Why did Iceland face near national bankruptcy during the 2008 financial crisis?

Alright, let's delve into Iceland's experience during the 2008 financial crisis and why the nation nearly faced 'bankruptcy'.

This story is quite similar to an ordinary person taking out a massive loan to 'start a big venture,' only for it to spectacularly fail.

Step One: The Audacious 'Little Guy'

You can imagine Iceland as an ordinary family with a modest income, but this family had three particularly ambitious 'children' – Iceland's three major banks (Kaupthing, Landsbanki, Glitnir).

After 2000, these three banks had an epiphany: earning money in the small pond of Iceland was too slow. They decided to make a splash in the 'big ocean' of international finance.

How did they do it?

• Borrowing Frenzy: They went to other European countries and borrowed huge sums of money (e.g., euros, US dollars) at very low interest rates.
• High-Interest Deposits: Then, they turned around and opened online banks in places like the UK and the Netherlands (such as the famous Icesave), attracting ordinary people's deposits with very tempting high interest rates.

This trick worked exceptionally well. European citizens saw that Icelandic banks offered much higher interest rates than their own countries, so they poured their money in.

In just a few years, the total assets of these three banks swelled to more than 10 times Iceland's annual GDP (Gross Domestic Product)!

What does this mean? Imagine your household earns $100,000 a year, but you took out loans to buy a luxury car worth $1 million and a mansion worth $10 million. It might look incredibly prosperous, but in reality, your debt had far outstripped your ability to repay.

Step Two: The Bubble Burst, The Party's Over

Banks couldn't just sit on all that borrowed money. So, they went on a global spree of investing and lending. Domestically, Iceland experienced a boom; everyone felt like a stock market guru, buying houses and cars, living it up.

However, problems arose.

In 2008, Lehman Brothers collapsed in the US, triggering the global financial crisis. The market's 'faucet' was suddenly turned off.

The international big banks that had previously lent money to Icelandic banks were now short on cash themselves, and they all demanded that Icelandic banks 'pay up!' At the same time, British and Dutch depositors who had money in Icesave panicked and started withdrawing their funds frantically.

This was a death blow. Icelandic banks faced:

1. Old debts to repay, no new money to borrow.
2. Bank runs, cash flow disruption.

Many assets held by the banks (such as stocks, bonds, and loans) plummeted in value during the financial crisis and couldn't be sold for cash.

Step Three: Why Was the 'Nation' on the Brink of Bankruptcy?

At this point, logically, the state should step in to rescue the banks, right? The US did, and the UK did too.

But Iceland couldn't.

Remember? The banks' debt was 10 times the nation's economic output. Even if the Icelandic government emptied its treasury, it couldn't fill this hole. It's like your son owes a hundred million, and even if you sell your house and car, you can at most scrape together a million – completely futile.

The Icelandic government faced a desperate choice:

• Rescue the banks? The government would immediately go bankrupt, and the entire nation's pensions, civil servant salaries, and public services would collapse.
• Don't rescue the banks? The banks would collapse, depositors would lose everything, leading to massive international disputes and domestic social unrest.

Ultimately, the Icelandic government chose to cut its losses. They announced that the three major banks would be allowed to go bankrupt! At the same time, to protect its own citizens, the government used foreign exchange reserves to guarantee the deposits of domestic Icelandic depositors.

But for foreign depositors (like those in the UK and the Netherlands), the Icelandic government initially stated, 'We simply have no money to compensate.' This directly led to severe diplomatic disputes between Iceland and countries like the UK and the Netherlands.

So, strictly speaking, it wasn't Iceland the 'nation' itself that filed for bankruptcy, but rather its banking system completely collapsed, and its scale was so immense that it exceeded the state's capacity to rescue, leading the entire nation's economy and credibility into a situation akin to bankruptcy.

In Summary

Simply put, Iceland's tragedy was:

A small nation that allowed its banking sector to play a global financial game with 'ultra-high leverage.' When the market was good, they raked in huge profits, and the whole nation celebrated; but when the global crisis hit, the borrowed money instantly dried up, the massive debt bubble burst, and the hole was so large that the state was utterly unable to bear it. Ultimately, they could only watch as the banking giants collapsed, dragging the entire national economy into the abyss.