Iceland’s banks insist they have addressed concerns raised over low deposit ratios, a lack of communications and their use of capital markets. Silvia Pavoni reports.

Overheating is no longer the principal threat to Iceland’s economy. Economists now say that the country’s biggest challenge is convincing the markets that current levels of growth are sustainable.

Although prime minister Geir Haarde has expressed confidence in the country’s ability to emerge from 15 years of rapid growth in a stable manner, ahead of elections in May, some analysts remain cautious.

Over the past year, the country has been in the headlines because of its negative analyses and forecasts from rating agencies.

In February 2006, Fitch revised its outlook for Iceland from stable to negative, due to the country’s overheating economy, large current account deficit and rising external debt. The krona, stock market and government bond prices all fell and some forecasts expected the country’s gross domestic product (GDP) to decline in 2007. The fast expansion of the banking sector was also criticised.

A year later, in February 2007, a report by Standard & Poor’s highlighted that the Icelandic economy was slowing and that the banking sector’s business model could be tested. The sector is characterised by high concentration where the top three commercial banks, Kaupthing, Landsbanki and Glitnir, already own 90% of the domestic market.

But then in the following month, Moody’s unexpectedly upgraded the banks to AAA and then soon after settled on Aa3 following criticism of its analysis.

“[Moody’s] giving them AAA ratings was a surprise to the market as well as the Icelandic banks themselves, and it gave people a lot of reasons to be sceptical about Moody’s methodology,” says Leo-Hendrik Greve, managing director in the financial institutions group within debt capital markets at Citi. “The reality is, however, that these banks have addressed many of the problems that fixed-income investors saw: some of their crossed shareholdings, their liquidity positions and their acquisition strategies. By and large, they have excess capital now, their ratings have stabilised, and their spreads have consequently tightened significantly.”

Capital improvements

In particular, the financing of such acquisition strategies had created capital markets turmoil in the past. Merger and acquisition activity was financed purely through debt and short-term issuance. Things have improved there too. “They have longer debt maturity profiles now, which eases refinancing pressure,” says Mr Greve. “In general, they have better capital structures.”

The tensions in the capital markets that characterised 2006 were also due to a lack of information on both the economy and on what the top three banks were doing, say the banks. “[Last year we went out and explained] what we were doing and released as much information on the market as we possibly could,” says Ingólfur Bender, head of research for Glitnir.

“Last year was from many perspectives good for us,” adds Steinunn Kristin Thordardottir, managing director of Glitnir UK and south Europe. “It ensured that we kept things in check. And people here reacted to it extremely well. They put extra effort and extra time to travel around the world and educate [the market], and simply put the extra hours in to make things work. As an Icelandic person, it makes me very proud.”

Securing deposits

Another issue the Icelandic banks had to face was their reliance on proprietary trading books and the need of a more classic balanced bank portfolio, which would limit the dependence on the capital markets. Given the size of the Icelandic market, it is only natural that banks have been looking abroad to address their low deposit levels. Some have undergone the corporate deposit root: Kaupthing, with its Danish operation FIH, focused on small and medium businesses; others, such as Landsbanki, have undertaken successful retail strategies.

“The Icelandic retail market is a relatively stable market,” says Brynjólfur Helgason, deputy CEO of Landsbanki. “It’s not a big market and there is a high level of competition between the main players, which are the three large banks and the savings banks. [With regards to Landsbanki] it’s unlikely that there will be big growth from the domestic market. We expect to grow by 15% to 20% organically, as a group, and we expect the expansion to come from abroad.”

Landsbanki’s main success overseas this year has been the UK online retail product Icesave, which has seen deposits increasing from £75m (€109m) at the end of 2006 to £2.8bn in May. “This has been a very successful product and has also strengthened Landsbanki’s liquidity, as well as helping decrease our dependence on the capital markets,” says Mr Helgason.

As Iceland’s market is so limited in size it is considered essential for the banks to develop business overseas.

“I think that the banking system is moving further away from the Icelandic economy,” says Mr Bender. “In the next two to four years it will definitely do so even more. All the banks are trying to expand abroad and I think that [moving away from the domestic economy] is quite a positive development. The banks need to become global competitive players.”

No mergers forecast between Kaupthing, Lansbanki or Glitnir then? “It is unlikely that the regulator will let [a domestic merger] happen,” says Mr Greve. “It is keen to maintain three banks, even though it is a small country. The financial services sector, especially the mortgage area, was liberalised not too long ago and I think the regulators would feel that a merger of two of the big banks would create an institution with too big a market share.”

Icelandic banks have come a long way in the past year. They have addressed their lack of communications, low deposit ratios and their use of capital markets. And the markets have generally responded positively to the banks’ changes.

However, prices of five-year credit default swaps on the top three banks are still wider than normal for A rated banks – which is, according to analysts, the rating these top three banks are traded at despite their official Aa3 rating. This indicates some concerns about these issuers.

Ownership issues

Furthermore, research company CreditSights believes that cross shareholdings that control the Icelandic banking sector – typical of the country’s corporate ownership structure – remain one of the causes of such higher pricing. The ownership issues have improved recently but might not be perceived as entirely solved yet. Other analysts, however, believe that conflicts of interests have satisfactorily been addressed, with the possible exception of the cross shareholding between Lansbanki and investment bank Straumur-Burdaras.

Given their past showing, Icelandic banks will likely get to work to resolve any remaining concerns that the markets might still have.


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