Stephen Timewell reports from Reykjavik on Iceland’s rapid transformation into a pan-European banking force. Iceland is a truly amazing country. And it is not just the volcanoes, the geo-thermal springs or even singer Bjork that make it unique.

Iceland boasts a banking sector that almost doubled in asset size last year, an economy that grew at 5.2% in 2004 and an expected 6.6% this year and a GDP per capita amongst the highest in the world at $40,250 in 2004.

Also, for visitors, it seems to be about the most expensive place on the planet.

So how do less than 300,000 people brought up on fishing, lava flows and Arctic temperatures produce three banks in the first 500 of The Banker’s latest Top 1000 World Banks listing (The Banker, July 2005) and look set to move further up the ranking again this year?

The plaudits are not just for the banking sector. The IMF in its Article IV Consultation statement in June this year concluded: “Overall, economic performance in Iceland has been impressive. The government should be commended for its consistent commitment to implementing and following policies that have laid a sound foundation for sound economic growth. These policies include structural reforms that have increased the economy’s dynamism and flexibility, significant improvement in financial supervision, the introduction of a flexible exchange rate and inflation targeting, and a sustained period of sound fiscal management.”

Birgir Gunnarsson, governor of the Central Bank of Iceland, is happy that the IMF came to the conclusion that the financial system is sound and he points to the privatisation of the banks as the underlying explanation for the recent rapid growth. “The banks could not grow by keeping to Iceland. Privatisation has been a good development for Iceland; it has broadened business operations.”

The central bank’s Financial Stability report in April outlines not only the governor’s position but the overall changes taking place and the close relationship between the fortunes of the banks and the economy. “The year 2004 marks a milestone in Icelandic banking. Total assets of the commercial banks and largest savings banks almost doubled due to acquisitions of foreign subsidiaries and lending growth. The point has now been reached where half of the assets of the three large commercial banks are held by their foreign subsidiaries.”

Overseas shopping

The report neatly encapsulates not only what is happening among the banks but also among Iceland’s large corporates, which are also on an overseas spending spree. “Overseas expansion by Icelandic commercial banks has a raft of consequences. Icelandic banks have become larger and more international in character and the core of their consolidated balance sheets is shifting abroad, even though their headquarters, risk management and liquidity management remain in Iceland.

“Acquisitions of foreign subsidiaries have broadened the banks’ income base and dispersed their risks, leaving them less exposed to domestic shocks, but correspondingly more exposed to foreign risks.”

Are the banks expanding too rapidly? Mr Gunnarsson notes: “The banks have increased their equity as they have expanded and, as long as they increase their equity, they can grow.”

Ragnar Haflidason, deputy director general of the Financial Supervisory Authority, the bank regulator, explains that growth concerns have led the authorities to decide on high minimum capital ratios and the introduction of a law on stress testing. He adds that banks must pass particular stress tests and that they cannot go below a minimum 9.5%-10% total capital ratio. At the end of 2004 the capital adequacy ratio of the commercial banks and largest savings banks was 12.8%, the highest ratio since 1995.

While banks’ capital and liquidity positions look strong the authorities are cautious. The Financial Stability report notes: “Equity purchases are increasingly leveraged with borrowed funds, which could be questionable if equity markets turn down again, and the total amount of large exposures has risen.”

Growing macroeconomic imbalances have emerged over the past year or more and have been reflected in rapidly growing domestic demand, increasing inflation, high asset prices and a widening current account deficit that is expected to reach 12% of GDP this year, the largest in post-war history. Net external debt is high and growing, hitting 85.4% of GDP at the end of 2004, mainly as a result of the banks, which account for two-thirds of the debt.

Despite the above cautions though, Mr Gunnarsson forecasts growth of 6.2% next year. That and large scale investment projects in aluminium smelting that exploit Iceland’s comparative advantage in clean energy, along with financial developments, combine to provide a sound outlook in the eyes of most analysts.

Whiff of corruption

Perceptions, however, can be important, especially in a small, tightly-knit business community such as Reykjavik. Iceland’s reputation appears to have taken a jolt in recent months in a high-profile case involving Jon Asgeir Johannesson, chairman of Icelandic venture capital group Baugur, which has made major retail investments in the UK recently. In August, Mr Johannesson was charged in an Icelandic court on 40 counts, including embezzlement, following a three-year investigation that is claimed to have involved former prime minister David Oddsson.

The Baugur chief denies all the charges, which he says are politically motivated. Whatever the outcome – and it may amount to nothing with a lower court in Iceland throwing out all charges in late September – damage has been done not only to Mr Johannesson but also to the squeaky-clean image of Icelandic institutions, banks included. Unsurprisingly, bankers baulk at speaking openly on the subject.

Despite all that, in July Baugur added to its British retail empire with a £117m ($210m) acquisition of Jane Norman fashion chain, which it bought in tandem with Kaupthing Bank.

The big banks

The importance of the big banks is amply demonstrated by their dominant role on the Iceland Stock Exchange. Of the 33 companies listed, the financial sector accounted for 62% of the market capitalisation in June. Kaupthing Bank alone accounted for 25% followed by Islandsbanki (12.6%) and Landsbanki Islands (10.8%). Following 58.9% growth in 2004, the ICEX-15 index grew by a further 23% in the first half of 2005 but turnover was slightly down. Equity prices, however, are said to have done nothing more than keep pace with profit growth.

In focusing on the banks, the biggest success story is Kaupthing. From a virtual start-up in 1994, the bank has doubled in size every year for the past eight years, says 35-year-old chief executive Hreidar Mar Sigurdsson, achieving remarkable growth. Based on 2004 figures, Kaupthing jumped 248 places in The Banker’s latest Top 1000 listing to become the 211th largest bank in the world.

How has this happened? “It is no miracle,” says Mr Sigurdsson. “We have had the same management team for 12 years and we set the strategy in 1996 that we had to grow outside Iceland.” He acknowledges that privatisation and the reduction of corporate tax from 45% to 18% have been a stimulus but the key has been targeted acquisitions.

“We have focused on achieving one big deal each year and we have been able to do this for the last five years. It is also important that we have integrated each deal before moving on to the next.”

One of Kaupthing’s biggest deals came in the summer with the purchase of long-established London-based financial services group Singer & Friedlander (S&F) for an undisclosed sum. This big UK acquisition follows that of Danish bank FIH Erhvervsbank, in 2004, the merger with Bunadarbanki Islands in 2003 and the purchase of Sweden’s Aragon and JP Nordiska in 2002.

Along with its strong retail franchise in Iceland, Kaupthing has built an international wholesale investment banking network that at the end of 2004 covered 10 countries and included 1600 employees. With operations in the UK, US, Luxembourg and Switzerland as well as the Nordic countries, Mr Sigurdsson is well on the way to achieving his aim of Kaupthing being the leading Nordic investment bank.

Wider focus

Following the S&F deal, Kaupthing is being transformed from being not only an Icelandic and Nordic bank, but also a northern European operation with a focus on the UK and Denmark. The change in its income stream reflects its new structure dramatically. In 2002, income from Iceland was 80% but this figure dropped to 56% in 2003 and to just 41% in 2004. Mr Sigurdsson told The Banker that he expects income from Iceland to fall to less than 20% by the end of this year with the integration of S&F, thus making Kaupthing a truly pan-European operation but owned and managed out of Reykjavik. The 300% increase in profits to $467m in its recent interim results clearly demonstrates this new structure.

Iceland’s second largest bank, Íslandsbanki (ISB), is also pursuing an aggressive growth policy and rose 194 places to finish 441st in The Banker’s Top 1000 listing. Although Kaupthing is bigger and is grabbing more headlines, Íslandsbanki is no slouch, matching Kaupthing with a 113% growth in pre-tax profits in 2004 (reaching $224m), a 52.1% growth in assets and a 34.3% return on equity.

Narrower strategy

Like its competitors, ISB has sought expansion abroad but, as chief executive Bjarni Armannsson explains, the bank has pursued a narrower strategy, concentrating on creating a second home market in Norway and a number of niche market segments, namely the seafood industry, sustainable energy and offshore supply vessels.

Besides “rightsizing” the domestic branch network down to 25 branches and expanding the oil rig and oil vessel business, Mr Armannsson has also been busy with acquisitions. Earlier this year, he concluded the purchase of two Norwegian banks: the fourth largest commercial bank in Norway, BNbank, a key mortgage lender, and the smaller KredittBanken. At the end of 2004, BNbank was the 725th largest bank in the world with total assets of $6.6bn.

“We have doubled in asset size in 2005 with the Norwegian acquisitions,” says Mr Armannsson. As of April 2005, Norway accounts for 51% of ISB’s loan book, overtaking Icelandic exposure at 38%.

The CEO estimates that one third of net income this year will come from Norway and following integration ISB is planning to further increase its exposure to Norway. Pre-tax profits for the first half of 2005, reflecting the purchases, rose to a record ISK12.3bn ($200m), a 41.2% increase over last year. And with a $450 rights issue, completed in January, ISB has been able to fund the BNbank deal and strengthen its capital adequacy for further growth.

Landsbanki Islands is the smallest of the “big three” in capital terms but it is the largest mover in our Top 1000 listing, jumping 253 places to be the 471st largest bank in the world. Established in 1885, Landsbanki is the largest retail bank in Iceland, with 46 branches and leadership in virtually all segments of the domestic market. Privatised in 2003, the bank, like the others, has expanded rapidly with pre-tax profits in 2004 rising by 319.7% to reach $241m. Brynjolfur Helgason, alternate group CEO, notes that his bank has a one-third market share in Iceland with a share of up to 50% in corporate advisory. Asset size has tripled from the end of 2002 to the first quarter this year, he adds.

Offering an alternative approach to the others, Landsbanki has a strong domestic strategy, based on fast-growing corporates and households, along with an international strategy based on a strong emphasis on corporate and investment banking. Mr Helgason explains that the bank has no focus on Nordic markets but is concentrating on building a diversified UK corporate investment bank and extending its operations in Luxembourg.

In 2004, the bank bought UK broker Teather & Greenwood to add to its London corporate finance operations and the specialty services of its UK subsidiary, Heritable Bank. Mr Helgason says that he hopes overseas lending will reach 50% in the next two years. Last month, Landsbanki acquired pan-European securities house Kepler Equities (formerly Julius Baer Brokerage) in a €76.1m deal.

Home loaning

Besides the three major banks, Iceland has 24 savings banks which together own Icebank. This grouping represents the fourth force in financial services and, with 55 branches, has 25%-30% of the domestic retail market. With Kaupthing deciding to take on the virtual monopoly of the Housing Financing Fund last year and the opening up the mortgage market to wider competition, housing could also become an important new segment for the savings and commercial banks.

For Iceland and its major banks, the critical issue is whether they can manage their burst of overseas expansion. Growth in the past two years has been extraordinary but it has also been accompanied by commensurate capital growth. While well aware of the dangers of overheating, regulators seem satisfied for the moment that any shocks are under control. But can the tightly-knit management and openness that has prompted the banks’ amazing growth be sustained when the bulk of the banks’ assets are a long way from Iceland?

The banks have shown they have the ability to grow, the next few years will show whether they can manage their new international empires out of Reykjavik and keep the foreign risks under control.


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