Is there a danger of the Icelandic banking market overheating?
The growth of Iceland's banks – now centred on three main groups, profiled on the following pages – is one of the success stories of the past decade. The pace of development has led to concerns that such growth might be problematic and unsustainable. But the banks themselves are confident they are well placed for the future.
ICELAND IS THE country laissez faire enthusiasts dream about. A largely barren island with a population of less than 300,000, it is testament to the power of privatization and liberalization. In a decade, the country has shaken off a reputation for being a backwater with an economy largely founded on fishing and has transformed itself into a dynamic and entrepreneurial powerhouse punching well above its weight, particularly in financial services. Iceland's transformation can be traced to accession to the European Economic Area in 1994. Membership provided access to the wider European market and reinvigorated a stalled liberalization programme and a sense of entrepreneurial spirit. But this spirit is deep-rooted, according to Bjarni Armansson, CEO of Íslandsbanki. "The hunting mentality is crucial to understanding people in Iceland," he says. "Dynamism has always been necessary to survive."
One of the main drivers of Iceland's strong growth – GDP grew by 5.8% in 2004 – has been the country's banks. They lent heavily to rapidly growing local companies, including the Baugur Group, which now has a strong position in UK high street retailing. At the same time, the leading banks consolidated the domestic banking market and expanded rapidly overseas.
The banking sector is now centred on three banks – Kaupthing, Landsbanki and Íslandsbanki – and about 20 smaller savings banks. The three big banks have made significant acquisitions internationally in recent years, including Kaupthing's purchase of British merchant bank Singer & Friedlander, Landsbanki's acquisition of UK broker Teather & Greenwood and Íslandsbanki's purchase of Norway's BNbank.
As Ragnar Haflidason, deputy director general of Iceland's financial supervisory authority (FME) notes, 2004 was a landmark year, with total assets of the commercial banks and largest savings banks almost doubling as a result of acquisitions of foreign subsidiaries and lending growth. Half of the assets of the three large commercial banks are held by their foreign subsidiaries. "The banking system in Iceland is scarcely recognizable from just a few years ago," says Haflidason.
At first glance it is hard to see what observers of Iceland's banking scene could possibly be worried about. Profitability is strong at the commercial banks and at the largest savings banks the average return on equity of 31% in 2004 is extremely attractive by international standards. Kaupthing, Landsbanki and Íslandsbanki have all reported record results for the first half of the year.
There have been persistent concerns about the ability of the leading banks to integrate their ever-expanding empires, but Paul Avery, director in the financial institutions group at Barclays Capital in London, notes that the banks are well managed and that their acquisitions have been both largely sensible and well integrated into existing operations. Similarly, concerns about lack of managerial experience as a result of Iceland's youthful population – especially in international operations – appear unfounded.
There are, though, concerns about the scale of borrowing by the leading banks and their exposure to the international debt markets. The FME notes that Iceland's external debt – especially that of the banking sector – has soared in recent years and is now equivalent to twice the annual GDP. Corporate debt rose a record 23% in 2004 to reach a staggering 167% of GDP – one of the highest rates in the world.
The Icelandic banks have found it easy to grow the asset side of their balance sheet through lending in the new markets they have entered. But they have not grown their deposit base to the same extent, notes Malcolm Long, associate director in the financial institutions group at Barclays Capital. "To date, none of the major banks has bought a large savings operation overseas. Consequently they are reliant on the wholesale markets and that will always be a constraint on their ratings," he says.
Common sense dictates that as banks become more dependent on international markets they become more vulnerable to volatility in those markets. No-one is under any illusion that the unprecedented period of low interest rates and tight credit spreads of the past few years is permanent: the next stage of the global economic cycle could increase borrowing costs substantially.
Yet the leading banks have made good progress in preparing for such an eventuality. Christoffer Mollenbach, head of the financial institutions group at Nomura in London, says that there has been a change in strategy by the Icelandic banks, encouraged by the central banks, to extend their maturity profiles. "Kaupthing has been especially successful," he notes, "most recently with a seven-year issue in early August."
Nevertheless, given the leading banks' dependence on funding from the bank and capital markets rather than from deposits – as a proportion of total liabilities deposits were 23%, compared with 35% at the end of 2003 – the quality of assets at the banks has become increasingly important. At the moment, the rating agencies and analysts are uniformly positive about asset quality, with loan quality considered to be high.
One concern on the horizon, highlighted by the FME's stability report, is the high level of equity holdings at the banks. Iceland's banks have always had a high level of listed and unlisted equity holdings because the economy is small and there are limited funding options for corporates. As Janne Thomsen, analyst at Moody's in London, notes, such positions make the banks vulnerable to any downturn in the market. "Banks would be hit on both the equity and the debt side if there was an asset quality crisis," she says.
The leading Icelandic banks all claim that – excluding strategic holdings – their exposure to listed equities is limited. "Our position in listed equities is comparable to banks in similar business spheres," says Sigurdur Einarsson, chairman of Kaupthing. And he notes that while the bank has a limit of 3% of its total assets in unlisted securities, the figure is just 0.6%.
Furthermore, as Asgeir Jonsson, economist at Kaupthing in Reykjavik, notes, investment in unlisted companies has been one of the great success stories of the Icelandic banks. "It has been the strategy of most of the large banks to work with unlisted companies to provide both venture capital and lending with a strategy of exiting at a later point in their development," he says. "It is correct that such equity exposure can be risky but historically it has worked well."
Reasons to be cheerful
But plenty of people are only too happy to accentuate the positives for Iceland's banks. As Íslandsbanki's Armansson says, the larger part of Iceland's record debt as a percentage of GDP has nothing to do with Iceland itself: instead it has been used to fund assets elsewhere. Similarly, Kaupthing's Einarsson agrees that as a statistic it is misleading and does not take into account substantial assets within the country, not least the country's fully funded pension system, which has assets equivalent to 115% of GDP.
If the potential risks of such high levels of debt are discounted and instead there is a focus on the ability of the country's banks to continue to finance themselves, the picture also looks fairly rosy. "Analysts continually comment that lines [for Iceland] are getting tougher but the reality is that deals are still being done," says BarCap's Avery. "The FRN market continues to surprise by absorbing more Icelandic debt. The natural constraint seems to be soggy around the edges."
The reason for such an attitude among investors appears to be a realization that Icelandic banks are no longer really Icelandic. Although Armansson notes that Íslandsbanki continues to be treated solely as Icelandic risk, analysts report increasing ambivalence among investors about specific country lines, given that well over half of the leading banks' activities are now overseas.
Although the leading Icelandic banks continue their relentless – but targeted – expansion abroad, they have also found a lucrative new opportunity on their own doorsteps.
Last year the Housing Financing Fund (HFF) announced that it would raise its loan-to-value ratio and maximum loan amounts, provoking a spurt of activity among other lenders, which had previously not been able to compete on a cost basis with the triple-A rated government-owned HFF.
The property market in Iceland has soared in recent years – not least as a result of the massive migration to Reykjavik, where almost 60% of the population now lives. As a consequence, property prices in the city increased 149% between 1997 and 2004 and huge demand for mortgage lending has resulted.
The FME says that, provided moderate loan-to-value ratios are observed and liabilities are appropriately matched to assets, increased mortgage lending will consolidate the banks' operating base. Moody's Thomsen agrees that increased retail lending would be beneficial to the banks. "It's higher margin and it's stickier," she says.
Meanwhile, the FME notes that the capital adequacy ratio of commercial banks and the largest savings banks was 12.8% at the end of 2004 – the highest since 1995 – with the commercial banks showing an increase on the previous year. In the FME's judgement, the capital position of the commercial banks is sound. But that soundness might soon be tested by a change in the economic climate. The banks will need the astonishing business acumen and financial dexterity they have shown in recent years if they are to prosper in more troubled times.