THE ICELANDIC government has taken over Glitnir, the island's third-largest bank, by injecting €600 million of equity after the lender's funding position sharply deteriorated.

The bank rescue confirmed market worries about the ability of Iceland's banks to withstand the credit squeeze, given their weak base of deposits at home and their dependence on wholesale funding.

Icelandic banks have increased their balance sheets aggressively in recent years to expand out of their volatile home market.

Shares in Glitnir were halted ahead of the announcement, but other banks fell sharply, with Kaupthing, the largest by market capitalisation, sinking 4 per cent.

Glitnir said the bank had experienced adverse developments in its funding position in the past few days, forcing it to initiate talks with the government.

"Having the government as an owner strengthens the capital base of the bank and removes all doubt about Glitnir's financial strength," chief executive Larus Welding said in a statement.

The government is due to inject €600 million of equity for a 75 per cent stake. "The purpose of this action is to enhance stability within the financial system," the government said in a statement, adding that it did not intend to hold the stake for an extended period.

The Icelandic authorities insist that Glitnir's capital and asset portfolio remains solid and that its loan book is of good quality. Glitnir's capital adequacy ratio will be 14.5 per cent after the bailout. - ( Financial Times service)