FINANCIAL STABILITY IN ICELAND

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					 FINANCIAL STABILITY IN ICELAND
                     FREDERIC S. MISHKIN
         GRADUATE SCHOOL OF BUSINESS, COLUMBIA UNIVERSITY


                 TRYGGVI T. HERBERTSSON
         INSTITUTE OF ECONOMIC STUDIES, UNIVERSITY OF ICELAND


PPRESENTATION AT THE SCANDINAVIA HOUSE, NEW YORK MAY 3 2006
INTRODUCTION


•   BECAUSE OF HIGH VOLATILITY IN FINANCIAL MARKETS ICELAND HAS BEEN
    RECEIVING A LOT OF ATTENTION LATELY

•   AFTER A NEGATIVE REPORT BY FITCH RATINGS THE CURRENCY (ISK) AND
    THE STOCK MARKET FELL

•   MARKET ANALYSTS HAVE BEEN RAISING CONCERNS ABOUT ICELAND'S
    FUTURE STABILITY – WORRYING THAT ICELAND MIGHT GO DOWN THE
    ROUTE OF THAILAND AND TURKEY TOWARD FINANCIAL MELTDOWN

•   OUR REPORT PROVIDES A FRAMEWORK TO THINK MORE SENSIBLY ABOUT
    ICELAND'S POTENTIAL FOR FINANCIAL FRAGILITY

     1. UNIQUENESS OF ICELAND'S ECONOMY


     2. ANALYSIS OF HOW FINANCIAL INSTABILITY OCCURS
THE PLOT…

1. OVERVIEW OF THE ICELANDIC ECONOMY

    1.1 UNIQUE IN SIZE
    1.2 ADVANCED COUNTRY WITH EXCELLENT INSTITUTIONS
    1.3 STRONG FISCAL POSITION
    1.4 UNIQUENESS OF THE FINANCIAL SECTOR


2. UNDERSTANDING FINANCIAL INSTABILITY

    2.1 WHAT IS FINANCIAL INSTABILITY
    2.2 WHAT CAUSES FINANCIAL INSTABILITY TO OCCUR?
    2.3 ROUTES TO FINANCIAL INSTABILITY

3. IS ICELAND GOING DOWN TRADITIONAL ROUTES TO FINANCIAL INSTABILITY

    3.1 FINANCIAL LIBERALIZATION WITH WEAK PRUDENTIAL REGULATION AND SUPERVISION?
    3.2 SEVERE FISCAL IMBALANCES?
    3.3 IMPRUDENT MONETARY POLICY?
    3.4 BUT WHAT ABOUT THE CURRENT ACCOUNT DEFICIT?
    3.5 ICELAND IS NOT AN EMERGING MARKET ECONOMY
THE PLOT…

4. ARE THERE OTHER FINANCIAL STABILITY CONCERNS?

    4.1 COULD BANK REFINANCING BE A PROBLEM?
    4.2 COULD RAPID CREDIT GROWTH OF BANKS BE A PROBLEM?
    4.3 IS THE FINANCIAL SUPERVISORY AUTHORITY MONITORING RISK SUFFICIENTLY?
    4.4 COULD THERE BE MULTIPLE EQUILIBRIA?


5. CONCLUSIONS AND POLICY

    RECOMMENDATIONS
    5.1 MICROECONOMIC POLICIES
    5.2 MACROECONOMIC POLICIES
OVERVIEW
UNIQUE IN SIZE

•   SMALLEST COUNTRY IN THE WORLD WITH ITS OWN CURRENCY AND FLEXIBLE EXCHANGE RATE



•   CURRENT ACCOUNT DEFICIT VERY HIGH CURRENTLY, BUT HISTORY SHOWS THAT THE ECONOMY AND
    CURRENT ACCOUNT ADJUST RAPIDLY

•   FLEXIBLE ECONOMY
UNIQUE IN SIZE

•   CURRENT ACCOUNT IS MORE VOLATILE IN SMALL COUNTRIES SO IT HAS TO BE
    INTERPRETED DIFFERENTLY




•   CURRENT ACCOUNT DEFICIT COULD BE OPTIMAL:
     –   LARGE, LUMPY INVESTMENTS FOR SMALL ECONOMY RESULT IN LARGE CA DEFICIT
     –   EXCHANGE RATE UNUSUALLY FAVORABLE, OPTIMAL FOR HOUSEHOLDS TO BORROW TO FINANCE
         CONSUMPTION OF IMPORTED GOODS (CONSUMPTION SMOOTHING)
ADVANCED COUNTRY WITH EXCELLENT INSTITUTIONS




•   ONE OF THE RICHEST COUNTRIES IN WORLD (#5 IN PPP TERMS)

•   INSTITUTIONAL RANKINGS:

     –   5 FOR ECONOMIC FREEDOM

     –   1 FOR LOW CORRUPTION

     –   4 FOR COMPETITVENESS

     –   1 FOR FREEDOM OF THE PRESS
STRONG FISCAL POSITION




•   CURRENTLY HAS LARGE BUDGET SURPLUS

•   NET DEBT OF CENTRAL GOVERNMENT ALMOST ZERO

•   PENSION SYSTEM IS FULLY FUNDED AND AGE STRUCTURE OF POPULATION
    IS FAVORABLE

•   BOTTOM LINE: U.S., JAPAN AND EUROPE WOULD LOVE TO BE IN ICELAND'S
    SHOES
STRONG FISCAL POSITION
STRONG FISCAL POSITION




•   HOWEVER, EXTERNAL DEBT HAS GROWN DRAMATICALLY IN RECENT YEARS
UNIQUENESS OF FINANCIAL SECTOR



•   FINANCIAL SECTOR WAS HIGHLY REPRESSED UNTIL 1980S WHEN
    FINANCIAL LIBERALIZATION STARTED

•   LIBERALIZATION ESSENTIALLY COMPLETE BY 1995 (PRIVATIZATION
    SOMEWHAT LATER

•   BANKING SYSTEM TRANSFORMS FROM DOMESTIC LENDER TO
    INTERNATIONAL FINANCIAL INTERMEDIARIES

     –   IN LAST FIVE YEARS!!!


•   ICELAND MOVES TOWARD BECOMING LIKE HONG KONG, NETHERLANDS,
    SWITZERLAND AS INTERNATIONAL FINANCIAL CENTER (BUT ON A SMALLER
    SCALE)
UNIQUENESS OF FINANCIAL SECTOR
UNIQUENESS OF FINANCIAL SECTOR
FINANCIAL INSTABILITY
UNDERSTANDING FINANCIAL INSTABILITY




•   WHAT IS FINANCIAL INSTABILITY?

     –   FINANCIAL INSTABILITY OCCURS WHEN THERE IS A DISRUPTION TO FINANCIAL MARKETS
         IN WHICH ASYMMETRIC INFORMATION AND HENCE ADVERSE SELECTION AND MORAL
         HAZARD PROBLEMS BECOME MUCH WORSE, SO THAT FINANCIAL MARKETS ARE UNABLE
         TO EFFICIENTLY CHANNEL FUNDS TO THOSE WHO HAVE THE MOST PRODUCTIVE
         INVESTMENT OPPORTUNITIES.
WHAT CAUSES IT TO OCCUR?

•   DETERIORATION IN BANK BALANCE SHEETS

    –   BANKS ARE SPECIAL BECAUSE THEY SOLVE ASYMMETRIC INFO PROBLEMS, SO IF THEIR
        LENDING IS IMPAIRED BY WEAK BALANCE SHEETS, OVERALL LENDING DECLINES AND
        ECONOMY CONTRACTS

    –   IF THE DETERIORATION IS SEVERE ENOUGH BANK PANICS CAN OCCUR, WITH EVEN
        SHARPER CONTRACTION IN ECONOMIC ACTIVITY



•   DETERIORATION IN NON-FINANCIAL BALANCE SHEETS

    –   NET WORTH DECLINES => LESS COLLATERAL TO SOLVE

        ADVERSE SELECTION PROBLEM => LENDING DOWN

    –   NET WORTH DECLINES => FIRM HAS LESS AT STAKE

        => MORAL HAZARD INCENTIVES TO TAKE RISK

        INCREASES => LENDING DOWN
WHAT CAUSES IT TO OCCUR?

•   CURRENCY CRISES

     –   WITH FOREIGN CURRENCY DEBT, LIABILITY DOLLARIZATION

     –   DEPRECIATION RAISES VALUE OF LIABILITIES IN DOMESTIC CURRENCY => BALANCE
         SHEETS DETERIORATE => ADVERSE SELECTION AND MORAL HAZARD INCREASE =>
         LENDING DOWN

     –   HOWEVER, ONLY HAPPENS FOR FIRMS WHOSE ASSETS ARE VALUED IN DOMESTIC
         CURRENCY



•   HOWEVER IF ASSETS VALUED IN FOREIGN CURRENCY, THEN
    DEPRECIATION RAISES ASSET VALUE IN DOMESTIC CURRENCY TO OFFSET
    RISE IN VALUE OF LIABILITIES

•   I.E., LIABILITY DOLLARIZATION IS HEDGED (EITHER NATURALLY OR WITH
    DERIVATIVES)
WHAT CAUSES IT TO OCCUR?


•   FLOATING FX REGIME LESS LIKELY TO LEAD TO INSTABILITY THAN PEGGED REGIME

     1. FX RISK APPARENT SO FIRMS AND BANKS MORE LIKELY TO HEDGE

     2. CHANGE IN EXCHANGE RATE LESS NON-LINEAR

     3. LIABILITY DOLLARIZATION LESS LIKELY



•   FLOATING FX REGIME LESS LIKELY TO LEAD TO INSTABILITY THAN PEGGED REGIME,
    STANLEY FISCHER:

     EACH OF THE MAJOR INTERNATIONAL CAPITAL MARKET-RELATED CRISES SINCE 1994-MEXICO IN

     1994, THAILAND, INDONESIA AND KOREA IN 1997, RUSSIA AND BRAZIL IN 1998, AND ARGENTINA AND

     TURKEY IN 2000- HAS IN SOME WAY INVOLVED A FIXED OR PEGGED EXCHANGE RATE REGIME. AT THE

     SAME TIME, COUNTRIES THAT DID NOT HAVE PEGGED RATES - AMONG THEM SOUTH AFRICA, ISRAEL IN 1998,
     MEXICO IN 1998 - AVOIDED CRISES OF THE TYPE THAT AFFLICTED EMERGING MARKET COUNTRIES WITH
     PEGGED RATES.
ICELAND AND FINANCIAL INSTABILITY
ROUTES TO FINANCIAL INSTABILITY


•   1. FINANCIAL LIBERALIZATION WITH WEAK PRUDENTIAL REGULATION AND
    SUPERVISION

     –   BANKS GO ON LENDING SPREE => BAD LOANS => BANK'S BALANCE SHEETS DETERIORATE => BANK
         LENDING DOWN => INVESTMENT AND ECONOMY CONTRACT

•   DETERIORATION IN BANK BALANCE SHEETS TRIGGERS CURRENCY CRISIS
    GOVERNMENT CAN'T DEFEND CURRENCY BY RAISING INTEREST RATES BECAUSE WILL
    DO FURTHER DAMAGE TO BANKS: ONCE MARKETS REALIZE THIS, SPECULATORS PILE
    ON AND ATTACK CURRENCY
     –   CURRENCY CRISIS => DESTRUCTION OF FIRMS‘ BALANCE SHEETS IF LIABILITY DOLLARIZATION =>
         ADVERSE SELECTION AND MORAL HAZARD RISE => LENDING FALLS AND ECONOMY CONTRACTS


•   SOLUTION TO PROBLEM IS GOOD PRUDENTIAL REGULATION AND SUPERVISION

•   IN COUNTRIES WITH WEAK INSTITUTIONAL ENVIRONMENT (CORRUPTION, UNFREE
    PRESS) POWERFUL BUSINEES INTERESTS MAKE SURE IT DOESN'T HAPPEN.

     –   SEE MISHKIN: THE NEXT GREAT GLOBALIZATION: HOW DISADVANTAGED NATIONS CAN HARNESS THEIR
         FINANCIAL SYSTEMS TO GET RICH (PUP FALL 2006)
ROUTES TO FINANCIAL INSTABILITY




•   IS ICELAND GOING DOWN THIS ROUTE?


• NO
ROUTES TO FINANCIAL INSTABILITY



•   PROBLEMS WITH FINANCIAL LIBERALIZATION USUALLY COME WITHIN 5
    YEARS: ICELAND COMPLETED IT OVER TEN YEARS AGO

•   STRONG INSTITUTIONAL ENVIRONMENT IN ICELAND SUGGESTS
    PRUDENTIAL REGULATION AND SUPERVISION IS OF HIGH QUALITY

•   STRESS TESTS INDICATE BANK CAPITAL IS SUFFICIENT

•   FOREIGN DENOMINATED DEBT IS TO FOREIGN FIRMS OR DOMESTIC FIRMS
    WHOSE CASH FLOW IS DENOMINATED IN FOREIGN CURRENCY

•   HOUSEHOLDS DO NOT HAVE FOREIGN DENOMINATED DEBT AND DEBT
    SERVICE RATIOS ARE NOT ABOVE LEVEL IN 2000
ROUTES TO FINANCIAL INSTABILITY




•   2. SEVERE FISCAL IMBALANCES

•   FISCAL IMBALANCES LEAD TO PLACING OF GOVERNMENT DEBT ON BANKS
    BALANCE SHEETS (ARGENTINA) WHEN CONCERNS ABOUT DEFAULT
    OCCUR, VALUE OF GOVT DEBT FALLS => DETERIORATION IN BANK
    BALANCE SHEETS => FINANCIAL INSTABILITY

•   PROSPECT OF GOVT DEFAULT => PEOPLE PULL MONEY OUT OF COUNTRY
    => CURRENCY CRISIS => DETERIORATION OF BALANCE SHEETS =>
    FINANCIAL INSTABILITY
ROUTES TO FINANCIAL INSTABILITY




•   IS ICELAND GOING DOWN THIS ROUTE?


• NO
•   ICELAND HAS A VERY STRONG FISCAL POSITION
ROUTES TO FINANCIAL INSTABILITY




•   3. IMPRUDENT MONETARY POLICY

•   BAD MONETARY POLICY LEADS TO INFLATION AND UNHEDGED LIABILITY
    DOLLARIZATION THAT MAKES FINANCIAL SYSTEM MORE FRAGILE

•   WEAKENING OF CENTRAL BANK CREDIBILITY LEADS TO DEPRECIATION OF
    CURRENCY => DETERIORATION OF BALANCE SHEETS => FINANCIAL
    INSTABILITY (ANOTHER PART OF ARGENTINA STORY)
ROUTES TO FINANCIAL INSTABILITY




•   IS ICELAND GOING DOWN THIS ROUTE?


• NO
ROUTES TO FINANCIAL INSTABILITY


•   INFLATION TARGETING HAS WORKED WELL AND CENTRAL BANK OF ICELAND HAS
    HIGH CREDIBILITY. AFTER INITIAL PERIOD OF HIGH INFLATION IN 2001-2002, INFLATION
    HAS BEEN LOW, PARTICULARLY IF HOUSING IS TAKEN OUT FROM INFLATION MEASURE
ROUTES TO FINANCIAL INSTABILITY




•   BUT WHAT ABOUT THE LARGE CURRENT ACCOUNT DEFICIT?

    –   THEORY OF FINANCIAL CRISES DOES NOT GIVE THEM PROMINENT ROLE: RATHER
        DEEPER FUNDAMENTALS DRIVE FINANCIAL INSTABILITY



    –   CA DEFICITS AND COUNTERPART OF LARGE CAPITAL INFLOWS CAN LEAD TO LENDING
        BOOM THAT PRECIPATE FINANCIAL INSTABILITY, BUT THIS HAS NOT BEEN A PROBLEM IN
        ICELAND WHERE LARGE CURRENT ACCOUNT DEFICITS HAVE BEEN REVERSED WITH

        LITTLE STRESS ON FINANCIAL SYSTEM
ROUTES TO FINANCIAL INSTABILITY




•   BOTTOM LINE:

•   ICELAND IS NOT LIKE THAILAND OR ANY OTHER EMERGING MARKET
    COUNTRY THAT HAS EXPERIENCED A FINANCIAL CRISIS
ARE THERE OTHER CONCERNS?
ARE THERE OTHER CONCERNS?

•   1. COULD BANK REFINANCING BE A PROBLEM

     –   ICELAND'S BANKS HAVE HAD SOME TROUBLE LATELY REFINANCING




     –   REFINANCING PROBLEMS REFLECTED IN CDS SPREADS


     –   BANKS ARE LIQUID AND HAVE CREDIT LINES, BUT THERE IS A RISK FROM REFINANCING PROBLEMS


     –   HIGHLY UNLIKELY THAT ICELAND'S BANKS WILL BE THE NEXT CREDIT EVENT!
ARE THERE OTHER CONCERNS?

•   2. COULD RAPID GROWTH OF BANKS BE A PROBLEM?

    –   COULD LEAD TO DETERIORATION OF BANK BALANCE SHEETS IF THEY HAVE NOT
        DEVELOPED ORGANIZATIONAL CAPITAL TO HANDLE NEW BUSINESS



    –   SITUATION IN ICELAND IS UNPRECEDENTED: MOVEMENT TO INTERNATIONAL BANKING
        CENTER IN 5 YEARS MAKES THESE CONCERNS LEGITIMATE - INCREASED INVESTMENT
        BANKING ACTIVITIES HAVE MADE BANKS LESS TRANSPARENT



    –   BANKS ARE BEGINNING TO DEAL WITH THIS PROBLEM
ARE THERE OTHER CONCERNS?

•   3. IS THE FINANCIAL SUPERVISORY AUTHORITY MONITORING RISK
    SUFFICIENTLY?


     –   IS THE FSA ABLE TO MANAGE UNPRECEDENTED TRANSITION OF BANKS TO
         INTERNATIONAL FINANCIAL INTERMEDIARIES?



     –   FSA IS WELL AWARE OF PROBLEM: LATEST ANNUAL REPORT



     –   ON THE OTHER HAND, THE RAPID GROWTH IN THEIR FOREIGN OPERATIONS, ESPECIALLY
         IN ACQUIRING EXISTING FINANCIAL ENTERPRISES, MEANS NEW RISKS AND CALLS FOR
         MORE COMPLEX AND MORE ROBUST RISK MANAGEMENT THAN BEFORE.
ARE THERE OTHER CONCERNS?

•   4. COULD THERE BE MULTIPLE EQUILIBRIA?

     –   UNIQUE SMALL SIZE OF ICELAND MAKES IT VULNERABLE BECAUSE ONLY SMALL SHIFT
         IN INTERNATIONAL PORTFOLIO FLOWS WOULD HAVE A HUGE IMPACT ON ICELAND AND
         LEAD TO SELF FUFILLING PROPHECY OF FINANCIAL MELTDOWN EVEN THOUGH
         FUNDAMENTALS DON'T WARRANT IT



     –   HOWEVER, THEORY OF MULTIPLE EQUILIBRIA INDICATES BAD EQUILIBRIUM MUCH MORE
         LIKELY TO OCCUR WHEN FUNDAMENTALS ARE WEAK



     –   FUNDAMENTALS IN ICELAND ARE STRONG
POLICY RECOMMENDATIONS
CONCLUSIONS & POLICY RECOMMENDATIONS




•   POSSIBILITY OF MULTIPLE EQUILIBRIA WHICH COULD DO SERIOUS DAMAGE
    TO ICELAND'S ECONOMY SUGGESTS NEED FOR POLICIES TO BOLSTER
    CONFIDENCE

•   TWO TYPES OF POLICIES:
     –   MICRO

     –   MACRO
CONCLUSIONS & POLICY RECOMMENDATIONS


•   1. FINANCIAL SUPERVISION MIGHT BE MORE EFFECTIVE IF IT WAS CONSOLIDATED
    INSIDE THE CENTRAL BANK OF ICELAND.

     –   GOOD REASONS TO HAVE PRUDENTIAL SUPERVISION IN CENTRAL BANK

     –   CBS NEED INFO TO DO LENDER-OF-LAST-RESORT PROPERLY

     –   GOODFRIEND AND KING (1988), MISHKIN (1992) AND BERNANKE (2005) MAKE THIS ARGUMENT


•   ICELAND HAS ADDITIONAL REASON BECAUSE OF SMALL SIZE

     –   TINY POPULATION MEANS IT IS HARD TO FIND ENOUGH INDIVIDUALS WITH EXPERTISE IN PRUDENTIAL

         SUPERVISION

     –   DANGER OF SPREADING EXPERTISE TOO THIN IF PRUDENTIAL SUPERVISION IS IN TWO PLACES

     –   CB ALREADY HAS TO WORRY ABOUT SYSTEMIC RISKS AND ISSUES FINANCIAL STABILITY REPORT
         (PUBLISHED TOWMORROW)

     –   MAKES SENSE TO PUT SUPERVISION UNDER ONE ROOF AT THE CB
CONCLUSIONS & POLICY RECOMMENDATIONS




•   2. ICELAND'S COMMERCIAL BANKS SHOULD BE ENCOURAGED AND
    SHOULD ALSO SEE THAT IT IS IN THEIR BEST INTEREST TO DISCLOSE MORE
    INFORMATION ABOUT THEIR ACTIVITIES.

     –   WHEN FUNDAMENTALS ARE SOUND, DISCLOSURE MAKES BAD SELF-FULFILLING
         PROPHECY LESS LIKELY
CONCLUSIONS & POLICY RECOMMENDATIONS


•   3. THE CENTRAL BANK OF ICELAND SHOULD CHANGE THE MEASURE THAT
    IT USES FOR ITS INFLATION TARGET TO MINIMIZE THE INFLUENCE OF
    HOUSING PRICE FLUCTUATIONS.

    –   MONETARY THEORY SUGGESTS THAT CB SHOULD TARGET ON INFLATION MEASURES
        THAT ARE MOSTLY COMPRISED OF PRICES THAT ARE STICKY, AND SO EXCLUDE ASSET
        PRICES SUCH AS HOUSING, BUT WHICH CAN TAKE ACCOUNT OF THE IMPUTED RENTS

        FROM THESE ASSETS: THIS HELPS STABILIZE OUTPUT FLUCTUATIONS



    –   CPI MEASURE IN ICELAND A PARTICULAR PROBLEM BECAUSE IT MAKES CB LOOK LIKE IT
        HAS NOT BEEN DOING A GOOD JOB WHEN IT HAS - CREATES UNWARRANTED
        CREDIBILITY PROBLEMS
CONCLUSIONS & POLICY RECOMMENDATIONS




•   4. THE GOVERNMENT SHOULD IMPLEMENT A FORMAL FISCAL POLICY RULE
    IN ORDER TO DAMPEN THE ICELANDIC BUSINESS CYCLE TO SUPPORT
    MONETARY POLICY BETTER

    –   FISCAL RULE THAT MAKES ICELAND'S FISCAL POLICY LESS PROCYCICAL WOULD HELP
        DAMPEN CURRENT ACCOUNT SWINGS AND BUSINESS CYCLE FLUCTUATIONS



    –   HAS WORKED WELL IN CHILE
CONCLUSIONS




•   THE FOUR RECOMMENDATIONS, WHICH ARE BY NO MEANS EXHAUSTIVE,
    WOULD INCREASE STABILITY OF ICELAND'S ECONOMY AND LOWER
    PROBABILITY OF MULTIPLE EQUILIBRIA

•   BOTTOM LINE: LIKELIHOOD OF FINANCIAL MELTDOWN IS VERY LOW

				
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