## EXECUTIVE SUMMARY

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---

### Key findings
- Notwithstanding the three-year recession, Finland’s banking system remains well capitalized and profitable.
- Low interest rates have squeezed net interest income; banks have increased income from trading and insurance and reduced cost-income ratios, helping to maintain profitability.
- Nonperforming loans have remained low and capitalization ratios are well above requirements, though buffers may be exaggerated by the aggressive use of risk weights.
- The Net Stable Funding Ratio suggests that vulnerabilities from maturity mismatches are limited in aggregate.
- The banking system remains largely reliant on external wholesale funding.
- Social safety nets have helped protect disposable income recently, supporting households’ debt servicing capacity, but fiscal buffers have been eroded.
- Household debt is rising, increasing vulnerability to income and interest shocks.
- Key macrofinancial risks include:
  - a lackluster recovery from the domestic recession;
  - adverse macroeconomic or financial shocks in a Nordic country;
  - a sharp growth slowdown in advanced economies, in particular the euro area.
- Stress tests indicate:
  - banks are largely resilient to solvency shocks but exposed to liquidity shocks;
  - risk-weighted capital ratios would remain above regulatory minima under a severe macroeconomic stress scenario, while unweighted leverage ratios would fall below the hurdle rate;
  - a severe disruption in external wholesale funding or in the covered bond market could lead to systemic liquidity shortfalls.
- The prolonged period of low interest rates has heightened risks in the non-bank financial sector:
  - policies with implied guaranteed rates substantially above current interest rates comprise up to 40 percent of insurer’s technical provisions;
  - solvency is depressed by low risk free rates used as discount factors to calculate technical provisions and own funds;
  - pension insurers and pension funds have increased the riskiness of their investment portfolios.

### Macrofinancial setting
- The economy emerged from a three-year recession; the decline of the paper industry and Nokia, exacerbated by weak external demand, contributed to a 3 percent drop in GDP over 2012–14.
- The fiscal deficit breached the Stability and Growth Pact’s 3 percent of GDP threshold in 2014, and public debt exceeded 60 percent of GDP in 2015.
- Growth turned positive in 2015 and is expected to solidify over the medium term but remain well below its pre-crisis average.
- Headline inflation recently turned positive; unemployment is high and projected to slowly fall.
- Financial cycle and structural indicators:
  - the credit-to-GDP gap has steadily declined since 2009 and was slightly positive as of end-2015;
  - credit to the private non-financial sector is at a historic peak of 183 percent of GDP (near the OECD median);
  - household debt (including tenant-owned housing company loans) is at 125 percent of disposable income, a historic high (though below other Nordic countries);
  - house prices have declined slightly since 2013 and standard valuation measures do not indicate significant overvaluation.
- External positions by sector:
  - banks and non-financial corporations (NFC) are net debtors to the rest of the world (in NFCs nearly 60 percent of external liabilities are equity);
  - the government is a net creditor to the rest of the world, largely due to pension schemes being included as part of the government in the national accounts;
  - households are net external creditors, largely through institutional investors (pension funds, insurers, investment funds).

### Supervision, macroprudential framework, and CPCM (summary observations)
- Authorities are encouraged to ensure adequate bank capital and liquidity cushions are maintained.
- The Finnish authorities should pursue their plan to set risk weight floors for mortgages and the ECB should proceed with its comprehensive review of banks’ internal risk models, and reinforce ongoing monitoring.
- Supervisory financial and human resources need augmentation and regulatory authorities need adequate powers:
  - bank and non-bank supervision, macroprudential policy making and contingency planning have become more intense, intrusive, and resource-intensive, stretching FIN-FSA and FFSA resources;
  - the FIN-FSA needs powers to credibly enforce supervisory action and legal/operational frameworks to strengthen legal protection of officials, staff, and agents should be improved.
- In light of Nordea Finland’s likely conversion to a branch:
  - conclude the multilateral supervisory MoU under negotiation with Sweden’s Financial Supervision Agency and other regional supervisors to strengthen the role of host supervisors of systemically important bank branches within existing EU regulations;
  - Nordea will remain systemically important in Finland even after conversion, with nearly one third of domestic deposits;
  - cross-border liquidity transfer ease within banking groups poses a particular concern for Finland.
- Macroprudential instruments:
  - several instruments have been formally approved and activated recently, but the toolkit should be expanded and data gaps filled;
  - FIN-FSA’s mandate should be broadened beyond tools explicitly approved in legislation (the systemic risk buffer should be made available for activation if needed);
  - consider macroprudential tools based on loan terms (maximum maturity limit) and borrower eligibility (loan-to-income cap);
  - create a loan registry system to enable effective use of these measures and granular risk analyses.
- Contingency planning and crisis management (CPCM):
  - CPCM framework rests on strong foundations; separation of functions (supervision, resolution, liquidity provision) reduces conflicts;
  - assign overall responsibility to actively oversee crisis preparedness and management at national and Banking Union levels;
  - strengthen CPCM cooperation among Nordic countries to compensate for diminished role in resolution planning and decision-making that would follow Nordea Bank Finland’s conversion to a branch;
  - expedite resolution planning for systemic banks;
  - ensure operational capacity to rapidly deploy recovery and resolution tools.

### Key recommendations (selected)
- General
  - Increase the FIN-FSA and FFSA’s financial and human resources in accordance with the increase in regulatory complexity and supervision intensity in (i) prudential supervision of banks (including systemic branches), (ii) prudential supervision of insurers, (iii) contingency planning/crisis management, (iv) macroprudential policy analysis, and (v) investment funds and their managers. — Timing: I, C
  - Expand cooperation arrangements with other Nordic supervisors to include (i) formal region-wide sharing of supervisory data and coordinated inspections, including foreign branches and cross-border management of investment funds, (ii) conduct Nordic stress tests, (iii) strengthen collaboration with macroprudential authorities, and (iv) enhanced CPCM cooperation on systemically important branches and regular crisis simulation exercises. — Timing: NT
  - Strengthen legal protection for staff of all financial oversight agencies — Timing: I, C
- Risk Analysis & Banking Supervision
  - Ensure banks’ Internal Ratings Based models are calibrated to reflect severe stress. — Timing: NT
  - Intensify monitoring of banks’ liquidity positions in foreign currencies and crossholdings of covered bonds used as collateral. Perform liquidity stress tests for various time horizons and stand ready to take supervisory action if imbalances emerge. — Timing: NT
  - Amend law to grant the FSA full Pillar 2 powers for decisions on capital and liquidity requirements and other supervisory measures. — Timing: NT
  - Ensure effective ongoing monitoring of banks’ internal risk models following the upcoming SSM comprehensive review (TRIM project). — Timing: MT
- Macroprudential Policy Framework
  - Clearly define a macroprudential policy mandate of the FIN-FSA beyond the measures approved in laws. — Timing: NT
  - Create a household loan registry. — Timing: NT
  - Introduce a systemic risk buffer and a loan-to-income limit. — Timing: I, NT
  - Finalize the plan to introduce floors for the risk-weights used in internal models. — Timing: I
- Contingency Planning and Crisis Management
  - Formalize inter-agency cooperation on crisis preparedness and management at the national level, possibly through an expanded mandate for the FFSA Advisory Council. — Timing: I
  - Under the oversight of the FFSA Advisory Council, ensure agency-specific and national financial crisis planning. — Timing: I, C
  - Expedite resolution planning for systemic financial institutions. — Timing: I
  - Define strategies for liquidity assistance to banks in resolution and introduce an indemnification arrangement for ELA losses if incurred by the BoF. — Timing: NT
- Non-banks
  - Upgrade legislation to cover the supervisory actions and any other measures required in the event of pension insurer or fund distress and if resolution becomes necessary. — Timing: I
  - Ensure adequacy of action plans for life insurers to meet Solvency II requirements, including by conducting regular stress testing under adverse scenarios. — Timing: NT
  - Monitor fund managers’ risk management processes, increase the use of supervisory data to analyze risks, and improve FIN-FSA’s capability to conduct market surveillance. — Timing: NT, C

Timing key: C = continuous; I (immediate) = within one year; NT (near term) = 1-3 years; MT (medium term) = 3-5 years.

### Financial system size, composition, and funding (key statistics)
- Financial system assets: about 400 percent of GDP (2015).
- Banks’ assets: 230 percent of GDP.
- Foreign-owned banks’ assets: 160 percent of GDP.
- Pension funds manage assets worth 51 percent of GDP.
- Insurance companies manage assets worth 35 percent of GDP.
- Other financial intermediaries manage assets worth 72 percent of GDP.
- Non-banks account for nearly 40 percent of the financial system.
- The three largest banks account for 93 percent of assets and 88 percent of loans.
- Two foreign-owned banks—Nordea Bank Finland (NBF) and Danske Bank Finland—account for 70 percent of banks’ assets.
- NBF accounts for nearly two thirds of the banking system’s assets and nearly one third of domestic deposits and lending.
- The large domestic cooperative bank accounts for over a third of domestic lending and deposits.
- Loan-to-deposit ratio: about 124 percent.
- Funding structure (2015, percent of total funding): Retail deposits: 45%; Wholesale deposits: 21%; Covered bonds: 10%; Senior bonds/Other: 10%; Repos: 8%; CPs/CDs: 6%.
- Funding structure by source (2015, percent of total funding): Foreign wholesale funding: 43%; Domestic wholesale funding: 12%.
- Cross-border banking assets: around 120 percent of GDP.
- Cross-border banking liabilities: around 150 percent of GDP.
- Cross-border credit share of banks’ assets (liabilities): 33 percent (45 percent).
- Cross-border derivatives share of banks’ assets (liabilities): 25 percent (23 percent).

### Banking sector vulnerabilities and concentration
- Funding risks:
  - NSFR of 114 percent for the three largest banks in aggregate; some banks have a ratio below 100 percent.
  - Wholesale funding accounts for over half of banks’ funding; most wholesale funding is provided by foreign financial institutions and about three quarters is short-term.
  - Bank funding could be vulnerable due to mostly foreign investors in covered bonds and potential deterioration in the cover pool’s credit ratings.
- Contagion risks:
  - Substantial integration amongst Nordic countries implies exposure through valuations of banks’ foreign assets and derivatives, and potential withdrawals of foreign funding, including from parent institutions.
  - Banks operating under a foreign branch model would face heightened risk from parent funding withdrawals.
  - A sharp slowdown or drop of house prices in Sweden could have large effects in Finland.
- Capitalization concerns:
  - Capital adequacy ratio (CAR) of 23.1 percent in 2015.
  - Leverage ratio (capital to total assets) of 5.6 percent in 2015, above the 3 percent requirement but lower compared to peer countries.
  - High share of assets with no risk-weights or low risk-weights (e.g., public sector exposures, IRB models) suggests banks’ ability to absorb losses may be less than implied by the CAR.
  - Finnish authorities plan to adopt risk weight floors for mortgages.

### Stress testing — solvency, liquidity, contagion (key results)
- Solvency (severe adverse scenario):
  - Aggregate Common Equity Tier 1 (CET1) ratio (fully-loaded CRR definition) would drop to 8.3 percent.
  - Main drivers of CET1 decline (cumulative, in percentage points of RWAs): funding costs (-6.4), credit losses (-6.1), change in risk-weighted assets (-2.8).
  - Two banks would see CET1 fall below the requirement of 4.5 percent, by 0.2 percent of GDP.
  - A third bank would need to use part of its capital conservation buffer.
  - Aggregate leverage ratio would fall to 2.3 percent under the severe scenario.
  - The four banks’ leverage ratios would decline below the hurdle rate of 3 percent in 2018, by an amount equivalent to 2 percent of GDP.
- Liquidity:
  - All banks meet the standard LCR test with withdrawal rates of 25-40 percent of different types of unsecured wholesale funding.
  - If unsecured wholesale funding were withdrawn entirely, aggregate LCR would fall to 66 percent and total liquidity shortfall relative to the 2018 minimum requirement would amount to €45 billion (22 percent of GDP).
  - Liquidity shortfall based on Basel III NSFR: €25.4 billion.
  - Separate LCR-liquidity stress tests on foreign currency positions reveal shortfalls in two banks ranging between 0.5 and 1.4 percent of GDP.
  - Cash-flow maturity analysis: the banking system would not have enough buffers to counterbalance net outflows at one maturity bucket (16 to 30 days).
  - Retail deposit withdrawal shock: increasing withdrawal rates yields a total liquidity shortfall of €17 billion (8 percent of GDP).
  - Reverse liquidity stress test: withdrawal rates of retail deposits alone would need to be 30 to 40 percent to cause system-wide LCR to fall below 100 percent.
- Household stress tests:
  - Current implied households’ PDs estimated at 3.9 percent using micro data.
  - A combined drop in incomes and shock to real estate prices increases implied households’ PDs to 13.6 percent (multiplier of 3.5).
  - Households are particularly vulnerable to a drop in incomes.
- Contagion analysis:
  - Minimum Tier 1 requirements (including capital conservation buffer) of the most exposed banks would fall below the hurdle rate of 8.5 percent if about 40 percent of payments from one country were not met.
  - A 34 percent reduction of cross-border funding from one country would deplete one bank’s liquid assets, potentially leading to asset fire sales and solvency problems.
  - Variance decomposition of weekly equity price changes indicates Sweden and Finland share the strongest linkages among the Nordics.

### Non-banks: pension insurers, life insurers, and financial conglomerates
- Pension insurers and employment based pension funds:
  - Majority of compulsory and voluntary occupational pension schemes are financed by group insurance contracts.
  - Employer based pension schemes have faced falling contributions and investment income and rising pensions.
  - Investment managers have increased the risk profile of investments; an equalization methodology dilutes the impact of the market-risk based solvency requirement.
  - A FIN-FSA test showed main pension insurers would breach their risk-based solvency margins under a severe shock scenario on account of equity losses.
  - Recommendation: monitor closely the riskiness of pension fund portfolios and sensitivity through stress.
- Life insurers:
  - Guaranteed-return products still comprise 37 percent of sectoral technical provisions.
  - The average required yield to meet capital guaranteed commitments is 2.3 percent.
  - Six life insurers have been granted transitional solvency terms to meet Solvency II capital requirements.
  - Recommendation: regularly test vulnerability of life insurers with significant exposures to high guaranteed return products with plausible shocks.
- Financial conglomerates and insurers:
  - Direct contagion risk from non-bank to banking sector appears limited; reputational risk is the greatest concern.
  - Linkages to banks through bond and cash holdings and net counterparty exposures are modest.
  - Insurers rely on banks for distribution of products and would be adversely affected if a bank suffered distress.

### Banking supervision, branchification, and regional cooperation
- Supervisory challenges and model risk:
  - Supervisors need to be vigilant regarding possible overestimation of capital levels and underestimation of risk-weighted assets; banks struggle to classify loans under EBA definitions of ’non-performing’ and ‘forborne’ exposures.
  - Risk weights for mortgage exposures applied by Finnish banks using IRB models are, on average, the lowest in Europe.
  - The proposed floor on risk weights of mortgage exposures is to become effective by July 2017.
  - The SSM Targeted Review of Internal Models (TRIM) should address aggressive use of IRB models and ensure comparability.
- Nordea branch conversion implications:
  - Once Nordea converts its Finnish subsidiary into a branch, prudential supervision, liquidity support and resolution would shift to Sweden.
  - NBF will remain systemically important even if converted to a branch.
  - Measures to mitigate concerns include an updated multilateral supervisory MoU, cooperative liquidity support arrangements, and consideration of alternative resolution strategies.
- Non-bank supervision and resources:
  - Legal infrastructure aligns with EU Directives but employment based pension funds governance under Finnish law remains incomplete; regulatory ladders and resolution procedures for distressed pension funds are not clearly spelled out.
  - FIN-FSA resources and insurance expertise should be strengthened to meet increased demands from Solvency II and group supervision.
  - FIN-FSA should monitor fund managers’ risk management processes, compile supervisory data, and consider an automated market surveillance system.

### Macroprudential policy and data
- Institutional arrangement:
  - Macroprudential mandate is shared between Finnish authorities and the ECB; domestic framework formalized in 2014 designated the FIN-FSA to implement a set of macroprudential instruments.
  - Since 2014 the ECB was designated as a macroprudential authority for the euro area, with the ESRB advisory.
- Implemented measures:
  - Board designated four banks as systemically important and subjected them to additional capital requirements from January 2016.
  - A loan-to-collateral cap for housing loans became effective as of mid-2016.
  - The counter-cyclical capital buffer has not been activated.
  - Planned introduction of a floor on risk weights for housing loans recognizes heightened vulnerabilities.
- Improvements recommended:
  - Clarify a broader macroprudential policy mandate in law; expand FIN-FSA human resources for macroprudential policy.
  - Create a loan registry system to fill a data gap related to household indebtedness.
  - Broaden the toolkit to include the systemic risk buffer, maximum maturity limits, and caps on loan-to-income or debt-service-to-income ratios.
  - Strengthen regional cooperation on supervisory information sharing and joint stress-testing.

### Contingency Planning, Crisis Management, and AML/CFT
- CPCM strengths and gaps:
  - New legislation and a national resolution authority (FFSA) and revised deposit insurance system have been introduced.
  - Functional separation between supervision, resolution, and emergency liquidity support aids crisis preparedness.
  - CPCM framework is untested; additional resources, clarified responsibilities, strengthened legal protection for officials, and indemnification arrangements for central bank ELA exposures are needed.
  - Consider assigning overall responsibility for crisis preparedness and management to an expanded FFSA Advisory Council.
- Cross-border arrangements:
  - SRM complexity could delay European-level decision making; define roles for the ECB and Single Resolution Board in overseeing collective crisis preparedness.
  - Strengthen Nordic cooperation, possibly via a revamped Nordic-Baltic Stability Group (NBSG) and MoUs among agencies.
- AML/CFT:
  - Finland has made good progress implementing the 2012 standard; most main deficiencies from the 2007 mutual evaluation report have been addressed.
  - Draft changes include setting up a register of owners and beneficial owners of Finnish legal entities, implementing a greater risk-based approach, and strengthening supervision and sanctions for non-compliance.
  - Finland conducted its first ML/TF national risk assessment; an update is intended in 2017 ahead of Finland’s 2018 AML/CFT assessment.

*Italic source attribution line.*

### EXECUTIVE SUMMARY ___________________________________________________________________________  6

### EXECUTIVE SUMMARY

### Key findings
- Notwithstanding the three-year recession, Finland’s banking system remains well capitalized and profitable.
- Low interest rates have squeezed net interest income; banks have increased income from trading and insurance and reduced cost-income ratios, helping to maintain profitability.
- Nonperforming loans have remained low and capitalization ratios are well above requirements, though buffers may be exaggerated by the aggressive use of risk weights.
- The Net Stable Funding Ratio suggests that vulnerabilities from maturity mismatches are limited in aggregate.
- The banking system remains largely reliant on external wholesale funding.
- Social safety nets have helped protect disposable income recently, supporting households’ debt servicing capacity, but fiscal buffers have been eroded.
- Household debt is rising, increasing vulnerability to income and interest shocks.
- Key macrofinancial risks include:
  - a lackluster recovery from the domestic recession;
  - adverse macroeconomic or financial shocks in a Nordic country;
  - a sharp growth slowdown in advanced economies, in particular the euro area.
- Stress tests indicate:
  - banks are largely resilient to solvency shocks but exposed to liquidity shocks;
  - risk-weighted capital ratios would remain above regulatory minima under a severe macroeconomic stress scenario, while unweighted leverage ratios would fall below the hurdle rate;
  - a severe disruption in external wholesale funding or in the covered bond market could lead to systemic liquidity shortfalls.
- The prolonged period of low interest rates has heightened risks in the non-bank financial sector:
  - policies with implied guaranteed rates substantially above current interest rates comprise up to 40 percent of insurer’s technical provisions;
  - solvency is depressed by low risk free rates used as discount factors to calculate technical provisions and own funds;
  - pension insurers and pension funds have increased the riskiness of their investment portfolios.

### Macrofinancial setting
- The economy emerged from a three-year recession; the decline of the paper industry and Nokia, exacerbated by weak external demand, contributed to a 3 percent drop in GDP over 2012–14.
- The fiscal deficit breached the Stability and Growth Pact’s 3 percent of GDP threshold in 2014, and public debt exceeded 60 percent of GDP in 2015.
- Growth turned positive in 2015 and is expected to solidify over the medium term but remain well below its pre-crisis average.
- Headline inflation recently turned positive; unemployment is high and projected to slowly fall.
- Financial cycle and structural indicators:
  - the credit-to-GDP gap has steadily declined since 2009 and was slightly positive as of end-2015;
  - credit to the private non-financial sector is at a historic peak of 183 percent of GDP (near the OECD median);
  - household debt (including tenant-owned housing company loans) is at 125 percent of disposable income, a historic high (though below other Nordic countries);
  - house prices have declined slightly since 2013 and standard valuation measures do not indicate significant overvaluation.
- External positions by sector:
  - banks and non-financial corporations (NFC) are net debtors to the rest of the world (in NFCs nearly 60 percent of external liabilities are equity);
  - the government is a net creditor to the rest of the world, largely due to pension schemes being included as part of the government in the national accounts;
  - households are net external creditors, largely through institutional investors (pension funds, insurers, investment funds).

### Supervision, macroprudential framework, and CPCM (summary observations)
- Authorities are encouraged to ensure adequate bank capital and liquidity cushions are maintained.
- The Finnish authorities should pursue their plan to set risk weight floors for mortgages and the ECB should proceed with its comprehensive review of banks’ internal risk models, and reinforce ongoing monitoring.
- Supervisory financial and human resources need augmentation and regulatory authorities need adequate powers:
  - bank and non-bank supervision, macroprudential policy making and contingency planning have become more intense, intrusive, and resource-intensive, stretching FIN-FSA and FFSA resources;
  - the FIN-FSA needs powers to credibly enforce supervisory action and legal/operational frameworks to strengthen legal protection of officials, staff, and agents should be improved.
- In light of Nordea Finland’s likely conversion to a branch:
  - conclude the multilateral supervisory MoU under negotiation with Sweden’s Financial Supervision Agency and other regional supervisors to strengthen the role of host supervisors of systemically important bank branches within existing EU regulations;
  - Nordea will remain systemically important in Finland even after conversion, with nearly one third of domestic deposits;
  - cross-border liquidity transfer ease within banking groups poses a particular concern for Finland.
- Macroprudential instruments:
  - several instruments have been formally approved and activated recently, but the toolkit should be expanded and data gaps filled;
  - FIN-FSA’s mandate should be broadened beyond tools explicitly approved in legislation (the systemic risk buffer should be made available for activation if needed);
  - consider macroprudential tools based on loan terms (maximum maturity limit) and borrower eligibility (loan-to-income cap);
  - create a loan registry system to enable effective use of these measures and granular risk analyses.
- Contingency planning and crisis management (CPCM):
  - CPCM framework rests on strong foundations; separation of functions (supervision, resolution, liquidity provision) reduces conflicts;
  - assign overall responsibility to actively oversee crisis preparedness and management at national and Banking Union levels;
  - strengthen CPCM cooperation among Nordic countries to compensate for diminished role in resolution planning and decision-making that would follow Nordea Bank Finland’s conversion to a branch;
  - expedite resolution planning for systemic banks;
  - ensure operational capacity to rapidly deploy recovery and resolution tools.

### Key recommendations (from Table 1)
- General
  1. Increase the FIN-FSA and FFSA’s financial and human resources in accordance with the increase in regulatory complexity and supervision intensity in (i) prudential supervision of banks (including systemic branches), (ii) prudential supervision of insurers, (iii) contingency planning/crisis management, (iv) macroprudential policy analysis, and (v) investment funds and their managers. (Box 1, ¶30, ¶36, ¶43, ¶44, ¶48, ¶51) — Timing: I, C
  2. Expand cooperation arrangements with other Nordic supervisors to include (i) formal region-wide sharing of supervisory data and coordinated inspections, including foreign branches and cross-border management of investment funds, (ii) conduct Nordic stress tests, (iii) strengthen collaboration with macroprudential authorities, and (iv) enhanced CPCM cooperation on systemically important branches and regular crisis simulation exercises. (¶13, ¶47, ¶44, ¶52) — Timing: NT
  3. Strengthen legal protection for staff of all financial oversight agencies (¶50) — Timing: I, C
- Risk Analysis
  4. Ensure banks’ Internal Ratings Based models are calibrated to reflect severe stress. (¶19) — Timing: NT
  5. Intensify monitoring of banks’ liquidity positions in foreign currencies and crossholdings of covered bonds used as collateral. Perform liquidity stress tests for various time horizons and stand ready to take supervisory action if imbalances emerge. (¶23, ¶41) — Timing: NT
- Banking Supervision
  6. Amend law to grant the FSA full Pillar 2 powers for decisions on capital and liquidity requirements and other supervisory measures (¶38) — Timing: NT
  7. Ensure effective ongoing monitoring of banks’ internal risk models following the upcoming SSM comprehensive review (TRIM project). (¶40) — Timing: MT
- Macroprudential Policy Framework
  8. Clearly define a macroprudential policy mandate of the FIN-FSA beyond the measures approved in laws. (¶48) — Timing: NT
  9. Create a household loan registry. (¶48) — Timing: NT
  10. Introduce a systemic risk buffer and a loan-to-income limit. (¶48) — Timing: I, NT
  11. Finalize the plan to introduce floors for the risk-weights used in internal models. (¶48) — Timing: I
- Contingency Planning and Crisis Management
  12. Formalize inter-agency cooperation on crisis preparedness and management at the national level, possibly through an expanded mandate for the FFSA Advisory Council (¶51) — Timing: I
  13. Under the oversight of the FFSA Advisory Council, ensure agency-specific and national financial crisis planning. (¶51-52) — Timing: I, C
  14. Expedite resolution planning for systemic financial institutions. (¶52) — Timing: I
  15. Define strategies for liquidity assistance to banks in resolution and introduce an indemnification arrangement for ELA losses if incurred by the BoF. (¶51) — Timing: NT
- Non-banks
  16. Upgrade legislation to cover the supervisory actions and any other measures required in the event of pension insurer or fund distress and if resolution becomes necessary. (¶42) — Timing: I
  17. Ensure adequacy of action plans for life insurers to meet Solvency II requirements, including by conducting regular stress testing under adverse scenarios. (¶30) — Timing: NT
  18. Monitor fund managers’ risk management processes, increase the use of supervisory data to analyze risks, and improve FIN-FSA’s capability to conduct market surveillance. (¶32) — Timing: NT, C

- Timing key: C = continuous; I (immediate) = within one year; NT (near term) = 1-3 years; MT (medium term) = 3-5 years.

*Italic source attribution line.*

### 4.      Finland’s financial system is relatively large with credit institutions constituting the

### 4.      Finland’s financial system is relatively large with credit institutions constituting the

### Overview of the financial system
- Financial system assets were equivalent to about 400 percent of GDP in 2015.
- Banks’ assets were 230 percent of GDP, of which foreign-owned banks assets were 160 percent of GDP.
- Pension funds manage assets worth 51 percent of GDP.
- Insurance companies manage assets worth 35 percent of GDP.
- Other financial intermediaries manage assets worth 72 percent of GDP.
- Non-banks account for nearly 40 percent of the financial system.

### Banking sector structure and concentration
- The three largest banks account for 93 percent of assets and 88 percent of loans.
- Two foreign-owned banks—Nordea Bank Finland (NBF) and Danske Bank Finland—account for 70 percent of banks’ assets.
- NBF accounts for nearly two thirds of the banking system’s assets (including derivatives), and nearly one third of domestic deposits and lending.
- The large domestic cooperative bank accounts for over a third of domestic lending and deposits.
- There are no state-owned banks; Municipal Finance is jointly owned by municipalities and lends only to municipalities and municipality-owned firms.

### Funding structure and liquidity
- The loan-to-deposit ratio stands at about 124 percent.
- Wholesale funding accounts for over half of banks’ funding, including deposits from credit institutions, covered bonds, and senior unsecured bonds.
- Most wholesale funding is provided by foreign financial institutions, including parent banks; about three quarters is short-term.
- Funding structure (2015, in percent of total funding):
  - Retail deposits: 45%
  - Wholesale deposits: 21%
  - Covered bonds: 10%
  - Senior bonds/Other: 10%
  - Repos: 8%
  - CPs/CDs: 6%
- Funding structure by source (2015, in percent of total funding):
  - Foreign wholesale funding: 43%
  - Domestic wholesale funding: 12%

### Lending composition and non-bank interlinkages
- About two thirds of bank loans go to domestic sectors; slightly above half of domestic lending goes to households (mostly mortgage loans).
- Major sectoral exposures: real estate and manufacturing.
- About one third of lending is to non-residents, including financial firms.
- Households rely on banks for about 90 percent of household debt.
- For non-financial corporations (NFCs):
  - Domestic MFIs provide about 25 percent of their borrowing.
  - Inter-company loans account for 24 percent of NFCs’ borrowing.
  - A third of NFC borrowing is from abroad, primarily loans.
  - Equity financing constitutes 52 percent of NFCs’ total liabilities; debt constitutes 38 percent.
- Significant links exist between banks and non-bank financial firms; many non-banks are part of financial conglomerates (e.g., OP Financial Group controls both the largest domestically-owned bank and the largest non-life insurance company).
- Example of cross-ownership: Sampo Group controls two of the largest insurance companies in Finland and owns over 20 percent of Nordea.

### Non-bank financial sector characteristics
- Five Finnish financial conglomerates control most of the domestic insurance and fund management companies.
- Non-banks deliver a large component of social insurance (e.g., mandatory occupational pension system partially funded by the private sector).
- Investment funds allocate most of their assets abroad, reducing households’ financial exposure to the domestic economy.
- About 40 percent of insurers’ portfolios are invested in foreign assets.
- Pension funds’ portfolios are heavily weighted towards foreign assets, mainly equities.

### Cross-border exposures and currency composition
- Banking sector cross-border assets and liabilities are around 120 percent and 150 percent of GDP, respectively, most within the Nordic region.
- Cross-border credit (loans, and debt securities) account for 33 percent (45 percent) of banks’ assets (liabilities).
- Cross-border derivatives account for 25 percent (23 percent) of banks’ assets (liabilities).
- Finnish banks are heavily dependent on intra-group funding within Nordic banking groups (deposits and debt securities).
- Most foreign exposures are in euros, followed by U.S. dollars and other Nordic currencies.

### Risks and vulnerabilities
- Households and firms have so far maintained debt servicing ability, aided by low interest rates and generous social safety nets; however, higher levels of debt increase vulnerability to interest and income shocks.
- Expected slow recovery will help improve financial sector indicators but will not sufficiently address key vulnerabilities; with slow growth, debt levels and fiscal vulnerabilities will remain elevated.
- Key risks to the outlook include:
  (i) a sharp rise in risk premia including distress in the euro area bond market;
  (ii) a sharp growth slowdown in advanced economies, in particular the euro area;
  (iii) heightened geopolitical risks in parts of the Middle East, Africa, and Europe, including a resurgence in tensions between the EU and Russia;
  (iv) adverse macroeconomic or financial shocks in a Nordic country;
  (v) a sharp increase in energy prices.
- Direct risks from Brexit primarily result from the exposure to derivatives cleared at a central counterparty in the United Kingdom.
- Energy import dependency and Russia exposure (as reported): Finland has an oil and natural gas import dependency of 100 percent; energy imports from Russia account for 60 per cent of the value of all energy imports into the country (imports from Russia include oil, coal, gas, nuclear fuel and electricity).

### Key statistics (as reported)
- Financial system assets: about 400 percent of GDP (2015).
- Banks’ assets: 230 percent of GDP.
- Foreign-owned banks’ assets: 160 percent of GDP.
- Pension funds: 51 percent of GDP.
- Insurance companies: 35 percent of GDP.
- Other financial intermediaries: 72 percent of GDP.
- Three largest banks’ market shares: 93 percent of assets; 88 percent of loans.
- Two foreign banks’ share of banks’ assets (NBF and Danske Bank Finland): 70 percent.
- NBF share: nearly two thirds of banking system’s assets; nearly one third of domestic deposits and lending.
- Cooperative bank share: over a third of domestic lending and deposits.
- Loan-to-deposit ratio: about 124 percent.
- Wholesale funding: over half of banks’ funding; about three quarters short-term.
- Cross-border banking assets: around 120 percent of GDP.
- Cross-border banking liabilities: around 150 percent of GDP.
- Cross-border credit share of banks’ assets (liabilities): 33 percent (45 percent).
- Cross-border derivatives share of banks’ assets (liabilities): 25 percent (23 percent).
- Funding structure (2015, percent of total funding): Retail deposits 45%; Wholesale deposits 21%; Covered bonds 10%; Senior bonds/Other 10%; Repos 8%; CPs/CDs 6%.
- Funding by source (2015): Foreign wholesale funding 43%; Domestic wholesale funding 12%.

*Sources: Statistics Finland and Fund staff calculations.*

### 14.      Despite generally sound indicators, there are important vulnerabilities in the banking

### 14.      Despite generally sound indicators, there are important vulnerabilities in the banking system

### Banking system vulnerabilities — summary findings
- Funding risks
  - NSFR of 114 percent for the three largest banks in aggregate; some banks have a ratio below 100 percent.
  - Bank funding could be vulnerable due to mostly foreign investors in covered bonds and potential deterioration in the cover pool’s credit ratings (mainly mortgages) which would reduce banks’ ability to obtain funding from the central bank.
- Contagion risks
  - Substantial integration amongst Nordic countries implies exposure through valuations of banks’ foreign assets and derivatives, and potential withdrawals of foreign funding, including from parent institutions.
  - Banks operating under a foreign branch model would face heightened risk from parent funding withdrawals.
  - A sharp economic slowdown or drop of house prices in Sweden could have large effects in Finland.
- Capitalization concerns
  - Capital adequacy ratio (CAR) of 23.1 percent in 2015.
  - Leverage ratio (capital to total assets) of 5.6 percent in 2015, lower compared to peer countries but above the 3 percent requirement.
  - High share of assets with no risk-weights or low risk-weights (e.g., public sector exposures, IRB models) suggests banks’ ability to absorb losses may be less than implied by the CAR.
  - Finnish authorities plan to adopt risk weight floors for mortgages.
- Profitability
  - Aggregate return on equity (ROE) is relatively high (Figure 9).
  - Sustainability questions: lower interest income has been offset by higher trading and insurance income, and reduced cost-income ratios.
- Nonperforming loans (NPLs)
  - NPLs at 1.6 percent of total loans at end-2015.
  - Interest-only mortgages now account for less than 4 percent of the total following the end of temporary amortization holidays.
  - Prolonged economic deterioration, particularly with reduced fiscal space for safety nets, could cause NPLs to rise significantly.
- Derivatives
  - Derivatives are considerable, mostly used to hedge interest rate and exchange rate risks, posing counterparty risks.
  - Derivatives cleared through Central Counterparties (CCPs) limit individual counterparty risk but remain subject to the tail-risk of CCP default.

### Bank solvency stress tests — design and scenarios
- Tests: “top-down” stress tests focused on supervisory data of the 4 significant institutions, integrating liquidity and solvency via projected funding costs.
- Horizon: three-year horizon (2016-18).
- Scenarios:
  - Moderate stress in the euro area: driven by risk aversion affecting the European “periphery”, adverse investment sentiment, slowdown in emerging market economies; GDP growth and inflation turn negative, unemployment rises slowly, bond and equity prices decline.
  - Severe stress specific to Finland: shock similar in size to the early-1990s Nordic banking crisis; severe disruption in Finland’s European partners (including large declines in house and other asset prices in Nordic neighbors), amplified by domestic demand confidence shock and a significant decline in residential real estate prices; a 3-notch sovereign downgrade and reduced social benefits; GDP would decline 2.7 percent per year on average and unemployment would rise sharply.

### Bank solvency stress tests — key quantitative results
- Under the severe adverse scenario:
  - Aggregate Common Equity Tier 1 (CET1) ratio (fully-loaded CRR definition) would drop to 8.3 percent.
  - Main drivers of CET1 decline (cumulative, in percentage points of RWAs): funding costs (-6.4), credit losses (-6.1), change in risk-weighted assets (-2.8).
  - Two banks would see CET1 fall below the requirement of 4.5 percent, by 0.2 percent of GDP.
  - A third bank would need to use part of its capital conservation buffer.
- Leverage ratio outcomes:
  - Aggregate leverage ratio would fall to 2.3 percent under the severe scenario.
  - The four banks’ leverage ratios would decline below the hurdle rate of 3 percent in 2018, when it becomes binding, by an amount equivalent to 2 percent of GDP.
  - The discrepancy between risk-weighted capital ratios and the leverage ratio suggests internal models may underestimate risks.

### Sensitivity and concentration tests
- Sensitivity tests show results are robust to variations in risk factors.
- Finnish banks have comparatively small exposure to domestic sovereign risk (except one bank), interest rate risk, foreign exchange risk, and equity risk.
- Concentration credit risk test: banks are adequately capitalized to absorb losses from default of large exposures, though one bank relies heavily on financial guarantees and thus on guarantor strength.

### Bank liquidity stress tests — design and scenarios
- Three shock scenarios tested across four metrics:
  - Standard Liquidity Coverage Ratio (LCR) tests at a 30-day horizon.
  - Retail shock with large retail deposit withdrawals.
  - Complete dry-up of unsecured wholesale funding (as in the 2008 crisis).
- Metrics analyzed:
  - LCR with variants;
  - Basel III net stable funding ratio (NSFR);
  - Cash-flows by maturity buckets;
  - Reverse liquidity stress test to identify conditions causing failure of predefined liquidity requirements.

### Bank liquidity stress tests — key quantitative results and implications
- Wholesale funding shock vulnerability
  - All banks meet the standard LCR test with withdrawal rates of 25-40 percent of different types of unsecured wholesale funding.
  - If unsecured wholesale funding were withdrawn entirely, aggregate LCR would fall to 66 percent and total liquidity shortfall relative to the 2018 minimum requirement would amount to €45 billion (22 percent of GDP).
  - Separate LCR-liquidity stress tests on foreign currency positions reveal shortfalls in two banks ranging between 0.5 and 1.4 percent of GDP.
  - Liquidity shortfall based on Basel III NSFR: €25.4 billion.
  - Cash-flow maturity analysis: the banking system would not have enough buffers to counterbalance net outflows at one maturity bucket (16 to 30 days).
  - Policy implication: authorities should ensure adequate liquidity cushions are maintained.
- Retail deposit withdrawal shock
  - Increasing withdrawal rates of stable retail deposits from 5 percent to 20 percent and of less stable retail deposits from 10 percent to 30 percent (relative to standard LCR) yields a total liquidity shortfall of €17 billion (8 percent of GDP).
  - Reverse liquidity stress test: withdrawal rates of retail deposits alone would need to be very high (30 to 40 percent) to cause system-wide LCR to fall below 100 percent.

### Household stress tests
- Micro-level household stress test findings:
  - Current implied households’ PDs estimated at 3.9 percent using micro data.
  - A combined drop in incomes and shock to real estate prices increases implied households’ PDs to 13.6 percent (multiplier of 3.5).
  - Households are particularly vulnerable to a drop in incomes.

### Contagion analysis — cross-border credit and funding linkages
- Cross-border credit risk
  - A sizeable portion of cross-border claims would need to be impaired for banks to become undercapitalized.
  - Minimum Tier 1 requirements (including capital conservation buffer) of the most exposed banks would fall below the hurdle rate of 8.5 percent if about 40 percent of payments from one country were not met.
  - Scenario affects subsidiaries of foreign-owned banks more than domestically-owned banks.
  - Some of the largest banks in Finland share some of the largest single cross-border borrowers, raising systemic risk if credit quality of these entities deteriorates.
- Cross-border funding reversal risks
  - A 34 percent reduction of cross-border funding from one country would deplete one bank’s liquid assets, potentially leading to asset fire sales and solvency problems via the liquidity-solvency nexus.
- Market data evidence
  - Variance decomposition of weekly changes of equity prices indicates Sweden and Finland share the strongest linkages among the Nordics.
  - Strong intra-regional connections arise from regional banking activity, extensive use of wholesale funding, and large cross-holdings of covered bonds by banks, insurers, and pension funds.

### Non-banks (financial conglomerates and insurers)
- Direct contagion risk from non-bank to banking sector appears limited.
- Reputational risk is the greatest concern.
- Financial conglomerates generally have well-capitalized insurance operations.
- Linkages to banks through bond and cash holdings and net counterparty exposures are modest.
- Insurers rely on banks for distribution of products and would be adversely affected if a bank suffered distress.

*Source: IMF staff calculations and Finnish authorities as presented in the chapter.*

### 27.      Facing demographic and economic pressures, pension insurers have increased the

### _cr16370 - 27.      Facing demographic and economic pressures, pension insurers have increased the

### Pension insurers and employment based pension funds
- The majority of compulsory and voluntary occupational pension schemes in Finland are financed by group insurance contracts.
- Employer based pension schemes have faced falling contributions and investment income and rising pensions (Figure 17).
- Investment managers have increased the risk profile of investments to generate higher long term returns, supported by the introduction of a complex equalization methodology that dilutes the impact of the market-risk based solvency requirement governing portfolio risk.
- A recent FIN-FSA test showed that the main pension insurers would breach their risk-based solvency margins under a severe shock scenario on account of equity losses.
- Recommendation: The authorities should monitor closely the riskiness of pension fund portfolios and their sensitivity to key assumptions through stress.

### Life insurers
- The prolonged period of low interest rates has hurt life insurers.
- Products without guaranteed returns have increased, but guaranteed-return products still comprise 37 percent of sectoral technical provisions.
- The average required yield to meet capital guaranteed commitments is 2.3 percent, which is well above yields on the safest bonds.
- Continued declines in the risk free rates used as discount factors to calculate technical provisions are depressing insurers’ own funds for supervisory oversight purposes (Figure 18).
- Six life insurers have been granted transitional solvency terms to meet Solvency II capital requirements (SCR), which became effective in early 2016.
- Recommendation: The vulnerability of life insurers with significant exposures to high guaranteed return products should be regularly tested with plausible shocks.

### Banking supervision — regulatory and supervisory framework
- Finland has reinforced its regulatory and supervisory framework, including in the context of the transition to the Single Supervisory Mechanism (SSM).
- Participation in the Banking Union allows Finland to apply best international supervisory practices across Europe.
- FIN-FSA’s resources should be increased: the lack of a sufficient number of skilled and experienced staff constrains the FIN-FSA’s ability to accommodate the more intense, intrusive and resource-intensive supervisory approach of the SSM on significant institutions (SIs), to reinforce supervisory intensity of less significant institutions (LSIs), and to meet increasing demands on macroprudential policy analysis, contingency planning and crisis management.
- The enforcement and sanctioning framework has been reinforced, with expanded powers in national legislation, including through the transposition of CRDIV. The SSM framework assigns powers either to the ECB or National Competent Authorities (NCAs); this arrangement has not been tested in Finland.
- The SSM Supervisory Review and Evaluation Process (SREP) is well structured, though powers granted by Finnish legislation to the FIN-FSA do not appear aligned with those required by the CRD, limiting FIN-FSA’s ability to impose supervisory measures (e.g., for deficiencies in internal governance or to require adjustment of provisions for prudential purposes).

### Banking supervision — model risk, liquidity and funding
- Supervisors need to be vigilant regarding possible overestimation of capital levels and underestimation of risk-weighted assets; recent on-site inspections revealed banks struggle to classify loans under EBA definitions of ’non-performing’ and ‘forborne’ exposures.
- Upcoming SSM review of internal models can help reintroduce adequate conservatism in banks’ IRB models and should be accompanied by ongoing monitoring of models. Risk weights for mortgage exposures applied by Finnish banks using IRB models are, on average, the lowest in Europe.
- The proposed floor on risk weights of mortgage exposures is to become effective by July 2017.
- The planned Targeted Review of Internal Models (TRIM) by the SSM should address aggressive use of banks’ IRB models and ensure comparability across the SSM. Internal models for market and counterparty risk on derivative exposures also need review and monitoring.
- The regulatory and supervisory framework for liquidity and funding risk has improved since the last FSAP, but vulnerabilities persist: supervisory actions mitigated wholesale funding vulnerabilities (e.g., improved maturity structure), yet large cross-holdings of covered bonds among Nordic banks—favored as EU-eligible High Quality Liquid Asset buffers for the LCR—could be a source of contagion if regional house prices correct drastically.
- Recommendation: Coordinate regional analysis and, if needed, action by relevant supervisors (e.g., through supervisory colleges) to address systemic risks from bond cross-holdings.

### Branchification (Nordea)
- Once Nordea converts its Finnish banking subsidiary into a branch, Finnish authorities and the ECB would not have direct supervisory authority over a systemic institution; prudential supervision of the branch’s operations, along with liquidity support and resolution, would shift to Sweden (planned for early 2017).
- As host supervisors, Finnish authorities and the ECB would continue to have access to information from the home supervisor and the branch. FIN-FSA will participate in the College of Supervisors and Resolution College because Nordea’s branch would likely be designated as ‘significant’ (over 2 percent of deposits in Finland) and Nordea expects to establish a Finnish mortgage subsidiary.
- The FIN-FSA’s powers to supervise Nordea’s banking operations in Finland are reduced under CRD IV once the subsidiary is converted to a branch. Finnish authorities would need to rely on the capacity and willingness of Swedish authorities to identify and address problems in the parent and its branches in a manner that would not adversely affect Finnish financial stability.

- Measures to mitigate concerns from Nordea’s branchification (could mitigate but not eliminate):
  - An updated multilateral supervisory MoU (under negotiation) with Sweden, the ECB and other Nordic supervisors to enhance monitoring and identification of vulnerabilities of Nordea, including full access to supervisory information and participation in and initiation of on-site inspections in close cooperation with the home supervisor; using Finland’s role in the College of Supervisors to promote a conservative and intensive ex ante approach to supervision and regulation; and provision for Swedish authorities to use existing supervisory resources in Finland, Denmark, Norway, and the ECB to inspect and monitor Nordea.
  - Use of cooperative agreements among the Nordic central banks and the ECB to provide liquidity support to Nordea in the event of a crisis.
  - An alternative resolution strategy by Finland in case the Swedish resolution plan cannot be executed.
  - Over the longer term, consideration of how the CRD could be amended to provide host supervisors of systemically important branches with adequate authority in close collaboration with the home supervisor.

- Box 1 (Implications of Nordea’s change in legal structure) — key points:
  - Nordea Bank Finland (NBF) will remain systemically important even if converted to a branch; NBF is designated as a Significant Institution by the ECB and its parent is one of the 30 G-SIBs by the Financial Stability Board.
  - Three major implications:
    - Adequacy of supervisory resources: shift increases demand on Swedish FSA resources and lowers FIN-FSA fee income; transferring in-depth supervisory knowledge to Swedish FSA will be challenging.
    - Depositor protection: protection of Finnish customers shifts from Finland’s DGS to Sweden’s DGS; effectiveness can only be judged when tested.
    - Bank Resolution: responsibility for resolution would rest with Swedish authorities.

### Non-Bank Supervision
- Legal infrastructure for insurers and pension funds aligns with EU Directives, but employment based pension funds were granted a derogation and are governed under Finnish law; this law is still incomplete—regulatory ladders and resolution procedures for distressed pension funds are not clearly spelled out and have had to be managed on an ad hoc basis.
- Priority: rectify this statutory weakness.
- FIN-FSA has a best practice insurance supervisory model but resources should be strengthened in line with increased international requirements. Solvency II introduction in early 2016 has put considerable pressure on insurance supervision, requiring supplementary group and financial conglomerate supervision.
- In practice, significant responsibility for implementation has rested with insurers’ appointed actuaries and risk managers; resources need to be increased to handle more than one pension insurer requiring enhanced supervision at a time. FIN-FSA’s board and senior management would benefit from additional insurance expertise.
- Enhancements to fund management supervision are needed, supported by sufficient resources:
  - Apply differentiated review processes for various investment fund types based on investor protection and financial stability grounds.
  - Emphasize firms’ own governance, controls and risk management through FIN-FSA supervision.
  - Build closer Nordic cooperation to conduct joint supervision where appropriate and raise issues at ESMA to enhance EU level convergence.
- Oversight should focus on significant long term social insurance liabilities:
  - Periodically estimate the present value of deferred liabilities.
  - Consider an actuarial peer review system focusing on non-life long tail statutory technical provisions.
  - Bringing external auditors into the Solvency II process (through their internal actuarial staffs) would align with the EIOPA guideline.
- FIN-FSA should monitor fund managers’ risk management processes and enhance its ability to use reported data to analyze risks and supervise cross-market and cross-border trading.
  - At end-February 2016, 28 percent of funds were invested in Finland and 57 percent in the euro area.
  - Funds sold in Finland tend to be unleveraged, without active derivative trading.
  - Major fund managers have appropriate risk management processes; some smaller ones have riskier structures.
  - Resources at the FIN-FSA should be sufficient to assess all fund managers’ risk management processes.
  - FIN-FSA should leverage existing investment fund data and systematically compile other supervisory data to support risk analysis and supervisory targeting.
  - Less than 40 percent of trading in Finnish issuers’ shares takes place in Finnish trading platforms; to effectively supervise trading in the fragmented environment FIN-FSA should acquire an automated market surveillance system.

### Macroprudential Policy Framework
- The macroprudential mandate is shared between Finnish authorities and the ECB; a domestic framework formalized in 2014 designated the FIN-FSA as authority to implement a set of macroprudential instruments and established a coordination mechanism among domestic authorities, including the BoF and the MoF.
- With the start of the SSM in 2014, the ECB was designated as a macroprudential authority for the euro area, with the ESRB continuing an advisory role. The BoF and FIN-FSA regularly discuss financial stability risks with Nordic and Baltic counterparts in the Nordic Macroprudential Forum.
- At the national level, the new institutional arrangement appears to work well with high de facto interagency collaboration:
  - The BoF and the FIN-FSA jointly conduct systemic risk monitoring, prepare vulnerability analyses and preliminary recommendations; FIN-FSA Director General makes proposals to the Board on macroprudential tool implementation.
  - Since the Act on Credit Institutions in 2014, the Board designated four banks as systemically important and subjected them to additional capital requirements from January 2016.
  - A loan-to-collateral cap for housing loans became effective as of mid-2016.
  - Other instruments, including the counter-cyclical capital buffer, have not been activated given inconclusive evidence on heightened systemic risks.
  - The planned introduction of a floor on risk weights for housing loans recognizes heightened vulnerabilities.
- Improvements to consider:
  - Institutional arrangement: Clarify a broader macroprudential policy mandate in law to strengthen accountability and willingness/ability to act; expand FIN-FSA human resources for macroprudential policy; consider formalizing (i) chairmanship of BoF representative in decision making meetings, and (ii) staff-level cooperation framework among FIN-FSA, BoF and MoF.
  - Data: Create a loan registry system to fill a data gap related to household indebtedness at a disaggregated level to better target systemic risks and calibrate tools.
  - Toolkit: Broaden tools available; add the systemic risk buffer to the toolkit (activation and level may need further analysis); consider tools based on terms of loans (e.g., maximum maturity limit) and borrowers’ eligibility (e.g., caps on loan-to-income or debt-service-to-income ratios) and complementary use, given potential cross-border leakages for capital-based tools and household sector risks.
  - Regional cooperation: Further strengthen regional cross-border cooperation arrangements, especially supervisory information sharing and joint stress-testing given high Nordic interconnectedness and reduced host supervisor influence on regional bank branches’ operations.

### Anti-Money Laundering/Countering the Financing of Terrorism (AML/CFT)
- Finland has made good progress strengthening its AML/CFT framework and is taking steps to implement the 2012 standard.
- Most main deficiencies identified in Finland’s 2007 mutual evaluation report have been addressed: strengthened the money laundering (ML) offense (including criminalizing some instances of self-laundering), terrorist financing (TF) offense, and AML/CFT controls.
- Minor deficiencies remain. Authorities are taking steps to implement the FATF 2012 standard and the Fourth EU AML Directive. Draft changes include:
  - Setting up a register of owners and beneficial owners of Finnish legal entities.
  - Implementing a greater risk-based approach.
  - Strengthening supervision and sanctions for non-compliance with AML/CFT requirements.
- Finland recently conducted its first ML/TF national risk assessment in consultation with different agencies and the private sector; it highlights key ML/TF risks arising from, among others, the transportation of cash and front companies.
- The authorities intend to conduct an update in 2017, ahead of Finland’s 2018 AML/CFT assessment.

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

### 47.      Legislative reforms should take into account the current standard and Finland’s main

### _cr16370 - 47.      Legislative reforms should take into account the current standard and Finland’s main

### Anti–Money Laundering/Countering the Financing of Terrorism (AML/CFT) — Legislative reforms and supervisory scope
- Authorities should ensure that adequate, accurate and up-to-date information on beneficial ownership and control of Finnish legal entities is available to the competent authorities in a timely fashion.
- Ensure effective AML/CFT controls are in place to mitigate the risk emanating from cross-border remittances.
- Encourage alignment so that the ML and TF offenses and the mechanism to freeze terrorist assets are fully in line with the standard.
- Ensure that all reporting entities, including lawyers, are subject to effective AML/CFT supervision.
- Reference: The Finnish report (and its summary in English on page 7) was published in October 2015 and can be found at: http://www.polamk.fi/en/rdi/projects/archives/national_risk_assessment_of_money_laundering_and_terrorist_financing

### Contingency Planning and Crisis Management (CPCM) — recent changes and strengths
- Establishment of the Banking Union introduced:
  - SSM and the Single Resolution Mechanism (SRM).
  - Direct ECB supervision over systemic banks.
  - Requirement that systemic banks be subject to recovery and resolution planning.
- Complemented by previously introduced EU-wide systemic risk monitoring through the ESRB.
- Finland has introduced new legislation and established a national resolution authority (the FFSA), and revised its deposit insurance system.
- Framework strengths:
  - Track record of good cooperation between financial oversight agencies could facilitate coordination in crisis.
  - Functional separation between supervision, resolution, and emergency liquidity support aids crisis preparedness.
  - Strong tradition of testing system-wide operational risks, including a recent test.

### CPCM — Gaps, resource needs, and recommended actions
- The CPCM framework is untested; actions needed to ensure operational capacity to rapidly deploy recovery and resolution tools:
  - Additional resources are needed because of extensive consultations at EU levels, at a time when the Finnish financial oversight agencies have been undergoing rationalization of their resources.
  - With fee revenues of the supervisory and resolution authorities expected to decrease substantially, the authorities should ensure adequate and sustainable financial and human resources for all financial oversight agencies.
  - Strengthen the legal and operational framework for legal protection of officials, staff, and agents of the agencies.
  - Bolster the central bank’s balance sheet with indemnification arrangements against potential exposures due to emergency liquidity assistance during crises and under strategies for liquidity support in resolution.
  - The MOF is responsible for strategic guidance on financial policies and considers itself responsible for overall stability. However, responsibility to actively oversee national crisis preparedness and management, including communication planning and regular financial crisis simulation exercises, has not been clearly assigned at the national level.
    - Possible approach: assign this role to an expanded mandate for the existing FFSA Advisory Council, where member agencies cooperate in responding to financial crises while each agency continues to exercise its individual powers.

### Cross-border arrangements — clarification and regional cooperation
- SRM complexity:
  - With the SRM involving a host of national and European officials, it could delay European-level decision making.
  - Responsibility—and possible role for the ECB and the Single Resolution Board—to actively oversee collective crisis preparedness and management at the level of the Banking Union should be defined.
- Nordic cooperation:
  - Close CPCM cooperation among Nordic countries is desirable given significant linkages.
  - A revamped Nordic-Baltic Stability Group (NBSG) could be a useful platform; supported by MoUs between Finnish agencies and their Nordic-Baltic counterparts on pertinent issues within their respective mandates, the NBSG could oversee cross-border crisis preparedness and management, and organize regular cross-border CSEs.
- Liquidity support in resolution:
  - Legal and operational clarification is needed to ensure effective application of temporary liquidity support in resolution.
  - In the medium term, Finland would benefit when Banking Union is completed, including a common SRM-wide deposit insurance scheme and permanent, common bank-stop funding arrangements for the EU Single Resolution Fund.

### Appendix I — Risk Assessment Matrix (selected entries)
- I. Sharp rise in risk premia with flight to safety and protracted uncertainty associated with negotiating post-Brexit arrangements
  - Overall Level of Concern: Medium
  - Relative Likelihood: Medium
  - Expected Impact: Medium
  - Notes: Finland could be affected by reemerging sovereign and financial sector stress in the Euro area; direct impact of the UK departure from the EU on Finland is expected to be limited.
- II. Structurally weak growth in key advanced and emerging economies
  - Overall Level of Concern: High
  - Relative Likelihood: High
  - Expected Impact: High
  - Notes: Finland’s exports tightly linked to Euro area markets; weak external demand could push Finland into stagnation.
- III. Heightened risk of fragmentation/security dislocation in part of the Middle East, Africa, and Europe, leading to a sharp rise in migrant flows
  - Overall Level of Concern: Medium
  - Relative Likelihood: Low
  - Expected Impact: Medium
  - Notes: Russia is Finland’s fifth largest export market; downturn in Russia could shave as much as a couple tenths of a percent of GDP growth.
- IV. Adverse macroeconomic and house price shock in an interconnected neighboring Nordic country
  - Overall Level of Concern: Medium
  - Relative Likelihood: Medium
  - Expected Impact: Medium
  - Notes: The two largest banks in Finland are Swedish and Danish.
- V. Persistently lower energy prices, triggered by supply factors reversing more gradually than expected
  - Overall Level of Concern: Low
  - Relative Likelihood: Low
  - Expected Impact: Medium
  - Notes: Lower oil prices could reduce inflation and inflation expectations; conversely, oil supply disruptions could dent purchasing power and firms’ profitability.

### Appendix II — Banking Sector Stress Testing Matrix (STeM) — Solvency, Liquidity, and Contagion frameworks (highlights)
- Banking Sector: Solvency Risk
  - Institutional perimeter:
    - Institutions included: 4 banks
    - Market share: 93 percent of MFI’s assets
    - Data and baseline date: Publically-available and set of supervisory data; Baseline date: end- December 2015
  - Methodology:
    - Satellite models developed by the FSAP team; balance sheet-based approach; market data-based approaches.
    - Models for credit losses, pre-impairment income, credit growth; integration of solvency-funding interactions; methodology to calculate sovereign risk and losses from bonds and money market instruments.
    - No accrued income on NPL loans.
  - Stress test horizon: 3 years (2016/2018)
  - Scenario analysis:
    - Finland-specific adverse scenario: GDP growth rate declines to -5.0, -3.1 and +0.2 percent, in 2016, 2017 and 2018 respectively.
    - Market shocks calibrated to magnitudes close to those observed in 2008/2009.
  - Output presentation: System-wide capital shortfall; Number of banks and percentage of banking assets in the system that fall below certain ratios.
- Banking Sector: Liquidity Risk
  - Institutional perimeter:
    - Institutions included: 4 largest banks in the system
    - Market share: 93 percent of MFI’s assets
    - Latest data: December 2015; Source: supervisory data
  - Methodology:
    - Basel III-LCR and NSFR type proxies, based on European Commission Delegated Act.
    - Cash-flow based liquidity stress test using maturity buckets by banks; Reverse liquidity test by banks.
  - Risks and buffers:
    - Risks: Funding liquidity (liquidity outflows); Market liquidity (price shocks).
    - Buffers: Counterbalancing capacity; Central bank facilities.
  - Tail shocks:
    - Run-off rates calculated following historical events and LCR/NSFR rates; Bank run and dry up of wholesale funding markets, taking into account haircuts to liquid assets.
  - Output presentation: Liquidity gap by bank, and aggregated; Survival period in days by bank, number of banks that can still meet their obligations.
- Banking Sector: Contagion Risk
  - Institutional perimeter:
    - Institutions included: 4 banks; Bank, insurance company and real estate investment trust sectors stock indices
    - Market share: 93 percent of MFI’s assets
    - Latest data: December 2015; Source: supervisory and market data
  - Methodology:
    - Network interbank model by Espinosa-Vega and Solé (2010); Diebold-Yilmaz variance decomposition connectedness methodology; Data-driven correlation networks.
  - Tail shocks:
    - Pure contagion: default of institutions; Spillover index and transmission.
  - Output presentation: Number of undercapitalized and failed institutions, and their shares of assets in the system; Evolution and direction of spillovers within the network.

### Appendix III — Status of the Recommendations of the 2010 FSAP (selected entries and implementation status)
- Monitor bank mortgage pricing practices and household debt service capacity closely. Increase efforts to compile information on banks’ mortgage portfolio, including loan-to-value (LTV) ratios. Frequency: annually
  - Status: Implemented. Loan-to-value ratios have been monitored through two cross-sectional surveys in 2010 and 2012. Under legislation which came into force on July 1, 2016, banks have to report LTVs of new housing loans to the FIN-FSA on a quarterly basis.
- Enhance the top-down stress testing framework by (i) modeling macrofinancial linkages on a bank-by-bank basis; (ii) further integrating bank and sectoral data; (iii) incorporating financial conglomerate dimension; and (iv) improving the synergies between the Bank of Finland’s (BoF) Research and Financial Stability Divisions and the FIN-FSA. Exercise can be conducted quarterly.
  - Status: Implemented. Macrofinancial modeling linkages, annual top-down stress testing exercises, and close cooperation between the FIN-FSA and the BoF. Under way: improvement of existing models including liquidity stress tests. Since the establishment of the SSM in 2014, the ECB TD models, which include macrofinancial linkages, have played a bigger role in euro area banking sectors’ stability oversight.
- Make available quarterly core financial soundness indicators using the data dissemination system already in place.
  - Status: Implemented. Information regarding capital adequacy, profitability, and credit risks are published by the FIN-FSA on a quarterly basis. The BoF publishes financial risk indicators (macroprudential report annex).
- Set up a bank-specific resolution regime to enhance cost-effectiveness and speed of bank resolution.
  - Status: Ongoing. A bank-specific resolution regime has been set up along with the implementation of BRRD and bank-specific resolution plans are being developed. The Act on Resolution of Credit Institutions and Investment Firms has been in effect from January 1, 2015.
- Use Core Principles for Effective Deposit Insurance Systems to evaluate and assure operational resources of the Deposit Insurance Scheme commensurate with needs.
  - Status: Largely implemented on governance, protection of depositors, funding, coverage, and cooperation with other safety net participants, including central banks and supervisors. The Deposit Guarantee Scheme complies with EU regulations, though a specific evaluation of the new scheme has not been performed yet. The DGS is administered by the Finnish Financial Stability Authority, which began operations in2015.
- Improve FIN-FSA’s supervisory powers to impose administrative fines and/or penalty payments beyond the current securities markets related scope; increase the maximum amount of such fines and penalties.
  - Status: Implemented. The new Act on Credit Institutions, including new sanctioning powers, entered into force in August 14, 2014. This CRD IV implementation enhanced sanctioning powers to a great extent.
- Increase the effectiveness of cross-border supervision, including information sharing with home supervisors with respect to the activity of foreign branches.
  - Status: Largely implemented: Nordic/Baltic countries MoU (08/2010) on exchange of information, enhanced cooperation framework, and management and resolution of cross-border systemic crises. On the supervision of a non-Euro area banks with significant branches in Finland, the cross-border cooperation and the exchange of information can still be improved. The SSM also enhances cross-border supervision.
- Increase the focus on liquidity risk, using the forthcoming liquidity standard of FIN-FSA as a catalyst for detailed analysis of supervised institutions’ funding profiles.
  - Status: Implemented: The new CRD 4 & CRR regulatory framework including the LCR (Liquidity Coverage Ratio) is now in force improving supervisory powers. Focus on liquidity and funding has been steadily increasing over the years.
- Further integrate procedures and practices of banking and insurance supervision, with a view to enhancing FIN-FSA’s analysis of the (consolidated) risk profile of complex financial groups active in Finland.
  - Status: Mostly implemented: Procedures and practices in supervision are integrated as much as it is possible taking into account certain differences of banking and insurance industries.

*Source: IMF country report content provided in the supplied PDF excerpt.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16370.pdf_