Key Lesson From Iceland Crisis: “Let Banks Fail”

What Iceland Teaches Us: “Let Banks Fail”

Agence France-Presse notes:

Three years after Iceland’s banks collapsed and the country teetered on the brink, its economy is recovering, proof that governments should let failing lenders go bust and protect taxpayers, analysts say.

***

“The lesson that could be learned from Iceland’s way of handling its crisis is that it is important to shield taxpayers and government finances from bearing the cost of a financial crisis to the extent possible,” Islandsbanki analyst Jon Bjarki Bentsson told AFP.

“Even if our way of dealing with the crisis was not by choice but due to the inability of the government to support the banks back in 2008 due to their size relative to the economy, this has turned out relatively well for us,” Bentsson said.

***

Nobel Prize-winning US economist Paul Krugman echoed Bentsson.

“Where everyone else bailed out the bankers and made the public pay the price, Iceland let the banks go bust and actually expanded its social safety net,” he wrote in a recent commentary in the New York Times.

“Where everyone else was fixated on trying to placate international investors, Iceland imposed temporary controls on the movement of capital to give itself room to maneuver,” he said.

During a visit to Reykjavik last week, Krugman also said Iceland has the krona to thank for its recovery, warning against the notion that adopting the euro can protect against economic imbalances.

***

Iceland’s former prime minister Geir Haarde, in power during the 2008 meltdown and currently facing trial over his handling of the crisis, has insisted his government did the right thing early on by letting the banks fail and making creditors carry the losses.

“We saved the country from going bankrupt,” Haarde, 68, told AFP in an interview in July.

As I noted last week:

Iceland told the banks to pound sand. And Iceland’s economy is doing much better than virtually all of the countries which have let the banks push them around.

Barry Ritholtz noted in May:

Rather than bailout the banks — Iceland could not have done so even if they wanted to — they guaranteed deposits (the way our FDIC does), and let the normal capitalistic process of failure run its course.

They are now much much better for it than the countries like the US and Ireland who did not.

Bloomberg pointed out in February:

Unlike other nations, including the U.S. and Ireland, which injected billions of dollars of capital into their financial institutions to keep them afloat, Iceland placed its biggest lenders in receivership. It chose not to protect creditors of the country’s banks, whose assets had ballooned to $209 billion, 11 times gross domestic product.

***

“Iceland did the right thing by making sure its payment systems continued to function while creditors, not the taxpayers, shouldered the losses of banks,” says Nobel laureate Joseph Stiglitz, an economics professor at Columbia University in New York. “Ireland’s done all the wrong things, on the other hand. That’s probably the worst model.”

Ireland guaranteed all the liabilities of its banks when they ran into trouble and has been injecting capital — 46 billion euros ($64 billion) so far — to prop them up. That brought the country to the brink of ruin, forcing it to accept a rescue package from the European Union in December.

***

Countries with larger banking systems can follow Iceland’s example, says Adriaan van der Knaap, a managing director at UBS AG.

“It wouldn’t upset the financial system,” says Van der Knaap, who has advised Iceland’s bank resolution committees.

***

Arni Pall Arnason, 44, Iceland’s minister of economic affairs, says the decision to make debt holders share the pain saved the country’s future.

“If we’d guaranteed all the banks’ liabilities, we’d be in the same situation as Ireland,” says Arnason, whose Social Democratic Alliance was a junior coalition partner in the Haarde government.

***

“In the beginning, banks and other financial institutions in Europe were telling us, ‘Never again will we lend to you,’” Einarsdottir says. “Then it was 10 years, then 5. Now they say they might soon be ready to lend again.”

Even the IMF praises Iceland’s strategy:

As the first country to experience the full force of the global economic crisis, Iceland is now held up as an example by some of how to overcome deep economic dislocation without undoing the social fabric.

While the conditions in Iceland are in many ways different from the conditions in the U.S., Iceland’s lesson applies to America, as well.

Specifically, a study of 124 banking crises by the International Monetary Fund found that propping banks which are only pretending to be solvent hurts the economy:

Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.

Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery.

***

All too often, central banks privilege stability over cost in the heat of the containment phase: if so, they may too liberally extend loans to an illiquid bank which is almost certain to prove insolvent anyway. Also, closure of a nonviable bank is often delayed for too long, even when there are clear signs of insolvency (Lindgren, 2003). Since bank closures face many obstacles, there is a tendency to rely instead on blanket government guarantees which, if the government’s fiscal and political position makes them credible, can work albeit at the cost of placing the burden on the budget, typically squeezing future provision of needed public services.

Indeed, numerous Nobel prize winning and otherwise highly-regarded American economists say that our economy cannot recover until the big banks are broken up.

If the politicians are too corrupt to break up the big banks (because the banks have literally bought the politicians), let’s break them up ourselves.

Many people are doing just that.