Iceland Financial Crisis

Topics: Monetary policy, Central bank, Inflation Pages: 7 (1636 words) Published: July 17, 2015
Iceland Financial Crisis (2008-2011)
Iceland experienced a significant financial meltdown and subsequent economic downturn after the 2008 financial crisis struck the country, known as Icelandic Financial Crisis. The crisis was a major economic and political event happened in Iceland that involved the collapse of all three of the country’s major privately owned commercial banks, following their difficulties in refinancing their short-term debt and a run on deposits in the Netherlands and the United Kingdom. Relative to the size of its economy, Iceland’s systematic banking collapse is the largest crisis experienced by any small country in economic history. Since 1980s, Iceland's macroeconomic stability had been constantly deteriorated by the most volatile annual CPI and asset-price inflation dynamics in the OECD. More than a decade of robust growth dynamics left behind an internationally over-exposed banking sector which exceeded the size of country's GDP by nearly 10 times. The failure of Lehman Brothers and a global credit crunch, in turn, raised CDS rates on Icelandic banks which immediately declared insolvency after the global interbank lending froze. Causes

There are several reasons that inflicted the financial crisis in Iceland. Deregulation and privatization of the banking sector was believed as the ultimate root of the Iceland’s financial crisis. There were three largest commercial banks, Glintir, Landisbanki and kaupthing in Iceland, had total assets of more than $168 billion USD, which its total assets had exceed the country’s economy by several times and the central banks inevitably fails as the lender of last resort, mostly because it is impossible for the central bank to build up strong foreign reserves. The ultimate causes of the crisis was the failure of the central bank’s mismatched regulation of the banking sector and its failure to forecast the possibility of the financial crisis in a series of the policymaking failures among which the wrong use of inflation targeting is the headline failure.

Besides that, the expansion of banking activities abroad of the banks’ in Iceland, was a reasonable consequence of the high interest rate which did not simulate domestic investment in krona-denominated loans. Instead, the banking sector was seeking loans in foreign currency which then brought a significant appreciation of the krona and at the same time, increased the exposure of the Iceland’s banking sector to the foreign shocks. In addition to this, after the Icelandic economy shrank into the 2002 recession, there was a negative output gap and policy makers enacted further tax cuts to boost the economy’s short-term growth potential. After the short-lived recession, the economy boomed. In 2004, the economy growth rate was 7.7% and the following year had expanded by 7.45%. In the meantime, central bank increased the discount rate on overnight loans from 8.25% in 2004 to 15.25% in 2007, but the share of the domestic loans in the portfolio of major banks remained negligible. Because the banking sector expanded internationally, there was a high probability of a growing external indebtedness that would vastly exceed the fiscal and reserve capacity of the Icelandic economy and its central bank. As the banks expanded abroad to places such as United Kingdom, Luxembourg and the Nordic countries, loans were not backed by either deposits or reserve currency, means given high leverage of the banks’ balance sheet, lending operations were driven by the debt. As soon as the world credit markets froze in the light failure of Lehman Brothers and the collapse of Bear Stearns, the Icelandic banks were unable to fuel their lending capacity and thus unable to fulfill its depository obligations. Therefore, the financial crisis in Iceland is not resulted from the an immediate set of measures that caused the failure of highly leveraged banking sector, but rather a consequences of a combination of global financial...
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