Lessons for Spain in how Iceland handled the financial crisis

The Telegraph carried an interesting article on how Iceland handled its bank solvency led financial crisis and the lessons that Spain could learn from this.

Simply, Iceland adopted the Swedish model and required its banks to recognize all the losses on and off their balance sheets.  Four years later, Iceland has an investment grade debt rating and its economy is growing.

Iceland tore up the traditional rulebook.

Actually, there are two traditional rulebooks.

There is the rulebook preferred by bankers who are interested in receiving their bonuses.  This rulebook is called the Japanese model and requires that bank book capital levels be protected at all costs.

There is the rulebook preferred by a country's citizens that says that they come first.  This rulebook is called the Swedish model and requires that banks recognize all of the losses on and off their balance sheets today.

Iceland simply chose the rulebook that put its citizens first.

First, retail depositors were given priority over bondholders. 

Then, alongside the deposits, all domestic assets were transferred to new banks at "fair value" – the shrunken, market price of the debt. The new banks, recapitalised by the state, took over the vital payments system that kept the wheels of the economy turning....

Please note that in a modern financial system with deposit guarantees and access to central bank funding, the banks do not have to be recapitalized by the state.  They can rebuild their book capital levels by retaining future earnings.

Shut out of the international money markets and with the country's economic model broken, Iceland tapped the International Monetary Fund for a $2.1bn emergency loan.... 

The IMF was an immediate stabilising influence. Rather than preach austerity, it backed a state-sponsored stimulus package, agreeing to postpone planned cuts for a year. 

Poul Thomsen, a director of the IMF's European department, said in December 2008: "We think it is wrong, in the face of a deep recession, to embark on fiscal consolidation."

Your humble blogger has been advocating that the state funds that would be used in an unnecessary bailout of the banks instead be used to support an economic stimulus package.

The Icelandic government then took unorthodox measures to alleviate the debt burden on households. Banks were made to accept reductions in mortgage interest payments of up to 40pc, while the most distressed households had some of their debt written off.

Iceland effectively required the banks to absorb the losses on the excess debt in the financial system.  By doing so, it protected its real economy.

Ireland did not do this prior to bailing out its banks and it is still fighting with its banks to get them to recognize the losses on the mortgages they hold.

The medicine is working.

This is no surprise as the Swedish model has worked everyplace it has been implemented.  This includes the US (during the Great Depression) and Sweden.

The economy contracted 6.8pc in 2009 and another 4pc in 2010, but bounced back to grow 3.1pc last year. The IMF has been repaid and, in February, the country regained its investment grade credit rating after Fitch raised it from the "junk" status of BBB- to BB+....

But compared with Ireland, which has seen national debt soar from 11pc to 96pc of GDP after bailing out bank bondholders rather than cutting them loose, Iceland has been an amazing tale. 

It may have been so small as to be irrelevant to the global financial system, but the IMF has said there are lessons to be learned. Spain, whose banks pose a much greater risk than its public finances, is a case in point. 

As Julie Kozack, IMF mission chief for Iceland, said: "For a country whose entire financial system collapsed, Iceland is doing remarkably well."

It is nice to have the IMF confirm that the Swedish model is the policy of choice for countries that have to deal with a bank solvency led financial crisis.