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.

 

12 April 2018

Key risks

Risk in the financial system is within moderate limits, as external conditions have been favourable to financial institutions in the recent past. There have been signs, however, that risk appetite is on the rise and that financial system risk may be building up. The effects of one of the longest GDP growth episodes in Iceland are now showing in increased credit growth, which nevertheless is still modest, particularly among households. Corporate lending has grown somewhat more rapidly, however. House prices have continued to rise, although the pace of the increase has eased in the recent term. Increased scope for households to take on debt coupled with historically low mortgage lending rates and high house prices could stimulate further credit growth and push house prices still higher. Such a combination of events could exacerbate risks and imbalances in the financial system. Rapid growth in tourism has also caused house prices to rise. Risks attached to developments in tourism could therefore disrupt the housing market. Commercial property prices have also risen steeply in recent years, and real prices are close to a two-decade high. Prices have risen by over 10% annually for four years running. High property prices are now accompanied by more rapid credit growth, and when the two go hand-in-hand, risk in the financial system can accumulate. There has been discernible unrest in foreign credit markets in 2018 to date. Market agents have demonstrated increased risk appetite in the recent past, and risk premia are historically low. Expectations of rising inflation and interest rates have affected foreign asset markets this year. Possible repricing of risk premia could also affect asset prices. In a more open environment, Iceland is more vulnerable to changes in external conditions that could exacerbate risk. Icelandic households’ and businesses’ financial position is still strong, and the banks are resilient. The banks’ capital and liquidity ratios have been well above regulatory minima in the recent term, which gives them some scope for dividend payments. Sizeable dividends paid out recently and plans for further dividends later this year have brought the banks’ capital ratios much closer to the Financial Supervisory Authority’s required minimum, however. The banks must maintain their resilience after the financial cycle has peaked so that shocks do not jeopardise the stability of the financial system, with the associated repercussions for the domestic economy. As a result, it is important that dividend payments and changes in the banks’ funding structure take account of increased risk appetite and of the financial cycle position.

 

Financial institutions’ operating environment

Economic developments continue to be favourable. GDP growth is strong, the net international investment position is positive, there is a surplus on external trade, and the foreign exchange market has been well balanced in the recent term. Brisk economic activity in the recent past has improved firms’ operating performance and strengthened their position. Households’ financial position has strengthened as well, with improved equity and increased purchasing power. Credit growth has gained pace in the recent past but is still moderate. Global GDP growth and inflation have risen, and the slack in the economy has narrowed. Both the US Federal Reserve and the Bank of England have raised interest rates, while the European Central Bank has held its policy rate at zero. The global financial markets have been rather turbulent recently. Rising interest rates following a protracted lowinterest phase and potential repricing of risk premia could affect asset prices.  

 

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

In recent years, loans increased as a share of the domestic systemically important banks’ (D-SIB) assets, and credit growth was moderately strong in 2017. The banks’ liquidity position remained strong, and their efforts to secure market funding in Iceland and abroad have been successful. The D-SIBs’ earnings and profitability declined year-on-year in 2017, owing to a reduction in irregular income and estimated items. On the whole, net interest income and operating expenses were broadly similar between years, although developments vary from one bank to another. The D-SIBs’ capital increased marginally between years in spite of sizeable dividend payments in 2017, but because of an increase in the risk-weighted assets, their capital ratios declined year-on-year. The banks’ capital ratios are likely to fall further as a result of additional dividend payments. Credit rating upgrades and improved access to market funding gives them greater scope to change their funding structure as regards the composition and size of their capital base. However, reductions in capital and changes in the composition of the capital base must always take place in accordance with capital requirements, with full capital buffers, and the liquidity position.

Other lenders

The Housing Financing Fund (HFF) is still beset by large-scale retirement of loans, although the Fund has attempted to mitigate the negative effects of the prepayments on its interest rate spread by investing in asset-backed indexed bonds. The pension funds’ foreign assets increased markedly between years, as the funds continued to invest abroad in 2017, primarily in equities and unit shares.