The local government spending watchdog has begun an internal inquiry after it emerged that it had invested £10 million in collapsed Icelandic banks this year.

The Audit Commission admitted today that it had deposited nearly 20 per cent of its reserves in two Icelandic banks — Landsbanki Islands and the Heritable Bank — in April and July.

The disclosure is highly embarrassing for the Commission as its remit is to ensure that councils spend public money “economically, efficiently and effectively”.

In the past week 116 councils have come under criticism for investing nearly £1 billion in Icelandic banks, a tenth of their reserves. 13 now have cash flow difficulties with three, with Wyre Forest, Tamworth, near Birmingham, and Uttlesford, Essex, said to be in serious trouble.

The Government said this week that it would send troubleshooters into the three hardest hit, but it is not clear whether financial aid, such as increased borrowing powers, will be offered.

Tamworth district denied today that it was in financial difficulty and said services and wages were not in immediate jeopardy. However, local government leaders conceded tonight that it might take months or years before any money is secured after the lengthy process of administration.

Alastair Darling, the Chancellor, has refused to extend the guaranteed protection offered to invididual depositors to public bodies, charities or businesses.

Tonight the National Audit Office, which scrutinises all public finance, announced that it too would examine how the Audit Commission had exposed its finances to risky Icelandic investments.

“We naturally evaluate the management of financial risk as part of our external audit of the Audit Commission,” it said. “We will be looking at the circumstances surrounding the Commission’s exposure to Icelandic banks.”

Michael O’Higgins, chairman of the Audit Commission, said that the investments were part of £55 million of reserves that had been deposited in tranches of £5 million across 11 different institutions in order to spread the risk.

“Given the scale of the financial crisis it is probably inevitable that one of the eleven, if not more, would be hit,” he said. “Because the deposits were made on a fixed term they are not due to mature till 2009, therefore whether the Commission’s exposure to the Icelandic banks will lead to losses is yet to be determined.”

He insisted that the ratings agencies had been continuing to give the banks a top F1 credit rating as recently as last month. Preliminary investigations had suggested that the deposits were in full compliance with its own guidelines on prudent investment, he said.

Mr O’Higgins said the Audit Office's review into the Commission, which would examine the internal findings, would be made public. “We are anxious that this review is as transparent as possible, given our public role.”

Oxford University has also admitted that it was among 12 English universities that held deposits with Icelandic banks. The total amount deposited between them was about £77 million, with Oxford alone investing £30 million.

Giles Kerr, Oxford’s director of finance, has written to the Higher Education Funding Council for England (HEFCE), urging it to do all in its power to help to protect the higher education sector from the impact of the crisis.

He called for co-ordinated action between HEFCE, the Department for Innovation, Universities and Skills and the Treasury.

“We expect them to do all they can to protect the position of higher education institutions, which are vital to the country’s future prosperity,” he said.

Mr Kerr said that the University’s own exposure in Iceland is about five per cent of its overall cash pool, which in itself represents only a small part of the collegiate university’s overall wealth. He added that the university’s cash pool had more than sufficient liquidity to meet their requirements, but said that it would make every effort to recover deposits in Iceland in full.

Times Recommends

• Why Witherspoon is highlighting domestic violence
• No, MP does not stand for Mostly Plastered
• Don’t bottle out of your champagne moment