A question of risk-reward · UBS Investment Research Icelandic banks A question of risk-reward Growth normalisation following years of exceptional performance We initiate coverage

UBS Investment Research

Icelandic banks

A question of risk-reward

Growth normalisation following years of exceptional performance We initiate coverage of two Icelandic banks, Kaupthing (Neutral, price target ISK960) and Glitnir (Sell, ISK20). Icelandic banks differ from other Europeanbanks through their equity investments, acquisition-fuelled growth and high corporate and investment banking earnings. Based on our risk-return analysis, Kaupthing offers greater potential upside for investors with a higher risk appetite.

Has the tide turned against Icelandic banks? Kaupthing and Glitnir have benefited from expansion into Europe over the pastfive years, against a backdrop of accelerating economies, low interest rates and high risk appetite. All three factors have now turned, topped by a 45bps rate hike inNovember, yet there is little reflection of this in the banks’ share prices. We believe EPS growth in 2007-09 will moderate to an average of 6% for Kaupthing and 4% for Glitnir, against 10% for the European banks.

Preference for Kaupthing over Glitnir We prefer Kaupthing to Glitnir. Glitnir depends more on Iceland, a slowingNorwegian market and is more likely to make acquisitions, while Kaupthing ismore diversified (Iceland accounts for <25% of group income) and already reflectsthe capital increase from the purchase of NIBC. Glitnir is also more expensive inour view, at 12.7x 2008E PE, vs. Kaupthing on 10.2x and Eurobanks on 9.5x.

Near-term caution on Icelandic banks We value Glitnir (EPS 17% below 2008E cons.) and Kaupthing (-14% below 2008E consensus which includes NIBC) using a one-stage Gordon growth model (CoE 10.7% (70bps above the Eurobanks average) and 3.0% long-term growth.

Global Equity Research

Europe Including UK

Banks

Initiation of Coverage

5 December 2007

www.ubs.com/investmentresearch

Michael SchenkAnalyst

[email protected]+44 20 7568 0623

Chart 1: Icelandic banks vs. Corporate & Investment banking and Nordic peers

UBS Price TP Up-/ Down Mcap. Price Perf. EPS growth PERRec. in LC in LC side in % in € 2006 2007 YTD 06/05 07/06E 08/07E 2006 2007E 2008E

IcelandGlitnir Sell 24.3 20.0 -17.7% 4bn 35% 6% 98% -23% -1% 7.3x 10.3x 10.2x

Kaupthing Neutral 930.0 960.0 3.2% 10bn 17% 9% 53% -21% 0% 8.7x 12.7x 12.7x

SwedenSwedbank Buy 205.5 290.0 41.1% 11bn 15% -17% -7% 7% 9% 11.4x 8.9x 8.2x

Nordea Neutral 106.5 115.0 8.0% 30bn 28% 1% 43% -6% -9% 9.6x 10.3x 11.2xSEB Buy 181.0 270.0 49.2% 14bn 33% -17% 52% 7% 5% 11.7x 9.1x 8.7xSHB Neutral 201.0 220.0 9.5% 14bn 5% -3% 19% -4% 0% 10.2x 10.3x 10.3x

DenmarkDanske Bank Neutral 205.0 240.0 17.1% 19bn 13% -18% 14% -5% -9% 10.7x 8.5x 9.0x

NorwayDnB Nor Neutral 85.3 93.0 9.0% 14bn 23% -4% 15% 5% -6% 10.1x 10.0x 9.9x

CIB PeersDeutsche Bank Neutral 89.4 99.0 10.8% 47bn 24% -12% 81% 13% -14% 10.4x 8.3x 7.9x

Natixis Neutral 14.1 13.8 -1.8% 17bn 51% -34% 22% 9% -18% 12.4x 8.9x 9.1x

Source: UBS estimates

This report has been prepared by UBS Limited ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 80. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

ab

mailto:[email protected]

Icelandic banks 5 December 2007

UBS 2

Contents page

Executive summary 3 — Icelandic banks – building pan-Euro platforms .....................................................3 — Investment cases – preference for Kaupthing.......................................................6

Are Icelandic banks good investments? 8 — Strong price performance in 2006 and H1 07 .......................................................8 — 2008 earnings are unlikely to keep up the pace....................................................9 — The business mix has changed ............................................................................9 — Support from cross-shareholdings......................................................................11

Macro profile: Slowing trends 13 Glitnir (Sell, PT ISK20, -19%) 17

— An acquisition-fuelled story ................................................................................17 — The best part of the story may be behind us.......................................................19 — UBS profit and loss forecasts .............................................................................19 — Valuation............................................................................................................23 — Glitnir’s capital adequacy profile.........................................................................27 — Glitnir’s liquidity profile........................................................................................28 — Glitnir’s currency exposure.................................................................................29 — Glitnir’s dividend profile ......................................................................................30

Kaupthing (Neutral, PT ISK960, +3%) 32 — Ten years of rapid transformation.......................................................................32 — Exposure to sub-prime .......................................................................................35 — UBS forecasts for Kaupthing ..............................................................................36 — PART I: Kaupthing P&L (ex-NIBC) .....................................................................37 — PART II: The acquisition of NIBC .......................................................................39 — PART III: Kaupthing Bank and NIBC pro forma ..................................................45 — Valuation............................................................................................................46 — Kaupthing’s capital adequacy profile ..................................................................50 — Kaupthing’s liquidity profile.................................................................................51 — Kaupthing’s dividend profile................................................................................52 — The role of Exista, Kaupthing’s largest shareholder............................................52

The Icelandic banking model 56 — A banking sector like no other in the world .........................................................56 — How do Icelandic banks differ from peers...........................................................60

Financial stability matters 67 — Main vulnerabilities and strengths ......................................................................67 — Stress tests ........................................................................................................70

Macro facts about Iceland 72 — The economy .....................................................................................................72 — Interest rates......................................................................................................73 — The exchange rate remains a key risk factor ......................................................74

Risk – opportunity scorecard 76 Appendix 78

Michael Schenk

[email protected]

+44 20 7568 0623


UBS 3

Executive summary Icelandic banks – building pan-Euro platforms We initiate coverage of Icelandic banks with a Neutral rating on Kaupthing (price target ISK960) and a Sell on Glitnir (PT ISK20). Two other Icelandic banks not currently under our coverage are Landsbanki and Straumur; research restrictions involving an advisory mandate for Close Brothers are currently in place on Landsbanki, while Straumur is the smallest of the listed Icelandic banks. This is the first time UBS Equity Research has covered any Icelandic companies in any sector, which is a reflection of their growing importance in Europe.

Icelandic banks differ from other European banks through their aggressive expansion outside their home market, their entrepreneurial, almost private-equity-like approach, and the fact that they have almost no legacy in any of the markets that they enter. Icelandic bank earnings are largely made up of corporate and investment banking (CIB) and private equity earnings against the backdrop of a local stock market that has outperformed substantially. The banks are well managed and have established a track record as savvy investors. Their disclosure is generally good but could be improved with regard to segmental disclosure and equity investments. We highlight three key questions facing Icelandic banks:

Can above-average earnings growth be maintained? We believe that growth will moderate to 6% average EPS growth for Kaupthing and 4% for Glitnir between 2008-09, against 10% for the European banking average.

Why pay a premium for above-average earnings risk geared to financial income? The quality of revenues has deteriorated or is a direct function of the markets close to the end of the cycle for wholesale banks.

Can the potential rewards justify the risks? A benign capital market environment in 2008 and 2009 would be a necessary prerequisite for this, but the European banks sector is now spoilt with cheap banking stocks.

Chart 3: Kaupthing – total income breakdown Chart 4: Glitnir – total income breakdown

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

NII as % of TI F&C as a % of TI Fin Inc as a % of TI Other Inc as % of TI

-20%

0%

20%

40%

60%

80%

100%

2,001 2,002 2,003 2,004 2,005 2,006 2007E 2008E 2009E 2010E

NII as % of TI F&C as % of TI Fin Inc as % of TI Other Incas % of TI

Source: Kaupthing and UBS estimates for Kaupthing standalone Source: Glitnir and UBS estimates

Initiating on Kaupthing at Neutral and Glitnir at Sell

Chart 2: Expansion into Europe

AUSTRIAHUNGARY

CZECH

SERBIA

CROATIA

FINLAND

ITALY

SPAIN

SWEDEN

NORWAY

GERMANY

FRANCE

PORTUGAL

ROMANIA

BULGARIA

DENMARK

POLAND BELARUS

UKRAINESLOVAKIA

GREECE

CYPRUS

NETH.

BELGIUM

IRELAND

MOLDOVA

LITHUANIALATVIA

ESTONIA

LUX.

SWITZ.

ICELAND

UK

LIECH.

RUSSIA

Home marketAcquisitions in new marketsOther EU member countries

AUSTRIAHUNGARY

CZECH

SERBIA

CROATIA

FINLAND

ITALY

SPAIN

SWEDEN

NORWAY

GERMANY

FRANCE

PORTUGAL

ROMANIA

BULGARIA

DENMARK

POLAND BELARUS

UKRAINESLOVAKIA

GREECE

CYPRUS

NETH.

BELGIUM

IRELAND

MOLDOVA

LITHUANIALATVIA

ESTONIA

LUX.

SWITZ.

ICELAND

UK

LIECH.

RUSSIA

AUSTRIAHUNGARY

CZECH

SERBIA

CROATIA

FINLAND

ITALY

SPAIN

SWEDEN

NORWAY

GERMANY

FRANCE

PORTUGAL

ROMANIA

BULGARIA

DENMARK

POLAND BELARUS

UKRAINESLOVAKIA

GREECE

CYPRUS

NETH.

BELGIUM

IRELAND

MOLDOVA

LITHUANIALATVIA

ESTONIA

LUX.

SWITZ.

ICELAND

UK

LIECH.

RUSSIA




UBS 4

An above-average risk premium

Investors have to decide if this is commensurate with their risk appetite. In recent years, above-average macro and investment risk has been compensated by outsize returns delivered by the banks. Our analysis of the bank sector indicates that growth and returns will moderate assuming more normalised growth in corporate banking and capital markets in 2008 and 2009.

GDP growth in Iceland has been slowing and will most likely be around 1% this year, although it has been significantly above the euro zone for many years. Interest rates were raised by 45bps in a surprise move by the central bank on 2 November to rein in inflation concerns. The policy rate now stands at 13.75%. The currency has benefited from rising interest rates but this has only further contributed to rising inflation expectations and the current account deficit. The consensus is that the Icelandic krona (ISK/EUR90) is probably overvalued by 10-15% and may fall in conjunction with the first easing steps by the central bank, which we expect in mid-2008.

Chart 5: Icelandic banks – investment profile, past and present Chart 6: Icelandic banks – macro profile

Past 3 years 2007-2009ELow High Low High

Growth GrowthStrategic Positioning Strategic PositioningReturns ReturnsValuation ValuationRisk RiskManagement Management

Past 3 years 2007-2009E

Low High Low HighGDP Growth GDP GrowthInterest rates Interest ratesInflation InflationExchange rate risk Exchange rate riskCurrent account Current account

Financial stability Financial stability

Source: UBS estimates Source: UBS estimates

In our opinion, the strategic positioning of the Icelandic banks has been improved but needs to go further. We believe Kaupthing offers the most attractive entry into this market at reasonable valuations, but note that growth at Kaupthing has been driven to a large extent by acquisitions; most of its organic growth has been driven by financial investments. Our impression is that synergies have been generated more by turning undermanaged targets around, while cross-regional integration will likely be the next big step.

Chart 7: Kaupthing’s growth has been driven by acquisitions and financial income

0

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2003

Orga

nic

Acqu

ired

2004

Orga

nic

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ired

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2006

in €

m

Operating income Organic Acquired

Source: Kaupthing and UBS

The ROIC and ROE of acquisitions by Kaupthing and Glitnir indicate that Kaupthing has been more successful in extracting value from its acquisitions,

An investment in Iceland carries above-average macro risk

Slowing Nordic and European economies

The strategic positioning of Icelandic banks has not been vastly improved despite numerous acquisitions


UBS 5

but every acquisition dilutes its own financial investment-fuelled ROE and some of this improvement was due to the up-streaming of equity to the group. Data on Glitnir’s integration successes is more limited. BNbank, Glitnir’s biggest acquisition to date in Norway, showed no improvement in ROE between 2004 and 2006.

Chart 8: ROE & ROIC of Kaupthing acquisitions since 2004 Chart 9: ROE 2004-06 Glitnir’s acquisition of BNbank in Norway

0%5%

10%15%20%25%30%35%

NIBC KSF FIH KaupthingROIC ROE ROE (planned by 2008)

9.0%

9.5%

10.0%

10.5%

11.0%

2004 2005 2006RoE Bnbank

Source: Kaupthing and UBS estimates Source: Glitnir

The Icelandic banks now trade on premium levels relative to other European and US CIB banks. Glitnir has the highest PE and PBV multiple. When we compare their market caps with the total number of employees, the Icelandic banks already offer a highly efficient workforce. The question then is: how much further can this be improved?

Chart 10: Icelandic banks surpassed only by Goldman’s on 2007E PBV and PE

Chart 11: Icelandic banks are already significantly more productive on a market cap/staff basis

0.0x

0.5x

1.0x

1.5x

2.0x

2.5x

Kaupthing Glitnir LehmanBrothers

MorganStanley

Merrill Ly nch GoldmanSachs

SEB DeutscheBank

Natix is

0.0x

2.0x

4.0x

6.0x

8.0x

10.0x

12.0x

14.0x

16.0x

18.0x

20.0x

PBV (LHS) Adj EPS (RHS)

0%

50%

100%

150%

200%

250%

300%

Kaupthing Glitnir LehmanBrothers

MorganStanley

Merrill Ly nch GoldmanSachs

SEB DeutscheBank

Natix is

Mcap/staff

Source: UBS estimates Source: UBS estimates

Two contrary market views, few ratings and not much written research

(1) “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.” (J.M. Keynes). This is the more negative view that the Icelandic banks have copied each other’s business model and have potentially taken on excessive risk.

(2) “Daring ideas are like chessmen moved forward. They may be beaten, but they may start a winning game.” (J.W. Goethe) This view sums up the transformation of the Icelandic banks. A few years ago they were looking at an insignificant home market, rapid transformation of the banking world and were sitting on the sidelines. The choice was essentially to “evolve or

Multiples and franchise valuations


UBS 6

die”. Today the Icelandic banks are an integral part of the European banking universe, with a combined market cap approaching €25bn.

The main challenge for the Icelandic banks is to develop their regional platforms into integrated business models that can sustainably deliver attractive returns based on meaningful market shares. They are no longer small enough to operate below everyone’s radar screen, but not yet big enough to compete with the larger local and international CIB banks.

A key support factor remains a tight net of inner Icelandic share ownership and cross-holdings, which will, however, get diluted with every new acquisition. JC Flowers group, for instance, is going to hold 15.9% of the share capital in Kaupthing in lieu of payment for NIBC, a transaction that was announced in August and will close in January 2008, with a lock-up until the end of next year.

Chart 12: The challenge: evolution into sustainable business models

Chart 13: Icelandic banks – shareholding structure

Star

Cash Cow

Question marks

Pets

Mar

ket g

row

th ra

te

Market share in the markets of operation relative to competition

high

low

lowhigh

Icelandic banks 5 years ago in a consolidated home marketIdeal mid term end point for

investment case

Current stage: High growth but need to gain sustainable market share

Undesirable outcome: ex growth, no significant market share

Swedish banks

Ideal long term end point for Investment case without further investments

Star

Cash Cow

Question marks

Pets

Mar

ket g

row

th ra

te

Market share in the markets of operation relative to competition

high

low

lowhigh

Icelandic banks 5 years ago in a consolidated home marketIdeal mid term end point for

investment case

Current stage: High growth but need to gain sustainable market share

Undesirable outcome: ex growth, no significant market share

Swedish banks

Ideal long term end point for Investment case without further investments

Landsbanki

Glitnir Straumur

Kaupthing

LB Holdings Ltd

Merrion Capital Group

SP-Fjarmognun hf

Íslandsbanki (Glitnir)safnreikningur

Arion safnreikningur(Kaupthing)

Exista B.V.

Egla Invest B.V.

Norvest ehfGnupurfjarfestingafelag hf JC Flowers Group

23.0%

9.9%

1.99%3.5% 2.4%

50.1%

67%

Pattur International ehf

FL GLB Holding B.V.

FL Group HoldingNetherlands B.

Jotunn holding ehfGlitnir Banki hf

5.0%

7.0%

13.1%

17.1%

4.9%

5.2%

5.2%

Lífeyrissjóðurverslunarmanna

2.3%2.8%

Samsoneignarhaldsfélag ehf

FjárfestingasjóðurÍS-15

40.7%

32.9 %1.0%

0.8%

1.9%5.7%

3.2%

Straumur Burdaras Löngusker ehf

3.8%

Storebrand, Norway 20%

2.8%

Citibank

2.0%

24.2 %

1.0%

6.8%

3.7%

Property Group50.0%

0.8%

Stamford Partners Ltd50.0%

7.2%

2.5%

Fjárfestingasjóður ÍS-15

1.0%

0.8% 0.8%

Union Group AS

Kreditkont hf

Glitnir Real Estate

50.1%

55.0%

59.0%

2.3%

3.7%

ChairmanSigurður Einarsson

CEO Hreiðar Sigurðsson

1.1%

0.98%

LífeyrissjóðirBankastræti

2.4%Proteus

Global holding

2.0%

Gildi Pension Fund

1.8%

Sund ehf

1.4%

Kepler Equities SA100%

Mezzanine Cap, DK

20%Drake Mgmt, US

FiNoble Adv, India

22.7%

20%

Samson Globaleignarhaldsfélag ehf

GLB Hedge (Glitnir)

LI- Hedge (Landsbanki)

Landsbanki Lux

Wood & Co50.0%

Saxbygg Invest ehf

Kaupthing bank Luxembourgh S.A.

15.9%*

*15.9% is the new share in the company

Landsbanki

Glitnir Straumur

Kaupthing

LB Holdings Ltd


SP-Fjarmognun hf



Exista B.V.

Egla Invest B.V.


23.0%

9.9%

1.99%3.5% 2.4%

50.1%

67%


FL GLB Holding B.V.



5.0%

7.0%

13.1%

17.1%

4.9%

5.2%

5.2%


2.3%2.8%



40.7%

32.9 %1.0%

0.8%

1.9%5.7%

3.2%


3.8%


2.8%

Citibank

2.0%

24.2 %

1.0%

6.8%

3.7%

Property Group50.0%

0.8%


7.2%

2.5%


1.0%

0.8% 0.8%

Union Group AS

Kreditkont hf

Glitnir Real Estate

50.1%

55.0%

59.0%

2.3%

3.7%



1.1%

0.98%


2.4%Proteus

Global holding

2.0%

Gildi Pension Fund

1.8%

Sund ehf

1.4%


Mezzanine Cap, DK

20%Drake Mgmt, US

FiNoble Adv, India

22.7%

20%


GLB Hedge (Glitnir)


Landsbanki Lux

Wood & Co50.0%

Saxbygg Invest ehf


15.9%*


Source: UBS estimates based on BCG growth matrix. Note: Landsbanki and Starumur are not rated by UBS

Source: UBS estimates and company reports. Note; Chart for illustrative purposes only; for an enlarged version please see page 12

The Icelandic banks’ sub-prime exposure appears manageable. At Q3 Kaupthing had exposure to seven synthetic CDOs (€350m) and 25 ABS transactions (€281m). On 26 November Kaupthing announced it would reduce its ABS exposure from €1.6bn to €450m by mid-December. Simultaneously it will also terminate a €1.3bn liquidity line.

Kaupthing has no direct exposure to US sub-prime assets or CDOs. It has lowered its indirect exposure, related to the funding provided to the sellers of NIBC, to US$136m. Kaupthing expects to take a charge in Q4 of €85m (or ISK7650m). Q3 profits were affected in Treasury which posted a loss of ISK1.8bn, or €22m. Glitnir said at the time of its Q3 results that it had no exposure. The results were, however, affected by bond portfolios due to credit spread widening.

Investment cases – preference for Kaupthing We initiate coverage of Kaupthing at Neutral, price target ISK960, and Glitnir at Sell, price target ISK20. Based on our risk-return analysis Kaupthing offers more potential upside for investors with above-average risk appetite.

The challenge: building sustainable businesses

Impact of the current market crisis


UBS 7

We do not believe that 12.7x 2008E PE for Glitnir is attractive when there are plenty of other banks available at cheaper valuations and whose earnings track records have been proven in times of boom and bust. Kaupthing is trading at a more reasonable 10.2x 2008E PE. Icelandic banks trade in line with Greek banks, whose earnings profile is much more driven by pent-up demand in retail banking. The UBS European banks average is 9.5x for 2008E.

Our valuation of Kaupthing includes NIBC (to be closed in January 2008), whose performance in 2008 may be affected by its reliance on corporate lending, levered finance, commercial real estate, securitisation and syndications.

The acquisition comes at 17x 2008E PE, and the shares issued have increased from 150m to a maximum of 210m, which affects the EPS-accretion at a business which we expect to deliver no more than 10% RoE by 2009, based on 2006 equity. Overall, Kaupthing is more diversified though, with Iceland accounting for less than 25% of income once the NIBC deal has closed.

Glitnir remains much more dependent on Iceland (50%+) and potentially lower-growth retail banking exposure at BNbank in Norway, and has higher acquisition risk. Glitnir is more expensive, with excessive reliance on commissions and financial income.

Table 1: Icelandic banks vs. Corporate & Investment banking and Nordic peers UBS Price TP Up-/ Down Mcap. Price Perf. EPS growth PERRec. in LC in LC side in % in € 2006 2007 YTD 06/05 07/06E 08/07E 2006 2007E 2008E

IcelandGlitnir Sell 24.3 20.0 -17.7% 4bn 35% 6% 98% -23% -1% 7.3x 10.3x 10.2x

Kaupthing Neutral 930.0 960.0 3.2% 10bn 17% 9% 53% -21% 0% 8.7x 12.7x 12.7x

SwedenSwedbank Buy 205.5 290.0 41.1% 11bn 15% -17% -7% 7% 9% 11.4x 8.9x 8.2x

Nordea Neutral 106.5 115.0 8.0% 30bn 28% 1% 43% -6% -9% 9.6x 10.3x 11.2xSEB Buy 181.0 270.0 49.2% 14bn 33% -17% 52% 7% 5% 11.7x 9.1x 8.7xSHB Neutral 201.0 220.0 9.5% 14bn 5% -3% 19% -4% 0% 10.2x 10.3x 10.3x

DenmarkDanske Bank Neutral 205.0 240.0 17.1% 19bn 13% -18% 14% -5% -9% 10.7x 8.5x 9.0x

NorwayDnB Nor Neutral 85.3 93.0 9.0% 14bn 23% -4% 15% 5% -6% 10.1x 10.0x 9.9x

CIB PeersDeutsche Bank Neutral 89.4 99.0 10.8% 47bn 24% -12% 81% 13% -14% 10.4x 8.3x 7.9x

Natixis Neutral 14.1 13.8 -1.8% 17bn 51% -34% 22% 9% -18% 12.4x 8.9x 9.1x


We value both banks using a single-stage Gordon growth model, with a COE of 10.7% and a long-term growth rate of 3.0% for 2008E ROE. For detailed valuations please refer to the company sections in this report.

Table 2: Icelandic banks – UBS EPS forecasts vs. consensus

2007E UBS 2007E Cons In % 2008E UBS 2008E Cons In %

Glitnir 1.96 2.08 -5.7% 1.95 2.36 -17.0%

Kaupthing 91.1 102 -10.6% 91.2 107 -14.0%

Source: UBS estimates. Note that the consensus range is very limited, particularly in the case of Glitnir


UBS 8

Are Icelandic banks good investments? Strong price performance in 2006 and H1 07 Icelandic banks have outperformed year-to-date, weathering the upheaval in credit markets better than many other European peers.

The key question for us going forward is whether this is more related to short-term effects such as the strengthening of the funding profiles which began after the brief localised financial crisis last year and during the market exuberance in the first half of 2007, or if there is something materially different in their models that will allow them to keep up the growth momentum.

Chart 14: Icelandic banks’ long-term performance vs. MSCI Europe

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OMX ICELAND ALL SHARE - PRICE INDEX MSCI EUROPE - PRICE INDEXKaputhing GlitnirLandsbanki

Source: Thomson Financial and UBS

Performance in the first six months of this year certainly had a lot to do with catch-up potential due to much higher-than-expected growth from equity divestments and capital market activity. The world has change materially over the summer. We believe that now is the time for investors to ask themselves where the Icelandic banks can go medium term, and what multiples one should pay for these earnings streams and how they will weather any potential storms.

Chart 15: Price performance vs. UBS forecast EPS growth in 2008 for some capital market exposed stocks in Europe

Chart 16: Icelandic banks against the MSCI European banks index year-to-date

-40%

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Kaup

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ir

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Natix

is

Performance YTD EPS 2008/07E

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29 J

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ov 0

7

KAUPTHING BANK GLITNIR BANKI DEUTSCHE BANK NATIXIS SEB 'A'

Source: UBS estimates, Thomson Financial. Note: UBS forecasts are based on IBES Source: Thomson Financial and UBS


UBS 9

2008 earnings are unlikely to keep up the pace European banks have performed -10% in absolute terms year-to-date. Against this, Glitnir’s 6% year-to-date price performance contrasts with our expectation of -1% profit growth for FY 2008. In the case of Kaupthing, +10% price performance compares with our forecast 0% EPS growth next year that includes the dilution effect from the NIBC financing.

These growth rates are much more in tune with the current environment and other UBS forecasts for banks with a comparable business mix. Icelandic banks have grown faster than most other European banks, outgrowing the European banking average by 40% since 2002, which we believe might have been an exceptional period as the base from which to grow was very small.

Table 3: Net income CAGR of Kaupthing and Glitnir, 2002-06 and forecasts for 2008-09

Net income CAGR 2002-06 Net income 2008-09E

Kaupthing 76% 6.0%

Glintir 63% 4.0%

European banks 28% 10.0%

Source: UBS estimates and company reports

Higher interest rates and funding costs, falling GDP growth rates globally and high imbalances in the Icelandic economy have yet to be reflected fully in the Icelandic banks’ share price performances.

While we believe that, longer term (1) the Icelandic banks’ model is sustainable; (2) management is good; and (3) the expansion of Glitnir and Kaupthing into Europe is fundamentally the right strategy, we believe that market is potentially looking at their earnings streams from a blue-sky scenario. The precise timing of such a normalisation is difficult to predict. The chances of this becoming the case over the next year or so are higher than at any time over the past five years in our view.

When it happens we will get to see how resilient the capital market businesses really are and if the fast expansion of the loan book has gone hand in hand with quality lending. Naturally this is more likely to be the case in a retail banking driven business model than in a corporate bank. We believe the risk/reward relationship in the event of a normalisation or even a downturn in capital markets and credit provisions may be stacked against the Icelandic banks; conversely, though, in an expansion phase we believe they will perform better than many other European banks.

The business mix has changed Internationalisation

Even if we are too cautious on earnings growth, we believe that one important additional consideration has to be carefully assessed by investors: internationalisation also means linkage into local economic cycles where underlying growth and local stock market performance has been much more in sync with the large global economies. Overall these have shown signs of slowing even if we are talking only about a mid-cycle slowdown.

Icelandic banks are no longer a play on the local economy


UBS 10

Icelandic banks used to be plays on the local economy and stock market. This remains true only to a certain degree today. At present all three major Icelandic banks earn at least 45% of their income outside Iceland: in Kaupthing’s case it is already 75%.

Chart 17: Kaupthing – net operating income post NIBC acquisition

Chart 18: Glitnir 1H07– PBT (before FIM acquisition, Nordic part will increase)

Chart 19: Landsbanki 1H07– net operating income

Iceland, 25%

Scandinav ia, 23%

UK, 19%

Benelux , 25%

Other, 8%

Iceland, 55%

Nordic, 25%

Europe, 5%

International, 16%

Iceland53%

UK/Ireland19%

Lux embourg6%

Nordic and Cont.Europe22%

Source: Kaupthing and UBS estimates Source: Glitnir Source: Landsbanki

Corporate & Investment banking driven

Icelandic banks are working on the basis of a corporate and investment banking business model with a focus particularly on small and medium-sized enterprises. This function gets combined with the ability to underwrite and distribute, and to provide market access through brokerage operations. A key differentiator to other Nordic and European banks is the high reliance on income from financial transactions. The latter has been one of the main drivers for performance over the past two years, as conditions for asset disposals were extremely favourable and risk appetite high.

In terms of business mix, all three banks are hugely dependent on capital markets, corporate revenues and investment banking. This income segment is significantly above the European average and should be more volatile than other European banks’ earnings streams.

Chart 20: Kaupthing segmental overview (operating income FY 2007E)

Chart 21: Glinir segmental overview (PBT H1 2007)

Chart 22: Landsbanki segmental overview (PBT H1 2007)

Capital Markets23%

Inv estment Banking

16%

Treasury 8%

Banking43%

AM & PB10%

Corporate Banking, 30%

Markets, 26%

Retail Banking, 21%

Inv estment Banking, 12%

Inv estment Management, 9%

Treasury and Other, 2% Retail Banking

11%

Corporate Banking

35%

Investment Banking

50%

Asset management and Private Banking

4%

Source: Kaupthing and UBS estimates Source: Glitnir and UBS estimates Source: Landsbanki and UBS estimates

Under what circumstances would a more positive view be justified?

(1) The worst of the credit crunch is behind us and normalisation sets in over the coming months, which would limit the negative effect on net interest income from higher funding costs and allow wider asset margins to fall right through to the bottom line. It would also be a positive sign for NIBC’s securitisation and syndication platforms and equity divestments in general.

Business model is CIB-driven


UBS 11

(2) The new investment cycle in Iceland that is expected to start 2008-09 makes itself felt earlier than anticipated.

(3) Should inflation be less of an issue central bank easing could start earlier. Lower inflation pressure together with an interest rate cut might instil more confidence in the economy, perhaps with a negative short-term adjustment effect on the currency. Following that we could look to the future with greater confidence.

(4) Capital markets continue to perform well and opportunities to harvest more of the investments remain strong. Revenues from financial investments have been strong all year but are, in our view, at unsustainably high levels. Since at a large part of the portfolios is related to listed entities, a positive mark-to- market effect remains a function of the markets. Our assessment is that equity markets remain by and large stable or move slightly upwards over the next 12 months, but that investor appetite for risky assets is nowhere near where it was a few months ago.

Support from cross-shareholdings As shown in Chart 23, Icelandic banks have benefited from a dense network of cross-shareholdings and nominee funds (some in Luxembourg). It would be a plus for the investment case if the nature of these investment companies could be made clearer.

Another point to make is that Icelandic pension funds have likely been net buyers of the banks this year. Going forward we believe that they will likely remain strong supporters of the banks and other local companies simply due to the fact that if you have ISK liabilities, from a long term risk management perspective you are in a much more comfortable position by holding ISK denominated assets. We note, however, that there is no obligation to be invested in Icelandic stocks, as is the case, for instance, in Australia’s ‘super annuity’ scheme. Overall we believe that the network of cross-shareholdings and local pension funds may, however, act as a cushion against sharp price movements.

Every major acquisition requiring external capital is likely to erode these strong links a bit further, as the 15.9% stake of JC Flowers group in Kaupthing post the capital increase for NIBC is an example for. While there is a lock-up until year-end 2008 for 110m of the 140m shares that JC Flowers will be paid for NIBC, medium term this will increase the likelihood for shares to come to the market.

The other function that these stakes have is that they provide some take-over protection. We do not see the M&A angle as a way to play any of the banks for now.

We believe the Icelandic banks are acquirers rather than targets and that their valuations should reflect that risk, as they use FCF generated from their own high RoE core business and equity investments into lower-ROE businesses, as we highlight in more detail in the section on Kaupthing’s acquisition activity.

Performance has been supported by a dense web of cross-shareholdings

No M&A plays but more likely acquirers


UBS 12

Chart 24: Icelandic banks – shareholding structure

Landsbanki

Glitnir Straumur

Kaupthing

LB Holdings Ltd


SP-Fjarmognun hf



Exista B.V.

Egla Invest B.V.


23.0%

9.9%

1.99%3.5% 2.4%

50.1%

67%


FL GLB Holding B.V.



5.0%

7.0%

13.1%

17.1%

4.9%

5.2%

5.2%


2.3%2.8%



40.7%

32.9 %1.0%

0.8%

1.9%5.7%

3.2%


3.8%


2.8%

Citibank

2.0%

24.2 %

1.0%

6.8%

3.7%

Property Group50.0%

0.8%


7.2%

2.5%


1.0%

0.8% 0.8%

Union Group AS

Kreditkont hf

Glitnir Real Estate

50.1%

55.0%

59.0%

2.3%

3.7%



1.1%

0.98%


2.4%Proteus

Global holding

2.0%

Gildi Pension Fund

1.8%

Sund ehf

1.4%


Mezzanine Cap, DK

20%Drake Mgmt, US

FiNoble Adv, India

22.7%

20%


GLB Hedge (Glitnir)


Landsbanki Lux

Wood & Co50.0%

Saxbygg Invest ehf


15.9%*


Landsbanki

Glitnir Straumur

Kaupthing

LB Holdings Ltd


SP-Fjarmognun hf



Exista B.V.

Egla Invest B.V.


23.0%

9.9%

1.99%3.5% 2.4%

50.1%

67%


FL GLB Holding B.V.



5.0%

7.0%

13.1%

17.1%

4.9%

5.2%

5.2%


2.3%2.8%



40.7%

32.9 %1.0%

0.8%

1.9%5.7%

3.2%


3.8%


2.8%

Citibank

2.0%

24.2 %

1.0%

6.8%

3.7%

Property Group50.0%

0.8%


7.2%

2.5%


1.0%

0.8% 0.8%

Union Group AS

Kreditkont hf

Glitnir Real Estate

50.1%

55.0%

59.0%

2.3%

3.7%



1.1%

0.98%


2.4%Proteus

Global holding

2.0%

Gildi Pension Fund

1.8%

Sund ehf

1.4%


Mezzanine Cap, DK

20%Drake Mgmt, US

FiNoble Adv, India

22.7%

20%


GLB Hedge (Glitnir)


Landsbanki Lux

Wood & Co50.0%

Saxbygg Invest ehf


15.9%*


Source: UBS estimates based on company disclosures YE 2006 with updates reflected YTD where available


UBS 13

Macro profile: Slowing trends We believe the high GDP growth rate that the Icelandic economy has shown over the past four years is likely to be below trend between 2007 and 2009. Our UBS economists have also been revising their growth estimates downward for the Nordic countries, the euro zone and the UK next year. While we believe that the banks can continue to perform well in a European context in an expansion phase, we believe that the risk/reward balance is stacked against them for the next 6-12 months and that growth expectations may be too ambitious.

Chart 25: Icelandic banks – macro profile Past 3 years 2007-2009E

Low High Low HighGDP Growth GDP GrowthInterest rates Interest ratesInflation InflationExchange rate risk Exchange rate riskCurrent account Current account



What is the basis for our assessment?

(1) Negative GDP revisions: We have seen negative GDP growth revisions in major economies over the past year. Iceland is due to post is lowest GDP growth figure in five years: GDP growth is widely expected to be around 1% this year. The recovery may take longer, based on developments in other major economies, investment projects, high interest rates and the delay to the easing cycle after the recent rate hike.

Table 4: GDP growth forecasts relevant to the Icelandic banks’ investment case

2005 2006 2007E 2008E 2009E

EU13 1.6 2.9 2.6 1.6 1.7

Germany 1.0 3.1 2.6 1.9 1.8

France 1.7 2.2 1.8 1.5 1.5

UK 1.8 2.8 3.0 1.8 2.0

Netherlands 1.5 3.0 2.6 1.8 2.2

Belgium 1.4 3.0 2.6 1.9 2.0

Finland 2.9 4.9 3.6 3.4 3.5

Sweden 2.9 4.5 3.2 2.5 2.2

Norway 2.9 2.8 5.2 2.6 2.3

Denmark 3.1 3.5 1.4 1.0 1.7

US 3.1 2.9 2.1 2.0 2.5

World 4.7 5.1 4.8 4.3 4.1


We also expect 2008 will be a slower year for both Sweden and Norway, with slower global growth taking a toll on both economies. We recently downgraded our 2008 GDP growth forecasts, expecting Sweden to slow to 2.5% (from 3.2% in 2007), and Norway to slow to 2.7% (from 5.2%). We forecast the Swedish


UBS 14

Riksbank and Norges Bank to be easing by late 2008, which should help to limit downside economic performance going into 2009.

(2) Interest rates are likely to slow demand and recovery: On 2 November the Icelandic central bank, Sedlabanki, increased its policy rate by 45bps to 13.75% in an unexpected move, citing higher-than-expected inflation risk and imbalances in the economy.

The assessment of the economics departments at local banks is that rates will remain on hold until the middle of next year, when we may see the first easing steps provided inflation shows signs of meeting the price adjustment target set out by the central bank.

Chart 26: 3m REIBOR Chart 27: CPI

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

Aug

98

Aug

99

Aug

00

Aug

01

Aug

02

Aug

03

Aug

04

Aug

05

Aug

06

Aug

07

3-month REIBOR

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

Jan-

04

Apr-0

4

Jul-0

4

Oct-0

4

Jan-

05

Apr-0

5

Jul-0

5

Oct-0

5

Jan-

06

Apr-0

6

Jul-0

6

Oct-0

6

Jan-

07

Apr-0

7

Jul-0

7

Oct-0

7

CPI

Source: Sedlabanki and UBS Source: Sedlabanki and UBS

Table 5: UBS Interest rate forecasts

Euro-area Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Dec-07

Refi rate 4.00 4.00 4.00 3.75 3.50 3.50 3.50 3.50 3.50 3.50

3 month Interest Rate 4.58 4.65 4.55 4.20 3.85 3.75 3.70 3.65 3.60 3.55

10 year Bond Yield 4.30 4.05 3.90 3.85 3.90 4.00 4.10 4.20 4.30 4.30

Norway Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Dec-07

Deposit Rate 5.00 5.25 5.50 5.50 5.25 5.00 5.00 5.00 5.00 5.00


10 year Bond Yield 4.81 4.80 4.45 4.30 4.25 4.30 4.40 4.50 4.60 4.70

Sweden Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Dec-07

Repo Rate 4.00 4.00 4.25 4.25 4.25 4.00 4.00 4.00 4.00 4.00


10 year Bond Yield 4.20 4.30 4.05 3.90 3.80 3.85 3.95 4.05 4.15 4.25

United Kingdom Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Dec-07

Repo Rate 5.75 5.75 5.50 5.25 5.00 5.00 5.00 5.00 5.00 5.00


10 year Bond Yield 4.81 4.80 4.75 4.75 4.80 4.80 4.80 4.80 4.85 4.85


In Norway the picture of strong growth in H1 2007 is largely confirmed; and it looks like 2007 growth will likely come in well above the 5.25% that the Norges


UBS 15

Bank currently expects. The implication is that we believe the Norges Bank will continue to hike rates, with a December move to 5.25% now all the more likely. Stronger than expected GDP data imply that the output gap is probably wider than the Norges Bank expected it to be at this stage in the cycle, hence the chances of another rate hike to 5.50% have also probably increased.

(3) Exchange rate volatility: The Icelandic central bank maintains that the exchange rate of the Icelandic krona (ISK) is a source of uncertainty for the inflation outlook for the next few years. A high real exchange rate and the prospect of continuing external debt accumulation weaken the foundations of the ISK. The ISK could depreciate abruptly if global market conditions deteriorate to any substantial degree. While local banks generally agree with this statement, we believe that, short term, the exchange rate will strengthen rather than weaken following the surprise interest rate hike. For some banks with hedges to protect their equity ratios against a fall in the exchange rate this will cause short-term treasury losses (as was the case for Landsbanki and to some extent Glitnir at recent Q3 results). It will likely be an issue for Q4 as well, ceteris paribus. Longer term, Icelandic banks consider the ISK about 10-15% overvalued.

Chart 28: ISK/EUR avg. and 1 standard deviation since 1999 Chart 29: Current account balance is negative

65

70

75

80

85

90

95

100

Jan

99Ap

r 99

Jul 9

9Oc

t 99

Jan

00Ap

r 00

Jul 0

0Oc

t 00

Jan

01Ap

r 01

Jul 0

1Oc

t 01

Jan

02Ap

r 02

Jul 0

2Oc

t 02

Jan

03Ap

r 03

Jul 0

3Oc

t 03

Jan

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r 04

Jul 0

4Oc

t 04

Jan

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r 05

Jul 0

5Oc

t 05

Jan

06Ap

r 06

Jul 0

6Oc

t 06

Jan

07Ap

r 07

Jul 0

7Oc

t 07

ISK/EUR

AVG

+1 STDV

-1 STDV

-50%

-40%

-30%

-20%

-10%

0%

10%

1:19

992:

1999

3:19

994:

1999

1:20

002:

2000

3:20

004:

2000

1:20

012:

2001

3:20

014:

2001

1:20

022:

2002

3:20

024:

2002

1:20

032:

2003

3:20

034:

2003

1:20

042:

2004

3:20

044:

2004

1:20

052:

2005

3:20

054:

2005

1:20

062:

2006

3:20

064:

2006

1:20

072:

2007

Income account balance Serv ice account balance Mercandice account balance

Source: Thomson Financial and UBS Source: Sedlabanki and UBS

(4) The financial stability of the Icelandic banking system is sound but CDS spreads remain at very elevated levels: Irrespective of our assessment of the Icelandic banks’ equity story, we believe that structurally the central bank and FME (the financial regulator) have done a very good job in reducing the banks’ wholesale funding reliance and increasing their deposit-taking activities after the ‘mini’ crisis last year and long before this became a major topic among the European banks this year. Icelandic banks can survive without capital market access and without curbing their normal business activity for at least a year. We describe a few stress-test scenarios in the section entitled “Financial stability matters”.

We are concerned that CDS spreads for Icelandic banks remain at elevated levels. However, once Kaupthing’s capital raising has been completed before year-end we expect them to normalise.


UBS 16

Should this not happen this would be a negative for our investment case. For now the very generous maturity profile of 420 days of secured liquidity at Kaupthing and the other Icelandic banks gives us little to worry about. The last Kaupthing USD issue came with a 9% coupon, and Kaupthing also issued debt in Mexico recently.

Going forward we expect higher funding costs to slow net interest income, at least for next year.

Chart 30: CDS spreads for Icelandic banks and ITRAXX, to 15 November

0

20

40

60

80

100

120

140

160

180

May06

Jun06

Jul06

Aug06

Sep06

Oct06

Nov06

Dec06

Jan07

Feb07

Mar07

Apr07

May07

Jun07

Jul07

Aug07

Sep07

Oct07

Kaupthing Glitnir Landsbanki Itrax x Financial Europe

Source: Landsbanki and UBS; Kaupthing had the highest CDS spreads at mid-November 2007

Overall the market has treated the Icelandic banks pretty well during periods of financial crisis, despite their high level of corporate banking, capital market and private equity exposure. However, this may not be a guide for the future, in particular if the current credit crisis takes much longer than expected to unwind.

Chart 31: Icelandic banks’ performance during periods of financial crisis

Start 2-Oct-87 17-Jul-90 28-Jan-94 6-Aug-97 17-Jul-98 7-Sep-01 1-Jan-03 2-Apr-04 2-May-06 1-Jul-07End 7-Dec-87 12-Oct-90 4-Nov-94 12-Jan-98 22-Sep-98 21-Sep-01 12-Mar-03 19-May-04 30-May-06 30-Nov-07Duration 5 5 6 2-3 4 1 2-3 1 1 5

Wall

stree

t Cra

sh (

5 mon

ths)

First

Iraq W

ar

(5-

month

s)

Bond

mar

ket c

rash

(6 m

onths

)

Asian

bank

ing cr

isis (

Oct97

/Jan9

8)

Russ

ian de

fault

(Ju

l/Sep

98)

Sept.

11th

terro

rist a

ttack

(7-2

1Sep

01

Seco

nd Ir

aq w

ar (J

an/M

ar03

)

April/

May 2

004

May/J

une 2

006

July/

Nov 2

007

Kaupthing n/A n/A n/A n/A n/A -15.2% 6.5% 7.1% 6.1% -16.9%Glitnir n/A n/A n/A n/A n/A -2.9% 7.6% 1.9% 4.1% -14.2%Landsbanki n/A n/A n/A n/A n/A -4.1% 7.7% 1.9% 4.7% -1.3%Straumur n/A n/A n/A n/A n/A n/A n/A n/A 3.6% -24.3%Europe Local Stock market -26.0% -12.0% -1.3% 1.3% -19.2% -15.2% -13.8% -4.4% -6.0% 3.1%Europe banking sector -23.3% -15.7% -7.2% 4.1% -28.0% -19.8% -15.0% -4.3% -6.4% -5.1%

Source: UBS and Thomson Financial


UBS 17

Glitnir (Sell, PT ISK20, -19%) An acquisition-fuelled story We initiate coverage of Glitnir with a Sell rating and a price target of ISK20. Chart 32 below outlines the bank’s investment profile.

Chart 32: Glitnir investment profile Past 3 years 2007-2009E

Low High Low HighGrowth GrowthStrategic Positioning Strategic PositioningReturns ReturnsValuation ValuationRisk RiskManagement Management


In our view, Glitnir’s main attributes can be summarised as follows:

Glitnir is the second-largest of the Icelandic banks by market cap (~€5bn). Glitnir has grown rapidly into 11 countries over the past five years, and now describes itself as a “Nordic Financial Group”. Its next key challenge will be the consolidation and integration of the acquisitions made over recent years.

Glitnir has bought into retail banks in Norway, commercial real estate operations in Sweden and an asset management company in Finland. A main feature of the recent investor day was that these companies need to be better integrated into the group than they already are. In the case of the Norwegian operations growth has been disappointing and possibly led to a management change earlier this year. Glitnir no longer shows growth rates of its Norwegian franchise separately in its divisional results, where it has switched to segmental reporting.

Glitnir is a bank whose risk profile is significantly above the European average. Over the past few years this has been compensated by exceptionally high returns from financial and commission income. We believe that the next stage for Glitnir will be to consolidate and achieve sustainability. This typically goes hand in hand with a slowdown of earnings growth but more predictability. We do not forecast that market-related revenues will decline but apply growth rates similar to those of other major CIB-focused banks in our forecasts. We forecast a net profit decline of 1% next year. As soon as the valuation has moved back into more attractive territory we will reassess our rating.

New management team: Glitnir’s new CEO, Larus Walding, was head of Landsbanki’s London branch until Q1 07, and has been developing a new strategic plan for Glitnir that was presented to the market on 1 October. This presentation focused among other things on how Glitnir intends to build a stable revenue base from investment and retail banking in its second home market, Norway. Glitnir wants to pursue targeted geographical expansion through a niche strategy focusing on internal and external growth.


UBS 18

Glitnir’s strategy going forward will be to further strengthen its CIB footprint in the Nordic region and develop its areas of expertise (seafood, geothermal energy, shipping etc.) globally where they are a reference point for global clients and have an edge over the competition. The latter argument makes absolute sense to us, while the former indicates investments in expensive new staff and platforms at what may not be the right time in the cycle.

Arguments for a cautious view

We fully appreciate the growth and expansion that has been created at Glitnir over the last few years. We also think it is important to note that our cautious view is not based on an assessment that management cannot build on what has been created over the past few years. On the contrary, we believe that management can deliver, but we believe it typically takes longer to create an integrated franchise, as many other multi-regional mergers have shown.

We are also concerned that the growth rates that a business such as Glitnir’s should achieve at this point in the cycle, following four years of strong growth for corporate banking models, may disappoint. Specifically, we believe Glitnir will struggle to deliver the high growth rates that have been built into the share price in its capital market and corporate banking operations.

At the same time we do not believe that its Norwegian operations can structurally pick up in growth and deliver the same growth rates Glitnir has shown in the past, given that GDP growth rates have slowed in this market.

Glitnir trades at a significant premium to the European banks average, both on a PE and PBV basis. Moreover, it offers little support from a dividend perspective, where it offers 1.8% yield against an average of 4.1% for the European banks.

Another point for consideration: If Glitnir was to trade at a multiple in line with European banks average next year net profits would have to grow by 30%.

Chart 34: Glitnir asset and PBT growth since 2000

0

5

10

15

20

25

30

2000 2004 2005 2006 H1 2007

0

100

200

300

400

500

600

700

800

900

1000

Assets (€bn) PBT (EURm)

Domestic consolidator in Iceland

+13%

Kredittbankenin Norw ay

+43%

Bnbank &FactoNor in Norw ay

+20%

Norse Securities & Union in Norw ayFischer Partners,

Sw edenNorsk Priv atOkonomi

in Morw ay

+17%

FIM in FinlandLeimdörfer &

BSA

Source: Glitnir and UBS

Chart 33: Glitnir trading and fair value assets as a % of total assets

0%

5%

10%

15%

20%

25%

2001

2003

2005

2007

2009

Trading & fair v alue assets in % of Total assets

Source: Glitnir and UBS estimates


UBS 19

The best part of the story may be behind us We believe Glitnir’s management may struggle mainly with its outlined revenue and profit growth target of 10-20% over the forecasting period. On the revenue side we forecast that Glitnir will deliver growth at the lower end of its target range in 2008-10, while we forecast net profits will be in the single-digit area. Glitnir should make its dividend targets, in our view.

We fear that revenue and profit growth may ultimately succumb under the weight of a larger franchise that is less agile than it used to be and is now competing for business that other regional banks see as part of their core operations. In particular if Norway’s still generous 19% yoy corporate credit growth rates begin to slow.

Table 6: Glitnir’s medium-term targets

ROE Tier-1 ratio Cost-income

ratio Revenue and profit growth Dividend

Glitnir Risk-free rate

+6%

Tier-1 ratio>8%

CAD>11% <45% 10-20%

20-40% of

profits

Source: Company reports

We view the quality of the revenue mix as below the average of our European banks universe. It is driven predominantly by non-interest-income lines, which are market driven.

Chart 35: 2007E revenue mix for Glitnir

Net Interest Income44%

Net Fee & Commission Income

46%

Net financial income4%

Other operating Income

6%


UBS profit and loss forecasts Our revenue forecasts point to 8% growth in 2008 driven by NII and

commission income. Our assumption of a pick up in 2009 in NII is driven by expectations of a new investment cycle to begin in Iceland, which could prove too optimistic. Moreover we note that for many other Nordic banks we forecast falling NII growth rates over the next two years. We assume no

Quality of the revenue mix


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further increase from already high normalised levels of net financial income. We assume that this income will start growing again to the tune of 12% in 2009 and 14% in 2010. Our Q4 net financial income does not forecast an exceptionally high contribution, as was the case in Q4 2006. We have no information as to what the strategy is with regard to the portfolio of financial investments, but would consider any material contribution as a low-quality item.

Our expense forecasts assume significant investments for 2007 in particular in areas of capital markets and investment banking where staff costs are higher. Expense growth is likely to slow to 6%, leaving 2% positive operating leverage, which may be too optimistic. Over the past two years Glitnir has delivered negative jaws, and we believe expenditure could easily outstrip revenues again.

Our credit provisioning forecasts assume an increase from 22bps for 2007 over customer loans to 35bps for 2008. Over the forecast period we do not anticipate provision requirements hitting the peak level of 82bps seen during the past downturn: the peak level in our model is set at 65bps, for 2010. We note that the relatively young nature of the book may disguise future credit provisioning needs for some time. Our risk for credit provisions may therefore be slightly to the downside short term, but medium term the pace of new provisioning requirement could surprise us on the upside, which indirectly typically also affects costs negatively.

We assume that the effective tax rate for Glitnir will stay below the official tax rate for Iceland of 18%. We assume 16% for 2007 and 17-18% thereafter.

On the bottom line we forecast net profits to fall 1% next year, which is a touch more positive than we expect for French banks, for instance. We expect profits to rise again by 6% in 2009 and 8% in 2010.

Chart 36: Glitnir’s PBT breakdown – exposure to Iceland remains high

Iceland, 55%

Nordic, 25%

Europe, 5%

International, 16%


Below we summarise our P&L forecasts in more detail. Glitnir reports in Icelandic krona. Kaupthing has recently announced it intends to switch to euros, since going forward only about 25% of earnings will be generated in Iceland


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itself. Glitnir may do likewise in due course, as and when non-Icelandic income streams surpass domestic income.

Chart 37: Glitnir Bank P&L forecasts Profit & Loss in ISKm Reported Forecasts Forecasts CAGR

in ISK millions 2001 2002 2003 2004 2005 2006 2007E 2008E 2009E 2010E 2007E/2006 2008E/2007E 2009E/2008E 2010E/2009E 2002/2006Net Interest Income 10,049 9,708 11,039 12,776 22,351 37,084 36,968 39,697 45,914 53,103 0% 7% 12% 14% 40%Net Fee & Commission Income 3,591 3,480 3,752 6,610 8,773 26,459 38,366 41,435 45,578 51,048 45% 8% 10% 12% 66%Net financial income -706 65 3,271 8,614 3,993 8,503 2,976 2,976 3,214 3,600 -65% 0% 8% 12% 238%Other operating Income 191 625 229 525 1,294 555 4,995 5,495 6,044 6,648 800% 10% 10% 10% -3%Total Income 12,921 14,074 19,061 28,525 36,411 72,601 83,304 89,602 100,750 114,399 15% 8% 12% 14% 51%Salaries and salary related -15,747 26,140- 27,708- 29,648- 32,316- 66% 6% 7% 9%Other operating expenses 7101 7723 -9,769 -14,357 -15,731 -11,554 17,909- 18,983- 20,312- 21,937- 55% 6% 7% 8%Total Operating Expenses -7,101 -7,723 -9,769 -14,357 -15,731 -27,301 - 44,049 - 46,692 - 49,960 - 54,253 61% 6% 7% 9% 37%GOP 20,022 21,797 9,292 14,168 20,680 45,300 39,256 42,911 50,790 60,145 -13% 9% 18% 18% 20%Impairment losses on loans and receivables - 2,113 - 2,184 - 2,864 - 3,137 - 2,205 - 4,759 4,647- 7,985- 13,118- 19,612- -2% 72% 64% 50% 21%

Provisions in bps 73 79 82 60 19 27 22 35 50 65 -19% 59% 43% 30%Loans and receivables 290,811 276,578 349,759 524,020 1,174,428 1,760,368 2,112,442 2,281,437 2,623,652 3,017,200 20% 8% 15% 15%

Share of profit of associates 146 1,262 1,470 147 154 170 187 -90% 5% 10% 10%Net gains on non-curr assets classified as held for sale 2,916 3,323 4,244 849 891 980 1,078 -80% 5% 10% 10%PBT 17,909 19,613 6,428 14,093 23,060 46,255 35,604 35,971 38,822 41,799 -23% 1% 8% 8% 24%Income tax -567 -760 -593 -2,135 -4,174 -8,024 5,697- 6,115- 6,988- 7,524- -29% 7% 14% 8% 80%

Tax rate 3.2% 3.9% 9.2% 15.1% 18.1% 17.3% 16% 17% 18% 18%Net Profit 17,342 18,853 5,835 11,958 18,886 38,231 29,907 29,856 31,834 34,275 -22% 0% 7% 8% 19%Minority interest 0 0 0 0 -871 -1307 -1437 -1581 -1739 50% 10% 10% 10%Attributable Net Profit 3,140 3,407 5,835 11,958 18,886 37,360 28,601 28,419 30,253 32,536 -23% -1% 6% 8% 82%

Adjustments/ Exceptionals 0 0 0 0 0 -4,500 0 0 0 0

Adjusted Net Profit 3,140 3,407 5,835 11,958 18,886 32,860 28,601 28,419 30,253 32,536 -13% -1% 6% 8% 76%

Earnings per share, ISK (as repoted by Glitnir) 0.32 0.36 0.63 1.18 1.47 2.68 1.96 1.95 2.07 2.23 -27% -1% 6% 8%Adjusted EPS 0.36 0.63 1.18 1.47 2.36 1.96 1.95 2.07 2.23 -17% -1% 6% 8%Stated PE 13.0x 10.3x 9.7x 11.7x 8.7x 12.4x 12.5x 11.7x 10.9xAdjusted PE 13.0x 10.3x 9.7x 11.7x 9.9x 12.4x 12.5x 11.7x 10.9x


This table below summarises our quarterly P&L forecasts for Q1 06 to Q4 08. Seasonality patterns have yet to establish themselves at Glitnir given the speed of its organic growth and acquisitions.

Chart 38: Glitnir – quarterly forecasts

Quarterly results Forecasts

Q1 2005 Q2 2005 Q3 2005 Q4 2005 Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008

Net Interest Income 4,465 5,586 6,491 5,809 7,827 11,525 9,722 8,010 7,943 9,658 9,618 9,749 9924 9924 9924 9924Net Fee & Commission Income 1,660 2,198 2,007 2,908 5,626 5,534 5,093 10,206 7,298 8,888 10,864 11,316 10359 10359 10359 10359Net financial income 1,248 1,737 803 205 3,348 203 -188 5,140 651 792 790 743 744 744 744 744Other operating Income 484 30 54 726 47 181 228 99 59 1,879 2,518 539 1374 1374 1374 1374Total Income 7,857 9,551 9,355 9,648 16,848 17,443 14,855 23,455 15,951 21,217 23,791 22,345 22401 22401 22401 22401Salaries and salary related -4,807 -7,126 -7,063 -7,144 -6927 -6927 -6927 -6927Other operating expenses -4,219 -3,743 -3,539 -4,230 -5,872 -6,293 -6,692 7,303 -3,830 -5,002 -4,674 -4,403 -4746 -4746 -4746 -4746Total Operating Expenses -4,219 -3,743 -3,539 -4,230 -5,872 -6,293 -6,692 -8,444 -8,637 -12,128 -11,737 -11,547 -11673 -11673 -11673 -11673GOP 3,638 5,808 5,816 5,418 10,976 11,150 8,163 15,011 7,314 9,089 12,054 10,799 10728 10728 10728 10728Impairment losses on loans and receivables -501 -565 -494 -645 -1,424 -1,354 -328 -1,653 -1,232 -247 -1,671 -1,497 -1996 -1996 -1996 -1996Share of profit of associates 50 141 281 790 1186 140 69 75 -136 118 16 149 39 39 39 39Net gains on non-curr assets classified as held for sale 0 3,300 3 20 0 2,444 1,785 15 208 360 -3 284 223 223 223 223PBT 3,187 8,684 5,606 5,583 10,738 12,380 9,689 13,448 6,154 9,320 10,396 9,734 8993 8993 8993 8993Income tax -570 -1,199 -1,024 -1,381 -2,083 -2,101 -1,562 -2,278 -1,408 -1,766 -1,759 -764 -1529 -1529 -1529 -1529

23% 19% 17% 8% 0 0 0 0Net Profit 2,617 7,485 4,582 4,202 8,655 10,279 8,127 11,170 4,746 7,554 8,637 8,970 7464 7464 7464 7464Minority interest 0 0 0 312 162 -1,345 -393 -84 -753 -77 -359 -359 -359 -359Attributable Net Profit 3,038 7,519 4,801 3,528 8,655 9,967 7,965 10,773 5,139 7,638 9,390 6,434 7105 7105 7105 7105


UBS balance sheet forecasts

The key points for our balance sheet forecasts are a slowdown in customer loan growth this year to ~20%, having been 124% in 2005 and 50% in 2006. This lends support to our thesis that growth rates from the core business are likely to


UBS 22

moderate going forward. Our forecasts for financial assets held for trading and at fair value through the P&L also contain a marked slowdown but do not directly feed into our P&L forecasts.

On the liability side, we forecast deposits will continue growing rapidly, which should further improve the profile further. At Q3 Glitnir had increased deposits by 53% year-on-year, driven by money market deposits in the UK and by Finnish retail deposits. The loan-to-deposit ratio now stands at 300%, which is still high even compared with traditionally high levels in the Swedish banks universe.

Chart 39: Glitnir – balance sheet forecasts

Balance sheet in ISKm Forecasts Forecasts

ASSETS 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2005/2004 2006/2005 2007/2006 2008/2007 2009/2008 2010/2009Cash with central banks 16,345 9,902 9,774 6,242 20,861 20,417 40,834 44,917 44,917 44,917 234% -2% 100% 10% 0% 0%Loans and receivables 290,811 276,578 349,759 524,020 1,174,428 1,760,368 2,112,442 2,281,437 2,623,652 3,017,200 124% 50% 20% 8% 15% 15%Financial assets held for trading 29,835 17,888 50,691 109,046 151,897 227,251 295,426 324,969 341,217 341,217 39% 50% 30% 10% 5% 0%Financial assets at FV through P&L 3,632 96,438 200,864 291,253 320,378 352,416 387,657 2555% 108% 45% 10% 10% 10%Financial assets available-for-sale 11,065 3,611 3,746 4,121 4,533 4,986 5,485 -67% 4% 10% 10% 10% 10%Derivatives used for hedging 1,793 2,352 5,721 6,293 6,922 7,615 8,376 31% 143% 10% 10% 10% 10%Investments in associates 2,429 2,995 7,960 2,605 8,081 4,379 4,817 5,299 5,828 6,411 210% -46% 10% 10% 10% 10%Investment Property 1,560 - - - - - - n/a n/a 0% 0% 0% 0%Property and equipment 3,278 1,145 3,283 2,617 1,987 3,296 3,626 3,988 4,387 4,826 -24% 66% 10% 10% 10% 10%Intangible assets 309 270 11,588 11,866 10,824 18,310 51,268 56,395 59,215 62,175 -9% 69% 180% 10% 5% 5%Tax assets - 456 268 264 290 319 351 387 -41% -1% 10% 10% 10% 10%Non-current assets held for sale 593 551 409 450 495 544 599 -7% -26% 10% 10% 10% 10%Re-insurer's Share in Insurance Fund 1,607 1,308 - - - - - - n.a n/a 10% 10% 10% 10%Other assets 5,204 3,589 9,281 513 647 1,314 1,445 1,590 1,749 1,924 26% 103% 10% 10% 10% 10%Total assets 348,211 312,367 443,943 677,316 1,471,945 2,246,339 2,812,265 3,051,242 3,446,878 3,881,175 117% 53% 25% 8% 13% 13%Non-Performing Loans 4,815 4,258 9,098 13,637 16,365 17,674 20,325 23,373

LIABILITIES 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2005/2004 2006/2005 2007/2006 2008/2007 2009/2008 2010/2009Deposits from banks and central banks 32,104 24,150 27776 22,676 30,656 78,576 48,717 53,589 58,948 64,842 35% 156% -38% 10% 10% 10%Customer (other deposits) 77,823 85,827 107,672 155,602 304,136 438,272 701,235 757,334 870,934 1,001,574 95% 44% 60% 8% 15% 15%Wholesale funding (Borrowings) 200,318 164,077 231,944 382,020 937,794 1,377,787 1,653,344 1,736,012 1,909,613 2,100,574 145% 47% 20% 5% 10% 10%Subordinated loans 13,062 11,099 15,709 19,366 47,464 108,998 98,098 107,908 118,699 130,569 145% 130% -10% 10% 10% 10%Financial liabilities held for trading 12,546 28,791 51,729 82,766 91,043 100,147 110,162 129% 80% 60% 10% 10% 10%Derivatives used for hedging 3,677 7,233 13,869 13,176 14,493 15,942 17,537 97% 92% -5% 10% 10% 10%Post-employment obligations 2,607 418 529 899 989 1,088 1,197 -84% 27% 70% 10% 10% 10%Tax liabilities 3,563 5,086 10,647 15,438 16,982 18,680 20,548 43% 109% 45% 10% 10% 10%Other liabilities 3,916 5,893 10,649 7,331 25,830 19,813 79,252 87,177 95,895 105,484 252% -23% 300% 10% 10% 10%Deferred Income Tax Liability 701 357 1,357 - - - - na na 10% 10% 10% 10%Minority interest - 1,541 3,698 4,068 4,475 4,923 na na 140% 10% 10% 10%

o/w Retainted Earnings 3,140 1,779 3,700 8,397 13,996 28,162 21,451 21,314 22,690 24,402 67% 101% -24% -1% 6% 8%

Minority interest - 1,541 1,695 1,865 2,051 2,256 10% 10% 10% 10%Shareholders' funds 20,287 20,964 29,423 48,474 84,537 146,119 169,265 190,579 213,269 237,671 74% 73% 16% 13% 12% 11%Total liabilities and equity 348,211 312,367 424,530 657,862 1,471,945 2,246,339 2,842,744 3,038,860 3,385,001 3,770,679 124% 53% 27% 7% 11% 11%


Glitnir’s divisional forecasts

Glitnir has restated its divisional reporting several with the Q3 results. Looking at trends and making like-for-like comparisons with Icelandic and Nordic peers is therefore not an easy task. Until H1 07 Glitnir broke out its commercial baking operations for Iceland and Norway separately: Glitnir is moving in the same direction as Kaupthing has done in trying to present a segmental rather than a regional breakdown. As with other companies that have been trying to do this (ABN AMRO, Raiffeisen), we note that the appetite in the market for comparing regional results remains very high, such that companies have tended to give local results as well.

We note that the retail and commercial banking results in the table below are not like-for-like comparables, which makes an assessment of Glitnir’s earnings streams difficult.


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Chart 40: Glitnir – divisional forecasts (restatement in 2007 prevents like-for-like comparison of divisional results)

Break-up Analysis Forecasts Growth yoy Forecasts as a % of group Forecasts

Revenues 2004 2005 2006 2007 2008 2009 2005/2004 2006/2005 2007/2006 2008/2007 2009/2008 2004 2005 2006 2007 2008 2009 Retail Banking 12,938 16,881 22,433 17,833 19,006 20,738 30% 33% -21% 7% 9% 47% 55% 34% 21% 21% 21% Corporate Banking 3,038 6,580 12,478 22,827 23,521 25,695 117% 90% 83% 3% 9% 11% 21% 19% 27% 26% 26% Investment Banking - - 7,815 10,587 10,964 11,687 na na 35% 4% 7% 0% 0% 12% 13% 12% 12% Markets 3,372 3,956 17,856 21,537 22,563 24,385 17% 351% 21% 5% 8% 12% 13% 27% 26% 25% 25% Investment Management - - - 8,587 9,459 10,405 na na na 10% 10% 0% 0% 0% 10% 10% 11% Treasury 3,473 1,715 4,397 2,661 3,615 4,535 -51% 156% -39% 36% 25% 13% 6% 7% 3% 4% 5% Other 4,600 1,715 296 385 1,146 981 -63% -83% 30% 198% -14% 17% 6% 0% 0% 1% 1% Group 28,525 36,411 72,601 83,304 89,602 100,750

Growth yoy as a % of group Expenses 2004 2005 2006 2007 2008 2009 2005/2004 2006/2005 2007/2006 2008/2007 2009/2008 2004 2005 2006 2007 2008 2009 Retail Banking - 7,597 - 8,293 - 11,057 - 12,163 - 12,771 - 13,793 9% 33% 10% 5% 8% 53% 54% 37% 28% 28% 28% Corporate Banking - 1,136 - 2,483 - 3,231 - 8,756 - 9,194 - 9,929 119% 30% 171% 5% 8% 8% 16% 11% 20% 20% 20% Investment Banking - - - 1,686 - 2,870 - 3,071 - 3,317 na na 70% 7% 8% 0% 0% 6% 7% 7% 7% Markets - 1,068 - 984 - 6,735 - 12,123 - 13,335 - 14,402 -8% 584% 80% 10% 8% 7% 6% 23% 28% 29% 29% Investment Management - - - - 6,230 - 6,853 - 7,538 na na na 10% 10% 0% 0% 0% 14% 15% 15% Treasury - 314 - 1,807 - 6,735 - 400 - 440 - 484 475% 273% -94% 10% 10% 2% 12% 23% 1% 1% 1% Other - 4,226 - 1,807 - 109 - 1,000 - 500 - 550 -57% -94% 817% -50% 10% 29% 12% 0% 2% 1% 1% Group - 14,357 - 15,731 - 27,301 - 44,049 - 46,692 - 49,960

Growth yoy as a % of group Provisions 2004 2005 2006 2007 2008 2009 2005/2004 2006/2005 2007/2006 2008/2007 2009/2008 2004 2005 2006 2007 2008 2009 Retail Banking - 2,303 - 1,402 - 2,781 - 1,109 - 1,264 - 1,610 -39% 98% -60% 14% 27% 73% 60% 59% 22% 20% 19% Corporate Banking - 499 - 765 - 1,846 - 3,719 - 4,882 - 6,779 53% 141% 101% 31% 39% 16% 33% 39% 74% 77% 79% Investment Banking - - - 25 - 27 - 30 - 33 na na 8% 10% 10% 0% 0% 1% 1% 0% 0% Markets 1 - - 7 - 3 - 4 - 4 -100% na -59% 40% 8% 0% 0% 0% 0% 0% 0% Investment Management - - - - 125 - 137 - 151 na na na 10% 10% 0% 0% 0% 2% 2% 2% Treasury - - 90 - - - - na -100% na na na 0% 4% 0% 0% 0% 0% Other - 344 - 90 - 32 - 34 - 37 - 41 -74% -64% 6% 10% 10% 11% 4% 1% 1% 1% 0% Group - 3,137 - 2,205 - 4,759 - 4,647 - 7,985 - 13,118

Growth yoy as a % of group PBT 2004 2005 2006 2007 2008 2009 2005/2004 2006/2005 2007/2006 2008/2007 2009/2008 2004 2005 2006 2007 2008 2009 Retail Banking 3,038 7,176 8,677 4,643 5,057 5,426 136% 21% -46% 9% 7% 23% 36% 20% 13% 13% 14% Corporate Banking 1,403 3,332 7,401 10,352 9,445 8,987 137% 122% 40% -9% -5% 11% 17% 17% 29% 25% 23% Investment Banking - - 6,105 7,697 7,871 8,345 na na 26% 2% 6% 0% 0% 14% 22% 21% 21% Markets 2,305 2,972 11,114 9,411 9,223 9,978 29% 274% -15% -2% 8% 18% 15% 26% 26% 25% 25% Investment Management - - - 2,232 2,469 2,716 na na na 11% 10% 0% 0% 0% 6% 7% 7% Treasury 3,159 3,151 4,288 2,261 3,175 4,051 0% 36% -47% 40% 28% 24% 16% 10% 6% 8% 10% Other 3,092 3,151 5,299 - 949 279 27 2% 68% -118% -129% -90% 24% 16% 12% -3% 1% 0% Group 14,093 23,060 46,255 35,604 35,971 38,822

Growth yoy as a % of groupNet Income 2004 2005 2006 2007 2008 2009 2005/2004 2006/2005 2007/2006 2008/2007 2009/2008 2004 2005 2006 2007 2008 2009 Retail Banking 2,578 5,877 7,172 3,900 4,197 4,449 128% 22% -46% 8% 6% 23% 36% 20% 13% 13% 14% Corporate Banking 1,190 2,729 6,117 8,592 7,839 7,459 129% 124% 40% -9% -5% 11% 17% 17% 29% 25% 23% Investment Banking - - 5,046 6,389 6,533 6,926 na na 27% 2% 6% 0% 0% 14% 22% 21% 21% Markets 1,956 2,434 9,186 7,811 7,655 8,282 24% 277% -15% -2% 8% 18% 15% 26% 26% 25% 25% Investment Management - - - 1,853 2,050 2,255 na na na 11% 10% 0% 0% 0% 6% 7% 7% Treasury 2,680 2,581 3,544 1,877 2,635 3,362 -4% 37% -47% 40% 28% 24% 16% 10% 6% 8% 10% Other 2,624 2,581 4,380 - 788 231 22 -2% 70% -118% -129% -90% 24% 16% 12% -3% 1% 0% Group 11,958 18,886 38,231 29,907 29,856 31,834


Valuation Glitnir’s core valuations indicate that in PE terms the company is more expensive than Kaupthing. Moreover, the premium is substantial on a PE basis relative to the UBS European banking average, which comprises more than 60 banks. Glitnir currently trades in line with the Greek banks, whose earnings streams are driven by strong pent-up demand in retail as opposed to predominantly wholesale banking.

Bringing Glitnir into line with the European banking average over the next two years would imply double-digit revenue growth in 2007 and 2008. While we remain cautiously optimistic about revenue growth next year, we believe that it will be a weaker year than 2007 in terms of capital market and private equity activity. Glitnir’s business is cyclical and if the macro outlook is right then it may be facing at least a mid-cycle slowdown. We believe it would be unreasonable therefore to assume higher growth rates in particular, since


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Glitnir’s overall business activity is now almost 50% related to activities outside Iceland.

Table 7: Glitnir – valuation overview

2006 2007E 2008E 2009E 2010E

Adjusted PE 9.9x 12.7x 12.7x 12.0x 11.1x

European banks PE 10.1x 9.5x 8.5x NA

Premium in % +26% +34% +41% NA

PBV Glitnir 2.2x 2.1x 1.90x 1.7x 1.5x

PBV European banks 1.55x 1.45x NA NA

Premium in % 35% 31% NA NA

Cost/income 38% 53% 52% 50% 47%


We forecast Glitnir’s post-tax RoE is to decline from 22% last year (19% on an adjusted basis) to 17%, which was boosted by one offs from non current assets held for sale amongst others in 2006. We forecast Glitnir’s 2008 ROE will be in the region of 15%, assuming a slowdown in revenue growth to 8% and expense growth of 6%.

Table 8: Glitnir – ROE forecasts

In % 2006 2007E 2008E 2009E 2010E

Adj. RoE 19% 17% 15% 14% 14%


Our primary valuation model for Glitnir uses a one-stage Gordon growth model, the main variables being our ROE forecast for 2008 of 15%, a cost of equity level of 10.7% and a long-term growth factor of 3.0%.

Our cost of equity assumption looks at the major funding markets that Glitnir uses, which are mainly in the euro zone and the United States. Our average for Europe is typically 10%. We add 70bps in the risk premium to reflect higher refinancing costs in Iceland, above-average earnings volatility and investment risk in general.

Our long-term growth factor of 3.0% is in line with the UBS European average, reflective of our assumption of slowing growth rates over the forecast period. We note that a lot of the growth at Glitnir has been driven by expansion into the Nordic region into banks which are not growing very rapidly – as highlighted by the example of Glitnir’s operation in Norway – or whose performance is directly related to capital market performance, which is by definition volatile.

Our valuation model yields a 2008 target price of ISK20, which implies 19% downside risk to the current share price.

One-stage GGM valuation, based on 2008E ROE of 15%, COE of 10.7%, long-term growth of 3.0%


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Apart from the numbers cited above, we believe an investment thesis also has to incorporate the following risk factors:

Synergy benefits across Glitnir’s 11 markets have yet to be become a more dominant theme: Among the synergies that we currently see are a Nordic DMA-focused brokerage (fifth-largest market share) and fund products from newly acquired FIM asset management, which will be rolled out into Glitnir’s other markets. Glitnir also plans to expand the corporate banking model further. Activities in other areas appear to have a predominantly local focus.

Potentially the wrong time in the cycle: We believe this may be the wrong time in the cycle to invest in corporate and investment banking driven models after 4 years of very buoyant markets. Moreover, Glitnir’s book is amongst the youngest in the region and has yet to stand the test of time. It has been grown at a very fast pace over the past few years and we have no insight as to what the risk (vintages) are that have been taken on the balance sheet.

Success in niche strategy: We believe Glitnir has the clear expertise to succeed in investment and corporate niches such as seafood beyond that we remain more sceptical.

Table 9: One-stage GGM (post tax forecast RoE) 2008E

Valuation: One-stage Gordon growth model (actual RoE) 2008E

Forecast post-tax ROE 15.0%

CoE 10.7%

LT growth 3.0%

Implied PBV 1.55

BVPS 13.02

Price target ISK20

Upside/downside in % -16.8%


Alternative valuation scenarios Blue sky scenario

In a blue sky scenario we assume that high profitability levels can be maintained. This scenario extends the average achieved ROE between 2002 and 2006 into perpetuity. We assume in this scenario the same long-term growth factor of 3%. The target price in such a scenario would be ISK28, offering 17% potential upside. We attach no more than 20% probability of this scenario materialising as long as risks related to liquidity and a US recession remain a valid option.

Blue sky scenario yields fair value of ISK28


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Table 10: One-stage GGM (post tax forecast RoE) 2008E

Valuation: One-stage Gordon growth model (actual RoE) 2008E

Forecast post tax ROE 19.7%

CoE 10.7%

LT growth 3.0%

Implied PBV 2.25

BVPS 13.05

Price Target ISK28

Upside/downside in % +16.7%


Normalised growth valuation scenario

In the scenario below we introduce an alternative valuation approach where we normalise the P&L drivers over the forecast period. The underlying picture does not change materially.

In this scenario we continue to grow F&C income and financial income at double our forecasts next year and apply a cost-income ratio of 50%. Based on the assumptions set out below there is still 22% downside risk to our numbers. Only if we were to incorporate materially stronger top-line growth forecasts, materially higher cost flexibility, or a much more benign credit cycle, could we currently argue for value upside.

Such a scenario would be if the current turmoil in the market proves to be more short-lived than we currently anticipate and the underlying macro picture of the global economy holds up better than expected. In such a case a more positive view would be justified. In our normalised P&L scenario we assume

Net interest income growth of 10%

Fee and commission growth of 15%

Financial and other income growth of 20%

A cost/income ratio in line with the 2002-06 average of 50%

Impairments at 20% on net interest income, which is optimistic

A tax rate of 17%, which is equivalent of the YE 2006 rate

Minorities at our forecast level.


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Chart 41: Normalised growth valuation approach for Glitnir

Valuation: Extrapolating 2002-2006 growth 2006 2007E 2008E 2009E 2010E 2007E/2006 2008E/2007E 2009E/2008E 2010E/2009E(normalised

UBS Net Interest Income Cross Cycle 37,084 36,968 40,665 44,731 49,204 0% 10% 10% 10% 10%Net Fee & Commission Income Cross Cycle 26,459 38,366 44,120 50,738 58,349 45% 15% 15% 15% 15%Net financial income Cross Cycle 8,503 2,976 3,571 4,286 5,143 -65% 20% 20% 20% 20%Other operating Income Cross Cycle 555 4,995 5,245 5,507 5,782 800% 5% 5% 5% 5%Total Income Cross Cycle 72,601 83,304 93,601 105,262 118,478 15% 12% 12% 13% CI ratio atTotal Operating Expenses Cross Cycle 27,301- 44,049- 46,800- 52,631- 59,239- 61% 6% 12% 13% 50%GOP Cross Cycle 45,300 39,256 46,800 52,631 59,239 -13% 19% 12% 13%Impairment losses on loans and receivables Cross Cycle 4,759- 4,647- 8,133- 8,946- 9,841- -2% 75% 10% 10% 20%Other operating Income Cross Cycle 5,714 996 1,046 1,150 1,265 PBT Cross Cycle 46,255 35,604 39,713 44,835 50,663 -23% 12% 13% 13%Income tax Cross Cycle 8,024- 5,697- 6,751- 7,622- 8,613- 17%Net Profit Cross Cycle 38,231 29,907 32,962 37,213 42,051 Minority interest Cross Cycle 871- 1,307- 1,437- 1,581- 1,739- at forecast levelAttributable Net Profit Cross Cycle 37,360 28,601 31,525 35,632 40,312

Cross Cycle Valuation 2006 2007E 2008E 2009E 2010ETarget price cross cycle 20 22 25 29 upside/downside in % upside/down -16.1% -8.0% 4.1% 17.9%


Glitnir’s capital adequacy profile Glitnir reported a Tier I ratio of 8.5% at its Q3 07 results. The minimum defined by the FME (the Icelandic financial supervisory authority) is 8%. Other banks define the minimum at 9%.

Over the forecasting period we expect Glitnir to remain at these levels. Any larger-scale acquisition in the Nordic area would, however, necessitate a capital raising, in our view, as the Icelandic authorities aim for a high capital safety cushion with regard to unforeseen shocks, as this year has clearly demonstrated.

We forecast Glitnir’s core Tier I ratio at 7%, which is at the upper end of the UBS European banking average but reflective of the bank’s higher risk profile and the potentially limited domestic resources should Glitnir or any other Icelandic bank get into trouble.


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Table 11: Glitnir’s capital adequacy profile (ISK million?)

Capital adequacy 2006 2007 2008 2009 2010

Shareholder equity 144,578 168,920 190,234 212,924 237,326

Minority interest 1,541 3,698 4,068 4,475 4,923

Total shareholder equity 146,119 172,619 194,303 217,399 242,249

Intangible assets - 18,310 - 51,268 - 56,395 - 59,215 - 62,175

Core capital 127,809 121,351 137,908 158,185 180,074

Hybrid core capital 41,725 37,749 37,749 37,749 37,749

Tier I capital 169,534 159,100 175,657 195,934 217,823

Subordinated loans, excl. hybrid core capital 66,651 60,651 60,651 60,651 60,651

Other deductions - 1,070 - 1,046 - 1,046 - 1,046 - 1,046

Capital base 235,115 218,705 235,262 255,539 277,428

Total RWA 1,564,300 1,835,210 1,991,161 2,249,342 2,532,753

RWA as % of total assets 65% 65% 65% 65%

Core Tier I ratio 8.2% 6.6% 6.9% 7.0% 7.1%

Tier I ratio 10.8% 8.7% 8.8% 8.7% 8.6%

Total capital ratio 15.0% 11.9% 11.8% 11.4% 11.0%

Source: Glitnir and UBS estimates

Glitnir’s liquidity profile Glitnir’s overall liquidity position remains strong (for additional details please also refer to our financial stability section).

Glitnir’s policy is for immediate liquidity to cover all maturing debt of the parent company other than general deposits for the next six months.

In addition, all debt maturing within the next 12 months must be covered with immediate liquidity and other liquid assets.

Liquid funds are split into two categories which do not include contractual inflow from long-term assets: (1) immediately available funds such as cash, money market placings, the liquidity portfolio, unused repo-eligible ISK bonds and committed credit lines; and (2) loans and securities that can easily be traded or converted into cash.


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Chart 42: Glitnir liquidity profile as of Q3 2007

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in IS

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Total Asstets Total Liabilities


Glitnir’s currency exposure Glitnir generates income in 11 markets, of which Iceland, Norway, the euro zone, the US and UK are all important contributors to assets in different currency zones, harking back to the days when exchange rate fluctuations could materially affect results.

We see this mix of different currency assets as no different than that of other banks, but for an investor based in the euro zone absolute positive performance may still be mitigated by falling exchange rates. We believe the macro outlook is at best mixed and that the ISK could depreciate by 10-15% relative to the euro by mid-2008.

Chart 43: Glitnir’s asset and liability profile split out by currency

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Glitnir’s dividend profile Glitnir’s dividend policy reflects that of any growth story involving low payout ratios and a focus on capital preservation. There is no reason from an investment perspective to look at Glitnir as a dividend yield stock. The long-term target range has been set at between 20% and 40% by management.

If momentum slows then we would assume that Glitnir could adopt a different payout structure. We use 25% payout ratio, which is the same as for the full year 2006.

Table 12: Glitnir – dividend overview

2006 2007E 2008E 2009E 2010E

Stock price 23.3 25.4 25.4 25.4 25.4

Dividends 9,198 7,150 7,105 7,563 8,134

Payout ratio 25% 25% 25% 25% 25%

Retained earnings 28,162 21,451 21,314 22,690 24,402

DPS 0.66 0.49 0.49 0.52 0.56

Dividend yield 2.8% 1.9% 1.9% 2.0% 2.2%



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Glitnir banki hfPer share (Isk) 12/05 12/06 12/07E 12/08E 12/09EEPS (stated) 1.5 2.7 2.0 1.9 2.1EPS (UBS adjusted) 1.5 2.4 2.0 1.9 2.1GOPS 1.6 3.3 2.7 2.9 3.5DPS 0.4 0.7 0.5 0.5 0.5BVPS (stated) 6.6 10.5 11.6 13.0 14.6BVPS (adjusted) 6.6 10.5 11.6 13.0 14.6Profit & Loss (Iskm)Net interest income 22,351 37,084 36,968 39,697 45,914Other income 14,060 35,517 46,337 49,905 54,836Total revenues 36,411 72,601 83,304 89,602 100,750Expenses (15,731) (27,301) (44,049) (46,692) (49,960)Operating profit 20,680 45,300 39,256 42,911 50,790Provisions and other items (2,205) (4,759) (4,647) (7,985) (13,118)Profit before tax 23,060 46,255 35,604 35,971 38,822Pre-exceptional net income 18,886 37,360 28,601 28,419 30,253Capital dynamics (Iskm)Risk-weighted assets 946,428 1,564,300 1,835,210 1,991,161 2,249,342Tier one capital 93,290 169,534 159,444 176,001 196,278Total capital 119,429 235,115 219,049 235,606 255,883Tier one ratio 9.9% 10.8% 8.7% 8.8% 8.7%Total capital ratio 12.6% 15.0% 11.9% 11.8% 11.4%Net profit after tax 18,886 37,360 28,601 28,419 30,253Tier 1 requirement 9.0% 9.0% 9.0% 9.0% 9.0%Less: Working capital requirement 55,608 24,382 14,036 23,236 25,507Less: Dividends 4,890 9,198 7,150 7,105 7,563Surplus capital generated (41,612) 3,780 7,415 (1,922) (2,817)Surplus capital generation ratio -98.7% 4.1% 4.4% -1.2% -1.6%Balance sheet (Iskm)Assets 1,471,945 2,246,339 2,812,265 3,051,242 3,446,878Customer loans 1,174,428 1,760,368 2,112,442 2,281,437 2,623,652Customer deposits 304,136 438,272 701,235 757,334 870,934Funds under management 345,000 424,000 1,000,000 1,100,000 1,210,000Loans : assets 79.8% 78.4% 75.1% 74.8% 76.1%Deposits : assets 20.7% 19.5% 24.9% 24.8% 25.3%Loans : deposits 386.2% 401.7% 301.2% 301.2% 301.2%Shareholders funds : assets 5.74% 6.44% 5.20% 5.55% 5.53%Asset quality (Iskm)Non-performing assets 9,098 13,637 16,365 17,674 20,325Total risk reserves 2,205 4,759 4,647 7,985 13,118NPLs : loans 0.77% 0.77% 0.77% 0.77% 0.77%NPL coverage 24% 35% 28% 45% 65%Provision charge : average loans 0.26% 0.32% 0.00% 0.36% 0.53%Net NPLs : shareholders' funds 8.2% 6.1% 8.0% 5.7% 3.8%ProfitabilityNet interest margin (avg assets) 2.08% 1.99% 1.46% 1.35% 1.41%Provisions : operating profit 10.7% 10.5% 11.8% 18.6% 25.8%RoE 28.4% 32.8% 20.0% 18.5% 17.2%RoAdjE 28.4% 0.3% 0.2% 0.1% 0.1%RoRWA 2.71% 3.05% 1.76% 1.56% 1.50%RoA 1.28% 1.46% 1.02% 0.93% 0.88%ProductivityCost : income ratio 43.2% 37.6% 52.9% 52.1% 49.6%Costs : average assets 1.5% 1.5% 1.7% 1.6% 1.5%Compensation expense ratio 0.0% 25.8% 40.0% 39.2% 36.9%MomentumRevenue growth +27.6% +99.4% +14.7% +7.6% +12.4% Operating profit growth +46.0% +119.1% -13.3% +9.3% +18.4% Net profit growth +57.9% +97.8% -23.4% -0.6% +6.5% Dividend growth +8.6% +73.7% -25.8% -0.6% +6.5% Value*UBS bank valuationLeveraged P/ERisk tendency P/EMerger P/E

Market capitalisation (Iskm) 181,381 277,348

Conventional valuationMarket cap./RevenuesMarket cap./Operating profitP/E (stated)P/E (UBS adjusted)Dividend yield (net)P/BV (stated)P/BV (adjusted)Source: UBS estimates, * Historical, current, & future valuations are based on a share price of Isk0.0 as at close on 04 Dec 2007

+0.0%+20.0%+40.0%+60.0%+80.0%

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05 06 07E 08E 09E-40.0%-20.0%+0.0%+20.0%+40.0%+60.0%+80.0%+100.0%+120.0%+140.0%

Rev. growth (LHS) Op. profit growth (RHS)

0.0x 0.2x 0.4x 0.6x 0.8x 1.0x 1.2x

05 06 07E 08E 09E0.0x 0.2x 0.4x 0.6x 0.8x 1.0x 1.2x

P/BVPS (LHS) P/E (RHS)

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Momentum (Revenue & Operating profit growth)

Balance Sheet Growth

Value (P/Adj. BVPS & P/Adj. EPS)

0.0%5.0%

10.0%15.0%20.0%25.0%30.0%35.0%

05 06 07E 08E 09E0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%

RoE (LHS) RoRWA (RHS)

+0.0%+20.0%+40.0%+60.0%+80.0%

+100.0%+120.0%+140.0%

05 06 07E 08E 09E+0.0%+20.0%+40.0%+60.0%+80.0%+100.0%+120.0%+140.0%

Assets (LHS)Customer Deposits (LHS)Customer Loans (RHS)

Glitnir is the second biggest of the Icelandic banks by market cap (€6bn).Glitnir has grown rapidly into 11 countries over the past 5 years. It nowdescribes itself as a 'Nordic Financial Group'. The next importantchallenge will be the consolidation and integration of the acquisitionsmade over recent years. Glitnir bought into retail banks in Norway,commercial real estate operations in Sweden and an asset managementcompany in Finland.


UBS 32

Kaupthing (Neutral, PT ISK960, +3%) Ten years of rapid transformation We rate Kaupthing Bank a Neutral PT ISK960 and summarise its investment case below.

Chart 44: Kaupthing investment profile Past 3 years 2007-2009E

Low High Low HighGrowth GrowthStrategic Positioning Strategic PositioningReturns ReturnsValuation ValuationRisk RiskManagement Management


Kaupthing is the largest of the Icelandic banks by market cap (~€10bn). Kaupthing has expanded rapidly into 12 countries over the past five years. It now describes itself as a “Leading Merchant Bank in Western Europe”. The next important challenge will be the integration of recently acquired Dutch merchant bank NIBC. At €3bn it is Kaupthing’s biggest acquisition to date. €1.6bn in equity will be raised for this acquisition, with the remainder to come from debt capital and excess cash. We assume smooth execution and our investment case assumes that CDS spreads will revert to more normal levels following this transaction.

Kaupthing bought into corporate & investment banks in Sweden, Denmark, the UK and the Benelux. These companies have yet to be integrated more noticeable into the group. In the case of the last three big transactions FCF from Kaupthing’s own higher ROE streams has been swapped into lower-yielding franchises. However, Kaupthing has established a very good track record in quickly making its acquisitions more profitable. Some of these improvements have come from simplifying the corporate structure and equity contained in them rather then being purely revenue driven.

Kaupthing’s risk profile is significantly above the European average. Kaupthing’s corporate & investment baking profile, and reliance on equity investments in addition to a wholesale-oriented funding base, mean it more closely resembles a private equity fund than a bank in the classic sense. Above-average risk has been more than compensated by exceptionally high returns over the past few years from financial income from its equity holdings, asset management and corporate banking.

The next stage for Kaupthing will be to consolidate its acquisitions, consider the long-term value of its equity investments for the investment case and achieve earnings sustainability. Typically, this goes hand in hand with a slowdown of earnings growth, but should end in higher earnings quality, predictability and, over time, help to lower Kaupthing’s CoE. We do not forecast that market-related revenues will decline, but apply growth rates similar to that of other major CIB focussed banks in our forecasts. We

Iceland’s largest bank by market cap has a varied investment case based on its track record of profitable acquisitions …


UBS 33

forecast a net profit rise to be flat next year from an adjusted base. On a stated basis we expect net profits to be up.

Valuation remains reasonable but above the European average. Our valuation of the enlarged Kaupthing group includes NIBC. Even after financing-related costs, the valuation multiples going forward remain reasonable – albeit still at a premium to the European banking sector. While we are feeling more comfortable about the outlook for Kaupthing than Glitnir, this premium rating together with an above average risk profile will act as break for rapid price performance once recovery sets in.

Management team: Kaupthing’s CEO Hreidar Mar Sigurdsson has continued the internationalisation of Kaupthing started by Chairman Sigurdur Einarsson. Going forward, the management team must demonstrate that, not only can it successfully acquire and turn banks around, but that it can also integrate and run them through the cycle.

JC Flowers group will hold 15.9% in the bank after the capital increase. While there is a lock up until year end 2008 for 110m of 140m of the shares that JC Flowers will be paid for NIBC, in the medium term, this will increase the likelihood for shares to come to the market. Exista will remain the biggest shareholder at 20-22% after the rights issue in Q1 2008.

Kaupthing’s strategy going forward will be to further strengthen its CIB footprint in the Nordic and Eurozone regions, and to develop its areas of expertise in SME and markets in which it believes it has an edge over the competition. Nordic competition is tough, and the challenge for Kaupthing is whether it can remain small enough to be able to maintain its close relationship with SMEs while below the radar screen of its larger Nordic investment banking peers or if increasing in size has made it more vulnerable to increasing competition and higher costs. We believe the latter could become an increasing issue as we move forward.

We believe that Kaupthing can deliver on its targets by slightly relevering which may not be an option near term.

Table 13: Icelandic banks company targets

ROE Tier-1 Ratio

Kaupthing 15% Tier-1 ratio=8% CAD=11%

Source: Company reports

Origins

Kaupthing caters to a market niche as an integrated financial services provider for SMEs, institutional investors and high net-worth individuals, which the bank believes are not adequately served by larger financial institutions. Kaupthing was originally established as a small agency for financial advisory and securities brokerage.

In October 2000 Kaupthing was listed on the Iceland Stock Exchange (OMX Iceland). Smaller initial acquisitions included the acquisitions of the brokerage Sofi Oyj in Finland in 2001 (now Kaupthing Bank Oyj) and Swedish bank JP Nordiska AB (now Kaupthing Bank Sverige AB) in 2002.

..and above-average valuation

Kaupthing targets SMEs, institutional investors and high net-worth individuals


UBS 34

In 2003 Kaupthing Bank and Búnadarbanki merged under the name Kaupthing Bank. This move constituted a considerable expansion of the bank’s activities, as Kaupthing Bank had been an investment bank while Búnadarbanki a corporate and retail bank. Consolidation of the home market was complete.

Three big acquisitions since 2004

Kaupthing’s most significant acquisitions were the most recent, as they strategically positioned Kaupthing Bank in major markets overseas. All past acquisitions have come at a reasonable price in our view. The average P/BV paid was 1.5x, which is reasonable for corporate banking assets. The RoE lift up at FIH and KSF looks impressive at first sight but has been helped by the simplification of the corporate structures which allowed equity to be up streamed to the group level.

Table 14: Kaupthing paid an average of 1.5x PBV for its acquisitions

NIBC Kaupthing Singer

Friedlander FIH –

Erhvervsbanks Bunadarbanki Islands JP Nordiska Kaupthing Bank

in comparison

Year of acquisition 2007 2005 2004 2003 2002 n/A

Country NL UK Denmark Iceland Sweden n/A

Consideration in €bn €3.0bn €0.8bn €1.0bn n/A €0.1bn n/A

Business focus Credit fixed income Equity & Commercial RE SME Lending Deposit gathering, debt Equity, Nordic FX n/A

PBV 1.5x 1.5x 1.5x n/A n/A n/A

PE 12.7x n/A n/A n/A n/A n/A

RoE 2004 n/A 7% 10% n/A n/A 26%

RoE H1 2007 0.2% 16% 18% n/A n/A 32%

Implied ROIC n/A 11% 12% n/A n/A

Comment Profit after tax from continuing operations 10.1%

RoE x2.0 in 18m RoE x1.8x


(1) Danish bank FIH Erhversbank A/S was acquired in 2004, securing Kaupthing a firm foothold for the bank in the Danish corporate lending market. FIH has a very similar profile to NIBC. Both banks were set up in the aftermath of World War II to support the industrial reconstruction of their respective country.

(2) UK’s Singer & Friedlander Group plc was acquired in 2005 and merged with the bank’s other operations in the UK to form Kaupthing Singer & Friedlander. The main achievement of Kaupthing management was to simplify the corporate structure, replacing all but one of the divisional managers and to move the capital held in the sprawling divisions of Singer & Friedlander upstream to increase the RoE.

(3) NIBC was acquired in August 2007 after turbulence in the credit markets had forced NIBC to write down their MBS book, which wiped out almost the entire first half 2007 profit . The owner, JC Flowers, will be partially paid in cash and partially in shares in Kaupthing Bank, which is a clear positive for the investment case as the JC Flowers group remains actively involved in the European banking sector through investments in Germany.

Past acquisitions have come at a reasonable price


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Chart 45: Contribution of Kaupthing’s acquisitions to growth

0

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Table 15: Organic & acquisition growth: revenues yoy & growth contribution

2004 2005 2006

Total income growth organic 39% 64% 26%

Total income growth acquired 18% 40% 13%

Organic contribution to growth 68% 62% 66%

Acquired contribution to growth 32% 38% 34%


Exposure to sub-prime Kaupthing’s overall exposure to sub-prime and related assets (in particular CDOs) is manageable but could lead to a negative quarterly surprise if taken down through the P&L. Excess capital protects Kaupthing from any negative surprises. Kaupthing recorded net financial loss in Q3 of ISK1.9bn due to mark-to-market changes in derivatives and bonds owned by the bank.

On November 26th Kaupthing announced a charge of €85m to be taken in Q4: it will reduce its ABS exposure from €1.6bn to €450m by mid-December. At the same time, it will also terminate a €1.3bn liquidity line (see below). It has no direct exposure to US sub-prime assets or CDOs and decreased its indirect exposure (related to the funding provided to the sellers of NIBC) to US$136m. Kaupthing expects to make a charge in Q4 of €85m (or ISK7,650m).

Financial Floating Rate Notes: As part of its liquidity strategy the bank has invested €1,223m in Financial FRN. This portfolio consists of highly rated

No direct sub-prime exposure and an indirect exposure of US$136m


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bonds, 88% above A-, with an average rating of AA- and is well diversified among 19 countries. Predominantly the portfolio is used for repo activities.

7 Corporate Synthetic CDOs in the amount of €350m: These consist of five private and two public transactions with up to 125 names each. The underlying exposures are highly-rated corporate names, 60% above A- and well diversified across 38 sectors. Kaupthing previously closed five of its Corporate Synthetic CDOs, all at a profit, most recently in October 2007.

25 ABS transactions in the investment book totalling €281m. The portfolio comprises High yield CLO, CMBS and CDO CRE, CDO Squared, CDO of high grade ABS, CDO of mezzanine ABS with a weighted average rating of A+. This is the riskiest part of the portfolio.

The bank has no direct or indirect exposures to SIVs or SIV lites. The Bank has a liquidity line to a financial institution of €1.3bn that has not been drawn (in the Q3 presentation it transpired that this line is related to a vehicle (Beethoven) from Dresdner Bank. Through this liquidity line the bank has indirect exposure to highly rated ABS (average rating: AA+). The portfolio is diversified across 85 transactions, 97% of which are rated AAA and AA. Three transactions (1.5%) have seen negative ratings action (one downgraded by a notch and two on negative watch). The portfolio has no direct and some indirect exposure to US sub-prime. The portfolio is accounted for on a hold to maturity basis.

What could the mark to market effect be on these tranches? If we assume further potential mark to market effects for Q3 we would expect a cumulative loss rate of 15% in line with SocGen’s adjustments which would have been equivalent of €30m adjustment (-ISK2,647m which explains some, but not all, of the losses in Q3 in Treasury). The adjustment, based on an - ISK7bn swing qoq, was therefore likely higher with the remainder to come from Kaupthing’s exposure to Nordic financials.

Stress test: In a stress test scenario a write-off of 20% for high-grade CDOs would be equivalent to €70m. We adjust the ABS transaction through a haircut of 25%. This would be a blended rate for various instruments listed: we assume 100% adjustment in a stress test to mezzanine CDO tranches, 20% to high grade CDOs and 10% to sub-prime RMBS / ABS exposure. This would be equivalent to €70.3m. In total, the potential stress loss amount would be €140m. This compares to €850m in excess capital on the balance sheet (assuming a 9% minimum Tier I ratio), or 16.5% before the financing of NIBC.

UBS forecasts for Kaupthing The valuation of Kaupthing is complicated by two factors. The first is the integration of NIBC. The second, the increase in Kaupthing’s stake in Norwegian insurance company Storebrand from 10% to 20% in H1 2007. Storebrand’s acquisition of SPP from SHB increases the equity affiliate income in the other income line going forward.

Cumulative loss rate could be 15%


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As a consequence, our model for Kaupthing is a merger model. The acquisition of NIBC was announced in August and has not yet been approved by the regulators. NIBC is fully reflected in our forecasts as is the rights issue and the changes in the stake in Storebrand.

Part I - Kaupthing standalone

Part II - NIBC in Euro

Part III - Kaupthing + NIBC

PART I: Kaupthing P&L (ex-NIBC) This is the P&L of Kaupthing Bank standalone. The revenue split up for 2007E is heavily skewed towards corporate banking and capital market income.

Kaupthing is organised along five business segments: investment banking, capital markets, treasury, corporate banking and AM & PB. Within banking there is some retail banking income, but it remains by far below that of other European banking peers and comes mainly from Kaupthing’s 2003 merger with Bunadarbanki Islands.

Chart 46: Kaupthing 2007E revenue split

Capital Markets23%

Inv estment Banking

16%

Treasury 8%

Banking43%

AM & PB10%


Below we highlight our stand alone P&L and quarterly results tables. As of Q1 2008 Kaupthing will report in euros.

Kaupthing valuation based on the various mergers going through


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Chart 47: Kaupthing Bank P&L stand alone (ex NIBC)

Reported Forecasts in %

P&L - Kaupthing Bank standalone 2005 2006 2007 2008 2009 2010 2006/2005 2007/2006 2008/2007 2009/2008 2010/2009Net Interest Income 32,710 52,362 75,336 83,080 94,289 108,137 60% 44% 10% 13% 15%

Net Commission Income 22,428 37,284 53,689 57,984 63,782 71,436 66% 44% 8% 10% 12%

Net Financial Income 37,282 60,157 26,507 26,507 29,158 32,073 61% -56% 0% 10% 10%

Other Income 9,778 17,413 15,672 16,769 17,943 19,199 78% -10% 7% 7% 7%

Total income 102,198 167,216 171,203 184,340 205,171 230,845 64% 2% 8% 11% 13%

Salaries and Related Cost - 20,318 - 33,570 43,641- 46,696- 51,365- 57,016- 65% 30% 7% 10% 11%

Other Administrative Cost 14,411- 26,437- 30,931- 33,096- 36,406- 40,411- 83% 17% 7% 10% 11%

Total Expenses - 34,729 - 60,006 74,572- 79,792- 87,772- 97,426- 73% 24% 7% 10% 11%

GOP 67,469 107,210 96,631 104,548 117,400 133,419 59% -10% 8% 12% 14%

Impairment on loans - 2,450 - 4,857

Impairment on other assets - 1,939 1,270- Loan Impairments - 4,389 - 6,127 - 6,510 - 10,516 - 18,017 - 27,376 40% 6% 62% 71% 52%

Impairments over customer loans (in bp) 28 24 24 36 55 73 -15% -2% 50% 53% 33%

Impairments over total assets (in bp) 17 15 14 20 30 40 -13% -7% 43% 50% 33%

Loans to customers 1,543,700 2,528,609 2,730,898 2,949,370 3,303,294 3,765,755 64% 8% 8% 12% 14%

Total assets 2,540,811 4,055,396 4,650,344 5,258,248 6,005,647 6,844,105 60% 15% 13% 14% 14%

PBT 63,080 101,083 90,120 94,031 99,383 106,042 60% -11% 4% 6% 7%

Income tax -11,228 -14,636 -16,582 -17,866 -18,883 -21,208 30% 13% 8% 6% 12%

Tax rate 18% 14% 18.4% 19.0% 19.0% 20.0%

PAT 51,852 86,447 73,538 76,165 80,500 84,834 67% -15% 4% 6% 5%

Minority interest -1,796 -1,145 -1,718 -1,889 -2,078 -2,286 -36% 50% 10% 10% 10%

Net attributable profit 50,056 85,302 71,821 74,276 78,422 82,548 70% -16% 3% 6% 5%

Adjustments / exceptionals 0 -33521 -3,495 0 0 0Adjusted net profit 50,056 51,781 68,326 74,276 78,422 82,548 3% 32% 9% 6% 5%

Earnings per share, ISK 75.32 115.20 94.60 97.83 103.30 108.73 Adjusted EPS 75.32 69.93 90.00 97.83 103.30 108.73


Chart 48: Kaupthing quarterly earnings progression

Quarterly results Reported Forecasts

Q1 2004 Q2 2004 Q3 2004 Q4 2004 Q1 2005 Q2 2005 Q3 2005 Q4 2005 Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008Net Interest Income 3,498 3,133 5,118 6,510 7,046 6,647 9,487 9,529 10,484 14,384 12,687 14,806 16,265 19,849 20259 18,963 20770 20770 20770 20,770Net Commission Inc 3,210 2,623 2,196 5,279 4,433 4,930 6,862 6,203 8,602 9,184 7,632 11,866 12,337 15,189 13374 12,789 14496 14496 14496 14,496Net Financial Inc 2,713 4,275 7,803 1,536 6,777 11,773 4,772 13,960 13,505 -2,607 37,256 12,003 13,456 10,772 2634 -355 6627 6627 6627 6,627Other Income 214 414 201 1,222 3,570 771 1,788 2,855 2,860 10,102 2,210 2,241 2,002 5,996 3553 4,121 4192 4192 4192 4,192Total income 9,635 10,445 15,318 14,547 21,826 24,121 22,909 32,547 35,451 31,063 59,785 40,916 44,060 51,806 39,820 35,517 46085 46085 46085 46,085Salaries and Related Cost -2,677 -2,890 -3,172 -4,112 -3,982 -4,318 -5,178 -6,840 -7,420 -8,263 -7,315 -10,572 -10,534 -11,833 -10921 -10,353 -11674 -11674 -11674 -11,674Other Administrative Cost -2,267 -2,425 -2,749 -3,333 -2,623 -3,017 -4,334 -4,437 -5,133 -6,542 -6,488 -8,274 -7,173 -7,184 -8428 -8,146 -8274 -8274 -8274 -8,274Total Expenses -4,944 -5,315 -5,921 -7,445 -6,605 -7,335 -9,512 -11,277 -12,553 -14,805 -13,803 -18,846 -17,707 -19,017 -19348 -18,500 -19948 -19948 -19948 -19,948GOP 4,691 5,130 9,397 7,102 15,221 16,786 13,397 21,270 22,898 16,258 45,982 22,070 26,353 32,789 20,472 17,017 26137 26137 26137 26,137Impairment -1,136 -1,113 -555 -1,022 -894 -779 -928 -1,789 -710 -961 -2,819 -1,637 -1,423 -1,075 -1723 -2,289 -2629 -2629 -2629 -2,629PBT 3,555 4,017 8,842 6,081 14,327 16,007 12,470 19,481 22,188 15,299 43,163 20,433 24,929 31,715 18,748 14,728 23508 23508 23508 23,508Income tax -548 -534 -1,862 -1,292 -2,888 -1,894 -2,429 -4,018 -2,595 -2,618 -7,630 -1,793 -4,236 -5,653 3,962- -2,731 -4466 -4466 -4466 -4,466

Net Earnings 3,006 3,483 6,980 4,789 11,439 14,113 10,041 15,463 19,593 12,680 35,533 18,640 20,694 26,062 14,786 11,996 19,041 19,041 19,041 19,041Minority interest -21 -5 403 175 346 440 333 678 796 -354 140 564 413 578 380 347 -472 -472 -472 -472Net attributable profit 3,027 3,488 6,577 4,614 11,093 13,673 9,708 14,786 18,798 13,035 35,393 18,077 20,281 25,484 14,406 11,650 18,569 18,569 18,569 18,569


The segmental analysis highlights each segment’s contribution to important P&L lines, but does not show the other income and corporate center functions that have not been disclosed consistently. Our group level forecasts from 2007 onwards include the acquisition of NIBC on a pro forma basis, while divisional data is on a Kaupthing standalone basis.


UBS 39

Chart 49: Kaupthing segmental analysis (>2007+ (includes NIBC on a pro forma basis)

>2007+ (includes NIBC on a pro forma basis)

Break-up Analysis Reported Forecasts Growth yoy in % as a % of group

Revenues 2003 2004 2005 2006 2007 2008 2009 2010 2004/2003 2005/2004 2006/2005 2007/2006 2008/2007 2009/2008 2010/2009 2004 2005 2006 2007 2008 2009 2010 Capital Markets 7,609 8,872 19,653 13,795 34,288 31,600 34,760 38,236 17% 122% -30% 149% -8% 10% 10% Capital Markets 18% 19% 8% 20% 17% 17% 17% Investment Banking 5,435 10,423 23,849 49,256 24,375 26,813 29,494 32,443 92% 129% 107% -51% 10% 10% 10% Investment Banking 21% 23% 29% 14% 15% 14% 14% Treasury 3,592 4,046 8,734 22,856 11,437 4,217 4,638 5,102 13% 116% 162% -50% -63% 10% 10% Treasury 8% 9% 14% 7% 2% 2% 2% Banking 11,579 20,916 38,892 59,028 73,354 67,681 77,906 89,499 81% 86% 52% 24% -8% 15% 15% Banking 42% 38% 35% 43% 37% 38% 39% AM & PB 2,082 2,767 5,988 13,541 14,706 15,847 17,432 19,120 33% 116% 126% 9% 8% 10% 10% AM & PB 6% 6% 8% 9% 9% 8% 8% Other operations and Eliminations Group 31,780 49,946 102,198 167,216 171,203 184,340 205,171 230,845 57% 105% 64% 2% 8% 11% 13% Group Expenses 2003 2004 2005 2006 2007 2008 2009 2010 2004/2003 2005/2004 2006/2005 2007/2006 2008/2007 2009/2008 2010/2009 Expenses 2004 2005 2006 2007 2008 2009 2010 Capital Markets - 2,080 - 2,482 - 3,113 - 6,205 - 10,238 - 11,057 - 11,942 - 12,897 19% 25% 99% 65% 8% 8% 8% Capital Markets 23% 15% 18% 23% 23% 23% 23% Investment Banking - 940 - 1,150 - 1,808 - 3,636 - 4,545 - 4,909 - 5,301 - 5,725 22% 57% 101% 25% 8% 8% 8% Investment Banking 11% 9% 10% 10% 10% 10% 10% Treasury - 821 - 921 - 1,481 - 3,078 - 4,155 - 4,488 - 4,847 - 5,234 12% 61% 108% 35% 8% 8% 8% Treasury 8% 7% 9% 9% 9% 9% 9% Banking - 3,918 - 4,830 - 10,580 - 14,969 - 18,412 - 19,885 - 21,476 - 23,194 23% 119% 41% 23% 8% 8% 8% Banking 44% 50% 42% 41% 41% 41% 41% AM & PB - 1,417 - 1,527 - 4,186 - 7,380 - 7,528 - 8,130 - 8,780 - 9,483 8% 174% 76% 2% 8% 8% 8% AM & PB 14% 20% 21% 17% 17% 17% 17% Other ops. & Eliminations Other ops. & Eliminations Group - 18,493 - 23,625 - 34,729 - 60,006 - 74,572 - 79,792 - 87,772 - 97,426 28% 47% 73% 24% 7% 10% 11% Group Gross Operating Profit 2003 2004 2005 2006 2007 2008 2009 2010 2004/2003 2005/2004 2006/2005 2007/2006 2008/2007 2009/2008 2010/2009 Gross Operating Profit 2004 2005 2006 2007 2008 2009 2010 Capital Markets 5,529 6,390 16,540 7,590 24,050 20,543 22,818 25,339 16% 159% -54% 217% -15% 11% 11% Capital Markets 18% 22% 6% 21% 21% 20% 20% Investment Banking 4,495 9,273 22,041 45,620 19,830 21,904 24,193 26,718 106% 138% 107% -57% 10% 10% 10% Investment Banking 26% 29% 37% 18% 22% 22% 21% Treasury 2,771 3,125 7,253 19,778 7,282 - 271 - 209 - 132 13% 132% 173% -63% -104% -23% -36% Treasury 9% 10% 16% 6% 0% 0% 0% Banking 7,661 16,086 28,312 44,059 54,942 47,797 56,431 66,306 110% 76% 56% 25% -13% 18% 17% Banking 45% 37% 36% 49% 49% 50% 52% AM & PB 665 1,240 1,802 6,161 7,178 7,717 8,651 9,638 86% 45% 242% 17% 8% 12% 11% AM & PB 3% 2% 5% 6% 8% 8% 8% Other ops. & Eliminations Other ops. & Eliminations Group 13,287 26,321 67,469 107,210 96,631 104,548 117,400 133,419 98% 156% 59% -10% 8% 12% 14% Group Provisions 2003 2004 2005 2006 2007 2008 2009 2010 2004/2003 2005/2004 2006/2005 2007/2006 2008/2007 2009/2008 2010/2009 Provisions 2004 2005 2006 2007 2008 2009 2010 Capital Markets - - - - 123 - 108 - 1,191 - 1,966 - 2,162 #DIV/0! #DIV/0! #DIV/0! -12% 1000% 65% 10% Capital Markets 0% 0% 2% 2% 7% 7% 7% Investment Banking - - - 22 1 - 6 - 132 - 145 - 160 #DIV/0! #DIV/0! -105% -699% 2100% 10% 10% Investment Banking 0% 1% 0% 0% 1% 1% 0% Treasury - 118 - 24 - 6 - 5 - 10 - 19 - 20 - 22 -80% -75% -17% 103% 83% 10% 10% Treasury 1% 0% 0% 0% 0% 0% 0% Banking - 3,776 - 3,795 - 2,395 - 4,851 - 5,999 - 15,712 - 25,925 - 30,419 1% -37% 103% 24% 162% 65% 17% Banking 99% 99% 79% 98% 92% 92% 93% AM & PB - - - - 1,138 - 1 - 1 - 2 - 2 #DIV/0! #DIV/0! #DIV/0! -100% 10% 10% 10% AM & PB 0% 0% 19% 0% 0% 0% 0% Other ops. & Eliminations Other ops. & Eliminations Group - 3,894 - 3,825 - 4,389 - 6,127 - 6,510 - 10,516 - 18,017 - 27,376 -2% 15% 40% 6% 62% 71% 52% Group PBT 2003 2004 2005 2006 2007 2008 2009 2010 2004/2003 2005/2004 2006/2005 2007/2006 2008/2007 2009/2008 2010/2009 PBT 2004 2005 2006 2007 2008 2009 2010 Capital Markets 5,529 6,390 16,540 7,467 23,942 19,352 20,853 23,177 16% 159% -55% 221% -19% 8% 11% Capital Markets 20% 22% 6% 22% 24% 25% 24% Investment Banking 4,495 9,273 22,019 45,621 19,824 21,772 24,048 26,558 106% 137% 107% -57% 10% 10% 10% Investment Banking 29% 30% 39% 18% 27% 29% 28% Treasury 2,653 3,101 7,259 19,773 7,272 - 290 - 229 - 155 17% 134% 172% -63% -104% -21% -32% Treasury 10% 10% 17% 7% 0% 0% 0% Banking 3,885 12,291 25,917 39,208 48,943 32,085 30,506 35,887 216% 111% 51% 25% -34% -5% 18% Banking 38% 35% 33% 46% 40% 36% 38% AM & PB 665 1,240 1,802 5,023 7,177 7,716 8,650 9,636 86% 45% 179% 43% 8% 12% 11% AM & PB 4% 2% 4% 7% 10% 10% 10% Other ops. & Eliminations Other ops. & Eliminations Group 9,393 22,496 63,080 101,083 90,120 94,031 99,383 106,042 139% 180% 60% -11% 4% 6% 7% GroupNet Income 2003 2004 2005 2006 2007 2008 2009 2010 2004/2003 2005/2004 2006/2005 2007/2006 2008/2007 2009/2008 2010/2009 Net Income 2004 2005 2006 2007 2008 2009 Capital Markets 4,654 5,186 13,558 6,386 19,632 15,868 17,099 19,005 11% 161% -53% 207% -19% 8% 11% Capital Markets 20% 22% 6% 22% 24% 25% 24% Investment Banking 3,784 7,526 18,050 39,015 16,256 17,853 19,719 21,778 99% 140% 116% -58% 10% 10% 10% Investment Banking 29% 30% 39% 18% 27% 29% 28% Treasury 2,233 2,517 5,950 16,910 5,963 - 238 - 188 - 127 13% 136% 184% -65% -104% -21% -32% Treasury 10% 10% 17% 7% 0% 0% 0% Banking 3,270 9,976 21,245 33,531 40,133 26,309 25,015 29,427 205% 113% 58% 20% -34% -5% 18% Banking 38% 35% 33% 46% 40% 36% 38% AM & PB 560 1,006 1,477 4,296 5,885 6,327 7,093 7,901 80% 47% 191% 37% 8% 12% 11% AM & PB 4% 2% 4% 7% 10% 10% 10% Other ops. & Eliminations Other ops. & Eliminations Group 7,907 18,259 51,852 86,447 73,538 76,165 80,500 84,834 131% 184% 67% -15% 4% 6% 5% Group

Source: UBS estimates, Note: forecasts on group level from 2007 onwards include the acquisition of NIBC while divisional data is on a Kaupthing stand alone basis.

PART II: The acquisition of NIBC Kaupthing’s new structure and business diversification will mainly benefit from NIBC’s expansion of its regional footprint into continental Europe. We believe that there will be limited revenue synergies, which we detail further below, but no meaningful cost synergies.

So far, our model factors in synergies in a more positive revenue progression at NIBC than otherwise, but we highlight that the risk from revenue attrition may be higher than expected given that NIBC’s business model depends to some extent on syndications and securitisations.

Following the NIBC acquisition, Kaupthing also announced a small add-on acquisition in the form of Robeco’s private client (e-)customers in Belgium and a small off shore deposit business on the Isle of Man. This former platform is mainly designed to tap into the very deposit-rich Benelux savings market as a means of further reducing Kaupthing’s wholesale funding dependency.

NIBC acquisition expands Kaupthing’s footprint into four major European regions


UBS 40

Chart 50: Kaupthing’s business structure by region and workforce

Kaupthing NIBCEmployees

Q3 07Investment

bankingCapital markets Treasury Banking AM &PB

Iceland 1226 0 1226 Kaupthing Kaupthing Kaupthing Kaupthing KaupthingUK 782 53 835 both Kaupthing Kaupthing both bothNetherlands 0 595 595 NIBC NIBC NIBC NIBC NIBCSweden 357 0 357 Kaupthing Kaupthing Kaupthing Kaupthing KaupthingDenmark 355 0 355 Kaupthing Kaupthing Kaupthing Kaupthing KaupthingLuxembourg 217 0 217 Kaupthing Kaupthing Kaupthing Kaupthing KaupthingFinland 110 0 110 Kaupthing Kaupthing Kaupthing Kaupthing KaupthingNorway 103 0 103 Kaupthing Kaupthing Kaupthing Kaupthing KaupthingUS 12 20 32 Kaupthing NIBCGermany 0 29 29 NIBC NIBC NIBCFaroe Islands 28 0 28 Kaupthing Kaupthing Kaupthing Kaupthing KaupthingSingapore 0 17 17 NIBC NIBC NIBCBelgium 0 11 11 NIBC NIBC Robeco NIBC RobecoTotal 3190 725 3915

Source: Kaupthing

The acquisition of NIBC, priced at €3bn, has been Kaupthing’s largest to date. It offers Kaupthing access to the Benelux corporate banking market and increasingly access to the important German market. Kaupthing will add 770 staff, which represents around 25% of the workforce.

As a consequence, Kaupthing will become a truly pan-European bank, with balanced operating income contributions from four major European regions.

Chart 51: Kaupthing operating income by region, 2006

Chart 52: NIBC operating income by region, 2006

Chart 53: Kaupthing and NIBC operating income by region, 2006

33%

31%

25%

8% 3%

Iceland Scandinav ia UK Benelux Other

75%

25%

Benelux Other

Iceland, 25%

Scandinav ia, 23%

UK, 19%

Benelux , 25%

Other, 8%

Source: Kaupthing and UBS Source: Kaupthing and UBS Source: Kaupthing and UBS

NIBC is more asset intensive than Kaupthing. NIBC also contributes proportionately more net financial income than Kaupthing as a whole. As a yardstick, revenue and expenses will come 25% from NIBC and 75% from Kaupthing.


UBS 41

Chart 54: Total income contribution Kaupthing + NIBC 2006 Chart 55: Operating income Kaupthing and NIBC per region

70%87%

69% 78% 75%

30%13%

31% 22% 25%

0%

20%

40%

60%

80%

100%

120%

Net InterestIncome

Net fee andComission

Income

Net FinancialIncome

Other Income Total Income

Kaupthing NIBC

75% 77% 71%57%

25% 23% 29%43%

0%

20%

40%

60%

80%

100%

120%

Total Income Operating Ex penses Net Income Total Assets

Kaupthing NIBC

Source: Kaupthing and UBS Source: Kaupthing and UBS

In NIBC, Kaupthing has acquired a business that returned 12% on equity in 2006 (10.1% at H1 2007 from ongoing operations) compared to 33% at Kaupthing. Kaupthing dilutes its own financial income fuelled RoE with lower RoE businesses. KSF & FIH generate RoEs of 16% and 18%, respectively.

We believe that when equity investment gains moderate – which eventually they will – underlying growth rates in the business will be much more in line with the average of the European banks sector, hence our overall lower long-term growth valuation assumption for Kaupthing.

Chart 56: NIBC and Kaupthing RoE comparison in 2006

0%5%

10%15%20%25%30%35%40%45%50%

Cost/Income Return on Equitiy Tier1 Capital

Kaupthing

NIBC


The core engine of NIBC is a classic “originate & distribute” as opposed to a “buy and hold” model. One of the key questions in the investment case is the outlook for syndications and securitisations in the near term. Moreover, the NIBC’s treasury operation will no longer benefit from yield pick-up through investments in sub-prime AAA MBS which led to the €137m write down in H1 2007. Subsequently, this led to the sale of the group by a consortium headed by JC Flowers.

NIBC RoE much below that of Kaupthing at 2006


UBS 42

Chart 57: NIBC segmental organisation Chart 58: NIBC’s regional origination - global distribution model

Key Business Areas

Average FTEs 2006 (#)

Operating Income2006 (EUR m)

Profit after tax from continuing operations 2006 (EUR m)

Corporate Finance

Client CoverageM&A AdvisoryCapital MarketsCredit Portfolio

Real Estate Markets

Residential and Commercial MortgagesSecuritisation and Fund Development

Financial Markets

Client Marketing and TradingTreasury and Investment Portfolios

Principal Investments

Corporate / Buy-out Infrastructure / PPP

Investment Management

NIBC Credit ManagementGeneral Partnership Participations

Corporate Center

Human ResourcesGroup Finance and TaxInternal AuditGroup Technology and OperationsInvestor RelationsGeneral Counsel and Corporate Secretary

Risk Management

% of Total

178 87 106 73 25 47

34% 17% 21% 14% 5% 9%

249 58 103 34 55 156

77 49 68 54 1 4

NIBC

IssuerClients

Multi-Product Client Franchises Product / Market Combinations Investment Management of Alternative Asset Classes

Global Distribution Network

General Industries

Food & Retail

Financial Sponsors

CommercialReal Estate

Financial Institutions

Transport & Energy

Infrastructure

ResidentialReal Estate

Commercial Real Estate

Finance

Transport & Energy Finance

Infrastructure Finance

Residential Mortgages

CorporateLending

Leveraged Finance Private

Equity

Mezzanine

InvestorClients

Warehousing&

Portfolio Management

Syndications

Fund Development

Securiti-sations

Investment Management

SecuritisedDebt

Products

SyndicatedLoans

InstitutionalInvestors

PensionFunds

InsuranceCompanies

Family Offices

Banks

Asset Managers

Hedge Funds

Funds

Regional OriginationRegional Origination

Issuer ClientsIssuer Clients

Credit Fixed Income Products

Credit Fixed Income Products

Private Equity Products

Private Equity Products

Global DistributionGlobal Distribution

Investment Products

Investment Products

Investor ClientsInvestor Clients

Source: NIBC and UBS Source: NIBC and UBS

Capital raising for NIBC & EPS impact

We see limited synergies in this acquisition given that the overlap in terms of regional set-up and product orientation remains low. The regional diversification effect is nonetheless a good thing, in our view. Based on our combined forecasts for Kaupthing and NIBC after the capital increase and issuance of additional Tier I debt we believe that the acquisition will be 7% EPS dilutive at the start and will only approach the EPS neutral mark (-3%) by 2010 given that that the number of shares to be issued is 60m higher than originally expected.

NIBC will be Kaupthing’s biggest acquisition to date and will be financed by a mixture of new Kaupthing shares, a pre-emptive rights issue, a Tier I hybrid bond and excess cash on balance sheet.

Table 16: New shares at Kaupthing to finance NIBC

Number of shares Originally planned Revised on November 26th

Old Kaupthing Bank 740,453,053 740,453,053

Price for NIBC 2,995,000,000 2,995,000,000

Issuance for NIBC In € In €

Issuance in the value of €1.6bn (balance in debt & cash) 1,360,000,000 1,600,000,000

Number of shares Number of shares

Original number of shares to be issued 110,000,000 140,000,000

Pre-Emptive rights issue (~40m new shares but could be higher) 40,000,000 70,000,000

New number of shares 150,000,000 210,000,000

Total New Kaupthing shares 898,813,053 950,453,053


The remaining gap will be financed through a hybrid Tier I issuance and cash. We assume that Kaupthing can use all of its excess capital, which we define as Tier I capital in excess of 9% (which is in excess of the 8% prescribed by the central bank), but at a level desired by the company. At November 26th

Acquisition should be EPS neutral by 2010


UBS 43

Kaupthing announced that it will increase the number of shares to be issued to the JC Flower consortium from the planned 110m to 140m (total shares to be issued 210m). JC Flowers opportunely locked in the pre-crisis value of NIBC, which we estimate has preserved €550m in value for the group. We assume the remaining gap will be financed through excess cash.

Chart 59:Kaupthing share price since the NIBC acquisition: Purchase price of €2,995m locks in ~€550m for JC Flowers group

800

850

900

950

1000

1050

1100

1150

1200

1250

15 A

ug 0

7

22 A

ug 0

7

29 A

ug 0

7

05 S

ep 0

7

12 S

ep 0

7

19 S

ep 0

7

26 S

ep 0

7

03 O

ct 0

7

10 O

ct 0

7

17 O

ct 0

7

24 O

ct 0

7

31 O

ct 0

7

07 N

ov 0

7

14 N

ov 0

7

21 N

ov 0

7

Kaupthing share price Kaupthing 15 AUG

€550m v alue locked in since the NIBC sale


Table 17: Utilisation of excess capital and hybrid Tier I instruments

In euros

Acquisition price in EUR 2,985,000,000

Market price of capital raised in EUR 2,181,666,667

Gap to be financed through cash, TI hybrids in EUR 803,333,333

Excess cash (Ti > 9%) in EUR 829,863,578

TI financing requirement in EUR 0

TI subordinated bonds coupon 9%

TI financing costs pa in EUR 0


In an environment where markets do not remain supportive (we are looking at 10% revenue decline year on year in 2008 at NIBC) the rationale for the acquisition is no longer as compelling. This could be the case if syndication and securitisation markets do not recover sufficiently over the next two years.

We have included the following integration synergies in our NIBC forecasts:


UBS 44

Table 18: Synergy path for NIBC

2007E 2008E 2009E 2010E

Assumed Revenue synergies €0m €5m €23m €18m

expressed in % of you growth 0% 1% 4% 7%

Assumed Cost synergies €0m €0m €0m €0m


Chart 60: EPS enhancement/ dilution path assuming UBS base case forecasts for NIBC

-14%

-12%

-10%

-8%

-6%

-4%

-2%

0%

2007 2008 2009 2010

EPS enhancement path


Below we present a pro forma P&L for NIBC bank which feeds into our combined P&L forecasts for the future combined group. Based on our profit trajectory for NIBC this would be equivalent to 9% ROE in 2010 and 7% ROIC.


UBS 45

Chart 61: NIBC P&L (in €m)

P&L - NIBC standalone EUR million 2005 2006 2007 2008 2009 2010 2006/2005 2007/2006 2008/2007 2009/2008 2010/2009Net Interest Income 275 251 216 229 248 273 -8.73% -13.86% 6.14% 8.00% 10.00%

NII yield over customer loans 3.87% 3.64% 2.85% 2.75% 2.70% 2.70%NII yield over total assets 0.85% 0.77% 0.60% 0.59% 0.59% 0.60%Customer loans 7,098 6,897 7,587 8,345 9,180 10,098 -3% 10% 10% 10% 10%Total assets 32,194 32,636 35,900 38,844 42,046 45,530 1% 10% 8% 8% 8%

Net Fee & Commission Income 43 61 70 67 72 79 42% 15% -5% 8% 10%Dividend income 27 35 77 81 89 98 30% 120% 5% 10% 10%Net trading income 87 92 55 58 64 73 6% -40% 5% 10% 15%Gains less losses from equity investments 21 45 41 38 42 47 114% -10% -5% 10% 10%Share in profit of associates and JVs 4 16 5 5 5 6 300% -70% 5% 5% 5%Other operating income 3 16 5 5 5 6 433% -70% 5% 5% 5%Non Interest Income 185 265 252 254 278 308 43% -5% 1% 9% 11%Estimated synergies from integration

o/w assumed revenue synergies - 5 23 18 expressed in % of you growth 1% 4% 7%

Total income 460 516 469 484 525 581 12% -9% 3% 9% 11%Salaries and Related Cost -122 -130 -139 -147 -158 -169 7% 7% 6% 7% 7%Other Administrative Cost -50 -68 -72 -76 -82 -87 36% 6% 6% 7% 7%Depreciation -11 -11 -11 -11 -11 -11 0% 0% 0% 0% 0%o/w assumed expense synergies 0 0 0 0

Other Operating Expenses -183 -209 -222 -235 -251 -267 14% 6% 6% 7% 7%GOP 277 307 246 249 275 313 11% -20% 1% 11% 14%

Impairment of goodwill -1 0

Impairment of financial assets 39 14

Total Impairments / writebacks 38 14 -2 -25 -46 -61 -63% -116% 1000% 83% 32%Impairments over customer loans (in bp) 53.5 20.3 3.0 30.0 50.0 60.0Impairments over total assets (in bp) 11.8 4.3 0.6 6.4 10.9 13.3 Customer loans 7,098 6,897 7,587 8,345 9,180 10,098 -3% 10% 10% 10% 10%Total assets 32,194 32,636 35,900 38,844 42,046 45,530 1% 10% 8% 8% 8%

Results on disposal of subsidiaries 0 1 0 0 0 0PBT 315 322 244 224 229 253 2% -24% -8% 2% 10%Income tax -81 -69 -42 -47 -48 -53 -15% -40% 13% 2% 10%Tax rate 26% 21% 17% 21% 21% 21%Net profit 234 253 203 177 181 200 8% -20% -13% 2% 10%Discontinued operations -107 35 0 0 0 0 -133% -100% nA nA nANet profit 127 288 203 177 181 200 127% -30% -13% 2% 10%Minority interest 31 0 0 0 0 0 -100% nA nA nA nAAdj. Net attributable profits 158 288 203 177 181 200 82% -30% -13% 2% 10%Adjustments 0 0 -137 0 0 0Net profit stated 158 288 66 177 181 200


PART III: Kaupthing Bank and NIBC pro forma For the combined entity we forecast EPS growth of 3% in 2008 and 2009 (10% on an adjusted basis) which we believe is ambitious for a CIB oriented bank at this stage in the cycle. For next year we are looking at a slowdown in total income growth to 7% which will then rise above 10% again. This assumes that results remain supported from equity disposals in an environment of at least stable markets.

On the expense side, we assume ongoing negative operating leverage (7% expense rises 2008E yoy) due to continuing costs from expensive hires this year. On the provisioning side, our assumptions take as a base case a slightly more moderate cycle. We note that Kaupthing’s loan book is much younger than that of the average European bank and has not had to weather the stress of a full blown downturn.

EPS growth of 8% in 2008E and 2009E


UBS 46

Chart 62: Kaupthing & NIBC provision cycle: Loan impairments over total assets

0

10

20

30

40

50

60

70

80

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

in b

ps

Kaupthing loan impairments ov er total assets NIBC loan impairments ov er total assets

Source: Kaupthing, NIBC and UBS estimates, Note: 2007 and beyond refers to UBS forecasts

This is the merger pro forma P&L based on an exchange rate of ISK90 to the euro over the forecast period. We expect that the currency could devalue by 10-15% when the central bank starts easing, most likely be in mid-2008.

Chart 63: Kaupthing & NIBC pro-forma merger accounts P&L - Kaupthing Bank + NIBC (merged entities) Merged accounts based on Kaupthing disclosure structure!

ISK million 2005 2006 2007 2008 2009 2010 2006/2005 2007/2006 2008/2007 2009/2008 2010/2009Net Interest Income 53,470 74,643 94,795 103,735 116,596 132,675 40% 27% 9% 12% 14%Net Commission Income 25,674 42,699 60,002 63,982 70,260 78,562 66% 41% 7% 10% 12%Net Financial Income 47,775 76,846 42,482 42,916 47,185 52,167 61% -45% 1% 10% 11%Other Income 10,004 18,833 16,104 17,222 18,419 19,699 88% -14% 7% 7% 7%Operating IncomeTotal income 136,923 213,021 213,384 227,856 252,460 283,102 56% 0% 7% 11% 12%TI financing costs pa in EUR 3,474- 3,474- 3,474- 3,474- Salaries and Related Cost 29,528- 45,110- 56,160- 59,966- 65,565- 72,209- Other expenses 19,016- 33,450- 38,408- 40,963- 44,754- 49,274- Total Operating Expenses 48,544- 78,559- 94,568- 100,929- 110,318- 121,482- 62% 20% 7% 9% 10%Total expenses 48,544- 78,559- 98,042- 104,402- 113,792- 124,956- GOP 88,380 134,462 115,342 123,453 138,668 158,146 52% -14% 7% 12% 14%Loan Impairments 1,520- 4,884- 6,715- 12,770- 22,148- 32,829- 221% 37% 90% 73% 48%

Impairments over customer loans (in bp)Impairments over total assets (in bp)

PBT (incl Storebrand & SPP) 86,859 129,578 108,626 110,684 116,520 125,317 49% -16% 2% 5% 8%Income tax 17,343- 20,761- 20,319- 22,092- 23,211- 25,986- 20% -2% 9% 5% 12%Tax rate 20.0% 16.0% 18.7% 20.0% 19.9% 20.7%Net incomeProfit after tax 69,517 108,906 88,308 88,591 93,309 99,331 57% -19% 0% 5% 6%Minority interest 544 1,145- 1,718- 1,889- 2,078- 2,286- -310% 50% 10% 10% 10%Net attributable profit 61,983 110,868 86,590 86,702 91,231 97,045 79% -22% 0% 5% 6%Adjustments / exceptionals - 33,521- 12,330- 0 0 0Adjusted net profit 61,983 77,347 74,260 86,702 91,231 97,045 25% -4% 17% 5% 6%

Earnings per share, ISK 75.3 115.2 91.1 91.2 96.0 102.1 53% -21% 0% 5% 6%Adjusted EPS 75.3 69.9 78.1 91.2 96.0 102.1 -7% 12% 17% 5% 6%


Valuation On our pro forma numbers for the Kaupthing + NIBC combined entity, the stock trades on 10.2x 2008E PE which is 8% above the European banks average. We consider this premium rating as more attractive than that of Glitnir but believe that, given the higher risk investment profile, other European banks currently offer a better risk-return function.

Kaupthing + NIBC combined entity trades on a premium to the European average, which is undeserved, in our view


UBS 47

Table 19: Price earnings, RoE and PBV

ROE & retained earnings 2005 2006 2007E 2008E 2009E 2010E

Price 746 841 930 930 930 930

PE 9.9x 7.3x 10.3x 10.2x 9.7x 9.2x

PBV 2.6x 1.9x 1.6x 1.5x 1.3x 1.2x

ROE 32% 34% 16% 14% 13% 13%

Adj ROE 32% 24% 14% 14% 13% 13%

Pre-Tax RoE 45% 40% 20% 18% 17% 16%


We value Kaupthing on a Gordon Growth methodology with a price target of ISK960. We split our valuation into two parts:

(1) We value the estimated private equity investments at 1x PBV given that a large part of these have been kept on a mark-to-market basis. Unrealised gains on the unlisted part of the portfolio have not been disclosed by Kaupthing but we estimate these to be still positive. In the end they depend on the market environment. At the moment, the outlook is at best clouded for many of the investments undertaken at the more aggressive valuations. Near-term disposals of older investments could, however, support financial income for a while longer. Given that we have no insight into this part of the business, we attach a value of ~1xPBV to it.

(2) Kaupthing has begun to outsource 2007 PE investments into Kaupthing Capital Partners II. From the beginning of 2007 PE investments have been pooled in this fund. Private equity investments until end of 2006 will, however, not go into this fund. At the end of Q3 Kaupthing warehoused two Kaupthing Capital Partners II investments, i.e. Phase Eight and ADP. These are expected to be pooled in the fund during the fourth quarter. The fund is in the process of closing at £560m, with £200m capital committed by Kaupthing and £360m from employees, institutional and high net worth investors and investment companies.

(3) Our valuation approach values the assumed core banking business separately on a GGM based on a 2008 ROE of 12.3% for the banking business, COE of 10.7% and a long term growth factor of 3.0% given that newly acquired operations will likely be growing more in tune with the bank sector trends in their home countries.

On a combined basis we derive a price target for the group of ISK960. Table 20: Valuation of Kaupthing based on 2008 basis

Valuation - Equity holdings at 1x PB 2007E 2008E 2009E 2010E

Equity holdings estimated

Total 166,950 166,950 166,950 166,950

Listed 119,700 119,700 119,700 119,700

Unlisted 47,250 47,250 47,250 47,250

(1) Total Icelandic estimated 55,650 55,650 55,650 55,650

o/w Icelandic listed 42,000 42,000 42,000 42,000

ISK960 price target based on Gordon Growth valuation of the bank’s two main businesses


UBS 48

Valuation - Equity holdings at 1x PB 2007E 2008E 2009E 2010E

o/w Icelandic unlisted 13,650 13,650 13,650 13,650

(2) Total other 111,300 111,300 111,300 111,300

o/w other listed 77,700 77,700 77,700 77,700

o/w other unlisted 33,600 33,600 33,600 33,600

Equity holdings 166,950 166,950 166,950 166,950

Assumed portfolio yield 7% 7% 7% 7%

Portfolio contribution to P&L from Equity holdings 11,687 11,687 11,687 11,687

Net attributable profit (ex assumed portfolio gains) 74,904 75,015 79,545 85,359

EPS (ex portfolio gains) 79 79 84 90

PE (ex portfolio gains) 11.9x 11.8x 11.2x 10.4x

Value of portfolio at 1x BV 166,950 166,950 166,950 166,950

BVPS (post capital increase) 569 642 719 801

Adj ROE (ex equity holdings) 13.8% 12.3% 11.6% 11.2%

COE 10.7% 10.7% 10.7% 10.7%

LT growth 3.0% 3.0% 3.0% 3.0%

Implied PBV 1.41 1.21 1.12 1.07

Implied price core 802 775 807 854

Equity holdings at BV 166,950 166,950 166,950 166,950

New Kaupthing shares 950,453,053 950,453,053 950,453,053 950,453,053

Equity holdings at BV per share 176 176 176 176

Multiple 1.0 1.0 1.0 1.0

Valuation of Equity holdings 176 181 181 181

Target Price 977 960 989 1,037

Upside / Downside 5% 3% 6% 12%


Valuation alternatives

Group including equity investments

Using a GGM for the entire new group achieves the same target price of ISK960, based on a COE of 10.7% and a long-term growth factor of 3.5%. The increase in the long-term growth factor expresses faster growth in the equity holdings near term, while we expect materially slower growth to come from this side through the cycle.


UBS 49

Table 21: Group valuation based on GGM (Core banking business + equity holdings combined)

Valuation 2007E 2008E 2009E 2010E

ROE 16.0% 14.2% 13.3% 12.8%

COE 10.7% 10.7% 10.7% 10.7%

LT growth 3.5% 3.5% 3.5% 3.5%

Implied PBV 1.75 1.50 1.38 1.29

Target price 995 961 990 1,036

Current price 935 935 935 935

Upside/Downside 6% 3% 6% 11%


Equity holdings on a 10x PE

If we put the equity holdings on a 10x PE this scenario gets us to a target price of ISK1016, which would also indicate a Neutral rating on the stock.

Table 22: Group valuation based on GGM (Equity holdings at 10x PE)

Valuation - equity holdings at 10x PE 2007E 2008E 2009E 2010E

Assume net profit contribution from equity holdings 11,687 11,687 11,687 11,687

Multiple on these earnings 10.0 10.0 10.0 10.0

Valuation 116,865 116,865 116,865 116,865

New Kaupthing shares 950,453,053 950,453,053 950,453,053 950,453,053

Valuation contribution per share 123 123 123 123

Adj ROE (ex equity holdings) 13.8% 12.3% 11.6% 11.2%

CoE 10.7% 10.7% 10.7% 10.7%

LT growth 3.0% 3.0% 3.0% 3.0%

Implied PBV 1.44 1.22 1.13 1.07

BVPS (post capital increase) 569 642 719 801

Valuation (Core) 818 784 813 858

Valuation (Equity holdings) 123 123 123 123

Target price 941 907 936 981

Upside / Downside 1% -3% 0% 5%



UBS 50

Kaupthing’s capital adequacy profile Kaupthing’s capital adequacy profile is strong, driven by the Icelandic central bank’s very conservative rules to safeguard against potential risks from high CIB and equity investment exposure. We forecast after the capital increase that Kaupthing’s Tier I ratio will remain above 10% and its core Tier I ratio above 9%. Based on a minimum Tier I ratio of 9% that other banks define as a minimum level (theoretically the central bank and FME require a still high 8%), we estimate the excess capital to be €850m, which we assume will be used for the cash portion of the deal.

If excess cash is used to a lesser degree , the Tier I hybrid (which we assume would have a coupon in the region of 9%) would have to make up the difference and add to funding costs of the deal. We assume that the yield loss on equity owned is lower than the coupon of the Tier I issue.

In a stress-test the FME that we present later has calculated the effects of simultaneous shocks on the capital ratios of the largest Icelandic banks. The stress test scenario incorporates shocks that simultaneously affect changes in the value of shares, market bonds, non-performing/impaired loans and appropriated assets and the ISK without allowing its capital adequacy ratio drop below 8%. Kaupthing’s capital ratio before the test was 12.1% at end 2006, the Tier I ratio 8.7% and after the test the total capital ratio remianed at 9.2%

Table 23: Capital adequacy

in ISK m 2005 2006 2007E 2008E 2009E 2010E

Weighted assets 1,841,833 2,875,539 4,852,329 5,509,842 6,220,113 6,987,770

Book value 194,183 323,510 539,148 612,205 691,124 776,419

RWA in % of BV 9.49 8.89 9.00 9.00 9.00 9.00

Assets deducted from equity - 62,590 - 66,922 - 123,806 - 136,186 - 149,805 - 164,785

Guarantees and other items not included in B/S 166,028 259,023 259,023 284,925 313,418 344,760

RWA 1,945,271 3,067,640 5,031,794 5,694,578 6,391,324 7,131,421

2005 2006 2007E 2008E 2009E 2010E

Equity 202,512 334,892 544,064 616,204 691,968 772,383

Intangible assets - 54,943 - 65,276 - 71,804 - 78,984 - 86,882 - 86,882

Assets deducted from Equity - 6,742 - - - - -

Subordinated loans 41,201 51,817 56,999 62,699 68,968 68,968

Tier I capital 182,028 321,433 529,259 599,919 674,054 754,469

Subordinated loans 61,285 160,717 176,789 194,468 213,914 213,914

We forecast that Kaupthing’s Tier I ratio will remain above 10% following the capital increase


UBS 51

in ISK m 2005 2006 2007E 2008E 2009E 2010E

Investment in credit institutions - 6,451 - 21,324 - 21,324 - 21,324 - 21,324 - 21,324

Tier II capital 54,834 139,393 155,465 173,144 192,590 192,590

Total Capital 236,862 460,826 679,808 769,063 865,800 951,095

2005 2006 2007E 2008E 2009E 2010E

Core Tier I ratio 7.6% 8.8% 9.4% 9.4% 9.5% 9.6%

Tier I ratio 9.4% 10.5% 10.5% 10.5% 10.5% 10.6%

Total capital ratio 12.2% 15.0% 13.6% 13.6% 13.6% 13.3%

UBS defined Min Tier I ratio 9% 9% 9% 9% 9% 9%

Min Tier I capital required 175,074 276,088 452,861 512,512 575,219 641,828

Tier I capital 182,028 321,433 529,259 599,919 674,054 754,469

Excess capital In ISK m 6,954 45,345 76,398 87,407 98,835 112,641

Excess cap in EUR 849 971 1,098 1,252

Source: UBS estimates, Note UBS defined minimum Tier I ratio uses Landsbanki’s more conservative approach which we believe reflects current policy thinking more closely

Kaupthing’s liquidity profile Kaupthing can survive without capital market access for more than 365 days. The funding maturity profile has been lengthened after the brief financial crisis in Q2 2006 which has helped tremendously during this year’s liquidity freeze. As of September 30th Kaupthing’s liquidity profile was 394 days without access to capital markets through cash repo-able loans as well as other liquidity sources such as committed revolvers and backup facilities with maturities > 1 year and without MAC clauses. At the same time NIBC has got a very good funding base of its own and right through the peak of the current crisis has been a net contributor to the interbank market.

In a release on November 26th Kaupthing said that it is committed to its liquidity policy of maintaining sufficient secured liquidity to repay all maturing obligations for at least 360 days and at the same time maintain a stable level of business without accessing the capital markets. The secured liquidity consists of cash, high grade international repo-able bonds and back-up facilities with a maturity of over one year and without MAC clauses. As of 15 November Kaupthing Bank had more than 420 days of secured liquidity. The cash payment due to the Sellers of NIBC is taken into account when the Bank's liquidity position is calculated.

The secured liquidity of NIBC calculated the same way is more than 720 days and pro-forma combined secured liquidity of Kaupthing group and NIBC is more than 600 days.

Kaupthing funds itself through the parent company and its two self-funded subsidiaries: FIH in Denmark and Kaupthing Singer & Friedlander in the UK. Kaupthing (parent) has €1.7 billion of long-term debt maturing in 2008 and the Group has €3.7 billion. In comparison, Kaupthing (parent) had, as of 15

Liquidity profile of 394 days without access to capital markets


UBS 52

November, raised close to €6 billion in long-term financing since the beginning of the year. As part of the financing of the NIBC acquisition Kaupthing has also issued US$400 million in Tier 1 subordinated bonds and sold them to investors in Asia.

Even though Kaupthing says that it has not experienced an increase in the cost of funding so far compared to 2006, high CDS spreads going forward will make it more expensive to fund through international capital markets, which is one of the reasons we forecast Net Interest Income to slow. Recent issues to US & Mexican investors (MXN$2.3bn) of Tier I debt out of Kaupthing and a NIBC issued a €750 million Residential Mortgage Backed Security backed by Dutch mortgages that benefit from a State guarantee in September 2007, give some comfort that the funding model will continue to work.

Chart 64: Kaupthing maturity of LT funding (bonds, subordinated and other loans at parent, KSF, FIH in ISKbn)

Chart 65: Debt maturing in 2008 as a % of total debt

0

100

200

300

400

500

600

Q4 2007 2008 2009 2010 2011 2012 >2013

Kaupthing maturity of LT funding (bonds, subordinated and other loans at parent, KSF, FIH in ISKbn)

Source: Kaupthing and UBS Source: Kaupthing

Kaupthing’s dividend profile We forecast a stable pay-out ratio of 20% over the forecasting period.

Table 24: Kaupthing dividend forecasts

ROE & Retained earnings 2004 2005 2006 2007E 2008E 2009E 2010E

Dividends -3,260 -6,646 -10,366 -13,510 -18,035 -18,941 -20,104

Pay out ratio 18% 13% 20% 15% 20% 20% 20%

Retained earnings 20,967 56,702 95,668 76,554 72,140 75,764 80,415

DPS (reported) 5.0 10.0 14.0 14.2 19.0 19.9 21.2


The role of Exista, Kaupthing’s largest shareholder Exista’s market capitalisation is ISK281bn or €3.1bn. Exista is the largest shareholder in Kaupthing Bank and holds 23% in the company before the capital increase and will subsequently hold around 20-22%.

Exista is a financial services group with operations in the areas of insurance, asset finance and investments. The company is a leading insurance underwriter in Iceland, as well as the country’s largest provider of asset finance products.


UBS 53

Strategic Holdings in Financial Companies are influential stakes in listed financial companies with a long-term view. Strategic holdings in financial companies are accounted for using the equity method in the Group’s accounts. Exista has strategic holdings in several financial companies, including

Sampo Group, 20% stake

Kaupthing Bank currently a 23% stake

Other investments are controlling stakes in public and private non-financial companies.

Bakkavör Group, 39.6% and

Skipti (Iceland Telecom), 43.6% before the listing of the company.

Exista’s goal is to use its financial strength for the further development of its business in Northern Europe. Exista is listed on the OMX Nordic Exchange in Iceland.

Exista’s shareholders

Exista’s shareholders are dominated by three groups. Once more there is a cross-shareholding in place.

Chart 66:Exista - Bakkabraedur Holding - Bakkavor Group Chart 67: Exista’s main shareholders

Bakkabraedur Holding45.0%

100%EXISTA

Lýdur GudmundssonÁgust Gudmundsson 39.6%

Bakkavor Group

Bakkabraedur Holding

45%

Sav ings Banks16%

Pension Funds6%

Others33%

Bakkabraedur Holding Sav ings Banks Pension Funds Others

Source: Exista and UBS Source: Exista and UBS

Exista is dominated by Bakkabraedur Holding B.V. which is a holding company owned by Lýdur Gudmundsson and Águst Gudmundsson. Together, they founded Bakkavör Group twenty years ago. Exista holds 39.6% in Bakkavor Group. Lýdur Gudmundsson and Águst Gudmundsson are board members of Exista hf.

Kista Investments is an investment company founded by six savings banks intended to hold their stake in Exista hf.

Castel SARL is owned by Glenalla Properties Limited. Glenalla Properties Limited is 95% owned by Investec Trust (Guernsey) Limited as Trustee of the Tchenguiz Family Trust of which Robert Tchenguiz is beneficiary. Robert Tchenquiz is a board member at Exista hf.


UBS 54

Exista’s role in the upcoming rights issue of Kaupthing

Financial services group Exista will exercise its rights in Kaupthing Bank's forthcoming share rights issue, which is a part of the financing for the acquisition of the Dutch bank NIBC.

Exista has committed to subscribe for its full rights (approximately 13 million shares) in the issue, which is expected to take place prior to the end of the first quarter of 2008.

Up to 210 million new Kaupthing Bank shares will be issued in relation to the acquisition of NIBC, including 70 million shares in the form of a rights issue. Exista has agreed in principle to underwrite up to 50% of the rights issue, or a total of 35 million shares (including the 13 million shares already subscribed for).

The equity increase will dilute Exista's shareholding from more than 23% to approximately 20-22% after the rights issue. A consortium of shareholders led by J.C. Flowers & Co has agreed in principle to underwrite the remaining 50% of the rights issue.


UBS 55

Kaupthing BankPer share (Isk) 12/05 12/06 12/07E 12/08E 12/09EEPS (stated) 75.3 115.2 91.1 91.2 96.0EPS (UBS adjusted) 75.3 69.9 78.1 91.2 96.0GOPS 101.5 144.8 127.3 137.7 154.6DPS 10.0 14.0 13.7 18.2 19.2BVPS (stated) 292.2 436.9 569.3 642.3 719.1BVPS (adjusted) 209.5 344.7 501.1 574.0 650.8Profit & Loss (Iskm)Net interest income 32,710 52,362 94,795 103,735 116,596Other income 69,488 114,854 118,588 124,120 135,864Total revenues 102,198 167,216 213,384 227,856 252,460Expenses (34,729) (60,007) (98,042) (104,402) (113,792)Operating profit 67,469 107,209 115,342 123,453 138,668Provisions and other items (4,389) (6,127) (6,715) (12,770) (22,148)Profit before tax 63,080 67,561 108,626 110,683 116,520Pre-exceptional net income 50,056 85,302 74,260 86,702 91,231Capital dynamics (Iskm)Risk-weighted assets 1,945,271 3,067,640 5,005,223 5,642,999 6,314,736Tier one capital 182,028 321,433 526,307 594,188 683,458Total capital 236,862 460,826 681,772 767,331 858,135Tier one ratio 9.4% 10.5% 10.5% 10.5% 10.8%Total capital ratio 12.2% 15.0% 13.6% 13.6% 13.6%Net profit after tax 50,056 51,780 86,590 86,702 91,231Tier 1 requirement 9.0% 9.0% 9.0% 9.0% 9.0%Less: Working capital requirement 101,013 174,382 57,400 60,456 64,358Less: Dividends 6,646 10,366 12,989 17,340 18,246Surplus capital generated (57,603) (132,969) 16,202 8,905 8,627Surplus capital generation ratio -31.6% -73.0% 5.0% 1.7% 1.5%Balance sheet (Iskm)Assets 2,540,811 4,055,396 4,650,344 5,258,248 6,005,647Customer loans 1,543,700 2,528,609 2,730,898 2,949,370 209,968Customer deposits 486,176 750,658 1,201,053 1,321,158 1,453,274Funds under management 1,050,000 1,403,000 1,543,300 1,697,630 1,867,393Loans : assets 60.8% 62.4% 58.7% 56.1% 3.5%Deposits : assets 19.1% 18.5% 25.8% 25.1% 24.2%Loans : deposits 317.5% 336.9% 227.4% 223.2% 14.4%Shareholders funds : assets 7.97% 8.26% 11.88% 11.83% 11.57%Asset quality (Iskm)Non-performing assets 15,078 25,506 27,493 52,280 90,675Total risk reserves 4,389 6,127 6,715 12,770 22,148NPLs : loans 0.98% 1.01% 1.01% 1.77% 43.19%NPL coverage 29% 24% 24% 24% 24%Provision charge : average loans 0.19% 0.24% 0.26% 0.23% 0.67%Net NPLs : shareholders' funds 5.3% 5.8% 3.8% 6.4% 9.9%ProfitabilityNet interest margin (avg assets) 1.60% 1.59% 2.18% 2.09% 2.07%Provisions : operating profit 6.5% 5.7% 5.8% 10.3% 16.0%RoE 29.1% 20.0% 20.0% 15.1% 14.1%RoAdjE 29.1% 26.4% 16.0% 14.2% 13.3%RoRWA 5.33% 1.84% 2.19% 1.66% 1.56%RoA 1.97% 1.28% 1.86% 1.65% 1.52%ProductivityCost : income ratio 34.0% 35.9% 45.9% 45.8% 45.1%Costs : average assets 1.7% 1.8% 2.3% 2.1% 2.0%Compensation expense ratio 23.1% 23.8% 32.7% 32.7% 32.1%MomentumRevenue growth +104.6% +63.6% +27.6% +6.8% +10.8% Operating profit growth +156.3% +58.9% +7.6% +7.0% +12.3% Net profit growth +182.7% +70.4% -12.9% +16.8% +5.2% Dividend growth +100.0% +40.0% -2.4% +33.5% +5.2% Value*UBS bank valuationLeveraged P/ERisk tendency P/EMerger P/E

Market capitalisation (Iskm)

Conventional valuationMarket cap./RevenuesMarket cap./Operating profitP/E (stated)P/E (UBS adjusted)Dividend yield (net)P/BV (stated)P/BV (adjusted)Source: UBS estimates, * Historical, current, & future valuations are based on a share price of Isk968.0 as at close on 30 Nov 2007

+0.0%+20.0%+40.0%+60.0%+80.0%

+100.0%+120.0%

05 06 07E 08E 09E+0.0%

+50.0%

+100.0%

+150.0%

+200.0%

Rev. growth (LHS) Op. profit growth (RHS)

0.0x 0.2x 0.4x 0.6x 0.8x 1.0x 1.2x

05 06 07E 08E 09E0.0x 0.2x 0.4x 0.6x 0.8x 1.0x 1.2x

P/BVPS (LHS) P/E (RHS)

Profitability (RoE & RoRWA)

Momentum (Revenue & Operating profit growth)

Balance Sheet Growth

Value (P/Adj. BVPS & P/Adj. EPS)

0.0%5.0%

10.0%15.0%20.0%25.0%30.0%35.0%

05 06 07E 08E 09E0.0%1.0%2.0%3.0%4.0%5.0%6.0%

RoE (LHS) RoRWA (RHS)

+0.0%+10.0%+20.0%+30.0%+40.0%+50.0%+60.0%+70.0%

05 06 07E 08E 09E-150.0%-100.0%-50.0%+0.0%+50.0%+100.0%+150.0%+200.0%

Assets (LHS)Customer Deposits (LHS)Customer Loans (RHS)


UBS 56

The Icelandic banking model A banking sector like no other in the world The Icelandic banking market is dominated by three banks: Kaupthing, Glitnir and Landsbanki. In addition, a specialist investment bank called Straumur caters predominantly to investment banking clients and has recently been given a full banking licence. At all four banks capital market, corporate & investment banking businesses contribute the majority of earnings. Retail banking plays a subordinate role. Glitnir is the only bank having bought a mid-sized mortgage bank and more recently a fund manager-cum-broker.

In addition, equity holdings have been flattering core banking earnings significantly in recent years, driven by the Icelandic stock market’s rampant performance, over an above what can be described as excellent conditions elsewhere.

There are two very contrary views in the financial markets on the strategies of the Icelandic banks and also not much written research.

“A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.” (J.M. Keynes). This is the more negative view that the Icelandic banks have copied each other’s business model and have potentially taken on excessive risk.

“Daring ideas are like chessmen moved forward. They may be beaten, but they may start a winning game.” (J.W. Goethe) This view sums up the transformation of the Icelandic banks. A few years ago they were looking at an insignificant home market, rapid transformation of the banking world and were sitting on the sidelines. The choice was essentially to “evolve or die”. Today the Icelandic banks are an integral part of the European banking universe, with a combined market cap approaching €25bn.

Corporate banking focus

Historically the Icelandic banks have been corporate banks, and retail mortgage banking was reserved for specialist banks close to the Icelandic government. Retail deposit gathering was made difficult by the small size of the Icelandic home market of only 300,000 people. Banks have only recently been able to break into the mortgage segment, mostly through specialised products.

An unprecedented bull market on the OMX Iceland fuelled expansion

Through the linkage of the Icelandic banks to equity investment earnings, progression has been driven by the phenomenal development of the Icelandic stock market over the past four years as well as rapid internationalisation of the businesses. Our assumption is that future performance may still be good but, at a valuation of c2.7x PBV, it will be more difficult to see how these investments can remain decoupled from trends in the rest of Europe, which is trading at 2.3x 2007E PBV.

Icelandic banks focus on corporate banking; retail banking plays a subordinate role

Equity holdings have flattered core banking earnings significantly


UBS 57

Chart 68: Icelandic banks vs OMX Iceland and MSCI Europe Chart 69: OMX Iceland All Share vs MSCI Europe

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OMX ICELAND ALL SHARE - PRICE INDEX MSCI EUROPE - PRICE INDEXKaputhing GlitnirLandsbanki

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Nov

97

Nov

98

Nov

99

Nov

00

Nov

01

Nov

02

Nov

03

Nov

04

Nov

05

Nov

06

Nov

07

Icelandic banks all share v s. MSCI Europe

Source: Thomson Financial, UBS Source: Thomson Financial, UBS

A consolidated home market

With only three dominant banks, consolidation of Iceland’s small home market came to its natural end a few years ago. The next phase had to be the internationalisation of the banks’ businesses. Expertise in niche areas of corporate banking, such as seafood and vessel financing, drove the expansion into adjacent Nordic countries and the UK. This was followed by the build-up of sizable equity portfolios in Iceland, the Nordic region and UK. The latest development has been the acquisition of NIBC bank in the Netherlands by Kaupthing in August this year for €3.0 billion.

Chart 70: The push for a larger home market

AUSTRIAHUNGARY

CZECH

SERBIA

CROATIA

FINLAND

ITALY

SPAIN

SWEDEN

NORWAY

GERMANY

FRANCE

PORTUGAL

ROMANIA

BULGARIA

DENMARK

POLAND BELARUS

UKRAINESLOVAKIA

GREECE

CYPRUS

NETH.

BELGIUM

IRELAND

MOLDOVA

LITHUANIALATVIA

ESTONIA

LUX.

SWITZ.

ICELAND

UK

LIECH.

RUSSIA


AUSTRIAHUNGARY

CZECH

SERBIA

CROATIA

FINLAND

ITALY

SPAIN

SWEDEN

NORWAY

GERMANY

FRANCE

PORTUGAL

ROMANIA

BULGARIA

DENMARK

POLAND BELARUS

UKRAINESLOVAKIA

GREECE

CYPRUS

NETH.

BELGIUM

IRELAND

MOLDOVA

LITHUANIALATVIA

ESTONIA

LUX.

SWITZ.

ICELAND

UK

LIECH.

RUSSIA

AUSTRIAHUNGARY

CZECH

SERBIA

CROATIA

FINLAND

ITALY

SPAIN

SWEDEN

NORWAY

GERMANY

FRANCE

PORTUGAL

ROMANIA

BULGARIA

DENMARK

POLAND BELARUS

UKRAINESLOVAKIA

GREECE

CYPRUS

NETH.

BELGIUM

IRELAND

MOLDOVA

LITHUANIALATVIA

ESTONIA

LUX.

SWITZ.

ICELAND

UK

LIECH.

RUSSIA


Source: UBS

Table 25 and the following charts (Chart 71 and Chart 72) illustrate just how rapid the internationalisation of the Icelandic banks has been over the past five years. In Kaupthing’s case, just below 80% of total group’s assets have been made up by acquisitions.

c80% of Kaupthing’s total group assets have been acquired


UBS 58

A brief history of Icelandic banking

Phase I – 1986–2006 banking liberalisation: In 1986, a new act on commercial banks and savings banks granted Icelandic deposit institutions increased independence from the central bank. They began to set their own deposit and lending rates and service charges. Free competition arrived in the financial market practically overnight. Price levels in Iceland underwent a transformation following the collective bargaining agreements of 1990, generally referred to as a ‘national consensus’. The entrenched inflation that persisted in the preceding two decades subsided to a certain degree but remained at levels above the eurozone.

Phase II – privatisation of the state-owned banks: Privatisation began in late-1997 with the incorporation of Landsbanki Íslands hf. The first cautious steps were taken with public share offerings, following which the state sold a 45.8% holding in Landsbanki to Samson Holding ehf., at the end of 2002.

Phase III – internationalisation: Kaupthing established the first global mutual fund in Iceland and was the first Icelandic financial institution to launch a company abroad (in Luxembourg). The other banks followed (see Table 25). Today the Icelandic profile is receding more and more as demonstrated by Kaupthing’s plan to change its reporting currency into euro.

Table 25: Total assets of Icelandic banks’ foreign subsidiaries

YE 2006, ISK bn Kaupthing Glitnir Landsbanki

NIBC 2,872 FIM (AUM 8.5bn) 4.4 Lux 303

FIH 1,222 BNbank 557 Heritable Bank 122

UK Singer & Friedlaender 536 Lux 153 Kepler Equities 44

Lux 478 Bank Norway 67 Guernsey 17

Sweden 180 AB 20 Teather & Greenwood 17

Robe Bank Belgium 25 Other 8.4 Other 13

Finance 44

Oyj 22

Norway 14

Norvestia Oyj 16

Kaupthing Glitnir Landsbanki

Total foreign assets of group 5,409 Total foreign assets of group 810 Total foreign assets of group 516

Total group assets 6,927 Total group assets 2,250 Total group assets 2,173

Source: Sedlabanki, UBS estimates


UBS 59

Chart 71: Icelandic banks foreign assets vs total group assets (YE 2006)

Chart 72: Total foreign assets as a % of group assets at the Icelandic banks

0

1000

2000

3000

4000

5000

6000

7000

8000


Total foreign assets of group Total Group assets

0%10%20%30%40%50%60%70%80%90%


Total foreign assets of group

Source: Sedlabanki, UBS Note: Kaupthing’s assets have been increased by the assets of NIBC, an acquisition announced in August 2007, and Glitnir’s by FIM, an acquisition announced in Q1 07.

Source: Sedlabanki, UBS Note: Kaupthing’s assets have been increased by the assets of NIBC, an acquisition announced in August 2007, and Glitnir’s by FIM, an acquisition announced in Q1 07.

The following two charts understate the fact that the Icelandic economy has been growing fast and lending growth has been well above the European average. Despite the recent slowdown, the Icelandic banks’ lending growth still outpaces that of the core eurozone.

Chart 73: EMU customer loan growth average y/y, 1999-2008E Chart 74: Icelandic lending growth y/y (domestic and foreign)

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

EMU Customer loan change y oy

-20%

0%

20%

40%

60%

80%

100%

120%

140%

160%

Dec-

98

Jun-

99

Dec-

99

Jun-

00

Dec-

00

Jun-

01

Dec-

01

Jun-

02

Dec-

02

Jun-

03

Dec-

03

Jun-

04

Dec-

04

Jun-

05

Dec-

05

Jun-

06

Dec-

06

Jun-

07Total lending domestic Total Lending Foreign Currency

Source: UBS estimates Source: Sedlabanki

Income streams show the same diversification effect, which mitigates the effect of currency devaluation.


UBS 60

Chart 75: Income from abroad YE 2006 and lending to customers from abroad YE 2006

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Kaupthing Glitnir Landsbanki Total

Income from abroad YE 2006 Lending to customers from abroad YE 2006

Source: Sedlabanki, UBS

How do Icelandic banks differ from peers Nordic competition

The Nordic banking sector is dominated by medium-sized retail/corporate banks that tend to be relatively risk averse in their lending to clients. The Icelandic banks differ from this model because they have created far wider pan-European networks, which include a significant earnings proportion from investment banking and private equity.

Chart 76: Total foreign lending (%) by the three largest commercial bank groups, 2006

Chart 77: Domestic versus foreign lending (SKbn)

0

5

10

15

20

25

30

35

40

45

50

Nordic UK and Ireland Benelux North America Germany Other Europeancountries

Other

Total foreign lending by the three largest commercial bank Groups in %

0

500

1,000

1,500

2,000

2,500

2005 2006

Domestic lending Foreign lending

+42%

+64%

Source: Sedlabanki, UBS Source: Sedlabanki, UBS

Market capitalisation

Kaupthing is Iceland’s largest bank and the 7th biggest bank by market capitalisation in the Nordic region. Over time, we believe that Kaupthing could overtake Swedbank and SHB, given that the acquisition of NIBC will increase Kaupthing’s market cap further. This means that Icelandic banks have become credible players in the region and occupy profitable niches elsewhere, where further expansion will most likely continue to come from, markets permitting.

Icelandic banks have a wide pan-European footprint

Icelandic banks have become credible players in the region and occupy profitable niches elsewhere


UBS 61

Chart 78: Icelandic banks versus Nordic peers

-5,000

10,00015,00020,00025,00030,00035,000

Nord

ea

Dans

keBa

nk

DNB

NOR

SHB

SEB

Swed

bank

Kaup

thing

Land

sban

ki

Glitn

ir

OKO

Stra

umur

in EURm Market cap incl NIBC

Source: Thomson Financial 2005 and 2006 data

Peer group

Icelandic banks typically choose their peers from the Nordic banks. From an earnings point of view, this is justified to a certain degree, although one would have to increasingly add other European wholesale banks to this list. Icelandic bank earnings are now driven, to a large extent, by UK, Dutch and Irish earnings.

Chart 79: Icelandic banks, more expensive than other European banks

Chart 80: Dividend yield comparison – Icelandic banks payout ratio is below the European average

-

2.00

4.00

6.00

8.00

10.00

12.00

PBV PE 2007E PE 2008E DY

Icelandic banks w eighted av g

European banks w eighted av g

-

1.00

2.00

3.00

4.00

5.00

6.00

DNB

NOR

OKO

Nord

ea

SHB

Swed

bank

Dans

keBa

nk SEB

Kaup

thing

DY

Source: Thomson Financial, UBS estimates Source: Thomson Financial

International universal and investment banks tend to cover only the larger corporates and institutions, usually with super-regional teams, partially or wholly based in London. Local partnerships have so far had a limited regional impact. Apart from the focus on size, there is also a lack of depth in individual country coverage. Icelandic banks have been successfully snapping up businesses that were below the radar screen of the bulge-bracket investment banking firms or large European wholesale banks. They have also benefited from the fact that corporate banking as such and broking businesses have gone out of favour in recent years. They are now getting to a size where the Icelandic banks are firmly on the radar screens of the local Nordic banks.


UBS 62

Table 26: Icelandic banks main competitors by region

Iceland Nordic region Benelux & Germany UK and Ireland

Kaupthing Glitnir Landsbanki Straumur

SEB, Nordea, Carnegie, SHB, Danske, Alfred Berg

ABN AMRO, Fortis, NG Barclays, RBS, Deutsche Bank, etc

Niche investment banks

Glitnir Kaupthing, Landsbanki Straumur

Nordea, DnBNor, SEB

N/A N/A

Landsbanki Kaupthing, Glitnir, Straumur

SEB, Nordea, Carnegie, SHB

Local and international brokers

Local and international brokers


Valuations

On a price-to-earnings basis, Icelandic banks are much closer to the Nordic average than what the P/BV view suggests. At the same time, Icelandic banks pay out much less than their regional peers, given that growth has been so strong and cheap funding in the form of deposits is not easy to come by.

Chart 81: PE – Icelandic banks more expensive than other European banks, 2008E

Chart 82: PBV – Iceland’s top 3 lead Nordic banks league table (as at Nov 15th)

-

2.00

4.00

6.00

8.00

10.00

12.00

14.00

OKO

Glitn

ir

Nord

ea

SHB

SEB

Kaup

thing

DNB

NOR

Swed

bank

Dans

ke B

ank

PE 2008

-

0.50

1.00

1.50

2.00

2.50

3.00

Glitn

ir

Kaup

thing SEB

Nord

ea

SHB

Swed

bank

DNB

NOR

OKO

Dans

ke B

ank

Stra

umur

P/BV

Source: Thomson Financial Source: Thomson Financial

RoE

The RoE of the Icelandic banking system has been spectacular and almost reached the 40% mark at year-end 2006. This outpaces the European UBS 70 bank average by almost 20%, which naturally raises questions of sustainability. We forecast that the Icelandic banks will almost, by definition, have to converge with the European average, due to their rapid diversification of earnings into structurally slower growth businesses and economies. We have yet to see a full cycle for the Icelandic banks whose loan portfolios and equity investments are all relatively young and have yet to stand the test of time.


UBS 63

Chart 83: ROE – Icelandic banks, 2000-06 Chart 84: Icelandic banks outpaced the UBS European ROE average by almost 20% at YE 2006

0%

5%

10%

15%

20%

25%

30%

35%

40%

2000 2001 2002 2003 2004 2005 20060%

5%

10%

15%

20%

25%

30%

35%

40%

RoE AVG

0%5%

10%15%20%25%30%35%40%

2000 2001 2002 2003 2004 2005 2006

RoE UBS Eurobanks Cash ROE

Source: Sedlabanki, UBS Source: Sedlabanki, UBS estimates

Building a pan-European footprint

The four large Icelandic banks – Kaupthing, Glitnir, Landsbanki and Straumur – have reached a relatively advanced stage in developing their pan-European footprint. Forced to look abroad for further business opportunities, they were too small until very recently to be taken seriously by competitors even in the closer proximity of the Nordic region.

Chart 85: Regional footprint of the four Icelandic banks

Kaup

thin

g

Glitn

ir

Land

sban

ki

Stra

umur

Kaup

thin

g

Glitn

ir

Land

sban

ki

Stra

umur

Kaup

thin

g

Glitn

ir

Land

sban

ki

Stra

umur

Kaup

thin

g

Glitn

ir

Land

sban

ki

Stra

umur

Kaup

thin

g

Glitn

ir

Land

sban

ki

Stra

umur

Kaup

thin

g

Glitn

ir

Land

sban

ki

Stra

umur

Curre

ncy g

roup

Geog

raph

y

Iceland ISK

UK GBP

Ireland

Netherlands

Belgium

Germany

France

Italy

Finland

Sweden

Denmark

Norway

Luxembourg

Switzerland

US & Canada

Russia & CEEKaupthing Glitnir Landsbanki

Euro

zone

cou

ntrie

s

Nor

dic

AM & PBRetail bankingCMIB Corp. bankingTreasury

Source: Company disclosure

The argument that Icelandic banks are operating in a universe of their own, which is essentially confined to the Iceland and equity investments in the local economy, is certainly no longer true as the charts below demonstrate. The Icelandic banks’ earnings mixes are now directly linked into that of the Nordic


UBS 64

zone, UK and parts of the euro area. All three banks have branches inside the euro area and therefore have access to the ECB discount window.

Chart 86: Kaupthing net op income* Chart 87: Glitnir PBT* Chart 88: Landsbanki net op income

Iceland, 25%

Scandinav ia, 23%

UK, 19%

Benelux , 25%

Other, 8%

Iceland, 55%

Nordic, 25%

Europe, 5%

International, 16%

Iceland53%

UK/Ireland19%

Lux embourg6%

Nordic and Cont.Europe22%

Source: Kaupthing, UBS Note: * Post NIBC acquisition.

Source: Glitnir, UBS Note: * Before FIM acquisition which will likely increase the Nordic part.

Source: Landsbanki

Business model: CIB driven

The Icelandic banks operate within an integrated financing business model, and focus particularly on small- and medium-sized enterprises. This function is combined with the ability to underwrite and distribute, and to provide market access through brokerage operations. A key differentiator versus other Nordic and European banks is the Icelandic banks’ high reliance on income from financial transactions.

All three banks are dependent on capital markets, corporate revenues or investment banking.

Chart 89: Kaupthing segmental overview (operating income, FY 2006)

Chart 90: Glitnir segmental overview (PBT, H1 2007)

Chart 91: Landsbanki segmental overview (PBT, H1 2007)

Treasury , 15%

Asset Mgt&Pv t Banking, 9%

Markets, 17%CIB, 59%

Corporate Banking,

30%

Markets, 26%

Retail Banking, 21%

Inv estment Banking, 12%

Inv estment Management, 9%

Treasury and Other, 2% Retail Banking

11%

Corporate Banking

35%

Investment Banking

50%

Asset management and Private Banking

4%

Source: Kaupthing, UBS estimates Source: Glitnir, UBS estimates Source: Landsbanki, UBS estimates

The Icelandic banks’ total income generation reveals that commission and financial income account for more than 50% of revenue at all three banks. As year-end 2006, Kaupthing had the highest contribution to total income from financial investments at 27%, while Glitnir was most reliant on fee and commission income from its investments in mid-tier European brokerage companies. Kaupthing is in the process of closing a fund where it has moved some of its 2007 equity investments. In this fund the holding will be less than 40%, which should reduce the immediate impact of marked-to-market swings on the results.


UBS 65

Chart 92: Icelandic banks – total income split, YE 2006 Chart 93: Fee & commission income & financial income YE2006

42% 47% 46%

24%

42%32%

27%

11%22%

0%10%20%30%40%50%60%70%80%90%

100%


Other Income

Net Financial Income

Net fee and Comission Income

Net Interest Income

0%

10%

20%

30%

40%

50%

60%


Commission + Financial income

Source: Company reports, UBS estimates Source: Company reports, UBS estimates

Credit quality

Credit quality has not been an issue since 2003, when impairments of loans as a percentage of net interest income (NII) peaked at 38%. We calculated the average ‘through the cycle’ charge for credit impairments as 23% of NII. Chart 94 shows that loan impairment levels as a percentage of NII were about 11% below the average charge over the past six years.

Chart 94: Impairment of loans and the assumed ‘through the cycle’ rate, 2000-06

0%

5%

10%

15%

20%

25%

30%

35%

40%

2000 2001 2002 2003 2004 2005 2006

Impairment as a % of NII Av erage 'through the cy cle'

Source: Sedlabanki, UBS

Equity investments

Equity investments constitute an important part of earnings at Kaupthing. This is one of the areas international investors feel least comfortable with and not just in the case of the Icelandic banks.


UBS 66

Chart 95: Kaupthing equity exposure as a % of balance sheet Chart 96: Landsbanki equity exposure as a % of balance sheet

6%4.3%

2.9% 2.8%1.5%

3%

0.8%1.6%

0.9%1.3%

0%1%2%3%4%5%6%7%8%9%

10%

2003 2004 2005 2006 1H 2007

Listed shares Unlisted shares

4.0% 4.1%

4.3% 4.3%

2.3%

2.9%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

2002 2003 2004 2005 2006 1H2007

Equity ex posure as a % of Balance sheet

Source: Company accounts Source: Company accounts

At Kaupthing the total equity exposure is limited to 35% of risk capital, of which, the unlisted exposure or private equity should not exceed 15%. This is still a material position.

Table 27: Kaupthing equity investments, YE 2006

YE 2006 ISK bn % of risk

capital % of Tier I

capital % of B/S

Total 159 34.5% 49.0% 3.9%

Listed 114 24.7% 35.0% 2.8%

Unlisted 45 9.8% 14.0% 1.1%

Total Icelandic 53 12.0% 17.0% 1.3%

o/w Icelandic listed 40 9.0% 12.0% 1.0%

o/w Icelandic unlisted 13 3.0% 4.0% 0.3%

Total other 106 23.0% 33.0% 2.6%

o/w other listed 74 16.0% 23.0% 1.8%

o/w other unlisted 32 7.0% 10.0% 0.8%



UBS 67

Financial stability matters In the Central Bank of Iceland’s Financial Stability Report 2006, published in May 2006, its main findings were that the financial system was broadly sound but more challenging waters lay ahead. Two main causes of concern were identified and have either been addressed over the past year or are currently in the process of being addressed:

Macroeconomic imbalances

Uncertainty about the commercial banks’ refinancing of their foreign borrowing.

In the year since the last financial stability report was published:

Refinancing has been successfully completed and the maturity profile and funding mix of the main banks has improved significantly.

However, macroeconomic imbalances have increased.

A year ago the focus was on short-term risks on the liabilities side of the financial companies’ balance sheets, but now it has shifted more to long-term asset quality.

Main vulnerabilities and strengths The Icelandic banks’ key vulnerability is their funding situation – a large

part of the international assets that have been taken on-balance-sheet over the past five years have to be financed in the international bond markets. Icelandic banks remain among the most wholesale-funding-reliant banks in the whole of Europe, caused by the absence of a meaningful home market.

Table 28: Deposits as a percentage of customer loans

(%) 2004 2005 2006 2007E

Kaupthing 21% 31% 30% 43%

Glitnir 77% 80% 78% 78%

Landsbanki 51% 49% 57% N/A

Source: Company accounts, UBS estimates


UBS 68

The mini confidence crisis in 2006 was a timely wake-up call for the Icelandic banks and regulators. Over a short period of time last year international investors lost confidence in the macro outlook and started to speculate against the currency. One of the consequences was a sharp short-term correction in the Icelandic stock market and a drying up of liquidity for the major banks. The central bank reacted in the two ways that it could:

— It forced the banks to increase their deposit-taking activities outside Iceland. This was done by following various strategies. Kaupthing and Glitnir approached corporates and municipalities for their deposits and were able to negotiate an attractive tenor.

— It sought to improve the banks’ maturity profiles: Over the course of the past 12 months all three Icelandic banks (1) increased their long-term funding, (2) diversified their funding markets away from Europe, and (3) made sure that there was enough liquidity on their balance sheets to be able to operate essentially without capital market access for 365 days before ordinary business activities would have to be curbed. So far, these measures have been a success in the present 2007 liquidity crisis. Even after the most recent acquisition of NIBC, Kaupthing has been able to operate for 365 days without funding access.

Chart 98: Average maturity of Icelandic banks versus wholesale funding dependency

Source: Sedlabanki

Rapidly rising credit – both domestic and foreign

Credit growth rates in Iceland have been significantly above the European average over the past five years (Chart 99). This increase has been driven by domestic credit demand (which includes international projects) and, to an even greater extent, by foreign credit. We expect this rapid phase of growth to show signs of slowing and to see growth rates more commensurate with the rest of developed European banking market.

Chart 97: Icelandic banks funding mix 2006

Equity8%

Subordinated Loans

4%

Wholesale Borrow ings

58%

Deposits27%

Other3%

Source: Sedlabanki


UBS 69

Chart 99: The banking system – credit growth fuelled by foreign credit and equities

0500,000

1,000,0001,500,0002,000,0002,500,0003,000,0003,500,0004,000,0004,500,0005,000,000

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

ISKm

Foreign credit and equities Domestic credit Domestic equities

Source: Icelandic Central Bank and UBS

Other important adjustment factors have been described in more detail in the macro section of the financial stability report. They mainly include:

Interest rates: The policy rate has just been raised to 13.75%, which will slow the beginning of the next investment cycle at least until the end of 2008.

Foreign exchange adjustments: Most observers believe the ISK to be 10-15% overvalued. An adjustment is, however, only likely when the first rate cuts of the central bank come through.

Terms of trade: Export prices could drop and oil prices rise further. Such unfavourable developments could widen the already very high current account deficit and erode national income. The central bank’s macroeconomic forecasts assume a deterioration in the terms of trade.

Fiscal position: The Treasury’s position is strong with consecutive fiscal surpluses. Net external treasury debt, including foreign reserves, is virtually zero. No pension gap is foreseeable, unless there is a severe correction in international equity markets.

Chart 100: Select advanced economies net external debt YE05 Chart 101: Net external debt and net interest payments

Source: Central Bank of Iceland Note that data for Iceland is as of YE 2006.

Source: Central Bank of Iceland, Statistics Iceland


UBS 70

Stress tests Commercial banks’ loan portfolio quality

The FME (Icelandic financial market regulator) has calculated the effects of simultaneous shocks on capital ratios of the largest Icelandic banks. Each Icelandic bank must be in a position to withstand a number of shocks simultaneously. These scenarios incorporate changes in the value of shares, market bonds, non-performing/impaired loans and appropriated assets, and the Icelandic krona without having the capital adequacy ratio (total capital) drop below the 8% Basel I minimum. The aforementioned simultaneous shocks on capital ratios are as follows:

A 20% fall in value of non-performing/impaired loans and appropriated assets

A 25% fall in value of foreign shares at own risk of the bank

A 35% fall in value of domestic shares at own risk of the bank

A 7% fall in value of bonds owned by the bank

A 20% weakening of the Icelandic krona, ISK

Table 29: Stress testing simultaneous shocks on Icelandic banks capital ratios

Kaupthing Glitnir Landsbanki Straumur

Total capital ratio 12.1% 13.7% 15.1% 31.7%

Tier 1 ratio 8.7% 9.1% 12.9% 30.2%

Total capital ratio after stress test 9.2% 12.5% 12.7% 24.0%

Source: Sedlabanki, FME

On another measure, this time conducted by the Icelandic Central Bank, the expected loss rates on Icelandic banks loan portfolio are as follows:

Chart 102: Stress testing commercial banks’ loan portfolio quality

Source: Sedlabanki

These results indicate that the banks have adequate buffers for meeting expected impairments. The banks’ provisioning leaves their equity resilient to a considerable change in the assumptions of the model.

There is, however, no obligation by the Icelandic authorities to bail out a bank that is in trouble, even though it is widely assumed that a bank in difficulty


UBS 71

would receive support. Given the financial institutions’ rapid growth compared to the Icelandic economy’s overall small size, it remains questionable whether the authorities in Iceland, if a state of financial turmoil that would also affect the currency, would be in a position to provide help or whether a pan-Nordic/European solution would have to be the answer.


UBS 72

Macro facts about Iceland Chart 103: Icelandic banks macro profile

Past 3 years 2007-2009ELow High Low High

GDP Growth GDP GrowthInterest rates Interest ratesInflation InflationExchange rate risk Exchange rate riskCurrent account Current account



The economy 4% average GDP growth between 1945 and 2005, which is significantly

above the European average. Over the past 10 years the average growth rate has been 4.5% compared to 2.7% for the OECD average.

More recently, growth has slowed in Iceland: The Icelandic Central Bank expects less than 1% GDP growth in 2007. The next investment cycle is supposed to begin in 2008.

Iceland has a very prosperous economy – with GDP per capita of US$54,000 (or €43,000) in 2005. In PPP adjusted terms this was 20% above the OECD average or the fifth highest within the OECD.

A young and well-deployed population where the average age is just 36 years. The unemployment rate is very low, currently at 2%, due to strong economy activity which results in a high labour participation of greater than 80%.

Outlook for the Icelandic economy in Q4 07

Economic growth is expected to by local banks and the central bank to slow down relative to previous years and will likely be less than 1% for 2007. The main growth driver will ultimately be foreign trade, once again, which is expected to pick up due to increased sales of aluminium ore. Government spending is expected to contract this year. Overall government debt is virtually non existent reducing the macro risk at least from this side. Private consumption had slowed by 1.2% in the first quarter of 2007 but picked up again by mid-year, driving inflation expectations.

The expected positive effect on the current account deficit has not happened and it is expected to be ~17% this year potentially slowing to ~13.5% in 2008 and 2009.


UBS 73

Chart 104: Real GDP growth rate, 1997-2007 Chart 105: GDP growth in Iceland, 1992-2006

-1.00.01.02.03.04.05.06.07.08.09.0

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Real GDP Grow th Rate(%)

-4%-2%0%2%4%6%8%

10%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

GDP growth Iceland 1992-2006 Average+1STDEV -1STDEV

Source: Thomson Financial, Sedlabanki, UBS Source: Statistics Iceland, UBS

When could the economy pick up again? There are several indications that the Icelandic economy is taking off again. So far, most relate to housing and private consumption. Moreover, several bad news items, such as the reduction in the cod quota, in the first half of the year have not managed to shake the confidence of Icelandic consumers that is currently running high.

Interest rates The central bank announced an unexpected rise in the policy rate of 0.45 percentage points on 2 November. The Sedlabanki policy rate now stands at 13.75%, and was last increased in December 2006.

Previously the central bank’s position was that rate rises were not seen to be in the interest of the economy due to delays in the transmission process of monetary policy, which in other parts of Europe typically takes 12-18 months to take effect.

The rationale to increase interest rates now therefore came as a surprise and the general consensus of analysts in Iceland was for policy rate to remain unchanged at 13.3%. Most commentators viewed this increase as unexpected, possibly having little effect on inflation and short-term undesired positive effects on what is otherwise seen as a 10-15% overvalued currency.

Inflationary pressures need to be addressed

Inflation has persisted since the central bank published its forecasts in July, being higher than the bank forecast in both Q2 and Q3.

Importantly for such an economy the cut in the cod quota for the fishing year starting 1 September was bigger than the bank had anticipated.

The output gap was bigger than the central bank assumed in its most recent forecast published at the beginning of July.

The central bank now forecasts higher inflation in Q4 – 1% higher than in the original July forecast – driven largely by rising housing costs (which are not included, to the same extent, in other European countries).

Possibly the most important driver for the rate hike was the view that the inflation outlook for 2008 would be worse than expected; not least because the labour market remains tight following wage increases and the purchasing


UBS 74

power of disposable income has been rising rapidly. These affect consumer good purchases and car import figures, which remain at very high levels.

Despite uncertainties in the world economy, Icelandic consumer optimism for next year has increased. Higher-than-forecast consumption growth will, however, lead almost certainly to higher inflation.

Rates outlook – interest rates have little bite

According to the central bank’s macroeconomic outlook, the policy rate will likely remain unchanged until the middle of next year. A rate cut will follow as soon as it is clear that the monetary transmission process is working. The base case of most local banks is that the policy rate will be lowered around the middle of next year. We do not expect any change when the central bank holds an additional session on 20 December. Many observers believe that when the ISK’s appreciation comes to an end the bite will be felt.

Chart 106: Interest rates – 3-month interbank rate Chart 107: Interest rates – 10-year treasury yield

0.02.04.06.08.0

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Source: Thomson Financial, Sedlabanki, UBS Source: Thomson Financial, Sedlabanki, UBS

Inflation remains high but, due to demand and FDI, is on the way down.

Chart 108: 12-month CPI change and inflation target Chart 109: Current central bank inflation forecast, Q2 2007-2010

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The exchange rate remains a key risk factor Following the surprise interest rate hike by the central bank, the ISK appreciated, not least due to rate cuts in the US at about the same time.


UBS 75

We believe that the Icelandic central bank will start easing as soon as the desired scenario of a soft landing materialises, and current imbalances begin to show signs of correction by mid-2008. With a potential decline in the ISK, private consumption is likely to soften further.

Most commentators believe that the current GDP slowdown should be short-lived. Economic activity is set to increase a gear in 2009, not least because of several large-scale investment projects and, once again, rising consumption. Some scenarios put economic growth for 2009 in the region of 3%, which would once more be above the European average.

Chart 110: ISK to the euro Chart 111: ISK to the British pound

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Source: Thomson Financial, UBS Source: Thomson Financial, UBS


UBS 76

Risk – opportunity scorecard Table 30: Macro risk – opportunity screen for the macro and micro investment case, 10 themes

Risk factor Current situation Outlook 2008 Risk/opportunity score (10= high risk or, 1 = low risk or opportunity)

PART I MACRO ECONOMY and CAPITAL MARKETS Overall score: 6.8

THEME I - Economic growth

Expected to be below 1% this year. The IMF expects a new investment cycle to begin in 2008. GDP growth averaged 7% pa between 2000 and 2007.

Growth should pick up next year but may be delayed by the recent rate hike. The main risk is a slowdown in the global economy, which may hurt the open Icelandic economy more than others. If a soft landing materialises growth could surprise on the upside.

7 UBS base case is for a soft landing in the US and other important economies.

THEME II – FX risk

In 2006 a crisis of confidence led to a significant swing in the currency. This could happen again affecting returns for investors outside Iceland.

A high C/A deficit and slow growth are not ideal for FX stability. Given the dependency on a mix of at least 3 currencies, results will be affected more by exchanges than most other eurozone banks.

7 The currency has devalued against the euro already and it may be close to equilibrium for the time being. We expect it to be supported in the short run and then to weaken in conjunction with, or anticipation of, interest rate cuts. The change of Kaupthing’s reporting currency to euro may also affect the exchange rate negatively.

THEME III- Interest rates & CA deficit

Stands at 26% and is among the highest in Europe. Iceland’s comparatively tiny GDP and large investments provide some explanation for this even though personal consumption has been strong. Interest rates have recently risen unexpectedly by 45bp to 13.75%, which is likely to dampen economic growth and delay the start of a new cycle.

There are signs that the CA deficit will shrink but it is likely that any new large-scale investment project particularly in the aluminium sector will keep it negative. In addition, cod quotas have been smaller than anticipated. Interest rates are likely to go down by mid-2008, which is going to affect FX rates.

8 A high real exchange rate and the prospect of continuing external debt accumulation weaken the foundations of the ISK. The ISK could depreciate abruptly if global market conditions deteriorate to any substantial degree.

THEME IV – Stock market performance and valuation

The OMX Iceland had performed strongly over the past 5 years, outperforming all other western European market indices by a margin.

Stock markets performance will be a reflection of the global economy. EPS downgrades have recently become more frequent but it is too early to ascertain if the profit cycle has really turned.

5 Our assessment is that equity markets remain by and large stable over the next 12 months.

THEME V – Inflation

Inflation remains high, held up by persistently higher-than-expected private consumption.

Expected to fall moderately next year allowing rate cuts to come through.

7 Inflation risk was the main concern for the Icelandic central bank to raise interest rates.



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Table 31: Micro risk – what do we think about the Icelandic banks? PART II MICRO UBS assessment Outlook 2008 Overall Score: 6.0

THEME VI Strategy

Traditionally banks have had a much stronger focus on corporate & investment banking than on retail banking. Investment track record strong but into banks with lower ROEs. Rapid acquisition integration with visible success based on a private equity philosophy.

At Kaupthing the diversification of the earnings base has improved this year with the acquisition of NIBC. 2008 will be the first full year of integration against a possibly more difficult macro backdrop. Equity investment returns will depend on the risk appetite in the market and are uncertain. Glitnir has to prove that its cobbled together network in the Nordic region can deliver sustainable returns. Its Norwegian retail and corporate banking operations are underperforming.

7 We remain cautious that the same high growth rates can be maintained. Above-average growth rates in recent years were supported by the economic cycle and the Icelandic stock market more than anything else. Previous acquisitions need to be integrated and there is the risk of add-on acquisitions at Glitnir over the next 2 years.

THEME VII Management

Management tends to be of good quality. In the case of Kaupthing they have several years of experience and a stable leadership structure. In the case of Glitnir management has changed recently and needs to establish a track record first.

Management at Kaupthing will be preoccupied with the integration of NIBC, its biggest acquisition to date. Glitnir may devote more time to integrate its new asset management unit FIM with the rest of the group, and to establish further synergies in its securities brokerage platforms and corporate banking platforms.

4 We believe that management has been doing a good job to transform what have been previously no more than peripheral banks into pan-European mid-sized players. The main risk is to get stuck in an ABN AMRO situation where the units don’t come together.

THEME VIII Sustainability of earnings

Earnings growth has been supported by rapid growth of business activities not least through acquisitions inside and outside Iceland. A key driver has been equity investments which are by nature cyclical and 2/3 in mark-to-market portfolios. Valuations have been supported by the rapid appreciation of the Icelandic stock market for which there is a natural limit.

Our view is that risk appetite in capital markets has changed and that financing risky buyouts or takeovers has become more difficult as a consequence of the credit crunch. We believe that contributions from equity investments should be in line with 2007 in 2008, as long as markets overall are holding up, which nevertheless means a significant slowdown from previous years.

8 The Icelandic banks are above-average risk investments. Investors have to be aware that leverage works both ways. In the scenario of a continuation of the high risk appetite equity valuations and economic growth, Icelandic banks will enjoy good operating conditions. Conversely, if the market and economy slow, Icelandic banks are likely to be more affected.

THEME IX Credit quality and equity investments

Credit quality remains at very low levels. Measured in bp over customer loans, current IFRS provisioning requirements are only a touch higher than what appears to be the absolute low in 2006. Going forward, banks expect them to increase but are unsure what the trajectory will be and have based their forecasts on increased forecasts at other European corporate and investment banks.

- Equity portfolios have risen rapidly in recent years. This raises the question about prices paid, vintages and vulnerability to a slowdown. Many other European banks have reduced their equity portfolios after painful marked-to-market experiences during the last downturn.

Corporate banks have yet to see credit provisions rise. The key question will be what the trajectory of this increase will be. Our forecasts assume lower peak levels than during the past downturn, which may be optimistic in particular given that the portfolio is very new.

- Equity investments are core P&L contributions for Kaupthing and to a lesser degree for Glitnir. So far, there has not been any sign that these contributions may be materially affected as equity markets generally have been holding up in what has so far been an insulated liquidity crisis in the banking sector.

6 We know very little about the portfolio vintages of Glitnir and Kaupthing. What we know is that in the niche markets that they are operating in such as seafood, geothermal energy and shipping etc, they are experts and leading the competition. In other areas of their recent expansion we have yet to see how much risk they have taken on. We know that Kaupthing and Glitnir have been active in commercial RE lending in the UK and Norway and, going forward, this will be reinforced through NIBC. This has been an area of extreme caution by many investors recently.

- Weaker equity markets and investments made at the top of the cycle may affect revenues negatively, as these are items that have to be treated on a marked-to-market basis.

THEME X: Funding

Banks had to resort to wholesale funding in order to fund rapid asset growth. Following the brief period of financial turmoil in 2006, Icelandic banks have strengthened their funding structures and weathered the credit crunch pretty well so far, which also finds confirmation in a positive outlook report by Fitch. One of the measures taken by banks has been to increase their deposit-taking activities, which now average between 30% and 70% of customer loan activity.

Funding cost in 2008 will likely develop tot levels above this seen in 2006 & 2007YTD, which may affect NII at Kaupthing and Glitnir negatively. CDS spreads for Glitnir are currently much lower than for Kaupthing where an equity issuance for NIBC has yet to be completed.

5 The maturity profile of the Icelandic banks is very long term and deposit-gathering activities have brought deposit funding back to levels seen before the expansion programmes started in 2002. The only impact we would expect is on profitability and not so much on financial stability, as long as CDS spreads for Kaupthing do not stay permanently at current very high levels.

COMBINED SCORE 6.4 = above average

Source: UBS Source: UBS estimates


UBS 78

Appendix Table 32: Price performance and EPS growth comparisons

Price performance 2006 2007 YTD EPS growth 2006/05 EPS growth 2007/06E EPS growth 2008/07E

Iceland Kaupthing 16% 9% 55% -18% 0%

Glitnir 36% 5% 98% -23% -1%

Sweden Swedbank 15% -19% -7% 7% 9%

Nordea 28% 2% 43% -6% -9%

SEB 33% -19% 52% 7% 5%

SHB 5% -3% 19% -4% 0%

Denmark Danske Bank 13% -19% 14% -5% -9%

Norway DnB Nor 23% -3% 15% 5% -6%


Trading volumes in Icelandic stocks Chart 112: Kaupthing trading volumes and price development

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UBS 79

NPL history

In this section we have tested what a return to a normalised provision and profitability environment would mean for the Icelandic banks. In the current environment NPLs are at a cyclical low at all Icelandic and most European banks.

Chart 114: NPL history

0.00%0.50%1.00%1.50%2.00%2.50%3.00%3.50%4.00%

2001 2002 2003 2004 2005 2006 H1 2007

LandsbankiNPLs (>90day s past due) Kaupthing NPLs

Source: Company accounts and UBS


UBS 80

Statement of Risk

Bank earnings are affected by movements in interest rates, the level of economic growth and activity levels in the capital markets and can be negatively impacted by a slowing of the economy and reduced levels of, and activity in, the capital markets. These companies are also subject to regulatory, legislative, and judicial risk particularly relating to potential changes in accounting practices, liability arising from perceived conflicts of interest, or damaged corporate clients. These companies are dependent on market and transaction volumes and are subject to technology and operational risk, both of which can impact financial results. Additionally, changes in market structure can adversely impact their ability to compete.

Analyst Certification

Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers; and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report.


UBS 81

Required Disclosures This report has been prepared by UBS Limited, an affiliate of UBS AG. UBS AG, its subsidiaries, branches and affiliates are referred to herein as UBS.

For information on the ways in which UBS manages conflicts and maintains independence of its research product; historical performance information; and certain additional disclosures concerning UBS research recommendations, please visit www.ubs.com/disclosures.

UBS Investment Research: Global Equity Rating Allocations

UBS 12-Month Rating Rating Category Coverage1 IB Services2

Buy Buy 55% 40%Neutral Hold/Neutral 36% 35%Sell Sell 9% 22%UBS Short-Term Rating Rating Category Coverage3 IB Services4

Buy Buy less than 1% 29%Sell Sell less than 1% 0%

1:Percentage of companies under coverage globally within the 12-month rating category. 2:Percentage of companies within the 12-month rating category for which investment banking (IB) services were provided within the past 12 months. 3:Percentage of companies under coverage globally within the Short-Term rating category. 4:Percentage of companies within the Short-Term rating category for which investment banking (IB) services were provided within the past 12 months. Source: UBS. Rating allocations are as of 30 September 2007. UBS Investment Research: Global Equity Rating Definitions

UBS 12-Month Rating Definition Buy FSR is > 6% above the MRA. Neutral FSR is between -6% and 6% of the MRA. Sell FSR is > 6% below the MRA. UBS Short-Term Rating Definition

Buy Buy: Stock price expected to rise within three months from the time the rating was assigned because of a specific catalyst or event.

Sell Sell: Stock price expected to fall within three months from the time the rating was assigned because of a specific catalyst or event.


UBS 82

KEY DEFINITIONS Forecast Stock Return (FSR) is defined as expected percentage price appreciation plus gross dividend yield over the next 12 months. Market Return Assumption (MRA) is defined as the one-year local market interest rate plus 5% (a proxy for, and not a forecast of, the equity risk premium). Under Review (UR) Stocks may be flagged as UR by the analyst, indicating that the stock's price target and/or rating are subject to possible change in the near term, usually in response to an event that may affect the investment case or valuation. Short-Term Ratings reflect the expected near-term (up to three months) performance of the stock and do not reflect any change in the fundamental view or investment case. EXCEPTIONS AND SPECIAL CASES UK and European Investment Fund ratings and definitions are : Buy: Positive on factors such as structure, management, performance record, discount; Neutral: Neutral on factors such as structure, management, performance record, discount; Sell: Negative on factors such as structure, management, performance record, discount. Core Banding Exceptions (CBE) : Exceptions to the standard +/-6% bands may be granted by the Investment Review Committee (IRC). Factors considered by the IRC include the stock's volatility and the credit spread of the respective company's debt. As a result, stocks deemed to be very high or low risk may be subject to higher or lower bands as they relate to the rating. When such exceptions apply, they will be identified in the Company Disclosures table in the relevant research piece. Company Disclosures

Company Name Reuters 12-mo rating Short-term rating Price Price date Glitnir banki hf2, 4, 22 GLB.IC Not Rated N/A Isk24.65000 03 Dec 2007 Kaupthing Bank2, 4, 5, 22 KAUP.IC Not Rated N/A Isk968.00000 03 Dec 2007

Source: UBS. All prices as of local market close. Ratings in this table are the most current published ratings prior to this report. They may be more recent than the stock pricing date 2. UBS AG, its affiliates or subsidiaries has acted as manager/co-manager in the underwriting or placement of securities of

this company/entity or one of its affiliates within the past 12 months. 4. Within the past 12 months, UBS AG, its affiliates or subsidiaries has received compensation for investment banking

services from this company/entity. 5. UBS AG, its affiliates or subsidiaries expect to receive or intend to seek compensation for investment banking services

from this company/entity within the next three months. 22. UBS AG, its affiliates or subsidiaries held other significant financial interests in this company/entity as of last month`s end

(or the prior month`s end if this report is dated less than 10 working days after the most recent month`s end). Unless otherwise indicated, please refer to the Valuation and Risk sections within the body of this report.


UBS 83

Glitnir banki hf (Isk)

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Source: UBS; as of 03 Dec 2007 Kaupthing Bank (Isk)

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Source: UBS; as of 03 Dec 2007


UBS 84

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A question of risk-reward · UBS Investment Research Icelandic banks A question of risk-reward Growth normalisation following years of exceptional performance We initiate coverage

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