In a word — quite possibly insolvency.
The full English version of the investigative report into Iceland’s banking collapse is not yet available on the special committee’s website, due to “unexpected difficulties.”
However, Appendix 3: Iceland’s failed banks – a post-mortem, by Mark J Flannery of the University of Florida, and in English, is enough to keep anyone enthralled concerned terrified.
It’s also enough to make one wonder — why didn’t more people see the collapse coming?
To wit, the extraordinary growth of Iceland’s banks in the run-up to the financial crisis. Not only, according to the report, were they posting a year-on-year organic growth rate of 51 to 36 per cent between 2004 and 2007, they were simultaneously reporting amazingly high profitability and capital:
That last chart is worth a few extra words from Flannery:
Remarkably, the Icelandic banks’ high Return on Equity [ROE] was accomplished with very high capital ratios … In each sample year except 2007, the Icelandic mean return on assets was at least double that of the other Nordic banks. Put another way, in the same markets and under the same world financial conditions, the Icelandic banks had found a way to earn substantially more than their more experienced, overseas competitors. Moreover, these higher earnings were attained with a higher cost of funds, because the Icelandic banks relied more heavily on relatively expensive wholesale funding.
How were they doing this?
For a start — on the capital point — they were issuing quite a few subordinate or hybrid bonds.
In other Nordic countries such instruments, which have characteristics of both debt and equity, were allowed to comprise no more than 15 per cent of banks’ Tier 1 regulatory capital. In Iceland, as of 2005, they could comprise 33 per cent. Iceland’s banks duly maximised that allowance.
But you still have the suggestion by Flannery that there was something else going on.
Capital quality aside, with such rapid expansion you might have expected a deterioration in loan quality — and that would show up in the banks’ books as a big flashing warning sign. Instead, Icelandic banks reported quite steady loan loss provisioning between 2002 and 2008, with even a dip in 2006-2007.
Here’s what Flannery says:
The average allowance for loan losses [ALL] occupies a central place in presenting a bank’s financial results. Bank accounting standards give managers substantial discretion in recognizing credit impairments, and these recognitions can have a first-order effect on a bank’s apparent condition. An under-stated ALL not only misleads outsiders about the quality of the bank’s assets, but it also generates artificially high reported earnings.
As it is, some people did see potential trouble brewing for Iceland’s banks, based on the whiff of something suspicious among those loans, and a general lack of disclosure.
It’s all further discussed in part II of our Icelandic epic.
Related links:
Iceland’s theatre of financial horror – FT Alphaville
Put-upon Iceland’s latest woes – FT Alphaville
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