Iceland's tumble raises key questions

By Hugh Pym
BBC economics editor, Reykjavik, Iceland

It has been an extraordinary couple of days for the Icelandic nation as the eyes of the financial world have turned to this small island economy seemingly battling the financial elements alone.

Prime Minister Haarde is asking Russia for help

How did an economy with annual output valued at the same sort of level as a British company like Centrica or Marks & Spencer, find itself with commercial bank international liabilities running to five times that level?

How did it get to the stage where Prime Minister Geir Haarde had to warn his people that their nation faced bankruptcy?

The answers may not be clear for some time.

But for a nation that claims credit for the discovery of North America 700 years ago, the discovery of American style bank borrowing had something to do with it.

Deregulated banks, fuelled by high interest rates, attracted flows of capital from round the world.

They then found innovative ways to lend it, not least to Icelandic companies on the acquisitions trail in Europe.

Big name retailers on the British High Street benefitted from investment and loans from Icelandic institutions.

House of Fraser, Hamleys and Oasis are three of the better known ones.

Wholesale markets provided a ready source of cash, just as they did for all major banks on both sides of the Atlantic.

State steps in

But nobody in the Icelandic Government, or indeed in the investment community seemed to notice that the banking system has grown so large relative to the economy or the Government's ability to support it.

Glitnir has been taken over by the state

When the credit crisis developed, any bank over-reliant on wholesale market funding, for example Northern Rock, ran into trouble.

The markets soon woke up to Iceland's fragility.

The currency plummeted and alarm bells started to ring.

The third largest bank Glitnir was taken into state ownership.

Overseas woes

Since Monday morning an astonishing sequence of events has unfolded.

Prime Minister Haarde later revealed that his nation's banks had seen their credit lines with major banks cut off.

Bank shares were suspended.

That night at a highly charged media conference Mr Haarde announced sweeping new powers to force banks into mergers or nationalisation.

He explained the gravity of the crisis and a desire to take Icelandic banking back to where it used to be, in other words funding Icelandic commerce.

But that was easier said than done.

Extricating Iceland's banks from their overseas investments would be far from straightforward.

Hostile mood

On Tuesday there was another media conference with the Prime Minister, this time in the bizarre setting of an upstairs room of a restaurant in the capital.

There was more dramatic news with the announcement of the nationalisation of Landesbanki, Iceland's second largest bank.

Mr Haarde could not provide much information for British savers, with money tied up in the subsidiary Icesave, though he said he was trying to line up a Russian loan to provide funds to support his currency.

He criticised other countries, without naming them, for failing to come to Iceland's aid.

By now the mood was more hostile.

Icelandic journalists asked aggressively why mistakes had been made and why bank directors were allowed to stay in their jobs.

Mr Haarde said that he did not believe Iceland would default on her sovereign debt.

But that will be for the markets to decide.

Iceland will now stage a hasty retreat, hoping to restore banking on a smaller scale.

Yet the speed of international markets may make further announcements inevitable.