The Board of the International Monetary Fund has issued a seemingly matter-of-fact statement concerning the status of the Fund’s investigation of its Managing Director Dominique Strauss-Kahn and allegations of abuse of power in a relationship with a subordinate.  The purpose of the statement seems to be to address an inference that might be drawn from media reports that some members of the board were gunning for DSK — in particular the person in overall charge of the probe, Shakour Shalaan, who is Egyptian.  Egypt is on a quiet roll in international policy circles at the moment with its finance minister becoming chairman of the International Monetary and Financial Committee, the first developing country minister to get that job.  But don’t leap to the conclusion that Egypt must have had the trump card to explain this success:

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Edward has been keeping you all up to date on the resurgence of calls to the IMF fire extinguisher due to the global banking crisis, and the Fund has no doubt welcomed the renewed interest in its present and future functions.  But in an unfortunate weekend news dump, it’s been revealed that IMF Managing Director Dominique Strauss-Kahn is being investigated by the Fund over an affair with another staffer [UPDATED].

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Iceland Chamber of Commerce working paper May 2006, “FINANCIAL STABILITY IN ICELAND” by FREDERIC S. MISHKIN & TRYGGVI T. HERBERTSSON –

There are concerns that the banks could experience refinancing problems. Although the banks’ reliance on external financing poses the biggest risk to the financial system right now, the probability of a credit event occurring is low. The rapid credit growth in the banking system and the banks’ transformation from concentrating on domestic lending, to becoming international financial intermediaries, also presents some risk because the banks may not have been able to develop organizational capital fast enough to run their new business safely. These concerns have led to criticism of Iceland’s banks for lack of transparency. However, the Financial Supervisory Authority’s awareness of these risks and the fact that Iceland has high quality governmental institutions make it unlikely that there are serious problems with safety and soundness in the banking system.

OK, it’s easy to go back 2 years and do this.  But Mishkin is a big name who went to a 2 year stint on the US Federal Reserve Board of Governors right after this paper came out.   Thus if nothing else it’s symbolic of the optimistic conventional wisdom at the very top that financial globalisation could be handled.  It’s unlikely many Icelanders feel now that they had “high quality government institutions”.

So to avoid the awkwardness of a Eurozone summit in Paris excluding Europe’s biggest financial centre, Gordon Brown went to Paris before the meeting and it sounded like he and Nicolas Sarkozy were on the same wavelength about how bailouts should work.  One section of the Elysée summit declaration (version fr) says

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A few days ago, Edward explored the gap between the Eurozone’s monetary and political architecture (and the lack of the latter) as a potential risk to the Eurozone itself.   But in what looks likely to be a weekend of rapidly changing events, here is a new wrinkle: Nicolas Sarkozy has convened an emergency heads of state/government summit for the Eurozone countries, along with the ECB and EU Commission presidents, at 5pm in the Elysee Palace on Sunday.  Since it is a Eurozone and not EU summit, neither Gordon Brown or most of the eastern European EU heads will be present; thus the outcome at best will be a coordinated initiative among the euro countries rather than the EU as a whole.  Which is still better than nothing, but it does raise the question of how any spillover from a new initiative (e.g. a Eurozone interbank liability guarantee) would be handled.   It also puts a new spanner in the works of the G7 and G20 finance/central bank meetings in Washington this weekend, since the outcome of the Paris summit won’t yet be known when they meet.   About the only statement we can make with certainty is that the bankers and politicians better keep their Blackberries charged.

Asset freezes.  Threats of litigation.  Expressions of mystification about the intentions of a foreign government.  The latest round with another axis of evil country?  No: the current state of relations between the UK and Iceland.  As we were saying before we were so rudely interrupted, Iceland is leading the way from a banking crisis to a sovereign debt crisis, and significant overseas impact is being felt in the UK given the presence of subsidiaries of Icelandic banks.  The recent statements from Alistair Darling tell the story.

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With European countries in a rush to take banking sector liabilities onto the public balance sheet, they might want to take a look at where that route goes, in extremis: Iceland, as a banking crisis becomes a full blown macroeconomic crisis.  Today has seen a bewildering series of events, even against the backdrop of a problem that had been viewed as unsustainable for a long time (gross external debt 550% of GDP).  We have: Russia apparently emerging as the lender of last resort (which must indicate other requests that were turned down), and the adoption of a what looks like a crazily overvalued peg for the króna (130/euro official when it’s trading at 200/euro).  The underlying cause is the huge size of the banking sector and its reliance on overseas liabilities relative to the size of economy — a situation that will have uncomfortable echoes in non-Eurozone eastern Europe.   Indeed, it’s only that Iceland is so small that the situation has not already caused more panic than it has.   But it’s a disturbing parable for the overall banking crisis.

One of the diagnoses of why the Great Depression was so bad is that countries engaged in “competitive devaluation” — weakening their exchange rates to make exports cheaper, but when all try to do this, no one gains, and confidence runs out.  One wonders today if Ireland has created a new version of this risk with the dramatic government announcement that it is providing a public guarantee to all liabilities of banks with their HQs in the Republic of Ireland.  That means every debt that these banks have to anyone: to their depositors, interbank lenders, and bondholders. 

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When the dust settles on whatever form of banking bailout the US Congress eventually approves, attention will turn to reassessing the philosophy that got the US to this point.  But perhaps Europe will have to revisit some conventional wisdom too.  Consider the case of Benelux financial services giant Fortis, which if this evening’s reports are to be believed, will soon be getting some kind of bailout of its own, most likely with the Belgian and Dutch central banks taking on some of the bad assets.  Fortis has been stuck for cash since it joined a Royal Bank of Scotland consortium bidding for ABN Amro against Barclays — the latter bid being trumped by the higher cash portion in the former.  The consortium’s idea was to break up ABN Amro, whereas Barclays was bidding for the group as a whole.  The Dutch central bank was uneasy about the breakup idea, but just over 15 months ago, it was seen as the brave new world of cross-border European banking.  Now it looks like classic winner’s curse.  Barclays lost but since got to pluck the meat from Lehman Brothers.  And Europe gets sucked into banking bailouts, big time.