Emergency measures in troubled Iceland

Read the article in the Cayman Financial Review Magazine  


 In June 2008 the combined balance sheets of Glitnir, Kaupthing and Landsbanki, Iceland’s three largest banks, were more than ten times the country’s GDP. In October 2008, the high flying Icelandic economy abruptly crashed, and with it the three banks.  

Bewildered Icelanders looked on as a once booming financial system crumbled, the value of the national currency dropped like a stone on global markets, households and companies faced a serious debt crisis with the government politically isolated both at home and abroad. Abroad – and in the UK and the Netherlands in particular – depositors in the three banks’ internet banking operations turned to their governments seeking to recover their deposits.

At the root of the economic problems Iceland faced were a combination of excessive liquidity fostered by central banks around the world, expansionary fiscal policies in Iceland and inadequate understanding of impact of the flood of capital that had poured into Iceland over the past few years and overwhelmed its financial institutions.

Regulatory failures at both the EU and Icelandic levels exacerbated problems rather than correcting them. In particular, the Icelandic deposit insurance scheme proved inadequate to cope with the simultaneous collapse of all three major banks and their foreign branches and subsidiaries.1 The Icelandic banks reacted to the first hints of market scepticism over their soundness by creating internet banks to attract foreign deposits, particularly from the UK and the Netherlands. As explained below, these subsidiaries posed a serious problem in the resolution process.

More generally, the Icelandic financial crisis exposed important problems arising out of cross border financial regulation and surveillance. The debate over the larger issues continues both in Iceland, where the electorate recently turned out the post-crash Socialist government, and abroad. In this article, I examine how Iceland addressed the bank resolution issues.

The emergency measures

On the eve of the 2008 collapse, the Icelandic parliament, the Althingi, passed Emergency Act No 125/2008, which authorised the country’s Financial Surveillance Authority (the FME) to take control of the three largest banks. Because of the banks’ size, a bailout was never on the table.

The Emergency Act enabled the FME to appoint a Resolution Committee (RC) to each of the fallen banks to transfer assets and liabilities to new banks for the purpose of safeguarding the functioning of the domestic banking system and restoring public confidence. In general, domestic assets and liabilities were placed in the new banks, while foreign assets and liabilities were left in the bankrupt estates of the old banks. Essentially, the estates of Glitnir, Kaupthing and old Landsbanki, kept a portion of the domestic assets portfolios, and all operations and assets in foreign branches and subsidiaries, which had mainly been funded through issuance of bonds and foreign deposits. All liabilities other than domestic deposits stayed in the estates of the old banks.

To facilitate the transfer of domestic deposit liabilities to the new banks, the Emergency Act rearranged the order by which the banks’ creditors would recover their money. Insured deposits were handed priority status in the winding-up process, subordinating bondholders, uninsured depositors2 and general creditors.3 The estimated value of the assets transferred to the new banks was around 2,090 billion Icelandic Krónur, against estimated value of liabilities of around ISK1.8 billion.

The government relatively quickly reached a settlement with the resolution committees on behalf of the creditors of Kaupthing and Glitnir concerning the transfer of assets and liabilities to the new banks and their initial funding. Kaupthing acquired through its equity contribution 87 per cent of shares in the new bank, Arion banki, while the government retained a 13 per cent shareholding and gave the new bank a subordinated loan to strengthen its capital ratio.4 Similarly, Glitnir received 95 per cent of the new Islandsbanki’s share capital, with the government retaining 5 per cent and providing a subordinated loan to the new bank.5

A different approach was used in settling the transfer of assets and liabilities from the old Landsbanki, with the government contributing ISK122 billion in equity in return for 81 per cent of its share capital. The new bank issued a ten year ISK260 billion bond to the old bank, against a collateral in the new bank‘s assets, to be paid in foreign currencies. The old bank temporarily received 19 per cent of the new bank’s shares for its contribution.6 The difference in treatment is widely regarded to have been influenced by the representatives of British and Dutch depositors, not interested in becoming shareholders in the new Landsbanki, while general bondholders played a larger role in the estates of Kaupthing and Glitnir.

In spring 2009 the District Court of Reykjavik appointed Winding-Up Boards to oversee the liquidation process of the bankrupt estates and the handling of claims. Based on recent creditor reports of Kaupthing, Glitnir and Landsbanki, the winding-up boards have accepted claims in the amount of around ISK8.4 billion while the assets are valued at around ISK2.6 billion.7
The government‘s action was challenged in a series of lawsuits. Because Iceland is a member of the EFTA (but not the EU) and the EEA Agreement8, this included challenges by the EFTA Surveillance Authority (ESA) at the EFTA Court.9

In December 2010 the ESA closed seven cases over the Emergency Act, finding the act compatible with the EEA Agreement. The ESA concluded that depositors “were in a different situation than general creditors and in a greater need of protection in the event of insolvency of a bank.”10

Furthermore, ESA concluded that the Emergency Act and the FME decisions did not constitute discriminatory treatment of general creditors in conflict with the principle of free movement of capital under the Agreement and found the measures justified despite being restrictive. The president of the ESA stated: “This conclusion is of major importance when it comes to the division of assets of the estates of the collapsed banks and the restructuring of the Icelandic banking system.”11

On 28 October, 2011 the Supreme Court of Iceland accepted the priority status of the claims of the British and the Dutch depositors’ funds in the estates of Landsbanki, regarding the disputed Icesave accounts, and thereby found the Emergency Act compatible with the Icelandic constitution which had been contested by general creditors.12

Resolving the Icesave affair

The EFTA Surveillance Authority’s decision in regard to the Emergency Act discussed above did not affect the infringement proceedings against Iceland at the EFTA Court, initiated by the ESA on 26 May 2010, concerning Iceland‘s obligations under EU Directive 94/19 on deposit guarantee systems. The ESA claimed that in failing to ensure payment of compensation of up to EUR20,000 per depositors holding deposits in Landsbanki’s internet bank branches (known as “Icesave”) in the United Kingdom and the Netherlands, within the time limits laid down in the Directive, Iceland had breached its obligations under the Directive.

This dispute highlights an important flaw in the regulatory framework of the European financial markets related to deposit guarantees.

The funding of the three Icelandic banks through European internet bank depositors was in part a response to earlier international criticism of the lack of diversified funding strategies of the banks. Indeed, the move was applauded by rating agencies and credit analysts alike even as it created considerable risk in the event of an international liquidity crisis. Each of the banks created subsidiaries or branches seeking deposits outside Iceland for ISK denominated accounts. These accounts drew in additional deposits, enabling the banks to continue to expand after the 2006 “Geysir” mini-crisis initially rattled financial markets’ confidence in the banks.

Landsbanki‘s Icesave was created as an Icelandic branch of its parent rather than as a subsidiary, a distinction that proved important in the crisis. While the subsidiary is a part of the host country‘s financial surveillance and deposit guarantee system, the branch arrangement created jurisdictional uncertainty in financial surveillance; but more importantly meant that the approximately 400,000 foreign depositor accounts were backed only by the ISK 13 billion left in the account of the tiny Icelandic deposit guarantee fund, representing just 0.41 per cent of total deposits in the Icelandic banking system. As with other such funds in Europe, the Icelandic fund had funds barely sufficient to handle a liquidity crisis of a medium-sized local bank, but did not have the assets necessary to handle a systemic crisis of the whole deposit banking sector, let alone one that spread over to other jurisdictions.

No obligation to bail out depositors

After the downfall of Landsbanki, which was partly triggered by the UK government’s invocation of its emergency powers against the bank under anti-terror legislation,13 the British and the Dutch governments decided to bail out retail depositors in the Icesave branches in their countries. When they then sought to recover the cost from Icelandic taxpayers – which would have required the 123,000 households in Iceland to guarantee the payment of GBP2.2 billion and EUR1.3 billion – the Icelandic public protested the proposed agreements.

This led to the president of Iceland twice using his constitutional power to refuse to sign acts authorising ratification of agreements negotiated by the Icelandic government, triggering two referenda in which voters rejected the agreements by landslide votes. These dramatic vetoes were just the second and third in Iceland’s history since independence. With the failure of the negotiations, the dispute continued before the EFTA Court based on the infringement pleas of the ESA.

In January 2013, the EFTA Court dismissed all of ESA’s pleas, noting that “it must be held that Article 7 of the Directive does not lay down an obligation on the State and its authorities to ensure compensation if a deposit guarantee scheme is unable to cope with its obligations in the event of a systemic crisis“.14

In addition, the court also noted that “even as regards the important objective to avoid bank runs, the wording of recital 4 in the preamble to the Directive is limited to a failure of a single credit institution that may lead to massive withdrawals also from healthy institutions“15 and that “EEA states enjoy a wide margin of discretion in making fundamental choices of economic policy in the specific event of a systemic crisis“.16

This ruling is final in regard to potential obligations of Iceland towards the British and Dutch governments under Directive 94/19, leaving them with only their priority claims to the assets of the estate of the old Landsbanki. However, it currently appears there may be sufficient assets in that estate that the two governments will ultimately fully recover their cost of bailing out their Icesave depositors.

The Icelandic experience clarified the obligations of European states with respect to deposit insurance under Directive 94/19, limiting their obligations to their domestic insurance funds and providing considerable flexibility in addressing large banking crises. However, amendments have been made to Directive 94/19 on deposit guarantee schemes, which may in the future lead to the obligation of the Member States to guarantee the payment of EUR100,000 per depositor.

What the future holds

When the crisis began, Iceland swiftly enacted strict restrictions on capital movements not related to the trade in goods and services. In attempts to prevent further weakening of the ISK, the restrictive measures have been gradually tightened. While Iceland is operating the ISK under capital controls with borrowed currency reserves from the IMF and elsewhere, many fear that financial stability will be seriously threatened when the foreign creditors ultimately seek to transfer their recoveries from the estates out of Iceland.

Moreover, the governor of the Central Bank of Iceland is already on record claiming that the new Landsbanki will be unable to honour its obligations, in foreign currency, under the present terms negotiated with the old Landsbanki, without jeopardising national financial stability. The new government has made clear in light of the situation that further haircuts on creditors’ claims are a precondition to the lifting of the capital controls. Plans to conclude the winding up proceedings of Kaupthing and Glitnir through composition agreements have been brought to a halt and it seems as if the foreign creditors are all but stuck in Iceland.

However, offshore trade in the claims has been active. According to the claims registers of the bankrupt estates, most of the original creditors have realised their losses and traded their rights. Among the buyers are hedge funds specialising in distressed debt investment.17 Many in Iceland believe this has given the government the moral high-ground in attempting to make these foreign creditors share more of the costs.

Though such measures may be the only way to prevent a new financial collapse in Iceland, and the new holders of distressed debt may reasonably have expected such an outcome, the stage has been set for further legal controversies.

Although Iceland‘s recovery process has been hailed internationally as a success story,18 an overall verdict is premature at best. During the four year term of the socialist government ending in May this year economic freedom has been substantially undermined.19 This will delay real economic recovery in Iceland and is not merely a consequence of the capital controls, which stifle foreign investment.

In particular, reform of the oversized public sector continues to be postponed, as the Icelandic government is heading for the sixth consecutive year running a fiscal deficit, with public debt already at 130 per cent of GDP. Credible plans for the construction of a sound, internationally viable financial system, including addressing whether the Icelandic economy is large enough to support its own currency, have not been presented. With the net external position of the economy, including the liabilities of the fallen banks, at around 480 per cent of GDP, the economic policies implemented in Iceland in recent years – such as the introduction of over 100 tax increases in almost all sectors of the economy – have undercut the recovery.

As a result, foreign creditors mhttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=2016295ay have to settle for greater haircuts on their claims than they anticipated in the winding up proceedings.


  1. See an in depth analysis of the Icelandic financial crisis co-authored by this author: Birgir T. Petursson & Andrew P. Morriss, Global Economies, Regulatory Failure and Loose Money: Lessons for Regulating the Finance Sector from Iceland‘s Financial Crisis, Alabama Law Review, Volume 63, Number 4, 2012, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2016295. 
  2. Uninsured depositors are those, domestic as well as foreign, which hold deposits excluded by the Act on Deposit Guarantees and Investor Compensation Scheme no 98/1999 (which enacted the EU Directive No 94/19 on Deposit Guarantee Systems) from enjoying a protection from such a scheme. The distinction has been termed by the EFTA Court and the EU Commission as between a technical and a functional definition of a deposit. Uninsured depositors are for example Icelandic credit institutions (members of the Icelandic deposit guarantee fund) holding deposits for their own account in another credit institution.
  3. The Emergency Act changed the Act on Financial Undertakings no. 161/2002 so that deposits, as defined in Act no 98/1999 were to be treated in the winding-up process of the estates of the fallen banks as priority claims according to Article 112 of the Act on Bankruptcy No 21/1991 rather than as general unsecured claims according to Article 113 of the same act.
  4. http://eng.fjarmalaraduneyti.is/news/nr/12699 
  5. http://eng.fjarmalaraduneyti.is/news/nr/12593 
  6. http://eng.fjarmalaraduneyti.is/news/nr/12733. In April this year the government acquired all the shares the old Landsbanki‘s held in the new Landsbanki against an additional issuance of a debt from the new bank to the old in foreign currency (equivalent of ISK92 billion ).
  7. 28,167 claims were lodged in the estate of Kaupthing in the total amount of ISK7,316 billion. 8,685 claims were lodged in the estate of Glitnir in the total amount of ISK3,436 billion. And 11.993 claims were lodged in the estate of Landsbanki in the total amount of ISK6,299 billion.
  8. Members of EFTA (the European Free Trade Association) also include Switzerland, Norway and Liecthenstein. The EEA Agreement (on the European Economic Area), connects the EFTA Members (all but Switzerland which rejected EEA Membership) to EU‘s Single Market.
  9. The ESA oversees EFTA Members‘ compliance with the EEA Agreement. The EFTA Court is within the EFTA pillar the equivalent of the European Court of Justice (ECJ) within the EU pillar, a part of the EEA‘s two pillar set-up. The EFTA Court has competence in cases regarding EEA Member States which are not EU members. The ECJ on the other hand deals with cases in respect to EU members.
  10. http://www.eftasurv.int/press–publications/press-releases/internal-market/nr/1345 
  11. See footnote 10.
  12. Cases no. 340/2011 (Arrowgrass and others vs. Landsbanki Íslands hf. and The Financial Services Compensation Scheme Limited) and 341/2011 (Arrowgrass and others vs. Landsbanki Íslands hf. and De Nederlandsche Bank N.V.)
  13. At 10.00 am 8 October the British Treasury issued the Landsbanki Freezing Order 2008, which included the finding that “the Treasury believe that action to the detriment to the United Kingdom‘s economy (or part of it) has been or is likely be taken by certain persons who are the government of or resident of a country or territory outside the United Kingdom. The Treasury, in excercise of the powers conferred by sections 4 and 14 of and Schedule 3 to the Antiterrorism, Crime and Security Act 2001(1), make the following order [taking control of the bank]“. This use of antiterrorist legislation to freeze the assets of Landsbanki, meant that the bank, as well as the Icelandic Treasury and the Central Bank of Iceland were on a list with Al-Qaida for 24 hours. Iceland’s permanent representative to NATO strongly protested the United Kingdom’s use of anti-terrorism legislation against Iceland at a NATO conference in October 2008.
  14. http://www.eftacourt.int/uploads/tx_nvcases/16_11_Judgment_EN.pdf, par 144.
  15. See footnote 14, par 151.
  16. See footnote 14, par 227.
  17. According to Icelandic reports these include Davidsson Kempner Capital Management and Paulson Credit Opportunities Fund to name but a couple of known investors. Some estimates put the rate of recovery for unsecured creditors (with all due reservations) in Landsbanki at 15 per cent, Kaupthing at 30 per cent and Glitnir at 40 per cent which means that some of the late arrivals may enjoy a handsome profit on their investment in the claims, rumoured to have been traded as low as at 3% and as high as 30%, depending on the estate.
  18. http://www.forbes.com/sites/traceygreenstein/2013/02/20/icelands-stabilized-economy-is-a-surprising-success-story/ 
  19. According to the Reports on the Economic Freedom of the world of the Fraser Insitute, Iceland has dropped in the world ranking from being the 9th freest economy of the world in 2006 to 65th in 2010. Icelanders voted for a change at the end of April this year and elected a centre-right government which took office in May. The socialist parties which formed the government voted out only received support of 25 per cent of the voters in the election, decribed by analysts as the worst election result of any government in western Europe since WWII.