June 2011 "Crisis Busters: From Marx to Krugman" Case Study A look into the Iceland Crisis The study is an account of the Icelandic response to the 2008 financial crisis. Drawing on official and bank sources, an account is made of the methods used in bailing-out the major Icelandic banks, the response to the subsequent sovereign debt crisis, and the resulting post-crisis regulatory framework. Because 2008-2010 was a highly volatile time throughout the OECD which saw the failure of many banks across the world as the global financial system came under extreme stress, a closer look should be taken into Iceland’s policy responses to the crisis. Because of Iceland’s size in relation to its banks, the lessons drawn are highly relevant with respect to the “Too-Big-to-Fail” (TBTF) problem. Essentially, Iceland’s banks – which would have been TBTF in a larger country – were “Too-Big-to- Bail” Icelandic standards. Nevertheless, Iceland carried out a successful bailout from which smaller forms of the primary national banks emerged with the financial support of the financial stakeholders of the previous primary banks. As a result of Iceland’s actions, its banking sector is no longer too big to rescue. This paper has financial policy implications for both how small nations should handle large financial crises and for the financial crisis policy in the EU. Andre Kolodziejak Maxens Berre
Transcript
June 2011
"Crisis Busters: From Marx to Krugman"
Case Study
A look into the Iceland Crisis
The study is an account of the Icelandic response to the 2008 financial crisis. Drawing on official and
bank sources, an account is made of the methods used in bailing-out the major Icelandic banks, the
response to the subsequent sovereign debt crisis, and the resulting post-crisis regulatory framework.
Because 2008-2010 was a highly volatile time throughout the OECD which saw the failure of many
banks across the world as the global financial system came under extreme stress, a closer look should
be taken into Iceland’s policy responses to the crisis. Because of Iceland’s size in relation to its banks,
the lessons drawn are highly relevant with respect to the “Too-Big-to-Fail” (TBTF) problem.
Essentially, Iceland’s banks – which would have been TBTF in a larger country – were “Too-Big-to-
Bail” Icelandic standards. Nevertheless, Iceland carried out a successful bailout from which smaller
forms of the primary national banks emerged with the financial support of the financial stakeholders
of the previous primary banks. As a result of Iceland’s actions, its banking sector is no longer too big
to rescue. This paper has financial policy implications for both how small nations should handle large
financial crises and for the financial crisis policy in the EU.
Andre Kolodziejak
Maxens Berre
1
1: Introduction
In early October 2008, Kaupthing, Landsbanki, and Glitnir -Iceland’s three major international banks- collapsed. All three banks encountered difficulties refinancing their short-term debt and subsequently suffered a run on their deposits.1 This short-term debt was drawn largely from international markets.
Kaupthing, the largest of Iceland’s three major banks had a 2007 asset value of €58.34 Billion.2 Landsbanki, the second largest of the country’s major international banks had a 2007 asset value of €33.4 Billion3. By comparison, Iceland’s GDP figure for 2007 stood at €8.5 Billion.4
As the events began to unfold, Iceland’s parliament, The Althing, enacted “The Emergency Act”
(Icelandic Law No 125/2008) on October 6, 2008, allowing Iceland’s Financial Services Authority
(FME) to intervene in the operations of, or to nationalize the Icelandic banks.5 Within three days, the
FME had taken control of all three major banks, appointing resolution committees to assume the
powers of bank directors and shareholders, while financial regulatory authorities across Europe had
begun assuming control of deposits and liabilities in overseas branches of Kaupthing and Landsbanki
(Kaupthing Edge and Icesave).
What followed was the splitting of the three banks into smaller domestic banks which were kept
solvent by means of state intervention and bad banks, in which foreign liabilities were housed.
Ultimately the effects of the Icelandic crisis were a 5.5% drop in Icelandic GDP, a 90% reduction in
the market capitalization of the Icelandic Stock Exchange, and the dramatic and permanent reduction
of the Icelandic banking sector.
Within the EU the repercussions of the Icelandic banking crisis were felt by depositors and debt-
holders across the region. While the internet-based arm of Landsbanki had nearly €7 Billion of
deposits owned Dutch and British depositors, Kaupthing and Glitnir had subsidiaries across
Scandinavia, Switzerland and the EU.
The Icelandic response to the financial crisis was one of guaranteeing continuation of domestic
banking services via the erection of new domestic banks, transferring overseas assets the new banks,
and the subsequent abandonment of some overseas depositors and debt-holders, while other
overseas claimants were compensated with equity of the new domestic banks.
While the intervention of FME and the Icelandic state served to restore and recapitalize domestic
banking services in Iceland, foreign branches and subsidiaries of Kaupthing and Glitnir were left to
their respective fates, while the collapse of Landsbanki left Icesave’s overseas depositors to their
own devices. In some subsidiaries, depositors were compensated by the state-appointed resolution
committees. Other subsidiaries experienced intervention by local governments in the countries
where they operated. In some cases, other private also banks assumed responsibility for local
liabilities. The Icelandic response also included the compensation of foreign claims on the failed
1 EFTA Surveillance Authority, 2011
2 Kaupthing, 2008
3 Landsbanki, 2008 4 Statistics Iceland, 2008
5 Mishcon de Reya, 2009
2
banks with equity to the new banks in order to secure both continuity of investment and the
alignment of interests.
Overall, while such a policy response was quite effective vis-à-vis the Icelandic national interest, it
might be considered by some to be disruptive of international financial trade outside its own
borders. For this reason, better regulatory coordination is necessary between the EU, its member
nations, and its trading partners. Indeed, Iceland’s response was vigorously protested by both the UK
and the Netherlands. This case should also be indicative that special regulatory attention should be
given to the too-big-to fail issue.
The remainder of this case study is organized as follows: The next section provides an account of the
regulatory and market environment prior to the Icelandic financial crisis. Account is provided of both
the state of affairs on the eve of the crisis, as well as the buildup to the Icelandic financial crisis.
Section three draws on policy documents and policy sources in order to provide an account of
Iceland’s response to the financial crisis. Section four examines the response of Icelandic authorities
to the crisis. Section five meanwhile, analyses the aftermath of the Icelandic financial crisis. Attention
is paid to both the domestic consequences of the crisis and the fallout of the crisis across the EU and
EFTA countries. The final section provides conclusion and policy analysis.
2: Background: What Happened in Iceland Prior to the Financial Collapse?
The story the Icelandic financial crisis, which unfolded in late 2008 in fact, had its roots elsewhere,
across a variety of places and times. The EFTA Surveillance Authority’s investigation of the systemic
crisis identifies both financial-sector-wide sources of financial instability and regulatory weaknesses
due to the regulatory environment both at home and in the EU. Meanwhile, the 2010 Icelandic
Parliamentary report on the crisis found that, whatever the underlying background causes, the
explanation of the bank-sector collapse is linked primarily to the sustained radical growth of the
balance sheets of Kaupthing, Landsbanki, and Glitnir.
Prior to 2000, the banking sector in Iceland was mostly state-owned in Iceland was largely state-
owned and domestic in nature. The combined financial position of the three main Icelandic banks at
that time was roughly equivalent to Iceland’s GDP.6
However, in late 2003 the privatization of the state-run banks was finalized. That year Kaupthing
merged with Bunadarbanki, becoming the largest bank in the country. 2003-2004 also saw the
overseas expansion of all three major Icelandic banks. Subsequently, the size of the three private-
sector Icelandic banks grew dramatically over a short period of time.
The Microprudential Environment
Beginning in 2004, growth in lending by the main Icelandic banks’ parent companies grew 50% per
year on average. Both organic growth and external growth were dramatic during this period. The
findings of the Icelandic Parliamentay Report on the crisis are that the radical organic growth of the
banks’ financial positions led to a dramatic decrease in asset (loan) quality, which contributed heavily
6 Althingi, 2010
3
to the banks’ subsequent collapse, while the dramatic external growth of the main Icelandic banks
caused the banks to overpay for the acquisition of externally-acquired assets. Table 1 outlines the
organic and external growth of the three main Icelandic banks in the years immediately prior to the
crisis.
Table 1: Organic and external growth of Glitnir, Kaupthing, and Landsbanki
Ultimately, both loan quality and conflicts of interest also proved to be problematic for the Icelandic
banks. The 2010 Icelandic parliamentary report on the financial crisis outlines theoretical relating to a
possible connection between the radical organic growth of the main Icelandic banks’ balance sheets
and the reduction of asset quality as a result of reckless expansionism. 7
In fact, the situation of asset quality was somewhat more severe than the theorized regulatory
concern. One month prior to the collapse of the three banks, internal documents from Kaupthing
documenting improper lending practices were acquired by Wikileaks. Kaupthing had made and
subsequently written-off large loans to 205 major shareholding entities in amounts at or in excess of
€45 Million.8 Kaupthing’s lawyers responded with legal threats relating to Kaupthing’s rights to
privacy. 9
Landsbanki and Glitnir were also found to have conflicts of interest in their loan books.
In 2007, Baugur Group and FL Group significantly increased their holdings in Glitnir Bank.
Subsequently, a new board took over the bank in the spring of 2007. Later that year, Glitnir’s loans
(as well as those of Glitnir’s parent company) to Baugur and FL (and related companies) spiked
dramatically, increasing from €900 Million in the spring of 2007 to €2 Billion in spring of the following
year.10 Underlying this increase in loans was the fact that Baugur’s equity share in Glitnir bank was
more than 80% at its peak, just prior to the Icelandic financial crisis. The investment company Fons hf
shared a similar relationship with Glitnir Bank and also suddenly received a high proportion of
Glitnir’s loans.11
7 Althingi, 2010
8 Wikileaks 2009
9 Ibid 10
Althingi, 2010 11 Ibid
4
Baugur Group also received large loans in late 2007 from Kaupthing and Landsbanki. In fact, the
group received a subordinated loan from all three banks in the amount of 25 Billion ISK (of which, 15
Billion ISK was provided by Glitnir Bank, while Kaupthing and Landsbanki each provided 5 Billion
ISK).12
At Landsbanki, Samson Holding Company was the bank’s biggest shareholder prior to the crisis. The
relationship can be traced to Landsbanki’s privatization. Two principal shareholders of Samson,
Björgólfur Guðmundsson and Björgólfur Thor Björgólfsson, subsequently were recipients of 23% of
Landsbanki Luxembourg’s loans13.
Overall, the Icelandic Parliamentary Report came to the conclusion that independence of the
Icelandic banks from their parent companies was sorely lacking. This was found to have seriously
interfered with prudential management of said banks.
In retrospect, it would appear that microprudential standards and oversight was wholly absent from
the lending and portfolio management practices of Iceland’s three largest banks. This is particularly
shocking given the high-risk systemic environment in which these banks were operating.
Incentive Schemes
According to the Althing Report, this extreme level of risk-taking was ultimately incentivized by the
compensation schemes at the three banks, which set unrealistically high return targets, while
facilitating loans to employees and owners of the bank. Furthermore, the role of short-term profits
was overemphasized by the banks’ incentive schemes.
In all three banks, remuneration in shares, options and bonuses increased dramatically after 2000.
While the Icelandic Parliamentary Report on the crisis examines this aspect of the crisis at length, it is
sufficient (for the purposes of this study) to summarize that the incentive schemes were found by the
Althing to be a failure in as far as that they encouraged reckless and imprudent behavior by the
management of all three of Iceland’s main banks in the run-up to the crisis, despite the fact that the
environment in which they were operating was becoming increasingly risky and uncertain.
The Macroprudential Environment
The macro-environment in which Glitnir, Landsbanki, and Kaupthing operated in became dramatically riskier and more unstable as these banks grew in the early-mid 2000’s. Essentially, the three banks, encouraged by reckless financial policy both at home and across Europe, grew too large for the size of Iceland’s economy. Nevertheless, precious little was done about it by either Iceland or the other economies in which the three banks operated.
12
Ibid 13 Ibid
5
The balance sheets of the main private-sector banks also grew to be several times the size of Iceland’s GDP during the 2003-2007 period. 14 Figure 1 outlines the growth of the Icelandic banking sector vis-à-vis the country’s GDP during the pre-crisis period.
Figure 1: Banks’ Assets and Leverage15
Liquidity meanwhile was quite weak. Figure 2 outlines liquid asset ratios of several of the world’s
major banking economies. What Iceland and Ireland have in common is low liquid asset ratios vis-à-
vis their short-term borrowing. In both Hong Kong and Singapore, the opposite is the case. Therefore,
not only was leverage unsustainably high, but liquidity was also dangerously low.
Figure 2: Iceland’s Liquid Assets and Short-Term Borrowing as a Percentage of Total Liabilities16
14 Althingi, 2010 15
CBI, 2009 16 CBI, 2009
6
Additionally, the European Economic Area’s “European Passport” system allowed the newly
consolidated and privatized banks unfettered access to European credit and financial markets.17
Under this passport system, unrestricted access to the EU market is granted to EEA member nations
without having to join the European Union. The easy access to foreign credit was further reinforced
by the AAA rating given to both Iceland and the three major banks. The logic underlying the AAA
ratings of the three main banks was that they were safe debtors because they were too-big-to-fail
given their asset sizes vis-à-vis Iceland’s economy and would therefore be guaranteed by the
Icelandic state. As a result, the overseas branches of Glitnir and Kaupthing, as well as Icesave’s
internet banking accounts could be operated in Europe while under supervision from Reykjavik.
On the eve of the Icelandic financial crisis, 80% of the country’s €50 Billion total external debt was
held by the financial sector.18 In 2007, due to the launching of Icesave accounts the previous year,
the foreign-owned share of Landbanki’s deposits was over 50% of total deposits.
As the banks grew, it became clear to European authorities that Iceland’s budgetary capability was
too small to provide deposit insurance to savers in Icelandic banks and that the Central Bank of
Iceland lacked sufficient reserves to act as a lender of last resort in the event of a bank run or
liquidity crisis.19 By late 2007, the nation’s short-term debts were fifteen times larger than the foreign
exchange reserves of the CBI.
Exacerbating the situation was that fact that two-thirds of the balance sheets of the main Icelandic
banks were dominated in foreign currency. This served to further undermine the CBI’s credibility as
the lender of last resort. While the Icelandic central bank has the capacity to dramatically expand its
balance sheet in the short-run in order to engage in sudden and radical monetary action on the
domestic front, sudden monetary action concerning a bank with foreign-currency-denominated
assets would require either international cooperation, or large-scale access for foreign currency and
foreign-currency-denominated assets.20
Truly, these banks had grown too large to be rescued and too dependent on international markets in
order to maintain sustainability. In the context of an economy of Iceland’s scale, the three main
banks did not simply become too big to fail. Rather, they grew so large relative to Iceland’s GDP that
they became too big to rescue in the face of even idiosyncratic volatility. Furthermore, they did so
while having insufficient liquidity levels and unsustainable financial practices. Clearly, Iceland’s
banking sector was not well positioned for a financial downturn of any kind.
Unfortunately, a major cyclical downturn was not far-off. By early 2008, several official sources
including the International Monetary Fund and Iceland’s Ministry of Finance were forecasting that a
recession was just on the horizon21. The CBI’s numbers however were slightly more optimistic.22 The
underlying cause of the doomsday predictions was the country’s ballooning external debt caused by
Iceland’s banks. Figure three outlines the IMF’s GDP forecast attached to the Iceland Article IV
consultation undertaken in the summer of 2008, just prior to Iceland’s financial crisis. The IMF
17 Gudmundsson, 2011 18
CBI, 2009 19
House of Commons, 2009 20 Gudmundsson, 2011 21
IMF, 2008 22 Gudmundsson, 2011
7
predicted that economic growth would be zero that year, due to the negative impact of the financial
sector. The IMF (along with most official sources) predicted a recession thereafter.
Figure 3: Article IV GDP Growth Projections for Iceland23
3: The Collapse: What Happened? What were the Effects?
Across the world, financial institutions began to experience severe difficulties refinancing short-term
debt. On September 15, 2008 Lehman Brothers filed for bankruptcy, thereby initiating global panic
and stress on financial markets.
Shortly thereafter, problems began to unfold in Iceland. Seeing that its banks were in trouble, the
government attempted to rescue Glitnir Bank on September 29, 2008 by announcing a plan to inject
€ 600 million into the bank in exchange for 75% of its shares. Unfortunately, this did little to reassure
investors. The share prices of the three Icelandic banks collapsed and credit ratings were
downgraded. The total lack of confidence in the repayment ability of the other two Icelandic banks
initiated dramatic bank runs with severe liquidity problems as a consequence. On October 6, 2008,
the private interbank market cut credit facilities to Icelandic banks.
Unfortunately, disorderly and hostile cross border crisis management played a critical role in actually
setting-off the crisis in Iceland.24
In response to the access problems to the interbank market, the Icelandic government granted
Kaupthing a €500 million loan against collateral in Kaupthing’s Danish subsidiary, FIH Erhvervsbanken
on October 6th. However, the loan agreement included a clause whereby Kaupthing would enter
default in the event of default of one of the bank’s large subsidiaries defaulted.
Nevertheless, on October 8, 2008 Kaupthing’s UK subsidiary Kaupthing, Singer, and Friedlander (KSF)
was judged to be in a state default for the purposes of the UK’s Financial Services Compensation
Scheme. The assets and liabilities of KSF were subsequently frozen and transferred to ING. This move
put Iceland’s largest bank in default.
23
IMF, 2008 24 Gudmundsson, 2011
8
4: Crisis Management: What was Icelandic Response?
Overall, the Icelandic governmental response to the emergence of the crisis was strongly-focused on
the maintenance and smooth-transition of domestic banking services. While the Icelandic state did
not have sufficient budget, GDP or currency reserves to guarantee the overseas operations of the
country’s three main banks.
In view of the scale of the systemic collapse in comparison to the resources at the Icelandic
government’s disposal, and the lack of information available at the time of taking control of the
banks, it would not have been prudent to attempt to fully restructure the financial system at that
stage. As such, a forced split to maintain domestic banking services while scaling down the size of the
Icelandic banking system was considered most prudent.
Plans were then made to nationalize, rescue, and recapitalize all three banks by:
1. Placing a resolution committee in charge of the assets and liabilities of each,
2. Replacing their operations with smaller domestic banks,
3. Capitalizing the smaller banks with assets from the large failed banks,
4. Engaging in a debt-for-equity swap whereby claimants against the three newly failed banks
would be compensated by shares of the new domestic banks, which they would then have to
5. Capitalize with the remaining assets from the large failed banks.
The Emergency Act
On October 6, 2008, The Althing enacted Icelandic Law No 125/2008. Known informally as “The
Emergency Act” and formally as The Law on Authority for Treasury Disbursements due to Unusual
Financial Market Circumstances allows Iceland’s Financial Services Authority to intervene in the
operations of, or to nationalize the Icelandic banks during times of crisis or in cases of default.
In addition, this law allows for the state to appoint as well as remove members of the board of
financial institutions who have come into financial difficulties and decide on the disposal of their
assets and liabilities. Deposits are also given priority over other unsecured claims by this act.25
Critically, the Emergency Act also authorizes the Icelandic Ministry of Finance to establish new banks. In the three days following the establishment of the Emergency Act, Kaupthing, Glitnir, and Landsbanki were all nationalized. Their boards of directors were replaced with resolutions and new banks were established in order to handle domestic banking activities.
Glitnir
Glitnir was the first bank to be saved. The Icelandic government’s plan to nationalize Glitnir by
injecting €600 Million into the bank in exchange for 75% of its equity, which was originally proposed
25 Gudmundsson, 2011
9
on September 27, was ultimately implemented on October 7, after a solid legal basis for the
nationalization was legislated.
On October 21, 2008 the Norwegian subsidiary of Glitnir was sold for 300 Million NOK (€ 33 Million)
to a coalition of 20 savings banks. Sparebanken Midt-Norge acquired a 25% stake in the Norwegian
subsidiary. The bank was renamed BN Bank on January 1, 2009.
On October 15 2008, the FME founded New Glitnir (later renamed Islandsbanki) to take over the
domestic assets, domestic deposit liabilities and operations of Glitnir. In July of 2011, the Icelandic
government announced its bank recapitalization plan. Islandsbanki was recapitalized with 60 billion
ISK. As a result of the bank recapitalization plan, Glitnir’s shareholders were ultimately given 100%
ownership of Islandsbanki.
Landsbanki
Landsbanki was nationalized on October 7, 2008 alongside Glitnir Bank.
The following day, Landsbaki’s UK assets, liabilities, and operations were frozen under the auspices of
the UK’s Anti-terrorism, Crime and Security Act of 2001. This included Landsbanki’s two UK-based
subsidiaries as well as UK-based internet bank accounts of Landsbanki’s internet bankin arm, Icesave.
That same day, the UK Chancellor of the Exchequer announced that the UK would bail-out British
Icesave depositors at a total cost of ₤4 Billion. Landsbanki Luxembourg was placed under local state
administration.
Thereafter, the FME erected New Landsbanki (later renamed Landsbankinn). On October 9, 2008, the
Icelandic assets and liabilities of Landsbanki were transferred to New Landsbanki. Because
Landsbanki, had acquired many domestic assets by using foreign liabilities (both loans and deposits),
New Landsbanki’s assets exceeded liabilities by a massive 558 Billion ISK.
In July of 2011, the Icelandic government announced its bank recapitalization plan. New Landsbanki,
was to receive 140 Billion ISK from the Icelandic state. This amounted to slightly more than the
recapitalization granted to both New Kaupthing and New Glitnir combined. Furthermore, New
Landsbanki was to remain in government ownership. The bank was to issue bonds as part of the
recapitalization plan.
Ultimately, New Landsbanki was recapitalized with 122 Billion ISK. In exchange, the Icelandic Ministry
of Finance kept an 81% stake in New Landsbanki’s equity. Creditors in ownership of the now defunct
Landsbanki were compensated with a 19% stake in New Landsbanki, as well as a 10-year debt
instrument worth 260 Billion ISK.
The claims against the now defunct Landsbanki were resolved primarily by means Landsbanki’s
resolution committee. Claims against Landsbanki’s UK branches and Landsbanki’s UK- based
subsidiary Heritable Bank were resolved in 2010 by Landsbanki’s resolution committee.
In July of 2010, an agreement was reached between Landsbanki’s resolution committee, the
creditors of Landsbanki Luxembourg, and the Central Bank of Luxembourg (BCL), whereby:
10
1. Landsbanki Luxembourg’s largest creditors other than Landsbanki and the BCL agreed to a
substantial haircut on their claims
2. Depositors gained priority over other creditors
3. Landsbanki would assume a greater role in the management of Landsbanki Luxembourg’s
assets
4. Bond guaranteeing funding from the BCL shall be held to maturity26
Kaupthing
At the onset of the crisis in Iceland the government did not immediately save Kaupthing. In the hope
that Kaupthing could avoid the fate of fellow Icelandic banks Glitnir and Landsbanki the government
granted a loan against collateral in Kaupthing’s Danish subsidiary. Unfortunately, this was insufficient
to bolster its credibility in all foreign markets.
Three days later, Kaupthing’s UK subsidiary was determined to be unable to meet its minimum
obligation to depositors and was judged to be in a state default for the purposes of the UK’s Financial
Services Compensation Scheme. This also put Kaupthing in default in Iceland. The following day,
Kaupthing’s board of directors resigned and the Iceland’s FME took control of Kaupthing, while the
bank’s UK subsidiary was put under cessation of payments. The FME took control of Kaupthing
through the appointment of a resolution committee in order to guarantee the continuation of its
domestic retail operations. Shortly after appointing the committee the government founded New
Kaupthing (later renamed Arion Bank), which was wholly owned by the state.
Once New Kaupthing was established the government transferred 417.4 Million ISK of domestic
deposits to New Kaupthing. Furthermore, some of Kaupthing’s assets which were linked to domestic
operation were transferred to New Kaupthing, while Kaupthing was remunerated the difference
between the value of the assets transferred and the value of the liabilities. In order to balance these
liabilities, New Kaupthing was given an initial capital injection of 775 million (€5 million) in cash. In
October of the following year, a further 71.2 ISK Billion was injected by the state as Tier I capital.
In July 2009, the Joint Capitalization Agreement was announced whereby Kaupthing’s creditors were
granted the option of acquiring majority shareholding in Arion Bank. This would in principle, involve
Kaupthing bank providing the majority of the capital in Arion Bank. In exchange for majority
shareholding, Kaupthing transferred assets 66 Billion ISK to Arion Bank in December 2009.
At the start of 2010, Arion Bank’s new board took control of the bank. In this current incarnation of
Kaupthing, the Icelandic state continues to own 13% of the shares and appoints one of the six
directors to Arion’s board.
5: Aftermath: What did this all mean for Europe?
The Icelandic crisis created fallout across Europe (in both the EU and the EEA). As the three main
Icelandic banks were placed into receivership, both internet banking services and local subsidiaries of
26 Landsbanki, 2010
11
the Icelandic banks were frozen. Furthermore, the new reincarnations of Kaupthing, Landsbanki, and
Glitnir did not have overseas responsibilities in terms of deposits or other liabilities. Nevertheless,
many assets purchased with the cash generated from these overseas liabilities are located in Iceland
and were in fact transferred to the new Icelandic banks. The remainder of this chapter describes the
largest cases which flowed from the collapse of the Icelandic banks but which took place in Europe.
The Dispute over Icesave
Icesave was the online banking arm of Landsbanki, which began operation in the UK in 2006 and in
the Netherlands in 2008, shortly before the Icelandic crisis. When Landsbanki was nationalized by
the Icelandic government in October of 2008, approximately 300,000 accounts in the UK as well as
100,000 accounts n the Netherlands were frozen.
Nevertheless, the deposits of Icesave were kept in the now defunct Landsbanki and were not
transferred to New Landsbanki. Unfortunately, assets purchased in Iceland with these liabilities were
transferred to New Landsbanki. Thus Landsbanki was left with a massive assets-liabilities gap of
around €10 Billion.
Deposit insurance requirements for Iceland are based on European Union Directive 94/19/EC, which
requires a minimum guarantee of €20,000 per depositor. It was transposed into Icelandic national
law in 1999. As a result of the legislation, Iceland founded the Depositors' and Investors' Guarantee
Fund in order to ensure deposits. Nevertheless, the Depositors' and Investors' Guarantee Fund was
nowhere near the size needed to cover the totality of the claims. In fact, the fund held only around
10.8 Billion ISK (approximately €68 Million).
Shortly after Landsbanki’s collapse, a preliminary agreement was reached with the Dutch
government whereby the Netherlands would loan the Icelandic government an amount equal to the
estimated liabilities owed by the Icelandic deposit insurance scheme to Dutch depositors. This
agreement was never ratified by the Althing.
The basis of the British and Dutch legal argument in the Icesave dispute is the fact that Landsbanki
was required by deposit insurance rules to guarantee as a minimum, the first €20,000 of each
depositor. Also at the basis of the UK and Dutch case is the claim that Iceland’s bailout of Landsbanki
was discriminatory towards foreign creditors.
The position of the Icelandic government however, is that the law does not impose a sovereign
guarantee on the deposit insurance scheme and was not meant to ensure against a systemic
collapse. Thus the Icelandic state is not obligated to provide a guarantee of last resort should the
deposit insurance scheme fail.
Despite the impasse, the Dutch central bank (DNB), began compensating Dutch depositors up to
€100,000 in December of 2008.
In August of 2010, the Althing voted to compensate Dutch and British depositors more than €3
Billion. This amounted to approximately 6% of the Icelandic GDP. Unfortunately, the Dutch and
British governments did not accept this arrangement. In December of 2009 therefore, the Althing
12
voted an amended bill making it possible for the Dutch and British governments to recover a
combined total of €3.8 Billion lost by Icesave depositors in their respective countries. The amended
bill was then put before a referendum by Iceland’s president and subsequently voted down by the
voters. Further referenda held in 2010 and 2011 also rejected repayment deals.
On the matter of the Icesave dispute, the EFTA Surveillance Authority ruled in 2011 that Iceland did
not fail its duties outlined under Directive 94/19/EC. Nevertheless, the Icelandic government is
responsible for paying out the minimum guarantee to all of Icesave’s depositors. Because the Dutch
and British governments had already taken action to guarantee the remuneration of Icesave’s
depositors, the EFTA Surveillance authority has decided that the Icelandic government must now
compensate the Dutch and British governments for costs borne.
The Resolution of Kaupthing’s Overseas Subsidiaries and Online Business
While Iceland’s rescue plan ensured the continuation of domestic banking services, the overseas
arms of Kaupthing were left to the devices of either the markets, or the host countries in which they
operated. Unlike overseas branches and subsidiaries of Landsbanki, those of Kaupthing were too
large to be wholly and smoothly resolved by the bank’s resolution committee.
The first subsidiary to fall was Kaupthing, Singer, and Friedlander in the UK, which was placed under
Cessation of Payments, determining that KSF was in default for the purposes of the UK Financial
Services Compensation Scheme on October 8, 2008, pushing Kaupthing into default in Iceland.
Deposit accounts were subsequently transferred to ING.
Hours after Iceland’s takeover of Kaupthing, Finland’s Financial Supervisory Authority took over
Kaupthing’s Finnish subsidiary in order to prevent Finnish savings from being transferred overseas.
Local liabilities were paid using loans and local Kaupthing assets were seized to help finance the
operation. A few days later the Norwegian government followed suit, taking over control of
Kaupthing’s local liabilities.
The accounts of Kaupthing Bank Luxembourg were frozen in all the countries in which this subsidiary
operated immediately after Icelandic authorities sized Kaupthing in Iceland. Thereafter, Kaupthing
Luxembourg’s local Luxembourgish operations were bough-out by Blackfish Capital Management.
Belgian operations of Kaupthing Luxembourg meanwhile, were taken over by Keytrade Bank on July
16, 2009. Keytrade’s parent company, Crédit Agricole took over these accounts in February 2010.
Kaupthing Bank Luxembourg’s Swiss operations meanwhile were rescued by the deposit insurance
scheme of the Swiss federal Banking Commission on November 17, 2008.
In Sweden and Germany meanwhile, Kaupthing’s depositors were remunerated by means of agreement with Kaupthing’s resolution committee.
6: Conclusion
The three main banks Iceland were too big to be rescued. Accordingly the repercussions of their
collapse were felt across a host of countries, far from Iceland’s shore.
13
Lax financial regulation on various levels was a major contributing factor to the crisis. Sources from
the Althing, the CBI, the British House of Commons and the EU all confirm this point.
On the microprudental level, conflicts of interest were not investigated. Furthermore, asset positions
were allowed to grew completely and totally out of proportion to the country’s GDP, while leverage
levels -and hence sensitivity to both economic downturns and idiosyncratic shocks- also grew to
unsustainable high levels. The banks’ massively large -and risky- balance sheets were also allowed to
develop a makeup composed largely of foreign-currency-denominated assets and liabilities. This
made central bank monetary reaction to the collapse of one of these banks largely implausible.
On a transnational level, EU and EEA passport legislation granted the Icelandic banks unfettered
access to EU financial markets, asking for no oversight requirements in exchange.
The actions of Icelandic authorities were designed to ensure the continued survival and viability of
domestic banking services in Iceland. This came partially at the expense of creditors and financial
liability-holders on across countries the European continent. At the same time as Iceland
implemented its crisis response measures, Iceland’s European trading partners also intervened in
local branches, subsidiaries, and operations of the Icelandic banks. Truly, the policy response to the
collapse of the Icelandic banks was a chaotic and disorganized affair in which every country
responded to the collapse on their own and the interests of several countries, as well as those of
creditors and depositors in said countries were pitted against the interest of Iceland and its citizens.
Many would contend that given the circumstances, Iceland could not have delivered an outcome
which was substantially different. This is especially true given the size of the main banks vis-à-vis the
country’s economy, as well as the proportion of foreign-currency-denominated assets and liabilities
relative to the central bank’s foreign currency reserve.
The Icelandic crisis has shown us the direction in which policy needs are likely to evolve. What is
needed is international financial supervision. This is especially true of cross-border banks and
financial entities.
The consequence of ignoring this issue and continuing to rely solely upon national-level financial
crisis response measures is the repetition of such domestically-focused crisis response. While highly
successful on the national level vis-à-vis Iceland’s interest, this crisis response has given rise to cross-
border disputes. Iceland’s response also led to the contraction of the Icelandic banking sector and to
the ceasing of large-scale cross-border banking in Iceland. It must also be said that lack of cross-
border coordination of crisis response also played a key role in the emergence of this crisis. Overall,
effects have the potential to become more pronounced should a larger European nation suffer a too-
big-to-rescue financial collapse.
The proliferation of such nationally-focused crisis response might lead to a general decline in the
European banking and financial sectors. Cross-border banking would especially come under
regulatory strain, spurred-on by nationally-focused policy response measures, which entail best-
practice crisis response measures vis-à-vis the domestic interest as well as national-level anti-too-big-
to-fail banking regulations. This can ultimately be described in a prisoner’s dilemma framework.
In order to counteract this possibility, multilateral supervision and EU-wide crisis-response
mechanisms are necessary.
14
Since the 2008 financial crisis we have in fact seen the rise of such policy initiatives in the EU. Starting
in 2010, national-level financial stability is jointly-arranged by the European Financial Stability
Facility, whose funding is proportionally guaranteed by the EU member states and by the European
Financial Stability Mechanism, whose funding is guaranteed by the European Union.27 Furthermore,
EFSF funding can be applied directly to the banking sector.28 This should have the effect of
distributing the costs of a financial crisis across the EU in a more broad and sustainable manner. After
mid-2013, this competence shall be transferred entirely to the EFSM. European macroprudential
regulation meanwhile is now the domain of the European Systemic Risk Board. The EU has also
established regulatory agencies for banking (EBA), financial markets (ESMA), and insurance markets
(EIOPA) under the auspices of the European System of Financial Supervisors.
The development of such European regulatory and crisis-response mechanisms should play an
increasingly central role in the development of European financial sector in the coming decades. This
is especially the case concerning European cross-border banking.
Beyond the European Union, the G20 has also been exploring intentional crisis-response
mechanisms. Most notably, a foreign-exchange safety-net, which would secure precisely the type of
central bank swaps, which the Central Bank of Iceland tried– and failed– to secure immediately
before the Icelandic financial crisis. If such a safety net would come into existence, the ramifications
for cross-border banking would be quite pronounced, particularly for small, open economies.
The alternative is most-likely a de-facto disintegration of European cross-border banking, as the 21st
century wears on.
7: References
- Allthingi (Icelandic Parliament), 2010, “Report of the Special Investigation Commission”
Delivered 12 April 2010, in accordance with Act No. 142/2008
- European Financial Stability Facility, 2011 “The European Financial Stability Facility (EFSF) –
FAQ” Luxembourg
- European Free Trade Area Surveillance Authority, 2011, ‘Notices concerning the European
Economic Area’, Offical Journal of the European Union, pp 7-30
27
European Financial Stability Facility, 2011 28 Ibid
15
- Gudmundsson, Már, 2011, “Lessons from the Iceland Crisis”, Lecture at Maastricht
University, Brussels, 21 March 2011
- Gudmundsson, Már, 2011, “The Financial Crisis in Iceland: Reflections, on Causes,
Consequences, and Lessons Learned. Lecture at Bank of England, 11 May, 2011
- Haarde, Geir H., 2008 “Address to the Nation by H.E. Geir H. Haarde, Prime Minister of
Iceland" Retrieved July 26, 2011 http://eng.forsaetisraduneyti.is/news-and-articles/nr/3035
- Iceland Review Online, 2009 “Glitnir ASA in Norway Sold under Value” retrieved on July 20,
