Consultation - report from the Financial Crisis Commission
(Official Norwegian Report no. 2011:1)
Norges Bank's letter of 3 May 2011 to the Ministry of Finance.
We refer to the letter from the Ministry of Finance of 2 February 2011 enclosing the Report from the Financial Crisis Commission (Official Norwegian Report No. 2011:1). The Commission discusses lessons learned from the financial crisis and notes the need for new regulations and international coordination. Norges Bank concurs in the main with these analyses and notes that the proposals in the report are largely in agreement with international recommendations.
It is especially important to establish a credible crisis resolution framework that reduces the need for, and expectations of, government support for financial institutions in distress. Such a framework will enable financial institutions and their creditors to correctly price risk, thereby reducing the buildup of systemic risk. In addition, it will reduce the costs to society when financial institutions experience payment problems. We would also emphasise the need for better regulation of banks' capital adequacy and liquidity management. This will reduce risk in the banking sector, making banks more robust to crises. The introduction of the Basel III framework will be an important step in the right direction.
Oversight and regulation of cross-border banking activities pose particular challenges within the EEA. An EEA licence and home state supervision prevent host country authorities from setting the same regulatory requirements for a branch of a foreign financial institution as those it sets for the host country's own financial institutions, even if the branch accounts for an important share of that country's financial market. A greater degree of host state regulation can be achieved through cooperation between home state and host state authorities. Norges Bank agrees with the Commission that such cooperation on rules that exceed EU minima for national regulations should be sought at Nordic level and supports the proposal that Norwegian authorities take the initiative for expanded Nordic cooperation in the area of financial markets. Until such cooperation is sufficiently well developed, host country authorities' powers to set regulatory requirements for branches should be increased. Norges Bank therefore agrees with the Commission that Norwegian authorities should work to establish a legal basis under EU/EEA law allowing host countries to require conversion from branch of a foreign bank to subsidiary and a corresponding authorisation to require Norwegian banks to organise their activities abroad through subsidiaries rather than branches.
Furthermore, Norges Bank endorses the Commission's recommendation that the authorities assess the impact of a limited market for government bonds, especially in the light of new EU regulations that will be implemented in Norway in the coming years. Norges Bank also supports the Commission's description of the way the Norwegian Interbank Offered Rate (NIBOR) is quoted, and refers to its letter to Finance Norway (FNO) of 6 October 2010, "The quoting of interbank rates - NIBOR”.
In its consultative letter, the Ministry of Finance has invited comments from consultative bodies on some of the Financial Crisis Commission's recommendations. Norges Bank has supplementary comments on the following of the Commission’s proposals:
- The Commission proposes that Norges Bank be given a clearer formal responsibility for providing advice on the use of discretionary measures in the macroprudential regulation of the financial sector.
- The Commission recommends exploring what changes should be made to the Norwegian crisis resolution system, including interventions regulated by the Guarantee Schemes Act.
- The Commission recommends the imposition of a stability tax on Norwegian financial institutions.
- The Commission recommends assessing the feasibility of a financial activities tax as an alternative to value-added tax on financial services.
The Bank's comments on these proposals from the Financial Crisis Commission appear below.
1. Oversight and regulation of systemic risk
Norges Bank shares the Commission's assessment that oversight and regulation of systemic risk should be given more weight ahead. Financial stability will not necessarily be assured by the oversight and regulation of individual institutions or financial markets alone. Even with adequate microprudential oversight of the soundness of individual financial institutions, considerable risk can build up in the system as a whole. In such cases, disturbances in an individual institution or market may spread to the wider financial system, constraining the supply of credit and capital in the economy. Systemic risk can build up over time through rapid asset inflation and credit growth, in the form of interdependency among institutions or because institutions are exposed to the same risk factor, including with regard to funding.
1.2 Measures for limiting systemic risk
The most important measures for limiting systemic risk are establishing a credible crisis resolution system and ensuring that financial institutions have sufficient equity capital to absorb losses and sufficiently robust funding to weather financial turbulence. The new Basel III framework will be a step in the right direction and should be phased in as soon as possible. A credible crisis resolution system and an effective general framework of capital adequacy and liquidity standards are important structural measures for mitigating systemic risk.
Financial stability is one of Norges Bank's primary objectives in its work to promote economic stability. The Bank’s tasks and responsibilities in this area are set out in Section 1 of the Norges Bank Act, which states that the Bank shall “promote an efficient payment system domestically as well as vis-à-vis other countries and monitor developments in the money, credit and foreign exchange markets”, and that the Bank may “implement any measures customarily or ordinarily taken by a central bank”. Section 3 states that "the Bank shall inform the ministry when, in the opinion of the Bank, there is a need for measures to be taken by others than the Bank in the field of monetary, credit or foreign exchange policy". Norges Bank also acts as lender of last resort: Norges Bank can provide extraordinary liquidity to individual institutions in the financial sector or to the banking system when liquidity demand cannot be met from alternative sources. This role provides an independent justification for Norges Bank’s oversight of the financial system as a whole and its particular focus on the risk of systemic failure.
Together with the Bank's established macroeconomic expertise and experience, this gives Norges Bank a sound starting point for assessing measures to limit systemic risk. Since the banking crisis of the early 1990s, Norges Bank has monitored the financial system in order to identify a buildup of systemic risk. The Bank's assessments of the financial stability outlook are published in separate reports twice a year. Advice on policy measures that can dampen the buildup of systemic risk is a key element of this monitoring.
Structural measures should be supplemented by targeted, discretionary measures that can be used when needed to dampen the buildup of systemic risk. The purpose of such measures is not to fine-tune developments, but to curb the buildup of systemic risk and to enable bank lending to continue should a crisis materialise. These include measures to limit the build up of imbalances caused by rapid credit growth and asset inflation, measures to limit the buildup of risk in the form of growing interdependencies among institutions and measures to limit increasing risk concentrations in the financial system.
The countercyclical capital buffer under the Basel III framework is an instrument that can counteract systemic risk. The Basel Committee has recommended that the countercyclical buffer be designed so that additional capital requirements can be imposed on banks when high and rising credit growth increases systemic risk in the economy. The authorities can remove the countercyclical buffer when systemic risk abates, or if a systemic crisis occurs. Thus, the countercyclical capital buffer will put banks in a better position to cover losses they might incur as a result of higher systemic risk. Early implementation of such measures may also slow the buildup of debt. However, a countercyclical capital buffer regime is not especially suited to influence certain sectors' borrowing, and the measure can be expected to have a fairly moderate effect on overall credit growth. Therefore, in certain cases it may be desirable to supplement the countercyclical capital buffer with other macroprudential measures. These should be measures that slow the buildup of systemic risk and/or enhance the loss-absorbing capacity of the financial system. Beyond this, their impact should be limited.
Possible measures include:
- Loan-to-income and loan-to-value ceilings may slow credit growth in an upturn. The same applies to restrictions on interest-only loans.
- Additional capital requirements for systemically important banks is a possible measure to reflect the far more serious impact of problems in such institutions than in smaller institutions.
- In general, the risk weights in the calculation of capital requirements under the Basel framework do not take into account systemic risk. At the same time, historical experience suggests that high growth in mortgage lending and high house price inflation can push up risk in the financial system as a whole. Risk weight floors are then a possible measure for underpinning financial stability.
The use of discretionary macroprudential measures to reduce systemic risk is an area of banking regulation that is still being developed. We have limited experience in the use of such instruments, both in Norway and internationally. It is therefore also uncertain how economic agents will adapt to the instruments and what effect the measures will have. For example, it is uncertain which requirements it will be appropriate to vary over time, rather than designing them as permanent, structural measures. Further consideration should therefore be given to measures in addition to the countercyclical capital buffer in the Basel III framework that may be suitable for inclusion in a specific mandate for regulating systemic risk.
1.3 Relationship between systemic risk and monetary policy
Higher interest rates can curb the rise in both debt and house prices during an economic upturn. Interest rate setting takes into account the risk that future financial imbalances may disturb activity and inflation somewhat further ahead. But systemic risk will depend on both the vulnerabilities that accumulate internally in the banking system and the sources of risk outside the banking system. The interest rate may only have a dampening effect on the buildup along some of these dimensions.
There are limits as to how many tasks the interest rate can fulfil. The interest rate also has effects on other asset prices, such as the krone exchange rate. A monetary policy that aims at influencing the price of domestic assets can easily push the value of the krone in the opposite direction.
In assessing the different considerations, monetary policy must stick to the operational objective - low and stable inflation. Without results showing that the inflation target is actually attained over time, there is a risk of weakening confidence in monetary policy. There is therefore a need for more targeted instruments that can curb systemic risk.
1.4 Division of responsibilities in oversight and regulation of systemic risk
Introduction of the countercyclical capital buffer under Basel II and any other discretionary macroprudential measures requires a division of labour in the oversight and regulation of systemic risk. Measures of this type will generally be relevant during upturns marked by optimism. At the same time, the immediate benefits of these measures will not be readily apparent, since benefits will primarily take the form of a reduced risk of turbulence somewhat further ahead. Such measures are therefore likely to face opposition, and more so since some of the relevant measures, such as loan-to-value and/or loan-to-income ceilings, will have an impact on access to credit for certain categories of borrower.
The Commission proposes establishing a clear division of responsibilities and roles among the government bodies taking part in macroprudential oversight and regulation. The Commission's model gives Norges Bank formal responsibility for providing advice on the use of discretionary instruments in the macroprudential regulation of the financial system. Norges Bank should provide the advice in the form of open submissions to the Ministry of Finance and Finanstilsynet (the Norwegian financial supervisory authority (FSA)). The FSA will have to explain what it does to follow up the recommendations from Norges Bank, or why it has decided to not follow up the recommendations. The Commission also notes the need for the FSA to be given sufficient authority to make use of relevant instruments. Furthermore, the Commission recommends predefined criteria determining when instruments in macroprudential regulation should be employed.
Overall, Norges Bank finds that the model proposed by the Financial Crisis Commission will provide an appropriate division of roles and responsibilities among the Ministry, Norges Bank and the FSA in this area. The model is based on the current division of responsibilities among the three parties in financial stability work and ensures that good use is made of the expertise in the various institutions. Given that new instruments for oversight and regulation of systemic risk are introduced, the model will, in Norges Bank's view, be a natural continuation of this division of labour.
The Ministry of Finance has overriding responsibility for the work on financial stability. The Ministry will also have this responsibility in the model the Commission is proposing, by determining objectives and considerations to be taken into account and the instruments that can be used.
The FSA is responsible for ensuring that individual financial institutions have sound management and control routines and comply with legislation and requirements applicable at any time, such as capital adequacy and liquidity standards. This will not be changed in the Commission's proposed model. In many respects, measures to limit systemic risk will entail the use of the same instruments as used in microprudential regulation, though the purpose is addressing overall risk in the financial system. The FSA should inform financial institutions of the level of the countercyclical capital buffer under Basel III through regulations and guidelines and ensure compliance, just as the FSA implements other requirements and administrative orders vis-à-vis financial institutions. The same applies, for example, to additional capital requirements for systemically important banks and requirements for loan-to-income and loan-to-value ceilings. In Norges Bank's view, the FSA should assess and dimension discretionary countercyclical measures separately from measures aimed at individual institutions' solvency, including determining capital requirements under Pillar 2 of the Basel framework. This is also proposed by the Commission. The distinction between requirements the FSA has imposed on institutions to address system-wide risk and requirements that have been imposed to address institution-specific risks will then be clear.
As discussed in 1.2, financial stability is one of Norges Bank’s main objectives in the work on promoting economic stability. Norges Bank has a duty to inform the Ministry of Finance when, in the Bank’s judgment, there is a need for measures to be taken by others than the Bank in the field of monetary, credit or foreign exchange policy. The Commission’s proposal to assign clearer formal responsibility to Norges Bank to give advice on the use of discretionary measures to limit systemic risk is a natural extension of the Bank’s existing role in this area.
1.5 Mandate for systemic risk regulation and oversight
A formalised advisory role may be defined in a number of ways. The Commission proposes a model where Norges Bank gives advice about the use of instruments and where the FSA is responsible for their implementation, or for providing an explanation of why recommendations have not been followed.
In the opinion of Norges Bank, the Commission’s proposed model provides for a clear division of responsibilities. Such a model will require a clear mandate with clear procedures for the institutions involved. The mandate, ie the legal basis for the competencies of both the FSA and Norges Bank, must specify the instruments to which it applies and must clearly define the purpose of the instrument. There must be confidence that both the advice on the use of instruments and the FSA’s implementation are determined on the basis of thorough professional assessments. It will be important to maintain a high degree of transparency around the analyses on which the recommendations are based and the supervisory authority’s implementation. As principal, the Ministry of Finance should ensure that the exercise of macroprudential regulation is reviewed and evaluated regularly, both with regard to the regulatory framework, systems of analysis and implementation. Such reviews will contribute to building up confidence in the system. For the same reason, the advice provided should be based on an established system of analysis.
The Commission recommends pre-defined criteria for the use of instruments. In Norges Bank’s view, any pre-defined rules must be supplemented by judgment to function well in practice. One of the reasons for this is the risk of financial instability related to various aspects of banking activity and conditions outside the banking system. Macroprudential oversight must therefore be conducted using instruments appropriate to the situation at any time and be based on discretionary judgment. At the same time, this highlights the need for a high degree of transparency concerning the methodological basis for the use of instruments.
2. Crisis resolution
The Financial Crisis Commission proposes exploring a number of changes that should be made soon in the Norwegian crisis resolution system. These include:
- instructing banks to draw up a resolution plan, or living will, to ensure that banks can be wound up or restructured without exposing the economy to considerable burdens in the form of financial instability or high public expenditure.
- the possibility of splitting up a bank or establishing a bridge bank to facilitate the continued provision of banking services while shareholders and unsecured creditors absorb losses.
- the possibility of forced conversion of debt to equity, for example through convertible bonds that are converted to equity capital when capital falls below a certain threshold or statutory debt to equity conversion.
Furthermore, the Commission proposes a review of the thresholds under the Guarantee Schemes Act that determine when the authorities should intervene. Preparations should be made to allow for sufficiently early intervention and threshold values should reflect both bank capital and bank liquidity. The Commission also proposes that a permanent government body should be responsible for using the above crisis resolution tools.
Norges Bank supports the Commission’s proposals for a closer examination of the changes in the Norwegian crisis resolution system. Reference is made to the attachment to the Bank’s letter of 29 November 2010 to the Ministry of Finance concerning Norges Bank’s assessment of stability in the financial system in autumn 2010 and to the joint consultative statement concerning crisis resolution recently submitted to the European Commission by Norges Bank and the FSA. Concrete crisis resolution proposals will be forthcoming from the European Commission. The Financial Stability Board and the Basel Committee are also expected to propose crisis resolution tools for the largest financial institutions at global level.
Norges Bank would highlight that a credible crisis resolution system that enables the continued operation of key banking services, while losses can be allocated to both shareholders and unsecured creditors when a bank encounters problems, is the most important instrument for preventing moral hazard in the financial system. If it is likely that creditors will be allocated losses in the event of severe problems in a bank, they will lend at rates more commensurate with the risk on the bank’s balance sheet. For a crisis resolution system to be credible, there must be no doubt as to the legal basis for the instruments the authorities wish to apply in relation to a problem bank. It must also be possible to apply the instruments promptly, particularly when problems arise in large and complex banks. The objective of a more credible crisis resolution system may therefore have consequences for the level of complexity in group structures in the financial sector that should be permitted by the authorities.
Situations may arise, however, where the authorities judge that it will take too long, or be too complicated, to ensure continuity of essential banking services in separate units of a bank. It is therefore important that the authorities also have instruments at their disposal to ensure continued operations in such a situation.
Norges Bank agrees with the Commission that mandatory conversion of debt to equity may be such an instrument. The European Commission is currently discussing the introduction of such instruments (1). Conversion must be possible even if only part of a bank’s equity is considered lost. One way of doing this is to require all banks to issue debt instruments that automatically convert to common equity if the bank’s Tier 1 capital ratio falls below a certain level. This level must be well above the minimum capital requirement. Convertible instruments of this kind have recently been issued by some large European banks.
Another way of converting unsecured debt to equity is to introduce a legal basis for imposing some of a bank’s losses on unsecured creditors by converting creditors’ claims to equity even if all of the bank’s equity capital is not considered lost. This will provide a broader base of convertible debt and increase creditors’ incentive to price credit commensurate with their perception of the risk taken by banks. The criteria for the use of such an instrument must be defined as clearly as possible beforehand, including in particular an assessment of which creditors mandatory debt conversion could apply to and how retroactive effects can be avoided.
In Norges Bank’s view, both the requirement to issue debt instruments that can be converted to equity capital and a legal basis for converting unsecured debt to equity should be explored further to assess the implications in both a legal and market context. International reports and proposals for the introduction of such instruments could be drawn on, as well as experience of convertible debt instruments already issued internationally.
In the attachment to its letter of 29 November 2010, Norges Bank referred to the possibility that the authorities may have incentives to postpone crisis measures in a bank in the hope that the situation will improve without intervention. A clearer obligation for supervisory authorities to intervene in an institution when specific solvency or liquidity indicators fall below certain values may therefore strengthen the credibility of the crisis resolution system.
Norges Bank agrees that crisis resolution should be the responsibility of a permanent government body. In the interests of resource efficiency, responsibility may be assigned to an already existing government body. A guarantee fund controlled by the banking industry cannot be assigned this systemic responsibility.
3. Higher taxation of the financial sector
The Financial Crisis Commission discusses various forms of financial market failure and refers to the under-taxation of the financial sector, which may result in a financial sector that grows too rapidly and becomes too large, particularly during an upturn. The Commission therefore proposes that two types of taxation should be explored; a stability tax on financial institutions’ market funding and an activities tax to adjust for the sector’s exemption from VAT. The two proposed taxes have in common that their introduction could curb growth in the sector, with the taxes functioning as automatic stabilisers. Such taxes must be expected to increase borrowing costs for bank customers, which may dampen credit growth. However, the way the two taxes work and the reasoning behind them are different.
3.1 Stability tax
The stability tax is proposed because banks pay less for their market funding than implied by their risk exposure, which is related to the expectation that, in some circumstances, the authorities will provide financial support to a bank in distress. The expectation of government support is reflected in the two types of ratings assigned to large financial institutions by rating agencies, one normal rating and one weaker rating based on the assumption that the institution will not be bailed out by the authorities. The first rating applies when the institutions borrow in the market. The difference between the interest rate financial institutions actually pay for market funding and the rate they would have had to pay without an expectation of support is a financial benefit for the banks. This difference can be regarded as a subsidy equivalent to the value of the implicit public guarantee perceived by banks, enabling banks to grow more quickly and operate with lower leverage ratios than would have been possible without the implicit guarantee. This is a particular advantage to large, systemically important institutions as it is more likely in their case that the authorities will provide support in a crisis.
Norges Bank supports the intent of the Commission’s proposed stability tax. In the interests of financial stability, it is inadvisable to underprice risk and subsidise debt financing. This results in bank capital ratios that are too low. A tax on market funding will to some extent redress the balance. Norges Bank therefore supports the proposal to explore such a tax further.
Norges Bank would at the same time emphasise that such a tax is one of a number of instruments to reduce the value of the implicit public guarantee perceived by banks. The most important instrument to reduce the value of this implicit guarantee will be to introduce an effective crisis resolution regime that will credibly impose losses on creditors, cf. discussion above. Additional capital requirements for systemically important banks can also rectify the undesirable consequence of the implicit guarantee reflected in market pricing of bank debt. The need for a stability tax must be assessed in the light of the degree of success in counteracting behaviour that contributes to systemic risk using other instruments.
The stability tax must also be considered in the context of other charges, in particular the fee to the Norwegian Banks’ Guarantee Fund. In its letter to the Ministry of Finance of 12 September 2008, Norges Bank remarked that the current guarantee scheme leads to considerable moral hazard, in part because the fee banks pay for deposit insurance does not adequately reflect the differences in risk across banks. This makes deposit funding particularly attractive for high-risk banks. Underpricing of risk is particularly high because the fee does not apply when the fund reaches a minimum level. Norges Bank therefore recommended that the fee to the guarantee fund should to a greater extent be differentiated on the basis of banks’ risk exposure and that banks should also pay a fee when the fund exceeds the statutory minimum level. Such a change in deposit insurance will be a natural step towards reducing moral hazard related to underpricing of risk.
A stability tax will have a greater restraining impact on rapid credit growth in Norway if it also applies to branches of foreign banks in Norway. In the event of double taxation because a similar tax is levied by banks’ home countries, a tax credit for the tax paid to the home country should be considered.
In Europe, some countries channel the stability tax into a fund, while other countries have chosen to have the tax paid directly to the national treasury. Norges Bank is generally critical of a fund mechanism. The existence of such a fund could in itself generate expectations that institutions will be rescued.
3.2 Financial activities tax
The Financial Crisis Commission proposes exploring the basis for and consequences of a tax on financial institutions’ profits and wages, referred to as a financial activities tax. The purpose is to tax value added generated in the financial sector and thereby compensate for the sector’s exemption from VAT.
Norges Bank agrees that the exemption of financial sector activity from VAT is undesirable. Under-taxation causes distortions that lead to the allocation of excessive resources to the financial sector. In the interests of financial stability, Norges Bank is of the view that a financial activities tax, if introduced, should be designed in such a way that it does not make it less expensive for banks to rely on debt financing rather than equity financing, which would further weaken banks’ incentives to build up capital buffers.
Norges Bank refers to the question, circulated for comment by the European Commission in February 2011, of whether such an activities tax should be introduced at EU-level. The introduction of such a tax in Norway without the introduction of a corresponding tax at roughly the same rate and with the same tax base in the EU countries will provide strong incentives for tax avoidance. In addition, an undesirably large share of financial services for the Norwegian market may also be offered by financial institutions with only minimal physical presence in Norway. Norges Bank therefore recommends that further exploration of an activities tax should wait until a proposal for such a tax is presented by the European Commission.
1) DG Internal Market and Services Working Document: Technical details of a possible framework for bank recovery and resolution (EU Commission, 2011).