a.

Household indebtedness relative to household disposable income is high when compared with other countries, in spite of the substantial decline in this ratio from levels in previous years. Highly leveraged households are typically more sensitive to adverse economic and financial conditions or adverse developments in the residential real estate market, which can affect their debt-servicing capacity and lead to reductions by them in consumption. Indebted households are, however, less vulnerable to increases in interest rates, given the prevalence of fixed interest rate loans.

b.

In terms of the structure of household debt, loans indexed to the consumer price index (hereinafter ‘CPI-indexed loans’) (12) have historically been common in Iceland, and may pose some risks for highly leveraged households. Even though the share of CPI-indexed loans as a proportion of new loans is decreasing, the share of these loans as a proportion of the existing stock of loans is, nevertheless high. Moreover, CPI-indexed loans typically have negative amortisation schedules early in the repayment period, depending on the level of inflation, which could further increase the accumulation of debt. Loans of this type can have both mitigating and amplifying effects on households’ vulnerability to risk. In the event of high inflation, households would experience less impact on their ability to service mortgage debt in the short term — as the CPI-indexed loans would smooth out the debt service — whereas the monthly repayments on non-CPI-indexed loans would increase more steeply over the short term. However, over the long term, households with CPI-indexed loans may need to further constrain consumption, since in the event of economic distress coupled with increasing inflation they would not see their debt eroded by inflation. High indebtedness is partially explained by the indexation of annuity mortgage loans with maturities of up to 40 years, which allow low-income borrowers to borrow higher amounts at affordable debt service levels. However, during the last decade inflation has been close to the Central Bank of Iceland’s target and consequently the share of non-indexed loans has been growing.

c.

Housing credit has been growing moderately over recent years, and on average lending standards appear to be prudent. However, as regards the distribution of the debt-to-income (DTI) ratios of households which have taken out loans of this type, a significant share of households may be vulnerable to adverse economic and financial conditions or adverse developments in the residential real estate market. In spite of growing vulnerabilities in Iceland’s RRE sector, the Icelandic credit institutions appear to be resilient. National authorities have conducted a number of stress tests on Iceland’s three largest credit institutions; those stress tests included scenarios incorporating sharp price decreases in the housing market in conjunction with large negative shocks to the overall economy and the results indicated that those banks should be able to withstand such shocks.

d.

Furthermore, there is some concern related to house price overvaluation. House price appreciation has decelerated in recent quarters, following steady growth over the past eight years. House price growth over the medium-term has been high by international comparison. Given the high rate of home ownership in Iceland, a decrease in house prices could lead to households in negative equity. Nevertheless, potential direct credit losses from mortgage loans are expected to be contained, as the loan-to-value ratios of mortgages held by households are relatively low.

e.

Adverse economic and financial conditions or adverse developments in the residential real estate market may lead to the materialisation of direct and indirect risks to financial stability, given the vulnerabilities mentioned above. Potential direct risks to the banking system in Iceland relate both to the potential losses generated by default of loans granted in an environment of possibly overvalued house prices, and to competitive pressures that may lead to the loosening of lending standards. Moreover, households may experience a negative wealth effect or fall into negative equity if the decrease in house prices is significant. Given the low potential direct credit losses anticipated from mortgage loans and the prevalence of fixed interest rate loans with indexation to CPI, households are not expected to experience constraints on their debt servicing capacity that are large enough to lead to defaults. However, if, for example, unemployment increases and/or household income growth decreases, some households may find it more difficult to service their debts over the long-term. The associated negative household income and wealth effects may reinforce the initial shock if households are required to reduce spending in order to service their housing loans. This could lead to second-round effects and an increase in risks to credit institutions and the financial system.

f.

The ESRB takes note of the fact that Iceland has in place various mechanisms — limits to loan-to-value (LTV) ratios; creditworthiness assessments related to borrowers’ incomes; and capital buffers — all of which are aimed at ensuring the resilience of both credit institutions and borrowers. The countercyclical capital buffer and the systemic risk buffer are expected to strengthen the resilience of credit institutions against the materialisation of vulnerabilities stemming from private sector indebtedness. Nevertheless, special attention should be also paid to the non-bank lenders (i.e. the pension funds and the government-owned Housing Financing Fund), which are more present in the housing sector in Iceland than in most other countries. The LTV ratios were applied in the expansionary phase of the financial cycle in order to strengthen the resilience of borrowers, prevent deterioration of lending standards and mitigate excessive credit and house price growth. As the LTV ratios are applied to all lenders, potential leakages across sectors are avoided. Moreover, microprudential requirements currently in place require the assessment of the credit-worthiness of borrowers taking out new loans. Therefore, any potential future borrower-based measures should also apply to all lenders, in order to avoid leakages.

g.

The current policy measures are assessed to be partially appropriate and partially sufficient to mitigate the identified systemic risks related to vulnerabilities in the residential real estate sector in Iceland. In particular, the high level of household indebtedness may not be sufficiently addressed by the current macroprudential measures. Though at the aggregate level, debt may have decreased, at the individual level, pockets of risk associated with highly leveraged households persist. While the ESRB acknowledges the initiatives taken as regards monitoring of residential real estate, further measures may be needed concerning lending to households with high DTI ratios. Iceland may consider a pre-emptive implementation of explicit guidelines on income-based measures, either in the form of a recommendation or of legally-binding borrower-based measures. Income-based measures may help to better prevent households from becoming overly indebted, should the strong growth in house prices persist. Such measures could be particularly relevant, as the growth in house prices may have reduced the effectiveness of the cap on LTV ratios.