Thirty Years After Icesave, Iceland Is Once Again Trusting Its Banks

The Icesave debacle was supposed to be Iceland's cautionary tale. In 2008, thousands of savers—chiefly in Britain and the Netherlands—lost money after placing their deposits with Icelandic banks that had expanded rapidly under a regime of remarkably light supervision. Customer funds were treated with a degree of abandon more commonly associated with a casino than a regulated financial system. Ever since, "Icesave" has become shorthand among financial professionals for the dangers of an under-supervised banking sector. Iceland's political class promised that the lesson had been learnt. Banks would be more tightly regulated, their influence curtailed and oversight strengthened. A judgment delivered by Iceland's Supreme Court last week suggests those ambitions may have proved more aspirational than real.

Sanctions Without Evidence

The case concerned the sanctioning and effective expropriation of a Swiss entrepreneur who had acquired the Icelandic engineering company Velfag. After allegations that he was a Russian spy, Iceland's Ministry for Foreign Affairs effectively deprived him of control over the company. When he sought access through the courts to the files and evidence underpinning those allegations, the government refused, invoking national security.

That position sat uneasily with one inconvenient fact: neither the European Union, nor the United States, nor even Ukraine had considered the evidence sufficient to justify sanctions. Yet Iceland's Foreign Minister, Þorgerður Katrín Gunnarsdóttir, remained unmoved.

As the prospect emerged that the Ministry might face damages running into the hundreds of millions, the government's legal position evolved. Responsibility for sanctions, it argued, did not in fact rest with the state. Rather, Iceland's private financial institutions—most notably its banks—possessed the authority to impose and lift sanctions themselves.

The claim was remarkable. Ms Gunnarsdóttir has consistently presented herself as one of Iceland's most ardently pro-European politicians. Yet the notion that core sovereign powers should be exercised by private commercial banks would sit awkwardly with established European legal principles. Few, if any, advanced democracies entrust such powers to profit-seeking financial institutions.

Arion Bank, for its part, offered a less than unequivocal defence. It acknowledged that the sanctions had formally been imposed by the bank but maintained that it had acted upon the Foreign Minister's explicit instructions. Ms Gunnarsdóttir denied having intervened, despite press reports and documentary evidence suggesting otherwise. In any event, she argued, the ultimate legal authority rested with the bank.

Last week Iceland's Supreme Court largely accepted that reasoning. It concluded that imposing sanctions on individuals and companies does not fall within the competence of the Icelandic government, but instead lies with private actors—principally banks. For a country seeking closer integration with the European Union and expected to hold a referendum on EU membership this August, that conclusion is difficult to overlook. It also raises an awkward question: after all the promises made in the aftermath of Icesave, just how much has really changed?

A Regulatory Blind Spot

The implications extend beyond one legal dispute. If a privately owned bank may impose sanctions according to its own assessment, without meaningful regulatory supervision, conflicts of interest become less an exception than a structural feature of the system. The scope for arbitrary decision-making is obvious.

Taken to its logical conclusion, such a framework implies that the power to sanction could become inseparable from ownership itself. A controlling stake in an Icelandic bank would confer not merely commercial influence but a measure of quasi-sovereign authority. That is an unusual arrangement in any liberal democracy. That the authority should rest with institutions whose overriding duty is to their shareholders makes it more unusual still.

Prime Minister Kristrún Frostadóttir's government appears willing to accept that trade-off. Whether investors, businesses and Iceland's international partners will prove equally sanguine remains another matter.

The judgment has prompted broader questions within financial circles. If Iceland's regulatory framework has produced such an outcome in the area of sanctions, has it also left weaknesses elsewhere? That question is becoming harder to dismiss.

For years successive governments have pointed to the regulatory reforms enacted after the financial crisis. Yet legislation is easier to draft than to test. Iceland's unusually close relationship between political elites and the financial sector has long attracted scrutiny, and recent economic indicators offer little reassurance. Interest rates remain close to 8.5%. Loan defaults are increasing. Economists continue to warn that the country's property market appears increasingly vulnerable. Inflation, at around 5.2%, remains stubbornly elevated.

None of these developments, taken individually, need herald another financial crisis. Together, however, they form an uncomfortable backdrop against which to relax regulatory discipline. Iceland learnt once that asking banks to police themselves can prove expensive. The Supreme Court's ruling suggests that, in at least one important respect, the country may once again be placing considerable faith in precisely the institutions whose judgment it once concluded required rather closer supervision.