2 English summary of the Commission’s report

2.1 Introduction

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. The full consequences of the financial crisis remain to be known. So far, the crisis has initiated the strongest global recession since the Great Depression of the 1930s, with sharply rising unemployment and extensive welfare cuts in many countries.

Historically, economic downturns which have coincided with a financial crisis have been deeper and led to a more protracted recession than others. This finding is related to the specific interactions between the real economy on the one hand, and a problem-stricken financial sector on the other. With increasing losses, banks’ ability to provide credit is weakened. Households and businesses may then be forced to postpone investment due to a lack of access to credit, and economic activity drops. Lower economic activity and increased unemployment may in turn cause borrowers to have trouble servicing their debt. This further increases bank losses, and, the negative spiral continues.

This financial crisis shares many common features with earlier crises. A prolonged period of high economic growth, innovation and optimism led to the 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

Although most countries implemented extensive measures to restore confidence in the financial system and sustain banks’ ability to lend, the financial crisis has had very serious consequences globally. Millions of people have been driven into unemployment. 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 experience trouble managing their sovereign debt, government budgets are squeezed, and public welfare services are being cut dramatically.

The owners and management of international financial institutions have had to bear a disproportionately small share of the costs of the financial crisis, despite being largely responsible for it. The costs have largely been absorbed by public finances, employees and other businesses.

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. A number of aspects of the Norwegian economy, the financial markets and financial market regulation helped to mitigate the effects of the crisis. In addition, strong monetary and fiscal stimulus, and effective support measures helped to stabilize the economy.

Also, when compared with the Norwegian banking crisis of the 1990s, the effects in Norway of the international financial crisis have been mild. While the Norwegian banking crisis in the 1990s had a domestic origin, resulting from excessive debt accumulation by households and firms, and subsequent solvency problems in banks, this financial crisis originated from the outside.

This financial crisis did not reveal significant inadequacies in the financial market regulation in Norway. In certain key areas, the Norwegian regulation was somewhat stricter than in many other countries and stricter than what have been the minimum requirements in the EU. This contributed to the Norwegian financial institutions being better capitalized at the outbreak of the crisis. In addition, financial regulation in Norway was designed to encompass all relevant financial sector entities, strongly limiting the possibility to exploit regulatory differences.

However, Norway may face significant challenges in the future. For a small, 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 financial crisis provides several lessons for Norway, including when it comes to regulatory challenges. A new financial crisis may arise as a result of domestic imbalances, or as a result of global or regional shocks hitting the Norwegian economy. Efforts to ensure financial stability must take into account that the next financial crisis can be very different from the current.

The Commission’s mandate states that the understanding of the workings of financial markets and regulation should be reconsidered in light of the current experiences. The Commission has given particular emphasis on what lessons should be drawn from the crisis – both from the events in Norway and internationally. The key question is how to best reduce the likelihood of, and mitigate the effects of, a future crisis in Norway. The Commission has formulated proposals for overall national priorities, as well as a number of specific measures. Taken together, these priorities and proposals could contribute to strengthen financial stability and to enhance the resilience of the Norwegian economy towards future crises.

Part I of the report deals with financial crises and financial markets in general, and the current crisis in particular. The main causes of the financial crisis as well as its costs are discussed in an international perspective.

Part II deals with the financial crisis’ impact and development in Norway. This analysis addresses whether there are particular features of the Norwegian economy, financial markets, or the financial market regulation, that may have contributed to curb, or reinforce, the impact of the crisis on Norway.

Part III deals with guidelines for regulatory changes and other measures, primarily in the form of a Norwegian regulatory tradition and regulatory obligations of the European Economic Area (EEA) Agreement. This section also gives an overview of the international regulatory initiatives that are being considered in the wake of the financial crisis, not least in the G20 and the EU.

Part IV contains the Commission’s assessments of which lessons that should be drawn from a Norwegian point of view, and how these should be followed up in the form of regulatory changes or the like. The Commission has placed particular emphasis on the regulation and supervision to safeguard the interests of consumers, financial strength of financial institutions and effective competition in the markets.

2.2 Impact of the financial crisis in Norway

2.2.1 Impact and effects

Norway is among the countries that have been the least affected by the financial crisis. However, the failure of the international financial markets during the autumn of 2008 gave acute challenges to Norwegian banks, and extensive government measures were implemented. The temporary collapse in world trade also hit 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 was a clear decline in GDP for mainland Norway from the third quarter 2008 to the first quarter 2009. The decline was widespread throughout the private sector, but particularly strong in manufacturing and construction. Lower private consumption, investments and exports of traditional commodities, contributed to lower activity. However, investment in the petroleum sector increased, and this helped to cushion the downturn in the Norwegian economy. The overall downturn in the Norwegian economy turned out to be rather moderate compared with other countries. Also the impact on unemployment was relatively modest in Norway.

The peak in the interest rate premiums in the United States spread quickly to the Norwegian money market. The difference between money market rates and official interest rates, which had already risen considerably after the problems in the US subprime marked were revealed, more than doubled in a few days in September 2008. In addition, the supply of US dollar liquidity was at times insufficient. On one occasion the kroner-dollar exchange rate failed to be determined, and the Norwegian money market interest rates could not be quoted.

Norwegian authorities conducted a series of measures to improve banks’ access to liquidity, both to help to maintain the banks’ lending activities and to prevent solvent banks from having payment problems. Among other measures, Norges Bank injected large amounts of liquidity into the banking system, the maturity of liquidity was extended, and collateral requirements for loans was temporarily eased. The government established an arrangement in which banks could obtain government securities in exchange of covered bonds. Banks that participated in the arrangement could obtain financing through the sale of the government securities directly or by borrowing in the market using the government securities as collateral. In addition the Government Finance Fund was created to put the Norwegian banks in a better position to maintain normal lending activities, by providing solvent banks with core capital.

From the second half of 2008, Norges Bank gradually reduced the interest rate to 1.25 pct. Fiscal policy was also powerfully shifted in an expansionary direction. In January 2009, the government presented a fiscal stimulus package of NOK 20 billion to mitigate the negative impact of the financial crisis in the Norwegian economy.

The strong monetary and fiscal stimulus, and the government support measures to the financial sector, contributed to stabilize the development in Norway. Lower interest rates quickly resulted in an improvement in the housing market and eventually increased demand from households. Gradually the activity in the Norwegian economy picked up again.

2.2.2 Some features of the Norwegian real economy

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, such as so-called consumer durables (e.g. automobiles, consumer electronics, etc.) were particularly important. The demand from the petroleum sector remained high, which was important for the Norwegian oil service sector. Moreover, Norway has a large public sector and a well-developed social safety net. Most likely this contributed substantially to stabilize the demand for goods and services.

Norwegian households have a high ratio of debt to income compared with households in other countries, partly because home ownership is widespread. Furthermore, Norwegian households primarily hold floating rate loans. High debt levels and extensive use of floating interest rates resulted in interest rate cuts having fast and powerful impact on household income, and thus their demand. The demand effects of the expansionary monetary policy were therefore probably greater in Norway than in many other countries.

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. Although the financial crisis caused a sharp decline in the value of the Government Pension Fund, and although tax revenues dropped significantly, there was never uncertainty about the government’s financial robustness.

2.2.3 Some features of the Norwegian financial sector

The international financial crisis primarily affected the Norwegian financial sector through the difficulties in funding markets. Without special liquidity measures by the authorities the banking sector could have run into serious problems. The deposit funding remained fairly stable during the crisis, possibly due to the Norwegian deposit guarantee scheme both being credible and having a sufficient coverage. Deposits are an important funding source for Norwegian banks and for the smaller banks in particular.

The financial crisis was not a solvency crisis for Norwegian financial institutions. Banks’ losses on securities were limited, and because the Norwegian economy fared relatively well through the crisis, loan losses have also been relatively modest. The Norwegian banks do not have extensive ownership in securities, and in particular they had a very low exposure to the securities that were the most impaired, such as US subprime papers. The insurance companies managed well through the crisis, but they had negative results in 2008 due to the sharp decline in value of securities.

Norwegian financial institutions are subject to a regulation that in some areas are stricter than what is common internationally, including strict quality requirements to regulatory capital, and strict regulation regarding securitization of loan portfolios. Good earnings in the years before the financial crisis contributed to the banks financial strength and resilience. Experiences from the Norwegian banking crisis in the 1990s may also have contributed to strengthen the resilience. It led to improved regulatory design and supervisory practice, and it may have caused banks’ risk taking to be less intense.

2.3 Considerations for new measures and regulatory changes

2.3.1 Bounds for Norwegian financial markets regulation

Financial institutions differ from other enterprises in several ways, and are therefore subject to a specific and comprehensive regulation. Until the mid-1980s, the regulatory regime in Norway, as in many other countries, was characterized by strict quantitative rules for the supply of credit. In the 1980s, financial markets were subject to extensive deregulation, where active government intervention was largely replaced by market mechanisms, which called for major regulatory changes. At this point, the principle of common rules for all types of financial institutions in key business areas was introduced, including identical rules for capital adequacy regulation.

For the past 20 years, regulatory developments in Norway have been characterized by implementation of an increasing number of EU / EEA rules in Norwegian law. However, in certain areas, the Norwegian rules have been stricter than the minimum requirements in EU, including requirements for the quality of banks’ equity.

The design of the Norwegian financial market regulation must take into account the obligations imposed by international agreements, including the EEA Agreement. The EEA Agreement in particular sets some limits for national discretion. Also, national authorities are required to implement certain rules of law, and to commit not to carry out provisions that violate them.

2.3.2 Measures and regulatory changes internationally

The financial crisis revealed the need to change the regulation of financial markets in important areas. The specific initiatives for reform are carried out in international forums, in recognition that global markets require a global approach, with a view to establishing a better and more consistent regulatory regime across countries and markets. For Norway, which has a small, open economy, the outcomes of these processes are of great importance.

G20 summits are central to this process, and in the last two years agreement has been reached on important issues such as tighter requirements for capital and liquidity for banks, new regulation of derivatives trading, hedge funds, credit ratings, improved international accounting standards, and rules for the remuneration of employees of financial institutions.

The EU is committed politically to follow up the G20 recommendations, and aims to lead in both the development and implementation of the new regulations. The European Union has, as a supranational authority, implemented a number of independent and self-initiated processes. Particularly important are the changes in the EU capital requirements directive, which includes capital and liquidity requirements for banks. The first rounds of changes have already entered into force in EU / EEA. The largest changes will probably come in the next round of changes – based on the so-called Basel III reforms, which are scheduled to be implemented in Europe between 2013 and 2019.

Furthermore, the EU has proposed and implemented measures and regulatory changes in a number of other areas, including deposit guarantees, winding up schemes for banks, consumer protection, securities trading, hedge funds, credit rating agencies, European supervisory structure etc.

Most countries have in parallel with, and to some extent independent of the EU, initiated their own processes to address the lessons learned from the financial crisis. For instance Sweden, Germany and Britain, have implemented stability taxes aimed at banks. Britain is also among the countries that after the crisis is likely to change the organization of supervisory authorities in the financial sector. The US has adopted a comprehensive reform of the financial market regulation and supervision structure. The US is also politically committed to follow up the consensus in the G20, for example regarding stricter capital and liquidity requirements to banks.

Also in Norway, a series of processes and initiatives are initiated as a result of the lessons learned from the financial crisis. Some of these processes regard changes in EU legislation (through the EEA Agreement), other are the result national initiatives, international initiatives, or stem from the public debate in general.

2.4 Lessons learned and proposals for change

Proposals and considerations from the Commission, or a majority in the Commission, are hereinafter referred to as the Commission’s proposals and considerations. Minority proposals and considerations appear in chapters 10 – 20 (in Norwegian).

2.4.1 International lessons, Norwegian challenges and priorities

The good economic times preceding the financial crisis led to over-optimistic and unrealistic risk assessments. Lack of knowledge and excessive optimism led to poor judgements, poor investment choices and excessive borrowing.

The risks associated with economic imbalances and increased leverage seem to have been underestimated in the economic policy in many countries. Expansionary monetary policy in several countries, including in the US, resulted in a prolonged period of low interest rates, and the subsequent search for yield led to alternative and often more risky investments. International financial institutions did not set aside enough capital to carry the risk they took on.

Inappropriate incentives are identified as a major cause of the international financial crisis. Financial institutions sought to benefit from regulatory avoidance. Major financial institutions have relied on a public safety net. Within many financial institutions weaknesses in management and variable compensation systems resulted in excessive risk taking, with management chasing short-term gain or giving poor customer guidance. In some cases, national authorities did not have strong enough motivation to follow up on unfortunate developments. In some countries political aspirations to build a major financial sector may have given incentives to relax the regulatory and supervisory review of financial institutions.

In the years preceding the financial crisis the process of financial innovation was intense, particularly in the United States. The innovations were typically intended to give borrowers and investors access to products with better-adapted risk and return characteristics, but in many instances they resulted in overly complex products which served to increase the vulnerability in the international financial sector. The crisis may serve as a reminder that effective and well-functioning markets cannot be taken for granted.

World financial markets, financial institutions and economies are more closely intertwined than ever before. The need for international coordination of financial market reforms is greater than before. All countries face challenges in their efforts to ensure financial stability. While some challenges are universal, others may be specific to certain countries. The Norwegian challenges are characterized by the fact that Norway is a small country with an open economy. Our economy and our financial institutions are greatly affected by the international economic and political developments.

The financial crisis and measures to counteract it has resulted in major costs for governments, both financial and economic costs. The cost and the distribution of these raises the question of what role the financial sector should have in the future, what activities the economy as a whole is served by engaging in the sector, and who should bear the costs problems in the sector.

In the Commission’s view it is important that a broad set of measures are employed to ensure that the financial sector in Norway is robust and appropriate. Taxes or fees should supplement regulation and supervision in a useful manner. It should also be more transparency to the market about the activities and risk-taking in financial institutions, including the banks’ own calculation capital requirements. Financial services should be organized in a transparent manner, so that any economic problems in an entity propagates in a straight line up the group structure, and such that these issues do not impact on other operational entities.

Governments should seek to improve the conditions for effective competition in the Norwegian financial markets, including setting the stage for a sufficient number of competitive participants, and should foster easier and more comparable products and services. The demand side in the financial markets are complex and represent many different needs, which also should be reflected in the structure of the supply side.

Banks are in a unique position in terms of the risk that the EU principles of home country regulation and branch establishments may imply for each country’s financial system, economy and public finances. 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. Financial institutions expanding abroad through branches may also involve risk to the institution’s home state.

In the Commission’s view Norwegian authorities should work to reform the entry law in the EU / EEA, such 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 organise their business abroad through subsidiaries rather than branches.

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 a national scope, 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. The Commission also believes that Norwegian authorities should take the initiative to strengthen the cooperation on financial market regulation and supervision in the Nordic area further, e.g. in the form of a new institution.

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. The possibility of stricter regulatory framework in Norway than in other countries should not easily be disregarded.

2.4.2 Macroeconomic policy

Economic policies may help to prevent crises in the financial system, and to make the economy robust and resilient. A balanced economy will have a better basis for dealing with a crisis than an economy with imbalances. In this context it may be several lessons to draw from the recent financial crisis.

There is broad consensus that the prolonged period of very low interest rates contributed to the build-up of financial imbalances in individual countries and in the world economy in the years preceding the crisis. Moreover, the substantial budget deficits and high public debt levels, which many countries had taken on in the years preceding the crisis, limited the possibility to mitigate the economic impact when the financial crisis was a fact. Also tax policies can affect the development of financial imbalances. Policies for employment and wage formation, as well as the social safety net, are important for how economic shocks translate into labour markets and for how the degree of uncertainty translates into lower demand and economic activity.

In Norway, the challenges of low interest rates may be higher than in other countries. Mortgage loans are given mainly given at floating rates, and it appears mainly to be the short-term interest rates that drive the development in housing prices. This suggests that periods of low interest rates may result in greater fluctuations in house prices and debt than in Norway than in other countries. While it may be beneficial that the interest rate changes is quickly reflected in activity and employment when the central bank wants to curb or stimulate demand growth, it can often lead to situations where the interest rate cannot address both inflation and financial stability concerns in an appropriate manner.

In the face of sharply weaker prospects for economic growth and inflation, central banks in most countries quickly ran interest rates down, which helped to cushion the downturn in the real economy. Thus, the contrast is great with the situation during the Norwegian banking crisis of the 1990s, when interest rates in Norway were kept high in order to contribute to a stable exchange rate. Overall, flexible inflation targeting has been an effective monetary policy regime to mitigate the economic consequences of the international financial crisis. However, the financial crisis made clear that it is crucial that central banks take sufficient account of developments in asset prices and credit growth. At the same time the Commission acknowledges that the interest rate, as a single policy instrument, cannot readily be used to fulfil too may targets.

The financial crisis has shown that fiscal policy still has a key role in stabilization policy. Automatic stabilizers provide crucial assistance by curbing the second round effects of the crisis, while discretionary fiscal policy measures are effective at negative shocks, especially in situations where the impact of further interest rate cuts may be weaker than normal. In Norway, automatic stabilizers are probably effective, and fiscal policy may be used actively.

The Commission believes that the fiscal policy framework in Norway gave a good basis for applying stabilizing policies during the financial crisis, and finds no lessons from the financial crisis that indicate necessary changes in this framework. The crisis has illustrated that fiscal autonomy and confidence in government finances must be built up in good times. The Commission therefore supports the recommendations made by OECD and IMF, that state that as the Norwegian economy improves, priorities should be given to build a sufficient room for future fiscal policy actions, equipped to meet also the next downturn. Countries with exposure to resource revenues, such as Norway, should have particularly large financial buffers.

The Norwegian labour market is characterized by strong negotiation powers on both the employer and the employee side, a high degree of labour union membership, high contract coverage, relatively highly coordinated and centralized wage determination, and a formal three-way collaboration between the social partners and the state. This type of cooperation has over time coincided with the evolvement of an efficient and flexible labour market in Norway. In addition, cooperative collaboration makes it easier to reach the necessary reforms in society, which may particularly important when a country has ended up in a difficult financial or economic situation. The Commission emphasizes the importance of government and social partners continuing the income policy cooperation in the years ahead.

2.4.3 Price bubbles

Historically, financial crises have often been characterized by sharp and credit-driven gains in equity, housing and property prices prior to the crisis, followed by a sharp decline. Large price fluctuations can contribute to financial vulnerability, distributional effects and bad investment decisions.

When price fluctuations are the result of prices deviating substantially from what the fundamentals suggest, there may be an asset price bubble, and thus reason for concern. In practice it is difficult to distinguish situations where large asset price increases are due to a rational adjustment to new information from situations where the increase can be attributed to bubble tendencies. Bubbles are usually finally identified after they have ruptured. While prices are still rising, growth is often explained by the fact that there have been tangible and significant changes in the underlying factors believed to drive the prices.

Historically, it appears that sharp falls in house prices in particular often coincides with a sharp economic downturn, while the relationship between the sharp falls in equity markets and real economic downturn is less strong. The Commission has in this context, therefore, given priority to discuss matters relating to the housing market.

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. Furthermore, the authorities may try to influence households’ propensity to choose floating or fixed interest rates on their mortgages.

The Norwegian Financial Supervisory Authority (FSA – Finanstilsynet) established in March 2010 guidelines for prudent lending to households, recommending that loans normally should not exceed 90 percent of the property’s market value, or three times the total gross income of the borrower. In the Commission’s view, this policy act was an appropriate measure to support financial stability. However, the Commission recommends that the authorities consider whether the guidelines should be clarified further to include what kind of interest rate increase assumption banks must use when assessing their customers’ ability to pay, and whether similar guidelines may also be suitable for lending to commercial property.

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.

The households’ extensive use of floating interest rates on mortgages may contribute to increased volatility in house prices, and Norway are among countries in Europe with the lowest proportion of fixed rate loans. However, there are also benefits from the use of floating interest rates for households, including that loans can always be redeemed at par value, and that interest rate will tend to be lower when the probability of being unemployed is high. Thus, it is not evident that all households would be better choosing fixed-rate loans.

2.4.4 Consumers

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 knowledge of the recipient, and that it is standardized and comparable across different institutions.

As financial products generally have become more complex, the information that the consumer needs to possess has grown both in quantity and complexity. The prevalence of so-called structured investment products is one example. Knowledge of and experience with the new products were weak among both buyers and sellers. As a result, many consumers were enticed by the marketing push to put savings in untested alternatives. In retrospect it was clear that many had invested in products that were hardly in line with their investment plan, their liquidity needs nor risk tolerance. One factor that made the products particular unfavourable, was the widespread loan financing of such investments.

It is the Commission view that it may be desirable to introduce new rules that can make it easier for consumers to make smart investment decisions, for example in the form of specific requirements for the use of the term “savings product” and alike. Also it may 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.

Beyond the need for good and correct information to consumers purchasing savings and investment products, also the problems related to inappropriate incentives and conflicts of interest should be addressed. As long as the provider and the distributor of a savings or investment product are the same institution, or are otherwise financially intertwined, the client’s interests could be harmed. In the Commission’s view such dependence should be regarded as a violation of the conflict of interest rules.

A number of factors make it challenging to maintain good supervision of financial institutions and other market participants’ behaviour towards consumers. High degree of financial innovation and widespread use of oral communication make it particularly important that effective supervision is in place, ensuring that institutions provide relevant and understandable information about various financial products, and offer services and products in line with good business practices. The Financial Supervisory Authority, the Competition Authority, and the Consumer Authorities have all important responsibilities in this area.

In the Commission’s view, the Norwegian authorities should be given an even clearer statutory responsibility to safeguard consumers’ interests and rights in the financial markets. Moreover, the Financial Supervisory Authority of Norway should take a more active role in monitoring developments in the financial area of financial retail products, and increasingly make and propose adjustments in the regulations.

A majority of the Commission refers to the fact that Norway as a whole has positive experiences with having an integrated financial supervisory body, and that a number of factors suggest integrated supervision should be continued. The majority believes that the FSA should continue to have responsibility for consumer-related audits and regulatory developments, in order to ensure consistent and comprehensive regulatory and supervisory practices, and based on the fact that Norway is a small country with limited resources for financial supervision.

A minority of the Commission believes the FSA will have difficulties in maintaining solvency considerations on the one hand, and at the same time the interests of demand side (including consumers) on the other hand in a satisfactory manner. A new institution should be established, with the ability to combine the role of a supervisor and that of being a resource centre with particular emphasis on savings and investment products. The minority suggests that the detailed design of the mandate, tasks and organizational solution for such an institution should be investigated further.

The Commission also proposes that issuing a standardized disclosure document with the sale of savings and investment products should be mandatory, a continuation of the right of customers to net their exposure when loans are transferred from a bank to a mortgage company, that financial institutions that do not comply with tribunal decisions in the consumer’s favour must meet the consumer’s cost of handling the case in the first court, and expanded legal basis for the FSA to impose administrative sanctions.

2.4.5 Improved taxation of the financial sector

Risks, weaknesses and vulnerabilities identified in the financial sector are primarily sought handled through enhanced financial market regulation. This will often be the most effective form of corrective measure, and also builds on a long tradition of regulation, both internationally and nationally. However, taxes and fees have other properties as policy instruments, and may contribute to increased flexibility and more national discretion than regulation when it comes to targeting specific issues.

The financial crisis has shown that there is significant discrepancy between private and social costs of the activity in the financial sector, and that regulatory and other policy instruments do not sufficiently adjust for this discrepancy. Due to this the financial sector may evolve in a direction where it becomes too large and the risk taken is too high.

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. The financial sector has large resources and significant influence, both economically and politically. These factors may have contributed to an over-emphasis on expansion. However, in Norway the financial sector is relatively small compared to many other countries.

In general, introduction of a new corrective tax on the financial sector may contribute to change the financial institutions’ role in the economy, and push the activity in the financial sector towards less risky business activities. If risk is priced correctly, for example as a result of a tax that reflects the costs to society that are otherwise not internalised, the risk would be reflected in the price of financial services more clearly.

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 will in certain situations implement support measures. In many countries, banks and financial institutions are not charged for the benefits of such an implicit government guarantee.

In the Commission’s view a stability fee should be imposed on Norwegian financial institutions based on the institutions’ debt in excess of equity and guaranteed deposits, which reflects any expectations of creditors that their risk is reduced as a result of the likelihood of government intervention (implicit government guarantee). It is advantageous if the same or similar charges are introduced in several countries simultaneously. If future EU rules do not imply proper charges, Norway should work towards a harmonized approach among the other Nordic countries. The critical issue of a tax is that it can correct a market failure, promote financial stability, and help to finance future government intervention.

Turnover and distribution of financial services are exempt from VAT. The reason for the exemption, which applies in Norway and 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. However, the Commission acknowledges that it can be very difficult to introduce VAT on financial services in Norway. This suggests alternative solutions, and international cooperation.

In the Commission’s view the Norwegian authorities should examine the basis for – and the possible consequences of – an additional tax on financial institutions’ profits and wage payments as a way to tax the value added created in the financial sector and thus correct for the sector’s VAT exemption. If such a tax is designed in an appropriate manner, it may provide significant income, and at the same time reduce distortions in consumption and industrial structure as a result of financial services being taxed in line with other goods and services.

2.4.6 Banks

Norwegian banks have fared better through the crisis than banks in many other countries. This is to a large extent due to the particularly favourable macroeconomic development in Norway compared with most other developed economies in the recent years. Structural and regulatory factors have also played an important role. The significant government measures helped mitigate the problems that arose. Lessons from the Norwegian banking crisis of the 1990s may also have contributed to caution among Norwegian banks compared with banks in other countries.

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. Also, internationally there has been a sign that banks have been unable to renew their market financing. Financial institutions financed investments with long maturity using very short-term market funding. A relatively large share of Norwegian banks’ market financing was in foreign currency and with a foreign counterpart.

Experiences from other countries have also demonstrated the need for larger equity buffers in the banking sector, and that capital must be of a type that can actually be drawn on, on a going-concern basis. Many international banks had very low equity ratios, made possible through the use of sophisticated models for risk management and overly optimistic loss provisions. In addition, the capital was of varying quality.

It is often difficult to raise new equity capital during bad times. In order for banks to have sufficient capital to maintain active lending operations during periods of significant unrest, it must build up capital buffers during good times.

G20 countries have endorsed the Basel Commission’s proposals for changes in the international capital adequacy framework, commonly referred to as “Basel III”. The EU proposals will likely be implemented through changes in the EU capital requirements directive, which will have direct implications for Norway through the EEA Agreement. The Basel III reform gives important changes in the requirements for financial institutions’ liquidity and funding, as well as capital requirements. The rules, however, are the result of compromises, and are showing signs of being adapted to the weak economies and fragile banking sectors in many European countries. The rules will probably not be fully phased in until 2019.

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 minimum. If Nordic cooperation on standards beyond the minimum requirements is not successful, the Norwegian authorities should make an independent assessment of whether there is a need for capital beyond the EU minimum requirements for Norwegian banks.

It is particularly important that the systemically important financial institutions have sufficient capital at any time, so that the likelihood that such institutions will end up in financial difficulties is reduced to a minimum. This implies that higher capital requirements are imposed on the systemically important institutions than on other financial institutions. Since the international financial crisis led to a liquidity crisis, not a solvency crisis, for the Norwegian banks, the new liquidity rules should be given particular priority.

The Commission also has proposals regarding the deposit guarantee scheme level, its fees and funding, and the remuneration systems in financial institutions. Regarding the latter, the Commission believes that supervision should give particular emphasis on the compensation systems in banks, and that additional capital requirements should be imposed where remuneration systems that invite for too high risk-taking are uncovered.

2.4.7 Securities markets

Well-functioning securities markets are important for financial stability. When crises occur, many companies need to increase their equity share, and at the same time increase the maturity of outstanding debt. Experience shows that those who escape a crisis best are the ones who were best positioned when the crisis occurred, and for many players it will often be too late to provide robust funding when the crisis has arrived.

Many interest rates in NOK are linked to NIBOR rates. Banks participating in the determination of the Norwegian money market rates, NIBOR rates, determine the rules for which banks should participate, and how the rate should be calculated. There are no written agreements or regulations, and there is little public information available about the arrangement. In the Commission’s view there should be greater transparency and clearer rules about the determination of NIBOR rates. The rules should, among other things, contain an unequivocal definition of NIBOR.

The financial infrastructure, including trading platforms and payment systems, functioned well during the crisis. However, there is still need for improvement, particularly when it comes to derivatives trading, which are mainly being made through bilateral agreements. Central counterparties may help reduce risk in these markets.

Increased transparency and better access to information about instruments, infrastructure and regulation, may help maintain liquidity in the markets during periods of market turmoil and uncertainty among investors. Covered bonds have been important for Norwegian mortgage companies and banks, and more accessible information on regulations, credit risk and the market place can help to create a broad and stable investor base for covered bonds. Issuers should arrange for such openness. Norwegian authorities can contribute as an advocator and facilitator.

Despite the fact that the Norwegian government has limited need of borrowing, it is appropriate to maintain a government securities market. The interest rate on government securities with different maturities could form a basis for benchmark interest rates, and there is also a contingency element in maintaining a market for government securities. The creation of the swap arrangement with the covered bonds and government securities during the financial crisis is illustrative of this. Furthermore, several international regulatory processes may affect demand for the Norwegian government securities in the future, especially the Basel III rules on liquidity buffers and the Solvency II for insurance companies. The Commission proposes that the government considers the consequences of a limited market for government bonds in general, and also in light of upcoming legislation.

2.4.8 Life insurance and pensions

The strength of the Norwegian pension system is to a very limited degree impaired as a consequence of the financial crisis. In the parts of the pension system that is funded, the fall in value resulting from the crisis was either absorbed by the pension providers or transferred to customers in the form of lower pension requirements (reduced benefits). The financial crisis has not identified a need to change the Norwegian regulation of insurance companies and pension funds out of financial stability considerations.

The financial crisis may have long-term effects on the life insurance sector, primarily in that the nominal interest rates can remain low internationally for some time. In a low interest rate scenario, it can be challenging for pension providers to achieve an adequate return on already paid premiums, and low interest rates may require premium increases for future earnings. Such premium increases will make the schemes more expensive for employers, and / or result in lower future pension payments to employees. It can lead to a faster transition to defined contribution pension plans.

Overall, Norwegian pension providers are facing major challenges in the coming years. The new EU solvency framework (Solvency II) will imply that assets and liabilities are carried at market value. Combined with a prolonged period of low interest rates, large holdings of paid-up policies, the right for customers to move their policies, and the annual interest rate guarantees, the situation may be 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.

Market developments have shown that there are some aspects of both defined contribution and defined benefit (final salary based) occupational pension schemes that should be closely examined. This includes the extent to which employees and retirees are exposed to market risk, the level and predictability of pension costs for employers, costs, and the consideration of pension providers’ financial strength. In the Commission’s view, new legislation for alternative products that combine features from defined contribution and defined benefit pension products should be examined more closely.

Most Norwegian workers who have occupational pension schemes with investment choice may choose among three to four risk profiles, typically differentiated with respect to the portion of common equity in the investment. However, there are few employees who actively choose a profile themselves. Defined contribution plans’ standard 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 this issue should be examined in more detail, and whether any new requirements should apply to the investment management and the design of the standard risk profiles to ensure that workers and retirees receive an appropriate market risk exposure. It is particularly important that the risk is reduced as the employee approaches retirement.

2.4.9 Macro prudential supervision and regulation

The international financial crisis showed how the vulnerability can be built 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.

The financial crisis has confirmed that banking and financial crises often follow after periods of high debt growth which has financed rapid growth in asset prices. Systemic risk increases with the debt level – both within and outside the financial system.

The Commission believes that it is important to strengthen the efforts to monitor systemic risk in the financial sector and facilitate new means of limiting systemic risk, such as macro dependent regulative measures. For example, counter-cyclical capital requirements may successfully improve banks’ capital adequacy over the cycle, and may serve to slow excessive credit growth. This measure is recommended by the Basel Committee (Basel III rules).

In order to implement macroeconomic measures that are justified on the grounds of the system as a whole, the Commission proposes that the FSA is given sufficient authority to make use of relevant macro measures that can mitigate the build-up of financial instability. There should be pre-defined criteria for when the measures are to be employed.

It is necessary to have a clear division of responsibilities and roles between the Ministry of Finance, FSA and Norges Bank. The experiences we have in Norway suggest that we build on the existing roles. The system must be designed with clear procedural requirements, including transparency of advices received and decisions taken.

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. Norges Bank should provide the advice in the form of publicly available submissions to the Ministry of Finance and the FSA. The FSA should explain what it does to follow up the recommendations from Norges Bank, or why it has decided to not follow up the recommendations. The Ministry of Finance should explain the recommendations, assessments and actions to the Parliament, for example in the form of a report.

2.4.10 Crisis management and moral hazard

Problems in the financial sector can rapidly deteriorate into a systemic crisis, especially if a good system for dealing with problems in individual institutions is absent. To prevent this, authorities and central banks in many countries, including Norway, have initiated a number of measures during the international financial crisis. The comprehensive measures came quickly, and sought to restore confidence and the functioning of financial markets and to mitigate the effects on the real economy.

It is important that the government has contingency plans and exercise flexibility in the face of a possible new crisis in the financial system. Governments should be prepared to intervene early with appropriate interventions, tailored to the current situation in the markets and the economy. It cannot be assumed that the measures that worked well in the previous crisis would be appropriate in the face of the next.

One of the dilemmas of government measures aimed at the financial institutions in crisis is that the measures can contribute to expectations of emergency assistance in the future. This type of moral hazard may generate risk in the form of excessive risk-taking among owners, management, and creditors of a bank, with the final effect that the probability of future crises increases. Crisis management rules must target these issues as well as being efficient tools when called for.

The Norwegian crisis management system was not seriously tested during this financial crisis. The activities of the crisis-hit Icelandic banks in Norway were handled in an efficient manner and without the customers suffering losses. Internationally, however, the financial crisis showed the need for better systems for banking crisis resolution, including the need for uninterrupted access to banking services when banking institutions are in trouble.

The system for crisis resolution in individual institutions is something that can and should be established long before any crisis. If the system is well designed, it can reduce the risk of financial instability, and increase the quality and progress of the decision making process during a crisis. The European Commission has initiated a process that can lead to the introduction of a comprehensive set of instruments in this area, and to improved coordination of systems across borders. In the Commission’s view it should be examined in more detail what changes should be made in the Norwegian crisis resolution system.

Today’s Norwegian regulation contains both qualitative and quantitative targets for the authorities to take action against a bank where problems seem to be arising. The Ministry of Finance will implement a process that gives the King in Council the right to decide both to write down the existing common stock, and who will be able to contribute new capital, if less than 25 percent of the equity capital is intact. In the Commission’s view this process should be initiated at a higher level of capital than today. The Commission recommends that the thresholds for when government can and should intervene, and what measures can then be applied, are examined more closely.

The organization of crisis resolution efforts should also be considered, including the role of the Deposit Guarantee Fund. A private agency should not manage such a crisis resolution tool, as there could be conflicts of interest between those who control the private body (the banks) and the State.

2.4.11 Economic and administrative consequences

The Commission’s report contains proposals on a number of areas. Common to the proposals is that they can contribute to a more stable financial system and a financial system that supports a sound economic development.

More stringent capital and liquidity requirements will probably mean higher costs for banks, but there will be gains for the economy in the form of lower risk of financial crises and a more stable economic environment. This also implies long-term gains for public finances. Part of the increase in banks’ costs will likely be offset by savings resulting from lower interest rates on bank loans, since banks become less risky borrowers.

The consequences of the proposed stability and activity tax (value added taxation) will depend on the specific design and whether other countries introduce similar taxes and fees. A thorough assessment of the consequences must therefore be carried out in connection with designing the specific rules. In general, however, such taxes increase the costs for financial sector institutions, and the profitability after tax will be reduced.

Increased taxation will contribute to a smaller financial sector, closer in size to what it would have been if they were treated equally with other sectors, and will also strengthen the public finances. There is reason to believe that a change in taxation of the financial sector, towards being more in line with the taxation of other sectors, will involve an economic gain for society.

A number of the Commission’s proposals deals with requirements regarding the amount and type of information financial institutions are obliged to provide to its customers. These proposals would involve costs for the existing institutions. However, common for all the proposals is that the costs will be outweighed by the benefits that could accrue to the customers in that they can make more informed decisions.

A significant part of the Commission’s proposals consists of requesting further work and recommendations for the adjustment of regulations. This will require considerable research and preparations. Beyond the use of resources for the study and design of legislation, the economic and administrative consequences of the Commission’s proposals largely depend on the final outcome of the investigations requested by the Commission. The further consequences will therefore have to be evaluated in these studies.