## 1islea2023002

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### EXECUTIVE SUMMARY — Background and recent developments
- Iceland’s financial system weathered the Covid pandemic well due to post-GFC reforms including:
  - restructuring of banks; the merger of the CBI and the FSA; strengthening of banking supervision since the 2014 ROSC; implementation into Icelandic law of EU regulations and directives; set-up of a macroprudential framework; and creation of a resolution authority at the CBI.
- Financial and non-financial balance sheets were relatively strong at pandemic onset.
- Policies during the pandemic eased burdens on households and key sectors (tourism and fishing).
- Rising inflation prompted policy rate hikes; macroprudential policies related to real estate exposures were tightened.

### Principal risks
- Key risks: a tightening of global financial conditions and stagflation.
  - Potential impacts: disruptions to cross-border funding; credit risk from real estate market adjustment causing losses to banks and connected pension funds; excessive debt burdens and distress among some non-financial corporates and households.
- Cyber-risks, including risks to payment systems, are highlighted.
- Domestic financial system is highly interconnected and exposed to inward cross-border contagion; banks and pension funds can transmit shocks to each other.

### Resilience and vulnerabilities — Stress-test highlights
- Solvency
  - D-SIBs are resilient to solvency stress under the adverse scenario calibrated to a GFC-like real GDP decline over two years.
  - Bank capitalization falls by 5.6 percentage points (aggregate CET1 decline reported elsewhere as 5 .2 percentage points at trough in a related test) but remains above hurdle rates.
  - Real estate sector is particularly prone to cyclical risks; sensitivity analyses show high bank sensitivity to interest rate changes.
  - Simultaneous default of five largest NFC borrowers under LGD 100 percent: aggregate CET1 ratio declines by 9.3 percentage points; two out of three D-SIBs may not meet regulatory minimum CET1.
  - Additional parallel 2 percentage points yield curve increase causes an additional 210 basis points decline in aggregate capital at the trough and 250 basis points by end-horizon; two banks fail to meet hurdle rates under that shock.
- Liquidity
  - Banks’ aggregate LCR is resilient but exposed to pension fund and foreign funding outflows.
  - Aggregate LCR declines from 210 percent to 122 percent in the most severe scenario; with additional pension and foreign funding outflows aggregate LCR falls to 76 percent and an additional bank breaches the minimum.
  - Cashflow-based stress tests indicate vulnerabilities beyond 30 days and currency-specific vulnerabilities for EUR and USD; none of the D-SIBs would meet Krona threshold under the most severe currency scenario.
  - Systemic FX liquidity stress tests point to FX gaps: banks could face FX liquidity gaps reaching 3.4 billion US dollars (about half of gross international reserves as of end-2022) when local currency conversion is allowed and NBFIs and the private sector move assets offshore.
  - Gross international reserve is at USD 5.8 billion as of end-2022; net international reserves (netting FX government bonds placed as government deposits at the CBI) roughly 3.7 billion US dollars.
- Pension funds
  - Median pension fund pension values decline by 13 percent in 2023 and another 3 percent in 2024 under the adverse scenario before recovering in 2025.
  - Representative member with 10 years to retirement sees future pension values decline by 9-15 percent (median 13 percent).
  - Exposures to Icelandic banks amount to 10 percent of PF assets; exposure to the largest banking counterparty close to 4 percent.
  - Exceptional Pillar III withdrawals noticeably impact pension funds’ cashflows.

### Interconnectedness and contagion
- Domestic financial system is highly interconnected across banks, pension funds, and investment funds.
- Interbank direct contagion is limited; however, contagion between banks and pension funds via credit and funding channels is sizeable.
  - Model assumptions used: LGD during a credit shock set at 70 percent; loss factor due to funding shortfall in a funding shock set at 50 percent.
- Cross-border: Icelandic banks face inward spillovers from U.S., Belgium, Canada, Norway, Denmark and other European countries; two-thirds of exposures from European countries; exposures outside Europe (U.S. and Canada) account for 30 percent.

### Systemic vulnerabilities and cyclical risks
- Financial Cyclical Indicator (FCI) peaked end-2021 and has declined but remains high.
- Real estate price misalignment estimated between 6.2 and 17.6 percent as of 2022:Q2.
- Household and CRE vulnerabilities: household leverage, high real estate valuations, and increased risk-taking in CRE via higher bank lending.
- Non-financial corporate debt around 95 percent of GDP end-2022; share of external corporate debt down to 17 percent by end-2022 from about 50 percent in 2008.

### Macroeconomic and financial starting indicators (selected)
- Public debt declined by more than 50 percentage points of GDP since the Global Financial Crisis.
- Private and external debt declined by 200 percent of GDP since the GFC.
- International reserves remained above 20 percent of GDP in 2022; gross international reserves 22 percent of GDP by end-2022.
- Real GDP increased by 6.4 percent in 2022.
- External debt 75 percent of GDP by end-2022.
- Unemployment rate 3.1 percent by December 2022.
- Total financial sector assets 410 percent of GDP in September 2022.
- Banking system assets 135 percent of GDP; three commercial banks account for 95 percent of banking assets.
- Pension fund sector assets 176 percent of GDP at end-2022; PF foreign-denominated assets 35 percent as of end-2022; bill approved to gradually allow higher allocation up to 65 percent by 2036.
- Households’ asset position 310 percent of GDP by end-2021; >60 percent of household asset exposures to PFs, ~13 percent to banks.

### Stress-test scenarios and key calibrated shocks
- Bank solvency adverse scenario: implies a 13 percent shock to real GDP growth relative to baseline and a 9.3 percent decline relative to starting point over two years; calibrated to a 2.2 standard deviation shock to real GDP growth over 2023-2024.
- Liquidity stress scenarios S1–S6 include calibrated run-off/shock parameters (selected examples preserved exactly):
  - Stable retail deposits: S1 5% ; S2 10% ; S3 5% ; S4 10% ; S5 10% ; S6 10%.
  - Non-operational deposits other than financial institutions: S1 20-40% ; S2 20-40% ; S3 30-50% ; S4 30-50% ; S5 30-50% ; S6 30-50%.
  - Non-operational deposits financial institutions: 100% across S1–S6.
  - Pension funding (other than non-operational deposit): S1 0% ; S2 0% ; S3 0% ; S4 0% ; S5 10% ; S6 15%.
  - Foreign funding (other than non-operational deposit): S1 0% ; S2 0% ; S3 0% ; S4 0% ; S5 15% ; S6 25%.
  - Level 1 covered bonds: S3 -20/-3% ; S4 -20/-3% ; S5 -20/-3% ; S6 -20/-3%.

### Key FSAP recommendations (summary by theme)
- Macroprudential policies
  - Close data gaps related to non-financial private sectors (households, NFCs). — CBI: I
  - Continue closely monitoring cyclical risks in the real estate market and corporates; take further macroprudential measures if risks persist.
  - Develop a heatmap and regularly publish reports on risk analysis; strengthen analytical capacity on tail risks, spillovers, systemic risks and calibration of macroprudential tools.
- Banking supervision and regulation
  - Safeguard the CBI’s independence, accountability, and operational effectiveness for banking supervision by:
    - removing MoFEA staff from the Financial Supervision Committee (FMEN);
    - implementing a formal delegation of authority for decision making within the CBI;
    - developing and implementing a streamlined and independent budgetary process for supervision;
    - ensuring legal protection of supervisors;
    - increasing staffing in key risk areas; and
    - adopting specific national guidance in certain key risk areas.
  - Issue application regulations or supervisory guidance to banks for proportional implementation of EU rules and EBA guidelines; ensure compliance with Basel standards.
  - Implement a comprehensive on-site inspection program covering all material risk domains and integrate climate-risks into supervisory processes.
- Pension funds regulation and supervision
  - Strengthen legislative framework for governance and internal controls; enact more stringent rules on outsourcing.
  - Expand CBI supervisory and sanctioning powers; increase on-site inspections at larger pension funds; define infringements and sanctions in the Pension Fund Act.
  - Align rules with IORP II or Solvency II; perform data quality checks and expand automated validation rules.
- Crisis management, resolution, and safety nets
  - Establish a coordination body on resolution issues between MoFEA and the CBI (RA) while preserving RA independence.
  - Increase RA resources and operationalize the resolution framework:
    - Put in place implementation rules and procedures; operationalize resolution plans; develop operational guidance on FOLTF and all resolution tools; approve and test crisis management handbook; operationalize application of all resolution tools (not just bail-in).
  - Strengthen the Deposit Guarantee Fund (TVF) in line with IADI Core Principles and reduce maximum disbursement deadline to seven days.
- Systemic liquidity management
  - Develop a repo market; intensify monitoring of ELA-eligible collateral; strengthen cooperation through swap lines with other central banks to ensure FX liquidity access in stress.
  - Operationalize ELA collateral eligibility and testing.
- Cyber-resilience
  - Produce a financial sector–specific cybersecurity strategy, particularly for payment systems.
  - Improve oversight resources; investigate alternative domestic retail payment solutions; refine playbooks to test cash distribution in a crisis.
- AML/CFT
  - Deepen supervisory AML/CFT risk assessment; increase supervisory presence.
  - Ensure banks maintain adequate, accurate and up-to-date beneficial ownership information; continue detecting unlicensed VASPs.
- Climate-related financial risks
  - Integrate climate-related financial risks into supervisory process via a concrete action plan addressing data gaps and enhanced supervision.

### Implementation timing — selected items (timing labels preserved)
- NT—near-term: 1–3 years; MT—medium-term: 3–5 years; I—Immediate: within one year.
- Examples:
  - Increase CBI resources for oversight of market risks, IRRBB, financial climate risks, operational risks (ICT risk and cybersecurity); and for the RA. — CBI: NT
  - Close data gaps related to non-financial private sectors (households, NFCs). — CBI: I
  - Remove MoFEA staff from CBI’s FMEN and implement internal delegation of powers framework. — MoFEA, CBI: NT
  - Develop a repo market and operationalize the ELA, including assessment of collateral eligibility. — CBI: NT
  - Adopt a seven-day deadline for the Icelandic Depositors’ and Investors’ Guarantee Fund (TVF) disbursements and grant TVF access to adequate external funding sources. — CBI (RA): NT

### Authorities’ views and priorities
- Authorities welcomed the positive assessment of financial system resilience and progress since 2008, broadly agreed with systemic risk assessment and noted resilience reflects strong capital buffers and reforms.
- Agreed priorities include strengthening ELA framework for resolution, improving bank recovery and resolution framework, increasing RA resources, and developing crisis preparedness and management.
- Authorities confirmed continuing to strengthen AML/CFT and to develop a strategy for banking supervision of climate-related financial risks; they have devoted resources to strengthen cyber-risk oversight, including implementation of the European TIBER framework in Iceland.

### Appendix II — Stress test frameworks and selected quantitative outputs
- Banking solvency top-down:
  - Institutions: top three commercial banks (about 95 percent of deposit-taking corporations’ assets).
  - Adverse scenario calibrated to a 2.2 standard deviation shock to real GDP growth over 2023-2024; VARX with endogenous vector: real GDP, unemployment rate, CPI, policy rate, NEER, real loans; exogenous: US real GDP and oil price + GFC dummy.
  - Reverse-stress-testing: an additional 80bps of CCyB (relative to 2 percent starting point) required for all banks to remain above hurdle rate; CCyB of 2.8 percent keeps all banks above hurdle in reverse-stress test.
- Liquidity and cash-flow stress tests:
  - LCR hurdle: 100 percent aggregate; NSFR limit 100 percent.
  - Cash-flow horizon up to 12 months; LCR one-month horizon.
  - Systemic FX gap under severe scenario: 3.4 billion US dollars.
- Pension fund top-down adverse scenario (2023-2025) shocks (reported exactly):
  - Interest rates: short-term rates +171 bps, long-term rates +212 bps in 2013.
  - Equity price: -79.8 percent for listed domestic shares, and -32.0 percent for foreign shares in 2013.
  - ISK depreciation: -30.6 percent in 2023.
  - Inflation: 8.6 percent in 2023.
- Macro-financial second-round findings (SVAR):
  - Macroeconomic trough (occurs in 2024): Real GDP 3.8 percent lower; Unemployment 1.6 percentage points higher; Housing prices 9 percent lower.
  - Aggregate CAR lower than in first round by 1.2 percentage points in 2024 and by 1.7 percentage points in 2027.
  - In the second round one of the three banks falls slightly below at the trough while aggregate capitalization remains above the hurdle rate.

*Source: IMF 2023 FSAP Executive Summary and selected chapters (content unit: 1islea2023002).*

### EXECUTIVE SUMMARY __________________________________________________________________________ 8

### EXECUTIVE SUMMARY

### Background and recent developments
- Iceland’s financial system weathered the Covid pandemic well, reflecting substantially improved macro-financial frameworks since the GFC, including:
  - restructuring of banks;
  - the merger of the CBI and the FSA;
  - strengthening of banking supervision since the 2014 ROSC;
  - implementation into Icelandic law of EU regulations and directives;
  - set-up of a macroprudential framework; and
  - creation of a resolution authority at the CBI.
- Financial sector and non-financial sectors’ balance sheets were relatively strong at the onset of the pandemic.
- During the pandemic, policies eased burdens on households and key sectors (tourism and fishing).
- Rising inflation prompted policy rate hikes, and macroprudential policies related to real estate exposures have been tightened.

### Principal risks
- Key risks: a tightening of global financial conditions and stagflation.
  - Potential impacts: disruptions to cross-border funding of banks and other funding markets; credit risk from real estate market adjustment causing losses to banks and connected pension funds; excessive debt burdens and distress among some non-financial corporates and households.
- Cyber-risks, including risks to payment systems, are highlighted.
- The domestic financial system is highly interconnected and exposed to inward cross-border contagion; banks and pension funds can transmit shocks to each other.

### Resilience and vulnerabilities (stress-test findings)
- Solvency
  - Systemically important banks (D-SIBs) are resilient to solvency stress under the adverse scenario.
  - The real GDP decline over a two-year horizon in the adverse scenario is broadly aligned with the GFC.
  - Bank capitalization remains above the hurdle rate, falling by 5.6 percentage points at the trough.
  - Real estate sector is particularly prone to cyclical risks.
  - Sensitivity analyses show high bank sensitivity to interest rate changes.
  - Stress tests of the non-financial corporate sector confirm presence of some vulnerabilities.
- Liquidity
  - Banks’ LCR on aggregate are resilient to adverse liquidity conditions but exposed to liquidity outflows from pension funds and foreign funding.
  - Cashflow-based stress tests indicate vulnerabilities beyond 30 days.
  - Both LCR and cashflow-based tests reveal vulnerabilities to individual currency-denominated outflows.
  - Systemic liquidity stress tests point to FX gaps; international reserves of the central bank appear adequate to backstop liquidity needs.
- Pension funds
  - Stress tests point to substantial decline in pension funds’ assets during early years of the projection horizon, materially reducing future pension values.
  - Concentrated exposures towards domestic banks have risen further.
  - Exceptional withdrawals from Pillar III have a noticeable impact on pension funds’ cashflows.

### Interconnectedness and contagion
- The domestic financial system is highly interconnected.
- Banks and pension funds can transmit shocks to each other.
- There is exposure to inward cross-border contagion.

### Key FSAP recommendations (summary by theme)
- Macroprudential policies
  - Close data gaps related to non-financial private sectors (households, NFCs).
  - Continue closely monitoring cyclical risks in the real estate market and corporates; take further macroprudential measures if risks persist.
  - Further enhance transparency and accountability by developing a heatmap and regularly publishing reports on risk analysis.
  - Strengthen analytical capacity on tail risks, spillovers, systemic risks and calibration of macroprudential tools.
- Banking supervision and regulation
  - Safeguard the CBI’s independence, accountability, and operational effectiveness for banking supervision by:
    - removing MoFEA staff from the Financial Supervision Committee (FMEN);
    - implementing a formal delegation of authority for decision making within the CBI;
    - developing and implementing a streamlined and independent budgetary process for supervision;
    - ensuring legal protection of supervisors;
    - increasing staffing in key risk areas; and
    - adopting specific national guidance in certain key risk areas.
  - Issue application regulations or supervisory guidance to banks for appropriate and proportionate implementation of EU rules (ensure compliance with Basel standards) and EBA guidelines.
  - Implement a comprehensive on-site inspection program for banks’ risk management practices across all material risk domains and integrate climate-risks into supervisory processes.
- Pension funds regulation and supervision
  - Strengthen legislative framework for governance and internal controls (board nominations and oversight; actuarial and compliance functions).
  - Enact more stringent rules on function outsourcing.
  - Expand CBI supervisory and sanctioning powers; increase on-site inspections at larger pension funds; define infringements and sanctions in the Pension Fund Act.
  - Align rules on governance, internal controls, risk management with IORP II or Solvency II.
  - Perform data quality checks for pension funds’ supervisory reporting data; require corrections and expand automated validation rules.
- Crisis management, resolution, and safety nets
  - Establish a coordination body on resolution issues between MoFEA and the CBI (RA) while preserving RA independence.
  - Increase RA resources and continue strengthening the resolution framework, including:
    - putting in place implementation rules and procedures;
    - operationalizing resolution plans;
    - developing operational guidance on FOLTF and all resolution tools;
    - approving the crisis management handbook and testing it in a crisis simulation exercise; and
    - operationalizing the application of all resolution tools (not just bail-in).
  - Strengthen the Deposit Guarantee Fund in line with IADI Core Principles and reduce maximum disbursement deadline to seven days.
- Systemic liquidity management
  - Develop a repo market, including proper incentives for market participants.
  - Intensify monitoring of ELA-eligible collateral.
  - Strengthen cooperation, through swap lines, with other central banks to ensure banks’ access to FX liquidity if significant stress emerges.
- Cyber-resilience
  - Produce a financial sector–specific cybersecurity strategy, particularly for payment systems.
  - Improve resources for oversight and investigate alternative domestic retail payment solutions in the event of significant disruption to the credit and debit card system.
  - Refine playbooks to test how cash will be distributed and used in a crisis.
- AML/CFT
  - Deepen the supervisory AML/CFT risk assessment; enhance supervisory effectiveness through increased supervisory presence.
  - Ensure banks maintain adequate, accurate and up-to-date information on beneficial ownership and control of legal persons; continue detecting unlicensed virtual asset service providers.
- Climate-related financial risks
  - Further integrate climate-related financial risks into the supervisory process through a concrete action plan addressing data quality and availability gaps and more thorough banking supervision of climate-related risks.

### Implementation timing (selected items from Table 1)
- NT—near-term: 1–3 years; MT—medium-term: 3–5 years; I—Immediate: within one year.
- Examples:
  - Increase resources at the CBI for oversight of market risks, IRRBB, financial climate risks, operational risks (ICT risk and cybersecurity); and for the RA. — CBI: NT
  - Close data gaps related to non-financial private sectors (households, NFCs). — CBI: I
  - Remove MoFEA staff from CBI’s FMEN and implement internal delegation of powers framework. — MoFEA, CBI: NT
  - Develop a repo market and operationalize the ELA, including assessment of collateral eligibility. — CBI: NT
  - Adopt a seven-day deadline for the Icelandic Depositors’ and Investors’ Guarantee Fund (TVF) disbursements and grant TVF access to adequate external funding sources. — CBI (RA): NT

*Source: IMF 2023 FSAP Executive Summary (Iceland).*

### 1.      Iceland entered COVID-19 with favorable economic conditions and weathered the

### 1islea2023002 - 1. Iceland entered COVID-19 with favorable economic conditions and weathered the

### Macroeconomic starting point and pandemic impact
- Public debt has declined by more than 50 percentage points of GDP since the Global Financial Crisis.
- Private and external debt have declined by 200 percent of GDP.
- International reserves have remained above 20 percent of GDP in 2022; gross international reserves stood at 22 percent of GDP by end-2022.
- Banks’ balance sheets have been solid, with significant capital and liquidity buffers.
- The tourism sector was paralyzed by the pandemic—the engine of growth since 2012—prompting a range of monetary, fiscal, and macroprudential measures to ease the burden on households and the most affected sectors.

### Recovery, inflation, and labor market
- Real GDP increased by 6.4 percent in 2022, driven mainly by domestic demand and export recovery, and exceeding its pre-pandemic level.
- Recovery contributed to inflation and current account deficits and reversed a decade-long trend of surpluses.
- External debt was 75 percent of GDP by end-2022.
- Unemployment rate was 3.1 percent by December 2022, below pre-pandemic levels.

### Monetary and macroprudential policy response
- The Central Bank of Iceland (CBI) raised policy rates 13 times by a total of 800 basis points since April 2021, reaching 8.75 percent in May 2023.
- Macroprudential measures:
  - Debt-service-to-income (DSTI) limit introduced in 2021; DSTI limit is set at 35 percent in general, but for first time buyers it stands at 40 percent.
  - Loan-to-value (LTV) limit for mortgages lowered from 85 percent to 80 percent; LTV for first-time mortgage borrowers was lowered from 90 to 85 percent in June 2022.
  - Countercyclical capital buffer (CCyB) raised up to 2.5 percent in March 2023.
- Rising housing costs, strong domestic demand, and second-round effects of global energy and food prices fueled core inflation and inflation expectations, with concerns about de-anchoring in 2022.

### Climate-related risks
- Iceland is exposed to climate-induced physical risks including sea acidification and melting of glaciers, and adaptation risks affecting fishery and transportation sectors.
- Transportation and manufacturing sectors are exposed to transition risks.
- The 2020 Climate Action Plan and the 2021 Strategy on Adaptation to Climate Change include objectives towards carbon neutrality.

### Financial sector structure and scale
- Total financial sector assets reached 410 percent of GDP in September 2022.
- Banking system assets were 135 percent of GDP; four commercial banks and five savings banks; three commercial banks account for 95 percent of banking assets.
- Pension fund (PF) sector:
  - Total assets of the fully funded PF sector amounted to 176 percent of GDP at end-2022.
  - PFs provided mandatory Pillar II and Pillar III pensions via 21 autonomous PFs; most schemes categorized as defined ambition.
  - Funding ratios of most defined-ambition schemes have dropped below 100 percent.
  - Exposures: PFs’ exposures to Icelandic banks account for 10 percent of total PF assets and 14 percent of banks’ financial liabilities; holdings of sovereign bonds account for 21 percent of PF assets.
  - PFs active in mortgage market with outstanding volume amounting to 23 percent of the outstanding mortgage volume.
  - Share of foreign-denominated assets reached 35 percent of assets as of end-2022.
  - For Pillar II pension funds, share of foreign-denominated assets is capped at 50 percent; a bill was approved to gradually allow higher allocation up to 65 percent by 2036.
- Households’ asset position amounted to 310 percent of GDP by end-2021; more than 60 percent of HHs’ asset exposures are to PFs and around 13 percent are to banks.

### Interconnectedness and cross-border exposures
- Interconnectedness increased, driven by households’ and PFs’ assets and exposures to banks, and PFs’ exposure to investment funds.
- Icelandic banks’ largest cross-border counterparties include U.S., Belgium, Canada, Norway, and Denmark; around two-thirds of exposures come from European countries; exposures outside Europe (U.S. and Canada) account for 30 percent of total exposures.

### Systemic vulnerabilities and cyclical risks
- A Financial Cyclical Indicator (FCI) shows vulnerabilities started to decline from the peak at end-2021 but remain high.
- Key vulnerabilities include household leverage amid high real estate valuations and signs of increased risk-taking in Commercial Real Estate (CRE) via higher bank lending.
- Real estate price misalignment estimated to range from 6.2 to 17.6 percent as of 2022:Q2; higher building costs, income growth, net migration, and short-term rental demand from tourism contributed to price inflation.
- An abrupt correction in real estate prices could cause financial losses to corporates, households, and financial institutions.

### Banking system soundness and risks
- Banks’ capital ratios are well above regulatory minima; CET1 ratio at 20 percent as of 2022Q3.
- Liquidity: LCR increased from 151 in mid-2022 to 210 percent in 2022Q3, driven by a one-off inflow to pay off maturing bonds, but banking sector liquid assets overall shrunk in 2022.
- Profitability is robust due to high interest margin, low provisions, high fees and commissions, and low cost-to-asset ratio.
- Non-performing loans are below 2 percent, supported by economic recovery; many tourism loans were placed under forbearance when loan deferral program expired in September 2020.
- Indexed exposures: as of 2022Q3, roughly 22 percent of total loans and 17 percent of total liabilities are inflation-indexed; indexed and non-indexed products pose differentiated credit risks and merit close monitoring.
- Funding vulnerabilities:
  - Foreign funding (mainly unsecured debt securities and nonresident deposits) accounts for about 25 percent of total funding and funds FX-denominated corporate loans.
  - It is expected that 16 percent (or 130 billion Krona) of FX bond will mature in 2023, and 23 percent (or 185 billion Krona) will mature in 2024.
  - Pension funds are an important funding source through holdings of shares, direct deposits, or covered bonds; banks could face funding pressures if PFs shift investments from domestic to foreign markets.

### Non-financial corporates and corporate distress
- Non-financial corporate sector debt was around 95 percent of GDP at the end-2022.
- Share of external debt in total corporate debt declined from about 50 percent in 2008 to 17 percent by end-2022.
- NFCs remain highly dependent on loan financing.
- Pandemic effects:
  - Enterprises’ sales dropped and corporate debt distress increased; profitability declined while leverage remained contained.
  - Firm-at-risk and debt-at-risk (ICR lower than 1.5) increased by 2.4 and 3.1 percentage points, respectively, in 2020 compared to the prior year.
  - Aggregate non-performing loans on D-SIBs’ lending to NFCs increased marginally during the pandemic.

*Source: IMF staff compilation from the provided chapter text.*

### 17.      Household debt increased marginally during the pandemic but has been on a

### 17.      Household debt increased marginally during the pandemic but has been on a

### Household debt trends and debt-service capacity
- Household debt increased marginally during the pandemic but has been on a downward trajectory since the GFC (Figure 11).
- As of end-2022, floating rate mortgages account for 45 percent of total mortgages. The fixed rate loans are not fixed for longer than 3 to 5 years.
- Real wage increase, about 7 percent higher than in 2019, has boosted households’ debt service capacity.
- Outstanding debt-to-disposable income and DSTI dynamics are tracked in Figure 11 (Debt and Debt Service to Income).

### Debt-service-to-income (DSTI) simulations and borrower vulnerability
- CBI simulations suggest that, comparing the DSTI at origination versus in January 2023:
  - the share of borrowers with DSTI above 35 percent increases from about 7 percent to 15 percent.
  - Based on updated income as of January 2023, the share increases from about 7 percent to 9 only.
- Change in Debt Service of New Mortgages is presented across DSTI buckets (e.g., 2,5% up to >60%).

### Bank solvency stress tests — design and scenario severity
- Stress test covered 3 D-SIBs, accounting for about 95 percent of total banking system assets, using supervisory data as of Q3-2022.
- Adverse stagflation scenario:
  - Shock to real GDP is as severe as the GFC over a two-year horizon.
  - Scenario implies a 13 percent shock to real GDP growth relative to the baseline, and a 9.3 percent decline relative to the starting point over a two-year horizon.
  - Severity closely aligned with the 5 percent Growth-at-Risk estimate, implying the 13 percent shock noted above.
- Scenario design references μ and σ as historical mean and standard deviation of the 2-year cumulative GDP growth.

### Solvency stress-test results and contributors to capital decline
- The solvency stress test confirms the sector’s resilience to severe but plausible macroeconomic shocks (Figure 14).
- Aggregate fully loaded CET1 ratio declines by 5 .2 percentage points at the trough, and no bank sees its capital ratios fall below the hurdle rates, owing to high initial capital positions.
- Credit risk provisioning is by far the largest contributor to the decline in capital ratios.
- Contribution from market risk is relatively small given small holdings of trading securities.
- Hurdle rates under the adverse scenario: minimum CET1, T1, CAR ratio (4.5, 6 or 8 percent) plus SRB, O-SII and Pillar II buffer; banks allowed to deplete CCyB and CCoB under the adverse scenario.

### Interest-rate sensitivity
- Sensitivity analysis: an additional 2 percentage points parallel increase along the yield curve causes:
  - an additional 210 basis points decline in aggregate capital relative to the initial adverse scenario results at the trough,
  - and 250 basis points by the end of horizon.
- Under that additional interest-rate shock, two banks fail to meet the hurdle rates.
- Risk-factor decomposition includes LLP=loan loss provision, NII=net interest income, MtM=marked-to-market of tradable securities, other=net impact mainly from RWA and reduced dividend distribution.

### Corporate-default and concentration risk analysis
- Simultaneous default of the five largest NFC borrowers under zero-recovery (LGD 100 percent) scenario:
  - Aggregate CET1 ratio declines by 9.3 percentage points, and two out of three D-SIBs may not meet the regulatory minimum CET1 capital.
- Under LGD 40 percent and LGD 60 percent scenarios, no banks breach hurdle rates.
- Increasing PD values for key sectors indicate the highest capital impact would come from real estate activities.
- Concentration risk chart reports CET1 impacts by industry (Agriculture, forestry and fishing; Manufacturing; Construction; Accommodation and food service activities; Real estate activities) and by original PD and higher PDs (OriginalPD=10, PD=20, PD=30).

### Macro-financial second-round effects (feedback to banks)
- VAR-based second-round analysis links initial capital shock to bank lending and macro variables.
- Results: in the second-round, one of the three banks falls slightly below at the trough but aggregate capitalization remains above the hurdle rate (Appendix VIII).

### Liquidity stress tests — bank-level resilience and vulnerabilities
- Across three main stress scenarios, aggregate LCR:
  - declines from 210 percent to 122 percent in the most severe scenario, and one bank’s LCR falls marginally below the minimum.
  - When assuming additional liquidity outflow from pension and foreign funding, one more bank breaches the minimum threshold, and aggregate LCR falls to 76 percent.
- Bank cashflow-based stress test indicates potential liquidity gaps beyond 30-days due to maturity mismatch between cash inflows and outflows.
- Currency-specific vulnerabilities:
  - Under the most severe scenario, one bank would breach the 100 percent threshold in Euros and another in U.S. dollars.
  - None of the D-SIBs would meet the threshold in Icelandic Krona.
  - Post-shock total currency NSFR saw no bank falling below the 100 percent threshold, but US dollar vulnerabilities remain material.
- For individual significant currencies, current LCR regulatory minimums: 50 percent for Krona, 80 percent for Euro. There is no LCR limit set for the US Dollar.

### Systemic liquidity stress tests and FX liquidity gap
- Systemic liquidity stress test simulates joint FX outflows from domestic household and corporate deposits, nonresident deposits, maturing international bonds, and additional funding shocks from PFs and other NBFIs as they move assets offshore; exercise allows currency conversion into FX.
- Findings point to an FX liquidity gap for the banking sector; under the severe scenario:
  - banks could face FX liquidity gaps reaching 3.4 billion US dollars (about half of gross international reserves as of end-2022) when local currency conversion is allowed and NBFIs and the private sector move some domestic assets offshore.
- Gross international reserve is at USD 5.8 billion as of end-2022.
- When netting FX government bonds placed as government deposits at the CBI, net international reserves amount to roughly 3.7 billion US dollars.
- Even under the most severe scenario, gross and net international reserves remain positive.

*Source: IMF Staff.*

### 27.      Contagion risks from interbank exposures through credit and funding channels are

### 27. Contagion risks from interbank exposures through credit and funding channels are limited, but they are sizeable between banks and pension funds.

### Interbank contagion and funding channels
- Domestic interbank exposures are small; no single failure of a domestic bank would trigger failure of other banks in the system and none of the three banks are found to be undercapitalized after shock.
- PFs (pension funds) are large creditors of banks and would be significantly impacted by a credit shock from banks; banks are in turn vulnerable to funding shocks from pension funds.
- Model assumptions and parameters:
  - Loss-given-default (LDG) during a credit shock is set at 70 percent.
  - Loss factor due to funding shortfall in a funding shock is set at 50 percent.
- Bank FX cash flow analysis (Figure 19) indicates inward spillovers from other financial centers can negatively affect Icelandic banks even though Icelandic banks are not a source of contagion risk to other major economies; the Icelandic banking sector remains resilient after the shocks are considered.

### Cross-border contagion
- Icelandic banks are exposed to cross-border contagion via inward spillovers from other financial centers, though they are not a major source of contagion to other economies.
- After considered shocks, the Icelandic banking sector remains resilient (Figure 19).

### Risk analysis of pension funds (PFs)
- Methodology:
  - The analysis projects differences in pension values at retirement age between baseline and adverse scenarios for representative members with 10 to 30 years to retirement.
  - Accrued pension benefits are shocked with market risk stresses in each of the first three years of the projection horizon; afterwards annual investment returns return to baseline.
- Asset and pension-value impacts under the adverse scenario:
  - For the median pension fund, pension values decline by 13 percent in 2023 and another 3 percent in 2024, before recovering in 2025.
  - For a representative member with 10 years to retirement, future pension values decline by 9-15 percent (median decline cited as 13 percent).
  - Impact for members at 30 years to retirement is described as modest.
  - In the first year, depreciation of the Krona increases the value of FX-denominated investments, partially offsetting losses.
- Sensitivities and drivers:
  - Lowering the reference rate from 3.5 to 3.0 percent would increase the value of liabilities by almost 15 percent and deteriorate the actuarial position.
  - Assuming a decline of mortality rates by 10 percent would increase liabilities only slightly by around 2 percent.
- Liquidity and flows:
  - Withdrawals from Pillar III funds impact liquidity conditions; Pillar II does not allow withdrawals except for retirement, death, or disability.
  - Pillar III cash flows affected by transfers between funds, mortgage loan repayments deductible from contributions, and extraordinary withdrawals (which occurred during the GFC and the pandemic and noticeably impacted PFs' cashflows).
- Asset-side vulnerabilities:
  - Losses on mortgage loans have been very low in recent years, but default probabilities could increase as interest rates rise.
  - All large PFs have the three large domestic banks among their largest single-name corporate exposures; while exposures remain below microprudential limits, sectoral concentration and contagion findings warrant close monitoring.
  - Exposures towards the domestic banking sector have increased to 10 percent of assets.
  - The exposure towards the largest banking counterparty amounts to close to 4 percent.
  - Mean LTV ratios of newly issued mortgage loans have been fluctuating around 50 percent recently; mean DSTI ratios have increased slightly, ranging slightly above 20 percent for most pension funds as of mid-2022.

### Policy and supervisory recommendations for pension funds and data quality
- The CBI (FSA) should continue striving for enhanced supervisory reporting quality and closely monitor risks:
  - Use automated validation rules to reject inconsistent PFs’ reporting.
  - Closely monitor effects of high interest rates and inflation on PFs’ investment behavior, counterparty default risk, and Pillar III cash flows (particularly for smaller PFs).
  - Investigate pricing of mortgage loans and related risk management.
- Targeted review recommendations:
  - Strengthen governance and internal controls in the Pension Fund Act (board nominations and oversight, actuarial and compliance functions).
  - Enact more stringent rules on outsourcing.
  - Expand sanctioning powers of the CBI and transfer regulatory and supervisory tasks from the MoF to the CBI.
  - Conduct more on-site inspections at larger pension funds and re-establish institutionalized supervisory dialogue.

### Stress tests of the non-financial corporate (NFC) sector
- Key stress-test findings:
  - Debt at risk increases under the adverse scenario:
    - The share of debt for firms with an ICR<1 rises to 96 percent, 26 percentage points higher than under the baseline in the first year.
    - The share of debt in firms with negative cash balance surges 25 percentage points higher than under the baseline.
  - Interest-rate sensitivity:
    - A 30 percent change in interest expenses increases the share of debt for firms with an ICR<1 by 13 percent.
    - A hike in interest rate expenses also yields a surge in the share of firms with cash balance below zero.

### Microprudential oversight of banks — findings and recommendations
- Progress since 2014:
  - Implementation of Basel III requirements and transposition of the EU legislative framework and EBA guidelines into Icelandic banking law.
  - Adoption of the EBA SREP methodology focusing mainly on the three D-SIBs.
- Remaining supervisory gaps and recommended actions:
  - Safeguard CBI independence and governance:
    - Remove MoFEA staff from the Financial Supervision Committee (FMEN) to avoid conflicts of interest and ensure CBI discretion over prudential supervision decisions.
    - Implement a formal delegation of authority for decision making within the CBI to ensure accountability.
    - Develop and implement a streamlined and independent budgetary/funding process to ensure timely funding of banking supervision.
    - Update legislation to ensure legal protection of supervisors, broaden the legal definition of related-party transactions, and broaden CBI/FSA’s prudential oversight power over banks’ external auditors.
  - Increase staffing in key risk areas: market risk, IRRBB, and operational risk (including ICT risk and cybersecurity) to address key person vulnerabilities and enhance supervisory coverage.
  - Issue national, risk-focused supervisory guidance tailored to the domestic environment in areas such as operational risk, FX funding risk, and monitoring LCR by currency; address outlier banks through Pillar 2 and supervisory actions.
  - Strengthen on-site inspections and supervisory planning:
    - Increase SREP coverage frequency for low/medium-low impact banks.
    - Deepen and broaden on-site inspection scope to assess risk management practices across all risk domains.
    - Plan off-site thematic reviews on a multi-year cycle involving prudential supervision, conduct supervision, and financial stability functions.

### Oversight of climate-related financial risks
- Current status:
  - Climate-related credit risk analyses and ESG considerations have been incorporated within SREP for larger banks; enhanced Pillar 3 ESG disclosure occurred in 2022.
  - Data collection challenges and limited human resources/expertise on climate constrain comprehensive risk assessment; no comprehensive risk assessment performed to date.
- Recommended implementation steps:
  - (i) Tailor EU/EBA regulations to Iceland’s specifics and supervisory needs.
  - (ii) Address data quality and availability gaps on climate-related financial risks without waiting for EU/EBA regulation.
  - (iii) Structure a concrete action plan to implement the strategic supervisory priority on sustainable finance.
  - (iv) Develop a combination of risk-based and targeted supervisory tasks that involve financial stability oversight, microprudential supervision, and conduct supervision.
  - (v) Ensure banks fully incorporate climate-related risks into risk management, determine whether capital and liquidity buffers are adequate, and raise buffers as needed.
  - (vi) Estimate CBI’s additional human resources and budget needs for the next 3 to 5 years.
  - (vii) Enhance coordination between ministries and the CBI to support adequate consideration of climate-related financial risks.

### Macroprudential framework and policy
- Institutional strengths:
  - Macroprudential mandate assigned to the Financial Stability Committee (FSN) chaired by the Governor; the Financial Stability Department provides analyses to support policy.
  - CBI has hard powers to apply a range of macroprudential tools (including CCyB, SRB, O-SII buffer, LTV cap, net open FX positions, loans in foreign currencies, and limits on DSTI and LTI ratios).
  - Institutional arrangements facilitate domestic coordination via the Financial Stability Council and international cooperation with Nordic-Baltic countries and reciprocity arrangements elsewhere.
- Surveillance and tools:
  - CBI employs comprehensive quantitative information, models, and stress tests (top-down and bottom-up) and uses granular mortgage debt information.
  - Recommended enhancements to systemic risk monitoring:
    - Develop a heatmap as a risk monitoring tool.
    - More actively cover NBFIs and the non-financial private sector.
    - Strengthen assessment of interactions between banks and non-banks.
    - Enhance analysis of tail risks, spillovers, systemic risks, and calibration of macroprudential tools.
    - Develop stress tests incorporating macro-financial feedback loops.
    - Monitor transmission of shocks between financial balance sheets.
  - Remaining important data gaps include CRE sector data, micro household and NFC balance sheet data, and climate risks.

*Source: IMF staff calculations and supervisory data as presented in the IMF Financial Sector Assessment (selected excerpts).*

### 48.      The authorities should continue to closely monitor risks, in particular in the real estate

### 1islea2023002 - 48.      The authorities should continue to closely monitor risks, in particular in the real estate

### Macroprudential policy, real estate, and NBFI risks
- Findings:
  - Authorities have increased the CCyB, introduced limits on DSTI, and tightened LTV, mainly to address vulnerabilities stemming from households’ indebtedness and CRE risks.
  - Vulnerabilities persist in the real estate and NBFI sectors.
- Policy recommendations:
  - Continue to closely monitor risks, in particular in the real estate and NBFI sectors, and stand ready to take further macroprudential measures if needed.
  - If existing measures prove insufficient to contain CRE risks, consider sectoral capital buffers and /or borrower-based measures targeted at CRE firms.

### Cybersecurity risks and resilience
- Findings:
  - Oversight assessment of cyber resilience focused on Payment Systems.
  - Dependence on debit and credit card payments is rising; international connectivity and cooperation from card providers pose a systemic macro risk.
  - CBI faces a key person risk as operational risk expertise is limited to a few individuals.
  - Icelandic Computer Emergency Response Team (CERT-IS) runs cybersecurity scenario exercises.
- Policy recommendations and actions needed:
  - CBI should continue to investigate alternative domestic retail payment solutions, refine crisis playbooks and test how cash will be distributed and used in a crisis.
  - Produce a financial sector-specific cybersecurity strategy clarifying the roles and responsibilities of each party.
  - Recruit more staff with operational risk expertise to allow CBI to introduce on-site examinations, probe deeper into and properly challenge firms’ self-assessments, and adopt a more judgement-based approach to financial institutions’ operational risk management.
  - CERT-IS should continue and expand cybersecurity scenario exercises to include a wider range of financial institutions and government agencies.

### Systemic liquidity management
- Findings:
  - The CBI has a well-defined liquidity management framework for banks with quantitative and qualitative rules on risk management.
  - Liquidity risk management of NBFIs could be improved.
  - Banks have high LCR and NSFR ratios but are potentially exposed to large liquidity shocks.
  - Interbank transactions have declined and are now limited; banks currently exchange liquidity on an unsecured basis with the central bank as backstop.
  - International reserves are adequate in size and liquid.
  - CBI recently developed a framework to provide bilateral emergency liquidity assistance (ELA) to eligible financial institutions, but operationalization and testing are incomplete.
- Policy recommendations:
  - Improve preparedness of NBFIs' liquidity risk management framework through regulation and supervision.
  - Set appropriate risk/reward and regulatory incentives to develop a repo market to promote interbank transactions for longer maturities and support the development of the yield curve; the central bank’s backstop should be needed only in systemic liquidity risks.
  - Complete work on collateral eligibility to improve capacity to provide liquidity in times of stress or resolution, and enhance monitoring of banks’ eligible collateral, including high-quality liquid assets.
  - Continue cooperation with other central banks and consider broadening swap arrangements beyond the Nordic countries to central banks with reserve currencies such as the ECB and FRB.
  - Finalize preparedness for ELA in resolution, including effective operationalization and testing of collateral eligibility and rules/procedures with counterparties.
- Footnote:
  - NBFIs are not considered as ELA eligible financial institutions, and as such are not subject to CBI liquidity regulation.

### Crisis preparedness, bank resolution, and safety nets
- Findings:
  - Iceland has transposed the BRRD into domestic law, but implementation rules and procedures are not in place, affecting crisis management operationalization.
  - Resolution tasks are handled within the CBI but the resolution authority (RA) has only 2 working-level staff.
  - There is an operational separation of supervisory and resolution functions within the CBI.
  - The Deposit Guarantee Fund (TVF) currently has a maximum disbursement deadline of one year.
- Policy recommendations and priorities:
  - Fill remaining gaps, in particular regarding:
    - (i) escalation triggers in recovery plans;
    - (ii) guidance on the adoption of FOLTF of a bank;
    - (iii) valuation in resolution;
    - (iv) operationalization of the full range of resolution powers, including bridge bank and transfer powers;
    - (v) procedures and systems to ensure quick pay-outs to insured depositors by the Investors’ Guarantee Fund (TVF).
  - Establish a coordination body between the MoFEA and CBI (RA) to develop a structured dialogue on resolution issues with direct fiscal impact while preserving RA independence.
  - Strengthen, better resource, and fully operationalize the resolution framework set up in 2020, including:
    - Operationalize the application of all resolution tools (not just bail-in);
    - Ensure operational continuity and liquidity in resolution;
    - Enable separability of assets and identify significant impediments to resolution (in particular from state-ownership);
    - Develop detailed operational guidance on procedures related to FOLTF, valuation, and operationalization of all resolution tools.
  - Strengthen the Deposit Guarantee Fund (TVF) in line with IADI Core Principles:
    - Reduce the maximum deadline for disbursements to seven days as in EU (currently one year).
    - Introduce a “least cost test” for resolution.
    - Provide TVF legal access to external funding sources, including a fully operationalized public backstop (from government or central bank).
- Footnote:
  - The crisis management framework is evaluated against international standards (e.g., the FSB Key Attributes of Effective Resolution Regimes for Financial Institutions).

### Financial integrity (AML/CFT)
- Findings:
  - Iceland’s AML/CFT framework for banks has undergone reforms since 2019; in 2020, technical compliance for the “Regulation and Supervision of Financial Institutions” was rated “Largely Compliant”.
  - Limited geographical reach of Iceland’s banking network and low levels of unexplained transnational financial flows reduce inherent ML risk.
  - Iceland has the most limited geographical reach among the Nordic-Baltic region, lowest number of countries with unexplained flows, and the highest average value of economic linkages with a counterparty-country.
  - Banks’ AML/CFT systems and controls are still maturing despite significant supervisory efforts since the 2018 FATF Mutual Evaluation.
  - The VASP sector is small: three VASPs serving an overwhelmingly domestic customer base.
- Data and statistics:
  - The aggregate turnover in the sector is 4,3 billion Icelandic krona with a total volume of transactions of 19.928 in 2021-2022.
  - The total number of active customers is 6.633.
- Policy recommendations:
  - Further refine supervisory ML/TF risk assessment tools and increase data collection:
    - (i) develop a more comprehensive supervisory analysis and list of high-risk jurisdictions;
    - (ii) increase granularity in risk variables and emphasize product risks for banks’ sectoral risk assessment;
    - (iii) enhance the risk assessment model to delineate between inherent risk and AML/CFT systems and controls;
    - (iv) broaden AML/CFT supervisory data collection to cover transaction-level data and financial flows analysis.
  - Enhance supervisory presence and targeted efforts (including thematic inspections and more frequent supervisory interactions) to drive improvements in AML/CFT compliance and effectiveness.
  - Continue steps to ensure banks maintain adequate, accurate, and up-to-date beneficial ownership and control information; improve IT infrastructure supporting the electronic registration system administered by the Register of Enterprises.
  - Continue CBI efforts to supervise VASPs, detect unlicensed activities, and enhance AML/CFT supervision of banks.

### Authorities’ views
- Main points:
  - Authorities welcomed the FSAP’s positive assessment of financial system resilience and progress since the 2008 crisis.
  - They found recommendations tailored and helpful and intend to consider them carefully; they indicated willingness to publish the FSSA, the DAR and Technical Notes.
  - They broadly agreed with the systemic risk assessment, noting resilience reflects strong capital buffers in the D-SIBs and reforms over the past decade.
  - They emphasized systemic liquidity management is a key focus for a small open economy with independent monetary policy and floating currency.
  - They agreed to assess how to integrate vulnerability assessments of NFCs into systemic risk monitoring and noted real estate risks warrant continued close monitoring and possible further macroprudential actions if they don’t abate.
  - They welcomed recommendations to address resources, accountability, and operational effectiveness of the CBI after the 2020 merger of the FSA with the CBI, while noting constitutional and parliamentary fiscal authority considerations for any funding arrangement changes.
  - They commended FSAP work on pension fund oversight and acknowledged governance shortfalls in the systemically important pension system that could be improved.
  - They confirmed continuing to strengthen the AML/CFT regime is a priority and are committed to developing and implementing a strategy for banking supervision of climate-related financial risks.
  - To improve cyber-resilience, they have devoted resources to strengthen oversight of cyber-risks, including implementation of the European TIBER framework in Iceland.

*Source: IMF staff report content provided in the supplied PDF excerpt.*

### 68.      The authorities considered the findings and recommendations on crisis management

### 1islea2023002 - 68.      The authorities considered the findings and recommendations on crisis management

### Authorities’ response and policy priorities
- The authorities found the findings and recommendations on crisis management and safety nets very useful.
- Agreed priorities:
  - Strengthen the ELA framework for resolution.
  - Continue improving the bank recovery and resolution framework.
  - Increase the resources of the resolution authority.
  - Continue developing the crisis preparedness and management framework.

### Financial system structure and recent developments (high-level)
- Pension funds’ assets reached 200 percent of GDP (figure context).
- Banks’ profitability has improved; household mortgages are a larger share of bank portfolios (figure context).
- Real estate prices have risen significantly over the past 20 years and there are signs of overvaluation (figure context).
- Household debt has declined since the GFC but remains high as a percentage of disposable income (figure context).
- Corporate debt declined since the GFC but is rising relative to income and is mostly accounted for by domestic indexed and non-index loans and by FX loans (figure context).

### Selected macroeconomic and fiscal indicators (highlights from Table 2)
- Stress test horizon: 5 years (2023-2027).
- Data and series reported include:
  - Output growth (Gross domestic product): 4.2 (2017), 4.9 (2018), 1.8 (2019), -7.2 (2020), 4.3 (2021), 6.4 (2022), 3.2 (2023 Prel.), 1.9 (2024 Proj.), 2.1 (2025 Proj.), 2.1 (2026 Proj.), 2.1 (2027 Proj.), 2.2 (2028 Proj.).
  - Gross domestic product (ISK bn.): 2,642 (2017), 2,844 (2018), 3,024 (2019), 2,919 (2020), 3,245 (2021), 3,766 (2022), 4,117 (2023), 4,353 (2024), 4,603 (2025), 4,843 (2026), 5,103 (2027), 5,384 (2028).
  - Gross domestic product ($ bn.): 24.7 (2017), 26.3 (2018), 24.7 (2019), 21.6 (2020), 25.6 (2021), 27.8 (2022), 29.1 (2023), 31.4 (2024), 33.9 (2025), 36.4 (2026), 39.1 (2027), 42.0 (2028).
  - GDP per capita ($ thousands): 73.1 (2017), 75.4 (2018), 69.1 (2019), 59.2 (2020), 69.3 (2021), 74.0 (2022), 75.2 (2023), 81.6 (2024), 87.1 (2025), 92.4 (2026), 98.3 (2027), 104.5 (2028).
  - Unemployment rate (percent of labor force): 3.3 (2017), 3.1 (2018), 3.9 (2019), 6.4 (2020), 6.0 (2021), 3.8 (2022), 3.3 (2023), 3.6 (2024), 3.7 (2025), 3.8 (2026), 3.9 (2027), 4.0 (2028).
  - Consumer price index (average): 1.8 (2017), 2.7 (2018), 3.0 (2019), 2.8 (2020), 4.5 (2021), 8.3 (2022), 8.7 (2023), 4.6 (2024), 3.6 (2025), 2.6 (2026), 2.5 (2027), 2.5 (2028).
  - Overall balance (percent of GDP): 1.0 (2017), 0.9 (2018), -1.5 (2019), -9.0 (2020), -8.4 (2021), -4.3 (2022), -2.7 (2023), -2.9 (2024), -2.5 (2025), -1.7 (2026), -1.9 (2027), -1.9 (2028).
  - Gross debt (percent of GDP): 71.7 (2017), 63.2 (2018), 66.6 (2019), 77.8 (2020), 75.6 (2021), 68.7 (2022), 65.1 (2023), 61.2 (2024), 60.0 (2025), 58.2 (2026), 56.5 (2027), 55.2 (2028).
  - Current account balance (percent of GDP): 4.2 (2017), 4.3 (2018), 6.5 (2019), 1.0 (2020), -2.4 (2021), -1.5 (2022), -1.6 (2023), -1.3 (2024), -0.7 (2025), -0.1 (2026), 0.6 (2027), 1.2 (2028).
  - Gross external debt (percent of GDP): 90.3 (2017), 73.3 (2018), 78.4 (2019), 90.4 (2020), 82.8 (2021), 75.2 (2022), 75.2 (2023), 69.3 (2024), 64.1 (2025), 59.6 (2026), 55.4 (2027), 51.5 (2028).
- Sources reported: Central Bank of Iceland; Ministry of Finance; Statistics Iceland; and IMF staff projections.
- Note: For 2023, central bank 7 day term deposit rate reported as of end-May. In 2020, the general government definition was expanded to include 24 new entities.

### Key risks from the Risk Assessment Matrix (Table 4)
- Intensification of regional conflict(s)
  - Relative Likelihood: High
  - Impact if Realized:
    - Escalation would trigger commodity price shocks and a global slowdown.
    - Worldwide tourism flows further subdued; spillovers from lower trading partner activity.
    - Medium-impact domestic effects: de-anchoring of inflation expectations, tighter financial conditions, higher credit risk.
    - Mitigating factor: Iceland’s low dependence on fossil fuels.
- Abrupt global slowdown or recession
  - Relative Likelihood: Medium (U.S.) / High (Europe)
  - Impact if Realized:
    - High-impact: spillovers through trade and financial channels, downward pressures on commodity prices, lower tourism earnings, higher unemployment, defaults, housing market correction.
- Monetary policy miscalibration
  - Relative Likelihood: Medium
  - Impact if Realized:
    - Medium-impact domestic channels: currency depreciation and inflation pressure, rise in interest rates exacerbating vulnerabilities in household balance sheets (floating rate mortgages), pension fund asset depreciation.
- A sudden correction in the domestic real estate market
  - Relative Likelihood: Medium
  - Impact if Realized:
    - Medium-impact: higher bank impairments, defaults/delayed repayments, depressed domestic demand and bank profits.
- Systemic financial instability
  - Relative Likelihood: Medium
  - Impact if Realized:
    - Medium-impact: valuation losses on marketable assets, intensified credit risks, volatile net interest margins and profit losses.

### Banking sector: Top-down solvency stress test assumptions (FSAP team)
- Institutional perimeter
  - Institutions included: Top three commercial banks (under IFRS9).
  - Market share: The top three commercial banks account for about 95 percent of the deposit taking corporations (excl. central bank) assets.
  - Data source and baseline date: Supervisory data provided by the Central bank of Iceland; other public and commercial sources; data as of October 2022; consolidated at national bank level.
- Channels of risk propagation
  - Methodology: Balance sheet-based tool developed by MCM; satellite models developed by the FSAP team.
  - Satellite models:
    - Credit risk: Parameter (PD, LGD, EAD) projections generated by product; modeling relies on IFRS9 modeling and transition matrices; starting points are PDs and LGDs reported by banks.
    - Net Interest Income: Two approaches (structural and empirical); empirical approach uses regression estimates and pass-through; structural model uses repricing ladders.
    - Net fees and commission income and other income/expenses: bank-panel model or by assumption.
    - Market risk: Duration approach for interest rate instruments; considers equity, FX and inflation risks.
- Tail shocks and scenario design
  - Baseline: March 2023 WEO.
  - Adverse scenario: severity calibrated to a 2.2 standard deviation shock to real GDP growth relative to baseline over 2023-2024.
  - Macro-financial simulations realized based on an Iceland-specific VAR model and benchmarked against “other advanced economies” group dynamics in GFM.
  - VARX specification:
    - Endogenous vector (Y_t): real GDP, unemployment rate, CPI index, policy rate, nominal effective exchange rate (NEER), and a measure of real loans (CPI-deflated sum of NFC and household loans).
    - Exogenous vector (X_t): US real GDP and oil price, plus a dummy for the GFC (2008Q4).
    - Lag lengths: L_1 and L_2 chosen to be L_1=L_2=4.
  - Macro-financial scenarios for foreign countries and relevant interest rates rely on GFM simulations.
- Sensitivity and additional analyses
  - Concentration analysis on top lending and funding exposures.
  - Sensitivity to further rises in interest rates.
  - Sensitivity to further credit deterioration in covid-sensitive sectors.
- Risks and buffers assessed
  - Credit risk (corporates, households, sovereign), interest rate risk in the banking book, market risk from fixed income securities, FX, inflation and equity risks.
  - Behavioral adjustments: credit growth assumed such that credit-to-GDP ratio remains constant; scenarios with cures/no cures and write-offs; portfolio composition unchanged over time.
- Regulatory/accounting standards
  - PDs and LGDs obtained from supervisory files or estimated at asset class level.
  - Regulatory capital ratios and IFRS9 accounting standards applied.
- Output presentation
  - Aggregate results and contributions to evolution of capital ratios.

### Banking sector: Top-down liquidity and cash-flow stress test assumptions (FSAP team)
- Institutional perimeter and data
  - Institutions included: Top three commercial banks.
  - Market share: The top three commercial banks account for about 95 percent of the deposit taking corporations (excluding central bank) assets.
  - Data and baseline date: Liquidity Coverage Ratio, Net Stable Funding Ratio, and cash flow table from supervisory data; data as of October 2022; consolidated at national bank level.
- Methodology and horizons
  - Cash-flow stress test analyzes net cash balance accounting for available unencumbered assets, contractual cash inflows/outflows, and behavioral flows.
  - Tests repeated for all significant currencies for reporting banks.
  - Complemented with LCR and NSFR stress tests.
  - Horizon: cash-flow analysis up to 12 months depending on scenario; LCR stress test horizon is one month.
- Risks and buffers
  - Funding liquidity risk reflected in funding and asset roll-off rates; asset roll-offs provide cash inflows linked to non-renewal of maturing assets.
  - Market liquidity risk reflected in asset haircuts (fire sales, collateral supply).
  - Behavioral adjustments: liquidity from central bank ELA is not considered.
  - Cash-flow analysis may include behavioral assumptions on counterparties’ willingness to transact based on banks’ solvency and liquidity.
- Regulatory and market-based calibration
  - Stress funding run-off rates, asset roll-over rates, and asset haircuts calibrated on empirical evidence and international experience.
  - HQLA haircuts informed by market value declines from the solvency stress test where applicable; other haircuts informed by ECB valuation haircut when repoing assets to the central bank.
  - Icelandic banks do not hold securities under the amortized (or equivalently HTM) category.
  - LCR hurdle rate: 100 percent at the aggregate currency level (per Basel III and domestic regulation) and 100 percent for significant foreign currencies (per domestic regulation).
  - NSFR: per Basel III; limit of 100 percent.
- Reporting outputs
  - Outputs include (1) changes in the system-wide liquidity position, (2) number of institutions with LCR/NSFR below regulatory limits, and (3) amount of liquidity shortfall.
- Infrastructure
  - Infrastructure developed by IMF staff based on FINREP/COREP data input.

### Liquidity stress test scenarios and calibrated run-off / shock parameters (selected values)
- Stress scenario mapping S1–S6 and selected calibrated run-off / shock parameters (as reported):
  - Stable retail deposits: S1 5% ; S2 10% ; S3 5% ; S4 10% ; S5 10% ; S6 10%.
  - Other retail deposits: S1 10% ; S2 20% ; S3 10% ; S4 20% ; S5 20% ; S6 20%.
  - Operational deposits: S1 5-25% ; S2 5-25% ; S3 15-35% ; S4 15-35% ; S5 15-35% ; S6 15-35%.
  - Non-operational deposits other than financial institutions: S1 20-40% ; S2 20-40% ; S3 30-50% ; S4 30-50% ; S5 30-50% ; S6 30-50%.
  - Non-operational deposits financial institutions: 100% across S1–S6.
  - Committed facilities to retail customers: S1 5% ; S2 10-15% ; S3 5-10% ; S4 10-15% ; S5 10-15% ; S6 10-15%.
  - Committed facilities to corporate customers: S1 10-30% ; S2 10-40% ; S3 20-50% ; S4 20-50% ; S5 20-50% ; S6 20-50%.
  - Pension funding (other than non-operational deposit): S1 0% ; S2 0% ; S3 0% ; S4 0% ; S5 10% ; S6 15%.
  - Foreign funding (other than non-operational deposit): S1 0% ; S2 0% ; S3 0% ; S4 0% ; S5 15% ; S6 25%.
  - Level 1 assets: S1 no ; S2 no ; S3 -5/0% ; S4 -5/0% ; S5 -5/0% ; S6 -5/0%.
  - Level 1 covered bonds: S1 no ; S2 no ; S3 -20/-3% ; S4 -20/-3% ; S5 -20/-3% ; S6 -20/-3%.
  - Level 2A assets: S1 no ; S2 no ; S3 -15/-5% ; S4 -15/-5% ; S5 -15/-5% ; S6 -15/-5%.
  - Level 2B assets: S1 no ; S2 no ; S3 -25/-5% ; S4 -25/-5% ; S5 -25/-5% ; S6 -25/-5%.

*Source: IMF staff (content unit: 1islea2023002 - 68.      The authorities considered the findings and recommendations on crisis management).*

### Appendix II

### Appendix II

### LCR Stress Test Parameters — Institutional Perimeter and Data
- Institutions included:
  - Interbank network: 3 commercial banks (out of 4) accounting for 95 percent of total banking sector assets, ranked by unconsolidated assets.
  - Inter-pension fund network: largest 15 pension funds ranked by total assets.
  - Inter-Investment fund network: largest 15 investment funds ranked by total assets.
  - Inter-financial sector network: banks, pension funds, and investment funds for the network and exposure analysis.
  - Aggregate cross-sectoral exposure data: financial sector and domestic real sector interconnectedness.
- Data and starting position:
  - Domestic interconnectedness.
  - Data source: supervisory data.
  - Starting position: three snapshots: 2011, 2017, and 2022 to reflect evolvement; Data granularity: institutional level bilateral exposure data among all entities, including within the banking sector, pension fund sector, and investment fund sector; and across-sectors including between central bank, banks, pension funds, other financial corporates, non-financial corporates, general government, households, and the rest of the world.
  - Cross-border interconnectedness.
  - Cross-border data for banking sector and pension funds at institutional level, based on the supervisory data and BIS cross-border exposures statistics.
  - Financial market data for sovereign CDS spreads and equity returns data from 2001 to 2022.

### Methodology and Risk Framework
- Overall framework:
  - Interbank and cross-border balance sheet exposure based on Espinosa-Vega and Juan Sole (2010).
  - Failure thresholds are institution-specific, considering regulatory requirements and applicable buffers.
  - Cross-border: Market price-based spillover model by Diebold and Yilmaz (2014).
  - Assess overall price-based banking sector and pension funds international interconnectedness and main spillover directions.
- Risks and buffers:
  - Risks: Credit shock and funding shock bringing capital impairment due to interbank exposures and intra-financial exposures.
  - Buffers:
    - Domestic interconnectedness: institution’s own capital and liquidity buffers.
    - Banks: minimum CET1 ratio is considered.
    - Pension funds: minimum solvency capital ratio.

### Reporting and Output Presentation
- Output presentation includes:
  - Domestic and cross-border interconnectedness and contagion analysis.
  - Inter-financial sector network: a network chart based on exposures.
  - Aggregate inter-sectoral network: a network chart based on the exposures between CB, ODCs(banks), PFs, OFCs, NFCs, GG, HHs, and ROW.
  - Index of vulnerability and contagion for inter/intra-sectoral exposures at institutional level.
  - Distribution of the spillover indices based on institution size, institutional sector, and other characteristics.
  - Market data contagion analysis.
  - Cross-country interconnectedness charts on sovereign CDS and equity return.
  - Spillover indices at country level on sovereign CDS and equity return.

### Pension Funds: Perimeter, Scenarios, and Risks
- Institutional perimeter:
  - Number of institutions: 7 occupational pension funds (defined ambition): Almenni, Birta, Frjalsi, Gildi, LSR, LV, Stapi.
  - Market share: 77 percent of Pillar II assets, 76 percent of Pillar II contributions; excl. closed defined-benefit schemes.
  - Data: Statutory returns, company submissions; Company submissions.
  - Reference date: December 2022.
- Channels of risk propagation and methodology:
  - Investment assets: market value changes of assets after price shocks, affecting future pension values.
  - Liabilities: valuation change after changing assumptions on future wage inflation, asset returns.
  - Liabilities: valuation change after changing the regulatory discount rates and biometric assumptions.
  - Time horizon:
    - Adverse scenario: 2023-2025.
    - Medium- to long-term projections for replacement rates (up to 30 years).
    - Instantaneous shock.
- Scenario analysis — Tail shocks and sensitivities:
  - Adverse scenario (Top-down):
    - Interest rates: short-term rates +171 bps, long-term rates +212 bps in 2013.
    - Equity price: -79.8 percent for listed domestic shares, and -32.0 percent for foreign shares in 2013.
    - ISK depreciation: -30.6 percent in 2023.
    - Inflation: 8.6 percent in 2023.
  - Sensitivity analysis:
    - Default of largest bank / non-financial counterparty.
    - Reduction in the discount rate from 3.5 to 3.0 percent.
    - Decrease in mortality by 10 percent across all age cohorts.
- Risk factors assessed:
  - Market risks: interest rates, share prices, property prices, FX rates, credit spreads.
  - Credit risks: Default of largest bank (and non-financial) counterparty.
  - Regulatory risk / interest rate risk.
  - Biometric risks: Mortality.
- Reporting formats for results:
  - Top-down outputs: Impact on value of assets; Impact on future pension values; Dispersion across companies; Contribution of individual shocks.
  - Bottom-up outputs: Impact on value of assets and liabilities; Dispersion across companies; Contribution of individual shocks.

### Non-Financial Corporates Risk Analysis — Top-down
- Institutional perimeter:
  - Institutions included: About 8,500 non-financial companies.
  - Market share: About 25 percent of active firms in 2020.
  - Data source and reference date: Orbis (Bureau van Dijk) database for company level data; Statistics Iceland for aggregate sectoral key indicators; Data as of December 2020.
- Channels of risk propagation and methodology:
  - Methodology: Dynamic Scenario-Based Stress Tests and Sensitivity Analysis (Tressel, T. and Ding, X., 2021, “Global Corporate Stress Tests—Impact of the COVID-19 Pandemic and Policy Responses”, IMF WP 21/212).
  - Probability of default (PD).
  - Time horizon: Instantaneous shock and 3 years (2021-2023).
- Scenario analysis:
  - Baseline scenarios in line with the bank solvency stress test and October 2022 WEO.
  - An adverse scenario with a lower GDP growth consistent with the severity of bank solvency stress test, and a tightening of financial conditions, global supply chain disruptions, and rise of commodity prices.
  - Sensitivity analysis: Interest rate shock.
- Risks and reporting:
  - Risks/factors assessed: Bankruptcy, default on any loans or bonds, ICR falling below specific thresholds.
  - Behavioral adjustments: None.
  - Regulatory/accounting standards: National accounting standards in line with EU Directives and Regulations.
  - Output presentation: Aggregate results with the impact on debt distress, contribution of individual shocks.

### Implementation Status of 2008 FSAP Recommendations (Status March 2023)
- Recommendations implemented (selection):
  - Increase capital adequacy ratios to historical levels and evaluate need for additional increases in the context of the ICAAP review process: Implemented.
  - Strengthen the quality and sources of bank capital, by identifying and reducing possibilities of excessive exposure to shareholders, and, where necessary, attracting new shareholders: Implemented.
  - Evaluate banks’ liquidity plans using scenario analyses of future cash flows and banks’ ability to sell securities in an illiquid market: Implemented.
  - Monitor credit quality, taking remedial actions as warranted, such as establishing reserves for future credit losses: Implemented.
  - Develop contingency plans for resolving funding limitations by bank and by currency: Implemented.
  - Require greater disclosure in financial statements identifying and reducing cross holdings, related-party lending, and concentration in lending: Implemented.
  - Address market concerns about the size of the large banks by (i) ensuring banks have strong capital not reliant on borrowing as a source; (ii) making ownership structure more transparent; and (iii) increasing liquidity buffers: Implemented.
  - The FME should carefully examine the extent to which the size of banks’ balance sheets is appropriate given risk management, operational controls, and systemic vulnerabilities: Implemented.
  - Strengthen existing crisis management arrangements, including provisions for information exchange and contingency plans for banking distress: Implemented.
  - Establish a bank bankruptcy regime that strengthens the remedial action and enhances the tools for bank resolution: Implemented.

### Analysis of Macro-Financial Second-Round Effects — Findings and Policy Implications
- Approach:
  - A structural VAR (SVAR) model was used to identify the macroeconomic effects of a shock to bank capitalization. Domestic variables: Iceland’s real GDP, CPI, nominal exchange rate (all in logs), unemployment rate, and policy interest rate. External variables: US real GDP, oil price (both in logs) and US policy rate (external variables enter the VAR as exogenous regressors).
  - A banking block added: bank capital; bank outstanding loans to domestic households and non-financial corporates (both in logs and divided by CPI to express them in real terms); spread between the lending rate and the policy rate.
- Key quantitative outcomes (second-round scenario vs first-round):
  - Macroeconomic trough (occurs in 2024):
    - Real GDP: 3.8 percent lower.
    - Unemployment: 1.6 percentage points higher.
    - Housing prices: 9 percent lower.
  - Impact on bank capital ratios:
    - Aggregate CAR is lower than in the first round by 1.2 percentage points in 2024 (on average for the three banks) and by 1.7 percentage points in 2027.
    - While deleveraging reduces RWAs (tending to increase capital ratios), lower profitability driven by higher credit risk (mainly due to higher PDs from higher unemployment) dominates, producing net lower capital ratios.
    - In the first round all banks remain above the hurdle rate throughout the stress-testing period; in the second round one of the three banks falls slightly below at the trough while aggregate capitalization remains above the hurdle rate.
- Policy implications and CCyB calibration:
  - The macro-financial linkages exercise confirms aggregate resilience of the banking sector in terms of solvency even in a severely adverse scenario, while pointing to some vulnerabilities which could be addressed with macroprudential tools like the CCyB.
  - Reverse-stress-testing to calibrate CCyB:
    - The reverse-stress-testing exercise indicates that an additional 80bps of CCyB (relative to the 2 percent at the starting point) would be required for all banks to remain above the hurdle rate.
    - A CCyB of 2.8 percent would keep all banks above the hurdle rate throughout the stress-testing horizon with the third-round scenario. This value would be similar if the reverse-stress-testing exercise were based on the second-round scenario instead; this is because the improvement in the macro-outlook due to the higher bank capitalization induced by the CCyB is roughly offset by the higher RWAs that result from higher bank leverage.

*Source: 1islea2023002 - Appendix II*

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_Source: https://www.imf.org/-/media/files/publications/cr/2023/english/1islea2023002.pdf_