Iceland takes on Too Big to Fail

Bloomberg reports that Iceland is in the process of taking on the Too Big to Fail banks.

Regular readers will recall that Iceland put its society ahead of banker bonuses and adopted the Swedish model for handling a bank solvency led financial crisis at the beginning of the crisis.

Having saved society and recovered its investment grade bond rating, Iceland is now taking the next step in banking reform by forcing its banks to separate their investment banking and commercial banking businesses.

The last step in insuring that the bankers don't take excessive risk again is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off balance sheet exposure details.

With this data, market participants, including regulators, can exert discipline on the banks and restrain their risk taking and proprietary betting.

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 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.

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.

“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.”...

Unfortunately, the EU, UK and US chose the Japanese model for handling a bank solvency led financial crisis.  Under this model, policies are designed to benefit the banks rather than society.

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....

Your humble blogger continues to say that ultra transparency is needed so that market participants do not have to depend on the financial regulators to spot problems.  With ultra transparency, market participants can independently assess the banks for themselves.

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....

Confirming the success of adopting the Swedish model for handling a bank solvency led financial crisis.

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....

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.”

Even in Iceland, the Financial-Academic-Regulatory Complex fights banking reform.