Arion banki hf

ICEX:ARION

Earnings Call Analysis

Strong Quarter with Noteworthy Financial Developments

In the second quarter, Arion showcased a solid performance with net operating income increasing 14% to ISK 16.6 billion, driven by a 6% rise in net interest income and an 18% surge in net commission income. Despite a one-off ISK 0.6 billion administrative fine impacting return on equity (ROE), the bank maintained a robust capital position, launching a new ISK 2.5 billion share buyback program. Lending and asset management fees flourished, reflecting strong business momentum. The net interest margin held steady at 3.2%, with positive effects expected from mortgage portfolio resets in the latter half of the year.

A Strong Quarterly Performance Amidst Challenges

In the second quarter, Arion Bank showcased a commendable performance, achieving net profits of ISK 5.5 billion. This result underscores the strength of its core operational capacities, with total operating income increasing 14% from the prior quarter, amounting to ISK 16.6 billion. However, this success was slightly tempered by a one-off settlement fine of ISK 0.6 billion related to regulatory issues. Without this cost, the Return on Equity (ROE) would have nearly met the bank's 13% target, reflecting an adjusted ROE of 12.7%.

Fee Generation and Net Interest Margin Growth

A key highlight of the quarter was the substantial growth in the bank's fee-generating operations, which rose sharply following a lackluster first quarter. Net commission income surged by 18%, and overall fee income significantly contributed to gross profits. Concurrently, net interest income saw a 6% rise to ISK 11.9 billion, supported by a net interest margin (NIM) that held steady at a robust 3.2%. The bank anticipates further enhancement of its NIM, particularly due to the ongoing resets of its fixed-rate mortgage portfolio, with approximately ISK 45 billion in mortgages set to reset in the upcoming half of the year.

Strategic Growth in Insurance and Asset Management

The insurance sector of Arion Bank also reported impressive results, with income increasing by 12.8% year-over-year. Notably, new sales to individuals soared by 30%, indicating solid traction in this segment. Furthermore, assets under management reached an unprecedented ISK 1,500 billion, marking a 10% increase compared to the previous period. These developments reflect the bank's strategic initiatives and its successful positioning in the market.

Operating Expenses and Strategic Cost Management

Total operating expenses rose by 9% mainly due to the one-time regulatory fine. Excluding this item, expenses only grew in line with inflation, demonstrating the bank's effective cost management strategies. Additionally, the cost-to-core income ratio remained favorable at 42.8%, well above the target of 45%, signaling operational efficiency despite the backdrop of increasing costs associated with union wage agreements.

Robust Capitalization and Shareholder Returns

Arion Bank maintains a strong capital position, holding Tier 1 capital at 18.5%. This places it 330 basis points above the statutory minimum and showcases resilience in its balance sheet strategy. The bank has initiated a share buyback program of ISK 2.5 billion as part of its ongoing capital optimization efforts. These actions emphasize the bank's commitment to enhancing shareholder value while maintaining capital discipline amid evolving market dynamics.

Market Outlook and Economic Signals

Looking ahead, the market presents both opportunities and challenges. The bank noted signs of a cooling economic environment, particularly within the labor market and tourism sector, which could impact lending growth. Despite potential headwinds, the management remains confident in their strategy to navigate through changing conditions, including efforts to enhance mortgage products amidst rising interest rates. The expectation of policy rate reductions towards the end of the year could provide additional tailwinds for the bank's financial performance.

Earnings Call Transcript 2024-Q2

[Benedikt Gislason, executive]

Good morning. We welcome you to this Earnings Call for the Second Quarter Financials of Arion. My name is Benedikt Gislason, I'm the CEO of Arion, and with me here today to present the second quarter results is Olafur Hoskuldsson, our CFO.

Please feel free to submit your questions during this presentation, which will be followed by a Q&A session as we've done in previous earnings calls.

It's fair to say that this was a solid quarter with good momentum in most areas of the business, particularly asset management, card services and loans. One of the factors affecting return on equity in the period was an administrate fine following an inspection by the FSA in the summer of 2022 of the Bank's measures to combat money laundering and terrorist financing. The FSA inspection revealed shortcomings in the Bank's practices. We took these findings with the utmost seriousness and undertook a comprehensive review of our practices, and we have now significantly reinforced our money laundering defenses by enhancing our systems and expanding our AML team, which performs this vital role. If it hadn't been for this settlement, the Bank's ROE would have been 12.7% in the quarter -- second quarter and closer to our financial target of 13%.

The quality of earnings in this quarter is well reflected in the core operating income versus risk exposure market, which comes in at 7.3%, above our financial target of 7.2%. This target was first introduced in 2019 when our focus shifted to capital velocity and better use of capital deployed in our business. So loan growth only partially reflects our credit activity, and this is likely to become the fourth year where around 4% of the corporate loan book could be expected to be syndicated to third parties through acting as an intermediary rather than a direct lender.

The insurance business also performed well with income growing by 12.8% in the second quarter. Vordur also posted positive financial results despite the fact that the largest single claim in the company history was made during the period with the participation of reinsurers dampening the impact of the claim and also impacting returns of Vordur business was that investment portfolio continued to have low returns.

Excluding the administrative fine, the cost-to-core income ratio came in at 42.8%, well [ above ] our 45% target. And finally, the Bank is strongly capitalized with Tier 1 capital at 18.5% or 330 basis points above the statutory minimum. And our capital optimization plan continues -- or continued in this last quarter with ISK 4.5 billion of buybacks conducted and a new ISK 2.5 billion share buyback program launched on the publication of second quarter results.

Our focus on running a reliable business and providing outstanding financial services with convenient digital services at the forefront have resulted in Arion Bank having been named the Bank of the Year in Iceland for the last 3 years by The Banker magazine. In addition, Euromoney recently named Arion as the Bank of the Year in Iceland for 2024 and as Iceland's #1 digital bank. This mirrors the results of a survey conducted by Maskina in June, which revealed that bank customers in Iceland, rated the Arion app the best banking app in Iceland for the 8th year in a row now. And we are, of course, grateful for this positive response to our efforts, and it inspires us to do even better in the future.

Other highlights for the first half, and are worth mentioning is the 10% growth in asset under management and asset under management exceeded ISK 1,500 billion for the first time and now compares to our balance sheet, is close to being the size of our own balance sheet or 97%. Activity in our corporate and investment banking continue to be strong, and we are involved with all major activities in that front.

To reflect a little bit better on the insurance -- bancassurance progress, you can see here on this slide that the bancassurance ratio continued to trend up and are in line with our financial sort of targets for the year. And it was particularly good to see how this cooperation between Arion and Vordur is reflected in sales growth to individuals through the Arion sales team, which was 47% up year-over-year. And our leadership in capital markets continues.

Now this slide, we have never presented a detailed time line of our property development assets before. And I think it's important to note that we're making good progress on both fronts. The Arnarland project is smaller in nature, 9 hectare property development area, where it's estimated that 530 apartments will be built and a commercial property. And our book value reflects an overall value of ISK 1.5 billion with us owning 51% stake. And as this is coming to a complete, when it comes to planning process, we expect to explore monetizing this asset later in the year.

The Blikastadir project is a more comprehensive and extensive one. It's the largest property development area in the capital and it's in 3 phases. And the first phase is effectively, as you can see from the time line, a year behind the Arnarland project. There, we continue to work extensively with the local municipality on the planning process, both the overall planning and the district planning and expect the first phase to be finalized towards the end of next year. And here, we continue to explore some of the options that we presented in our Capital Markets Day in March.

And I think it's worth mentioning as well that obviously, when these two areas come into development or construction, it will ease -- help ease the shortage of supply in the housing market considerably.

My final slide here before turning over to our CFO, who will go in detail through the numbers, is on the economy, which is clearly slowing down. We're seeing leading indicators clearly pointing into that direction. And I think the sort of the economic data that Central Bank is probably observing closest now apart from obviously the mostly CPI numbers is the labor market, which are now -- is now showing early indications of cooling off a bit. And I think it's worth mentioning that, for example, the tourist industry, which employs around 20,000 workers is experiencing somewhat slower growth or even a slight decrease in demand, and that should be -- and we should expect sort of a particular cooling in that area when it comes to the labor market.

I think it's also worth mentioning that the Statistics Iceland changed the way it measures the housing component in the CPI in June, making it more harmonized with the way that European and Western world countries do it, and we expect to see less volatility in the CPI numbers going forward on the back of this as we start effectively calculating what's been referred to as investment returns of housing. So I think it's hard to predict when we will see policy rates easing. But based on the leading indicators, I think it's fair to assume that we will see policy rates starting to move lower towards the end of the year with 2 policy rate meetings in October and November.

And with that, I'm going to hand over to Olafur.

[Olafur Hoskuldsson, executive]

Thank you, Benedikt, and good morning.

So now looking more closely at the results for the quarter. And starting with the key highlights as I usually do. Overall, a good solid quarter where core earnings drivers -- key core earnings drivers for our business, like Benedikt mentioned earlier, were all showing good positive momentum. The headline ROE of 11.5% is below our 13% target. But as Benedikt outlined, this is primarily because of the one-off ISK 0.6 billion settlement fine that was outlined earlier. Without this fine, the ROE for the quarter would have been just below our target of 12.7%.

A key positive in the quarter was the strong results for our fee generating business, which had an unusually subdued first quarter of the year. Asset management, cards and lending fees all contributed to a strong period in terms of fee generation.

Net interest margin was also holding at a strong level at 3.2%. And the ongoing resets of the fixed rate mortgage portfolio is starting to have a positive effect on our margin, and this will accelerate for the second half of this year.

And finally, and of course, always very importantly, our capital funding and liquidity position remains very robust, and we are continuing our capital optimization commitment by launching the ISK 2.5 billion buyback program of shares today.

So now looking more closely at the income statement. Total operating income in the quarter was ISK 16.6 billion, which is up 14% from the first quarter. And again, these are driven by our core income lines. Net interest income increased by 6% and net commission income increased by 18%. Insurance service results were also solid in the quarter at ISK 0.5 billion with a combined ratio of below [ 90% ]. Financial income was again subdued in the quarter. And during the quarter, we did tender a senior bond in euros, which was maturing at the end of the year, and we had a one-off cost in the financial income line of around ISK 500 million, but this will be countered for the remainder of the year through lower interest expense.

Operating expenses increased by 9% between quarters, and primarily, this is driven by the settlement fine mentioned earlier. Impairments were then somewhat up from the previous quarter at ISK 0.8 billion, which represents a cost of risk of around 28 basis points, in line with our previous guidance. And then again, we had the high effective tax rate in the quarter of 32.5%, which is impacted by the settlement expense, which is not tax-deductible and therefore, explains the high effective tax rate. So net profit in the quarter, ISK 5.5 billion, which then takes the net profit for the year to ISK 10 billion.

So now looking more closely at some of the key income statement items and starting with net interest income. Net interest income was ISK 11.9 billion, which is up from ISK 11.2 billion at the end of the Q1 -- for Q1. And the net interest margin, as mentioned, increased to 3.2% of interest-bearing assets. As mentioned earlier, we had, this year, started a new phase in the rate hiking cycle, where our fixed rate mortgage portfolio began to reset. This is a tailwind for our NIM and especially for the second half of this year. In the first half, we have seen just under ISK 15 billion of mortgages resetting while we have ISK [ 45 ] billion of mortgages resetting in the second half of the year. On the other hand, we had a negative impact in the quarter from the increase of the Central Bank of the interest-free reserve requirements from 2% to 3%. This effectively lowers our interest income from our liquidity reserves by around ISK 200 million per quarter.

So fees, as discussed, are strongly up this quarter following an unusually subdued first quarter of the year. This is pleasingly driven by a broad-based increase in most of our fee-generating businesses. Asset management, for an example, had a strong quarter with ISK 1.3 billion in fees and assets under management, as Benedikt mentioned earlier, increased sharply by ISK 75 billion during the quarter, representing a 10% increase in assets under management. We also saw strong activity on the lending side, both on the retail and corporate side, contributing to lending fees of just under ISK 1.2 billion. Card fees also picked up during the quarter to just under ISK 700 million. As discussed in Q1, we need to mention that the comparison between years is slightly impacted by the closure of the Keflavik airport branch and the reclassification of card insurance fees at Q1 this year. And combined, these 2 items contributed to ISK 220 million in fees for the second quarter last year.

So looking at insurance service results, we continue to see very positive momentum. Revenue growth continues to be strong, and revenues increased by 13% year-on-year, which is in line with its growth trajectory over the past years. Also, very importantly, we are seeing very good traction in terms of new sales, where, for example, new sales to individuals were up 30% between years. Claims were impacted during the quarter, as Benedikt outlined, primarily by a single event, a fire in a shopping center in Reykjavik. The current estimate is that the net loss after reinsurance for Vordur is around ISK 270 million. And we continue to evolve the bancassurance cooperation and identifying synergies within the group. And this contributes to another quarter where costs are -- the cost ratio is below 20%. So the combined ratio in the quarter was therefore 89.4% and 93.6% for the first 6 months of the year.

And now looking at total operating expenses, which include the insurance -- the operating expenses from the insurance business. Total operating expenses in the quarter were ISK 8 billion, which are, of course, impacted by the ISK 585 million settlement fine. And if we exclude this item, growth year-over-year is 9% compared to around 7% inflation during this period. Included in the salaries line is a one-off impact of around ISK 100 million, which relates to the fact that recent union wage agreements were backdated to February. And then the monthly increase in salaries from these agreements is estimated at around ISK 120 million per quarter for the group. So in general, the theme is similar to before, we continue to manage expenses conservatively while maintaining our investment commitment in key business areas, which we, of course, outlined in our Capital Markets Day in March.

So now moving on to the balance sheet and starting with the loan book, which grew by 2% or ISK 24 billion during the quarter. Out of the total growth in the quarter, ISK 8.4 billion is a result of inflation impact on our CPI loan book -- CPI-linked loan book. Despite the high interest rate environment, we do continue to see solid lending opportunities in the market. And our capital and liquidity position allows us to be opportunistic in this market. Clearly, this is a continuously evaluated scenario, along with the evolving economic environment, and we will continue to manage loan growth dynamically. The loan book continues to be very well balanced, 48% mortgages, 5% loans to -- other loans to individuals and 47% loans to corporates.

Looking at provisioning, total loss allowance at the end of the quarter is just under ISK 9 billion or 0.74% of the loan book. It should be noted that there was a reduction in Stage 2 loans to individuals, which relates to mortgages in Grindavik. These loans have been transferred to an SPV co-owned by the Icelandic state, and this exposure is now classified at fair value. In general, apart from the specific exposures related to Grindavik, the theme is very similar to what I've outlined in previous calls. We are seeing an uptick in nonperforming loans, which is to be expected in the current rate environment. And we, of course, continue to monitor this evolving market backdrop and work with our clients proactively.

While the overall position of nonperforming loans is still, from a historical perspective, relatively comfortable; clearly, the longer the current rate environment persists, this will impact our clients to a greater extent. We continue to see, through the cycle, expected loss of the loan book of 20 to 25 basis points through the cycle. And in the next 12 months, we see this as being slightly higher or around 29 basis points based on the current loan book composition.

In terms of deposits, deposits grew strongly in the quarter by ISK 45 billion or 6%. Total deposits now stand at ISK 847 billion, representing just under 62% of total liabilities. As we have discussed previously, our strategy has been very clear in this regard, and we are focused on being competitive in terms of stable categories of deposits. And we have highlighted in the top right chart of this page that the growth over the past year has been in these categories.

So moving on to wholesale funding. A key positive, of course, over the -- recently has been the continued strong trend in our spreads -- funding spreads and these have continued this quarter. This was again evident in our euro senior preferred issue, which we completed in the quarter, which was the tightest new issue for an Icelandic bank for close to 3 years and was 8x -- more than 8x over-subscribed. The solid investor sentiment was then further supported when Moody's affirmed their A3 rating with a stable outlook during this quarter. And as always, we continue to manage our funding maturity proactively, utilizing our domestic ISK and [ Scandi ] markets, along with euro and other currencies periodically.

Looking at capital, our position continues to be very strong, common equity ratio of 18.5% or 330 basis points above the requirements. During the quarter, pleasingly, our Pillar 2 requirement was reduced by the regulator by 30 basis points to 1.8%. The leverage ratio, of course, continues to be very strong at just below 12%. The common equity position includes a foreseen dividend payment in line with our dividend strategy of 50% payout ratio and also includes the full ISK 2.5 billion buyback program, which we are launching today. Based on our management buffer targets, we currently have surplus equity, therefore, of around ISK 10 billion to ISK 18 billion.

As highlighted before, we should mention that we have outstanding warrants of around 52 million shares, which are currently in the money. And the last exercise window for these warrants is now in August. Should all these warrants be exercised, the surplus capital is estimated to increase by around ISK 6 billion. Related to this, we have also obtained the regulatory approval for a ISK 5 billion additional buyback program, which is conditional on the capital increase related to the utilization of the warrants. And finally, just quickly on the MREL position, we continue to be very robust in terms of MREL and currently have over 10% buffer above requirements.

So before I hand over to Q&A, just very briefly highlighting some of the key themes going forward. We conclude a solid quarter with very good momentum in all our key core earnings drivers. We do remain committed toward optimizing our capital position and are launching a new share buyback program today. And finally, our diverse businesses are strong and mature market position in all key business units, combined with a very robust balance sheet in terms of liquidity, capital and funding means that we are in a very good position to navigate what continues to be an evolving external market environment.

So thank you. And I would now like to welcome Theodor Fridbertsson to manage the Q&A session.

[Theodor Fridbertsson, executive]

Thank you. Good morning, everyone. Before we start, I'd like to remind participants online that they can still submit questions through the platform. But as usual, I think we will start with the questions online. And we have a couple of questions already.

Number one is on the assets under management. Can you please comment a bit on the growth in assets under management, i.e., what are the key drivers?

[Benedikt Gislason, executive]

Yes. Now since this first half hasn't been particularly good when it comes to investment returns, it's not a function of the returns. It's I think 2 components. Our -- the products that we own and/or service on the pension fund side continue to sort of enjoy strong influx. So there's sort of a positive savings there. And then with Stefnir, which had a particularly strong quarter in terms of growing assets under management. It has to do with the recently announced initiative by Stefnir and participation of the pension funds of [indiscernible] the housing rental company and demonstrates a new category of asset management with the group, focusing on the housing market, a very positive step.

[Theodor Fridbertsson, executive]

And then secondly, around the funding, we have a question about what are the funding ambitions in the next few quarters, especially on the senior and subordinated level.

[Benedikt Gislason, executive]

Yes. [ Oli ]?

[Olafur Hoskuldsson, executive]

Yes. I think it's very pleasing that we have a very solid market in terms of funding, especially in the FX markets currently. And we have a senior bond -- euro senior bond that is maturing for second half of next year. And then we have a call date in AT1 first half of next year, and we are looking at these markets, and we'll be opportunistically looking at issuing potentially. No decision yet on the call on the AT1. But clearly, the market dynamics are strong.

[Benedikt Gislason, executive]

Yes. And I think it's worth mentioning during an event like that, we have the -- obviously, the opportunity of optimizing the kind of the maximum allowance for these buckets of different capital instruments. So for example, for the AT1, we could issue an amount that is probably 25% higher than the outstanding amount to take full use of the AT1 bucket.

[Theodor Fridbertsson, executive]

I believe that concludes the questions online. So we'll move on to the auditorium. Do we have any questions today? Yes?

[Unknown Analyst]

[indiscernible]

[Theodor Fridbertsson, executive]

Can you maybe repeat the questions?

[Benedikt Gislason, executive]

Yes. So we had a question on the CPI imbalance, which is a ISK [ 150 ] billion at the end of June, if I remember correctly, and how we sort of project that to develop into the second half as kind of fixed rate market has come to a reset. There is a clear trend with the refinancing activity taking place in the mortgage market but borrowers at least partially open for CPI-linked mortgages. So we would expect this trend to continue. We're obviously looking at ways to manage the CPI imbalance in some way. And I guess it involves finding someone in our economy that is short in CPI and would want to exchange the CPI on a swap basis with a counterparty like ours, but it's -- there aren't many there, and this market isn't liquid. So I think it's fair to assume that this imbalance could grow, and it will bring as Olafur has explained in previous quarters, in our couple of markets they will increase the volatility of [indiscernible] earnings.

[Olafur Hoskuldsson, executive]

Yes. I think there's probably not much to add on this. I think maybe we are -- I mean, for a period, we saw CPI-linked being effectively the only product being on the mortgage side. I think we're seeing some move back to the non-CPI-linked. I think one thing to mention is, of course, that the borrowers that are resetting now are borrowers that took a mortgage at 4.5%, 5% when they could have taken a mortgage at 1% CPI-linked at the time. So if there's a type of borrower that potentially is more likely to take on CPI-linked, I think in general, also our borrowers, they actually -- borrowers know CPI-linked mortgages very well. The borrower and us as the bank, we know this product very well. It's a historical [indiscernible]. So we know how to manage the net interest margin through this, but we also know -- I think there's also a willingness from the borrower side to mix this and take a portion when they can of non-CPI-linked, so I think over time, especially when rates start to come down, which hopefully happens like [ better ] development in the second half of this year, the mix will be moved back to a mix between CPI and non-CPI. But I think in the short term, we should be expecting that imbalance to increase.

[Benedikt Gislason, executive]

Yes. And to elaborate a little bit on the volatility that it brings, it's obviously a function of the real policy rates as well. So it depends on how the real policy rates come in over a particular quarter, what kind of impact this could have. So currently, the real policy rates are at close to 3%. So it depends a little bit on how that is recorded over the relevant quarter.

[Theodor Fridbertsson, executive]

Yes. And as we've been guiding, we also expect sort of more volatility when it comes to NIM relating to this. Because obviously, it's going to be more sensitive towards inflation development.

[Benedikt Gislason, executive]

A good question. First question I got from the auditorium in many quarters. So thank you.

[Theodor Fridbertsson, executive]

Any other questions? No? I guess that concludes the Q&A today. Thank you all for attending, and have a great rest of the summer.

[Benedikt Gislason, executive]

Thank you.

[Olafur Hoskuldsson, executive]

Thank you.