Assessment of financial stability 2021
Norges Bank assessment of vulnerabilities and risks in the financial system in 2021.
The recovery is strengthening financial stability
The Norwegian financial system has weathered the pandemic well. At the same time, there is still a risk of shocks that could weaken financial stability. Vulnerabilities in the Norwegian financial system persist but have been met by measures to increase resilience. Norwegian banks are well-equipped to withstand a new downturn.
The reopening of society has resulted in a marked upswing in the Norwegian economy, and activity is now higher than before the pandemic. Pandemic-related uncertainty has receded.
“The recovery of the Norwegian economy has improved the financial stability outlook”, says Deputy Governor Ida Wolden Bache.
There is still a risk of shocks that could weaken financial stability. A resurgence of the pandemic may dampen the economic upturn, and a sudden rise in global interest rates and risk premiums could lead to shocks that spill over to the Norwegian financial system.
Norges Bank considers high household debt to be the main vulnerability in the Norwegian financial system. High debt makes households vulnerable to a loss of income, higher lending rates and a fall in house prices. Regulations, such as requirements for banks’ capital, liquidity and credit standards, increase bank resilience and reduce vulnerabilities. This helps dampen the impact of shocks and downturns.
Norwegian banks have ample access to funding and ample capacity to absorb losses. Banks’ credit losses have been lower than feared in 2020. Losses are expected to remain low, but the outlook is still somewhat more uncertain than normal.
“The stress test in this Report shows that the largest Norwegian banks can weather a sharp downturn without having to tighten lending substantially”, says the Deputy Governor.
Following the market stress in spring 2020, it has been discussed whether central banks should have instruments aimed at non-bank market participants. Banks’ crucial role in payment and credit intermediation is the reason that they are Norges Bank’s monetary policy counterparties and may obtain liquidity support if deemed necessary. Collateralised loans to banks are therefore Norges Bank’s preferred instrument in periods of market stress.
Cyber attacks are a potential threat to financial stability. It is therefore necessary to increase financial sector cyber resilience. There is also a need for expanded collaboration between various authorities and financial system participants. In September, Norges Bank approved the introduction of a framework for testing financial sector cyber resilience in collaboration with Finanstilsynet (Financial Supervisory Authority of Norway).
Climate change and the climate transition affect all segments of society. The analyses in this Report show that Norwegian banks’ direct exposure to transition risk appears to be moderate and their exposure to known physical climate risks is small. To ensure that information about climate-related risks facing firms and banks is comparable and reliable, it is important to continue to develop reporting standards.
The prevalence and market capitalisation of crypto-assets are increasing. Crypto-assets are not considered a threat to financial stability yet, but this can change in the future. Norges Bank and other central banks are therefore monitoring developments and assessing the need for regulation. International regulatory initiatives can help ensure that developments do not pose a threat to financial stability.
Financial stability 2021 - in a nutshell
Improvements in the economy are strengthening financial stability in Norway
The Covid pandemic resulted in a less pronounced economic downturn and lower bank losses than feared. The reopening of society has improved the situation in the Norwegian economy, and pandemic-related uncertainty has receded. The financial stability outlook is therefore somewhat brighter than at the same time last year.
There is still a risk of shocks
There is still a risk of shocks that can weaken financial stability. A resurgence of the pandemic may dampen the economic upturn. High risk appetite in global and domestic financial markets can lead to market stress in the Norwegian financial system.
Financial system vulnerabilities can amplify stress
Financial system vulnerabilities can amplify stress. In Norway, high household debt makes the financial system vulnerable. House prices rose sharply through the pandemic, but house price inflation is now more moderate. The financial system is also vulnerable to cyber attacks, which are a growing threat.
The banking sector is well equipped to face new shocks
Banks’ loss absorbing capacity is good, and banks have ample access to funding. The stress test in this Report shows that the largest Norwegian banks can weather a sharp downturn without having to tighten lending substantially. Banks are also well positioned to address climate-related risks.
Loans to banks are Norges Bank’s preferred instrument in periods of market stress
Following the market stress in spring 2020, it has been discussed whether central banks should have instruments aimed at non-bank market participants. Banks play a crucial role in payment and credit intermediation. Collateralised loans to banks are therefore Norges Bank’s preferred instrument in periods of market stress.
Financial stability outlook
The Norwegian financial system has weathered the pandemic well. The gradual reopening of society, along with government support measures, has helped keep bank losses low. Financial system vulnerabilities in Norway persist, but have been met by measures to increase resilience. At the same time, the risk of shocks, particularly from abroad, represents a threat to financial stability. Uncertainty regarding the further evolution of the pandemic has diminished since Financial Stability Report 2020, but banks are resilient and have ample capacity to absorb losses.
The recovery is contributing to financial stability
The pandemic resulted in a less pronounced economic downturn and lower bank losses than widely feared last year. Extensive government support measures, good welfare arrangements and an expansionary monetary and fiscal policy have dampened the economic impact of the pandemic. Nevertheless, some households and firms have been hit hard. Bank losses have been limited, thanks to both the support measures and banks’ low exposures to the hardest-hit industries. A resilient banking sector has been crucial for maintaining a well-functioning financial system, and a lower countercyclical capital buffer rate gave banks greater space to extend credit through a period of considerable uncertainty. Norges Bank’s extraordinary liquidity measures and foreign exchange market interventions helped dampen the turbulence so that financial markets functioned better. The measures also eased bank funding and countered an undesirable credit tightening, which could have amplified the downturn. Against the background of the recovery over the past year, Norges Bank now assesses the overall financial stability outlook as little changed since before the pandemic hit.
The reopening of society has resulted in a marked upswing in the Norwegian economy, and activity is now higher than before the pandemic. A gradual rise in Norges Bank’s policy rate has begun, and increases in the countercyclical capital buffer have been announced. The extraordinary liquidity measures were unwound on the back of an improvement in the functioning of money and credit markets. The last extraordinary loan to banks matured in August 2021. Fiscal policy measures are also being phased out as the economy normalises.
Risk of shocks
Uncertainty about the future evolution of the pandemic is lower than at the time of the 2020 Report. Even so, a resurgence of the pandemic may dampen the economic upturn, weaken business profitability and push up bank losses.
During the years prior to the pandemic, global interest rates were historically low. The pandemic resulted in even more expansionary monetary policy, and extensive fiscal policy measures were introduced. This has supported the economic recovery, but has also reduced many countries’ fiscal and monetary policy space. Persistently low interest rates abroad can also induce market participants to assume greater risk. Global vulnerabilities have built up in the form of increased debt and higher asset prices. Policy rate expectations and long-term interest rates have risen markedly through autum. Expectations of higher inflation and possible monetary tightening globally have likely pushed up market interest rates. Higher interest rates could restrain debt accumulation and asset inflation. This may reduce the build-up of vulnerabilities. A sudden rise in interest rates and risk premiums can lead to stress in the Norwegian financial system, owing to its close interconnectedness with the global economy and financial markets. This interconnectedness came into evidence during the market turbulence at the beginning of the pandemic.
Financial system vulnerabilities persist, but have been met with measures
Financial system vulnerabilities in Norway can lead to shocks having more serious consequences for financial stability. Overall vulnerabilities are assessed as being broadly at the same level as prior to the pandemic.
High household debt has long been the main financial system vulnerability in Norway. Leverage is high both historically and compared with other countries. High debt makes households vulnerable to a loss of income, higher lending rates and a fall in house prices. The risk that many households tighten consumption at the same time constitutes a threat to financial stability. Banks’ high commercial real estate exposures are also a vulnerability that can lead to substantial credit losses if commercial property prices fall, as shown by the stress test in this Report. In addition, banks’ interconnectedness, partly owing to their cross-exposures, can propagate and amplify shocks.
Credit and property and financial asset prices have often shown a pronounced rise ahead of financial crises. Residential and commercial property prices fell during the first phase of the pandemic, but have since risen sharply, as have financial asset prices. Low interest rates over a long period have driven down yields, and risk premiums are now at very low levels. Unexpected events can therefore result in considerable corrections in asset prices. Property price inflation has recently been more moderate. Credit growth picked up somewhat through the pandemic, but has recently levelled off.
Regulations, such as requirements for banks’ capital, liquidity and credit standards, increase bank resilience and reduce vulnerabilities. This helps dampen the impact of shocks and downturns.
In autumn, Norges Bank was given decision-making responsibility for the countercyclical capital buffer and formal advisory responsibility for the systemic risk buffer. These two buffer requirements constitute a significant part of banks’ total capital requirements. The Committee decides on the countercyclical capital buffer rate each quarter and is to advise on the systemic risk buffer at least every other year, for the first time in 2022. In line with Norges Bank’s new areas of responsibility, the Committee will prepare a framework for its advice on the systemic risk buffer in 2022.
Bank resilience has not weakened during the pandemic
The Norwegian banking sector is solvent and well-equipped to withstand shocks. Bank profitability is solid, and banks’ have ample access to funding. Solid underlying profitability has resulted in earnings sufficient to cover the losses incurred during the pandemic, while increasing lending. In addition, restrictions on dividend distribution have compelled banks to retain more earnings than normal during the pandemic. This has increased equity and thus loss-absorbing capacity. Higher interest rates ahead will improve bank profitability. Losses on corporate loans have declined as the economy improved. There are no signs that the business sector has drawn substantially on its financial buffers, and credit losses are expected to remain low. Even so, owing to the uncertainty about the further evolution of the pandemic, loss prospects are somewhat more uncertain than normal.
It is difficult to identify and assess the risk of new shocks, of which the pandemic is an example. The stress test in this Report shows that if the Norwegian economy is hit by a renewed sharp downturn, the capital buffers in the largest Norwegian banks as a whole are sufficient to absorb the losses. The implications for banks’ capital situation depends on which industries are affected. The stress test shows that weak developments in commercial real estate and other sector-specific shocks can induce banks to tighten lending, which can amplify an economic downturn. Banks can dip into their capital buffers to avoid tightening lending. Banks can also use freed-up capital if the countercyclical capital buffer rate is lowered. Analyses show that a number of Norwegian banks will have limited scope to dip into other capital buffers, such as the systemic risk buffer, without breaching the minimum requirement for own funds and eligible liabilities (MREL). This may reduce the effectiveness of the buffers in a crisis. Banks preferring to maintain the flexibility that capital buffers provide can issue enough non-preferred senior bonds so that MREL does not hinder the use of capital buffers. If the buffer requirements are reduced in a sharp downturn, the most binding MREL requirement will be reduced accordingly and the buffers will be able to function as intended.
Liquidity measures and market stress
Extraordinary loans to banks during the market stress in spring 2020 ensured banking sector liquidity and the transmission of the policy rate to money market rates. At the same time, there was an increased need for liquidity by investment funds and other asset managers when the value of their securities fell and the krone depreciated. Fire sales to meet this need amplified the market stress. There is a discussion internationally and in Norway about whether central banks should have instruments that can be aimed directly at securities markets and non-bank market participants in periods of market stress.
Norges Bank’s liquidity policy instruments are aimed directly at banks. Banks create and receive deposits and thus play a key role in payment and credit intermediation. This is the reason they are Norges Bank’s counterparties and receive liquidity support if Norges Bank deems it necessary. Norges Bank’s risk is contained by the fact that banks’ liquidity and credit risk is strictly regulated, loans are extended against collateral and the terms and conditions for support are intended to give banks incentives to use market solutions first.
Instruments aimed directly at securities markets or non-bank market participants may entail a greater risk to the central bank. Asset purchases entail a higher risk than secured lending. Other market participants may face less strict regulation than banks, and their importance for payment and credit intermediation may be less critical. Loans to these counterparties may thus increase the central bank’s risk and can to a lesser extent be justified on the grounds that they are critical to the financial system. Such use of instruments also increases the risk that the central bank contributes to socialisation of potential losses, while the risk taker keeps any gains. This could give rise to excessive risk-taking and market adjustments that are detrimental to long-term financial stability. The central bank should therefore be cautious in resorting to such extraordinary measures. In line with the principle that risk should be borne as much as possible by financial market participants, loans to banks are Norges Bank’s preferred instrument in periods of market stress.
Resilient market participants must always be the first line of defence against market stress. Banks and other financial market participants are responsible for managing their own liquidity risk and cannot rely on support from the central bank. Strict criteria and terms and conditions for central bank measures are meant to help ensure this. Systemic risk connected with derivatives contracts, which played out at the beginning of the pandemic, have prompted a number of asset managers to make changes to their risk management. These changes may make them better positioned in periods of market stress.
The Norwegian financial system is vulnerable to cyber attacks
Cyber attacks are a potential threat to financial stability. Extensive digitalisation and interconnectedness make the financial system vulnerable. Financial institutions report more and increasingly sophisticated attacks. A more aggressive threat landscape is amplifying cyber risk.
The potentially systemic ramifications of cyber attacks entail a need for strengthened regulation and expanded collaboration between various authorities and financial system participants. A number of new regulatory initiatives have been proposed to increase financial sector cyber resilience. In September, Norges Bank’s Executive Board approved the introduction of a framework for testing entities’ capabilities in detecting and responding to cyber attacks (TIBER-NO). TIBER-NO has been prepared in collaboration with Finanstilsynet (Financial Supervisory Authority of Norway). This will help strengthen financial sector cyber resilience and provide additional knowledge about how cyber attacks can impact the financial system.
Identifying key financial and operational dependencies in the financial system known as cyber mapping, is useful for ascertaining how cyber attacks can threaten financial stability. This is also a prerequisite for system-wide monitoring of cyber risks and proper incident management in the event of a cyber attack. In Norway, such cyber mapping work is underway in view of the new Security Act. This work is laying an important foundation for greater understanding of and new measures to address systemic cyber risk in Norway.
Other societal trends have implications for financial stability
The financial system is evolving in pace with technological innovation. Norway is at the technological forefront, and the payment methods we use have undergone extensive changes in recent years. An efficient and secure payment system is essential to financial stability. Norges Bank is studying whether the introduction of a central bank digital currency (CBDC) will promote an efficient and secure payment system and safeguard confidence in the payment system. In the coming two years, Norges Bank will conduct experimental testing of technical solutions.
In recent years, the prevalence and market capitalisation of crypto-assets have increased substantially. Crypto-assets are not considered a threat to financial stability yet, either globally or in Norway, but this can change in the future. A number of international regulatory initiatives can help ensure that developments do not pose a threat to financial stability. Central banks and other authorities should monitor developments and assess whether further regulations are needed that can reduce risks associated with crypto-assets.
Climate change and the climate transition affect all segments of society, also the financial system. The longer one waits to implement measures to make the necessary adaptations, the faster substantial changes will have to be made. Adapting suddenly and quickly may entail a risk to financial stability. The transition to lower greenhouse gas emissions and new regulations entail a transition risk for the Norwegian economy in the coming years, which is amplified by the importance of the oil and gas industry for Norway. Climate risk also relates to the physical consequences of climate change. Banks should ensure that they are well equipped to manage climate risk. The analyses in this Report show that Norwegian banks’ direct exposure to higher prices for greenhouse gas emissions is moderate. For now, Norwegian banks’ exposure to “known” physical climate risks is small, but the ramifications of climate change may be far more extensive than currently assumed.
Within their mandates, central banks and financial supervisory authorities can promote financial stability by ensuring that all risks are backed by sufficient capital and by encouraging the financial sector to include and communicate climate risk in their risk assessments and financial reporting. The ability of banks and other financial institutions to price climate risk correctly is crucial for the ability of borrowers to make good investment decisions. A sound information basis and transparency regarding exposures to climate risk also provide a solid basis for market participants to compare banks. Reporting standards are under development internationally. It is important to continue to develop climate reporting to obtain the most accurate picture of the climate risks facing Norwegian banks.
Ida Wolden Bache
3 November 2021