Jane Wardell, THE ASSOCIATED PRESS

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LONDON - As the world suffers a hangover from the financial excesses of the past few years, the tiny island nation of Iceland has a bigger headache than most.

The Nordic country was until recently lauded for its rapid generation of wealth despite its small size, as deregulation of domestic financial markets in the 1990s fuelled a stock market boom that underpinned an acquisition spree by cash-rich Icelandic banks and other companies.

But that success could become its downfall. The banking sector has grown to dwarf the rest of the economy with assets valued at nine times annual gross domestic product of 14 billion euros (US$19 billion), leaving Iceland heavily exposed to the global credit squeeze.

A decision by the government this week to take over the country's third-largest bank, Glitnir Bank HF, prompted major credit rating agencies to downgrade both Iceland's government and its four major banks.

Glitnir Bank specializes in lending to fish companies and had provided financial services to some of the biggest players in the Canadian fishing industry, including Clearwater Fine Foods, Highliner Foods (TSX:HLF), the Barry Group and the defunct FPI Ltd.

Iceland's central bank bought a 75 per cent stake in Glitnir Monday for more than $890 million.

Iceland's krona tumbled more than 20 per cent against the U.S. dollar this week, spurred partly by speculation that the central bank will struggle to bail out any more failing commercial banks after its rescue of Glitnir.

"Iceland is a standout case," said Venla Sipila, a senior economist at Global Insight in London, which downgraded the country's sovereign rating.

"The situation looks really volatile because it is so dependent on external developments now."

With a population of just 320,000 people, the remote island nation between Europe and Canada has punched far above its weight in recent years, shifting from its mainstay fishing industry into an international investment force.

The Iceland Stock Exchange, or ICEX, was Europe's top-performing market in 1994, leaving Icelandic companies with a large liquidity pool. Kaupthing, Iceland's biggest bank, has doubled in size every year since 1996.

Another standout success was retailing investment group Baugur, which has expanded from one discount store in 1989 to a company that owns or has stakes in dozens of major retailers - including enough to make it Britain's largest private company - and employs more than 50,000 people.

In Canada, HF Eimskipafelag Islands has done C$1.1 billion in acquisitions in the cold-storage business in the past two years, buying the Atlas Cold Storage Income Trust and Versacold Income Fund, and also owns Dutch-based Daalimpex beheer, one of Europe's biggest cold-storage operators/

But the qualities that made Iceland attractive to foreign investors and funded its expansion - essentially making it one big Viking hedge fund - are suddenly not as sought after.

A major concern is that some of Iceland's banking liabilities will migrate on to the government's balance sheet.

Part of problem is that Iceland's tiny size has led to a high level of cross-ownership between banks and companies, which creates a house-of-cards scenario.

"There is still a number of cross-shareholdings ... which increases the risk of contagion," said Alexandre Birry, a director at Fitch Ratings in London.

Those worries were highlighted by the decision of investment firm Stodir, which has a major holding in Glitnir, to apply for temporary protection from creditors after the nationalization - and just before it had been due to take a 39 per cent stake in Baugur.

The risk that the crisis could spread like wildfire led to rumours this week that Baugur would be forced to sell overseas businesses to survive.

That prompted a rare public statement from the usually tightlipped company, saying that while market conditions are tough "it is business as usual."

The krona is also suffering from a withdrawal by a falloff in what are called carry trades - where investors borrow cheaply in a country with low rates, such as Japan, and invest in a country with higher returns - and often risks.

Prime Minister Geir Haarde has said that the Glitnir bailout is not the end of the banking crisis in Iceland, but he has so far shunned suggestions that Iceland join the euro currency, which analysts say could provide a measure of protection.

In the longer term, Iceland is putting faith in its growing hydroelectric and geothermal energy industries to carry it through the credit squeeze and back to growth - aluminum products are expected to overtake the traditional marine products industry in terms of revenue this year.

But with a current account deficit out of control, inflation running at more than 12 per cent and interest rates at a record 15.5 per cent, it first has to ride out a rocky patch.