Resolving Iceland‘s Debt Crisis: Causes, Sovereign Debt and Future Prospects

Introduction

2008 will enter the annals of financial history alongside the Great Depression, Black Monday of 1987 and the dotcom bubble of the early 2000s as one of the most significant market collapses in the history of modern finance. The fall of Lehman Brothers, one of the major participants in the international money market, was the largest insolvent liquidation to date: it amounted to roughly $615bn and dwarfed the combined insolvencies of Enron, Worldcom and General Motors.¹ The global nature of its business had a far-reaching impact on the financial markets and institutional investors worldwide. The result was felt acutely in Iceland. The country had enjoyed a booming investment and commercial banking industry which grew rapidly through a series of aggressive mergers and acquisitions throughout the 1990s and 2000s. The ensuing financial and economic crisis made it clear that their business model, founded on the premise of constant and easy availability of credit from the international money markets, was flawed. Three major Icelandic banks, Landsbanki, Kaupþing and Glitnir, were amongst the Lehman Brothers’ clients. When its liquidation effectively froze the world’s financial markets, two of them, Glitnir and Landsbanki, were unable to meet their immediate liabilities and were forced into receivership² pursuant to the Act on Authorisation for Treasury Disbursements due to Unusual Financial Market Circumstances, no 125/2008, commonly known as the Emergency Act. Kaupþing “fell” a few days later, after a controversial statement made by the UK Prime Minister, Gordon Brown. It however remains unclear whether this statement was truly fatal, or if the bank was doomed anyway.

This short paper pursues three aims. First, it provides an overview of the causes which forced the Icelandic government to nationalise the banks and face the conse- quences in the form of colossal debt obligations. The causes of the crisis will be discussed from the perspective of international finance. Secondly, it will look at some of the implications with regards to the country’s current debt and draw parallels with the South Korean banking crisis. The author suggests that on balance the nationalisation of banks was probably the right decision at a time of immense economic and social distress as it effectively prevented the potential collapse of the Icelandic housing market and preserved a viable domestic banking industry. Finally, it presents three options to resolve the crisis at the time when Iceland finds itself at crossroads: to pay the debt; to liquidate the banks’ domestic operations and wipe out the debt; or to securitise the debt either publicly or privately. The author will make a case for the third option and explain why it would be preferential for Iceland at this point in crisis.

The Icelandic Banking Crisis: Causes

Iceland has long boasted its financial stability, social security and unrivalled eco- nomic development, consistently scoring at the top of the UN Human Development Index since early 1990s.³  The collapse of the country’s banking industry was dramatic and resulted in a rapid contraction of Iceland’s economy. It was not however entirely unpredictable. One of the early concerns about the aggressive acquisitions strategy was raised in 2004 by Tony Shearer, the then CEO of Singer & Friedlander, a British investment bank taken over by Kaupþing. In particular, Mr Shearer raised his concerns over the state of Kaupþing’s public accounts and professional experience of its executives, communicating his doubts to the UK Financial Services Authority (FSA).⁴ The takeover nonetheless went ahead, and in 2008 the bank was put into receivership as a result of the liquidity crisis. 

Another good example is the Icelandic banking crisis and what to do about it report prepared in April 2008 (with an updated version followed in July) for Landsbanki: a joint collaboration of Willem Buiter, a former member of the Monetary Policy Committee of the Bank of England and Professor of Political Economy at the London School of Economics, and Anne Sibert of Birkbeck College, University of London. The authors identified the major weaknesses of the Icelandic banking sys- tem which, they said, could lead to “a potential, and possibly unnecessary, financial and economic crisis:”⁵

• The authors considered Icelandic banks as “highly leveraged institutions,”⁶ with long-term illiquid assets as opposed to short-term liabilities (maturity mismatch).⁷ To be able to address rapidly maturing liabilities, such institutions constantly have to tap into the international capital markets for extra finance effectively bringing more debt onto their balance sheets. Once the availability of credit dried up as a result of the failure of the US subprime mortgage market, such institutions defaulted on their liabilities and required a bailout.

• The government bailout was unfortunately not an option for the Icelandic banks: the Central Bank of Iceland was inadequate as a lender of last resort (LOLR), the authors argued.⁸ Most of the banks’ business was carried out in foreign currency, and the Central Bank did not have adequate foreign exchange reserves on its books, nor was it able to quickly acquire additional reserves to act as a foreign currency LOLR.

• The Icelandic banks were also vulnerable to a bank run: a hectic withdrawal of deposits when customers are served on a first-come, first-served basis and those at the end of the queue are usually left with very little.⁹  The equivalent of the bank run in financial markets would be triggering the event of default clause in a loan agreement as a result of a failure to make the next scheduled repayment or the outright insolvency of the borrower, which results in the acceleration of the defaulted loan facility. This acts as an incentive for other creditors to trigger cross-default clauses in other loan agreements and accelerate their respective facilities, which may result in catastrophic consequences for the borrower. Creditors may also refuse to extend the existing line of credit even when the terms stipulated in the conditions precedent clause¹⁰ are met. They may also refuse to purchase the debt instruments issued by the borrower, thus further exacerbating a dire financial state of the institution in question.¹¹  This was effectively the event which brought Glitnir down: the bank expected to finance the next repayment with the sale of assets which did not take place as planned due to the bankruptcy of Lehman Brothers.

The authors maintained that “Iceland’s business model, operating internationally in the financial markets with high leverage, [was] not compatible with its currency regime.”¹² The problem was not so much in exposure to  subprime debt (the assets of Icelandic banks were of higher quality¹³), as in the inability to refinance quickly maturing liabilities due to the liquidity crisis which, in turn, resulted in a loss of investor confidence and subsequent panic. The latter can be particularly demoralising and destructive for a country or institution already struggling to meet their liabilities: it increases the costs of arranging new financing and can cross-contaminate from one entity to the other, even crossing national borders to affect allied nations. For example, Ukraine struggled to refinance its dollar borrowing when faced with costs of up to 30% after the Russian default in 1998.¹⁴

In some respects, Iceland’s current financial position is unique: it is the first developed country to seek IMF relief since the 1976,15  whereas the vast amount of the lit- erature on sovereign insolvency concerns the financial troubles of developing countries. It means that conventional debt restructuring and relief solutions may not be suitable or palatable for Iceland as a developed country with a strong human rights record and functional legislative mechanisms for creditor protection. This peculiar position may have two major implications for Iceland: first, that the creditors will expect the country to pay in full and its attempts to impose caps on debt repayment are likely to be significantly limited; secondly, that Iceland could potentially have access to additional lines of credit from private lenders if necessary, provided that it abides by its current liabilities and adheres to the plan of repayment. Both factors have a direct bearing on the possible solutions that are considered in the conclusion.

Sovereign debt issues

Currently the three Icelandic banks are operating only their domestic branches; their foreign subsidiaries have been either liquidated, or put into receivership. The fact that Icelandic Financial Supervisory Authority, Fjármálaeftirlitið (FME), took control of their domestic operations in October 2008 as a result of the Emergency Act is sometimes confused with nationalisation which it is not per se. Nationalisation is when the state becomes a majority shareholder in the company in question by way of a statute and administers the nationalised entity by a ministerially appointed board.¹⁶ Whilst the Icelandic state never obtained a majority stake in any of the three banks,¹⁷ they are currently operating under the control of FME. The Icelandic government guaranteed their financial solvency; the act which has turned them into state entities for the purpose of debt management and restructuring. Therefore it may be argued that the principles of sovereign debt rescheduling apply to this case, although it must be stressed that Icelandic banking crisis is not a sovereign debt crisis in the conventional sense, e.g. as in Latin America and Asia during the 1980s-90s. This section will further discuss the issues of debt management and refer to the insolvency of South Korea and the lessons which may be learned from that case study for Iceland.

The nature of sovereign debt is such that “[it] lacks collateral and the judicial contract enforcement that typifies domestic lending:”¹⁸ it cannot be enforced by foreign agencies; moreover, such intervention may also be interpreted as a violation of state sovereignty. It is however a common practice among states to include a waiver of sovereign immunity clause in loan agreements.¹⁹ State assets located abroad usually remain in the ownership of the debtor state in question, subject to sovereign immunity.²⁰  There is generally a widespread agreement among the nations that “foreign offices are not debt-collecting agencies.”²¹ What determines repayment of a loan is not the country’s fiscal ability to pay; rather it is its willingness to pay.²²  History shows that the amount of debt can be managed. Finland is a rare example of a country which repaid its First World War sovereign debt in its entirety. Although it did not receive preferential treatment or any concessions subsequently, it maintained a reputation as an honest borrower²³  which matters for sustainability of the international financial system, as the current recession has demonstrated.

The international financial system is ultimately built on faith. This premise can be best illustrated by the role of banks as intermediaries between depositors and borrowers:²⁴  banks engage in the business of lending money which carries a risk of a maturity mismatch; they borrow short and lend long. This means that banks are constantly quasi-insolvent; this fact however does not deter customers from making regular deposits into their current accounts. International financial markets operate on the same premise, the only difference is the amount of money being lent, the complexity of loan facilities and the relevant clauses in loan agreements. Loss of faith leads to a loss of investor confidence and disrupts cash flows between various market participants.

Sovereign lending and post-insolvency rescue can have an even greater impact on the market volatility since states are perceived to be more reliable borrowers than private entities, especially those awarded with investment grade ratings. In reality this is not always true. While the waiver of sovereign immunity clause is included in the majority of the loan agreements and security is usually taken in the form of government bonds with different periods of maturity, the argument above shows that the repayment remains largely at the discretion of the borrower which effectively makes such a loan unsecured. Even though a repudiation cannot, and does not, cancel the legal claim,²⁵  creditor remedies do not extend much further than litigation in the national courts which would be impractical. It is therefore of ultimate importance for both lenders and borrowers to act in good faith and honour contractual obligations. Examples from history demonstrate that the amount of debt can be managed provided that there is sufficient willingness on both sides (lender and borrower/debtor) to negotiate terms of repayment and relevant concessions (rollovers, write-offs etc).

The world economy was hit by a string of sovereign insolvencies in the eighties and nineties which included both developed countries and emerging economies.²⁶ The case closest to Iceland would be the one of South Korea which failed to adjust to currency overvaluation in 1997. They are similar because most of the South Korean debt was owed by the country’s private borrowers who had absorbed large investments to fund a series of mergers and acquisitions with the purpose of creating global conglomerates. Total (both short-term and long-term) debt was $248.5bn at the height of the crisis.²⁷

There were three key stages in the South Korean economic crisis. First, once the local currency, the won, depreciated, the country resisted accepting financial help from the IMF even though the domestic foreign currency reserves were insufficient to alleviate the consequences of the crisis. It is noteworthy that the people voted for the strongest opponent of the IMF relief at the presidential elections in December 1997 Kim Dae Jung. In the end, the country voluntarily accepted a package of $57bn when it became clear that local efforts to save the plummeting economy were inadequate. The major problem however was to restructure short-term loans which were coming due on 31 December 1997. The second stage in the rescue process was thus the decision adopted by the US Federal Reserve, the Bank of England, the Bundes- bank and other central banks to urge major commercial banks to adopt a programme of short-term rollovers and long-term restructuring. Indeed, South Korea did reach an informal agreement with lenders to roll over its short-term debts for varying length of time. In the end (third stage) it chose the model suggested by Société Générale which involved converting outstanding debt into floating rate, government guaranteed notes with short-term maturities and a floating exchange rate of 2.25%, 2.5% and 2.75% over the six-month LIBOR (London Interbank Offering rate). This proved an efficient effort to revive the economy and by 1999 the crisis was declared to be over, although concerns remained over the country’s economic fragility.²⁸

The case of South Korea demonstrates that the most successful solutions are reached in a bilateral cooperation between lenders and borrowers: “[f]reely negotiated debt restructurings are still the best solution.”²⁹  Sovereign insolvency is best managed where both parties are interested in abiding by the terms of already existing agreements to reach a win-win solution and uphold professional relationships in the long term. It may be more difficult to reach such an agreement for the parties in the Iceland case after the infamous Landsbanki Freezing Order 2008 which substantially hurt the relations between Iceland and the UK. The next section will look at the financial and economic lessons to be learned from the crisis and puts forward some potential solutions. 

Implications and lessons

The scale and impact of the current recession were significant and dramatic, and resulted in a large number of academics and professionals rethinking previously favoured strategies of high-risk, uncertain investment. The recession has shown that reckless lending and borrowing not substantiated with an understanding of the quality or origin of the assets being traded can undermine institutions and states alike. This is the case when the ‘too big to fail’ thinking no longer works, as the failure of Lehman Brothers demonstrated. Here are some of the lessons derived from the crisis, both for Iceland and global economy combined.

• The problem referred to in literature on sovereign insolvency as moral hazard: a deliberate engagement in risky undertakings or reckless borrowing with an expectation that the IMF will bail out the country once it has defaulted.³⁰ It is of lesser significance in the Icelandic banking crisis, where there was a confident expectation that markets would not collapse, and warnings about the absence of the foreign currency LOLR which could provide a cushion during the crisis were ignored.³¹  However the period from 1990 onwards, the longest running bull market in history, gave rise to expectations that trading in poorly- understood complex financial products could be quickly rewarded with little or no risk at all. This business strategy was founded on the presumption that extra cash in the international financial markets will always be available. Once the music stopped and the free flow of money within the market was halted, risks crystallized.

• There are three elements of the national financial systems missing in the international financial system: a bankruptcy regime, a financial regulator (the likes of FSA and FME) and a lender of last resort.³²  The IMF is indeed frequently perceived as a LOLR for insolvent states; although there is an argument which says this role further promotes moral hazard.³³  Iceland, faced with enormous debt and crippled economy, had little other choice but to be bailed out by the IMF. In that context, pressure coming from British and Dutch governments for the ratification of the Icesave agreement in exchange of extra lines of credit is unhelpful at the very least. There is a perceived need for a genuine international LOLRL vested with monitoring functions wich operates independently of state governments, although questions will be raised as to its financing and legal status.

• The recession has also raised a question of the reliability of credit ratings and competency of agencies which assign them. Before the collapse, Iceland and its institutions have all been given triple A ratings, now reduced to that of high yield (‘junk’). One of the criticisms of credit rating agencies is that their rating systems does not adequately reflect true systemic risks. There is clearly a need for an independent and unbiased benchmark of financial stability, but it requires an effort within the global financial and political community to produce one.

• The Icesave dispute raised the issue of the efficiency of the EU/EEA regime for cross-border bank regulation and deposit insurance in particular. This was addressed in the Turner Review, a major UK policy document which puts forward certain suggestions for improvement of the future financial system of the UK and EU. Previously, according to the EU Second Banking Directive ‘home-country control’ rule,³⁴  subsidiaries of companies incorporated in one of the EEA Member States were subject to control of the financial regulator in the country where the subsidiary carries out its operations; branches required an authorisation by the financial regulator of the recipient state but were subject to control of the regulator of their country of origin. The Turner Review concludes that “existing single market rules can create unacceptable risks to depositors or to taxpayers.”³⁵

• Finally, there is an obvious conclusion with regards to “the need to monitor and manage balance sheet positions pre-emptively.”³⁶ It must be noted however that simply toughening regulatory controls may not be sufficient since they are likely to be relaxed once there is no longer a perceived danger of a financial crisis. The author advocates a balanced, systemic approach mainly through executive education about the risks, combined with adequate domestic and EEA-wide regulation.

 

​These are just some of the conclusions about the recession in general and the Icelandic banking crisis in particular. Further recommendations have been presented by Kaarlo Jännäri and are cited in the Iceland’s Financial Stability Report 2009.³⁷ They concern the creation of a smaller, more efficient financial regulatory system in Iceland, expansion of FME powers, tougher regulation and more active participation in EU/EEA financial regulatory regime.

Options for Iceland

In conclusion, this paper presents some of the potential options Iceland has for future debt management. These are some of the immediate options Iceland could implement in the near future, although all of them have long-term implications and consequences.

First, Iceland can repay the debt. Current Icesave agreement treats the loan as a standard term loan facility and defers the beginning of repayment by seven years from now with an interest rate of 5.55% per annum. There is a debate about whether this interest rate is too high; otherwise the agreement consists of standard clauses which are present a model LMA (Loan Market Association) agreement. The most serious one is a cross-default clause (11.1.5 in the Loan Agreement between The Depositors’ and Investors’ Guarantee Fund of Iceland, Iceland and The State of The Netherlands; and 12.1.5 in the Loan Agreement between The Depositors’ and Investors’ Guarantee Fund of Iceland, Iceland and The Commissioners of Her Majesty’s Treasury) under which the facility may be accelerated should Iceland default on any of its external obligations not connected with the present facilities. The repayment of debt now depends on the outcome of the upcoming referendum, after the President of Iceland refused to sign the Icesave bill into law.³⁸

Secondly, Iceland can liquidate its domestic banking operations: a move which would effectively wipe out the entire debt. This however will affect all of the current and savings accounts being held in the three banks; accelerate the repayment of loans and mortgages; hinder regular business transactions; rapidly decrease share value; and result in a chaos in the real economy in Iceland, leading to defaults and foreclosures. This is the fastest way to remove all the debt but the consequences are so severe that this option is strongly discouraged.

Finally, Iceland can securitise its debt. Securitisation is a process whereby a portfolio of assets or receivables (in this case the assets of Icelandic banks which were gathered prior to the liquidity crisis) is transferred into a special purpose vehicle (SPV), a company created solely for the purpose of holding the assets, in return for a purchase price payable immediately upon the transfer of assets. The SPV raises finance to purchase the debt from the originator by issuing bonds which are then purchased by third party investors, which could be UK and Netherlands government or the leading institutional investors specialising in high yield bonds in our case. The originator (one of the Icelandic banks) is appointed the 'servicer' of receivables on behalf of the SPV for further management of the portfolio, and the SPV pays a servicing fee to the servicer. The originator makes a profit from the surplus income from the receivables once the bondholders have been paid an interest.³⁹  It must be noted that all of the underlying transactions are secured. An additional security is provided in the form of limited recourse rights of the bondholders, which ensure that SPV’s assets are always greater than its liabilities thus eliminating the insolvency risk. Further, the use of non-petition covenants attached to the bonds stipulates that creditors will not petition to wind up the SPV, also eliminating solvent liquidation as a risk.

Securitisation is not the means of raising finance to cover debts in the international capital markets, which would incur further liabilities. However it has the advantages of removing debt from the balance sheets of the originator, improving their capital adequacy and transferring the risk to the investors who will invest in bonds issued by the SPV.⁴⁰  In this sense it is a mechanism for effective debt management. For Iceland, securitisation may have further advantages with regards to the rating of the bonds issued by the SPV, which are usually rated higher than a direct loan to the originator.⁴¹ In the case of Iceland, the potential bondholders may be more willing to invest if they look at the quality of the underlying receivables; as it has been shown previously, Iceland had little exposure to subprime debt and the banks’ assets were of good quality. Besides, having the British and Dutch governments as bondholders and the Icelandic banks as the originator will provide for a win-win situation: the former will take interest on the notes issued by the SPV and the latter will benefit from the remaining surplus and the servicing fees. Although securitisation will not eliminate the debt, it will remove it from the national balance sheets allowing the economy to recover and attract external investment, keeping Iceland as part of the international banking system at the same time.

While the banking crisis was a hard blow for Iceland and the recovery is not expected to be easy, the leading banking institutions have been preserved. In the long term, this means that, although the rate of international exposure previously maintained is unlikely to be repeated, Icelandic banks can successfully serve the needs of the domestic Icelandic industry, in particular its geothermal energy sector. Besides, if Iceland’s application to join the EU is successful, the country will have access to the emergency funding from the European Central Bank which significantly mitigates the chance of a similar banking collapse occurring in the future.

Acknowledgements

The author is grateful to Professor Giorgio Baruchello PhD, Dr Michael Waibel and Professor Alyson Bailes for their invaluable comments on the paper. She is particularly indebted to Ranulph Day for his stimulating support and inspiration without which these ideas may not have emerged.