Gavin McCrone: Bullying Iceland is no way to get our money back

Iceland's president, Olafur Ragnar Grimsson, faced with widespread public opposition, used his constitutional power to put to a referendum the deal narrowly agreed by the Althing (the Icelandic parliament), whereby the British and Dutch governments would be repaid part of the cost of protecting depositors in the failed Icesave internet bank.

Iceland has a population of 320,000, substantially fewer that the city of Edinburgh. The banking crisis has resulted in its currency, the krona, losing more than half its value against the euro since 2007, scores of people have lost large amounts of money, consumption has fallen by close on a quarter and unemployment, which before the crisis was negligible, has risen dramatically.

For Iceland, this is not just a recession, it is a depression. It is a systemic failure of a kind not seen in an advanced European country since the Second World War.

The situation has arisen because the three Icelandic banks, Glitnir, Landsbanki and Kaupthing, expanded recklessly during the boom years to the point where their combined debt exceeded six times Iceland's gross domestic product.

Membership of the European Economic Area gave free trading status with the European Union and its banks the right to operate in other European countries, provided there was an insurance scheme to protect depositors. Iceland had such a scheme, financed by the banks that gave protection up to 20,000.

But the funds now available do not meet this commitment, and the British and Dutch governments, who decided to protect retail depositors in Icesave accounts fully when the bank failed, are trying to reclaim from Iceland the part of that cost that the insurance scheme should have covered.

This amounts to 3.9 billion and is close to 50 per cent of Iceland's reduced GDP.

The deal involves payment over 15 years, with interest at 5.5 per cent. Icelanders consider this interest rate to be unreasonable when central bank rates are close to zero.

It is hard to see this deal as anything other than crippling for the economy, and it is not hard to understand how the Icelanders feel. If a deal were imposed on Scottish taxpayers to meet the cost of money lost by English and overseas depositors as a result of reckless expansion by the Scottish banks, the reaction would be equally strong.

The humiliating failure of the Scottish banks is sometimes used as an argument against Scottish independence, on the grounds that a Scottish government could never afford the cost that the UK government has had to bear to save the two Scottish banks. But the issue is not as simple as this, and Iceland, where the banks actually failed, rather than being propped up, does not offer a parallel.

I have always assumed that, had Scotland been independent when RBS and HBOS got into difficulty, the Scottish and UK governments would have had to negotiate urgently on how to support them. Although both banks were headquartered in Scotland, their activities in England were greater than in Scotland and no government in Westminster could contemplate the consequences of their failure.

Governments bail out banks because the consequences of letting them fail would be too serious for the economy. No doubt it would be a difficult negotiation, but there is a precedent for this with the Fortis bank, where the governments of Belgium, the Netherlands and Luxembourg jointly supported it when it was threatened with insolvency.

The particular problem with Icesave arises because it was a branch of Landsbanki and therefore not subject to regulation by the UK Financial Services Authority.

As a branch, it was regulated by the Icelandic authorities and covered only by Iceland's deposit protection scheme. Had it been set up as a subsidiary company in the UK, it would have been regulated by the SFA and would also have come within the scope of the UK government's deposit protection scheme.

Kaupthing, one of the other Icelandic banks, owned the UK bank Singer and Friedlander, which was a subsidiary company, and no claim on the Icelandic taxpayer can be made by its depositors from the failure of its parent bank.

Several lessons need to be learned from this saga. First, cross-border banking, if that involves guarantees that may ultimately fail to be paid by taxpayers in the parent bank's country, is not sustainable. Operations outside the parent country, if undertaken at all, must be through a subsidiary company regulated in the country where it operates, with the deposit insurance scheme that applies there.

Secondly, banks can be too big for a country to support. The financial crisis has shown that the taxpayer is the lender of last resort for banks in distress. Iceland's banks were certainly too big for its economy, but the same might be said of Ireland's banks, or even Britain's banks, since they are going to leave taxpayers with a huge burden for many years to come. If Scotland were to become independent, this would be an issue here.

Finally, depositors need to be much more alert to risk than they have been. British local authorities had increased their deposits with Iceland's banks dramatically to 953 million just before they failed, and even the Audit Commission invested money because their interest rates were higher than elsewhere.

But this should have been a sign of weakness: Iceland's banks were offering high interest in a desperate attempt to attract funds.

The downgrading of the banks by the credit rating agencies should also have given a warning.

Not surprisingly, the Icelanders took exception to the British government's use of anti-terrorism legislation to freeze UK accounts in their banks, and I do not think that bullying Iceland, as Lord Myners appears to be doing by threatening to block its application to join the EU, is either acceptable or sensible.

Whatever the strict legal position, forcing impoverishment on Iceland's population is neither justified morally, nor serves our interest. Besides, it ill befits Britain to lecture anyone on how to run their financial sector when we have made such a mess of our own.

The main difference between Britain and Iceland is that there fewer Icelanders to pay for the bankers' mistakes.