Now that Greece has controls on outtake from banks, capital controls, many commentators are comparing Greece to Iceland. There is little to compare regarding the nature of capital controls in these two countries. The controls are different in every respect except in the name. Iceland had, what I would call, real capital controls – Greece has control on outtake from banks. With the names changed, the difference is clear.
Iceland – capital controls
The controls in Iceland stem from the fact that with its own currency and a huge inflow of foreign funds seeking the high interest rates in Iceland in the years up to the collapse in October 2008, Iceland enjoyed – and then suffered – the consequences, as had emerging markets in Asia in the 1980s and 1990s.
Enjoyed, because these inflows kept the value of the króna, ISK, very high and the whole of the 300.000 inhabitants lived for a few years with a very high-valued króna, creating the illusion that the country was better off then it really was. After all, this was a sort of windfall, not a sustainable gain or growth in anything except these fickle inflows.
Suffered, because when uncertainty hit the flows predictably flowed out and Iceland’s foreign currency reserve suffered. As did the whole of the country, very dependent on imports, as the rate of the ISK fell rapidly.
During the boom, Icelandic regulators were unable and to some degree unwilling to rein in the insane foreign expansion of the Icelandic banks. On the whole, there was little understanding of the danger and challenge to financial stability that was gathering. It was as if the Asia crisis had never happened.
As the banks fell October 6-9 2008, these inflows amounted to ISK625bn, now $4.6bn, or 44% of GDP – these were the circumstances when the controls were put on in Iceland due to lack of foreign currency for all these foreign-owned ISK. The controls were put on November 29 2008, after Iceland had entered an IMF programme, supported by an IMF loan of $2.1bn. (Ironically, Poul Thomsen who successfully oversaw the Icelandic programme is now much maligned for overseeing the Greek IMF programme – but then, Iceland is not Greece and vice versa.)
With time, these foreign-owned ISK has dwindled, is now at 15% of GDP but another pool of foreign-owned ISK has come into being in the estates of the failed bank, amounting to ca. ISK500bn, $3.7bn, or 25% of GDP.
In early June this year, the government announced a plan to lift capital controls – it will take some years, partly depending on how well this plan will be executed (see more here, toungue-in-cheek and, more seriously, here).
Greece – bank-outtake controls
The European Central Bank, ECB, has kept Greek banks liquid over the past many months with its Emergency Liquid Assistance, ELA. With the Greek government’s decision to buy time with a referendum on the Troika programme and the ensuing uncertainty this assistance is now severely tested. The logical (and long-expected) step to stem the outflows from banks is limit funds taken out of the banks.
This means that the Greek controls are only on outtake from banks. The Greek controls, as the Cypriot, earlier, have nothing to do with the value or convertibility of the euro in Greece. The value of the Greek euro is the same as the euro in all other countries. All speculation to the contrary seems to be entirely based on either wishful thinking or misunderstanding of the controls.
However, it seems that ELA is hovering close to its limits. If correct that Greek ELA-suitable collaterals are €95bn and the ELA is already hovering around €90bn the situation, also in respect, is precarious.
How quickly to lift – depends on type of controls
The Icelandic type of capital controls is typically difficult to lift because either the country has to make an exorbitant amount of foreign currency, not likely, a write-down on the foreign-owned ISK or binding outflows over a certain time. The Icelandic plan makes use of the two latter options.
Lifting controls on outtake from banks takes less time, as shown in Cyprus, because the lifting then depends on stabilising the banks and to a certain degree the trust in the banks.
This certainly is a severe problem in Greece where the banks are only kept alive with ELA – funding coming from a source outside of Greece. This source, ECB, is clearly unwilling to play a political role; it will want to focus on its role of maintaining financial stability in the Eurozone. (I very much understand the June 26 press release from the ECB as a declaration that it will stick with the Greek banks as long as it possibly can; ECB is not only a fair-weather friend…)
Without the IMF it would have been difficult for Iceland to gather trust abroad in its crisis actions – but Greece is not only dependent on the Eurozone for trust but on the ECB for liquidity. Without ELA there are no functioning Greek banks. If the measures to stabilise the banks are to be successful the controls are only the first step.
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Today, the Reykjavík District Court ruled in the most extensive banking case so far, a case of market manipulation and loans to Kevin Stanford and other businessmen to buy shares in Kaupthing, alleged to have part of the market manipulation by Kaupthing senior managers.
This is a complicated case, where the Office of Special Prosecutor went through, in court, months of trades to show a pattern they claimed was consistent with charges of market manipulation. – The judgement will no doubt be appealed by those who were sentenced.
Sigurður Einarsson ex-chairman of the board of Kaupthing was sentenced to a year. Hreiðar Már Sigurðsson, the banks CEO at the time, was found guilty but not sentenced to prison because he has already been sentenced in another case, the al Thani case. According to Rúv, Einarsson sentence will be added to the four years he was sentenced to in the al Thani case. Ingólfur Helgason, Kaupthing manager of Icelandic operations was sentenced to 4 1/2 year. Magnús Guðmundsson manager of Kauphing’s Luxembourg operations was acquitted as was another employee, Björk Þórarinsdóttir member of Kaupthing’s credit committee. Bjarki Diego credit officer at the time was sentenced to 2 1/2 year. Three employees, who carried out the relevant trades, got suspended sentences of 18 months to two year.
One thing, which has proved valuable in this case as in other similar cases, is phone tabs. Interestingly, they have all been done after the collapse.
A complicated case – and contrary to what some seem to think Iceland has a similar legislation regarding market manipulation and other financial fraud as other Western countries. The difference is that there is a will to prosecute these cases: they are time-consuming to investigate but it is perfectly doable and the stories are simple. The fact that big banks are too big to investigate in other countries is only because there is a lack of appetite among authorities and politicians – there really is no other reason, no other explanation.
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The waiting for Godot turned into a theatrically staged presentation at Harpa by the prime minister and minister of finance, assisted by their two main Icelandic experts. The grand plan to lift capital controls has now seen the light of day. If realised as planned the future looks bright for Iceland. But there are still political risks until the planned good deeds are indeed done.
Here are the main points of the new plan: the size of the problem is ISK1200bn, $9bn, ca. 60% of Icelandic GDP where ISK300bn, $2.2bn, is the original overhang from October 2008 (mostly carry trade funds, which flowed to Iceland in the years before the collapse) and then ISK900bn, $6.7bn, in the estates of the failed banks: ISK500bn, $3.7bn, is pure ISK assets, ISK400bn, $3bn, is debt paid in FX by Icelandic entities.
According to the new plan, there are “non-negotiable stability conditions” the estates of the three failed banks have to meet. These conditions are defined in the plan, but not spelled out in króna. On the basis of these conditions the estates have to pay a “stability contribution,” as part of the composition agreement; again, the amount of the contribution is not stated.
The composition agreement has to be in place by the end of the year. If not, the estates will be forced into bankruptcy and will then have to pay a 39% “stability tax,” a one-off tax, of ISK850bn, $6.3bn, due on 15 April 2016. However, there is a deduction to the tax, meaning it will be, according to the presentation, ISK680bn, $6.3bn.
This is all stated in the plan – but in interviews afterwards Bjarni Benediktsson minister of finance the contribution, which he aims at and not the tax, will be ISK500bn.
The rhetoric used implied that the state could, on the basis of emergency and imminent danger, overrule private property rights, i.e. of the creditors. This sounded somewhat bombastic given that Iceland is a thriving country and well capable of solving the problems related to the foreign-owned ISK. Also, there was emphasis on solving the problems for the “real economy” – all of this was interesting, clearly used to create a sense of the danger the government is averting with its plan. This is the rhetoric in the world of staged politics and the Icelandic government is no exception here (except that its spin is always rather visible, i.e. not very professional as good spin should be invisible).
According to the presentation “For seven years there were no realistic proposals from the estates” – given the fact that Glitnir and Kaupthing presented their composition draft in 2012 and 2013 and have waited for answers and clear guidelines this is again part of the rhetoric. The government’s tactic has so far been like inviting the creditors to a game of dart without telling them where the dartboard was.
As already explained, I doubt the size of the problem as related to the estates: I estimate it being ISK500bn, not ISK900bn. The higher number is, as far as I can see, again to underline the danger and justify the means. But again, this is part of the staged performance; the numbers were flashed up again and again.
Will the stability contribution be ISK500bn? From calculations I have seen the likely contribution is in the range of ISK300bn to ISK420bn, $3.1bn, – reaching ISK500bn does not seem likely. The contribution will be paid over time, most likely two to three years. It depends on values of assets etc that change over time, therefore the uncertainty. Further insight into the numbers can be gauged from the letters received from the three estates, see here. Whatever the estates agree to 60% of creditors have to vote for it.
A tax of ISK682bn, $5bn, as stated in the press release, is also, as far as I understand too high a number; ISK620bn, $4.6bn, would be more likely.
The old overhang will be resolved by the CBI in the classic way of auctioning and offering long-term bonds, no surprise there as this plan is already on-going.
Tax (= stick) or contribution (= carrot)?
What does the government want, a tax or contribution? Interestingly, the tax was the main focus of the presentation and little time and attention given to the contribution. The same in the press release, where composition and contribution is merely mentioned en passant whereas the tax is spelled out in great detail.
This however seems to have been part of the show. I understand that the advisers are wholly on the side of composition and contribution, as are the creditors. The emphasis on the tax would then be wielding the stick to make sure the creditors go for the carrot (another matter if a stick was needed).
While emphasising tax and bankruptcy, the refrain was that the capital controls liberalisation is NOT a money-making scheme for the treasury but to lift the controls and nothing else.
The government’s chief negotiator Lee Buchheit also stressed this aim to the Icelandic media but he did put a number on the outcome. His number was ISK650bn, $4.8bn, (see here, at 9:55 min; the number comes up at 15:49) in spe for the government. As far as I can see, an unrealistically high number, closer to the tax, which no one officially wants, than the desired contribution.
Buchheit had earlier mention another thing: that lifting the controls would take a short time, only about six years. This may not be what most people understand as “a short time” but it is a realistic time frame: it will take some time to carry out this plan.
In spite of the emphasis on giving priority to the “real economy” easing of controls for people, businesses and pension funds will only come later. On this, the presentation gave no dates. According to my sources, new Bills in parliament coming autumn or winter will clarify this issue.
Moral hazard and political risk
In spite of the government rhetoric of big funds to come, the debate in Iceland has mostly been characterised by relief: at last a plan, which seems realistic. The opposition has embraced it, pointing out that this is very much what had always been the plan.
There have been some voices asking why Greece and Argentina are struggling with their creditors while Iceland has so effortlessly negotiated with its creditors. The answer is of course that creditors in Iceland are not creditors to the state, contrary to Greece and Argentina, where the problem is sovereign debt; not the case in Iceland.
As stated earlier it is clear that the government aims at composition and contribution, not tax and bankruptcy. There is however always a political risk and the possibility of panic politics. The Progressive party has fallen from 25% of votes in the election in 2013 to 9% in the opinion polls in spite of successfully carrying out the promised “debt correction.”
The party very much got elected on the basis of its promises to fight the “vulture funds,” mentioning ISK800bn days before the election after talking about “only” ISK300bn to ISK400bn. And this was a promise of funds right into the state coffers, not to pay down sovereign debt as is now the plan; a plan that might annually free up ISK30bn, $200m to ISK40bn, $300m, otherwise used on interest payments.
The government had been adamant about not negotiating with creditors. Since talks have been going on over the last months the government has now defined these as “conversations,” not negotiations. No matter the word used it is clear that the largest creditors agree to the plan – and what they agree to is the outlined composition. Tax is a different matter.
For some reason, the old Roman saying “Pacta sunt servanda” has never quite reached Iceland. Icelanders and Icelandic governments over decades have repeatedly understood agreement made as being only valid until they have a different idea as to what they want. This will now again be tested.
Could the composition fail if an agreement on composition is not in place by the agreed deadline at end of the year? My understanding is that this is not likely: if needed, the deadline will be extended but that would of course only happen if things are moving in a realistic way.
Having had their patience tested over the last few years, creditors and the winding-up boards are no doubt both eager and well-prepared for the coming negotiations. Unless there will be a political itch to pick a fight, serving either political interests and/or special interest groups, things could look really bright in Iceland by the end of the year, otherwise the darkest time in Iceland.
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There were negotiations and changes until last minute. So much, that the various press releases published after the presentation of the plan to lift capital controls do not have the same numbers as to the percentage of a possible tax.
The Task Force’s preliminary analysis suggested that to achieve the goal of neutralizing a threat to the balance of payments, this Stability Tax would be set at a rate of 37% of the total assets of each estate (measured as of end-June 2015), with an automatic exemption of ISK 45bn for each estate, which would bring the effective tax rate down to about 35%.
Tax of 37%, de facto 35% after exemption, on the assets as they are at the end of June this year – was then changed and the automatic exemption was removed. The changes were the tax as it was presented at the press conference and in a general press release following the presentation:
A new bill of legislation on a stability tax imposes a one-off 39% tax on the total assets of the failed commercial or savings banks in accordance with their assessed value as of 31 December 2015.
This indicates that the tax was in the end higher than had been negotiated with representatives of the creditors, who were not amused, or so I hear, when they saw the changes.
*I am writing this ca. 8 hours after the press releases have been published but this has not yet been corrected.
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In a heavily staged appearance, prime minister Sigmundur Davíð Gunnlaugsson told Icelanders that ISK850bn, ca 45% of Icelandic GDP would fall into the state coffers, used to reduce the public debt, not for pet projects as earlier announced. With
The size of the problem to solve amounts to ISK1200bn, i.e. this is the sum of ISK, in the estates of the banks and Glacier bonds etc., that cannot be converted to FX and therefore cannot be paid out to creditors right now. What amounts to ISK850bn, or 39% of the assets of the estates at the end of this year will have to be paid off in a stability “contribution” if composition is negotiated and then this amount will be reduced – or tax and bankruptcy if no composition, to fulfil what the government calls “stability conditions.”
Glacier bond-holders and others will either be able to take part in auctions in autumn or buy long-term bonds. All of this is done under the auspice of a phrase repeated over and over again: “National interests takes precedence over interests of private parties.” Here is the English press release, carefully worded and not very clear.
After dealing with this amount, pension funds and ordinary Icelanders will have greater movement. Some quick thoughts on some of the topics du jour:
Size of the problem:
It is clear that the ISK300bn (actually ISK290bn) of the remains of the old overhang (see my last blog before this one on the barest essentials) cannot be paid out in FX – so this amount is clearly a part of the problem. But this is already being dealt with and that action will now continue: the CBI will hold auctions in autumn and those ISK-owners can also buy long-term bonds to come, either in ISK of FX.
That leaves ISK900bn – and this is a more questionable size: ISK500bn (ISK507bn exactly) is the number I have been posting earlier as the size of the problem because these are ISK assets. The remaining ISK400bn are FX assets in Iceland, i.e. assets in Iceland paid off in FX, which I would think was a more debatable size but this is how the government defines the size of the problem.
Stability “conditions” – contributions and tax:
So the problem that needs to be solved amounts to ISK1200 – and by reducing it by 39% the rest can be paid out. Or that seems to be the calculation.
The conditions, i.e. the numbers, are non-negotiable, as was repeated again and again. If the estates negotiate a composition by the end of the year they do not pay a tax but a “contribution”: in fact the same numbers, i.e. 39% or ISK850 but – as far as I understand this will be some reduction so the amount will be ISK500-600bn.
If they do not negotiate a composition the estates go into bankruptcy and pay the full amount: 39%.
This leaves some angles since the ISK850 is well above the ISK500bn but not quite the ISK900bn and well, the ISK300bn is outside of this equation. How these numbers were found I do not know but well, this is how the non-negotiable numbers look like.
The non-mentioned dates
Apart from foreign creditors smarting from controls there are the Icelanders: here, pension funds will be able to invest for ISK10bn a year, more or less what they have asked for, until 2020, unclear from when. And ordinary people will at some non-mentioned date be able to feel liberalisation on certain transactions.
What will creditors do?
Some creditors have already been negotiating with representatives of the government so the plan is indeed not quite out of the blue. According to a Glitnir announcement today, 25% of their creditors agree to this.
Kaupthing’s situation is different, less ISK assets, which might mean that Kaupthing creditors will be less happy to pay. However, no chance to tell until there is an announcement. Everyone might be happy to see an end to this and possible payout in sight.
Either this will all go well, composition beckon and much good will. Or not and the future is legal wrangling in multiple jurisdictions for a decade, like in Argentina. Today, the Icelandic government has taken the country on a journey along a very narrow road above a precipice. If all goes well, everyone reaches the final destination on the other side and there will be much rejoice.
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There are many misconceptions floating around regarding Iceland and capital controls. Here are the barest essentials:
Iceland introduced capital controls on November 29, seven weeks after the official collapse date October 2008. The reason was not money flowing out of banks, as in Cyprus but because foreigners, mostly those who had invested in Icelandic bonds, so called “Glacier bonds”, were converting their Icelandic funds into foreign currency, rapidly draining the none-too large currency reserves. At the time, these holdings amounted to 44% of GDP.
Over time, this original overhang of 44% of GDP has been reduced and now amounts to 16%. This is a process overseen by the Central Bank of Iceland, CBI, which has held auctions to match in- and outflows. The original overhang is further being worked on; the Central Bank of Iceland recently announced measures and more will come as part of a plan to lift capital controls.
The controls are on CAPITAL, meaning that capital, i.a. for investment can not be moved in our out of the country. This means that Iceland no longer adheres to the four freedoms of European Economic Area, EEA, i.e. freedom on goods, services, people and capital.
However, the controls are NOT on goods and services, meaning that money to pay for goods and services can move freely.
With time however another reserve of foreign-owned ISK has formed, i.e. ISK in the estates of the three failed banks. Since foreign creditors hold ca. 95% of the claims to these three estates the ISK assets of the estates are another pool of foreign-owned ISK, now ca. 25% of GDP. FX assets of Glitnir amount to 63% but the FX ratio in Kaupthing is 72%.**
These two pools of foreign-owned ISK holds the controls in place, which is why a plan needs to tackle both of them. As said earlier, the old overhang is already part of a process. What now needs to be tackled is the ISK pool within the estates of the three banks.
The simple and classic way to solve this kind of a problem (Iceland certainly is not the first country to face this problem) would be to negotiate with creditors on a haircut of the ISK assets in the estates. This is what the creditors have been hoping for and this is what the Icelandic government has not been willing to do.
The government’s reasoning has been that engaging with creditors was none of their business and could expose the government to legal risk. After all, the estates are of private companies, no relation to the state. However, the estates cannot be resolved unless it is clear how to deal with their ISK assets and since they cannot be taken out of the country the creditors cannot be paid out, i.e. the estates cannot be resolved. Which means that really, the government holds the threads, i.e. because it has put legislation in place regarding the estates and so, the government is already part of this equation.
Now it seems that the creditors will get some sort of an offer – maybe with a scope to negotiate, maybe only a take-it-or-leave-it offer. Remains to be seen until all the government’s cards are on the table, probably Monday afternoon.
What complicates matters is that the government seems to want not only to get a cut of the ISK assets but of the foreign assets as well. There is no balance-of-payment reason for taking foreign funds though the government refers to “stability tax.”
Further, the Icelandic capital controls are NOT a sovereign debt problem, such as lie at the core of the Argentinian dispute with creditors nor is it parallel to the Greek situation, another sovereign debt problem. And the Icelandic capital controls are not comparable to the Cypriot controls, which were put in place to keep money in the banks and prevent them from collapsing as funds flowed out.
*For data regarding the estates and capital controls see the latest CBI Financial Stability report.
**UPDATE: sorry, I wrote earlier that this was the ISK ratio – it is of course the FX ratio!
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The Icelandic government, or some parts of it, keep on its game of leaking key information always to the same journalist. Now it is the first big step towards lifting capital controls. As could be expected, this seems more about political posturing than a convincing solution. The coming measures may however provide creditors with their long awaited break to negotiate. If not, Iceland faces the same as Argentina: years of wrangling with ever more aggressive creditors – as the chief foreign adviser to Iceland should be able to inform the government on, from first hand experience.
In March, the Ministry of Finance published three links to regulation and documents regarding duty of silence of advisers, parliamentarians and civil servants who might be in possession of information related to the lifting of capital controls. This was part of a concerted effort to keep under wraps anything related to the lifting of the capital controls – until that day came when the government announced its plans. Whatever the source, DV’s journalist Hörður Ægisson, who over the last few years has been a diligent receiver of government information, published on Friday the outline of this plan, introduced at a cabinet meeting that day, most likely to be made public at a press conference on Monday. The question is if the Ministry of Finance will now look into this leak, considering the measures it took in March.
The Icelandic media landscape is a sorry sight: independent media is weak, the money is where the special interests are. This will no doubt be made clear yet again in the coming weeks as the details of the capital controls plan-to-come will be discussed and debated.
The estates will now have a few weeks to negotiate a composition agreement. If creditors do not accept the parameters the government has in mind the estates will be put into bankruptcy proceedings. So far, the estates and their creditors have been hoping for a composition, since creditors can then run the estates and resolve it when they deem best contrary to bankruptcy proceedings, which are time-limited. Both proceedings do though have the same aim: to maximize the creditors’ recovery.
The problem at the core of this is the foreign-owned ISK: assets worth ISK320bn in Glitnir, ISK160bn in Kaupthing, which means that the size of the ISK problem is different for the two banks – also making it respectively a different case for the two estates for find a solution. The Icelandic government seems to want to get hold of these ISK assets, remains to be seen how it goes. An expected stability tax of 40% can hardly be on priority claims, because that would then hit the UK claims, not the intention. It is difficult to see that the tax could be put in place sooner than 2017, which means no lifting of controls for Icelandic entities until after that, which means still years of capital controls. However, this is speculation until the plan is published.
Among themselves, the hardliners have been talking about getting creditors with their back to the wall facing a gun, i.e. with no options but to follow the government’s diktat. However, Iceland has a rule of law and creditors have legal options in Iceland and abroad. It remains to be seen, as the Icelandic saying goes, who laughs last.
The worrying thing for Iceland is if protracted legal dispute keeps going for years, hindering the lifting of the capital controls. The government seems to be taking the risk of just kicking the process off, in this way, then seeing where it leads to.
Lee Buchheit, advising the government on these issues as on Icesave earlier, brings with him experience, which hopefully will not be relevant. Cleary Gottlieb, the firm he represents, is adviser to the Argentinian government (not Buchheit though but his colleagues). At a conference in Buenos Aires recently, Buchheit foresaw that Argentina’s dispute with creditors might run for at least a decade. Probably not what Cleary envisaged for its stubborn Argentinian client – and hopefully not what is in spe for Iceland.
It certainly has to be kept in mind that Argentine’s problem is sovereign debt and a mismanaged restructuring whereas Iceland has a balance-of-payment problem vs estates of failed private banks. It would take quite a few wrong steps to put the Icelandic government in the situation where it would be directly in dispute with creditors, as is the Argentinian government. So far, no one has really believed the government could end there.
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Icelanders have been drip-fed with promises of an almost-there plan to lift capital controls, so far nothing but the question is if this plan is now about to be introduced. A plan will most likely need to be supported by a new Bill, on much-mentioned tax, either exit tax or recently mentioned stability tax, which means it should first be presented to the government, which would mean either any Tue. or Fri., the two days the government holds its regular meetings.
However, this government does not always follow the normal route, remains to be seen if a plan will emerge at all, how it will be presented and, most of all, what it will contain.
There is indeed still a plan in place, from 2011, as I have pointed out before but what is needed is i.a. how to deal with ISK assets in the estates of the failed banks. A tax on the estates will not solve the underlying issue of the foreign-owned ISK, which are holding the controls in place. But it will fulfill promises made by prime minister Sigmundur Davíð Gunnlaugsson, at least if it will not end in legal wrangling in various jurisdictions and hinder the easing of the controls.
As I have often outlined earlier, it seems that Gunnlaugsson and minister of finance Bjarni Benediktsson have not been looking into the same direction for a solution: Gunnlaugsson has underlined the moral necessity of the banks paying for the harm caused and that there would, unavoidably, be a windfall for the state; Benediktsson has stressed the need for an orderly process that should take as little time as possible and not incur a legal risk.
Given that the prime minister’s party now hovers at 8% in the opinion polls, after harvesting 25% in the elections two years ago the question is whether he will be prone to panic politics, i.e. instigating a conflict with creditors he would try to orchestrate as a victory. After all, he has very little to lose – the party can hardly sink further. It is always a dangerous situation when politicians have little to lose and much to gain. Close to him is ex-PM and ex-governor of the CBI Davíð Oddsson, who is adamant that his legacy especially of his time at the CBI is without a blemish. Oddsson has often shown that he prefers a hard line against creditors, no matter what.
As I have said time and again (after all, most things have been said regarding the capital controls, now it is just waiting to see what there is to come…) Benediktsson’s leadership will be seriously tested by the big Plan to-come. Although leading the same party Oddsson led, the Independence Party, Benediktsson seems further from Oddsson on these issues than the PM. If Gunnlaugsson’s – and Oddsson’s – view prevails it means that Benediktsson is literally powerless in this government. After all, capital controls are his remit, not the PM’s and he would lose all credibility as a leader in his sphere.
The topic of capital controls is muddled in the debate. Very few seem to remember that the problem, which holds them in place is foreign-owned ISK, the old over-hang (now much reduced and already being worked on by the CBI; further steps awaited) and the ISK in the estates of the old banks. Any action that does not solve this problem is no solution at all. Taxing the estates clearly does not solve the problem – after all, this is not a problem of debt but of currency shortage, not enough to convert the foreign-owned ISK. Iceland does not lack funds but funds – the estates are failed private companies, unconnected to the state – and the easiest way would be a haircut of some sort.
The effect for Iceland of a plan will not only be on the economy but very much a political effect. If Benediktsson loses this battle his party – or at least the more sensible part of it – must ask itself if the Independence party is only in government to promote policies of the coalition party. Certainly a role, which would have been unthinkable in earlier times, for example at the time Oddsson was the party leader and PM.
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Austria was one of the eleven founding members of the Eurozone in January 1999 but the Austrians never quite put their money where their mouth was: Austria is the only euro country where households flocked to take out foreign currency loans. About three quarters of these loans are coupled with repayment vehicles. Unfortunately, the Austrian authorities have known for more than a decade that the repayment vehicles add risk to the already risky FX loans: the crunch time for domestic foreign currency loans will be in 2019 and later when 80% of these loans mature. – This is the saga of authorities that knew full well of the risks and yet allowed the banks to turn households into carry traders.
Foreign currency loans are “… not suitable as a mass market product” – This was the lesson that the Austrian Finance Market Authority, FMA, had already in 2008 drawn from the extensive foreign currency, FX, lending to Austrian households; only in 2013 did the FMA state it so clearly. Long before these risky loans shot up by 10-15%, following the dramatic Swiss decap from the euro in January 2015, the risks were clear to the authorities.
From 1995, Austrian banks had turned a finance product, intended only for specialised investments, into an everyman mass-market product. Contrary to other founding euro countries, the euro did not dampen the popularity of the FX loans, mostly in Swiss francs, CHF. Austrian banks expanded into the neighbouring emerging markets, offering the same product there. Consequently, Austrian banks have turned households at home and abroad into carry traders.
From the beginning, the FMA and later also the Austrian Central Bank, ÖNB had been warning the fast-growing financial sector, with kind words and kid-gloves, against FX loans to unhedged households. The warnings were ignored: the banks raked in fees, FX lending kept rising until it topped (on unadjusted basis) in 2010, not in 2008 when the FMA claimed it banned FX lending.
FX loans in Austria are declining: in 2008 270.000 households had FX loans, 150.000 in March 2015. In February 2015 the FX loans to households amounted to €26bn, ca 18% of household loans. With maturity period of ten to 25 years serious legacy issues remain.
Further, three quarters of these loans, ca. €19.5bn, are coupled with repayment vehicle, sold as a safety guarantee to pay up the loans at maturity. Ironically, they now risk doing just the opposite: according to FMA the shortfall by the end of 2012 (the latest available figure) stood at €5.3bn. An FMA 2013 regulation to diminish this risk will only be tested when the attached FX loans mature: 80% of them are set to mature in or after 2019.
Added to the double risk of the domestic FX loans and the repayment vehicles are FX loans issued by small and medium-sized Austrian banks in the Central European and South-Eastern European, CESEE (the topic of the next article in this series). All this risk is susceptible to multiple shocks, as the IMF underlined as late as January 2014: “Exchange rate volatility (e.g., CHF) or asset price declines associated to repayment vehicles loans (RPVs) could increase credit risk due to the legacy of banks’ FCLs to Austrian households.”
Consequently, as stated by the ÖNB in April this year, seven years after the 2008 crisis FX loans “continue to constitute a risk for households and for the stability of the Austrian financial system” – a risk well and clear in sight since Austria became one of the founding euro countries in 1999. There are still significant challenges ahead for Austrian Banks. Nonperforming loans are rising – Austrian banks are above the European average, very much due to Austrian banks’ operations in CESEE.
Add to all of this the Hypo Alpe Adria scandals and the Corinthia guarantees and the Austrian hills not alive with the sound of music but groaning with well-founded worries, to a great extent because Austrian authorities did not react on their early fears but allowed banks to continue the risky project of turning households into carry traders – yet another lesson that soft-touch regulation does work well for banks but not for society.
Kid-gloves against a mighty and powerful banking (and insurance) sector
There are over 800 banks in Austria, but the three largest, Erste, Raiffaisen and UniCredit Bank Austria, “account for almost half of total bank assets” according to the IMF, which in 2013 pointed out that the financial system, “dominated by a large banking sector,” faces “significant structural challenges, especially the smaller banks.”
Six Austrian banks, three of which are Raiffeisenbanks in different parts of Austria, were included in the ECB Asset Quality Review in October 2014. As expected, the Österreichische Volksbank, partially nationalised, did not pass but the others did. However, the Austrian banks require an additional loan provisioning of €3bn.
The size of the banking sector as a ratio of GDP has been rising, at 350% by mid 2014. The expansion of small Austrian banks in CESEE, where non-covered non-performing loans in these banks’ operations are high, is a serious worry. As is the sector’s low profitability, seen as a long-term structural risk, as is a domestic market dominated by a few big banks and large CESEE exposures.
Theoretically, unhedged borrowers alone bear the risk of FX loans but in reality the risk can eventually burden the banks if the loans turn into non-performing loans en masse, which make these loans significant in terms of financial stability as the IMF has been warning about for years.
Intriguingly, already in 2013 the IMF pointed out that Austria needed to put in place a special bank resolution scheme and should not await the formal adoption of the EU Directive on bank recovery and resolution. It should also pre-empt the coming EU Deposit Guarantee Scheme Directive and the Basel Committee on Banking Supervision (BCBS) Core Principles for Effective Deposit Insurance Schemes as minimum standards. However, the progress in this direction has been slow.
Austrian FX loans: from a specialised product to everyman mortgage
In the mid 1990s Austrian households cultivated an appetite for FX loans, unknowing that they were indeed turning into carry traders without the necessary sophistication and knowledge. The trend started in the 1980s in Vorarlberg, the Bundesland in Western Austria where many commute for work to neighbouring Switzerland and Liechtenstein.
At the end of the 1980s 5% of household loans in Vorarlberg were in FX, compared to the Austrian average of 0.2%. From 1995 there was a veritable Austrian boom in FX lending, with borrowers preferring the CHF, and to a lesser degree, the Japanese yen, to the Austrian Schilling. This trend only got stronger as the interest rate differential between these currencies and the Schilling widened.
Quite remarkably, the introduction of the euro January 1 1999 did not dampen the surge: the Austrians kept their faith to the currency of their Swiss neighbours. At the end of 1995 FX loans to individuals amounted to 1.5% of total lending; in 2000 this had risen to 20%. The popularity of the FX loans was clear: in December 2000 82% of household loans issued that month were in FX. Even though the CHF appreciated by over 6% in 2000 it did not affect the popularity of the FX loans. The FX selling machine was well-oiled.
Since household debt in Austria was fairly low, Austria being among the lower middle group of countries as to the debt-to-equity ratio, the ÖNB was relatively relaxed about these changes – but not quite: already in its first Financial Stability report, published in 2001, it underlined the risk of FX lending and borrowing.
FX loans issuance to Austrian households continued to increase. In 2004, 12% of households reported a mortgage in FX. The trend topped in 2006, after which the demand fell. By the end of 2007 the FX loans, measured in euro, amounted to €32bn, i.e. almost 30% of the volume of loans issued. Here it is interesting to keep in mind that with the exception of few months annual growth rates of FX loans to households have always exceeded the growth of household loans in the domestic currency, until late 2006.
FX loans in Austria are declining: 2008 270.000 households had FX loans, 150.000 in March 2015 but the size of the problem is by no means trivial: in December 2014 “18.9% of the total volume of loans extended to Austrian households was still denominated in foreign currency;” in February 2015 the FX loans to households amounted to €26bn.
There are also indications that because the FX loans seemed cheaper than the euro loans households tended to borrow more. The ÖBN has pointed out that the growth in household borrowing in 2003 to 2004 “can to a large part be attributed to foreign currency loans.” As I have mentioned earlier, the fact that FX loans seem cheaper than loans in the domestic currency, lends them the characteristics of sub-prime lending, i.e. leads to households borrowing more than sensible, thus yet fuelling the FX risk.
This FX lending boom did not only signify borrowers’ taste for carry trade but also that financial products, earlier only on offer for large-scale investments had now become an everyman product, as was ominously pointed out in the first ÖBN Financial Stability report 2001.
Why did (only) Austrians turn into a nation of carry traders?
Nowhere in Europe were FX loans to households as popular as in Austria, as the ÖBN noted in its first Financial Stability report in 2001. At the introduction of the euro, FX loans had been popular in various European countries. Around 2000 Austria stood out but so did Germany where FX loans were being issued at the same rate as in Austria. But only in Austria did the trend continue.
The question is why Austrian households favoured FX over euro loans.
A study in the December 2008 Financial Stability report sketched a profile of Austrian household borrowers, based on an Austrian 2004 wealth survey of 2556 households. The outcome suggested “that risk-loving, high-income, and married households are more likely to take out a housing loan in a foreign currency than other households. Housing loans as such are, moreover, most likely taken out by high-income households. These findings may partially assuage policy concerns about household default risk on foreign currency housing loans.” – This profile only tells who was most likely to choose FX loans over domestic loans, not why this group in Austria differed from the same social groups in the other euro countries.
As I have explained earlier, FX loans often characterise emerging markets, as in the CESEE, where Austrian banks have indeed promoted them, or in Asia in the 1980s and the 1990s. FX tend to gain ground in newly liberalised markets, as in Australia in the 1980s. Then there is Iceland where the banks, fully privatised in 2003, expanding and borrowing abroad, hedged themselves by issuing FX loans, also to households.
FX loans are often an indication of instability where people try to bypass a fickle domestic currency, the apparition of bad policies and feeble politicians. In addition, there are interest rate margin, which may look tempting, if one ignores the fact that currencies rarely have a stable period of more than a few years, making them risky as an index for mortgages, normally runnig for ten to twenty years or more.
None of this is particularly fitting for Austria or any more fitting for Austria than the other mature European economies.
As always when FX loans turn into a problem, the banks blame the borrowers for demanding these highly risky products. If this were the case it could only happen because banks do not fulfil their duty of care, of fully informing the clients of the risks involved. As an Australian banker summed up the lessons of the Australian FX lending spree in the 1980s: “…nobody in their right mind, if they had done a proper analysis of what could happen, would have gone ahead with it (i.e. FX loans).”
According the ÖNB’s December 2008 Financial Stability report banks did claim there was so much demand for these loans that in order to be competitive they had to issue FX loans. But Peter Kolba from the Austrian Consumers Association, Verein für Konsumentinformation, VKI, disagrees that the demand came from the customers: in an information video he claims the loans were very much peddled by the banks, which reaped high fees from these loans.
It is indeed interesting that from 1995 to 2000 Austrian banks experienced a veritable fee surge of 75%, part of which the ÖNB attributed to the increase in FX lending. For the banks there was an extra sugar coating on the increased FX lending profits: “the interest rate and exchange rate risks are borne largely by the borrowers. However, the risk of default by debtors has increased the risk potential of such operations” – the possibility of a default did of course expose the banks to a growing FX risk.
There is one aspect of the Austrian FX lending, which seems to have greatly underpinned their popularity: the loans were widely sold by agents, paid directly for each loan, thus with no incentive to inform clients faithfully about the risk. In addition, the same agents often sold the repayment vehicles, thus reaping profits twice from the same customer.
As summed up by ÖNB’s spokesman Christian Gutlederer (in an e-mail to me) there were specific Austrian structural weaknesses: “Presumably, the interplay of the role of financial service providers, extensive media coverage and rational herding behaviour would offer the most plausible explanation for the popularity of such products in Austria. Tax incentives provided one additional layer: payments of life insurance premiums (the most important kind of repayment vehicle loans) and, in some cases, interest payments for mortgages can be deducted from the tax base.”
The above caused an Austrian FX loans surge, contrary to other euro countries. In addition, the fact that the authorities were so timid in clamping down on the risky behaviour of the banks is worth keeping in mind: the lesson for policy makers is to act decisively on their fears.
Lessons of domestic FX loans: “not suitable as mass product”
Being so aware of the risk the ÖNB and the FMA, have over the years taken various measures to mitigate the risk stemming from the FX lending, though timidly for the first many years.
Already in 2003 the FMA issued a set of so-called “Minimum Standards” in FX lending to households but this did little to dampen rise in FX loans to Austrian households. In 2006, the FMA and the ÖNB jointly published a brochure for those considering FX loans, warning of the risk involved. At the time, businesses were less inclined to take out FX loans: whether the brochure or something else, there was a decline in FX loans 2006 but only temporary.
Andreas Ittner, ÖBN’s Director of Financial Institutions and Markets worried at the time that “private borrowers in particular are unaware of all of the risks and consequences.” FMA Executive Director Kurt Pribil found it particularly worrying that “people seem to be unaware of the cumulative risks involved and of the implications this might have, especially if you consider the length of the financing.”
Though contradicted by the rise in FX lending to households, the two officials emphasised that restrictions put in place in 2003 were working. There was though a clear unease at the state of affairs: “At the end of the day, any foreign currency loan is nothing more than currency speculation.”
On October 10 2008, during turbulent times on the financial markets, the FMA “strongly recommended” that banks to stop issuing FX loans to households. The FMA has since repeatedly claimed FX loans were “banned” in 2008 but that was not the wording used at the time. Funnily enough there is no press release in the ÖBN web archive from this date related to the October restrictions. In its 2014 Annual Report it talks of the autumn 2008 measures “de facto ban” on issuance of new FX loans to households.
According to the IMF, in 2013, the measures “introduced in late 2008 to better monitor and contain FC liquidity risks, by encouraging banks to diversify FC funding sources across counterparties and instruments, and lengthen FC funding tenors.”– There was no ban, not even a “de facto ban.”
FMA’s 2003 “Minimum Standards” for FX lending were revised in 2010. By then, the FMA and the ÖNB had been warning about the FX loans for a decade or longer. In spite of the “non-ban” 2008 measures, it was only in 2010 that Austrian banks “made a commitment to stop extending foreign currency loans associated with high levels of risk, in line with supervisory guidance provided to this effect (“guiding principles”).” In January 2013 the FMA issued revised the “Minimum Standards,” also taking into account recommendations by the European Systemic Risk Board, ESRB.
All of these warnings are in tip-toeing and kid-glove central bank and regulator speak: there is no doubt that behind these Delphic utterances there were real concern. All along, Austrian authorities have underlined that these standards were not rules and regulations, more a kind advice to the banks to act more sensibly.
The IMF has over the years voiced concern in a much stronger tone and language than the Austrian authorities. As late as January 2014 the IMF underlined the possibility of multiple shock: “Exchange rate volatility (e.g., CHF) or asset price declines associated to repayment vehicles loans (RPVs) could increase credit risk due to the legacy of banks’ FCLs to Austrian households.”
It was not until 2013, five years after the crisis hit and, counting from 2000 when the FX lending had soared, numerous currency fluctuations later that the FMA finally had a clearly worded lesson for the banks and their household FX borrowers: “foreign currency loans to private consumers are not suitable as a mass product…”
Another dimension of FX lending risks: other shocks accompany exchange volatility
In the FMA’s latest regular FX lending overview, from December 2014 it points out that following initiatives to limit the risk on outstanding FX loans, as well as what it there (as elsewhere) calls ban in 2008 on new loans, the volume of borrowings has been falling: outstanding FX loans to private individuals, as a share of all outstanding loans end of September 20014 is now at 19.1%; 95% of these loans are denominated in CHF, the rest mostly in Japanese yen.
Correctly stated, the FX lending is declining but the devilish nature of FX loans is that the principal is affected by chancing rates of the currency the loans are linked to. The number of loans issued may have been declining – the ÖNB points out FX loans to Austrian borrowers have indeed been declining since autumn 2008 but the real decline in the FX lending has been “offset by the appreciation of the Swiss franc.” As seen from ÖNB data the loans did indeed not top until 2010 (see Table A11).
The ceiling set by the Swiss National Bank, SNB, in late summer 2011 helped stabilise the exchange rate – but this stability ended spectacularly in January this year.
What further adds to the risk of FX lending is that it is easy to envisage a situation where banks and borrowers are not hit only by a single shock wave stemming from currency fluctuations but by other simultaneous shocks, such as a slump in asset prices; again something that the ÖNB has underlined, i.a. as early as in the bank’s Financial Stability report April 2003.
If several private borrowers would become insolvent due to rising exchange rates, “the simultaneous and complete realization of the above-mentioned collateral would considerably dampen the price to be achieved.” Thus, banks with a high percentage of foreign currency loans incur a concentration risk, which would endanger financial stability in the region, if the collaterals needed to be sold. It is an extra risk that the banks with the highest share of FX lending were small and medium-sized regional banks in Western Austria; in some cases up to 50% of total assets were FX loans.
Repayment vehicles = no guarantee but an even greater risk
The fact that the majority of Austrian domestic FX loans comes with a repayment vehicle has often been cited as a safety net for FX borrowers and consequently for the banks. This is however a false safety and both the ÖNB and the FMA, as well as foreign observers such as the IMF have, again for a long time, understood this risk.
In order to gauge the risk it is necessary to understand the structure of the FX loans: almost 80% of the FX loans are balloon loans, i.e. the full principal is repaid on maturity: interest rates, according to the LIBOR of the currency and repriced every three months, are paid monthly. The FX loans can normally be switched to euro (or any other currency) but at a fee; another aspect in favour of the bank is a forced conversion clause, allowing the bank to convert the loan into a euro loan without the borrower’s consent.
The repayment vehicle is usually a life insurance contract or an investment in mutual fund, paid into the scheme in monthly instalments. The majority of those who have taken out the FX loans coupled with repayment vehicle have done so via an agent, clearly an added risk as mentioned above.
Consequently, for borrowers there is a twofold risk attached to FX loans with repayment vehicle: firstly, there is the currency risk related to the loans themselves; second there is the real risk of a shortfall in the repayment vehicle, clearly born out by the volatility in 2008. As pointed out in the ÖNB’s Financial Stability October 2008 report the repayment vehicles “in addition to other risks, are exposed to exchange rate risk.”
The ÖNB had however been aware of the repayment vehicle risk much earlier than 2008. Already in its Financial Stability October 2002 report, the risk was spelled out very clearly: the repayment vehicles “usually do not serve to hedge against exchange rate or interest rate risk; rather, they add risk to the entire borrowing scheme.”
If the repayment vehicle does not perform well enough to cover the principal of the FX loan one may try to switch to other investments but at a cost. “If the performance of these repayment vehicles cannot keep up with the assumptions used in the provider’s model calculations, the borrower, who is already exposed to high exchange rate and interest rate risk, becomes exposed to even greater risk.”
In short: on maturity, there is high risk that the repayment investment will not cover the loan, i.e. the alleged safety net has a hole in it. In the present environment of low interest rates it is a struggle to avoid this gap.
Following a 2011 survey there was already a growing shortfall in sight, according to an FMA statement in March 2012. At the time, FX loans with repayment vehicle amounted to €28.6bn. By the end of 2008 the shortfall had been €4.5bn, or 14% of the loan volume. End of 2011 the shortfall in cover amounted to ca. €5.3bn, at the time 18% of the outstanding loans; the increase between 2011 and 2012 had been €800m, an increase in the shortfall by 22%.
In 2013 the FMA put in place regulation, which obliges the insurance companies to create provisions from their own profits should these repayment vehicles fail. This will however only be tested when the attached FX loans mature: 80% of them are set to mature in or after 2019; a “significant redemption risks to Austrian banks” according to the ÖNB in December 2014.
The ÖNB and the FMA are indeed paying extra attention to the interplay between FX loans and the repayment vehicles: the two authorities are conducting a survey in the first quarter of 2015 to uncover the risks posed by these two risk factors, the FX loans and the repayment vehicles. Somewhat wearily, the ÖNB points out that the two authorities have been warning against these loans for more than ten years. Though reined in and declining FX loans still “continue to constitute a risk for households and for the stability of the Austrian financial system.”
Austrian consumer action in sight
Following the Swiss decap in January the Austrian Consumer Association, VKI, has taken action to inform FX borrowers on their options.
The Austrian FX loan agreements normally have a “stop-loss” clause, seemingly a protection for the borrower to limit sudden losses because of currency appreciation. Sadly, following the Swiss decap in January many FX borrowers have discovered that this clause did not limit their losses. These clauses have been the cause of many queries made at the VKI. The FMA, claiming it can not act on this, has advised borrowers to bring the matter to the attention of the banks, but gave the end of February 2015 as a deadline; a remarkably short time.
VKI is also advising FX borrowers to try to negotiate with the banks regarding coast of converting CHF into euro loans or loss incurred from the FX loans compared to euro loan, arguing that these costs should not be carried by the borrowers alone but shared with the bank.
As elsewhere, the Austrian banks have taken fees for administering the FX loans, typically 1 to 2%, as if they had incurred costs by going into the market to buy CHF in connection to the FX loans. However, as elsewhere, the Austrian loans are CHF indexed, not actual lending in FX. In the Árpad Kásler case the European Court of Justice, ECJ, ruled that this cost was illegal since there were no actual services carried out. Consequently, this might be of help to Austrian FX borrowers; also that part of the ruling, which obliges banks to inform clients properly.
If these actions take off this could mean a considerable hit for the banks. After all, 150.000 households have FX loans of €25bn in total, not a trivial sum.
Given the fact that so many of these loans and the repayment vehicles were sold through agents their responsibility for informing clients has to be tested at some point: it is inconceivable that important intermediaries between banks and their clients bear no responsibility at all for the products they arrange to be sold.
As in other countries, Austrian FX borrowers have already been heading for the courts. So far, the cases are few but have at least in some cases been positive for the borrowers.
The question is whether Austrian politicians will be firmly on the side of the banks or if they will come to the aid of FX borrowers. But there really is good reason for political attention, given that the problem certainly is still lingering. It should also be of political concern that the ÖNB and the FMA chose to treat banks with kid-gloves lightly – though full well knowing that the products being sold to consumers were highly explosive and hugely risky both to the borrowers and the country.
* This is the second article in a series on FX lending in Europe: the unobserved threat to FX unhedged borrowers – and European banks.The next article will be on Austrian banks and FX lending abroad. The series is cross-posted on Fistful of euros.
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Will they or won’t they? That is the question regarding how, if and when the Icelandic government will take the long-announced decisive action on easing the capital controls.
The news keeps seeping out in Iceland is that the Icelandic government is just about to present a plan for lifting capital controls. That would then, most likely and uncontroversially, entail the second part of the CBI action from earlier, when investment opportunities for offshore ISK were reined in. Seems, as I mentioned in a blog on earlier CBI action, that this would then be bonds, most likely in FX, with long maturity.
The main interest for foreign creditors will be what measures are chosen regarding the estates of the failed banks, most notably what form of levy or tax will be chosen. Stability tax is the latest jargon to circulate whereas minister of finance Bjarni Benediktsson mentioned an ISK haircut in his March report on capital controls progress.
As often mentioned on Icelog there is “sky and ocean between” (this is an “Icelandicism”) cutting foreign-owned ISK assets or targeting the entire assets – the former is a classic way under similar circumstances, the latter would be an all-Icelandic solution.
What the government is really struggling with here is how to tax only foreigners without touching Icelandic entities. If such discrimination were simple it would have been done long ago but it clearly is not: a whiff of discrimination would unleash the litigation hounds. This is the main issue and also the main reason for it taking so looong to come up with a solution: the government has, I am told although this is staunchly denied, been looking for a solution that does not exist. And that is famously very time-consuming – a grand “sprecatura” as the Italians would say.
As before, the Icelandic economy is slowly being starved of oxygen – and as before, qui vivra verra.
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