UNIVERSITY OF MALTA

Title: The Impact of the Global Economic Slowdown on Two Small Island States of Europe, Iceland and Malta

EST 3333:Dissertation

Jacob Borg

[2011]

To my family and girlfriend.

Acknowledgments

ii

I would like to thank my tutor Ms. Moira Catania for her help in giving my

ideas a structure and coherence and Dr. Glorianne Briffa for proof reading my

work.

UNIVERSITY OF MALTA

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FACULTY/INSTITUTE/CENTRE:

DECLARATION

Student’s I.D. /Code

Student’s Name & Surname

Course

Title of Dissertation

I hereby declare that I am the legitimate author of this dissertation and that it is my original work.

No portion of this work has been submitted in support of an application for another degree or qualification of this or any other university or institution of learning.

Signature of Student Name of Student

Date

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Abstact

The financial crisis and resultant global economic slowdown caught

many by surprise, but the underlying vulnerabilities in the financial sector had

been building up for years. This dissertation argues for the inclusion of financial

stress indicators as a supplement to the more ‘traditional’ macroeconomic

indicators and tracks the lead up and impact of the crises on two small European

states, Iceland and Malta.

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Table of Contents

Chapter One: Introduction................................................................................11. Introduction.....................................................................................................21.1 A Global Overview.........................................................................................21.2 Research Question and Methodology.............................................................41.3 Data Collection and Graphical Representation...............................................61.4 Literature Review............................................................................................71.4.1 Financial indicators..............................................................................111.4.2 Regional integration.............................................................................141.5 Dissertation Structure....................................................................................15Chapter Two: Iceland.......................................................................................162. Iceland.............................................................................................................172.1 Background and Politics...............................................................................172.2 EEA Membership and Deregulation.............................................................182.3 Macroeconomic Indicators and the Financial Sector....................................202.3.1 Inflation and Current Account...................................................................242.3.2 Icelandic Central Bank and Financial Services Authority.........................272.4 Aftermath of the crises..................................................................................28Chapter Three: Malta.......................................................................................313. Malta...............................................................................................................323.1 Background and Politics...............................................................................323.2 EU Membership and Foreign Investment.....................................................333.3 Macroeconomic Indicators............................................................................373.3.1 Inflation and Current Account...................................................................393.4 The Financial Sector.....................................................................................433.4.1 Key Exposures...........................................................................................443.5 Aftermath of the crises..................................................................................46Chapter Four: A theoretical framework for analysing the crisis.................484. A theoretical framework for analysing the crises...........................................494.1 The importance of financial indicators.........................................................494.2 Hyman Minsky..............................................................................................494.2.1 Displacement stage.....................................................................................504.2.2 The boom phase.........................................................................................524.2.3 Euphoria stage............................................................................................524.2.4 Profit taking and Bust.................................................................................564.3 Cumulative Financial Indicators...................................................................604.4 A Holistic View.............................................................................................64Chapter Five: Financial Regulatory Lessons Learnt from the Crisis..........655. Financial Regulation.......................................................................................665.1 Financial regulatory shortcomings................................................................665.2 Cross border responsibility...........................................................................675.3 Financial Stability Reporting........................................................................685.4 The De Larosière report................................................................................715.5 Procyclicality in Financial Regulation..........................................................725.6 The Role of Monetary Policy........................................................................755.7 Taking heed of the lessons learnt..................................................................75Bibliography......................................................................................................78

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Table of figures:

2.1 Procyclicality and Volatility ……………………………………………….232.2 Employment Rate ………………………………………………………….232.3 Unemployment Rates …………………………...…………………………242.4 12 Month Inflation ………………………………………………………... 262.5 Króna v. Euro ……………………………………………………………...29

3.1 FDI Flows 2003-2008 ……………………………………………………..353.2 Exports of Goods by Sector ……………………………………………….363.3 Exports of Services by Sector ……………………………………….……. 363.4 Government Current Expenditure …………………………………………413.5 Capital Expenditure ………………………………………………………. 413.6 Unemployment Rates ……………………………………………………...423.7 Employment Rate ………………………………………………………….423.8 Inflation Rates ……………………………………………………………..43

4.1 Bank Assets as a % of GDP, Iceland-Malta ……………………………… 514.2 Bank Assets as a % of GDP Malta ……………………………………….. 514.3 Stock Market Indices Iceland and others …………………………………. 544.4 Stock Market Indices Malta and others …………………………………... 544.5 Property Prices in Iceland ………………………………………………… 554.6 Property Prices in Malta ………………………………………………….. 554.7 GDP Growth Iceland v. Malta ……………………………………………. 574.8 General Government Surplus/ Deficit Iceland v. Malta ………………….. 584.9 General Government Debt Iceland v. Malta ……………………………… 584.10 Unemployment Rates Iceland v. Malta …………………………………. 594.11 Inflation Rates Iceland v. Malta ………………………………………….594.12 M2 Money Supply y.o.y % change Iceland v. Malta …………………….624.13 M2 Money Supply since 2003 Iceland v. Malta ………………………… 624.14 Total Credit to Residents y.o.y % change Iceland v. Malta …………….. 634.15 Total Credit to Residents since 2003 Iceland v. Malta ………………….. 63

5.1 Number of Countries Publishing FSR’s …………………………………...695.2 How to existing FSR’s compare? …………………………………….........695.3 Property Relates Loans …………………………………………………… 745.4 Traditional and Dynamic Provisions ……………………………………....74

Abbreviations

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CBM Central Bank of Malta

EEA European Economic Area

FDI Foreign Direct Investment

FSA Financial Supervisory Authority

FSR Financial Stability Report

GDP Gross Domestic Product

ICB Icelandic Central Bank

IMF International Monetary Fund

EFTA European Free Trade Agreement

EU European Union

M2 Broad Money

MFSA Maltese Financial Services Authority

SMEs Small and Medium Enterprises

UHM Union Ħaddiema Magħqudin

UNCTAD United Nations Conference on Trade and Development

UNDP United Nations Development Programme

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Chapter One: Introduction

1.Introduction

1.1 A Global Overview

The financial crisis and ensuing global economic slowdown adversely

affected most states integrated into the global economy, with world trade

contracting by 12.2% in 2009.1 Small states by nature are inherently more

vulnerable to external shocks due to their “structural openness to international

trade, high dependence on a narrow range of exports and reliance on strategic

imports”.2 These vulnerabilities can be split into two categories: inherent and

self imposed. Inherent vulnerabilities relate to issues such as smallness and

geographical location, whereas self imposed vulnerabilities concern

macroeconomic management, fiscal policy and governance. It is the self

imposed vulnerabilities and resilience building that will be analysed in this

paper, with the points of focus being Iceland and Malta, in order to establish

how the two country’s policy decisions in the macroeconomic and political

sphere helped them fare throughout the crises.

It is important to draw a distinction between the initial economic

effects felt by the financial crisis and the second round effects brought about by

the global economic slowdown. The latter filtered down to the real economy and

put pressure on governments fiscal management, more so in a country like

Iceland that already had to contend with a state bailout of its' banking system.

Iceland's troubles began during the outbreak of the financial crisis due to its over

1 “The Trade Situation in 2009/2010,” World Trade Organisation, 23 Jul. 2010, 9 Feb. 2011,

< http://www.wto.org/english/res_e/booksp_e/anrep_e/wtr10-1_e.pdf>.

2 Lino Briguglio, et al., “Profiling Economic Vulnerability and Resilience in Small States:

Conceptual Underpinning,” Economics Department, University of Malta, 2006: 1.

2

extended banking sector, a problem with which Malta's more conservative

financial sector did not have to contend with initially.

Iceland was faced with a sweeping contraction in economic activity

leading to a significant fall in real gross domestic product (GDP) of -6.9% in

2009 after sluggish growth of just 1% in 2008. This was coupled with a 50%

drop in investments, particularly in the construction and services sector, and a

16% decline in private consumption.3

Iceland’s public finances were also badly hit as the banking sector had

to be bailed out, driving a government deficit of -13.5% of GDP in 2008 during

the height of the crisis, and -9.1% in 2009 following on from surpluses of 6.3%

and 5.4% in 2006 and 2007 respectively.4 The Icelandic Króna also

depreciated by more than 70% in 2008,5 which lead to the

extreme measure of placing capital controls on non-resident

Króna holdings, the amount of which totalled 40% of GDP 6 to

prevent further outflows and downward pressure on the

currency value.

Malta’s GDP growth during the crisis decelerated to

2.1% in 2008, down from 3.9% in 2007,7 largely reflecting

global conditions. Spiralling oil prices in 2008 hit the island

3 “European Economic Forecast Autumn 2010: Iceland,” European Commission, Brussels 29 Nov. 2010: 157.

4 “Public Balance and General Government Debt,” Eurostat, 29 Nov. 2010, 2 Apr. 2011, <http://epp.eurostat.ec.europa.eu/>. 5“Iceland: Selected Issues,” IMF Country Report, No. 07/296, Washington, D.C. Aug.2007: 5.

6 Ibid. 12.

7 “Implementation of the Lisbon Strategy Structural Reforms,” European Commission, Brussels 28 Jan. 2009: 38-39.

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badly, as it is almost 100% dependent on imported energy,

pushing inflation up. Real GDP fell by -2.1% in 2009,

exacerbated by the fact that the government had to strike a

balance between economic stimulus and fiscal sustainability,

given the fact that Malta’s deficit was -4.8% of GDP in 2008 and

-3.8% in 2009,8 leading the European Commission to initiate the

excessive deficit procedure. The stability of the Euro also

played its part in sheltering the Maltese economy from the

worst of the crisis, but by no means is the single currency a

panacea to all economic woes, as has been proven in Greece,

Ireland and Portugal.

The global economic slowdown further destabilised Iceland's already

volatile economy, putting the need for fiscal consolidation on the back burner

given the more urgent need of bailing out the collapsed banking sector in order

to avoid further damaging the economy. Malta, having been spared the worst

effects of the financial crisis, was in a better position to respond to the

slowdown in the real economy. However, several industries particularly in the

manufacturing and tourism sectors did not fare well and the recent trend of

falling government deficit and debt was also reversed.

1.2 Research Question and Methodology

One of the main scopes of this dissertation is to look at the factors that

led to two similarly sized small states, both with populations under the 500,000

8 “Public Balance and General Government Debt,” Eurostat, 29 Nov. 2010, 2 Apr. 2011, <http://epp.eurostat.ec.europa.eu/>.

4

mark and very open economies, being affected so differently by the global

financial and economic crises. In addition to this, the potential use of financial

stress indicators to supplement macroeconomic indicators when compiling

resilience indices will be analysed, along with their usefulness in predicting

asset price bubbles and financial market distress. Finally, the role of the

European and global financial regulatory framework in contributing to the crises

and their effect on Iceland and Malta will also be assessed.

The similarity in size and economic composition is the reason as to

why Iceland and Malta were selected for comparison. Both countries have

governments that are highly involved in the domestic sector, with government

expenditure reaching 45.8% of gross domestic product (GDP) in Iceland, 9 and

45.6% of GDP in Malta in 2009. 10 The two countries also enjoy a comparable

level of trade freedom according to the Index of Economic Freedom,11 with

Iceland assigned a rating of 88.2/100 and Malta 87.6/100. Malta’s average tariff

rate in 2008 was 1.3% as set by the EU, where as Iceland’s was 1.1% in 2008.12

However, non tariff barriers, in particular in the agricultural sector are high in

both Malta and Iceland. The fact that they are both small states means that

imports and exports play a large part in their economies, Malta’s trade

integration (Trade as a % of GDP) is 183.0% and Iceland’s 112.9%, 13 therefore

9“Iceland: Fiscal Freedom,” Heritage Foundation and The Wall Street Journal, 2011, 9 Feb. 2011, <http://www.heritage.org/Index/Country/Iceland#fiscal-freedom>.

10“Malta: Fiscal Freedom,” Heritage Foundation and The Wall Street Journal, 2011, 3Feb. 2011, <http://www.heritage.org/Index/Country/Malta>.11

?“2011 Index of Economic Freedom,” Heritage Foundation and The Wall Street Journal, 2011, 16 Apr. 2011, <http://www.heritage.org/Index/>.

12 Ibid.

13 “World Trade Indicators 2009/2010,” World Bank, 2011, 10 Mar. 2011, <http://web.worldbank.org.>.

5

rewarding the sectors in which they possess a comparative advantage. The

Icelandic banking sector was one such niche in which a comparative advantage

was enjoyed, and the lack of diversification may have been one of the reasons

why Iceland’s economy was hit so badly during the crises.

Economic indicators are necessary to help identify the

main differences in Iceland and Malta’s macroeconomic

stability. Thus data from the real economy, such as inflation

and unemployment, the fiscal position of the respective

governments, external debt to GDP ratios and state of the

financial sector prior to the crisis will all be taken into account

in order to help deduce whether there is a link between these

different factors and the performance during the crisis. In order to

do this it is also necessary to analyse a variety of pre-crisis economic and

political conditions in the two countries in question. The time span taken into

consideration will mainly range from 2003 to 2009 in the case of economic data,

with qualitative political data from the early 1990’s also being examined.

The early 1990’s was an important period for both countries as they

were looking to increase their integration with the European continent through

different avenues. Iceland’s membership of the European Economic Area (EEA)

in 1994 gave its economy the impetus needed for rapid expansion as trade and

access to a larger market is of great benefit to small economies due to their high

trade to GDP ratios. Malta's membership of the EU and Euro zone will also be

taken into account.

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1.3 Data Collection and Graphical Representation

The bulk of the quantitative economic data14 presented in this paper is

sourced from specialist international reports, journals and databases, such as

Eurostat and UNCTAD. International Monetary Fund (IMF) country reports and

European Commission reports on Iceland and Malta were of particular

importance when compiling this dissertation due to their pragmatic and

unbridled nature. Other important sources of information were publications from

the two nations’ respective central banks and statistical offices. Whenever

possible, the graphs in this dissertation were compiled by the author using the

program SigmaPlot.

Qualitative data was also of importance, particularly reports outlining

the developments taking place prior and during the crises in the form of official

reports, critical analyses and regulatory proposals.

1.4 Literature Review

There is much debate in the literature as to whether statistical indices

can effectively help identify vulnerabilities building up in the real economy and

financial sector and also be of sufficient accuracy to help policy makers respond

to these build ups in a proactive rather than reactive manner.

Brigulgio15 identifies economic vulnerability as being “the exposure of

an economy to exogenous shocks arising out of economic openness,” whereas

resilience is defined as “the policy induced ability of an economy to withstand

14 The cut off point for new data was April 2011.

15 Lino Briguglio, et al., “Profiling Economic Vulnerability and Resilience in Small States:

Conceptual Underpinning,” Economic Department, University of Malta, 2006

7

or recover from the effects of such shocks.” Briguglio presents four scenarios

into which states may be placed, namely: best case, worst case, self made and

prodigal son. Both Iceland and Malta are in the self made category, which is

defined as “countries with a high degree of inherent economic vulnerability but

that are economically resilient through the adoption of prudent policies that

enable them to withstand or cope with the effects of their inherent

vulnerabilities.”16

In the construction of a resilience index Briguglio places importance

on four broad factors that help identify the effect of shock absorption or shock

counteraction policies across countries.17 The factors in questions are:

– “Macroeconomic stability”

– “Microeconomic market efficiency”

– “Good governance”

– “Social development.”

The macroeconomic pillar is constructed using three variables namely,

the fiscal deficit to GDP ratio, the sum of unemployment and inflation rates

and the external debt to GDP ratio. These variables only give a snapshot of a

country’s economy over a three year period 18 and are highly susceptible to

being skewed by one off results. For example, general government debt in

relation to GDP was a relatively low 26.1% in Iceland during 2005, whereas

in previous years it was 44.5%, 39.0% and 36.0% (2002-2004).19 Another

16 Lino Briguglio, et al., “Economic Vulnerability and Resilience: Concepts and Measurements,” United Nations University, Research paper No. 2008/55, May 2008: 2. 17 Ibid 7.

18 Lino Briguglio, et al., “Profiling Economic Vulnerability and Resilience in Small States:Conceptual Underpinning,” Economic Department, University of Malta, 2006: 14.

19“Commission Opinion on Iceland’s Application for Membership of the EU,” European Commission, Brussels, 24 Feb. 2010: 92+.

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example in Malta’s case is the government deficit registered in 2003 which

stood at 9.7% of GDP20, a figure disproportionately higher than those from

previous years due to the cost of restructuring the entities formerly known as

Malta Dry Docks and Malta Shipbuilding.

The use of unemployment figures covering a short period of time is

not without its perils, especially in small states like Malta or Iceland, where the

public sector is often used to lower the unemployment rate during an election

year. Furthermore, if an economy is at or nearing full employment as is usually

the case near the peak of a business cycle, unemployment figures will be close

to their natural level but this will not capture the underlying vulnerabilities

potentially building up in the economy as characterised by Iceland’s low

unemployment rate of 2.6% and high employment rate of 83.8% in 2005.21

The application of a five year average as opposed to three years for the

above variables may serve to smooth out some inaccuracies that may result from

one off results, although Briguglio’s resilience index spans 86 countries from a

variety of regions all around the globe, so it is worth acknowledging that

feasibility constraints both in time and finances may exist in doing so.

Microeconomic market efficiency is another variable used by

Briguglio in the compilation of the resilience index. In an earlier study,

Briguglio equates efficiency in the financial markets with the markets ability to

respond to adverse shock by means of higher interest rates and lower asset

prices.22 To measure this, Briguglio utilises a component of the Economic

20“Report From the Commission: Malta in accordance with Article 104(3) of the treaty,” European Commission, Brussels, 12 May 2004: 2.

21 Commission Opinion on Iceland’s Application for Membership of the EU,” European Commission, Brussels, 24 Feb. 2010: 95.

22 Lino Briguglio, et al., “Profiling Economic Vulnerability and Resilience in Small States:

9

Freedom of the World index. This index measures markers such as: the amount

of private firms in the banking industry, the ability of foreign banks to compete

in the market, the amount of credit supplied to the private sector and the extent

to which credit controls interfere with the credit market.23 Easy access to credit

is certainly a marker of a bank doing what banks do best, that is, taking risks.

However, the problem of excess liquidity and its upward pressure on asset prices

has been demonstrated all too clearly in the financial crisis.

Whilst giving a fair overview of the openness and ability of individual

undertakings to compete freely in the financial market, the inclusion of these

variables in the resilience index does little to indicate whether the market as a

whole is sufficiently resilient to shocks. The fact that Iceland was ranked in first

place out of 86 countries on the resilience index, with a near perfect score in the

microeconomic efficiency category, would indicate some deficiencies in the

factors taken into account for the purpose of this index.

The last two variables used in the compilation of Briguglio’s resilience

index, namely good governance and social development, are taken from the

Economic Freedom of the World Index and UNDP human development index

respectively. Zahra24 identifies the ‘good governance’ part of the index as being

the main shortcoming of Briguglio’s study but this deals with “the impartiality

of courts, protection of intellectual property rights, military interference in the

rule of law, the political system and integrity of the legal system.” Therefore, it

is less problematic than the weaknesses already pointed out in the

macroeconomic and microeconomic indicators. Iceland and Malta both fared

Conceptual Underpinning,” University of Malta, 2006: 1+.

23 Briguglio 8.

24 Larkin Zahra, “Iceland’s Application to join the EU,” Diss. University of Malta, 2010: 28.

10

similarly in this part of the resilience index and going into the merits and

demerits of these two categories would be beyond the scope of this study. To

improve the resilience index more indicators from the financial sector need to be

incorporated into it. Some of these will be analysed below and in Chapter 4.

1.4.1 Financial indicators

Today’s financial markets are highly interconnected, driven on by the

forces of globalisation. Motout and Vitale25 identify four factors that challenge

the monetary transmission mechanism, which deals with the process in which

interest rate changes affect inflation.26 The first factor is the reduction of what

the authors term “home bias,” a swell in cross border capital flows driven by the

liberalisation of national financial markets,27 as exemplified in the case of

Iceland. Secondly, financial transactions have increased in importance in

relation to trade and services, thus heightening their influence on exchange and

interest rates. Thirdly, the interplay between exchange and interest rates has

been influenced by the uptake of inflation targeting and currency pegging by

central banks. Such inflation targeting often puts the need for asset price

monitoring on the back burner, leading to the possibility of asset price bubbles

appearing in a low inflation context.28 Fourthly, financial markets have become

extremely innovative, with multiple techniques for the transfer of risks, hence

25 Philippe Motout and Giovanni Vitale, “Monetary Policy Strategy in a Global Environment,” European Central Bank, Occasional Paper Series, No. 106/ Aug. 2009.

26“Monetary Transmission Method,” Biz/Ed, 2011, 14 Mar. 2011, http://www.bized.co.uk/virtual/bank/economics/mpol/mpc/theories1.htm>.

27 Motout 14.

28 Ibid 16.

11

increasing the channels of dissemination and transmission of financial shocks

across sectors and countries.29

Claudio Borio30 points towards the historic link between financial

distress and common exposure to macroeconomic risk factors across

institutions. Analysing macroeconomic indicators from the real economy and

microeconomic efficiency in the financial system in isolation makes it very

difficult to gain a clear picture of the health and resilience of an economy as a

whole, as in reality the two are intrinsically linked. The underlying causes

behind the collapse in Iceland did not occur overnight as the financial

imbalances built up over time. Borio states that “these financial imbalances,

associated with aggressive risk taking, are driven by, but also feed, an

unsustainable economic expansion.”31

Booms in asset prices are seen as one indicator of potential financial

distress. Another is the rapid expansion of credit and above average capital

accumulation.32 One study from the year 2000 found that a one percentage point

increase in the rate of growth of domestic credit increases the probability of a

banking crisis in the following year by 0.056%33. The main aim of such studies

is to help policy makers identify potential vulnerabilities in real time, using

readily available indicators and focussing on cumulative processes. Apart from

the lack of financial stress indicators, this is one of the key weaknesses of

29 Motout 14.

30 Claudio Boro, “The Macroprudential Approach to Regulation and Supervision: Where do we Stand?, Bank of International Settlements , 2006.

31 Claudio Borio, “Assessing the Risk of Banking Crises-Revisited,” BIS Quarterly Review Mar. 2009: 30.

32 Claudio Borio, “Asset Prices, Financial and Monetary Stability- Exploring the Nexus,” BIS Working Papers No.114 Jul. 2002: 1.

33

? Borio 11.

12

Briguglio’s indices as vulnerabilities are generally built up over an extended

period. 34

Borio also finds that problems exist when relying on the extent to

which inflation correlates with financial stability because it is possible for

financial imbalances to build up without any noticeable increases in inflation,

citing Japan’s negligible inflation rates from 1986 to 1988 whilst stock prices

nearly tripled 35 in the same period, together with a boom in property prices. A

similar low inflation environment was also present in Asia before the crisis in

1997, despite significant rises in asset prices and credit.36

A study carried out by Olafsson samples 46 medium to high income

countries in order to attempt to explain the cross-country disparity in post crisis

experience. His findings suggest that domestic macroeconomic imbalances and

vulnerabilities were a factor in determining the incidence and severity of the

crisis.37 Olafsson also singles out the importance of financial factors stating that

large banking systems tended to be associated with a deeper and more protracted

consumption contraction and a higher risk of a systemic banking and currency

crisis. The study finds that large banking systems with major cross border

operations are more vulnerable to a liquidity crisis, which tallies with the

Icelandic experience, as the Central Bank was limited to the domestic currency,

of which only a small portion of the banking system’s assets and liabilities were

made up of. Olafsson advocates that no blanket explanations can be given when

34 Borio 12.

35 Ibid 19.36

? Ibid 20.

37 Thorvardur Tjorvi Olafsson, et al., “Weathering the Financial Storm: The Importance of Fundamentals and Flexibility, Central Bank of Iceland, Working Paper No.51, Oct. 2010: 2.

13

attempting to explain the variation between countries and it is important to view

the conditions in each country prior to the crises in order to understand the post

crises outcomes.38

1.4.2 Regional integration

Pace39 believes that resilience building is of primary importance for

small states, and that they can do so by following prudent domestic policies and

by strategically positioning themselves in the regional and global system. He

argues that without access to the wide market offered by the European Union

(EU), European micro-states would be hard pressed to ensure their survival in

today’s globalised world. Small states tend to be more dependent upon external

trade as a driving force behind their economy because the domestic market is

not large enough to support large scale industries.40 Macroeconomic stability41 is

another advantage singled out by Pace in relation to EU membership and the

fiscal and monetary measures required for Malta to satisfy the Maastricht

criteria prior to the crisis certainly left the country in a more resilient position.

Both Iceland and Malta are highly engaged in European integration,

tallying with Thorhallsson’s belief that small states favour the

institutionalisation of interstate relations42 because all members are usually

38 Olafsson 2.

39 Roderick Pace, “ Malta and EU Membership: Overcoming ‘Vulnerabilities’, Strengthening ‘Resilience,” European Integration, Vol. 28 No.1, Mar. 2006: 33-49.

40 John Sloman, Economics, [Pearson Education Limited, England], 2003: 656.41

? Pace 37.

42 Baldur Thorhallsson and Anders Wivel, “ Small States in the European Union: What Do We Know and What Would We Like to Know,” Cambridge Review of International Affairs, Vol.19, No.4, Dec. 2006: 655.

14

subject to the same rules and face the same sanctions if they are broken.

Theoretically this allows small states to compete on a more level playing field

but in reality European Economic Area (EEA) members are less able to

influence EU regulations from the outside in what Norway has termed as a ‘fax

democracy,’ in reference to the fact that Brussels simply faxed new directives

for the Norwegians to follow.43 Wade points out that “adopting a set of rules is

one thing; enforcing them is another,”44 in reference to the regulation adopted by

Iceland’s Financial Services Authority as part of its EEA obligations. The

orientational nature of some of the European Union's regulatory framework puts

the onus on national administrations and regulatory bodies to properly

implement the regulations and directives, which often throws up differing

interpretations and results.

1.5 Dissertation Structure

The rest of the dissertation is structured as follows: chapter two deals

with the lead up to the crises in Iceland and its impact, chapter three deals with

Malta, chapter four places the crises within a theoretical framework and the final

chapter offers an overview of the main weaknesses in the European and global

financial regulations applicable to both Iceland and Malta.

43 Ivar Ekman, “ In Norway, EU Pros and Cons( The Cons Will Win),” The New York Times, 27 Oct. 2005, 16 Apr. 2011, <http://www.nytimes.com/2005/10/26/world/europe/26iht-norway.html?_r=1>.

44 Robert Wade, “The Crisis: Iceland as Icarus,” Challenge, May/June 2009: 21.

15

Chapter Two: Iceland

2. Iceland

2.1 Background and Politics

Iceland's economy has always been small and highly volatile but, prior

to the financial crisis in 2008, the tiny Nordic nation made pragmatic use of its

natural resources to achieve high growth rates and a standard of living

comparable to that of even the richest European countries. GDP per capita was

higher than that of the EU-27 average.1 High levels of both income and

corporate tax, close to the 50% mark in the mid-1990’s,2 helped fund a generous

welfare system, thus ensuring an even distribution of wealth and an educated

population, with literacy rates standing at 99.9%.3

Iceland had long been governed by a coalition government, mainly

between the Conservative and Progressive parties, leading to a situation where

politicians representing different parties and interests had little incentive to

curtail their spending demands. Individual ministries tended to function as small

empires, with inward looking policies and a lack of cooperation between

ministries loyal to different parties. Fiscal management had a propensity to

serve political rather than economic objectives, with a particular bias towards

procyclicality. The IMF 4 notes that this was particularly pronounced during the

good times, as government revenue is seen as common property between the

1 Commission Opinion on Iceland’s Application for Membership of the EU,” European Commission, Brussels 24 Feb. 2010: 94.

2 Hannes Gissurarson and Daniel J. Mitchell, “The Iceland Tax System,” Prosperitas, Aug. 2007 Vol. V11, Issue V: 4.

3 “Background Note: Iceland,” U.S Department of State, 21 Mar. 2011, 29 Mar. 2011, <http://www.state.gov/r/pa/ei/bgn/3396.htm>.

4 “Iceland: Selected Issues,” IMF Country Report, No. 07/296, Washington, D.C. Aug.2007: 10-11.

17

coalition, leading to higher spending, particularly on the government wage bill

(Figure 2.1) or tax cuts.

A number of reforms were adopted in 1990's to lessen the prevalent

fiscal mismanagement, one of which being the 'frame budgeting method.' This

method set goals with regards to revenue and expenditure of the treasury, after

which expenditures are divided amongst ministries and expenditure categories.

Each minister is responsible for his budget frame effectively acting as a minister

of finance for his affairs.5 Despite its best intentions, the frame budgeting

method failed to act as a sufficient deterrent to overspending, as notwithstanding

existing regulations, budget overruns rarely had any real consequences, due to a

lack of their enforcement.6

2.2 EEA Membership and Deregulation

The early 1990's also saw Iceland's membership of the EEA, an

economic agreement between the EU and EFTA (European Free Trade Area)

countries. The EEA gave Iceland access to a much wider market, allowing it to

benefit from the four freedoms associated with the EU's internal market. This

arrangement served to increase economic growth but at the same time it

increased the potential for risk taking as it gave Icelandic businessmen the right

to operate in Europe without any Icelandic government control. Being a small

state outside of the European Union with a limited administrative capacity,

Iceland had to implement a lot of EU legislation without having any say in the

decision making process.

5 Thorsteinn Thorgeirsson, “Frame Budgeting and Cost Assessment,” Ministry of Finance in Iceland, 6 Dec.2007: 1.

6 IMF 2007: 15.

18

Prior to EEA membership Iceland was very hesitant to join

international organisations for fear of surrendering its sovereignty. The small

size of the Icelandic Foreign Service and limited importance that politicians had

attached to international activity restricted its international capacity. 7 The lack

of experience and links in the international sphere had a negative impact on

Iceland once the financial crisis hit as it found it very difficult to garner support

and sympathy for its cause among its political allies.

Privatisation in the financial sector began in the late 1990's, signalling

a marked departure from the heavy government presence and tight regulation of

the domestic economy from the 1950's through to the 1980's. The main Icelandic

banks were privatised in a staggered manner towards the end of the 1990's

amidst claims of partisanship as the commercial banks were closely linked with

one or another of the main political parties8. Eventually the banking sector was

handed over to local businesses with absolutely no foreign ownership.

Iceland's membership of the EEA means that the country is subject to

European Union banking regulations, with the onus of enforcement placed on

the relevant national authorities, which in Iceland's case was the Central Bank of

Iceland and the Financial Supervisory Authority. The Central Bank alone was

concurrently run by three different governors,9 two of whom were nominated by

each party in the governing coalition, with the third place available to candidates

not necessarily affiliated to a political party. The Prime Minister’s Office and

various ministries were also involved in the regulatory web, making it very

7 Baldur Thorhallsson, “Iceland and European Integration: On the Edge,” Shackled bySmallness, ed. Baldur Thorhallsson [London and New York: 2004] 170-171.8

? Robert Wade, “The Crisis: Iceland as Icarus,” Challenge, May/June 2009: 10-11.

9“History: Central Bank of Iceland,” Central Bank of Iceland, 2002, 14 Mar. 2011, <http://www.sedlabanki.is/?PageID=192>.

19

difficult to discern who was ultimately in charge. This created unnecessary

bureaucracy and uncertainty.

The combination of privatisation and deregulation was the seminal

seed that opened up the Icelandic banking sector to brisk growth, spurred on by

access to foreign capital markets and cheap finance. The build up of

vulnerabilities during upswings of the business cycle in the financial system are

prone to occur in a veiled manner. Generally the perception of risk during

periods of boom is limited, only tending to be realised towards the tail end of the

upward cycle when risk awareness is enhanced, thus exacerbating the

downturn.10

2.3 Macroeconomic Indicators and the Financial Sector

Despite the fiscal mismanagement that was inherent in the political set

up in Iceland, the government had been able to turn a budget surplus ever since

the deficit of -2.8% of GDP registered in 2003.11 This was mainly done by

raising tax revenues in the low to middle income bracket and by reducing taxes

on businesses and financial earnings in what was hailed as a success by supply

side economists.12 In 2004 the budget was on an even keel at 0.0% of GDP,

followed by surpluses of 4.9%, 6.3% and 5.4% in the next few years, and a

deficit of -13.5% in 2008 13 after the government intervention to bail out the

financial sector.

10“Financial Stability 2010,” Central Bank of Iceland, ed. Tryggvi Palsson et al., Reykjavik, Iceland 2 Jun. 2010: 67.

11 Commission Opinion: 93.

12 Wade: 11.13 Commission Opinion: 93.

20

For this very reason, the financial sector should not be viewed in

isolation of the real economy, because in actual fact they are both intrinsically

linked. In Iceland, the three main banks, namely Glitnir, Kaupthing and

Landsbanki accumulated assets that amounted to 900% of GDP by the end of

2007, up from 100% of GDP in 2004. This had the effect of putting the

commercial banks far beyond the safety net offered by the Icelandic Central

Bank.14

The size of the banking sector within Iceland’s financial system prior

to the crisis resembled that of an inverted pyramid, balanced upon a precarious

foundation. The commercial banks stretched themselves far beyond their modest

domestic depositor base, with a huge financial exposure from markets around

the world. Modest unemployment rates played a part in enhancing the general

lack of awareness about the vulnerabilities building up in the Icelandic economy

as households were confident about their ability to service debt.15 Employment

rates (Figure 2.2) were almost 20% higher than the EU average, signalling both

a highly sophisticated and active labour force, as well as indicating that the

Icelandic economy was reaching full capacity. Unemployment as a percentage

of the labour force was 2.9% in 2006, 2.3% in 2007 and 3.0% in 2008 16 (Figure

2.3). These low unemployment rates combined with easy access to credit led to

a huge increase in indebtedness, with household debt standing at 216% of

disposable income at the end of 2006 as compared to 165% in 2000.17

14“Iceland: Request for Stand-By Arrangement,” IMF Country Report, No. 08/362, Washington, D.C. Nov.2008: 4-5.

15 IMF 2007: 27.

16 Commission Opinion: 94.

17 IMF 2007: 5.

21

Besides the rapid and uncontrolled expansion of the banking sector,

another factor behind the macroeconomic boom in Iceland was the proliferation

of aluminium smelting plants, which looked to exploit Iceland’s cheap energy

stemming from hydroelectric and geothermal generation. Aluminium exports

made up 18.65% of all exports in 2005, rising to 23.6% in 2006, 26.49% in

2007, before peaking at 39.31% in 2008, even overtaking Iceland’s traditional

export powerhouse, the fisheries industry which saw its share of exports fall to

31.10% in the same year.18 By way of comparison, the 3rd most significant

exporting industry in 2008 was the aircraft parts sector, enjoying 6.16% of total

exports.

These figures point towards yet another problem in the Icelandic

economy, that of lack of diversification. Relying on a narrow range of exports is

a major source of vulnerability for small states, increasing their susceptibility to

external shocks. To highlight this volatility, the aircraft parts industry’s share of

total exports fell to just 0.73% in 2009.19

Figure 2.1

18“Trade Competitiveness Map: Exports of Iceland,” International Trade Centre, 2011, 14 Mar. 2011, <http://www.intracen.org/appli1/TradeCom/TP_EP_CI.aspx?RP=352&YR=2009>.

19 Ibid.

22

Source: IMF.

Source: Eurostat.

23

Source: European Commission.

2.3.1 Inflation and Current Account

The Icelandic Central Bank (ICB) held an inflation target of 1.8%20

(Figure 2.4), but the last time inflation was actually below that target was back

in 2004. Excessive growth of the money supply looked to be one of the main

driving forces behind this persistent inflation, as the broad money supply (M2)

rose by 27.26% in 2004, 39.88% in 2005, 6.46% the following year, before

increasing by a massive 78.85% in 2007, falling by 6.23%21 once the crisis hit.

The latter figure would have undoubtedly been higher had capital controls not

been put in place to stem the flow of money fleeing the country. The total credit

extended to residents by monetary institutions also expanded rapidly, from 13

20 “Price Developments,” Central Bank of Iceland, 2011, 29 Mar. 2011, <http://www.sedlabanki.is/?pageid=201>.

21 Commission Opinion: 92-94.

24

108 (million euro) in 2004,22 increasing by 111.72% in 2006, and increasing by

a further 30.83% in 2007, before falling by -8.34% in 2008.

The Central Bank’s ability to respond to the creeping inflation over the

corresponding period was somewhat blunted as lending rates were already at a

relatively high 15.3% by 2006, having doubled between then and 2003 when the

rate stood at 7.7%.23 This is indicative of the fact that the Icelandic Central Bank

was already aware that the Icelandic economy was overheating. Deposit interest

rates had also shot up from the 2003 level of 2.8%, reaching 9.0% in 2005 and

12.8% in 200624.

Far from easing the inflationary pressures on the Icelandic economy,

the interest rate hikes by the ICB may have inadvertently been feeding it.

Against the back drop of low international interest rates, the Icelandic rates were

highly attractive to foreign investors undertaking carry trade, where money is

borrowed in the currency with the lowest interest rate and deposited elsewhere at

a higher rate,25 fuelling capital inflows through the banking sector and also

through the issuance of “glacier bonds.” These bonds added further liquidity to

an already overheating economy. By the end of March 2007, the worth of the

bonds issued had reached almost 37% of Iceland’s GDP.26 These bonds were

regarded as a short term opportunistic investment by the international markets

rather than a must hold, adding to the instability already present in the economy.

22 Commission Opinion: 92-94.

23 Ibid.

24 Ibid.

25 Buttonwood, “Good Losers,” The Economist, 5 May 2011, 8 May 2011, <http://www.economist.com/node/18651608>.

26 IMF 2007: 33.

Iceland’s current account deficit follows a similar path and timeline to

the rapid and under regulated expansion of the banking sector, as the

commercial banks looked to diversify their portfolios abroad. The deficit almost

doubled from -9.84% of GDP in 2004 to -16.10% in 2005, further increasing to

-25.97% in 2006, -16.27% in 2007 and -25.98% in 2008.27 Theory suggests that

a current account deficit implies that a country’s economy is functioning on

borrowed means which, looking at the gross foreign debt to GDP ratio for the

2004-2008 period, would seem to be the case. Gross foreign debt reached 858%

in 2008, from 159% in 2004, with the 2008 figure roughly tallying with the

banking sectors total assets which was also just under 900% of GDP. 28

Figure 2.4

2.3.2 Icelandic Central Bank and Financial Services Authority

27 IMF 2007: 33.

28 Ibid.

With its aggressive monetary policy in the form of high interest rates

already working near capacity by 2006 and few signs of the Icelandic economy

cooling off, the ICB must have been aware that economic conditions were fast

reaching an untenable position. Inflation targeting has been the headline goal for

most Central Banks in advanced economies over the past two decades, including

Iceland’s,29 but its failure to reign in inflation despite hefty successive hikes in

interest rates severely compromised the institutions credibility. The other tool

available to the ICB was its regulatory authority in collaboration with the

Financial Services Authority, but the vulnerabilities building up in the financial

systems either went unnoticed, or were ignored.

Before the global financial crisis struck, financial supervisors tended to

look at micro prudential factors when assessing risks and vulnerabilities, which

involved scrutinising financial undertakings in isolation, with the assumption

being that the financial system as a whole was stable if each individual

undertaking was solid. It was also thought that risk was exogenous, in other

words, independent of the actions of the individual financial institutions.30 This

approach would seem to explain how even during the second quarter of 2008

individual stress tests on Iceland’s four main banks by the Financial Services

Authority yielded positive results, indicating that the banks were sufficiently

capitalised to withstand severe shocks.31

2.4 Aftermath of the crises

29 Eswar Prasad, “After the Fall,” IMF, Jun. 2010, 14 Mar. 2011, <http://www.imf.org/external/pubs/ft/fandd/2010/06/prasad.htm>.

30“Financial Stability 2010: 66-68.

31“Iceland’s FSA says big banks past stress test,” Reuters, 14 Aug. 2008, 23 Mar. 2011, <http://uk.reuters.com/article/2008/08/14/iceland-banks-idUKL2528425520080814>.

As the turmoil in the banking sector became more apparent to the

outside world, extreme downward pressure was exerted on the Icelandic Króna,

resulting in the loss of 70% of its value in the off-shore market32, and by October

the 5th 2008 practically all trade in the Króna ceased in the face of excess supply.

The Króna’s value in terms of the Euro had been fairly stable prior to 2006

(Figure 2.5) before the pressure from capital inflows led to a sharp appreciation.

The IMF believed that the Króna was overvalued, with different measurements

suggesting that this overvaluation was in the range of 7% to 25%.33

Iceland’s three biggest banks, Glitnir, Kaupthing and Landsbanki had

to be nationalised in October and a new bank/old bank approach was taken, with

the domestic banking needs served by the “new” bank, and foreign liabilities

transferred to the “old” bank.34 A government guarantee was given on all

domestic deposits but foreign held deposits were not covered. Capital controls

were put in place and the authorities set up a foreign exchange auction in order

to help fund imports and gradually let the market find a new equilibrium. Banks

were permitted to deal in foreign exchange outside of the auction on the explicit

understanding that it would not be used to support capital outflows.35

Figure 2.5

Króna value v. Euro

32 IMF 2008:4-5.

33 IMF 2007: 3-8.

34 IMF 2008: 6.

35 Ibid.

Source: ECB

Following on from repeated delays, mainly instigated by the United

Kingdom and the Netherlands over the Icesave issue,36 the IMF granted Iceland

a loan of $2.1 billion, the bulk of which was to be paid in instalments subject to

quarterly reviews. GDP fell by -6.9% in 2009 and a further -3.5% in 2010 and

general government debt to GDP shot up to 57.4% in 2008 from 29.3% the

previous year.37 Similarly the unemployment rate shot up to 7.2% in 2009 from

3.0% in 2008, and stabilised at 7.6% in 2010.38 Along with the long term debt

and reform obligations that have been entered into with the IMF, the biggest

challenge faced by the Icelandic economy to date has been controlling the

rampant inflation rate. Inflation reached 12.8% in 2008 and 16.3% in 2009.39 In

36 This dispute relates to Iceland’s refusal to settle debts with Britain and the Netherlands for

compensating residents who held an account with Icesave, a branch of the failed Landsbanki.37

? “Public Balance and General Government Debt,” Eurostat, 18 Jan. 2011, 2 Apr.2011, <http://epp.eurostat.ec.europa.eu/>.

38 “Unemployment rate,” Statistics Iceland, 18 Jan. 2011, 2 Apr.2011, <http://www.statice.is/>.

39 “HICP all Items, Annual Average Inflation Rates (%),” Eurostat, 18 Jan. 2011, 2 Apr.2011,

this respect social partners and workers alike have played their part in limiting

the upward pressure on wages,40 which would only exacerbate the current

situation.

Perhaps the most difficult task will be going through with the

necessary political and institutional changes required to ensure that the kind of

mismanagement witnessed in Iceland will never manifest itself again. To that

end, some important changes have already been implemented. The Icelandic

Central Bank is no longer headed by three governors, but by one governor and a

vice governor. A monetary policy committee was also set up to make decisions

on interest rates.41 Furthermore, the management at the Financial Services

Authority was shuffled or replaced.42 Iceland also applied for membership of the

EU in 2009 but it remains a contentious issue, not least due to the Icesave

problem and the weakened appeal of the euro after the sovereign debt crisis in

Europe.

<http://epp.eurostat.ec.europa.eu/>.

40 “Iceland: Staff Report for First Review under Stand-By Arrangement,” IMF Country Report No. 09/306, Washington, D.C. Oct. 2009: 26. 41 “Accountability and Independent,” Central Bank of Iceland, 2010, 26 Apr. 2011, < http://www.sedlabanki.is/?PageID=192>.

42 IMF 2009: 26.

Chapter Three: Malta

3. Malta

3.1 Background and Politics

Malta is the smallest economy in the euro area, having adopted the

currency in 2008, following on from its accession to the EU in 2004. The GDP

per capita is below the EU average1 and the island is restricted by a lack of

natural resources,2 but has managed to prosper none the less by shifting away

from its traditional manufacturing base and diversifying into other areas by

focusing on higher value added exports.3

Maltese politics is dominated by two political parties, namely the

Nationalist Party and Labour Party. Given the majority rule system, the

incumbent party is usually in a strong position to govern, thus ensuring relative

political stability. The Nationalist Party has been in control of government since

1987, barring the period between 1996-1998. Over the years the government

has pursued a policy of gradual economic liberalisation, reducing its

intervention in the market but still maintaining a large socialist bureaucracy. The

majority of government spending is allocated to housing, education and

healthcare.4 Of particular concern is the sustainability of the country’s pay as

1 “Volume Indices per Inhabitant,” Eurostat, 20 Jan. 2011, 18 May 2011, <http://epp.eurostat.ec.europa.eu>.

2 Rose Marie Azzopardi, “Malta’s Open Economy: Weathering the Recessional Storm,” South European Society and Politics, ed. Susannah Verney et al. [Routledge Vol.14 No.1, Mar.2009] 103.

3 “Malta: Staff Report for the 2009 Article IV Consultation,” IMF Country Report, No.09/287, Washington, D.C. Sep.09: 3.

4 “Malta:,” Heritage Foundation and The Wall Street Journal, 3Feb. 2011, <http://www.heritage.org/Index/Country/Malta>.

32

you go pension system as the long term budgetary impact of age related

spending is significantly higher than the EU average.5

3.2 EU Membership and Foreign Investment

Malta’s membership of the EU in 2004 was a make or break moment

for many businesses on the island but, on the whole, the ‘shock’ of membership

was handled well. Many protectionist measures had to be dismantled, opening

the economy up to increased competition but at the same time giving Maltese

businesses and consumers’ access to a much wider market. Malta is heavily

dependent on foreign direct investment (FDI), the flows of which have helped

the island diversify from its formerly narrow economic base of tourism and

electronics,6 two sectors that are extremely vulnerable to exogenous shocks as

demonstrated by the global economic slowdown (Figure 3.1).

FDI flows have generally been on an upward trend since 20047 (Figure

3.2) and most of it has been directed towards new export activities both in the

manufacturing sector as well as other ‘new’ areas such as aircraft maintenance

and pharmaceuticals (Figure 3.2 and 3.3). The services industry has been

another sector that has been driven by FDI since 2004, with the online gaming

industry in particular taking advantage of Malta’s favourable regulatory

conditions. A number of call centres have also taken the opportunity to relocate

to the island to exploit the largely English speaking and low wage workforce.

5 “Malta: Macro Fiscal Assessment,” European Commission, Brussels, 7 Apr. 2010: 23.

6 IMF 2009: 7.

7 “UNCTAD Statistics Overview,” United Nations Conference on Trade and Development, 17 Sep 2010, 26 Apr. 2011, <http://www.unctad.org/>.

33

The online gaming industry in particular has been a buttress of growth

with 500 companies registered in Malta in 2008, the revenues from which

amounted to 7.82% of GDP in 2008, well above the EU average of 0.68%.8 One

must add the caveat that, despite undoubtedly contributing to Malta’s resilience

through diversification in the short run, many of the new industries that have set

up operations on the island are particularly footloose in nature and any

harmonisation of regulations at EU level may compete Malta’s comparative

advantage away.

The lack of domestically driven investment, especially in the area of

research and development is one of the main reasons why Malta is so dependent

on FDI. A report by the World Economic Forum in 2006 ranked Malta in last

place out of the then EU-25 in terms of research and development, but the

country achieved a high score for its information society and high internet

penetration rates.9 Businesses in the domestic economy are mainly small and

medium enterprises and therefore the capital intensive nature of research and

development is often beyond their means. The University of Malta has also been

a laggard in engaging with industry for research and development purposes 10

and more potential exists in this area. In theory the drive for economic

liberalisation and scaling back of the public sector since the early 2000’s should

have given the domestic private sector more room for such investment in

8 “Green Paper n On-line Gambling in the Internal Market,” European Commission, Brussels, 24 Mar. 2011: 9.

9 Jennifer Blanke, “The Lisbon Review 2006: Measuring Europe’s Progress in Reform,” World Economic Forum, Geneva, 2006: 6.

10 Karl Montford and Stefano Mallia, “The Maltese Economy post-EU Membership.” UHM, 7 Mar. 2009: 22.

34

research and development as the crowding out effect was lessened but this has

not come to bear.

In keeping with the criteria set out in the Maastricht treaty and the

desire to adopt the euro as soon as possible,11 the Maltese government was

required to undertake some fiscal consolidation in order to preserve

macroeconomic stability, with particular focus on the government deficit and

long term debt. Malta joined the exchange rate mechanism (ERM II) in 2005,

pegging the previous currency the Lira at a fixed rate to the euro, without

allowing the ± 15% fluctuation that was permissible under the mechanism.

Source: UNCTAD. (2011)

11 Azzopardi 114.

35

Figure 3.2

Exports of goods by sector, % change 1995-2006

Source: IMF.

Figure 3.3

Exports of services by sector, % change 1995-2007

Source: IMF.

3.3 Macroeconomic Indicators

36

The government deficit as a percentage of GDP has been on a

downward trend ever since the high of -9.7% reached in 2003. The deficit in

2004 was -4.9%, continuing to fall consistently to -3.1% and -2.7% until

reaching -2.3% of GDP in 2007, increasing again in 2008 to -4.8%/.12 The

deficit registered in 2008 was in part due to non-recurrent expenditure

increasing items. 13 Despite a generally decreasing deficit in relation to GDP up

until 2008, delving further into government expenditure by its main components

shows some cause for concern in certain areas. Spending on current expenditure

such as compensation to employees, social benefits and intermediate

consumption has increased significantly since 2003 (Figure 3.4). These

components include spending on health, education, housing and social

protection. Spending in these areas tends to be entrenched, therefore reducing it,

or even just maintaining it at current levels is both difficult and politically

unpopular.

By contrast government capital expenditure, which tends to have a

more long lasting and positive effect on the economy, at least from a Keynesian

point of view, has been on the decrease since 2003, with the investment

component falling from 206.8 million to 132.2 million in 2008. The level of

capital transfers has remained more consistent (Figure 3.5), barring the 2003

figure of 139.4 million which was notably higher due to restructuring of the

state owned dry docks and shipyard. Public sector interests in core parts of the

country’s infrastructure has devolved markedly as part of the drive to push

12 “General Government Deficit under the Maastricht Treaty: Second Reporting for 2010,” National Statistics Office, Malta, 22 Apr. 2010: 2-3. 13

? Malta: Macro Fiscal Assessment: 6.

37

through economic liberalisation, most notably in areas such as

telecommunications, postal services and airport and port services.14

On paper one of the more successful consolidations undertaken by the

Maltese government has been in reining in the long term general government

debt. The debt level has fallen from a high of 72.4% of GDP in 2004 to a more

sustainable 63.0% in 2008.15 Looking at the debt figure alone gives a somewhat

panglossian view, as sales of non-financial public assets often increase before

countries join the euro16 in order to bring down borrowing without actually

bettering fiscal sustainability. Asset sales did in fact increase in Malta, peaking

at 153.7 million in 2008, up from 95.5 million in 2006 and 108.5 million in

2007.17

Malta’s unemployment rates remained consistently under those of the

EU average from 2003 to 2008 (Figure 3.6) but, conversely, the employment

rate is one of the worst in the EU, being well below average (Figure 3.7). For

example, in 2006, the Maltese employment rate stood at 53.6%, a full 10%

below the EU average of 64.5%.18 Low participation rates are harmful for

Malta’s growth and such a small state can ill afford to underutilise such an

important resource. However, despite various budgetary initiatives by the

government, the female participation rate in particular, remains stubbornly low.

14 “Malta: Staff Report for the 2008 Article IV Consultation,” IMF Country Report, No.08/276, Washington, D.C. Aug. 2008: 3.

15 IMF 2009: 27.

16 “Economics Focus-Ties that sometimes bind,” The Economist, London, Vol. 399, No. 8733.

17 “Quarterly Review 2010:1,” Central Bank of Malta, Valletta, Vol.43 No.1: 88.

18 “Employment Rate, Age Group 15-64,” Eurostat, 18 Jan. 2011, 2 Apr.2011, <http://epp.eurostat.ec.europa.eu/>.

38

3.3.1 Inflation and Current Account

One major source of vulnerability for the country is its 100% reliance

on oil for its energy production needs. This, coupled with high trade openness,

leaves Malta highly susceptible to imported inflation. Inflation in Malta has

been above the EU average since 2003 (Figure 3.8), barring one year in 2007

when it was markedly lower than the average at 0.7%, before jumping up to

4.7% in 2008,19 the highest it has been since the introduction of the new retail

price index in 1996.20

Above average inflation in a currency union will hurt Malta’s

competitiveness21 both in exports and in the tourism sector. Maltese consumers

had long been sheltered from the effects of rising oil prices on the international

markets in part due to generous subsidies offered by the government. These

subsidies were removed towards the end of 2008 just as oil prices were

beginning to crash and the uncertainty about the global financial crisis was at its

peak. The removal of these subsidies in part explains the mismatch in inflation

rates between Malta and the EU average as energy prices began to fall elsewhere

but rose on the island. Upward pressure was also placed on prices following the

country’s adoption of the euro on January 1st 2008.

Expansion of the money supply in Malta has been relatively modest

and mostly out of synch with the increases in inflation witnessed. Since 2003,

the percentage increase per annum of the broad money supply (M2) has been

19 “HICP All Items, Annual Average Inflation Rates,” Eurostat, 23 Dec. 2010, 2 Apr. 2011, <http://epp.eurostat.ec.europa.eu/>.20

? Azzopardi 117.

21 “Speech Given by Michael C Bonello, Governor of the Central Bank of Malta, at the annual dinner of the Institute of Financial Services,” Central Bank of Malta, 20 Nov. 2010, 8 Apr. 2011, <http://www.centralbankmalta.org/>.

39

2.4% in 2004, 4.2% in 2005, 5.2% in 2006 and jumping up to 11.5% in 200722,

which incidentally was Malta’s best performing year in terms of inflation, at

0.7%. It again increased in 2008 by another 6.64%. The heavy reliance on

imports of fuel, food and components for export products puts particular

pressure on the country’s external trade balance. These inherent vulnerabilities,

coupled with an insufficient level of domestic savings to finance investment,

have shown up as a persistent deficit in the current account of the balance of

payments. The deficit has been on the increase since its 2003 level of -3.12% of

GDP, reaching -6.01% the following year and peaking at -9.15% in 2006, before

falling to -7.11% in 200723 and -5.7% in 2008. 24

22 “Economic Survey October 2010,” Ministry of Finance, Valletta, 25 Oct. 2010: 212.

23 “Current Account Balance (% of GDP) in Malta,” Trading Economics, 2010, 8 Apr. 2011, <http://www.tradingeconomics.com/malta/current-account-balance-percent-of-gdp-wb-data.html>.

24 Bonello.

40

Source: Central Bank of Malta.

Source: Central Bank of Malta.

41

Source: Eurostat.

Source: Eurostat.

42

Source: Eurostat.

3.4 The Financial Sector

The Maltese financial sector escaped the direct effects of the financial

crisis due to its relative lack of cross border linkages and exposure to toxic

subprime assets originating from America, barring one local bank with a minor

investment in the Lehman Brothers.25 The European Commission has described

the Maltese financial system as being ‘less sophisticated than that of other

member states’,26 but the sector is expanding rapidly. Since 2004, the sectors’

total assets have doubled, reaching over seven times Malta’s GDP in 2008.27

25 Azzopardi 106.

26 Azzopardi 104.27

? IMF 2009: 35.

43

The main focus of domestically orientated banks is based on the

traditional funding model 28 with heavy reliance on retail deposits. Contrary to

the seizing up of interbank activity experienced due to the financial crisis in

countries like Iceland, the interbank market in Malta continued to function

normally, with entry into the euro zone actually promoting such activity, as the

total volume of deals increased six fold in 2008.29 From a financial regulatory

point of view, euro entry has brought forward a number of new challenges as

several internationally oriented banks started to integrate into the domestic

financial sector.

The body responsible for regulating the financial sector is the Malta

Financial Services Authority (MFSA), which was established in 2002, taking

over from the role previously fulfilled by the Central Bank of Malta (CBM) with

regards to supervision of the banking sector.30 The recent establishment of the

MFSA reflects on the relative infancy of the Maltese financial sector and the

authority lacks the experience of its more established European counterparts

especially in dealing with internationally oriented banks.

3.4.1 Key Exposures

As witnessed in Iceland an inexperienced regulator can have negative

repercussions on the whole financial sector. Malta is currently undergoing a

28 “IMF Public Information Notice: IMF Executive Board Concludes 2009 Article IV Consultation with Malta,” IMF Public Information Notice, No.09/116, Washington, D.C. 14 Sep.

2009:2 29 IMF 2009: 37. 30 Blanche Gatt, ed. “Finance Malta 2010/2011 Edition,” Country Profiler, Malta: 153.

44

similar proliferation of operators in the sector and it may potentially become a

source of vulnerability.

The key exposure of domestically oriented banks is in the real estate

market which had undergone a boom in recent years. The amount of

development permits issued in 2007 increased by 85% when compared to

2003,31 increasing supply in what was already an overcrowded market. At the

beginning of 2004 property price inflation peaked at just under 40% before

falling rapidly to around 5% in 2005 and going into negative territory at the end

of 2007.32

The amount of property related loans held by banks between 2003-

2008 rose by 10% pushing the total up to 55%. 33 The significance of the peaks

and troughs in real estate prices on domestic banks is twofold. Firstly the

amount of non performing loans may increase as prices fall and property owners

find themselves in negative equity. Secondly the mark to market accounting

principles requires banks to decrease the value of their assets to reflect the fall in

prices, resulting in more capital having to be held in reserve, therefore reducing

the amount of money that banks can lend out.

Small and medium enterprises (SMEs) make up the bulk of companies

in the Maltese economy. SMEs are highly dependent on easy access to credit in

order to operate and expand and, when credit conditions tighten, they are usually

the first to suffer. This means that stability in the financial sector is imperative

for the overall well being of the Maltese economy, further intertwining the

linkages between the financial sector and macro economy.31 “Quarterly Review 2010:1,” Central Bank of Malta, Valletta, Vol.43 No.1: 109.32

? Ibid 34.

33 IMF 2009: 40.

45

The stability of the financial sector during the crisis actually saw the rate

of domestic corporate borrowing rise from 73% of GDP in 2007 to 81% at the

end of 2008.34 During the same period 9 corporate insolvencies were reported in

2008, mainly from the manufacturing, wholesale and retail, and real estate

sectors, up from 2 the previous year.35

3.5 Aftermath of the crises

The fallout from the financial crisis in Malta was mild in comparison

to many other countries but the government was still obliged to introduce a

deposit guarantee scheme, if only to reassure the public.36 In reality such

schemes are rather pyrrhic as the costs of actually funding it were it to be needed

would devastate public finances and cause country wide financial distress. This

happened in Ireland where the government guaranteed the banks obligations “to

a reckless degree.”37

The economic slowdown highlighted the extent to which Malta’s two

traditional pillars of growth namely tourism and manufacturing are reliant on

external demand, as tourist arrivals fell by 8.4% in 2009 and gross value added

in the manufacturing sector fell by more than 18%.38 GDP growth declined by -

2.1% in 2009 but this was still above the Euro area average of -4.1%.

34 “Financial Stability Report 2008,” Central Bank of Malta, Valletta, 2008: 17.

35 Ibid.

36 “Minister Explains Deposit Guarantee Scheme,” The Times of Malta, 8 Oct. 2008, 16 Apr. 2011, <http://www.timesofmalta.com/articles/view/20081008/local/dddd>.

37 Charlemagne, “A Parable of Two Debtors,” The Economist, London, Vol. 399. No.8729: 32.

38 Bonello.

46

Unemployment increased to 7.0% compared to 5.9% in 2008 but once again this

was below the Euro area and EU-27 average. Inflation eased from the record

high of 4.7% in 2008 but at 1.8% it was well above the Euro area average of

0.3%, eroding Malta’s competitiveness across both the whole spectrum of

exports as well as tourism.

Government finances held up well during the crisis. The deficit as a %

of GDP fell by 1% to -3.8%, despite measures to support the ailing

manufacturing sector, micro-credit schemes for SME’s and tax allowances for

investment,39 although as previously mentioned the 2008 budget was subject to

one off expenditure. General government debt increased to 68.6% from 63.1%,40

and the current account deficit widened to -6.9% from -5.7% in 2008.41

39 “Malta: Macro Fiscal Assessment: 6.40

? “Pubic Balance and General Government Debt,” Eurostat, 23 Dec. 2010, 2 Apr. 2011, <http://epp.eurostat.ec.europa.eu/>.41

? Bonello.

47

Chapter Four: A Theoretical Framework for Analysing the Crisis

4. A theoretical framework for analysing the crisis

4.1 The importance of financial indicators

Relying on macroeconomic indicators to assess a country’s overall

economic well being without considering the appropriate financial indicators

can lead to a one dimensional view and thus offer a false sense of security.

One of the lessons learnt from the financial crisis is that the traditional

economic assumption of ‘rational actors’ wanting to maximise profits still holds

true, but it is a very short term goal that can have extremely detrimental effects

in the long run as people seek greater returns at an even greater risk. The herd

mentality has been seen on numerous occasions be it for technology stocks in

the late 1990’s or property in the mid 2000’s.1 Therefore, analysing trends in

popular asset classes, such as real estate or stocks can help identify a potential

source of vulnerability for a country whose economy is heavily reliant on the

financial sector.

4.2 Hyman Minsky

Using Hyman Minsky hypothesis on financial instability2 can help

better elucidate the cycle that occurs in the lead up to a financial crisis which

may lend insight on how to detect and dampen future crises. The five stages in

this hypothesis are:

1 “Buttonwood: The Foolishness of Crowds,” The Economist, 7 Apr. 2011, 21 Apr. 2011 <http://www.economist.com/node/18529721?story_id=18529721>.

2 Paul Barnes, “ Minsky’s Financial Instability Hypothesis: Information Asymmetry and Accounting Information,” Nottingham Business School, U.K., 2007.

49

1.“Displacement”

2.“Boom”

3.“Euphoria”

4.“Profit taking”

5.“Panic.”

4.2.1 Displacement stage

During the displacement stage, investors and institutions get excited

about a new paradigm3 which, in the case of Iceland, can be identified as the

privatisation and deregulation of the banking sector that started in the mid-

1990’s, along with membership of the EEA. Malta underwent a similar

displacement phase a decade later with privatisation and deregulation in the lead

up to EU and euro zone membership (Figures 4.1 and 4.2).

3 “5 Steps of a Bubble,” Investopedia, 2011, 21 Apr. 2011, <http://www.investopedia.com/articles/stocks/10/5-steps-of-a-bubble.asp>

50

Figure 4.1Bank assets as a % of GDP 2002-2006, Iceland-Malta and other counterparts

Source: IMF.

Figure 4.2Bank assets as a % of GDP 2003-2010, Malta and other counterparts

Source: IMF.

4.2.2 The boom phase

51

The boom phase of the Minsky hypothesis is largely self-explanatory.

In Iceland banks started increasing their cross border operations and their

investment arms acquired stakes in companies as diverse as toy shops

(Hamleys), fashion brands (All Saints) and airlines (Sterling Airlines).4 A

number of branches were opened in the UK and the Netherlands in order to

acquire more capital, a marked problem for the Icelandic banks given the

country’s small population and limited depositor base. The main boom years

were between 2004 and 2006, fuelled by easy access to credit, which lead to a

huge increase in property prices and a rallying of the Icelandic stock market.

The boom in Malta following on from the displacement phase was

much more controlled perhaps either due to uncertainty about whether the

country would fulfil the Maastricht criteria and adopt the euro as scheduled in

2008, or because of the banks’ inherently cautious approach. Credit expanded at

a constant pace and was mostly channelled towards the property market, which

saw a spike in prices in 2004. Domestic banks’ foray into the European markets

remained limited but a number of internationally oriented banks and hedge

funds started to base their operations in Malta.

4.2.3 Euphoria stage

The euphoria reached its peak in Iceland with a massive influx of ‘hot

money’ in 2007 which drove asset prices sky high. The stock market had

increased nine-fold since 2001 and housing prices virtually doubled in a short

period of time5 (Figures 4.3 and 4.5). In Malta property prices started to

4 J. Eric Ivester, “Icelandic Banking Crisis Offers Insight Into Global Financial Meltdown,” Turnaround Management Association, 15 Sep. 2010, 21 Apr. 2011, <http://www.turnaround.org/Publications/Articles.aspx?objectId=13306>.

5 Ivester.

52

decrease after the short boom witnessed in 2004 and the stock market remained

relatively stable, therefore avoiding the euphoria stage that usually precedes a

crash in asset prices (Figures 4.4 and 4.6).

Figure 4.3Stock market indices (Iceland and others)

53

Source: IMF.

Figure 4.4Stock market indices (Malta and others)

Source: Malta Financial Stability Report 2009

Figure 4.5Property prices in Iceland: Year on year % change

54

Source: Financial Stability Report 2010 Iceland.

Figure 4.6Property prices in Malta: Year on year % change

Source: Central Bank of Malta Quarterly Review 2010(1).

4.2.4 Profit taking and Bust

55

By 2007 the growing instability in the financial sector was starting to

manifest itself through the macroeconomic indicators in Iceland as inflation

started to rise and the current account deficit widened. At this point the ‘smart

money’ started to flee in what was the profit taking stage in Minsky’s

hypothesis. Towards the end of 2007 and beginning of 2008, as the financial

conditions began to worsen in the US, credit conditions tightened which meant

that Icelandic banks began to struggle to raise capital on international markets.

To borrow another characterisation put forward by Minsky, the Icelandic banks

were essentially functioning like “ponzi structures,”6 in that their cash inflows

were insufficient to cover their cash outflows. They relied heavily on

international capital markets to cover the shortfall, rendering them highly

vulnerable to exogenous shocks.

That shock came in 2008 once the panic phase set in as asset prices

started to plummet and capital fled the country leaving the banks with no

sources of finance as the credit crunch kicked in and the Icelandic Króna

became virtually worthless. The impact on institutions in the Maltese financial

sector was limited because they functioned more like what Minsky termed as

“hedge firms,” in that they were able to meet their financing obligations and had

positive net cash flows.7

Iceland quite comprehensively outperformed Malta in the

macroeconomic indicators used for the Briguglio resilience index, namely: fiscal

deficit to GDP, the sum of inflation and unemployment, and the external debt to

GDP ratio (Figures 4.7-4.11). However, history has shown that asset price

bubbles and financial crises often break out following on from periods of benign

6 Barnes 8. 7

? Ibid.

56

macroeconomic conditions. This has been witnessed as far back as the great

depression, the Japanese crisis in the late 1980’s, the Asian crisis in 1997 and

the 2007 financial crisis.

Source:Eurostat.

57

.

Source:Eurostat.

58

Sources: European Commission, Eurostat.

Sources: European Commission, Eurostat.

4.3 Cumulative Financial Indicators

59

As has already been mentioned in the first chapter, there is a need to

look at cumulative processes rather than growth rates over a short period, as

vulnerabilities generally build up over an extended period.8 Asset bubbles are

often the result of excess liquidity and most inflation baskets do not take the

popular asset classes like property into consideration. Looking for sudden

increases in the broad money supply (M2) is one indicator that can signal

potential financial distress building up and may be of some use as a supplement

to the Briguglio index. Iceland saw a 78% per annum increase in the M2 money

supply between 2006 and 2007 and a 240% increase between 2003 and 2007.

When compared to a country like Malta that didn’t suffer from a financial crisis,

these increases appear to be significantly above the norm (Figures 4.12 and

4.13).

Looking at the M2 money supply alone is not sufficient because an

asset price boom might be fuelled by rising prosperity rather than excessive

debt.9 Therefore the rate of credit growth granted to residents is another

important indicator to look at in the financial sector. The risk of rapid credit

expansion is two fold; it increases the exposure of banks to potential defaults

and it increases the leverage of the private sector, especially when GDP doesn’t

grow fast enough to sustain it. Property related loans in particular pose a double

risk. Lenders are required to set aside less capital for property loans due to its

security as collateral.10 Borrowers have the opportunity to take on a large

8 Claudio Borio, “Asset Prices, Financial and Monetary Stability- Exploring the Nexus,” BIS Working Papers No.114 Jul. 2002: 12. 9

? “Latin America’s Housing Boom: It’s not all froth,” The Economist, 5 May 2011, 8 May 2011, <http://www.economist.com/node/18651524>.

10 “The Perils of Property,” The Economist, 3 Mar. 2011, 25 May 2011, < http://www.economist.com/node/18281764?story_id=18281764>.

60

amount of leverage, sometimes even 100%. Credit growth increased by 282% in

Iceland from 2003 through to 2007, whereas in Malta it grew by 51% over the

same period (Figures 4.14 and 4.15).

Above average increases in some of the asset classes already

mentioned, like the stock market and property prices, are also useful indicators

of potential financial distress building up in the market. However what

constitutes an above average increase for these types of assets needs to be the

subject of further empirical research. The nine fold increase on the stock market

and doubling of property prices witnessed in Iceland are obvious examples of an

asset price bubble, which certainly brings into question Iceland’s ranking as the

most resilient country in the May 2008 paper published by Briguglio.11

Rapid expansion of the banking sector in the form of total assets as a %

of GDP is another useful indicator that can indicate potential vulnerability build

ups in the sector. The above mentioned indicators look at the endogenous factors

inside a country but, as the financial crisis showed, cross border activities and

financial linkages played a major part in the contagion originating from

America. Therefore it is necessary to try and capture the financial exposure to

the global economy12 and the most commonly used measure found in the

literature is the ratio of the sum of foreign assets and liabilities to GDP.

11 Lino Briguglio, et al., “Economic Vulnerability and Resilience: Concepts and Measurements,” United Nations University, Research paper No. 2008/55, May 2008: 17.

12 Thorvardur Tjorvi Olafsson, et al., “Weathering the Financial Storm: The Importance of Fundamental and Flexibility, Central Bank of Iceland, Working Paper No.51, Oct. 2010: 9.

61

Source: Central bank of Malta, European Commission and author’s calculation.

Source: Central bank of Malta, European Commission and author’s calculation.

62

Source: Central bank of Malta, European Commission and author’s calculation.

Source: Central bank of Malta, European Commission and author’s calculation.

4.4 A Holistic View

As the saying goes, the benefit of hindsight is always 20-20. If spotting

63

asset bubbles in financial markets was that easy then the occurrences of crises

would be much reduced. The financial crisis and global economic slowdown has

somewhat tempered the belief that free markets are best at ensuring an efficient

allocation of resources. Therefore any above average trends may signal a

potential build up of financial distress, especially during periods when the cost

of borrowing is cheap. This is because investors borrow money for the purchase

of assets, driving prices up even higher.13

At times even seemingly benign indicators such as FDI may provide a

hint of trouble to come. As demonstrated in Iceland, sudden influxes of FDI

leave a country vulnerable to capital inflows reversal.14 Between the years 2000

and 2003 (both years included), FDI averaged just under 4% of GDP, whereas

between 2004 to 2007 FDI averaged 37% of GDP and outflows of -22.56% of

GDP were recorded in 2008. Not all FDI flows are highly susceptible to sudden

reversals, but hasty increases driven by carry trade or risk mispricing tend to be

highly volatile. Policy makers need to take a holistic range of financial

indicators into account when assessing the overall health of the financial system,

looking out for interlinked and extraordinary events.

13 “Asset Markets: The Danger of the Bounce,” The Economist, 7 Jan. 2010, 20 May 2011, <http://www.economist.com/node/15211520?story_id=15211520>.14

? See Chapter 2, pgs. 25-26.

64

Chapter 5: Financial Regulatory Lessons Learnt from the Crisis

5. Financials Regulation

5.1 Financial regulatory shortcomings

The financial crisis and global economic slowdown have highlighted

the need to better comprehend the way in which monetary policy interacts with

the financial system and the responsibility and accountability of operators and

regulators within that system. Ample liquidity combined with low interest rates

did not show up through the usual medium that is inflation of goods and

services, but instead in rapidly rising asset prices.1 This led many central banks

to believe that monetary policy did not need to be tightened. Those that did raise

interest rates, like Iceland, were faced with an influx of capital as banks and

investors sought ever greater returns as risk became seriously mispriced.

The Icelandic case raised many questions about the EU’s financial

regulatory framework and serves as a pertinent example of the risk of a

mushrooming financial sector in a similarly small economy like Malta. Malta is

playing host to an increasing number of internationally oriented banks, some of

which are starting to collect deposits from Maltese residents. By the end of 2008

internationally oriented banks held €0.2 billion in residential deposits that would

have been eligible under the government’s Deposit Guarantee Scheme.2

1 Jacques de Larosière, “The High-Level Group of Financial Supervision in the EU,” European Commission, Brussels, 25 Feb. 2009: 7.

2 “Malta: Staff Report for the 2009 Article IV Consultation,” IMF Country Report, No.09/287, Washington, D.C. Sep.09: 39.

66

5.2 Cross border responsibility

One of the many issues raised by the financial crisis in Iceland was

which national authority was ultimately responsible in the case of cross border

operations as well as the implications of a state being unable, or unwilling, to

honour a deposit guarantee scheme for a branch on foreign soil, as demonstrated

by the still unresolved Icesave dispute. Under EU law a cross border branch is

the responsibility of the national home state whereas a subsidiary set up under

local law is regulated at host state level. 3 This often means that host authorities

lack the necessary information and tools to gauge the well being of the

institution operating in its territory, having instead to rely on the integrity of the

home authority. This case has interesting implications for Malta given the

increasing amount of internationally oriented banks operating on the island, and

their gradual incursion into the domestic market as “cross-border banks are

international in life, but national in death.”4

A proposal by the author of the aforementioned quote, Charles

Goodhart, is to separate the macroprudential and microprudential controls

between host and home country when dealing with cross border banks.

Macroprudential control should be under the remit of the host country and its

central bank, whereas microprudential control should be undertaken by a single

financial supervisory authority in the home country.5 In theory the logic of this

is pretty sound given that central banks are more economically oriented and are

best placed to understand and assess the interaction between markets and

3 Larosière 72.

4 Charles Goodhart, “Procyclicality and Financial Regulation,” Central Bank of Spain, Financial Stability Report No.16, Oct. 2010: 16.

5 Ibid 15.

67

institutions in its own national economy. On the other hand financial

supervisory authorities should be more concentrated on the operations of

individual institutions and the prevention of fraud, being primarily staffed by

accountants and lawyers.6 However in reality the competence and candour of

different national institutions varies significantly.

5.3 Financial Stability Reporting

The very definition of financial stability is sometimes hard to arrive at,

as noted by the European Central Bank’s 2005 financial assessment. The report

states that “Financial stability assessment as currently practiced by central banks

and international organisations compares with the way monetary policy

assessment was practiced by central banks three or four decades ago-before

there was a widely accepted, rigorous framework.”7

The first ever financial stability report (FSR) was published by the

bank of England in 19968 and since then the number of reports published by

central banks around the world has risen substantially (Figure 5.1). At face value

this may seem like a good thing but the reality is that a lot of these financial

stability reviews were of sub-optimal quality when viewed against the IMF’s

financial stress indicators (Figure 5.2).

Figure 5.1

6 Goodhart 16.

7 Charles Goodhart, “Analysis of Financial Stability,” London School of Economics, 2007: 19.

8 Howard Davies, “Banking on the Future: The Rise and Fall of Central Banking,” London School of Economics, Public Lecture, 12 May. 2010.

68

Source: LSE Public Lecture-The Rise and Fall of Central Banking.

Figure 5.2

Source: LSE Public Lecture- The Rise and Fall of Central Banking.

The financial stability report published by the Icelandic central bank in

May 2008 is a glaring example of the overly optimistic nature sometimes

adopted in such reports. The following are a few excerpts from the 2008 FSR:

“In the analysis published in Financial Stability 2007, the Central Bank of

Iceland concluded that the financial system was broadly sound. That has not

69

changed.”9 “Iceland’s banking system meets the demands made of it, and it

performs well on stress tests conducted by the Central Bank and Financial

Supervisory Authority.”10 “The banks’ capital ratios are satisfactory,

profitability is strong from broad-based operations, and assets are diversified.”11

The three main banks in Iceland collapsed within the span of a week and were

duly nationalised in October 2008,12 just 5 months after the reassurances given

in the FSR.

The Maltese Central Bank only started publishing a FSR in 2008 and it

too had a few shortcomings. The chief concern voiced by the IMF was the need

to incorporate internationally oriented banks into the stress test process, in

keeping with the need to take a more macroprudential view of the financial

system.13 Macroprudential control takes a top-down approach with the aim of

limiting financial system wide distress, whereas microprudential control is a

more bottom-up approach that focuses on limiting the distress of individual

institutions. The downside of microprudential control is that is tends to overlook

the common exposure and interlinkages between financial institutions.14

9 “Financial Stability 2008,” Central Bank of Iceland, ed. Tryggvi Palsson et al., Reykjavik, Iceland May 2008: 3.

10 Ibid 8.

11 Ibid 9.

12 “Iceland: Request for Stand-By Arrangement,” IMF Country Report, No. 08/362, Washington, D.C. Nov.2008: 5.

13 IMF Malta 2009: 20.

14 Claudio Borio, “The Macroprudential Approach to Regulation and Supervision: Where do we stand,”The Financial Supervisory Authority of Norway, 2006: 109-110.

70

5.4 The De Larosière report

The De Larosière report called for the setting up of a “European

Systemic Risk Council15” under the auspices of the ECB.16 This was established

in January 201117 in order to add an overarching body to the EU’s financial

system. The aim of the council18 is to analyse the relevant macroeconomic and

macroprudential indicators in all the financial sectors and essentially function as

an early warning system by liaising with the relevant national central bank

and/or financial supervisor. As a Member State, Malta enjoys full representation

and voting rights on the board but Iceland faces the age old dichotomy that

comes with EEA membership,19 in that its participation will be “strictly limited

to issues of particular relevance to those countries (in reference to EEA

countries),” and only on an “ad-hoc basis, as an observer.”20

The De Larosiere report also emphasises the lack of consistency and

cohesiveness in Europe’s regulatory framework, 21 in particular when it comes to

the enforcement of common directives. Regulatory arbitrage was clearly

prevalent in Iceland and such inconsistent application of regulations undermines

the single financial market and leads to competitive distortions among financial

institutions. The onus is clearly on EU Member States and EEA members to be

15 Now know as the European Systemic Risk Board.16

? Larosiere 36.

17 “Financial Supervision: Overview,” Europa , 31 Jan. 2011, 21 Apr. 2011, <http://ec.europa.eu/internal_market/finances/committees/index_en.htm>.

18 Now formally known as the European Systemic Risk Board.

19 See Chapter 1, pgs. 12-13.

20 “Article 9(5) of Regulation EU No: 1092/2010,” European Parliament and Council, Brussels, 24 Nov. 2010: 331/7. 21

? Larosière 28.

71

more consistent when transposing directives. This is a long standing problem

encompassing all the legislative spheres and is unlikely to change overnight.

More effort has to be made when drafting directives in sensitive areas like the

financial sector to limit the amount of interpretations that can be thrown up

when transposing a directive.

5.5 Procyclicality in Financial Regulation

Faults in the EU’s financial regulations are far from being the only

weakness in the European financial system, as a number of international

standards applied by European banks also have their faults. One of the

requirements of the Basel II regulations is mark to market accounting. This

accounting principle requires banks to assign a fair value on asset and liability

prices based on current market prices.22 The problem with this regulation is that

it is inherently procyclical.23 This is because at the height of an asset price

bubble the value of the banks assets in the banking book will have to be

reflected on the banks balance sheet, effectively meaning that less capital has to

be held in reserve. If asset prices then begin to deflate the value of those assets

have to be revised downwards, putting pressure on banks’ capital adequacy ratio

and potentially contributing towards a credit crunch.

One domestically oriented bank in Malta has already felt the squeeze

on its capital adequacy ratios in 2008 as a result of the mark to market principle,

with the result of its profitability taking a hit.24 Coupled with the heavy exposure

22 “Mark to Market,” Investopedia, 2011, 21 Apr. 2011, <http://www.investopedia.com/terms/m/marktomarket.asp>.

23 Charles Goodhart, “Analysis of Financial Stability,” London School of Economics, 2007: 20.

24 “Stock Market Review- ‘Mark to Market Rules Dent BOV’s Profitability but Returns Remain Commendable,” The Times of Malta, 6 Nov. 2008, 6 May 2011,

72

of local Maltese banks to property related loans (Figure 5.3), the mark to market

principle has the potential to bring instability into the Maltese financial system

were property prices to fall by a large amount.

One possible solution being touted to counter the procyclicality in the

mark to market principle is the dynamic provisioning scheme. This scheme has

been practiced in Spain since July 2000 25 in response to the increased risk

following on from a period of significant credit growth.26 In very basic terms

dynamic provisioning requires banks to build up reserves during an upswing in

order to dampen credit growth and leave banks with more liquidity during a

downturn. The overall effect is to smooth out the peaks and the troughs of the

lending cycle (Figure 5.4), thus helping both macroeconomic stability when it is

applied systemically and the individual banks’ own financial well being. It is of

course no panacea as Spain has suffered its own property bust and banking

problems but, if applied at EU level by the European Systemic Risk Board, it

could help target excessive credit expansion in one or more member countries.27

Figure 5.3

<http://www.timesofmalta.com/articles/view/20081106/business-news/stock-market-review-mark-to-market-rules-dent-bovs-profitability-but-returns-remain-commendable.232119>.

25 Jesus Saurina, “ Dynamic Provisioning: The Experience of Spain,” The World Bank, Washington, D.C, July 2009: 1.

26 Ibid.

27 Larosiere 181.

73

Source: Central Bank of Malta.

Figure 5.4Traditional and Dynamic Provisions across a Simulated Lending Cycle.

Source: Banco De Espana.

74

5.6 The Role of Monetary Policy

Most agree that central banks should not use short term interest rates

for any goal other than that of achieving price stability. Therefore it is

imperative to use other tools, like the ones mentioned above to regulate and

influence the financial sector in order to counter asset price bubbles and achieve

financial stability. That being said, another argument brought forth is that a

proper definition of price stability should also include housing prices. These are

not included in the European consumer price index.28 In addition pre-emptive

tightening of interest rates during an upswing has a more beneficial effect on the

wider economy than a central bank having to pick up the pieces after a credit

bubble has burst through pre-emptive easing.29

The dilemma faced by central banks is best epitomised during the

recovery phase of a crisis. The seeds of the next bubbles are being sown as

investors take advantage of the low interest environment, but raising interest

rates during such a sensitive period could harm the economic recovery.

5.7 Taking heed of the lessons learnt

There is no shortage of literature on the negative impacts that the

financial crisis and global economic slowdown had on economies around the

world. However, hopefully in years to come, the lessons learnt from the crises

will have a positive impact on the way that the financial sector is regulated and

the need for truly independent and unbiased institutions.

28 Charles Goodhart,” Lessons From the Crisis for Financial Regulation: What we need and what we do not need,” London School of Economics: 2. 29

? Howard Davies, “Banking on the Future: The Rise and Fall of Central Banking,” London School of Economics, Public Lecture, 12 May. 2010.

75

The financial crisis in Iceland clearly demonstrated that underlying

instability in the financial sector doesn’t always manifest itself through

macroeconomic indicators. Placing too much emphasis on these indicators

without factoring in the relevant financial indicators discussed in Chapter Four

can give a false reading on an economy’s overall well being, especially those

with disproportionately large financial sectors.

The fallout on the real economy caused by the banking sector taking on

too much risk in Iceland has important repercussions for Malta. Given the

oligopolistic nature of domestically oriented banks in Malta, all of the main

banks can be considered as ‘too big too fail’ due to their systemic importance.

With this knowledge Maltese banks may be tempted to take on riskier behaviour

in search of ever greater profits, knowing that the state would have little choice

but to bail them out should things go wrong. The expanding financial sector is a

dynamic pillar of growth for the island, but one that should be closely monitored

and regulated. In terms of Minsky’s theory Malta’s displacement phase took

place several years after Iceland’s, so the island may be heading towards the

latter stages of the cycle.

Resorting to regulatory arbitrage should be avoided at all costs as local

regulators may quickly find themselves overwhelmed as the sector proliferates,

much like the “understaffed and inexperienced” Icelandic Financial

Supervisory.30 Properly integrating into the European Union’s systemic risk

board should be a top priority, as this will further help understand the potential

risks brought about by the increasing amount of internationally oriented banks

operating on the island.

30 Andrew Ward, “Iceland Accused of Negligence over Banking Crisis,” The Financial Times, 13 Apr. 2010, 20 May 2011, < http://www.ft.com/intl/cms/s/0/92366e06-4696-11df-9713-00144feab49a.html#axzz1Mt7GhizC>.

76

Governments also have a role to play. The days of care free spending

are over and the importance of a balanced budget and long term planning cannot

be overstated. The temptation for procylical policies that are tailored around a

politician’s term in office and maximisation of re-election chances are

irresponsible and damaging. More checks and balances need to be put in place

with regards to government spending especially in small states like Iceland and

Malta where the government plays a proportionately large role in the economy.

77

Bibliography

Books

Sloman, John. “Economics.” (Pearson Education Limited: England, 2003.)

Thorhallsson, Baldur. “Iceland and European Integration: On the edge.” (Routledge: London, 2004.)

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“Commission Opinion on Iceland’s Application for Membership of the EU.” European Commission. Brussels. 24 Feb. 2010.

“Economic Survey October 2010.” Ministry of Finance. Valletta. 25 Oct. 2010.

“European Economic Forecast Autumn 2010: Iceland.” European Commission. Brussels. 29 Nov. 2010.

“Financial Stability Report 2008.” Central Bank of Malta. Valletta. 2008.

“Financial Stability 2010.” Central Bank of Iceland. Reykjavik. 2 June 2010.

“Green Paper on On-line Gambling in the Internal Market.” European Commission. Brussels. 24 Mar. 2011.

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“Iceland: Request for Stand by Arrangement.” International Monetary Fund. Report No. 08/362. Washington D.C. Nov. 2008.

“Iceland: Staff Report for First Review under Stand by Arrangement.” International Monetary Fund. Report No. 09/306. Washington D.C. Oct. 2009.

De Larosiere, Jacques. et al. “The High-Level Group on Financial Supervision in the EU.” European Commission. 25 Feb. 2009.

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“Malta: Macro-Fiscal Assessment.” European Commission. Brussels. 7 Apr. 2010.

“Malta: Staff Report for the 2008 Article IV Consultation.” International Monetary Fund. Report No. 08/279. Washington D.C. Aug. 2008. “Malta: Staff Report for the Article IV Consultation.” International Monetary Fund. Report No. 09/287. Washington, D.C. September 2009.

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Journals, Periodicals and Newspapers.

Azzopardi, Rose Marie. “Malta’s Open Economy: Weathering the Recessional Storm.” South European Society and Politics. Eds. Susannah Verney et al. Vol.14 No.1 Mar. 2009.

“Asset Markets: The Danger of the Bounce.” The Economist.<http://www.economist.com/node/15211520?story_id=15211520>.

Barnes, Paul. “Minsky’s Financial Instability Hypothesis: Information Asymmetry and Accounting Information.” Nottingham Business School. 2007.

Borio, Claudio and Philip Lowe. “Asset Prices, Financial and Monetary Stability: Exploring the Nexus. Bank for International Settlements. July 2002.

Borio, Claudio. “The Macroprudential Approach to Regulation and Supervision: Where do we stand?” The Financial Supervisory Authority of Norway. 2006.

Briguglio, Lino, Gordon Cordina, Stephanie Bugeja and Nadia Farrugia. “Profiling Economic Vulnerability and Resilience in Small States: Conceptual Underpinning.” University of Malta. 2006.

Briguglio, Lino, Gordon Cordina, Stephanie Bugeja and Nadia Farrugia. “Economic Vulnerability and Resilience: Concepts and Measurements.” United Nations University. Research Paper No. 2008/55. May 2008.

Buttonwood. “The Foolishness of Crowds.” The Economist. London. Vol. 399 No. 8728.

Buttonwood. “Good Losers.” The Economist. London. Vol. 399 No. 8732.

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Charlemagne. “A Parable of two Debtors.” The Economist. London Vol. 399 No.8729.

“Economics Focus-Ties that sometimes bind.” The Economist. London. Vol. 399. No. 8733.

Ekman, Ivar. “In Norway, EU Pros and Cons (The Cons still win).” The New York Times. 27 Oct. 2007.

Foley, Duncan. “Hyman Minsky and the Dilemmas of Contemporary Economic Method.” Columbia University[NY]. Dec. 1998.

Goodhart, Charles. “Lessons from the Crisis for Financial Regulation: What we need and what we do not need.” Financial Market Group, LSE. 2009.

Goodhart, Charles, “Procyclicality and Financial Regulation.” Central Bank of Spain. Financial Stability Report No. 16. Oct. 2010.

Goodhart, Charles and Dimitrios Tsomocos. “Analysis of Financial Stability.” Financial Market Group, LSE. Special Paper No. 173. 2007.

Gissurarson, Hannes and Daniel J. Mitchell. “The Iceland Tax System.” Prosperitas. Vol. 11 Issue V. 2007.

“Latin America’s Housing Boom: It’s not all froth.” The Economist. London. Vol. 399. No. 9732.

Motout, Philippe and Giovanni Vitale. “Monetary Policy Strategy in a Global Environment.” European Central Bank. Occ. Paper. No. 106 Aug. 2009.

Montford, Karl and Stefano Mallia. “The Maltese Economy post-EU.” UHM. 7 Mar. 2007.

Olafsson, Tjorvi Thorvadur and Petursson, G. Thorarinn. “Weathering the Financial Storm: The Importance of Fundamentals and Flexibility.” Central Bank of Iceland. Working Paper No. 51. Oct. 2010.

Pace, Roderick. “Malta and EU Membership: Overcoming ‘Vulnerabilities’, Strengthening ‘Resilience’.” European Integration. Vol. 28 No.1 Mar. 2006.

Saurina, Jesus. “Dynamic Provisioning: The Experience of Spain.” The World Bank. July 2009.

“The Perils of Property.” The Economist. 3 Mar. 2011. 25 May 2011. < http://www.economist.com/node/18281764?story_id=18281764>.

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Thorhallsson, Baldur and Anders Wivel. “Small States in the European Union: What do we know and what would we like to know?” Cambridge Review of International Affairs. Dec. 2006.

Wade, Robert. “Iceland as Icarus.” Challenge Vol. 52, No.3. May/June 2009.

Ward, Andrew. “Iceland Accused of Negligence over Banking Crisis.” The Financial Times. < http://www.ft.com/intl/cms/s/0/92366e06-4696-11df-9713-00144feab49a.html#axzz1Mt7GhizC>.

Speeches and Lectures

Bonello, C. Michael. “Speech given at the annual dinner of the Institute of Financial Services.” Central Bank of Malta. 20 Nov. 2010.

Davies, Howard and David Green. “Banking on the Future: The Rise and fall of Central Banking.” London School of Economics. Public Lecture 12 May 2010.

Dissertations

Zahra, Larkin. “Iceland’s Application to join the EU. Diss. U. of Malta, 2010.

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Ivester , J. Eric. “Icelandic Banking Crisis Offers Insight into Global Financial Meltdown.” Turnaround Management Association. 15 Sep. 2010. 21 Apr. 2011.<http://www.turnaround.org/Publications/Articles.aspx?objectId=13306>.

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