Risk Outlook – June 2023
Published: 8 June 2023
Document number: 6/2023
High debt in Norwegian households and elevated residential and commercial property prices represent the key vulnerabilities in the Norwegian financial system. Norwegian banks are particularly vulnerable in a scenario characterised by an economic downturn, a sharp rise in interest rates and a property market crash.
Considerable uncertainty attends future developments in the real economy and the financial markets, both in Norway and internationally. Underlying inflation has remained high and interest rates have risen considerably over a short period of time. Central banks have announced further rate hikes if this is necessary to bring inflation back to set targets. The uncertainty is reinforced by the war in Ukraine and the geopolitical level of tension.
Commercial property prices have risen markedly over several years as a result of increasing rental prices and low required rates of return. The banks have a significant loan exposure to commercial property companies. Against this background, Finanstilsynet has conducted a thematic review of selected banks' lending activities in the commercial property market. The review shows that many commercial property companies will be severely affected by interest rate increases, lower rental income and reduced property values.
“A strong rise in interest rates and higher risk premiums may lead to a substantial fall in commercial property prices and increased credit risk for the banks. Commercial property companies have large volumes of debt falling due over the next few years and are thus subject to considerable refinancing risk,” says Per Mathis Kongsrud, Deputy Director General, Digitalisation and Analysis.
The debt burden of Norwegian households is high, both in historical terms and compared with households in other countries. There has been an increase in the proportion of households with a high debt burden in recent years. Only a small proportion of overall household debt carries fixed interest rates.
“The higher interest rate level has led to a significant increase in households’ interest burden. Many households with high debt are vulnerable to a further rise in interest rates, loss of income or declining house prices,” says Kongsrud.
On average, Norwegian banks have a high level of profitability and meet regulatory capital and liquidity requirements. Activity remains high in the Norwegian and global economy, but there is a considerable risk of an economic downturn combined with persistently high inflation, so-called stagflation. Such international developments may result in substantial losses and financial market turbulence.
Finanstilsynet’s stress test for 2023 shows that Norwegian banks may be strongly affected in the event of a serious setback in the Norwegian economy. In the stress scenario, it is assumed that inflation and policy and market rates will increase further internationally, that global trade and the production of goods and services will decline, and that unemployment will rise.
Norwegian banking groups' CET1 capital ratio is estimated to decrease from approximately 18 to 12 per cent, primarily as a result of higher loan losses. The capital adequacy ratios of a number of banks will decline substantially.
If large losses were to occur and it becomes necessary to draw on capital buffers, experience shows that banks can rapidly lose market confidence and experience liquidity problems.
“In light of the considerable economic and financial uncertainty, Norwegian banks should seek to meet regulatory requirements by an ample margin. Finanstilsynet expects Norwegian banks to apply caution with respect to dividend payments and share buybacks,” says Kongsrud.
Life insurers and pension funds
Life insurers and pension funds enjoy a strong solvency position. They manage extensive capital and have major investments in the real estate sector. Sensitivity analyses show that a sharp fall in commercial property prices, as assumed in Finanstilsynet's stress test of banks, will result in substantial losses and a pronounced weakening of Norwegian life insurers’ buffer capital.
“Finanstilsynet expects the pension institutions’ capital planning to factor in the considerable downside risk,” says Kongsrud.