In the midst of a global public health emergency, Iceland has fared exceptionally well amongst Western nations, with only 1,804 reported cases and 10 deaths. Twelve years ago, however, the story was very different; Iceland was facing collapse as a result of a Wall Street contagion, another pandemic that would expose the fundamental weaknesses of deregulated financial systems. Within a week, the entire banking sector imploded, sparking prolonged political instability, and striking at the core of the national Icelandic consciousness.

The saga began with the spectacular rise of Icelandic banking in the early 2000s. Iceland is a small, tightly-knit nation, built on trust and a communal Nordic ethos: their banking sector was small, viewed as an internationally insignificant player, providing risk-free mortgages and small business loans with low returns. By the turn of the millennia, this was changing dramatically. Capital controls were demolished, followed by the end of ring-fencing and the privatisation of the banks. Expanding from about 100% of GDP in 1998, Iceland’s three largest banks- Kaupþing, Glitnir, and Landsbanki- grew to an unwieldy size, with their balance sheets reaching 900% of GDP at the time of their failure in 2008. As with all financial bubbles, its symptoms passed unnoticed; the credit ratings of these Icelandic banks in the 10 years before the financial crisis remained “very good” right until the end. Icelandic bank bonds were “cheap” in their rating class (they had high returns relative to assets with comparable ratings), attracting many foreign investors: these bonds were a good way of increasing the credit rating of the CDOs (collateralised debt obligations) with which they were bundled, without compromising the returns. When it transpired that these credit ratings were simply a lie, the whole system unravelled.

The post-mortem carried out by Sigríður Benediktsdóttir, leader of the Special Investigation Commission (SIC), is extremely revealing. Unlike in most Western countries, the Icelandic parliament was not suppressed by the banking lobby. Indeed, it was able to lift all laws on bank secrecy in the public interest, granting unparalleled access to all the information needed to form a prosecution. They revealed systemic fraud in a financial system built on sand: the rise of the banks was inflated by credit alone, fuelled by brazenly illegal activities, most notably market manipulation and insider trading. Whilst fraud was undoubtedly a part of the 2008 financial crisis, most Western companies used loopholes or legitimately engaged in excessive risk-taking behaviours. Icelandic banks, however, had taken it to a whole new level. They created opaque ownership structures to lend to holding companies that were connected back to the original bank, utilising the very same holding companies to fund share purchases in listed domestic firms, particularly in the banks themselves. Furthermore, most of their collateral consisted of shares in the banks themselves, which then allowed the banks to borrow even more. Legislation concerning large credit exposures prescribe that a bank can only lend up to 25% of its own funds to a group of connected parties. These rules were not bent, but instead broken in the run-up to the crisis.

Before the crisis, these banks had increasingly operated in foreign currency, but with no credible lender of last resort in those currencies (Iceland is not an EU member). Their gargantuan size meant that the Central Bank of Iceland’s foreign currency reserves were meagre when compared to the short-term foreign liabilities of Icelandic banks. In just three days in October 2008, 92% of Iceland’s banking sector was wiped out. Investors panicked and Icelandic investments were dumped on the markets; as foreign investors pulled out, the value of the Icelandic króna plummeted. Since most mortgages were sold in foreign currency (particularly Japanese yen- the interest rates were cheaper), the devaluation fed straight through to Icelandic households. Inflation spiked, which then fed into loans tied to the consumer price index, affecting almost all mortgages in Iceland at the time, which suddenly left home owners facing debts that had doubled overnight. Mass defaulting by households and firms threatened to substantially worsen the ongoing financial crisis, leaving the Central Bank of Iceland with few options. To stem the bleeding, capital controls were adopted on November 28, 2008.

Fighting to regain control over the economy, the Icelandic parliament passed the Emergency Act, saving the domestic operations of the financial system by creating new banks; contrary to urban legend, Iceland’s banks were not allowed to completely collapse, as the domestic part of its banking system was saved by the government. The old banks were liquidated and placed into receivership, resulting in huge losses for foreign creditors and their shareholders. Once the immediate threat of a credit crunch had been averted, the government pursued aggressive deleveraging- for as short a time as possible- of both the balance sheet of the banks, and of household debt. Although the pain caused by these measures was deep (GDP declined more than 10% from peak to trough in 2010), Iceland’s recovery has been remarkably strong, given the unprecedented size of Iceland’s financial sector relative to GDP. To date, Iceland remains the only country in the world to expose and clean out the financial system, successfully prosecuting, convicting, and imprisoning its senior bankers.

Where does that leave us today?

For Iceland, the economy has rebounded and appears to have been secured from further financial crises, even though public trust in institutions is still frayed, and political instability has never fully been quelled. Moreover, growth prospects look bleak as tourism, an invaluable crutch for the post-crisis economy, representing 40% of total exports, is set to dwindle. Tourism is unsustainable in the long run, as it can only offer predominately low-paid, unskilled work; in recent years, this has led to the mass exodus of Iceland’s youth for whom there is simply no employment suitable to their level of education. In the face of Covid-19, it seems that tourism’s short-term boost to Iceland’s economy may finally fizzle out.

For the rest of us, Iceland’s story represents a cautionary tale against complacency and uncontrolled risk-taking, demonstrating the effects of leaving banks virtually unregulated and unchallenged, even in a democratic country perceived to be amongst the least corrupt in the world. Yet, outside of Iceland, nothing has changed: subprime lending is on the rise and has already surpassed pre-crisis levels, credit agencies and corporate structure remain opaque, and economic policy is swinging back towards the pre-crisis consensus. If Iceland’s saga has shown anything, it is that banks simply cannot regulate themselves. Covid-19 may have brought us some time but, if we continue on the same trajectory as before, we may become closer than ever to even greater banking disasters.