In late February Iceland agreed to a referendum on the latest deal for the government to assume responsibility for repayments of sums the UK and Dutch governments paid out to compensate depositors in Icesave, the internet arm of collapsed Landsbanki. Any news from Iceland is a reminder that at least one country has already made the stark choice of saving domestic depositors in its collapsing banks while letting the banks’ international bondholders go hang.
The widespread assumption seems to be that Iceland has got away with this and that it deserves to. In late 2008, with food disappearing from the shelves and two of its three big banks facing imminent collapse, the country found itself facing a financial crisis as severe as any developed nation has confronted since the 1930s.
The government passed an emergency law that prioritized the claims of depositors over other unsecured creditors with which depositors had previously ranked pari passu. The banks were restructured, leaving the foreign bondholder and bank creditors to hope for some recovery on the banks’ largely foreign-currency problem assets.
Ever since, the Icelandic government has been locked in sometimes vituperative negotiations with UK and Dutch government deposit insurance schemes. It has been forced to accept that if the country could get away with prioritizing depositors, it would have to extend this priority to all depositors, including foreign ones.
Iceland has appeared to benefit from increasing acceptance of the essential validity of the emergency law that prioritized depositors. In December last year, the Efta surveillance authority, which monitors compliance with European economic area rules in Iceland, Norway and Liechtenstein as a condition of their participation in the single European market, upheld the principle that depositors require preferential protection to general creditors.
Iceland’s key argument was that the subsidiarization of bondholders’ interests was the unfortunate consequence of a proportionate response to the crisis.
But before we elevate Iceland to the model for others to follow, it’s worth remembering two things. First, it is not entirely in the clear yet. Two large groups of creditors, one predominantly comprising bank lenders, the other bondholders, still feel they have legitimate claims to press and have been left with next to nothing.
It is noteworthy that none of these creditors is making wild claims that Iceland will never be able to borrow again. They know that memories are short and that where profitable financing can be done, lenders will step up. Iceland might have to pay an enhanced risk premium in future for its actions, but it won’t be shut out.
In such circumstances the only rational course for creditors is to litigate to the last court they can. The decision to relegate their property claims over Icelandic bank assets might yet be heard in the European Court of Human Rights. And while their chances of overturning the emergency law look quite remote, if they were to win, then the next day they would hand Iceland a very large bill.
The other reason for caution before holding up Iceland as a model to struggling peripheral sovereigns is that Iceland was not constrained by membership of the eurozone. Its efforts to save the banking system in 2008 led to imposition of capital controls to prevent deposit flight from domestic investors seeking to put their savings in hard currency. Could the threat of a victory for foreign bondholders in the European Court of Human Rights spook a flight of deposits when controls are lifted? It’s a threat bondholders hope might yet bring the country to some accommodation.
