The Rise, Fall and Rise of Iceland: Lessons for Small Countries

Short Summary:

This is a study of the causes of the 2008 Icelandic bank collapse and its relevance to Europe. The main cause of the collapse was a systemic error in the financial institutions of Europe: the operational field of individual European banks was the whole of Europe, while the field of institutional support was the home country of the bank, at least for Iceland. The U.S. Fed refused the same liquidity support to Iceland as it provided to other European countries, and the U.K. government closed down British banks owned by Icelanders and invoked an anti-terrorist law against Iceland.

The obvious systemic error which brought down the Icelandic banking sector was the vast discrepancy or asymmetry between the banks’ operational field—the whole European market consisting of the EU, the EEA and Switzerland—and their field of institutional support which turned out, in the end, to be only Iceland itself. Since the banks had in 2004–2008 grown to tenfold GDP, Iceland by itself, the central bank and the government, could not provide sufficient liquidity to the banks in financial crises like the one which hit the markets in 2007–8. But the size of the Icelandic banks was not an independent cause of the collapse, since Switzerland and Cyprus had similarly relatively big banking sectors, and they did not collapse, at least not wholly. Indeed, Switzerland received much liquidity from the U.S. Fed in the form of dollar swap deals. Iceland was refused such dollar swap deals, unlike both Switzerland and the three Scandinavian countries. The conclusion in the study is that the reason for the refusal was not that the Icelandic banks had grown too big—because the Swiss banks were just as big relatively—but that Iceland was expendable. It was not regarded as systemically important.

The author of the study also rejects another possible cause often mentioned in connection with the collapse of the Icelandic banks: This is the free-market policies pursued by the governments of 1991–2004. He points out that the regulatory framework of the financial markets was the same in Iceland as in the other member states of the EEA and the EU. Moreover, even if economic liberty increased considerably in the years 1991–2004, Iceland had still the 14th freest economy in the world which meant that 13 economies were freer, and their banking sectors certainly did not collapse.

The author recognises that the Icelandic banking sector grew very rapidly before the collapse. But while this created a vulnerability, it was not a direct cause of the collapse, no more than the fact that glass is fragile is a cause of it breaking. Something needs to be done to break a piece of glass. What really made the Icelandic banking sector collapse was both the non-action of the U.S. Fed, i.e. the decision not to make dollar swap deals with the Icelandic central bank, and two actions by the U.K. Labour government: to close down the British banks owned by the Icelanders, at the same time as an immense rescue package was announced for all other British banks (some of them undoubtedly owned partly by foreigners); and to invoke an anti-terrorist law against Iceland, not only one of the banks, Landsbanki, but also, even if briefly, against the Icelandic central bank and the Icelandic government. Both those measures made things much worse. The British banks closed down in 2008 have now gone through a resolution process, and it turns out that they were fully solvent: Heritable bank has a recovery rate of around 100p on the pound, and KSF of around 86p on the pound, even if hundreds of millions of pounds have been absorbed into fees of lawyers and accountants. In other words, the whole affair was based on a ghastly mistake. It was the conclusion of a British parliamentary committee in 2009 that the use of the anti-terrorist law was at best an overreaction. It illustrates, in general, the danger of giving wide-ranging powers to government. Iceland, a long-time ally of the U.K., is a tiny, powerless and peaceful country which does not even have its own military.

The author also discusses the 2008–2013 Icesave dispute between the U.K. government and Iceland: The U.K. government had unilaterally paid depositors in the Icelandic bank Landsbanki and demanded that the Icelandic public reimburse it. The Icelanders refused, as they regarded themselves as not being responsible for private transactions between two entities, a bank and its customers, and they had fulfilled all EEA-EU regulations on deposit insurance. After difficult negotiations and bitter domestic struggle in Iceland, including two national referenda where deals between the U.K. government and Iceland were struck down, the EFTA Court which had jurisdiction decided that Iceland had not been under any obligation to reimburse the U.K. government for its outlays. The assets of Landsbanki estate have however been sufficient to pay back the depositors, as was indeed argued from the beginning by the Icelanders. But the U.K. government only withdrew its use of the anti-terrorist law against Iceland after the first deal on Icesave had been made in 2009.

The Rise, Fall and Rise of Iceland: Lessons for Small Countries

Iceland’s fall in the autumn of 2008 was spectacular.[1] A small, prosperous country on the outskirts of Europe suddenly saw its whole banking sector collapse. Not only did Iceland’s traditional allies in the neighbourhood—certainly with many problems of their own in the midst of an international financial crisis—refuse to help Iceland keeping its large banks afloat, but they also supported hefty financial claims against the Icelandic state by the United Kingdom government relating to the operations of an Icelandic bank, Landsbanki, in the UK. Moreover, while Iceland was struggling to save at least a part of its banking sector, the UK invoked its anti-terrorism law against this particular bank, Landsbanki, in order to freeze its assets, and, briefly, extending the law also against the Central Bank of Iceland. The result was that the country suddenly found itself cut off from foreign supplies, even of food and medicine, and without any means of transferring money in and out of the country. It had to apply for emergency assistance from the International Monetary Fund, IMF, subsequently given on the condition that Iceland promised to enter into negotiations with the UK about its claims. What had happened? Several explanations have been offered: That the bank collapse was the result of a failed neo-liberal experiment;[2] that the Icelandic banks were too big; and that the Icelandic bankers were less experienced and more reckless than their colleagues elsewhere.[3] Here, I shall argue that these explanations are inadequate, although they may capture partial truths, and that three foreign factors were crucial in the collapse: The refusal of the American Federal Reserve System, the Fed, in the beginning of the international crisis, to open dollar swap lines to the Central Bank of Iceland, and the two decisions of the British government both to refuse assistance to the Icelandic banks operating in the UK and to invoke the anti-terrorism law against not only Landsbanki but also against the Central Bank of Iceland.

A Vulnerable Situation

While it is an exaggeration to say that Iceland conducted a “neo-liberal experiment” in 1991–2004, it is true that the governments of that era, all led by David Oddsson, then leader of Iceland’s conservative-liberal Independence Party, implemented comprehensive liberal reforms. First, government subsidies to unprofitable companies were cut or abolished, while special government investment funds were wound up. Economic mistakes were corrected rather than continued. In the second place, taxes were cut: for example, the corporate income tax went down from 45% to 18% in 1991–2004; the turnover tax on corporations and the wealth tax on individuals both were abolished; the estate tax was greatly lowered; the personal income tax (the part imposed by government, not municipalities) was reduced by 8%; moreover, a special surcharge on high incomes (previously creating, in effect, a progressive income tax) was abolished. The tax cuts were quite successful. In fact, after a while tax revenue increased as a result of the larger tax base, a good illustration of the “Laffer Effect”.[4] Third, pension provisions were reformed in order to make them sustainable: the “pay-as-you-go” system was replaced by a fully funded system. In 2004, the assets of the Icelandic pension funds were the second-largest in the world in proportion to the country’s Gross Domestic Product, GDP. Fourth, the development of a system of individual transferable quotas in the Icelandic fisheries was continued: Iceland was one of few countries where fisheries were both sustainable and profitable. Fifth, a programme of fiscal and monetary stabilisation was implemented. In a few years after 1991, the government deficit disappeared, and inflation, traditionally high in Iceland, fell to the same level as in the neighbouring countries. Sixth, various government enterprises were privatised, including a coastal shipping line, travel agency, printing plant, publishing company, pharmaceutical factory, a number of fish processing plants, and, most importantly, the two commercial banks which had remained under government control when the first one had been privatised (by the social democrats) in 1990. The revenue from privatisation was used mainly to reduce public debt. Seventh, foreign trade and the capital market were liberalised, while Iceland joined the European Economic Area, EEA, in 1994, adopting the same regulatory framework as the other member states—all the EU countries in addition to Norway and Liechtenstein—and gaining access to the vast European market.[5] In 2004, the Icelandic economy was the world’s 10th most prosperous one, in terms of GDP per capita,[6] and the 13th freest one of a total of 130 economies surveyed.

.7As a result of the 1991–2004 economic reforms and the prudent fiscal and monetary policies in that period, Moody’s ratings of the Republic of Iceland went up, from A2 in 1991 to A1 in 1996, to Aa3 in 1997, and to Aaa in 2002, remaining at that high level for the next few years.[7] The three private banks, Glitnir, Landsbanki and Kaupthing, benefitted immensely from the good reputation Iceland had earned abroad. Their managers suddenly found themselves having an almost unlimited access to cheap capital from abroad. Meanwhile, the Icelandic economy had changed, first gradually and almost imperceptibly, then drastically. A small group of venture capitalists led by controversial retailer Jon Asgeir Johannesson suddenly became very powerful. This group controlled almost two-thirds of the retail market and many companies in other sectors of the tiny domestic economy. Johannesson, under investigation for book-keeping irregularities and tax evasion, but with his pockets full of money after successful investments in the United Kingdom had decided that it served his interests to buy up all the private media in Iceland. He directed his newspapers and television station to fight against a law which Prime Minister David Oddsson proposed in 2004 which would have made it difficult or almost impossible for any one person or company to control all the private media. Despite Johannesson’s fierce opposition, the Parliament passed the proposal. However, Iceland’s President, Olafur Ragnar Grimsson, who had close ties with Johannesson, refused to sign the proposal. Instead of referring the law to a referendum, Oddsson’s government decided to withdraw it. But this battle about the media law showed not only how powerful Johannesson and his cronies had become but also that they were willing to use this power whenever they deemed it necessary. In the fifty years’ history of the Icelandic Republic, the President had never before gone against Parliament by refusing to sign a proposal passed by it into law.[8]

In 2004, not only did Johannesson win the battle about the media law, but Prime Minister David Oddsson also suffered a bout of cancer and stepped down in the autumn. Johannesson was now the most powerful man in Iceland. Hardly anyone dared to challenge him; commentators in his newspapers sang his praises; judges, closely monitored by his newspapers and his television station, showed surprising leniency in legal cases against him (although eventually he was convicted both of book-keeping irregularities and tax evasion); he and his cronies were regular guests at President Grimsson’s official residence; many politicians, not least Social Democrats, but also members of the conservative-liberal Independence Party, were happy to receive his political and financial support. More importantly, the managers of the three banks, with the almost unlimited access to foreign capital they enjoyed as a result of Iceland’s high ratings, believed, in the words of one of them, that Johannesson was a “winner” and opened their funds up to him.[9] Everything which this latter-day Croesus touched seemed to turn into gold. And the early 2000s seemed full of opportunities. As a consequence of the EEA treaty, all the EU countries were open to him in addition to Norway and Liechtenstein. Of the three dominant business groups in Iceland later identified by a Special Investigation Commission into the bank collapse, SIC, Johannesson and his cronies occupied a unique position because of their ever-increasing total debt, reaching almost six billion euros in early 2008. As Johannesson managed his debts in all three banks through a series of intricately connected companies, the immense scale (in the Icelandic context) of his operations was not clear to anyone else at the time. In the mid-2000s, as the government was paying up the public debt, the total external debt of Iceland, mainly created by the banks, rapidly increased. Suddenly the liabilities of the Icelandic banking sector became many times the GDP. As the SIC later concluded, there was consequently a special hidden systemic risk in the Icelandic banking sector, consisting mainly in extensive cross-ownership of the biggest debtors. While other Icelandic businessmen followed Johannesson’s lead, he and his cronies were in a class of their own.[10] In vain, former Prime Minister David Oddsson, appointed as governor of the Central Bank in 2005, warned in 2007 against the rapid expansion of the banks: “Iceland is becoming uncomfortably beleaguered by foreign debt. At a time when the Icelandic government has rapidly reduced its debt and the Central Bank’s foreign and domestic assets have increased dramatically, other foreign commitments have increased so much that the first two pale into insignificance in comparison. All can still go well, but we are surely at the outer limits of what we can sustain for the long term.”[11]

The Collapse

In 2006–7, some foreign fund managers and bank analysts began to realize that Iceland was vulnerable, both because of the extensive cross-ownership of the banks’ biggest debtors and also because it would obviously be beyond the capability of the Central Bank of Iceland to keep the banks afloat in the case of major disturbances in international financial markets. However, the Icelandic economy seemed basically sound, with its well-managed fisheries, large energy resources, well-educated labour force, and record of responsible fiscal and monetary policies. Moreover, two of the three Icelandic banks, Landsbanki and Kaupthing, started accepting foreign deposits, in the United Kingdom and in the Netherlands, as they could under the EEA treaty. Thus, they could re-finance themselves despite the fact that the almost limitless supply of cheap capital in the international financial markets came to an end in 2006–7. A sharp downturn in the Icelandic economy was nevertheless widely predicted, and expected, after the long period of economic growth starting in 1995.[12] This was, of course, something to worry about, but not too much: The Icelanders, with their volatile economy, had a lot of experience in dealing with booms and busts. But hardly anyone foresaw three crucial decisions about Iceland, made abroad after the collapse of Lehman Brothers in mid-September 2008, and the subsequent panic seizing the international financial markets. The first decision was on 24 September 2008 when the American Federal Reserve System announced dollar swap deals with the central banks of Sweden, Norway and Denmark.[13] Those banks were already able, as are all central banks, to print money in their local currencies and lend to their commercial banks in emergencies. The dollar swap lines to them from the Fed meant that now those central banks were also, in effect, able to print dollars and lend them to their commercial banks. Here, as almost always, what was interesting was the dog that did not bark. Why had no dollar swap line been opened to Iceland at the same time as to the other Nordic countries outside the Eurozone? Indeed, the absence of a dollar swap deal with Iceland, while the Fed was busily making such agreements with not only the other Nordic countries but also with almost all other developed countries outside the Eurozone, including Switzerland, the United Kingdom, Australia and New Zealand, sounded the death knell of the Icelandic banks.[14] It became painfully obvious that Iceland had no plausible lender-of-last-resort. While the Central Bank of Iceland had relatively large foreign currency reserves, they would not have been sufficient to rescue the Icelandic commercial banks from a run on their deposit accounts abroad or a sudden termination, even if only temporary, of most foreign credit. The Icelandic banks were doomed.

The first bank which was unable to meet its foreign obligations was Glitnir, owned and controlled by Johannesson and his cronies. The Central Bank of Iceland refused its request of a loan in foreign currency, amounting to a significant part of the currency reserves, instead announcing on 29 September, that the government was recapitalising the bank and taking a 75 per cent stake in it. Almost immediately companies with large and now almost worthless shares in Glitnir had to file for bankruptcy. But because all three banks were closely connected through the cross-ownership of their biggest debtors, especially Jon Asgeir Johannesson and his associates, and because people abroad did not make a clear distinction between the Icelandic banks, the other two banks suddenly suffered an acute liquidity problem as well. Their credit ratings were immediately lowered, and creditors consequently cancelled loans or requested more money or securities to back them up (the so-called margin calls), while depositors started to take out their money. Denied almost all temporary foreign assistance, the Icelandic government was clearly unable, on its own, to keep the Icelandic banks afloat. In the evening of 6 October 2008, the Icelandic Parliament passed an Emergency Act trying to stop a possible run on the banks by giving depositors’ claims priority to those of other creditors. The banks were also divided up between the domestic part, which government then announced that it would fully back up, and the foreign part left to fend for itself. British depositors in the two Icelandic banks operating in the UK, Landsbanki and Kaupthing, became worried. There was, however, an important difference between guarantees offered to depositors in the two banks. In the UK, Landsbanki operated a branch which meant that deposits were nominally guaranteed by the Icelandic Guarantee Fund of Depositors and Investors. It was quite clear, though, that in the case of Landsbanki failing, the Fund did not have sufficient means immediately to pay off all the guaranteed deposits. On the other hand, Kaupthing operated a subsidiary so deposits there were covered by the British depositors’ guarantee scheme.

The leaders of the British Labour government reacted strongly to the Emergency Act passed in Iceland and the likely imminent failure of the Icelandic banks. They did not seem to realize that the Emergency Act actually protected the interests of British depositors as well as the Icelandic ones, by giving priority to depositors’ claims over those of other creditors.[15] In the morning of 7 October, the Chancellor of the Exchequer, Alistair Darling, telephoned the Icelandic Minister of Finance, Mr. Arni Mathiesen, and asked him whether the Icelandic government guaranteed deposits of British citizens in the Landsbanki branch in London. While Mr. Mathiesen chose his words cautiously, he said that the Icelandic government was trying to resolve the difficult situation to the satisfaction of all those concerned. A difficult situation it was indeed: Both Landsbanki and Glitnir collapsed on this very day and had to be taken over by the government. There was some hope that the biggest and strongest Icelandic bank, Kaupthing, would survive. However, the next morning, on 8 October, the British government made three fateful moves. First, the Treasury assumed control of Landsbanki’s operations in the United Kingdom. In the second place, it issued a freezing order on Landsbanki invoking an anti-terrorism law against it and, initially, also against the Central Bank of Iceland.[16] Landsbanki was placed on the Treasury’s online list of organisations and states subject to financial sanctions, alongside the terrorist organisations Al Qaida and the Taliban, and the governments of Sudan, Iran and North Korea.[17] The impact of invoking the anti-terrorism law was sudden and dramatic. Almost immediately, all money transfers to and from Iceland stopped; Icelandic credit cards were not honoured abroad; in the following days, almost no goods would be sent to the country without prepayment in cash. Even if the Treasury freezing order was only about one of the three commercial banks, little or no distinction was made abroad between the Icelandic banks, and nobody wanted to be in breach of the British anti-terrorism law. With practically all private financial ties severed to the external world, the Central Bank of Iceland staff worked day and night to ensure that necessities such as food and medicine were available to the Icelandic population and to assist Icelanders abroad who would otherwise have been stranded penniless. The third fateful move of the British government was against the only surviving major Icelandic bank, Kaupthing. When the manager of its British subsidiary, KSF, expressed interest in participating in the bank rescue programme announced 7 October, the director of the FSA simply replied: “Those funds are not for you”.[18] The same morning as the anti-terrorism law was invoked against Landsbanki, 8 October 2008, Chancellor Darling announced that British authorities would transfer the online accounts in KSF to its main competitor in online banking, the Dutch bank ING Direct.[19] This was implemented in the early afternoon. Consequently, the parent company, Kaupthing in Iceland, collapsed and had to be taken over by the government. The online accounts of the Landsbanki branch in the UK were also transferred to ING.

A Country on its Own

In only two days, all three major Icelandic banks had collapsed. By refusing to include Kaupthing in the rescue programme for British banks and by invoking the anti-terrorism law against Landsbanki the British Labour government had extinguished whatever small hope against hope that at least a part of the Icelandic banking sector could be salvaged. The purpose publicly given for invoking the anti-terrorism law against Landsbanki and the Icelandic authorities was that of hindering illegal transfers of money from the UK to Iceland. But as the Treasury had already taken control of Landsbanki’s UK operations, it was hard to see how the law was needed for this purpose. In a 2009 report, the House of Commons Treasury Committee indeed criticized the use of the anti-terrorism law against Landsbanki, however politely: “We call on the Treasury to consider how appropriate the use of this legislation would be in any similar circumstances in the future. The use of the Act inevitably stigmatises those subject to it and a less blunt instrument would be more appropriate.” The committee also discussed controversial public statements by Chancellor Darling. On 8 October 2008, the day after the Chancellor had had the conversation with Mr. Mathiesen, he said in an interview on BBC Radio 4: “The Icelandic government have told me, believe it or not, have told me yesterday they have no intention of honouring their obligations there.” Perhaps unfortunately for Chancellor Darling, the conversation was taped by the Icelanders. After reviewing the matter in 2009, the House of Commons Treasury Committee concluded: “In the published transcript Mr Mathiesen did not state that Iceland would not honour its obligations. Rather, he explicitly indicated that Iceland planned to use its compensation scheme to try to meet obligations to British depositors.” The Committee added: “We note that the published transcript of the Chancellor’s conversation with the Icelandic Finance Minister does not confirm that the Icelandic Government had stated that it would not honour its obligations.”[20] But this was long after the bank collapse, and little consolation for the Icelandic authorities or bankers.[21]

In retrospect, it can be seen that two kinds of systemic risks made the Icelandic banks more vulnerable than many of their counterparts elsewhere. One such risk was the extensive, but largely hidden, cross-ownership of the banks’ biggest debtors, especially Jon Asgeir Johannesson and his associates. But by itself, this systemic risk would probably not have brought down the whole banking sector. Against the debts, there were assets, often quite valuable. The other systemic risk special to the Icelandic banking sector was more important. It was that the banks’ field of operations—the whole of the European Economic Area, under the EEA agreement—was much bigger than what turned out to be their field of institutional support—Iceland alone. This is the grain of truth in the frequent explanation of the bank collapse that the Icelandic banks were too big. But in a deeper sense, this explanation is inadequate. Too big relative to what? If Iceland had been allowed to be a part of the international effort to increase liquidity and save banks from collapse, this argument would not have been relevant. Consider Scotland. Is its banking sector over-sized? In 2012, Scottish banks had assets totalling around 1254 per cent of Scotland’s GDP. “In comparison, at the end of 2007, Icelandic banks had assets equivalent to 880 per cent of GDP—a major contributor to the cause and impact of the financial crisis in Iceland”, as it is put in a 2013 Treasury report on Scotland’s banking sector. The Treasury officials go on to remind their readers that the UK government spent €45 billion recapitalising the Royal Bank of Scotland, RBS, and that, in addition, the bank received £275 billion of state support in the form of guarantees and funding. In total, this would have been 211 per cent of Scotland’s GDP. They add: “Scotland would not have been able to afford such interventions alone. Other countries such as Ireland, Iceland and more recently Cyprus were unable to absorb the implications of the financial crisis on their own.”[22] This is precisely the point. Scotland was not on its own. Neither was the UK itself, for that matter. The Fed provided dollar swap lines to the Bank of England for $919 billion in the aggregate.[23] If Scotland had not been a member of an institutional, multi-national financial support scheme, the Scottish banks would have been too big. But otherwise, they were not too big. Iceland was however on its own. The problem was not that its banks were too big; it was that Iceland was too small.

The course of events clearly shows, also, how implausible the explanation is that the bank collapse constituted a failure of Oddsson’s “neo-liberal” experiment. First, the immense debt accumulation in and of the banks, mostly driven by Jon Asgeir Johannesson and his cronies, really began in 2004, the year Oddsson stepped down as Prime Minister and Johannesson became the most powerful man in Iceland. Secondly, and more importantly, the Icelandic banks were subject to the same legal and statutory framework as their counterparts in other member states of the EEA, comprising the whole of the EU and Norway, Iceland and Liechtenstein. The error which eventually brought about the bank collapse was systemic: it turned out that the Icelandic banks did not have access to the institutional support which needs to go with the access to the immense European market where the banks operated. This leads directly to the third inadequate explanation for the bank collapse: that the Icelandic bankers were less experienced and more reckless than their colleagues in other countries. The logical flaw in this is that it just moves the explicandum—that which has to be explained—by one square. How were the Icelandic bankers able to obtain credit from their presumably more experienced foreign colleagues? Were they not reckless, in turn, by lending to the Icelanders? Secondly, many banks in other countries would have collapsed if they had not been rescued. What was the real difference between them and the Icelandic banks? The Royal Bank of Scotland, RBS, has already been mentioned. Even the Swiss banks, past symbols of solidity, came close to collapsing. The Swiss National Bank used $466 billion in the aggregate in dollar swap lines from the Fed.[24] Thus, it saved the country’s biggest bank, UBS, from the fate of the Icelandic banks. It should be noted that Switzerland had a relatively larger banking sector than Iceland. In 2008, the ratio of short-term bank liabilities to GDP was 260% in Switzerland and 211% in Iceland.[25] A third example is Denmark’s biggest bank, Danske Bank, which also came close to collapse.[26] It was saved by the Danish National Bank which received $73 billion in dollar swap lines from the Fed in the aggregate.[27]  Ironically, a fourth example was the Dutch bank ING to which the British government moved the online accounts in both Landsbanki and Kaupthing, without compensation. ING received €10 billion recapitalisation as well as liquidity guarantees from the Dutch government in October 2008, and more assistance in 2009.[28]

Iceland Was Too Small

The three major Icelandic banks, Glitnir, Landsbanki and Kaupthing, were by no means blameless. Their managers had indeed been reckless, mostly by allowing Jon Asgeir Johannesson and his cronies to accumulate their enormous debts. But it should be pointed out that the Icelandic banks held very little of the subprime mortgages which elsewhere turned out to be so treacherous. It is fair to say that the Icelandic bankers were probably no better and no worse than the managers of RBS, UBS, Danske Bank and ING. Certainly the record shows that they deserved even less to be labelled terrorists. After all, some of the rescued banks were not exactly paragons of virtue. Even before the financial crisis, RBS had been subject to harsh criticisms for the conduct of its business. The bank spent large sums on new headquarters in Edinburgh and in the US; its executives travelled in a private Dassault Falcon 900 Jet; the bank also spent large sums on generous pension schemes for its retiring managers, and on celebrity endorsements. Since then, many scandals involving RBS have been exposed. To mention a few: On 6 February 2013, it was announced that the RBS was paying $612 million to the US government for its part in manipulating the London Interbank Offered Rate, LIBOR, in 2006–2009. On 11 December 2013, it was announced that RBS had agreed to pay $100 million to US authorities for having engaged in illegal dealings in 2005–9 with entities in countries under US sanctions, mostly Iran and Sudan—two countries regarded by the British Treasury as worthy of occupying places on the same list as Landsbanki.[29] UBS has an even worse record than RBS. In early 1997, a night watchman accidentally caught UBS staff members at the bank’s Zürich headquarters destroying documents on accounts opened before and during the Second World War, mostly by Jews persecuted by the Nazis. This was in breach of a Swiss law prohibiting the destruction of such documents. A year later, UBS and another big Swiss bank decided to settle lawsuits against them in the US by paying $1.25 billion to Jewish victims.[30] In February 2008, evidence was presented to US authorities that UBS staff members had actively been assisting wealthy Americans in evading taxes and hiding assets. A year later, UBS consequently paid a fine of $780 million to the US government. Big scandals continued to haunt the Swiss bank. In December 2012, UBS paid a fine of $1.5 billion to the US government for its role in rigging the Libor—London Interbank Offered Rate—during the preceding six years.[31] ING was not spotless, either. In 2012, for example, ING paid the US government $619 million in a settlement for having potentially illegally moved billions of dollars through the US financial system on behalf of sanctioned entities such as Iran—which had been on the British Treasury’s list of terrorist regimes, with Landsbanki.[32] Many other rescued banks, such as Lloyds in the UK and Credit Suisse in Switzerland, were also tainted by scandals.[33]

Iceland was too small. It was expendable; therefore, the Fed refused to extend the same dollar swap lines to it as it did to the UK and many other European countries, including Sweden and Switzerland neither of which had been a US ally, like Iceland was in the Second World War and in the Cold War; therefore, the UK Labour government could refuse to include the Icelandic banks in its rescue programme and even, incredibly, put one of the banks on its official list of terrorist regimes. It should not be forgotten, also, that in the European financial markets the Icelandic banks were regarded by many as upstarts; lean and mean, they competed vigorously with more traditional banks; their costs of operating online accounts were much lower than the costs of High Street banks, so they could offer more attractive rates. There was also the persistent rumour, even apparently investigated by the British secret service in 2005, of illegal Russian money in Icelandic banks; the investigation did not turn up any evidence for this.[34] Perhaps more importantly, British Labour leaders disliked Scottish nationalists referring to an “arc of prosperity” reaching from Ireland through Scotland to Iceland. Former Chancellor Alistair Darling wrote, almost gleefully, in his 2011 book on the financial crisis: “It was now an arc of insolvency.”[35] Be that as it may, the problems between the UK and Iceland were by no means over with the bank collapse. Since the Landsbanki online accounts in the UK were operated by a branch of the Icelandic bank, and not by a subsidiary, the Icelandic Guarantee Fund for Depositors and Investors was responsible for compensating depositors (up to a certain limit) in the case of Landsbanki’s failure. But at the time of the bank collapse, the Fund did not have sufficient means to fulfil its obligations. On its own initiative, therefore, the British government compensated the depositors and subsequently presented a bill to the Icelandic government, £2.35 billion, with interest—an enormous sum by Icelandic standards. The response of the Icelandic government was that it was the Icelandic Guarantee Fund, set up properly according to EEA rules, not the Icelandic government which was legally responsible to the depositors. When Iceland applied however for emergency loans from the IMF and some European countries, the British government used its clout to make it a condition for the loans that Iceland would enter into negotiations on the British demands. Rather ignominiously, the IMF was thus turned into a hand-collector for the British government.

Meanwhile, the political repercussions in Iceland of the bank collapse were severe. At first, the Icelanders were bewildered; then they became angry. A serious blame game started. After street riots for weeks, almost unprecedented in this peaceful and civilized Nordic democracy, the coalition government of the conservative-liberal Independence Party and the Social Democrats broke apart, whereupon the Social Democrats formed a government with the Left Greens, calling early parliamentary elections and winning them handsomely. The new left wing government fired David Oddsson and the two other governors of the Central Bank and used a quaint old law to indict outgoing Prime Minister Geir H. Haarde, leader of the Independence Party, for neglecting his ministerial duties before and during the bank collapse. Oddsson was however promptly hired as editor of Iceland’s leading daily, the conservative-liberal Morgunbladid, becoming a forceful critic of the new government, especially its pliability in negotiations with the British government: twice, repayment deals between the two governments were voted down by the Icelanders. After a lengthy process before a specially convened court, Haarde was acquitted of all charges except one, that he had not held sufficiently many ministerial meetings before and during the financial crisis; no punishment was prescribed to him, and the court ordered his legal costs to be paid by the state; in Horace’s words, it was as if the mountains had been in labour, and only a ridiculous little mouse had been born. After the two rejections by the Icelandic voters of the repayment deals with the UK, the dispute was referred to the EFTA Court. In January 2013, shortly before the scheduled parliamentary elections, the Court decided that the Icelandic government had not been legally responsible for compensating depositors, as the British government had claimed.[36] The left wing government, having twice tried to force through repayment deals, became totally discredited by this decision. This, and a series of political blunders made during its term of office, including the indictment of Geir H. Haarde and a failed attempt to change the constitution, resulted in an electoral debacle of the two government parties. The two centre-right opposition parties won a majority and formed a new government.

Iceland Rises Again

Slowly, in the five years after the bank collapse, the Icelandic economy has recovered. Its recovery was mainly based on two important decisions made in the midst of the collapse, out of necessity rather than preference. One decision was to allow the Icelandic crown, krona, to plunge. This meant that the purchasing power of ordinary Icelanders was greatly reduced, but the export sectors benefitted, mainly the well-managed fisheries, but also tourism and aluminium factories, driving the recovery. Needless to say, this road to recovery would not have been possible in the Eurozone.[37] The other important decision was implied in the Emergency Act of 6 October 2008: It was to ring-fence the domestic part of the banking sector and to leave the foreign part to be dealt with by the banks’ creditors. This amounted to a refusal to bail out the Icelandic banks after their rapid expansion abroad. The consequence was that the Icelandic taxpayers were not saddled with an enormous long-term debt, as they would otherwise have been. In 2014, Iceland’s general government net debt is estimated to be 63.6 per cent of Gross Domestic Product, while the corresponding figure for Ireland is 107.9 per cent.[38] But was it then a blessing in disguise that Iceland was refused dollar swap lines by the Fed and assistance from the UK? Not necessarily. The bank collapse was very costly, both in economic and social terms. Many bank assets were for example quickly sold at a much lower price than they would have fetched even a few months later. The social cohesion of Iceland was also threatened by the collapse, as the street riots clearly showed; there was a general loss of faith in Icelandic institutions and traditions from which the nation is still suffering. It is, however, doubtful that the IMF programme, implemented after the bank collapse, made much of a difference. Iceland did not need a big loan after the collapse: the money was never used, but kept in an account in New York, bearing interest. The IMF was very accommodating to the left wing government, not really insisting on any fiscal constraint. Again, the slow recovery which Iceland certainly made was not because of, but in spite of government policies. The loud mouthed left-wing ministers scared investors away, raised taxes and tried, ultimately unsuccessfully, to change the efficient system of individual transferable quotas in the fisheries—an attempt deemed almost “suicidal” by the editor of Wall Street Journal.[39]

What lessons can be learned from this short and sad Icelandic saga? The Icelanders made a lot of mistakes, both before and after the collapse. The banks expanded far too rapidly; they were beholden to a small group of ruthless businessmen; politicians, journalists, academics and even judges were in their thrall. The Icelandic Financial Supervisory Authority was also weak, a good example, it seems, of regulatory capture. After the collapse, instead of political parties working together like the Swedes did after their 1991–1992 banking crisis, the Icelandic left wing thought of little else than to use the situation to seek revenge against old enemies. None of these mistakes were crucial, however, unlike the decisions made by the US Fed and by the British Labour government to leave Iceland out in the cold. Ultimately, this saga shows the old truth that states do not have friends; they only have interests. Thucydides sums it up in his famous Melian dialogue when he has the Athenians say to the Melians: “You know as well as we do that right, as the world goes, is only in question between equals in power, while the strong do what they can and the weak suffer what they must.”[40]


[1] This paper is based on a talk given at the Danube Institute in Budapest 15 November 2013. For brevity, I leave out here the dispute between Iceland and the Netherlands related to the Icelandic banks. The author was a member of the Overseeing Board of the Icelandic Central Bank in 2001–2009. He has benefitted from discussions with the former Prime Minister Geir H. Haarde and the former Finance Minister Arni Mathiesen, three former governors of the Central Bank of Iceland, David Oddsson, Eirikur Gudnason and Ingimundur Fridriksson, and with the directors of the three fallen Icelandic banks, in particular Sigurjon Arnason of Landsbanki, Armann Thorvaldsson of KSF and Larus Welding of Glitnir. For his research project in connection with this paper, he has also interviewed former Chancellor of the Exchequer Alistair Darling.

[2] Robert Wade and Silla Sigurgeirsdottir, “Lessons from Iceland”, New Left Review, Vol. 65, September–October 2010, pp.  5–29; H.-J. Chang, 23 things they don’t tell you about capitalism. Allen Lane, London, 2010.

[3] The two latter explanations are argued for in the Report of the Special Investigation Commission, Vol. 7, Chapter 21. Althingi [Icelandic Parliament], Reykjavik, 2010. Retrieved from See also Gudrun Johnsen, Bringing down the banking system: Lessons from Iceland. Palgrave Macmillan, Basingstoke, Hampshire, 2014.

[4] H. H. Gissurarson and Daniel Mitchell, “The Iceland Tax System: Key features and lessons for Policy Makers,” Prosperitas, Vol. VIII, No. V, August 2007. Retrieved from

[5] H. H. Gissurarson, “Miracle on Iceland”, Wall Street Journal, 29 January 2004. Retrieved from H. H. Gissurarson, “The Icelandic Model: Neither Scandinavian nor Anglo-Saxon”, in H. H. Gissurarson and T. Th. Herbertsson (eds.), Cutting Taxes to Increase Prosperity, Bokafelagid, Reykjavik 2007, pp. 139–153.

[6] Disregarding oil-rich, but underdeveloped Arab countries. The nine more prosperous countries were Australia, Canada, Denmark, Luxembourg, Netherlands, Norway, Singapore, Switzerland and the United States. World Economic Outlook data, IMF. Retrieved from

[7] Asgeir Jonsson, Why Iceland? McGraw Hill, New York, 2009, p. 91; also Asgeir Jonsson, unpublished paper, delivered at a conference in Reykjavik 7 October 2013.

[8] Roger Boyes, Meltdown Iceland, Bloomsbury, London, 2009, has an account of this battle about the media law (and what he considers the feud between David Oddsson and Jon Asgeir Johannesson) in his lively, but not always reliable, book.

[9] Based on the author’s private conversations with a director of Landsbanki.

[10] It is however well documented in the Report of the Special Investigation Commission, Vol. 7, Chapter 21. Althingi [Icelandic Parliament], Reykjavik, 2010. Retrieved from See also H. H. Gissurarson, “Explanations of the Icelandic Bank Collapse”, Thjodarspegillinn, Vol. XVI, October 2013, especially Figure 2, drawn with data from the SIC. Retrieved from

[11] David Oddsson, Speech to the Icelandic Chamber of Commerce, 6 November 2007. Retrieved (in an English translation) from

[12] Gylfi Zoega and Robert Aliber (eds.), Preludes to the Icelandic Financial Crisis, University of Chicago Press, Chicago 2011. Needless to say, while some of the authors of that book predicted that the Icelandic bubble would burst, none foresaw the three crucial decisions discussed here, by the Fed and by the British government.

[13] Federal Reserve System, Press Release 24 September 2008. Retrieved from The deals were revised upwards 29 September: Federal Reserve System, Press Release 29 September 2008. Retrieved from

[14] Report to Congressional Adressees. Federal Reserve System. Government Accountability Office, Washington DC, 2011, Table 24: Foreign Central Banks’ Use of Dollar Swap Lines by Aggregate Dollar Transactions, p. 205.

[15] The British authorities did not seem to distinguish between the Emergency Act, giving priority to (all) depositors over other bank creditors, and a public announcement (with no legal force) by the Icelandic government that it would fully back up the operations of the domestic part of the Icelandic banks, including guaranteeing all deposits in the domestic branches of the banks. This confusion is even to be seen in a ruling of High Court of Justice on the legality of the transfer order, 20 October 2009, [2009] EWHC 2542 (Admin), The Queen (on the application of Kaupthing Bank hf) and H.M. Treasury, where the High Court (Lord Justice Richards) says (article 20) that “the Icelandic government enacted emergency legislation which included guarantees for depositors in the Icelandic branches of the banks”. This is not correct: the legislation did not include such guarantees; they came in an announcement.

[16] The Landsbanki Freezing Order 2008. Retrieved at

[17] In the SIC 2010 Report, Chapter 20 (only in Icelandic), p. 153, there is an extraordinary photograph of the online list from 10 October 2008. The title is “Current Regimes”, and the list is, line by line: Al-Qaida & Taliban, Belarus, Burma/Myanmar, Democratic Republic of Congo, Federal Republic of Yugoslavia & Serbia, International Criminal Tribunal for the former Yugoslavia, Iran, Iraq, Ivory Coast, Landsbanki, Lebanon and Syria, Liberia, North Korea (Democratic People’s Republic of Korea), Sudan, Terrorism and terrorist financing, Zimbabwe.

[18] Armann Thorvaldsson, Frozen Assets, John Wiley, Chichester 2009, p. 226.

[19] “Kaupthing’s UK arm put into administration”, Financial Times 8 October 2008 (at 2.51 pm). Retrieved from

[20] House of Commons Treasury Committee, Banking Crisis: The impact of the failure of the Icelandic banks, House of Commons, London, 31 March 2009, p. 23.

[21] Many in the UK also criticized the conduct towards Iceland, Daniel Hannan, MEP for the Conservatives, for example, in “Gordon Brown’s Raid on Iceland was Cowardice, not Courage”, The Times 15 October 2008, and Dr. Eamonn Butler, Director of the Adam Smith Institute, in The Rotten State of Britain, Gibson Square, London, 2009.

[22] Scotland analysis: Financial services and banking. Presented to Parliament by the Chief Secretary to the Treasury, The Treasury, London, May 2013, p. 7 and 23.

[23] Report to Congressional Adressees. Federal Reserve System. Government Accountability Office, Washington DC, 2011, Table 24: Foreign Central Banks’ Use of Dollar Swap Lines by Aggregate Dollar Transactions, p. 205.

[24] Report to Congressional Adressees. Federal Reserve System. Government Accountability Office, Washington DC, 2011, p. 205.

[25] F. Norris, “The World’s banks could prove too big to fail — or to rescue”, New York Times, 11 October 2008, p. B3.

[26] “Danske Bank i fare i 2008.” Sikke en fest. DR1, 2012. Retrieved from Also: “Skatteyderne mistede milliarder på en nat.” Sikke en fest. DR1, 2012. Retrieved from

[27] Report to Congressional Adressees. Federal Reserve System. Government Accountability Office, Washington DC, 2011, p. 205.

[28] Bank State Aid in the Financial Crisis, Centre for European Policy Studies, Brussels, October 2010, pp. 77–8.

[29] “RBS Securities Japan Limited Agrees to Plead Guilty in Connection with Long-Running Manipulation of Libor Benchmark Interest Rates”, Department of Justice Press Release 6 February 2013. Retrieved at “Consent Order under New York Banking Law”. Retrieved at; “Settlement with US Authorities regarding OFAC compliance. RBS Press Release”, 11 December 2013. Retrieved at

[30] Stuart Eizenstat, Imperfect Justice: Looted Assets, Slave Labor, and the Unfinished Business of World War II, Public Affairs, New York, 2003.

[31] “UBS Enters into Deferred Prosecution Agreement. Department of Justice”, Department of Justice Press Release 18 February 2009. Retrieved at “UBS Securities Japan Co. Ltd. to Plead Guilty to Felony Wire Fraud for Long-running Manipulation of LIBOR Benchmark Interest Rates”. Department of Justice Press Release 19 December 2012. Retrieved at

[32] “ING Bank N.V. Agrees to Forfeit ¢619 Million for Illegal Transactions with Cuban and Iranian entities,” Department of Justice Press Release, 12 June 2012. Retrieved at

[33] See, for example: “Lloyds TSB Bank Plc Agrees to Forfeit $350 Million in Connection with Violations of the International Emergency Economic Powers Act”, Department of Justice Press Release, 9 January 2009. Retrieved at And: “Lloyds TSB Bank Plc Agrees to Forfeit $350 Million in Connection with Violations of the International Emergency Economic Powers Act”, Department of Justice Press Release, 9 January 2009. Retrieved at And: “FCA fines Lloyds Banking Group firms a total of £28,038,800 for serious sales incentive failings”, FCA Press Release, 11 December 2013. Retrieved from The list for Credit Suisse, a heavy beneficiary of the international bank rescue effort, is even longer.

[34] Roger Boyes, Meltdown Iceland, Chapter Four. According to Boyes the secret agent undertaking the investigation was not working in or for the British Embassy in Reykjavik. In the Acknowledgements section at the end of his book, Boyes says that the British Ambassador to Iceland, Alph Mehmet, read the manuscript over.

[35] Alistair Darling, Back from the Brink, p. 138.

[36] EFTA Court, Judgement of the Court 28 January 2013, Case E-16/11. Retrieved from

[37] Steven Gjerstad and Vernon L. Smith, Balance Sheet Crises: Causes, Consequences, and Responses, Cato Journal, Vol. 33, No. 3 (Fall 2013), pp. 437–470.

[38] World Economic Outlook Dataset, IMF. Retrieved at

[39] Brian M. Carney, “Fishing for Trouble in Iceland”, Wall Street Journal 9 October 2012.

[40] Thucydides, History of the Peloponnesian War, Penguin Books, London 1972, Book 5, Article 89.