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own currency, and with an internationally active and internationally exposed financial
sector that is very large relative to its GDP and relative to its fiscal capacity.
Even if the banks are fundamentally solvent (in the sense that their assets, if
held to maturity, would be sufficient to cover their obligations), such a small
country – small currency configuration makes it highly unlikely that the central
bank can act as an effective foreign currency lender of last resort/market maker of
last resort. Without a credit foreign currency lender of last resort and market
maker of last resort, there is always an equilibrium in which a run brings down a
solvent system through a funding liquidity and market liquidity crisis. The only
way for a small country like Iceland to have a large internationally active banking
sector that is immune to the risk of insolvency triggered by illiquidity caused by
either traditional or modern bank runs, is for Iceland to join the EU and become
a full member of the euro area. If Iceland had a global reserve currency as its
national currency, and with the full liquidity facilities of the Eurosystem at its disposal,
no Icelandic bank could be brought down by illiquidity alone. If Iceland
was unwilling to take than step, it should not have grown a massive on-shore
internationally exposed banking sector.
This was clear in July 2008, as it was in April 2008 and in January 2008 when
we first considered these issues. We are pretty sure this ought to have been clear
in 2006, 2004 or 2000. The Icelandic banks’ business model and Iceland’s global
banking ambitions were incompatible with its tiny size and minor-league currency,
even if the banks did not have any fundamental insolvency problems.
Were the banks solvent?
Because of lack of information, we have no strong views on how fundamentally
sound the balance sheets of the three Icelandic banks were. It may be true, as argued
by Richard Portes in his Financial Times Column of 13 October 2008, that ‘Like fellow
Icelandic banks Landsbanki and Kaupthing, Glitnir was solvent. All posted good
first-half results, all had healthy capital adequacy ratios, and their dependence on
market funding was no greater than their peers’. None held any toxic securities.’
The only parties likely to have substantive knowledge of the quality of a bank’s
assets are its management, for whom truth telling may not be a dominant strategy
and, possibly, the regulator/supervisor. In this recent crisis, however, regulators
and supervisors have tended to be uninformed and out of their depth. We doubt
Iceland is an exception to this rule. The quality of the balance sheet of the three
Icelandic banks has to be viewed by outsiders as unknown.
The collapse of Iceland’s banks: the predictable end of a non-viable business model 25

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