Fed with credit: financial “liberalization”, deregulation and the role of credit in Iceland’s collapse

Beginning in the 1990s, Iceland embarked on a major “liberalization” policy, privatizing its financial sector and reorganizing regulation. The resulting highly concentrated banking sector refocused on investment banking and international operations, while businesses, consumers and the finance industry itself borrowed heavily. In October 2008, Iceland experienced a spectacular financial collapse: all Icelandic commercial banks became insolvent; the stock market index fall by 95 percent and over one-fifth of large corporations were restructured or liquidated. Relative to the size of its economy, Iceland’s systemic banking collapse was the largest experienced by any country in economic history. The crisis led to a severe economic depression in 2008-2010 and significant political unrest.
Erik Larson’s interesting article “Demand for credit, international financial legitimacy, and vulnerability to crises: Regulatory change and the social origins of Iceland’s collapse” analyzes how credit expanded to culminate in 2008 financial crisis and advances theories about financial crises, regulatory change, and the role of credit.
Larson complicates popular accounts of Iceland’s collapse that focus on the actions of unrestrained bankers by examining the larger context that facilitated these banking practices. After financial “liberalization”, Icelandic businesses and households had strong demand for credit as a result of: the institutional meaning of credit, an emergent growth strategy of aggressive international expansion, and increasing consumption. Incorporating business demand for credit extends demand-side theory of crises and shows how dominant strategy and shared government and business orientation toward opportunity shaped credit expansion. Credit-based consumption also stabilized social relations despite increasing inequality. Notwithstanding warnings of risk, regulation did not restrain risky leverage. International market reactions reinforced beliefs about Icelandic success to limit regulatory reach, as Iceland’s international financial legitimacy produced market-based measures that leaders interpreted as signals of economic success.
In this excellent and insightful case study Larson also demonstrates how market-based regulations result in ineffective prudential supervision. In Iceland, regulation failed not because the government regulator or international bodies were oblivious to the underlying problems. Rather, market-produced indicators narrowed the grounds for regulatory action.