abcd a POLICY INSIGHT No. 44 JANUJANUARY 2010 The saga of Icesave Jon Danielsson London School of Economics The President of Iceland 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 banks 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 Europe, 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 bank can do this, by T current deal unreasonable. a branch or subsidiary. Landsbanki 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 market 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 To download this and other Policy Insights visit www.cepr.org JANUARY 2010 2 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 Central Bank, 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.