Iceland: Kaupthing Emergency Liquidity Program, 2008

In 2008, increasing funding pressures because of falling stock and real estate prices signaled worsening market expectations and contributed to a decline in the quality and amount of collateral Kaupthing—one of Iceland’s three largest banks, which, along with Glitnir and Landsbanki accounted for 80% of the financial system—could post at the CBI. This challenged the banks’ ability to sufficiently collateralize their borrowing from central banks. Kaupthing and the other banks turned to issuing bonds to each other and using these bonds as collateral to secure loans from central banks. This novel practice allowed them to bypass central bank funding limits, as they could issue these bonds—often referred to as “love letters”—whenever needed in virtually unlimited amounts. By August 2008, the ECB had concerns about the quality of the collateral being provided by Icelandic banks’ Luxembourg subsidiaries and refused to accept any additional Icelandic bank bonds as collateral, restricting Kaupthing’s access to central bank borrowing from the ECB; however, the CBI continued to accept these “love letter” bonds out of concerns of systemic stress (Baudino, Sturluson, and Svoronos 2020).

Although the Icelandic banks had no direct exposure to Lehman Brothers, its collapse on September 15, 2008, indirectly affected Icelandic banks by freezing interbank credit markets, further aggravating Kaupthing’s liquidity issues (Baudino, Sturluson, and Svoronos 2020).

The Icelandic Financial Supervisory Authority partially took over Glitnir on September 29, and this led to a downgrade of Iceland’s sovereign credit rating, which in turn resulted in credit lines for Icelandic banks being cut or subjected to margin calls (Baudino, Sturluson, and Svoronos 2020).

Following the downgrade, Kaupthing and other Icelandic banks faced large-scale deposit runs (Baudino, Sturluson, and Svoronos 2020). Between late September and early October, Kaupthing Edge saw 30% of its deposits withdrawn (FME 2009).

In a meeting in the early morning hours of October 6 among the CBI and three representatives from JPMorgan, the JPMorgan representatives suggested that the broader financial system could not be saved, but there was still hope to defend Kaupthing (Parliamentary Research Committee 2010). On the morning of October 6, 2008, the governor of the CBI stated in a phone call with the prime minister that Kaupthing would go bankrupt if it did not provide the loan on the same day (CBI 2019).  

Later that afternoon, on October 6, the CBI transferred EUR 500 million into Kaupthing’s account at Deutsche Bank, using Kaupthing’s 99.89% stake in FIH Erhversbank A/S as collateral. The assistance was intended to act as a bridge loan to help Kaupthing survive its liquidity crisis (Baudino, Sturluson, and Svoronos 2020; CBI 2019).

It was not until months following the collapse of Kaupthing, Glitnir, and Landsbanki that sufficiently accurate information on the banks’ solvency positions became available (Baudino, Sturluson, and Svoronos 2020). Mark Flannery writes, in “Iceland’s Failed Banks: A Post-Mortem” (a report prepared for the SIC), that while it is not possible to definitively state whether one or all of the major banks were insolvent in the first week of October, “it is quite possible” that the banks were insolvent (Flannery 2009, 106). Later valuations of the domestic portion of the major banks’ asset portfolios find large losses attributable to poor underwriting and overreliance on equity shares as collateral (Flannery 2009). Baudino, Sturluson, and Svoronos write that even a conservative estimate of the banks’ assets would have overstated their capital due to connected lending and because customers had pledged the banks’ own shares as capital. They write that if Kaupthing’s solvency had been clearer in early October, it would have shown that granting emergency liquidity assistance wouldn’t have prevented its collapse, as the issue was solvency not liquidity (Baudino, Sturluson, and Svoronos 2020).

On October 6, the same day the CBI granted the emergency liquidity assistance to Kaupthing, the prime minister announced in a public address the government’s intent to fully guarantee domestic deposits, stating that “deposits by Icelanders and private pensions savings in all Icelandic banks are secure and the exchequer will ensure that such deposits are reimbursed to savers in full” (Haarde 2008, 3). This guarantee did not extend to foreign depositors. For a full case study on the deposit guarantee, see Kulam (2022).

Also on October 6, the FME announced a temporary halt on trading of all financial instruments issued by Kaupthing, Glitnir, Landsbanki, Straumur-Burdarás Investment Bank, SPRON hf., and Exista hf. on regulated exchanges (CBI 2008b).

In the first quarter of 2008, the CBI sought to strengthen its reserves by establishing bilateral swap facilities with the Danmarks Nationalbank, Norges Bank, and Sveriges Riksbank. These agreements allowed the CBI to borrow up to EUR 500 million from each central bank, and while initially the agreements were precautionary, the CBI could use the funds to maintain financial stability. On October 14, only eight days after the CBI provided emergency liquidity assistance to Kaupthing, it drew EUR 200 million from both Danmarks Nationalbank and Norges Bank (Hoffner 2023).^FSveriges Riksbank did not initially allow the CBI to draw under the agreement, owing to the CBI and Icelandic government’s failure to honor the commitments outlined in the swap memo (Hoffner 2023).These actions were a temporary solution until Iceland secured a support package from the International Monetary Fund (IMF) on November 19, 2008 (Ingves 2022). For a full case study on Scandinavian central bank swaps with Iceland, see Hoffner (2023).

On October 7, 2008, the Icelandic Parliament passed emergency legislation, Act No. 125/2008, that provided the legal basis for the resolution process for banks in Iceland (Baudino, Sturluson, and Svoronos 2020). The emergency legislation granted the Ministry of Finance the ability to provide funds and capital to establish new banks or restructure existing banks; authorized the supervisory authority to take control of failing banks; and changed the hierarchy of claims, prioritizing customer deposits over unsecured claims in a financial institution’s bankruptcy proceeding (Icelandic Government 2008). This act provided the legal basis for the takeover of Landsbanki on October 7, Glitnir on October 8, and ultimately Kaupthing on October 9 (BCBS 2010).

In Finland, the Finnish Financial Supervisory Authority blocked the transfer of assets owned by Icelandic banks, including Kaupthing, from leaving the country on October 6 (Brostrom 2008).

On October 8, the Swedish Riksbank provided a 5 billion Swedish kronor loan to Kaupthing Sverige, the Swedish subsidiary of Kaupthing Bank. The Riksbank believed Kaupthing Sverige to be solvent and provided the loan to protect depositors and creditors of both Kaupthing Bank Sverige AB and Kaupthing’s Swedish branch (Kaupthing Edge)—as well as to safeguard financial stability in Sweden (Sveriges Riksbank 2008).

The bank’s UK subsidiary, Kaupthing Singer & Friedlander, also faced a deposit run—particularly from its Edge online accounts (BCBS 2010). Following a period of intensified oversight, the UK Financial Services Authority concluded on October 8, 2008, that KSF no longer met the requirements to operate as a credit institution. The FSA triggered the Financial Services Compensation Scheme, the UK’s statutory compensation fund of last resort for customers of financial services firms and ordered it to halt new business. That same day, the UK government used special powers to transfer KSF’s Edge deposits to ING Direct—financed by the FSCS and the government, which became KSF’s creditors (HM Treasury 2008).

The legal basis for the CBI’s emergency liquidity intervention was established in the provisions of Act No. 36/2001, the guiding laws for the CBI. Article 7 broadly establishes the CBI’s authority to provide liquidity assistance to commercial banks and savings banks; it adds however, that the CBI may deviate from standard rates and collateral requirements to preserve the stability of the country’s financial system. The CBI is authorized to conduct credit transactions in both domestic and foreign currencies (Icelandic Government 2001, 9). In the 2019 report on the emergency loan granted to Kaupthing, the CBI further defends the legality of the loan, stating that during the extreme market turmoil, rapid intervention was required, allowing the CBI to circumvent specific processes required to provide a loan to Kaupthing (CBI 2019).

In 2019, the Icelandic Parliament updated its Central Banking laws in the new Act on the Central Bank of Iceland, No. 92/2019, which merged the FME into the CBI, hoping to enhance the stability and integrity of Iceland’s banking and financial systems (Icelandic Government 2019; O’Dwyer 2022). This act also mandates that any decision to provide guarantees or loans to institutions facing liquidity issues must occur in a meeting convened by the governor and include the deputy governors (Icelandic Government 2019).

There are no documents that can be interpreted as a loan request from Kaupthing with the loan amount, period, or terms (CBI 2019). The central bank’s board decided to grant the emergency assistance after the governor of the central bank consulted with the prime minister in a phone call (Iceland Monitor 2017), and only two bank managers worked on the preparation of the loan. No agreement was formally signed because of the time and speed at which the case was processed (CBI 2019).

The timeline to finalize the loan was rushed. The CBI decided to grant the liquidity assistance around noon on October 6, and the loan needed to go out the same day—leading to limited time to assess the collateral and value of FIH (Parliamentary Budget Committee 2013). The CBI reached out to two governors of Danmarks Nationalbank to ask if they considered FIH solid collateral for a short-term loan of EUR 500 million; the governors agreed that it was. The CBI did not have the time to independently verify the valuation of FIH (CBI 2019).

Due to time constraints, there was not enough time to transfer ownership of FIH to the CBI in either electronic or paper form. Instead, a pledge was signed in two parts: one by Kaupthing’s CEO and the other by Kaupthing’s treasury managing director and its general counsel (CBI 2019).

Although the loan agreement was never finalized, the CBI transferred the funds into Kaupthing’s account at Deutsche Bank as soon as the collateral pledge was received—by mid-afternoon on October 6. The CBI’s payment instructions specified that the euros should be made available to Kaupthing on the same day (CBI 2019).

Following the collapse of the banks, the CBI created a holding company to unwind assets that had been taken over by the CBI and Treasury during the crisis. This holding company became responsible for the sale of FIH (Benediktsdóttir, Eggertsson, and Þórarinsson 2017).

The emergency liquidity provided by the CBI to Kaupthing had minimal oversight owing to the urgent timeline, as Kaupthing needed the loan on October 6 to avoid bankruptcy (CBI 2019). By law, the governor of the central bank was permitted to take such drastic actions on his or her own (Icelandic Government 2001). In this case, the decision was made swiftly through informal discussions between the central bank’s board and the prime minister (CBI 2019). In 2019, a bill was introduced requiring that decisions on granting last-resort loans be made during meetings attended by the central bank’s governor and three deputy governors, with the decision formally documented in the meeting minutes.

Following the collapse of all three major Icelandic banks, the Icelandic Parliament established the Special Investigation Commission, whose mandate was to investigate and analyze the events leading up the banking collapse. The SIC report was published in April 2010 (SIC 2010). In addition to the SIC report, parliamentary hearings provided further post-crisis assessments (Parliamentary Budget Committee 2013).

Two days before the CBI provided liquidity assistance, then–Kaupthing chairman Sigurdur Einarsson dismissed rumors of instability, noting Kaupthing’s sound fundamentals, liquidity position, and strong international portfolio. The Icelandic government also attempted to calm fears by denying to the media that it would have to rescue Kaupthing after the partial takeover of Glitnir—while stating that it was working on a broad-based rescue plan for the Icelandic economy (Goodman 2008).

On October 7, after the Parliament passed the emergency legislation overnight, Act No. 125/2008 (see Key Design Decision No. 2, Part of a Package), Kaupthing released a statement that it had not been approached by the FME and that the CBI had “provided Kaupthing with a 500 million euro loan to facilitate operations” (Kaupthing 2008a). This report was picked up the same day by various news outlets, which reiterated that Kaupthing was committed to working with the government to ensure regular workings of the Icelandic financial system (Esmerk 2008; Pollard 2008).

No official press briefing was issued by the CBI regarding the loan provided to Kaupthing on October 6, 2008. However, on a television program on the evening of October 7, the chair of the CBI was asked about the loan, where he described it as a bridge loan for a very short period of time, just to give this bank a chance to develop and not let it fall short because it has been subjected to perhaps harsh measures (CBI 2019). When asked about concerns over the loan not being repaid, he responded with a reference to the loan’s collateral, saying that the central bank would acquire a very good bank in Denmark if Kaupthing couldn’t repay the loan in cash (RÚV 2008).

On October 8, in its press release announcing its provision of liquidity to Kaupthing, Sweden’s central bank, Sveriges Riksbank, mentioned the support provided by the CBI (Sveriges Riksbank 2008).

The first official Icelandic press release on Kaupthing came on October 9, 2008, from the FME when it took control of Kaupthing, but there was no mention of the emergency liquidity (FME 2008b). In an October 27 press release, the CBI referenced the assistance it had provided to Kaupthing, explaining that it was intended to help the bank meet the demands of the UK’s Financial Supervisory Authority “regarding the status of [Kaupthing’s] subsidiary in London” (CBI 2008e, 1).

Disclosure on key details of the emergency liquidity program were lacking in the years following the crisis. A 2013 Parliamentary Budget Committee report notes that the committee had learned of the existence of a transcript of the October 6, 2008, phone call between the prime minister and governor of the CBI discussing the loan to Kaupthing but that the CBI had repeatedly denied the committee’s request to review the transcript, citing confidentiality laws (Parliamentary Budget Committee 2013). The call contained CBI Governor Oddsson’s comment that he didn’t believe the CBI would get its money back from the loan, despite its analysis earlier in the year that the bank was solvent (CBI 2019). The Icelandic government released the transcript of the phone call in November 2017, despite the protests of the former prime minister who said that he was not aware the phone call had been recorded (Pálsson 2019).

Following the sale of FIH, the CBI was under pressure to disclose the decision-making details behind both the loan provided to Kaupthing as well as why it had taken FIH as collateral. After delays, which the CBI blamed on the heavy workload at the bank, the CBI released the report discussing the liquidity assistance to Kaupthing in 2019 (CBI 2019).

The CBI agreed to grant Kaupthing a loan of EUR 500 million (approximately ISK 77.5 billion) on October 6, 2008 (Parliamentary Budget Committee 2013). The funds came directly from the reserves of the CBI and represented approximately one-fifth of the country’s entire foreign exchange reserves (Baudino, Sturluson, and Svoronos 2020). The loan was disbursed the same day; CBI withdrew from its accounts in foreign banks to deposit the funds into Kaupthing’s account in Deutsche Bank Frankfurt (CBI 2019). The payment instructions noted that the euros should be made available to Kaupthing the same day (CBI 2019; Parliamentary Budget Committee 2013).

On November 18, 2018, the prime minister of Iceland submitted a written request to the CBI prompting the central bank to acquire information on how Kaupthing used the funds. The CBI then requested the information from Kaupthing and received an examination completed in 2010 that tracked the inflows and outflows of Kaupthing’s euro account at Deutsche Bank Frankfurt from the morning of October 6 until the bank was taken over by the FME on the evening of October 9. The account showed about EUR 800 million of outflows from October 6 through 8, of which the largest portion, EUR 225 million, went to satisfy Kaupthing Edge deposit withdrawals, as displayed in Figure 2 (CBI 2019).

Source: CBI 2019.

Kaupthing’s euro account at Deutsche Bank in Frankfurt showed a balance of EUR 600,000 by end of day on October 8 (CBI 2019).^FThe EUR 0.9 million discrepancy between the inflow-outflow difference (EUR 1.5 million) and the reported balance at the end of the day on October 8 (EUR 0.6 million) is attributed to rounding error.

The interest rate charged on the loan was 9.4% (Parliamentary Budget Committee 2013). This rate was equivalent to the interbank interest rate in the euro area at the time plus 5% (CBI 2019).

Although the reasoning behind this particular rate choice was not disclosed, the CBI was authorized to deviate from standard rates (Icelandic Government 2001, 9). The CBI’s key interest rate at the time was the collateralized lending rate, and the rate on seven-day collateralized lending was 15.5% on October 6, 2008 (CBI n.d.). At the time, because of the risks facing the Icelandic banking system, Icelandic debt traded at a substantial premium to Eurozone interest rates (CBI 2008a).

The loan duration for Kaupthing’s emergency liquidity assistance was four days (Baudino, Sturluson, and Svoronos 2020).

According to the CBI, a duration period of four days was Kaupthing’s request. However, the CBI noted that it did not find any official documents that can be interpreted as a loan request from Kaupthing; such a document would have formally listed Kaupthing’s requested loan terms and information on how the money would be used (CBI 2019).

On October 7, 2008, then–Chair of the Board of Governors of the CBI Davíð Oddsson participated in a televised interview during which he described the loan to Kaupthing as a bridge loan for a very short period of time (Davíðsdóttir 2009).

On October 9, one day before the scheduled end of the loan period, the FME announced that it had become involved in the operations of Kaupthing and established a resolution committee (CBI 2009). The FME and CBI agreed to begin looking for a buyer for FIH with the understanding that the funds from the sale would go directly to the CBI. When the new owners took over FIH on January 6, 2011, the CBI received a payment of approximately EUR 255 million (CBI 2019).

On October 5, 2008, Kaupthing and Landsbanki submitted a joint proposal to the Icelandic government on how to respond to the crisis. This proposal included providing Landsbanki with EUR 1 billion and Kaupthing with EUR 500 million. It is within this context that Kaupthing discussed putting FIH, a bank it owned in Denmark, up as collateral for the loan (Parliamentary Research Committee 2010).

Although this proposal was declined by the CBI and dismissed as too risky because the banks were likely to fail in a matter of days, the use of FIH as collateral was implemented for the loan that was eventually granted to Kaupthing the next day. In a meeting at about 2am on October 6 among the CBI and three representatives from JPMorgan, the JPMorgan representatives suggested that the broader financial system could not be saved, but there was still hope to defend Kaupthing (Parliamentary Research Committee 2010). Later that morning, the governor of the CBI stated in a phone call with the prime minister that Kaupthing would go bankrupt if it did not provide the loan on the same day (CBI 2019).

As collateral for the EUR 500 million emergency liquidity assistance from the CBI, Kaupthing put up all of the bank’s shares in FIH (Baudino, Sturluson, and Svoronos 2020). FIH was the sixth-largest bank in Denmark; as of June 30, 2008, its equity amounted to 8 billion Danish kroner, which corresponded to about EUR 1.07 billion (CBI 2019). The book value of the company was thus more than 200% of the loan amount (Baudino, Sturluson, and Svoronos 2020).

In a phone call between then–CBI Chair Davíð Oddsson and Prime Minister Geir H. Haarde on October 6, 2008, Oddsson stated that he expected the CBI would not get the money back by the end of the loan period and to expect otherwise was wishful thinking (CBI 2019). According to a report from Sturla Pálsson, director of market business and treasury management of the CBI, who was present for the call, the loan was granted even though Oddsson thought there was little to no chance of the money being recovered (Seljan 2016). In the call, Oddsson emphasized the importance of having high-quality collateral given the high risk associated with a loan to Kaupthing (Baudino, Sturluson, and Svoronos 2020). However, since the decision to finalize a loan between the CBI and Kaupthing was made at approximately noon on October 6 and the funds were set to be disbursed the same day, there was not much time to verify the status of the collateral before the end of the business day in Denmark (Parliamentary Budget Committee 2013).

The CBI contacted two governors of the Danish central bank on October 6 and asked whether FIH represented solid collateral for a short-term loan of EUR 500 million. The Danish authorities responded that they believed it was true that FIH constituted solid collateral. The CBI did not independently assess the value of FIH, stating that there was not enough time to do so (CBI 2019). The CBI’s annual report from 2008 states that all of the collateral attached to the loans it had issued to commercial banks were, “regarded of good quality,” including, “all the outstanding shares of the Danish bank FIH” (CBI 2009, 59).

Shares in FIH had not been issued (electronically or on paper) on a stock exchange. Therefore, the administrator of the share register of FIH entered a note in the share register stating that all of Kaupthing’s holdings were pledged to the CBI. Written confirmation of this act was received by the CBI on October 6. A report from the CBI notes that Kaupthing’s holdings in FIH amounted to 99.89% of the issued share capital in the bank (CBI 2019).

When Kaupthing collapsed on the night of October 9, its holdings in FIH that had been submitted as collateral remained in Kaupthing’s liquidation estate. FIH remained in the liquidation estate as opposed to immediately being transferred to the CBI because of concerns regarding potential provisions in FIH’s foreign loan agreements that stipulated that ownership lenders could demand immediate repayment of loans upon change of ownership. Kaupthing’s resolution board (established on October 9) and the CBI agreed to look for a way to sell FIH, and JPMorgan was brought in as a consultant to find potential buyers, assist in valuing FIH, and document the process. The CBI agreed that it was in the best interest of FIH and the shareholders that FIH be transferred directly from Kaupthing’s liquidation estate to the prospective buyer and that the sale price would then go directly to the CBI to settle the cost of the loan (CBI 2019).

The part of the CBI responsible for addressing the sale of FIH was the CBI Holding Company, which was created to unwind assets that had been taken over by the CBI and the Treasury during the crisis (Benediktsdóttir, Eggertsson, and Þórarinsson 2017).

Sales attempts in the last few months of 2008 were unsuccessful (CBI 2019). In 2010, a consortium consisting of ATP, PFA, Folksam, and CP Dyvig & Co. presented an offer to buy FIH (CBI 2010a). When negotiating the terms of the sale, Kaupthing and the CBI initially intended to receive at least the equivalent of EUR 550 million (the initial loan amount plus interest). The CBI and the consortium of buyers signed a purchase agreement on September 18, 2010, and ownership of FIH was transferred over to the buyers on January 6, 2011 (CBI 2019).

Per the purchase agreement, when FIH was sold to its new owners, the CBI received a payment of approximately EUR 255 million (CBI 2019). With the sale of FIH, the CBI recovered only about half of the emergency loan, resulting in a loss of about 2.5% of GDP (Benediktsdóttir, Eggertsson, and Þórarinsson 2017).

There were other stipulations in the purchase agreement that potentially would have allowed the CBI to recover more of the loan amount (CBI 2019). The initial purchase price of FIH was EUR 670 million, and consisted of the EUR 255 million cash payout, an earn-out payout of up to EUR 415 million that would be adjusted for actual losses incurred by FIH until December 31, 2014, and an additional earn-out payment dependent on the buyer’s realized gain on the investment in FIH at the latest on December 31, 2015 (CBI 2010a). During the 2018–2019 legislative session, the prime minister’s office was asked about the status of the CBI’s recovery of the loan. There was no final status on the recovery of the funds, and while the CBI could potentially collect more recovery funds, it was very unlikely that any further collections would result in recoveries significantly exceeding the initial EUR 255 million payout (Jakobsdóttir n.d.).

Before the GFC, more than two-thirds of lending and over three-quarters of deposits were denominated in foreign currency for the three largest banks in Iceland (Glitnir, Landsbanki, and Kaupthing). The central bank reserves denominated in foreign currency of were 21% of GDP—or, if including a swap agreement with the Nordic countries and other committed credit lines, 35% of GDP. This meant that the CBI had limited resources for the emergency liquidity operations in terms of foreign exchange. The banks’ large foreign currency balance sheets and their size relative to the size of Iceland’s GDP were key vulnerabilities that contributed to their collapse (CBI 2010b).

The liquidity granted to Kaupthing in euros amounted to about one-fifth of the country’s entire foreign exchange reserves (Baudino, Sturluson, and Svoronos 2020). In the October 6 call between Oddsson and the prime minister, Oddsson mentioned that they could gather EUR 500 million, which might support Kaupthing for four or five days, but it would prevent them from assisting Landsbanki (Seljan 2016).

During a portion of the loan duration period (October 7 and 8), the CBI tried to create stability around the exchange rate of the Icelandic krona (CBI 2008d). The CBI was exchanging foreign currency at a rate of ISK 131 to the euro, which differed from the rate that had been established on the interbank market. On October 7, the bank sold EUR 6 million for ISK 786 million (CBI 2008c). However, on October 8, the CBI published another press release stating that the 131 kronur per euro exchange rate did not have enough support, and the CBI would be abandoning its attempts to peg the currency at that rate (CBI 2008d).

The collapse of Kaupthing on October 9 represented the last of the three big banks to fail, and the domestic market therefore became disconnected from the offshore market, where the krona continued to depreciate (CBI 2010b).

In the 2019 document that the CBI published to review the loan, the central bank notes that it did not impose any additional conditions on Kaupthing for the usage of the loan. The loan was therefore added to Kaupthing’s liquid assets on October 6, 2008, and was utilized at Kaupthing’s discretion (CBI 2019).