Just as Icelandic monetary policy is shaped by memories of corrosive inflationary cycles, large sections of its banking regulation are a legacy of the financial crisis of 2008.
It is the Central Bank’s unshakeable commitment to ensuring that none of the mistakes of the early 2000s are repeated that underpins one of the strongest banking regulatory frameworks in the world, let alone in Europe.
“For the banking industry, we tend to adopt EU regulations and then take them one step further,” says Arion Bank’s chief economist, Erna Björg Sverrisdóttir.
One of the most striking recent examples of the so-called ‘gold plating’ of the Icelandic banking system — perhaps more accurately, its ‘armour plating’ — has been the Central Bank’s use of the countercyclical capital buffer. Originally introduced after the 2008 crisis, the countercyclical buffer was suspended during the pandemic and reinstated in September 2022, at 2%.
In March 2023, in response to concerns about growing inflationary pressures, the Central Bank announced that this buffer would rise to 2.5%, the upper end of its range, from March 2024.
This made Iceland one of only three European banking systems — the others are Denmark and Norway — with a countercyclical buffer of 2.5%. Theódór Friðbertsson, head of investor relations at Arion Bank, says that as this comes on top of a systemic risk buffer of 3%, a systemically important institutions buffer of 2% and a capital conservation buffer of 2.5%, Iceland’s banks are faced with “significant buffer requirements”.
The [Central] Bank believes it needs to be more vigilant than some other regulators and signal very clearly that it is on top of any inflationary threat to the system
Mark Naur, Danske Bank
The Central Bank’s Financial Stability Committee (FSN) said at the time of the increase in the countercyclical buffer that this was “conducive to bolstering resilience still further in the face of the risks that have accumulated and could materialise in the coming term”.
Mark Naur, senior analyst in the research department at Danske Bank in Copenhagen, says that Iceland’s Central Bank has compelling reasons for its highly conservative regulation of the three banks that emerged from the smouldering wreckage of the 2008 crisis.
“The Central Bank is very aware that there are still plenty of international investors whose fingers have been burnt in the past in Iceland,” he says. “So the Bank believes it needs to be more vigilant than some other regulators and signal very clearly that it is on top of any inflationary threat to the system.”
Highest quality
The result today is that, thanks in part to its uncompromising regulation, the credit quality of the three banks that emerged from the crisis has reached an all-time high. “Never in Iceland’s history have our banks been as strong as they are today,” says Sturla Pálsson, director of markets at the Central Bank of Iceland.
To the frustration of Reykjavik-based bankers, rating agencies have been hesitant to give the banks full credit for this strength. “One of the challenges we face is that the ratings agencies continue to classify both the Icelandic economy and the banking system as being riskier than we consider them to be,” says Hreiðar Bjarnason, CFO at Landsbankinn. “Our ratings have been improving in recent years, but we still have some way to go to persuade them that we have a regulatory environment that is on a par with those in other Nordic countries.”
The most recent recognition of the strengthening of the banks’ credit profiles was the upgrade of Arion Bank, Íslandsbanki and Landsbankinn by S&P Global Ratings in early April.
Noting that the economic risks facing Icelandic banks have abated thanks to a stabilising housing market and significant private sector deleveraging, S&P upgraded the long- and short-term ratings on each of the banks to BBB+ and A-2 respectively.
Never in Iceland’s history have our banks been as strong as they are today
Sturla Pálsson, Central Bank of Iceland
A notable barometer of the strength of Iceland’s banks is their capital ratios, which are all well above their regulatory minima. At the end of the first quarter of 2024, total reported capital ratios reached 23.2% at Arion Bank, 23.6% at Íslandsbanki and 24.9% at Landsbankinn, with common equity tier one (CET1) ratios standing at 18.8%, 19.9% and 22.2% respectively.
At Íslandsbanki, head of international funding William Symington says that even these relatively high levels understate the true capital ratios of Iceland’s banks. This is because all three banks continue to use a standardised rather than an internal ratings-based (IRB) method for calculating their regulatory capital. “This means that although our headline ratios look high, on a like-for-like basis they would be stratospheric compared with other Nordic banks,” says Symington. “If we expressed them the same way the Swedish banks do, our total capital ratios would be 40%-plus.”
Evening out those distortions by migrating across to IRB is something that the Icelandic banking industry has been studying for a long time, according to Bjarnason at Landsbankinn. “The problem we face is that the requirements of the IRB approach are very strict,” he says. “For example, they call for a long history of data loss reporting. This would mean that the effects of the 2008 crisis would need to be included in the historical data, which would give a distorted picture of our true credit profile.”
He adds: “It would be beneficial for us to apply an IRB approach, which would improve our capital ratios. But I don’t think it would do so as significantly as you might expect.”
Besides, says Bjarnason, an equally important measure of stability among Iceland’s banks is their leverage ratios. “Leverage ratios were around 13% or 14% in 2023, which compares to an average closer to 5% for the large Nordic banks,” he says.
Neither their capital and liquidity ratios, nor the profitability of the Icelandic banks, is likely to be affected in any meaningful way by the volcanic activity in the Reykjanes peninsula, which recurred at the end of May.
Decisive move
The government moved decisively to meet the needs of households and business directly affected by the eruptions when they began in late 2023. Most of these are concentrated in the town of Grindavik, which in November 2023 accounted for about 0.9% of Iceland’s population.
Residents whose homes have been damaged or destroyed by seismic activity in the region have been invited to sell their properties to a state-owned special purpose vehicle — Fasteignafélagið Thórkatla — with the right to buy them back after three years.
Those buying new houses, meanwhile, benefit from a relaxation of the Central Bank’s rules on debt service-to-income (DSTI) and loan to value (LTV) ratios. Until March 2027, the maximum DSTI for these borrowers rises from 35% to 40% while the maximum LTV is increased from 35% to 40%.
The impact on the banks has been minimal. Bjarnason says that Landsbankinn is by far the most exposed of the three Icelandic banks, with a share of close to 60% of mortgage loans in the Grindavik area. “Although we are the most affected bank, the area accounts for only about 1.8% of our mortgage portfolio and for 0.8% of our total loan book,” he says.
People are much more aware of the dangers of over-leverage, which is helping the economy through this point in the rates cycle
Theódór Friðbertsson, Arion Bank
Nor have there been any signs that Iceland’s restrictive monetary policy is having a discernible impact on non-performing loans at any of the banks. Having reached a high of 8.9% for the banking system as the pandemic tightened its grip in mid-2020, problem loans had declined to 1.9% at Arion and Íslandsbanki, and to 1% at Landsbankinn, by the first quarter of 2024.
One of the reasons for this decline is the high share of inflation-linked mortgages in Iceland, which has neutralised much of the impact of high nominal interest rates. “Our cost of risk has barely changed over the last year, in part because people have been free to transfer their nominal rate loans into inflation-linked mortgages,” says Íslandsbanki’s Symington.
Another explanation for falling levels of bad loans is the legacy of the financial crisis. “One of the main reasons impaired loans are low is that since the financial crisis we have seen the overall leverage positions of the household, as well as the corporate, sector drop quite significantly,” says Theódór Friðbertsson, head of investor relations at Arion Bank. “People are much more aware of the dangers of over-leverage, which is helping the economy through this point in the rates cycle.”
This is echoed by S&P, which notes that leverage in Iceland’s private sector has fallen “markedly” relative to GDP. It forecasts that GDP will continue to outpace loans in 2024, with private sector debt stabilising at around 145% of GDP over the next two years, significantly below S&P’s 152% four-year (2021-24) rolling average forecast.
Conservative calculation
As with their capital ratios, Icelandic banks’ reported return on equity is calculated conservatively, according to Symington. “We’re all generating ROEs of about 10%,” he says. “But if we were to calculate them on the same basis as the main Nordic banks, they would be more like 20%.”
Given their exclusively domestic focus, the scope for Iceland’s banks to raise these ROEs will remain limited. “Our target ROE will remain above 10%,” says Bjarnason at Landsbankinn. “I think that will be comfortably achievable in the current interest rate environment, but obviously with high capital and leverage ratios it will be hard for any of the Icelandic banks to increase ROEs to the mid to high teens that we see in some European countries.”
The potential for extracting more efficiencies from declining cost-to-income ratios may also be limited. Although Íslandsbanki saw its cost-to-income ratio creep up from 42.1% in the first quarter of 2023 to 44.9% in the corresponding period this year, at Arion the ratio fell sharply from 46.9% to 35.7% over the same period. Landsbankinn, meanwhile, reported a continued fall to 33.6% compared with almost 47% at the end of 2022.
