Good morning, welcome to this presentation of Arion Bank's Third Quarter Results. This was a particularly robust quarter, we continue to deliver on our strategy in a challenging economic environment. For two consecutive quarters now, we have posted above 10% return on optimized equity, we posted a solid income growth in the quarter of some 6.2%.
Our emphasis on operating efficiency is further demonstrated with a lowering of operating expenses by some 11% in the quarter, a strong cost-to-income ratio, which is now below 50% for the first nine months. Now, it helps to have a diversified income stream in economic situations like these, our distribution channels, which we have invested heavily in the last two years, have also demonstrated their value.
For example, volume-driven fees in our retail banking are obviously down due to lower economic activity, but we saw a continued strong growth in lending and guarantees business. Our digital distribution channels have been able to mitigate against the fact that most of our employees are working from home at the moment.
At the same time, we're enjoying the highest growth in mortgage applications in Arion Bank's history. This indeed has accelerated our transformation of our branch network into sales and service centers, which is focusing on providing customers with service and advice with the full product suite. Arion has a significant balance sheet strength, and Stefán will go into that later on, and a high dividend capacity.
The CET1 ratio is now among the highest in Europe. Leverage ratio is significantly stronger than European peers because we are one of few systematically important banks that operate with a standardized approach. We have currently over ISK 40 billion of surplus capital on top of our CET1 70% target, but in fact, it's closer to ISK 70 billion in excess of regulatory requirements.
Quite a strong equity position at the moment. We have a unique position within our small economy as well because we have a, we say, a broad market access due to our dual listing and our international investor base. That has demonstrated itself this year. We've used this strong investor access across Europe and globally to work on our capital structure.
We issued additional Tier 1 earlier this year. I'm sure this will continue to benefit us for the benefit, obviously, of our clients. Now, I said challenging economic environments. They are indeed very challenging these days. The spread of COVID-19 and travel bans introduced have had a negative impact on the Icelandic economy, especially tourism. When we compare the GDP changes in the second quarter, for example, with our neighboring countries, we rank in the middle.
What has been particularly good to see is the strong fiscal and monetary response. Even though unemployment rate has come up quite a lot, those who are employed are enjoying, as our chief economist pointed out yesterday in her macroeconomic forecast, the employed are enjoying quite a favorable environment where real net disposable income continues to go higher.
Borrowing costs have come down by 30% in the last two years, and house prices continue to rise, so they are feeling the wealth effect of home ownership. I think that is helping the economy and explains why our markets portfolio is performing particularly strong despite the higher unemployment rate. As you can see from this slide, the fiscal response has been strong compared to rest of the Nordics, and there is quite a substantial headroom to do more, as you can see from the leverage position of the Treasury.
Now, I mentioned our investments into digital channels and how that's benefited us in these challenging times. It's very interesting to see that due to, obviously, lower interest rates and high activity in refinancing of mortgages, we are seeing the strongest growth for new markets applications in the Bank's history.
As you can see from this slide, in the first nine months, we have now processed more mortgage applications through our digital channels than we did for all of the mortgage applications in 2018, and more than twice what we did last year. Our investments are proving to benefit us and be a success. We have our employees taking advantage of the digital channel streams and being able to service our clients even from home.
We've been focusing as well on new products, and we are influenced by our ESG strategy here. Our latest product is the green mortgage offering, where we are offering those who are investing in residential property, which has been environmentally certified, a $0 loan origination fee. That is, for example, financed through Arion Bank now with Green Deposits, which we rolled out earlier this year.
We're also taking part in making our car fleet greener because we have a better offering for car financing on vehicles which run entirely on electricity or other renewables. Before I hand over to Stefán, I just want to go briefly through the earnings bridge for this quarter, which I'm particularly proud of. As I said, we're delivering on our strategy.
The increase in core income is just over 6% of the quarter. If we adjust for the redundancy costs that took place in the third quarter of last year, our operating expenses are down by 11%. Combined, this amounts to some ISK 1.3 billion in the quarter, which is close to actually 1% of our CET1 capital in the quarter or then close to 4% on an annualized basis pre-tax, which is quite an achievement.
We will continue to focus on both items, both the revenue items and the cost items. With that, I hand over to Stefán Pétursson, the CFO.
Good morning, ladies and gentlemen, thank you, Benedikt. Let me just reiterate what Benedikt said. We are delivering on strategy. Our balance sheet is very strong. We do have ample dividend capacity. Thirdly, we are actually closing in on our medium-term financial targets. If we look at the highlights of the third quarter, then on the strategy, our NIM is improving 30 bps year-on-year.
We are seeing net interest income to credit risk improving year-on-year. Our core revenues, as Benedikt said, they're up 6.2%, and OpEx is down a massive 25%. If we exclude for one-off items, it is down 10.7%, which is quite substantial. We are turning around the operations at Valitor, maybe not fully out of the woods yet, but a massive improvement there in the first nine months of the year.
Our risk exposure amount remains stable even if the balance sheet is growing, and we have surplus capital that we very much would like to return to our shareholders at the earliest opportunity. Looking at the medium-term targets, our return on equity in the quarter was 8.3%. It is actually 10.4% when we assume our 70% target CET1. Our operating income over risk exposure amount was 7.2%, well above the 6.5% target that we have. Cost-to-income ratio, I tend to look more at the nine months rather than the quarter itself. We are below our 50% target for the first nine months at 49.5%. CET1 ratio, where our target is 17%, is 22.5%. That is both a challenge as well as an opportunity.
Looking at the income statement, then we can see that on a core basis, interest income, commission income, and insurance income, the story is very positive. Maybe especially on the interest income side, where we had an 8% growth year-over-year on a relatively similar loan book. Operating income in total is 5% up year-over-year.
Over to the salary side, a whopping 39% decrease from the same quarter of last year. We need to remember that we had substantial redundancy costs in the third quarter of last year. Still, total OpEx is down 25%, and again, 10.7% if we exclude the one-off of last year. The bank levy has been reduced. It is now 14.5 basis points down from the 37.6 basis points that we started the year out with. This lowering is here to stay.
Net impairment in the quarter is ISK 1,340 million from 19 basis points. Earnings before tax are up 19% from last year. Income tax, relatively modest in the quarter. Net earnings from continuing operations are up 31% year on year. As you can see, we are very much delivering on what we set out to do. We do have a markdown in our held-for-sale assets, so discontinued operations are negative by almost ISK 1 billion, taking net earnings to just under ISK 4 billion, which is up more than four times from the same quarter of last year.
We are very proud of our achievements on the loan book and the funding side. We are able to maintain the NIM at 2.9% in a challenging environment. The base rate is at an historical low. We've been issuing Tier 2 and AT1. We have, in a way, excess liquidity.
At the same time, we're able to maintain NIM at 2.9%. We are increasing net interest income substantially year-on-year. We are maintaining and actually increasing our net interest income over credit risk. I think that says a lot about our management, both on the lending side and on the funding side.
In a way, that is demonstrated at the bottom graph there on this slide, where we see that, yes, we do have lower income from bond holdings and loans to credit institutions and from our loans to customers.
Our sub debt is obviously more expensive than other funding, but that is more than made up by lower cost of deposits, lower cost of wholesale funding. Inflation, which is slightly higher this quarter than it was last quarter or same quarter last year, is also assisting the situation.
OpEx is trending down, which is very positive. This has been and will continue to be a focus point as a bank, as is the case with, I think, every bank in the Western world. As I said before, our cost-to-income ratio during the first nine months is under 50%. It's just over 40% in the quarter.
We are seeing the number of employees down 5% year on year at the bank itself. This is a trend that we can expect to continue. Other OpEx is stable, that is something that we will obviously continue to look at very closely as well. The balance sheet, strong, simple. It grew by 14.3% from year end, the increase mainly being liquid assets.
Our loan book increased by 4.4% and is well diversified between individuals and corporates. Our liquidity position is very strong.
Total LCR of over 200% and 177% in ISK, which means that we, as a bank, we are in a very solid position to either support our customers or eventually distribute capital. Loans to customers are rising, as I said, 4.4%. That is almost solely in the mortgage space, where we have been very active.
We have seen both new mortgage lending and refinancing amounting to almost ISK 70 billion in the quarter, ISK 150 billion year to date. There is a slight concern there in a lowering interest rate environment that the front book comes at a slightly lower NIM than the back book, especially when funding rates and mainly deposit rates are closing in on zero. Luckily, we don't expect the base rate to fall any further than it already has. It is now at 1%.
COVID-19 obviously has impacted bank. We have done a special study on how COVID has impacted our loan book. As we see it, obviously, we use IFRS 9. We don't feel that that fully fathoms the situation. We have made certain management overlays on the loan book. Our conclusion is that COVID impacts around ISK 150 billion of our loan book, around 18%.
Out of that, ISK 118 billion is collateralized with real estate. What we have done in our assessment is that in our overlay, we have basically downgraded the affected sectors as we see them or the affected groups of loans. We have downgraded those and increased impairments. We have also given out payment moratoria or payment holidays both to individuals and corporates. It is actually very interesting to see the development of this.
We see that on the right-hand side of the graph, started this in March. We saw individuals picking up on this very quickly, and payment holidays or payment moratoria for individuals peak in May. It has been coming down ever since and is now only at ISK 10.5 billion. On the corporate side, the corporate started slightly later, started in April, and it has been trending up, and in a way, we believe that jury is still out on how that will continue on the corporate side.
Same with loss allowance. That has been increased substantially. Clearly, as you see there on the right-hand side, the tourist sector, we have sort of been very active on that front. That sort of feeds into the corporate side for the most part. The interesting thing is that we have not had to increase allowance on individuals. It has actually been stable.
As Benedikt said, most of our individual lending is mortgages, and that asset base is actually in very good shape. The liability side is, as before, well-balanced, very strongly capitalized and strong leverage ratio, good balance in our wholesale funding, both in covered bonds and senior unsecured. We have not been active this year on that front because we have been so liquid, and we have been liquid because of the growth in the deposit space.
We are particularly pleased to see our core deposits go up by some 11% from year-end. When we say core, then we're talking about retail, SMEs, and corporates. We talk about capital strength all the time, and that's because it's true. Our capital ratio is 27.6%. It is down slightly from the second quarter for two reasons.
We had a small increase in our risk exposure amount, and then we have started, again, what we did not do in the second quarter, we are deducting 50% of net earnings according to our dividend policy. We feel that that is an appropriate sign to the market that we want to pay dividends when the Central Bank opens up for that and we hope that that will be next year.
Leverage ratio at 14.3%, which is obviously very strong in an international context. To conclude on our side, we feel that we are delivering on our strategy, but we aim to do better. We will continue on this path and build on what we have achieved over the last two quarters.
Clearly, we're a part of the Icelandic economy, but we feel we are in a very good position to be a part of the rebound of the economy that we expect will happen next year. There's obviously a lot of economic uncertainty still due to COVID, and we see what's happening both here in Iceland and around the world. Still, we believe that we are seeing better into our asset quality.
Again, we have had massive impairments, not massive credit losses. They may start in the new year, but we hope that we have already impaired part of what may happen. We have not ruled out the possibility that this situation may lead to some opportunities.
It goes without saying that we are following closely the discussion that is taking place both in the U.S. and Europe on bank dividends, and we obviously realize how important it is for our shareholders that this bank is able to continue its capital release. Having said that, I think we give it over to the moderator for Q&A. Thank you.
Our first question comes from the line of Johan Ström of Carnegie. Please go ahead. Your line is open.
Thank you very much. I would perhaps like to start by congratulating on a really good quarter in challenging times. It's good to see the strong cost-to-income ratio line. I would like to ask you to be a little bit more precise on how you think or how we should think about some P&L items. First on costs.
The Q3 level is low, of course, and have really improved the cost development further. How should we think about the run rate going forward? Is it fair to assume that quarterly costs will be below ISK 6 billion, for example, in the next couple of quarters?
Yeah. Thank you so much. If I answer this, there is clearly seasonality in our salary line, and that is due to vacation. When employees use up their vacation allowance, then we have already accounted for that as an expense and that reduces the salary line. I would encourage you to look at the seasonality from previous quarters as well.
There are clearly COVID-19 related impacts, traveling expenses are down, and other employee-related expenses are down because people are mostly working from home. On the other side, I think we will continue to focus on costs and one cost item that is under special sort of-
Scrutiny.
-sc rutiny now is the IT cost, which is the largest cost item.
We've historically invested quite a bit, and now we think that we can reap the benefit from that. Yeah, a continued focus on costs and effort is always to bring it further down.
If I add to that, I think, Johan, you need to look at the trend over a longer period of time, and I think we cannot give out an exact number on that.
Sure. Okay. Thanks anyways. On commission income, it's been kind of stabilized at very high levels now for the past three quarters. Is it fair to assume that we should look at these loan prepayments as a non-recurring item? You've come up, especially the lending guarantees contribution to a quite high level, close to ISK 1 billion. How do you think about this? Is this non-recurring or something that we should expect in the medium term as well, or just a short-term item?
Actually, it's to a limited extent because of loan repayments. Most of the mortgage portfolio does not enjoy a kind of a fee structure. There are some sort of seasoned vintages that have that. It's primarily because our focus on capital velocity and charging more for the use of our balance sheet that is resulting in this, and we're quite confident that we can continue on that path. I think historically the bank, in comparison, may be generated less of fees and commission income from this activity. I think we're now closing in on some of our peers.
For sure, something very positive. Lastly, can you say a few words on the competitive situation in Iceland now? Are the pension funds able to follow you down on pricing? If not, do you think that you can maintain the high growth pace at sufficient margins in the near term?
It's a really good question. Yeah, currently the real policy interest rate level is negative.
Yeah.
The inflation is hovering around 3% and the policy rate is at 1%. That has made the banks more competitive when it comes to the mortgage space and the most favorable product or the most sought-after mortgage product is the non-CPI variable rate product. I think more than 80% of the demand is in that asset class.
There, yeah, the pension funds have not been willing to engage in competition for that product. They continue to offer the best rates when it comes to fixed CPI and even variable CPI in some cases. That is not the product that our clients are preferring at the moment, and that's why we are, for first time in a long period, are enjoying a favorable competing position. That belongs to all three banks.
Yeah.
They're enjoying the same kind of increased activity.
Yeah. It sounds a lot better. Thanks very much for that, Benedikt, and let's hope we can see another quarter like this in Q4. Thank you.
Thank you.
Thank you. Our next question comes from the line of Marcus Hobbs of Goldman Sachs. Please go ahead. Your line is open.
Hi there. Good morning from my side as well. Just a couple of questions, please. Firstly, it's good to see that you're now back to accruing dividends, 50% of your 2020 profits. I was just wondering, how would you think about proposing dividends for 2019 profits given the very strong capital position that the group has?
Is there any regulatory approval that you would need if you wish to do so? Obviously, we've seen a couple of few banks in Europe now that have done that, and one in the Nordic space as well. That's my first question. Second question, just on the corporate segment, and in particular, the repricing of the corporate book that you've been talking about in the past.
I'm just wondering, is that something that you're still pursuing or doing, or what is the progress here, if you can just update on that? Thanks.
Thank you, Marcus. Good questions. If I start with the dividend, and I know what you're referring to, and we had a look at it. Actually, the Icelandic legislation does not limit us as, for example, in Norway when it comes to dividends. Any retained earnings that we have, irrespective from what the year can be distributed in later years. There is not a cut-off at the end for this.
What we've previously said is that we just follow the guidance of the regulator, and we will have to see. What we would like to see is obviously that the regulator would put some kind of a quantitative measure on capital strength and allow banks in Europe to release some of the excess capital that then is with the stronger capitalized banks.
The blanket dividend restriction is not a good thing in the long run for banks that tend to have fairly high capital and have to rely on equity investors for the capital that is deployed in the business. Retaining, Stefán, you want to elaborate a bit on our accounting method for retaining the dividends now?
Yes. What we did last year, because you asked about the 2019 dividends, we actually did in our 2019 disclosures, we did assume 50% payout and we altered that when we had a dividend proposal of ISK 10 billion and when that was cancelled, then we added that back to our capital position.
When paying that out, that will be an extraordinary dividend payment. As Benedikt said, there's nothing that prohibits us from a regulatory perspective of paying extraordinary dividends. In our case, that really doesn't matter too much. As Benedikt said, the only regulatory hindrance that we would have on distribution is on buybacks-
Formal approval
-a formal approval from the regulator. Obviously we listen closely to what our regulators are saying on dividends and it is obviously very positive for us when we listen to what's happening in Europe.
Yeah.
The ECB seems to be worried about the effect on investors and obviously that a blanket ban is maybe not the best idea.
Precisely. On the corporate book, this is a continued effort to reprice the book. I think actually the same applies here as for the mortgage is now when we have real interest rates, policy rates at -1.5%, -2%, I think the bank is in actually a pretty good position competing for some of the corporate credit here locally.
A lot of the longer maturities are CPI-linked fixed rate, predominantly invested by or financing provided by the pension fund system. We are now enjoying healthy demand for non-CPI variable rate financing. I think many of our clients, they're comfortable with the interest rate levels now and don't see the policy rate moving higher anytime soon.
I think that is partially a function of the fact that Iceland is now even with a really small currency, is supported by strong renewable export industries both on the energy intensive side and then for protein fish where we're seeing salmon fish farming the latest newcomer here with big growth coming from that sector.
The fact that as our chief economist pointed out yesterday in her macroeconomic forecast, that we've enjoyed seven years of current account surplus and she's forecasting that we'll have a positive balance of payments for the next three, four years as well. Even though there's temporarily a strain on the krona now once things normalize she's expecting the krona to strengthening again, which is also supportive for lower policy rates for longer.
The interest rate environment in Iceland is changing and that's to the benefit of banks rather than the pension funds.
All right, great. Thanks for that. Thank you.
Thank you. Our next question comes from the line of Maria Semikhatova of Citibank. Please go ahead, your line is open.
Yes. Hello. Thank you for the presentation. A couple of questions from my side. First of all, following up on repricing the corporate segment because there are different moving parts. You mentioned that you see front book pressure in the mortgage lending. Just want to check if all the rate cuts that have been implemented so far already filtered through your NII line, just maybe generally how you see your margins developing from here.
Second question on asset quality. Could you maybe shed more light on payment holidays that you provided for your corporate customers when they expire how customers behave so far if there's been any expiration particularly on the corporate side? Maybe more generally since you said that you have better visibility now in the asset quality outlook, are you comfortable to provide guidance for cost of risk for next year?
Just want to confirm what is the outlook for 2020. Just finally on opportunities that you could see in the sector, how aggressive would you be if there is still regulatory ban on capital distribution? Maybe if there's anything you can expand on potential consolidation in the banking sector. Thank you.
Very good questions. On the NIM going forward, as Stefán mentioned, there is clearly pressure on our mortgage portfolio where the front book is due to high refinancing activity, is probably enjoying slightly lower NIM than the back book. That will put a pressure on our NIM, but we're hoping that we're able to mitigate against that with continuing to reprice our corporate book and, to an extent, consumer finance, which we've not been very active in.
The consumer finance portfolio is relatively small with the bank, there might be an opportunity to selectively go further into that space. I would say, assuming that the policy rates do not move any lower-
Yeah
-that it would be a good outcome if we were able to maintain the current kind of NIM position. Would you agree?
Yeah, that's a very good way of putting it.
Yeah.
We believe that the risk is more on a slight downside, but obviously we are fighting to maintain it.
Yeah, precisely. On asset quality, as Stefán mentioned, we've identified 18% of the portfolio with COVID-19 related exposures, but a lot of that is collateralized with real estate. We've been conservative on the LTV side. I think we discussed it in our AGM. If I remember correctly, the LTV in our commercial real estate portfolio averaged some 67%.
Yeah
in end of last year, but commercial real estate prices have come down somewhat. There is a buffer, as you can hear. The industry-wide payment holiday or payment moratoria elapsed end of September. Going into that, to our surprise, because our clients were able to, in the market space, to use their ability before end of September to extend for another three - six months.
Most of our clients didn't, and that explains why we have such a low ratio of residential mortgage borrowers in moratoria at the end of the third quarter. It's also low for corporates because this industry-wide effort elapsed. What we will now do is do it on a case-by-case basis, and I expect that we will see payment moratoria creeping up again or increasing in the next few quarters, but that is primarily related to this 18% kind of exposure.
Other industries seem to be doing quite well, and if you look at some of our largest exposure towards large operating companies, some of them listed on the stock exchange, the leverage ratio is quite low at the moment in historical context.
Let me just add to that, Benedikt.
Yeah.
I think also what you need to assume, we believe that cost of risk will come down, but it won't normalize next year, but we believe it will come down and normalize over, let's call it two and a half years.
Yeah, we're hoping that what we've already impaired and will have to realize as losses in first and second and maybe third quarter of next year will suffice, that we've been foresighted in our provisioning.
Exactly.
On opportunities in the sector, it's a very good question. We would like to grow our asset management business. We're seeking opportunities to grow externally or internally there by investments. I think in most other spaces, I mentioned consumer finance as a potential growth area. That would be an internal growth thing primarily.
I think due to our market position, there would be constraints to other acquisitions here locally. We, up until now, have not defined our core home market as anything else other than Iceland. We have indeed a decent size portfolio towards the seafood industry in Europe and North America. As part of that, we have been active in Faroe Islands, for example. That could be an opportunity as well.
Yeah, due to our size, there's clearly limited growth potential, and investing into asset management, which is in itself not a capital-intensive business, will not require heavy investments.
Yeah. Thank you so much for very detailed answers. Just maybe a quick follow-up. I don't know if I'm looking way too much into the future, but since you mentioned the normalized cost of risk, so what do you see normalized? I'm not pressing for timing when you think that's going to happen, but with your current portfolio breakdown, what do you think is an appropriate cost of risk assumption?
We haven't given guidance on that, but one reference point that I would like to point you to is the fact that 43%, or 42%, 43% now of our loan portfolio are residential mortgages, and they enjoy much lower cost of risk than anything else in our portfolio. I think our models, if you look at the latest Pillar 3 report, assume somewhere between 5 and 7 basis point cost of risk.
Based on our competitive position there and the activity in our business, residential mortgages will be a key pillar of our credit portfolio, and it would be really good to see other kind of exposures normalize at the cost of risk level, which is, what did you say? Below 50 basis points or even lower?
Yeah. Even lower. Let's be careful on that because we haven't guided on that.
No. At least, I mean.
Okay. Thank you so much.
Yeah.
Thank you. Once again, if there are any further questions, please dial 01 on your telephone keypads now.
Okay. We don't have any audiences in the auditorium, so I guess this concludes our presentation. Thank you very much for listening in and all the good questions that you came with. We'll see you in three months' time. Thanks.
Thank you.
Thanks.