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Robert Wade and Silla Sigurgeirsdóttir, guest bloggers

Firms subject to a regulator generally use one of three tactics to render the regulator ineffective: emasculate, capture or discredit it – or some of all three. Iceland’s financial regulatory agency, the FME (with similar functions as the UK’s Financial Services Authority), has experienced all these tactics since its creation in 1998. A sustained campaign has recently been waged to discredit the CEO appointed in the wake of Iceland’s Great Crash in October 2008, culminating in his firing at the beginning of March 2012. His case illustrates wider issues in the relations between regulators and powerful interest groups subject to their regulation and supervision, in Iceland and beyond.

His case, and the recent history of Iceland’s financial regulatory agency more generally, also acquires wider interest from the spectacularly mistaken assessments by two well-known economists, one American, one British, that Iceland’s financial system was – with some qualifications — in good health in 2006 and 2007, thanks in part to good financial regulation. Frederic Mishkin of Columbia Business School and former Governor of the US Federal Reserve was memorably interviewed by Charles Ferguson in the film Inside Job:

“In 2006 you co-authored a study of Iceland’s financial system [which stated] ‘Iceland is an advanced country with excellent institutions, low corruption, rule of law. The economy has already adjusted to financial liberalization, while prudential regulation and supervision is generally quite strong’.

[Mishkin replied], “And that was a mistake….It turns out that the prudential regulation and supervision was not strong in Iceland”.

“What led you to think that it was?”

“… the view was that Iceland had very good institution and was a very advanced country”.

Mishikin and co-author’s report was in 2006. In 2007 the British economist Richard Portes co-authored another report on the Icelandic banks, also commissioned by the Icelandic Chamber of Commerce. Portes and co-author summarized one of their key findings in The Financial Times:

“In the European Economic Area, Iceland could not get away with ‘as light a regulatory touch as possible’ [a quote from Wade’s earlier article in The Financial Times].  It has had to apply exactly the same legislative and regulatory framework as European Union member states and its Financial Services Authority [known as the FME] is highly professional” .[1]

The Icelandic Chamber of Commerce paid Mishkin $124,000 for  co-authoring his report, and paid Portes £58,000. It is not clear to what extent their willingness to assert the “highly professional” quality of Iceland’s financial regulator and the basic stability of the banks was influenced by the size of their fees from an organization which had a strong vested interest in securing their favorable  “expert” opinion; and to what extent their willingness reflects the wider epistemology of economics, which since the neoclassical  ascendancy has given little weight to meticulous observation of people and organizations (as in the approach of Alfred Marshall). The slightest acquaintance with Iceland’s financial regulator in 2006 and 2007 would have questioned Mishkin’s and Portes’ judgement.

The story started at the end of the 1990s and early 2000s, when the government privatized two staid public banks and sold them to people closely connected to the two political parties then in coalition government. A third big private bank was formed at the same time.

The new banks took off, aiming to grow as fast as possible by borrowing on international money markets at one to a few years’ term and lending long. One of them was so successful that it grew its assets at an average rate of over 90% a year from 2000 to the end of 2007, almost doubling its balance sheet every year. By 2006, tiny Iceland (with a population of only 320,000) had three banks in the world’s 300 biggest. Its ratio of bank assets to GDP was the second highest in the world, slightly below Switzerland – after only six years’ experience in international banking. Government and business circles talked of making Iceland an international financial center in the North Atlantic, conveniently midway between Europe and North America, reducing the economy’s dependence on exports of fish and aluminum.

To a degree unrivalled in other developed countries, Iceland’s bank owners lent to private holding companies owned by themselves or closely related parties. The private holding companies, as well as the banks directly, bought and sold domestic assets back and forth between related companies at continually inflated prices, boosting each other’s balance sheets. And they bought and sold foreign assets, using their ability to make deals very quickly as a competitive advantage: they persuaded sellers to sell quickly, often by overpaying.

Housing and market boom

From their soaring foreign profits, the banks and private equity companies distributed a portion back into Iceland in the form of rapidly rising remuneration of staff and dividends, new buildings, and charitable donations to universities, hospitals and concert halls. With the huge infusion of foreign borrowing and foreign profits, a housing and stock market boom took hold as households and firms loaded up on debt. Happiness surveys over the 2000s showed Icelanders at the top of the world happiness league. (But the results probably reflect a mistranslation of an Icelandic word for “splendid”, “great” or “top rank”, which in everyday usage means just “so so”.)

In 1998 the government established a financial regulatory agency outside of the central bank, the FME. Its mandate matched European standards for financial regulation, and its website made it look fully professional. But it had a staff of little more than 30 by the early 2000s, housed in decrepit offices tucked away behind a fast-food joint. The high-powered financiers and lawyers of the banks were scornfully dismissive when called for meetings there. This was the emasculation tactic in action.

By 2006 staff numbers had risen to 46 for supervising three of the world’s 300 biggest banks. Staff turnover was well into double digits, as staff walked across the street to join a bank and multiply their salary. With this prospect in mind, they had already been captured before they left the regulator.

Politicians and banks justified the small size and budget of the regulator by invoking the idea of the efficient market hypothesis – that banks should be left to regulate themselves via their own sophisticated risk models, with only “light touch” regulation from outside. They pointed to the UK and the US as the standard of best practice, where the idea of the efficient market hypothesis also justified the desirability of “light touch” regulation.

The same spirit prevailed right across the organizations of the state. When the Tax Agency set up a special unit in 2004 to inspect taxes of a set of Iceland’s biggest companies and this unit began to substantially curb corporate tax evasion, the Ministry of Finance made plans to shift the unit into the core of the ministry, where it could be better controlled by the minister. (But as the crisis built up the plans were put on hold.) In 2002 the government abolished the National Economic Institute (which had published  critical reports, including on tax evasion), justifying the move by saying that since the best people now worked for the banks, the banks’ research departments were best placed to provide impartial information and analysis on the economy.  The banks were suitably grateful.

Behind the “shop window” displays of regulators, tax inspectorates and other formal organizations of the modern state the Icelandic system of corruption flourished: not money bribery as in envelopes stuffed with cash (whose absence in dealings with foreigners is why Iceland regularly scored as among the least corrupt countries in the world by Transparency International’s corruption perception index). This was “favor bribery”, mutual backscratching amongst the relatively closed elite, including favorable planning applications (to build beyond-the-rules houses in national parks, for example) and favorable civil service appointments. The top civil service position in a ministry might be filled on the basis of a one-on-one interview with the minister, with no-one else present.

One of the favored behaviors of top civil servants was to keep their minister uninformed about information that could land the minister in trouble for not acting – information about the growing financial fragility of the banks, for example. The ministerial code says that ministers cannot be held accountable for what they don’t know. This means that much of the communication is verbal, and deniable. One of the senior-most politicians later defended her inaction when, as she admits, she was warned that money was pouring out of  banks, saying that at the critical meeting in April 2008 nobody mentioned the words “bank run”.

The 2008 crash

Then came the Great Crash in October 2008. The CEO of the FME was fired for negligence, creating a vacancy. Of the 19 applicants, one stood out head and shoulders above the others. The Board of the FME, chastened by what had just happened, appointed this person in April 2009.

The new CEO, Gunnar Andersen, had an unusual background. His father had been a diplomat for Iceland and a prominent international lawyer, with an LLM from Harvard. So Andersen grew up largely outside Iceland: after graduating from the University of Iceland, went to live in the United States for 16 years and took an MBA from a prominent US university. In the closed circles of the Icelandic elite, he was almost a foreigner.

While running the New York-based subsidiary of a big Icelandic shipping company in 1985, Andersen discovered major fraud going on in the parent company, and reported it in the media. As a result of his whistleblowing and an investigation by an inquisitive journalist, the shipping company’s CEO – one of Iceland’s most prominent businessmen – received a 12-month (suspended) jail sentence. Ever since, the owner of the shipping company and his son (who became even more prominent and wealthy over the 1990s and 2000s, with close Russian connections) have been sworn enemies of Andersen.

During the 1990s Anderson  worked for a state-owned bank named Landsbanki Íslands (Landsbanki), becoming one of its managing directors, in charge of the bank’s trading desks and all its funding, domestic and international. When the government sold it in 2002 to none other than his sworn enemies, the father-and-son team, he resigned.

Through the latter half of the 2000s, Andersen worked for the Social Insurance Administration as deputy director general, in charge of fraud prevention and detection.  He exposed several major frauds, some involving prominent people. At the same time he also served as director general of the European Healthcare Fraud and Corruption Network in Brussels.

When he was appointed CEO of the FME in April 2009, which by now had a staff of 70, Andersen’s top priority was to strengthen the organization’s analytical skills to enable it to assess the true financial condition of supervised entities and detect undesirable developments at an early stage. He thought this forensic task had been underplayed, compared with box-ticking legal formalities. Another top priority was to provide evidence to the Special Prosecutor for the banking collapse, securing special funding for the purpose. He and his newly motivated staff found abundant evidence of market manipulation, insider trading, fraud, false reporting and outright theft going back for years, which the FME had managed to overlook under previous leadership. In May 2009 Andersen gave a speech to the confederation of financial firms setting out his determination to see wrongdoers prosecuted.

Attacks on the regulatory agency

Soon stories began to appear in the media criticizing the FME and Andersen himself. MPs began making criticisms in parliament, saying the FME was an agency out of control.

In 2010 a report claimed that, in 2001, the FME had asked Landsbanki (then a state-owned bank) for records of its foreign operations. Andersen, then one of the Landsbanki managing directors, failed to declare two specific Guernsey offshore companies of which he was one of three directors.  The 2010 report claimed that the offshore companies not reported to the FME in 2001 were used for a range of illicit purposes, including manipulating Landsbanki’s share price and shifting liabilities off the bank’s balance sheet. The implication was that Andersen had acted illegally, and was therefore not fit to be head of the regulator. Andersen, however, claimed that, in 2001, he took advice from PricewaterhouseCoopers, Landsbanki’s chief legal counsel, the Icelandic Stock Exchange and from an FME lawyer, and that all agreed that as these specific offshore companies were owned by a trust, they did not legally have to be listed.

In response to these contradictory views the FME board in 2010 asked a Supreme Court attorney to review the case. When the attorney found nothing illegal or undermining Andersen’s fitness to be CEO, the first discrediting tactic failed.

The FME continued to present cases to the Special Prosecutor. By early 2012, now with a staff of 115, it had handed over the details on 77 cases implicating well over a hundred individuals (some of them featuring in more than one case).  The Special Prosecutor – a former small-town police chief who, in the final months of the government which had presided over the build up of the bubble, looked as though he had been appointed precisely for his lack of qualifications – was turning out to be a man of integrity and determination to prosecute wrongdoing.

Alarm bells

By 2011, the alarm bells were ringing loudly in business and political circles. Andersen apparently had to be got rid of in a hurry; and the discrediting campaign had to be intensified. But Iceland is not Panama or 1990s Russia, so it had to be done legally, or with an appearance of legality. The chairman of the FME Board, a lecturer in negotiation skills with no political base of his own, had to be enlisted.

Last November, a TV news show (from the state-run TV channel) screened a long interview with a lawyer. The lawyer showed a report which Andersen had written back in 1997 when still employed at Landsbanki, at the behest of one of Landsbanki’s co-CEOs, setting out how, amongst other things, Landsbanki could set up offshore companies. The lawyer linked this report to the earlier-mentioned 2010 report alleging that Andersen had conspired to withhold information about Landsbanki offshore companies from the FME in 2001.The lawyer said that the CEO was now investigating similar manipulation, as he himself had done in the 1990s, and therefore had to be dismissed as chief regulator. The lawyer brushed aside the fact that the investigation by the Supreme Court attorney had cleared Andersen of wrongdoing. The introduction to the interview also skipped quickly over the fact that the lawyer had defended the owners of one of the three banks and the director of another failed bank, and therefore could not be called impartial.

After the TV news show, the Board succumbed to the mantra that “perception is truth”. The chairman asked the same Supreme Court attorney to review the whole case again. Then the chairman began strenuously to press Andersen to resign, on grounds that whatever the truth of the allegations, the TV interview with the lawyer had damaged his reputation. Andersen refused. A week later, the chair proposed that a senior position might  be arranged for him in the State Banking Agency. Andersen refused. A month later the chair told him that “we” could persuade a lawyer to write a glowing report on his conduct in office: he could leave with head held high, and get two years’ severance salary. He refused for the third time, now all the more determined to stand up to what he saw as a whole culture of financial wrongdoing  – particularly because the FME was close to passing still more cases to the Special Prosecutor.

Meanwhile, the Supreme Court attorney presented his new report, which reached the same conclusion as before: there were no grounds for impugning Andersen’s integrity or fitness for office.

So the chairman asked several more lawyers to review the case; each refused. Finally another Supreme Court attorney agreed and, working with an accountant, set to work to review the whole case.

When the second Supreme Court attorney presented his nine-page report (of 16 February 2012) he made its bottom line clear: “Could [Andersen’s continuing as CEO] damage the FME? Our answer is definitely no.” There were no grounds in civil service law, he said, for removing the CEO either temporarily or permanently. He agreed that some of what Andersen had done years before, when at Landsbanki, could be interpreted so as to raise questions about his integrity. But he went on to say that anyone working at senior level in the same field would have done things which, with hindsight, could be construed negatively; so it would be difficult to find anyone else whose record could withstand the scrutiny directed at Andersen. He explicitly rejected the main charges made by the lawyer in the TV interview, and went on to raise the alarm about allowing a situation to develop in which it is possible for the head of an agency to be removed on the basis that interested parties say: “We can’t trust him.”

This second report was bad news for those running the discrediting campaign. Or it would have been had it been accurately reported. But the media told the public that the report justified dismissing Andersen,  because perception is truth.

The day after the second report was delivered the chairman informed Andersen that the Board intended to fire him on grounds of its interpretation of the second attorney’s report. This was on a Friday, and the chairman gave him until Monday to decide on his course of action. Andersen called his lawyer, who told the media that he had requested the Ministry of Finance, in charge of civil service appointments and dismissals, to rule on whether the civil service code applied to the position of head of the FME. If it did then the Board was in breach of the code, because the code stipulates that dismissal can only be activated after the person has received a written warning and been given time to improve performance.

It was clear to everyone involved in the case that the civil service code did apply to the CEO’s position and that his impending dismissal was almost certainly illegal. By then it was also becoming widely known that the media interpretation of the second attorney’s report was quite wrong. Suddenly the Board’s campaign began to backfire on the Board itself and its chairman. Suddenly the Board’s integrity was in question.

Just at this time, in late February 2012, a series of mysterious events began which threw the case onto a new track. Anonymous packages of information about Landsbanki operations – including account information, minutes of loan and write-off meetings etc. – began turning up at Reykjavik houses of people unrelated to the case. In one of these incidents, the messenger who delivered the parcel claimed that Andersen himself had requested the information to be delivered to him via the intermediary.

On 29 February, the Ministry of Finance issued its expected ruling, that the civil service code did apply to the CEO’s post and therefore that Andersen could not be dismissed without going through formal warning procedures.

But the murky allegation about Andersen requesting information about a Landsbanki client (not incidentally a member of parliament well-known for orchestrating criticism of Andersen), and the passing of the case to the police, ostensibly allowed the civil service code to be set aside. The chairman pounced. He turned up on the CEO’s doorstep on the morning of 1 March and handed him a letter of immediate dismissal.

Why so determined a campaign?

All of this raises the question of why there was such a determined campaign to oust Andersen? Here outsiders can only guess. But one obvious motive is that more than a hundred financiers and politicians who got fabulously wealthy during the boom and now have their fate in the hands of the Special Prosecutor are extremely angry at Andersen and the FME, and hope that undermining the integrity of the head of the agency may help to undermine the credibility of the evidence against them.

Then there are those involved in the remaining banks whose cases are still to be brought to the Special Prosecutor (now working at top speed with a team of almost 100). The CEO can influence which cases go to the Special Prosecutor; and there are grounds for thinking that some of these cases may be even more toxic than those already passed, implicating even more central people and even grosser illicit money making. Some of the remaining cases may question the viability of some of the still-operating savings and loans banks, which tend to be valuable sources of patronage for members of parliament from the same region. These savings and loans are in any case extremely angry at the FME for imposing a capital adequacy ratio of 16% as a condition of continued government assistance; and yet Andersen refused to lower the requirement.

The FME also made many enemies when, under Andersen’s direction, it carried out oral examinations of the competence of board members of banks, insurance companies and pension funds. In the exams about 10% of board members of banks and insurance companies failed; and about 50% of pension fund board members failed. These results put the Ministry of Finance under pressure to revoke the licenses of some of the pension funds, or renew their boards.  But the Ministry of Finance is very anxious to maintain good relations with the pension funds, for the same reason that Willie Sutton robbed banks: because that’s where the money is. Iceland’s pension funds account for 130% of GDP, and the government wishes to draw on them as a source of investment funding for many public and public-private investment projects, such as infrastructure, hydro dams and the like. So the ministry too sees the FME as a thorn in its side.

There are other plausible hypotheses, including the central bank governor’s wish to bring banking supervision back inside the central bank, as it was before 1998 (in which case a politically-appointed governor would probably be less inclined to allow 77 cases to go to the Special Prosecutor).

Andersen, the now former CEO, may appeal his dismissal. It is possible that the spotlight for dismissal may swing to the Special Prosecutor; that one of the most powerful politicians in the government may face an uncertain future in connection with his public statements about the FME case; and that the already very fragile Social Democratic-Left-Green coalition government may fall. If this happens before the end of June, when the government has set the date for a referendum on a new post-crash constitution, the incoming government (probably consisting of the same parties discredited by the Crash) may delay the referendum by calling for a hopefully protracted revision of the draft of the new constitution. Stalling has no deadlines.

The Icelandic state system and its public produced several integrity-strengthening responses to the Great Crash. They include the appointment of a CEO of the financial supervisory agency with a history of integrity, the establishment of a Special Investigation Commission which produced a remarkably forthright 9 volume report on the build-up to the Crash, the empowerment of a Special Prosecutor for the banking crisis, the election of a constitutional council to draw up a new constitution for the parliament to submit to a referendum, and the activation of a mechanism of ministerial responsibility to put the boom-time prime minister on trial for negligence before a Court of Impeachment never before convened. These and other steps strengthen the impersonal rule-bound operations of the state and erode the reach of favor bribery within elite circles.

But so far the proposal to introduce something akin to a civil service commission, to assess all senior appointments in the civil service by a politically-impartial test of merit, has got nowhere, being regularly rejected on grounds that it would introduce “excessive centralization of power”. However, the constitutional bill presented to parliament by the Constitutional Council in 2011 stipulates the establishment of such a civil service commission, as well  as a clause encouraging parliament to grant special protection to key state supervisory and data gathering agencies.

In this context the popular notion of “state capture” is misleading, for it implies that the state is hapless victim of others’ actions. In the history of Iceland’s financial regulator, tax inspectorate and other such bodies we see how the state — in the form of top politicians and those they often appoint as their civil servants or chairmen of boards – invites itself to be “captured” and made to work for the sectional interests of the private sector winners. Directors or chairmen of regulatory agencies can be appointed who are incompetent or who treat the regulated firms rather than the public at large as their clients. Budgets can be kept sufficiently small to prevent real regulation; salaries can be kept low enough to make gifts or offers of prospective jobs seem very attractive. Or the director who seems too effective for the liking of the regulated can be discredited by one means or another, so as to allow someone more acceptable to take his or her place. It can all be justified with a neoliberal argument which in the primitive version says “government is not the solution, government is the problem” – or in the more sophisticated version says “effective government regulation depends on the regulator cooperating closely with the regulated.”


[1] Fridrik Mar Baldursson and Richard Portes, “Criticism of Icelandic economy does not square with the facts”, letter, Financial Times, 4 July 2008.

Robert Wade is professor of political economy at the London School of Economics. Silla Sigurgeirsdottir is lecturer in public policy at the University of Iceland.

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9 Responses to “How to discredit a financial regulator: the strange case of Iceland”

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  3. [...] care about Icelandic financial regulation they should join Wade and Sigurgeirsdottir (and me) in demanding that Gunnar Andersen be returned to leading the financial regulatory [...]

  4. [...] care about Icelandic financial regulation they should join Wade and Sigurgeirsdottir (and me) in demanding that Gunnar Andersen be returned to leading the financial regulatory [...]

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