Financial assets managed by NBFI have increased

In line with international developments, financial assets managed by Norwegian non-bank financial institutions (NBFI), have steadily increased over the past 20 years, as shown in figure 1A. Examples of NBFI are asset managers, pension funds, life insurers and insurance companies. Their total assets under management currently amount to NOK 4000 bn, and consist of pension- and insurance contributions, investment inflows and accumulated return. Moreover, the growth in this sector has been larger than that of the traditional banking sector. In general, increased savings are related to increased wealth and prosperity, and structural factors like demographics. In addition, a decade of low interest rates post-GFC, in combination with regulatory developments such as the pension reform of 2011, has likely incentivised contributions to individual saving schemes.

Roughly half of these investments are allocated to foreign assets, likely for diversification purposes and for return enhancement. Investments denominated in foreign currency necessitate transactions in the FX market through various mechanisms. Part of these investments are hedged back to NOK to reduce or eliminate FX exposure. There may be various incentives for this, e.g. reducing portfolio volatility and preservation of purchasing power in domestic currency. There is also a regulatory incentive to hedge, as the solvency rules for pension- and insurance companies require additional capital for unhedged FX exposure.

On the other hand, there are also reasons not to hedge foreign investments. There are costs associated with hedging, both through transaction costs (implementation costs, carry element), and through collateral requirements (margin calls[1]) during the lifetime of the FX contract.

The decision to hedge or not ultimately boils down to risk management. Subject to asset composition, FX exposure can at times offset the changes in asset valuations. For a Norwegian investor this has been the case for foreign equity investments, as historically the NOK has weakened when global equity indices have fallen during turbulent market conditions. Thus, open FX exposure has contributed to reduced portfolio risk. The opposite is likely to be true for a global fixed income portfolio, where an FX hedge would prevent FX fluctuations dominating returns of the bond portfolio.

Figures 1A and 1B: Financial assets (net value holdings) through investment funds, pension- and insurance schemes (1A). Financial sector asset and liabilities in foreign currency (1B). Billion kroner. Quarterly from 2003-2023. Source: Statistics Norway (SSB) and Norges Bank.

Figure 1B gives an institutional breakdown of net foreign financial claims, that mirrors the gross FX exposure in the Norwegian financial sector. The light blue area shows NBFI’s assets holdings abroad, where a portion are FX hedged to mitigate the risk of NOK strengthening. The dark blue area shows the traditional banking sector, with a share of its wholesale funding abroad. The banks largely hedge their net foreign liabilities, to mitigate the effect of NOK weakening and protect their equity capital. Official turnover statistics from the FX market in NOK,[2] shows that the combined turnover by banks and NBFI counterparties have increased over time and dwarfs the turnover by non-financial (commercial) entities. The same development is also found for major currencies, where the global FX market has become more "financialised" with FX transactions from financial entities dominating the marketplace.

Inflows to NBFI and ongoing value changes of their global investment portfolios will lead to FX transactions needs, but these needs do not necessarily match those of banks in time nor size. There is generally less fluctuation in the valuation of bank debt, and therefore less rebalancing needs through FX transactions. Banks, being the price makers and intermediaries in the FX market, will provide their balance sheet and risk capacity at a cost. In times of large, simultaneous, and one-sided order flows aggregated from the NBFI sector there are potentially significant impacts on the Norwegian krone exchange rate in the short term.

Mechanisms that motivate NOK FX transactions

When decomposing NBFI needs to buy or sell NOK, we can identify three simplified mechanisms related to FX hedging risk management strategies that motivate FX spot or forward[3] transactions in the NOK market.

The first mechanism is when assets under management increase through capital inflow. When a certain share is allocated to foreign investments unhedged, this necessitates selling NOK to buy foreign currency.

The second mechanism is when a certain share of the foreign portfolio is already hedged, and underlying value changes affect the hedging ratio. For example, if global equity portfolios decrease in value, the portfolios become over-hedged. To rebalance back to the original hedging ratio, the asset manager needs to repurchase foreign currency equivalent to the portfolio value change and sell a corresponding amount of NOK[4].

And finally, transactions can be motivated by asset managers seeking to adjust the hedging ratio during the investment horizon. In the case of hedging ratios being reduced, this will also require a repurchase of foreign currency by selling NOK.

An empirical approach supporting the mechanisms

Detailed and high-frequency transaction statistics from the FX market are limited, and so is transparency of the NBFI FX hedging mechanisms. However, to find empirical evidence of the rebalancing mechanisms, we can use available portfolio data and statistics on FX transactions[5] to identify a correlation between changes in portfolio valuations and FX transactions. We examine weekly value changes of a traditional equity/fixed income portfolio[6], displayed on the X-axis in figure 2A, plotted against weekly net purchase of NOK by asset managers (NBFI) on the Y-axis. The scatter plot indicates a positive correlation between changes in portfolio valuation and NOK transactions. However, the relationship is not strictly linear, suggesting that a certain threshold of value change is required to trigger a mechanical rebalancing of FX hedges.

Some extreme cases, highlighted in red, during the most turbulent weeks in March 2020 as well as around quarter-end in Q3 2022 are noteworthy.

Figures 2A and 2B: Value changes of a global foreign asset portfolio, in percent, against net NOK purchases by Norwegian NBFI from Norges Bank’s statistics on FX transactions, in NOK bn, 2019-2023 (2A). Weekly net NOK purchases by Norwegian NBFIs, in NOK bn, 2020 (2B). Source: Bloomberg, Statistics Norway (SSB) and Norges Bank. 

In March 2020, at the start of the pandemic, volatility in financial markets was extraordinary. Figure 2B illustrates that the NBFI were both buyers and sellers of NOK before and after March 2020. However, in March continuous declines in both global equity and fixed income values contributed to NBFI’s global asset portfolios being significantly over-hedged relative to mandated hedging ratios, necessitating substantial and simultaneous rebalancing by selling NOK.

Thus, we have identified that the rebalancing effect, with the need to buy or sell NOK, is most pronounced during periods of abrupt shifts in global financial market valuations when the arising FX transaction needs become one-sided.

Introduction of a new reporting amongst NBFIs

The experience from the pandemic in 2020 highlighted the liquidity risk associated with NBFI’s FX hedging mechanisms and market value changes of derivative contracts.[7] Recognizing the need for improved transparency and insights, Norges Bank has initiated new reporting[8] amongst the largest Norwegian asset managers. The purpose is to provide comprehensive insight into the scale and nature of FX hedging and liquidity requirement stemming from margin calls on derivative exposure. Per year-end 2023 the survey shows that their total volume of FX hedging into NOK amounts to NOK 600 bn, see figure 3A. The hedging ratio varies within each asset class.

The survey includes a sensitivity analysis should the NOK depreciate by 20 percent, as shown in figure 3B. Related to outstanding derivative contracts, the respondents estimate additional margin calls totaling NOK 100 bn, of which 60 percent must be posted as cash collateral, whereas securities can be posted for the remainder. It is reported that half of the cash collateral may be covered by existing liquidity buffers, whereas the residual must be covered by asset sales or through use of repo facilities.

Figures 3A and 3B: AUM in foreign denominated assets and hedged amount by allocation style, in NOK bn, and derived hedging ratios, in percentage (3A). The discretionary category entails assets not managed through mutual funds, for example pension contributions.  Sensitivity analysis: estimated margin calls if NOK weakens 20 percent, and estimation of how these funds will be covered, in NOK bn. (3B). Source: Norges Bank, reporting per year-end 2023.

Footnotes

[1] To mitigate counterparty risk, FX forward and FX swap contracts between financial counterparties requires daily exchange of variation margin, covering the change in mark-to market value of the contracts.

[2] For further insights on the BIS statistics, see blogpost “The foreign exchange market for Norwegian krone and its main participants”

[3] A spot or forward transaction is the exchange of one currency for another at an agreed settlement date, respectively T+2 or at a forward date. In contrast to a swap, these products consist of delivering one currency for another, and have the most direct effect on the exchange rate. Typically the initial hedge is done by entering a FX swap, and subsequent adjustments are done through forward transactions.

[4] A simplified example of the rebalancing mechanism: A Norwegian asset manager (NBFI) has invested USD100 in a US asset, and with a full FX hedge the NBFI has (typically through a FX swap) sold USD100 and bought NOK at a forward date. During the investment horizon however, the market value of the US asset falls by 20 percent, thus the NBFI’s investment is over-hedged. To rebalance the FX hedge back to required hedging ratio, the NBFI must repurchase USD20, equivalent to the valuation changes, and sell NOK, at the forward date.

[5] For further reading about the weekly statistics on foreign exchange transactions, see blogpost “Valuable insight into the NOK market”

[6] We use Bloomberg values of a 60/40 portfolio, which is a traditional investment strategy that allocates 60 percent of the assets to equities, and 40 percent to fixed income (bonds).

[7] Read more in staff memo “Bond market fire sales and turbulence in the Norwegian FX market in March 2020”

[8] Read more about this survey in the latest Financial Stability Report