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 PA LG R AV E M AC M I L L A N S T U D I E S I N
BANKING AND FINANCIAL INSTITUTIONS
S E R I E S E D I TO R : P H I L I P M O LY N E U X

The Icelandic
Financial Crisis
A Study into the World´s Smallest Currency Area
and its Recovery from Total Banking Collapse

Ásgeir Jónsson
Hersir Sigurgeirsson
Palgrave Macmillan Studies in Banking
and Financial Institutions

Series Editor
Professor Philip Molyneux
Bangor University
UK
The Palgrave Macmillan Studies in Banking and Financial Institutions series
is international in orientation and includes studies of banking systems in
particular countries or regions as well as contemporary themes such as
Islamic Banking, Financial Exclusion, Mergers and Acquisitions, Risk
Management, and IT in Banking. The books focus on research and
practice and include up to date and innovative studies that cover issues
which impact banking systems globally.

More information about this series at

http://www.springer.com/series/14678
 Ásgeir Jónsson • Hersir Sigurgeirsson

The Icelandic
Financial Crisis
A Study into the World´s Smallest Currency Area
and its Recovery from Total Banking Collapse
Ásgeir Jónsson Hersir Sigurgeirsson
University of Iceland University of Iceland
Reykjavik, Iceland Reykjavik, Iceland

Palgrave Macmillan Studies in Banking and Financial Institutions

ISBN 978-1-137-39454-5 ISBN 978-1-137-39455-2 (eBook)
DOI 10.1057/978-1-137-39455-2

Library of Congress Control Number: 2016955815

© The Editor(s) (if applicable) and The Author(s) 2016

The author(s) has/have asserted their right(s) to be identified as the author(s) of this work in accordance
with the Copyright, Design and Patents Act 1988.
This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether
the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of
illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and
transmission or information storage and retrieval, electronic adaptation, computer software, or by similar
or dissimilar methodology now known or hereafter developed.
The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication
does not imply, even in the absence of a specific statement, that such names are exempt from the relevant
protective laws and regulations and therefore free for general use.
The publisher, the authors and the editors are safe to assume that the advice and information in this book
are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or
the editors give a warranty, express or implied, with respect to the material contained herein or for any
errors or omissions that may have been made.

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Printed on acid-free paper

This Palgrave Macmillan imprint is published by Springer Nature

The registered company is Macmillan Publishers Ltd.
The registered company address is: The Campus, 4 Crinan Street, London, N19XW, United Kingdom
The economic, political and moral fallout of the collapse of Iceland’s
banks was enormous. This fascinating book gives a full and comprehen-
sive account and analysis of the Icelandic banking crisis, its aftermath and
the struggles and policies that led to Iceland’s remarkable recovery after it
was hit by the “perfect storm”. It will be required reading by scholars,
regulators and policy makers interested in financial crises, their conse-
quences and how to respond to them.
—Friðrik Már Baldursson, Professor of Economics,
School of Business, Reykjavik University

Iceland’s 2008 financial crisis and subsequent recovery is a rich story, and
the debate on the causes and lessons to be learned will doubtless go on for
years to come. Ásgeir Jónsson’s Why Iceland was an important early
contribution to the history of the prelude to the crisis and became
considered a “must read”. Now Ásgeir Jónsson and Hersir Sigurgeirsson
have written a sequel on the financial sector recovery that has the promise
to fall into the same category.
—Már Guðmundsson, Governor, Central Bank of Iceland

v
 Contents

1 Introduction 1
1.1 Gala at Harpa 1
1.2 One Letter and Six Months? 6
1.3 The Unfinished Business of 2011 11
1.4 Lessons Learned? 17
1.4.1 Lessons in Banking 18
1.4.2 Lessons in International Finance 24
1.5 The “Appalling Blank” 29

2 The Worst Case Scenario 35

2.1 Midnight at the Mansion 35
2.2 The Botched Bailout 39
2.3 A Rejection from the US Fed 43
2.4 The WaMu Way? 48
2.5 The Geyser Warning 53
2.6 A Force Majeure Action 58
2.7 God Bless Iceland 62

vii
viii Contents

3 Reykjavik on the Thames 67

3.1 The Problem with the Banks’ Owners 67
3.2 An Act of Terrorism? 78
3.3 Will the Payment System Collapse? 83
3.4 Reykjavik on the Thames 90
3.5 Sound and Fury 95

4 Day Zero 103

4.1 When the Phones Went Silent 103
4.2 How to Value Assets? 111
4.3 How to Partition the Banks? 115
4.4 A Troubled Childhood: The Operation of the
New Banks 124
4.5 Dealing with Blame, Shame and Punishment 133

5 Worthless Currency? 139

5.1 The Transfer Problem 139
5.2 The Icesave Debacle 147
5.3 The Carry Trade Hangover 152
5.4 The Current Account and the Capital Controls 159
5.5 The Currency Auctions 163
5.6 The Political Fallout 168

6 Meet the Hedge Funds 173

6.1 The Sir Philip Moment 173
6.2 Business at the Old Banks 180
6.3 The Asset Base of the Estates 184
6.4 Hedge Funds as Bank Owners 188
6.5 What Kind of Resolution? 193
6.6 Asset Return at Composition 201
6.7 Sharing the Profits with the Public 204
 Contents ix

7 The Faustian Bargain of Capital Controls 209

7.1 Would You Like to Own a Stake in Deutsche Bank AG? 209
7.2 The Operation of the Controls 219
7.3 The Capital Controls as a Bargaining Tool 226
7.4 The Carrot and Stick Approach 233
7.5 The Stability Contributions 239
7.6 The Textbook Case? 247

8 Dealing with Monetary Pollution 251

8.1 What Happens If You Quadruple the Money Supply
in Four Years? 251
8.2 Doubling the Money Multiplier 260
8.3 The Love Letters 265
8.4 Helicopter Drops and the Bernanke Doctrine 272
8.5 The Different Meaning of Money in Small Currency
Areas 275
8.6 Deposit Funding as a Currency Risk 279
8.7 The Stability Conditions 285

9 A Full Recovery: Fiscal Cost of the Crisis 289

9.1 To Cut the Link Between the Sovereign and Banks 289
9.2 Central Bank Collateralized Loans and Treasury
Securities Lending 296
9.3 Recapitalization of the Commercial Banks 299
9.4 Recapitalization of the HFF and the Savings Banks 304
9.5 The CBI Loan to Kaupthing and State Guarantees 307
9.6 Special Taxes and Stability Contributions of the Estates 309
9.7 Fiscal Gains from the Capital Controls 311
9.8 A Net Gain 313

Bibliography 317

Index 341
 List of Figures

Fig. 3.1 Moody’s rating of the Icelandic republic 1989–2009 68

Fig. 3.2 The ratio of bank assets to GDP from 1998 to 2009 in Iceland
and Moody’s rating of Kaupthing 2003–2009 and its
predecessor Búnaðarbanki 1999–2003 (Source: The Central
Bank of Iceland and own calculations) 70
Fig. 4.1 Division of assets and liabilities between the estates and the new
banks. The old banks’ balance sheets are consolidated balance
sheets as of end of June 2008. The estates’ assets are priority
claims paid on the one hand and their assets at year-end 2014 on
the other. Liabilities of the estates are recognized claims as of
year-end 2014. The assets and liabilities of the new banks are the
part of the assets and liabilities that were transferred from the old
banks. Amounts in billion euros at the exchange rate 150 ISK per
euro (Source: Six month interim financial statements of Glitnir,
Kaupthing, and Landsbanki in 2008, annual financial statements
of Glitnir, Kaupthing, and LBI for 2014 and annual financial
statements of Íslandsbanki, Arion bank, and Landsbankinn
2008) 114
Fig. 4.2 Household debt in Iceland as percentage of GDP from 2004
to year-end 2015 categorized according to contract terms
(Source: Central Bank of Iceland) 130

xi
xii List of Figures

Fig. 4.3 Corporate debt in Iceland as percentage of GDP from 2004

to year-end 2015 categorized according to contract terms
(Source: Central Bank of Iceland) 131
Fig. 4.4 The new banks’ profit before taxes in the years 2010–2015.
Amounts in million euros (Source: The CBI Financial
Stability 2016/1) 132
Fig. 4.5 Capital adequacy ratios of the new banks in the period
2009–2016 (Source: The CBI Financial Stability 2016/1) 133
Fig. 5.1 Monthly turnover on the interbank foreign exchange market.
Amounts in billion ISK (Source: Central Bank of Iceland
statistics) 158
Fig. 5.2 Iceland’s current account in 2000–2015. Quarterly figures as
percentage of GDP (Source: Central Bank statistics) 160
Fig.5.3 The Merchandize trade balance and the service trade balance
in Iceland from 2000 to 2015, quarterly numbers in billion
ISK (Source: Central Bank of Iceland statistics) 162
Fig. 6.1 Estimated value of LBI’s assets and payment of priority claims.
The light gray columns show the estimated value of LBI’s total
assets, the dark gray shows cumulative payments of priority
claims, and the light grey line shows the estimated amount of
priority claims at each time. Amounts in billion euros (Source:
Announcements from LBI’s resolution committee and LBI’s
quarterly financial information) 183
Fig. 6.2 Largest creditors of the Icelandic banks in terms of value
according to the first available lists of claims. Amounts in
million euros (Source: Glitnir List of Claims December 2009,
LBI list of Claims November 2009, Kaupthing List of Claims
January 2010) 191
Fig. 6.3 The largest hedge funds at composition agreements in real
terms. Amounts in million euros (Sources: Glitnir, Kaupthing
and LBI voting lists November 2015) 193
Fig. 6.4 Prices of Glitnir, Kaupthing and Landsbanki claims in cents on
the dollar (Source: Moelis & Company, Birwood, and Keldan.
is) 202
Fig. 7.1 Iceland’s Capital Account balance 1990–2015, annual figures
as % of GDP (Source: Central Bank of Iceland) 213
 List of Figures xiii

Fig. 7.2 The onshore and off-shore rate of the Icelandic krona
towards the euro and rates in currency auctions of the CBI
(Source: Reuters and the Central Bank of Iceland) 223
Fig. 7.3 Total size of the stability contributions of the three largest
banks. Amounts in million euros (Source: Report from the
Icelandic Ministry of Finance. 28.10.2015) 242
Fig. 8.1 Money supply (M3) from 1993 to 2016 in billion ISK
(Source: Central Bank of Iceland) 257
Fig. 8.2 The money multiplier in Iceland measured as the ratio of
M3 over M0 from 1994 to 2016, monthly numbers filtered
as a 12-month moving average (Source: Central Bank of
Iceland) 264
Fig. 8.3 Outstanding Repo loans at the CBI from 1994 to 2016 in
billion ISK (Source: Central Bank of Iceland) 266
Fig. 8.4 Total deposits and GDP in Iceland from 2003 to 2016,
nominal values in billions of ISK (Source: Central Bank of
Iceland) 281
Fig. 8.5 Money supply (M3) as a ratio of GDP from 1900 to the
present (Source: Central Bank of Iceland) 284
Fig. 9.1 Total central government debt in selected countries, as a
percentage of GDP in 2007–2013 (Source: World Bank:
World Development Indicators) 292
 List of Tables

Table 6.1 Number and amounts of claims lodged, the amount accepted
and amount of priority claims for each estate. Amounts in
million euros 184
Table 6.2 Ultimate recoveries by the creditors of the estates, showing
domestic deposits transferred to the new banks, foreign
deposits which were priority claims on the estates, and general
claims on the estates. Amounts in million euros 185
Table 6.3 Breakdown of the assets of the three estates at year-end 2014.
Amounts in billion euros 188
Table 6.4 Annual return (IRR) on claims purchased on the banks under
three different hypothetical scenarios 203
Table 6.5 Comparison of the returns of Baupost and Davidson
Kempner in terms of internal rate of return (IRR) and net
present value (NPV) in million euros 204
Table 7.1 Total contributions and other mitigating actions taken by the
three estates. Amounts in million euros 244
Table 7.2 Direct, indirect and total contributions from all estates 246
Table 9.1 International Monetary Fund estimate of the fiscal cost of the
crisis in 2008–2011, as a percentage of GDP 295

xv
xvi List of Tables

Table 9.2 Fiscal cost of the Central Bank loans and treasury securities
lending collateralized with ‘love letters’ in million euros and
as a percentage of GDP 299
Table 9.3 Treasury returns on the re-establishment of the commercial
banks, in million euros (accounting return) and as a
percentage of GDP for each year 303
Table 9.4 The treasury’s returns on the re-establishment of the banking
system, in million euros and as a percentage of GDP,
assuming that the treasury’s holdings in the three commercial
banks is sold at 60 %, 80 %, 100 %, or 120 % of book value
at the end of 2015 304
Table 9.5 Net financial cost to the treasury due to the collapse and
re-establishment of the savings banks in million euros and as a
percentage of GDP 307
Table 9.6 Central Bank returns on the October 6, 2008, loan to
Kaupthing Bank hf., secured by shares in FIH Bank. The loss
on the loan totaled 2.6 % of GDP during the years
2008–2010 308
Table 9.7 Special tax payments by the estates of Glitnir, Kaupthing, and
LBI, in 2012–2015 in million euros 310
Table 9.8 Estimate of the net cost ( ) and gain (+) to the treasury from
the crash in million euros in the period 2008–2015 314
Table 9.9 Estimate of the net cost ( ) and gain (+) to the treasury from
the crisis as a percentage of GDP in the period 2008–2015 315
 1
Introduction

1.1 Gala at Harpa

At 8 a.m. on October 27, 2011, the brand new Reykjavík Concert Hall
and Conference Centre, Harpa, received a steady stream of formally
attired dignitaries, both national and foreign. They were attending a
conference presented jointly by the Icelandic government and the Inter-
national Monetary Fund (IMF): “Iceland’s Recovery – Lessons and
Challenges.”1 An impressive panel of speakers had assembled, including
Nobel laureates Paul Krugman and Joseph Stiglitz, Willem Buiter, chief
economist of Citigroup, and various ministers representing Iceland’s
government. As often had been the case in Iceland over the past several
years, the event also attracted a throng of protesters, who waved picket
signs denouncing the IMF, the local government, or the general conclu-
sion that three years after an epic collapse, Iceland was now an example of

1
International Monetary Fund (2011, October 27). Iceland’s Recovery – Lessons and Challenges.
http://www.imf.org/external/np/seminars/eng/2011/isl/index.htm

© The Author(s) 2016 1

Á. Jónsson, H. Sigurgeirsson, The Icelandic Financial Crisis,
DOI 10.1057/978-1-137-39455-2_1
2 The Icelandic Financial Crisis

successful economic rehabilitation. As this was an international confer-

ence, the crowd had written out their slogans in English.
Harpa was the ideal location for such a meeting. What better symbol-
ized Iceland’s pre-crisis folie de grandeur and its Icarus-style downfall? Set
against the backdrop of Faxa Bay and the Esja mountain range to the
north, Harpa sits on the east side of Reykjavík’s old harbor like a giant
iceberg washed onto shore, directly facing the Central Bank to the south.
According to tradition, this is precisely where it all started. In 874, the
legends say, the Norwegian chieftain Ingólfur Arnarson became an outlaw
in Norway and fled the country. He set his sights on a new, uncolonized
island in the North Atlantic Ocean. When land was in sight, he threw his
high seat pillars into the sea and swore to the gods that he would build his
farm wherever they directed the pillars. After three years of searching
along the coastline, his slaves found the pillars on the east side of a small
bay on the southwest coast – what would become Reykjavík’s harbor.
Although his slaves thought it a remote headland, Ingólfur nonetheless
made good on his oath and founded the first organized settlement in the
new country at that very place.
Whether divine guidance played a role in Harpa’s construction is left to
speculation. But accomplished hands certainly guided its planning and
design. Henning Larsen Architects designed the building in cooperation
with Ólafur Elíasson, a Danish-Icelandic artist. The building’s steel
framework is clad in geometrically shaped glass panels of different colors
and mirrored finishes. Fitted together, the panels create the effect of a
crystallized rock wall, reminiscent of Iceland’s crystalline basalt columns,
which glitters magnificently in the dark. The winner of various architec-
tural awards, Harpa has been cited as an example of how “architects are
only now gaining the courage to crawl out from the under their (func-
tionalist) rocks and begin to explore, once more, the frivolous joys of
ornament,”2 and received the Mies van der Rohe prize for modern
architecture in 2013.3

2
Gibberd, Matt and Hill, Albert. (2013, August 20). The return of ornamentation. The Telegraph.
http://www.telegraph.co.uk/luxury/property-and-architecture/7279/the-return-of-ornamentation.html
3
Mies van der Rohe Prize. (2013). Harpa – Reykjavik Concert Hall and Conference Centre. http://
www.miesarch.com/work/535
 1 Introduction 3

Decades in the making, Harpa was the dream-home to the Iceland

Symphony Orchestra, a source of great pride since the foundation of the
republic in 1944. Nearly 70 years after independence, Iceland’s popula-
tion had almost tripled to 330,000,4 but it still had fewer residents than at
least 50 American cities.5 Nevertheless, Icelanders wanted world-class
accommodation for their orchestra as a matter of principle. This is a
nation that expects its sporting teams – football, handball, chess or any
other – to compete on equal footing with the best, and win. To this end,
the nation offers its champions total devotion. Icelanders are driven by the
almost incessant urge to show the world they deserve a seat alongside more
populous nations. Quite often, their implacable will can triumph against
long odds, even in popular sports such as football. In the European
Championship of 2016, Iceland progressed to the quarter-final stage
after an unbeaten three-match streak in the group stage, and captured a
historic win against England in the first knockout round before losing to
hosts France at their national stadium. Quite remarkably, these games
were attended by almost 10 % of the island’s entire population.
Back home, the best performers deserved the best buildings. In the
early 1990s, the football scene in Iceland had been revolutionized with
large-scale investments in thermally heated indoor football stadiums,
which allowed the Icelandic youth to play through the long winters.
Soon, Iceland was rewarded with a trove of world-class players. In 2005,
the nation’s newfound wealth funded the construction of a new Reykjavík
landmark: Harpa.
The first genuine, purpose-built musical hall in Reykjavík, Harpa was
only one part of the ambitious “World Trade Center Reykjavík” redevel-
opment plan that would transform the east harbor district. The plan also
included a 400-room five star hotel, luxury apartments, retail units,
restaurants, a car park, and the new headquarters of Landsbanki, one of
the three Icelandic banking giants. All these projects were to be funded
and built by private enterprises – without state assistance – when con-
struction began in 2007, at the apex of the financial bubble.

4
Iceland’s population in 1944 was 126,000 (Statistics Iceland, hagstofa.is).
5
United States Census Bureau. American FactFinder. http://factfinder.census.gov/faces/tableservices/
jsf/pages/productview.xhtml?src¼bkmk
4 The Icelandic Financial Crisis

About a year later, in October 2008, the financial crisis engulfed the
economy and the whole project went bankrupt. Like most other building
projects on the island, Harpa stood half-built, awkward, in stasis, and its
incomplete, ghostly cement walls testified both to aspiration and failure,
in equally grand proportions. It was a true testament to Iceland’s most
recent saga of boom and bust.
In March 2009, the World Trade Center project was “bailed out” and
nationalized, and acquired at scrap value by a company jointly owned by
the treasury and the municipality of Reykjavík.6 Construction resumed on
Harpa, and the nationalization effort was subject to hot debate. Some
believed that Harpa should remain unfinished: its bare walls a memorial to
– and a warning of – the financial follies and blind ambition that had
nearly bankrupted the nation. Others called it a white elephant whose
development was totally unacceptable at a time of downsized state budgets
and IMF oversight. Any money earmarked for Harpa would be better
spent on the struggling national health system.7 Various bloggers and
commentators swore they would never set foot inside such a wasteful,
outrageous monument to snobbery.
Despite the criticism, work continued. The Icelandic Symphony
Orchestra held its first concert in Harpa on May 4, 2011. The total cost
of the building turned out to be €164 million (ISK 27 billion) or about
1–2 % of Iceland’s GDP at the time. This more than doubled the initial
cost assessment of €73 million (ISK 12 billion). But much of the cost was
borne by foreign creditors – Deutsche Bank in particular – since the first
year of construction was basically written off prior to the nationalization.8
At about the same time Harpa opened, the Icelandic economy turned a
corner and embarked on a new growth path, which did not go unnoticed
abroad. It was not only that Iceland had become better: other European
countries had grown a lot worse as the international financial crisis

6
Reykjavík Mayor. (2013, February 5). Tillaga að fjármögnun Hörpu. (A proposal for Harpa’s financing.)
(Letter no. R13010037), http://reykjavik.is/sites/default/files/Frettir_skjol/tillaga_greinargerd_harpa.pdf.
7
For example, this was the position of MP Þór Saari when debating the national budget in 2011,
http://www.althingi.is/altext/raeda/140/rad20111110T160252.html
8
Minister of Finance. (2016, May 31). Svar fjármála- og efnahagsráðherra við fyrirspurn frá Haraldi
Einarssyni um byggingarkostnað Hörpu. (The Minister of Finance’s answer to Haraldur Einarsson’s
inquiry on the cost of construction of Harpa.) http://www.althingi.is/altext/145/s/1388.html
 1 Introduction 5

morphed into the Eurozone crisis. Initially seen as a warning, Iceland was
increasingly hailed as an example. In 2008, Iceland had been the first
advanced country to seek the assistance of the IMF since the UK in 1977.
To the surprise of many, the nation had sought and received leeway to
deviate from the Washington consensus of free market liberalism by
imposing capital controls, thus creating a firewall against the punishing
forces of international financial markets. Furthermore, the IMF’s insis-
tence on austerity and fiscal adjustment had been much less strident than
had been the case in previous programs in Asia or South America. The
IMF had also provided a seal of approval for a wide range of force majeure
measures implemented by the Icelandic authorities just before the collapse
of the nation’s three main banks. These, most notably, included emer-
gency legislation that rewrote the bankruptcy code for financial institu-
tions and gave priority to deposits. The legislation also gave the Icelandic
Financial Supervisory Authorities (FSA) the power to seize these
guaranteed deposits and Icelandic assets from the collapsing banks at
“fair value,” which then were used to found new domestic banks.9
Just two months before the October Iceland-IMF conference, Iceland
graduated from the IMF program with flying colors. “Iceland’s Fund-
supported program has been a success, and program objectives have been
met,” declared a press release that accompanied the sixth and final review
from the IMF.10
The Icelandic government was keen on showcasing its success and
refurbished international reputation. The first center-left government in
Iceland’s post-war history had been elected in the spring of 2009 and was
led by Jóhanna Sigurðardóttir, the chairman of the Social Democrats and the
first female prime minister of Iceland. The minister of finance was the
chairman of the Left-Green Party, Steingrímur J. Sigfússon. A long-time
radical, Sigfússon had on numerous occasions denounced the IMF as the

9
Ministry of Finance. (2011, March). Skýrsla fjármálaráðherra um endurreisn viðskiptabankanna.
(Minister of finance report on the restoration of the commercial banks).
10
International Monetary Fund. (2011, August). Iceland: Sixth Review Under the Stand-By Arrange-
ment and Proposal for Post-Program Monitoring. IMF Country Report No. 11/263. https://www.imf.
org/external/pubs/ft/scr/2011/cr11263.pdf
6 The Icelandic Financial Crisis

watchdog of international capital. He originally protested the IMF plan as an

MP, but found himself having to work directly with the IMF once in office.
This pair – Sigurðardóttir and Sigfússon – had an agenda, and declared
they were going create a “new Iceland” through enactment of many
controversial moves: applying for European Union (EU) membership;
initiating a nationwide vote on a special assembly to rewrite the constitu-
tion; and imposing new taxes on the wealthy and big businesses, which in
Iceland meant fishing companies and aluminum smelters. Political forces
from both left and right lodged criticism of this vision. On one hand, the
ruling coalition was accused of anti-business bias; on the other they were
taunted as IMF sell-outs. There were also calls for household debt relief
from across the political spectrum, which grew louder by the day. Indeed,
many protesters outside Harpa on October 27 were advocates of debt
relief. In a letter sent to the media and all speakers of the conference, the
main advocates of the protests pointed out that the general price level had
risen about 40 %, and household purchasing power subsequently
decreased by 27 % since 2007.11 Since about 80 % of all household
loans in the country were inflation-indexed, the principal of the loans had
also increased by 40 %. Thus, the protesters maintained, the burden of
the crisis was borne by the public while the banks were being restored
under the auspices of the IMF.
So, after three years of extreme hardship, Iceland was mending fences
with the IMF and Europe. And while its citizens objected – loudly and
openly – to the new status quo, few could deny the nation had made
remarkable progress after its spectacular financial wreck. But what exactly
was the lesson to be gleaned from the nation’s crisis and recovery?

1.2 One Letter and Six Months?

In the autumn of 2008, London traders popularized this joke: “What’s
the difference between Iceland and Ireland? Answer: One letter and about
six months.”12 Both countries were staggering under the weight of a
financial sector bloated to eight to ten times the national GDP. The

11
Statistics Iceland. www.hagstofa.is
12
Krugman, Paul. (2010, November 25). Eating the Irish. The New York Times.
 1 Introduction 7

banks began to look like dead weight after the Lehman Brothers default
on September 15, 2008, which eroded market confidence.
Ireland’s response was a blanket guarantee of its domestic banks on
Monday, September 29. It was successful in the sense that it was credible
and the bank run stopped. Ireland was a part of the euro area and was able
to supply its banks with a reserve currency. With the guarantee in place,
harsh austerity measures were hammered through the Irish parliament. It
was tough economic medicine, but there stood Iceland as an imminent
warning of what might happen should Ireland refuse it.
In Iceland, also on September 29, the government had attempted to
nationalize Glitnir, one of the three massive, now failing, banks. The
consequences were disastrous. Carnage ensued with a severe ratings
downgrade: Moody’s took Glitnir down three notches, from A2 to
Baa2 on September 30.13 This triggered covenants in loans and credit
lines, which were contingent on the maintenance of certain ratings.
Glitnir, which originally needed €600 million in liquid funds, suddenly
faced a hole €2 billion deep.14 The other two large banks, Kaupthing and
Landsbanki, also suffered downgrades and liquidity evaporation. (See a
more detailed discussion in Sect. 2.2.) As the smallest currency area in the
world (no other nation with less than 2 million citizens has its own
currency), Iceland could only respond to the crisis by printing illiquid
krónur (ISK). Lacking a lender of last resort, all three banks collapsed by
the end of the following week. Within months, almost all financial
institutions in Iceland – except for some small rural savings banks and
investment management boutiques – would go under.
But much had changed in both Ireland and Iceland in the aftermath of
these shocks. The comparison between the countries was no longer a joke.
As early as 2010 there arose healthy debate over which response to the
crisis had worked out better.

13
Moody’s Investors Service. (2008, September 30). Rating Action: Moody’s downgrades Glitnir to
Baa2/Prime-2/D from A2/Prime-1/C-.
14
Baldursson, F. M., & Portes, R. (2013, September). Gambling for resurrection in Iceland: the rise
and fall of the banks. Available at SSRN 2361098.
8 The Icelandic Financial Crisis

In the third review by the IMF on the progress of the economic

program, made public on October 4, 2010, the IMF’s economists
would write the following conclusion:

Under the recovery program, Iceland’s recession has been shallower than
expected, and no worse than in less hard-hit countries. At the same time, the
krona has stabilized at a competitive level, inflation has come down from 18 to
under 5 percent, and CDS spreads have dropped from around 1000 to about
300 basis points. Current account deficits have unwound, and international
reserves have been built up, while private sector bankruptcies have led to a
marked decline in external debt, to around 300 percent of GDP. The outlook is
for an investment-led recovery to begin during the second half of 2010, and for
growth of about 3 percent in 2011.15

This would prompt Paul Krugman to write, in a November 24, 2010

blog post:

What’s going on here? In a nutshell, Ireland has been orthodox and responsible –
guaranteeing all debts, engaging in savage austerity to try to pay for the cost of those
guarantees, and, of course, staying on the euro. Iceland has been heterodox: capital
controls, large devaluation, and a lot of debt restructuring – notice that wonderful
line from the IMF, above, about how “private sector bankruptcies have led to a
marked decline in external debt”. Bankrupting yourself to recovery! Seriously. 16

Earlier, in June the same year, Krugman had written in a blog post:

The moral of the story seems to be that if you’re going to have a crisis, it’s better
to have a really, really bad one. Otherwise, you’ll end up taking the advice of
people who assure you that even more suffering will cure what ails you.17

15
International Monetary Fund. (2010, October). Iceland: 2010 Article IV Consultation and Third
Review under Stand-By Arrangement and Request for Modification of Performance Criteria. IMF
Country Report No. 10/305. https://www.imf.org/external/pubs/ft/scr/2010/cr10305.pdf
16
Krugman, Paul. (2010, November 24). Lands of Ice and Ire. The New York Times. http://
krugman.blogs.nytimes.com/2010/11/24/lands-of-ice-and-ire/?_r¼0.
17
Krugman, Paul. (2010, June 30). The Icelandic Post-crisis Miracle. The New York Times. http://
krugman.blogs.nytimes.com/2010/06/30/the-icelandic-post-crisis-miracle/?scp¼1&sq¼+Iceland%
 1 Introduction 9

Krugman reiterated this view nearly a year later when he addressed the
assembled group at Harpa. He praised the heterodox policies
implemented in Iceland, whose success, he argued, validated his convic-
tion that fiscal austerity was a draining, misguided policy response to this
particular crisis.18
He concluded by issuing a stark warning to the Icelanders not to let go
of their currency and adopt the euro.
Citigroup’s chief economist, Willem Buiter, a former Professor at
London School of Economics, drew the exact opposite lesson from the
Icelandic experience (although he was just as brash in his conclusions and
rhetoric as Krugman). He began by using phrases such as “collective
madness,” “near universal suspension of common sense,” and “collective
stupidity that I have not seen in any advanced countries” to characterize
the precursors to the Icelandic crisis.19 In his view, the collapse showed
that countries without the ability to print a reserve currency could not
sustain an international banking system. Furthermore, this collapse
displayed the importance of scale: Iceland was just too small to sustain
its own currency and conduct independent monetary policy. There
simply was not enough brainpower to staff the necessary institutions for
an independent currency area (even without the collective madness). It
was important to think beyond the present stabilization policies, Buiter
said. In his view, the capital controls could never be fully abolished on
portfolio financial flows in and out of Iceland. Only foreign direct
investment (FDI) should be given free passage. Small countries such as
Iceland needed to “join larger clubs.” This prompted the following policy
advice: “Pray that the EU survives, pray that the euro survives.”
To conclude the sermon, Buiter suggested that Iceland should have “a
jubilee in the biblical sense.” Literally speaking, this meant a total debt
write-off every 50 years. Buiter, however, thought writing mortgage debt
down to about 70 % of the value of the underlying collateral was sufficient
– the rest should be turned into equity and handed over to the banks.

18
“Iceland’s Recovery – Lessons and Challenges”, IMF, Reykjavik, October 27, 2011. http://www.
imf.org/external/np/seminars/eng/2011/isl/
19
“Iceland’s Recovery – Lessons and Challenges”, IMF, Reykjavik, October 27, 2011. http://www.
imf.org/external/np/seminars/eng/2011/isl/
10 The Icelandic Financial Crisis

There was no clear agreement at the conference over what had been
done correctly in Iceland and what corrective measures had failed. Alto-
gether, it seemed somewhat of a mixed bag. Some thought that capital
controls had been a mistake. Others argued that the domestic/foreign
division of the banks was the problem – a good bank–bad bank division
was the optimal categorization. And then there were those that thought
Iceland was not really a success case at all.
For one sitting in the newly completed Harpa on that bright day of
October 27, it nonetheless seemed that Iceland had been vindicated after
its utter humiliation just three years earlier. At least the nation was back in
the international spotlight – and mostly for positive reasons. However, the
ultimate lesson, the one that made sense of so much crisis and correction,
proved elusive, and Iceland’s way forward was no clearer than any other
recovering nation’s. In fact, few Icelanders would have described their
conditions as ideal in 2011. In 2012, the IMF estimated both the gross
debt incurred during the crash and its aftermath in 2008–2011, and the
net cost to the treasury, accounting for the value of assets acquired against
that debt.20 This analysis found that the direct fiscal cost of the Icelandic
collapse amounted to 43.1 % of GDP; the net fiscal cost, adjusted for
appropriated assets, totaled 19.2 % of GDP. The biggest single item was
the recapitalization of the Central Bank of Iceland (CBI) owing to losses
from repurchase agreements (repo lending), or about 6.8 % of GDP. By
comparison, the recapitalization of the commercial banks amounted to
only 2.3 % of GDP. (See a more detailed discussion in Chap. 9.)
All in all, Icelandic public debt had increased by a staggering 72 % of
the GDP between 2007 and 2012 (jumping from 41 to 113 % of GDP in
those years). This is comparable to Ireland’s increase in public debt –
amounting to 82 % of GDP – during the same period. To be sure, Ireland
was spared the collateral damage caused by the currency crisis, double-
digit inflation, banking collapse, and the social upheaval that engulfed
Iceland. In addition, Ireland was not effectively locked out from the rest of
the world by capital controls and denied access to foreign capital invest-
ment. The protesters outside Harpa had abundant evidence on their side.

20
International Monetary Fund. (2012. April). Iceland: Ex Post Evaluation of Exceptional Access
Under the 2008 Stand-by Arrangement.
 1 Introduction 11

The ideals stated in the emergency legislation, which cut the links
between the sovereign and the banks, may have appealed to economists.
But everyday lives and business still felt the pain of radical choices.

1.3 The Unfinished Business of 2011

In 2011 there was little sense of how policies enacted in the crisis would
turn out when the recovery finally came, which probably explains why
views at the Harpa conference diverged to such an extent. The domestic/
foreign partition of the failing banks at the heat of the crisis had created a
new banking system with a lot of non-performing loans, and at the start
about 70 % of the new banks’ loan portfolios was in arrears – not exactly
trustworthy status. All in all, about 20 % of households went under with
negative equity, and 15 % of mortgages went into arrears. The numbers
were much more severe for corporations, 70–80 % of which went into
negative equity territory.
In 2011, after numerous debates between the banks, creditors, and the
government (and much handwringing), universal debt restructuring mea-
sures were implemented, which effectively transposed the write-downs
that had been made at the founding of the new banks to actual debt
reduction for the banks’ clients. Small to medium-sized businesses (with
total outstanding debt below 1 billion ISK, or €7 million) would go onto a
fast track and could apply for debt relief if they could credibly document
positive cash flow (EBITDA) from future activities. About a third of the
restructuring involved a convertible loan with a deferred repayment after
three years, which the company could buy from the bank at a discount prior
to maturity. These led to corporate debt write-offs that amounted to about
60–70 % of Iceland’s GDP. (See a more detailed discussion in Sect. 4.4.)
The households would also get their debt reduction. Household mort-
gage debt in excess of 110 % of the fair value of each property was written
off. Furthermore, specific relief measures (administered by a bank or a
new debtors’ ombudsman) were put in place for those that could not
service a reduced loan. Low-income, asset-poor households with high-
interest mortgage payments got a temporary subsidy from the govern-
ment. In addition, the government attempted to bolster the bargaining
12 The Icelandic Financial Crisis

power of individuals against the banks by making bankruptcy an easier

process, and by allowing claims, as a general rule, to expire only two years
after a formal default.
This, however, was not enough for the public. In the spring of 2013,
the left-wing government suffered a crushing defeat. The combined
electoral strength of the two coalition parties went from 51.5 % down
to 23.8 % – a record loss in Iceland for any government since indepen-
dence. A new right-wing government ascended while promising general
household debt relief, which it delivered in 2014 to the benefit of 100,000
households (out of about 180,000). The relief was funded with a special
tax on the old banks’ estates, with the motto “culprits should pay.” (See a
more detailed discussion in Sect. 5.6.)
In 2011, the currency reserves of the CBI – net of foreign debt – were
still close to zero. The bank had been unable to replenish the foreign
currency reserves by open market purchases. On the contrary, the bank
had to be a net seller in the market while tightening the currency controls
to support the ISK. Even though the 50 % devaluation of the ISK had led
to a sharp reduction in imports, thereby engineering a turnaround of the
balance of trade, the export sector was stationary. This was unsurprising,
since fishing and aluminum smelting, the main export industries, both
faced quantity restrictions.
Government-issued quotas, based on the estimated size of fishing
stocks, determine how much fishing firms are allowed to catch. The
marine output of the country is thus determined by biology, not the
export prices.
Aluminum smelters always run on full and stable capacity, regardless of
currency movements. And given that domestic investment levels had
collapsed to historical lows – and there was no FDI coming from abroad
– there were no new export sectors in the making. Indeed, when the new
banks were criticized for not lending out, they would simply answer that
lending is a two-way street: they were open for business, but there were no
new clients asking for new loans – just the old ones asking for debt
reduction.
However, in 2010 the glacier-volcano Eyjafjallajökull erupted, which
blocked flight traffic over the North Atlantic for weeks and brought the
international spotlight back to Iceland. The short-term effects of the
 1 Introduction 13

eruption on the Icelandic tourist industry were disastrous, but at the same
time it was a breath-taking advertisement for the country’s geology and
landscapes. (It also became a new tongue twister for the linguistically
inquisitive!) In the next few years, nature’s marketing campaign paid off.
In 2011, Iceland received about half a million foreign visitors; by 2016,
visitors had almost quadrupled to 1.8 million. The tourist industry
subsequently became the leading driver of the economy in terms of export
earnings, real estate prices and job creation. There was further benefit
from Reykjavík’s rapid development as a transatlantic flight hub, thanks
to the rapid expansion of Icelandair, the flag carrier. Today 25 airlines use
Keflavík International Airport; a decade ago there were only two or three.
(See a more detailed discussion in Sect. 5.4.)
The volcanic deus ex machina did not draw much attention at the 2011
Harpa conference, but soon afterwards there was abundant new foreign
demand that altered all economic fundamentals, for the better. The new
growth came in the wake of the extensive debt restructuring, and these
two forces restored the equity ratios of both companies and households.
The banks’ position also changed drastically as the ratio of
non-performing assets went south and their profitability went north.
The new banks were able to mark up assets they had received from the
old banks at “fair” value. The surge in tourism also facilitated a northward
shift in the current account, and finally gave the CBI the chance to
replenish its foreign reserves. From 2014 onwards, the CBI has purchased
about 50–70 % of all currency offered in the interbank market and
accumulated €3.3 billion (500bn ISK) in reserves. (See a more detailed
discussion in Sect. 5.3.)
In a national referendum in April 2011, voters rejected an extension of a
government guarantee on the Icesave online accounts. These had been
offered prior to the collapse by Landsbanki in the UK and the Netherlands
with an Icelandic deposit guarantee. There had been about 425,000 online
accounts (300,000 in the UK and 125,000 in the Netherlands). The total
sum the Icelandic population was asked to guarantee was up to €4 billion,
or 40–60 % of Iceland’s GDP, depending on the valuation of the ISK. It
was known in 2011 that the asset recovery of the Landsbanki estate would
be sufficient to repay the principal, but nevertheless there were large claims
outstanding from both the British and the Dutch concerning interest
14 The Icelandic Financial Crisis

payments. In 2011 these respective governments resorted to litigation.

With a ruling on January 28, 2013, the Court of Justice of the European
Free Trade Association (EFTA) States cleared Iceland of all charges –
leaving the governments with only “first priority claim” on the Landsbanki
receivership. Landsbanki made its last installed payment on January
11, 2016 – thereby closing the claim. (See a more detailed discussion in
Sect. 5.2.)
In 2011, offshore ISK assets, the remains from the once blooming carry
trade, stood at the equivalent of €3.1 billion, or 30 % of GDP.21 The
principal purpose of capital controls in the wake of the collapse was to
prevent large-scale outflows from burdening the general public via an
excessively low exchange rate. In 2011, the CBI started efforts to eliminate
the accumulated overhang within the scope of the capital account.22 It
created a special auction market where asset swaps could be conducted at a
lower exchange rate than the publicly quoted onshore rate. This prevented
the reduction from disturbing the real economy by lowering the ISK
exchange rate and ensured that the trade surplus was not used to convert
offshore ISK to foreign currency. The overhang had been cut in half by
year-end 2015. (See a more detailed discussion in Sect. 5.5.)
In 2011, the main challenge associated with the Icelandic recovery was
still practically unnoticed: this was the transfer problem resulting from the
distribution from the old banks’ default estates. The original intention
had been to partition the banking system into a domestic part, which
would be recapitalized, and a foreign part that would go into liquidation.
It did not turn out that way. To start with, owing to FSA controls, some
domestic assets were not transferred to the new banks. Examples include
derivatives and assets moved to foreign special purpose vehicles (SPVs).
Second, and more importantly, the deposits of the domestic branches of
the failed banks were considerably less than the value of their domestic
assets, owing to large-scale wholesale funding. On a parent company basis,
domestic deposits were 18 % of Glitnir’s total funding, and 14 % of
Landsbanki’s and Kaupthing’s. Half of the banks’ wholesale funding was

21
Central Bank of Iceland. (2011, March 25). Aætlun
um losun gjaldeyrishafta. (A plan for lifting
capital controls.) http://www.cb.is/lisalib/getfile.aspx?itemid¼8673
22
Ibid.
 1 Introduction 15

foreign, and the banks subsequently reloaned this to Icelandic and foreign
corporations (this is reflected by the fact that at the beginning of 2008,
around 68 % of total bank lending to Icelandic corporations was in
foreign currency, or currency-linked). Even after steep write-offs, the
new banks had considerably more assets than deposits, and had to issue
bonds to the old banks to cover the difference. (See a more detailed
discussion in Sect. 6.2.)
Recapitalizing an entire banking system with a significant amount of
non-performing assets of uncertain value entailed a huge risk for the
government – if not from loan losses then by litigation by the creditors.
Thus, the government was quite happy to be relieved from some of that
burden by letting the creditors pick up the tab from the recapitalization by
converting the bonds issued by the new banks to the old banks into
equity. It retained only 5 % in Íslandsbanki (New Glitnir) and 13 % in
Arion (New Kaupthing), but with a shareholder agreement that gave the
government-appointed board member veto power regarding these
“privatized” banks in certain situations. However, the government kept
80 % of Landsbanki and later acquired the bank almost in full. Further-
more, by allowing the creditors to turn bonds into equity, and thus
assume the risk and benefits from a downside or upside for the new
banks, the government was able to avoid litigation risk concerning the
“fair value” of the asset transferred to the new banks from the estates.
Instead, everyone could just agree on a rather low initial valuation of the
asset base of the new banks, since the creditors would, as shareholders,
reap the benefits from a later mark-up. (See a more detailed discussion in
Sect. 6.3.)
Thus, when the tourist boom began to move the economy, the banks
churned out profits that would bolster their equity. By 2014, the new
banks had equity ratios of about 20–30 % despite having paid out
substantial dividends. Thus, the estates held ISK assets to the tune of
€5–6 billion, or about 50 % of Iceland’s GDP, most of which was equity
holdings in the new banks. Since the overwhelming majority of the
creditors were foreign, the distribution of these ISK assets had to go
through the currency market. Of course, there are limits on how much
capital can be transferred from one currency area to another through the
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