RebelEconomist apologises, if anyone cares, for his lack of posts recently, which has been mainly due to computer breakdowns that made posting cumbersome. Fortunately, his new laptop has arrived in time for him to post about a financial issue that will hit the headlines again in the next few days, and on which most media coverage so far has been, in RebelEconomist's opinion as a former central banker who knows a little about the regulatory principles involved, misleading. That issue is the dispute over to what extent, and on what terms, Iceland should reimburse the British and Dutch governments for deposit insurance payments they made to depositors in the British and Dutch Icesave branches of the Icelandic bank Landsbanki after its collapse in October 2008.
A bill passed by Iceland's parliament providing for repayment on terms acceptable to the British and Dutch is to be put to a referendum of the Icelandic people on March 6th after Iceland's President Olafur Ragnar Grimsson refused to ratify it. If Icelanders reject the bill as expected, the dispute will escalate. Inevitably, the argument comes down to legal and financial technicalities, but perhaps because this particular case involves two relatively large countries claiming money from a small one, to meet the cost of a financial bailout when public sympathy for bailouts is exhausted, discussion in even the more analytical British newspapers, like the Financial Times, Times, Guardian, Independent and even the Daily Telegraph has tended to be superficial and sentimental. RebelEconomist therefore sets out his understanding of the issue here, and offers his own assessment. In his opinion, Iceland is morally obliged to pay, and the British (for brevity I will mostly refer to the dispute between Iceland and Britain only from here on, although I believe that the Dutch position is practically the same) have dealt with Iceland fairly if rigorously. As could have been expected when Iceland allowed its economy to become dominated by financial services provided by a few institutions, the failure of one of them left Icelanders with a disproportionately large mess for a small country to clear up. Although this burden is not impossible for Iceland to carry, there is a case for all the countries of the European Economic Area (EEA) to help, since the EEA single market regulations made a substantial contribution to the debacle. Whether or not readers agree with its conclusions, RebelEconomist hopes that this post can at least facilitate a more informed debate around the referendum by providing some relevant facts with links to sources.
How European deposit protection schemes work
In order to appreciate the basis for the British claim, it is necessary to understand how deposit protection schemes work, both in general and in the EEA in particular, so please bear with a couple of paragraphs of explanation.
When a bank fails, any creditor may make a claim on the residual assets of that bank like any other business, and as ordinary unsecured creditors, bank depositors rank towards the bottom of the creditor hierarchy. Depositors are, however, generally also protected to a limited extent by a deposit guarantee scheme, designed to pay them up to a set amount in lieu of their deposit quickly, without waiting for the outcome of the liquidation procedure (known as the
Under the rules of the EU's single market, extended by the EEA Agreement to EFTA countries like Iceland, banks established in one member country (described as their "home") are allowed to operate branches in any other ("host") country with minimal supervision from the host country bank supervisors. Host countries are obliged to accept that supervision by "competent" authorities in a bank's home country is satisfactory to check the solvency of the whole bank including its branches throughout the EEA. As a safeguard, however, stipulated in Directive 94/19/EC of the European Parliament and Council, any bank operating in the single market must be covered by a deposit protection scheme, which all member countries must ensure is provided in their territory (Article 3 of the directive). This scheme has to guarantee at least 90% of the aggregate deposits of each depositor in the same bank up to an amount no less than €20,000 (Article 7), regardless of currency or location, within three months of their deposits becoming "unavailable" (Article 10). A bank's home country deposit protection scheme covers its branches in host countries (Article 4.1), but with a view to promoting
What is the nature of the British claim?
Landsbanki was covered by the Icelandic Depositors and Investors Guarantee Fund (DIGF) guaranteeing 100% of each customer's deposits up to €20,887, and in addition, Icesave was a
A common but misguided criticism of the British claim has been that it seeks to recover an excessive level of compensation that the British authorities unilaterally promised to UK Icesave depositors. Certainly, the FSCS guarantee for £35,000 was already more than double the DIGF guarantee, and, as they closed Icesave, the British authorities actually increased the guarantee to an unlimited amount for retail depositors. This action was taken with the aim of forestalling any runs on other questionable banks, in the light of Britain's experience of the run on Northern Rock the year before, which demonstrated the fragility and critical importance of depositor confidence. But note from the preceding paragraph that the value of the FSCS guarantee does not affect the size of the aggregate British claim on Iceland anyway, because the claims of the FSCS and uncompensated depositors have equal rank; as far as Iceland is concerned, the only difference is that the larger the FSCS guarantee, the more UK depositors claim through the FSCS rather than in their own right.
Note, however, that the size of Britain's claim does depend on the value of DIGF guarantee. Like the British, the Icelandic authorities chose, as Landsbanki collapsed, to extend their deposit guarantee to the entire value of domestic deposits – in their case including wholesale deposits too – to stabilise the domestic banking system. According to Directive 94/19/EC (its third "whereas" recital, to be precise), "depositors at any branches situated in a Member State other than that in which the credit institution has its head office must be protected by the same guarantee scheme as the institution's other depositors", a principle of
Many commentators have objected to what seems to be a demand on behalf of "greedy" depositors attracted by the relatively high rates of interest offered by Icesave and who should have associated this with greater risk. In fact, Icesave's attractive interest rates were attributed to its low operating costs as a largely online bank, and were not viewed with particular suspicion. Motivated again by the need to maintain confidence in the shaky banking system of late-2008, the British authorities began to settle compensation claims from depositors in British branches of Icesave within weeks of its closure, without waiting for money from the DIGF. This means that Britain is now asking Iceland for money to repay the British taxpayer, rather than to pay depositors. Not that the British taxpayer will escape anyway – even if Iceland pays what Britain asks, British taxpayers will still have to cover the cost of the British
How far can the State of Iceland be held responsible for compensation?
Unfortunately, when Landsbanki failed there was not nearly enough money in the DIGF to meet its guarantee obligations. While no official statement of DIGF assets at the time of the Landsbanki failure seems to have been made, its 2007 Annual Report showed a plan for the fund to reach ISK10.9bn during 2008, which would have been worth just €80mn or £62mn on the day that Landsbanki was closed (October 7th 2008). This compares with Britain's claim on the DIGF alone for £2.35bn. Essentially, the Icelandic deposit guarantee scheme was ex-post funded, being mandated to hold just 1% of the Icelandic banks' average amount of guaranteed deposits over the previous year. In theory, the DIGF would have borrowed as much as required to compensate Landsbanki depositors, and recovered the money over time by raising the insurance fees paid by the surviving banks. In practice, this would have been hardly feasible, because Iceland's banking system was dominated by just three banks, Kaupthing, Landsbanki and Glitnir (each of which had a market share by assets of about 30%), meaning that the failure of one of them would leave a crippling burden on the other two even if they were not hit by the same problem. In such circumstances, a strictly
Some commentators have argued that, since the DIGF is supposed to be a
It has also been argued that it is not reasonable to expect a deposit scheme to cope with a collapse of the banking system it covers, as opposed to a single bank. In fact, the Q&A section of the DIGF website explains that if two banks (ie likely to mean about two thirds of the Icelandic banking system) became insolvent at the same time, a customer with deposits in both banks would receive compensation for both.
Nevertheless, as the problems facing the Icelandic banks became increasingly clear in Autumn 2008, various Icelandic government representatives were specifically asked whether the government would stand behind the DIGF and said that it would, namely Triggvi Herbertsson, an advisor to the Icelandic Prime Minister interviewed on the BBC Radio Moneybox programme on October 4th and Jonina Larusdottir of the Ministry of Business Affairs in a letter of October 5th to the UK Treasury.
Did Britain really brand Icelanders as "terrorists"?
Notwithstanding these Icelandic government officials' commitments to support the DIGF made just before the demise of Landsbanki, the statements of more senior officials as the bank was in the process of being closed were more equivocal. Interviewed on Icelandic television on October 7th, central bank governor David Oddsson, a former
While it is possible to interpret these comments to give Iceland the benefit of the doubt (eg that David Oddsson meant that the State of Iceland would not simply assume Landsbanki's foreign liabilities in full and that Arni Mathiesen was acknowledging Iceland's limitations but did not mean that the domestic depositors' guarantee would be paid even if the foreign depositors' guarantee was not), in the absence of unqualified reasurrance (the Financial Times report of this conversation puts the burden of proof on the wrong side), the British government used the legal powers at its disposal to freeze Landsbanki's British assets to ensure that UK Icesave depositors would get at least something back. Here, the attitude of the British government may well have been hardened by its experience in the previous month of the difficulty of recovering money transferred from Lehman Brothers' London branch to its New York headquarters immediately before Lehman was declared bankrupt. It so happened that the legislation enabling the freezing order had been most recently updated to cope with terrorist organisations, and so was included in the Anti-Terrorism, Crime and Security Act, 2001 (which amended legislation from the less startlingly titled Emergency Laws
Shouldn't negligent British regulators share the blame?
Many critics of the British claim argue that the British authorities were partly responsible for depositors' Icesave losses, because they allowed a risky bank insured by an inadequate deposit protection scheme to operate in the UK, and failed to prevent or even warn investors about the danger of its collapse. This criticism is unfair; because Icesave was a branch of a bank from another EEA country, the single market regulations practically obliged Britain's bank regulators, the Financial Services Authority (FSA), to accept the approval of the bank's solvency by its home regulators, Iceland's Financial Supervisory Authority (FME), at face value (according to the FSA's review of the Icelandic banking crisis on page 19 of its 2009 Financial Risk Outlook 2009, the FSA had only limited powers to supervise Icesave's local liquidity and conduct of business). And it is not hard to imagine the outcry if the FSA had suggested that Iceland was too small a country to support a secure deposit protection scheme (Dutch banking regulators evidently felt similarly constrained). In fact, when the FSCS merely advised British depositors that there could be a delay in receiving compensation in the event of the closure of a branch of a foreign bank, Icesave complained that this warning was a "violation of European law". Clearly, to some extent, the EEA's single market regulations contributed to the Icesave problem, by clearing the way for some banks to operate in the larger European economies with minimal scrutiny from those economies' relatively
How costly could Icesave compensation be for Iceland?
According to recent press reports, the British and Dutch deposit insurance schemes have now compensated 229,000 and 114,000 Icesave depositors respectively. Many of these depositors will have had deposits of less than €20,887, so the British and Dutch claims total £2.35bn (reflecting the sterling value of the
The final fiscal cost to Iceland, however, can be expected to be much less than this, because the liquidation of Landsbanki's assets will recover substantial value for its creditors. The latest information from the Landsbanki winding up board projects a recovery rate for priority claims (which includes the DIGF) of 89%. At that rate, the final cost to the Icelandic taxpayer of compensating Icesave depositors would be about 5% of GDP.
Some Icelanders, notably lawyer Ragnar Hall, contend that the DIGF should take priority in the Landsbanki liquidation over the uncompensated (by the DIGF) claims of foreign deposit protection schemes and unrepresented depositors, in which case the DIGF could expect to recover more than 89% of its claim. They consider that the British government, by asserting a right to a pari passu share of the Landsbanki liquidation proceeds on behalf of the FSCS in addition to compensation from the DIGF, is asking for two bites at the residual assets of Landsbanki. Giving the DIGF precedence would, however, mean that the smaller depositors would be effectively being partly paid off out of the wealth of the larger depositors, making the DIGF more of a redistribution scheme than a compensation scheme. Although European law defers to national bankruptcy law on this point, European law is clear (reportedly unlike Icelandic law) – Directive 94/19/EC (Article 11) states that "schemes which make payments under guarantee shall have the right of subrogation to the rights of depositors in liquidation proceedings for an amount equal to their payments". Indeed, in the light of this clause (which also appears as Article 12 of Directive 97/9/EC on investor compensation schemes) Britain removed the preference formerly given to its own deposit protection scheme when it introduced the FSCS in 2001 (see, for example, section COMP 7.3.2C of the FSA handbook).
It may also be significant that the way that the Icelandic authorities chose to protect domestic deposits was to take control of Landsbanki and abstract a new "good bank" Nyi Landsbanki, comprising domestic deposits and associated liabilities plus new capital contributed by the Icelandic government, leaving foreign branch depositors in a "bad" bank destined to be wound up (as described in pages 15 and 16 of Iceland's request for an IMF stand-by arrangement). Whether this is significant depends on whether the assets of the old Landsbanki are allocated equitably to the creditors of the good and bad banks. Any unfavourable allocation to the bad bank will reduce the value available to be distributed to its (predominantly foreign) creditors.
Defenders of Iceland's preferential treatment of its depositors and banks argue that this was justified to preserve the domestic banking system, which is vital to the whole Icelandic economy. No doubt this is true, but it has to be said that the reason why Iceland's economy was so dependent on domestic banks is that foreign banks found it difficult to enter the Icelandic market. According to Report 1/2006 of the Nordic competition authorities on Competition in Nordic Retail Banking (page 15), at the end of 2005, all 178 bank branches operating in Iceland were branches of domestic banks (the report suggests the explanation may be that the cost of transferring accounts out of the incumbent banks had been prohibitively high).
The disagreement about deferred payment terms
The impact of the financial crisis on Iceland's economy (not to mention its dispute with Britain and the Netherlands) damaged Iceland's credit standing and made it prohibitively expensive if not impossible for Iceland to borrow in the capital markets as much as might be needed to repay the British and Dutch before much cash could be realised from the liquidation of Landsbanki and raised from future deposit insurance fees. Those countries therefore offered to effectively lend the necessary amount to the DIGF, subject to an Icelandic sovereign guarantee, by deferring repayment until 2016, with the plan being that the debt is repaid in 32 equal quarterly instalments from 5th June 2016 to 5th March 2024.
The terms of this loan is one of the key points of disagreement. Iceland contends that the proposed interest rate of 5.55% is too high. Critics of the deal, including some who ought to be able to produce a more rigorous assessment, compare the interest rate unfavourably with the interest rates that the British and Dutch governments pay on their fixed interest rate debt. In fact, this is not a reasonable comparison, for at least two reasons. Firstly, unlike a typical government bond, Iceland is not required to make any payments for the first seven and a half years of the loan; a more appropriate comparison would be with
Since proposing the original loan agreement in June 2009, the British and Dutch have offered some concessions that soften the terms of the loan. They agreed to an amended loan agreement in which annual repayments were capped at 6% of Iceland's GDP, with any such reduced repayments being recovered from one or more five year extensions of the loan (ie effectively giving Iceland a put option). This modified form of the loan was included in the bill which Iceland's President refused to ratify. In recent days, Britain and the Netherlands have reportedly offered loan terms involving a floating interest rate (based on terms Iceland has accepted for loans from other Nordic countries), which Iceland is said to have rejected on the grounds that the British and Dutch were not passing on their own lower cost of borrowing. If the loan terms are the only obstacle to reaching an agreement, one way forward might be for the three countries to agree a mutually acceptable loan structure, for Britain and the Netherlands to structure some of their own growing debt in this way, to auction it to obtain market terms, and pass these through to Iceland.
Is it reasonable to expect Iceland to bear the Icesave compensation burden?
Although most of Iceland's politicians may have accepted Iceland's obligation to repay the British and Dutch governments the amount of money due from the DIGF, and are now negotiating mainly about the timing of the outlay, a large fraction if not the majority of Iceland's general public apparently regard the British and Dutch claim as excessive and unjust, and are expected to vote against accepting it if the referendum goes ahead. Even in Britain, the dispute is commonly portrayed as two
Of course, bank depositor compensation will only represent part of the cost of the financial crisis for Iceland, but comparison of the burden on Iceland of compensating Icesave depositors with the reparations demanded from Germany after World War One, which proved impossible to pay and led to the resentment that contributed to the Second World War, looks exaggerated. Under the London schedule of payments of 1921, Germany was required to pay 50bn gold marks (ie nearly 18,000 tonnes of gold) in reparations from 1921 to 1933, representing 125% of 1921 German GNP (and more later if possible, up to 132bn gold marks).
In reality, the fundamental cause of Iceland's present misfortune is that, especially in the early years of the current century, Iceland's financial services industry grew rapidly and came to dominate its economy. That high degree of concentration of economic activity meant that Iceland's economic fortune would be extremely good during financial market booms, as in 2007 before the financial crisis, when Iceland had one of the highest per capita incomes in the world, but suffer a relatively large decline during financial market busts. Iceland's leaders were not shy about proclaiming Iceland's success during the boom; reading the bragging May 3rd 2005 London speech by Olafur Ragnar Grimsson, including the, with hindsight, personally unfortunate claim that the Icelandic "style of entrepreneurship breeds leaders who know that they are responsible", provides an antidote to sympathy for Iceland. Similarly, Iceland's banking industry was itself highly concentrated, meaning that Iceland was unwise to adopt the kind of
Update on March 9th 2010
Sadly, the people of Iceland rejected RebelEconomist's advice to vote yes; of the 62.7% turnout of registered voters, 93.2% voted no, and only 1.8% voted yes. However, while the result is decisive, it is less clear what it means. Although there were undoubtedly some who voted against the whole idea of a perceived capitulation to British and Dutch bullies demanding payment for bailing out greedy depositors of reckless private sector bankers, the majority seemed to accept repaying the amount of DIGF compensation disbursed by the British and Dutch but to reject what were regarded as unfair terms of the loan from Britain and the Netherlands. Indeed Iceland's prime minister Johanna Sigurdardottir had described the poll as "pointless", on the grounds that nobody was in favour of the bill in question anyway, since a "more favourable solution" had been offered by the UK and the Netherlands. The problem that RebelEconomist has with this position is that he is not sure exactly what Iceland would consider fair, or even whether the new offer from Britain and the Netherlands really is better from Iceland's point of view.
Assuming that by "fair", Icelanders mean that the British and Dutch should just cover their own borrowing costs rather than adding some "profit" margin on top (although judging by credit default swaps, a margin of about 4% to cover Iceland's credit risk would represent "fair market" terms), it is not clear that the proposed interest rate of 5.55% was unreasonable, as explained in the original post. And even if no allowance is made for the duration and flexibility of the loan, a crude comparison of this interest rate and current swap rates of a similar duration – say eleven years – would suggest that in LIBOR terms, this interest rate represents LIBOR plus about 1½%. Yet the new offer reportedly involves floating rate interest of LIBOR plus 2¾%. Even though this may imply a current loan rate of less than 5.55%, market expectations that interest rates will rise from their present anomalously low levels would suggest that a new deal of LIBOR plus 2¾% would probably be worse for Iceland in the long run (although the reported offer of an interest "holiday" too would also need to be taken into account to make such a judgement). Iceland sought legal advice on the draft loan agreement with Britain and the Netherlands; perhaps Iceland should also seek financial advice on the loan terms from an impartial investment bank (if it has not already done so).
To quote H.L.Mencken, "democracy is a pathetic belief in the wisdom of collective ignorance".