Iceland's Banks Collapse

"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 authorities. ... 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. ... 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). ... The main message of our paper is, however, that it was not the drama and mismanagement of the last three months that brought down Iceland's banks. Instead it was absolutely obvious, as soon as we began, during January 2008, to study Iceland's problems, that its banking system was not viable. ... 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. ... If the solvency gap of the banking system exceeds the unused fiscal capacity of the authorities, only choice that remains is between banking sector insolvency and sovereign insolvency. The Icelandic government has rightly decided that its tax payers and the beneficiaries of its public spending programmes (who will be hard hit in any case) deserve priority over the external and domestic creditors of the banks (except for the insured depositors)", my emphasis, William Buiter and Anne Sibert (B&S), 30 October 2008 at http://voxeu.org/index.php?q=node/2498.

B&S have a lesson for bond buyers, no matter what: you think or a bond indenture reads, you go to the bottom of the seniority pile when push comes to shove. If you don't like it, raise an army and do something about it. Some gems: expect bank managements to lie, and an omission. Omission? B&S do not include bank CPAs as "parties likely to have a substantive knowledge of the quality of a bank's assets". Well old PCAOB buddy Mark Olson, we know these failed banks were in Iceland, but do you think US bank auditors should meet this test? Look at the choice B&S leave the banking authorities. Why haven't US authorities faced it? I went to Landsbanki's website to look for gems in its 2007 Annual Report. "During the past few years, Landsbanki has gradually reduced its market risk and changed the composition of its portfolio. ... The bank has effective risk controls and prudent credit loss provisions. ... The bank comfortably exceeds mandatory capital and liquidity requirements and passes stringent stress tests administered by the financial authorities by a wide margin. Landsbanki's capital adequacy ratios in fact rank with the highest among European banks", page 9. Who audited Landsbanki: PriceWaterhouseCoopers. I wonder what if anything PWC will tell us this year about the American banks it audits.