Iceland: the predictable end

of a non-viable business model

It has been known for a while that Landsbanki, Iceland's second biggest commercial bank, had commissioned an academic study of the vulnerabilities of the country's banking system; and that the study was confidential.

Now that the worst case scenario from the study has come true, the paper has been released as CEPR Policy Insight #26, and the blog VoxEU has a very nice post discussing the highlights

The problem is simple: if your country has a non-reserve currency, ie if the currency is not the dollar or euro, then if you have an international banking sector, and if the liabilities are large compared to the national finances (currency reserves, or GDP), then the system is unstable to liquidity crises - whether through bank runs or market illiquidity of the long term assets - and further, I infer, the instability can be triggered if the amounts are small enough. ie larger systems are less vulnerable simply because it is harder for external agents to game them through market perturbations.

This was presented not just to the commercial banks, but also the finance ministry and central bank.
They knew.
Some of the early response to the crisis was also precisely wrong, in that it increased Iceland's national exposure to the crisis, in what was apparently a futile attempt to stabilize the banks.

The VoxEU post is also very damming of the UK actions that brought the final stages of the crisis to a head.

In the meantime, another 4,000 people were laid off - that is equivalent per capita to 4,000,000 people losing their jobs in the US this month. Several thousand more job losses are in the pipeline. Unemployment projections in Iceland have now been increased to over 10% by mid-'09.
Ouch.

The second stage of loans to bail Iceland out have been proposed from the EU.
The Icelandic finance ministry and parliament people are currently quibbling over the terms - basically they are worried that the UK is trying a force majeure clause on them through the EU deal, where Iceland ends up taking greater liability for UK depositor losses than required by contract.
My understanding is that this is not the case, rather the EU is finding out that there are other nations lined up needing a bailout, and there are limited funds.

So, guys, STFU, take the money and thank the nice people.
It is better than owing the Russians.

Oh, and the paper identified other vulnerable small non-reserve economies with large international exposures, and therefore vulnerable to evil hedgies playing games: Denmark, Switzerland, Sweden...

Gonna be interesting times.

For our next trick: will Obama's folk at State and Treasury sit down the with the EU before inauguration to sort out some things?
I know they're going to be busy, but I think they're going to need to talk sooner rather than later.