The 2008 Icelandic Bank Collapse: Foreign Factors A Report for the Ministry of Finance and Economic Affairs Centre for Political and Economic Research at the Social Science Research Institute University of Iceland Reykjavik 19 September 2018 1 Summary 1. An international financial crisis started in August 2007, greatly intensifying in 2008. 2. In early 2008, European central banks apparently reached a quiet consensus that the Icelandic banking sector was too big, that it threatened financial stability with its aggressive deposit collection and that it should not be rescued. An additional reason the Bank of England rejected a currency swap deal with the CBI was that it did not want a financial centre in Iceland. 3. While the US had protected and assisted Iceland in the Cold War, now she was no longer considered strategically important. In September, the US Fed refused a dollar swap deal to the CBI similar to what it had made with the three Scandinavian central banks. 4. Despite repeated warnings from the CBI, little was done to prepare for the possible failure of the banks, both because many hoped for the best and because public opinion in Iceland was strongly in favour of the banks and of businessmen controlling them. 5. Hedge funds were active in betting against the krona and the banks and probably also in spreading rumours about Iceland’s vulnerability. In late September 2008, when Glitnir Bank was in trouble, the government decided to inject capital into it. But Glitnir’s major shareholder, a media magnate, started a campaign against this trust-building measure, and a bank run started. 6. On 7–8 October 2008, at the same time as the British Labour government presented a rescue package of £500 billion for all other British banks, it closed down two British banks owned by Icelanders, Heritable and KSF. Their resolution processes reveal that they had both been solvent. 7. On 8 October, the British government froze all assets of Landsbanki under an Anti-Terrorism Act. On the Treasury’s website, Landsbanki (and, briefly, the CBI and other Icelandic institutions) was put on the same list as Al-Qaeda and the Talibans. The alleged purpose was to hinder money transfers to Iceland. But on 3 October a Supervisory Notice had been issued by the FSA to Landsbanki which hindered all money transfers out of the UK. 8. The Icelandic government had decided to try and save Kaupthing and allow the other banks to fail. But the decision by the British government to close down KSF brought about the downfall of its parent company Kaupthing, because of loan covenants, and hence the collapse of the whole banking sector. 9. The decisions by the British government in early October 2008 appear to be politically motivated. Prime Minister Gordon Brown and Chancellor Alistair Darling wanted: to divert attention from their rescue of big Scottish banks; to show Scottish voters the risks of independence; to placate worried depositors; to demonstrate, at little risk, their own toughness; and to improve their bargaining position against Iceland on the resolution of depositors’ claims. 10. If the crucial decisions by European central bankers, the US Fed and the UK government had not been made, then Iceland might have had a chance to resolve her financial crisis in the same way as Sweden did in 1991–2, without a traumatic collapse. 11. After the collapse, in Norway, Finland and Denmark local businessmen, with the connivance of the authorities, profited by buying assets of Icelandic banks at low prices. 12. After the collapse, the British and Dutch governments—supported by four Nordic countries—tried to force Iceland into accepting liability for deposits in the fallen Landsbanki in the UK and Netherlands: The debt thus created, as initially estimated, would have been heavier per capita than reparations paid by Finland to the Soviet Union after the 1941–4 war. In two referenda, the Icelanders rejected these demands; in 2013 the EFTA Court found no government liability. 13. The collapse has been blamed on oversized banks, most importantly by a Special Investigation Commission, SIC. But Switzerland and Scotland had banking sectors of a similar relative size and even bigger, without bank collapses. 14. The collapse has been blamed on reckless bankers. While Icelandic bankers took high risks, growing their balance sheets rapidly, bankers elsewhere were reckless, too. Many banks, including RBS in Scotland, UBS in Switzerland and Danske Bank in Denmark, would have failed if not bailed out. 15. Other countries may derive a lesson from the way in which Iceland handled the collapse: If depositors gain a priority claim on bank estates, other kinds of creditors become more cautious, and government guarantees—creating moral hazard—may be unnecessary. 2 TABLE OF CONTENTS Introduction · 6 A Note on Methodology · 8 Timeline of Events · 10 1. The Findings of the Special Investigation Commission (SIC) 14 1. The SIC’s Main Explanation: Over-sized, Reckless Banks 2. The Impeachment Case Against Geir H. Haarde 3. Strictures Against Other Government Ministers 4. Strictures Against the CBI Governors 5. Strictures Against the IFSA Director 6. The Limited Options of Decision Makers 7. The SIC’s Incomplete Explanation 2. Hedge Funds Bet on Icelandic Collapse · 32 1. The Drobny Conference in Santa Monica 2. The First Bets Against the Banks 3. Negative Publicity in Denmark 4. Hedge Fund Managers Visit Iceland 5. Betting Against the Banks and the Krona, 2008 3. The Role of European Central Banks · 41 1. CBI Requests for Currency Swap Deals 2. The IMF Preliminary Assessment 3. CBI Request Turned Down in London 4. A Fateful Dinner in Basel 5. Increased Hostility Towards the Icelandic Banks 6. Consensus in Europe Against the Banks 7. The ECB Moves Against the Icelandic Banks 4. The Role of the US Federal Reserve Board · 55 1. An expendable, remote island 2. CBI Turned Down by the Fed 3. Iceland Out in the Cold 4. The Russian Loan Offer 5. Yet Another Rejection 6. US Help to Other Countries in the Crisis 5. The Role of the British Government · 68 1. ‘The Arc of Prosperity’ 2. Concerns in London about Landsbanki 3. Darling’s Misconceptions about Iceland 4. Darling Meets the Icelanders 5. Darling’s Phone Call to Haarde 3 6. A Crucial Document: The First Supervisory Notice to Landsbanki 7. Brown’s Phone Call to Haarde 8. Darling’s Phone Call to Mathiesen 9. All British Banks But Two Rescued 10. Darling’s Inaccurate Account of His Dealings with the Icelanders 6. The Use of an Anti-Terrorist Act Against Iceland · 87 1. Haarde’s Phone Call to Darling 2. There Was an Alternative to the Freezing Order 3. Brown’s Hostile and Inaccurate Comments about Iceland 4. Brown Reveals British Pressure on the IMF 5. The Brutal Treatment of the Icelanders in a European Perspective 6. Political Motives 7. Voices in Protest 7. Sale of Bank Assets in Norway, Finland and Sweden · 100 1. Icelandic Investments in the Nordic Countries 2. The Sale of Glitnir Bank in Norway 3. The Sale of Glitnir Securities and Other Activities in Norway 4. The Sale of FIM in Finland 5. The Sale of Other Icelandic Assets in Finland 6. The Sale of Icelandic Assets in Sweden 7. Help to Local Banks in the Nordic Countries 8. Sale of FIH Bank in Denmark · 111 1. Kaupthing Buys FIH Bank 2. FIH Bank Provided with Liquidity 3. The CBI Sells FIH Bank 4. The Strategy of the New Owners 5. The Liquidation of FIH Bank Assets 6. Help to Danish Banks 7. Possible Other Scenarios for FIH Bank 9. Moral Issues in Fire Sales of Bank Assets · 123 1. Cases of Insider Trading? 2. Voluntary and involuntary Market Transactions 3. The Spring Owner or the Alexandrian Merchant? 10. Sale of Bank Assets in the UK · 129 1. Solvent and Law-Abiding Icelandic-Owned Banks 2. Heritable Bank and Landsbanki’s London Branch 3. The Close-Down of Heritable Bank and Landsbanki’s London Branch 4. Kaupthing Singer & Friedlander 5. The FSA and KSF 6. The Close-Down of KSF 7. The Close-Down of KSF 8. The Court Case Against the Treasury 9. The Resolution of KSF 10. Investigations of Kaupthing and KSF Managers 11. The Irony of the Transfer to ING DIRECT 12. No Losses for British Taxpayers 13. A Digression on Rescued Banks 4 11. The Icesave Dispute, 2008–13 · 154 1. The British and Dutch Demands on Iceland 2. Icesave I (the Gestsson Deal) 3. Controversy on the Gestsson Deal 4. Icesave II (The Amended Gestsson Deal) 5. The Campaign Against Icesave II 6. Icesave III (the Buchheit Deal) 7. The Campaigns For and Against Icesave III 8. Arguments before the EFTA Court 9. The EFTA Court Decision in Favour of Iceland 12. Moral Issues in the Icesave Dispute · 168 1. The Concept of Collective Responsibility 2. No Responsibility of the Icelandic Nation 3. No Negligence by Icelandic Authorities 4. No Discrimination of Depositors by Icelandic Authorities 5. Discrimination Between Depositors and Bondholders 6. The Responsibility for the Bank Run and the Street Riots 7. The Collective Responsibility of the British Nation 8. An Apology is Called For Conclusions · 181 1. The Banks Were to Blame, But Also the Financial Framework 2. First Lesson: Decisive Leadership is Crucial 3. Second Lesson: No Disaster to Let Banks Fail 4. Third Lesson: Priority of Depositors’ Claims 5. Fourth Lesson: No Government Guarantee of Deposits 6. Fifth Lesson: Discretionary Power Will Be Abused 7. Sixth Lesson: Iceland is On Her Own 8. Final Remarks References · 193 List of Figures and Tables · 211 5 Introduction On 7 July 2014, representatives of the Icelandic Ministry of Finance and Economic Affairs and the Social Science Research Institute at the University of Iceland signed an agreement that the Centre for Political and Economic Research, affiliated with the Social Science Research Institute, would undertake to conduct research into the 2008 Icelandic bank collapse, especially its foreign factors, and to deliver a report with its findings to the Ministry.