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Lending to Icelandic Banks

Brian Davey | 13.10.2008 04:57 | Analysis | Other Press

This is a letter sent to councillors about the potential losses through lending to Icelandic banks. Reasonably competent financial officials should have known about the risks.

Dear Councillor,

Of the local authorities hit by the collapse of the celandic banks only Kent County Council had a bigger exposure - 50million compared to Nottingham City Council's £42 million. However, Kent County Council has a population of nearly 1,400,000 - which is about 5 times as big. Measured as a per capita figure the potential loss in Kent was about £35.85 per head and the possible loss in Nottingham could be £150.69 for every woman, man and child in the city.

Was this loss avoidable? To answer this we must ask the question whether it was forseeable to reasonably competent financial officials and their political supervisors. If it was foreseeable then it was avoidable.

The case for the prosecution:

According to the Financial Times a few alarm bells were already ringing in 2004 when the Iceland central bank worried about a debt fueled speculative boom in the share prices of Icelandic companies. A year later the nternational Monetary Fund was advising the Icelandic authorities to stress test the financial sector against exchange rate fluctuations and interest rate changes because the Icelandic banks were intermediating a rapidly growing volume of foreign lending.

In 2006 the ratings agencies downgraded the Icelandic banks who resorted to borrowing on deposit abroad more - including in the UK.

IN 2007 the Icelandic banks were beginning to retrench, selling assets, reducing lending growth and reducing costs.

By early this year it was common knowledge in the financial markets that the Iceland banks were in trouble. They had made money specialising in the so called Carry Trades ( borrowing money in currencies with a low interest rate
and lending it in markets with a higher interest rate) but this was becoming too risky as markets became very turbulent. So they speculated against their own currency the Krona, to make money - in that way increasing the amount of
foreign debt by 4 times compared to 2004. By March 2008 the Icelandic Krona had fallen by 25% against the Euro and the Iceland stock market index had fallen 25% compared to the beginning of the year. The Icelandic banks were now being reported in the newspapers as "topping the risk league"

 http://www.thisismoney.co.uk/investing-and-markets/article.html?in_article_id=433257&in_page_id=3

By the middle of April the situation had moved on - the hedge funds had noticed that Iceland was in trouble and smelled a way of making money.

To quote a Guardian article. "Tiny country like a canary in a coalmine signalling crisis in toxic economies.....Critics have compared the country to a "toxic hedge fund" built on debt that could be about to go spectacularly wrong.....The concern is that the banks and corporations that have put
Iceland on the map expanded too rapidly, borrowing during the years of readily available money. Now they face problems refinancing that debt. The banks in particular have been facing astronomical costs for insuring their debt (credit default swaps or CDSs) as the markets speculate that they could be in deep trouble. Based on recent prices in the credit markets, Kaupthing was seven times more likely to default than the average European bank. The chief worry appears to be whether or not the Icelandic Central Bank would have the muscle to rescue one of the banks if things went wrong. Iceland is facing some unfavourable comparisons. Bear Stearns recently suggested the tiny nation was about as safe an investment as Kazakhstan."

 http://www.guardian.co.uk/business/2008/apr/17/creditcrunch

It was not just the Guardian but all the newspapers picked up on the situation. For example, the Daily Mail picked up that hedge funds had begun to speculate against the banks in the country:

"Leading Icelandic bank Kaupthing has taken the extraordinary step of accusing four London hedge funds of illegally trying to drive it towards bankruptcy for their own profit.

In what looks likely to lead to a massive legal showdown in financial markets, the bank, which has attracted billions from UK savers to its Kaupthing Edge accounts, claimed the hedge funds deliberately spread false rumours about
financial difficulties at Icelandic banks to make profits on complex financial investments."

In such a situation it was fairly obvious, if one was looking, that a country with a population only slightly bigger than Nottingham, was vulnerable. The protection for bankers is their central bank which can act as lender of last resort - but the Icelandic central bank issues Krona, not sterling, euro or dollars, the currencies in which the Icelandic banks had massive liabilities. Moreover the money owed by the banks to foreigners amounted in the second
quarter to 6 times the total goods and services produced by the Icelandic economy over the whole year. Thus, even if the banks were solvent (could have paid all their debts by selling their assets at current market values ) a run
on the banks would be dangerous. In a situation in which confidence broke, depositors and short term creditors wanting their money back could and would render the banks illiquid (not enough immediate cash) and the central bank
and country did not have enough of the right currencies to lend the banks to pay the creditors....

Summing up the prosecution case

For a whole year we have been told almost daily that the banks do not trust each other enough to lend - for fear that any bank to which money is lent might go bust. This ought to have had some influence on a half way competent financial manager of the city council's funds - alerting the officials concerned to be extra cautious and diligent.

For some time, and certainly since early this year, the Icelandic banks have been repeatedly in the news as being particularly vulnerable.

The small size of the Iceland economy compared to the international scale on which its banks operated and the limited ability and power of its central bank to support the Icelandic banks if they got into trouble should have been
blindingly obvious.

The officials who lent money to the Icelandic banks were clearly not up to their job. Whoever was supervising them should at the very least have been urging caution in regard to where council funds were kept. (I wrote to you a
few months ago about the banking crisis and its effects on the city. Anyone who reads the newspapers ought to know what is going on).

For the defence perhaps it should be acknowledged that no less than 108 local councils were invested in Icelandic banks - though the overwhelming majority of these by much smaller amounts. This perhaps shows that the a large number
of local authority finance officials have simply not be awake while the financial crisis developed. One should not be surprised at this. The broker who brought the Barings Bank to its knees with his illegal dealings said this
of the people who are supposed to regulate the markets:

According to Nick Leeson alongside the "best brains" in the trading rooms, competing fiercely and taking risks, there are also " the grey men of the back office.... They do the paperwork behind the traders' deals and run the
regulatory systems. It is their job to monitor the markets and ensure checks and balances are properly applied. These bankers are invariably not up to it. The front end of the business is far more profitable. The brightest and best
are seduced by the lure of big bonuses, leaving the third-raters and burn-outs to take safe desk jobs in staid institutions such as the Bank of England."

Or work in local authority finance departments and give advice to local politicians perhaps.......

 http://www.dailymail.co.uk/pages/live/articles/news/news.html?in_article_id=482060&in_page_id=1770

To conclude:

Commentaries about the financial crisis in the newspapers continually describe the process in financial jargon as a "re-pricing of risk". However, what we have seen is that Nottingham City council WERE DANGEROUSLY COMPLACENT about
the risk involved in the financial crisis. Perhaps it was because they were investing other people's money and not their own. Whatever. This dangerous complacency does not bode well for the sense of urgency with which the city
council should be approaching contigency planning for the financial crisis about to hit this city. For years they have been looking in the wrong direction and going the wrong way. The problems that we are facing have been predictable for a very long time. This is what they should have been paying attention to - it is the url to an essay I wrote on Nottingham's economy in 2004, 4 years ago.

 http://www.bgmi.us/web/bdavey/NottmDebtfuel.htm

Yours sincerely

Brian Davey (writing in a personal capacity)

Brian Davey
- e-mail: Brian.Davey@cooptel.net

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