The problem that loomed around this time a year ago is a thing of the past and terms in the secondary market are more favourable again. The Central Bank underlines that global market conditions can take a sudden turn for the worse and it is important to be on the alert and prepared for such a contingency. The current episode of ample liquidity and lower interest rates which has been ideal for risk-seeking investors may change unexpectedly. Short-term interest rates have been rising in most markets recently and capital costs are no longer so favourable. The Icelandic banks are better equipped for such a reversal than a year ago, because experience has taught them to extend and disperse their borrowing, and build up substantial liquid reserves in foreign currency. In 2006 the spotlight was on the banks’ liquidity risk. Now that this risk has ebbed, the focus has shifted to credit risk and the potential impact of higher interest rates and a depreciation of the króna. Amidst the turbulence of 2006, the banks slowed down their credit growth and expansion of their balance sheets. No major foreign financial companies were acquired and equity exposures were reduced. Nonetheless, it is natural to consider their credit risk and vulnerability towards a fall in asset prices. Icelandic households’ debts with credit institutions have soared in recent years, especially averageincome and young households.
It is critical to achieve some redress of imbalances before external conditions tighten. Strange as it may sound, the banks’ efforts to hedge against the effect of a conceivable depreciation of the króna on their equity ratios has increased the market risk on their foreign exchange exposures. Credit institutions fulfil the Central Bank’s rules on foreign exchange balance, but have been permitted to maintain separate additional currency balances. Thus the banks’ capital positions are well hedged against a conceivable depreciation of the króna, but a short-term appreciation cannot be ruled out. The banks’ customers, on the other hand, are less protected against shocks from a depreciation, although data from the banks show that most of their borrowers of foreign currency-denominated loans also have substantial currency earnings and thereby a natural hedge against exchange rate movements. Financial Stability 2006 reported on a Central Bank stress test of the impact of a serious shock involving a simultaneous large rise in global interest rates, depreciation of the króna and fall in asset prices. This simulation has now been repeated using new data and assuming an even larger depreciation and decrease in house prices. Were all these shocks to coincide, estimates show that the contraction in national expenditure could prove considerably greater than in the Central Bank’s most recent macroeconomic forecast in Monetary Bulletin in March 2007. The pressure on the financial sector will be determined to some extent by the pace of the adjustment and the banks’ own responses to it.