What Iceland Teaches Us: “Let Banks Fail”

Agence France-Presse notes:

Three years after Iceland’s banks collapsed and the country teetered on the brink, its economy is recovering, proof that governments should let failing lenders go bust and protect taxpayers, analysts say.

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“The lesson that could be learned from Iceland’s way of handling its crisis is that it is important to shield taxpayers and government finances from bearing the cost of a financial crisis to the extent possible,” Islandsbanki analyst Jon Bjarki Bentsson told AFP.

“Even if our way of dealing with the crisis was not by choice but due to the inability of the government to support the banks back in 2008 due to their size relative to the economy, this has turned out relatively well for us,” Bentsson said.

***

Nobel Prize-winning US economist Paul Krugman echoed Bentsson.

“Where everyone else bailed out the bankers and made the public pay the price, Iceland let the banks go bust and actually expanded its social safety net,” he wrote in a recent commentary in the New York Times.

“Where everyone else was fixated on trying to placate international investors, Iceland imposed temporary controls on the movement of capital to give itself room to maneuver,” he said.

During a visit to Reykjavik last week, Krugman also said Iceland has the krona to thank for its recovery, warning against the notion that adopting the euro can protect against economic imbalances.

***

Iceland’s former prime minister Geir Haarde, in power during the 2008 meltdown and currently facing trial over his handling of the crisis, has insisted his government did the right thing early on by letting the banks fail and making creditors carry the losses.

“We saved the country from going bankrupt,” Haarde, 68, told AFP in an interview in July.

As I noted last week:

Iceland told the banks to pound sand. And Iceland’s economy is doing much better than virtually all of the countries which have let the banks push them around.

Barry Ritholtz noted in May:

Rather than bailout the banks — Iceland could not have done so even if they wanted to — they guaranteed deposits (the way our FDIC does), and let the normal capitalistic process of failure run its course.

They are now much much better for it than the countries like the US and Ireland who did not.

Bloomberg pointed out in February:

Unlike other nations, including the U.S. and Ireland, which injected billions of dollars of capital into their financial institutions to keep them afloat, Iceland placed its biggest lenders in receivership. It chose not to protect creditors of the country’s banks, whose assets had ballooned to $209 billion, 11 times gross domestic product.

***

“Iceland did the right thing by making sure its payment systems continued to function while creditors, not the taxpayers, shouldered the losses of banks,” says Nobel laureate Joseph Stiglitz, an economics professor at Columbia University in New York. “Ireland’s done all the wrong things, on the other hand. That’s probably the worst model.”

Ireland guaranteed all the liabilities of its banks when they ran into trouble and has been injecting capital — 46 billion euros ($64 billion) so far — to prop them up. That brought the country to the brink of ruin, forcing it to accept a rescue package from the European Union in December.

***

Countries with larger banking systems can follow Iceland’s example, says Adriaan van der Knaap, a managing director at UBS AG.

“It wouldn’t upset the financial system,” says Van der Knaap, who has advised Iceland’s bank resolution committees.

***

Arni Pall Arnason, 44, Iceland’s minister of economic affairs, says the decision to make debt holders share the pain saved the country’s future.

“If we’d guaranteed all the banks’ liabilities, we’d be in the same situation as Ireland,” says Arnason, whose Social Democratic Alliance was a junior coalition partner in the Haarde government.

***

“In the beginning, banks and other financial institutions in Europe were telling us, ‘Never again will we lend to you,’” Einarsdottir says. “Then it was 10 years, then 5. Now they say they might soon be ready to lend again.”

Even the IMF praises Iceland’s strategy:

As the first country to experience the full force of the global economic crisis, Iceland is now held up as an example by some of how to overcome deep economic dislocation without undoing the social fabric.

While the conditions in Iceland are in many ways different from the conditions in the U.S., Iceland’s lesson applies to America, as well.

Specifically, a study of 124 banking crises by the International Monetary Fund found that propping banks which are only pretending to be solvent hurts the economy:

Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.

Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery.

***

All too often, central banks privilege stability over cost in the heat of the containment phase: if so, they may too liberally extend loans to an illiquid bank which is almost certain to prove insolvent anyway. Also, closure of a nonviable bank is often delayed for too long, even when there are clear signs of insolvency (Lindgren, 2003). Since bank closures face many obstacles, there is a tendency to rely instead on blanket government guarantees which, if the government’s fiscal and political position makes them credible, can work albeit at the cost of placing the burden on the budget, typically squeezing future provision of needed public services.

Indeed, numerous Nobel prize winning and otherwise highly-regarded American economists say that our economy cannot recover until the big banks are broken up.

If the politicians are too corrupt to break up the big banks (because the banks have literally bought the politicians), let’s break them up ourselves.

Many people are doing just that.

Category: Bailouts

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

22 Responses to “Key Lesson From Iceland Crisis: “Let Banks Fail””

  1. philipat says:

    Sweden did the same thing much earlier, with similar results. The Banks were temporarily Nayionalised, their shareholders and bondholders wiped out and the Boards and Managements fired. Then the Banks were re-structured and re-capitalised, then IPO’d with the proceeds going to the taxpayer, offsetting the re-structuring costs. The Swedish economy is now one of the strongest in Europe. In a true capitalist system moral hazard doesn’t exist and Individuals or Corporations who make bad investment decisions go under.

    Even having bailed out the systemically dangerous Banks, they are still insolvent. The US is following the Japanese model so, in the paraphrased words of EInstein, it’s insane to expect the results to be any different?

    Why do we keep allowing the Banksters to screw us, other than that the politicians are wholly-owned by the Banksters and the Corporatocacy? Crony capitalism doesn’t work. except for the 0.01%.

  2. JerseyCynic says:

    Done.

    I moved my pittance to the Nutmeg State FCU just before “treemageddon” last week. The kids are in the process now. They have come to understand that in order to be truly free in this rich man’s world, they had best stay away from “all those services”. When it comes time for them to consider going into debt, their experience with a CU approach to finances — as opposed to “banking with the big boys” — will assist them in curbing their enthusiasm for this ridiculous pursuit of the american dream via debt.

  3. Neildsmith says:

    I’m with JerseyCynic… it’s not enough to just move your meager deposits from the big boys bank. To stay even reasonably safe in these times, one cannot use debt at all. Cash and carry is the only way.

  4. InterestedObserver says:

    In a superficial emotional way, I can see how bailing out the banks has, in principle, an appeal.

    It’s a tentative incremental solution. It’s the solution of the timid. If it doesn’t seem to be working…, just do more of it. Rinse/repeat.

    You have to have commitment for the long haul to let the banks fail. You’re all in from the start, there’s no turning back, although there’s obviously some flexibility in the actual full path.

    You’ll also have lot’s of interests that you mix with on a daily basis rather annoyed at you, and therein lies the rub. At the end of the day, it’s easier to muddle along putting band-aids on that gaping wound rather than perform the required surgery…. Sure, it’s not as good for the patient, but it’s not about the patient, is it?

  5. BusSchDean says:

    InterestedO: Agree but it depends on your definition of the patient. Apparently the only emotions or interests missing are those of securing the integrity of a process so fundamental to who we are as a country that our short terms fears turned us into something else. (Actually, the transformation has been going on for awhile.)

  6. mark says:

    As always there is a Wall St. aphorism to sum this up: When you gotta eat shit, don’t nibble at it.

  7. Finster says:

    I completely agree with this take:

    Mr. Hussman is pushing for this approach since over 2 years, insisting that there is enough bond holder capital on the bank’s balance sheets to protect the depositors. The scandalous developement is that the banks through CDS and the hedging of an appreciation of their phantom DVA gains are taking the system ever more hostage (booking a profit from their declining credit worthiness, then writing CDS on other systemically dangerous banks to profit when the debt moves to normal).
    These institutions need to be stopped from putting a gun to their heads and telling us to save them or we will be plunged into economic chaos, while they engineer that very outcome.
    Let the leveraged shortsellers of currency go bust. Do away with this banking sector that makes a living collecting rent on capital it lends out that it does not even have. The financialization of everything in the economy is nothing less than a tax on everything paid to a paranational cartel.

  8. InterestedObserver says:

    @BusSchDean – “Agree but it depends on your definition of the patient.”

    Absolutely. In my younger days, I’d maintain that it’s obvious…., then I visited the Internet/Cable/talk radio and saw that simple definitional items plain to me, escaped the minds of many.

  9. ToNYC says:

    I remember the vilification set upon the Icelanders by the monopoly Banks media’s hounds; not far different from the monopoly Energy masters vilification of any country that resists foreign involvement in its Sovereign Natural resources. Step back from Species Domination space and humans will sort it out like they did when they first met in the schoolyard, rather than a decade later when they were set against themselves for the “greater good” …of the Monopolies.

  10. Jim67545 says:

    I think the principal difference here is politicians which are willing to permit temporary pain in return for longer term mending. In this country no one wants any temporary pain, or setback so they vote for policies which paper over the problem short term but ultimately cause just what they seek to avoid. I won’t bore anyone with examples. You can do your own.

    On the issue of banks vs. credit unions, I’ll admit that I am biased as an officer of a small community bank. My choice is not the TBTF banks but a small community bank. Why? 1. The thousands of community banks have not generally engaged in the abuses and poor underwriting often discussed here. Punishing them is misplaced. 2. The community banks invest in their local communities. Credit Unions do also but they cannot commit more than 10% of their assets to commercial loans. So they support local businesses to a much smaller extent than community banks can. 3. I find it repugnant that credit unions have a federal income tax exemption even though the original purpose of the exemption – assisting tiny credit unions who serve a small deposit group (such as one company’s employees) has long been replaced by a credit union model virtually indistinguishable from community banks. So, if you dislike the industry engineered tax subsidies given to oil companies, et al. you should dislike this too.

  11. zcwotun says:

    sadly Iceland’s example (pop. 300k) will never fly in mass-media-driven, low-information-voters America.

    Ever since 1789 in America, there has been a wedge issue (tariffs, gold standard v dual coinage, religion, slavery, immigration, abortion, etc) that caused a big chunk of the electorate to ally with elites/a political party that acted against their economic interests.

  12. Irwin Fletcher says:

    What about Fannie and Freddie? Let them fail? Or keep screwing the taxpayers?

  13. Jim67545 says:

    If one truly wants to switch from a TBTF or other large bank to a credit union or community bank (see article among Tues reads) of course, be aware that not all are created equal. Some are good citizens and live, work and succeed or fail based on the local market. Some are leeches sucking off of the local market. We have gone through a difficult economic period. Has the insitution generally supported the local businesses and families during this period?

    Calculated Risk periodically reports the troubled bank list (about 930 now.) One could look there and follow the links on the attached list to see why the institution is in trouble. (Incidentally, no CUs are reported.) If it is in trouble because of malfeasance or compliance problems I would suggest it might be a “bad” bank. If it is in trouble due to delinquent loans in an area which is in bad shape economically, then I’d suggest that the institution may have made the “good” mistake of investing in its market which then fell apart. I would not deposit over the FDIC insurance limit in these instutions but also would not automatically discard them.

    Ultimately, without some internal information one cannot know the source of loan problems. Local banks sometimes reach for income into markets (geographic or segment such as HELOCs) where they don’t know the risk, among other types of self destruction.

  14. Bill Wilson says:

    “Where everyone else bailed out the bankers and made the public pay the price, Iceland let the banks go bust and actually expanded its social safety net,” he wrote in a recent commentary in the New York Times.

    I like that quote by Krugman. Although I disagree with Krugman on the idea that government stimulus can accelerate the economy to an escape velocity. I am a believer in automatic stabilizers and the social safety net. Let people fail, just don’t let them freeze or starve.

    Today’s debate seems to be dominated by people who hate government too much, or love it too much. It kind of reminds me of the OJ trial. We should all hate the the government when it’s stupid, love it when it’s usefull. Bailing out failed bankers is stupid.

  15. Jim67545 says:

    One of the Tues reads mentions in passing a large Ohio bank which focused on charging high fees on the poor and weak financially. This phenomenon is probably widespread at some level as banks try to attract more profitable customers which have multiple relationships (=better off) by reducing fees to them while offsetting it by charging non-profitable customers (= the poor) higher overdraft fees, etc. Another example is the use of credit scores to set interest rates on consumer loans (such as auto loans.) The low and moderate income generally have higher debts to income and are less able to maintain a clean credit history and so pay higher rates on consumer loans and credit cards. In too many cases it results in their only being able to obtain credit from sub-prime sources or check cashing stores at extremely high interest rates.

    This is a contributor to the income disparity situation we see but which I do not believe has been mentioned here. Bye.

  16. James Cameron says:

    Iceland’s former prime minister Geir Haarde, in power during the 2008 meltdown and currently facing trial over his handling of the crisis, has insisted his government did the right thing early on by letting the banks fail and making creditors carry the losses.

    Maybe more than anything, this caught my attention: placing leadership on trial . . .

  17. ToNYC says:

    Sometimes when a man (Geir Haarde) takes a stand, he must remain standing.

  18. aiadvisors says:

    The article fails to mention the Japanese experience. In the late ’80′s, Japanese banks were the largest in the world, by assets. Following the stock and land busts in ’90 and ’91, Japan elected to either hide or ignore the banks losses (zombie banks) and have been doing so ever since. I’m not aware of a single Japanese bank failure in the last 20 years. What did they get for it? Two, going on three, lost decades of economic growth.

  19. jhnovick says:

    I think this article ignores a certain level of interconnectivity and systemic risk that exists in some markets. Let us not forget what happened when we let Lehman fail. Money market funds holding Lehman paper almost broke the buck. Counterparties needed to make good on CDS agreements. Other counterparties struggled to collect what Lehman owed them. If in the height of 2008 we let Bank of America fail, protected the deposits and let the creditors take the hit, I think the result would have been catastrophic. Defaulting on their bonds would wreak havoc on mutual funds, pensions, insurance companies, etc. Plus you would have a company like AIG that is unable honor their CDS obligations. Letting someone like B of A fail might have been the first domino. The Icelandic banks could fail without causing shockwaves simply because they were not that big and that did not have an international presence. Do not get me wrong, I am not a fan of the bailouts but it may have been the lesser of two evils. Allowing banks to fail may have purged the system but it also may have left us without a system.

  20. ToNYC says:

    “Do not get me wrong, I am not a fan of the bailouts but it may have been the lesser of two evils. Allowing banks to fail may have purged the system but it also may have left us without a system.”

    You have a point that you don’t self-extinguish? A bailout is better but really not-so-much?

  21. Brian B says:

    What I find so curious is that after the government intervenes massively in markets through bailouts (which Krugman was for before he was against) and the markets remain hobbled and distorted, it is free markets themselves that the likes of Krugman and other statists attempt to blame for the mess not clearing.
    And then years later, without the slightest sense of irony or credit given to the sensible people who said bailouts were a bad idea and the market should be allowed to clear itself from day one, the same knotheads act as though they’ve discovered some new principle of economics that no one ever thought of before.
    Pathetic.

  22. [...] the threat of a fake alien invasion. Barry Ritholtz thinks we should just do what Iceland did and let the banks fail: “Rather than bail out the banks — Iceland could not have done so even if they wanted to — [...]