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Bruegel: Right choice to 'let banks fail'

Wednesday 4 January 2012 - by Karina Whalley

Iceland's banking system erupted much like its volcano
 Banks with a faulty business model can and should be allowed to fail as proven by the epic collapse of the Icelandic banking system which has successfully overcome its problems, a leading Brussels think tank argues.

Bruegel has released a report which compares the policy mix of Iceland, Ireland and Latvia after the financial crises in 2008 and makes a strong case for a European banking federation and an EU-wide bank resolution regime.

"The experience with the collapse of the gigantic Icelandic banking system suggests that letting banks fail when they had a faulty business model is the right choice," says research fellow Zsolt Darvas who penned the paper.

The Icelandic government simply did not have the means to save the enormous banking system when wholesale funding dried up and as a result three major banks - Glitnir, Kaupthing and Landsbanki - were allowed to fail.

Their international arms were wound up with new banks created to continue domestic operations which, the paper notes, are currently doing well.

Ireland on the other hand, was blocked by the EU from letting any banks collapse due to fear of contagion. Latvian banks were two-thirds foreign owned - mostly by Scandinavian banks which took on the bank losses helped by the European Central Bank, said Darvas.


But Iceland came out of the crisis with the smallest drop in employment and gross domestic product among the three countries, despite having had the greatest shock to its financial system, the report says.

The paper also highlights the successful bond issue on international markets that Iceland and Latvia held in June.

"This is especially remarkable for Iceland, a country that still maintains strict capital controls and let its banks default on their foreign liabilities," it said.

But Darvas does note the difficulty in isolating the impact of "individual elements of the policy mix" which include exchange rate regime and the use of capital controls.

All three countries are on the path to recovery but the study says: "The very high level of interconnectedness of European banks and potential cross-country spillovers of national bank resolution practices strongly call for an EU-wide bank resolution regime.

"Yet EU-wide resolution could work if regulation and supervision are also centralised, and an EU-wide deposit guarantee would also make the financial system more resilient," it said.

"There is a strong case for a 'European banking federation'."


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