Capital Controls and the Resolution of Failed Cross-Border Banks: The Case of Iceland

Abstract

We examine Iceland's capital controls, which were imposed in October 2008 in order to prevent massive capital flight and a complete collapse of the exchange rate. The controls have not been lifted yet, primarily because of the risk of outflows of domestic holdings of the failed cross-border Icelandic banks. A substantial restructuring of domestic holdings of foreign creditors of the old banks is required before capital controls can be lifted. We argue that even if the controls are damaging, the gains from lifting them are likely to be much lower than the costs associated with a potential currency crisis following a premature liberalisation of capital outflows. The case of Iceland illustrates the difficulty of resolving large cross-border banks situated in a small currency area.