Wednesday, 3 March 2010

On thin ice


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 "pay-box" function). The money that the deposit protection scheme disburses is typically raised from insurance fees on deposits, and in principle may either be drawn from a contingency fund built up in anticipation of defaults ("ex-ante" funding) or borrowed as required – from government if not commercially – and repaid from a levy on surviving banks ("ex-post" funding). In practice, a combination of ex-ante and ex-post funding is used, with a bias towards ex-post funding to avoid the more complex administration of a large standing fund and the need for banks to tie up assets in the deposit protection scheme. In such cases it would not be alarming for a large default to more than deplete the deposit protection fund. As it pays each depositor, the deposit protection scheme takes over, or in legal jargon, is "subrogated" to, their claim on the failed bank for the amount paid (although it may additionally assist the depositor by taking responsibility for pursuing the claim for the whole deposit and splitting any proceeds with them). Thereafter the deposit protection scheme has a claim which generally ranks on a par with the claims of any other depositors, meaning that it should receive a share of the liquidator's distribution to depositors in proportion to the value of its aggregate claim ("pari passu").

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 cross-border competition, the directive allows for branches to join a host country's deposit protection scheme where this provides a higher level of protection (Article 4.2). In such a case, the host country guarantee is supposed to supplement ("top-up") the home country guarantee, and should be charged for accordingly (Annex II).

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 top-up member of the British Financial Services Compensation Scheme (FSCS), which until the Icesave collapse covered 100% of up to £35,000 per depositor. This meant that, when Landsbanki, and hence Icesave, was put into administration by the Icelandic and British regulators on the 7th and 8th of October 2008 respectively, the British authorities were bound to ask the Icelandic authorities (theoretically the FSCS would deal with the administrators of the DIGF, although in view of the importance to both countries the matter was raised to government level) for (1) payment within three months, of an amount equal to the lesser of either the value of their deposit or €20,887, for each depositor qualifying for DIGF compensation among the over 200,000 Icesave UK depositors, and, (2) on behalf of all UK depositors with a claim on the FSCS, a pari passu allocation of eventual Landsbanki liquidation distribution to all depositors and their representatives including the FSCS (not to mention the Dutch deposit protection scheme).

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 non-discrimination enshrined in Article 4 of the EEA Agreement which states that "any discrimination on grounds of nationality shall be prohibited". Strictly, therefore, the DIGF ought to offer the same level of compensation to depositors in UK branches of Landsbanki as it did to domestic investors. The implication is that the British claim on Iceland is actually smaller than it could be, because the UK has a case to ask the DGIF (as opposed to the Landsbanki liquidator) for the entire value of all UK deposits in Icesave.

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 top-up component of Icesave depositors' compensation, and since the FSCS unlimited guarantee did not cover wholesale depositors like local authority treasurers, many of those taxpayers will have sustained uncompensated losses at local government level too.

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 privately-funded DIGF would have found a loan on commercial terms either unavailable or impossible to repay. The conventional assumption is, however, that deposit protection schemes have state backing, in the form of loans or loan guarantees if not government grants, in the event that the fund does not have the means to compensate depositors when called on. The British authorities therefore looked to Iceland's government to either fund the DIGF or provide it with a state guarantee to allow it to borrow enough money to provide its contractual level of compensation to Icesave depositors despite there being little chance of future deposit insurance fees from the Icelandic banking system being sufficient to repay that debt.

Some commentators have argued that, since the DIGF is supposed to be a private-sector-funded scheme, the State of Iceland cannot be held responsible for DIGF obligations. On this question, Directive 94/19/EC is ambiguous. It says (in its penultimate "whereas" recital) that "this directive may not result in.....member states.....being made liable in respect of depositors if they have ensured that one or more schemes guaranteeing deposits.....and ensuring the compensation or protection of depositors under the conditions prescribed in this directive have been introduced". Iceland undoubtedly ensured the introduction of a deposit protection scheme that promised to provide at least as much compensation as prescribed by the directive, but a scheme likely to require ex-post funding of compensation covering one third of the banking system by the remaining two thirds could not realistically be described as "ensuring" that level of compensation. It is true that no government commitment to back up Iceland's banks' deposit protection scheme existed when Icesave was rapidly accumulating deposits in 2006-7. But this absence of a formal government back-up is normal – it is understood that governments do not want to absolve banks from contributing enough to make their own deposit protection scheme robust, and, in Europe at least, a deposit protection scheme backed by a relatively wealthy state could be considered to give the banks it covers an unfair competitive advantage in attracting deposits (in the words of Directive 94/19/EC, it is "not appropriate" for deposit protection "to become an instrument of competition"). And Icelandic regulators never attempted to dispel the notion promulgated by influential advisers such as Moody's that the Icelandic banks would ultimately receive state support. To do otherwise would have disadvantaged Icelandic banks in the European market. Moreover, since deposit insurance exists primarily to deter runs on banks by reassuring the majority of depositors that their money is secure, the Icelandic banking system itself may well have been unstable or even unviable if depositors in Icelandic banks had believed that their protection was limited to the resources of a fund obliged to hold only 1% of insured deposits.

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 prime-minister, said, according to the translation reported in the Wall Street Journal, "These players lent this money to make a profit.....and they must face the consequences and not innocent citizens.....we have made this rather drastic decision and say: we are not going to pay the banks' foreign debts". No doubt alarmed by such comments and being aware of the fact that the Icelandic government had fully guaranteed domestic deposits, British Finance Minister Alistair Darling telephoned his opposite number in Iceland, Arni Mathiesen, to verify that UK Icesave depositors would get at least the €20,887 (then equivalent to about £16,000) guaranteed by the DIGF and that the comprehensive compensation given to Icelandic depositors of Landsbanki would not be at the expense of depositors in foreign branches, but Alistair Darling did not get the categorical reassurance the situation demanded. According to the transcript of the conversation, when asked whether British depositors would get the DIGF compensation, Arni Mathiesen said "I hope that will be the case. I cannot visibly state that or guarantee that now.....", adding later that "We need to secure the domestic situation before I can give you any guarantees for anything else.".

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 Re-enactments and Repeals Act, 1964). Use of this legislation did not, as some Icelanders have protested, brand Iceland as a terrorist regime, and in fact the freezing order applied to Landsbanki specifically, rather than Iceland or Icelanders generally. And the freezing order was soon lifted once it became clear that Iceland did not intend to preclude any losses for its own citizens before releasing anything for foreign Landsbanki creditors.

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 well-resourced and experienced regulators, so there is a case for sharing the cost of compensating Icesave depositors across the whole EEA.

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 euro-denominated Icelandic guarantee when Landsbanki was closed) and €1.33bn respectively. Based on the January 2010 Central Bank of Iceland forecast of 2010 Icelandic GDP of ISK1316bn and present exchange rates, together these payments represent 44% of Iceland's GDP.

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 zero-coupon rates derived from British and Dutch government bond (gilts and DSLs respectively) yield curves. The interest rate set apparently reflects market interest rates as at the beginning of January 2009 (ie allowing for the statutory delay of up to three months before compensation is paid), at which time, according to Bank of England yield curve data, seven-and-a-half to fifteen year zero coupon gilt yields ranged from about 3¼ to 4%. And gilt yields are quoted on a semi-annual compounding basis, whereas the 5.55% specified in the loan agreement is expressed as an annual rate (which accounts for about tenth of one percent on the loan rate). Secondly, since the loan allows for early repayment as the DIGF receives money from the Landsbanki liquidation, it effectively incorporates a call option (the right but not the obligation to repurchase the debt) for Iceland. In practical terms, this means that if interest rates fell and Iceland was able to borrow more cheaply than the cost of the loan, it could reduce its expenses by borrowing elsewhere and paying off Britain early, whereas if interest rates rise and gilt yields exceeded the cost of the loan, Iceland could make some money back by investing the liquation proceeds in gilts and repaying the loan as late as possible. It has to be said that the terms of the loan might have been less contentious if the British and/or Dutch had set out how the rate was determined.

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 tight-fisted governments of relatively powerful countries bullying a small nation into accepting poverty to pay for the damage done by a few greedy compatriots for whom the majority were not responsible. In fact, many countries have had to meet the cost of fixing banking crises in the past, and several are suffering one now like Iceland, and if the Icesave compensation does end up costing Iceland 5% of GDP, and similar losses are generated by Glitnir and Kaupthing (which were also taken over by the Icelandic government), the fiscal cost of the Icelandic banking crisis would be in line with the average fiscal cost of banking crises which is 16% of GDP. The cost of Iceland's banking crisis is painful but not unprecedented or unbearable.

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 ex-post funded deposit protection scheme covering the larger European countries. Iceland is arguably the world’s most experienced democracy, and Icelanders elected the people who made these mistakes or allowed them to occur. They should accept their responsibility, and approve the bill.

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".


Andri Haraldsson said...

As cogent an analysis of this debacle as I've seen anywhere. A couple of points:

1. Regardless of the debating society style of politics that dominates the Icelandic Althing, it is decidedly not in the best interest of the EU/EEA to allow this debate to fester. A matter of relatively low importance and amounts has been elevated to the political sphere. This means that the puppy-dog strategy of the Icelandic government may well work, and in the final agreement Iceland will end up having other countries subsidize the cost of cleaning up its banking crises. This is probably penny wise and pound foolish for Iceland (as it delays eventual rebuilding of its economy), but the initial dismissive negotiating stance of the British and Dutch governments has provided demagogues in Iceland the ammunition to prolong this contract dispute.
2. There is a greater lesson in this that must be addressed within the EU/EEA. Namely, what must the larger countries do to ensure smaller countries adequately execute the letter and intent of EU directives? The larger countries surely have some responsibility to both their own citizens and the ‘greater good’ to limit the downside of lax oversight and insufficient ability of smaller countries to police business and finance within the common market? Iceland is no doubt responsible in this matter, as ignorance or inexperience should not absolve it from responsibility, but on the flip-side, should the EU have given a country as populous as Bradford full and unfettered access to depositors across the continent? And at the end of the line, how dearly should widows and orphans in Iceland pay for this failure of the common market?

Björn Jónasson said...

In your otherwise well written analysis, you manage to find not one redeeming point for the Icelandic stance.

You brush off a complicated legal argument by saying "The conventional assumption is, however, that deposit protection schemes have state backing...." I´m afraid there is no conventional wisdom here. And this is the crux of the matter.

You therefore build your whole argument on a fallacy, i.e. that everybody agrees on the British legal interpretation. Iceland does not agree and has argued (which you conveniently fail to mention) that since there are legal uncertainties, the matter should be decided in court. Britain does not like the idea and does not say why.

The whole article is therefore like an ambitious construction built 10 feet off the ground: Very well built admittedly, but without foundation.

FF said...

A very detailed, yet clear account of the IceSave debacle. Good to get some light amongst all the heat.

I would like to reply to Björn Jónasson. Many Icelanders have raised this point before.

As long as the assumption holds that Iceland will pay, I can't see why Britain or the Netherlands would want to go to court. They would only go to court if Iceland said, no, we're not paying.

The more relevant question is, does Iceland itself want to go to court at this point. I don't see any evidence of this and note that Icelandic officials always state at the critical points that the loan will be paid (ie no mention of dispute). It's not hard to see why. Any court proceedings will tie up Iceland's recovery process for years until the uncertainty is removed.

I believe the second iteration of the Icesave loan (the one rejected by the Icelandic President) allows Iceland to challenge its obligation under the EEA Directive. This seems to me to be both practicable and fair. The loan can be set up on the assumption that Iceland does have a legal obligation to compensate foreign Icesave depositors. It enables the IMF loan and other necessary steps leading to a rebuilding of confidence.

But Iceland can go to court during the interest-free period. If they win, they don't need to pay anything.

Björn Jónasson said...

FF, point taken. But one could just as well turn this around. Why not first go to court and when judgement has been passed, we can take matters from there.

In the Equitable Life dispute, the British Government chose not to compensate people on beforehand inspite of pleadings from the Ombudsman and European Courts urging them to do so. And in the meantime many of the would be compensees are conveniently passing away.

I would also like to add, that the majority of the population in Iceland would like the matter to be settled in court.

When it comes to it, Britain compensated her domestic taxpayers out of self interest to calm the waters locally. And this is what soverign nations tend to do. So I suggest we be pragmatic about this. If this is such a small amount to Iceland, what is it to Britain in comparison?

RebelEconomist said...

Thanks Andri.

I guess that by "dismissive negotiating style" you refer to Britain's use of its anti-terrorism laws. Here I do think that the British government has been remiss in not explaining its actions. One can imagine that following his conversation with Arni Mathiesen on October 7th, Alistair Darling believed that he was faced with a situation in which Iceland apparently intended to make as much use of Icesave's British assets as necessary to fully compensate Icelandic depositors before the €20,887 for British depositors was even considered. If Alistair Darling wanted to prevent that, he had to use whatever powers he could muster, literally overnight, and even if he already had some idea of what could be done, he could not have revealed that in the conversation, because that would have given Iceland time to circumvent the freezing order if they had been determined to do so. But after the event, I do think that HM Treasury should have explained why they used anti-terrorism laws rather than a Mareva injunction, which I believe is the freezing order normally used in civil cases. Maybe there was a good reason (eg that sovereign immunity prevented the use of civil procedures after Landsbanki had been nationalised; I don’t know) which might mitigate the offence felt by Icelanders. As for withholding approval of IMF loans or EU membership, I suppose that the British and Dutch are using what little leverage they have over Iceland. The problem for them is they are trying to reclaim something from Iceland, and as the saying goes, "possession is nine tenths of the law"!

Although there is no doubt that some of the EU legislation that applies in the Icesave case, especially Directive 94/19/EC, needs to be clearer, perhaps the dispute may set a precedent that may come to be seen as a useful clarification of the EEA single market regulations, rather than a failure; namely, that small states are responsible for upholding the regulations in their territory, and that failure to do so will be very costly for them. In short, independence implies liability as well as control. My hope is that this will force small states to set national pride aside and think objectively about what activities they can realistically manage themselves, and what they should contract in from larger and more comprehensive neighbours or allies, as, I imagine, Monaco imports various services from France. I would have no objection to a small country like Iceland choosing to specialise in financial services that would presumably have a collectively large balance sheet relative to the size of its national economy, but then Iceland would have to (1) either have a proportionately large financial regulator or accept regulation from a larger country like Denmark or the UK, and (2) would need to either devote a lot of resources to its investor compensation scheme, perhaps via some reinsurance arrangement, or again, join the scheme of a larger country (unless it could operate without one, requiring investors to sign a disclaimer). And of course, a country with a less diversified economy would have to accept that its income would naturally tend to be relatively volatile.

FF said...

Picking up on RebelEconomist's last comment, one way for Iceland and other smaller countries to avoid Landsbanki sized liabilities would be to require their banks to set up foreign subsidiaries instead of branches.

This is what Kaupthing, another Icelandic bank, did. Although there was criticism in Iceland over the way the UK authorities foreclosed the Kaupthing subsidiary, the crucial point is that the UK, not Iceland, is responsible for all the deposit guarantees for this bank.

FF said...

Björn alludes to another complaint many Icelanders make, which is that the UK and Dutch authorities pre-empted Iceland's freedom to act by unilaterally and unnecessarily compensating their depositors.

On the whole, I don't think this is valid. Iceland's obligation, to the extent it has one, is to individual savers. It remains so even though the UK and Dutch authorities have paid out an advance. Some further conditions may be introduced by the loan agreement, but the basic €4 billion obligation isn't affected.

It's a red herring, in effect.

Björn Jónasson said...

FF, this is not the first dispute in human history.

You say:"I don't think this is valid"

I say:"I don´t agree with you."

So what do we do? We let the courts decide.

They even got a name for it. It is called The Rule of Law.

Andri Haraldsson said...

I meant something a little bit broader than the “terror law” incident, although it factors in. It’s a little hard for me to reconcile my own thoughts here, especially how much of this is simply the benefit of hindsight. But let me try.

From the standpoint of Dutch/British authorities this has been a matter of formally concluding the terms of a loan agreement to finalize Iceland’s commitments pursuant to a bridge-loan made to shore up the Icelandic deposit insurance fund. And formally this is basically what the negotiations are about. But in Iceland, Icesave is about a lot more than that. It’s about avarice, hubris, incompetence, cronyism, government failure, insider trading, and grand theft. And it’s also about national pride, embarrassment, paranoia, and fear the bottom may still drop out of Iceland’s economy.

There isn’t anything Britain/Holland can do about this, these are internal affairs of Iceland. And there is the bigger picture that of course Iceland has to shoulder its responsibilities as a sovereign country. But from the first draft of the (then) onerous contract terms and through this protracted negotiation, neither Holland nor Britain has acted magnanimously. Mind you, I’m not suggesting such actions are owed to Iceland. I’m just pointing out that given the mess Iceland finds itself in, it cannot possibly be expected to get out this on its own. And right now, precious time and money is being lost in executing the absolutely critical IMF package for Iceland, all because of this haggling.

Here are examples of simple things which could have helped tremendously along the way: i) broaden the scope of the conversation, even offer Iceland legal assistance to ensure that before actual repayment of the loan legal uncertainty is settled. This would not put the Dutch/British taxpayer at risk, since in the event EEA directives are found wanting it would be a joint EEA responsibility to find an agreeable method of reimbursing Holland/Britain; ii) find some economic and/or cultural partnerships that can be executed along with the narrow repayment contract; iii) show respect and humanity and arrange for a goodwill summit among the three countries; iv) decouple the IMF package and the loan repayment – this has been a major issue in Iceland as it makes a small country feel very much abused when an international body is used as a strong man for debt collection; v) offer official advise and help in identifying and prosecuting any culprits in the Icelandic banking fiasco (this has been done at the staff level, but not on a bilateral basis as part of the negotiation).

In conclusion, I am not so much finding fault with the British or the Dutch, as I am pointing out that their stance has made these negotiations more difficult, and has made it all but impossible for the marginally functioning government in Iceland to sell the deal. I also realize that I am asking for far more from the two governments than I would ever dare ask of the Icelandic one – both magnanimity and patience… And, ironically, I think one of the reasons for the apparent glumness of the British and Dutch governments has been a request by the Icelandic government for them to lay low, for fear it would upset people in Iceland. But I think a stance that was more welcoming of Iceland and emphasized that it was being dealt with as an equal, and that there was real commitment in Holland and Britain to aid in Iceland’s recovery, would have gone a long way to quell those voices that now appear to have gotten the average citizen into a frenzy.

Anonymous said...

Rebelblogger,the notion that the Iceave net debt will only come to about 5% of GDP is based on less than certain figures by the winding up board of Landsbanki. The forecasted 90% recovery rate of Old Landsbanki assets is by no means certain since the recovery rate is based in large part on the bond issued by new Landsbanki. Those bonds are in no way triple A. Eventual recovery rate will ultimately depend on both external economic factors as well as Icelandic economic and political factors. If the recovery rate was somewhat certain, at around 90%,the UK would probably just accept the banks assets and Iceland cover the 10% difference.

Anonymous said...

I will not comment on the legal issue, but your estimation on the cost of Icesave sounds a bit fishy. I dont know how you came up til this 5% of GDP, since the yearly intrests alone are about 3% of GDP. Unless your estimation is for yearly 5% cost, it surely is far to low.

As for the 15% of GDP total cost of the financial collapse, that is also far from reality, since goverment debts are now estimated at something like 100% of GDP, but was about 0% before the collapse, the increase mostly due to the banking crisis.

As for the moral part, lets use the Euro as a value base. Within days of the banking crisis the value of icelandic deposits had fallen by 50% in Euro's. The Icesave deposits had risen by about 100% in IKR. The directive states that deposits can be refunded in the currency of the home country, or in IKR. So will the Icesave depositers be happy with being refunded in IKR at the exchange rate at the time of the overtaking by the icelandic goverment, with the 50% reduction the icelandic depositers had to accept? I think that would be accepteble to the icelandic public.

RebelEconomist said...

Yes Bjorn, I am afraid that I do not find many redeeming points for the Icelandic stance, though I can understand that ordinary Icelanders are distressed to find themselves presented with a bill for a venture were not aware that they were involved in.

With regard to the question of state backing, I have enhanced that section of the post (ie "How far can the State of Iceland be held responsible for compensation?") to include some thoughts from a discussion I had on the website, so please have a look at that section again. In my view the Icelandic stance on deposit protection is revisionist. Back in 2006, when concerns about Icelandic banks became prominent (recall, for example, Iceland's protest about Norway's sovereign wealth fund short-selling Icelandic bank shares), it suited the Icelandic authorities to allow depositors to proceed under the tacit understanding that the Icelandic deposit protection scheme did have a state guarantee. Instead of facing a run on Icelandic banks that might well have occurred then if depositors had doubted that the deposit protection fund would be backed up by the government, and had found that its existing resources were limited to about 1% of insured deposits, Landsbanki was able to smoothly replace funding from increasingly wary wholesale investors with retail deposits raised first from Britain and then later from the Netherlands. At that time, depositor belief in state backing was convenient for the Icelandic authorities, because it allowed a crisis to be forestalled. Only now, when the absence of an explicit state guarantee for the Icelandic deposit protection scheme allows the Icelandic government to contest its presumed liability, does it disclaim the existence of such backing. Iceland may have grounds for a legal argument, but morally, it should just pay up.

Presumably the reason why the British and Dutch resist taking the matter to court is that they feel that they have nothing to gain (suppose, for example, that the court accepted my mischievous argument that Iceland, having guaranteed the entire value of domestic deposits, ought to repay all Landsbanki depositors all their money back, and what's more, immediately and with compensation for failing to pay compensation within three months; could and would Iceland pay?), while any reduction in Iceland's liability might destabilise Europe's entire banking system. I think you are right to say that the UK paid the DIGF component of depositor compensation to Icesave depositors to reassure British depositors generally, but in the long run, this probably did small countries like Iceland a big favour, because if the Icelandic guarantee had been withheld, banks incorporated in small countries might have ceased to be viable.

In my admittedly poorly-informed view, Equitable Life is like a mirror image of the Icesave dispute. In the case of life assurance, the conventional assumption was that policies are not guaranteed, but the Equitable Life policyholders are exploiting the fact that the UK government encouraged individuals to make their own pension provision to argue that the government should cover all their losses. The fact that Equitable Life policyholders have progressed their case so far reflects the professional, articulate and influential nature of the individuals affected, compared with, for example, the no-less-deserving but poor savers in the Farepak Christmas hamper club.

Finally, I think that Icelanders would be wise not to use the "big burden for a small country" argument. While it might be dangerous to mention cod, I am old enough and from the right part of the UK to recall people saying "why should so few Icelanders have so many fish?"!

RebelEconomist said...


No doubt British and Dutch sensitivity to Icelanders' feelings would help, and should be easier to maintain than in the desperate days of autumn 2008. But, as I hinted in my earlier reply to you, I do think that nations ought to have ambitions and influence roughly in line with their size. Unless they do, Europe will become unworkable as almost any distinct unit of people will aim for independence within the EU, with a ministerial seat in the council, commissioner, governor at the ECB etc; hell, even a six month stint in the presidency every few years. In looking into the Icesave dispute, I was impressed by the range of the Icelandic nation. It seems that, for almost any piece of information I wished to find, there is an Icelandic organisation corresponding to one in the UK, with a helpful website. It is hard to believe that these functions can all be either efficient or world class in a country of just 317,000 people. I did wonder, for example, whether the ex-post funded nature of the DIGF, which is obviously unsuitable for a banking system comprising just three banks, was uncritically copied from the larger European countries with the motivation "we should have one of those".

By the way, while I would not deny that any settlement would be onerous for Iceland, I do question whether the terms of the original loan offer were other than fair, and even whether the new offer is better for Iceland. See the update that I have added to the post commenting on the referendum result.

Andri Haraldsson said...

Let me first say that I think you are spot on about Iceland. In my less charitable moments I refer to it as the ‘land of sometimes brilliant amateurs. ‘ Now, there’s a difference between an amateur professional, and a professional amateur. Reykjavik’s attempt to become a financial center was the collusion of professional amateurs in the political class, and amateur professionals in the business ranks. But regardless of the mechanics, smallness is at the heart of this colossal meltdown.

The growth of Iceland’s financial sector was out of control for a little while. Many in Iceland feel that the City took ample advantage of naïve Icelandic bankers and businessmen, fobbing off worthless assets to the amateur professionals. And these Icelanders admit that while the country may have been too ignorant of high finance to enter it so forcefully, they also feel they were being played for a fool, and the smart money and smart governments watched it happen, and didn’t take steps to protect either their own depositors, or minimize the risk to Icelandic taxpayer who might have to ex-post fund the party. It is not my argument, but it is one which I’ve read in various incarnations in Icelandic blogs.

One statistic, however, which lends a little support to this line of reasoning is that if Poland, which sported roughly the same banking tradition during the cold war as did Iceland, had seen its banking sector grow as much in five years, then it could have handled all of Europe’s banking.

So we find ourselves in this dismal situation. The very small population of Iceland has been asked to complete the almost impossibly complex calculus of which is better: to honor the obligations as stated and soldier on, or to dig in their heels a little longer and hope a better deal can be struck before it’s too late to avoid defaulting on previously outstanding sovereign debt. All cod and kidding aside, need anyone be surprised at the path Iceland has chosen?

Jon Steinar said...

This article obviously has its origin in the left spin factory in Iceland. There are entire chunks of text practically straight from recent articles by gov sponsored professors up here.
An interesting way to push the propaganda, making it look as it comes from abroad.
How much did you get payed for this?

RebelEconomist said...

FF, I like your suggestion that small countries should require their international banks to operate abroad as subsidiaries rather than branches. If I recall correctly, the British FSA wanted Landsbanki to make Icesave a subsidiary, but Landsbanki was reluctant to commit the resources needed to independently capitalise Icesave, so the FSA had to accept its continued operation as a Landsbanki branch.

It is ironic, in view of Icelanders' present sensitivity to any perceived bullying by Britain and the Netherlands, that those countries' scrupulous respect for the competence of Icelandic banking supervision contributed to the debacle. It would be easier if the drive to make foreign banks operate as subsidiaries rather than branches emanates from their home regulators.

Björn Jónasson said...

DIRECTIVE 2000/12/EC (chapter 22 art 8)provided the Brits with all the powers needed to stop the banks on their home turf.

This directive farce defies all logic. If the police sees a crime committed in the city (say a murder), they would not turn their head away, saying this is not their jurisdiction. How about some common sense here?

RebelEconomist said...

Anonymous at 9 March 2010 at 10:06:

You raise an interesting point about the value of the bond from Nyi Landsbanki. This is going to need careful handling, or the (predominantly foreign) creditors of the old Landsbanki will cry foul. To be fair to the creditors of the old Landsbanki, the market value of the bond must be no less than the value of the extracted good bank. I guess that means that the bond should have a larger nominal value the lower its credit rating. At the moment, since Nyi Landsbanki is state-owned, the bond will presumably have the Icelandic sovereign rating, but it should be given an explicit government guarantee to protect its value against any future privatisation of Nyi Landsbanki.

My estimate of the cost of the banking crisis to Iceland of about 15% of GDP is quite rough (ie 11% of 44% of GDP, times three given three banks), but it is sufficiently realistic to support my point the cost is a lot less than the "slavery" stories bandied about. Even if the failed bank recovery rate is much lower than the 89% presently projected, the burden is affordable if Icelanders are prepared to make sacrifices. I am often struck by the contrast between peoples' attitude to costs that they incur willingly and unwillingly. When houses cost five times the average annual income, and rise 20% in a year, as happened in some countries during the recent boom, the implied increase in expenditure for new households of an entire year's worth of income is barely discussed. Similarly I dare say that many Icelanders will happily spend 44% of their annual income on a vehicle at some time. This is not just a dig at Icelanders; we British, and the Americans and Greeks, are in my view denying the necessity to reduce consumption as much as our post-boom economies require. I applaud countries like Ireland and Estonia that have accepted austerity to face up to their problems.

RebelEconomist said...

Anonymous at 9 March 2010 at 16.31:

I am referring to the present value of the cost of Icesave compensation to Iceland. If the expenditure is delayed with interest, it will naturally increase in money terms, but remain the same in present value terms if the interest rate paid is a fair market rate that is appropriate for discounting future cashflows. I am puzzled where you get an annual interest cost of 3% from – 44% of Iceland's 2010 GDP is the absolute maximum assuming no recovery at all from Landsbanki assets, and the annual interest costs are presumably 5.55% of that, or about 2.5% of 2010 GDP. So to get to an annual interest cost of 3%, the Landsbanki assets would have to prove worthless and Iceland's nominal GDP would have to shrink by a further 17% in sterling terms.

As for the morality of the deposit guarantee, please check out my enhanced discussion of this issue in the post. The point I am now making more clearly there is that the deposit protection scheme existed as much for Iceland's benefit as the depositors' benefit, because its principal purpose was to deter bank runs and therefore stabilise the Icelandic banking system. The morality-testing question is, would existing depositors have stayed with Landsbanki, and could new depositors like those in Icesave have been attracted to Landsbanki, if the deposit guarantee had been denominated in ISK? Not so many, I reckon. And those Icelanders who are quibbling now about the meaning of the DIGF guarantee that covered Landsbanki should consider the future - who will trust a significant amount of money to Icelandic banks in future, if they believe that their deposits are protected by a fund with no government back-up and standing resources of just 1% of the value of deposits and, regardless of the currency deposited, paying compensation in ISK only?

RebelEconomist said...


Thanks for your open-minded comments, especially if you are an Icelander. Actually, I reckon that if Iceland can see through its present difficulties, it has a brighter per capita future than the UK. In my opinion, a major contribution to the financial crisis has been a failure of the existing developed countries to recognise the challenge that they face from the re-entry of countries like China into the global economy. This process can be expected to weaken the existing developed countries' terms of trade, as increased competition from China reduces the price of the manufactured goods that both types of country sell and raises the price of resources that they both buy, such as oil. Some of the existing developed countries have initially responded (abstracting from the internal mechanisms like asset price bubbles, growing inequality etc that determined their response) to these price developments by consuming more goods and borrowing more to maintain their consumption of resources, especially as borrowing was facilitated by China's high propensity to save. For many of those countries, the troublesome result has been an unsustainable level of consumption and a build-up debt that will be painful to correct. By contrast, Iceland is, in its own particular ways, rich in scarce natural resources like energy, food, clean water and space, so its terms of trade should improve. Iceland may even benefit from global warming.

RebelEconomist said...

Jon, the similarity may be due to the fact that I have taught finance in a university myself. If people who specialise in studying finance (who are, in my experience, rarely left-wing) tend to reach the same conclusion on a financial question, it might be that this is the most reasonable conclusion.

RebelEconomist said...


Thanks for referring me to that undoubtedly relevant directive; they seem to get longer the later they were written, don't they? Are you sure though that you don't mean Article 22 (covering the "Power of the competent authorities of the host Member State"), paragraph 8, of Directive 2000/12/EC? That is, "Host Member States may exercise the powers conferred on them under this Directive by taking appropriate measures to prevent or to punish irregularities committed within their territories. This shall include the possibility of preventing institutions from initiating further transactions within their territories."

I guess Landsbanki would have protested that they were not doing anything "irregular" or as you put it, committing any "crime", especially in Britain and the Netherlands, where Icesave was essentially just raising funding for Landsbanki. And, if the FSA did not back off, sue the FSA for "restraint of trade", or something like that.

When I was a central banker, I resisted all attempts to make me a bank supervisor – it's a thankless task!

Björn Jónasson said...

Rebel Economist. Thank you for correcting me.

The spirit of the 2000/12/EC is consumer protection. (Learned articles have been written about this by amongst others, French economist Alain Liebitz.)

Normally the British do not feign at the task of protecting their citizens against foreign threat. Why this sudden timidity?

Your treatment of the Equitable Life case was disappointing, especially the analogy between people´s life-savings of potentially hundreds of thousands of pounds and the Farepak Christmas debacle on the other hand where people lost a couple of hundred pounds.

Another thing: The next problem for the UK is its own bail-out. As you may be aware of, a law was passed in the autumn 2007, which allowed the BoE to lend to financial institution (in the UK, mind you, no discrimination there?) without disclosure. This means that nobody in the UK, including the press knows the extent of the exposure. Anybody worried about that? This is potentially a bigger problem for the British taxpayer than the Icesave case.

Anonymous said...

Thank you for a good analysis. There is one vital point missing though. The so called Emergency Legislation (nr. 125 7. October 2008) makes deposits have priority above all other claims. The winding up board of Landsbanki states that the recovery rate for priority claims will be 89%. The Emergency Legislation is being contested in courts and there will be years until courts will decide whether it does or does not go against the constitution. The Landsbanki winding up board has stated it will not pay into any of the IceSave claims until this has been resolved which is one of the reasons there will be no payments of the IceSave debt for several years. However, the main point is that if the court rules that this part of the Emergency Legislation is unconstitutional, the recovery rate will be much less. Eva Joly, which assists in the criminal investigations started in the wake of the collapse, has stated the recovery rate will be 30% if this happens.

It will also have a much wider impact, since non-insured claimants (like counties, hospitals and others) are currently getting much more of their claims recovered than they would if this Emergency Legislation had not been approved.

This is also the case with the other two banks.

If this would happen (the law being ruled unconstitutional), the payout process would have to be rolled back, which I don't have the imagination to have an idea how to implement. The total claims to the Icelandic government would rise substantially, probably to unsustainable levels.

So there is great risk involved in taking on the IceSave debt, much more than discussed. This is a critical point that must be taken into account.

Anonymous said...

An addition to my previous comment: Please note the "Emergency Legislation" was passed the night before Landsbanki was taken over. Needless to say, changing the order of claim priority the night before bankruptcy is highly dubious and likely to be ruled unlawful.

Björn Jónasson said...

Who can rule "emergency law" unlawful?

FF said...

One difficulty that I have as an interested outsider is understanding what would unlock the deal for Icelanders. I assume most Icelanders want a deal, if only to move on from Icesave, renew credit and credibility and start rebuilding their economy. But what’s the deal-breaker that currently preventing this happening?

Icelanders appear to have three main objections to the Icesave loan: 1) they have no legal obligation to compensate Icesave depositors in the UK and the Netherlands; 2) the interest rates are too high; 3) the debt is too big a burden for a small country, they never signed up for anything like this and it would be more reasonable for the larger countries to take it on instead.

Although government officials and others mainly point to the interest rate as the issue, I suspect this isn’t the crux of the matter, because it would be pretty straightforward to sort out. With any pricing negotiations you haggle, sit down over the mint tea and come to a price that both parties can live with in the interest of getting a deal. So there looks to be a residual issue of legal obligation or affordability that’s holding Iceland back from agreeing the loan. In a sense they are similar: Icelanders are reluctant to do deal because they don’t see why they should.

In principle, the legal issue is also easy to sort out: you go to an agreed court and get a judgment. In my previous comment I have explained one reason why I don’t think Iceland is actively pursuing this course in spite of complaints about British and Dutch reluctance to do the same. But there is another point to make. The Icelandic party requested a legal opinion at the start of the negotiations over the Icesave loan. The selected panel of experts came back with an assessment that emphatically asserted Iceland’s obligation to compensate Icesave depositors in full - Now, a panel experts isn’t the same as a court of law, but we have to accept a high probability that the competent court would come to the same conclusion. In this case, would Icelanders say, “Fair enough, that’s my issue dealt with. Let’s pay what’s due”? Or would they say it’s just an anti-Iceland plot?

(For the absence of doubt, if the court decides that Iceland has no legal obligation, that’s the end of the matter as far as I am concerned. The British and the Dutch governments voluntarily compensated depositors in their countries and can try to claim as much as they can from residual Landsbanki assets – in this hypothetical case it has nothing to do with the Icelandic government).

Which leads onto the final question. Does Iceland have a moral obligation to pay on the assumption that the treaty (Directive 94/19) says that they should or is the scale of the debt so large that it should be let off all or part of it? The important point to make here is that Iceland genuinely has a choice: no-one can force it to pay for the Icesave guarantees if it doesn’t want to. Equally, it should expect negative consequences if it chooses not to (and by the way don’t blame Britain and Holland over these consequences – they have relatively little leverage over whether other countries and organisations extend credit to Iceland). So Iceland would need to trade off the cost of fulfilling the legal obligation against the damage of not doing so. I suspect, as RebelEconomist indicates, that the cost is less but the damage is more than some Icelanders assume.

FF said...

Finally, should Britain and the Netherlands unilaterally reduce the burden on Iceland because of shared responsibility or because these countries are bigger than Iceland? Up to now, we have discussed everything from an Icelandic perspective, but here we need to introduce a UK/Dutch angle – something I’m conscious of as a UK taxpayer. The responsibility question is dealt with by the legal situation, which is assumed to be that Iceland is responsible for the first €20 877 and UK/Netherlands for the rest.. Regulation for Icesave was the sole responsibility of the Icelandic authorities – there is no shared responsibility. In terms of scale, I don’t think the UK or the Netherlands should in the first instance take on the Icelandic burden because a) it’s Iceland’s responsibility, not ours (Heaven knows, we have plenty of our own bank messes to deal with, not least Kaupthing, Singer and Friedlander, the UK subsidiary of another Icelandic bank) b) if it’s not taken by Icelandic taxpayers, the burden falls on UK and Dutch taxpayers instead. Upto now and quite possibly in the future too, Icelanders have been wealthier than Britons and the Dutch. It would be inequitable for poorer taxpayers to take on a burden that formally belongs to people who are richer; c) we don’t know what the burden will be yet and how much will be refunded through Landsbanki assets. If at the end of all of this, the burden is genuinely unaffordable for Icelanders, we may need to think again. But the case has to be made with concrete figures.

Anonymous said...

Björn: It is the Supreme Court of Iceland.

Bromley86 said...

"The directive states that deposits can be refunded in the currency of the home country, or in IKR."

I don't think that this is the case.

The Icelandic law does say that ISK can be used, but sets their convertability so that they're worth 20,887 euros:
"This amount shall be linked to the EUR exchange rate of 5 January 1999"

I couldn't see any mention of local currencies in 94/19/EC. Just minimum 20,000 ECU.

Andri Haraldsson said...

I think FF hits on what I (implicitly I suppose) see as the only thing that really matters at this point: how can this dispute be settled, given where it has landed. I have some insights here as an Icelander, although I have lived in the US for 20 years and thus am not in Iceland to gauge things first hand.

My previous comments allude to the challenges. Iceland is very small and despite claiming to be the bastion of modern democracy has really never been very democratic. First it was governed by clans, then foreign kings and their local henchmen. Finally as happened with many freed former colonial countries, once Iceland gained independence it came to be ruled by a small elite that put itself in charge and siphoned off much of the wealth creation. The stunt the Icelandic president played with the referendum was really just tapping into the deep-seated resentment the average Icelander feels towards this Mandarin class after the collapse.

As RebelEconomist pointed out, it is also difficult to maintain a very high level of sophistication in every branch of government/civic life, with only 300.000 people. One of the traits that characterizes Icelanders is that they are by-and-large, the self-reliant jack-of-all-trades types. Good thing too, since everyone seems to have multiple job functions. The downside to this, though, is lack of respect for true expertise. So it’s quite common to see even people in position of authority put on equal basis the ramblings of some TV talking-head who spent 5 minutes on Wikipedia reading up on things, and the measured and sophisticated analysis of someone who has spent a lifetime gaining insight into an issue.
Combine this with everyone being everyone’s second cousin, and you have a civil discourse that is neither. So all across the Icelandic blogosphere and newspapers, you can see that a very large share of the commentators are not trying to make sense of what is in Iceland's best interest, but rather they are caught in an emotional brawl, which very quickly descends into some mistaken notions of what constitutes national pride.

And this is only the first of the problems. On the political side, the president’s gambit has produced a major constitutional crisis that in effect leaves it wholly in doubt that the Icesave crises can be concluded without the direct involvement and acquiescence of a nominally powerless president who is trying to ride a wave of resentment in an effort to salvage his legacy. His involvement is necessitated as there it is practically inconceivable that any Icesave accord will be passed in a national referendum. (Note my comments about the resentment against the establishment above.)

Indeed more than half of all people in Iceland feel they should not pay anything—and it’s in large part because they feel let down by all of their leaders. So the net result is that the parliament has to pass a new agreement AND it has to convince the president to sign it. Understanding this, the British/Dutch governments demanded any further negotiation would be done with all parties in parliament. This is understandable but unworkable. For this approach to work it relies on the good intentions of all parties. This seems naïve, as the two former ruling parties have no particular incentive to see any deal struck, as this would simply ensure the government they are not party to will serve another 3 years. Moreover, they are now maneuvering to be seen to be on ‘the side of the people’ in all of this.

This is why I have little hope for a resolution. Churchill’s admonition “[the] United States invariably does the right thing, after having exhausted every other alternative” is probably applicable. The difference of course is that Iceland cannot afford this approach, and if it tries, it may not in the end afford to pay Icesave at all.

RebelEconomist said...

Thanks for all your comments. I had not lost interest; it turned out that I had been optimistic to believe that my laptop problems were over.

Bjorn on 10 March 2010 at 14.04:
Equitable Life, Bank of England lending? Bjorn, I get the impression that you are trying to dig up dirt to throw at Britain. In the case of BoE lending, I would expect details of both the loans and their collateral to be commercially confidential – if a bank's large exposures are known, the bank is liable to be quoted worse terms for unwinding them. This confidentiality is standard central banking practice; for the same reason, the Fed is resisting a Freedom of Information request to disclose details of its emergency lending activities. Given the security provided by the collateral, the BoE, and by implication the UK public sector, should be largely protected against credit loss, so I think Britain has bigger worries at the moment. I cannot defend our conduct in the crusades or the slave trade though!

Anonymous on 10 March 2010 at 15.21 and 15.30:
It did strike me that the projected recovery rate for Landsbanki deposits was high – I was involved in some risk management work a few years ago that assumed a recovery rate for bank deposits of 50%. Do you know what the other Landsbanki liabilities are that would rise up the creditor hierarchy if deposits were not given priority? Bonds maybe? If rescinding priority for deposits would lower the recovery rate for deposits to 30%, there must be a lot of these other liabilities. I do agree that passing a law to fix the creditor hierarchy when it was known that the bank was about to fail has to be highly dubious.

FF on 10 March 2010 at 16.46:
I was not aware of the existence of that document (ie the one on the Channel Four news website); thanks for the reference. I agree that, even though Britain and the Netherlands may feel that taking the matter to court effectively forces them to win the argument twice, if Iceland promises to abide by the ruling, it might be a chance worth taking to resolve the dispute.

Even if Icelandic law does allow the deposit guarantee to be paid in ISK, since the TIF expresses (eg at the link given in the post) the guarantee in euros, I do not think that it would be fair to insist on paying in ISK, especially if the payment is fixed using a disadvantageous exchange rate. I dare say that a serious attempt to interpret the guarantee in such a creative way would scare many of Icelanders' potential business counterparties. Maybe Iceland could offer a choice of some proportion in ISK, which might be acceptable if Britain or the Netherlands are willing to hold some ISK for investment purposes, or some Icelandic asset, such as a site for a naval base or a scientific research station.

Andri on 11 March 2010 at 07.57:
Your thoughtful if pessimistic comment brought to mind a couple of ways that Iceland could spread the burden of repaying the British and Dutch: seek contributions from the Icelandic diaspora, and encourage immigration to enlarge Iceland's population (not to mention its gene pool)!

Anonymous said...


To the best of my knowledge, bonds would have equal priority to deposits.

There were other branches of Icelandic banks which held deposits. One example is Kaupthing Edge in Germany. It was a branch of the Icelandic Kaupthing. They were able to recover all deposits. But how? The reason is the Emergency Legislation.

What happens if it is ruled unconstitutional? The claimants which are not depositors will have to be paid back according to the original legislation. How will that be implemented?

I don't think non-insured British, Dutch or German depositors (like councils, counties, hospitals and charities) would be happy to pay back what they had recovered.

This is the biggest risk facing Iceland right now, and one that will continue to exist for many years to come.

Andri Haraldsson said...


I think the Icelandic diaspora could possibly help with the repayment--but first there has to be a deal. I for one will help both through remittances and through attempts to bring business to Iceland. But the diaspora of the past 50-100 years is also not large as Iceland has not had as much brain-drain as many smaller countries; and the great migrations to the US in the 1800 may not have sufficiently direct linkage to Iceland by now.

A bigger way the diaspora could help would be through participation in much needed constitutional reform that might break up dysfunctional power struggles. However, there appears to be little interest in this participation on behalf of people living in Iceland, and often regarded as meddling.

On your second point, of increased population. It actually flows the other way. Most of Iceland's foreign currency income is created by a very small proportion of the population, even when counting supporting industries. I'm not sure of the exact percentages, but upwards of 2/3s of all foreign currency is generated by fisheries and a few aluminum smelters. And Iceland is a Scandinavian welfare society with a large public sector. Consequently Iceland might actually benefit financially in the short term from the 'right kind' of depopulation.

But despite my pessimism for a deal in the near term, I have not doubt that if Iceland got out of it's own way and finalized the Icesave agreements soon, it would survive this fine. My despondence stems from seeing that the windows of opportunity may be closing with no solution in sight.

halldor said...

An interesting twist in this semi dormant saga.

The EFTA Surveillance Authority (ESA) recently (May 26th) made public a letter of formal notice sent to the Icelandic Authorities (see )

The letter basically states that Iceland is obliged to pay, and it rebuts in some detail the Icelandic position that:
a) there is no state backing for a fund since setting up a guarantee scheme is enough to fulfill obligations under the Directive,
b) the Directive does not apply when deposits are unavailable due to a major and general banking crisis.

With regards to point a) ESA effectively says that a fund that is not properly financed cannot be regarded as having met the directive requirements:

"If the obligation outlined above has not been achieved or cannot be achieved by the schemes established pursuant to the Directive, depositors are not compensated or protected by it. Consequently, the exoneration of liability does not come into play."

With regards to the second point, they review court rulings and conclude that " Consequently, exceptional circumstances do not release the Icelandic Government from its responsibility".

Furthermore, they raise the discrimination issue, and find that "the Icelandic authorities cannot advance any viable justification for the discriminatory measures taken against the foreign deposits in the circumstances of this case"

Interesting, enough the ESA letter which as a "letter of formal notice is the first stage in infringement proceedings" could lead to the issue ending up in the Court of Justice.

And as usual both sides claim victory. Those that want to take the issue to court, ignore the fact that the ruling goes completely against them and happily assert that the ruling supports the Icelandic contention that this should go to court.

And the Dutch simply say that the ESA letter agrees with their position that Iceland is obliged to pay.

Meanwhile negotiations are moving at a snails pace...

RebelEconomist said...

Thanks for your informative comment with its useful link, halldor. I am gratified to see that the EFTA Surveillance Authority finds that EEA law supports what I consider to be the moral obligation on the (State of) Iceland to meet the cost of the minimum compensation paid to British and Dutch Icesave depositors. I was also interested to note in April the publication of the Icelandic Special Investigation Commission (SIC) report into the collapse of the Icelandic banks ( ), which (judging by the English translation) described the flaws in Iceland's business culture and financial supervision that contributed to the debacle, and revealed more about the difficulties that the Icelandic banks' UK and Netherlands operations posed for the British and Dutch supervisory authorities. The objectivity of the SIC report is a credit to Iceland's present authorities, and goes some way to restoring the reputation for trustworthiness and reliability that Iceland once had in the UK, and which Icesave exploited (Ch 18, page 5 of the SIC report).

Whether Iceland has the means or will to pay the British and Dutch is another question, but I suppose that failure to pay a legally valid liability would constitute default.

Anonymous said...

Load of crap.

There is a common assumption in some circles in London City that the Government of Westminster will bail them out.

But that is a rare exception not extending far beyond the City and perhaps only heard of in Westminster government quarters.

Else where in the wide world banking is a private enterprise conducted by businessmen - not civil servants of the socialist state.