%&'( _ POLICY INSIGHT No. 44 JANUJANUARY 2010

The saga of Icesave

Jon Danielsson School of Economics

The President of has refused to sign a parlia- • Strong likelihood of state support in the event of mentary bill agreeing to compensate the governments systemic shock of the UK and Netherlands for deposit insurance pay- • Good financial fundamentals outs because of Icesave. This does not mean a rejection • Good efficiency levels of the country's obligations, nor any form of default. • Diversification of income On the contrary, the decision by the president stems • Capable credit risk management and good qual- from the fact that over 70% of Icelanders find the terms ity loan portfolios of the current deal unreasonable. • Adequate capitalisation • Prudent liquidity management Origin of the problem This coincided with one of the biggest asset bubbles the Iceland has traditionally had limited experience with world has ever seen, where anybody taking a highly international banking (Buiter and Sibert 2008). The leveraged bet was assured outsized profits. Eventually, financial system was highly regulated and politicised, the balance sheet of the swelled to 10 times the with the bulk of the system in government hands and GDP of Iceland. (See Danielsson and Zoega 2009). insulated from the outside world with capital controls until 1994. This all changed with the deregulation and So what is Icesave? privatisation of the financial system. Iceland adopted a new regulatory structure, in line with EU regulations, The Iceland banks started experiencing increasing prob- because of its European Economic Area membership. lems raising funds in international capital markets in Importantly, this meant that Icelandic banks could 2006. To avoid deleveraging and continuing expanding, 4 operate in the EU with the so called "one passport". the banks hit on the idea of establishing internet banks 4 in , collecting high interest deposits. This was . The decision by the president stems easy to do is because of the European financial pass- o from the fact that over 70% of port. Moreover, it was a favoured move by the rating N agencies (Moody's 2006). Icelanders find the terms of the There are essentially two ways a can do this, by T current deal unreasonable. a branch or subsidiary. opted to set up

H branches, under the name of Icesave, supervised and Unfortunately, both the banks and government were insured from Iceland. They offered above inter- G

I woefully ill-prepared for this. There was no institution- est rates, starting in October 2006, eventually amassing

S al experience in how to regulate and run an interna- £4.5 billion in the UK. In 2008, the FSA was concerned

N tional and free banking system, as can be found in and applied increasing pressure on Landsbanki to limit

I other, more established, banking centres. The banks deposits. The response was to start raising deposits in passed into the hands of highly leveraged holding com- the Netherlands, staring in May 2008 and eventually Y panies that became the biggest debtors of the banks collecting €1.7 billion from the region. C and invested alongside them. Significant parts of the I economy were controlled by a handful of investment What about risk? L groups running financial institutions, non-financials

O and media, with close connections to main political par- Landsbanki, along with many other financial institu-

P ties. tions, was affected by the global crisis of 2007 and Deregulated and privatised, the banks proceeded to started experiencing serious funding difficulties in R gear up, using borrowed funds to acquire assets across 2008. Capital markets viewed Landsbanki, along with P the world. Favourable ratings did help here, for example the other Icelandic banks, as more risky than most, if E a Moody's report in December 2006 which lists the not all, banks in Europe. Thanks to Icesave, Landsbanki

C strengths of the Icelandic banking system as: was often considered the safest of the three main

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Icelandic banks, the idea being that deposits are a sta- a couple of percentage points above prevailing deposit ble source of funding. Subsequent events have proven rates in the UK, than paying much more in internation- this belief to be wrong. al capital markets. This may have been done with the International capital markets increasingly seem to encouragement of the UK FSA, being worried about the have viewed the Icelandic banks and the government of funding position of Landsbanki. Iceland as a single joint entity from a risk point of view. The question remains why the rating agencies did not The country risk became the same as the bank risk, seem to understand the risk created by Icesave, and to where high risk activity by one bank directly affected what extent the Icelandic and UK authorities under- the other banks and the government. The Icelandic stood this risk. authorities and the banks would have been well aware Both depositors and governments were exposed. The of this externality, but this awareness does not appear first €21,000 of deposits was insured by the Icelandic to have translated into any concrete actions to reduce deposit insurance fund (more on this later). The the risk. On the contrary, both the banks government Netherlands eventually provided insurance for up to seem to have gambled for resurrection. €100,000 in retail deposits and the UK eventually pro- vided unlimited insurance for retail deposits. Wholesale This coincided with one of the biggest depositors such as local government and charities asset bubbles the world has ever seen, invested with Landsbanki, but not as a part of Icesave, where anybody taking a highly and thus did not enjoy this protection. There were therefore five different entities with direct leveraged bet was assured outsized exposure to Landsbanki: the Icelandic, British and profits. Eventually, the balance sheet Dutch deposit insurance funds, retail depositors in the of the banks swelled to 10 times the Netherlands with excess of €100,000, and all wholesale depositors. GDP of Iceland. The Audit Commission in the UK (2009) investigated the investments of public authorities into the Icelandic The CDS spreads of Landsbanki started rising sharply banks and concludes that some authorities "have been in 2008, see Figure 1, reaching 865 March 31 when they less cautious by following ratings [not credit but inter- started taking deposits in the Netherlands, after which est paid] exclusively and perhaps striving to achieve a they dropped to 291 May 23, before reaching 715 by high yield without due regard to the risk involved. And early August. a small group of authorities has been negligent in their Singh and Spackman (2009) calculate the implied stewardship of public funds." This last group put £33 probability of default for March 31 2008 as 22% using million into the Icelandic banks in October 2008, when an assumption of 40% recovery, and 77% if using sto- one Icelandic bank had already failed, and the bank- chastic recovery and probability, a methodology they ruptcy of the rest was imminent. One council invested recommend. £1.5 million on the day the CDS spread on Landsbanki The reason Landsbanki put so much emphasis on exceeded 3,000. Icesave seems to be because it is much cheaper to pay 4 4

. Figure 1 CDS spreads on Landsbanki, 2007–2008 o % N 3000 T H 2500 G I

S 2000 N I 1500 Y C

I 1000 L

O 500 P

R 0 P E Jul-07 Jul-08 Apr-08 Jun-07 Oct-07 Jan-08 Jun-08 Oct-08 Nov-07 Feb-08 Mar-08 Aug-07 Sep-07 Aug-08 Sep-08 Dec-07 May-08 C

To download this and other Policy Insights visit www.cepr.org JANUARY 2010 3 Who knew? The relevant authorities were also aware of the pre- The risk was out there for everybody to see. As far back carious state of the Icelandic banks. For example, as 2005 the financial press in Scandinavia was saying Gunnarsson (2009) notes that in April 2008, Trichet that the Icelandic financial system was a gigantic hedge called the governor of Bank of Iceland angrily com- fund, naming its activities "pyramid schemes" and plaining that the Icelandic banks were conducting claiming Icelandic entities were buying assets in abnormal fake transactions with the ECB via Scandinavia at far too high prices, which would eventu- Luxembourg. Apparently, the Icelandic banks had ally bankrupt them. The Icelandic response at the time obtained €4 billion from the ECB by selling each other was to label this as simply malice and envy. Two reports bonds with the explicit purpose of exploiting opportu- were commissioned in Iceland, Herbertsson and Miskhin nities with the ECB . Gunnarsson (2009) in his discus- (2006) and Baldursson and Portes (2007), both painting sion makes it clear that the relevant authorities in the Icelandic economy and its banking system in Europe were monitoring the situation closely and that favourable terms. they applied increasing pressure on Landsbanki to limit By 2008 anybody with access to Bloomberg could see deposits. Furthermore, he states that the Dutch Central that the CDS spreads on Landsbanki were amongst the Bank demanded in July that Landsbanki stop collecting highest in the Europe for banks. deposits, to which Landsbanki responded by offering to place all deposits above a certain amount on account Apparently, the Icelandic banks had with the Dutch , an offer that was reject- obtained €4 billion from the ECB by ed. selling each other bonds with the explicit purpose of exploiting Bankruptcy and responsibility opportunities with the ECB Landsbanki eventually collapsed in October 2008 along with the rest of the Icelandic financial system. While the The risk was widely discussed in media. This is Money specific timing may have had something to do with the in the UK had an article on March 16 2008 called failure of Lehmans, it is clear that the global financial ‘Iceland's banks top “riskiness league”’ where in dis- community viewed the bankruptcy of Landsbanki as cussing the Icelandic banks state "These banks are now imminent by September 2008 judging by the CDS seen as the most unsafe in the developed world." spreads. MoneyWeek in the UK on March 19, 2008, had a simi- After the failure of Landsbanki, the government of the lar story stating "Landsbanki (owner of the popular UK fully compensated all retail depositors, while the Icesave internet banking business) has to pay the credit government of the Netherlands compensated retail markets 6.0% more than risk-free rates and 4.2% more depositors up to €100,000. The first €21,000 however than ING does, for funds. Given that Icesave pays 6.05% fell onto the Icelandic deposit insurance fund, which on their easy access internet savings account and ING only contained a fraction of the needed amount. pays 6.0%, perhaps shopping around for the highest Under EU law, if the deposit insurance fund is not savings rate right now is not actually the best thing to sufficient, it falls on the other banks in the country to 4 do. Perhaps, just perhaps, we should pay more attention make up the shortfall. But the law is unclear on what 4 to the risk side of the equation too." happens if all of the banks fail, and there seems to be . o Figure 2 The Icesave loan payment schedule N

800 kr. T

) 160 kr. K H S I ( 700 kr. s n G 140 kr. o i ) I l

l tayments from [L K i S b

600 kr. I ( S n i 120 kr. s n s t o i N l n tayments to ÜY and Iolland l e i

I 500 kr. b m

y 100 kr. n i a p t s Y t

e /umulated interest 2009- n 400 kr. r e e

80 kr. t 2016 and repayments m C n i n 2016-2024 r I d e v n trincipal and accumulated a o 300 kr. L g 60 kr. l

a interest d p i n c a O n i t 200 kr. r

n 40 kr. P e P m y a

p 100 kr. R

e 20 kr. r I L P 0 kr. 0 kr. E C 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

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no obligation for the government to make up the short- The claim on the estate of Landsbanki is fixed in fall. The uncertainty on this issue is reflected in a letter Icelandic krona at an exchange rate from April last year, from HM Treasury (2008) to the Ministry of Business while the obligation is in pounds and euros. Iceland is Affairs in Iceland. therefore assuming a considerable currency risk. Already The consistent position of the Icelandic government the debt has increased by 6%. If the economy performs has been that it does not have the obligation to top up badly, it will have to pay more because of the exchange the deposit insurance fund, while the equally consistent rate. position of the EU is that it does. The independent legal Iceland is already just about the most indebted coun- advice indicates that the law is unclear. (See for exam- try in the world as a consequence of the crisis, with gov- ple the Mishcon de Reya Solicitors report 2009). ernment debt to GDP perhaps around 140%, the bulk It is this uncertainty which is the foundation of of which is in foreign currency (considerable uncertain- Iceland's reluctance to compensate the UK and ty exists about the exact debt position of the Icelandic Netherlands. Responsibility for allowing Icesave to oper- government, especially foreign debt). By contrast, ate falls onto the shoulders of the home supervisor before the crisis government debt was quite low. The (Iceland) and it had the legal remedies to prevent it. economy is in dire straits, but stabilising. If the Icesave repayments become too burdensome they may trigger a If the Icesave repayments become too sovereign default meaning that the UK and Dutch tax- burdensome they may trigger a payers would be unlikely to get reimbursed at all. sovereign default meaning that the Two forms of pressure UK and Dutch taxpayers would be unlikely to get reimbursed at all. In order to press their case, the EU has applied consid- erable pressure on Iceland, primarily using two different The host supervisors of the UK and Netherlands, methods. however, also have a duty to protect depositors in their • First, the EU has used its influence to hold up countries. The Dutch authorities have repeatedly stated approval of IMF aid, further weakening the that there was little they could do. (The UK authorities Icelandic economy. This would seem counterpro- have kept quiet.) Both countries did provide deposit ductive, since it increases the eventual cost of insurance above and beyond the legal minimum. But if the rescue package. Furthermore, such a use of the authorities do not have the legal remedies to pro- the IMF as a collection agency in bilateral dis- tect their depositors and tax payers, it signals a fault in putes between governments is questionable. European financial regulations. • Secondly, Iceland has applied to join the the EU, The Icelanders have not rejected their obligation, but see Danielsson (2009), and its application claim that because of the legal uncertainty, the UK, appears to be conditional on settlement. Netherlands, and EU share a part of the responsibility. It However, since the majority of Icelandic voters is the terms under which Iceland compensates the UK have consistently opposed EU membership, this and Netherlands that is at the heart of the dispute. pressure is currently not all that effective. 4 Ironically, as well as cementing opposition to 4 What is the issue? Icesave, repeated public threats by Dutch politi- . cians against Iceland have served as to solidify o The overall amount involved might not seem excessive, Icelandic voters against EU membership. N around €3.9 billion, but only around 315,000 people live in Iceland, so that equates to about €13,000 per Conclusion T person. According to the current deal, Iceland is to pay

H 5.55% interest per year, or €217 million, and replay the The responsibility for Icesave falls jointly on Iceland, UK

G money between 2016 and 2024. and the Netherlands. It is in the best interests of all I Adjusting for population size the overall deal implies three governments, as well as the IMF and the EU, to S that the UK would have to pay over €800 billion, with come to a reasonable agreement, enabling Iceland to

N €43 billion per year in interest. For the Netherlands it is make good on its obligations, without tipping the econ- I as if it had to pay €202 billion, with €11 billion in inter- omy into the abyss. est per year. I suspect neither country would be inclined Y to agree to such an agreement if their private banks had References C

I incurred similar obligations abroad.

L The recovery rate for Landsbanki is expected to be Audit Commission (UK), (2009), Risk and return. English 88.2%, but payout will not start until next year earliest, local authorities and the Icelandic banks. O and probably last beyond 2020. Meanwhile Iceland pays Baldursson and Porters (2007), "The Internationalisation

P interest. I calculated the debt profile here in Danielsson of Iceland's Financial Sector", The Iceland Chamber of (2010), with the specific calculations available online Commerce. R here. At current exchange rates, Iceland can be expect- Buiter, Willem and Anne Sibert (2008). "The collapse of P ed to pay €2.82 billion, of which €2.16 billion is accu- Iceland's banks: the predictable end of a non-viable E mulated interest. This is just under the government business model", VoxEU.org, 30 October.

C expenditures in 2010. Danielsson, Jon (2010), "Icesace: Cost and Risk", mimeo

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