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26 with an October 2008 update.
Early in 2008 we were asked by the Icelandic bank Landsbanki (now in receivership)
to write a paper on the causes of the financial problems faced by Iceland and
its banks, and on the available policy options for the banks and the Icelandic
We sent the paper to the bank towards the end of April 2008; it was titled:
“The Icelandic banking crisis and what to do about it: the lender of last resort
theory of optimal currency areas.”
On July 11, 2008, we presented a slightly updated version of the paper in
Reykjavik before an audience of economists from the central bank, the ministry of
finance, the private sector and the academic community.
It is this version of the paper that is now being made available as CEPR Policy
Insight No 26. In April and July 2008, our Icelandic interlocutors considered our
paper to be too market-sensitive to be put in the public domain and we agreed to
keep it confidential. Because the worst possible outcome has now materialised,
both for the banks and for Iceland, there is no reason not to circulate the paper
more widely, as some of its lessons have wider relevance.
A banking business model that was not viable for Iceland
Our April/July paper noted that Iceland had, in a very short period of time, created
an internationally active banking sector that was vast relative to the size of its
The collapse of Iceland’s banks:
the predictable end of a non-viable
business model
Willem Buiter and Anne Sibert
London School of Economics and Political Science,
University of Amsterdam and CEPR; Birkbeck College,
London and CEPR
very small economy. Iceland also has its own currency. Our central point was that
this ‘business model’ for Iceland was not viable.
With most of the banking system’s assets and liabilities denominated in foreign
currency, and with a large amount of short-maturity foreign-currency liabilities,
Iceland needed a foreign currency lender of last resort and market maker of last
resort to prevent funding illiquidity or market illiquidity from bringing down the
banking system. Without an effective lender of last resort and market maker of last
resort – one capable of providing sufficient liquidity in the currency in which it
is needed, even fundamentally solvent banking systems can be brought
down through either conventional bank runs by depositors and other creditors
(funding liquidity crises) or through illiquidity in the markets for its assets
(market liquidity crises).
Iceland’s two options
Iceland therefore had two options. First, it could join the EU and the EMU, making
the Eurosystem the lender of last resort and market maker of last resort. In this
case it can keep its international banking activities domiciled in Iceland. Second,

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