Íslandsbanki hf. (ISB) Earnings Call Transcript & Summary

Good morning, and welcome to the Íslandsbanki second quarter earnings call. I hope you're all enjoying your summer. I just came off a 3-day hike to the biggest glacier here in Iceland called Vatnajökull, 3-day hike with everything on my back. So it's been a difficult start of the week, but an exciting one. Our guide for the hike was a guy called Leifur Örn Svavarsson, and I mentioned this because I find it quite interesting. He has summit'ed the highest peaks in all 7 continents and been to the North Pole and the South Pole. And he's the only guy in the world that has done this twice. That's something I learned on the trip. So I can safely say I was in very safe hands. Now over to our earnings. And in terms of the call itself, I'm accompanied here with Ellert Hlodversson, our CFO. And I'm Jon Omarsson, the CEO of Íslandsbanki. We will go through the earnings. And at the end of the call, we will take a Q&A. In terms of the earnings, we were quite happy with the return on equity in the second quarter at 13.3%, giving us a return on equity of 13.4% roughly for the half year. The earnings of the bank obviously are impacted quite heavily by the macroeconomic environment where we are seeing high interest rates and high inflation. The high inflation feeds positively through our interest income, but the environment obviously has a negative impact as well. The inflation impacts, obviously, the cost numbers and also the high interest rate environment has a negative impact on our fee income ability and the generation. But nonetheless, the overall impact and obviously, from our business is that we are quite happy with the return on equity. The cost income is also in line with our targets at roughly 43%. And even though that we have returned about ISK 28 billion to shareholders through dividends and buybacks during the first half of this year, we still remain extremely well capitalized and well over our targets, giving us potential for future capital returns. In terms of our targets, we have now updated our guidance for the year. The guidance at the start of this year was that we expected to see around 12% return on equity. We are now guiding towards being above 12.5% and this is obviously quite impacted by, again, the inflation numbers and how that will pan out for the rest of the year. Here, we are assuming quite modest inflation, especially in the fourth quarter of the year. But I think we can say that the risk is there on the upside in terms of inflation and thereby also in terms of our return on equity numbers. We are also assuming here that we will have normalized impairments in the second half of the year. The current outlook is that we are seeing quite a healthy loan book. So we are quite fairly optimistic for the second half of the year. But obviously, in this fairly turbulent environment, it is difficult to tell how impairments will pan out. But as I said, the assumption is that we will have through the cycle impairments for the second half. The cost/income ratio is guided towards 41% to 43%. In terms of the macroeconomic environment, we are expecting slow growth this year, but then the growth will pick up in the following 2 years. The Central Bank is obviously trying to bring growth down, you could say, by having high interest rates. And that is especially impacting the construction sector where we are seeing quite a steep slowdown in that sector. And also that's impacting unemployment, which has been picking up quite a bit over the past 12 months. And we do expect to see it picking up even more in the second half of this year. Exports continue to be fairly robust, but slow growing. And again, the expectation is that we will see more growth next year and the years following. But having said that, the export sectors have been doing quite well. The seafood sector has been enjoying extremely high prices for the products and tourism is going quite well. It will be a quite interesting day in August on the 12th of August, where we have a solar eclipse here in Iceland. And I can safely say that Iceland is completely sold out during that day. Now the inflation is obviously has been rampant and interest rates as well. And so therefore, we are still expecting to see 1 or 2 more 25 basis points hikes towards the end of this year. In terms of the tax environment, we wanted to note that even though Iceland has the highest taxes on banks in all the neighboring countries or other countries that we compare ourselves to, especially Scandinavia, where we have taxes when we compute the overall taxes on operating income, we can see that our taxes are 60% to 100% higher than we see in the neighboring countries. At the bottom right, you can see that not only are the taxes high, but they are quite -- well, on various fronts, both on salaries, revenue and on the liability side of the balance sheet. And we wanted to know this because there are discussions now within the government to even increase the taxes more and making the Icelandic banking system less competitive, thereby, which is obviously extremely surprising. The extent of the increase is still unknown and how it's going to be implemented. But we will see that, obviously, I expect now in the second half of the year. And -- but we obviously -- we will hope that this will be less of an impact than initially has been noted. Now moving on in terms of our business on Private or Personal Banking, we have introduced earlier this year our loyalty scheme. And we have now already 50,000 customers that have joined the scheme, and we are seeing now that the customers are then to get more points and then rising up and getting more favorable rates, they are choosing more products. And that's obviously part of the reason for the scheme is to have a bigger share of wallet from our customers. We have been quite keen on selling pension savings and have been picking up steam on that front. As you can see in the middle here, we have a very substantial increase in new sales there over the first half of this year. This is obviously extremely stable assets under management, but at the same time, enhancing the financial health of our customers. We have been at the bottom right here, we note that we have been offering our -- especially the older generation amongst our customers, so-called tech cafe, where we invite them to come to the bank and where we introduce and guide them through the app and to show all the possibilities they have on the technology front. And this has been extremely well received and will be now rolled out throughout the country during the rest of the year. On the Business Banking side, we continue to enjoy the highest market share among the Icelandic banks. We've been seeing a very good strong loan growth in Ergo, which is our leasing arm and overall, quite substantial new lending in 2026 of around ISK 69 billion. The business environment for SMEs remains challenging as for large corporates obviously as well with the high interest rates and high inflation. And we are hoping, obviously, that the economy will stabilize so that we will have a more normalized environment from next year onwards. We would like to note 2 new clients that we have been working with. First, Askja, which is a distributor of Mercedes-Benz, Kia, Honda and others and Una, which is XPENG, the Chinese car manufacturer, extremely interesting to work obviously with new clients and household names like these. And on the clothing front, also Föt og skór, a new client, which sells BOSS suits and has -- and children clothing as well. So great new additions there to our client relationships. On the Investment Banking front, we continue to enjoy extremely good market share in terms of brokerage, both in equities and bonds. At the same time, however, the turnover in that sector is quite low now and in the capital markets in general, down by almost 50% year-on-year. And that's obviously having an impact on the earnings and the fee income generation from that business. At the same time, we have been quite active in issuing bonds, both on behalf of the bank and for our clients. And Corporate Finance concluded a transaction where we were mandated to be the adviser to sell a real estate company and with about ISK 13.1 billion in terms of the sales proceeds, passing [indiscernible]. Obviously, very happy to see that concluded in the current environment. And then we concluded the financing of a new pelagic vessel for Skinney-Þinganes, a great ship that I actually got the opportunity to visit and see now earlier in the summer, huge ship with great facilities with only 9 people that work on the ship. And it's very good facilities, I can say, for the employees there. Now moving on in terms of the digital adoption. We continue to invest in our app and make improvements there for the service for our customers. Customers now can have better access to the fund overviews and fund subscriptions and international payments. And we have quite a few more additions that we'll be rolling out now in the next few weeks. AI obviously continues to be the buzzword across the economy basically and business-wise. We at the bank have been an early adopter there, and we see 87% of our employees being active users of AI. We use Copilot and Claude and all the tools. And so obviously, we have now been having a general education for our employees. It will now move more into specific education and adaptation into individual teams. We have also set up a subsidiary, which we call Bank Bank, which we use basically to have a more expedient development of certain products and technologies, which is an outside of the bank where we can move a bit faster in terms of development and many more initiatives on that front. And this is also what we call a marathon season here at Íslandsbanki. The Marathon, Reykjavík Íslandsbanki Marathon is the biggest charitable event of the year. And we are obviously extremely proud to be the biggest sponsor there. And everything is colored by the marathon basically here at the bank throughout August. Over the past few years, obviously, the charities here in Iceland have relied quite substantially on the marathon with over ISK 2 billion raised since 2006. And we are obviously quite keen to see as many participate as possibly can and obviously raising funds for the charities here locally. Having covered that, over to you, Ellert, on the financials.

Thank you, Jón Gudni. As stated earlier in the presentation, we are quite happy with the results, turning a profit of around ISK 7.1 billion for the quarter and return on equity of 13.3% or 13.4% for the first half of the year. And looking at the bridge between -- sorry, Q2 '25 to Q2 '26 we can see that we have considerable growth in net interest income on the back of inflationary effects as inflation has been drastically higher this year compared to the previous year, offset by, I would say, fee and commission income, which is impacted by the same high interest rate and inflationary environment. In terms of operating expenses, we are seeing growth between years, mainly related to the expense of variable compensation system as well as one-off items. Should we take the one-off items aside, return on equity in the quarter would have been 13.9% instead of the reported 13.3% and for the first half, around 13.7% compared to the registered 13.4%. And digging into the interest rate, the bank reported ISK 15.3 billion of net interest income, as you can see on the top left-hand side. Comparing that in a margin environment on the bottom left-hand side, the net interest margin was 3.4% compared to a level of 3.3% in the previous year. We note that 143 bps of inflation passed through our books this quarter compared to 151 bps in the previous years, indicating that the growth in margin on the back of lower -- on lower inflationary ticks indicates strong margin control and strong control of the interest rate -- the interest rate in the bank. For Q3, we are expecting 135 bps of inflation to be accounted in our books. And for Q4, we are expecting a very low accounting tick of around 0.2%, indicating that we expect net interest margins and net interest income to come down in the fourth quarter. Focusing on fees, we are seeing drop in fees of around 2.4% for the first half of the year and around 10% during the quarter, where fee income is comparable between the first quarter this year and the second quarter this year. This is mainly due to slow activity in capital markets adversely impacting revenues from both asset management as well as investment banking as well as, I'll say, reductions within cards and payment processing, mainly related to higher expenses due to loyalty schemes. As before, market risk is a limited part of the bank's balance sheet. We're closed off with equity risk exposure of around ISK 6.2 billion towards the half year, thereof ISK 3.1 billion for listed shares. As before, other operating income and net FX gain tend to be a limited part of the operation as well. Focusing on costs, our cost-to-income ratio closed off at 43.1% for the quarter. And as before, it is mainly comprised of around 60% salaries and 40% OpEx. Salaries were rising of around ISK 800 million year-on-year or around 9%. Thereof, around -- for the quarter, around ISK 430 million were related to employee variable compensation plan and are close to ISK 670 million looking at the first half of the year. In addition, around ISK 370 million were expensed during the quarter related to organizational changes, both within the parent company as well as Íslandssjóðir. We had previously in our Q1 earnings call, indicated around ISK 260 million related to organizational changes within the bank itself in April. Aside from that, other operating expenses were growing 1.2% less than inflation, thus contracting in real terms year-on-year. And focusing on the balance sheet. As before, it's a relatively simple balance sheet from the asset side of things, around 18% is liquid assets and loan book comprises close to 79%. And on the liability side of things, deposits account for 59% of the balance sheet and other stable funding close to 38%. Taking into the loan book, the composition remains healthy, as you can see on the top right-hand side, where the composition is comparable to previous quarters. The loan book closed off at around ISK 1,416 billion, having grown by 3.7% year-to-date, reflecting around 7.5% growth on an annualized basis. As before, it is highly collateralized, around 94% of the book is covered by collateral, where LTVs are modest or around 52%. Currently, around 5% of loans are to customers, which are international parties. In our previous earnings calls, we have indicated that we have wanted to grow this part of the business from a position of around 1% when we started and are aiming for somewhere between 5% and 10% -- for this segment to grow somewhere between 5% and 10% and are now, as I said before, stating that we have reached this around 5% level. Despite slowdown in the economy, asset quality remains high. If looking at Stage 3 lending on the top right-hand side, Stage 3 grew from 2% to a 2.6% level from Q1 to Q2, which is mainly related to exposure within the construction sector and mainly related to a single exposure in the construction sector as seen on the bottom left-hand side. Impairments in the quarter amounted to close to ISK 500 million or cost of risk of around 13 bps. As before, this reflects borrower-specific circumstances. We do note that sale of new residential real estate remains prolonged. And as Jón Gudni stated before, there are signs that status for the construction sector have been -- are turning towards. But as of now, we do not view this segment of our loan book to be in structural difficulties. Looking at the liability side of things, similar story. Around 52% of the balance sheet is funded through deposits. Customer loans-to-deposit ratios remain strong and deposit growth has been healthy of around 3% in the second quarter, along with the same for real estate -- for retail deposits, sorry. This, of course, translates into favorable LCR ratios where total liquidity coverage ratio closed off at 188% compared to a level of 151% for the ISK part. This allows the bank to be flexible when it comes to wholesale funding. The bank is fully MREL funded for the year. And as you can see on the top right-hand side, maturities are very low for the remainder of the year or close to ISK 12 billion. For the next year, we are reporting maturities of around ISK 100 billion, thereof around ISK 40 billion in an FX covered bond, which is a highly specialized market. We are pleased to see that the development of our euro funding spreads remain stable in line with market positions and believe that this is a factor of good funding strategy where we are diversifying across products, maturities, geographies and other aspects. We note that in September, our original AT1 subordinated bond is callable, and we expect that to be called on the first call date. Refinance is subject to capital at that point in time, and we will also choose which market to refinance through at a later date. And lastly, capital. Capitalization remained strong at the end of the quarter, as Jón Gudni stated. From a CET1 standpoint, the bank closed off at 19.1% compared to a target level of 17.2%, which is assuming the midpoint of the management buffer. And from a total capital standpoint, 23% compared to a level of 21.5%. The bank received a decision by the Financial Supervisory Authority towards the end of June, indicating additional capital requirement of 1.8% of REA follow our Pillar 2 requirements. REA ratio, as you can see on the bottom right-hand side, closed off at 58.4%, having come down quite a lot from -- following a very favorable CRR3 implementation end of '25 as well as further reduction when the Central Bank accepted the loan splitting approach for IPRE mortgage exposure. This, of course, is a factor that is related to the fact that the bank is still standardized is using the standardized approach. So REA ratios remain high and leverage remains low, where our leverage ratio closed off at 11.7% end of the quarter. End of the second quarter, the bank held around 23.1% in distribution capacity, either for growth as well as for distributions to shareholders, assuming a fully optimized capital structure, which is on back of the fact that during the first half, the bank has distributed 27.8%, thereof 15.2% through buybacks. As before, the bank remains committed to its efforts to optimize capital structure. And to close off, we are quite happy to see the strong performance in the quarter, having returned a 13.4% return on equity in the first half, 13.3% for the second quarter. Excess capital remains strong with a position of 23.1%. And we are also pleased to announce an updated guidance of being above 12.5% ROE for the year 2026 and state that we will either reaffirm or revise that guidance following our Q3 results. With that, we turn the floor to questions.

Thank you, Ellert. Maybe we will start with the written questions. But starting with the written questions, do we have any such questions?

You have 3 questions from [indiscernible]. Stage 3 rose from 2.0% to 2.6% in the quarter, largely construction. Can you talk us through how you're thinking about credit quality right now? Is this quarter's migration something you see as contained to a handful of loan projects or the start of a broader trend? And how comfortable are you with current provisioning coverage against it? The second question, loans grew ISK 14.8 billion in the quarter, yet REA fell ISK 5.7 billion, resulting in lower REA density. Is this a result of loan mix or something else? And finally, the third one, CPI imbalance of ISK 231 billion after the covered bond maturity. Is this target range or a transitionary peak to be managed down?

Very good. I'll start with the first one. In terms of the construction sector, obviously, the higher interest rates are having an impact, and we are seeing that especially in terms of apartments, it's taking longer to sell new apartments and oftentimes, they are selling at lower than the asking price. Having said that, we have seen single name exposures that have had difficulties where the bank needs to step in, in a couple of cases. But those are quite isolated, like I said, to single names. So in general, our borrowers in that sector are very strong companies and doing quite well and have had very strong earnings over the past few years that they can now use as buffers through this environment. And also having said that, we expect to see this to be a relatively slow environment over the coming months. We are hearing, obviously, there are fewer new projects coming on, so less construction activity than we have seen over the past few years. So that obviously can feed into and have an impact on unemployment as well, impacting then some other industries. But overall, we are quite positive. The macro environment is obviously fairly harsh at the moment. But when the Central Bank has managed to get, let's say, calm things down and can go to a normalized environment, we see here at the banking system that we have seen a huge growth in deposits. So once the rates come down, we have plenty of liquidity in the system to restart and enhance investments across the board. We have impaired sufficiently, obviously, against these exposures. So we are happy on that front. And so we think that we are just adequately basically impaired, and we don't foresee additional impairments on these single name exposures. Now having said that, obviously, in the current environment, there's always uncertainty regarding impairments. And as I noted before, in our expectation for the year for the ROE of 12.5%, we are assuming through the cycle impairments. But at this moment, I can say that I'm fairly optimistic that it can be lower. But again, given the caveat that it's difficult to expect and to project impairments into the future. In terms of the other 2 questions, over to you, Ellert.

Thank you. With regards to REA, it's been favorable to see the development of the REA density. I mean we are coming down from a level of close to 65% down to a current level of 58.4%. And this is mainly related to, I would say, beneficial implementation of CRR3 towards the end of last year as well as the additional IPRE exposure adaptation during this year, which further reduced REA by around 2 percentage points. So this is a combination of -- I would say, this result is a combination of many aspects. It's -- I'd say, it's a composition of the loan book, but it's also with regards to how we have structured our products, how we have structured our terms within certain products to take advantage of credit conversion factors, et cetera. So it's a mix of many things. However, we still believe that REA density is high on back of the fact that we are obviously a standardized bank, which is impacting comparability and, I would say, competitiveness in an international standpoint. So the bank is, I'll say, is looking into further REA reducing efforts, which is -- which will provide us with additional metrics on that sense. With regards to the CPI target, we are currently at around ISK 235 billion following the maturity of covered bond in May. We are happy with that level, and we aim to be competitive when it comes to offering loan products. What we have seen historically is that the lending aside from, I would say, lending less new issuances is roughly funded is roughly, I would say, net 0 and that we have maturities as well. There are some maturities on the CPI-linked side on over the course of '27, which may impact the imbalance, but there is no ambition to grow it drastically or as well as we are not afraid to have it at the current levels given -- I would say, given the real rate in the banking book.