Iceland has three banks. Between them they have $61 billion in liabilities, or about 12 times Iceland’s GDP — which clearly makes it impossible for the Icelandic government to bail them out.
But who lent Iceland’s banks so much money? Would you believe — the Germans? At the end of June, German banks had $21 billion in exposure to Iceland, more than five times the exposure of UK banks. The Bavarian state bank alone lent €1.5 billion to Icelandic banks.
Why on earth would BayernLB do such a thing? The Icelandic banks weren’t nearly as active in Germany as they were in the UK and Scandinavia. And Iceland isn’t even part of the EU. One might understand sleepy German banks ignoring their counterparties’ credit risk back in 2006, but in mid-2008, that simply doesn’t wash as an explanation: one look at Iceland’s banks’ credit-default swaps would have told BayernLB that they were getting into a very risky bet. And as far as I know, there aren’t any cultural or historical reasons why Germans should lend tens of billions of dollars to Icelandic banks.
Maybe it’s just that Germany was running a massive current-account surplus, and needed to lend lots of money abroad, and that German banks as a consequence would lend to just about anyone. After all, the $21 billion in exposure to Iceland might be multiples of Iceland’s GDP, but it’s still a mere fraction of German banks’ $311 billion exposure to Spain, or their $241 billion exposure to Ireland.