How not to resolve a banking crisis

By Jon Danielsson, Reader in Finance at the London School of Economics

Much of macroeconomic policymaking is trial and error. This column discusses calamitous error on the part of Iceland’s policymakers, in the hope that others can at least try something else.

The Icelandic banking system collapsed in October 2008 and its three internationally active banks were taken over by the government. Disregarding best international practice, the government opted to restructure the banks on national grounds. Soon after two of the three passed into the hands of foreign ‘vulture’ funds which had no expertise or interest in running a banking system – they just wanted to cash out assets. The government has also maintained direct control of the banks, implementing an overarching regulatory structure and discouraging regular banking activities.

As a result, Iceland is saddled with a dysfunctional banking system more interested in maximising short-term asset recovery and compliance than providing the core banking services necessary for economic recovery.

Crisis and resolution

Best practice in resolving banking crises is the good bank/bad bank model, as used by Sweden in 1992 (Buiter 2009, Jonung 2009). A key objective is to create viable financial institutions able to provide uninterrupted banking services, thus helping economic recovery. In spite of receiving advice from Scandinavia, the Icelandic authorities at the time of the collapse rejected this approach.

Instead, they opted to split the banks on geographical lines. Keep the Icelandic operations separate from the international operations, with the idea that somehow Iceland could be protected from international default. Not surprisingly, this was impossible. Not only were the Icelandic assets of low quality and part of the same asset pool as foreign assets, but international creditors had claims on both types of assets so bank resolution schemes necessarily had to consider both types jointly.

The end result was three new domestic banks, not quite stillborn, but as they were saddled with the domestic loan book of the old banks, they were anything but healthy.

The authorities at the time had it within their powers to do a good bank/bad bank split, but within a few months that option disappeared as the resolution process moved into its second phase.

A new banking system is formed

Soon after the banks collapsed, their international creditors wrote down their Icelandic exposures, selling them on the secondary market for around 4-6 cents on the dollar. The purchasers were mostly vulture funds specialising in distressed assets.

After a change in government in early 2009, it fell on the incoming government, along with the IMF, to reconcile creditor demands. The international parts of the banks were left in the winding up stage with large international banks remaining significant creditors, while the domestic parts, called new banks, took over retail banking responsibilities in Iceland and domestic asset recovery.

Two of the three new banks passed indirectly into the hands of foreign vulture funds in 2009, with the government retaining a share and a veto power on the board. The last bank, Landsbanki, is likely to remain in government hands – at least until the Icesave issue is settled.

The new beneficial owners of the new banks are vulture funds that have neither much banking experience nor any interest in running a banking system. Instead they specialise in maximising short-term distressed asset recovery. However, their freedom to act is limited by both the legal resolution process and the government, at least until they formally assume ownership when the new banks become incorporated.

Regulations and governance

After the crisis of October 2008, the government was determined to prevent a future crisis and in short order created an expansive regulatory structure suitable for the three international Icelandic banks prior to the collapse, a regulatory structure that supposedly would have prevented the banking crisis ex post. This approach failed to take into account that the banks emerging after the collapse were quite different than before, only a very small fraction of their previous size, and focused on domestic operations.

After the crisis, banks and bankers were demonised in the media and the incoming bank administrators, chosen because they were not bankers, adopted that view, beefing up compliance and sharply curtailing regular banking operations.

One example of the regulatory changes was an immediate increase in capital requirements to 16%. In light of the current international debate on the impact of increasing bank capital to much lower levels and the long timetable for the implementation, it is hard to see the logic behind that decision.

The banks as asset managers

The new beneficial owners of the banks treat them more as asset management institutions than providers of financial services. That entails maximising recovery from creditors and profiting from running failed firms that they have fully or partially taken over. The banks are reluctant to write down loans, so they roll them over. The practice, known as ‘evergreening’, is more the norm than the exception.¹

Firms that escaped default in the crisis are at a significant disadvantage compared to worse-run competitors who failed and passed into the hands of the banks since the banks favour their own companies in access to credit. In turn, this holds back recovery and discourages investment because any new firm would have to obtain banking services from the very same banks competing against them.

Conclusion

If the banking system of Iceland had been restructured on best practice international grounds, Iceland would now have a vibrant banking system, providing the necessary if not sufficient conditions for economic recovery. Instead, the Icelandic government, with IMF support, created a dysfunctional banking system that continues to prevent recovery.

The government can still solve the problem, starting by clarifying beneficial ownership of the banks, reducing its focus on compliance and regulations, and encouraging normal bank practices. At the same it should require the direct separation between the asset management function of the banks and the provision of banking services.

References

Buiter, Willem (2009), “Good Bank vs Bad Bank: Don’t touch the unsecured creditors! Clobber the tax payer instead. Not.”, VoxEU.org, 14 March.

Jonung, Lars (2009), “The Swedish model for resolving the banking crisis of 1991-93: Is it useful today?”, VoxEU.org, 14 March.

¹ To reduce their loans and thus boost capital ratios, banks – who cannot get rid of their bad loans without acknowledging a write-down –rollover bad loans and reduce their good loans instead. This buys the banks time to run down the bad loans slowly, thus earning its way out of trouble.

This article originally appeared at VoxEU.