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New regulations on capital requirements

The Ministry of Finance today issued regulations on new capital adequacy requirements for Norwegian banks etc. "The regulations are designed to ensure that banks subject to Norwegian regulation and Norwegian supervision remain financially sound. When framing the regulations we also kept in mind the need for a competitive regulatory framework for Norwegian banks", says state secretary Bjørn Arild Gram (Centre Party).

General notes on the new capital requirement regulations
The legislation on new capital requirements that was adopted by the Storting (Parliament) in June 2006 lays down key principles for, and the structure of, the new capital adequacy requirements. Under the new rules financial institutions are free to select among three different approaches to calculating credit risk, and institutions will be allowed to use their own internal risk models to calculate capital charges.

The details of the various approaches are set out in the regulations now adopted. The new regulations apply to commercial banks, savings banks, finance companies, mortgage companies, holding companies in financial groups, investment firms and management companies for securities funds.

With the adoption of the new law and regulations, EEA-provisions corresponding to the new EU capital requirements (directives 2006/48/EC and 2006/49/EC) are hereby transposed into Norwegian law within the deadline of 1 January 2007. Since the directives are minimum directives, national authorities cannot establish rules that result in capital requirements less strict than those prescribed by the directives. The directives contain a number of options that allow for national discretions, and thought was given to exercising this leeway when framing the regulations. This involved weighing the interest of financial strength against the interest of Norwegian financial institutions' competitiveness.

"Strong competition is evident in the Norwegian banking market, and foreign banks are highly active, particularly in relation to home mortgage borrowers. With the choices we have now made, Norwegian financial institutions have a regulatory framework which in our view comes out well in an international comparison," says state secretary Gram.

The regulations comprise a detailed and wide-ranging body of rules with major implications for banks. The changes made entail a significant realignment of solvency regulation of Norwegian financial institutions and investment firms. Since the capital requirements now established are more risk sensitive, own funds in the banking sector can be put to more effective use. This means that financial soundness and stability can be safeguarded at somewhat lower overall capital levels in the banking industry.

“The regulations will result in a lower requirement on regulatory own funds in Norwegian financial institutions. The fall will be most marked in the case of financial institutions using the most advanced approaches to calculate capital charges. However, lower capital requirements are matched by stricter requirements on risk management. Emphasis has been given to supporting the competitiveness of banks that opt for simpler approaches. It is partly for that reason that we are continuing to limit home mortgages to 80 per cent of property valuation", says state secretary Bjørn Arild Gram.

Although the overall capital requirement is reduced, the regulations contain transitional arrangements which limit institutions that use advanced approaches in the initial years from freeing up this capital. How institutions actually choose to adapt their capital levels will also depend on the outcome of their processes for assessing capital needs and the evaluation of Kredittilsynet (the Financial Supervisory Authority of Norway). The complexity of the rules and new risk sensitive capital requirements widen Kredittilsynet’s responsibility for monitoring and supervising the individual financial institution. Kredittilsynet's power to impose capital requirements beyond those entailed by the regulations has been similarly widened.

"We note that a number of consultative bodies, including representatives of the financial industry, have urged that the power to establish such capital requirements should be exercised," says state secretary Gram.

The new capital requirement rules also reinforce financial institutions' duty to disclose information on their risk profile and capitalisation as well as management and control. This is important both because it makes for greater transparency and because it can bolster market discipline.

"Banks and financial institutions clearly need good capital ratios if they are to enjoy access to reasonable funding," says Gram.

Some key features:

• Retention of the current 8 per cent minimum capital adequacy requirement for institutions.
• Changes in the calculation of capital requirements for credit risk and market risk.
• Introduction of a specific capital requirement for operational risk.
• Institutions to be allowed to compute capital requirements for credit risk using the standardised approach or internal ratings-based (IRB) approaches.

• The following applies under the standardised approach:
  • Exposures collateralised by residential property are assigned a 35 per cent risk weighting.
  • The loan-to-value ratio for such exposures set at 80 per cent of fair property value.
  • No change in the risk weighting of exposures to local and regional authorities.
  • Surety requirement removed.
  • Retail exposures to be assigned a risk weighting of 75 per cent.
  • Collateral in the form of commercial real estate not to be taken into account.
  • Exposures classified as high-risk to be assigned a risk weighting of 150 per cent.
  • Kredittilsynet can approve the use of external ratings to determine an exposure's risk weight.

• The following applies under the IRB approach:
  • The IRB approach is based on three key parameters for computing credit risk.
  • The IRB approach distinguishes between a foundation and an advanced approach.
  • In the IRB foundation approach Loss Given Default (LGD) and the conversion factor are fixed by the supervisor, while the Probability of Default (PD) is estimated by the institution. In the case of the retail market, including home mortgage loans, the institution estimates all three parameters.
  • Under the advanced approaches all three parameters are estimated by the institution itself.
  • Permission must be sought from Kredittilsynet in order to utilise IRB approaches.

• Another innovation is the introduction of concrete rules for credit derivatives and securitisation.

Furthermore, IRB banks are now subject to a “transitional floor” that limits the reduction of their capital requirement upon the introduction of new rules.

Information from Kredittilsynet (the Financial Supervisory Authority of Norway)
Kredittilsynet briefed the press on the new capital requirements on 14 December.