Irreverent Economics

A VoxEU piece.

The Icelandic banking system collapsed in October 2008 and its three internationally active banks were taken over by the government. Disregarding best international practice, the government opted to restructure the banks on national grounds. Soon after two of the three passed into the hands of foreign ‘vulture’ funds which had no expertise or interest in running a banking system – they just wanted to cash out assets. The government has also maintained direct control of the banks, implementing an overarching regulatory structure and discouraging regular banking activities.

As a result, Iceland is saddled with a dysfunctional banking system more interested in maximising short-term asset recovery and compliance than providing the core banking services necessary for economic recovery.

Crisis and resolution

Best practice in resolving banking crises is the good bank/bad bank model, as used by Sweden in 1992 (Buiter 2009, Jonung 2009). A key objective is to create viable financial institutions able to provide uninterrupted banking services, thus helping economic recovery. In spite of receiving advice from Scandinavia, the Icelandic authorities at the time of the collapse rejected this approach.

Instead, they opted to split the banks on geographical lines. Keep the Icelandic operations separate from the international operations, with the idea that somehow Iceland could be protected from international default. Not surprisingly, this was impossible. Not only were the Icelandic assets of low quality and part of the same asset pool as foreign assets, but international creditors had claims on both types of assets so bank resolution schemes necessarily had to consider both types jointly.

The end result was three new domestic banks, not quite stillborn, but as they were saddled with the domestic loan book of the old banks, they were anything but healthy.

The authorities at the time had it within their powers to do a good bank/bad bank split, but within a few months that option disappeared as the resolution process moved into its second phase.

A new banking system is formed

Soon after the banks collapsed, their international creditors wrote down their Icelandic exposures, selling them on the secondary market for around 4-6 cents on the dollar. The purchasers were mostly vulture funds specialising in distressed assets.

After a change in government in early 2009, it fell on the incoming government, along with the IMF, to reconcile creditor demands. The international parts of the banks were left in the winding up stage with large international banks remaining significant creditors, while the domestic parts, called new banks, took over retail banking responsibilities in Iceland and domestic asset recovery.

Two of the three new banks passed indirectly into the hands of foreign vulture funds in 2009, with the government retaining a share and a veto power on the board. The last bank, Landsbanki, is likely to remain in government hands – at least until the Icesave issue is settled.

The new beneficial owners of the new banks are vulture funds that have neither much banking experience nor any interest in running a banking system. Instead they specialise in maximising short-term distressed asset recovery. However, their freedom to act is limited by both the legal resolution process and the government, at least until they formally assume ownership when the new banks become incorporated.

Regulations and governance

After the crisis of October 2008, the government was determined to prevent a future crisis and in short order created an expansive regulatory structure suitable for the three international Icelandic banks prior to the collapse, a regulatory structure that supposedly would have prevented the banking crisis ex post. This approach failed to take into account that the banks emerging after the collapse were quite different than before, only a very small fraction of their previous size, and focused on domestic operations.

After the crisis, banks and bankers were demonised in the media and the incoming bank administrators, chosen because they were not bankers, adopted that view, beefing up compliance and sharply curtailing regular banking operations.

One example of the regulatory changes was an immediate increase in capital requirements to 16%. In light of the current international debate on the impact of increasing bank capital to much lower levels and the long timetable for the implementation, it is hard to see the logic behind that decision.

The banks as asset managers

The new beneficial owners of the banks treat them more as asset management institutions than providers of financial services. That entails maximising recovery from creditors and profiting from running failed firms that they have fully or partially taken over. The banks are reluctant to write down loans, so they roll them over. The practice, known as ‘evergreening’, is more the norm than the exception.¹

Firms that escaped default in the crisis are at a significant disadvantage compared to worse-run competitors who failed and passed into the hands of the banks since the banks favour their own companies in access to credit. In turn, this holds back recovery and discourages investment because any new firm would have to obtain banking services from the very same banks competing against them.

Conclusion

If the banking system of Iceland had been restructured on best practice international grounds, Iceland would now have a vibrant banking system, providing the necessary if not sufficient conditions for economic recovery. Instead, the Icelandic government, with IMF support, created a dysfunctional banking system that continues to prevent recovery.

The government can still solve the problem, starting by clarifying beneficial ownership of the banks, reducing its focus on compliance and regulations, and encouraging normal bank practices. At the same it should require the direct separation between the asset management function of the banks and the provision of banking services.

It is clear that a key reason for the 2008 crisis was the failure of financial regulations. Therefore we should redesign the regulatory structure. Indeed, this is underway in Basel III and other initiatives.

I do however question the qualifications of those calling for and making new regulations. After all, the latest crisis is wholly created by governments themselves and even worse, they keep on making the crisis worse by inability to make decisions. This does not show a good example for how to make financial decisions.

How can the very same governments and their financial experts be qualified to design effective future financial regulations if they display such incompetence in managing their own financial affairs?

I think all of this suggests what asset class one should be investing in.

Written with Casper G. de Vries

European politicians will make decisions in the next few weeks that are likely to determine the future prosperity of Europe. The leaders have two choices. Feed the crisis by ignorance, political disagreement, forbearance, muddling through and inaction, or recognize reality, face the upfront cost of restructuring, remove the information uncertainty and create conditions for future prosperity. By our analysis the relative benefit of opting a properly managed default is a gain of 22% of the European GDP over the coming two decades.

In order to estimate the cost of the ostrich attitude it is useful to look at what has happened in other large economies facing similar choices, with no better example but Japan, as the EU approach to crisis management does have a strong parallel with how Japan handled its crisis in the early 1990s. The slow crisis management approach of the Japanese state to its crisis is eerily similar to what we see now from the EU authorities: Hoping for the best, doling out partial bailouts, ever greening loans, and trying to maintain the status quo ex ante. This created zombie banks, triggering years of debt deflation and economic stagnation. The cost to Japan has been an economic growth of 0.67% a year for the past two decades, a reasonable estimate if the EU opts for inaction.

In the case of the Euro, the main reason for slow growth would be the continuing political risk and the ongoing uncertainty regarding the strength and exposures of commercial banks. There is even a real fear we have started to see the emergence of zombie banks Japanese style, as the ECB is becoming the lender of first resort for many banks, entire banking systems and even national governments. This leads to a vicious feedback loop between the dry-up of liquidity, reduced lending and diminished economic growth.

The alternative for the EU authorities is to recognize reality and allowing restructuring ofGreek and possibly Portuguese debt.

We suspect the benefits of a default would be substantial for the entire European economy, including those defaulting. A default will break the vicious cycle between a lack of confidence, banking crisis, increasing borrowing costs and fall in liquidity has been created.

A reasonable estimate of the cost of recognizing realty is the average growth in the Eurozone over the past 20 years or 1.67%. In this case the euro area GDP would be 22% higher after 20 years, or €3.5 trillion, while muddling only yields €1.3 trillion in GDP.

It would be preferable if the default were orderly instead of being the chaotic endgame it would likely be in the ostrich approach. The authorities would need to be prepared for possible liquidity and balance of payments problems for countries like Italy and Spain. The IMF, the institution set up for that purpose, should stand ready to provide the necessary support.

The government’s task of effectively provide being bailouts is complicated by several factors, both the close connections between governments and industry and lack of experience and knowledge on behalf of senior government advisers.

The financial system in many countries is in effect an oligopoly of very large powerful and well—connected financial institutions. In some countries, the industry might have very close connections with the government, such as France, while in other countries the relationship is more arms length. Indeed, one could say the more banks a country has, the less political power they have. The revolving door between the industry and government in some countries, like the US, can exasperate this problem.

Government institutions are also at a disadvantage when it comes to the industry. Not only can banks vastly outbid the government when it comes to human capital, they also have orders of magnitudes more people working for them. This can be particularly problematic when it comes to addressing highly complex issues by relatively junior staff members.

In addition, the governments problem in understanding the complexity of the financial system is made worse by the fact that it is task is more difficult the task of any bank. The bank has only to worry about its own risk, the government has to worry about the risk of each and every bank, individually and in aggregate — an impossible task.

All of this suggests that when it comes to regulating the financial industry and providing bailouts when it fails, the interests of the taxpayers are at a serious disadvantage. Not only can the banks exert targeted lobbying at the government, the technical ability of the government to respond effectively unlimited.

In a crisis, this becomes especially difficult. Senior government ministers and their advisers are unlikely to understand the underlying problem in detail. How is the government to know when a banker comes to it saying “if you do not bail me out the financial system will  collapse” whether that is true or not? If the government then brings in expertise from the industry, perhaps even putting them in charge of government ministries, it is unclear whom they actually represent. The interests of industry or the interests of the taxpayer.

Noam Chomsky visited Iceland last weekend, give a public talk and got the star treatment – which he does deserve. That included an interview on the premier news analysis program on Icelandic TV. The 3 parts of the interview  can be seen on the program website linking to YouTube.

Chomsky is one of the most perceptive public intellectuals around and listening to him is always a delight. However, in this interview he strayed into the areas of my expertise — economics and Iceland and either told things that are not true, misrepresented facts or did not provide the necessary connection to understand what he was advocating. There were several such things in his discourse, here are the three worst:

1. He said Iceland had found a unique solution, including not paying back the money. He was not clear on who paid the money back, but we do know that the government of Iceland has paid back every penny it owes and been rewarded with lower credit spreads than for example Spain. There is a myth of Iceland not paying back debt — sparked by Icesave — which is simply not true. His fact here is wrong.
2. He talked about the idea of efficient markets as something like a religious orthodoxy that people still clung to, even though it is  supposedly false and to blame for the excesses of the crisis.  He does not know what the efficient market hypothesis is. All it says is that one cannot systematically make money forecasting the markets. So he used it in a completely incorrect sense and then criticized people who still think it is  correct as being like religious fanatics. This is populism at its worst.
3. Finally, he talked about the end of the Bretton Woods system and the start of floating currencies as some sort of a capitalist plot decided on by evil bankers and implemented by corrupt politicians. Yikes. Talking about not knowing your facts. The Bretton Woods system collapsed because it was unsustainable, the bankers very much would’ve liked for it to continue. The sad truth is we have tried every arrangement for currency management and they all fail. Not because of evil plans by bankers and corrupt politicians but because they ignore economic fundamentals.

This makes me worried about everything else he says. It sounds very convincing and I am not an expert in those areas so cannot assess the veracity of his analysis. However, for someone who is as liberal with the truth, everything else he says becomes suspect. And that is sad. He is one of the sharpest public intellectuals there are and we need such people.