Scandinavia: Central Bank Swaps to Iceland, 2008

In the lead-up to the Global Financial Crisis, Icelandic banks rapidly expanded their balance sheets, largely financed through foreign currency bonds as well as wholesale funding markets in Europe (Benediktsdóttir, Danielsson, and Zoega 2011). In comparison to the Guidotti-Greenspan rule—which recommends that a country’s reserves should equal its short-term external debt—Iceland’s reserves were just 7% of its short-term debt (Benediktsdóttir, Danielsson, and Zoega 2011; SIC 2010b, 1:167). In a January 2008 report, the rating agency Moody’s recommended that Iceland increase its foreign reserves to build up a larger safety net in the event of a banking crisis (Moody’s 2008). In March, the Central Bank of Iceland began soliciting currency swaps agreements with major central banks (SIC 2010b, 1:167). The CBI first approached the central bank of Denmark (Danmarks Nationalbank) and shortly thereafter approached the central banks of Sweden (Sveriges Riksbank) and Norway (Norges Bank) to discuss establishing bilateral Scandinavian swap lines. The CBI entered into similar swap discussions with the BoE, the ECB, and the Fed (CBI 2008a).

On May 16, 2008, after the BoE, ECB, and Fed rejected swap deals, the CBI signed bilateral swap line agreements with three Scandinavian central banks (Danmarks Nationalbank, Norges Bank, and Sveriges Riksbank) (SIC 2010b, 1:173–75). Under the agreements, the CBI could draw euros against Icelandic krona from each of the three central banks “if needed to ensure financial stability” (CBI 2008b; DNB 2008a). Each bilateral agreement provided a maximum of EUR 500 million, giving the CBI access to EUR 1.5 billion total (CBI 2008b).

As part of the agreement, the Icelandic government produced a confidential memo for the lending Scandinavian central banks, which described the intended purpose of the swap lines as follows:

The purpose of the swap facility is to strengthen confidence in the Icelandic economy in the short term, thereby providing a window for addressing fundamental issues. The swap facility is not intended to be drawn upon. (SIC 2010b, 175)

On October 24, 2008, the IMF agreed to lend Iceland USD 2.1 billion, conditional upon Iceland adhering to an economic stability program. The IMF formalized the agreement on November 19, and by then, the governments of Denmark, Norway, Sweden, and Finland pledged additional loans totaling USD 2.5 billion to support the IMF relief for Iceland (DNB 2009). On the basis of the IMF loan package, Denmark, Norway, and Sweden agreed to extend the swap lines, initially expiring in 2008, through the end of 2009 (Allen and Moessner 2010; DNB 2008b; Norges Bank 2008a).

The central banks of Denmark, Norway, and Sweden established additional swap lines with the Fed and ECB in late September and October 2008. In December 2007, the ECB extended a EUR 10 billion swap line to Sveriges Riksbank. In October 2008, Danmarks Nationalbank received a EUR 12 billion ECB swap line, which would “remain in place as long as needed” (DNB 2009). On September 24, 2008, the three Nordic central banks established temporary reciprocal swap lines with the Fed “to address elevated pressures in U.S. dollar short-term funding markets” (DNB 2009, 101–102). Under the agreements, Danmarks Nationalbank and Norges Bank each received swap lines of USD 5 billion, while Sveriges Riksbank received a line of USD 10 billion, all set to expire January 30, 2009 (Allen and Moessner 2010; Fed 2008). Days later, on September 29, the Fed expanded these swap lines, tripling the size of each of the lines and extending the expiration date to April 30, 2009 (Allen and Moessner 2010; DNB 2009).

On December 16, 2008, in addition to the Scandinavian-CBI swap lines, Danmarks Nationalbank and Sveriges Riksbank established swap lines with the Bank of Latvia totaling EUR 500 million, which served as a bridge loan for an expected IMF relief program for that country (Allen and Moessner 2010).

With the exception of Norges Bank, research has not been able to locate relevant legal documents authorizing the Scandinavian central banks to establish swaps with the CBI. Norges Bank’s 2008 annual report notes that before formalizing the swap line with the CBI in May 2008, Norges Bank received approval from Norway’s minister of finance (Norges Bank 2009). Section 26 of the contemporary Norges Bank Act, as amended in 2007, classified swap lines as international agreements, which were subject to the approval of the King of Norway (Norwegian Government 2007).

The central bank governors of Denmark, Norway, Sweden, and Iceland negotiated the swap lines. In order to reach swap agreements with the Scandinavian central banks, CBI Governor Oddsson also included the Icelandic prime minister in the negotiations. On May 15, 2008, the three CBI governors together with the Icelandic prime minister, foreign minister, and finance minister signed off on several concessions aimed at financial and economic reforms. This memo served as a precondition for the swap arrangements established the following day, May 16 (SIC 2010b, 1:175–76).

As part of the concessions, the CBI could not use the swap lines for exchange market intervention or bank recapitalizations. The CBI also had to report to the Scandinavian central banks on developments related to the concessions (SIC 2010b, 1:175–76). See Key Design Decision No. 14, Other Restrictions, for the list of concessions made by the Icelandic authorities.

Sveriges Riksbank staff prepared the preliminary draft of the Scandinavian-CBI swap agreements in April 2008 (SIC 2010c, 6:173).

The agreement permitted the CBI to draw on the three swap lines, if necessary, but required approval by the lending Scandinavian central banks. This is evidenced by Sveriges Riksbank rejecting the CBI’s request to draw on the swap lines in October 2008 (Ingves 2022). At the same time, the CBI successfully drew on the swap lines with Danmarks Nationalbank and Norges Bank by providing ISK as collateral (CBI 2008c). According to the May 15 concessions, if the CBI drew on the swap lines, the government (fiscal authorities) had to borrow an amount equivalent to the drawings on the market; research has not been able to identify whether the government honored this commitment (SIC 2010b, 1:175).

In the months prior to the signing of the Scandinavian-CBI swap deal on May 16, 2008, the CBI asked several central banks for swap arrangements. Danmarks Nationalbank, the first central bank the CBI approached, responded positively to the initial proposal (CBI 2008a). In April 2008, Sveriges Riksbank staff began drafting the Scandinavian-CBI swap agreement (SIC 2010c, 6:173). While the ECB, BoE, and Fed also discussed swaps with the CBI, by early May, it seemed these deals would not materialize. As a result, the Scandinavian central banks became reluctant to finalize the swap lines (SIC 2010a; SIC 2010b, 1:174–75). On May 16, 2008, following confidential concessions from the Icelandic prime minister and the CBI to implement banking system reforms, the Danish, Norwegian, and Swedish central banks signed off on the swap lines (SIC 2010b, 1:175–76).

Immediately after the announcement of the swap deal with the CBI on May 16, 2008, the krona appreciated by 4% against the euro (Iceland Review 2008a; New York Times 2008).

In its Monetary Review for the second quarter of 2008, Danmarks Nationalbank summarized the modest effects of the swap facility announcement:

The Icelandic krona has stabilized after the announcement of the agreement, and the credit default swap (CDS) spread (the price of insurance against credit risk in Icelandic banks) has narrowed, but remains high. (DNB 2008c, 12)

Although Danmarks Nationalbank, Norges Bank, and Sveriges Riksbank established additional swap lines with other central banks during the Global Financial Crisis, the CBI was the only borrowing central bank in the bilateral Scandinavian swap lines established in May 2008 (CBI 2008b).

Prior to securing the EUR 1.5 billion Scandinavian swap lines (divided evenly among the three Scandinavian central banks), the CBI had requested and hoped for swaps of similar sizes from the BoE and ECB, and later the Fed (SIC 2010b, 1:173–76). In rejecting the CBI’s request, BoE Governor King stated that “the amount of money is very small relative to the potential need for funds should a problem arise with one or more of your banks” and that “the swap might look rather like a political gesture rather than a credible financial strategy” (SIC 2010b, 173).

After entering into the Scandinavian swap deal, the CBI attempted to petition the Fed for a similar arrangement. On June 6, 2008, in a letter to then–Federal Reserve Bank of New York (FRBNY) President Tim Geithner, CBI Governor Oddsson argued that the Scandinavian deals demonstrated that the size of the swap line was not the only important characteristic:

Also, as demonstrated by the Nordic facility, the size of the arrangement is not necessarily a decisive issue at this juncture. In my view the perception of strong allies is more important. An arrangement with the Fed would therefore be of monumental significance. (SIC 2010b, 179)

The Fed viewed the size of swaps as an important factor in determining whether or not to extend swaps to Iceland or other requesting countries. On October 3, 2008, following further swap requests from the CBI, the Fed sent a memo to the CBI explaining its decision not to extend a swap line. According to the memo, the size of Iceland’s banking system, compared to the country’s GDP, necessitated a much larger swap line than what the Fed was ready to make (CBI 2008a; SIC 2010b, 1:180).

Internally, during an FOMC meeting in late October 2008, Sheets, then director of the International Finance Division at the Fed, noted that one of the Fed’s main criteria for evaluating swap requests was whether or not the swap line might make a difference to the borrowing country. Sheets explained that Iceland did not meet this condition, saying that a “$1 billion to $2 billion swap line was very little ammunition to use against a potential loss in confidence in [Iceland’s] $170 billion financial system” (FOMC 2008, 33).

On October 14, 2008, in the first activation of the Scandinavian-CBI swap lines, the CBI drew EUR 400 million total, split evenly between Danmarks Nationalbank and Norges Bank (CBI 2008c). At the time, Sveriges Riksbank did not permit the CBI to draw on its bilateral swap line (Ingves 2022). Sweden later allowed the CBI to draw on the line; the CBI had EUR 450 million (EUR 150 million from each Scandinavian central bank) outstanding at the end of 2008 (CBI 2009).

Research has discovered little public information about the procedure for drawing on the Scandinavian-CBI swap lines. The initial swap agreement stipulated that if the CBI drew on the swap line, the Icelandic government (fiscal authority) would need to borrow from the market an amount equivalent to the swap drawings (SIC 2010b, 1:175–76). The CBI’s initial utilization of the Scandinavian swap lines on October 14, 2008, provides evidence that the drawings on the facility required approval from the lending Scandinavian central banks. At first, the CBI drew only on the swap lines of Danmarks Nationalbank and Norges Bank since Sveriges Riksbank did not authorize the CBI to draw on its bilateral swap line (Ingves 2022). However, in the November 20 press release announcing the extension of the Scandinavian-CBI swap lines, Danmarks Nationalbank noted that the CBI’s swap line drawings would be “equally distributed on the three central banks” (DNB 2009, 81).

As stated in the confidential memo produced by the CBI and the Icelandic government, the Scandinavian swap lines were not intended to be drawn upon but rather to generate confidence in the Icelandic economy. Icelandic authorities noted in the confidential memo that if the facility were drawn upon, the proceeds would “be used to increase available liquid foreign exchange reserves . . . and not for exchange market intervention” (SIC 2010b, 175).

In early October 2008, Iceland’s banking system collapsed and foreign exchange markets froze (Benediktsdóttir, Danielsson, and Zoega 2011). On October 14, 2008, the CBI drew on two of its Scandinavian swap lines, borrowing EUR 200 million each from Danmarks Nationalbank and Norges Bank. Iceland’s minister of industry said that the euro drawings were used “to secure trade for essentials like medicine, oil and, if need be, food products” (Iceland Review 2008b).

The CBI’s 2008 annual report notes that the Scandinavian swap contracts had one-month maturities and were “renewed on a monthly basis” (CBI 2009, 52).^FIt is unclear if the swap contracts “renewed on a monthly basis” refers exclusively to swap drawings or the includes the standby agreement as well (CBI 2009).

The CBI, according to its annual report, paid roughly 3% interest on drawings under the Scandinavian swap lines (CBI 2009).

See Key Design Decision No. 14, Other Restrictions, for the list of concessions.

As part of the precautionary swap arrangements, the CBI and the Icelandic government agreed to several additional measures outlined in a confidential memorandum, addressed to the three Scandinavian central banks. The memorandum was signed on May 15, 2008, by the three CBI governors and Iceland’s prime minister, foreign minister, and finance minister:

1. To increase available foreign exchange reserves, the Government will, with urgency raise EUR 1–2 bn. If the swap facility is drawn on, the Government will borrow an amount commensurate to the total amount of swap transactions.

2. The Central Bank and the Supervisory Authority will use their powers to pressure the banks to reduce the overall size of their balance sheets, in line with the measures suggested by the IMF.

3. ln order to increase the effectiveness of monetary policy and to remove distortions, a credible plan for the restructuring and reform of the Housing Finance Fund system will, with urgency, be formulated and made public.

4. To maintain fiscal prudence and to avoid further net-borrowing our intention is to keep the public debt level at its current low level as well as to strengthen the fiscal framework along the line suggested by the IMF. We will consider how to address the concerns on real wage clauses in the wage settlements.

5. Given the vulnerabilities of the financial system, an IMF [Financial Sector Assessment Program] update is welcome to assess the situation in more detail. The forthcoming Article IV consultation discussions also provide a welcome opportunity to assess the overall situation.

6. The Central Bank of Iceland will keep participating central banks fully and promptly informed of the measures listed above. (SIC 2010b, 175–176)

Between the signing of the swap agreement, in May 2008, and the first swap draws in October 2008, the CBI sent two memos (in July and September) to the Scandinavian central banks, updating them on developments to the commitment from the confidential memo (SIC 2010b, 1:177–78). In keeping with the first commitment in the confidential swaps memo, the Icelandic Parliament passed a law on June 7, 2008, authorizing the Treasury of Iceland to raise up to ISK 500 billion (USD 6.6 billion or EUR 4.2 billion) for the year.^FPer Yahoo Finance, USD 1.00 = ISK 75.96 and EUR 1.00 = ISK 117.91 on June 6, 2008. Due to the worsening terms of Icelandic credit markets, the CBI raised a total of only EUR 1 billion. The CBI and the Icelandic government also failed to deliver on the commitment to exert pressure to downsize the Icelandic banks. The commitment to restructure the Housing Finance Fund also fell through (SIC 2010b, 1:177–78).

Then–Governor of Sveriges Riksbank Stefan Ingves, who was present at the negotiations over the Scandinavian swap lines, likened these swap conditions to that of an IMF program, atypical for conventional swap lines. Ingves pointed to the CBI and Icelandic government’s failure to deliver on the commitments as a reason for Sveriges Riksbank’s initial rejection of the CBI’s swap draw request in October 2008 (Ingves 2022). Ingves noted that once the IMF program went into effect, “we felt that somebody was keeping track of what they were doing and we could step back in” and permit swap draws (Ingves 2022, 10).

In late March 2008, the CBI secured a credit line with the BIS for USD 500 million. However, the CBI forgot to file an extension for the credit line before the deadline in late April. After discovering the error, the CBI requested an extension, which the BIS rejected (SIC 2010d, 7:21).

In April, the CBI discussed with the ECB potential swap agreements. The ECB, however, insisted the Iceland enter into a program with the IMF as a precondition for an ECB swap line (SIC 2010c, 6:161). Shortly thereafter, CBI Governor Oddsson met with FRBNY President Geithner and described the precondition as a “Kiss of Death,” warning that the announcement of IMF assistance may exacerbate concerns over the health of Icelandic banks and prompt runs (SIC 2010c, 161). Iceland ultimately did not enter into an IMF program until after the collapse of the banking system in October 2008.

Although most documentation on the Scandinavian swap facility did not specify an initial expiration date, Norges Bank later revealed that the arrangement was set to expire on December 31, 2008 (Norges Bank 2008b).

On October 14, 2008, the CBI activated the Scandinavian swap lines, borrowing EUR 200 million each from Danmarks Nationalbank and Norges Bank (CBI 2008c). According to Iceland’s minister of industry, the proceeds were used “to secure trade for essentials like medicine, oil and, if need be, food products” (Iceland Review 2008b). Shortly thereafter, on October 24, the IMF reached an agreement with Iceland to provide a USD 2.1 billion conditional loan in exchange for Iceland adhering to a set of economic stability measures (DNB 2009). On November 3, Norges Bank announced an extension of its bilateral CBI swap line through the end of 2009, under the assumption that the IMF agreement would be approved (Norges Bank 2008a). On November 19, the IMF finalized the loan, and on November 20, Danmarks Nationalbank and Sveriges Riksbank agreed to extend the CBI swap lines through the end of 2009 (DNB 2009; Sveriges Riksbank 2008).

In November 2009, the CBI repaid EUR 100 million to each Scandinavian central bank, eliminating the outstanding swap drawings on the facility (CBI 2010).