To paint with a broad brush, we can say that economic and financial developments in Iceland during the last decade or so are a combination of two separate but interrelated stories. On the one hand, there is Iceland’s boom-bust cycle and problems with macroeconomic management in small, open and financially integrated economies. This is a well known story that has played out in Iceland and other countries several times. On the other hand, we have the story of the rise and fall of three cross-border banks operated on the basis of EU legislation (the European “passport”). That story, at least for smaller countries, is much more unique than the first. In my remarks today, I will concentrate mostly on the second story, which is probably more suited to this audience, as I understand that the conference is oriented towards microeconomics and finance. However, it must be remembered that although these two stories are different, they interact in important ways. Thus the unsustainable boom that Iceland experienced during the years 2005–2007 was fuelled by a combination of favourable external conditions, macroeconomic mismanagement, and aggressive domestic bank lending. It may well be that the banks’ international activities and the easy access to foreign credit that came with those activities fuelled stronger growth in domestic bank lending than would have occurred in a more traditional small-country banking system.
This problem was significantly mitigated with the FX swap lines that the US Fed negotiated with the ECB and other major central banks, especially after these became uncapped in some cases. But the problem was not confined to currency pairs involving the US dollar, and a similar kind of dynamic played out for smaller currencies in Europe vis-à-vis the euro, especially where banking systems had significant short-term foreign refinancing needs, or what can also be called rollover risk in terms of foreign currency. In some cases, FX swap lines were granted vis-à-vis the dollar, the euro and the yen, and in some cases not. Where swap lines were granted, it helped. And for some of the smaller players, it might not have mattered terribly much which of the major international currencies they hooked on to in this sense, especially after the uncapped swap lines had been established. What we observed during this peak of the crisis was thus a run on cross-border banking operations. We know how to solve such problems domestically by letting central banks lend to markets and/or institutions through their almost unlimited short-run capacity to expand their domestic balance sheet. However, when it comes to foreign currency, a central bank’s capacity to help banks to refinance the foreign liquidity denied them on the market is limited by the size of its reserves or the willingness of its big neighbours to help. This is what did the Icelandic banks in.