Seðlabanki Íslands
Financial stability in Iceland d
Capital controls
29 November 2012
Financial Stability Department
Overview
• Run up to the financial crises
• Current economic affairs
• Main risks to financial stability
• Capital controls
• Prudential rules
Iceland
• In the 20th century Iceland went from being one of the poorest economies in Europe to a prosperous one – High but volatile growth, -mostly led by fisheries
– From 2/3 of labour force in agriculture to 2/3 in services
• In past decades: liberalization, deregulation and privatization
• Member of the EEA in 1994 – Free movement of capital
– European “passport” for financial institutions headquartered in any country within the area
• At the turn of the century things started to heat up – … and the banks grew
External Imbalances
• External and internal imbalances were great in Iceland. – Capital inflow
– Strengthening of the currency
• The foreign exposure of Iceland, primarily through the banks, grew fast.
0%
100%
200%
300%
400%
500%
600%
700%
800%
900%
2000 2001 2002 2003 2004 2005 2006 2007 2008
% of GDP
External Debt
EBank External Debt/ GDP Other External Debt / GDP
Source: Central bank
Bank External Debt / GDP
Housing prices
-50
0
50
100
150
200
250
300
350
5.1.2004 5.1.2005 5.1.2006 5.1.2007 5.1.2008
Stock market indexes
OMXI15 OMX Copenhagen 20
OMX Stockholm 20 Index S&P 500
Growth of the banks
• The big three banks grew 20-fold in
size in seven years.
• Such growth is commonly associated
with poor underwriting or record-
keeping, which can lead to solvency-
related difficulties within a few years
• Quality of the Icelandic banks loan
portfolios eroded under these
circumstances.
• How did this happen?
Shares 54%
Cash 3%
Other Collateral
24%
Without Collateral
19%
Collateral in new lending from January 2007-October 2008
Source: SIC
How did they grow?
• A opening of global debt financing markets drove the growth of the banks.
• High credit ratings inherited from Iceland’s sovereign debt rating.
• Early 2006 internatinal debt funding dried up temporary – Geysir Crises
0
2.000
4.000
6.000
8.000
10.000
12.000
14.000
16.000
2004 2005 2006 2007 2008
bln.Euro
Aggregate bond issues the three big banks
EMTN USMTN OtherSource: SIC
Too big to Save •Reserves
– Short term liabilities of the economy grew to 16-fold the foreign currency reserve
– Foreign currency deposits grew to be 8 fold the foreign currency reserve,
0%
20%
40%
60%
80%
100%
120%
Central Bank Foreign Reserves % of Foreign Deposits
Source: Central Bank and SIC
Domestic operations put into new banks
• Each of the three commercial banks was split into a new bank and an old bank.
Old (foreign)
New (domestic)
Commercial bank
•Domestic operations
•Funded by local deposits
Old: Kaupthing
87% 13%
The State Old:
Landsbanki Old: Glitnir
The State The State
Landsbankinn Arion Íslandsbanki
81% 19% 5% 95%
Capital controls
• Implemented on November 28th 2008 – Up to 80% depreciation from
start of year 2008
• Capital controls not currency controls – Conventional trading in goods
and service
• Use of credit cards when traveling
– Cross border movement on capital related to contractual instalment payments
– Cross border movement related to interest- and dividend payments, wages
60
80
100
120
140
160
180
200
220
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Exchange rate of the krona Kr/EUR
What happened
2008 – 2009 • GDP declined about 10 percent
– and continued declining in Q1 2010
• Consumption declined about 24%
• Investment declined about 40%
• 75% decline in stock market index
– Wealth loss 150% of GDP
• Unemployment above 8%
• Increase in household debt – 13% of household debt in foreign currency,
80% indexed
• Increase in firms debt – Over 80% of firms debt in foreign currency,
Where are we today?
• Domestic economy recovery
• Iceland’s output growth was among the strongest in developed OECD countries in the first half of 2012
• Central Bank projects that growth in 2012 will be 2.5% and 2.9% in 2013
• IMF projects tha only two OECD countries will fare better than Iceland in 2012
Where are we now?
• Seasonally adjusted unemployment is down to 5.6% in Q3.
– 2% decline year on year
– The labour market recovery has continued but at a slower pace than expected
• Gross government debt is about 100% of GDP
– This is high in international context
Where are we today?
• The Banks seem strong – Average CAD over 23%
– but we are mindful that they are operating under capital controls
• Deleveraging is ongoing – Financial conditions of households
and firms are improving
Main risk factors: Financial Stability Report October 5th
• Ongoing sovereign and financial crises in Europe
• Foreign refinancing risk
• Capital controls
– Risks connected to the liberalization
• Legal uncertainty and uncertainty about government actions
• The Housing Finance Fund
Payment flows independent of the controls
• Residents need in the coming years to refinance or make payment off substantial amounts of foreign debt. – Can cause instability in the
foreign exchange market if access to foreign credit markets are not available.
• High instalments as a percentage of year-2011 current account balance, which was around 50 b.kr.
• The old banks estate add to this problem
Capital controls are costly in the long run
• Limited risk diversification – Limited investment opportunities
• Distorted asset prises, low interest rates – Bad investment decisions which
affect the future economic growth
• Distortion of competitive environment
• Direct cost of the regulation
• Vaste when investors circumvent the capital controls – Can erode business ethics
• Less foreign direct foreign
Why are they not just lifted then?
• “Offshore krónur” or liquid krona assets held by non-residents
– End of August they were 402 b.kr., or about 23% of GDP,
– The estates of the old banks may increase this amount by between 190 b.kr. and 400 b.kr. in the next years.
• Firms and households are still very leveraged
• The repayment schedule of foreign debt is steep in the coming years
– How fast should we deleverage?
• Prudential rules
Capital liberation strategy is conditional based.
Libariation conditions
• Strong overall economic conditions
• Lowering of the stock of Icelandic kronas in the hands of impatient foreign investors
• Lengthening the maturity profile for sovereign debt – Less dependent on financing from impatient foreign investors
– Government surplus by 2014
• Strengthening banks – Less reliant on deposits from impatient foreign investors
– Strengthening their capital ratios and loan portfolios
• Orderly process for unwinding old banks estates
• Access to foreign financial markets
• Set in place prudential rules
Capital controls liberalisation strategy
Auctions
Prudential rules
Bond swap
Exit Levy
Phase I Reduction of offshore króna positions
Phase II Removal of controls of
on shore króna
Sovereign bonds and bills
Foreigners 22%
Banks 28%
Mutual- and equityfunds
10%
Pension funds 27%
Others 13%
Owners of Sovereign bonds 31. august 2012
Source: Lánamál Ríkisins
Foreigners 70%
Banks 9%
Mutual- and equityfunds
12%
Others 9%
Owners of Sovereign bills 31. august 2012
Source: Lánamál Ríkisins
Liquid krona assets, refinancing risk and old banks estates
Refinancing -w/o treasury
Now 402 b.kr. From the old banks 211 b.kr.
Totla 613 b.kr.
Liquid krona assets
No onshore effects
1.746
402 b.kr.
2.544 b.kr.
Refinancing n 366
Liquid krona assets 211
Liquid krona assets
Refinancing - w/o old bank estates and treasury
Old bank estates
Equity in new banks (book value) 221 b.kr.
Equity in new banks 221
Adding old banks on….
Liquid krona assets 402 Addition from estates 211 Total 613 Book Value of Equity 221
Solutions must be sought to insure that the winding up process does not
threaten financial and economic stability
Prudential rules following capital controls • Macroprudential rules that should be in place
before the capital controls are lifted
– Currency mismatch
– Maturity mismatch
– Pro-cyclicality of capital flows
– Temporary actions
• Pension funds
39
Maturity mismatch and collection of depositis abroad
40
0
2.000
4.000
6.000
8.000
10.000
12.000
m.e
uro
s
Deposits in foreign subsidieris
Source: SIC
0
1.000
2.000
3.000
4.000
5.000
6.000
7.000
8.000
1.6
.20
06
1.8
.20
06
1.1
0.2
006
1.1
2.2
006
1.2
.20
07
1.4
.20
07
1.6
.20
07
1.8
.20
07
1.1
0.2
007
1.1
2.2
007
1.2
.20
08
1.4
.20
08
1.6
.20
08
1.8
.20
08
m. euro
Repo loans in foreign currency
Others ECBSource: SIC
• Limits on deposit taking abroad
• Liquidity rules on FX that require banks to withstand an extended period of
stress in foreign funding markets
0
2
4
6
8
10
12
14
16
18
20
50
52
54
56
58
60
62
64
66
68
70
mar
.'04
okt
.'04
maí
'05
des
.'05
júl.'
06
feb
.'07
sep
.'07
apr.
'08
nó
v.'0
8
jún
.'09
jan
.'10
ágú
.'10
mar
.'11
Loans in foreign currency
Firma (v.as) Personer (h.as)
Currency mismatch
• There was a steep increase in loans in foreign currencies to unhedged parties.
– Firms and individuals
• Proposals:
• Rules on liquidity and foreign currency balance
• Limits on fx loans to un-hedged parties
Firms (l. axis) Individuals (r. axis)
Pro-cyclicality of capital flows
• Procyclicality of capital flows – Instruments for the Central
Bank or a independent macroprudential authority
– Levies on capital transfer or special reserve requirement for foreign currency funding
-30%
-25%
-20%
-15%
-10%
-5%
0%
5%
Current account
Tradebalance Servicebalance
Factor income Current account
Source: Central Bank of Iceland