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Finland: Selected Issues and Analytical Notes

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International Monetary Fund
Published Date:
August 2012
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V. Analytical Note 5: Basel III and the Finnish Financial System1

This note reviews the challenges for Finnish banks in the context of the revised prudential requirements prompted by Basel III and potential funding risk associated with the ongoing euro area sovereign debt crisis. Though Finnish banks have maintained access to financial markets so far, a worsening of the crisis could impact the Finnish financial sector. Against this background, a banking sector stress test shows that while Finnish banks have ample capital, liquidity risk remains a concern.

A. Implementing Basel III Recommendations—Challenges for Finnish Banks

1. New capital, liquidity, and leverage requirements will involve reviewing Finnish banks’ business models and finding additional funding resources. Basel III requirements—enforced in the EU through a directly applicable regulation and a directive—will take effect gradually from 2015. These new requirements will likely impact Finnish banks’ business models, whether banks are mostly active in retail operations or perform more sophisticated transactions. With the large spectrum of business models in the banking system, the requirements will necessitate the mobilization of larger, more stable, long-term resources.

2. Finland’s traditional business model is likely to be substantially impacted by the leverage ratio requirement. The leverage ratio, defined as the debt-to-equity ratio, is a risk-insensitive metric. Hence, it is likely to penalize financial institutions that have low-risk but high-volume traditional loans—typically, local banks with traditional mortgage lending, banks that pool resources for other banks, and mortgage credit institutions. In particular, the equity capital of Finnish banks is likely to fall short of the required increase in capital. Moreover, the leverage ratio could create incentives for riskier loans over more conventional lending given Finland’s squeezed profit margins.

3. The introduction of liquidity ratio requirements is likely to weigh on Finnish banks’ profitability. Two liquidity ratios will be gradually introduced from 2015.2 Both ratios set mandatory thresholds, which recent evidence suggests are above current levels in Finnish banks. As a result, the new thresholds will require a significant effort by banks to increase both the level and quality of liquid assets, with more substantial precautionary liquidity buffers for larger Finnish banks than for smaller ones. For example, the largest Finnish banks are below the net stable funding ratio (NSFR) requirement, with end-2010 levels between ½ and ¾ of Basel III required highly liquid assets. Smaller banks need to increase their liquid assets by a much narrower margin. In addition, the Finnish monetary authorities may be compelled to accept larger classes of assets as collateral and provide emergency liquidity assistance to local branches of foreign-owned banks to avoid a bank run if foreign parent banks siphon away liquidity held by their subsidiaries in Finland.

4. In addition, counterparty credit risk is likely to strain balance sheet flexibility of Finnish banks. Finnish banks are highly interconnected with other Nordic financial institutions, with derivative operations concentrated in a few entities. Hence, new procedures on counterparty credit risk can have significant importance for Finnish banks. With the implementation of Basel III, all credit risk must go through a Central Counterparty Clearing House (CCP), which currently requires a zero Exposure at Default (EAD), instead of being over-the-counter (OTC). Furthermore, banks must hold additional capital based on the credit risk that goes through the CCP. In turn, these additional capital buffers could strain the business model of certain banks. For example, Nordea Group opted to centralize all its financial derivative operations in its Finnish subsidiary. Hence, the additional required capital buffers would involve beefing up core capital of Nordea Finland to match counterparty risk.

5. As the definition of core capital in Basel III excludes several key instruments for Finnish banks, securing additional long-term funding may prove challenging. Basel III requires that capital meets own-funds criteria and thus has greater loss-absorbency capacity. As a consequence, the revised definition of core capital excludes minority interests at the group level and investment in insurance companies—important for Finnish banks as many groups moved recently towards integrating insurance. Supplementary cooperative capital of banks will also undergo stricter accounting treatment. Accordingly, the implementation of Basel III will require that Finnish banks supplement their capital with long-term instruments. Additionally, as mentioned, assets that carry counterparty risks, such as OTC derivatives, will have higher capital requirements.

6. Some Finnish banks will need to increase their capital holdings to abide by the new requirements under Basel III. Basel III will include new requirements both at the micro prudential and macro prudential levels, aimed at increasing the share of loss-absorbing capital instruments. At the micro level, capital will have to reach 10.5 percent of Risk-Weighted Assets (RWA). At the macro level, an extra capital charge applies if found necessary by the authorities when banks are deemed systemically important financial institutions (SIFIs). In addition, the banking sector is subject to countercyclical common equity buffers of up to 2.5 percent of RWA, updated on the basis of aggregate national credit growth. At end-2011, not all Finnish banks fulfilled the forthcoming new capital requirements, suggesting a need to strengthen capital with high-grade loss absorbing instruments.

Basel III Capital Requirements

(Percent of Risk-Weighted Assets)

Source: European Commission.

B. Funding Risk Associated with Increasing Capital

7. When seeking funding in the transition to Basel III, Finnish banks must navigate international financial markets amidst the euro area sovereign debt crisis. Currently, financial markets continue to have a positive view of Finnish banks, and banks still retain full access to international markets, reflecting a confirmed AAA sovereign rating. However, market sentiment can rapidly change amidst the continuing euro area sovereign debt crisis. In particular, market analysts3 point to Finnish banks’ high reliance on wholesale funding, weaker profitability, and a more fickle investor base, mainly made up of institutional investors, than in other Nordic countries. These factors render the banks prone to risks of severe medium-term deterioration given the worsened economic outlook in the euro area.

5-year CDS Spreads, 2008–12

(Basis points)

Sources: Datastream and Fund staff calculations.

8. So far Finnish banks have maintained access to international markets. Although Finnish banks benefit from solid retail deposits, they rely on sizeable amounts of wholesale funds, in particular in the form of covered bonds. However, with a Tier 1 capital ratio at 13.0 percent, compared to an EU27 average at 10.9 percent at end-June 2011, Finnish banks maintain higher capital ratios than their European peers. Hence, Finnish banks are currently considered a safe investment option and have been able to find sufficient funding on international markets. This was true even at times of the most severe financial stress during the euro area sovereign debt crisis.

Finland: Issuances on International Markets, 2008–12

(Billions of euros)

Sources: Dealogic and Fund staff calculations.

1/ At end-February. Not annualized. Preferred shares are zero.

9. However, with a weak investor base and low profitability, Finnish banks are vulnerable to a significant economic slowdown. Fierce competition for households’ business has contributed to erosion of bank profitability, prompting the FIN-FSA to warn that the extremely low interest rates charged would affect profitability and boost consumer indebtedness.4 Moreover, market analysts find that the Finnish wholesale funding market remains deprived of a solid core investor base. Further financial sector tensions in the euro area could prompt investors to shift away from euro-related assets into safer, non-euro assets, thereby rendering funding more problematic for Finnish banks.

C. Stress Tests of the Finnish Banks

10. The need to increase capital and, in particular, liquidity buffers is also essential in case of a severe economic slowdown. To examine the Finnish banking system’s performance in case of a protracted worsening of the economic outlook over 2012–15, the Finnish authorities have conducted a top-down stress test based on end-December 2011 data. The stress scenario involves a shock to external trade, which adversely impacts corporations, with attendant increase in bankruptcies and unemployment rates. Simultaneously, financial conditions deteriorate, with equity prices declining by a cumulative 50 percent and Euribor rates remaining below 1 percent. This prompts a decline in household consumption and contraction in housing prices by a cumulative 22 percent over the period. The scenario assumes unchanged accounting methods under Basel II and unchanged capital base and excludes managerial decisions to realize the asset portfolio in response to the shock. On the basis of first round effects measured on banks’ balance sheets, the exercise provides aggregate results for the entire banking sector as well as separately for the seven largest banks.

Selected Stress Test Macroeconomic Assumptions(In percent)
BaselineAdverse scenarioDeviationMemo
2011201220132012201320142015201220132009
Real GDP growth2.90.41.8−6.4−2.0−2.0−1.0−6.8−3.8−8.4
Real export growth (goods and services)−1.1−1.74.4−19.7−5.0−1.00.0−18.0−9.4−21.5
Real investment growth13.80.72.6−12.6−4.0−2.0−1.0−13.3−6.6−21.7
Real consumption growth2.40.61.3−1.4−1.0−0.50.0−2.0−2.3−1.6
Unemployment rate7.87.98.09.810.912.514.01.92.98.2
HICP inflation3.32.32.20.70.80.70.6−1.6−1.41.6
3-month Euribor1.41.21.60.70.70.80.8−0.5−0.91.2
Equity price growth4.05.0−30.0−5.0−7.5−7.5−34.0−10.015.4
Yield on 10-year Finnish government bond1.83.63.94.04.34.34.40.40.43.7
House price growth2.83.02.0−7.0−5.0−5.0−5.0−10.0−7.07.9
Note: The stress test does not include the insurance arm of the Finnish financial system.
Note: The stress test does not include the insurance arm of the Finnish financial system.

11. The baseline scenario confirms that the banking sector remains adequately capitalized through end-2013, albeit with some dispersion in individual results. On aggregate, the Finnish banking sector has a 12.7 percent Tier 1 capital both in 2012 and 2013 under continuing mild growth conditions.

12. On aggregate, banks are resilient to shocks and maintain ample capital buffers, but concerns arise for individual banks and the macro consequences. In spite of the assumed severe and protracted shock, the Finnish banking sector has a 9.5 percent Tier 1 capital ratio in 2015 after contracting by a cumulative 4 percentage points of RWA over four years but remains above the Basel II minimum requirement.

13. Liquidity provisions may be insufficient and leave banks vulnerable. The authorities also conducted an attendant, albeit separate, liquidity test exercise subjecting the largest six banks to the conditions of the Liquidity Coverage Ratio (LCR).5 The exercise showed that only one bank would overcome the added stress to its liquidity buffers, keeping about 90 percent of its pre-crisis liquidity intact. The remaining five banks would suffer substantial depletion of their liquidity buffers. While this does not entail immediate use of emergency liquidity assistance, it suggests that banks would need to rely on additional collateral and higher-grade investment assets to restore pre-crisis liquidity conditions. Overall, liquidity shortage could lead banks to record possible losses on forced sales of top portfolio assets.

14. Recent evidence suggests that cross-border macro-financial linkages have become more complex and extensive. In fact, Finnish subsidiaries serve increasingly as financing hubs to their foreign parent banks in accessing financial euro markets. Further, subsidiaries are supporting more actively their parent companies through short-term funding, which reached 12.5 percent of Finnish banks’ asset at end-January, compared to 6.3 percent a year earlier.

Finland: Aggregate Stress Test Results, 2011–15
BaselineAdverse scenario
20112012201320112012201320142015Change (2011–15)
Total income (percent change from previous year) 1/3.04.06.03.0−17.5−3.5−21.6−5.1−47.9
Profitability (operating profit after taxes, percent of own funds, RoE)8.48.28.88.41.4−1.7−9.1−8.5−16.9
Tier 1 capital (percent of risk-weighted assets)13.612.712.813.612.612.010.79.5−4.0
Tier 1+2 capital (percent of risk-weighted assets)14.213.713.814.213.112.410.99.6−4.6
Memorandum item:
Risk-weighted assets (billion euros) 2/147.8162.3167.3147.8159.3164.1169.0174.117.8
Sources: Bank of Finland, FIN-FSA, and Fund staff calculations.

Change (2011–15) computed as the sum of the 2012–15 growth rates.

Change (2011–15) denotes the percentage change over the period.

Sources: Bank of Finland, FIN-FSA, and Fund staff calculations.

Change (2011–15) computed as the sum of the 2012–15 growth rates.

Change (2011–15) denotes the percentage change over the period.

Prepared by Michelle Hassine.

The two ratios are (i) the Liquidity Coverage Ratio (LCR), which targets that banks hold sufficient high-quality, unencumbered assets to survive a 30-day period of acute stress; and (ii) the Net Stable Funding Ratio (NSFR), which is intended to promote more medium- and long-term funding by establishing a minimum acceptable amount of stable funding.

Moody’s, Standard and Poor’s, Fitch, and JP Morgan Cazenove were surveyed.

The FIN-FSA Annual Report for 2011 notes that 94 percent of all housing loans are priced on the basis of floating rates.

The LCR is a Basel III liquidity requirement that becomes enforceable on January 1, 2015. The LCR measures the available liquid resources through a 30-day stress situation of a combined idiosyncratic and market-wide shock.

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