5 April 2018
Speech
Már Gudmundsson, Governor of the Central Bank,
delivered at the 57th Annual Meeting of the Central Bank of Iceland, 5 April
2018.
Mr. President; Prime Minister, other Ministers, Speaker of Parliament, Directors
and Ambassadors; Ladies and Gentlemen!
The Icelandic economy has been in fine fettle recently, with full employment, to
say the least, as we have had to import a large number of workers to support
economic activity. The risk of overheating has receded somewhat in the past
year, however; the positive output gap has narrowed, and the residential housing
market is less stretched than it was a year ago.
Until last month, inflation had been close to target but below it for four years
running. Inflation expectations have been at target by most measures in the
recent past. It is this that has enabled the Bank to lower its policy interest rate by
0.75 percentage points since our last Annual General Meeting. Inflation
expectations have fallen to the target and have become more firmly anchored
there, reflecting the success of monetary policy in the recent term. The Bank's
Chief Economist recently published a Working Paper explaining this success,
noting as well that the decline in inflation to the target between 2012 and early
2014 was virtually costless, partly because of increased credibility of monetary
policy.1 If changes are made to the monetary policy framework in the coming
term, it is important to preserve this success.
One of the main reasons for reduced demand pressures in the economy is that
GDP growth has subsided after peaking in 2016 and is now approaching its
longterm trend rate. The slowdown in GDP growth reflects weaker export growth, as
the tourism boom cannot be expected to continue at the pace seen in the recent
past. Furthermore, the improvement in terms of trade has slowed down
considerably. This means that the effects of the positive shocks that enabled us
to grow rapidly and simultaneously keep inflation low are tapering off. The
a major role in the economy's adjustment to
appreciation of the króna played
these shocks. However, the Bank intervened in the foreign exchange market and
imposed a special reserve requirement (SRR) on capital inflows to prevent the
króna from overshooting. Now, however, a significant additional rise in the real
exchange rate would be risky.
Interest rates in Iceland are currently low in historical context, particularly in
view of the business cycle position. With one short-lived exception, indexed
Treasury bond rates have never been lower, and indexed mortgage lending rates
are also at a historical low. Apart from a short period early in this decade, when
Iceland was at an entirely different point in the business cycle than it is now, the
Central Bank's interest rates are at their
lowest since the early 1990s, when they
became an important monetary policy instrument. We must therefore consider
realistically whether we can expect further reduction of interest rates without an
outright slack in the economy. Developments in Central Bank rates over the
coming term will be determined by economic developments, which could be in
either direction.
When we met a year ago for the Bank's Annual Meeting, the vast majority of
the capital controls had just been lifted. As expected, exchange rate volatility
increased afterwards. But that volatility proved temporary, and short-term
fluctuations in the exchange rate subsided markedly in the latter half of the year.
In recent months, short-term volatility has actually been limited in historical and
international context. The Central Bank has not intervened in the foreign
exchange market in recent months, supporting the conclusion that this reduced
volatility is due to improved balance in capital flows.
According to currently available forecasts, GDP growth is set to remain robust
and the domestic economy will experience a "soft" landing. The outlook is
uncertain, however, and various risks could materialise, not only in Iceland but
also abroad, where uncertainty is considerable at present. In addition, it is
important that there is considerable scope for interest rates and large foreign
exchange reserves to respond to adverse developments. The longer long-term
inflation expectations are anchored to the target, the greater that scope will be.
One of the main tasks of monetary policy, of course, is to foster such an outcome.
However, if other decisions that affect domestic cost levels and demand pull in
another direction, such a tug-of-war could result in a further rise in the real
exchange rate and could adversely affect employment levels.
Honoured guests: Although nearly all of the capital controls were lifted in March
2017, a few restrictions on capital transfers remain: on the one hand, restrictions
on offshore krónur, and on the other, restrictions on speculative derivatives
transactions involving the króna and other transactions that could undermine the
efficacy of the SRR.
In order to be released from the current exemptions provided for in international
agreements on free movement of capital, vis-à-vis both the EEA and the OECD,
we must lift these restrictions, and it is appropriate that we aim to do so as soon
as possible. The Central Bank is of the view that the economic preconditions are
in place to take the final step towards full capital account liberalisation. This also
applies to the stock of offshore krónur, which now equals about 31⁄2% of GDP,
down from 40% in late 2008, when the capital controls were first imposed. But
this cannot be done without statutory amendment.
The Bank does not consider it appropriate yet to begin lowering the SRR. The
interest rate differential with abroad is still too wide, although it has narrowed
considerably since the SRR was imposed in June 2016. Given how high the real
exchange rate is, this is not a good time to take the risk of pushing it higher than
economic fundamentals warrant. If forecasts materialise, the conditions for
lowering the SRR will improve in the coming term, as Iceland's positive output
gap is projected to keep narrowing and global interest rates are expected to rise.
When the SRR was introduced, there were still broad-based restrictions on
capital outflows. The SRR was justified in part with reference to the
liberalisation process, and there were concerns that the offshore krónur that
via the Bank's June 2016 auction would
exited re-enter immediately in search of
a new carry trade opportunity. It is surely counterproductive to open the gates
for large-scale carry trade before the carry trade positions from the last spree
have been closed out. On the other hand, there will be grounds to revisit the level
of the SRR and the asset classes affected by it when the final capital account
liberalisation measures are taken.
The Bank's large international reserves, which have been financed
domestically
for the most part, are the result of the strategy of building up large enough
reserves to reduce the risks associated with capital account liberalisation, and of
the positive shocks that made it possible to build up the reserves without foreign
borrowing. That build-up took place over a very short period in 2014-2016, when
foreign currency inflows were at a peak.
In my speech at last year's Annual Meeting, I outlined the benefits of
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maintaining the reserves benefits enjoyed by many and I also discussed
the costs, which fall mainly on the Central Bank. These costs derive from a
negative interest rate differential, as the reserves are currently invested abroad at
low interest rates, while the rates on the Bank's króna-denominated debt are
much higher. Extrapolations carried out last year indicated that because of this,
the Bank's operating results would be negative by roughly 18 b.kr. per year. New
calculations indicate that this loss has shrunk to 15 b.kr. per year, mainly because
the international reserves are smaller and the interest rate spread is narrower.
Central banks do not become insolvent in the conventional sense, even if they
have negative equity; indeed, many respected central banks have operated under
such conditions for longer or shorter periods. This is because the purchasing
power of the reserves is intact as regards the purpose they serve, and central
banks themselves issue the currency they use to pay domestic costs. Even so, it
could be detrimental if the Central Bank of Iceland has significantly negative
equity, as this could undermine its independence and its ability to achieve the
price stability objective. In the near future, a number of actions will be taken to
improve the Bank's financial outcome, including through having the
commercial
banks participate indirectly in covering the costs of the reserves. It could also
come to pass that the Bank will call in a portion of the callable equity provided
for by law.
Honoured guests: We have made significant strides in rebuilding the banking
system and placing it on a stronger footing than before the financial crisis. The
banks focus primarily on providing services to domestic households and
businesses. They are much more resilient now than they were before. Their
capital ratios are well above the thresholds set by the Financial Supervisory
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Authority thresholds that are much higher than before the crisis. Their
liquidity position is good as well. The same can be said of borrowers, whose
position has improved radically.
These improvements in the banking system's position play a major part in the
Financial Stability Council's conclusion at recent meetings that there are few
risks to financial system stability at present. Nevertheless, the Council has
pointed out some risk factors.
One of them is the high price of residential and commercial real estate, which
could, in combination with low interest rates and ample collateral capacity, lead
to a strong increase in indebtedness, with the associated risk of a setback
followed by increased loan losses. To a degree, the authorities have responded
to this risk: last year the Financial Supervisory Authority imposed a ceiling on
residential loan-to-value ratios, following analysis and discussion within the
Systemic Risk Committee, which works for the Financial Stability Council, and
upon receiving an opinion from the Council. Developments in the real estate
market will continue to be monitored closely in this respect, and the possibility
of applying additional macroprudential tools will be considered.
Another risk factor that the Financial Stability Council has identified is
uncertainty about future developments in the tourism sector and the potential
impact that a setback in the industry would have on the position of the banking
system. At the end of 2017, lending to the tourism sector accounted for 9% of
the large commercial banks' total lending, but because growth in tourism has
eased recently, this ratio has held broadly steady. The Central Bank of Iceland
conducts an annual stress test in consultation with the Financial Supervisory
Authority, in which it examines the impact of macroeconomic scenarios on the
commercial banks' resilience. The results are published in the autumn issue of
the Bank's Financial Stability report. The last stress test assumed that there
would be a recession in trading partner countries, plus a drop in major export
prices and a steep decline in the number of tourists visiting Iceland. In this
scenario, the banks' capital ratios would fall by an average of 31⁄2 percentage
points, to a level close to the minimum capital ratios currently required by the
Financial Supervisory Authority.
These two risks could easily occur in tandem, however. According to a new
working paper by two Central Bank staff members, growth in private property
rentals to tourists via Airbnb has increased real house prices by 2% per year in
the past three years; furthermore, it explains about 15% of the rise in real prices
over this period.2 A contraction in tourism could therefore exacerbate a drop in
house prices stemming from other causes. The impact on the banking system
would then be greater. It is nevertheless unlikely that they would be unable to
withstand such a turn of events, but they would probably need to use the capital
buffers that are designed to cushion against such shocks.
That gives rise to the question of how high the banks' capital ratios should be.
Their combined capital, including subordinated loans, was equivalent to 25% of
the risk-weighted asset base of the three systemically important banks at the end
of 2017, and their so-called gearing ratio was just under 17%. The gearing ratio
measures net equity relative to total assets without risk adjustment. Approved
dividend payments will lower the capital ratio to 231⁄2% and the gearing ratio to
just under 16%. These figures can be expected to fall even further during the
year, owing to dividend payments and changes in the composition of capital. The
ratios are certainly comfortably above the Financial Supervisory Authority's
capital adequacy requirements, which are close to 20% for the three commercial
banks. They are also well above the levels generally seen in neighbouring
countries. For example, European banks of a size similar to Iceland's banks have
capital ratios of just over 18% and gearing ratios of about 8%. Elsewhere in the
world, capital ratios are higher than those in Europe in some cases. Furthermore,
many observers consider the actual capital in the European banking system is
too limited and that Europe is therefore not the best reference for Icelandic
banks. Nonetheless, there is some scope to lower the banks' capital ratios - and
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gearing ratios in particular with dividend payments and changes in the
composition of capital. On the other hand, the banks are being cautious in
"management premium" over and above the Financial
maintaining a so-called
Supervisory Authority's minimum requirement, as it could erode confidence in
the banks if their capital ratios fall below the minimum were they to face only
mild headwinds. Moreover, the banks must bear in mind that the countercyclical
capital buffer is currently 1.25%, but the Financial Stability Council has
signalled that it could increase it in stages to 2.5% as the financial cycle gets
more wind in its sails.
level for the banks' capital, it is important to remain
In assessing a desirable
aware of the costs and benefits. At times, international discussion of this topic
has been somewhat misleading and, to some extent, affected by bank executives'
interest in maximising their own remuneration through risk-taking, knowing that
a portion of possible losses would be absorbed by taxpayers. Capital is not dead
money, as is sometimes implied. It is available for disposal in order to finance
the assets side of the balance sheet, including lending. Furthermore, there is no
universal principle that says banks with more capital have less lending capacity;
in fact, research has confirmed that banks with stronger capital had an easier time
obtaining funding during and after the financial crisis, and they reduced their
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lending to customers less than other did aside from merely surviving.
2
Lúdvík Elíasson and Önundur Páll Ragnarsson (2018) "Short-term renting of residential
apartments, Effects of Airbnb in the Icelandic housing market", Central Bank of Iceland
Working Paper
no. 76. See: www.sedlabanki.is
Most companies need equity, as banks and other lenders are usually reluctant to
grant loans to companies without it. But where banks are concerned, other
factors are involved. Banks receive sight deposits, which are a part of payment
intermediation in any country, but at the same time they are long-term investors
on the assets side, with the associated risk of a run that could render them unable
to honour their obligations. Such runs on banks are often connected to
uncertainty about the banks' capital. This is where central banks come in as
liquidity providers and lenders of last resort, in addition to deposit insurance and
other contingency measures that are part of the official safety net for the banking
system. But the safety net creates a moral hazard that entails taking excessive
risk at taxpayers' expense. This is where the regulatory framework enters in: to
place limits on risk and to set capital requirements so as to reduce the likelihood
of a run on the banks, leaving taxpayers to pay the bill. How high the
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requirements must be is always a balancing act, as it is hardly possible and
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actually undesirable to set them high enough to render the banks bullet-proof.
We must not allow the banks' current resilience to blind us to the great
challenges facing them. These challenges centre, among other things, on rapid
technological advances, increased competition with other financial institutions
and companies that offer payment services and loans, increased regulatory
burdens, high cost levels, operational risk, cybersecurity threats, and ownership
issues. Of course, it is the task of the banks themselves and their owners to take
on these challenges, which - as always - represent both threats and
opportunities. But the legislature and supervisory institutions also have a part to
play. The regulatory burden should not be any more stringent than is needed to
limit risk at any given time. Simultaneously, it must be ensured that the
regulatory framework extends to all financial market service providers that could
contribute to the creation of systemic risk. Maintaining effective consumer
protection is important as well; otherwise, there is the risk that justified
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dissatisfaction will develop dissatisfaction that will ultimately erode
confidence in all financial institutions. In this context, one important issue that
calls for supervisory involvement is the boundary lines between financial
institutions' cooperation on infrastructure and security, on the one hand, and
competition concerning front-line services, on the other. Studies have shown that
Icelandic banks cooperate considerably less on security and infrastructure than,
for instance, banks in the Nordic countries. In the recent past, the Competition
Authority, the Financial Supervisory Authority, the Central Bank, and the banks
have worked together to develop a shared understanding on these matters,
thereby laying a strong foundation for further cooperation. An example of this is
the recent establishment of a temporary cooperative forum on operational
security of financial infrastructure, including representatives from the banks, the
Icelandic Banks' Data Centre, the Financial Supervisory Authority, and the
Central Bank.
The financial system is more than banks; it encompasses financial institutions,
financial market infrastructure, and financial markets themselves. Systemic risk
can accumulate in all of these and is sometimes amplified by interactions among
them. A detailed discussion of these functions is beyond the scope of our meeting
today, but I would like to emphasise that the Financial Supervisory Authority
and the Central Bank monitor risk in all of these areas and review it in depth at
meetings of the Systemic Risk Committee and the Financial Stability Council.
Nevertheless, I cannot leave the topic of the financial system without mentioning
the massive overhaul of financial market infrastructure that is currently
underway and the germination of ideas in the area of payment intermediation, as
the Central Bank is integrally involved with both.
The renewal of the most important core infrastructure elements used for decades
to operate the financial system began recently. The investment as a whole
the financial system's largest IT investment ever undertaken. The
represents
overhaul will move us away from solutions to standardised
"home-grown"
international systems. The systems being renewed are the banks' internal
payment systems, the Central Bank's
interbank payment systems, and the
Nasdaq securities depository's securities settlement system.
A variety of benefits accompany new financial market infrastructure, but the
implementation process can be risky, partly because the new systems must
communicate with the old ones during the transition phase. Supervisory bodies
monitor this risk. It is analysed at meetings of the Systemic Risk Committee and
is identified as a risk factor in statements issued by the Financial Stability
Council. Such a risk materialised to an extent last November and the cooperative
forum on operational security of financial market infrastructure that I just
mentioned was set up afterwards. In that forum and elsewhere, work will be done
to minimise the operational risk accompanying the ongoing renewal process.
At the same time as the renewal of core financial market infrastructure is
underway, a great deal is happening in the field of payment intermediation, both
internationally and here in Iceland, owing to new technological solutions and
changes in the regulatory framework that will stimulate competition in this area.
Among the topics under consideration is the new EU Payment Services
Directive, which is to be implemented in Iceland in the near future. In addition,
virtual currencies have come into use as a medium of payment, both nationally
and across borders, and there is a great deal of discussion at present of the pros
and cons of central bank issuance of electronic money.
In view of the many changes currently underway in the field of payment
intermediation, the Central Bank has previously discussed the necessity of
establishing a permanent information and cooperation forum representing all
stakeholders in this area. In the near future, the Bank will take the initiative on
this, with the aim of establishing the forum before the end of this year.
Apart from its Financial Market Infrastructure report, issued in June, the Bank is
planning to publish two reports on these topics quite soon. One is a report on
retail payment intermediation from the standpoint of preparedness and financial
stability, which focuses on debit card use, real-time settlement, and the
importance of effective electronic payment intermediation in Iceland, both in
favourable and unfavourable conditions. The other report focuses on the possible
issuance of electronic krónur.
I don't want to reveal too much now, but there are a few points worth considering
in this context. First of all is the importance of real-time settlement, which
enhances efficacy and security. This has been a feature of payment
intermediation in Iceland for a decade and a half, and it is where other countries
are heading. It is therefore vital that we preserve that feature during the changes
now taking place. Second, it is important to keep the cost of domestic payment
intermediation down. New and more diverse solutions that, for example, work
directly with core financial market infrastructure, such as bank deposits and the
Icelandic Banks' Data Centre's systems, could help in this regard.
Third, it is
important that it be impossible to stop domestic payment intermediation through
some sort of foreign intervention. Fourth, there must be alternate routes in the
system, in case anything goes wrong. This could call for some diversity in
payment intermediation, using different types of technology. Electronic krónur
could play a role in this. But the topic of electronic krónur gives rise to big
questions that must be discussed - questions about the possibilities for the
general public to use electronic claims against the Central Bank (and indirectly
against the State) as a medium of payment instead of bank deposits, and
questions about the repercussions this could have on the role and stability of the
banking system. The discussion promises to be an interesting one, and it is just
beginning.
In closing, I would like to thank the Supervisory Board and the Monetary
Policy Committee for their work over the past year, and I wish to thank the
Central Bank's many colleagues and collaborators for their -
cooperation not
least the Prime Minister's Office, the Ministry of Finance and Economic
Affairs, and the Financial Supervisory Authority. I would also like to thank the
financial institutions with which the Bank interacts for their cooperation.
Furthermore, I would like to thank the Parliament of Iceland, particularly the
Economics and Commerce Committee, for their collaboration. And last but
certainly not least, I want to thank the staff of the Central Bank for a job well
done over the past year.