Davíð Oddsson: The commercial banks are more resilient
Opening statement by Mr Davíð Oddsson, Chairman of the Board of Governors of the Central Bank of
Iceland, on behalf of the Board of Governors at a Press Conference on the occasion of the publication
of the Bank's Financial Stability 2007, 25 April 2007.
* * *
In its analysis published in Financial Stability at the beginning of May 2006, the Central Bank of
Iceland's finding was that the financial system was broadly sound, but more challenging waters lay
ahead. Two main causes of concern were identified: macroeconomic imbalances and uncertainty
about the commercial banks' refinancing of their foreign borrowing. Refinancing was successfully
completed. However, macroeconomic imbalances increased. A year ago the focus was on short-term
risks on the liabilities side of the financial companies' balance sheets, but now it has shifted more to
the long-term asset quality.
The most pressing economic policy task is to restore stability. The conclusion of large investments in
the aluminium and power sectors will automatically reduce imbalances, but other adjustment has been
slower than expected. Increased foreign debt service has delayed the unwinding of the current
account deficit, which will hardly be brought down to a sustainable level without a substantial
contraction in demand. The latest forecast in Monetary Bulletin in March 2007 indicates that such a
contraction lies ahead, as growth of investment and private consumption slows down. As discussed in
this report, a depreciation of the króna coinciding with a fall in asset prices - possibly originating in
tighter global financial conditions - could amplify the forecast contraction.
The necessary reduction of pressures in the economy will squeeze businesses and households, many
of which are vulnerable due to heavy debt. They could withstand a short-lived reversal, but a lasting
contraction would be difficult to weather.
In late autumn 2005, after a surge in borrowing by Icelandic banks in international bond markets,
investors revised their risk assessments of the banks. CDS spreads and secondary market yields on
their issues increased. The banks deferred further borrowing in the European bond markets, which
had been their main source of funding. Foreign analysts and agencies published negative reports
about the banks and the state of the Icelandic economy. The climate turned most adverse at the end
of February 2006 after Fitch Ratings changed Iceland's sovereign outlook from stable to negative,
claiming inter alia that the banks' tight financing could have implications for the Treasury.
This situation and its aftermath squeezed the banks for a while, forcing them to respond firmly to the
uncomfortable position that had arisen. They made efforts to explain the structure and organisation of
the Icelandic banks. The banks adjusted certain aspects of their operations and cross-ownership in
response to relevant criticisms, and refuted what was less relevant with both communication and
successful business performance. Temporarily they needed to look beyond their traditional markets for
funding, with issuance in the US and Japan. The problem that loomed around this time a year ago is a
thing of the past and terms in the secondary market are more favourable again.
The Central Bank underlines that global market conditions can take a sudden turn for the worse and it
is important to be on the alert and prepared for such a contingency.
The current episode of ample liquidity and lower interest rates which has been ideal for risk-seeking
investors may change unexpectedly. Short-term interest rates have been rising in most markets
recently and capital costs are no longer so favourable. The Icelandic banks are better equipped for
such a reversal than a year ago, because experience has taught them to extend and disperse their
borrowing, and build up substantial liquid reserves in foreign currency. In 2006 the spotlight was on
the banks' liquidity risk. Now that this risk has ebbed, the focus has shifted to credit risk and the
potential impact of higher interest rates and a depreciation of the króna.
Amidst the turbulence of 2006, the banks slowed down their credit growth and expansion of their
balance sheets. No major foreign financial companies were acquired and equity exposures were
reduced. Nonetheless, it is natural to consider their credit risk and vulnerability towards a fall in asset
prices.
Icelandic households' debts with credit institutions have soared in recent years, especially
averageincome and young households. Debt service has not risen by the same proportion, due to rising
incomes and easier credit terms, and arrears are at a low. However, some borrowers have stretched
their capacity to the limit and the most indebted group has seen its debt grow substantially as a
proportion of income and assets in recent years. Conditions will not need to change much to cause
them serious difficulties. The bulk of household debt is in the form of CPI-indexed mortgage loans,
making low inflation critical. Household debt in foreign currency was very low, but has been increasing.
High levels of foreign currency-denominated debt could prove questionable for households with no
income in foreign currency. Since house prices are currently buoyant, they are likely to rise by less
than general inflation or even fall in nominal terms. Household equity could shrink under such
conditions.
Business profitability appears to have been strong in 2006, in spite of a massive increase in financial
expenses from exchange rate losses on foreign borrowing, higher interest expenses and a substantial
increase in interest-bearing debt. Debt of listed companies grew as a ratio of equity and the same is
probably true of other businesses. Higher debt levels leave them more vulnerable to a contraction in
the economy.
Equity prices have soared in Iceland in recent years. One explanation for the increase may be that
Icelandic companies were undervalued by the markets, for example by international comparison, and
another that bold investment ventures have driven up their value. But risk and high yield often go hand
in hand and it must be assumed that equity prices can fall just as easily as rise.
The Central Bank has assessed the banks' credit portfolio quality on the basis of geographical and
sectoral distribution. It is no longer enough to focus solely on activities in Iceland, because
threequarters of the banks' total lending on a consolidated basis was to non-residents, especially in the
other Nordic countries and the UK. The assessment indicates that the banks' loss provisioning is more
than adequate to meet expected losses. However, this view must be tempered by hefty credit growth
in recent years and the large increase in leveraged buyouts and forward contracts connected with
them. House prices are at a historical peak in real terms and may unwind. Equity prices reflect
expectations of ongoing rapid output growth, but such sentiment can quickly reverse, as recent
experience has shown. Arrears and impairment are minimal, but both may be expected to increase in
the coming years.
One major vulnerability of the Icelandic economy at present is the risk of a rapid and unforeseen rise
in international interest rates and premia. Short-term rates have already risen widely and may go up
further. Long-term rates have not changed much but could begin to climb. Premia are prone to change
at short notice due to shifts in investors' risk assessments or risk-seeking.
The Icelandic economy has never been so sensitive to changes in global markets, which could
significantly affect it. It is critical to achieve some redress of imbalances before external conditions
tighten.
Strange as it may sound, the banks' efforts to hedge against the effect of a conceivable depreciation
of the króna on their equity ratios has increased the market risk on their foreign exchange exposures.
Credit institutions fulfil the Central Bank's rules on foreign exchange balance, but have been permitted
to maintain separate additional currency balances. Thus the banks' capital positions are well hedged
against a conceivable depreciation of the króna, but a short-term appreciation cannot be ruled out.
The banks' customers, on the other hand, are less protected against shocks from a depreciation,
although data from the banks show that most of their borrowers of foreign currency-denominated loans
also have substantial currency earnings and thereby a natural hedge against exchange rate
movements.
Financial Stability 2006 reported on a Central Bank stress test of the impact of a serious shock
involving a simultaneous large rise in global interest rates, depreciation of the króna and fall in asset
prices. This simulation has now been repeated using new data and assuming an even larger
depreciation and decrease in house prices. Were all these shocks to coincide, estimates show that the
contraction in national expenditure could prove considerably greater than in the Central Bank's most
Monetary Bulletin
recent macroeconomic forecast in in March 2007. The pressure on the financial
sector will be determined to some extent by the pace of the adjustment and the banks' own responses
to it. Although the adjustment would ultimately be greater if it occurred slowly, a very rapid contraction
would deliver such a jolt to the finances of many households and businesses that loan losses would
result.
It is likely that a range of risks will have to be faced, but efforts must be made to minimise the
probability of a financial crisis that could harm potential output and living standards. In the final
analysis, the critical factor is how strong and well equipped the financial system is to withstand shocks,
i.e. its resilience.
The crucial factor behind the Central Bank's assessment that the financial system is now more
resilient to shocks is the banks' stronger liquidity and equity positions than a year ago. The major
commercial banks have a diversified income base that extends to many countries. Another advantage
is the somewhat different business models they have used in their expansion. Their diversified assets
give less reason to fear the consequences of an unexpected strain on the financial system.
Iceland's strong fiscal position underpins the banks' international credit ratings. Other important factors
have been the strengthening of Iceland's foreign reserves and the Central Bank's capital. Both
measures represent natural responses to changes caused in the Central Bank's operating
environment by the very rapid expansion of the commercial banks, especially abroad.
Although the main function of a financial stability report is to highlight risks, factors conducive to
strengthening the long-term economic outlook should also be duly noted. Iceland's economy is
advanced, transparent and dynamic. The population is relatively young, well educated and quick to
adapt to technological and scientific innovations. A strong fully funded pension system has been built
up and, unlike other countries, there is no reason to fear for its sustainability. GDP per capita ranks
with the highest in the world, and the economic and social infrastructure is solid. The openness of the
economy results in a smaller effect from a contraction in domestic demand on employment than might
be expected.
The authorities shape the framework in which businesses and the financial system operate. Through
its membership of the European Economic Area, Iceland enjoys similar operating conditions to those
within the European Union. Nonetheless, it retains various features that influence economic
advancement, such as a rather business-friendly tax environment, efficient public administration and
flexible labour market. Extensive and rapid transformation of the financial sector puts supervisory
agencies under pressure. The Financial Supervisory Authority (FME) has been granted an
increasingly wide remit in recent years and its activities have been strengthened. One task is to
monitor the banks' transactions with main shareholders and executives.
Payment and settlement systems are a key component of an efficient and sound financial system.
Steps have recently been completed towards bringing their regulatory framework into line with
international best practice. Although such work tends to go relatively unnoticed, it is crucial for
enhancing security of settlements and reducing technical risks.
The main financial sector vulnerabilities are presented in the table below. The first three relate to
macroeconomic imbalances that could cause a further widening of the current account deficit, higher
external debt and a depreciation of the króna. Vulnerability on these counts is no less than a year ago,
and higher global interest rates and premia could have widespread repercussions. On the other hand,
much of the uncertainty about the banks' access to financing has been dispelled and they have built
up ample liquid reserves. Under such conditions, the focus shifts to asset quality.
The second table highlights factors that contribute to financial system resilience. The most noteworthy
development is the banks' stronger position in the form of ample liquidity and capital adequacy ratios
which are very acceptable and historically high.
On the whole, the Central Bank's finding is that the financial system is broadly sound. It is equipped to
withstand shocks to the economy and financial markets, to mediate credit and payments, and to
redistribute risks appropriately. In other words, it is capable of performing its function in an orderly and
efficient way. Iceland's banking system meets the demands made of it and performs well on stress
tests conducted by the Central Bank and FME.
Table 1 Main vulnerabilities
Risk Explanation
Exchange rate
Macroeconomic imbalances are pronounced. The current account deficit
developments
poses the risk of a depreciation of the króna. Shifts in carry trades and
other exposures could catalyse a sudden turnaround. The FX market
relies on three market makers and is still relatively thin. Some borrowers
from the commercial banks have little or no hedge against exchange rate
movements.
Global interest rates and In recent years, interest rates and premia have been at a historical low.
premia Interest rates have begun to climb and sooner or later premia will rise
again, increasing corporate financing costs.
Terms of trade Export prices could drop and oil prices rise. Unfavourable developments
could widen the current account deficit and erode national income.
Economic and social infrastructure is sound. The Central Bank's
macroeconomic forecast assumes a deterioration in the terms of trade.
International market High dependence on market funding and deposits on call makes credit
funding ratings and global market conditions crucial for the commercial banks.
Experience shows that credit assessment can shift suddenly.
Asset quality of Rapid credit growth often eventually leads to poorer loan quality. Loans
commercial banks with equities as collateral are substantial. Prices of equities and real
estate are buoyant. Although arrears and impairment are at a low, they
are unlikely to remain so over the next few years.
Table 2 Resilience
Resilience Explanation
Economy
The economy is flexible and in the past has shown itself capable of
tackling cyclical swings through adjustment of imports. Investment and
output growth have been robust. The long-term economic outlook is
favourable.
Strength of the
The commercial banks' liquidity and capital ratios have never been
commercial banks
higher. They have built up liquidity in foreign currency and secured
refinancing into 2008. Profitability is strong from the bank's diverse
operations and assets are diversified.
Institutional and
Iceland's framework is the EEA Agreement and its guidelines are
supervisory framework
international best practice and transparency. Economic and social
infrastructure is sound. Financial supervision has been boosted and
extensive cross-border cooperation is in place.
Payment and settlement
Payment system infrastructure is largely electronic and efficient. Steps
systems
have been taken to enhance security and contingency plans. Systems
meet international standards.
Fiscal position
The Treasury's position is strong with consecutive fiscal surpluses. Net
external Treasury debt, including foreign reserves, is virtually zero. No
pension gap is foreseeable.
BIS Review 41/2007