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Love letters from Iceland: Accountability of the Eurosystem

Investigation of Iceland's meltdown has revealed dodgy behaviours ranging from neglect to criminal fraud. This column describes how Icelandic banks issued “love letters” to each other – swapping their debt securities and using the other bank’s debt as collateral. This ruse ensnared not just the Icelandic Central Bank, but also the ECB – a fact that has only recently come to light. The ECB's lack of transparency on this is a serious problem.

In the lead up to the crisis, it was common practice in Iceland for two banks to swap their debt securities with each other and for each to use the other’s debt as collateral in their borrowing from the central bank. Such collateral was referred to as a “love letter” (Flannery 2009, p101, Hreinsson et al. 2009, p44, and Jännäri 2009, p18).

Surprisingly, it was not just the Central Bank of Iceland that was willing to make loans against love letters – the Eurosystem was as well. Between the start of February and the end of April 2008, subsidiaries of the three large Icelandic banks, Kaupthing, Glitnir and Landsbanki, increased their borrowing from the Central Bank of Luxembourg by €2.5 billion. A significant amount of their collateral was in the form of love letters (Hreinsson et al. 2009, p44). It is questionable whether Icelandic bank debt should have been acceptable as collateral in the Eurosystem for any borrower. Given their inter-linkages, the Icelandic banks’ fortunes were far too highly correlated for one Icelandic bank’s debt to be satisfactory collateral against another Icelandic bank’s borrowing.

By late April 2008, the ECB had become concerned about its loans to Icelandic banks and on 25 April, the ECB President, Jean-Claude Trichet, phoned Icelandic central bank governor Davíð Oddsson and demanded a meeting with Icelandic banks and monetary and regulatory authorities (Hreinsson et al. 2009, p44). As a result, an informal agreement was made in Luxembourg on 28th and 29th April to limit the use of love letters as collateral. This proved ineffective. By the end of June, loans to the Icelandic banks had risen sharply to €4.5 billion. At the end of July, the Central Bank of Luxembourg finally prohibited the further use of love letters altogether and lending to Icelandic banks fell back to around €3.5 billion.1 In the autumn of 2008, five counterparties defaulted on their Eurosystem loans and three of these were subsidiaries of the large Icelandic banks (European Central Bank 2009).

In March 2009 a member of the Economic and Monetary Affairs Committee of the European Parliament questioned President Trichet on the Central Bank of Luxembourg’s loans of €800 million to Kaupthing and €1 billion to Landsbanki, saying “What do you think of this? Is there any dialogue on this subject? It is an enormous risk after all!” Trichet responded with, “I do not know the details – you are very will informed: you are better informed than I am. I have to say, at the moment – but I have no doubt that the Luxembourg bank is complying precisely with the requirements imposed by its position as a member of the Eurosystem and is applying the Eurosystem rules to the banks that submit eligible collateral to it.” (ECON 2009).

Central banking questions

The questionable lending to Icelandic banks and the seeming reluctance of the ECB to discuss the matter with the European Parliament raise some disquieting questions about the accountability and transparency of the Eurosystem. Should an independent and unelected body be allowed to engage in such a risky and political activity? If it does, does it not have an obligation to be transparent about its actions? Even if confidentiality considerations or concerns about revealing market-sensitive information justified keeping certain things from the public for a while during the crisis, it should not have prevented President Trichet from giving a complete and honest answer to the European Parliament’s question. That question was asked five months after the Icelandic banks met their demise.

Since the onset of the current financial crisis, the financial stability role of the ECB has been significantly enlarged. The ECB and the national central banks have greatly expanded the scope of their actions and the size of their balance sheets. National central banks have officially conducted lender-of-last-resort actions for their own governments’ accounts; the ECB has participated in currency swaps with other governments on its own account and, through the provision of repo facilities, to non-Eurozone countries such as Hungary. On 9 May, the ECB purchased Eurozone government bonds outright as part of the financial support scheme for heavily indebted Eurozone member states. In acting as lender of last resort or otherwise intervening in financial markets, the Eurosystem is taking on risk and redistributing income. Allowing an independent and unelected institution to take on such a political task is only palatable in a democracy if the institution has legitimacy.

Legitimacy as accountability

A key component of legitimacy is accountability; it is difficult for the citizenry to view an institution as legitimate if it is not accountable. Schedler (1999) defines accountability as "A is accountable to B when A is obliged to inform B about A’s (past or future) actions and decisions, to justify them, and to suffer punishment in the case of eventual misconduct". From this definition, it is seen that accountability has three components for the Eurosystem; first, the public should be able to observe or be provided with the relevant information about its actions and decision-making process; second, it should explain and justify its actions; third, it should be possible to reward or punish its policymakers in response to good or bad behaviour. The first two components are often referred to as formal accountability; the third component is often referred to as substantive accountability (see Buiter 2006 and 2008).

The Eurosystem is subject to little substantive accountability. It is clear that no one, not the European Parliament, nor the Council of Ministers, nor the European Commission can impose sanctions on the Eurosystem. Members of the Executive Board serve eight-year, non-renewable terms; national central bank governors serve at least 5-year terms. Their compensation is internally decided. Governors of national central banks and members of the Executive Board can be fired only in the event of incapacity or serious misconduct. Mere gross incompetence is not a firing offence. The only checks are the fear of shame and embarrassment, the threat of being reviled by the press and reputational concerns. While the independence associated with a lack of substantive accountability may be attractive for the ECB as monetary policymaker – it shields policymakers from politicians who might want to use monetary policy opportunistically – it is far less desirable for the Eurosystem in its financial stability role.

With little substantive accountability, formal accountability is imperative for legitimacy. When the Eurosystem engages in lending activities, it must value the collateral that it is offered, decide whether to accept or not, and to impose a proper liquidity “haircut” or discount on this valuation. If the collateral is valued properly and the right haircut is imposed, then the risk-adjusted expected return to the Eurosystem on its lending will equal the market risk-free rate: there will be no ex ante subsidy or tax. But, if the ECB is not sufficiently aggressive with its valuations and haircuts, then it is transferring wealth to the borrower: a political act that could threaten its legitimacy.

Is the ECB being sufficiently aggressive? In the case of the Icelandic banks, did it just look at their ratings when deciding whether or not to accept their love letters and what haircut to impose? Or, did it consider the warnings from the CDS market? Did it consider the correlation of the risks it was taking on? In a financial crisis, a security offered as collateral may not have traded recently or it may not be marketable, how then is the security valued? The ECB does not publish the models it uses to value illiquid collateral, nor does it publish the actual valuations of this collateral, on an instrument-by-instrument basis, so that independent third-party evaluation of the ECB’s procedures is possible ex post.

Members of the European Parliament have questioned the President of the ECB about its policies with regard to collateral and its balance sheet, but without success. At the December 2009 Quarterly Dialogue, an ECON committee member asked President Trichet, “To increase its legitimacy, the ECB should publish the minutes of Governing Council meetings … And should not this transparency also apply to the internal models used to value liquid collateral?” President Trichet responded by ignoring the question and extolling the ECB’s supposed transparency: “We have transformed the way in which transparency is looked at.”2

ECB transparency and legitimacy

The Eurosystem has not been transparent or accountable with respect to its lending activities. Outside the Eurozone, an increased financial stability role for the central bank may make it appealing to take away some of an imperfectly accountable central bank’s independence. The monetary policy committee might then be made a separate and independent entity, charged solely with setting the policy rate. Within the confines of the Treaty and Statute, however, this is not possible and if the ECB to retain its legitimacy, it needs to become much more forthcoming.


Buiter, Willem H (2006), "How Robust is the New Conventional Wisdom in Monetary Policy? The surprising fragility of the theoretical foundations of inflation targeting and central bank independence", CEPR Discussion Paper 5772.
Buiter, Willem H (2008), "Monetary economics and the political economy of central banking: inflation targeting and central bank independence revisited", in Jorge Carrera (ed.), Monetary policy under uncertainty; proceedings of the 2007 Money and Banking Seminar, Buenos Aires, Banco Central de la República Argentina.
ECON (2009), “Quarterly Dialogue with the President of the European Central Bank, ECON committee of the European Parliament”, 9 March.
European Central Bank (2009), “Eurosystem Monetary Policy Operations in 2009”, Press Release.
Flannery, Mark J (2009), “Iceland’s Failed Banks: A Post-Mortem,” report prepared for the Icelandic Special Investigation Commission, 9 March.
Hreinsson, Páll, Tryggvi Gunnarsson and Sigríður Benediktsdóttir (2009), “Causes of the Collapse of the Icelanldic Banks – Responsibility, Mistakes and Negligence,” report prepared for the Icelandic Special Investigation Commission, 9 March.
Jännäri, Kaarlo (2009), “Report on Banking Regulation and Supervision in Iceland: past, present and future,” report commissioned by the Icelandic government’s part of its Stand-By Arrangement with the International Monetary Fund, 30 March.
Schedler, Andreas (1999), "Conceptualizing accountability," in Andreas Schedler, Larry Diamond, Marc F Plattner (eds.), The self-restraining state: power and accountability in new democracies, London, Lynne Rienner Publishers.

1 Hreinsson et al (2009), p. 44. On 30 June the Central Bank of Luxembourg advised Landsbanki that it could no longer use unsecured Icelandic bank debt at more than 25% of its collateral and that it must phase out is use of this type of collateral as soon as possible. See Flannery (2009), p. 101.
2 The questioner must have meant to say illiquid assets. See also ECON committee member Philippe Lamberts’ complaint in December 2009 that the committee has no understanding of how the ECB values asset-backed securities.


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