Iceland’s three major banks — Kaupthing, Landsbanki, and Glitnir — had grown to have assets totaling 10 times Iceland’s GDP, funding themselves with wholesale international borrowing. Icesave, an online savings product from Landsbanki, had attracted £5 billion from 400,000 depositors in the UK and Netherlands with high interest rates.
When the GFC hit global funding markets in September 2008, the Icelandic banks lost access to wholesale funding they needed to roll over. Within one week in October 2008, all three collapsed. The Icelandic government — a country of 300,000 people — could not bail out banks with liabilities equivalent to 10 times its GDP. It nationalized domestic operations and let foreign creditors fail.
The UK government froze Icelandic assets using anti-terrorism laws (a diplomatic catastrophe). Depositors in Icesave eventually received partial compensation years later. Iceland imposed capital controls, devalued the krona, and prosecuted banking executives. By 2011 growth had returned and Iceland was cited by economists including Paul Krugman as the model for crisis management.
The prevailing view before the reckoning
Icesave deposits were guaranteed by the Icelandic government. The banks were innovative financial institutions that had transformed Iceland into a financial hub. The government would find a way to honor all obligations. Iceland had graduated from fishing economy to financial services economy.
Banks can be too big to save
The TBTF doctrine has limits set by sovereign capacity. When bank liabilities exceed sovereign capacity, there is no bailout option — only triage.
Default plus devaluation beats austerity
Iceland’s recovery was faster than Ireland, which chose bank bailout and austerity. The debt overhang is the problem; eliminating it through default accelerates recovery.
Capital controls have a role in extreme situations
Iceland imposed capital controls against IMF advice and they worked. This changed the profession’s view of capital account management in extreme crises.
Prosecuting bankers matters for credibility
Iceland jailed 26 banking executives. This did not happen in the US or UK. Whether this accelerated the recovery is debated but it addressed the moral hazard problem directly.