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Iris Erlingsdottir
Iris Erlingsdottir

Icelandic journalist and writer
Posted: February 10, 2010 05:56 PM
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Moral Hazard in Iceland
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One of the fundamental concepts in insurance is that of moral hazard. Whenever a party is insulated from the adverse consequences of his actions, he will tend to engage in more risky behavior than he would do otherwise.

We see aspects of moral hazard around us every day. Politicians make public spending decisions based on information that is much less than they would require for their personal spending decisions, since the money does not belong to them. Investment advisors push stocks on their customers that they would never buy themselves, because they're too risky. Drivers talk on cell phones and text while driving, knowing that any resulting accident will be covered by insurance.

As Iceland's economic collapse has unraveled, it has become clear that many of the current problems now facing Icelanders are the result of moral hazards present in traditional Iceland culture, amplified by the neo-liberal philosophy that dominated our politics until the banks failed in late 2008. Until the conditions that permitted individuals and commercial entities to avoid personal liability for their errors are eliminated, we will be doomed to endless cycles of boom and bust.

Because of its small size (Iceland's population is currently around 310,000), there has always been a very close link between the elite and the dispensation of justice. During the time of the sagas, the goði (chieftains) were not only the wealthiest individuals, but they controlled their warriors and served as the judges at the annual meeting of clans in Þingvellir. Disputes were resolved as much by the force as by any agreed-upon law.

Our colonial overlords maintained a similar system, in which they used their monopolies over commerce and the use of force to ensure that justice favored the colonizers, rather than the natives. When we finally achieved our independence from Denmark in 1944, the families that had grown fat under foreign rule were the only ones with the experience or wealth required to build a modern state.

They maintained a stranglehold on all aspects of Icelandic society--media, fishing, banking, commerce, travel, politics--until they were forced to broaden their numbers as more Icelanders earned university educations and obtained commercial experience, and as the working classes exercised their new-found right to vote, but they ceded control reluctantly, step-by-step.

The new members of Iceland's elite included a group of young libertarian ideologues, led by Davíð Oddsson, Geir H. Haarde and Hannes Hólmsteinn Gissurarson, who took control of the dominant Independence Party and made Iceland into testing ground for the free market ideas of Friedrich Hayek, James M. Buchanan and Milton Friedman. Taxes were slashed and public resources were privatized.

Unfortunately, the privatization process was highly politicized, and the fisheries and the banks ended up in the hands of the ruling parties' patrons, generally for free or for greatly reduced prices. The banks immediately financed a massive spending spree that regulators had neither the expertise nor the resources to effectively oversee.

Not to worry, said the government, the market will regulate itself, and if worse comes to worst, the Central Bank will be there.

If the government had awarded these valuable resources in public sales to the best qualified parties, maybe. However, there was a fundamental imbalance of information. The government did not have the means or the will to conduct a fair sale; it had no way of knowing whether one bidder was better qualified than another. All the politicians knew was that their friends wanted the banks, and would spread some of the wealth their way.

The Icelandic public was largely left out of the decision-making process. There was no transparency: independent expert assessments of the ability of the new owners and their plans were never made public (if they were ever conducted). Politicians were never asked to report family ties to the banks, and were never required to recuse themselves from voting on measures that benefitted them personally.

The beneficiaries of the state's largesse created extremely elaborate corporate structures to mask control and to shield themselves from potential personal liability. Until Merrill Lynch went public in 1971, investment banks were private partnerships in which each partners was personally liable for any losses caused by the partnership. These partnerships' transformation into public corporations was the single most important factor in the banks' risk-taking behavior in the 2000s. As Daniel Gross recently wrote in Slate, "The shift to public ownership ... replaced the accountability of partnerships--when there are no profits, there are no partner bonuses--with the dangerous fecklessness of public boards."

In a partnership, it was in the partners' interest to ensure that junior employees did not take excessive risk. However, as Jón Daníelsson and Con Keating observe, "When proprietary trading forms a significant share of total profits in limited liability institutions, it impedes effective risk monitoring as senior management generally does not have the appropriate incentives to restrict risk-taking activities."

When the banks failed, the shareholders were wiped out, but the employees and officers who had been paid outrageous salaries and unconscionable bonuses did not have to return them, even though the collapse was the direct result of their ineptitude. If the banks had been private entities, it would have been the partners who would have been wiped out.

What is especially disheartening in Iceland is that, not only did the banks' leaders get to retain their compensation; they continue to draw salaries from their new positions of authority in the new banks and in the government, at a time when most Icelanders are being buffeted on all sides by inflation, debt, and unemployment.

Now that the bankers see that their risk-taking did not cause them any personal damage, what chance is there that they will modify their behavior?

Moral hazard also distorts other aspects of the banks' decision-making.

Iceland's Central Bank created moral hazard by implicitly promising to act as the lender of last resort for the banks as they expanded to about ten times the size of the entire domestic economy. To minimize the danger of excessive risk-taking the Central Bank should have closely regulated and supervised the banks, but it was singularly incapable of doing so.

For one thing, the office was seen as a political position. Davíð Oddsson, who had orchestrated the privatization of the banks when he was Prime Minister, had appointed himself as head of the Central Bank, despite his lack of training or experience (he considers himself to be a poet). For another, the high interest rates maintained by the Central Bank in an unsuccessful attempt to control inflation led numerous consumers to take out foreign loans and encouraged massive foreign speculation, apparently to the tune of 50% of GDP. Finally, the Central Bank made no real effort to acquire foreign reserves to prevent the exchange rate appreciation and to prepare for any crisis.

Before the collapse, the banks had every incentive to take crazy risks. The Central Bank did not impose any discipline, but pretended to be a backstop if some pitches were wild. The bubble's inflationary period led to extravagance and decadence that would have shamed Caligula. The Icelanders saw themselves as innately superior businessmen destined to lord over Europe, just as Europe had lorded over Iceland for so long. They weren't tied down by archaic concepts, such as generally accepted accounting principles (GAAP), independent boards, or lending standards, and could be more nimble in seizing opportunities.

Of course, gravity never goes away, and, as Daníelsson has noted, "If the banks become too big to save, their failure becomes a self-fulfilling prophecy." The banks' sheer size relative to Iceland's economy and Central Bank inevitably pulled them down to size.

One consequence of this imbalance is that the Icelandic state has itself become the ultimate insurer of the banks' losses. The IceSave matter that currently dominates domestic debate is a direct result of Landsbanki's desperate attempt to raise capital once its liquidity had evaporated, and some intemperate remarks from Oddsson and Haarde to British authorities.

Rather than swallowing this bitter pill, it appears that the coming national referendum will reject the compromise hammered out by the current government. There are many voices telling Icelandic voters that they have no obligation to reimburse the British and Dutch depositors under international law, that others are primarily to blame (the depositors should have known better, the British and the Dutch should have regulated Landsbanki better, etc.), that they can walk away with impunity.

Perhaps.

Most likely, though, the British and the Dutch recognize the moral hazard in letting Iceland off the hook. If a country is unable or unwilling to create institutions capable of regulating complex international transactions or to punish individuals who take outsized risks, then the country itself must suffer, or other countries will duplicate its behavior. If you forgive Iceland, why not Spain, Greece, Ireland, the Baltic States, and all the other countries currently going through economic hell. How can you expect them to forgive Iceland when Iceland has done nothing to punish the individuals who furthered the IceSave fraud? And how would you force them to adopt and enforce prudent banking regulations if there is no downside?

In Iceland's case, reforms that would be necessary to ensure a return to the global economy must include much tighter control of the banks by knowledgeable independent regulators and directors, which will almost certainly have to be foreign. Elimination of the corporate form for investment banks would ensure much more prudent lending standards. Increased transparency is called for throughout our government, but especially here.

Unfortunately, the party just plays on. The individuals and institutions responsible for the kreppa keep giving one another second and third and fourth chances. For example, when Arion Banki (the former Kaupþing) recently decided to list the reorganized retail chain Hagar on the Reykjavik stock exchange as a public listed company, it insisted that the company's founder, Jóhannes Jónsson, keep ten percent of the stock and remain as chairman of the board. Never mind that Jónsson and his son, Jón Ásgeir Jóhannesson, represented the paradigm of the Icelandic irresponsibility. Never mind that Arion is looking to sell 85% of the company's stock without giving investors control over its direction. Never mind that there are, in Iceland, competent, responsible, experienced businessmen with records of running their companies in a financially prudent manner who could have been brought in.

The former Landsbanki employee responsible for marketing the IceSave accounts, Erla Ósk Ásgeirsdóttir, was recently given a seat in Iceland's parliament--the Althingi--by the Independence Party. Since the IP is currently the single most popular political party in Iceland, despite its central role in the financial bubble, it is very possible that she will be setting policy for the country in short order.

Until Iceland makes serious structural changes, and demonstrates to the world that it can punish incompetent and crooked individuals, it is simply not realistic to expect mercy. Icelanders have succumbed to every moral hazard that has come our way, and we cannot expect to be asked to rejoin the global economic community until we accept responsibility in a demonstrable fashion.

http://www.guardian.co.uk/business/2010/jan/26/sfo-raids-icelandic-firms

Icelandic tycoons at centre of SFO raids

Serious Fraud Office carries out series of raids on offices of firms linked to Lýdur and Ágúst Gudmundsson

• guardian.co.uk, Tuesday 26 January 2010 20.37 GMT

Simon Bowers

The Serious Fraud Office and counterparts from Iceland carried out a series of co-ordinated raids today on the offices of companies linked to Icelandic tycoons Lýdur and Ágúst Gudmundsson, including the Lincolnshire headquarters of Bakkavor, one of Britain's largest chilled food suppliers.

Before the banking sector meltdown brought the small north Atlantic island's economy to its knees in October 2008 the Gudmundsson brothers, both of whom have homes in Belgravia, were among Iceland's most influential and wealthy entrepreneurs. The holding company Exista, in which they hold a near-45% stake, was the largest shareholder in Kaupthing, Iceland's biggest bank, before its collapse.

But yesterday's raids are understood to be focused on other alleged activities at Exista. Among the actions under scrutiny is the sale of a major stake in Bakkavor by Exista to the Gudmundsson brothers shortly after the banking meltdown.

Raids in the UK were conducted by the SFO and British police at four addresses, including Exista offices in Paddington, at the request of Icelandic prosecutors and do not relate to investigations being pursued by UK authorities. Inquiries were sparked in part by a dossier on Exista that was passed to criminal prosecutors by administrators to Kaupthing.

Intelligence exchanges between the SFO and the Office of Iceland's Special Prosecutor Ólafur Hauksson have been building for months, but searches at UK addresses mark a new level of collaboration. Hauksson said he expected more UK raids to follow, relating to other inquiries in Iceland.

Meanwhile, Hauksson's team today carried out simultaneous raids at eight addresses in Iceland linked to Exista. In addition to their own lines of investigation, Icelandic prosecutors were carrying out a formal search request from the SFO relating to their inquiry into past activities at British sportswear retailer JJB.

A joint venture between Exista and businessman Chris Ronnie jointly acquired a 29% stake in 2007 in a deal financed by Kaupthing. Ronnie was later appointed to the JJB board, quickly becoming chief executive. He was suspended last year after it emerged the stake had been seized by administrators to Kaupthing.

The SFO announced in September that it is investigating suspected criminal price-fixing and fraud in the sportwear retail industry. It is focusing its attention on Sports Direct as well as JJB. JJB has negotiated immunity in exchange for whistle-blowing co-operation.

Bakkavor, the launchpad for the Gudmundsson brothers, began as a sleepy fish roe processing firm. In a series of Kaupthing-brokered takeovers in the UK it swallowed Katsouris Fresh Foods — a company five times its size in 2001, and four years later bought Geest,making it one of the largest suppliers of ready meals, pizzas, desserts and sliced fruit to Britain's supermarkets. A year later Laurens Patisseries was acquired from serial entrepreneur Andreas Liveras.

http://www.guardian.co.uk/business/2010/jan/26/sfo-raids-icelandic-firms

Icelandic tycoons at centre of SFO raids

Serious Fraud Office carries out series of raids on offices of firms linked to Lýdur and Ágúst Gudmundsson

• guardian.co.uk, Tuesday 26 January 2010 20.37 GMT

Simon Bowers

The Serious Fraud Office and counterparts from Iceland carried out a series of co-ordinated raids today on the offices of companies linked to Icelandic tycoons Lýdur and Ágúst Gudmundsson, including the Lincolnshire headquarters of Bakkavor, one of Britain's largest chilled food suppliers.

Before the banking sector meltdown brought the small north Atlantic island's economy to its knees in October 2008 the Gudmundsson brothers, both of whom have homes in Belgravia, were among Iceland's most influential and wealthy entrepreneurs. The holding company Exista, in which they hold a near-45% stake, was the largest shareholder in Kaupthing, Iceland's biggest bank, before its collapse.

But yesterday's raids are understood to be focused on other alleged activities at Exista. Among the actions under scrutiny is the sale of a major stake in Bakkavor by Exista to the Gudmundsson brothers shortly after the banking meltdown.

Raids in the UK were conducted by the SFO and British police at four addresses, including Exista offices in Paddington, at the request of Icelandic prosecutors and do not relate to investigations being pursued by UK authorities. Inquiries were sparked in part by a dossier on Exista that was passed to criminal prosecutors by administrators to Kaupthing.

Intelligence exchanges between the SFO and the Office of Iceland's Special Prosecutor Ólafur Hauksson have been building for months, but searches at UK addresses mark a new level of collaboration. Hauksson said he expected more UK raids to follow, relating to other inquiries in Iceland.

Meanwhile, Hauksson's team today carried out simultaneous raids at eight addresses in Iceland linked to Exista. In addition to their own lines of investigation, Icelandic prosecutors were carrying out a formal search request from the SFO relating to their inquiry into past activities at British sportswear retailer JJB.

A joint venture between Exista and businessman Chris Ronnie jointly acquired a 29% stake in 2007 in a deal financed by Kaupthing. Ronnie was later appointed to the JJB board, quickly becoming chief executive. He was suspended last year after it emerged the stake had been seized by administrators to Kaupthing.

The SFO announced in September that it is investigating suspected criminal price-fixing and fraud in the sportwear retail industry. It is focusing its attention on Sports Direct as well as JJB. JJB has negotiated immunity in exchange for whistle-blowing co-operation.

Bakkavor, the launchpad for the Gudmundsson brothers, began as a sleepy fish roe processing firm. In a series of Kaupthing-brokered takeovers in the UK it swallowed Katsouris Fresh Foods — a company five times its size in 2001, and four years later bought Geest,making it one of the largest suppliers of ready meals, pizzas, desserts and sliced fruit to Britain's supermarkets. A year later Laurens Patisseries was acquired from serial entrepreneur Andreas Liveras.

How the Icelandic saga should end

By Martin Wolf

Published: January 14 2010 20:24 | Last updated: January 14 2010 20:24

Iceland is famous for its sagas. But the latest one is truly dramatic: the balance sheets of its privatised financial sector grew from twice to 10 times gross domestic product, in five years. In the absence of a lender of last resort, this story had to end badly. In the panic of 2008, it did.

Because Iceland was a member of the European Economic Area, its banks were allowed to set up branches freely. To raise money, Landsbanki, one of Iceland’s now collapsed banks, set up an internet bank, Icesave, which gulled depositors by offering attractive interest rates. Under the European Union directive, Iceland also had an obligation to establish a deposit insurance scheme, which it did, through a levy on those banks.
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Then came the collapse. Some Icelanders blame Gordon Brown, Britain’s prime minister, for pulling the plug on their banks. That is unreasonable. Competent observers had long concluded that the financial system was a house of cards. It was sure to collapse in a panic. Less unreasonable is the complaint over the UK’s use of a section of its anti-terrorism laws to freeze assets. But some such action was justified.

Since the banks had turned Iceland into a hedge fund, with massive short-term foreign currency liabilities used to finance risky long-term assets, the economy was doomed. According to the September 2009 economic survey by the Organisation for Economic Co-operation and Development, between 2007 and 2010 the fall in real consumption will be close to a quarter and that of domestic final demand almost 30 per cent. This is a depression. The burden of debt and loss of purchasing power are worsened by the collapse of the krona, which has lost more than half its value against the euro since July 2007.

So far, so bad. But, for ordinary Icelanders, it gets even worse. The British and Dutch governments take the view that the taxpayers of Iceland have a duty to refund the amount promised by Iceland’s collapsed deposit insurance fund. The total claimed by the UK is £2.35bn and by both countries together €3.9bn. The latter is now some 50 per cent of Iceland’s shrunken GDP. In the UK context, this would be equivalent to a demand for £700bn. It is not hard to imagine how far Mr Brown would get with a suggestion that the UK should accept such a debt to refund depositors in foreign branches of bankrupt UK banks.

This, then, is the background to the decision by Olafur Ragnar Grimsson, Iceland’s president, to put the latest version of an agreement negotiated under duress to a referendum. Lord Myners, the UK’s City minister, has stated that if the Icelandic people were to reject the deal, they would “effectively be saying that Iceland does not want to be part of the international financial system”. After their recent painful experiences, Icelanders may wonder why that is so worthwhile. But without agreement to repay, a $10bn rescue plan funded by the International Monetary Fund and Nordic countries is now in doubt.

So do the ordinary Icelandic taxpayers have a legal obligation to meet the liabilities of their collapsed deposit insurance fund? The answer to that is, to say the very least, that it seems to be very far from evident. Moreover, any British or Dutch depositors who thought their money was safe because the government of Iceland guaranteed it were mad.

Do Iceland’s taxpayers have a moral obligation to pay this loan? My view is: no. The delusion that finance was the path to riches was propounded by countries that should have known far better. I cannot blame Icelanders for succumbing. I certainly do not want generations of Icelanders to bear the cost.

The final and, in truth, most important question is whether these demands are reasonable. After all, in every civilised country it has long been accepted that there is a limit to the pursuit of any debts. That is why we have introduced limited liability and abolished debtors’ prisons. Asking a people to transfer as much as 50 per cent of GDP, plus interest, via a sustained current account surplus is extraordinarily onerous.

Against this, the UK government argues that it is offering a lengthy grace period and an interest rate that is close to the cost of funding for the UK Treasury. It also argues that as much as 90 per cent of the repayment it seeks could come from liquidation of Landsbanki’s assets.

Yet the obvious answer to the latter point is this: if the assets of the bank are that valuable, why not write off the debt, in return for the claims on these assets? That would be a generous gesture. It is, more importantly, one that would do much to improve the morale of a battered and vulnerable little country. Threatening such a country with destruction, as Lord Myners has done, is simply shameful. The UK and the Netherlands should stop this self-righteous bullying at once.

Yet they – and everybody else – must learn the really big lesson here. The combination of cross-border banking with generous guarantees to creditors is unsustainable. Taxpayers cannot be expected to write open-ended insurance on the foreign activities of their banks. It is bad enough to have to do so at home.

martin [dot] wolf(?)ft [dot] com

Dominique Strauss-Kahn, President of the IMF, said this evening that: “If many countries in the international community feel that we should wait with our review of our recovery package for Iceland, then we must do that”.

Strauss-Kahn said this at a Washington press conference today. He said he understands the anger of the people in Iceland because of the huge debts they are left with following the banking collapse. He reiterated that an Icesave deal is not essential for continued IMF assistance; but that Icelanders have to understand the IMF is controlled by the international community and must listen to its will. He added though, that the IMF is no country’s personal debt collection agency.

The IMF itself relies on international co-operation just the same as Iceland now does, Strauss-Kahn told the press conference.

At the beginning of the meeting, Strauss-Kahn took the opportunity to send his condolences to the victims of the Haiti earthquake and said the Fund will shortly be sending USD 100 million to the crisis-struck country with further assistance to follow.

Push for Icesave unity in Iceland parliament

By Alex on Jan 12, 2010 in Holland, Iceland, International, MBL, Politics, United Kingdom

ríkisstjórn-íslandsLeaders of Iceland’s government and opposition parties are attempting to reach a united position on the Icesave issue.

Prime Minister Johanna Sigurdardottir yesterday held a meeting with leaders of all parliamentary political parties and later told journalists that renegotiation of the entire Icesave contract with Britain and the Netherlands had not been dismissed at the meeting.

Icelandic ministers have had many conversations with counterparts in the UK and Netherlands, as well as from Iceland’s other ally nations. Sigurdardottir told reporters that the British and Dutch PMs have both expressed to her their deep disappointment with the fact that the Icesave Bill has been sent to a national referendum, Visir.is reports.

Lipietz rejects rejection of his Icesave rejection

By Alex on Jan 12, 2010 in Holland, Iceland, International, MBL, Politics, United Kingdom, european union

alain-lipietzThe French economist and MEP Alain Lipietz, who claimed on Sunday on Icelandic television that European rules do not indicate that Iceland is responsible for the Icesave debt in the Netherlands and UK, has rejected Icelandic government claims that he has misunderstood elements of the law.

He told the Silfur Egils television programme that the Passport Rules do not call for a home country to cover the deposits of its banks in a host country. The Icelandic government countered that he was probably referring to the fact that Iceland is not an EU member; but pointed out that as an EEA member, the country’s responsibilities are exactly the same and do call for repayment.

Lipietz’s words have grabbed headlines in Iceland, as he said that European law on depositors’ guarantee funds shows that the British and Dutch were required to regulate Landsbanki (Icesave) in their jurisdictions. The Icelandic government’s assertion yesterday that he was in fact wrong on this point, and was mistakenly assuming Icesave was a daughter company of Landsbanki and not a branch, was quickly rejected by the French MEP who said he stands by what he said.