## _cr08368

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### Executive Summary and Overall Assessment — Key findings
- Icelandic financial system dominated by three large banking groups: Glitnir, Kaupthing, and Landsbanki.
- Consolidated bank assets expanded from 100 percent of Icelandic GDP in 2004 to almost 900 percent at end-2007.
- By end-2007, over 50 percent of the banks’ assets were held abroad in branches and subsidiaries, principally in the Nordic countries and the U.K.
- Expansion funded in global wholesale markets doubled banks’ foreign debt and increased counterparty risk (CDS spreads rose sharply) as global turbulence began in mid-2007.
- Reported financial indicators:
  - Bank capital averaged almost 13 percent of risk-weighted assets between 2003 and 2006, dropped to 12 percent in 2007 and to approximately 11 percent in the first half of 2008; regulatory minimum is 8 percent.
  - Liquidity ratios are above minimum levels but increasingly reliant on central banks’ liquidity facilities.
- Vulnerabilities and pressures:
  - Global international liquidity declined significantly in the past 12 months.
  - Capital levels are below the five-year average and may not provide adequate buffers given market uncertainty.
  - Foreign debt maturities of the financial sector are relatively short, concentrated in the period 2008–2010.
  - Asset quality concerns: reported NPLs are low but increasing; exposure to market risk via securities holdings and collateralized lending.
- Banks’ remedial measures:
  - Diversifying funding toward retail deposits.
  - Paying down market debt by reducing loan books, selling noncore assets, withdrawing from marginal markets.
  - Estimation of sufficient liquidity to meet debt service requirements through early 2009 and obligations maturing over the medium term.
  - CBI provided much of domestic liquidity; banks augmented liquidity via covered bonds, sales of noncore assets, raising private capital, and structuring loans into securities eligible for repo operations with major central banks.
- Risks and uncertainties:
  - Funding and asset quality pressures likely to remain at least until 2010.
  - Lower profitability, declining asset quality, uncertainties about capital quality and shareholder strength, complex ownership, and perceived related party lending may hinder mobilization of funds.
  - A financial misstep in one bank could prompt market penalties across all Icelandic banks.
- Central Bank of Iceland (CBI) role and risk:
  - CBI became principal provider of market liquidity domestically; CBI collateralized lending to commercial banks increased steadily since 2006.
  - CBI holdings of bank securities reached 370 percent of capital by early 2007.
  - Policy may undermine other macroeconomic objectives, exposes CBI to possible losses, and may generate a need for future recapitalization.
- Supervision:
  - Supervisory framework strengthened; FME capacity enhanced; issues from 2003 BCP assessment addressed.
  - Prudential laws and regulations updated; FME and CBI increased emphasis on liquidity management and contingency planning, extending scope to foreign activities of banking groups.
  - Recommendation: more consistent contact among host-country supervisors.

### Systemic Risk Exposures — Macroeconomic risks and outlook
- Macro context:
  - Domestically driven, foreign-funded boom lifted real output by over 25 percent during 2003–2007.
  - Boom produced large macroeconomic imbalances, highly indebted private-sector balance sheets, and high dependence on foreign financing.
  - As external liquidity constraints tightened and market sentiment soured, banks and the currency came under significant pressure; the overheated economy showed signs of cooling.
- Projections and risks:
  - Real GDP growth projected to come to a standstill in 2008 and contract by 2 percent in 2009, led by a retrenchment in domestic demand.
  - Inflation expected to remain above target well beyond 2008, reflecting króna depreciation, deteriorating expectations, and global inflationary pressures.
  - Current account deficit expected to narrow.
  - Public debt minimal but fiscal position set to deteriorate sharply in the near term.
  - External liquidity risks remain key given high foreign debt of the private sector (chiefly related to the banking system).
  - Further capital outflows could lead to additional króna depreciation and tighter domestic credit conditions.
  - Significant risks: inflation, house and equity prices, private sector indebtedness, and foreign currency exposures.

### Household and Corporate Debt Levels — Key statistics and exposures
- Corporate sector:
  - Corporate balance sheets expanded through debt-financed acquisitions abroad.
  - Leverage: debt of nonfinancial corporations exceeded 300 percent of GDP in 2007.
  - Domestic banks financed about two-thirds of such debt; 70 percent of that financing was in foreign currency.
  - Corporate syndicated loans increased fivefold between 2003 and 2006 to close to US$8 billion (50 percent of GDP).
- Households:
  - Household debt (predominantly mortgages) reached 103 percent of GDP by 2007 (about 220 percent of disposable income).
  - Some 80 percent of household debt is indexed and another 13 percent is denominated in foreign currencies.
  - Owner-occupied housing: 90 percent; loan-to-value ratios relatively modest.
  - Net asset position of households strengthened in recent years.

### Financial System Strengths and Vulnerabilities — Banking system, stress testing, funding, and asset quality
- Banking system size and structure:
  - Total financial sector assets over 12 times GDP at end-2007.
  - Deposit-taking institutions represent almost 80 percent of total financial sector assets or 966 percent of GDP.
  - Three large banks’ consolidated assets: 923 percent of GDP at end-2007.
  - By end-2007, almost 50 percent of the three banks’ assets were held abroad.
  - 75 percent of their borrowing was dependent on wholesale markets.
- Market indicators and CDS:
  - CDS spreads for Icelandic banks increased sharply during mid-2007, peaked in April 2008, remained above European peers during spring recovery, and peaked again in summer 2008.
  - Contributing factors: thin CDS market, króna volatility, unwinding of CDO structures, high wholesale funding dependence, deteriorating domestic outlook, rating downgrade concerns.
- Profitability and capital:
  - Return on equity (ROE) averaged 2.5 percent in 2005–2006; ROE fell to 1.5 percent in 2007.
  - Bank capital averaged about 13 percent of risk-weighted assets between 2003 and 2006, falling to 12 percent in 2007.
  - Capital ratios for the three large banks fell to 11.2 percent and 10.7 percent in the first and second quarters of 2008, respectively.
  - Regulatory minimum capital ratio: 8 percent.
  - Capital quality concerns: highly indebted controlling shareholders, connected counterparties, complex ownership, regulatory allowance for Tier I hybrid capital up to 30 percent (Nordic limitation is 15 percent).
  - Banks increased long foreign exchange positions with derivatives from about 20 percent of capital at end-2006 to 58 percent and 72 percent in December 2007 and March 2008, respectively.
  - Recommendation: increase capital levels and assess adequacy within Pillar II including additional charges for risks not covered in Pillar I.
- Credit risk and asset quality:
  - Credit growth averaged over 50 percent between 2004 and 2006 and grew by almost 60 percent in 2007.
  - Nonperforming loans increased from 0.5 percent of total loans in 2006 to 1.0 percent at end-2007.
  - FME mid-2007 survey: about 90 percent of loans considered good quality.
  - Risk factors: loan indexing/foreign currency exposure with up to one third of domestic borrowers unhedged; over half of total lending is abroad; top 20 borrowers represent between 250 percent and 300 percent of Tier I capital; reported 6.5 percent of total lending to related parties; over 300 new holding companies created each year in last three years.
  - Indications of slippage: impaired asset flows increasing (almost doubling in some banks over a three-year period); increased loan loss provisioning; collateral sales related to contractual margin calls increased sharply in 2008.
  - Recommendation: require reserves for future losses, encourage forward-looking provisioning, ensure asset values and collateral valuation are accurate.
  - Risk note: heavy use of equity-collateralized lending may shift credit risk to market risk and create volatile margin-call spirals.
- Liquidity and funding risk:
  - Debt repayments due for all three banks large in 2009 and 2010; one bank has significant repayments in the second half of 2008.
  - All three banks accessed markets in Q1 2008; subsequent issuance very limited.
  - New foreign deposits grew by 90 percent and 112 percent for Kaupthing and Landsbanki, respectively.
  - Banks contracting and rationalizing assets, selling subsidiaries, reducing noncore loan portfolios.
  - Banks report adequate resources to meet debt obligations over the next 12 months and are preparing for prolonged wholesale market closure.
  - Bank liquidity highly dependent on central banks’ liquidity facilities.
  - Banks exploring covered bonds and securitization to make loan portfolios eligible for major central bank repos (ECB, Bank of England).
  - FME should examine robustness of funding instruments under limited global liquidity and develop contingency plans.
  - Caveats: foreign deposits may be more volatile and reduce margins; securitization may concentrate credit risk as riskiest tranches remain on bank balance sheets.
- Market risk and complexity:
  - Equity securities are 15 percent of total assets; direct equity holdings approximately 2–3 percent of total assets.
  - Approximately 70 percent of lending to Icelandic corporates denominated in foreign currency; about one-third of foreign-denominated lending to households has no natural hedge.
  - Large banks maintain small open FX positions and establish long FX positions to protect regulatory capital from exchange rate changes.
  - Limited options for rapid size reduction; abrupt sales may be negatively interpreted and affect sovereign spreads.
  - Immediate priorities: ensure strong capital and liquidity buffers, improve corporate transparency, attract new investors.

### Institutional Investors, Pension Funds, Housing Finance, and Capital Markets
- Pension funds:
  - Pension fund assets under management grew to 122 percent of GDP at end-2007.
  - System: three basic pillars; 32 fully operational occupational pension funds; 10 largest hold 80 percent of system assets.
  - Actuarial positions appear solid; returns were high in the past four years; significant fall in market values led to slightly negative returns in 2007.
  - Pension funds use derivatives to acquire long positions in domestic real interest rates and are highly exposed to domestic inflation-linked securities.
  - About 10 percent of pension funds' assets represented by mortgage lending to contributing members with reportedly low LTV ratios and delinquencies.
- Housing Finance Fund (HFF):
  - HFF has no foreign exchange exposure; government-owned with a government guarantee; funds itself through bond issuance.
  - HFF loan quality remained strong; most loans for owner-occupied homes with LTV ratios of 60 percent historically.
  - Since 2004 banks entered mortgage market aggressively, lowering rates and increasing LTVs; HFF market share declined.
  - June 2008: new HFF lending programs introduced allowing HFF to finance banks’ mortgage portfolios and origination activities; loan limits increased to 80 percent of purchase price subject to ISK 20 million loan limit.
  - New framework allows banks to obtain liquidity from HFF and CBI, effectively sharing credit risks between the two public institutions.
- Capital markets and FX:
  - Domestic bond stock about 100 percent of GDP; most liquid bonds issued by HFF (about ½ of the market) and government t-notes.
  - Glacier bonds: Eurobonds issued by nonresidents, denominated in ISK, about US$5 billion outstanding.
  - FX market turnover increased five times between 2004 and 2008 due to carry trades; monthly volumes averaged US$10 billion; monthly volumes are 60 times interbank market volumes.
  - Notional gross positions on FX markets, including derivatives, reached US$150 million.
  - Equities market capitalization over 170 percent of GDP; largest four banks comprise 63 percent of the index.
  - Equity index gained over 400 percent (2004–mid-2007) and lost about 60 percent since the onset of the credit crisis.
  - Securities markets large relative to the economy but small compared with Nordic peers; liquidity tends to be low and market concentrated.

### Stress testing — practices and recommended enhancements
- Authorities (CBI and FME) have developed comprehensive stress testing exercises; tests indicate resilience to a variety of historical shocks but global market deterioration warrants more stringent tests.
- CBI credit risk model (CreditRisk+ based):
  - Baseline model subjected to three stress scenarios including increasing PDs for selected industries and a 10 percentage point decline in selected industry recovery rates.
  - Model based on limited portfolio data; estimated PDs use historic averages when default rates were low.
  - Recommended improvements: obtain complete loan-level information (including sectorization of holdings companies), more complete data on portfolios abroad, stronger PD assumptions, improved transparency on calibration and parameters.
- Liquidity testing:
  - CBI requires liquidity sufficient to satisfy a liquidity stress test; liquidity ratio for positions under three months must exceed one.
  - Liquidity tests report banks can meet obligations over the next 12 months.
  - Recommendation: complement tests with scenarios of slow global recovery and develop liquidity plans for prolonged market disruptions.
- FME stress testing:
  - Quarterly balance sheet stress tests for credit and market risks are published.
  - Standard stress shocks include: foreign share prices (-25 percent), domestic share prices (-35 percent), weakening of the króna (25 percent), fall in long-term bond values (-7 percent), decline in contemporaneously reported nonperforming loans (-20 percent).
  - Based on end-2007, no bank undercapitalized under the standard scenario.
  - Since 2007, supplemental tests increase nonperforming and impaired assets via two shocks: (i) increase impaired asset categories by largest 12-month observed category-specific increase; (ii) increase magnitude well above historical experience; then reduce impaired assets by 20 percent to reflect stress recovery.
  - Under the most severe supplemental scenario, three of four banks remain above regulatory minimums and a fourth becomes only marginally undercapitalized.
  - Recommended expansions: evaluate significant tail events, joint effects of declining equity markets on collateralized credit portfolios and banks’ own portfolio holdings, impact of declining collateral values, and threats to profitability from hedging positions related to long FX positions and derivative use.

### Supervision, regulation, cross-border coordination, and crisis management
- Legal and institutional framework:
  - Iceland strengthened legal framework for effective banking supervision; Basel II implemented in 2006; IFRS implemented in 2005.
  - FME published guidelines covering Pillar I and Pillar II: stress testing, risk concentration, interest rate risk in banking book, ICAAP, liquidity risk management.
- FME organization and operations:
  - FME is integrated supervisory authority; staff planned growth from 56 to 64 employees; almost one-half of staff supervises credit institutions.
  - Off-site analysis and on-site inspection quality and efficiency enhanced; supervisory review adapted to institutions’ structure and complexity.
  - Introduced forward-looking elements including stress tests and scenario analysis.
  - Gaps/recommendations: require regular transmission of risk management and internal audit reports; increase frequency of prudential meetings with senior management as needed; further strengthen staff skills as banks shift to Basel II.
- Cross-border cooperation and crisis management:
  - Cooperation with foreign regulators increased (U.K., Nordic host supervisors); FME participates in CEBS and has MOUs with several non-EEA authorities.
  - Recommendation: establish a “forum of supervisors” or “college” for each bank to enhance home/host coordination, risk reviews, and remedial planning.
  - Suggest reaching agreements with host supervisors on crisis management responsibilities: coordination of emergency lender-of-last-resort facilities, cross-jurisdictional liquidity policies, early supervisory interventions, and resolution of failing institutions.
  - Current bank resolution framework: general banking law with broad supervisory powers and court-guided resolution; recommendation: introduce a special problem bank resolution regime (separate bank bankruptcy regime) to provide additional tools including purchase-and-assumption authority, holding/bridge banks, and facilitation of mergers once shareholder capital depleted.

### Contingency planning for a possible bank failure and market infrastructure
- Contingency planning:
  - Plans could specify when government support is needed and the form such support could take.
  - Possible forms of government support mentioned: an explicit, temporary guarantee to support asset prices; use of existing governmental institutions to provide temporary support; subscription of subordinated debt.
  - Authorities advised to discuss and agree contingency plans for more drastic scenarios.
- Domestic liquidity market:
  - Iceland’s interbank market shallow and became more so after recent turmoil; transactions small, infrequent, mostly overnight.
  - Example: June 2008 interbank transactions averaged ISK 10 billion each; weekly transactions at the CBI: ISK 400.
  - Larger banks reluctant to take credit risk, preferring collateralized lending by the CBI.
  - CBI as principal provider of market liquidity:
    - Seven-day collateralized loans each Wednesday; on average 10–12 banks borrow weekly; CBI regularly rolls over maturing debt.
    - CBI does not impose access limits or total exposure limits; does not conduct competitive bidding.
    - Collateral restrictions eased in January 2008 and again in March 2008 to align with ECB regulations.
    - CBI accepts treasury notes, HFF bonds, A-rated commercial paper in both króna and foreign exchange.
    - All collateral supplied is króna-denominated.
  - Continued use of CBI window exposes CBI to potential risks:
    - CBI holdings of bank securities: almost 240 percent of CBI capital at end-2006; 278 percent at end-2007; 370 percent by April 2008.
    - Heavy collateralized lending in early 2008 as banks borrowed domestically to swap króna into foreign currency.
    - Policy may undermine other macroeconomic objectives and expose CBI to potential losses and future recapitalization needs.
    - Note: "The CBI is reviewing the operation of the collateralized lending facility and is considering measures to improve the quality of collateral and establish access limits."
- Foreign liquidity and FX developments:
  - Recent currency volatility and increased counterparty risk reduced attractiveness of carry-trades.
  - March 2008 widespread sale of króna positions caused rapid króna depreciation; CBI increased target interest rate and issued floating-rate notes which offered the CBI policy rate to investors; high interest rates and low CDS on the Iceland sovereign generated new carry-trade opportunity and pressure on the exchange rate subsided.
- Payments system and securities settlement:
  - Payment systems improved: intraday credits and netting exposures collateralized; participants can monitor exposures in real time and limit them.
  - DvP settlement adapted in 2007 to settle off-exchange trades; technical setup supports DvP but system rules do not fully support the process.
  - Some high-value transactions reportedly settled without DvP—investigation recommended.
  - FME and CBI plan CPSS-IOSCO assessment of securities settlement in cooperation with ISD and market participants; authorities encouraged to complete this assessment.
  - ISD preparing to offer settlement for Icelandic equities denominated in euro through TARGET in accounts with the Bank of Finland; continued harmonization with Europe recommended.
- Key market-liquidity statistics:
  - CBI holdings of bank securities: almost 240 percent of CBI capital at end-2006; 278 percent at end-2007; 370 percent by April 2008.
  - Interbank transactions in June 2008: averaging ISK 10 billion each; weekly transactions at the CBI: ISK 400.
  - Selected macro and financial table excerpts:
    - Gross domestic product: 4.3 3.9 0.1 2.4 7.7 7.5 4.4 3.8 -0.3 -2.1
    - Consumer price index: 5.1 6.6 4.8 2.1 3.2 4.0 6.8 5.0 11.7 9.7
    - Central bank gross reserves (bln USD): 0.4 0.4 0.5 0.8 1.1 1.1 2.3 2.6 2.9 3.1
    - Gross external debt: 108.3 123.3 110.6 139.6 179.1 285.8 445.9 557.9 545.7 545.3
    - Nominal GDP (bln ISK): 683.7 771.9 816.6 841.5 928.7 1,026.3 1,167.7 1,279.4 1,424.0 1,502.0
    - Total financial system total assets: 14,919 (in billions of ISK); Assets/GDP: 1,212.7
    - Banks: Number 37; Total assets 12,798; Asset share 85.8; Assets/GDP 1,040.3
    - Deposit-taking institutions: Number 25; Total assets 11,883; Asset share 79.7; Assets/GDP 966.0
    - Regulatory capital as percent of risk-weighted assets (CAR): 9.8 11.4 12.2 12.3 12.8 12.8 15.1 12.1
    - CAR excluding subordinated loans: 6.6 8.1 9.1 9.2 9.5 7.6 10.9 6.5
    - Capital as percent of assets: 6.2 6.5 7.2 7.1 7.1 7.4 7.8 6.9
    - Non-performing loans (NPL) as percent of gross loans: 1.5 2.0 2.6 2.1 0.9 1.1 0.8 ...
    - Liquid assets as percent of short-term liabilities: 120.2 120.8 118.9 120.3 130.0 150.0 200.0 170
    - Foreign currency loans as percent of total loans: 41.6 44.3 39.6 49.0 51.3 51.9 57.7 68.6
    - Loans as percent of deposits: 210.0 210.0 190.0 190.0 240.0 320.0 280.0 220

### Policy recommendations and supervisory / crisis management actions (Box 1 and other recommendations)
- Bank-level options:
  - Increase capital positions to meet expected deterioration in asset quality.
  - Further diversify funding base.
  - Enhance liquidity in both local and foreign currency.
  - Refocus activities and further reduce noncore assets; consider more aggressive downsizing if necessary.
- Authority-level options:
  - Enhanced monitoring to ensure capital and liquidity buffers are adequate.
  - Ensure loan provisioning is adequately forward looking.
  - Develop contingency plans for further serious market disruption and strengthen crisis management framework.
  - Introduce a special problem bank resolution regime including currently unavailable tools.
  - Enhance cooperation between home and host supervisors; develop emergency lending protocols and problem bank resolution options.
  - Mitigate investor concerns about related-party lending and shareholder strength by increasing transparency.
- Box 1 — Key Policy Recommendations (numbered as in source):
  1. Increase capital adequacy ratios to historical levels and evaluate need for additional increases in the ICAAP review process.
  2. Strengthen quality and sources of bank capital; identify and reduce excessive exposure to shareholders; attract new shareholders where necessary.
  3. Evaluate banks’ liquidity plans using scenario analyses of future cash flows and banks’ ability to sell securities in an illiquid market.
  4. Monitor credit quality; take remedial actions such as establishing reserves for future credit losses.
  5. Develop contingency plans for resolving funding limitations by bank and by currency.
  6. Require greater disclosure in financial statements identifying and reducing cross holdings, related-party lending, and concentration in lending.
  7. Address market concerns about size of large banks by (i) ensuring banks have strong capital not reliant on borrowing; (ii) making ownership structure more transparent; and (iii) increasing liquidity buffers.
  8. FME should examine whether banks’ balance-sheet size is appropriate given risk management, operational controls, and systemic vulnerabilities.
  9. Establish a “college” or fora for home/host supervisors for each bank to enhance cooperation and coordination.
  10. Strengthen existing crisis management arrangements, including information exchange and contingency plans for banking distress.
  11. Establish a bank bankruptcy regime that strengthens remedial action and enhances tools for bank resolution.

*Source: Executive Summary and Overall Assessment — IMF Financial Sector Assessment Program (FSAP) content unit.*

### Executive Summary and Overall Assessment ...........................................................................5

### _cr08368 - Executive Summary and Overall Assessment ...........................................................................5

### Executive Summary and Overall Assessment — Key findings
- The Icelandic financial system is dominated by three large banking groups (Glitnir, Kaupthing, and Landsbanki).
- Rapid expansion: consolidated assets of the banks expanded from 100 percent of Icelandic GDP in 2004 to almost 900 percent at end-2007.
- By end-2007, over 50 percent of the banks’ assets were held abroad in branches and subsidiaries, principally in the Nordic countries and the U.K.
- Expansion funded in global wholesale markets doubled banks’ foreign debt and increased counterparty risk (CDS spreads rose sharply) as global turbulence began in mid-2007.
- Reported financial indicators:
  - Bank capital averaged almost 13 percent of risk-weighted assets between 2003 and 2006, dropped to 12 percent in 2007 and to approximately 11 percent in the first half of 2008; regulatory minimum is 8 percent.
  - Liquidity ratios are above minimum levels but increasingly reliant on central banks’ liquidity facilities.
- Vulnerabilities and pressures:
  - Global international liquidity declined significantly in the past 12 months, creating unforeseen challenges.
  - Capital levels are below the five-year average and may not provide adequate buffers given market uncertainty.
  - Foreign debt maturities of the financial sector are relatively short, concentrated in the period 2008–2010, creating funding risks amid limited market funding and perceived counterparty risk.
  - Asset quality concerns are rising: reported NPLs are low but increasing; banks are exposed to market risk via securities holdings and collateralized lending.
- Banks’ remedial measures:
  - Diversifying funding toward retail deposits.
  - Paying down market debt by reducing loan books, selling noncore assets, and withdrawing from marginal markets.
  - Estimation that they have sufficient liquidity to meet debt service requirements through early 2009 and to meet obligations maturing over the medium term.
  - CBI has provided much of banks’ domestic liquidity needs; banks augmented liquidity via covered bonds, sales of noncore assets, raising private capital, and structuring loans into securities eligible for repo operations with major central banks.
- Risks and uncertainties:
  - Funding and asset quality pressures likely to remain at least until 2010.
  - Lower profitability, declining asset quality, uncertainties about capital quality and shareholder strength, complex ownership, and perception of substantial related party lending may hinder mobilization of funds.
  - A financial misstep in one bank could prompt market penalties across all Icelandic banks.
- Central Bank of Iceland (CBI) role and risk:
  - CBI became principal provider of market liquidity domestically; CBI collateralized lending to commercial banks increased steadily since 2006.
  - CBI holdings of bank securities reached 370 percent of capital by early 2007.
  - This policy may undermine other macroeconomic objectives, exposes CBI to possible losses, and may generate a need for future recapitalization.
- Supervision:
  - Supervisory framework strengthened; FME capacity enhanced; all issues from 2003 BCP assessment addressed.
  - Prudential laws and regulations updated; FME and CBI increased emphasis on liquidity management and contingency planning, extending scope to foreign activities of banking groups.
  - More consistent contact among host-country supervisors recommended.

### Systemic Risk Exposures — Macroeconomic risks and outlook
- Macro context:
  - The domestically driven, foreign-funded boom lifted real output by over 25 percent during 2003–2007, the biggest increase among industrialized economies.
  - The boom produced large macroeconomic imbalances, highly indebted private sector balance sheets, and high dependence on foreign financing.
  - As external liquidity constraints tightened and market sentiment soured, banks and the currency have come under significant pressure; the overheated economy is showing signs of cooling.
- Projections and risks:
  - Real GDP growth is projected to come to a standstill in 2008 and contract by 2 percent in 2009, led by a retrenchment in domestic demand.
  - Inflation is expected to remain above target well beyond 2008, reflecting króna depreciation, deteriorating expectations, and global inflationary pressures.
  - The current account deficit is expected to narrow.
  - Public debt is minimal but the fiscal position is set to deteriorate sharply in the near term.
  - Uncertainties considerable; risks firmly on the downside, dominated by external considerations.
  - External liquidity risks remain key, given high foreign debt of the private sector (chiefly related to the banking system).
  - Further capital outflows could lead to additional króna depreciation and tighter domestic credit conditions.
  - Risks related to inflation, house and equity prices, private sector indebtedness, and foreign currency exposures are substantial.

### Household and Corporate Debt Levels — Key statistics and exposures
- Corporate sector:
  - Corporate balance sheets expanded through debt issues financing acquisitions abroad.
  - Leverage increased substantially: debt of nonfinancial corporations exceeded 300 percent of GDP in 2007.
  - Domestic banks financed about two-thirds of such debt; 70 percent of that financing was in foreign currency.
  - Growing share of foreign-currency denominated debt is owed by companies with no overseas operations.
  - Bank international bond issuance and corporate syndicated loans were major factors in increased foreign debt.
  - Corporate syndicated loans increased fivefold between 2003 and 2006 to close to US$8 billion (50 percent of GDP).
- Households:
  - Household debt, predominantly mortgages, reached 103 percent of GDP by 2007 (about 220 percent of disposable income).
  - Some 80 percent of household debt is indexed and another 13 percent is denominated in foreign currencies.
  - High owner-occupied housing (90 percent) and relatively modest loan-to-value ratios partially mitigate concerns.
  - Net asset position of households strengthened in recent years.

### Financial System Strengths/Vulnerabilities — Banking system and stress testing
- Banking system indicators and resilience:
  - Reported capital and liquidity ratios are above regulatory minimums.
  - Stress tests conducted by CBI and FME indicate resilience; under most stressed scenarios the banking system remains above regulatory capital minimums.
  - Recommendation to strengthen stress tests to:
    - (i) assume continued disruption in global markets;
    - (ii) envision a sharper deterioration in credit quality;
    - (iii) consider joint impact of market declines on collateralized credit portfolios and bank balance sheets.
- Funding profile and liquidity dependence:
  - Reliance on global wholesale markets exposed banks when international liquidity declined.
  - Liquidity ratios now depend more on access to central banks’ liquidity facilities; reductions in such access would require changes in banks’ liquidity management strategies.
  - Foreign debt maturities concentrated in 2008–2010 heighten funding risk.
- Asset quality:
  - Asset quality concerns increasing amid likely slowdown in Iceland and host countries, higher inflation, exchange rate pressures, and restricted credit supply.
  - While reported NPLs are low, they are rising.
- Banks’ adjustment measures and market confidence actions:
  - Diversify funding (increase retail deposits), reduce loan books, sell noncore assets, withdraw from marginal markets.
  - Augment liquidity via covered bonds, sales of noncore assets, private capital, structuring loans into securities eligible for major central bank repo operations.
  - Some borrowing from foreign banks possible but at much higher cost.
- Policy limits and needs:
  - Near-term policy options limited; priority on mitigating risks and strengthening market confidence via boosting buffers, contingency plans, and transparency.

### Policy recommendations and supervisory/ crisis management actions
- Bank-level options:
  - Increase capital positions to meet expected deterioration in asset quality.
  - Further diversify funding base.
  - Enhance liquidity in both local and foreign currency.
  - Refocus activities and further reduce noncore assets.
  - If insufficient, more aggressive downsizing may become necessary.
- Authority-level options:
  - Enhanced monitoring to ensure capital and liquidity buffers are adequate.
  - Ensure loan provisioning is adequately forward looking.
  - Develop contingency plans for further serious market disruption and strengthen crisis management framework.
  - Introduce a special problem bank resolution regime including currently unavailable tools.
  - Enhance cooperation between home and host supervisors, including development of emergency lending protocols and problem bank resolution options.
  - Mitigate investor concerns about related-party lending and shareholder strength by increasing transparency.
- Box 1 — Key Policy Recommendations (numbered as in source)
  1. Given the challenges of operating in an adverse financial environment, increase capital adequacy ratios to historical levels and evaluate the need for additional increases in the context of the ICAAP review process.
  2. Strengthen the quality and sources of bank capital, by identifying and reducing possibilities of excessive exposure to shareholders, and, where necessary, attracting new shareholders.
  3. Evaluate banks’ liquidity plans using scenario analyses of future cash flows and banks’ ability to sell securities in an illiquid market.
  4. Monitor credit quality, taking remedial actions as warranted, such as establishing reserves for future credit losses.
  5. Develop contingency plans for resolving funding limitations by bank and by currency.
  6. Given market concerns, require greater disclosure in financial statements identifying and reducing cross holdings, related-party lending, and concentration in lending.
  7. 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.
  8. The FME should examine carefully the extent to which the size of banks’ balance sheets is appropriate given risk management, operational controls, and systemic vulnerabilities.
  9. Establish a “college” or fora for home/host supervisors for each bank to enhance cooperation and coordination of home/host supervision.
  10. Strengthen existing crisis management arrangements, including provisions for information exchange and contingency plans for banking distress.
  11. Establish a bank bankruptcy regime that strengthens the remedial action and enhances the tools for bank resolution.

*Source: Executive Summary and Overall Assessment — IMF Financial Sector Assessment Program (FSAP) content unit.*

### 7.      Iceland’s financial system is large relative to the economy, with total financial

### _cr08368 - 7.      Iceland’s financial system is large relative to the economy, with total financial

### Overview
- Total financial sector assets amounting to over 12 times GDP at end-2007.
- Deposit-taking institutions represent almost 80 percent of total financial sector assets or 966 percent of GDP.
- The three large banks have total consolidated assets exceeding 900 percent of GDP.
- Institutional investors (pension funds, insurance companies, and mutual funds) make up the remaining 20 percent of financial sector assets.
- Approximately 70 percent of bank lending to Icelandic corporates is denominated in foreign currency.
- Pension funds are allowed net exposures to foreign securities up to 60 percent of portfolios, but actual exposures are significantly below the limits.
- The Housing Finance Fund has no foreign exchange exposure.

### A. Banking System — Structure and exposures
- Consolidated assets of Glitnir, Kaupthing, and Landsbanki increased from 100 percent of GDP in 2004 to 923 percent at end-2007.
- By end-2007, almost 50 percent of the three banks’ assets were held abroad.
- 75 percent of their borrowing was dependent on wholesale markets.
- The consolidated financial reports show capitalization and liquidity ratios above regulatory requirements, but quality of bank capital is uncertain.
- Large share of banks’ liquidity is held in assets primarily used for repos with central banks.

### Recent turmoil in CDS markets and market indicators
- CDS spreads for Icelandic banks increased sharply during the credit markets turmoil in mid-2007 and peaked in April 2008; spreads remained above European peers during the spring recovery and peaked again in summer 2008.
- Factors contributing to CDS dynamics include:
  - Thin CDS market exacerbating volatility.
  - Króna volatility and unwinding of carry trades.
  - Unwinding of CDO structures referencing Icelandic assets returning to balance sheets and creating demand for hedges.
  - High dependence on wholesale funding, deteriorating domestic outlook, and concerns about rating downgrades.

### Bank performance, profitability, and capital
- Return on equity (ROE) averaged 2.5 percent in 2005–2006.
- ROE fell to 1.5 percent in 2007.
- Bank capital averaged about 13 percent of risk-weighted assets between 2003 and 2006, falling to 12 percent in 2007.
- Capital ratios for the three large banks fell to 11.2 percent and 10.7 percent in the first and second quarters of 2008, respectively.
- Regulatory minimum capital ratio is 8 percent.
- Key capital quality concerns:
  - Controlling shares owned by highly indebted shareholders; large shareholders allowed to borrow as much as two-thirds of their invested capital.
  - High incidence of connected counterparties.
  - Complex ownership structures complicating identification of beneficial owners and related-party borrowing.
  - Icelandic regulation allows Tier I capital to include up to 30 percent of hybrid capital (Nordic limitation is 15 percent); banks appear to use fully the authorized amount with holdings of hybrid capital in excess of the Tier I limit included in Tier II capital.
- Banks increased long foreign exchange positions with derivatives from about 20 percent of capital at end-2006 to 58 percent and 72 percent in December 2007 and March 2008, respectively.
- Recommendation: Capital levels should be increased to restore market confidence; supervisors should assess adequacy of bank capital within the context of Pillar II to determine additional charges for risks not adequately covered in Pillar I.

### Credit risk and asset quality
- Credit growth averaged over 50 percent between 2004 and 2006 and grew by almost 60 percent in 2007.
- Nonperforming loans increased from 0.5 percent of total loans in 2006 to 1.0 percent at end-2007.
- FME survey in mid-2007 found about 90 percent of loans were considered to be of good quality.
- Factors threatening credit portfolio strength:
  - Loan portfolios indexed to inflation or denominated in foreign currency; up to one third of domestic borrowers are unhedged.
  - Over half of total lending is abroad.
  - Top 20 borrowers represent between 250 percent and 300 percent of Tier I capital.
  - Reported 6.5 percent of total lending is to related parties.
  - Over 300 new holding companies created each year in last three years; opacity exacerbates uncertainties about loan concentration and related-party lending.
- Indications of slippage:
  - Flow of impaired assets has increased, almost doubling in some banks over a three-year period.
  - Banks have increased loan loss provisioning and provisioned prudently.
  - Collateral sales related to contractual margin calls increased sharply in 2008.
- Policy recommendation: FME could require banks to establish reserves for future losses and encourage forward-looking provisioning policies; supervisors should ensure asset values are accurate, provisioning levels are adequate, and collateral valuation is appropriate.
- Risk note: Significant portion of credit is extended on the basis of collateral (often equities), which may shift credit risk to market risk and create potential for volatile equity-price-driven margin-call spirals.

### Liquidity and funding risk
- Debt repayments due for all three banks are large in 2009 and 2010; one bank has significant repayments in the second half of 2008.
- All three banks accessed markets in Q1 2008, but subsequent issuance has been very limited.
- Banks have diversified funding by developing deposit-taking businesses abroad; new deposits grew by 90 percent and 112 percent for Kaupthing and Landsbanki, respectively.
- Banks are contracting and rationalizing asset structures, selling subsidiaries and reducing loan portfolios in noncore areas.
- Banks report adequate resources to meet debt obligations over the next 12 months and are preparing for a long closure of wholesale markets.
- Bank liquidity has become highly dependent on central banks’ liquidity facilities.
- Banks are exploring covered bonds and securitization to make loan portfolios eligible for repos with major central banks, including the ECB and the Bank of England.
- FME should examine robustness of instruments (interbank deposits, committed lines, structured securities) under limited global liquidity and develop contingency plans.
- Caveats on new funding sources:
  - Foreign deposits may be more volatile and result in lower interest margins.
  - Securitization may provide temporary liquidity relief but concentrate credit risk as riskiest portions remain on bank balance sheets.

### Financial group size, complexity, and market risk
- Rapid expansion through acquisitions between 2004 and 2006 challenged internal risk management and operational controls, aggravated funding and asset quality concerns.
- Limited options exist for quickly reducing bank size; abrupt sales may be negatively interpreted and affect sovereign spreads.
- Immediate priorities:
  - Ensuring strong capital and liquidity buffers.
  - Improving corporate transparency.
  - Attracting new investors to fortify capital levels.
- Market risk specifics:
  - Portion of equity securities in total assets is 15 percent.
  - Direct equity holdings are approximately 2–3 percent of total assets.
  - Significant share of loans collateralized with equities increases exposure to market risk.
  - Approximately 70 percent of lending to Icelandic corporates is denominated in foreign currency; about one-third of foreign-denominated lending to households has no natural hedge.
  - Large banks maintain small open foreign exchange positions and establish long foreign exchange positions to protect regulatory capital from exchange rate changes.

### B. Institutional Investors — Pension funds
- Pension fund assets under management grew to 122 percent of GDP at end-2007.
- System includes the three basic pillars.
- There are 32 fully operational occupational pension funds; the 10 largest hold 80 percent of system assets.
- Actuarial positions appear solid; returns were high in the past four years.
- Significant fall in market values of domestic and foreign equities in portfolios resulted in slightly negative returns in 2007.

* _cr08368 - 7.      Iceland’s financial system is large relative to the economy, with total financial_

### 32.      The pension funds use derivatives to acquire long positions in domestic real

### _cr08368 - 32.      The pension funds use derivatives to acquire long positions in domestic real

### Pension funds and housing finance
- Pension funds use derivatives to acquire long positions in domestic real interest rates and are highly exposed to domestic inflation-linked securities; the long-term investment and real return structure matches well their liability structure.
- Regulations allow net exposures to foreign securities to represent 60 percent of portfolios though actual exposures are significantly below the limits.
- About 10 percent of pension funds' assets is represented by mortgage lending to their contributing members, with reportedly low loan-to-value ratios and delinquencies.
- Historically, the Iceland Housing Authority or Housing Finance Fund (HFF) was the main housing finance provider; HFF is government-owned with a government guarantee and funds itself through bond issuance.
- HFF loan quality has remained strong as most loans are for owner-occupied homes with relatively low LTV ratios (60 percent).
- Since 2004, domestic banks entered the mortgage market aggressively, lowering interest rates, increasing loan-to-value ratios, and allowing refinancing and takeout cash; HFF market share declined and regulatory limits on HFF’s admissible loan amounts became binding as house prices soared.
- In June 2008, new HFF lending programs were introduced to ease mortgage market liquidity: new loan classes allow HFF to finance banks’ mortgage portfolios and origination activities (including rental housing) subject to HFF mortgage lending requirements.
- Loan limits were increased to 80 percent of the purchase price of the property, subject to a loan limit of 20 ISK million.
- The new framework allows banks to obtain liquidity from both the publicly owned HFF and from the CBI, effectively sharing credit risks between the two public institutions.

### Capital markets — structure and key metrics
- Iceland capital markets comprise: a money market in króna, an interbank foreign exchange market, a bond market, and an equities market; pension funds are the largest investors in the domestic securities market.
- Outstanding stock of domestic króna-denominated bonds is about 100 percent of GDPs.
- The most liquid bonds are issued by the HFF (about ½ of the market) and government t-notes.
- Glacier bonds: Eurobonds issued by nonresidents, denominated in ISK, popular from 2005 to mid-2007; about US$5 billion outstanding.
- Foreign exchange market:
  - Turnover increased five times between 2004 and 2008 due to carry-trade activities.
  - Monthly volumes averaged US$10 billion.
  - Monthly volumes are 60 times the volumes traded in the interbank market.
  - Notional gross positions on foreign exchange markets, including derivatives, reached US$150 million.
  - The three largest commercial banks dominate FX trading operations.
- Equities market:
  - Market capitalization is over 170 percent of GDP.
  - Market capitalization of the largest four banks comprises 63 percent of the index.
  - After gaining over 400 percent in the period 2004 to mid-2007, the index has lost about 60 percent since the onset of the credit crisis; performance fell sharply since mid-2007, in excess of other EU stock exchange indexes.
  - Turnover is low and the market is heavily concentrated in a limited number of financial sector names, amplifying stock volatilities.

### Bond and liquidity characteristics
- Domestic bond market: outstanding stock: USD 19,075 as of 05.15.08 (Figure 8).
- Securities markets are large compared with the size of the economy but small compared with Nordic peers, and liquidity tends to be low.
- The domestic bond market is comprised mainly of issues by domestic public and private credit institutions and the government.

### Stress testing — practices and recommended enhancements
- Authorities (CBI and FME) have developed comprehensive stress testing exercises; tests indicate financial system resilience to a variety of historical shocks but global market deterioration warrants more stringent tests.
- Observations and areas for strengthening:
  - CBI credit risk model:
    - Developed and published a credit risk modeling exercise (based on CreditRisk+) that evaluates banks’ capital positions under stylized assumptions on default and recovery rate distributions.
    - Baseline model subjected to three stress scenarios including an increasing range of probability of default (PDs) for selected industries and a 10 percentage point decline in selected industry recovery rates.
    - Model results are based on limited access to data on banks’ portfolios; estimated PDs are based on historic averages when default rates were low.
    - Recommended improvements: obtain more complete information on individual loans (including sectorization of credits to holding companies), more complete data on portfolios held abroad, and stronger assumptions about PDs; improve transparency on calibration and parameterization of stress scenarios.
  - Liquidity testing:
    - CBI requires banks to maintain liquidity sufficient to satisfy a liquidity stress test; liquidity ratio for positions under three months must exceed one.
    - Liquidity tests report banks can meet obligations over the next 12 months.
    - Recommendation: complement evaluations with scenarios assuming global markets recover slowly and develop liquidity plans for prolonged market disruptions.
  - FME stress testing:
    - Conducts quarterly balance sheet stress tests for credit and market risks and publishes results.
    - Stress scenario assumptions include shocks: foreign share prices (-25 percent), domestic share prices (-35 percent), a weakening of the króna (25 percent), a fall in value of long-term bonds (-7 percent), and a decline in the value of contemporaneously reported nonperforming loans (-20 percent).
    - Based on end-2007 results, no bank becomes undercapitalized under the standard scenario.
    - Since 2007, FME supplemented standard tests with additional tests increasing levels of nonperforming and impaired assets via two alternative shocks: (i) increase impaired asset categories by the largest 12-month observed category-specific increase in the historical record; (ii) increase magnitude well above historical experience; following each shock, impaired assets are reduced by 20 percent to reflect a stress recovery rate.
    - Under the most severe supplemental scenario, three of the four banks remain above regulatory capital minimums and a fourth bank becomes only marginally undercapitalized.
    - Recommended expansions: evaluate significant tail events, joint effects of declining equity markets on credit portfolios and banks’ own portfolio holdings, impact of declining collateral values, and threats to profitability from hedging positions related to long foreign exchange positions and derivative use.

### Strengths and vulnerabilities of the policy framework — supervision and regulation
- Legal and institutional framework:
  - Iceland strengthened legal framework for effective banking supervision and enhanced the FME’s capacity; issues from the BCP assessment of 2003 have been addressed.
  - Basel II implemented in 2006; FME published guidelines covering Pillar I and Pillar II issues including stress testing, risk concentration, interest rate risk in the banking book, the ICAAP, and liquidity risk management.
  - IFRS implemented in 2005.
- FME organization and operations:
  - FME is an integrated supervisory authority for credit institutions, insurance companies, securities markets, and pension funds.
  - FME staff planned growth: from current 56 to 64 employees; almost one-half of staff supervises credit institutions.
  - Off-site analysis and on-site inspections quality and efficiency enhanced; supervisory review process adapted to institutions’ structure and risk complexity.
  - Introduced forward-looking elements including stress tests and scenario analysis.
  - Current gaps and recommended procedures:
    - FME does not require regular transmission of risk management and internal audit reports nor regular meetings with those functions during on-site inspections; advisable to introduce such procedures and increase frequency of prudential meetings with senior management on a case-by-case basis.
    - Further strengthening of staff skills needed as banks increasingly shift to Basel II; most banks rely on standardized approaches rather than internal models; first ICAAP reports have been produced and FME is working with banks to ensure capital reflects risks.

### Cross-border policy coordination and crisis management
- Cross-border cooperation:
  - Cooperation with foreign regulators increased, including with U.K. and Nordic host supervisors; FME participates in CEBS and has MOUs with several non-EEA supervisory authorities.
  - Recommendation: broaden contacts and establish a “forum of supervisors” for dedicated supervisors from relevant jurisdictions to enhance risk reviews, assessments, and remedial planning.
  - Suggest reaching agreements with host supervisors on crisis management for the large banks, including: coordination and communication with institutions and stakeholders; responsibilities for emergency lender-of-last-resort facilities and cross-jurisdictional liquidity policies; coordination of early supervisory interventions; and coordination of resolution of a failing institution.
- Crisis management and problem bank resolution:
  - Current bank resolution framework is based on general banking law with broad supervisory powers: require higher capital, remove licenses, remove management and Board members, place an expert in the bank (not on the Board), withdraw license and seek court approval to liquidate a failed bank; the resolution is court-guided but supervisory judgments cannot be reversed by the court.
  - Recommendation: introduce a special problem banks resolution regime (a separate bank bankruptcy regime) to provide additional resolution tools, including:
    - Authorization to conduct purchase and assumption transactions to rapidly transfer performing assets and depositors to an open bank.
    - Authority to establish a holding bank or “bridge bank” if a critical institution cannot be immediately transferred to private investors.
    - Legal facilitation of mergers of failing institutions once shareholder capital is depleted.

*Source: _cr08368 - 32.      The pension funds use derivatives to acquire long positions in domestic real; canonical URL: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08368.pdf*

### 59.      Development of contingency plans for a possible bank failure, particularly of one

### Development of contingency plans for a possible bank failure, particularly of one of the three large banks

### Contingency planning for a bank failure
- Recent European developments indicate that financial difficulties can emerge unexpectedly and spread rapidly.
- Contingency plans could allow the authorities to make difficult decisions quickly and efficiently.
- If shareholders are unable to maintain their bank solvent and liquid, contingency plans could indicate:
  - when government support would be needed, and
  - the form such support could take.
- Possible forms of government support mentioned:
  - an explicit, but temporary, guarantee to support asset prices;
  - use of existing governmental institutions to provide temporary support;
  - subscription of subordinated debt.
- While none of these options are described as optimal, contingency plans for more drastic scenarios should be discussed and agreed on among the authorities.

### IV. MARKET INFRASTRUCTURE — A. Systemic Liquidity Management

Subtheme: Domestic liquidity market
- Iceland’s interbank market is generally shallow and has become more so following recent turmoil.
- Transactions on the interbank market are small and infrequent and mostly overnight.
- Example statistic: in June 2008 there were only a few transactions, averaging ISK 10 billion each, compared to weekly transactions of ISK 400 at the CBI.
- Larger banks reportedly reluctant to take credit risk, preferring collateralized lending by the CBI.
- The CBI has become the principal provider of market liquidity:
  - The CBI makes seven-day collateralized loans each Wednesday.
  - On average, 10–12 banks borrow at the window each week and the CBI regularly rolls over maturing debt.
  - The CBI does not impose access limits or limits on total exposure to borrowing from the facility, nor conducts competitive bidding.
  - Collateral restrictions were eased in January 2008 and again in March 2008, bringing them in line with the ECB regulations.
  - The CBI now accepts treasury notes, HFF bonds, A-rated commercial paper in both króna and foreign exchange.
  - All collateral supplied is króna-denominated.
- Continued use of the CBI window exposes the institution to potential risks:
  - CBI holdings of bank securities increased from almost 240 percent of CBI capital at end-2006 to 278 percent at end-2007 and 370 percent by April 2008.
  - Heavy use of collateralized lending occurred in early 2008, as banks borrowed domestically to meet obligations by swapping króna into foreign currency.
  - This policy may undermine other macroeconomic policy objectives and exposes the CBI to potential losses, which could require future recapitalization.
- Note: "The CBI is reviewing the operation of the collateralized lending facility and is considering measures to improve the quality of collateral and establish access limits."

Subtheme: Foreign liquidity
- Recent currency volatility and increased counterparty risk of the Icelandic banks reduced the attractiveness of carry-trades.
- In March (2008), a widespread sale of króna positions caused a rapid acceleration in the króna depreciation.
- The CBI's responses included increasing its target interest rate and issuing a new type of security:
  - floating-rate notes are currently the only security that offers the CBI policy rate to investors.
- The high interest rates of such securities and the low CDS on the Iceland sovereign were successful in generating a new carry-trade opportunity for international investors and the pressure on the exchange rate subsided.

### IV. MARKET INFRASTRUCTURE — B. Payments System Risks
- Payment systems have been developed further with rules to help participants monitor risks and with tools to manage central bank risks.
- Corrective actions recommended by the 2001 FSAP concerning rules of the system, understanding and management of risks and transparency have been broadly implemented.
- Risk-management features:
  - intraday credits and exposures in the netting system are collateralized;
  - participants can follow exposures in real time and limit them.
- Transparency improved with information about systems and central bank oversight.
- DvP settlement process:
  - Adapted in 2007 to settle off-exchange trades (previously only on-exchange trades).
  - Technical set up can deliver the risk management entailed by DvP, but system rules do not fully support the DvP process.
  - Some market participants report settling some high value transactions, particularly those involving foreign participants, without DvP—this may reflect weaknesses or inefficiencies and should be investigated.
  - The FME and CBI plan an assessment of securities settlement in Iceland according to the CPSS-IOSCO recommendations; authorities are encouraged to complete this assessment in cooperation with the Icelandic Settlement Depository (ISD) and market participants.
- Harmonization with European market practices:
  - Nordic securities markets are increasingly integrated with European securities markets.
  - ISD is preparing to offer settlement for Icelandic equities denominated in euro through TARGET in accounts with the Bank of Finland.
  - Continued work on harmonization would improve the climate for foreign traders and bring liquidity to Icelandic securities.

### Key statistics and selected indicators (as presented)
- Example market-liquidity figures and ratios cited:
  - CBI holdings of bank securities: almost 240 percent of CBI capital at end-2006; 278 percent at end-2007; 370 percent by April 2008.
  - Interbank transactions in June 2008: averaging ISK 10 billion each; weekly transactions at the CBI: ISK 400.
- From Table 1 (selected rows shown in source):
  - Gross domestic product: 4.3 3.9 0.1 2.4 7.7 7.5 4.4 3.8 -0.3 -2.1
  - Consumer price index: 5.1 6.6 4.8 2.1 3.2 4.0 6.8 5.0 11.7 9.7
  - Central bank gross reserves (bln USD): 0.4 0.4 0.5 0.8 1.1 1.1 2.3 2.6 2.9 3.1
  - Gross external debt: 108.3 123.3 110.6 139.6 179.1 285.8 445.9 557.9 545.7 545.3
  - Nominal GDP (bln ISK): 683.7 771.9 816.6 841.5 928.7 1,026.3 1,167.7 1,279.4 1,424.0 1,502.0
- From Table 2 (selected figures):
  - Total financial system total assets: 14,919 (in billions of ISK); Assets/GDP: 1,212.7
  - Banks: Number 37; Total assets 12,798; Asset share 85.8; Assets/GDP 1,040.3
  - Deposit-taking institutions: Number 25; Total assets 11,883; Asset share 79.7; Assets/GDP 966.0
- From Table 3 (selected indicators, 2000–07):
  - Regulatory capital as percent of risk-weighted assets (CAR): 9.8 11.4 12.2 12.3 12.8 12.8 15.1 12.1
  - CAR excluding subordinated loans: 6.6 8.1 9.1 9.2 9.5 7.6 10.9 6.5
  - Capital as percent of assets: 6.2 6.5 7.2 7.1 7.1 7.4 7.8 6.9
  - Non-performing loans (NPL) as percent of gross loans: 1.5 2.0 2.6 2.1 0.9 1.1 0.8 ...
  - Liquid assets as percent of short-term liabilities: 120.2 120.8 118.9 120.3 130.0 150.0 200.0 170
  - Foreign currency loans as percent of total loans: 41.6 44.3 39.6 49.0 51.3 51.9 57.7 68.6
  - Loans as percent of deposits: 210.0 210.0 190.0 190.0 240.0 320.0 280.0 220

### Policy implications and recommendations (explicit or implied)
- Develop and agree contingency plans among authorities for possible bank failures, especially for one of the three large banks.
- Specify triggers and forms of government support in contingency plans (temporary guarantees, use of governmental institutions, subordinated debt subscription).
- Review and consider imposing access limits and exposure limits on the CBI collateralized lending facility, and improve collateral quality.
- Investigate reported DvP settlement exceptions and complete CPSS-IOSCO assessment of securities settlement in cooperation with ISD and market participants.
- Continue harmonization of market practices with Europe to attract foreign participants and enhance liquidity.

*Source: IMF staff report content (excerpt provided).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08368.pdf_