Sighvatsson, Arnór; Gunnarsson, Gunnar --- "Iceland’s Financial Disaster and its Fiscal Impact" [2011] ELECD 493; in LaBrosse, Raymond John; Olivares-Caminal, Rodrigo; Singh, Dalvinder (eds), "Managing Risk in the Financial System" (Edward Elgar Publishing, 2011)

Book Title: Managing Risk in the Financial System

Editor(s): LaBrosse, Raymond John; Olivares-Caminal, Rodrigo; Singh, Dalvinder

Publisher: Edward Elgar Publishing

ISBN (hard cover): 9780857933812

Section: Chapter 8

Section Title: Iceland’s Financial Disaster and its Fiscal Impact

Author(s): Sighvatsson, Arnór; Gunnarsson, Gunnar

Number of pages: 22

Extract:

8. Iceland's financial disaster and its
fiscal impact
Arnór Sighvatsson and Gunnar Gunnarsson

8.1. INTRODUCTION

In October 2008, Iceland experienced a financial calamity of unprec-
edented scale. The sustainability of government finances immediately
came into question. Overnight, after the implosion of all of its major
banks, with massive losses to foreign creditors, Iceland became ostracized
from international capital markets for an extended period of time. The
sudden stop of international capital flows lead to the collapse of Iceland's
currency, which depreciated by 60 per cent from 1 September 2008 until
capital controls were instated on 28 November 2008. Although the scale
of the twin crisis was without precedence (see Figure 8.1), the build-up
of unsustainable macroeconomic imbalances and misalignments in asset
prices followed a typical pre-crisis pattern described in the literature.1 Lax
risk management and low perceived risks based on optimism about the
future prospects of the booming economy made the financial institutions
and the private sector far too willing to assume imprudent risks. Financial
institutions overextended themselves, not only domestically but particu-
larly abroad. The large scale of the banks' cross-border and cross-currency
operations while their principal lender of last resort (LOLR), the Central
Bank of Iceland (CBI), could by and large provide them with liquidity
only in domestic currency made them particularly vulnerable to a run on
their foreign liabilities.2
In a few years, the three major banks had become among the largest in
the world relative ...