Bailing Out – The Iceland Way

Posted in Finance Articles, Total Reads: 2314 , Published on 08 December 2011
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“…[Case of] AIG highlights the urgent need for new resolution procedures for systemically important nonbank financial firms. If a federal agency had had such tools on September 16, they could have been used to put AIG into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate. That outcome would have been far preferable to the situation we find ourselves in now…” – Ben Bernanke, Chairman of Federal Reserve, Testimony on AIG Bailout.

Unlike US and other European nations, who bailed out their financial institutions using taxpayer’s money, Iceland actually went ahead and did what Bernanke wished for. In the winter of 2008, the three biggest banks of Iceland were facing refinancing problems and instead of bailing them out, Iceland allowed them to fail and protected only the domestic accounts. The cost of this breach of trust was about 8% contraction in real GDP, 10% unemployment rate, more than 80% fall in stock markets, central bank raising interest rates to 18% and a significant devaluation of its currency. Surprisingly, today Iceland is recovering well, with the three rechristened banks posting profits upwards of $300 million in 2010, inflation down by around 200 basis points, unemployment levels of around 6% and CDS rates on government bonds falling more than 70%.

Bailing Out Iceland

This is surprising as markets seemed to have punished Iceland lightly as compared to Ireland or Latvia, who faced similar banking crises and actually protected the creditors using taxpayers’ money. The essence of the story is that Iceland successfully did what true capitalism promotes that the risk takers should share gains as well as losses.

The assets of the three Icelandic banks were almost 6 times the GDP of the country and hence the government could never have bailed them out. The government did the best things it could do, allow the banks to go under receivership and at the same time strengthen the social safety net for its citizens. The result of this was the economy coming down to grinding halt and severe economic hardships but by addressing the root problem, Iceland ensured that it maintains its debt levels and thereby lowered the risk premium for the investors.

 Percent Change in Employment

Percent Change in Real GDP

The graphs above highlight the performance of Iceland since the pre-crisis days, and it clearly shows that situation is still bad in Iceland, but it could’ve been much worse had it taken the traditional route of bailing out its banks. In comparison, Ireland who rescued its six banks with a package of €7 billion is in a much worse shape and struggling with its recovery.

Coming back to the Bernanke’s statement mentioned at the beginning, it could’ve been a possible solution for Wall Street and judging by the mood of recent “Occupy Wall Street” protests, such an orderly unwinding of distressed financial institutions would also have been popular on Main Street. But right since the days of Penn Central bankruptcy in 1970, US government has preferred bailing out the institutions and this has worked for them in last 4 decades. This time, though, by bailing out financial institutions in 2008 without having a proportional oversight on them, Federal Reserve has sent out a wrong message of privatizing gains and socializing losses, a message which got amplified due to information technology and global nature of crisis.

The Iceland story has shown that bailouts are not always the best solutions and the trust of the markets can be gained by being decisive and transparent in your approach. These days “Too Big to Fail” is flouted on Wall Street in support of bailouts, but in case of Iceland, the banks actually became “Too Big to Save” and paid the price of their decisions. The important point to note here is that bailouts have worked in case of USA and they are essential to maintain a systemic stability. But to a certain degree, recent bailouts by US government don’t really seem to address the structural problems (mainly proper regulations) and just seem to spray a pain killer on a fractured hand. Capitalism always leads to creative destruction in search for more efficient systems and this has to be accepted by authorities and the society. In case of USA, while trying to maintain the stability of the system, the Federal Reserve seems to have overlooked these basic tenets of the capitalism.

This article has been authored by Kushal Bagadiya & Tanmay Borse, MBA Core, NMIMS, Mumbai.

“…[Case of] AIG highlights the urgent need for new resolution procedures for systemically important nonbank financial firms. If a federal agency had had such tools on September 16, they could have been used to put AIG into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate. That outcome would have been far preferable to the situation we find ourselves in now…” – Ben Bernanke, Chairman of Federal Reserve, Testimony on AIG Bailout.

Unlike US and other European nations, who bailed out their financial institutions using taxpayer’s money, Iceland actually went ahead and did what Bernanke wished for. In the winter of 2008, the three biggest banks of Iceland were facing refinancing problems and instead of bailing them out, Iceland allowed them to fail and protected only the domestic accounts. The cost of this breach of trust was about 8% contraction in real GDP, 10% unemployment rate, more than 80% fall in stock markets, central bank raising interest rates to 18% and a significant devaluation of its currency. Surprisingly, today Iceland is recovering well, with the three rechristened banks posting profits upwards of $300 million in 2010, inflation down by around 200 basis points, unemployment levels of around 6% and CDS rates on government bonds falling more than 70%.

This is surprising as markets seemed to have punished Iceland lightly as compared to Ireland or Latvia, who faced similar banking crises and actually protected the creditors using taxpayers’ money. The essence of the story is that Iceland successfully did what true capitalism promotes that the risk takers should share gains as well as losses.

The assets of the three Icelandic banks were almost 6 times the GDP of the country and hence the government could never have bailed them out. The government did the best things it could do, allow the banks to go under receivership and at the same time strengthen the social safety net for its citizens. The result of this was the economy coming down to grinding halt and severe economic hardships but by addressing the root problem, Iceland ensured that it maintains its debt levels and thereby lowered the risk premium for the investors.

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The graphs[2] above highlight the performance of Iceland since the pre-crisis days, and it clearly shows that situation is still bad in Iceland, but it could’ve been much worse had it taken the traditional route of bailing out its banks. In comparison, Ireland who rescued its six banks with a package of €7 billion is in a much worse shape and struggling with its recovery.

 

Coming back to the Bernanke’s statement mentioned at the beginning, it could’ve been a possible solution for Wall Street and judging by the mood of recent “Occupy Wall Street” protests, such an orderly unwinding of distressed financial institutions would also have been popular on Main Street. But right since the days of Penn Central bankruptcy in 1970, US government has preferred bailing out the institutions and this has worked for them in last 4 decades. This time, though, by bailing out financial institutions in 2008 without having a proportional oversight on them, Federal Reserve has sent out a wrong message of privatizing gains and socializing losses, a message which got amplified due to information technology and global nature of crisis.

 

The Iceland story has shown that bailouts are not always the best solut

“…[Case of] AIG highlights the urgent need for new resolution procedures for systemically important nonbank financial firms. If a federal agency had had such tools on September 16, they could have been used to put AIG into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate. That outcome would have been far preferable to the situation we find ourselves in now…” – Ben Bernanke, Chairman of Federal Reserve, Testimony on AIG Bailout.

Unlike US and other European nations, who bailed out their financial institutions using taxpayer’s money, Iceland actually went ahead and did what Bernanke wished for. In the winter of 2008, the three biggest banks of Iceland were facing refinancing problems and instead of bailing them out, Iceland allowed them to fail and protected only the domestic accounts. The cost of this breach of trust was about 8% contraction in real GDP, 10% unemployment rate, more than 80% fall in stock markets, central bank raising interest rates to 18% and a significant devaluation of its currency. Surprisingly, today Iceland is recovering well, with the three rechristened banks posting profits upwards of $300 million in 2010, inflation down by around 200 basis points, unemployment levels of around 6% and CDS rates on government bonds falling more than 70%.

This is surprising as markets seemed to have punished Iceland lightly as compared to Ireland or Latvia, who faced similar banking crises and actually protected the creditors using taxpayers’ money. The essence of the story is that Iceland successfully did what true capitalism promotes that the risk takers should share gains as well as losses.

The assets of the three Icelandic banks were almost 6 times the GDP of the country and hence the government could never have bailed them out. The government did the best things it could do, allow the banks to go under receivership and at the same time strengthen the social safety net for its citizens. The result of this was the economy coming down to grinding halt and severe economic hardships but by addressing the root problem, Iceland ensured that it maintains its debt levels and thereby lowered the risk premium for the investors.


The graphs[2] above highlight the performance of Iceland since the pre-crisis days, and it clearly shows that situation is still bad in Iceland, but it could’ve been much worse had it taken the traditional route of bailing out its banks. In comparison, Ireland who rescued its six banks with a package of €7 billion is in a much worse shape and struggling with its recovery.

Coming back to the Bernanke’s statement mentioned at the beginning, it could’ve been a possible solution for Wall Street and judging by the mood of recent “Occupy Wall Street” protests, such an orderly unwinding of distressed financial institutions would also have been popular on Main Street. But right since the days of Penn Central bankruptcy in 1970, US government has preferred bailing out the institutions and this has worked for them in last 4 decades. This time, though, by bailing out financial institutions in 2008 without having a proportional oversight on them, Federal Reserve has sent out a wrong message of privatizing gains and socializing losses, a message which got amplified due to information technology and global nature of crisis.

The Iceland story has shown that bailouts are not always the best solutions and the trust of the markets can be gained by being decisive and transparent in your approach. These days “Too Big to Fail” is flouted on Wall Street in support of bailouts, but in case of Iceland, the banks actually became “Too Big to Save” and paid the price of their decisions. The important point to note here is that bailouts have worked in case of USA and they are essential to maintain a systemic stability. But to a certain degree, recent bailouts by US government don’t really seem to address the structural problems (mainly proper regulations) and just seem to spray a pain killer on a fractured hand. Capitalism always leads to creative destruction in search for more efficient systems and this has to be accepted by authorities and the society. In case of USA, while trying to maintain the stability of the system, the Federal Reserve seems to have overlooked these basic tenets of the capitalism.

ions and the trust of the markets can be gained by being decisive and transparent in your approach. These days “Too Big to Fail” is flouted on Wall Street in support of bailouts, but in case of Iceland, the banks actually became “Too Big to Save” and paid the price of their decisions. The important point to note here is that bailouts have worked in case of USA and they are essential to maintain a systemic stability. But to a certain degree, recent bailouts by US government don’t really seem to address the structural problems (mainly proper regulations) and just seem to spray a pain killer on a fractured hand. Capitalism always leads to creative destruction in search for more efficient systems and this has to be accepted by authorities and the society. In case of USA, while trying to maintain the stability of the system, the Federal Reserve seems to have overlooked these basic tenets of the capitalism.


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