Gudrun Johnsen

Wages of Failure

People sometimes ask me whether it is possible that the Icelandic bankers, given the rate at which they drove their banks into the ground, always expected that as the eventual outcome.

Playing Tricks on the European Central Bank

In early 2008, the three banks weren’t just experiencing lack of liquidity in Iceland; they also lacked foreign currency, as well as assets to pledge as collateral. Through their subsidiaries in Luxembourg, the banks had access to collateralized lending of the European Central Bank (ECB), the so-called main refinance operations, which are short-term loans, usually for a week.

Illusion of Prosperity

I have always had considerable respect for those who pursue their entrepreneurial vision, risking their money and foregoing consumption during the first few years of their business with the hope of future gains. This is what I used to think of as the fundamental element of capitalism.

The Geyser Crisis

Every time I think about the Geyser Crisis, the first thing that comes to mind is a missed opportunity—the opportunity for Icelandic politicians and regulators to step on the brakes, apply prudential policies, and avert the full-fledged financial crisis that later ensued.

Tunneling Money through Related-Party Lending

Every bank has a certain level of moral hazard. When banks take on big risks, shareholders and employees, who are incentivized through cash bonuses, benefit from the if the results are positive. If market circumstances are unfavorable—even if fraudulent behavior has been practiced within the bank—the shareholder only bears part of the loss. The rest of the loss from the risk taking is borne by creditors, bondholders, uninsured deposit holders. In the case of systemically important institutions it is the public that picks up the tab. This is commonly referred to as privatization of gains and socialization of losses.1

Love Letters to the Rescue

Banks have developed a wide array of methods and tools to manage the risk that is inherent in their business, and to maintain a cushion against changing customer behaviors and needs, as well as the changing conditions in financial markets.

Market Manipulation and Falsification of Equity

At any given time, the value of a loan is determined by the interest rate it carries, current interest rates in the market, and the probability of the loan being repaid. Loan value also reflects the expected value recovered in the case of a default, which in turn is determined by the value of the collateral, and how expensive it would be to realize cash from the pledged asset.1 To properly assess the quality of a loan book, it is therefore necessary to analyze the quality of all collateral.

Funding the Banks

As the new owners of the three largest Icelandic banks took over, the funding of the banks consisted of 6.7 percent shareholder’s equity, approximately 30.5 percent customer deposits, and 62.7 percent bonds issued to foreign banks based on long-standing business relationships.1 The funding profile changed after privatization, however, as the banks began issuing bonds in the European Medium Term Note (EMTN) market (see Figure 6.1).

The Web of Ownership

As early as 2004, market participants noticed the rapid growth of the balance sheets of the Icelandic banks. It was widely acknowledged that the banks were engaged in takeover activities as well as in establishing their branches abroad from the ground up. As it turned out, the year-over-year organic growth of the combined assets of the three banks—excluding all acquisition activities—was phenomenal, ranging from 36 to 66 percent.1 External growth (reflecting acquisitions) was also intensive, especially in 2004–2005 (Table 10.1).2

Funded by the Ill-Informed

After the wholesale run on the Icelandic banks during the Geysir crisis in 2007, they needed to find alternative means of funding. Landsbanki, better prepared for this drought on the wholesale market, had already in early 2007 started to pay down its bond issues with wholesale deposits.1