Iceland not responsible for the liabilities of its deposit insurance scheme
In a landmark decision, the EFTA Court on 28 January 2013 dismissed all claims brought by the EFTA Surveillance Authority against Iceland in the Icesave case. The Authority had alleged that Iceland had breached its obligations under Directive 94/14/EC on deposit guarantee by failing to compensate Icesave depositors and had violated the prohibition on non-discrimination in the Directive and Article 4 of the EEA Agreement by prioritising payments to domestic savers. The court, referring to the collapse of the Icelandic banking system as an “enormous event” (para. 161), found that Iceland was not responsible for the liabilities of the Icelandic deposit insurance scheme that was overwhelmed with claims following the collapse of Iceland’s three major banks.
Icesave refers to two branches of the Icelandic bank Landsbanki that accepted deposits offering comparatively high interest rates in the UK and the Netherlands. Deposits in these branches were primarily the responsibility of the Icelandic Depositors’ and Investors’ Guarantee Fund (TIF). Following the wholesale collapse of Iceland’s banking system in October 2008, savers in the UK and the Netherlands lost access to their deposits on 6 October 2008. The Icelandic Parliament adopted emergency legislation on the same day to split Landsbanki into a good and a bad bank. By virtue of the same legislation, it gave priority to depositors as compared to other creditors (for further background on the Icesave dispute, including the unsuccessful negotiations between Iceland and the UK/Netherlands, see my ASIL Insight Iceland’s Financial Crisis – Quo Vadis International Law).
The court sided fully with Iceland on the crucial legal and policy question that resonates far beyond Iceland: whether the state is and should be liable for liabilities of a national deposit insurance scheme. In its submissions, Iceland had argued that “to underwrite a deposit-guarantee scheme using the resources of the State creates its own problems. These include huge costs for the State, moral hazard on the part of the banks, and a linkage between the liabilities of the banks and the financial exposure of the State. That kind of link can have very serious consequences. A severe financial crisis easily turns to a possible sovereign default.” (Judgment, para. 103). Iceland added that a systemic banking crisis resulting in the collapse of the almost the entire banking sector could only be addressed with other policy tools. No existing deposit insurance scheme would be capable of paying out all depositor claims in a crisis of such magnitude.
Liechtenstein and Norway, as interveners, supported Iceland on this point. Liechtenstein submitted that the “Directive was intended to deal with the failure of individual banks; not with the collapse of an entire banking system. Liechtenstein contended that it was not envisaged that a general and automatic State responsibility covering the costs of the failure of the whole banking system would arise from the Directive.” Norway similarly argued that “general and automatic State responsibility for compensation of depositors as a last resort would impose an extensive financial burden on EEA States. Without a clear and precise wording in the Directive, the existence of such an obligation cannot be assumed. An obligation of such kind on the part of the EEA States does not follow from the preamble to the Directive or the preparatory works. Moreover, recital 24 in the preamble to the Directive appears to exclude automatic State responsibility.” (para. 113).
Conversely, the UK, the Netherlands and the European Commission, argued that the Icelandic deposit guarantee scheme was an emanation of the Icelandic state, and as such, any failure to pay by TIF was attributable to the Icelandic state. The Directive created obligations for the state to establish an effective deposit guarantee scheme, and not for the TIF. They also gave short thrift to Iceland’s defence of force majeure, arguing that even a financial crisis of the magnitude experienced by Iceland could at most delay the payment obligations, but not alter the obligation to pay.
The Court emphasised first that it was important to look at the specific provisions of the Directive in order to assess whether it imposed an obligation of result, i.e. an obligation on Iceland to ensure that all deposit holders were repaid following the failure of Icesave. It underscored that deposit insurance was subject only to minimum harmonisation. Generally, directives left the choice of means to the member state concerned, proscribing only a certain result, in this case establishing and supervising a deposit insurance scheme. It also underscored that the question of Iceland’s potential state liability for loss and damage to individuals was a separate one, and outside the scope of its judgement.
The Court relied on substantial changes to deposit insurance in the European Union (see Directive 2009/14) following the global financial crisis to conclude that Iceland was no obliged to guarantee TIF’s liabilities under the Directive 94/14 that applied in the Icesave case and offered more limited protection to depositors. Directive 2009/14 provides that “Member States shall ensure that the coverage for the aggregate deposits of each depositor shall be at least EU 50000 in the event of deposits being unavailable.” This new formulation, the Court explained, indicated that member states were now obliged to ensure that payment of that amount was in fact made by their deposit insurance scheme. Conversely, Directive 94/14 in its Article 7 provides that “Deposit-guarantee schemes shall stipulate that the aggregate deposits of each depositor must be covered up to ECU 20 000 in the event of deposits’ being unavailable.”
The EFTA Court referred to the judgment of the Court of Justice of the EU in Paul and Others as authority for the proposition that Article 7 of the Directive obliged states only to set up and ensure the proper functioning of their deposit insurance scheme, without a need for states to guarantee their liabilities. As a result, the Court held that the Directive does not envisage that “EEA states have to ensure the payment of aggregate deposits in all circumstances.” (para. 135). Under Directive 94/14 that applied in the Icesave case, “[t]he obligation on the EEA States is limited to the maintenance or adoption of rules that provide for an effective right to file an action against the guarantee scheme particularly in the case of non-payment.” (para. 143).
The Court also agreed with Iceland, Liechtenstein and Norway that the Directive was designed to deal with the failure of individual banks, not with systemic banking crisis affecting a country’s banking sector as a whole. It found that the Directive was expressly limited to the failure of a single credit institution (referring to recital 4 in the Directive’s Preamble). In further support of this conclusion, the Court referred to (i) a 2010 Impact Assessment of the European Commission, already taking into account the Icelandic experience in 2008, that contemplated a coverage ratio in member states’ deposit insurance schemes that would be unable to cope with a crisis of Icelandic magnitude; (ii) Directive 94/14 that contained no provisions on the mechanisms for funding deposit guarantees schemes, (iii) failure to provide for a specific level of funding and was and (iv) the Directive’s silence on the consequences of a deposit insurance scheme becoming unable to pay, except to provide for a right of action against the scheme, but not the State. The burden of deposit insurance schemes properly fell on the other creditor institutions, not the member state concerned. The court declares that “it is for the remaining credit institutions to make up the difference. In other words, the bankruptcy of a financial institution is covered – as in a classic insurance system – by the rest of the institutions active in the market.” (para. 159).
Guarantees by a member state to credit institutions directly would distort competition and amount to state aid. Similar distortions for competition would result from a state guarantee for the deposit insurance scheme. The court referred to the 1992 proposal for the deposit insurance directive by the Commission in which the Commission decided against prohibiting assistance to deposit guarantee schemes in exceptional circumstances. To the Court, the decision not to prohibit state bailouts of deposit guarantee schemes indicated that the drafters did not provide for an obligation for states to inject state funds into deposit guarantee schemes. Whether or not to bailout deposit insurance schemes was an economic policy decision that was not constrained by Directive 94/14. As a result, the State of Iceland was not obliged to make payments to depositors in the failed Icesave branches in a major banking crisis.
A major factor underlying the Court’s decision is concern about moral hazard. The Court took the view that a high degree of deposit insurance was costly, and had to be balanced against the benefits to savers. How this balance ought to be struck was, for the most part, an economic policy decision. The Court referred to recital 16 in the Preamble to the Directive 94/14 which explains that deposit insurance “might in certain cases have the effect of encouraging the unsound management of credit institutions.” The Court approvingly quotes Nobel Prize Laureate Joseph Stiglitz to the effect that an important downside of extensive deposit insurance was that savers lost incentives to evaluate the quality of their deposit-taking institutions. On this basis, the Court underscores that “moral hazard would also occur in the case of State funding, serving to immunise a deposit-guarantee scheme from the costs which have, in principle, to be borne by its members.” (para. 168).
The Court dealt with prayers 2 and 3, the prohibition on discrimination found in both Article 4 of the EEA Agreement and the Directive itself, in the briefest terms. It relied on a formal ground to dismiss the claims. The Court concludes that the alleged act (i.e. the emergency legislation passed by the Icelandic Parliament and the act of creating a good and bank Landsbanki by the Icelandic supervisor) are outside the scope of the prohibition on discrimination. The deposit insurance scheme was not involved in these macroeconomic policy decisions. The obligation for TIF to pay was triggered only after the transfer of the domestic deposits to the new Landsbanki had already occurred. No depositor protection applied to savers in the new domestic Landsbanki branch. The mostly Icelandic depositors at the new bank were, as a result, not a comparable class to savers in the UK and Dutch branches of Icesave, to whom the Directive applied. According to the Court, there was simply no comparable situation.
The Court underscored that its finding of discrimination was necessarily a limited one, given the scope of the application by the EFTA Authority. The Authority had asked the Court only to declare whether Iceland engaged in prohibited discrimination by failing to pay the minimum amount of compensation due under the Directive, like it did for domestic depositors (to whom no such payment was ever made because the new Landsbanki was a going concern). In obiter, however, the court added that even with a broader formulation of the Authority’s pleas on discrimination, the result would not necessarily change: “EEA States enjoy a wide margin of discretion in making fundamental choices of economic policy in the specific event of a systemic crisis” (para. 227).
The judgment is a vindication not only of Iceland’s crisis resolution strategy, but also a success for the International Monetary Fund. The IMF had a major influence on how Iceland dealt with its failed banks, including the decision to split off a viable part of Landsbanki and give priority to depositors over general unsecured creditors. The EFTA Court, given the uncertainty in the Directive as to whether a state was obliged to stand behind its deposit guarantee scheme, refused to hold the Icelandic state liable for private debts. The court endorsed the view that Iceland has no clear obligation to pay for the liabilities of its deposit insurance fund. A similar outcome to the Icesave dispute, without the damaging effects of uncertainty and the costly delay, could have been achieved much earlier in negotiations between Iceland and the UK/Netherlands, if the latter had shown more willingness to compromise. The Court’s decision is now likely to put the Icesave saga that has spanned more than 4 years to rest.
Over time, the Court’s decision could become an influential authority for the proposition that state and private liabilities are separate, unless a State has expressly assumed such liabilities. Directive 94/14, on which this dispute principally turned, left this question unclear. The Court refused to read an obligation of Iceland to assume private liabilities into the Directive. The Court, absent clear indications to the contrary, abstained from issuing a judgment with major financial implications for the many states with oversized banking sectors.
In the short-term, some will be concerned that this judgement confirms that the protection of depositors in the single market is limited, and unlikely to be available in the event of another systemic banking crisis putting strains on the deposit insurance scheme as whole. Conversely, others will welcome the court’s principled stance on moral hazard and deposit insurance that is likely to have a disciplining effect on savers and credit institutions. The Court put the ball back into the legislator’s court (where many would argue it properly belongs). Whether to provide deposit insurance with a state guarantee in the single market, just like the intensely debated issue of joint deposit insurance in the Eurozone, is a matter for the parliaments to decide, not for the courts.