Islandsbanki hf

ICEX:ISB

Earnings Call Analysis

Company Navigates Market With Stable Margin

The company experienced healthy growth in net interest income, although fee income fell due to turbulent markets. With rising Icelandic interest rates now at 9.25%, the Central Bank's actions aim to cool down the economy, indicating a potential slowdown in loan growth. Wage inflation negotiations are underway, expected to settle around 7-8%, making future costs uncertain. Net interest margin is anticipated to remain at a stable 3% give or take a few points, reflecting a cautious approach amid variable inflation rates. While the bank operates at a cost-income ratio under the target of 39%, they maintain a robust capital position, allowing for a strategic approach to capital returns and future growth.

Navigating Turbulent Markets and Strong Liquidity

The company has faced challenges in investment banking and brokerage sectors due to volatile capital markets, which have impacted assets under management. However, there's an anticipation of market recovery and an increase in revenue for these segments. Furthermore, the company has maintained healthy growth in cards and payment processing. Despite the turbulent markets, the cost-income ratio is at satisfactory levels, although expenses like Anti-Money Laundering (AML) costs are rising, prompting a focus on efficiency improvements. The company remains highly liquid with excess capital, opening avenues for shareholder distributions or future growth.

Loan Portfolio Adjustments and Real Estate Sector Analysis

The company experienced strong loan growth in the first half but saw a downturn in the third quarter, attributed to increased competition in foreign currency lending and seasonal variations in car loans. A single credit case influenced impairments, but there are no worrying signs across specific economic sectors, and no increase in nonperforming loans is observed thus far. Many borrowers are opting for Consumer Price Index (CPI) linked loans due to interest rate hikes, and this shift is expected to continue. While the real estate sector is cooling by design, borrowers are performing well. On the deposit side, a steady growth, particularly in retail deposits, is a positive sign.

Capital Strength and Shareholder Remuneration Strategy

The company boasts a strong Common Equity Tier 1 (CET1) capital position at 20.9%, with regulatory requirements providing a significant cushion, placing the company's capital structure in a place of strength for capital optimization. This could include a share buyback program, with around ISK 1 billion possible per month, aiming to complete an ISK 5 billion program possibly before the next annual general meeting, subject to market conditions. The presence of excess CET1 capital also allows for potential increased shareholder remuneration or support for continued growth.

Wage Inflation Concerns and Net Interest Margin Prospects

Looking ahead, wage inflation is an area of uncertainty, with the company's chief economist projecting around 7-8% increases. The net interest income faced downward pressure but is expected to stabilize around a 3% margin. Factors such as foreign exchange costs and funding costs may continue to influence results, with the third quarter showing signs of moderation. The company's long position on inflation and adjustable rates present reduced risk and an opportunity to maintain interest margins.

Predictions on Loan Growth and Responses to Economic Measures

Expected to grow in line with nominal GDP over time, loan growth has been projected at around 5-6%. However, in the short term, growth is anticipated to be moderate due to active market cooling measures by the Central Bank. The mortgage competition landscape could lead to further shifts in market shares towards pension funds, particularly amid the trend of customers moving to inflation-linked mortgage products.

Enhancing Capital Structure and Engaging Shareholders

The company's capital optimization strategies may extend to exploring Additional Tier 1 (AT1) markets in the coming year, given the market's recovery post initial hardships. Engaging with shareholders for further opportunities, including potential adjustments to the capital buffer for higher countercyclical requirements, facilitates a balanced approach to capital management and continues to prioritize shareholder value.

Customer Behavior Trends and Deposit Account Optimization

Customer behavior shows a shift towards higher-yielding deposit products, indicating savvy financial decisions amidst changing interest rate environments. In lending, particularly mortgages, the trend is towards inflation-linked products. Corporate borrowers with inflation-aligned revenues are naturally hedging by choosing similar borrowing products. Monitoring these trends is essential for adjusting product offerings and maintaining competitive positioning.

Earnings Call Transcript 2023-Q3

[Bjarney Anna Bjarnadottir, executive]

Good morning all, and welcome to Islandsbanki's Friday, where we present the financial results for the third quarter of 2023. I'm Bjarney Anna, Investor Relations, and I will be moderating today's session. I'm joined by our CEO and acting CFO, Jon Guoni Omarsson. Before I hand the session over to Jon Guoni, I wanted to mention that as per usual, we will have a Q&A session following the presentation. You can participate in the session via the conference call using the dial-in details and the operator will give you the floor. You can also submit questions in writing using the webcast form or e-mail us at [e-mail].

Now over to you, Jon Guoni.

[Jon Guoni Omarsson, executive]

Thank you very much, Bjarney, and thank you all for joining this call. Islandsbanki had a robust earnings in the third quarter of 2023 and that we are happy with the results in a relatively mixed business environment. We are obviously seeing quite uncertain times abroad. Here domestically, the economy has been going quite well, very strong tourism season. But at the same time, we have quite high interest rates and high inflation, and we have now natural agreements coming up in terms of salaries across the board here in Iceland. So some uncertainties here in the environment.

We saw good growth between years in net interest income, but a bit of a reduction in fee income due to very turbulent markets. And the markets here in Iceland have been quite soft and softer than we have seen internationally, probably due to the fact that we have seen interest rates here go a bit further up, and the Central Bank rate is now at 9.25%.

The cost/income is well below our guidance and targets at 39% in the third quarter. That's a bit in the quarter, we see a bit of a seasonality as we accrue salaries or leave or the other months of the year and taking that through revenue in the third quarter. And therefore, the cost in the third quarter is usually a bit lower than in the other quarters of the year.

The deposit base has been growing quite steadily. As you can see at the bottom left here, and we're obviously extremely happy especially to see good growth in retail deposits. At the same time, asset quality has remained very strong. And even though that we have this high interest rate and inflation environment. There are, however, certain signs that some of our borrowers obviously are starting to feel a bit of a pressure from this environment. And we are seeing quite a few borrowers moving into inflation-linked loans to reduce their monthly payments.

If we look at our targets, we have met all of our targets in this quarter, obviously, in terms of return on equity and cost/income. And we have, as I'll describe a bit more later, capital buffers, obviously, well above our targets.

In terms of the economy, we are seeing fairly strong growth this year, probably around 2% and expect to see similar growth next year. And the biggest driver is the tourism sector, which has been picking up quite well after COVID. The housing market, which was a flaming hot, you could say, a year ago, had been rising over 20% year-on-year, has now moderated and we actually seen close to 0% real change or even a bit of a reduction over the past 12 months.

What helps us, obviously, in this environment is that Iceland is moderately leveraged. And you can see at the bottom left here, if you compare to the Nordic countries. And the comparison obviously looks even better if we compare to many European countries in general. But as I mentioned before, our main challenge at this time is the inflation, which is running quite high. And the interest rate level at the same time. The Central Bank has been quite active in raising rates quickly to fight against inflation. The main driver of inflation has been rising housing prices and obviously imported inflation. We believe that both of those are moderating, but the question is now more in terms of internal wage increases, domestic wage increases.

All of our business units did very well in the quarter. As you can see here, very strong earnings across the board. The average earning for the bank is obviously lower than we see for the profit units. And the reason being is that all our excess capital, which is quite substantial, sits within treasury, idly, you could say. And that's obviously, as we have noted before, we plan to optimize the balance sheet structure and the capital structure before the end of next year.

Over to you Bjarney.

[Bjarney Anna Bjarnadottir, executive]

Thank you, Jon Guoni. Like in other countries, customers in Iceland are increasingly experiencing fraud attempts online or in the digital channels. Obviously, we take these increases seriously and do our best to raise awareness through training and education, thereby hopefully limit the number of instances customers experience throughout. We have also implemented numerous ways to limit the effects of fraud including requiring customers to confirm an online purchase through customer-specific electronic ID, implementing a solution where customers can sign out on multiple devices with one click in the case of a security threat. And lastly, we offer our customers around-the-clock service to assist with frauds when they come. These increased services have been very well received by our customers and is a clear indicator that this is a real concern.

We're constantly working on ways to increase and enhance customer services while also promoting efficiency. Frooi is a great example where this goes hand in hand. And to thank Frooi, our friendly chatbot is only 3 years old and already with his long list of achievements and award is remarkable.

To give an example of Frooi's ability, he now answers more than half of all customer service chats, he consistently get positive feedback from our customers, some even doubting that Frooi is a program and not a living person. Alongside the evolution of Frooi, we've implemented an innovative solution based on natural language processing in partnership with Mioeind, an Icelandic AI and NLP innovation company, giving us the opportunity to strengthen and preserve the Icelandic language in an increasingly digital world and thereby being a force for good.

Speaking of being a force for good in society, Islandsbanki supports the blossoming start-up and entrepreneurial community in Iceland in various ways. One way is through our entrepreneurship fund where we are now accepting grant applications for the annual allocation that will take place before the end of the year. The fund has in the last 3 years awarded ISK 165 million to projects that support the 4 UN Sustainable Development Goals, the bank has chosen to focus, displayed on the slide.

The bank contributes a part of the annual balance of Vaxtasproti savings account to the fund, and I'm really looking forward to seeing the list of projects that receive an allocation later this year.

And now to an annual event held here by many. It was a glorious day in August when we celebrated with more than 11,000 runners and walkers during Islandsbanki Reykjavik Marathon. The day was a huge success and it only made our smiles bigger when it was clear that ISK 200 million were raised for charities by the participants, a record amount for fundraising alongside Islandsbanki Reykjavik Marathon.

Now over to Jon Guoni for a more in-depth encounter of the financial results.

[Jon Guoni Omarsson, executive]

Thank you, Bjarney. I ran the Marathon 10K with my 14-year-old daughter, not my best time. I think it was 1 hour and 20 minutes, but definitely quality time with the teenage daughter, not often you get that amount of time to speak to teenagers. So it was a great time and a great event across the board.

Now moving again to the financials. When we look at the bridge between the years in terms of the earnings, as you can see here, net interest income has obviously gone up. But the main disadvantage obviously has been -- operating expenses have also been going up due to wage increases and increased inflation. Net impairments obviously show a negative impact in this quarter where we had a positive impairment last year. So quite a big change there. And that's the largest contributor to the change between years.

If we look at the net interest income on the right side, you can see that we have seen the same trend over the past few quarters. Lending and deposit volumes still going up. And the lending margin, obviously reducing a bit as rates go up, but the deposit margin has been quite stable. The deposit beta has been quite high over the past few weeks and quarters basically as the rates are now at a quite high level.

As I noted before in Other interest ISK 185 million, where we see the benefit of the higher rate environment. But when we compare quarter-on-quarter, so the second quarter of this year to the third quarter, we see a bit of a drop. The reason being there is that we have a bit long inflation and inflation even though it has been quite high, it was actually running at 9% in the second quarter, but only 5% in the third quarter. So that explains quite a big part of the drop there between quarters. Also, we have seen increased reserve requirement from the Central Bank and also some increased costs of FX liquidity.

So looking ahead, we expect that the interest margin will probably remain at a fairly stable level at around 3%, now slightly below that level.

In terms of the fee income, like I mentioned earlier, a bit of a drop there. And the main reason being investment banking and brokerage and that's used just due to very turbulent capital markets. The assets under management have come down, obviously, as a result of the negative earnings and a negative impact from markets. But hopefully, we are now seeing the markets recovering and seeing an increase going forward on this revenue item. At the same time, however, cards and payment processing continue at a healthy rate, where we have seen, obviously, Icelanders travel abroad quite substantially.

The net financial income, we have seen here at the bottom left here, the factors behind that, the biggest item is the shares and related derivatives. If we look at those in isolation, again, obviously due to the turbulent market share over the past few weeks. And then we have a bonds and derivatives and other derivatives, which would net each other out to a quite a large degree. So the shares and those derivatives are the main contributing factor here.

In terms of the cost/income, again, we are obviously, well below our targets in a very good place there in terms of the cost/income level. Costs, however, are running quite high this year. We have pretty much the same number of FTEs as we had last year. But obviously, looking forward, we will be looking at the possibilities to continue to increase efficiencies on that front.

We have invested quite substantially this year in strategic projects with consultants working with us on various fronts. And then also, we have seen quite increased AML costs. We are strengthening our defenses and increasing our team on the AML side and the KYC. So that's something that obviously we have to look into also going forward how we can increase the efficiency on that front.

In terms of the lending growth, we saw quite strong growth in the first half of this year, but a bit of a reduction in the third quarter. The reason being that, firstly, we have seen some reduction in the market share in foreign currency lending here domestically, where we have seen due to a bit higher cost for the Icelandic banks, some foreign banks gaining a bit of a market share there, which is something that we have seen before in this kind of environment and will hopefully moderate quite soon.

Then we also see a bit of a seasonality in the car loans in Ergo where obviously they peak during the summer months, and then they start repayments in the fall as the tourism season winds down. The pipeline is now quite strong and so we expect to see reasonable growth in the fourth quarter.

In terms of the impairments, the impairments this quarter were largely due to a single credit case, which is quite specific. So we are not seeing any specific sectors or any clear indications or worrying signs in specific sectors of the economy. So overall, our borrowers are doing quite well, but high rates and inflation are obviously having impact on their earnings. But like I said, we are not seeing any increase in nonperforming loans as of yet.

The mortgage book, we have seen quite a bit of a shift now into CPI loans there. That's obviously a product that has been around here in Iceland for 40 years and is quite common. A lot of our borrowers moved into non-inflation linked. There's regular loans, many on fixed rate in the past couple of years, especially as rates went quite far down during COVID. But now the normal rates have gone back up and obviously at a quite high level. So some of our borrowers see the benefit of moving into inflation linked to see their monthly payment reducing. And as you can see on the top left here, we have seen quite a steady flux into that product now, and we expect to see that in the months ahead as well.

In terms of the real estate sector, that's doing quite well as well. That sector is, however, slowing down, and that's obviously part of the what the Central Bank has been doing. That's basically to raise rates to cool down that market. But overall, our borrowers there are doing quite well.

In terms of deposits, like I mentioned before, we have seen a steady growth there and particularly good to see the growth in the individuals and retail deposits. In terms of the borrowings, we have now basically finished our maturities this year. You can see the maturities in the middle of the graph. And then we have basically very stable maturities over the coming years in line with our policies on that front. We are extremely liquid at the moment. And excessive liquid, you could say, with ISK 370 billion of liquid assets and with the liquidity ratios running at an extremely high level. And so that's something that's part of the optimization exercise in terms of our balance sheet that we will look into in the coming few quarters. But obviously, in a bit of a mixed environment, now it's good to have strong liquidity.

Same for capital, where we have seen the capital base growing, obviously, on the back of earnings, a bit of a reduction in the loan book this quarter. But also we have been focusing on our REAs and the optimization project on that front and seeing some benefits from there. So at this moment, we are now at 20.9% CET1 capital. Currently, our sweet spot in terms of CET1 is 17.2% and will grow to 17.7% once the countercyclical buffer goes up by 50 basis points early next year. And that means that we have around 300 basis points of excess CET1 capital in excess of our sweet spot. But overall, the excess of CET1 is 580 basis points based on the regulatory requirements as they stand today.

So extremely strong capital position and gives us the opportunity, obviously, either to return some of that to shareholders or to see additional growth in the next 2 years.

So back over to you, Bjarney, in terms of the Q&A.

[Bjarney Anna Bjarnadottir, executive]

Yes. Now we open up for a Q&A session. You can participate in the session via the conference call and the operator will give you the floor. You can also submit questions in writing using the webcast form. Operator, are there any questions on the line?

[Operator]

[Operator Instructions]

The next question comes from Sofie Peterzens from JPMorgan.

[Sofie Peterzens, analyst]

Yes. Here is Sofie from JPMorgan. So maybe just to ask a question on your last comment. You have plenty of excess capital even if you adjust your kind of capital buffer for a higher countercyclical, you're well above 500 basis points. I saw that you started the ISK 5 billion share buyback. How should we think about shareholder remuneration going forward? Because at the current level, you are accumulating quite a lot of capital. So maybe if you could just talk a little bit about that?

And then how should we think about wage inflation in 2024? Kind of where do you see kind of wage growth settling and what have you agreed with the staff. And then final question would be on the net interest income -- net interest income was a bit weak, but it seems that it was a little bit driven by, I don't know if they are one-off, but maybe you could just talk about the sustainability of the items that the negative impact on NII in the quarter and how we should think about these factors going forward.

[Jon Guoni Omarsson, executive]

Okay. Thank you, Sofie. First, in terms of the capital, the buybacks, so we have now started on that program. Based on the turnover in the market, we can buy back around ISK 1 billion per month. And so we have now made the first step of ISK 1 billion and then obviously, we'll just assess how the market is on the back of that but the plan is to continue and finalize the ISK 5 billion program. And we will see how far we can get before our Annual General Meeting next year. And then obviously, we will ask our meeting for further opportunities there. And as we have stated, we plan to optimize the capital structure before the end of next year. So again, subject obviously to market conditions. And so that's what we're looking into.

In terms of wage inflation, that's actually quite difficult to tell these -- the wage -- the general wage agreements are now starting. And it's very difficult for me to predict what will be the outcome there. Our chief economist, I think, has been expecting somewhere around 7%, 8%. But again, it's a very difficult question also how it will be for different unions and different -- basically different industries because in the past, we have had actually fixed salary increases, fixed number rather than percentages. Now the big question is whether that will be again going forward. So it's a bit tricky for me to say exactly how that will pan out.

In terms of the net interest income, as I mentioned, we expect to be running at around 3%, somewhere in that range, 2.8% to 3.2% probably. And the factors that I mentioned, the reduction from the second to the third quarter, the FX costs, those will obviously continue. And then we will see in the quarters ahead, how our funding costs there will develop, and they obviously have moderated quite substantially during the third quarter based on the secondary trading in the markets. Yes, it's the inflation part, and that obviously depends on both the rates, the nominal rates, the real rates and the inflation.

So that's something that can move a bit around between quarters. But we have -- firstly, we are long inflation, and it's mostly on floating rates or adjustable rates, which we can adjust basically based on the environment, which obviously reduces our risk there quite substantially. So I think that's the best indication I can give around 3% plus/minus a couple of percentage points. in terms of the margin.

[Sofie Peterzens, analyst]

Thank you. What about the loan growth or should we think about loan growth going forward?

[Jon Guoni Omarsson, executive]

Yes. So in terms of loan growth, we expect -- through the cycle, we expect to grow with nominal GDP, nominal GDP growth in Iceland over the longer term is expected to be around 5%, 6%. Then it's also questioned within certain periods. Now it's obviously running at high rates. The Central Bank is trying to cool down the market. So I would expect to see lower growth in the coming few months on the back of that. And then it's a question of -- in terms of the mortgages, how the competition environment will be there, a lot of customers moving to inflation linked. So we do expect to see some market share moving over to the pension funds on that front. So I would think that we will see a rather moderate loan growth in the near term, but over the longer term to grow in line with normal GDP.

[Sofie Peterzens, analyst]

Thank you. That's very clear.

[Bjarney Anna Bjarnadottir, executive]

Are there any additional questions from the platform?

[Operator]

[Operator Instructions]

There are no more questions at this time. So I hand the conference back to the speakers for any closing comments.

[Bjarney Anna Bjarnadottir, executive]

Thank you. We have here questions on the platform. [indiscernible] from JPMorgan asks, is there any update on talks with Kvika? Have you resumed the discussions? Or is it completely dropped for now?

[Jon Guoni Omarsson, executive]

Okay. Yes. So that was quite clear in the summer that those discussions were basically aborted, and there have not been any indications or any discussions since then.

[Bjarney Anna Bjarnadottir, executive]

And for a final question. No? They are adding more. And from Namita Samtani from Barclays on net interest income, do you see customers shift to higher-yielding saving products? Could you explain what type of customer behavior you are seeing on the deposit side and also on the lending side?

[Jon Guoni Omarsson, executive]

Okay. So on the deposit side, yes, we are seeing some shift to high-yielding products. Customers are becoming quite aware. And obviously, it's quite easy to move between deposit accounts. So we are definitely seeing some shift there, and we expect that there will be a trend going forward as well. On the lending side, like I said, the main trend is especially on the mortgage side. borrowers moving into inflation linked. We see a bit of that on the corporate side, but much less so.

Some of our corporates have, for example, rental agreements where they have revenue which is inflation linked. So it's a natural hedge for them to move into that. That kind of a borrowing. So that's, I would say, the main trends at the moment.

[Bjarney Anna Bjarnadottir, executive]

Okay. And a question from [ Ileana Gallo ] 2 questions actually. One on asset quality. Could you please comment on the one exposure which drove the higher impairments this quarter? You can comment on industry or whether it was an idiosyncratic one. And the second on capital optimization. You mentioned further capital optimization. Could you consider on AT1.

[Jon Guoni Omarsson, executive]

Yes. So in terms of the asset quality, obviously, I can't comment on the borrower, but I can say that it's a very idiosyncratic. So it's not a -- it was a very specific case. So it does not indicate a trend in a specific sector. It was a very specific case. In terms of the capital optimization, we will certainly look into the AT1 market that obviously had a very difficult time for that market in the first half of this year, but has been strengthening again, and we will be looking into that in the coming year or so to see if we find opportunities there.

[Bjarney Anna Bjarnadottir, executive]

Thank you. And as I see no further questions, I want to thank you for joining us this morning. We appreciate all the questions and the time you have committed to join our webcast this Friday morning.

[Jon Guoni Omarsson, executive]

Thank you.