Iceland shows that forcing banks to take losses works to end financial crisis

For the last several days, your humble blogger has been writing a number of posts on the Japan model and the Swedish model for handling a financial crisis.

Under the Japan model, governments do everything they can to protect the meaningless bank book capital values.  This includes allowing the banks to recognize losses as banks generate earnings to absorb the losses, shielding the banks from market discipline by providing an implied guarantee when regulators proclaim that stress tests show the banks are solvent, and adopting zero interest rate policies.

The Japan model puts the interest of the banks ahead of the interests of society.

Under the Swedish model, governments require the banks to recognize the losses on the excesses in the financial system today.  Banks then rebuild their book capital through future retained earnings and equity issuance.

The Swedish model puts the interests of society ahead of the interests of the banks.

Today, I would like to focus on two interesting data points.  First, Japan has been following the Japan model for 2+ decades since its credit bubble burst with no end in sight.  Second, Iceland has been following the Swedish model for 3 years since its credit bubble burst, the financial crisis is effectively over and it has returned to investment grade.

Which model appears to work better:  bend over for the bankers or kick them in the backside?

So why exactly has the US, UK and Eurozone chosen the Japan model?

Bloomberg ran an article on Iceland and the victory of the Swedish model for handling financial crisis.

Icelanders who pelted parliament with rocks in 2009 demanding their leaders and bankers answer for the country’s economic and financial collapse are reaping the benefits of their anger. 

Since the end of 2008, the island’s banks have forgiven loans equivalent to 13 percent of gross domestic product, easing the debt burdens of more than a quarter of the population, according to a report published this month by the Icelandic Financial Services Association. 

“You could safely say that Iceland holds the world record in household debt relief,” said Lars Christensen, chief emerging markets economist at Danske Bank A/S in Copenhagen. “Iceland followed the textbook example of what is required in a crisis. Any economist would agree with that.”...

“The lesson to be learned from Iceland’s crisis is that if other countries think it’s necessary to write down debts, they should look at how successful the 110 percent agreement was here,” said Thorolfur Matthiasson, an economics professor at theUniversity of Iceland in Reykjavik, in an interview. “It’s the broadest agreement that’s been undertaken.” 

Without the relief, homeowners would have buckled under the weight of their loans after the ratio of debt to incomes surged to 240 percent in 2008, Matthiasson said.... 

Iceland’s approach to dealing with the meltdown has put the needs of its population ahead of the markets at every turn.

An observation that your humble blogger has made a number of times.

Once it became clear back in October 2008 that the island’s banks were beyond saving, the government stepped in, ring-fenced the domestic accounts, and left international creditors in the lurch. The central bank imposed capital controls to halt the ensuing sell-off of the krona and new state-controlled banks were created from the remnants of the lenders that failed. 

Activists say the banks should go even further in their debt relief. Andrea J. Olafsdottir, chairman of the Icelandic Homes Coalition, said she doubts the numbers provided by the banks are reliable. 

“There are indications that some of the financial institutions in question haven’t lost a penny with the measures that they’ve undertaken,” she said.

According to Kristjan Kristjansson, a spokesman for Landsbankinn hf, the amount written off by the banks is probably larger than the 196.4 billion kronur ($1.6 billion) that the Financial Services Association estimates, since that figure only includes debt relief required by the courts or the government. 

“There are still a lot of people facing difficulties; at the same time there are a lot of people doing fine,” Kristjansson said. “It’s nearly impossible to say when enough is enough; alongside every measure that is taken, there are fresh demands for further action.”... 

According to Christensen at Danske Bank, “the bottom line is that if households are insolvent, then the banks just have to go along with it, regardless of the interests of the banks.”