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The saga of Icesave: A new CEPR Policy Insight

Icelanders may well reject the terms of the financial deal with Britain and the Dutch in a March referendum. This column introduces a new CEPR Policy Insight arguing that responsibility for Icesave losses falls jointly on Iceland, Britain and the Netherlands. Regardless of the vote, the three governments should come to a more reasonable agreement that enables Iceland to pay its obligations without tipping the economy into the abyss.

The President of Iceland has refused to sign a parliamentary bill agreeing to compensate the governments of the UK and Netherlands for deposit insurance payouts they made to Icesave depositors. This does not mean a rejection of the country’s obligations nor any form of default. On the contrary, the decision by the president stems from the fact that over 70% of Icelanders find the terms of the current deal unreasonable.

Iceland has traditionally had limited experience with international banking. Yet upon joining the European Economic Area in 1993, it adopted EU regulations and its banks could operate in the EU with the so-called "one passport".

The banks proceeded to gear up, aided by favourable ratings, e.g. a December 2006 Moody’s report noted “strong likelihood of state support in the event of systemic shock”. Eventually, the balance sheet of the banks swelled to 10 times the GDP of Iceland.

So what is Icesave?

Icelandic banks started experiencing increasing problems raising funds in international capital markets in 2006 and hit on the idea of establishing Internet banks in Europe. The European financial passport made that easy to do, and the rating agencies favoured the move, see e.g. the Moody’s (2006) report.

As I explain in greater depth in CEPR Policy Insight No. 44, there are essentially two ways a bank can do this, by a branch or subsidiary. Landsbanki opted to set up branches, under the name of Icesave, supervised and insured from Iceland. They offered above-market interest rates, starting in October 2006, eventually amassing £4.5 billion in the UK. This may have been done initially with the encouragement of the UK FSA, being worried about the funding position of Landsbanki.

In 2008, the FSA became concerned and applied increasing pressure on Landsbanki to limit deposits, to which it responded by starting to raise deposits in the Netherlands in May 2008, eventually collecting €1.7 billion there.

What about risk?

International capital markets increasingly seem to have viewed the Icelandic banks and the government of Iceland as a single joint entity from a risk point of view. The country risk became effectively the same as the bank risk.

The CDS spreads of Landsbanki started rising sharply in 2008, see the Figure, reaching 865 on 31 March 2008 when they started taking deposits in the Netherlands, after which they dropped to 291 on 23 May, before reaching 715 by early August.

Figure 1. CDS spreads on Landsbanki, 2007–2008

Singh and Spackman (2009) calculate the implied probability of default for 31 March 2008 as 22%, using an assumption of 40% recovery, and 77% if using stochastic recovery and probability, a methodology they recommend.

Who knew?

By 2008 anybody with access to Bloomberg could see that the CDS spreads on Landsbanki were amongst the highest in Europe for banks. The risk was widely discussed in media. This is Money in the UK had an article on 16 March 2008 that placed Iceland’s banks atop the "riskiness league", saying “these [Icelandic] banks are now seen as the most unsafe in the developed world.” MoneyWeek in the UK on 19 March 2008 had a similar story, stating “perhaps, just perhaps, we should pay more attention to the risk side of the equation too.”

The relevant authorities were also aware of the precarious state of the Icelandic banks. For example, Gunnarsson (2009) notes that in April 2008 ECB President Jean-Claude Trichet called the governor of Bank of Iceland in anger, complaining about the Icelandic banks. Gunnarsson (2009) states that Landsbanki was under close scrutiny by the relevant authorities in Europe, who applied pressure to limit deposits.

Bankruptcy and responsibility

Landsbanki eventually collapsed in October 2008 along with the rest of the Icelandic financial system. After the failure of Landsbanki, the government of the UK fully compensated all retail depositors, while the government of Netherlands compensated retail depositors up to €100,000. But the first €21,000 fell on the Icelandic deposit insurance fund, which only contained a fraction of the needed amount.

Under EU law, if the deposit insurance fund is not sufficient, it falls on the other banks in the country to make up the shortfall. However, the law is unclear on what happens if all of the banks fail. See e.g. the Mishcon de Reya Solicitors report (2009).

This uncertainty is the foundation of Iceland’s reluctance to compensate the UK and Netherlands. It has not rejected its obligations but rather the terms under which Iceland compensates the UK and Netherlands, which is at the heart of the dispute.

What is the issue?

The overall amount involved might not seem excessive, around €3.9 billion, but only around 315,000 people live in Iceland, so that equates to about €13,000 per person. Factoring in recovery, the cash flows schedule and accumulated interest payments, I estimate that, at current exchange rates, Iceland can be expected to pay €2.8 billion (Danielsson, 2010). This is just under its government's total expenditures in 2010.

Because of the structure of the deal, Iceland’s net payments increase if its economy performs badly. It is already just about the most indebted country in the world as a consequence of the crisis, and if the Icesave repayments become too burdensome, a sovereign default is a possible eventuality.


The EU has used its influence to hold up approval of IMF aid, and Iceland’s EU application appears to be conditional on settlement. However, since the majority of Icelandic voters have consistently opposed EU membership, this pressure may not at not be all that effective.

The responsibility for Icesave falls jointly on Iceland, UK and the Netherlands. It is in the best interests of all three governments, as well as the IMF and the EU, to come to a reasonable agreement, enabling Iceland to make good on its obligations, without tipping the economy into the abyss.


Danielsson, J, (2010), “Icesave: Cost and Risk,” mimeo.

Danielsson, J. (2010), "The Saga of Icesave," CEPR Policy Insight No. 44.

Danielsson, J. and Zoega, G. (2009), "Collapse of a country", mimeo.

Gunnarsson, Styrmir. (2009). Umsátrið.

Mishcon de Reya Solicitors (2009), “Report to the Budget Committee of the Icelandic Parliament”.

Moody’s (2006), “Banking system outlook”, Report on the Icelandic banking system, December.

Singh, M. and Spackman, C. (2009). "The Use (and Abuse) of CDS Spreads During Distress," IMF Working Paper 09/62.

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