Abstract
This Selected Issues paper estimates the gap between the real effective exchange rate (REER) and its equilibrium (medium-term) value. The paper explores certain features of fiscal policy in Iceland, and examines various aspects of fiscal frameworks in other European countries that are possibly worthy of emulation. It provides a detailed summary of the key issues affecting fiscal policy in Iceland. It argues that political economy factors lead to procyclical fiscal trends, and this is exacerbated by macroeconomic volatility. The paper also provides an overview of the structure of the banking sector of Iceland.
III. Iceland: Financial Sector Developments and Risks to the Outlook12
A. Introduction
32. Iceland’s banking sector posted record profits in 2006, having withstood significant macroeconomic and financial market turbulence in H1 2006. Indeed, the banking sector remained resilient against the stress experienced in international financial markets in February and March this year (Figures 1 and 2). Further, market reaction had been relatively muted following the sovereign downgrades by rating agencies since December 2006, compared to the sharp declines experienced in H1 2006, when the rating outlook was changed by Fitch Ratings.
33. Last year, Icelandic banks gradually overcame investor concerns, raised by the events during the first-half of the year, by taking concrete actions, and learning to better manage perceptions. Key actions taken by banks include: (i) reducing their holdings in equities; (ii) divesting cross-shareholdings and clarifying custody services versus actual shareholding in related companies; (iii) refinancing earlier than scheduled, and paying a higher spread; (iv) diversifying funding sources and improving their short-term liquidity management; and (v) improving the dissemination of information to the market about the measures taken and explaining the unique macroeconomic situation in Iceland.13
Iceland: Stock Prices of Major Banks
(In króna)
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Bloomberg LP.Iceland: Stock Prices of Major Banks
(In króna)
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Bloomberg LP.Iceland: Stock Prices of Major Banks
(In króna)
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Bloomberg LP.
Iceland: CDS Spreads of Major Banks
(In basis points)
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Bloomberg LP.Iceland: CDS Spreads of Major Banks
(In basis points)
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Bloomberg LP.Iceland: CDS Spreads of Major Banks
(In basis points)
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Bloomberg LP.34. Notwithstanding the positive outcome for the banking sector from last year’s turbulence, risks need to continue to be monitored closely. The relative size of the banking sector within the Icelandic financial system means that any severe shock could have potentially significant implications for the economy.14 As at end-2006, the combined assets of Iceland’s credit institutions amounted to more than eight times GDP, while the domestic credit-to-GDP ratio was above 280 percent.
35. This report is structured as follows. Section B focuses on the all-important banking sector. Specifically, the section provides an overview of the structure of the sector, provides an assessment of its risks and vulnerabilities, and broadly discusses issues relating to regulation, supervision and crisis prevention and management. Developmental issues relating to Iceland’s capital markets are presented in Section C. Section D concludes with recommendations to further strengthen financial stability.
B. The Banking Sector
Structure of the Banking Sector
36. The three large commercial banks—Kaupthing, Glitnir and Landsbanki—dominate activity in the Icelandic banking sector. The total assets of these banks account for 88 percent of the total assets of Iceland’s credit institutions, that is, more than seven times GDP (Table 1). The investment bank, Straumur-Burdaras, is the next single largest domestic bank.
Iceland: Size of Credit Institutions by Category, as at end-2006
(In billions of euro)
Iceland: Size of Credit Institutions by Category, as at end-2006
(In billions of euro)
| Category | Total Assets | Percent of Total | |||
|---|---|---|---|---|---|
| 3 major commercial banks | 90.0 | (Parent 60.0) | 88.1 | ||
| 1 savings banks’ bank | 0.9 | 0.9 | |||
| 21 savings banks | 4.6 | 4.5 | |||
| 11 “other credit undertakings” | |||||
| Straumur-Burdaras Investment Bank | 4.4 | 4.3 | |||
| Others | 2.3 | 2.3 | |||
| Total | 102.2 | 100.0 | |||
Iceland: Size of Credit Institutions by Category, as at end-2006
(In billions of euro)
| Category | Total Assets | Percent of Total | |||
|---|---|---|---|---|---|
| 3 major commercial banks | 90.0 | (Parent 60.0) | 88.1 | ||
| 1 savings banks’ bank | 0.9 | 0.9 | |||
| 21 savings banks | 4.6 | 4.5 | |||
| 11 “other credit undertakings” | |||||
| Straumur-Burdaras Investment Bank | 4.4 | 4.3 | |||
| Others | 2.3 | 2.3 | |||
| Total | 102.2 | 100.0 | |||
37. Among the “big three” banks, Kaupthing is by far the largest. It has 48 percent of the total assets of the three, followed by Glitnir with almost 27 percent and Landsbanki with 25 percent of the assets. These three institutions represent almost 50 percent of Iceland’s total stock market capitalization, with Kaupthing alone making up about a quarter of market capitalization.
38. The expansion of Icelandic banks overseas began in earnest in 2004. Acquisitions of FIH Erhvervsbank AS in Denmark by Kaupthing in 2004, BNbank in Norway by Glitnir in 2005, and Singer and Friedlander in the United Kingdom by Kaupthing in 2005, resulted in a sharp rise in Iceland’s banking group assets. These purchases were financed by foreign market borrowing and equity issuances. To date, Icelandic banks have largely expanded to advanced European countries (Table 2). The latest acquisition has been that of Bridgewell, a U.K. brokerage and investment bank, by Landsbanki in H1 2007, while Straumur-Burdaras announced the purchase of a 50 percent share in Wood and Company in the Czech Republic in June 2007. Meanwhile, Glitnir has announced plans to purchase Tamm & Partners Fondkommision, a Swedish securities firm, having recently completed the acquisition of Finnish asset management company, FIM.
Iceland: Overseas Operations of Local Banks
(Number of entities)
Iceland: Overseas Operations of Local Banks
(Number of entities)
| Category | December 31, 2005 | May 1, 2007 | In process |
|---|---|---|---|
| Subsidiaries | 21 | 27 | 1 |
| Branches | 4 | 15 | 7 |
| Representative offices | 1 | 4 | 0 |
| Foreign countries | 12 | 19 | 1 |
Iceland: Overseas Operations of Local Banks
(Number of entities)
| Category | December 31, 2005 | May 1, 2007 | In process |
|---|---|---|---|
| Subsidiaries | 21 | 27 | 1 |
| Branches | 4 | 15 | 7 |
| Representative offices | 1 | 4 | 0 |
| Foreign countries | 12 | 19 | 1 |
39. Given the increasing move by Icelandic banks into offshore businesses, it is not surprising that their foreign subsidiaries account for a substantial proportion of their total assets and income (Figures 3 and 4). Indeed, 62 percent of Kaupthing’s assets are now offshore, while Glitnir’s foreign assets make up 36 percent of its total assets. Both Kaupthing and Landsbanki earn more than 50 percent of their income overseas, and more than three-quarters of Kaupthing’s lending is outside Iceland.
Iceland: Composition of Commercial Banks’ Total Assets by Domicile, as at end-2006
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Financial Supervisory Authority.Iceland: Composition of Commercial Banks’ Total Assets by Domicile, as at end-2006
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Financial Supervisory Authority.Iceland: Composition of Commercial Banks’ Total Assets by Domicile, as at end-2006
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Financial Supervisory Authority.
Iceland: Commercial Banks’ Foreign Income and Lending Activity, as at end-2006
(In percent)
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Central Bank of Iceland.Iceland: Commercial Banks’ Foreign Income and Lending Activity, as at end-2006
(In percent)
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Central Bank of Iceland.Iceland: Commercial Banks’ Foreign Income and Lending Activity, as at end-2006
(In percent)
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Central Bank of Iceland.40. Net interest income represents the most important component of Icelandic banks’ operating income (Figure 5). However, net fee and commission income is becoming more important as banks diversify their earning sources. Net financial gain (e.g., gain from equity investments) has also been a key component of income. Arguably, the standard business model for Icelandic commercial banks tends to be more similar to that of typical investment banks, due to the importance of their trading portfolios in their asset composition.
Iceland: Composition of Banks’ Operating Income, 2006 Average
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Financial Supervisory Authority.Iceland: Composition of Banks’ Operating Income, 2006 Average
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Financial Supervisory Authority.Iceland: Composition of Banks’ Operating Income, 2006 Average
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Financial Supervisory Authority.Risk Assessment
41. Liquidity risk continues to be an important consideration for Icelandic banks. The deposit base is relatively narrow, providing funding for 31 percent of total assets as at the end of Q2 2007. As a result, banks have been very reliant on wholesale funding in international markets to fund their operations and overseas expansions. The popularity of the króna-denominated eurobond (“glacier bond”) carry trade in international financial markets remains an important source of funding for Icelandic banks.15 These banks are expected to continue to participate in international debt markets to bridge the funding gap as they further expand their businesses, which means that they will be exposed to market shocks as a matter of course.
42. Focus has shifted from the short-term risk on the liabilities side of the balance sheet back to the more natural issue of longer-term asset quality.16 Credit to both domestic businesses and households have continued to grow strongly in Q1 2007, at 27 percent and 18 percent year-on-year respectively, albeit having slowed sharply over the course of 2006 (Figure 6). Importantly, there may be signs of an easing in lending standards by banks. For instance, the proportion of mortgage loans with loan-to-value ratios (LTVs) of more than 90 percent has increased, and currently, some 16 percent of mortgage loans by commercial banks fall into this category.17
Iceland: Credit Growth
(In percent year-on-year)
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Central Bank of Iceland.Iceland: Credit Growth
(In percent year-on-year)
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Central Bank of Iceland.Iceland: Credit Growth
(In percent year-on-year)
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Central Bank of Iceland.43. Overall, debt levels are high and rising. Household debt stood at 216 percent of disposable income as at end-2006 (compared to 165 percent in 2000), and at 116 percent of GDP (compared to 90 percent previously). In the corporate sector, very high levels of indebtedness have increased banks’ credit risk from this segment of the market. Total corporate debt amounted to 275 percent of GDP as at end-2006, having increased by 61 percent in 2006. The bulk of commercial bank lending in Iceland is to the domestic corporate sector, where foreign currency loans continue to grow in importance (Table 3).
Iceland: Composition of Commercial Bank Lending
(In billions of króna)
Iceland: Composition of Commercial Bank Lending
(In billions of króna)
| Category | All | Foreign Currency | Foreign Currency Loans as a Percentage of All Loans | ||||
|---|---|---|---|---|---|---|---|
| End-2005 | End-2006 | End-2005 | End-2006 | End-2005 | End-2006 | ||
| Domestic lending | 1,490 | 2,120 | 634 | 1,018 | 43 | 48 | |
| Corporates | 1,042 | 1,522 | 597 | 936 | 57 | 61 | |
| Households | 420 | 538 | 25 | 60 | 6 | 11 | |
| Foreign lending | 491 | 804 | 474 | 771 | 97 | 96 | |
| Total | 1,981 | 2,924 | 1,108 | 1,789 | 56 | 61 | |
Iceland: Composition of Commercial Bank Lending
(In billions of króna)
| Category | All | Foreign Currency | Foreign Currency Loans as a Percentage of All Loans | ||||
|---|---|---|---|---|---|---|---|
| End-2005 | End-2006 | End-2005 | End-2006 | End-2005 | End-2006 | ||
| Domestic lending | 1,490 | 2,120 | 634 | 1,018 | 43 | 48 | |
| Corporates | 1,042 | 1,522 | 597 | 936 | 57 | 61 | |
| Households | 420 | 538 | 25 | 60 | 6 | 11 | |
| Foreign lending | 491 | 804 | 474 | 771 | 97 | 96 | |
| Total | 1,981 | 2,924 | 1,108 | 1,789 | 56 | 61 | |
44. Although asset quality remained high as at end-2006, this tends to be a lagging indicator. Indeed, there are some recent signs of an uptick in the average corporate default ratio in Q1 2007, to almost one percent, from 0.5 percent as at end-2006. The default ratio for households has remained relative stable at just below one percent.
45. Another potential concern is that risk may be underpriced in the lending market. Banks are competing aggressively for mortgage market share with the Housing Financing Fund (HFF), which has 44 percent of the mortgage market, that is, equal to the banking sector; the balance is held by pension funds. The HFF issues state-guaranteed, long-term inflation-linked bonds and prices its mortgage loans accordingly. This suggests that banks may not be pricing credit risk appropriately, in order to compete against the state-owned body.
46. Icelandic banks’ assets are also susceptible to market risk, notably, equity market risk, exchange rate risk and interest rate risk.
Icelandic banks hold a high proportion of equities on their balance sheet, compared to more traditional banks. Specifically, loans with equities as collateral are vulnerable to stock market volatility; 29 percent of the market capitalization of listed equities on OMX in Iceland is held as such collateral. Additionally, banks have also extended credit to companies in which they hold sizeable stakes, as well as to the owners of the latter.
Foreign currency borrowing has been growing strongly (up by 61 percent in 2006), and this could potentially become an important indirect credit risk for banks. Corporate foreign currency-denominated debt has increased sharply. As at end-2006, the outstanding amount with credit institutions was equivalent to 85 percent of GDP, compared to 68 percent as at end-2005. A key concern is that the share of foreign currency-denominated debt in the corporate sector has grown substantially in the services, retail and construction sectors, where income sources are likely to be domestic.
Foreign currency borrowing has become an increasingly attractive avenue of financing for households, which are largely unhedged. It is cheaper relative to borrowing in króna, and some banks are reportedly marketing foreign currency loans aggressively to their customers. This shift by households may be predicated on an implicit belief that the Central Bank of Iceland (CBI) will continue to support the króna indirectly by maintaining a tight monetary policy.
Banks’ mortgage loans are CPI-indexed, with fixed real interest rates and maturities of up to 40 years.18 Since only part of banks’ mortgage lending is matched with funding of similar profile, banks are exposed to interest rate risk. Indeed, sensitivity analysis by the Financial Supervisory Authority (FME) indicates that the biggest commercial banks would have lost some 33 billion króna ($465 million) from a two percentage point rise in market interest rates as at end-2006, given this mismatch.
47. Banks’ business risk profiles are changing. Some institutions are increasingly expanding in the areas of corporate and investment banking and capital markets activity, through either organic growth or acquisitions. This has changed their risk profile from the more traditional retail and corporate business mix. Further, with rapid expansions into other countries and businesses, banks are also having to ensure that their risk management systems and expertise keep up with the greater complexity of operations.
Capacity to Absorb and Manage Risks
48. The performances of the major Icelandic banks have been characterized by high profitability and strong capitalization in 2006.19 The Tier 1 capital ratios of the major commercial banks are healthy, each in excess of 10 percent as at end-2006. That said, mortgage lending is currently not profitable for banks. Due to the high interest rates and the distortions caused by the HFF, banks are unable to fund themselves in the market and issue mortgages at a rate that would yield appropriate risk-adjusted rates of return. Instead, banks are bundling other services (such as insurance) with mortgage loans, in order to generate profits from other products. Over the longer-term, such strategies are likely to be unsustainable and could potentially weaken bank soundness.
49. Banks have acted to reduce their liquidity risk and improve their liquidity coverage over the past year. As a result of the closure of access to European markets last year, banks have diversified their sources of wholesale funding across more countries, for example, to the United States and Asia (Figure 7). Banks have also been able to extend the maturity of their financing, to an average of 4–5 years, which compares quite well against their Nordic neighbors (Figure 8). Encouragingly, the big three banks have secured sufficient funding at longer-term maturities to meet their 2007 obligations, albeit at higher cost. These banks have also set up contingent liquidity facilities, which would employ a myriad of instruments such as covered bonds, repos and securitization. These measures are intended to be both precautionary and preemptive, with banks now able to cover existing business obligations for 12–18 months, without needing market access.
Iceland: Sources of Foreign Funding for Banks, as at end-2006
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Financial Supervisory Authority.Iceland: Sources of Foreign Funding for Banks, as at end-2006
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Financial Supervisory Authority.Iceland: Sources of Foreign Funding for Banks, as at end-2006
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Financial Supervisory Authority.
Nordic Banks’ Funding and Maturity
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Central Bank of Iceland.Nordic Banks’ Funding and Maturity
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Central Bank of Iceland.Nordic Banks’ Funding and Maturity
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Central Bank of Iceland.50. Meanwhile, the sustainability of the glacier bond carry trade activity as an important avenue of króna financing for banks may be tenuous. Ultimately, the demand for these eurobonds will depend on the attractiveness of króna yields, and the continuing interest and confidence of international investors in holding Icelandic assets. Market participants note that Iceland is largely seen as an opportunistic investment rather than a “must hold”, and could therefore be relatively more vulnerable to a sell-off. In turn, this could have some repercussions for banks’ foreign exchange exposures (see below).20
51. The extent of banks vulnerability to market risk is mixed:
The major banks have tried to reduce their equity market risk through 2006. This was achieved partly through the divestment of cross-shareholdings (Kaupthing’s sale of Exista shares) and the reduction of related-party exposures (Landsbanki’s sale of its stake in Straumur-Burdaras).
Foreign exchange risk appears to be largely hedged. The bulk of foreign currency-denominated lending by parent banks is made to borrowers with substantial foreign currency incomes. Residents account for 61 percent of total foreign currency lending by parent banks, with resident businesses representing 92 percent of this amount. Around 7 percent of foreign currency lending to residents is made to those who do not have any foreign currency income.
Foreign currency lending to households, which are largely unhedged, still only represents a relatively small proportion of the total, albeit having grown sharply. Presently, total foreign currency loans to households represent 11 percent of total household loans. The household sector only accounts for 6 percent of foreign currency-denominated lending to residents. However, this segment of lending expanded strongly in 2006, growing by 140 percent over the previous year, and could eventually become a problem if the pace of growth continues and the króna exchange rate weakens significantly.21
Banks appear to have increased their buffer against interest rate exposures over the past year. FME estimates suggest that banks’ fixed interest rate exposures (based on a one percentage point rise in market interest rates) amounted to 3.6 percent of Own Funds in 2006, slightly down from 5 percent as at end-2005.
52. For the medium term, the focus is on banks’ credit risk. The positive aspects are that loan portfolios have become more diversified, by geographic location and by sector (Figure 9). In terms of asset quality, the general consensus is that there is still further upside for prices in the housing market as a result of rising demand and the availability of liquidity, while corporates continue to be profitable. The very low unemployment rate in Iceland (1.1 percent in May 2007) also provides strong support for households’ ability to service debt. On the other hand, household debt has risen to very high levels, notwithstanding the strong employment environment in Iceland.
Iceland: Geographic Composition of Commercial Banks’ Loans, as at end-2006
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Financial Supervisory Authority.Iceland: Geographic Composition of Commercial Banks’ Loans, as at end-2006
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Financial Supervisory Authority.Iceland: Geographic Composition of Commercial Banks’ Loans, as at end-2006
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Financial Supervisory Authority.53. FME stress tests to date suggest that all banks are sufficiently capitalized to withstand a combination of extreme credit and market shocks.22 However, the stress testing models used by the FME and the CBI require further improvement. The current FME stress tests only take into account the impact from an initial shock, and thus underestimate the impact on bank soundness from second-round shocks. The CBI’s stress test uses a simple regression model with macro variables; it does not integrate macroeconomic with financial sector developments. The authorities concur that continuing improvements in stress testing models are necessary.
Regulation, Supervision and Crisis Management
54. Basel I and Basel II reporting will be conducted throughout 2007. Two banks have applied to the FME to use the Internal Ratings Based (IRB) approach. The banks and the FME are currently working with external experts to objectively validate the banks’ models.
55. In the area of financial reporting, the FME notes that the issue of reporting in foreign currencies by the banks needs to be comprehensively examined, but it does not take a particular stance on the issue. Presently, at least 70 percent of banks’ assets and about 80 percent of liabilities are denominated in foreign currencies, while half of banks’ total income is earned abroad.23 If banks prepare their financial reports in foreign currency, they would not need to build up as large a positive net foreign currency position to mitigate the impact of króna fluctuations on their capital adequacy ratios (CARs).24 A concern raised by the authorities is that any concentrated move by financial institutions to change their accounting currency could potentially lead to some volatility in the króna as banks rebalance their foreign currency positions.25
56. Supervisors need to ensure that any change in financial reporting to a foreign currency is effected with due care to safeguard financial sector stability. In this context, the FME notes that its responsibility is to ensure that financial institutions comply with the relevant laws and regulations; it does not expect financial reporting in foreign currencies by Icelandic companies to pose significant supervisory difficulties.
57. The CBI’s reasons for being cautious about banks adopting foreign currency accounting are twofold.
The first is a technical issue, in that the definition of “functional currency” under International Financial Reporting Standards (IFRS) and its application to Icelandic banks remains unclear (Box 1). Given that Icelandic banks have expanded into several European countries, not all of which are in the eurozone area, the choice of an appropriate functional currency may be less than clear-cut in some instances.
The second concern is that if the major banks shift to foreign currency accounting, the volume of króna debt instruments and króna currency markets could decline. Since there are currently three króna market-makers in Iceland—that is, the major commercial banks—any shift to foreign currency accounting might make it less attractive for these banks to continue their króna market-making activity. Given the relatively small size of the market, this could have a severe impact on liquidity.
IFRS and Financial Accounting in Foreign Currencies
Under IFRS, when an entity prepares its financial statements it must use its functional currency and measure its financial position and results in that currency. The functional currency is the currency of the primary economic environment in which the entity operates, namely, the currency in which funds are generated and spent; the currency that influences the sales prices for the entity’s services, etc. Therefore, if a bank has transactions in foreign currencies or has foreign operations, it must translate both into its functional currency following the translation method prescribed by IFRS and subject to specific rules for disclosures and comparative data.
An entity may also prepare its financial statements in a currency other than the functional currency. For example, when a group comprises entities with different functional currencies, the financial position and results of each entity must be expressed in a “common” currency so that consolidated financial statements may be presented. If such is the case, IFRS allow that financial statements be prepared using a presentation currency, again, subject to specific rules for disclosures, comparative data, and additionally, explaining the use of a currency other than the functional currency.
It should be noted that IFRS put the emphasis on preparing financial statements using the currency of the economy that determines the price of transactions rather than the currency in which transactions are just denominated.
58. Contingency exercises and plans for crisis management have taken place between the FME and CBI.26 Further, the authorities anticipate eventually moving towards a model similar to the U.K. Cross-Market Business Continuity Group (CMBCG) collaboration between the authorities and the private sector in the future. Currently, crisis management preparedness also includes on-site visits of financial institutions by the FME. The supervisors recently concluded its visit to Icelandic bank branches in the United Kingdom, in May 2007.
59. There exists long-standing cooperation and collaboration between Iceland and other Nordic supervisors. Nordic central banks have been focused on cross-border issues for quite some time; the concern started with the expansion of Nordea Bank in the region, but has since developed to encompass banking activity across these countries. The Nordic central banks and financial supervisors had held joint exercises previously.
60. The joint Nordic financial system contingency exercise scheduled for September 2007 will also involve the finance ministries of the respective countries, while the Baltic countries will attend as observers. The exercise will examine intra- and inter-country communications, the sharing of information among authorities, contingencies, and stress testing, among other issues. Upon completion of the exercise, a report will be issued and an abridged version will be sent to the EU. It is unlikely that a burden-sharing model will be agreed upon during the exercise, given the difficulty in designing models for the myriad of crisis situations that could occur.
C. Capital Market Development
61. The Iceland Stock Exchange (ICEX) lists both equities and bonds. The equity market is by far the largest in terms of capitalization, and equities are the most actively traded. The OMX Iceland 15 is the benchmark stock index.27 In the bond market, HFF bonds have the biggest share and are the most actively traded. Icelandic securities are largely domestically owned. Foreign investors currently hold an estimated 25–30 percent of the fixed income market, while foreign ownership is lower in the equity market, estimated at around 10–15 percent.
62. The OMX purchased the ICEX in December 2006, and membership of the OMX is seen to provide credibility to the Icelandic market. There is a single trading system and the same trading rules apply to all. Further, the regulatory environment and disclosure requirements across the Nordic countries are very similar. Meanwhile, NASDAQ has expressed interest in acquiring the OMX. If a deal does go ahead, it is anticipated that the OMX in general—and Iceland in particular—would become a more attractive proposition for international investors.
63. There are two factors that are considered key barriers to market development. While all the exchanges in the Nordic area use the same trading system, the use of different clearing and settlement (C&S) systems by different Central Securities Depositories (CSDs) in each country, each requiring separate arrangements, is seen as an important technical barrier. The use of the króna as the quotation and trading currency is perceived by market participants as another barrier. Foreign investors are reportedly reluctant to take risks on both, the underlying asset and the króna. One solution suggested by market participants is that listed Icelandic companies register their share capital in euro, and that stocks be quoted and traded in euro to remove some of the short-term volatility associated with the króna.
64. Financial assets in Iceland are not seen as being overpriced currently. Although some market participants note that good investment opportunities are becoming more difficult to find, others feel that the sharp rise in the ICEX-15 in recent years has been justified on the back of the strong performance of Iceland’s multi-nationals (Figures 10 and 11). Banks have also been more profitable than anticipated. However, given the high capitalization of banks in the stock market, the strength of the stock market is closely tied to the health of the banks. Conversely, banks derive a substantial portion of their income from equity trading gains, and have loan exposures to listed corporates.
65. Private equity activity is said to be growing in Iceland, although little data exist to provide a clearer picture at this stage. Some market participants argue that private equity deals are a negative development for the ICEX as they shrink the already-small stock market; that said, some new listings are anticipated. There is reportedly little hedge fund activity in Iceland at present.
Nordic Stock Market Indices
(January 4, 2000 = 100, benchmark index)
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Bloomberg LP.Nordic Stock Market Indices
(January 4, 2000 = 100, benchmark index)
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Bloomberg LP.Nordic Stock Market Indices
(January 4, 2000 = 100, benchmark index)
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Bloomberg LP.
Valuation of Nordic-Baltic Stock Markets
(In price-to-earnings ratio, benchmark index)
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Bloomberg LP.Valuation of Nordic-Baltic Stock Markets
(In price-to-earnings ratio, benchmark index)
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Bloomberg LP.Valuation of Nordic-Baltic Stock Markets
(In price-to-earnings ratio, benchmark index)
Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A003
Source: Bloomberg LP.D. Summary and Recommendations
66. Following the market turbulence in early-2006, banks have taken important steps over the past year to reduce vulnerabilities and increase their resilience. Specifically, short-term liquidity management has been strengthened. Ownership structures have been made more transparent with the sell-down of some cross-shareholdings. Given the complexity of cross-shareholdings within the Icelandic corporate sector, transparency will continue to be key for maintaining investor confidence.
67. Looking ahead, some new risks may be emerging. Credit risk should be a key focus for banks and supervisors. Lending growth remains very strong, and while loan default rates remain low, they are lagging indicators. Lending standards and the quality of loan collateral need to be monitored closely. Further, banks’ foreign-currency lending to households, which has increased sharply, could potentially become an important indirect credit risk as unhedged households may underestimate the impact of currency movements on their debt-service costs.
68. Strong risk management and robust stress testing models are essential. Stress tests conducted by the financial supervisor (FME) suggest that banks have adequate capital to withstand a combination of extreme credit and market shocks. However, these scenarios may underestimate the second-round effects of such shocks and therefore improvements in stress-testing techniques should continue. As banks continue to expand rapidly and the complexity of their operations increases, it is crucial that their risk management capabilities develop and improve commensurately.
69. Appropriately, the authorities are placing great importance on regulation and supervision of the financial sector. Given the rapid expansion of the financial sector, further strengthening of the FME’s resources is envisaged. At the same time, the authorities’ are emphasizing cross-border collaboration in supervision and crisis prevention and management, following the sharp growth in Icelandic banks’ overseas interests.
70. Reform of the publicly-owned HFF is crucial. The competition for market share between the HFF and domestic banks is preventing the CBI’s policy instrument from effectively reducing domestic demand pressures. Further, this competition appears to be distorting the pricing of risk in the lending market, which poses a concern for financial stability. As a first step in HFF reform, its lending limits and loan-to-value ratios should be reduced immediately to increase competition and pricing efficiency. This should be followed by a gradual and permanent removal of the distortions in the domestic financial market arising from the presence of the publicly-owned institution.
71. The continued development of local capital markets is encouraging. Deep, diversified capital markets would provide reliable, alternative sources of financing for Icelandic companies outside of the banking sector, while enabling banks to further diversify their equity holdings. Meanwhile, increased participation by international investors would broaden the investor base, and continue to promote transparency and enhance the pricing of risk in the market.
Appendix I. The Króna-Denominated Eurobond (“Glacier Bond”) Carry Trade
The first glacier bond was issued in August 2005. The combination of high domestic interest rates and an appreciating currency, against a background of generally low international interest rates, resulted in strong international demand for glacier bonds. Following a drop-off in 2006, issuances have since picked up, reaching a record high in January 2007. As at end-March 2007, glacier bond issuance had reached 418 billion króna ($6.3 billion), equivalent to almost 37 percent of Iceland’s GDP. A positive consequence of the huge interest in glacier bonds is the improved liquidity in Iceland’s domestic financial markets, which has enhanced price formation and enabled smooth trading of large volumes.28
Issuers of glacier bonds are typically highly-rated institutions, such as governments, international organizations or corporates, who want to minimize their borrowing costs. Issuing institutions generally have little or no desire to hold the króna. Rather, their interest is founded on the comparative advantage that AAA-rated international financial institutions and corporates have relative to Icelandic banks and other players in the domestic debt market.29 These issuing institutions are able to place króna-denominated bonds with investors at lower interest rates than are available in the local bond market, but still higher than in most international markets. The issuer is thus able to obtain króna from investors in the glacier bond at a cheaper rate than participants in the domestic debt market. For these investors—the majority of whom are domiciled in Europe—the combination of a high-yielding currency together with the fillip of a AAA-rated issue is a very attractive proposition. By taking this circuitous route, issuers are thus able to achieve lower funding costs than would otherwise be available to them by issuing directly in either the dollar or euro currency market.
The individual parties to the transaction are then able to separately hedge out their respective exposures. Upon receiving the króna proceeds from investors, the issuer undertakes a currency swap with, usually, the bond originator, and normally for euro, removing all currency risk for the issuer. The originator may then choose to pass on some or all of this currency risk via a reverse swap in the local market, in this case, with Icelandic banks which need to fund their balance sheets. These banks would thus hold a local-currency denominated fixed-interest liability and a foreign currency-denominated claim at a variable interest rate plus a fixed margin. To minimize their currency risk, the domestic banks could seek to match their foreign currency asset with a suitable liability by borrowing foreign currency at a variable interest rate plus a fixed margin. To hedge their interest rate risk, these banks could purchase Treasury notes in the domestic market or on-lend the funds, on fixed interest rate terms, in the local market.
Appendix II. Icelandic Banks and the Issue of Financial Accounting in Foreign Currencies30
In Iceland, banks and other companies which intend to prepare their accounts in foreign currency require a special authorization from “The Annual Accounts Registry.” Authorization would only be granted if the applicants fulfill certain conditions regarding the degree of foreign operations and/or income in their activities. The provisions of the law regarding this issue were introduced in 2002. There were 130 companies that were authorized to draw up their annual accounts in a foreign currency as at end-August, 2006, with the majority choosing the U.S. dollar.31 Further, Iceland’s listed companies were required to draw up their consolidated annual accounts in conformity with International Financial Reporting Standards (IFRS) in 2005, and their individual accounts in 2007.32
More than 70 percent of activity in the financial statements of Icelandic banks are in foreign currency. As a result, fluctuations in the króna exchange rate significantly affects the capital adequacy ratios (CARs) and returns on equity (ROEs) of the banks when their financial reports are prepared in króna. Specifically, the disparity between foreign items in banks’ Own Funds relative to their risk-weighted assets (RWA) leads to fluctuations in their CARs when the króna fluctuates against other currencies (Box A.1).
From the point of view of a bank which may be significantly affected by such fluctuations in CARs, changing to financial reporting in a foreign currency may be a logical move. A bank which prepares its accounts in króna may find it difficult to attain the corresponding ratio of foreign items in its Own Funds and RWA without building a positive net currency position. Estimates by the FME suggests that in order for the three largest commercial banks to achieve this balance as at end-2006, they would have had to increase their net foreign currency position by around 230 billion króna ($3.2 billion). Meanwhile, any open currency position could induce fluctuations in income, since any profit or loss from foreign exchange translation would have to be put through the profit and loss statement. In contrast, exchange differences arising from the translation of net investment in foreign operations and of related hedges are transferred to the Translation Reserve in the balance sheet, and not put through the profit and loss statement.
Example of Financial Accounting in Króna versus Foreign Currency
An Icelandic bank, which prepares its accounts in króna with equity denominated in króna, has the following position:
Foreign items make up 75 percent of its RWA.
Subordinated loans in foreign currency amount to 25 percent of Own Funds.
A net foreign currency position of zero in the beginning.
An initial CAR of 13.3 percent.
In the current position, the CAR would fall if the króna depreciates (Scenario 1 in Table A.1). However, the bank could mitigate the impact of such exchange rate movements on the CAR by building a net positive foreign currency position.
Króna Accounting: Impact of Changes in the Króna Exchange Rate on Bank Capital Adequacy Ratio and Return on Equity
Króna Accounting: Impact of Changes in the Króna Exchange Rate on Bank Capital Adequacy Ratio and Return on Equity
| Scenario | Foreign Currency Position Relative to Equity | Foreign Currency Position Relative to Own Funds | CAR Adjusted for Net FX Position | Following a 20 Percent Depreciation of the Króna | ||
|---|---|---|---|---|---|---|
| CAR | Change from Initial Position | Return on Equity from foreign exchange | ||||
| (1) | (2) | (3) | (4) | (5) | (6) | |
| 1 | 0.0 | 0.0 | 13.3 | 11.9 | -1.40 | 0.0 |
| 2 | 33.3 | 25.0 | 12.9 | 12.2 | -0.70 | 8.3 |
| 3 | 50.0 | 37.5 | 12.7 | 12.3 | -0.36 | 12.5 |
| 4 | 66.7 | 50.0 | 12.5 | 12.4 | -0.04 | 16.7 |
| 5 | 100.0 | 75.0 | 12.1 | 12.7 | 0.58 | 25.0 |
Króna Accounting: Impact of Changes in the Króna Exchange Rate on Bank Capital Adequacy Ratio and Return on Equity
| Scenario | Foreign Currency Position Relative to Equity | Foreign Currency Position Relative to Own Funds | CAR Adjusted for Net FX Position | Following a 20 Percent Depreciation of the Króna | ||
|---|---|---|---|---|---|---|
| CAR | Change from Initial Position | Return on Equity from foreign exchange | ||||
| (1) | (2) | (3) | (4) | (5) | (6) | |
| 1 | 0.0 | 0.0 | 13.3 | 11.9 | -1.40 | 0.0 |
| 2 | 33.3 | 25.0 | 12.9 | 12.2 | -0.70 | 8.3 |
| 3 | 50.0 | 37.5 | 12.7 | 12.3 | -0.36 | 12.5 |
| 4 | 66.7 | 50.0 | 12.5 | 12.4 | -0.04 | 16.7 |
| 5 | 100.0 | 75.0 | 12.1 | 12.7 | 0.58 | 25.0 |
Subsequent calculations show that holding a positive net foreign currency position mitigates the fluctuations in the CAR when exchange rates change. In contrast, fluctuations in income, as measured here by ROE, increase as a result of the profit/loss from the foreign currency position. As noted above, the difference in their impact is due to the fact that exchange rate differences arising from the translation of net investment in foreign operations and of related hedges are transferred to the Translation Reserve in the balance sheet, but any profit/loss from foreign exchange translation would have to be put through the profit and loss statement.
Not surprisingly, the CAR is most stable when the ratio of foreign items in Own Funds is closest to the ratio of foreign items in RWA. In this case, it is when the net foreign currency position amounts to 50 percent of Own Funds (Scenario 4 in Table A.1, columns 2 and 5). This amount, added to the ratio of subordinated loans which are in foreign currency of 25 percent of Own Funds, produces the same weight in foreign currency items in Own Funds as that of the RWA, that is, 75 percent.
Assume that the bank in question changes to reporting in foreign currency, with the following assumptions:
Foreign currency items make up 75 percent of its RWA, the balance is in króna.
The entire amount of Own Funds is in the accounting currency, i.e., the foreign currency.
A net króna position of zero initially.
An initial CAR of 13.3 percent (in foreign currency terms).
In this case, the króna would be the risky currency in which a net positive position must be built. Given the lesser importance of the króna in this instance, the change in the exchange rate should have less impact on the CAR than in the previous example (Table A.2).
Foreign Currency Accounting: Impact of Changes in the Króna Exchange Rate on Bank Capital Adequacy Ratio and Return on Equity
Foreign Currency Accounting: Impact of Changes in the Króna Exchange Rate on Bank Capital Adequacy Ratio and Return on Equity
| Scenario | Króna Position Relative to Equity | Króna Position Relative to Own Funds | CAR Adjusted for Net FX Position | Following a 20 Percent Depreciation of the Króna | ||
|---|---|---|---|---|---|---|
| CAR | Change from Initial Position | Return on Equity from foreign exchange | ||||
| (1) | (2) | (3) | (4) | (5) | (6) | |
| 1 | 0.0 | 0.0 | 13.3 | 14.0 | 0.70 | 0.0 |
| 2 | 33.3 | 25.0 | 12.9 | 12.9 | 0.07 | -6.7 |
| 3 | 50.0 | 37.5 | 12.7 | 12.4 | -0.24 | -10.0 |
| 4 | 66.7 | 50.0 | 12.5 | 11.9 | -0.54 | -13.3 |
| 5 | 100.0 | 75.0 | 12.1 | 11.0 | -1.12 | -20.0 |
Foreign Currency Accounting: Impact of Changes in the Króna Exchange Rate on Bank Capital Adequacy Ratio and Return on Equity
| Scenario | Króna Position Relative to Equity | Króna Position Relative to Own Funds | CAR Adjusted for Net FX Position | Following a 20 Percent Depreciation of the Króna | ||
|---|---|---|---|---|---|---|
| CAR | Change from Initial Position | Return on Equity from foreign exchange | ||||
| (1) | (2) | (3) | (4) | (5) | (6) | |
| 1 | 0.0 | 0.0 | 13.3 | 14.0 | 0.70 | 0.0 |
| 2 | 33.3 | 25.0 | 12.9 | 12.9 | 0.07 | -6.7 |
| 3 | 50.0 | 37.5 | 12.7 | 12.4 | -0.24 | -10.0 |
| 4 | 66.7 | 50.0 | 12.5 | 11.9 | -0.54 | -13.3 |
| 5 | 100.0 | 75.0 | 12.1 | 11.0 | -1.12 | -20.0 |
The analysis shows that a smaller net króna position is sufficient to stabilize the CAR when the króna exchange rate changes (Scenario 2 in Table A.2, columns 2 and 5). As before, the CAR is most stable when the ratio of the risky currency (króna) in Own Funds is around the same ratio as that in RWA, in this case, around 25 percent. The changes in ROE are also of lesser magnitude, given the smaller impact of the exchange rate on the profit and loss statement.
References
Central Bank of Iceland, 2007, Financial Stability (Reykjavik).
Fitch Ratings, 2006, “Republic of Ireland,” International Credit Analysis, Sovereigns (London).
Fridriksson, Ingimundur, 2007a, “Turbulence in Iceland’s Financial Markets in 2006,” keynote address, UBS Annual Reserve Management Seminar for Sovereign Institutions, Thun, June.
Fridriksson, Ingimundur, 2007b, “Monetary Policy and its Implementation,” BIS Review, No. 16 (Basel: Bank for International Settlements).
Kristinsson, Halldor Sveinn, 2002, “The Icelandic Bond Market,” Monetary Bulletin, Vol. 4, No. 1.
Mitra, Srobona, 2006, Risks and Vulnerabilities in Icelandic Banks, IMF Staff Country Report No. 06/297 (Washington: International Monetary Fund).
Olafsson, Thorvardur Tjorvi, 2005, “Króna-Denominated Eurobond Issues,” Monetary Bulletin, Vol. 7, No. 4.
Prepared by Li Lian Ong, with contributions from Alicia Novoa and Mark Walsh (all MCM).
See Fridriksson (2007a) for a discussion on the authorities’ response to reassure investors during the market turbulence in 2006.
As a comparison, the total group assets of Icelandic banks as at end-2005 amounted to around 5.5 trillion króna; pension funds’ net assets were 1.2 trillion króna, while the total assets of Icelandic insurance intermediaries were 188 billion króna.
See Appendix I for a discussion on glacier bonds carry trade activity.
See also Mitra (2006).
This amount is equivalent to less than 10 percent of the own funds of the three major banks.
Some banks have the option of resetting interest rates after five years.
Fitch Ratings (2006) notes that the impact of any sharp reversal in carry trade activity continues to hang over the sovereign rating.
The FME’s Pillar II risk assessment under the Basel II framework requires financial institutions to cover all risks that they are exposed to, including unhedged foreign currency loans, beyond the risk components covered under the Pillar I minimum regulatory capital requirements. The supervisor will assess if such additional risk components are reflected in the financial institutions’ overall level of capital, and this may result in a requirement for additional regulatory capital to be set aside. The FME is currently developing a framework for how additional risks under Pillar II will be measured and translated into regulatory capital amounts, which is expected to be in place in late-2007. At that time, the three largest financial institutions will conduct such Pillar II risk assessments; it will then become mandatory for all financial institutions in 2008.
The results of FME’s stress tests are published on its website, http://www.fme.is.
It should be noted that the ratios do not include off-balance sheet items.
See Appendix II for a detailed discussion.
To date, none of the commercial banks have applied to adopt foreign currency accounting; only the investment bank, Straumur-Burdaras has done so.
In February 2006, a Memorandum of Understanding was signed between the Office of the Prime Minister, Ministry of Finance, Ministry of Commerce, FME and CBI, on consultation relating to financial stability and contingency plans. The CBI and FME have held joint contingency exercises in January 2004 and January 2006, covering financial markets as a whole. Another exercise was held in January 2007 to test responses to shocks to the payment and settlements systems. CBI (2007) provides an overview of the central bank’s role during the 2006 market turbulence.
The OMX Iceland 15 replaced the ICEX-15 from April 2, 2007.
See Olafsson (2005).
Based on excerpts from the FME’s report on financial accounting in foreign currencies.
As at this date, nine companies listed on the ICEX reported their annual accounts in a foreign currency, with five using the euro, two the U.S. dollar and two the pound sterling.
Iceland is a member of the European Economic Area (EEA). Consequently, Icelandic companies listed in a EU/EEA securities market prepared consolidated statements using IFRSs starting in 2005. Iceland required the application of IFRS for listed companies’ individual accounts beginning in 2007.
