Advice on the systemic risk buffer
Norges Bank's letter of 7 November 2022 to the Ministry of Finance.
Norges Bank’s Monetary Policy and Financial Stability Committee has decided to advise the Ministry of Finance to keep systemic risk buffer requirement unchanged at 4.5 percent.
Norges Bank is responsible for preparing a decision basis and providing advice on the systemic risk buffer (SyRB) at least every other year. The Ministry of Finance sets the SyRB rate. The SyRB requirement was introduced in Norway in 2013 and was increased to 4.5 percent in 2020.
Owing to vulnerabilities in the financial system, shocks may have more serious consequences for the financial system and Norwegian economy. The SyRB helps to ensure that banks hold sufficient capital to weather future downturns. The SyRB should reflect the assessment of structural vulnerabilities in the financial system, which are persistent features of the financial system that change rarely or little from year to year, such as high debt levels and interconnected banks.
This letter and Norges Bank’s Financial Stability Report 2022 is the decision basis for the advice on the SyRB rate, in addition to the set of indicators for the SyRB (see attachment). The decision basis is in line with recommendations and guidance from the European Systemic Risk Board (ESRB). Norges Bank’s framework for the advice on the SyRB is described in Norges Bank Papers 5/2022. In preparing its advice, Norges Bank has exchanged information and assessments with Finanstilsynet (Financial Supervisory Authority of Norway).
Assessment of structural vulnerabilities
In the assessment of the SyRB, Norges Bank places particular emphasis on three structural vulnerabilities in the Norwegian financial system: i) high indebtedness in many households, ii) high bank exposure to commercial real estate (CRE) and iii) that one bank’s funding is another’s liquidity reserve.
High indebtedness in many households is the most important structural vulnerability in the Norwegian financial system. Household leverage is close to a historically high level, and it is high compared with other countries. Household debt in Norway largely reflects elevated house prices and a large proportion of home ownership. High indebtedness makes households vulnerable to loss of income, higher interest rates or a fall in house prices. If many households reduce consumption sharply, firms’ earnings are impaired and banks may face higher losses on corporate exposures. This constitutes a risk to the financial system and can amplify a downturn in the Norwegian economy. A sharp fall in house prices may also lead to substantial bank losses on non-performing residential mortgages of households with a high debt-to-value ratio. Household leverage is approximately at the same level as before the pandemic.
Bank’s exposures to CRE are high. Banks’ CRE lending accounts for around half of total corporate lending. Experience from banking crises in Norway and abroad have shown that losses on CRE exposures have been an important factor behind solvency problems in the banking sector. The CRE share of banks’ exposures has been stable over the past few years.
Covered bonds issued by other Norwegian banks’ account for a substantial portion of banks’ liquidity reserves. This implies that problems at one bank can more easily spread to other banks. If there are simultaneous fire sales of covered bonds by a number of banks, prices may fall sharply. Banks will then incur losses and the value of banks’ liquidity portfolios will be reduced, making them less able to withstand liquidity problems. The share of covered bonds in banks’ liquidity reserves has fallen over the recent years. At the same time, banks’ covered bond holdings are little changed.
Other structural vulnerabilities were also given weight when the SyRB rate was increased in 2020. Banks account for a large share of household and corporate credit and are therefore important for the Norwegian economy. Furthermore, the banking sector is concentrated, and the business sector is characterised by a low degree of diversification. These vulnerabilities have changed little in recent years.
The vulnerabilities in the financial system are addressed by a number of regulations. Requirements for banks’ capital, liquidity and lending standards help improve financial system resilience and may also mitigate vulnerabilities.
The SyRB is not intended to reflect vulnerabilities that can be fully addressed by other capital requirements. Floors for risk weights are primarily a backstop that prevents banks’ capital levels from becoming too low following a fall in risk weights. Systemically important banks are required to maintain a larger capital buffer because problems in a systemically important bank can have severe negative consequences for the economy. The countercyclical capital buffer should primarily reflect the assessment of cyclical vulnerabilities in the financial system. The requirements in the Lending Regulation affect household borrowing more directly.
Assessment of banks’ total need for capital
Bank crises are costly to society. Norges Bank has analysed the economic costs and benefits of bank capital requirements. The Bank’s estimates indicate that Norwegian banks’ capital ratios are within a reasonable range for long-term capital adequacy. The Bank’s analysis does not take into account that vulnerabilities may vary over time. The estimates are based on a number of assumptions, and the results are uncertain. The analysis shows that economic costs are higher if banks adjust to a capital adequacy ratio that is too low rather than too high.
Stress tests conducted by Norges Bank and Finanstilsynet show that sharp economic downturns can result in such large bank losses that banks will draw down their capital buffers. How far banks draw down their capital buffers depends on the scenarios. Stress tests show some of the many possible negative events that the financial system can face and outline possible outcomes of how the financial system copes with sharp, but not inconceivable, downturns. Stress tests have often included scenarios of a sharp global economic downturn, a steep fall in oil and gas prices and higher credit premiums, which result in a sharp economic downturn in Norway and large bank losses. Norges Bank’s stress tests take into account that financial system vulnerabilities amplify economic downturns, and the depth of the crisis will therefore depend on the vulnerabilities. The stress test in Financial Stability Report 2022 is based on a scenario of high inflation combined with a severe downturn in the Norwegian economy. The stress test shows that the capital buffers of the largest Norwegian banks as a whole are sufficient to absorb losses in such a scenario. There is uncertainty as to how large losses will be in a downturn. A sensitivity analysis in the stress test illustrates how higher losses and a weaker interest margin may induce banks to draw down the SyRB. In the event of a pronounced downturn, the SyRB rate can be lowered if a CCyB rate reduction is insufficient. This can contribute to dampening the downturn. The SyRB should only be reduced if the banking system is assessed to be sufficiently capitalised to weather the downturn.
In the assessments of the total capital need, it is the banks’ equity capital available to absorb losses that is of importance. The analyses consider the effects of the current capital regulations. Several changes to the regulations have been introduced in recent years. Among other things, the discount in risk-weighted assets for loans to small and medium-sized enterprises has been introduced, and the Basel I floor for risk-weighted assets for IRB banks has been removed. Some capital regulations have also been tightened, for example stricter requirements for banks’ internal models for calculating risk weights, and the introduction of floors for risk weights for residential and commercial real estate. In sum, the regulatory changes have contributed to reducing risk-weighted assets, regardless of whether the risk associated with the loans has changed accordingly. This contributes in isolation to higher CET1 ratios for banks. The introduction of the minimum requirement for own funds and eligible liabilities (MREL) may, on the other hand, dampen crisis costs and crisis probabilities and contributes in isolation to reducing the need for CET1 capital adequacy.
Exposures subject to the SyRB requirement
In Norges Bank’s view, the SyRB requirement should apply to all Norwegian and foreign banks’ exposures in Norway. The SyRB requirement is justified by structural vulnerabilities in the Norwegian financial system, and it is uncertain how these vulnerabilities will affect the composition of bank losses in a downturn.
Foreign banks account for a large share of the Norwegian lending market. If the Norwegian authorities are to maintain national governance over time, it is important that other countries recognise Norwegian regulations, so that Norwegian capital requirements also apply to foreign banks’ exposures in Norway. Accordingly, the SyRB rates of foreign countries will apply to Norwegian banks’ exposures in the relevant country, provided that these requirements are justified by the systemic risk in that country and apply to all banks operating in that country. This facilitates mutual cross-border recognition (reciprocation) of banking regulation and was introduced in the Norwegian regulation in 2020 when the Norwegian SyRB rate was increased.
Less than half of EU countries have a SyRB requirement, and Norway and Belgium are the only countries with a SyRB requirement above 3 percent. Belgium has a sectoral SyRB requirement of 9 percent, only applicable to IRB banks’ residential mortgages in Belgium. The ESRB has so far recommended that EEA countries reciprocate the SyRB requirements in Norway, Belgium, Lithuania and Germany. In these countries, except Norway, the SyRB applies only to real estate loans in the relevant country. In several other countries with a SyRB requirement, the SyRB applies only for a subset of banks, but for all exposures in these banks.
Assessment of the SyRB level
Norges Bank’s assessment is that structural vulnerabilities in the financial system are at approximately the same level as when the SyRB requirement was increased to 4.5 percent. Furthermore, it is our assessment that the SyRB at 4.5 percent helps to ensure that banks hold sufficient capital to weather future downturns.
The risk of a downturn in the Norwegian economy has increased, and the financial stability outlook has weakened. There are considerable spillovers in both Europe and globally from the ongoing war in Ukraine and the after-effects of the Covid-19 pandemic. There is substantial uncertainty about the economic outlook. Norwegian banks satisfy the capital requirements and are highly profitable, making them well equipped to absorb higher losses. It is now especially important that the financial system remains resilient so that it can perform its tasks effectively also in the event of severe economic downturns and crises. Maintaining the SyRB requirement contributes to this aim.
Norges Bank’s Monetary Policy and Financial Stability Committee has unanimously decided to advise the Ministry of Finance to retain the 4.5 percent SyRB rate for all exposures in Norway, applicable to all banks.
Ida Wolden Bache