The financial system: outlook and major risks
Risk in the financial system has declined in the past year, according to some financial indicators. Restructuring of household and corporate debt moved forward and non-performing loans at the three largest commercial banks fell from 23% to 15% in 2012. Corporate indebtedness dropped by 30% of GDP, while household debt relative to GDP was virtually unchanged. After a final conclusion in Iceland’s favour was reached in the Icesave dispute, the country‘s sovereign rating has been edging upwards. Credit spreads on 5Y and 10Y foreign-denominated treasury obligations have declined by almost 200 bp in the last 12 months, to 190 bp and 210 bp respectively. At the beginning of this year Arion Bank issued a bond in Norway for the equivalent of over 11 b.kr., the yield on the issue was however rather high.
Financial undertakings’ resilience has increased. The capital ratios of the commercial banks rose from 22% to 25% in 2012, and non-performing loans have declined. Commercial banks’ short-term liquidity is strong. Their foreign currency balance has improved and, for the first time since the autumn of 2008, all the commercial banks are operating without exemptions from the rules on foreign exchange balance. A high proportion of non-performing loans, large-scale loan revaluations and capital controls necessitate strong resilience on the part of financial undertakings.
The economic recovery in Iceland has slowed, and the outlook has deteriorated somewhat. Product prices have decreased on the country’s major export markets, especially in Europe. Average export prices for marine products have fallen and aluminium prices have also been low. Private sector investment remains low and planned investments are limited.
Currently the main risks to the financial stability stem from the settlements of DMBs in winding-up proceedings, the capital controls and their liberalisation, refinancing risk, the situation of the Housing Financing Fund (HFF) and political risk. It is important for financial stability that political decisions concerning the financial system and the relaxing of controls are well thought out, and taken with due consideration for stability in the economy.
HFF’s position is weak
The Housing Financing Fund is weak and there is a risk that the Treasury will have to absorb further losses due to the Fund. Since 2008, HFF’s accumulated losses total 52 b.kr.; equity contributions made by the Treasury since 2010 amount to 46 b.kr. HFF’s imputed interest margin on its borrowing and lending is insufficient to cover its cost of operation, defaults are high and prepayment risk remains. All of this makes the position of the largest provider of housing mortgages weak and its business model is insufficient in the current environment.
Settlement of DMBs in winding-up proceedings could cause instability
It is very important that settlements of DMBs in winding-up proceedings do not disrupt financial stability. Based on the book value of the estates and the breakdown of claims into domestic and foreign, the estimated impact of their winding-up on the net IIP will be negative by the equivalent of 45% of 2012 GDP. How payment is made to foreign creditors is of vital importance for financial stability. Putting aside the question of the bonds issued by the new Landsbankinn to the old Landsbanki (see below), proper handling of the sale of holdings by the estates in the new banks is crucial. Other assets of the estates which could have a negative impact on stability in the next few years amount to about 250 b.kr., makingit necessary to find ways of ensuring these distributions do not upset the stability which has been achieved since the banks’ failure. Before the relaxation of capital controls can even be considered, the settlement of DMBs in winding-up proceedings must be placed in a firm framework and the repayment period of bonds between Landsbankinn and the old bank must be extended.
Capital controls and impatient króna assets
Relaxing capital controls can cause instability of the Icelandic krona, increase funding costs for the Treasury and have a significant impact on the banks’ loan portfolios and their liquidity position. Liquid króna assets held by non-residents currently amount to 367 b.kr., “offshore” krónur plus some 80 b.kr. which are liquid króna assets of DMBs in winding-up proceedings. These assets can be expected to flow out of the country fairly quickly once controls are relaxed.
Long-standing capital controls are not without cost to the economy, and which increases as time passes. The increased risk of asset bubbles developing under the control regime can add to systemic risk, undermining financial stability if no action is taken. Most indications suggest, however, that the benefit of proceeding slowly in lifting controls is as yet greater than the cost of maintaining them.
High refinancing risk in foreign currencies
Estimated instalments until 2018 on foreign loans of domestic parties, other than the Treasury and the Central Bank, are substantial. These instalments will increase from 87 b.kr. in 2014 to 128 b.kr. in 2015, when instalments of the bonds between Landsbankinn and the old bank begin in full. By comparison, the estimated underlying current account surplus in 2012 was 52 b.kr. If the current account balance in coming years is similar to what it has been in recent years, around 3-3.5% of GDP, parties other than the Treasury and the Central Bank will have to refinance the equivalent of 265 b.kr. until 2018.
The repayment profile of Landsbankinn’s bonds is too heavy for the economy. The bonds will have to be extended or refinanced. Without extensions or substantial refinancing it is evident that there is no leeway, in the near term, to utilise the current account surplus in order to allow the exit of non-residents’ króna assets. The interaction of relaxing controls and repayments of foreign loans forms the greatest risk in the financial system.