NZD: the Iceland lesson

[UPDATE: 11:30AM Thursday 30/10/2008:

- an anthem of gloom. We say we are a trading nation, but we continue to export less than we import. Weak, very weak - structurally weak too, we've been in this position for some time and the plasma screens are still on order by the looks of it.]

Five months on, after Iceland's crisis and crash, the question remains pertinent.

The collapse of Iceland’s banks: the predictable end of a non-viable business model makes for some sobering reading. In the conclusion the authors mention Switzerland, Sweden and Denmark as possibly being vulnerable for the same reasons. Well they should have widened their scope beyond Europe to include us.

Because the worst possible outcome has now materialised, both for the banks and for Iceland, there is no reason not to circulate the paper more widely, as some of its lessons have wider relevance.
[...]
With most of the banking system’s assets and liabilities denominated in foreign currency, and with a large amount of short-maturity foreign-currency liabilities, Iceland needed a foreign currency lender of last resort and market maker of last resort to prevent funding illiquidity or market illiquidity from bringing down the banking system. Without an effective lender of last resort and market maker of last resort – one capable of providing sufficient liquidity in the currency in which it is needed, even fundamentally solvent banking systems can be brought down through either conventional bank runs by depositors and other creditors (funding liquidity crises) or through illiquidity in the markets for its assets (market liquidity crises).

This weakness is what the RBNZ was addressing earlier today when it released this statement:


The Yanks will bail us out - that's the message. Depending on if and how it works I wouldn't be surprised if it ends up as a mechanism to bail them out. Anyway:

During the final death throes of Iceland as an international banking nation, a number of policy mistakes were made by the Icelandic authorities, especially by the governor of the Central Bank of Iceland
[...]
The decision of the government to take a 75 percent equity stake in Glitnir on September 29 risked turning a bank debt crisis into a sovereign debt crisis. [...] then, on October 7, the Central Bank of Iceland announced a currency peg for the króna without having the reserves to support. It was one of the shortest-lived currency pegs in history. At the time of writing (28 October 2008) there is no functioning foreign exchange market for the Icelandic króna.
[...]
The main message of our paper is, however, that it was not the drama and mismanagement of the last three months that brought down Iceland’s banks. Instead it was absolutely obvious, as soon as we began, during January 2008, to study Iceland’s problems, that its banking model was not viable. The fundamental reason was that Iceland was the most extreme example in the world of a very small country, with its own currency, and with an internationally active and internationally exposed financial sector that is very large relative to its GDP and relative to its fiscal capacity.
[...]
The Icelandic banks’ business model and Iceland’s global banking ambitions were incompatible with its tiny size and minor-league currency, even if the banks did not have any fundamental insolvency problems.
[...]
In this recent crisis, however, regulators and supervisors have tended to be uninformed and out of their depth. We doubt Iceland is an exception to this rule. The quality of the balance sheet of the three Icelandic banks has to be viewed by outsiders as unknown.

The RBNZ says they have $11 billion in foreign currency to play with, they call it "intervention capacity". Domestic credit, I note, keeps expanding 10% a year - far in advance of what growth we have had. NZ's overseas debt increased by about $30b in the last year: