Iceland: Selected Issues
Author: International Monetary Fund
Publication Date:
27 Jul 1999
eISBN:
9781451819212
Language:
English
Keywords:
ISCR; CR; central bank; exchange rate; secondary market; financial system; foreign currency; banking sector; Stock markets; Loans; Bank credit
Download PDF (2.8 MB)

This Selected Issues paper focuses on the European Monetary Union and the monetary policy framework in Iceland. It concludes that in terms of an exchange rate regime, the two most realistic options for Iceland are to continue with the existing arrangement or adopt a unilateral peg to the euro. However, it is argued that both options entail the need for enhancing the independence of the central bank, which will require reforming the Central Bank of Iceland Act. The paper also discusses a Scandinavian forecasting model for inflation in Iceland.

Abstract

This Selected Issues paper focuses on the European Monetary Union and the monetary policy framework in Iceland. It concludes that in terms of an exchange rate regime, the two most realistic options for Iceland are to continue with the existing arrangement or adopt a unilateral peg to the euro. However, it is argued that both options entail the need for enhancing the independence of the central bank, which will require reforming the Central Bank of Iceland Act. The paper also discusses a Scandinavian forecasting model for inflation in Iceland.

V. FINANCIAL SECTOR STRUCTURE AND REFORMS1

A. Introduction and Overview

93. Financial markets in Iceland have developed rapidly over the past decade. Some nonbank financial institutions have grown, and a recent effort to privatize public credit institutions has gathered momentum. The regulatory environment has been aligned more closely with that of the EEA. At the same time, the capital account has been liberalized and measures have been taken to develop financial markets. This chapter will examine changes that have occurred in each of these areas, including how reforms were intended to improve economic performance. This chapter also discusses whether there are signs that these changes have increased financial vulnerability along the lines of other, notably Nordic, countries following financial liberalization.

94. Following a brief overview, Section B discusses the evolving structure of the financial sector, focusing on the main institutional players. The framework for supervision and regulation of the financial sector is presented in Section C and some indicators of recent prudential performance of banks are examined. The development of financial markets and reforms are outlined in Section D. Finally, Section E assesses macroeconomic performance in Iceland following financial and capital account liberalization.

95. A process of liberalization and legislative reform has created conditions in which market forces play an increasing role in Iceland. The current Central Bank Act was adopted in 1986 and at the same time deregulation of interest rates was completed. In the mid-eighties the Iceland Stock Exchange was established, securities companies emerged and the first mutual funds were established. Towards the end of the decade a process of rationalization in the banking sector took place through mergers. The Basle standard for rules on capital adequacy of commercial and savings banks was implemented at the beginning of 1993. In connection with the European Economic Area (EEA) Agreement,2 new legislation was enacted in 1993, including acts governing the operations of commercial and savings banks, other credit institutions, securities transactions, mutual funds and the Iceland Stock Exchange. The legislation was aimed at imposing stricter rules on the minimum capital ratio and exposure to risk to ensure the economic health of banks and other financial institutions, and to strengthen banking supervision. A new Foreign Exchange Act became effective in November 1992, implementing a policy of a phased elimination of foreign exchange restrictions by the beginning of 1995. Changes in monetary policy instruments and increasing independence of the Central Bank of Iceland, discussed in Chapter IV, have also helped develop financial markets. With the deregulation of markets, there has been a rapid increase in the issuance of new bonds and other financial instruments. The Government, banks and other financial institutions have become active in this market. Financial institutions have also started to offer financial services not previously available in Iceland.

B. Financial Institutions

96. This section describes the main institutions in the financial market. An overview of the structure of the financial system as of 1996 is presented in Table 14.

Table 14:

Structure of the Financial System, 1996

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Source: OECD Bank Profitability, 1998

Commercial banks and savings banks

97. Iceland’s banking sector is dominated by the four commercial banks. Islandsbanki hf., the only fully private limited liability commercial bank was established on January 1, 1990 with a merger of four banks. The merger was a major step in the restructuring of the banking industry in Iceland, which had been completely state-owned from the 1930s through 1990, and had been incurring large losses at the end of the 1980s. The four merging banks were the Union Bank, Ltd., established in 1970, the Industrial Bank of Iceland, Ltd. (1953), The Fisheries Bank of Iceland, Ltd. (1930), and Iceland Bank of Commerce, Ltd. (1961). The National Bank of Iceland (Landsbanki Íslands), the largest commercial bank, and the Agricultural Bank Ltd (Búnaðarbanki Íslands) had been fully state-owned banks until 1998. They were turned into limited liability companies at the beginning of 1998, and a public offering of 15 percent new equity for each bank came to market in autumn 1998. The Minister of Commerce is authorized to sell new equity up to 35 percent of the former equity position. The Government has announced its intention to seek parliamentary approval for a full privatisation of the bank in 1999. The main objectives of this privatization program are to increase competition and improve financial services in all sectors and regions, and to increase private domestic and foreign ownership. These three commercial banks perform all the traditional banking operations. The two partly privatized state banks will not incur state guarantees on new obligations.

98. The fourth commercial bank, Icebank Ltd. (Sparisjódabanki Íslands hf.), is owned by the 26 savings banks in Iceland. As the central bank of the Icelandic savings banks, its operations are fundamentally different from those of other commercial banks, although still governed by commercial banking legislation. It functions as a service bank for the savings banks and their subsidiaries. It handles foreign exchange transactions and other overseas activities for the savings banks, acts as their clearing bank and fulfills the required reserve deposits with the Central Bank on their behalf. The operations of Icebank allow the savings banks to take on larger lending operations which would, due to size or extent of borrowing requirement, otherwise be beyond their individual capacity, by sharing risk and by syndicating loans within the savings banks group and to other financial institutions.

99. Savings banks provide some competition to the commercial banks, but are individually quite small on average. However, the 26 savings banks together form a group that controls about one fourth of the banking market, with 51 outlets throughout Iceland. Since the savings banks have avoided major contributions to loan-loss reserves, total equity has grown much faster than the commercial banks. Savings banks are owned by holders of the bank’s guaranteed capital, provided by the original depositors. However, these owners have the right to elect only 60 percent of the Board of Directors with the remainder appointed by the local government of the region in which they each serve. Moreover, distribution of bank profits and transfer of ownership require approval of the board and there are additional restrictions on the residency and total share of each owner. This has led to a pattern of self-ownership without declaration of dividends. The Icelandic savings banks cooperate closely in the areas of marketing, technology, and training and operate a joint computer center. In addition to Icebank, they also jointly own an investment bank and securities firm, a life insurance company, a leasing company, and shares of two credit card companies.

100. In addition to commercial and savings banks there are two other types of deposit-taking institutions, namely the savings departments of cooperatives and the Post Giro.

101. There have been major changes in balance-sheet items of deposit money banks over the last two decades (Table 15 and Figure 10). Banks’ total assets have increased as a percentage of GDP. New items have appeared, such as bonds sold to the public and marketable securities held as assets, while others have disappeared, such as produce loans and loans repurchased by the Central Bank. In fact, the Central Bank numbers have decreased considerably in the balance sheet of the banks—required reserves and other funds held at the Central Bank have dropped from a peak of about 15 percent of total assets to a stable 3 percent of total assets. This decline coincides with reductions in required reserve ratios. Foreign debt other than produce loans had been declining steadily until 1995, after which it rose sharply to the highest level of the period. Net liquid domestic and foreign assets have dropped in the most recent two years, both becoming negative in 1998, The outcome for 1998 may reflect the abolition of liquidity requirements in March. The sectoral distribution of credit has also been changing significantly (Figure 11). The proportion of total credits granted to households has increased at the proportional loss of lending to the business sector. The rise in lending to the central government through 1995 has been reversed as fiscal consolidation in the past several years permitted the Treasury to repay debt.

Table 15:

Accounts of deposit money banks

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Source: Central Bank of Iceland

Produce loans, bonds and SDR quota.

Figure 10.
Figure 10.

Iceland: Balance Sheet Composition of Deposit Money Banks, 1985–1998

Citation: IMF Staff Country Reports 1999, 068; 10.5089/9781451819212.002.A005

Source: Central Bank of Iceland
Figure 11.
Figure 11.

Iceland: Credit and Sectoral Lending

Citation: IMF Staff Country Reports 1999, 068; 10.5089/9781451819212.002.A005

Source: Central Bank of Iceland

102. Total credit of deposit money banks has expanded sharply relative to total deposits since 1995—the growth has been particularly rapid in 1998. Part of the explanation for the steep increase in lending is related to the method chosen to partially privatize the two state banks. The issuance of 15 percent new equity in these banks, rather than the sale of existing shares, provided additional capital that allowed the banks to expand lending activities. Moreover, the incentive existed to increase lending in advance of the share issuance in order to enhance the return on equity and other ratios thought to make the stock more attractive to the public.

103. An international comparison of bank profitability indicators by Malkämaki and Vesala (1996) and OECD Bank Profitability (1998) data show that operating expenses in Iceland’s banking sector have been more than double the average of OECD countries over the period 1980–94 (Table 16). High costs likely reflect the large number and dispersion of savings banks across Iceland, and the lack of significant competition for financial services until recent years. Lack of competition and high operating costs have also resulted in a spread between lending and deposit rates of more than double the OECD average. In the 1980s, real loan growth surged and pre-tax profitability was higher than the OECD average. This period of rapid lending growth, combined with a recession in the early 1990s, led to sharp increase in provisions for bad debt in 1992–94 and a corresponding deterioration of profitability.

Table 16:

Bank Profitability: International Comparisons

(In percent of balance sheet total; average)

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Source: Malkämaki and Vesala (1996); OECD Bank Profitability, 1998

Investment credit funds

104. In addition to commercial banking, the Icelandic government has been heavily involved in credit markets though financial institutions known as investment credit funds. There have been around a dozen investment credit funds (ICFs) in Iceland in recent years. ICFs have played an important role in the Icelandic financial system with regard to long-term financing, providing housing finance, and channelling credit to the various business sectors of the economy (Table 17). New legislation took effect as of January 1, 1998 which merged four investment credit funds (the Fisheries Investment Fund, the Industrial Loan Fund, the Industrial Development Fund, and the Export Credit Fund) into two new entities; the Icelandic Investment Bank Ltd. (Fjarfestingabanki atvinnulifsins or FBA) and the New Business Venture Fund. A 49 percent share offering was held in mid-November 1998 for the Iceland Investment Bank Ltd. The remaining 51 percent is expected to be sold in 1999. These institutions will not be authorized to take deposits. The FBA will provide all sectors of the economy with long-term credit and will develop a broader range of advanced banking services, such as non-recourse project finance, securitization, and securities underwriting. There will be no state guarantees on new obligations. The New Business Venture Fund, a state-owned institution, is expected to play an active role in the early stages of venture capital and projects financing, consistent with the government’s view that state involvement needs to be redirected from traditional to more complex financial services that would not be provided by the market. The government will only guarantee new obligations of the Export Loan Insurance Department.

Table 17:

Balance sheet of investment credit funds 1/

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Source: Central Bank of Iceland

Kaupping hf. is included as of December 1997. In October 1998, the Commercial Loan fund merged with Islandsbanki hf., one of the commercial banks.

Preliminary.

105. There were three government-owned housing funds in 1998 with roughly equal shares of the market—the State Housing Fund, the Housing Bond Department, and the Workers Building Fund. These funds represented a relatively small source of lending until 1980, but they experienced a rapid expansion following the indexation of nearly all long-term debt instruments and the progressive increase in the supply of funds from pension funds. Their assets grew to more than double the size of the other industrial investment credit funds. Legislation approved by the Parliament in June 1998 is aimed at rationalizing the existing state housing fund system, and establishing a new State Housing Fund in the beginning of 1999.

Institutional investors

106. Although the financial structure has been dominated by the banks and government credit and housing funds, institutional investors have increased in prominence. The rise of institutional investors is expected to provide a disciplining effect to corporate managers by creating large, influencial shareholders, and also will provide a mechanism whereby private savings can be channelled more efficiently into equity investments. They may also provide competition for financial services that will encourage banks to reduce their operating costs.

107. Currently there are 65 pension funds in Iceland. They are now among the largest financial institutions in Iceland and are the most important source of long-term finance in the country. The pension funds receive payments from employers and employees and also extend credit to members. They have typically channelled a large share of their assets to the housing sector of the economy through the government guaranteed housing funds. They also traditionally invested in bonds issued by the Treasury, other financial institutions, municipalities and companies (Table 18). In recent years the pension funds have started to invest in foreign securities. Holdings of foreign assets grew by more than 80 percent in 1998 to 11½ percent of net assets at year-end. Foreign assets were roughly evenly distributed between equities, equity funds and bond funds. Pension funds have scope to increase their holdings of foreign assets as the law limits their exposure to 40 percent of net assets. The increase in foreign asset holdings will diversify household wealth and potentially reduce its correlation with shocks to domestic income. Pension funds also expanded their holdings of domestic equities by 22½ percent in 1998.

Table 18:

Balance sheet of pension funds

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Source: Central Bank of Iceland

Estimation based on sample of the largest pension funds

108. Mutual funds were first established in Iceland in 1985. There are now eleven closed-end mutual funds in operation. They are limited liability companies, and nine of them are quoted on the Iceland Stock Exchange. There are eight open-end mutual funds that are operated in 32 divisions. One credit institution, Kaupþing, also operates mutual funds quoted on the Luxembourg Stock Exchange.

109. There are now 15 insurance companies licensed to operate in Iceland. Three of them are life-insurance companies, representing only 4.5 percent of total assets of the companies. One reason for the relatively small share of life insurance can probably be traced to the employees’ compulsory membership in pension funds. About half of the insurance companies’ portfolio consists of marketable securities, which make them fairly sizeable investors in the Icelandic securities market. In addition, 126 foreign insurance companies have licenses to provide services in Iceland, of which two have established branches.

110. Several well established domestic securities companies are active in Iceland. They perform services such as arranging new issues and private placements, and fund management. They have been advisors and provided placement services in the government’s privatization program. Some of the securities houses also operate mutual funds, or unit trusts, including funds which invest partly or solely in foreign securities.

Other

111. There are three leasing companies in Iceland at present, the first having been established in 1985. Their growth was rapid in the first few years of operation, but slowed when the economic downturn of the early 1990s led to a dropoff of investment in Iceland. Recently the leasing companies have diversified their activities to some extent by granting loans in addition to making conventional leasing contracts.

112. No incentives are offered to financial institutions to conduct offshore business in Iceland. The measures taken to insulate the domestic market from illegal offshore transactions are presumably the same as in neighboring countries. Money laundering, for example, is forbidden by law and the supervisory body has made an effort to educate financial sector agents in this respect.

C. Banking Soundness and Prudential Framework

113. This section discusses the framework for prudential supervision and regulation of Iceland’s financial system, and examines some indicators of the current prudential behavior of banks.

Supervision of financial institutions

114. On January 1, 1999, a new supervisory authority, the Financial Supervisory Authority (FSA), was established to supervise the activities of financial institutions. This represents a merger between the two prior supervisory entities: the Bank Inspectorate, which had been a part of the Central Bank, and the Insurance Supervisory Authority, which was an independent government agency. The merger is thought to provide a more efficient use of supervisory expertise, and greater coordination in supervision, especially since the boundaries between participants in the financial sector have eroded over time. The main task of the FSA is to ensure that the activities of financial institutions are conducted in accordance with the relevant laws and regulations, and they remain sound in other respects. The field of supervision covers the whole range of financial institutions, including all credit and deposit-taking institutions, insurance companies, securities firms, mutual funds, stock exchanges and other regulated markets, central securities deposits, and pension funds. These institutions and firms are obligated to provide all the information considered necessary by the FSA and to permit access to their premises. The FSA can recommend corrective action for institutions in violation of laws and regulations, and is authorized to appoint an inspector at the expense of the party subject to supervision. In addition, the FSA can impose daily financial penalties and can recommend the withdrawal of license. Operational expenses of the FSA are met through quarterly fees paid by all institutions and firms subject to supervision. The FSA reports to the Ministry of Commerce. The Board of the FSA is composed of three members, appointed by the Minister of Commerce for a term of four years at a time. One board member is appointed on the recommendation of the Central Bank.

115. The enacting legislation specifies close cooperation with the Central Bank, including through regular consultative meetings. Moreover, the Central Bank has created a Financial Stability Committee for continued in-house oversight of the stability of the financial system. While the role of the FSA will be to ensure that individual institutions under its supervision operate within the legal and regulatory framework, the committe will act in an advisory capacity for the Central Bank Governors on all aspects of the stability and security of financial institutions and markets, the stability of the financial system as a whole, and the relationship between economic developments, economic management and financial system stability.

Banking regulations and supervisory practices

116. In connection with Iceland’s participation in the European Economic Area, the Icelandic legislation and regulations regarding credit institutions and other financial institutions have been adapted to the various regulations and directives of the European Union. The current rules on capital adequacy for credit institutions and securities firms became effective in 1993 and are based on the Basle guidelines and the EU capital adequacy directive, which specify a minimum capital ratio of 8 percent. According to rules imposed by the Central Bank, commercial and savings banks are limited in their foreign exchange exposure and in their exposure to indexed assets and liabilities to 30 percent of equity as defined by the Capital Adequacy Directive. Appendix I presents details on the legal and regulatory framework for banking supervision.

Deposit insurance schemes

117. Parliament recently adopted changes in legislation and regulation of the banking sector to ensure full conformity with the EEA agreement. The Second EU Banking Directive provides the model for deposit insurance. The existing deposit insurance scheme requires banks to contribute an amount equal to 0.15 percent of their deposits annually to a fund until it reaches a minimum of 1 percent of total assets. There are separate schemes for the commercial banks and for the savings banks. The present law stipulates that the commercial banks’ insurance fund is a government entity, while the savings banks own their insurance fund. According to a provisional Act, the two schemes will be merged in the near future.

118. The role of the Deposit Guarantee Funds is to guarantee depositors full payment of their deposits. However, in the event that the assets of the deposit guarantee funds are not sufficient to repay the total amount of guaranteed deposits in the relevant commercial bank or savings bank, the repayment from the funds will be divided between depositors in such a way that the total amount of deposits of each depositor up to 1.7 million krónur (linked to the exchange rate of the ECU as of January 3, 1995) will be fully compensated, but everything in excess of this sum will be compensated proportionally to the extent of the assets of the funds.

Payment and clearing systems

119. The banks, together with the central bank, operate a clearing system through the Banks’ Data Centre.3 The Centre facilitates the clearing of checks and the flow of payments, including giro payments. The same clearing system functions both as an interbank circuit and as a retail clearing system. The net results from the daily clearing are settled on the participants’ current accounts with the central bank the same day. Cross-border payments are carried out almost exclusively via the SWIFT network and correspondent banking relations. The banks, including the central bank, are all SWIFT members connected via the Banks’ Data Centre. In 1998, a working group was appointed to consider the present structure of the payments system and recommend changes. In December 1998, the working group delivered proposals for reforms to the payments system including the establishment of a clearer distinction between wholesale and retail payments systems. Some proposals are being debated, such as those that would affect the operations of the Icelandic Banks’ Data Centre.

120. A Central Securities Depository (CSD) for dematerialized securities, which will also handle clearing and settlement, is due to begin operations in 1999. In accordance with the Act on Electronic Registration of Securities, which became effective on January 1, 1998, the CSD will use a book-entry only system and initially operate the central registry for all securities listed on the Iceland Stock Exchange. Securities will be held in separate accounts, as nominee accounts are not allowed. Ownership will be recorded through account institutions (banks, brokerage firms) which will be remotely linked to the CSD.

Indicators of financial sector vulnerability

121. Evidence on financial sector vulnerability is mixed, but recent trends point to an increase in some types of risks (Tables 19 and 20). Credit by deposit-taking banks surged by over 30 percent year-on-year at end-1998, compared to around 12 percent at end-1997.4 5 Loans to the real estate sector do not appear to represent a large share of total loans—this sector accounts for roughly 7½ percent and the proportion has been trending down slightly over the past few years. However, banks have large sectoral exposures to households and to the fishing industry, which represent 25 percent and 22 percent of total loans, respectively, in 1998. The net liquid position of banks has fallen considerably in the most recent year—it stood at a negative 4¾ percent of total assets at end-1998. By end-January 1999, the net liquid foreign assets and net liquid domestic assets were each around −3¼ percent of total assets.

Table 19:

Selected Financial Institution Indicators

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Source: Financial Supervisory Authority

Some data for 1998 is at end-June or end-November.

Table 20:

Commercial and Savings Banks, Profit and Loss Indicators

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Source: Financial Supervisory Authority

122. A large part of the credit expansion in 1998 was financed by external borrowing, increasingly at shorter maturities. Short-term external debt at end-1998 was more than twice as large as foreign exchange reserves. Direct foreign exchange exposure of the banks appears to be small—foreign currency linked assets and liabilities are nearly identical as most external borrowing by banks is relent in foreign currency loans or exchange rate indexed domestic loans. As an illustration of this typical relending activity, foreign currency liabilities accounted for 12 percent of total liabilities of commercial and savings banks at end-1996, of which the amount owed to non-residents was twice as large as the amount owed to residents (Table 21). However, foreign currency assets of the banks (14 percent of total assets) consisted mainly of claims on residents (12 percent of total assets). The export sector is responsible for a large part of the relent foreign loans. Nonetheless, the relending of foreign funds increased by about 55 percent year-on-year in 1998 when real export activity expanded by only around 3 percent. This development and other anecdotal evidence suggests that some of the expansion of relent foreign credit was directed to other resident firms and to individuals that are not naturally hedged to exchange rate movements through their income stream. Thus, the indirect foreign exchange exposure of banks may have increased through the credit risk of their customers that have taken on the exchange rate risk.

Table 21:

Assets and Liabilities of the Banking System, 1996 by Currency and Residency

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Source: OECD, Bank Profitability, 1998

123. The average lending spread has declined in recent years, perhaps as a result of greater competitition between banks and other financial institutions. This has not resulted in lower profitability, however, as pre-tax profits have risen. The outcome is in part due to the attendant decline in operating costs. In addition to the positive trend in profitability, recent credit ratings have been favorable. In the past three years, Moody’s Investor Service has twice upgraded Iceland’s country ceiling for foreign currency debt and bank deposits, and recently gave Icelandic banks a stable credit outlook, citing good economic conditions and the strengthening of the banking system.6

124. Capital adequacy ratios of the commercial banks and largest savings have been above 8 percent in recent years, although they have generally been declining through June 1998. In some cases, however, capital adequacy ratios excluding subordinated loans have been below 8 percent. Although the Basle standard for capital adequacy is achieved at a ratio of 8 percent, it is only a minimum standard. A level significantly above 8 percent is typically considered prudent, especially for banks in less diversified and more volatile economies such as Iceland. Savings banks in Iceland have typically maintained higher ratios on average than the commercial banks, especially the state-owned banks. Moreover, banks could use their increased profitability of the last few years to strengthen the capital base. Rules permitting (up to a total of 35 percent) new share issuance in the partially-privatized state banks may help facilitate an increase in the core capital base.

125. Nonperforming loans have declined over the past four years to 4 percent of total bank loans.7 Total provisions for loan losses have also receded in recent years, to under 3 percent of total loans in 1998. This downward trend follows a peak in net provisions in 1992, which occurred after a substantial boom in real lending growth in the late 1980s (Figure 12). On the basis of the experience of the last two decades, there appears to be a lag of a few years between real lending growth and provisions for bad debt. This is consistent with the argument that rapid lending growth can result in a deterioration of loan quality, although the performance of the loans may not decline immediately and likely also depends on overall economic conditions. In fact, the peak of net provisioning in 1992 occurred at the same time as a major recession in Iceland.

Figure 12.
Figure 12.

Iceland: Selected Banking Sector Data

Citation: IMF Staff Country Reports 1999, 068; 10.5089/9781451819212.002.A005

Source: OECD Bank Profitability, 1998; International Financial Statistics

D. Financial Market Policies and Reforms

126. Reforms initiated in the mid 1980s aimed at reducing state involvement in financial markets, making room for market forces to play an increasing role in the development of the financial system.8 In the 1990s, the authorities have taken further steps with a view to strengthening financial market efficiency and liquidity. This section examines recent reforms in the markets for foreign exchange, short- and long-term debt instruments, and equity. Box 2 sketches the chronology of major events. Although changes in the financial markets have occurred mainly by design, economic conditions have influenced them as well.

Financial Sector Chronology

This was temporarily reinstated in February 1999.

Capital movements

127. In recent years the rules and regulations governing inward and outward capital transactions in Iceland have been liberalized. Foreign direct investment in Iceland is regulated by Act No. 34/1991 on investment by non-residents in business enterprises, as amended in May 1996. Direct investments and purchases of residence abroad by Icelanders are fully liberalized. However, there are still restrictions on direct investments by foreigners in the sectors of fishing and fish processing, energy, and aviation:

  • Direct investments by non-residents in fishing and fish processing is prohibited, indirect investment is limited to a maximum of 33 percent.

  • Residents and companies residing inside the EEA are allowed to invest in energy production and energy distribution in Iceland. Residents and companies residing outside the EEA can apply to parliament for such rights.

  • Investments by residents outside the EEA in aviation companies are restricted to 49 percent.

128. At the beginning of 1994 long-term portfolio investments were completely deregulated, and restrictions on short-term movements were eased. The final step in the liberalization of external capital movements was taken on January 1, 1995, when all restrictions on short-term capital movements were abolished. There are now no restrictions on non-resident trades in Icelandic debt instruments or debt derivatives (futures, options, forward contracts, or swaps). Non-resident trades in shares in Icelandic enterprises are subject to the same restrictions as direct investment by non-residents in enterprises. There are also no restrictions on the repatriation of capital, interest or dividends for all investments in Iceland’s financial markets. Non-residents may open accounts with resident depository institutions. The regime on external capital movements in Iceland is now in full accord with the EEA agreement and the regime in EU countries. Foreign exchange conversions for current payments have been unrestricted since a new Act on Foreign Exchange and the Regulation on Foreign Exchange became effective on January 1, 1993. Payments in connection with trade in goods and services are also fully liberalized, including travel expenses, interest payments, dividends and other forms of income from capital. Parliament must approve foreign borrowing by the Treasury and government institutions as listed in the annual budget. In addition, there is a standing authorization to refinance outstanding public debt.

129. Despite the liberal environment, there has been little foreign interest in Icelandic securities. This is largely attributed to lack of market liquidity, settlement and clearing risk, and the previous widespread indexation of the market. A large part of inward foreign direct investment has been directed to energy generation and power intensive sectors. The fishing industry has expanded in recent years, accounting for the bulk of foreign direct investment abroad.

The foreign exchange market

130. The Central Bank has recently reorganized the foreign exchange market in order to support market development and promote market-determined prices. Under previous arrangements, the Central Bank had played a central role in the market. Fixing meetings had been held between the Central Bank and the commercial banks each morning, during which most interbank transactions took place. The daily foreign exchange fixing meetings were abolished in July 1997 and the market became continuous. Commercial banks assumed the obligation to post continuous two-way quotes. Nevertheless, the Central Bank continues to intervene in the foreign exchange market for monetary policy objectives.

131. Derivative instruments are playing an increasing role in the foreign exchange market, since the commercial banks started to offer forward and swap contracts to their customers. Some securities houses have started to offer currency options over-the-counter.

Money market

132. Despite deregulation of interest rates in 1986, money markets have developed only in recent years. The market in short-term government paper emerged after the Treasury’s unlimited access to a central bank overdraft was phased out between 1992 and 1994. The Treasury began auctioning standardized 3, 6, and 12-month bills on a regular basis. Prior to that time, Treasury bills were only sold on tap at a price decided by the Ministry of Finance. The amount and maturity had been chosen by the investor, making the bills unsuitable as instruments for secondary market trading. The Central Bank can make non-competitive bids at auctions, but is not required to do so. The bills have been listed on the Iceland Stock Exchange and the secondary market for bills has developed rapidly to become the largest financial market in Iceland in terms of traded volume. The Central Bank is the only market-maker in Treasury bills, and commercial and savings banks are the most common traders. The Central Bank has been considering transferring market-making responsibility to the commercial banks in order to facilitate monetary policy operations, which may currently be hampered by the obligation to post two-way quotes.

133. The interbank market for short-term securities was reorganized in 1998 in conjunction with the changes in monetary policy instruments. The Central Bank issued new rules that became effective in early June. Under prior arrangements, the Central Bank intermediated in all loan transactions as it always stood ready to engage in repurchase or resale agreements. Repo-transactions were limited to one day a week in order to increase the volume of interbank transactions. Eight institutions are now active members in this market—four commercial banks, two investment banks, and two savings banks. The new regulations require members to quote indicative interest rates for interbank loans and deposits for different maturities. On demand from another market participant, binding quotes must be given for minimum amounts for a specified maturity. Each morning, the Central Bank calculates the average of the quotation of the market participants for the different maturities and displays them publicly on the Reuters information system.9 Trading volume in the interbank market started to rise following the change in monetary policy instruments in March, and increased sharply after the new arrangement became effective. Plans were developed to offer maturities of three, six, and twelve months in addition to the prior shorter-term maturities. An interbank market for free overnight reserves has been operated via telephone for several years by the four commercial banks. Other short-term instruments include commercial and savings bank bills, which are tailor-made and usually not traded on a secondary market. A primary market also exists for units of money market mutual funds.

Bond market

134. The securities market in Iceland has expanded gradually. The government has issued indexed government bonds since 1964, and bond market development has also been asssisted by the deregulation of interest rates in 1986 and the commencement of regular weekly auctions of government securities in 1992. A secondary market for government bonds began to develop following the establishment of the Iceland Stock Exchange in 1985 as a joint venture of several banks and brokerage firms. For the first few years, domestic government bonds were the only instruments traded on the Exchange and until 1993 they were the dominant component of trading value. In recent years the supply of Treasury bonds has slowed as the the budget has been brought into surplus. This has created opportunities for other issuers and nearly 40 corporations and municipalities have listed their bonds on the Exchange. Table 22 shows the turnover and market capitalization of various short and long term securities on the Iceland Stock Exchange.

Table 22

Turnover on the Iceland Stock Exchange

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Market Capitalization on the Iceland Stock Exchange

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Source: Central Bank of Iceland

As of end November, 1998

135. Another milestone in the development of the bond market occurred in February 1996, when the Central Bank of Iceland relinquished its role as a market-maker for long-term government bonds. The Central Bank’s control over interest rates has been weakened as the long-term market deepened. In addition, attempts to exercise control over long rates sometimes compromised other monetary policy targets. Therefore, based on the judgement that the markets could function smoothly without daily intervention from the central bank, an agreement was concluded with three securities houses according to which they assumed the responsibility to maintain liquidity in the secondary market. The central bank handed over a part of its stock of government bonds to the securities houses in order to facilitate market-making and to finance their operations. The new system has operated successfully—spreads have narrowed and the volume of trade has increased. Ultimately this reform will be instrumental in fostering increased depth and liquidity of financial markets.

136. Another major sector of Iceland’s domestic securities markets consists of housing bonds issued by the State Housing Board. These are 25-year inflation indexed bonds carrying a government guarantee. The housing bond system was introduced in 1989, and housing bonds were listed on the ISE in 1990. They quickly became the benchmark bonds for long-term interest rates and have grown to be comparable in size to that of government bonds. The housing bond system involves a non-market allocation of credit and places housing credit risk on the government. Discussion of alternatives has been inconclusive, with the most obvious solution—transferring housing credit to the banks—running up against the banks’ capital adequacy requirements.

137. A major characteristic of Iceland’s securities market had been the extensive practice of indexation of financial obligations to inflation. Throughout the 1970s, high and variable inflation, combined with controlled nominal interest rates led to negative real interest rates and a sharp fall in saving. Indexation of government bonds was introduced to generate positive real interest rates, and later indexation was extended to bank deposits and loans. As price stability has been established, indexation is receding from the short to medium-term end of the securities market. Moreover, the government has been trying to phaseout the use of indexed obligations by issuing only non-indexed medium-term securities. The reduction of indexation is expected to help develop markets for short-term nominal instruments, encourage foreign participation in Iceland’s financial markets, and reduce the disinflation risk of banks, which have typically had more indexed assets than liabilities.

Public debt management

138. The National Debt Management Agency (NDMA) was established by Parliament in 1990. This action transferred responsibility for the marketing and management of public debt to the NDMA, thereby reducing the role of the monetary authorities in the bond market. The legislation assigned the domestic and foreign borrowing and debt management functions of the Treasury, and government guarantees to the NDA. However, under a special agreement the Central Bank is responsible for the execution of foreign borrowing for the Treasury.

139. The debt management strategy has involved diversification of the debt with respect to maturity, currency composition, and interest rates. The Icelandic government has borrowed on both foreign and domestic financial markets, in roughly equal proportions during the 1990s. The policy has generally been to borrow at longer maturities. The average maturity and duration of external public debt at the end of 1997 were 4 years and 3 years, respectively, although the profile extended to the year 2016. The currency mix of external debt is determined with a broad reference to Iceland’s trade patterns. In this respect, U.S. dollar denominated debt has represented a large but declining share of the foreign currency composition of the debt. Most of the foreign debt has been contracted at fixed interest rates. The floating component includes the borrowings through the Euro Commercial Paper Programme, which Iceland established in 1985. Iceland’s credit ratings on various types of debt were upgraded by Moody’s and Standard & Poor’s in 1996, and again by Moody’s in 1997. Iceland’s ECP Programme has been assigned the highest possible short-term credit ratings.

Equity market

140. Development of Iceland’s equity market has been slow during the first half of the 1990s, but has accelerated rapidly in the last three years. On the primary equity market, the supply of new equity (public offerings and privatization) receded between 1992 and 1995 (Table 23). One reason was the delay in implementation of privatization plans. In addition, weak economic conditions were reflected in low company earnings and declining interest rates, favoring the use of the debt during those years. New issue of equity on the primary market has grown rapidly in 1996–98 in line with the strength of domestic output. The growth also led to increased turnover on the secondary market and higher prices.

Table 23

Equity Listed on the Iceland Stock Exchange

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Public Issues of Equity, Equity Privatization and Turnover on Secondary Market

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Source: Central Bank of Iceland

The OTC market is an unregulated equity market.

141. The secondary equity market does not have a very long tradition in Iceland. Limited liability companies have existed for many years, but they often obtained new share capital through rights issues. Underdeveloped financial markets and a low level of primary issuance are partly to blame. In some cases, secondary market trading has been restricted by company resolutions. Equities were first listed on the Iceland Stock Exchange in 1990, but no equity trades took place until the following year. As a result many companies began the listing process in 1992, with an average of six new listings per year from 1992 to 1996. At year-end 1996 a total of 32 companies had been listed, but 1997 provided a big boost, as 19 more companies were listed in one year. By the end of 1998, 67 companies listed their shares on the Exchange with a current market capitalization of around 230 billion krónur (39 percent of GDP).

142. Some trading also takes place outside the ISE. Many small firms had problems raising equity capital due to the prohibitively high costs of listing on the ISE. In 1992, the largest brokers in Iceland started operating an over-the-counter (OTC) market for non-listed shares, and the Exchange allowed its members to use the trading and information system for trading in this market. Some companies have recently moved from the OTC market to the Stock Exchange.

The new Business Venture Fund is expected to assist in the early stages of business development of small and medium sized firms.

143. New legislation, adopted in April 1998, requires the Icelandic Stock Exchange to be converted into a limited liability company and abolishes its monopoly on exchange activities. At the same time, the legislation permits the Exchange to offer new services such as trading systems for electricity and fishing quotas. Given the small size of the Icelandic financial market, the emergence of local competition to the ISE seems remote. Members of the Exchange include the Central Bank, all the commercial banks and securities houses and some savings banks. Securities listed on the exchange include stocks, government bonds, notes and bills and various private bond issues, primarily by credit institutions. There is no Securities and Exchange Commission, so the regulatory aspects are divided between the Ministry of Commerce, the Financial Supervisory Authority and licenced securities exchanges or regulated securities markets. The Iceland Stock Exchange has issued rules on membership, listings of securities, disclosure, the trading and system, as well as a schedule of charges. Turnover on the exchange has risen rapidly in recent years. At the end of 1998, the market capitalization of listed securities was about 600 billion krónur, equivalent to 67 percent of GDP. Of this amount, bonds comprised about 60 percent and equities 35 percent.

E. Macroeconomic Effects of Liberalization

144. The previous sections have described the many developments and reforms that have taken place in Iceland’s financial sector over the past several years. This concluding section examines how various aspects of economic behavior and macroeconomic control have been affected by these changes, and what risks lie ahead for the future.

Economic behavior following liberalization

145. Household behavior in Iceland over the past two decades has been characterized by declining saving ratios and an accumulation of household debt (Figure 13). One explanation for this may be the relaxation of borrowing constraints following financial deregulation. Another explanation may be that households borrow for current consumption when their expected future incomes rise. An upward revision to income expectations could occur when the government engages in credible policies to increase growth, reduce inflation or other economic distortions. A stable economic environment can also reduce the need for precautionary savings. Another explanation could be that households consume more as their wealth increases. Indeed, total net household wealth has increased over the period. However, the rise can be attributed to a sharp increase in pension fund assets, since net wealth excluding pensions has fallen steadily. Moreover, the ratio of debt to fixed assets has risen. Some features of the tax system, such as mortgage interest rebate schemes, may encourage the accumulation of debt.

Figure 13.
Figure 13.
Figure 13.

Iceland: Financial Sector Indicators

Citation: IMF Staff Country Reports 1999, 068; 10.5089/9781451819212.002.A005

Source: Central Bank of Iceland; International Monetary Fund, World Economic Outlook, and International Financial Statistics.1/ As a percentage of household disposable income.2/ As a percentage of total fixed assets.Sources: National authorities; and Bank for International Settlements.1/ The real estate price series splices an index of apartment prices in the Reykjavik area prior to Jan. 1996 together with a more general index that includes larger dwellings starting in Jan. 1996. This may introduce a bias since the fall in the price of larger dwellings will not be fully reflected in the index, whereas the recent increases will be.

146. In the event, these recent trends are somewhat worrisome: households have committed themselves to an increased level of debt service and cannot expect to rely on pension fund assets, which are generally illiquid until retirement. Other assets, such as equity, are subject to price declines that can quickly erode net wealth. Thus households have become more vulnerable to income shocks in meeting their obligations. As discussed earlier, there are some indications that the buildup in household debt obligations includes credit from the banking system in foreign currency or foreign currency linked terms. The expansion of household debt has been used in large part to finance purchases of new automobiles and durable goods, the stock of which had deteriorated during the recession of the early 1990s. Consequently, Iceland’s current account deficit has widened to nearly 6 percent of GDP in 1998, only partly reflecting imports of investment goods.

147. The behavior of the private sector as whole parallels that of households. Capital account liberalization and financial deregulation has been followed by an upswing in economic activity over the last 3 years, and in 1998 output is estimated to have been above potential by about 2 percent. Investment grew briskly by around 23 percent in constant prices in 1998. Although the share of lending to firms contracted as the share to households grew, the growth rate of lending from the banking system to firms was over 30 percent in 1998. The upswing has also been accompanied by a rapid rise in bank lending which has outstripped the increase in domestic deposits, as discussed in earlier sections. Much of the new lending has been financed by increases in banks’ liabilities to nonresidents. According to BIS data, external debt of Iceland’s banking system and private sector have risen in the past few years, while public sector external debt fell.

148. In the three Nordic countries of Norway, Sweden, and Finland, economic behavior followed a similar pattern after financial deregulation. Households reduced their savings and borrowed aggressively, partly to finance purchases of consumer durables. This was set in an environment of low and declining unemployment and led to large current account deficits. Similar economic behavior has also been observed in other countries where short-term external debt has been used to finance a consumption and import boom. Positive terms of trade shocks also contributed to strong domestic demand growth in the Nordic countries during their boom period, and have occurred in Iceland recently as well. The bank lending boom in Iceland also mirrors developments in Norway, Sweden, and Finland prior to the Nordic banking crisis.

149. However, some elements of the typical post-liberalization pattern do not yet seem to be present. Many countries, including the Nordic countries (IMF Occasional Paper 161), experienced booms in stock and real estate markets. In Iceland, the exposure of banks to real estate has actually declined slightly over the past few years as a percent of total loans (although this may be due to a stronger competitive position of the government housing funds for mortgage financing). Real estate prices have been fairly stable over the past few years, and have only picked up somewhat in recent months. Icelandic stock prices have risen strongly in the past few years, but the increases have been in line with stock price movements in other Nordic economies.

Sequencing of reforms

150. It is generally agreed that capital account liberalization, especially of short-term inward capital flows should come after liberalization and reform of the domestic financial system. Timing is also important: liberalization can contribute to instability if it occurs at a time when the banking system is weak, or when there are significant macroeconomic imbalances or economic distortions. Given the macroeconomic momentum that often follows liberalization, policy-makers must respond quickly or preemptively to developments; otherwise, financial stability may be compromised. For example, deregulation in some of the Nordic countries was followed by a strong macroeconomic expansion. These conditions, combined with weak banking supervision and delayed policy responses led to excessive lending, followed by a banking crisis triggered when macroeconomic conditions deteriorated.

151. In Iceland, the main initiatives to liberalize financial markets and the capital account have occurred within a few years of each other, and some financial sector initiatives such as privatization of state-owned banks have not yet been completed. Moreover, responsibility for supervising the financial system has been transferred from the Bank Inspectorate to the newly established Financial Supervisory Authority. Thus, there are some elements of financial reform that have not preceeded the removal of all capital flow restrictions.

152. Yet, Iceland has not experienced destabilizing inflows of portfolio capital following capital account liberalization. The prospects for these in the near future are unlikely due to the small size of and relative unfamiliarity with Iceland’s financial markets. Iceland has attracted considerable foreign direct investment, mostly in energy intensive sectors. As described above, however, external debt intermediated through the banking system has risen sharply and domestic demand is growing at a frenetic pace. The burden of quelling economic activity has fallen primarily on monetary policy and the sequence of interest rate increases have widened the interest rate differential with abroad, thus increasing the attractiveness of external debt as a financing source.

Monetary policy transmission

153. This section discusses the ways in which monetary policy transmission may have been affected by financial liberalization. There are three main channels of monetary policy transmission: (i) the bank lending channel, (ii) the interest rate or balance sheet channel, and (iii) the exchange rate channel. Monetary policy can affect the supply of bank credit through open market operations, changes in reserve requirements, and changes in interest rates. Changes in the supply of bank credit and the level of real lending rates will impact investment and consumption decisions that rely on bank credit. The second channel relates changes in policy interest rates to changes in interest rates along the entire maturity spectrum and also typically affect the prices of other real and financial assets. These changes in interest rates also affect private consumption and investment and in turn national output. In addition, changes in asset prices can impact investment and consumption through wealth or balance sheet effects. Finally, changes in short term interest rates can lead to capital flows that alter the exchange rate. Exchange rate movements then affect the import component of the domestic price level and also impact aggregate demand by changing the volume of imports and exports.

154. Monetary policy transmission can be affected in different ways following financial liberalization. Financial liberalization could be expected to weaken transmission through the bank lending channel, but strengthen it through the balance sheet channel. Monetary policy conducted through open market operations affects the availability of bank credit. However, financial liberalization provides firms with alternative sources of funding. As the availability of bank credit becomes less binding than in the past, open market operations may not be as effective in controlling the expansion of economic activity. On the other hand, financial liberalization also reduces credit constraints of firms and households, frequently leading to greater leverage. The debt servicing costs of leveraged firms and indebted households become more responsive to changes in interest rates, especially if loans are contracted at adjustable interest rates. In addition, the wealth effects of changes in interest rates become more important, especially since prices of assets used as collateral for loans fluctuate in response to interest rates.

155. The exchange rate channel can also strengthen the transmission mechanism provided that the central bank does not intervene to prevent appreciation. Liberalization of capital flows leads to greater interest elasticity of the exchange rate. In this case, an increase in interest rates would lead to upward pressure on the exchange rate, which then reduces the foreign component of consumer prices and contracts domestic output. On the other hand, if exchange rate appreciation is resisted by unsterilized official intervention, the monetary base would expand in concert with higher net foreign assets. In addition, an appreciation of the exchange rate in response to higher interest rates could reduce the debt servicing costs of foreign currency-denominated debt, allowing an expansion of output due to the increased availability of internal finance from retained profits.

156. In Iceland, financial sector reforms have indeed led to the development of alternative sources of financing, including marketable securities, foreign direct investment, and foreign debt. These would be expected to reduce the effectiveness of monetary policy from open market operations. On the other hand, households and firms in Iceland have become more indebted over the past several years. The ratio of household debt to disposable income and to fixed assets has increased sharply. This development raises the sensitivity of these sectors to interest rate changes. This is particularly relevant since more than half of borrowing in Iceland is contracted at flexible interest rates. The use of inflation indexed loans—an important feature of the Icelandic financial system in the past—may have an ambiguous effect on real interest rate sensitivity. The extent of indexation in Iceland has declined substantially, however, as a low inflation environment has prevailed over the past several years.

157. The Central Bank of Iceland has produced a number of econometric studies on interest rate determination in Iceland, which are summarized in the Central Bank’s 1997 Autumn Statement. According to this research, the exchange rate channel is very effective in Iceland and has become more so since capital account liberalization in 1995. The short-term interest rate differential has a significant impact on capital flows, which in turn have a significant impact on the exchange rate. Research confirms a strong relationship between the exchange rate and domestic inflation. Moreover, an increase in the nominal exchange rate leads to an increase in the real exchange rate, which subsequently lowers the demand for domestically produced goods (via the substitution of imports) and reduces the demand for labor. The econometric studies also indicate that there has been a shift in interest rate determination in response to financial market development and reforms. During the formative years of the domestic financial system, Central Bank policy had a greater focus on long-term bond yields, which in turn had a pivotal impact on bank rates and short-term money market rates. However, the Central Bank has ceased trading in long-term bonds, using short-term interest rates as the monetary policy instrument. Consequently, and in conjunction with the rapid development of the money market, short-term interest rates now play the leading role in the transmission mechanism. Housing bonds appear to have replaced government bonds as the trend setter for long-term interest rates.

International Convergence in Asset Returns

158. Economic theory dictates that increased openness of a country’s capital account would be accompanied by an increase in the correlation of interest rate and asset price movements since in equilibrium the risk-adjusted expected returns on all freely tradeable assets should be equalized. Empirical estimation by the Central Bank of Iceland shows that there is a significant relationship between foreign short-term interest rates, especially of the U.S., and short-term krónur interest rates. The relationship has strengthened considerably after the liberalization of short-term capital movements in the beginning of 1995.

159. Staff estimations show that there is also a significant relationship between the price changes of the U.S’s S&P500 stock price index and Iceland’s ICEX all-share stock price index. In particular, changes in the S&P500 index Granger cause changes in the ICEX index. This result is very robust to the number of lags used in the Granger causation procedure. However, the results do not indicate increased elasticity to the S&P500 after 1995 compared to the prior years.

Impact of financial reforms on long-run growth

160. Financial reforms can enhance growth by three main routes: (i) increasing savings, (ii) increasing the proportion of savings channelled to investment though improved intermediation, or (iii) improving resource allocation.

161. Financial liberalization in Iceland has heretofore been accompanied by reduced private savings as discussed above. However, Iceland’s increased public savings since 1995 has helped offset this trend. The rise of mutual funds and pension funds can provide a cost-effective mechanism for channelling individual savings into equity investments and may also increase savings by providing access to assets with higher expected returns. Government privatization efforts may help increase savings also. Indeed, recent public offerings of shares of government owned commercial and investment banks kindled substantial public interest. In addition to financial reforms, recent fiscal measures may increase the available savings that can be channelled to investment and thereby increase growth. A new fully funded public pension system has been introduced (Chapter VI) and some of the large fiscal surpluses (on a cash basis) are expected to shore up the old pension fund. Also, the government has increased the percent of personal income that will exempted from taxes if contributed to a pension fund. These measures will raise the importance of pension and mutual funds as alternative sources of funding and contribute to savings and growth.

162. Financial liberalization can reduce intermediation costs in a number of ways. The rise of institutional investors and various types of marketable securities may, as noted above, provide banks with incentives to reduce costs and thereby reduce the interest rate spread. Indeed, the average lending-deposit interest rate spread has declined by over one percent since 1995. The reduction in the spread, accompanied by lower bank operating costs, reduces the proportion of wasted resources that could have been used to finance investment and growth. Intermediation can also benefit from the sharp recent reduction in reserve requirements in Iceland, from greater financial innovation, and from the broader range of available financial instruments. The aggregation of idiosyncratic risks provided by mutual funds and pension funds can reduce the need to hold unproductive liquid balances.

163. Resource allocation could improve from the discipline imposed by creditors. For example, the rise of large institutional shareholders can influence corporate managers to maximize wealth and reduce costs. Over time, deregulated financial institutions can contribute to improved corporate performance by learning to screen investment projects, assess collateral, and monitor projects. On the other hand, increased competition in the financial markets in some countries following financial liberalization has sometimes led to competition for deposits through higher deposit rates that could only be supported by riskier lending activity. Often the lending was directed to unproductive projects or to property markets and contributed to speculative bubbles. In subsequent years, there have been large fiscal costs required to bailout the banking system. Moreover, the rise in provisions for bad loans and weak bank balance sheets reduced available credit for a few years. Resource allocation may have improved due to fiscal consolidation in Iceland over the past several years. This reduced the government’s absorption of national savings, providing firms with greater access to credit, and thereby increasing the investment ratio. However, the proportion of lending to firms has actually declined as bank credit to households has risen.

Financial reforms and cyclical fluctuations

164. How have financial sector reforms affected the economy’s vulnerability to shocks? There are many opposing factors, but a few main points can be mentioned:

  • The trend toward greater private indebtedness increases the sensitivity of the economy to negative shocks. On the other hand, the public sector has been reducing its debt, thereby reducing the impact of interest rate changes on interest expenditures.

  • The stability of the banking system is an important element of the economy’s overall vulnerability to shocks. Indicators of banking soundness have been discussed in an earlier section. While the evidence is mixed, on balance the indicators tend to suggest an increase in the vulnerability of the banking sector to shocks.

  • As new financial institutions and new funding sources grow in relation to the banking sector, the trend could reduce the potential for a problem in one bank to paralyze the financial system. However, as banks and individuals increase their ownership of financial assets, movements in assets prices could have greater wealth effects that exacerbate economic downturns. As the derivative market, which is still in its infancy, develops, it will provide the ability to hedge against shocks, but also provides an outlet for speculative behavior.

  • The development of financial markets may help diversify the economy by providing access to alternative forms of financial intermediation, and especially access to risk capital, which may foster the growth of new industries.

  • The increased correlation of Icelandic interest rates with international rates since the opening of the capital account will likely increase the transmission of some international economic shocks to Iceland.

  • To the extent that the transmission of monetary policy has been strengthened by liberalization, control of macroeconomic fluctuations may be enhanced.

APPENDIX: Legal and Regulatory Framework for Banking Supervision

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