Pillars of Society: How the Financial System can sustain or undermine (Un)Healthy Businesses – the

Icelandic Case

Guðrún Johnsen, Assistant Professor of Finance

University of Iceland

Overview

• Kaupthing’s Business Model in a nutshell

• Credit growth and credit allocation in Iceland 1998-2016

• Wages of Failure: Incentives at the individual level

• Who lost and who gained?

• How do “pillars of society” look?

• Level playing field? Sustainable business models?

Kaupthing’s Business Modelbuilt on Kaupthinking• https://youtu.be/Rkz-hjpch38

Unsustainable path?

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1998 2000 2002 2004 2006

Bank Credit to the Private Sector / GDPIceland

Banks can create money out of thin air

• Deposit Money Multiplier

• Sustainable lending practices • Recuperate principal and interest

• Interest rates and lending terms need to reflect the underlying risk

• Investment opportunities gained or created?

• Credit growth of systemically important institutions typically needs to reflect economic growth -

Boom-bust cycle

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1998 2000 2002 2004 2006 2008 2010 2012* 2014 2016**

Bank Credit to the Private Sector / GDPIceland

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62

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Domestic credit provided by financial sector (% of GDP)1960-2016

Domestic credit provided by financial sector (% of GDP)

Too much focus on supply side of credit?

Source: Borst, (2013) Measuring Excess Credit Growth in China, Peterson Institute for International Economicshttp://blogs.piie.com/china/?p=3119

in China

..what about the demand side?

• Where does the money end up?

• How is credit allocation during credit booms, busts and normal times?

• How is it possible to increase a balance sheet of systemically important bank by 500% in three years?

How?

Source: SIC report, Vol. 9., Appendix 2, pp. 23

Bank Credit to Icelandic Households2000-2008

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Glitnir Kaupthing Landsbanki

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Glitnir Kaupthing Landsbanki

Bank Credit to the Corporate Sector 2000-2008

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. EU

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Corporate Sector Holding Companies Foreign entities

Credit allocation

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Household sector Corporate Sector Holding Companies

Foreign entities Public Sector Other

Corporate Sector

Holding Companies

Foreign (holding) companies

Household Sector

Stories from the Pre-Crash Era• Web of firms became increasingly complex

Milestone

Karl Wernersson

Steingrímur Wernerss.

Leiftri Ltd44.6%

28.2%

22.2%

Þáttur eignarhaldsf.Sj1 ehf Sj2 ehf Sjóvá-Almennar

100%

Skeggi ehf

Þáttur Intern. ehfK9 ehf

33% 45%

49%

50%

39% 69% 78%

.. Large exposure limits heavily violated

Glitnir‘s exposure to its owners:

Source: SIC report, Vol. 2, Ch. 8, pp. 137 and 151

.. Increased leverage pushed asset prices up to unsustainable levels

Wages of failure – Incentives at the individual level

Share in total compensation costGlitnir

Share in total compensation costKaupthing

Share in total compensation costLandsbanki

Percentage of employeesPercentage of employeesPercentage of employees

.. the compensation structure changed in Glitnir and Landsbanki, but Kaupthing kept its course for the main part

Composition of annual salary at the top1% percent earnersGlitnir

Composition of annual salary of the top1% percent earnersLandsbanki

Composition of annual salary of the top1% percent earnersKaupthing

Base salary

Employers pension contribution

Bonus Excercised OptionsBase salary

Employers pension contribution

Bonus Excercised Options Base salary

Employers pension contribution

Bonus Excercised Options

Leaving options behind – attempt to avoid taxes

Outstanding option grantsMln. sharesKaupthing

Options granted at the different strike price

Pushing it over the edge

Performance pay scheduleGlitnir 2006-2008

Share of annual bonus target paid out

Return on Equity

Incentive schemes waiting to be manipulated

Performance based option grants CEO of Landsbanki 2001-2003Options granted in mln. kr.Nominal amount

Return on Equity

No skin in the game

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2004 2005 2006 2007 2008

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Stock ownership and level of leverageMarket Value

CEO of Glitnir: Bjarni Armannsson*

Stocks Liabilities

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Stock ownership and level of leverageMarket Value

CEO Kaupthing: Hreiðar Már Sigurðsson*

Stocks Liabilities

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Stock ownership and level of leverageMarket Value

Chair of BOD Kaupthing: Sigurður Einarsson*

Stocks Liabilities

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Stock ownership and level of leverageMarket Value

Landsbanki: Halldór J. Kristjánsson*

Stocks Liabilities

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Stock ownership and level of leverageMarket Value

Co-CEO Landsbanki: Halldór J. Kristjánsson*

Stocks Liabilities

How much was in it for the bankers?

Combined total salary of CEOs during the period 2004-2008 was 6,1 bln. ISK – > 800 USDDividend payments amounted 700 Mln. ISK – > 9,2 million USD

Dividend Payments2004 2005 2006 2007 2008 Total

Bjarni Ármannsson 33,054,721 31,214,072 88,729,634 204,128 - 153,202,554

Halldór J. Kristjánsson 1,833,745 10,808,487 10,808,487 10,808,487 - 34,259,207

Hreiðar Már Sigurðsson 10,025,455 27,992,390 75,925,346 124,704,780 - 238,647,971

Sigurður Einarsson 12,559,895 37,444,230 89,157,922 143,608,460 - 282,770,507

Total 57,473,816 107,459,179 264,621,389 279,325,855 708,880,239

Total compensation of the CEOs of the three big banks 2004-2008 current prices ISK

2004 2005 2006 2007 2008 Total ISK

Sigurjón Þ. Árnason Landsbanki 42.089.283 112.820.768 218.169.279 234.332.638 355.180.856 962.592.824

Halldór J. Kristjánsson Landsbanki 33.775.376 262.837.573 143.907.350 105.839.025 133.623.686 679.983.010

Bjarni Ármannsson Glitnir 80.057.080 137.467.312 230.381.360 570.844.544 11.149.876 1.029.900.172

Lárus Welding Glitnir 387.661.792 35.823.212 423.485.004

Hreiðar Már Sigurðsson Kaupthing 141.786.672 310.321.280 822.697.403 811.964.856 458.917.504 2.545.687.715

Ingólfur Helgason Kaupthing 5.391.704 139.805.184 126.305.760 129.493.760 77.966.954 478.963.362

Total: 303.100.115 963.252.117 1.541.461.152 2.240.136.615 1.072.662.088 6.120.612.087

• Worth of loans and related liabilities was exaggerated in the banks' financial statements for 2007 and the semi-annual statements for 2008.

• The values of the assets of the three big banks were adjusted in November 2008.• Before they were assessed at IKR 11,764 billion• After the adjustments they were assessed at IKR 4,427 billion• A write-down of IKR 7,337 billion or about 60%.• The write-down at the end of June 2008 was IKR 67 billion or 0.7% of the companies’ total assets at that time.

• Write-down of the assets of the fallen financial institutions corresponded to five times Iceland’s GDP in 2008.

Amounts in billion IKR

Assets before value

adjustment Adjusted value

Write-downs as a percentage of

assets

Write-downs (%)

Landsbanki Íslands hf. 4.353 1.994 2.359 54%

Kaupthing banki hf. 3.505 1.073 2.432 69%

Glitnir banki hf. 3.906 1.360 2.546 65%

Total 11.764 4.427 7.337 62%

Source: SIC presentation on 12th of April 2010, available at sic.althingi.is

How much did creditors loose?

After 9 years of asset management within the compostition framework unsecured claimholders set to get 20-30% of their claims – current claimholder’s recovery depends on at what price they bought the claims

Estimated total recovery 57%, including priority claimholders before taxes and stability contribution(Benediktsdottir et al. 2017)

How much did society loose?

• Depends on how much the new banks will be sold at

• Direct fiscal cost of the government a net gain/loss as share of GDP• Leven & Valencia (2012) 44% gross cost, net 20% cost

• Benediktsdottir, Eggertsson & Thorarinsson (2017) 44% gross cost, net cost from 5% to gain of 1% of GDP

• Excludes cost of creditors, cost of pensioners, cost of unemployment, cost of loss of social cohesion, cost of deteriorated credit rating, opportunity cost of extended capital controls, transfers due to market etc.

How much equity? How much leverage?

Firm A

FirmB

FirmC

Liability: 10Equity: 10

Liability 20Equity 20

Liability: 60Equity: 40

Assets: 20In the form of Firm B

Assets: 100

Assets: 40In the form of Firm C

Remaining questions on sustainability

• Sustainability and tax avoidance• Our preliminary results suggest that firms in business groups pay lower taxes

than stand-alone firms (Zheng & Johnsen, 2017)

• Level playing field?• Are competitors really competing?

• Is risk adequately priced in the banking sector?• If not – are banks adequately capitalized?