The Vote for Brexit: Reykjavik-on-Thames, Redux?

Nina Eichacker

Nina Eichacker is a lecturer in economics at Bentley University. She has written previously for Triple Crisis on German financialization and the eurozone crisis and on financial liberalization and Iceland’s financial crisis.

On October 8, 2008, the British Chancellor issued the “Landsbanki Freezing Order 2008,” freezing the assets of Landsbanki, one of Iceland’s three largest banks, after the Icelandic Finance Minister’s statement that Iceland would not guarantee UK citizens’ deposits in Landsbanki’s retail banks, after it had gone into receivership. The British Treasury and Financial Supervision Authority (FSA) froze billions of pounds sterling in Landsbanki’s assets in Britain. Icelandic banks had been badly overleveraged: In 2007, Icelandic GDP was $16.3 billion dollars; Icelandic banks held $176 billion in assets, $166 billion in liabilities, and owned three times as many foreign assets as domestic ones (Buiter and Sibert, 2011, Aliber, 2011). Consequences of this crisis included billions of dollars in banks’, firms’, and households’ losses on bank shares, economy-wide recession, austerity policies and international pressure for the Icelandic government to guarantee banks’ liabilities with taxpayers’ money.

On November 13, 2008, Willem Buiter wrote a post sub-titled “Is London Really Reykjavik-on-Thames?” arguing that the UK should consider the risk of similar financial events occurring. The UK was also a small global economy with an outsize financial sector relative to total GDP, though UK banks’ balance sheets were only 450% of UK GDP, compared to Icelandic banks’ 900% of GDP (Buiter, 2008). External assets and liabilities of UK banks were large: 400% of GDP in gross external assets and liabilities, compared to Iceland’s 800% and the United States’ 100% (Buiter, 2008). Buiter argued further that most UK banks in 2008 were very vulnerable to a banking crisis, followed by sovereign-debt and currency crises (Buiter 2008). UK banks had the potential to set off another triple crisis. This didn’t come to pass: banks like Lloyds and HBOS received large bailouts, the government oversaw mergers of smaller banks into larger banks, and mandated banks’ sale of shares to raise capital, and improve overall bank resilience, while the Bank of England engaged in expansionary monetary policy.

Could Brexit or the vote to leave bring about that potential crisis?

Britain has a longer history of economic and financial liberalism than Iceland. The UK eliminated trade and capital controls by the 1950s, predating Iceland’s current and capital account liberalization in the 1990s (Voth, 2003). The London Stock Exchange’s “Big Bang,” the elimination of barriers to entry in the UK’s securities markets in 1986, opened British banks up to international investment opportunities; Iceland didn’t liberalize short-term or long-term capital markets or FDI until the mid-1990s. In principle, British banks’ experiences navigating international capital markets would inform their investment decisions, and be less destabilizing for the overall economy than Iceland’s banks turned out to be. While this did not prevent Britain’s experience of the global financial crisis, capital flight seems like less of a risk for Britain, even in the event of Brexit.

Wide ownership of bank shares by the Icelandic government and the general public exacerbated the costs of Iceland’s financial crisis for its overall economy (Sigurjonsson, 2011). These practices increased overall Icelandic vulnerability to financial shocks and crisis, and spread the costs of Iceland’s crisis deep into the public. Icelandic households also took on significant debt in this period, both mortgage borrowing during a housing bubble, as well as foreign denominated debt, as those households borrowed in foreign currency to purchase expensive consumer goods (Zoega, 2011; Johnsen, 2014). British households also took on larger shares of debt from the 1990s through 2008, and acquired more financial assets in that period. The global financial crisis exposed those families to financial losses; recession in the UK exposed them to job loss, tighter lending standards, and greater risk of default (Claessens, et al, 2010; Brown and Taylor, 2008). However, Britain’s status as a large economy within the EU gave it leverage over other countries that owed UK banks; it has argued for bailouts and austerity on the European stage since 2009, which have ensured the stability of British banks (Johnson, 2010). The UK’s ability to maintain that leverage following Brexit is uncertain. Until Britain leaves the EU, it will likely use these powers to benefit finance within its borders; should it leave, this loss of leverage would be costly.

From 2009 through 2015, British banks increased capital holdings, according to the Bank of England. UK banks’ leverage ratios, measured as the ratio of the sum of monetary and financial institutions currency and deposits, debt securities, and loans, over equity liabilities, declined from 51.5 in 2008, to 30.2 in 2014. At the same time, holdings of different securitized assets of these institutions have increased by billions, despite the role securitized instruments played in the onset of the subprime mortgage crisis and the global financial crisis of 2007-2009 (Davies, Richardson, Katinaite, and Manning, 2010). External asset and liability holdings fell from 350% in 2009 to roughly 250% in 2014, though the Bank of England warned about large British exposure to emerging markets in late 2015.

Though the Bank of England warned that UK financial stability decreased since the “leave” vote, policy-makers seem united in preserving stability through different mechanisms. The Bank of England is committed to supporting the British currency, and has made extra capital available to banks to promote stability (BBC, 2016). Depreciation of the pound sterling has settled, and the pound even appreciated as of July 14, in anticipation of a rate cut by the Bank of England. Finance, a large employer in Britain, has an implicit authority, and the Tory government now led by Theresa May is likely to continue supporting it through policy measures as well, despite the anti-elite sentiments on display in the vote to leave. The risk of losing financial business to intermediaries in Dublin, Frankfurt, or Paris will further spur policy-makers in both their protection for British finance, as well as their attempts to maintain international connections in finance. The UK financial system seems likely to stay intact following this vote and for potential Brexit; welcome news for employees and asset holders, but uncertain as to the distribution of its gains for whole economy.

Sources:

Aliber, Robert. 2011. “Introduction.” In Zoega and Aliber, eds, Preludes to the Icelandic Financial Crisis; pages 1 – 12. London: Palgrave MacMillan.

Aragao, Marianna. 2016. “Pound Sterling Makes Gains Ahead of First Interest Rate Decision Since Brexit Vote.” The Independent. 07/14/16. Accessed 07/16; available at: www.independent.co/uk

BBC. 2016. “Bank of England Warns Brexit Risks Beginning to Crystallize.” 07/05/16. Accessed 07/16; available at www.bbc.com.

Brown, S., & Taylor, K. 2008. “Household debt and financial assets: evidence from Germany, Great Britain and the USA.” Journal of the Royal Statistical Society: Series A (Statistics in Society), 171(3), 615-643.

Buiter, Willem. 2008. “How Likely is a Sterling Crisis or: Is London Really Reykjavik-on-Thames?” Financial Times Comment. Accessed 07/16; available at: blogs.ft.com

Buiter, Willem, and Anne Sibert. 2011. “The Icelandic Banking Crisis and What to Do About It: The Lender of Last Resort Theory of Optimal Currency Areas.” In Zoega and Aliber, eds., Preludes to the Icelandic Financial Crisis; pages 241 – 275.

Claessens, S., Dell’Ariccia, G., Igan, D., & Laeven, L. 2010. “Cross-country experiences and policy implications from the global financial crisis.” Economic Policy, 25(62), 267-293.

Davies, Richard, Peter Richardson, Vaiva Katinaite, and Mark Manning. 2010. “Evolution of the UK Banking System.” Bank of England Quarterly Bulletin 2010 Q4. Available at SSRN: http://ssrn.com/abstract=1730160; accessed 07/16.

Epstein, Gerald, and Arjun Jayadev. 2005. “The Rise of Rentier Incomes in OECD Countries: Financialization, Central Bank Policy, and Labor Solidarity.” In Epstein (ed) Financialization and the World Economy (2005). Northampton, MA: Edgar Elgar.

The Guardian. 8/6/12. “Financial Crisis Timeline.” The Guardian newspaper. Accessed 07/16; available at: www.theguardian.com.

Johnsen, Gudrun. 2014. Bringing Down the Banking System: Lessons from Iceland. London: Palgrave Macmillan.

Johnson, Simon. 2010. “Will Ireland Default? Ask Belgium.” NYTimes Economix Blog Post, November 25, 2010. Accessed 07/16; available at: http://economix.blogs.nytimes.com/2010/11/25/will-ireland-default-ask-belgium/

Sigurjonsson, Throstur. 2011. “Privatization and Deregulation: A Chronology of Events.” In Zoega and Aliber, eds, Preludes to the Icelandic Financial Crisis; pages 26 – 40. London: Palgrave MacMillan.

Voth, Hans-Joachim. 2003. “Convertibility, Currency Controls, and the Cost of Capital in Western Europe, 1950 – 1999.” International Journal of Finance and Economics: 8(3), pages 255 – 276. Accessed 07/16; available at: upf.edu

Zoega, Gylfi. 2011. “A Spending Spree.” In Zoega and Aliber, eds., Preludes to the Icelandic Financial Crisis; pages 296 – 301.

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