On December 18, 2003, the Governors of the Central Bank of Iceland sent the following letter to the Chief Executives and Chairmen of the Boards of the Icelandic commercial banks and the largest savings bank in the country. The letter to the banks and the largest savings bank was published in Icelandic on the Central Bank's website on January 7, 2004:
At its recent meetings with representatives of the commercial banks
and SPRON [Reykjavík and Environs Savings Bank], the Board of Governors of the
Central Bank of Iceland was pleased to receive confirmation that the commercial
banks and largest savings banks have strengthened their position during the
year. Hopefully the ensuing period will prove of even further advantage to them
in this respect.
The Board of Governors has examined the lessons that it considers may
be learnt from these meetings. Its main finding is that the concerns that the
Board expressed at the meetings, in particular about rapid lending growth and
short-term foreign financing, were justified. With this letter, the Board of
Governors of the Central Bank is reiterating those concerns.
Domestic lending growth has been rapidly gaining pace in recent
months. Total lending by deposit money banks over the twelve months to the end
of October 2003 grew by almost 16%, which is beyond a level compatible with
price stability and economic stability in the long run. An immediate case in
point is the period from 1998 to 2001 and the consequences of the large credit
growth that took place then. Arrears and loan losses increased as a result and
the commercial banks' and savings banks' foreign financing became tighter for a
while. The period of contraction and the strain imposed on the financial system
came to an end, but in part it was thanks to relatively favourable economic
conditions and a sharp turnaround that financial undertakings did not suffer
greater setbacks than proved to be the case.
At the meetings it emerged that competition for corporate lending is
intense, especially to larger, highly rated companies. It was the unanimous view
that competition has cut risk premiums on basic lending rates by so much that
they no longer reflect potential loan losses. This situation is unsustainable.
At the same time, the growth in funding for acquisitions of other companies and
real estate is likely to have contributed to the recent rise in asset prices.
The Board of Governors of the Central Bank hopes that credit institutions have
learnt from the past and will exercise caution in their lending
decisions.
The increase in loans denominated in foreign currency to borrowers
with no foreign currency income is questionable. While one of the sharpest
growth rates for lending has been to foreign borrowers, loans denominated in
foreign currency to domestic borrowers have also risen, in fact by more than 28%
over the past 12 months. By no means all the foreign-denominated lending is to
domestic businesses and households which earn incomes in foreign currency or
hedge their foreign exchange risks by other means. This poses a particular risk
for both borrowers and creditors.
It was also mentioned that foreign banks have reduced their direct
lending to Icelandic corporations. This been replaced by foreign
currency-denominated loans from domestic commercial banks. It was claimed that
foreign banks baulked at taking part in the tough competition for the custom of
larger corporations with correspondingly thinner interest rate premiums. This
prompts the question whether this development does not confirm that the credit
risk has been underestimated.
The commercial banks and savings banks have increasingly been
financing their activities with foreign borrowing, which amounted to more than
700 b.kr. at the end of November. Just under half of this amount will fall due
during the period until the end of November 2004, creating a large refinancing
requirement for the banks during the year. It is important to continue to extend
the maturities of foreign financing. Foreign assets of the commercial banks and
savings banks have not grown on the same scale as their foreign debts over this
period. It should also be pointed out that the trend towards increasingly larger
individual bond issues denominated in foreign currency exacerbates the
refinancing risk. The Board of Governors of the Central Bank reiterates its
concerns about this development and the refinancing risk that it creates for the
Icelandic financial system.
In 2003, foreign market conditions were highly favourable for note
issues by Icelandic banks. Part of the explanation lies in the upgraded credit
ratings awarded to the
Credit rating agencies and international economic institutions have
focused on
Finally, the Board of Governors of the Central Bank urges the
commercial banks and savings banks to take advantage of opportunities arising in
the near term to strengthen their positions even further with moderate levels of
lending and by maintaining balance in their financing.
Yours sincerely,
CENTRAL BANK OF
cc: Financial Supervisory Authority
(FME)