Outside Iceland it is widely believed that the collapse of the Icelandic financial sector in October 2008 came at no expense to Icelandic taxpayers. This contrasts with taxpayers in Ireland, the UK, Greece, Spain and Portugal, who have recapitalized their banking sectors. However, based on a recent estimate of public funds put into the financial sector since the collapse, we calculate that the cost accruing to the Icelandic State amounts to 20 to 25% of GDP – which means that Iceland cannot be taken as an example of a country that did not bail out any banks. This is of some interest since Iceland is now a popular comparison for economists studying crisis-stricken European countries.
The IceSave saga
As the citizens of Iceland have twice, in national referendums, turned down agreements undertaken by the Icelandic state to guarantee payments to the governments of the UK and the Netherlands, this has been seen as an act of defiance against bailing out the banks. But this is only a part of the story of public funds going into the Icelandic financial sector. In spite of the IceSave outcome, public funds have indeed gone into the Icelandic financial sector, at a great cost to Icelandic taxpayers.
It is, however, important to understand the IceSave saga, which has shaped the perception of what happened in Iceland. It stems from high interest savings accounts, called IceSave, that an Icelandic bank, Landsbanki, offered savers in the UK and the Netherlands. As the British and the Dutch operations of Landsbanki were assigned to a branch and not to a subsidiary, depositors were covered by the Icelandic Deposit Guarantee Scheme, DGS.
When Landsbanki collapsed in October 2008, the funds of the Icelandic DGS amounted to just a fraction of claims from UK and Dutch customers. Partly in order to prevent a run on their own banks, the governments of the UK and the Netherlands decided to reimburse IceSave depositors, hoping to recover the funds, in due course, from the Icelandic government.
The successive IceSave agreements instructed that the estate of the failed Landsbanki would pay out most of the funds owed by the Icelandic DGS, with the Icelandic Government guaranteeing any outstanding claims. By turning down the agreement in two referendums, it was, in effect, the top-up of the remaining balance that Icelandic voters refused to guarantee.
The EFTA Surveillance Authority has now brought the IceSave dispute to the EFTA Court, claiming that by not reimbursing the UK and the Dutch IceSave deposit holders – and by discriminating between domestic and foreign accounts – Iceland is in breach of Directive 94/19/EC of the European Parliament and of the Council of 30 May 1994 on deposit-guarantee schemes. In particular, the outcome of the discrimination part of the ESA case could potentially pose a financial risk to Iceland.
As pointed out above, there is more to the collapse of the Icelandic financial sector in October 2008 than the IceSave debacle and the refusal to reimburse foreign depositors. When it came to losses, the biggest one was incurred by domestic transactions with the Central Bank of Iceland, CBI. Bank facilities that the CBI had accepted as collaterals against repo loans became worthless overnight when the three big banks – Kaupthing, Glitnir and Landsbanki – collapsed.[i] The CBI was in reality bankrupt and had to be recapitalised by the state to the sum of ISK267.2bn.
As listed in Table 1, the government also stepped in to secure the operations of several smaller financial institutions – some of which quickly failed in spite of public funds – and of one major insurance company. Most importantly, the government had to supply equity for the operations of the “new” banks, set up on the ruins of the fallen ones. Government involvement was in form of direct transfers, state guarantees and of providing equity in return for shares in the new banks.
Table 1 makes it clear that the government did offer some form of assistance to most Icelandic financial institutions after the three big banks failed. And this has come at a cost.
The National Audit Office in Iceland has only recently published a report tallying the size of funds transferred to the financial sector from the Icelandic State as well as the guarantees given by the State in response to the collapse of the Icelandic financial sector in October 2008.[ii] This report however makes no attempt to calculate what could potentially be the total loss of the sovereign. Columns (1) and (2) of table 1 report the findings of the National Audit Office.
We proceed by taking into the account that the size of a guarantee indicates the maximum potential loss accruing to the guarantor, not the expected loss. Some of the guarantees will never be tested, shares in banks will be sold and some funds will have to be written off. By calculating the expected real cost of the collapse of the Icelandic financial sector, we assign probabilities for bank sector repayments.
Columns (3) and (4) report our estimates for those probabilities. Our approach is to assign a 100% probability of a loss where the losses have already been realized. The loss assigned to capital invested in bank shares reflects the foregone interest on the capital transferred as seed capital from the sovereign to the new banks taking into account the estimated value of the equity of the new banks. For other assets, we assume either high or low probability of losses, ranging from 20 to 40%, somewhat arbitrarily based on the difference between the carrying value and fair value of the assets of the Kaupthing Winding-Up Committee as estimated in their most recent report.[iii]
As column (5) and (6) of the table show, the total capital at risk for the sovereign is around ISK700bn. The share of the Icelandic state in the equity of the three big banks amounts now to some ISK180bn. Foregone interests (measured by the interest rate charged by the CBI for loans against collateral) amount to ISK48bn. Thus, the real loss for the State from restoring the three big banks is a minuscule ISK5-6 bn.
As pointed out above, the biggest loss stems from the evaporation of collateral at the Central Bank, ISK267.2bn. Consequently, we calculate the expected losses to be in the range of ISK348-393bn, which amounts to 20-25% of GDP. This number might rise if further costs will arise from the ruling of the EFTA Court on IceSave.
The cost to the UK taxpayers of saving UK banks
In order to get a comparison from a country that has behaved in the same manner as Iceland – saved some banks but let others fail – we looked at the case of the UK. The British National Audit Office has tallied the cost accruing to British taxpayers due to the interventions in support of the financial sector in the UK post Lehman Brothers.[iv] The total outstanding support is estimated to amount to GBP228bn in March of 2008. Value of bank-shares acquired by the government due to intervention post-Lehman is GBP27bn less than money spent. The government guarantees additional GBP109bn. By using comparable methods to those applied in Table 1, one can assume that the cost of the intervention will be in the range of 3,5 to 5% of British GDP.
We are aware that the final cost, accrued from supporting the Icelandic financial system, to the Icelandic State will not be clear for some time to come. But there is a cost – and as we have shown above it is possible to plausibly calculate the potential cost. Since Iceland has become a popular comparison for economists studying crisis-stricken European countries we feel it merits this attempt. Our calculation shows that Iceland cannot be taken as an example of a country, which did not bail out its banks.
Compared to the UK, Icelandic taxpayers will pay 5 to 7 times more for government interventions in the financial market than is the case in the UK. Hence, the widely held belief that Icelandic citizens did force bondholders, bankers and shareholders of financial firms to shoulder the burden of the collapse of the Icelandic financial sector is wrong. Icelandic taxpayers used what amounts to almost a year’s worth of taxes to recapitalise the domestic part of the financial sector. Whether these bailouts were necessary or not can be debated but the cost of 20-25% of GDP is, according to our calculations, a reality.
However, a major difference, in terms of costs to UK and Icelandic taxpayers is that foreign creditors carry the bulk of the cost of the Icelandic collapse – as the three big banks failed in October 2008 these creditors lost what amounts to 5 to 6 times the Icelandic GDP. But that is a wholly different saga.
[i] Skýrsla Rannsóknarnefndar Alþingis (Report of the Special Investigative Commission, SIC) vol. 2, p43-44.