Good results at Norwegian banks a sound basis for improved solidity

Risk factors

Activity levels in the Norwegian economy remain high, and prospects are relatively good. However, the risk of a weaker trend in the world economy has grown, and the IMF's growth estimates for both 2013 and 2014 have been revised down. A setback in the international economy would likely have a negative impact on Norwegian business and industry, in particular competitively exposed segments which are already struggling with a high cost level and stagnating markets. Slower growth in emerging economies increases the risk of a substantial, lasting decline in the oil price which would have negative spillover effects on the Norwegian economy. A marked downturn would impair the debt servicing capacity of firms and households, and banks' loan losses would increase. High house prices and record-high household indebtedness could trigger or intensify a downturn in the Norwegian economy.

"Developments over recent months indicate that house prices are levelling off, but household debt continues to grow faster than incomes. The rising indebtedness makes more households vulnerable in the event of income reduction and/or higher interest rates. An interest rate hike would compel many households to devote a large part of their income to servicing debt. Their consumption would fall, with negative consequences for business and industry and for the banks," says Morten Baltzersen, Director General of Finanstilsynet.

Banks – earnings, financial strength and funding

Norwegian banks have shown sound profits for several years. Low loan losses have been the main contributory factor. Banks' net interest income relative to total assets rose somewhat in the first half-year as a result of higher lending margins, at the same time as banks continued their drive to improve cost efficiency. Growth in lending to corporate borrowers has fallen, but growth in lending to households remains high. Foreign branches continue to grow at a slower rate than Norwegian banks.

Norwegian banks have in recent years improved their funding structure by increasing their long-term funding and strengthening their liquidity buffers. However, funding through international money and capital markets continues to account for a large portion of banks' market funding, rendering them vulnerable in the event of turbulence in international markets. Banks' issuance of covered bonds has put their funding on a longer term footing. It is at the same time important for banks to be keenly aware of the funding risk that may result from encumbering large portions of their assets.

Banks' common equity (CET1) ratios have risen in recent years due to improved equity positions, but also because risk weighted assets have grown more slowly than total assets. Sound profits have given a good basis for increasing equity positions through high profit retention. Some banks have also issued new equity. All Norwegian banks met the common equity ratio requirement of 9 per cent at the end of the first half-year; they averaged 11 per cent. Their common equity capital relative to unweighted total assets has also risen in recent years, although for banks overall the level is still lower than in the early 2000s. The largest banks' common equity ratios and unweighted capital ratios are generally lower than those of smaller banks.

Strengthening of financial positions

Capital requirements on Norwegian financial institutions will gradually rise in the period to July 2016. The common equity requirement will rise for all financial institutions, with an additional requirement for systemically important institutions. The Ministry of Finance can in addition impose a countercyclical buffer requirement of up to 2.5 per cent.

Higher capital requirements will compel a number of Norwegian banks to strengthen their core capital position in the period ahead. Their overall capital need depends on the growth in risk weighted assets, on what institutions are defined as systemically important and on the level of the countercyclical buffer. Finanstilsynet's position is that banks must maintain an adequate margin to the regulatory requirements, and Finanstilsynet may impose requirements over and above those in effect for individual institutions or groups of institutions.

Banks' use of models to measure risk and compute capital charges is subject to much uncertainty. Risk parameter floors have been established, along with a floor for overall risk-weighted assets, to prevent risk models from diluting capital requirements and to help to ensure that relevant risk is captured. Common equity capital can be strengthened by retaining profit or issuing new equity, and Finanstilsynet expect banks, in 2013 as previously, to retain significant portions of their substantial profits. Robustness and financial strength over time are a competitive advantage for banks. 

Residential lending practices

In March 2010 Finanstilsynet issued guidelines for prudent mortgage lending practices by banks. The guidelines were tightened in December 2011 in light of the trend in house prices and household debt. The requirement of good debt servicing capacity is a key aspect of the guidelines. It is also important that the loan-to-value ratios are not excessive, so that banks and customers are cushioned against a house price fall. The guidelines accordingly state that the loan-to-value ratio should not be higher than 85 per cent of property value. In the case of a higher ratio, either additional collateral must be provided or the bank must have made a particular prudential assessment.

Households' high debt-to-income ratio increases the risk faced. For many households a house price fall could entail loss of their entire equity, and the tightening may be larger than it would have been given a lower level of debt.

"The home mortgage loan survey conducted in autumn 2013 indicates that Finanstilsynet's guidelines for prudent residential lending practices are largely complied with. This is important both with regard to risk at the individual bank and in the financial system, and in order to reduce the risk of borrowers incurring debt that they are unable to service later on", says Mr Baltzersen.

Finanstilsynet's home mortgage loan survey shows that the volume of loans with a loan-to-value ratio in excess of 85 per cent is somewhat lower than in 2012. However, the loan-to-value ratio remains high among young borrowers. This group of borrowers in particular takes up large loans relative to income. The volume of interest-only mortgages and the length of the instalment-free period has fallen compared with 2012.

Life insurers and pension funds

Stock markets have shown a positive trend thus far in 2013, contributing to higher financial earnings among life insurers and pension funds. Results in the first half-year were accordingly good, and buffer capital increased. The stock market trend ahead is a matter of considerable uncertainty. The low interest rate level poses a major challenge since insurance contracts include rate-of-return guarantees. New mortality tables, taking account of rising longevity in the population, take effect in 2014, as a result of which life insurers and pension funds need to increase their technical provisions. Several life insurers and pension funds have devoted their surplus returns in 2011 and 2012 to increasing their reserves, but a further increase is required.

Sound financial positions are crucial if life insurers and pension funds are to maintain sufficient risk-bearing capacity to invest in securities that provide satisfactory return over time while at the same time managing the risk attached to such investments. While many are compliant with the current capital requirements, a number of them may face problems in meeting the capital requirements under the new solvency regulation, Solvency II, which is scheduled to come into force in 2016.