November 14, 2018

IMF published its staff report and selected issues report under the 2018 Article IV consultation with Iceland. Directors supported the creation of an integrated financial supervisor by merging the financial regulator into the central bank, to cover all aspects of the financial sector, including pension funds. While the merger should tap into synergies and increase simplicity, it is recommended that efforts should focus on ensuring a smooth transition and maintaining regulatory and operational independence.

The staff report noted that macro-prudential policy should focus on ensuring system-wide stability. Concerns are limited at this time, yet it is good that the toolkit of Iceland is well-developed. Capital buffers imposed by Financial Supervisory Authority (FME)—8.75% in total for the three main banks—will become increasingly binding, as dividend-taking reduces excess capitalization. The rules of the Central Bank of Iceland on liquidity coverage, net stable funding, and net open foreign currency positions help ensure banking sector resilience; they should be complemented by preemptive use of new powers to limit foreign currency lending to unhedged borrowers. Importantly, FME’s new loan-to-value ceilings on mortgages—set at 85% to 90%—help limit household borrowers’ leverage by acting on lending standards directly, for all types of lenders. The authorities consider the macro-prudential regime of Iceland to be one of the most active in Europe. They see the rigorous capital buffer requirements already beginning to influence bank behavior. Noting that the buffers are high compared to average requirements across Europe, they reminded that the countercyclical capital buffer is set to increase further, from 1.25% to 1.75%, in May 2019.

The report highlighted that Iceland stands poised to take decisive steps to upgrade financial sector oversight. Much restructuring of the financial system has been achieved since the crisis and the three main banks appear sound at this time. Non-performing loans (NPLs) are low, but there is room to further develop the credit risk register of FME as a supervisory tool to assess loan quality. The credit register may become a valuable tool for onsite inspection planning. Liquidity risk has fallen, but banks’ reporting of liquidity coverage ratios well in excess of the regulatory floor warrants further analysis. Oversight of other non-banks and markets, too, must be rigorous, as must consumer and investor protection. During the assessment of the 2014 Basel Core Principles in Iceland, FME was found to be weak, which resulted in staff emphasizing the need for further improvements. Staff saw merit in unifying prudential oversight and resolution of banks. This would capitalize on the established independence of the Central Bank of Iceland; recognize basic synergies between the oversight, lender-of-last-resort, and resolution functions; allow an integrated approach to micro- and macro-prudential policy; and create a less complex system well-suited to a country as small as Iceland. It would also eliminate the unnecessary overlaps between the Central Bank of Iceland and FME in bank liquidity oversight. 

However, the staff warned that, to succeed, the new oversight function would need powers and resources. Restructuring would entail risks—central bank independence could be challenged as new, politically sensitive roles are taken on and incentives for regulatory forbearance could arise when lender-of-last-resort exposures are large. Conversely, though, if the supervisory agency was left beholden to the executive branch, the legislature, or both for its resources and authority, then regulatory and supervisory independence would be fundamentally hobbled. Ultimately, in any structure, political will, operational independence with accountability, rulemaking and enforcement powers, technical capacity, and resource adequacy would remain central and indispensable. The report also noted that a white paper on the future of financial services in Iceland, currently being prepared by a government-appointed committee, is expected to lay out a vision for state ownership in the financial sector. Staff urged that Iceland energize its efforts to combat financial crime. The Financial Action Task Force’s 2018 mutual evaluation report has identified priority areas and made a series of recommendations, indicating that insufficient progress could push Iceland to its gray list. With events elsewhere showing how anti-money laundering deficiencies can create stability risks, it is important that such reclassification be preempted by implementing the needed correctives.

 

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Keywords: Europe, Iceland, Banking, Article IV, Macro-prudential Policy, CCyB, Resolution, FME, IMF

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