Thorvaldur GylfasonJoint Vienna Institute Course on

Macroeconomic Policies in Times of High Capital Mobility

Vienna, AustriaMay 16–20, 2011

1.The Great Crash and its consequences

2.What is a systemic banking crisis?3.Main origins of a crisis4.From crisis recognition to crisis

management5.Theories of financial crises6.Policy responses in financial crises7.Banks and incentives8.Twelve lessons from recent crisis

The Great Depression 1929-39 produced a deep slump in output in the US and elsewhere, with dramatic consequences

It also triggered reforms that reduced volatility in output, reducing the likelihood of another great crash Stabilization Stabilization of output Regulation Regulation of banks and other financial

institutions

11

Canada had no major bank

failures during Great

Depression, and did not

establish its Deposit

Insurance Corporation until

1967

How about the U.S. next

door?

Change in Canada’s per capita GDP from year to year 1871-2003 (%)

Source: Maddison (2003).

Standard deviation of per capita GDP fell from 6.6% 1871-1945 to 2.3% 1947-2003 Yet per capita GDP growth remained virtually the

same (2.1% vs. 2.2%) In postwar period, active stabilization was the

norm plus careful federal rather than decentralized financial supervision

Canada’s banks are universaluniversal, offering both commercial and investment banking services Even so, recent financial crisis passed Canada by Firewalls between commercial banking and

investment banking were not in place in Canada

Change in US per capita GDP from year to year 1871-2003 (%)

Perhaps bank regulation during

Great Depression also helped

stabilize GDP

Roosevelt-era firewalls between

commercial banking and

investment banking (Glass-

Steagall Act 1933)

Source: Maddison (2003).

Standard deviation of per capita GDP fell from 6.4% 1871-1945 to 2.4% 1947-2003 Yet per capita GDP growth remained virtually the

same (2.3% vs. 2.1%) From the 1960s onward, active stabilization

was the norm, as was federal as well as local financial supervision from 1933 onward

Automatic stabilizers helped From 1870 to 1914, federal expenditures

decreased from 5% of GDP to 2%, rising back to 5% by 1929

From 1945 to date, federal expenditures doubled from 10% of GDP to 20%

Change in UK per capita GDP from year to year 1871-2003 (%)

Not quite as clear, but standard deviation of per

capita growth fell from 3.1% 1831-1945 to 1.8%

1947-2003

Perhaps bank regulation during

Great Depression also helped

stabilize GDP

Source: Maddison (2003).

Change in French per capita GDP from year to year 1821-2003 (%)

Perhaps bank regulation during

Great Depression also helped

stabilize GDP

Source: Maddison (2003).

Change in German per capita GDP from year to year 1851-2003 (%)

Perhaps bank regulation during

Great Depression also helped

stabilize GDP

Stefan Zweig (1942)Die Welt von Gestern

Source: Maddison (2003).

Perhaps bank regulation during

Great Depression also helped

stabilize GDP

Source: Maddison (2003).

Change in Swedish per capita GDP from year to year 1821-2003 (%)

The emergence of systemic banking crises has been associated with the liberalization of financial systems worldwide

However, since the mid- to late 1990s a number of crises have been of unprecedented scale and consequences: Mexico 1994 Asian Crisis 1997-1998 Russia 1998, Ecuador 1998, Turkey 2001,

Argentina and Uruguay 2002 US 2007 and its aftermath, including Iceland

22

A banking crisis is systemic in nature if a loss of confidence in a substantial portion substantial portion of the banking system is serious enough to generate significant adverse effects on the significant adverse effects on the real economyreal economy

The adverse effect on the real economy adverse effect on the real economy arises from disruptions to the payments system, to credit flows, and from the destruction of asset values

Let’s look at some evidence which demonstrates the devastating nature of systemic crises

Banking Problems Worldwide 1980-2002Banking Problems Worldwide 1980-2002

Banking Crisis

Significant Banking Problems

No Significant Banking Problems/Insufficient Information

Source: IMF.

Chile

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

1970

1975

1980

1985

1990

1995

2000

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

Trend GDP

GDP

Ecuador

150

175

200

225

250

275

300

1987

1989

1991

1993

1995

1997

1999

2001

150

175

200

225

250

275

300

Trend GDP

GDP

Finland

50

75

100

125

150

1980

1984

1988

1992

1996

2000

50

75

100

125

150

Trend GDP

GDP

Indonesia

100,000

200,000

300,000

400,000

500,000

600,000

1986

1989

1992

1995

1998

2001

100,000

200,000

300,000

400,000

500,000

600,000

Trend GDP

GDP

In billions of local currency

Finland Indonesia

Sweden

1,000

1,250

1,500

1,750

2,000

2,250

2,500

1980

1983

1986

1989

1992

1995

1998

2001

1,000

1,250

1,500

1,750

2,000

2,250

2,500

Trend GDP

GDP

Thailand

1,000

2,000

3,000

4,000

5,000

1986

1989

1992

1995

1998

2001

1,000

2,000

3,000

4,000

5,000

Trend GDP

GDP

In billions of local currency

Sweden Thailand

Source: IMF.

Chile

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

1970

1975

1980

1985

1990

1995

2000

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

Trend GDP

GDP

Ecuador

150

175

200

225

250

275

300

1987

1989

1991

1993

1995

1997

1999

2001

150

175

200

225

250

275

300Trend GDP

GDP

In billions of local currency

Ecuador

Source: IMF.

Korea

100,000

200,000

300,000

400,000

500,000

600,000

1986

1989

1992

1995

1998

2001

100,000

200,000

300,000

400,000

500,000

600,000Trend GDP

GDP

Norway

500

625

750

875

1,000

1,125

1,250

1976

1980

1984

1988

1992

1996

2000

500

625

750

875

1,000

1,125

1,250

Trend GDP

GDP

In billions of local currency

Korea Norway

Source: IMF.

Need to distinguish betweenCauses and origin of a systemic crisisTrigger of the crisis

Two views (or schools of thought) on origins of systemic crisesInstitutional failure leads to systemic

crisis (classical viewclassical view)Common exposure of financial sector to

certain risks (endogenous cycle viewendogenous cycle view)

33

Some weak banks in the system, they stay above water until an external shock hits E.g., weak management, weak risk management

systems, leading to balance sheet deficiencies, mismatches

External shock can be anything (e.g., exchange rate shock, political crisis)

Weak banks go under and, through contagion, pull others into problem zone Crisis become systemic

Helps explain some crises, but not recent ones Source: Diamond and Dybvig (JPE, 1983)

Systemic crisis follows from fact that banks have common exposures to macroeconomic risks

Origin of scenario leading to endogenous cycle may differ from crisis to crisis, but …

… pattern of response is similar I.e., how they get these common

exposures Sources: Minsky (1982), Kindleberger (1996)

Starting point: Economic conditions are considered favorably

Risk evaluation is also favorable Access to credit is relaxed (subprime!) Profits go up Generalized state of euphoriaGeneralized state of euphoria Boom in asset prices and markets Asset price bubble is forming Risk perceptions remain favorable But, imbalances start to emerge here and

there … … and suddenly the situation goes into reverse

E.g., through a change in mood

Endogenous orself-feeding cycle

Procyclical behavior

(amplification)

The trigger can be anything E.g., change in mood, bad economic or political

news, problems in neighboring countries, rumors Irrespective of origin, a crisis first emerges as

a liquidity problemliquidity problem in one, some, or all banksSymptoms

Bank goes repeatedly to interbank market Bank calls repeatedly upon lender-of-last resort and

requests roll-overWhen the rumors spread, liquidity problems trigger

deposit withdrawals (Asia) or credit lines that are being cut (Turkey)

Liquidity problems are typically symptoms of symptoms of underlying solvency problemsunderlying solvency problems

Start of crisis often seems chaotic When a problem arises in one bank

Is it an isolated case or will it spread?It takes time to assess situation and

recognize that it is systemicLack of preparedness on the

authorities’ side Vested interests in delaying

recognition, i.e., in avoiding fiscal costs as well as in accepting blame

44

0 10 20 30 40 50 60

Norway 1987-1989

United States 1984-1991

Sweden 1991-1993

Malaysia 1997-2001

Finland 1991-1993

Venezuela 1994-1995

Mexico 1994-1995

Ecuador 1998-2001

Korea 1997-present

Turkey 2000-present

Thailand 1997-present

Chile 1981-1983

Indonesia 1997-present

Sources: IFS, WEO and national authorities.

Gross Cost

Net Cost

Liquidity support If banks prove insolvent, and can’t repay

liquidity support received earlier from central bank

Deposit insuranceGovernment pay-outs as part of deposit

insurance scheme or blanket guarantee Bank recapitalization

Through the government If the government agrees to assist in recapitalizing the banks

through some scheme

Through restructuring of impaired assets A (government) asset management company buys impaired

assets from banks in exchange for government bonds

% of GDP Billions of USD

Liquidity support provided by central bank, and taken over by budget

12 20

Recapitalization, including blanket guarantee

23 40

Purchase of NPLs and capital provided to asset management company

12 20

Interest cost (for the budget)

3 5Total 51 85

How long it takes politicians to recognize that they are face a crisis (+) …

… and the time from the point of recognition to the time of action

Quality of institutions (-) Level of corruption (+) Efficiency of judicial system (-) Restructuring approach (+/-)

Strict vs. accommodating strategy (moral hazard) Types of incentives given during recapitalization

Handling of impaired assets (+/-) Possible payback to government (+/-)

Source: BIS (2009).

Need for political leadership and coordination

Managing a financial crisis Is a macro-undertaking with lots of

micro-decisions Involves tackling a number of politically

contentious (vested interests), and often technically complex, issues

Involves burden sharing and redistribution of wealth, with most parts of society affected

Economic theories of financial crisis have tended to follow events Different models correspond to specific country cases

Recent theories tend to reflect failure of markets to avert socially costly outcomes, with focus On problems in the markets themselves (particularly in

asset markets) due to asymmetric information/agency problems, etc.

On the role of economic policymakers (esp. central banks) that, in attempting to control credit creation to stabilize economy, unwittingly amplify boom/bust cycles

On why markets do not always produce optimal solutions, see Freefall (2010) by Stiglitz The Origin of Financial Crisis (2008) by Cooper This Time Is Different (2009) by Rogoff and Reinhart

55

Large deficitsCurrent account deficits

Government budget deficits

Poor bank regulationGovernment guarantees (implicit or explicit), moral

hazard

Stock and composition of foreign debtRatio of short-term liabilities to foreign reserves

MismatchesMaturity mismatches (borrowing short, lending long)

Currency mismatches (borrowing in foreign currency, lending in domestic currency)

Increased inequality

-40

-35

-30

-25

-20

-15

-10

-5

0

5

Beyond our means, yes, big time:

Investment (housing, hydro-

projects) Consumption (jeeps, jets, Elton

John)

Mid-2008

End 2008

Pepper, salt,

or gold,

anyone?

Many crises are characterized by over-leveraging Increases vulnerability of debtors to external changes

I.e., risk aversion, interest rate/exchange rate changes

Usually, crises involve debt repayment difficulties for government, households, or corporate sector Debt servicing tends to become harder as crisis

develops Foreign credit dries up, banks need to deleverage, value of

collateral falls, trade credit becomes more difficult, etc.

Does this help crisis prediction or crisis prevention? Extent of debt depends on interest rate/exchange rate What appears to be a manageable situation, proves

unmanageable when variables change Debt levels change and so, too, does bank capital

Net External Debt (% of GDP)*Net External Debt (% of GDP)*

*Excluding risk capital

Mid-2008

End 2008

International Investment Position (% of GDP)*International Investment Position (% of GDP)*

*Including risk capital

Mid-2008

End 2008

Barclays: 100% of Britain’s GDP

Deutsche Bank: 80% of

Germany’s GDP

Source: Union Bank of Switzerland

Mid-2008

Mid-2008

End 2008

Three-month Rule

Giudotti-Greenspan Rule

Mid-2008

End 2008

Guidotti-Greenspan rule

Increased inequality in distribution of US income and wealth during roaring 1920sBubble conducive to higher incomes

at top end of distribution, and vice versa

Crisis of 2007 Subprime lending supported and made

possible in part as compensation for increased inequality (Rajan)

If so, inequality helped trigger crisis

Source: Internal Revenue Directorate.

Shift of tax burden from the rich to the

rest

To restore confidence in a financial crisis, a policy program needs to be announced that is seen by creditors as comprehensive and fully financed

First policy dilemma How to halt pressure on currency while

bolstering domestic demand Should interest rates be temporarily raised? Should fiscal policy be tightened? Should capital controls be introduced?

66

Second policy dilemmaShould financial and firm-sector problems be

tackled up front or left until later?Should banks be recapitalized with public

funds? Perhaps no choice Solvency issues Forms of restructuring

Should there be regulatory forbearance?Should public or private debts be

restructured?Should government be involved in corporate

restructuring?

Pros and cons Increasing rates

Helps external adjustment, reduces capital flight

Deflationary when domestic demand is already in decline

Places further stress on over-leveraged firmsMiddle class bonus

Reducing ratesExerts greater pressure on exchange rateObscures/postpones structural problemsCredit supply constrained by banking

problems

“Mistake” in Thailand IMF program 1997Rationale for tighter fiscal policyFiscal space in Iceland program 2008

Fiscal policy in KoreaDifficulty of running a deficitSocial programs in Asia

Fiscal policy in ArgentinaSize of haircut and extent of fiscal adjustment

Preparing for post-crisis vs. getting through the crisis

IMF’s conditional support for fiscal stimulus

Short-run constraints on fiscal policyTime lagsCredibilityType of fiscal action

Longer-term issues of debt sustainability Difficulty of specifying a medium-term

framework in the midst of a financial crisis Different speeds of recovery Impact on potential output

Exit from fiscal stimulusEconomics and politics

Speculation in Asian crisis Experience of Malaysia and Hong KongMalaysian speculationCapital flightMahathir’s controlsHong Kong and the hedge fund

conspiracyTransparency and regulations against short selling

Source: Finance and Development, September 1999.

Mexico, '93-95

Korea, '96-97

Mexico, '81-83

Thailand, '96-97

Venezuela, '87-90

Turkey, '93-94

Venezuela, '92-94

Argentina, '88-89

Malaysia, '86-89

Indonesia, '84-85

Argentina, '82-83

0 10 20 30 40 50 60Billion dollars

10% of GDP

12% of GDP

9% of GDP

18% of GDP

15% of GDP

11% of GDP

6% of GDP

10% of GDP

7% of GDP

5% of GDP

4% of GDP

Growing acceptance of use of prudential regulations to limit systemic risk in banking system and, more generally, in national and international economyCountercyclical use of prudential ratios

BlanchardLiquidity ratios

Differentiated by currencyReserve requirements

Differentiated by maturityLimitations

Regulatory arbitrage Nonfinancial sector flows

Recent cross-country evidence on effectiveness of capital controls Controls tend to have short-term impact, over

time market participants find ways of circumventing

Controls tend to change composition rather than overall volume of flows

But, Ostry et al. (IMF Staff Position Note 10/04) find that “in the recent crisis the output decline of the countries that had maintained capital controls in the run-up to the crisis was lower than in other countries without capital controls”

There are difficulties in empirical testing – how to measure capital control, what measures introduced at same time, what was counter-factual? Source: Global Financial Stability Report, IMF, April

2010.

Financial globalization is often blamed for crises in emerging markets It has been suggested that emerging

markets had dismantled capital controls too hastily, leaving themselves vulnerable

More radically, some economists view unfettered capital flows as disruptive to global financial stabilityThese economists call for capital controls

and other curbs on capital flows (e.g., taxes)

Others argue that increased openness to capital flows has proved essential for countries seeking to rise from lower-income to middle-income status

Capital controls aim to reduce risks associated with excessive inflows or outflows

Specific objectives may includeProtecting a fragile banking systemAvoiding quick reversals of short-term

capital inflows following an adverse macroeconomic shock

Reducing currency appreciation when faced with large inflows

Stemming currency depreciation when faced with large outflows

Inducing a shift from shorter- to longer-term inflows

Administrative controlsOutright bans, quantitative limits, approval

procedures Market-based controls

Dual or multiple exchange rate systemsExplicit taxation of external financial

transactions Indirect taxation

E.g., unremunerated reserve requirement Distinction between

Controls on inflowsinflows and controls on outflowsoutflowsControls on different categories of capital

inflows

IMF (which has jurisdiction over current account, not capital account, restrictions) maintains detailed compilation of member countries’ capital account restrictions

The information in the AREAER has been used to construct measures of financial openness based on a 1 (controlled) to 0 (liberalized) classification

They show a trend toward greater financial openness during the 1990s

But these measures provide only rough indications because they do not measure the intensity or effectiveness of capital controls (de jure versus de facto measures)

Structural characteristics can sometimes be seen as root cause of a crisis In Korea, exceptionally high debt-equity ratios, low profitability of

corporate sector, and increasing use of foreign currency bank loans to shore up finances in largest chaebol were viewed as indicative of structural problems, including lack of corporate governance, nonstandard accounting rules, directed lending, barriers to entry in various industries, failure of prudential regulation, etc.

But many of these problems had been integral parts of the previously successful model of development

IMF program 1997/98 contained many structural reforms to tackle these problems, some relevant, some dubious The criticism of these structural conditions was that their

implementation prolonged the crisis; they were not immediately necessary.

The counter-argument was that if changes had not been made at that time they would not have been introduced at all

Only in the midst of a crisis could political support be mobilized to effect large institutional changes

The case of Indonesia and crony capitalismToo many conditions, too political

IMF programs and political stability Streamlining of structural

conditionality Recent IMF programs and structural

measures Linkages between structural measures

and macroeconomic stability

Testing banks for solvencyHow big is too big to fail?

Closing banks in the absence of a deposit guarantee Indonesia

Public ownership of private banksWhat conditions are needed?

Purchasing “bad assets”– finding a price

Proposals for regulatory reform in previous crises focused on widening coverage to prevent regulatory arbitrage and separating regulators and enhancing independence of supervision so as to reduce influence of governments and central banks

The theme emerging from the global financial crisis is different in that prudential regulation was seen to pay insufficient attention not only to the risk management techniques of financial institutions but also to the build up of systemic risk

Regulators need to look at a wider view of risk than from focusing on stability of financial institutions in isolation

One proposal is that regulators focus rather on macro-prudential monitoring of the financial system as a whole

While some calls have been made for changes that place regulators back within central banks, other recent proposals (in US House of Representatives, US Senate, UK, EU) call for the creation of councils, each comprising existing supervisory authorities and national central banks within their country (area), that would monitor the buildup of domestic financial systemic risk

For the banks themselves, most authorities see the need for larger capital requirements, particularly for systemically important institutions, i.e., those with high degree of interconnectedness within the system

However, consensus on the modalities of capital surcharges has not yet emerged

Corporate debt restructuring and IMF programsKorea, Indonesia, more recently Latvia,

Iceland Case for government intervention Three different approaches

Case-by-case market-based approachAcross-the-board with direct government

involvement Intermediate approach with government

financial incentives

See Thomas Laryea: Approaches to Corporate Debt Restructuring in the Wake of Financial Crises, IMF Staff

Position Note, January 2010

Government’s role in allocating the costs of a crisisTax policiesSocial programs and redistribution

during crisisSubsidies to financial institutions and

enterprisesSocializing losses and inter-

generational effects Impact of government policies on

future incentives

Insurance and externalities of crisis mitigation

IMF and allocation of costs of crisis between countries

Incentive effects of “bailouts” Future crisis prediction and

prevention

Different causes in each new wave of crises

There are limits to individual country risk analysis

Cross-section econometric techniques

Market Pressure Indices Mecagni et al. (2007)

Index = -(FXt – FXtrend) – ln(NEERt/NEERt-1) + St – Kt

Combines individual indicators FX (international reserves) NEER (nominal effective exchange rate) S (secondary market spread on sovereign bonds) K (net private capital flows as a ratio to GDP)

All variables are standardized with their mean = 0 and their standard deviation = 1

The aim is to show deviations from normal levels of the components

The start of a crisis is identified as the first of two consecutive quarters in which the value of the index is positive

Financial Stress Indicators (IMF, 2008) rely on financial variables for 17 countries

Equal-variance weighted average of seven variables

1. Banking-sector beta2. TED spread3. Inverted term spread4. Corporate spread5. Stock decline6. Time-varying stock volatility7. Time-varying real exchange rate volatility

Financial stress if index is one standard deviation above its trend

Typical Signal Indicators: Overvaluation of currency in real

termsFinancial liberalizationLow output growthFall in asset pricesWeak exportsHigh interest ratesRise in inequalitySee Kaminsky and Reinhart (1999)

Type I and Type II ErrorsBoth probability models and signal

extraction models give too many false alarms

Particularly difficult to get timing right In general, the empirical record of

crisis prediction remains poor, particularly in out-of-sample tests

Desirable elements to help prevent crisesSound macroeconomic policies Sound financial sector regulation

and regular surveillanceSufficient international reservesRigorous debt sustainability analysis

International Monetary Fund. “What Happens During Recessions, Crunches and Busts?”, Stijn Claessens, M. Ayhan Kose and Marco E. Terrones, Working Paper WP/08/274, December 2008

International Monetary Fund. “The Role of Indicators in Guiding the Exit from Monetary and Financial Crisis Intervention Measures —Background Paper”, IMF Policy Paper, January 2010

International Monetary Fund. “Lessons and Policy Implications from the Global Financial Crisis”, Stijn Claessens et al., Working Paper WP/10/44, February 2010 

Paul Volcker, Chairman of the Fed 1979-87, said 8 December 2009 at a conference organized by the Wall Street Journal: ““I wish someone would give me one shred of I wish someone would give me one shred of

neutral evidence that financial innovation has neutral evidence that financial innovation has led to economic growth – one shred of led to economic growth – one shred of evidence.”evidence.”

He added that in the U.S. the share of financial services in value added had risen from 2% to 6.5%, and then asked: ““Is that a reflection of your financial Is that a reflection of your financial

innovation, or just a reflection of what you’re innovation, or just a reflection of what you’re paid?” paid?”

77

“The Best Way to Rob a Bank is to Own One” When a senior officer deliberately causes bad loans

to be made he does not defraud himselfdoes not defraud himself He defrauds the bank’s creditors and shareholdersdefrauds the bank’s creditors and shareholders,

as a means of optimizing fictional accounting income

It pays to seek out bad loans because only those who have no intention of repaying are willing to offer the high loan fees and interest required

1. Grow really fast 2. Make really bad loans at higher yields 3. Pile up debts4. Put aside pitifully low loss reserves

When the title says it all

Article by Akerlof and Romer:

“Looting: Bankruptcy for

Profit”

Four-point recipe

“The Best Way to Rob a Bank is to Own One” When a senior officer deliberately causes bad loans

to be made he does not defraud himselfdoes not defraud himself He defrauds the bank’s creditors and shareholdersdefrauds the bank’s creditors and shareholders,

as a means of optimizing fictional accounting income

It pays to seek out bad loans because only those who have no intention of repaying are willing to offer the high loan fees and interest required

1. Grow really fast 2. Make really bad loans at higher yields 3. Pile up debts4. Put aside pitifully low loss reserves

The script is from Mel

Brooks’s movie, The

Producers (1968):

A flop pays better than a hit

Four-point recipe

1. 1. Need legal protection against predatory Need legal protection against predatory lending because of asymmetric informationlending because of asymmetric information

Like laws against quack doctors, same logicPatients know less about health problems than doctors,

so we have legal protection against medical malpractice

Same applies to some bank customers vs. bankers, especially in connection with complex financial deals

2. 2. Do not let rating agencies be paid by the Do not let rating agencies be paid by the banksbanks

Fundamental conflict of interestAlso, prevent accountants from cooking the books

3. 3. Need more effective regulation of banks and Need more effective regulation of banks and other financial institutionsother financial institutions

Work in progress, Paul Volcker in charge

88

4. 4. Read the warning signalsRead the warning signalsFour rules, or stories

The Aliber RuleCount the cranes!

The Giudotti-Greenspan RuleDo not allow gross foreign reserves held by the

Central Bank to fall below the short-term foreign debts of the domestic banking system

Failure to respect this rule amounts to an open invitation to speculators to attack the currency

The Overvaluation Rule Sooner or later, an overvalued currency will fall

The Distribution Rule• The distribution of income matters

Source: Internal Revenue Directorate.

Shift of tax burden from the rich to the

rest

5. 5. Do not let banks outgrow Central Bank’s Do not let banks outgrow Central Bank’s ability to stand behind them as lender – ability to stand behind them as lender – or borrower – of last resortor borrower – of last resort

6. 6. Do not allow banks to operate branches Do not allow banks to operate branches abroad rather than subsidiaries, thus abroad rather than subsidiaries, thus exposing domestic deposit insurance exposing domestic deposit insurance schemes to foreign obligationsschemes to foreign obligations

Without having been told about it, Iceland suddenly found itself held responsible for the moneys kept in Landsbanki by 300.000 British depositors and 100.000 Dutch depositorsMay violate law against breach of trust

7.7. Central banks should not accept rapid Central banks should not accept rapid credit growth subject to keeping inflation credit growth subject to keeping inflation low low

As did the Fed under Alan Greenspan and the Central Bank of Iceland

They must restrain other manifestations of latent inflation, especially asset bubbles and large external deficits

Put differently, they must distinguish between “good” (well-based, sustainable) growth and “bad” (asset-bubble-plus-debt-financed) growth 

8.8. Erect firewalls between banking and politicsErect firewalls between banking and politicsCorrupt privatization does not condemn

privatization, it condemns corruption9.9. When things go wrong, hold those When things go wrong, hold those

responsible accountable by law, or at least responsible accountable by law, or at least try to uncover the truth: Do not cover uptry to uncover the truth: Do not cover up

In Iceland, there have been vocal demands for an International Commission of Enquiry, a Truth and Truth and Reconciliation CommitteeReconciliation Committee of sorts

If history is not correctly recorded if only for learning purposes, it is more likely to repeat itself

Public – and outside world! – must knowNational Transport Safety Board investigates every

civil-aviation crash in United States; same in Europe

10. 10. When banks collapse and assets are When banks collapse and assets are wiped out, protect the real economy by a wiped out, protect the real economy by a massive monetary or fiscal stimulusmassive monetary or fiscal stimulus

Think outside the box: put old religion about monetary restraint and fiscal prudence on ice

Always remember: a financial crisis, painful though it may be, typically wipes out only a small fraction of national wealth Physical capital (typically 3 or 4 times GDP) and

human capital (typically 5 or 6 times physical capital) dwarf financial capital (typically less than GDP)

So, financial capital typically constitutes one fifteenth or one twenty-fifth of total national wealth, or less

The structure

can withstand

the removal of

the top layer

unless the

financial ruin

seriously weakens the

fundamentals

Even so, tremendous damage in

Iceland, equivalent

to up to 7

times GDP

11.11. Shared conditionality needs to become Shared conditionality needs to become more commonmore common

As when the Nordic countries providing nearly a half of the $5 billion needed to keep Iceland afloat imposed specific conditions on top of the IMF’s conditions

This may come up again elsewhere E.g., in Greece now that the EU and the IMF have

been called on to support Greece together For this, clear and transparent rules tailored

to such situations ought to be put in place 

12.12. Do not jump to conclusions and do Do not jump to conclusions and do not throw out the baby with the bathwaternot throw out the baby with the bathwater

Since the collapse of communism, a mixed mixed market economymarket economy has been the only game in town

To many, the current financial crisis has dealt a severe blow to the prestige of free markets and liberalism, with banks having to be propped up temporarily by governments, even nationalized

Even so, it remains true as a general rule that banking and politics are not a good mixbanking and politics are not a good mix

But private banks clearly need proper regulation proper regulation because of their ability to inflict severe damage on innocent bystandersinnocent bystanders

Do not reject economic, and legal, help from abroad

The EndThe End