Central Bank Raises Capital Buffers to Enhance Resilience

Central Bank

Iceland’s Central Bank published its semi-annual Financial Stability report today. As noted in the report, the Financial Stability Committee has decided to increase the countercyclical capital buffer rate from 2% to 2.5%, a record high. The report also notes that although the financial system is “on solid footing,” the finances of households and companies continue to deteriorate due to persistent inflation.

The Financial Stability Committee

This morning, the Central Bank’s Financial Stability Committee (FSN) released its semi-annual Financial Stability report. The report presents an overview of the position of the financial system, its strengths and potential weaknesses, and the macroeconomic and operational risks it may face.

The report notes that the “systemically important banks” – whose capital and liquidity positions are strong – have delivered solid results and managed to provide support to households and businesses, the latter of which have struggled:

“Households’ and businesses’ financial conditions are tightening because of high inflation and interest rates. The outlook is for inflation to be stubbornly high and debt service burdens to grow heavier,” the report reads.

FSN also notes that the struggle of financial companies in international markets should serve as a reminder of the need for depository institutions to maintain sufficient strength so as to fulfil their roles, and that – given that domestic demand was strong and that developments in the financial markets were uncertain – it was “important to preserve the resilience of domestic financial institutions.”

Enter the countercyclical capital buffer.

Countercyclical capital buffer

As noted in an article in Vísir, during the restructuring of the banking system after its collapse in 2008, the defences of the financial system were strengthened and various safeguards were put in place. Among other things, a so-called countercyclical capital buffer was introduced, which is a requirement that the banks accumulate capital to create buffers to enhance the resilience of the banking sector during periods of stress. It was abolished in the fall of 2020 but reinstated last year (at 2%).

As noted in the Financial Stability report, the FSN has decided to increase the countercyclical capital buffer rate from 2% to 2.5%, a record high. (The Committee’s decision will take effect twelve months from now.)

Vísir quoted Governor of the Central Bank Ásgeir Jónsson as saying that this increase should serve to, on the one hand, “slow down the banking system’s lending,” and, on the other, be of benefit in case there is “a hard landing in the economy in a year or two.” “So with these measures, we are actually trying to slow down the financial system,” Ásgeir observed.

As noted by Vísir, Ásgeir was unwilling to comment on the likelihood of the Central Bank further raising the interest rate (the decision will be announced on Wednesday next week); most forecasters expect the interest rate to rise by up to 0.75%. It would be the Central Bank’s twelfth interest rate increase in a row.

GDP Expected to Contract by 8% in 2020

Central Bank of Iceland

In its most recent quarterly report, the Financial Stability Committee of the Central Bank expects GDP to contract by 8% in 2020. The report notes that while Iceland’s three commercial banks are in a strong capital and liquidity position, there is the risk that the Central Bank’s easing of policy instruments could lead to an increase in asset prices and an increase in the likelihood of systemic risk within the economy.

The financial system on “sound footing”

The Financial Stability Committee (FSC) of the Central Bank is required to assess the value of the countercyclical capital buffer (i.e. macroprudential instruments to help counter procyclicality in the financial system) on financial institutions on a quarterly basis.

In accordance with this obligation, the FSC has published its newest quarterly report, which forecasts that GDP will contract by 8% this year. The report notes that despite the effects of the COVID-19 pandemic, Iceland’s financial system is “on sound footing,” with private sector balance sheets having grown stronger in recent years, reinforced by deleveraging and higher equity ratios.

Despite positive measures taken by the Central Bank, however, the report also states that the pandemic has accelerated the contraction of the tourism industry and the reduced access to corporate loans from financial institutions, a trend that began last year.

A possible “wave of insolvencies”

The report further outlines a number of negative side effects that can be traced to the pandemic: uncertainty about Iceland’s foreign currency revenues; a possible “wave of insolvencies” among companies in the tourist sector; a drop in aluminium prices; the disruption of marine-product sales; rising unemployment; and a drop in commercial property prices (residential property prices remain relatively unchanged).

Over the past weeks and months, the Government and the Central Bank have responded to the crisis with the adoption of wide-ranging measures, including expanding access to credit and the lowering of financing costs. These measures – which could help to reinvigorate the economy – do not come without some risk, however:

“The low-interest environment resulting from pandemic response measures exacerbates the risk of a debt bubble, either in specific sectors or in the broader economy, at a time when the financial stability policy stance is more accommodative than before. This could undermine financial stability in the coming term. It is therefore essential to take appropriate action if increased risk appetite leads to excessive credit growth when the impact of the pandemic tapers off and the economy starts to recover.”

Unemployment to reach its zenith

Haukur C. Benediktsson, Director of Financial Stability at the Central Bank, and Ásgeir Jónsson, Governor of the Central Bank, introduced the report’s findings in a press conference earlier today. Summarising the findings of the report, Haukur predicted that unemployment would reach previously unknown levels in 2020. The FSC  expects unemployment to peak at between 7.4-10% in 2020, with labour-intensive sectors to be hit the hardest:

“The COVID-19 pandemic and its implications have had a profound impact on Icelandic households. The most serious is the impact on the labour market, with many companies scaling down or even halting operations. As a result, large numbers of employees have either had their working hours reduced or have lost their jobs entirely. Unemployment has soared and, according to the Bank’s most recent macroeconomic forecast, is expected to approach 12% in Q3 and measure 9% for the year as a whole, as compared with 3.6% in 2019 and the post-crisis peak of 7.6% in 2010.”