Financial stability outlook

The Norwegian financial system has weathered the pandemic well. The gradual reopening of society, along with government support measures, has helped keep bank losses low. Financial system vulnerabilities in Norway persist, but have been met by measures to increase resilience. At the same time, the risk of shocks, particularly from abroad, represents a threat to financial stability. Uncertainty regarding the further evolution of the pandemic has diminished since Financial Stability Report 2020, but banks are resilient and have ample capacity to absorb losses.

The recovery is contributing to financial stability

The pandemic resulted in a less pronounced economic downturn and lower bank losses than widely feared last year. Extensive government support measures, good welfare arrangements and an expansionary monetary and fiscal policy have dampened the economic impact of the pandemic. Nevertheless, some households and firms have been hit hard. Bank losses have been limited, thanks to both the support measures and banks’ low exposures to the hardest-hit industries. A resilient banking sector has been crucial for maintaining a well-functioning financial system, and a lower countercyclical capital buffer rate gave banks greater space to extend credit through a period of considerable uncertainty. Norges Bank’s extraordinary liquidity measures and foreign exchange market interventions helped dampen the turbulence so that financial markets functioned better. The measures also eased bank funding and countered an undesirable credit tightening, which could have amplified the downturn. Against the background of the recovery over the past year, Norges Bank now assesses the overall financial stability outlook as little changed since before the pandemic hit.

The reopening of society has resulted in a marked upswing in the Norwegian economy, and activity is now higher than before the pandemic. A gradual rise in Norges Bank’s policy rate has begun, and increases in the countercyclical capital buffer have been announced. The extraordinary liquidity measures were unwound on the back of an improvement in the functioning of money and credit markets. The last extraordinary loan to banks matured in August 2021. Fiscal policy measures are also being phased out as the economy normalises.

Risk of shocks

Uncertainty about the future evolution of the pandemic is lower than at the time of the 2020 Report. Even so, a resurgence of the pandemic may dampen the economic upturn, weaken business profitability and push up bank losses.

During the years prior to the pandemic, global interest rates were historically low. The pandemic resulted in even more expansionary monetary policy, and extensive fiscal policy measures were introduced. This has supported the economic recovery, but has also reduced many countries’ fiscal and monetary policy space. Persistently low interest rates abroad can also induce market participants to assume greater risk. Global vulnerabilities have built up in the form of increased debt and higher asset prices. Policy rate expectations and long-term interest rates have risen markedly through autum. Expectations of higher inflation and possible monetary tightening globally have likely pushed up market interest rates. Higher interest rates could restrain debt accumulation and asset inflation. This may reduce the build-up of vulnerabilities. A sudden rise in interest rates and risk premiums can lead to stress in the Norwegian financial system, owing to its close interconnectedness with the global economy and financial markets. This interconnectedness came into evidence during the market turbulence at the beginning of the pandemic.

Financial system vulnerabilities persist, but have been met with measures

Financial system vulnerabilities in Norway can lead to shocks having more serious consequences for financial stability. Overall vulnerabilities are assessed as being broadly at the same level as prior to the pandemic.

High household debt has long been the main financial system vulnerability in Norway. Leverage is high both historically and compared with other countries. High debt makes households vulnerable to a loss of income, higher lending rates and a fall in house prices. The risk that many households tighten consumption at the same time constitutes a threat to financial stability. Banks’ high commercial real estate exposures are also a vulnerability that can lead to substantial credit losses if commercial property prices fall, as shown by the stress test in this Report. In addition, banks’ interconnectedness, partly owing to their cross-exposures, can propagate and amplify shocks.

Credit and property and financial asset prices have often shown a pronounced rise ahead of financial crises. Residential and commercial property prices fell during the first phase of the pandemic, but have since risen sharply, as have financial asset prices. Low interest rates over a long period have driven down yields, and risk premiums are now at very low levels. Unexpected events can therefore result in considerable corrections in asset prices. Property price inflation has recently been more moderate. Credit growth picked up somewhat through the pandemic, but has recently levelled off.

Regulations, such as requirements for banks’ capital, liquidity and credit standards, increase bank resilience and reduce vulnerabilities. This helps dampen the impact of shocks and downturns.

In autumn, Norges Bank was given decision-making responsibility for the countercyclical capital buffer and formal advisory responsibility for the systemic risk buffer. These two buffer requirements constitute a significant part of banks’ total capital requirements. The Committee decides on the countercyclical capital buffer rate each quarter and is to advise on the systemic risk buffer at least every other year, for the first time in 2022. In line with Norges Bank’s new areas of responsibility, the Committee will prepare a framework for its advice on the systemic risk buffer in 2022.

Bank resilience has not weakened during the pandemic

The Norwegian banking sector is solvent and well-equipped to withstand shocks. Bank profitability is solid, and banks’ have ample access to funding. Solid underlying profitability has resulted in earnings sufficient to cover the losses incurred during the pandemic, while increasing lending. In addition, restrictions on dividend distribution have compelled banks to retain more earnings than normal during the pandemic. This has increased equity and thus loss-absorbing capacity. Higher interest rates ahead will improve bank profitability. Losses on corporate loans have declined as the economy improved. There are no signs that the business sector has drawn substantially on its financial buffers, and credit losses are expected to remain low. Even so, owing to the uncertainty about the further evolution of the pandemic, loss prospects are somewhat more uncertain than normal.

It is difficult to identify and assess the risk of new shocks, of which the pandemic is an example. The stress test in this Report shows that if the Norwegian economy is hit by a renewed sharp downturn, the capital buffers in the largest Norwegian banks as a whole are sufficient to absorb the losses. The implications for banks’ capital situation depends on which industries are affected. The stress test shows that weak developments in commercial real estate and other sector-specific shocks can induce banks to tighten lending, which can amplify an economic downturn. Banks can dip into their capital buffers to avoid tightening lending. Banks can also use freed-up capital if the countercyclical capital buffer rate is lowered. Analyses show that a number of Norwegian banks will have limited scope to dip into other capital buffers, such as the systemic risk buffer, without breaching the minimum requirement for own funds and eligible liabilities (MREL). This may reduce the effectiveness of the buffers in a crisis. Banks preferring to maintain the flexibility that capital buffers provide can issue enough non-preferred senior bonds so that MREL does not hinder the use of capital buffers. If the buffer requirements are reduced in a sharp downturn, the most binding MREL requirement will be reduced accordingly and the buffers will be able to function as intended.

Liquidity measures and market stress

Extraordinary loans to banks during the market stress in spring 2020 ensured banking sector liquidity and the transmission of the policy rate to money market rates. At the same time, there was an increased need for liquidity by investment funds and other asset managers when the value of their securities fell and the krone depreciated. Fire sales to meet this need amplified the market stress. There is a discussion internationally and in Norway about whether central banks should have instruments that can be aimed directly at securities markets and non-bank market participants in periods of market stress.

Norges Bank’s liquidity policy instruments are aimed directly at banks. Banks create and receive deposits and thus play a key role in payment and credit intermediation. This is the reason they are Norges Bank’s counterparties and receive liquidity support if Norges Bank deems it necessary. Norges Bank’s risk is contained by the fact that banks’ liquidity and credit risk is strictly regulated, loans are extended against collateral and the terms and conditions for support are intended to give banks incentives to use market solutions first.

Instruments aimed directly at securities markets or non-bank market participants may entail a greater risk to the central bank. Asset purchases entail a higher risk than secured lending. Other market participants may face less strict regulation than banks, and their importance for payment and credit intermediation may be less critical. Loans to these counterparties may thus increase the central bank’s risk and can to a lesser extent be justified on the grounds that they are critical to the financial system. Such use of instruments also increases the risk that the central bank contributes to socialisation of potential losses, while the risk taker keeps any gains. This could give rise to excessive risk-taking and market adjustments that are detrimental to long-term financial stability. The central bank should therefore be cautious in resorting to such extraordinary measures. In line with the principle that risk should be borne as much as possible by financial market participants, loans to banks are Norges Bank’s preferred instrument in periods of market stress.

Resilient market participants must always be the first line of defence against market stress. Banks and other financial market participants are responsible for managing their own liquidity risk and cannot rely on support from the central bank. Strict criteria and terms and conditions for central bank measures are meant to help ensure this. Systemic risk connected with derivatives contracts, which played out at the beginning of the pandemic, have prompted a number of asset managers to make changes to their risk management. These changes may make them better positioned in periods of market stress.

The Norwegian financial system is vulnerable to cyber attacks

Cyber attacks are a potential threat to financial stability. Extensive digitalisation and interconnectedness make the financial system vulnerable. Financial institutions report more and increasingly sophisticated attacks. A more aggressive threat landscape is amplifying cyber risk.

The potentially systemic ramifications of cyber attacks entail a need for strengthened regulation and expanded collaboration between various authorities and financial system participants. A number of new regulatory initiatives have been proposed to increase financial sector cyber resilience. In September, Norges Bank’s Executive Board approved the introduction of a framework for testing entities’ capabilities in detecting and responding to cyber attacks (TIBER-NO). TIBER-NO has been prepared in collaboration with Finanstilsynet (Financial Supervisory Authority of Norway). This will help strengthen financial sector cyber resilience and provide additional knowledge about how cyber attacks can impact the financial system.

Identifying key financial and operational dependencies in the financial system known as cyber mapping, is useful for ascertaining how cyber attacks can threaten financial stability. This is also a prerequisite for system-wide monitoring of cyber risks and proper incident management in the event of a cyber attack. In Norway, such cyber mapping work is underway in view of the new Security Act. This work is laying an important foundation for greater understanding of and new measures to address systemic cyber risk in Norway.

Other societal trends have implications for financial stability

The financial system is evolving in pace with technological innovation. Norway is at the technological forefront, and the payment methods we use have undergone extensive changes in recent years. An efficient and secure payment system is essential to financial stability. Norges Bank is studying whether the introduction of a central bank digital currency (CBDC) will promote an efficient and secure payment system and safeguard confidence in the payment system. In the coming two years, Norges Bank will conduct experimental testing of technical solutions.

In recent years, the prevalence and market capitalisation of crypto-assets have increased substantially. Crypto-assets are not considered a threat to financial stability yet, either globally or in Norway, but this can change in the future. A number of international regulatory initiatives can help ensure that developments do not pose a threat to financial stability. Central banks and other authorities should monitor developments and assess whether further regulations are needed that can reduce risks associated with crypto-assets.

Climate change and the climate transition affect all segments of society, also the financial system. The longer one waits to implement measures to make the necessary adaptations, the faster substantial changes will have to be made. Adapting suddenly and quickly may entail a risk to financial stability. The transition to lower greenhouse gas emissions and new regulations entail a transition risk for the Norwegian economy in the coming years, which is amplified by the importance of the oil and gas industry for Norway. Climate risk also relates to the physical consequences of climate change. Banks should ensure that they are well equipped to manage climate risk. The analyses in this Report show that Norwegian banks’ direct exposure to higher prices for greenhouse gas emissions is moderate. For now, Norwegian banks’ exposure to “known” physical climate risks is small, but the ramifications of climate change may be far more extensive than currently assumed.

Within their mandates, central banks and financial supervisory authorities can promote financial stability by ensuring that all risks are backed by sufficient capital and by encouraging the financial sector to include and communicate climate risk in their risk assessments and financial reporting. The ability of banks and other financial institutions to price climate risk correctly is crucial for the ability of borrowers to make good investment decisions. A sound information basis and transparency regarding exposures to climate risk also provide a solid basis for market participants to compare banks. Reporting standards are under development internationally. It is important to continue to develop climate reporting to obtain the most accurate picture of the climate risks facing Norwegian banks.

Øystein Olsen

Ida Wolden Bache

Øystein Børsum

Ingvild Almås

Jeanette Fjære-Lindkjenn

3 November 2021

1 Financial system vulnerabilities and risks

Vulnerabilities in the financial system can have more serious consequences for financial stability in the face of shocks. The uncertainty surrounding the pandemic has abated, but high global risk appetite has driven up asset prices. The most important structural vulnerabilities in the Norwegian financial system are high household debt, high bank exposures to commercial real estate and the close interconnectedness of banks. Overall cyclical vulnerabilities are at pre-pandemic levels, but clearly lower than in the years preceding the financial crisis. House prices in particular have risen through the pandemic, and low yields have resulted in higher prices for commercial property and financial assets. Measures such as requirements for bank capital, liquidity and credit standards have addressed these vulnerabilities, increasing the resilience of the financial system.

1.1 Risk of shocks

Shocks that can threaten financial stability can come from different parts of the economy and financial markets. Such shocks may be difficult to foresee. Shocks often spread to Norway from abroad since the financial system largely operates across borders. Cross-border integration is particularly close in securities markets. Large Norwegian banks obtain substantial funding abroad, and foreign banks account for over a quarter of loans in Norway. This integration provides opportunities for diversification of risk, but also enables contagion from global turbulence and uncertainty to the Norwegian financial system.

The Covid pandemic is an example of a shock that was difficult to foresee, but that had considerable consequences for the real economy and immediately led to substantial financial market stress. Extensive government measures stabilised markets quickly and later limited the pandemic’s impact on banks and their customers. This helped banks to weather the pandemic well. There has been little turbulence in global financial markets this past year, and the Norwegian economy has recovered. Uncertainty about the pandemic is lower than at the time of Financial Stability Report 2020.

High global risk appetite

Prior to the pandemic, global financial markets were characterised by low yields and high risk appetite. This pushed down risk premiums and pushed up prices for assets, such as property and equities. The pandemic triggered a sharp downturn and heightened fears about the future, which partly reversed these trends. Extensive government measures, including an expansionary monetary policy, eased financial conditions. Considerable progress in fighting the pandemic has also contributed to the economic recovery.

Risk appetite is high again. According to the International Monetary Fund’s (IMF) aggregate index, financial conditions in most advanced economies are now as they were prior to the pandemic (Chart 1.1). In the US, similar financial conditions have not been seen since before the financial crisis. Developments especially reflect lower interest rates, higher equity prices and higher house prices. High merger and acquisition activity, a growing number of initial public offerings and increased high-yield debt issuance also indicate high risk appetite.

Chart 1.1 Greater stimulus from financial conditions over the past year1

IMF’s aggregate financial condition index. Standard deviation from the mean

This autumn, global equity prices have varied more, and long-term interest rates have edged up. At the same time, global economic growth has slowed somewhat, and the outlook is more uncertain. This may reflect bottlenecks in global and domestic distribution chains on the back of the rapid recovery after the pandemic. The bottlenecks and higher energy prices have pushed up inflation. Policy rate expectations have risen in a number of countries, and some central banks have raised their policy rates. This may be favourable for financial stability in that it restrains debt accumulation and the rise in asset prices.

Sudden shifts in inflation or interest rate expectations can reduce risk appetite substantially and lead to higher riskpremiums and repricing in global financial markets, with a related decline in asset prices and higher financing costs and contagion to the Norwegian financial system.

High indebtedness increases the risk of financial stability in the event of a sudden and pronounced tightening of financial conditions. Global non-financial sector debt now accounts for around 250% of GDP, up from around 180% prior to the financial crisis in 2008. This means that vulnerabilities to an interest rate increase are historically high. Both public and private debt-to-GDP ratios have risen sharply through the pandemic. Some of this reflects the fall in GDP. In the private sector, the increase in debt is strongest for non-financial corporates, where debt-to-GDP ratios are also clearly higher than prior to the financial crisis (Chart 1.2). However, advanced economies’ total household debt is lower than it was prior to the global financial crisis.

Chart 1.2 Corporate debt has risen in many countries2

Non-financial corporate debt as a share of GDP. Percent

Growing complexity due to more market-based financing and increasing role of non-banks

Globally, firms’ market-based financing has increased over the past 10 years, and this continued during the pandemic. The market share of non-bank financial institutions has increased. Globally, there is now more capital under management by such entities than by banks (Chart 1.3). Growth in various types of investment funds has been particularly strong.

Chart 1.3 Banks losing market share globally3

Composition of the global financial sector. Capital under management in trillions of USD

Increased market financing and a greater role for non-banks provide better opportunities for spreading risk between the banking sector and other financial system participants. This may reduce concentration risk but at the same time expose the system to other risks and new contagion channels in the event of market stress. The financial system may become more complex, which can result in other kinds of financial crises that call for different sorts of measures than previously.

Following the financial crisis in 2008, bank liquidity and solvency were strengthened owing to new international regulation. This made the banking sector more resilient to shocks and helped ensure that it largely functioned well during the pandemic. Stricter banking regulation also contributed to migration of risk to the less heavily regulated non-bank sector, likely for profitability reasons. The turbulence in spring 2020 revealed weaknesses in this portion of the global financial system. Therefore, an extensive worldwide effort is now underway to increase resilience in the non-bank sector.4

In Norway, the market turbulence in spring 2020 presented challenges to investment managers and also spread further to other parts of the financial system. Large movements in prices for financial assets and the sharp krone depreciation led to high margin calls for Norwegian asset managers.5 This subjected many managers to liquidity squeezes and also adversely affected other participants by pushing up bond market risk premiums. A number of Norwegian asset managers have made changes to their risk management, including greater use of repurchase agreements and increased collateral eligibility of bonds. These changes may make them better positioned in the event of renewed market stress and mitigate the risk of shocks spreading to the rest of the financial system.

1.2 Structural vulnerabilities in the Norwegian financial system

Owing to vulnerabilities in the Norwegian financial system, negative shocks can have more severe consequences for financial stability. In the assessment of vulnerabilities, we distinguish between cyclical vulnerabilities, which typically vary over time (see Section 1.3), and vulnerabilities of a more structural nature (see "Financial system vulnerabilities in Norway and measures implemented"). The main structural vulnerabilities are high household debt, banks’ large commercial real estate exposures and bank interconnectedness. Extensive digitalisation also entails a vulnerability to cyber attacks (see Section 1.4).

A number of measures have addressed structural vulnerabilities. Several of these measures affect banks’ total capital requirements, such as requirements for the systemic risk buffer, risk-weighting and the leverage ratio, and a minimum requirement for own funds and eligible liabilities (MREL). There are also requirements for banks’ liquidity and credit standards. The level of the systemic risk buffer was raised from 3% to 4.5% with effect from end-2020.6 Norges Bank supported the increase in the buffer level.7 This autumn, Norges Bank was given formal advisory responsibility for the systemic risk buffer and will develop a framework for providing advice on the buffer rate in 2022.

Financial system vulnerabilities in Norway and measures implemented

In Norges Bank’s assessment, there are number of key structural and cyclical features leading to vulnerabilities in the Norwegian financial system (see diagram above). The vulnerability assessment is based on historical experience of what causes downturns and financial turbulence and assessments of new features of the financial system. It is difficult to distinguish clearly among vulnerabilities, since they are generally partly structural and partly cyclical, and the different vulnerabilities can reinforce one another.

Vulnerabilities are identified to assess whether sufficient measures have been implemented. Since the financial crisis in 2008, the Norwegian authorities have introduced a number of rules to mitigate vulnerabilities and increase financial system resilience (see diagram above). For more detailed information about the measures, see "Important measures to mitigate financial system vulnerabilities in Norway".

The measures primarily help to increase financial system resilience, but can also mitigate vulnerabilities. Many of the measures contribute generally to increased resilience, and measures are often justified on the basis of a number of vulnerabilities, both those mentioned in the diagram and other financial system vulnerabilities. The countercyclical capital buffer is the only measure purely justified on the basis of cyclical vulnerabilities. High bank profitability and a robust bank funding structure also strengthen resilience (see Section 2).

Vulnerabilities will still exist even after a large number of measures are introduced. However, systemic risk is assessed after taking into account these measures and the resilience of the financial system and the wider economy. If necessary, Norges Bank will implement or advise the adoption of measures.

Households are highly indebted

High household debt has long been the main structural vulnerability in the Norwegian financial system. Household leverage is high both historically and compared with other countries. High household debt in Norway partly reflects elevated house prices and a large proportion of home ownership. High indebtedness makes households vulnerable to a loss of income, a rise in lending rates or a fall in house prices. The risk that many households tighten consumption at the same time represents a threat to financial stability. Such a tightening may amplify an economic downturn. This can reduce firms’ earnings and debt-servicing capacity, leading to increased losses on banks’ corporate exposures.

In recent years, debt growth has slowed somewhat but continues to rise a little faster than income, pushing up household leverage (Chart 1.4). Owing to low interest rates, households’ interest burden, ie the share of income spent on interest payments on loans, is low from a historical perspective, despite high household leverage. This is because nearly all debt is floating rate. Overall debt service ratios, which include both interest and estimated principal, are high and are expected to rise from 14.0% in 2021 Q2 to 15.3% at end-2024, primarily owing to higher lending rates (see Monetary Policy Report 3/21).

Chart 1.4 Household leverage is high and edging higher8

Percent

Data from pre-completed tax returns9 for 2020 make it possible to see the breakdown of debt across different groups and show that debt-to-(gross) income ratios increased for all age groups in 2020 (Chart 1.5). This reflects sustained debt growth through the pandemic, while income growth slowed. Among younger groups, average debt-to-income ratios fell in 2019, largely owing to relatively high income growth, though debt ratios picked up again in 2020.

Chart 1.5 Higher leverage in all age groups in 2020

Debt as a share of gross income. Percent

Even though household debt is rising somewhat faster than income, wealth has increased owing to high house price inflation and high household saving through the pandemic. Increased saving reflects limited consumption opportunities and greater uncertainty about the future. Much of the increased saving took the form of bank deposits, which are liquid and stable assets. Data from pre-completed tax returns show that the increase in bank deposits has been broad-based in the population.10 Both those with high and with low debt-to-income ratios increased their bank deposits substantially in 2020. The data also show that household financial assets excluding bank deposits increased in all age groups in 2020.

Unsecured debt, such as consumer credit, grew sharply over many years and accounts for around 3% of household debt. After the introduction of the consumer credit regulation in 2019 and the establishment of credit registers, the volume of consumer credit fell. The fall continued through the pandemic (Chart 1.6). There are substantially fewer borrowers with very high consumer debt than previously.

Chart 1.6 Consumer debt is falling11

Unsecured interest-bearing debt with an interest rate above 8 percent. In billions of NOK

Measures by the authorities to limit borrowing, such as regulation of banks’ credit standards, have contributed to more moderate growth in total household debt since 2017. Requirements for banks’ credit standards limit in particular excessive borrowing by vulnerable households. The requirements are in force until 2024, but are to be evaluated in 2022. Moreover, banks’ requirement to hold a systemic risk buffer is warranted in part by the high level of household debt.

Older persons account for a growing share of the population. The pension reform has given people greater responsibility for their own pensions and how their pensions will be drawn. Life expectancy has also risen, which means having to stay on at work longer to receive the same pension as before. Individuals are also more exposed to return risk on their pension assets. Many older persons may experience a substantial fall in income after the transition from wage income to a pension in the years ahead. Combined with rising leverage, this can make older persons more vulnerable to higher interest rates or a fall in house prices, for example, or if they cannot remain at work as long as they like.12 Our assessment is that these trends overall do not represent a material threat to the financial system. Among other reasons, this is because older persons generally have solid finances and the most at-risk groups hold a relatively small share of household debt. Moreover, the financial sector and future pensioners have time to adjust to the changes.

Banks’ exposures to commercial real estate are high

Another key structural vulnerability is banks’ high commercial real estate exposures, which reflect in part high commercial property prices. CRE exposures account for around half of total corporate lending (Annex Chart 4), and all large banks’ CRE exposures are high. Experience from Norway and other countries shows that losses in this sector can be substantial in sharp downturns.

CRE firms are more leveraged than other firms, making them vulnerable to interest rate increases or a fall in rental income. A majority of the banks in Norges Bank’s lending survey reported that the ordinary maturity of new commercial property mortgages over the past six months was under five years, little changed compared with prior to the pandemic. Short maturities expose CRE firms to refinancing risk. Rapid price rises in recent years (Chart 1.11) have not been matched by corresponding borrowing by CRE firms. This has boosted these firms’ equity ratios, making them better equipped for a price fall. In the lending survey, most banks report ordinary loan-to-value (LTV) ratios of between 60% and 80%. LTV ratios are little changed from pre-pandemic levels.

CRE firms’ income is assured in the short term by existing leases, as long as the tenants are able to pay rent. In the event of higher commercial property vacancy rates and a fall in rental prices, CRE firms’ income may gradually weaken as existing leases expire. In that case, loan defaults may increase, and banks may incur losses if the properties’ mortgage value is lower than the value of the loans. A marked fall in commercial property prices in a stress situation can lead to substantial bank losses, as shown in the stress test in Section 3. The level of the systemic risk buffer is warranted in part by banks’ substantial CRE exposures. In addition, minimum requirements for risk weights on CRE exposures have been introduced.

Banks are closely interconnected

Banks are directly interconnected through interbank exposures and indirectly through common or similar securities portfolios among other things. Close interconnectedness represents a key financial system vulnerability because shocks spread more easily. Nevertheless, a high level of interbank cooperation in the fixed income market is crucial for ensuring the distribution of liquidity and the effective transmission of monetary policy.

Bank interconnectedness through the covered bond market represents a particular vulnerability. Covered bonds account for two-thirds of banks’ wholesale funding, while banks own approximately 60% of covered bonds issued in NOK (Charts 1.7 and 1.8), which means they act both as issuers and investors in this market. Banks mainly hold covered bonds as part of their liquidity portfolios (see Section 2). The high ownership share reflects the view that covered bonds are safe securities that are used to satisfy liquidity requirements and as collateral for loans from Norges Bank. Banks’ share of covered bond holdings rose after the Liquidity Coverage Ratio (LCR) was introduced in 2014.

Chart 1.7 Banks’ covered bond funding is substantial13

Breakdown of bond funding outstanding. Percent

Chart 1.8 Banks’ hold the majority of covered bonds in NOK14

Ownership breakdown of bonds issued by Norwegian mortgage companies in NOK. Percent

The purpose of the liquidity portfolio is to enable banks to sell or pledge securities if they have difficulty obtaining new funding. Simultaneous fire sales of covered bonds by a large number of banks can drive down the prices for these securities and thus the value of the liquidity portfolios. This can aggravate banks’ liquidity situation and make it difficult for them to raise new covered bond funding. A concurrent fall in house prices can further exacerbate funding problems and amplify the sell-off of both covered bonds and other securities banks hold to address liquidity problems.

Earlier analyses have shown that fire sales of securities can result in contagion effects that can lead to losses in the Norwegian banking sector.15 The losses are primarily due to the potential for a bank’s fire sales of securities to drive down prices for both the securities being sold and other similar securities. Other banks holding these securities then need to reduce the carrying amount to the new and lower price. The systemic risk buffer requirement is warranted in part by the ramifications of a closely interconnected financial system.

1.3 Cyclical vulnerabilities in the Norwegian financial system

Debt growth and asset price inflation have often been high prior to financial crises and are therefore indicators of cyclical vulnerabilities. Overall, cyclical vulnerabilities are assessed as little changed compared with before the pandemic. A broad set of indicators of cyclical vulnerabilities is now at a medium level from a historical perspective, while the indicators signalled high cyclical vulnerabilities prior to the financial crisis (see "A broad set of indicators indicates medium cyclical vulnerabilities"). The indicators in the analysis include changes in credit, house prices, commercial property prices and equity prices.

Banks should build and hold a countercyclical capital buffer when cyclical vulnerabilities are building up or have built up. In the event of a sharp downturn and markedly reduced access to credit, the countercyclical capital buffer rate can be reduced to increase banks’ lending capacity. In March 2020, the buffer rate was reduced from 2.5% to 1% to prevent tighter bank credit from amplifying the downturn. In June 2021, it was decided to increase the countercyclical capital buffer rate to 1.5% from 30 June 2022. In September, Norges Bank announced that based on its assessment of economic developments and the prospects for bank losses and lending capacity, the buffer rate will be raised to 2.0% in December, effective from 31 December 2022. Norges Bank has further stated that it expects the buffer rate to return to 2.5% somewhat further out.

House prices have risen sharply through the pandemic

High house price inflation over time increases the risk of price falls that can lead to a tightening of household consumption and thus to bank losses. Moreover, a sharp fall in house prices can create shocks to banks’ liquidity and covered bond funding.

After several years of rapid house price inflation, where prices rose faster than household income, house price inflation over the few years prior to the coronavirus outbreak was at a moderate level (Chart 1.9). At the start of the pandemic, house prices fell (Chart 1.10). However, house prices rose markedly through summer 2020, and the rise in prices was high in the period to spring 2021. The rapid rise reflects low residential mortgage rates and homebuyers’ preference for using a greater share of income on housing, among other reasons because remote working has increased and consumption opportunities have otherwise been limited. Growth in household debt accelerated through the pandemic owing to rapid house price inflation, but has now levelled off.

Chart 1.9 House prices have risen faster than income through the pandemic16

Index. 1998 Q4 = 100

Chart 1.10 House price inflation has been moderate over the past half-year17

House prices. Percent

House price inflation has been more moderate in recent months. Moderate house price inflation is expected ahead (see Monetary Policy Report 3/21). This reflects higher lending rates, normalising household consumption patterns and an increase in residential construction.

Low yields have resulted in high commercial property price and financial asset inflation

Prices for commercial property and a number of financial assets, such as equities and bonds, have risen considerably through the pandemic. The swift rise reflects factors such as historically low interest rates, with low yields in a number of markets. This is an important global trend (see Section 1.1), but it also applies to Norway.

In the CRE sector, the office market is particularly important for financial stability since banks’ exposures to this segment are substantial. A large share of the stock of office buildings is located in Oslo, and prices for prime office space in Oslo is one of many indicators of cyclical vulnerabilities (see "A broad set of indicators indicates medium cyclical vulnerabilities").

Commercial property prices, measured as selling prices for prime office space in Oslo, have risen considerably in the years after the financial crisis (Chart 1.11). Selling prices fell somewhat at the start of the pandemic, but the fall was quickly reversed and prices continued to rise. Prices have levelled off during autumn. Selling prices are calculated as rents divided by yield.

Chart 1.11 Commercial property prices have risen considerably18

Estimated selling prices for prime office space in Oslo. In thousands of NOK per square metre

Lower yields in particular have pushed up commercial property prices through the pandemic. This largely reflects lower interest rates. The risk premium, measured as the difference between the yield and the five-year swap rate, rose during the pandemic, but is now close to its pre-pandemic level (Chart 1.12). The risk premium in Oslo is low compared with other European cities. Since the yield is at a low level, prices are sensitive to increases in risk premiums or long-term interest rates. A sharp fall in commercial property prices can lead to large bank losses (see Section 3). However, moderate commercial property price inflation is expected in the coming years (see Monetary Policy Report 3/21).

Chart 1.12 Risk premium in Oslo is low19

Yield less five-year swap rate. Percentage points

Rental prices fell weakly at the start of the pandemic but are now back to around their pre-pandemic level. Norges Bank has recently changed its provider of price statistics (see"New provider of commercial property price data"). The new data source is likely to give a more representative picture of developments in office rents in Oslo as a whole, since the new statistics include a broader set of office premises. The statistics show somewhat lower rents, and thus lower selling prices, than before. New price statistics and our recent access to microdata for most commercial buildings in Norway help to improve the basis for analyses of commercial property.20

New provider of commercial property price data

Norges Bank has recently changed provider of price statistics for prime office space from CBRE to Jones Lang LaSalle (JLL). The new statistics for prime office space in Oslo are based on a broader set of office premises. CBRE’s rents are closer to the most expensive leases for office space at Aker Brygge and Vika than JLL’s rents (Chart 1.A). The gap between the indexes widened considerably in 2017, when CBRE’s rents rose markedly. In this period, CBRE narrowed its definition of what is regarded to be prime office space, which has probably contributed to the wider gap. Differences in the providers’ information basis and assessments can also contribute to differences between the price indexes.

Chart 1.A New rental price index is more representative1

Annual office rents in Aker Brygge and Vika. NOK per square metre

JLL’s rents are probably more representative of developments in rental prices for the office segment as a whole. The rental price index from JLL shows broadly the same developments as the quality-adjusted rental price index for Oslo as a whole and for Aker Brygge and Vika.2

Commercial real estate selling prices are calculated as rental prices divided by yield. The yield in JLL’s and CBRE’s statistics is fairly similar (Chart 1.B). Lower rents lead to a lower level of selling prices with JLL’s data, but both sets of statistics show high overall selling price rises through the pandemic.

Chart 1.B The yield is fairly similar3

Yield for prime office space in Oslo. Percent

1 Period: 2007 Q1 – 2021 Q3. Data for the most expensive and median rents are at annual frequency.

2 Se Financial Stability Report 2019 for a comparison of the quality-adjusted rental price index with CBRE’s rental index.

3 Period: 2007 Q1 – 2021 Q3.

Lower yields and increased risk appetite have also fuelled high financial asset inflation. Equity prices have made strong advances through the pandemic (Chart 1.13). The Oslo Børs Benchmark Index has risen by 27% so far in 2021, and the index is now 32% higher than at the beginning of 2020. Price-to-earnings and price-to-book ratios for Norwegian listed equities now appear to be high, compared with averages for the past 15 years (Chart 1.14). In the corporate bond market, issuance volumes have been high so far in 2021, and risk premiums are close to pre-pandemic levels.

Chart 1.13 Equity prices have made strong advances21

Oslo Børs Benchmark Index

Chart 1.14 Equity valuations are high22

Market capitalisation-to-earnings and price-to-book ratios. Sample of Norwegian listed companies

A sharp fall in financial asset prices can threaten financial stability through a number of channels. Pension funds can incur large losses since portions of their benefit obligations are fixed. Banks’ liquidity portfolios, and thus banks’ liquidity, will also be impaired by a price fall. A substantial fall in financial asset prices can also adversely impact a number of other financial institutions, such as investment firms and insurance companies. In addition, many households own financial assets, even though their primary residence and other real estate account for most of household wealth. Households’ financial assets increased through the pandemic, which has bolstered households’ resilience. However, the increase in household financial assets increases the risk that a substantial fall in financial asset prices can lead to a tightening of consumption and bank losses, if firms default on their debt.

A broad set of indicators indicates medium cyclical vulnerabilities

Empirical analyses show that financial crises hit harder when cyclical vulnerabilities are high prior to a crisis. With the aid of quantile regressions, we have linked the risk of sharp falls in GDP to measures of cyclical vulnerabilities.1

We use a broad set of cyclical vulnerability indicators. They include five-year changes in credit, house prices and household debt service ratio and three-year changes in commercial property prices and equity prices. Each indicator is normalised based on its historical distribution in the period, so that all indicators are scaled the same. Historical observations indicate that the estimated risk of a fall in GDP (vertical scale) rises with the level of cyclical vulnerabilities (horizontal scale) (Chart 1.C). Possible falls in GDP are measured at the 5th percentile, which means that five out of 100 cases of possible GDP growth are expected to be lower than this. The 5th percentile will be much lower than expected growth and provides a good starting point for quantifying possible crisis depth in stress tests (see Section 3).

Chart 1.C Linkages between cyclical vulnerabilities and GDP growth2

Cyclical vulnerabilitiy indicators (normalised) on the horizontal scale and 5th percentile projections for GDP growth on the vertical scale

Overall, this analysis indicates that cyclical vulnerabilities are at a medium level relative to the indicators’ historical distribution. The vulnerability indicators are spread from low to high, but most lie at a medium level (Chart 1.D). Most indicators were also at a medium level prior to the coronavirus pandemic, while they were at high levels prior to the financial crisis. The two indicators showing the highest vulnerabilities for 2021 Q2 are growth in household and corporate credit as a share of GDP. High values for these two indicators largely reflect the fall in GDP through the pandemic, and the indicators will decline as GDP normalises. The projections in Monetary Policy Report 3/21 for credit, house prices, commercial property prices and GDP suggest that the indicators of cyclical vulnerabilities will edge down ahead.

Chart 1.D The analysis indicates a medium level of cyclical vulnerabilities3

Cyclical vulnerability indicators (normalised) on the horizontal scale and 5th percentile projections for GDP growth on the vertical scale

The analysis provides measures of cyclical vulnerabilities and appurtenant estimates of how far GDP can fall in the event of a sharp downturn (5th percentile). However, in the analysis, we do not have sufficient data to identify the importance of measures. Measures targeting banks, such as capital and liquidity requirements and risk management requirements, may help reduce vulnerabilities, but is the most important channel increasing banks’ resilience. This will better enable banks to absorb high credit losses and weak earnings without contributing to amplifying a downturn. Other requirements, eg mortgage requirements, can have a greater impact on household leverage and increase household resilience.

1 See Arbatli-Saxegaard, E.C., K.R. Gerdrup and R.M. Johansen (2020) “Financial imbalances and medium-term growth-at-risk in Norway”. Staff Memo 5/2020. Norges Bank.

2 Period: 1985 Q1 – 2021 Q2. HH stands for households and NFC stands for non-financial corporations. 3Y and 5Y stand for three- and five-year change, respectively.

3 Period: 1985 Q1 –2021 Q2.

1.4 The Norwegian financial system is vulnerable to cyber attacks

Cyber attacks are a potential threat to financial stability and are thus a source of systemic risk in the financial system.23 Even though cyber attacks have affected individual institutions, so far, cyber attacks have not given rise to financial crises, either in Norway or globally. The lack of an empirical basis makes it a challenge to assess the level of this vulnerability in the financial system. At the same time, serious cyber attacks appear to be trending upwards, resulting in a need for greater attention to cyber risk and development of measures to address it.

Digitalisation and interconnectedness constitute vulnerabilities

Extensive digitalisation in the Norwegian financial system, particularly in the payment system, increases efficiency. At the same time, it entails a vulnerability to cyber attacks. Moreover, considerable financial assets, key infrastructure and large quantities of sensitive data make the financial sector an attractive target. Financial and operational dependencies mean that the consequences of cyber attacks can spread quickly and widely across the financial system.

The Norwegian financial sector has largely outsourced ICT operations and development to third-party providers. Critical functions in the financial infrastructure are dependent on a few key ICT providers (see Financial Infrastructure Report 2021). Such concentration raises the risk that a cyber attack can affect much of the financial system. Increased outsourcing of ICT services results in longer and more complex supply chains for financial institutions. Long digital supply chains provide a large number of attack surfaces, making it more difficult to monitor and manage cyber risk.

In order to perform its tasks, the financial system depends on the availability and integrity of the information in its possession. For example, payment system operators need to be able to trust account information to execute payments. This makes the system vulnerable to cyber attacks that encrypt or manipulate information. In addition, traditional contingency measures are usually also dependent on access to correct information.

A more aggressive threat landscape

The Norwegian National Security Authority (NSM) assesses the digital threat landscape as more aggressive.24 Cyber attacks on Norwegian entities are increasing in scope. Threat actors also appear to be more professional and specialised, so that the complexity of attacks is increasing. Financial institutions report to Finanstilsynet (Financial Supervisory Authority of Norway) that digital attacks by criminal actors are becoming increasingly sophisticated.25 The majority of attacks on the financial sector are economically motivated. At the same time, the security authorities point out that state actors represent a serious threat to Norwegian interests, including through digital mapping and possible sabotage of critical Norwegian infrastructure, including the financial system.26

NSM considers supply chain attacks to be a growing risk. Threat actors can have a wide-ranging impact by exploiting providers’ security holes. For example, the hacking of the software developer SolarWinds and weaknesses in Microsoft Exchange have shown supply chain attacks’ considerable potential for harm. In connection with these two cases, Finanstilsynet has received notifications from Norwegian financial institutions that have been exposed to the compromised software, but no signs have been found that the security hole has been exploited.27 Nevertheless, these incidents illustrate risks related to supply chains.

Use of ransomware is increasing. The attack on the Colonial Pipeline in the US show that such attacks can have serious societal ramifications if they target key infrastructure. In Sweden, Coop had to close all of its approximately 800 stores for several days owing to a ransomware attack on Kaseya, a subcontractor for its cash register system. A more recent feature of ransomware attacks is that in addition to demanding ransom for decrypting data, attackers also demand payment for not publishing or selling sensitive data obtained in the attack. A ransomware attack on a financial institution where sensitive data fall into the wrong hands can have negative consequences for the reputation of the affected institution, but also for trust in the entire financial sector. In its threat assessment, DNB refers to ransomware as the greatest digital threat to DNB.28

Resilience to cyber attacks must be strengthened

In Financial Infrastructure Report 2021, Norges Bank considers the financial infrastructure to be secure and efficient, but points out that testing for and identifying risks of cyber incidents in the banking and payment system can be improved. In its latest review of financial sector ICT use, Finanstilsynet considers overall risk relating to cybercrime to be high. Nevertheless, Finanstilsynet points to steady improvements in financial institutions’ cyber resilience work, with attacks largely averted before they have serious consequences.

There is broad agreement both internationally and in Norway that resilience to cyber attacks in the financial system must be strengthened. In 2020, the European Commission presented a draft Digital Operational Resilience Act (DORA). Existing Norwegian rules are already close to the requirements in the proposed EU regulation.29 An important new element of DORA is the introduction of a supervisory framework for ICT providers. Norges Bank has previously recommended further study of the best way to supervise key ICT providers and data centres.

In 2018, the European Central Bank (ECB) published a framework for testing entities’ ability to detect and respond to cyber attacks, Threat Intelligence-based Ethical Red Teaming (TIBER-EU). Its purpose is to strengthen the cyber resilience of financial sector entities and thus promote financial stability. Moreover, TIBER testing provides additional knowledge about how cyber attacks can affect the financial system. In collaboration with Finanstilsynet, Norges Bank has developed a framework for implementation in Norway (TIBER-NO), based on TIBER-EU.30 TIBER-NO was approved by Norges Bank’s Executive Board in September. Norges Bank will establish a Norwegian TIBER Cyber Team (TCT-NO) to administer and operationalise TIBER-NO. A steering group, of which Finanstilsynet is also a member, is tasked with ensuring that critical functions in the financial system are tested and with quality-assuring the tests. Testing under TIBER-NO is expected to be conducted in 2022 at the earliest.

Cyber attacks’ potential for systemic consequences requires a broader perspective than supervision and oversight of individual institutions and systems. It also requires expanded collaboration between various authorities and financial system participants. Cyber mapping identifies key financial and operational dependencies in the financial system, between financial institutions, the financial infrastructure and third-party providers. It provides useful insight into how a cyber incident can threaten financial stability and is also a prerequisite for monitoring systemic cyber risks and proper incident management in the event of a cyber attack.

In Norway, such work is underway to map fundamental national functions in the financial system in connection with implementing the new Security Act. Fundamental national functions are functions necessary for the government’s ability to protect national security interests.31 This mapping is to include sub-functions and the entities, systems and providers that are crucial or critical for performing these functions. This work is laying an important foundation for further management of systemic cyber risk in Norway.

1.5 Other societal trends are important for financial stability

Climate change is creating considerable challenges in many areas, but banks are well positioned to manage the risks. Crypto-assets are not considered to be a threat to financial stability yet, either globally or in Norway. This can change in the future, but a number of regulatory initiatives can lessen the threat to financial stability.

Climate change is creating major challenges, but banks are well-positioned to address the risks

Average global temperatures have risen by around 1.1°C compared with the period 1850–1900. The UN Intergovernmental Panel on Climate Change has determined that anthropogenic greenhouse gas emissions to the atmosphere are the main reason for the increase in temperatures.32

Climate change, along with mitigation policies, will have global macroeconomic consequences in the coming years.33 Both the private and public sectors must make substantial investment to cut emissions and to prepare for changes in weather patterns owing to climate change that has already taken place. The longer one waits to take action, the more expensive it is assumed that this process will be. Growth in such climate investment must come at the expense of other investment or financed by reduced net financial investment or reduced consumption.34

Norway is relatively little exposed to the adverse effects of physical climate change.35 Norway produces substantial amounts of clean energy, and Norwegian firms and households have already come far in electrifying their energy consumption. On the other hand, Norway is a major producer of oil and gas. A quick transition to less use of fossil fuels globally will place considerable demands on the energy sector’s restructuring capabilities.

By virtue of their role in credit intermediation, banks have an important function in allocating capital to new projects. Banks must further develop their credit assessments to make them better able to evaluate firms’ exposure to climate change and increased climate risk. The authorities can contribute by requiring more standardised reporting.

At the same time, climate change can increase the risk of losses on existing exposures. This can be due to transition risk, ie firms are unable reduce emissions from their operations, and physical risk, ie losses resulting from damage caused by climate change. There is reason to believe that climate change will have a more profound impact on equity investments, which reflect firms’ long-term returns, than on loans, which normally have a shorter horizon and are secured with collateral. Our analyses show that Norwegian banks have moderate exposures to firms with large climate exposures (see "Norwegian banks’ exposure to climate risk"). Norwegian banks have limited exposures to carbon-intensive industries. In addition, climate change can affect regulation and market requirements, which may be of importance for bank funding (see "Forthcoming climate-related reporting").

Growing use of crypto-assets requires new regulations

Crypto-assets encompass a number of asset types. Besides the best known cryptocurrencies, such as Bitcoin and Ethereum, crypto-assets also include various digital representations of assets (“tokens”). Tokens use cryptocurrency systems as an infrastructure for issuance and trading. One type of crypto-asset is “stablecoins”, which aim for a stable value against a benchmark, normally a national currency, with the US dollar the most used. The use of cryptocurrency systems as financial services platforms is often referred to as decentralised finance.

The total market capitalisation of all crypto-assets has been relatively volatile during 2021 (Chart 1.15). Periodically, the market capitalisation has been over USD 2 000bn, of which Bitcoin accounts for just over 40%, while stablecoins account for around 5%. Bitcoin’s share of crypto-assets’ total market capitalisation has fallen so far in 2021, among other reasons because the volume of cryptocurrencies used as infrastructure for decentralised finance has risen.

Chart 1.15 Crypto-assets market capitalisation has fluctuated considerably in 202136

Total market capitalisation of crypto-assets and market shares of different crypto-assets

Cryptocurrencies began as an underground phenomenon for payments about 10 years ago, but quickly assumed a role as a speculative investment. The development of stablecoins has enabled greater use of crypto-assets for payments, but there are still few transactions other than crypto-asset trades. It is likely that speculation is still an important driver of valuations and the substantial swings in cryptocurrency values. Social media and tech platforms have fuelled market hype and simplified crypto-asset transactions. The IMF does not consider crypto-assets to be a risk to global financial stability yet, but recommends that developments should be monitored closely.37

Institutional investors have shown a growing interest in crypto-assets, both globally and in Norway. Surveys show that the possibility of substantial gains is also a key motivator for institutional investors.38 Internationally, banks and other traditional financial institutions are also considering the possibility of exposing their balance sheets to crypto-assets and of offering customers related services. To our knowledge, Norwegian banks and other Norwegian financial institutions do not have material exposure to crypto-assets.

Crypto-assets can fall sharply in value, and the falls in value can be sudden and unpredictable, eg, if the assumptions regarding the technology fail. A substantial fall in the value of crypto-assets can have ripple effects on the financial system, if banks and other systemically important institutions are significantly exposed. The Basel Committee has drafted a proposal for capital requirements for banks exposed to crypto-assets.39 This proposal mainly entails that if banks wish to hold unhedged crypto-assets on their balance sheets, the assets must be fully financed by equity. This substantially reduces the risk of ripple effects on the financial system caused by large price falls.

Global stablecoins may become systemically important if they become widespread. Stablecoins can be secured in various ways. Some are secured on more or less liquid assets, while others are secured on other crypto-assets. Stablecoins secured on securities share similarities with money market funds, and in the event of uncertainty regarding the cryptocurrency’s value, may be subject to large scale conversions to another currency by investors. In that case, the underlying securities need to be quickly liquidated to pay those wanting to convert. Such a fire sale of securities can have systemic effects. The Financial Stability Board (FSB) has formulated overall principles for regulating global stablecoins.40 In the EU there is work on extensive regulation of crypto-assets, which also includes regulation of stablecoin providers41. The regulation seeks to promote innovation, protect consumers and protect financial stability.

Crypto-assets can also affect financial stability by affecting payment system security. If crypto-assets are used for payments in sufficient volume, technical failures can have systemic effects. There may therefore be a need for special regulations that address risk related to the use for payments in the same way as traditional payment systems are regulated. Financial Infrastructure Report 2021 discusses such regulations in detail. The Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) are working on principles for stablecoins used for systemically important stablecoin arrangements.42 The principles are meant to address some of the challenges mentioned above and may mean, for example, that certain stablecoins cannot be used for systemically important transactions.

Crypto-assets can also lead to less use of national currencies,43 affecting the ability to conduct monetary policy, for example. This is primarily a challenge for countries with fairly inefficient payment systems, lack of trust in the monetary system and unstable currencies. This is therefore considered to be a small risk for Norway in the foreseeable future.

2 Bank resilience

Norwegian banks are resilient. They have ample access to funding and satisfy liquidity requirements by a good margin. Banks are solvent and fulfil capital requirements by a solid margin. In addition, banks’ profitability has normalised over the past year, primarily owing to lower credit losses.

Banks perform important tasks in the economy. They facilitate saving, channel capital, execute payments and redistribute risk (see Norway’s financial system 2021). Banks need to be resilient in order to perform these socially important tasks in periods of market turbulence and higher losses.

2.1 Funding and liquidity

Norwegian banks have ample access to funding

Norwegian banks have ample access to wholesale funding. After rising markedly in connection with the coronavirus outbreak, premiums in the Norwegian money market and risk premiums on banks’ long-term wholesale funding fell back quickly in 2020, owing in part to extraordinary measures by central banks and other authorities. Over the past year, the risk premiums banks pay on long-term bond funding declined further, and premiums are now somewhat lower than pre-pandemic levels (Chart 2.1). Profitable operations and solid capital adequacy help ensure that Norwegian banks have ample access to wholesale funding.

Chart 2.1 Risk premiums on banks’ long-term market funding are lower than pre-pandemic levels1

Risk premiums in the Norwegian bond market. Five-year maturity. Percentage points above three-month Nibor

Up until the end of December 2020, Norges Bank offered extraordinary F-loans to ensure the transmission of the policy rate and promote well-functioning markets. At its highest, banks’ use of this facility totalled nearly NOK 200bn. A number of the guidelines for pledging collateral for loans from Norges Bank were also temporarily relaxed until the last extraordinary loan matured at the end of August 2021.

Customer deposits are the most important funding source for Norwegian banks. The deposit-to-loan ratio has increased somewhat over the past year. Both households and firms have increased deposits since the beginning of the pandemic (see Section 1 and Monetary Policy Report 3/21).

Banks fulfil applicable liquidity requirements by a good margin

Liquidity regulation is intended to help banks meet their obligations even if fresh funding should become temporarily unavailable. Doubt as to whether a bank is able to meet its obligations can result in a deposit runoff and a reluctance of lenders to issue new loans. This can happen as a result of, for example, large losses, cyber attacks on the bank or other events that cause a loss of confidence. The deposit guarantee scheme helps to counter bank runs by guaranteeing deposits up to NOK 2m per depositor per bank.2 In addition, banks’ access to funding can be affected by other financial system participants, of which the selling pressure in the bond market in spring 2020 is an example.3 Since banks play a special role in credit and payment intermediation, liquidity insurance from the central bank may be warranted if there is a threat to banks’ liquidity positions (see Section 4). Liquidity regulation helps better equip banks to weather a dry-up of funding without such liquidity support.

Liquidity regulation comprises two requirements, the Net Stable Funding Ratio (NSFR) and the Liquidity Coverage Ratio (LCR).4 The NSFR requires illiquid assets, such as loans, to be funded with stable, long-term financing, which makes banks less dependent on frequent refinancing. The NSFR is not yet a formal requirement in Norway, but is expected to be incorporated into Norwegian law as a part of the EU’s banking package in the course of 2022. The NSFR has increased somewhat in recent years, and Norwegian banks overall fulfil the upcoming requirement by an ample margin.

Under the NSFR, bond funding with a residual maturity of more than one year is considered stable. The average residual maturity of bank bonds outstanding is 2.5 years for senior bonds and 3.5 years for covered bonds. Overall, the maturity structure of banks’ bond debt is smooth, which reduces the risk that they will need to refinance a large part of their funding at the same time. Deposits covered by the deposit guarantee scheme are also considered very stable. Such deposits account for approximately 30% of Norwegian-owned banks’ and mortgage company funding.5

The LCR requires banks to hold sufficient liquid assets to meet their obligations in a stress scenario lasting 30 days with large withdrawals and financial market stress. At the end of 2021 Q2, all Norwegian banks satisfied the LCR requirements. Overall, the LCR has increased somewhat in both NOK and foreign currency compared with prior to the pandemic.

The LCR is a liquidity stress test with a 30-day horizon and does not measure banks’ liquidity in the event of more prolonged stress. An analysis conducted by Norges Bank shows that if the same stress scenario assumed for the LCR were to last 90 days, a majority of the largest Norwegian banks would become illiquid (Chart 2.2)6. The number of banks that become illiquid in this scenario is little changed compared with prior to the pandemic. This is a severe scenario, where it is also assumed that banks are unable to refinance any of their maturing wholesale funding. Banks have spare capacity in their mortgage companies that can be used to issue new covered bonds. If it is assumed in the analysis that banks make use of this potential source of funding, they will remain liquid through the period (Chart 2.3).

Chart 2.2 Few banks remain liquid in a 90-day period of severe liquidity stress7

Number of liquid banks

Chart 2.3 Banks remain liquid for 90 days if they can issue new covered bonds8

Number of liquid banks

Banks are dependent on well-functioning covered bond markets

Both the LCR and the Bank’s analysis rest on the assumption that banks can sell their liquid assets in the market when faced with difficulties obtaining fresh funding. Banks’ liquidity portfolios primarily consist of covered bonds, central bank deposits and government securities. The Norwegian government securities market is small compared with other countries, which accounts in part for the high share of covered bonds in banks’ NOK-denominated liquidity portfolios. The LCR requirement in NOK is 50%, while the requirement for all currencies combined is 100%.9 The lower NOK requirement helps to limit the concentration of covered bonds in the portfolios overall. Marketability and value preservation in the covered bond market are nevertheless important for banks’ ability to sell from their liquidity portfolios.

There can be a considerable difference in the way the market functions in normal times and in times of market turbulence, as witnessed in spring 2020. Respondents to Norges Bank’s semi-annual market liquidity survey reported an improvement in liquidity in the Norwegian secondary market for covered bonds in the first half of 2021. Because of the greater interconnectedness of the banks that act as investors, issuers and market makers in the covered bond market, problems at one bank can more easily spread to others. This is a key financial system vulnerability in Norway (see Section 1).

Banks raise non-preferred senior debt

Banks that are particularly important to the financial system will not be wound up if they are failing. Instead, they will be recapitalised without recourse to taxpayer funds (see "New minimum requirement for own funds and eligible liabilities (MREL)"). Finanstilsynet has classified 14 Norwegian banks as particularly important in this context. To meet the minimum requirement for own funds and eligible liabilities (MREL), these banks now issue what are referred to as non-preferred senior liabilities, ie bonds with lower priority than ordinary senior liabilities but higher priority than subordinated debt. Under the new regulatory framework expected to be introduced in 2022, the requirement for non-preferred senior liabilities will be more lenient than the current Norwegian rules. By the beginning of 2024, for banks that are subject to these requirements, non-preferred senior debt must account for between 1.5% and 2% of their total balance sheets.10 Banks are well on their way to reaching this target. The amount of non-preferred senior debt held by banks will have an impact on how other capital requirements function during downturns (see "Relaxation of risk-weighted capital requirements and MREL from buffer requirement reductions").

Transition to new reference rates

From 2022, Libor will be replaced by new reference rates in several currencies. In Norway, the regulation of Nibor has strengthened over the past year, although important advances have been made for the introduction of Nowa, the alternative NOK reference rate (see "Transition to new reference rates". The fact that parties are well-prepared to use new reference rates promotes financial stability.

2.2 Profitability

Profitability is banks’ first line of defence against losses. Bank profitability has normalised over the past year following a weakening at the beginning of the pandemic. In 2021 Q3, return on equity for the largest Norwegian banking groups was close to the average for the past decade (Chart 2.4), primarily owing to lower credit losses (Chart 2.5).

Chart 2.4 Bank profitability has normalised11

Return on equity. Percent

Chart 2.5 Improvement in bank profitability due to lower credit losses12

Contributions to change in return on equity. Four-quarter moving average. Percentage points

Higher interest rates will improve profitability

Weak developments in net interest income13, which is the most important income source for Norwegian banks, have lowered profitability during the pandemic. A historically low interest rate level reduces net interest income from the portion of the loans financed by equity and the portion financed by deposits. All loans are in part financed by equity. Since banks do not pay interest on equity, the reduction in income from lower lending rates will not be compensated for by lower interest expenses on this financing. On the other hand, the profitability of the portion of loans financed by deposits is largely influenced by the interest margin, ie the difference between lending and deposit rates. In spring 2020, when Norges Bank reduced the policy rate to 0% in response to the pandemic, banks reduced lending rates by more than deposit rates and the interest margin fell as a result (Chart 2.6).

Chart 2.6 Low interest rates weaken the interest margin14

Sample of banks and mortgage companies. Percent

The fall in the interest margin reflects a lower deposit margin, ie the difference between deposit and money market rates (Chart 2.6). Banks are reluctant to set deposit rates below zero because depositors may prefer to withdraw their deposits if they are charged for keeping them in the bank. The low level of interest rates has therefore contributed to the smaller reduction in banks’ deposit rates than in banks’ lending rates.

The effect of low interest rates on net interest income has been dampened by lower wholesale funding prices. In addition, banks have compensated for some of the decline in deposit margins by increasing their lending margins. But lending margins have fallen back since June 2021 and are now broadly at pre-pandemic levels.

The competition for lending limits how far lending margins can be increased. An analysis conducted by Norges Bank also indicates that greater competition can reduce the correlation between the lending margin and the risk of loan losses.15 This can weaken banks’ first line of defence against losses.

There are a number of factors that may increase lending competition. Technological advances have simplified comparing loan conditions and changing banks, particularly for household loans. Bond market developments may have also put some pressure on corporate lending rates. Since corporate bond risk premiums are low, more firms may prefer bond funding to bank loans if banks raise lending margins. Pressures on lending margins and capital requirements for bank loans may also make it more profitable for banks to arrange bond issues than to extend corporate loans. In recent years, the volume of firms’ debt securities has increased more than their bank debt, and DNB and the other large Nordic banks have increased their market shares in arranging fixed income issues.

Looking ahead, banks’ net interest income is projected to increase in line with the projected rise in the policy rate in Monetary Policy Report 3/21. This will in isolation improve banks’ profitability. In August, DNB Markets conducted a survey among the 50 largest Norwegian banks. Of the banks in the survey, 72% expect their interest margin to increase in the coming year, primarily owing to a higher deposit margin. Certain calculations indicate that a 1 percentage point rise in the policy rate in isolation can increase banks’ net interest income by approximately 10% and return on equity by over 1 percentage point.16 In addition, credit growth is expected to hold up, which will increase net interest income.

Credit losses have fallen

Increased credit losses pulled down the return on equity of the large Norwegian banks in 2020, but lower losses have improved profitability in recent quarters (Charts 2.5 and 2.7).

Chart 2.7 Credit losses have fallen to low levels17

Credit losses as a share of lending. Annualised. Percent

Credit losses so far in 2021 have been lower than what both Norges Bank and market participants had expected, with reversals of earlier impairment losses making a substantial contribution. An important reason for the reversals is probably that banks have revised up their macroeconomic forecasts. Accounting rules for impairment recognition, IFRS 9, require banks’ impairment losses to be based on more forward-looking assessments than under the previous standard (IAS 39). Under IFRS 9, banks must therefore adjust impairment recognition to changing economic prospects to a greater degree.

Credit losses ahead are expected to remain close to the average for the past 20 years (Chart 2.7). Financial reporting data for 2020 indicate that the corporate sector has drawn little on its financial buffers during the pandemic. In addition, oil and gas prices are now at a higher level than before the pandemic broke out. This dampens banks’ risk of losses on oil-related exposures. Moreover losses on exposures to other industries are not expected to be high. Banks’ exposures to industries that have been hard hit by the pandemic are modest. Banks also have modest corporate exposures owing to deferred direct and indirect taxes. The phasing out of pandemic-related support measures is unlikely to result in many bankruptcies ahead.18 Owing to uncertainty about the evolution of the pandemic, the outlook for losses is somewhat more uncertain than normal.

Norwegian banks’ operating costs are low

In recent decades, Norwegian banks have markedly reduced operating costs (Chart 2.8), in part by automating and digitalising operations.19 Pandemic-related restrictions may have led to increased digital customer contact and further accelerated digitalisation. For example, a survey conducted by the Finance Industry Authorisation schemes shows an increase in the share of new residential mortgage loans granted both wholly and partly online during the pandemic.20 In addition, banks’ travel, entertaining and training expenses have fallen. A number of Norwegian banks have also implemented other cost-cutting measures during the pandemic. This may reduce costs in the longer term, but in the short term they may be a source of restructuring costs, such as severance packages and investment in new technology. The results of DNB Markets’ survey show that most banks will not downsize or close branches in the year ahead. In addition, most expect to maintain or increase investment in digital solutions.

Chart 2.8 Norwegian banks’ operating expenses are low21

Banks’ operating expenses. Percent

Looking ahead, banks’ cost-to-assets ratios are projected to increase slightly in 2022. A slight fall in cost-to-assets ratios is projected thereafter as banks reap the benefits of increased digitalisation.

2.3 Solvency

Norwegian banks are solvent and satisfy the capital requirements by a solid margin. This strengthens banks’ resilience to higher losses and gives them the flexibility to lend to creditworthy firms and households.

Banks have to meet both risk-based and leverage-based capital requirements. The authorities set risk-based capital requirements measured by Common Equity Tier 1 (CET1) capital, Tier 1 capital and regulatory capital. The risk-weighted requirements are intended to ensure that banks’ capital is sufficient relative to the risk of losses, so that banks with risky assets must hold more capital than banks with safer assets. This can improve banks’ risk management. If the underlying risk weights do not reflect the banks’ overall risk of losses, the risk-weighted requirements can give the impression of better loss absorbing capacity than is actually the case. The leverage ratio requirement is not dependent on the assets’ risk of losses and therefore functions as a backstop for the risk-based requirement. The leverage-based requirement will normally not be binding for banks. All Norwegian banks must meet a minimum leverage ratio requirement of 3% plus a leverage buffer requirement of at least 2%. Systemically important banks must have an additional buffer of at least 1%.

Following the financial crisis, tighter capital requirements have contributed to an increase in banks’ capital ratios (see Chart 2.9 and Norway’s Financial System 2021). Common Equity Tier 1 (CET1) capital ratios (risk-weighted) increased in 2019 in particular, when the removal of the Basel I floor in Norway occurred at the same time as the reduction in risk-weighted assets for exposures to small and medium-sized enterprises (SMEs), known as the SME discount. The reduced risk-weighted assets, ie the denominator in the capital adequacy ratio, contributed to a 2 percentage point increase in the CET1 ratio. The regulatory change did not affect loss-absorbing capacity or leverage ratios.

Chart 2.9 Banks’ capital ratios have risen22

All Norwegian banks. Percent

Capital requirements satisfied by wide margins

During the pandemic, restrictions on dividend distribution compelled banks to retain a large share of earnings, which has pulled up equity capital and thus capital ratios. Together with the reduction in the countercyclical capital buffer, this has enabled banks to meet their own capital targets by wide margins (Chart 2.10). Banks’ capital targets are in part based on risk-weighted CET1 capital ratio requirements and Finanstilsynet’s assessment that banks should hold a margin in the form of CET1 capital over and above the total CET1 requirement.

Chart 2.10 Banks satisfy their capital targets and capital requirements by an ample margin23

Largest Norwegian-owned banking groups. At 2021 Q3. Percent

The leverage ratio has remained approximately unchanged in recent years. Banks are well above the leverage requirement, and Norwegian banks also have higher leverage ratios than the large Nordic banks. The leverage requirement will become less effective as a backstop when the EU’s Capital Requirements Regulation II (CRR II) is implemented in Norway because the leverage-based buffer requirements cannot be retained in their current form under CRR II.

Several factors are expected to contribute to a slight fall in risk-weighted capital ratios over the coming years (Chart 3.5). Dividend restrictions were lifted at the end of September 2021, which means that banks will likely distribute a larger share of profits. In isolation, this will pull capital ratios down. In addition, new requirements for internal ratings-based (IRB) models may reduce capital ratios.24 On the other hand, CRR II will reduce risk-weighted exposures to SMEs and infrastructure projects (see box below), which will limit the decline in capital ratios for most banks.

New capital adequacy regulations reduce banks’ risk-weighted assets

Banks must meet capital adequacy requirements. Banks’ capital adequacy is calculated as capital as a percentage of risk-weighted assets.

Capital adequacy regulations in Norway are subject to EU rules. Rules adopted by the EU with EEA relevance are incorporated into the EEA Agreement and implemented in Norwegian law. The EU has adopted a new capital framework (CRR II) that will likely apply to Norwegian banks in the course of 2022. CRR II introduces new capital requirement discounts for portions of banks’ exposures that reduce risk-weighted assets. The discounts increase reported capital ratios without improving actual solvency.

CRR II includes three capital requirement discounts:

•Risk-weighted exposures to infrastructure projects are reduced by 25%.

Risk-weighted exposures to small and medium-sized enterprises (SMEs)1 are reduced by two discounts.

•The existing discount reduces the capital requirement for exposures of up to EUR 1.5m by 23.81%. The new discount raises the maximum exposure limit to EUR 2.5m.

•A new and smaller SME discount of 15% will be introduced for exposures exceeding EUR 2.5m.

In the consultation document on the EU banking package, it was assumed that the expansion of the SME discount could increase Common Equity Tier 1 (CET1) capital by between 0.3 and 0.8 percentage point for larger banks.2

1 The capital adequacy regulations define SMEs as enterprises with a maximum of 250 employees, a maximum annual turnover of EUR 50m and/or a maximum balance sheet of EUR 43m.

2 See Ministry of Finance (2020) “Høring – gjennomføring av bankpakken mv.” [Consultation – implementation of banking package etc]. 6 January 2021 (in Norwegian only).

3 Stress test and the usefulness of banks’ capital buffers

Solvent banks are essential for financial stability. If the recovery in the Norwegian economy were to shift to a deep downturn, it is important that banks have sufficient capital that can be used to maintain lending standards so that banks do not amplify the downturn. Norwegian banks have available reserves in large capital buffers and satisfy the capital requirements by an ample margin, but the stress test shows that weak developments in commercial real estate (CRE) and other industry-specific shocks could result in banks tightening lending and amplifying a downturn.

3.1 Stress scenario

The purpose of the stress test is to assess whether banks’ capital ratios will be sufficient so that they do not amplify a macroeconomic downturn. The analyses are done with the help of a model framework where banks are affected by, and they themselves affect, economic developments.1 In order for banks to be able to meet credit demand and maintain other important functions in a downturn, banks must have sufficient capital. The stress test and the analyses on which the stress test is based are part of the basis for Norges Bank’s decisions and advice on banks’ capital buffer requirements.

Crisis depth depends on economic vulnerabilities

The stress test is based on the current situation and a normalising Norwegian economy in line with the baseline scenario (Chart 3.1). The baseline scenario for activity in the Norwegian economy reflects the projections in Monetary Policy Report 3/21.

In the stress test, the economy is exposed to large shocks that are amplified by vulnerabilities in the Norwegian financial system. Crisis depth in the stress scenario is calibrated given the Bank’s vulnerability assessment, which is partly based on the Growth-at-Risk framework (see "A broad set of indicators indicates medium cyclical vulnerabilities").

Overall vulnerabilities are now assessed to be broadly at the same level as before the pandemic and clearly lower than prior to the financial crisis in 2008 and the banking crisis at the end of the 1980s.

The stress scenario describes a pronounced, but not unlikely, downturn in the Norwegian economy. The downturn is assumed to be the outcome of lower growth abroad, global financial market stress and falling oil prices (Table 3.1). Norway is a small open economy and international developments contribute to a pronounced domestic downturn. Property prices are assumed to fall sharply, and the stress pushes up both the risk premium on the Norwegian krone and banks’ funding costs. The money market premium rises sharply in 2022 Q1 before gradually falling back. The macroeconomic downturn results in a substantial fall in commercial property rents. Heightened uncertainty and reduced risk appetite lead to a marked rise in the yield, which contributes to a near halving of commercial property selling prices2 in the stress period. A decline in income and house prices prompts households to tighten consumption, and domestic demand falls.

History has shown that the effects of deep economic downturns are generally uneven, and in the 2021 stress test, the Bank has chosen to highlight the petroleum-related shipping segment as an example of a sector that could be hard hit. This sector could face substantially lower demand in a deep global downturn with lower oil prices and an increased focus on climate change.

Vulnerabilities associated with high house prices amplify the downturn. In the stress scenario, it is assumed that house prices fall by a good 25%, partly as a result of reduced income expectations and higher lending rates. Since the policy rate is already very low, monetary policy can only to a limited extent contribute to lower lending rates. High debt ratios combined with a shortage of liquid assets make households vulnerable to a sharp fall in house prices, even though savings in the form of bank deposits rose during the pandemic. High leverage for many households amplifies the fall in consumption in the stress scenario. In addition, a weak housing and CRE market results in lower construction activity. Compared with the baseline scenario, the stress scenario implies a GDP level that is more than 8% lower at the end of 2024 (Table 3.1 and Chart 3.1).

Table 3.1 Macroeconomic aggregates in the stress scenario.1 Percentage change from previous year2

1 As a technical assumption, the CCyB is kept at 1% in 2022–2025.

2 Unless otherwise stated. Level variables measured as annual averages. Projections for 2021 Q3–2021 Q4 for mainland GDP, unemployment, three-month Nibor, house prices, household credit (C2) and oil price taken from Monetary Policy Report 3/21.

3 It is assumed that a higher market premium will only affect new bonds.

4 Rents and selling prices for prime office space in Oslo.

5 Selling prices are calculated as rental prices divided by yield.

6 NFCs are non-financial corporations.

Sources: Eiendomsverdi AS, Entra, Finn.no, JLL, Norwegian Labour and Welfare Administration (NAV), Real Estate Norway, Statistics Norway and Norges Bank

Chart 3.1 Crisis depth reflects vulnerabilities3

GDP in the stress scenario and baseline scenario. Index. 2021 = 100

The stress scenario is not a forecast of how the economy will develop in the event of a pronounced downturn, but describes potential developments given Norges Bank’s assessment of vulnerabilities in the Norwegian financial system. As a technical assumption, the policy rate is set to 0% and remains at 0% until the end of the stress period, while it is assumed that extraordinary fiscal policy measures are not implemented.

3.2 Banks’ credit losses

In the stress scenario, banks’ losses increase significantly, driven to a great extent by the fall in residential and commercial property prices. At their highest, total credit losses are at 2% of lending (Chart 3.2), which is lower than during the banking crisis at the beginning of the 1990s, but higher than during the financial crisis.

Chart 3.2 Losses depend on crisis depth4

Losses as a percentage of loans, total and by sector. Stress scenario and baseline scenario

In the household sector, the fall in house prices and higher unemployment result in higher credit losses in line with historical experience. Estimated corporate credit losses are based on a combination of micro-level analyses of firms and historical relationships between weak growth and credit losses in Norway and globally.5 This results in total credit losses as a percentage of corporate lending of 4.5% in 2023 (Chart 3.2).

Particularly sharp falls in specific industries result in substantial losses on banks’ corporate loans

In order to estimate banks’ losses on corporate loans, the macro scenario from the stress test is incorporated into Norges Bank’s framework for expected losses.6 The framework differentiates between falls in activity across industries. Developments in earnings are then calculated for each firm, based on the relevant industry and given firm-specific data. Firms’ bank loans are linked to lender banks. Finally, we examine the impact of losses on these loans on the macro bank, which is a weighted average of nine large Norwegian banks.7 The framework makes it possible to take into account Norwegian banks’ actual exposures and link the loss projections to the specific downturn affecting the economy. If capital-intensive industries are severely affected, losses increase because firms in such industries typically borrow more than those in other industries from both banks and other sources. In the stress test, the fall in property prices and earnings problems in the shipping sector are important loss drivers (Charts 3.3 and 3.4).

Chart 3.3 CRE and construction dominate losses

Share of total losses on corporate exposures. Stress scenario. Estimates for 2023. Percent

Chart 3.4 Loss rates have been high for several years8

Losses as a percentage of loans to the sector

Defaults on CRE exposures increase owing to both a fall in turnover and a fall in property prices. The stress test uses information on loss given default (LGD) from Finanstilsynet’s database of banks’ corporate exposures, and this information is linked to each individual loan. As property prices remain low for a while, it is assumed in the scenario that banks’ LGD on CRE loans rises. The fall in commercial property prices dominates loss estimates in the initial years of the stress period. In the stress scenario, more than 60% of corporate credit losses in 2023 are related to CRE or construction exposures.

In addition, banks’ credit losses in the scenario increase because profitability in oil-related shipping segments gradually weakens. In the model, this is done by assuming that loans in this shipping segment are moved up one stage in the impairment assessment according to IFRS 99 during 2022. For example, loans in Stage 1 are moved to Stage 2. Later in the stress scenario, banks are assumed to place a majority of their loans in this shipping segment in Stage 3, which is the stage for loans with the highest risk of losses.

3.3 Banks’ adjustment in the stress scenario

Banks’ loss-absorbing capacity is fundamentally sound. Extraordinary government measures during the pandemic have reduced banks’ credit losses, and dividend restrictions have contributed to lifting capital ratios. It is assumed that the macro bank in the baseline scenario will move to a capital target of about 17% in the long term, which is equivalent to a capital margin above total capital requirements of 1% if the countercyclical capital buffer (CCyB) is 2.5%. Capital ratios therefore fall somewhat in the baseline scenario (Chart 3.5).

Chart 3.5 Banks’ capital margin above total requirements disappears10

Macro bank’s capital requirements and CET1 ratio, baseline scenario and stress scenario. Percent

The current high capital margin above total requirements is drawn down to cover losses

Persistently weak economic activity in the stress scenario results in the loss of most of banks’ capital margin above total requirements (Chart 3.5). Credit losses are the main reason for this (Chart 3.6). Other factors also have an impact on banks’ capital ratios. Low yields are considered a key source of cyclical vulnerability (see Section 1). When the downturn affects the economy in 2022, the value of banks’ equity and bond holdings falls immediately by 40% and 5%, respectively.

Chart 3.6 Losses result in a fall in capital ratios11

Change in macro bank’s CET1 ratio and estimated contribution from different components. Percentage points

Banks will seek to maintain net interest income to curb the fall in capital ratios, and the interest margin is assumed to be roughly constant in the stress scenario. Most banks retain some profit from 2024, and it is assumed that banks will then pay out normal dividends given that their capital ratios are higher than the sum of the minimum requirements and buffer requirements.

Once the capital margin above total requirements has been used, lending standards are tightened

In the stress scenario, when losses increase and profitability falls, the macro bank responds by tightening lending standards to prevent its capital ratios from falling all the way to the minimum required. This may be because banks find that dipping into regulatory capital buffers is costly since restrictions will be triggered on dividend payments, bonuses and some other banking conditions. Initially, as a technical assumption, the CCyB is kept unchanged at the 2022 Q1 level (1%) throughout the period. Banks tightening of lending standards and lower credit demand then lead to negative credit growth from 2022 in the stress scenario (Chart 3.7).

Chart 3.7 Fall in credit growth depends on capital buffer requirements12

Credit growth in past four quarters in baseline scenario and stress scenario. Percent

Reduced buffer requirements limit banks’ tightening of credit

The stress test shows that if the CCyB is set at 0% in 2022 instead of remaining positive throughout the period, credit growth rises (Chart 3.7). Banks can then draw on the capital to maintain lending standards without breaching the buffer requirement, and this dampens the economic downturn.

Banks’ profitability is the first line of defence against losses. The results of the stress test are therefore sensitive to net interest income assumptions. In the stress test, it is assumed that banks maintain interest margins and that this makes a positive contribution to capital ratios. However, a number of factors may make it difficult for banks to support interest margins and net interest income. For example, in the face of financial market turbulence, banks may be willing to pay more relative to the money market rate to retain deposits out of fear of liquidity problems, which will put pressure on the interest margin. If net interest income falls further through the crisis, banks’ CET1 capital ratios will fall further (Chart 3.8) and credit growth will be weaker than if interest margins are stable (Chart 3.7).

Chart 3.8 Banks dip into capital buffers if net interest income also falls13

Macro bank’s capital requirements and CET1 ratio, baseline scenario and stress scenario with lower net interest income. Percent

The stress test shows that banks need considerable capital buffers to maintain lending standards in the event of a downturn. The need is greater when the downturn is amplified by vulnerabilities in the Norwegian financial system. In a severe downturn, both the CCyB and the systemic risk buffer may be lowered to enable banks to maintain lending standards. The buffers can be reduced when other capital in the banking system is assessed to be sufficient to weather the downturn without threatening solvency.

Important that regulatory buffers are reduced if they are to play a useful role

Under the capital adequacy rules, capital used to satisfy regulatory buffer requirements that are not reduced may also be used in bad times. At the same time, other requirements may prevent banks from dipping into these capital buffers, particularly if the consequences of breaching other requirements are more serious than the consequences of breaching the buffer requirements. This is because the capital held by banks to satisfy the buffer requirements is also used to satisfy the leverage ratio requirement, and some of the minimum requirement for own funds and eligible liabilities (MREL) (see "Relaxation of risk-weighted capital requirements and MREL from buffer requirement reductions"). These requirements can therefore become binding if banks dip into their buffer capital. In the stress scenario, the macro bank’s leverage ratio is kept well above the forthcoming minimum requirement of 3%. This suggests that this requirement is not very close to being binding. MREL, on the other hand, might be binding. If we assume that banks adjust to MREL by a small margin14, calculations show that some of the banks in the stress scenario must use all remaining capital buffers and some of the surplus capital to satisfy MREL. Capital buffers will then not necessarily function as intended because banks must maintain capital or reduce risk-weighted assets to satisfy MREL. Banks that wish to maintain the flexibility provided by capital buffers should issue sufficient subordinated debt so that MREL does not prevent banks from using the buffers. If capital buffer requirements are reduced instead, rather than banks only being able to dip into them, the most binding MREL requirement will be reduced correspondingly and the buffers can function as intended.

4 Liquidity measures and market stress

Extraordinary loans to banks during the period of market stress in spring 2020 ensured banking sector liquidity and the transmission of the policy rate to money market rates. Nevertheless, liquidity needs increased for investment funds and other asset managers when securities prices fell and the krone depreciated. The question of whether central banks should have tools designed for securities markets and non-bank market participants for use in times of market stress is the subject of discussion internationally and in Norway.

Norges Bank’s liquidity policy instruments are aimed at banks because banks have a specific role in payment and credit intermediation. Liquidity support tools designed for securities markets and other market participants could increase the central bank’s balance sheet risk. The fundamental principles of Norges Bank’s liquidity policy and the experience gained in spring 2020 suggest that secured loans to the banking sector should continue to be the preferred instruments in periods of market stress.

4.1 Banks have a particular role in credit and payment intermediation

Banks play a key role in Norway’s financial system. Bank loans make up about 80% of all domestic credit to the private sector. Banks’ provision of credit to the private sector is matched by increased deposits by the private sector. Demand deposits are funds held in an account at a bank and are used by the general public as a means of payment. Banks are the only economic agents that can create and receive demand deposits, giving them a particularly important role in credit and payment intermediation. Demand deposits are liquid funds that are at the free disposal of depositors, while bank loans are less liquid. This exposes banks to liquidity risk. Bank lending also involves credit risk. Because they play such an important role in society, banks are strictly regulated and are subject to supervision by Finanstilsynet (Financial Supervisory Authority of Norway).

Regulatory minimum requirements with regard to capital, liquidity and stable long-term funding limit banks’ exposure to credit and liquidity risk. The motivation behind the minimum requirements is to ensure that banks are resilient to losses and remain liquid in periods of market stress without support from public authorities. The Norwegian deposit guarantee scheme that guarantees deposits up to a certain amount also dampens liquidity risk. In addition, liquidity risk can be limited by replacing deposits with fixed-term wholesale funding. Wholesale funding is normally more expensive than deposit funding and exposes banks to refinancing risk at certain times.

One of the core functions of a central bank is to provide liquidity insurance for the financial system by being lender of last resort. The aim of such liquidity insurance is to reduce the economic losses that can ensue from severe disruptions in the payment system or other financial services. Norges Bank offers liquidity insurance to banks in normal times through a standing overnight lending facility (D-loans). In addition, banks are offered loans over quarter-ends. The loans are provided against collateral in the form of high-quality securities, normally at a price higher than the policy rate. The terms for such liquidity insurance reflect the same principle as the regulatory requirements for banks. Risk must primarily be borne by banks themselves and be reflected in the pricing of bank lending and borrowing in the market. This will also limit risk on the central bank’s balance sheet.

In addition to the standing lending facilities, Norges Bank can provide liquidity to the banking system as a whole by offering extraordinary loans. Such liquidity insurance is only offered when deemed necessary by the central bank in order to ensure financial stability and to implement monetary policy. During both the 2008/2009 financial crisis and the period of market stress in spring 2020, Norges Bank offered extraordinary loans to the banking sector. The loans dampened the uncertainty surrounding banks’ liquidity situation and contributed to improving the policy rate pass-through to money market rates (Chart 4.1). The fundamental principles of liquidity management policy also apply in periods of financial turmoil.1 The terms for extraordinary loans are designed to promote the central bank’s objectives while minimising moral hazard, ie that the terms for such support do not contribute to excessive risk-taking. Banks are given incentives to manage risk without support from the central bank.

Chart 4.1 Extraordinary loans dampened uncertainty in the money market2

Outstanding volume of extraordinary F-loans and premium in three-month Nibor

4.2 Do central banks need other tools in times of market stress?

Internationally, market-based credit has grown in volume since the 2008/2009 financial crisis, and in many countries, well-functioning securities markets have become more important for financial stability (see Section 1.1). The Financial Stability Board (FSB) and others stress that the functioning of securities markets may be threatened at an earlier stage than previously in periods of financial turmoil. Stricter margining requirements for derivative positions between financial market participants may have increased the need for liquid funds in periods of high price volatility. Higher capital adequacy and leverage ratio requirements have increased banks’ resilience to losses. At the same time, stricter rules require banks to set aside more capital to cover both risky and risk-free assets on their balance sheets. This may have reduced banks’ willingness to act as market makers in securities markets. Selling pressures in securities markets may therefore arise more rapidly in periods of market stress if many participants need liquidity at the same time, signs of which were also observed in the Norwegian bond markets in spring 2020.

The Bank of England3 and others have proposed that central banks should consider liquidity policy tools specifically aimed at securities markets and non-bank market participants. One instrument could be that the central bank acts as market maker of last resort (MMLR) in situations where the traditional market makers – banks – do not have sufficient balance sheet capacity to act as intermediary between buyers and sellers in the market. Another instrument is providing access to central bank lending facilities for non-bank market participants. In Norway, the Norwegian Fund and Asset Management Association (VFF) has suggested that investment funds should be given access to the central bank’s lending facility in order to avoid fire sales in periods of market stress. VFF also suggests that Norges Bank should assume responsibility for the management of the Government Bond Fund to allow the central bank to provide direct support to securities markets.

Measures that bypass banks may have advantages …

MMLR means that the central bank buys and sells securities in securities markets in situations where private market makers are absent and markets are dysfunctional. The Bank of England’s asset purchase programme in the secondary market for UK corporate bonds4 is one of few examples of central banks acting as MMLR. The programme was introduced in 2009 as outright asset purchases, but was augmented in 2010 to include sales of bonds from the central bank’s holdings. The aim was to improve secondary market liquidity after banks had reduced their market making activities. The asset purchase programmes established by several other central banks following the financial crisis were initiated for a different purpose. With the central bank acting as MMLR, the objective is not to influence the general level of interest rates or asset prices but to improve the functioning of securities markets.5 The assets purchased by the central bank as MMLR will normally be sold back to the private sector as soon as possible.

MMLR may have advantages compared with supporting the functioning of securities markets indirectly by providing loans to banks. When the central bank provides liquidity support by offering banks loans against collateral, the effect on securities markets will depend on whether banks are willing and able to increase their balance sheet size and risk. Regulatory requirements, which are otherwise highly necessary and well-founded, can impose restrictions on banks’ capacity to use collateralised central bank funding to purchase securities. When the central bank provides a bank with loans against collateral, the bank’s deposits at the central bank increase on the asset side of its balance sheet corresponding to the borrowed amount on the liabilities side. This leads to a decrease in the bank’s leverage ratio, but has no effect on its risk-weighted capital ratio because deposits at the central bank have a risk weight of 0%. If a bank uses this funding to purchase securities from the general public, the bank’s securities holdings increase on the asset side and the general public deposits increase on the liabilities side. This leads to a further decrease in the leverage ratio. If the securities have a risk weight higher than zero, the bank’s risk-weighted capital ratio also falls. If the central bank purchases securities from the general public, either directly or through banks, banks’ risk-weighted capital ratios will not be affected as the risky securities are held on the central bank’s balance sheet. Such asset purchases also lead to a smaller decrease in banks’ leverage ratios than if banks finance asset purchases using collateralised central bank funding. Another possible advantage of MMLR is that it allows the central bank to decide which market segment to support and to what extent. Thus, MMLR may be a more accurate tool than loans to banks.

… but entail higher risk on the central bank’s balance sheet

The effect and accuracy of MMLR depends on the prices quoted by the central bank and the risk it takes on. When the central bank provides loans against collateral, risks are mitigated by adjusting the market value of the collateral on a daily basis and applying collateral haircuts. There is no such safety mechanism when the central bank purchases securities. To act effectively as MMLR, the central bank must purchase securities at prices other market participants are not willing to bid. It is unlikely that valuations made by the central bank are fundamentally better than those made by other investors in the market. This makes it difficult to assess whether the prices quoted by the central bank contribute to a well-functioning market and to assess the risk taken on by the central bank. Securities markets can be exposed to large shocks and still be functional. Large price fluctuations are not enough to warrant an MMLR intervention. This suggests that the central bank should be very wary of purchasing securities in such situations. As is the case for other central bank actions, MMLR will be associated with moral hazard. Market participants may to a lesser extent take full account of the risk associated with their investments if they expect the central bank to intervene in the market when price volatility is high. Thus MMLR can contribute to functional markets in the short term but weaken the market mechanism in the longer term. Incorrect pricing of risk can lead to a build-up of vulnerabilities in financial markets and a greater need for central bank interventions in the future.

One alternative to collateralised loans to banks and MMLR could be collateralised loans to other market participants, such as investment funds, insurance companies or other types of asset managers. Collateralised loans entail lower risk for the central bank than acting as MMLR. Nor will the effect of such loans be limited by banks’ balance sheet capacity, but may be limited by restrictions on participants’ borrowing.6 Market participants with a different function from banks in the financial system are regulated differently and to some extent less strictly. Loans to these counterparties therefore normally entail higher risk for the central bank than loans to banks. Furthermore, central bank provision of liquidity protection to non-bank participants may be difficult to justify. Less strict regulation reflects the fact that these participants are less critical to payment intermediation and the financial system than banks.

Banks had capacity to purchase securities in spring 2020

Norwegian banks fulfilled capital requirements by a solid margin at the beginning of the period of market stress in spring 2020. On average, the distance to the risk-weighted capital requirements was 1–1.5 percentage points and somewhat more to the leverage ratio. Banks’ capacity to purchase securities was therefore not constrained by capital requirements, even though the requirements may have constrained individual banks on certain days. In March 2020, Norges Bank provided banks with loans with maturities of up to one year at full allotment. Norges Bank reduced the countercyclical capital requirement by 1.5 percentage points at the same time. Norges Bank also decided to allow banks to use 100% of one security (ISIN) as collateral for a loan, as against the normal limit of 20%. This meant that banks could more easily buy back bonds financed by loans from Norges Bank, which probably contributed to the improvement in bond market liquidity. Banks borrowed approximately NOK 200bn from Norges Bank.

Banks increased their securities holdings between the end of February and the end of August 2020 by NOK 185bn (Chart 4.2), with most of the increase occurring in March and April. About half of the increase was banks’ purchases of new covered bonds from their own mortgage companies, but holdings of municipal bonds and other securities also increased. Banks also increased their own senior unsecured bond repurchases with short residual maturity in the same period, even though these bonds could not be used as collateral for loans from Norges Bank. The substantial increase in securities on banks’ balance sheets in March and April illustrates that the banks had capacity to increase their borrowing from Norges Bank and purchase securities from non-bank market participants in need of liquidity.

Chart 4.2 Banks expanded their securities holdings in spring 20207

Norwegian banks’ holdings of bonds and short-term paper by issuer sector. In billions of NOK

Risk should as far as possible be handled and priced in the market

Liquidity policy tools are used in periods of market stress to ensure policy rate transmission to market rates and to contribute to financial stability. The instruments are at the same time deployed in such a way that risk is as far as possible managed by private agents and priced in the market. Banks play a specific role in credit and payment intermediation and are therefore Norges Bank’s counterparties in the liquidity management framework. In periods of market stress, extraordinary measures aimed at banks can be a less effective means of influencing securities markets if banks are subject to capital or other regulatory constraints. Experience from the period of market stress in spring 2020 implies that banks had the capacity to increase balance sheet size and risk and that Norges Bank’s measures aimed at banks contributed to improving conditions in money and securities markets. In the light of this experience and the fundamental principles of the liquidity management policy, loans to banks are Norges Bank’s preferred instrument in periods of market stress. Public intervention in the markets should in any case not contribute to a socialisation of losses while the profits are retained by the risk-taker. Both banks and other financial market participants are responsible for managing their own liquidity risk without relying on support from the central bank. Regulations issued by the authorities and the central bank’s terms for liquidity insurance are designed to contribute to this.

Annex

Important measures to mitigate financial system vulnerabilities in Norway

Footnotes

1 The requirement pertains to the customer’s total debt.

2 Prior to being laid down in a regulation, the requirements were issued as guidelines, for residential mortgage loans in 2010 and for consumer credit in 2017.

3 Up to a certain percentage of the total value of new mortgage loans/consumer credit granted each quarter may be loans in breach of one or more of the requirements.

4 Exemption for credit cards with credit limits below NOK 25 000 and exemption for loan refinancing as long as the value of the refinanced loan (and associated costs) does not exceed the value of the existing loan (and associated costs).

5 See explanation of capital requirements in Norway’s financial system 2021, pages 99–106.

6 From 2002, hybrid capital could account for up to 15% of Tier 1 capital.

7 In 2013, the minimum requirement increased from 4% to 6% when CRR/CRD IV were implemented in the Norwegian rules.

8 Applies to IRB banks from end-2020, while the 3% requirement applies to other banks until end-2022.

9 From the end of June 2022, Nordea Eiendomskreditt AS shall be classified as systemically important and be subject to a 1% buffer requirement.

10 Liabilities eligible for MREL must be lower in priority than senior debt. However, before 1 January 2024, ordinary senior bonds issued before 1 January 2020 may also be used to satisfy MREL.

11 The loss absorption amount requirement is the larger of the leverage-based Tier 1 capital requirements and total risk-based capital requirements (minimum requirement, Pillar 2 requirements and buffer requirements). In Norway, the risk-based requirement is the most binding.

12 Applies only to banks subject to resolution and not liquidation under public administration.

Sources: Ministry of Finance and Finanstilsynet

The Norwegian banking sector

See Norway´s financial system 2021 for a further description.