Financial system

The department keeps abreast of the developments in the financial system in Iceland and abroad, as well as gauging its strengths and effectiveness and assessing the effects of economic factors on the system as a whole. The tasks of central banks in this field differ from conventional financial supervisory functions in that, instead of primarily monitoring individual financial institutions, they focus on factors that could entail risks for the financial system as a whole. In order to contribute to strong foundations and the health of the financial system, the Central Bank and the Financial Supervisory Authority have concluded a cooperation agreement.

 

6 April 2017

Key risks

An assessment of financial stability must take into account two major factors: risks and resilience, or the ability to withstand risks. The financial institutions’ operating environment has been favourable in the recent past, and there are no obvious signs of imminent systemic risk. There are a number of factors, however, that merit close monitoring. The tourism industry has grown by leaps and bounds and is now Iceland’s largest export sector. Its growth has brought with it substantial foreign currency inflows, which, together with other inflows, have strengthened the króna in spite of large-scale foreign currency purchases by the Central Bank. There is always the risk that such rapid change will be accompanied by volatility and that adjusting to a new equilibrium will not be entirely smooth. Tourism has also put increased pressure on house prices. Demand for housing far outstrips the available supply, and there is the risk that credit growth will soar in the wake of steep increases in house prices. In the long term, overheating in the economy could spread to the financial system, although there are no signs of excessive credit growth yet. It should also be noted that although it is positive that the banks have good access to foreign credit markets and terms have improved, this opens up the possibility that unhedged resident borrowers will take foreign-denominated loans. If such loans are granted on a large scale, it could undermine the stability of the financial system.At present, none of these risks poses a threat to financial stability, but they could evolve into systemic risk. The financial system is strong at present: capital ratios are high, liquidity is sound, and default is low, as borrowers’ position is good. The banks are therefore well equipped to withstand shocks.

 

 

Financial institutions’ operating environment

External conditions have been favourable to the Icelandic economy in the recent term. The credit ratings of the sovereign and the banks have been upgraded, terms of trade have improved, and GDP growth remains export-driven. This economic upswing has had a positive impact on the banks’ operating environment. The ratio of private sector debt to GDP has continued to fall, owing mainly to strong GDP growth. Households’ position continues to improve, with rising real wages and high employment levels. Firms’ position has strengthened as well, as the buoyant economy has stimulated demand for goods and services. Iceland’s international investment position (IIP) is positive for the first time in half a century, and a large external trade surplus plus other foreign currency inflows have put significant upward pressure on the exchange rate of the króna. In mid-March, virtually all of remaining capital controls on households and business were lifted. It is too soon to predict the impact of this but without capital controls, the domestic economy will be more affected by external developments than before.  

 

Financial market entities

The structure of the financial system has changed in recent years. The pension funds have increased their share, deposit institutions’ share has shrunk, and the shadow banking system has grown. The assets held by domestic systemically important banks (D-SIB) account for about 98% of deposit institutions’ assets.

Systemically important banks

The combined returns and profits of Iceland’s systemically important banks (D-SIB) declined markedly between 2015 and 2016. There was a marked decline in income from irregular items and an increase in net interest income. Credit growth has picked up, and default is low. There is limited demand for the banks’ domestic market issues, but their foreign market funding efforts have been successful. The banks are strong, their liquidity and leverage ratios are high, and their capital position is good. In March, a group of foreign hedge funds and asset management companies acquired a 29% stake in Arion Bank, and further sales of holdings in the banks lie ahead.

Other financial market entities

The Housing Financing Fund (HFF) is still battling large-scale early retirement of loans at a time of limited demand for new loans from the Fund. There has been a significant increase in pension fund assets backed by domestic real estate, through direct lending, real estate company bonds, and specialised investments. The shadow banking system’s share in the financial market has grown, as have its links to deposit institutions