The Financial Crisis Commission

 

Press note, 25 January 2011

 

NOU 2011: 1 Better positioned against financial crises

Official Norwegian Report no. 2011: 1

The autumn of 2008 saw the outbreak of the most serious international financial crisis in our time. Never before have problems in the financial sector given so quick and severe fallout in the real economy. Norway is among the countries that, at least so far, have been the least affected by the financial crisis. This is probably due to a combination of luck, skill and caution. The impact could have been far more severe in absence of the comprehensive support measures provided by the Government. There were vulnerabilities in the Norwegian economy and in the financial system prior to the crisis, many of which still are of concern.

It is not possible to foresee the nature of the next financial crisis, how it will affect Norway, or whether it will originate domestically or abroad. The Norwegian financial system thus needs to be better positioned against financial crises in general. The Commission points to a range of measures and policy options that should be implemented or reviewed more closely. The recommendations can be grouped into five important policy areas:

• Long term economic policies
• The use of taxes and fees as policy instruments
• Strengthening financial regulation
• Introducing macro prudential policy
• Strengthening consumer protection

The Commission, which was broadly composed, largely achieved agreement regarding main assessments and suggestions. This gives Norwegian authorities a solid basis for further work.

Costly Lessons – the international financial crisis

The financial crisis initiated the strongest global recession since the Great Depression of the 1930s, with sharply rising unemployment and extensive welfare cuts in many countries. In the OECD area, the unemployment rate reached 8¼ per cent by the end of 2010. This means that the number of unemployed individuals was nearly 15 million in excess of average figures. We know that we can add to this a substantial number of individuals that has withdrawn from the work force due to resignation in efforts to find work. In 2009, GDP in the OECD area decreased by 3½ per cent, following an increase of just ¼ per cent in 2008.

The public finances have been greatly weakened in many countries as a result of the financial sector support measures, the decline in tax revenues, and the active use of fiscal policy to dampen the impact of the crisis. Many countries have trouble managing their sovereign debt, government budgets are being squeezed, and public welfare services are being cut dramatically. Never before have problems in the financial sector given so quick and severe fallout in the real economy or affected this many countries simultaneously.

Prior to the financial crisis, benign economic conditions, intense financial innovation and excessive optimism led to underestimation of risk, inflated asset prices and heavy debt accumulation in many countries. International financial institutions benefited from moving operations to less regulated types of institutions and markets. Many institutions took on high risk, sometimes without knowing it, through the purchase and sale of ever more complicated financial instruments. The international banking sector was weakly capitalized, and when the risk eventually materialized, the banking sector did not have sufficient capital to bear the losses. At this point, the increased financial complexity obscured where the risks really were located.

There were large differences across countries and continents in how the crisis evolved, for instance between the U.S. and countries that experienced more traditional banking crises that originated in the real estate market.

Luck, skill and caution – the crisis’ impact on Norway

Norway is among the countries that, at least so far, have been the least affected by the financial crisis. This is probably due to a combination of luck, skill and caution. The failure of international financial markets nevertheless led to acute funding challenges for Norwegian banks, and comprehensive regulatory measures were implemented. Without the extraordinary liquidity measures, the Norwegian banks could have run into serious trouble. The temporary collapse in international trade hit the Norwegian exporters hard. Weaker prospects for economic growth, higher lending rates and a tightening of bank lending standards, contributed to rapidly falling property prices and a weakening of household demand.

There are several factors that contributed to dampen the impact of this financial crisis in Norway. The fact that Norwegian manufacturing to a very small extent produces goods that were exposed to the greatest decline in demand internationally, and that the demand from the petroleum sector remained high, was particularly important. Moreover, Norway has a large public sector and a well-developed social safety net, which had a stabilizing effect on the economy during the crisis. Norwegian authorities had greater flexibility in economic policy than most others due to the solid financial situation of the Norwegian state. This flexibility contributed to strengthen the markets confidence in the Norwegian financial institutions, and also made the extensive support measures for the financial markets and the real economy possible.

The strong monetary and fiscal stimulus, and the government support measures to the financial sector, contributed efficiently to stabilize the development in Norway. The effect of interest rate cuts on demand was probably particular strong, due to the extensive use of floating interest rates on loans to the household sector. Moreover, the Norwegian regulation was somewhat stricter than in many other countries and stricter than what have been the minimum requirements in the EU. Examples of this include stricter requirements to the quality of regulatory capital, stricter requirements to securitization activities, and encompassing capital. This contributed to the Norwegian financial institutions being better capitalized at the outbreak of the crisis.

The experiences from the Norwegian banking crisis in the early 1990s have influenced greatly on the evolvement of financial regulation in Norway. The crisis demonstrated that the loss bearing capacity of bank capital (i.e. quality of regulative capital) was a vital factor for stability in the financial system. Furthermore, when resolving the crisis, the Norwegian authorities let the shareholders of the crisis-struck banks take losses, which may have caused banks’ risk taking to be less intense prior to the current crisis.

Challenges for Norway – the next crisis

Norway may face significant challenges in the future. For a small and open economy, changes in the international economic environment are of particular importance. There is still uncertainty about the effects of comprehensive international regulatory reform, and the financial imbalances that built up in advance of the crisis are still not corrected. The difficult sovereign debt situation in many countries makes the economic outlook highly uncertain, also for Norway.

The next financial crisis may come as a result of domestic imbalances, or as a result of global or regional shocks affecting the Norwegian economy. Efforts to ensure financial stability must take into account that the next financial crisis can be very different from the current. Several of the factors that worked to dampen the impact of the current crisis on the Norwegian economy may represent vulnerabilities in other scenarios. Widespread home ownership, heavy household sector debt burden and extensive use of floating interest rate loans in residential financing may combine to make the Norwegian economy particularly vulnerable to high interest rates and falling house prices.

Better positioned against financial crises – priorities

Although managing relatively well through the current crisis, Norway needs to be better positioned against future crises.

The Commission has put particular weight on discussing which lessons that should be drawn from the current crisis. Lessons can be drawn both from events abroad and home. The vulnerabilities that were revealed in Norwegian financial markets – such as short term bank financing – should be addressed immediately. However, it is also important to draw lessons from the international experiences from the crisis.

The Commission has articulated general national priorities, as well as formulating a range of specific measures that should be implemented in various policy areas. Taken together, these priorities and proposals could contribute to financial stability and to enhance the resilience of the Norwegian economy against future crises.

General priorities

Well-functioning financial markets are vital for both economic growth and financial stability. Interruptions in the functionality of the financial sector may give immediate adverse effects on the real economy. Internationally, the costs of the current crisis were significant, both in terms of public finances and general welfare losses. Thus attention is drawn to the issue of what role the financial sector should play in the future, and to which of its activities that are beneficial for society. The issue of prudent debt levels and sufficient risk bearing capacity for the financial sector and other sectors are of particular importance. More capital and less short term financing in the financial system, as well as sustainable debt levels in the economy as a whole, are crucial factors for resilience to financial instability.

It is the view of the Commission that a wide range of measures should be considered in order to ensure that the financial sector in Norway is robust and appropriate. Taxes and fees should supplement the toolbox of regulation and supervision. In addition to being used as policy instruments, new taxes and fees can address the current under-taxation of the financial sector.

Financial groups should be organized in a clear and transparent manner, such that problems in operative entities propagate in a straight line up to the group holding company, with minimal adverse effects on other operative entities in the group. Furthermore, the authorities should improve the conditions for effective competition in the financial sector, e.g. by ensuring that the number of competing players is sufficient, and that the products and services offered are transparent and easily comparable. The demand side in financial markets is complex and represents many different needs, which also should be reflected in the structure of the supply side.

Financial markets in the Nordic area are largely integrated and are in many ways a natural and appropriate common regulation area. If it is desirable to have rules that, within national discretions, are more stringent or otherwise go beyond the EU minimum requirements, it is the Commission’s view that this first and foremost should be achieved at the Nordic level, through the harmonization of the relevant policies in the Nordic countries. However, Norwegian authorities should still consider the various regulatory issues case by case, and on an independent basis. Norway should have an active attitude to whether national discretions within the EEA obligations should be used.

Branches of foreign banks may constitute important parts of financial markets in a host country, but the authorities in the host country do not readily have the legal mandate to set forth requirements to financial strength or to the quality of the supervision of the institution. This is due to the EU principles of home country regulation and the right to establish branches in the EU/ESA area. Furthermore, financial institutions expanding abroad through branches may also involve risk to the institution’s home state, and in particular if the expansion is rapid and involves high risk segments. In the Commission’s view Norwegian authorities should work to reform the entry law in the EU/EEA, so that the host country can require conversion of the branch of a foreign bank into a subsidiary (i.e. a legal entity under host regulation), and for a corresponding right for any country to require that their own banks organize their business abroad through subsidiaries rather than branches.

The Commission proposes a range of measures that may contribute to further improve financial market regulation in Norway, in light of international experiences from the financial crisis. Certain aspects of current regulation and supervision in Norway should be highlighted and developed further, e.g. current requirements to the organization of financial groups, and strict requirements to the quality of regulatory capital. In these areas requirements have been stricter in Norway than in many other countries.

Long term economic policies

The framework for monetary and fiscal policy in Norway gave a good basis for applying stabilizing policies during the financial crisis. The crisis has illustrated that fiscal autonomy and confidence in government finances must be built up in good times in order for a country to be well positioned against financial crisis and economic set-backs. Countries with resource revenues, such as Norway, should have particularly large financial buffers.

Historically, it appears that sharp falls in house prices particular often coincides with sharp economic downturns. In addition to monetary policy, authorities have three main policy channels which may influence the fluctuations in house prices: taxation, regulation of bank lending for housing, and regulation affecting the supply of land or otherwise the supply of housing.

There is broad agreement among economists that housing and real estate in general is insufficiently taxed in Norway, although it is unlikely to have played any significant role in the current financial crisis. However, in the Commission’s view, the current tax bias for housing investment clearly has undesirable aspects, including that households are probably more vulnerable to fluctuations in house prices. The Commission therefore recommends that the taxation of housing is brought more in line with the taxation of other assets. The Commission emphasizes that there is a need for stable and predictable tax rules for housing and that there may be significant challenges if major reforms are undertaken quickly.

Taxes and fees as policy instruments

Compared with regulation, taxes and fees have other properties. Taxes and fees may therefore be useful supplements to regulation when it comes to targeting specific issues in the financial market.

There are indeed some special features of the financial sector that could cause it to grow too quickly and become too large. Elements of information asymmetry between customers and financial institutions can increase sales and profits, and many financial institutions enjoy a so-called implicit government guarantee, which may reduce the institutions’ funding costs. The financial sector is also under-taxed compared to other sectors, as a result of the sale and dissemination of financial services generally being exempt from VAT.

Currently banks are charged with a fee in order to have membership in the Norwegian Banks’ Guaranty fund, whereby deposits are insured. It is the opinion of the Commission that the deposit guarantee charge should reflect the risk in each bank as best as possible, and that the charge should not be abolished when the size of the fund reaches certain thresholds. These are issues currently under review by the Norwegian Banking-law Commission.

In addition to the explicit deposit guarantee for which banks pay a fee, banks and other financial institutions may, to varying degrees, enjoy an implicit government guarantee because market participants expect that the government in certain situations will implement support measures. In the Commission’s view a stability fee should be imposed on Norwegian financial institutions based on the institutions’ liabilities except equity and guaranteed deposits, which reflects any expectations of creditors that their risk is reduced as a result of the likelihood of government intervention. Such a fee may act to correct a market failure, promote financial stability, and help to finance future government interventions. Systemically important financial institutions should be charged with a higher fee than other institutions.

Financial services are exempt from VAT. The reason for the exemption, which applies in Norway and in most other countries, is that it is difficult to determine an appropriate basis for the tax. In the Commission’s view it is unfortunate that the services produced in an entire sector are exempt from VAT. If the value added in financial institutions had been taxed in line with other sectors in the economy, this would have given substantial tax revenues and at the same time reduced distortions in consumption and industrial structures.

Introducing VAT on financial services in Norway would be difficult. The Commission therefore suggests that the Government consider whether alternative approaches, such as an activities tax levied on profits and wage payments, can be designed to give similar effects.

Strengthened financial regulation

The financial crisis did not trigger a solvency crisis in the Norwegian banks, but banks’ liquidity management was not sufficiently robust to face the unrest that occurred in the money and capital markets.

In Norway, the economy is growing and the institutions in the financial sector are sound. This is to some extent also the case in the other Nordic countries. It gives these countries greater freedom to consider what is the appropriate capital and liquidity requirement for financial institutions in light of the experience of the international financial crisis.

The Commission proposes that the Norwegian authorities work to strengthen the regulatory cooperation in the Nordic area, with the aim that Nordic authorities can agree on stricter capital requirements than the EU minima, and with surcharges for systemically important institutions. The Commission suggests that the new liquidity rules announced with the Basle III reform should be implemented earlier in Norway, than what is indicated by the EU enforcement plan.

Many interest rates in NOK are linked to NIBOR rates. In the Commission’s view there should be greater transparency and clearer rules about the determination of NIBOR rates.

Despite the fact that the Norwegian government has limited need of borrowing, it is important to maintain a government securities market, e.g. to facilitate the demand for risk free investments. The Commission proposes that the government considers the consequences of the limited market for government bonds in general, and also in light of upcoming legislation for banks and insurance companies.

The financial crisis has not identified a need to change the Norwegian regulation of insurance companies and pension funds with regard to financial stability considerations. However, the crisis may have long-term effects on the life insurance sector, primarily in that nominal interest rates can remain low internationally for some time. Considering the large holdings of paid-up policies, the right for customers to move their policies, and annual interest rate guarantees, the situation may become more demanding in Norway than in many other countries. The Commission therefore proposes that further investigations are initiated in order to address these particular challenges.

By the year end of 2009, defined contribution pension plans included nearly 940000 employees in Norway. This number is likely to increase in the coming years. In this type of arrangement market risk is borne by the employee (the insured). The Commission proposes that the Government set the stage for alternative products that allow combinations of properties from both defined contribution plans and defined benefit plans.

Introducing macro prudential regulation

Vulnerabilities may build up in the financial system as a whole, even if each financial institution in the system appears to be solid. Financial stability cannot be handled only by the supervision and regulation of each financial institution or the individual financial market. It is also necessary to monitor the financial system as a whole and take action if there is a risk of interference to vital financial services. This can be described as macro prudential supervision, or macro prudential regulation, of the financial sector.

Increased efforts to monitor systemic risk in the financial sector and facilitate new means of limiting systemic risk, such as macro dependent regulative measures, are recommended by the Commission. For example, counter-cyclical capital requirements may successfully improve banks’ capital adequacy over the cycle, and may serve to slow excessive credit growth. Restrictions on banks credit granting, e.g. in the form of “loan-to-value”-requirements, or restrictions on interest-only loans, are other potential measures.

The Commission recommends Norwegian authorities to put emphasis on macro prudential regulation and supervision, and that a clear division of roles and responsibilities between the different national authorities is established. The Commission proposes that Norges Bank is provided a clearer formal responsibility to periodically provide accurate advice on the use of discretionary measures in macro regulation of the financial system.

Strengthened consumer protection

Many of the choices consumers need to make in financial markets differ substantially from the choices in other areas of life. Choices regarding pension savings, loans for house purchases and securities investments may involve substantial risk to the individual, and there is little room for learning by “trial and error.” It is therefore important that the information provided to consumers by financial institutions is tailored to fit with the financial literacy of the recipient, and that it is standardized and comparable across different institutions.

It is the Commission’s view that it may be desirable to introduce new rules that can make it easier for consumers to make good investment decisions, for example in the form of specific requirements for the use of the term “savings product” and alike. It may also be warranted to require sales personnel and financial advisors to always inform about the benefit of a simple alternative, such as bank deposits or loan repayments.

The Commission also proposes that

• a standardized information sheet is required with the sale all savings and investment products,
• there is a continuation of the right to set-offs when loans are transferred from a bank to a mortgage company,
• the authorization of the FSA to impose pecuniary sanctions are extended and
• that the FSA is given a clear and statutory responsibility to safeguard consumer interests in financial markets

An increasing number of Norwegian workers have occupational pension schemes with investment choices, typically differentiated with respect to risk. The default risk profile, i.e., the risk profile that is made applicable to the individual if no active choice is made, is therefore of particular importance for how the defined contribution assets are managed, and for how much risk that is borne by the individual. In the Commission’s view, the issue of how to ensure that employees and retirees receive an appropriate market risk exposure should be investigated more closely. It is particularly important that the risk is reduced as the employee approaches retirement age.

Crisis resolution schemes

The Norwegian crisis management system was not seriously tested during this financial crisis. However, in accordance with the international experience, there is a need for better systems for crisis resolution, including uninterrupted access to banking services when banks are in trouble. Furthermore, it cannot be assumed that the measures that worked well during this crisis will be effective and appropriate when the next crisis erupts.

It is important that the government has contingency plans and exercise flexibility in the face of a new crisis in the financial system. Governments should be prepared to intervene early with appropriate measures, tailored to the current situation in the markets and the economy

The system for crisis resolution in individual institutions is something that can, and should, be established long before any crisis. An appropriate system can reduce the risk of financial instability, and also increase the quality and progress of the decision process during a crisis. In the Commission’s view certain elements of the Norwegian crisis solution scheme should be reviewed more closely. These include:

• requiring all banks to set up plans of how the bank, in the case of insolvency, can be wound up without extensive public costs and with minimum risks for contagion,
• explore the possibilities to split up, alternatively establish a bridge bank, to facilitate the continuation of vital services provided by a problem-struck bank in a situation where shareholders and creditors take substantial losses and
• the possibility of forced conversion of debt to equity when capital adequacy falls below certain thresholds.

If the risk of moral hazard is to be contained, it is of vital importance that winding up problem-struck financial institutions is a credible policy option. Those who have contributed to the risk taking of failing institutions – shareholders and creditors – has to take their part of the losses, also when the institution can be continued, in some form.

The Commission proposes that new crisis resolution tools are delegated to a permanent government body.

The Commission’s report – a basis for future work

The Commission, which was broadly composed, largely achieved agreement regarding main assessments and suggestions. This gives Norwegian authorities a solid basis for further work to promote financial stability, and to ensure that Norway is well positioned against future financial crises.

It is not possible to foresee the nature of the next financial crisis, how it will affect Norway, or whether it will originate domestically or abroad. The Norwegian financial system thus needs to be better positioned against financial crises in general. The Commission’s recommendations covers i.a. sustainable economic policies, taxes and fees as policy instruments, strengthened regulation of financial markets, macro prudential regulation, and enhanced consumer protection.

See also:

• Press release from the Ministry of Finance
• Press release from the Commission
• English summary of the Commission’s report in Appendix 2 of NOU 2011:1