An investigation into the credit default swaps market is adding to the Icelandic banking system’s woes, but banks’ soundness and international reach should help them once the storm is over, writes Silvia Pavoni.

That hedge fund managers tend to be based at the most exclusive addresses in the world is a well-known fact. They also often meet their clients or potential business ­partners in some of the most sophisticated locations. In the US, wealthy Greenwich, Connecticut, offers an exclusive, leafy setting. In the UK, ­London’s Mayfair area exquisitely ­combines work with leisure. And if a conclusion should be taken by Iceland’s recent financial market developments, the ­stylish 101 Hotel in Reykjavik is the country’s high power wine-and-dine address.

In January this year, as widely reported by the press, representatives of a group of international hedge funds were flown to Iceland by Bear Stearns, the US investment bank and leading prime broker that collapsed in the following two months. In Iceland’s close financial community, the hedge funds’ dinner meeting has taken on ­legendary status. Participants were said to have talked openly about short ­positions.

Investigation under way

Short positions are perfectly OK but recent market activity has prompted the country’s financial supervisory authority to launch an investigation into what it suspects might be speculative attacks on currency, banking and stocks market and distribution of misleading information. At the end of March, credit default swap (CDS) ­values for Iceland’s three main banks rocketed to record values, more than 1000 basis points (bp) in the case of Kaupthing and Glitnir, and more than 800bp for Landsbanki. Values have since diminished to about 600bp for the first two banks and less than 400bp for the latter.

What hedge funds seem to be attracted by is Iceland’s economic ­troubles and its fragile banking system. The krona had lost about a fifth of its value against the euro in the first quarter, which forced the central bank to raise interest rates to 15.5% – Europe’s highest – in an effort to restore confidence in the currency. In May, inflation was at a 20-year record high of 12.3% – after April’s 11.8% and March’s 7.8% – much higher than the 2.5% target, which might lead to further interest rate increases. Furthermore, economic growth was 2.9% in 2007 and is expected to be about zero this year. On a positive note, the current account deficit has narrowed from 26% of gross domestic product (GDP) in 2006 to 16% in 2007.

Co-operation agreement

In a move aimed at restoring investors’ confidence, the Central Bank of ­Iceland (CBI) signed €1.5bn of swap agreements in May with the central banks of Sweden, Norway and Denmark. The plan allows the CBI to acquire up to €500m each from the Scandinavian neighbours in case of an emergency, enabling it to swap ­Icelandic krona for euros, if needed. This would nearly double its existing foreign exchange reserves of €1.7bn and enhance its ability to support the local banks and the financial system.

“The Nordic central banks’ agreement was hugely positive and I hope there will be further action,” says Peter Mason, director of northern European financial institutions in Citigroup’s debt capital markets group. “The local Scandinavian financial institutions might think: why should our central banks help the Icelandic banks out? But there has been a memorandum of understanding for some time between the central banks by which if there was a crisis in any of the countries, they would provide support.”

Furthermore, Iceland’s government is seeking to borrow up to Ikr500bn (€4bn), its largest loan ever, to defend its currency and offset the risk of a ­systemic banking crisis.

Plans for additional support from its Nordic neighbours have been mentioned but no details have been released yet – to the disappointment of investors. They still feel they need more to put their investments on the tiny north Atlantic island. One banker says: “Speaking to an investor recently, I asked him if he would invest in Icelandic banks. He said no because he wanted to see further action to solidify the understanding between Nordic central banks and ­Iceland. This would bring more confidence. [It would be better to do it] sooner rather than later.”

Peculiar system

It is not just Iceland’s economy that is raising concerns. The local banking system presents some peculiarities, too. It is very limited in size, given the island’s 300,000 population, and it accounts for a substantial multiple of the country’s GDP. Banking assets were 96% of GDP in 2000 and were eight times the size of GDP at the end of 2006 as the economy and the housing market boomed. They are now about 10 times GDP.

Despite such alarming data, Iceland’s banks are sound by international standards, with deposit ratios in line with international requirements, high capital adequacy ratios by European standards and credible funding profiles. The three leading banks’ first-quarter results, announced in May, have shown healthy income, good capitalisation and a conservative approach, in spite of what their reputation might suggest.

Core earnings – from net interest, fees and commissions – rose for all three, with a 27% increase for ­Landsbanki and 12.6% for Glitnir. Kaupthing’s net interest grew 31%. Tier 1 capital ratios were also healthy: 9.1% at Kaupthing, 8.8% at Landsbanki and 7.7% at Glitnir. Although this data is positive, analysts are also aware of the 29.6% depreciation of the krona during the quarter, which would have impacted positively on income and introduces significant ­currency risk and volatility.

The banks’ reliance on internet deposits for funding has also raised some concerns because they are perceived as ‘un-sticky’ and could be withdrawn quickly as depositors chase higher rates. However, the banks claim a higher number of internet accounts and a bias towards longer-term deposits, such as individual savings accounts. In addition, they have engaged in intensive wholesale funding activities for the past year, visiting potential investors and financiers in new markets outside of Europe.

International players

Positive results accompanied by tumultuous economic and exchange concerns should not surprise regular observers of Iceland’s banking sector. This is because Icelandic banks are no ­ordinary banks and have based their growth on international markets. Kaupthing, the country’s biggest lender, is an indicative example. It has an established presence in the UK, Sweden, Denmark, Luxembourg, ­Finland, Norway and Belgium, either through organic growth or acquisitions, and it is expanding to the US and the Middle East.

Diversified income

Kaupthing’s income is well diversified, with Iceland and the UK contributing almost a third each, the Scandinavian region contributing 26% and the remainder coming from other regions. “We have been expanding abroad since 1998 and our goal is to diversify our operations outside of Iceland,” says Thortur Polsson, managing director and head of business development for ­Kauthing. “This strategy has proved very successful and we now have more than 50% of income and 50% of assets outside of Iceland.”

Banking and capital markets contribute 49% and 21% respectively, while investment banking generates 17% of income and private banking and asset management contributes 10%.

The bank’s funding mix also seems sound, with a good customer deposit base, access to European markets and recently also to the international market. In the first quarter of this year, Kaupthing concluded a series of bond private placements for a total value of $1.67bn to investors in the US and Europe. It has also arranged a bilateral loan with another European bank. The new funding adds to Kaupthing’s ­liquidity position, which is further ­supported by the fact that Kaupthing Singer & Friedlander, its UK corporate, investment and private banking outfit, will be exiting its asset finance and commodity trade finance business. The move is expected to free up £1bn.

The bank has also been launching new retail products and it is very confident about Kaupthing Edge – a range of high interest online accounts – which was launched at the end of last year and continues to grow in various European markets. As of May, Kaupthing Edge had reached 155,000 clients and generated €2.3bn for the bank.

New ventures abroad

Landsbanki, the second lender by assets, has also recently launched its new retail venture, Icesave, in the Netherlands. Brynjólfur Helgason, managing director of international banking and alternate group CEO, is particularly proud of this achievement and plans to launch Icesave in other European markets, too. In the UK in the past 18 months, the product has attracted 220,000 accounts across a range of categories since inception. UK and Ireland are the second markets after Iceland in terms of core revenue generation: they contribute 35% to Landsbanki’s income.

The UK has also offered healthy business opportunities in other banking areas. In the second half of last year, Landsbanki completed its acquisition of Bridgewell Group, a corporate and investment banking business, which has now been merged with Teather & Greenwood, a stockbroker acquired in 2005, to create Landsbanki Securities (UK). The acquisition further advanced the Icelandic bank in the UK small and mid-cap corporate clients market.

Niche strategy

Similarly to its Icelandic peers, ­Glitnir has expanded in the Nordic countries but considers Iceland and Norway its domestic markets. Besides Finland, Sweden, the UK and Luxembourg, Glitnir also has a presence in the US, Canada, China and Russia, and plans to open an office in India in the second half of this year.

The peculiarity of the bank’s expansion is that it is primarily driven by two specialised industry sectors: seafood and sustainable energy. This strategy has proven successful, with 60% of advisory fees being related to niche markets. On a wider scale, operating costs have decreased by 12% since last year’s fourth quarter and ­Glitnir has been able to strengthen its ­liquidity position and capital ratios during a period of significant global market stress.

  “It has been necessary for all financial institutions to focus on increasing internal efficiencies to provide consistent levels of profitability and to increase competitiveness,” says Lárus Welding, CEO at Glitnir. “The second quarter will see a continuing focus on increasing income, preserving our ­liquidity position and managing our cost base.”

Good businesses

Although Icelandic banks have admitted that they have been hit by the credit crisis, and are duly concerned about the country’s imbalances and alleged market speculations, they are holding their ground. “We’ve been ­waiving the flag for Iceland for a number of years,” says Mr Mason.

“We fundamentally believe that the ­Icelandic banks have some great ­individual businesses.

“Look at Kaupthing: both FIH Erhvervsbank in Denmark and Singer & ­Fried­lander in the UK are fantastic individual franchises. There are some great crown jewels here. Glitnir bought into the Norwegian banking system, and Norway is one of the strongest economies in the world right now. Landsbanki has Teather & ­Greenwood in the UK, and we see great value in the future of that business.”

If the banks weather the current market uncertainties, there could be good times ahead.


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