Icelandic Banks: Asset Composition and Quality of Banks’ Balance Sheets

In this article we will take a look the asset composition of the Icelandic banks and the concentration risk in the system.

There are several factors that contribute to the deteriorating asset quality of the banks. This includes:

Let’s take a closer look at their assets.

Loans to Corporates

Corporate loans amounted to 83% of their total loan portfolio. This was driven by their reliance on the simple Standardized approach to measuring risk-weighted assets rather than developing their own internal rating-based model.
The Icelandic banks also expanded outside of Iceland to diversify their loan portfolio. By 2008, the loans outside of Iceland increased to 2/3 of total loans. Due to fierce competition, they could not charge a higher risk premium in other countries.
The banks were also lending for stock purchases, where they accepted domestic stocks as collateral. This exposed the banks to market liquidity risk.
Since the Inflation in Iceland was very high, there was an incentive for Icelandic companies to finance through low-interest foreign currencies. Almost 75% of bank loans to corporates were foreign exchange linked. This was an indirect credit risk for the Icelandic banks because even though the banks’ foreign currency exposure was fully hedged, the customers were left with open foreign currency exposure. Customers were dependent on krona earnings to repay debt and interest denominated in foreign currency. So, if krona depreciated, the customers won’t be able to pay the now huge amounts in foreign currency.

Loans to households represented a small portion of the banks’ loan portfolio.
Banks underpriced risk as they were competing with the state-supported HF fund.
To make their offerings attractive, they softened their criteria for extending loans, for example, attractive loan-to-value ratios.
Banks also promoted low-interest foreign currency loans. This lead to a sharp increase in foreign currency linked loans (causing indirect credit risk for banks).
The fall in real estate prices was not however a main reason behind the banking crisis.