The Collapse of the Icelandic Banking System

René Kallestrup and David Lando

Contents

Introduction to 'Lessons from the Financial Crisis'

1.

The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can be Learned?

2.

Underwriting versus Economy: A New Approach to Decomposing Mortgage Losses

3.

The Shadow Banking System and Hyman Minsky’s Economic Journey

4.

The Collapse of the Icelandic Banking System

5.

The Quant Crunch Experience and the Future of Quantitative Investing

6.

No Margin for Error: The Impact of the Credit Crisis on Derivatives Markets

7.

The Re-Emergence of Distressed Exchanges in Corporate Restructurings

8.

Modelling Systemic and Sovereign Risks

9.

Measuring and Managing Risk in Innovative Financial Instruments

10.

Forecasting Extreme Risk of Equity Portfolios with Fundamental Factors

11.

Limits of Implied Credit Correlation Metrics Before and During the Crisis

12.

Another view on the pricing of MBSs, CMOs and CDOs of ABS

13.

Pricing of Credit Derivatives with and without Counterparty and Collateral Adjustments

14.

A Practical Guide to Monte Carlo CVA

15.

The Endogenous Dynamics of Markets: Price Impact, Feedback Loops and Instabilities

16.

Market Panics: Correlation Dynamics, Dispersion and Tails

17.

Financial Complexity and Systemic Stability in Trading Markets

18.

The Martingale Theory of Bubbles: Implications for the Valuation of Derivatives and Detecting Bubbles

19.

Managing through a Crisis: Practical Insights and Lessons Learned for Quantitatively Managed Equity Portfolios

20.

Active Risk Management: A Credit Investor’s Perspective

21.

Investment Strategy Returns: Volatility, Asymmetry, Fat Tails and the Nature of Alpha

The collapse of Iceland’s three largest banks in late September and early October 2008 was the biggest banking failure relative to the size of an economy in modern history. Financial crises are of course always easier to spot with the benefit of hindsight, but it is fair to say that there were many indications that the fall of the Icelandic banking system was an accident waiting to happen. Not only were commonly used early warning indicators of banking crises very strong in the case of Iceland, but there had in fact already been a mini funding crisis in early 2006. In this chapter we list the warning indicators and document how the Icelandic banks managed to continue their aggressive growth despite the funding crisis in 2006. Strong reported financial key figures masked the true riskiness of the Icelandic business model and the extreme concentration risk in the financial system. In addition, investors and rating agencies overestimated the value of potential sovereign support from a country whose fiscal capacity was limited compared with the size of the banks’ assets. Helped by strong credit ratings and implicit sovereign guarantees, the banks were able to fund their risky business

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