The International Monetary Fund (IMF) has approved a $2.1 billion (£1.4 billion) loan to Iceland to support the country through its economic crisis.

Iceland will receive $827 million up front and the rest in eight instalments to restore confidence in its battered financial system.

In addition, Finland, Sweden, Norway and Denmark have agreed to lend Iceland an extra $2.5 billion.

The country had also been in discussions with Russia for a $4 billion loan but talks collapsed.

John Lipsky, first deputy managing director and acting chairman for the IMF, said: “Iceland is in the midst of a banking crisis of extraordinary proportions.

“The three main banks, accounting for about 85 percent of the banking system, collapsed within a time span of less than one week. The krona fell sharply, the equity market plummeted, and severe disruptions in the external payments followed.

“As a result, Iceland is facing a severe recession, given the high debt level in the economy and significant dependence of the private sector on foreign currency and inflation-indexed debt.”

The IMF intends to stabilise the country’s exchange rate, develop a strategy for bank restructuring and ensure fiscal sustainability.

The loan means Iceland should be able to pay back the UK government, which promised to honour personal savings lost in the collapse of Icesave and Kaupthing Edge.

However, there has still been no agreement on whether local authorities who had savings with the bank will get any of their money back.