The internationalisation of Iceland's financial sector

Abstract

The internationalisation of the Icelandic financial sector proceeded from market liberalisation, European integration, and privatisation, on the base of a strong, well-funded pension system and an exceptionally healthy institutional framework.

The growth of the banks has been spectacular: total assets of the banking sector have grown from 96% of GDP at the end of 2000 to eight times GDP at the end of 2006. The majority of the banks’ revenues originate outside Iceland, mainly in other northern European countries. Rapid financial sector expansion and growing cross-border activities, together with macroeconomic tensions, led to market suspicion and the mini-crisis of early 2006. The exchange rate depreciated by approximately 25%, the OMXI15 stock index fell by a comparable percentage, and the banks were in trouble.

The ‘mini-crisis’ of 2006 was an informational crisis, arising from external criticisms of the banks’ reliance on market funding with short maturities, questions of earnings quality, crossownership, and lack of transparency, as well as perceived macroeconomic imbalances in the Icelandic economy.

The Icelandic financial sector responded quickly and decisively: * They expanded their deposit base, and deposit ratios are now higher. * They extended and broadened the maturities and geographical scope of their market funding. * They have mainly eliminated cross-holdings. * They put great effort into increasing transparency and information dissemination about their structure and activities.

The resilience and responsiveness of the banking sector have been impressive. Yet in the current financial turmoil, is that enough? Despite their strong performance, Icelandic banks still have lower ratings than their Nordic peers, and a much higher risk premium is currently placed on their debt. We see no justification for this in their risk exposure. This suggests that either the markets are not fully aware of their situation, or that markets place a country premium on the banks.

Our report examines closely the current state of the Icelandic banks and financial sector, as well as the regulatory and macroeconomic environment.

The institutional and regulatory framework appears highly advanced and stable. Iceland fully implements the directives of the European Union’s Financial Services Action Plan (unlike some EU member states). The budget of its Financial Services Authority was recently doubled.

We see reasons for concern, however, with macroeconomic imbalances. Although the fiscal position is enviably strong, the economy has been running at a high pressure of demand, because of major investment projects in aluminium and hydroelectricity, as well as capital inflows. The resulting current account deficit is very high, the net international investment position is highly negative and is increasing. But the current account deficit has already fallen significantly from its 2006 peak, and we believe the path will prove sustainable. That is partly because the official data exaggerate the deficits. In addition to doubts about the data raised by other observers (including the IMF), our own calculations of the apparent rate of return on Iceland’s foreign assets and liabilities yield implausible results. The data suggest that Iceland’s investments abroad are substantially less profitable than foreigners’ investments in Iceland. This is simply inconsistent with the outstanding profitability and growth of Iceland’s international banks and corporations in recent years.

We therefore strongly recommend efforts to improve the collection of data to account more accurately for the balance of international income and the international investment position. The CBI should also publish parallel accounts for items such as equities where the most glaring inconsistencies arise.

We conclude that analysis should focus less on the current account deficit and NIIP numbers and more on the resilience of the financial system – which has proven to be excellent – and the flexibility of the economy, where Iceland has a proven track record over many decades. In an economy so small and so highly leveraged in international financial markets, one might expect a high volatility of financial variables: the exchange rate, equity prices, and bond yields. We do not find especially high volatilities. We focus in particular on the Icelandic krona, which many see as an important risk factor for Iceland and the Icelandic banks. In fact, the krona is not much more volatile against major currencies than the currencies of New Zealand, Sweden and Australia.

The banks are now hedged fully against currency volatility, so their exchange rate risk is primarily associated with loan quality. Icelandic firms have a long history of borrowing in foreign currency. For many this provides a natural hedge, others are in a strong market position and can pass exchange rate effects into prices. Households have increasingly been borrowing in foreign currency. This is still only a minor share (7-8%) of overall lending, but the risk there bears continued attention.

The krona does represent a disadvantage for listed firms, because it tends to fluctuate with equity prices. Exchange rate volatility is therefore added to stock market volatility. This makes shares in firms listed in ISK less attractive to foreign investors, so equity financing is more costly for firms. These firms are now moving to adopt the euro as their listing currency and to use the euro rather than the krona in other ways as well.

The euro is evidently becoming more important in Iceland. As it is outside the EU, Iceland cannot join the European Monetary Union. The possibility remains, however, of unilateral adoption of the euro – ‘euroisation’.

We do not recommend for or against unilateral euroisation. This is an issue that requires extensive political as well as economic debate. We do, however, caution against the possible destabilising consequences of a gradual shift to using the euro.

The CBI is on an inflation target of 2.5%. Inflation driven by housing prices, however, has remained above the target for some time. The policy rate of the CBI is very high, and monetary policy appears to be ineffective. First, the Housing Financing Fund is a major obstacle to the transmission of monetary policy. We agree with many other commentators (including the IMF) that the HFF’s role should be changed so that it no longer competes with banks in mortgage markets. Second, price indexation of financial contracts is widespread, which tends to weaken monetary policy. Third, the CBI has undermined its own policy by linking its decisions to exchange rate developments. The high policy rate leads to distortions in the financial system, such as the large carry trade. If only for that reason, we urge the CBI to reconsider its strategy.

On the criteria of deposit ratios, the characteristics of market funding, and others, Icelandic banks come out well in a comparison with their Nordic peers – and their overall and core profitability is higher. That is despite the high CAD and Tier 1 ratios with which they counterbalance their equity exposure. They are well-hedged against volatility in the krona. Stress tests by the FSA indicate that the banks can withstand quite extreme movements in market variables specific to Iceland. The banks have negligible exposure to the US subprime market, structured finance products, and related financial vehicles.

Most fundamentally, the banks exploit strong competitive advantage, arising from their entrepreneurial management, flat management structures, and unusual and strong business models.

We conclude that the Icelandic economy and financial sector are highly resilient, as shown in their response to the mini-crisis of early 2006 and their stability in the current turmoil. With regard to both the macroeconomic situation and the characteristics and performance of the banks, we consider that the current market premium on Icelandic banks is excessive relative to their risk exposure and in comparison with their Nordic peers. If this is in fact a country risk premium, we think it is not justified by Iceland’s economic situation. It is reasonable to expect the CDS spreads (for example) for Icelandic banks to return to more normal levels. Overall, the internationalisation of the Icelandic financial sector is a remarkable success story that the markets should better acknowledge.