The collapse of the Icelandic economy has some consequences and lessons for New Zealand.

The consequence is the failure of Credit Sails, a credit derivative swap (CDS) product that was sold to a number of the country’s charitable organisations.

Investors have lost more than 98 per cent of the money invested in Credit Sails, mainly because it had large exposures to three failed Icelandic banks, Kaupthing Bank, Glitnir Bank and Landsbanki.

The lessons are that countries with poorly regulated financial institutions, which attract hot overseas money, can suffer major downturns when these organisations fail and overseas investors lose confidence.

Two years ago Icelandic businessmen were conquering the world, fuelled by a buoyant Reykjavik Stock Exchange and aggressive lending by their domestic banks.

But this came to an abrupt end in October 2008 after the banks over-extended themselves and the Government was forced to take control of Kaupthing, Glitnir and Landsbanki.

Asgeir Jonsson, an Icelandic economist explained in his book Why Iceland?: “Iceland’s approach to banking was far more cautious than that of any other Western European nation during the twentieth century, and the excessive governmental controls kept its financial system immature.

“Once it was embroiled in the worldwide investment bubble that grew in the late 1990s, the lack of institutional memory allowed all participants, bankers and government officials alike, fundamentally to underestimate systemic risk.

“In the modern day, the presence of one aggressive international investment bank would have been a tremendous benefit to Iceland. But once its entire financial system was put in this high gear, there was trouble in store.

“Had Iceland’s banks been examined independently, they would not have looked so different from any other bank in Europe. But looking at them in aggregate, crowded onto a tiny island dependent on foreign wholesale funding, they would form an outsized systematic risk for the country.”

Michael Lewis wrote in Vanity Fair: “An entire nation without immediate experience or even distant memory of high finance had gazed upon the example of Wall Street and said, “We can do that”.

For a brief moment it appeared that they could.

In 2003, Iceland’s three biggest banks had assets of only a few billion dollars, about 100 per cent of its gross domestic product. Over the next three and a half years they grew to more than $140 billion and were so much greater than Iceland’s GDP that it made no sense to calculate the percentage of it they accounted for.

It was, as one economist put it to me, “the most rapid expansion of a banking system in the history of mankind”.

Iceland’s problems effectively began in the early 2000s when the Government deregulated the country’s banking system and allowed retail banks to participate in investment banking activities.

The separation of retail and investment banking was one of the key reforms of the post 1930s Depression period because investment bankers, who are fee driven, can force their retail banking colleagues to make high risk loans in order to generate fee income for the investment banking division. The requirement to separate investment and retail banking was also abolished in the United States in the late 1990s and partly explains why investment bankers, who work for retail banks, continue to receive huge bonuses while the retail banking divisions suffer large losses.

The next big development in Iceland was the privatisation of the government-owned banks, Landsbanki and Bunadbarbanki, in 2002. This was a major political issue, as was the sale of the Bank of New Zealand more than 20 years ago.

Advocates of privatisation believe that any form of private ownership is better than government ownership and the two Icelandic banks were sold to highly leveraged holding companies.

We avoided that fate in the 1980s, mainly because Jim Anderton made a strong stance against the sale of the Bank of New Zealand to Brierley Investments although a major shareholding was later sold to Michael Fay and David Richwhite.

Subsequently, a former Governor of the Reserve Bank of New Zealand strongly opposed to the establishment of Kiwibank yet our central bank did little to monitor and regulate our privately owned, high-risk, finance companies.

After the Icelandic privatisation the three main banks, Kaupthing, which acquired the former government owned Bunadbarbanki, Glitnir and Landsbanki went on a major international acquisition and borrowing spree.

They attracted hot money to Iceland as the central bank raised interest rates to 10.5 per cent in an attempt to dampen the boom.

On March 31, 2006 Jeremy Warner wrote in the Guardian: “The effect of high interest rates in Eastern Europe, Turkey, Israel, New Zealand and Iceland relative to the big developed economies has been to attract a wall of hot, international money, able to borrow cheap and lend a lot more expensively. This in turn has fuelled a boom in domestic demand. The success of this so-called “carry-trades” depends vitally on the currency remaining strong”. In March and April 2006 the Icelandic krona fell sharply and it looked as if the boom was over.

But the Icelandic economy and its banks were rescued by the proliferation of credit derivative swap products of which Credit Sails was one.

Thus Credit Sails effectively invested in the three major Icelandic banks when concerns had already been expressed about the viability of their business models.

Moody’s upgraded all three Icelandic banks to triple A ratings in early 2007, a jump of between four and five notches.

However the use of the credit derivative swaps linked Iceland to US capital markets and when Lehman Brothers collapsed in September last year, the three major Icelandic banks, which represented 85 per cent of the country’s banking system, quickly followed in early October.

According to the OECD there was “a lack of macro-prudential framework that would have reacted to unsustainable developments in credit, leverage and risk”.

“By the end, the size of the banks far exceeded the limited capacity of the Icelandic authorities to rescue them.”

Iceland seems like a long way away as far as New Zealand is concerned but the latest 109-page OECD Economic Survey on the country, which was released this week, contains a large number of tables and graphs where New Zealand features prominently. These are on overseas debt, net international liabilities, house price growth to disposable income, personal debt and financial leverage.

In nearly all of these tables and graphs we rank just ahead of or just behind Iceland.

As the accompanying table shows we rank fifth behind Iceland, Greece, Hungary and Portugal in terms of net international liabilities to Gross Domestic Product.

The OECD report has a particularly gloomy outlook on the Iceland economy and expects it to contract by 7 per cent this year and 0.8 per cent in 2010.

However there is a big difference between Iceland and New Zealand. Iceland’s major banks were owned by local high-risk entrepreneurs whereas our major banks are substantial Australian-owned organisations.

This is in contrast to the 1980s and early 1990s when the Bank of New Zealand was a perfect example of the situation where the wrong ownership and governance structures can lead to major problems.

However, New Zealand shouldn’t be complacent about its large net international liabilities, banking sector and regulatory structure as Moody’s gave the three major Icelandic banks AAA credit ratings at the beginning of 2007 yet 18 months later they all collapsed with ruinous consequences for Iceland’s economy.