The problem with Iceland’s banking system has resulted in problems for British savers. Including private investors, businesses, local councils, and charities; the exposure for councils alone amounts to nearly £1bn. But how did such a small country get into this position?

There are many reasons, with complex relationships between them. Primarily because of rapid economy growth in recent years, pushed on by foreign investment in aluminium smelting, which was made easier by low cost hydro-electricity. Unemployment fell to 1%, an incredible situation, unless you’re an employer.

As in Britain and many more countries, property prises had risen dramatically. The Icelandic house price index has risen by 153% from its start in March 2000 to its peak in March 2008. Which dwarves the growth in British property which was134% from March 2000 to its peak in October last year.

On top that, people did not save. The Economist claims, household debts reached 213% of spendable income, as opposed to ‘just’ 163% here. Net annual savings are negative.

To try ans slow things down a little and bring inflation back under control, interest rates were inreased. This added fuel to the ‘carry trade’; banks and other institutions were able to source funding cheaply abroad, especially in Japan where short-term money was practically given away, and then invest locally at higher interest rates. Money for nothing, as long as the local currency maintained its value. But put simply, why should the Krona maintain its value, when high inflation means you cannot buy as much with it?

The banks were picking up pennies in front of a steamroller. This was very lucrative while bulk money was inexpensive, but was inpossible to sustain when it became expensive and difficult to source.

The critical ratio in this instance is the deposit-to-loan ratio, which indicates what proportion of a bank’s lending is funded by deposits from savers, and how much from elsewhere. When Iceland’s 3 major banks came to realise they had a problem, they made every effort to increase the amount of deposits they could get onto their books, however the Icelandic public was not saving and were insignificant in relation to the size of the banks, as a result of expansion abroad.

A big part of this was an attempt to attract foreign investors with above average interest rates, as a result of this Icelandic banks became increasingly popular in the UK. However this is another version of the carry trade, an apealing interest rate to a British saver is still cheap money for an Icelandic bank, where the interest rate is more than 15 per cent.

Landsbanki had the most success recruiting new deopsitors, with a deposit-to-loan ratio of 62 per cent, while Kaupthing had 44%, and Glitnir 35%. Compare this to the most conservatively managed UK bank, HSBC (LSE: HSBA), has a ratio of about 111% (i.e. it has more savings on deposit than loans issued). Lloyds TSB (LSE: LLOY) reportedly has around 70%, and HBOS (LSE: HBOS) approximately 56%. Northern Rock had 33% deposit-to-loan before it was nationalised.

Because of this expansion, the three big Icelandic banks made up just short of three quarters of the Icelandic stock market back in June. If you include some of the smaller banks, it was just short of 90 per cent. The total market capitalisation of the banks related to 25 per cent of Iceland’s GDP; British banks, on the other hand relate to 13% of domestic GDP.

The three major Icelandic banks have now been nationalised, and the stock market was suspended for 3 days, which makes the picture look very different. The ICEX15 index fell by 77 per cent when the stock market reopened on Tuesday, and has been reduced by 93 per cent from its high point, in local currency. Add to this the fact that the Krona’s value has been reduced to just short of half, and the fall looks even more severe.

Analyzing the numbers, it would appear that Iceland took things slightly further than Britain, but the consequences appear to have been far more dramatic.