The Collapse of the Icelandic Banking System

René Kallestrup and David Lando

The collapse of Iceland’s three largest banks in late September and early October 2008 was the biggest banking failure relative to the size of an economy in modern history. Financial crises are of course always easier to spot with the benefit of hindsight, but it is fair to say that there were many indications that the fall of the Icelandic banking system was an accident waiting to happen. Not only were commonly used early warning indicators of banking crises very strong in the case of Iceland, but there had in fact already been a mini funding crisis in early 2006. In this chapter we list the warning indicators and document how the Icelandic banks managed to continue their aggressive growth despite the funding crisis in 2006. Strong reported financial key figures masked the true riskiness of the Icelandic business model and the extreme concentration risk in the financial system. In addition, investors and rating agencies overestimated the value of potential sovereign support from a country whose fiscal capacity was limited compared with the size of the banks’ assets. Helped by strong credit ratings and implicit sovereign guarantees, the banks were able to fund their risky business