Risk Management

Arion Bank faces numerous risks arising from its day-to-day operations as a financial institution. Managing risk and taking informed decisions is a crucial component of the Bank's activities and its responsibility towards society. The key to effective risk management is a process of ongoing identification of significant risk, quantification of risk exposure, action to limit risk and constant monitoring of risk.

The Board of Directors is ultimately responsible for implementing risk management and approves risk policies which specify the risk framework, governance structure and appropriate monitoring systems among other things. The risk management of subsidiaries is the responsibility of that subsidiary. For the parent company (the Bank) the Board sets the risk appetite, which is translated into exposure limits and targets monitored by the Bank’s Risk Management division.

The CEO is responsible for sustaining an effective risk management framework, processes and controls as well as maintaining a high level of risk awareness among the employees, making risk everyone’s business.

The Bank’s Risk Management division is headed by the Chief Risk Officer. The division is independent and centralized and reports directly to the CEO.
Further information on Risk Management.

Further information on Risk Management


The Bank operates several committees to manage risk. The Board Risk Committee (BRIC) is responsible for supervising the Bank’s risk management framework, risk appetite and internal capital adequacy assessment process (ICAAP) and internal liquidity adequacy assessment process (ILAAP). The Board Credit Committee (BCC) decides on all major credit risk exposures.

The CEO has appointed four risk committees. The Asset and Liability Committee (ALCO) manages the asset-liability mismatch, liquidity risk, market risk, interest rate risk, and capital management. The committee also makes decisions on underwriting and investments. The roles of the Operational Risk Committee (ORCO) is to ensure the effective management of operational risk at the Bank in accordance with risk appetite and legal requirements. The committee is responsible for managing non-financial risk, including information security and data risk, financial crime, business processes, outsourcing, model risk, compliance risk and conduct risk. The Arion Credit Committee (ACC) takes decisions on lending exposures and is responsible for the Bank’s credit rules, and the Arion Composition and Debt Cancellation Committee (ADC) makes decisions on composition and debt cancellation. The ACC and ADC operate within limits set by the BCC.

The most significant risks to which the Bank is exposed are credit risk, liquidity risk, interest rate risk, concentration risk, cyber risk and business risk. The Bank’s Pillar 3 Risk Disclosures 2020 report discusses risk factors and risk management in detail.

Capital adequacy

The Bank’s capital is intended to meet the risk of unexpected loss in its operations. The size of the Bank’s own funds should reflect the risk at any given time and account for any potential adverse future development. Risk on the Bank’s balance sheet is assessed by calculating the risk-weighted exposure value (REA). The Bank uses a standardized approach for calculating REA which is generally designed to be more conservative than methods based on internal models. Capital is calculated in accordance with the Financial Undertakings Act No. 161/2002 and Regulations on Prudential Requirements for Financial Institutions No. 233/2017, under which the European Union’s capital requirement directives, CRD IV and CRR, both based on Basel III, are being implemented in Iceland. The provision on lower capital requirements for small and medium-sized entities did not come into effect until 1 January 2020 with the adoption of the Capital Requirements Regulation (CRR) in to the agreement on the European Economic Area.

The Bank’s total own funds were ISK 201.2 billion at the end of 2020. Common Equity Tier 1 capital (CET1) accounted for ISK 166.0 billion. At the beginning of the year, the Bank planned to reduce its capital by paying dividends and buying back own shares. However, due to the COVID-19 pandemic this plan was abandoned and it was decided at an extended annual meeting on 14 May that no dividend would be paid in respect of the financial year 2019. On 31 December 2020, the foreseeable dividend and buyback is the aggregation of a dividend distribution of ISK 3 billion, which adheres to the guidance of the FSA, and planned buyback of own shares amounting to ISK 15 billion which has received permission from the FSA.

The Bank’s REA amounted to ISK 745.8 billion at the end of 2020, increasing by ISK 26 billion over the year. The increase is mainly due to the change in the treatment of the Bank’s shareholding in Vördur tryggingar hf. The company is removed from the group when calculating the Group’s capital in accordance with capital regulations. Previously, the Bank’s holding of Vördur’s equity was deducted from the Group’s own funds but now it contributes instead towards risk-weighted exposure amount with a risk weight of 250%. In other respects, the net change in REA is minimal despite the fact that the loan book grew by ISK 49 billion. There are several factors behind this, particularly the aforementioned rules on lower capital requirements for SMEs and the huge increase in mortgages which have a low risk-weighting, coinciding with a contraction in assets which tie up more capital, such as corporate loan and financial assets in the investment book. Calculations of the Bank's capital adequacy are based on the Group’s consolidated situation according to prudential requirements and according to these rules, subsidiaries in the insurance sector are outside of the consolidated situation. Special solvency requirements apply to companies in the insurance sector. The Bank’s average risk-weighting (REA as a percentage of total assets of the Group’s consolidated situation) was 63.6%.

The Bank’s capital ratio at the end of 2020 was 27.0% and CET1 ratio was 22.3%.

Capital ratio
Risk-weighted exposure amount

In addition to measuring its minimum capital requirement under Pillar 1 in accordance with the rules on prudential requirements, the Bank also assesses its additional capital requirement by performing an Internal Capital Adequacy Assessment Process, ICAAP. ICAAP is designed to ensure that the Bank has in place sufficient risk management processes and systems to identify, manage and measure the Bank’s total risk exposure. ICAAP is designed to identify and measure the Group’s risk across all risk types, including those which are not provided for under Pillar 1, and to ensure that the Group has sufficient capital in accordance with its risk profile. The Financial Supervisory Authority (FSA) supervises the Group, receives the Group’s internal estimate of capital adequacy and sets additional capital requirements following a Supervisory Review and Evaluation Process (SREP). The capital adequacy in respect of the FME's internal evaluation in addition to the mandatory 8% requirement under Pillar 1 is called an additional capital requirement under Pillar 2. The additional requirement under Pillar 2 at the end of 2018 was 3.1% of REA and this figure is based on the Group consolidated situation which excludes subsidiaries in the insurance sector. Due to the COVID-19 pandemic the FME decided to shorten SREP 2020 and the additional requirement under Pillar 2 remained unchanged. The FSA can also set a capital target (Pillar 2G) on top of Pillar 1, Pillar 2 and capital buffers on the basis of the results of stress tests, but the FSA has decided not to do so.

Under the Financial Undertakings Act No. 161/2002 the Bank must meet a combined capital buffer requirement, which is designed to ensure that the Bank maintains a minimum level of capital despite severe shocks. The FSA has decided on the level of capital buffer in accordance with a proposal from the Financial Stability Council and it has defined Arion Bank as a systemically important financial institution in Iceland. The combined capital buffer requirement was 9.25% at the end of 2019, increasing to 9.5% on 1 February 2020 due to the increase in the countercyclical capital buffer and decreasing again to 7.5% on 18 March when the countercyclical capital buffer was abolished. Effective capital requirements for the countercyclical capital buffer are determined using the weighted average capital buffer in the countries where the Bank has exposure and risk-weighting is decided by the percentage of credit risk in REA. The systemic risk buffer is only applied on domestic exposures. The other capital buffers are the capital conservation buffer and the buffer for systemically important financial institutions. The combined effective capital buffer for the Bank was 7.3% at the end of the 2020.

Introduction of capital buffers
Capital ratio and total capital requirement taking into account management buffer

The Group’s total own funds meet the total capital requirement in respect of Pillar 1, Pillar 2 and capital buffers. The total requirement is 18.4% of REA and the total own funds are 27.0% of REA. The Bank has set itself the target of 17.0% CET1 and this target includes an internal management buffer.

Credit risk

Credit risk is defined as the current or prospective risk to earnings and capital arising from the failure of an obligor to discharge an obligation at the stipulated time or otherwise to perform as agreed. Loans to customers and credit institutions are by far the largest source of credit risk.

Loan book composition

Strong mortgage portfolio with low default rates and high loan-to-value

Mortgages are a core product for Arion Bank. The mortgage portfolio represented 48% of the total loan portfolio at the end of the year, up from 12% since the end of 2010. The key to this rapid growth rate was the acquisition of a mortgage portfolio from Kaupthing in 2011 and the acquisition of retail loan portfolios and increased lending. The Bank has been at the forefront of innovation on the mortgage market, offering for example, non-indexed mortgages and digital solutions for mortgage financing. At the end of 2020 non-indexed mortgage loans represented 53% of the mortgage portfolio, the remainder being CPI-linked loans. This represents a significant change from the end of 2019, when the percentage of non-indexed loans was 39%.

Mortgage portfolio growth and composition
ISK bn.

The quality of the mortgage portfolio has improved in recent years with lower average loan-to-value and a reduction in default rates. At the end of 2020 the percentage of mortgages subject to a payment moratorium due to COVID-19 was 2.5% and this largely explains the decrease in defaults between 2019 and 2020. It is unclear how and to what extent defaults will increase once payment moratoria and other general measures expire.

Mortgage loans in over 90 days default
Mortgage portfolio by location

At the end of 2020, 88% of the mortgages, by value, had loan-to-value below 80%, compared with 87% at the end of 2019. The great majority of mortgage properties are located in the Greater Reykjavík area or 69% of the portfolio value. The Bank’s mortgage portfolio has grown by 23% in 2020 and at year-end 44% of the portfolio had a loan-to-value of 60-80%, compared with 34% at the end of 2019.

Loan to value of mortgage loans
ISK bn.

Well diversified loan portfolio

Loans to customers are well diversified. Loans to individuals represent 51% of total loans to customers and credit institutions, of which 87% are mortgages. The corporate portfolio is mainly represented by three sectors: real estate and construction, fishing and fish processing and wholesale and retail trade, which represent 33%, 21% and 13% of the corporate portfolio respectively. Although sector diversification is good, some single name concentration remains.

Loan book concentration
Industry sector concentration of corporate loans

Single name concentration

At the end of 2020 the Bank had one single exposure to a group of related parties, excluding exposure to financial institutions, that exceeded 10% of the Bank's eligible capital (so-called large exposures). The sum of related exposures, excluding loans to financial institutions, exceeding 2.5% of own funds has decreased from the previous year – it was 106% at the end of 2020, compared with 148% at the end of 2019.

Single name concentration

Collateral coverage of loans to customers

Mortgages over residential properties and charges over commercial real estates are the most common types of collateral obtained by the Bank, representing 80% of total collateral. Fishing vessels and other fixed and current assets, such as cash and securities, are also used to secure loans. The Bank places emphasis on collateral maintenance, valuation and central storage of collateral information. At the end of 2020 loans to customers (gross value ISK 822,941 million) are secured by collateral valued at ISK 745,390 million, giving a collateral coverage ratio of 91%, but as shown in the following diagram this ratio varies between different sectors.

Collateral coverage of loans to customers in 2020 down to sectors
Collateral by type

Quality of loan book stable between years

The Bank defines problem loans as loans in the third and highest risk stage according to the IFRS 9 accounting standard. The problem loan ratio is currently 2.6% and remains unchanged between years, and 49.6% of these loans are in serious default without being impaired due to sufficient collateral. 4.2% of loans to customers are subject to a payment moratorium at the end of 2020. More specifically 2% of loans to retail customers and 6.6% of corporate loans are subject to a payment moratorium. Loans in the portfolio subject to a payment moratorium are assessed as having increased credit risk.

Problem loans
Breakdown of problem loans
Problem loans and COVID-19 related moratoria for companies
Problem loans and COVID-19 related moratoria for individuals

Due to the current unprecedented circumstances it has been necessary to resort to special measures for customers who have been most heavily impacted by COVID-19. Our customers include persons and companies in the travel industry who have received business support loans, bridge loans or been granted payment moratoria. The total book value of these loans is ISK 108 billion, or 14% of the Bank’s loan portfolio.

Breakdown of loans to customers affected by COVID-19

Operational risk

Operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, human and system error, or from external events that affect the Bank's operations. The Bank defines legal risk, model risk and conduct risk as subcategories of operational risk.

Each business unit of the Bank is responsible for managing its own operational risk. Risk Monitoring and Framework is responsible for developing and maintaining tools for identifying, measuring, monitoring and controlling operational risk. The operational risk management framework is based on the effectiveness of managing processes, their risks and controls, analyzing deviations from best practices and continuously improving the operation.

Market risk

Market risk is the risk that price changes and interest rate changes will negatively affect the value and cash flow from the Bank’s financial instruments and the Bank's earnings and capital. The main types of market risk are interest rate risk, indexation risk, equity price risk and foreign exchange risk.

Interest rate risk is primarily related to the fact that for a part of the balance sheet there is a mismatch between interest-bearing assets and liabilities and a gap in interest-fixing periods. At year-end 2020, the Bank had a short net position in indexed krona while having a long position in non-indexed krona. Lower real rates would therefore result in depreciation of the net fair value of interest-bearing assets and liabilities while higher nominal rates would result in depreciation of the net fair value. The relationship between inflation and interest rates should be considered in this context. A decrease in nominal rates is often accompanied by a lowering of inflation or expectations thereof and lower inflation reduces the Bank’s net interest earnings as the Bank’s indexed assets exceed its indexed liabilities, see below. The Bank’s sensitivity to changes to foreign interest rates is limited.

The figure below shows the Bank’s sensitivity to interest rate movements. The Bank’s calculations of interest rate sensitivity take prepayment risk and behavioral duration of non-maturing deposits into account.

Sensitivity to interest rate movements – loss in fair value (not book value) due to a parallel shift of yield curves upwards by 1%
ISK bn.

The Bank’s position in listed equities has decreased significantly in recent years following asset divestment and remained low in 2020.

The Bank’s position in equities in the proprietary trading book and due to securities margin lending was relatively stable during the year. Risk Management closely monitors risk and ensures that positions are kept within limits and that collateral is in place.

Equity positions
ISK millions

Foreign exchange risk is the risk that movements in the exchange rate of the Icelandic króna could have a negative impact on the Bank's earnings. The Group’s currency imbalance at the end of 2020 was positive by ISK 7.2 billion. The Bank uses derivatives to hedge against foreign exchange risk.

The net position of indexed assets and liabilities at the end of 2020 was ISK 55.1 billion, a decrease of ISK 34 billion from the previous year. The decrease is explained by prepayments of indexed loans, and the fact that demand for mortgages has shifted from indexed to non-indexed.

Currency imbalance
ISK millions
Indexation imbalance
ISK bn.

Liquidity risk

Liquidity risk is defined as the risk that the Group, though solvent, either does not have sufficient financial resources available to meet its liabilities when they fall due or can secure them only at excessive cost.

The Bank also carries out an Internal Liquidity Adequacy Assessment Process, or ILAAP. This process is designed to ensure that the Bank has sufficient liquidity and that appropriate plans, policies, methods and systems are in place to analyze, manage and monitor liquidity risk.

The Central Bank of Iceland monitors the Bank’s compliance with requirements and obligations in respect of liquidity risk.

Further on liquidity and liquidity risk