The Return of Trust?

Throstur Olaf Sigurjonsson, David L. Schwarzkopf, Murray Bryant, Throstur Olaf Sigurjonsson, David L Schwarzkopf, Murray Bryant

• Publisher: Emerald Publishing Limited
• Year: 2018
• ISBN:
  9781787439528
• Topic: Business
• Subtopic: Finance
• Index: Business

Trust is the fundamental facilitator between actors in society, yet the past decade has seen the public openly question through demonstrations and elections whether business and political institutions deserve the trust society has placed in them—or whether the common person has been abandoned in favour of organisations and systems that are 'too big to fail'. The tenth anniversary of the crisis that shook financial markets in the early years of this century provides a chance to reflect on institutions' efforts to regain the trust lost in that debacle. It is particularly instructive to examine the steps that financial and governmental institutions have taken in one of the hardest-hit economies, Iceland. Those who witnessed the crisis and its aftermath know the wrenching effects it had on society, underscored by scepticism toward political and economic institutions. As the crisis spread almost worldwide, so too did the public's disenchantment. Since Iceland was one of the first societies affected, it has had the most time to work on and chart its recovery. This collection addresses the broad theme of how institutions in the small, close-knit Icelandic society have gone about trying to recapture other institutions' and the public's trust. Insights from these studies expand our understanding of how institutions try to rebuild their relationships with communities in the face of political and economic change in fractured Western societies.

Part I: The Situation

A Summary of the Chapters in Part I

The macro-economic setting for the crisis. The foreshadowing. Data on the loss of trust. Reflection: What is trust after all?

Taking an economics perspective, Gylfi Zoega looks at the actions that financial and political institutions considered in the immediate aftermath of the crisis – both the steps finally taken and those that never came to fruition. He provides background to the macro-economic conditions prevalent at the time, including the role of international financial arrangements. In contrast to the foundations on which bankers, politicians and citizens put their trust in the large banks, he points out the faults in those foundations that led to the banks being ‘not too big to fail, but too big to save’. The chapter includes a discussion of the effects on Icelandic monetary policy as a result of the crisis.

David L. Schwarzkopf and Throstur Olaf Sigurjonsson apply social network analysis to Icelandic newspaper articles appearing in the first week after a 2006 report from Danske Bank that cautioned the Icelandic banks had grown too large too quickly. The analysis shows the fast growth of networks of arguments and actors that made it difficult for the public to appreciate the insights contained in the report. The actors included analysts, bankers and politicians, who made both economic and emotional arguments, effectively forestalling action on financial system reform during this ‘mini-crisis’. In hindsight, the delays proved costly as the country moved on to the full-blown crisis of 2008.

In the first of their two chapters, Guðrún Johnsen and Sigurbjörg Sigurgeirsdóttir present their analysis of data from Gallup-Iceland’s annual surveys of individuals’ trust in political, financial, law enforcement and social service institutions. They help us see the rapid drop (the lift down) in trust shown across nearly all Icelandic institutions, and the slow rise (the stairs up) that is occurring as trust returns at uneven rates. As many contributors to this volume indicate, recovering trust is a work in progress. These authors show with data how drawn-out that process can be.

Einar Már Guðmundsson examines the crisis and its aftermath from the perspective of an individual trying to make sense of his time. He asks whether we would even have to talk about trust if there were already trust in society. With references to Brecht, Daðason, Norse poetry and the French Revolution, he draws our attention to the role of money and ambition in recent events, while calling on citizens and institutions to address those follies with fairness, transparency and openness.

Chapter 1

Restoring Confidence in the Aftermath of Iceland’s Financial Crisis

Gylfi Zoega

Abstract

Following the collapse of the banking system in October 2008, the Icelandic authorities attempted to restore confidence in the country’s institutions, improve their functioning and gradually improve the country’s credit rating. The authorities took ownership of an International Monetary Fund-sponsored economic programme that managed to turn the macroeconomic development around when, following a trough in the summer of 2010, an economic expansion started that has continued ever since. They applied for membership in the European Union in order to show their commitment to be part of the international economic community and to have a lender of last resort in the European Central Bank in future crises. The causes of the collapse were investigated and many bankers were prosecuted. Finally, financial regulations were made stricter and the structures of the Central Bank and the supervisory authority were changed for the better. The net effect was to lower the credit default swap rate on the government’s debt, gain access to capital markets and make the Iceland story one of resurrection rather than only hubris and collapse.

Keywords: Currency crisis; Icesave; institutional investors; international finance; International Monetary Fund; monetary policy

Introduction

This chapter is about the attempts of the government of Iceland to restore trust and confidence in the country’s economy among international investors and creditors as well as among the local population following the financial crisis of 2008. The crisis involved the collapse of all three major banks in the economy, a currency crisis, inflation and unemployment. In effect, this was a perfect storm that received a lot of attention in the international media. In restoring confidence in the economy, the authorities attempted to be able to liberalise capital flows, borrow at reasonable rates and negotiate affordable settlements with creditors. The collapse of the banks in October 2008 had destroyed what remained of trust and confidence in the local financial system as well as trust in the national government. It therefore became a priority to rebuild this trust. Building confidence involves an interaction between sound policies, an incentive structure that leads one to believe that those policies will be implemented over the long term, and good public relations about those policies. The Icelandic authorities were challenged on all three fronts in the years that followed the collapse.

The flow of capital into Iceland during the period from 2003 to 2008 slowed in 2007 and stopped completely in the spring and summer of 2008, resulting in the collapse of the banking system and a currency crisis. Prior to this sudden stop, the inflow had taken the form of international bond issues by domestic commercial banks, borrowing by domestic holding companies from foreign banks and ‘hot money’ in the form of carry trade.¹

As it became increasingly difficult to borrow in foreign capital markets in 2007 and 2008, the domestic commercial banks faced liquidity problems and the prospect of default. The carry trade unwound in 2008 when owners of domestic-currency bonds amounting to around 40% of gross domestic product (GDP) tried to exit the currency, resulting in a sharp depreciation. The domestic stock market also fell dramatically because of the credit contraction, having been driven more by credit and speculation than by fundamentals. This made a significant part of the collateral behind the banks’ lending worthless, undermining their solvency. Thus, insolvency and illiquidity were intertwined in the collapse of the banking system.²

The boom and bust of the Icelandic economy had all the characteristics of a sudden stop of capital inflows, similar to those affecting Chile in 1982, Thailand and other East-Asian countries in 1997 and Greece, Ireland and Spain in the 2000s.³ Capital inflows preceded all these events and in Iceland these flows became very large in the first decade of the century due to very low US interest rates and current account imbalances globally. For example, as shown by Katsimi and Zoega (2016), the positive correlation between domestic national savings and domestic investment had vanished in the eurozone, indicating perfect capital mobility.⁴

The relationship between a borrower and a lender is inevitably based on trust. The trust that Icelandic financial companies enjoyed in international capital markets, which attracted capital inflow, rested on several pillars. Firstly, the three main banks were clearly too big to fail. Hence, the state could be expected to do its best to save them if they got into trouble. The sovereign had a triple-A (AAA) rating and this rating was also given to the banks, not because the banks themselves had any history in international credit markets but because the state had this rating. Secondly, if the state turned out to be unable to save the banks, it might be expected to seek help from the International Monetary Fund (IMF). In that case the lenders would possibly get their money back while the taxpayers would be saddled with debt to the IMF. Thirdly, the Icelandic state had never defaulted on its debt, giving the country the reputation of a culture of paying back debt. Finally, the association in lenders’ minds of Iceland with the other Nordic nations – Denmark, Finland, Norway and Sweden – may have had the same effect.

The sudden stop of the capital inflow and the shutting out of domestic banks from foreign capital markets marked the disappearance of this trust between domestic borrowers and foreign lenders. It was clear that the banks were not too big to fail, they were too big to save; the Central Bank was not able to come up with enough foreign currency; the government could not borrow in foreign currencies; and the inability to borrow reflected the lack of confidence by foreign governments and central banks towards the domestic authorities. Hence, confidence evaporated as the scale of the debt problem became known – the banks’ balance sheets added up to 10 times the country’s GDP – and domestic authorities appeared to have lost control of the country’s financial system. The banking adventure that had looked like an impressive accomplishment now looked more like a manifestation of hubris and excesses, and the country became a symbol of western financial crisis.⁵

The government did not seek the assistance of the IMF prior to the collapse of the banks. Instead, the summer of 2008 passed without any significant measures being taken that could have averted the collapse. After the collapse, however, the government did not have any alternatives because other countries, including notably the Nordics, were willing to provide financial assistance only if Iceland had an IMF programme. Before asking for assistance, the government took the important step of passing emergency legislation that prioritised deposits over bonds – that is, depositors would be paid from the banks’ assets first and bondholders only thereafter. This turned out to be a wise decision in retrospect. Other measures were more fumbling and less impressive. There was the unsuccessful and embarrassing attempt to secure a loan from the Russian government, a confused attempt to nationalise one of the banks (which only hastened the collapse of the whole banking system) and an exchange rate peg at a non-credible level, an effort that lasted for only a few hours.

In November, Iceland signed an agreement with the IMF that described the economic policies to be followed, while the Nordic countries, as well as Poland and the Faroe Islands, had agreed in advance to provide financial assistance in the context of an IMF programme. T...