Icesave Decision: Hard Case, Bad Law

It has been said that hard cases make bad law. The ruling by the EFTA Court that the Icelandic government had no obligation to ensure payment of a minimum compensation to depositors after the collapse of the Icelandic online bank Icesave in 2008 is a case in point.

Landsbanki, one of Iceland's three large investment banks, had solicited funds from British and Dutch consumers by offering high-interest internet savings accounts through its online IceSave program. It was generally assumed by the consumers in the United Kingdom and the Netherlands that, since Iceland had agreed to the same European Economic Area (EEA) rules that their governments had agreed to, their deposits were insured in the same manner that deposits were insured with domestic banks. They were to find out otherwise.

Fall of Iceland's house of cards
On the night Landsbanki was seized by Icelandic regulators, the head of Iceland's Central Bank and Iceland's Finance Minister Árni Mathiesen indicated that perhaps only domestic accounts would be insured by the government. British authorities reacted immediately, freezing Landsbanki's assets pursuant to anti-terrorist legislation. The Netherlands soon followed suit.

Since the Icelandic financial regulators had not asserted any meaningful control over Landsbanki's rapid ascension in the 2000s and had not properly evaluated the level of risk or charged the Icelandic banks a sufficient premium to fully fund the deposit-guarantee scheme, the deposit insurance fund was incapable of meeting the 20,887 euro guarantee--about 3.7 billion euros for the non-Icelandic accounts--when Iceland's house of cards began to fall.

To avoid a more widespread run on the banks, the British and Dutch governments immediately paid their domestic depositors, then asked how Iceland intended to repay them

Doesn't have to work, just say it does
The EFTA Court ruled that, although EEA States were required by Directive 94/19 to introduce and officially recognize a deposit-guarantee scheme and had to fulfill certain supervisory tasks in order to ensure the proper functioning of the deposit-guarantee scheme, it was not envisaged that EEA States had to ensure the payment of aggregate deposits in all circumstances. The only obligation Iceland had was to adopt national rules and to maintain a coverage level of at least EUR 20,000. It was apparently irrelevant whether the deposit-guarantee scheme was likely to be effective, only that it said it was.

The EFTA Court underlined the fact that the Icelandic financial system was in total meltdown in October 2008, and that a sovereign default appeared possible, even likely. The Directive, it ruled, only dealt with the failure of individual banks, not with a systemic crisis.

The Rule is the Rule but we have no Rule
A major concern was the moral hazard that would arise if the government, rather than the financial sector, was the guarantor of last resort: The intention of the Directive was to protect consumers by ensuring a minimum level of deposit protection, but "consumer protection under the Directive does not entail full protection, since increasing consumer protection may reach a point where the costs outweigh the benefits." (The benefits to whom, one is tempted to ask).

At this point, the Court's reasoning falls apart: "How to proceed in a case where the guarantee scheme is unable to cope with its payment obligations remains largely unanswered by the Directive. obligation on the State or a possible action against the State in those circumstances is not envisaged in the Directive's provisions. [I]t is likely that, had the European legislature sought to adopt a different approach...this would have been expressly stated in the Directive."

It is "likely"? How's that for reassurance from a court of law? In other words, the rule should be the rule, but we have no rules about what to do in cases like this, so we're making one up right now.

Poets, Vets & Banking
The responsibility for guaranteeing bank deposits should, of course, fall upon the entire financial sector. In a world in which the regulators are honest, competent, and thorough, that is exactly how it should work.

In Iceland in the 2000s, the regulators were not honest, competent, or thorough. Iceland had come into banking only recently, and did not have the institutions, regulatory scheme or experienced examiners required to maintain a large international presence. The head of Iceland's Central Bank was a former prime minister who was more interested in poetry than in spreadsheets. The finance minister was a veterinarian. The banks' managers were--several years earlier--fishermen, teachers, and restaurateurs. The fastest path to a good job with a bank's was a couple of years' experience working as a bank examiner. ... No, just kidding, the fastest path was through political connections and nepotism.

Moral hazard lessons don't apply to Iceland
The official investigation of the misdeeds leading up to the collapse (the so-called "Black Report") gives a detailed account of the incompetence and fraud that pervaded Iceland during this critical time period. There was a complete failure by Iceland's legislature and institutions to rein in the excesses.

Iceland is a country of only 330,000 individuals. The line between finance and politics (or anything else, really) is very fine indeed. To say that the moral hazard could be averted by placing the full burden of the guarantee on the financial sector is to misunderstand Icelandic society. The moral hazard aspect underlying the court's reasoning - quoting Joseph E. Stiglitz that: "[T]he more and better insurance that is provided against some contingency, the less incentive individuals have to avoid the insured event, because the less they bear the full consequences of their actions" - doesn't apply to Iceland, because there is no meaningful division between the private and public sector.

"Remember how good things were?"
All this decision teaches the banks is to make damn sure that the politicians are well in hand--like they were last time--and that the regulators never come up with a deposit-guarantee scheme that accurately assesses the risk of developing an outsized financial sector (i.e., too big to fail or jail) and charges appropriate deposit insurance premiums. If the government had been charging the appropriate premiums in the first place, the banks never would have created the illusion of wealth we enjoyed in the run up to 2008.

Now that the Icelandic government has been exonerated, I predict that the politicians who were in charge in 2008--and who provided the legal framework for the plundering of Iceland's banks in the first place--will be restored to power in the forthcoming legislative elections. "Remember how good things were when we were running this country? We were wrongfully persecuted by these foreigners, but reasonable minds ultimately prevailed."

The few bankers who have been prosecuted have only received slaps on the wrist with a wet noodle. The individuals who ransacked the banks and their enablers still have their ill-gotten gains, their mansions, their yachts and jets, and now their "honor."

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