Academic journal article Baltic Journal of Economics

Small States and Big Banks - the Case of Iceland

Academic journal article Baltic Journal of Economics

Small States and Big Banks - the Case of Iceland

Article excerpt

Abstract

The Icelandic economy was hit hard by the global economic and financial crisis that started in the fall of 2008. During this crisis the three largest banks all collapsed and many other smaller banks and companies went bankrupt in the aftermath of the crisis with severe consequences for the economy and the people. Prior to the crisis, Iceland, a high income economy, had experienced strong growth rates and unprecedented expansion in overseas investment and activities, especially in the financial sector. This article focuses on action by top government officials during this expansion as well as during and after the collapse of the Icelandic banks. The findings of the study are that the government showed negligence and made mistakes by not taking credible action to manage risks following a rapid cross border expansion of the Icelandic banking system. This had severe consequences and resulted in the collapse of the Icelandic economy in October 2008. The discussion can have a wider relevance than that for Iceland only. This is especially true for small countries with a large banking sector, using their own currency, and with limited fiscal space to support their banks during a crisis.

Keywords: Economic and financial crisis, economic policy, international expansion of firms, risk management.

JEL Classification: F21, G32, H12

1. Introduction

The Icelandic economy was hit hard by the global economic and financial crisis that started in the fall of 2008. During this crisis the three largest banks (Glitnir, Kaupthing, and Landsbanki)2 all collapsed and many other smaller banks and companies went bankrupt in the aftermath of the crisis with severe consequences for the economy and the people. Prior to the crisis, Iceland, a high income OECD economy, had experienced strong growth rates and unprecedented expansion in overseas investment and activities, especially in the financial sector. This article will focus on action by top government officials during this expansion as well as during and after the collapse of the Icelandic banks. Did the government of Iceland fuel the international expansion of the Icelandic banking sector that eventually resulted in collapse? How did it react to the banks' expansion and what action did it take, or not take, to protect the economy from collapse? How did it respond to international concerns about the banks' overseas expansion? Can its behavior be classified as negligence?

The government officials focused on are the President of Iceland, who has traditionally been a symbolic and ceremonial figure in the government, as well as the role of key cabinet ministers including the Prime Minister, the Minister of Finance, and the Minister of Business Affairs. After this brief introduction the article will be organized as follows: (i) the expansion of the banking sector in Iceland, (ii) what did experts say about the health of the Icelandic banks before and after the collapse in October 2008 (were the banks solvent after all?), (iii) how did the government react to concerns and criticism about the banking system prior to the crisis, (vi) the Special Investigation Commission and its report to the parliament, (v) the President of (iv) Iceland and the expansion of the Icelandic banks, (vi) the role of the Central Bank of Iceland (CIB) and the Icelandic Financial Supervisor (FME), (vii) some thoughts on how the crisis could have been prevented, and finally (viii) conclusions.

This article is based on a review of theoretical literature, reports, public speeches, local and international media news, and secondary data. This is a case study on Iceland. Some of the lessons, however, can have a wider relevance than for Iceland only. This is especially true for small countries with a large banking sector, using their own currency, and with limited fiscal space to support their banks during a crisis.

2. The expansion of the banking sector in Iceland

Prior to the global economic and financial crisis that started in October 2008 the Icelandic banks had grown extraordinarily. …

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