May 17, 2016

Hunting Iceland's Banking Monster in Panama

SMITH BRAIN TRUST — A team of Icelandic researchers went looking for answers after the 2008 financial crisis and found a "cross-ownership monster" lurking in the country's banking system. But tracking the creature to its multiple lairs became tricky when the trail led to offshore accounts. Management science professor Margrét V. Bjarnadóttir from the University of Maryland’s Robert H. Smith School of Business, one of the sleuths on the case, says new clues have emerged in the Panama Papers, a massive leak that shows how the world’s rich and powerful use shell companies and tax shelters to stash their money.

Hunting a Nordic Dragon

Revelations from the Panama Papers already have triggered a huge fallout in Iceland. The Nordic country’s prime minister stepped down after he got caught in a lie denying offshore holdings. And Iceland’s president is under scrutiny because his wife is among the names in the millions of documents leaked from a boutique Panamanian law firm.

The public outcry in Iceland has been intense because the small country was hit especially hard in 2008. Prior to the banking collapse, Iceland’s economy was booming, thanks to credit-fueled foreign investments coming into the small country. As it turned out, this inflow of capital masked an alarming rate of money flowing out of Iceland in the form of dividend payments to offshore companies where ownership was more often than not concealed. The Panama Papers provide clues as to where those dividends may have ended up. New research by Bjarnadóttir and two coauthors based in Iceland shows that the blow could have been lessened if banks had been more careful about lending to companies held by people too closely related. The research brings quantitative decision-making to credit decisions for banks.

After the financial meltdown, the Icelandic government created a special commission to investigate the crisis and figure out why the country’s whole economy crashed in a matter of 10 days. The government granted the commission unprecedented data access including banking documents, stock trades and tax returns of every entity in the country. Prior to the crash, there were indicators that company ownership was becoming increasingly complicated, companies were becoming increasingly leveraged and large players in the economy were gaining control of the banks. The commission hired Bjarnadóttir, an Icelandic native who specializes in big data research, to map the cross-ownership holdings of Iceland. Her goal was to discover who owned what, and how they were related to owners of other companies.

Bjarnadóttir expected to find easy-to-understand patterns of company ownership. "But what emerged was what is now called the 'cross-ownership monster,' showing us the ownership patterns were so complicated that there was no obvious structure,” she says. "A lot of companies owned stakes in the banks, and the banks owned stakes in the companies. So when the banks fell, the whole economy fell like dominoes.” 

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Ignoring Safeguards

Banks have rules and regulations that limit their exposure to related parties. In Europe and the United States, this risk management is thought of as one of the pillars of banking regulation: A bank can’t have too large of an exposure to connected parties. If one party fails, others connected to it might also fail, making a bank’s exposure risk too big.

“We took a look at what the banks were doing at that time, and — without passing too harsh a judgment — banks were ignoring obvious ties,” Bjarnadottir says. “For example, they didn’t consider married people connected. They did not consider a father and son connected. And companies clearly owned by the same parties, they conveniently decided they were not connected. They were doing this ad-hoc. And this was obvious even though we were unable to identify the ultimate owners of a number of offshore firms that the banks lent funds to that still had a concealed ownership after we combed all the data we had methodically through official firm registries, tax data, banking email and documents related to banks’ lending decisions.”

Leading up to the crash, Bjarnadottir says, the researchers saw that dividends were increasingly being funneled out of the country, thanks to the convoluted web of cross-ownership. "These ownership companies with owners unknown to the Icelandic regulatory body were getting a larger and larger chunk of the dividends of the companies in Iceland,” she says. “This relates directly back to the Panama Papers.” In other words, money that might have been reinvested in the Icelandic economy could have been sitting in a shell company in Tortola. The flow of money out of the country was one of the key factors leading to the collapse. And Bjarnadottir and her coauthors research shows the blow could have been lessened if banks had been more careful about lending to companies with often the same ultimate owners.

Lessons for Other Countries

In their paper, Bjarnadottir and her coauthors translate the methodology they used to map out the cross-ownership of the entire country to a methodology that banks can use to support their credit decisions and, hopefully, avoid the house of cards that was Iceland’s economy. “If you have the information about who owns what, you can reveal which parties are connected,” she says. “Any bank, or their supervisors (regulatory authorities), can use this methodology to decide whether parties are too connected, to estimate their current exposure and whether to lend money to them.” The research brings quantitative decision-making to credit decisions for banks.

In the United States, data is not always as freely available as in Iceland and some other European countries, so banks would have to request the right information to discover the ultimate owner of a company. “But even with partial information, you can apply the methodology and see how much of the overall picture is missing,” Bjarnadottir says. Then bankers can request additional information to make their credit decisions.

Bjarnadottir says one takeaway from the research is that better data transparency is needed across borders. Finances are no longer contained within a single country’s borders. “We could see that something was happening, but because the dataset was limited to Iceland, we were unable to construct the complete picture.”

Read more
“Large exposure estimation through automatic business group identification,” Annals of Operations Research, Sept. 7, 2015, by Sigríður Benediktsdóttir, Margrét V. Bjarnadóttir and Guðmundur A. Hansen.

Media Contact

Greg Muraski
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About the University of Maryland's Robert H. Smith School of Business

The Robert H. Smith School of Business is an internationally recognized leader in management education and research. One of 12 colleges and schools at the University of Maryland, College Park, the Smith School offers undergraduate, full-time and flex MBA, executive MBA, online MBA, business master’s, PhD and executive education programs, as well as outreach services to the corporate community. The school offers its degree, custom and certification programs in learning locations in North America and Asia.

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