Economic uncertainty compounded by high household debt and high house prices
Published: 4 November 2014
Last updated: 11 February 2020
Document number: 31/2014
Low unemployment, high wage growth and low interest rates have spurred substantial growth in household debt and incomes in recent years. However, household indebtedness has risen more quickly than incomes, and the ratio of debt to incomes is unprecedentedly high. The high level of household debt renders the Norwegian economy vulnerable to negative shocks.
House prices are now at a historically high level, having risen steeply in the year's first three quarters. The strong rise in house prices has increased households' wealth and provided a basis for consumption growth. A turnaround in the housing market will have the opposite effect.
"Developments ahead are uncertain. Several types of shock could hit the Norwegian economy and Norwegian financial institutions, and the high level of household debt and house prices make us vulnerable," says Finanstilsynet's Director General, Morten Baltzersen.
Since most mortgages in Norway carry floating interest, an interest rate hike rapidly reduces households' disposable income. For many households, debt significantly exceeds twice their income, and their financial buffers are limited. Moreover, many mortgages have interest-only periods, which limit households' build-up of equity. Finanstilsynet's survey of residential lending shows an increase in the past year in the proportion of mortgages with a high loan-to-value ratio, possibly indicating that lending practices have been relaxed at a number of banks. This increases banks' vulnerability.
The Norwegian economy has enjoyed a marked improvement in its terms of trade since the beginning of the 2000s. The rise in the price of oil has been a major contributor, and the high oil price has brought excellent profits for petroleum-related activities. The petroleum sector has a major bearing on the Norwegian economy. A high and rising cost level has spilled over to other business and industry, making for increased vulnerability in the event of an economic downturn.
The outlook for the international economy remains highly uncertain. In parts of Europe unemployment is high, and the euro area has seen a weaker-than-anticipated development. Growth in several emerging economies has slowed in the past three years. Particular uncertainty focuses on the Chinese economy, which has seen rapid credit growth and overinvestment.
The oil price has fallen appreciably since the summer. A steep, lasting fall in the price of oil could have major negative effects on the Norwegian economy. Production and earnings in oil-related activity will be hit. A further fall in the oil price will intensify the decline in oil investment. Other industries and households stand to be affected by reduced activity in the oil sector.
Banks – earnings, financial position and funding
Banks enjoy good earnings, and capital adequacy has improved in the years since the international financial crisis. Minimum common equity Tier 1 requirements, including buffer requirements, increased to 10 per cent as from 1 July 2014, and all Norwegian banks met the requirements at the end of the first half year. However, Norwegian banks' total assets have grown significantly faster than risk weighted assets, which have changed little in the period from 2007 to the present. The leverage ratio (measured as core tier 1 capital over total assets) is about 6.3 per cent, which is higher than in 2007, but still no larger than it was in the mid-1990s.
Solid, profitable banks are highly important. Norwegian buffer requirements are being gradually stepped up in the period to 1 July 2016, and banks need to adapt to minimum requirements and buffer requirements by a good margin. With continued good earnings and prudent dividend payouts, banks will be in a position to meet the requirements through profit retention.
"Should the imbalances in the non-financial private sector's indebtedness and in the housing market continue to accumulate, the banks must be prepared to meet further buffer requirements, and they should exploit the good times in the industry to build up equity capital by retaining the bulk of their net profit," says Finanstilsynet's Director General, Morten Baltzersen .
Life insurers and pension funds
Rising stock prices and capital gains on bonds have brought good results for pension institutions (life insurers and pension funds) so far this year. However, the institutions face major challenges in coming years. Low interest rates are making it difficult for them to secure a return above the guaranteed minimum rate. Although the volume of defined contribution pensions is rapidly growing, the bulk of life insurers' liabilities still consists of contracts providing a guaranteed annual return.
The new solvency framework, Solvency II, will take effect in the EU on 1 January 2016. Solvency II reflects insurance risk better than the existing solvency framework, and will bring substantially higher capital charges for a number of life insurers. The latter must either reduce risk or increase their capital to meet the new requirements. Insurance liabilities are recognised at market value, and the interest rate in effect at any time affects the value of the liabilities. In recognition of the challenges facing many European life insurers, the Directive amending Solvency II, Omnibus II, permitted some relaxation, or a more gradual introduction, of the requirements. Finanstilsynet has recommended applying some of these relaxations to Norwegian life insurers to give them more time to adapt to the new capital requirements.
Rising longevity in the population entails a need for pension institutions to increase their provisioning for future pension obligations. As from 1 January 2014 a new mortality tariff was introduced that takes account of rising longevity. The tariff entails higher premiums for policyholders and a need to considerably strengthen pension institutions' technical provisions. Much of this need was met in the period 2011-2013, but a significant increase in provisioning will be required in the years ahead.