Bringing Down the Banking System: Lessons From Iceland

I was very fortunate today to attend the STOR Collquium at UNC. Gudrun Johnsen of the University of Iceland gave a talk, “If you look close enough you can see a whole lot: Data collection and analysis of the Parliamentary Investigation Commission looking into the Icelandic Banking Collapse in 2008.”

The combined bankruptcy of the three largest banks in Iceland in October 2008 is the 3rd largest bankruptcy in world history, behind Lehman Brothers and Washington Mutual.

Ms. Johnsen started with a history lesson on the Pujo investigation into the American “money trusts” in 1912-1913. This investigation revealed a system of overlapping financial networks used to dominate utilities, railroads, banking, and financial infrastructure. While the committee’s work resulted in the passage of the Federal Reserve Act and the Clayton Antitrust Act, it was severely hampered by insufficient access to data.

Fast forward to 2008, when the banking system in Iceland collapsed. The Icelandic Parliament’s Special Investigation Commission (SIC) did not have the problem of insufficient access to data. Parliament lifted all confidentiality from bank employees, government officials, and others. The SIC was given the power to issue subpoenas, and the authority to walk into any bank and examine or seize any records, in any form.

What they uncovered was astounding. The banks had grown 20-fold in size in just seven years, to the point where their outstanding loans were 20 times the countries GDP. The SIC also discovered a web of ownership, related-party lending, market manipulation, and flawed incentives. A bank would purchase a corporation, lend money to that corporation, and the corporation would then invest the money in the bank. The end result would be that the banks own shares were pledged as collateral for loans made by the bank. A number of holding companies were created to prevent any firm from having more than 50% control, which would trigger consolidation under Icelandic law. There were circular arrangements where Company A owned Company B which owned Company C which owned Company A.

So all of this money was being lent and borrowed, by entities who had no “skin in the game.” While the American banks were “too big to fail,” the Icelandic banks had grown so big, so fast, that they were “too big to save.”

Johnsen concluded her talk as she concludes her book: with the results of the investigations (top management at all three banks have been sent to prison), and some ideas for future research.

I greatly enjoyed her talk, and I’m looking forward to reading the book.