Iceland Shows Banks Are Not Too Big To Fail

Few nations were hit harder initially by the financial crisis in 2008 than Iceland. It’s economy had grown rich around four very large (relative to Iceland) banks that were players in the big global casino financial industry expansion.  In the U.S., U.K., and most other large developed countries governments responded with large bank-bailout packages.  The economic logic is that the banks and the banking system is too interconnected, too large, and too important to let it fail.  There’s a part of this argument that has economic truth.  To the extent that the creditors (depositors) of a bank are ordinary citizens and businesses in the country, letting a bank fail will have disastrous macroeconomic consequences.  But this is only true to the extent that these ordinary depositors get wiped out and lose their deposits.  Depositors were in large part not protected in 1929-33 when banks failed across the U.S. and that led to worsening of the Great Depression. It also led to the creation of Federal Deposit Insurance Corporation.  The FDIC is still on the job protecting little depositors (and our economy).

But in the Great Global Financial Crisis, the U.S. government didn’t just try to rescue the little depositors, it rescued the banks themselves.  There’s a huge difference. In rescuing the banks as corporations, the government rescued the large wealthy depositors who should have known better. They rescued the shareholders who selected the managers that caused the banks to get in trouble. They rescued the very management teams that had just failed so spectacularly.  At the time, the argument made by the government for rescuing the banks was that they were “too big to fail”.  This little phrase, often abbreviated as TBTF, came to be a short-hand logic for bailing out the banks.

The problem is that the economic justification for a “bailout” calls for protecting the little, ordinary depositors, not the banks.  In practice, that’s what FDIC does. It “rescues” the little depositors when the bank fails.  It lets the bank and it’s management fail. But the Bush and Obama administrations did not do that. Instead they bailed out the banks and the bank shareholders, arguing there was no alternative.

Iceland, however, shows there was an alternative. Iceland rescued (guaranteed) deposits by ordinary Icelanders and let the banks themselves fail. It has worked pretty well. Much better than Ireland’s approach that rescued the banks themselves. From the New Zealand Herald by way of Daily Bail:

Unlike other nations, including the US and Ireland, which injected billions of dollars of capital into their financial institutions to keep them afloat, Iceland placed its biggest lenders in receivership. It chose not to protect creditors of the country’s banks, whose assets had ballooned to US$209 billion, 11 times gross domestic product.

The crisis almost sank the country. The krona lost 58 per cent of its value by the end of November 2008, inflation reached 19 per cent in January 2009, GDP fell 7 per cent that year and the Prime Minister resigned after nationwide protests.

But with the economy projected to grow 3 per cent this year, Iceland’s decision to let the banks fail is looking smart.

  • “Iceland did the right thing by making sure its payment systems continued to function while creditors, not the taxpayers, shouldered the losses of banks,” says Nobel laureate Joseph Stiglitz, an economics professor at Columbia University in New York. “Ireland’s done all the wrong things, on the other hand. That’s probably the worst model.”

 

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