In the panic that gripped global financial markets after the collapse of Lehman Brothers, these banks were faced with a wholesale run on their foreign currency liabilities and were therefore heading towards a default on those liabilities in the absence of LOLR assistance in foreign currency. However, given the size of the banks, it was impossible for the Icelandic authorities to provide such assistance on their own. There was actually a plan to nationalise one of the banks in late September 2008. Fortunately it failed, as nationalising the bank would have turned a private bank’s foreign currency refinancing problem into a sovereign problem, with the serious risk that the sovereign might have defaulted on such foreign currency payments, thus initiating a full-scale sovereign debt crisis. Figure 2 gives a sense of the potential scale involved in the case of the three banks, by comparing the foreign currency liabilities of the banks and the Central Bank’s FX liquidity at the time. Figure 2  2  BIS central bankers’ speeches  Based on published financial accounts and the analysis of the supervisor, the Icelandic authorities assumed that the banks were solvent. On that premise, the authorities tried to build defences against potential foreign currency liquidity problems at the banks by negotiating swap lines and tapping foreign capital markets, in both cases with limited success. Now, however, we know that there were hidden vulnerabilities in the banks’ capital positions. However, given the lack of international cooperation, the Icelandic authorities were forced to consider radical solutions.
This effort has been sufficient to create a primary surplus and, along with growth in the economy from H2/2010 onwards, to put debt on a downward trajectory as a share of GDP, which is predicted to be 85% gross and below 60% net in 2015. But this has not come without significant pain, and again, would not have been possible if private bank liabilities had been guaranteed more than was needed to keep the domestic payment system and basic banking services up and running. Let me conclude by summarising some of the potential lessons from this tale: 1. Iceland did not allow its entire banking system to collapse, it did not nationalise its banking system, and it did not default on sovereign debt. So, in spite of what one sometimes hears, the Icelandic case does not teach any lesson on the pros and cons of such measures. 4  BIS central bankers’ speeches  2. Iceland avoided sovereign default through a good initial fiscal position, the ringfencing of the sovereign as much as possible from collapsing cross-border banks, and a medium-term fiscal consolidation programme. The lesson is to practise fiscal prudence and avoid the socialisation of private sector losses. 3. Iceland protected its domestic payment system and deposits. The lesson might be bail-in, separability in resolution between the public utility element of banking from the rest, and deposit preference. 4. The EU system for cross-border banking is deeply flawed.