The crisis in Iceland

Ref The Economist dt Dec 13, 2008

The collapse of the krona and nationalisation of the country’s three largest banks in early October, 2008 have left Iceland facing a huge financial crisis.This is probably the biggest banking failure in history relative to the size of an economy. How did this happen?
Iceland ilustrates the dangers of a large globalised banking system in a small domestic economy. In 2007 Iceland’s three main banks made loans equivalent to about nine times the size of the booming economy, up from about 200% of GDP after privatisation in 2003. Only about one-fifth of those loans were in kronur; interest rates on these were very high. SO many Icelanders instead borrowed from their banks in cheaper currencies such as yen and Swiss francs.
But after the banks collapsed in early October, the currency slumped and domestic interest rates rose sharply. Exchange controls imposed in the heat of the crisis have severely restricted access to hard currency.
The IMF forecasts that the economy will contract by 9.6% next year. Many workers have been laid off. Many young Icelanders, who have never known unemployment, are expected to lose their jobs.
With unemployment rising, citizens talk openly about defaulting on their home and car loans. Principal payments on local-currency mortgages are indexed to inflation, which is expected to be 20% this year. This and their foreign-currency exposure means many households’ debts have roughly doubled in krona terms.
The failure of the banks may cost taxpayers more than 80% of GDP. Relative to the economy’s size, that would be about 20 times the Swedish government's banking rescue act in the early 1990s. The cost would also be several times that of Japan’s serious banking crisis a decade ago.
The crisis was fulelled by the aggressive business model of Iceland’s two largest banks, Landsbanki and Kaupthing Bank. These banks could attract only paltry sums in the domestic market. In 2006, they decided to use the internet to attract foreign deposits, using the cost savings from online banking to offer higher interest rates to savers. These banks were soon sucking deposits away from bricks-and-mortar banks across Europe. When Landsbanki collapsed in October, the country ended up owing $8.2 billion to foreign internet depositors of its banks, or about half of Iceland’s entire GDP.
Now the debate has intensified whether Iceland should join the Euro. Here opinion is divided among Icelanders. And even if the country decides to join the Euro zone, it will take quite sometime.