The Icelandic and Irish banking crises: alternative paths to a credit-induced collapse.

• Author: Howden, David
• Position: Essay

Standard illustrations of an Austrian business cycle (ABC) center on a central bank-controlled money supply being expanded so as to lower the market rate of interest below its natural (i.e., savings- and investment-determined) level. The result is a discoordination between consumption, savings, and investment manifested in two forms: malinvestment along the temporal structure of production and/or overconsumption (Friedrich Hayek [(1935) 1967] focuses on the former, whereas Ludwig yon Mises [(1949) 1998] and Roger Garrison [2001] utilize a combination of the two). Although this approach has wide appeal based on its use of "the" interest rate as a general cause of economic downturns, it suffers from its near-exclusive focus on the central bank-controlled money supply as the unique source of the artificially low interest rate.

This paper uses Iceland and Ireland's recent banking crises to demonstrate that although centralized monetary authorities can create artificially low interest rates via monetary expansion, this method is not the sole method for doing so. Both countries are compelling cases for examination because the extent of their recessions is formidable. Ireland's main stock index, the ISEQ, fell nearly 80 percent between 2007 and 2008, and Iceland's (now-defunct) ICEX15 collapsed more than 97 percent. Per capita gross domestic product (GDP) in Iceland declined 30 percent from peak to trough, and Ireland's GDP fell 12 percent over the same period. (The equivalent decline in the United States was about 5 percent.) The use of these countries is also appealing because their crises offer similar symptoms--large buildups of debt that propagated speculative banking activity and unsustainable consumption patterns. These two countries are also interesting in that their debt buildups have several common denominators: increases in the money supply, inflation, and low real interest rates enticed what are now identified as excess debt levels. A general theory, such as ABC theory, is useful to explain why these disruptions to the money side of the economy trigger such widespread effects. By focusing on changes to risk perceptions in each economy, I can illustrate that the general theory holds true with less onus placed on the central bank. In this way, this essay is influenced by Tyler Cowen's book Risk and Business Cycles (1997, especially chapter 3), which phrases a traditional ABC in terms of increased risk taking through manipulations to the natural rate of interest.

In particular, I contrast three sources of disruption on the money side of the economy that promoted debt buildups in each country. First, and consistent with the traditional exposition of an ABC, I explore what role each country's central bank had in setting interest rates too low and in expanding their money supplies too quickly to be sustainable. Second, I assess the assets in which banks in each country focused their investment activities--equity in Iceland and real estate lending in Ireland. Finally, I discuss the guarantees secured by governmental or institutional arrangements that skewed risk perceptions and led to artificially high risk-adjusted returns. I conclude by giving a summary view of the effects of these three disruptions and why it is important that ABC theorists move toward giving a more holistic account of crises that includes these additional factors.

The Lead-Up to Iceland's Bust

When the Central Bank of Iceland (CBI) floated the krona in March 2001, it also adopted an inflation-targeting regime. Under this regime, the CBI targeted yearly consumer price inflation of 2.5 percent. Despite this target, Iceland's annual inflation rate averaged 4.7 percent from 2001 to 2006 and peaked at 9.4 percent in 2007. By its own admission, it had done an unsatisfactory job at targeting inflation over this period (CBI 2007, 12-13). Part of this error can be explained in part by a faulty inflation-targeting model (as discussed in Bagus and Howden 2011, 16-18) and in part by the large influx of foreign bank funding) With inflation remaining above target for most of the early 2000s, artificially low real interest rates spurred domestic borrowers to take on increasing amounts of debt.

The CBI's monetary expansion had the twofold effect of increasing inflation while simultaneously holding nominal interest rates low. This interest-rate policy did not just affect domestic borrowing but also filtered through to foreign lenders. By 2005, the Icelandic banks had more or less exhausted the amount of domestic funds that the approximately 320,000 Icelandic residents could deposit in the narrow banking system or invest in the broader financial sector (Portes and Baldursson 2007, 36-38; Jonsson 2009, 107-12). In a bid to continue financing their expanding operations, Icelandic banks turned to foreign depositors who were seeking higher interest rates than their own countries provided. These nominal interest rates may have been low by Icelandic standards but were high compared to other countries' rates. This disparity can be explained in part by a lower inflation premium on borrowing in other countries, especially within the core of Europe.

Although high inflation and low real interest rates incentivized Icelanders to borrow funds instead of loaning money to the banking system, the same did not hold true for foreigners. A foreign lender is not concerned with Icelandic inflation (except through effects on the exchange rate); his focus is centered only on his own domestic rate of inflation rate. High nominal Icelandic interest rates coupled with lower foreign inflation premia translated to high real returns for the foreign investor interested in lending money to an Icelandic financial institution. To the extent that higher Icelandic inflation would also depreciate the exchange rate, the expected return on a krona and home-currency investment would be equalized for the foreigner. As discussed later, a robust carry trade maintained the krona's strength and mitigated fears of depreciation, thus leading to above-average risk-adjusted returns for foreigners investing in the Icelandic market.

Icelandic Bank Operations

Icelandic banks were able to enhance their credit-issuing capabilities through two changes that occurred in the 2000s. First, the internationalization of its financial markets allowed them to start seeking foreign retail funding after a long period of reliance on domestic deposits. Second, the banking system was able to enhance its credit-issuing capabilities endogenously by investing in inflation-sensitive assets to finance external growth. This type of investment commonly resulted in equity-based bank assets, in contrast with the more usual financial position for banks with debt-based assets.

By not only holding assets in the form of loans, but also taking a position in the equity of companies, the Icelandic banks realized significant returns on their assets from 2000 to 2007. (2) By 2006, 80 percent of bank income came from gains on assets as distinct from the more usual interest income from loan portfolios (figure 1), which enabled them to increase their liabilities commensurately without endangering their liquidity, primarily by increasing the money supply. In 2004 and 2005, Icelandic bank investments in equities grew by 57.5 percent and 24.7 percent (Report of the Special Investigation Commission 2010, chap. 21). External growth was strong from 2004 to 2007, with Icelandic outward investment hovering around 33 percent of its GDP in each of these years (Portes and Baldursson 2007, 39). Internal growth composed the bulk of the banking system's growth from 2006 to the crash. The primary driver of this growth was expansion of these previously undertaken equity activities, usually by decreasing the quality of the investments made (Flannery 2009, annex 3).

The market liberalizations of the late 1990s opened the Icelandic financial sector to the well-established world of global finance. One way to look at the internationalization of Iceland's financial arena is in terms of the current-account deficit that built steadily throughout the mid-2000s, peaking at nearly 20 percent of GDP in 2006 (table 1). By the end of 2006, the net international investment position of Iceland was negative, 121.5 percent of GDP--quite high also by international standards (Portes and Baldursson 2007, 43-44).

Less-risk-averse investors could invest directly in the Icelandic market via "Glacier Bonds"--krona-denominated bonds that were marketed directly to foreigners in a bid to attract foreign capital. Issuances of Glacier Bonds commenced in August 2005 and reached their peak in spring 2007 with $6.3 billion of these bonds outstanding, equivalent to almost 40 percent of the country's GDP (Bagus and Howden 2011, 63).

High nominal interest rates spurred on by high levels of inflation coupled with a comprehensive deposit-insurance scheme managed by the CBI incentivized banks to push into foreign markets to obtain lower-cost funding. In particular, online retail branches were set up in several European countries--notably the United Kingdom and the Netherlands--to attract foreign customers. These foreign retail deposit accounts offered foreigners the chance to capitalize on higher Icelandic interest rates in their own domestic currency, thus eliminating the risk of an adverse foreign- exchange movement. As an example, a Dutch saver could lend euros to an Icelandic subsidiary operating in the Netherlands. The Icelandic bank would convert these euros to krona and pay the Dutch saver the higher interest rate made possible through the resultant krona investment. The Dutch saver was able to earn a rate of return closer to that of the krona investment, and the Icelandic bank used the less costly euros to fund Icelandic investment activities.

The Icelandic deposit-insurance plan insured clients of the foreign branches of Icelandic banks, thus mitigating risk from the venture...