The bankers that froze Iceland

Anyone interested in what can happen when bankers start acting really badly should have a look at the official report on the 2008 collapse of the Icelandic financial system.

A 2,000-page report from Iceland's independent Special Investigation Commission – dubbed the "truth commission” in the English media – gives a fascinating insight into how one of the world's richest countries was pushed to the brink of financial ruin after the collapse of its three biggest banks in October 2008. The report exposes banker behaviour that would make even the most brazen Wall Street executive blush.

A summary of the report was released at a press conference in Reykjavik overnight. It starts off blandly enough, blaming the banks' rapid growth for many of their subsequent problems.

The three big Icelandic banks grew 20-fold in the seven years up to 2008, and this growth, the commission notes "is commonly associated with poor underwriting or record-keeping, which can lead to solvency-related difficulties within a few years”. The commission also noted this strong growth also led to a decline in the quality of banks' loan portfolios.

This exorbitant growth in the size of the Icelandic banks was itself driven by the opening of global debt financing markets. Armed with high credit ratings (reflecting Iceland's own sovereign debt rating), the three Icelandic banks hit the market. In 2005, the three banks raised $US19 billion in loans, which was a little more than Iceland's entire GDP that year, mainly in three-to-five year debt. When global markets started drying up in 2007, Icelandic banks turned to foreign deposits and short-term securitisation for funding.

But where the report gets really interesting is when it comes to the relationship between the banks and their biggest shareholders.

According to the report, "the owners of all three big banks had an abnormally easy access to loans in these banks, apparently in their capacity as owners”.

The biggest borrowers of all three banks were their owners used a portion of these bank loans to buy shares in the banks, which pushed up the share prices of the three banks.

By mid-2008, the three banks had financed a total of 300 billion Icelandic krona ($US2.4 billion) of their shares, which was slightly more than one-quarter of the banks' combined capital base. If cross-financing (financing each others' shares) is included, the figure rises to nearly 70 per cent of core capital.

As the commission notes, the fact that so much of the equity of the Icelandic banking system was based on borrowing from the same system threatened the stability of the whole system, and meant that losses to depositors and creditors were more onerous than in a normal banking bankruptcy.

The report found that when funding started drying up in late 2007 and early 2008, "it seems that the boundaries between the interests of the banks and the interests of the shareholders were often blurry and that the banks put more emphasis on backing up their owners than can be considered acceptable.”

The problems were exacerbated because Iceland's biggest investment companies had borrowed from foreign lenders, often using Icelandic bank shares as securities. When the share prices of the Icelandic banks started falling, foreign lenders started making margin calls, or cutting credit lines.

The three Icelandic banks then stepped in to take over the loans of the foreign lenders, even though their own funding was drying up. The commission cites a number of reasons for this extraordinary response. In the first place, there was the 'bet for life'. The banks had lent so much money to the investment companies that they faced huge losses should they fail. Another reason was that investment companies had borrowed from foreign lenders in order to buy bank shares. If foreign lenders sold up the bank shares they held as security, the share prices of the big Icelandic banks would fall. In addition, the commission notes that the investment companies "had an abnormally easy access to loans in the banks in the capacity of their ownership and influence within them.”

The commission also found that the Icelandic banks were slow to recognise the extent of their losses, and that the "worth of loans and related liabilities” was exaggerated in the banks' accounts at the end of 2007, and at mid-2008.

But the day of reckoning finally came in November 2008. At that point the three banks wrote off the value of their assets by about 60 per cent. The write-downs were massive – equivalent to about five times Iceland's total GDP for that year.

As Iceland's prime minister, Johanna Sigurdardottir, noted: "Mistakes were certainly made. The private banks failed, the supervisory system failed, the politics failed, the administration failed, the media failed, and the ideology of an unregulated free market utterly failed.”