Icelandic banking collapse

320,000 people ran banks worth ten times their GDP. All three fell in a single week.

The world stops matching the model. Regime change and leverage turn a small error fatal.

Room: Q4 Where models die
Year: 2008
Impact: $85B
Sector: Banking
Region: Europe
Category: Economic

Why this room

The event sits in q4 because the banks' solvency and funding models remained internally coherent only while the regime that produced them held: open wholesale funding markets, a stable krona, and cross-border deposit passporting under the EEA. When that regime changed in 2007-2008, a small mispricing of funding and FX risk became fatal, because the three banks had grown to roughly nine to ten times Iceland's GDP and their liabilities were overwhelmingly in currencies the Central Bank could not print. The classification turns on the mismatch between model and world, not on the presence of fraud: the Central Bank's own lender-of-last-resort model assumed it could support a banking system it had no capacity to support in foreign currency, and the banks' capital ratios assumed equity that was substantially financed by lending against the banks' own shares.

The record

The Special Investigation Commission found the Icelandic financial system had grown to nine times the country's gross domestic product, a scale at which, in the SIC's words, the roles of regulator and regulated are reversed.certain
The BIS Financial Stability Institute puts the aggregate balance sheet of Kaupthing, Glitnir and Landsbanki at 10 times Iceland's GDP, with the three banks making up over 80% of the financial system.certain
All three banks were taken over inside three days: the FME suspended Landsbanki's board on the morning of 7 October 2008 and Glitnir's that evening, and appointed a resolution committee for Kaupthing on the eve of 9 October 2008.certain
Lending growth by the banks' parent companies averaged nearly 50% a year from the start of 2004 until the collapse.certain
Central Bank of Iceland collateralised lending to financial institutions rose from ISK 30 billion in autumn 2005 to ISK 500 billion by early October 2008, of which ISK 300 billion was to the three large banks.certain
When Glitnir collapsed, its outstanding loans to Baugur and affiliated companies exceeded ISK 250 billion (a little less than EUR 2 billion), equal to 70% of the bank's equity base.certain

Sources

The book

This entry is one of 111 in the register. The full story, and what it cost the people who lived it, is in Risky Business by Claudia Zeisberger, David Munro and Joanna Reijgersberg-Siew.

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