In May 2008, the central bank entered into swap agreements with other Nordic central banks, in an effort to secure liquid foreign exchange should the need arise. In September, the government borrowed 300 million Euro to further boost reserves. At the same time, the central bank had been increasing liquidity provision, easing rules on eligible collateral (including by accepting uncovered bonds from banks) and reducing reserve requirements. But renewed global pressures in late September led to a swift loss of investor confidence in the Icelandic economy and financial system, and a massive depreciation of the króna. The three main banks could not secure payments for their due obligations, and the government decided to promptly intervene rather than to continue what was considered to be an eventually unsustainable process of supporting the three banks.“ As I have already mentioned, the Central Bank responded to developments and prospects in 2008 by monitoring the banks’ liquidity even more frequently and maintaining close contact with them. In addition, the Bank’s contingency committee had been mobilised and worked continuously from the fall of 2007 onward. The advisory committee from the Prime Minister’s Office, Ministry of Finance, Ministry of Business Affairs, Financial Supervisory Authority, and Central Bank met frequently and exchanged information. The committee prepared contingency plans and had a legislative bill drafted – the bill that later became the emergency legislation passed in early October. It is obvious that the banks had become too large in relation to the Icelandic economy.
The Icelandic banking sector experienced a dramatic expansion in just a few years, funded by cheap foreign financing, which allowed it to boost its assets from 100 to almost 900 percent of GDP between 2004 and end-2007. This expansion made the Icelandic banking system one of the largest in the world in relation to GDP. As global conditions deteriorated in early 2008, banks’ CDS spreads rose to unprecedented levels. In response, banks slowed lending growth, enhanced liquidity buffers, reduced costs, and started a process of downsizing non-core operations and laying off staff. But their ability to deleverage was limited by the global risk aversion. A recent FSAP update and Article IV Consultation conducted in June 2008 pointed to several risks that were mounting throughout 2008: (i) liquidity and funding risks, associated with the banks’ reliance on market funding and their large funding needs over the short run; (ii) credit and market risks, resulting from foreign currency, equity exposures, and high indebtedness of domestic borrowers, as well as collateralized lending, connected lending, and large exposures; (iii) operational risks, associated with the banks’ rapid expansion in recent years; and (iv) quality of capital risks, related to complex ownership structures. In this light, the Staff Report concluded that “if risks were to materialize in full, Iceland could face severe financial strains.” Despite the authorities’ attempts to prepare for contingencies earlier in the year, the crisis brought down the three main banks within a week.