Arion banki hf

ICEX:ARION

Earnings Call Transcript 2023-Q2

[Benedikt Gislason, executive]

Good morning all, and a warm welcome to this Earnings Call for our Second Quarter Results for 2023.It's fair to say that Arion Bank's second quarter financial results are in line with our expectations and reflect the stability which has characterized the bank's operations in recent quarters with operating income increasing 8% compared with the same quarter of last year. Return in the quarter continues to exceed our 13% financial target. And all of our other financial targets were exceeded or met in this quarter.I want to highlight here that we have now set a time line for a Capital Markets Day in the first quarter of 2024. This will be our third Capital Markets Day after we listed. We will provide update on our strategy and direction. And also, our medium-term targets will be under review for that meeting.Here are a number of key operational highlights in the second quarter. I want to start by highlighting that in the second quarter, we received a FSA of the Central Bank results of its annual SREP process where it concluded that the additional capital requirement would be lowered by 1.4 percentage points. This decision is positive for the bank and is a validation of our diversified business model as we now have the lowest Pillar II surcharge of the 3 [ PCIPs ] in Iceland.So at the end of the second quarter, our CET1 ratio was 18.9%, which is 4 percentage points higher than the minimum requirement. And Arion's liquidity and funding position also remains robust, but rating consideration will, however, impact capital management near term as will be explained later in this presentation.Other highlights include Hampidjan, an established company, which has made innovation an integral to the business, which engaged Arion to manage its IPO to complete the financing of the acquisition of the Norwegian company Morenot and making its return to the main market of NASDAQ Iceland. The partnership between Arion Bank and Vordur continues to grow from strength to strength and insurance premiums at Vordur increased in the second quarter by 14.4% compared with the same quarter last year. The highest growth rate was in corporate insurance, as we've explained in our earnings announcement, which is due to the incorporation of Vordur's Corporate Services division into the bank's CIB business. And this move obviously has helped Vordur to broaden its revenue basis and continues then to diversify the risk base of Vordur.Other highlights that I want to draw your attention to here is the successful launch of deposit account. So yet another savings account, where Arion was the first to launch a CPI-linked 90-day term deposit on the back of a change from the regulator. So now our depositors can place deposits on a CPI-linked account and don't have to term it out for 3 years. There is obviously a lot of upcoming interest rate resets in our mortgage portfolio, and we have decided to take a proactive engagement with our customers there. And we're well prepared to support our customers by offering various products and solutions to manage the market's debt service. And here, we are operating in a highly competitive market, not only with the banks but also the pension funds.I will touch up on some of the other highlights in following slides. Starting with our merchant banking operations. It is vital that we continue to nurture the innovation in this country as the IP industry has become the fourth pillar of the nation's export revenue. And the role here is to take calculated risk as we do with our retail and corporate customers each and every day. And in this slide, we explain how we support growth companies by leveraging our merchant banking expertise. And even though our merchant banking book is only a small component of our corporate book, it has been a good business to be in, and it's great to be able to support the IP industry on their international growth journey. One great example of that is Kerecis, another Unicorn that has been created here in Iceland. It's a great example. And we're obviously delighted to have been just a minor participant in the journey and the bank will recognize income of ISK 560 million in the third quarter on top of around ISK 300 million released in previous quarters from the sale of Kerecis.Several other Icelandic startups are doing amazing things today, which we have also been involved with and here are 2 other examples of that. Now in June, the municipality of Mosfellsbaer announced its new land use plan for the largest undeveloped piece of land in the capital city area, which is owned by Arion. This is a 93 hectare area and set to undergo further development. And the secondary land use plan will be announced at a later stage. We expect that the total up to 3,700 homes will be planned to be built, a mixture of single family and multifamily residents as well as 150 apartments with people aged 55 and over, schools, sports facilities and commercial property.After this important milestone was reached and uncertainty over the future of this key project has been reduced, the bank has upgraded its valuation of the land and this had a positive impact in the quarterly results, resulting in a ISK 1.6 billion fair value change on this investment property minus tax effect of ISK 320 million. And obviously, as this is a very important social project, we're looking forward to watching this area develop. This represents a much needed addition to the housing market. and is expected to represent around 10% of the housing need in Iceland over the next 10 years.Now going briefly through the macroeconomic environment. We saw a strong GDP growth in the first quarter of 7%. However, growth has now slowed down in general, which is not surprising or unsurprising given the economic growth in Iceland has also begun to slow down. However, various positives can be found in the Iceland economy at the moment. Inflation has finally begun to recede while the international rating agencies, S&P and Moody's have both recently upgraded the sovereign outlook from stable to positive. And it is also really good to see our tourist industry back on track. And I think here, because Iceland has always been put into the context of being a country that relies on tourism. I think it's important to note here that this is not only a function of the interest of visitors to come and visit Iceland and have a look at the nature and the volcanoes, one of them active today. But this is also due to the fact that we have a strategic international airport that is a connecting hub between North America and Europe. And there are more flights, for example, to North America from this airport and collectively from all of the other Nordic airports, major airports. And if you compare the tourist arrivals with another very efficient international airport, which is also kind of a connecting hub, the airport in Copenhagen, Kastrup Airport, the kind of the tourist arrivals are very similar to tourist arrivals in Denmark.Now I said the sort of, we're seeing growth slowing down. But what we think might be a contributor going forward to economic growth in Iceland is the fourth pillar, the IP sector or the knowledge space sector. And we see kind of a potential upside revisions to economic growth coming from export growth from sectors like healthcare products, aquaculture and then sort of the development in tourism is also positive. You can see in this slide that we've seen on a price-adjusted basis, consumption coming down, and it's now trending below 0%, which is, I think, a healthy sign. And another healthy sign is to see that the net savings rate of households is still quite favorable and high, as you can see from the graph on the right-hand lower side, and so the consumption, it doesn't look like consumption is borrowed by any means here in Iceland.We say here that there are mixed signals in the housing market. But what is really driving the housing market now is shortage of supply and then the population growth. The population of Iceland was 394,200 at the end of the second quarter and increased by 3,370 inhabitants in that quarter. And we are probably on the track to reach this 400,000 mark for a population before year-end. And this is really sort of putting a strain on the housing market and even though we've seen reprices moving into negative territory in recent quarters, we don't expect any major price changes in this market for the coming years.Now I mentioned that inflation is on the decline. And I think our last record or our last print of the inflation was 7.6%. And here, you can see the components to the inflation and the housing component, which is quite unusual to have in the CPI. Iceland is one of very few countries in Europe that include housing prices in the kind of CPI measurement. The contribution of housing prices into inflation has [ receded ] and same applies to imported goods, but other kind of inflation, domestic inflation is still at high and we're hoping to see on the back of slower consumption growth this to come down. And that's why we think that terminal rates are inside, this somewhat relies on collective rates agreements that start in the autumn and the winter. But the signals are positive.And with that, I conclude my part of the presentation and invite our CFO, Olafur Hoskuldsson, to state.

[Olafur Hoskuldsson, executive]

Thank you, Benedikt, and good morning, all.So now I look more closely at the second quarter results and starting as usual with my key highlights. First, another solid quarter with a net profit of ISK 7.1 billion and a return on equity of 15.5%. This continues to be supported by ongoing momentum across our diverse businesses, while retaining discipline around balance sheet management and provisioning. Second, as Benedikt mentioned earlier, we are updating the book value of the Blikastadir land development, which is held within a subsidiary [ Lande ] of ISK 1.6 billion in the quarter. This reflects an enhanced certainty around key valuation drivers for this project.Third, our balance sheet remains very robust. Capital position is strong with a Common Equity Tier 1 ratio of 18.9%, which represents a 400 basis points buffer above the regulatory minimum. As Benedikt mentioned, the Pillar II requirements were reduced during the quarter from 3.5% to 2.1%, which increased both the capital buffer and the [indiscernible] buffer. Our deposit base is robust and well diversified and grew again in the quarter by just under 1%. Our wholesale maturity profile is light over the coming years. And in terms of liquidity, the position remains very strong with an LCR ratio of 163%.And finally, it is worth highlighting that during this quarter, we implemented IFRS 17, which has some impact on our accounts. This is mainly a transfer between line items, and the main difference relates to the insurance service results line, which now includes full operating expenses related to the insurance business. Comparative numbers in the accounts have been adjusted accordingly.So now looking more closely at the results. Again, net profit of ISK 7.1 billion and an ROE of 15.5%. And then this takes the net results for the half year to ISK 13.4 billion and the ROE to 14.5%. Core income again grew by 8% between years and 10% from the first quarter. The valuation uplift of Blikastadir is included in the other income line. Also of note is that the effective tax rate is again high this quarter at 31%, which is mostly due to equity losses, which are, of course, not deductible.So now looking more closely at the key line items. Starting with net interest income, which again grew in the quarter and has increased by 17% between years. The net interest margin increased slightly during the quarter to 3.2%. Cost of deposits, as we have discussed previously, has been increasing steadily over the past quarters, and we are now effectively passing most of the policy rate hikes to our savings accounts. We have remained focused, as we have discussed, especially on being competitive when it comes to deposits from clients which have multiple products with the Group as well as in terms of term deposits.Countering some of the margin pressure on the funding side is the upcoming interest rate hikes on the ISK 152 billion fixed rate mortgage portfolio, which is due to reset starting from this autumn and over the next couple of years. As Benedikt mentioned, we are managing this proactively and have begun a dialog with the borrowers around debt service cover options. Commissions were again strong in the quarter of ISK 4.2 billion. Fees and commissions now cover 62% of operating expenses, which is up from around 35% a few years ago. All key fee drivers delivered a solid quarter. The asset management business again demonstrated its resilience with a very strong ISK 1.3 billion in fees in what continues to be a challenging market. Lending fees were slightly down from Q1 and also from Q2 last year. But it should be noted that both of those quarters were especially high in terms of lending fees.So looking at insurance. As mentioned earlier, the presentation of the insurance result is somewhat impacted by the IFRS 17 implementation and the main impact that these numbers now are net of operating expenses related to the insurance business. But overall, this was a solid quarter for the insurance business. This is, of course, the combined ratio ended at 79%, which is considerably lower than we've seen in recent quarters. Of course, this is a seasonal business, but we are seeing signs that claims are starting to show positive signs following very challenging quarters recently. Also in terms of the cost ratio, this has now become more normalized following a couple of quarters, which were impacted by one-off items.Overall, there are a number of positives in terms of the broad bancassurance project. Corporate Insurance sales have, for example, been very strong with significant synergies with the corporate banking business. There's also a good traction in terms of online sales, and there are significant further opportunities here in the future through bancassurance development, both on the product and service side.So looking at operating expenses. And it's worth noting at the start that this page shows the full Group operating expenses. So including the net insurance operating expenses, which are moved to the insurance line in the accounts. So when I presented the first quarter results, I highlighted some of the one-off items that were impacted cost in that quarter. The second quarter now is somewhere cleaner representation of the run rate operating expenses and totaled ISK 6.8 billion for the Group, down from ISK 7.3 billion for the first quarter. Again, we are generally managing this relatively stable cost base despite what is of course a continuing inflationary environment. Over the past year, significant efficiency gains have been made in this business. And of course, this continues to be an ongoing project.So now moving on to the balance sheet and starting with the loan book, which grew by 1.8% or around ISK 20 billion in the quarter. As has been the trend over recent quarters, growth in mortgages has been slowing and was ISK 3 billion or 0.6% during this quarter. On the corporate side, there was more activity, but we are also seeing this growth coming down. Loan growth on the corporate side was ISK 17 billion or 3.2% in the quarter. Out of this total growth, it is worth mentioning that ISK 9 billion is related to the inflation impact of our CPI-linked loan portfolio. Our loan portfolio continues to be well balanced, 47% in mortgages, 5% in other loans to individuals and 48% to corporates.So now looking at our provisioning position. Total loss allowance at the end of the quarter was 0.6%, and the net impairment for the quarter was just under ISK 600 million. We have seen a slight uptick in nonperforming loans over the past few months with this to be expected, of course, in the rapid changes in the rate environment. The size of this is still, however, low in a historical perspective. During the quarter, we have again prudently reflected the evolving economic outlook in our IFRS 9 assumptions. In the first quarter, we increased the weight of the pessimistic scenario in our models. And during this quarter, we have again increased haircuts and real estate collateral assumptions. We continue to see through-the-cycle cost of 25 basis point cost of risk in this business based on the current loan book composition.So deposit growth positively continued during the quarter with an increase of 1%, taking total deposits to ISK 781 billion with just around 60% of our total liabilities. Our loan-to-deposit ratio has been relatively stable at the 145% level. As we have discussed, our strategy in this area has been to compete, especially in the more stable categories of deposits, being deposits from our core clients with a number of products with the Group as well as in terms of term deposits. It's good to see that recently, the growth in deposits has been in this area. The Group gains, of course, from having a strong client group, which has been built up over decades by Arion and its predecessors. The deposit book is well diversified and robust with 42% of total deposits insured by Deposit Guarantee Fund and around 80% of deposits from individuals.So moving on to wholesale funding. During the quarter, we issued EUR 300 million senior preferred 3-year bond, and this prefinanced the next maturity that we had in May 2024. And this maturity has now been largely prepaid through a tender offer. Clearly, refinancing this early and at the current funding levels is expensive, but we have aimed to manage this area conservatively considering the volatile funding markets over the past year and therefore decided to utilize this issuance window. This funding means that we have a very light maturity profile over the coming year with the max maturity being a ISK 25 billion covered bond in Q2 2024 and then EUR 300 million senior preferred in Q4 2024. This senior issue also means that our [indiscernible] buffer now remains very strong at over 12%. We will continue to manage our funding position conservatively and aim to be active in the ISK covered market regularly over the next year as well as looking at opportunities in other markets going forward.So looking at capital, our position, again, very strong with a Common Equity Tier 1 ratio of 18.9% and a leverage ratio of 11.7%. During the quarter, our Pillar II requirements again were reduced considerably or from 3.5% to 2.1%, which means our management buffer is now 400 basis points above the requirements. This position, as before, has included the foreseen dividend payment corresponding to 50% of our net earnings. Obviously, this is well above our medium-term management buffer targets, which is 150 to 250 basis points. Based on this target, we have around ISK 15 billion to ISK 25 billion of surplus capital over the regulatory management buffer level.Our capital planning, however, was impacted recently when S&P confirmed an increase in our economic risk assessment of the Icelandic banking sector. Effectively, this increased the Tier 1 capital requirement at our current rating level by around 2.5% and corresponds to a Tier 1 buffer threshold at our current rating level of around 400 to 500 basis points. In the near term, we will manage our capital plan according to these parameters. However, over the medium term, we do anticipate that regulatory and rating agency capital benchmarks should converge to a greater extent, again, as the Iceland economy demonstrates its resilience and or through other rating factor uplifts. Clearly, these factors are only partially within our control, but we will continue to retain agility considering the evolving position.So before I hand over to Q&A, I just want to summarize some of the key highlights going forward. We conclude another solid quarter with all our key businesses delivering a positive operational momentum. This position continues to support the business through what continues, of course, and remains a rapidly evolving external environment. The Icelandic economy has to date demonstrated strong resilience, and it was another good signal of this to see the positive outlook updates for the Icelandic sovereign from both S&P and Moody's in recent weeks. Arion has continued to exercise discipline when it comes to our funding strategy and loan provisioning. During the quarter, this was again demonstrated by early refinancing of [indiscernible] maturities and again, conservative changing to our IFRS 9 provisioning position. Our capital position continues to be very strong with a management buffer of 400 basis points. Capital management, as discussed near term will be impacted by the rating agency considerations, but we remain agile and we'll manage this carefully. And finally, we look forward to presenting updated strategic initiatives as well as a revised view of our key targets when we host our next Investor Day, which is planned for Q1 2024. We will confirm the date for this shortly, but hopefully, we will see most of you there. Thank you as well. And now I'll hand over to Q&A and welcome Theodor Fridbertsson to manage the questions.

[Theodor Fridbertsson, executive]

Good morning all. We already have a few questions already pending from our online participants. And so I will start on first on the net interest margin. This is from Tellimer. Your full year guidance is 3%, but the Q2 margin was 3.2%. So do you expect the margin to fall below 3% in the second quarter? Maybe [ Olafur ]. I think in general, it's not the 2023 guidance. But...

[Olafur Hoskuldsson, executive]

I think the guidance I'll be talking about 3% is for the medium-term outlook. I think in the near term, we have a positive sensitivity to the policy rate hikes. And in general, there is sort of at least a month lag in our lending repricing on the sorting rate from when the policy rates are implemented. And we have another policy rate hike in Q2...

[Theodor Fridbertsson, executive]

In May... late May.

[Olafur Hoskuldsson, executive]

Late May. So I think we're not going to be going down to the 3% level straight away, but this is more of a medium-term sort of trend that we're guiding to.

[Theodor Fridbertsson, executive]

Secondly, are you expecting a significant intensification and competition for deposits?

[Benedikt Gislason, executive]

I think it's fair to say that it's already started, we're probably a little bit ahead of the curve in Europe here because policy rates hikes started earlier and are obviously at higher levels. So we see other banks sort of guiding for a higher deposit beta going forward. And I think this has already materialized to a great extent in Iceland. So when kind of short-term deposit accounts are offered at somewhere between 7.5% and 8%. And then you have a really kind of strong competition.

[Theodor Fridbertsson, executive]

And then thirdly, on the buybacks, how soon do you think the rating assessment of your capital requirements could convert with that of the regulators? Could we see buybacks recommends before year-end?

[Olafur Hoskuldsson, executive]

I think it's very positive to see both rating agencies having uplifted the sovereign to a positive outlook. And the rating implications that affect our capital management are related to the economic risk. And so with both rating agencies having set sovereign on a positive outlook, clearly indicates that the economic risk is reducing. So I think it's difficult to say when we might see a change in this, but...

[Benedikt Gislason, executive]

So we have the signals. But of course, this is out of our control. We're not going to determine the time line of the rating agencies.

[Olafur Hoskuldsson, executive]

Yes.

[Theodor Fridbertsson, executive]

And then on the loan quality, the volume of Stage III loans has risen since the beginning of the year. Do you see this trend continuing and which segments of the loan book could be most vulnerable to higher interest rates and which to slower macro growth?

[Olafur Hoskuldsson, executive]

I mean, this is an evolving position. I think we've seen a significant rate increase in Iceland, like Benedikt mentioned, the timing of this has been faster than you've seen in most other countries. And still, this increase in problem rolls is relatively small. I mean we're seeing a sort of slight uptick in the sort of the first uptick that we saw was [indiscernible], then the consumer lending business, but this is still, like I said in the presentation, this is still, in most factors, low on a historical perspective. This is something that we, of course, just continue to monitor.

[Benedikt Gislason, executive]

Yes. But I think the industries that are maybe most exposed are, and that relates also to wage inflation, in Iceland are kind of smaller midsized companies that are kind of industrial companies that produce for the local market. But then again, if you look at the leverage ratios or borrowing levels for those industries and business in general in Iceland, it's low, both in international context and from a historical standpoint as well. So the ability to service the debt is greater than in the past.

[Theodor Fridbertsson, executive]

Yes. Then regarding a couple of other questions here regarding the insurance income. Is it right to assume that on a like-for-like basis, the net insurance income line, if it had been unchanged, would have been around ISK 740 million higher and the OpEx higher by the same amount, looking at the presentation?

[Olafur Hoskuldsson, executive]

If you look at that roughly the numbers or the big impact is, like you said, is the on the operating expense line. And that is roughly the amount that of the insurance cost that is now included in the life insurance line. So yes, that's correct.

[Theodor Fridbertsson, executive]

And then the final question, can you comment on the OpEx guidance going forward in general?

[Olafur Hoskuldsson, executive]

I mean I think what I mentioned in the presentation is that we had a Q1, which was impacted greatly by one-offs. So there was ISK 400 million, ISK 500 million, which we stated in Q1 that were one-offs. So this is now a more sort of normalized quarter which should be looked at. But of course, we are in an inflation environment and there are always one-offs, there's also some seasonality to it, but I think we're managing this relatively well.

[Benedikt Gislason, executive]

But it was good to see the development in the second quarter based on kind of the inflationary environment that we operate in that we were able to keep a lid on costs in the quarter, and we continue to run operational efficiency programs and find ways to kind of optimize our cost base. And what is also good to see is that we were able to keep the costs relatively flat in the quarter, but still enjoy kind of earnings or income growth. So the kind of the synergies of having Vordur and Stefnir in our headquarters and having shared services is really showing in our numbers. We've been able to support the growth of Vordur without kind of incurring greater costs. And this is something that we look to do in all our business lines.

[Theodor Fridbertsson, executive]

All right. That concludes the questions from the online participants. Are there any other questions from the auditorium? No? Well, I guess that concludes the presentation. Thank you all for participating, and have a good summer.