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The internationalisation of
Iceland’s financial sector
Richard Portes
London Business School and Centre for Economic
Policy Research
Fridrik Már Baldursson
Reykjavik University
In collaboration with
Frosti Ólafsson
Iceland Chamber of Commerce
Road map
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Iceland: an exceptional case
The banks: growth and external orientation
Mini-crisis of 2006 and response
Institutional and regulatory framework
Macroeconomics and finance
Monetary policy
The banks: peer comparisons, resilience
Conclusion: excessive country risk premium
Recommendations
A very small country, highly
geared…
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Population 300,000, GDP € 13 bn
Per capita GDP $ 40,000 (PPP) – 6th in OECD
Open in trade: ½ (imports + exports)/GDP = 38%
Exceptionally open in finance: external assets 395% of
GDP, external liabilities 517% of GDP (end-2006),
significant carry trade
Non-resident workforce of Icelandic companies
approximately equals resident workforce
Four largest companies’ total market cap is twice GDP
Smallest country with independent monetary policy,
floating exchange rate, inflation targeting
Solid basis for internationalisation of
financial sector
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From early 1990s: market liberalisation,
European integration, privatisation
Fully funded pension system
Highly flexible economy
Excellent institutional framework – health,
education, infrastructure, political stability,
founding member of EEA
Fiscally sound: net debt of central
government 4% of GDP, gross debt 14% of
GDP, budget surplus
Spectacular growth of the banks
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Total assets of banking sector were 96% of
GDP in 2000, 800% of GDP in 2006
The majority of banks’ revenues originate
outside Iceland
Mini-crisis in early 2006
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Exchange rate depreciated 25%
Equity prices fell 25%
An ‘informational crisis’
- perceived macroeconomic imbalances
- queries about banks
reliance on market funding at short maturities
doubts on earnings quality (growth ‘too fast’)
cross-ownership
lack of transparency
Financial sector responded
strongly
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Expanded deposit base
Extended and broadened maturities and
geographical scope of market funding
Eliminated most cross-holdings
Emphasized transparency and information
dissemination
…and continued expansion
Deposit ratios up sharply
Market funding maturities
extended substantially
Is that enough? Markets still
have doubts…
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Icelandic banks have lower ratings than their
Nordic peers
They carry significantly higher risk premium
Either markets aren’t fully informed, or there
are other negative factors, or markets put a
country risk premium on the banks
So what is the story?
Institutional and regulatory
framework are highly advanced
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Financial Services Authority is highly
professional, and its budget was recently
doubled
Central Bank of Iceland achieves high
standard in its financial stability analyses
Iceland fully implements directives of EU
Financial Services Action Plan – including
MiFID (unlike several EU countries!)
But there are macroeconomic
imbalances – suggestions of ‘hard
landing’
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Economy has been running at very high
pressure of demand – unemployment
negligible, inflation at 4% (1.5% above CBI
target), housing market boom
High current account deficit and highly
negative net international investment position
But fiscal position enviably strong (though
deteriorating somewhat – inappropriately
expansionary in 2007)
NIIP deteriorated sharply in
2005-2006
Still, external position is
sustainable
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Current account deficit was 25.5% of GDP in 2006, will
be 15-17% of GDP this year, falling to around 10% by
2010 – as officially measured
Real exchange rate may be somewhat overvalued
But factor income and NIIP are mismeasured
Official data indicating that Iceland’s investments abroad
are substantially less profitable than foreigners’
investments in Iceland…
…are inconsistent with high profitability and growth of
Iceland’s international banks and corporations
Capital markets will finance deficits of a healthy economy
(cf. New Zealand, Norway in 1970s)
Factor income deficit down sharply,
trade deficit falling as growth falls
Bottom line: ‘hard landing’
improbable
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current account deficit on sustainable
downward track
Mismeasurement should be cleared up
Central bank reserves substantial for a
floating exchange rate regime
Fiscal soundness is a key ‘buffer’ – zero
probability of default on sovereign debt
(because there is so little!)
Financial volatility not a threat
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Volatilities of exchange rate, equity prices, and bond
yields are not exceptionally high
The krona (ISK) is not much more volatile against
major currencies than the currencies of New Zealand,
Sweden, and Australia
Carry trade significantly influences exchange rate
Banks are fully hedged against ISK volatility
Many firms have high foreign revenues, so borrowing
in foreign currency is a natural hedge – others can
pass on exchange rate effects into prices
Households borrow increasingly in foreign currency –
still only 7-8% of debt, but risk requires watching
Exchange rate volatility low, with 3
spikes
Exchange rate closely correlated
with other carry trade targets
Shift towards use of euro
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ISK is a problem for OMX ICE listed firms,
because equity prices rise when ISK appreciates,
so exchange rate volatility accentuates stock
market volatility
Hence ISK-denominated shares are unattractive
to all but risk-loving foreign investors
Large banks and companies moving to adopt
euro as listing currency and as their ‘functional’
currency (in accounts, denomination of equity)
Equity volatility spikes much
higher in euros than in ISK
But Iceland outside EU, can’t
enter EMU
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Still, could unilaterally adopt euro
Although EU and ECB oppose unilateral
euroisation for countries that might end up as
candidates for EMU, that’s not a block
But the issue requires extensive political as well
as economic debate
So we do not recommend for or against – but we
caution against possible destabilising
consequences of gradual shift towards using euro
domestically
Monetary policy ineffective
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With inflation at 4%, CBI has raised policy rate to
13.75% – yet at real rate of almost 10%, the
economy doesn’t contract
Housing Financing Fund and price-indexed
financial contracts both weaken monetary policy
transmission
CBI policy and statements appear to put a floor
under ISK
Resulting distortions in financial system – in
particular, large carry trade
Banks perform well in
comparison with Nordic peers
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Deposit ratios strong, market funding maturities
relatively long, overall and core profitability high
This is despite high capital adequacy ratios with
which they counterbalance high equity exposure
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Negligible exposure to US subprime market,
structured finance products, related financial
vehicles
FSA stress tests indicate they could withstand
quite extreme movements in market variables
specific to Iceland
Icelandic banks’ return on equity
superior to Nordic peers
Tier 1 capital ratios superior to
Nordic peers
Market risk premium on
Icelandic banks is excessive
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These banks exploit strong competitive advantages:
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highly entrepreneurial management
careful risk control
flat management structures
unusual and strong business models
Economy and financial sector are flexible and highly
resilient – effective response to mini-crisis of early
2006, stability in current turmoil
Current market premium (e.g., CDS spreads) is high
relative to risk exposure and Nordic peers
If it is a country risk premium, we believe it is not
justified by Iceland’s economic situation
Icelandic banks’ credit default
spreads are high
Internationalisation of Icelandic
financial sector is a major success…
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…but could do better, of course, so we recommend…
Iceland should undertake a deep political and
economic discussion of unilateral euroisation
Government should change role of Housing Financing
Fund so that it no longer competes with banks
CBI should fundamentally rethink its strategy
Authorities should make major efforts to account
better for the balance of international income and
international investment position (jobs for
economists!)