2 Financial stability

2.1 Introduction

The economy as a whole may suffer considerable damage in the absence of a well-functioning financial system. Facilitating financial stability is therefore an important responsibility for the authorities. Financial stability is conditional upon financial institutions holding sufficient capital buffers to handle losses, and upon the payment system being adequately safeguarded. Financial stability also depends on the financial system being robust enough to endure turbulence in the economy.

This chapter addresses the financial stability outlook. It contains overviews and assessments of market conditions, risk developments for financial institutions, as well as the solvency and earnings of such institutions. The first section provides a brief overview of the efforts to ensure financial stability in Norway.

Background details and data for this chapter have in large part been obtained from Norges Bank and Finanstilsynet (the Norwegian financial supervisory authority).

2.2 Efforts to ensure financial stability in Norway

The financial system comprises market participants, market places and transaction infrastructure. The system effects payments and enables players in the real economy to manage and reallocate financial risk and allocate resources over time. Financial institutions assume liabilities and risks in their capacity of intermediaries and counterparties to such trades. It may be difficult for players in the real economy to prepare for the eventuality that financial institutions may default on their liabilities. There are numerous examples to the effect that players in the real economy are entirely dependent on the financial institutions involved being able to discharge their liabilities. Problems in financial institutions will therefore readily affect the real economy.

Due to the economic interaction between financial institutions, weaknesses in a limited part of the financial market may damage the financial market as a whole. Problems may be exacerbated through negative interactions between the financial markets and the real economy. Authorities may seek to bring such negative interaction to an end by using monetary policy tools, by stimulating the economy through fiscal policy or, in serious cases, by extraordinary measures aimed directly at financial institutions.

If financial institutions have low equity-to-assets ratios, or have come to depend on funding from unstable sources, it may be particularly demanding to counteract negative interactions between the financial markets and the real economy. If the measures taken by authorities are sufficiently comprehensive, even states may end up in financial difficulties owing to the expenditure associated with such measures. Consequently, fewer resources are often required to prevent excessive risk taking, which may result in financial crises, than to counteract the effects of financial crises. Facilitating financial stability is therefore an important responsibility for the authorities.

The authorities work to prevent solvency and liquidity crises in the financial system through statutory and regulatory requirements, as well as through supervision of financial institutions and financial markets. In Norway, we have attached considerable weight to comprehensive and consistent regulation by for example regulating the same type of risk in the same way irrespective of its location, thus preventing risk from accumulating where it is subject to the least regulation. This principle has underpinned Norwegian financial markets regulation for many years. It is also an important prerequisite for financial stability – and an important objective in itself – to have good consumer protection in the financial markets.

Efforts to ensure financial stability in Norway are shared between the Ministry of Finance, Norges Bank and Finanstilsynet. The Ministry of Finance holds the overall responsibility for ensuring a well-functioning financial system. Norges Bank and Finanstilsynet shall contribute to a robust and efficient financial system, and therefore oversee financial institutions, securities markets and payment systems to identify any element that may threaten stability. Finanstilsynet also supervises financial institutions and market places. As central bank of Norway, Norges Bank is lender of last resort.

In 2006, so-called tripartite meetings on financial stability between the Ministry of Finance, Norges Bank and Finanstilsynet were established. Information about, among other things, Norwegian and international economic developments and the state of financial markets is exchanged in the tripartite meetings. The meetings constitute an important channel for the exchange of information between the three institutions, and contribute to a comprehensive overview of the financial stability outlook. Such meetings are generally held every six months, but more frequently when needed. Tripartite meeting have been held more frequently in recent years as a result of the financial crisis and the volatile state of international financial markets. Four tripartite meetings were held in 2011, whilst three meetings have been held thus far in 2012.

The Ministry of Finance is considering measures to improve the macroprudential supervision of systemic risk in Norway based on input from a working group established by the Ministry to examine how the macroprudential supervision of the financial sector should be organised in Norway. The report from the group is discussed in Chapter 3.

2.3 Main features of the financial stability outlook

2.3.1 Developments in financial markets

International financial market developments in 2011 were characterised, in particular, by mounting concern that some EU countries might default on their sovereign debt, and that governments in Europe would not be able to implement necessary support measures and budget cuts. The measures implemented during the autumn were not sufficient to bring the negative developments to an end. Doubts were first confined to Greece, Portugal and Ireland, but spread in 2011, especially to Italy and Spain. Interest rates on Italian and Spanish sovereign bonds increased to levels that are not sustainable in the long run, but decreased somewhat towards the end of 2011 and into 2012, cf. Box 2.1. CDS prices on European sovereign debt also increased markedly in 2011, and several countries were downgraded by credit rating agencies.

When the market loses confidence in the ability of a country to service its debts, the interest rate on its sovereign debt will increase. This will also add to the danger that the country will in fact be unable to service its debts. Several European countries were caught in such a negative spiral in 2011.

Boks 2.1 The state of sovereign debt in some EU countries

Sovereign debts in several industrialised countries have in recent years increased to levels previously only observed during times of war. The latest calculations from the IMF show that aggregate gross debts on the part of the traditional industrialised countries are likely to increase from about 104 per cent of GDP in 2011 to 109 per cent in 2013. The average for the Euro zone is currently at about 88 per cent and is likely to increase to 91 per cent in 2013. The countries in the worst positions are well above this level, cf. Figure 2.1A. In the spring of 2012, the IMF calculated that in order to reduce the debts of industrialised countries to 60 per cent of GDP by 2030, those countries would on average have to reduce their primary balances (budget balance before interest costs) by 8.6 per cent of GDP between 2011 and 2020, and thereafter maintain this at a steady level.

In the last two years, there have been particular doubts about the ability of some states in Europe to service their debts. In the first half of 2010, interest rates on sovereign loan increased steeply in several European countries, in some cases to non-sustainable levels, cf. Figure 2.1B. Greece obtained emergency loans from the Euro zone countries and the IMF in May 2010, and in November 2010 and April 2011 emergency loans were also granted to Ireland and Portugal, respectively. In the spring of 2011, it became evident that Greece needed more assistance. In March 2012, Greece obtained a rescue package from the EU and the IMF. The loan was approved when Greece managed to reduce its sovereign debt by EUR 100 billion through a debt relief operation. Greece itself had to make additional budget cuts and introduce a number of fundamental structural reforms. The market has reacted by steeply reducing interest rates on Greek sovereign debt, but the interest rate still remains very high. The rescue package and the measures underpinning it may reduce sovereign debt to 117 per cent of GDP by 2020, down from about 160 per cent at present.

Most Euro zone countries are now in the process of improving their budget balance, and are during the period 2013-2015 likely to get below the EU treaty limit on maximum government budget deficits, which is 3 per cent of GDP. Some countries will need more time than that. Budget balances within the Euro zone were on average strengthened by about 2 per cent in 2011, and it is expected that the average budget deficit will decline from 6.2 per cent in 2010 to 2.7 per cent in 2013.

In addition to granting emergency loans to exposed countries, the EU has agreed and implemented a number of measures to improve economic coordination in the EU, to regain confidence in the financial markets and prepare for, and prevent, new crises. Some of the measures are still subject to approval by national parliaments. The measures may be briefly summarised as follows:

• The Euro zone countries established two interim schemes for emergency funding for Euro zone countries, the ESFS and the EFSM, in May 2010. The heads of the Euro zone countries have agreed to replace these schemes by a permanent scheme, called the ESM, in July 2012. The maximum lending volume is EUR 500 billion for new lending. In addition, existing lending of about EUR 200 billion shall remain in place under the EFSF.

• In January 2011, the EU introduced new budget procedures and procedures for the coordination of economic policy in the EU, called the “European semester”.

• In December 2011, the EU introduced, inter alia, stricter enforcement rules for Euro zone countries that breach the limits stipulated in the Stability and Growth Pact (SGP) with regard to maximum budget deficits and indebtedness. New rules were also introduced to monitor and rectify macroeconomic imbalances at an earlier stage.

• The Euro Plus Pact was agreed in March 2011. This is a political agreement on closer coordination of economic policy and budget policy.

• On 2 March 2012, the EU countries, with the exception of the United Kingdom and the Czech Republic, signed a new intergovernmental agreement (a financial pact) that, inter alia, obliges the states to incorporate stricter budget rules in their national legislation than those require under the SGP. Annual structural budget deficits shall not exceed 0.5 per cent of GDP. The Euro zone countries shall also improve coordination of both economic policy and budget policy, and it was agreed that two Euro summits would be held during every six-month term.

A virtually unlimited offer for 3-year loans (against collateral) from the European Central Bank has been of special importance, and interest rates on Italian and Spanish sovereign debts stabilised in early 2012. Renewed turmoil occurred in March and April 2012 due to weaker growth outlook, delays in austerity plans, and increased capital needs in Spanish banks.

Kilde: European Commission, OECD and IMF

The sovereign debt problems and downscaled growth projections for the world economy also contributed to price drops and major fluctuations in the stock markets in 2011, cf. Figure 2.2A. Developments were fairly stable in the first half of 2011, until new disquiet concerning the state of sovereign debt in Europe resulted in steep declines in late summer. Prices rebounded to some extent during the autumn, in part as the result of coordinated measures from central banks. Financial institutions’ stocks have underperformed relative to the market as a whole, both in Norway and abroad.

Many European banks hold large investments in European sovereign debt. Increasing uncertainty about the repayment of sovereign debt results in a depreciation of the banks’ sovereign debt securities holdings. Weaker earnings and concerns about losses make funding more expensive and less available for banks. Depreciation of the sovereign debt securities also means that banks are not able to furnish the same amount of collateral to secure loans. A third element is that solvency problems on the part of some states reduce their ability to support banks in the event of a crisis.

Many European banks have experienced funding difficulties in 2011, and not much bond debt has been issued by banks. The difficulties were reflected in credit spreads, cf. Figure 2.2B. Short-term money market rates are usually close to policy rates, and increased credit spreads are often a sign of concern in the market. Because European banks were facing the maturity of a significant part of their funding at the beginning of 2012, and conditions in the funding markets did not appear to be improving, prospects were bleak towards the end of 2011. A virtually unlimited offer of 3-year loans (against collateral) at an interest rate of 1 per cent from the European Central Bank (ECB) probably prevented a significant escalation of the problems. More than 500 European banks borrowed a total of about EUR 490 billion in the first allotment on 21 December 2011. This corresponds to about 5 per cent of GDP in the Euro zone. In the second allotment, on 28 February 2012, 800 banks borrowed about EUR 530 billion. In addition to helping the banks, there is much to suggest that the measure has also improved conditions for the most vulnerable debtor countries in the Euro zone, as the banks to a large extent have used the liquidity to purchase sovereign bonds. This may turn out to be profitable for the banks if there is no default on the sovereign debt, since the interest rates on the sovereign debt are markedly higher than the 1 per cent interest rate they are paying to the ECB.

Nordic banks are less affected by the volatility in Europe than are European banks in general, but CDS prices of Nordic banks has nonetheless increased considerably in 2011, cf. Figure 2.2C. Volatility abroad affects conditions for the Nordic institutions because, inter alia, the funding market is to a large extent an international market. Nevertheless, the figure shows that the CDS prices of DNB and Nordea have increased less, and from a lower level, than the average for European banks (the iTraxx index). This may indicate that investors believe that Nordic banks are less exposed to loss, for example due to favourable developments in the Nordic economies and the banks’ relatively high capital ratios. Developments for Danish banks have, on the other hand, had more in common with developments for European banks in general than with developments for Norwegian and Swedish banks. This is related to the problems in the Danish banking sector, cf. Box 2.2. For the Norwegian credit undertaking Eksportfinans ASA, 2011 was a turbulent year, cf. the discussion in section 2.5.

Taken together, conditions improved somewhat in international and Norwegian financial markets towards the end of 2011 and in the beginning of 2012. Stock prices have increased, CDS prices have declined, credit spreads in money market rates have fallen somewhat, and indicators suggest that investors are more willing to assume risk. Interest rates on sovereign bonds from countries like Italy and Spain have fallen from their top levels in November 2011. Nevertheless, future developments are subject to considerable uncertainty. Many European countries find themselves in an uncertain economic situation, and sovereign debt default on the part of one or more countries may have very serious and unpredictable consequences. The European sovereign debt problems may spread to the US economy and to emerging economies, and the danger that European banks may severely tighten credit supply to the European real economy has not passed.

In Figure C, the CDS price is the price of insurance against default on bond debt in the form of credit default swaps (CDS). CDS prices are defined as a percentage of the (nominal) value of the insured asset, or an index, and apply for one year at a time (although the payments tend to be quarterly).

Kilde: Bloomberg, Norges Bank, Reuters Ecowin and Statistics Norway

2.3.2 Norwegian financial institutions

Norwegian banks and mortgage companies have in recent years funded a larger part of their activities by issuing bonds and certificates, and much of this wholesale funding has been obtained abroad and in foreign currency. Whilst it is primarily the larger banks that are directly dependent on wholesale funding, turbulence in international funding markets may spread swiftly to the smaller banks as well, because the larger banks are important funding sources for the smaller banks. Although the funding structure has become somewhat more robust over the last year, short-term wholesale funding still accounts for a fairly large portion of the wholesale funding of Norwegian banks and mortgage companies as a whole.

The international financial crisis demonstrated that banks may experience liquidity problems without suffering any evident underlying solvency problem. The recent market turbulence has demonstrated that Norwegian institutions also are vulnerable. If institutions place themselves in a situation where they virtually at all times are dependent on refinancing in foreign markets, they are exposed to problems abroad. Norwegian banks have already to a large extent exploited the potential for funding new lending by transferring residential mortgages to residential mortgage companies. It is therefore now important for the banks to reduce their liquidity risk in other ways, and for them to be able to cope with sustained periods of turmoil in financial markets. It is important for the economy as a whole that the financial system is able to offer new credit to those who need it, also in times of turbulence.

In October 2011, it was agreed at the ministerial level in the EU that major European banks should enhance the quality and quantity of their capital, so that all major banks will have a common equity tier 1 (CET1) capital ratio of at least 9 per cent by 30 June 2012. In Norway, Finanstilsynet expects all Norwegian banks to have a CET1 capital ratio of at least 9 per cent by 30 June 2012. Most Norwegian banks already exceed this target. As per yearend 2011, Norwegian banks had an average CET1 capital ratio of 11 per cent.

Norwegian banks have strengthened their solvency considerably since 2008, including in 2011. This is achieved in part by retaining profits – which have been high over this period – and by issuing new equity, rather than deleveraging or otherwise shrinking of balance sheets. Profits in recent years and future prospects indicate that banks will be well placed to further strengthen their solvency by retaining profits. They may also increase their own funds by issuing new equity. It is, as discussed in Box 2.9 below, not necessarily the case that banks’ overall funding costs will increase significantly with the equity capital ratio. Since more equity capital means less risk for both owners and creditors, banks can expect a decline in the return on equity required by investors, as well as a decline in their funding costs. Generally, the socially optimal level of equity capital in banks is higher than what banks themselves may consider optimal. Moreover, several surveys have concluded that the socially optimal CET1 capital ratio is significantly higher than that implied by the minimum requirements under the Basel III standards, cf. Box 2.9 below.

Banks’ risk outlook is closely linked to the capacity and willingness of their borrowers to pay interest and instalments on loans. Norwegian banks’ corporate borrowers are currently enjoying good solvency and earnings, but the credit risk on these exposures is sensitive to the business cycle. If the Norwegian economy is exposed to major new shocks, or if economic growth internationally weakens, the outlook may change quickly. Developments in the Norwegian real estate markets will also have a major influence on risk, partly because loans to corporations within the commercial property sector represent a large portion of Norwegian banks’ corporate loans, and partly because of the link between housing price developments and household demand. If households’ finances worsen or households’ housing wealth is reduced as the result of a housing price decline, they can be expected to reign in their consumption, which would affect corporations. A major decline in housing prices may saddle banks with higher losses on their corporate sector loans, whilst the collateral on their household sector loans depreciates.

Residential mortgages account for the greater part of banks and mortgage companies’ lending. Households’ capacity to service their debts can be measured by the so-called debt and interest burdens, cf. Figure 2.2D. The debt burden is currently at about 195 per cent, and it is expected to increase to almost 220 per cent by 2015 due in part to low interest rates and increasing housing prices. At the last peak in household debts, just before the Norwegian banking crisis in the early 1990s, the debt burden was about 150 per cent. The interest burden is low at present, but will increase as interest rates revert to a more normal level. There is a danger that many household are now making decisions in the expectation that interest rates will remain low and that labour market conditions will remain favourable for a very long time.

In Norway, neither housing prices, nor household debts, have ever been as high as at present, and interest rates are very low. A decline in housing prices may result in significantly higher losses for banks, on both residential mortgages and corporate lending. Special caution is therefore called for, and banks and mortgage companies should cushion loans in both segments by more capital. There is a danger that high growth in housing prices may give rise to expectations of further price growth, again contributing to price growth. A corrective decline in prices may in such a case be steeper than otherwise, exacerbated by expectations of further price declines.

Major Norwegian banks use to a large extent internal models (the IRB approach) to calculate their capital requirements for lending exposures, which may in general result in lower capital requirements than under the less complicated standardised approach. In order to prevent usage of internal models from excessively reducing the capital requirement, a transitional arrangement has been introduced under which banks using internal models shall have a total capital corresponding to no less than 80 per cent of the capital requirement under the former Basel I rules (the “Basel I floor”). One may ask whether internal models are suited for calculating the risk of major losses on lending exposures. Internationally, several of the banks incurring the largest losses during the financial crisis had extensive experience with such models. One of the reasons why internal models have failed is that they are largely based on statistics that only to a limited extent have reflected changes in fundamental conditions. In some areas, such as residential mortgage credit risk, it is evident that the historical data used in internal models provides a limited measure of risks associated with new lending.

Life insurance companies face major challenges ahead. Life expectancy amongst the insured is increasing by more than the companies have taken into account, which increases the value of their liabilities. Interest rates have fallen to a level that may make it challenging for Norwegian life insurers to stably achieve a return in excess of the interest rate guarantee. The life insurers should therefore strengthen their capital buffers and secure revenue streams not directly dependent on market developments. For collective pension plans, where policyholders make pre-payments for the interest rate guarantee every year, it is important that the life insurers charge adequate premiums for the guarantee and that they use the revenues to build sound buffers for leaner years.

For paid-up policies, Norwegian life insurers cannot charge annual guarantee premiums. Instead insurers share in any return in excess of the interest rate guarantee. Consequently, a return on capital lower than the interest rate guarantee for a sustained period of time, pose at potential problem for the insurers.

The new EU solvency requirements for insurance companies (Solvency II) shall apply from 2014 and imply, among other things, that the value of insurance liabilities shall be assessed on the basis of market rates. The final wording of the new rules remains uncertain, but it is likely that Norwegian life insurance companies will have to increase their buffer capital to satisfy the new requirements. Some companies, in particular those companies for which paid-up policies represent a considerable part of their business, are facing major challenges. The Norwegian Banking Law Commission is currently working on draft rules on new types of pension schemes, adapted to the Solvency II rules and new accounting standards. Such new schemes will ease the transition to Solvency II for Norwegian life insurance companies. It is nevertheless important for life insurance companies to prepare for the Solvency II transition by strengthening their capital buffers.

It is, as the Ministry of Finance has emphasised over several years in the annual financial markets reports, of particular importance that life insurers with an adequate margin of safety ensure that their risk taking is balanced out by their solvency. The situation ahead requires efficient risk management and adequate capital buffers.

Risk developments, earnings and solvency conditions for Norwegian financial institutions are further discussed in sections 2.4 and 2.5 below.

2.3.3 The macroeconomic backdrop

Global economic growth gradually picked up in the second half of 2009 and in 2010, but fell back in 2011. A number of factors had a negative impact on growth during the year. These included an increase in the oil price from USD 80 to 112 per barrel in 2011, largely caused by the unrest in important producer countries in North Africa and the Middle East. The price increases reduced purchasing power and depressed activity in oil-importing countries. The natural disaster suffered by Japan in March 2011 put a great strain on that country and cut important supply lines in the car industry and the manufacturing of electronics around the world.

The sovereign debt crisis, with severe tightening of fiscal policy and mounting uncertainty for households and corporations, slowed down activity within the Euro zone. Activity in the Euro zone countries in 2011 suffered, especially from developments in the most indebted countries, but Germany also experienced negative growth.

The United States and Japan are also facing major fiscal challenges. Activity in the United States expanded throughout 2011, and sentiment indicators suggest increased optimism. Unemployment has remained high, but fell somewhat at the beginning of 2012. Growth in emerging economies in Asia was affected by the turbulence in the industrialised countries, and China has also suffered a drop in domestic demand. GDP growth in China was in the final quarter of last year the lowest for more than two years.

Ahead, it is expected that very tight fiscal policy and persistently weak competitiveness will act as a brake on activity in the Euro zone countries, and forecasters expect GDP to decline in 2012. The positive developments in the United States are expected to continue. Growth estimates for China and other emerging economies in Asia have recently been revised somewhat downwards, but remain high when compared to the estimates for the traditional industrialised countries. Future developments are subject to considerable uncertainty.

Norway has fared better than most other industrialised countries. Strong growth in demand from the petroleum sector meant that value creation in the mainland economy rebounded swiftly in the wake of the international financial crisis, and GDP has now been growing for nine quarters in a row. Growth in the mainland economy last year was more or less in line with the Ministry’s assumptions in the National Budget for 2012. In addition to higher demand from the petroleum industry, increased housing investments contributed to expanding activity in the mainland economy. On the other hand, moderate growth in household consumption acted as a brake on growth in the mainland economy, and household savings have now reached a high level. Employment is also increasing, and unemployment in Norway is low from both an international and a historical perspective.

Lower prices for imported consumer goods and Norwegian agricultural produce have resulted in low underlying inflation, if excluding changes in indirect taxes and in energy prices. High water levels in reservoirs are expected to result in low electricity prices over the near future. Wage growth increased from 3.7 per cent in 2010 to 4.3 per cent in 2011.

At present, there is a clear tendency towards a bifurcation of the Norwegian economy, with suppliers of goods and services for the petroleum sector experiencing growth, whilst businesses that rely on more traditional exports are struggling. Exports of traditional goods were more or less unchanged from 2010 to 2011, although they fell quite significantly towards the end of 2011. The prices of traditional export goods also declined somewhat in the 2^nd half of 2011. A high cost level in Norway makes the situation especially demanding for Norwegian export businesses. Furthermore, the Norwegian krone (NOK) has appreciated thus far in 2012, and the import-weighted NOK exchange rate is now about 4 per cent above the average for the last 5 years.

In the interest rate meeting on 14 March 2012, Norges Bank reduced the key policy rate by ¼ percentage point, to 1.5 per cent. Norges Bank’s Executive Board put special emphasis on the prospects of low growth abroad and the strong Norwegian krone. Norges Bank also published a new interest rate path, which for the period 2013-2015 is approximately 1¼ percentage points below the interest rate path published in October 2011. The three-month Norwegian money market rate (Nibor) fell markedly from mid-November 2011 to mid-January 2012, and has since remained fairly stable at around 2.7 per cent. Interest rates on Norwegian sovereign bonds have declined in line with the reduction in corresponding interest rates in the United States and Germany, and are very low from a historical perspective.

Thus far in 2012, sentiment indicators for the Norwegian economy have pointed upwards, and consumption growth has shown signs of acceleration. In the National Budget for 2012, the Ministry estimated that GDP growth in mainland Norway would be 3.1 per cent this year. It is likely that growth will be lower than this due to slower growth amongst Norway’s trading partners. The Ministry will present new estimates in the Revised National Budget later in May 2012.

2.4 Risk developments for financial institutions

2.4.1 Introduction

In analyses of risk developments for financial institutions it is common to distinguish between a particular set of risks, such as liquidity risk, credit risk, market risk and operational risk. This section addresses developments within these four risk categories for Norwegian financial institutions, followed by a discussion of so-called systemic risk, which has received more attention in the wake of the international financial crisis.

2.4.2 Liquidity risk

The term liquidity risk denotes the risk that a player in the economy is unable to meet liabilities upon maturity despite being solvent. Players are deemed to be solvent when the value of their assets is higher than the value of their liabilities, i.e. when they have positive net assets. Liquidity risk may arise when the maturity structures of assets and liabilities are mismatched. Since banking largely involves funding long-term, illiquid lending through liquid deposits, banks are particularly exposed to liquidity risk. If banks are, in addition, funding long-term loans or other illiquid assets through short-term borrowing in funding markets, banks’ liquidity risk increases.

During the international financial crisis, Norwegian banks also experienced that it became difficult to obtain new funding in international markets. The situation was alarming for banks because it could not continue for long without banks sooner or later experiencing liquidity problems. The situation was alarming for the economy as a whole because it might have resulted in a steep decline in the supply of credit. In order to keep up credit supply, Norwegian authorities established the swap arrangement whereby banks in exchange for covered bonds could acquire government liquidity in the form of government certificates. Norwegian banks have to a large extent transferred their residential mortgages to mortgage companies, implying that residential mortgages now in practice are largely funded by mortgage companies’ issuance of covered bonds.1 As per yearend 2011, outstanding covered bonds represented about 45 per cent of the residential mortgages of Norwegian banks and residential mortgage companies. The transfer of mortgages to mortgage companies has been of assistance to banks during a period of unstable access to market funding for banks themselves. This method of addressing funding problems has now, however more or less been exhausted because most of banks’ residential mortgages eligible for covered bonds have already been used for that purpose. Consequently, it is now important for banks to reduce their liquidity risk by other means.

Covered bonds valued at NOK 154 billion, i.e. about 22 per cent of outstanding covered bonds, were placed in the government swap arrangement as per yearend 2011. The swaps will mature over the next few years, with especially large maturities in 2014. This entails refinancing risk for banks and mortgage companies. The government has therefore provided for early termination of the swap agreements. This may contribute to a more gradual increase in the supply of covered bonds in the market, and to help smooth the participating institutions’ funding refinancing over time.

Covered bonds are a fairly low-cost funding source for the institutions because of the low risk for investors investing in these securities, cf. Figure 2.10 in section 2.5.3 below. As per yearend 2011, Norwegian mortgage companies had issued NOK 717 billion worth of covered bonds. Covered bonds generally have longer maturities than bank bonds, cf. Figure 2.3C, and the liquidity risk of the mortgage companies issuing covered bonds is therefore limited. The opportunity to fund banks’ lending through the transfer of loans to mortgage companies has also contributed to a more robust funding structure in Norwegian banks, because their dependence on other wholesale funding has been reduced.

In addition to customer deposits, covered bonds and interbank borrowing, banks and mortgage companies are funding their activities by issuing bonds and certificates. Figure 2.3A shows that this wholesale funding has become a more important funding source for Norwegian banks and mortgage companies as a whole in recent years. These developments continued in 2011.

For purposes of Figure A, long-term bonds have maturities of more than one year, whilst short-term bonds and certificates have maturities of up to one year.

Kilde: Finanstilsynet, Norges Bank and Stamdata

The international financial crisis demonstrated that the demand for bank issued bonds and certificates at times may disappear altogether. Internationally, one saw several examples of banks that encountered liquidity problems because they were unable to refinance their liabilities, without underlying solvency problems being evident.

In order to avoid such funding difficulties, it is important that banks during prosperous times build sufficient liquidity buffers to pull through prolonged periods during which new bond and certificate funding is unavailable.

Looking at banks and mortgage companies as a whole, they have after the international financial crisis made themselves somewhat less dependent on the most short-term forms of wholesale funding. Bond and certificate borrowings with a maturity of one year or less represented 8 per cent of the overall funding of banks and mortgage companies as per yearend 2011, about the same as in 2010, cf. Figure 2.3A. This is about 1/3 less than as per yearend 2008. The portion accounted for by long-term wholesale funding (with a maturity of more than one year) has increased steadily over several years, and represented in excess of 26 per cent of overall funding as per yearend 2011. The maturity of the long-term wholesale funding has, on the other hand, remained fairly stable for a long time, and was as per yearend 2011 about 4 years on average for banks and mortgage companies, cf. Figure 2.3B.

Norwegian banks and mortgage companies obtain much of their wholesale funding abroad and in foreign currency. Disturbances in the international markets therefore have an impact on the liquidity risk in the Norwegian financial system. Conditions in the international markets have at times been difficult in 2011, especially from summer and throughout autumn. The turbulence attributable to the sovereign debt problems in the Euro zone contributed to a weakening of the supply of long-term funding, and to funding becoming more expensive for those banks that nevertheless issued debt securities with a longer maturity. The European market for covered bonds functioned better than the market for bank debt. The situation has improved after the end of the year, which to some extent probably is owing to the European Central Bank in December 2011 and February 2012 extending a virtually unlimited offer of 3-year loans (against collateral) at an interest rate of 1 per cent to European banks.

The larger Norwegian banks are more dependent on wholesale funding, and on obtaining it abroad, than are the smaller banks. The larger banks are important funding sources for smaller banks. Consequently, turbulence in the international funding markets may spread to Norwegian banks that only to a limited extent depend directly on wholesale funding. Figure 2.3C shows that it is particularly the most short-term bond funding for banks that has been obtained in foreign currency. This situation has remained stable for a long time. If banks place themselves in a situation where they are at virtually all times dependent on obtaining new funding in foreign markets, they are exposed to problems abroad. Thus far, Norwegian and other Scandinavian banks have enjoyed investor confidence and fairly good access to funding in international markets.

Customer deposits and borrowings from customers represented 43 per cent of the overall funding of banks and mortgage companies as per yearend 2011, which is much less than the level in recent years. The reason is that the increase in banks’ lending has outpaced the increase in deposits. For banks alone, deposits have accounted for a significantly larger part of their funding after 2008, because of the transfer of large loan portfolios to mortgage companies (which are primarily funding themselves by issuing covered bonds). From a deposits-to-loans ratio of about 64 per cent until the autumn of 2008, the deposits-to-loans ratio of Norwegian banks had increased to 81 per cent as per yearend 2011.

Customer deposits are normally considered a stable funding source for banks, even though depositors generally have access to their funds without any lock-in or notice period. Sound bank solvency, as well as a good and credible deposit guarantee scheme, strengthen the confidence of depositors as to the security of their deposits. If these conditions are met, it is appropriate for a bank to use deposits to fund long-term lending.

The Norwegian deposit guarantee scheme contributes to making customer deposits a stable funding source for Norwegian banks. The arrangement functioned well during the international financial crisis. Unlike in several other countries, it was not necessary to expand on the Norwegian guarantee scheme or to issue government guarantees for banks’ assets or liabilities during the crisis.

As mentioned in Box 2.3, the Norwegian deposit guarantee scheme is backed up by the capital in the Norwegian Banks’ Guarantee Fund. The pre-funding of the Guarantee Fund contributes to the credibility of the deposit guarantee scheme, and to the Guarantee Fund’s capacity to handle problems in the banking system.

The Norwegian deposit guarantee scheme covers up to NOK 2 million per depositor per bank, cf. Box 2.3. The European Commission has presented a proposal for a new directive on deposit guarantee schemes that among other things includes harmonisation of the coverage level of EU deposit guarantee schemes at EUR 100,000. If the proposal of the European Commission was to be implemented in Norway, the coverage level in the Norwegian deposit guarantee scheme would decrease by as much as 60 per cent. The Ministry of Finance is working actively to maintain the current coverage level in the Norwegian scheme, cf. further discussion in Chapter 3.

A major effort is currently underway to improve international bank liquidity regulations, as discussed in Chapter 3. Of particular importance is the consensus on the Basel III standards, which is likely to bring about the introduction of quantitative liquidity and funding structure requirements within the EU/EEA and in other important jurisdictions in a few years’ time. In Norway, Finanstilsynet (the Norwegian financial supervisory authority) has already introduced mandatory reporting based on the expected new requirements. The recent liquidity developments in Norwegian banks and mortgage companies may in part be related to an adaption to expected changes in the regulatory framework. Nonetheless, the Norwegian credit institutions have some way to go to fully comply with the expected new requirements, and should therefore increase their holdings of low-risk, realisable assets, as well as obtain longer term and more stable funding.

The introduction of rules corresponding to the Basel III standards can also have a positive impact on the demand for covered bonds, since the requirements applicable to banks’ holdings of liquid low-risk securities will become more stringent. Depending on how covered bonds are classified under the EU/EEA framework implementing the Basel III standards, covered bonds can be an alternative to other liquid low-risk securities, such as sovereign bonds. Insurance companies may also become more interested in covered bonds in coming years, particularly if interest rates on, and the supply of, low-risk sovereign bonds in desired currencies remain low. The implementation of the new Solvency II rules may also contribute to insurers becoming more interested in covered bonds.

Taken together, the liquidity risk outlook of Norwegian banks and mortgage companies is dominated by the uncertain situation in international financial markets. Norwegian institutions’ funding structure has become somewhat more robust over the last year, but market turbulence has at the same time demonstrated that institutions remain exposed. Short-term wholesale funding still accounts for a fairly large portion of their wholesale funding. This makes it necessary to build sufficient liquidity buffers to be able to pull through protracted periods of turmoil in financial markets.

For the economy as a whole, it is important that the financial system is able to supply to those who need it with credit, in turbulent times as well as in prosperous times. It is not realistic to require pre-funding of lending, and it is a fundamental task for banks to assume liquidity risk by transforming liquid deposits into long-term, illiquid lending. Although it is important to improve rules and requirements on liquidity, financial stability is premised on banks being solvent and dependable borrowers in bond and certificate markets.

2.4.3 Credit risk

2.4.3.1 Definition and scope

Credit risk is the risk of not obtaining repayment of all or part of a claim or a loan, with the subsequent loss thereby incurred after deduction of collateral.

Banks are exposed to credit risk through their lending to households and corporations. Mortgage companies have a rapidly growing market share of lending to households, largely because they can issue covered bonds. Lending comprises about 80 per cent of the total assets of banks and residential mortgage companies, and credit risk is thus normally the main risk facing Norwegian banks and other credit institutions.

2.4.3.2 Credit growth

The credit indicator C2 offers a broad measure of the gross debt owed by the Norwegian general public (households, non-financial corporations and municipalities) to Norwegian credit sources. Credit growth as measured by this indicator declined steeply in the wake of the financial crisis, primarily due to a reduction in borrowing on the part of non-financial corporations, cf. Figure 2.4A. Twelve-month growth in credit to this group of borrowers has increased almost every month since the autumn of 2010, and was in excess of 5 per cent as per yearend 2011. Twelve-month growth in credit to households has also increased during 2011, and was 7.3 per cent as per yearend.

Economic upturns are usually characterised by high credit demand. In downturns one can expect credit demand to fall, the risk on existing loans to increase, and the ability of banks to absorb risk to decline. In aggregate, these factors may steeply reduce credit growth. If credit supply falls because banks lack own funds or other necessary funding, this will intensify the recession.

Figure 2.4B shows developments in credit growth to Norwegian non-financial corporations in the wake of the Norwegian banking crisis in the 1990s, the dot-com bubble in the early 2000s and the international financial crisis in 2008. There was a steep decline in credit growth over the months following the financial crisis in 2008, but from a high level. The decline after the two other crises was less steep, but lasted longer; about 34 months after the Norwegian banking crisis and 42 months after the burst of the dot-com bubble. Credit growth was negative for three and a half years following the banking crisis. Credit growth to non-financial corporations increased swiftly and steeply following the financial crisis. The last observation on the financial crisis curve in Figure 2.4B concerns January 2012. Then, twelve-month growth was almost 6 per cent. At the same stage in the wake of the banking crisis and the dot-com bubble, twelve-month growth was -3.7 and 1 per cent, respectively. Because the problems following the dot-com bubble did not have its origin in a crisis in financial institutions, there is reason to believe that much of the decline in credit growth after the burst of the dot-com bubble resulted from a fall in the demand for credit.

In Figure B, the month in which credit growth peaked before a crisis is denoted t = 0. Thereafter, the t-s show months after t = 0. For the Norwegian banking crisis, t = 0 is set to May 1990. For the dot-com bubble, November 2000 is t = 0, while April 2008 is t = 0 for the international financial crisis.

Kilde: Norges Bank and Statistics Norway

2.4.3.3 Household sector credit risk

Banks’ credit risk is strongly linked to the capacity and willingness of households to pay interest and instalments, and to developments in the housing market. Lending to household retail customers from banks and residential mortgage companies accounted for 55 per cent of overall lending as per yearend 2011. About 91 per cent of these loans were loans secured on residential property. For banks alone, lending to household customers represented about 39 per cent of overall lending.

Households’ capacity to service debt can be measured by the so-called debt and interest burdens. The debt burden is defined as households’ debt as a percentage of their disposable income, whilst the interest burden is their interest expenditure as a percentage of disposable income.

Growth in household debts has for several years exceeded growth in household incomes, thus implying an increasing debt burden. The debt burden has levelled off in the wake of the financial crisis, but has subsequently increased again. The debt burden is currently at about 195 per cent, cf. Figure 2.2D above. Projections from Norges Bank show that the debt burden is likely to increase over the next couple of years, primarily due to low interest rates and growth in housing prices. The projections indicate that the debt burden may reach almost 220 per cent by 2015. At the last peak in household debts, just before the Norwegian banking crisis in the early 1990s, the debt burden was about 150 per cent.

Although the current debt burden is high in a historical context, households’ interest burden is relatively low due to the low interest rate level, cf. Figure 2.2D. As interest rates revert to a more normal level, the interest burden will increase as well. This will weaken households’ capacity to service debts, and increase banks’ credit risk. According to Norges Bank’s projections, low interest rates will keep the interest burden at about the same level as today until 2014, before it will increase into 2015. The projections are uncertain. If interest rates increase more rapidly than assumed in the projections, the interest burden will also increase more rapidly. If the currently high credit spreads on banks’ borrowings persist, or if interest rates on household lending increase more than expected for other reasons, one can also expect the interest burden to increase by more than suggested by the projections in Figure 2.2D. Finanstilsynet and Statistics Norway have, for example, calculated that the quarter of households accounting for half of overall household debts may end up with an interest burden in excess of 20 per cent if the interest rate increases to 6.7 per cent in 2013.

Households’ financial margin can be defined as annual income after tax, less interest expenditure and necessary costs of living (calculated by the Norwegian National Institute for Consumer Research). If a household has a financial margin lower than the amount needed to pay loan instalments, there is a danger that its debt as a percentage of income will increase. As calculations of the financial margin are based on information from tax returns, the most recent figures relate to yearend 2009. At that time, about 14 per cent of Norwegian households had a financial margin equal to less than one month’s salary. If the interest rate at the time had been, for example, 5 percentage points higher, 23 per cent of households would have had a financial margin of less than one month’s salary. This is about the same level as in 1987, when many Norwegian households started to face financial difficulties.2 The figures may indicate that a relatively large number of Norwegian households are now making decisions in the expectation that interest rates will remain low and that labour market conditions will remain favourable for a very long time.

Despite of the savings rate increase, debt growth and losses on securities contributed to an impairment of households’ financial buffers in 2011, cf. Figure 2.6A. Net assets as a percentage of disposable income (the net asset ratio) declined by over 6 percentage points from 2010 to 2011. The ratio as per yearend 2011 was marginally lower than the lowest level during the international financial crisis. The net financial assets of households have been reduced by a total of 44 per cent from yearend 2006 until yearend 2011. Households’ liquid financial buffer has been reduced by even more because illiquid insurance claims account for a large and growing portion of households’ financial assets. Norges Bank expects households’ savings rate to continue increasing for the next couple of years, cf. the figure. In uncertain times one will often see more households consume less to repay debt or accumulate financial reserves by increasing their financial assets. The uncertainty about economic developments internationally may therefore contribute to an increase in Norwegian households’ precautionary saving, as one observed during and after the international financial crisis.

The majority of household savings take the form of housing investment. If the value of the large housing wealth is taken into account, the financial position of Norwegian households as a whole is good. The housing wealth may serve as a good buffer against individual financial problems. Nevertheless, housing wealth is of limited relevance when examining the overall financial stability outlook, because the value of housing wealth can be expected to vary in line with the economic cycles.

Developments in households’ debts are strongly influenced by developments in the housing market, since a large portion of the debt is taken on to fund housing investments. High housing prices in high-demand areas will therefore over time contribute to the growth in households’ debt. Those who are already established in the housing market may increase their mortgage loans (secured on their homes) when their homes increase in value. Optimism may also contribute to high credit demand from households. For example, Norwegian wage earners’ good income growth, expectations of continued low interest rates and favourable developments in the labour market may contribute to the demand. Optimism may also contribute to expanded credit supply. In recent years, there has been intense competition for customers in the residential mortgage market, whilst banks have enjoyed good access to funding in the capital market.

Boks 2.4 Developments in the housing market

Norwegian housing prices increased by about 9 per cent in 2011, as against 8 per cent in 2010, cf. Figure 2.5. The growth rate was high throughout 2011, but declined somewhat towards the end of the year. Thus far in 2012, growth has been fairly high, but lower than in 2011. In February 2012, twelve-month growth in housing prices was 7 per cent. After the turnaround in the housing market in December 2008, housing prices have on average increased by 0.75 per cent each month. If adjusting for inflation, prices as per the end of February 2012 were about 8.5 per cent higher than at the previous peak in prices in 2007.

Housing prices have increased considerably in several countries in recent years, until they started to decline from 2007 in most countries, cf. the figure. Norway is one of the countries that has experienced the highest housing price growth. Apart from a few months following the financial crisis, there has not been much of a decline in prices in Norway when compared to other countries. Housing prices have increased again in many countries after the financial crisis in 2008 and 2009, but not as rapidly as before the crisis. Denmark is amongst the countries with the largest decline in housing prices.

Explanations of fluctuations in housing prices can be found on both the supply side and the demand side, as well as in the interaction between the two. Because the supply of homes of a certain quality is fairly inelastic in the short run, changes in demand may have a major impact on prices.

The demand for homes depends on several factors. When employment is high, income developments are favourable and interest rates are low, the willingness and ability to pay increases on the part of those wishing to purchase homes.

In the longer run, there is a closer correlation between housing prices and the cost of building homes. Real housing prices have nevertheless increased by much more than the cost of building homes in Norway over the last few decades, cf. Figure 2.5.

Kilde: Statistics Norway, Norwegian Association of Real Estate Agents, ECON Pöyry, Finn.no, Norwegian Association of Real Estate Agency Firms and Norges Bank

Growth in housing prices has been high in recent years, cf. the discussion in Box 2.4. As per yearend 2011, twelve-month growth was about 9 per cent, as compared to 8 per cent in the previous year. Norway is amongst the countries with the highest housing price growth, both before and after the international financial crisis.

If there is a significant drop in housing prices, the risk of banks’ incurring losses on residential mortgage loan increases. An element that may contribute to this is the fact that an increase in the loan-to-value ratio above a certain threshold may make mortgage loans eligible for debt restructuring.

Finanstilsynet has since 1994 been surveying how banks are practising lending secured on residential property. The most recent survey was carried out in the autumn of 2011, and encompassed the 15 largest banks in the Norwegian residential mortgage market. In aggregate, these banks accounted for about 75 per cent of overall lending from banks for housing purposes. The loans in the survey were primarily disbursed in August 2011.

The survey shows that the proportion of new loans with a high loan-to-value ratio has increased markedly since 2010, cf. Figure 2.6B. More than 26 per cent of new loans (loan volume) exceeded 90 per cent of the value of the home, as compared to just over 20 per cent in the previous survey in 2010. If looking only at those loans for which the purpose was the purchase of a home (and not refinancing or other purposes), about 38 per cent of new loans (loan amounts) had a loan-to-value ratio of 90 per cent or more. This is also an increase from the previous year. At the same time, there has been an increase in the volume of loan-to-value loans secured by additional collateral. About 53 per cent of the loans in the survey with a loan-to-value ratio of 90 per cent or more were secured by additional collateral.

Unsurprisingly, it is the younger borrowers, in particular, who obtain large loans relative to the value of their homes and their annual income. The net present value of future income is also highest when one is young. At the same time, uncertainty about future individual incomes is the highest in this age group, and the youngest borrowers may be particularly exposed to an increase in unemployment. For new loans to borrowers under the age of 35 years, the proportion with a loan-to-value ratio in excess of 90 per cent increased from 34 per cent in the autumn of 2010 to 38 per cent in the autumn of 2011, according to Finanstilsynet’s survey. As far as loans for home purchase purposes are concerned, the proportion was 10 percentage points higher (48 per cent), which was 2 percentage points higher than in 2010. Borrowers under the age of 35 years who obtained such loans ended up with an average debt equal to 343 per cent of disposable income. This is 24 percentage points more than in the 2010 survey.

Every fourth residential mortgage in Finanstilsynet’s mortgage survey was on interest-only terms. This is the highest level registered in any of the mortgage studies, which have, as mentioned, been conducted since 1994. The average interest-only period registered in the 2011 survey was somewhat in excess of four years, and it was primarily the youngest borrowers who took on interest-only loans. Interest-only periods may act as buffers against financial difficulties for households, but interest-only terms also imply that the entire loan amount is exposed to any future interest rate increase. A large volume of interest-only loans may contribute to a mounting interest burden for households, as interest rates revert to a more normal level. In periods with low interest rates it will therefore normally be advisable to pay both instalments and interests on loans.

A low percentage of fixed-rate loans implies that Norwegian households are more exposed to unexpected interest rate increases than are households in countries with a higher percentage of fixed-rate loans. In the 2011 mortgage survey, 1.6 per cent of the loans were fixed-rate loans, which is about one percentage point less than in the 2010 survey.

In March 2010, Finanstilsynet issued guidelines for prudent residential mortgage lending. The guidelines were tightened in December 2011, and now stipulate, inter alia, that residential mortgage loans should normally not exceed 85 per cent of the value of the home, cf. Box 2.5. Finanstilsynet explained the tightening by noting that Norwegian households’ debt levels are increasing, interest rates are low, housing price growth is high and that banks’ lending practices have been too lax.

The tightening of the guidelines harmonises well with recent recommendations from the IMF and the OECD, as well as with pre-existing rules in several other countries. In Sweden, for example, one has since the autumn of 2010 had guidelines stipulating, like those of Finanstilsynet, that residential mortgages should normally not exceed 85 per cent of the value of the home. In February 2012, the IMF published a special report on the Norwegian economy, a so-called Article IV consultation, in which the organisation drew attention to the high level of household debt and to developments in the housing market as risk factors. The IMF applauds the changes to Finanstilsynet’s guidelines, but also writes that the guidelines “need to be more tightly enforced to be sufficiently effective”, and that “More binding guidelines are (…) necessary to achieve the desired reduction in high-risk loans”. This is also a theme in a review of the Norwegian economy from the OECD, titled Economic Survey of Norway, which was also published in February 2012. Among other things, the OECD concludes that “The financial vulnerabilities resulting from high household indebtedness at floating interest rates may need to be addressed by further action on macro-prudential policy and consumer protection”.

Finanstilsynet has submitted a proposal for a statutory authority to issue regulations on prudent lending practices. The proposal has, together with other potential measures, been studied by a working group that has examined how the macroprudential supervision of the financial sector should be organised in Norway, and is discussed in Chapter 3.

The tightening of Finanstilsynet’s residential mortgage lending guidelines may contribute to households not taking on mortgage loans beyond their capacity, and to banks not granting loans with high risk of loss. A survey done by Norges Bank on Norwegian banks’ lending shows that banks tightened credit supply to households in both the 4^th quarter of 2011 and in the 1^st quarter of 2012, cf. Figure 2.6C. The background figures indicate that this is in particular explained by Finanstilsynet’s guidelines for residential mortgage lending, but also banks’ concern for their capital ratio is mentioned as a reason. Banks do not expect further tightening in 2^nd quarter of 2012.

The credit risk associated with lending to the Norwegian household sector appears to have worsened somewhat for the banks over the last year. The risk that more households are taking on excessive debt has increased. The net financial assets of households have declined, the debt burden is on the increase again, and a normalisation of the interest rate level may result in a steep increase in the interest burden for many households. Developments in the Norwegian economy are favourable, but the international outlook still remains highly uncertain.

Changes in housing prices have a major impact on the Norwegian economy and on banks’ credit risk. Housing prices are high and growing. If housing prices were to decline considerably, the value of the collateral securing mortgage loans will be reduced, and banks may incur increased losses on their corporate sector lending due to weakened corporate earnings stemming from lower household demand.

In Figure C, banks’ replies have been converted to a point scale from –100 to 100. If, for example, all banks in the sample were reporting some tightening of credit standards, the overall net figure would be –50.

In Figure E, the operating margin is corporations’ operating profit before tax, as a percentage of operating revenues. The operating margin data in the figure are influenced by developments in the petroleum sector. The equity-to-assets ratio is equity as a percentage of the sum of equity and liabilities.

Kilde: Finanstilsynet, Norges Bank and Statistics Norway

2.4.3.4 Corporate sector credit risk

Loans to non-financial corporations accounted for about 52 per cent of Norwegian banks’ overall lending as per yearend 2011. Lending to corporations has increased by about 22 percentage points since 2004, as a portion of overall lending from banks. This relative increase is mostly due to the effects of banks’ transfer of a large part of their residential mortgage loans to residential mortgage companies. Figure 2.7D shows that commercial property lending accounts for a large part of banks’ corporate lending. Shipping is also an important industry for Norwegian banks, which is reflected in the large portion of lending to foreign corporations evidenced in the figure. Norwegian banks’ lending to commercial property and shipping are discussed in Box 2.6.

Boks 2.6 Norwegian banks’ lending to commercial property and shipping

Norwegian banks’ lending to commercial property and shipping accounts for more than half of the banks’ lending to non-financial corporations. Developments in these industries have a major effect on the loan losses and solvency of banks. Credit granted to corporations within the commercial property and shipping industry represented 245 per cent and 156 per cent, respectively, of the total capital of the banks as per the end of the 3rd quarter of 2011.

The risk associated with commercial property lending is closely related to developments in the Norwegian economy. In the autumn of 2011, banks reported that the risk had been reduced in recent months, and that write-downs had declined somewhat. Generally speaking, write-downs are largest within the category ”other”, which includes, among other things, loans for hotel properties, industrial premises and warehouses. In the 3rd quarter of 2011, write-downs in this category accounted for just below 2.5 per cent of drawn loans.

The equity-to-assets ratio of corporations in the commercial property industry has increased in recent years, and was about 44 per cent as per yearend 2010. There has, at the same time, been a structural change on the borrower side, with so-called financial real estate corporations having largely replaced corporations that purchased real estate for their own business activities. Financial real estate corporations purchase real estate for investment purposes, as an alternative to investments in, for example, securities. Financial real estate corporations often have a high loan-to-value ratio when purchasing real estate, in order to provide their owners (the investors) with high returns. Because banks’ lending to commercial property is to a larger extent channelled to fewer and larger real estate corporations than before, banks’ concentration risk may have increased.

Within commercial property industry, lending to corporations that own office properties account for a large part of banks’ exposures, cf. Figure 2.7. The supply of offices has a major impact on the earnings prospects of office property corporations. In Oslo, which represents a large portion of the Norwegian office property market, several new buildings will be introduced onto the market over the next couple of years, which may make it more difficult to let premises, and may also dampen selling and rental prices.

Within shipping, lending to offshore activities represent a large portion of banks’ exposures, cf. Figure 2.7. The traditional shipping segments (dry bulk carriers, tankers, container vessels, as well as chemical, product and gas carriers) each account for about 10 per cent.

Following the reversal in the world economy from 2008, rates and vessel values fell steeply within several segments. The market has rebounded somewhat, but overcapacity still remains a problem in traditional shipping segments like dry bulk carriers, tankers and container vessels. Persistently low freight rates represent a risk to the profitability of several ship-owning corporations within these segments. Lower collateral values and an impaired ability to service debts increase the risk of losses. DNB and Nordea account for a large portion of Norwegian banks’ lending to shipping corporations.

Kilde: Finanstilsynet

The profitability of Norwegian listed corporations improved in the first half of 2011, before declining somewhat from the 2^nd quarter.3 Both the profits and the equity-to-assets ratios of listed corporations increased during the first part of the year, cf. Figure 2.6E. The equity-to-assets ratio was stable in subsequent quarters, whilst profits declined somewhat. Norwegian listed corporations’ debt-servicing capacity declined steeply during the financial crisis in 2008 and 2009, but has subsequently improved as the result of lower debt growth and lower interest expenditure, cf. Figure 2.6F. The background figures show that the debt-servicing capacity increased within most industries. One can expect a lower debt-servicing capacity ahead, because corporations’ funding costs are increasing due to widening credit spreads, while their debt levels are growing.

Developments in the commercial property market and the shipping market account, as mentioned in Box 2.6, for an important part of the overall risk outlook for Norwegian banks. Declining rent revenues and selling prices may impair the debt-servicing capacity of corporations engaged in the commercial property business, and inflict losses on banks. For shipping, the risk outlook differs for different segments. If developments in the world economy are weak, more shipping corporations may find it difficult to service their debts to creditors, including the two largest Norwegian banks.

The number of new bankruptcies in 2011 was about the same as the year before, cf. Figure 2.6F. About 3,200 corporate bankruptcies were registered, excluding sole proprietorships, which was marginally more than in 2010. The majority of corporations declared bankrupt in 2011 were small corporations with low turnover, few employees and relatively low bank debt. This has curtailed loan losses incurred by banks. Historically, corporations’ debt-servicing capacity has traced bankruptcy developments with a certain time lag (and in reverse), cf. the figure. Consequently, bankruptcy developments may signal a stabilisation of corporations’ debt-servicing capacity.

The solvency and earnings of non-financial corporations are good at present, but banks’ risk associated with lending to this group of borrowers is sensitive to business cycle fluctuations. If the Norwegian economy is subjected to major new disturbances, or developments in the world economy are weak, the outlook may change rapidly. About 40 per cent of banks’ lending to non-financial corporations is lending to businesses exposed to international competition. Lower demand for goods and services from Norway’s trading partners may reduce corporate earnings. Furthermore, developments in the Norwegian real estate markets may have a major impact on the risk associated with corporate loans, both directly and indirectly. Directly because loans to corporations within the commercial property sector represent a large portion of Norwegian banks’ corporate loans. Indirectly because of the link between housing price developments and household demand.

2.4.4 Market risk

Market risk is the risk of financial loss or gain as the result of changes in the market prices of, for example, equities, interest-bearing securities, commodities and real estate. Norwegian banks have relatively low exposure to market risk, because their investments in securities markets are small relative to their total assets. Norwegian banks also have low market risk because both their borrowing and their lending primarily take the form of floating-rate loans. Consequently, banks carry only limited risk relating to the difference between borrowing rates and lending rates.

Life insurance companies and pension funds are particularly exposed to market risk. This is because much of their total assets are invested in securities, whilst the majority of their liabilities carry a promise of a certain return on capital (interest rate guarantee). If equities prices decline, insurance companies and pension funds with large equities holdings relative to their capital buffers must therefore either swiftly reduce the equity component or raise additional own funds.

Figure 2.8A shows that there has in recent years been a close correlation between equities prices and the equity component of Norwegian life insurance companies’ total assets. The equities holdings of life insurance companies were sharply reduced during the international financial crisis, through both divestment and a drop in value. The lower equities holdings made the companies less exposed to further reductions in equities prices, but they also benefited less from price increases. This was repeated, although on a smaller scale, in 2011. As per yearend 2011, equities represented 15.7 per cent of life insurance companies’ total assets, which is 4 percentage points less than in 2010. The largest reduction came towards the end of the year, largely due to large-scale equities divestment on the part of one of the largest life insurance companies.

When life insurance companies reduce their equity component, they use much of the funds thus released to purchase interest-bearing securities carrying a lower risk than equities, cf. Figure 2.8B. The part of companies’ total assets comprising bonds and certificates, and recorded at fair value in the accounts, increased by almost 2 percentage points from 2010 to 2011, to about 30.5 per cent. Bonds held to maturity are not intended to be sold in the market, and their accounting value is therefore not influenced by changes in market rates. The portion of total assets comprising bonds held to maturity remained more or less unchanged in 2011.

As per yearend 2011, about half of life insurance companies’ overall bond and certificate portfolio was invested in Norwegian securities, and the majority of these were debt securities issued by banks. The companies have in recent years increased their holdings of covered bonds issued by mortgage companies. Covered bonds are low-risk securities that may become even more attractive for life insurers when the Solvency II rules enter into effect, because capital requirements for investments in such securities are relatively low. The demand for covered bonds may also be higher in Norway than in other countries owed to the small market for Norwegian sovereign bonds.

Life insurance companies have fairly low exposures to sovereign bonds issued by the most heavily-indebted Euro zone countries, cf. Figure 2.8C. A large part of exposure is to securities issued by Italy, but even these represent less than 1 per cent of the companies’ total assets. The majority of the Italian securities, and in practice all of the Portuguese securities, are intended to be held to maturity, and have therefore not been written down in line with the reduction in market value. The majority of the Italian, Portuguese and Spanish sovereign debt securities are held by one of the large companies, and the exposure to these three countries represents about 5 per cent of the overall bond portfolio of that company.

In addition to equities and interest-bearing securities, Norwegian life insurance companies invest in real estate. Real estate has in recent years represented a stable portion of total assets, and accounted for about 13 per cent as per yearend 2011, cf. Figure 2.8B. From 2007, life insurance companies have invested more in lending and claims valued at amortised cost.4 As per yearend 2011, such investments accounted for 16.4 per cent of total assets, which is almost 2 percentage points more than the previous year.

The asset management activities of Norwegian pension funds differs from those of life insurance companies inasmuch as the equity component has been larger and more stable, and that most of the interest-bearing securities are recorded at fair value in the accounts. The larger equity component implies more risk and larger value fluctuations, but also higher return potential. The higher risk is countervailed by more buffer capital, cf. section 2.5.4 below.

Changes in the prices of many debt securities were unusually large during 2011, and uncertainty about the value of many debt securities still remains high. At the same time, interest rates on low-risk investments are low. This makes the risk management aspects of the asset management activities of life insurance companies and pension funds challenging, and it is highly important that life insurers with an adequate margin of safety ensure that their risk taking is balanced out by their solvency. Issues relating to life insurers’ solvency and the low interest rates are discussed in section 2.5.4 below.

Kilde: Finanstilsynet

2.4.5 Operational risk

Operational risk is the risk of loss as the result of insufficient or inadequate internal processes, systems failure or human error. Among other things, operational risk includes legal risk and reputational risk. It may, for example, include risk as the result of inadequate procedures, ICT systems failure, procedural violations, fire, terrorist acts, breach of trust, etc. The delineation against other types of risk is not precise, and losses that are classified under credit risk or market risk often have some basis in operational failure, for example weaknesses in credit evaluation processes.

The Ministry of Finance seeks to promote systematic preventive efforts to make Norwegian financial institutions and financial markets less vulnerable, and to ensure adequate contingency measures to handle risk events.

The Financial Infrastructure Crisis Preparedness Committee (the BFI) was established to ensure the best possible coordination of the financial infrastructure contingency work in Norway. The Committee examines operational stability, risk and vulnerability in the financial infrastructure. The Committee has in 2011 held three ordinary meetings and one extraordinary meeting, and has also conducted two emergency preparedness exercises. The extraordinary meeting was held in June 2011 to discuss the consequences of a potential strike in the Norwegian financial sector.

Operational risk in the financial sector is increasingly related to the operation of ICT systems, where continuous access to telecommunications and stable electricity supply are of decisive importance. Electronic financial transactions need to pass through many links, including customer systems (online banks, cash dispensers, point-of-sale terminals, etc.) and interbank systems. This ICT infrastructure is complex and vulnerable, and implies mounting operational risk for banks and the banking system. In addition, banks’ outsourcing of ICT activities may have made the Norwegian payment system more exposed to operational deviations. Developments within this area are moving towards service providers increasingly using resources in low-cost countries. If large parts of ICT activities within the financial sector are outsourced to foreign players, it may result in weaker systems control and increased operational risk.

The payment systems are of critical importance to society and represent an important part of the core activities of the financial sector. There was a high degree of stability in the Norwegian payment systems in 2011, but there were also several serious events relating to the operation of payment and ICT systems.

Norwegian online banks were exposed to several so-called Trojan and phishing attacks during the year. The objective of such attacks is to steal sensitive information for gain or to cause damage, often by passing oneself off as a reliable and known counterparty. In February 2011, there was a massive and coordinated attack against Norwegian online banks, and new attacks came in waves throughout the year. The methods of attack were changed continuously, and different banks and banking groups were attacked one after the other. The banks are devoting large resources to countermeasures, and losses relating to such attacks in 2011 were limited. Finanstilsynet has announced that it will be evaluating online bank security and examine whether measures are needed to enhance security.

During Easter 2011, there were problems with card authorisation in payment systems operated by service providers on behalf of Norwegian banks. The problems had serious consequences for businesses and cardholders. The most serious effect was that cardholders’ disposable funds were reduced due to card payment errors causing double and multiple charges to their bank accounts. The event revealed that both service providers and banks lacked knowledge about the value chain for credit and debit card transactions, and that the coordination of contingency measures was inadequate. Following the event, Finanstilsynet ordered all banks to chart and document critical components of their ICT systems and report on these to Finanstilsynet. Finanstilsynet also ordered banks to coordinate their contingency measures with the contingency measures of their service providers.

High risk taking in financial institutions as the result of remuneration arrangements incentivising employees to adopt short-term perspectives and to take on high risk, has been pointed to as one of the causes of the international financial crisis. On 1 December 2010, the Ministry laid down regulations on remuneration arrangements in financial institutions, investment firms and securities’ fund management companies, which entered into effect on 1 January 2011. The regulations require the boards of directors of such financial undertakings to adopt guidelines and limits for a remuneration arrangement that shall apply to the undertaking as a whole, and support and stimulate good management and control of the undertaking’s risk in the long run. Consequently, the regulations may contribute to reduced risk taking in financial undertakings.

2.4.6 Systemic risk

Systemic risk may be defined as the risk of disturbances in the supply of financial services due to problems in all or part of the financial system, which may have serious negative repercussions for production and employment. It is important to identify good tools for handling systemic risk. The Bank for International Settlements (BIS) analyses systemic risk along two dimensions: a structural dimension and a time dimension.

In the structural dimension, one looks at how problems or shocks are spreading in the financial system and what are the joint risk factors for various parts of the system. Interwoven financial markets and financial institutions’ exposure to the same risks may, for example, contribute to spreading and exacerbating disturbances. If the institutions within a financial system have large exposure to each other, for example through equity instruments, problems in one institution may spread with particular rapidity to the other institutions. The same applies if a problem arises on the part of an institution that operates important infrastructure. Moreover, the market’s confidence in one institution may be based on its confidence in other institutions.

In the time dimension, one looks at how the accumulation of risk in the financial system and the economy is related to business cycle fluctuations and to the interactions between the financial system and the real economy. Risk may, for example, accumulate in the financial system during periods of economic boom, typically characterised by high credit and debt growth, rapid growth in asset prices and high risk taking on the part of financial institutions. The international financial crisis demonstrated how negative interactions between the financial system and the real economy may exacerbate recessions and disturbances in the financial system.

Consequently, systemic risk is closely related to the risks otherwise examined in analyses of the financial stability outlook, such as liquidity risk, credit risk, market risk and operational risk. An overall assessment of these risks, as featured in most analyses of the financial stability outlook, may serve as a basis for the monitoring of systemic risk. It is, for example, noted in section 2.4.3 above that there is considerable risk associated with developments in the housing market and in household debts. This source of risk is a typical and important component in the time dimension of systemic risk. Previous crises in Norway and other countries have shown that problems in households create problems for banks and corporations, which dampen economic activity and add to the problems of households. What is new in the Norwegian economy is, as mentioned, that both housing prices and household debts are higher than ever before, while at the same time interest rates are very low. Since we do not have experiences with situations similar to the current, we should be especially aware of the risk this entails.

An example of an analysis that says a lot about the structural dimension of systemic risk is found in section 2.4.2 above, on banks’ liquidity risk. If banks have a similar funding structure, or if one or a small number of banks supply large parts of the banking system with funding, this may contribute to spreading and exacerbating disturbances. The same applies to the actual services provided by banks: If they grant loans to the same groups of borrowers, they will be hit in the same way if one or more groups of borrowers fail to service their debts.

The Norwegian banking market is characterised by a low number of large, and a relatively high number of small and medium-sized, banks. The market share of the three largest banks in Norway, measured as a percentage of total assets in the banking sector, has increased in recent years, and is now just below 60 per cent. The largest bank, DNB, has a market share of about 35 per cent, cf. section 2.5.2 below. Although the market shares of the three largest banks are lower in Norway than in, for example, Denmark, Finland and Sweden, the concentration in the Norwegian banking market may nevertheless be such that it makes a significant contribution to the systemic risk in Norway.

Institution- and market-oriented financial markets regulation is also of fundamental importance for keeping systemic risk under control. In addition, macroprudential supervision is needed to monitor, identify and reduce systemic risk in the financial system, in order to make the system more robust against financial instability. Macroprudential supervision resembles institution-oriented regulation in terms of the tools used and the players on which these are used, cf. Box 2.7.

The Ministry of Finance is considering measures to improve the macroprudential supervision of systemic risk in Norway. The Ministry will consider, inter alia, the detailed wording of, and procedures for, new capital buffer requirements for financial institutions (referred to as capital conservation buffer and counter-cyclical buffer in the context of the Basel III standards), on the basis of proposed new EU rules (the so-called CRD IV rules) and input from a working group appointed by the Ministry of Finance to examine how the macroprudential supervision of the financial sector should be organised in Norway. The report from the group is discussed in Chapter 3, cf. section 3.8.

2.5 Market structure, earnings and solvency

2.5.1 Introduction

Below follows, at first, an overview of the structure of Norwegian financial markets. Thereafter, this section offers a discussion of the earnings and, in particular, the solvency of Norwegian financial institutions.

2.5.2 Market structure

2.5.2.1 Overview of Norwegian financial markets

The key players in Norwegian financial markets are banks and other credit institutions (mortgage companies and finance companies), insurance companies, pension funds, investment firms and securities’ fund management companies. Major structural changes often result from mergers or demergers. No such major structural changes have taken place in the Norwegian financial markets in 2011.

Figure 2.9 illustrates the total assets of Norwegian financial institutions and securities funds.5 Total assets increased the most in credit institutions from 2010 to 2011, by a total of about 11 per cent. Total assets of life insurance companies and pension funds increased by 5 and 3 per cent, respectively, whilst total assets remained more or less unchanged on the part of non-life insurance companies and securities’ funds.

Kilde: Finanstilsynet

There are seven major financial groups in Norwegian financial markets, cf. table 2.1. DNB is by far the largest financial group in Norway, with a total market share of about 32 per cent. Other large groups/alliances are Sparebank 1 Gruppen/Samarbeidende Sparebanker, Storebrand, KLP, Terra-Gruppen and Gjensidige. The Swedish financial group Nordea is represented in Norway through Norwegian subsidiaries, and has a total market share of 10 per cent. Overall, the financial groups register their largest market shares within life insurance and banking. Foreign players also have large market shares through both branches and subsidiaries, especially within non-life insurance and financing.

2.5.2.2 Credit institutions

As per yearend 2011, there were 220 credit institutions in the Norwegian credit market. These included 142 banks, 30 mortgage companies and 48 finance companies. The mortgage companies are primarily offering mortgages for the funding of business activities and the purchase of homes, whilst the finance companies are principally engaged in financial leasing, car financing, card-based lending and consumer loans. Most of the residential mortgage companies were established in 2008 and 2009, as the result of the government swap arrangement enabling banks to exchange covered bonds for government liquidity in the form of Norwegian sovereign certificates.

In 2011, the number of credit institutions was reduced from 226 to 220. The number of banks declined by two, whilst the number of mortgage companies and finance companies declined by one and three, respectively. The reduction in the number of banks resulted from four small savings banks merging into two.

Aggregate total assets in the credit market were NOK 5,405 billion, with banks, mortgage companies and finance companies accounting for NOK 4,035 billion, NOK 1,620 billion and NOK 125 billion, respectively. DNB was the largest player with 35 per cent of total assets. Sparebank 1 Gruppen and Nordea were the second and third largest, respectively, with market shares of 13 per cent and 11 per cent. There were 35 branches of foreign credit institutions in total in the Norwegian market as per yearend 2011. These had a market share of 13 per cent.

2.5.2.3 Insurance and pension

There are 22 life insurance companies in the Norwegian market. This is unchanged from 2010. Of the 22 companies, 12 are Norwegian companies, whilst 10 are small branches of foreign companies. Aggregate total assets were NOK 907 billion as per yearend 2011. The market share of the three largest companies, DNB Livsforsikring, Storebrand Livsforsikring and Kommunal Landspensjonskasse (KLP) was 82 per cent as measured by total assets. This has remained virtually unchanged for a long time.

There are 95 private and municipal pension funds in Norway, with aggregate total assets of about NOK 201 billion.

There are 96 institutions offering non-life insurance in the Norwegian market through various establishment in Norway. The four main non-life insurance companies, Gjensidige Forsikring, If Skadeforsikring, Tryg Vesta and Sparebank 1 Skadeforsikring, had an overall market share of 65 per cent as measured by gross premiums due as per yearend 2011. The majority of the small non-life insurance companies are marine insurance companies and so-called captive companies (companies established within a group or an organisation to handle own risks).

2.5.2.4 Securities

As per yearend 2011, there were 140 investment firms in the Norwegian market. Of these, 29 were banks. Branches of foreign investment firms and cross-border investment service activities are not included. The investment services of investment firms that are also banks are provided in connection with ordinary banking. Assets under active management for all investment firms were about NOK 758 billion.

The securities fund management companies held total assets of about NOK 826 billion as per yearend 2011. NOK 485 billion of these were managed for Norwegian-registered securities’ funds, whilst NOK 341 billion were assets under active management. Securities funds are collective investment undertakings and separate legal entities.

2.5.3 Credit institutions’ earnings and solvency

2.5.3.1 Banks

Norwegian banks’ earnings were somewhat lower in 2011 than in 2010. The banks’ overall pre-tax profits were in excess of NOK 33 billion, about NOK 2 ½ billion less than in 2010. However, when adjusted for large non-recurring effects in 2010, relating to pension costs and consolidation gains, 2011 profits were nevertheless 5 per cent higher than 2010 profits. When compared to total assets, profits in 2011 were on a par with the average for the last 10 years, cf. Figure 2.10A.

The return on equity after tax declined from 13 per cent in 2010 to 10.8 per cent in 2011, but the reduction was minimal if taking into consideration the large non-recurring effects in 2010. Three small banks posted negative profits in 2011.

Banks’ most important revenue source is net interest revenue, which is the difference between interest revenue and interest expenditure. These revenues have been declining for several years when compared to average total assets, but have been stable for the last couple of years, cf. Figure 2.10A. Interest revenue developments are closely related to developments in the interest rate margin, which is the difference between the average lending rate and the average deposit rate. Figure 2.10B shows that the overall interest rate margin has remained more or less unchanged over the last couple of years, whilst the margins on lending and deposits have varied considerably. Developments in the margins on lending and deposits are in part influenced by the intensifying competition in the residential mortgage market, as well as competition for customer deposits as a funding source.

Moreover, banks are facing more expensive wholesale funding, which is not reflected in the interest rate margin. The credit spread on banks’ bond borrowings is markedly higher than during the period prior to the international financial crisis, cf. Figure 2.10C. As the borrowing obtained before the financial crisis matures, and is replaced by new borrowing with higher credit spreads banks’ funding costs will increase.

On the other hand, banks’ costs have been declining for several years, cf. developments in operational costs in Figure 2.10A. Costs have been declining relative to both revenues and total assets, and the reduction is equally distributed across personnel costs and other operational costs.

In Figure B, the lending margin is the percentage point difference between the effective Nibor (3 months) rate and the average lending rate, whilst the deposit margin is the difference between Nibor and the average deposit rate. The overall interest rate margin is the percentage point difference between the average lending and deposit rates.

In Figure C, “swap rates” are interest rates in interest rate swap agreements with a 5-year maturity, concluded between banks. Under such interest rate swap agreements, a fixed rate is swapped for a floating rate. Swap rates are used in the calculation of the indicative credit spread because the swap rates reflect expected 3-month money market rates over 5 years.

In Figure E, the “Basel I floor” denotes a transitional arrangement whereby institutions using internal models (IRB approach) shall have a total capital corresponding to at least 80 per cent of the minimum capital requirement under the Basel I rules.

In Figure F, the categories “Others (large)” and “Others (small)” encompass other banks with total assets of more and less than NOK 10 billion, respectively.

Kilde: DNB Markets, Finanstilsynet, Norges Bank and Statistics Norway

Banks’ loan losses represented 0.24 per cent of overall lending (or 0.18 per cent when compared to total assets, see table 2.2) in 2011, against 0.22 per cent in 2010. The amount of losses in 2011 was NOK 6.9 billion. If the losses of DNB Bank through its subsidiary DNB Nord are excluded,6 Norwegian banks’ loan losses represented 0.19 per cent of overall lending. The marginal increase from 2010 resulted from a small increase in the losses of DNB Bank (to 0.26 per cent of lending), and a doubling of the losses of Nordea Bank Norge (to 0.31 per cent of the lending). The increase in the losses of Nordea is primarily the result of losses on a few large corporate exposures. In aggregate, the other banks registered a decline in losses from 2010 to 2011.

Defaults, which may serve as an indicator of future loan losses, were at the same level in 2011 as the year before, cf. Figure 2.10D. For banking groups, defaults represented 1.7 per cent of lending in 2011. The number is to some extent influenced by the fact that banks have transferred low-risk residential mortgages to mortgage companies, although the number includes defaults registered by mortgage companies that form part of banking groups. If the transfer of low-risk residential mortgages to mortgage companies continues, banks’ lending portfolios will in the future contain a larger portion of corporate loans and a smaller portion of less risky residential mortgages. This may result in higher and more fluctuating losses for banks in the coming years.

Banks’ capacity to absorb losses without depositors and other ordinary creditors incurring losses, depends on the level and quality of banks’ tier 1 capital and other capital. It follows from the capital adequacy rules that the tier 1 capital shall represent no less than 4 per cent of risk-weighted assets, and that total capital shall represent no less than 8 per cent. The capital adequacy rules are accounted for in Box 2.8.

In recent months, the so-called common equity tier 1 (CET1) capital ratio, where hybrid capital instruments (instruments sharing some of the characteristics of both debt and equity) have been omitted from the calculation, has become a more frequently used measure of banks’ solvency. In October 2011, it was for example agreed at the ministerial level in the EU that major European banks should have a CET1 capital ratio of at least 9 per cent by 30 June 2012. The European Banking Authority (EBA) has followed up on this consensus. The EBA has advised national supervisory authorities in the EU on how banks can be recapitalised to reach the target. In Norway, Finanstilsynet expects all Norwegian banks to have a CET1 capital ratio of at least 9 per cent by 30 June 2012.

Norwegian banks have strengthened their solvency considerably since 2008, cf. Figure 2.10E. From yearend 2010 to yearend 2011, the CET1 capital ratio increased from 10.7 per cent to 11 per cent. The total capital ratio, which includes hybrid capital instruments and subordinated loan capital, was 13.6 per cent as per yearend 2011, down 0.6 percentage points from the previous year. The banks have expanded their total assets whilst at the same time increasing their CET1 capital ratios. This demonstrates that Norwegian banks have strengthened their solvency by increasing the amount of CET1 capital rather than deleveraging or otherwise shrinking their balance sheets. The strengthening of solvency has in large part been achieved by retaining profits – which have been high over this period – and by issuing new equity.

Most Norwegian banks already have CET1 capital ratios in excess of the 9 per cent minimum recommended by EU ministers, cf. Figure 2.10F. Finanstilsynet is pursuing a dialogue with those banks that are below 9 per cent, and has ordered them to prepare plans setting out how to reach 9 per cent by 30 June 2012. There is reason to believe that the EU recommendation may give rise to a higher market standard for bank solvency. When combined with the uncertainty concerning future economic developments, this suggests that banks should aim to maintain a certain buffer on top of a CET1 capital ratio of 9 per cent.

Implementation of the Basel III standards in EEA law will imply higher minimum capital requirements than apply at present, cf. the discussion in Chapter 3. Adaptation to the new minimum requirements also heralds strengthened solvency, although Norwegian banks are already well positioned for compliance with these future minimum requirements.

Banks’ earnings in recent years, and the outlook ahead, indicate that banks are well placed to further strengthen their solvency by retaining profits. They may also increase their own funds by issuing new equity. Several of the large Norwegian savings banks raised new equity in 2011, whilst others announced in early 2012 that they would be issuing equity instruments in the market. As discussed in Box 2.9, it is not necessarily the case that banks’ overall funding costs will increase with the equity capital ratio. Since more equity capital means less risk for both owners and creditors, banks can expect a decline in the return on equity required by investors, as well as a decline in their funding costs.

The purpose of the Basel II capital ratio rules, which have applied since 2007, is to take into account banks’ risks more precisely than under the less sensitive Basel I rules. The larger Norwegian banks are to a large extent using the internal ratings based (IRB) approach to calculate their risk-weighted assets, and thus also their regulatory capital requirement. Other banks use the standardised approach resulting in a capital requirement more or less on a par with the level resulting from calculations pursuant to the Basel I rules, cf. Figure 2.11A below.

Banks using the IRB approach shall, as a transitional arrangement, have a total capital corresponding to no less than 80 per cent of the minimum capital requirement under the Basel I rules. The transitional arrangement, referred to as the “Basel I floor”, prevents use of internal models within the IRB approach from excessively reducing risk-weighted assets, and applies in all Nordic countries. Figure 2.10E shows the impact of this arrangement on banks’ reported solvency.

Figure 2.10E also shows how much CET1 capital banks hold as a percentage of their non-risk weighted total assets. Until 2008, this non-weighted ratio declined by more than the risk-weighted ratio, whilst after 2008 it has been growing more slowly than the risk-weighted ratio. The difference between these two measures of solvency shows that asset growth has exceeded the increase in capital requirements. The difference has increased steadily over time, and has never been greater than as per yearend 2011. A new capital requirement related to a non-weighted solvency measure, often referred to as a leverage ratio backstop, is likely to be introduced in a few years’ time in the EU/EEA and elsewhere, cf. Chapter 3. The background is the experience from the international financial crisis, when it was observed that weaknesses in IRB models may hide or underestimate risk.

Use of the IRB approach generally brings about reduced capital requirements through lower risk weights, cf. Figure 2.11A. This is seen both internationally and in Norway, although actual capital requirements are significantly higher in those countries applying the Basel I floor (which in practice stipulates a limit as to how low the applied risk weights may be). One may ask whether the lower risk weights resulting from the IRB approach do in fact reflect improved risk management and control, especially when considering that the Basel II rules (which paved the way for use of internal models within the IRB approach) were introduced at a time when both financial markets and the real economy had been prosperous and stable for a long period of time. Although it was explicitly required that the models used in the IRB approach were to be calibrated with this in mind, models are influenced by historical data, and probably especially by the more recent observations. There is considerable uncertainty as to how well suited current IRB models are for calculating future risk. In some areas, such as residential mortgage credit risk, it is evident that the historical data used in internal models provides a limited measure of the risks.

Figure 2.11A and 2.11B illustrate that capital requirements reflect historical losses. Even during the Norwegian banking crisis in the early 1990s, the losses on loans to retail customers, which predominantly take the form of residential mortgage loans, were low compared to the losses on corporate loans. When households’ finances are impaired, it has until now often been the case that households have prioritised servicing their mortgages, whilst cutting down on consumption and other expenses. This is the case in several countries. In periods of financial turbulence or lower economic activity, losses incurred by banks on residential mortgages may therefore be relatively small even though households may be the first to encounter financial difficulties. Lower demand from households reduces corporations’ earnings, and increases banks’ losses on corporate loans.

As mentioned in section 2.4.3 above, developments in the housing market and households’ debts represent a major risk for banks. Neither housing prices, nor household debts, have ever been as high as at present, whilst the interest rate level is very low. Banks have no experience with situations similar to the current. If the risk is triggered, losses may increase considerably on both residential mortgages and corporate loans. Special caution is therefore called for, and banks and mortgage companies should cushion loans in both segments by more capital.

The model-based weights in Figure A are weighted averages as per the 2^nd quarter of 2011 for the part of institutions’ loan portfolios on which internal models are applied for calculating the capital requirement. The institutions are to a varying extent applying the standardised approach and their own, internal models (the IRB approach) to various parts of their loan portfolios, as far as both corporate loans and residential mortgages are concerned. Moreover, the model-based weights are not fully representative of the actual capital requirement, because the applicable Basel I floor defines a limit as to how low the actual weights can be. The Basel I floor is a transitional arrangement implying that institutions that use internal models shall have total capital corresponding to no less than 80 per cent of the minimum capital requirement under the Basel I rules.

In Figure B, the sector-specific losses are only losses on the part of banks (parent banks). Because losses on loans to retail customers are higher on the part of banks than on the part of residential mortgage companies (which hold the most secure residential mortgages), the losses on loans to the retail customers of banks and mortgage companies as a whole will be lower than indicated by the figure.

Kilde: Finanstilsynet and Norges Bank

2.5.3.2 Mortgage companies and other credit undertakings

Profits before tax for Norwegian credit undertakings (not including Eksportfinans ASA) were NOK 5.7 billion in 2011, as compared to NOK 5.2 billion in 2010. When compared to average total assets, profits declined from 0.50 per cent to 0.47 per cent, principally as the result of a decline in net interest revenues. The activities of mortgage companies amount to a large part of the total activities of Norwegian credit undertakings. Owed to this, Norwegian credit undertakings as a whole raise most of their funding by issuing covered bonds. The market for covered bonds has been influenced by the general volatility in the financial markets in 2011, but Norwegian mortgage companies have not encountered problems with issuing such securities. Mortgage companies’ interest costs have nevertheless increased during 2011, since credit spreads on such securities have also increased somewhat, in particular towards the end of the year, cf. Figure 2.10C above.

The recorded losses of Norwegian credit undertakings are low, and somewhat lower in 2011 than in 2010, when compared to average total assets. Defaults are also low, although a small increase has been registered since 2011.

There has been a large increase in lending from credit undertakings in recent years. The main reason is the banks’ transfer of lending portfolios to residential mortgage companies, cf. above. Norwegian credit undertakings’ lending increased by 19 per cent to about NOK 1,100 billion in 2011. The previous year it increased by about 30 per cent. As banks can transfer residential mortgages to mortgage companies, banks can in practice use the market for covered bonds to fund their activities. Thus far, issuances of covered bonds secured on commercial property mortgages have been small, but banks are also holding a fair amount of such loans that may be eligible for transfer to mortgage companies.

Norwegian credit undertakings are subject to the same capital requirements as Norwegian banks. As per yearend 2011, the credit undertakings (excluding Eksportfinans) had a CET1 capital ratio of 10.3 per cent, which was marginally higher than the previous year. The total capital ratio (including hybrid capital and subordinated loan capital) was 11.8 per cent.

For Eksportfinans ASA, an export credit provider, 2011 was a turbulent year. Among other things, the company’s debts were downgraded by the rating agencies after it became known that the company would no longer be administrating the Norwegian government scheme for subsidised export credits. The downgrading resulted in a steep decline in the market value of the debt securities issued by Eksportfinans. This was reflected in Eksportfinans’ accounts as a large, unrealised gain, as Eksportfinans records most of its own debts at so-called fair value. Recording of financial instruments at fair value in the accounts will most often imply that one applies the instruments’ market prices. Consequently, Eksportfinans’ pre-tax profits were especially high in 2011. The accounts show that whilst the company posted profits of NOK 600 million in 2010, profits for 2011 were as much as NOK 42 billion. Without the unrealised gain on its own debts, profits for 2011 would probably have been more or less on a par with 2010.

2.5.3.3 Finance companies

Norwegian finance companies’ pre-tax earnings were, at NOK 1.8 billion, more or less unchanged from 2010 to 2011. When compared to average total assets, profits declined somewhat in 2011. This resulted from an increase in the companies’ funding costs, principally via higher funding costs of their parent companies. When compared to average total assets, loan loss fell from 0.9 per cent in 2010 to 0.6 per cent in 2011. The finance companies’ CET1 capital ratio remained practically unchanged from 2010 to 2011, at about 17 per cent as per yearend.

A number of the finance companies and some banks offer consumer loans. These loans are primarily granted without any collateral requirement, and involve high credit risk. The consumer loan segment comprise card-based lending and other types of loans, and most loans are in the region of NOK 10,000 kroner to NOK 400,000 kroner. Figure 2.12 shows developments in such lending for a selection of Norwegian finance companies, together with loss and default developments. Lending growth contracted markedly in 2009, but has rebounded over the last couple of years. Losses on consumer loans are generally higher than on other types of loans to retail customers, but have declined steadily in recent years, and represented 1.5 per cent of total consumer lending in 2011.

Whilst the majority of consumer loans were granted to borrowers aged between 40 and 50 years, it is borrowers under the age of 30 years who most frequently default on their consumer loans.

Kilde: Finanstilsynet

2.5.4 Insurance companies and pension funds’ earnings and solvency

2.5.4.1 Life insurance companies

The recorded profits of Norwegian life insurance companies before tax and customer profit sharing were halved from 2010 to 2011, and ended at NOK 6 billion, cf. table 2.4. The value adjusted profits (which take account of unrealised capital gains) before tax and customer profit sharing were about NOK –3.4 billion in 2011. This is considerably lower than in 2010 and 2009, when value adjusted profits were NOK 23 and 15 billion, respectively, but not as low as in 2008, when they ended at NOK –22 billion. Profits in 2011 were affected by developments in international stock markets, especially in the 3rd quarter of 2011. The life insurance companies registered positive profits in all other quarters of 2011.

When compared to average total assets, premium revenues were 9.7 per cent and compensation payments were 6.1 per cent in 2011, more or less unchanged from 2010. The predominant part (about 80 per cent) of premium revenues originated from collective pension schemes. Of this, revenues from private and municipal schemes represented 46 and 54 per cent, respectively. The portion of premium revenues accounted for by defined contribution pension plans continued to increase. In 2011, 40 per cent of premium revenues from the collective private schemes originated from defined contribution plans.

The recorded return on capital in life insurance companies’ collective portfolio (which shall primarily cover liabilities subject to a certain interest rate guarantee) was 4.2 per cent in 2011, which is about one percentage point lower than in 2010, cf. Figure 2.13A. The value adjusted return on capital (which takes account of unrealised capital gains) ended at 2.8 per cent in 2011, down from 6.8 per cent in 2010.

Figure 2.13B shows that interest revenues constitute a stable and important part of the revenues from the assets in the collective portfolio. When compared to average total assets, these revenues were marginally higher in 2011 than in 2010, although the interest rates on the most secure securities fell in 2011. The revenues from bonds held to maturity were not immediately affected by the lower interest rate level. Interest revenues also held firm due to a general increase in the credit spread on less secure interest-bearing securities, and because the life insurance companies increased their holdings of interest-bearing securities. The revenues from equities are highly volatile and have a large effect on the overall return on capital. The equities generated (predominantly unrealised) losses in the 3rd quarter of 2011, but appreciated markedly in value towards the end of the year.

Kilde: Finanstilsynet

The buffer capital is a measure of life insurance companies’ capacity to absorb losses without falling short of the stipulated minimum capital requirements. The buffer capital comprises own funds (in the form of tier 1 capital in excess of the minimum requirement) and policyholders’ funds (in the form of supplementary provisions up to one year’s interest rate guarantee, fluctuation reserves and risk equalisation funds). When compared to total assets, Norwegian life insurance companies’ aggregate buffer capital was 4.8 per cent as per yearend 2011, which is one percentage point lower than the previous year. The level and composition of the buffer capital as per yearend 2011 was more or less the same as per yearend 2009, cf. Figure 2.13C. The decline in 2010 resulted from a reduction in the fluctuation reserves, which reflects (unrealised) changes in the market value of the assets in the collective portfolio. The situation improved considerably in the 4th quarter of 2011.

All life insurance companies satisfied the minimum capital ratio requirement and the solvency margin requirement as per yearend 2011. Life insurance companies’ overall capital ratio was 15.7 per cent.

The majority of Norwegian life insurance companies’ liabilities are liabilities subject to a certain interest rate guarantee vis-à-vis the policyholders. The average guaranteed rate was about 3.3 per cent in 2011, which was somewhat lower than in 2010, cf. Figure 2.13D. The figure also shows that interest rates on secure interest-bearing securities have fallen to a level that may make it challenging for the companies to stably achieve a return on policyholders’ funds in excess of the interest rate guarantee. In order to meet this challenge, the companies need to strengthen their capital buffers and secure revenue streams not directly dependent on market developments.

Pursuant to rules applicable under the Norwegian Insurance Activity Act since 2008, all policyholders with collective pension plans featuring contractually-determined benefits shall every year pay premiums for the management of funds relating to the insurance policy, including the insurance company’s market risk, i.e. pre-payments for the interest rate guarantee. Consequently, it is important that the life insurance companies charge adequate premiums for the interest rate guarantee, and that the companies use these revenues to build sound capital buffers for those years in which the return on policyholders’ portfolios is lower than the guaranteed rate. The companies may change the interest rate guarantee premiums from year to year, and thus generate revenues also in years when interest rates are low.

Instead insurers share in any return in excess of the interest rate guarantee. Consequently, a return on capital lower than the interest rate guarantee for a sustained period of time, poses a potential problem for the insurers.

The life insurance companies’ risk is different for paid-up policies and individual insurance policies issued prior to 2008, as different rules apply. For these policies, the companies cannot charge annual guarantee premiums, but instead earn their revenues by sharing any return in excess of the interest rate guarantee with the policyholder. Consequently, a return on capital lower than the interest rate guarantee for a sustained period of time, pose at potential problem for the companies. Paid-up policies and individual insurance policies issued prior to 2008 accounted for about 28 per cent of Norwegian life insurance companies’ liabilities as per yearend 2011.

Defined benefit municipal occupational pension schemes with interest rate guarantees cannot be terminated (but they can be transferred between companies). In the private sector, however, such schemes may be terminated and replaced by defined contribution occupational pension schemes. In these cases, the existing liabilities in the defined benefit scheme are converted into paid-up policies, on which life insurance companies cannot charge interest rate guarantee premiums. If the interest rate guarantee premiums charged to corporations with defined benefit occupational pension schemes increase, for example as the result of low interest rates, the likelihood that more of them will terminate these schemes will increase, and thus the likelihood that life insurance companies will have to handle more paid-up policies will also increase.

The Norwegian Banking Law Commission has recently proposed regulatory amendments permitting the issuance of paid-up policies with an investment option and no interest rate guarantee, cf. Box 2.10. If such schemes are permitted, it may reduce the challenges facing life insurance companies with regard to existing and future paid-up policies.

Most elements of the new EU solvency requirements for insurance companies (Solvency II), shall according to the current timetable be incorporated into Norwegian law with effect from 2014. These changes to the regulatory framework will also pose challenges for Norwegian life insurance companies in coming years. The changes are expected to be relatively major for the companies, especially in terms of new solvency requirements, but also asset management requirements and reporting systems. The Solvency II rules imply that the value of insurance liabilities shall be assessed on the basis of market interest rates.

The details of the upcoming Solvency II regulations have not been determined by the EU, and the final wording of the rules remains uncertain. Solvency II is discussed in further detail in section 3.3 of Chapter 3. Nonetheless, it should be mentioned in an analysis of the financial stability outlook that it is likely that Norwegian life insurance companies will have to increase their buffer capital to satisfy the new requirements. Stress tests based on preliminary draft rules show that the buffer capital of Norwegian life insurance companies is too low, and that some companies are facing major challenges upon the transition to Solvency II. This is especially the case for those companies for which paid-up policies represent a considerable part of their business.

The Banking Law Commission is currently working on draft rules on new types of pension schemes, adapted to the Solvency II rules and new accounting standards. Such new schemes will ease the transition to Solvency II for Norwegian life insurance companies. It is nevertheless important for life insurance companies to prepare for the Solvency II transition by strengthening their capital buffers.

A large portion of Norwegian life insurance companies’ portfolio of insurance policies includes obligations to make life-long payments to the insured. The companies are therefore exposed to the risk that the insured will live longer than expected when premiums were paid and funds were allocated to cover the companies’ obligations. Life expectancy is on the increase in Norway and has until now increased by more than the companies have taken into account. Even a small increase in life expectancy may significantly increase the necessary provisions to cover the increased value of the companies’ obligations. The companies updated their life expectancy assumptions a few years ago, and increased their provisions as a result of that. Since life expectancy continues to increase, the companies have to recalculate their liabilities and further increase their provisions to ensure solvency. Finanstilsynet has announced that it will require the life insurance companies to apply new and updated life expectancy assumptions as from 2013.

It is, as the Ministry of Finance has emphasised over several years in the annual financial markets reports, of particular importance that life insurance companies and pension funds with an adequate margin of safety ensure that their risk taking is balanced out by their solvency. The situation ahead requires efficient risk management and adequate capital buffers.

2.5.4.2 Pension funds

Norwegian pension funds’ profits before tax and customer profit sharing were NOK 2.9 billion in 2011, down from NOK 4.8 billion in 2010.7 When compared to total assets, profits were 1.6 per cent, a reduction from 2.8 per cent in 2010. The decline in profits resulted from a fall in the net revenues from financial assets (the return on capital), and somewhat lower premium revenues.

Pension funds must, in the same way as life insurance companies, pay heed to minimum annual return requirements (interest rate guarantees). The recorded return on capital in the pension funds’ collective portfolio was 4.8 per cent in 2011, down from 5.5 per cent in 2010, cf. Figure 2.13A above. The value adjusted return on capital declined by more than 9 percentage points, to –0.2 per cent, principally due to reduced equities values. The value adjusted return on capital of private pension funds declined by more than that of municipal pension funds, because the private funds had invested a larger portion of their portfolios in equities.

Kilde: Finanstilsynet

Pension funds generally have a larger equity component in their asset management than life insurance companies. In order to do so, the pension funds also hold more buffer capital than do the life insurance companies. The buffer capital of the pension funds, like that of the life insurance companies, was reduced in 2011. For private and municipal pension funds as a whole, the buffer capital amounted to was 8.8 per cent as per yearend, as compared to 12.4 per cent as per yearend 2010, cf. Figure 2.14. In relative terms, the decline in the buffer capital was about the same in private and municipal pension funds, to 10.1 and 6.5 per cent, respectively, as per yearend 2011. The decline resulted from a reduction in the market value adjustment reserve.

2.5.4.3 Non-life insurance companies

Norwegian non-life insurance companies’ aggregate profits before tax were about NOK 3 billion in 2011, as compared to about NOK 4 billion in 2010 (not including captive companies). Technical profits were higher in 2011 than in 2010, since the increase in premium revenues outpaced the increase in claims payments and operational costs. A decline in financial revenues of more than NOK 1.5 billion resulted in overall profits being weaker in 2011 than in 2010, cf. table 2.5. Although the non-life insurance companies held a smaller equity component than the life insurance companies, the turbulence in the international financial markets resulted in a major reduction in financial revenues.

The sum of claims payment costs and other insurance-related, own-account operational costs measured as a percentage of own-account premium revenues, is called the combined ratio. This indicates how profitable the actual insurance activities are, i.e. what portion of their expenses the non-life insurance companies can cover through their premiums. If the combined ratio exceeds 100 per cent, the company needs other revenues to break even, such as, for example, financial revenues. In 2011, the combined ratio for Norwegian non-life insurance companies’ was just below 96 per cent, which is about one percentage point lower than over the last couple of years, cf. Figure 2.15. The improvement is explained by lower operational costs. Claims payment costs remained more or less unchanged in 2011, for the year as a whole, despite high payments at the beginning of 2011, following the extreme cold snap in 2010.

The Norwegian non-life insurance market is characterised by a large number of companies. In 2011, 19 non-life insurance companies recorded negative profits before tax, as compared to 7 in 2010. In aggregate, the solvency of non-life insurance companies was good as per yearend 2011, and more or less on a par with the previous year. The capital ratio was 40 per cent.

Kilde: Finanstilsynet

2.5.5 Investment firms and management companies’ earnings

Norwegian investment firms that are not banks had operating revenues of NOK 6.2 billion in 2011, which is about NOK 1.4 billion less than in the previous year. In 2011, the most important revenue sources for investment firms that are not banks were corporate finance activities, investment advice and active management of portfolios on behalf of insurance companies, pension funds and private corporations. The investment firms that are not banks registered aggregate operating profits of NOK 520 million in 2011. This is as much as NOK 1.3 billion less than the previous year.

Traditionally, securities brokerage has also been an important source of revenues for investment firms that are not banks. Structural changes and new trading patterns through, among other things, more automated and direct trading has reduced the need for traditional brokerage in recent years. These developments have continued in 2011. The prices of traditional brokerage services have also been under pressure, which has contributed to a steep decline in investment firms’ revenues from brokerage, cf. Figure 2.16. This has resulted in an impairment of several investment firms’ solvency.

Many banks are licensed to engage in securities activities. These activities generated operating revenues of NOK 7.4 billion for Norwegian banks in 2011, down from NOK 8.5 billion in 2010. In 2011, most of the banks’ revenues from investment services and supplementary services originated from services rendered in connection with trading in derivatives, fixed-income instruments and foreign exchange.

The most important revenue sources for the securities fund management companies are remuneration for the management of funds, as well as revenues from active management of portfolios. Aggregate operating profits for Norwegian securities fund management companies were NOK 871 million in 2011. This represents a reduction of 21 per cent from 2010.

Kilde: Finanstilsynet