Financial System Reconstruction - The Task Ahead as Viewed by the Minister of Commerce

5/5/09

Financial System Reconstruction – the Task Ahead as Viewed by the Minister of Commerce

Much work still lies ahead. This work is underway in particular in the Prime Minister’s Office, the Ministries of Finance and Commerce, the Financial Supervisory Authority (FME) and the Central Bank of Iceland. As the following summary indicates, many of these projects are directed by the Ministry of Finance. A committee co-ordinating the actions of these parties is led by Mats Josefsson. The ultimate aim of this work is to ensure the operation of a viable and solid banking system in Iceland for the long term. The following is an outline of how the Minister of Commerce views the main projects currently underway.

1. Valuation of the assets and liabilities transferred from the old banks to the new

The FME decisions of October 2008 provide for the transfer of certain assets and liabilities from the old banks to the new ones. FME then concluded an agreement with Deloitte LLP to evaluate the assets and liabilities transferred, and with the international consultancy Oliver Wyman, to supervise the assessment of these assets. FME instructed Deloitte LLP to base its assessment on the concept of fair value, which assumes that the new banks will continue to operate as fully financed Icelandic banks on the domestic markets and will neither be required to sell-off assets (nor settle liabilities) precipitously or through forced sale. The results of this valuation have now been delivered and stakeholders are acquainting themselves with them in accordance with the relevant policy.

2. Payment for assets transferred from the old banks to the new – ownership of the new banks

A committee set up by the Ministry of Finance, the Prime Minister’s Office and the Ministry of Commerce was entrusted to handle this task. The Ministry of Finance engaged a special employee to work on the task and concluded an agreement with the consultancy Hawkpoint in March 2009 to advise the state in the negotiations which will take place with the old banks (creditors) concerning the assets transferred from the old banks to the new. In connection with these negotiations, a decision has to be taken as to whether the state is prepared to negotiate on the possible ownership of the new banks by

the old banks or their creditors. The operating budgets of the new banks, as well as their audited financial statements, also need to be available. The Ministry of Finance is also in the final stages of hiring lawyers to look after drafting of documents and provide advice. It is now assumed that it will be possible to conclude this project in June.

3. FX imbalance in the banks’ balance sheets

As more foreign-denominated assets than liabilities were transferred from the old banks to the new, an imbalance in this respect was created in the new banks’ balance sheets. This results in some currency risk for the banks and the possibility of a loss on their operations due to the interest rate differential between interest earned on these assets and interest paid on deposits. The amounts of the instruments which are to be used as payment by the new banks to the old banks for the assets transferred to them will not be sufficiently high to fully compensate for this imbalance. It is now established that the Treasury will not be able to conclude a derivative agreement to equalise this imbalance, as the banks had hoped would be the case. A committee under the auspices of the Prime Minister’s Office has been working on this problem, and is expected to deliver its conclusions this week. Furthermore, an advisor in the Ministry of Finance is heading a special group from the Ministries of Finance and Commerce which includes representatives of the new banks and the Central Bank, to resolve this issue. Clearly, neither the financing of the new banks nor agreements with creditors can be finalised until a solution has been agreed; this is expected to be achieved by the end of June.

Tasks 1-3 and 6 are clearly closely related. If one or more of the new banks is owned by the old banks or their creditors, it will be easier to resolve them. Nonetheless, it remains to be ensured that the new banks have an acceptable foreign currency balance.

4. Currency controls – ways to allow the exit of impatient capital

A Memorandum of Intent issued by the Icelandic government concerning the IMF loan affirms the government’s intent to stabilise the ISK exchange rate. Concern was expressed that a large-scale capital outflow from the country would result in further substantial depreciation of the currency.

To counter this risk, it was considered urgently necessary to apply temporary restrictions to cross-border capital movements. As a result, legislation was passed amending the Foreign Currency Act and temporarily authorising the Central Bank to issue rules, approved by the Minister of Commerce, restricting specific capital movements which do not involve trade in goods and services. The Central Bank’s authorisation is temporary and its period of validity coincides with that of the Economic Recovery Programme agreed by the government and the IMF until 30 November 2010. Following the entry into force of the legislation in November 2008, the Central Bank issued rules which were revised on 15 December 2008. This legislation was amended at the end of March 2009, to

ensure that payment for exports of goods and services was made in foreign currency. Following the imposition of currency controls, efforts have been underway to resolve the situation of non-resident investors holding ISK assets which they wish to dispose of. Several private parties have suggested ways of resolving this problem through asset swaps or auction of debt instruments. Resolving this question is a pre-requisite for relaxing currency controls.

5. Asset Management Company – dealing with corporate debt

It is established that a large number of Icelandic companies are struggling with repayment difficulties. Due to the significance of certain commercial enterprises for Icelandic society, it is necessary to ensure that their activities are not disrupted despite the

difficulties they face. A bill introduced into the Icelandic parliament Althingi by the Minister of Finance during the last legislative session was not dealt with before the session ended. The bill proposed to authorise the Minister of Finance to establish a special publicly owned, limited-liability, asset management company (AMC), with the purpose of acquiring holdings in commercial enterprises which are in such financial straits that part or all of the corporation is now owned by financial institutions. The purpose of establishing the AMC would be to enable it to undertake financial and operational restructuring of those enterprises to make their operations viable as soon as possible. Similar AMCs have been set up by various countries to ensure that corporate restructuring is carried out in a transparent and non-discriminatory manner. The bill assumed that this would be only a temporary measure, as companies were expected to be disposed of as soon as market circumstances made this feasible and that the AMC itself would be wound up once its objectives had been achieved.

In connection with this undertaking, the Ministry of Commerce expects that an advisor will need to be engaged to make proposals concerning agreements concluded between the

AMC and the banks. It will also be necessary to examine the methods used by the banks to deal with corporate difficulties, harmonise these actions and ensure they are transparent, and assess whether there is a need for a centralised debtors’ ombudsman. A bill dealing with this issue is expected to be submitted to a summer Althingi session.

6. State ownership of the banks – policy on ownership

In view of the fact that the state has acquired the country’s three largest commercial banks, a policy on ownership needs to be formulated. In this connection, questions need to be examined as to whether a special company should be established to control the state’s holdings in the banks, and on the size of the banks, based on assumptions concerning their current and future operations. Many countries have elected to put some distance between political power and the decision-making authority in banking operations. This task is the responsibility of the Ministries of Finance and Commerce. It would be desirable to have results available before the refinancing of the banks is completed.

7. Review of the Act on Financial Undertakings

Finnish banking expert Kaarlo Jännäri, who was engaged to review the legal framework for the financial market in Iceland, delivered his report some weeks ago. Although his main conclusion was that the Icelandic legal framework was comparable to that of other EEA states, he pointed out the necessity of making the legislation more precise and stringent in several areas. A committee appointed by the Minister of Commerce to review the legislative framework has been drafting new legislation taking Kaarlo Jännäri’s recommendations into consideration. The committee has focused in particular on revising provisions containing various rules on conduct and eligibility. These include, for example, granting of credit secured by own shares, cross-ownership, risk management, loans to related parties and large exposures, expanding possibilities of monitoring owners of qualifying holdings and eligibility of directors and managing directors. The committee expects to deliver its proposals to the Minister of Commerce this month.

8. Icesave negotiations

Since early October, Icelandic authorities and the Depositors' and Investors' Guarantee Fund have been negotiating with foreign states concerning the position of depositors of the banks’ foreign branches and of creditors following the emergency legislation. Several meetings were held before the end of 2008 without reaching any conclusion. In February the government decided to appoint a negotiating committee comprised of representatives of the Ministries of Finance and Commerce, the Ministry of Foreign Affairs, the Prime Minister’s Office and the Central Bank of Iceland, to reach agreements with the Dutch and UK authorities on Landsbanki’s Icesave accounts. Kaupthing Bank will repay in full deposits held by all its foreign branches. The negotiating committee is headed by the representative of the Ministry of Finance.

9. Savings Banks – contribution from the Treasury and revision of legislative environment

The so-called “emergency legislation”, Act No. 125/2008, authorised the Minister of Finance to make an allocation of up to 20% of the book value of equity of savings banks. Eight savings banks currently operating have already applied for an allocation. Opinions have been obtained from both the Central Bank and FME, in accordance with rules to this effect of the Ministry of Finance. Work is underway at the Ministry of Finance in processing these applications. While it is desirable that this work be completed as soon as possible, it is clear that the accounts of the savings banks in question, together with their current operations and future strategy, must be examined carefully. Steps must also be taken to ensure that the Treasury obtains a holding in the savings banks commensurate with the capital it has injected in each instance.

Work is underway in the Ministry of Commerce on a comprehensive review of the chapter in the Act on Financial Undertakings dealing with savings banks. A draft of a bill of legislation is already available. The bill needs to be dealt with at the summer session of the Althingi.

10. Depositors’ Guarantee Fund

In light of the banks’ collapse and the enormous obligations which this has meant for the Depositors’ and Investors' Guarantee Fund, a complete review is called for of legislation on deposit guarantees and an investor compensation scheme. The European Union has also passed amendments to its Directive on deposit guarantees which will increase the amounts of deposit guarantees and shorten the payment time, which must be transposed into Icelandic legislation once incorporated into the EEA Treaty. Clearly this work needs to be expedited as much as possible, with the aim of having draft legislation ready for the autumn of 2009.

Ministry of Commerce

5 May 2009