UPDATE 8-Iceland adopts sweeping bank powers to stem crisis

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By Omar Valdimarsson

REYKJAVIK, Oct 6 (Reuters) - Threatened with national bankruptcy, Iceland agreed to adopt sweeping powers over banks on Monday as its financial system tottered, its currency plunged 30 percent and a leading agency cut its credit ratings.

The ruling alliance and opposition parties united on a bill that gives the state the ability to intervene at will in the country's battered banks. Parliament, in session late on Monday, was expected to pass the bill imminently.

"We were faced with the real possibility that the national economy would be sucked into the global banking swell and end in national bankruptcy," Prime Minister Geir Haarde said.

In an address to the nation, he said Iceland's top financial regulator would have wide-ranging authority to dictate a bank's operations and could even force it to merge with another firm or declare bankruptcy.

Standard and Poor's agency downgraded Iceland's credit rating by two notches to "BBB" from "A-", saying the authorities' actions would help to limit the risks to the budget but would also cut banks' access to international markets, causing the economy to contract much more sharply than foreseen.

"This economic contraction, combined with the depreciation of the krona, will hurt the asset quality of the banks, depress the fiscal revenues of the state and markedly alter what had been low government debt levels," it said.

Iceland is an island in the middle of the North Atlantic, home to just 300,000 people. But it has found itself on the fault line of the global financial crisis.

The country's financial stature had swelled in recent years as its banks expanded overseas, investors took large positions in its high-yielding currency and foreign firms poured money into local projects.

But by Monday, the prime minister raised the spectre of a complete financial collapse had the bill not been agreed.

"The legislation is necessary to avoid that fate," Haarde said.

The bill will also allow the government to take over housing loans held by the banks and put them in a government housing fund, an effort to help thousands of islanders who faced the loss of their homes amid an ever-widening credit crunch.

The bill's provisions are due to take effect immediately.

BORROWING SPREE

The government held marathon talks through the weekend, with Haarde holding out hope such drastic measures would not be needed.

"As recently as last night, it looked like the banks could continue operations for a while," Haarde said. "This morning and today, things have totally changed for the worse."

The government ordered a halt in trading in all of the island's banks before the stock exchange opened on Monday.

But as the crown collapsed, the situation for Icelandic banks became dire. During the boom years that came to an abrupt halt late last year, Iceland's banks took on massive foreign debts as they expanded overseas.

The crown's fall means those debts have now become much more expensive to finance.

The crown, a volatile currency at the best of the times, began a descent on Monday that made its previous slides pale in comparison.

By late Monday, it had shed some 30 percent on the day to a record low of close to 230 per euro. In the wake of the currency fall, inflation in the country, which is heavily dependent on imports, is set to rocket.

Haarde said it was hoped the banking system would not collapse but that was not yet certain. "It is possible that some banks may not be able to function without our intervention," he said.

Haarde and an official at Iceland's central bank said the bill did not contain any provisions for a loan to Iceland's biggest bank, Kaupthing KAUP.IC.

This had followed confusion as an early version of the bill, posted briefly on the Internet, was said to contain language that spoke of a central bank loan to Kaupthing. A later version of the bill did not contain the language.

Kaupthing had said on Sunday it was healthy. But markets were wary as authorities and bankers for months had said the financial sector was sound, and yet only last week Iceland's then-number three bank, Glitnir GLB.IC, had to be rescued.

Part of Iceland's plan has been to persuade pension funds to repatriate cash. Local news media reported over the weekend that the Icelandic Pension Funds Association had agreed to the idea, with pension funds being asked to transfer 200 billion Icelandic crowns ($1.8 billion) to the state.

The pension fund association issued a statement on Monday confirming it had encouraged its members to bring back capital. It said total assets of the funds amounted to 1.8 trillion Icelandic crowns, with about 500 billion in foreign securities.

The association has asked members to sell up to 50 percent of their foreign securities. (Reporting by Omar Valdimarsson via Stockholm Newsroom, writing by Anna Ringstrom and Adam Cox; Editing by Jonathan Oatis and Mark Trevelyan)