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The lessons from the Icesave rejection

Icelanders have voted against providing a government guarantee for claims made by the UK and the Dutch governments against Iceland’s deposit insurance fund. This column argues that the heated debates surrounding the referendum may provide a glimpse into the challenges that lie ahead for European policymakers as they attempt to allocate losses suffered by banks between the taxpayers of different countries.

The population of Iceland has refused – for the second time – to pay the minimum guaranteed deposits of UK and Dutch depositors in its failed Icesave high-interest accounts. This would have reimbursed the governments of the UK and Netherlands for unilaterally compensating savers in Icesave, the failed Icelandic bank operating accounts in these two countries.

The terms of the deal negotiated between the governments of Iceland, the UK, and the Netherlands were fair and reasonable, offering much better terms than those offered to Eurozone states needing bailouts. In spite of this, the deal has been rejected by Iceland’s voters.

The refusal does not seem to be based on cold and rational economic calculations. After all, the amounts of money are small, even for a country the size of Iceland.

The reasons for the refusal were essentially emotive. The population, by 60% to 40% with a high turnout, rejected the agreement because they refused to have ordinary people meet the obligations created by a failed private bank. Other reasons include nationalism, worries about future taxes, a rejection of future EU membership and a desire for legal clarity. If a court rules against Iceland, we expect Iceland to pay the amount mandated by the court, likely to be much higher than stipulated in the negotiated settlement.

The outcome is inconvenient to European governments since if the UK and the Netherlands prevail in a court case, it might eliminate the constructive ambiguity the EU prefers on deposit insurance and integrated financial markets.

Similarly, a loss in court, or alternatively not taking this to court would help establish the principle that a European country does not have to honour some obligations expected of them by the EU. It also might encourage those seeking to default on sovereign debt in Europe.

Indeed we suspect that the UK and the Netherlands along with the EU will find both winning and losing the court case almost equally unpalatable. The failure to find a negotiated settlement is therefore surprising, especially given the small amounts involved.

A quick background to Icesave

Icesave has been well documented here on Vox (see e.g. Danielsson 2010 and Gylfason 2010). It arose from an Icelandic bank (Landsbanki) taking advantage of weaknesses in European financial regulations to provide high-interest deposits in the UK and Netherlands under the name of Icesave. By the time Landsbanki collapsed in the fall of 2008 it had been one of the riskiest banks in the world for quite some 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 was insured and regulated there.

When the Icelandic banking 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 they were not obliged to do so, the governments of the UK and Netherlands felt it necessary at the time to repay its depositors in accordance with their deposit insurance norms in order not to upset their own banking system at a time when they were already looking quite unstable. The governments acted unilaterally with the expectation that they could claim the money back from the deposit insurance fund in Iceland. The British and Dutch governments are claiming from Iceland the amount required to cover the minimum EU deposit insurance.

How much money are we talking?

At the time of its collapse, Icesave had amassed about €6.8 billion, split between retail deposits and wholesale deposits (made by institutions like local governments). Of the retail deposits, €3.9 billion were covered by the minimum EU deposit guarantee of €21,000. Retail deposits, but not wholesale deposits, constitute a priority claim into 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 is likely to exceed 90% and may even reach 100% with payout expected to commence at the end of this year. The governments of the UK and Netherlands are claiming the amount of priority claims not recovered from the estate, as well as interest paid, since they had to fund the full €3.9 billion in October 2008. The interest payments are likely to exceed the shortfall in recovery.

Over time, the interest rate demanded of Iceland by the UK and the Netherlands has fallen, it was initially 6.7% with a short repayment period, then 5.5% with a longer repayment period, rejected in a referendum last year. The recent referendum rejected a deal with 3.2% interest, with a nine-month interest holiday.

The cost to the UK, Netherlands and the EU: Much less than €1 billion

The direct financial cost incurred by the UK and Netherlands is of the magnitude of less than 10% of the total amount of €3.9 billion. This amount has to be financed until they claim from the estate. Given this, we can estimate the total cost to the government of the Netherlands and the UK, from meeting the minimum EU deposit guarantee, to be in the range of about €375 million to €840 million, depending on recovery rates and timing, with about 2/3 falling on the UK.

In spite of these relatively low amounts, the governments of the UK, and especially the Dutch government have pursued their claim vigorously with the approval of the EU and the Scandinavian government and even attempted to use their positions within the IMF to support their claim.

Why demand the money?

Given the determination to reclaim such relatively small amounts, the strong desire for Iceland to settle this seemed to be based on reasons other than direct economic costs. There seem to be three main reasons for this.

  • First, allowing Iceland to walk away from offering the government guarantee would dilute the principle that a country cannot ignore its financial obligations, thus undermining the assumptions underpinning the common European market in financial services.
  • Second, the Icelandic government discriminated between domestic savers and foreign savers. This would seem contrary to EU law.
  • Finally, the political atmosphere in the Netherlands, but not the UK, has called for a demonstration of strength by the Dutch government. Consequently, the Dutch authorities have repeatedly issued strong public statements, demanding repayment, accompanied by a variety of threats.
A court decision is not desired

If there is no settlement, the UK and the Dutch government could give up their claim. Finding a face-saving way to that might be easier in the UK than in the Netherlands given the heated discussion of the matter there.

The alternative is taking the matter to the European Free Trade Association (EFTA) court. This is the route being followed by the EFTA authorities. Procedurally, it is not up to the Netherlands and the UK to initiate such proceedings, instead the EFTA Surveillance Authority is expected to file such a case against Iceland in the coming months.

The case is somewhat unclear. EU law states that a country is required to maintain a deposit-insurance scheme, funded by countries’ financial institutions, not by the national governments. This is deliberate, since national governments may want to leave open the option not to give government guarantees to deposit insurance funds in a crisis, even if some have opted to do so in recent years.

However, the case against the Icelandic government is strengthened by senior government officials in that country declaring prior to the bankruptcy that the government was backstopping the deposit insurance fund. Furthermore, the government of Iceland guaranteed deposits in Icelandic branches of the same bank fully following the crash of its banking sector, and this might be judged to be discriminatory under EU law, implying that depositors in foreign branches were entitled to be compensated fully.

We suspect that neither government, nor the EU, is keen to have the Icesave issue settled in court. An adverse court ruling might establish the principle that a country can reject its obligations, and allow discrimination based on nationality. It might also encourage those seeking to default on sovereign debt in Europe. Similarly, a positive court ruling could establish the principle that the taxpayer is required to backstop deposit insurance.

The cost to Iceland

Calculating the cost to Iceland of a settlement is more difficult and not directly comparable with the British and Dutch costs. The reason is that the Icelandic government has a claim on the estate, fixed in Icelandic krona while the obligation is in foreign currency. This means that throughout the repayment period, Iceland would be running considerable exchange-rate risk. Given the historical weakness of its currency, this represents significant risk.

At current exchange rates, assuming they will remain unchanged, the undiscounted obligation once the deposit insurance fund has been depleted is about €196million, assuming 90% recovery, or about 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 amount is capped by recovery limits) while a falling exchange rate could increase the amount quite significantly. This could also lead to continuance of capital controls in the short run, to contain the risk of a falling exchange rate.

However, leaving Icesave unsettled is also quite costly. Following the vote Fitch Ratings declared that the vote had diminished the prospects of Iceland regaining an investment grade rating in the near future; Moody’s left its Baa3/P-3 rating with a negative outlook – one notch above junk status unchanged – and Standard & Poor’s has put the ratings of the sovereign on a negative watch from its current BBB- status. But the magnitude of the impact on the pricing of government bonds to be placed in international capital markets remains uncertain. The access of Icelandic companies to international capital markets could also remain curtailed and capital controls are likely to remain.

The importance of the Icesave dispute issue for the Icelandic economy, including the capital controls and access to foreign capital markets, should not be exaggerated however. It is one of many issues that have to be resolved in Iceland in order to enhance business confidence and promote growth. Other issues include foreign direct investment policy, settled property rights and political stability.

The failure to settle is surprising

A negotiated settlement was of interest to everybody involved. It is therefore unfortunate that the situation has reached the stage where the Icelandic government is unable to continue negotiating and the three governments have no alternative to seeing the EFTA Surveillance Authority prepare its court case against Iceland.

Of the three countries, the only government that has publically handled the situation sensibly is the UK, because at no stage have any of its politicians or civil servants made public statements about Icesave. All negotiations there have been handled quietly.

In contrast, senior political leaders in the Netherlands have repeatedly made threatening comments inflaming the opposition to the agreement in Iceland.

The government of Iceland mishandled the negotiations to begin with. Initially, it sent a team lacking experience to negotiate. Unfortunately, the team was too politicised. This resulted in a lack of confidence in the agreement and the government once criticism of the agreement started to emerge. Only towards the end did they employ more professional negotiators, which succeeded in getting a better agreement. By then it was too late. Public opposition was strong, with the populist president vetoing the agreement for the second time. By that time, public opinion had become so inflamed that a rejection was almost inevitable.


There are several lessons to be drawn from this episode.

First, trying to force a population to pay for something they feel no responsibility for can lead to very strong reactions and may inflame nationalist sentiments, even if the payments are justifiable in terms of financial stability or international relations. When events get to this stage, a previously soluble problem can become unsoluble and an undesirable chain of events set in place.

In general, the episode reveals a gap between what a government perceives to be in a country’s national interests and what individual voters may think. While all Iceland’s leaders handling the issue have wanted to accept, voters have had different reasons not to – the most important one being that they did not want to spend own money to pay for something they did not find themselves responsible for. At a more abstract level, one might even go further and paraphrase Mancur Olson by asking why each voter should desire what a government thinks is good for the country when preoccupied with its own bread and butter issues?

It follows that governments of European countries – as well as their citizens – may balk at accepting austerity programmes required to pay foreign creditors. Moreover, the populations of countries that attempt 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 basic economic case for accepting the agreement was clear. However, the rejection was only partially based on economic arguments. More important was the principled refusal to bail out the obligations created by a private bank.

The outcome points to a limitation of the perceived understanding 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 might be better served if European policymakers were more explicit about how the financial system is supposed to operate.

Unfortunately, having direct rules and enforcing those rules may get in the way of political objectives. As this case shows, and the much bigger Eurozone crisis which has many of the same roots, the current attitudes in Europe to fiscal and financial policy seem flawed.


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

Danielsson, Jon (2010), “The saga of Icesave”, VoxEU.org, 26 January.

Gylfason, Thorvaldur (2010), “Eleven lessons from Iceland”, VoxEU.org, 13 February.

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