Much of the work of the FSAP was conducted prior to the COVID-19 outbreak. The FSAP’s findings and recommendations for strengthening policy and institutional frameworks remain pertinent. The risk assessment quantifies the impact of the COVID-19 crisis on bank solvency.

Abstract

Much of the work of the FSAP was conducted prior to the COVID-19 outbreak. The FSAP’s findings and recommendations for strengthening policy and institutional frameworks remain pertinent. The risk assessment quantifies the impact of the COVID-19 crisis on bank solvency.

Executive Summary

Much of the work of the FSAP was conducted prior to the COVID-19 outbreak. The FSAP’s findings and recommendations for strengthening policy and institutional frameworks remain pertinent. The risk assessment quantifies the impact of the COVID-19 crisis on bank solvency.

Norway took welcome steps to strengthen the financial system after the last FSAP. Regulatory capital requirements for banks were raised and actions were taken to bolster the weak capital position of insurers. Alongside other macroprudential measures, temporary borrower-based measures for residential mortgages were introduced, which seem to have had some moderating impact on segments of the housing market. The resolution framework was also strengthened, with the implementation of the Bank Recovery and Resolution Directive (BRRD) and the designation of Finanstilsynet (FSA) as the resolution authority.

Nonetheless, several vulnerabilities remained on the eve of the pandemic. Several risk factors identified in the last FSAP remained prominent. These included banks’ high exposure to real estate risks against a backdrop of elevated residential real estate (RRE) valuations and high household debt levels, as well as banks’ reliance on international wholesale funding markets. New risks had also emerged, including from a tight commercial real estate (CRE) market. Meanwhile, even as regulatory and institutional frameworks had evolved, some key weaknesses had not been fully addressed.

Stress tests suggest that banks entered the COVID-19 crisis well-prepared, but the current uncertainty calls for vigilance. The solvency stress tests show resilience of the banking sector under COVID and market risk scenarios, although in the most severe scenario a few banks would exhaust their capital buffers above the hurdle rates of about 10 percent CET1 ratio. Banks’ liquidity positions were found to be generally robust in the short-term, but risks become significant over longer horizons. While the stress tests suggest considerable resilience of banks, they highlight the sizable impact that shocks—such as the COVID-19 pandemic—can have. This suggests a need for caution given the high uncertainty of the current moment and underscores the importance of continued strong financial sector policies.

A novel assessment of climate-related transition risk suggests that sharp increases in carbon prices would have a significant but manageable impact on banks’ loan losses. Given Norway’s role as a major oil producer, transition risks to higher carbon prices are important. Following a price hike for corporate carbon emissions, banks’ overall debt-at-risk would remain small, though the impact varies across banks. A permanent fall in global oil demand due to higher carbon prices would lead to loan losses for banks comparable to those experienced during the 2014–16 oil price decline.

The macroprudential policy setup should be strengthened further to ensure its continued effectiveness. Developing and publishing a macroprudential policy strategy would foster accountability, facilitate communications and help prepare the market for possible adjustments of bank capital and liquidity buffers. Also, semiannual meetings between the Ministry of Finance (MoF), Norges Bank, and the FSA should be used more effectively to jointly discuss risks and specific policy actions to address them. To bolster the macroprudential perspective in times of systemic stress, Norges Bank should be given recommendation powers over capital and liquidity tools that can be relaxed. The temporary borrower-based measures for RRE should be made permanent features of the framework. Consideration should be given to broadening the toolkit for addressing CRE risks.

Microprudential oversight is thorough, but there remains scope for further improvement. To ensure that the FSA can effectively fulfill its mandate, it should be given more independence in its regulatory powers and operations, and over its budget. In the prioritization of its supervisory activities, the FSA should give more consideration to banks’ risks, which would strengthen oversight over systemic foreign branches and small banks. Given the importance of real estate and funding risks, scrutiny of banks’ risk management in these areas could also be increased. Meanwhile, the authorities should continue their efforts to maintain strong capital levels after the adoption of the EU capital framework, including through the FSA’s oversight of banks’ Internal Ratings-Based (IRB) models. The risks emanating from the unfolding COVID-19 shock make these recommendations even more pertinent. In the area of insurance supervision, the FSA needs to step up its risk monitoring and conduct its own stress tests of the insurance sector. The authorities should also address remaining weaknesses in the effectiveness of AML/CFT oversight.

Norway’s cybersecurity risk mitigation framework is advanced, but potential threats are evolving rapidly. Building on an already strong basis, there is scope to further strengthen the authorities’ cybersecurity risk supervision and oversight. In particular, the collection, sharing, and handling of information on cybersecurity incidents could be further improved. Both the FSA’s cybersecurity risk supervision of financial institutions and Norges Bank’s cyber security oversight of payment systems would benefit from more structured and comprehensive approaches, with clearly-defined expectations and procedures. Critical service providers for payment systems should be monitored more closely, including by mandating audits or on-site inspections.

While substantial progress has been made, the resolution framework and crisis management arrangements should be further developed. In particular, the new legal framework for resolution would be enhanced if the FSA, as the resolution authority, had clearly defined statutory resolution objectives and accountability. A stronger integration of the Banks’ Guarantee Fund (BGF) into the resolution framework would also be desirable. In addition, it is key that the new resolution tools included in the updated Financial Institutions Act are made operational without delay. In the area of crisis management, it would be beneficial to establish an overarching coordinating body with a mandate for system-wide coordination of activities related to crisis prevention and management. Finally, as a host to significant foreign bank branches, Norway would benefit from further strengthening the cross-border crisis management arrangements within the Nordic-Baltic region.

Additional efforts in data collection and development of analytical models would help to strengthen financial systemic risk monitoring. The authorities should collect data on the liquidity position of foreign bank branches; expand data gathering on commercial real estate; maintain accurate and updated “maps” of the internal composition of borrower groups; accelerate improved data collection for derivatives transactions and related counterparty risk; and seek to collect more granular data on bank lending to allow further development of models of banks’ credit risk.

Table 1.

Norway: Key Recommendations

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I Immediate (within 1 year); ST Short term (1–3 years); MT Medium Term (3–5 years)

Background

A. Context

1. Norway is a major oil exporter with significant financial buffers. Over the past few decades, since the discovery of oil, the country has amassed one of the largest sovereign wealth funds in the world with about US$1 trillion in assets, or about 260 percent of GDP. Public finances were in rude health at the onset of the COVID-19 pandemic. Social safety nets are strong. Norway had a major banking crisis in the early 1990s but proved mostly resilient during the global financial crisis (GFC). The pandemic is having a major impact on Norway and has come to dominate the short-term outlook. In the longer-term, the potential of the economy will face structural headwinds from population aging, slow productivity growth, and an anticipated decline in oil production.

2. The 2015 FSAP found the financial sector broadly resilient to shocks but identified also key vulnerabilities—many of which remain in place. Risk factors pertaining to house prices, household debt, and wholesale funding remain as relevant today as they were in 2015. Meanwhile, regulatory frameworks have evolved but several key weaknesses highlighted in the last FSAP are yet to be partly or fully addressed (Table 2). The 2020 FSAP revisited these areas and focused on the authorities’ ability to effectively manage persistent real estate and funding risks. In view of advanced digitalization of payments in Norway, the FSAP also assessed cyber risk oversight.

Table 2.

Authorities’ Comments on Status of Key Recommendations of the 2015 FSAP

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3. Much of the work of the 2020 FSAP was conducted prior to the COVID-19 outbreak. This report has been updated to reflect key developments and policy changes since the mission work on the FSAP was completed. Also, new risk analysis was added that quantifies the possible impact of the COVID-19 crisis on bank solvency.

B. Macrofinancial Developments

4. The Norwegian economy had shown strong performance since the last FSAP, until the COVID-19 pandemic caused major disruptions. Following a slowdown after the 2014-oil price drop, growth recovered strongly during 2016–18, supported by rebounding oil prices, accommodative policies, and krone depreciation (Figure 1, Table 3). Subsequently, the economy maintained this positive growth momentum until, starting from late February 2020, the global COVID-19 shock hit Norway hard, including on account of a nation-wide lockdown and the sharp drop in oil prices. The adverse developments triggered a sharp decline in economic activity, a spike in unemployment, and substantial further depreciation of the krone. Whereas Norges Bank had raised its key policy rate four times between September 2018 and September 2019, to 1.5 percent, during March–May 2020 it cut rates to zero percent in three quick steps. These were part of a strong set of emergency measures that the authorities took in response to the COVID-19 crisis (Box 1).

Figure 1.
Figure 1.

Norway: Indicators of Macrofinancial Conditions

Citation: IMF Staff Country Reports 2020, 259; 10.5089/9781513550930.002.A001

Table 3.

Selected Economic Indicators, 2017–22

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Sources: Ministry of Finance, Norges Bank, Statistics Norway, International Financial Statistics, United Nations1/ Based on market prices which include “taxes on products, including VAT, less subsidies on products”.2/ Includes the contribution from the mainland GDP residual.3/ Projections based on authorities’s 2019 revised budget removes both petroluem revenues and expenditures.4/ Authorities’ key fiscal policy variable; excludes oil-related revenue and expenditure, GPFG income, as well as cyclical effects. Non-oil GDP trend from MOF.5/ Over-t he -cycle deficit target: 3 percent of Government Pension Fund Global

5. Real estate prices and household debt have risen strongly over past decades. Continuing an uptrend that started in the 1990s, residential real estate (RRE) prices increased by 70 percent over the last decade, while rising more in the larger cities (particularly Oslo, where they doubled). The housing boom can be attributed to a combination of factors including population growth, cheap financing in the prolonged low-interest rate environment, and supply constraints. Higher house prices have led households to take out larger mortgages, which has fueled household debt levels (Figure 2). These now exceed 200 percent of disposable income on average, high compared to peers. The distribution of household debt is an additional concern as the share of households with debt levels exceeding five times their gross income has been on an upward trajectory. Commercial real estate (CRE) has also boomed especially Oslo’s prime office market. Corporate debt levels are about average in international peer comparison.

Norway’s Financial Sector Policy Response to COVID-19

COVID-19 has had a major impact on Norwegian society and on economic activity. As COVID-19 cases started to emerge in Norway from February/March 2020, the government swiftly implemented measures to contain the spread of the disease, including travel restrictions, social distancing measures, and closures of schools, universities and businesses. As elsewhere in the world, these measures had a deep negative impact on economic activity, which was compounded by the tightening of global financial conditions and a sharp drop in oil prices. In this backdrop, the authorities have taken wide-ranging policy measures to stabilize the economy—including extensive fiscal support to corporates and households—and to ensure financial stability. The latter set of financial sector measures is elaborated below.

Key Policy Measures to Safeguard Financial Stability:

Monetary policy actions have focused on providing liquidity to the financial sector to address heightened interest rate volatility and higher risk premia in money markets as the crisis unfolded. The actions also included three rate cuts, which have brought the main policy rate to zero percent (from 1.5 percent). The measures aim to lower borrowing costs for corporates and households, while supporting banks’ asset quality.

  • - Norges Bank has provided liquidity support to banks through extraordinary NOK loans with maturities ranging from 1-week to 1-year and with full allotment. Collateral requirements for liquidity support were also eased by removing limits on the use of non-government securities. Meanwhile, the FSA underscored that the use by banks of high-quality liquid assets held to satisfy the LCR requirement is permitted, provided it is properly reported.

  • - Norges bank agreed a US dollar swap line with the Federal Reserve for up to US$30 billion and has provided US dollar liquidity to Norwegian banks.

Macroprudential measures include a relaxation of the countercyclical capital buffer (CCyB) from 2.5 percent to 1 percent, to ease constraints on bank lending and thereby support continued provision of financial services. The authorities also indicated that no increase in the CCyB is anticipated until at least the first quarter of 2022. Mortgage lending regulation was also relaxed by temporarily allowing banks to deviate from LTV, DTI, and other requirements for up to 20 percent of new loans during 2020Q2, compared to a previous “speed limit” of 10 percent (8 percent in Oslo). This could support debt restructuring and temporary home-equity withdrawals to reduce borrowers’ financial distress.

Microprudential actions include appeals by the FSA and MoF on banks and insurers to restrict dividend payouts until economic uncertainty is reduced. Regulatory reporting of short sales of domestic equity shares has been enhanced.

6. Monetary and macroprudential policy tightening had already led to some moderation in the residential housing market before the COVID-19 shock. Stepwise increases in the countercyclical capital buffer ( which had been raised to 2½ percent as of end-2019), and the introduction of temporary household sector tools—including a stressed-interest rate debt servicing test for borrowers, loan-to-value ratio (LTV) caps and amortization requirements—aided by Norges Bank’s policy rate increases, had had some success in curbing RRE price increases in more recent years—although CRE price increases had mostly continued. The sharp downturn caused by the COVID-19 crisis may now cool real estate markets, although data through May 2020 has shown resilience thus far. In any event, historical experience suggests that housing market tensions are likely to eventually return once a recovery takes hold.

Figure 2.
Figure 2.

Norway: Sectoral Balance Sheets

Citation: IMF Staff Country Reports 2020, 259; 10.5089/9781513550930.002.A001

C. Structure of the Financial System

7. The Norwegian financial sector is sizable. Financial sector assets, excluding the globally-invested government pension fund (GPF-G), total 290 percent of GDP (Figure 3; Table 4). The GPF-G is another 260 percent of GDP as of mid-2019. The financial sector comprises 135 commercial banks (54 percent of financial system assets), mortgage companies (held mainly within the banking groups; 23 percent), insurers (18 percent), state-lending institutions (3 percent), and finance companies (2 percent). Branches of foreign banks account for about one-quarter of banking system assets, making up about 35 percent of lending to corporates and 20 percent of retail lending, with similar shares for deposits. Foreign banks are mainly from the Nordic region.

Figure 3.
Figure 3.

Norway: Evolution of Financial System Structure

(Percent of total assets; 2019 Q2 versus at last FSAP)1, 2, 3

Citation: IMF Staff Country Reports 2020, 259; 10.5089/9781513550930.002.A001

Source: Norges Bank, 2019.1 System assets total about 10.2 trillion NOK (1.2 trillion USD, or 290 percent of GDP), excluding the GPF-G, which at mid-2019 had assets of about 9.2 trillion NOK, or 260 percent of GDP.2 Inner ring is for 2014, outer for 2019 Q2 as reported in November 2019 Norway Financial Stability Report3 The “Banks” category includes branches of foreign banks.
Figure 4.
Figure 4.

Norway: Banks’ CET1 and Leverage Ratio Requirements1

(In percent; March-2020)

Citation: IMF Staff Country Reports 2020, 259; 10.5089/9781513550930.002.A001

Source: Norges Bank.1 These requirements apply to branches of foreign banks operating in Norway as well.
Table 4.

Structure of the Financial System, 2019 Q2

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Source: Norges Bank IMF World Economic Outlook [WEO], IMF staff estimates.

8. Banks exhibited high capitalization and liquidity ratios before the COVID-19 shock (Figures 47). Banks’ total regulatory capital ratio was 24.2 percent as of end-2019, with a Common Equity Tier 1 Capital Ratio (CET1) capital ratio of 18.0 percent, in line with local regulatory requirements that are consistent with Basel III (Table 5). Two domestic systemically important credit institutions face an additional two percent requirement. Banks’ liquidity levels were in full compliance with the liquidity coverage ratio (LCR) requirements, which follow the EU framework. Liquidity coverage in foreign currencies generally exceeds that in Norwegian krone owing to a shortage of domestic, high-quality liquid assets (HQLA). Bank profitability was strong in peer comparison, owing to low operating expenses (partly due to high digitalization) and low credit losses. Asset quality was high overall, with nonperforming loans (NPLs) below one percent, though NPLs on consumer debt (four percent of bank lending) are much higher at 11 percent at end-2019. Banks’ provisions provide about 85 percent coverage of NPLs.

Figure 5.
Figure 5.

Norway: Banking Developments1

(2019 Q4 or Latest Available)

Citation: IMF Staff Country Reports 2020, 259; 10.5089/9781513550930.002.A001

1 Data shown is for domestic banks only.
Figure 6.
Figure 6.

Norway: Comparison of Selected Financial Indicators1

(2019 Q4 or Latest Available)

Citation: IMF Staff Country Reports 2020, 259; 10.5089/9781513550930.002.A001

Sources: IMF Financial Soundness Indicators, European Banking Authority, Norges Bank, Country Authorities.1 Data relating to Norway is for domestic banks only and excludes branches of foreign banks operating in Norway.
Figure 7.
Figure 7.

Norway: Banking Asset-Liability Structure1

(2019 Q2 or Latest Available)

Citation: IMF Staff Country Reports 2020, 259; 10.5089/9781513550930.002.A001

1 Data is for domestic banks and mortgage companies, the latter being mainly included within banking groups.
Table 5.

Financial Soundness Indicators for the Banking Sector

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Sources: Norges Bank, FSI database, Haver analytics.

9. Banks have high exposures to real estate. Overall, close to 60 percent of banks’ lending is related to residential and commercial real estate, with most loans at variable-rates. The high exposure makes banks vulnerable to adverse developments in these markets.

10. Wholesale markets are an important source of funding. As credit demand structurally exceeds deposits and the scope for expanding the deposit base is limited, Norwegian banks obtain nearly half their overall funding from wholesale markets. The maturity of such market funding has lengthened, however, since the last FSAP and about two-thirds of wholesale funding now comes from covered bonds. The latter have partially substituted for other riskier sources of wholesale funding, such as senior-unsecured and short-term wholesale funding. There is substantial cross-ownership of covered bonds between banks, however, as they hold these as HQLA. This further adds to the real estate exposure on the asset side of banks.

Systemic Risk Analysis

A. Vulnerabilities and Risks

11. Key underlying vulnerabilities in Norway pertain to banks’ high exposures to domestic real estate—both residential and commercial—and wholesale funding (see Risk Assessment Matrix in Table 6). A deterioration in the ability of highly leveraged households or corporates to service their loans, a sharp real estate price correction, or a combination of these, will affect banks’ asset quality. And while banks have a diversified funding structure—which should generally contribute to overall funding stability—and prudently manage foreign exchange (FX) and interest rate risks, their relatively high dependence on international wholesale funding and derivatives markets implies risks in situations when liquidity in these markets were to be compromised.

12. A deterioration in borrowers’ debt servicing capacity can arise from a sharp slowdown in economic growth and from rising borrowing costs. The first could follow from a domestic output shock, lower growth in key trading partners, or a combination of both—as is currently unfolding amid the COVID-19 pandemic. The impact will be pronounced if the growth shock is accompanied by a sustained drop in oil prices—a potent transmission channel for Norway. Rising borrowing costs may result from an increase in global risk aversion. With the scope for a monetary policy offset constrained by the effective lower bound, increases in spreads will raise funding costs for banks, which could be quickly passed onto corporates and households given the prevalence of variable-rate loans. Such a development is likely to push up NPLs and put pressure on real estate valuations. There could be a feedback loop from slowing credit to the overall economy.

13. Other significant structural sources of risk relate to climate change, cybersecurity threats, and financial integrity. While physical risks from climate change are low by international comparison, the impact of an abrupt transition to a low-carbon economy (so called transition risk) could be high given Norway’s reliance on the production and export of oil. Operational risks are important as well. A cyber attack on a critical payment infrastructure could result in severe dislocations in Norway’s mostly cashless system. This could hurt confidence and lead to deposit outflows. The emergence of more episodes of financial misconduct or violations of market integrity—as the alleged breach of customer due diligence rules at DNB, Norway’s largest bank— could also lead to a loss of confidence and financial losses, including from sanctions.

B. Banking System Resilience and Stress Testing

14. Several of the vulnerabilities and risks mentioned above have been considered in stress tests of banks. These include both solvency and liquidity stress tests, as well as a tentative exploration of banks’ exposure to climate-related transition risk.1

Solvency Assessment

15. The top-down solvency exercise analyzes risks over a 3-year horizon and includes the 11 largest domestic banks. These banks account for about 80 percent of domestic banking assets (i.e., excluding the Norwegian assets of branches of foreign banks) and 60 percent of total banking system assets. The hurdle rate for each of the exercises includes all capital requirements and buffers in place after the adoption of the European capital framework but excluding the Capital Conservation Buffer (CCB) and the Countercyclical Capital Buffer (CCyB) in line with Basel Committee guidance on buffer usability. While precise hurdle rates differ per bank, they average about 10 percent, which is conservative in comparison with the Basel minimum requirement of 4½ percent. The assessment encompasses both COVID scenarios and the FSAP’s original market shock analysis.

COVID-19 Solvency Stress Test

16. Given the sharp deterioration of the outlook after the FSAP missions, additional scenario analyses have been performed to quantify the impact of COVID-19. The COVID scenarios are calibrated with the same satellite models estimated for the market shock scenario (see below) and were estimated over the same 3-year horizon. They also incorporate the effects of the measures already taken by the authorities to ease financial conditions (Box 1). A “central” and a “downside” scenario are considered.

  • The COVID central scenario reflects the projected baseline outlook—for Norway and the global economy—as of June 2020.2 In this scenario, Norwegian mainland GDP contracts by almost 5½ percent in 2020 (Table 7). The economy starts to rebound from the second half of 2020.

  • The COVID downside scenario corresponds to a situation of persistent uncertainty and a further deepening of the downturn. This is approximated by a downward divergence of a 1 standard deviation of the core variables (GDP, employment, oil price) from the central path, resulting in a GDP decline of about 7 percent in 2020 and a more gradual recovery from that point.3

17. The illustrative scenarios show that the COVID-19 shock will likely have a large impact on banks, though they would continue to meet capital requirements. At the end of the risk horizon the aggregate CET1 ratio for the in-sample banks drops by about 4 percent under the central scenario and 4½ percent under the downside one. Under the COVID downside scenario, one bank would exhaust its buffers in excess of the hurdle rate, though without breaching it.

18. While uncertainty is high and worse outcomes are possible, the COVID scenarios show a somewhat less severe impact than the market shock scenario analyzed during the missions (Figure 8). Although the frontloaded profile of the COVID-19 shock causes a comparable or worse impact on capital in the first year of the stress tests, in the second and third years the market shock scenario leads to significantly larger losses. The differences reflect both a comparatively faster recovery under the COVID scenarios and the easier financial conditions that help mitigate the real economic shock and prevent a sharper impact on banks’ net income.

Figure 8.
Figure 8.

Norway: Solvency Stress Test Results—COVID Scenarios

Citation: IMF Staff Country Reports 2020, 259; 10.5089/9781513550930.002.A001

Market Shock Solvency Stress Test

19. The FSAP’s market shock analysis remains relevant as it also examines the impact of a sharp tightening of financial conditions, combined with a deep real estate market slump. These elements feature less prominently in the COVID scenarios. While the forceful international monetary policy response and liquidity support operations have thus far mitigated market risks, stress testing such additional shocks is highly relevant given Norwegian banks’ specific exposures. For the exercise, FSA and Norges Bank ran parallel top-down solvency stress tests, based on the same scenario.4 A bottom up stress test using the same assumptions was conducted by the three largest domestic banks, which comprise 60 percent of domestic banks’ assets.

  • The market shock scenario assumes a multi-year recession that causes a fall in the level GDP of over 5 percent by the second year—an almost 3 standard-deviation shock from the long-term GDP trend—with only a very limited recovery in the third year. The cumulative drop in GDP in this scenario is worse than in the COVID scenarios and more severe than that experienced during the banking crisis of the late 1980s and the global financial crisis (Figure 9, top left panel). Property prices decline over the risk horizon by 35 percent for RRE and by more than 50 percent for CRE. Equity prices fall by 40 percent over the first two years, and the oil price drops to US$27 per barrel. To allow a clear view on the impact of the shock, no policy response is assumed.

Figure 9.
Figure 9.

Norway: Solvency Stress Test Results—Market Shock Scenario1

Citation: IMF Staff Country Reports 2020, 259; 10.5089/9781513550930.002.A001

1 Results are for domestic banks only and exclude branches of foreign banks operating in Norway

20. Under the market shock scenario, the banking system is hit hard. NPL ratios would increase substantially, up to levels not seen since the mid-1990s (Figure 9). Loan losses would rise in all sectors, with the mining sector (including oil extraction and related services) and transport and storage particularly affected (Figure 9, middle right panel). The results are driven by the protracted recession and the real estate slump, with the latter accounting for about 30 percent of overall losses.5 Loan loss provisions would be the primary drain on capital, with additional losses from debt and equity portfolios and the increase in risk-weighted assets contributing to an overall average drop in the CET1 ratio of 5 percentage points by the end of the risk horizon (Figure 9, bottom left panel). The results of the FSA exercise are similar on average, while the exercise performed by Norges Bank estimates a somewhat larger average drop in the CET1 ratio—on the order of 6.2 percentage points (Figure 9, bottom right panel).

21. However, also under this scenario there are no material breaches of the hurdle rates in the FSAP and FSA exercises. In the FSAP top-down test, buffers in excess of the hurdle rates would be depleted only partially for most banks and fully for three of them. The bottom-up stress tests run by the three largest banks also projected a decline in their capital ratios, though more contained than in the top-down exercises. The solvency stress test is complemented by a sensitivity analysis on securities market risk, which shows that risks from banks’ securities holdings are largely contained. The banks in scope of the bottom-up stress tests also ran sensitivity tests of their interest rate and FX risks, revealing low levels of risk. This result is consistent with the banks’ hedging of such risks.

Liquidity Stress Tests

22. The liquidity stress tests reveal broad short-term resilience, but with potential tensions arising over longer time horizons. The liquidity of 11 banks (the same as in the top-down solvency stress test) was assessed at different time horizons by stressing the LCR under standard assumptions and through a cash-flow analysis. The potential for specific liquidity spillovers from declines in real estate prices was not tested separately owing to data limitations. In practice, substantial mandatory degrees of overcollateralization of covered bond issuances limit immediate risks, but in the event of very severe house price declines the liquidity of these instruments could still be compromised. During the international financial turmoil surrounding the onset of the COVID-19 crisis in March 2020, Norwegian banks’ liquidity held up well—including with precautionary nonstandard central bank FX liquidity support—and potential tensions did not materialize.

23. Banks’ liquidity positions appear solid over the 1-month horizon of the LCR. The LCR stress testing was based on the combination of three “haircut” scenarios with seven “outflow” scenarios. The first scenarios assume, starting from LCR standard assumptions, increasing haircuts on banks’ counterbalancing capacity (i.e., on the assets that banks rely on to obtain liquidity in secondary markets or through standard central bank facilities). The outflow scenarios include (i) a regulatory scenario, (ii) three stress scenarios routinely used in FSAPs, assuming shocks on retail funding, wholesale funding, and both, and (iii) three stress scenarios designed by the FSA and Norges Bank consistent with their own liquidity stress test. In all individual scenarios, the average LCR for the 11 banks would remain above 100 percent over a one-month horizon, though some banks would breach the threshold under more severe scenario combinations (Figure 10, top left panel). Similarly, the LCR in domestic currency—for which a 50 percent floor applies for some banks—remains above the threshold on average, with only one bank experiencing difficulties under a severe scenario combination (Figure 10, top right panel). Norwegian banks are generally very liquid in EUR and USD and their LCR in these currencies remains well above 100 percent in all cases.

Figure 10.
Figure 10.

Norway: Liquidity Stress Test Results1

Citation: IMF Staff Country Reports 2020, 259; 10.5089/9781513550930.002.A001

1 Results are for domestic banks only and exclude branches of foreign banks operating in Norway.

24. Over longer time-horizons, an additional cash flow analysis points to some gaps in the counterbalancing capacity under severely adverse conditions. The cash flow analysis explores the balance between outflows, inflows, and counterbalancing capacity over 18 maturity buckets (from overnight to one year). The analysis is run under mildly and severe adverse scenarios, based on carefully calibrated assumptions about the stress factors (run-off, roll-off, and haircut rates). All banks would comfortably handle net outflows up to one year with their initial counterbalancing capacity under the mildly adverse scenario, though some would encounter difficulties under a severely adverse one. Starting from the 3–4 months bucket, the whole system would experience counterbalancing capacity gaps under the severely adverse scenario (Figure 10, middle right panel). A delicate role is played by debt issuance, highlighting rollover risks that banks would face under dislocations in capital markets (Figure 10, bottom panel). Difficulties in rolling over derivative transactions for hedging interest rate and FX risks also contribute to liquidity shortages. Difficulties could be compounded by possible margin calls, though an assessment of such additional drains would require detailed transaction-level data that are currently not available.

Interconnectedness

25. A partial analysis of the linkages among banks in the Nordic region suggests that interconnectedness remains important but varies over time. The 2015 FSAP conducted an in-depth analysis mapping linkages and interconnectedness in the financial system, finding that these played an important role in the system. The mission used market data to gauge how those linkages have evolved since. Specifically, spillovers between the market-valuations of large, publicly listed Nordic banks were analyzed, following the approach by Diebold and Yilmaz (2014). The analysis suggests that spillovers tend to vary considerably through time, with some weakening of the links since 2017. The results, however, should be interpreted with care. Due to data limitations, the analysis is partial and does not necessarily capture, for example, the implications of the derivatives exposures among banks. The latter are likely important and significantly concentrated. An interaction of these exposures with the cross-holdings of securities could possibly result in significant shock amplification. Norges Bank recently carried out a separate assessment of direct and indirect contagion effects within the banking sector and found that these could amplify capital depletion under stress by 1 percent on average and up to 2.5 percent in the worst case considered.6

Climate Transition Risk

26. Two partial-equilibrium analyses explore climate-related transition risks. These risks originate from the transition to an economy that emits fewer greenhouse gases and can be driven by changes in policy, advances in technology, or a combination of both.7 Due to Norway’s role as a major producer of oil and gas, transition risks play a larger role than physical risks from climate change (such as those related to flooding or hurricanes), to which it is comparatively less exposed. The analysis examines two questions. First, how would an increase in domestic carbon prices impact Norwegian banks’ credit exposures? Second, how would a fall in oil sector revenues affect Norwegian banks’ loan losses? The sensitivity tests are conducted in partial equilibrium and, among other simplifications, do not account for the use of revenues from higher carbon taxes.

27. Following a price hike for corporate carbon emissions, banks’ debt-at-risk remains small for the system as a whole, though the impact varies across banks. To analyze the impact of higher domestic carbon taxes on banks’ corporate credit exposures, a firm-level balance sheet approach is used. The exercise investigates how the additional cost from higher carbon taxes would impact firms’ debt-servicing ability and, thereby, the stability of banks. Specifically, banks’ debt-at-risk is calculated, defined as the share of exposures where the interest coverage ratio of firms’ earnings drops below a threshold value. An increase of carbon prices is simulated, to an average of US$75 and US$150, respectively—levels drawn from the literature as considered necessary to achieve emission reductions in line with Paris targets. Under these assumptions, firms employed in emission-intensive sectors such as waste management and transportation would be materially impacted (Figure 11, top panel). Banks’ increase in debt-at-risk remains small on average but is significant in banks with lending concentrated to exposed sectors (Figure 11, middle panel).

Figure 11.
Figure 11.

Climate Transition Risk Analysis

Citation: IMF Staff Country Reports 2020, 259; 10.5089/9781513550930.002.A001

Note: Supply curves are based on break-even prices for global oil production sites as provided by Rystad Energy. Demand curves are based on median price elasticity of oil demand from estimates in the literature.

28. A permanent fall in global oil demand would lead to significant loan losses for Norwegian banks. Higher global carbon taxes would put a wedge between the global oil supply and demand curves and would structurally reduce external oil demand. This would result in a fall in oil revenues that could potentially impact financial stability. To examine this channel, the impact of lower Norwegian oil sector revenues on the Norwegian economy is estimated. The analysis suggests that loan losses of banks and mortgage corporations would be significantly impacted by shocks in oil revenues. The fall in revenues stemming from a carbon price of US$75 is estimated to increase loan loss rates by about 0.3 percentage points—a doubling from pre-COVID levels—while a carbon price of US$150 would to lead to an increase by roughly 0.4 percentage points. These results are comparable to the increase in loan loss rates experienced during the oil price decline of 2014–16. This said, dynamics under a carbon price scenario can be expected to differ from past episodes since perceptions of the persistence of the shock will be different in case of a permanent policy change.

Risk Monitoring and Data

29. The authorities are encouraged to further strengthen their own analysis of financial sector vulnerabilities. While data availability is generally good, in the context of the stress testing work some important gaps emerged. In particular, authorities should establish a regular collection of data on the liquidity position of foreign bank branches; maintain accurate and updated ‘maps’ with the internal composition of borrower groups; accelerate the data collection and methodological steps needed to analyze margining arrangements for derivative transactions and related counterparty risk; and develop more analytical and granular models for credit risk at the bank and asset-class levels.

Financial Sector Oversight

A. Macroprudential Policy

30. Norway’s unusual institutional set up for macroprudential policy remains unchanged since the last FSAP. The Ministry of Finance (MoF) is the single ultimate macroprudential decision-maker in Norway, which is rare in international practice.8 Norges Bank and the FSA play important advisory roles, however, and operate most of the policy tools. They each also have relatively sophisticated risk monitoring frameworks and publish financial stability reports. Coordination across the three institutions has a long history but relies mostly on informal traditions. Norges Bank and the FSA make policy recommendations to the MoF for selected tools, some with explicit ‘comply-or-explain’ mechanisms. Policy debate mostly takes the form of public consultations (initiated by the MoF) during which the FSA and Norges Bank state their respective positions in public letters. Biannual triparty meetings take place but do not play a major role in policy formation.

31. However, the authorities have demonstrated a strong willingness and ability to act in recent years. Although the central role of the MoF has the potential for politicization of macroprudential policy, in practice the authorities have taken substantive and wide-ranging measures over the past decade, and more than observed in most other advanced economies (Figure 12, Table 8).

  • Broad-based tools. Since the introduction of a CCyB in 2015, to address growing cyclical risks, the buffer was raised three times to reach 2½ percent from end-2019. To provide for structural risks, a systemic risk buffer (SRB) was introduced in 2013. Initially set at 2 percent over all banks’ exposures, and raised in 2014 to 3 percent, the authorities had envisaged raising the SRB further to 4½ percent from end-2020, though narrowing its basis to domestic exposures only. This active use of capital tools has contributed to banks’ high capital levels, which now provide valuable buffers in the COVID-19 shock and have allowed the authorities to reduce the CCyB to 1 percent in March 2020, while leaving space for further relaxation.

  • Borrower-based household measures. To address high and rising household debt and cool the housing market, the authorities converted prior mortgage guidelines—including on LTV limits and stressed financial margins—into binding regulations. The regulations expire periodically (12 or 18 months) but have thus far been renewed. A debt-to-income (DTI) limit of 500 percent, and tighter underwriting restrictions for Oslo were also introduced. The borrower-based tools are subject to a “flexibility quota” (or “speed limit”), which during normal times allow banks to deviate from the requirements for 10 percent of lending (8 percent in Oslo). In the context of the COVID-19 outbreak, the flexibility quota was temporarily increased to 20 percent for all new loans extended during 2020Q2.

  • Measures to address CRE risks. These include: the introduction of a 100 percent risk-weight floor on CRE exposures for banks using the standardized approach in 2014, intensified oversight and Pillar II capital add-ons for banks with concentrated exposures in 2018; as well as the CCyB increases discussed above. A new temporary risk weight floor for CRE of 35 percent for IRB banks is slated to become effective end-2020 (as part of a package of measures designed to offset the weakening of capital requirements implied by the adoption of EU rules—see ¶40).

Figure 12.
Figure 12.

Norway: Macroprudential Policies

Citation: IMF Staff Country Reports 2020, 259; 10.5089/9781513550930.002.A001

32. To help ensure continued effective policy action, the institutional framework could be further strengthened by articulating a strategy, and closer interagency coordination. The existing institutional setup has important desirable features, including a high level of transparency. While these strengths should be preserved, enhancements can further improve the robustness and effectiveness of the framework. Developing and publishing a macroprudential policy strategy would help further insure against inaction bias, foster accountability, facilitate external communications and prepare the market for possible adjustments to buffers. Regarding process, the semiannual triparty meetings should be used more effectively to jointly discuss risks and the specific policy actions needed to address them.

33. To bolster the macroprudential perspective in times of systemic distress, Norges Bank should have advisory powers over tools that can be relaxed. Norges Bank should be given recommendation powers, with a comply-or-explain mechanism, over tools—such as the SRB and the LCR in significant currencies—that could be considered for relaxation in case the structural risks they target materialize. Doing so would send a welcome signal about the potential for (partial) easing of these tools during severe stress episodes, and it would complement the recommendation powers Norges Bank already has over the CCyB.

34. Key elements of the temporary household measures should be made permanent features of the framework. The duration of the measures should match the structural nature of the risks they address. This argues for making them permanent, as was also recommended in recent Article IV consultations. Keeping household tools in place (and adjusting them occasionally if needed) would be more prudent and cost effective than removing and reintroducing them over the housing cycle.

35. Although CRE market risks are now on the downside, broadening the toolkit for CRE vulnerabilities could help address these in a more targeted manner during future upswings. The authorities should consider the introduction of a sectoral CCyB, which has been used effectively in Switzerland, or a sectoral SRB to specifically address banks’ CRE exposures. Such targeted tools would help contain CRE risks without imposing undue costs on banks with low CRE exposures.

36. To facilitate systemic risk analysis and tool calibration, data collection should be expanded. Data quality and availability is generally good, and further progress was recently made with the establishment of a credit registry for consumer lending. Nonetheless, there are important remaining data gaps. Specifically, it would be useful to collect data on NPLs and financial distress for households to guide calibration of borrower-based tools. As recommended in the last Article IV consultation, the collection of more granular and comparable data on CRE is also desirable to facilitate monitoring and analysis, as well as the possible future development of new instruments.

B. Banking Sector Supervision

37. The FSA has thorough supervisory processes and tools, with key improvements made in recent years. The oversight framework is solid, and the FSA has the required supervisory powers to limit or address unsound bank practices and risk-taking behavior. The framework has also been further strengthened since the last FSAP. Improvements included the adoption of higher regulatory capital requirements and key updates to supervisory modules. Also, new temporary requirements were introduced for RRE and consumer loans, and the LCR was fully phased-in.

38. However, weaknesses remain in the FSA’s operational independence and oversight of smaller banks and foreign branches. Two key issues identified by the 2015 FSAP remain. First, the FSA’s operational independence continues to be limited, with the MoF setting the FSA’s budget. The MoF also has the power to decide on prudential regulations, set goals and issue instructions, grant and revoke bank licenses, and to overturn the FSA’s supervisory decisions. Second, the FSA adopts an approach to supervision that focuses mostly on the largest domestic banks. Consequently, there is less focus on other banks’ risk profiles, which could leave medium and smaller-sized banks— particularly those with elevated risks—inadequately supervised individually or in the aggregate. Prudential oversight of foreign bank branches (some systemic) is conducted by the home supervisors, and the FSA’s engagement is mainly through cross-border cooperation and participation in supervisory colleges.

39. The FSA should be given more independence in its regulatory powers, operations, and budget. To ensure the ability of the FSA to effectively fulfill its mandate, its independence should be strengthened. The FSA should have powers to issue binding regulations and to decide on bank licenses and their withdrawal. In addition, the MoF’s powers to issue instructions to the FSA and decide on appeals to FSA supervisory decisions should be limited. More budgetary autonomy for the FSA, appropriately paired with a higher level of accountability, would help it to manage and control its resources more effectively.

40. Greater consideration of banks’ risk profiles and stronger oversight of systemic foreign bank branches is also warranted. The FSA’s current supervisory approach is understandable given the systemic reach of the largest banks. However, when planning and performing its supervisory activities, a deeper consideration of banks’ risk profiles would help ensure better coverage of high-risk medium and small-sized institutions which, in aggregate, can be significant to the banking system. Notwithstanding the FSA’s active involvement in cross-border supervisory cooperation with the home supervisors of foreign banks, the FSA should also consider increasing its direct monitoring and onsite supervision of foreign branches, especially systemic ones. These improvements may require an increase in the FSA’s resources, which underscores the importance of granting the FSA more budgetary autonomy.

41. The authorities should continue their efforts to maintain strong capital levels after the adoption of EU rules. The adoption of the EU capital adequacy framework in 2020 represents a weakening of existing requirements in Norway, including because of the removal of the Basel I floor and the introduction of the supporting factor for loans to small and medium-size companies (SMEs). The European framework also limits the authorities’ room for maneuver under Pillar 1 (i.e., minimum capital requirements). In response, the MoF increased some capital requirements and the FSA has initiated steps to enhance the requirements of the IRB models for credit risk. The mission supports these efforts and encourages the authorities to monitor the implications of the transposition of the EU rules on banks’ capital and take actions as needed to maintain strong capital levels. In this context, the FSA should continue to enhance its oversight of banks’ IRB models. It should also provide banks with a transparent and detailed description of its Pillar 2 approach and decisions.

42. The FSA should further bolster the regulatory framework for banks’ credit risk and its oversight of related systems and models. Credit risk, particularly in real estate lending, is the predominant risk exposure of Norwegian banks. The FSA should therefore develop supervisory guidance on prudential aspects of loan loss provisioning and the valuation of real estate. Making the temporary prudential regulations for residential real estate and consumer lending permanent (see above) will also be important in this regard. The authorities should also develop supervisory guidance on CRE exposures to supplement their intensified supervisory scrutiny of this asset class.

43. Prudential oversight of banks’ liquidity and funding should be strengthened. The LCR has been in force since 2015 and minimum requirements for LCR in significant currencies were added in 2017. However, liquidity oversight could usefully be extended beyond this. In particular, the Net Stable Funding Ratio (NSFR), currently reported by banks, should be introduced as a requirement according to the EU framework timeline. Given banks’ significant reliance on covered bonds in their liquidity management and funding—and the more lenient treatment of such instruments in European LCR framework—the FSA should also further enhance its oversight of banks’ liquidity and funding risk management. This is important because cross-holdings of covered bonds among banks and their link with the real estate market may exacerbate risks.

C. Insurance Sector Supervision

44. Norway has a significant insurance sector. The sector has balance sheet assets of NOK 1820 billion, or about 18 percent of the total financial system. The life insurance business, including pensions, dominates and accounts for 90 percent of the sector. Non-life (property and casualty) makes up the remaining 10 percent. Many insurers are part of broader conglomerates.

45. Capital levels of insurers have improved significantly in recent years. At the time of the last FSAP, the Norwegian insurance sector was under considerable pressure from the low-interest rate environment and capital levels had weakened. Since then, and in the run-up to the adoption of Solvency II, the authorities took several steps to boost capital for the industry, including by requiring greater profit retention. Insurers also increased capital through the issuance of subordinated debt, reduced costs, and lowered their investment risk.

46. Several insurers continue to face challenges from the protracted low interest-rate environment, though changes to their business models are gradually reducing these risks. Life insurers in the private sector have ceased offering products with interest rate guarantees or significantly reduced them. Similarly, a transition from defined-benefit to defined-contribution schemes in occupational pension plans is reducing solvency risks in the long run. However, as guarantees in Norway have been often provided for life, the legacy of past commitments will continue to affect insurers’ solvency position for a considerable time.

47. While oversight is robust, the FSA’s risk analysis of insurers could be enhanced. In particular, the FSA should strengthen risk-monitoring at group and industry-wide levels to better cover systemic risks. The FSA should also conduct its own market-wide stress tests of the insurance sector, instead of relying on EIOPA exercises, which covers only the two largest insurers. The authorities should monitor banking-insurance conglomerates more closely to assess the aggregation of any counterparty linkages and common exposures.

48. The FSA should also consider a broader set of risk measures to guide its supervisory activities. The FSA follows a risk-based approach to supervision and prioritizes its supervisory review of insurers based on two factors—risk and impact, with impact is measured by insurers’ market share and risk measured by a firm’s solvency ratio. The FSA should consider strengthening the risk dimension of their classification by adding additional metrics. These could usefully include market risk, credit risk, profitability and liquidity, as well as the quality of risk management and governance in the supervised entities. These metrics should help identify not only current risk levels, but also their evolution over time.

49. Recent measures to reduce regulatory arbitrage between banks and insurers are welcome but more can be done to contain insurers’ risks from housing exposures. To minimize incentives for regulatory arbitrage within conglomerates, steps were recently taken to make capital requirements on holdings of mortgage portfolios more consistent for banks and insurers. These measures are welcome, but the FSA should also consider establishing a comprehensive monitoring and reporting framework to track the evolution of the real estate market and risks from residential mortgage lending faced by individual insurers. In addition, it will be useful to monitor closely how the new rules affect insurers’ and conglomerates’ investment behaviors.

D. Cyber Resilience

50. In a backdrop of considerable vulnerabilities, the cybersecurity risk mitigation framework is mature and advanced (Figure 13). Norway has been at the forefront of digitalization of payments and financial services, which has made continuously evolving cyber threats an increasingly prominent risk factor. A specific concern is outsourcing of information technology (IT) services by critical payment systems to external service providers, which are not directly supervised by the authorities. Given the elevated risks, threat-intelligence collection and crisis management platforms used by financial institutions and Financial Market Infrastructures (FMIs) are well developed. Also, cybersecurity risk regulation and supervisory practices are generally sound. The FSA has adequate regulatory tools and expertise to fulfill its responsibilities, though cyber expertise at the payment systems oversight function in Norges Bank is comparatively less developed.

Figure 13.
Figure 13.

Norway: Cyber Security Oversight Landscape1

Citation: IMF Staff Country Reports 2020, 259; 10.5089/9781513550930.002.A001

Source: IMF staff1 CERT refers to a Computer Emergency Response Team.

51. Building on a strong basis, there is scope to further strengthen cybersecurity risk supervision and oversight. As a pilot exercise, the Norway FSAP has been the first to cover cybersecurity risk mitigation. Although existing regulation and supervisory practices are sound, the assessment of the cybersecurity framework suggests room for further improvement. In particular:

52. The incident reporting and crisis management frameworks for systemic cyber incidents could be further improved. Norway has a well-established cybersecurity information and threat-sharing system that promotes the timely sharing of information. However, the incident-reporting framework could be further improved by setting clearer qualitative or quantitative thresholds for cyber incidents and by further defining processes and formats for incident reporting, including to facilitate swift corrective measures when needed. Norges Bank and the FSA would also benefit from information sharing agreements on cybersecurity incidents between them as well as a clearly defined crisis management framework on how to maintain financial stability if systemic cybersecurity incidents occur.

53. Cybersecurity risk supervision at the FSA would benefit from a more structured and comprehensive approach. The FSA has adequate expertise and regulatory tools to fulfill its responsibilities as cybersecurity risk supervisor. However, it could follow a more structured approach for cybersecurity risk supervision. This should include a clear description of how off-site supervision on cybersecurity should be conducted, and how assessments influence the overall risk assessments of institutions by the general supervisors. The FSA is also encouraged to issue additional enforceable guidance to the supervised institutions on IT/cybersecurity risk and to increase the intrusiveness of on-site cybersecurity risk inspections.

54. Norges Bank’s cybersecurity risk oversight of payment systems should be intensified. Following a more structured and comprehensive approach to cybersecurity risk would also help increase the effectiveness of the oversight function at Norges Bank. This includes utilizing a portfolio of tools and techniques to assess cybersecurity risk against set expectations, reaching clear conclusions and identifying specific remedial measures. Further cybersecurity training for overseers is also important, to strengthen the oversight function’s capabilities. Additionally, clear communication of expectations by Norges Bank to the market, supplementing the Committee on Payments and Market Infrastructures-International Organization of Securities Commissions (CPMI-IOSCO) guidance, would increase the cyber-resilience of inter-bank payment systems. Finally, the oversight function should be given adequate independence and resources to conduct thorough oversight of the Norwegian Real Time Gross Settlement (RTGS) system (NBO).

55. More attention needs to be given to critical service providers. Given the importance of a small number of external service providers for interbank payment systems, the oversight function should use its existing legal powers to seek greater assurance and transparency from critical service providers. This could include, amongst other tools, performing or mandating regular cybersecurity audits and/or onsite inspection.

E. Anti-Money Laundering and Countering Terrorism Financing (AML/CFT)

56. A recent assessment by the Financial Action Task Force (FATF) indicates that the Norwegian authorities have made progress in addressing AML/CFT deficiencies. Norway’s previous AML/CFT mutual evaluation, conducted by FATF in 2014, found shortcomings both on technical compliance with standards and in the effectiveness of ML/TF risk mitigation. Since the 2014 evaluation, Norway has substantially strengthened its AML/CFT legal framework, including by adopting a new AML Act and regulations in 2018. This has improved legal compliance, resulting in higher ratings on 20 (out of 40) FATF recommendations in the recent reassessment, leaving only five recommendations less than largely compliant. The 2019 FATF follow-up assessment also noted progress regarding the framework’s effectiveness. In particular, Norway has demonstrated significant improvement of its understanding of ML/TF risks, developed a national AML/CFT strategy, improved national coordination and operational cooperation, and prioritized awareness of vulnerabilities in high-risk areas, including banking and payment institutions. This progress has resulted in higher ratings on the understanding of risks and national AML/CFT coordination.

57. However, the FATF assessment also points to important remaining weaknesses. Notwithstanding the progress noted, the FATF’s rating on the overall level of effectiveness of AML/CFT oversight has remained unchanged at “moderate.” Although the FSA has taken actions to link supervisory activities to identified ML/TF risk, in practice the scope, intensity and frequency of its supervision remains insufficient and not always in step with the identified level of risk. In particular, AML/CFT supervisory activities relating to banks (including foreign bank branches) and money transfer services are not proportionate to the high levels of risk in these sectors. The FATF also noted that the FSA had not used its powers to impose monetary penalties. However, after the assessment the FSA imposed penalties on three banks for breaches of AML/CFT compliance.

58. Further improvements are needed to strengthen the effectiveness of AML/CFT supervision. Specifically, the FSA should increase the frequency of its onsite AML/CFT inspections of banks, including branches of foreign banks, particularly in the form of targeted and thematic inspections. The recent increase in the FSA’s budget for AML / CFT inspections is welcome. In addition, the FSA should further improve its risk-based approach to AML/CFT and its supervisory tools and methodologies. Building on the recent progress made in applying the new sanctioning powers under the recent AML act, the FSA should also pursue an active enforcement approach by applying monetary penalties as needed to address banks’ AML/CFT deficiencies.

Systemic Liquidity

59. The FSAP assessed the functioning and resilience of key funding markets. Given a limited deposit base, Norwegian banks rely on a diversified funding mix with a relatively large role for market-based funding. Banks’ high usage of market funding, and related foreign currency exposures and cross holdings of covered bonds, make them vulnerable to changes in investor sentiment and market conditions, both domestically and abroad. Against this background the FSAP reviewed the functioning of key funding and hedging markets, as well as the authorities’ ability to manage liquidity conditions in normal times and times of stress.

60. FX swap and covered bond markets—which are key to bank funding operations—are functioning well, though there are important tail risks. The functioning and resilience of FX swap markets is key for Norwegian banks because of the role swaps play in their liquidity management and their importance as a hedging instrument for funding in foreign currencies. In the assessment of the FSAP, these markets function well, and their trading activity has demonstrated resilience with stable turnover during past episodes of financial market turbulence as well as during the COVID-19 related volatility thus far The same can generally be said of primary and secondary covered bond markets, where the investor base is stable and mostly comprises institutions with long-term investment horizons (e.g., pension funds and insurance companies). Fundamentally, however, the demonstrated resilience of these markets in the past does not preclude possible liquidity problems in the future. The potentially high impact of funding and liquidity disruptions require effective systems for liquidity management and support.

61. Norges Bank has an effective framework for managing liquidity in normal times. Norges Bank carries out well-established operations that are generally effective in keeping banking system liquidity neutral in a context of often-large government transactions. The high correlation between the policy rate and the operational target (Norwegian Overnight Weighted Average rate, NOWA) confirms the effectiveness of the liquidity forecasting framework and the regular open market operations. However, the reported NOWA rate spikes at quarter-end, suggesting that banks are unwilling to lend at these times when they have to meet leverage ratio requirements (Figure 14). The authorities should consider whether the leverage ratio requirement could be averaged over each quarter to reduce incentives for this behavior.

Figure 14.
Figure 14.

Norway: Developments in Structural Liquidity

Citation: IMF Staff Country Reports 2020, 259; 10.5089/9781513550930.002.A001

Source: Norges Bank.

62. The framework for managing liquidity during stress is also well-defined. Norges Bank can provide bilateral emergency liquidity assistance (ELA), including in foreign currency, to eligible financial institutions and has developed a framework to provide market-wide liquidity support, which can be carried out through longer term lending operations. Norges Bank’s forceful response to the liquidity pressures following the COVID-19 shock—which included extended lending operations in NOK and USD—confirms this assessment.

63. However, it would be useful to analyze and monitor more closely the availability of collateral across eligible counterparties. Monitoring information on the amounts of eligible collateral, including high-quality liquid assets, held by banks would allow Norges Bank to gauge the impact of liquidity regulation, for example relating to the LCR requirement, and assess in real time developments in, and risks to, the liquidity buffers of banks.

64. Completing ongoing work to facilitate acceptance of loan portfolios as nonstandard collateral would improve Norges Bank’s capacity to provide liquidity in times of stress. Such a framework would substantively broaden the universe of potentially acceptable collateral and improve Norges Bank’s capacity to provide both bilateral ELA and market-wide liquidity support. The preparation should involve relevant counterparties to develop and test the exchange of relevant loan and portfolio information in a timely and accurate manner.

65. The authorities have improved the accuracy and integrity of key benchmark interest rates. The European Union Benchmark Regulation entered into force in Norway in December 2019 and the framework for the Norwegian interbank offered rate (NIBOR) was changed with effect of January 1, 2020. Further adjustments to the improved NIBOR should be made if and as needed to ensure smooth market functioning and market integrity.

Financial Safety Nets and Crisis Management

66. Progress has been made with the resolution framework and crisis management arrangements. An important step has been the adoption of the European Bank Recovery and Resolution Directive (BRRD) per January 2019, which has led to several changes to the resolution framework. The FSA has now been formally designated as the resolution authority and the resolution framework has been enhanced, including by the introduction of a bail-in tool framework for senior unsecured liabilities. Financing arrangements for bank resolutions were recently established by moving part of the funds accumulated in the deposit insurance fund—the Banks’ Guarantee Fund (BGF)—into a new resolution fund, with a separate fee structure. Key governance reforms were also implemented at the BGF, particularly by reducing the number of active bankers in its board. Regarding crisis management, the continuing close cooperation between the Nordic-Baltic authorities is commendable. However, a recent cross-border crisis-simulation within the Nordic-Baltic Stability Group revealed weaknesses in communication and coordination on ELA.

67. The legal framework should be further enhanced by giving the FSA, as the resolution authority, clearly defined statutory resolution objectives and accountability. While the FSA has been established as the resolution authority, the MoF retains significant resolution powers under the new legislation. To effectively perform its designated role, however, and consistent with the FSB Key Attributes, the FSA should be able to autonomously execute its resolution mandate without undue interference from the government or industry. Government involvement should be limited to resolutions that require public funds. Also, the new framework needs to be refined by clarifying the responsibilities, accountabilities, procedures and information-sharing arrangements among the relevant bodies. This includes a stronger integration of the BGF with the resolution framework. The authorities should exclude any active bankers from the BGF Board. The BGF should not provide open bank assistance, given the risks to which it exposes the deposit insurer.

68. The new resolution tools should be made operational without delay. This includes establishing the mechanics of a bridge bank and asset separation tools as well as preparing modalities to finance the relevant operations. The resolution fund should be made operational as soon as possible. Since the resolution tools are untested in Norway, the authorities should continue to conduct intra- and cross-institutional crisis simulation exercises to test those tools. The build-up of MREL, including the subordinated component, is a high priority. More work is also needed for the practical execution of the bail-in tool, given that the large majority of MREL (subordinated) instruments are likely to be held by foreign investors. The FSA should consider applying multiple resolution options, in particular given the limited experience with bail-in. It would also be advisable for the existing court-based winding-up and liquidation procedures to be integrated in the new administrative resolution framework. The authorities should consider taking a policy decision to the effect that the public interest test is met by default for most banks.

69. The authorities should consider establishing an overarching system-wide crisis management framework. While the informal channels for interaction on crisis management are well-established and actively used by the FSA, Norges Bank and the MOF; it would nevertheless be beneficial to establish a high-level coordinating body that would have a mandate for system-wide contingency planning and for coordination of policies and information sharing across relevant agencies in all aspects related to crisis prevention and management.

70. As a host to significant foreign branches, Norway would benefit from enhancing cross-border crisis management arrangements within the Nordic-Baltic region. The Nordic-Baltic Stability Group (NBSG) meets regularly, at least annually, and can meet more often under extraordinary circumstances; relevant EU authorities (e.g., the ECB and SRB) can be invited as guests. The establishment of resolution colleges and the work carried out there has been an important step in strengthening the cross-border bank resolution framework. However, the resolution colleges should not be seen as substitutes for (high-level) official crisis management preparedness.

Table 6.

Risk Assessment Matrix

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Table 7.

Key Variables in Stress Test Scenarios

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Source: IMF staff.
Table 8.

Key Macroprudential Measures Related to the Housing Market

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Source: Norges Bank, Financial Stability Report, October 2019.99
Table 9.

Financial Sector Policy Recommendations in Recent Article IV Consultations

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Source: IMF Staff.

Annex 1. Banking Sector Stress Testing Matrix (STeM)

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1

The FSAP did not stress test the insurance sector because such an exercise had been performed in the 2015 FSAP and the health of the insurance sector has improved since then. Instead, the FSAP allocated resources to the targeted assessment of insurance oversight, which was not covered in the previous FSAP.

2

The COVID-19 stress tests are based on a preliminary version of the June WEO forecasts for Norway. The forecasts were subsequently revised up somewhat (the latest forecasts are shown in Table 3).

3

The GDP path in the COVID downside scenario is comparable in severity to the adverse scenario in the June 2020 WEO Update, while the assumed oil price drop is substantially larger than in the WEO scenario. Market variables such as equity and house prices are estimated with models based on the path of the core macro variables.

4

Time and resource constraints did not allow for similar parallel and bottom up exercises for the COVID-19 exercise.

5

This assumes that about three-quarters of the losses from retail loan portfolios are related to mortgages.

6

See ‘Assessment of Contagion Effects in The Banking Sector’, Financial Stability Review 2019, Norges Bank.

7

Vermeulen et al. (2018) An energy transition risk stress test for the financial system of the Netherlands. De Nederlandsche Bank Occasional Studies, Volume 16–7.

8

Denmark has a somewhat similar set-up, with the Minister for Industry, Business and Financial Affairs designated as macroprudential authority under CRD IV. However, Denmark’s Systemic Risk Council is the macroprudential authority established in accordance with ESRB recommendations. Denmark effectively has two authorities, Norway only one.

Norway: Financial System Stability Assessment-Press Release; and Statement by the Executive Director for Norway
Author: International Monetary Fund. Monetary and Capital Markets Department