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.

Get this man a job!

Thanks once again to Anya the eyes for finding exactly the sort of absurd news stories which appeal to the Ministry of Puffins. Apparently a certain Halldór J. Kristjánsson is thinking of leaving Iceland to try to find gainful employment abroad. Sadly, there's nothing unusual about that these days, with unemployment up 650% in the last twelve months. Halldór says he wants to work in the financial sector, so I guess it makes sense to look for work in a country which actually has a financial sector – somewhere like Albania, for example, which this week managed to apply for EU membership, a feat which seems beyond Iceland's political class.

Does Halldór have any experience in this type of work? Well, that depends what you count as "experience". Until 8 October 2008, Halldór was chief executive of Landsbanki: he lost his job when the Icelandic government had to take over the bank. His disastrous scheme of taking deposits in Britain and Holland and lending them to Icelanders without the means to repay them has cost the country thousands of billions of krónur. Unsurprisingly, he has been unable to find steady employment in Iceland since he bankrupted the country (with a little help from his friends), hence his search abroad.

Still, it pains me to think of Halldór sitting doing nothing in Reykjavík, using social security benefits which could go to more deserving causes, so the Ministry of Puffins is making this appeal: if you know of a job, preferably a long way from Iceland, that Halldór could do, please let us know, and I'll do my best to pass on the information.

I'll start the ball rolling with a job offer I found from a company at 41/42 London Wall, in the heart of the City of London (postcode EC2M 5TB, telephone +44 20 7638 7787): Halldór can even apply online here… i'm lovin' it®

On glacier bonds and Frankfurters

On the eve of today's elections the newspaper Morgunblaðið (linked to Sjálfstæðisflokkurinn, the "Independence" Party, as are many of the Icelandic media) published a report, translated at NewsFrettir, on the glacier bond problem. See "More euro madness" and "How much is a króna worth?" for the Ministry of Puffins' take on the issue.

Morgunblaðið claims (quite plausibly in my opinion) that the European Central Bank has been left holding 100 billion krónur in these once-cool financial instruments, money which is now trapped behind behind Iceland's currency controls. That's about one-fifth of the total outstanding value of the glacier bonds, according to several estimates seen by the MoP. The ECB accepted the bonds – 57 billion krónur in Íbúðalánasjóður (Housing Finance Fund) bonds, 28 billion krónur in Iceland treasury bills and 15 billion in króna-denominated bonds issed by Dutch bank RaboBank – as collateral for a euro loan to Landsbanki Luxembourg S.A., a subsidiary of Landsbanki h.f. which is now in suspension of payments.

Less plausibly, Morgunblaðið also claims that the interest payments on glacier bonds are driving down the króna exchange rate. Foreign investors are allowed to convert króna interest payments into hard currency under the currency controls; only the principal (capital) is locked into Iceland. But with some 500 billion krónur in glacier bonds, even the interest payments are a significant drain on Iceland's foreign currency. Significant, yes, but nothing compared to Icelandic domestic debt – 4827 billion krónur according to the latest available figures, of which a whopping 60% is denominated in foreign currencies according to the IMF. Although the foreign-currency loans to households (with no foreign-currency income) represent the pinnacle of stupidity, these are only a small proportion of the total: most of these loans are to Icelandic businesses. The hard currency which goes on paying off these loans can't be used for other things, like paying for imports, so the businesses have to buy more hard currency for squidgy-soft krónur, which pushes the value of the króna down.

Don't expect to hear any of this from Sjálfstæðisflokkurinn in the foreseeable future: it's simply more than they could humanly bear, to admit that sold the independence that they pretend to cherish so dearly, all for a fist full of euros (no less!).

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.)

Dreamland (1)

Draumalandið ("Dreamland" in English) opened in Reykjavík a couple of weeks ago. It's not a fashion store (who'd open one of them in Iceland these days?), it's a film based on the book of the same name by Andri Snær Magnason. The book is available in English, translated by Nicholas Jones and published by Citizen Press, ISBN 978-0955136320.

Both the book and the film tell the story of the Kárahnjúkavirkjun power plant in East Iceland, a 690 MW hydroelectric power station built to serve a new aluminium smelter in Reyðarfjörður… at a huge cost. You can find English comments about the film at the Iceland Weather Report and at Economic Disaster Area. Alda in particular claims it to be "quite possibly the most important Icelandic film ever made".

So what is all the fuss about this documentary (whose subtitled trailer you can find here)? Well the project was (and is) very controversial in Iceland. It has been hailed as the biggest single civil engineering project ever attempted in the country, and lambasted as a pointless destruction of the natural environment. It is far from clear that it will ever make a single króna in profit. But also it has been claimed that it is one of the causes of the kreppa. Aluminium smelting in Iceland is a topic which deserves its own post, so I shall concentrate on the third of these points for today.

The hydroelectric plant was built with immigrant labour and foreign money. It is good for Iceland that it was built with immigrant labour: it would have cost even more had the contractors been obliged to hire Icelanders at the then-going rates! The 2005 estimate of its cost was 90 billion krónur (roughly €1 billion, at the going exchange rates of the time).

Now readers of this blog might see a sign here. 90 billion krónur is a lot of money, but it is far less than many of the sums described here. The glacier bond problem is something like 500 billion krónur; the Icesave "problem" is even larger, roughly 800 billion krónur, but hopefully less serious in the short term as there seem to be agreements not to make too much of a fuss about it.

Let's take the example of Landsbanki. At 30 June 2008, it had:

• 345 billion krónur in ISK deposits, but 1372 billion krónur in loans in Iceland;
• 989 billion krónur in sterling deposits, but only 528 billion krónur in loans in Britain and Ireland.

There are many honest and honourable reasons to object to the expansion of aluminium smelting in Iceland, but the idea that it was responsible for the kreppa is not one of them. The kreppa was created by Iceland's commercial banks sucking money into Iceland, regardless of such schemes as Kárahnjúkavirkjun. White elephants are often born during economic bubbles, and they never help, but it goes too far to accuse this one of having caused the whole financial meltdown.

The £200 million question

Like a mosquito on a summer's night, one question keeps buzzing back into the collective consciousness just as we try to think of something else. Did the UK authorities offer to take Landsbanki under British jurisdiction in return for the Central Bank of Iceland granting one last liquidity loan (of GBP 200 million, all the same, hardly small change even in the City of London)? If so, the refusal of the CBI would weigh heavily on its responsibility for the meltdown of Iceland's banking system. Or is this just a delusion (for not to say an outright lie) of Björgólfur Thor Björgólfsson, one of the former owners of Landsbanki? After all, as I pointed out on Wikipedia back in October, the whole thing sounds more like "I know a few guys in London who'll solve all our problems, but they need 200 million GBP to do it…" rather than a serious business proposition worthy of backing with large quantities of public money. Both the British and Icelandic authorities have denied the existence of any agreement, although neither set of clowns enjoys much confidence in either country these days.

One thing everyone admits is that there were talks between British and Icelandic officials in Reykjavík over the weekend of 4–5 October 2008 concerning the position of Icelandic banks operating in the UK. These talks led to a formal letter from the Icelandic government to its British counterpart on Sunday 5 October, explaining Iceland's position regarding deposit insurance. Apart from formalities, the letter reads:

If needed the Icelandic Government will support the Depositors' and Investors' Guarantee Fund in raising the necessary funds, so that the Fund would be able to meet the minimum compensation limits in the event of a failure of Landsbanki and its UK branch.

There's no mention here of the UK Financial Services Compensation Scheme taking over responsibility for Icesave deposits: indeed the letter assumes that Iceland's Tryggingarsjóður would retain responsibility for insuring the first tranche of deposits (the first €20,887 of each account, in practice more than half the total amount insured).

On the other hand, both governments were aware of the need for liquidity in Landsbanki's London branch, responsible for the Icesave accounts. It is mentioned in the now-famous telephone conversation between British Chancellor of the Exchequer Alistair Darling and Icelandic Minister of Finance Árni M. Mathiessen on Tuesday 7 October, after Landsbanki had been intervened in Iceland but before its UK assets were frozen:

AD: What I… I take it therefore that the promise Landsbanki gave to us that it was going to get £200 million of liquidity back into it has gone as well.

ÁMM: Yes, they didn’t get that liquidity.

This exchange is from near the end of the conversation, but it is notable that AD refers to "the promise Landsbanki gave to us", not to any agreement between the two governments (despite the talks of the previous weekend). The promise to which AD presumably refers was leaked to the Icelandic press last month, just after Björgólfur Thor had repeated his claims on the influential Kastljós television programme (see Alda's blog about the emission). It takes the form of an email from Landsbanki to the UK Financial Services Authority, sent in the early hours of the morning of Monday 6 October, and reads:

I have been informed by my CEOs that a transfer of the amount of GBP 200 million in favour of Landsbanki London branch is required tomorrow morning to meet potential further Icesave outflows and the amount of GBP 53 million in favour of Heritable bank by end of tomorrow. We have been working on arrangements, including a repo transaction with the Central Bank and have submitted to them our pool of assets for those purposes. We understand that the Central Bank will deal with this tomorrow. As soon as the repo transaction has been completed we will transfer the required funds as discussed. I trust this meets the requirements discussed earlier tonight with you and Mr. Hector Sants.

Before I enter into the textual analysis of the email, let's take another look at the sums involved. Two hundred million pounds is a lot of money in anyone's terms – Icelanders might like to think of it as 40 billion krónur (at the exchange rates of the time), while Brits should consider it as £600 from each and every Icelander. Yet it is small change compared to the (then potential) liabilities of Landsbanki failing. Landsbanki had £6.26 billion in sterling deposits from customers at the end of June 2008, according to its interim financial statement, of which most was presumably from the United Kingdom. Not all of those deposits were covered by EEA deposit insurance schemes: initial estimates spoke of £4 billion in insured deposits in the UK, although more recent estimates I've seen put the figure slightly lower.

Björgólfur Thor is alleging that the UK authorities were willing to take on the deposit insurance liabilities of Landsbanki's London branch for a "price" of 5% of the total risk. That's a lot more than the 1% that Tryggingarsjóður (the Icelandic deposit insurance scheme) requires, but it would be a remarkably generous offer for a bank in the middle of a run on its deposits and which could not obtain the necessary liquidity from the private markets or its own central bank. A bank, in short, which was already in the middle of failing (or are we supposed to believe that high-level weekend meetings between British and Icelandic officials are normal, run-of-the-mill events?)

The email leaked to the Icelandic media (in this case, visir.is) makes no mention of Landsbanki's London branch becoming a full member of the UK Financial Services Compensation Scheme. In fact, it was quite specific: the £200 million was "to meet potential further Icesave outflows". That the London branch needed liquidity is not really in question: even once the Icesave liabilities had been set aside, it still needed a loan of £100 million from the Bank of England (formally guaranteed by HM Treasury) to restart its UK operations.

The leaked email gives us another clue to the nature of the discussions in referring to a separate £53 million needed by Heritable Bank. Had Landsbanki wanted to place its UK Icesave liabilities under British jurisdiction, it could have transferred them (with sufficient assets to cover them) to its wholly owned Scottish subsidiary, Heritable Bank. Such a move would have required the approval of the UK authorities, but would have been much simpler than setting up a new subsidiary. However, and unlike Kaupthing, Landsbanki chose to keep its UK retail deposits within a structure governed by Icelandic law. Why we can only imagine, but the decision has turned out very expensive for Icelandic taxpayers. I could mention the relative rates of capital gains tax – 18% in the UK, 10% in Iceland – but I doubt this is the whole reason.

To conclude, Björgólfur Thor's allegations have to be dismissed on the evidence available, without wanting to suggest that he doesn't believe them himself. History is full of deluded people who think they can dig themselves out of financial holes with one last try at the same game, from King Midas onwards.

Nevertheless, had Landsbanki wanted its Icesave deposits guaranteed by the UK compensation scheme, there were many ways they could have done it, and much earlier than the weekend that those very deposits were dragging the whole bank under. But Landsbanki wanted to stay with the Tryggingarsjóður, and hit out strongly this time last year at suggestions that other EEA schemes might not be as rapid at repaying depositors than the UK FSCS: this was a "falsehood", and the mere suggestion was a violation of EEA law, in Landsbanki's eyes. With the benefit of hindsight, the Icelandic scheme proved not only slow but incapable of paying out, and the attitude of Landsbanki has proved remarkably damaging to Iceland.

***UPDATE (Wednesday 22 April)***
I should have credited freelance journalist Friðrik Þór Guðmundsson (blog in Icelandic here), who went to the trouble of demanding detailed responses from the UK authorities (HM Treasury and the Financial Services Authority) under the UK Freedom of Information Act 2000. He has been kind enough to forward one of the responses to me, which basically confirms that the UK FSA regarded the £200 million as a regulatory issue (the FSA is not obliged to go any further under the FoIA). In other words, this money was connected with Landsbanki's current status in the UK, not with any possible change of status.