After Crisis, Iceland Holds a Tight Grip on Its Banks

An angular glass building on the waterfront here used to be the headquarters of a banking giant with operations in Europe, North America and the Middle East.

Now, it houses a shadow of that behemoth â€" a small bank doing business only in Iceland and lacking both the trading culture and ambitions of its failed predecessor.

The metamorphosis is a result of one of the biggest bank crashes any country has ever had. The risk in Iceland’s financial system has dissipated, but the basic businesses of banking have shrunk as well. Lending to consumers and businesses has slowed to a fraction of what it was before the crisis.

“We moved from a situation where the one that took the biggest risk was the employee of the month, to a situation where the one that took the least risk became the employee of the month,” said Bjarni Benediktsson, the Icelandic finance minister. “I think we need to find a balance in between.”

Iceland is a living experiment in what can happen when a country forces its financial firms to go under, rather than bailing them out, as much of the rest of the world did during the global financial crisis.

In October 2008, all three of Iceland’s major banks collapsed. None failed more spectacularly than Kaupthing, the bank whose glass headquarters were on the waterfront. At one point, it had a balance sheet four times as large as the annual economic output of the entire country. Last month, four former Kaupthing executives were sentenced to multiple-year prison terms.

Emerging from the crisis are three new ventures, including Arion Bank, the successor to Kaupthing, that hold only the local assets of the old firms. They also have a different mind-set from the brash tenacity that prevails elsewhere in the financial industry.

“The mandate was to build a new bank on the foundations of the old collapsed bank,” said Hoskuldur Olafsson, the chief executive of Arion Bank, sitting in his sparsely decorated office overlooking the water. “It didn’t look good. It had no direction whatsoever. What we needed to do in the beginning was find some sort of a direction for where we would go with this bank.”

Iceland’s unusual path has been held up as a successful model of what can happen when a country opts to let its financial firms go under. The result in Iceland is that new banks are missing the big bonuses and risky trading desks that have fed populist anger elsewhere.

“We are a new bank with new business ethics and a new way of doing things,” said Steinthor Palsson, the chief executive who was brought on to run Landsbankinn, the largest of Iceland’s new banks. Revenue from trading operations at Landsbankinn is down to 10 percent of what it was in 2006.

But a transformation of the financial system can accomplish only such much in a country that faces such a long road to recovery.

Many companies and households in Iceland are still deeply indebted. Birgir Gudjonsson, a 37-year-old policeman in Reykjavik, said that the banks had been too interested in rebuilding their businesses and their balance sheets, and not helpful enough to homeowners like him who bought their first homes just before the crisis. Because many Icelandic loans are linked to inflation, Mr. Gudjonsson owes more than he initially borrowed.

“We’ve been hearing, almost weekly, ‘Oh look at this, everything is great,’ ” he said in the two-bedroom apartment where he lives with his wife and two daughters. “We just have to look in our wallet to see the reality.”

Companies and homeowners that want to borrow more are also having difficulty given the conservatism of the banks and a lack of access to foreign investors. In the first nine months of last year, for instance, Landsbankinn’s net new lending to corporations and individuals was 0.8 percent of what in was in all of 2006.

“There is no easy way out of a deep crisis,” said Mr. Benediktsson, the Icelandic finance minister, who recently came into office after an election that hinged on economic discontent.

Iceland’s leaders did not see bailouts as an alternative when they took control of the banks in October 2008. The three major banks were 10 times as large as the country’s gross domestic product, in contrast to the United States, where bank assets were about the same size as the annual G.D.P. Even if it wanted to, Iceland did not have the resources to save its banks.

Instead, the government took the banks and separated off all the loans and financial products that were outside Iceland â€" the majority of the assets â€" and stuffed them into a so-called bad bank with no government backing. The government also made it illegal to move money out of the country, halting a run on the local currency, the krona.

Even with these steps, the economy shrank 16 percent over the next year, and the unemployment rate rose to nearly 10 percent, from around 2 percent.

In Iceland, blame for the crisis fell almost entirely on the country’s financiers. While banks in other parts of the world were tangled up in bad bets on the American mortgage market, banks in Iceland had taken on mountains of debt to bet on speculative assets, and had spun a web of self-serving loans. Almost all the top executives were fired and many are now facing criminal prosecution.

Initially, the government was in charge of the banks, running them on an emergency basis. Soon, though, new companies were set up to oversee the mortgages and corporate loans in the country, with ownership split between the government and the creditors of the old banks.

To run the new companies, the government looked for people who were not tainted by involvement with the banks in the boom years. Mr. Palsson had been working outside Iceland, at a pharmaceutical company, when he was chosen to run Landsbankinn. Mr. Olafsson came to Arion Bank from the local subsidiary of Visa.

When these men arrived, they said, they faced entirely demoralized work forces, and a public that saw all bankers as villains. In a country where policemen do not carry guns, some bank executives were assigned guards to protect them at home.

“If the United States on the Richter scale was a three, Iceland was a nine,” said M.J. Bryant, a professor at the Ivey Business School in Canada who has written case studies on Iceland. “You have to place this all against the background of a complete betrayal of trust.”

After Mr. Palsson assumed the helm at Landsbankinn, he fired all eight executives directly beneath him and put advertisements for their jobs in a local newspaper. A new law required that his executive team be at least 40 percent women.

Mr. Palsson said he realized the first thing he had to do was improve the mood among the bank’s staff of 1,300 â€" down from 5,000 before the crash. He called all of the bank’s employees to Reykjavik’s main cinema, where he gave a pep talk with his new strategy.

He then moved to address the public’s anger, holding a series of public meetings around the country, where he sat on the stage with his other executives. Many of the meetings were filled with people berating Mr. Palsson’s team for the bank’s sins.

“Some people thought we were crazy doing this because people were very angry,” Mr. Palsson said. “But it was really a good therapy for many people who were angry.”

The banks’ first task was restructuring the loans of companies and households that could no longer pay them. The government passed a law mandating that loans had to be reduced to no more than 110 percent of the underlying property â€" helping homeowners who had ended up underwater, though it did not eliminate the inflation-linked loans that people like Mr. Gudjonsson have.

Landsbankinn went further and began a campaign to reduce the debt of any company or household that was unable to pay off its loans. This pressured the other banks to make similar efforts.

Another law made it illegal for banks to pay bonuses more than 25 percent of base salaries, and until recently none of the banks paid any bonuses at all.

But this has been one of the areas where the banks have realized the limits of reform. After some employees were poached by banks elsewhere in Scandinavia, where there were no bonus limits, Arion Bank and Islandsbank recently began offering bonuses for select executives.

The restructuring of the financial sector â€" and the government steps to protect the currency â€" have allowed unemployment to fall to 5.6 percent, and economic growth to begin.

Many economists, though, say that the banks are too focused on the past, and not doing enough to make new loans and build a business for the future. The banks have also been conservative about continuing to shrink their work force, which has left costs high.

“They are sort of in a standstill,” said Fridrik Mar Baldursson, a specialist in finance at Reykjavik University. “There is so much inertia in the system.”