009) recalls that Fitch Ratings published a report in February 22 which said that the agency had revised the outlook on Icelands long-term sovereign rating to negative from stable. Fitch described the macroeconomic


imbalances and raised concerns about how well the broader financial system would cope if the economy suffered a hard landing. As a result, domestic liquidity was in risk due to the credit downgrade. Icelands banks had to pay more, through interests, in order to obtain more capital from foreign markets, which in turn, contributed to the depreciation of the Krona and to a high inflation. Ultimately, the support that the banking industry needed after the credit downgrade came in the form of a sharp increase in collateralized lending. As part of the deregulatory policy of 2002, the government of Iceland allowed the use of collateralized debt to fund its banking industry (Centonze, 2011). The banks were borrowing around 150 billion ISK (around $1.13 billion) at the beginning of the year 2007, but that had increased to well over 400 billion ISK (around $3.4billion) in the summer of 2008 and topping of at close to 500 billion ISK ($3.9 billion) as the banks started to falter after the middle of September 2008 (Benediktsdottir, Danielsson, & Zoega, 2010). In consequence, Jonsonn describes that the capital of the Icelandic banks at the end of 2007 was nearly eight times larger than at the end of 2002. By 2007 external assets exceeded 400% of GDP and external liabilities exceeded 500% of GDP. At the end of 2007, the total assets of the banks had grown from 96% of GDP in 2000 to 900% of GDP.xxv The use of collateralized debt was the final leveraged funding activity that the Icelandic banks incurred to before the financial crisis of 2008. The 2008 Crisis 2008 was the year when the high leveraged, privatized bank industry of Iceland sunk. As explained by Benediktsdottir, Icelands banking system collapsed over a period of two weeks in October 2008 and the stock market was almost completely wiped out with over a 75% decline in


the main stock market index during those two weeks (2010). Between November 2007 and June 2008 the Krona dropped 24% against the euro.xxviThe fall in the Krona skyrocketed inflation and the CBI (Central Bank of Iceland) raised its policy rate to 15.5% in April 2008 in order to slow inflation, but it was not successful.xxvii The fall in the Krona pushed inflation into double digits to an annual rate of 11.8%, the highest in 18 years.xxviii GDP decreased in real terms by 6% between 2008 and 2009.xxix Unemployment rose from 2,3% in 2007 to 7,2% in Central government budget deficit went from 0% to 14% of GDP.xxxi The cause of the collapse of the financial sector of Iceland is, in essence, attributable to the public policies of deregulation and the privatization of its banking sector, topped with inadequate macro policies, such as its financial internationalization policies. The public policies that allowed the banks to rise and lend huge amounts of leveraged capital did not include proper supervision and control of the banking high leveraging activities. The country had no officials with the oversight and mandate to make independent observations about systemic risk and viability (Centonze, 2011). The authorities did not realize how fragile the banking system was since they had been led to believe by the banks that they had liquidity that would last until the end of 2009.xxxii The public policies that internationalized the banking sector of Iceland allowed bankers to take risks with money sourced from their customers in the agencies outside of Iceland, which in turn, diminished the motivation from authorities to bring back some regulation to the control of capitals of the private banks that were given up in the privatization era (1992-2002). It seems that there was simply too much money being made in Iceland with the risk being passed to foreign individuals. Back to the Basics: the Nationalization of the Landsbanki, Buraoarbanki and Glitnir


The crisis led the government to use aggressive public policy, but this time, they nationalized back the banks. As explained by Centonze, British depositors in Landsbanki's Icesave accounts panicked at the news from Icelands collapse and withdrew approximately 200 million (ISK38.9 billion) from their accounts. The UK Financial Services Authority (FSA), Britain's financial regulator, demanded that Landsbanki replenish its London branch with the same amount. The banks, due to their lack of liquidity, were not able to do so and looked for government assistance. In consequence, the first nationalized bank was Landsbanki in October of 2008. The government assured Icelandic depositors that their money was save, but it did not show the same convictions with the money of the depositors of the international branch of Landsbanki, Icesave. Depositors in the UK Austria, France, Germany, Russia, the Netherlands and other countries across Europe also discovered how their deposits were threatened by the financial crisis of Iceland. As a result, political frictions aroused between Iceland and the countries in which it opened the international branches of its banks. The UK took extreme measures against Iceland. On October, 2008 the UK government invoked its 2001 anti-terrorism legislation to impose financial sanctions against Iceland's actions which it believed to be detrimental to the country's economy (Centonze, 2011). At the same time, Buraoarbanki and Glitnir defaulted and looked for government help as well. However, the nationalization of the three banks provided little relief to the financial burden that the combined obligations of the banks represented. The debt was simply too big for the country to control. Hence, Iceland asked the assistance of the IMF (International Money Fund) at the end of 2008. The assistance of the IMF amounted to a two-year $2.1 billion standby


arrangement.xxxiii In addition, the Fund made $827 million immediately available to pay for due obligations.xxxivJonsson (2009) mentions that the loan made Iceland the first western European country to receive an IMF loan since the UK in 1976. Subsequently, as with any loan that the IMF extends to a country, there were strings attached to it. The Icelandic government had to make deep changes to its public policy and the structure of its financial system in order to receive the help from the IMF. First the IMF ordered the restructuration of the 3 now nationalized banks. This restructuration prohibited the banks to engage in international transactions. It only allowed inflows from national deposits. Also, the IMF ordered an equaling a capital adequacy ratio of at least 10%, and apply stronger regulatory and supervisory practices to the banking sector (Centonze, 2011). Second, Iceland had to allow foreign experts to build the new financial framework in which the banks would now operate, increasing supervisory practices and allowing the international auditors to value the assets of the banks. Third, settle all the disputes that the banks had through their international branches for losses on deposits. Fourth, plan for a medium-term fiscal consolidation program beginning with the 2010 budget to achieve a small structural surplus by 2011 and debt (approximately 80% of GDP at the time of the crisis) sustainability going forward (Centonze, 2011). Evidently, the measures imposed to Iceland show how the country lost the majority of its sovereignty in public policy decisions towards its financial system. The IMF restructured the financial frameworks that were enacted and grew from the early 1990s to the privatization of the banks in 2002. The IMF deducted that the privatization of the banks was not properly regulated. In addition, the EEA revised its policies. Benediktsdottir et al explain that, It (the EEA) is currently proposing to set up bodies tasked with monitoring and supervising financial institutions in Europe. These are the European Systemic Risk Board (ESRB), and European Banking


Authority (EBA) and European Securities and Markets Authority (ESMA) (Benediktsdottir, Danielsson, & Zoega, 2010). The creation of more solid policies by the EEA shows how the crisis in Iceland impacted the policies of the whole European economic sector. Conclusion The events that transcended in 2008 in Iceland have been recorded as the worst financial crisis in the history of the world relative to the size and the population of the country. The adoptions of public policies that were supposed to strengthen the financial markets of Iceland consumed the country in less than 20 years. In 2008, I remember watching in the news how Icelanders took the streets and protested on how their government sold the country to the bankers. The crisis, which included a 100 percent currency depreciation, collapse of property prices, 95 percent wipeout of the stock market, 10 percent unemployment, terrorist sanctions, a credit freeze, double-digit inflation and so on, Iceland. The crisis culminated with the IMF and the EU intervention. The intervention has been heavily criticized by the citizens of Iceland because they know that the sovereignty of their country has been mocked in order to make up for the mistakes that generated millions of Krona to the financial sector of Iceland. Finally, I would like to present an excerpt of the conclusion of the report that the Special Investigation Commission (SIC) conducted. It summarizes the consequences of the public policies that changed Iceland forever. When the size of the financial system of a country is nine times its gross domestic product the roles are reversed. This was the case in Iceland. It appears that both the turmoil the entire, successful economy of


parliament and the government lacked both the power and the courage to set reasonable limits to the financial system. All the energy seems to have been directed at keeping the financial system going. It had grown so large, that it was impossible to risk that even one part of it would collapse.


Works Cited Benediktsdottir, S., Danielsson, J., & Zoega, G. (2010). Lessons from a collapse of a financial system. Yale University; London School of Economics; University of Iceland and Birkbeck . Centonze, A. (2011). Iceland's Financial Meltdown. Journal of Financial Education, 37(1/2), , pp. 131-166. Jonsson, . (2009). Why Iceland? McGrow Hill. O.E.C.D.. (1998 ). Deregulation of the financial sector. OECD Economic Surveys: Iceland. S.I.C. (2010). Report of the Special Investigation Commission (SIC). Retrieved from



(JNSSON, 2009) (JNSSON, 2009) iii (Benediktsdottir, Danielsson, & Zoega, 2010) iv Such as the fishing sector (Centonze, 2011) v (Benediktsdottir, Danielsson, & Zoega, 2010) vi (Centonze, 2011) vii OECD Economic Surveys: Iceland viii OECD Economic Surveys: Iceland ix This act separated investment and commercial banking activities. x (Benediktsdottir, Danielsson, & Zoega, 2010) xi (OECD, 1998 ) xii (Centonze, 2011) xiii (Centonze, 2011) xiv (Centonze, 2011) xv (Benediktsdottir, Danielsson, & Zoega, 2010) xvi (Centonze, 2011) xvii Norway, Finland, Sweden and Denmark, Austria, Germany, UK, Ireland, Canada, US and China. xviii (JNSSON, 2009) xix (Centonze, 2011) xx (JNSSON, 2009) xxi Top of the Fitch credit rating scale. xxii Interest rates of only 15 to 25 points over the benchmark interest rate (BGH (2010), chapters 7 and 21). xxiii consolidated total regulatory capital / total risk-weighted volume xxiv A countrys total imports of goods, services and transfers compared to the country's total export of goods, services and transfers.ii xxv

(Centonze, 2011) (Centonze, 2011) xxvii (Centonze, 2011) xxviii (Centonze, 2011) xxix (Centonze, 2011) xxx (Centonze, 2011) xxxi (Centonze, 2011) xxxii (Benediktsdottir, Danielsson, & Zoega, 2010) xxxiii (Centonze, 2011) xxxiv (Centonze, 2011)xxvi