## 1islea2023006 - 2023. It was led by Mr. Etienne B. Yehoue. This

## Source details

**Canonical URL:** [1islea2023006 - 2023. It was led by Mr. Etienne B. Yehoue. This](https://www.imf.org/-/media/files/publications/cr/2023/english/1islea2023006.pdf)

## Other formats

- [Markdown version](/-/media/files/publications/cr/2023/english/1islea2023006.pdf.md)
- [Structured JSON version](/-/media/files/publications/cr/2023/english/1islea2023006.pdf.json)

---

### Executive summary: main findings and assessments
- Macroprudential policy in Iceland recently has centered on the property market because of its importance for households’ balance sheets, banks’ loan portfolios, and potential systemic risks.
- The Central Bank of Iceland (CBI) holds the macroprudential mandate and has proactively used property-related macroprudential tools to safeguard financial stability and ensure borrower prudence.
- Institutional strengths:
  - CBI has a clear mandate and well-defined objectives revised after the merger of the CBI and the Financial Supervisory Authority (FSA).
  - The Financial Stability Committee (FSN) within the CBI is assigned the macroprudential mandate.
  - The Financial Stability Department provides supporting analyses and the CBI uses a range of communication tools to establish accountability.
- Capacity and monitoring:
  - Surveillance relies on comprehensive quantitative information, industry dialogue, models, and stress tests, including top-down solvency stress tests for the household sector based on granular mortgage debt information.
  - The systemic risk monitoring framework is generally good but can be enhanced in several areas.
- Key vulnerabilities:
  - Household leverage amid high real estate valuations after a long period of loose financial conditions.
  - Signs of increased risk-taking in commercial real estate (CRE), one of the most leveraged corporate sectors.
  - Pension funds’ role can generate contagion effects across a highly interconnected financial system.
- Policy stance and readiness:
  - Authorities have tightened broad-based capital (CCyB) and borrower-based measures (limits on DSTI and LTV).
  - Authorities should stand ready to take further actions if vulnerabilities persist.

### Institutional framework: willingness, ability, coordination
- Legal mandate and powers:
  - CBI objectives under Chapter 1, Article 2, of the Central Bank Act No.92/2019 include: (1) ensure the stability of the financial system; (2) promote sound and safe financial activities; (3) sustain the safe and effective operation of domestic and cross-border payment intermediations; (4) maintain international reserves; and (5) supervise the financial system.
  - As of January 1, 2020, the CBI assumed tasks entrusted to the Financial Supervisory Authority.
- FSN composition and functions:
  - FSN established in 2020; chaired by the Governor and comprises Deputy Governors and three experts appointed by the Minister; the permanent secretary of the Ministry of Finance and Economic Affairs (or representative) participates as a nonvoting member.
  - Principal tasks: (1) assess financial system outlook and systemic risk; (2) define actions to strengthen financial stability; (3) approve governmental directives and decisions entrusted by law; (4) decide which entities and markets are systemically important.
- Ability to act:
  - FSN may issue, amend, or revoke instruments including CCyB, SRB, capital surcharges, LTV cap, net open FX positions, loans in foreign currencies, limits on DSTI, and on LTI ratios.
- Coordination:
  - Domestic: Financial Stability Council (FSC) is a formal cooperation forum; concentration of responsibilities in the CBI facilitates coordination.
  - International: CBI cooperates with Nordic-Baltic countries and has reciprocity arrangements with EEA countries for macroprudential implementation, especially CCyB.

### Governance, communication, staffing, and data powers
- Governance and decision-making:
  - FSN operates as a collegial body; decisions by majority vote; Governor has casting vote.
  - Meetings have a quorum if five of seven members attend.
  - Decision making on macroprudential tools under CBI’s power is the responsibility of the FSN.
- Communication and accountability:
  - Semiannual Financial Stability Report; press releases and press conferences; Economic Indicator Report (quarterly); working papers; media engagement.
  - Recommendation: periodically publish systemic risk analysis, heatmap, policy recommendations, and summary of thematic studies.
- Staffing and structure:
  - Financial Stability Department: around 26 staff.
  - General Secretariat: 35 staff.
  - Economics and Monetary Policy Department: 22 staff.
  - Microprudential Supervision Department: 35 staff.
- Data and information powers and gaps:
  - Adequate information-collection powers enshrined in national law; limited access to individuals’ tax reports.
  - Data gaps: commercial real estate; NBFIs (especially investment funds); intra-NFC lending; microdata on household and NFC balance sheets and income; climate risk data.
  - CBI often collects additional data via topical bank, household, and NFC surveys when required.

### Systemic risk monitoring: methods, data strengths, and gaps
- Monitoring practices:
  - Biannual Financial Stability Report production; variety of models and stress tests integrating top-down and bottom-up approaches.
  - Identification of vulnerabilities uses indicators across sectors, industry dialogue, and international discussions.
- Data and analytical strengths:
  - Data quality generally good; progress in expanding credit registry coverage.
  - Top-down solvency stress tests for households use granular mortgage debt information.
  - Credit registry contains borrower profiles, loan characteristics, collaterals; new granular account-level data on housing loans started August 2020.
  - Complete information on exposures to corporates (all exposures above 300 million ISK) started in September 2022.
- Analytical enhancements recommended:
  - More active coverage of nonbanks (pension funds, insurers, asset management companies).
  - Develop macroprudential stress tests that incorporate feedback loops between financial system and real economy and assess macroprudential instruments.
  - Deeper understanding of shock transmission between financial balance sheets.
  - Develop a heatmap and strengthen assessment of bank–nonbank interactions.
  - Enhanced analysis of tail risks, spillovers, systemic risks, and calibration of macroprudential tools.

### Macroprudential toolkit in use and recent calibrations
- Borrower-based measures:
  - LTV caps:
    - Introduced July 24, 2017: maximum LTV 85 percent; FTBs up to 90 percent.
    - Effective June 30, 2021: maximum LTV 80 percent; FTBs up to 90 percent (Rules No. 778/2021).
    - Effective June 15, 2022: maximum LTV 80 percent; FTBs up to 85 percent.
    - Last change: June 2022.
  - DSTI caps:
    - Effective December 1, 2021: maximum DSTI 35 percent of monthly disposable income; FTBs 40 percent.
    - A 5 percent general exemption (speed limit) applies per quarter.
    - Debt service calculation: maximum maturity 40 years for nonindexed mortgages and 25 years for indexed mortgages.
    - Minimum interest rates for debt service calculations: 5.5 percent for nonindexed and 3 percent for indexed mortgages.
    - Last change: June 2022.
- Broad-based capital and liquidity tools:
  - CCyB:
    - Implemented since March 1, 2016.
    - CCyB rate increased to 2.5 percent as communicated in March 2023 and effective March 2024.
    - Last change: March 2023.
    - Activation timeline: March 1, 2016: 1 percent; November 1, 2017: 1.25 percent; May 15, 2018: 1.75 percent; February 1, 2019: 2 percent; March 18, 2020: 0 percent; September 29, 2021: 2 percent; March 15, 2023: 2.5 percent.
  - Capital conservation buffer (CCoB): since July 2, 2015; CCoB 2.5 percent since January 3, 2017; last change January 2017.
  - Systemic risk buffer (SRB): introduced July 2, 2015; SRB 3 percent for systemically important deposit-taking institutions as of April 1, 2016; non systemically important required 3 percent as of January 1, 2020; last change May 2018.
  - O-SII buffer: effective April 1, 2016; buffer rate 2 percent for Arion banki, Íslandsbanki, and Landsbankinn; last change April 2016.
  - Leverage ratio limit: not lower than 3 percent since September 13, 2016; last change September 2016.
  - LCR and NSFR:
    - Minimum LCR for credit undertakings: 1.0; Icelandic króna minimum LCR: 0.5; euro minimum LCR for relevant institutions: 0.8.
    - LCR framework implemented December 1, 2013; new rules effective March 31, 2017, and January 1, 2019; latest amendment announced December 7, 2022 and effective January 1, 2023; last change December 2022.
    - Minimum NSFR: 1.0; last change June 2021.

### Stress testing, financial cycle indicators, and resilience
- Stress testing and surveillance:
  - D-SIBs stress tests integrate top-down and bottom-up approaches for microprudential and macroprudential surveillance.
  - Household sector: top-down solvency stress tests and sensitivity analysis based on granular mortgage debt.
- Financial cyclical indicator (FCI):
  - FCI started to decline from the local peak at end-2021 but remains above historical median.
  - Dynamic FCI provides early warning up to six quarters ahead.
  - Recent decrease mainly due to developments in household loans and a drop in correlation between individual FCI sub-indicators.
  - Theoretical FCI value excluding correlation effect is the highest since 2014.
- CCyB stress-test findings:
  - FSAP stress tests suggest capital buffers are enough to absorb adverse macrofinancial shocks.
  - FSAP bank solvency stress tests simulate credit shocks via output drops, higher interest expense, and higher unemployment; they confirm banks’ overall resilience.
  - The exercise found meaningful credit losses for households, which remain less than for corporates.

### Household sector, mortgages, and housing market vulnerabilities
- Household indebtedness and composition:
  - Households’ debt stood at 148 percent of disposable income at end-2022, almost two percentage points higher than the historical average.
  - Around 81 percent of household debt is mortgages.
- Mortgage composition and trends:
  - Nonindexed mortgages accounted for more than half of mortgage stock in June 2021.
  - Share of CPI-indexed loans in existing household debt decreased from 69 percent at start of COVID-19 pandemic to 43 percent in 2022Q3.
  - Share of CPI-indexed new mortgage loans reached 50 percent of total new loans by January 2023.
  - Share of variable interest rates declined to 44 percent in 2022Q3.
- Refinancing behavior and risks:
  - Borrowers increasingly refinance toward indexed loans to shelter from rising nominal interest payments on nonindexed loans.
  - Indexed mortgages: lower real interest rates in high inflation periods but add inflationary adjustments to principal, which can erode home equity and cause negative amortization in high inflation.
- Debt-service capacity and distress indicators:
  - CBI loan-level data since 2020 used to measure DSTI exceeding 35 percent.
  - CBI simulations assuming conversion of all nonindexed fixed-rate loans to nonindexed variable-rate loans at March 2023 market rate indicate:
    - Fewer than 3 percent of households would have DSTI above 35 percent, with incremental change less than 1 percentage point.
  - Approximately half of non-indexed mortgages have a fixed interest rate; most fixed-rate loans not released until 2024 and 2025.
  - Share of households with debt service exceeding 35 percent of disposable income rose from about 7 percent in January 2020 to 9 percent in January 2023 (increase of two percentage points).
- House price misalignment estimates:
  - Models suggest price misalignment potentially ranging from 6 percent to 7 percent.
  - Box 2 overvaluation estimates in 2022Q2: HP GAP 17.6%, Kalman GAP 6.9%, Regression model 6.2% (range 6.2 percent to 17.6 percent).
- Policy recommendation:
  - Continue monitoring housing market and stand ready to take further actions; consider further tightening borrower-based measures over time if vulnerabilities persist.

### Corporate sector, CRE, funding, and NBFI interconnectedness
- Corporate debt and exposures:
  - Gross corporate debt of NFCs has remained relatively stable at 80-90 percent of GDP since 2017.
  - By end-2022, NFCs relied on loan financing from banks and other financial institutions with an average share of 82 percent.
  - Loans mainly to real estate, fisheries, and services sectors (65 percent); real estate accounts for a quarter of corporate loans.
- Commercial real estate (CRE):
  - CRE NPLs’ share of total NPLs is above 30 percent.
  - Banks' credit to CRE and construction and CRE prices have risen rapidly; CRE prices are historically high and far above trend.
  - FSAP sensitivity analysis: a sharp PD increase would have highest negative impact on banks' capital from real estate sector.
- Corporate foreign-currency debt:
  - Corporate debt in foreign currencies amounted to more than 28 percent of GDP and around 36 percent of total corporate debt at end-2022 Q3.
  - Composition: 40 percent were foreign loans and 12 percent were marketable bonds issued abroad.
  - Around 35 larger Icelandic nonfinancial companies finance themselves in whole or in part abroad.
- Funding, liquidity, and resilience:
  - Loan-to-deposit ratio around 134 percent at end-2022.
  - D-SIBs’ combined liquidity ratio in all currencies: 165 percent (above 100 percent minimum).
    - Liquidity ratio in foreign currencies: 316 percent.
    - Liquidity ratio in Icelandic krónur: 121 percent.
  - D-SIBs’ NSFR for all currencies combined: 117 percent.
    - Funding ratio in foreign currencies: 165 percent.
    - Funding ratio in Icelandic krónur: 108 percent.
  - Aggregate liquidity and stable funding sufficient but could be insufficient during stress; liquidity stress tests show resilience but vulnerabilities remain to outflows from pension and nonresident FX funding.
- Structural size and interconnectedness:
  - Total banking sector assets accounted for 135 percent of GDP as of 2022 Q3.
  - Three largest banks (Arion Banki, Íslandsbanki, Landsbankinn) account for 95 percent of banking assets.
  - Pension funds (PFs) assets at 173 percent of GDP; PFs’ exposure to banks doubled from 2017 to 2021 and accounted for 10 percent of total PF assets (corresponding to 14 percent of banks’ financial liabilities).
  - PFs hold around 23 percent share in outstanding mortgage loans by end-2022 and compete actively with banks in mortgage market.
  - PFs are main buyers of corporate bonds, mainly issued by large real estate companies, power companies, and fishing industry.
- Recommendation:
  - CBI should closely monitor NBFI developments and develop a policy framework to address potential systemic risks from these developments.

### Macroprudential options and targeted measures for CRE and nonbanks
- Rationale:
  - Broad-based capital measures help resilience but are too blunt to target specific CRE risks; sectoral measures can directly address exposures and valuations.
- Recommended additions:
  - Sectoral capital measures:
    - Target banks with higher exposures to riskier sectors; introduce risk weights (risk weight floors or LGD floors) to build capital buffers and increase cost of credit to slow corporate credit growth.
    - Capital buffers (SRB/CCyB) are adjustable and can be relaxed in downturns.
  - Borrower-based measures for CRE:
    - Consider if combinations of existing and sectoral capital measures are insufficient.
    - Directly target excessive credit growth and stretched valuations while increasing borrower resilience.
    - Operational challenges include sector heterogeneity and data limitations.
- Nonbank toolkit:
  - Consider options to broaden bank, nonbank, and borrower-based macroprudential toolkit aimed at mitigating CRE vulnerabilities as needed.
  - Develop capacity for financial stability stress tests of NBFIs, including systemic perspective.
  - Pay close attention to PFs’ and IFs’ quasi-banking activities and be ready to act if risks increase.

### Key recommendations (selected from Table 1)
- Institutional arrangements:
  - Develop a heatmap and regularly publish reports on risk analysis to enhance transparency and accountability. — Responsible: CBI — Timeframe: I
- Systemic risk monitoring (selected):
  - Collect microdata on household and NFC balance sheets and income to advance analysis. — Responsible: CBI — Timeframe: I
  - Close remaining data gaps, including CRE sector, intra-NFC lending, and climate risks. — Responsible: CBI — Timeframe: ST
  - Strengthen analysis of tail risks, spillovers, systemic risks, and interconnections between bank and nonbank sectors. — Responsible: CBI — Timeframe: ST
  - Strengthen calibration of macroprudential tools using granular data and analytical tools. — Responsible: CBI — Timeframe: ST
  - Develop macroprudential stress tests incorporating feedback loops and contagion effects. — Responsible: CBI — Timeframe: MT
  - Develop capacity for financial stability stress tests of NBFIs from a systemic perspective. — Responsible: CBI — Timeframe: ST
  - Continue careful monitoring of real estate market and stand ready to take further policy actions if systemic risks persist. — Responsible: CBI — Timeframe: I
  - Continue monitoring CRE vulnerabilities and take actions (higher CRE risk weights, sectoral SRB) if risks intensify. — Responsible: CBI — Timeframe: I
- Toolkit actions:
  - Consider broadening macroprudential toolkit for bank, nonbank, and borrower-based instruments to mitigate CRE vulnerabilities. — Responsible: CBI, MoFEA — Timeframe: I
  - Develop a policy framework to address potential systemic risks from nonbank financial sector developments. — Responsible: CBI — Timeframe: ST
- Timeframe key: I = Immediate (within one year); ST = Short Term (within 1-2 years); MT = Medium Term (within 3-5 years).

*IMF staff summary of Chapter 8 and related sections of the CBI macroprudential framework (from the supplied PDF content).*

### 2023. It was led by Mr. Etienne B. Yehoue. This

### 1islea2023006 - 2023. It was led by Mr. Etienne B. Yehoue. This

### Executive Summary: Main findings and assessments
- Macroprudential policy in Iceland recently has centered on the property market, given the importance of this market for households’ balance sheets, banks’ loan portfolios, and the potential systemic risks.  
- The Central Bank of Iceland (CBI) is the authority with the macroprudential policy mandate and has proactively used property-related macroprudential tools to safeguard financial stability and ensure borrower prudence.
- Institutional strengths:
  - The CBI has a strong institutional framework assuring willingness to act, with a clear mandate and well-defined objectives revised after the merger of the CBI and the Financial Supervisory Authority (FSA).
  - The Financial Stability Committee (FSN) within the CBI is assigned the macroprudential mandate.
  - The Financial Stability Department provides essential supporting analyses; the CBI uses a range of communication tools to establish accountability.
- Capacity and monitoring:
  - CBI surveillance and systemic risk assessment rely on comprehensive quantitative information, industry dialogue, models, and stress tests, including top-down solvency stress tests for the household sector based on granular mortgage debt information.
  - The systemic risk monitoring framework is generally good but can be enhanced in several areas (see recommendations).
- Key vulnerabilities identified:
  - Household leverage amid high real estate valuations following a long period of loose financial conditions.
  - Signs of increased risk-taking in some sectors, most notably commercial real estate (CRE), which is among the most leveraged corporate sectors.
  - Pension funds play a vital role and can generate contagion effects across a highly interconnected financial system.
- Policy stance and readiness:
  - Authorities have tightened broad-based capital (CCyB) and borrower-based measures (limits on DSTI and LTV) to address household indebtedness and CRE risks.
  - Authorities should stand ready to take further actions if vulnerabilities persist (see Toolkit and Recommendations).

### Institutional framework: willingness, ability, and coordination
- Legal and mandate features:
  - Under Chapter 1, Article 2, of the Central Bank Act No.92/2019, the CBI objectives include: (1) ensure the stability of the financial system; (2) promote sound and safe financial activities; (3) sustain the safe and effective operation of domestic and cross-border payment intermediations; (4) maintain international reserves; and (5) supervise the financial system.
  - As of January 1, 2020, the CBI is responsible for tasks entrusted by law and governmental directives to the Financial Supervisory Authority.
- FSN composition and functions:
  - The FSN (established within the CBI in 2020) is chaired by the Governor and comprises: the Deputy Governor for Financial Stability, the Deputy Governor for Monetary Policy, the Deputy Governor for Financial Supervision, and three experts in financial market affairs or economics appointed by the Minister. The permanent secretary of the Ministry of Finance and Economic Affairs, or his representative, participates as a nonvoting member who may address the meeting and present proposals.
  - FSN principal tasks: (1) assess current situation and outlook for the financial system, systemic risk, and financial stability; (2) discuss and define actions to strengthen financial stability, involving governmental authorities when warranted; (3) approve governmental directives and make decisions entrusted to the committee by law; and (4) decide which supervised entities, infrastructure, and markets are systemically important.
- Ability to act:
  - As financial supervisor, the CBI controls prudential tools and has hard powers under various legislations. The FSN may issue, amend, or revoke certain policy instruments, such as: the countercyclical capital buffer (CCyB), systemic risk buffer (SRB), capital surcharges for systemically important institutions, loan-to-value (LTV) cap, net open foreign exchange positions, loans in foreign currencies, limits on debt service-to-income (DSTI), and on loan-to-income (LTI) ratios.
- Coordination:
  - Domestic coordination: The Financial Stability Council (FSC) is a formal cooperation forum of public authorities for financial stability; concentration of responsibilities in the CBI facilitates coordination.
  - International coordination: The CBI has cooperation arrangements with Nordic-Baltic countries and reciprocity arrangements with countries in the European Economic Area (EEA) to ensure effective implementation of macroprudential policies, especially for CCyB measures.

### Systemic risk monitoring: capacity, gaps, and enhancements
- Current monitoring practices:
  - Monitoring structured around biannual production of the Financial Stability Report, facilitating exchange of views.
  - Use of various models and stress tests integrating top-down and bottom-up approaches for microprudential and macroprudential surveillance.
  - Identification of systemic vulnerabilities is based on analysis of a variety of indicators across sectors, industry dialogue, and international fora discussions.
- Data and analytical strengths:
  - Data quality and availability are generally good; recent progress made in expanding credit registry coverage.
  - Top-down solvency stress tests for households based on granular mortgage debt information.
- Identified data gaps and analytical enhancements needed:
  - Data gaps: commercial real estate (CRE) sector, micro households and nonfinancial corporates’ (NFC) balance sheet data, intra-NFC lending, and climate risks.
  - Analytical enhancements recommended:
    - More active coverage of nonbanks (pension funds, insurers, asset management companies).
    - Development of truly macroprudential stress tests that incorporate feedback loops between the financial system and the real economy and allow assessment of macroprudential instruments.
    - Deeper understanding of shock transmission between financial balance sheets.
    - Development of a heatmap as a risk monitoring tool.
    - Strengthened assessment of interactions between banks and nonbanks.
    - Enhanced analysis of tail risks, spillovers, systemic risks, and calibration of macroprudential tools.

### Vulnerabilities and macroprudential toolkit: assessments and options
- Persisting vulnerabilities and areas of concern:
  - Total amount of cyclical risks accumulated remains high in the financial sector despite slowed speed of new cyclical risk accumulation.
  - Household indebtedness and high real estate valuations are key vulnerabilities.
  - CRE exhibits increased risk-taking and is among the most leveraged corporate sectors.
  - Nonbank financial sector developments (notably pension funds) may create systemic risks due to interconnected exposures.
- Macroprudential tools currently in use or available to the CBI:
  - Borrower-based measures: limits on Debt Service-to-Income (DSTI) and Loan-to-Value (LTV).
  - Capital measures: Countercyclical Capital Buffer (CCyB), systemic risk buffer (SRB), capital surcharges for systemically important institutions.
  - Other instrument powers: limits on net open foreign exchange positions, loans in foreign currencies, limits on loan-to-income (LTI).
- Recommended toolkit actions if risks persist:
  - Continue careful monitoring of the real estate market and stand ready to take further policy actions if systemic risks persist.
  - Consider introducing temporary risk-weight floors or adding temporary risk weight add-ons on CRE exposures.
  - Consider introducing borrower-based measures targeted at CRE firms if combinations of existing and sectoral capital measures prove insufficient to contain CRE risks.
  - Pay close attention to developments in the nonbank financial sector and develop a policy framework to address potential systemic risks arising from these developments.
  - Consider options to broaden bank, nonbank, and borrower-based macroprudential toolkit aimed at mitigating CRE market vulnerabilities as needed.

### Key recommendations (extract from Table 1)
- Institutional Arrangements:
  - Further enhance transparency and accountability by developing a heatmap and regularly publishing reports on risk analysis. — Responsible: CBI — Timeframe: I
- Systemic Risk Monitoring (selected):
  - The CBI should significantly advance its analysis of the households and corporate sectors' vulnerabilities by collecting microdata on household and NFC balance sheets and income. — Responsible: CBI — Timeframe: I
  - Close remaining data gaps, including the CRE sector, intra-NFC lending, and climate risks. — Responsible: CBI — Timeframe: ST
  - Enhance systemic risk monitoring by strengthening the analysis of tail risks, spillovers, and systemic risks and deepen understanding of interconnections between the bank and nonbank sectors. — Responsible: CBI — Timeframe: ST
  - Strengthen the calibration of macroprudential tools by using granular data and analytical tools. — Responsible: CBI — Timeframe: ST
  - Develop macroprudential stress tests that take feedback loops between the financial system and the real economy more fully into account while incorporating contagion effects across financial institutions. — Responsible: CBI — Timeframe: MT
  - Develop capacity for financial stability stress tests of NBFIs, including from a systemic perspective. — Responsible: CBI — Timeframe: ST
  - Continue to carefully monitor developments in the real estate market and stand ready to take further policy actions if systemic risks persist. — Responsible: CBI — Timeframe: I
  - Continue monitoring CRE vulnerabilities and take actions (higher CRE risk weights, sectoral systemic risk buffer) if risks intensify. — Responsible: CBI — Timeframe: I
- Toolkit:
  - Consider options to broaden the bank, nonbank, and borrower-based macroprudential toolkit aimed at mitigating CRE market vulnerabilities as needed. — Responsible: CBI, MoFEA — Timeframe: I
  - Pay close attention to developments in the nonbank financial sector and develop a policy framework to address potential systemic risks that might arise from these developments. — Responsible: CBI — Timeframe: ST
- Timeframe key: I = Immediate (within one year); ST = Short Term (within 1-2 years); MT = Medium Term (within 3-5 years).

*This technical note has been prepared by Knarik Ayvazyan as part of the 2023 FSAP for Iceland. The author would like to thank the Icelandic authorities for their excellent engagement and open dialogue.*

### 8. The FSN operates as a collegial body. Decisions are made by the committee according to

### 8. The FSN operates as a collegial body. Decisions are made by the committee according to

### Governance and decision-making
- The Financial Stability Committee (FSN) operates as a collegial body; decisions are made by the committee according to a majority vote, and the Governor of the CBI, who chairs the FSN meetings, has the casting vote.
- Meetings have a quorum if five of its seven members are in attendance.
- All committee members have an equal opportunity to share their views on the work program and agenda.
- Within this collegial framework, the Financial Stability Department regularly monitors systemic vulnerabilities and prepares analysis and preliminary recommendations for the FSN meetings.
- Decision making on macroprudential tools under the CBI’s power is the responsibility of the FSN.
- According to Article 117(b), Paragraph 3, of Act No. 161/2002, FSN approval is not required in relation to CBI’s rules on liquidity coverage ratio (LCR) or net stable funding ratio (NSFR) requirements.
- According to Article 4 of Act No. 70/2021, committee approval is not required for the CBI to maintain a special reserve requirement on capital inflows.
- The FSN has decision making power over other macroprudential measures including capital buffers, net open foreign exchange positions, loans in foreign currencies, caps on loan-to-value (LTV) and debt service-to-income (DSTI) ratios, and so on.

### Communication and public accountability
- The CBI uses various communication tools to establish commitment and public accountability:
  - Semiannual publication of the Financial Stability Report presenting overview of financial system developments, potential risks and vulnerabilities, and the financial system’s resilience.
  - Press releases on macroprudential policy measures and a press conference where the CBI Governor and Deputy Governor for Financial Stability present an overview of global and domestic economic and financial system developments and the rationale for adopting measures.
  - Publication of the Economic Indicator Report, a quarterly summary of economic developments and an update on the financial system.
  - Publication of working papers on financial stability issues throughout the year and communication via newspaper interviews and articles.
- Such tools can help the public establish whether the authority is taking appropriate actions to achieve its objectives.
- Recommendation: To further transparency and accountability, the CBI should periodically publish an analysis of systemic risks, including regularly publishing the heatmap and a note evaluating systemic risks, policy recommendations to address emerging risks, and a summary of thematic studies undertaken by CBI staff.

### Staffing, structure, and capacity to act
- The willingness to act is supported by a dedicated Financial Stability Department and cooperation across CBI departments.
- CBI Financial Stability Department: comprising around 26 staff; supports the FSN with assessments of systemic risks and analyses of macroprudential policy and financial stability issues.
- General Secretariat: 35 staff; plans FSN meetings, prepares statements, and takes minutes.
- Economics and Monetary Policy Department: 22 staff; develops and uses macroeconomic models and incorporates financial variables into those models to analyze effects on the real economy and define paths for economic variables in annual stress test scenarios.
- Microprudential Supervision Department: 35 staff; provides insights into D-SIBs balance sheets, credit risk, nonperforming loan (NPL) development, and loan growth.
- Institutional arrangements provide adequate powers to ensure CBI’s ability to act after merger of the CBI and the FSA; CBI oversees all financial institutions in Iceland and has the mandate to promote financial stability, forming the basis of its macroprudential policy framework.
- CBI has hard powers under various legislations (for example, the Financial Undertaking Act, Consumer Loan Act, Foreign Exchange Act) to apply specific policy tools for macroprudential purposes.
- Several macroprudential policy tools are currently being used to address imbalances in the housing market and systemic risk accumulation.

### Data and information powers and gaps
- The CBI has adequate information-collection powers; data-collection arrangements for macroprudential purposes are enshrined in various articles of national law.
- The CBI has limited access to tax reports from individuals.
- The CBI shares required information with the FSN without any formal arrangement.
- Data gaps exist in:
  - commercial real estate;
  - nonbank financial institutions (NBFIs), especially investment funds;
  - intra-NFC lending;
  - microdata on household and NFC balance sheets and income;
  - the transition and physical impact of climate risks on banks.
- Closing data gaps is one of the intermediate objectives in the Icelandic macroprudential policy strategy.
- When required data are inadequate, the CBI often collects additional data through topical bank, household, and NFC surveys.

### Coordination and cooperation (domestic and international)
- Coordination within CBI benefits from broad mandate and integrated model of financial supervision across sectors.
- High-level CBI committees provide internal checks and formal structures to coordinate macroprudential and microprudential policies, including:
  - FSN (Financial Stability Committee);
  - MPC (Monetary Policy Committee), which advises on monetary policy instruments including interest rate paths, transactions with credit institutions other than loans of last resort, reserve requirement rates, securities, and foreign exchange market transactions aimed at achieving price stability;
  - Financial Supervision Committee, which sets financial supervisory policy of the CBI and articulates focus, approach, and methodology in financial supervisory activities.
- Governor of the CBI and Deputy Governors for Financial Stability and Monetary Policy are members of both FSN and MPC.
- All policy decisions of the FSN are presented to and discussed by the MPC and vice versa.
- Analysis by Financial Stability Department and Monetary Policy Department is often shared and discussed within and between departments.
- Policy coordination in crisis times is facilitated as crisis management may require policy action—including monetary easing and emergency liquidity assistance—beyond relaxation of macroprudential tools.
- Financial Stability Council (FSC):
  - A formal cooperation forum of public authorities for financial stability.
  - Principal tasks include: (1) formulating official policy on financial stability; (2) monitoring economic imbalances, financial system risks, undesirable incentives, and other conditions likely to jeopardize financial stability; (3) assessing effectiveness of macroprudential policy tools.
  - FSC mainly relies on CBI's proposals or analysis when processing its projects.
  - Council members: Governor of the CBI and the Minister of Finance and Economic Affairs (MoFEA), who is also the chair.
  - They meet at least three times a year, and more as needed.
- International cooperation:
  - At the European level, CBI participates in the European Systemic Risk Board (ESRB) working groups and committees including the Advisory Technical Committee (ATC) and its Expert Groups: Analysis Working Group (AWG) and Instruments Working Group (IWG).
  - CBI is an active observer at the European Banking Authority (EBA), European Securities and Market Authority (ESMA), and European Insurance and Occupation Pension Authority (EIOPA) regarding macroprudential issues.
  - CBI participates in the Nordic-Baltic Macroprudential Forum (NBMF), whose workstreams produce biannual reports on risk assessment and macroprudential tools activated by member states.

### Macroprudential measures in use (high-level calibrations and last changes)
- Broad-Based Tools
  - Countercyclical capital buffer (CCyB):
    - Iceland implemented CCyB framework since March 1, 2016.
    - As communicated in March 2023 and effective March 2024, the CCyB rate increased to 2.5 percent.
    - Last change: March 2023.
  - Capital conservation buffer (CCoB):
    - Implemented since July 2, 2015.
    - Since January 3, 2017, credit institutions need to meet a CCoB of 2.5 percent.
    - Last change: January 2017.
  - Limit on leverage ratio:
    - As of September 13, 2016, the leverage ratio may not be lower than 3 percent for credit institutions, credit undertakings, and other undertakings.
    - Last change: September 2016.
  - Systemic risk buffer (SRB):
    - Introduced by changes to the Act on Financial Undertakings No. 161/2002, July 2, 2015.
    - As of April 1, 2016, the SRB is 3 percent for systemically important deposit-taking institutions; non systemically important deposit-taking institutions were required to maintain 3 percent SRB as of January 1, 2020.
    - Last change: May 2018.
  - Capital surcharges for other systemically important institutions (O-SIIs):
    - Effective April 1, 2016; O-SII buffer rate set at 2 percent for the three largest commercial banks: Arion banki, Íslandsbanki, and Landsbankinn.
    - Last change: April 2016.

- Liquidity Tools Applied to the Banking Sector
  - Liquidity coverage ratio (LCR):
    - Minimum LCR for credit undertakings and consolidated credit undertakings is 1.0.
    - Minimum LCR in Icelandic krónur for credit and consolidated credit undertakings is 0.5.
    - Minimum LCR in euros for credit institutions whose euro-denominated liabilities equal 10 percent or more of their total liabilities is 0.8.
    - LCR framework implemented December 1, 2013; new rules took effect March 31, 2017, and January 1, 2019.
    - As announced December 7, 2022, and effective January 1, 2023, new LCR rules were issued, amending national options in foreign currency, but the LCR requirement in all currencies combined remains the same.
    - Last change: December 2022.
  - Net stable funding ratio (NSFR):
    - Minimum NSFR for credit undertakings and consolidated credit undertakings is 1.0.
    - NSFR based on BCBS standards issued in 2014 and incorporated via Regulation (EU) No. 2019/876 (CRR II); implemented via amendments to Regulation on Prudential Requirements for Credit Institutions, No. 233/2017.
    - Last change: June 2021.

- Household Sector Tools
  - Cap on loan-to-value (LTV) ratio:
    - Introduced July 24, 2017. Maximum LTV was 85 percent; FTBs up to 90 percent.
    - As announced and effective June 30, 2021, maximum LTV is 80 percent; FTBs up to 90 percent. See Rules No. 778/2021.
    - As announced and effective June 15, 2022, maximum LTV is 80 percent; FTBs up to 85 percent.
    - Last change: June 2022.
  - Cap on debt service-to-income ratio (DSTI):
    - As announced and effective December 1, 2021, maximum DSTI ratio is 35 percent of borrower’s monthly disposable income; for FTBs, maximum is 40 percent.
    - A 5 percent general exemption (speed limit) applies per quarter.
    - When calculating debt service, maximum maturity is 40 years for nonindexed mortgages and 25 years for indexed mortgages.
    - Minimum interest rates used when calculating debt service: 5.5 percent for nonindexed and 3 percent for indexed mortgages.
    - Last change: June 2022.

- Corporate Sector Tools
  - Exposure limit:
    - As of December 31, 2016, limit on size of exposure to a single borrower is 25 percent of capital.
    - Last change: December 2016.

- Limits on Foreign Exchange Positions
  - Net foreign exchange positions:
    - For systemically important supervised entities: open position in individual foreign currencies may be neither positive nor negative by more than the equivalent of 10 percent of own funds; total foreign exchange balance may be neither positive nor negative by more than 10 percent of own funds—but may never exceed 25 b.kr.
    - For a credit undertaking that is not systemically important: open position in individual foreign currencies may be neither positive nor negative by more than the equivalent of 15 percent of own funds; total foreign exchange balance may be neither positive nor negative by more than 15 percent of own funds—but may never exceed 25 b.kr.
    - Last change: August 2018.
  - Foreign exchange swaps or derivative positions:
    - Effective June 30, 2021, limits introduced on derivative positions involving contracts specifying the Icelandic króna against a foreign currency:
      - (1) commercial banks' forward foreign currency position vis-à-vis each individual counterparty (long or short) may not exceed 10 percent of their capital base;
      - (2) commercial banks' gross forward foreign currency position may not exceed 50 percent of their capital base.
    - Calculation rules detailed in Article 3 of Rules No. 765/2021.
    - Last change: June 2021.

### Systemic risk monitoring — assessment and process
- Monitoring and assessment of systemic vulnerabilities is crucial for translating risk assessment into policy actions.
- This section assesses:
  - (1) the use of indicators and different econometric and modeling methods in risk analysis;
  - (2) the process between risk analysis and policy decision; and
  - (3) data gaps to be addressed and analytical tools to be enhanced.

*Source: IMF staff summary of Chapter 8 and related sections of the CBI macroprudential framework (from the supplied PDF content).*

### 19. Macroprudential policy decisions in Iceland are based on several indicators and

### 19. Macroprudential policy decisions in Iceland are based on several indicators and judgments.

### Framework and approach
- Guided discretion approach: key indicators identify risks to assess when policy action might be needed, but the decision is based on judgment that considers all relevant information.
- The FSN reviews a data factsheet of a broad set of macrofinancial indicators and analyzes macroeconomic, credit market, liquidity, solvency, and foreign exchange (FX) risks.
- Macrofinancial data and indicators are complemented by model-based indicators (for example, growth-at-risk indicator, probability of impending financial crisis) and analytical tools (for example, financial cycle indicator, domestic systemic risk indicator, and financial condition index) developed by the CBI.

### Stress testing and surveillance
- The CBI uses D-SIBs stress tests for surveillance and risk assessment, integrating top-down and bottom-up approaches for both microprudential and macroprudential surveillance.
- For the household sector, CBI uses top-down solvency stress tests and sensitivity analysis based on granular mortgage debt information assessing the debt servicing implications of shocks on the interest rate and income.

### Data, coverage, and recent improvements
- Data quality is generally good; availability of a comprehensive credit registry database helps fill knowledge gaps.
- CBI has broad powers to collect data under various legislation for financial stability mandates.
- Credit registry contains detailed information on borrowers’ profiles, loan characteristics (including debt servicing), and collaterals by type of exposure, including domestic credit to corporate and mortgage credit to households.
- Complete information (all exposures above 300 million ISK) on exposures to corporates (including commercial real estate loans) only started in September 2022.
- Granular data and account-level information on new housing loans started in August 2020.
- With the merger of the CBI and the FSA, supervisory data with individual exposure-level data on investment funds’ (IF) and pension funds’ (PF) exposures have become available.
- The system of cross-border capital transfers and FX transactions has been revised and improved and should be used again soon.
- CBI relies on survey data and constructive dialogue with market participants and industry specialists; CBI's quarterly bank lending survey evaluates changes in lending conditions and expectations for the coming six months.

### Analytical orientation and gaps
- Analytical framework for systemic risk monitoring and stress testing is primarily oriented toward the banking sector, households, corporates, and housing sectors.
- There is scope for better incorporating NBFI risk analysis into common risk assessment, particularly given the size of this sector and interconnectedness in the Icelandic financial system.
- Need to deepen analytical capability to understand:
  - transmission of shocks between financial balance sheets within a group; and
  - extending macro stress testing to NBFIs (specifically pension funds and investment funds), including from a systemic perspective.

### Recommendations to develop macroprudential capacity
- Develop macroprudential stress test frameworks that consider feedback loops between the financial system and the real economy and allow for looking at the impact of macroprudential instruments.
- Strengthen risk assessment capacity of systemic risk and calibration of macroprudential tools:
  - In addition to the GDP-at-risk analysis, consider implementing at-risk analyses for house prices.
  - Calibration and assessment of effectiveness of macroprudential tools should be supported by data-driven and technical analysis (for example, network methods to identify and determine the buffer size of banks subject to the systemic risk buffer (SRB)).
  - Use future credit registry data to establish a model for the probability of default (PD) based on explanatory variables, including the DSTI level of the borrower and their financial margins.
  - Continue to monitor, qualify, and improve alternative indicators of cyclical risk; there is no single measure of systemic risk.
  - Produce heatmaps and a risk dashboard to group vulnerabilities within a sector into key components (debt growth, leverage, and liquidity risk) and aggregate different indicators to strengthen macrofinancial risk analysis and improve communication and accountability.

### Data gaps to address
- More granular and timely data on intra-NFC lending to supplement analysis of trends in nonbank financial intermediation.
- Collect climate data and incorporate climate risks into general financial stability assessments.
- Obtain micro data on households and NFCs to refine risk analysis; credit registry does not include loan level data for consumer and other loan exposures.
- Regular reporting of CRE companies’ financial conditions to monitor and assess repayment risks to banks.
- Conduct a comprehensive assessment of data gaps and swiftly address existing gaps to support a comprehensive assessment of systemic risk.

### Systemic risks and macroprudential tools: assessment approach
- Systemic vulnerabilities are assessed based on developments in multiple signaling indicators, FSAP’s financial sector risk analysis, and the IMF “Staff Guidance Note on Macroprudential Policy” (IMF 2014a) supplement, “Detailed Guidance on Instruments” (IMF 2014b).
- Recommendations for Iceland’s macroprudential policy follow the assessment of each type of vulnerability.

### Financial cycle indicators and recent dynamics
- The financial cyclical indicator (FCI) started to decline from the local peak reached at the end of 2021 but remains above its historical median level.
- The dynamic FCI provides an early warning signal of potential materialization of risks six quarters ahead.
- Recent decrease in the FCI was mainly due to developments in loans to the household market and a sizeable drop in the correlation between the individual FCI sub-indicators.
- Net new household loans (particularly mortgage lending) slowed significantly, accompanied by declining year-on-year changes in household debt into gross disposable income.
- The theoretical FCI value excluding the effect of the correlation increased further and is the highest since 2014, indicating mixed signals regarding future cyclical systemic risks.

### Construction and composition of the FCI
- Steps to construct FCI:
  - choose variables that capture buildup rather than materialization of risks;
  - normalize variables to the range (0,1) by using a Gaussian kernel estimate of the cumulative distribution function;
  - estimate a time-varying variance-covariance matrix based on the exponentially weighted moving average method (EWMA);
  - choose weights through a Monte Carlo 30000 simulation analysis to produce a FCI that best predicts loan loss impairment six quarters ahead;
  - aggregate variables into a single indicator using standard portfolio theory per equation 퐹퐶퐼푡 = (푤표푠푡)′퐶푡(푤표푠푡).
- Table of variables and generated best weights:
  - 1. New bank loans to households - an annual moving sum of new loans: 0.241
  - 2. New bank loans to nonfinancial corporations - an annual moving sum of new loans: 0.239
  - 3. Property prices y-o-y change in the price index: 0.162
  - 4. Household debt/gross disposable income (moving annual total)- y-o-y change, %: 0.143
  - 5. Nonfinancial corporations’ debt/gross operating surplus (moving annual total) - y-o-y change, %: 0.05
  - 6. Spread between the rate on new loans to households and 3M interbank rates: 0.045
  - 7. Spread between the rate on new loans to NFCs and 3M interbank rates: 0.041
  - 8. Stock prices y-o-y change in the price index: 0.04
  - 9. Current account deficit/GDP % p.a.: 0.038

### Broad-based capital tools and buffers
- Authorities have actively introduced Basel III and its European counterpart into law, and actively apply capital buffers in those regulations.
- Prudential regulations on capital are aligned with EU rules and EBA guidelines, including capital buffers applicable to banks.
- Pillar 2 capital requirements are substantial, based on in-house benchmark models developed and disclosed by the CBI to capture risks not covered in Pillar 1, including concentration risk and interest rate risk in the banking book (IRRBB).
- The CCyB, CCoB, and SRB provide resilience against shocks given observed imbalances.

### CCyB activation history and stress test findings
- CCyB guiding approach characterized as “early activation and buildup,” with an eye to reaching 2.5 percent of risk-weighted assets (RWA) in a timely manner.
- Timeline of CCyB rates:
  - March 1, 2016: CCyB rise to 1 percent.
  - November 1, 2017: CCyB increased to 1.25 percent.
  - May 15, 2018: CCyB increased to 1.75 percent.
  - February 1, 2019: CCyB increased to 2 percent.
  - March 18, 2020: CCyB decreased to 0 percent.
  - September 29, 2021: CCyB increased to 2 percent.
  - March 15, 2023: CCyB increased to 2.5 percent.
- FSAP stress tests suggest capital buffers are enough to absorb adverse macrofinancial shocks.
- FSAP bank solvency stress tests simulate a credit shock to households and corporates mainly via a drop in output and increase in interest expense and unemployment rates; they confirm banks’ overall resilience to severe and plausible macroeconomic shocks.
- The exercise found meaningful credit losses for households, which remain less than for corporates.

### Vulnerabilities from the housing and household sectors
- Household indebtedness:
  - Households’ debt stood at 148 percent of disposable income at the end of 2022, which is almost two percentage points higher than the historical average.
  - Around 81 percent of household debt is made up of mortgages.
- According to IMF's Scorecard estimates, Iceland's household vulnerability scored 4 out of a maximum of 6 in the second quarter of 2022. The overall score summarizes three indicators (house price misalignment, mortgage market risk, and household indebtedness).

*Source: 1islea2023006 - 19. Macroprudential policy decisions in Iceland are based on several indicators and judgments (IMF).*

### 34. The share of CPI (consumer price index)-indexed and variable loans has continued to

### 34. The share of CPI (consumer price index)-indexed and variable loans has continued to

### Mortgage composition and recent trends
- For the first time, nonindexed mortgages accounted for more than half of the mortgage stock in June 2021.
- The share of CPI-indexed loans in the stock of existing household debt decreased from 69 percent at the beginning of the COVID-19 pandemic to 43 percent in the third quarter of 2022.
- The share of CPI-indexed new mortgage loans rose subsequently, reaching 50 percent of total new loans by January 2023.
- The share of variable interest rates declined significantly since the third quarter of 2021, reaching 44 percent in the third quarter of 2022, likely reflecting monetary policy rate hikes by the CBI.

### Household refinancing behavior and risks from indexed vs non-indexed loans
- Households can switch between indexed and non-indexed mortgages by refinancing during the loan term.
- Recent behavior suggests borrowers increasingly refinance toward indexed loans to shelter from rising nominal interest payments on non-indexed loans.
- Indexed mortgages:
  - Utilize real interest rates, which are lower than nominal interest rates in periods of high inflation, but
  - Add inflationary effect onto the principal of the loans, keeping the debt servicing burden predictable.
- Risk trade-off:
  - Short-term benefit: lower interest payments.
  - Longer-term risk: price level adjustments to outstanding loan amounts could erode home equity and lead to negative amortization during times of high inflation.

### House price developments and misalignment
- House prices have grown rapidly in recent years.
- Contributing factors include building cost, income growth, increased net migration flows, and short-term rental contracts demand generated by tourism.
- IMF Systemic Risk Tracker and house price misalignment estimations indicate susceptibility to macrofinancial shocks and an increased likelihood of price correction.
- Models where long-term house price growth is changeable (house price misalignment model and Kalman filtration) suggest a price misalignment potentially ranging from 6 percent to 7 percent, which, if corrected, could result in financial losses to households and financial institutions.
- Box 2 estimates of overvaluation in 2022Q2 range from 6.2 percent to 17.6 percent (HP GAP 17.6%, Kalman GAP 6.9%, Regression model 6.2%).

### Household debt-service capacity and distress indicators
- CBI loan-level data since 2020 provide insight on household debt distress measured by DSTI exceeding 35 percent.
- CBI simulations (based on loan-level data) under the assumption that all nonindexed fixed-rate loans are converted to nonindexed variable-rate loans at the market rate of March 2023 indicate:
  - Fewer than 3 percent of households would have a DSTI ratio above 35 percent, with the incremental change being less than 1 percentage point.
- Approximately half of all non-indexed mortgages have a fixed interest rate; most of these fixed-rate loans will not be released until the years 2024 and 2025.
- Over the past three years, the share of households whose debt service exceeded 35 percent of disposable income rose by two percentage points (from about 7 percent in January 2020 to 9 percent in January 2023).

### Policy measures undertaken and calibration
- Maximum loan-to-value (LTV) ratio implemented in July 2017:
  - Initial limit: 85 percent in general and 90 percent for first-time homebuyers.
- LTV tightened in June 2021 and in June 2022:
  - Resulting general maximum LTV ratio: 80 percent and 85 percent for first-time homebuyers.
- Cap on DSTI in September 2021:
  - General cap: 35 percent.
  - First-time buyers cap: 40 percent.
- Changes to Rules on Maximum Debt Service-to-income Ratios for Mortgage Loans to Consumers (Act: No. 701/2022):
  - When calculating debt service, the higher of contractual interest rates or a reference interest rate must be used:
    - Reference interest rate of 3 percent for indexed mortgages.
    - Reference interest rate of 5.5 percent for non-indexed mortgages.
  - Maximum maturity period for indexed mortgage loans reduced from 30 years to 25 years.
  - Maximum maturity for non-indexed mortgage loans remains unchanged at 40 years.
  - Calibration of reference interest rates aligns with an estimation of the equilibrium real interest rate.
- LTI (loan-to-income), defined as the total amount of mortgage loans to the annual disposable income of the borrower, has not been implemented yet; LTI can be restricted in the range of 5 to 9.
  - The CBI can implement this tool after receiving approval from the FSN.

### Effectiveness of borrower-based measures and recommendation
- Empirical research: borrower-based tools, such as LTV and DSTI caps, effectively reduce the buildup of vulnerabilities over time and provide households with buffers.
- Recent IMF Selected Issues Paper suggests tightening (for example, lower LTV and/or lower DSTI) dampens house prices significantly for a few quarters with transitory effects.
- Literature indicates the impact of borrower-based measures on the growth rate of house prices and credit is limited in advanced countries, but these measures remain useful for building buffers and enhancing financial stability.
- Recommendation:
  - The authorities should continue monitoring developments in the housing market and stand ready to take further actions if systemic risks persist.
  - Over time, if vulnerabilities associated with housing finance persist, further tightening for borrower-based measures could be considered.

### Corporate sector vulnerabilities and links to real estate
- Gross corporate debt of NFCs has remained relatively stable at 80-90 percent of GDP since 2017.
- By end-2022, the Iceland NFCs depended on loan financing from banks and other financial institutions with an average share of 82 percent.
- Largest exposure (about 70 percent of total loans) is to the banking system, followed by other financial institutions.
- Loans are mainly to the real estate, fisheries, and services sectors (65 percent of the loans); the real estate sector accounts for a quarter of corporate loans.
- The pandemic increased corporate vulnerability via higher profitability risks, stock valuation risks, and default risks; sectoral NPL increases were largest in service and tourism-related sectors.
- CRE sector:
  - CRE NPLs’ share as a proportion of total NPLs is above 30 percent in Iceland.
  - Banks' credit to CRE and construction and CRE prices have risen rapidly in recent years; CRE prices are historically high and far above trend.
  - FSAP sensitivity analysis indicates that a sharp increase in probability of default would have the highest negative impact on banks' capital from the real estate sector, given higher exposure and relatively higher loss given defaults.
- Corporate debt in foreign currencies:
  - Amounted to more than 28 percent of GDP and around 36 percent of total corporate debt at the end of 2022 Q3.
  - Composition: 40 percent were foreign loans and 12 percent were marketable bonds issued abroad.
  - Around 35 larger Icelandic nonfinancial companies finance themselves in whole or in part abroad, mainly through borrowing.
  - Net new loans to companies in foreign currencies and changes in the stock indicate corporate FX borrowing has remained relatively stable as a share of total corporate debt in recent years.
  - Corporations borrowing in foreign currencies are mainly firms with foreign revenues (for example, fisheries, transport, and tourism).

*Source: IMF staff analysis and CBI data as presented in the provided content.*

### 46. The CBI has been proactive in identifying measures to address risks from the corporate

### 1islea2023006 - 46. The CBI has been proactive in identifying measures to address risks from the corporate

### Corporate exposures and commercial real estate (CRE)
- Banks are required to conform with a 25 percent exposure limit (of capital) to a single borrower, effective December 31, 2016.
- Aggregate corporate debt has declined since the peak of the global financial crisis, with the largest exposure to the banking sector.
- Banks’ exposure to the CRE sector and construction is continuously rising.
- CRE prices are historically high and above their trend level (CR HP Trend determined using a Hodrick-Prescott (HP) filter with λ = 400,000).
- Most of the corporate debt is nonindexed and bears variable interest.

### Credit growth, nonperforming loans (NPLs), and risk monitoring
- Strong growth of domestic bank lending to CRE and the construction sector warrants attention.
- Close monitoring should continue of: credit, overall indebtedness, and other risk indicators of the NFCs; and real estate and construction sector–related corporate finance—where strong demand for credit is supported by price overvaluation.
- The NPL ratio on the D-SIBs’ corporate loans continued to decline (sectoral NPL ratios shown by sector in source charts).

### Stress testing and solvency assessment
- The solvency stress test shows that despite relatively high capital depletions over adverse scenarios, no bank would face a capital shortage below the minimum capital requirement stress.
- Some banks’ losses associated with large, indebted corporates may increase notably under stress.
- The balance sheets of corporates may further worsen if financial condition tightening continues, which can have substantial spillovers in case of a stress event.
- The CBI should monitor and evaluate the risks from corporate exposures and stand ready to act if corporate vulnerabilities increase.

### Macroprudential toolkit: recommendations for CRE vulnerabilities
- Rationale: existing broad-based capital measures help safeguard bank resilience but are too blunt for targeting specific CRE risks; sole reliance on broad measures may not be effective in containing price and credit booms.
- Recommended additions:
  - Sectoral capital measures
    - Target banks with higher exposures to riskier sectors (important for CRE exposures which vary across Icelandic banks).
    - Introduce risk weights to help withstand corporate credit losses by building capital buffers; may also increase the cost of credit and slow corporate credit growth.
    - A higher risk weight can be implemented by a risk weight floor or LGD floors in calculating RWAs.
    - Capital buffers (SRB/CCyB) are adjustable over the cycle and can be relaxed to allow losses to be absorbed and credit to flow when needed.
  - Borrower-based measures
    - Could be considered if combinations of existing and suggested measures are insufficient to contain CRE risks.
    - Directly target reducing excessive credit growth and stretched valuations while increasing borrowers’ resilience.
    - Are less procyclical than some capital tools but have substantial operational challenges related to sectoral heterogeneity and data limitations.
    - An in-depth assessment of CRE loan riskiness is still hindered by data quality issues despite ongoing work on improving data availability.

### Funding, liquidity, and resilience
- The Icelandic banking sector has relied on wholesale funding; retail deposits explain only half of the funding structure.
- The loan-to-deposit ratio was around 134 percent at the end of 2022.
- Retail deposits were just around 38 percent in 2014 (current funding structure is an improvement).
- At end-2022, D-SIBs’ combined liquidity ratio in all currencies was 165 percent, above the 100 percent minimum required under CBI rules.
  - Liquidity ratio in foreign currencies: 316 percent.
  - Liquidity ratio in Icelandic krónur: 121 percent.
- D-SIBs’ net stable funding ratio (NSFR) for all currencies combined was 117 percent (above the 100 percent minimum requirement).
  - Funding ratio in foreign currencies: 165 percent.
  - Funding ratio in Icelandic krónur: 108 percent.
- Aggregate liquidity and stable funding are sufficient, but could be insufficient during periods of stress.
- Liquidity stress tests indicate the banking system is broadly resilient to adverse liquidity conditions but not immune to additional liquidity outflows from pension and nonresident FX funding, especially over the longer term.
- Stress tests focusing on individual currencies reveal common vulnerabilities to domestic and foreign currency–denominated outflows.

### Structural vulnerabilities and interconnectedness (banking, NBFIs, and pension funds)
- Total banking sector assets accounted for 135 percent of GDP as of 2022 Q3.
- Banking system concentration: the three largest banks—Arion Banki, Íslandsbanki, and Landsbankinn—account for 95 percent of banking assets.
- The banking sector is highly interconnected with NBFIs.
- Among NBFIs, pension funds (PFs) have assets at 173 percent of GDP and play a vital role.
- Other financial intermediaries (IFs), money market funds (MMFs), equity funds, and so on have total assets just over 35 percent of GDP.
- FSAP analysis (end-2021) findings:
  - Total value of households' assets amounted to 307 percent of GDP.
  - More than 60 percent of households’ asset exposures are with PFs, and around 13 percent are with banks.
  - PFs’ exposure to the banks more than doubled from 2017 to 2021, accounting for 10 percent of total pension fund assets—this corresponds to 14 percent of banks’ financial liabilities.
  - NFCs are the largest borrowers, with debt held by banks, NBFIs, and other NFCs.

### Role of pension funds and investment funds in credit intermediation
- By end-2022, PFs hold around 23 percent share in outstanding mortgage loans and are in active competition with the banks in the mortgage market.
- PFs generally have stricter lending standards than banks; borrower-based macroprudential tools apply to them as well as to all mortgage lenders in Iceland.
- PFs are an important provider of credit to the NFC sector; their share of total NFC credit increased about three times in the past ten years.
- PFs are the main buyers of corporate bonds in Iceland, mainly bonds issued by large real estate companies, power companies, and the fishing industry.
- IFs’ NFC lending has increased in recent years, largely limited to loans to bigger companies and often connected to real estate projects; there are instances of IFs lending to SMEs and buying loan portfolios from banks.
- While IF lending to corporates is small in scope, the CBI should closely monitor and be ready to act if risks increase.

### Systemic importance and supervisory measures
- Three institutions are assessed by the CBI to be systemically important and are subject to capital surcharges.
- The O-SII buffer was set at 2 percent for the three largest commercial banks and has remained unchanged since its introduction (April 1, 2016).
- The O-SII buffer captures the exposure of the individual institution to system-wide risks; identification of institutions subject to O-SII buffer is based on EBA guidelines.
- Recommendation: The CBI should continue to pay close attention to developments in the nonbank financial sector and develop a policy framework to address potential systemic risks from these developments.
  - In addition to monitoring mortgage lending, the CBI should pay close attention to NBFIs’ other quasi-banking activities (e.g., increased share of PFs credit to the NFCs, and PFs’ lending activities connected to real estate projects) as they could become potential sources of systemic risk.

*Source: 1islea2023006 - 46. The CBI has been proactive in identifying measures to address risks from the corporate (IMF staff content provided).*

---


_Source: https://www.imf.org/-/media/files/publications/cr/2023/english/1islea2023006.pdf_