Finanstilsynet presents its report “Risk Outlook 2012” today. The report describes and analyses developments in the real economy, markets and financial institutions. It also assesses households’ and firms’ financial position, and covers stress tests of banks and households.
Banks’ funding and solvency has strengthened, but further improvement needed
The international financial crisis shows that conditions in banks’ funding markets can deteriorate dramatically. Banks’ funding was more robust when lending markets tightened in autumn 2011 than when lending markets dried up following the Lehman bankruptcy in autumn 2008. European lending markets have been brighter thus far this year, above all due to the European Central Bank’s move to supply banks with a large volume of favourably priced long-term loans.
– However, the turbulence is not yet behind us, and we must be prepared for the possibility of a new period of tight lending markets. To this end Norwegian banks need to make their funding even more robust by expanding their liquidity buffers, putting their funding on a longer-term footing and improving their liquidity management, says Finanstilsynet’s Director General, Morten Baltzersen.
Norwegian banks are solid and profitable. Losses are low, and financial positions have strengthened in recent years. The banks are retaining the bulk of their profits for 2011 to strengthen their capital. However, Finanstilsynet’s stress test of the banks shows that loan losses may increase sharply in the event of a downturn in the Norwegian economy.
– It is encouraging that Norwegian banks are devoting the bulk of last year’s buoyant profits to bolster their equity capital position. At the same time we need to allow for the possibility that the Norwegian economy will be harder hit by the international turbulence. Banks need to increase their equity capital further to prepare for increased losses and reduced profitability, says Mr Baltzersen.
Uncertainty with regard to the economy is accompanied by great uncertainty with regard to the ability of the banks’ risk measurement and risk management systems to capture underlying systemic risk. To assure robust regulation of the financial sector, supervision and regulation must take into account the fact that probability calculations and models do not capture all relevant risk.
Household debt and house prices at record levels
Household debt and house prices have reached very high levels, and are still rising. Rising indebtedness has increased the household sector’s vulnerability in the event of unemployment, income reduction or interest rate increase. According to calculations by Statistics Norway on behalf of Finanstilsynet, even a moderate interest rate increase produces a sharp rise in the proportion of households with a high interest burden.
In 2011 it is estimated that some 170,000 households had interest expenses in excess of 20 per cent of income; of these about 55,000 had interest expenses in excess of 30 per cent of income. With an interest rate increase of just over 2 percentage points, the number of households with interest expenses in excess of 20 per cent of income will rise to some 450,000, of which about 180,000 will see interest expenses in excess of 30 per cent of income. (See account in “Risk outlook”, page 48). Debt has risen most among the youngest borrowers and low-income groups, rendering these groups vulnerable in an economic downturn.
Experience gained in Norway as elsewhere shows that when households are compelled to substantially tighten consumption, the knock-on effects to the rest of the economy are substantial. Much of the business sector will be hit, unemployment will rise and banks will see heavier loan losses, particularly on loans to corporates.
– With a view to reducing the vulnerability of individuals and the financial system, Finanstilsynet tightened in December 2011 the guidelines for prudent residential mortgage lending practices. Banks' compliance with the guidelines is being closely monitored by surveys and on-site inspections, says Mr Baltzersen.
Customer protection is at centre stage of financial market regulation and of the supervision of financial services providers such as banks, insurers and investment firms. Many individuals have lost money on investments in complex financial products after receiving poor investment advice and insufficient information about the products’ costs, risk and potential return. Finanstilsynet has uncovered a number of gross, systematic breaches of requirements for good business practices.
– Interest rates are now low, and many are seeking higher return than that available on bank deposits. Concurrently banks and investment firms are seeking to compensate loss of income earned on traditional securities broking with income from other sources. There is a danger that sales of complex, high-risk products will increase for this reason. Finanstilsynet will keep a close watch on investment advisory services and will apply any sanctions needed where consumer protection requirements are seriously violated, says Mr Baltzersen.
Challenges facing life insurers
Almost 90 per cent of life insurers’ liabilities relate to life-long pension products with a guaranteed return. Interest rates have fallen steeply in recent years, posing challenges in terms of fulfilling the rate of return guarantee. This is particularly true of paid-up policies where interest rate risk cannot be priced through premium payments. At the same time the current low interest rates require higher premiums for existing defined benefit pension schemes, potentially prompting more employers to terminate them. The liabilities are then converted to paid-up policies, amplifying insurers’ risk related to guaranteed return. Further, life expectancy in Norway continues to rise more quickly than assumed when the pension premiums were paid. Provisions for increased life expectancy will need to be further strengthened in due course.
The Banking Law Commission has recommended that holders of paid-up policies be allowed to convert the pension portion of their paid-up policies to unit-linked pension agreements. Moreover, consideration is being given to new pension products where interest rate risk and longevity risk are distributed between policyholder and pension provider. Finanstilsynet recommends that current buffer arrangements be replaced with a new, larger buffer fund making for simpler rules and greater flexibility. This could encourage more long-term management of policyholders’ assets while mitigating risk to insurers.
– The challenges facing life insurers call for expansion of their buffers. Rule changes that reduce vulnerability related to paid-up policies and increase insurers' opportunity to equalise risk over time are likely to encourage more long-term management of pension assets. Such changes will also make it simpler for life insurers to increase their equity capital, comments Morten Baltzersen.