The 2008 Iceland banking crisis remains a cautionary tale—one that underscores the dangers of unfettered financial ambition and inadequate regulatory oversight. But as we dive into the events that unfolded within Iceland’s banking sector more than a decade ago, we discover—far more alarmingly—that the regional banking crisis facing the U.S. today eerily echoes this tiny Scandinavian country’s past woes. Here’s what happened in 2008—and what it means for us in 2023.
Nestled several degrees south of the Arctic Circle in the North Atlantic Ocean, Iceland is esteemed as one of the most beautiful countries in the world. Often hailed as “The Land of Fire and Ice,” this Nordic island nation boasts the largest glaciers in Europe, breathtaking geothermal hot springs, cascading waterfalls, and the world’s most active volcanoes.
However, beneath this picturesque landscape lies a haunting tale that Iceland still struggles to forget—the 2008 banking crisis. Driven in part by privatization and deregulation, Iceland underwent a remarkable transformation in the early 2000s, shifting from an economy heavily reliant on fishing and aluminum smelting to a global financial hub.
By mid-2008, Iceland’s three largest banks—Landsbanki, Glitnir, and Kaupthing—had grown into massive entities, surpassing the island nation’s real economy’s size by over tenfold. In late 2008, the bubble burst when the three banks collapsed, marking the largest bank collapse by a country in economic history.
The 2008 Iceland banking crisis remains a cautionary tale—one that underscores the dangers of unfettered financial ambition and inadequate regulatory oversight. But as we dive into the events that unfolded within Iceland’s banking sector more than a decade ago, we discover—far more alarmingly—that the regional banking crisis facing the U.S. today eerily echoes this tiny Scandinavian country’s past woes. Here’s what happened in 2008—and what it means for us in 2023.
The Rise of Iceland’s Three Largest Banks
In the latter half of the 20th century, Iceland enjoyed a successful resource-based economy with a GDP per capita comparable to other Nordic countries. However, its banking sector remained relatively undeveloped and localized, predominantly state-owned, and highly politicized.
In the 1980s and 1990s, Iceland began to deregulate and privatize its banking sector. Under the leadership of Davíð Oddsson, the country implemented sweeping structural reforms—chief among which included establishing a national stock and bond exchange and an interbank market for foreign exchange, as well as liberalizing interest rates and capital movements in and out of the country.
As a member of the European Economic Area (EEA), Iceland adopted European Union (EU) directives and regulations of the Single European Market (SEM) beginning in 1994. This integration made the Iceland currency, the króna, convertible to Euros and opened doors for Icelandic banks to operate across Europe.
Initially, the impact of these changes was modest as banks remained government-owned and conservative in their approach to lending and growth. However, things changed in 2003 following the complete privatization and consolidation of Iceland’s three largest banks, Landsbanki, Glitnir, and Kaupthing.
Unshackled from government restraints and answerable exclusively to a coalition of ambitious and risk-seeking shareholders, the three newly privatized banks pursued rapid expansion abroad. Armed with the EU single passport and the country’s good credit rating, Iceland banks tapped into the international financial markets—specifically, the European Medium-Term Note (MTN) market—to fuel their growth.
The Icelandic banks pursued an aggressive expansion strategy, acquiring subsidiaries and smaller financial institutions in other Scandinavian countries, in addition to the United Kingdom, Luxembourg, and France.
Armed with the sudden influx of liquidity, Iceland’s economy heated up. Inflation rose to 4.4% in 2005, exceeding the upper tolerance limit of 4%. In an effort to tame rising prices, the central bank raised its policy interest rate aggressively starting in May 2004, pushing it to 10.25% by October 2005.
Although high interest rates were only intended to dampen domestic inflation, they also inadvertently sparked the intrigue of foreign investors. That’s because the high interest rate spread between the Icelandic króna and other major funding currencies made the Nordic island’s national currency a preferred choice for carry trades in Europe, where investors borrowed in currencies with lower rates and invested in higher-yielding króna-denominated assets. As a result, the value of the króna appreciated against the Euro by about 20% in the two years between January 2004 and January 2006.
To capitalize on this rising demand, Icelandic banks issued glacier bonds, which further spurred capital inflows into an already booming financial market. With easy access to foreign credit at low interest rates, Landsbanki, Glitnir, and Kaupthing expanded at an astounding rate: The three banks collectively grew their balance sheets by eightfold from €8.6 billion in 2000 to €71.5 billion in 2005.
By 2006, Landsbanki, Glitnir, and Kaupthing had grown so rapidly that they each ranked among the 300 largest banks in the world.
The Mini-Crisis of 2006: The Geyser Crisis
Despite the appearance of prosperity, macroeconomic troubles were brewing beneath the surface. The banking sector’s external debt had surged from 6% of Iceland’s gross domestic product (GDP) in 1995 to 242% of GDP by the end of 2005. Household debt, meanwhile, climbed to 207% of disposable income over the same decade-long period.
On February 21st, 2006, multinational credit rating agency Fitch downgraded Iceland’s outlook from stable to negative, citing “macroeconomic imbalances” in addition to a widening current account deficit. Fitch’s concerns were well-founded: The country’s deficit had nearly doubled since 2005, reaching approximately 27% of GDP in 2006. Extensive research by major institutions like Merill Lynch and Danske Bank also revealed similar vulnerabilities in Iceland’s banking system.
As a result, investor confidence in Iceland’s financial stability began to decline. This limited access to the European bond market—a crucial source of short-term lending for the country’s banks. The króna also fared poorly, depreciating against the Euro by roughly 19% during the second quarter and third quarters of 2006. In an attempt to stabilize the value of the króna, the Central Bank of Iceland (CBI) again aggressively hiked interest rates to 14.25% in December 2006.
Hoping to stave off a potential liquidity crisis, Icelandic banks rushed to establish online-only banks that offered high deposit interest rates as a means to attract foreign deposits. Landsbanki opened Icesave in Britain and the Netherlands, while Kaupthing formed Edge.
By mid-2008, foreign deposits soared to over 16 billion euros, making up 15% of Landsbanki and Kaupthing’s combined balance sheets. Despite surviving the mini-crisis relatively unharmed, Reykjavík took little action to regulate the financial system.
The 2008 Meltdown
By mid-2007, economies across Europe began to contract, and international deposits slowed to a trickle. In response, Icelandic banks turned to collateralized borrowing from the European Central Bank (ECB) and the Central Bank of Iceland (CBI) for liquidity. By the end of 2007, Landsbanki, Glitnir, and Kaupthing had borrowed €9 billion from the two central banks.
As the Global Financial Crisis continued to unravel, investors grew increasingly alarmed about the escalating risks facing Icelandic banks. They were concerned that the banks’ large size relative to the domestic economy—when combined with broader macroeconomic headwinds and rapid balance sheet growth—posed dangerous threats to the near-term stability of Iceland’s banking sector. Meanwhile, the banks’ combined assets continued to grow unchecked. At the conclusion of 2007, Landsbanki, Glitnir, and Kaupthing’s assets had ballooned to €124.5 billion, or nearly 900% of GDP.
These fears severely limited Icelandic banks’ access to global capital markets, and made it difficult for Iceland’s largest banks to finance the country’s current account deficit, which had grown to 16.7% of GDP by 2008.
This caused the Icelandic króna to sharply depreciate against the Euro between the last quarter of 2007 and the second quarter of 2008. To prevent capital flight, Iceland’s Central Bank increased its policy rate by 125 basis points in March 2008 and a further 50 basis points in April, pushing it to 15.5% by mid-year.
While this strategy initially appeared effective, it was not enough to dodge the crisis. When Lehman Brothers collapsed in September 2008, Iceland’s largest banks found themselves unable to refinance their short-term debt.
Worse still, Landsbanki, Glitnir, and Kaupthing were still on the hook for foreign-denominated debts worth €50 billion or 9.553 trillion krónur. But the three banks severely lacked the funds to make their creditors whole—this amount, after all, was equivalent to 700% of Iceland’s GDP.
For this reason, Iceland faced an exquisitely difficult conundrum. Unlike other countries facing a financial crisis, a government bailout was not a viable option—the banks’ assets eclipsed GDP by over tenfold while the country’s foreign exchange reserves stood at a measly €1.8 billion. Landsbanki, Glitnir, and Kaupthing were, in other words, “too big not to fail”.
Efforts to restore the banking system—including the nationalization of Glitnir—were thus predictably unsuccessful. In early October of 2008, all three banks—accounting for over 90% of the Icelandic banking system—collapsed, leading to a 90% decline in the OMX Iceland 15 and the suspension of currency trading.
Echoes of Iceland’s Crisis in U.S. Regional Banks
Fast forward twelve years, and it appears that another banking crisis is upon us—this time not in Iceland, but in the United States. In the first half of 2023, the country witnessed three of the four largest regional bank failures in history when Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank all collapsed within a two-month period.
While the regional banking crisis facing the nation today is not causally connected with the 2008 Iceland banking crisis, these two events bear striking similarities. Among its many lessons, the Icelandic banking crisis emphasized the risks of inadequate regulatory oversight and supervision—takeaways that regulators in the United States have not heeded.
2018 amendments to the Dodd-Frank Act, for instance, increased the threshold for stricter regulations to $250 billion, which allowed banks with smaller balance sheets like Silicon Valley Bank and Signature Bank to dodge stringent requirements.
Had these banks been subject to comprehensive stress tests and resolution plans, potential dangers stemming from interest rate hikes and an overreliance on uninsured deposits might have been spotted earlier, averting their downfall.
Both the Icelandic banking crisis and the U.S. regional bank failures also highlight the perils of aggressive expansion driven by short-term funding. Icelandic banks capitalized on abundant international liquidity and low-interest rates to fuel long-term growth through short-term lending, leading to a liquidity crisis when funds dried up. Similarly, regional lenders in the U.S. like Silicon Valley Bank (SVB) rapidly expanded during a near-zero interest rate era, tripling its assets to $220 billion by March 2022. However, investments in long-dated treasury bonds and mortgage-backed securities left SVB exposed to significant unrealized losses as interest rates rose.
Another aspect is that banks with a large concentration of uninsured deposits are vulnerable to potential bank runs and cascading failures, where the collapse of one financial institution leads to the failure of another. In the 2008 Icelandic banking crisis, the nationalization of Glitnir raised concern among foreign investors. This led to a rush of withdrawals, especially from Landsbanki’s wholesale depositors who used Icesave and were therefore uninsured.
Similarly, the lion’s share of depositors at the three failed U.S. regional banks held significant amounts of uninsured deposits, making them susceptible to sudden withdrawals. For instance, 93.8% of SVB’s deposits were uninsured, while 89.3% of Signature Bank’s deposits were likewise uninsured.
Following the collapses of these two banks and faced with both a weak balance sheet and a similarly high number of uninsured deposits, First Republic’s depositors raced to pull out their money, and the 38-year-old bank soon failed.
As the U.S. regional banking situation evolves, making sound investment decisions becomes crucial.
At The Spaventa Group, we offer expert guidance and investment opportunities across various asset classes, empowering you to navigate economic fluctuations with confidence and clarity.
Whether you’re a new investor looking for pointers or a seasoned investor in the market for alternative asset classes, get in touch with us today to see how we can partner in shaping your financial future.
