Sigrún Davíðsdóttir's Icelog

At the time, the collapse of the three largest Icelandic banks in October 2008 was blamed on the Brits and Gordon Brown became a hate figure in Iceland. A nine volume report finally told Icelanders what had happened and why the banks collapsed. Only then, did it become clear how politicians had ignored warning signals, regulators were too lax and bank managers were, at best, economical with the truth. Rumours of foul play in the banks led to setting up an Office of the Special Prosecutor, which has already indicted leading bankers and shareholders. – Finding out the truth does not resolve economic woes but it answers the questions necessary to learn the right lessons. This is what Cyprus can learn from Iceland.

The first Icelandic reaction: it’s Gordon Brown’s fault

There is an old Icelandic belief that speaking ill of someone will give this person a hick-up. If that were true, Prime Minister Gordon Brown would have had the mother of all hick-ups during the second week of October 2008. The PM turned into a hate-figure in Iceland where he was blamed for having, single-handedly, driven the two largest banks – Kaupthing and Landsbanki – into bankruptcy. The state had already taken over 75% of the third bank, Glitnir, only to retract on it as it became obvious that even this part of the smallest bank was too much for the sovereign to shoulder.

An emergency legislation was passed late on October 6 2008, i.a. for steering the three biggest banks into resolution if needed. The next day the Icelandic Financial Services Authority, FME, took control of Landsbanki. Although those who understood that abroad the three banks were seen as closely linked and the collapse of one would spell the end of them all, there were desperate attempts to save Kaupthing. This is puzzling since Bank of England had already on October 3 stopped all new deposits going into the bank.

After months of wrangling with the banks’ managers in the UK and with Icelandic authorities and politicians, UK authorities lost patience on October 8 and closed down Kaupthing’s UK subsidiary, Kaupthing Singer & Friedlander. A day later, the FME took over control of Kaupthing.

The irritation and distrust of the British authorities surfaced when the UK Treasury used a freezing order, also used against alleged terrorist organisations, on all Icelandic companies in the UK. The measure was aimed at Landsbanki but the action was only narrowed down later and did cause many Icelandic companies and individuals great difficulty until it was finally revoked in June 2009.

These two actions – closing down of KSF and using the freezing order so broadly –caused angry and bewildered Icelanders to vent their anger towards PM Gordon Brown and British authorities. International media – on its first European banking collapse outing – had a field day, interviewing angry Icelanders.

Substitute the name “Angela Merkel” for “Gordon Brown” – and Cypriots will know how Icelanders felt these days in October 2008. Also Icelanders felt at the time they were under siege from a foreign power.

SIC – OSP

In December 2008, the Icelandic Parliament voted for two novelties: to set up a special investigative committee, SIC, to investigate what led to the banking collapse – and secondly, reacting to rumours about foul play within the banks, to set up an Office of Special Prosecutors to investigate alleged crimes related to the collapse.

Just after the collapse, before the SIC was set up, Kaarlo Jännäri – a Finnish expert – was asked to write a report on the causes of the collapse. In only 30 pages he outlined what was later confirmed and covered extensively by the SIC and concluded that the causes were a combination of bad banking, bad policies and bad luck. Interestingly, the media focused mostly on the bad luck when the report was published in March 2009. Yet, one of his conclusions was that even without an international crisis, the Icelandic banking model was not sustainable and the banks would eventually have failed.

The SIC was chaired by High Court judge, together with the Parliament’s Ombudsman and an economist. The SIC was supposed to take a year but it took longer. Eventually, on April 12 the great day dawned when the committee presented their findings and the report was published, in nine volumes in addition to on-line appendixes. The country came to a standstill on the morning the SIC press conference was broadcasted live. The first 2000 printed copies sold out the same day but the report is available on-line.

The SIC report: much worse news than anticipated

Most Icelanders, suffering from mistrust brought on by the collapse, did not expect much from the SIC and many felt that most things were known anyway. Both these expectations were wrong. The report unearthed events that were much worse than anyone had anticipated – and the report was both extremely thorough and extensive. It laid bare the complete failure of regulators to supervise, ia because as soon as FME staff gained insight into the banks the banks poached them. The economic policy of governments from 2000 and onward had been expansive, even during boom times.

Already in 2006, when things started to go downhill, most politicians only listened to the bankers, not critical voices, especially not if they came from abroad. Icelanders did not realise that funding dried up in 2006 but the banks narrowly saved themselves. Needless to say, the day of reckoning would have been less dramatic and less costly if it had happened in October 2006 and not two years later.

In trying to secure a currency swap in 2008 with foreign central banks the Central Bank of Iceland got no swaps but only stark words of warning in every bank they turned. Warnings the CBI chose to ignore.

Foul play in the banks

The report showed very clearly how the largest shareholders, together with their business partners, had also been the largest borrowers. Collaterals were frequently insufficient when lending to these favoured clients. The banks lent copiously to entities that bought shares in these same banks.

The OSP has recently indicted managers and staff from two of the banks for alleged market manipulation, partly carried out through lending companies to buy shares in the banks. Other cases brought by the OSP i.a. relate to breach of fiduciary duty. So far, around 15 bank managers and employees from the three banks have been indicted, in addition to two large shareholders, Olafur Olafsson and Jon Asgeir Johannesson.

The report was thorough not only because of the great expertise of its authors but also because the SIC had extensive powers to source information. It was i.a. allowed to waive bank secrecy and analyse loan documents.

Unfortunately, the report was not translated into English but here is a link to those parts, which have been translated, i.a. an executive summary, chapter 21, 160 pages, which summarises the whole report and an overview especially on the operations of the banks, by Mark Flannery.

No other crisis-struck country has as thoroughly investigated what happened – and specifically investigated alleged crime connected to its financial calamities. Both of these things have, to my mind, greatly benefitted Icelanders. It is easier to live in a country where a catastrophe that touches each and every person is understood and where events are analysed in order to learn from them. And most of all – that those who possibly are responsible for crimes hidden in the catastrophe have to answer for their deeds.

Surely, many Icelanders think that things have not changed enough and the justice is milling too slowly – but there is at least a point of reference as to what happened and why.

And now to Cyprus: the Greek haircut does not explain it all

Already now there are plenty of indications that there are things to unearth and investigate in Cyprus. In an interview with the Economist, former Central Bank governor Athanasios Orphanides says that the former government deflected all attempts from abroad to alert it to the increasingly serious situation and get it to react. Interestingly, Orphanides concludes that the €2.5bn loan from Russia at the end of 2011 was a mixed blessing: nothing was resolved and the loan badly used. It would have been better if no loan had been forthcoming, forcing the government to face reality. – Surely some untold stories here that Cypriots have a right to know of in detail.

As to the banks, why did they offer such high interest rates? How was that possible unless there were some high-risk investments at the other end? Or an unsustainable competition for deposits – the only means of funding for a banking sector, largely isolated from European markets.

The Greek haircut is blamed for the troubles of the two banks – Bank of Cyprus and Laiki Bank – but why did these two banks choose to gamble with €50bn – 250% of GDP – by buying Greek sovereign bonds? It is neither an excuse nor an explanation that sovereign bonds were seen as a safe bet at the time. The banks would surely have bought insurance (?). This high-stake bet on Greek bonds needs to be clarified, as this is the single most fateful action contributing to the recent demise – though it is only the last drop but not the real cause for the demise. The real reasons were actions or non-actions taken over a number of years, both by politicians and bankers.

Iceland and Cyprus: ignored warnings and hubris

And it is not true that no one ever said anything. Some experts have been worried for some years. In 2011, Constantinos Stephanou from the World Bank wrote an article in Cyprus Economic Policy Review, with the telling title: The Banking System in Cyprus: Time to Rethink the Business Model? The article spells out quite clearly the weaknesses of the Cypriot banking system, which in contrast to the oft-cited Luxembourg system relies not on foreign banks like Luxembourg but on few big domestic banks. Stephanou concludes with concrete policy advise on what needed to be done in order to secure safe banking operations. The question is if this advice was heeded – and if not, why not.

In November 2011 an IMF report contained stark warning on significant weaknesses (emphasis mine):

The large banking sector, with assets totaling (sic) over 8 times GDP by the broadest measure, and with significant exposure to Greece, is a significant vulnerability. Banks face significant capital needs to reflect mark to market valuations on their sovereign bond holdings and to achieve a 9 percent core tier one capital ratio, as mandated by the European Banking Authority. Non-performing loans are increasing, and further loan deterioration could add to recapitalization needs. Meanwhile, the system is also vulnerable to an outflow of deposits in the event of adverse circumstances. Cypriot banks receive significant liquidity support from the European Central Bank.

Yes, this was all clear whole eighteen months ago…

The Cypriot story is similar to the Icelandic one: there were warnings but hubris and wishful thinking made politicians immune to them. IMF reports are not the daily reading of the man on the street and if the media ignores them no one outside expert circles hears of them.

A list of Cypriot people and companies that had loans written off in Cypriot banks in previous years has now surfaced. The matter will now be investigated by three former Supreme Court judges. That is a very myopic approach – there is a lot more to investigate in the banks, the government, the regulators. What went wrong because of ignorance – and what happened because of corrupt practices? Do the Cypriots dare to unearth all of this?

The easy option of blaming the foreigners – and “we are all to blame”

As long as nothing is done to clarify what happened and investigate eventual criminal deeds, Cypriots have good reasons to be upset and angry – but less with Merkel & Eurozone Co than with Cypriot politicians in power for the last decade or so and the bankers who over the years made the wrong decisions and quite possibly worse. Blaming the Eurzone leaders – as the UK media has reported so diligently – and saying that “we are all to blame” are two ways of masking what really happened. And that some bear more blame than others.

A financial crash is not a catastrophe governed by laws of nature – it cannot be compared to an earthquake or a volcanic eruption. It is an event that comes about at the end of a long string of wrong or bad decisions. Analysing what happened, over the last few years leading up to the catastrophe, is necessary in order to learn from it. The shock in Cyprus is not just about money lost – it is about betrayal of politicians, civil servants, bankers and others in power. Those who suffer it need to know what happened and why – and they need to be sure that possible criminal acts are investigated.

What Iceland can teach others in terms of economics can be debated – but the SIC and the OSP are two things that can truly be an example for other crisis-struck countries.

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