Iceland's Banking Turmoil Continues as Moody's Announces Latest Sovereign Rating Downgrade

Moody's Joins In

Moody's is the latest international rating agency to downgrade the sovereign over the past weeks. The string of sovereign downgrades seen in the recent days reflects the rapid deepening of Iceland's banking sector stress as the international financial crisis has intensified, at an accelerating pace adding to the troubles of Icelandic banks which have excessive external exposures.

Standard and Poor's (S&P) last week cut its long-term foreign currency sovereign rating to A- (25 on the Global Insight scale), placing the country on Credit Watch with negative implications, following the announcement that the Icelandic government had acquired a 75% stake in Glitnir Bank, Iceland's third-largest bank, for 600 million euro (US$860 million; see Iceland: 30 September 2008: S&P Downgrades Sovereign as Government Acquires Majority Stake in Iceland's Third-Largest Bank). Fitch then downgraded its own rating to A+ to A- (25 on the Global Insight scale; see Iceland: 1 October 2008: Fitch Downgrades Icelandic Sovereign on Rising Banking Sector Distress) and we enacted a downgrade from 15 to 20 (A on the generic scale) as liquidity position further worsened (see Iceland: 2 October 2008: Global Insight Downgrades Icelandic Sovereign Ratings on Rising Contingent Liability Risk). Materialising contingent liability risk then further led to a two-notch downgrade to 30 (BBB+ on the generic scale) in our assessment of Iceland's medium-term sovereign creditworthiness, while S&P also further cut its own rating by two steps to BBB (35 on the Global Insight scale).

Increasing Pressure on Government Finances

When enacting its downgrade, Moody's noted that as international liquidity has dried up, the difficulties of Icelandic banks have intensified and the task for the government to restore financial stability has grown more complicated in the challenging international financial environment. Moody's sees that the sovereign is now faced with a deteriorating balance sheet and increasing public debt. While the sovereign itself is not burdened with any short-term pressure on its foreign currency liquidity, the pressure from contingent liabilities is likely to increase looking forward. While the government has stated that it will not bail out the whole banking system at the cost of impairing its own creditworthiness, Moody's sees that while this crisis management approach will give Iceland some breathing space, some of the banks' excessive external liabilities will in any case end up burdening the government's own balance sheet.

Further Rating Cut by Fitch

Yesterday's move by Moody's has already been followed by Fitch, which today took its long-term foreign currency rating for Iceland to BBB- (40 on the Global Insight scale), further down by three notches from A-, keeping the rating on negative watch. This credit standing represents the lowest investment grade. The agency notes that the rating is supported by the Icelandic authorities' commitment to prioritise sovereign debt service. However, Fitch adds that the extent to which the government will be able to avoid taking the banking sector's external liabilities onto its own balance sheet remains uncertain.

Escalating Banking Turmoil

Iceland's troubles are increasing at an almost daily momentum which is now affecting the country's international relationships. The United Kingdom and Iceland have seen their once-warm relationship rapidly deteriorate after U.K. Prime Minister Gordon Brown said yesterday that he would sue to recoup money owed to U.K. depositors in Iceland's collapsed banks. Iceland's government is refusing to guarantee the savings of over 300,000 U.K. depositors in the country's two recently nationalised banks Landsbanki and Kaupthing and the collapsed online Icesave bank (part of Landsbanki). Although the U.K. retail sector has the greatest exposure to Kaupthing, the U.K. government is more concerned with protecting the individual depositors, the majority of whom saved with Icesave/Landsbanki. The Icelandic compensation scheme only covers the first 15,000 euro of a deposit, while the U.K. government would be accountable for the rest, including those exceeding the 65,918-euro U.K. limit for compensation.

Amid an increasing desire to calm panicked investors, the U.K. government has guaranteed all retail customers' savings with the Icesave online bank. The guarantee is likely to cost the government close to £4.5 billion for the Icesave savings, however, given the nationalisation of the two other banks the U.K. government will be under pressure to extend this guarantee if Landsbanki and Kaupthing also collapse. The U.K. government has also gone the extra mile and frozen the British arm of Landsbanki under the 2001 Anti-Terrorism, Crime and Security Act. Yesterday the U.K. Treasury again took pre-emptive action and arranged for Dutch bank ING Direct to take over the £2.5 billion of deposits of 160,000 customers of Kaupthing's online arm, Kaupthing Edge. ING Direct is also taking control of £538 million worth of savings from just over 22,000 people with savings in the Heritable bank, which is owned by Landsbanki. The U.K. government has taken a considerably more hard-line stance to the dozens of local councils who had hundreds of million of pounds of taxpayers' money invested with Iceland's struggling banks, with Brown refusing to extend the same protection guarantee to the councils. The international element of the dispute over Iceland's banks is unlikely to end with the United Kingdom, since the Netherlands has already announced that it is considering the appropriate response to protect Icesave's 120,000 Dutch clients and their 1.6 billion euro in savings.

Outlook and Implications

We have increasing concerns about the Icelandic sovereign's solvency, which is set to deteriorate as the country needs to increase its borrowing to boost reserves. In addition, it seems unlikely that the deleveraging of the enormous banking sector will be achievable without a clear deterioration in the sovereign's own balance sheet.