Primary navigation:

QFINANCE Quick Links
QFINANCE Reference

Home > Capital Markets Viewpoints > The Distorted System: Iceland’s Lessons Yet To Be Learned

Capital Markets Viewpoints

The Distorted System: Iceland’s Lessons Yet To Be Learned

by Anat Admati and Gudrun Johnsen


“The truth is incontrovertible. Panic may resent it, ignorance may deride it, malice may distort it, but, there it is.” Winston Churchill

In October 2008, 97% of the Icelandic banking sector collapsed in a matter of three days. The triggering event was the fall of Lehman Brothers, with the subsequent collapse of interbank lending, the fall in asset prices, and the evaporation of trust among financial market participants. Focusing on this trigger is convenient for the culprits of the collapse in Iceland, who have every incentive to push the blame on to someone else. Policymakers elsewhere also prefer to create the impression that the crisis was akin to a natural disaster, diverting attention from their own failures prior to the crisis.

The fall of Lehman, however, was not the true cause of the collapse of the Icelandic banking sector, a point reinforced by the fact that only massive action by governments and central banks to bail out and support weak or insolvent banks prevented the collapse of the global financial system in fall 2008. The subsequent great recession is still causing significant pain for many millions of people around the world. Yet there has been no comprehensive, in-depth analysis to identify the major weaknesses, build a foundation for the future, and reconstruct a sustainable banking system. In fact, Iceland is the only country in the world that has dared to look inside the Pandora’s box and allow researchers complete access to the financial system’s data in order to carry out a comprehensive post mortem and figure out the true causes of the collapse.

Findings of the Icelandic Special Investigation Commission

The findings published in the report of the Special Investigation Commission set up by Iceland’s Parliament in 2008 and published in 2010 reveal malpractice on the part of the bankers, complete lack of oversight on the part of public servants, incompetence in financial surveillance, and, as a consequence, helplessness among top government elected officials in steering clear of the financial abyss which awaited every single Icelandic citizen as their banking system collapsed in early October 2008.

The collapse has had a lasting impact on the Icelandic people. Almost six years after the calamity hit, the nation is still deeply entangled in the complexities of resolving the banking crisis and a lengthy foreign dispute over deposit guarantees. Capital controls are still in force, investments are at a historic low for the sixth year running, and real wages—which were cut in half—are a long way from being restored to their pre-crisis levels. The debt burden of the Icelandic state and the austerity policies adopted by the government after the crash have undermined other societal infrastructures, including the education system and the health care system. Although the social security system has been safeguarded, it is under heavy strain. The country also faces the looming threat of a brain drain, including a shortage of medical doctors.

The Commission’s report also revealed an incestuous web of ownership between listed and nonlisted firms, as well as massive manipulation of stock market prices and of financial results and leverage. The banks’ loan portfolios were marked by excessive risk, with the majority of loans extended in the form of zero coupons to related parties up to concentrations that were well above the legal threshold of large exposures of banks.

This structure of interconnected conglomerates and special-purpose vehicles, which was designed to circumvent legal constraints in credit allocation, gave rise to a massive build-up of systemic risk. The resulting vulnerability of the system was what brought it down, with supervisors unable to detect the interconnectedness and correlation between assets of the banks in a timely manner. In addition, the equity cushions of the firms that received credit from the banks were extremely thin, leaving virtually no room for a drop in asset prices.

The banks therefore became wholly dependent on the well-being of relatively few customers. With the size of the banking sector growing to 10 times Iceland’s GDP, the government’s well-being and that of the country’s citizens was at risk. Not only did the banks distort financial markets in Iceland, they distorted the entire Icelandic economy—with an inevitable effect on the Icelandic krona, the smallest floating currency in the world. Unfortunately, no policymaker had the competence or the courage to recognize that the emperor was naked and avoid the collapse that ensued.

The Icelandic banks were able to grow as much as they did because they were able to piggyback on the stellar credit rating of the almost-debt-free Icelandic state. Although at times the banks were willing to pay interest rates similar to those paid by emerging market institutions with much lower credit ratings, their growth was spurred by implicit government guarantees that lowered their interest rates and enabled them to continue to borrow.

Back to Table of contents

Further reading


  • Admati, Anat, and Martin Hellwig. The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It. Princeton, NJ: Princeton University Press, 2013. Makes the case for stronger and more effective capital regulation. Chapter 11 provides an outline for both immediate steps to take and improved capital regulations. (For more discussion at a policy level, see Admati et al., 2013.) Online:
  • Johnsen, Gudrun. Bringing Down the Banking System: Lessons from Iceland. New York: Palgrave Macmillan, 2014. A detailed account of the findings of Iceland’s parliamentary Special Investigation Commission on the causes and events leading up to the collapse of the country’s banks in 2008. Online:


  • Admati, Anat R., Peter M. DeMarzo, Martin F. Hellwig, and Paul Pfleiderer. “Fallacies, irrelevant facts, and myths in the discussion of capital regulation: Why bank equity is not socially expensive.” Revised October 22, 2013. Online:
  • Carney, Mark. “The UK at the heart of a renewed globalisation.” Speech given at an event to celebrate the 125th anniversary of the Financial Times on October 24, 2013. Online:
  • Rannsóknarnefndir Alþingis. “Report of the Special Investigation Commission.” April 12, 2010. Icelandic Parliament page with links to selected parts of the report in English. Online:


Back to top

Share this page

  • Facebook
  • Twitter
  • LinkedIn
  • Bookmark and Share