Financial Stability 2022/2

The global economic outlook has deteriorated in recent months, in part because of the war in Ukraine, continuing pandemic-related public health measures, and high inflation, which has cut into households’ purchasing power. Governments have scaled down pandemic support measures for households and businesses, central banks have responded to stubborn inflation by raising interest rates, and the macroprudential stance has been tightened. These actions combine to slow down the global economic recovery, as can be seen in asset prices, among other things. Iceland has not been spared the surge in global inflation, although the effects of higher energy
prices are far weaker here than in most other countries. Iceland’s GDP growth outlook for 2022 is still good, although growth is expected to lose momentum in 2023.

House prices are high by virtually all measures. The first signs of cooling in the housing market have begun to emerge. The number of homes for sale has risen, fewer purchase agreements are concluded, and the average time-to-sale has grown longer. The past several months’ steep rise in house prices over and above fundamentals indicates imbalances in the market, and the likelihood of a correction has increased. At the same time, rent prices have fallen in real terms, and increased demand for rental housing can be expected to push rent upwards in the coming term.

Households took advantage of low interest rates during the pandemic to refinance existing debt and invest in real estate and motor vehicles. Real growth in household debt peaked at nearly 7% year-on-year in Q2 and Q3/2021. The growth rate has now slowed markedly and was marginally negative in July. Nevertheless, the ratio of household indebtedness to either disposable income or GDP is historically low. The debt burden should therefore be manageable for most households. It is clear, though, that higher interest rates and inflation add to that debt burden, and arrears can be expected to increase.

The three large commercial banks are strong. Their returns on regular income have increased, their cost-to-income ratios are down, and household and corporate arrears have declined. The banks’ asset quality is improving, reflecting this year’s rapid economic rebound. Their capital ratios are high. The Central Bank stress test for 2022 shows that the banks are highly resilient, well prepared to respond to external economic shocks, and able to support corporate and household borrowers to withstand such shocks.

The three large commercial banks’ liquidity ratios have fallen in recent months and are now broadly where they were before the pandemic struck. Their liquidity is somewhat above regulatory minimum. Competition for deposits has picked up, and market conditions for bond issuance in Iceland and abroad have been challenging in recent months. Credit spreads on the banks’ foreign market funding have been on the rise and their foreign refinancing risk is increasing.

Cyberattacks and attempted cyberattacks are continually increasing. In order to provide for business continuity and guarantee system security, financial institutions and operators of financial market infrastructure must shore up their contingency measures against such attacks. Coordinated action plans play a key role in this preparedness. Simultaneously, it is vital to work quickly and securely on alternate routes that can be used if the need arises. This work requires the participation of financial institutions, financial market infrastructure operators, the Central Bank, and the Government.