Sigrún Davíðsdóttir's Icelog

Many controlling shareholders in China have pledged shares as collaterals for bank loans – this was a common practice in Iceland up to the October 2008 banking collapse. Now, this practice seems to be causing suspensions of trading in shares in China. If this is indeed a widespread Chinese practice the well-studied effects in Iceland provide a chilling lesson: when the steady rise of Icelandic share prices, both in banks and other companies stopped and prices fell this practice turned into a major calamity for the banks and companies involved. In hindsight, it was a sign of an incestuous and dysfunctional business environment. The Icelandic experience was well covered in the 2010 report by the Icelandic Special Investigation Committee, SIC, and provides food for thought for other countries where these practices surface.

One of the most stunning and shocking findings of the Icelandic SIC report was the widespread use of shares as collaterals for loans in all Icelandic banks, small and large but most notably the three largest ones – Kaupthing, Landsbanki and Glitnir.

It is necessary to distinguish between two types of lending against shares as practiced in Iceland: one is a bank funding purchase of its own shares, with only the shares as collaterals. The other type is taking other shares as collaterals.

These loans with shares as collaterals were mainly offered to the banks’ largest shareholders – in the big banks these were the main Icelandic business leaders – their partners and bank managers. In the smaller banks local business magnates who in many cases were partners to those Icelandic businessmen who operated abroad, as well as in Iceland. Thus, this practice defined a two tier banking system: with services like these to a small group of clients – that I have called the “favoured clients” – and then normal services for anyone else.

As a general banking model it would not make sense – the risk is far too great. But this lending mechanism and the ensuing stratospheric risks seem to have been entirely unobserved by not only the regulators in Iceland but also abroad where the Icelandic banks operated.

The SIC report, published 10 April 2010, explained in depth the effects of shares as collaterals: when share prices fell the banks could not make margin calls without aggravating the situation further. Consequently the banks lost their independent standing vis à vis their largest shareholders and clients – effectively, the banks and the business elite were tied to the same mast on the same ship and all would sink together in case the ship ran aground (as then happened).

Being familiar with the Icelandic pre-collapse situation it was with great interest that I read an article in the FT,* explaining what might be the reason behind the suspended trading in shares of almost 1500 Shanghai- and Shenzen-listed companies, mostly on the ChiNext stock exchange:

“Some analysts believe the suspensions are instead related to one of the scariest “known unknowns” surrounding the market meltdown — just how many controlling shareholders have pledged their shares as collateral for bank loans.”

If this is indeed the case the Icelandic experience indicates a truly scary outlook and dysfunctional Chinese banking. There might be further troubles ahead.

Bank lending against own shares – or – turning the loan book into equity

In Iceland, the use of shares as collaterals counted both for shares in the banks themselves, by the largest and large shareholders and their business partners and then also by managers of the banks – and shares in other companies (not banks) owned by these same investors or those of their business partners.

The use of banking shares and non-banking shares pose somewhat different problems though the fundamental problem is the same, when this is practiced on a large scale to a chosen group of “favoured clients” with complicated cross-ownership as was the case in Iceland.

The SIC report mapped all of this but before its publication there were already rumours and stories related to the practice. I started hearing these stories from Icelandic bankers and others very soon after the banking collapse in October 2008. A foreign accountant I spoke to at the time was familiar with South American examples some decades earlier of banks lending to buy own shares – not an exemplary way of banking, in his opinion. “By lending against own shares a bank is effectively converting its loan book into equity,” was his way of describing this practice.

Asking a foreign banker in London if this was a general practice that banks lent clients to buy the bank’s share with the bank’s own shares as the only collateral he said he knew of this Icelandic practice: “It’s so insane that I don’t even know if it’s legal or not. No bankers in their right mind would consider it.”

But Icelandic bankers did.

Funding own share purchase – weak(ened) equity

What the SIC report pointed out regarding banks funding their own share purchases was the following:

“The capital ratio of Glitnir, Kaupthing Bank and Landsbanki was, in their annual reports, always slightly above the statutory minimum. However, these capital ratios did not reflect the real strength of the banks and the financial system as a whole or the capacity to withstand shock. This was due to considerable risk exposure stemming from the banks’ own shares, both through primary collaterals and forward contracts on their own shares. If equity no longer provides a cushion for protecting depositors and creditors it is not equity in the economic sense. Under such circumstances it is no longer possible to take the capital ratio into account when evaluating the strength of a financial institution, as the risk of loss stemming from the institution’s own shares lies with itself.

The banks had invested their funds in their own shares. Share capital, financed by the company itself, is not the protection against loss it is intended to be. Here this is referred to as “weak equity”. Weak equity in the three banks amounted to about ISK 300 billion by mid year 2008. At the same time, the capital base of the banks was about ISK 1,186 billion in total. Weak equity, therefore, represented more than 25% of the banks’ capital base. If only the core component of the capital base is examined, i.e. shareholders’ equity, according to the annual accounts, less intangible assets, the weak equity of the three banks amounted to more than 50% of the core component in mid year 2008.

In addition to the risk that the banks carried on account of their own shares, the SIC assessed how much risk they carried from each other’s shares. Here this is referred to as “cross-financing”. Around mid year 2008, direct financing by the banks of their own shares, as well as cross-financing of the other banks’ shares, amounted to about ISK 400 billion. If only the core component of the capital base is examined this amounted to about 70% of the core component in 2008.

The SIC is of the opinion that the financing of owners’ equity in the Icelandic banking system had been based, to such a great extent, on borrowing from the system itself that its stability was threatened. The shares owned by the biggest shareholders of the banks were especially leveraged. This resulted in the banks and their biggest owners being very sensitive to losses and the lowering of share prices.

Overstatement of a bank’s equity increases its growth potential. However, the bank’s ability to deal with setbacks decreases at the same time. The risk of bankruptcy is thereby increased. Under these circumstances, the loss to depositors and other creditors becomes greater than it would otherwise have been. If the bank in question is systemically important, as was the case with all of these three banks in Iceland, the costs to society will also be significant, as has been the case.”

The spiral to hell

The Icelandic banking system was fully privatised in 2003 but anecdotal evidence indicates that these practices of banks lending against own shares or taking shares as collaterals on favourable terms had started earlier, albeit on a much smaller scale. It is interesting to keep in mind that quite intriguingly the management of the banks did not change radically with privatisation. There were the same managers in place before and after privatisation.

Apart from weakening the banks’ equity the lending against own shares turned into a major headache for the Icelandic banks already in 2007 with the drying up of credit markets. The share price of the banks started falling, forcing the banks to make margin calls.

Under normal circumstances the banks would have taken the shares, liquidated them and pocketed the money to cover the losses. But by accepting own shares as collateral the banks had created anything but normal circumstances.

These circumstances were further aggravated with cross-ownership and close connections between holding companies and the banks. Thus, the collateralised shares, banking shares or not, created a highly poisonous circumstances where the banks could not follow normal business practices: by liquidating the shares the price would have fallen further – this really was a spiral straight to hell.

2007-2008: increased lending to “favoured clients” instead of shrinking the balance sheet

But shares in Icelandic banks and companies were not only placed as collateral in the Icelandic banks. Foreign banks had to some extent taken them as collateral for loans to the major Icelandic businessmen who were making splashes abroad – all of them major shareholders of the Icelandic banks – and their companies. During the winter 2007 to 2008 the foreign banks started making margin calls, threatening liquidation, in reality threatening the existence of the Icelandic banks.

During these winter months all the Icelandic banks did the same thing: they bailed out these large businesses, i.e. the banks lent funds to repay the foreign loans in order to prevent the market to be flooded with shares in the Icelandic banks and the major holding companies, owned by the big players and their partners.

By Easter 2008 this concerted action was more or less completed and now, the Icelandic banks were the main backers of their own shareholders and the main businesses, as well as vanity objects such as chalets, jets and yachts.

Loans to the already highly leveraged businesses went up, in some cases even doubled. And this at a time when the banks should have been shrinking their balance sheet, not expanding. Indeed, practically no one, outside of the “favoured clients” was getting loans. This did of course greatly increase the losses when the game of musical chairs stopped in October 2008.

Icelandic banks and businesses really felt the effect when funding on international markets dried up in summer and autumn 2007. Much of this panic lending in the winter of 2007 to 2008 was possible only because the banks were at the time funded by foreign depositors – most notably Landsbanki with Icesave and to some extent Kaupthing with its Icesave copy-cat product, Kaupthing Edge – but also deposits from charities, universities and local councils, mostly in the UK. Kaupthing used i.a. deposits in its Isle of Man entity that it had bought earlier.

Kaupthing – a business plan based on “parking” own shares

All of this was practiced in all the Icelandic banks – large and small – but as far as I can see none practiced lending against own shares as diligently as Kaupthing. It is not an exaggeration to say that Kaupthing’s business plan was partly just this: to lend funds to buy Kaupthing shares, i.a. extra funds to large clients, who were borrowing for other things.

These loans were allegedly presented as “risk free” in the sense that there were no private guarantees attached to these loans; the client would just place the shares as collateral and nothing more could be lost than just the shares. In addition to Kaupthing share-buying loans to large clients Kaupthing managers were offered these loans.

While the going was good these “share holders” mostly pocketed the dividend instead of necessarily paying off the loans. However, the bank management seemed to place great trust in having a large chunk of its shares “off market” and i.a. not shorted.

Kaupthing managers mostly pledged a personal guarantee in addition to the shares. Just days before the bank collapsed the bank decided to absolve all the managers of their personal guarantee. This decision was later turned around in court and these loans have turned into a millstone around the neck of some of these managers.

Many of the top-level Kaupthing managers have claimed that they never sold any of their shares, thus accruing losses. However, there is evidence that at least in one case a manager sold his own shares by letting another company he himself owned purchase shares, needless to say financed by a Kaupthing loan and no guarantee or collateral but the shares. Thus he did pocket a considerable sum of money from selling Kaupthing shares though outwardly still owning them.

Why Icelandic winding up boards ended up owning big stakes in foreign companies

There is nothing inherently wrong about using non-banking shares as collaterals but prudence is a must. The shares must be valued not a par but well below if shares are to make any business sense to a bank. Also, the bank must not be dependent of the share price staying high, i.e. not falling. This rule of prudency seems not to have been followed when it came to share collaterals by “favoured clients” in the Icelandic banks.

When the holding companies of some of these big clients, such as Jón Ásgeir Jóhannesson, failed it turned out that the resolution committees (later winding-up boards) of the failed Icelandic banks ended up owning large shareholdings in companies earlier owned by Icelandic businessmen, i.e. companies such as Iceland, the supermarket chain and the toy shop Hamley’s owned by Jón Ásgeir Jóhannesson.

Shares as collaterals = sign of dysfuntion and (possibly) corruption

In hindsight, one could say that these were bad banking decisions taken when the world seemed to be made of only rising share prices and infinite funding. However, I beg to differ. As pointed out above, these offers of both funding for shares – whether shares in the same bank, the other banks or in companies always owned by a small circle of businessmen – and then taking the shares as collaterals was not a general service but only offered to a circle of “favoured clients.”

Of the European countries in crisis only the operations of the Icelandic banks have been thoroughly analysed. From hearsay and sporadic reporting my feeling is that a similar scrutiny of operations of i.e. the Spanish and the Irish banks would bring interesting stories to the surface. Spanish bankers are being charged and stories might come up in court. I keep being amazed at how remarkably relaxed Irish politicians and high-level civil servants seem to be regarding evidence of shenanigans in the Irish banks and yet these same banks brought calamity and hardship to Ireland.

As to China and Chinese banking I will for sure be interested if similarities with Icelandic banking will materialise. If that is the case, it is a bad sign.

*Thanks to Stefan Loesch for directing me to the FT article. – This post is cross-posted on Fistful of Euros.

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