Meginmál

Letter to the Icelandic commercial banks and the largest savings bank

NOTE: This article is from 13. January 2004 and is therefore more than 5 years old.

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:

December 18, 2003

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 Republic of Iceland and the commercial banks, along with improved experience in procuring credit in new markets. Nonetheless, it is imprudent to rely on conditions being always as favourable as at present. Experience teaches otherwise. Changes in conditions in foreign capital markets and in creditors' attitudes to conditions in Iceland could constrict the present scope for procuring finance. Likewise, it is worth bearing in mind the potential contagion effect that unsuccessful offerings would have, and market resistance if many Icelandic borrowers seek to obtain funds at the same time.

Credit rating agencies and international economic institutions have focused on Iceland's foreign debt, not least its heavy short-term debt. The public sector and the Central Bank have improved their external positions, but those of others have worsened in recent years. The outlook is for a current account deficit in the next few years and some further debt accumulation. A downgraded credit rating for the Republic of Iceland would have serious repercussions for refinancing of the credit system as a whole. Thus it would be in the joint interest of the Republic and the banks to safeguard the current credit ratings, and where possible improve them. Good foreign borrowing terms are crucial for an indebted economy. In this context it is important for the banks to reduce their dependence on foreign short-term financing.

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 ICELAND

Birgir Ísl. Gunnarsson      Eiríkur Guðnason            Jón Sigurðsson Chairman                          Governor                           Governor

cc: Financial Supervisory Authority (FME)