Department of Law Autumn Term 2018
Master’s Thesis in Financial Law 30 ECTS
The Icelandic Banking Saga
The ways to deal or not to deal with a systemic banking crisis
Author: Kristina Borodina
Supervisor: Rebecca Söderström
Acknowledgments
I genuinely believe that everything in life happens for a reason. Both good and bad things happen to give us a possibility to learn, grow and, most importantly, to guide us in the right direction.
The year 2011 me, my now ex-husband and our two-year-old daughter were doing everything we could to move to Stockholm from Västerås. We found a sublet apartment in Stockholm and once we signed the rental contract for the apartment, we terminated our rental agreement for our sublet apartment in Västerås. In other words, there was no way back. While having everything ready for the move, including a rental agreement signed by both parties, the person who was going to rent us the apartment suddenly disappeared with our money. He neither replied to our e-mails, nor phone calls. We had paid him a 3-month deposit and all that money was gone. We considered hiring a lawyer, but unfortunately, we invested all our savings into the 3-month deposit, so we had no funds to pay for a lawyer. That week I spent many hours reading the Swedish Contract Law (Se Avtalslagen) and I browsed the internet trying to find any person that had any connection to the man who was going to rent us the apartment. I finally found a contact number to his father, whom I contacted and explained that his son had breached the rental contract, since that the agreement was fully signed. I also pointed out that if taken to court, we would be demanding compensation not just for the money he had taken from us, but also for the harm inflicted, since we were basically homeless. I also informed him of the fact that we had found a lawyer who could help us. In reality, there was no lawyer and all the information about the contract breach I had previously found on the internet. Within a couple of days, we got our money back and a little extra compensation. That situation was not a pleasant one, but I am happy it happened. If that situation did not happen, I would not be where I am today.
These past four years were tough. In 2014 I went through a divorce, and I had to move three times within Uppsala. Studying with a child was a big challenge as well. Especially while not having any family in Sweden. I remember all those mornings when I had to wake up at 4:30 in the morning in order to prepare for the seminars before my daughter would wake up at 7 o’clock. After one year at Law School, I realized that I both needed
extra money and extra experience. For the past 2,5 years, I have been working besides my studies. My first working experience in the area of law was at Carlsberg Sverige AB where I worked as a legal assistant. Later the same year I initiated my employment at the Swedish Social Insurance Agency (Se Försäkringskassan). So for almost two years, I was combining two jobs, law school and being a parent. Finishing law school in four years instead of 4,5 years feels like a cherry on the top too. I am not sure how I managed to do all of this, but one thing is true: Nothing is impossible where there is determination, will, and discipline.
I would like to express special thanks to my mom Fargana Borodina, for all her support and especially for all her trips from Russia to Sweden to help me take care of my daughter during those weeks when I was intensively studying for exams. Special thanks to my daughter Shara for being the light of my life and my biggest motivation. Special thanks to my ex-husband Carl-Henrik Lindqvist for teaching me valuable lessons in life.
Special thanks to Þorsteinn Friðrik Halldórsson, for having a big impact on my life.
Special thanks to my friends Bea S, Lovisa E, Carla Z, Anna S, Anna L, Amanda S, Camilla G, Maria P, Sophie B, Alice W, Frida Ö, Emma F, Sarah Å and Viktoria E for making my time during these studies more meaningful, for helping me with both proofreading my legal texts in Swedish during the course of the studies and for their help babysitting my daughter when their help was needed. I would also like to express my profound gratitude to two amazing women. Special thanks to Anna Orlander, my former boss at Carlsberg Sverige AB and now a partner at Baker McKenzie, for always giving me opportunities to grow and develop. I consider her my big inspiration, and I am thankful to her for stipulating my interest in corporate law. Finally, special thanks to Rebecca Söderström, my thesis supervisor, for stimulating my interest in financial law, guiding me and giving me inputs during the thesis process.
Kristina Borodina Uppsala/Reykjavik
For those who always believe, hope, forgive and love and
For those who think that there can be miracles when you believe1 (Whitney Houston)
1 This does not apply to the case of the Icelandic banks, however.
“The best people to monitor banks are not, in fact, the bankers themselves.”
Alan Greenspan, an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006, in his 2008 congressional hearing.
(author adds emphasis)
Table of Contents
Abstract
List of abbreviations Timeline of the events
Abstract 1
1 Introduction 6
1.1 Opening remarks 6
1.2 Problem description 7
1.3 General aims and objectives 10
1.4 Outline 10
1.5 Methods 11
1.6 Sources 13
2 The “volcanic eruption” of the international banking in Iceland 14
2.1 The EEA Agreement and provided guarantees 14
2.2 With great freedom comes even greater responsibility 16
3 Plausible causes of the Icelandic collapse 18
3.1 Banks’ owners as banks’ borrowers 18
3.1.1 Glitnir Bank 18
3.1.2 Kaupþing Bank 18
3.1.3 Landsbanki 19
3.1.4 Summary 19
3.2 Risk concentration and rules on large exposures 20
3.2.1 Landsbanki: Actavis 21
3.2.2 Kaupthing Bank hf: Baugur and Mosaic Fashion 23
3.2.3 Glitnir Bank hf: Stím and FL Group 24
3.3 Equity Problems 25
4 The problems of the Supervisory Authority and of the CBI 26
4.1 Administrative problems 27
4.2 Lack of funds 28
4.3 Incorrect prioritization 28
4.4 Insufficient cooperation between the FME and the CBI 29
5 The potential inadequacy of the Deposit Guarantee Scheme 31
5.1 Functions of the banks 31
5.2 Regulatory tools to prevent bank runs 33
5.2.1 Lender of last resort 33
5.2.2 Deposit guarantee schemes 34
5.3 A rapid increase of deposits in Icelandic banks and its effects on the Depositors’ and
Investors’ Guarantee Fund 36
5.4 The implementation of the Directive 94/19/EC on Deposit Guarantee schemes and The
Deposit Guarantee Funds’ obligations 38
5.5 Financing and the Size of the Fund 42
5.5.1 Three methods of Deposit- Guarantee Fund’s funding mechanisms 42
5.5.2 The method applied in Iceland 43
5.5.3 Risk-based method of calculating and the missing links of the 1994 Directive 46 5.6 The (failed) attempts to strengthen the Deposit-Guarantee Scheme in Iceland 49 5.7 The assessment regarding the question of state responsibility 55
5.7.1 General remarks 55
5.7.2 Discussion based on EU legislation 56 5.7.3 Discussion based on available academic literature up until 2008 57
5.7.4 Summary 60
5.7.5 Discussion based on court judgments up until 2008 60
5.7.6 Discussion based on reports written by other governments 64 5.7.7 Discussion on deposit-guarantee schemes’ ability to deal with a systemic collapse 64
5.7.8 Summary 67
5.8 Case E-16/11 EFTA Surveillance Authority v Iceland 68
5.8.1 Articles of the Directive 69
5.8.2 The overall purpose of the 1994 Directive 70
5.8.3 The Discrimination claim 72
5.8.4 Summary and analysis of the court’s judgment 73
6 The moral of the Icelandic Banking Saga: concluding reflections 75
7 Bibliography 80
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Abstract
Every key feature of the Icelandic banking in the run-up to the 2008 year meltdown can be viewed as an emblem of the concept systemic banking crisis. The concept of a banking crisis is usually defined as “an event that shows significant signs of financial distress in the banking system and which is usually associated with significant bank runs, big losses in the banking system and bank liquidations.”2 The detailed bank data, attained after the secrecy laws were being lifted after the crisis,3 sheds light on five core problems that, in my estimate, portray the Icelandic crisis the best. These problems are unreliable deposit insurance system, fictional collaterals, inside dealing, the inadequacy of foreign reserves and supervision problems.
Due to banks’ central role in economic welfare, the main scope of the regulations and laws in the area of banking is to contribute to operational stability in financial corporations, increase the credibility of the system, protect the customers and increase the confidence of the public. Failure of one bank can lead to disastrous consequences for the whole economic system.4 Probably one of the most critical situations is a scenario of a bank run. Bank runs are usually seen as depositors’ reaction to fear about the bank’s solvency.5 They are usually characterized by a massive simultaneous withdrawal from banks that in many cases may lead to liquidity problems due to the liquidity mismatch of the banks.6 A bank’s liquidity is defined as bank’s capacity to quickly react to a sudden withdrawal without having to sell off illiquid assets.7 The phenomenon of bank runs has two very particular features: (1)they are associated with a tendency to “run” as soon as there is a signal of potential solvency problems, and (2) a tendency to create
2 L. Laeven, F. Valencia, IMF Working Paper, Systemic Banking Crises Revisited, 2018; C. P. Kindleberger, R.
Aliber, R. Solow, Manias, Panics, and Crashes: A History of Financial Crises, 2005; National Bureau of economic research by author F. S Mishkin, Anatomy of a financial crisis, 1991.
3 Bank secrecy laws were lifted by the Special Investigation Commission (SIC).
4 A. Busch, Banking Regulation and Globalization, pp. 23-25; E. P. Ellinger et al., Modern Banking Law, p. 27.
5 J. Armour, D. Awrey, P. Davies, L. Enriques, J. N. Gordon, C. Mayer, J. Payne, The Principles of Financial Regulation, p. 320.
6 Ibid., p. 316; R. Söderström, Sound banking, p. 18.
7 J. Armour, D. Awrey, P. Davies, L. Enriques, J. N. Gordon, C. Mayer, J. Payne, The Principles of Financial Regulation, p. 316.
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feedback.8 The first feature implies that the depositors are most likely to withdraw their funds as soon as they see the slightest sign of potential insolvency. The second feature is a reaction to the first signal, when depositors, who not necessarily believe in signals, run because they do not want to be the last ones to withdraw their money. Lost confidence in one bank may eventually spread to other banks and result not just in a failure of the banks involved, but even in a systemic failure. In light of the aforesaid, many countries take different measures in order to prevent bank runs and financial panic.
Among these measures is an establishment of deposit-guarantee schemes( DGS).9 The significant increase in deposits in Icelandic banks not only had the effect of transforming the financing of the Icelandic banking system but, as it will be discussed in the next chapters, eventually led to catastrophic consequences as about half of the deposits were deposited with the banks’ branches abroad and in foreign currency. This increase of deposits in foreign branches resulted in a substantial increase in the obligations of the Icelandic Depositors’ and Investors’ Guarantee Fund (TIF). 10 However, the TIF was unable to cope with such an increase. When depositors lost trust in Icelandic banks, and when there was no clear information whether the TIF covered the branches of Icelandic banks in the UK and Netherlands, a scenario of bank run was inevitable. Bank runs were seen not only in Iceland but also at the branches and subsidiaries of the Icelandic banks abroad. As stated above, a scenario of a bank run usually involves many depositors simultaneously withdrawing their deposits from a bank, which in its turn causes liquidity problems.11 In the Icelandic case that is precisely what happened with bank accounts in Icelandic branches in the UK and Netherlands, since Icelandic banks were experiencing big liquidity problems in foreign currency.
8 Ibid.
9 Deposit-guarantee schemes are also called ”deposit insurance.” For the sake of good order, the author will be using the term “deposit-guarantee schemes” in the thesis.
10 Tryggingarvernd innstæðueigenda og fjárfest (TIF) is the Icelandic Depositors and Investors Guarantee Fund.
11 R. Söderström, Sound banking, p. 18.
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Timeline of the events
1994 Iceland becomes a founding member of the EEA
1991 The Depositor’s and Investor’s Guarantee Fund (TIF) was established in Iceland 2000 The TIF started its operations
2003 Privatization of state-owned banks completed
2004 The consultative group, responsible for the contingency plan, was established in Iceland
2006 Icelandic banks started receiving deposits abroad 2008 The beginning of the financial crisis in Iceland
- 6 October – Emergency Act was adopted in Iceland
- 8 October – The Government of the UK put Icelandic banks on the British Anti- Terrorism Act
- 9 October to 22 October – The domestic Icelandic deposits were transferred to the “New Landsbanki”
- 27 October – The FME made the decision, claiming the deposits of the “old”
Landsbanki being unavailable
2009 The 1994 Directive on deposit-guarantee was amended 2010 The Special Investigation Report was released
2011 The ESA brought an action against Iceland in the Icesave dispute 2013 The EFTA Court reached its decision in the Icesave dispute
2014 The SFO (Serious Fraud Office) decided to remove all the charges from Robert Tchenguiz, and the SFO had to pay him 6.4 million US dollars in damages to settle his claims of malicious prosecution
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List of abbreviations
TIF – Tryggingarvernd innstæðueigenda og fjárfest ( The Deposit Guarantee Fund of Iceland)
CDO – Collateralized Debt Obligation DGS- Deposit Guarantee Scheme GDP – Gross Domestic Product
SIC - Special Investigation Commission
FME -Fjarmalaeftirlitið (Financial Supervisory Authority of Iceland)
TRS-System -Transaction Reporting System (system that is used by the supervisory authorities)
EFTA Court- The Court of Justice of the European Free Trade Association States (a supranational judicial body judging in questions that refer to Iceland, Liechtenstein and Norway)
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1 Introduction
”Iceland should be a model of the world.”
(Arthur Laffer, American economist, in November 2007)
1.1 Opening remarks
After the end of the Second World War in 1945, an era of economic growth began in the world. This flourishing period of the world economy lasted for four decades with the United States paving the way for other countries. The United States came to be the world’s largest economy without suffering from a single financial crisis. This fact, however, would change when Ronald Reagan was elected President in 1981. He initiated a period of liberalization in the financial markets that continued under the next presidents Bill Clinton and George W. Bush. The American deregulation along with technological development led to the introduction of new financial instruments like collateralized debt obligation (CDO).12 These instruments spread to an excessive extent, and without the control of the authorities, CDOs became a foundation of the unsustainable boom of the financial markets around the world. The most severe global financial crisis was inevitable. The consequences were devastating: investment banks collapsed, families were forced to leave their homes, and many countries experienced severe financial struggles. One of the countries seriously affected by the crisis was Iceland. Iceland had chosen to follow the U.S. and went through drastic liberalization at the beginning of 1998. When completed in 2003, the financial sector consisted of three major banks: Glitnir, Kaupþing Bank, and Landsbanki. These three banks, which together constituted approximately 85% of the entire financial sector in Iceland, grew from about 100 % of the gross domestic product (GDP) 13 in 1998 to 900% of GDP by the time of collapse in October 2008 (figure 1).
12 CDOs can, in my opinion, be hardly considered financial instruments due to their “artificial” nature. CDOs can be rather seen as financial tools, used by the banks to recategorize individual loans into a product that is further sold to investment firms. That was done with the purpose of affecting share prices and increasing profit.
The party that had to pay for this “investment game” were the depositors of the banks.
13 GDP is one of the most effective ways to measure a country’s economy. GDP is calculated according to the following formulae: C+I+G(X-M); where C stands for the personal consumption expenditures, I is the Business Investment, G is the Government Spending, X is the Exports and, finally, M stands for the Imports.
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Figure 1. Liabilities of Glitnir, Kaupþing, and Landsbanki are shown as a percentage of GDP during the years 2004-2008.
Source: The Board meeting minutes of the three banks
1.2 Problem description
With the purpose of better understanding the reasons to why Iceland’s financial system collapsed so spectacularly, it is essential to look at the roots of the Icelandic economy.
Iceland’s wealth grew from an economy which was among the poorest in Western Europe at the end of the Second World War.14 Despite being a geographically isolated country, Iceland towards the second part of the 19th century became a fast-growing economy. The factors behind that were the following: Iceland’s significant fish export, a small population of 300,000 (as of the mid-2000s) with a high level of education, a Lutheran work ethic and a strong sense of national identity having its foundation in Icelandic language and literature.15 In 1994, due to joining the European Economic Area Agreement (EEA Agreement), Iceland became part of the European market in goods, services, labor, and capital.16 Being, for various reasons,17 officially outside the European Union, this agreement gave Iceland the same access to financial markets as
14 S. Sigurgeirsdottir, Iceland´s meltdown: the rise and fall of international banking in the North Atlantic, p. 685.
15 Ibid.
16 S. Benediktsdóttir, J. Danielsson, G. Zoega, Lessons from a collapse of a financial system, p. 6.
17 Some of the reasons, named in the academic literature, to why Iceland is still not a member of the EU are the following: (1) Iceland has a perception that membership in the EU would have an adverse effect on the fishing industry, (2) Iceland’s strong economic, diplomatic and military collaboration with the U.S. decreased Iceland’s need to be a part of the EU, (3) Icelandic nationalism and Icelandic mentality as a colonial country and (4) Iceland has unfortunately minimized their chances of joining EU due to the Icesave dispute with the Netherlands and the UK.
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EU member countries. Iceland’s membership in the EEA Agreement made it easier for Iceland to set up branches in EU countries, collect deposits in Europe and to borrow from foreign banks since Iceland was now adopting EU regulations. By 2003 the two major state-owned banks Glitnir and Landsbanki were privatized, and the third bank (Kaupþing Bank) was created from mergers with the smaller ones. Two questions, namely, who bought these banks and how these purchases were financed and the answers to these questions are, in my opinion, significant for the understanding of the Icelandic crisis. The owners of these banks started to take out giant loans from other banks both with the purpose of funding their bank’s acquisition and for their personal use. In the majority of cases, the owners used shares in their banks as collateral for those loans.
What they usually did with the money they had borrowed, was to buy assets in other firms and companies. Many of the bank owners had private equity companies, and the loans were used to finance those companies. It is especially noteworthy to mention that all three banks were granting loans to buy each other’s shares. As an example, it can be mentioned that Kaupþing financed 70 % of the acquisitions of Landsbanki. Meanwhile, Landsbanki financed 35 % of the acquisition of Bunadarbanki, which was some months later acquired by Kaupþing.18 That was the beginning of a vicious circle: a scenario where loans were taken, assets were bought with those loans, and where the shares in the banks were used as collateral for significant loans. It should have been apparent to all the involved parties that the Icelandic banks were exposing themselves to the interdependence. That means that if one bank would crash, so would the other two.
A big wave of overconsumption could be observed in Iceland by the year 2004, that is when Icelandic lending capacity increased rapidly due to lending to domestic private households for the purchase of cars or real estates. However, the most significant increase in lending was to holding companies and to foreign parties.19 That increase was particularly significant during the latter part of 2007. As it is stated in the Special Investigation Commission Report (SIC Report), by the beginning of 2007 the lending capacity of the Icelandic banks to foreign borrowers increased by 800 million EUR, to
18 S. Benediktsdóttir, G. Bergþóruson Eggertsson, E. Þórarinsson, The Rise, Fall, and Resurrection of Iceland: A Postmortem analysis of the 2008 Financial Crisis, 2017.
19 The Special Investigation Commission, Causes and build up to the collapse of the Icelandic banks in 2008, chapter 21, p. 3.
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8.3 billion EUR. Right after the beginning of the international liquidity crisis in the middle of 2007, the lending capacity skyrocketed by 11.4 billion EUR, to 20.7 billion EUR. Such an increase in lending to foreign companies and households, which was estimated at 120% in just six months, can be assumingly connected with the liquidity crisis in the financial markets around the world. What the SIC Report suggests as one of the main reasons to such rapid growth of the Icelandic banking in just six months, is that many new customers turned to Icelandic banks as they had been previously denied service at other banks. Through the aforesaid, Iceland within some years transitioned from fishing, energy, and aluminum smelting country into an international financial center. However, as the saying goes, what goes up must eventually come down. As Mark Flannery, American economist, pointed out in the SIC Report, unlike many other countries like Switzerland, the Netherlands or Belgium, Iceland did not have any experience in supervising big international banks.20 The rapid expansion of private banks grew at a much higher rate than the Financial Supervisory Authority (the FME) itself, the banking supervisor in Iceland. Both understaffed and unqualified, which will be described further in chapter 4.1, the FME failed to both carry out its monitoring duties as well as to make sure that the financial corporations complied with the law. The FME had repeatedly ignored numerous warning signs coming from the Icelandic banks which, if properly investigated, could have been used to detect the undesirable activities on the financial market at an earlier stage. That is where the importance of not only correct implementation of regulation but also strong supervision plays a crucial role. When performed effectively, supervision can both detect excessive risk-taking within the financial system of a country and expose threatening for financial stability behavior. 21 The purpose of this thesis, which will be described further in the next section, is to study and look at the reasons for the failure of the Icelandic financial markets. My focus will be on discussing in what way the weaknesses present in the Directive 94/19/EC on deposit-guarantee schemes (the 1994 Directive), that were subsequently transported into the Icelandic law, have contributed to the collapse of Icelandic banks.
20 M. Flannery, The Importance of government supervision in producing financial service (SIC Report 2010), p.
3.
21 J. Armour, D. Awrey, P. Davies, L. Enriques, J. Gordon, C. Mayer, J. Payne, Principles of financial regulation, p. 577.
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1.3 General aims and objectives
The scope of this thesis is to present the Icelandic crisis as a fascinating case study that highlights many questions with regard to the 1994 Directive. I consider that the problems associated with the 1994 Directive and its implementation into the Icelandic law are some of the main explanations for the systemic financial crisis in Iceland.
However, the Icelandic banking crisis emphasizes also other issues that usually characterize the notion of a systemic banking crisis, namely, cross-currency banking, insider borrowing, breaking the rules on large exposures and supervision problems.
Though it may seem impossible, within the framework of this thesis, to exhaustively analyse each stage of the Icelandic financial “bonanza”, the author of this thesis made an attempt to highlight possible problems that can be identified in the economic literature regarding the operations of financial markets and factors that may lead to a systemic banking crisis.
More specifically, the thesis will aim to fulfill its purpose by investigating the following central questions:
(1) What were the obligations imposed by the 1994 directive?
(2) Was the 1994 Directive implemented into Icelandic law correctly?
(3) May the arrangement and the position of the Icelandic Depositor’s and Investor’s Guarantee Fund have contributed to the collapse of the Icelandic banks in October 2008?
(4) Is the arrangement of a deposit-guarantee scheme capable of coping with a systemic banking crisis?
(5) Did the Icelandic Government have any responsibility, in light of the 1994 Directive, to step in and take responsibility for the reimbursements to the depositors, when the deposit-guarantee scheme established in Iceland proved to be insufficient?
1.4 Outline
The current chapter includes a presentation of the problem description, the aim, the outline, the methods and the sources used in this thesis. Chapter two seeks to provide an overview of the factors that resulted in the rapid growth of Icelandic international
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banking. Chapter three presents an examination of the possible reasons behind the collapse of the Icelandic banks. Some of these issues are banks’ owners being banks’
biggest loan takers, risk concentration within the banks and weak equity. Chapter four discusses the supervision in Iceland during the crisis years. This chapter addresses the problems of the Supervisory authority and its incapacity to monitor risk-seeking behavior in the Icelandic banks. Chapter five is the most extensive chapter of this thesis, and it discusses the deposit-guarantee scheme in Iceland. In this chapter, I aim to analyze the adequacy of the 1994 Directive and whether it was implemented in the Icelandic law correctly. Moreover, in chapter five I discuss the Icelandic Deposit Guarantee Fund and whether it was capable of coping with its obligations during the crisis. This chapter also sheds light on a question whether the Icelandic government had any responsibility to reimburse the depositors when it was clear that the Icelandic Deposit Guarantee Fund was unable to do so. Chapter six contains an overview of some lessons from the Icelandic crisis. Finally, chapter six is also the chapter where the author of this thesis provides the final analysis and concluding reflections on the Icelandic Banking Saga.
1.5 Methods
Regulation within the banking sector is mostly based on economic reasons.22 My goal is thus to use a law and economics approach in this thesis. Economic analysis of law belongs to the field of economics that has the purpose of analyzing synergy between law and economics.23 Economic analysis of law helps predict consequences and outcome of legislation, legal standards and thus can be used to make recommendations to lawmakers and legislators.24 In my opinion, it is essential to establish legal economic theories before starting the description of legislation and legal standards connected to the events described in the thesis. The approach of applying law and economics aims at answering several important questions regarding legal rules, namely, whether legal rules are efficient, what are the effects of legal rules on the behavior of relevant actors and
22 R. Söderström, Sound Banking, p. 42.
23 Ibid., p. 39.
24 Ibid.
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whether the effect of these rules is socially desirable.25 That is particularly true when it comes to discussion of deposit guarantees, one of five critical themes that, in my estimate, portray the Icelandic financial system the best.26 This thesis relies predominantly on the economic theories and conclusions established by economic analysts and experts in the financial sector. The ambition is to draw my conclusions based on knowledge and reasoning regarding the functions and characteristics of the banking sector. I intend to use basic theoretical arguments as departure points for my analysis and with the help of these economic arguments and theories to form an essence to the legal material that is going to be used in this thesis.
Since the ambition of this thesis is to examine a real-life situation from the past, besides a law and economics approach, I am also going to apply a case study research method. In my opinion, a vital strength of any case study method consists of using multiple sources in the data gathering process. To achieve a clear picture of what happened during the Icelandic crisis, I will be using several sources from the period 1994–2018. My ambition is, through studies of reports, articles, scholar writings, academic literature, annual accounts, and board meeting minutes, to bring an understanding of what happened during the crisis years. In those areas of my research where no answers to the questions set out in this chapter were found in already existing reports or annual accounts, the legal analysis was carried out by the author of this thesis.
I employed this method to examine Icelandic and European legislation with the focus on the tasks of supervisory authorities, rules on large exposures, equity rules and legislation regarding deposit-guarantee schemes. All parts of the study aimed at fulfilling the objective of examining the reasons behind the Icelandic crisis.
In some parts of this thesis, certain words are emphasized through the use of italics font. This is done with the purpose of ensuring that readers recognize the words that require emphasis; when introducing a new term or in a quotation.
25 L. Kaplow and S. Shavell, Economic Analysis of Law, p.1; H-B. Schäfer and C. Ott, The Economic Analysis of Civil Law, pp. 11-12.
26 The other four critical matters that, in my opinion, were the main causes of the Icelandic financial crisis are the following: fictional collateral, inside dealing, the inadequacy of foreign reserves and supervision problems.
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1.6 Sources
Getting an overview of the banks’ loan portfolio, internal documents and memorandum that give a clear and honest picture of banks’ operations is a challenging task. It is depending both on bank secrecy laws and on opaque ownership nets of the firms that receive money and the banks themselves. In the aftermath of the crisis, the Icelandic Parliament (Alþingi) established a Special Investigation Commission (SIC) with the purpose of investigating and analyzing the development within the Icelandic banking system that eventually caused all three big banks in Iceland to collapse. With the purpose of investigating the circumstances that eventually led to the financial crisis and letting the SIC make their assessment more accurate, Alþingi lifted bank secrecy laws, making some of the underlying data public. Central to the conduct of this thesis is thus the data from Iceland’s three biggest banks obtained through the report of the SCI that was released in April 2010. This report that is often considered to be the most authoritative analysis of the reasons for the collapse of the Icelandic economy was published in seven massive volumes.27 However, not all the published chapters were in English. The author of this thesis had access to chapter 17 and chapter 21 of the SIC report, which both are in English. I will, therefore, be using these two chapters as the departure point for further analysis. However, one challenge that I have encountered while studying the SIC report is that after the SIC had published its report, the evidence that the report is based on was not available to the public. The author of this thesis has been in contact with the Managing Director of the Icelandic Depositors’ and Investors’ Guarantee Fund (TIF), in order to get access to some of the board meeting minutes that were mentioned in the SIC report. However, the following is the answer that was received:
“The minutes of the Board of Directors of TIF are as a general rule subject to confidentiality and are not made public. TIF is, unfortunately, unable to do what you request.”28
Thus the second source for this thesis was obtaining the material available online by studying the board meeting minutes, annual accounts, memorandums and press releases
27 A report for the Ministry of Finance and Economic Affairs, The 2008 Icelandic Bank Collapse: Foreign Factors, 2018, p. 8.
28 The quotation from the e-mail that was received on the 27th September 2018 by the author of the thesis from Brynjar Kristjánsson, Managing Director of TIF.
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from the banks and the Icelandic authorities. That was done in order to conduct my independent research so that light could be shed on those subjects and questions that, in my view, were either not exhaustively covered in the report or needed additional research in light of the aims of this thesis. I have also discussed two case studies that are essential for the discussion of the deposit-guarantee schemes.29 These decisions and their value as a source of law will be discussed in chapter 5.
2 The “volcanic eruption” of the international banking in Iceland
“Iceland should be the new financial center.”
(David Oddsson, The Chairman of the CBI during the crisis years)
2.1 The EEA Agreement and provided guarantees
Icelandic entrance on the global financial arena can be compared with a scenario of a child entering the candy store for the first time. Unaware of consequences, risks or other responsibilities, Iceland was seeking capital abroad with hungry eyes. Two factors promoted that access.
The first factor was that Iceland joined the EEA Treaty. The second factor was the two types of guarantees that Icelandic banks received. The first guarantee was received from the state, that in case of a setback the Central Bank of Iceland (the CBI) could step into its role as the lender of last resort (LOLR). The second guarantee, received by the TIF, provided that should a bank’s assets become unavailable, the depositors of such a bank would be compensated for their losses according to the minimum levels established in the 1994 Directive. In this context, it’s worth mentioning that a LOLR and deposit- guarantee schemes, together with prudential supervision, belong to a so-called financial safety net.30 The two factors mentioned above, namely, the EEA Treaty and the provided guarantees, will be discussed below.
29 The author is referring to the European Free Trade Association’s rulings.
30 The notion of “financial safety net” is usually explained as actions taken by a government in order to maintain the stability and soundness of the financial institutions and thus the system in whole. That is done by, on the one hand, by protecting the core functions of the banks (loaning and borrowing) and on the other hand, by ensuring the stability of the whole financial system.
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In the first case, great freedom of action could be seen for Icelandic banks after entering the EEA-Agreement, which entered into force on 1 January 1994. Iceland’s membership in the EEA-Agreement made it easier for Iceland to set up branches in EU countries, collect deposits in Europe and to borrow from foreign banks since Iceland was now adopting EU regulations.31 The EU Directives on banking activities are built on the principle of mutual recognition. According to this principle, all the Member States32 are required to recognize the operating licenses of other financial institutions within the EEA. It should be mentioned that Article 4 of the EEA-Agreement prohibits any discrimination by nationality under the scopes of the agreement. In light of the principle of mutual recognition, the Icelandic banks could thus engage in banking operations abroad through branches or subsidiaries. In October 2006, Landsbanki opened a branch in the UK which provided online savings accounts under the brand name Icesave. Two years later, in May 2008 a similar online deposit branch of Landsbanki started its operations in the Netherlands. Seeing the success of Landsbanki’s foreign operations, both Kaupþing and Glitnir set up similar operations in their branches abroad. Kaupþing started collecting foreign deposits under the brand name Edge in the bank’s branch in Finland in November 2007, and Glitnir started operations under name Save&save at the end of June 2008.
Additionally, Kaupþing eventually started receiving deposits both through branches and subsidiaries even in other countries in Europe. It is worth pointing out that the legal status of deposits received through branches and through subsidiaries varied. While subsidiaries, following the rules of the deposit-guarantee of the country in question, were considered independent legal entities, the branches of the Icelandic banks were considered a responsibility of the TIF. In other words, it was of substantial importance for the obligations of the TIF to decide from the beginning whether the deposits were to be collected in branches or the subsidiaries. Attractive interest rates can explain the success behind the Icelandic foreign deposits in branches and subsidiaries abroad.
However, as it was seen after the banking collapse, the depositors in Iceland received
31 S. Benediktsdottir, J. Danielsson, G. Zoega, Lessons from a collapse of a financial system, p. 6.
32 It should be noted by the author of this thesis that in some EU-documents, both “Member States” with capital letters and “member states” with small letters are used. However, since the EU institutions use “Member States”
with capital letters, that is the version the author of this thesis will be applying in this work.
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full protection whereas the depositors in the Netherlands and the UK were left without any or any equal protection (see further discussion in chapter 6.8).
The second factor that made Icelandic banks very attractive to European depositors was their promises of having a deposit-guarantee scheme that would cover both domestic and foreign deposits.33 Information about the deposits of the Icelandic branches being covered by a deposit-guarantee scheme was extensively advertised on home pages of the banks. In general, promotional material on these web pages referred to the TIF protecting the deposits in the branches. Sometimes reference was made to deposit-guarantees being in accordance with the EU directives on deposit-guarantee schemes.34 Whether this statement was true or not will be assessed further in this thesis.
2.2 With great freedom comes even greater responsibility
As a result of the EEA Agreement and in conjunction with the adoption of the EU’s Directives into Icelandic law, some directives provided for minimum coordination of some matters concerning establishment and operations of the financial institutions.
Other matters were left to the Member States to decide over. The 1994 Directive that is based on the previously mentioned principle of mutual recognition. According to Article 7(2) of the directive, the Member States “may provide that certain depositors or deposits shall be excluded from a guarantee or shall be granted a lower level of guarantee.” The list of deposits that may be excluded is provided in Annex 1 to the Directive. Deposits by financial undertakings; deposits by a government; deposits by a credit institution’s directors, managers or parties related to them, are some of the examples of such deposits that could be excluded from the obligations of the Fund. The general term that describes such deposits is a wholesale deposit. They are usually described as deposits held by professional clients, those who possess better knowledge than private clients and those who in general are more experienced to assess the risks in the operations of financial institutions. Such clients do not need the same level of protection as clients that possess less knowledge about banking. In the preamble to the 1994 Directive, it is stated that the
33 K. M. E. Dominguez, comment to “Rise, Fall and Resurrection of Iceland: A Postmortem Analysis of the 2008 Financial Crisis”, p. 284.
34 The Special Investigation Commission, Causes and build up to the collapse of the Icelandic banks in 2008, chapter 21, p. 81.
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goal of consumer protection, protection for savers and depositor confidence are among the goals of the Directive. Thus, excluding or minimizing the level of protection for the wholesale deposits would not only be in line with the aim of the directive but would also significantly minimize the obligations of the TIF. In the review of the SIC, the possibility to exclude both Icelandic and foreign wholesale deposits from the deposit- guarantee protection, following the Directive, was not applied by the Icelandic legislator.35 The explanatory documents, provided to the Parliament during the implementation period of the Directive into the Icelandic law through Act No.98/1999 on Deposit-Guarantee and Investor-Compensation Scheme (the Act No.98/1999), made it clear that the reason behind it was the desire to improve the competitive conditions of Icelandic financial institutions in the EEA and to create a more attractive image of the Icelandic banks abroad. It will be further discussed in chapter 5, but it is worth briefly mentioning it here, that the Icelandic Fund was established in 1999 and Icelandic banks started receiving significant amounts of deposits abroad in October 2006. As it was stated in the SIC report, no amendments were made to the Icelandic Act since it was adopted in 1999.36 It can seem alarming that no actions had been taken to amend the regulations, despite the increased commitments of the Fund. In my opinion, freedom of choice that was provided in Article 7 of the 1994 Directive should have been used responsibly and to a much greater extent by the Icelandic authorities. It can, for example, be suggested that wholesale deposits should have been excluded from the deposit- guarantee protection. That should have been primarily considered after the year 2006 when a significant increase in wholesale deposits was observed in foreign branches.
As a consequence of the Icelandic banks, extensively receiving deposits abroad, the obligations of the TIF increased, and the ability of the CBI to step as a LOLR decreased.
As a foretaste of the following conclusions in the next chapters, it can be summarized that one of the main reasons for the collapse of the banks Glitnir, Kaupþing Bank, and Landsbanki, in my opinion, lies in their rapid growth and especially their rapid growth abroad. In the following chapter, I will be discussing crucial matters for this rapid growth.
35 The Special Investigation Commission, Causes and build up to the collapse of the Icelandic banks in 2008, chapter 21, p. 19.
36 Ibid., p. 21.
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3 Plausible causes of the Icelandic collapse
3.1 Banks’ owners as banks’ borrowers
The SIC Report established three main business groups operating in the Icelandic economy: Baugur group, Exista, and Landsbanki. These groups were criticized for borrowing significant amounts from the banks, thus bending the rules on large exposures and creating systemic risk. While analyzing the annual reports of the banks, it can be noted that all the three banks’ biggest shareholders were also banks’ biggest loan takers.
3.1.1 Glitnir Bank
When it comes to Glitnir, this interconnectedness becomes evident when analyzing Glitnir’s annual report from 2007. Figure 2 below shows that FL Group is Glitnir’s most prominent owner. FL Group was in its turn related to Baugur Group, and Baugur Group was the company that all three banks did their most notable national lending to. As it is stated in the SIC report, during the period of the end of 2007 and beginning of 2008, the lending from Glitnir to FL group and Baugur with the companies related to it had reached its peak. The loans increased from 900 million EUR in the spring of 2007 to about 2 billion EUR a year later.37 This cannot be interpreted in any other way than this effortless access to loans from Glitnir is explained by their role as bank owners.
Figure 2: Largest Shareholders at Year-end 2007, Glitnir38
Shareholder´s name Holdings Share
FL Group Holding Netherlands B.V 2,640,079,742 17,7%
FL GLB Holding B.V 1,950,614,919 13,1%
Þáttur International ehf. 1,041,649,091 7,0%
3.1.2 Kaupþing Bank
According to Kaupþing Bank’s annual report from 2007, an Icelandic financial services group called Exista was Kaupþing’s most prominent owner (see figure 3). A British
37 The Special Investigation Commission, Causes and build up to the collapse of the Icelandic banks in 2008, chapter 21, p. 7.
38 Glitnir’s other big owners were: Þáttur International ehf. with 7,0% of the shares, Glitnir Banki hf. With 5,4 % of the shares, Saxbygg Invest ehf. With 5,0 % of the shares, Jötunn Holding ehf. With 4,9 % of the shares, LI- Hedge with 4,6 % of the shares and Stím ehf. with 4,3 % of the shares.
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investor and businessman Robert Tchenguiz owned shares in both Exista and Kaupþing.
When the SIC report was published, it was stated that Robert Tchenguiz had in total borrowed 2 billion EUR from the bank. All that money was backed up by his shares in the same bank. Interestingly, the significant increase in lending to Robert Tchenguiz occurred when Robert Tchenguiz’s companies started to experience problems in late 2007. According to the Kaupþing’s board minutes from 2007, the lending to Tchenguiz was done so that he could pay back to other banks.39 In other words, when other banks started to sense that they may not ever see again the money they had borrowed to Tchenguiz, that is when Kaupþing’s lending to Tchenguiz reached its peak. It is highly questionable whether he could have achieved the same possibility of borrowing from the bank if he were not taking those loans in his capacity as an owner. This example shows a scenario where not only the banks are too big to fail, but it confirms the notion of customers being too big to fail.
Figure 3: Larges Shareholders at Year- End 2007, Kaupþing
Shareholder´s name Shares Share
Exista B.V 170,439,413 23,02%
Egla Invest B.V 73,153,352 9,88%
Other smaller shareholders n.a 67,1%
3.1.3 Landsbanki
A similar picture can be seen in the loan history of Landsbanki. There was one significant shareholder (Samson Holding Company), where father and son, Mr.
Björgólfur Gudmundsson and Mr. Björgólfur Thor Björgólfsson, equally owned parts of the company. As it is stated in the SIC report, the loan from Landsbanki to Samson Holding Company was very significant.
3.1.4 Summary
The biggest question that may arise when the owners of a bank also happen to be a bank’s biggest borrowers is whose interests are they going to consider in case of a crisis?
The answer seems obvious. In my opinion, what happened in Iceland is an example of a system where big banks are characterized by maximizing the benefits of the
39 Kaupþing Bank’s Board Meeting Minutes from 2007.
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shareholders than contributing to the development of a robust financial system. In the 2010 Report, the SIC expressed concern over the supervisory authority’s task of monitoring the operations of the owners of the banks. If the banks were supervised correctly, the borrowing activities of the owners of all three banks might have been limited significantly.
3.2 Risk concentration and rules on large exposures
The core element of the successful operations of a bank is making sure that a bank’s portfolio of assets is constructed in such a way that the risks are widely spread. If operations of a bank depend too much on success or fall of one single counterparty or groups of connected counterparties, there is a significant risk that the operations of the bank will reflect the operations of the customer. A sudden default of a big customer or groups of connected customers may cause a sudden default of the bank. A bank with a long-term interest in becoming a robust bank should thus do its best to not concentrate exposures to individual counterparties. This can be summarized as risk diversification.
Risk diversification can be achieved for example by investing in different sectors of the economy or by investing in companies located in different parts of the world.40 The rules that play an essential role in the risk diversification are the rules on large exposures.
These rules usually apply to individual banks and therefore cannot protect the whole financial system in the country. However, if applied and followed correctly in individual banks, these rules can prevent a domino effect of the whole financial system and thus minimize the probability of a systemic failure.
Rules regarding large exposures are practically universal. The importance and the need for banks to track and limit the size of large exposures have long been a subject of discussion by the Basel Committee on Banking Supervision. The first issued standard on this topic was published in January 1991.41 The reason behind these rules is to protect banks from a downfall due to a sudden default of a single counterparty or a group of
40 J. Armour, D. Awrey, P. Davies, L. Enriques, J. Gordon, C. Mayer, J. Payne, Principles of financial regulation, p. 278.
41 Measuring and controlling large credit exposures.
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large borrowers.42 In order to minimize risk concentration and increase risk diversification in banks, Iceland adopted European rules on large exposures. Rules on large exposures deriving from European directives were incorporated in Icelandic law through of Act No. 161/2002 on Financial Undertakings( Act No 161/2002). According to Article 30(1) of this Act “Exposure resulting from one client, or a group of connected clients, shall not exceed 25% of a financial undertaking´s capital base.” According to the SIC Report, these rules caused a significant amount of discussions and conflicts between the Icelandic banks and the supervisory authority.43 The most pressing question that the banks and the FME could not reach an agreement on was the definition of the concept of financially related parties. I will now turn to some examples of how this problem became evident in the crisis years.
3.2.1 Landsbanki: Actavis
On 22 March 2007 Landsbanki received a letter from the FME where the authority addressed the problem of the bank´s biggest shareholder Mr. Björgólfur Thor Björgólfsson (this name was already mentioned once in the previous chapter) being financially related to Actavis Group hf. According to the Actavis annual report from 2006, Mr. Björgólfsson owned at the time a total of 38,84 % of shares in Actavis Group hf, which is a global pharmaceutical company.44 The FME expressed further concern over Mr. Björgólfssons relation to Landsbanki where he was the biggest shareholder, and at the same time, the bank was one of the biggest shareholders in Actavis Group.
By 1 March 2007 Landsbanki Luxembourg S.A and Landsbanki Islands hf owned a total of 10,74 % shares in Actavis Group hf.45 The supervision authority considered that Mr.
Björgólfssons connection to Landsbanki was so closely related that the bank´s shares had to be defined in conjunction with Mr. Björgólfssons shares. The FME concluded in the same letter, based on rules on large exposure, that Landsbanki´s exposure to Mr.
Björgólfsson and the related parties has reached ISK 51.3 billion or 49,7 % of the bank’s
42 S. Benediktsdóttir, G. Bergþóruson Eggertsson, E. Þórarinsson, The Rise, Fall, and Resurrection of Iceland: A Postmortem analysis of the 2008 Financial Crisis, p. 219.
43 The Special Investigation Commission, Causes and build up to the collapse of the Icelandic banks in 2008, chapter 21, p. 11.
44 Actavis Annual Report 2006, p. 40.
45 Ibid., p.42.
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equity the same year.46 In their reply to the FME:s letter, Landsbanki on 30 April 2007 rejected the authority’s interpretation of the related parties and added that “Mr.
Björgólfsson and the related parties did not exercise control over Actavis Group and there was no risk of financial difficulties between those parties.”47 It was further explained in the same later that no risk of financial difficulties could be observed due to Mr.Björgólfsson’s “strong financial standing.” Surprisingly enough, The FME accepted this explanation and, in a report on large exposures in Spring 2007, authorized Landsbanki to record these exposures as if they were not related. The supervisory authority pointed out, however, that in the next report in June 2007 this would not be accepted. From the evidence obtained during the investigation of the SIC, in June 2007 the exposures were still recorded separately. In September 2007, the FME dropped the case.48 The bank thus ignored the recommendations from the supervisory authority, and the supervisory authority failed to enforce the compliance.
The description above is a vivid example of a situation where the supervisory authority severely lacked the force necessary to ensure that the bank would comply with the law.
In my view, not only the actions of Landsbanki should be criticized, but also the passivity of the supervisory authority itself. An essential question in the context of large exposures within Landsbanki is whether the FME was complying with the law when the authority failed to take further actions. The answer to this question becomes particularly evident when the laws under which the FME operates are analyzed. According to Article 10(1) of Act No. 87/1998 the following is stated: “Should it be revealed that a regulated entity does not comply with the law or other regulations governing their activities, the Financial Supervisory Authority(FME) shall insist that the situation is rectified within a reasonable time limit.” According to Article 11(1) of the same Act, the financial corporation that fails to provide the requested information within a reasonable time limit would face daily fines or penalties. By not imposing Landsbanki the time limit within which the bank should remedy the situation, according to the Article 10, the FME
46 The Special Investigation Commission, Causes and build up to the collapse of the Icelandic banks in 2008, chapter 21, p. 12.
47 Ibid.
48 The Special Investigation Commission, Causes and build up to the collapse of the Icelandic banks in 2008, chapter 21, p.12; the reference was made in the report to a memo from the FME No. 2, which discusses an in- house meeting on 29 March 2007.
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has thus failed to follow one of the rules under which the authority itself is operating.
The only thing that the FME requested was that Landsbanki would reply no later than 20 April 2007. The bank replied on 30 April 2007. It can be subject to discussion whether the FME’s request to answer no later than 20 April 2007 can be considered as a reasonable time limit. In any case, Landsbanki’s late reply should have caused the FME to take immediate action and proceed by taking disciplinary actions towards the bank. None of that was done. My conclusion of the above described is that Landsbanki failed to comply with the rules on large exposures according to Act No.161/2002 on Financial Undertakings. Additionally, the FME, while showing a great deal of complacency and passivity, failed, in this case, to carry out its primary task: supervising and monitoring of the bank.
3.2.2 Kaupthing Bank hf: Baugur and Mosaic Fashion
A similar level of risk exposure can be observed in the case of the Kaupþing bank. In its credit risk report of the bank, the FME addressed the conflict of the two companies, Baugur, and Mosaic Fashion hf. The FME determined that Baugur Group exercised control over Mosaic Fashion hf. Moreover, another company ISP ehf. was considered directly related to Baugur Group, since that the owner of ISP ehf. was Ms. Ingibjörg Pálmadóttir, the wife of Mr. Jóhannesson, the principal owner of Baugur Group. The exposures of these and other related to them companies had reached a total of ISK 139.5 billion or 31 % of the bank’s equity on 30 June 2007. As it was previously stated above, according to the rules on large exposures, the exposures may not exceed 25% of the bank’s equity. The FME made remarks on the stated above level of exposure. However, the bank ignored these comments by continuing reporting the parties mentioned above as non-related parties. It is evident from the reports on large exposures submitted by the bank to FME during the years 2007 and 2008, that was done not only once, but repeatedly during these two years.49 It shows that the bank entirely ignored the comments from the FME. The same level of structural problems in the FME as mentioned earlier can be observed in this case. It can be summarized by saying that the FME did not ensure that the case was proceeded along proper legal channels, according
49 Reports on large exposures from Kaupþing Bank to FME in 2007 and 2008.
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to the Articles 10 and 11 of Act No. 87/1998, after the employees of the supervisory institution had concluded that a violation of rules had taken place.
3.2.3 Glitnir Bank hf: Stím and FL Group
Together with the Landsbanki’s case, the case of Glitnir is, in my view, one of the most
“picturesque” cases of risk exposure during the Icelandic crisis. One-third of assets in the Icelandic company Stím consisted of shares in FL Group. Referring to Article 2(b) of Rules on large exposures incurred by financial undertakings No 216/2007, the FME stated that these two companies were together forming a group of connected clients. The group of connected clients was in Article 2(b) defined as “two or more natural or legal persons who are to be regarded as constituting a single risk because they are so interconnected that, if one of them were to experience financial problems, the other would be likely to encounter repayment difficulties.”
The situation was worsened even more by the fact that by 2008, the only assets in Stím were the shares in the Glitnir bank itself and FL Group. Those shares were in large part financed with a loan from Glitnir bank, and the only collateral was the shares. It is worth noting that the supervisory authority of Iceland did not in any way exercise power to inform the bank of the necessity of lowering the significant risk exposure, that had accumulated within the bank.
After the SIC report was published, it was speculated, that the “creative accounting”
helped the banks to avoid breaking the rules on large exposures.50 Whether it is the creating accounting or pure recklessness, is neither for the author of this thesis nor for the reader to judge. However, the evidence speaks for itself. It might not come as a shock, not even to the bankers themselves, when in October 2008, Glitnir and the other two banks collapsed. On 21 December 2015, the Former CEO of Glitnir Bank Lárus Welding was sentenced to five years in prison. Another 29 people were sentenced for market manipulation and fraud. It can thus be stated, that not only the banks themselves suffered from, i.a., bending the rules of large exposure, but also the whole financial system of Iceland.
50 Sigrun Davidsdottir’s Icelog, Lessons from Iceland: the SIC report and its long- lasting effect/10 years later.
Sigrun is a journalist and writer, who became the London correspondent for the Icelandic National Broadcasting Service RÙV and who was covering the news during the 2008 Icelandic financial crisis. The author is most certainly referring to bending accounting rules when speaking of “creative accounting”.
