Viking accounting

Just before last weekend’s election, the FME (Iceland’s Financial Supervisory Authority) received two reports on the health of to “New” banks (New Kaupthing, NBI and Íslandsbanki), one from accountant Deloitte and the other from management consultants Oliver Wyman. The reports have not been made public, but were leaked to Morgunblaðið, whose article has been translated by Anya. Apparently, 40% of the assets of the new banks are “non-performing”: ie, they consist of loans which are not being paid back.

While 40% of worthless assets may seem a lot, it is actually far less than the FME's initial estimates. These were not made public either, although we know some details thanks to the IMF. The FME wanted to write off 66% of Kaupthing’s Icelandic loan book and 50% of Landsbanki’s (later upped to 55%). The FME didn’t dare give an exact figure for Glitnir, but crossing the FME's figures with Glitnir's 2008Q2 financial statement suggests that they were working on a 75% write-off! “We do not intend to pay the debts of banks that have been a little heedless” toned central bank chairman and former Prime Minister Davíð Oddsson on 7 October, in comments that are widely suspected of having prompted the UK government to freeze the British assets of Landsbanki. For a while, it appeared that the Icelandic authorities didn’t expect individual Icelanders and Icelandic companies to pay their debts either.

Icelanders built up household debts of more than twice their disposable income in a credit frenzy fuelled by their banks’ foreign borrowings, making Americans, with household debts of “only” 134% of disposable income, seem positively virtuous in comparison. Iceland’s companies went even further: corporate debt is more than three times GDP, compared to 77% in the eurozone. An old British adage runs that if you owe the bank a thousand pounds you have a problem, but if you owe the bank a million pounds then the bank has a problem. If so, Iceland’s new banks have a very big problem.

The new banks were set up to take on the assets and liabilities in Iceland, and the assets (mostly loans) far outweigh the liabilities (mostly deposits), at least in book value. But how much are those assets actually worth? The question is doubly important because the new banks have to compensate their predecessors for the net value of the assets. That money will then help pay the old banks’ overseas creditors. The larger the provisions, the lower the net value of the new banks’ assets and the less they will have to pay out to their predecessors. The FME’s provisions amounted to a 4000 billion krónur loss for the foreign creditors of the old banks; the leaked report would put these provisions at nearer 2500 billion krónur. The difference – roughly the size of Iceland's GDP – would have to made up in part by increasing the capital of the new banks.

The valuation of the assets of the new banks was supposed to be completed with ninety days: it has dragged on for more than twice as long. Yet it is absolutely fundamental to any recovery plan for the Icelandic economy. Until the initial balance sheet is known, there can be no capital injection into the new banks, no restructuring of loans, and no sale of assets to pay off the debts. One can only hope that the new government will move swiftly to publish the relevant parts of the reports after the holiday weekend: to do so might be politically painful within Iceland, but it is essential for regaining Iceland's international credibility.

***UPDATE*** (Saturday 2 May)
See also this press release from the Ministry of Business Affairs and this article in today's Iceland Review.

Jekyll and Hyde

There were a couple of bits of good news from Kreppaland this week. Firstly, the assets of Kaupþing banki h.f. are reckoned to be enough to pay off German depositors in Kaupthing Edge. The Kaupthing Edge accounts in Germany were operated under the disastrous "branch" model chosen by Landsbanki for its Icesave accounts, rather than the more conservative "subsidiary" model that Kaupþing chose for most of its overseas retail markets. The news from Kaupþing's Icelandic administrators is equivalent to €1.2 billion that the Icelandic state will not now have to take on in short term loans: Prime Minister Jóhanna Sigurðardóttir was justifiably pleased at last week's annual meeting of the Central Bank.

A second piece of good news came from the United Kingdom. The administrators of Landsbanki's Scottish subsidiary Heritable Bank plc reckon that uninsured depositors (mostly UK local councils) will get 70–80% of their money back. As a spokesman for Kent County Council put it, they'd have lost more money had they invested their reserves on the London Stock Exchange.

The news about Heritable Bank didn't cause many ripples in Reykjavík, for reasons I'll come to in a moment. However Iceland's finance minister and tireless promoter of relations with Norway, Steingrímur J. Sigfússon, was ready with a comment: "It is very positive that there are valuables at hand but it does matter how they are disbursed of the interest of the nation."

The problem for Steingrímur Jóhann is that these "valuables" are not available to be disbursed "of the interest of the nation". Heritable Bank was a subsidiary of Landsbanki h.f., or to put it another way, Landsbanki was Heritable's shareholder. Shareholders are always the last to get paid in a liquidation and, if depositors are only getting 70–80%, it seems very unlikely there will be anything left afterwards. As a Scottish company, Heritable Bank was a full member of the UK Financial Services Compensation Scheme, which picked up the £500 million deposit insurance bill but which will also be reimbursed at "70–80%". The only benefit to Iceland is a bit of good press, and a reminder that the banks had (and have) assets as well as debts, but even that is welcome these days with all sorts of ludicrous claims being exchanged in multiple fora.

Now Steingrímur Jóhann is a geologist, not a lawyer, but one would hope that he understands the principle of limited liability corporations, especially given his current job. Icelandic Wikipedia doesn't have an article on them, but I found this one in Nynorsk if it helps him at all… After all, it's hardly the first time he's put his foot in it in less than three months as finance minister, a job that one would think is pretty important (not to say hellishly difficult) in today's Iceland.

On the other hand, like the character from the Robert Louis Stevenson novella, Steingrímur Jóhann has another side to his (political) personality. As well as being finance minister, he is also minister of fisheries and agriculture, a subject dear to puffins!

Steingrímur Jóhann's party, the Vinstrihreyfingin–grænt framboð (Left–Green Movement) were long ridiculed by "those who decide[d]" for Iceland: until, that is, the kreppa came and people started to realise that the old decisions were not as sensible as had been claimed. Steingrímur Jóhann was born on a sheep farm in Northeast Iceland, and already had experience as agriculture minister (1988–91), but was still taking on one of the more conservative sectors of any society from the position of leader of the "loony left". And, despite all the anxiety which surrounded his appointment, he has done remarkably well at the helm.

His predecessor in the fisheries ministry left a poisoned chalice in the form of a controversial set of fishing quotas, especially for the section devoted to commercial whaling. Steingrímur Jóhann sensibly decided not to take on the powerful fishing lobbies in a head-to-head, saying that there were probably more important things for the nation to be arguing about, but neither did he simply dodge the argument. In one of his last acts before tomorrow's election, he has commissioned a study of the contribution of whaling to the Icelandic economy, which many believe to be zero if not negative. He has calmly cooperated with the European Commission in their review of the EU Common Fisheries Policy – possibly a far more effective way to insure the future of 8% of the Icelandic workforce than any hypothetical hardball negotiation.

The last opinion polls suggest a clear victory for the parties of the current coalition government, and hence a clear break with the hegemony of Sjálfstæðisflokkurinn (Independence Party). But as Heilög Jóhanna prepares her new government, she will still have to take account of grubby little demands like "another job for one of ours!" or "the best job for me!" I can only hope that she manages to place as many ministers as possible with portfolios that they will do well. That means removing finance from Steingrímur Jóhann, but keeping him as fisheries and agriculture minister. The next few days will really show the commitment of Iceland's political class to move ahead together for the good of the country – or not as the case may be.

IgNobel nominations (3)

(continued from this morning's post)


Mr. Sigurður Einarsson, former Chairman of Kaupþing banki h.f., Reykjavík, Mr. Björgólfur Guðmundsson, former Chairman of Landsbanki h.f., Reykjavík, and Mr. Þorsteinn Már Baldvinsson, former Chairman of Glitnir banki h.f., Reykjavík, for their studies on high-leverage banking in a small economy.

This nomination is for a long-term study whose pertinence is only now becoming apparent. It began around 2003, with the deregulation of the Icelandic banking sector under the government of Davíð Oddsson (see separate nomination). It is useful to recall some “vital statistics” from that period:

• Bank lending to the domestic sector: ISK 698.3bn
• Credit system total lending: ISK 1,970.9bn
• Króna M3: ISK 393.6bn
• Central Bank of Iceland policy rate: 5.8%
• Króna exchange rate index: 126.6
• Estimated labor force: 154,600

The small size of Iceland’s economy was an obvious handicap to the three commercial banks in their plans for expansion. All three decided that would have to set up operations in places where there were more people if they ever wanted to earn more money (and who doesn’t?). But, for the very same reason that they wanted to expand abroad, they didn’t have the money to do so: so they borrowed it.

The three banks set up, bought or maintained operations in at least ten jurisdictions of the European Economic Area, as well as in Switzerland, the Isle of Man, Guernsey, Canada, the USA and Japan. These operated either as branches or as subsidiaries, and offered the normal range of banking services, especially (but far from exclusively) to Icelandic companies. However the range of lending opportunities was somewhat limited in these mature banking markets, so much of the money was lent instead in the ‘captive’ Icelandic market, as can be seen from the “vital statistics” at the end of 2007:

• Bank lending to the domestic sector: ISK 3,004.5bn
• Credit system total lending: ISK 5,386.4bn
• Króna M3: ISK 1,145.2bn
• Central Bank of Iceland policy rate: 13.75%
• Króna exchange rate index: 121.8
• Estimated labor force: 169,600

Such a business strategy creates obvious exchange rate risks – the banks were buying króna assets (loans) with liabilities in euros and dollars. Fortunately the banks were able to use two devices that they did not themselves invent: lending at index-linked interest rates and lending in foreign currencies. The latter obviously transfers the entire exchange rate risk to the bank’s client. To understand the former, it is sufficient to note that the Icelandic consumer price index is approximately half-composed of imported products: hence, in this case, half the exchange rate risk is transferred to the client. It should also be mentioned that the króna remained strong throughout most of the study, thanks to the high nominal interest rates imposed by the central bank in an attempt to stem the inflation caused by the commercial banks’ lending.

Nevertheless, the commercial banks felt obliged, from 2006 onwards, to seek alternative funding sources, and so started taking deposits in their overseas markets. Again, they were helped in this by the high nominal interest rates in Iceland that they themselves were maintaining by their business strategy. The Icelandic banks could offer extremely competitive interest rates to depositors in the rest of Europe because they were using the money to lend in Iceland. At the end of 2007, the three commercial banks had deposits of ISK 3,465bn and borrowings of ISK 5,198bn: these figures are 268% and 402% (respectively) of Iceland’s 2007 gross domestic product.

As the interbank lending market dried up in 2008, the banks found it increasing difficult to roll over their borrowings. They continued to expand their overseas deposit-taking operations – the last such operation was set up by Landsbanki in Austria on September 4th, 2008 – but were increasingly dependent on the fickle confidence of their overseas clients. The króna as well seemed to lose the confidence of international investors, along with 35% of its value, between January and September 2008. Our final snapshot of the “vital statistics” is from just before the collapse of the Icelandic economy:

• Bank lending to the domestic sector: ISK 4,827.4bn
• Credit system total lending: ISK 6,731.4bn
• Króna M3: ISK 1,230.3bn
• Central Bank of Iceland policy rate: 15.5%
• Króna exchange rate index: 151.8
• Estimated labor force: 148,600

All three commercial banks collapsed within the space of less than a week in early October 2008. Their Icelandic operations were ring-fenced off in an attempt to preserve some semblance of a domestic banking system: the domestic assets (ie, loans) of the banks exceeded their domestic liabilities (ie, deposits) by at least ISK 3,714bn, or 287% of Iceland’s 2007 GDP. The new banks were forced to provision against the non-repayment of between half and two-thirds of the value of these loans. All the same, the Icelandic government has had to supply capital equivalent to 30% of GDP, while the new (state-owned) banks start life with liabilities to their predecessors’ (mostly foreign) creditors of 90% of GDP. Deposit insurance liabilities in the UK, the Netherlands and Germany are estimated at €3.8bn: given the current uncertain value of the Icelandic króna, it is impossible to express this figure as a proportion of GDP, but it is at least half Iceland’s 2007 output. Another €2bn is trapped in “glacier bonds” – private, króna-denominated debt sold to offshore investors attracted by the high nominal interest rates – waiting for currency controls to be relaxed.

It could be said that any Ig Nobel Prize should be shared more widely. Perhaps an Ig Nobel Special Mention could go to the anonymous managers at Glitnir who allegedly engineered an unauthorized loan of €47 million for their bank from the Norwegian government; or the anonymous manager at Landsbanki who allegedly transferred €695,000 into his personal account in order to “save deposits”: but these cases are currently before the courts where they belong. I could nominate Mr. Geir H. Haarde, Prime Minister of Iceland 2006–2009 and finance minister 1998–2005; Mr. Björgvin G. Sigurðsson, minister of “business affairs” (with responsibility for banking) from 2007 until January 2009 or his predecessor Mr. Jón Sigurðsson… but an Ig Nobel Prize is traditionally reserved for “achievements”, and so it seems inappropriate to honor these people for simple inactivity, no matter how essential that inactivity was to the pursuit of the studies in question.

I shall rest my case, believing that I have shown that the nominees have indeed made “achievements that cannot or should not be reproduced” in their field (even if the exact field were not their chosen one) and hoping that the Distinguished Members and the random passer-by will agree with me.

(data from the Central Bank of Iceland, the International Monetary Fund and the 2007 Annual Reports of Kaupþing banki h.f., Landsbanki h.f. and Glitnir banki h.f.)