Can the Icelandic meltdown be avoided?

As banks across the globe continue to suffer from the credit crunch, liquidity concerns have never been more evident than in Iceland. Fears of a banking sector collapse and insufficient lender of last resort capabilities on the part of the government have caused liquidity to dry up and credit default swap (CDS) spreads on Icelandic banks to skyrocket.

Five-year CDS spreads for one leading bank, Glitnir, hit 1,436 basis points on March 31, while Kaupthing and Landesbanki have seen spreads of up to 1,394 and 1,139 respectively. On the back of these fears, the Icelandic krona depreciated 33% against the euro between January 1 and March 31. Inflation, meanwhile, shot up to 8.7% in March, a development that prompted the Central Bank of Iceland to raise its key policy interest rate to 15.5% on April 10.

The main problem in investors’ eyes has been the sheer size of the country’s banking system, combined with the level of debt outstanding. At about nine times gross domestic product, the size of the Icelandic banking system dwarfs the overall economy, while wholesale funding remains a vital part of their financing. “While Landesbanki has decreased its reliance on wholesale funding to finance its loan book to about 25%, for Kaupthing and Glitnir this ratio stands around 60%, with the remainder financed by deposits,” says Alexander Birry, director in Fitch Ratings’ financial institutions team in London.

Such factors have proven to be detrimental in the current credit crunch. As Richard Thomas, head of research at Merrill Lynch in London, comments: “There is just too much debt. Icelandic banks have about €45 billion of external debt outstanding, while the total size of the economy is only about $20 billion (€12.9 billion). Those figures matter, especially if they may not be able to refinance it, and as there is currently no appetite for any new Icelandic debt, that refinancing risk is a real one.”

The situation bears an eerie resemblance to the liquidity problems that brought down UK mortgage lender Northern Rock in 2007, which was forced to accept a government bailout. “Northern Rock didn’t have subprime exposure, it didn’t have a solvency problem, it didn’t have asset quality problems, but it was reliant on wholesale funding. And if you need liquidity at a time when nobody wants to give it to you then you have a problem,” says Gordon Scott, managing director in Fitch Rating’s financial institutions team in London.

As a result, investors have begun to look to the sovereign for backup support. But given the sheer size of the banking sector, fears have been raised that the banks may not only be too big to fail, but also too big to rescue. “The sheer scale of the banking sector relative to GDP is certainly an issue, because it has to impact the ability of the sovereign to resolve any problems,” says Scott. “There is certainly a strong willingness to support the system, but whether the government has the ability to produce as much cash as some people think is required, is not clear. It would certainly be more difficult for them to do.”

Some analysts, however, say investors’ fears may be overstated and could result in an unnecessary bank panic. They point out that, in principle, the government’s position is relatively strong. Gross general government debt is equivalent to only "about 30% of GDP and 60% of annual revenues", according to Moody’s. Although Iceland’s foreign currency reserves currently stand at just $2.55 billion as of the end of 2007, the government intends to increase this through greater borrowing.

“The government would like to borrow funds to increase the central bank’s foreign exchange reserves. Of course, because of that, we have already started to prepare the process, but no final decision has been made,” said David Oddson, chairman of the board of governors of the Central Bank of Iceland, during a press conference on April 10. The central bank has also increased its issuance of short-term Treasury notes and electronic registration of central bank certificates of deposits.

Meanwhile, Iceland’s top banks have sufficient funding to support them for up to a year, in addition to a large equity base. According to Moody’s, the parent companies of Icelandic banks have liquid assets of €3.2 billion available, as well as alternative sources of funds, including liquidity portfolios and back-up lines amounting in aggregate to €17 billion. Rating agencies also say the quality of assets within banks' portfolios is relatively sound, with Landesbanki and Kaupthing reporting headline non-performing loans at just 0.24% and 1.03% respectively, at the end of 2007. However, non-performing loans are likely to increase, if inflation remains high (it hit 11.8% in April) and leads to a contraction in the economy.

Despite this, the government's pledge to increase foreign exchange reserves, along with its aggressive hike in interest rates, appears to have helped. The currency has strengthened from its low of 123.2 against the euro on March 31, to 115.6 on April 30. Credit spreads have also tightened, with the cost of protection on Kaupthing, Glitnir and Landesbanki falling to 675bp, 694bp and 463bp respectively on April 25.

But despite signs that the crisis may have reached its peak and assurances that Icelands banks have sufficient liquidity to weather the current turbulence in the wholesale markets, a lengthy prolongation of the credit crunch could still pose problems. Much will therefore depend on whether the current attempts by the government to stabilise the market are considered sustainable, and if the central bank will truly be able to take on the role of lender of last resort if all three banks are unable to raise financing.


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