Continued from part I, in which FT Alphaville first discusses a portion of the investigative report into Iceland’s banking collapse written by Mark J Flannery.
In 2006, something very worrying for the Icelandic banking system took place.
Analysts and ratings agencies began to issue notes like the below:
“The credit boom in Iceland gives most cause for concern … the risk is that if the credit cycle turns and equity and property prices fall sharply, banks will suffer a deterioration in loan quality with an adverse impact on financial performance. Icelandic banks, through a combination of direct equity holdings and collateralised exposure to Icelandic corporates, have a relatively large exposure to the small and volatile stock market. ”
- Fitch Ratings, February 6, 2006
“At this stage, we have very poor visibility … as to how asset quality may evolve at the banks. However, we do have some concrete reasons to be concerned about the impact of a cyclical change in the credit cycle at the Icelandic banks.”
- Merrill Lynch, March 7, 2006
“… in terms of big risks to the banks themselves, we think they are (assuming the funding holds) the crossholdings and related party and equity based lending. Given the small domestic market, it is perhaps not surprising that there is some level of cross-holdings among the major investment companies, corporates and banks, but we are surprised at the level.”
- JP Morgan, March 24, 2006
So began a mini-Icelandic banking crisis; one which hampered the funding abilities of Iceland’s financial institutions all the way until 2008 — when the collapse of Lehman Brothers in the United States prompted their ultimate downfall.
You can see the effect of the funding crisis here, but suffice to say that the market had suddenly woken up to some of the structural problems inherent in Iceland’s financial system.
Why the abrupt realisation?
JP Morgan had a nice explanation, included in Flannery’s report:
“… as these issuers were too small and their bonds were off-benchmark for the majority of funds. More recently the firms have grown to a size where their funding needs dictated a much bigger presence on the international debt markets and have consequently attracted more attention. More importantly, an active CDS market has developed and this has allowed people with strong negative opinions to exercise their views. ”
The banks dealt with the new-found funding crisis in a few ways.
Most significantly, some of them began seeking more deposits — including from the UK — to alleviate their reliance on wholesale markets. They also borrowed from their own central bank, and sought non-krona-denominated assets from the European System of Central Banks, via their Luxembourg-based subsidiaries.
But efforts to sooth the market didn’t make much of an impact; those lingering questions about credit quality remained in investors’ minds, even as reported loan losses and provisions at Icelandic banks remained relatively flat.
Here’s what Flannery concludes:
The proximate cause of the Icelandic banks’ demise in October 2008 was their inability to access funds in wholesale debt markets. This was a problem shared by many major financial institutions in the wake of Lehman Brothers’ collapse. However, the Icelandic banks were particularly vulnerable to such a market disruption because of issues first raised by outside analysts in early 2006. Even with such clear warnings, the banks had not managed or communicated their situations very effectively to world financial markets.
Probably their most serious omission was their inability to convince outside investors that they were following conservative loan underwriting standards. (Perhaps they were not.) Although their accounting statements showed high asset quality, high earnings, and high capitalization, all three of these characteristics depended on an important managerial judgment: the accuracy of the banks’ loan loss allowance. As the Icelandic economy deteriorated (and later as the European economies also weakened), the three big Icelandic banks reported no increase in their expected loan losses. This reflected either extraordinary underwriting standards or a reluctance to admit that problems were building up. Which was it? The answer to this question was particularly important for banks relying so heavily on wholesale debt markets. It seemed very likely that the banks would suffer some losses after their rapid loan growth, but the books reflected nothing. Fixed income investors can deal with most uncertainties provided they know the potential risks. Nevertheless, the Icelandic banks left investors to wonder: “How bad is the situation, really?”
The follow-on question from uncertainties surrounding loan quality has to be; were the banks actually solvent when Iceland’s Financial Supervisory Authority finally took them over from October 2008?
To that end, accountancy firm Deloitte produced some interesting estimated values for the banks’ assets post-takeover, though these where never accepted as valid by all the parties concerned.
Thus Flannery is left to speculate:
In the end, we cannot establish definitively whether one or all of the banks was in fact insolvent during that first week of October. However, their increasing loan delinquencies after March 2008 and the low recovery values implied by the FME’s ultimate settlement with the Old (receivership) banks imply that insolvency was a good possibility even before the banks encountered their terminal funding crises. One is left with the strong suspicion that some or all of the banks were insolvent – and hence that the market’s unwillingness to lend was rational.
Related links:
Shadow bank losses – FT Alphaville
Icelandic leaders accused of ‘negligence’ – FT
Iceland’s crisis “just like Madoff”, judge says – FT Alphaville
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