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Source link: http://archive.mises.org/10100/icelands-banking-crisis-the-meltdown-of-an-interventionist-financial-system/

Iceland’s Banking Crisis: The Meltdown of an Interventionist Financial System

June 9, 2009 by

Icelandic Prime Minister Geir Haarde’s resignation on January 23rd of this year marked the first political casualty of the current financial crisis. While the Icelandic situation has received scant attention relative to other calamities reverberating through the world’s financial markets, the source of Iceland’s woes can be found in many of the same locales. FULL ARTICLE

{ 13 comments }

Dennis June 9, 2009 at 9:42 am

The following quote of Mises from “The Theory of Money and Credit” in 1912 was included by the authors at the end of their article:

“For the activity of the banks as negotiators of credit the golden rule holds, that an organic connection must be created between the credit transactions and the debit transactions. The credit that the bank grants must correspond quantitatively and qualitatively to the credit that it takes up. More exactly expressed, ‘The date on which the bank’s obligations fall due must not precede the date on which its corresponding claims can be realized.’ Only thus can the danger of insolvency be avoided.”

Interestingly, Mises (in 1912) was apparently arguing for, or the logical implications of his statement would require banks to maintain 100% reserves for demand deposits. Since a bank’s obligations, i.e. its demand deposits, fall due literally at any time, the only way that the date on which a bank’s obligations fall due will not precede the date on which the corresponding claims can be realized is for banks at all times to maintain 100% reserves for demand deposits.

I realize that a loan made by a bank that the bank can require to be repayed at any time would solve the mismatch problem, but how many bank loans actually contain this condition?

Mises’s position regarding fractional reserve banking has been subject to some debate among Austrian School economists; however, the implications of his above 1912 statement would support 100% reserve requirements for demand deposits.

Mushindo June 9, 2009 at 10:29 am

I have no argument with the substance of the article, which I find impressive and articulate. I hope I may be forgiven for highlighting a few minor lexical errors which jumped out at me.

In the first paragraph, I think the word ‘populous’ should read ‘populus’ when used in this sense. (Iceland is not a very populous country, but it does have a small populus….).

6th paragraph , this passage:

‘If an event arose whereby Icelandic banks failed to find new borrowers to continue rolling over their liabilities, they could face a liquidity crisis and,…’

I suspect you mean ‘….find new LENDERS’. Bank liabilities come from lenders or (sore point with Austrians…), depositors. A bank’s borrowers are where its assets lie, (and in the case at hand there is no shortage of those……)

In the final paragraph, the word ‘exasperate’. I think the word you were looking for is ‘exacerbate’.

I normally have a distaste for such pedantry, but given the editor’s note about what the basis of the article is destined for, I thought it might help in polishing its future incarnations.

I rather suspect the fault largely lies with MS spell-check, whose hamfisted attempts to correct my spelling and usage never cease to, um, exasperate me (I swear, if it tries to replace my esses with zeds ( sorry, zees) one more time, I think I’ll scream!).

Kind regards

KMcC June 9, 2009 at 11:09 am

the word you seek is ‘populace’.

Similarly, in the fourth par, you use the word ‘exasperate’ where you mean ‘exacerbate’.

If I find any more solecisms I’ll let you know – but the article itself is very interesting and these are small points that should have been picked up during editing

A. Viirlaid June 9, 2009 at 12:14 pm

It is sad that even well-informed investigators (Buiter and Sibert — 2008) cannot put their fingers on the exact causes of the Icelandic economic tragedy.

So that this same difficulty — to properly understand financial reality — occurs elsewhere should not surprise us. Even today the FED in America fails to appreciate (or at least admit to) its own central role in causing “The Great Recession”.

Perhaps the FED might better appreciate its own ‘contributions’ by studying how similar ‘techniques’ were used in other places, like Iceland, to cause housing booms — because, as Bagus and Howden so eruditely demonstrate, it was not just in the U.K. and in America where these tragedies unfolded.

Indeed, thanks to this article by Philipp Bagus and David Howden, we are closer to showing The Federal Reserve and others, how inextricably linked the polices of various Central Banks were — fatally-so — even though none of these policies were enacted consciously, maliciously or intentionally with any harm in mind.

Especially enlightening are the main areas of focus of the article on:

1. capital misallocation (i.e., malinvestments),
2. moral hazard,
3. enticement of people to borrow to the hilt to buy houses, and
4. the sad (implicit) participation of the Bank of Japan (yet again another complicit central bank) in the creation of “money”, at below-natural-market cost of capital, which so directly enabled the tragedy to unfold in Iceland.

None of these practices will stop until and unless Central Banks understand the harm they do with their manipulation of money. There is no cost-free way to obtain a free lunch. And yet the heads of Central Banks on the whole are oblivious to this seemingly obvious truth.

Observation in fact suggests that they believe the opposite. That money can make magical things happen, when it is manipulated artificially by central bankers. They ‘can do no wrong’. They ‘walk on water’. Really?

One would think that when the party really gets going, and the boom is booming, that intelligent central bankers would see red flags going up all over the place. After all, isn’t one sign of “when it’s too good to be true” known by most intelligent people to be “it probably isn’t true”?

As one former FED head (William McChesney Martin, Jr) said, it is the job of the Federal Reserve “to take away the punch bowl just as the party gets going”.
Please see http://en.wikipedia.org/wiki/William_McChesney_Martin,_Jr.

In the final analysis, the various Central Banks’ respective governments must come to an internationally agreed upon Treaty to no longer allow any type of ‘beggar thy neighbor’ policies — policies that these governments currently tolerate from their respective Central Banks.

punter June 9, 2009 at 10:16 pm

Another quibble, aluminium isn’t mined in Iceland, it is smelted (from alumina). Bauxite is mined, but not in Iceland.

Joe B June 9, 2009 at 11:34 pm

Apparently there is going to be a workshop on “Managing Financial Instability in Capitalistic Economies” in – you guessed it – Reykjavik.

http://sites.google.com/site/managingfinancialinstability/

Maybe this paper could be submitted to offset some of the pseudoscientific econometric garbage that will likely dominate that conference.

Jukka M June 11, 2009 at 5:42 am

One of the best articles in a long time, thanks!

Could someone please explain the concept of currency mismatch a little further?

From reading the article I got the impression that the term refers to the act of banks getting foreign financing, but that in itself shouldn’t be a problem, so what am I missing here? Where is the ‘mismatch’?

A. Viirlaid June 12, 2009 at 6:49 pm

Hi Jukka M,

Both “mismatching” concepts are fairly straightforward IMO.

I may explain this in terms that are way too simplistic for you — in that case please forgive me.

The “mismatching” concepts (whether “maturity” or “currency”) relate to a bank (or other FI – Financial Institution) having to repay money it has borrowed to finance an activity it has undertaken.
They can both occur together within the same financing activity or separately.

It is easiest to think of one transaction, and of one type, at a time so as to more easily understand the concepts.
Of course, these “mismatches” can both occur within the same transaction.

Also, most often they occur within many different transactions, since banks and other FI-s are not doing one transaction only during any given period of time.
These FI-s normally try to “match” up all their transactions as classes or groups so as to minimize risk of not making a return.

The maturity issue is one of timing.
That is, there is a future time when the money is DUE to be paid back.
Then there also is the future time when the FI or bank makes a return from the activity it financed with that borrowed money.

If the time comes that the FI owes the money back, but has not earned any money itself on the financed investment — “mismatched” earned money versus owed money — there is a risk that the FI can default.

The currency issue is one of exchange rates.
The bank or FI borrows money from a foreigner (country or persons) that lends to the FI in that foreign currency.

That foreign entity EXPECTS repayment in that foreign currency.
But during the lifetime of the financed activity, exchange rates can vary.

As an example, the bank in Iceland may lend out this foreign (say Japanese) money in Icelandic currency to the homeowners in Iceland for their mortgages. Before it lends the money out to its fellow citizens, it first goes into the foreign exchange market and converts the borrowed Japanese money into Icelandic currency.

Then even if the maturity dates of the borrowed Japanese money and the lent Icelandic money were the same, there is a risk that the Icelandic bank cannot buy the Japanese currency it owes to its Japanese creditors at a favorable-enough exchange rate in the foreign currency market.

It can lose on the conversion, and end up making a negative return on the money it lent for those mortgages.

For another example of mismatched maturities, the bank may just borrow money for 1-year terms (from its depositors buying one-year GIC-s from it) and then invest that money in long-term government bonds (even in the same currency) because the long-term money pays a higher interest rate than the bank has to pay out on the one-year GIC-s.
The bank could theoretically earn the difference for itself.
But the bank has to be careful because in 1 year it will have to repay those GIC investors. If the bank cannot “rollover” the equivalent amounts into new GIC-s that it hopes to sell to its depositors, then where will it get the money?

It could hope to borrow it somewhere. But if it has to pay a higher interest rate for such borrowed money at the time it needs to finance the paybacks to the original GIC purchasers, it will lose any profit it might have hoped to make.
Worse, what if it cannot can find anyone to lend it any more money at all, at any rate?
The FI or bank is now in default on the money it owes to the GIC investors.

The problem is that both types of “mismatching” create a significant risk that the bank or FI cannot pay back the money it owes at the “due date” and in the amounts owed.

In the case of maturity mismatching, the bank borrows money it is obligated to pay back at some later due date. This “payback” date is earlier than the date that the bank expects to see any meaningful return from the thereby-financed undertaken activities.

In this maturity mismatching the bank uses the borrowed money in some activity where it would normally expect to see payback much later than that at the loan-due date of the money it has borrowed.

You can clearly understand that this could be a problem.

But if such activities that such a bank undertakes are “insured” against failure by other entities (like the nation’s central bank or government) then the potential profit might be large enough to encourage that bank to take the risk. It has bitten the apple of Moral Hazard. It figures that it cannot REALLY lose — someone will make the loss “good”.

Furthermore, the bank is — under normal conditions — rightfully expecting to be able to “roll over” the original short-term debt it has taken on to another (or even the same) lender. This allows the FI or bank to EXPECT that it can forever finance its profitable activities with borrowings of either relatively cheap foreign money or relatively cheap short-term money of its own home currency.

So justifiably in most cases the bank does not really foresee a problem. And in most cases there really is no problem. That is THE problem. People are poor students of history — especially it would seem, bankers.

In the case of pure “currency mismatching” there is a no difference between the “dates” — although there could be both matching problems in play at the same time, as I explained before.

The “dates” of course are the due (payback) date of borrowed money and the expected date of making the expected profit from the use of that money.

From the article:

The island’s currency — the króna — plunged in value, making bankers, both private and central, unable to raise the cash necessary to continue funding their liabilities.

This preceding statement refers to the inability to borrow since the Japanese lenders could see that there were real problems in Iceland’s banks being now able to use their own home currency with which to buy Japanese Yen in order to pay back to the Japanese lenders that money that Iceland had borrowed.

From the article:

Before asking why the Central Bank of Iceland has been so ineffective in mitigating the current crisis, it is important to point out that the drying up of liquidity and the ensuing negative effects on financial assets’ values by stopping the necessary rollover did not occur by pure accident, as many economists seem to think.

Rather, it was triggered by the malinvestments that were caused by the mismatching practices — both maturity and currency — in the first place.

When commodity and housing prices started to fall and consumer goods’ prices soared, it became obvious that many assets of the Icelandic banking system would lose value and that the structure of production of Iceland had to be readjusted accordingly.

This triggered the run on the króna that ended the rollover [activities].

I hope this gives you some feeling for both of these risk types.

Cheers!

p.s. Just a small postscript — the role of Central Banks is key IMO to what Moral Hazard is created during these phony Financial Boom Times.

They create MOST ALL of the conditions required for Artificial Borrowing to Occur.
Clearly without cheap financing, also known as the so-called monetary “accommodation” done by central banks (perhaps most egregiously exemplified by The Federal Reserve Bank of the United States), THERE CAN NEVER BE SUCH a BOOM EVER OR ANYWHERE. We have our Central Bankers to “give thanks to”.

The Social Engineers in these Central Banks often think they are doing good. And most of us might agree (at least during the boom they have created).

It is the hangover from the ‘party’ that we would wish to do without.

But as all Austrian Economists know, that hangover is a price that WILL BE PAID, no matter how long we try to put it off.

p.p.s. What is perhaps MOST EGREGIOUS is that the same central bankers who caused these problems are now saying they can fix the problems with the SAME EXACT techniques they used for creating the problems in the first place!!!

Go Figure!

Peter Schiff can’t figure them out and neither can I.

A.Viirlaid June 13, 2009 at 2:23 pm

BTW, Jukka, if you have time please also read about Angela Merkel of Germany also not being able to fully understand what the heck Central Bankers think they are doing at

http://online.wsj.com/article/SB124398546796379239.html?mod=googlenews_wsj#top-of-comments

Merkel has an idea of course, but she is worried that the Central Bankers don’t understand the nature of the FIRE they are playing with. And I think she is RIGHT — she actually does understand far MORE than say Ben Bernanke who “respectfully” disagrees with her. Please, Dr. Ben Bernanke, give me a break!

When these Central Bankers take resources from the future (via more debt, or worse, from just plain old “money-printing” which is just counterfeiting, pure and simple) OR from other parts of the economy (the so-called “Crowding-Out”) the Central Bankers think they are “healing” the economy, softening the downturn.

They are actually only “staving off the inevitable” at the further HUGE cost of more financial and thus, social, damage. This is a mirage, a parlor game, a bait-and-switch, a con job, a shell game.

All they are encouraging is more false investment, exactly the same kind that our writers, Philipp Bagus and David Howden, mention.

These Central Bankers actually think that if they can loosen up the Credit from the Credit Crunch that places like Iceland are experiencing, that “things will go back to normal”.

What is this “normal”?

Is it “normal” to take chances with OPM (Other People’s Money) the way that Icelandic banks did?

Is it “normal” for those banks to mismatch huge groupings of assets (loans and investments they made) to huge groupings of liabilities (borrowings they made to finance those asset-acquisiton-sprees)?

No it is not.

The acquisition of such huge mismatched portfolios of assets and liabilities is only done when an entity thinks that one can get away with it, and “make money”.

So why are the Central Banks so driven to get back to this “normality” since it was such a catastrophic failure?

Your guess is as good as anyone else’s, Merkel’s, Schiff’s, or mine.

Cheers.

Jukka M June 15, 2009 at 5:53 am

Thank you so much for your time, A.Viirlaid! You could make a great teacher / lecturer / blogger with your skill to explain complicated things in a clear way.

Now I’m off to read the WSJ article.

A. Viirlaid June 16, 2009 at 9:21 am

You are very welcome Jukka M!

Kiitos.

Find an Interventionist August 30, 2010 at 9:36 pm

Wow! Didn’t think this article was going to be what I thought it was going to be, but great read!

Find an Interventionist

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