Investment banking in crosshairs as Iceland explores limits

[REYKJAVIK] Few countries conjure up images of financial ruin like Iceland. Its economy was famously gutted in 2008 when its over-sized banks all collapsed within weeks of each other.

A decade later, the island nation is still trying to crisis-proof its financial system. A key goal is to shield banking operations that are vital to the economy, such as deposit-taking, payments and lending. To that end, the government is taking a page from Britain's post-crisis playbook with a plan to force banks to separate their retail and investment operations.

In the UK, banks are required by the start of next year to split retail banking from their wholesale and investment arms, a process known as ring-fencing. Core services on which households and companies depend will be inside the fence, protected against a meltdown elsewhere in the banking group and against wider market turmoil. The Bank of England's aim is to ensure that banks can continue to service the economy in a crisis.

"History tells us that we need to be cautious," Finance Minister Bjarni Benediktsson said in an interview in Reykjavik. "Even though we have fundamentally changed the regulatory framework of the financial system in recent years, the discussion of the risk associated with the investment banking side has remained."

Iceland is late to the ring-fencing game. The UK's efforts began in 2011, when the Independent Commission on Banking headed by John Vickers published a report that led to legislation two years later. The European Union scrapped a similar proposal last year after the bill had mouldered for ages in the European Parliament.

Gudjon Runarsson, chairman of the government-appointed committee in Iceland that's resurrected the idea, says his country's example shows how quickly things can get out of control.

Though Iceland's banks are now safe, Mr Runarsson says new laws need to take into account "recent history," which shows "banks move quite quickly from being in one position to another when the economy is growing fast." "Icelandic banks wouldn't be allowed to increase that business endlessly without something happening," he said.

Mr Runarsson's committee held a teleconference with Vickers in the course of its work, and also looked at legislation in Belgium, France and Germany. In addition to ring-fencing, changes may also be needed to Iceland's rules on derivatives trading and so-called carry trades, according to the central bank.

The banks that failed in 2008 were Glitnir, Kaupthing and Landsbanki. Iceland didn't have the means to bail them out, so international investors were cut loose and local authorities focused on trying to keep a functioning domestic financial industry so that Icelanders could receive their salaries and pay for their groceries.

The failed banks have all come back in new, more modest forms, and the government is still in the process of selling the stakes it took to prop up the new lenders. It just exited Arion - formerly Kaupthing - and is looking into selling all or parts of Landsbankinn and Islandsbanki, previously known as Landsbanki and Glitnir.

Iceland's handling of its 2008 crisis has so far drawn praise, including from Nobel laureate Paul Krugman and the International Monetary Fund. Its next steps may well offer more lessons in how to handle an entire economy's resurrection from economic and financial ruin.

Mr Runarsson says there's no need to immediately split up investment and retail banking, "because of the drastic measures that were taken in Iceland in 2008." His committee has recommended a threshold for when that should take place; it will be incorporated into a broader review of Iceland's banking system scheduled for completion in May.

But it is "clear that we will make law changes which respond to worries about the mixed operations of the banks," Mr Benediktsson said. Doing so will help "create a foundation for the potential sale of state shares in the future."

BLOOMBERG