BICRA Highlights

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Economic activity has slowed but growth prospects remain comparatively benign.  After a solid recovery in 2021-2023 with GDP growth averaging 6%, economic momentum has slowed since second-half 2023, primarily due to softened domestic demand. Still, growth prospects remain sound, and we forecast GDP growth will average 2.4% over 2024-2026. Alongside tourism, we expect Iceland's economy will continue to benefit from a favorable demographic profile and expanding nascent economic sectors, such as biotechnology and sea- and land-based fish farming.

We consider that economic risks facing Icelandic banks have faded with a stabilizing housing market and reduced private sector leverage.  The residential property market has cooled off since the mid-2022 peak and housing prices corrected by 4.5% in real terms in 2023. We expect the recent resurgence in prices is temporary, partly owing to government measures to support Grindavik residents affected by the volcanic activity and forecast relatively balanced real house price growth of 2%-4% over the next two years. At the same time, private sector leverage has fallen, and we expect it to remain at 145%-150% of GDP over 2024-2026, from 148% of GDP as year-end 2023.

We expect Iceland's banks will remain resilient with robust profitability despite rising operating expenses, including cost of risk and increased presence of domestic pension funds in the mortgage market.   Although earnings prospects have moderated, we still expect credit growth and sound operating efficiency will support strong profitability. We believe the three incumbent banks will maintain their dominant positions in the market, despite the expanding position of pension funds in mortgage lending. Our base-case scenario sees the domestic systemically important banks' (D-SIBs') average return on assets edging down to 1.3%-1.5% over 2024-2026, from close to 1.7% in 2023, a level that still compares very favorably to peer banking markets.

Economic And Industry Risk Trends

The trend for economic risk in Iceland, as it affects the domestic banking sector, is stable. Risks emanating from economic imbalances have moderated, in our view, in tandem with a stabilized housing market and lower private sector leverage, although residential property prices remain overvalued by most measures.

Downside risk relates to Iceland's still high inflation and tight monetary policy stance, as well as tail-risk from the threat of further volcanic activity causing greater economic damage than seen so far. Any unexpected shifts to its key export sectors could also alter our outlook on Iceland's small, open economy.

We view the trend for industry risk in the Icelandic banking sector as stable and project profitability will remain sound and continue to support robust risk-adjusted capitalization, despite the prospect of moderating margins and rising operating expenses including cost of risk. The D-SIBs' foreign funding maturities are well distributed through 2028 and refinancing risk is further mitigated by banks' ample liquidity buffers.

We could, over time, positively adjust our view on industry risk if banks' maintained robust risk-adjusted profitability through the cycle and demonstrated resilience to persistent competition from domestic pension funds.

Economic Risk  |  4

Economic resilience: Cooling economy but sound growth prospects ahead

A wealthy, albeit concentrated, economy with sound growth potential.  Iceland is a prosperous economy. We project per capita GDP at $85,500 for 2024, which compares favorably with that of peers in BICRA group '4'. The economy expanded by 4.1% in 2023, following an already significant recovery in 2021-2022, buoyed by the tourism sector which has benefited from a strong post-pandemic recovery.

Economic momentum has slowed since mid-2023 but growth prospects remain relatively benign, projected to average 2.4% over 2024-2026. Alongside tourism, domestic demand will be key to growth, partly due to a growing population, a comprehensive union-led wage agreement, and the expansion of knowledge-based and new economic sectors, such as biotechnology and sea- and land-based fish farming.

Nevertheless, Iceland fundamentally remains a small and open economy, with a population of only about 384,000, and an estimated GDP of about $34 billion in 2024. Despite growth in new economic sectors, Iceland's export base remains concentrated in marine products, processed aluminum, and tourism, jointly representing close to 70% of its total goods and services exports.

Fiscal consolidation and tight monetary stance amid still-elevated inflation.  Iceland's strong economic growth has strengthened its fiscal outlook in recent years, and the government has tightened its fiscal stance, thereby also supporting efforts to control inflation. We expect fiscal consolidation measures will help reduce the general government deficit to an average of 1.1%-1.6% in 2024-2027, compared with a high average of about 7.9% of GDP in 2020-2021, with net general government debt reaching a moderate 41% of GDP by 2027.

While accumulated net foreign currency reserves provide the Central Bank of Iceland (CBI) with some policy headroom, we fundamentally still view Iceland's monetary policy effectiveness as constrained. The underlying economy represents one of the smallest currency areas globally and, historically, domestic inflation has been heavily influenced by developments abroad. The country's real effective exchange rate also tends to fluctuate over the economic cycle and could be subject to large valuation swings, exacerbating the cyclicality inherent in the economy.

Stable institutions and policymaking.  In our view, Iceland's institutional arrangements remain a rating strength, with functioning checks and balances between various institutions. The country's swift and effective policy response to the pandemic underpins our view of generally effective and stable policymaking. The current government coalition, comprising three political parties that span the center-left and center-right, has progressed with a broad consensus-oriented approach to policymaking.

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Economic imbalances: Housing market stabilization but overvaluation remains

We forecast balanced property price growth over the next two years.  Following a cool-off period with slowing price appreciation since mid-2022, residential house price growth have regained momentum since late 2023 in tandem with higher market activity. This has, however, in part been attributable to government measures to support households affected by the volcanic activity on the Reykjanes peninsula and Grindavik residents relocating and re-entering the market. We believe these temporary effects will abate and forecast relatively balanced real price growth of 2%-4% per year in 2024-2026, compared with a contraction of 4.5% in 2023. Still, by most measures the housing market remains overvalued which continues to pose downside risk, although this should be seen in light of recent years' strong economic activity, high immigration, and lagging supply of new housing.

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Despite tight financial conditions and suppressed household consumption, underlying demand remains robust. High wage growth, above 9% per year in 2022-2023, and a flexible mortgage market have aided households' capacity to service debt and finance new housing. The Icelandic population, which grew by around 3% in 2023, has at the same time continued to support demand. New supply of housing has fallen slightly in 2024 amid higher financing and construction costs, but forward-looking indicators suggest that new construction activity should gain momentum again, which would support balance in the market.

Commercial property prices remain elevated as a result of recent years' growing demand and subdued supply since the 2008 financial crisis. However, construction of commercial real estate has slowly picked up and grew by an average of 1.7% per year in 2022-2023. This could, in our view over time translate into better balanced supply and demand dynamics.

D-SIB lending to commercial real estate and construction companies has grown significantly, by 23% in 2023 and 11% in first-half 2024, now accounting for almost 20% of their total lending, out of which around one-third is directed at construction. While potentially indicative of a higher risk appetite and a source of concentration risk, asset quality remains sound and credit risk is partly mitigated by generally sound average loan to value ratios, and lengthened loan maturity profiles of commercial real estate companies.

Resilient credit growth aided by inflation-linked lending practices.  Private sector credit contracted by 1% in real terms over 2023. Still, underlying nominal growth have remained relatively robust aided by lending to real estate and construction companies and the increasing share of inflation-indexed loans in the system. We project loan growth to households and corporates will remain largely stable at 5%-7% over the next two years, compared with 5.6% in 2023, and turn positive in real terms as inflation subsides. We forecast inflation will remain elevated at 4%-5% by end-2024, from 6.0% in August, and reach the CBI's target of 2.5% in 2026.

Current account and external debt position.  Iceland's current account moved into a surplus position in 2023, following two years of small deficits, partly as a result of robust tourism. We forecast current account deficits averaging 0.8% of GDP throughout 2024-2027. We project that Iceland's net external asset position will remain roughly stable, at about 39% of GDP over the next few years (2023: 40%). Iceland has been in a net external asset position since 2016, with a marked increase in 2020-2021 and some contraction in 2022 due to asset revaluations.

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Credit risk in the economy: Reduced private sector leverage underpins debt serviceability

High debt capacity supported by high wealth and household's strong asset positions.  Leverage in Iceland's private sector has fallen markedly relative to GDP in tandem with the strongly growing economy and slowing credit growth, standing at around 148% as of year-end 2023. This is significantly below the pre-pandemic level of 158% and our 154% four-year rolling average (2021-2024 forecast) which we typically use to inform our assessment. While we consider this level to be material, it compares favorably with most Nordic peers.

In our view, risks emanating from high indebtedness is partly offset by the private sector's large debt capacity and significant asset position. Iceland has a wealthy population as reflected by households' financial assets valued at more than 200% of GDP. Consequently, their net asset position is greater than 100% of domestic output. While asset wealth can be susceptible to a sharp fall, it provides a buffer for debt levels.

The banking sector's exposure profile mirrors the domestic economy.   Banks' loan books are well balanced and rather equally distributed over households and corporates, as well as over corporate sectors with some concentration in real estate, construction, and fisheries. Still, the domestic focus makes banks highly sensitive to developments in Iceland's small and concentrated economy. For example, we expect corporate loan portfolios to be correlated with the tourism sector, accounting for an estimated 10% of banks' total loans and around 30% of Iceland's total exports, directly and indirectly.

Icelandic banks have moderately conservative lending standards, in our view.  We consider Iceland's payment culture and rule of law to be strong. The country consistently has a top 10% ranking in the World Bank governance indicators for rule of law and control of corruption. Mortgage lending standards are overall sound with healthy average loan-to-value ratios estimated at slightly below 55% for the D-SIBs. This partly reflects macroprudential controls first implemented in 2017 and tightened as property overvaluation and mortgage debt risks built over 2020-2022. The amount of foreign-currency lending remains relatively small, at about 15% of credit outstanding, and has largely been extended to domestic multinational corporates with foreign currency revenue.

The rise in interest rates has fueled a resurgence in demand for inflation-linked loan products, and inflation-linked mortgages rose to 54% of total mortgage loans by first-quarter 2024, from 44% at end-2022, a trend we expect will continue over 2024-2025. While supporting serviceability by offering a lower interest rate, indexed loans have the principle upward adjusted with inflation, which risks eroding borrower equity and weighing on collateralization levels. That said, the average Icelandic household has a comfortable equity position and sound loan-to-value following the recent house price growth cycle.

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Credit losses: We forecast credit loss provisioning will average 20-25 basis points (bps) over 2024-2026.

We expect tight financial conditions for borrowers and the slowdown of the Icelandic economy will exert moderate downside pressure on incumbent banks' asset quality with nonperforming loans rising to 2.0%-2.2% over the next two years, from 1.9% as of June 30, 2024. We project this will drive a slight uptick in provisioning needs with cost of risk at an average of 20-25bps over 2024-2026. Still, stage 2 loans remain low and declined marginally to 4.9% of gross loans in first-half 2024. Broader asset quality is supported by Iceland's low unemployment, which is expected to rise slightly to 4% from a low of 3.4% in 2023, as well as ample household assets and robust social safety nets.

Industry Risk  |  5

Institutional framework: Iceland is continuously building its post-2008 track record

Iceland has strengthened the regulatory and supervisory framework.  Iceland has transposed the EU regulatory framework into national law and banks are required to comply with European Banking Authority (EBA) guidelines. The CBI has fully implemented a risk-based supervisory framework including on- and off-site supervision, a new law for banking resolution, and a resolution authority within the CBI.

Iceland has adopted global best practices in Basel III and banks are subject to extensive capital requirements, including individual bank specific pillar 2 requirements, and additional buffer requirements (the combined buffer requirement for the three D-SIBs amounted to 10% as of June 30, 2024) to counteract shocks and to safeguard bank solvency. Banks are also subject to the net stable funding ratio and liquidity coverage ratio minimum requirement of 100% measured in all currencies combined. The liquidity coverage ratio includes a minimum requirement of 50% for the domestic currency and 80% for euros, applicable to financial institutions the euro-denominated liabilities of which exceed 10% of total liabilities.

Moreover, the CBI has in recent years increased its efforts to bolster the financial system's resilience against cyberattacks. Efforts to advance its agenda on sustainability climate issues is ongoing and it published its first sustainability report in 2021. Climate risks are also incorporated into the supervisory review and evaluation process for regulated banks.

The regulatory track record continues to develop after the 2008 crisis.  Iceland's prudential and stability authorities have gradually built a post-crisis track record in managing financial sector risk. We believe that the Financial Supervisory Authority (FSA), in conjunction with the CBI's Financial Stability Committee, was proactive and showed pragmatism at the onset and throughout the pandemic. Together, authorities were timely in changing the countercyclical capital buffer, implementing measures against rising imbalances, and monitoring the banks' asset quality. We expect the FSA will closely monitor the ongoing privatization of the banking system and the composition of new shareholders.

We consider governance and transparency as neutral to our assessment.  Banks appear to employ transparent and timely reporting standards and sound compensation practices. Their disclosures of risk exposure related to the pandemic support this view.

Competitive dynamics: Concentrated banking sector with sound earnings.

Banks' sound core profitability supports robust loss-absorption capacity.   Incumbent banks' earnings have stabilized at a higher level in recent years, aided by widened net interest margins, solid cost control, notwithstanding elevated inflation, and contained provisioning needs. On average the D-SIBs reported aggregated return on equity of 11.6% in 2021-2023 compared with its pre-pandemic 2017-2019 average of 5.9%.

Although we expect D-SIBs will continue to demonstrate sound profitability over the next two years, we consider earnings prospects have softened somewhat with a slowing economy, rising operating expenses including cost of risk, and our anticipation of a gradually declining net interest margin. We forecast return on equity of 9%-10% in 2024-2026, compared with 10.2% for the first half of 2024 and 11.9% in 2023.

Relative to the Euro area, the pass-through of monetary policy rates to customer deposits rates has been comparatively high in Iceland. Consequently, although D-SIBs' net interest margins have widened, it has not been as profound as in many peer countries. When interest rates decline, we therefore expect pressure on net interest income to be comparatively lower which, alongside our expectation of robust credit growth, will continue support banking sector revenues.

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Oligopolistic banking sector with manageable competition from domestic pension funds.  The three incumbent D-SIBs benefit from scale and institutional expertise in their domestic market, underpinning the stability of the banking sector. The sector's high digital advancement, with close collaboration between incumbents and emerging technology firms, and only limited foreign competition, will continue to contain disruption risk, in our view.

Accounting for about 45% of financial sector assets, domestic pension funds play a prominent role in the Icelandic market. The interconnection with banks is high with pension funds being the largest private owner, the main investor in banks' covered bonds as well as a competitor in lending. Although we do not think the competition is significantly distorting mortgage pricing, we acknowledge pension funds are not subject to the same capital requirements as banks, which presents a competitive advantage.

After withdrawing from the market amid historically low interest rates and compressed mortgage margins, competition from domestic pension funds in mortgage lending has again been rising--15.5% in 2023 against a growth rate of 4.3% for commercial banks. While we anticipate pension funds will further increase their market share, from 25% as of year-end 2023, we expect banks can navigate this and still earn sufficient risk-adjusted returns.

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In addition, we do not believe the banking sector's ongoing privatization presents unforeseen risk. We expect the government will sell its remaining share in Islandsbanki over 2024-2025, following its previous divestments in 2021-2022. Although we do not rule out the possibility that the government could reduce its ownership in Landsbankinn over time, currently holding 98%, we expect them to keep a blocking majority. Regardless, the government is largely independent from management and the board and, consequently, we see little risk of government influence.

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Systemwide funding: Structural funding gap is partly offset by demonstrated access to several wholesale funding markets.

The banking sector is mainly funded by customer deposits complemented by domestic covered bonds and foreign senior bonds.  Similar to Nordic peers, households hold their savings in pensions, life insurance, mutual funds, and equities, as well as bank deposits. Part of these savings are funneled into the banking sector via banks' issuance of covered and senior bonds. However, this structure results in a lower share of stable deposits relative to systemwide loans. By our definition, core customer deposits (100% of retail and 50% of nonfinancial corporates) will therefore likely continue to account for less than half of domestic lending, which is low in a global comparison.

Nevertheless, core customer deposits have outpaced the growth of domestic loans over recent years. Household deposits grew 17% and 9% for corporate deposits year on year as of first-half 2023, slightly lowering the sector's reliance on wholesale funding. We expect deposits will remain the banks' largest source of funding, accounting for some 60%-65% of D-SIB funding, in line with their 10-year historical average. Around half of D-SIBs' total deposits (45%-55%) comprise household deposits, of which roughly two-thirds is covered under the state guarantee.

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Icelandic banks have a structural dependence on external wholesale funding.  Incumbent banks' funding gap is predominantly filled by issuance of domestic covered bonds and foreign senior bonds, accounting for 12% and 15% of D-SIB's total funding as of June 30, 2024. Banks have historically issued covered bonds in domestic currency, and mostly to domestic pension funds, but have over recent years also issued covered bonds in foreign markets. While this might raise the system's dependence on external funding, we also consider this positive for the diversity of banks' wholesale funding options and an indication of the sector's good access to foreign investors.

Funding conditions have at times been difficult and after recovering from the capital markets volatility in early 2023, spreads on Icelandic banks' senior instruments temporarily widened again on increased geopolitical uncertainty in October 2023. Still, foreign bond issuance has been stable and totaled Islandic krona (ISK) 218 billion in 2023 (5% of D-SIBs' total funding), an indication of continued strong market access, in our view. Moreover, D-SIBs' foreign bond maturities are well spread through 2028 with annual foreign maturities below 5% of their combined funding base, and the banks also hold sizable liquidity buffers in foreign currency.

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The domestic debt capital market exceeds 25% of nominal GDP, which we view as sizable in relation to the economy. However, the market is small in absolute terms and very concentrated with the Icelandic pension funds as the banks' major domestic wholesale funders. Together, they own more than half of the systemwide stock, posing some concentration risk. Consequently, we are unlikely to view a shift in banks' focus toward offshore covered bond issuance, and therefore an increase in dependence on net external funding, as raising the sector's funding risk.

The government has demonstrated pragmatic flexibility over recent episodes of stress.   The CBI expanded its liquidity provision to banks in April 2020, by offering a special temporary collateralized borrowing facility and simultaneously easing collateral requirements and asset haircuts. When this was discontinued in January 2022, the central bank announced a permanent precautionary liquidity facility in addition to that undertaken for conventional monetary policy operations. We consider this could counter threats to a disorderly liquidity demand in stressed conditions.

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Peer BICRA Scores

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Iceland has a wealthy and prosperous economy, consistent with peers in BICRA group '4'. The country has a comparably high GDP per capita and resilient private sector. Still, we believe the concentrated economy and associated volatility this can create for the banking sector counterbalance this. Compared with Nordic country peers', Iceland's banking sector faces higher risks from economic volatility and imbalances in the property market, and the structural wholesale funding dependence coupled with the concentrated nature of the domestic wholesale funding market renders higher funding risks, in our view.

Government Support

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In our view, the likelihood of government support for Icelandic banks is uncertain.

Since May 2022, we have viewed the Icelandic resolution regime as sufficiently effective. As a member of the European Economic Area, Iceland implemented the EU's first Bank Recovery and Resolution Directive (BRRD I) in September 2020 and is in the process of fully implementing the second directive (BRRD II), including a requirement for a portion of eligible liabilities to be subordinated. In November 2021, the CBI's financial stability committee announced that it considers the three D-SIBs resolvable. Resolution plans for the three D-SIBs were updated in the fall of 2023 and for four savings banks in early 2024.

The resolution authority has issued a binding policy on the minimum requirement for own funds and eligible liabilities (MREL) and has set institution-specific MREL requirement. These relate to the three D-SIBs: Islandsbanki hf (BBB+/Stable/A-2), Landsbankinn hf. (BBB+/Stable/A-2), and Arion Bank (not rated).

Related Criteria

• Banking Industry Country Risk Assessment Methodology And Assumptions, Dec. 9, 2021
• Financial Institutions Rating Methodology, Dec. 9, 2021
• Environmental, Social, And Governance Principles In Credit Ratings, Oct. 10, 2021
• Sovereign Rating Methodology, Dec. 18, 2017

Related Research

• Banking Industry Country Risk Assessment Update: August 2024, Aug. 29, 2024
• Three Icelandic Banks Upgraded On Receding Economic Imbalances; Outlooks Stable, April 4, 2024