Sigrún Davíðsdóttir's Icelog

In Iceland, the rating agencies and their uncritical look at the Icelandic banks isn’t likely to be forgotten soon. I have just blogged on the Icelandic experience, tied to other more recent examples, at the Left Foot Forward blog, see here.

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Icelog has earlier dealt extensively dealt with the saga of the Landsbanki Luxembourg equity release loans. As pointed out there seem to be good reasons to question both how Landsbanki dealt with its customers before its demise in October 2008 and then later how the administrator has allegedly dealt with these loans, as well as ignoring questions regarding the Landsbanki Luxembourg operations.

The clients, mostly elderly people, have shown great resilience in drawing attention to questions seeking answers but the authorities in Luxembourg have not been too keen in taking up the issues raised by the group. One of many remarkable events was when the Luxembourg Prosecutor went out of his way to issue a press release defending the administrator, i.a. by throwing doubt on the victims’ motives, though he did not publish any tangible proof for these allegations.

As reported earlier, the group has now sought legal assistance and is seeking ways how best to proceed with their claims. The group has now open a website with all relevant information, contact details etc.

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Fitch Ratings have upgraded Iceland’s status – it is now BBB instead of BBB-. The upgrade, as a similar move by Moody’s recently, partly stems from the EFTA Court’s Icesave ruling, which has removed uncertainty of possible state liabilities. Fitch underlines the improved economic situation, not least the debt status of the sovereign, all moving in a positive direction and gives Iceland a slightly higher rating than Moody’s and S&P.

The capital controls are the great unknowns. But first, a few words on the situation in Iceland here and now, relevant to the capital controls.

In the wake of the collapse of the Italian political system, following the corruption investigations in the early 1990s, old powers in the new centre around Silvio Berlusconi found ways of conquering the political vacuum. The collapse of the Icelandic banks set the scene for similar movements, not only for power but for assets as well. Shortly after the collapse of the banks a person with a great insight into Icelandic society said to me that we would, in the coming years, see a fierce battle for assets and power in Iceland.

This battle is now taking place, centered around the ownership of the holding companies which control the two banks, Islandsbanki and Arion. The owners of these two holding companies are foreign creditors, ca half and half original creditors and funds that have bought claims. The crux of the matter is if the two holding companies will go through an orderly composition and a sale of asset at the best possible time or if the companies will be brought into bankruptcy, forcing them to sell off assets in a relatively short time, assumedly at a knock-down price.

Mar Gudmundsson governor of the Central Bank of Iceland has expressed that the best solution would be to sell one of these banks for foreigners who brought in fresh foreign currency. The delicacy of the situation is partly that whichever bank is sold first will, in a sense, knock down the price of the remaining one, especially if there are only Icelandic buyers interested.

The latest is that a fund owned by Icelandic pension funds, in conjunction with major shareholders of MP Bank, are negotiating a purchase of Islandsbanki. The group is led by Skuli Mogensen, who after leaving a bankrupt IT company OZ ca ten years ago, made his fortune in Canada, and like in a novel, returned to his homeland a rich investor, keen on building his fortunes there again. In MP Bank he has allied himself with two investors, who have previous Icelandic ties – David Rowland and Joe Lewis.

However, the “ruler” in deciding the turn of events re selling the two banks is the CBI. The bank will have the last word on agreements re the composition, which have to be weighed against the pressure on the Icelandic krona due to lack of foreign currency in Iceland. The CBI is well aware of the problems and yet, some forces in Iceland are trying to undermine its authority by insisting on political control and the role of the Parliament in deciding the fate of the two holding companies.

Before the privatisation of the Icelandic banks they were run like political fiefdoms. Following the privatisation, fully in place by 2003, the banks were still run as fiefdoms, this time with the largest shareholders as the bank ruling class. The publication of the SIC report drew a concise, insightful and bleak image of these convoluted alliances and power structures.

One way of understanding the ongoing struggle in Iceland re ownership of the two major banks is to see it as the attempt of those who used to rule, before 2008, to reclaim their position. Others might say that this sounds like fiction – but lets wait and see. The outcome of the elections will be a decisive factor in constructing the future of Iceland.

Now, back to Fitch. Below is the Fitch press release, emphasis is mine.

Fitch Ratings has upgraded Iceland’s Long-term foreign currency Issuer Default Rating (IDR) to ‘BBB’ from ‘BBB-‘ and affirmed its Long-term local currency IDR at ‘BBB+’. The agency has affirmed the Short-term foreign currency IDR at ‘F3’ and upgraded the Country Ceiling to ‘BBB’ from ‘BBB-‘. The Outlooks on the Long-term IDRs are Stable.

KEY RATING DRIVERS The upgrade reflects the impressive progress Iceland continues to make in recovering from the financial crisis of 2008-09. The economy has continued to grow, notwithstanding developments in the eurozone; fiscal consolidation has remained on track and public debt/GDP has started to fall; financial sector restructuring and deleveraging are well-advanced; and the resolution of Icesave in January has removed a material contingent liability for public finances and brought normalisation with external creditors a step closer.

The Icelandic economy has displayed the ability to adjust and recover at a time when many countries with close links to Europe have stumbled in the face of adverse developments in the eurozone. The economy grew by a little over 2% in 2012, notwithstanding continued progress with deleveraging economy-wide. Macroeconomic imbalances have corrected and inflation and unemployment have continued to fall. Iceland has continued to make progress with fiscal consolidation following its successful completion of a three-year IMF-supported rescue programme in August 2011. Fitch estimates that the general government realised a primary surplus of 2.8% of GDP in 2012, its first since 2007, and a headline deficit of 2.6% of GDP. Our forecasts suggest that with primary surpluses set to rise to 4.5% of GDP by 2015, general government balance should be in sight by 2016.

In contrast to near rating peers Ireland (‘BBB+’) and Spain (‘BBB’), Iceland’s general government debt/GDP peaked at 101% of GDP in 2011 and now appears to be set on a downward trajectory, falling to an estimated 96% of GDP in 2012. Fitch’s base case sees debt/GDP falling to 69% by 2021. Net public debt at 65% of GDP in 2012 is markedly lower than gross debt due to large government deposits. This also contrasts with Ireland (109% of GDP) and Spain (81% of GDP).

Renewed access to international capital markets has allowed Iceland to prepay 55% of its liabilities to the IMF and the Nordic countries.

Risks of contingent liabilities migrating from the banking sector to the sovereign’s balance sheet have receded significantly following the favourable legal judgement on Icesave in January 2013 that could have added up to 19% of GDP to public debt in a worst case scenario. Meanwhile, progress in domestic debt restructuring has been reflected by continued falls in commercial banks’ non-performing loans from a peak of 18% in 2010 to 9% by end-2012. Nonetheless, banks remain vulnerable to the lifting of capital controls, while the financial position of the sovereign-owned Housing Finance Fund (HFF) is steadily deteriorating and will need to be addressed over the medium term.

Little progress has been made with lifting capital controls and EUR2.3bn of non-resident ISK holdings remain ‘locked in’. However, Fitch estimates that the legal framework for lifting capital controls will be extended beyond the previously envisaged expiry at end-2013, thereby reducing the risk of a disorderly unwinding of the controls. Fitch acknowledges that Iceland’s exit from capital controls will be a lengthy process, given the underlying risks to macroeconomic stability, fiscal financing and the newly restructured commercial banks’ deposit base. However, the longer capital controls remain in place, the greater the risk that they will slow recovery and potentially lead to asset price bubbles in other areas of the economy.

Iceland’s rating is underpinned by high income per capita levels and by measures of governance, human development and ease of doing business which are more akin to ‘AAA’-rated countries. Rich natural resources, a young population and robust pension assets further support the rating.

RATING SENSITIVITIES The main factors that could lead to a negative rating action are: – Significant fiscal easing that resulted in government debt resuming an upward trend, or adverse shocks that implied higher government borrowing and debt than projected – Crystallization of sizeable contingent liabilities arising from the banking sector. In this regard, the HFF represents the main source of risk.

– A disorderly unwinding of capital controls leading to significant capital outflows a sharp depreciation of the ISK and a resurgence of inflation. The main factors that could lead to a positive rating action: – Greater clarity about the evolution capital controls and, in particular the mechanism for releasing offshore krona.

– Enduring monetary and exchange rate stability.

– Further signs of banking sector stabilisation accompanied by continued progress of private sector domestic debt restructuring.

– Continued reduction in public andexternal debt ratios.

KEY ASSUMPTIONS In its debt sensitivity analysis, Fitch assumes a trend real GDP growth rate of 2.5%, GDP deflator of 3.5%, an average primary budget surplus of 3.2% of GDP, nominal effective interest rate of 6% and an annual depreciation of 2% (to capture potential exchange rate pressures resulting from the lifting of capital controls) over 2012-21. Moreover a recapitalization of HFF equivalent to 0.7% of GDP is assumed in 2013. Under these assumptions, public debt/GDP declines from its current level to 69% of GDP in 2021. The debt path is sensitive to growth shocks. Under a growth stress scenario (0.2% potential growth), public debt would remain on a downward trajectory but it would stabilise at a markedly higher level (90% of GDP) by 2019. While Iceland’s debt dynamics appears to be resistant to an interest-rate stress scenario, a sharp deterioration in the exchange rate (possibly associated with a disorderly unwinding of capital controls) would have a more adverse effect.

Similarly, a scenario with no fiscal consolidation (primary deficit of 0.3% of GDP in the medium-term) would reverse the debt downward path: debt would reach 100% of GDP in 2015 and would remain above that level for 2015-21.

Fitch assumes that contingent liabilities arising from the banking sector (mainly through HFF) will be limited. Under a scenario where contingent liabilities arise due to the recapitalisation of HFF and they account for 4% of GDP each year from 2014 to 2016, public debt would still remain on a downward trajectory. However, it would reach 81% of GDP by 2021 (versus 69% under the baseline).

Fitch assumes that capital controls will ultimately be unwound in an orderly manner.

Fitch assumes that the eurozone remains intact and that there is no materialisation of severe tail risks to global financial stability.

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Someone will have to take losses as Cypriot banks deleverage and the sovereign debt is brought down. The next big date for Cyprus is the beginning of June when a redemption on a €1.4bn euro bond is due – not a trivial sum in an €18bn economy. It might all be undramatic ­– but so far the EZ has shown amazing aptitude for tension and brinkmanship

After Pimco was hired to find out how much would be needed to recapitalise the Cypriot banks the first number the Pimcoans aired was €10bn, not a trivial sum in an €18bn economy. Following this shock, Blackrock was asked to review the Pimco methodology, after which Pimco continued its work. Instead of publishing the report as first intended it will be kept confidential until a bailout has been negotiated (or until it is leaked).

The number optimistic Cypriots are hoping for from Pimco is €8bn but that might be somewhat optimistic – €8.8bn might be more realistic. That the report isn’t made public might indicate that Pimco landed on the scary €10bn.

Now, why would 10bn be scary? Because, in this €18bn economy the €10bn adds to the 2.5bn loan already received from the Russians and to the ca €5bn the state will need to fulfil its obligations until it can return to the market. At the end of the third quarter of last year the public debt stood at 82% of GDP. The worst case bailout need of roughly a GDP would pull the debt up to a crippling 140% or so.

The feeling in Cyprus is that €10bn for the banks means that there will a great pressure on the island’s government to privatise in full. There are still plenty of semi state-owned entities, i.e. companies where the state owns 51%. This counts for telecoms, utilities companies and many others. – This makes me think of Iceland after the war and up to the 80s when political power was concentrated around state-owned companies, creating some very cosy relationships but not the most effective use of resources.

In spite of a left-leaning population in Cyprus the unwillingness to privatise doesn’t necessarily stem from ideological aversion but from the envisaged pain from sacking people, adding to the growing number of unemployed people. In a country of only 800.000 this is understandable. Unavoidably, privatisation spells loss of jobs and those in charge know it will hit family and friends. Privatisation in Cyprus will no doubt happen – but it will be painful if it needs to be done in a short span of time at exactly the time austerity is arriving on the shores of Cyprus.

Cyprus clearly has unrealised state-owned assets, which it wants to make money on according to its own plan. The same counts for revenue in sight from gas resources, now in sight off the shores of the island. Cyprus doesn’t want to pledge this revenue against the coming loans. The worse the situation is shown to be the less flexibility there is for the new Cypriot government following presidential election on February 17 and a second round a week later, in case no candidate gets a majority. The strongest candidate is Nicos Anastasiades, a conservative from Angela Merkel’s sister party in Germany. Merkel has already showed up on the island to support Anastasiades.

This time, the Troika won’t be the only lender. Russia has a stake in keeping the island afloat and has alread indicated it wants to add to the bailout packet, through the IMF.

The bailout hinder right now is the persistent rumour of money laundering in the island. Cypriot authorities have answered by pointing at the island’s track record in fulfilling the requirement of the OECD and other international instituations. That hasn’t helped and now, having realise that more is needed, the Cypriot Parliament and ministers have promised that whatever needs to be investigated can be so, however the Troika will want to go about it.

In summer when Cyprus requested a bailout my first impression of the Cypriot situation was that Cyprus will be another Greece with bad news surfacing over months and possibly years. My Cypriot sources strongly reject this theory and are adamant that in spite of being geographical neighbours, Cypriots and Greeks couldn’t be more different.

For a bailout to do the trick two things seem to be essential – to force the banks to shed debt and to find some way of writing down or extending maturity on Cypriot debt. This will have to be done, in order to find a sustainable solution but the question is how fast and how, which ultimately means that someone is going to lose. With no write-down, the bailout won’t be sustainable anymore than it was first and second time around in Greece.

Only recently Germany’s finance minister Wolfgang Schäuble last aired his argument that Cyprus isn’t important enough to save but he seems to be isolated here. The reputational argument is: if the EU can’t bail out one of its smallest brothers how convincing is it that they are able to see a big brother like Spain through its difficulties? The troika will fix a programme and loan for Cyprus. From EU sources it seems likely that Olli Rehn’s view will prevail – no write-down.

The financial argument is that there are no proper private sector investors to drag to the barber’s chair, forcing them to take a haircut. The bank debt hasn’t yet migrated to the state except for the €2.5bn Russian loan. As to the two biggest banks one is 85% owned by the Cypriot state and in the other the shareholders are the general Cypriot public, with the largest shareholder owning 1%. A hair-cut will hit domestic investors and the state.

How might things proceed? The wishful scenario is that after the signing of the MoU, possibly in March, Cyprus will – as it has already started – implent the necessary measures, demanded by the lenders. Well on track, let’s say six months later, it will ask for longer maturities. Russia has already indicated it is willing to extend the maturity of the five year loan 2.5bn loan from end of 2011. This needs to have happened by beginning of March when a €1.4bn is due on a Cyprus euro bond.

This is the undramatic version. Something dramatic might of course upset this smooth forecast. There has been a flurry of guesses today, following an FT article last night, which spelled out options, ia some form of a bail-in – looks like capital controls – that would hinder depositors in moving their money, to be discussed at an EZ meeting of finance ministers in Brussels today. Cypriot ministers ruled this firmly out. The EZ group chairman Jeroen Dijsselbloem refused to answer such a hypothetical question when asked if he would like to keep his money in a Cyprus bank. After the EZ meeting we seem to be back to wishful scenario. Until the unforeseen strikes.

*An earlier Icelog on Cyprus, a link to a recent update on Cyprus on the Prodigal Greek – and another earlier blog on Iceland and Cyprus.

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Tonight, BBC’s Panorama shed further light on the investment in Barclays, made by Middle Eastern investors in autumn 2008 – an investment that has some striking similarities with the investment from the same part of the world in Kaupthing in September 2008. At that time, Kaupthing managers proudly announced that a Qatari investor, Sheihk Mohammed bin Khalifa al Thani, had so much faith in the bank that he had bought 5.1% of the bank’s shares.

Only later did it transpire that the faith in Kaupthing wasn’t quite as strong as the statements indicated. Kaupthing lent money to companies connected to the Sheikh and allegedly channeled $50m, an in-advance profit, to a company controlled by the Sheikh. As reported earlier on Icelog the Office of the Special Prosecutor in Iceland has charged ex Kaupthing managers – Sigurdur Einarsson, Hreidar Mar Sigurdsson and Magnus Gudmundsson – and the bank’s second largest shareholder at the time Olafur Olafsson – for alleged misdoings related to this investment. The Sheikh has not been charged in this loan saga.

Interestingly, the Panorama programme indicated that allegedly and as far as it could be gauged from Barclays public documents the Abu Dhabi sovereign investment fund made the investment whereas profit went into an offshore company controlled by Sheikh Mansour bin Zayed al-Nahyan.

An FT article on Qatari debt illustrates Qatar’s toughness in squeezing as much as possible out of every deal and the global power they derive from their financial strength. According to the FT “Qatar is notorious for trying to get something for nothing,” says one observer of the region’s financial institutions. “You have to almost pay them to do the deal.” Indeed an interesting statement in view of the Kaupthing Qatari deal. The Panorama programme indicates this toughness might apply to some of their neighours as well.

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The Icelandic Supreme Court has sentenced Jon Asgeir Johannesson to one year  prison, suspending the sentence for two years for tax evasion. In addition, Johannesson is ordered to pay ISK62m, €371.445. The case is a part of a case that has been running since Baugur’s offices were raided in 2002. In the summer of 2008 he was sentenced to 3 month prison, also suspended, for fraud, in a case that also sprung from the raids in 2002. In its sentencing the Supreme Court reprimanded the Reykjavik County Court for giving Johannesson too much scope to delay the case. The sentence was more lenient, according to the judgement, because the criminal behaviour stems from tax returns in the years 1999-2003. The charges were not brought until 2008.

But this is not the only case that brings Johannesson to court these days. The Office of the Special Prosecutor has charged Johannesson and Glitnir managers for causing Glitnir fraudulent losses, as recounted earlier on Icelog. In another case the Glitnir Winding-up Board is suing Johannesson and eight others – Glitnir managers and board members – for a fraudulent lending of ISK15bn to companies related to Johannesson. In both these cases Johannesson is effectively being charged and sued as a shadow director – as someone who was not legally a director but who acted like one who by putting pressure on managers and board caused these huge losses, stemming from loans issued to companies related to Johannesson and his close business partners.

The Glitnir case is related to a case the WuB tried to bring to a New York court but failed. This case is now being fought in Iceland but the New York exercise did probably help the WuB gather valuable information, which will benefits its case in Reykjavik. Johannesson’s defender claimed in court today that his client had no powers to manipulate the Glitnir management. Johannesson emphasises his innocence in both cases.

Johannesson has lately made some investments in the UK, on behalf of his independently wealthy wife. His investment in Muddy Boots, a very successful fine food start-up, made headlines recently. News of his investment indicated he would be on the board of Muddy Boots. It is unclear if this sentencing will affect these plans but with this sentencing he can’t sit on boards of Icelandic companies in the near future. After the sentencing in 2008 he was forced to step down from the board of some UK companies where he had been a board member.

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Kaupthing hf – the Winding-up Board of Kaupthing bank – has announced it has reached “an agreement concerning the settlement of all claims and liabilities between them. This agreement has been reached on a commercial basis with no admission of liability by any party. As a result of the settlement, the proceedings commenced in Iceland by Kaupthing against Sheikh Mohammed Bin Khalifa Bin Hamad Al Thani have been discontinued and all other claims and liabilities have been released. All other terms of the settlement remain confidential.”

According the SIC report Kaupthing loaned companies owned by Sheikh al Thani to buy shares in Kaupthing. This loan was allegedly behind the purchase of Kaupthing shares in September 2008. As reported earlier on Icelog the Office of the Special Prosecutor has charged three former Kaupthing managers and Kaupthing’s second largest shareholder in relation to this loan in a case similar to Barclays and the Qatari investors: neither bank declared it had allegedly loaned the investors money to buy the shares. In addition, Kaupthing lent the Sheikh against future profits. The Sheikh has not been charged of any wrong doing in Iceland but according to Icelandic media the OSP has indicated it might want to call him in as a witness in this case.

So what is Kaupthing hf settling? The SIC report and the OSP charges indicate that as well as issuing two loans in ISK, now around €157m, one of the Sheikh’s companies got a loan of $50m. This loan was “parts of the profits from the transaction” according to a Kaupthing overview of loans issued or discussed in one of the bank’s credit committees just before it collapsed. According to the writ, these three loans have never been repaid.

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From 1998-2000 I lived in Denmark and followed how things evolved both there and in the Nordic neighbouring countries. Outside, these countries seemed an oasis of tranquillity, peace and harmony though that feeling was less prominent inside. Of course, there were a lot of problems to be discussed and solved at a closer look – and it is that closer look that colours the public debate.

In the summer of 1992 I spent some weeks on an Italian beach immersed in hectic, loud and lively Italian family life. One of these summer days, the Sicilian judge Paolo Borsellino was assassinated, only a few months after the assassination of his colleague Giovanni Falcone. These were tense and tragic times and the uncertainty and power vacuum following spectacular corruption cases, the rise of “mani pulite” and the collapse of the Italian “partitocrazia” was palpable. There were even rumours that the army was thinking of asserting itself. Returning home to Copenhagen I opened the door. The Swedish newspaper “Svenska Dagbladet” was on the doormat. The main headline was “Bad ventilation in public places” – surely, this can only make headlines when all problems have been solved.

Moving to the UK in 2000, I looked back at these countries with certain nostalgia – compared to most, almost all, other countries the Nordic countries just seemed to have solved all problems. I nodded approvingly at the recent Economist’s front page coverage of the Nordic countries as a supermodel, excluding Iceland, embodied by a Viking. I was also glad to see the use of the term “Nordic” – a native English speaker once told me this term was not English. Well, it has now turned English though in the Nordic countries themselves the term includes the five countries – Denmark, Finland, Iceland, Norway and Sweden.

There is a good case for not including Iceland among the Nordic supermodels – the social structure is different, so is the value system. In the four other countries, social democrats have been the political architects. In Iceland it has been the conservative, the Independence Party. And so on.

Yes, there is much to be learnt from the four Nordic countries, in particular the natural inclination to egalitarianism and taking it for granted that society is made up of men and women and should be accommodating to both – an attitude woefully lacking ia in the UK. Research after research shows that such societies thrive and grow and it is not prohibitively extravagant to expect these fundamentals to be in place. Which of course doesn’t abolish political dispute but that is what democracy is for – to discuss these issues in a more or less civilised way and reach a workable conclusion and compromise.

My own country made the front page of the FT February 5, also with a Viking, this time a statue holding the Icelandic flag, embodying “The Icelanders’ angst; Saga of a society in rehab. Analysis.” The feeling is more chatty Hello than stern FT; the analysis done not with graphs and statistics but with mini portraits of seven Icelanders, all well known in Iceland. The point is to show that in spite of good economic numbers – such as unemployment falling from a peak of 9.2% to 5.7% (or 5.6% according to Iceland Statistics) and a growth of ca 2% – Icelanders are still “struggling, some are angry and some are keen to move on.”

Right, there is the whole gamut of feelings, as in most countries but angst? No, I don’t think angst is the prevailing mood among Icelanders and even much less now than a week ago when the EFTA Court ruled on Icesave. “Not enough done” has however been a common theme in the political debate. The government has been spectacularly bad at taking credit for the recovery that has, in spite of problems, taken place, giving the opposition plenty of space to spread its own version of too little, too late, wrong and bad.

Recently, I was on the Pat Kenny show on Irish Rte, explaining the Icelandic 110% way, the extensive write-downs of mortgages, one of the measures to get things moving again. Kenny asked if this meant that had he a mortgage of €400 and the value of his property was only €200 would he then get his mortgage written down to €220. Yes, exactly. There was a few seconds’ stunned silence. This would be seen as quite something to do, universally and over the line in Ireland or in any other country. In Iceland, people shrug their shoulders; yes, it’s good – but it’s not enough. Not for everyone.

Right, it’s not the panacea solution for everyone but it is quite helpful to many. The same goes for changes in bankruptcy law, to shorten the time of bankruptcy to two years and some other measures. Daniel Gros, CEPS, thinks that small countries like Latvia and Iceland do not have much to teach bigger countries re austerity. He might have a point in general but some of the measures taken in Iceland could prove of use to others, ia Ireland and Spain.

Icelanders are notoriously good at spending. The Icelandic term is “eyðslukló” – “spending claw” – and the Icelandic spending claw is now at it again. Going abroad, buying this and that, thereby showing some optimism. The spending claw is certainly not showing any sign of angst, not even now, in mid winter. According to Gallup Iceland “National Pulse” (Þjóðarpúlsinn) the mental state of the nation is slightly down from summer – as normally happens during this naturally dark time of the year – but it peaked higher in July last year than the previous year and is now also slightly higher than same time last year. Consumption of smaller goods was ISK5bn over Christmas a year ago, this time ISK7.1bn. And so on.

Plenty of things Icelandic in the international media recently. “Have you seen the front page of the International Herald Tribune,” an Icelander asked me in Brussel last Friday. “It’s the most beautiful IHT front page I have ever seen.” Right, the Esja – the majestic mountain cuddled up under white clouds on the other side of the bay from Reykjavik – was naturally well at ease on the front page and so was Olafur Hauksson, the special prosecutor and poster boy of bankers and financiers’ investigations in Iceland. The headline, “Iceland, Fervent Prosecutor of Bankers, Sees Meager Returns.”

I am not sure what the “meagre returns” mean here. The Office of the Special Prosecutor, headed by Hauksson, was set up in early 2009 with no staff and nothing. Now, three men are in prison related to financial dealing before the collapse. Some high-placed managers and large shareholders have been charged but these cases are still being processed by the Courts. HSBC has admitted to money laundering going back to the early 2000s. No one has been charged. It is only recently that bankers involved in Libor rigging, also going back number of years here in the UK are being investigated – it seemed at first there would only be fines. The investigations in Iceland are going far slower than most would like – but the bankers and other major players in the financial boom in Iceland are actually being investigated. That is more than can be said for most countries.

Is it necessary to make criminal investigations into what went on during the bubble years in Europe? Some say not, that one should look forward and not backward. I can’t see that one excludes the other. Human beings are not one-track beings and society can put efforts into both. Moreover, I think that the palpable anger in countries like Greece, Spain and Ireland – though expressed in different ways – also stems from the fact that little has been done to throw light on, investigate – and prosecute where appropriate. In addition, there is the immensely illuminating report of the Special Investigative Commission, set up at the behest of the Icelandic parliament, whose report was published in April 2012. No country has recently done comparable investigation.

It is perhaps the dark, cynical and prodding mind of editors that come through in the headlines mentioned above – there is often discrepancy between articles and headlines – but when their behaviour is scrutinised Icelanders do not seem to be particularly angst-ridden. Though the OSP investigations are taking time they take less time than some of the major SFO investigations. The judgements in OSP cases so far indicate that at least in a certain type of cases, of which there will no doubt be more, sentencing is likely, in some cases severe sentencing. The OSP might certainly experience some setbacks; charges might be thrown out, those charged found not guilty but at least Icelanders can’t say that nothing is being done in bringing bankers and financiers to justice. Too big to fail, to important to jail doesn’t quite hold in Iceland.

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What is the reaction to the EFTA Court’s Icesave ruling in Iceland and abroad? In Iceland, there is no gleeful victory, in Brussels people worry about the effect on perception and depositors’ protection and in the UK and the Netherlands politicians sense that there is no obvious way to recuperate their respective cost of paying Icesave depositors

I keep being asked if Icelanders are celebrating after the unexpected Icesave ruling of the EFTA Court. The answer is: no, not really. There is no victorious glee, as far as I can sense, but a huge relief. A friend who sat at a café in Reykjavik the morning after the judgement mentioned palpable relief but said people were also talking about the irresponsible behaviour of Landsbanki and the other banks.

The measured mood can be seen here where Prime Minister Johanna Sigurdardottir (the second lady from the right) took a few dance steps while waiting on Monday to go on air after the EFTA Court judgement on Monday – very small steps, no big swings.

It will be interesting to see how and if the EFTA Court judgement will influence the electoral campaign in Iceland where election is expected latest in April. After the leaders of the Progressive Party declared they would propose a vote of no confidence against the Government they then changed their mind. After all, the voters will have a say very soon.

It seems that Facebook – a much used tool in Icelandic public debate – was overflowing with unflattering comments about politicians who were in favour of earlier Icesave agreements. However, many do recognise that the judgement was truly unexpected. At the time, negotiating an agreement to end the dispute and eradicate the accompanying uncertainty seemed like the sensible thing to do at the time.

Membership of the European will be an election topic. At first, I thought the judgement would be a weapon for the eurosceptics – after all, it had paid to go against the received wisdom of negotiating. Now I am less sure. It can also be reasoned that the EFTA Court – part of the European Economic Area pillar – did save Iceland from the British and the Dutch claims. The Dutch and the British opted to use the European Economic Area, EEA, Treaty and EFTA Surveillance Authority to challenge the Icelandic position of not paying. At the end of that path lay victory for Iceland. – Suffice it to say that the judgement is not a clear-cut weapon for any one party.

The view from Berlaymont

It is no exaggeration to say that people at Berlaymont and elsewhere in EU institutions are gobsmacked and shaken by the EFTA Court ruling. So is indeed everyone else who has read the ruling. To have it black on white – albeit from the EFTA Court and not the European Court of Justice (but there should be homogeneity between the two) – that the Directive on deposit guarantee schemes does not protect depositor in a major collapse shook the ground under the whole European banking system though depositors may not have noticed it. At least not yet.

An excellent legal reading of the judgement on European Law Blog summarises the judgement regarding the Directive by saying it “might be called a lifejacket, but it doesn’t mean it’s built for emergencies.

The ruling is based on the deposit Directive as it was in 2008 – it has been changed since – but it has, as far as I can see, not been changed in such a way as to make it unequivocal that the state is the final guarantor. If the idea with the changes in 2009 was to make states guarantee deposits a short sentence saying that they did, could have been inserted. That was not done. Understandably so, because it raises moral hazards as is pointed out in the ruling.

The Directive was designed to give depositors the feeling the state did indeed guarantee the DGS and make investors think that no, of course the state doesn’t do that. This was always an impossible task, it just went unobserved – until the EFTA Court judgment on Icesave. – It is, I believe, still not clear from the Directive that the state guarantees a result.

According to the statement by Stefaan de Rynck, Michael Barnier’s spokesman, the Commission will study the judgement but so far, it has not changed an iota in the Commission’s understanding of the Directive: “The Commission maintains its interpretation of the current Deposit Guarantee Scheme (DGS) in the EU.  The deposit guarantee schemes in the 27 Member States also apply in the event of a systemic crisis, and Member States are responsible to ensure that national deposit guarantee schemes effectively pay the compensation guaranteed by EU law within the whole single market.” – I have also heard that not everyone in the Commission is unhappy with the judgement. Some think this clarification was useful because the Directive was flawed as it was and the changes have not repaired the flaws.

No doubt, the ruling will be read back and forth over the coming weeks. But one thing could be taken as a lesson, not from the ruling but from action taken in Iceland in October 2008: make deposits priority claims in case of a bank collapse. This has indeed put the foreign Landsbanki depositors in a better place than would have been in a comparable situation with any other bank.

Another point Iceland emphasised is that a state facing a situation like the Icelandic one, will do whatever it takes to save its own interests – and it will not necessarily use a deposit guarantee scheme. Iceland moved domestic deposits to a new bank. The British Government moved Kaupthing Edge deposits to the Dutch ING (which interestingly went bust shortly after).

I can see that deposits need to be protected – but I have some aversion to DGS as I find the moral hazard too great. On this topic the Court quotes an article by Joseph Stiglitz – a first time the Court quotes anything but another judgement in its own ruling (see paragraph 167).

There are some concerns within the EU Commission that the European Court of Justice might have ruled differently on the Directive, ie that the EFTA Court’s ruling was more narrow than its rulings hitherto, leaving a sense of divergence between the EFTA and EU pillar of the single market. After all, there should be homogeneity between or within the two pillars. However this feeling will develop DGS and especially the joint one now being discussed are not a matter for courts to decide but, as Michael Waibel points out in his summary of the judgement, “a matter for the parliaments to decide.”

The Court concludes that the Directive does not apply to systemic failure like in Iceland. But that does not mean depositors are unprotected as seen from the examples of above. And the very best deposit guarantee is to regulate and supervise banks so they simply don’t fail. In any case, as paragraph 161 in the EFTA judgement reminds the reader, a state will not only use one tool to save a bank but all tools needed: “They may benefit from other provisions of EEA law regarding financial services, as well as the activities of supervisors, central banks, and governments.”

What will the Dutch and the Brits do?

The feeling is that the Dutch are most unwilling to forget the Icesave dispute, the British less so. Therefore, the Dutch are no doubt seeking and searching for ways to recuperate the costs accrued by paying out Icesave depositors. The deposits themselves will come – and are coming – from the Landsbanki estate. Not the cost.

As far as I can sense there is no willingness in the corridors of Berlaymont to support Dutch Icesave grievances. The Berlaymontians are worried but neither for the Dutch nor the British but for the EU financial system, EU consumers and depositors.

There are all sorts of rumours as to what the Dutch are mulling over. It is even being mentioned they are looking at the nuclear option – of leaving the EEA. (Normally, the EEA countries are said to be Iceland, Norway and Liechtenstein but since the EU is part to the EEA treaty so are the EU member states.) As the Grexit debate clarified there are no provisions for leaving the EU. With the EEA it is different. If the Dutch left it would put the EEA – already a bit of an eyesore in the EU landscape for some – it would put that construction in jeopardy. The question how much political goodwill the Dutch would reap from an action that does look more like a tantrum of a spoiled kid than a carefully planned policy. The EU does not much need yet another event to challenge its equilibrium.

At the beginning of the Icesave dispute the Dutch and the British had two options to pursue their goal of recuperating costs. There was the EEA/ESA route, eventually chosen and, since the two states were of the opinion that Iceland had promised to pay but later retracted an earlier promise, there was the option to sue Iceland for contractual breach.

For the British there was no single contract but what they consider a string of broken promises. For the Dutch, in addition to a similar string, there is a Memorandum from October 11 2008, signed by the then Dutch Ambassador and two Icelandic civil servants – the director of the Icelandic deposit guarantee fund, TIF and the permanent secretary of the Ministry of Finance.

In to the Memorandum the Dutch Government declared it would lend Iceland what amounted to EUR20.887 (the European minimum guarantee of EUR20.000 with added currency cost) – there was no total amount mentioned – against 6.7% interest (quite hefty at the time of low interest rates). This money would then be put at the disposal of the Dutch Central Bank and used to pay out the Icesave depositors.

That Iceland never paid according to the agreement can be explained by the fact that the loan was never issued. Further, these civil servants signed on behalf of their Governments but no further governmental contract or agreement was made. However, the Dutch might still try to use this – as far as I can see rather feeble ground – to sue Iceland for contractual breach. The Dutch may claim they have some further documentation but I find it difficult to believe there are still unknown documents related to Icesave (though I would not exclude it).

Icesave – the end?

Is the January 28 EFTA Court judgment the end of the Icesave saga? As far as I can see it is the end to the dispute between the three countries – Iceland, Britain and the Netherlands. It also seems the EU has come to the same conclusion.

However, the effect of the judgement on the Directive will rumble on for a while with EU’s legal heads and other studying it closely. The EU Commission must figure out how to respond. It won’t be easy to reach the same opaque equilibrium as previously now that the EFTA Court has spoken. A drastic rethinking on DGS, also in terms of a pan-European scheme in a planned banking union, would be desirable. But that is perhaps hoping for too much.

Addita: In response to an FT Editorial on Icesave here is a letter of mine to the FT, published January 31:

A misleading version of Iceland’s recovery

Sir, After all the excellent FT reporting on Icesave it is astounding that your editorial should have turned the history of Iceland’s recovery into a heroic saga of a small island challenging the big powers and the bankers of this world.

This is a highly misleading version of the recovery saga. Correct, it didn’t bail out the three banks but smaller financial institutions were bailed out, to the exorbitant cost of 20-25 per cent of gross domestic product.

What Iceland has, however, done wisely is to write down debt, both of companies and private individuals, as well as easing its bankruptcy law, thereby avoiding a zombie economy. This part, not the Icesave saga, is “the victory for law and economic sense”. That is what debt-ridden countries could learn from the Icelandic recovery.

In general, not only in Iceland, voters tend to vote for the future by evaluating what the various political programmes means for them instead of focusing on the past. Voters can punish politicians for their policy but I rather doubt they will punish the parties for their stance on Icesave – I would guess their perspective is broader.

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