Iceland's Capital Controls and the Resolution of its Problematic Bank Legacy

34 Pages Posted: 5 Jul 2017

See all articles by Fridrik M. Baldursson

Fridrik M. Baldursson

Reykjavik University

Richard Portes

London Business School - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Eirikur Elis Thorlaksson

Reykjavik University

Date Written: July 3, 2017

Abstract

Iceland’s capital controls were imposed in October 2008 in order to prevent massive capital flight and a complete collapse of the exchange rate. The controls were in place for more than eight years, primarily because of the risk of large outflows of domestic holdings of the failed Icelandic banks. As argued in a precursor to this paper (Baldursson and Portes, 2014), significant restructuring of domestic holdings of foreign creditors of the banks was required before the controls could be lifted. Such a restructuring was finally accomplished in January 2016. Broadly in line with the recommendations of Baldursson and Portes (2014), the resolution involved a voluntary – in much the same sense as the Greek debt restructuring was voluntary – restructuring of the banks’ debt, under which most of the Icelandic krona assets of the banks were relinquished to the state or tied up in Iceland. An attempt at resolving so-called ‘offshore kronas’ – the remains of the carry trade into Iceland in the years before the 2008 crisis – failed resulting in a dispute with international investors. We model the strategic interaction between Iceland and creditors on the resolution of the failed banks as well as the interaction between Iceland and investors on the resolution of the offshore krona holdings. The model explains why the bank resolution was successful and why the offshore krona auction was not. Resolution of the old banks will cut Iceland’s public debt, but it will still be substantially higher than before the crisis. The net international investment position of Iceland has, however, turned positive and is stronger than it has been in decades. In March 2017, the capital controls were removed in practice, albeit not by statute. Inflow measures remain.

Keywords: capital controls, cross-border banking, Icelandic banks, resolution of failed banks

JEL Classification: E58, F31, G21

Suggested Citation

Baldursson, Fridrik M. and Portes, Richard and Thorlaksson, Eirikur Elis, Iceland's Capital Controls and the Resolution of its Problematic Bank Legacy (July 3, 2017). Available at SSRN: https://ssrn.com/abstract=2996631 or http://dx.doi.org/10.2139/ssrn.2996631

Fridrik M. Baldursson (Contact Author)

Reykjavik University ( email )

Ofanleiti 2
Reykjavik, 103
Iceland
+3545996200 (Phone)

Richard Portes

London Business School - Department of Economics ( email )

Regent's Park
London, NW1 4SA
United Kingdom
+44 20 7000 8424 (Phone)
+44 20 7000 8401 (Fax)

HOME PAGE: http://faculty.london.edu/rportes/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Eirikur Elis Thorlaksson

Reykjavik University ( email )

Ofanleiti 2
Reykjavik, 103
Iceland

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