Councils trapped in £1bn black hole

Council tax payers are facing increased bills or cuts in services to pay for a £1bn black hole in Britain's town hall finances caused by the sudden collapse of Iceland's banks.

One by one, 127 public bodies owned up yesterday to having multimillion-pound sums frozen with Icelandic financial institutions that have gone bust. Gordon Brown, threatened to retaliate against Iceland's "unacceptable behaviour" by taking legal action to seize its assets in the UK.

So far, public and voluntary bodies are estimated to have frozen deposits of £973m, and rising. The Local Government Association put the total loss for English and Welsh local authorities at £798m. Fifteen police authorities have a further £100m deposited in Iceland. Transport for London, which runs the capital's transport system, cannot access £40m.

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Financial experts expressed incredulity that so few councils had tried to get their money out before the Icelandic banks went bust. They said there had been clear signs for at least a fortnight that Iceland's economy was exposed to massive losses from over-lending.

The Government, which provides 75 per cent of council funding, warned it was unlikely to bail out the institutions, potentially pushing the burden on to taxpayers. The losses could add up to £50 for each of Britain's 25 million households. Otherwise, authorities may have to cut public services as the economy slides into recession.

As diplomatic relations between Britain and Iceland headed into a deep chill, Mr Brown described the behaviour of the Icelandic government as "totally unacceptable", adding: "We are holding the Icelandic authorities responsible. We are demanding the money be paid back to the local authorities. We are prepared to consider all forms of action including attempting to freeze assets."

The Icelandic Prime Minister, Geir Haarde, immediately hit back, insisting court action was the wrong way to deal with the issue that he hoped could be settled in a "civilised manner". He said he wanted to resolve the issue in full co-operation with the UK.

The Government stressed that deposits with three major Icelandic banks Glitnir, Landbanski, and Kaupthing Singer & Friedlander were not necessarily lost. But there was fear that some councils with large sums on loan or deposited with the country's banks could suffer almost instant cashflow problems as large holes opened up in their balance sheets.

Kent County Council headed the list of losers with £50m of investments. Haringey faces losses of £37m, Dorset £28m and Barnet £27m. Westminster could lose £17m of its £70m reserves. The Metropolitan Police Authority has £30m frozen. One well-known charity which is staying anonymous fears it has lost millions.

Merrick Cockell, leader of Kensington and Chelsea and London Councils, said authorities across the country could lose a total of £1bn. In London, one council had been expecting £20m on 14 October just as wages were due to be paid. "The monies involved are very substantial amounts and in some cases exceed reserves, especially in the more reserved boroughs," Mr Cockell said. "The councils involved have not been taking unnecessary risks. However, we are looking at cashflow problems and short-term problems with the payroll."

Local authorities held crisis talks with the Department of Communities and Local Government, hoping the Government would extend its guarantee to underwrite losses from individuals to local authorities. Last night, the Department made it clear there was unlikely to be any extra money but it said authorities would be allowed to increase borrowing or bring forward budgets to avoid cuts to services. The Government argued that, unlike private savers, local authorities had financial expertise with access to professional financial advisers and credit-rating agencies.

Council leaders insisted there was nothing they could have done to withdraw the money because they were often held in fixed-term savings plans. "If you want to get your money back earlier you have got to negotiate with the bank and the bank has the right to say no," said Transport for London.

The Local Government Association dismissed any claim that councils had been naïve or incompetent. "There is no evidence of recklessness by local authorities," it said in a statement. "Many authorities have already publicly stated that any risk is not a threat to frontline services but a small number of authorities may have specific problems." Some local authorities pulled their money out of Iceland, before the banks' collapse. Brighton and Hove Council declined to put any more money with Kaupthing Singer & Friedlander last year, amid concerns about the rapid expansion of Iceland's financial sector. "Our watchword is caution," said the finance councillor, Jan Young.

South Norfolk District Council leader John Fuller said he felt like he had "won the lottery" when he found out that the council has removed its £2m savings when their fixed term expired, in August and September. Some of the money was transferred to the Britannia Building Society.

Council leaders pointed out that many other local authorities had experienced problems. Exeter City Council said it has £5m in two Icelandic banks.

Many in financial circles had no sympathy for the council money men. Ben Yearsley, investment manager at financial adviser Hargreaves Lansdown, said: "You have to question the logic of why a local authority like Kent has £50m in an Icelandic bank. Why wasn't money like that deposited with gilts, which are more secure? A Government body or public bodies should not have been taking risks with money on deposit.

"There have been stories about the vulnerability of Icelandic banks for weeks and you have to consider why they were offering such a high rate. They were offering a high rate because they wanted money to come in."

Eric Pickles, the Shadow Communities Secretary, said that the councils' investment strategies stemmed from guidance issued by the then Deputy Prime Minister, John Prescott, in 2004. Mr Pickles said the Chancellor, Alistair Darling, needed to rewrite the advice and provide reassurance that council tax bills would not rise or local services be cut because of the crisis.

Britain's biggest union, Unison, urged the Government to protect local authorities from making cuts.