The three main Icelandic banks, Glitnir, Landsbanki and Kaupthing, once again came under attack during the last year as the global credit crunch amplified fears about their viability and led a continuing struggle against market perceptions of their high leverage and risky business models.
While their credit default swaps have at times been trading in upfront territory this year at levels over 1,000bp and as the Icelandic economy has weakened, it is in some ways not surprising that the market has reacted negatively.
However, the level to which the banks have come under attack is perhaps disproportionate and an overreaction to accusations that could so easily be levelled at banks in other small European countries.
The recent history of the banks explains both why they are in such deep trouble now, and why the trouble is no longer of their own making.
The story begins with all three of Icelands main banks enjoying a period of strong growth in the middle of the decade, making a number of acquisitions as well as developing organically.
In 2005 alone, Glitnir took over the Norwegian BNbank, Landsbanki acquired UK firms Teather & Greenwood and Kepler Equities and Kaupthing took over UK bank Singer & Friedlander.
However in 2006, the Icelandic banks got their first taste of turbulence. Amid worries about their domestic market and reliance on the wholesale market, which had traditionally been the source of around two thirds of their funding, the banks CDS spreads peaked at around 80bp-100bp what was then considered a worryingly wide level.
"These banks benefited tremendously from the credit boom, and arranged themselves to raise their profile," says Alex Birry, a director in Fitch Ratings financial institutions team in London. "However, when sentiment turned, they have had to face the costs."
Following that crisis, the banks were able to alleviate some of investors concerns. The biggest change followed criticisms about the banks reliance on the wholesale markets for funding and all three focused on growing retail deposits.
Landsbanki has run IceSave, an online savings unit, in the UK since 2006 and launched in the Netherlands in May of this year. Kaupthings online savings venture, Kaupthing Edge, which operates in 10 European countries, grew its deposit base by Eu2.2bn in quarter two of 2008. And Glitnir has made harvesting institutional deposits in the UK a central part of its funding plans.
"The priority of the bank over the last 12 months has been to maintain liquidity. We have also focused on strengthening the deposit base of the bank, shifting from wholesale to retail funding," says Erikur Jensson, head of funding at Kaupthing in Reykjarik. "We raised a total of Eu3bn in retail deposits through Kaupthing Edge in just over six months which we view as a great success."
It was the 2006 crisis that initially led to these initiatives and in some ways the difficulties the banks faced in wholesale funding at the time may have been actually been beneficial to the Icelandic banks when this years storm hit.
"The troubles in 2006 were helpful in a sense, as it prompted the banks to improve transparency and communication with investors," says Beat Sigenthaler, chief strategist of emerging markets at TD Securities in London. "Without this, they would have found the current turbulence more difficult."
Daniel Shore, head of Northern Europe financial institutions debt capital markets origination at HSBC in London agrees: "The Icelandic banks already had their first tremor back in 2006. The widening spreads in the debt capital markets mean that now banks of all nationalities are struggling to issue. But Icelandic banks have already had their warning and have been more prudent in the lead up to the current credit crisis."
Public funding grinds to a halt
All three banks had done some significant funding in the later months of 2007.
Glitnir raised $1bn of senior debt from the public market in September. In October Kaupthing printed $400m of hybrid tier one capital while Landsbanki issued $400m of hybrid tier one securities.
The banks CDS levels since then have had a big effect on their access to the public markets. At the beginning of this year, refinancing needs for the three banks were calculated at more than Eu12bn, after they had intermittently tapped the public markets late in 2007. That 2008 requirement has largely been met through growth in deposits and private funding initiatives.
In March, Kaupthing announced it had made a series of private placements with institutional investors totalling Eu1.3bn, at a price well inside its CDS spread. In total in the 12 months since July 2007 it has raised around Eu3.5bn in private placements out of total funding of Eu5.5bn. And so far in 2008, Glitnir has raised Eu2.4bn, all from private deals.
"We are in a comfortable position and can afford to play the waiting game," said Brynjólfur Helgason, managing director of international banking and Alternate Group CEO at Landsbanki in Reykjavik, which in the first six months of this year raised around Eu1.454bn through private placements.
"However, we do plan to get back in the market and back on a maintained growth curve as soon as we can. Until then we will continue to put an emphasis on building up retail deposits and pursue zero growth."
Part of the difficulty of accessing public debt markets can be ascribed to the general global widening of spreads as investors become more risk-averse and liquidity tightens few outside the top tier of UK and European financial instituations have been able to issue during the last 12 months. However, the situation of the Icelandic banks is even more extreme than for firms of other nationalities.
"In the past, they had been very reliant on a small market," said Birry at Fitch. "They have diversified, which does mitigate the risks in that one market, but it may be the areas that they have diversified into capital markets, investment banking and economies such as the UK are now at risk. It may seem unfair that the banks have taken all of these steps but are still in the same place, but the reality is the banking world is not the same anymore."
Unlike in 2006, there seems to be very few measures which the banks can take to alleviate the current worries, which some see as an overreaction to events in Iceland itself.
Despite having the bulk of their assets and operations outside of the country, the Icelandic banks are inherently linked in investors minds with the economy of Iceland itself, and this has weakened over the last year. Standard & Poors reported in May 2008 that "following a vigorous upturn in 2004-2007, the economy is now heading for a long and deep recession." Although the fundamentals of the economy remain strong, the agency expects growth in the Icelandic economy to remain negative until 2010. Alongside this was a 33.7% depreciation of the Icelandic krónur in the first half of 2008.
Even before this, there were worries that the Icelandic economy was too small to support the bulk of the Icelandic banks, which have grown substantially over the last five years. In 2007, the Icelandic banks overseas funding stood at almost 220% of the national GDP.
In the past when international liquidity was abundant, the banks access to international investors meant the size differential between the Icelandic economy and its banks balance sheets had not caused any major problems. Now all three banks emphasise that they are not dependent on the Icelandic economy, with more than 50% of their activity coming from outside of their domestic market. All have expanded into other European countries, with plans for further diversification over the next few months.
Overwhelming the central bank
However, now investors are increasingly risk-averse, international liquidity available to the Icelandic banks seems to have dried up, leading to another problem. As the banks are so much larger than their own central bank, there is no lender of last resort available to provide liquidity at times of need.
According to some, the central bank has been very slow in responding to the crisis. There had been discussion about a bond issue and even a non-deal road-show for the central bank but a deal never materialised. However, some thought that the central bank should have grasped the nettle with the issue. As one analyst said, "funding is costly for everyone at the moment, and arguably there is more of a cost of them doing nothing."
The banks themselves argue that the capacity of the central bank should not be of concern to investors.
"Many of the questions aimed at the Icelandic banks are very hypothetical and could go on endlessly," said Erikur Jensson, head of funding at Kaupthing. "The same questions arent asked of banks of other nationalities but in very similar situations."
However, Siegenthaler at TD Securities counters that the issues with Iceland are distinctive. "Iceland is such a unique place that there are unique problems, "he says. "Other countries like Switzerland or Luxemburg also have banking sectors that are very large in relation to the countries they are based in, but this is a much more extreme example. In the current financial backdrop it is a very practical problem that they do not have a lender of last resort."
The spike in the Icelandic banks CDS prices illustrates the markets extreme reaction to Iceland. In an increasingly risk averse market, these banks are regarded as especially risky. Although not necessarily deserved and almost certainly an overreaction to the actual events, this reputation has important implications for the banks ability to fund.
"Perception is very important. For example, the banks have actually profited from the depreciation of the krónur with sizeable gains, and most analysts had thought the currency was too strong," Siegenthaler. "The general view was that it would depreciate. But when it happened, some reports pointed out that only the Turkmen manat and the Zimbabwean dollar had a worse performance this year, which certainly didnt help the Icelandics cause."
What is more perverse in this situation is that for the Icelandic banks this reputation has apparently been quantified by ratings agencies to calculate ratings.
Standard & Poors referred to the Icelandic banks "unusually high reputation risk" in a report outlining their increasing vulnerabilities, and in July, the agency announced that it would retain Glitnirs negative outlook BBB+ rating. Although it recognised the banks strong liquidity position, it stated that it "is concerned about the effect on Glitnirs reputation and its future ability to raise additional funding should the bank be forced to reduce this liquidity buffer to meet forthcoming maturities."
This creates the clumsy situation where the agencies are simply reflecting rather than guiding the opinions of the market. Although this is not a practice confined to the Icelandic banks, it has created a difficult situation for them in seemingly confirming the perception of the markets.
The banks, then, are stuck between a rock and a hard place. Unlike in 2006, when they were able to alleviate the fears of the market by addressing specific concerns, the banks will find it very difficult to address such intangible issues of perception.
As there seems to be no proactive action that can be taken by the banks to rectify their situation, it seems that sustained stability would be of most benefit to them.
"Time will be a healer," said Shore. "Over the next six months, I expect them to continue to reduce the reliance on wholesale funding and terming out deposits. If there is a consistent run of good results, then the story may become more positive."
Bill Symington, managing director of long term funding at Glitnir in London is equally upbeat about the future: "This has been a positive year and the numbers are good. In contrast to a lot of other players, the bank is still profitable and has assets that do extremely well.
"As a bank, we are not growing but we are still performing. We should see Icelandic inflation start to come down and an appreciation of the krónur, and then I imagine we will see CDS start to improve."