The broad level implications of the Icelandic financial crisis has been widespread, to say the least. Banks suffered the most, but this financial stumble also ensured industries like real estate, and aviation took the dominoes effect on them. Lot of companies declared bankruptcy. Even the Krona, Iceland’s national currency, took a major hit, as a result of which Iceland’s economy is in complete doldrums. Before we study the causes of the Icelandic financial crisis, here are some ripples for you to know – The Gross Domestic Product of Iceland slipped by 5.5% in the first half of 2009. The total debt of Iceland is about 9.5 Trillion Kronur. Compare this with GDP evaluation of Iceland to be at 1.9 Trillion Kronur, and you know that Iceland is neck deep in debts.
Here are the causes of the Icelandic financial crisis
Banks unable to refinance their debts
In 2001, when the banking industry in Iceland was de-regulated, debts started to be uploaded by the banks. This came at a time when foreign companies accumulated. By 2008, three banks in Iceland, all of them big names, ran up debts worth 50 Billion Euros. Compare this with the GDP of Ireland of 1.9 Billion Euros, and you know that there is a mismatch.
Inflation due to expansion
Iceland accomplished most of its expansion activities in the new economy by taking loans on the interbank lending market. External debt also played a key role in financing the expansion. The fact that household debts were about 200% of the average disposable income of the family, fuelled the prices of essential commodities to rise. This resulted in inflation, which got further attested by the Central Bank of Island issuing loans on uncovered bonds, to banks.
Over-estimation of the Kronur
Running up to September 2008, the prices rose to 14%, considered to be the steepest price rise in the history of Iceland, ever. The Central Bank of Island tried to cover this by having a high interest rate (15%). These rates were absolutely unheard of, in the European countries, where interest rates are at the most, 5%. A high interest rate like this resulted in a lot of countries to pump their money in Iceland. This resulted in the Kronur being extremely over-valuated; proving that here was a bubble that was just ready to burst.
Action on bank loans, incomplete, resulting in a free-fall for banks
Most banks in Iceland refused to make fresh loans. The larger banks also found it difficult for them to roll over their loans in the interbank market, as their creditors asked them for repayment. In such a tough scenario, banks approach the largest bank, which they did, in approaching the Central Bank of Iceland. The problem was – The Central Bank of Iceland refused to take ownership and the government of Iceland couldn’t guarantee repayment of debts, as institutionally, the Central Bank of Iceland is much larger than the Government of Iceland. All of this resulted in an absolute free-fall for banks, as credit was just not readily available for banks.
Icesave, working as a subsidiary of Landsbanki worsening the issue
Technically, Icesave should have worked as an independent entity, but it didn’t. It operated under the brandname of Landsbanki, and had to rely on it for emergency funds. Icesave couldn’t rely on Bank of England due to this restriction. Plans to change all of this were put in words, but they never materialized. Basically, the Icelandic financial crisis was a systemic malady though concerned only with the banking sector, unlike the sub-prime crisis which was a joint effort of real estate and finance. That said, for a small economy like Iceland, the financial sector getting hit means the country’s economy getting hit at the worst possible place.