## _cr15252

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### Executive summary: key findings and vulnerabilities
- Norway’s financial system coped well with the global financial crisis and has further increased buffers to deal with potential shocks.
- Significant financial imbalances have built up since the crisis, driven by prolonged low interest rates and high oil prices.
- Housing market estimated to be overvalued by 25–60 percent.
- Household debt-to-disposable income ratio is about 220 percent.
- To finance increased lending to households, banks have relied extensively on wholesale funding.
- Norway’s close regional and global interconnectedness is a source of potential spillover risks.
- Stress tests indicate that under a combination of severe shocks (including protracted low oil prices and a sharp contraction in house prices), the aggregate capital shortfall for banks could be up to 4.6 percent of GDP over five years.
- Norwegian banking groups face liquidity gaps in domestic currency, exposure to maturity mismatches and rollover risks due to reliance on currency swaps.
- Insurers’ solvency ratios would decline sharply under a combination of severe shocks under the Solvency II framework; the transition rule to Solvency II would significantly reduce the immediate need for insurers to raise capital.
- The Financial Supervisory Authority of Norway (FSA) should continue to constrain dividend distribution by weakly capitalized insurance institutions and ensure insurance businesses of conglomerates are adequately capitalized on a solo basis.

### Policy recommendations and near-term priorities
- Strengthen bank resilience:
  - Ensure adequate capital buffers, including through discretionary requirements under Pillar II of the capital framework.
- Contain systemic risks from real estate prices and household indebtedness:
  - Consider stricter loan-to-value (LTV) ratios.
  - Consider loan-to-income (LTI) or debt service ratio (DSR) to supplement the affordability test.
  - Consider reducing tax incentives for mortgage finance.
  - Consider relaxing planning and building requirements to reduce housing market imbalances.
- Address banks’ wholesale funding risks:
  - Consider measures to contain risks related to banks’ wholesale funding (e.g., limits on mismatch between maturity of currency swaps and maturity of underlying exposures).
- Enhance stress testing and liquidity monitoring:
  - Intensify Norges Bank (NB) and FSA cooperation to exploit synergies between macro- and micro-prudential stress testing.
  - Further enhance stress testing frameworks.
  - Consider supplementing Basel III liquidity requirements with stress tests aligned with banks’ funding and cash flow profiles.
  - Improve liquidity monitoring by performing liquidity stress tests using cash-flow structures at various maturities; or applying customized versions of the LCR along the maturity ladder.
- Insurance sector actions:
  - Enhance stress test framework for insurance sector.
  - Allocate more resources to FSA to assess liability-side risks and validate models and assumptions used in bottom-up stress tests.
  - Achieve recapitalization of weakly capitalized insurance companies; continue to restrict dividend payouts by companies with weak capital adequacy.
- Institutional and macroprudential governance:
  - Improve procedures for advice by NB and FSA to the Ministry of Finance (MOF); adopt a more transparent “comply or explain” approach by decision makers.
  - Provide an annual broader overview of collective purpose, impact, and effectiveness of macroprudential instruments.
  - Consider greater delegation of decision-making powers over macroprudential instruments to NB or FSA based on clear mandates, objectives, and accountability; alternatively, establish a formal committee.
- Strengthen FSA operational independence and supervisory capacity:
  - Augment FSA’s de jure operational autonomy.
  - Expand FSA powers (particularly corrective actions and sanctions) and supervisory resources to increase frequency and depth of inspections of small institutions.
  - Upgrade FSA supervisory approach to AML/CFT issues, including increasing supervisory activities and providing guidance.
- Financial Market Infrastructure (FMI) oversight:
  - Strengthen operational risk management related to outsourcing in systemically important payment systems.
  - Consider deepening regulatory cooperation to assess operational risks and manage dependencies on critical service providers.

### Macroeconomic and financial sector setting: essential data and interpretation
- Real mainland (non-oil) GDP growth has averaged about 2.9 percent in the last two decades.
- Unemployment was 3.5 percent in 2014.
- Norway’s flexible inflation-targeting framework and flexible exchange rate have helped anchor inflation expectations and absorb foreign shocks.
- High oil production and exports, combined with Norway’s fiscal rule and Government Pension Fund Global (GPFG), have produced strong fiscal and external positions.
- Norway’s net creditor position vis-à-vis the rest of the world has reached more than 200 percent of mainland GDP.
  - Public sector (including the central bank) and institutional investors have a net external creditor position of about 280 percent of mainland GDP.
  - Banks (including mortgage companies) and corporations have a net debtor position equivalent to about 85 percent of GDP.
- Availability of external credit facilitated private sector imbalances: domestic credit demand outstripped deposit evolution, prompting banks and mortgage companies to rely increasingly on wholesale (particularly external) funding.
- Credit growth has outpaced GDP growth with rapid increases in real estate prices, resulting in household and corporate indebtedness well above OECD averages.

### Financial system structure, funding, and concentration
- Structure and concentration:
  - Sector concentrated and dominated by conglomerates, some based in other Nordic countries.
  - DNB is the largest domestic financial group and acts as the settlement bank for 97 smaller banks.
  - Regulatory firewalls and restrictions on intra-group financial transactions are in place.
- Funding structure and mortgage companies:
  - Banks and mortgage companies rely extensively on wholesale funding, in particular covered bonds.
  - Banks’ lending operations exceed deposits by a margin of almost two to one.
  - Covered bonds issued through mortgage companies account for banks’ dominant source of financing.
  - Transfers of mortgage loans to covered bond companies:
    - Banks, excluding DNB, have transferred about 45 percent of their mortgage loans to their partly or fully owned covered bond companies.
    - DNB has transferred 80 percent.
  - Overall funding of Norwegian banks (figures):
    - Market funding 51%
    - Customer deposits 40%
    - Equity and subordinated debt 9%
    - Market funding by type: Covered bonds 40%, Senior bonds 20%, Other wholesale funding, incl. interbank 40%
    - Market funding by maturity: Greater than one year 66%, Three to twelve months 10%, Less than three months 24%
    - Market funding by source: Foreign 60%, Domestic 40%
- State ownership and systemic importance:
  - Government holds a 34 percent stake in DNB.
  - Two of the three banks designated as D-SIBs are at least partly state owned; Kommunalbanken is fully state owned.

### Financial sector performance and selected indicators (selected FSIs, exact figures)
- Regulatory capital to risk-weighted assets: 2006 11.2; 2007 11.7; 2008 11.2; 2009 13.0; 2010 14.2; 2011 13.6; 2012 14.5; 2013 15.5; 2014 16.5
- Regulatory Tier 1 capital to risk-weighted assets: 2006 8.7; 2007 9.3; 2008 8.6; 2009 10.5; 2010 11.8; 2011 12.1; 2012 13.2; 2013 13.8; 2014 14.5
- Nonperforming loans net of provisions to capital: 2006 4.4; 2007 3.8; 2008 5.7; 2009 9.4; 2010 10.9; 2011 10.9; 2012 10.2; 2013 8.5; 2014 7.1
- Provisions to nonperforming loans: 2006 26.9; 2007 22.4; 2008 21.4; 2009 21.0; 2010 22.1; 2011 21.5; 2012 19.4; 2013 20.9; 2014 20.1
- Nonperforming loans to total gross loans: 2006 0.6; 2007 0.5; 2008 0.7; 2009 1.3; 2010 1.6; 2011 1.6; 2012 1.6; 2013 1.4; 2014 1.3
- Sectoral distribution of loans to total loans (2014): Nonfinancial corporations 29.8; Households (including individual firms) 37.2; Nonresidents (including financial sectors) 22.8
- Return on assets (ROA): 2006 0.9; 2007 0.8; 2008 0.5; 2009 0.5; 2010 0.8; 2011 0.6; 2012 0.6; 2013 0.7; 2014 0.8
- Return on equity (ROE): 2006 16.5; 2007 15.6; 2008 11.1; 2009 10.4; 2010 14.1; 2011 10.5; 2012 9.5; 2013 10.7; 2014 12.7
- Leverage ratio: At 6½ percent, the leverage ratio for Norwegian banks is well above the proposed 3 percent minimum under Basel III.

### Key financial stability risks and macrofinancial vulnerabilities
- Principal risks:
  - Sharp reductions in oil prices and their durability over the medium term.
  - High and rising household debt and property prices.
  - Banks’ reliance on wholesale borrowing.
  - Regional interconnectedness and spillovers from the Nordic region and global markets.
- Household sector vulnerabilities:
  - Household debt was at about 220 percent of disposable income at end-2014.
  - About 85 percent of household debt is residential mortgages.
  - About 14 percent of new loans are interest only.
  - Mortgage lending accounts for about 57 percent of total bank lending.
  - House prices may be overvalued by about 25–60 percent.
- Corporate and commercial property vulnerabilities:
  - Commercial property sector is a source of vulnerability, particularly in Oslo.
  - Banks’ exposures to shipping, fisheries and fish farming are modest in aggregate but can be large for individual banks.

### Household Debt Stress Tests (Box 1)
- Vulnerability under current conditions (Norges Bank study):
  - Only about 2 percent of household debt is “more vulnerable.”
  - The proportion of vulnerable households is about 1 percent.
- Vulnerability criteria (household debt meeting all three):
  - (i) debt above five times disposable income;
  - (ii) financial margin below one month of after-tax income;
  - (iii) net debt larger than the value of dwelling.
- Stress shocks applied (separately and combined):
  - (i) lending rate increase of 2 percentage points;
  - (ii) real house price drop by 40 percent;
  - (iii) income (after tax) drop of 20 percent.
- Impact on share of vulnerable debt and vulnerable households (In percent):
  - Interest rate increase: 4.6 / 1.9
  - House price fall: 5.5 / 2.5
  - Fall in income: 8.1 / 3.4
  - Combination of the three shocks: 21.0 / 8.6
- Distributional effects:
  - Lower income and younger households are disproportionately affected; aggregate proportions remain below 10 percent under the severe combined scenario but mask concentration in specific cohorts.

### Banking-sector stress scenarios and TD results (top-down IMF estimates)
- Macroeconomic adverse scenario calibrations:
  - Adverse scenario with no monetary policy response:
    - Level of GDP declines by 16.1 percent below the baseline by 2019.
  - Adverse scenario with a monetary policy response:
    - Assumes a 1½ percentage point cut in the policy rate in 2015-16; level of GDP declines 13.9 percent below the baseline by 2019.
  - Adverse scenario calibration assumptions:
    - Sustained lower nominal oil prices at US$40 per barrel over the entire stress testing horizon (baseline projection US$77 by 2019).
    - Increase in money market rates by about 200 bps and wholesale funding spreads by an additional 150 bps (relative to the baseline).
    - 40 percent decline in real property prices over five years.
  - Severity measure: declines translate to a decline of 2¾ to 3.1 standard deviations of five-year cumulative real GDP growth rate relative to the baseline.
- CET-1 impact (IMF TD estimates):
  - Under the adverse scenario without policy response, the CET-1 ratio would fall by 6.7 percentage points to 6.3 percent.
- Drivers of CET-1 decline:
  - Higher loan losses: about 1.4 percent a year.
  - Rise of RWAs: about 0.8 percent a year.
  - Higher funding costs: about 0.3 percent a year.
- Recapitalization needs:
  - Recapitalization needs under the adverse scenario without policy response are estimated at 4.6 percent of GDP by 2019.
  - Of the potential recapitalization needs by 2019, about 1.4 to 1.9 percent of GDP would be attributable to the introduction of Basel III (depending on the TD approach).

### BU versus TD stress-test comparison and liquidity stress tests
- BU versus TD capitalization effects:
  - BU approach: CET-1 ratio declines by 0.6–1.4 percentage point over the stress testing horizon.
  - TD approach: CET-1 ratio drops by 6.7 percentage point.
  - Discrepancy driven by lower credit loss rates in BU, expert judgment on large corporates, and muted household loss estimates by banks.
  - Implied recommendation: banks should consider introducing more conservative assumptions in their models.
- Credit concentration (BU sensitivity):
  - Defaults of up to the 10 largest borrowers indicate banks can absorb such defaults with average CET-1 ratios remaining above regulatory minimum.
- Liquidity stress tests — NOK and FX:
  - Scenarios: (i) complete dry-up of unsecured wholesale funding; (ii) complete dry-up of secured wholesale funding and strong outflows of committed credit and liquidity facilities.
  - Baseline NOK LCR: some banks fall short of the 60 percent minimum NOK LCR proposed by NB.
  - Aggregate NOK LCR under dry-up of unsecured wholesale funding declines from 33 percent to 18 percent.
  - NOK liquidity gap grows to NOK 306 billion from NOK 120 billion in the baseline.
  - FX liquidity: most banks are above 100 percent threshold under Basel III; aggregate FX LCR at 124 percent in case of a complete dry-up of unsecured funding.
  - FX funding gaps increase up to NOK5.3 billion in case of a complete dry-up of unsecured wholesale funding from NOK3 billion in the baseline.
  - Recognition of covered bonds as HQLAs improves liquidity ratios only partly.
  - Recommendation: perform liquidity stress tests using cash-flow structures at various maturities; adopt customized LCRs aligned with banks’ funding profiles.

### Insurance sector stress tests and solvency implications (Solvency II simplified)
- Stress test design: market shocks combined with underwriting, counterparty default, and other insurance shocks as in FSA/EIOPA exercises; third scenario with tailored ad hoc shocks (e.g., interest rates decline by 100 bps).
- Life insurers — impact:
  - Solvency indicators drop substantially; capital buffer wiped out under all three severe scenarios.
  - Buffer capital utilization ratio (BCU) would increase to 139, 142, and 180 percent, respectively, under the three scenarios.
  - Largest contributors: shocks to equity prices, real estate prices, and credit spread.
  - Capital shortfall estimates without transition rules: 39 percent, 42 percent, and 80 percent of the sample’s available capital before stress in the three scenarios respectively; in GDP terms: 1 percent, 1.1 percent, and 2.1 percent of 2014 GDP, respectively.
  - With Solvency II transition rules (over 16 years, including envisaged volatility adjustment), estimated regulatory capital needs are significantly reduced.
- Non-life insurers: higher resilience due to smaller asset-liability duration mismatches and gain from discounting liabilities under Solvency II.
- Conglomerates: could weather combined banking and insurance losses at conglomerate level but competing capital claims could complicate resolution.
- Recommendations:
  - Require solo recapitalization of weakly capitalized insurers.
  - Identify systemically important insurers and require resolution planning and resolvability assessments.
  - FSA should continue to constrain dividend payouts by weakly capitalized companies.

### Prudential, microprudential, and macroprudential framework
- By July 2016 Norwegian banks to be subject to:
  - Minimum CET1 requirement of 7 percent (including the capital conservation buffer).
  - 3 percent systemic risk buffer.
  - 2 percent capital D-SIBs surcharge.
  - 1.5 percent countercyclical capital buffer.
- Other measures:
  - FSA active use of Pillar 2 capital requirements.
  - Banks required to implement an 85 percent LTV ceiling on residential mortgage lending and an affordability test applying a 5 percentage point increase in the interest rate when granting mortgage loans.
- Gaps and recommended additional measures:
  - Consider limits on (i) proportion of short-term wholesale funding from abroad and (ii) mismatches between maturity of currency swaps and underlying exposures.
  - Increase transparency and consider restrictions on asset encumbrance from covered bonds; adoption of TLAC/MREL over time to limit encumbrance.
  - Improve institutional structure for macroprudential policy advice to MOF; adopt “comply or explain”; provide annual reviews of instrument effectiveness; consider delegation to NB or FSA or a formal committee.
  - Consider fiscal and structural measures to reduce housing market imbalances: phase out tax incentives for home ownership; relax planning and building requirements.

### Financial Market Infrastructures (FMIs), AML/CFT, and crisis management
- FMIs:
  - FMIs modern and stable; strong legal basis and adequate resources for supervision and oversight.
  - Ongoing assessments of FMI critical service providers.
  - Recommendations: leverage NB and FSA expertise for oversight expectations; review crisis management framework and enhance the Financial Infrastructure Crisis Preparedness Committee role; enter foreign cooperation arrangements to oversee licensed central counterparties operating in Norway.
  - Strengthen operational risk management and governance in NICS and business continuity in NBO and NICS.
  - Require FMIs to conduct and publish regular assessments (every two years) against the CPMI-IOSCO Disclosure Framework for FMIs.
- AML/CFT:
  - 2014 FATF assessment found important shortcomings and recommended:
    - Commence a robust national risk assessment with full stakeholder engagement and develop national AML/CFT policies and strategies.
    - Update AML/CFT law to ensure preventive measures align with FATF 2012 Recommendations.
    - Enhance AML/CFT supervision based on ML/TF risks and ensure supervisory actions for deficiencies are dissuasive, proportionate, and effective.
- Safety nets, crisis management, and resolution:
  - Legal and institutional foundations generally well developed but require enhancements to align with FSB Key Attributes.
  - Resolution authorities require adequate operational independence.
  - BGF: well funded but lacks a standing source of back-up funding and formal recusal policies for board members; should consider spinning out liquidity and solvency support functions.
  - NB has ELA policies in place limiting assistance to solvent banks; BGF and MOF need formal policies for liquidity and solvency support and a committed back-up funding facility.
  - MOF should initiate resolution planning for largest banks and delegate responsibilities to FSA; define expectations for Norway-specific elements of recovery/resolution plans for foreign subsidiaries/branches.
  - Legal framework enhancements needed: resolution toolkit, operational independence, legal protection for resolution authorities and administration boards, earlier triggers for resolution, cross-border resolution mechanisms, and distinction between going concern and gone concern resolution.

### Risk Assessment Matrix (selected entries)
- High / Medium likelihood — Protracted period of slower growth in key advanced and emerging economies:
  - Expected Impact (High): weaker non-oil exports, lower oil prices, economic slowdown, higher unemployment, and lower GPFG returns.
- High likelihood — A surge in global financial volatility:
  - Expected Impact (Medium): renewed stress in wholesale funding markets causing liquidity strains for FX-funded Norwegian banks; impaired global demand reduces exports and oil investments.
- Medium likelihood — Protracted low energy prices:
  - Expected Impact (High/Medium): weaker mainland growth, reduced housing demand, and potential housing market effects via confidence and immigration.
- Medium likelihood — A significant drop in house prices:
  - Expected Impact (High): contraction in private consumption and residential investment, higher default rates, and higher solvency risks for banks.

### Stress testing frameworks and matrices (overview)
- Banking STeM (solvency):
  - Institutions: Top 6 commercial and savings banks (DNB Bank, Nordea Bank Norge, SpareBank 1 SR-Bank, SpareBank 1 SMN, SpareBank 1 Nord-Norge, Sparebanken Vest).
  - Market share: 75 percent of banking sector assets (unconsolidated excl. mortgage companies); 67 percent including mortgage companies (consolidated).
  - Baseline data: Banks’ internal and supervisory data as of December 2014; commercial data as of September 2014.
  - Horizon: 5 years.
  - Shocks: sustained oil price at US$40, money market rates +200 bps, wholesale spreads +150 bps, 40 percent real property decline over 5 years; two adverse variants (with and without monetary policy response).
  - Behavioral assumptions: static balance sheets except credit growth; no deleveraging; zero dividend payout under stress; no new capital issuance.
- Liquidity STeM:
  - Institutions: Top 6 banks including mortgage companies.
  - Market share: 67 percent of banking sector assets (consolidated).
  - Horizon: 30 days.
  - Scenarios: dry-up of unsecured wholesale funding; dry-up of secured wholesale funding plus deposit runs; LCR/NSFR metrics and asset fire-sale haircuts applied.
- Contagion STeM:
  - Institutions: up to 95 percent coverage of banking sector assets via domestic and cross-border banks and BIS reporters.
  - Methodologies: network analysis, balance sheet bilateral exposures, market-based models.
  - Shocks: funding shock (95 percent not rolled over; asset sale at 50 percent discount) and credit shock (50 percent LGD).
- Insurance STeM (Solvency II):
  - Institutional perimeter: three large life and three large non-life insurers; life market share 80 percent (assets); non-life 60 percent (premiums), 51 percent (assets).
  - Baseline date: 31/12/2014; market-consistent valuation; horizon aligned with 2015-19 banking scenarios.
  - Calibrations: interest rates +250 bp/-100 bp; equity -45 percent/-55 percent; real estate -29 percent/-33 percent/-40 percent; FX depreciations; spread shocks; FSA/EIOPA assumptions.

*Source: _cr15252 - EXECUTIVE SUMMARY*

### EXECUTIVE SUMMARY ___________________________________________________________________________ 6

### _cr15252 - EXECUTIVE SUMMARY ___________________________________________________________________________ 6

### Executive summary: key findings and vulnerabilities
- Norway’s financial system coped well with the global financial crisis and has further increased buffers to deal with potential shocks.
- Significant financial imbalances have built up since the crisis, driven by prolonged low interest rates and high oil prices.
- Housing market estimated to be overvalued by 25–60 percent.
- Household debt-to-disposable income ratio is about 220 percent.
- To finance increased lending to households, banks have relied extensively on wholesale funding.
- Norway’s close regional and global interconnectedness is a source of potential spillover risks.
- Stress tests indicate that under a combination of severe shocks (including protracted low oil prices and a sharp contraction in house prices), the aggregate capital shortfall for banks could be up to 4.6 percent of GDP over five years.
- Norwegian banking groups face liquidity gaps in domestic currency, exposure to maturity mismatches and rollover risks due to reliance on currency swaps.
- Insurers’ solvency ratios would decline sharply under a combination of severe shocks under the Solvency II framework; the transition rule to Solvency II would significantly reduce the immediate need for insurers to raise capital.
- The Financial Supervisory Authority of Norway (FSA) should continue to constrain dividend distribution by weakly capitalized insurance institutions and ensure insurance businesses of conglomerates are adequately capitalized on a solo basis.

### Policy recommendations and near-term priorities
- Strengthen bank resilience: ensure adequate capital buffers, including through discretionary requirements under Pillar II of the capital framework.
- Contain systemic risks from real estate prices and household indebtedness:
  - Consider stricter loan-to-value (LTV) ratios.
  - Consider loan-to-income (LTI) or debt service ratio (DSR) to supplement the affordability test.
  - Consider reducing tax incentives for mortgage finance.
  - Consider relaxing planning and building requirements to reduce housing market imbalances.
- Address banks’ wholesale funding risks:
  - Consider measures to contain risks related to banks’ wholesale funding (e.g., limits on mismatch between maturity of currency swaps and maturity of underlying exposures).
- Enhance stress testing and liquidity monitoring:
  - Intensify Norges Bank (NB) and FSA cooperation to exploit synergies between macro- and micro-prudential stress testing.
  - Further enhance stress testing frameworks.
  - Consider supplementing Basel III liquidity requirements with stress tests aligned with banks’ funding and cash flow profiles.
  - Improve liquidity monitoring by performing liquidity stress tests using cash-flow structures at various maturities; or applying customized versions of the LCR along the maturity ladder.
- Insurance sector actions:
  - Enhance stress test framework for insurance sector.
  - Allocate more resources to FSA to assess liability-side risks and validate models and assumptions used in bottom-up stress tests.
  - Achieve recapitalization of weakly capitalized insurance companies; continue to restrict dividend payouts by companies with weak capital adequacy.
- Institutional and macroprudential governance:
  - Improve procedures for advice by NB and FSA to the Ministry of Finance (MOF); adopt a more transparent “comply or explain” approach by decision makers.
  - Provide an annual broader overview of collective purpose, impact, and effectiveness of macroprudential instruments.
  - Consider greater delegation of decision-making powers over macroprudential instruments to NB or FSA based on clear mandates, objectives, and accountability; alternatively, establish a formal committee.
- Strengthen FSA operational independence and supervisory capacity:
  - Augment FSA’s de jure operational autonomy.
  - Expand FSA powers (particularly corrective actions and sanctions) and supervisory resources to increase frequency and depth of inspections of small institutions.
  - Upgrade FSA supervisory approach to AML/CFT issues, including increasing supervisory activities and providing guidance.
- Financial Market Infrastructure (FMI) oversight:
  - Strengthen operational risk management related to outsourcing in systemically important payment systems.
  - Consider deepening regulatory cooperation to assess operational risks and manage dependencies on critical service providers.

### Institutional arrangements, crisis management, and safety nets
- Legal and institutional foundations for crisis management, safety nets, and resolution are generally well developed, but enhancements are needed.
- Resolution authorities require adequate operational independence.
- Preponderance of active bank executives on the Banks’ Guarantee Fund (BGF) board raises potential conflicts and frictions impeding integration into resolution and safety net framework.
- Recovery planning by largest banks is proceeding well; resolution planning and resolvability assessments for such banks have yet to be initiated by the MOF.
- Policies for Emergency Liquidity Assistance (ELA) by NB are in place; policies for liquidity and solvency support by the BGF are required.
- BGF is well funded but has no standing source of back-up funding and lacks formal recusal policies for board members with actual or potential conflicts of interest.
- The legal framework delegates substantial powers that have been effectively used to resolve banks, but amendments and enhancements are required to comply with the FSB Key Attributes (in particular: resolution toolkit, operational independence, legal protection for resolution authorities and administration boards, earlier triggers for resolution, cross-border resolutions, and distinction between going concern and gone concern resolution).

### Macroeconomic and financial sector setting: essential data and interpretation
- Real mainland (non-oil) GDP growth has averaged about 2.9 percent in the last two decades.
- Unemployment was 3.5 percent in 2014.
- Norway’s flexible inflation-targeting framework and flexible exchange rate have helped anchor inflation expectations and absorb foreign shocks.
- High oil production and exports, combined with Norway’s fiscal rule and Government Pension Fund Global (GPFG), have produced strong fiscal and external positions.
- Norway’s net creditor position vis-à-vis the rest of the world has reached more than 200 percent of mainland GDP.
  - Public sector (including the central bank) and institutional investors have a net external creditor position of about 280 percent of mainland GDP.
  - Banks (including mortgage companies) and corporations have a net debtor position equivalent to about 85 percent of GDP.
- Availability of external credit facilitated private sector imbalances: domestic credit demand outstripped deposit evolution, prompting banks and mortgage companies to rely increasingly on wholesale (particularly external) funding.
- Credit growth has outpaced GDP growth with rapid increases in real estate prices, resulting in household and corporate indebtedness well above OECD averages.

### Table 1: Key FSAP Recommendations (priorities and timing)
- Consider additional measures to contain systemic risks from growth of house prices and household indebtedness (e.g., stricter LTV ratios, and LTI or DSR to supplement the affordability test) — Priority: S (short term).
- Consider measures to contain risks related to banks’ wholesale funding (e.g., limits on mismatch between maturity of currency swaps and underlying exposures) — Priority: S.
- Improve institutional structure for macroprudential policies: more standardized and transparent advice procedures to MOF; transparent “comply or explain”; greater delegation of decision-making powers over macroprudential instruments to NB or FSA — Priority: M (medium term).
- Improve liquidity monitoring via cash-flow structured liquidity stress tests or customized LCR along the maturity ladder; consider options to discourage cross-ownership of covered bonds — Priority: M.
- Enhance stress test framework for insurance sector; allocate more FSA resources to assess liability-side risks and validate models — Priority: M.
- Achieve recapitalization of weakly capitalized insurance companies; continue restricting dividend payouts by companies with weak capital adequacy — Priority: S.
- Enhance FSA de jure operational independence, powers, and supervisory resources; strengthen supervision of small banks via more frequent comprehensive assessments — Priority: M.
- Upgrade FSA supervisory approach to AML/CFT issues, increasing supervisory activities and guidance — Priority: S.
- Strengthen operational risk management related to outsourcing in systemically important payment systems — Priority: S.
- MOF should initiate resolution planning for largest banks, delegate responsibilities to FSA, and define expectations for Norway-specific elements of recovery/resolution plans of foreign bank subsidiaries and branches — Priority: S, M.
- Enhance legal framework for resolution to comply with FSB Key Attributes (resolution toolkit, operational independence, legal protection, earlier triggers, cross-border resolutions, going vs gone concern distinction) — Priority: S.
- BGF should adopt policies specifying conditions under which board members must recuse themselves, considering actual and prospective conflicts of interest — Priority: S.

*Source: _cr15252 - EXECUTIVE SUMMARY*

### 4.      Norway’s financial system is large relative to the country’s economy and population,

### 4.      Norway’s financial system is large relative to the country’s economy and population,

### Structure and concentration of the financial system
- The sector is concentrated and dominated by conglomerates, some of which are based in other Nordic countries.
- The largest domestic financial group, DNB, holds a significant market share and acts as the settlement bank for 97 smaller banks.
- Regulatory firewalls, including restrictions on intra-group financial transactions, are in place.
- In normal times conglomerate structures lend themselves to risk diversification; in more extreme situations they could increase risks of contagion.
- Figure 2 highlights:
  - Total Banking System Assets, 2013 (As a percentage of GDP): Norway at 54.8 (placing it smaller than most peer countries listed such as Finland, Sweden).
  - Lending market shares (Percent, June 2014): DNB Bank dominant in retail and corporate markets relative to subsidiaries and branches of foreign banks, domestic savings banks, and other commercial banks.
  - Mortgage companies account for a growing share of the banking system’s assets (Financial System Structure: 2014 vs 2003, In percent of total assets).

### Funding structure and mortgage companies
- Banks and mortgage companies rely extensively on wholesale funding, in particular covered bonds.
- Banks’ lending operations exceed deposits by a margin of almost two to one.
- Covered bonds issued through mortgage companies have become banks’ dominant source of financing.
- The government-led swap arrangement during the financial crisis allowed banks to swap covered bonds for Treasury bills, accelerating the set-up of mortgage companies.
- Transfers of mortgage loans to covered bond companies:
  - Banks, excluding DNB, have transferred about 45 percent of their mortgage loans to their partly or fully owned covered bond companies.
  - DNB has transferred 80 percent.
- Figure 3 (Overall Funding of Norwegian Banks):
  - Market funding 51%
  - Customer deposits 40%
  - Equity and subordinated debt 9%
  - Market funding by type: Covered bonds 40%, Senior bonds 20%, Other wholesale funding, incl. interbank 40%
  - Market funding by maturity: Greater than one year 66%, Three to twelve months 10%, Less than three months 24%
  - Market funding by source: Foreign 60%, Domestic 40%

### State ownership and systemic importance
- State ownership of financial institutions is significant; institutions are managed along commercial lines.
- Two of the three banks designated as D-SIBs are at least partly state owned.
- The government holds a 34 percent stake in DNB but does not intervene in day-to-day operations, keeping an arm’s length.
- Market power and implicit government support for DNB may cause distortions in the Norwegian credit market.
- The other D-SIB, Kommunalbanken, is fully owned by the government and mainly finances local governments.

### Financial sector performance and indicators
- Norwegian banks coped well with the global financial crisis; there were no bank failures and only a modest increase in nonperforming loans (NPLs).
- Banks have increased reliance on wholesale funding, including foreign borrowing.
- Norwegian banks have remained profitable and well capitalized.
- NPLs are low; profitability has been stable and higher than in most peer countries.
- Risk-weighted capital ratios have increased significantly since adoption of Basel II in 2007, partly due to reduced risk weights by banks adopting the IRB approach.
- Authorities have tightened requirements on banks’ IRB models and maintained the “Basel I floor rule” ensuring RWAs of IRB banks are not lower than 80 percent of Basel I RWAs.
- Leverage ratio: At 6½ percent, the leverage ratio for Norwegian banks is well above the proposed 3 percent minimum under Basel III.
- Table 2. Norway: Financial Soundness Indicators (FSIs) (In percent) — selected series (exact annual figures preserved):
  - Regulatory capital to risk-weighted assets: 2006 11.2; 2007 11.7; 2008 11.2; 2009 13.0; 2010 14.2; 2011 13.6; 2012 14.5; 2013 15.5; 2014 16.5
  - Regulatory Tier 1 capital to risk-weighted assets: 2006 8.7; 2007 9.3; 2008 8.6; 2009 10.5; 2010 11.8; 2011 12.1; 2012 13.2; 2013 13.8; 2014 14.5
  - Nonperforming loans net of provisions to capital: 2006 4.4; 2007 3.8; 2008 5.7; 2009 9.4; 2010 10.9; 2011 10.9; 2012 10.2; 2013 8.5; 2014 7.1
  - Provisions to nonperforming loans: 2006 26.9; 2007 22.4; 2008 21.4; 2009 21.0; 2010 22.1; 2011 21.5; 2012 19.4; 2013 20.9; 2014 20.1
  - Nonperforming loans to total gross loans: 2006 0.6; 2007 0.5; 2008 0.7; 2009 1.3; 2010 1.6; 2011 1.6; 2012 1.6; 2013 1.4; 2014 1.3
  - Sectoral distribution of loans to total loans (Deposit-takers, Nonfinancial corporations, Households, Nonresidents): selected 2014 figures — Nonfinancial corporations 29.8; Households (including individual firms) 37.2; Nonresidents (including financial sectors) 22.8
  - Return on assets (ROA): 2006 0.9; 2007 0.8; 2008 0.5; 2009 0.5; 2010 0.8; 2011 0.6; 2012 0.6; 2013 0.7; 2014 0.8
  - Return on equity (ROE): 2006 16.5; 2007 15.6; 2008 11.1; 2009 10.4; 2010 14.1; 2011 10.5; 2012 9.5; 2013 10.7; 2014 12.7
  - Interest margin to gross income and Noninterest expenses to gross income: series provided in Table 2 (exact values preserved there).
- Figures 4 and 5 show Norway’s relative positions on Regulatory Capital to Risk-Weighted Assets, Tier 1 ratios, NPLs to gross loans, ROA, ROE, and Capital to Assets compared with peers.
- Risk-weighted capital adequacy has risen significantly, but leverage ratios have seen only a small increase.
- Some increase in capital adequacy ratio was due to changes in risk weights.
- Banks are expected to meet new capital requirements.
- Banks have increased maturity of liabilities, but a recently stable funding ratio has somewhat declined.

### Insurance companies and pension funds
- Under Solvency I, the financial condition of insurance companies and pension funds has been satisfactory.
- The insurance sector is relatively small and concentrated.
- Insurance companies have low expense ratios and stable solvency levels under Solvency I.
- Figure 6 observations:
  - Life insurers have recorded relatively strong returns in the collective portfolio (guaranteed products) and been profitable in recent years.
  - Non-life insurers’ earning performance has been strong and combined ratios have been reduced.
  - Solvency ratios have been broadly stable.
  - The solvency ratio in the non-life sector is among the highest in the world.

### Progress on FSAP recommendations
- Good progress was made in implementing the 2005 FSAP recommendations, although only limited steps were taken to strengthen the formal independence of the FSA.

### Key financial stability risks and macrofinancial vulnerabilities
- Key risks: impact of sharp reductions in oil prices and their durability over the medium term; high and rising household debt and property prices; banks’ reliance on wholesale borrowing; and regional interconnectedness.
- Lower oil prices, declining oil investments, or a housing price correction would affect financial institutions mainly through weaker economic activity, higher unemployment, and deteriorating corporate and household balance sheets.
- A protracted period of low oil prices or slow growth in advanced and emerging economies, or a disruption in global liquidity, could have a major impact on Norway.
- Despite sound policy frameworks and large fiscal buffers, protracted lower oil prices could have significant adverse effects on growth and employment and erode bank loan portfolio quality.
- Norway is exposed to real and financial shocks through close interconnectedness with the Nordic region and the rest of the world.
- High household indebtedness is a key source of vulnerability:
  - Household debt was at about 220 percent of disposable income at end-2014.
  - About 85 percent of household debt is residential mortgages.
  - About 14 percent of new loans are interest only.
  - Banks are highly exposed to households through mortgage lending, which accounts for about 57 percent of total bank lending.
- House prices have risen steadily in real terms since the early 2000s with short-lived reversals in 2007–2008 and 2013.
  - Estimates suggest housing prices may be overvalued by about 25–60 percent, depending on measures of overvaluation.
- Households are particularly vulnerable to house price corrections and interest rate risks; a sharp rise in interest rates, especially if coupled with large house price declines or lower household income and employment, could force households to cut consumption sharply, increasing banking sector credit risks.
- Under current conditions risks seem contained, supported by Norway’s well-developed safety nets, but the share of vulnerable household debt could rise if economic conditions deteriorate significantly.
- Corporate sector:
  - Corporate borrowing from banks has recently slowed; enterprises have raised more capital in the bond market and abroad.
  - Debt servicing capacity of the enterprise sector has been stable at the pre-crisis level; equity ratio has increased since the global financial crisis.
  - The commercial property sector is a source of vulnerability due to the large share of bank lending to this sector, particularly in Oslo where commercial property prices have increased more rapidly than residential prices since the mid-2000s.
  - Banks’ total exposures to other risky sectors such as shipping, fisheries and fish farming are modest, but individual bank exposures can be large.

### Household vulnerability metrics and indicators
- Figures and indicators highlight:
  - The share of households with debt above five times disposable income (age cohorts shown).
  - The share of households with less than two months of margin (defined as income minus taxes, interest and standard cost of consumption below two months of after-tax income).
  - The share of households with net debt larger than the value of collateral.
  - Household Debt to Income Ratio and Household Debt to Disposable Income Ratio (latest figures included).
  - Interest burden remains low due mainly to low interest rates.
  - Households’ high share of property assets and small liquid asset buffers imply housing price shocks can adversely affect consumer spending.
  - Distribution of vulnerability by ages of main income earners (Percent, 2012) and households’ balance sheet by asset values (2013, Thousands of NOK) are presented in figures.

*Source: Excerpt from IMF staff report content provided in the supplied PDF chapter.*

### Box 1. Household Debt Stress Tests

### Box 1. Household Debt Stress Tests

### Household vulnerability under current conditions
- Norges Bank study findings:
  - Only about 2 percent of household debt is “more vulnerable.”
  - The proportion of vulnerable households is about 1 percent.
- Vulnerability criteria (household debt meeting all three):
  - (i) debt above five times disposable income;
  - (ii) financial margin (income minus taxes, interest and ordinary living expenses) below one month of after-tax income;
  - (iii) net debt (debt minus deposits) larger than the value of dwelling.

### Stress scenarios applied to household sector
- Shocks applied (separately and combined):
  - (i) lending rate increase of 2 percentage points;
  - (ii) real house price drop by 40 percent;
  - (iii) income (after tax) drop of 20 percent.
- Impact on share of vulnerable debt and vulnerable households:
  - Lending rate increase: about 5 percent (debt); proportion of vulnerable households not specified here but table shows 1.9 percent.
  - Real house price drop: about 6 percent (debt); table shows 2.5 percent households.
  - Income drop: about 8 percent (debt); table shows 3.4 percent households.
  - Combination of the three shocks (severe scenario): share of vulnerable debt increases to 21 percent; proportion of vulnerable households rises to about 9 percent.
- Distributional effects:
  - Lower income and younger households are disproportionally more affected by the three combined shocks.
  - The proportion of vulnerable households remains below 10 percent under the severe scenario, but the aggregate number masks distributional effects.

### Share of Household Debt and Households Breaching the Three Criteria (In percent)
- Debt / Households
  - Interest rate increase: 4.6 / 1.9
  - House price fall: 5.5 / 2.5
  - Fall in income: 8.1 / 3.4
  - Combination of the three shocks: 21.0 / 8.6
- Note: Margin below two months after-tax income was used for the second criterion.

### Banking-sector stress scenarios and calibration
- Macroeconomic adverse scenarios (baseline and two adverse variants):
  - Adverse scenario with no monetary policy response:
    - Assumes an upsurge in global financial market volatility and slowdown in global growth.
    - Level of GDP declines by 16.1 percent below the baseline by 2019.
  - Adverse scenario with a monetary policy response:
    - Assumes a 1½ percentage point cut in the policy rate in 2015-16 (without fiscal measures).
    - Level of GDP declines 13.9 percent below the baseline by 2019.
- Adverse scenario calibration:
  - Sustained lower nominal oil prices at US$40 per barrel over the entire stress testing horizon (baseline projection US$77 by 2019).
  - Increase in money market rates by about 200 bps and wholesale funding spreads by an additional 150 bps (relative to the baseline).
  - 40 percent decline in real property prices over five years.
- Severity measure:
  - These shocks translate to a decline of 2¾ to 3.1 standard deviations of five-year cumulative real GDP growth rate relative to the baseline.

### Bank stress-test outcomes (top-down IMF estimates)
- CET-1 impact:
  - Under the adverse scenario without policy response, the CET-1 ratio would fall by 6.7 percentage points to 6.3 percent.
- Drivers of CET-1 decline (contributions to annual decline in CET-1 ratio):
  - Higher loan losses: about 1.4 percent a year.
  - Rise of RWAs: about 0.8 percent a year.
  - Higher funding costs: about 0.3 percent a year.
- Recapitalization needs:
  - The recapitalization needs under the adverse scenario without policy response is estimated at 4.6 percent of GDP by 2019.
  - Of the potential recapitalization needs by 2019, about 1.4 to 1.9 percent of GDP would be attributable to the introduction of Basel III (depending on the TD approach).
- Methodological note:
  - Parallel FSA and NB stress tests estimated slightly lower losses than the IMF, reflecting the IMF’s use of parameters based on global experience with severe crises.

*Source: _cr15252 - Box 1. Household Debt Stress Tests.*

### 31.      The adverse effects on capitalization are significantly milder in BU stress tests,

### _cr15252 - 31.      The adverse effects on capitalization are significantly milder in BU stress tests,

### Banking sector: BU versus TD stress tests — capitalization effects
- Under the BU approach, the CET-1 ratio for the banking sector declines by 0.6–1.4 percentage point over the stress testing horizon.
- Under the TD tests, the CET-1 ratio drops by 6.7 percentage point.
- Discrepancy drivers:
  - Much lower credit loss rates in the BU approach.
  - Expert judgment in modeling losses on large corporate exposures.
  - Banks’ estimates of household losses are relatively muted, given limited history of past losses.
- Recommendation implied by findings:
  - Banks should consider introducing more conservative assumptions in their models.

### Credit concentration risk (BU sensitivity tests)
- BU simulations evaluated defaults of banks’ largest borrowers (up to the 10 largest borrowers).
- Finding:
  - Banks were found to be able to absorb defaults of their largest clients, with average CET-1 ratios remaining above the regulatory minimum.

### Liquidity stress tests — NOK and FX liquidity
- Scenarios evaluated:
  - (i) Complete dry-up of unsecured wholesale funding (motivated by 2008 crisis experience).
  - (ii) Complete dry-up of secured wholesale funding (including corporate deposits), and strong outflows of committed credit and liquidity facilities.
- Baseline observations:
  - Even in the baseline (based on assumptions under the standard LCR) some banks fall short of the 60 percent minimum NOK LCR currently proposed by NB.
- NOK LCR and liquidity gap under dry-up of unsecured wholesale funding:
  - Aggregate NOK LCR for the banking sector declines from 33 percent to 18 percent.
  - NOK liquidity gap grows to NOK 306 billion from NOK 120 billion in the baseline.
- FX liquidity positions:
  - Most banks are above the 100 percent threshold under Basel III.
  - Aggregate FX LCR at 124 percent in case of a complete dry-up of unsecured funding.
  - FX funding gaps increase up to NOK5.3 billion in case of a complete dry-up of unsecured wholesale funding from NOK3 billion in the baseline.
- Recognition of covered bonds:
  - Banks’ liquidity ratios improve only partly under broader recognition of covered bonds as HQLAs in the new EU LCR rules.
- Recommendation / scope for improvement:
  - Authorities could consider performing liquidity stress tests using the structure of cash flows at various maturities.
  - Authorities could perform customized versions of the LCR more closely aligned with banks’ funding profiles.
  - Adoption of such approaches could take place over time to facilitate a more systemic approach to identifying potential liquidity difficulties.

### Insurance sector — Solvency II (simplified) stress tests and results
- Stress test design:
  - Combines market shocks with underwriting, counterparty default, and other insurance-related shocks as applied under the FSA/EIOPA stress tests.
  - A third scenario analyzed: combination of ad hoc shocks better tailored to insurers (e.g., interest rates decline by 100 bps instead of a 250 bp increase).
- Life insurers — impact:
  - Solvency indicators drop substantially; capital buffer wiped out under all three severe scenarios.
  - Buffer capital utilization ratio (BCU, reverse of SCR) would increase to 139, 142, and 180 percent, respectively, under the three scenarios.
  - Largest contributors to deterioration: shocks to equity prices, real estate prices, and credit spread.
- Capital shortfall estimates:
  - Without transition rules, companies’ capital shortfall to fully cover all risks (without restoring capital) would amount to 39 percent, 42 percent, and 80 percent of the sample’s available capital before stress, in the three scenarios respectively.
  - In GDP terms: 1 percent, 1.1 percent, and 2.1 percent of 2014 GDP, respectively.
  - With the Solvency II transition rules (over 16 years, including envisaged volatility adjustment), these estimated regulatory capital needs are significantly reduced.
- Non-life insurers:
  - Show much higher resilience due mainly to smaller asset-liability duration mismatches and gain from discounting liabilities under Solvency II.
- Conglomerates:
  - At a conglomerate level, institutions could weather combined banking and insurance losses.
  - Concern: competing demands on conglomerate capital during a crisis would complicate resolution.
- Recommendations for insurers and conglomerates:
  - Require insurers with weak capital adequacy to be recapitalized on a solo basis.
  - Identify systemically important companies and require them to prepare a resolution plan and conduct resolvability assessments.
  - FSA should continue to constrain dividend payouts by weakly capitalized companies.

### Prudential framework — summary assessment and recommendations
- Overall assessment:
  - Norway has robust prudential frameworks with well-developed micro and macroprudential policies, but scope exists for further improvements.
  - Authorities have been proactive and adopted more stringent capital requirements than many peers.
- By July 2016 Norwegian banks will be subject to the following capital requirements:
  - Minimum CET1 requirement of 7 percent (including the capital conservation buffer).
  - 3 percent systemic risk buffer.
  - 2 percent capital D-SIBs surcharge.
  - 1.5 percent countercyclical capital buffer.
- Other prudential measures:
  - FSA makes active use of Pillar 2 capital requirements.
  - Banks required to implement an 85 percent LTV ceiling on residential mortgage lending and an affordability test by applying a 5 percentage point increase in the interest rate when granting mortgage loans.
- Gaps and recommended additional measures:
  - Take additional measures to contain systemic risks from growth of house prices and household indebtedness, for example stricter LTV and consider loan-to-income or debt service ratio limits to supplement affordability test.
  - Contain risks related to banks’ wholesale funding:
    - Consider limits on (i) proportion of short-term wholesale funding from abroad (subject to CRR constraints) and (ii) mismatches between maturity of currency swaps (and other hedging techniques) and maturity of underlying exposures.
    - When setting individual currency LCR requirements, consider whether it provides sufficient incentives to limit short-term wholesale funding.
    - Run more severe funding and liquidity stress tests to identify most effective measures.
  - Continue close monitoring of banks’ issuance of covered bonds and consider when such issuance should be limited.
    - NB’s proposal to increase transparency about asset encumbrance is welcome.
    - FSA should use power to restrict excessive asset encumbrance if needed.
    - Adoption of TLAC/MREL in due course will limit asset encumbrance.
  - Improve institutional structure:
    - More standardized and transparent procedures for giving advice to MOF.
    - Transparent “comply or explain” approach by decision-makers.
    - Annual broader overview of collective purpose, impact, and effectiveness of macroprudential instruments.
    - Greater delegation of decision-making powers over macroprudential instruments to NB or FSA based on clear mandates, or exercise some functions through a formal committee.
  - Build a more comprehensive and coordinated macroprudential framework over time:
    - Clear specification of overall objectives of macroprudential policy and instruments.
    - Expected benefits and costs, and post-implementation reviews of effectiveness.
    - Consider setting medium- to long-term broad ranges for key financial stability ratios (e.g., wholesale funding) as a communication tool.
  - Consider fiscal and structural measures to reduce longer-term demand and supply imbalances in the housing market:
    - Phase out tax incentives for home ownership.
    - Relax planning and building requirements to stimulate supply of new housing units.

### Microprudential framework — supervisory strengths and weaknesses
- Strengths:
  - Regulatory and supervisory framework generally good and largely based on EU supervisory laws transposed into national laws.
  - FSA uses a risk-based approach with enhanced focus on institutions of systemic importance.
  - Supervisory framework is comprehensive and supervision of large banks is frequent and intensive.
  - Consolidated supervision of financial groups is satisfactory.
  - Solid cross-border supervisory cooperation, including participation in supervisory colleges; strong cooperation among Nordic supervisors.
- Weaknesses and recommended actions:
  - Strengthen de jure operational autonomy of the FSA.
  - Increase supervisory resources to allow greater frequency and depth of inspections of small institutions.
  - Expand the range of sanctioning tools available to the FSA.
  - Upgrade rules on related party lending (currently narrowly defined).
  - Improve limited AML supervision.
  - Expand frequency of supervisory assessment for small banks and the range of sanctioning tools.
  - Strengthen banks’ non-ICT operational risk management.
- Insurance sector regulatory developments:
  - New law incorporating Solvency II adopted in 2015 (applies to all life and nonlife businesses, excluding very small marine insurers).
  - Pension funds not subject to Solvency II but required to report stress tests based on a simplified Solvency II approach.
  - All insurers asked to undertake ORSA and report results to the FSA.

*Source: IMF staff estimates and assessments as presented in the provided content.*

### 48.      Norway’s financial market infrastructures (FMIs) are modern and stable. There is a

### Norway’s financial market infrastructures (FMIs) are modern and stable. There is a

### Financial Market Infrastructures (FMIs): assessments, oversight, and risks
- FMIs are described as modern and stable.
- There is a strong legal basis for the supervision and oversight of FMIs, and the authorities have adequate resources to discharge their duties.
- Assessments of FMI critical service providers are ongoing.
- The supervisory and oversight framework for FMI appears to be effective, but there is room to strengthen regulatory cooperation to handle potential risks related to the dependence of FMIs on critical service providers.
- Risk-reducing measures recommended include:
  - Leveraging by the NB of the FSA’s operational and technical expertise in payment systems and establishing oversight expectations for FMI critical service providers.
  - Reviewing the crisis management framework in existing cooperation arrangements, and enhancing the role of the Financial Infrastructure Crisis Preparedness Committee led by the FSA.
  - Norwegian authorities entering into foreign cooperation arrangements with foreign authorities to oversee central counterparties that have been licensed to operate in Norway.
- Outsourcing of operations in systemically important payment systems has enhanced efficiency but raised oversight challenges.
- Potential improvements for payment systems include:
  - Strengthening the risk management framework and governance arrangements in the NICS.
  - Improving the business continuity plan in the NBO and NICS.
  - Requiring FMIs to conduct and publish regular assessments (every two years) against the CPMI-IOSCO Disclosure Framework for FMIs.

*For the details, see the accompanying technical note on FMI.*

---

### Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT)
- Norway’s AML/CFT framework underwent a comprehensive assessment by the Financial Action Task Force (FATF) in 2014 which found a number of important shortcomings.
- FATF recommended the following priority actions:
  - Commence work on a more robust national risk assessment with a comprehensive assessment of ML/TF risks and full engagement by all stakeholders, and consequently develop AML/CFT national policies and strategies based on those risks.
  - Update the AML/CFT law to ensure that preventive measures are consistent with the FATF 2012 Recommendations.
  - Enhance AML/CFT supervision so that it is undertaken on the basis of ML/TF risks and assesses the effectiveness of reporting entities in implementing preventive measures, and ensure that any identified AML/CFT deficiencies are subject to supervisory actions that are dissuasive, proportionate, and effective.

---

### Safety nets, crisis management, and resolution framework
- The legal and institutional foundations for crisis management, safety nets, and resolutions are generally well developed, though certain matters will need to be addressed in the transposition of the EU Bank Recovery and Resolution Directive (BRRD) into local law.
- The legal framework for early intervention, resolution, and winding-up and liquidation contains substantial powers that have been effectively used to resolve banks in the past, but requires enhancements to bring it into compliance with international best practices and standards, including the FSB Key Attributes (KAs).
- Responsibilities among the four safety net players—MOF, FSA, NB, and BGF—are generally well defined, but:
  - Establishing adequate operational independence of the resolution authorities remains a challenge.
  - The BGF should consider spinning out its liquidity and solvency support functions to another institution and reconsider having a board comprised of active bankers.
- Recovery planning for the largest banks is on track, but resolution planning by the MOF, the lead resolution authority, has yet to be initiated.
  - The MOF should initiate resolution planning for banks that could be systemically significant if they fail, including assessing impediments to resolvability, and delegate explicit responsibilities to the FSA.
  - The MOF should adopt policies for the information it requires on the local aspects of recovery and resolution plans for subsidiaries and branches of foreign banks that could be systemically significant.
  - The MOF should assess impediments to resolvability of those subsidiaries and branches as stand-alone entities as a contingency.
- Sources of funding for liquidity and solvency support are in place, but the BGF requires formal policies for provision of ELA and solvency support and a committed back-up funding facility, and the MOF requires a source of resolution funding under its control.
  - NB policies for provision of ELA are in place, and limit assistance to solvent banks.
  - The BGF can offer ELA and solvency support to members, but needs to adopt policies addressing the circumstances, terms, and conditions for such support.
  - The BGF needs to adopt policies specifying when board members must recuse themselves, considering actual and prospective conflicts of interests in taking decisions on providing financial support to members.
  - BGF does not have a committed back-up funding facility and should put one in place.
  - The MOF does not have a ready source of resolution funding and should establish one.
- Authorities have used unilateral, bilateral, and tripartite crisis simulation exercises to enhance preparedness.
  - They should consider adopting a domestic level MOU on crisis preparedness.
  - They should consider means to better integrate the BGF into crisis preparedness arrangements and exercises.
- The existing legal framework for bank resolution contains some recommended key resolution tools, but will require enhancements to fully align with the FSB KAs. Key issues include:
  - Clear identification of the roles and responsibilities of each resolution authority and ensuring operational independence.
  - Establishing distinct sets of rules for going concern and gone concern resolution.
  - Legal protection for the authorities that carry out resolution actions, their officers and staff, for good-faith actions in resolution, including for administration boards under Chapter 4 of the GSA.
  - Provisions authorizing use of bridge banks and asset management companies in resolutions.
  - Full bail-in powers as a formal resolution power.
  - Establishing earlier triggers for resolution.
  - Ensuring the framework adequately addresses cross-border resolutions, in particular transparent and expedited mechanisms to give effect in Norway to foreign resolution measures.
  - Suspending early termination clauses that might otherwise be triggered by initiation of resolution but providing appropriate safeguards for financial contracts.
  - Ensuring courts cannot unwind resolution actions and that, in the event a decision is considered unlawful, the remedy is limited to monetary compensation.

---

### Appendix I: Status of selected recommendations of the 2005 FSAP (highlights)
- Monitoring household debt and housing market:
  - Authorities monitor household debt evolution regularly.
  - Concentrations of exposures to more vulnerable subgroups are monitored through the yearly home mortgage loan survey and onsite examinations.
  - In the home mortgage loan survey, borrowers are categorized by age. Borrowers with a high debt burden and a large proportion of mortgages with a high LTV ratio are usually in the younger age groups.
  - The FSA issued guidelines for prudent mortgage lending: banks must assess ability to service overall debt based on income and all costs of subsistence, allowing for an interest rate increase of at least 5 percentage points. Home mortgage loans must normally not exceed 85 percent of the property’s market value. Higher LTV ratios require additional collateral or a special prudential assessment.
  - These guidelines were made into regulations effective July 1, 2015.
  - FSA, with Statistics Norway, calculated interest burden (interest expenses/income after tax) in the household sector for 2013 and performed stress tests for interest rate increases of 2 and 5 percentage points relative to “today's level.”
- Capital requirements and Basel II:
  - The issue of reduced risk weighting of mortgages under Basel II and potential additional capital under Pillar 2 is addressed by amendments in Pillar 1.
- Two-tier payments arrangements and contingency:
  - NB oversees risks from two-tier payment arrangements; the oversight unit receives reports if banks exceed limits given by private settlement banks.
  - Preparedness and testing exist to change settlement bank from private settlement banks to direct participation in NBO to ensure Tier 2 banks can settle directly in NBO if needed.
- Securities and retail payment system enhancements:
  - A consultation paper (in Norwegian) on handling insolvencies in securities settlement systems was published by the MOF on February 18th, 2015, due for comments on May 19th, 2015, including a prescript to clarify insolvency provisions in the Payment Systems Act.
  - Daily settlement cycles for NICS netting/clearing results increased from two to four during the last few years.
  - Netting of payments of different formats in NICS has been merged.
  - Payments larger than NOK 25 million are automatically excluded from NICS netting and are settled on a gross basis at NBO. Payments below NOK 25 million can be settled gross if requested.
- Cross-border crisis management cooperation:
  - A “Cooperation agreement on cross-border financial stability, crisis management and resolution” was signed in 2010 among Nordic and Baltic authorities, establishing the Nordic Baltic Stability Group (NBSG).
  - Domestically, the three authorities conducted crisis exercises in 2012 and 2013, and one was planned for early 2016.
  - The banking law commission was assigned to revise banking crisis resolution legislation in accordance with the EU’s BRRD.
- Tripartite financial stability coordination:
  - Tripartite meetings on financial stability chaired by MOF and involving NB and FSA were established in 2006 and are generally held every six months, more frequently when needed. Regulatory issues are not discussed at the meetings.
- Deposit guarantee arrangements:
  - From January 2013, members of the Bank Deposit Guarantee Fund shall pay the full premium irrespective of the size of the fund.
  - From January 2013, the fund is required to pay eligible depositors in distressed banks their claims within one week of a decision by the FSA that guaranteed deposits should be paid out (previously up to three months).
  - EU Directive on deposit guarantee schemes sets coverage at EUR 100,000 with a transitional period of five years (until 2018) for countries with a higher coverage level. The current Norwegian coverage level of NOK 2 million is likely to be reduced accordingly through implementation.
- NICS SWIFT-net and interbank payments:
  - All payments above NOK 25 million are automatically settled on a gross basis in NBO; smaller transactions are cleared four times daily in NICS. Payments below NOK 25 million can be settled gross if requested.
- State ownership in DNB:
  - The Ministry of Trade and Industry presents white papers on state ownership every few years; the most recent white paper was presented in June 2014.
  - The government does not foresee reducing the government ownership in DNB to less than 34 percent.
- NB oversight and FMI standards:
  - NB’s “Financial Infrastructure Report” describes responsibilities for supervision and oversight of financial infrastructure systems and evaluates Norwegian FMIs (including NBO) against CPSS-IOSCO principles.
  - The Financial Infrastructure Unit oversees the NBO and oversight is to be based on the FMI principles from CPSS-IOSCO.
- NB collateral risk management:
  - Requirements regarding collateral for loans from NB were revised several times since 2005; temporary easings in 2008 were gradually reversed in 2010 and 2012, including increases in haircuts, tighter standards for asset-backed securities, and removal of eligibility for securities issued by domestic or foreign banks or financial institutions.

*Norway — IMF staff content as provided in the supplied text.*

### Appendix II. Risk Assessment Matrix

### Appendix II. Risk Assessment Matrix

### Source of Risk and Relative Likelihood; Expected Impact
- High / Medium — Protracted period of slower growth in key advanced and emerging economies
  - Description:
    - Euro Area and Japan: Weak demand and persistently low inflation from a failure to fully address crisis legacies and appropriately calibrate macro policies, leading to a ”new mediocre” rate of growth.
    - Emerging markets: Maturing of the cycle, misallocation of investment, and incomplete structural reforms leading to prolonged slower growth.
  - Expected Impact if Threat is Realized (High):
    - Protracted slower global growth would weaken non-oil exports and contribute further to lower oil prices. This would result in economic slowdown and higher unemployment, due to a fall in exports and less oil investments.
    - Lower asset prices would impact negatively GPFG's rate of return.

- High — A surge in global financial volatility
  - Description:
    - Prices of risky assets drop abruptly as investors reassess underlying risk and move to safe assets, associated with a rise in actual and expected volatility. Global growth would be impacted negatively as some countries face a tight policy mix, given higher financing costs and fiscal sustainability concerns, and constraints on accommodative monetary policies.
  - Expected Impact if Threat is Realized (Medium):
    - Renewed stress in global wholesale funding markets would lead to liquidity strains for Norwegian banks that rely on FX wholesale funding. The large presence of foreign-owned banks increases spillover risks.
    - Impaired global demand would lead to an economic slowdown, due to a fall in exports, less oil investments, and impaired consumer confidence.

- Medium — Protracted low energy prices
  - Description:
    - Persistently low energy prices are triggered by supply factors, reversing only gradually, and weaker demand.
  - Expected Impact if Threat is Realized (High/Medium):
    - Persistently low oil prices would weaken growth directly via a reduction in oil-related demand for mainland goods and services, and indirectly via a reduction in demand for housing due to confidence effects or a reversal of immigrant inflows.

- Medium — A significant drop in house prices
  - Description:
    - Norway has the highest house price-to-rent ratio relative to its historical average among OECD economies. Although this can be partly explained by fundamentals, there is a risk of significant overvaluation.
  - Expected Impact if Threat is Realized (High):
    - A fall in house prices would dampen private consumption and reduce residential investment.
    - The high household debt level may cause a sharp contraction in household consumption and retail sales, leading to a potential rise in default rates and higher solvency risks for banks.

- Footnote on RAM probabilities:
  - The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

*IMF staff — Appendix II. Risk Assessment Matrix*

### Appendix III. Stress Test Matrix (STeM) for the Banking Sector — Solvency (Overview)
- Institutions included (Top 6 commercial and savings banks repeated across methodologies):
  - DNB Bank, Nordea Bank Norge, SpareBank 1 SR-Bank, SpareBank 1 SMN, SpareBank 1 Nord-Norge, Sparebanken Vest.
- Market share:
  - 75 percent of banking sector assets (excluding mortgage companies; unconsolidated basis).
  - 67 percent of banking sector assets (including mortgage companies; consolidated basis).
- Data and baseline date:
  - Banks’ internal data as of December 2014.
  - Bank-by-bank supervisory data as of December 2014.
  - Bank-by-bank commercial data and aggregate data as of September 2014.
  - Bank-by-bank supervisory data and aggregate data as of December 2014.
- Consolidation:
  - Consolidated and unconsolidated basis (2 tests).
  - Unconsolidated basis.
  - Consolidated basis (including mortgage finance companies).
- Methodology:
  - Banks’ internal risk management framework.
  - Guidance from FSAP team.
  - Finanstilsynet models.
  - Norges Bank’s models.
  - Global "rule of thumb" approach and balance sheet solvency framework.
- Stress test horizon:
  - 5 years.
- Exposure coverage:
  - Credit risks related to: (i) aggregate exposures; (ii) sectoral exposures (e.g., corporate, mortgages, other household lending; other financial institutions; FX loans); (v) exposures to industries; and (vi) exposures up to 10 largest obligors.
  - Credit risk-sensitive (corporate and household loans) and market risk-sensitive exposures (equity and debt).
- Shocks (scenario analysis — scenarios generated by the Norges Bank macroeconomic model):
  - Baseline: IMF staff macroeconomic projections as of December 2014, estimated via NB’s macro model.
  - Upsurge in global financial volatility and a considerable slowdown of global growth (w/out policy reaction):
    - A permanent rise in domestic and global spreads (money market spreads: up to 200 basis points; wholesale market spreads: to 150 basis points), starting in 2015; a slowdown of the world economy; sustained drop of oil prices (to $40) over stress-testing horizon, starting in 2015; a real house price decline of 40 percent over 5 years; a cumulative 5-year decline of 6.7 percent in real Mainland GDP (16.1 ppts cumulative drop relative to baseline).
  - Upsurge in global financial volatility and a considerable slowdown of global growth (w/ policy reaction):
    - Identical scenario, but allowing for monetary policy easing (policy rate at 0 percent); a cumulative 5-year decline of 4.3 percent in real Mainland GDP (13.9 ppts cumulative drop relative to baseline).
- Sensitivity analysis:
  - Exchange rate depreciation: Effect on the net open positions in the trading book. For each currency, the shock is set at two times the maximum shift of the annualized FX volatility from its long-term level.
  - Credit concentration risk: default of the largest one, three, five and ten exposures.
- Risks / factors assessed:
  - Market risk (incl. sovereign debt).
  - Funding cost risks.
- Behavioral adjustments:
  - Balance sheets are assumed to be static, except for credit growth, based on macro model (no deleveraging allowed). Corresponding funding increases in line with projections from macro model. Credit growth does not take into account any contemporaneous asset impairments.
  - No changes in structural business models and in managerial decisions (e.g., strategic asset disposals; changes in funding structure; dynamic RWA management) allowed.
  - Dividend payout ratio assumed to be zero under stress.
  - Income composition assumed to remain constant.
  - Asset disposals not permitted (apart from credit growth projection).
  - No raising of new capital allowed.
- RWA and parameter assumptions:
  - Risk-weighted Assets (RWA) assumed to be adjusted in line with PDs (IRB approach or standardized approach, depending on bank).
  - RWA assumed to follow the Basel IRB approach; TTC PDs estimated as updated on long-term average PiT PDs.
  - RWA for credit risk set to increase in line with problem loan shares. For new lending, the marginal risk weight is assumed to be 40% for lending to households and 80% for lending to corporates. Norway's transitional rule of the Basel I floor is taken into account.
  - RWA for operational risk estimated at 15 percent of (Net interest income + Net commission income + (net) Other income) * 12.5.
  - RWA for market risk is set as a fixed share of the holdings of financial instruments (at fair value).
- Regulatory standards:
  - RWA per Basel 2.5 and III.
  - Hurdle rates for regulatory capital (CET-1) based on Norway's schedule (accelerated Basel III schedule).
- Reporting format:
  - Post-shock solvency ratios and losses by type of exposure.
  - Distribution of capital ratios across the banking system; aggregated basis.

*IMF staff — Appendix III. Stress Test Matrix (STeM) for the Banking Sector*

### Appendix III. Stress Test Matrix — Liquidity
- Institutions included:
  - Top 6 commercial and savings banks: DNB Bank, Nordea Bank Norge, SpareBank 1 SR-Bank, SpareBank 1 SMN, SpareBank 1 Nord-Norge, and Sparebanken Vest.
- Market share:
  - 67 percent of banking sector assets (including mortgage companies; consolidated basis).
- Baseline date:
  - September 2014 and December 2014.
- Consolidation:
  - Consolidated basis.
- Risks:
  - Systemic funding and market liquidity risks (withdrawal and market freeze; uniform shocks across banks; independent of solvency tests).
- Buffers:
  - Counterbalancing capacity accessed via unencumbered assets at market values net of haircuts (by type of securities).
- Test horizon:
  - 30 days.
- Methodology:
  - LCR / NSFR.
  - Analysis assumes wholesale funding difficulties and deposit withdrawals (funding risk), and fire sales of assets (market liquidity risk) to meet liquidity constraints (market liquidity risk). Asset-specific haircuts are assumed.
- Shocks:
  - The magnitude of the shocks is in line with the severe liquidity difficulties experienced by banks globally after the Lehman bankruptcy (first scenario) and IMF analysis of past liquidity episodes (second scenario). Both scenarios are more severe than the historical experience in Norway.
  - Dry-up of unsecured wholesale funding: Inability to rollover maturing unsecured wholesale funding.
  - Dry-up of secured wholesale funding: Inability to rollover maturing secured wholesale funding; deposit runs and withdrawal of contingent liabilities.
- Regulatory Standards:
  - LCR ratios; liquidity gaps; NSFR ratios.
- Reporting format:
  - Distribution of banks with LCR under 100 percent (FX liquidity) and 60 percent (domestic liquidity).
  - Liquidity shortfall (in absolute terms), both FX and LCR.

*IMF staff — Appendix III. Liquidity STeM*

### Appendix III. Stress Test Matrix — Contagion
- Institutions included:
  - 8 banks for domestic bank analysis: DNB Bank, Nordea Bank Norge, SpareBank 1 SR-Bank, SpareBank 1 SMN, SpareBank 1 Nord-Norge, Sparebanken Vest, Sparebanken Sør, and Eika Gruppen.
  - 9 banks for domestic bank analysis: Nordea Group, Svenska Handelsbanken Group, Swedbank Group, Seb Group, Danske Bank, Jyske Bank, Sydbank and Pohjola Bank.
  - BIS reporting banks (undisclosed).
- Market share:
  - 95 percent of banking sector assets in Norway.
- Data and baseline date:
  - Institutions’ own data, BIS public and restricted data, and public data; 2010—2014Q3.
- Methodology:
  - Bank network analysis (Espinosa and Sole, 2014); network connectedness approach (Diebold and Yilmaz, 2014); distress dependence analysis (Segoviano and Goodhart, 2009).
  - Balance sheet model (institutions’ own data on bilateral exposures; BIS data at the country level); and market-based model (equity returns, CDS spreads, and EDF).
  - Pure contagion: default of institutions, market closure, and retrenchment of cross-border claims.
- Shocks:
  - Funding shock: 95 percent of funding is not rolled over; asset sale at 50 percent discount.
  - Credit shock: 50 percent loss-given-default (LGD).
- Reporting format:
  - Pass or fail (institutions’ own data and BIS data).
  - Contagion and vulnerability indices; network connectedness metrics; Bank Stability Index (Segoviano and Goodhart, 2009).

*IMF staff — Appendix III. Contagion STeM*

### Appendix IV. Stress Test Matrix (STeM) for the Insurance Sector — Solvency Risk (Overview)
- Institutional perimeter:
  - Institutions included: Three large life insurance and three large non-life insurance companies.
  - Market share: Life: 80 percent (assets). Non-Life: 60 percent (premiums); 51 percent (assets).
  - Data and baseline date: Data provided by the FSA. Reference date: 31/12/2014. Solo-entity basis.
- Channels of risk propagation:
  - Methodology: IMF & FSA staff estimates and companies’ internal models.
  - Valuation: Market-consistent valuation of assets and liabilities.
  - Stress test horizon: Applying cumulative changes in 2015-19 in bank stress testing scenarios. Instantaneous shocks in sensitivity analyses.
- Tail shocks / scenarios:
  - A combination of single factor analysis.
  - Scenario 1 and 2: Severe declines in asset prices, increasing interest rates.
  - Scenario 3: Severe declines in asset prices, and a sudden decline in interest rates.
- Risks and buffers:
  - Risks/factors assessed: Interest rates, equity, property, FX, credit spreads, lapses, concentration risks. Underwriting risks, counterparty risks, and operational risks. Summation of risks within scenarios with diversification effects.
  - Buffers: Absorption effect of technical provisions (profit sharing and policyholder buffer funds) for some products.
  - Behavioral adjustments: Limited to rules in place at the reference date.
- Calibration of risk parameters:
  - Interest rates: +250 bp parallel shift/-100 bp parallel shift.
  - Equity: -45 percent for ordinary shares (-55 percent for others).
  - Real estate: -29 percent, -33 percent, and -40 percent.
  - FX: 6.5/5.6/30 percent depreciation of NOK, 30 percent appreciation of NOK.
  - Spread risks: ratings based.
  - FSA/EIOPA assumptions for other risks.
- Regulatory and market-based standards:
  - Solvency II.
- Reporting format for results:
  - Output presentation: Impact on the buffer capital.
  - Capital shortfall for companies with a BCU above 100 percent.
  - Contribution of individual shocks.

*IMF staff — Appendix IV. Stress Test Matrix (STeM) for the Insurance Sector*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr15252.pdf_