The following OECD assessment and recommendations summarise Chapter 4 of the Economic Survey of Iceland 2006 published on 9 August 2006.
The financial market has expanded and is reported to be basically sound
Financial markets in Iceland are thriving and access to capital has greatly improved. A significant part of the responsibility for this development lies with government policy. Controls over the operation of financial markets have been lifted, commercial banks have been privatised and the sector has been opened up to international capital markets. This liberalisation programme has succeeded admirably and should be continued. Although supervisory and rating agencies believe that the financial system is broadly sound, the rapid growth of Iceland’s banks has raised concerns about financial stability. Stress tests suggest that the banks’ capitalisation can withstand very large shocks. Nonetheless, the authorities should continue efforts aimed at assessing the robustness of the financial system and take supervisory steps, if needed, to address possible shortcomings, including related to liquidity management.
Distortions in the housing market need to be reduced
The Housing Financing Fund (HFF) has advantages over other housing lenders that prevent fair competition, distort the allocation of resources and impede innovation. The government has announced its intention of moving the HFF into wholesaling of mortgages. While this is welcome, it could give rise to a conflict of interest between wholesaling and retailing activities, so the authorities should consider splitting the HFF into two separate entities. The more important priority is to remove or neutralise distortions in direct lending, in particular the government’s guarantee of HFF borrowing. One way of doing this would be to restrict HFF lending as the government has recently announced. A preferable approach may be to charge the HFF a fee to level the playing field, in particular to cover the cost of the government guarantee and the required return to capital. This would presumably result in a substantial reduction in the role of the HFF in direct mortgage lending. Measures such as these would alleviate the need for tight monetary policy and thus reduce pressures on the exchange rate. The social objectives of the fund should be addressed more transparently and cost-effectively through targeted transfers. For example, home ownership could be promoted through means-tested grants for first home owners, rather than cross-subsidisation of mortgage rates. Means-tested grants might also be preferable to the housing subsidy currently arising from the tax deductibility of mortgage interest payments.
There is little reason to restrict indexation in financial markets
An unusual feature of Iceland’s financial markets is the widespread indexation of loans to inflation. This practice is generally sensible for the borrowers and lenders involved as it eliminates the risk that unanticipated inflation may change the real value of their loans, and it may have wider benefits. However, the practice is restricted by prohibitions on indexation of bank deposits and loans. Remaining restrictions on indexation in financial markets have no clear rationale and should be repealed.
Providing sufficient funding for innovative star-ups is a challenge
One area where financial markets do not seem to work well is the financing of innovative start ups. This is a difficult problem encountered in most countries and best-practice guidelines are not obvious. The New Business Venture Fund has attempted to address some of the problems in this area but its performance so far has been disappointing. While lessons have been learned, there is understandable reluctance to repeat past failures. The government has proposed that some of the proceeds from the sale of Iceland Telecom go to a new investment fund -- with pension funds and financial enterprises also invited to contribute -- which would be directed towards firms in their early expansion phase, where there is a perceived gap in the market. Consideration should be given to whether government sponsored investment funds should not be run along private-sector lines.
Total loans to private sector and securities market capitalisation
as a ratio of GDP, 2000-2003 average
Source: World Bank Financial Structure database.
How to obtain this publication
The Policy Brief (pdf format) can be downloaded. It contains the OECD assesment and recommendations but not all of the charts included on the above pages.
The complete edition of the Economic Survey of Iceland 2006 is available from:
For further information please contact the Iceland Desk at the OECD Economics Department at firstname.lastname@example.org. The OECD Secretariat's report was prepared by Hannes Suppanz and Peter Tulip under the supervision of Patrick Lenain.