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OMAR ERLINGSSON: My name's Omar Erlingsson.
I'm in infrastructure security.
I'm here to present the speaker for today's special talk
with the Authors at Google series.
So our speaker is Gudrun Johnsen,
who is a statistician and economist from University
of Michigan, Ann Arbor, and she has worked for the Icelandic
Parliamentary Special Investigation Commission
on investigating the causes of the economic collapse that
happened in Iceland in 2008.
So for me, it's quite a personal subject.
I'm originally from Iceland.
My family and I moved there in 2007 from here
in Silicon Valley, where I've been working until then.
And on a trip back, one of my colleagues
asked me about what were the underpinnings
of the Icelandic economy, and I knew
that there was a lot of fish.
That's what had been there when I was growing up,
and I knew that there was a lot of banking,
and I didn't exactly know what.
There was some financing, banking, stocks,
and so on, and very soon after that,
it all came down with a ***.
95% of the market value of the stock market
vanished overnight.
Three of the six-largest bankruptcies in world history
are Icelandic banks, so quite a large turn of events.
As it turned out, what really happened
behind all of this, and this great, rapid rise in the banks,
seems to be all kinds of different shenanigans.
And so Gudrun is here to tell us about those shenanigans, which,
because Iceland is relatively small,
and because of this completely unprecedented
special commission set up by the Parliament, which had basically
total powers of investigative authority,
able to see all data everywhere, with no exceptions,
we actually know what happened there.
But I think in a greater context, most of us
had just moved to Iceland, and there's
a lot of stuff that's going on in world finance
and so on that is quite reminiscent of the shenanigans
that were happening there a few years ago, and I don't think,
fundamentally, very much has changed.
So anyway, with those words, I will give the word over
to Gudrun.
GUDRUN JOHNSEN: Thank you, Omar.
[APPLAUSE]
GUDRUN JOHNSEN: Thank you so much, and a special thanks
to Omar for inviting me here and organizing this event.
It's a great opportunity for me to be here with you.
I have been giving this talk mostly at financial
institutions and government agencies,
but I wrote this book, "Bringing Down the Banking System,"
as a wrapping up this 2,400-page report that we issued that
nobody read into manageable size of 200 pages,
but I wrote it for non-financiers, let's say,
if there's such a word.
So it's great to finally be in front of my targeted audience.
Now, as Omar mentioned briefly, 97% of the Icelandic banking
sector collapsed in October 2008,
and before we entered into the investigation
of the Special Investigation Commission,
where I was actually the first employee
to be hired by the Commission-- so I was there from day one
until the minute it was published in 2012--
we sort of had an idea why this happened.
But obviously, that wasn't enough for the Icelandic public
to be told that that was a result of a rapid growth
of credit, and size of the banking balance sheets to GDP,
and inadequate financial supervision.
I mean, that's the short, elevator story,
but we needed to tell them how exactly this is possible,
and how do you do this-- expanding your banking
sector from being about 1 times GDP to 10 times
GDP at the peak?
We also needed to tell them why would you ever want to do this,
given that this is a really risky strategy, so why would
you ever want to do this?
The third question we had to answer was why on earth
didn't anybody stop this development?
And finally, in my book, I try to bring forward
to the rest of the financial world
what we can learn from this calamity.
Now, I will ask you to jot down your questions.
We're going to save the best for last-- your questions.
It's quite a lot of material.
It demands quite a bit from the audience,
so I'll ask you to wait with your questions
until at the very end, unless something
is horribly vague or confusing.
Now, very briefly, on the SIC, it was installed by Parliament,
and there were three people appointed by the Parliament
to sit on the Commission.
There was a Supreme Court justice, Pall Hreinsson,
Sigridur Benediktsdottir, who was a lecturer at the Economics
Department at Yale University at the time,
and another lawyer, Tryggvi Gunnarsson,
who's Althingi's Ombudsman.
Althingi is the Icelandic parliament.
Now, the mandate was not of any insignificance.
It was to seek the truth, no less, behind the events leading
up to the fall of the Icelandic banks,
and what was also quite challenging
in a small society-- and bear this in mind
throughout the lecture.
Iceland is a large country, relatively large,
but we are only 330,000, roughly, who live there.
So somebody told me half of Frankfurt.
Half of Frankfurt-- that struck me as a quite a good benchmark.
Now, the challenging part was to basically find out
whether mistakes or negligence had occurred
in the course of the implementation of the laws
and other rules regulating, or providing control for,
the financial market.
And in addition, what persons may be responsible?
Now, the degrees of separation in Iceland
is obviously one or two, so this is a delicate matter.
This was a privilege to actually be involved with this effort,
simply because the Icelandic parliament thought
that it would be impossible to deliver a proper investigation
without full access to all data that the Commission deemed
necessary to deliver on their mission.
Now, we basically had powers to search all premises,
seize evidence considered necessary
for the purpose of its investigation,
subpoena witnesses.
And in return, we were to report any suspicious contact
to the special prosecutor, who was still working on cases
brought about as a result of this investigation and other.
The final product was a 2,400-page report,
published 12th of April 2010, and the task was quite big.
We did not like the Lehman examiner's report.
It's also 2,400 pages.
We'll go over that soon, but just to tell you,
the scope of the research was the third-largest bankruptcy
in history.
And we had to go into three banks--
not only one-- and all surveillance authorities
involved with oversight of the financial sector.
In addition, a special request from Parliament
was to investigate the cross-ownership
of Icelandic firms, and I think there,
the biggest contribution to the rest of the world of finance
lies.
This analysis into the cross-ownership
of Icelandic firms.
Now, we were 48 people.
We're, again, 330,000 people living in Iceland,
and it was quite remarkable that we
were able to find people who were not conflicted in any way.
Many of them had been living here in the States.
Most of them had done research, were PhDs from here
in the States-- Yale, Stanford, and elsewhere.
So basically, with all this data,
we collected data from the entire financial market,
funding of the banks, all loan portfolios of the banks,
so every single loan, including Visa statements,
the salary data, and also, what I'm particularly proud of-- we
gathered data from the stock market,
and down to basically individual investors
on both sides of the trade-- so this
is a high-frequency dataset.
In addition to the data I mentioned before, we also
received the entire registry of enterprises in Iceland,
and that was essential to be able to drill down
the cross-ownership of firms.
Now, just for the sake of comparison,
the cost of the investigation-- you
can find the whole report on this.
There are selected chapters translated in English.
2,400 pages, 800 pages supplement
online-- it took us 15 months, and the cost
was $2.5 million US.
Now, the examiner report on the fall of Lehman Brothers
is also available online.
It is 2,200 pages.
It took them 15 months to get it done.
The cost was $38 million-plus US.
So you can see that you can get experts
from Iceland on the cheap.
[LAUGHTER]
Now, to start answering the questions I proposed
in the beginning-- how did this happen?
At the early start, funding was easy,
and basically the bankers went into the European medium-term
note market, and received about 35 billion euros'
worth of bond issues.
AUDIENCE: Sorry, the European what market?
GUDRUN JOHNSEN: The European medium-term note market.
That is a standardized, bond-issuance program.
So you see here that the columns here
show that the European market had
a big appetite for the Icelandic bonds in 2005.
It dropped somewhat in 2006, and you
see what opened up-- that was the US medium-term note market.
It opened up for the Icelandic banks,
simply because of this very nice feature.
They had a stellar credit rating that was largely
inherited by the Icelandic state, which was virtually
debt-free at the time, but they were also
willing to pay high interest rates
at the level of other emerging-market institutions
a with lower credit rating.
Now, it was as if they didn't really think this through.
The appetite for issuing bonds was enormous,
but they were bond issues for three- to five-year maturity,
and in fact, the first big payment
was too big for them to deliver on.
So in October 2008, Glitnir bank went
to the Central Bank of Iceland, and basically said
that they wouldn't be able to meet this payment,
and asked for of a loan of last resort, and from then on,
things started to unravel quickly.
Now, the terms were good in the beginning,
as credit rating went through the roof.
In 2007, they received the highest grade,
top of the class, triple-A rating from Moody's, which
Moody's corrected in a couple of months.
Moody's thought that these banks were simply too big to fail,
and would be bailed out in whichever circumstances,
but failed to recognize that the banks had already
exceeded the GDP, where everything we produce
in Iceland 10 times, so we would never
be able to bail out those banks.
Now, as you see here, it's a nice-- here at Google,
the first thing you do is to plot your data--
and here you see Kaupthing five-year bond issues.
At the beginning, they are issuing 1 billion euros.
At the time, at a rate around 20, 20 to 30, and it rapidly
grows.
Here are some peculiar outliers.
Somebody is accepting much lower rate than the market is.
Now, we did receive our warning.
In 2006, a market analyst started
to point out that this rapid growth of the balance
sheets of the banks was unsustainable,
and, well, primarily, Danske Bank
came up with this very nice term for it-- the geysir crisis.
And it fitted this episode very well,
because the CDS spreads-- the Credit Default
Spreads-- they kind of blew up, but settled down quickly
again at a lower level.
But that did not measure up to what was to happen later on,
when the big, blue mountain blew up,
and we had CDS spreads going through the 1,000 mark.
Both Icelandic bankers and officials alike
dismissed this market signal completely,
and they claimed that the CDS market
was marked by collusion, ignorance--
it was a thin market, and so on, and so forth.
And it is just as if they didn't really
know what they were talking about,
or they didn't really look, because when the banks failed,
there were $70 billion US outstanding CDS
contracts on those three banks.
And again, comparing to Lehman, outstanding CDS contracts
on Lehman were $72 billion, so it
was, by no means, a liquid market, in that sense.
Of course, it's a market with insurance,
so it's not going to behave like stock markets, right?
Now, being faced with such a high cost of funding,
the banks simply had to turn elsewhere to refund the banks,
and where did they go?
They went into two directions.
One was to go to the supremely informed central banks,
and they managed to borrow the equivalent of 9 billion euros
at the very height.
Again, comparing to the financial rescue package
that Iceland received from the IMF and the rest of Scandinavia
was about 3.5 billion euros, so a significant amount of money
they borrowed from the central banks.
And how did they manage to do that?
Well, they backed it with bank bonds, to large degree.
Here you can see the collateralized lending
from the Central Bank of Iceland.
This is denominated in ISK, so you can see basically
how dependent they are of this short-term, fine-tuning funding
facility from the central bank, so for three years, they're
completely dependent here on the $100 billion-- at the time,
was roughly half of the budget of the Icelandic state.
AUDIENCE: [INAUDIBLE]?
GUDRUN JOHNSEN: Say again?
AUDIENCE: What's the conversion [INAUDIBLE]?
GUDRUN JOHNSEN: Roughly 100.
Now, they backed it with government-secured bonds,
but also with fellow bank bonds, and that they did
at an increasing rate.
The central bank acknowledged that
this collateralized lending was getting excessive,
so they tried to stem the funding to three banks,
but the bankers really didn't stop at that,
so they asked a rival, small, cooperative bank
to aid them in the process of virtually printing money out
of the Icelandic Central Bank.
So what they did was they issued new bonds, fresh bonds.
That's a certain interest term, and then they
turned to the rival bank, which received the bank bonds, which
then, again, turned to the Central Bank of Iceland
to get liquidity out the Central Bank of Iceland.
And the bankers reported it to the Special Investigation
Commission that this was a stunt that they played, and had
learned about from other European bankers, which
is a little bit worrying, obviously.
Now, they did try to play the same trick on the European
Central Bank.
They placed bonds as collateral against the loans
from the European Central Bank, but you
see how they pick up on it in May,
and the story goes that the ECB basically
directed their demands towards the governors of the Central
Bank of Iceland to have the bankers take this out,
realizing that they were swapping bonds.
There was no original investor backing them at the outset,
and after awhile, they basically disappeared from the books
as collaterals of the ECB.
Now, what they did, though, and the amounts
were quite steep-- 4.5 billion euros they received
at the very top from the European Central Bank--
so after having been asked to take out the Icelandic bank
bonds, well, they replaced them with CLOs and CDOs
that had ISK assets among them.
So collateral in ISK, in Icelandic krona,
against the loan in euros is not a good collateral at all,
so there's a whole story about that.
And the Icelandic Central Bank, in fact,
bought these CLOs from the European Central Bank
in the year 2010, and the European Central Bank
reported that it did not lose anything
on the deals with the Icelandic banks.
That was not the same story with the Icelandic central bank,
which virtually became bankrupt, as a result of receiving
collaterals that they couldn't collect
after the banks had gone over.
Back to the growth, and I know I'm cheating here a little bit.
I am showing you here nominal growth,
but it was reported-- nominal growth, 20-fold in seven years.
So prior to getting involved with the Special Investigation
Commission, I was working for the IMF, where we were studying
rapid credit growth, and I can tell you
that it's impossible to find data
that would show you larger growth of any banking sector.
Now, obviously, when you see banks grow this fast,
some people get worried.
They know that institutional structure,
or an institutional capacity, does not really
support this growth.
People cannot extend credit at this fast a pace,
and ensuring that all relevant documents have been collected,
and the credit scoring has been proper.
So the bankers basically pointed out,
after receiving this criticism, that they
were growing too fast.
Well, we are diversifying.
We are getting outside of Iceland,
acquiring new institutions, new banks, new endeavors.
But when we looked at this, and tried to verify this statement,
we saw that not only was the acquisition growth large,
but the organic growth was also quite large-- another world
record, basically.
We saw the banks grow 50%, 60%, 35%.
This is phenomenal.
So it surely was a strain on the institutional infrastructure.
Now, then you could ask yourself, again
with the 330,000 people, all of this money coming in,
what did they do with the money?
The Commission basically was able to,
although the data that was a little bit difficult there--
background variables weren't properly collected--
but there are features in the identification number,
or social security number in Iceland,
that aided us in categorizing the loans that
had been extended.
And we found out that about 60% of the loan books
were to foreign entities-- so implying diversification--
and to holding companies in 2007.
But after good cooperation with Luxembourgian authorities,
because we didn't, obviously, have the same data privileges
in the UK or Luxembourg or elsewhere,
where the Icelandic banks had operations.
We did not have any access to data from the subsidiaries.
The Luxembourgian authorities supplied us
with two data points, where we could
see that the maturity of the loan books of the subsidiaries
were also somehow connected to ISK risk,
so dismissing this statement that the growth was primarily
outside of the country, and at the hands of diversification.
Now, back to that small population,
you've got to wonder how is it possible to extend
such an amount of credit, given the legal constraint that one
banking institution can only extend about 25%
of its equity base towards a group of related parties?
Now, we think we know how you do that,
and this is basically how you do that.
This is the cross-ownership of firms in Iceland.
The red dots represent each firm,
and there are some ownership connections to the next dot,
but these are only large firms in Iceland, so let's say,
500 million ISK is $5 million US, roughly,
is the balance sheet of each and every firm here.
You see where the nodes lead?
These nodes are the banks themselves,
so this is the interconnectedness
of the Icelandic economy before the collapse.
Then our task was to assess who are the related parties,
according to the definition of the law?
And using an algorithm and this network analysis,
we were able to assess, or rather come up
with an unbiased methodology, to actually find out
who were connected, and here you see just two random examples.
And what was also a little bit scary to see
is the circular events that you see.
Here is a firm A that owns firm B that owns firm
C that owns firm A. So under these circumstances,
virtually no equity, no skin, is put in the game.
So one of the lessons is that if we don't properly
analyze ownership or ownership ties
or interconnectedness in our system,
we know that agents that play this game simply have-- the sky
is the limit, so there's really no limit to how much risk
they're willing to take, because they are not
risking their own money at all.
Now, after we had identified the related parties,
we then merged them to the portfolios
of the banks-- the loan portfolios-- and lo and behold,
we found out that the borrowers were, to a large extent,
the owners of the banks.
It varied a little bit in levels how much access
they had to their bank, but here, this particular group,
Baugur Group, received the equivalent of about 80%
of the equity base of Glitnir, where
they were controlling shareholders.
So here you see the legal limit is 25.
They exceeded it throughout the time.
Now, here's their business partner,
who also gained a controlling stake at the bank
at some point.
Somebody wants to venture a guess when that happened?
AUDIENCE: 2007.
GUDRUN JOHNSEN: So yeah, it's right here, in June 2007.
So as I say, it was the same pattern in all three banks.
Here Bjorgolfur Thor Bjorgolfsson,
one of the controlling stakeholders,
exceeded the 25% threshold throughout the four-year period
we had data for.
And the same goes for Exista, controlling stakeholder
in Kaupthing bank, again, dancing along the line
throughout the period.
Now, obviously the loan portfolios
were marked by excessive risk, and the next task
was to see the payment structure of these loans,
and that was also quite shocking to discover
that not only had they been extended
to holding companies that were tied to the owners
to a large degree, but also they were not
paying anything off the loans.
They were not paying interest rates,
and they were not paying off any of the loan
during the lifetime of the loan, so bullet loans
became the largest share of the portfolios.
Then you wonder, what type of collateral
are these borrowers putting forward?
And that really matters.
Because we had this beautiful data privilege and this dataset
from the stock market, and we had also access to the bank,
so we could see what was inside of the custodian
accounts of the banks, because that's an old trick in the book
to have your bank hold the stocks that you are pledged,
so your ownership is not disclosed at all.
So what did they pledge?
Basically, to a large degree, the banks
had received a collateral in the form
of listed stocks in Iceland.
There is a caveat here, because the data quality on collateral
was incredibly poor, so this was really
the only comprehensive data that we could receive,
in terms of collateral.
So this is a little bit misrepresentative here,
but still we saw that, for example,
FL Group was an investment boutique, or investment
closed-end fund, in fact, and about 70%
of all outstanding shares in this firm
were pledged into the banking sector.
To our horror, though, we saw that about 40% of Kaupthing
was pledged into Kaupthing as collateral, or as treasury
stocks.
Now, that is illegal.
You are only allowed, according to Icelandic law,
to hold 10% of treasury stocks.
This is illegal in the States.
At least if you do have treasury stocks,
you need to deduct them from your equity base.
It's money that hasn't been paid into the firm,
or equity that hasn't been paid into the firm.
The following question, after having discovered this,
we had to ask ourselves, how did they behave in the stock
market, then, I mean, now that they were
dependent on collaterals from the stock market?
And lo and behold, we saw a certain pattern there as well.
Here you see Kaupthing trading in own shares,
and Kaupthing is buying above 0, and they are selling below 0,
and the blue line here represents
the price of the share price of the Kaupthing stocks.
And you immediately-- it jumps out of the picture
that this is not symmetric, so they
are buying close to 60% of the volume.
Of all trades in Kaupthing, they are
on the buying side at the very end,
but what are they doing in terms of selling?
They're not selling anything.
So what were they then doing?
What type of business was this?
What we figured out was that they were primarily--
you see the blue columns here-- they are above 0,
so they are being bought on the stock exchange,
but Kaupthing is selling over the counter.
Now, one of my favorite pictures in the whole 2,400 pages
is right here.
It represents the level of leverage in the Icelandic stock
exchange.
It's a delta, so how much are we increasing,
in terms of taking collateral in the form of listed shares?
And as long as you are receiving more and more collateral,
or you're accepting more and more collateral
in the form of stocks they are buying on the margin
more and more, you see that the price is rising.
The red line there leveling out--
as soon as you stop accepting listed shares as collateral,
the price drops like a stone.
So this is virtually a picture of an asset price bubble.
AUDIENCE: Why were they buying [INAUDIBLE]?
GUDRUN JOHNSEN: Why were they buying
all these shares in themselves?
Basically they had become quite dependent on the share price,
and we will see it on the next slide, which
added to their demise, is that the largest
controlling stakeholders had also
borrowed money from the big investment houses in the US--
so Citigroup, Morgan Stanley, and those--
and they had pledged the Icelandic stocks
in the Icelandic banks as collateral
against these international loans.
Now, after the stock market had started to decline,
the Americans basically called on the margin,
and what the bankers in Iceland decided then-- well,
we can't allow this to happen, because they
will go into the market, and sell those shares,
and what will happen with our pool of collaterals?
It will decline.
So they decide to chip in, and pay the margin calls,
and refund those shares that were in themselves, accepting
their own shares as collateral.
So basically, a year before the banks
finally collapsed, they had become
so dependent on their own stock prices
that they decide to bat for life,
and take over this collateral that is no collateral,
if they themselves go under.
Which then, again, this would have been fine
if they had deducted the shares that they took
as collaterals from the equity base,
but they forgot about that.
So if we take that into account--
and here you see we only take that into account--
the capital adequacy ratio that they reported
was misreported basically, and here you see Glitnir.
It's, in fact, close to the legal limit, which
is 8%, a year before the bank collapsed.
For Landsbanki, it had already gone below the 8% limit,
so there the Financial Supervisory Authority
should have tapped in and taken over the operations.
And if you count cross-financing--
financing of the rivals-- in fact,
22% of the equity is basically funded this way, and 36%, 33%,
2008, so one third of the equity was basically not there,
and in my mind, that is falsification of equity,
but the report goes the route that claiming that this is weak
equity that cannot be drawn on in the case of bankruptcy.
Now, you've got to start wondering why people do this,
and the short answer is, they became rich.
Here you see the incentive schemes
pushed for excessive risk taking,
and just as a very small evidence
of that is that here you see the total share of base salary,
of total pay, in 2004 in Landsbanki.
Here's the 99th percentile, so the CEO is placed here,
and the key personnel-- they received about 40%
in base salary in 2004.
In 2007, it's below 10%, so economists--
we have sympathy towards the decision-making process that
happens there.
One, if you're not going to meet your bonus target, you going
to reduce your consumption by 90%?
No, there's is a very strong incentive
to start manipulating a little bit,
or extending the evergreening loans,
and so on, and so forth-- rolling over loans,
so that the picture looks a bit more rosy to meet the targets,
and that is exactly what happened.
There's enough material for a separate talk on the incentive
schemes themselves, but in short, whether intentional
or not, the management of the banks
used staff as vehicles to falsify equity.
In Landsbanki, for example, stock options
were issued one day, not as a bargaining tool in salary
negotiations, but one day, we have
a record within Landsbanki, where staffers were called up,
and said, hey, you've got an option grant now.
Please come up and sign.
And the management decided to hatch those options,
so basically in the beginning, they lent money into SPVs
in Cayman Islands and offshore, lent money
to have the SPV go into the market to buy the stocks,
and hold them until the options were vested
or they were exercised.
Now, this is a rather unusual and unnecessary hatch.
As I say, we can go into depth here,
but in short, obviously the management
decides on the timing on when to go into the market
and buy those shares, and what happens when you inject
into the market billions of ISK buying stocks in Landsbanki?
Well, the price will go up, of course,
and the options will be in the money immediately.
Kaupthing started out with this, but they faded out their option
program, and instead they had their staff borrow money
from the bank to go themselves into the stock market,
and buy the shares.
The shares were a collateral in that loan deal,
and therefore should have been deducted from the equity base.
Now, back to the funding side.
The banks were experiencing incredibly high prices
on funding, or terms, in the bond markets,
so apart from going to central banks,
they went into the streets of London and Amsterdam
to get money through deposit collection,
and here you can see the total debt of Landsbanki.
It changes rapidly.
The loans and deposits become the largest share
of the funding structure.
Now, as it is very risky to extend credit out rapidly,
it is also very risky to collect deposits very rapidly,
and they tend to be not so loyal.
And how were they ever able to attract all these 300,000
depositors in the UK in less than six months?
They basically offered the highest rate.
And you're not supposed to scrutinize this regression
analysis.
This is very crude, and you see that there is not very much
variation here, but basically we saw
that if Landsbanki reached the first place, as highest deposit
rates-- they attracted about 18 million, on average, a week
into the accounts, but if it dropped down to fifth place,
they lost 16 million, so these were not very sticky.
It's very volatile funding, and here
is a picture of basically outrun on the bank that happened here
in the early of 2008.
There's a whole story behind that,
but I will leave my book to tell you.
AUDIENCE: Are they able to pay those high rates
by attracting future customers?
GUDRUN JOHNSEN: So the question is, are they
able to pay those high rates?
Well, at the end of the day, no, of course not.
They were run upon.
Well, as they collecting, they paid the interest rates, yes,
but it was not sustainable model, as it turned out.
AUDIENCE: So is it sort of like a pyramid-scheme thing, where
by offering higher rates, we'll get
a lot of [INAUDIBLE] customers, and we
can use [INAUDIBLE] deposits, and pay the high rate?
[INAUDIBLE]
GUDRUN JOHNSEN: So is it like a Ponzi scheme, where
you are giving up high rates as you have the program open,
and then you just disappear?
Yeah, well, it was not intended like that,
but that is the effect of it.
Now, as you can see here, here's a random Icesave in April 2008,
and at the time, the management of Landsbanki
reported it to the Central Bank of Iceland
that with this outflow, they would
survive for six more days.
The Icelandic governors of the Central Bank of Iceland
then reported that to the government,
to the prime minister and the foreign minister,
and there was really no reaction to this news.
Icesave has been the largest foreign dispute
Iceland has had since the Cod Wars,
and this is an ongoing saga, and hasn't been fully resolved,
although the EFTA Court ruled on whether the Icelandic state was
liable for the deposits, or should pay out the deposit
insurance amount to the foreign depositors.
The Court ruled in favor of Iceland
basically, so we have figured out where the liability lies
with a state or with an insurance fund that
has been set up, and, in fact, in this case,
the insurance fund is liable.
Now, as Lehman Brothers failed, obviously that
proved to be an accelerator, in terms
of deciding the fates of the Icelandic banks.
After the collapse of Lehman, the collaterals
that had been pledged against loans from the ECB
fell sharply, so the ECB started to call on the margin.
Also, the depositors in the UK and the Netherlands
became uneasy, so they started to withdraw their funds
from the accounts, and essentially, Landsbanki
was run upon, and since they had collected the Icesave deposits
into a branch, which was under the supervision
of the Icelandic Financial Supervisory Authority,
the Brits had very little means to step in.
They knew that Landsbanki was not meeting its liquidity
requirements, because the money was just rolling out,
so they they found no other option
except for intervening through a legal act that
has become very controversial in Iceland--
the so-called Terrorist Act, whose name is,
in fact, Anti-Terrorism, Crime, and Security Act of 2001.
So the deposits of Landsbanki were moved out of Landsbanki,
and basically the fate of the bank was therefore decided,
or they had met their fate, let's say.
But we know now that the banks had little chance,
both because they were so interconnected,
and they had not enough equity as a buffer
to see any of their assets go down in value.
Now, basically Kaupthing met the same fate a day later.
The story is a little bit different there,
because Kaupthing adds, where they were collecting deposits
from the UK residents and elsewhere, was
done through a subsidiary.
And this is one of the lessons of the Icelandic episode
is the difference between a subsidiary and branch,
and who is responsible for the financial oversight.
Now, the Brits were responsible for the oversight in this case,
and after Northern Rock had failed-- first bank
in 150 years or so to fail in the UK--
the supervisory authority became quite worried that there might
be other vulnerabilities in their system,
and what they spotted immediately
were the Icelandic banks.
And basically the Deposit Insurance Fund was underfunded,
so the British depositors acknowledged
that in case of failure, it would be difficult
for them to reclaim the money.
So in all of the circumstances-- and obviously,
bear in mind that Lehman had just
failed-- the British had seen some movement of funds out
of the UK over to the US just prior
to the collapse of Lehman, the British authorities basically
set up a very stringent liquidity rule
against Kaupthing saying, 95% of those deposits
that you are collecting through Kaupthing Edge--
we need you to put them into liquid funds,
into treasuries and papers that can be converted into cash very
quickly.
So with this rule, the Kaupthing management
should not have been able to use it for their own good,
but, in fact, they managed to trick
the financial supervisory authority in the UK
for awhile, because they engaged in a liquidity
swap between the parent company and the subsidiary.
So in essence, they counted the money two or three times,
so the first time around, it was counted as liquid money.
The second time around it was just
their funds, which they could do whatever with, and including
sending it up to Iceland for the parent company
to meet their margins, or pay off their bonds,
and so on, and so forth, and that is exactly what happened.
Now, on top of this, so there were 1.1 billion pounds
sterling engaged in this, so missing
from the liquidity pool of Kaupthing.
But on top of that, the collateral
that they had pledged to the subsidiary for lending
from the daughter company declined in value,
but the subsidiary was irrespectively
willing to extend the credit lines by 500 million pounds,
without taking any collateral, and this
the British interpreted as siphoning money up
through the chain of firms, and up to the parent company.
And as a result, having waited for the management of Kaupthing
to react, the British authorities deemed
it necessary to take over the Kaupthing Edge deposits
and move them into ING, and withdraw the bank
license from the [INAUDIBLE] of KSF--
so a similar fate, slightly different story.
Back to Iceland, the debt-free state-- in early 2008,
suggestions were being made to the Icelandic authorities
that it should turn to the IMF for help.
That was after the Central Bank of Iceland
had tried to get credit or foreign-exchange
swaps with central banks in Europe,
and even here in America, without success.
And that is a signal that is fairly decisive--
a debt-free state unable to get any credit anywhere.
That should tell you something about the situation.
The only takers in the FX swap market
were the Scandinavian central banks,
who, in turn, put forward very strict conditions, in exchange
for the money swapped.
And the conditions were at the microeconomic management level,
such as, the centrally negotiated wages cannot
increase in real terms.
The Icelandic state cannot take on any further debt whatsoever,
so this is very invasive type of debt covenance, if you will.
And as it turned out, very few people knew about it
in Iceland, and the prime minister did not even
disclose this information to the entire cabinet,
and as a result, he got indicted and brought
before the special court in Iceland that rules on breaches
on the part of ministers in Iceland-- Landsdomur,
it's called.
So for the first time in 100 years' history of that court,
the case was brought against him.
Now, now you know how all this happened, and why it happened.
So the next question is, why didn't anybody
stop this development?
And the short answer is, it was too rapid of a credit growth,
and there were too few people to handle all of this,
or rather, the main cause here is, basically
the politicians didn't acknowledge
the need for strong supervision.
If you're going to build your economic system on the pillars
of a financial institution's being one
of the main industries of the economy,
well, you need to have something to back it up,
or strong oversight, and there, the policymakers basically
failed in Iceland.
So we had the Financial Supervisory Authorities
doing financial oversight of something
that was 10 times the GDP of Iceland with only 36 employees.
And for a trained statistician, such as myself,
it was a shock to observe that no proper data-analysis
equipment were used.
Data was gathered in Excel sheets of 47 sheets
from each and every institution-- hundreds
of small and large financial institutions in Iceland,
and this was the data archiving and collection,
so it's impossible to have an oversight
under these circumstances.
So Financial Supervisory Authorities, in short, there
were lack of experience and incompetence,
lack of proper IT systems.
Tool and processes for data analysis weren't in place.
There was lack of authority and follow-up.
Cases were kept too informal for too long.
Violations of the law went unnoticed,
and law was not enforced.
Now, the Central Bank of Iceland did have some more insight
into the risk, and also a legal obligation
to ensure financial stability in the country.
It, however, never formally or informally conveyed it
to the government what needed to be done to avert the risk,
and had it thought that they lacked the legal means to do
so, they did not report that either to the government.
Now, there were a host of tools in the policy toolbox
that could have been used, but were, in fact, not.
So one of the lessons-- and he put it very nicely out,
Thorarinn Petursson, senior economist of Central Bank,
the state of affairs in Iceland at the time--
"I think there is a fundamental misunderstanding of what
financial supervision is all about here in Iceland.
Not only at the FME, Financial Supervisory Authorities,
but also the Central Bank.
They thought that the role of these institutions
was to follow upon whether the letter of the law
was met by those under supervision.
So you are watching an entire financial system falling off
a cliff, and as long as you are following the law,
you are fine."
So one of the recommendations of the Turner review in Britain,
which was issued after their crisis,
is that the regulatory and supervisory coverage
should follow the principle of economic substance, and not
a legal form.
Just to inform you of the losses that
were incurred after the collapse, about five times
GDP was written off in a matter of four or five
months after the system collapsed,
and these delicate findings, or the challenges that we were
faced in the beginning, this special investigation
commission ruled that on the mistakes or negligence
by ministers and public officials in the period
leading up to the collapse of the banks,
the SIC is in the opinion that the Prime
Minister, the Minister of Finance,
the Minister of Business Affairs, Director
General of the FME, governors of the Central Bank of Iceland
showed negligence within the meaning of Article 1.1
of the law on the Special Investigation Commission.
And as I told you before, the prime minister
was found guilty on one count out of four of negligence
by a special court, Landsdomur.
Now, fraud or failure on part of the bankers
is still being decided.
Some of them have already received a sentence
on a regional level or a local court.
Management of Kaupthing has been sentenced
to three to five years in prison for fraudulent lending
practices and market manipulation.
They have appealed.
Cases are pending against the Landsbanki management for fraud
and market manipulation, and Larus Welding, CEO of Glitnir,
was found guilty, but acquitted by the Supreme Court.
Several other cases are pending against him.
The special prosecutor had over 200 cases in total.
58 are currently under investigation.
20 indictments-- 15 already brought
to court-- and eight cases have been
ruled upon against 46 individuals,
so this is already exceeding your legal efforts,
or prosecutional efforts, looking into savings and loans
crisis in the '80s.
Now, what can we learn?
My husband is a human factors engineer,
and he has taught me how the human mind perceives things
inadequately, and one of the things
is that we seem not to be able to sense acceleration.
We all know the story when we are going over the speed limit,
and we withdraw to the legal limit,
we find that we are not moving at all.
Taking this into account, you don't put anybody
at the seat of the F-18, is it?
18, 19, 16?
Thank you-- unless he or she has several thousand hours
in the air.
So banks are like monstrous machines,
so you need people that have the proper training
and the proper insight, and also at the realm of the Financial
Supervisory Authorities.
So that said, it is very important
that, as you do here so well in America,
acknowledging the efforts that go into further education,
and, yeah, that's the aim-- to put
the right people at the right spot.
But another lesson is the importance of equity.
These monstrous institutions, the banks,
are running at the very low-equity ratio,
so there's not much room for their assets
to move downwards at all.
This is one thing-- I mean, now in Iceland we
have banks that are set up, or have a funding
mix of up to 25% equity, and it's
just that incentives become very risky,
let's say, or people engage in risky activities,
and it all depends on how they are incentivized.
So if you have your own money in an enterprise,
you behave very differently from where
you have no money of your own in the operation.
Another lesson is that bankers need
to understand that when they are lending money in the holding
companies, they have a claim on the residual claim.
So these structures that I showed you should theoretically
not be possible to construct, simply because if you take
into account that you, the bank, you
are lending the money for the equity part,
you should price it accordingly, so there should be no money
left on the table for the constructors
of these structures.
So pricing obviously failed enormously
in the Icelandic banks.
Supervision should be built on [INAUDIBLE] substance.
We should try to have our legal framework set up in a way
that it supports potential policies that
need to be adjusted quickly.
The letter of the law is obviously fairly sticky.
It's difficult to change in a short period of time.
The medium-term effects in Iceland--
we had massive market manipulation on our hands.
People were not following the legal letter.
They were evading the rules and the law, so as a result,
we have a clear case where the markets break down.
They just disappear, and that is what happened.
The bond market was virtually non-functioning.
Stock market virtually disappeared.
There was no currency market right after the fall,
so in de facto, we had imposed capital controls
right after the collapse, because nobody
wanted to trade the Icelandic krona.
So there are a lot of small stories
to learn from, obviously, but I think
if there's only one that I can leave you with,
it is that we know how our system is interconnected.
It is a question whether you know
how your system is interconnected.
And now I am open for questions.
[APPLAUSE]
So to answer your question, which
was along the lines that, what happened
to the Icelandic people?
How many are unemployed, and so on, and so forth.
The short answer is, we had a spike in the unemployment
rate reaching 8%, 9%.
It has come down to 4%, roughly, now.
So we have had a history of very low unemployment in Iceland.
I mean, most of us had three or three or four jobs,
like you saw on my profile, but Iceland
has been portrayed, like here in the US media,
as a poster child of economic recovery after the crisis.
But I have to tell you, unfortunately,
that the judges haven't ruled on it yet.
We have still got the most challenge on our hand,
and that is to get rid of the capital
controls that were installed right after.
So, for example, if you're traveling abroad from Iceland,
you can only bring $3,000 or so for your rental car
and your hotel, and so on, and so forth,
so it's being sanctioned.
Currency is being sanctioned.
So net foreign direct investment is at a historic low.
Investment, in general, is very low,
so people are seeing their wages have
been cut in half in real terms.
Even nominal terms have been lowered.
Government officials, for example,
haven't seen a raise in eight years,
so this is a big chunk of a person's life's work,
or of career, so we are not part of the woods yet.
AUDIENCE: [INAUDIBLE].
GUDRUN JOHNSEN: They were primarily the loans
to holding companies that were just foam, or they were--
AUDIENCE: The holding companies didn't
want to be [INAUDIBLE], or what?
GUDRUN JOHNSEN: Yeah, they did.
The majority of them held the stocks of the banks themselves,
who became bankrupt, and then you had all this domino effect.
Most firms in Iceland have become technically bankrupt.
That has been the most challenge that we
have been faced with after the crash is to reorganize
and restructure the loan portfolios of the banks,
because more than every other loan of the portfolios
of the banks were nonperforming.
That's a very good question on how we kept politics out
of the reporting on the failures of the banks.
That's your question?
AUDIENCE: More or less.
I mean, we can't do that here.
How did you do it there?
GUDRUN JOHNSEN: I think that you might see different reactions
on part of your politicians if you
had your 97% of your banking sector collapse.
It's just such a severity of the situation that
did not allow for any scrutiny.
I mean, you can wonder about reasons
why the politicians, for example,
extended this type of data access.
I mean, this is unheard of that the one government that
has failed so miserably in their policy making actually
brings on themselves an investigation where
they can be exposed, and that is exactly what happened.
But you've got to applaud this type of behavior
on part of the politicians.
We're a small society.
We were a trusting bunch before the collapse,
and one of the guests that I had in the audience at one
of the financial institutions pointed out
that you need a healthy dose of mistrust in any system,
and that was lacking.
The mistrust was not enough, but now we
swung from the totally trusting system over to a full mistrust.
So there was a lot of scrutiny on part of the public.
Obviously we had a pots and pans revolution,
where people were banging on pots and pans
in front of Parliament, so that was not
much room for politicians to try to cast sand
into the eyes of the voting public.
In terms of incentives, the question
was, what type of prisons do you have,
where people involved in this sentence of guilty verdict--
where can they expect themselves to end up?
And one answer is, the length of the sentences in Iceland
are very short, so as it turns out,
we have had one case of insider trading
that has been ruled upon, and the person involved
has gone to jail for six months total.
The sentence was two years.
If you behave well in the prison,
you can get your sentence halved, and then you
can do community service for half of the remaining part,
so in this particular instance, the expected value
was positive, so--
AUDIENCE: And the conditions themselves are bad?
GUDRUN JOHNSEN: Oh, very nice.
[LAUGHTER]
You need to be trained to understand acceleration
and growth and what it means.
Lawyers, for example, are not trained in this way.
But the explanations need to be sought in the behavioral part,
and in small society, there's a big hurdle effect.
People were just cheering for those bankers,
and the government officials and the political leaders
were applauding the people who were in charge,
and so we basically risked being ridiculed,
and I was certainly one of those who had been doing research
on credit growth especially.
I pointed it out a year and a half before the banks failed,
and to tell you the truth, there was no reaction to it
whatsoever, so that's how that was.
Right, so what are the capital controls that
are in place, and what are they meant to prevent?
So they are meant to prevent a capital outflow of the country,
so if there are claims on the bankrupt estates, for one,
there are also foreign investors who own ISK-denominated bonds.
They want to get rid of their krona,
and buy foreign exchange for it, and leave the economy,
and if people do that massively, you
have a run on the bank situation.
So you want to prevent that to happen,
because if you allow that, the currency of the krona
will devalue, and most of mortgages in Iceland,
because we have had a history of high inflation in our economy,
they are index-linked, so they're
linked to the CPI index.
So if foreigners leave rapidly, the system-- the krona
devalues, and, for example, debt of corporates,
as well as households, will increase, as a result.
So you will have a turbulence-- probably nonperforming loans,
et cetera, so turbulence in the financial sector.
Financial instability is what you are trying to prevent.
Does it answer your question?
So thank you, everybody, for showing up here, and giving me
these great questions to answer-- inspiring questions.
Thank you so much.
[APPLAUSE]