Norwegian economy on a good trend and strong bank profits, but international uncertainties and continued high debt growth in the household sector

Finanstilsynet today presented its report "Risk outlook 2013", which summarises the state of the financial market and the prospects ahead.

- In a period of economic expansion featuring a high oil price, international uncertainties and low interest rates it is particularly important for government authorities and banks alike to apply a long-term perspective to their risk assessments, says Finanstilsynet's director general Morten Baltzersen upon presenting the report.

Norwegian and international economy

Norway's economy is solid, and the prospects are good. Should the world economy prove weaker than expected, however, the Norwegian economy will be affected. Recent years' favourable trend in Norway is due in part to a sharp improvement in the terms of trade. Norway's commodity-based exports, above all oil, command high prices on the world market. Import prices have fallen in step with new producer countries' entry to the markets for consumer goods.

The Norwegian economy is vulnerable to a weakening of the terms of trade. Many firms are already struggling with a high cost level and a strong Norwegian krone in stagnating markets, while the petroleum sector and sub-suppliers to this sector are seeing good earnings. The oil price is of particular significance. A lasting decline in the oil price will lead to lower activity in the petroleum sector, and will hit Norwegian firms that deliver goods and services to petroleum operators both on the Norwegian shelf and abroad. Lower international demand and a lower oil price will weaken corporate earnings and increase banks' loan losses. Impaired earnings could in turn lead to increased unemployment and reduced consumption, which would further intensify the decline in corporate earnings. A pronounced economic downturn would bring a serious weakening of corporate debt servicing capacity and a substantial rise in banks' loan losses.

International interest rates have been at a very low level since the financial crisis in 2008. They are expected to remain low for a long period, as reflected in the Norwegian interest rate level. Low unemployment, rapid income growth and low interest rates have contributed to record-high house prices and household indebtedness. Growth in house prices and household debt continues to outstrip growth in household incomes.

- Households' expectations of lasting low interest rates, high employment, a high oil price and strong income growth could readily turn to pessimism and economic setback. Weakened confidence in the Norwegian economy could lead to a fall in house prices or intensify an incipient decline, triggering substantial financial consolidation in the household sector. Knock-on effects to the wider economy may be substantial, and banks' loan losses will rise, says Mr Baltzersen.

Situation among banks

Norwegian banks again posted good performances in 2012, achieving a pre-tax profit of NOK 37bn, up 13 per cent on the previous year. The post-tax profit was NOK 28bn as against NOK 24bn in 2011. High activity in the Norwegian economy and low interest rates curbed loan losses. The common equity tier 1 ratio rose from 9.9 per cent at end-2011 to 11.1 per cent at the end of 2012. All Norwegian banks fulfil the target of a minimum common equity tier 1 ratio of 9 per cent, and only a minority were below the 10 per cent mark. Norwegian banks were little affected by international conditions and have thus far not experienced problems of note.

In the period since the international financial crisis, authorities and banks' lenders have increased their requirements on banks' financial soundness. Bank regulation is largely harmonised across the EEA, and the process will continue further once the new capital and liquidity requirements are introduced across the EU. Agreement has been reached in the EU on a new capital adequacy framework (CRD IV). The Ministry of Finance has on this basis proposed new statutory rules on capital requirements for Norwegian banks with a view to entry into force on 1 July 2013 and a gradual step-up in the period to 2016. Norwegian banks' have a sound basis on which to bolster their financial position in the years ahead in keeping with the new requirements. There will be some scope for national adjustments to accommodate specific national characteristics and economic conditions. Finanstilsynet will utilise these opportunities to foster well capitalised, liquid Norwegian banks.

Low interest rates and search for yield – need for consumer protection

In a situation of low interest rates on bank deposits many consumers may be willing to assume high risk to achieve higher return. There is also a danger of financial institutions marketing more risk-prone products. Finanstilsynet is keeping a close watch on developments in this area, in part by checking compliance with the rules governing the provision of information and advice which are designed to ensure that consumers are aware of the products' risk and receive appropriate investment advice.

In life insurance a gradual switch to defined contribution schemes is under way. In these schemes the policyholder bears the risk posed by the investment. Schemes with a high equity component may achieve a high long-term return, but they are also risky. Compliance with the requirements with regard to information and advice is particularly important where scope is given to convert existing paid-up policies to new unit-linked products.

Households' financial vulnerability

House prices are record high and still growing. Household indebtedness is also record high and growing faster than incomes. In the fourth quarter of 2012 household debt was about twice as high as the sector's incomes. The proportion of households with a heavy debt burden is on the increase. The interest burden is also growing, but is still far lower than prior to the financial crisis owing to the low level of interest rates. Despite their high saving rate, households' financial buffers have decreased in relation to their debt.

The growing proportion of heavily indebted households means that a growing number of households are more vulnerable in the event of income loss and an interest rate hike. Households must also expect to face a higher interest burden in the longer term. Greater recourse to interest-only loans, equity release loans, low interest rates and low house taxes are some of the factors that could be causing debt to grow faster than incomes.

Calculations performed by Statistics Norway for Finanstilsynet show that households' interest burden is very sensitive to interest rate increases. A lending rate of 6.6 per cent in 2014, which is 2.5 percentage points higher than the 2011 level, would cause the proportion of households needing to devote more than 20 per cent of their net income to interest expenses to rise from about 7 per cent to about 20 per cent. This corresponds to some 500,000 households. The proportion of households with an interest burden above 30 per cent would rise from about 2 per cent in 2011 to about 8 per cent. This corresponds to close to 200,000 households. A lending rate of 6.6 per cent is low by historical standards, and about on the same level as in 2008 (6.7 per cent). Should the lending rate increase to 9.6 per cent, i.e. a 5.5 percentage point increase from 2011, there would be a sharp increase in the proportion of households with in interest burden above 20 per cent, to 32 per cent or close to 800,000 households. A lending rate of 9.6 per cent would result in an interest burden in excess of 30 per cent for as much 18 per cent of households.

Non-financial enterprises' debt

Norwegian banks' losses on loans to corporates are low. This reflects the sound state of the Norwegian economy. If the Norwegian economy were to suffer a setback, however, business and industry's debt servicing capacity would rapidly deteriorate, leading to significantly higher loan losses. Finanstilsynet has carried out calculations illustrating the trend in loan quality in the event of a sharp economic setback which shows that losses could assume the same proportions as during the banking crisis at the start of the 1990s.