Friday is party night in the Icelandic capital of Reykjavik and not even the country’s financial collapse last week could keep young Icelanders from their Viking beers. As midnight passed, a steady stream of Porsches, BMWs, Audis and Ford Mustangs cruised down Laugavegur, the boutique-filled shopping avenue that had come to symbolise Iceland’s emergence as Europe’s coolest capital.

Yet despite the defiant show of bling, there was no escaping the change hitting Iceland. For the first time in recent years many seats in trendy bars were empty as nightclubbers faced the grim reality of an economy ruined by reckless excess.

One reveller marvelled at the quiet city centre. “There are even tables free at Kaffibarinn,” he said, referring to a bar once part-owned by Damon Albarn, lead singer of Blur. Normally, late on a Friday night, customers are queuing out of the door.

A thousand miles away from Laugavegur and Kaffibarinn, Iceland’s economic collapse is causing rather greater anxiety in Britain. This weekend the full amount of UK money locked in the accounts of collapsed Icelandic banks is estimated to be as much as £20 billion. While the Treasury has pledged that 300,000 small investors will be reimbursed, no such commitment has been made to hundreds of councils, police forces and other parts of Britain’s public sector that deposited money in the high interest accounts of Kaupthing, Glitnir, Landsbanki, Heritage and Icesave.

Iceland’s banks turned their eyes to the hefty reserves of Britain’s town halls about five years ago. Councils were offered double-digit returns for lending lump sums on fixed terms of between three months and two years.

At the latest count, 108 local authorities have combined deposits of more than £1 billion in Icelandic hands. Kent county council has £50m spread across three banks. Cheltenham borough council has £11m – about 12% of its annual budget.

Transport for London invested £40m, while a group of police authorities have at least £60m. Two NHS hospital trusts, one in north London and another in Manchester, have at least £8m in Icelandic banks. Naomi House, a children’s hospice near Winchester, has £5.7m in Kaupthing.

The National Housing Federation, which represents 1,300 housing associations, has begun a frantic ring round of its members. It has already uncovered two housing associations with “significant” investments in Iceland and understands it is “highly likely” that it will unearth many more. About 10 universities are also known to have poured in tens of millions.

As council taxpayers face the prospect of higher bills to pay for any losses, many are asking why local authorities invested in the banks. When the full extent of the crisis emerged on Wednesday night, the Local Government Association (LGA), the media-savvy lobby group that represents councils, claimed there had been no warnings of trouble.

The LGA said the City rating agencies that its members use to decide where to invest had changed their view of Iceland’s banks only in the “last few weeks”. It said that under guidance published by the government four years ago, councils were obliged to seek out safe investments that delivered the highest returns.

Last year, however, more prudent authorities decided Reykjavik had grown too risky. Brighton and Hove city council, which had invested £5m in Kaupthing, removed its money last October. Mark Ireland, a senior official in the council’s finance strategy department, said: “We’ve always been cautious with foreign accounts, putting no more than £10m in one place.”

Brighton and Hove was not the only local authority to go cool on Iceland. “There were too many people in the City too worried about Iceland for us to risk it,” said the finance director of another council based in the home counties. “Yes, the rating agencies may have been a little slow [to downgrade] – but you also listen to market intelligence. Wouldn’t anyone talk to people before investing any money?”

Ronnie Bowie, president of the Faculty of Actuaries, said that while he has sympathy for those councils caught out by the Icelandic collapse, it had been clear for some time that all was not as it should be in the Icelandic financial system. “These accounts were paying very high rates of interest and in this game there is no such thing as a free lunch,” he said.

Rating agencies such as Fitch, Moody’s and Standard & Poor’s have, in fact, been sounding the alarm on Landsbanki, Glitnir and Kaupthing for years. Even the government was aware of the risks months ago.

In July Lord Oakeshott, a Liberal Democrat peer with experience of managing pension funds, asked what steps ministers had taken to verify the “solvency and stability” of Icelandic banks operating in Britain.

Lord Davies, a Treasury spokesman, responded: “All UK-incorporated subsidiaries of Icelandic banks regulated by the Financial Services Authority continue to meet threshold conditions.”

A week later members of the Treasury select committee interrogated Kitty Ussher, then City minister, about the strength of the Icelandic Depositors’ and Investors’ Guarantee Fund. Members of the panel were concerned that only £88m had been placed in a fund that could have to repay £13 billion worth of investments. Ussher reassured them.

“I am satisfied that the law exists to guarantee them, yes,” she said of deposits made by British investors, adding: “I do not want to be pressed too far on this so as not to unduly alarm anybody.” When quizzed on precisely how British investors would get their money back if an Icelandic bank failed, Ussher said it would be laid out by the government after the summer recess.

What happens now? Ernst & Young, the accountant, is this weekend picking over the pieces of Heritage and Kaupthing, Singer & Friedlander, the British arms of the Icelandic banks pushed into administration by the Treasury last week. The creditors of these banks, many of whom are councils, will receive what is left. Those close to the administration suggest that creditors will receive only about 50p for every £1 they are owed.

Meanwhile, a team of senior officials from the Treasury and the Financial Services Authority, the City regulator, has been dispatched to Reykjavik on a mission to repatriate every penny of British funds.

These officials have a powerful bargaining chip. In a move that escalated tensions between the two countries, Britain last week used antiterror legislation to freeze about £4 billion of Icelandic assets in the UK. These include a welter of investments and property owned by Glitnir, Landsbanki and Icesave. Iceland’s authorities are being left in no doubt that these assets will not be returned unless British investors are compensated.

Attention will also increasingly turn to British businesses caught up in the Icelandic saga. The 2,000 staff of Austin Reed nearly went home unpaid this weekend because of the crisis. The upmarket retailer was depending on a £1.5m payment from a Landsbanki account in the UK, one of many frozen by the government.

After some hasty negotiations with the Treasury, Austin Reed received the funds. “It was touch and go,” said a source close to the firm. “If you can’t pay your staff or your suppliers, you’re dangerously close to going under.”

In Iceland itself there are grimmer prospects. “No more caviar and brut champagne,” moaned Haukur Magnusson, a contributor to The Reykjavik Grapevine, a popular alternative weekly magazine. “No more imported Kobe beef and foie gras. We are once more at the mercy of our Icelandic fish, which come in three categories: dried, salted and rotted.”

COUNTRY FOR SALE

Needs must. As Iceland faced the prospect of national bankruptcy, an interesting item appeared for sale on eBay. A trader calling himself “Lovejoy Antiques Emporium” placed an advert offering buyers a “unique opportunity to buy a Northern European country”.There was one proviso: the singer Björk, who is Icelandic, was excluded from the sale. Bids started at 99p and quickly passed to all of £1.20.

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