But risk and high yield often go hand in hand and it must be assumed that equity prices can fall just as easily as rise. The Central Bank has assessed the banks’ credit portfolio quality on the basis of geographical and sectoral distribution. It is no longer enough to focus solely on activities in Iceland, because threequarters of the banks’ total lending on a consolidated basis was to non-residents, especially in the other Nordic countries and the UK. The assessment indicates that the banks’ loss provisioning is more than adequate to meet expected losses. However, this view must be tempered by hefty credit growth in recent years and the large increase in leveraged buyouts and forward contracts connected with them. House prices are at a historical peak in real terms and may unwind. Equity prices reflect expectations of ongoing rapid output growth, but such sentiment can quickly reverse, as recent experience has shown. Arrears and impairment are minimal, but both may be expected to increase in the coming years. One major vulnerability of the Icelandic economy at present is the risk of a rapid and unforeseen rise in international interest rates and premia. Short-term rates have already risen widely and may go up further. Long-term rates have not changed much but could begin to climb. Premia are prone to change at short notice due to shifts in investors’ risk assessments or risk-seeking. The Icelandic economy has never been so sensitive to changes in global markets, which could significantly affect it.
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.