Lessons from the icesave rejection

Icesave has been well documented here on Vox (see e.g. Danielsson 2010 and Gylfason 2010). It arose from an Icelandic bank (Landsbanki) benefiting from weaknesses in European financial regulations to supply high-interest deposits in the united kingdom and Netherlands beneath the name of Icesave. By enough time Landsbanki collapsed in nov 2008 it turned out among the riskiest banks on the globe for a long time, resorting to high-interest savings accounts since other avenues for raising funds were closed. Since Icesave was run as a branch from Iceland, it had been insured and regulated there.

When the Icelandic bank operating system collapsed in October 2008 (see Benediktsdottir et al. 2011 for details) its deposit insurance fund contained just over a €100 million, not sufficient to cover the €3.9 billion insured deposits in the foreign branches of the Icelandic banks, according to EU rules.

Even though these were not obliged to take action, the governments of the united kingdom and Netherlands felt it necessary at that time to settle its depositors relative to their deposit insurance norms to be able never to upset their own bank operating system at a time if they were already looking quite unstable. The governments acted unilaterally with the expectation that they could claim the amount of money back from the deposit insurance fund in Iceland. The British and Dutch governments are claiming from Iceland the total amount necessary to cover the minimum EU deposit insurance.

During its collapse, Icesave had amassed about €6.8 billion, split between retail deposits and wholesale deposits (created by institutions like local governments). Of the retail deposits, €3.9 billion were included in the minimum EU deposit guarantee of €21,000. Retail deposits, however, not wholesale deposits, constitute important claim in to the estate according to emergency legislation passed by the Icelandic parliament in October 2008 and soon to be ruled on by the Icelandic Supreme Court.

Recovery of priority claims will probably exceed 90% and could even reach 100% with payout likely to commence towards the end of the year. The governments of the united kingdom and Netherlands are claiming the number of priority claims not recovered from the estate, along with interest paid, given that they had to fund the entire €3.9 billion in October 2008. The interest payments will probably exceed the shortfall in recovery.

As time passes, the interest demanded of Iceland by the united kingdom and holland has fallen, it had been initially 6.7% with a brief repayment period, then 5.5% with an extended repayment period, rejected in a referendum this past year. The recent referendum rejected a cope with 3.2% interest, with a nine-month interest holiday.

The direct financial cost incurred by the united kingdom and Netherlands is of the magnitude of significantly less than 10% of the quantity of €3.9 billion. This amount must be financed until they claim from the estate. With all this, we can estimate the full total cost to the federal government of holland and the united kingdom, from meeting the minimum EU deposit guarantee, to maintain the range around €375 million to €840 million, based on recovery rates and timing, with about 2/3 falling on the united kingdom.

Regardless of these relatively low amounts, the governments of the united kingdom, and especially the Dutch government have pursued their claim vigorously with the approval of the EU and the Scandinavian government and even attemptedto use their positions within the IMF to aid their claim.

Given the determination to reclaim such relatively smaller amounts, the strong desire to have Iceland to stay this appeared to be based on reasons apart from direct economic costs. There appear to be three main reasons because of this.

  • First, allowing Iceland to leave from offering the federal government guarantee would dilute the principle a country cannot ignore its obligations, thus undermining the assumptions underpinning the normal European market in financial services.
  • Second, the Icelandic government discriminated between domestic savers and foreign savers. This might seem unlike EU law.
  • Finally, the political atmosphere in holland, but not the united kingdom, has needed a demonstration of strength by the Dutch government. Consequently, the Dutch authorities have repeatedly issued strong public statements, demanding repayment, along with a selection of threats.

When there is no settlement, the united kingdom and the Dutch government could quit their claim. Finding a face-saving way compared to that might be easier in the united kingdom than in holland given the heated discussion of the problem there.

The choice is taking the problem to the European Free Trade Association (EFTA) court. This can be a route being accompanied by the EFTA authorities. Procedurally, it isn’t up to holland and the united kingdom to initiate such proceedings, instead the EFTA Surveillance Authority is likely to file such a case against Iceland in the coming months.

The case is somewhat unclear. EU law states a country must maintain a deposit-insurance scheme, funded by countries’ finance institutions, not by the national governments. That is deliberate, since national governments may choose to leave open the choice never to give government guarantees to deposit insurance funds in an emergency, even if some have opted to take action recently.

However, the case against the Icelandic government is strengthened by senior government officials for the reason that country declaring before the bankruptcy that the federal government was backstopping the deposit insurance fund. Furthermore, the federal government of Iceland guaranteed deposits in Icelandic branches of the same bank fully following a crash of its banking sector, which may be judged to be discriminatory under EU law, implying that depositors in foreign branches were eligible for be compensated fully.

We suspect that neither government, nor the EU, is keen to really have the Icesave issue settled in court. A detrimental court ruling might establish the principle a country can reject its obligations, and invite discrimination predicated on nationality. It could also encourage those wanting to default on sovereign debt in Europe. Similarly, a positive court ruling could establish the principle that the taxpayer must backstop deposit insurance.

Calculating the price to Iceland of funds is more difficult rather than directly comparable with the British and Dutch costs. Associated with that the Icelandic government includes a claim on the estate, fixed in Icelandic krona as the obligation is in forex. This means that through the entire repayment period, Iceland will be running considerable exchange-rate risk. Given the historical weakness of its currency, this represents significant risk.

At current exchange rates, assuming they’ll remain unchanged, the undiscounted obligation after the deposit insurance fund has been depleted is approximately €196million, assuming 90% recovery, or around 2% of GDP, according to calculations from the Central Bank of Iceland.

If the Icelandic currency appreciates this amount may fall slightly (the fall in the total amount is capped by recovery limits) while a falling exchange rate could raise the amount quite significantly. This may also result in continuance of capital controls in the short run, to support the threat of a falling exchange rate.

However, leaving Icesave unsettled can be quite costly. Following a vote Fitch Ratings declared that the vote had diminished the prospects of Iceland regaining an investment grade rating soon; Moody’s left its Baa3/P-3 rating with a poor outlook – one notch above junk status unchanged – and Standard & Poor’s has put the ratings of the sovereign on a poor watch from its current BBB- status. However the magnitude of the effect on the pricing of government bonds to be put into international capital markets remains uncertain. The access of Icelandic companies to international capital markets may possibly also remain curtailed and capital controls will probably remain.

The need for the Icesave dispute issue for the Icelandic economy, like the capital controls and usage of foreign capital markets, shouldn’t be exaggerated however. It really is one of many conditions that need to be resolved in Iceland to be able to enhance business confidence and promote growth. Other issues include foreign direct investment policy, settled property rights and political stability.

A negotiated settlement was of interest to everybody involved. Hence, it is unfortunate that the problem has reached the main point where the Icelandic government struggles to continue negotiating and the three governments haven’t any option to seeing the EFTA Surveillance Authority prepare its court case against Iceland.

Of the three countries, the only government which has publically handled the problem sensibly may be the UK, because at no stage have some of its politicians or civil servants made public statements about Icesave. All negotiations there were handled quietly.

On the other hand, senior political leaders in holland have repeatedly made threatening comments inflaming the opposition to the agreement in Iceland.

The federal government of Iceland mishandled the negotiations in the first place. Initially, it sent a team lacking experience to negotiate. Unfortunately, the team was too politicised. This led to too little confidence in the agreement and the federal government once criticism of the agreement began to emerge. Only towards the finish did they employ more professional negotiators, which succeeded in obtaining a better agreement. At that time it had been too late. Public opposition was strong, with the populist president vetoing the agreement for the next time. By that point, public opinion had become so inflamed a rejection was almost inevitable.

There are many lessons to be drawn out of this episode.

First, trying to force a population to cover something they feel no responsibility for can result in very strong reactions and could inflame nationalist sentiments, even if the payments are justifiable with regards to financial stability or international relations. When events reach this stage, a previously soluble problem may become unsoluble and an unhealthy chain of events occur place.

Generally, the episode reveals a gap between just what a government perceives to maintain a country’s national interests and what individual voters may think. While all Iceland’s leaders handling the problem have wished to accept, voters experienced different reasons never to – the most crucial one being that they didn’t want to invest own money to cover something they didn’t find themselves in charge of. At a far more abstract level, one may go further and paraphrase Mancur Olson by asking why each voter should desire just what a government thinks is wonderful for the united states when preoccupied using its own bread and butter issues?

It follows that governments of Europe – along with their citizens – may balk at accepting austerity programmes necessary to pay foreign creditors. Moreover, the populations of countries that try to bailout other countries may revolt against the perceived injustice of such a transfer of income.

The Icelandic population strongly rejected Icesave in a referendum. The essential economic case for accepting the agreement was clear. However, the rejection was only partially predicated on economic arguments. More important was the principled refusal to bail out the obligations created by an exclusive bank.

The results points to a limitation of the perceived knowledge of how European markets operate. The conditions for the problem were created by the constructive ambiguity in the European finance regulations. The resolution of the problem is hampered for the same reasons. Perhaps, Europe may be better served if European policymakers were more explicit about how exactly the financial system is meant to operate.

Unfortunately, having direct rules and enforcing those rules gets in the form of political objectives. As this case shows, and the much bigger Eurozone crisis which includes lots of the same roots, the existing attitudes in Europe to fiscal and financial policy seem flawed.

Benediktsdottir, Sigridur, Jon Danielsson, and Gylfi Zoega (2011), "Lessons from a collapse of a economic climate," Economic Policy, 66.