This memo from written by Frida Fallan for the deputy governor of the central bank of Sweden Lars Stefan Nyberg criticizes EU’s outdated supervisory and regulatory framework and in particular deposit guarantee schemes. This exclusive document was provided to me by the Riksbank in 2011.

1. For your information, this memo has not been discussed by the Executive Board of
the Riksbank. Nor has the Riksbank made any decisions on the basis of the content
of the memo or in any other way taken a stance on it.

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L. Nyberg
Draft to L. Nyberg by F. Fallan
1 December 2008
Iceland – prime victim of EU’s outdated supervisory and regulatory framework:
Response to Letter from Iceland 1
A few days ago an article with the title Letter from Iceland was published in the Financial
Times2
. It told the story of the rise and fall of Iceland as a financial centre. The story of the
build up and collapse of a banking system far larger than this small island’s economy,
allowing the Icelanders – like so many more of us – to live well on borrowed money. It told
the story of 300 000 Icelanders being left with an enormous debt burden as a result. The story
of a nation in shock, trying to grasp what has happened and wondering what went wrong. It
told the story of a people crying out their outrage towards the responsible bankers, and
blaming the policy makers for the disaster. The story of fierce demonstrations outside the
prime minister’s and central bank’s offices.
It was an open letter, addressed at no-one in particular. But I believe that it is a letter that
merits a reply. And that all of Europe should answer the call. Because the truth is, that while
the bankers are obviously to blame for their irresponsible and highly risky business practices,
and the Icelandic politicians and regulators are responsible for allowing this rapid, highly
leveraged expansion, they are not the only ones to blame. Because the failure of the Icelandic
financial system is also the failure of the EU supervisory and regulatory framework. And for
this, the Icelandic are hardly responsible.
What do I mean by this? I will try to explain. Iceland has not always been an indebted
country. On the contrary, its fiscal debt has up until a few weeks been one of the lowest in
Europe. Now, suddenly, it is the most indebted country. Much of the debt burden now on the
nation’s shoulders consists of obligations for deposit insurance for deposits at the Icelandic
1
Preliminary draft, some facts and data remain to be checked
2
Letter from Iceland, Nov 15 2008, By Robert Jackson, Financial Times

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banks foreign branches, mainly in the UK and NL. Under the EU supervisory and regulatory
system, all EU countries are responsible for setting up deposit guarantee schemes to protect
depositors in the case of a bank failure. The minimum amount was up until a month ago EUR
20 000 (this amount was recently lifted to EUR 50 000). Depositors in foreign branches fall
under the home country’s scheme. There are a few intricacies, however. The EU Directive
does not state explicitly that the state is responsible for guaranteeing the depositors; this
should be the responsibility of the banking system itself. It states merely that the state is
responsible for setting up a guarantee scheme. In Iceland’s case (as in many other countries)
the scheme is a private foundation, with very limited capital, and with an obligation for the
banks to come up with more money if needed.
So what is wrong with this system? First, there are few requirements on how to set up these
schemes. They do not even have to be funded – and many are not. It is enough that the other
banks are required to provide funds to compensate the depositors of the failing bank. Now,
this works in a small bank failure, but if it is a large bank that fails, the idea that the other
banks can come up with the necessary funds is not credible. The implicit assumption is that
the state will come to the rescue in the case of a large bank failure. The deposit insurance is
thus an implicit liability of the government. Of course, the preferred option will likely not be
to let a large bank fail, but rather to use other tools. But in the end, the cost may fall on the tax
payer – and the state will be the deposit insurer of last resort. However, this issue has not been
openly discussed. Rather, the policy debate in recent years has focussed on the need to ensure
that states do not contribute funds to the schemes (in the context of State Aid rules). Second,
and worse, this implies that the home country principle transfers the responsibility for what is
essentially consumer protection in the host countries to the tax payer in the home country.
The idea that the home country should be responsible for the foreign branches is a rather
recent EU principle. It was established in 1988. How on earth did the EU come up with such a
strange system in the first place, one may wonder? Well, it stems from the EU ambition to
establish a common market, where capital can be freely moved across borders. The rationale
behind the home country principle is that it allows banks from all of the EU to compete in the
other Member States. At the same time, the people in the host countries can rely on the home
country authorities to give them equal protection that is given to their own citizens. And there
are minimum rules for protection, so as to ensure that the home country protection is
sufficient. These are the EU “minimum harmonisation” and “mutual recognition” principles.

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The home country authorities of the branch are thus responsible for the supervision of the
branch and also for the deposit guarantee.
This system is rational from a market perspective. And it may also be acceptable from a
broader perspective in cases where the branch is just a minor part of the business. And this
was largely the situation at the time of the introduction of this principle. But quite evidently,
in cases where the branch is large, the effects from assuming this responsibility can be
devastating to the home country economy. And today, branches are getting increasingly
important within the EU. The regulatory system has not kept pace, though. Discussions on
this have been ongoing at the EU level, but no change has been implemented so far.
To this quite absurd and outdated regulatory system Iceland is associated through the EFTA
agreement. The above stated regulations are just a small part of the numerous and complex
legal texts that Iceland by the EFTA agreement is tied – even though it is not an EU Member
State and has had no chance to decide the rules. And the question is, did the Icelandic
politicians even fully understand the implications of the legal texts? Iceland’s handling of the
crisis initially suggests that they did not. And frankly, how could they be expected to? To
fully realise the intricacies of the EU legal framework, you probably need to be an insider. Or
else, have access to vast legal and economic expertise at you administration to analyse the
texts. Iceland, a tiny country far away from the European continent, is clearly not well
positioned here.
But it takes two to tango. And there are others here who must have understood what was
going on, and who had the ability to do something about it. But who failed to react. Oh, many
have surely whispered to Iceland that the she was moving too fast, risking her health. But did
anyone stop dancing; did anyone turn off the music? It seems not. First, there are the policy
makers in the EU countries and in the EU institutions. They have been made well aware, not
least by the Nordic authorities, of the fact that the present under-funded and inadequate EU
framework needs reform. Yet, the political willingness to make anything beyond marginal
changes to the system has been non-existent. Second, there are the host countries, with the
UK and the NL at the centre stage in the Icelandic case. It seems that they have hardly
bothered to inform their own populations on how the schemes work. If local communities,
pensioners and other depositors at the Icelandic banks’ branches had known that they were
protected by a small, private fund with about EUR 5 million in capital, a sum which should be

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compared to the guaranteed amount in the UK branches alone of EUR 6 billion, would they
have put their money there in the first place? The size of the Icelandic fund was no secret.
This information can be found for instance in public reports by the European Federation of
Deposit Insurers, to which all EU country deposit guarantee schemes belong. But no such
information could be found at the website of the UK authorities. Just a few weeks before the
failure of Landsbanki, the following information could be found at the website of Icesave, the
UK branch: “--- The compensation itself is provided by two schemes (sometimes referred to
as a passport scheme) – the end result being that the total amount protected is the same as if
your savings were only protected by the UK Financial Services Compensation Scheme”3
.
Again, the responsibility for supervision lies at the home country. But clearly a host country
can react and correct misleading information. Apparently, this was not done. Despite the fact
that these banks were offering very high interest rates, a classic early warning signal for risky
business.
The conclusion is clear: the EU host countries of the Icelandic banks are also to blame for
Iceland’s disaster. And consequently, it would be reasonable that they carry some of the
burden. After all, what we are talking about, again, is the burden of paying out consumer
protection in the host countries. What if the host country citizens were to shoulder a burden
equal to just a small share, say 1/10 of the amount which has been asked of an average
Icelander to pay for the depositor protection in the host countries? What if the EU also
stepped in, for instance by giving the European Bank for Reconstruction and Development a
right to contribute to the much needed recapitalisation of the Icelandic banks, with an option
for Iceland to acquire the shares at the issuing price in say 5 years? It would be a rather minor
cost to the host country economies and the EU. But it would greatly improve the chances for
Iceland. It is a step far beyond extending an IMF arrangement, which is, after all, only a loan
which will have to be repaid. It is, I believe, what is required for the host countries and the EU
to close their moral debt to Iceland. It is an act that may not be legally enforceable, but should
nevertheless be done. At a time when we ask bank owners and management to repay bonuses
and earlier profits on moral grounds, surely it is not too much to ask the same from our states.
And it should be done without Iceland being forced to the painful and humiliating procedure
of debt rescheduling at the Paris Club, the forum where debtor nations and creditors
traditionally meet.
3
Webpage of Landsbanki Icesave, 9 September 2008

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Now, the need for settling the moral debt with Iceland is the key message here. But what
about the lessons for the EU as a whole? This sad story should have a few lessons also for the
people of the EU. First, it tells the people of the EU what has so far been an issue of interest to
a limited number of people in our administrations: The present supervisory and regulatory
system is flawed and needs to be reformed. It cannot offer the people of Europe the safety and
confidence it its banking system it has a right to expect. The supervisory system is not fit to
discover the risks in the first place. And in the worst case scenario where the tax payer has to
step in, the burden may be unevenly and unfairly distributed among the nations. For banks
which, like the Icelandic ones, operate in a branch structure, the burden will mainly fall on the
home country. For banks operating in a subsidiary structure, each country is responsible for
its own bank. But also in this situation, the distribution of the burden may be unfair and
unexpected. Banks within a group shift assets within the group very frequently. As a tax-
payer, your burden may depend on whether your national subsidiary did, or did not, pay out a
large payment just before the failure of a bank in a banking group. This is hardly an
acceptable situation.
What could be done about it? Well, it is clear that authorities need to cooperate better in order
to supervise the banks properly. And it seems indeed now to be widely accepted that new
structures need to be built up. Basically, what is needed is an EU system of supervisory
colleges, with an overarching structure responsible for coordination and for ensuring
consistent methods and regulations. Deposit guarantee schemes also need to be reformed. But
experience tells us that it is extremely difficult to try to harmonise the national deposit
guarantee schemes. The long and cumbersome attempts in this regard over the past years have
resulted in only very marginal changes. So here, the solution is not harmonisation. Instead, we
need a Gordian solution – to cut the knot with a sword. We should simply abolish and
liquidate the present schemes and start all over. The new regime should recognise what has
been obvious in the present crisis, if not before; that the state only can assume such a
guarantee responsibility. The present obscure, contingent liability of the state should be
transferred into an explicit guarantee liability accounted for in the national accounts. For this
guarantee, the banks should pay premiums to the state, much like an ordinary insurance, with
the fees agreed at the EU level. In principle, there should be a budget appropriation reflecting
the expected cost of the deposit insurance with the premiums set to match this expected cost.

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In practice, there is a lot of uncertainty about the size of such a premium. The key thing is to
have a harmonised system, where premiums reflect a best effort estimate of the expected cost.
The distribution of responsibility between the home country and the host country should also
be better aligned with the economic importance of the business in question, and not only with
the legal domicile of the head office. This could be done by agreeing that branches, where the
deposits amount to, say more than 2% of either the home country’s or the host countries’ total
deposits, need to have a reinsurance policy from the host country government. In return for
reinsuring the deposits, the host country would receive the fees from the branch. And more
importantly, the host country should be allowed a say on the supervision of the bank. The
presumption should be for such agreements to be met, as this will be the most logical
regulatory response to the vision of a common market within the EU. Disputes could be
settled in a mediation mechanism under the overarching EU supervisory committee. If such
an agreement cannot be met, the branch’s business should not be allowed to expand further,
unless transformed into a subsidiary. There should also be an agreement on how to share the
burden between the home and host Member States in case there is a serious crisis. Possible
keys are guaranteed deposits, other banking balance sheet or business data, or keys related to
the countries’ GDP, possibly with some extra responsibility for the home state reflecting its
primary role in the supervision of the banking group. In the reform period, which needs to be
swift, depositors should be protected by general guarantees from the states, much in the way
as have been introduced in the present crisis due to stability reasons.
These are issues which will require some work, but which need not after all be very
complicated, as long as there is a political commitment. In addition to this, there is also need
for more fundamental reform of our insolvency framework for banks. That is, the legal
systems used for dealing with a bankruptcy in a bank. What is needed is a legal framework
which allows the authorities to take action to protect depositors as well as overall financial
stability, while at the same time making sure that shareholders should bear the losses as in any
other business. This seems to be a very difficult legal issue, requiring changes also in
corporate law, competition law and banking law. To proceed on a national basis seems
difficult within the EU, as an efficient framework may require carve-outs in EU company law
and competion law. Agreement is needed at least on what principles will take precedence
when different legal acts clash. It is very likely that the best way to proceed also in this area is
not by harmonising the different national frameworks, but by the establishment on the EU

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level of a special insolvency procedure for banks. Technically, there are different ways of
constructing such a framework, with the US Federal Deposit Insurance Corporation’s Prompt
Corrective Action system as one well-known and well-functioning model. The Swiss special
resolution regime for banks is another interesting model. Here, the supervisor has an
important responsibility for carrying out a write-down of capital and, if necessary, claims on
the bank and then to set the terms for any recapitalisation needed. In addition, special
measures to deal with situations where the stability of the financial system as a whole is at
risk also need to be provided for. Here, the crisis legislation introduced in various countries
may serve as inspiration. An example is the recently introduced Swedish Stabilisation Plan.
This Stabilisation Plan includes legislation on i.a. a guarantee scheme, possible capital
injections and compulsory share redemptions, with a view to ensuring financial stability while
maintaining at the same time a proper balance between the various interests involved. The
establishment of a common insolvency framework for banks is not a small task. But I think
that it is crucial for the functioning of our economies to have it in place. For countries which
have managed to agree on a common market, a common security policy and a common
currency, it should be doable. It would therefore be useful to give the Commission a strong
mandate to develop a blueprint for such an EU-wide insolvency framework for banks.
Let me conclude. The world is now experiencing the worst financial crisis since the 1930’s.
EU countries have found their frameworks largely deficient and seen the need for
extraordinary measures to deal with the crisis. Reforming this framework will be an important
issue for the EU policy makers in the months and years to come. This is necessary for the EU
to have an efficient market, while at the same time ensuring financial stability and an
adequate consumer protection. But future improvements will not help Iceland, of course.
Iceland has come out of the crisis worse than any other European country, and as a result is
plagued by a terrible debt burden. Here, the host countries of the Icelandic banks in particular,
and EU leaders in general, need to acknowledge that Iceland’s problems are not only due to
irresponsible lending and insufficient response by Icelandic authorities, but also largely due to
the defunct EU supervisory framework, which EU policy makers chose to turn a blind eye to.
EU leaders have taken extra-ordinary measures in recent months to ensure that the EU
banking sector, and ultimately its citizens, are now being protected by extended safety nets.
They have been applauded for their response and some have even labelled world saviours. But
having released the life boats and saved our citizens, there is one more thing to do. It is to turn
back to the people who have been left behind, who were met with pokes rather than with a

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helping hand. Because, even though Iceland’s waters actually never freeze, they are becoming
very cold. So turn around now, and find the right path quickly!