Image: Icelandic bank Glitnir
Olivier Morin  /  AFP - Getty Images
A branch of the Icelandic bank Glitnir in Reykjavik is shown. Most of Iceland’s once-proud banking sector has been nationalized as the nation feels the effects of a severe global financial crisis.
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updated 10/10/2008 1:33:26 PM ET 2008-10-10T17:33:26

Home to just 304,000 people, tiny Iceland is emerging as the biggest casualty of the global financial crisis. On Oct. 9, the government took control of the country's largest bank, Kaupthing, and halted trading on the Reykjavik stock exchange until Oct. 13. Authorities also used sweeping new emergency powers to hive off most of the domestic assets of the country's second-largest bank, Landsbanki, into a separate entity to be called "New Landsbanki" that will be fully owned by the government.

In a stunning turn of events over the past week, the vast majority of Iceland's once-proud banking sector has been nationalized. The government has taken control of Kaupthing, Landsbanki, and the No. 3 bank, Glitnir. Kaupthing also was forced to take an emergency $702 million loan from Sweden to prop up its Swedish arm, while the Norwegian Banks' Guarantee Fund offered $819 million in liquidity support to the local unit of Glitnir.

Now some believe that Iceland, which has transformed itself from one of Europe's poorest countries to one of its wealthiest in the space of a generation, could face bankruptcy. In a televised address to the nation, Prime Minister Geir Haarde conceded: "There is a very real danger, fellow citizens, that the Icelandic economy in the worst case could be sucked into the whirlpool, and the result could be national bankruptcy."

Help from Russia?
To avert financial disaster, the country — which is a founding member of NATO — may turn to Russia for help. The Russian government has said it would consider lending Iceland $5.5 billion. "We have not received the kind of support that we were requesting from our friends," Haarde said. "So in a situation like that one has to look for new friends." (Haarde was adamant, though, that any deal did not extend to military cooperation, refuting the suggestion that Russia might be given access to an airbase vacated by the U.S. Air Force in 2006.)

Haarde says the government will begin talks with Russia on Oct. 14. The loan, if secured, would be used to shore up the Icelandic krona, which tumbled by 30 percent on Oct. 6 — and not to fix the country's now nationalized banking system. The International Monetary Fund has sent a delegation to Reykjavik, but Haarde, speaking on Icelandic radio on Oct. 9, explained that seeking help from the IMF, "is an option, but we don't think it will come to that."

How did things get so bad so fast? Blame the Icelandic banking system's heavy reliance on external financing. With the privatization of the banking sector, completed in 2000, Iceland's banks used substantial wholesale funding to finance their entry into the local mortgage market and acquire foreign financial firms, mainly in Britain and Scandinavia. The banks, in large part, were simply following the international ambitions of a new generation of Icelandic entrepreneurs who forged global empires in industries from retailing to food production to pharmaceuticals. By the end of 2006, the total assets of the three main banks were $150 billion, eight times the country's GDP.

Mountain of foreign debt
In just five years, the banks went from being almost entirely domestic lenders to becoming major international financial intermediaries. In 2000, says Richard Portes, a professor of economics at London Business School, two-thirds of their financing came from domestic sources and one-third from abroad. More recently — until the crisis hit — that ratio was reversed. But as wholesale funding markets seized up, Iceland's banks started to collapse under a mountain of foreign debt.

Now the pressure is on the government to find a lasting solution—and fast. That's because the ramifications of Iceland's meltdown extend far beyond the tiny Nordic country. Over the past decade, Icelanders have taken advantage of low interest rates offered by the country's banks to finance rapid expansion beyond the island nation in numerous industries. Hafnarfjordur-based Actavis, for instance, is now one of the world's biggest generic drug companies.

Perhaps the best known overseas success story is Baugur Group which owns a vast swath of Britain's retail industry and earlier this year built up an equity stake in Saks Fifth Avenue in what many figured would become a takeover attempt. Although Baugur insists its British retail interests are safe, the collapse of the Icelandic banking system puts massive pressure on already struggling British retailers.

Offering higher interest rates than their counterparts in Britain, Icelandic banks have attracted huge inflows from British investors in recent years. Since its launch in October 2006, Icelandic internet bank Icesave, owned by Landsbanki, attracted $7 billion in deposits from 300,000 British retail investors. When the bank went bust, British Chancellor of the Exchequer Alistair Darling was forced to step in. On Oct. 8 he pledged to guarantee the deposits of all British retail investors in Landsbanki and its subsidiaries. The British government says it plans to sue Iceland to recoup at least some part of the savings of British customers in Icesave.

Forced sale of assets
While British retail depositors will be protected, others aren't so lucky. British entrepreneur Robert Tchenguiz' property empire collapsed along with Iceland's banking system. Tchenguiz managed to lose $1.7 billion in just 24 hours after Kaupthing took control of his stakes in British retailer J Sainsbury and Mitchells & Butlers as the Icelandic government forced huge sale of its banks' overseas assets.

Britons could lose out, too, because of higher taxes. That's because local government authorities in England and Wales are believed to hold an estimated $347 million in Icelandic banks. One local government council in Kent is said to have parked $87 million of taxpayer money in Icelandic banks. With no guarantee forthcoming from the British government, the Local Government Assn. plans to ask the government for temporary tax breaks to give members some breathing room.

In 2006, after a currency crisis that hammered the krona, some analysts raised concerns about the high level of leverage in the Icelandic banking system. But many eminent economists and commentators were quick to rush to the country's defense. They noted that Iceland had strong financial regulators, a sound economic environment with low unemployment, and a fully funded pension system. While the country had a large current account deficit, they said, comparing it to emerging economies such as Thailand or Turkey was misguided.

But as Frederic S. Mishkin, a professor at Columbia University and a former economist with the Federal Reserve, noted in a 2006 report titled Financial Stability in Iceland, "If a significant fraction of traders in international financial markets think that Iceland will be undergoing financial meltdown — even if fundamentals don't warrant it — they could create a self-fulfilling prophecy by massively pulling out of Icelandic assets." Mishkin's prophecy just came true.

Copyright © 2012 Bloomberg L.P.All rights reserved.

Video: Iceland bracing for 'severe recession'

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