Financial Crisis in Iceland Essay Example

Financial Crisis in Iceland Paper This assignment is part of ECM04 Economics of Capital Markets module on phase 2 in MSc. Finance and Investment at University of Brighton 2008-2009. The assignment is to analyze the Icelandic financial crisis which eventually led to the collapse of the Icelandic banking system and the economy as a whole. In order to analyse the Icelandic financial crisis we will begin to look at the background and what we regard as the causes, look at the consequences and future prospects. In the end we compare the Icelandic financial crisis to a model which Kindleberger covers in his book Manias, Panics and Crashes. Kindleberger (1978) describes financial crisis in the following way: What happens, basically, is that some event changes the economic outlook. New opportunities for profits are seized, and overdone, in ways so closely resembling irrationality as to constitute a mania. Once the excessive character of the upswing is realized, the financial system experiences a sort of distress, in the course of which the rush to reverse the expansion process may become so precipitous as to resemble panic. In the manic phase, people of wealth or credit switch out of money or borrow to buy real or illiquid financial assets. In panic, the reverse movement takes place, from real or financial assets to money, or repayment of debt, with a crash in the prices of commodities, houses buildings, land, stocks, and bonds in short, in whatever has been the subject of the mania. Background Causes European Economic Area Icelandic government control over the economy has reduced over time. The most dominant decision was when Iceland entered the European Economic Area (EEA) in 1994. When Iceland joined the EEA it got access to European markets and adopted European regulations. We will write a custom essay sample on Financial Crisis in Iceland specifically for you for only $16.38 $13.9/page Order now We will write a custom essay sample on Financial Crisis in Iceland specifically for you FOR ONLY $16.38 $13.9/page Hire Writer We will write a custom essay sample on Financial Crisis in Iceland specifically for you FOR ONLY $16.38 $13.9/page Hire Writer Joining the EEA had a positive impact on the economy, however opening an insular economy to the EEA without significant institutional reforms carried with it dangers. Neither the Icelandic authorities nor private firms were prepared to operate in such an environment. This is especially relevant in the case of banking where the aim of Icelandic government was to build up financial centre in Iceland. To be able to build up financial centre it was very important to join EES in order to have access to European markets and adopt European regulations. This was new experience for Iceland to have the access to foreign capital because for most of the 20th century the economy was heavily regulated. (Dani elsson Zoega, 2009) Free Capital Transfer and Privatization of the Banks In continuance of EEA agreement, Icelandic government decided to privatize the three biggest banks which started 1997 and was fully completed in 2003. The new owners of the banks had little or no experience of international banking, the same applied for the Icelandic government. When Iceland accessed EEA, it faced full freedom in export and import of capital transfer among other things and the new owners of the banks began to expand the old commercial banks into investment banking. The new investment banks could get cheap capital which was easy at that time. Figure 1 shows how foreign debts have increased since Iceland got independent and it is interesting to see how the foreign debts increased dramatically when the banks had been fully privatized in 2003. (i lafssson, 2008) Figure 1: Shows foreign debts of the Icelandic economy gross dept, long term debts and net foreign debts, in proportion of GDP. Source: i lafsson, 2008 Figure 1 illustrates how easy it was to get capital at that time and the new owners of the banks forced ahead on the capital markets to finance their investments abroad. Foreign debts of the Icelandic economy were seven times GDP just four years after privatization of the banks. The study of financial economics teach us that when foreign debts increase enormously, real estate and stock price rise, there is obvious signs of increasing risk of financial crisis. (Kindleberger, 1978) Figure 2: Shows net debts of the national economy year 2005, in multi-national comparison foreign and domestic debts in proportion of GDP. Source: i lafsson, 2008 Immediately in 2005, two years after the privatization of the banks, Iceland had become most indebted OECD country in the world, as can be seen from figure 2 (i lafsson, 2008). According to the picture the situation in Iceland was already worth of criticism in 2005, with net foreign debts around 125% of GDP. (Siguri sson Svavarsson, 2007) The banking expansion was the source of the rapid economic growth that took place between 2003 and 2007. It enabled households and firms to take advantage of the abundance of low-interest funds in international capital markets to finance domestic investment and consumption, as well as the acquisition of domestic and foreign firms. Because the banks got fund in the international wholesale market this was an externally financed boom. The inflow of capital had a predictable effect on the exchange rate, the stock market and the current account as can be seen in table 1 in Appendix B. (Dani elsson Zoega, 2009) Speculation Capitalism in Iceland The objects of speculation will differ from boom to boom and crisis to crisis. The alternative explanation of the un-sober upswing goes back to Irving Fisher, which emphasizes that the real rate of interest was too low. Prices rise on the upswing, while interest rates lag. This implies a fall in the real rate of interest. With real interest rates falling, and profit prospects either rising or steady, rational investors expand. Speculation often develops in two stages. In the first, sober stage of investment, households, firms, investors, or other actors respond to a displacement in a limited and rational way. In the second, capital gains play a dominating role. The first taste is for high interest, but that taste soon becomes secondary. There is a second appetite for large gains to make by selling the principal (Kindleberger, 1978). The Icelandic bubble fits well within the framework of Kindleberger regarding the destabilizing effects of speculative finance. The Icelandic bubble started with the excitement generated by the privatization and deregulation of financial institutions, and appear unlimited access to foreign capital markets at low interest rates. The capital inflows stimulated economic growth, the outlook brightened, further increasing the willingness to borrow. Asset prices started to rise. Euphoria developed, increasingly high-risk borrowers found easy access to capital, risk appetites increased, and firms and individuals started to borrow for speculative reasons. Borrowing on the margin to buy equities became a popular activity. Banks competition for market share intensified and they lent to increasingly high-risk borrowers. A real estate bubble ensued, fuelled by seemingly unlimited bank lending. Many of the largest asset shareholders of the Icelandic banks, was highly leveraged, were facing difficulties. Investigations has detected that largest shareholders resorted to borrowing from their own banks to buy bank stock, with a view to prop up the price. The collateral behind the loans was only the bought bank stocks. In the end, of course, the entire structure collapsed. (Dani elsson Zoega, 2007).