Risk Outlook - June 2020

The outbreak of covid-19 and measures to limit the spread of the virus caused extensive financial turmoil and a steep decline in economic activity in a number of countries within a short period of time. There was a pronounced fall in oil prices, and unemployment very quickly increased to historically high levels. In recent weeks, the authorities, both in Norway and in other countries, have gradually reduced their comprehensive infection prevention measures. Businesses have been able to reopen, and many have returned to work. Nevertheless, significant uncertainty attends future economic developments.

“Although the depth and duration of the crisis are uncertain, it must be taken into account that banks may suffer substantial loan losses in the period ahead when households and businesses do not have sufficient income to service their loans parallel to a fall in collateral values,” says Director General Morten Baltzersen.

The corona crisis has already caused a significant loss of income for many individuals and businesses. This is also the case in Norway, although the income loss has largely been borne by the government through its compensation schemes for individuals and businesses. Norway has considerable room for manoeuvre in fiscal policy that can be used to mitigate the economic downturn. Nevertheless, the government cannot be assumed to maintain activity levels and compensate for loss of income in sectors that face lasting production and income losses due to structural changes. Continuing record-low interest rates will make it easier to service loans. In spite of this, many borrowers who experience a lasting shortfall in income will fail to meet their payment obligations.

Norwegian banks are well positioned to absorb higher loan losses. The banks record strong earnings before losses, which represent their first line of defence, and they are well-capitalised after building up equity in the years following the international financial crisis.

“In order to avoid that the economic setback is reinforced by restraints on borrowing, it is important that banks have enough equity to cope with large loan losses while being able to extend new loans to creditworthy firms and households,” says Baltzersen.

The banks' capital determines their ability to bear risk. Lower capital requirements may contribute to increasing banks' risk appetite and thus their willingness to lend. However, if lower capital requirements prompt dividend payments and other distributions of equity, the banks' ability to provide new loans will be impaired.

 “In light of the high level of uncertainty and the significant loan losses that may arise, it is crucial that the banks retain their equity in the period ahead rather than make distributions in the form of dividends, etc.,” says Baltzersen.

As a result of strong debt growth over many years, households’ debt burden was very high at the start of the crisis, and their vulnerability to declining income was equally high. In addition, housing prices have risen sharply, heightening the potential fall if the crisis eventually causes a turnaround in the housing market. Although the authorities' extensive measures and a generally well-developed financial safety net will dampen the consequences of the crisis, a number of households may be strongly affected.

At end-March 2020, the volume of consumer loans to Norwegian customers in the institutions included in Finanstilsynet’s survey was almost 10 per cent lower than a year earlier. At the same time, the volume of non-performing consumer loans has increased markedly. The income shortfall resulting from the corona crisis increases the risk that vulnerable households have or will take out consumer loans that they will not be able to service.

Finanstilsynet’s stress test for 2020 is based on the challenges faced by the Norwegian economy in the wake of the pandemic and the fall in oil prices. Two possible scenarios have been worked out based on different assumptions about the progress of the pandemic and the design of measures. In the first scenario, it is assumed that the shutdown of Norwegian businesses largely will be lifted at the start of the third quarter. In the second scenario, the consequences for the Norwegian economy are more serious and last longer. Both scenarios show significant losses for the banks. In the most severe scenario, there is a sharp decline in banks’ common equity Tier 1 capital ratios, and a number of banks will not meet the regulatory capital adequacy requirements at the end of the stressed period. Consumer loan banks will be particularly hard hit.

Life insurers and pension funds have large securities holdings and were immediately affected by the market turmoil. The value of their equity portfolios fell sharply and quickly during the first quarter, while higher credit risk premiums gave an immediate reduction in the value of corporate bonds. The weak growth prospects are a factor behind the very low long-term interest rates, which give an increase in the present value of future liabilities and will make it more difficult in the longer term to achieve excess returns for pension funds and life insurers with a large proportion of guaranteed products sold to the private sector.

The market turmoil also caused significant investment losses for non-life insurers during the first quarter of the year. Non-life insurers will also be affected by the corona crisis through increased claims payments, partly related to travel insurance. In addition, the economic setback may contribute to lower premium income.

The low interest rates heighten the risk that private individuals will be offered savings in more complex products with high underlying risk. Finanstilsynet will focus particular attention on how alternative savings products are marketed in the period ahead.