Peril in Europe’s Periphery: A Comparison of the Banking Crises in Ireland, Iceland, and Cyprus

Abstract

As three small, open economies in Europe’s periphery, Ireland, Iceland and Cyprus each experienced large booms leading up to and during the first decade of the 21st century. Striking commonalities among them, including oversized banking sectors, lax financial regulation and easy access to credit, helped to funnel financial bubbles within the region. However, these financial bubbles burst abruptly as the 2007-2009 financial crisis spread to Europe’s borders. In reaction to the crisis, Ireland promised a blanket guarantee in September 2008 which covered all of the country’s bank liabilities. The negative repercussions from the substantial overhang of debt that resulted have spurred the question of whether Ireland could have considered better alternatives. The markedly different policy reactions of Iceland and Cyprus from that of Ireland thus form comparative case studies: Iceland allowed its banks to fail, while Cyprus was forced to bail-in its depositors. In terms of recovery, both Ireland and Iceland were hit equally hard, suggesting that both were overly extreme cases that are not viable policy alternatives for banking crises in the future. In retrospect, when comparing the actual events to the predicted trajectory, Cyprus may offer a moderate case study that is most conducive to successful recovery. Looking forward, since then the banking crises in Ireland and Cyprus have helped to shape the euro area’s response, a supranational banking union intended to prevent the next such banking and sovereign debt crises in the future. However, given the current absence of a common backstop fund which would serve as a necessary fiscal transfer mechanism, the banking union’s efficacy remains an open question mark.