Comparative Analysis Of The Ireland And Iceland Financial Crises

The purpose and focus of this essay is to compare the causes the Ireland and Iceland financial crises, and how these respective countries introduced fiscal policies and regulations to resolve themselves. Both banking crises coincided with the collapse of the US sub-prime mortgage market which led to a global financial crisis, widely considered to be the most severe since the ‘Great Depression. ’ The Irish banking crisis was preceded with unprecedented economic growth between 1997 and 2007 with real GDP averaging growth of 7%, known as the ‘Celtic Tiger’ Phenomenon. Ireland’s economic growth predominantly relied on the property sector, before the systemic failure of Ireland’s banking system. The adoption of the euro ensured Ireland could access credit cheaply.

Along with increased population, income and employment, property demand increased greatly, especially with low interest-rates. Therefore, construction became necessary to meet supply targets, with the sector contributing to 12% of employment by 2006 (IMF,2019). Government regulation was unmonitored due to high economic growth, so it was easy to purchase property, although this also meant high household indebtedness. All this inevitably led to unsustainable house prices. Mortgage-rates dropped towards historically low levels and house prices increased fourfold. Vast lending on property meant Irish banks assets were valued five times the GDP. Lehman Brothers collapsed in the US in 2008, laying the foundations to a most devastating global crises, including the demise of the ‘Celtic Tiger’. The ‘credit-fuelled property-bubble’ ensured a decade of rapid economic growth, before bursting leading to the worst economic downturn in Irish history. Income and employment decreased, mortgage defaults increased with borrowers unable to pay, and property demand dropped drastically. By 2010, unemployment increased by 300,000, making it a huge problem for Ireland, with construction workers accounting for the majority. Ireland’s real GDP dropped ten percent in subsequent years due to economic collapse. On the brink of catastrophic economic failure, the government announced a ‘blanket-guarantee’ on liabilities of the six major Irish banks lasting two years due to banks unable to ‘roll-over foreign borrowings’. With the current state of the Irish economy, the government deemed the major banks ‘too big to fail,’ which led to the full or partial nationalisation of five such banks, most notably the Anglo-Irish Bank, costing the government €30 billion.

With the bailout of the major banks, the Irish debt to GDP ratio rising over 100%, and Ireland unable to source funding after the two-year blanket-guarantee ended, the government turned towards the ECB for funding, before seeking further help with an EU-IMF programme (Whelan,2013). The EU-IMF programme funded Ireland with €67. 5 billion, provided fiscal adjustments and banking restructure occurred. Fiscal policies introduced included tax increases and budget cuts, amounting to almost €30 billion between 2007 and 2013, equivalent to 18% of their 2012 GDP. Such policies led to the reduction in the budget deficit from 32% of GDP in 2010 to 4. 3% in 2011. The excessive budget deficit in 2010 was largely down to the recapitalisation of Anglo-Irish. Ireland is one of the costliest banking crises, with output losses of 105% of GDP, fiscal costs of 41% and increase in public debt amounting to 73%. It may be the poorest banking system performance of recent times. However as of 2014, the Irish economy began to grow again, and house prices had started to increase for the first time since 2007. Another country affected following the 2007 global financial crisis was Iceland, becoming the first country to experience a banking crisis. Like Ireland, the root of economic disaster was easy access to credit, leading to an economic boom, resulting in assets and property bubbles. Iceland had access to the single market as members of the EEA, however, unlike Ireland, they weren’t members of the EU/EMU, and used their own currency. Effectively, Ireland had a lender of last resort due to their EU membership, whereas Iceland didn’t. Pre 2004, Iceland’s mortgage lending was down to government’s Housing Finance Fund (HFF). However, commercial banks had the means to finance mortgages with longer maturities and lower interest rates, making them an attractive alternative.

Government regulation relaxation on mortgages furthered demand for property, building upon high levels of inflation, as house prices surged in price. Deregulation of commercial banks gave them free access to expand credit through means of expansion to developed nations. The value of the Krona was attractively high to foreign nations, so Icelandic banks could raise capital by offering high rates to investors. This new-found credit allowed for Iceland’s international expansion. Therefore, similarities between the roots of Iceland and Irelands banking crisis was the heavy foreign borrowing used to finance the extraordinarily increasing demand for property, due to low mortgage interest rates. Before the crisis, investors bought Icelandic bonds as interest rates were high, and converted their Krona assets into foreign currency, rapidly depleting Iceland’s reserves for foreign currencies. On October 2008, Iceland became the first country on the brink of economic collapse, as its three major privately owned banks collapsed within a week of each other due to insolvency, accounting to over 85% of the banking sector. The banks had grown so much that the Central Bank of Iceland (CBI) were too small to act as a lender of last resort. Unlike Ireland whom had financial means to bailout their banks, Iceland was unable to provide a blanket-guarantee for their banks, as they had become ‘too big to save’. Despite previously being labelled ‘too big to fail’ the assets of the three major banks were eleven times the Icelandic GDP, thus the CBI couldn’t save them. Unable to seek financial assistance from other countries, Iceland entered a severe balance of payments crisis. In the absence of outside assistance, Iceland were the first developed country to seek IMF help in three decades. The IMF agreed to help stabilize Iceland’s economy with macroeconomic support, drawing up an ‘economic stabilization program,’ including a two-year $2. 1 billion loan. Iceland relied on foreign borrowing for years; however, the foreign exchange markets had collapsed, and the Krona was depreciating rapidly, and two thirds of corporate debt was in foreign currencies. The IMF introduced was the temporary imposition of capital controls, preventing complete collapse of the Krona, and avoiding large capital flight. The prevention of capital outflow was essential to restructure of the economy.

The introduction of capital controls helped to stabilise the exchange rate, as well as decreasing inflation. However, the capital controls weren’t as temporary as previously thought, as they weren’t fully lifted until 2017. Due to the collapse of their three biggest banks, Iceland were forced into the creation of three new banks, each one replacing a failed ‘old’ bank. Foreign assets and debts were kept in the ‘old’ banks, but domestic assets and deposits were transferred to the ‘new’ banks. The banking crisis led to substantial costs for Iceland, as the gross fiscal cost (including direct and indirect costs) equalled 80% of GDP. Direct costs include liquidity support, debt assumed by government, asset guarantees and equity injections. Gross direct costs amounted to 43. 2% of the GDP, and net direct costs came to 19. 2%. Most of such costs were due to recapitalisation of the CBI. The HFF and commercial banks were also recapitalised at high costs. Iceland was one of the costliest crises in history, relative to their size. The demise of the economy was allowing the banks to grow too large without government intervention, so prevention of future incidents is necessary. Regulation for banks has been tightened to promote a stable international financial system for the foreseeable future. Both Iceland and Ireland now follow the Basel III regulation to prevent future crises, so they can continue to grow without excessive risk. Basel III is a set of international regulation to help provide stability in the international financial system in response to the 2007 financial crisis, limiting banks’ ability to take on excessive risk.

The agreement includes “stringent capital regulation” and “liquidity requirements”. Unlike previous iterations, Basel III introduces macroprudential regulation alongside the existing microprudential regulations. Microprudential regulation is necessary to deal with systemic risk, but not sufficient as microprudential regulation focuses on banks individually to ensure they remain solvent. Macroprudential policy is cautiously approaching risks that may become systemic. Systemic risk refers to the risk of breakdown of an entire system rather than simply the failure of individual parts, like the 2007 global crisis. To conclude, Ireland and Iceland both entered severe recession after the global financial crisis, due to the failure of tightening and controlling fiscal policy. Relaxed regulation became the predominant issue, allowing banks to access easy credit, rapidly increasing their leverage ratio, before lending to high-risk borrowers. This was the case of both countries, as the central banks of both countries failed to recognise the extent of systemic risk. However, Iceland suffered collapse of the banking sector, whereas Ireland had the financial means to guarantee liabilities.

Other areas where the banking crises differed across the two countries was the difference in implementation of fiscal policies. Iceland were forced to introduce capital controls, under the IMF programme whereas Ireland relied more so on tax increases and budget cuts. Both economies are now prospering, despite being some of the costliest banking crises to occur.