The Country That Let Its Banks Fail

In September 2008, three Icelandic banks — Kaupthing, Landsbanki, and Glitnir — collapsed within a week. The three banks held aggregate assets that, by international standards, were modest. Within Iceland, the assets were extraordinary: approximately ten times the country's gross domestic product. The collapse, when it came, was effectively a national-scale balance-sheet failure rather than a corporate failure. The country's population of approximately three hundred thousand people inherited a sovereign-debt and currency crisis from which recovery would require nearly a decade.

The interesting structural feature of the Icelandic collapse, distinguishing it from most banking crises, was that the failed banks had not been making domestic loans to overheated property markets or speculative borrowers. They had been issuing foreign-currency bonds in international capital markets — primarily euros and pounds sterling — and using the proceeds to fund aggressive offshore lending operations across the United Kingdom, the Netherlands, and Scandinavia. The Icelandic banks were, in a particular sense, hedge funds wearing banking licenses.

The Funding Model. The three banks had grown extraordinarily fast during 2003-2008, doubling and tripling in asset size in a five-year span. The growth was funded by wholesale deposits and bond issuance in foreign currencies, not by retail savings or domestic equity. The lending was concentrated in property and leveraged-buyout transactions in larger European markets. When the 2008 global liquidity crisis hit, the wholesale funding markets froze. The Icelandic banks could not roll their short-term funding. The currency mismatch — assets in euros and pounds, liabilities also in foreign currency, but central bank lender-of-last-resort capacity available only in Icelandic kronur — meant that no Icelandic institution could provide emergency liquidity in the currencies actually needed.

The Resolution. The Icelandic government's response was, by international standards, unusual. Rather than guarantee the foreign deposits of the failed banks — a step Ireland took, with consequences for sovereign solvency — Iceland allowed the foreign creditors to bear losses while protecting domestic depositors. The decision was controversial. The Netherlands and the United Kingdom invoked anti-terrorism legislation to freeze Icelandic assets in their jurisdictions. International litigation continued for years. The Icelandic kronur devalued by approximately fifty percent against the euro within months. Inflation spiked. Real-estate prices collapsed.

The Recovery. What followed was, by historical-financial-crisis standards, a relatively rapid recovery. The currency devaluation made Icelandic tourism dramatically more affordable; the fishing-export industry, denominated in foreign currencies, generated windfall domestic revenue. By 2015, the country had repaid its emergency IMF program, restored sovereign credit ratings, and resumed access to international capital markets. The 2008 crisis remains the deepest economic shock in modern Icelandic history; the recovery model — devaluation, default on foreign-currency obligations beyond the deposit-insurance scheme, tourism-driven export rebuild — is studied as one of the unusually fast resolutions of a major sovereign-banking crisis.

The post-crisis regulatory reforms in Iceland are extensive. The pre-crisis banking system, which had been dominated by a small set of family-connected oligarchs, is now structurally different. The lessons, expensive at the time, have been broadly absorbed.