Risk Outlook – November 2017
Published: 29 November 2017
Last updated: 11 February 2020
After a period of weak growth in Norway's mainland (non-oil) economy since the oil price fall in 2014, the cyclical downturn now appears to be over. Low interest rates, a weak domestic currency and expansionary fiscal policy have helped to accelerate the rate of growth in the mainland (non-oil) economy. Unemployment has subsided. High property prices and a high household debt burden render the Norwegian economy vulnerable to an economic turnabout. House prices and households' debt burden are historically high, and also high by international standards.
House prices surged in 2016, but have fallen somewhat in the last half-year. The price fall is not dramatic, and the level of house prices remains high.
"The likely trend in the housing market ahead is uncertain. After a long period of steep house price growth, the possibility that we are entering a prolonged period of falling house prices cannot be ruled out. However, improved growth prospects and continued low interest rates could rekindle house prices," says Finanstilsynet's Director General, Morten Baltzersen.
The Ministry of Finance tightened the residential mortgage lending regulations at the turn of 2017, after which banks have tightened lending practices. The residential mortgage lending survey shows that the requirements of a maximum loan-to-value ratio and a maximum debt-to-assets ratio (capping mortgages at five times gross annual income) are binding for some borrowers. Finanstilsynet will advise the Ministry of Finance on possible amendments to the residential mortgage lending regulations by 1 March 2018.
The turnabout in the housing market has thus far not translated into slower credit growth. Households' debt burden has accordingly risen further in 2017. Households' interest burden is none the less low due to low residential mortgage lending rates. Norwegian borrowers have long preferred floating interest rates on their residential mortgages. This year's residential mortgage lending survey shows that the proportion of fixed-rate mortgages has fallen further, and is now as low as 4 per cent of new loans. Norwegian households will accordingly be hit rapidly by an interest rate hike, and this could have major negative repercussions for the Norwegian economy.
Recent years have seen very high growth in consumer lending. Although consumer lending remain low in terms of households' overall debt, its rapid growth gives cause for concern. Many banks and finance companies market such loans very actively. Finanstilsynet has introduced guidelines for prudent consumer lending practices which financial institutions are expected to comply with as from the start of the fourth quarter of the current year at the latest. Finanstilsynet has recently also tightened the capital requirements for consumer loan banks.
"Norwegian banks have considerably increased their equity capital since the financial crisis, largely due to substantial profit retention. This puts the banks in a better position to tackle a negative outturn in the Norwegian economy," says Finanstilsynet's Director General, Morten Baltzersen.
More than half of the banks' loan volume is to households, for the most part secured on residential property. A house price fall would reduce the value of banks' collateral, and the risk of losses on residential mortgages would increase. However, losses on residential mortgages are not considered to be the greatest risk facing the banks. Historically speaking, the heavy losses have been incurred on loans to corporates. When the debt burden is high, as at present, interest rate hikes or income lapses will trigger significantly stronger financial consolidation among households than when the debt burden is low. Reduced demand for goods and services will lead to lower earnings for Norwegian business and industry, an increase in defaults on corporate bank debt and higher loan losses for banks.
Banks have enjoyed good earnings and ample access to funding in 2017. A substantial share of banks' funding is from foreign sources. Turbulence in international financial markets could thus rapidly be of consequence for Norwegian banks.
Covered bonds (OMF) are an important funding source. Covered bonds are concurrently an important part of many banks' liquidity reserve. It is uncertain how the market for covered bonds will respond to a house price fall. The close interconnectedness brought about between actors through cross-ownership of covered bonds heightens the risk of contagion effects. The fact that all banks maintain a large holding of covered bonds as a part of their liquidity reserve could give rise to difficulties in a situation in which many actors are in need of liquid assets and are keen to divest covered bonds.
The introduction of Solvency II in 2016 brought challenges for life insurers, mainly because the new framework requires fair value measurement of liabilities and, to a greater extent than previously, sets capital requirements that reflect portfolio risk. Institutions have nonetheless, with one exception, thus far handled the transition to Solvency II through cost reductions, portfolio composition adjustments and changes in capital structure. Pension funds remain subject to the Solvency I framework, but are reporting stress tests based on fair value of assets and liabilities. Pension funds as a whole have strengthened their buffer capital in the first half-year, but several pension funds show a very high capital utilisation. The financial position of pension funds with a high proportion of paid-up policies is particularly sensitive to the low interest rate level.
"Insurers' new sales are dominated by products without a guaranteed rate of return and without lifelong benefits, the corollary being that policyholders with a need to save for their pension are required to bear more of the risk themselves, which includes taking the consequences of their own investment choices. This places a major demand on policyholders' knowledge and understanding of the risk inherent in the products, and requires market actors to inform, and give sound advice to, customers on the their investment choices," says Finanstilsynet's Director General, Morten Baltzersen.
Both in Norway and across the EU, legislation is giving increasing prominence to consumer protection and to institutions' obligation to inform and guide the policyholder. Finanstilsynet monitors compliance with the information and advice requirements through thematic inspections and selective inspections at individual institutions.