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Global financial crisis overwhelms tiny Iceland

Protests in the capital escalated Tuesday and Wednesday with calls for the prime minister and Central Bank head to resign.

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By 2006, many worried that the banks had become too big and globalized for an economy of 300,000 people to backstop. The balance sheets of the three big banks – Glitnir, Landsbanki, and Kaupthing – exceeded Iceland’s gross domestic product (GDP) by more than five times. A report from Copenhagen-based Danske Bank warned that the banks had outgrown the country.

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“The Icelandic banks, media, and officialdom saw the report as part of a conspiracy by representatives of the old colonial power,” recalls the report’s coauthor, Lars Christensen, who says the crisis could have been headed off if the banks had been reined in at that point.

“We were worried, but it’s difficult when you are in a competitive environment to take responsibility for macroeconomic solutions,” says Landsbanki chief economist Yngvi Orn Kristinsson. “Somebody else has to do that: the Central Bank.”

Bank controls were weak
But, the Central Bank and government regulators didn’t rein in the banks. By October, their liabilities had reached twelve times Iceland’s GDP. The banks had borrowed heavily to make these investments and were dependent on short-term loans to continue operations. When Lehman Brothers collapsed and global credit markets froze in September, the banks had nowhere to turn for help.

At the end of September, Glitnir executives turned to the Central Bank for a bridge loan. Instead, Central Bank chief David Oddsson – a former prime minister with no banking background – announced he would nationalize the bank.

Mr. Kristinsson, of Landsbanki, recalls: “We knew immediately that we wouldn’t have more than one or two weeks. It was a dangerous miscalculation, because analysts and credit institutions abroad believed that it was too much for the government to take on.”

Ratings agencies downgraded the value of Icelandic bonds, dragging down the currency, and cutting Landsbanki’s credit lines, triggering its failure. Mr. Oddsson then suggested that Icelandic banks might not pay British depositors, prompting British Prime Minister Gordon Brown to evoke antiterrorism laws to seize their British assets – a move that took down Kaupthing.

Icelanders were shocked to see Landsbanki listed alongside Al Qaeda and North Korea on Britain’s list of sanctioned “regimes.”

“We conceived of ourselves as a very peaceful, peace-loving people,” Bishop Sigurbjornsson says. “Being labeled as terrorists was something we could never have imagined.”

Most British and Dutch deposits will be guaranteed, largely by Iceland’s citizens using money borrowed from abroad. Many here are upset that they are left paying an enormous tab run up by wealthy bankers. Some economists compare the debt burden to the crushing one imposed on Germany after World War I.

Protesters want new leaders

The protesters’ main demand is for Oddsson and his longtime political ally, Prime Minister Geir Haarde to resign, which organizers say is the first step toward rebuilding public and investor confidence. Both have resisted.

“They want to be able to lead the nation out of the mess,” Mr. Haarde’s spokesman, Kristjan Kristjansson explains. “Walking away from the problem now would be to surrender to it.”

Tomorrow: How Iceland is trying to preserve its social safety net.