Executive Board’s assessment

In the Financial Stability Report, Norges Bank assesses vulnerabilities and risks in the Norwegian financial system and points to measures that can contribute to financial stability. The Executive Board discussed the content of the Report on 18 September and 23 October.

Financial system vulnerabilities in Norway have not changed substantially since the previous Report, which was published in October 2018. Household debt is high, and commercial and residential property prices are at high levels after rising sharply over a long period. However, over the past two years, debt growth and house price inflation have been more moderate than previously, and house prices have risen more slowly than disposable income. Over the past year, the rise in commercial property prices has also slowed, and household debt is now rising at close to the same rate as disposable income. Norwegian banks have maintained profitability and solvency and continue to have ample access to funding.

Global economic uncertainty poses a risk to financial stability in Norway. Events in the international economy and financial markets can spread to Norway, and the impact in Norway may be amplified by domestic financial system vulnerabilities. Two such contagion channels are Norwegian exports and banks’ foreign funding. The trade tensions between the US and China remain a source of uncertainty and the UK’s relationship with the EU remains unclarified. Over the past year, uncertainties surrounding growth prospects abroad have led to a broad decline in interest rates. Persistently low interest rates may give rise to high risk-taking and financial imbalances. So far, global uncertainties have not had serious consequences for the Norwegian economy, and Norwegian banks have felt little impact, but this situation can change quickly.

On balance, the financial stability outlook is broadly unchanged since the 2018 Report.

The Norwegian authorities have implemented a number of measures to mitigate financial system vulnerabilities. Requirements for banks’ credit standards limit excessive borrowing by the most vulnerable households. The regulation on new residential mortgage loans, first introduced in 2015, was tightened in 2017 and has functioned as intended. Norges Bank is of the opinion that debt growth and housing market developments do not warrant material changes to the requirements and in a consultation response on 14 October supported continuation of the regulation. There are also signs that measures targeting the consumer credit market have dampened consumer debt growth. In addition, the registers of unsecured debts, which were introduced on 1 July, have given banks more complete data on which to base credit assessments. Such registers should also include information on collateralised loans to enable banks and loan applicants to easily obtain the full picture of a loan applicant’s debt situation.

Banks’ loss absorbency capacity in an economic downturn is important for financial stability. Banks’ capital and liquidity requirements have become considerably stricter following the financial crisis. The stress test in this Report shows that the capital buffers of the largest Norwegian banks as a whole are sufficient to absorb the losses associated with a hypothetical downturn in the Norwegian economy. Nevertheless, in such a situation, banks may still tighten lending, which may amplify the downturn. To counter a sudden fall in lending, the authorities can reduce the countercyclical capital buffer and allow banks to draw on the remaining buffers. In that case, banks should be given sufficient time to rebuild the capital buffers.

In connection with the implementation of the remainder of the EU capital framework, many banks’ reported capital ratios will rise without this reflecting an improvement in solvency. Norges Bank is of the view that in the current situation, Norwegian banks’ capital levels should not be reduced. Structural systemic risk is high, particularly owing to high household leverage. Since the systemic risk buffer was introduced in 2013, banks have increased their property market exposures, and their cross-holding of covered bonds has also risen. In its consultation response on 30 September, Norges Bank supported as a countermeasure the proposal to increase the systemic risk buffer, an action that will help banks to maintain loss absorbency.

Financial stability considerations in each country should determine the scope of regulation, whether the lenders are domestic or foreign banks. Foreign banks’ share of the Norwegian market is high. It is therefore important that other countries recognise Norwegian regulations and vice versa.

Digital vulnerabilities may result in a higher risk of operational problems. Cyber attacks are becoming increasingly widespread and sophisticated. Moreover, the financial system depends on a few critical ICT service providers. This increases the risk that a cyber attack may pose a threat to financial stability. Finanstilsynet and Norges Bank have invited the industry and other relevant authorities to a dialogue to assess whether the European framework for Threat Intelligence-based Ethical Red Teaming (TIBER-EU) would be suited to Norway. In its consultation response on the ICT security bill, Norges Bank pointed out a need for further study of the best way to supervise critical ICT service providers and data centres.

Climate change and society’s adaptation to climate change will affect all segments of the economy and entail risks to financial stability. Changes in climate regulation, new technology and changing investor and consumer preferences may entail a transition risk for the Norwegian economy in the coming years, a risk amplified by the importance of the oil and gas industry for Norway. Climate change is a global challenge, which must primarily be addressed by the political authorities and instruments other than those available to central banks. Climate risk must be managed in the same way as other risks facing the financial sector. The instruments for strengthening banks’ resilience, such as capital requirements and prudential supervision, are thus basically the same as those used for managing other risks. Central banks and supervisory authorities can, within their mandates, promote financial stability by helping to pave the way for the financial sector to include climate risks in overall risk assessments and communicate relevant information and by ensuring adequate capital to support all risks.

1 Financial stability outlook

The key vulnerabilities in the financial system in Norway are high household debt, high house prices and high commercial property prices. Vulnerabilities have not changed substantially since Financial Stability Report 2018. Norwegian banks have maintained profitability and solvency and continue to have ample access to funding. Global economic uncertainty poses a risk to financial stability in Norway. Over the past year, uncertainties surrounding growth prospects abroad have led to a broad decline in interest rates. Persistently low interest rates may give rise to high risk-taking and financial imbalances. On balance, the financial stability outlook is little changed since the 2018 Report.

Since the financial crisis, the Norwegian authorities have introduced a number of measures to mitigate the risks in the financial system. The most important are stricter bank capital and liquidity requirements. Requirements for banks’ credit standards limit excessive borrowing by the most vulnerable households.

1.1 Risk of external shocks

Global turbulence can spread

The financial system largely operates across borders. Global turbulence and uncertainty may therefore spread to the financial system in Norway both from the global financial system and via the real economy. Small open economies like Norway are especially at risk. The IMF works to uncover financial sector vulnerabilities and provides advice on measures to address them (see "IMF assessment of the Norwegian financial system").

Large Norwegian banks obtain large amounts of funding abroad. At the same time, foreign banks account for around a quarter of all lending in Norway. Global financial turbulence may raise Norwegian banks’ funding costs and lower the supply of credit from foreign banks in Norway, both of which can reduce households’ and firms’ access to credit. Large firms that rely on the global bond market for financing may also be directly affected. Global turbulence has had little impact on Norwegian banks since the 2018 Report.

The European market is particularly important for the Norwegian economy. The situation at European banks is important for the European economy and may affect Norwegian banks’ funding markets. On the whole, European banks’ capital adequacy and liquidity coverage have improved considerably in recent years (Chart 1.1), but there are large differences across countries. The build-up of loss absorbency capacity appears to have come to a halt, and the average leverage ratio is lower for European banks than for Norwegian banks.1

Chart 1.1 Capital and liquidity coverage ratios in the EU banking system

Weighted average. Percent. 2015 Q1 – 2019 Q2

Source: European Banking Authority (EBA)

A large share of Norwegian financial institutions’ settlement takes place in foreign interbank systems, and large volumes of derivatives are cleared via UK central counterparties (CCPs). The UK’s withdrawal from the EU may entail challenges for these transactions. Temporary measures allow Norwegian firms to participate in UK CCPs even in the event of a no-deal Brexit.

Weaker growth expectations and lower foreign interest rates

Uncertainties surrounding trade tensions and the UK’s withdrawal from the EU have weighed on growth prospects for Norway’s trading partners (see Monetary Policy Report 3/19). So far, there are few signs that global uncertainties have damped growth in Norwegian exports. In August, enterprises in Norges Bank´s Regional Network reported continued solid export growth, despite increased uncertainties and Brexit-related turbulence.

Global markets have long priced in monetary policy normalisation and higher global interest rates, but the uncertain global outlook has contributed to a sharp fall in risk-free long-term interest rates, which are now at very low levels in some countries (Chart 1.2). Central bank measures have also contributed to lower interest rates. Around 30% of advanced economy sovereign bonds outstanding are now trading at negative yields.2 In a number of countries, new long-term corporate and household loans are now available at negative interest rates.

Chart 1.2 Yields on ten-year government bonds in selected countries

Percent. 1 January 2012 – 30 October 2019

Source: Bloomberg

Following the global financial crisis in 2008, lower interest rates have contributed to higher non-financial sector debt. Corporates have increased debt by nearly 20% of global GDP since 2008. This debt will be more vulnerable if firms’ debt servicing capacity is weakened in pace with weaker growth prospects. Global public debt has also risen substantially, while household debt is little changed. Since 2016, the global total debt-to-GDP ratio has levelled off, for both the public sector and non-financial enterprises.

Low returns on low-risk investments have for some time contributed to higher prices for securities and real estate. Global equity prices are broadly at the same level as one year ago (Chart 1.3). Lower growth prospects have pulled down equity prices, while lower interest rates have pushed them up. Global house price inflation has been high since the financial crisis (Chart 1.4).

Chart 1.3 Stock market indexes in selected countries

Index. 1 January 2008 = 100. 1 January 2008 – 30 October 2019

Source: Bloomberg

Chart 1.4 House prices in selected countries

Index. 2008 Q1 = 100. 2008 Q2 – 2019 Q2

Source: Bank for International Settlements (BIS)

Low interest rates over a longer period may weaken the financial stability outlook because they fuel increased debt accumulation and asset price inflation.

1.2 Vulnerabilities in the financial system in Norway

The key vulnerabilities in the financial system in Norway are high household debt, high house prices and high commercial property prices (see "Key financial system vulnerabilities in Norway"). Vulnerabilities have not changed substantially since the 2018 Report.

Over the past three years, growth in the Norwegian economy has been solid. The global upturn, low interest rates, improved cost-competitiveness, largely owing to a weaker krone, and higher oil prices have given a boost to activity.

Stable net interest income and low credit losses have enabled the large Norwegian banks to maintain profitability over the past year. All Norwegian banks satisfy the capital requirements. Further ahead, the risk of higher losses among oil-related companies and stronger competition from foreign banks and other operators could pose a threat to profitability.

Key financial system vulnerabilities in Norway

The table above shows Norges Bank’s assessment of the key vulnerabilities in the Norwegian financial system. Vulnerabilities can be time-varying or the result of permanent structural conditions in the financial system. Vulnerabilities can cause or amplify financial turbulence and an economic downturn when the economy is exposed to large shocks. The interaction between shocks and vulnerabilities can result in financial crises that restrain economic growth. Shocks that trigger financial crises can be difficult for the authorities to predict and influence. Shocks to a small open economy like Norway will often originate in other countries.

The vulnerability assessment is based on historical experience of what causes downturns and financial turbulence and assessments of new features of the financial system. The vulnerabilities identified as key vulnerabilities may change over time.

If vulnerabilities are categorised as orange or red, Norges Bank will consider issuing advice on measures to address them. These may be measures aimed at reducing the vulnerabilities directly or increasing financial system resilience. The authorities have already implemented a number of measures (Table 1.1).

Owing to high household indebtedness and house price overvaluation, the European Systemic Risk Board (ESRB) has issued a warning to Norway,1 in which it points out that the vulnerabilities are a source of systemic risk to the financial system.

1 See “Warning of the European Systemic Risk Board of 27 June 2019 on medium-term vulnerabilities in the residential real estate sector of Norway”. (ESRB/2019/14).

High household debt

Vulnerabilities related to household debt are high and broadly unchanged since the 2018 Report. High household debt will amplify the negative outcome of a sudden and sharp movement in interest rates, house prices or household income. Most households have room to defer principal repayments, draw on financial buffers or tighten consumption if they are exposed to economic shocks. The danger that a large number of households will tighten consumption at the same time constitutes a systemic risk. This may reduce firms’ earnings and debt-servicing capacity, leading in turn to higher losses on banks’ corporate exposures.

Household debt has long risen faster than household income, resulting in increasing household leverage (Chart 1.5). Household debt-to-income ratios are now showing signs of levelling off. Over the past few years, debt growth has edged down, while growth in household disposable income has risen. The higher interest rate level and continued moderate house price inflation are expected to restrain debt growth further (see Monetary Policy Report 3/19).

Chart 1.5 Household debt-to-income ratio1 and four-quarter change in debt and disposable income2

Percent. 1989 Q1 – 2019 Q23

1) Loan debt as a percentage of disposable income.

2) Income after taxes and interest payments. Adjusted for a break in the series. Four-quarter change in moving sum for the previous four quarters.

3) Projection for change in disposable income for 2019 Q2.

Sources: Statistics Norway and Norges Bank

The latest available data at individual level show an increase in the share of highly leveraged households (debt above five times gross income) and low debt-servicing capacity (annual margin below one month’s income) between 2016 and 2017 (Chart 1.6). Especially among first-time buyers, there was a large share that assumed debt corresponding to a debt-to-income (DTI) ratio of above five in 2017 (see "Higher share of highly leveraged households"). DTIs also rose for households that were not active in the housing market, many of whom experienced a fall in income. The share of households “underwater” (net debt higher than their dwelling’s market value) was broadly unchanged. The data suggest that the number of vulnerable households increased between 2016 and 2017. Since then more moderate credit growth and house price inflation has been observed, which may indicate a slowdown in the build-up of vulnerabilities.

Chart 1.6 Debt held by vulnerable households1. Share of total household debt.

Percent. 1987 – 2017

1) Households in breach of critical values for debt-to-income ratio (debt over five times gross income) and debt-servicing capacity (annual income after tax, less interest and standard consumption expenditure of less than one month’s income) and from 2010 also critical value for debt-to-value (net debt higher than dwelling’s market value).

Sources: SIFO, Statistics Norway and Norges Bank

Interest burdens, ie the share of income used to service interest on debt, are historically low owing to low lending rates (Chart 1.7). After the interest rate hikes over the past year, interest burdens have risen slightly. Owing to high debt levels, interest rate increases have a greater impact on household interest burdens than before. Debt service ratios, ie the share of income used to service interest and normal principal repayments, are already high and at the same level as prior to the financial crisis in 2008 and the banking crisis in the 1990s. Debt service ratios signal high risk in the heatmap (see "Developments in the heatmap").

Chart 1.7 Household debt service ratio1 and interest burden2

Percent. 1983 Q1 – 2019 Q2

1) Debt service ratio is interest expenses and estimated principal payments as a percentage of after-tax income.

2) Interest burden is interest expenses as a percentage of after-tax income.

Sources: Statistics Norway and Norges Bank

Consumer debt accounts for only 3%-4% of total household debt. Households with large consumer debt are therefore faced with high interest burdens owing to the high interest rates and consumer credit. Default rates on consumer debt are high and rising (Chart 1.8). More restrictive credit standards and reduced house price inflation may result in increased defaults among persons needing to refinance maturing consumer debt. Information from the new credit registers shows that there are many with little consumer debt, while relatively few owe large amounts (see "Credit register data show uneven distribution of consumer debt"). Growth in consumer credit to Norwegian households has long been high and rising, but has slowed since peaking in 2016.3 Lower growth reflects in part the introduction by the authorities in recent years of a number of measures to regulate consumer credit.4 The consumer credit regulation and credit registers may curb consumer credit growth further.

Chart 1.8 Annual change in consumer credit and default rates1 on consumer debt2

Percent. At year-end. 2008 – 20193

1) Gross non-performing consumer debt (90 days) as a share of gross consumer debt. Also includes finance companies' exposures abroad.

2) Based on the FSAs sample of banks and finance companies that cover most of the consumer credit market. Non-performing loans sold omitted from the sample.

3) At 30 June 2019.

Source: Finanstilsynet (Financial Supervisory Authority of Norway)

The credit registers provide details on an individual’s unsecured debt. Norges Bank recommends enlarging the registers to include information on secured debt. This will provide a more comprehensive picture of a loan applicant’s debt situation.

Developments in the heatmap

Norges Bank’s heatmap1 is one of a number of tools for assessing systemic risk in the Norwegian financial system. The heatmap monitors a broad set of indicators in three main areas: risk appetite and asset valuations, non-financial (household and corporate) sector vulnerabilities and financial sector vulnerabilities. Its primary objective is to measure cyclical or time-varying movements in vulnerabilities, and to a lesser extent vulnerabilities associated with structural aspects of the financial system or the wider economy.

Developments in the indicators are mapped onto a common colour coding scheme, where a green (red) colour reflects low (high) levels of vulnerability. The heatmap signals vulnerabilities in three segments of the financial system:

• Commercial property prices have risen sharply over many years. The gap between actual price developments and trend has therefore been and remains positive and relatively wide.2
• Household debt service ratios (interest and estimated principal payments on loan debt to after-tax income) are high.
• Assets and lending associated with institutions other than banks and mortgage companies3 have shown strong growth. Mutual funds’ assets have risen in recent years, partly owing to increased subscriptions by insurance companies and pension funds. Insurance companies in particular have seen strong lending growth, though levels remain low. Vulnerabilities are therefore not considered to be elevated.

Composite indicators in the heatmap. 1980 Q1 – 2019 Q2

1 See Arbatli, E.C. and R.M. Johansen (2017) “A Heatmap for Monitoring Systemic Risk in Norway“, Staff Memo 10/2017, Norges Bank, for a detailed description of the heatmap and the individual indicators.

2 See Norges Bank´s website: “Indicators of financial imbalances” for an illustration of the gaps.

3 Financial institutions other than banks and mortgage companies comprise money market mutual funds, other mutual funds, finance companies, government lending institutions, insurance companies and pension funds.

Moderate house price inflation reduces housing market vulnerabilities

High house prices are a key financial system vulnerability in Norway. Sharp and sudden declines in house prices may trigger tightening of household consumption and result in increased losses on banks’ loan portfolios. The covered bond market may also be weakened. This may create bank funding shocks (see Section 2 Bank profitability, solvency and funding).

House prices have risen sharply over a long period and in nominal terms are at historically high levels. Over the past two years, the rise has been moderate, and house prices relative to household disposable income have moved lower (Chart 1.9). The cooling-off of the housing market has reduced the risk of a sudden and more pronounced price fall further out, and vulnerabilities have declined somewhat since the 2018 Report.

Chart 1.9 House prices relative to disposable income1

Index. 1998 Q4 = 100. 1983 Q1 – 2019 Q2

1) Disposable income is income after taxes and interest payments. Adjusted for a break in the series.

Sources: Eiendomsverdi, Finn.no, Norwegian Association of Real Estate Agents (NEF), Real Estate Norway, Statistics Norway and Norges Bank

The recent moderate house price inflation may partly reflect increased residential construction.5 There was a record number of completions in 2018, and a new peak in the number of completions is expected in 2019 (Chart 1.10). Higher interest rates and the tightening of the regulation on new residential mortgage loans have also likely pulled down house price inflation.

Chart 1.10 Housing starts and completions, annual change in number of households

In thousands. 2005 – 20201

1) Projections for 2019 and 2020.

Sources: Statistics Norway and Norges Bank

Moderate house price inflation is expected to continue ahead (see Monetary Policy Report 3/19). Higher interest rates and the large number of completions pull down the rise in house prices. Prospects for continued high demand for housing in urbanised areas and higher wage growth pull in the opposite direction. A more moderate rise in house prices may help restrain the build-up of household debt ahead.

High commercial property prices

Vulnerabilities associated with high commercial property prices are broadly unchanged since the 2018 Report. In recent years, the rise in prices for commercial property in Oslo has been high, and real estate companies’ debt has risen. This has contributed to higher vulnerabilities for banks. Norwegian banks’ have sizeable exposures to commercial real estate (CRE) (see Section 3 Stress test). Even though in normal times, losses have been historically been low, CRE is the sector that has inflicted the most losses during crises.

Estimated real selling prices for prime office space in Oslo have been rising sharply over several years (Chart 1.11). Over the past year, the rise has been more moderate. Selling prices are estimated using rental prices and an estimated yield.

Chart 1.11 Real commercial property prices1

Index. 1998 = 100. 1983 Q1 – 2019 Q2

1) Estimated real selling prices per square metre for prime office space in Oslo. Deflated by the GDP deflator for mainland Norway. Average selling price for the previous four quarters.

Sources: CBRE, Dagens Næringsliv, OPAK, Statistics Norway and Norges Bank

In isolation, rising rental prices strengthen the debt-servicing capacity of CRE companies. Rents for prime office space in central Oslo have risen sharply over the past few years (Chart 1.12). In other parts of Oslo, average rental prices have risen, but the rise has been lower than for prime office space. Norges Bank has developed a rental price index that takes into account that rent depends on the attractiveness of the office space (see "New rental price index for commercial real estate in Oslo"). This quality-adjusted index confirms that rents for the most attractive office space have risen more sharply in recent years than what could be considered representative for Oslo. According to Entra’s consensus report, market participants expect rents to continue to rise in Oslo, though at a slower pace than in 2019.

Chart 1.12 Office rents in Oslo. NOK per square metre per year

Four-quarter moving average. 2008 Q4 – 2019 Q3

1) Market rents according to CBRE to 2019 Q2.

2) Calculated as the average rental price for signed leases, at lease signing date.

Sources: Arealstatistikk and CBRE

In line with falling interest rates, investors’ yields on CRE in Oslo fell over many years (Chart 1.13). In recent years, yields have been relatively stable. At the beginning of the year, market participants expected yields to gradually pick up in pace with the rise in long-term interest rates. When instead, long rates fell both abroad and in Norway, yield expectations also weakened somewhat. Market participants expect yields to remain broadly unchanged ahead.

Chart 1.13 Yield for prime office space in Oslo and long-term interest rates

Percent. 2006 Q1 – 2019 Q31

1) Yield to 2019 Q2.

Sources: CBRE and Refinitiv

Overall, market participants’ expectations regarding rental price increases and yields suggest a further slight rise in selling prices in 2019 and 2020, but at a more moderate pace (see Monetary Policy Report 3/19).

Other important vulnerabilities

Digitalisation adds to vulnerabilities

Norway is at the forefront in the use of digital financial services. This makes the financial system vulnerable to unintended operational incidents and cyber attacks. The latter are becoming increasingly widespread and sophisticated. If the financial system lacks the capacity to absorb shocks, rectify faults and ensure continuity of important economic functions, this may result in economic costs that may weaken confidence in the financial system.

Examples from the non-financial sector serve to illustrate how digital vulnerabilities may give rise to substantial losses. So far, there have been no extensive disruptions in the financial system in Norway, and the data for estimating the cost of malicious attacks and operational incidents are therefore limited. This also makes it a challenge to assess both the level of and changes in digital vulnerabilities.

Extensive outsourcing has resulted in the concentration of ICT operation and development in the hands of a small number of service providers. This entails a concentration risk that is difficult to manage for the individual financial market infrastructure owner. A disruption among critical ICT service providers may affect important components of the payment system and other critical functions.

Climate risk also impacts the financial system

Climate change and society’s response to it may affect all parts of the economy and entail risks to financial stability. Climate risk is associated with both the physical consequences of climate change and the consequences of transitioning to a low-carbon economy. In Norway, the oil and gas industry will be the most relevant source of transition-related credit risk Norge. In recent years, Norwegian banks have reduced their oil sector exposures, but the oil industry is still important (see Section 4 Climate risk).

Large losses for the banking sector overall are not likely before a structural decline in oil-related activities results in significant spillovers to the wider economy. In addition, other industries currently subject to low or no carbon pricing may be at risk if carbon pricing or emissions standards are introduced or increased. Banks are particularly vulnerable if such spillover effects affect loans secured on real estate, which constitute the largest share of banks’ exposures.

1.3 Measures to mitigate vulnerabilities

Following the financial crisis, there has been broad international cooperation to increase financial system resilience. A range of measures have been introduced in Norway (see Table 1.1), with many others being formulated or amended.

Banks

Proposal to increase the systemic risk buffer

Some parts of the EU capital rules (CRR/CRD IV) have not been introduced in Norway, but are now set for inclusion in the EEA Agreement and Norwegian law. These rules will likely enter into force during 2019, and Norwegian and European rules will become more harmonised. The changes will allow banks to report higher capital ratios without raising solvency levels. In June, the Ministry of Finance circulated for comment proposed adjustments to the requirements, including increasing the systemic risk buffer from 3% to 4.5%. In its consultation response6, Norges Bank supported the increase (see Section 2 Bank profitability, solvency and funding).

Recovery and resolutions plans being finalised

On 1 January 2019, new bank recovery and resolution rules for Norwegian banks in line with the EU framework entered into force. These rules are intended to provide a solid framework for managing troubled banks. Finanstilsynet intends to finalise recovery and resolution plans for the nine most important Norwegian banks by year-end. The resolution and recovery plan for each bank will set minimum requirements for own funds and eligible liabilities (MREL) (See Section 2 Bank profitability, solvency and funding).

Households

Proposal to tighten the regulation on residential mortgage loans

The regulation on requirements for new residential mortgage loans7 is intended to mitigate the risk of a substantial increase in debt among particularly vulnerable households. In September, the Ministry of Finance circulated for comment a proposal by Finanstilsynet to retain the regulation. Finanstilsynet recommends tightening the maximum debt-to-income (DTI) ratio (from 5 to 4.5) and the flexibility quota provision (from 10% to 5%), and repeal the Oslo-specific requirements. In its consultation response8, Norges Bank supported retaining the regulation, application for an indefinite period of time and nationally consistent requirements. In Norges Bank’s opinion, the maximum DTI requirement should not be changed.

Regulation on consumer credit introduced

The authorities have issued a new regulation on prudent standards for new consumer credit (Regulation on requirements for financial institutions’ consumer credit standards9), which entered into force in February 2019 and will remain in force until the end of 2020. The requirements in the consumer credit regulation largely echo the requirements in the regulation on requirements for new residential mortgage loans. A potential tightening of the maximum DTI in the latter regulation may therefore also have consequences for the former.

Credit registers have been established

The Debt Information Act is intended to improve the credit assessments of financial institutions that lend to retail customers and prevent debt problems from arising. From 1 July 2019, financial institutions are required on a daily basis to report debt information to credit registers on retail customers with unsecured debt.

Financial infrastructure

Strengthening cybersecurity10

To enhance cyber resilience and promote financial stability, the European Central Bank (ECB) the European framework for Threat Intelligence-based Ethical Red Teaming (TIBER-EU) for testing financial institutions’ detection, protection and response capabilities against sophisticated cyber attacks. Several neighbouring countries, including Denmark and Sweden, have introduced or are preparing to introduce TIBER-EU. Finanstilsynet and Norges Bank have invited the industry and relevant authorities to a dialogue to assess the suitability of introducing TIBER-EU in Norway.11

Over the past year, a number of international organisations have published further cyber security guidelines and frameworks. On 24 September 2019, the IMF published the report Cybersecurity Risk Supervision12. EU has introduced the EU Cybersecurity Act. Work is also ongoing at the European Systemic Risk Board (ESRB) to understand systemic cyber risk in the EU and assess whether cyber incidents may pose a financial stability threat. Norges Bank is participating in this work.

Follow-up of concentration risk, supervision and contingency arrangements

The ICT Security Commission, which presented its report in December 2018, has proposed measures to enhance the organisation and regulation of national ICT security.13 In its consultation response to the Ministry of Justice and Public Security, recommends further study of concentration risk, supervisory frameworks and contingency arrangements with a view to making specific proposals to address them (see Financial Infrastructure Report 2019).

Strengthening back-up arrangements for cash

Electronic contingency arrangements are the first line of defence in the event of a disruption in the payment system. Cash is a part of overall contingency preparedness. In 2018, the Ministry of Finance laid down a regulation14 to clarify banks’ obligation to supply cash in a contingency situation. For cash to function in a contingency, it must also be available and easy to use in a normal situation as well. Norges Bank is of the opinion that the current provision of cash services is not fully satisfactory and that a regulation governing the provision of cash services in a normal situation is needed.15

2 Bank profitability, solvency and funding

For Norwegian banks, credit losses are low and profitability is solid. Sustained profitability is expected in the coming years. Downside risks are higher losses and reduced margins owing to increased competition between banks and from new entrants.

Banks are solid and fulfil the capital requirements. The remaining parts of the EU capital framework will likely be implemented soon in Norway. Norwegian and European rules will then become more harmonised.

Norwegian banks have ample access to funding. They satisfy liquidity requirements and their vulnerability to a dry-up of short-term foreign currency funding is reduced. Finanstilsynet (Financial Supervisory Authority of Norway) aims to set resolution plans and requirements for own funds and eligible liabilities for the nine most important Norwegian banks by year-end 2019. In Norway, future regulations may permit securitisation, which is a new funding source for lending.

Banks play a key role in the economy and perform important tasks such as channelling funds, executing payments and distributing risk efficiently. Banks’ ability to absorb credit losses depends on underlying profitability and solvency. Robust liquidity is also important in order for banks to carry out their tasks well, even during periods of funding market stress.

2.1 Profitability

Continued solid profitability among Norwegian banks

The large Norwegian banks have maintained their profitability over the past year and are, together with Swedish banks, at a high level compared with other European banks (Chart 2.1).

Chart 2.1 Return on equity after tax. Large Norwegian banking groups1 and European2 banks

Four-quarter moving weighted average. Percent. 2016 Q1 – 2019 Q2

1) Weighted average of DNB Bank, Nordea Bank Norge (to 2016 Q4), SpareBank 1 SR-Bank, Sparebanken Vest, SpareBank 1 SMN, Sparebanken Sør (from 2016 Q1), SpareBank 1 Østlandet (from 2016 Q3) and SpareBank 1 Nord-Norge. Consolidated figures.

2) Based on a sample of 150 European banks. The sample varies over time.

Sources: European Banking Authority (EBA), Norwegian banking groups' quarterly and annual reports and Norges Bank

Stable net interest income and low credit losses have enabled Norwegian banks to maintain profitability (Chart 2.2). Banks’ primary revenue source is net interest income from traditional banking. The increase in net interest income improved the profitability of the largest Norwegian banks in 2017, 2018 and in the first half of 2019 (Chart 2.3). Lending rates have risen more than deposit rates, resulting in higher interest margins in recent quarters.

Chart 2.2 Decomposed change in profits. Large Norwegian banking groups1

As a percentage of average total assets. 2009 Q1 – 2019 Q2

1) Weighted average of DNB Bank, Nordea Bank Norge (to 2016 Q4),

SpareBank 1 SR-Bank, Sparebanken Vest, SpareBank 1 SMN, Sparebanken Sør (from 2014 Q1), SpareBank 1 Østlandet (from 2016 Q3) and SpareBank 1 Nord-Norge.

2) Commission income from part–owned mortgage companies in the SpareBank 1–alliance has been reclassified from other operating income to net interest income.

Sources: Bank's quarterly reports and Norges Bank

Chart 2.3 Estimated contributions to changes in large Norwegian banking groups'1 return on equity after tax

Four-quarter moving weighted average of annualised return. Percentage points. 2016 Q1 – 2019 Q2

1) Weighted average of DNB Bank, Nordea Bank Norge (to 2016 Q4), Sparebank 1 SR-Bank, Sparebanken Vest, Sparbanken Vest, SpareBank 1 SMN, Sparebanken Sør (from 2014 Q1), SpareBank 1 Østlandet (from 2016 Q3) and SpareBank 1 Nord-Norge.

2) Commission income from part–owned mortgage companies in the SpareBank 1–alliance has been reclassified from other operating income to net interest income.

Sources: Banks' quarterly reports and Norges Bank

Profitability expected to be maintained

Mainland GDP is expected to slow somewhat in the coming years (see Monetary Policy Report 3/19). Bank analysts’ average projection of the largest banking groups’ profitability for the coming years is at broadly the same level as in recent years (Chart 2.4). Norges Bank’s bankruptcy probability model1 indicates that banks’ credit risk on loans to non-financial enterprises will be fairly stable in 2019 and increase slightly in 2020. With prospects for continued low credit losses and the absence of major economic shocks, banks as a whole are therefore expected to maintain solid profitability in the coming years.

Chart 2.4 Analysts' estimates of return on equity in large Norwegian banking groups1

Percent. At 31 October 2019

1) As reported in banks' annual reports in 2018. The high profitability in 2019 reflects extraordinary revenues.

Sources: Banks' annual reports and Bloomberg

European banks’ profitability under pressure from negative interest rates

The profitability of large Danish banks has weakened in recent quarters (Chart 2.1), owing in part to the low interest rate level. Swedish, Danish and euro area money market rates have been negative since 2015. Banks are reluctant to offer negative deposit rates as depositors have the option of withdrawing their deposits in cash rather than pay a negative deposit rate. In spite of negative money market rates, average Swedish and Danish deposit rates are not negative.

Since banks’ wholesale funding includes a risk premium on top of the money market rate, the interest rate on wholesale funding can be positive even when the money market rate is negative. With deposit rates close to zero, wholesale funding costs will account for most of banks’ total interest expenses. This was the case for Handelsbanken, Swedbank, Danske Bank and Nordea in the period 2016–2018 (Chart 2.5). Deposit rates in Norway are positive, and for DNB deposit costs account for a large share of interest expenses. With a deposit rate close to zero, a further reduction in the interest rate level will likely merely reduce the cost of wholesale funding.

Chart 2.5 Large Nordic banking groups' interest expenses, interest income and net interest income

As a percentage of total assets. 2016–2018

1) 3-month Nibor, Stibor, Cibor and Euribor.

Sources: SNL / S&P MI, Refinitiv and Danske Bank's annual report

Reduced operating costs or increased revenue may compensate for the cost disadvantage of a limited pass-through to deposit rates when the money market rate is negative. Revenue can primarily be increased through higher lending growth, higher fees and higher lending margins. Banks in Sweden have kept their lending rates elevated, which has contributed to sustaining the level of net interest income (Chart 2.6). In Denmark, the low level of interest rates and falling interest margins have resulted in lower net interest income.2 Fee income has been relatively stable in Norway, Sweden and Denmark.

Chart 2.6 Operating income for selected banking groups in Norway, Sweden and Denmark1

As a percentage of total assets. 2010 Q2 – 2019 Q2

1) Norwegian banks: DNB, SpareBank 1 SR-Bank, SpareBank 1 SMN, SpareBank 1 Nord-Norge and Sparebanken Vest. Swedish banks: Handelsbanken, SEB and Swedbank. Danish banks: Danske Bank, Jyske Bank, Spar Nord Bank and Sydbank.

Source: SNL / S&P MI and Norges Bank

If interest rates remain very low or negative over a long period, structural changes may result in the financial system, which could also impact banks.3 Over time, depositors may opt for higher-risk investments, such as mutual funds, rather than keep their money in a bank at zero interest. Low interest rates over an extended period may also fuel a credit-driven rise in prices for assets such as equities and real estate. Low interest rates also make it difficult for pension and insurance companies to meet the rate-of-return guarantees for their pension products.

Risk of increased losses

Some uncertainty still remains about the need for further restructuring in oil-related enterprises. Such restructuring has inflicted losses on banks in recent years. The losses proved to be somewhat lower than initially expected following the fall in oil prices in 2014, and spillovers to other sectors have been more modest than assumed. Persistent overcapacity in segments of the oil service industry may lead to further restructuring accompanied by losses, since the debt-servicing capacity of many oil service companies has weakened in recent years (Chart 2.7). Banks’ direct oil-related exposures are nevertheless limited and account for less than 5% of total exposures (see "Banks and the experience gained from the downturn in the oil industry").

Chart 2.7 Debt-servicing capacity1 in the oil service industry

Percent. 2014 Q1 – 2019 Q2

1) Earnings before interest, taxes, depreciation and amortisation (EBITDA) for the last four quarters as a percentage of net interest-bearing debt. The EBITDA measure has been standardised by Bloomberg. Manual adjustments for EBITDA have been made where erroneous registrations appear in Bloomberg's measure.

Sources: Bloomberg, company quarterly and annual reports and Norges Bank

A substantial share of banks’ exposures is to commercial real estate (CRE) (Chart 3.8). Commercial property prices are at a high level (Chart 1.11). The rise in prices has often been strong prior to a substantial fall. Even though losses have historically been low in normal times, CRE is the sector where banks have historically incurred the larges losses during crises. The stress test in Section 3 shows banks’ vulnerability to CRE losses in the event of a pronounced downturn in the Norwegian economy.

Prospects for increased competition

Technological and regulatory developments are allowing the competitive landscape to change with the entry of new service providers in areas that are important for banks’ profitability.

Crowdfunding, or extending credit through digital platforms, is an example of how new participants can impact competition in the credit market. The extent of crowdfunding so far has been very limited and had no impact on banks’ profitability in Norway. In spring 2019, Norges Bank conducted a survey of all active participants engaged in debt- and equity-based crowdfunding in Norway.4 Debt-based crowdfunding accounts for the largest share of financial crowdfunding.5 Total lending in the period between 2018 Q1 and 2019 Q1 amounted to approximately NOK 110m (Chart 2.8). Lending to real estate projects and enterprises account for the largest share of lending. The share of consumer credit was approximately 5% and is growing.

Chart 2.8 Cumulative lending by crowdfunding companies by sector. In millions of NOK

2018 Q1 – 2019 Q1

Source: Norges Bank

The revised Payment Services Directive (PSD2) entered into force in Norway on 1 April 2019.6 PSD2 may provide customers with improved and less expensive banking services. The Directive permits third-party providers (TPPs) to offer account information services (AIS) and execute payments on behalf of banks’ customers. The TPPs are either new entrants or banks that already operate in the market. This may promote new services that facilitate comparison shopping for banking services. For example, a number of banks have upgraded their online banking platforms to enable customers to view multi-bank account details under a single portal.

By improving market transparency, PSD2 may promote competition in banking services and put pressure on banks’ interest margins and fee income. The effects of PSD2 on banks’ income will depend on how they adapt. Banks may strengthen customer loyalty by changing their services so that they are less vulnerable to increased competition. An example of this is customer dividends, which savings banks, for example, distribute to customers on the basis of amounts borrowed or on deposit over the preceding year. Banks may also offer customers benefits for purchasing services with lock-in periods or for purchasing bundled products.

If profitability in the Norwegian banking market continues to be higher than what foreign banks are able to attain in their domestic markets, foreign banks may want to increase their activity in the Norwegian market. Increased competition from foreign banks may put pressure on interest margins and reduce profitability in the Norwegian banking market. Foreign-owned banks and foreign branches already have a substantial share of both the retail and corporate lending markets (Chart 2.9).

Chart 2.9 Market shares measured by gross lending

Large banking groups in Norway. Percent. At 31 December 2018

1) Nordea, Danske Bank and Handelsbanken.

Source: Norges Bank

2.2 Solvency

Banks have increased their Common Equity Tier 1 (CET1) ratios since the financial crisis in 2008 (Chart 2.10), primarily by retaining earnings. In 2018, banks’ capital ratios were broadly unchanged, even though their profitability was solid. The dividend payout ratios for most of the large banks were, with few exceptions, unchanged in 2018 compared with 2017. Increased lending, including corporate lending, resulted in an increase in risk-weighted assets and kept capital ratios unchanged. Nevertheless, all Norwegian banks fulfil the capital requirements. The large banks’ CET1 capital ratios are near their long-term capital targets (Chart 2.11). The stress test shows that Norwegian banks have sufficient capital to absorb losses in the event of a hypothetical pronounced downturn in the Norwegian economy (See Section 3 Stress test).

Chart 2.10 Norwegian banks' Common Equity Tier 1 (CET1) capital ratios1

Share of risk-weighted assets and total assets. Percent. 1996–2018

1) Consolidated figures where available. Parent banks otherwise.

Source: Finanstilsynet (Financial Supervisory Authority of Norway)

Chart 2.11 Largest Norwegian banking groups' Common Equity Tier 1 capital ratios, leverage ratios and long-term capital targets

Percent. At 30 June 2019

Sources: Banks’ quarterly reports and Norges Bank

Norges Bank supports the Ministry of Finance’s proposed changes to capital requirements

The remaining portions of the EU capital framework (CRR/CRD IV) will likely be implemented in Norway soon. Norwegian and EU rules will then become more harmonised. As a part of this, the capital requirement for exposures to small and medium-sized enterprises will be reduced (SME discount). The SMB discount will provide the greatest capital relief to banks using the standardised approach, with high shares of SME exposures. In addition, rules will be relaxed for banks using internal ratings-based models (IRB banks), which will not be required to use the Basel I floor for risk-weighted assets when calculating their capital ratios. Both of these changes will allow banks to report higher capital ratios without changing solvency levels. For the largest IRB banks, the removal of the Basel I floor will have the most pronounced impact (Chart 2.12).

Chart 2.12 Effects of introducing CRR/CRD IV on CET1 ratios. Largest Norwegian banking groups

Percentage points. At 30 June 2019

1) Banks' estimates.

Source: Banks' quarterly reports and presentations

In June, the Ministry of Finance circulated for comment proposed adjustments to the capital requirements for banks, with a consultation closing date of 30 September. The proposed adjustments are intended to keep the capital requirements at a level that corresponds to risks in the Norwegian economy. The proposal also entails an increase in the systemic risk buffer from 3.0% to 4.5%. The Ministry has also proposed a temporary 35% floor for average risk weights for Norwegian commercial real estate (CRE) exposures, reflecting the wide variation in the risk weights for CRE exposures and thus the amount of capital underlying them (Chart 2.13 and "Material differences in risk weights for commercial real estate exposures").

Chart 2.13 Banks' average risk weights for commercial real estate (CRE) exposures

Required share of CRE exposures financed by CET1.1 Percent. At 31 December 2018

1) The total CET1 requirement is the sum of Pillar 1 requirements, hard Pillar 2 requirements and soft Pillar 2 requirements. A soft Pillar 2 requirement of 1% is assumed for Norwegian banks. The hard Pillar 2 requirement for standardised-approach banks is equal to the equally weighted average of the requirement for 79 Norwegian standarised-approach banks.

Sources: Banks' Pillar 3 reports, Finansinspektionen and Norges Bank

The Ministry of Finance intends to ask the European Systemic Risk Board (ESRB) to issue a recommendation to EU member state authorities to recognise the Norwegian requirements so that they will also apply to foreign banks with operations in Norway. This is desirable for financial stability reasons and for securing a level playing field for Norwegian and foreign banks. Norges Bank holds the view that it will be natural to apply the current systemic risk buffer rate in the host country.

Norges Bank supports the proposed increase of the systemic risk buffer.7 The Bank also supports the principle that the systemic risk buffer should be reviewed every other year and in this regard, will perform necessary assessments of systemic risk. Banks have substantial exposures to the real estate sector, through both residential mortgages and CRE loans. These exposures have increased since the systemic risk buffer requirement was introduced in 2013. Moreover, banks are closely interconnected, for example, through cross-holding of covered bonds.

2.3 Funding

Favourable funding conditions in capital markets

Along with customer deposits, bonds and short-term paper account for the most important funding sources for Norwegian banks. Norwegian banks and mortgage companies have ample access to wholesale funding in both NOK and foreign currency. Higher funding costs for Nordic banks under investigation for violating anti-money laundering rules have not spread to Norwegian banks. Greater focus on climate risk can have an impact on Norwegian banks’ funding costs owing to the oil industry’s importance for the Norwegian economy (see Section 4 Climate Risk).

Low yields on safe government securities have made investments with higher risk and higher expected returns more attractive to investors. This has reduced risk premiums on banks’ wholesale funding and created favourable funding conditions, also for Norwegian banks (Chart 2.14). Since Financial Stability Report 2018, uncertainty regarding future interest rate levels has increased, and long-term interest rates have fallen further globally (Chart 1.2). This may pull down banks’ funding costs further. At the same time, uncertainty related to trade tensions and Brexit may increase risk premiums in the short term and worsen banks’ access to wholesale funding.

Chart 2.14 Risk premiums in Norway.1 Spread over 3-month Nibor

Five-year maturity. Basis points. 7 January 2011 – 24 October 2019

1) On bonds issued by large Norwegian banks and mortgage companies in the Norwegian market.

Source: Nordic Bond Pricing

New requirements for reference rates

Reference rates play a pivotal role in the financial system. They simplify financial contracts by eliminating the need for agreement on the rate that will serve as the basis for each individual contract entered into.8 The value of loans and various financial products linked to reference rates is very high. The reference rate NIBOR must be adapted to new EU requirements (the Benchmarks Regulation) that will apply in Norway through the EEA Agreement. The rules are intended to ensure confidence in the reference rates among market participants and other parties (see "Towards more robust norwegian reference rates").

Norwegian banks dependent on covered bonds

Two-thirds of banks’ funding in the bond market comprises covered bonds (Chart 2.15). Norwegian banks and mortgage companies are the largest investors in the covered bond market, holding over 50% of the total. Most of the bonds are held as liquidity reserves. At the end of June 2019, covered bonds accounted for over half of banks’ liquidity reserves in NOK (Chart 2.16).9

Chart 2.15 Outstanding wholesale funding. Norwegian banks and covered bond mortgage companies

By bond and currency. Percent. January 2007 – September 2019

Sources: Bloomberg and Stamdata

Chart 2.16 Stock of liquid assets in NOK by asset type

Norwegian banks.1 After haircut and before caps. Percent. At 30 June 2019

1) Consolidated figures where available. Parent banks otherwise.

Source: Finanstilsynet (Financial Supervisory Authority of Norway)

Norwegian banks’ substantial covered bond holdings amplify the interconnectedness of Norwegian financial institutions and may constitute a systemic risk. This may intensify liquidity problems for Norwegian banks in situations where funding dries up and many banks are forced to liquidate large covered bond holdings at the same time. The value of the banks’ liquidity portfolio could then rapidly decline. A concurrent fall in house prices may worsen liquidity problems and force further sales of liquidity reserves.10 It is therefore important that banks’ liquid assets under the Liquidity Coverage Ratio (LCR) requirement can be traded without causing appreciable price changes.

Predicting the behaviour of market participants in a crisis is difficult due to limited experience as to how easily covered bonds can be traded and issued or to what extent their value will hold up against a fall in house prices. In periods of market turbulence, the liquidity of covered bonds has deteriorated less than that of unsecured bank bonds. An analysis of contagion effects in the banking sector illustrates how connectedness will affect banks’ capital ratios (see "Assessment of contagion effects in the banking sector").

Lower vulnerability to short-term foreign currency funding dry-up

Many international banks, including DNB, fund lending with short-term deposits and short-term paper in foreign money markets. Such short-term wholesale foreign currency funding accounts for about 12% of bank funding.

Short-term funding must be rolled over frequently, and it has been shown that such funding may dry up in turbulent times. Historically, professional investors such as money market funds, large companies and other banks have been quick to withdraw deposits from banks in which they have lost confidence. Mandate changes among institutional investors may also result in unexpected shifts in banks’ access to short-term funding.

Short-term foreign currency funding is largely invested in liquid and secure assets such as central bank deposits and other highly liquid securities. The share of short-term foreign currency funding that is not placed in central banks has declined in recent years and is now approximately 3% of total assets (Chart 2.17). The maturity of banks’ short-term foreign currency funding has also lengthened somewhat, possibly indicating that Norwegian banks have become less vulnerable to a dry-up of short-term foreign currency funding.

Chart 2.17 Short-term funding and central bank deposits in foreign currency1

Norwegian banks. Share of total assets. Percent. 2009–20192

1) Comprises deposits from foreign customers and central banks, and debt securities with less than 12 months' residual maturity.

2) Annual data at 30 June.

Source: Norges Bank

Norwegian banks satisfy the LCR requirements.11 The total LCR and the LCR in NOK have been high and stable over the past few years (Chart 2.18). However, banks may be vulnerable if they lose access to funding over the LCR’s 30-day horizon. A Net Stable Funding Ratio (NSFR) requirement may reduce these vulnerabilities. The NSFR is now finalised and adopted by the EU, but has not yet been transposed into Norwegian law. Nevertheless, Norwegian banks have reported their NSFRs for several years and satisfy the minimum requirement (Chart 2.19).

Chart 2.18 Liquidity Coverage Ratio (LCR)

Norwegian banks.1 Percent. July 2014 – June 2019

1) Consolidated figures where available. Parent banks otherwise.

Source: Finanstilsynet (Financial Supervisory Authority of Norway)

Chart 2.19 Net stable funding ratio (NSFR)

Norwegian banks.1 Percent. 2016 Q2 – 2019 Q2

1) Consolidated data where available. Parent banks otherwise.

2) DNB, SpareBank 1 SR-Bank, Sparebanken Vest, SpareBank 1 SMN, Sparebanken Sør, SpareBank 1 Østlandet and SpareBank 1 Nord-Norge.

3) Banks with total assets above NOK 10bn.

4) Banks with total assets below NOK 10bn.

Source: Finanstilsynet (Financial Supervisory Authority of Norway)

New requirement for banks’ own funds and eligible liabilities

On 1 January 2019, a new regulatory framework for bank recovery and resolution in Norway entered into force.12 The underlying principle is that if a bank is in trouble, the bank’s shareholders and then creditors must bear the losses and contribute towards the bank’s recapitalisation and taxpayer funds should not be used. For the efficient resolution of a bank that loses all or part of its equity, it must have own funds and eligible liabilities that can quickly be written down and/or converted to new equity (bail-in). Finanstilsynet aims to set resolution plans for the nine most important Norwegian banks by end-2019.13 In the resolution plans for these banks, minimum requirements for own funds and eligible liabilities (MREL) will be set.14 The requirements will be published.

For Finanstilsynet, an important principle is that MREL is met with either regulatory capital or with liabilities that rank below ordinary unsecured senior bonds, called subordinated liabilities. When MREL liabilities are subordinated, national resolution authorities can more easily treat creditors with the same priority equally when bail-in tools are applied at a failed bank.

Securitisation: a new funding source for lending

The EU has established a common securitisation framework, which entered into force 1 January 2019. One of its aims is to remedy the weaknesses that were revealed during the global financial crisis. Large losses were incurred on US securitised bonds, largely owing to the bonds issued for immediate resale, under the originate-to-distribute model. This model was little used in Europe, and losses associated with European securitisation were relatively moderate.

Securitisation is in practice currently not feasible in Norway. The Ministry of Finance has recently circulated for comment a proposal to implement the EU’s Securitisation Regulation in Norwegian law.15 The regulation includes general rules on securitisation and sets the criteria for a new class of simple, transparent and standardised (STS) securitisations.

Securitisation takes place when banks sell their loans to special purpose vehicles (SPVs), which fund the purchase of these loans by issuing securities in the market. Securitisation creates new opportunities for funding and risk management for banks, borrowers and investors.

The extent of securitisation remains fairly modest in the European countries where this form of financing has been used for some time. If securitisation were to reach the same extent in Norway as the average of these countries, it would amount to just over NOK 300bn or approximately 7% of banks’ and mortgage companies’ total lending.

3 Stress test – banks’ response to a pronounced downturn

The stress test analyses the impact on banks’ credit losses, capital ratios and behaviour in the event of a pronounced economic downturn. Banks have built up a substantial capital buffer since 2013, and the countercyclical buffer rate at the start of the stress scenario has increased since Financial Stability Report 2018, strengthening their resilience to a pronounced economic downturn.

The stress test shows that, on the whole, banks’ capital buffers are sufficient to absorb losses that may arise in a downturn, but banks may nevertheless tighten lending considerably. This may amplify an economic downturn. Owing to differences in exposure to various sectors, the impact of a downturn may be more pronounced for some banks than for others. An analysis of interconnectedness between banks shows that fire sales of securities may lead to further falls in banks’ capital. The stress test shows that banks can maintain credit supply by drawing on buffers.

3.1 Stress scenario

The purpose of the stress test is to analyse the macroeconomic effects of banks’ behaviour in the event of a pronounced downturn in the Norwegian economy. To enable banks to meet credit demand and conduct other business, banks must have sufficient capital when a crisis erupts. The analyses are framed to assess how banks are affected by, and how they themselves affect economic developments.1

Financial imbalances amplify the downturn

As a number of empirical calculations show that crises are more serious when preceded by a build-up of financial imbalances, Norges Bank seeks to cross-check the depth of the crisis against the Bank’s assessment of financial imbalances. A broad range of indicators and methodologies is applied to shed light on how severe the downturn can be (see "The Stress scenario reflects financial imbalances").

The stress scenario is based on a pronounced, but conceivable, downturn in the Norwegian economy (see Table 3.1). The methods used indicate a 5% probability that mainland GDP will fall as much or more than assumed in the stress scenario. In line with the balance of risks for the Norwegian economy, the downturn is about as severe as in Financial Stability Report 2018.

Table 3.1 Macroeconomic aggregates in the stress scenario. Percentage change from previous year1

1 Unless otherwise stated. Levels are measured as annual averages.

2 Projections for 2019 Q3 to 2019 Q4 for mainland GDP, private consumption, unemployment, 3-month Nibor, house prices and credit to households are from Monetary Policy Report 3/2019.

3 Projections for 2019 Q3 to 2019 Q4 for commercial property prices are based market participants’ price forecasts.

4 The higher premiums only have an effect on new bonds.

5 Change in stock measured at year-end.

6 Impairment losses based on IFRS 9.

Sources: CBRE, Eiendomsverdi AS, Entra, Finn.no, NAV, Real Estate Norway, Statistics Norway and Norges Bank

The stress scenario is not a forecast of how the economy will develop in the event of a pronounced downturn, but what may happen when financial imbalances have built up. In a crisis, the authorities would typically implement a number of extraordinary measures to achieve economic policy objectives. During and following the 2008 financial crisis, for example, many countries loosened fiscal policy, and several central banks undertook large-scale asset purchases. The financial crisis showed that banks’ pre-crisis capital levels were inadequate. The stress test focuses on the dampening impact of time-varying capital requirements on a downturn. Therefore no extraordinary fiscal or monetary policy measures are applied in the stress test. As a technical assumption, the policy rate is set at zero. In principle, a higher countercyclical capital buffer from the end of 2019 and a policy rate higher than in Financial Stability Report 2018 provide somewhat more flexibility in the use of tools.

In line with the global risk outlook described in Section 1 Financial stability outlook, a marked reduction in global GDP and increased risk premiums are assumed in financial markets. This may be because of rapidly growing protectionism and trade tensions, which reduce global trade and fuel uncertainty. The limited monetary and fiscal space still evident in many countries may amplify the global downturn. In the stress scenario, oil prices fall by about 40% owing to lower global trade.

Norway is a small open economy and the international developments in the stress scenario contribute to a pronounced downturn in the Norwegian economy. Despite setting the policy rate in Norway at zero, the money market rate remains elevated owing to increased risk premiums. Even though there is increased turbulence in financial markets, banks are assumed to have access to wholesale funding during the stress period, which may underestimate the effects on the Norwegian economy as historical episodes show that investors can choose to stop funding Norwegian banks in the event of uncertainty about bank solvency. Climate risk may also lead to bank losses, and uncertainty about climate exposure may result in funding problems (see Section 4 Climate risk). Any liquidity problems may amplify the financial crisis.

Financial market developments result in losses on banks’ securities portfolios. The value of banks’ stock of equities is written down by 40% and fixed-income instruments by 5% in 2020. The value of these instruments is kept unchanged thereafter.

Vulnerabilities associated with high household debt-to-income ratios and elevated property prices amplify the downturn. In line with international experience during crises, an abrupt fall in property prices is assumed at the start of the stress scenario. Historical experience also suggests that commercial property prices are more volatile than house prices. It is therefore assumed that the price level will be reduced by almost half in the course of the stress period (Chart 3.1). In the light of reduced income expectations and falling property prices, private consumption is sluggish and housing investment falls sharply. There is a marked reduction in investment willingness in the business sector.

Chart 3.1 House1 prices and commercial property prices2

Index. 2019 Q4 = 100. 1982 Q1 – 2023 Q43

1) Seasonally adjusted and deflated by CPI-ATE.

2) Estimated selling prices per square metre for prime office space in Oslo. Average selling price for the previous four quarters. Deflated by the GDP deflator for mainland Norway.

3) Projections for 2019 Q3 – 2023 Q4. Projections for property prices in 2019 are based on market participants' price forecasts.

Sources: CBRE, Dagens Næringsliv, Eiendomsverdi, Entra, Finn.no, OPAK, Real Estate Norway, Statistics Norway and Norges Bank

Weaker economic growth leads to high credit losses

The combination of weak economic growth and elevated interest expenses push up banks’ credit losses (Chart 3.2). On the back of lower demand from households, oil-related industries and Norway’s trading partners, combined with reduced collateral values, banks’ losses on loans to non-financial enterprises rise markedly.

Chart 3.2 Loan losses as a share of gross loans to the sector

Historically (for all banks and mortgage companies) and in the stress scenario (for the macro bank). Percent. 1987–20231

1) Projetions for 2019 Q3 – 2023 Q4. Historical loss distribution is used to allocate loan losses to enterprises and households.

Sources: SNL / S&P MI, Statistics Norway and Norges Bank

The increase in credit losses is in line with the level observed during the Norwegian banking crisis. The sharp rise in credit losses in the event of a severe downturn is also in line with international experience (Chart 3.3). The relationship between activity levels and credit losses in the sample countries indicates that weaker economic developments are associated with higher credit losses. The correlation depends on the type of historical loss event covered. In the most common situations (around the median), credit losses rise substantially less than losses from tail events (the 95-percentile).

Chart 3.3 Loan losses as a share of total loans (vertical scale) and GDP measured relative to trend1 (horizontal scale)

Percent. 1979–20142

1) International data cover 19 OECD countries. Measures of recognised impairment losses and the sample of financial institutions vary across countries and time. GDP trend estimations use a two-sided HP filter with lambda = 100. The lines show the estimated distribution of loan losses based on quantile regressions with GDP as a deviation from trend and country-specific fixed effects. The lines include fixed level effects for Norway. 2) The number of observations varies across countries. The data set covers a total of 23 crises and is based on the dating of crises in Anundsen, A.K, K. Gerdrup, F. Hansen and K. Kragh-Sørensen (2016) "Bubbles and Crises: The Role of House Prices and Credit". Journal of Applied Econometrics, 31(7) November/December, pages 1291-1311.

Sources: National central banks, OECD, SNL / S&P MI, Statistics Norway and Norges Bank

In the stress scenario, the possible impact of new accounting rules for impairment recognition (IFRS 9) introduced in 2018 has also been taken into account. Under IFRS 9, recognition of credit impairment is based on more forward-looking assessments than under the previous accounting standard (IAS 39). The analyses in "How does IFRS 9 affect impairment recognition in bad times?" indicate that just before and during a pronounced downturn credit losses are higher under IFRS 9 than under IAS 39. There is reason to believe that the impact of IFRS 9 may be stronger the worse the economic outlook is at the start of a downturn. As the downturn in the stress test is substantially more severe than the downturns analysed in the box, the effects will be more pronounced. One possible effect of IFRS 9 is therefore illustrated by substantially bringing forward banks’ credit losses (Chart 3.4).

Chart 3.4 Loan losses as a share of gross loans in the stress scenario

Including and excluding assumed effects of IFRS 9. Percent. 2019–20231

1) Projections.

Sources: Statistics Norway and Norges Bank

3.2 Banks’ adjustment to capital requirements

The macro bank in the stress scenario is a weighted average of nine large Norwegian banks.2 In principle, the stress test focuses on developments in the macro bank and does not incorporate the effect of differences in the banks’ behaviour.

The average Pillar 1 Common Equity Tier 1 (CET1) capital requirement for the banks in the stress test is 13.8%.3 The macro bank must also satisfy the Pillar 2 requirement set by Finanstilsynet (Financial Supervisory Authority of Norway). The average Pillar 2 requirement is 1.8%, bringing the total capital requirement for the macro bank to 15.6%. The macro bank also holds an additional buffer above the total capital requirement, and at the start of the stress period, the macro bank has a CET1 ratio of 16.0%.4

High losses impair banks’ profitability

Large losses on loans and securities lead to weak results for the macro bank throughout the stress period. As a result, the macro bank’s CET1 capital falls markedly (Chart 3.5). By the end of the stress period, CET1 capital is almost 14.7% lower than at the beginning. At the same time, risk weights increase somewhat as a result of higher credit risk exposure. Both factors reduce the CET1 ratio (Chart 3.6).5

Chart 3.5 The macro bank's change in Common Equity Tier 1 (CET1) capital in the stress scenario and contribution from different components

Percent. 20191–20232

1) Figures for 2019 are based on simple projections for the second half of the year.

2) Projections for 2019 Q3 – 2023 Q4

Sources: SNL / S&P MI and Norges Bank

Chart 3.6 The macro bank's Common Equity Tier 1 (CET1) ratio and the CET1 ratio requirement under Pillar 1 and Pillar 21) under different assumptions about developments in banks' capital requirements

Percent. 2018–20232

1) Pillar 2 requirements for the banks in the stress test are weighted by their risk-weighted assets.

2) Projections for 2019–2023

Sources: Finanstilsynet (Financial Supervisory Authority of Norway), SNL / S&P MI and Norges Bank

The fall in the capital ratio is reduced by the macro bank’s adjustment to meet the capital requirement. Cost-cutting measures through the stress period keep operating expenses broadly unchanged as a share of operating income. In addition, the macro bank does not pay dividends in the stress period. Banks’ capacity to maintain interest margins in the event of a downturn is uncertain, but during the banking crisis, margins were relatively stable. Margins against borrowing costs are assumed to be held constant during the stress period. On the one hand, banks will want to increase lending margins to compensate for higher risk and increase their earnings, but lower credit demand pulls in the direction of lower lending margins. These effects counteract each other in the stress scenario and provide the basis for unchanged margins.

The results of the stress test are sensitive to assumptions regarding lending margins. If margins against borrowing costs are assumed to be 0.5 percentage point lower in the stress period, banks’ earnings will weaken considerably, in isolation. This deterioration corresponds to a fall in the macro bank’s CET1 ratio of around 3 percentage points during the stress period.6

The macro bank also reduces the fall in the capital ratio by tightening the supply of new loans. It does this by requiring better collateral and by trying to increase lending margins. Lower credit demand, owing to the weakness in the housing market and lower business investment, also contribute to reduced lending growth.7

More buffer capital restrains the tightening of bank lending

In the stress scenario, the countercyclical capital buffer rate is set at zero to mitigate the procyclical effects of tighter bank lending, reducing the macro bank’s total capital requirement to 13.1%.

Under the capital adequacy rules, the remaining buffer under Pillar 1 may also be drawn on in bad times. At the same time, drawing on the buffer entails restrictions on dividend, bonus and some other banking activities. Banks must give notification and then draw up a plan to restore compliance with the total capital requirement. If the consequences of breaching the total capital requirement are perceived as costly or uncertain, banks may be reluctant to draw on the buffers, even in the event of substantial losses. The same applies if banks’ lenders and investors require a high level of capital adequacy in order to continue to provide funding to banks.

Setting the countercyclical capital buffer requirement at zero dampens the downturn. If the buffer were kept at 2.5%, banks would further tighten lending to meet the buffer requirement (Chart 3.6). The result would be weaker GDP growth and a more pronounced fall in credit supply (Chart 3.7).8 A higher countercyclical capital buffer rate compared with the level in Financial Stability Report 2018 provides somewhat greater flexibility in the use of instruments and makes it somewhat easier for banks to maintain lending. The analysis shows the importance of banks having sufficient time-varying capital buffers before financial crises arise, which also reduces the risk of Norwegian banks’ debt-servicing capacity being called into doubt, resulting in funding problems.

Chart 3.7 Total change through the stress period in mainland GDP and credit under different assumptions about developements in banks' capital requirements.1

Percent

1) Defined as the cumulative deviation from an estimated trend for GDP and the deviation from an estimated trend at the end of the stress scenario for total credit. Trend GDP growth in constant prices is set at 1.2 percent and trend credit growth is set at 3.7 percent.

Source: Norges Bank

Substantial differences between banks can amplify an economic downturn

The result from the macro stress test is nuanced if it is taken into account that the impact varies across banks. Detailed information from Finanstilsynet about banks’ credit exposure by industry is used to allocate the macro bank’s losses in the corporate sector to specific industries. The macro stress test is based on banks’ reported probability of default (PD) and estimates for the share of credit exposure that is expected to be lost in the event of default, loss given default (LGD) (see "Finanstilsynet’s exposure database and loss distribution assumptions"). This allocation of credit losses represents just one of many possible scenarios. The purpose of the analysis is not to identify risk in individual banks, but to illustrate the importance of having sufficient capital buffers that can be drawn on when a crisis occurs.

Using this method, PD and LGD levels at the end of 2018 indicate that relative losses are largest in international shipping and for oil service enterprises, but the level of banks’ overall lending to these industries is not high. Commercial real estate (CRE) loans account for the largest share of banks’ corporate lending9, but banks report lower PD and LGD figures for this type of exposure than for lending to many other sectors. Based on historical observations of losses in crises, CRE losses are generally low through normal business cycles, but high in severe financial crises.10 The stress test scenario assumes a pronounced downturn. PD and LGD values for CRE are adjusted upwards to illustrate the potential for substantial CRE losses in such a situation.11

Chart 3.8 shows the importance of the different assumptions. The inner circle shows loans by industry. If loans to various industries are assumed to have the same risk characteristics, the distribution of credit losses will be the same as in the stress scenario. The middle circle shows loan loss distribution based on banks’ reported PD and LGD figures. The loss rate on CRE loans then declines. The loss rate on loans to the international shipping industry and to oil service enterprises rises. The outer circle shows loss rates on CRE loans based on an upward adjustment of PD and LGD. The loss rate on CRE loans then rises considerably.

Chart 3.8 The macro bank's lending by industry (inner circle), loss by industry based on engagement data (middle circle), and losses by industry with upwardly revised PD and LGD for commercial real estate lending (outer circle)

Percent of total corporate lending at 31 December 2018

Sources: Finanstilsynet (Financial Supervisory Authority of Norway) and Norges Bank

The exposures of the stress test banks vary considerably (Chart 3.9). The same applies to the PD and LGD values for the different exposures applied in the analysis. The impact on some banks will therefore be more pronounced than on others. All of the banks have substantial CRE exposures, but the share of CRE loans varies between 30% and 60% of their corporate lending. For most of the banks, international shipping accounts for a small share of corporate lending, but at least one bank extends more than 10% of its corporate loans to international shipping. Lending to oil service enterprises also varies among the banks.

Chart 3.9 Stress test banks' lending by industry

Percent of corporate lending. At 31 December 2018

Sources: Finanstilsynet (Financial Supervisory Authority of Norway) and Norges Bank

There is considerable uncertainty attached to individual banks’ adjustments to higher losses and the possible consequences of such adjustments. Banks with substantial losses may tighten lending considerably, and if they are large banks or several small banks, the economic downturn may be more pronounced than when only the macro bank is analysed. The macroeconomic consequences will be more limited if the largest losses are isolated to banks that are less important for the Norwegian economy.

Banks can also make other adjustments that reduce the need to tighten lending. One possibility is to issue new equity capital, which may be both costly and difficult at a time of financial turbulence, combined with a weak economic outlook. Another possibility may be to sell assets, but at distressed prices, this can entail considerable losses and inflict further losses on other banks through contagion effects.

Interconnectedness across banks may lead to further losses

Banks are interconnected as they are exposed to one another and as they hold the same or similar securities. An analysis by Norges Bank shows that contagion effects may lead to further losses in the Norwegian banking sector (see "Assessment of contagion effects in the banking sector"). This is primarily due to indirect contagion from fire sales of securities with subsequent price falls. In the Bank’s model, such contagion effects entail up to a 2 percentage point fall in the CET1 ratio, depending on the assumptions made.

One of the uncertainty factors in the analysis is what is needed to trigger a fire sale. In the model, banks have funding problems when CET1 ratios fall below a defined level, which may be, for example, because lenders doubt banks’ debt-servicing capacity. To improve liquidity, banks will attempt to sell off liquid assets. In some cases, price falls may be substantial, but even small falls are important when large holdings of securities are affected. If funding problems start even when there is a modest fall in capital ratios, more banks will have to conduct fire sales, resulting in higher losses.

The systemic risk buffer is a component of the total buffer requirement and is intended to cover structural vulnerabilities and the consequences of a closely interconnected financial system.12 The analysis shows that the interconnectedness of banks may amplify total losses and illustrates the importance of maintaining an adequate systemic risk buffer rate requirement.

4 Climate risk and the financial system

Climate risk is of significance for financial stability. Climate risk is related to both the physical impacts of climate change and the implications of the transition to lower greenhouse gas emissions. Climate change is a global challenge that must primarily be addressed by the political authorities, using instruments other than those available to central banks. The financial system must at the same time adapt to climate risk. Climate risk may expose the financial system to credit losses, and uncertainty about climate risk exposure may result in funding problems. Central banks and supervisory authorities can, within their mandates, promote financial stability by helping to pave the way for the financial sector to include climate risks in overall risk assessments and communicate relevant information and by ensuring that financial institutions have adequate capital to support all risks. For Norwegian banks and financial markets, transition risks, particularly related to the oil and gas industry, may be important in the years ahead.

4.1 Climate risk and financial stability

Climate change and society’s adaptation to climate change will affect all segments of the economy and entail risks to financial stability. It has been established with a high degree of certainty that climate change has occurred and will occur, and the probability of outcomes that are far more severe than the most likely outcomes is not negligible.1 At the same time, there is considerable uncertainty as to the magnitude and timing of the changes, what the correct response is today and what the response will actually be. Climate risk is thus a source of market failure that may contribute to mispricing and inefficient resource allocation for society (see "Climate risk and financial market failure").

Analyses of the economic implications of climate risk often make a distinction between physical risk and transition risk. Physical risk is linked to the direct impacts of climate change, such as temperature increases and more extreme weather. Transition risk is related to various forms of adaptation to lower emissions, such as changes in climate regulation, new technology and changing investor and consumer preferences.

For Norwegian banks, climate risk can entail loan losses, reputational risk and consequences for financing. For banks as a whole, an increase in losses on loans to the retail and corporate sectors will likely be the most important. The biggest lending risk comes from unexpected shifts that entail consequences for ongoing projects. Climate-related direct costs and losses can arise when climate risk is not assessed in the project planning. Unexpected changes in market expectations, consumer preferences and regulation may also occur, for example in the wake of climate-related natural disasters. Moreover, developments in climate-friendly technology can reduce the cost of, and hence increase the probability of, abrupt tightening of regulation of old technology. For example, new energy sources could make it easier to phase out of fossil energy.

Physical risk – biggest risk from global conditions

According to Norway’s Climate Risk Commission, Norway’s exposure to direct physical climate change is limited, and its capacity to adapt is relatively good.2 Physical risk may nevertheless affect Norwegian firms and households. Physical risk is often systematic, undiversifiable and its impact is always negative. Managing this risk is challenging for financial institutions and other economic agents.

Global climate change can lead to an increase in goods and services prices, and give rise to a substantial risk of escalating global conflict and new migration patterns.

In Norway, property, agriculture, transport, fish farming, tourism and other weather- and climate-dependent sectors could be exposed to physical climate risk as a result of floods, landslides, avalanches and temperature increases. The Norwegian National Scheme for Natural Damage Assistance, which is based on payments from insurance undertakings, covers to a large extent physical damage to property.3 Large insurance settlements can result in higher insurance premiums and have implications for future regulation of the Scheme. An increase in insurance premiums may therefore be a consequence of physical climate risk in exposed areas, which may in turn have an impact on property values and lending for those areas.

Transition risk – most relevant climate risk for banks now

Transition risk exists in most sectors that could be exposed to climate regulation, emissions pricing, or competition from new climate-friendly technology. In addition, changes in customer preferences and investor demands can lead to unexpected shifts that have implications for existing projects. This could entail an increase in credit risk for bank lending. Since different agents are impacted in different ways, transition risk is unsystematic.4 Transition risk may therefore be diversifiable. At the same time, banks’ exposures will be a reflection of the Norwegian economy and industry structure. This can limit Norwegian banks’ genuine opportunities for diversification.

Transition risk can lead to financing risk. Higher transition-related credit risk can lead to higher risk of loan losses and hence higher financing costs or shorter maturities for banks’ financing. Mandate changes and other investor demands can result in an unexpected shift in the willingness to finance. If funding markets consider that some banks are highly exposed to transition risk, their access to financing may suffer. This may in turn lead to reduced access to financing for firms and households, also for those with low transition risk. Transition risk may, like many other forms of risk, contribute to systemic risk.

In Norway, the oil and gas industry is the main source of transition-related credit risk. For the Norwegian economy as a whole, this risk has declined as national wealth has been re-allocated from petroleum resources to diversified foreign investments. For banks, risk is determined by credit exposure. The risk in the oil industry is related to both a possible decline in global oil demand and structural changes to adapt production. A substantial decline in oil demand as a result of changes in climate policy, customer preferences or technological developments likely lies many years ahead. Expectations of a change may nevertheless cause a shift already today, partly because Norwegian oil and gas fields have a long life with substantial initial investments. Return requirements for financing projects and companies operating in the oil-related industry have increased in recent years, and may increase further. Countries with large oil reserves may increase the supply of oil today in response to uncertainty about future oil prices. This could push down oil prices and weaken the debt-servicing capacity of oil-related companies in Norway.

Norwegian banks have reduce their exposure to the oil industry in recent years (Chart 4.1), but it remains important for Norwegian banks. The experience of the oil price decline showed that oil service companies were just as vulnerable to oil price movements as operators on the Norwegian shelf (see "Banks and the experience gained from the downturn in the oil industry").5

Chart 4.1 Developments in DNB’s oil-related exposures

Percent of EAD1. At year-end. 2014 – 20192

1) Exposure at default.

2) Data for 2019 are at 30 June 2019.

Source: DNB

Large losses for the banks as a whole will likely occur if a structural decline in oil-related activities have large spillovers on other sectors of the economy. Banks are especially vulnerable should the spillovers lead to a sharp fall in prices for commercial and residential property, which account for the largest share of banks’ lending.

Property can also be affected by transition risk through stricter building and energy consumption requirements. Commercial property renters may increasingly prefer energy-efficient buildings in the interest of their own climate reporting, reputation and costs. This could lead to a price fall and increased need for investment in older commercial properties, while new buildings may increase in value.

Industries that have low or no emissions pricing today may be exposed to transition risk further ahead. Agriculture and fisheries are two examples (Chart 4.2). Other examples are imported goods and international freight transport, to which Norwegian banks are heavily exposed. The banks will be affected by whether, how and how fast emissions pricing or requirements are phased in.

Chart 4.2 Emissions pricing in Norway

NOK per tonne CO2-equivalent (vertical scale) and millions of tonnes CO2-equivalent (horizontal scale). 2016

Sources: Ministryof Finace, Norwegian Environment Acency and Statistics Norway

Since 2008, Norway has participated in the EU Emissions Trading System (ETS). The system covers a number of industries, and sets a cap on total allowed emissions for the ETS sector, instead of regulating emissions for individual operators (Chart 4.2). Emission pricing is determined by emissions trading in a market, and the ETS allowances of each company determines who reduces emissions and to what extent. The authorities impose emissions reductions by reducing the total allowance over time. The price of emissions allowances increased sharply in the EU in 2018, owing to extraordinary allowance reductions6 (Chart 4.3). The EU is planning to reduce allowances annually in the period to 2030. The risk of a sharp price rise for climate emissions constitutes a transition risk, particularly for companies that cannot compensate through selling prices. Flexible adaptation options, such as the choice between buying allowances and investing to reduce emissions, can contribute to mitigating transition risk.

Chart 4.3 Price of CO2 European emissions allowance

In EUR. 1 January 2015 – 25 October 2019

Source: Bloomberg

Stricter climate requirements can hasten the introduction of new technology. For some companies, this will entail closures or restructuring, while other may gain competitive advantages. Norway has access to climate-friendly electricity production. The transition to lower emissions can therefore give rise to opportunities for Norwegian companies and lower credit risk for some corporate exposures.

Banks and the experience gained from the downturn in the oil industry

The evolution of US shale oil production over the past decade is a structural shift that has had an impact on Norwegian oil-related industries, requiring them to adapt. In assessing the transition risks arising from this shift, the experience gained from the oil price decline in 2014 may therefore be relevant.

Risk associated with banks’ oil-related lending increased following the oil price fall in 2014, particularly in the offshore segment. Risk weights rose for DNB’s oil, gas and offshore loans (Chart 4.A).1 Applying higher risk weights can be an effective tool for banks in their management of climate-related risk. The level of capital a bank must hold against these loans rises, inducing banks to raise the threshold for providing new loans. Higher risk weights can also lead to increased lending rates or tighter credit standards.

Chart 4.A Risk weights for DNB’s aggregate corporate loans and oil-related loans

Healthy IRB portfolios. Percent. At year-end. 2014 – 2018

Source: DNB

There is reason to believe that risk may be higher in a larger number of segments in a structural, climate-related downturn compared with a cyclical downturn. In a structural downturn, investors are less likely to inject fresh capital into an enterprise. The result may be lower collateral values, higher probability of default rates and thereby higher bank losses. Since banks’ exposure to oil-related industries make up less than 5%2 of banks’ total exposure at default (EAD), Norwegian banks are nonetheless well positioned to absorb such losses if these losses are spread over several years.3

1 Risk weights could fall if loan losses are low for a longer period.

2 At the end of 2015, oil-related exposure accounted for 5% of total EAD for the 16 largest banks, according to Finanstilsynet (Financial Supervisory Authority of Norway). The bank with the largest nominal oil exposure, DNB, has reduced its oil-related exposures by 40% between the end of 2015 and the first half of 2019.

3 The loss-absorbing capacity of the banks with the highest oil-related exposure was about 21% of oil-related loans at the end of 2015 (see Hjelseth I.N., L.T. Turtveit and H. Winje (2016) “Bank’s credit risk associated with the oil service industry”. Economic Commentaries 5/2016. Norges Bank.

4.2 Banks’ adaptation

The attention devoted to climate risk by banks, other financial institutions and investors has increased. In 2018, Finance Norway published a “Roadmap for Green Competitiveness in the Norwegian Financial Sector”. The Norwegian Climate Foundation took stock of the work on climate risk at the 10 largest banks in the Norwegian market.7 All the large banks reported that they had discussed climate risk at senior management level in the past year. Over half of the banks had assessed how climate risk could influence the banks’ business and 40% had analysed the impact of climate change on their loan portfolios. The banks are still in the initial phase of analysing climate risk and building expertise.

A better information basis for analysing climate risk

Banks have various adaptation options for reducing their own climate risk. Improved and more relevant reporting of climate risk by companies can enhance the information basis and support more appropriate pricing of climate risk. For banks, this can also help increase focus on such risk internally, and build investor confidence.8 Investors are likely to request such information. Many of the most oil-exposed banks have regularly described and updated risk assessments of their oil exposures since the oil price decline in 2014. Similar actions can be used for climate risk.

Diversification and green securities can influence risk in loan portfolios

Banks can reduce climate risk in their loan portfolios in several ways. As transition risk can be diversifiable, banks have the option of mitigating risk by reducing their exposure to loans with high transition risk.

An increase in credit risk on loans to industries as a result of a risk of higher emissions prices can be matched by exposures to low-emission industries. Such industries, such as climate-friendly electricity production, can benefit from higher emissions prices. At the same time, there may be other risks associated with such “green” investments, which must be taken into account.

In recent years, a market for securities with a certified climate profile has emerged, referred to as green securities. In addition to the diversification motive, demand for green securities may be attributable to different factors, such as investor preferences and mandates for green securities for reasons of sustainability and reputation. Moreover, investors may assume that investments with lower climate risk will generate higher returns. A green security does not, however, necessarily feature lower risk. Some green securities are linked to new technology, which historically have entailed high risk.

For the green securities market to function well over time, formal and standardised requirements that can be evaluated should be introduced. The absence of such requirements can create uncertainty about whether green financing is actually used for climate-friendly projects. There are various certification schemes that classify securities as green to varying degrees. The classification of green investments is based on third-party evaluations that are conducted by research organisations or certification companies. Oslo Børs has its own list of green bonds. The EU is working on establishing standardised definitions, but they have yet to be adopted.9

4.3 Relevant financial sector measures

Climate risk encompasses a broad range of conditions, which to a large extent lie outside of central banks’ area of operation and area of direct influence. Climate change is a global challenge, which must primarily be addressed by the political authorities and instruments other than those available to central banks. The financial system must, however, adapt to climate risk. Central banks and financial supervisory authorities cannot, within their mandates, promote financial stability by contributing to the inclusion of climate risk in the financial sector’s risk assessments. Climate risk must be managed in the same way as other risks facing the financial sector. Other types of risk may also be systematic and characterised by the fact that historical data have uncertain relevance for future risk. The instruments for strengthening banks’ resilience, such as capital requirements and macroprudential supervision, are thus basically the same as those used for managing other risks.

The authorities can contribute to improved assessment of climate risk

Managing the uncertainty associated with the magnitude and effect of climate change may entail substantial costs. Simplified approaches may ignore or overestimate climate risk. The authorities can promote knowledge-based public debate and help reduce uncertainty by setting disclosure standards. A common framework for information and analysis of climate risk can facilitate comparison and assessment of climate risk in individual institutions. It can support more appropriate risk pricing. Such standardisation processes are underway in the EU and other fora. International cooperation can be useful in this work (see box to the left).

Climate risk should be an integral part of financial risk assessments

Both banks and authorities should assess the extent to which climate risk affects financial risks, such as credit risk, financing risk and systemic risk. This should be taken into account in risk assessments and hence into assessments of whether banks have adequate capital and long-term financing. Climate risk can entail a need to strengthen banks’ resilience, but a range of mechanisms have already been introduced to ensure that banks have adequate capital to cover unexpected losses.

Norwegian banks estimate risk weights using a long loss history, which includes loss experiences in the aftermath of the oil price decline in 2014. There is reason to believe that models based on historical data will not capture the risk associated with long-lasting structural changes such as climate risk. It is therefore possible that banks’ risk weights underestimate climate risk.

If financial institutions and analysts apply a planning horizon that is too short, banks may not fully take into account climate risk that could lie further ahead in time. The Swedish Financial Supervisory Authority (Finansinspektionen) and the Bundesbank have expressed concern about this aspect.10

In today’s system, additional capital requirements are to be assessed if a bank’s credit exposure constitutes a systemic risk. Climate risk should be included in such as assessment.

Norges Bank will continue to work on how climate risk should be integrated into the work on financial stability, inter alia by participating in the Network for Greening the Financial System (NGFS).

Annex

The Norwegian banking sector

See also Norway´s financial system 2019 for a description of the Norwegian financial system.

Chart 1 Lending market shares1,2

Percent. At 30 June 2019

1) All banks and mortgage companies in Norway.

2) See Table 2.

Source: Norges Bank

Chart 2 Gross domestic lending to the non-financial sector by credit source

In billions of NOK. At 30 June 2019

1) All banks and mortgage companies including Eksportfinans.

Source: Statistics Norway

Chart 3 Lending1 by all banks and mortgage companies

Percent. At 30 June 2019

1) Total lending of NOK 5 720bn.

Source: Norges Bank

Chart 4 Lending to the corporate market1 by all banks and mortgage companies

Percent. At 30 June 2019

1) Total corporate loans NOK 1 506bn

2) Other industries comprise “Oil service”, “Other transportation”, “Electricity and water supply” and “Extraction of natural resources”. Here, “Oil service” is narrowly defined.

Source: Norges Bank

Chart 5 Balance sheet1 of Norwegian-owned banks and covered bond mortgage companies2

Percent. At 30 June 2019

1) Intercompany items between banks and mortgage companies are not eliminated.

2) All banks and mortgage companies excluding subsidiaries and branches of foreign banks in Norway.

Source: Norges Bank

Table 1 Structure of the Norwegian financial industry at 30 June 2019

1 Lending to the public only, ie lending to credit institutions and foreign customers is excluded.

Sources: Finanstilsynet (Financial Supervisory Authority of Norway), Oslo Børs, Statistics Norway, VPS and Norges Bank

Table 2 Market shares1 of banks and mortgage companies in Norway at 30 June 2019. Percent

1 The market shares are calculated by summing the balance sheet items for the institutions in the different groups.

2 DNB Bank, DNB Boligkreditt and DNB Næringskreditt.

3 Nordea Bank AB (Publ), branch in Norway and Nordea Eiendomskreditt.

4 Danske Bank, Handelsbanken, Handelsbanken Eiendomskreditt, eight other branches and one mortgage lender.

5 SpareBank 1 SR-Bank, SpareBank 1 SMN, SpareBank 1 Østlandet, SpareBank 1 Nord-Norge, the other eleven savings banks in the Sparebank 1 Alliance, SpareBank 1 Boligkreditt og BN Bank, one commercial motgage lender, one mortgage lender and one other residential mortgage lender.

6 Eika Boligkreditt, Eika Kredittbank, 67 savings banks and three commercial banks which are owner of Eika Gruppen AS and three other residential mortgage lenders.

7 Sparebanken Vest, Sparebanken Vest Boligkreditt, Sparebanken Sør, Sparebanken Møre og Sparebanken Sogn og Fjordane, 13 other savings banks, seven residential mortgage lenders, one mortgage lender and one hybrid covered bond mortgage company.

8 Sbanken ASA, Santander Consumer Bank AS, Eksportfinans, Gjensidige Bank ASA, Storebrand Bank, Landkreditt Bank, 19 other commercial banks and five other residential mortgage lenders, Kommunalbanken and one municipal mortgage lender.

9 The retail market comprises wage earners, pensioners, benefit recipients and students.

10 The corporate market primarily comprises non-financial private enterprises and the self-employed.

Source: Norges Bank

Table 3 Rating by Moody’s1, total assets, leverage ratio2, capital adequacy2 and return on equity for Nordic and Norwegian banks at 30 June 2010. Consolidated figures

1 Rating at 30 October 2019. Moody’s scale of rating: Short-term: P-1, P-2,… Long-term: Aaa, Aa1, Aa2, Aa3, A1, A2,…

2 The share of the interim result included in the calculation of the CET1 capital ratio varies across institutions. The higher the proportion of (positive) interim result included, the higher the CET1 ratio. Owing to different national rules, such as consolidation rules for life insurance companies and the Basel I transitional floor, CET1 capital figures are not directly comparable across jurisdictions.

Sources: Banks' quarterly reports, Moody’s and Norges Bank

Table 4 Banks’¹ losses on loans² to various industries and sectors as a percentage of lending to the respective industries and sectors

1 All banks in Norway including foreign branches. Nordea is a branch of a foreign bank from 2017. The figures do not include mortgage companies.

2 Recognised losses, excluding changes in unspecified loss provisions/collective impairment losses.

3 The changes in losses on loans to some industries between 2016 and 2017 were relatively large, primarily reflecting sizeable losses on individual exposures or reversals of losses for some banks.

4 Financial institutions, central government and social security administration, municipal sector and foreign sector

Source: Norges Bank

Table 5 Loan defaults.1 All banks and covered bond mortgage companies.2 At year–end

1 Non-performing loans to 2008, 90 days or more past due, 2009–2017, 30 days or more past due and from 2018, 90 days or more past due.

2 Covered bond mortgage companies included from 2005.

Source: Norges Bank