The Stunning Collapse of Iceland

Home to just 304,000 people, tiny Iceland is emerging as the biggest casualty of the global financial crisis. On Oct. 9, the government took control of the country's largest bank, Kaupthing (KAUP.ST), and halted trading on the Reykjavik stock exchange until Oct. 13. Authorities also used sweeping new emergency powers to hive off most of the domestic assets of the country's second-largest bank, Landsbanki, into a separate entity to be called "New Landsbanki" that will be fully owned by the government.

In a stunning turn of events over the past week, the vast majority of Iceland's once-proud banking sector has been nationalized. The government has taken control of Kaupthing, Landsbanki, and the No. 3 bank, Glitnir. Kaupthing also was forced to take an emergency $702 million loan from Sweden to prop up its Swedish arm, while the Norwegian Banks' Guarantee Fund offered $819 million in liquidity support to the local unit of Glitnir.

Now some believe that Iceland, which has transformed itself from one of Europe's poorest countries to one of its wealthiest in the space of a generation, could face bankruptcy (BusinessWeek.com, 10/8/08). In a televised address to the nation, Prime Minister Geir Haarde conceded: "There is a very real danger, fellow citizens, that the Icelandic economy in the worst case could be sucked into the whirlpool, and the result could be national bankruptcy."

Help from Russia?

To avert financial disaster, the country—which is a founding member of NATO—may turn to Russia for help. The Russian government has said it would consider lending Iceland $5.5 billion. "We have not received the kind of support that we were requesting from our friends," Haarde said. "So in a situation like that one has to look for new friends." (Haarde was adamant, though, that any deal did not extend to military cooperation, refuting the suggestion that Russia might be given access to an airbase vacated by the U.S. Air Force in 2006.)

Haarde says the government will begin talks with Russia on Oct. 14. The loan, if secured, would be used to shore up the Icelandic krona, which tumbled by 30% on Oct. 6—and not to fix the country's now nationalized banking system. The International Monetary Fund has sent a delegation to Reykjavik, but Haarde, speaking on Icelandic radio on Oct. 9, explained that seeking help from the IMF, "is an option, but we don't think it will come to that."

How did things get so bad so fast? Blame the Icelandic banking system's heavy reliance on external financing. With the privatization of the banking sector, completed in 2000, Iceland's banks used substantial wholesale funding to finance their entry into the local mortgage market and acquire foreign financial firms, mainly in Britain and Scandinavia. The banks, in large part, were simply following the international ambitions of a new generation of Icelandic entrepreneurs who forged global empires in industries from retailing to food production to pharmaceuticals. By the end of 2006, the total assets of the three main banks were $150 billion, eight times the country's GDP.

Mountain of Foreign Debt

In just five years, the banks went from being almost entirely domestic lenders to becoming major international financial intermediaries. In 2000, says Richard Portes, a professor of economics at London Business School, two-thirds of their financing came from domestic sources and one-third from abroad. More recently—until the crisis hit—that ratio was reversed. But as wholesale funding markets seized up, Iceland's banks started to collapse under a mountain of foreign debt.

Now the pressure is on the government to find a lasting solution—and fast.

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