Second in a series about "too big to jail"

WASHINGTON — For many Wall Street hawks, Iceland represents the road not taken by the U.S. in the aftermath of the financial crisis — an alternative universe where banks were allowed to fail and the executives who drove them off the brink were prosecuted, found guilty and harshly punished.

The country's experience has been cited by various pundits and progressive voices as what the U.S. should have done during and after the crisis. Upon closer inspection, however, the comparison is not as simple as it appears.

"It's easy to say, 'If Iceland could do it, the U.S. should have,'" said Gudrun Johnsen, a former senior researcher for Iceland's Parliamentary Special Investigation Commission and author of "Bringing Down the Banking System: Lessons from Iceland." "But in Iceland, circumstances were quite extreme. What happened in Iceland was basically a huge Ponzi scheme."

To understand the appeal of Iceland's actions to many Wall Street critics, it's worth taking a deeper look at its experience during the crisis.

In 2008, Iceland's banking sector was dominated by three banks — Glintnir, Landsbanki, and Kaupthing. In the years leading up to the crisis, those three banks had expanded rapidly both domestically and internationally, driven by a thirst for foreign deposits and an even more voracious appetite for foreign assets. That appetite for acquisition ultimately left the banks with a combined asset sheet of roughly $182 billion by mid-2008 — vastly eclipsing the island nation's GDP, which was $21.45 billion that year.

The banks' investments were not necessarily in the overheated U.S. housing market, but in more dubious and overvalued assets like retail chains. Moreover, the banks were hugely leveraged, often using their regulatory capital as collateral for further acquisitions. Then, in October of that year, the bubble burst, nearly taking the country down with it.

Johnsen said that, in effect, the entire banking sector collapsed in a span of about three days. The resulting chaos was far greater than that experienced by the U.S. — in the country of roughly 317,000 people, nearly everyone was affected.

Eyvindur Gunnarsson, professor and dean of the University of Iceland law school, said that 85% of the country's banking sector failed in the crisis. But because those failures encompassed asset values that were far in excess of the government's revenues, the banks were allowed to fail primarily because there was no other choice.

Gunnarsson said the public reaction was extreme and unqualified in its demand that bankers be prosecuted, and in response the government held new elections in April 2009 and the parliament passed laws establishing a special prosecutor's office and an independent investigations office to examine the newly failed banks.

"When this crisis happened in October 2008, it was like the country went a bit berserk. It was like a revolution," Gunnarsson said. "Because of this atmosphere, politicians were not afraid to do something about it."

Johnsen said that because the banks failed — rather than being bailed out, as they were in the U.S., the U.K. and elsewhere — the special prosecutors and investigators had unfettered access to the banks' records and were able to uncover hard evidence of crimes, including conflicts of interest, insider trading and other criminal activities. Combined with the deep public outcry over the crisis, she said there was no interference and indeed substantial public pressure to comb the institutions carefully for violations. (Johnsen also sits on the board of Arion Bank, a state-owned heir to failed bank Kaupthing).

"The very, very important difference between the American investigation and the Icelandic one is that the Icelandic one had completely free access to all data they the commission required or deemed necessary to shed light on what had happened," Johnsen said. "The politicians never had any jurisdiction over the work of the inquiry, it was completely independent."

Another byproduct of the fact that Iceland's banks had failed was the absence of an incentive to make those distressed banks look as viable as possible, as was the case in countries that bailed their banks out in exchange for an ownership interest. In the U.K., for example, the Bank of England effectively nationalized the Royal Bank of Scotland and other smaller banks by buying controlling majorities in preferred and common stock, which gave the government ample incentive to get those institutions back on their feet as quickly as possible.

"In other countries you have the state coming in with money and saving the banks, and in many cases owning the shares," Gunnarsson said. "It's difficult … to prosecute the bank that you're going to privatize within a few years and get some of your forced investment back."

The U.S. Treasury Department bought bank shares as a condition of the Troubled Asset Relief Program, though those purchases in most cases did not amount to a controlling stake in the banks. The Federal Reserve Board also effectively bought a controlling stake in AIG in exchange for its bailouts to that company, though it did not apparently have to power to stop the firm's executives from giving themselves more than $165 million in bonuses only months later.

Iceland's prosecution of bankers was also assisted by a special provision in its criminal code that states that any person entrusted with financial decision-making authority who "abuses his/her position" is subject to up to two years in prison, with especially egregious offenses potentially carrying up to six-year prison terms. It is under this statute that most of the jailed bankers have been found guilty, and as one would expect, defense attorneys in those cases play on the statute's vagueness as to what constitutes abuse and what is simply bad banking, Gunnarsson said.

"There is a thin line between this criminal breach of trust and what you would just define as normal bad banking," Gunnarsson said. "The standard of proof is pretty much the same. It is a much higher standard than in civil cases — the prosecutor has to show that this was a reckless loan and has to meet a high standard of proof."

One other twist to the Icelandic experience was that, while its banks all failed, the government did step in to ensure that the deposits and other unsecured debt that they had acquired from overseas could not be withdrawn from the country — so-called capital restrictions that have effectively made the country a closed economy, Gunnarsson said. While that was a difficult fiscal choice to make, the world can survive Iceland's more limited participation in global commerce, but it can't survive if the U.S. had decided to wall off its financial system.

Rather than repaying the depositors' and creditors' debts, the government took over the banks and gave those creditors a stake in the new banks — a process that in many ways echoes a real-world application of the Basel-mandated process for resurrecting failed banks through its Total Loss Absorbing Capacity rules. Despite that turmoil and the severe restrictions on capital flow, Gunnarsson and Johnsen say the sector is vastly more secure than it was before the crisis and is chastened against excessive risk-taking.

"This is a closed economy — there is not free movement of capital, so it's difficult to say what happens when the capital controls are lifted," Gunnarsson said. "I think the general view is they are much more prudent, and there is no suspicion of criminal activity or anything like that."

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