## _cr14257 — Assessment of Icelandic banking regulation and supervision (IMF ROSC) ## Source details **Canonical URL:** [_cr14257 — Assessment of Icelandic banking regulation and supervision (IMF ROSC)](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14257.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14257.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14257.pdf.json) --- ### Summary and methodology - Assessment completed as a stand-alone Report on the Observance of Standards and Codes (ROSC) undertaken by the International Monetary Fund (IMF) during March of 2014 at the request of the Icelandic authorities. - Assessment reflects the regulatory and supervisory framework in place as of the date of completion; it is not intended to assess the response to the 2008 banking crisis or to represent an analysis of the state of the banking sector or crisis management framework. - Assessment focused on the Financial Supervisory Authority (FME) as the main supervisor of the banking system; did not cover specificities of regulation and supervision of other financial intermediaries except insofar as FME is a unified supervisor. - Icelandic authorities provided a comprehensive self-assessment, additional questionnaires, and facilitated access to supervisory documents and files. - Assessment performed according to the Revised Core Principles (BCP) Methodology issued by the Basel Committee on Banking Supervision (BCBS) in September 2012. - Icelandic authorities chose to be assessed and rated against only the Essential Criteria. - Grading system used: compliant; largely compliant; materially noncompliant; noncompliant. - Assessment is qualitative and applies proportionality to reflect supervisory expectations commensurate with banks’ complexity, interconnectedness, size, risk profile and cross-border operations. ### Key contextual facts and chronology - 2008: Iceland faced a banking crisis that led to collapse of the banking system. - Banking assets expanded from 100 to almost 900 percent of GDP between 2004 and end-2007. - April 2009: Informal assessment by Kaarlo Jännäri focusing on liquidity management, connected lending, large exposures, cross-ownership, and fit-and-proper status. - 2011: Authorities commissioned a new assessment to focus on implementation of reforms and strengthening supervisory structures. - August 2011: FME launched a comprehensive reform program with five project parts: (i) Global Risk Based Supervision Framework; (ii) Supervision Processes and Procedures; (iii) IT/IS infrastructure; (iv) Structure and management; (v) Human Resource Management. - Decision taken to postpone part of IT/IS infrastructure (document management and information system) until the beginning of 2015 due to lack of funding. - September 2013: Human Resource Management project part discontinued and activities moved into other project parts. - Original reform program timeline planned for three years to reach goals by end of year 2014; timeline extended to end of 2016 due to delays and financing uncertainty. - Revised BCPs increased principles from 25 to 29 and expanded essential criteria from 196 to 231 (including 35 new essential criteria). ### Findings on supervisory reforms, capacity, and remaining gaps - Legislative and regulatory changes after 2009 included proposals for discretionary powers for FME, establishment of a national credit registry at FME, tougher provisions on large exposures and connected lending, and fit-and-proper requirements for owners; amendments also to anti-money laundering and deposit insurance legislation. - FME reform program objectives: improve corporate structure, design and build risk-based supervision, document and establish process management framework, implement new risk assessment system. - Achievements noted; program adjustments required because of funding uncertainty (parts of IT/IS postponed; Human Resource Management project discontinued and reallocated). - FME lacks authority to issue prudential regulations and legally binding guidelines; some corrective actions may be based on inadequate legal/regulatory basis, risking costly contestation as banks grow. - FME implemented Supervisory Review and Evaluation Process (SREP) and Internal Capital Adequacy Assessment Process (ICAAP) requirement; SREP culminates in capital requirements and identification of deficiencies. - Licensing conditions imposed on Arion Bank, Landsbankinn and Íslandsbanki after the crisis included improvements in risk appetite setting; risk reporting fragmentation; limit setting metrics and procedure; risk return metric and target setting; Board role in risk management; management fit-and-proper requirements; analysis of impaired assets and restructuring. Follow-up (sign-off project) conducted jointly with external experts. - Lack of FME-issued standards, guidelines and rules concerning evaluation of banks’ risk management hinders transparency and internal consistency. - Human resources and institutional capacity issues: - About half of FME staff has been in the entity for 5 years or less; only a handful have over 10 years supervisory experience. - Need for strategy to retain staff: attractive salaries and career path, training and development programs, mentoring, partnerships with foreign supervisors. - Need to develop systems to free staff from compliance and data verification tasks to enable more analytical work. - Overall: FME was mid-way through restructuring and building a risk-based supervision approach; still developing regulations, rules and internal methodologies to monitor, assess and grade risks. ### Institutional framework, market structure, and key statistics (as of 30.06.2013) - Institutional responsibilities: - MoFEA, FME, and CBI have overall responsibility for financial markets; FME and CBI are independent agencies “under the auspices of MoFEA.” FME is an integrated supervisor of all types of financial intermediaries. - Legal and regulatory framework is harmonized with the European Union’s framework; as an EEA member Iceland must implement EU regulatory framework concerning the financial sector. - Supervision coverage, number of entities, and aggregate assets: - Deposit Money Banks: Number of entities 12; Total assets ISK 3,007 billion; Total assets % of GDP 170.6 - of which commercial banks: Number of entities 4; Total assets ISK 2,951 billion; Total assets % of GDP 167.4 - of which savings banks: Number of entities 8; Total assets ISK 56 billion; Total assets % of GDP 3.2 - Various credit undertakings: Number of entities 7; Total assets ISK 1,074 billion; Total assets % of GDP 60.9 - of which the Housing Financing Fund: Number of entities 1; Total assets ISK 873 billion; Total assets % of GDP 49.5 - Pension funds: Number of entities 27; Total assets ISK 2,546 billion; Total assets % of GDP 144.4 - Insurance companies: Number of entities 13; Total assets ISK 167 billion; Total assets % of GDP 9.5 - Mutual funds: Number of entities 60; Total assets ISK 243 billion; Total assets % of GDP 13.8 - Investment funds: Number of entities 42; Total assets ISK 97 billion; Total assets % of GDP 5.5 - Institutional funds: Number of entities 61; Total assets ISK 264 billion; Total assets % of GDP 15.0 - Total: Number of entities 196; Total assets ISK 7,398 billion; Total assets % of GDP 419.6 - Market structure and ownership: - Dominance of three banks: Arion Bank, Íslandsbanki and Landsbankinn, established after the 2008 crisis. - Treasury equity holdings: Landsbankinn 99 percent; Arion Bank 13 percent; Íslandsbanki 5 percent. - Remaining stakes in Arion Bank and Íslandsbanki are indirectly owned by old banks’ estates Kaupthing (83 percent) and Glitnir (95 percent) respectively. Around 90 percent of creditor’s claims on the two estates are held by foreign claimholders. - Following savings banks’ restructuring, the Treasury holds a majority stake in three of the eight savings banks. - Combined market share of the three biggest banks in total deposits is approximately 94 percent. - Market share of the three biggest banks in total lending at end-2012 amounted to approximately 66 percent; HFF and pension funds together account for some 34 percent of direct lending to households and business firms. - HFF and the pension funds are not obliged to comply fully with the same prudential rules as other financial undertakings (e.g., capital requirements and large exposures). - Capital, liquidity, performance, leverage (three largest banks): - Capital levels at end-Q3 2013: 24–27 percent (capital adequacy ratio); most is Tier 1 capital, between 20–27 percent of risk-weighted assets. - Leverage ratio (total assets to equity) at end-Q2 2013: 4.9–6.6. - Commercial banks’ return on equity: just over 12 percent (annualised) for the first nine months of 2013. - Return on total assets: 2.2 percent. - Profits before tax on core operations: 1.3 percent of total assets during the same period. ### Risks, macro context, and fiscal/monetary metrics - Key legal and political uncertainties: interpretation of Supreme Court decisions on exchange rate-linked loans; uncertainty concerning removal of the capital controls—both could affect loan valuation and funding. - Many borrowers remain highly leveraged and could need further debt restructuring. - Default ratios decreased considerably after a peak in late 2008 but remain high. - November 2013 government action plan to reduce housing debt: total scope estimated at around ISK 150 billion (8 percent of GDP) over a four-year period: - Debt relief applied to inflation-indexed housing mortgages estimated at around ISK 80 billion. - Utilisation of tax exemption on private pension savings estimated at around ISK 70 billion. - The estimate of the scope of the debt relief is subject to some uncertainty. - Housing Financing Fund (HFF): - Post-crisis loan losses at HFF required ISK 46 billion of new capital from the Treasury. - Capital ratio at end-Q2 2013: 2.5 percent; additional capital injection foreseeable. - Authorities are working on viable solutions for HFF’s operational problems and future position. - Financial stability and macro indicators: - October 2013 Financial Stability Report (CBI) identified main risks: settlement of banks in winding-up proceedings, intended removal of capital controls, foreign debt refinancing, high corporate debt levels, and HFF’s difficult situation could prove costly for the Treasury. - Treasury Budget for 2014 provides balanced Treasury operations for the first time since 2007. Estimated Treasury performance for 2015-2017 according to the 2014 medium–term budget plan as a percent of GDP: 0.1, 0.0, and 0.8, respectively. - Central government total liabilities at end-Q2 2013: 1,913 billion ISK or 109.1 percent of GDP. Net financial assets were negative by 864 billion ISK or 47.5 percent of GDP. - Monetary policy objective: price stability; formal inflation target adopted 27 March 2001 aiming for an annual rate of inflation “as close as possible to 2½ percent.” - Economic growth: 1.4 percent in 2012; projected 2 percent in 2013. Forecast for 2014 is 2.5 percent and 2.6 percent-2.8 percent per annum for 2015-2018. - Inflation: expected 3.8 percent in 2013 (deteriorating from 3.5 percent); predicted 3.6 percent in 2014, 3 percent in 2015, and hitting CBI’s target rate of 2.5 percent in 2016. - Registered unemployment: expected average rate 4.6 percent in 2013 and 4.4 percent in 2014. - Capital controls: - Capital controls shelter institutions from international volatility but exacerbate foreign refinancing risk and may distort asset prices. - CBI’s Capital Account liberalisation strategy: Phase I—reduction of offshore króna positions; Phase II—removal of controls on onshore króna. As of early 2014, Phase I is still in process and timing for Phase II is uncertain. ### Cooperation, contingency arrangements, legal foundations, and transparency - Cooperation agreement between FME and CBI issued January 2011 for information sharing and enhancing financial stability; working groups analyze main risk factors and prepare semi-annual meetings between Director General of FME and Governor of CBI. Cooperation contract under revision to be concluded in the first quarter of 2014. - MoU (April 2012) between Prime Minister’s Office, Ministry of Finance, Ministry of Commerce and Economic Affairs, FME, and CBI on tasks of the Committee on Financial Stability. MoFEA has established working groups to prepare proposals for legal framework on financial stability and macro-prudential surveillance, including a Financial Stability Board. - Emergency Act No. 125/2008 authorized Treasury recapitalization and gave FME special powers in extreme circumstances. - Deposit-guarantee and investor-compensation scheme: Depositors’ and Investors’ Guarantee Fund (TIF) established by Act No 98/1999 guarantees deposits up to EUR 20,887 per depositor. Iceland has not implemented 2009 amendments to EU Directive 94/19/EC which would raise coverage to EUR 100,000. TIF is a private foundation operating pursuant to Act No. 98/1999. - CBI lending: Article 7 of Act No. 26/2001 allows CBI to grant credit to credit institutions through collateralized lending or by other means against collateral deemed acceptable by CBI; facilities performed in domestic currency with allowance for case-by-case foreign currency transactions. Under exceptional circumstances, CBI may issue guarantees or grant loans on special terms. October 2008 government declaration: deposits in domestic commercial and savings banks and their branches in Iceland would be fully covered. - FME publishes a Transparency Policy and an Information Policy and discloses decisions and findings of inspections while withholding sensitive information that could disproportionately harm firms or the market. Issuers listed on the Stock Exchange are subject to additional public disclosure requirements under the Act on Securities Transactions (No. 108/2007). - External audit: external audit function considered compliant with international standards of auditing. Iceland has implemented IFRS in Icelandic law; commercial banks’ financial statements are IFRS-compliant. - Ease of Doing Business index 2014 ranking: Iceland ranks thirteen (out of 189 economies) for starting and operating local firms. Subcategories: Enforcing Contracts ranked third; Resolving Insolvency ranked eleventh. - Corruption Perception Index 2012: Iceland listed as the eleventh most favorable on anti-corruption. ### Main supervisory governance findings (CPs 1–3) and independence concerns - FME is the supervisor for the financial system including insurance and securities; close collaboration channels exist with domestic and foreign supervisors. - Regulatory framework is complex due to EEA membership and FME’s limited capacity to impose binding rules. FME depends on the Minister of Finance to put forward prudential legislation and regulation, generating: - Implementation delays: Many EU directives and regulations enacted since 2010 have been delayed mainly due to a constitutional interpretation that Regulations (EU) No 1093-1095/2010 cannot be implemented, creating a backlog of unimplemented directives and regulations dating back to 2010 across banking, insurance and securities. Implementation of CRD IV is expected to fill several legal and regulatory gaps, but the size of the CRD IV package will create a major strain on limited regulatory resources. - Limited regulatory powers and timeliness: FME cannot propose legislation and may only issue rules if explicitly authorized by legislation; consequently FME relies on non-binding guidelines to articulate supervisory expectations and interpret general law and regulation. - Independence, accountability and resourcing issues: - Legal framework embeds potential for political interference: Board members making major decisions are political appointees, and the Minister submits all FME-related legislation to Parliament including the budget. - A draft bill under discussion would end earmarked resources for supervision, directing fees collected by FME to the general treasury. - Law does not state independence of FME, nor is there a fixed minimum term for the Director General. Legal framework does not explicitly protect the supervisor against lawsuits. - These deficiencies were not considered material in practice given no public perception or evidence of government or industry influence and no cases of lawsuits, but legal corrections are recommended. ### Licensing, ownership, consolidated supervision, and corporate governance (CPs 4–14) - Licensing criteria and procedures are aligned with international standards, but implementation can be enhanced, in particular assessment of qualified holdings. - FME has not yet used licensing procedures in “normal” circumstances given extraordinary conditions when most licenses were given (post-2008 restructuring). - Definition of qualified holder includes a qualitative element, but in practice monitoring relies predominantly on quantitative thresholds; mechanistic interpretation can hinder effective monitoring. - Legislative framework provides FME authority to conduct consolidated supervision; bank structure is holding-company oriented with no financial conglomerates or cross-border establishments. - FME has not issued binding rules or guidance outlining expectations on sound governance practices; it monitors compliance with Chamber of Commerce guidelines and refers to EBA Internal Governance guidelines in assessments. - Recommendation: develop methodology and standards for assessing adequacy of corporate governance relative to each bank’s risk profile. ### Ongoing supervision practices and operational shortcomings (CPs 8–11, 12–13) - FME is building a supervisory process towards supervision-by-risk and is working on a methodology to grade individual risks and assign an overall risk level. - Ongoing practices include SREP reviews with additional capital requirements imposed as warranted; checklists for review of certain risks; automated report with key risk indicators and peer-comparisons; stress testing and review of business plans. - Shortcomings: - Procedures and internal guidance for risk analysis and grading are incomplete. - Feedback cycle to banks is slow; feedback tends to be mainly correspondence and meetings with full Board occur only at SREP conclusion. - Onsite inspections do not perform detailed reviews of banks’ internal controls; enforceable guidelines or standards for internal control expectations have not been developed. - FME lacks authority to require replacement of an external auditor it considers unqualified or to require expansion of audit scope. - Corrective and sanctioning powers: - FME can impose fines and revoke licenses and has used both; early intervention powers are limited. - FME lacks explicit capacity to suspend dividend distribution, bar individuals from the banking sector, or tools to make boards accountable. - Important emergency tools had been granted through Interim Provision VI, which at the time of assessment had expired; note that measures were subsequently re-enacted until December 2015 by Act 29/2014 (post-mission information reported by authorities). ### Prudential requirements, risk areas and supervisory guidance (CPs 15–29) - Capital and Pillar 2: - Banks are well capitalized after the crisis; supervisor actively imposes Pillar 2 requirements based on ICAAP. - Processes for application, analysis, validation, approval and constant monitoring of advanced approaches of Basel II are yet to be developed. - Authority is developing guidelines on ICAAP submission, risk management and internal control requirements; banks have little guidance on ICAAP expectations. - Credit, problem loans and provisioning: - Post-crisis corrective work (2009–2011) included sign-off project to correct credit practice deficiencies; sign-off project requirements were not transposed into regulatory requirements. - FME issued special rules and standards through the Loan Portfolio Analysis Report (LPAR) for monitoring restructured loans, forbearance and valuation. - Recommendation: build a problem loan supervisory framework; issue rules on risk rating of loans, definition of “cured” loans, impairment criteria and collateral valuation—developed with accountants and banks. - Large exposures and related parties: - Framework for large exposures has greatly improved; FME has discretionary powers to connect exposures and uses them. - Related party transactions framework is fragmented and incomplete; no single binding definition of related parties. FME has no discretion to apply a broad definition, set limits, deduct such exposures from capital, or require collateralization when assessing capital adequacy. - Recommendation: review and broaden related party framework, allow FME discretion, and establish legally binding requirements. - Market risk, IRRBB and liquidity: - FME and CBI collaborate on market risk analysis; FME needs internal procedures for valuation of market risk and guidelines for banks. - FME reviews IRRBB via stress testing, repricing gap analysis and quarterly reports on impact on capital of parallel shifts in interest rate curves: - parallel shifts used during SREP: 200 basis points for non-ISK, 240 basis points for indexed ISK and 400 basis points for non-indexed ISK. - CBI liquidity rules revised after 2008 to incorporate liquidity ratios in foreign currencies; liquidity requirements now extend to off-balance sheet items and apply at the group level with tighter requirements on reliance on liquidity lines. - Operational risk, internal control and disclosure: - No specific requirement for banks to have operational risk management strategies, policies and processes; Guidelines No. 1/2012 on Information Systems and outsourcing are non-binding but usually complied with. - Operational risk mainly reviewed in ICAAP and SREP; FME has required banks to increase capital related to operational/legal risks but lacks guidance on operational risk management structures. - Banks are required to publish information reflecting financial position and qualitative information on risk, governance and processes. ### AML/TF supervision and abuse of financial services (CP 29) - FME stepped up supervision of AML/TF and use of banking system for criminal activities following FATF/GAFI reports. - Assessors were given access to examination reports covering two off-site surveys and three on-site visits. - Regulatory gaps: - No requirement that banks report suspicious activities not only to the Police but also to the FME. - General guidance related to CDD needs adjustment to reflect FATF recommendations on identification of ultimate beneficiaries. - FME adopted new guidelines in June 2014 addressing definition and identification of ultimate beneficiaries. - FME refers to Art. 52c of Act No. 161/2002 for board’s and managing director’s obligation regarding reporting suspicious activities. ### Recommended actions (selected excerpts) - Principles 1, 2, 11: - Ensure planned legislative amendments clarify roles regarding supervision of liquidity risk, including corrective action, and clarify FME actions in enforcement of buffers. - Ensure planned amendments do not affect FME operational independence, in particular regarding budgetary allocation. - Amend legal framework giving FME explicit capacity to increase prudential requirements based on individual bank risk profile and enforce risk-based supervision. - Amend legal framework to provide FME with corrective tools enumerated in EC 4, usable according to gravity and in a timely way, before bank financial situations seriously deteriorate. - Amend legal framework giving FME explicit and broader powers to issue binding rules so prudential requirements can be timely updated and enforced. - Amend legal framework providing FME permanently with tools that existed under Interim Provision VI. - Amend legal/regulatory framework defining a mandate for the head of FME. - Develop training and a human resource strategy including salaries and career path to develop and retain qualified staff. - Principles 5–7: - Amend processes, systems and practices to use full definition of qualified holder beyond mere quantitative thresholds. - Define criteria used by supervisor to approve applications. - Principles 8, 9, 14, 15, 16, 17, 18, 21, 22, 23, 25, 26: - Develop rules and guidelines for banks on benchmarks, standards and procedures FME will follow in determining adequacy of bank’s risk management and governance systems. - Develop internal methods and guidelines for FME staff to analyze banks’ practices in risk areas. - Principles 9 and 10: - Finalize development of automated analysis (data quality verification) of reports received. - Produce risk reports from offsite analysis summarizing bank’s overall condition and main risks, pending actions and upcoming supervisory events. - Consider holding an annual meeting with the full Board of Directors to discuss FME supervision results and overall assessment. - Principle 18: - Develop definitions for “cured” loans. - Adopt rules detailing requirements for banks’ loan policies and internal loan review and classification systems. - Issue rules or regulations on loan classification and provisioning and views on events/factors providing objective evidence of impairment. - Principle 20: - Establish in law/regulation/rule a definition of related parties as defined in the Core Principles and include FME’s discretion to apply a broader definition case by case. - Introduce limits or requirements of limits, policies and controls for all related parties. - Introduce law/regulation/rule that related-party transactions should not be granted on more favorable terms. - Principle 27: - Review legislative options to address FME’s lack of authority to require replacement of external auditors or expansion of audit scope when inadequate. - Principle 29: - Introduce requirement that banks report suspicious activities not only to the FIU but also to FME. - Amend guidelines to ensure banks use the correct definition in identification of ultimate beneficiaries. ### Authorities’ response and planned actions - FME welcomes the assessment and intends to draw on recommendations to improve regulation and supervision; stresses constraints from EEA membership requiring transposition of EU Directives, Regulations and Technical Standards. - Principles 1, 2, 11: - FME participating with MoFEA in preparing for implementation of CRD IV and CRR (Directive 2013/36/EU and Regulation (EU) 575/2013). - A bill partially implementing Directive 2013/36/EU has been introduced to Parliament and is expected to be acted into Icelandic law in 2014. - A subsequent bill implementing remainder of CRD IV/CRR is expected to be introduced to Parliament before end of 2014. - Work is in progress regarding clarification of roles on supervision of liquidity risk. - A working group is preparing proposals for a legal framework on resolution and recovery to replace Interim Provision VI of Act No. 161/2002 and implement the new EU Directive on Recovery and Resolution. - Principles 5–7: - FME considers Act no. 161/2002 to allow interpretation that a shareholder may be perceived as a qualified owner even with less than 10 percent shares if significant influence exists; guidelines request information on close links and other relationships. - A criteria has been defined regarding licensing and qualified holders as explained in FME’s self-assessment. - Principles 8–26 (aggregated): - FME has been developing and will further develop guidance for banks, and will where applicable directly refer to EBA guidelines. - A restructuring plan covering development of internal methods and guidelines is to be finalized before end of the year 2016. - Principles 9 and 10: - Further improvement of automated analysis of reports received is part of the restructuring plan. - FME will produce risk reports from offsite analysis and will hold regular annual meetings with systemically important banks’ full Boards of Directors from now on. - Principle 18: - FME has started work on rules for loan classification and provisioning and guidelines on assessing loan quality; FME has already defined the term “cured” loans. - Principle 20: - FME will inform the legislator of the mismatch between current legislation and BCP Principle 20 and intends to review the related party framework. - Principle 27: - FME will inform the legislator of recommended amendments regarding its lack of authority over external auditors. - Principle 29: - In June 2014 FME adopted new guidelines addressing definition and identification of ultimate beneficiaries. - Regarding recommendation that banks be required to report suspicious activities to FME, FME refers to board’s and managing director’s obligation as established in Art. 52c of Act No. 161/2002. *Source: _cr14257 — IMF ROSC assessment as of March of 2014.* ### 1. The 2012 Revised Core Principles ______________________________________________________________ 10 ### 1. The 2012 Revised Core Principles ### Summary and methodology (A. Introduction) - Assessment completed as a stand-alone Report on the Observance of Standards and Codes (ROSC) undertaken by the International Monetary Fund (IMF) during March of 2014 at the request of the Icelandic authorities. - Assessment reflects the regulatory and supervisory framework in place as of the date of completion; it is not intended to assess the response to the 2008 banking crisis or to represent an analysis of the state of the banking sector or crisis management framework. - Assessment focused on the Financial Supervisory Authority (FME) as the main supervisor of the banking system; did not cover specificities of regulation and supervision of other financial intermediaries except insofar as FME is a unified supervisor. - Authorities provided a comprehensive self-assessment, additional questionnaires, and facilitated access to supervisory documents and files. Key contextual facts and chronology - 2008: Iceland faced a banking crisis that led to collapse of the banking system. - Banking assets expanded from 100 to almost 900 percent of GDP between 2004 and end-2007. - April 2009: Informal assessment by Kaarlo Jännäri focused on liquidity management, connected lending, large exposures, cross-ownership, and fit-and-proper status of owners and managers. - 2011: Authorities commissioned a new assessment to focus on implementation of reforms and strengthening of supervisory structures. - August 2011: FME launched a comprehensive reform program with five project parts: (i) Global Risk Based Supervision Framework; (ii) Supervision Processes and Procedures; (iii) IT/IS infrastructure; (iv) Structure and management; (v) Human Resource Management. - Decision taken to postpone part of IT/IS infrastructure (document management and information system) until the beginning of 2015 due to lack of funding. - September 2013: Human Resource Management project part discontinued and activities moved into other project parts. - Original reform program timeline planned for three years to reach goals by end of year 2014; timeline extended to end of 2016 due to delays and financing uncertainty. ### Findings on supervisory reforms, capacity, and remaining gaps - Authorities enacted legislative changes after 2009: proposals included discretionary powers for FME, establishment of a national credit registry at FME, tougher provisions on large exposures and connected lending, and fit-and-proper requirements for owners; amendments also to anti-money laundering and deposit insurance legislation. - FME reform program objectives: improve corporate structure, design and build risk-based supervision, document and establish process management framework, implement new risk assessment system. - Achievements noted, but program adjustments required because of funding uncertainty; parts of IT/IS postponed; Human Resource Management project discontinued and reallocated. - FME lacks authority to issue prudential regulations and legally binding guidelines; some corrective actions may be based on inadequate legal/regulatory basis, risking costly contestation as banks grow. - FME implemented Supervisory Review and Evaluation Process (SREP) and Internal Capital Adequacy Assessment Process (ICAAP) requirement; SREP involves meetings and interactions concluding with capital requirements and identification of deficiencies. - Licensing conditions imposed on Arion Bank, Landsbankinn and Íslandsbanki after the crisis included improvements in: risk appetite setting; fragmentation of risk reporting; limit setting metrics and procedure; risk return metric and target setting; Board role in risk management; management fit-and-proper requirements; analysis of impaired assets and restructuring. Follow-up review (sign-off project) conducted jointly with external experts. - Lack of standards, guidelines and rules issued by FME concerning evaluation of banks’ risk management hinders transparency and internal consistency. - Human resources and institutional capacity issues: - About half of FME staff has been in the entity for 5 years or less; only a handful have over 10 years supervisory experience. - Need for strategy to retain staff: attractive salaries and career path, training and development programs, mentoring, partnerships with foreign supervisors. - Need to develop systems to free staff from compliance and data verification tasks to enable more analytical work. - Overall assessment context: FME was mid-way through restructuring and building a risk-based supervision approach; developing regulations and rules and internal methodologies to monitor, assess and grade risks. ### Assessment methodology and scope (B. Information and Methodology Used for Assessment) - Assessment performed according to the Revised Core Principles (BCP) Methodology issued by the Basel Committee on Banking Supervision (BCBS) in September 2012. - Icelandic authorities chose to be assessed and rated against only the Essential Criteria. - BCP Methodology uses essential and additional assessment criteria: - Essential criteria (EC) are usually the only elements on which to gauge full compliance with a Core Principle (CP). - Additional criteria (AC) are recommended best practices for more complex systems; not included in this assessment. - Grading system: compliant; largely compliant; materially noncompliant; noncompliant. - Assessment is qualitative, applying the concept of proportionality to reflect supervisory expectations commensurate with banks’ complexity, interconnectedness, size, risk profile and cross-border operations. - Team reviewed laws, rules and guidance and held extensive meetings with FME, Central Bank of Iceland, Ministry of Finance and Economic Affairs, auditing firms, and banking sector participants. - Team appreciated very high quality of cooperation from authorities. ### The 2012 Revised Core Principles — emphasis and changes (Box 1) - Revised BCPs reflect developments since prior revision and lessons from the 2008/2009 crisis; informed by FSAP assessments, G-20 and FSB recommendations. - Key emphases: - Greater supervisory intensity and allocation of adequate resources for systemically important banks. - Application of a system-wide, macro perspective to microprudential supervision to identify, analyze and take pre-emptive action on systemic risk. - Greater focus on crisis preparation and management, recovery and resolution measures. - Fostering robust market discipline through corporate governance, disclosure and transparency. - Supervisors required to assess risks run by banks and risks banks pose to banking and financial systems; consider macroeconomic environment, business trends, and build-up and concentration of risk inside and outside the banking sector. - Heightened focus on actual use of supervisory powers and forward-looking early intervention. - Structural changes to the principles and criteria: - Number of principles increased from 25 to 29. - Number of essential criteria expanded from 196 to 231, including 35 new essential criteria. - For jurisdictions assessed against additional criteria, there are 16 additional criteria. - Revised methodology reinforces proportionality to allow application across a wide range of jurisdictions and risk profiles. _Italic: IMF ROSC assessment as of March of 2014._ ### 18. The Ministry of Finance and Economic Affairs (MoFEA), the Financial Supervisory ### 18. The Ministry of Finance and Economic Affairs (MoFEA), the Financial Supervisory ### Institutional framework and responsibilities - MoFEA, the Financial Supervisory Authority (FME), and the Central Bank of Iceland (CBI) have overall responsibility for financial markets. - FME and CBI are independent agencies “under the auspices of MoFEA.” - FME is an integrated supervisor, responsible for supervision of all types of financial intermediaries. - The legal and regulatory framework is in general harmonized with the European Union’s regulatory framework. Iceland, as a member of the European Economic Area (EEA), is obliged to implement in national legislation the EU regulatory framework concerning the financial sector. ### Supervision coverage, number of entities, and aggregate assets (as of 30.06.2013) - Deposit Money Banks: Number of entities 12; Total assets ISK 3,007 billion; Total assets % of GDP 170.6 - of which commercial banks: Number of entities 4; Total assets ISK 2,951 billion; Total assets % of GDP 167.4 - of which savings banks: Number of entities 8; Total assets ISK 56 billion; Total assets % of GDP 3.2 - Various credit undertakings: Number of entities 7; Total assets ISK 1,074 billion; Total assets % of GDP 60.9 - of which the Housing Financing Fund: Number of entities 1; Total assets ISK 873 billion; Total assets % of GDP 49.5 - Pension funds: Number of entities 27; Total assets ISK 2,546 billion; Total assets % of GDP 144.4 - Insurance companies: Number of entities 13; Total assets ISK 167 billion; Total assets % of GDP 9.5 - Mutual funds: Number of entities 60; Total assets ISK 243 billion; Total assets % of GDP 13.8 - Investment funds: Number of entities 42; Total assets ISK 97 billion; Total assets % of GDP 5.5 - Institutional funds: Number of entities 61; Total assets ISK 264 billion; Total assets % of GDP 15.0 - Total: Number of entities 196; Total assets ISK 7,398 billion; Total assets % of GDP 419.6 ### Market structure, ownership, and concentration - The financial system is characterised by the dominance of three banks: Arion Bank, Íslandsbanki and Landsbankinn, established by national authorities after the 2008 banking crisis. - Treasury equity holdings: Landsbankinn 99 percent; Arion Bank 13 percent; Íslandsbanki 5 percent. - Remaining stakes in Arion Bank and Íslandsbanki are indirectly owned by the old banks’ estates, Kaupthing (83 percent), and Glitnir (95 percent) respectively. Around 90 percent of the creditor’s claims on the two estates are held by foreign claimholders. - Following financial restructuring of the savings banks, the Treasury holds a majority stake in three of the eight savings banks. - Combined market share of the three biggest banks in total deposits is approximately 94 percent. - Market share of the three biggest banks in total lending at end-2012 amounted to approximately 66 percent, reflecting significant retail lending by Housing Financing Fund (HFF) and pension funds which together account for some 34 percent of direct lending to households and business firms. - HFF and the pension funds are not obliged to comply fully with the same prudential rules as other financial undertakings (e.g., capital requirements and large exposures). ### Capital, liquidity, performance, and leverage of the three largest banks - Capital levels at end-Q3 2013: 24–27 percent (capital adequacy ratio); most is Tier 1 capital, between 20–27 percent of risk-weighted assets. - Leverage ratio (total assets to equity) at end-Q2 2013: 4.9–6.6. - Commercial banks’ return on equity: just over 12 percent (annualised) for the first nine months of 2013. - Return on total assets: 2.2 percent. - Profits before tax on core operations: 1.3 percent of total assets during the same period. ### Risks, legal/political uncertainties, and policy measures - Key legal and political uncertainties: interpretation of Supreme Court decisions on exchange rate-linked loans; uncertainty concerning removal of the capital controls—both could affect loan valuation and funding. - Many borrowers remain highly leveraged and could need further debt restructuring. - Default ratios decreased considerably after a peak in late 2008 but remain high. - In November 2013 the Icelandic government announced an action plan aimed at reducing the country's housing debt. Total scope estimated at around ISK 150 billion (8 percent of GDP) over a four-year period. Of this: - Debt relief applied to inflation-indexed housing mortgages estimated at around ISK 80 billion. - Utilisation of tax exemption on private pension savings estimated at around ISK 70 billion. - The estimate of the scope of the debt relief is subject to some uncertainty. ### Housing Financing Fund (HFF) - Post-crisis loan losses at HFF required ISK 46 billion of new capital from the Treasury. - Capital ratio at end-Q2 2013: 2.5 percent; additional capital injection foreseeable. - Authorities are working on viable solutions for HFF’s operational problems and future position; overhauling HFF operations remains a challenge for reducing the government’s contingent liabilities. ### Financial stability assessment, macroeconomic context, and capital controls - October 2013 Financial Stability Report (CBI) identified main risks: settlement of banks in winding-up proceedings, intended removal of capital controls, foreign debt refinancing, high corporate debt levels, and HFF’s difficult situation could prove costly for the Treasury. - Treasury Budget for 2014 provides balanced Treasury operations for the first time since 2007. Estimated Treasury performance for 2015-2017 according to the 2014 medium–term budget plan as a percent of GDP: 0.1, 0.0, and 0.8, respectively. - Central government total liabilities at end-Q2 2013: 1,913 billion ISK or 109.1 percent of GDP. Net financial assets (financial assets less liabilities) were negative by 864 billion ISK or 47.5 percent of GDP. - Monetary policy objective: price stability; formal inflation target adopted 27 March 2001 aiming for an annual rate of inflation “as close as possible to 2½ percent.” - Economic growth: 1.4 percent in 2012; projected 2 percent in 2013. Forecast for 2014 is 2.5 percent and 2.6 percent-2.8 percent per annum for 2015-2018. - Inflation: expected 3.8 percent in 2013 (deteriorating from 3.5 percent); predicted 3.6 percent in 2014, 3 percent in 2015, and hitting CBI’s target rate of 2.5 percent in 2016. - Registered unemployment: expected average rate 4.6 percent in 2013 and 4.4 percent in 2014. - Capital controls shelter institutions from international volatility but exacerbate foreign refinancing risk and may distort asset prices; CBI’s Capital Account liberalisation strategy has Phase I—reduction of offshore króna positions and Phase II—removal of controls on onshore króna. As of early 2014, Phase I is still in process and timing for Phase II is uncertain. ### Cooperation, contingency arrangements, and legal foundations - Cooperation agreement between FME and CBI issued January 2011 for information sharing and enhancing financial stability; working groups analyze main risk factors and prepare semi-annual meetings between Director General of FME and Governor of CBI. Findings are forwarded to relevant ministers. The cooperation contract between FME and CBI is under revision to be concluded in the first quarter of 2014. - Memorandum of Understanding (MoU) issued April 2012 between Prime Minister’s Office, Ministry of Finance, Ministry of Commerce and Economic Affairs, FME, and CBI on tasks of the Committee on Financial Stability. MoFEA has established working groups to prepare proposals for legal framework on financial stability and macro-prudential surveillance, including a Financial Stability Board. - Emergency Act No. 125/2008 authorized Treasury recapitalization and gave FME special powers in extreme circumstances (e.g., assume powers of shareholders' meeting, dismiss boards, take over assets/rights/obligations). - Chapter 5 of the FME–CBI cooperation agreement stipulates responses to systemic risk or shock: requirement to report suspicion of imminent problems, cooperation on contingency planning and exercises, and cooperation on measures. MoU specifies Committee on Financial Stability tasks. MoFEA working groups prepare proposals for legal framework on resolution and recovery of financial undertakings. ### Legal, judicial, audit, and disclosure environment - Icelandic legal system: civil law; courts are independent per the constitution and handle criminal/civil actions including financial sector regulation. - State Aid to financial institutions is subject to scrutiny by EFTA Surveillance Authority (ESA). - Ease of Doing Business index 2014 ranking: Iceland ranks thirteen (out of 189 economies) for starting and operating local firms. Subcategories: Enforcing Contracts ranked third; Resolving Insolvency ranked eleventh. - External audit function considered compliant with international standards of auditing. Iceland has implemented International Financial Reporting Standards (IFRS) in Icelandic law; commercial banks’ financial statements are IFRS-compliant. - In 2012 Corruption Perception Index ranking: Iceland listed as the eleventh most favorable on anti-corruption. - Payment systems are considered effective and reliable. ### Deposit guarantee, central bank lending, and transparency - Deposit-guarantee and investor-compensation scheme: Depositors’ and Investors’ Guarantee Fund (TIF) established by Act No 98/1999 guarantees deposits up to EUR 20,887 per depositor. Iceland has not implemented 2009 amendments to EU Directive 94/19/EC which would raise coverage to EUR 100,000. TIF is a private foundation operating pursuant to Act No. 98/1999. - Article 7 of Act No. 26/2001 on the Central Bank of Iceland allows CBI to grant credit to credit institutions through collateralized lending or by other means against collateral deemed acceptable by CBI; facilities performed in domestic currency with allowance for case-by-case foreign currency transactions. Under exceptional circumstances, CBI may issue guarantees or grant loans on special terms. In October 2008 the Government declared that deposits in domestic commercial and savings banks and their branches in Iceland would be fully covered. - FME publishes a Transparency Policy and an Information Policy and discloses decisions and findings of inspections while withholding sensitive information that could disproportionately harm firms or the market. Issuers listed on the Stock Exchange are subject to additional public disclosure requirements under the Act on Securities Transactions (No. 108/2007). CBI publishes reports and forecasts on monetary issues, balance of payments, exchange rate and foreign exchange issues, and carries out economic research related to monetary policy and the financial system. ### Main findings — Responsibility, objectives, powers, independence, accountability and cooperation (CPs 1-3) - FME is the supervisor of the financial system including insurance and securities; close collaboration channels exist with domestic and foreign supervisors. A collaboration agreement with CBI and a MoU on participation in the Committee on Financial Stability are in place. - The regulatory framework is complex due to EEA membership and FME’s limited capacity to impose binding rules. FME depends on the Minister of Finance to put forward prudential legislation and regulation, generating two main problems: - Implementation delays: Many EU directives and regulations enacted since 2010 have been delayed mainly due to a constitutional interpretation that Regulations (EU) No 1093-1095/2010 cannot be implemented, creating a backlog of unimplemented directives and regulations dating back to 2010 across banking, insurance and securities. Implementation of CRD IV is expected to fill several legal and regulatory gaps, but the size of the CRD IV package will create a major strain on limited regulatory resources. - Limited regulatory powers and timeliness: Prudential legislation and regulation’s dependence on governmental action undermines timeliness of updates and may prevent FME from responding adequately if government and prudential interests conflict. FME cannot propose legislation and may only issue rules if explicitly authorized by legislation; consequently FME relies on non-binding guidelines to articulate supervisory expectations and interpret general law and regulation. *Source: _cr14257 - 18. The Ministry of Finance and Economic Affairs (MoFEA), the Financial Supervisory Authority (FME), and the Central Bank of Iceland (CBI).* ### 39. In a society very keen in its counter-argument and contestation rights, such ### _cr14257 - 39. In a society very keen in its counter-argument and contestation rights, such ### Ownership, Licensing, and Structure (CPs 4-7) - Licensing criteria and procedures are aligned with international standards, but implementation can be enhanced, in particular assessment of qualified holdings. - FME has not yet used licensing procedures in “normal” circumstances given extraordinary conditions when most licenses were given (restructuring following the collapse in 2008). - Assessment of qualified holdings affects licensing, transfer of ownership, acquisitions, monitoring of large exposures and related parties; current practice relies predominantly on quantitative thresholds. - The qualitative assessment of “other holding which enables the exercise of a significant influence over the management of the company concerned” exists in definition but in practice significant connections that may signify effective control can fall under FME’s radar. ### Methods of Ongoing Supervision (CPs 8-10) - FME is building a supervisory process/methodology aiming for supervision-by-risk and is working on a methodology to grade individual risks (liquidity, credit, market) within each bank and assign an overall risk level. - Ongoing practices: - Each bank is reviewed under the SREP process; additional capital requirements are imposed as warranted by the bank’s risk. - Procedures (checklists) have been developed to guide staff in review of certain risks (credit, liquidity). - An automated report with key risk indicators and peer-comparisons is produced from bank information and combined with ICAAP reviews in SREP. - Stress testing and review of banks’ business plans add a forward-looking perspective in SREP. - Targeted reviews: - Supervisors develop questionnaires referencing EBA/BCBS documents; questionnaires are maintained in a centralized database for reuse. - Recommendation: develop procedures for risk analysis and standards to facilitate deeper, more efficient and prompt reviews. - Feedback and communication: - The feedback cycle to banks does not provide timely information on FME’s assessments; feedback tends to be mainly correspondence. - There can be a significant time-lag between filing a report or concluding a supervisory review and the bank receiving feedback. - The feedback loop should include recurring meetings with the Board of Directors; currently a meeting with the full Board is held only at the conclusion of the SREP process. - Staff and judgment: - Effectiveness of risk-based supervision depends on informed, qualitative judgments by qualified and experienced staff. - Lack of internal guidance/methodology and regulatory guidelines for reviewing individual risks and making overall judgments will affect effectiveness and may result in conflicting conclusions/recommendations. ### Corrective and Sanctioning Powers of Supervisors (CP 11) - FME has wide capacity to impose fines and to revoke licenses—both instruments have been used several times—but early action powers are limited. - General early action is mostly limited to what the authority can do under the SREP process and the interpretation that “minimum” under Art. 84 of Act 161 means supervisory minimum. - FME lacks important tools regarding: - capacity to suspend distribution of dividends; - capacity to bar individuals from the banking sector; - tools to make board accountable. - Current compliance is influenced by extraordinary post-crisis conditions: all major banks have been restructured and boards are professional; this may change and banks historically have argued to the letter of the legal text rather than its spirit. - Recommendation: grant FME a stronger legal basis for swift early action, including all tools listed in the Core Principles, usable according to gravity and in a timely way. - Interim measures: - Important emergency tools had been granted through Interim Provision VI, which at the time of assessment had expired. - Footnote: After the mission, authorities have informed measures have been re-enacted until December 2015 by Act 29/2014, on April 4, 2014. ### Consolidated and Cross-Border Banking Supervision (CPs 12-13) - Legislative framework provides FME authority to conduct consolidated supervision. - Bank structure in Iceland is holding-company oriented; there are no financial conglomerates, banking groups or cross-border establishments—holding companies are one-bank only. - FME performs supervision on a consolidated basis and regularly reviews compliance with prudential standards and regulatory requirements. - FME does not have a cross-border home or host supervisory role due to lack of cross-border establishments; laws provide authority to share information with foreign supervisors. - FME has signed a number of MoUs and routinely participates in supervisory groups in the EU and EEA. ### Corporate Governance (CP 14) - FME has not issued rules or guidance outlining its expectations on sound governance practices for banks; it monitors compliance with guidelines issued by the Iceland Chamber of Commerce. - FME reviews banks’ business plans and discusses risk appetite but has not issued its own binding guidelines to address primary objectives set by FME. - EBA Internal Governance guidelines may be referred to in bank discussions, but FME should clarify standards to be applied and enforced. - Recommendation: develop a methodology for staff on assessing adequacy of corporate governance relative to each bank’s risk profile. ### Prudential Requirements, Regulatory Framework, Accounting and Disclosure (CPs 15-29) - Capital and Pillar 2: - Banks in Iceland are well capitalized after the crisis. - Supervisor has been actively imposing Pillar 2 requirements based on banks’ ICAAP process. - Processes for application, analysis of validation, approval and constant monitoring of advanced approaches of Basel II are yet to be developed. - Authority is still developing guidelines on ICAAP submission, risk management and internal control requirements that substantiate Pillar 2 requirements. - Banks have no good guidance on ICAAP expectations. - Risk management policies: - General lack of requirements issued to banks on risk management policies. - FME has not issued detailed guidance or standards on adequate operational risk management policies and procedures. - Credit practices and problem loan framework: - FME conducted significant corrective work with external consultancy in 2009-2011 to correct deficiencies in credit practices of the three large banks; sign-off project requirements were not transposed into regulatory requirements. - FME monitors credit trends and spot checks practices but lacks processes and procedures for review of banks’ credit risk and has not issued detailed rules for risk management policies. - FME issued special rules and standards through the Loan Portfolio Analysis Report (LPAR) for monitoring restructured loans, forbearance and valuation due to post-crisis programs. - Recommendation: build a problem loan supervisory framework and issue rules on risk rating of loans, what constitutes a cured loan, factors determining impairment and valuation of collateral—developed in collaboration with accountants and banks. - Large exposures, concentration risk, related party lending: - Regulatory and supervisory framework for large exposures has greatly improved since the collapse. - FME has discretionary powers to connect exposures composing limits and controls and has used them. - More needs to be done on concentration risk; no requirement or guidance on management of concentration risk. - Related party transactions framework is fragmented and incomplete; no single binding definition of related parties (closest is FME’s 2010 guideline which is not binding). - Supervisor has no discretion to apply a broad definition of related party, no power to set limits, deduct exposures from capital, or require collateralization when assessing capital adequacy. - Recommendation: review and broaden related party framework, allow FME discretion, and establish legally binding requirements in laws or regulations. - Market risk and IRRBB: - FME and CBI closely collaborate on market risk analysis; FME needs internal procedures for valuation of market risk and guidelines for banks on market risk management and internal policies. - CBI has issued rules and monitors foreign exchange activities; FME focuses on capital requirements and ICAAP/SREP review. - FME reviews interest rate risk in the banking book (IRRBB) via stress testing, repricing gap analysis and quarterly reports on impact on capital of parallel shifts in interest rate curves of 100 and 200 basis points. - During the SREP process parallel shifts of 200 basis points for non-ISK, 240 basis points for indexed ISK and 400 basis points for non-indexed ISK are used. - Liquidity: - FME devotes significant attention to liquidity and works with CBI in a joint technical working group. - After 2008 collapse, CBI liquidity rules were reviewed and revised to incorporate new requirements for liquidity ratios in foreign currencies; liquidity requirements now extend to off-balance sheet items and apply at the group level. - Tighter requirements on reliance on liquidity lines; purpose of new rules on foreign currency liquidity is to reduce foreign currency liquidity risk identified during the run-up to 2008 collapse. - Onsite inspections and external auditors: - During onsite inspections FME does not perform a detailed review of banks’ internal controls; no developed onsite inspection procedures to assess internal control systems. - Enforceable guidelines or standards for internal control system expectations have not been developed. - FME lacks authority to require a bank to replace an external auditor it considers unqualified or doing an improper job, and lacks authority to require expansion of audit scope. - Interactions between FME and external auditors are infrequent; recommendation: develop a protocol for collaboration and exchange of information. ### Table 1 — Summary Compliance with the Basel Core Principles (selected observations) - Responsibilities, objectives and powers: - Institutional and regulatory framework for banking supervision is complex. - Current legal framework appears to describe FME competencies with a compliance-based focus instead of the discretion needed for a risk-based approach. - Unclear whether enactment of CRD IV will provide FME with some of the powers it lacks. - Prudential legislation and regulation depend largely on governmental action, undermining timeliness of updates and FME’s ability to respond if there are conflicting interests between government and prudential supervision. - FME can issue rules only if explicitly commanded by legislation; reliance on non-binding guidelines has led to regulatory uncertainty and gaps. - Inadequate legal and regulatory framework “unnecessarily slows supervisory action, creates regulatory uncertainty and regulatory gaps which banks sometimes exploit, and uses up scarce supervisory resources.” - Some corrective tools were only available per Interim Provisions VI of Act 161; these had expired at the time of the mission but were reenacted subsequently (see footnotes). - Independence, accountability, resourcing and legal protection: - Legal framework embeds potential for political interference: Board members who make major decisions are political appointees, and the Minister submits all FME-related legislation to Parliament including the budget. - A draft bill under discussion would end earmarked resources for supervision, directing fees collected by FME to the general treasury, potentially increasing political interference. - Staffing: - About half of staff has been in the entity for 5 years or less; only a handful have over 10 years supervisory experience. - Institution is still adjusting after internal reorganization implemented in 2012/13. - Need for strategy to retain staff: attractive salaries and career path, training and development programs, mentoring programs and partnerships with foreign supervisors. - Legal independence: - Law does not state independence of FME, nor is there a fixed minimum term for the Director General. - Legal framework does not explicitly protect the supervisor against lawsuits. - These deficiencies were not considered material in practice given no public perception or evidence of government or industry influence and no cases of lawsuits, but legal corrections are recommended to guarantee operational independence and support staff development. *Italic: IMF staff assessment as presented in the provided content unit.* ### 3. Cooperation and ### 3. Cooperation and ### Cooperation and collaboration - The FME is the supervisor of the financial system, including insurance and securities and close collaboration channels have been established with domestic and foreign supervisors. - A collaboration agreement has been signed between the Central Bank of Iceland (CBI) and the Financial Supervisory Authority (FME). - Work between CBI and FME includes permanent working groups reviewing macro-micro issues that feed into the supervisory process. - A MoU was signed between the Prime Minister’s Office, the Ministry of Finance and Economic Affairs, FME and CBI on participation on the Committee on Financial Stability. ### Permissible activities and licensing - The permissible activities of licensed banks are well defined and the use of the word “bank” controlled. - Assessors reviewed recent licensing files and internal manuals and procedures. - Given the extraordinary conditions in which most licenses were given (restructuring of the sector following the collapse in 2008), FME has not yet used the procedures in “normal” circumstances regarding banks. ### Transfer of significant ownership and major acquisitions - Definition of qualified holder and control includes a qualitative assessment of “other holding which enables the exercise of a significant influence over the management of the company concerned,” but in practice processes are predominantly based on quantitative thresholds. - In a recent situation a qualified holder’s participation in a bank was reduced below the threshold, and FME has worked under the assumption that the bank has no major shareholder. - This mechanistic interpretation hinders effective monitoring (see CP 20). - FME has used its capacity to qualify acquisitions as temporary as an effective tool to prevent excessive exposure in non-banking activities. - The authorization and notification framework is based on the concept of qualifying holding; supervisors’ narrower practical concept risks missing acquisitions below the qualifying holding threshold that imply effective control, including in non-banking entities or abroad. - Intensive work to identify close links under Art. 18 of Act 161 has mitigated this deficiency in practice, but legislative and supervisory clarifications are needed. - The criteria used by the supervisor to approve applications needs to be clarified in rules and guidelines. ### Supervisory approach, techniques and tools - FME needs to map all qualitative and quantitative prudential and legal requirements under the scope of its supervision and determine if and how each condition is monitored. - There is a need to complete the current reform program on the risk-based supervisory framework and improve the drawing of conclusions from its offsite financial analysis. - Procedures to aid staff in analysis of individual risks need to be developed to increase depth of analysis and improve efficiency. - The feedback cycle with banks does not provide timely information to banks on FME’s assessments; the feedback loop should include meetings with the Board of Directors. - Effectiveness of supervisory techniques and tools is adversely impacted by: - A lack of detailed policies and procedures to aid in the performance of inspections and offsite analysis. - A lack of detailed regulations concerning requirements on corporate governance and risk management. - A need for increased communication and interaction with Boards and senior management. - Need to improve offsite analysis of financial indicators and other reports submitted by banks and produce executive summaries for FME senior management with overall assessment of bank condition, pending issues, planned supervisory activities, scheduled meeting with the Board any action required from FME management. - The follow-up and corrective process following identified deficiencies is not always graduated based on the gravity of the deficiency. - Lack of FME authority to issue enforceable guidelines in all risk areas. ### Supervisory reporting and corrective powers - FME has full access to information and collects relevant information for its work. - Analysis is mostly done manually until new automated systems and tools are fully functional; given the small number of banks under supervision this deficiency was not considered material, but fully developed systems will increase efficiency and free resources for analytical tasks (see CP 8 and 9). - FME has a wide capacity to impose fines and to revoke licenses; both instruments have been used several times. - Early action capacity—before any law or regulation is actually breached—is limited to what the authority can do under the SREP process and the understanding that “minimum” under Art. 84 of Act 161 means supervisory minimum. Imposing Art. 86 (convocation of a shareholder meeting, official recuperation plan, and revocation of license) based on this understanding of Art. 84 is not completely clear under the law. - FME lacks important tools regarding its capacity to suspend distribution of dividends, bar individuals from the banking sector, and has few tools to make boards accountable. - Banks comply with FME’s requests, but current extraordinary circumstances (restructured major banks, professional boards) may change in the future; past experience shows banks argue to the letter of the legal text rather than the spirit. - FME must be granted a stronger legal basis for swift early action, including all the tools described in this core principle, to be used according to the gravity of the situation in a timely and expeditious way. - Important tools granted through Interim Provision VI, which at the time of the assessment had expired (see CP1), should be given to FME on a permanent basis. ### Consolidated supervision and home-host relationships - Legislative framework provides FME with supervisory authority to conduct consolidated supervision. - Structure of banks in Iceland is holding-company oriented; there are no financial conglomerates, banking groups or cross-border establishments. The holding companies are one-bank only. - FME performs supervision on a consolidated basis and regularly reviews compliance with prudential standards and other regulatory requirements. - FME does not have a cross-border home or host supervisory role due to the lack of cross-border establishments, but laws and regulations provide authority to share information with foreign supervisors. - FME has signed a number of MoUs and routinely participates in supervisory groups in the EU and EEA involved in developing international best practices. ### Governance, risk management and internal controls - There is a lack of processes and procedures for FME staff to review banks’ compliance with existing laws, rules and recognized guidelines regarding corporate governance. - Existing legislation on corporate governance is general and mainly provides a listing of items that should be addressed. - FME has issued Rule 670/2013 and under Article 19 of 161/2002 can recommend bank compliance with the Chamber of Commerce Corporate Governance Guidelines, but FME has not issued standards detailing expectations for banks’ corporate governance policies. - Internally FME considers EBA corporate guidelines when assessing corporate governance, but has not issued a standard or rule communicating enforcement of the EBA guidelines. - There is a lack of FME methodology for review and evaluation of banks’ risk management processes, including effective Board and senior management oversight; current FME requirements are general and do not provide sufficient guidance. - Lack of issued guidance and clarity on FME methodology reduces transparency to banks of FME expectations and processes. ### Capital adequacy, credit, problem assets, and concentration - Banks in Iceland are well capitalized after the crisis, and the supervisor has been actively imposing Pillar 2 requirements based on banks’ ICAAP process. - Authority is still developing guidelines on the ICAAP submission, risk management and internal control requirements that substantiate Pillar 2 requirements; banks have little guidance on what is expected in terms of ICAAP. - Framework for imposition of systemic risk charge is pending CRD IV transposition into law. - Processes for application, analysis of validation, approval and constant monitoring of advanced approaches of Basel II are yet to be developed, although the legal framework allows use of advanced approaches based on internal measurements. - FME monitors credit trends and spot checks bank practices, but lacks processes and procedures for ongoing review of banks’ credit risk; FME has not issued detailed rules on what banks should have in risk management policies. - Post-crisis FME focused on addressing problem loans: ensuring proper valuation/recording of collateral, identifying connected lending, improving loan pricing and establishing provisions (sign-off project). - FME issued special rules and standards through the LPAR for monitoring restructured loans and valuation. - Need to build proper problem loan management requirements for non-crisis times. - Regulatory and supervisory framework for large exposures has greatly improved since the collapse; FME has discretionary powers to connect exposures composing limits and controls and uses them effectively. - More development needed on concentration risk: risk management, monitoring, mitigation and control; no legal requirement or guidance on concentration management. ### Related-party transactions and country/transfer risk - Legal and regulatory framework for related party transactions is fragmented and incomplete; no single definition of related parties (articles 1, 55, 57 of Act 161 and FME guidelines use different concepts). - Guideline 1/2010 provides the closer definition but is not binding. - Supervisor has no discretion to apply a broad definition of related party; existing limits and requirements mostly regard Board members. - Supervisor has no power to set limits, to deduct such exposures from capital when assessing capital adequacy, or to require collateralization of such exposures. - No requirements that banks have policies and procedures for identification, monitoring, or control of related-party transactions, nor general requirement that related-party transactions not be granted on more favorable terms. - Authorities must review and broaden the related party framework, allow FME discretion, and establish legally binding requirements. - No requirements or guidance to banks on identification, measurement, evaluation, monitoring, reporting and control or mitigation of country risk and transfer risk. - Country risk can in principle be covered in ICAAP and SREP but there is no specific guidance; currently country risk exposure is very limited due to capital controls and banking crash experience, but a robust country risk framework will be needed when normality returns. ### Market risk, interest rate risk, liquidity, operational risk, internal control, audit, and disclosure - Need to develop, implement and approve processes and procedures for valuation of market risk and criteria for appropriate market risk limits related to financial undertaking size and complexity; issue guidelines to banks on market risk management and internal policies. - FME focus has been on setting capital requirements and ICAAP/SREP discussions; a more intrusive analytical process should be implemented for ongoing supervision, including onsite reviews. - Lack of internal processes and procedures for review and evaluation of IRRBB reduces effectiveness of analysis; FME has not issued rules providing guidance on issues expected in bank policies. - FME devotes significant attention to liquidity and works with CBI in a joint technical working group addressing liquidity issues. - After the 2008 collapse, CBI’s liquidity rules were reviewed and revised to incorporate new requirements for liquidity ratios in foreign currencies; liquidity requirements now extend to off-balance sheet items and apply to credit institutions at the group level and tighter requirements on reliance on liquidity lines. - Purpose of new foreign currency liquidity rules is to reduce liquidity risk in foreign currencies, a significant risk during the run-up to the 2008 collapse. - No specific requirement for banks to have operational risk management strategies, policies and processes; Guidelines No. 1/2012 on Information Systems and outsourcing of internal audit and compliance functions are non-binding but usually complied with and used as basis for supervisory review. - Operational risk is mainly reviewed in relation to capital adequacy in ICAAP reports and during SREP; FME has required banks to increase capital related to operational risk, particularly legal risks. - Banks have no instructions on how to implement operational risk management structures or what is expected during ICAAP; addressing operational risk mostly through capital adequacy is inappropriate—monitoring, control and mitigation of operational risk are ultimately more relevant for bank soundness. - Lack of established FME methodology for reviews and evaluation of bank internal controls; communication between FME and banks’ internal control functions needs improvement. - FME lacks authority to require a bank to replace an external auditor it considers unqualified or to require expansion of audit scope when inadequate. - Banks are required to regularly publish information that is easily accessible and reflects their financial position, as well as qualitative information on risk, governance and processes. *Source: _cr14257 - 3. Cooperation and* ### 29. Abuse of financial ### 29. Abuse of financial services ### Findings on AML/TF supervision and use of banking system for criminal activities - FME has stepped up its supervision of AML/TF and general use of banking system for criminal activities following FAFT/GAFI reports. - Assessors were given access to examination reports focused on the topic for the first time since the crisis, covering two off-site surveys and three on-site visits to banks. - The regulatory framework still needs further adjustments: - There is no requirement that banks report suspicious activities not only to the Police but also to the FME. - General guidance related to CDD needs to be adjusted to reflect FAFT recommendations regarding identification of ultimate beneficiaries by banks. ### Recommended Actions (excerpt from Table 2) - Principles 1, 2, 11: - Ensure planned legislative amendments clarify the roles regarding banking supervision of liquidity risk, including corrective action. - Ensure planned legislative amendments clarify FME actions in the enforcement of buffers. - Ensure planned legislative amendments do not affect operational independence of the FME, in particular regarding budgetary allocation. - Amend legal framework giving FME explicit capacity to increase prudential requirements based on the individual risk profile of banks and enforce risk based (instead of compliance-based) supervision. - Amend legal framework to provide FME with corrective tools as enumerated in EC 4, which can be taken according with the gravity of the situation and on a timely and expeditious way, before the financial situation of banks is seriously deteriorated. - Amend legal framework giving FME explicit and broader powers to issue binding rules so that prudential requirements can be timely updated and enforced. - Amend legal framework providing FME permanently with the tools that existed under Interim Provision VI. - Amend legal/regulatory framework defining a mandate for the head of FME. - Develop training, and a human resource strategy including salaries and career path, among other elements, in order to develop and retain qualified staff. - Principles 5, 6, 7: - Amend processes, systems and practices in order to use the full definition of qualified holder, beyond the mere quantitative thresholds. - Define criteria used by supervisor to approve applications. - Principles 8, 9, 14, 15, 16, 17, 18, 21, 22, 23, 25, 26: - Develop rules and guidelines for banks on the benchmarks, standards and procedures that the FME will follow in determining the adequacy of bank’s risk management and governance systems. - Develop internal methods and guidelines for FME staff to be used in analyzing banks’ practices in risk areas. - Principles 9 and 10: - Finalize development of automated analysis (data quality verification) of reports received. - Produce risk reports from offsite analysis summarizing the bank’s overall condition and main risks, financial trends, status of any pending actions and addressing pending issues and upcoming supervisory events. - Consider holding an annual meeting with the full Board of Directors to discuss results of FME supervision and its overall assessment of the bank’s financial condition. - Principle 18: - Develop definitions for “cured” loans. - Adopt rules detailing requirements for banks’ loan policies and internal loan review and classification systems. - Develop guidelines for FME staff on assessing loan quality, and adequacy of repayment source to have discussions with banks on adequacy of provisioning and assessing the adequacy of banks’ loan review systems. - Issue rules or regulations on loan classification and provisioning, views on events or factors that provide objective evidence of impairment to strengthen FMÉ s authority to require provisions and define default. - Principle 20: - Establish in law or regulation or rule a definition of related parties as defined in the Core Principles, and include FME’s discretion to apply a broader definition on a case by case basis. - Introduce limits or the requirement of limits, policies and controls for all related parties. - Introduce law/regulation/rule requiring that transactions with related parties should not be granted on more favorable terms. - Principle 27: - Review legislative options to address the FME lack of authority to require a bank to replace an external auditor it considers unqualified or doing an improper job and to require an expansion of the audit scope when it is considered inadequate. - Principle 29: - Introduce requirement that banks report suspicious activities not only to the FIU but also to FME. - Amend guidelines to ensure banks use the correct definition in the identification of ultimate beneficiaries. ### Authorities’ response and planned actions - General: - FME welcomes the assessment and intends to draw on the recommendations to improve regulation and supervision. - FME shares the views expressed but stresses constraints from Iceland’s membership of the European Economic Area (EEA) requiring transposition of EU Directives, Regulations and Technical Standards. - Principles 1, 2, 11: - FME is participating with the Ministry of Finance and Economic Affairs in preparing for implementation of CRD IV and CRR (Directive 2013/36/EU and Regulation (EU) 575/2013). - A bill partially implementing Directive 2013/36/EU has been introduced to Parliament and is expected to be acted into Icelandic law in 2014. - A subsequent bill implementing the remainder of CRDIV/CRR is expected to be introduced to Parliament before the end of 2014. - Work is in progress regarding clarification of roles on the supervision of liquidity risk. - FME has raised concerns that a bill on abolition of earmarked taxes may end reserved resources for supervision and affect budgetary allocation. - A working group is preparing proposals for a legal framework on the resolution and recovery of financial undertakings to replace Interim Provision VI of Act No. 161/2002 and implement the new EU Directive on Recovery and Resolution of credit institutions and investments firms. - Principles 5, 6, 7: - FME considers Act no. 161/2002 to allow interpretation that a shareholder may be perceived as a qualified owner even with less than 10 percent shares if significant influence exists; guidelines request information on close links and other relationships. - A criteria has been defined regarding licensing and qualified holders as explained in FME’s self-assessment. - Principles 8–26 (aggregated): - FME has been developing and will further develop guidance for banks, and will where applicable directly refer to EBA guidelines. - A restructuring plan covering development of internal methods and guidelines is to be finalized before end of the year 2016. - Principles 9 and 10: - Further improvement of automated analysis of reports received is an integrated part of the restructuring plan. - FME will follow recommendations to produce risk reports from offsite analysis. - FME will hold regular annual meetings with systemically important banks’ full Boards of Directors from now on. - Principle 18: - FME has started work on rules for loan classification and provisioning and guidelines on assessing loan quality. - FME has already defined the term “cured” loans. - Principle 20: - FME will inform the legislator of the mismatch between current legislation and BCP Principle 20 and intends to review the related party framework. - Principle 27: - FME will inform the legislator of recommended amendments regarding its lack of authority over external auditors. - Principle 29: - In June 2014 FME adopted new guidelines addressing definition and identification of ultimate beneficiaries. - Regarding the recommendation that banks be required to report suspicious activities to FME, FME refers to board’s and managing director’s obligation as established in Art. 52c of Act No. 161/2002. *IMF staff report: Assessment of Icelandic banking regulation and supervision — chapter on "Abuse of financial services" (content unit _cr14257 - 29).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14257.pdf_