Europe shivers as credit freeze hits Iceland

Central bankers and officials in Iceland are locked in economic bailout talks this weekend, as Gordon Brown attempts to convince European leaders to back a £12bn fund for small businesses across the Continent.

Iceland's economy is on the brink of collapse, after the krona fell 27 per cent against the dollar last week. The fall sent fresh shockwaves through the UK financial system, as Icelandic banks have invested billions in the British economy. One of the biggest, Kaupthing, is estimated to have underwritten about £3bn in debt to finance deals in this country, and just two of the banks have more than 150,000 British internet customers.

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The Icelandic government is believed to be considering a bailout plan after it was revealed the three largest banks have liabilities eight times greater than the country's GDP. It has already effectively nationalised Glitnir, investing €600m (£470m) in exchange for a 75 per cent stake in the bank last Monday.

Bankers in the City of London, of which about 700 work for Kaupthing, are worried that further nationalisation might be inevitable. However, a bank spokesman said: "There are no plans for nationalisation. Our position is much stronger than Glitnir's."

Kaupthing's chairman, Sigurdur Einarsson, said last night the bank's problems had been exaggerated: "Seventy per cent of our business is outside Iceland. Kaupthing continues to manage its business prudently. With our strong fundamentals, we are naturally concerned when we hear malicious rumours and sensationalism about Kaupthing."

Pension funds, some of Iceland's most active investors, are understood to be in direct communication with central bankers this weekend to unravel their numerous positions. An adviser who works for both Icelandic and UK institutions tried to play down the crisis, saying: "We need to keep this in perspective. The situation is more serious in the UK than in Iceland. Will the Icelandics follow the UK's lead and inject liquidity into the banking system? Maybe."

While attention was focused on Iceland, Germany's second-biggest commercial property lender, Hypo Real Estate, was facing an uncertain future after the failure of a €35 (£27bn) rescue plan. A statement on the bank's website said that "alternative measures" were being investigated.

In Paris, heads of state from the UK, Germany, Italy and France gathered at the Elysée Palace for an emergency meeting yesterday. Also attending were Jean-Claude Trichet, head of the European Central Bank, and Jose Manuel Barroso, the president of the European Commission.

Gordon Brown insisted all "necessary action" to end the crisis must be taken. "I want the message to go out from this meeting that no sound, solvent bank should be allowed to fail through lack of liquidity. That is why we must take the action necessary to sort out whatever failings exist in the system.

"People will be very clear that every country represented here will want to do whatever is necessary to secure the stability of the system and to ensure the safety of hard-working families and businesses."

European leaders agreed to the French President Nicolas Sarkozy's call for greater co-operation. They also accepted Mr Brown's proposal for a £12bn fund to help European small businesses survive the credit crunch. No 10 said that the fund would help businesses continue their operations and pay staff.

The move will be welcome in the UK after a warning by its leading trade association that banks are hurting its members as they did in the Nineties, when many were forced into bankruptcy. A spokesman for the Federation of Small Businesses said: "There is evidence of banks jacking up overdrafts and transferring overdrafts into loans. Barclays, which deals with about 653,000 small businesses, has raised interest rates 4 per cent above base from 6.8 to 10.8 per cent, which brings total overdraft costs to 15 per cent. That's too much."

Lloyds TSB, which recently scooped up its ailing rival HBOS, has also been "renegotiating rates" for its 850,000 small business customers. Representatives from the Federation of Small Businesses met the outgoing Business Secretary, John Hutton, early last week to discuss the banks' squeeze.

Later this week, Mervyn King, the Governor of the Bank of England, will face pressure to cut interest rates by up to half a point, following figures from KPMG. The accountant's report will show that the five-year growth in salaries for permanently employed people has ended. With 1.7 million now unemployed, many economists would like to see a rate cut to spark life into the economy.

In the US, President Bush warned that it would take a "determined effort to get through this difficult period", though he insisted that the $700bn (£400bn) bailout package finally approved last week was "essential to helping America's economy weather the financial crisis". But the signing of the Bill was did not prevent US stocks suffering their toughest week since the 9/11 terrorist attacks. And Arnold Schwarzenegger, Governor of California, also warned that his state might require $7bn from federal government to maintain essential public services.