Iceland’s Banking Crisis: A Cautionary Tale of Carry Trade Exuberance

In the early 2000s, Iceland’s Central Bank (CBI) made a crucial decision that would have far-reaching consequences for the country’s economy. By not setting an explicit foreign exchange rate target alongside its inflation target, the CBI inadvertently contributed to the carry trade phenomenon.

The Birth of Carry Trade Exuberance

The CBI’s statements defending the króna against potential devaluations created a “one-way bet” for investors, fueling exuberance in the carry trade. The big three Icelandic banks - Kaupthing, Glitnir, and Landsbanki - took advantage of this situation by issuing bonds in European markets.

• They offered high yields to attract foreign investors seeking returns in a low-interest-rate environment.
• The bonds were highly rated due to Iceland’s strong sovereign credit rating and the assumption that the banks were too big to fail.

The Rise of Icelandic Banks

As the carry trade gained momentum, Icelandic banks’ funding needs increased rapidly. To support their growth, they turned to foreign deposit markets, attracting deposits online with high interest rates.

• However, this strategy was based on faulty assumptions:
  • Foreign deposits might not be as stable as domestic ones.
  • The protection provided by Iceland’s deposit guarantee scheme was limited.

The CBI’s Response

Instead of addressing these concerns through more restrictive liquidity requirements and increasing reserve requirements for banks’ foreign funding, the CBI responded to the growing funding needs of the banking sector with a series of smaller interest rate hikes.

Hindsight is 20/20

In hindsight, the CBI should have taken a more proactive approach to addressing the carry trade phenomenon. By doing so, it could have prevented the excessive growth of the Icelandic financial market and reduced the risk of a financial crisis.

The Consequences

The consequences of this inaction were severe:

• The banking sector collapsed.
• Iceland was forced to seek international assistance.
• The country’s deposit guarantee scheme struggled to reimburse foreign depositors, leading to widespread losses and a significant impact on the economy.

A Cautionary Tale

The Icelandic banking crisis serves as a cautionary tale about the dangers of carry trade exuberance and the importance of proactive monetary policy measures. By addressing these concerns through more restrictive liquidity requirements and increasing reserve requirements for banks’ foreign funding, central banks can prevent the buildup of excessive risk in the financial system and promote economic stability.

In conclusion, Iceland’s banking crisis is a stark reminder of the importance of responsible monetary policy and the need for central banks to proactively address potential risks in the financial system.