THE ICELANDIC ECONOMY & FINANCIAL SECTOR · 2017-10-18 · The Icelandic Economy & Financial Sector - Tantalizing play of fire and ice – October 2017 5 Beringer Finance Page 5 Bird

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Tantalizing play of fire ( ) and ice ( )

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The Icelandic Economy & Financial Sector - Tantalizing play of fire and ice – October 2017

Page 2 Beringer Finance

Introduction

Tantalizing play of fire ( ) and ice ( )

Iceland is back and open for business. The capital controls have been lifted and the econo-

my is in the process of adjusting to a new (higher) equilibrium of output driven by a boom in

tourism that is unlikely to reverse. Additionally, the system has undergone substantial

deleveraging and restructuring since the economy was devastated by the financial crisis.

Thus, the economy is entering what is probably the late expansion stage of a business cycle

boom from a position of considerable strength.

Nevertheless, Iceland’s historical challenge of low productivity (excl. the fishery and energy-

intensive sectors) remain. As is to be expected, the capital control regime (2008-2017) has

likely put further pressure on Iceland’s underlying international competiveness. However,

this presents an opportunity for international investors and industrial players; bring in e.g.

international best practices, global value chains, and/-or simply lower funding costs and

wipe the floor with the domestic competition. Costco and H&M have already proven these

are excellent propositions, with their respective huge openings in Iceland.

The primary purpose of this report is to provide the reader with an overview of the Icelandic

financial sector, yet, since the financial system’s performance is to a large extent a derivative

of the economy’s performance, this report is divided into two parts; (i) a look at the struc-

ture of the Icelandic economy, and (ii) an overview of the financial sector.

Position of strength – The credit cycle is lagging the business cycle

Credit system – Growth (%)

-25

-20

-15

-10

-5

0

5

10

1Q10 4Q10 3Q11 2Q12 1Q13 4Q13 3Q14 2Q15 1Q16 4Q16

Credit system loan stock Coporates Households

Financial system – NPL ratios (%)

0

5

10

15

20

25

30

35

40

45

2010 2011 2012 2012 2013 2014 2015 2016

Claim value Book value

Sources: Beringer Finance, Central Bank of Iceland


Beringer Finance Page 3

Table of contents

Structure of the Icelandic economy 4

Valhalla rising 4

Bird view – Iceland versus selected other economies 5

Capital controls – free at last 9

The country specific macroeconomic drivers 11

Tourism – adjusting to a new equilibrium 18

Salmon farming – a potential significant contributor 19

The Financial Sector 20

Monetary policy 20

Overview of the financial system 21

Credit volume – expanding again 22

The price of credit – Expensive 24

Credit quality – vast improvements 27

Profit mechanics – different than what you are used to 28

Financial sector ownership overview 31

Appendix 33

Abbreviations 33

Short on taxes 34

Disclaimer 35



Structure of the Icelandic economy

Valhalla rising

Iceland is back to financial normality and the economy is booming. Capital controls were

lifted in March (2017), with some small caveats that we will cover later, and the real economy

grew by 7.2% in 2016 – fueled by a thriving tourism industry. Thus, 9-years after Iceland’s

devastating banking crash, the economy is now back as a credible part of investor’s interna-

tional investment opportunity set. Importantly, the economy has deleveraged and its deficit

against the rest of the world has turned into a surplus. The result is that the current economic

expansion is both more robust and sustainable compared to the pre-crisis boom.

Iceland at a glance

Sources: Beringer Finance, Icelandic Central Bank, Icelandic FSA, Statistics Iceland, Keflavik Airport

Pre-crisis, Iceland was hemorrhaging capital (e.g. the current account balance was -14% of

GDP in 2007), the financial system had bloated to a size of 9x GDP in 2007 (roughly 10x in

2008), and the non-government sectors were highly leveraged (household debt was 107% of

GDP in 2007, while non-financial corporate debt was almost 200% of GDP). As a result, the

economy was in a highly vulnerable position when the financial crisis of 2008/2009 hit the

world economy. Iceland was forced to implement capital controls in 2008, when its three

largest banks imploded, and experienced a deep recession.

Today, on the other hand, things are looking much better for the small island. The current

account balance is positive, the financial system is much more robust, and the economy has

successfully deleveraged. Of course, as a small and primarily resource based economy, inves-

tors need a stomach for volatility when investing in Iceland – despite the recent strong mo-

mentum and positive outlook. On the following pages we will take a more in-depth look at the

Icelandic economy and uncover the potential risks and rewards.



Bird view – Iceland versus selected other economies

The Icelandic economy is an open developed economy operating under the Nordic model,

combining a free market economy with a welfare state. It is the smallest OECD economy with

a GDP of roughly EUR 19bn. The population is around 340-thousand (k) with the majority

living in- and around the capital Reykjavik. The country’s living standard, as measured by GDP

(PPP) per capita, is high and on par with other Nordic countries (ex. oil-rich Norway), and it

has outperformed most countries in the world when it comes to real GDP growth in recent

years – a trend that is expected to continue for a couple of years before subsiding.

Sample of well-known country rankings

14

1

1

2

6

5

6

11

18

3

14

8

4

3

9

6

5

5

5

9

1

12

3

12

16

16

10

10

13

7

7

17

9

23

3

3

2

13

10

1

2

9

14

14

20

20

27

0 5 10 15 20 25 30

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

0 5 10 15 20 25 30

Global peace index

Democracy index

Human development

Prosperity index

Corruption perception

Property rights

Ease of doing business

Global competitiveness

Sources: Beringer Finance, respective institutions

GDP per capita 2016 (PPP, ‘000)

69.2

57.4

49.8

49.1

48.0

42.5

42.2

Norway

US

Sweden

Iceland

Denmark

UK

Finland

Actual & Projected Real GDP CAGR

4.4 %

3.3 %

2.4 %

2.2 %

1.5 %

1.5 %

0.3 %

4.2 %

2.4 %

1.7 %

2.3 %

1.8 %

1.7 %

1.4 %

Iceland

Sweden

UK

US

Norway

Denmark

Finland

2014-2016 2017-2019

Sources: Beringer Finance, IMF

Additionally, Iceland consistently scores high in different global country rankings. However, it

is lagging its Nordic brothers and sisters in competitiveness rankings. This is obviously not the

easiest peer group to be in, as the Nordic economies are some of the most well-functioning

ones in the entire world. Yet, Iceland’s ‘competitiveness scores’ have been affected by the now

terminated capital controls. Thus, we would expect Iceland’s competitive position to improve

significantly now that the capital controls have been lifted.



First of all, without the capital controls, the Icelandic domestic sector will be exposed to a

higher degree of foreign competition. This will (or should) force the domestic sector to be-

come more efficient, with the alternative being that it will be outcompeted and lose market

shares in its own market. For example, the American membership-only warehouse club Cost-

co opened a superstore in Iceland in May 2017 and gained 60-thousand paying members

within its first month of operations (Costco’s biggest opening in a foreign market ever). More-

over, the Swedish clothing retailer H&M plans to open up stores in three different locations in

Iceland over the next two years. These greenfield entries by internationally competitive com-

panies will serve as a wake-up call to a relatively shielded Icelandic domestic sector. For inter-

national investors and industrial players, it represents an opportunity – utilize e.g. interna-

tional best practices, superior economies of scale, and/-or simply a lower cost of capital to

conquer the Icelandic market. This will benefit Iceland over the long-run.

Ease of doing business*

Iceland vs. rest of the Nordics

Ease of Doing Business Rank

Starting a Business

Dealing with Construction

Permits

Getting Electricity

Registering Property

Getting CreditProtecting Minority Investors

Paying Taxes

Trading across Borders

Enforcing Contracts

Resolving Insolvency

Iceland Nordics (excl. Iceland)

Iceland vs. Norway


Starting a Business

Dealing with ConstructionPermits

Getting Electricity



Paying Taxes


Enforcing Contracts


Iceland Norway

Iceland vs. UK


Starting a Business


Permits

Getting Electricity



Paying Taxes


Enforcing Contracts


Iceland UK

Iceland vs. USA


Starting a Business


Permits

Getting Electricity



Paying Taxes


Enforcing Contracts


Iceland US

Sources: Beringer Finance, The World Bank (2016)

*Normalized scores within variables and local space. Norm. (x, local

Nevertheless, the primary takeaway is that the underlying Icelandic economy is more attrac-

tive and competitive than certain competitiveness rankings indicate, especially now that the

capital controls have been lifted. For example, Iceland was ranked as number 27 in the 2016-

2017 Global Competiveness Report (published by the World Economic Forum, WEF), but this

result was adversely affected by the capital controls still being in effect. Iceland was number

17 in the world regarding the quality of its institutions, number 7 for health & primary educa-

tion, and number 11 for higher education & training. However, it was number 27 in goods

market efficiency, number 27 in business sophistication, and 53 in financial market develop-

ment – these are all categories that are difficult to achieve good scores in if you are under a

capital control regime. The point we want to make is that Iceland’s biggest problem compared

to peers is not that it is underdeveloped in terms of its institutions or regulatory framework,

or in other words; it scores well in the basic requirements for economic development/growth.



In general, it is considered that low productivity is Iceland’s biggest challenge compared to

neighboring countries (in terms of achieving long-term sustainable growth). Iceland has a very

high labor participation rate and its population is hard working. However, due to low produc-

tivity, the country has not fully benefitted from the hard work of its population. This problem

is very intuitively illustrated by the Icelandic Chamber of Commerce’s production function

graph, which we have reposted below (the Cobb-Douglas type methodology of the production

function is easy to criticize, but we just post it for illustrative purposes and it is a derivative of

a very extensive McKinsey analysis of the Icelandic economy from 2012). We note that the

total factor productivity (TPF) is the proxy for productivity in the framework.

Production function 2015 (from the Icelandic Chamber of Commerce)

Sources: The Icelandic Chamber of Commerce, secondary sources; IMF, OECD, McKinsey & Company, the Countries Statistical Bureaus

Notes: 1. GDP based on purchasing-power-parity per capita (2015), 2. Numbers for Sweden’s capital stock for 2015 were unavailable and

were therefore calculated based on average growth for the past 7 years, 3. Productivity is measured by the Solow residual with capital in the

power of 0.3 (alpha) and labor in the power of 0.7 (1-alpha).

The low productivity problems are also exuberated by the structure of the Icelandic economy.

As a small open economy, Iceland is highly dependent on trade, with e.g. the price of imports

determining 30% of the current consumer price index (CPI). Thus, the country is dependent

on a strong export sector. While Icelandic fisheries and aluminum production is considered

internationally competitive (more on this later), the country’s overall low level of productivity

is a weakness when it comes to building other export sectors.

Consequently, the inefficiency of the Icelandic domestic sector is an opportunity for interna-

tional investors and industrial players in the medium term, as they can disrupt the market

since the islander Vikings are not internationally competitive. However, if the country cannot

invent new export sectors after adjusting to a new (higher) production equilibrium (driven by

the growth in tourism) – the disruption proposition will be less attractive, as long-term real

growth rates will be at risk.

Nonetheless, Iceland is well aware of its shortcomings and the low productivity is, as we un-

derstand it, a topic of much debate. Moreover, the WEF reports that Iceland is among the

advanced countries where the future workforce is expected to be better equipped than cur-

rent workers, whereas e.g. Switzerland, Israel, and Japan are among those that may see their

currently high level of human capital diminish going forward.



Iceland is lagging its high performing Nordic peers in certain competitive dimensions, which

clouds the long-term growth outlook, but it has managed an impressive comeback after being

one of the worst-hit countries by the financial crisis. Iceland has used the last years to shore

up its current account balance and deleverage, and is now in the most secure quadrant if one

considers OECD countries and government debt vs. current account balance (see below).

The country’s improved position and outlook has resulted in rating upgrades from the major

rating agencies the two last years, albeit it is still several notches lower than its neighboring

countries (see the graph at the bottom of the page).

Debt vs. current account balance (2014 to 2016 for Iceland, 2016 for other)

Australia

Austria

Belgium

Canada

Cyprus

Czech Rep. Denmark

Estonia

Finland

France

Germany

Greece

Ireland

Israel

Italy

Japan

KoreaLatvia

Lithuania

Luxembourg

Malta

Netherlands

New Zealand

Norway

Portugal

Slovak Rep.

Slovenia

Spain

SwedenSwitzerland

United Kingdom

United States

Median; 63

Median; 2.4

Iceland

0

50

100

150

200

250

-6 -4 -2 0 2 4 6 8 10 12 14

De

bt

(% o

f G

DP

)

Current Account Balance (% of GDP)

Sources: Beringer Finance, IMF

Sovereign credit ratings

Sources: Beringer Finance, Fitch, Moody’s, S&P



Capital controls – free at last

Movement of capital to and from Iceland is currently unrestricted (effective from the 14th of

March 2017), apart from controls on speculative trading in derivatives. Although it is too early

to say for certain, it appears that the liberalization of the capital account has gone relatively

smoothly. The exchange rate volatility has increased, but it has been no major/uncontrollable

impact on the balance of payments. It is important to note that the Central Bank of Iceland

activated a new capital flow management measure (CFM) in mid-2016 with the purpose of

affecting the composition of capital inflow into the domestic bond market & high-interest rate

deposits and strengthen monetary policy transmission (i.e. the central bank’s ability to control

market interest rates, in order to avoid having to interfere through the volatile FX channel).

Capital inflows* (% of GDP)

-50

0

50

100

150

200

250

1980 1984 1988 1992 1996 2000 2004 2008

Ireland Iceland Median (excluding Iceland and Ireland)

Capital flows ISKbn (registered new investments)

-20

-10

0

10

20

30

40

50

60

70

Jan

-15

Ma

r-1

5

Ma

y-1

5

Jul-1

5

Sep

-15

No

v-1

5

Jan

-16

Ma

r-1

6

Ma

y-1

6

Jul-1

6

Sep

-16

No

v-1

6

Jan

-17

Ma

r-1

7

Ma

y-1

7

Jul-1

7

Capital inflows into government bonds Capital inflows into listed shares

Other capital inflows ** Capital outflows


*Capital inflows from abroad reflect non-residents’ net purchases of domestic assets. Flows are estimates and originally published in Broner, Didier, and Schmukler (2013).

**’Other inflows’ in March 2017 stems from foreigners’ acquisition of a holding in Arion Bank

The CFM applies to investments in electronically registered bonds and bills issued in domestic

currency and currency deposits bearing annual interest of 3% or above. If someone were to

put their money in such an instrument, a 40% reserve requirement on the new foreign cur-

rency would apply with a 0% interest rate for a period of one year. The primary purpose of

the CFM is to discourage carry trades (borrow in a low yielding currency, lend in a high yield-

ing one, and gamble on that interest rate parity does not hold over the investment horizon),

which historically have been a major problem for Iceland, as its interest rates have usually

been substantially higher than other developed countries. For example, the 3month inter-

bank rate (REIBOR) in Iceland is currently close to 5%, while negative for the Euro (EURIBOR).

Monetary policy transmission mechanism

Sources: Beringer Finance, Icelandic Central Bank



The carry trade is actually one of the primary reasons that Iceland had to implement capital

controls in the first place. To understand why, we need to travel almost 20years back in time:

In the early 21st century, interest rates and inflation fell in most of the western world as a

result of the recession triggered by the dotcom collapse and the flood of cheap imports from

Asia. In Japan, which had almost been in a constant recession since the early 90s, rates were

almost zero. Pension funds had incurred big losses in new technology shares and were eager

to make up the difference. The result was a massive flow of money from Tokyo to Reykjavik,

as investors borrowed heavily in Yen and bough Icelandic bonds (REIBOR was >15%). The

Icelandic banks in return borrowed heavily abroad (their outstanding foreign FX debt was

many times the Icelandic GDP). A lot of these flows were made possible by the perceived

strength of the Icelandic economy, with e.g. Moody’s assigning Iceland a triple A on foreign

currency risk in 2002 and keeping it there well into 2008. When the crisis hit, the Icelandic

Central Bank was forced to implement capital controls to avoid the country being sucked dry

of capital and assets (resulting in a collapse of the Krona), and the government was not even

close to being able to bail out the banks due to their size in relation to GDP.

One might ask at this time why the Icelandic interest rates are so high? The short story is that

the key policy rate (at 5%) is low in a historical perspective and that Iceland currently is expe-

riencing a positive output gap (the economy is showing signs of overheating). Thus, lowering

the key policy rate is not an option (more on this later).

While there are obvious advantages with the CFM, especially given Iceland’s interest differen-

tial with other developed economies, and it appears to be working (see the capital flow graph

on the previous page), there are risks associated with manipulating capital flows. For exam-

ple, capital flows redirected from the bond market might find its way into other undesired

asset classes or it might adversely affect the capital structures (cost of capital) of companies.

However, these risks are mitigated by the temporary and flexible structure of the CFM meas-

ure, plus that it primarily affects short-term bond issues (reserve requirement is one year).

Overall, the most notable effects of the capital controls on the Icelandic economy are the lack

of domestic competitiveness and the pension funds’ massive ownership of Icelandic equities

(we cover this later). However, we note that there is an ongoing discussion in Iceland regard-

ing the future monetary policy and the future of the Krona in this context. For example,

should Iceland revert back to an exchange rate targeting policy, peg the exchange rate to

another currency, or join a monetary union (EU)? It is generally considered that steps should

be taken to reduce exchange rate fluctuations, which contribute to economic volatility and

high interest rates. In March 2017 a three-person panel was appointed to evaluate Iceland’s

monetary policy framework, with the aim of identifying the framework best suited to promote

economic and financial stability in Iceland over the long run. A team of foreign experts has

been hired by the panel to address three topics in this regard: Iceland’s experience with infla-

tion targeting and possible reforms, alternative monetary policy measures for Iceland aside

from the current inflation targeting, and a comparative study of Icelandic Monetary Policy and

policies in the other Nordic countries. A final report, with suggestions, is scheduled to be

delivered to the government by the end of 2017.



The country specific macroeconomic drivers

In this section we will dive a bit deeper into the Icelandic GDP, in order to identify the current

(and future?) growth drivers. As already mentioned, Iceland is dependent on maintaining a

healthy current account balance due to its reliance on imports. If we use the expenditure GDP

approach (as in the graph below), most of the current account is represented through the

difference between exports and imports (net exports). The structure of the exports is narrow,

with most of it consisting of fisheries, tourism, and aluminum. From a production GDP ap-

proach, it is clear that the major exports are located in the resource sector – requiring domes-

tic natural resources as an input in production. Thus, in the long-run, the real growth rate

contribution from these sectors is constrained (more details later).

GDP drivers ISKbn

487

557

602

620

40 0 45 0 50 0 55 0 60 0 65 0

GDP 2Q14

Private consumption

Government consumption

Capital formation

Change inventories

Exports

Imports

GDP 2Q15

Private consumption


Capital formation

Change inventories

Exports

Imports

GDP 2Q16

Private consumption


Capital formation

Change inventories

Exports

Imports

GDP 2Q17

Composition 2Q15

50 %

23 %

18 %

9 %

Private

consumption

Government

consumption

Capital

formation

Net exports

Composition 2Q16

51 %

23 %

22 %

4 % Private

consumption

Government

consumption

Capital

formation

Net exports

Composition 2Q17

52 %

24 %

22 %

2 % Private

consumption

Government

consumption

Capital

formation

Net exports

Sources: Beringer Finance, Statistics Iceland

However, as in most developed economies, private consumption is the most important com-

ponent of aggregate GDP. Private consumption makes up 50%+ of Iceland’s GDP and is the

most important short-term GDP driver. Jumping back to the production GDP approach, the

primary driver of private consumption is the domestic sector (roughly 65% of GDP). The do-

mestic sector consists of industries that mostly provide non-tradable goods and services for

the domestic market. Government consumption (expenditure approach) is a significant part

of the domestic sector too. The gross fixed capital formation (gross investments) is spread

out across the three production approach sectors; the domestic (65% of GDP), resource (22%

of GDP), and international (13% of GDP) sectors. But, with a recent tilt towards tourism and

residential related investments. The international sector includes businesses that produce

tradable goods and services that are largely independent of local natural resources.



The Icelandic economy has experienced substantial and accelerating growth rates the last six

years. In 2016, the country’s economy grew by a massive 7.2% (real-rate). The growth has

been driven by a boom in tourism, which again have driven private consumption and invest-

ments (see the graph ‘real GDP growth & components’ below). However, it is now expected

that growth rates will turn lower, but remain at decent levels. The Central Bank of Iceland

believes that a relatively significant positive output gap materialized in 2016 and, thus, the

economy’s ability to increase its growth rate momentum is highly constrained. This constraint

is very visible in surveys over firms that consider themselves short-staffed (41%). Additionally,

54% of firms report that they are operating at or above full capacity, which is 16%age points

above its historical average.

Real GDP growth (%)

-8

-6

-4

-2

0

2

4

6

8

10

12

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

20

16

20

17

20

18

20

19

20

20

20

21

20

22

Real GDP growth IMF (April 2017) CB (August 2017)

Real GDP growth & components (%)

-6

-4

-2

0

2

4

6

8

10

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Private consumption Public consumption

Gross fixed capital formation Change in inventories

Net trade GDP

Unemployment* & output gap** (%)

-6

-4

-2

0

2

4

6

8

10

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Output gap Unemployment

Inflation (%)

0

1

2

3

4

5

6

7

2012 2013 2014 2015 2016 2017 2018 2019 2020

Inflation target Range*** Inflation

Sources: Beringer Finance, Icelandic Central Bank, IMF

*Percent of the active part of the labor force (Activity ratio was 83.6% in 2016)

**Actual GDP minus potential GDP (% of potential output)

***If inflation deviates by more than 1.5% in either direction from the 2.5% inflation target, the Central Bank must submit a public report to the Government, explaining the

reasons for the deviations and the means by which it intends to bring inflation back to target.

Given that the economy is firing on all cylinders, it is not surprising that GDP growth is ex-

pected to be driven by private consumption and investments going forward. What is surpris-

ing, in a textbook setting, is that inflation is subdued given the positive output gap. However,

here the peculiarities of the Icelandic economy come into play – a high-performing economy

tends to strengthen the exchange rate, which results in cheaper imports that constitutes 30%

of Iceland’s CPI. Thus, Iceland cannot really lower the key policy rate since that would be like

throwing gasoline on an economy already on fire (on fire like in sports, so positive), while

raising rates would risk making the Krona more attractive which would put a deflationary

pressure on the economy and encourage the output gap to widen further (cheaper imports).



At this point it is time to take a more granular look on the Icelandic CPI (graph below). The

CPI’s weights are; 30% imported prices, 26% housing, and 44% domestic prices excluding

housing. As can be observed in the graph below, Iceland’s inflation is only positive due to the

increasing housing prices. The strengthening Krona has exerted deflationary pressure on the

economy (excl. housing). Interestingly, the Krona has depreciated over the summer (e.g. 10%

against the EUR), which is good for tourism that again could cause further pressure on hous-

ing prices – while increasing the price of imports. This causality is driven by the capacity prob-

lems of the Icelandic hospitality sector and the extensive use of the sharing economy on Ice-

land (read Airbnb). We do not have a view on future Icelandic inflation, but note that inflation

and the exchange rate are especially difficult variables to control/predict in Iceland and one

need a stomach for volatility when investing in the economy.

Components of CPI inflation (%)

-4

-2

0

2

4

6

8

Jan

-12

Ma

y-1

2

Sep

-12

Jan

-13

Ma

y-1

3

Sep

-13

Jan

-14

Ma

y-1

4

Sep

-14

Jan

-15

Ma

y-1

5

Sep

-15

Jan

-16

Ma

y-1

6

Sep

-16

Jan

-17

Ma

y-1

7

Other components

Private services

Domestic goods excl. agri. products

Housing

Petrol

Imported goods excl. alcohol, tob. & petrol

CPI

Sources: Beringer Finance, Icelandic Central Bank, Statistics Iceland

Breaking down expected gross investments, we see that investments into the tourism and

residential sectors are expected to contribute the most to growth going forward (the majority

of business investments excl. ships, aircrafts, and energy intensive industries is related to

tourism). These investments are expected to alleviate the pressure on housing prices and the

capacity of the hospitality sector. Additionally, we see signs of a slightly accommodative fiscal

policy, as investments in the public sector is expected increase each year until 2019. Invest-

ments are expected to contribute to real GDP growth in 2017, but not really beyond that.

After the surge in investments the last years (since 2014), the lower level of gross investments

is a contributor to the lower expected growth rates going forward.

Components of gross fixed capital formation (%)

-20

-15

-10

-5

0

5

10

15

20

25

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Public sector

Residential

Ships and aircraft

Energy-intensive industry

Businesses excl. ships, aircraft, energy-

intensive industry

Gross fixed capital formation

Sources: Beringer Finance, Icelandic Central Bank, Statistics Iceland



The primary driver of GDP growth going forward is expected to be private consumption, driv-

en by rising asset prices, low unemployment, low inflation, and increased purchasing power.

The position of Icelandic households has strengthened every year since 2010, and it is fore-

casted by the Central Bank that this trend will continue. A large part of this improved position

is due to deleveraging, for which government debt relief measures (direct write-downs of ISK

19bn in 2016) and the use of third-pillar pension savings (ISK 14bn in 2016) for deleveraging

are important drivers (third-pillar pension savings are voluntary privately funded accounts). In

the autumn of 2016, parliament extended the authorization to use third-pillar savings to re-

duce mortgage debt for another two years. Everything else equal, this program is expected to

deleverage the system by 1.5% to 2.0% of GDP before it concludes.

Firms considering themselves short-staffed* (%)

0

20

40

60

80

100

All businesses

Manufacturing

Wholesale and retail

Fisheries

Transport, communications,

and tourism

Construction

Finance and insurance

Specialised services

May 2017 May 2016 March 2017

Net migration (% of population**)

-3

-2

-1

0

1

2

3

4

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 1H16 1H17

Foreign nationals Icelandic nationals Net migration

Sources: Beringer Finance, Gallup, Seðlabanki Íslands, Icelandic Central Bank, Statistics Iceland

*Seasonally adjusted figure. Percent of businesses.

**Net migration of persons aged 20-59 relative to total population of the same age as beginning of the year.

Households: Net asset (% of disposable income)

-400

-200

0

200

400

600

800

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

20

16

Liabilities

Third-pillar pension

assets

Second-pillar

pension assets

Other assets

Securities

Deposits

Real estate

Net assets

Net assets excl.

pension assets

Disposable income, spending (%) + savings rate*(%)

-20

-15

-10

-5

0

5

10

15

20

-20

-15

-10

-5

0

5

10

15

20

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

20

16

20

17

20

18

20

19

Household saving

(rhs)

Private consumption

(lhs)

Disposable income

(lhs)

Sources: Beringer Finance, Central Bank of Iceland, Statistic Iceland

*Spending is private consumption and is together with disposable income the YoY %The savings rate is in % of disposable income and is calculated based on the Central

Bank's disposable income estimates, as Statistics Iceland figures are rescaled to reflect households' estimated expenses over a long period.

Moreover, disposable income has been rising faster than private consumption and house-

holds’ saving rates are now at a historically relatively high level. Thus, including the rising

house prices, household wealth (net worth) has been rising rapidly.

On the income side, the primary drivers of aggregate disposable income are wage increases

and unemployment. Iceland has historically had an extremely low unemployment rate, but

the rate increased from 2% in 2007 to 6% in 2010 (unemployment to total potential labor

force). Since 2010, the rate has gradually declined to 2.5%, which is considered to be close to

the structural rate of unemployment.



The recent economic boom has also resulted in a high immigration rate; as domestic supply

is unable to meet the demand for workers. For example, roughly 15k people work in the con-

struction sector with 40% (6k) of those being foreign laborers. This implies that 25% of all

foreigner currently employed in Iceland work in the construction sector.

Wages has risen substantially in Iceland for a numbers of years, and the corresponding pur-

chasing power even more if we exclude housing costs (to see this visually; remember the

inflation component graph two pages ago and combine this with the difference between

nominal and real in the graph below). The average nominal wage increase in Iceland was

11.4% in 2016, compared to roughly 2% in the other Nordic countries. Additionally, wages

have increased on average 11% in the first 6months of 2017.

The large and sudden wage increases is partially a function of an Icelandic peculiarity – name-

ly the collective wage agreements (the effect can be seen in the graph to the right below):

Nominal and real wages (%)

-15

-10

-5

0

5

10

15

Jan

-99

Dec

-99

No

v-0

0

Oct-

01

Sep

-02

Au

g-0

3

Jul-0

4

Jun

-05

Ma

y-0

6

Ap

r-0

7

Ma

r-0

8

Feb

-09

Jan

-10

Dec

-10

No

v-1

1

Oct-

12

Sep

-13

Au

g-1

4

Jul-1

5

Jun

-16

Ma

y-1

7

Wage index Real wages (wage index deflated by CPI)

Private sector wage index by selected sectors*

95

100

105

110

115

120

125

130

Jan

-15

Ap

r-1

5

Jul-1

5

Oct

-15

Jan

-16

Ap

r-1

6

Jul-1

6

Oct

-16

Jan

-17

Ap

r-1

7

Manufacturing

Construction

Wholesale, retail, and

repair

Transportation and

storage

Information and

communication

Financial and

insurance activities

Sources: Beringer Finance, Central bank of Iceland

*Indexed to 100 in January 2015

Over 80% of the workforce in Iceland is part of a labor union, so collective wage negotiations

have a significant impact on the economy. For example, 40 wage agreements will expire and

be renegotiated in the second half of 2017. About 10% of the Icelandic workforce, mostly

public servants, will be part of these negotiations. The public servants are expected to de-

mand significant wage increases as top government officials received a substantial improve-

ment after their last agreement. Employers and employees cannot negotiate for lower wages

or worse terms than those provided in the collective wage agreements, but better terms are

allowed. Despite being highly unionized, the Icelandic labor market is considered to be rela-

tively flexible as hiring and firing is fairly easy. Additionally, excessive real wages can be ad-

justed by devaluing the Krona.

Overall, the private consumption outlook does look very favorable due to the increase in real

income and improved equity position. The risk to private consumption growth is most likely

on the upside, but firms could approach their limit regarding cost absorption from the labor

market. Yet, in this regard the exchange rate is probably a more important determinant,

which brings us to the most crucial piece of the sustainable growth puzzle – the balance of

payments and particularly the current account.

For a quick review, the current account consists of; (i) the balance of trade, (ii) net income

from abroad, and (iii) net current transfers. The balance of trade is the difference between

exports and imports. Net income from abroad is the earnings on foreign investments minus

payments made to foreign investors (also known as net ‘primary income’). Net current trans-

fers is gifts, aid etc. (secondary income).



As can be seen below in the ‘adj. current account balance split’ graph, the most important

part of Iceland’s current account is simply the trade balance. Note that the graph shows the

underlying current account balance, i.e. excluded the failed financial institutions from 2008 to

2015 (from 2016 the unadjusted current account and the adjusted one are the same).

The current account indicates whether a country is a net lender or borrower to the rest of the

world. As Iceland is so dependent on imports (30% of CPI), it is very important that Iceland

does not post consistent current account deficits. For example, it is nothing wrong with run-

ning certain types of current account deficits (the USA has been running one for basically

decades without it being a major problem), but Iceland’s standard of living becomes very

exposed to tail events if its balance against the rest of the world turns too negative. Addition-

ally, a current account surplus can indicate that your exports are competitive and contributes

to real growth (in Iceland’s case an important transmission channel is likely to be a higher real

exchange rate equilibrium). Very simply put; exports are Iceland’s growth engine.

Adj. Current account balance* (% of GDP)

80

90

100

110

120

130

140

150

160-25

-20

-15

-10

-5

0

5

10

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

20

16

20

17

20

18

20

19

Curr. Acc. Balance* (% GDP, lhs) Real Exchange rate (rhs)

Adj. Current account balance split* (% of GDP)

-25

-20

-15

-10

-5

0

5

10

15

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

20

16

20

17

20

18

20

19

Trade balance (% of GDP) Primary income* (% of GDP)

Terms of trade** (indexed)

80

85

90

95

100

105

110

115

120

Terms of trade (indexed @ 100, 2010)

Balance of Payments (% of GDP)

-80

-60

-40

-20

0

20

40

60

Current account Capital account Financial account

Sources: Beringer Finance, Central Bank of Iceland, Statistics Iceland

*Including secondary income. Excluding the effect of failed financial institutions 2008-2015 and the pharmaceuticals company Actavis 2009-2012 on primary income. Also

adjusted for the failed financial institutions' financial intermediation services indirectly measured (FISIM).

**Terms of trade (ToT) represents the price of exports relative to imports.

Iceland’s underlying account balance has been very healthy for years. After the crisis the sur-

plus was due to the significant depreciation of the Krona (lower imports), but in recent years

it has been driven by growth in tourism and an appreciation of the Krona (cheaper imports).

The disconnect between the correlation of the real exchange rate (inverse) and the current

account balance is a point of concern, as it is likely driven by a lower (short-term) sensitivity of

tourism to a stronger exchange rate compared to Iceland’s traditional exports. Thus, the tour-

ism sector can potentially crowd out investments into Iceland’s other export sectors. Howev-

er, these fears have been alleviated somewhat by the recent depreciation of the Krona.



So how important is tourism for Iceland’s exports? In 2016, tourism accounted for 39% of

Iceland’s exports, up from 26% in 2013. Overall, Iceland’s three main export sectors (tourism,

marine products, and aluminum) made up 74% of exports in 2016.

Additionally, the export decomposition reveals other weaknesses concerning the structure of

Iceland’s exports. That is, Iceland’s other exports are not growing. The Krona value of tourism

was up 25% between 2015 and 2016, but the Krona value of marine exports were down 12%,

the value of aluminum related exports were down 24%, and other exports down 2%.

Export of goods and services (ISKbn)

0

50

100

150

200

250

300

350

400

Marine products Manufacturing (exl. Alu) Aluminium related

Other Foreign travellers

Share of exports

0 %

10 %

20 %

30 %

40 %

50 %

60 %

70 %

80 %

90 %

100 %

1Q

13

2Q

13

3Q

13

4Q

13

1Q

14

2Q

14

3Q

14

4Q

14

1Q

15

2Q

15

3Q

15

4Q

15

1Q

16

2Q

16

3Q

16

4Q

16

1Q

17

2Q

17

Marine products Manufacturing (exl. Alu) Aluminium related

Other Foreign travellers

Sources: Beringer Finance, Statistics Iceland

The marine product decline can be partly explained by the very high catch volume in 2015, as

catch volume was down 19% from 2015 to 2016. However, aluminum production was only

down 0.3% from 2015 to 2016 and prices down roughly 4%. The point is that there are limited

possibilities for Iceland to increase volumes in the traditional marine product and aluminum

sectors. This leaves the other segments; manufacturing (excl. alu) and ‘other’. From the pro-

duction GDP approach, these are the sectors that Iceland refers to as the international sector.

Marine products: Catch & catch value

0

20

40

60

80

100

120

140

160

180

0

500

1,000

1,500

2,000

2,500

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

20

16

Volume 1,000T (lhs) Value ISKbn (rhs)

Aluminum production (1,000T)

0

100

200

300

400

500

600

700

800

900

1,000

Annual production 1,000T

Sources: Beringer Finance, Statistics Iceland, Central Bank of Iceland

*Annual aluminum production for 2017 is production from January to April.

The international sector includes businesses that produce tradable goods and services that

are largely independent of local resources. Compared to the size of the Icelandic economy,

the growth potential of the companies in the international sector is virtually unlimited. How-

ever, the growth potential is limited by the competitiveness of the companies themselves. As

discussed earlier, productivity is an Achilles heel for Icelandic companies, but at least the

elimination of the capital controls should be supportive of improvements. Lastly, before we

move in on the financial sector, we will take a slightly more granular look at tourism in Iceland

and the potential of fish farming as a growth engine.



Tourism – adjusting to a new equilibrium

Tourism has been the primary engine behind Iceland’s impressive comeback from the depths

of financial hell. The growth of the industry has been extremely rapid. For example, in 2016

almost 1.8m foreign tourists arrived in Iceland via the Keflavik airport (a 40% YoY). Addition-

ally, the foreign currency inflow accompanying the tourism flood is one of the reasons the

Krona has appreciated substantially, despite large-scale foreign currency purchases by the

Central Bank.

Interestingly, the rapid amount of growth in tourists has contributed to the substantial rise in

housing costs (both rents and direct ownership). A driver behind this is the sharing economy.

Overnight stays in all types of accommodations (k)

0%

5%

10%

15%

20%

25%

30%

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

2009 2010 2011 2012 2013 2014 2015 2016

Iceland (k) Foreigners (k) Growth foreigners (rhs)

International arrivals by modes of transport (k)

0 %

5 %

10 %

15 %

20 %

25 %

30 %

35 %

40 %

0

500

1,000

1,500

2,000

2,500

2009 2010 2011 2012 2013 2014 2015 2016

Waterway (k) Air (k) Growth (rhs)

Capital area hotel occupancy rates (%)

0

10

20

30

40

50

60

70

80

90

100

2013 2014 2015 2016 2017

Capital area hotel occupancy rates (%)

Capital area hotel occupancy rate per month (%)

0

10

20

30

40

50

60

70

80

90

100

2013 2014 2015 2016 2017

Sources: Beringer Finance, Central Bank of Iceland, Icelandic Tourist Board, Statistics Iceland

The traditional hospitality sector has not been anywhere near meeting the demand for ac-

commodation, thus the sharing economy has picked up the demand. This has put significant

pressure on house prices and rents, and in Reykjavik it has resulted in a sort of exodus of

natives from the center of the city and out to the suburbs.

We have no special insights regarding the future of the tourism industry in Iceland, but we do

note that the IMF’s experience is that booms in tourism are rarely reversed once they materi-

alize. However, it is important to note that tourism in Iceland is mainly nature based. The

scenic sites the tourists visit have limited capacity. Therefore, the growth potential is far from

unlimited. Nevertheless, the tourism sector will still have to build capacity to adjust to the

new equilibrium and the industry has made progress in reducing the seasonality (see e.g. the

increase in the capital area hotel occupancy rate for January in the graph above), which indi-

cate that further growth is possible/likely even without a capacity increase.



Salmon farming – a potential significant contributor

There are plenty of interesting (resource based) industries brewing in Iceland. For example,

four large projects regarding energy intensive silicon production is ongoing, the data center

industry is expanding rapidly, and the Icelandic and British authorities are exploring the pos-

sibility of constructing an electrical interconnector between the two countries. Additionally,

there is a significant growth potential in the Icelandic salmon farming sector. Beringer Fi-

nance released a report on the topic of the Icelandic salmon farming prospects this July titled

“A new era” (contact your Beringer contact to receive a copy).

Total catch volume & farmed salmon potential (1,000T) and value potential (ISKbn)

0

500

1,000

1,500

2,000

2,500

0

50

100

150

200

250

300

Value ISKbn Potential Value ISKbn Volume 1,000T (rhs)

Potential fishery employment (# of employees) & share of labor market (%)

0%

2%

4%

6%

8%

10%

12%

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

Fishing Fish processing Salmon farming Share (rhs)

Sources: Beringer Finance (Icelandic Salmon Farming Prospect report), Statistics Iceland

The main insight from the report is that salmon farming is likely to become a major contribu-

tor to the Icelandic economy. We believe that, based on current plans, the labor force em-

ployed in the sector has a 6% CAGR potential for the period 2016 to 2020 (from 8k to 10.5k

people employed). In the longer term we see a potential demand for labor at 14k. A lot of this

employment will take place in rural areas around Iceland. In terms of value creation, we see

revenue contributions from the potential growth of around ISK 45bn in the period 2016 to

2020. Over the longer term the marginal revenue contribution could reach ISK 120bn, or 5%

of Iceland’s 2016 GDP. There are significant pitfalls in building a fish farming industry, espe-

cially biological conditions can be challenging, yet Iceland has the correct climate and exten-

sive experience in the fish sector.



The Financial Sector

Monetary policy

The most prominent characteristic of Icelandic monetary policy is how tight it appears in an

international developed market perspective. However, in a historical perspective the interest

rates in Iceland are relatively low and current demand pressures in the economy call for a

tight stance. Given the yield curve, the central bank’s estimates, and market agents expecta-

tions, it is unlikely that Iceland’s key interest rate differential will narrow materially against

other developed economies. However, a potential inflection point is what Iceland decides to

do with their monetary policy framework and exchange rate policy. As discussed previously, a

government appointed panel will deliver a report towards the end of 2017 with recommenda-

tions regarding how to reduce exchange rate fluctuations, which contribute to economic vola-

tility and the high interest rates.

Interbank rates % (3M)

-2

0

2

4

6

8

10

12

14

16

18

20

CBI* REIBOR EURIBOR NIBOR LIBOR (USD)

Inflation & target % (Iceland)

0

1

2

3

4

5

6

7

2012 2013 2014 2015 2016 2017 2018 2019 2020

Inflation target Range Inflation

Exchange rates

0.003

0.004

0.005

0.006

0.007

0.008

0.009

0.010

0.011

jan. 11 jan. 12 jan. 13 jan. 14 jan. 15 jan. 16 jan. 17

USD/ISK EUR/ISK Inverted TWI**

3Q17 start

Foreign exchange reserves ISKbn (CBI)

-400

-200

0

200

400

600

800

1,000

1,200

1,400

2009 2010 2011 2012 2013 2014 2015 2016 2017

CBI and Treasury foreign den. debt Financed in ISK FX reserves

2Q17

Sources: Beringer Finance, Bloomberg, Central Bank of Iceland

*Central Bank of Iceland’s 7-day collateralized lending rate.

**Narrow TWI, which is a trade weighted currency basket. It is compiled as a weighted average (of trade) of exchange rates of home vs. foreign currencies.

For Iceland it is also important that the Central Bank maintain adequate foreign currency

reserves in order to be able to intervene in the FX market to protect the value of the Krona.

However, this is not currently a problem as the demand for the Krona has been strong over

some time now, which has allowed the Central Bank to build adequate reserves. Actually, the

Central Bank have had to purchase more foreign currency than it would like the last couple of

years to alleviate the upward pressure (appreciation) of the Krona. A large amount of Ice-

land’s FX reserves is now financed in the Krona, as opposed to foreign denominated debt,

which, in our opinion, is a much more comfortable position compared to the alternative.



Overview of the financial system

Distribution of assets (2016)

34 %

32 %

11 %

9 %

8 %

6 %Pension funds

DMBs

Other

Central Bank of Iceland

Housing Financing Fund

Mutual, investment, and inst. Invest. funds

Assets as % of GDP

0

20

40

60

80

100

120

140

160

180

2010 2011 2012 2013 2014 2015 2016

DMBs Pension funds HFF

PE

NS

ION

FU

ND

S

Market shares (assets)

21 %

17 %

13 %9 %

40 %

State employees*

The pension fund of commerce*

Gildi

Birta

Other pension funds

Distribution of assets

22 %

19 %

19 %

17 %

13 %

6 %

3 % 1 %Foreign assets

Housing Bonds etc.

Domestic equities, funds etc.

Other bonds and bills

Public sector

Loans to pension fund members

Deposits

Other assets

*State employees is Lífeyrissjóður starfsmanna ríkisins (LSR) and the pension fund of commerce is Lífeyrissjóður verzlunarmanna (LIVE)

DE

PO

SIT

MO

NE

Y B

AN

KS

Market shares (assets)

34 %

32 %

31 %

2 % 1 %

Landsbankinn hf.

Íslandsbanki hf.

Arion Bank hf.

Kvika banki hf.

Saving banks and other DMBs

Distribution of assets

73 %

13 %

8 %

4 % 2 %

Loans

Cash

Bonds and claims

Shares

Other assets

(i) Mkt. Share* – Mutual & Investment Funds (ii) Shadow banking** (9.8% of financial system***)

OT

HE

R I

NFO

RM

AT

ION

31 %

26 %

23 %

7 %

13 %Stefnir

Landsbréf

Íslandssjóðir

GAMMA

Other

31 %

20 %18 %

11 %

10 %

5 %5 %

Bond funds

Limited partnerships

Money market funds

Equity funds

Finance companies

Other funds

Hedge funds

Sources: Beringer Finance, Central Bank of Iceland, FSA Iceland

*Market share based on asset under management (AUM).

**Activities that entail the transfer of credit outside, with the participation of entities or activities, the conventional banking system.

***Not included the old banks’ holding companies that held 500 ISKbn at the end of 2016, down from 1,500 ISKbn at the end of 2015.



Credit volume – expanding again

On the previous page we presented an overview of the Icelandic financial system, and it show

that the Icelandic banking sector is highly concentrated with the three largest banks holding

roughly 97% of all assets in what the Central Bank has designated as the DMB segment.

These three banks (Arion, Islandsbanki, and Landsbankinn) are collectively known as the D-

SIBs, or the banks considered to be of systemic importance, and will work as our proxies for

the entire banking system in Iceland on the following pages. However, it is important to keep

in mind that the Icelandic pension funds are relatively active mortgage lenders, which is a

result of the capital controls.

D-SIBs 2016 – share of total lending (%)

5.0

14.811.6

3.11.4 2.2

0.7

5.5

10.3

0.0

45.3

Other Tourism

D-SIBs 2015 to 2016 – net new lending (ISKbn)

27

16

32

125

15

5

20

53

0

100

Asset fin. agreement FX loans Non-indexed Indexed

Credit system loan growth* (% YoY)

-25

-20

-15

-10

-5

0

5

10

Credit system loan stock Coporates Households

Household & non-financial corporate debt** (% GDP)

109125

132

167198

236 213193

158142

121108

9284 80

90 91 103 111 113 121 124 119 110 107 101 95 83 77 73

0

50

100

150

200

250

300

350

400

Households Corporates


*Loans from DMBs, the HFF and other credit institutions, pension funds, insurance companies, and State credit funds. Non-financial corporations only.

**Debt owed to financial undertakings and market bonds issued.

The Icelandic credit system has been characterized by massive deleveraging efforts since the

financial crisis. However, the underlying deleveraging ended in 2016 when the credit system’s

loan growth turned positive for the first time in many years. The loan growth is currently

driven by the tourism boom. As can be seen in the ‘D-SIB net new lending’ graph above, the

majority of net credit creation is happening in sectors that are affected by the tourism boom,

namely; the construction, services, and household sectors. Given the Icelandic economy’s

expected investment composition, we expect the demand for credit in these sectors to re-

main strong in the coming years. Additionally, the Icelandic private sector has the capacity to

take on more debt, especially the corporate sector.

The capital controls and the financial crisis has most likely resulted in suboptimal capital

structures in the Icelandic non-financial corporate sector, as equity financing has been the

dominant funding source.



With rising equity ratios and a high performing economy, the collateral capacity in the Ice-

landic private sector is increasing. In 2016, only the Danish corporate sector had a lower debt

ratio than Iceland of the Nordic countries. Additionally, the Icelandic households are the least

leveraged in the Nordic compared to GDPs. However, it must be said that the sectors not

related to tourism have seen their outlook deteriorate due to the appreciating Krona, thus

the willingness to use debt financing, or take on major investments, is not at an all-time high

in these segments.

Equity position households (% disposable income)

0

50

100

150

200

250

300

350

-400

-200

0

200

400

600

800

2000 2002 2004 2006 2008 2010 2012 2014 2016

Real estate Other Pension Liabilities Net assets ex. Pension (rhs)

Equity position corporates (% GDP)

0

5

10

15

20

25

30

35

40

45

-400

-300

-200

-100

0

100

200

300

400

2002 2004 2006 2008 2010 2012 2014

Assets Liabilities Equity ratio % (rhs)

Sources: Beringer Finance, Central Bank of Iceland, Statistics Iceland

Overall, the Icelandic private sector (households and non-financial corporates) currently holds

low level of debt compared to the other Nordic countries (as can be seen in the graph below).

This signals room for additional leverage in the system, but the caveat is that credit is more

expensive and the economy more volatile in Iceland. This probably entails that the private

sector in Iceland should not be as leveraged as their Nordic neighbors.

House prices* (index 100 = Jan. 2000)

50

70

90

110

130

150

170

190

210

Real house prices House prices to wages

House prices to building costs

Corporate & household credit (%GDP)

Denmark

Finland

Sweden

Norway

Iceland UK

USA

Euro Area

Germany

France

Spain

G20

Italy

Netherlands

AE**; 72.9

AE**; 85.5

20

40

60

80

100

120

140

160

20 40 60 80 100 120 140 160

Cre

dit

to

co

rpo

rate

s (%

GD

P)

Credit to households (% GDP)

Sources: Beringer Finance, BIS, Central Bank of Iceland, Statistics Iceland, Register Iceland

*House price index relative to CPI, wage index, and building cost index.

**Aggregated for advanced economies (AE)

Nevertheless, the outlook for credit growth related to the construction and residential sectors

looks very strong, because e.g. real disposable income is experiencing a strong momentum

and the ‘house prices to building costs’ ratio is at a very high level. Thus, house prices are

expected to appreciate further and the potential return on investment in the residential con-

struction sector is high in a historical perspective.



The price of credit - expensive

As already covered, the price of credit in Iceland is high compared to other advanced econo-

mies. However, there are some other characteristics worth mentioning too. Firstly, is the

prevalence of indexed-to-inflation lending. With a historically volatile inflation rate, it is not a

surprise that 38% of bank loans are indexed (2016). Additionally, 18% of loans are in foreign

currency (2016). This percentage is much higher than the banks’ foreign lending and has to do

with two factors; (i) the export sector has its income in foreign currency, thus it makes sense

to borrow in foreign currency too (the fishery industry is a prime example of this); (ii) borrow-

ing in foreign currency is cheaper than borrowing in the Krona, especially e.g. if you expect

the Krona to remain strong. Of course it is tempting for the banks to borrow in foreign cur-

rency and lend out in the Krona (basically engaging in carry trades), but the Icelandic regula-

tors are not interested in being fooled twice, so they have enacted some special regulations.

Average nominal interest rates (%)

0

2

4

6

8

10

12

14

0

2

4

6

8

10

12

14

Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17

Average interest rate on bank loans Average prime rate on bank loans

Yield on Treasury notes (RIKB 19 0226) Central Bank collateral loans

Average indexed interest rates (%)

0

2

4

6

8

10

12

14

0

2

4

6

8

10

12

14


Average interest rate on bank loans Average prime rate on bank loans

T-bond real yield (RIKS 21 0414) HFF bond real yield (HFF 150224)

Interest rate on nominal housing loans* (%)

2

3

4

5

6

7

8

9

2

3

4

5

6

7

8

9

Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-17

Arion bank Íslandsbanki

Landsbankinn hf. Average pension fund lending rates

Interest rates on indexed housing loans* (%)

2

3

4

5

6

7

8

9

2

3

4

5

6

7

8

9


Arion bank Íslandsbanki

Landsbankinn hf. Avg. pension fund lending rates

Housing Financing Fund (HFF)


*Lowest floating rates for non-indexed housing loans. Lowest fixed rates for indexed housing loans. Average pension fund lending rates is the average of the lending rates

charged by Gildi, Lífsverk, and Söfnunarsjóður lífeyrisréttinda.

Icelandic banks have special requirements when it comes to funding through the LCRs (liquid-

ity coverage ratios) and NSFR (net stable funding ratios). These ratios are part of the Basel

III/CRD IV regulations, but Icelandic banks need to maintain them >100% in foreign curren-

cies, as well as consolidated across currencies. The purpose of the LCR is to ensure that banks

have the necessary assets on hand to ride out short-term liquidity disruptions (30 days), while

the purpose of the NSFR is to ensure the same over longer periods (funding with maturity

greater than one year is considered stable). Moreover, the Central Bank sets rules on credit

institutions’ foreign exchange risk by preventing the credit institutions’ foreign exchange bal-

ances from exceeding certain limits (currently the limit is 15% of the capital base).



Regardless, if we take a Nordic perspective, it is not like the Icelandic credit institutions need

to engage in risky funding strategies to ensure healthy gross returns on their assets. For ex-

ample, the current indexed spread between lending and deposit rates is a solid 3.0%, while in

Norway the nominal spread is roughly 2.5% (more on this in the profit mechanics part). This

comparison is just a rough approximation since the indexed spread is a real measure.

Bank lending and deposit rates (%)

0

1

2

3

4

5

6

7

8


(i) Avg. indexed lending rates (ii) Avg. indexed deposit rates (5 yrs.) Spread (i-ii)


While the real spread between lending and deposit rates in Iceland is relatively stable (with a

downward sloping trend if we look at a four-year horizon), there are large movement in other

funding costs. As both the economic outlook and Iceland’s credit ratings have improved, the

price of the bank sector’s wholesale funding has decreased (as can be seen in the graph be-

low). We note that part of the spread compression must be attributed to a system wide com-

pression in foreign markets as well.

Spread at issue* (Bps) (Senior Unsecured)

ISLA D=4

Arion D=3Arion D=5

ISLA D=3

ISLA D=3

LBANK D=3

LBANK D=3.5

LBANK D=3.5

Arion D=3

Arion D=1.5

Arion D=3

ISLA D=4

LBANK D=4.5

Arion D=2

Arion D=4 LBANK D=4

LBANK D=4

Arion D=5

Arion D=3

LBANK D=5

Arion D=10

Arion D=6

LBANK D=3LBANK D=3

Arion D=3

ISLA D=1.5

ISLA D=1.5

ISLA D=1.5

Arion D=2

Arion D=3

0

50

100

150

200

250

300

350

Dec-14 Jul-15 Jan-16 Aug-16 Mar-17 Sep-17

Sources: Beringer Finance, Bloomberg

*D stands for duration

Nevertheless, the D-SIBs’ average net interest margin (NIM) only went up 20bps between

2015 and 2016, despite the improvements in wholesale funding spreads. During 1H17 there

were no clear improvement in NIMs amongst the D-SIBs either. This indicate that the banks

are transferring large parts of the lower funding costs to their clients. However, both interest

income and expenses are heavily affected by inflation, so one should not read too much into

short-term fluctuations in Icelandic banks’ NIM (unless you perform a very thorough analysis).



Another interesting feature is the composition of the D-SIBs funding side (equity & liabilities),

as the Icelandic banks relies to a large degree on equity funding, which we will take a closer

look at as to why in a couple of pages. The short answer is that they are required to do so.

Yet, this actually causes the reported net interest margins to be slightly overstated compared

to more traditionally leveraged banks. This is because equity is P&L neutral, while debt is not.

Simplified balance sheet composition ISKbn (2Q17 D-SIBs)

ISK 1,126ISK 1,047

ISK 1,111

437 572590

222 176251

380 227224

Arion Islandsbanki Landsbankinn

0

20 0

40 0

60 0

80 0

10 00

12 00

0

20 0

40 0

60 0

80 0

10 00

12 00

Assets Liabilities +

equity


equity


equity

Interbank

Loans

Other

Borrowings

Deposits

Equity

Sources: Beringer Finance, respective banks

The bias to the interest rate margin depends on the absolute difference between interest

income rates and expenses. For example, let say the cost of debt is 2% and the return on

assets is 5% for an unweighted spread of 3%. Furthermore, Icelandic banks run on equity

ratios of roughly 20% while a more common Nordic ratio would be around 5%. Given that

Icelandic banks would go from an equity ratio of 20% to 5%, then the net interest margin

would decrease 9% from 3.4% to 3.1% (everything else the same). From a RoE perspective,

the increased leverage would of course be beneficial, but not from a RoA perspective.



Credit quality – vast improvements

The Icelandic financial system still have higher non-performing loan (NPL) ratios than its

neighboring countries, yet the situation has improved drastically the last 6years. The gross

NPL ratio was 4.4% in 2016, but 5.1% for D-SIBs. Corporate NPLs (D-SIBs) are at a higher level

(5.8% 2016) compared to lending to individuals (4.2% 2016). From 2015 to 2016, NPLs de-

clined in most sectors, but increased among construction and industry. Even though the NPL

ratios are higher in Iceland compared to its neighbors their balance sheets could be consid-

ered stronger, as the Icelandic banks run on 1/4th of the leverage (see e.g. the Texas ratios).

NPL ratios* (2016)

5.7 %

4.4 %

3.7 %

3.1 %

2.5 %

2.5 %

1.9 %

1.3 %

1.2 %

1.0 %

Spain

Iceland

France

Denmark

Netherlands

Germany

UK

USA

Norway

Sweden

Historical NPL ratios (Icelandic banks)

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

2010 2011 2012 2012 2013 2014 2015 2016

Claim value Book value

NPLs ratios** (2016)

5.8 %

4.2 %

2.4 %

2.4 %

1.7 %

D-SIB corp.

D-SIB housholds

DNB

Danske Bank

Nordea

Texas ratios*** (2016)

22.1 %

18.6 %

17.9 %

12.6 %

10.6 %

9.9 %

Danske Bank

DNB

Nordea

Landsbankinn

Arion bank

Islandsbanki

Sources: Beringer Finance, IMF, EBA, ECB, Central Bank of Iceland, respective banks

*Claim value of NPLs, as defined by the Icelandic Central Bank. Book value NPLs ratio at 2.1% (2016).

**Gross NPLs divided by Gross lending. Core only for Danske Bank (lower is better). Might not be comparable across banks.

***Texas ratio = gross NPLs divided by tangible equity plus provisions (lower is better). Might not be comparable across banks.

Regarding the D-SIBs, one should be aware of the relatively high encumbrance ratios. Lands-

bankinn’s ratio fell seven percentage points to 11% in 2016. Islandsbanki and Arion Bank’s

encumbrance ratios were 15% and 21%, respectively. Arion’s has been high because of the

mortgage loan portfolio bought from Kaupthing in 2011 and used to back covered bonds.

The legacy of the three D-SIB banks, in terms of credit quality among other factors, is present-

ing opportunities in the Icelandic market for challengers. On the following pages we will cover

some of the other factors that opens up possibilities to disrupt.



Profit mechanics – different than what you are used to

The profit mechanics of the Icelandic banks are very different from other Nordic banks, espe-

cially when it comes to asset and cost efficiencies. We ignore the cost of risk (CoR) due to the

extent of the reversals of provisions for the Icelandic banks. In order to illustrate the differ-

ences, we have decomposed the RoEs in the table below.

Firstly, the Icelandic banks achieves a much higher asset efficiency compared to the national

champions from Norway (DNB), Denmark (Danske Bank), and Sweden/Finland (Nordea). One

could speculate that this difference is due to a lower degree of competition in Iceland, but it is

well documented that higher interest rates allows banks to extract larger absolute revenue

margins – both from commissions and interest rate spreads.

National champions comparison*

Profit mechanics I

# Formula 2014 2015 2016 2014 2015 2016 2014 2015 2016

i NII/TA 2.5 % 2.9 % 3.1 % 2.6 % 2.8 % 2.9 % 3.1 % 2.9 % 3.0 %

ii NC/TA 0.5 % 0.6 % 0.7 % 1.4 % 1.5 % 1.4 % 1.3 % 1.3 % 1.3 %

iii Other/TA 0.9 % 1.4 % 0.6 % 1.7 % 4.6 % 0.9 % 0.4 % 0.4 % 0.7 %

iv = i + ii + iii Net rev./TA 3.9 % 4.9 % 4.4 % 5.7 % 8.9 % 5.2 % 4.8 % 4.6 % 5.0 %

v OPEX/TA -2.1 % -2.1 % -2.1 % -2.9 % -2.9 % -3.0 % -2.7 % -2.5 % -2.7 %

vi CoR/TA 1.8 % 1.6 % 0.0 % 0.2 % -0.3 % 0.7 % 1.0 % 0.8 % 0.1 %

vii = iv + v + vi Pre-tax RoA 3.5 % 4.4 % 2.3 % 3.1 % 5.7 % 2.9 % 3.1 % 2.9 % 2.4 %

viii Effective tax rate 24.8 % 25.4 % 33.9 % 25.2 % 10.8 % 30.8 % 31.8 % 31.2 % 31.9 %

ix = vii * (1-viii) RoA 2.6 % 3.3 % 1.5 % 2.3 % 5.1 % 2.0 % 2.1 % 2.0 % 1.6 %

x = ix * xi RoE 12.1 % 14.2 % 6.5 % 14.2 % 27.1 % 10.1 % 10.6 % 9.9 % 9.0 %

xi = 1 / xii Equity multiplier 4.6 4.3 4.3 6.1 5.3 5.0 5.0 5.0 5.5

xii = xiii * xiv * xvii Equity ratio 21.9 % 23.2 % 23.1 % 16.4 % 18.7 % 20.2 % 19.9 % 19.8 % 18.2 %

xiii RWA/TA 77.1 % 77.2 % 76.3 % 75.7 % 77.3 % 76.3 % 76.2 % 71.3 % 67.1 %

xiv CET 1/RWA 28.3 % 29.9 % 30.0 % 20.1 % 22.0 % 24.3 % 25.8 % 27.4 % 26.6 %

xvii Equity/CET 1 100.4 % 100.7 % 100.9 % 108.1 % 110.2 % 108.8 % 100.8 % 101.4 % 102.1 %

Cost/Core-income 71.0 % 60.6 % 55.4 % 71.1 % 67.1 % 69.6 % 62.1 % 60.3 % 61.9 %

Cost/income 55.4 % 43.6 % 48.0 % 49.8 % 32.3 % 57.1 % 56.4 % 55.6 % 53.5 %

Landsbankinn Arion Islandsbanki

Profit mechanics II

# Formula 2014 2015 2016 2014 2015 2016 2014 2015 2016

i NII/TA 1.3 % 1.3 % 1.3 % 0.8 % 0.8 % 0.7 % 0.7 % 0.6 % 0.7 %

ii NC/TA 0.4 % 0.3 % 0.3 % 0.5 % 0.5 % 0.5 % 0.4 % 0.4 % 0.4 %

iii Other/TA 0.3 % 0.4 % 0.4 % 0.3 % 0.3 % 0.3 % 0.3 % 0.3 % 0.3 %

iv = i + ii + iii Net rev./TA 2.0 % 2.0 % 2.0 % 1.6 % 1.5 % 1.6 % 1.4 % 1.4 % 1.4 %

v OPEX/TA -0.8 % -0.8 % -0.8 % -0.8 % -0.8 % -0.8 % -0.7 % -0.7 % -0.7 %

vi CoR/TA -0.1 % -0.1 % -0.3 % -0.1 % -0.1 % -0.1 % -0.1 % 0.0 % 0.0 %

vii = iv + v + vi Pre-tax RoA 1.1 % 1.2 % 0.9 % 0.7 % 0.7 % 0.7 % 0.6 % 0.7 % 0.7 %

viii Effective tax rate 23.9 % 22.5 % 18.1 % 22.1 % 22.2 % 18.6 % 21.6 % 20.8 % 21.7 %

ix = vii * (1-viii) RoA 0.8 % 0.9 % 0.7 % 0.5 % 0.6 % 0.6 % 0.4 % 0.5 % 0.6 %

x = ix * xi RoE 13.7 % 14.3 % 10.0 % 11.4 % 12.0 % 11.9 % 10.0 % 11.9 % 13.1 %

xi = 1 / xii Equity multiplier 16.8 15.4 14.1 22.0 21.6 19.9 22.8 22.8 22.5

xii = xiii * xiv * xvii Equity ratio 6.0 % 6.5 % 7.1 % 4.5 % 4.6 % 5.0 % 4.4 % 4.4 % 4.5 %

xiii RWA/TA 43.7 % 42.9 % 41.5 % 23.1 % 21.9 % 21.9 % 25.7 % 25.2 % 24.3 %

xiv CET 1/RWA 12.2 % 13.6 % 15.2 % 15.3 % 16.1 % 17.4 % 14.9 % 15.6 % 16.2 %

xvii Equity/CET 1 111.4 % 111.8 % 112.5 % 128.5 % 131.2 % 131.9 % 113.9 % 111.6 % 113.0 %

Cost/Core-income 49.9 % 45.4 % 51.0 % 64.5 % 60.5 % 60.3 % 65.4 % 63.8 % 62.5 %

Cost/income 41.9 % 37.1 % 41.4 % 52.7 % 48.9 % 48.4 % 52.9 % 50.9 % 47.2 %

DNB Nordea Danske Bank


*All balance sheet items are averaged. NII = net interest income, NC = net commission income, TA = total assets, CoR = cost of risk (loan losses), RoA = return on assets, RoE =

return on equity, RWA = risk weighted assets, CET 1 = common equity tier 1, core income is NII + NC. Note that we have moved line-items around for the respective banks to

facilitate comparison. For Danske Bank we have not included some major goodwill impairments and its defined “non-core” items.



However, the Icelandic banks really need these higher margins due to their cost inefficiencies.

We discussed Iceland’s lack of productivity earlier in this report, and we now show that the

same apply to the financial sector. One could argue that the Nordic national champions have

the advantage of economies of scale against the much smaller Icelandic champions, yet this

argument does not hold for two reasons; (i) Nordea is much larger than DNB and Danske

Bank (Nordea is a G-SIB), but not more efficient, and (ii) plenty of smaller Nordic banks are as

efficient (or better) compared to the respective national champions.

In the graphs below we show that the cost efficiency differences are not due to personnel

expenses or administrative costs alone – but a mix of the two together. We report versions of

the classical cost-to-income ratio here, but this ratio does not tell us much when the revenue

generation is so much higher on Iceland due to higher interest rates. The underlying cost

efficiency is better approximated by cost-to-asset ratios when comparing banks that operate

in such different interest rates regimes.

Total OPEX vs. core-income & total assets (2016)

Landsbankinn

Arion

Islandsbanki

DNB

Nordea

Danske Bank

40 %

45 %

50 %

55 %

60 %

65 %

70 %

75 %

0.0 % 0.5 % 1.0 % 1.5 % 2.0 % 2.5 % 3.0 % 3.5 %

OP

EX

/ C

ore

-in

com

e

OPEX/TA

Staff & Admin. costs vs. total assets (2016)

Landsbankinn

Arion

Islandsbanki

DNB

Nordea

Danske Bank

0.0 %

0.2 %

0.4 %

0.6 %

0.8 %

1.0 %

1.2 %

0.0 % 0.5 % 1.0 % 1.5 % 2.0 %

Sta

ff c

ost

/ T

A

Admin. cost / TA

Staff costs vs. core-income & total assets (2016)

Landsbankinn

Arion

IslandsbankiDNB

Nordea

Danske Bank

10 %

15 %

20 %

25 %

30 %

35 %

40 %

45 %

50 %

0.0 % 0.5 % 1.0 % 1.5 % 2.0 %

Sta

ff c

ost

/ c

ore

-in

com

e

Staff cost / TA

Admin. costs vs. core-income & total assets (2016)

Landsbankinn

Arion

Islandsbanki

DNB

Nordea

Danske Bank

10%

15%

20%

25%

30%

35%

40%

45%

50%

0.0 % 0.5 % 1.0 % 1.5 % 2.0 %

Ad

min

. co

st /

co

re-i

nco

me

Admin. cost / TA


*Average total assets

Moreover, we estimate that the Icelandic banks spend over twice the amount running their IT

systems (in relations to assets) compared to the Nordic champions, which themselves are

subject to massive legacy burdens (IT costs are baked into administrative costs).

The Icelandic financial sector’s high revenue margins, low cost efficiency, and legacy NPLs (&

encumbered assets) are all factors that we believe make the market ripe for disruption.



Lastly, we take a look at the leverage, and ask; do the Icelandic banks really need to hold so

much equity? Their equity ratios are roughly four times that of the other Nordic national

champions. The short answer is that no; they sort of do not. The Icelandic capital require-

ments are, maybe unsurprisingly, very strict. Yet, Arion’s 2Q17 total regulatory capital re-

quirement was 20.5%, or a 15.1% CET 1 requirement. Thus, the banks do hold excessive capi-

tal combined with suboptimal capital structures. See the graphs below for an overview over

the capital requirements and the banks’ 2Q17 regulatory capital structures. However, even if

e.g. Arion were to adjust to an optimal capital structure it would not be able to employ the

same gearing as DNB that have roughly the same CET 1 requirement.

Capital requirement framework (Iceland)

4.500 %

3.000 %

2.000 %

1.250 %

2.500 %

3.375 %

1.500 %

1.125 %

2.000 %

1.500 %

16.625 %

1.125 %2.625 %

1.500 %

3.500 %

22.750 %

CET 1 Tier 1 Tier 2

Bank specific

6% is an example Only domestic assets

From 4Q17 (currently 1.0%)

D-SIBs 2Q17 capital ratios & capital requirement (not included management buffer)

16.0 %

27.20 %

15.10 %

27.70 %

14.30 %

23.30 %

22.10 %

27.60 %

20.50 %

28.40 %

19.20 %

23.50 %

Landsbankinn Arion Islandsbanki

0

0

0

1

1

1

10

0

0

0

0

0

0

Capital

requirement

Capital Capital

requirement

Capital Capital

requirement

Capital

Total capital req.

Tier 2

Tier 1

CET 1


The reason has to do with the RWA density (risk-weighted capital divided by assets). For ex-

ample, Arion’s 2016 average RWA density was 76%, while DNB’s was 42%. The difference does

not have much do to with risks on the balance sheets (it has a little bit to do with the Icelandic

banks having a proportional large share of corporate loans), but has a lot to do with the Ice-

landic banks not using IRB (internal risk based) models, but the standardized approach. CRD

IV (Basel III), which Iceland is following, opens up for banks employing IRB models, yet it re-

quires approval from the local regulator.



Financial sector ownership overview

The Icelandic State currently controls 13% of Arion Bank, 100% of Islandsbanki, and 98% of

Landsbankinn. Going forward, it is likely that the Government will hold a long-term stake in

Landsbankinn of 34% to 40%, while its shares in Islandsbanki and Arion will be fully divested.

At least these were the intentions put forward in the Government’s draft ownership strategy

for financial institutions from the 10th of February 2017. Of the three D-SIBs, it is Arion Bank

that is the closest to going public again.

Equity ownership (representing 99% of DMB assets as of 2016)

Arion

57.4 %

13.0 %

10.4 %

10.0 %

6.6 %

2.6 % 0.0 %

Kaupskil ehf.

Icelandic State Financial Invest.

Attestor Capital Advisors

Taconic Capital Advisors

Sculptor Investments s.a.r.l

ELQ Investors

Other

Islandsbanki

100 %

Icelandic State Financial Invest.

Landsbankinn

98.2 %

1.8 %

Icelandic State Treasury

Other

Kvika

25.1 %

9.9 %

9.6 %

55.4 %

Vátryggingafélag Íslands

RES II ehf.

Lífeyrissjóður verslunarmanna

Other


Arion Bank is the domestic residual of the failed bank Kaupthing. In March 2017, it was an-

nounced that Kaupthing (now a holding company) would sell a 29% stake in Arion. The stake

was acquired by three foreign hedge funds and Goldman Sachs (ELQ). The sales price was

0.81x of book value and the sales sum reverted back to the Icelandic Treasury as part of

Kaupthing’s stability contributions (measures that helped the Icelandic state lift the capital

controls). All of the foreign investors are existing investors in Kaupthing.

Kaupthing’s remaining stake in Arion is to be sold, but the path to a more normalized owner-

ship structure has not been determined yet. The preparatory work of an IPO began in 2016,

and it was for some time deemed likely that a listing would take place as early as April 2017.

However, after some political turbulence, a general election was called in Iceland and the

decision has been postponed to after this election. The election is due to be held the 28th of

October 2017.

The elections were not scheduled, Iceland held an election in 2016, but is a result of the for-

mer three-party coalition government’s collapse following a scandal involving the Prime Min-

ister’s father writing a letter recommending a convicted pedophile have his “honor restored.”



Lastly, in addition to the DMBs ownership structures, it is important to be aware of the Ice-

landic pension funds’ very high ownership percentage in the domestic equity market. At the

end of 2016, the pension fund’s owned at least 43.5% of all listed companies in Iceland. The

percentage is a minimum, as it is based on an examination of the 20 largest shareholders in

listed companies (by the Central Bank of Iceland). Thus, the instances where a pension fund is

an owner, but not on the top 20 list, are not included. The pension funds’ ownership percent-

age of listed equities has increased substantially in recent years and a part of the reason has

been the capital controls, plus the corresponding lack of investment options. The Icelandic

FSA estimate that the pension funds’ assets amounted to roughly 75% of Icelandic financial

assets (debt and equity) in 2016.

Pension funds’ listed equity mkt. share (%)

7.75.0

15.4

30.4

43.5

0

10

20

30

40

50

60

70

80

90

100

2004 2007 2010 2013 2016

Share held by 20 largest shareholders in listed companies

Portion held by pension funds*

Pension funds’ aggregate asset composition

7 % 10 % 12 %15 % 17 %

21 % 19 %

24 % 22 % 23 % 22 % 24 % 22 % 22 %

0 %

10 %

20 %

30 %

40 %

50 %

60 %

70 %

80 %

90 %

100 %

2010 2011 2012 2013 2014 2015 2016

Domestic equities, funds etc.

Deposits

Other bonds and bills

Housing Bonds etc.

Public sector

Loans to members

Foreign assets

Other assets


*Direct ownership; i.e., excluding assets held by pension funds through mutual funds and the Enterprise Investment Fund.

Since autumn 2015, the pension funds have been allowed to invest abroad (they have been

granted special exemptions for foreign investments). However, the funds have never fully

taken advantage of the opportunity. Additionally, the funds did invest ISK 70bn abroad in

2016 (2% of their assets), but their balance sheet share of foreign assets contracted slightly –

mainly due to the appreciation of the Krona. With the full liberalization of the capital controls,

the pension funds are allowed to invest abroad without restrictions. It is expected that the

pension funds will significantly increase their foreign investments over the coming years, in

order to achieve better risk diversification.

The gargantuan positions of the Icelandic pension funds in the domestic asset market (rela-

tive to the market size that is) makes them extremely important for the economy and finan-

cial stability. A sudden tilt in the funds’ investment preferences could have unintended and

significant consequences on Icelandic asset prices.



Appendix

Abbreviations

AE - Advanced economies

AUM - Asset under management

bn - Billion

BPS - Basis point (0.01%)

CAGR - Compound annual growth rate

CB - Central Bank

CET 1 Common equity tier 1

CoR - Cost of risk ("loan losses")

CPI - Consumer price index

DMB - Deposit money bank

D-SIB - Systemic important bank

EBA - European Banking Authority

ECB - European Central Bank

FSA - Financial Supervisory Authority

FX - Foreign exchange

GDP - Gross domestic product

HFF - Housing Financing Fund

IMF - International Monetary Fund

ISK - Icelandic Krona

k - Thousand ('000)

LCR - Liquididity coverage ratio

Lhs - Left hand side

m - Million

NC - Net commissions and fees

NPL - Non-performing loan

NSFR - Net stable funding ratio

OECD - Organization for Economic Cooperation and Development

OPEX - Operating expenses

PPP - Purchasing power parity

REIBOR - Reykjavik interbank offered rate

Rhs - Right hand side

RoA - Return on assets

RoAA - Return on average assets

RoAE - Return on average equity

RoE - Return on equity

RWA Risk weighted assets

T - Metric ton

TA - Total assets

TFP - Total factor productivity

ToT - Terms of trade

TWI - Trade weighted index

UK - United Kingdom

USA - United States of America



Taxes

The corporate tax rate in Iceland is 20%.

Capital gains are treated as ordinary income.

Social security contributions are 7.34% of salary costs.

Financial and insurance companies are subject to an additional financial activities tax

which is twofold; (i) A supplementary income tax of 6% on profits exceeding ISK 1 bil-

lion and (ii) a 5.45% levy on total salaries and benefits.

The standard VAT rate in Iceland is 24%. Some goods and services are either exempt

from VAT or subject to a lower rate of 11%. Foodstuff is subject to the lower rate of

11%. In addition, there are various excise duties, e.g. on imported motor vehicles and

fuel.

Land and property fees are collected by municipalities; rates vary according to use

and between municipalities. Fees include those levied on property, use of cold water,

waste disposal and other basic services.

Companies engaging in innovation can apply for a special tax credit against assessed

income tax of 20% of the incurred cost of its research and development projects.

Source: The Icelandic Ministry of Industry and Innovation

Simple* corporate tax rates (2017)

19.0 %

20.0 %

20.0 %

22.0 %

22.0 %

24.0 %

29.8 %

33.3 %

UK

Finland

Iceland

Denmark

Sweden

Norway

Germany

France

Sources: Beringer Finance, KPMG

*Headline corporate tax rates. Special rules may apply and the rates should be considered approximations.



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THE ICELANDIC ECONOMY & FINANCIAL SECTOR · 2017-10-18 · The Icelandic Economy & Financial Sector - Tantalizing play of fire and ice – October 2017 5 Beringer Finance Page 5 Bird