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. 

Current position and key risks

12 October 2016

Economic conditions broadly favourable

GDP growth is robust and, as in recent years, is driven primarily by growth in export revenues and disposable income, together with improvements in private sector balance sheets. Increased tourism revenues and favourable terms of trade have contributed to a sustained and sizeable current account surplus. The surplus plus capital inflows have led to foreign exchange inflows. The exchange rate of the króna rose by 11.6% over the first nine months of the year even though the Central Bank bought 290 b.kr. in foreign currency during the period. In the Bank’s opinion, the foreign exchange reserves are sufficient to support the general capital account liberalisation process, important parts of which have already been implemented this year. In early September, rating agency Moody’s Investors Service upgraded Iceland’s sovereign credit ratings by two notches, from Baa2 to A3. The upgrade was due in part to the reduction of Treasury debt and the successful steps taken towards capital account liberalisation. Iceland’s net external debt measured just over 1% of GDP at mid-year, the most favourable position in half a century and at the same time the interest premium on foreign-denominated Treasury bonds has fallen.

Private sector debt continues to decline

Households’ and businesses’ debt is now historically low relative to both income and GDP. With reduced indebtedness and increased net wealth, households and businesses are better equipped to withstand shocks than they have been for a long time. This is supported by real wage growth – as can be seen in a 10% rise in the real wage index over the past twelve months – persistent GDP growth, and the appreciation of the króna.

Important steps taken towards liberalisation

Important steps have been taken towards lifting the capital controls in recent months. In May, Parliament passed legislation on the treatment of offshore krónur, providing for amendments designed to ensure that the special restrictions applying to offshore krónur under the capital controls will hold even though large steps are taken to lift controls on individuals and businesses. In June, the Central Bank of Iceland held a foreign currency auction in which it invited owners of offshore krónur to exchange their krónur for euros before general liberalisation begins. Although most of the bids submitted in the auction were accepted, large owners submitted bids at an exchange rate higher than the Central Bank could accept, and the stock of offshore krónur was therefore reduced by one-fourth. During the summer, the Central Bank set the Rules on Special Reserve Requirements for New Foreign Currency Inflows, and afterwards there was a reduction in new investment in domestic Treasury bonds, which can prove to be a source of volatile capital flows. With the passage of a bill of legislation in October, most of the capital controls on individuals and usinesses have been lifted.

Risk could still be accumulating, particularly in the real estate market…

There are some signs of tension in the domestic economy, particularly in the labour market and the housing market, which could be conducive to financial imbalances in the long run. Real estate prices have continued to rise this year. In August, real house prices were up 12.1% year-on-year; furthermore, the twelve-month rise has measured over 5% virtually without exception for the past two-and-a-half years. The twelve-month increase in real commercial property prices in the capital area was 14.3% in Q2 and has exceeded 9% for more than two years. Real house prices are still highest in central Reykjavík, but in the recent term they have risen fastest in neighbourhoods further from the city centrum.

… but conditions are conducive to continuing credit growth…

Credit growth is still modest and remains below GDP growth. On the other hand, the positive output gap has widened, unemployment has fallen, and nearly half of corporate executives describe their firms as understaffed. Furthermore, rising asset prices provide household and corporate balance sheets with additional collateral capacity; indeed, rising real estate prices are generally a precursor to credit growth. These factors together create conditions conducive to private sector credit growth. Apart from changes in the credit stock due to price and exchange rate movements, demand for new loans has increased, albeit more among firms than among households.

… and the upswing could prove fragile

Tourism-generated revenues have grown rapidly in the past three years and have contributed significantly to the economic well-being that has developed in Iceland. The risks associated with swift growth in tourism must be monitored carefully. A large drop in the number of tourist arrivals could be followed by an economic recession, rising unemployment, and falling asset prices. This, in turn, could cause the banks to suffer operational losses, not least because of increased loan losses. Developments like these provide the basis for the adverse scenario in the Bank’s 2016 stress test carried out on the large commercial banks. Based on the assumptions in the stress test, the banks’ capital ratio could fall by nearly 4 percentage points from the end-2015; however, it would remain well above the regulatory minimum.

Conditions are favourable for liberalisation, but some uncertainty is inevitable

The planned liberalisation of capital controls is designed to reduce imbalances and the long-term costs associated with a capital controls regime. Large foreign exchange reserves, favourable macroeconomic conditions, and the banks’ strong liquidity position reduce the risks attached to the liberalisation process, although some uncertainty is unavoidable.

Improved access to foreign credit on favourable terms reduces short-term risk but could stimulate risk appetite further ahead

The banks’ improved access to foreign credit markets reduces, among other things the risk associated with liberalisation. It also reflects the banks’ relatively strong position. With economical foreign credit funding, the banks can provide foreign-denominated loans on better terms. About 20% of loans currently granted by deposit institutions are denominated in foreign currencies. At the end of June, growth in deposit institutions’ foreign-denominated corporate lending was up more than 13% year-on-year, after adjusting for the appreciation of the króna. In the long run, easier access to foreign credit could stimulate risk appetite. It is important that authorities can put restrictions on foreign-denominated loans to households and businesses that are unhedged against foreign exchange risk, as granting such loans on a large scale could undermine the stability of the financial system.