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Iceland's Banking Crisis: The Meltdown of an

Interventionist Financial System
Mises Daily: Tuesday, June 09, 2009 by Philipp Bagus (http://mises.org/articles.aspx?AuthorId=336) and David
Howden (http://mises.org/articles.aspx?AuthorId=1259)

[Editor note: If you are interested in helping to fund the

writing, publication, and distribution of a longer version of this
article, with more technical detail and analytics, please write
the development department (mailto:james@mises.org) .]

Icelandic Prime Minister Geir Haarde's resignation on January 23rd

of this year marked the first political casualty of the current financial
crisis. While the Icelandic situation has received scant attention
relative to other calamities reverberating through the world's financial
markets, the source of Iceland's woes can be found in many of the
same locales. Unfortunately, while the events affecting Iceland's
populace have been severe, the country's diminutive size —
approximately 320,000 residents — has made it a target all too easy
to miss. However, the repercussions on both the country's native
Icelanders as well as global financial markets give reason to dedicate
serious attention to the causes, and cures, of this unfortunate and
wholly avoidable event.

Regrettably, the current focus on the causes of the crisis continually

misidentifies its true source, resulting in prescribed cures that fall
short of the necessary actions. Peter Gumbel writing for the
December 4th, 2008, edition of Fortune reckons previous Prime Minister Davíð Oddsson's free-market reforms
during his 1991–2004 years in office are what ultimately gave rise to the bust. Likewise, the IMF's mission chief
sent to Iceland to survey the nature of the problem, Poul Thomsen, recently commented in an interview that the root
problem in Iceland was an unregulated environment that allowed an oversized banking system to develop.[1] (#note1)
Indeed, the post-privatization banking experienced in Iceland resulted in a banking sector that saw assets increase to
over 1,400% of GDP!

What analysts and authors commonly miss is the reason the banking sector could expand so rapidly. Indeed, as we
shall see, the incentive structure of the Icelandic economy was manipulated through government guarantees,
artificially low interest rates, and monetary spigots opened wide, allowing liquidity to be flushed through the
economy. In addition, Iceland's homeowners were offered tantalizingly low interest rates through the "Housing
Financing Fund" (HFF), a state agency that enjoyed explicit government guarantees on its debt, resulting in reduced
interest charges for homeowners. Interestingly, while the Fund's merely implicitly guaranteed American counterparts
— Freddie Mac and Fannie Mae — have been the center of much controversy, the HFF has remained relatively

The policy prescriptions in the wake of the crisis have called for more interventions, which will prove to exacerbate
the situation if put into effect. Only by gaining a true understanding of the unsustainable and artificial nature of the
boom of the past decade may we arrive at effective solutions to navigate the bust that engulfs the country.

Maturity Mismatching and Artificial Booms

Iceland's crisis shares a common bond with those that have infected other developed economies recently: all have

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banking systems heavily engaged in the practice of maturity mismatching. In other words, Icelandic banks issued
short-term liabilities in order to invest in long-term assets, as can be seen in figure 1, which presents the funding
gaps (i.e., liabilities less assets) of a given maturity for the three largest Icelandic banks — Kaupthing, Glitnir, and
Landsbanki.[2] (#note2)

Figure 1: Funding gap: Big Three Banks (in million króna)

Source: Kaupthing, Glitnir, Landsbanki: 2008 annual reports

Thus, the banking system had to continuously roll over (renew) their short-term liabilities until their long-term assets
fully matured. If an event arose whereby Icelandic banks failed to find new borrowers to continue rolling over their
liabilities, they could face a liquidity crisis and, more importantly, spark the collapse of the Icelandic financial
system; recent events have borne out this exact scenario.

Considering these recent events, the question that immediately comes to mind is, why did Icelandic banks engage in
such a risky practice in the first place? First of all, maturity mismatching can turn out to be a very profitable
business, involving a basic interest arbitrage. Normally, long-term interest rates are higher than their corresponding
short-term rates. A bank may then profit the difference — the spread between short- and long-term rates — through
these transactions. Yet, while maturity mismatching can turn out to be profitable, it is very risky as the short-term
debts require continual reinvestment (i.e., a continual "rollover" must occur).

As in other countries, Icelandic banks enjoyed guarantees by the government to bail them out should their bets on
the market turn erroneous. However, while this guarantee is merely implicit in most developed economies, the CBI
committed to it explicitly.[3] (#note3) The Central Bank of Iceland effectively functioned as the "roller-over of last
resort," providing fresh short-term debt as the market required it. Indeed, the three main Icelandic banks —
Kaupthing, Glitnir, and Landsbanki — were so big in comparison to the GDP that they could regard themselves as
too big to fail. This led to moral-hazard problems: If we have rollover problems threatening our solvency, someone
— be it the government or the central bank — will come to help us, lest a detrimental shock reverberate through the
financial community. The result of this explicit guarantee was excessive maturity mismatching.

The most obvious effect of this undertaking is that it represents a financially unsound practice and may lead to
banking-system instability. However, another even more important effect of excessive levels of maturity-
mismatched loans is that it leads to distortions in the real economy by distorting the capital structure, as
demonstrated by Austrian business-cycle theory. By expanding credit, banks create demand deposits (zero maturity)
in order to invest in loans issued to the public (longer-term maturity). A similar maturity mismatch occurred, as we

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shall see, when Icelandic banks borrowed in (mainly international) wholesale markets (via short-term interbank loans
and repurchase agreements, asset-backed commercial paper, etc.) in order to investment in long-term loans, such as
commercial and residential mortgages.[4] (#note4)

The ultimate problem with maturity mismatching is that there are insufficient savings available to finish the
artificially high number of projects undertaken. Lenders have only saved for 3 months (i.e., the term of the
commercial paper) or not saved at all (i.e., the term of the deposit), and not for 30 or 40 years (i.e., the term of the
mortgage or capital project). Maturity mismatching deceives both investors and entrepreneurs about the available
amount of real long-term savings. Hence, by borrowing short and lending long, long-term interest rates are artificially
reduced. Entrepreneurs think that more long-term savings are available than really exist and accordingly engage in
malinvestments that must be liquidated, once it becomes obvious that there are not enough real savings to sustain
them to completion.

In the Icelandic case, the malinvestments were made mainly in the aluminum and construction industries. Both
aluminum mines and residential and commercial housing represent long-term investment projects that were financed
by short-term funds and not by savings of an equal term.

Another consequence of malinvestment was that resources were drawn into the financial sector, which expanded
enormously. Thus, resources were redirected from consumer goods' industries into the financial sector. As one
professor noted, fishermen became investment bankers to meet the insatiable demands of the newly profitable
financial sector:

"Everyone was learning Black-Scholes" (the option-pricing model), says Ragnar Arnason, a professor of fishing
economics at the University of Iceland, who watched students flee the economics of fishing for the economics of
money. "The schools of engineering and math were offering courses on financial engineering. We had hundreds and
hundreds of people studying finance."[5] (#note5)

As a result, Iceland became an exporter of financial services and an importer of goods. As Iceland basically stopped
producing "real" goods and services, a substantial trade deficit developed, as shown in figure 2.

Figure 2: Balance of Trade (in million króna)

Source: Central Bank of Iceland, Statistics (2009)

This distorted structure of production threatened to "starve" the population during the currency breakdown last fall
when Iceland had problems obtaining foreign exchange to pay for the imports the country had become so reliant on

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However, maturity mismatching alone does not explain the Icelandic case sufficiently. As domestic funds for
profitable maturity mismatching were limited in Iceland's small economy while the financial sector was booming,
banks started to look elsewhere for funds. Thus, Icelandic banks borrowed foreign short-term funds to invest them
for the long term, both domestically and internationally. This was even more attractive as domestic interest rates
were higher than those of foreign central banks, which had undertaken even more extreme cases of loose-money
policies. This leads us to the second and more specific problem of Iceland: currency mismatching.

Who Lends to the Lender of Last Resort?

Over the past decade, the Icelandic financial system had accumulated a significant portion of its funding
requirements in foreign currencies. In figure 3, we can see the evolution of Icelandic deposit banks' accounts at the
CBI through the end of 2008. Most shockingly, we may draw attention to the increase in foreign liabilities that
occurred over the seven-year period, resulting in a 2,300% increase. Domestic liabilities, in contrast, also saw a
significant 600% increase — the result of low nominal interest rates, which hovered near zero when factored for
inflation. The evolution of bank assets may seem reserved by comparison with Icelandic foreign assets, now only
approximately the same size as domestic assets. However, looking at the relative positions from just seven years
ago, we see the much more "normal" position financial institutions prefer to be in — large asset holdings in the
domestic currency to minimize risks from exchange-rate shocks. Indeed, foreign assets become the asset class that
ballooned as much as any other, increasing a staggering 10,600% over the period!

Figure 3: Accounts of Deposit Banks at the central bank (in million króna)

Source: Central Bank of Iceland, 2008 annual report

One main source of external funding was Japanese-yen-denominated loans.[6] (#note6) The Bank of Japan has pursued a
loose monetary policy for many years to combat an extended period of recession. As a result of these artificially
low borrowing rates, yen-denominated loans could be obtained for historically low yields — sometimes as low as
1% per annum. As a result of these attractive yields, an ample amount of short-term liquidity was available, which
in turn was invested in the now-famous maturity mismatch. As long as the liquidity remained high, Icelandic banks
faced no problem continually obtaining new short-term funding. However, as the interbank lending markets dried up
last year after the collapse of Lehman Brothers, Icelandic banks found themselves unable to cover the short fall.

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One problematic area this foreign borrowing filtered into was the domestic mortgage market. In fact, this particularly
complex market went through a period of intensely discoordinating occurrences over the past decade, resulting in
the detrimental results now apparent.

The Housing Financing Fund (HFF), formed in 1999 to take over the assets and obligations of the previous State
Housing Board, lent domestic mortgages to Icelanders. By mid-2004, almost 90% of Icelandic households held an
HFF loan, and HFF issued bonds dominated over half of the Icelandic domestic bond market. While in many other
countries, state-controlled mortgage-assistance schemes were reserved for those deemed most in need, Icelandic
society — one that prides itself on treating everyone equally — saw no need to discriminate between those who
should receive assistance and those who should not.

Iceland's newly privatized banks, led by the big three, found themselves unable to compete with the state-supported
system based on low interest rates alone. Instead, they increasingly were forced to reduce the quality of the
collateral posted on their mortgages, an occurrence that resulted in a general underpricing of risk.

Mortgage market lending was further exacerbated by two central-bank policies. First, a central-bank reduction in the
reserve requirements in place in the country's fractional-reserve banking system (as shown in figure 4) caused a
sudden availability of liquidity in the financial market, resulting in many banks requiring a place to park the extra
liquidity (Hunt, Tchaidze and Westin 2005: 33n8).

Figure 4: Required reserves (%) and the CBI's policy rate (%)

Source: Central Bank of Iceland, Statistics (2009)

Second, an extremely accommodating monetary policy — both domestically and internationally — made ample
quantities of liquidity available to be borrowed and invested. In Iceland's specific case, broad-based monetary
aggregates such as M1, grew at a rate of 20–30% per annum every year between 2002 and 2007 (figure 5).[7] (#note7)

Figure 5: M1 growth rate (%)

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Source: Central Bank of Iceland, Statistics (2009)

Additionally, about half of the borrowing in Iceland carried short-term flexible interest rates, made at appealing low
interest rates, artificially reduced by the central bank. With a bountiful quantity of liquidity available at historically
low prices, the outlets of this monetary expansion saw their values rise to ever greater heights. The average house
price in Iceland saw its value increase almost 30% in domestic króna, and every year between 2003 and 2007 saw a
greater-than 10% annual price appreciation.

A significant boom had materialized, much of it realized in foreign currency at captivatingly low interest rates.
However, when the house of cards finally came tumbling down, this boom sustained on foreign currencies soon
came to an end. With the bankruptcy of American financial-service provider Lehman Brothers, the banks that had
engaged in maturity mismatching — the essence of the Icelandic model — found themselves in a squeeze to roll
over the necessary funds to maintain liquidity. Unfortunately, unlike many other areas of the world where
quantitative easing by the central bank has provided short-lived relief, Iceland was forced to suffer a much more
dire fate. The island's currency — the króna — plunged in value, making bankers, both private and central, unable
to raise the cash necessary to continue funding their liabilities.

Before asking why the Central Bank of Iceland has been so ineffective in mitigating the current crisis, it is important
to point out that the drying up of liquidity and the ensuing negative effects on financial assets' values by stopping
the necessary rollover did not occur by pure accident, as many economists seem to think. Rather, it was triggered by
the malinvestments that were caused by the mismatching practices — both maturity and currency — in the first
place. When commodity and housing prices started to fall and consumer goods' prices soared, it became obvious
that many assets of the Icelandic banking system would lose value and that the structure of production of Iceland
had to be readjusted accordingly. This triggered the run on the króna that ended the rollover.

In the end, a banking system once thought to be "too big to fail" was quickly seen as the white elephant it was —
"too big to bail." The liabilities of the banking system had been induced to make a shift from domestic to foreign
assets, which bred detrimental misallocations in the real economy. Furthermore, the relative increase in profit in the
banking sector caused many Icelandic resources to shift from the real economy — once dominated by marine
activities — to the more modern world of banking and finance. These imbalances will take time to repair
themselves, as the real economy must revert back to a sustainable structure, conducive to the desires and
preferences of consumers. Indeed, as one fisherman-turned-banker recently commented, "I think it is easier to take
someone in the fishing industry and teach him about currency trading, than to take someone from the banking

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industry and teach them how to fish" (Lewis 2009). Disruptions to this essential process will cause undue duress
and prolonged hardship for the Icelandic people.

Many analysts were caught completely off guard by the recent turmoil — epitomized by the Icelandic experience.
Three IMF economists — Robert Tchaidze, Anthony Annett, and Li Lian Ong — almost identified the problem two
years ago, noting, "Foreign currency borrowing has been growing strongly … and this could potentially become an
important indirect credit risk for banks" (2007). While they were quite correct as this potentiality became reality,
the indirect risk is decidedly more direct than once thought. Economists are only now awakening to the true risks
involved in currency mismatching; however, the larger problem — maturity mismatching — still proceeds unabated.

The systemic misallocations in the real structure of production — those activities that provide the livelihood of the
Icelandic residents — were disrupted as severely as anywhere else on the globe by the maturity mismatching
undertaken. While it may be all too easy at this juncture to blame the bankers' ignorance and arrogance concerning
this risky procedure as the cause of the consequent disaster, the root cause lies in a more concealed location.
Bankers, at least in the past, have been well aware of the risks of this procedure. In fact, the "golden rule" of
banking dates back over 150 years — the term of the loans a bank grants should be equal to the term of the loans a
bank receives (Hübner 1854).

Government interventions are at the root of the problem as they disrupt the incentive structure that bankers face,
limiting their propensity to abide by this sensible practice. The explicit guarantee by the Central Bank of Iceland
altered bankers' risk preferences, and resulted in the risky undertaking being gingerly assumed to be sustainable.
The continual liquidity injections by the central bank ensured that rolling over short-term loans would not pose a
significant problem. Finally, the collaborative effort of all central banks over the past decade to reduce interest rates
to historically low levels had ingrained in individuals' minds that cheap credit could drive a boom towards ever
greater heights. The events of the past year have demonstrated conclusively the fallacy of this viewpoint.

Unfortunately, most policy recommendations to Iceland have been undertaken with little to no knowledge as to the
true source of the bust. Willem Buiter and Anne Sibert (2008) have completed the most complete analysis of the
Icelandic crisis to date. By only dealing with the evident issues, they deem the real downfall of Iceland to have been
a central bank unable to issue the necessary credit when the need arose. Hence, as a recommendation, they believe
Iceland should look towards joining the European Monetary Union in order to gain a central bank credible as a
lender of last resort. What they fail to realize, unfortunately for those who will listen to their prescription, is that the
boom was unsustainable from the start; prolonging it will only offer temporary relief, if any at all. The
misallocations of capital disrupted the productive portion of the economy in ways that could not prevail indefinitely,
given the preferences of Icelanders as well as foreigners. The moral hazard created by the diminutive Icelandic
central bank has already provided us with a spectacular blowup; are we to believe that the moral hazard guaranteed
by the European Central Bank will be any less malign?

Instead, we find that the solution is not a central bank as a lender or

roller-over of last resort, but, as Ludwig von Mises had already stated in
1912 (http://mises.org/books/Theory_Money_Credit/Part3_Ch15.aspx) , the
solution is rather that banks conform to the golden rule of banking:

For the activity of the banks as negotiators of credit the golden

rule holds, that an organic connection must be created between
the credit transactions and the debit transactions. The credit that
the bank grants must correspond quantitatively and qualitatively
to the credit that it takes up. More exactly expressed, "The date
on which the bank's obligations fall due must not precede the date
on which its corresponding claims can be realized." Only thus can
the danger of insolvency be avoided. (The Theory of Money and
Credit (http://mises.org/store/Theory-of-Money-and-Credit-
The--P57C17.aspx) )

The fatality of the banking practices of mismatching assets and

liabilities has been exposed. Let's hope that the calls of some do not
exacerbate the situation by allowing it, indeed prompting it, to flourish and-Credit-The--P57C17.aspx)

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Philipp Bagus is an associate professor at Universidad Rey Juan Carlos, Madrid and a visiting professor at Prague
University. Send him mail (mailto:Philipp.Bagus@web.de) . See his article archives (http://mises.org
/articles.aspx?AuthorId=336) .
David Howden is a PhD candidate at the Universidad Rey Juan Carlos, in Madrid, and winner of the Mises
Institute's Douglas E. French Prize (http://mises.org/about/3323) . Send him mail (mailto:davidhowden@gmail.com) . See
his article archives (http://mises.org/articles.aspx?AuthorId=1259) .
Comment on the blog (http://blog.mises.org/archives/010100.asp) .
Helpful input from Juliusz Jablecki (http://mises.org/articles.aspx?AuthorId=784) is greatly acknowledged.

Andersen, Camilla. 2008. "Iceland Gets Help to Recover from Historic Crisis." (http://www.imf.org/external/pubs/ft
/survey/so/2008/int111908a.htm) IMF Survey Magazine 37(12). December 2.

Bagus, Philipp and David Howden. 2009. "The Legitimacy of Loan Maturity Mismatching: A Risky, but not
Fraudulent, Undertaking." (http://www.springerlink.com/content/pn81764318674wv0/) Journal of Business Ethics.

Buiter, Willem H., and Anne Sibert. 2008. "The Iceland banking crisis and what to do about it: The lender of last
resort theory of optimal currency areas." CEPR Policy Insight, 26.

Central Bank of Iceland. 2001. "New Act on the Central Bank of Iceland." (http://www.sedlabanki.is/?PageID=287&
NewsID=25) Press Release November 13.

Gumbel, Peter. 2008. "Iceland: The Country that become a hedge fund." (http://money.cnn.com/2008/12/01/magazines
/fortune/iceland_gumbel.fortune/) Fortune, December 4.

Hunt, Benjamin, Robert Tchaidze, and Ann-Margret Westin. 2005. Iceland: Selected Issues. IMF Country Report
No. 05/366. (http://www.imf.org/external/pubs/ft/scr/2005/cr05366.pdf)

Hübner, Otto. 1854. Die Banken. Leipzig: Verlag Heinrich Hübner.

Lewis, Michael. 2009. "Wall Street on the Tundra." (http://www.vanityfair.com/politics/features/2009/04/iceland200904)

Vanity Fair, April. (http://www.vanityfair.com/politics/features/2009/04/iceland200904?currentPage=1)

Mises, Ludwig von. [1912] The Theory of Money and Credit (http://mises.org/store/Theory-of-Money-and-Credit-
The--P57C17.aspx) .

Tchaidze, Robert, Anthony Annett, and Li Lian Ong. 2007. "Iceland: Selected Issues." IMF Country Report No.
07/296. (http://www.imf.org/external/pubs/ft/scr/2007/cr07296.pdf)

[1] (#ref1) See Andersen (2008) for the full IMF interview.

[2] (#ref2) These three largest banks dominated the Icelandic financial landscape, with assets which ballooned to
1100% of Icelandic GDP in 2007 (Buiter and Sibert 2008:4) and comprised nearly 80% of total Icelandic banking

[3] (#ref3) See CBI (2001) for the press release which, among other things, promises a new era of price stability
through an inflation targeting framework, and the formal provision of lender of last resort functions.

[4] (#ref4) There exist, however, important differences between credit expansion and other types of maturity
mismatching in that credit expansion always increases the money supply. Furthermore, an initially created unbacked
demand deposit may lead to a far greater expansion of demand deposits if the rest of the banking system follows
suit. Other types of maturity mismatching do not increase the money supply. Another difference lies in the ethical
status of the practices. Credit expansion can be regarded as fraudulent in nature, while borrowing short and lending
long (i.e., maturity mismatching) is merely risky. On this point see Bagus and Howden (2009).

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[5] (#ref5) As quoted in Lewis (2009).

[6] (#ref6) As Buiter and Sibert (2008: 16) report, approximately 80% of foreign currency loans made to households
were denominated in the two currencies with the lowest interest rates — Swiss Francs and Japanese yen.

[7] (#ref7) Additionally, even government agencies such as the HFF provided liquidity to an already saturated
system. In 2005 alone, the Fund funneled its own excess liquidity to commercial banks by extending loans of
approximately 80 billion krónur.

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