Transcript Icelandic banks 2008 in context

Thorvaldur Gylfason
 1929:

Compounded by massive public policy failure

Monetary contraction (Friedman-Schwartz story)

Protectionism (Smoot-Hawley tariff)
 1987:

Wall Street, again
Corrected through monetary expansion (Volcker)
 1997:

Wall Street collapse
Asian crisis
Preceded by construction boom in Thailand
 2000:
Dotcom collapse, limited impact
 2008: Subprime loan debacle in US

Where will it lead? Repeat from 1929? No.
 Exposes
a fundamental asymmetry of
information, leading to grave moral hazard


Selling mortgage loans to people with no jobs, no
incomes, no money to put down, no means of
paying back
Bankers convinced subprime customers that they
could pay higher interest on their mortgages
after a short grace period because house prices
would rise, but prices fell
 Dealers
have a vested private interest in
making socially destructive deals



The most they stand to lose is their jobs
The most they can win is astronomical wealth
You figure out the average of those two options
 Need

legal protection against predatory lending
Like laws against quack doctors, same logic


Patients know less about health problems than doctors,
so we have legal protection against medical malpractice
Same applies to some bank customers vs. bankers,
especially in connection with complex financial deals
 Subprime
assets of dubious value were packaged
into complex financial instruments of equally
dubious value that not even some of the
bankers themselves understood …
 … and were given top ratings by rating agencies
paid by the banks that pushed these instruments
 Do
not allow rating agencies to be paid by
the banks



Fundamental conflict of interest
Further, regulation was weak
In US, laws from 1930s (Glass-Steagall Act)
separating commercial banking from investment
banking were deliberately weakened around
1990, permitting banks again to blend the two
types of banking


Consider merging an electric utility providing a steady
stream of electricity to rate-paying customers and a
casino, making it possible for the casino, if it goes bust,
to bring down the utility
But this is controversial because, in good times, the
casino can support the utility
 Need
more and better regulation of banks
and other financial institutions, but exactly
how needs to be worked out

Work in progress
 Read

the warning signals
Three rules, or stories



The Aliber Rule
 Count the cranes
The Giudotti-Greenspan Rule
 Never allow gross foreign reserves held by the
Central Bank to fall below the short-term foreign
debts of commercial banks
 Failure to respect the Giudotti-Greenspan Rule
amounts to an open invitation to speculators to
stage an attack on the currency
The Overvaluation Rule
 Sooner or later, an overvalued currency will fall
 Read

First story


the warning signals
Professor Aliber in Iceland 2007: Count the cranes!
 Bangkok 1996: Many cranes, yes, but no clue
Second story


Thailand 1996: Ratio of foreign reserves to short-term
foreign debt had fallen below the critical number 1
 Speculators took notice, and attacked the baht
 Like others, IMF was caught off guard
Iceland took longer: Central Bank foreign reserves
dropped from 100% of short-term debt in the 1990s to
6% in 2008 while bank assets rose to 9 times GDP
% of short-term debt
140
120
100
80
60
40
20
0
 Read the warning
 Third story


signals
Overvaluation: Like many African countries, Iceland
has a long history of an overvalued currency
2007: Iceland’s per capita GDP had risen to 50% above
US per capita GDP
Clear sign that correction was due
Even so, many households and firms borrowed in cheap
foreign currencies at low interest even if their entire
earnings were in domestic currency
 Even senior bankers and ministers did this
 An indication of wide-spread euphoria



Other unmistakable signs





Large current account deficits, mounting foreign debts
Creeping inflation
Pervasive farm support, including fisheries
High domestic prices of tradable goods (Big Mac index)
Recently, also, carry trade
International Investment Position (% of GDP)
0
-20
-40
-60
-80
-100
-120
-140
-160
-180
2004
2005
2007
2007
2008
 Do
not let banks outgrow Central Bank’s
ability to stand behind them as lender – or
borrower – of last resort
 Do not allow banks to operate branches
abroad rather than subsidiaries, thus
exposing domestic deposit insurance schemes
to foreign obligations

Without having been informed about it, Iceland
(population 300.000) suddenly found itself to be
held responsible for the moneys kept in an
Icelandic bank by 300.000 British depositors, and
more in the Netherlands and Germany
Source: Union Bank of Switzerland.
10
9
8
7
6
5
4
3
2
1
0
Switzerland
Iceland
 “A
sound banker, alas, is not one who
foresees danger and avoids it, but one who,
when he is ruined, is ruined in a conventional
way along with his fellows, so that no one
can really blame him.”
J.M. Keynes


Icelandic banks copied each other’s business
model
This can be good when the going is good, but not
so good when the sea gets rough
 Erect

Iceland’s privatization of its state banks 1998-2003
was mismanaged in ways that contributed to
collapse and to weak restraints on bank growth




firewalls between banking and politics
Government ought to have constrained the banks
through taxes
Central Bank ought to have constrained them through
reserve requirements
Financial Supervision Authority ought to have applied
more stringent stress tests, appropriate to local
conditions
Besides, several earlier episodes of bank problems
when banks were state-owned were covered up

No accountability
 When
things go wrong, hold those responsible
accountable by law, or at least try to uncover
the truth: Do not cover up


In Iceland, there are now vocal demands for an
International Commission of Enquiry, a Truth and
Reconciliation Committee of sorts
If history is not correctly recorded if only for
learning purposes, it is more likely to repeat itself
with dire consequences
 When
banks collapse and assets are wiped
out, protect the real economy by a massive
monetary or fiscal stimulus


Think outside the box: put old religion about
monetary restraint and fiscal prudence on ice
Always remember: a financial crisis, painful
though it may be, typically wipes out only a
small fraction of national wealth


Physical capital (typically 3 or 4 times GDP) and
human capital (typically 5 or 6 times physical capital)
dwarf financial capital (typically less than GDP)
So, financial capital typically constitutes one fifteenth
or one twenty-fifth of total national wealth or less
Switzerland
South Africa
Iceland
Singapore
United Kingdom
United States
Japan
France
Russian Federation
China
India
Egypt, Arab Rep.
Brazil
Mauritius
Germany
Kenya
Botswana
Nigeria
Ghana
Cote d'Ivoire
0
50
100
150
200
250
300
350
Source: World Bank, World Development Indicators 2008.
 Do
not jump to conclusions and do not throw
out the baby with the bathwater





Since the collapse of communism, a mixed market
economy has been the only game in town
To many, the current financial crisis has dealt a
severe blow to the prestige of free markets and
liberalism, with banks having to be propped up
temporarily by governments, even nationalized
Even so, it remains true that governments are not
well suited to own and operate banks, so banks
will in due course need to be re-privatized
Banking and politics are not a good mix
Even so, private banks clearly need proper
regulation because of their ability to inflict severe
damage on innocent bystanders
From the IMF Data Mapper, October 2008
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