1. Carlos Diaz
10 May 2015
Too Big to Save
The period from 2007 -2011 was an era of catastrophic financial turmoil on a global scale. Many
nations during these years experienced significant economic collapse as central banking institutions,
among other financial institutions, were in a position where it became nearly impossible to finance their
daily operations, resulting in bankruptcy claims and bailouts. One notable crisis amidst this global panic
was the Icelandic financial crisis: a major economic and political event involving the default of the
country’s major privately owned commercial banks.1
Noted as the largest banking collapse by any
country in history relative to its size, the crisis would also lead to a depression as well as political unrest.1
As these banks became “too big to save,” the government saw no other option but to allow them to
collapse resulting in a the downward spiral well-documented today, including a 90 percent plunge in the
stock market and rising unemployment. With a banking sector that exceeded the size of the country’s
GDP by nearly 10 times, this begs the question, where did this all begin?
Background
To understand the causes behind Iceland’s economic collapse, one must look into its economic
history. Over the course of the late 20th
century, Iceland was faced with inflation, high unemployment,
and staggering economic growth.2
As stated in Rok Spruk’s paper, Iceland’s Financial and Economic
Crisis: Causes, Consequences and Implications, “In 1983, after a series of unsuccessful fiscal policy
attempts to cure the persistence of high inflation, the inflation rate reached as high as over 80 percent
annually, all while monetary policy remained in status quo” (Spruk 11). As a result GDP growth was
about 0.3% on average. Soon after World War II, Iceland experienced fluctuations in inflation due to
increases in spending, which led to excessive purchasing power. In an attempt to stabilize the economy
during this time, the central bank increased monetary aggregates while reducing interest rates. This had

2. been done under the assumption that increasing government spending would boost aggregate demand,
furthering growth. In reality, wage increases were being heavily demanded in order to for real
purchasing power. Inflation continued to rise during this period.
GDP Per Capita (1990 – 2015)
Growth and Prosperity
Under the leadership of David Oddsson in 1991 however, new policies were implemented in an
attempt to mitigate these fluctuations and stabilize Iceland’s economy. The reforms included reduction
in government spending, lowering of tax rates on labor and capital, privatization of state-owned
enterprises, liberalization of the labor and product markets, and further economic integration with the
World.2
Although not all reforms were carried out sequentially, GDP did in fact grow by 3.8 percent
between 1995 and 2003, as depicted in the chart. Furthermore, corporate income tax rate had been
declining: 45% in 1991 to 18% in 2001. Eventually, in 2007, Iceland implemented a 22.75 flat tax rate on
personal income. A few key changes during Iceland’s period of prosperity:
 Average household income increased by more than 17 percent

3.  Corporate tax was reduced to 18 percent
 Increase in tax revenue from 0.9% in 1985 to 1.5% in 2003
Among the many reforms implemented by the Oddsson regime was the restructuring and privatization
of the financial sector leading to financial innovation and positive stock market performance. General
government debt had also been reduced. As Spruk highlights,
Gross government debt shrank from 58.8 percent of GDP in 1995 to 27 percent in 2005. There
was also a marked reduction in foreign debt, since the latter is an important indicator given the
high interest rate differential between Iceland and the rest of the world. While in 1996, foreign
debt represented 28.1 percent of the government’s gross debt, it was reduced to 7.7 percent of
the gross government debt in 2006. In 2007/2008 United Nations’ Human Development Index,
Iceland occupied the 1st place. It also had the third longest life expectancy at birth in the World
and its GDP per capita (PPP-adjusted) was the 5th highest in the world. (17)

4. Included in the restructuring efforts was a change in the pension system. In short, a pension plan is a
retirement plan where an employer makes contributions toward a collection of funds that are set aside
for the employee’s future benefit upon retirement. With regards to Iceland’s reform on the pension
system, the government sought to increase retirement age and minimize incentives of early retirement.
Three key components are noted in this system:2
 Guaranteed minimum pension
 Fully-funded and privately managed occupational pension fund
 Individual savings accounts
The significance of this act was due mainly in part by the connection it has with labor market efficiency.
With the incentive to work longer hours and avoid early retirement, productivity, in turn, can grow to a
significant degree.
An Emerging Crisis…
Iceland’s efforts through international integration, acquisitions of foreign assets, and free-
market reforms seemed to have been a major benefit in its economic growth. With its new-found
wealth, investors and ordinary citizens sought new profitable ventures from other nations; meanwhile,
many did not foresee a possible crisis was imminent. In order to evaluate the collapse itself, one must
first analyze the possible “red flags” through previous monetary policies and actions by the financial
sector as well as government.
One possible indicator is again addressed in Spruk’s publication and that is inflation. Just as
previously mentioned, inflation rates had become notoriously volatile in Iceland compared to other
developed countries. During the period between 1980 and 2009, Iceland had the highest average

5. inflation rate of 16.51%. Through analysis of standard deviation, its standard deviation of inflation rate
was about 5 times the average standard deviation in OECD countries (20.45).2
The volatility in Iceland’s inflation rates spans throughout the late 20th
century into the brink of the 21st
where there is a sharp increase between 2007 and 2009, as shown above.
The Banks
Financial institutions, not surprisingly, had much to do with the financial crisis as well. As investment
banking became an important part of their operations into the 21st
century, the three big banks, Glitnir,
Kaupthing Bank, and Landsbanksi, would grow rapidly in total assets reaching ten times the GDP of
Iceland.4
Rannsoknarnefnd Aldingis provides an in-depth look into the financial market in Iceland leading into the
collapse in his work,” Causes of the Collapse of the Icelandic Banks.” Beginning in 2003, where the

6. privatization of the federal banks were in full swing,
banks began to grow both internally, and externally.
With the help of bank mergers, such as Kaupthing and
Bunadarbanki, existing portfolios and operations are
acquired and can, therefore, support the original
operation of those who acquire these institutions.3
However, there are a few issues that come with this
rapid growth: the quality of loans decreases while management becomes poorer, leading to sub-par
loan performance over time.
The above figure shows the growth in lending of the three big banks after the turn of the
century. During this period, these banks started competing with state-owned financial assistance
organizations by offering loans to private households.3
As shown in the graph, lending to foreign parties
was significantly larger compared to other entities: by more than 120% in roughly six months.3
It was

7. due to this rapid growth that the balance sheets and lending portfolios of these banks had grown
beyond their control and resulted in diminishing quality of their loan portfolio as well as a high-risk asset
portfolio.
Over time the Icelandic banks sought capital in foreign markets, namely European and American
debt securities. Because of their good credit rating, they faced no challenges with gaining access to
international financial markets and as a result, all three banks combined acquired about $14 billion in
foreign debt securities markets. The market shrunk significantly from 2005 (12 billion EUR) to 1006 (4
billion EUR);3
yet soon after, the American debt securities market emerged. At around 2008, the risk of
refinancing the banks became more and more significant and the Icelandic banks had to find new ways
to refinance their debt securities that were due as well as their lending practices. Their growth needed
to be restrained because of this.
Borrowing from Within
A look into the borrowing practices of the banks over this period shows that the owners were
among the biggest borrowers as well.3
Glitnir Bank
After a new board in 2007 took over the bank, it just so happened to coincide with parties
related to the companies Baugur Group and FL Group increasing their shares in the bank. Lending to
these companies nearly doubled from 900 million EUR in 2007 to 2 billion EUR a year later.3
Moreover, a
significant portion of that increase went to the biggest shareholder in the bank. Companies working
closely with Bauger and FL Group show similar increases in lending. One can suggest that their influence
as owners played a major part in this increase.

8. The following image depicts the sharp increase in lending by Glitnir to related parties:
Kaupthing Bank

9. Exista hf., Kaupthing Bank’s biggest shareholder, also experienced a sharp increase in loans received, as
shown by the graph:
Landsbanki and Straumur-Burdaras Investment Bank hf.
At the time Landsbanki was privatized, Samson Holding Holding Company was its biggest
shareholder.3
The bank’s loans to them were significant as can be seen in the following graph: As a note,
Mr. Bjorgolfr Guomundsson and Mr. Bjorgolfur Thor Bjorgolfsson owned parts of Samson. The graph
shows the loans from Landsbanki’s parent company to Mr. Björgólfur Guðmundsson.3

10. Based on this information, one begins to question the level of moral hazard through these
institutions as their owners are also among their biggest borrowers; a conflict of interest that arose due
to these owners/borrowers benefitting from their level of influence offering them more access to these
banking functions and getting better deals. It is therefore a reasonable judgment to be weary of the
possibilities of immoral practices within banks because of their privatization. In hindsight, according to
the Special Investigation Commission (SIC), the owners of the three big banks had “an abnormally easy
access to loans in these banks, apparently in their capacity as owners” (Alpingis 10).
When the banks became constricted as the autumn of 2007 and the year 2008 wore on, it
seems that the boundaries between the interests of the banks and the interests of their biggest
shareholders were often blured and that the banks put more emphasis on backing up their
owners than can be considered normal. (10)
Just as previously mentioned, it was no surprise that the relationships among bankers and
regulators proved to be a weakness within Iceland’s financial sector. With Iceland being a small nation
in general (approximately 300,000 people), this might be viewed as inevitable; for example, the Prime

11. Minister and Central Bank Chairman at the time was held by one man, David Oddsson.4
Furthermore,
with the rapid growth and lending practices of the three big banks spiraling out of control, as depicted in
the graphs, foreign denominated debts grew to about eight times that of the nation’s GDP.4
Banks’
stocks had risen to about 75 percent of Iceland’s stock market value as well.5
As for the three banks themselves, Glitnir, from heavy borrowing through expansion,
accumulated about 600 million EUR in debt; in addition to that, 150 million EUR needed to be paid as
part of a loan with German bank, Bayerische Landesbank. A total amount Glitnir could not pay in time.5
Landsbanki, being a magnet for foreign savers, experienced severe liquidity problems after
British depositors withdrew about $272 million in deposits.5
Kaupthing experienced a freeze in foreign assets due to the invocation of anti-terror laws by the
U.K. government after the Icelandic government guaranteed a higher level of deposits for Icelanders but
not foreigners.5
Beginnings of the Crisis
Iceland’s national currency, krona, had declined in value well through 2008 and its reason can be
traced back to the central bank’s response to the soaring inflation rate leading up to its collapse. With
the rise in inflation, the central bank raised the general interest rate as a response. As a result, domestic
firms and households began to borrow in foreign currency.2
High interest rates within Iceland, in
comparison with the rest of the world, cause speculation and the risk of over-appreciation. In general,
appreciation is defined as an increase in the value of an asset over time. This increase can occur for a
number of reasons, one of them being a change in interest rates; the case with Iceland. Foreign
borrowing and the inflow of foreign currency grew as the Icelandic krona grew rapidly.5
The bubble of
economic growth expanded further and further and as new sectors emerged through this boom period,
foreign currency became a significant part of the money supply. The risk of over-appreciation of the

12. krona was bound to happen. Instead of increasing federal reserves as an insurance against the
possibility of depreciation, the central bank did not choose to act on this “red flag.”
In conjunction with the financial crisis in 2008, the depreciation of the krona was an inevitable
scenario. It eventually took a nose dive in value with the collapse of Lehman Brothers in the U.S. as
America experienced a crisis of their own. Combined with the massive amounts of debt in foreign
currency owed by the three large banks, Iceland was in deep trouble. The banks were unable to meet
their maturing short-term obligations with the severely depreciated Icelandic krona.4
In summary,
The main concerns for the instability of the Iceland’s financial sector were extensive foreign
currency funding, overdraft spreads of credit default swaps, high interest rate differential
between Iceland and the rest of the world and an increasing stock of debt which emerged from
increased financing of mortgages. (Spruk 28)
As the national currency depreciated in value, inflation increased and in 2009, the inflation rate grew to
18.6 percent. With their banking system being a huge risk as the central bank could not have possibly
been a lender in an effort to mitigate the continuing financial deterioration, one possible solution
highlighted by Spruk was a relocation of foreign currency-based financial activities abroad in order to
avoid the interest risk.2
However, high interest rates were maintained and inflation rates remained
consistently high bringing a supply side shock to the private sector a collapse of the banking system. The
banks were forced to a state of bankruptcy.
Now in the midst of a financial crisis, outlook on Icelandic government bonds were downgraded
to Baa negative by Moody and similarly, Iceland’s sovereign debt had been reduced to a BBB rating by
Fitch.2
In addition, foreign-denominated mortgages became impossible to pay off with the Icelandic
krona.

13. Restructuring
The crisis was a major cause for the restructuring of Iceland’s financial sector. Organizations
involved included the central bank, fiscal authority (Finance Ministry), and the Financial Supervisory
Authority (FME). With Glitnir Bank, one of Iceland’s three banks, the FME acquired a 75 percent stake in
the bank.5
In about one week, laws were passed that enabled the FME to take over the banks and
through this, Landsbanki and Glitnir became formally nationalized.5
Kaupthing was eventually forced to
government takeover as well. Three new banks were created to continue regular operation, while the
older banks were used to handle foreign deposits and assets. Further reconstruction efforts include
securing $2 billion in loans from Denmark, Norway, the Faroe Islands and Poland as well as a $2.1 billion
economic stabilization program developed by Iceland and the International Monetary Fund, IMF, in
order to prevent further depreciation of the krona.5
This of course added to the nationwide debt of
Iceland’s economy, which was a central threat to a successful recovery. This, however, was an
inevitable outcome as a result of organizational efforts to reestablish financial stability.
Moving Forward
The International Monetary Fund Survey conducted an interview with Peter Dohlman, IMF Mission Chief
for Iceland, in March of 2015 looking into Iceland’s financial collapse in 2008 and the steps taken to
ensure a recovery was attainable. A few indicators were pointed out that gives a sense of their
economic picture today.6
 Iceland has been one of the top economic performers in Europe over the past several years in
terms of economic growth and has one of the lowest unemployment rates6
 Low inflation, stable exchange rate, and ready market access. Iceland’s strong balance of
payments has allowed it to repay early all of its Nordic loans and much of its IMF loans while
maintaining adequate foreign exchange reserves.6

14. One can see, based on this graph, Iceland’s economy experiencing a growth post 2009, reaching an
average rate of about 2.5 percent.
Conclusion
Looking back to Iceland’s economy before, during and after its financial collapse, one would
begin to wonder what led to these severe fluctuations. Through more in-depth research into their
financial practices, the “red flags” leading to the crisis becomes clearer. We can look back to when
the state-owned companies were privatized and financial markets were liberalized. Since then,
many monetary policies initiated at a federal level seemed questionable. After rising inflation rates
hit the economy from 2002 and on, interest-rates were raised by the central bank to combat it. This
led to rapid appreciation of the Icelandic krona discouraging the domestic banking sector from
borrowing in domestic currency. Moreover, households, firms and banks, felt more inclined to
borrow in foreign currency.
The second major issue was that of Iceland’s three major banks: Glitnir, Landsbanki, and
Kaupthing. As shown before, these banks expanded their operations and activities to foreign
markets after privatization was passed. Lending increased significantly; the bank’s assets and
liabilities grew and soon exceeded the size of Iceland’s economy 10 times over. After these banks

15. became too big to save, Iceland’s financial sector gave in leading to a state of crisis. It can be argued
as to what the main causes of the collapse were, however research points to lack of proper policies
in order to regulate the practices of these banks as one that most certainly led Iceland into the
wrong direction.