EN Official Journal of the European Union L 144/169

Public version of (1)

EFTA SURVEILLANCE AUTHORITY DECISION

No 291/12/COL

of 11 July 2012

on restructuring aid to Arion Bank (Iceland)

The EFTA Surveillance Authority (‘the Authority’)

HAVING REGARD to the Agreement on the European Economic Area (‘the EEA Agreement’), in particular to Article 61(3)(b) and Protocol 26 thereof,

HAVING REGARD to the Agreement between the EFTA States on the Establishment of a Surveillance Authority and a Court of Justice (‘the Surveillance and Court Agreement’), in particular to Article 24,

HAVING REGARD to Protocol 3 to the Surveillance and Court Agreement (‘Protocol 3’), in particular to Article 1(3) of Part I, Article 7(3) of Part II, and Article 13 of Part II,

Whereas:

I. FACTS

1. PROCEDURE

(1) Following informal correspondence in October 2008, and the passing on 6 October by the Icelandic Parliament (the Althingi) of Act No 125/2008 on the Authority for Treasury Disbursements due to Unusual Financial Market Circumstances etc. (referred to as the ‘Emergency Act’), which gave the Icelandic state wide-ranging powers to intervene in the banking sector, the President of the Authority wrote on 10 October 2008 to the Icelandic authorities and requested that state aid measures taken under the Emergency Act be notified to the Authority. Further contact and correspondence followed periodically including notably a letter sent by the Authority on 18 June 2009 reminding the Icelandic authorities of the need to notify any state aid measures, and of the standstill clause in Article 3 of Protocol 3. Following further correspondence and meetings, state aid involved in the restoration of certain operations of (old) Kaupthing Bank and the establishment and capitalisation of New Kaupthing Bank (renamed Arion Bank as from 21 November 2009) was eventually notified retrospectively by the Icelandic authorities on 20 September 2010.

(2) By letter dated 15 December 2010 (2) the EFTA Surveillance Authority (‘the Authority’) informed the Icelandic authorities that it had decided to initiate the procedure laid down in Article 1(2) of Part I of Protocol 3 in respect of the measures undertaken by the Icelandic State to restore certain operations of (old) Kaupthing Bank hf and establish and capitalise New Kaupthing Bank hf, now renamed Arion Bank (the opening decision) (3). The Authority also required that a detailed restructuring plan for Arion Bank be submitted within six months.

(3) By letter dated 24 March 2011 (4), the Authority received one comment from interested parties, which was forwarded to the Icelandic authorities on 25 May 2011. The Icelandic authorities did not respond to this comment.

(4) By letter of 31 March 2011, the Icelandic authorities submitted a restructuring plan for Arion Bank. An updated restructuring plan was submitted by e-mail on 30 April 2012.

(5) The Authority requested information with regards to the restructuring plan on 11 July 2011 and 13 February 2012. Replies to the requests for information were received from the Icelandic Authorities on 26 October 2011, 16 April 2012, 30 April 2012, 21 May 2012 and 6 July 2012. The final versions of the commitments made by the Icelandic authorities and Arion Bank were submitted on 3 July 2012 (5).

(6) In addition, the Authority's representatives met with the Icelandic authorities and representatives of Arion Bank on 7 June 2011 and 27-28 February 2012.

2. BACKGROUND

(7) The Authority will describe in this section those events, facts and economic, political and regulatory developments relating to the collapse and the reconstruction of the Icelandic financial system from October 2008 to date that appear necessary to set out the context in which the assessment of aid measures at hand is undertaken. Before doing so, it will recall in turn the chronology of Kaupthing Bank's breakdown.

2.1. The collapse of Kaupthing Bank

(8) In September 2008 a number of major global financial institutions began to experience severe difficulties. In the midst of the turbulence in global financial markets, Iceland's three biggest commercial banks, which had experienced extraordinary growth over the preceding years, encountered difficulties in refinancing their short term debt and a run on their deposits. Lehman Brothers filed for bankruptcy protection on 15 September, and on the same day it was announced that the Bank of America was to take over Merrill Lynch. Elsewhere, one of the United Kingdom's biggest banks, HBOS, had to be taken over by Lloyds TSB.

(9) The problems in the Icelandic financial sector unfolded more clearly on 29 September 2008, when the Icelandic Government announced that it had reached an agreement with Glitnir Bank whereby it would inject 600 million euros of equity into the bank in return for 75 % of its shareholdings. However, the Government's planned take-over of Glitnir Bank failed to reassure markets and was subsequently abandoned. The share prices of the three commercial banks plummeted and credit ratings were downgraded.

(10) Withdrawals of deposits from non-domestic branches of Landsbanki and Kaupthing increased dramatically and domestic branches also experienced massive withdrawals of cash. On the first weekend in October it became clear that another one of the three large banks, Landsbanki, was in severe difficulty. Glitnir Bank and Landsbanki were taken over by the FME on 7 October 2008. For a while it was hoped that Kaupthing Bank could escape the same fate and on 6 October 2008, the CBI granted Kaupthing a loan to the amount of 500 million euros against collateral in Kaupthing's Danish subsidiary, FIH Erhvervsbanken. However, the loan agreements and debt securities of Kaupthing Bank generally contained a clause stating that in the event of one of the bank's large subsidiaries defaulting, this would constitute a default by Kaupthing Bank which could lead to the bank's loans becoming due. On 8 October 2008, the UK authorities placed Kaupthing's subsidiary in Britain, Kaupthing Singer & Friedlander (KSF), under cessation of payments. The following day, the FME took control of the bank using powers conferred upon it by the Emergency Act.

2.2. The financial crisis and major causes of failure of the Icelandic banks

(11) In their notification of the aid granted to Arion Bank, the Icelandic authorities explained that the reasons for the collapse of the Icelandic banking sector and their need to intervene were set out in considerable detail in a report prepared by a Special Investigation Commission (‘SIC’) established by the Icelandic Parliament (6), whose remit was to investigate and analyse the processes leading to the collapse of the three main banks. The Authority summarises below the conclusions of the Commission concerning the causes of failure most relevant to the demise of Kaupthing Bank. The information is drawn from Chapters 2 (Executive Summary) and 21 (Causes of the Collapse of the Icelandic Banks — Responsibility, Mistakes and Negligence) of the SIC report.

(12) The global reduction in liquidity in financial markets that began in 2007 eventually led to the collapse of the three main Icelandic banks, whose business operations had become increasingly dependent on raising funding through international markets. The reasons for the demise of the Icelandic banks were however complex and numerous. The SIC investigated the reasons which led to the collapse of the main banks, and it is notable that the majority of the conclusions applied to all three banks and many are inter-related. Causes of failure related to the banks' activities are briefly summarised below.

Excessive and unsustainable expansion

(13) The SIC concluded that in the years leading up to the collapse the banks had expanded their balance sheets and lending portfolios beyond their own operational and managerial capacity. The combined assets of the three banks had increased exponentially from 1,4 trillion ISK (7) in 2003 to 14,4 trillion ISK at the end of the second quarter of 2008. Significantly, a large proportion of the growth of the three banks was in lending to foreign parties, which increased substantially during 2007 (8), most notably after the beginning of the international liquidity crisis. This led the SIC to conclude that much of this increase in lending resulted from loans made to undertakings that had been refused credit elsewhere. The report also concluded that inherently riskier investment banking had become an ever increasing feature of the banks' activities and growth had contributed to the problems.

The reduction in finance available on the international markets

(14) Much of the banks' growth was facilitated by access to international financial markets, capitalising upon good credit ratings and access to European markets through the EEA Agreement. The Icelandic banks borrowed 14 billion euros on foreign debt securities markets in 2005 on relatively favourable terms. When access to European debt securities markets became more limited, the banks financed their activities on US markets, with Icelandic debt securities packaged into collateralised debt obligations. In the period before the collapse, the banks were increasingly reliant on short-term borrowing, leading to major and, according to the SIC, foreseeable re-financing risks.

The gearing of the banks' owners

(15) In the case of each major Icelandic bank, the principal owners were among the biggest debtors (9). The SIC was of the view that certain shareholders had abnormally easy access to borrowing from the banks in their capacity as owners. The biggest shareholder in Kaupthing Bank was Exista hf., with just over a 20 % share in the bank. Exista was also one of the bank's biggest debtors. During the period from 2005 to 2008, Kaupthing's total lending to Exista and related parties (10) increased steadily from 400-500 million euros to 1 400-1 700 million euros and during 2007 and 2008 such lending was nearly equal to the bank's capital base. This increase in lending to major shareholders occurred despite the fact that Kaupthing was starting to face liquidity and refinancing problems. Loans to related parties were also often granted without any specific collateral (11). Kaupthing's Money Market Fund was the biggest fund of the Kaupthing Bank Asset Management Company and in 2007 the fund invested significantly in bonds issued by Exista. At year end it owned securities to the value of around 14 billion ISK. This represented approximately 20 % of the fund's total assets at that time. Robert Tchenguiz owned shares in Kaupthing Bank and Exista and also sat on the board of Exista. He also received major loan facilities from Kaupthing Bank in Iceland, Kaupthing Bank Luxembourg and Kaupthing Singer & Friedlander (KSF). In total, the loan facilities Robert Tchenguiz and related parties had received from Kaupthing Bank's parent company at the collapse of the bank amounted to around 2 billion euros (12).

Concentration of risk

(16) Related to the issue of the abnormal exposure to major shareholders was the conclusion of the SIC that the banks' portfolios of assets were insufficiently diversified. The SIC was of the view that European rules on large exposure were interpreted in a narrow way, in particular in the case of the shareholders, and that the banks had sought to evade the rules.

Weak equity

(17) Although the capital ratio of Kaupthing and the other two major Icelandic banks was always reported to be slightly higher than the statutory minimum, the SIC concluded that the capital ratios did not accurately reflect the financial strength of the banks. This was due to risk exposure of the banks' own shares through primary collaterals and forward contracts on the shares. Share capital financed by the companies themselves, referred to by the SIC as ‘weak equity’ (13), represented more than 25 % of the banks' capital bases (or over 50 % when assessed against the core component of the capital, i.e. shareholders' equity less intangible assets). Added to this were problems caused by the risk that the banks were exposed to by holding each other's shares. By the middle of 2008 direct financing by the banks of their own shares, as well as cross-financing of the other two banks' shares, amounted to approximately 400 billion ISK, around 70 % of the core component of the capital. The SIC was of the opinion that the extent of financing of shareholders' equity by borrowing from the system itself was such that the system's stability was threatened. The banks held a substantial amount of their own shares as collateral for their lending and therefore as share prices fell the quality of their loan portfolios declined. This affected the banks' performance and put further downward pressure on their share prices; in response to which (the SIC assumed from the information in their possession), the banks attempted to artificially create abnormal demand for their own shares.

The size of the banks

(18) In 2001 the balance sheets of the three main banks (collectively) amounted to just over a year of the gross domestic product (GDP) of Iceland. By the end of 2007 the banks had become international and held assets worth nine times the Icelandic GDP. The SIC report notes that by 2006, observers were commenting that the banking system had outgrown the capacity of the CBI and doubted whether it could fulfil the role of lender of last resort. By the end of 2007 Iceland's short-term debts (mainly incurred due to financing of the banks) were 15 times larger than the foreign exchange reserves, and the foreign deposits in the three banks were also 8 times larger than the foreign exchange reserves. The Depositors and Investors Guarantee Fund held minimal resources in comparison with the bank deposits that it was meant to guarantee. These factors, the SIC concludes, made Iceland susceptible to a run on its banks.

The sudden growth of the banks in comparison with the regulatory and financial infrastructure

(19) The SIC concluded that the relevant supervisory bodies in Iceland lacked the credibility that was necessary in the absence of a sufficiently resourced lender of last resort. The report concludes that the FME and CBI lacked the expertise and experience to regulate the banks in difficult economic times, but that they could have taken action to reduce the level of risk that the banks were incurring. The FME, for example, did not grow in the same proportion as the banks and the regulator's practices did not keep up with the rapid developments in the banks' operations. The report is also critical of the Government, concluding that the authorities should have taken action to reduce the potential impact of the banks on the economy by reducing their size or requiring one or more banks to move their headquarters abroad (14).

Imbalance and overexpansion of the Icelandic economy as a whole

(20) The SIC report makes reference to events concerning the wider economy that also impacted upon the banks' rapid growth and contributed to the imbalance in size and influence between the financial services sector and the remainder of the economy. The report concluded that government policies (in particular fiscal policy) most likely contributed to the overexpansion and imbalance and that the CBI's monetary policy was not sufficiently restrictive. The report also refers to relaxing the Icelandic Housing Financing Fund's lending rules as ‘one of the biggest mistakes in monetary and fiscal management made in the period leading up to the banks' collapse’ (15). The report is also critical of the ease with which the banks were able to borrow from the CBI, with the stock of CBI short-term collateral loans increasing from 30 billion ISK in the autumn of 2005 to 500 billion ISK by the beginning of October 2008.

The Icelandic króna, external imbalances and CDS spreads

(21) The report notes that in 2006, the value of the Icelandic króna was unsustainably high, the Icelandic current account deficit was over 16 % of GDP, and liabilities in foreign currencies less assets neared total annual GDP. The prerequisites for a financial crisis were in place. By the end of 2007 the value of the króna was depreciating and credit default swap spreads (CDS) on Iceland and the banks rose exponentially.

2.3. Measures taken to reconstruct the banking sector

(22) Following the collapse of the three biggest commercial banks in October 2008 (including Kaupthing) the Icelandic authorities were faced with the unprecedented challenge of safeguarding continued banking operations in Iceland (16). The policy followed by the Icelandic Government is primarily laid down in the Emergency Act (17) adopted by the Icelandic Parliament on 6 October 2008. The law grants extraordinary powers to the FME to take control of financial undertakings and to dispose of their assets and liabilities as required. The Minister of Finance was authorised, on behalf of the Treasury, to disburse funds in order to establish new financial undertakings. Moreover, in bankruptcy proceedings of financial undertakings, deposits would be given priority over other claims. The Government declared that deposits in domestic commercial and savings banks and their branches in Iceland would be fully protected.

(23) Policy priorities focused initially on securing the basic functioning of the domestic banking, payment and settlement systems. In the first weeks after the crash, the Icelandic Government also prepared an economic program in collaboration with the International Monetary Fund (‘IMF’), leading to the approval on 20 November 2008 of Iceland's request for a two year stand-by-arrangement from the Fund, which included a 2,1 billion USD loan from the IMF aimed at strengthening Iceland's currency reserves. Additional loans of up to 3 billion USD were secured from other Nordic countries as well as certain other trading partners. Of the IMF loan, 827 million USD was made available immediately, while the remaining amount was disbursed in eight equal instalments, subject to quarterly reviews of the program.

(24) The IMF Program was a broad-based stabilisation program focusing on three key objectives. Firstly, to stabilise and restore confidence in the króna so as to contain the negative impact of the crisis on the economy. The measures included the introduction of capital controls aimed at stemming capital flight. Secondly, the program included a comprehensive bank restructuring strategy, ultimately aimed at rebuilding a viable financial system in Iceland as well as safeguarding the country's international financial relations. Among subsidiary goals was to ensure fair valuation of the banks' assets, maximise asset recovery and strengthen supervisory practices. Thirdly, the program aimed at ensuring sustainable public finances, by limiting the socialisation of losses in the failed banks and implementing a medium-term fiscal consolidation program.

(25) The Icelandic authorities have underlined that due to the exceptional circumstances linked to the large size of the banking system in relation to the financial capacity of the Treasury, the policy options available to the authorities were limited. The solutions relied upon were therefore in many ways different to the measures taken by the governments of other countries facing threats to financial stability.

(26) On the basis of the Emergency Act, the three large commercial banks, Glitnir Bank, Landsbanki Íslands and Kaupthing Bank, were split into ‘old’ and ‘new’ banks. The Minister of Finance founded three limited liability companies to take over the domestic operations of the old banks and appointed them boards of directors. The FME took control of the old banks, allocated essentially their domestic assets and liabilities (deposits) to the new banks which continued banking operations in Iceland, while the old banks were placed under the supervision of their respective resolution committees (18). Foreign assets and liabilities were in the main placed in the old banks, which were later submitted to winding-up procedures and the eventual closure of all foreign operations (19).

(27) In the provisional opening balance sheets of the three new banks of 14 November 2008 it was estimated that the banks' combined total assets would amount to 2 886 billion ISK, with an equity to be provided by the State of 385 billion ISK. The total amount of bonds to be issued by the new banks in favour of the old banks as payment for the value of the assets transferred in excess of liabilities was estimated at 1 153 billion ISK. The FME appointed Deloitte LLP to perform assessments of the value of transferred assets and liabilities. In this process it transpired that the independent assessment would not result in fixed values of net assets transferred but valuations within certain ranges. It also emerged that the banks' creditors raised disagreements concerning the valuation process, which they considered not to be impartial, and complained that they were unable to protect their interests. These complications resulted in a change of policy for settling the accounts between the old and the new banks, entailing that instead of relying on valuations by an independent expert, the parties would try through negotiations to reach agreements on the value of the net assets transferred.

(28) It was clear that it would be difficult for the parties to reach agreements on the valuations as they were evidently subject to numerous assumptions on which the parties were likely to disagree. The state aimed to reach agreements on base evaluations providing a firm foundation for the initial capitalisation of the new banks. Price performance of assets in excess of the base evaluation could be attributed to the creditors in the form of contingent bonds or increases in the value of the banks' share capital, as it had emerged in the negotiations that the resolution committees of Glitnir and Kaupthing and a majority of their creditors could be interested to acquire holdings in the new banks, and this would allow them to benefit from potential increases in the values of the assets transferred.

(29) The full capitalisation of the three new banks and the basis of agreements with the creditors of the old banks was announced on 20 July 2009. The Government, as the sole owner of the three new banks, reached heads of agreements with the resolution committees of the old banks in relation to how compensation for the transfer of net assets into the new banks would be achieved and paid for. With regard to two of the new banks, Íslandsbanki and Arion Bank, this included conditional agreements for the old banks to subscribe for majority equity interests in the new banks.

(30) On the basis of the above tentative agreements, the resolution committees of the old banks decided in October 2009 (Glitnir) and December 2009 (Kaupthing Bank and Landsbanki Islands) to exercise the negotiated options and subscribe to shareholding in the new banks. On 18 December 2009 the Government announced that bank reconstruction had been concluded and that agreements had been reached between the Icelandic authorities and the new banks, on the one hand, and the resolution committees of Glitnir Bank, Landsbanki Íslands and Kaupthing Bank on behalf of their creditors, on the other hand, on settlements concerning assets which were transferred from the old banks to the new ones, and that the new banks were then fully financed.

(31) As it turned out, the Treasury's contribution to the new banks' equity was reduced substantially, from 385 billion ISK as originally envisaged to 135 billion ISK in the form of share capital and, in the case of two of the three banks, Íslandsbanki and Arion Bank, approximately 55 billion ISK of Tier II capital in the form of subordinated loans or a total of 190 billion ISK. In addition, the Treasury provided Íslandsbanki and Arion Bank with certain liquidity facilities. The share capital provided by the old banks to the new ones amounted in total to approximately 156 billion ISK. Total capitalisation of the new banks therefore amounted to approximately 346 billion ISK. Thus, instead of maintaining full ownership of the three banks, the agreements implied that the state's holdings would be reduced to approximately 5 % in the case of Íslandsbanki, 13 % in the case of Arion Bank and 81 % in the case of Landsbankinn.

(32) While this takeover of two of the three banks by the creditors of the old banks resolved major issues in the rebuilding of the financial sector and established firmer capital foundation for the new banks, numerous weaknesses remained which needed to the addressed. Since the autumn of 2009, the banks have concentrated their efforts mostly on internal issues, determining the overall strategy for their operations and in particular restructuring their loan portfolios, which represent the greatest risk factor to their operations and long-term viability. The restructuring process has been complex due to various complicating factors, including Supreme Court rulings on illegality of loans granted in ISK but indexed to foreign currencies. As for Arion Bank, in so far as relevant for its restructuring, these matters are discussed further below.

2.4. Macroeconomic environment

(33) Major economic turbulence followed the collapse of the banking system in October 2008. The difficulties in Iceland's financial system were coupled with a breakdown of confidence in its currency. The króna depreciated sharply in the first quarter of 2008 and again in the autumn, before and after the failure of the three commercial banks. Despite capital controls imposed in the autumn of 2008, currency volatility prevailed in the course of 2009 (20). This turmoil resulted in a severe recession in Iceland's economy, with a contraction of GDP by 6,8 % in 2009 and 4 % in 2010.

(34) Among the implications of the economic crisis was a sudden increase in unemployment from 1,6 % in 2008 to 8 % in 2009, a hike in inflation and a drop in real wages. Moreover, there was a sharp rise in corporate and household debt and of the share of non-performing loans in the banks' loan portfolios as well as a large scale takeover by the new banks of businesses in financial distress. At the same time the high fiscal cost of restructuring the banking system led to a sharp rise in the fiscal deficit and a major surge in public sector debt.

(35) Following the deep recession provisional data from Statistics Iceland indicates a turnaround in the second half of 2011 and for the whole year a growth of GDP of 3,1 % compared to the previous year.

(36) Economic growth in 2011 was mostly due to an increase in domestic demand, particularly a 4 % rise in private household consumption. This was supported by increases in wages and social benefits as well as certain policy initiatives undertaken to ease the payment burden of household debt, including a temporary interest rate subsidy, the freezing of payments on loans and the early reimbursement of private pension savings. Provisional data for 2011 also indicate a slow increase in investments, however from a particularly low level (21). Public consumption has remained at a subdued level during the past three years.

(37) The general macroeconomic data disguise more significant sectoral differences. In addition to the collapse in the financial sector a major contraction has taken place in construction and many other domestic production and service activities. Growth has on the other hand taken place in certain export sectors. Due to the low exchange rate of the króna and relatively stable prices in foreign currency for both marine and aluminium products, export revenue rose following the onset of the economic crisis, also with respect to tourism and other services exports. At the same time, imports fell sharply, turning the trade balance (22) temporarily to a surplus of approximately 10 % of GDP in 2010. However, with increased domestic demand in 2011, imports have grown again, leading to an overall smaller trade surplus of 8,2 % of GDP.

(38) Statistics Iceland forecast for 2012-2017 assumes that gradual economic recovery will continue with 2,6 % growth in 2012. A similar growth rate is expected throughout the forecast period. This forecast is however subject to several uncertainties. Planned large scale industrial investments might be further delayed. Iceland's terms of trade would be negatively affected by a prolonged recession in the main trading countries, implying a lower growth rate in Iceland. Slower progress than anticipated in tackling the debt burden of households and corporations would furthermore restrain domestic demand and the growth prospects of the economy. Growth could also be threatened by continued price instability linked to currency volatility in the context of removal of capital controls.

2.5. Financial supervision and improvements in regulatory framework

(39) Following the FME's initial work linked to the foundation of the new banks and the assessment of the value of the net assets transferred from the old banks, the FME conducted in the spring of 2009 an audit of the new banks and their business plans, financial strength and capital requirements in a so-called sign-off project. This was done with the assistance of the international management consultant firm Oliver Wyman.

(40) Having concluded the above process, the FME granted the banks operating licenses subject to various conditions. In view of the quality of the asset portfolios and the anticipated economic uncertainty, it was considered necessary to place higher capital requirements on the three banks than the statutory minimum. The FME therefore set the minimum capital adequacy (CAD) ratio for the three banks at 16 %, thereof a minimum of 12 % for the Tier I capital ratio. The requirements were applicable for at least 3 years unless reviewed by the FME. Liquidity conditions were also specified, requiring that available liquid funds should at any point amount to a minimum of 20 % of deposits and that cash or cash equivalents should amount to at least 5 % of deposits. Furthermore, requirements were made regarding other matters such as restructuring of loan portfolios, risk assessment, corporate governance and ownership. Comparable capital requirements were introduced by the FME regarding other financial undertakings.

(41) The economic stabilisation program established in consultation with the IMF provided for a review of the entire regulatory framework of financial services and supervision to improve defence against future financial crisis. The Government invited the former Director-General of the Finnish Financial Supervisory Authority, Mr Kaarlo Jännäri, to carry out an assessment of the existing regulatory framework and supervisory practices. Among the improvements proposed by Mr Jännäri was the creation of a National Credit Registry at the FME to diminish credit risks in the system. His report also suggested to lay down tougher rules and a stricter practice on large exposures and connected lending as well as to conduct more on-site inspections to verify off-site supervision and reports, particularly on credit risk, liquidity risk and foreign exchange risk. It was also recommended to review and improve the deposit guarantee system, following closely the developments within the EU.

(42) The Government subsequently proposed a bill of law to the Althingi, based, inter alia, on proposals made by Jännäri as well as amendments made to EEA law on financial activities from 2009 onwards, which was adopted and entered into force on 1 July 2010, as Act No 75/2010. With the new law, extensive amendments were made to the Act on Financial Undertakings. Several other amendments were later introduced to the law on financial undertakings as well as of regulation and supervision of financial services. These regulatory amendments are considered in more detail in the Annex.

2.6. Main challenges ahead (23)

(43) Despite major achievements in rebuilding a financial sector, Iceland continues to strive with the repercussions of the financial and currency crisis in the autumn of 2008. The financial crisis has revealed various flaws and deficiencies in the financial system, which must be addressed, if public confidence is to be restored. It seems evident that Iceland — as many other countries hard hit by the financial crisis — faces numerous challenges in adapting the legal and operating environment of financial services to support a viable and efficient financial system in the future and reduce as much as possible the risk of further systemic shocks to reoccur.

(44) The most immediate challenges currently facing Icelandic financial undertakings are linked to the fact that the banks are operating in a sheltered environment with capital controls and a blanket deposit guarantee. The banks now need to prepare themselves to operate in a more exposed environment, when the capital controls are removed and deposit guarantees revert to the arrangement set out in the relevant EU/EEA directives (24). The Icelandic authorities have underlined that extreme caution must be exercised when introducing new rules in this regard.

(45) Another major challenge is the need to adapt further the legal and regulatory framework to support a solid and efficient financial system which is also consistent with EEA and international law developments (25).

2.7. The state of competition in the Icelandic financial sector

(46) According to recent information from the Icelandic authorities (26), competition on the financial market has changed radically since the banking collapse. The number of financial undertakings has decreased, as several savings banks, commercial banks and specialised lenders are either being wound up or have been merged with other undertakings (27). The number of financial undertakings is still decreasing, most recently with the mergers of Landsbankinn and SpKef in March 2011, of Íslandsbanki and Byr in December 2011 and the merger of Landsbankinn and Svarfdaelir Savings Bank, approved by the Authority on 20 June 2012. With the reductions in the number of financial undertakings and the larger banks taking over deposits from the banks closing down, concentration in the domestic market has increased. The overall presence of the new banks on the EEA financial markets is on the other hand much smaller than that of their predecessors, as international banking operations have been closed down.

(47) In addition, the domestic market has shrunk considerably as certain sub-markets have disappeared or are largely subdued. The near disappearance of the stock market and the introduction of capital controls have reduced operations in the stock and currency markets and resulted in limited investment options. With the level of investments in the economy at a historically low level and households and companies generally highly leveraged, demand for credit is low. Since the collapse, the banks have concentrated their efforts on internal issues and restructuring of their loan portfolios as well as the restructuring of some of their major corporate clients.

(48) Before the financial crisis, the savings banks accounted collectively for a market share of approximately 20-25 % in deposits. This has now collapsed to approximately 2-4 %. The market shares lost by the savings banks and commercial banks exiting the market have been gained by the three major commercial banks, Arion Bank, Íslandsbanki and Landsbanki. Combined the three big banks now account for approximately 90-95 % of the market instead of 60-75 % earlier on, where Landsbankinn's market share is marginally highest. Apart from the 10 regional savings banks, currently accounting for approximately 2-4 % of the market, the only other market player is the restructured MP Bank (28), with a market share of approximately 1-5 %.

(49) The Icelandic financial market is thus clearly oligopolistic and the three largest companies could collectively achieve a dominant market position. According to the Icelandic Competition Authority (ICA), which the Authority had asked for its views on the state of competition in Iceland and potential remedies, there are significant entry barriers to the Icelandic banking market. This has detrimental effects on competition. There are also certain impediments for consumers to switch banks. The Icelandic authorities furthermore acknowledged that the exchange rate risks associated with Iceland's small and non-traded currency, the Icelandic króna, has further restricted competition and deterred foreign banks and companies from entering the Icelandic market.

(50) ICA has lately focused on a specific issue regarding IT infrastructure for the banks' operations and their cooperation in that regard. This relates to the financial institutions' jointly owned IT service provider, Reiknistofa bankanna (the Icelandic Banks' Data Centre; RB). This matter is of relevance for the assessment of the case at hand and was among the issues discussed by the Authority with the Icelandic authorities and the banks.

(51) RB is jointly owned by the three main Icelandic banks, two saving banks, the Icelandic Savings Bank Association and the three main payment card processors in Iceland. Landsbankinn owns 36,84 % of the shares in RB, Íslandsbanki holds 29,48 % and Arion Bank 18,7 %. Combined the three commercial banks therefore own 85,02 % of shares in RB. RB's clients are the owners, the Central Bank of Iceland and other financial institutions as well as other public entities. The banks' cooperation in this area is extensive, as RB has developed the clearing and settlement system in Iceland. It also provides a number of core banking solutions which are multi-tenant solutions, used by most of the Icelandic banks. RB furthermore operates an e-invoicing and e-payment system for corporates and consumers.

(52) According to ICA, the collapse in 2008 has made the smaller banks and savings banks particularly vulnerable. For the smaller financial undertakings, the required IT services were of crucial importance, as they can be viewed as one of the entry barriers for new market participants. The platform for IT services has been provided to a significant extent by RB as regards the bigger financial undertakings and, as regards the savings banks and smaller market players, by Teris. Following the closure of many smaller financial undertakings in recent years, Teris lost a significant share of its income, leading in January 2012 to the sale of some of its IT solutions to RB. According to RB and Teris, this transaction was, inter alia, aimed at securing continued provision of IT services to smaller financial undertakings.

(53) The ICA has been investigating two cases regarding RB. Firstly, whether the joint ownership and cooperation of the banks and other financial undertakings in the RB forum should be considered to be a breach of the ban on restrictive practices under Article 10 of the Icelandic Competition Act. Secondly, the compatibility of RB's purchase of Teris's major assets is being assessed under the merger provisions of the same act. However, in May 2012 these two cases were concluded with a settlement between RB and its owners, on the one hand, and the ICA on the other hand (29).

(54) Aside from the above concerns that relate directly to the Icelandic financial market, the ICA has in particular pointed to the need for the sale and restructuring of operating companies (30) to be completed without undue delay. Many operating companies have been taken over by the banks (being creditors of those companies) due to over indebtedness following the economic crash in 2008. According to ICA, it may create a conflict of interest when banks provide financial services to companies and own the companies at the same time. The ICA is of the opinion that the banks' direct and indirect ownership (31) is the most wide-spread and dangerous competition problem in the aftermath of the financial crisis, as this has an effect on almost every company and industry in Iceland. In ICA's view, faster restructuring of companies would improve competition in the financial market. When the banks' involvement in the restructuring of their corporate clients has been subject to the notification requirements under national merger control, the ICA has in this regard often set conditions regarding the banks' ownership. However, a comprehensive solution to the problem appears to be difficult, as it relates essentially to the high leverage of the Icelandic business sector.

(55) In their submission to the Authority, the three commercial banks, Arion Bank, Íslandsbanki and Landsbankinn, have all expressed the view that no major changes have taken place in the conditions of competition in the Icelandic financial market since autumn 2008 which should give cause for concerns. Effective competition prevailed in the market, without any evidence of collusive behaviour of the three biggest players. When examining the conditions of competition in the market, the ICA had overlooked certain key factors. Foreign banks, although without presence in Iceland, have for long and still are actively competing with Icelandic banks for the provision of corporate loans and other financial services to the biggest clients, such as undertakings in export-based activity (fisheries, power-intensive industry, etc.) as well as state and municipal activity.

(56) However, this view is contrary to the view expressed in the submission of the Icelandic authorities, as set out in the report referred to above by the Minister of Economic Affairs to the Althingi and to the views of ICA. Moreover, as will be outlined below, Arion Bank has, despite certain reservations regarding analysis of competition conditions, decided to provide certain commitments aimed at limiting distortion of competition linked to the aid measures concerned. Those commitments are reported in the Annex.

3. DESCRIPTION OF THE MEASURES

3.1. The beneficiary

(57) As described above, Kaupthing Bank collapsed in 2008, as did the two other large Icelandic commercial banks. So as to ensure the continuing operation of the domestic banking sector, the Icelandic authorities undertook certain measures to restore certain operations of (old) Kaupthing Bank hf, including the establishment and capitalisation of New Kaupthing Bank hf (now renamed Arion Bank).

3.1.1. Kaupthing Bank

(58) Prior to the financial crisis of 2008, Kaupthing Bank was the largest bank in Iceland. At the end of 2007 its balance sheet amounted to 5 347 billion ISK (58,3 billion Euros). Kaupthing was primarily a northern European bank operating in 13 countries. Kaupthing offered integrated financial services to companies, institutional investors and individuals, divided into five business segments: Corporate and Retail Banking, Capital Markets, Treasury, Investment Banking and Asset Management & Private Banking. In addition, the bank operated a retail branch network in Iceland, where it was headquartered, and to a lesser extent in Norway and Sweden. Kaupthing had banking licences through subsidiaries in Denmark, Sweden, Luxembourg and the UK and branches in Finland, Norway and the Isle of Man. Kaupthing's principal subsidiaries were Kaupthing Singer & Friedlander (UK) and FIH Erhvervsbank (Denmark), but the bank operated 16 other subsidiaries and branches in various countries in Europe, North America, Asia and the Middle East. At the end of 2007 the bank employed 3 334 people. Shares in the bank were listed on the OMX Nordic Exchange in Reykjavík and in Stockholm.

3.1.2. Arion Bank

(59) Kaupthing's successor, Arion Bank, is an Icelandic bank offering universal financial services to companies, institutional investors and individuals. The Bank aims to be a relationship bank with a focus on larger corporations and individuals seeking a broad range of financial solutions.

(60) The Arion Bank Group consists of the parent company and eight core subsidiaries which are an integral part of the Bank's operations (32).

(61) In relation to the recent and ongoing restructuring of its loan book, the Bank has taken over assets that are categorised as held for sale or if the recovery work is not finished, temporary operations. According to the Bank, it nevertheless endeavours to sell such assets without undue delay (33).

(62) Other key shareholdings are in Auðkenni (a holding company managing security keys for online banking; 20 %) and Reiknistofa bankanna (the Icelandic Banks' Data Centre, RB; 18,05 %). Arion Bank has closed down or is in the process of closing down a total of 15 companies, where the Bank has held equity interests. These companies are either in liquidation or have no assets or no operations.

(63) The main banking products fall into four categories: Asset Management, Investment Banking, Corporate Banking and Retail Banking, as further outlined below.

Asset Management

(64) This division consists of Sales and Services, Private Banking, and Institutional Asset Management. The Bank's subsidiary, Stefnir Asset Management Company, operates the fund management business and Arion Bank Asset Management is the main fund distributor. Asset Management is a leading participant in the Icelandic market with assets under management at Arion Bank and subsidiaries in excess of 659 billion ISK at the end 2011.

(65) Asset Management is responsible for managing assets on behalf of its clients, including institutional investors, corporations, high net worth clients and retail investors. It serves clients with differing investment objectives, offering a broad range of services. In addition to a variety of mutual funds, alternative investment vehicles and pension plan schemes, the division offers customised asset allocation strategies and managed accounts. The division also offers funds from other leading global fund management companies.

Investment Banking

(66) Investment Banking provides various services to corporate clients through its four main product areas: — M&A advisory — Capital market transactions — Acquisition and leverage finance — Principal investments.

(67) The division aims to combine advisory with the Bank's financing capabilities, creating an integrated solution for clients, in close cooperation with other divisions of the Bank, in particular Capital Markets and Corporate Banking.

Corporate Banking

(68) Corporate Banking is organized into 7 departments: Corporate Lending; Specialised Lending; Legal & Documentation; Portfolio Management; Corporate Services; Recovery; and Factoring. Corporate Banking offers a range of financing services and products for its corporate clients, from medium-sized businesses to large corporations. The prime focus of the division is to maintain long-term relationships with its clients as well as deliver tailor-made solutions and personalised services.

(69) Arion Bank considers that it is at the forefront in resolving corporate debt issues and has made considerable progress with the restructuring of companies. The Recovery unit within Corporate Banking is responsible for the Bank's debt recovery, i.e. the restructuring of companies which are experiencing payment difficulties. The work has progressed well and is close to completion.

Retail Banking

(70) Retail Banking has a 30 % market share in Iceland. There are 24 branches throughout Iceland and over 100 000 customers. The branches provide a comprehensive range of services, including advice on deposits and loans, payment cards, pension savings, insurance, funds and securities.

(71) The branch network is divided into seven clusters, each with its own business manager. Smaller branches capitalise on the strength of larger units within each cluster. More executive authority and responsibility is transferred to the branches and therefore closer to the customers. According to the Bank, this arrangement helps coordinate procedures and fully harness the expertise within the branches. Four of these business managers work in the greater Reykjavík area and three in larger urban areas. This structure is designed to reinforce the links between branches in the same part of the country.

Indications of market shares

(72) According to Arion Bank's calculations, its market share in deposits, based on the annual reports of Icelandic banks and savings banks, is [> 30] % or marginally lower than the shares of Landsbankinn ([> 30 %]) and Íslandsbanki ([> 30 %]). Other market players with only minor significance are MP Bank ([< 5 %]) and savings banks (collectively [< 5 %]).

(73) Arion Bank's share in loans to customers is approximately [15-25] % or similar to that of Íslandsbanki and slightly lower than Landsbankinn. The Housing Financing Fund has the biggest share in this market, [> 25] %. When counted collectively, pension funds also have a significant share in this market or [5-10] %, while the shares of other market players are insignificant.

(74) Arion Bank's market share in trade on the Icelandic Stock Exchange measured by turnover in the first 14 weeks in 2012 was [10-20] %, but the shares of each of the other commercial banks, Íslandsbanki, Landsbankinn and MP Bank, were [20-25] %.

3.2. Comparing the old and the new bank

(75) An indicative comparison of key financials in the old and new banks' balance sheets presented in Table 1 reveals a vast difference in the size and scope of the two operations (34). Arion Bank's total assets at the end of 2009 were only 11,5 % of those of Kaupthing Bank at mid-year 2008. The loan portfolio is the largest single asset category. The book value of Kaupthing Bank's loan portfolio at the end of June 2008 was 4 169 billion ISK compared to Arion Bank's loan portfolio of 358 billion ISK at the end of 2009, 8,6 % of that of Kaupthing. There is also a significant change in securities holdings of Arion Bank compared to Kaupthing Bank. Shares and derivatives are reduced by 96-100 %. The reduction is smaller as regards bonds, as bonds held by Arion Bank amounted to 25,7 % of Kaupthing Bank's holdings. Table 1 Comparison of Arion Bank and Kaupthing Bank balance sheets, amounts in billion ISK Kaupthing 30.6.2008 Arion 31.12.2009 Arion as % of Kaupthing Total assets 6 603 757 11,5 — Loans and receivables to customers 4 169 358 8,6 — Bonds and debt instruments 676 173 25,7 — Shares and equity instruments 172 7 4,1 Total liabilities 6 166 667 10,8 — Deposits 1 848 495 26,8 Total equity 438 90 20,6

(76) The income statements of the two entities display a similar difference is size and scope. Comparing Arion Bank in 2009 and Kaupthing Bank in 2007, net interest income of Arion Bank amounts to 15,2 % of Kaupthing and net fee and commission income of Arion was 10,7 % of that of Kaupthing. Arion Bank employed 1 057 people at the end of 2009 (including employees of subsidiaries) compared to Kaupthing Bank's 3 334 employees at the end of 2007. The total number of employees at Arion was therefore 32 % of the corresponding total for Kaupthing (35). Comparing the Icelandic operations of both banks, Kaupthing employed 1 133 people for the Icelandic operations (excluding employees of subsidiaries) at the end of June 2008, whereas in Arion Bank, there were 952 employees (excluding subsidiaries) at the end of 2009. Table 2 Comparison of Arion Bank and Kaupthing Bank income statements, amounts in billion ISK Kaupthing 2007 Arion 2009 Arion as % of Kaupthing Net interest income 80 12 15,2 Net fee and commission income 55 6 10,7 Operating income 166 50 29,9 Earnings before income tax 81 15 19,0

3.3. National legal basis

(77) The national legal basis for the aid measures is as follows: — Act No 125/2008 on the Authority for Treasury Disbursements due to Unusual Financial Market Circumstances etc., commonly referred to as the Emergency Act The Emergency Act gave the FME authority to intervene ‘in extreme circumstances’ and assume powers of financial institutions' shareholders meetings and board meetings, and decide on the disposal of their assets and liabilities. The FME was also granted power to appoint resolution committees to financial undertakings that it had taken over, which held the powers of shareholders' meetings. In winding up the institutions, the Act gives priority status to claims by deposit holders and deposit guarantee schemes. The Act also authorised the Icelandic Ministry of Finance to establish new banks. The Emergency Act includes amendments of the Act on Financial Undertakings, No 161/2002, the Act on Official Supervision of Financial Activities, No 87/1998, the Act on Deposit Guarantees and Investor-Compensation Scheme, No 98/1999, and the Act on Housing Affairs, No 44/1998. — Supplementary State Budget Act for 2008 (Article 4) — State Budget Act for 2009 (Article 6)

3.4. The aid measures

(78) The Icelandic authorities' intervention following the failure of Kaupthing Bank has been described above, and was set out in more detail in the opening decision. The essence of the interventions can be summarised as follows: The FME took control of Kaupthing on 9 October 2008, and domestic liabilities and (most) domestic assets were transferred to New Kaupthing. The old bank's estate was to be compensated for this transfer by receiving the sum of the difference between assets and liabilities. As determining this difference proved to be difficult and time-consuming, the State provided some initial capital and a commitment to contribute further capital if need be. It then capitalised the bank, before finally an agreement was reached between the State and the old bank on 1 December 2009, which led to the State's stake in the bank being reduced from 100 % to 13 % (36). The Authority considers this date — 1 December 2009 — to mark the beginning of the 5 year restructuring period, which will consequently last until 1 December 2014.

(79) The following section is limited to describing those aspects of the State's intervention that constitute measures relevant for assessment under Article 61 of the EEA Agreement.

3.4.1. Tier I capital

(80) The State provided Tier I capital twice — once, when New Kaupthing was created, and then again when it capitalised the bank fully (and retroactively); followed by an agreement with the old bank on behalf of its creditors according to which the State retained a 13 % stake in the bank.

3.4.1.1. Initial capital

(81) Following the establishment of New Kaupthing Bank in October 2008, the State provided 775 million ISK (37) (5 million Euros) in cash as initial capital to the new bank and in addition issued a commitment to contribute up to 75 billion ISK in total as Tier I risk capital to the new bank in return for its entire equity. The former figure corresponds to the minimum capital required under Icelandic law for the foundation of a bank. The latter figure was calculated as 10 % of an initial assessment of the likely size of the bank's total risk weighted assets. Appropriation to this amount was formally included in the state budget for the year 2009 as an allocation of government funds to address the extraordinary circumstances in financial markets. This allocation of capital was intended to provide an adequate guarantee for the operability of the bank until issues relating to its definite re-capitalisation could be resolved, including the size of its opening balances and a valuation of compensation payable to the old bank for assets transferred.

3.4.1.2. Capital injection and retention of a 13 % stake as a part of the settlement with the creditors of the old bank

(82) On 20 July 2009 the Icelandic Government announced that it had reached heads of agreement with the Resolution Committee of Kaupthing in respect of the initial capitalisation of New Kaupthing Bank (renamed Arion Bank as from 21 November 2009) and the basis for the compensation payable between the two parties. The Government conditionally agreed with the Resolution Committee of Kaupthing that the creditors should, through the Committee, be granted the option of acquiring majority shareholding in Arion Bank in order to facilitate the bank's independent development. This would in effect involve the old bank providing the majority of the capital in Arion Bank, as a part of the compensation agreement. In the event that Kaupthing Bank would not complete the subscription for shares in Arion Bank, the Government would retain full ownership.

(83) On 14 August 2009 the Government announced that it had committed to capitalise Arion Bank with 72 billion ISK of Tier I capital in the form of government bonds, giving the bank a Core Tier I ratio of approximately 12 %. The Government capitalisation of Arion Bank was executed on 9 October 2009, involving an injection of 71 225 million ISK into the bank, back-dated to 22 October 2008, in addition to the initial 775 million ISK in cash. Total Government share capital was therefore 72 billion ISK. In addition, the accrued interest on the government bond amounted to 9,2 billion ISK.

(84) On 4 September 2009 the Government announced that definitive agreements had been reached regarding the capitalisation of Arion Bank and the basis for compensation. In line with the heads of agreement of 20 July 2009, the agreement principally contained provisions for two alternative agreements: capitalisation under old bank (creditor) ownership (Joint Capitalisation Agreement) or capitalisation under Government ownership (Alternative Capitalisation Agreement) (38). Under the former agreement, the creditors of Kaupthing had an opportunity to acquire (through the Resolution Committee) control of Arion Bank by subscribing to new share capital. As the value of the liabilities transferred to Arion Bank exceeded the value of the assets transferred, Kaupthing was to pay for the new share capital from the old bank's own assets. The amount of that compensation was calculated at 38 billion ISK, but was to be re-evaluated on a regular basis, based upon future performance of a certain loan portfolio. The Government would hold minority ordinary share capital, amounting to 13 % of Arion Bank. In order to comply with the supervisory sign-off requirement of the FME for an additional 4 % of Tier II capital, the Government would also contribute to the capital of Arion Bank in the form of a subordinated loan amounting to 24 billion ISK.

(85) On 1 December 2009 an agreement was reached between the Government and Arion Bank, on the one hand, and Kaupthing's Resolution Committee, on the other, on settlements concerning assets and liabilities transferred from Kaupthing to the new bank. On the same day the Resolution Committee of Kaupthing decided to exercise the option provided for in the Joint Capitalisation Agreement to take over 87 % of the share capital in Arion Bank. The Government would retain the remaining 13 % of Tier I capital.

(86) Kaupthing paid for the acquisition by transferring assets from its estate valued at 66 billion ISK to Arion Bank. For this purpose Kaupthing used a combination of cash, Icelandic related corporate loans and a portfolio of mortgages and loans to Icelandic Government related entities. The Government capitalisation from 9 October 2009 was subsequently reversed and Arion Bank returned 32,6 billion ISK in government bonds to the Government and issued a subordinated bond in favour of the Government to the sum of 29,5 billion ISK.

(87) Complexities arose in respect of the 12 % Tier I and 4 % additional Tier II capital adequacy requirement as the transfer of non-risk free assets to Arion Bank implied an increase in the Bank's risk-weighted asset base. Since Arion Bank was re-capitalised by a transaction that involved a significant increase in risk-weighted assets, more capital was needed under the Joint Capitalisation Agreement than under the Government capitalisation, which was financed exclusively by government bonds. A greater portion of the funds returned to the Government had to take the form of a Tier II obligation than would otherwise have been the case. For the same reason, Kaupthing paid 66 billion ISK for 87 % of the shares instead of the 62,6 billion ISK that was originally envisaged (i.e. 87 % of 72 billion ISK). The Government paid 12,2 billion ISK for its 13 % share in Arion.

3.4.2. Tier II capital contribution

(88) The state also provided the new bank with two subordinated loans in order to strengthen its equity and liquidity position. Instrument A, denominated in foreign currency, corresponded at the time to an amount of 29,5 billion ISK. The loan was in the form of a capital instrument providing for Arion Bank to issue unsecured subordinated notes. Instrument B was in the amount of 6,5 billion ISK, and was used by Arion Bank for payment to the State of retained earnings (dividends) over the period until the Joint Capitalisation Agreement took effect. The Tier II instruments provided by the Government were based on a need to ensure a strong capital structure and were in accordance with the requirements of the FME.

(89) The term of instrument A is 10 years as of 30 December 2009. It has built-in incentives for exit in the form of a step-up of interest in five years. The interest rate per annum for the first five years is 400 basis points above EURIBOR, but in the period from five to 10 years the interest rate is 500 basis points above EURIBOR. The terms of instrument B are the same, except that for the first three years, the interest rate is 300 basis points above EURIBOR.

3.4.3. Deposit guarantee

(90) In order to comply with Directive 97/9/EC of the European Parliament and of the Council of 3 March 1997 on investor-compensation schemes (39) and Directive 94/19/EC of the European Parliament and of the Council of 30 May 1994 on deposit guarantee schemes (40), Iceland adopted Act No 98/1999 on deposit guarantees and investor-compensation scheme and thereby set up the so-called Depositors' and Investors' Guarantee Fund (‘TIF’), which has been funded by annual contributions from the banks, calculated in relation to the total deposits of that bank.

(91) According to the Icelandic authorities, and so as to provide further assurance and comfort to the general public on the safety of their deposits when the crisis struck, the bank rescue measures of the Icelandic Government of autumn 2008 also entailed an additional state backing of deposits in domestic commercial and savings banks, outside the scope of Act No 98/1999 implementing the deposit guarantee Directive 94/19/EC and the investor-compensation Directive 97/9/EC.

(92) An announcement from the Prime Minister's Office of 6 October 2008 stated that the ‘Government of Iceland underlines that deposits in domestic commercial and savings banks and their branches in Iceland will be fully covered’. This announcement has since been repeated by the Office of the current Prime Minister in February and December 2009. Moreover, reference was made to it in a letter of intent sent by the Icelandic Government to the International Monetary Fund (and published on the website of the Ministry of Economic Affairs and of the IMF) on 7 April 2010 (and repeated in a further letter of intent dated 13 September 2010). The letter (which was signed by the Icelandic Prime Minister, Minister of Finance, Minister of Economic Affairs and Governor of the CBI) states that ‘At the present time, we remain committed to protect depositors in full, but when financial stability is secured we will plan for the gradual lifting of this blanket guarantee.’ Furthermore, in the section of the bill for the Budget Act 2011 concerning state guarantees, reference is made in a footnote to the Icelandic Government's declaration that deposits in Icelandic banks enjoy a state guarantee (41).

(93) A recent statement of the current Minister of Economic Affairs and former Minister of Finance (2009-2011), Steingrímur Sigfússon in a debate in the Icelandic Parliament regarding the Government's cost related to Landsbankinn's taking over the savings bank SpKef, illustrates the above further. According to the Minister, one must keep in mind regarding this matter the State's declaration in the autumn of 2008 that all deposits in savings banks and commercial banks would be safe and protected. ‘Work has since in all instances been based on this (i.e. the declaration) and it is unfortunately correct that this (i.e. payments due to SpKef) will be one of the bigger bills footed directly by the state as costs for securing the deposits of all inhabitants of Suðurnes … and all SpKef's clients in the West Fjords and the West and North-West area … I do not expect that anyone has thought that deposit holders in those areas would be treated differently from other inhabitants, so the state did not have much of a choice in this matter’ (42).

(94) According to the Icelandic Government, the additional deposit guarantee will be lifted before the capital controls are fully abolished, which according to the Icelandic authorities is currently foreseen for the end of 2013.

3.4.4. Special Liquidity Facility

(95) The government financing of Arion Bank was carried out by means of an infusion of 72 billion ISK in repo-able government bonds in return for the bank's entire equity. Kaupthing Bank's decision to exercise its option to acquire 87 % of shares in the Bank, however, meant that the majority of these bonds were returned to the Government. Kaupthing Bank transferred assets from its estate to Arion Bank in return for the equity, significantly reducing the bank's holding of repo-able assets and threatening its capability to comply with supervisory requirements regarding liquidity reserves. In view of this and in the context of Kaupthing exercising the option referred to above, the Government agreed to provide an additional liquidity facility for Arion Bank. The liquidity facility was formulated as an extension to the SPRON swap arrangement described below.

3.4.5. The SPRON swap agreement

(96) On 21 March 2009, using it powers under the Emergency Act, the FME took control of Reykjavík Savings Bank (SPRON) and transferred most of its deposits to Arion Bank. A limited liability company to be owned by SPRON was established to take over SPRON's assets and also all collateral rights, including all mortgages, guarantees and other similar rights connected to SPRON's claims. The subsidiary, named Drómi hf, took over SPRON's obligations to Arion Bank for the deposits transferred and issued a bond to Arion Bank on 22 June 2009 for the amount of 96,7 billion ISK. All assets of SPRON were committed as collateral for the bond, including its shares in Drómi. However, the parties have so far been unable to reach an agreement on the interest to be paid on the bond (43).

(97) In heads of terms signed on 17 July 2009 the Government agreed to hold Arion Bank harmless with respect to the value of the SPRON bond. The parties further agreed to work towards the SPRON bond being made eligible as collateral for funding from the CBI.

(98) In a letter to Arion Bank on 3 September 2009, the Government extended the terms of the SPRON swap arrangement to cover not only potential outflow of the SPRON deposits, indemnifying the bank for taking over of the deposits, but also the liquidity required in order to comply with the FME's conditions. In the letter, the Government pledged to provide up to 75 billion ISK in government bonds if Kaupthing decided to exercise its option to become the majority owner of Arion bank. The amended facility envisages that other assets than the SPRON bond can serve as collateral on less favourable terms. This commitment by the Government was later formalised in an agreement dated 21 September 2010 on the loan of government bonds to Arion Bank to be used as collateral (44). This facility terminates on 31 December 2014, which coincides with the maturity of the SPRON bond. The amount of each drawdown on the facility shall be a minimum of one billion ISK. The government bonds shall only be used to secure loans against collateral from the CBI for the purpose of acquiring liquidity for Arion Bank (45).

3.5. The restructuring plan

(99) The Icelandic authorities submitted a restructuring plan for Arion Bank on 31 March 2011 and an amendment of that plan on 26 October 2011. An updated restructuring plan was submitted on 30 April 2012 together with a 5 year business plan and an Internal Capital Adequacy Assessment Process (ICAAP) report dated April 2012. The ICAAP report was submitted to the FME in April 2012.

(100) The restructuring plan addresses the substantive issues of viability, burden-sharing and limitation of distortions of competition. According to the restructuring plan, Arion Bank has solely operations in Iceland and aims to focus on traditional universal banking services.

3.5.1. Description of the restructuring plan

(101) The Icelandic authorities and the Bank consider that the restructuring of Arion Bank will ensure its return to being a solid, well-funded bank with sound capital ratios so that it can maintain its role as a supplier of credit to the real economy. Based on the information in the restructuring plan and the answers to questions from the Authority, this will be achieved through the following steps: (i) Setting the long-term strategic direction, scaling down the operations and limiting risk exposure (ii) Achieving and maintaining a strong capital position and satisfactory profitability (iii) Maintaining a solid liquidity position and improving the funding structure (iv) Restructuring of household and corporate loan portfolios (v) Limiting foreign exchange imbalances (vi) Rationalising the branch network and achieving cost efficiency

(102) Before describing the restructuring plan in more detail, it is appropriate to set out briefly the Bank's view on how the flaws that contributed to Kaupthing's demise are being addressed in the restructuring plan for Arion Bank. In this regard, it has been underlined that while Arion Bank's operations are based on the domestic operations and assets of Kaupthing Bank, it is nevertheless a new bank, with different commercial objectives and ownership, board of directors and management different from that of Kaupthing. The current management of Arion Bank has in fact stated that it considers itself not to be in a position to speculate on the specific weaknesses or the collapse of Kaupthing. Otherwise, Arion Bank refers firstly to the SIC report discussed above regarding the causes for the collapse of Kaupthing Bank. Secondly, it is pointed out that following the collapse of Kaupthing, actions has been taken to strengthen the infrastructure after an assessment of risk management and governance made by the FME.

(103) According to Arion Bank, two projects are particularly relevant regarding actions taken at the Bank in response to the above assessment. Firstly, regarding large and connected exposures. It has been alleged that Kaupthing held a ‘legalistic’ view of the treatment of connected exposures, allowing it to engage in lending to connected or related parties in excess of the legal limit of 25 % of risk capital. Through this project Arion Bank has extended its definitions of connected parties, and applies stricter processes in this regard, where Arion Bank's Risk Management has the ultimate authority if disputes arise. Large exposures are rigorously monitored and reported and as part of the credit granting process, a special report is given when the granting of credit would result in a large exposure. Changes to Icelandic legislation on financial institutions made following the crisis have significantly curtailed the ability of banks to lend to related parties. Lending to owners or key employees can no longer exceed 1 % of risk capital and can only be made against quality collateral.

(104) Secondly, more scrutiny is applied to cross-ownership and indirect exposures. Kaupthing Bank allegedly engaged in lending against its own shares which was certainly risky and possibly beyond the limits set by the Icelandic companies act. Changes to Icelandic legislation now make it impossible to engage in any lending against own shares or to engage in contracts where own shares are the underlying risk.

Assumptions of the restructuring plan

(105) The restructuring plan is prepared for the parent company as a part of the ICAAP process and also takes into account the effects of the subsidiaries. It is based on a set of general and economic assumptions, constituting the economic underpinning of the base case and stress case scenarios set out below.

(106) The assumptions include the following: — Economic, legal, political and regulatory uncertainties are still considerable in the Bank's operating environment and do affect its long-term forecast. For these reasons, no major changes are assumed in the Bank's operating activities. — Macroeconomic assumptions are based on a forecast prepared by Arion Bank's Research division, which includes the following key variables: Table 3 From Arion Bank Research Division economic forecast Percentage change from previous year 2012 2013 2014 GDP growth 3,0 3,9 3,5 Unemployment 6,2 5,3 4,9 Inflation 5,5 6,1 5,9 Reibor (46) 4,9 5,8 5,6 Libor 0,5 0,5 0,5 Euribor 1,0 1,0 1,0 Wages 9,2 9,7 8,4 ISK exchange rate index (TWI) (47) 4,9 5,0 5,0 — The Bank also makes assumptions in relation to for instance its market position, opportunities and threats, internal data and market development, including so-called key beliefs (48). — On-going growth is expected, driven mainly by consumption (49). — Consumption will continue to be driven by special measures (pension withdrawals and recalculations of foreign exchange loans, etc.). In addition, increasing housing prices will contribute to household wealth. A decrease in unemployment will also help to boost consumption. — During the financial crisis since 2008, investment as a percentage of GDP has been below past 50 years' minimum, but is expected to gradually pick up for the remainder of the restructuring period. — In line with the forecast increase in investment activity, the Bank expects demand for new loans to increase and its loan book to grow in the restructuring period. — Imports will increase more than exports but will reach a balanced level at the end of the forecast period. — Inflation and interest rates play a key role in the Bank's business and restructuring plan (50). It is assumed that inflation will remain high throughout the forecast period. — A 5 % weakening of the króna is expected, on average, throughout the forecast. — Arion Bank expresses doubts about the strategy related to the lifting of the capital controls and assumes that they will remain in place during the forecast period (51).

(i) Setting the long-term strategic direction, scaling down the operations and limiting risk exposure

(107) With a swift transformation from a Northern European bank with operations in 13 countries to a bank that has solely operation in Iceland, Arion Bank was faced with countless challenges, both internal and external, that needed to be addressed and overcome. The revaluation of transferred assets from Kaupthing to Arion Bank was one of them. Additionally the Bank's infrastructure had to be scaled down, and the Bank had to adjust to the new economic reality where many corporations, individuals and households found themselves with a severely diminished ability to service their debt.

(108) Many of the numerous challenges faced by the new bank were thus directly related to the circumstances surrounding its establishment. The transfer of domestic assets and liabilities from the estate of Kaupthing to Arion Bank created some unfavourable risk exposures for the Bank. However, in the broad efforts made to aligning the Bank's operations to a new economic reality, considerable success has been achieved in bringing the Bank's risk exposure down to a controllable level. The focus has been on: — Debt recovery of distressed loans (52). — Reducing the currency imbalance (53). — Reducing the credit concentration towards large and connected clients (54). — Increasing the capital level (55). — Increasing term deposits and securing alternative funding sources (56). — Reducing the inflation risk due to the Consumer Price Index (CPI) imbalance (57).

(109) During 2010, the long-term strategic direction for the Bank was set. According to Arion Bank, its customer portfolio is already leaning towards its goal of becoming a relationship bank and it is believed that this kind of banking model can be fully achieved.

(110) The organizational structure of the Bank has been simplified since its establishment (58) and corporate governance standards have been introduced, ensuring disclosure and transparency and increased accountability. The role and functions of support divisions, in particular the Risk Management division, have been enhanced. The division is independent and centralised and reports directly to the CEO. The CEO and the Board of Directors are responsible for defining and articulating a risk appetite for the Bank's operations. Risk appetite is translated into exposure limits and targets that are monitored by Risk Management, which reports its findings regularly to the CEO and the Board of Directors.

(111) The FME chose Arion Bank to take over all of the deposit obligations of Reykjavík Savings Bank (SPRON). In April 2009, the Bank acquired the regional Mýrasýsla Savings Bank (SPM), including all its assets and certain liabilities such as deposits (59). These actions brought 22 000 new customers to the Bank without expanding its existing branch network.

(112) On 22 December 2011 Arion Bank acquired the former Kaupthing Mortgages Institutional Investor Fund, KMIIF (now named Arion Bank Mortgages Institutional Investor Fund, AMIIF) (60).

(113) In 2012, the securities custodian Verdis, a fully owned subsidiary of the Bank, will be merged with the Bank. […].

(ii) Achieving and maintaining a strong capital position and satisfactory profitability

(114) As can be seen in Table 4, Arion Bank has been profitable since establishment, with return on equity (ROE) ranging between 10,5 and 16,7 %. Table 4 Financial overview 2009-2011 and forecast 2012-2014 (The data is for the parent company. Effects of subsidiaries are taken through other income. Amounts in million ISK) 2009 2010 2011 2012 2013 2014 Net interest income 14 258 24 440 25 480 […] […] […] Valuation change in loans 9 642 29 722 20 037 […] […] […] Commission income 3 914 3 379 4 454 […] […] […] Net financial income 13 460 – 5 681 1 223 […] […] […] Other income 1 713 1 047 4 364 […] […] […] Total income 42 988 52 908 55 559 […] […] […] Operating expenses – 13 133 – 14 226 – 15 791 […] […] […] Impairment – 14 470 – 23 067 – 26 582 […] […] […] Net earnings before taxes 15 384 15 614 13 186 […] […] […] Taxes and bank levy – 2 414 – 2 897 – 2 692 […] […] […] Net earnings 12 971 12 717 10 494 […] […] […] Return on equity (ROE) 16,7 % 13,4 % 10,5 % [10-20] % [5-15] % [5-15] % Net interest margin … … 3,6 % […] % […] % […] % Cost-to-income ratio … … 44,8 % […] % […] % […] %

(115) During 2009-2011, irregular items have had a major impact on the profit and loss account, in particular as concerns valuation change in loans. The Icelandic authorities have provided information on the total loans and discounts obtained from the old bank (61). The total face value of the loans transferred was 1 230 billion ISK and the book value 459 billion ISK. The total discount was thus approximately ISK 771 billion. When conditions have permitted, the loans have been re-valued, leading to a valuation change in loans, as indicated in Table 4 (62). However, for the remainder of the restructuring period, valuation change in loans are forecasted to be unsubstantial. The Bank's profitability will therefore not any longer depend on this irregular item.

(116) The capital requirements set by the FME as a condition for granting an operating license to Arion Bank was 12 % for the Tier 1 capital and 16 % for the total capital (CAD ratio). The Bank's capital policy is to maintain a strong capital base to support business development and to meet regulatory capital requirements, even in times of stress. Long-term capital planning at the Bank is currently based on a benchmark minimum of […] % for Tier 1 capital and a total CAD ratio of […] %. The capital position of the Bank has been strengthening gradually during 2009-2011 and has exceeded both the FME capital requirements and the Bank's internal targets. At the end of 2011, the Bank's CAD ratio was 20,5 %, with a Tier 1 ratio of 15,7 %. Table 5 Capital ratios year-end 2009-2011 and forecast 2012-2014 (The data is for the parent company. Effects of subsidiaries are taken through other income. Amounts in million ISK) 2009 2010 2011 2012 2013 2014 Tier 1 capital 88 302 98 715 106 459 […] […] […] Tier 2 capital 29 543 26 257 32 105 […] […] […] Total capital 117 845 124 972 138 564 […] […] […] Risk-weighted assets 685 702 678 563 675 998 […] […] […] Tier 1 ratio 12,9 % 14,5 % 15,7 % [15-20] % [15-20] % [15-20] % CAD ratio 17,2 % 18,4 % 20,5 % [20-25] % [20-25] % [20-25] %

(117) The Bank's assessment, according to the ICAAP report of April 2012, is that a capital of […] billion ISK is needed to cover its risk exposure. The Bank has a capital base of […] billion ISK and thus holds a capital buffer of […] billion ISK. Based on the current Risk Weighted Amount this translates to a capital ratio of […] %.

(118) It has been the policy of Arion Bank to refrain from paying dividends until 2013. This policy will only be altered in cooperation with the FME and only if Arion Bank and the FME jointly determine that a sustainable turnaround of the Icelandic economy has been achieved.

(iii) Maintaining a solid liquidity position and improving the funding structure

(119) Regarding liquidity, the FME requires that the bank must hold secured liquidity reserves of at least 20 % of deposits and cash reserves of 5 % of on-demand deposits. In addition, the Central Bank of Iceland sets rules on credit institutions' liquidity (63) according to which credit institutions' liquid assets and liabilities are classified by type and maturity and assigned weights according to risk. Credit institutions must have liquid assets in excess of liabilities within one month and after one month and up to three months. The rules also entail a certain stress test where a discount is applied to various equity items, but where it is assumed, on the one hand, that all obligations must be paid upon maturity, and on the other, that a portions of other obligations, such as deposits, must be paid at short notice or none at all.

(120) The Bank's liquidity ratios during 2011-2012 are set out in the graph below. It is apparent that the Bank has maintained a solid liquidity position, surpassing the requirements of the FME both with respect to the cash ratio requirement and the broader requirement of secured liquidity. According to the Bank's plans for 2012-2014, it will maintain a cash ratio between […] — […] % and a liquidity ratio of […] — […] %. The Bank has also complied with the CBI liquidity rules as its liquidity ratios (more than 1 and up to 3 months) at year end 2009-2011 have been in the range of 1,5-2,1. Chart 1 Arion Bank's liquidity ratios 2011-2012 [ Graph on Arion Bank's liquidity ratios under FME rules Values not disclosed for reasons of professional secrecy]

(121) While the Basel III liquidity requirements are not yet mandatory, Arion Bank has begun voluntary monitoring of the Liquidity Coverage Ratio (LCR) (64) according to those rules, and at year end 2011 its LCR was […] %.

(122) Arion Bank is to a large degree deposit-funded, but steps have been taken to diversify the funding by issuing covered bonds. In November 2011, Arion Bank was granted a license by the FME to issue statutory covered bonds. In February 2012, a EUR 1 billion covered bond program was completed. The funds will be used to finance Arion Bank's mortgage lending. It is recalled that at the end of 2011, Arion Bank bought the KMIIF mortgage fund, taking over the outstanding amount 127 billion ISK in covered bonds and continued as the issuer of covered bonds. The Bank deems that issuance of covered bonds in the domestic markets will meet the refinancing needs of the Bank and funding of new loans in the period 2012-2016.

(iv) Restructuring of household and corporate loan portfolios

(123) One of the most important tasks facing the Icelandic financial sector was the restructuring of household and corporate debt. This is a complex and sensitive issue with a number of financial, economic and ethical considerations.

(124) According to Arion Bank's submission, restructuring of the loan book has been a high priority and the Bank considers that it has been at the forefront in resolving corporate and household's debt issues and achieved good progress in that regard. A corporate recovery unit was set up at the Bank in 2009 and asset management companies were established for the management of foreclosed assets. The Bank has introduced a range of customized solutions designed to help households and individual borrowers tackle their debts.

(125) Corporate clients who have been unable to meet their obligations have entered the Bank's debt recovery process. The objective is to turn insolvent companies into solvent companies with a healthy balance sheet, thus enabling them to take on future business and contribute to the development of the economy. At the end of 2011, 986 companies had entered the Bank's corporate recovery programs, and conclusion was reached in 871 instances. In the Bank's view, the corporate debt restructuring is expected to be largely completed by the end of 2012.

(126) As for the restructuring of household debt, more than 14 000 personal customers have taken advantage of the Bank's debt solution packages, including the special debt relief programme. At the end of 2010, the Bank has also set up a dedicated debt advisory service for personal customers. In the Bank's view, this arrangement was important, given the high number of difficult debt recovery cases to be dealt with. The Bank aims to complete its household debt restructuring in 2012.

(127) The goal of the debt recovery programs is to improve asset quality. The share of non-performing loans has fallen from 37 % at the end of 2010 to 13 % at the end of 2011. At the end of 2011, 56 % of the loans in the loan book were categorised as performing, 18 % were ‘on watch’, 13 % sub-performing and 13 % non-performing.

(v) Measures to limit foreign exchange imbalances

(128) Foreign exchange (FX) loans in the loan portfolio are divided into FX/FX loans and FX/ISK loans. FX/FX loans are loans where the customers generate FX income but the FX/ISK loans are loans in FX where the customers generate ISK income. The Bank's FX imbalance is mainly due to the FX/ISK part. During 2010 and 2011 the Bank has made progress toward lowering its FX imbalance. The imbalance will continue to decrease during 2012 with redenomination of foreign currency loans to individuals into ISK as well as actions taken to encourage companies with limited foreign currency income to re-denominate their loans into ISK. There is still a legal uncertainty regarding the FX loans, but the Bank aims to reduce the FX/ISK imbalance so that by the end of 2012 the imbalance will be within CBI requirements.

(vi) Rationalization of the branch network and achieving cost efficiency

(129) In Arion Bank's view, the Icelandic market is ‘over banked’ in comparison with comparable economies. Banks will be forced to reduce cost to remain competitive. Arion Bank has focused on controlling its cost levels and considers that it has been at the forefront of the much needed rationalization within the financial sector.

(130) Arion Bank has streamlined the business by reducing the number of employees and rationalising the branch network. In March 2011 the rationalisation of the branch network was completed when three branches in the Reykjavík area were merged into one. A total of 15 branches have been closed and the remaining network of 24 branches is, according to the Bank, cost efficient while maintaining a high level of attention to customer needs. In relation to the above changes the Bank has reduced its workforce by approximately 10 % during 2011. Cost levels have been kept under firm control and the cost-to-income ratio is already down to 45 % at parent company level in 2011 and will be improved slightly further in 2012-2014, down to […] %.

3.5.2. Ability to reach viability under a base and stress scenario

(131) In the restructuring plan, with reference made to the ICAAP report, a stress scenario has been submitted for Arion Bank examining the Bank's ability to achieve long-term viability under different scenarios and risk exposures.

3.5.2.1. The base scenario

(132) The restructuring plan as described above including the assumptions on which it is based constitutes the base case.

3.5.2.2. The stress case scenario

(133) The restructuring plan includes a stress case scenario where the base case is run under the ‘Prolonged Deep Recession’ (PDR) assumptions, which are based on guidelines from FME. The objective of the stress test is to examine how earnings, credit losses, capital requirements, available capital/capital buffers and liquidity positions of the Bank would evolve under stressed economic conditions. The difference is that assumptions in the PDR scenario for 2009 are now assumptions for the year 2012 and so on. The assumptions are summarised in Table 6 below. Table 6 Main assumptions in Prolonged Deep Recession scenario (65) (%) 2012 2013 2014 GDP growth – 16,0 – 3,9 – 2,8 Unemployment rate 10,6 16,6 16,9 Inflation 9,7 0,1 0,3 REIBOR 10,0 7,0 8,0

(134) The stress scenario is designed against the background of unlikely but potentially plausible changes in the economic environment in which the Bank operates. The Bank's profitability is certainly adversely affected by the severe conditions of the prolonged deep recession scenario, as its return on equity will be significantly reduced (66). It will nevertheless make small profits and as the Bank's loan book and risk-weighted assets will shrink at the same time, its capital position will not be adversely affected (67). The Bank's liquidity position would also remain well above the minimum requirements.

(135) The ICAAP report is based on financial figures from 31 December 2011. Its main result is that it is the Bank's assessment that a capital of […] billion ISK is needed to cover the Bank's risk exposure, based on Pillar I and II. 16 % of risk-weighted assets (RWA) amounts to […] billion ISK. The Bank has a capital base of […] billion ISK and therefore holds a capital buffer of […] billion ISK. The capital assessment takes into consideration stress related factors, including the impact on the Bank's loan book. According to the ICAAP report, the Bank's Risk Management focuses on identifying, assessing and measuring all material risks faced by the Bank, where the risks are grouped into four classes: credit risk (including concentration risk), market risk, operational risk and other risks (including liquidity risk, business risk and political and legal risk). Table 7 displays the various risk factors taken into account in the capital assessment. Table 7 ICAAP results regarding capital assessment, amounts in billion ISK ICAAP 31.12.2011 Capital Requirement (Pillar I) […] Single name concentration […] Sector concentration […] Interest rate risk in the banking book […] Foreign exchange risk class C,D,E […] Tax authorities […] Valuation risk — unlisted equities […] Valuation risk — loan book […] Pillar II Capital Assessment […] Total capital adequacy assessment (Pillar I+II) […] 16 % of RWA […] Total Capital Base […] Capital Buffer […]

(136) The ICAAP report states that although much progress has been made in curtailing the large imbalance between foreign currency denominated loans to customers and Icelandic currency denominated deposits, work remains in order to eliminate the remaining imbalance in 2012. At the end of 2011, the imbalances still exceeded the legal limit and dispensation from the CBI was necessary. The Bank's strategy for reducing its currency imbalance is on the one hand the systemic ISK redenomination of currency loans to customers who have income in ISK, and on the other hand the hedging of currency imbalances through agreements with the CBI and through currency swaps with Icelandic customers.

(137) Liquidity risk is one of the Bank's most important risk factors. This stems from the fact that the maturity of loans exceeds the maturity of deposits. It is the Bank's strategy to closely monitor its liquidity position and to lengthen the maturity on the liability side, through careful analysis of the stickiness of deposits (68) and diversification of its funding. According to the Bank's internal requirements, the secured liquidity ratio should not go under […] % of deposits and the minimum cash ratio should be […] % or slightly above the FME requirements, which are 20 % for the secured liquidity ratio and 5 % for the cash ratio. As can be seen on Chart 1 above, the Bank has remained well above the FME and internal benchmarks. Through an analysis of its deposit base, where deposits are rated into seven groups according to stickiness, the Bank has stress tested its liquidity. Assuming that the capital controls would be lifted immediately, the Bank's secured liquidity ratio would […]. The cash ratio would […]. However, the Bank has formulated contingency plans to address a potential funding crisis, and would among other things […].

3.5.3. Exit strategy/repayment of the State

(138) As already described above, the Tier II capital contribution has 10 year duration from 30 December 2009. As for the remuneration, there is a built in step-up clause after 5 years (i.e. 2014), from 400bp to 500bp over EURIBOR. According to the Icelandic authorities, this step-up should act as an incentive for the bank to pay back this capital as from this time.

(139) As for the 13 % equity stake that the State retains in Arion Bank, the Government's holdings in financial undertakings are managed by the Icelandic State Financial Investments (the ISFI) (69). According to the State Budget for 2012, the Government has been authorised to sell the stakes that it currently holds in savings banks, but no decision has yet been made regarding sale of state holdings in the three major commercial banks. A working group has however been established by the responsible ministers to explore possible ways of disposing of shareholdings in the commercial banks. The Government has indicated that while it has no intention of reducing its holdings in Landsbankinn below two-thirds of the bank's share capital, the stakes in Arion Bank and Íslandsbanki could soon be offered for sale or sold with the banks in their entirety if their majority owners decide to sell, subject to certain prerequisites being resolved.

(140) The special liquidity facility is only available until 31 December 2014, which coincides with the maturity of the SPRON bond.

4. GROUNDS FOR INITIATING THE FORMAL INVESTIGATION PROCEDURE

(141) In the opening decision, the Authority preliminarily concluded that the measures by the Icelandic State to capitalise Arion Bank, as well as the liquidity facility, entail state aid pursuant to Article 61 EEA. Furthermore it could not exclude that state aid was present in the deposit guarantee. The Authority will take a final view on these measures, which continue to have a bearing on the assessment at hand, in the present decision.

(142) As for the compatibility of the measures assessed in the opening decision, the Authority considered that a final view could only be taken on the basis of a restructuring plan, which had not been submitted when the Authority opened the formal investigation procedure on 15 December 2010. It was in particular due to the absence of a restructuring plan more than one year after the establishment of Arion Bank that the Authority expressed doubts about the compatibility of the aid.

4.1. Comments from interested parties

(143) The Authority received a statement on behalf of the creditors of the old bank, in which they emphasised that they were to be considered as interested parties, and indicated to possibly submit further comments at a later stage.

4.2. Comments from the Icelandic authorities

(144) The Icelandic authorities accept that measures undertaken in establishing New Kaupthing Bank, now Arion Bank, constitute state aid. In the view of the Icelandic authorities, the measures are however compatible with the functioning of the EEA Agreement on the basis of Article 61(3)(b) of the Agreement, as they are necessary, proportionate and appropriate to remedy a serious disturbance in the Icelandic economy. In the view of the Icelandic authorities the measures taken are in all aspects in line with the principles set out in the Authority's state aid guidelines. They also submit that the aid is necessary and limited to the minimum amount necessary.

(145) Moreover, the Icelandic authorities emphasise that the former shareholders of Kaupthing Bank have lost all their shares and received no compensation from the state, that the aid is well designed to minimize negative spill-over effect on competitors and that the terms of the loans (the Tier II capital) are comparable to market rates.

(146) The Icelandic authorities do not regard the deposit guarantee as entailing state aid.

4.3. Commitments by the Icelandic authorities

(147) The Icelandic authorities have submitted a number of commitments, most of which related to the distortions of competition caused by the aid under assessment. The commitments are set out in the Annex.

II. ASSESSMENT

1. THE PRESENCE OF STATE AID

(148) Article 61(1) of the EEA Agreement reads as follows: ‘Save as otherwise provided in this Agreement, any aid granted by EC Member States, EFTA States or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, in so far as it affects trade between Contracting Parties, be incompatible with the functioning of this Agreement.’

(149) The Authority will assess the following measures (70) below: — The initial operating capital provided by the Icelandic State to the new bank; — The (temporary) full state capitalisation of the new bank; — The retention by the State of the 13 % share capital remaining after 87 % of the share capital in the new bank was transferred to the creditors of Kaupthing; and — The provision by the State of Tier-II capital to the new bank by way of subordinated debt. The above measures are referred to collectively below as ‘the capitalisation measures’. In addition, the Authority will assess: — The special liquidity facility agreement; — The SPRON swap agreement; — The Icelandic Government's statement to guarantee domestic deposits in all Icelandic banks in full.

1.1. Presence of state resources

(150) As the Authority already preliminarily concluded in the opening decision, it is clear that the capitalisation measures are financed through state resources provided by the Icelandic Treasury. State resources are also evidently present in the liquidity facility available to Arion Bank. As for the SPRON swap agreement, the State assumed the risk that the assets of SPRON/Drómi would be insufficient to cover the transferred liabilities (deposits) of SPRON. In essence it guaranteed to make up for the shortfall, which entails a (potential) transfer of state resources.

(151) Regarding the deposit guarantee, th