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Too-Big-to-Fail Prevention Is Tested in Post-Crisis Iceland

Photographer: Paul Taggart/Bloomberg

Residential housing and rooftops are seen in Reykjavik, Iceland. Close

Residential housing and rooftops are seen in Reykjavik, Iceland.

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Photographer: Paul Taggart/Bloomberg

Residential housing and rooftops are seen in Reykjavik, Iceland.

Iceland was brought to the brink of bankruptcy when its biggest banks failed four years ago. Now, the site of the world’s most spectacular financial collapse is becoming a pioneer in banking reform.

“We’ve been burned by this and that’s why we have to look very closely at what we need to do to prevent it happening again,” Economy MinisterSteingrimur J. Sigfusson said in an interview. “Icelanders are more interested in taking greater steps than small steps when it comes to regulating banking.”

His party, the junior member in Prime Minister Johanna Sigurdardottir’s coalition, has submitted a motion to parliament to stop banks using state-backed deposits to finance risky investments. The move puts Iceland on course to become the first western nation since the global financial crisis hit five years ago to force banking conglomerates to split their business.

It’s a proposal that’s gaining traction elsewhere. Even Sanford “Sandy” Weill, whose 1998 creation of New York-based Citigroup Inc. (C) triggered the Gramm-Leach-Bliley Act that paved the way for financial behemoths, now says investment banks should be separated from deposit-taking banks. Opponents including JPMorgan Chase & Co. (JPM) Chief Executive Officer Jamie Dimon say diverse businesses are needed to spread risk across divisions and stay competitive.

The Icelandic lawmaker who presented the motion, Alfheidur Ingadottir, says the best way to stop banks creating asset bubbles is to pass laws akin to the 1933 Glass-Steagall Act, which separated commercial and investment banking in the U.S. for more than six decades.

Forced Breakup

The law would force Arion Bank hf, Landsbankinn hf and Islandsbanki hf -- state-engineered successors to the banks that failed -- to break up their operations. Investment banking now makes up less than 5 percent of business at the banks, whose deposits are backed by the Icelandic state. Before the crisis, the ratio was as high as 33 percent at Iceland’s biggest lender, said David Stefansson, an economist at Arion.

Sigfusson, whose ministry oversees the financial industry, wants a “partial, or even complete, separation of commercial and investment banking,” he said. “It’s a way to prevent the riskier parts of banking being mixed with regular day-to-day banking and shouldered by regular customers or taxpayers,” he said.

The government has found support inside Iceland’s banking industry. The head of the island’s biggest investment bank says breaking up financial conglomerates is the most effective crisis prevention tool and one that would have prevented the nation’s meltdown.

Ruinous

“Giving banks too much of a free ride with deposits -- money they don’t need to repay if something goes wrong -- isn’t such a great idea,” Straumur Investment Bank hf Chief Executive Officer Petur Einarsson said in an interview.

Einarsson says Europe should look to Iceland to get a sense of how much damage an overgrown banking system can wreak.

“Europe is today feeling the pain of the same disease Iceland caught in 2008,” he said. “The changes that need to be made should benefit the depositors and businesses served by these financial institutions, rather than the institutions themselves.”

The excesses of Kaupthing Bank hf, Glitnir Bank hf and Landsbanki Islands hf proved ruinous for Iceland’s economy. The banks grew to about 10 times the nation’s total economic output before defaulting on $85 billion in 2008, forcing the government to impose capital controls and to resort to an international bailout.

Risks Overlooked

Kaupthing’s balance sheet ballooned by a factor of 85 between 2000 and 2007 to peak at 5.3 trillion kronur ($44 billion), compared with Iceland’s gross domestic product last year of $13.5 billion. The bank, Iceland’s biggest before it was put under state control in October 2008, opened offices in Luxembourg, New York and Dubai. Its size and complexity relative to the economy made proper risk analysis difficult. Moody’s Investors Service rated the bank A1, its fifth-highest grade, until the day the lender was seized by the state.

The financial regulator also missed the red flags. Iceland’s three biggest banks all had capital adequacy ratios of more than 10 percent of their risk-weighted assets as of the end of June 2008, the Financial Supervisory Authority said in August the same year. All three lenders passed FSA stress tests in a report published two months before they failed.

Crisis Pain

In the years that followed the banks’ collapse, Iceland’s unemployment rate jumped nine-fold and the economy was thrust into a recession that lasted through the first half of 2010. An 80 percent plunge in the krona against the euro offshore sent inflation soaring to 19 percent. That bloated the debt burdens of a household sector paying down inflation-linked mortgages.

Now, the government wants to ensure that the new banks are never again allowed to grow big enough to wreak such havoc. Preventing financial conglomerates from dwarfing the economy is key, according to Ingadottir.

“Running a commercial bank isn’t really compatible with running an investment bank, especially in regards to financial risk management,” she said in an interview.

Iceland’s economic reforms since the end of 2008 have so far proven successful. The economy will outgrow the euro area this year and next, the International Monetary Fund estimates. Iceland’s krona has appreciated 14 percent against the euro since the end of March, making it the best-performing emerging- market currency in the period. The krona was little changed today at 147.67 per euro.

Greenspan

Weill, who stepped down as Citigroup chairman in 2006, said in a July 25 interview with CNBC that the time has come to split investment and commercial banking.

Weill helped engineer the 1998 merger of Travelers Group Inc. and Citicorp, a deal that required the repeal of the Depression-era Glass-Steagall Act. Citigroup subsequently became the biggest bank in the world before taking a $45 billion taxpayer bailout in 2008.

Even former Federal Reserve Chairman Alan Greenspan, who had fought to abolish Glass-Steagall, said in 2009 that breaking up the banks might make them more valuable.

The Volcker rule, part of the Dodd-Frank financial overhaul law, is intended to limit transactions that put deposits insured by the U.S. government at risk. Regulators have said they hope to finish the rule by the end of the year and have given banks a July 2014 deadline, provided they make a good-faith effort to comply.

In the U.K., Bank of England Governor Mervyn King has said the scandal surrounding the London interbank offered rate underlines the urgency of implementing proposals in John Vickers’ Independent Commission on Banking, which recommends banks separate their consumer and investment units.

Crisis Wasted

Corners of Iceland’s bank industry remain apprehensive about a split. The nation’s Financial Services Association and the bank regulator say any overhaul should only take place after an analysis of the benefits and drawbacks.

Parliament may not want to wait that long.

“Lawmakers in all parties agree on the necessity of separation,” Ingadottir said. “So I’m confident that this will pass later this year.”

The worst outcome of the global financial crisis would be if policy makers and regulators fail to fix the mistakes of the past, according to Einarsson.

“If commercial and investment banking aren’t separated now, we might have to wait a long while before such an opportunity presents itself again,” he said. “This is going to be one of the defining issues of the coming years.”

To contact the reporter on this story: Omar R. Valdimarsson in Reykjavik valdimarsson@bloomberg.net

To contact the editor responsible for this story: Jonas Bergman at jbergman@bloomberg.net

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