Iceland banking collapse: diary of a death spiral

Despite rescue attempts, Iceland's banking crisis and its effect on the UK was sucked into panic and chaos of the financial crisis

Shortly after dinner on 5 October 2008, Gordon Brown spoke to Iceland's prime minister, Geir Haarde, in a frantic phone call. The world was in the grip of the most serious banking crises in living memory. Within 48 hours Iceland would experience a system-wide banking meltdown and British taxpayers would commit £500bn of bailout funds to help UK banks avoid a similar fate.

The conversation concerned Iceland's big three banks, Kaupthing, Glitnir and Landsbanki, which were locked in a death spiral as international investors stampeded out of high-risk financial institutions around the world.

It was clear Iceland was too small to offer a state bailout; the three banks had combined assets almost 10 times the size of the GDP. Brown urged his counterpart to immediately seek a rescue loan from the International Monetary Fund, a suggestion that within days became inevitable.

But Brown had a more pressing interest in the health of the tiny island economy that extended well beyond offers of sympathy to a far-flung friend.

Panic was spreading among hundreds of thousands of British savers who had put money into the Icesave online deposit accounts offered by Landsbanki. Depositors had been attracted by industry-beating interest rates and reassured that their savings would be covered by an Icelandic state guarantee scheme that was "fully funded".

By early October it was becoming increasingly clear that the capacity of the Icelandic government to stand behind the country's deposit guarantee scheme was in doubt. A run on deposits had begun as nervous British savers scrabbled to repatriate their cash.

These were difficult subjects Brown wanted to discuss, though they came as no surprise to Haarde. But then the British prime minister changed tack. He began to ask questions concerning Kaupthing Singer & Friedlander, a British bank owned by, but trading at arms-length from, Iceland's Kaupthing.

KSF had also attracted hundreds of thousands of British depositors with its own high-interest online account Kaupthing Edge. Because of its Icelandic ownership, panicky UK savers had begun emptying their accounts.

On the face of it this seemed irrational. KSF was a British bank, reporting to the UK Financial Services Authority, and its fortunes ought to have been distinct from those of the Reykjavik-based parent, Kaupthing. Moreover, retail depositors could be comforted that their savings were covered by the UK Financial Services Compensation Scheme, not the in-doubt Icelandic equivalent.

Brown dropped his bombshell. He explained to Haarde that there was a gaping hole in KSF's liquid funds, leaving the bank ill-prepared to deal with a deposit run. He pointed to £1.6bn which the FSA had informed him had been transferred from KSF to Kaupthing in Reykjavik in breach of British laws.

KSF was a British bank, reporting to the FSA, which had taken €3.5bn (£2.8bn today) in deposits from British savers since the launch of the Kaupthing Edge account eight months earlier.

In effect, Brown was telling Haarde that the equivalent of more than half of these cash deposits had been illegally spirited off to Reykjavik — an allegation that would later be withdrawn. "It was clear that he considered this a very serious matter," Haarde later told an Icelandic truth commission.

Brown's assertions took Haarde by surprise; he had been aware of a regulatory dispute over liquidity but nothing of this magnitude. He had understood from Kaupthing that the matter was much smaller, and that the bank had come to an agreement with the FSA over how it could be resolved.

After putting the phone down, Haarde contacted Kaupthing executives. He recalls being told that the bank was already aware of the £1.6bn sum referred to by Brown. The lion's share of the shortfall stemmed from a complex £1.1bn deposit arrangement KSF entered into with Kaupthing described internally as a "liquidity swap".

Under FSA rules, KSF was allowed to count these deposits with Kaupthing towards its liquidity requirements. Indeed, as soon as the liquidity swap was set up in early 2008, KSF management point out, it was included in liquidity reports that went to the FSA.

In truth, however, by the time the FSA was focused on the crisis facing KSF, it was clear to all that the liquidity arrangements with crisis-stricken Kaupthing could not be relied upon. On Tuesday the FSA published its finding that KSF failed to alert the regulator to the seriousness of the issue for several days. It made clear this had not been deliberate or reckless.

An examination of the collapse of Kaupthing and KSF by an Icelandic independent truth commission, convened by parliament two years ago found the liquidity swap was not subject to a formal written contract but sketched out in KSF and Kaupthing emails.

In the final days before the Icelandic bank's official failure on 9 October, Kaupthing executives worked around the clock looking for ways to plug the widening liquidity black hole at KSF and placate the furious FSA. In the space of a few days a KSF rescue by Barclays or JC Flowers was contemplated, as was a merger between Kaupthing and parts of the crisis-stricken Icelandic bank Glitnir.

It had been made clear to Kaupthing that without rapid repair of the £1.6bn black hole, the FSA would be forced to put KSF into administration, a move that would trigger default on many of Kaupthing's bonds and, therefore, spell the end for the Icelandic parent too.

Desperate promises of to shore up KSF's position were made to Hector Sants, FSA chief. Kaupthing chief executive Hreidar Mar Sigurdsson said Iceland's three largest pension funds, which were big shareholders in the bank, had agreed to sell assets and bring €500m-€1bn of foreign currency into Kaupthing.

Iceland's central bank was also preparing a €600m loan guarantee for the bank, secured against a basket of bonds and mortgages, despite having agreed a €500m facility for Kaupthing just days earlier. Neither would come to pass.

Back in London, KSF bosses threw themselves at the mercy of the Bank of England seeking help from the "lender of last resort". Given the state of relations with the FSA, however, the request was swiftly rejected.

On the morning of 8 October, a frantic conference call was held between Kaupthing, KSF and FSA boss Hector Sants. The Icelanders saw a glimmer of hope in the Treasury's announcement hours earlier of an unprecedented £500bn package of bailout funds for British banks.

Sigurdsson, suggested KSF was surely among likely candidates to receive access to this liquidity. Sants' response was curt. "Those funds are not for you."

Some liquidity had been found by this time, notably by calling in a huge loan from Kaupthing to the business empire of the Mayfair-based billionaire Robert Tchenguiz, the Icelandic bank's biggest borrower. Unable to meet a colossal repayment demand from the bank, Tchenguiz had forfeited swaths of his investments, including huge stakes in two blue-chip companies listed on the London stock market, J  Sainsbury, and Mitchells & Butlers, the pub operator behind O'Neills, All Bar One, Harvester, Browns and many other well know bar and restaurant chains.

In a falling market a fire sale of these shares generated a fraction of their value the previous year, but Kaupthing bosses felt they had little choice. They had to get liquid funds to KSF to appease the FSA at all costs.

The episode was extremely costly for Tchenguiz, who claims to have personally lost about £1bn in the failure of Kaupthing. The British investor was one of biggest losers of Iceland's banking crisis.

Meanwhile regulators were watching deposits gushing out of the bank. About £95.5m had been withdrawn from Kaupthing Edge accounts the previous day. Being an internet-based account, there were, of course, no snaking queues outside bank branches as there had been a year earlier with Northern Rock. But this was just as acute a loss of confidence.

The situation was untenable. At 2.49pm that afternoon KSF was placed into administration. The Treasury announced that, acting on the advice of the Bank and FSA, the chancellor had used emergency banking stability laws to transfer Kaupthing Edge retail deposits from KSF to the ING Group.

At the same time, in exchange for taking on these deposits ING received a Treasury guarantee. As administrators from Ernst & Young entered KSF's headquarters on Hanover Street in Mayfair, it quickly became clear the UK taxpayer was now KSF's largest creditor. Back in Iceland, Kaupthing was formally toppled the following morning.


Simon Bowers

The GuardianTramp

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