The IMF has published a self-evaluation of its massive lending program to Iceland — a program which Iceland has now exited. Although a little technical, it’s an interesting read, but of course the people who should read it — the Irish Department of Finance types who mocked Iceland in 2009-2010 — won’t. There are two take-aways from the report. One is what Iceland did about the banks; that ship has sailed for us now but it’s no harm understanding even after the fact how bad the choices were. The other is how to deal with the overhang of personal debt, which is still a big issue for Ireland and one where informed choices can be made. Quotes below the fold. Short version: no blanket guarantees, no pari passu rubbish about senior unsecured creditors, no NAMA, and an aggressive approach to reducing domestic corporate and household debt burdens (update: the IMF makes the Iceland case of household mortgage debt a centerpiece of their Spring 2012 World Economic Outlook).
[prior to the IMF program]
Following the collapse of the Iceland banking system, the authorities had few options but to ring-fence domestic stakeholders to preserve the financial system. The main objectives of the authorities’ strategy were to: (i) preserve the functioning off the domestic payment system; (ii) limit the absorption of private sector losses by public sector; and (iii) create the conditions for rebuilding a domestic-banking system. The government extended a blanket
guarantee to domestic depositors to stem bank runs and imposed controls on capital outflows to maintain domestic liquidity and avoid additional pressure on the exchange rate. The Emergency Act (October 6, 2008) empowered the FME with broad-based powers to intervene in failing institutions, granted all deposits seniority over the unsecured claims in case of bank failures, and allowed government to inject capital into the newly created domestic banks that were carved out from the failed banks.
While the authorities’ old/new bank restructuring approach had shortcomings, it ensured the continuity of vital domestic banking services. The authorities did not follow an established good-bank/bad-bank approach. Instead, they split the failed banks along domestic/foreign lines.10 This approach had some shortcomings, in particular: (i) the evaluation process proved extremely difficult, time-consuming, and contentious, thus delaying the
recapitalization of the new banks; (ii) the new banks remained with a large share of nonperforming loans (NPL)—45 percent of total loans in late 2008, leaving the resumption of the new banks’ intermediation function dependent upon a successful private-sector debt restructuring; and (iii) the new banks remained vulnerable to exchange rate fluctuations, given their substantial net open foreign currency positions, as a large share of domestic loans was
denominated in foreign currency or indexed to the exchange rate. However, the approach had crucial benefits—it preserved the functioning of domestic payment system (domestic payments and transaction accounts), achieved an immediate downsizing of the banking sector, and solved the problem of excessive reliance on wholesale funding as the new institutions were largely funded by deposits.
[during the program]
creditors of the new domestic banks were offered the option of converting their claims into equity holdings, thereby granting them potential upside gains insofar recovery rates turned out to be higher-than-originally estimated. Accordingly, given the difficulties in valuing the assets of the three large failed banks, an agreement was reached whereby the creditors of the old banks became the shareholders of two of the new banks through a debtto-equity swap operation (the third one remained fully state-owned), instead of receiving a compensatory note. The severely undercapitalized part of the savings banks sector was also intervened and either sold to other banks, resolved through purchase, or liquidated.Leasing and credit card management companies were restructured without public support. The net fiscal costs of the banking crisis are estimated at about 20 percent of GDP, with significant portion attributable to losses on loans made by the CBI in the months before the banks failed
[on private debt]
Given the scale of the problem, progress on private sector debt restructuring was initially slow due to a number of factors, but accelerated towards the end of the program. The authorities’ approach favored market-based voluntary workouts and strengthening the legal framework.* The framework for household and corporate debt restructuring was built up in stages during the program, with input from Fund staff, and aimed to encourage and expedite voluntary out-of-court workouts (given also limited court capacity); expand the coverage of debt-distressed individuals; reduce conflict of interest among creditors (the “hold out” problem) and asymmetry of information between debtors and creditors. These successive adjustments fueled private sector expectations of more generous debt relief offers in the future, holding back potential settlements. Following the October 2009 accord on payment smoothing, the authorities agreed with lenders towards the end of the program (December 2010) on a comprehensive package of measures and clearly indicated, as suggested by Fund staff, a sunset clause for the restructuring offer (mid-2011). Since then, the pace of private sector debt restructuring has accelerated, although the latest Supreme Court ruling (February 2012) may result in further delays of private debt restructuring.
* Initially, Fund staff and authorities contemplated the idea of establishing an Asset Management Company (first review). This could have helped reducing the uncertainty about banks’ balance sheet. However, the idea was subsequently dismissed (second review) on the ground that it would have entailed delays in the process due to the need to set up a new authority; upfront additional costs for the state, whose financial conditions were already distressed; and renewed conflicts with the new bank shareholders about asset valuation, which had been already marked down.