Brookings Papers on Economic Activity

ABSTRACT:

This paper documents how the Icelandic banking system grew from 100 percent of GDP in 1998 to 900 percent of GDP in 2008, when it failed during the global financial crisis. We base our analysis on data from the country's three largest banks that were made public when the Icelandic parliament lifted, among other things, bank secrecy laws in order to investigate the run-up to the financial crisis. We document how the banks were funded and where the money went, using a comprehensive analysis of their lending. The recovery from the crisis was based on policy decisions that, in hindsight, seem to have worked well. We analyze some of these policies—including emergency legislation, capital controls, alleviation of balance of payments risks, and preservation of financial stability. We also estimate the crisis's output costs, which were about average when compared with the 147 banking crises documented by Luc Laeven and Fabián Valencia (2012) and the 100 banking crises documented by Carmen Reinhart and Kenneth Rogoff (2014). Our computation of the Icelandic government's direct costs reveals that its recently concluded negotiations with foreign creditors may even leave it with a net surplus as a consequence of the crisis. However, there is still uncertainty about the ultimate cost, and our benchmark estimate is that the cost was about 5 percent of GDP. We summarize several lessons from the episode.