At The End of Another Decade

New Years Eve 2010 (around midnight): It’s not only another year, it’s also the beginning of a new decade. Looking back at the past 10 years, the stage is set for a mind-blowing decade of technological breakthroughs that have the potential to change or lives completely. unfortunately, we’re probably also in for a long period of financial instability and high levels of unemployment.

“It is possible that we are facing one of the most important decades in a very long time.”

econotwist

I remember New Years eve of 2000; dot-com-mania, emerging markets,Y2K. However, I also remember 1990; deregulation, digital revolution and another collapse in our financial system. I think I’ve detected two major screw-ups over the last two decades.

I covered the stock market crash in 1987, as one of my first assignments as a financial reporter.

By 1989 economists and politicians had declared the troubles were over, the major  global economies was back on track, producing new jobs.

In my mind, the most memorable from headlines from 1991 was delivered by the Swedish newspaper “Dagens Industri.”

Like the page 2 editorial:

“Dear God, please cool down our economy.”

And the – now historical – headline from the day the Swedish bank central bank kicked up its key interest rate to 500%:

“Good Night, Sweden”

This was about six months before the crisis hit the Scandinavian banks like a Norwegian heat-seaking Penguin missile, and forced the governments in both Sweden, Denmark and Norway to take public control over the private banks.

They were downsized, sliced up, sold out and merged, and the result was five, six   major banks who orderly divided the Nordic home markets between them, and have so far managed to keep any serious competition out of the region.

All three governments still holds significant ownership in the Nordic banking sector.

The Scandinavian banking crisis was recently held up as an example on how to handle a crisis in the financial industry.

Well, we now have five or six banks in three small countries that have become so “systemically important” that they are “too big to fail,” and will have to be bailed out of “no matter what.”

On a global scale; the creation of financial companies that are of “systemically importance” so they cannot be allowed to default must be (at least one of the) “Biggest Screw-up of the Decade – 1990/2000.”

As for the decade now ending, not keeping up with the developments in the financial industry, allowing it to become an invisible, almost uncontrollable, monster, and not putting a stop to it, is a really heavy regulatory blunder.

In the aftermath of 2001, several financial companies and their executives were accused or convicted of fraud for misusing shareholders’ money, and the U.S. Securities and Exchange Commission fined top investment firms like Citigroup and Merrill Lynch millions of dollars for misleading investors.

Thinking back, it seems like we’ve been moving around in a circle.

Systemically we’re right back where we was in 1992, financially we’re in even deeper trouble.

The new international regulations, as they emerge in the final reports from the Basel Committee (Basel III), doesn’t provide anything that will make any significant and systemically changes.

So, my guess is that we’ll have to struggle with a dysfunctional financial market, debt and “systemically important”banks for still a long time – perhaps another decade.

Sadly, this means that the much debated economic recovery, in form of a helluva lot of new jobs, probably not is going to happen anytime soon.

I’m afraid it could take about another decade to get where we would like to be last year, in terms of labor market conditions.

But I’m also sure the next decade will bring a boom in one particular sector:

On this new years eve, we have more people using Facebook than Google, 60.000 new pieces of malware released on the internet every 24 hours and the banks are setting up high frequency information systems, with super fast connections from major central banks, financial authorities and government offices directly into their high frequency trading machines.

It’s all set for another golden age for computer engineers.

As far as the financial industry goes, it reflects the new market conditions imposed by law makers worldwide.

It’s not that amusing to engineer new financial derivatives, so the focus have shifted to the technical side.

The danger is that the financial markets grows even more complex and unpredictable, tied together in an unofficial, unregulated intranet of dark fiber cables.

And this goes beyond the markets and the economy.

Judging by the rapid pace of development over the last 10 years, the next 10 is definitively not gonna be slower.

With the so-called quantum computers just three to five years away, the computer technology, and our whole way of life, is destined for another evolutionary quantum leap, practically.

It is possible that we are facing one of the most important decades in a very long time.

I wish you all the very best.

Happy New Year!

 

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PS:

I’d like to add a special greeting to all new readers/follower in 2010. Thanks for all your encouraging comments.

This summer the econotwis’t blogs (Swapper and Econotwist’s) blasted above  20.000 unique readers per month.

Many of you follow my Twitter, and I’m specially honored to welcome among my followers; the State of Israel, US Homeland Security and the EU Council.

Now that I got your attention; will you please tell the State of Kuwait to stop trying to hack into my computer!?

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Central Bankers Announces A Higher Form Of Capital Standards

At yesterday’s meeting, the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced a substantial strengthening of existing capital requirements. In addition the central bankers fully endorsed the agreements reached in July this year. Under the agreements, the minimum requirement for common equity will be raised from the current 2% level to 4.5%. The Tier 1 capital requirement will increase from 4% to 6%.

“Their contribution to long-term financial stability and growth will be substantial.”

Jean-Claude Trichet

In stores January 2011 (Limited Edition)

According to the press release, “systemically important banks” should have loss absorbing capacity beyond the standards announced Sunday, and work continues on this issue in the Financial Stability Board and relevant Basel Committee work streams. The Basel Committee and the FSB are also developing an integrated approach to the “systemically important” financial institutions which could include combination of capital surcharges, contingent capital and bail-in debt.

However, which banks that are regarded as “systemically important” are yet to be determined.

But even more interesting will be the list of banks that are “systemically unimportant.”

One might also wonder what the bankers mean by “a higher form of capital”…

“This reinforces the stronger definition of capital agreed by Governors and Heads of Supervision in July and the higher capital requirements for trading, derivative and securitization activities to be introduced at the end of 2011,” Bank of International Settlements writes in its statement.

After its meeting on Sunday, The Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced a strengthening of existing capital requirements and fully endorsed the agreements it reached on 26 July 2010.

“These capital reforms, together with the introduction of a global liquidity standard, deliver on the core of the global financial reform agenda and will be presented to the Seoul G20 Leaders summit in November,” Bank of International Settlements says in the press release.

The Committee’s package of reforms will increase the minimum common equity requirement from 2% to 4.5%.

In addition, banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirements to 7%.

This reinforces the stronger definition of capital agreed by Governors and Heads of Supervision in July and the higher capital requirements for trading, derivative and securitization activities to be introduced at the end of 2011.

Contribution To Stability And Growth

Jean-Claude Trichet

*

Mr. Jean-Claude Trichet, President of the European Central Bank and Chairman of the Group of Governors and Heads of Supervision, says that “the agreements reached today are a fundamental strengthening of global capital standards.” Adding that “their contribution to long term financial stability and growth will be substantial. The transition arrangements will enable banks to meet the new standards while supporting the economic recovery.”

Mr Nout Wellink, Chairman of the Basel Committee on Banking Supervision and President of the Netherlands Bank, adds that “the combination of a much stronger definition of capital, higher minimum requirements and the introduction of new capital buffers will ensure that banks are better able to withstand periods of economic and financial stress, therefore supporting economic growth.”

Sound Supervision

Under the agreements reached Sunday, the minimum requirement for common equity, the highest form of loss absorbing capital, will be raised from the current 2% level, before the application of regulatory adjustments, to 4.5% after the application of stricter adjustments.

This will be phased in by 1 January 2015.

The Tier 1 capital requirement, which includes common equity and other qualifying financial instruments based on stricter criteria, will increase from 4% to 6% over the same period.

The central bankers agree that the capital conservation buffer is a the regulatory minimum requirement and must be met with common equity – after the application of deductions.

“The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions,” BIS says.

This is described as “sound supervision.”

National Countercyclical Buffers

A countercyclical buffer within a range of 0% – 2.5% of common equity or other fully loss absorbing capital will be implemented according to “national circumstances.”

“The purpose of the countercyclical buffer is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any given country, this buffer will only be in effect when there is excess credit growth that is resulting in a system wide build up of risk. The countercyclical buffer, when in effect, would be introduced as an extension of the conservation buffer range.”

“These capital requirements are supplemented by a non-risk-based leverage ratio that will serve as a backstop to the risk-based measures described above.”

“In July, Governors and Heads of Supervision agreed to test a minimum Tier 1 leverage ratio of 3% during the parallel run period. Based on the results of the parallel run period, any final adjustments would be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration,” BIS adds.

Systemically important – Or Not?

“Systemically important banks should have loss absorbing capacity beyond the standards announced today and work continues on this issue in the Financial Stability Board and relevant Basel Committee work streams,” the central bankers informs.

The Basel Committee and the FSB are also developing an integrated approach to systemically important financial institutions which could include  a combination of capital surcharges, contingent capital and bail-in debt, according to the statement.

In addition, work is continuing to strengthen resolution regimes.

The Keeley Triangle

The Basel Committee on Banking Supervision have recently issued a consultative document proposal to ensure the loss absorbency of regulatory capital at the “point of non-viability.”

The point of non-viability refers to the contingency that a bank becomes unable to support itself in the private market such that it needs rescuing by the public sector, rather than in the narrow sense of insolvency or liquidation.

BCBS have considered three different options which could help ensure that, as a pre-condition of being treated as regulatory capital, an instrument (in particular a Tier 2 instrument) is capable of bearing loss at the point of non-viability:

Option 1: Developing national and international bank resolution frameworks that enable losses to be allocated to all capital instruments issued by internationally active banks that have reached the point of non-viability.

Option 2: Identifying systemically important banks and prohibiting them from including Tier 2 instruments in their regulatory capital.

Option 3: Mandating that all regulatory capital instruments include a mechanism in their terms and conditions that ensures they will take a loss at the point of non-viability.

BCBS ultimately chose to propose Option 3.

Option 1 was regarded as unrealistic in the short term, due to the need to achieve convergence of national insolvency laws and bank resolution regimes.

Option 2 would entail the practical difficulty of trying to identify systemically important banks, which itself gives rise to possible moral hazard issues and, therefore, would probably mean prohibiting all banks from including Tier 2 instruments in their regulatory capital, to the detriment of smaller, non-systemically important banks.

Here’s a copy of the proposal.

The Transition Arrangements

Since the onset of the crisis, banks have already undertaken substantial efforts to raise their capital levels, BIS points out.

Adding that the preliminary results of the Committee’s comprehensive quantitative impact study show that as of the end of 2009, large banks will need, in the aggregate, a significant amount of additional capital to meet these new requirements.

Smaller banks, which are particularly important for lending to the SME sector, for the most part already meet these higher standards, according to the statement.

The Governors and Heads of Supervision have agreed on transitional arrangements for implementing the new standards to help ensure that the banking sector can meet the higher capital standards through reasonable earnings retention and capital raising, while still supporting lending to the economy.

The transitional arrangements include:

* National implementation by member countries will begin on 1 January 2013. Member countries must translate the rules into national laws and regulations before this date. As of 1 January 2013, banks will be required to meet the following new minimum requirements in relation to risk-weighted assets (RWAs):

o 3.5% common equity/RWAs;

o 4.5% Tier 1 capital/RWAs, and

o 8.0% total capital/RWAs.

The minimum common equity and Tier 1 requirements will be phased in between 1 January 2013 and 1 January 2015.

On 1 January 2013, the minimum common equity requirement will rise from the current 2% level to 3.5%.

The Tier 1 capital requirement will rise from 4% to 4.5%.

On 1 January 2014, banks will have to meet a 4% minimum common equity requirement and a Tier 1 requirement of 5.5%.

On 1 January 2015, banks will have to meet the 4.5% common equity and the 6% Tier 1 requirements.

The total capital requirement remains at the existing level of 8.0% and so does not need to be phased in.

A Higher Form of Capital

The usual capital structure

*

The difference between the total capital requirement of 8.0% and the Tier 1 requirement can be met with Tier 2 and “higher forms of capital.”

* The regulatory adjustments (ie. deductions and prudential filters), including amounts above the aggregate 15% limit for investments in financial institutions, mortgage servicing rights, and deferred tax assets from timing differences, would be fully deducted from common equity by 1 January 2018.

* In particular, the regulatory adjustments will begin at 20% of the required deductions from common equity on 1 January 2014, 40% on 1 January 2015, 60% on 1 January 2016, 80% on 1 January 2017, and reach 100% on 1 January 2018. During this transition period, the remainder not deducted from common equity will continue to be subject to existing national treatments.

* The capital conservation buffer will be phased in between 1 January 2016 and year end 2018 becoming fully effective on 1 January 2019. It will begin at 0.625% of RWAs on 1 January 2016 and increase each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of RWAs on 1 January 2019. Countries that experience excessive credit growth should consider accelerating the build up of the capital conservation buffer and the countercyclical buffer. National authorities have the discretion to impose shorter transition periods and should do so where appropriate.

* Banks that already meet the minimum ratio requirement during the transition period but remain below the 7% common equity target (minimum plus conservation buffer) should maintain prudent earnings retention policies with a view to meeting the conservation buffer as soon as reasonably possible.

* Existing public sector capital injections will be grandfathered until 1 January 2018. Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out over a 10 year horizon beginning 1 January 2013. Fixing the base at the nominal amount of such instruments outstanding on 1 January 2013, their recognition will be capped at 90% from 1 January 2013, with the cap reducing by 10 percentage points in each subsequent year. In addition, instruments with an incentive to be redeemed will be phased out at their effective maturity date.

* Capital instruments that no longer qualify as common equity Tier 1 will be excluded from common equity Tier 1 as of 1 January 2013. However, instruments meeting the following three conditions will be phased out over the same horizon described in the previous bullet point: (1) they are issued by a non-joint stock company 1 ; (2) they are treated as equity under the prevailing accounting standards; and (3) they receive unlimited recognition as part of Tier 1 capital under current national banking law.

* Only those instruments issued before the date of this press release should qualify for the above transition arrangements.

“The supervisory monitoring period will commence 1 January 2011; the parallel run period will commence 1 January 2013 and run until 1 January 2017; and disclosure of the leverage ratio and its components will start 1 January 2015. Based on the results of the parallel run period, any final adjustments will be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.”

Here’s the full statement from Bank of International Settlements.

Annex 1: Calibration of the Capital Framework

Annex 2: Phase-in arrangements

Related by the Econotwist:

Basel III And The Fawlty Towers

Will Basel III Crush the Global Economy?

German Banks With More Than 200 Billion Euro In Faul Credits

European Banks Hunting For EUR 1,65 Trillion

Morgan Stanley: Governments WILL Default

*

Related Articles

• Announcement of Basel III bank rules (reuters.com)
• Here Are The New Capital Requirements For The Global Banking Industry (businessinsider.com)
• Basel Committee: Banks Need 7% Core Tier 1 Capital As Of 2015 (forexlive.com)
• Basel III has landed – full details (ftalphaville.ft.com)
• Factbox: Reactions to Basel III bank capital rules (reuters.com)
• New rules agreed to shore up banks (independent.co.uk)

Fear Of Norwegian Housing Market Collapse

The Norwegian Central Bank Chief, Svein Gjedrem, issue another strong warning against the bubbling Norwegian housing market.   “House prices can fall considerably over only a few years,” Mr. Gjedrem said in a speech in Oslo Wednesday. He also warns against the national banks strong dependency on short term funding.

“I think it is fair to say that housing finance in Norway is in its infancy. There is a large proportion of adjustable-rate loans. And last, but not least, banks finance their housing loans by means of short-term asset swaps in foreign markets. This is not a sustainable solution.”

Svein Gjedrem

(Full transcript of the speech in English)

After the Second World War, the credit market in Norway was regulated. Credit demand was high. The Norwegian state endeavoured to steer credit flows towards priority sectors and the state banks therefore played an important role as credit intermediaries.

From state to private housing finance

There were considerable housing shortages after the war. For some population groups, living conditions were poor. In 1946, the Norwegian State Housing Bank was established to provide credit for new residential construction. This bank and Statens Landbruksbank (the state agricultural bank) dominated housing finance for new house purchases up to the 1980s. State bank mortgage rates were initially set based on political objectives, but were over the years gradually revised up and adjusted to market rates.

With the gradual deregulation of the credit market in the 1980s, state lending institutions assumed a lesser role in housing finance and the private market took over. Sales of existing homes increased. In 1992 private banks provided the majority of residential mortgages. Their share of housing finance was also high compared with other Nordic countries. In Denmark and Sweden, mortgage institutions were the primary source of residential mortgages. Even though their importance has been reduced in recent years, mortgage companies still provide most residential mortgages.

With the predominance of mortgage companies, fixed-rate mortgages have been a tradition in Denmark and Sweden. This has not been the case for Norway. Mortgages from the State Housing Bank were primarily adjustable-rate loans. After credit market liberalisation, adjustable-rate mortgages were also offered by banks. The supply of fixed-rate mortgages was limited. Fixed-rate loans are less common in Norway than in the other Nordic countries.

From the 1980s to the 1990s, the Norwegian economy moved from high to low inflation with, until recently, falling nominal long-term interest rates. Borrowers with fixed-rate mortgages fared poorly in this period, and even more poorly than maturity or mortgage insurance premiums alone would imply. But with a clear monetary policy objective to keep inflation low and stable – and with an independent central bank tasked with achieving this objective – the result would be different. The high inflation expectations that were built into long-term interest rates no longer exist and a further marked fall does not seem likely, nor for that matter does any substantial inflation-driven increase in long-term rates. Purchasing a home is a long-term investment. A fixed-rate mortgage reduces borrowers’ uncertainty about expenses over the life of the loan.

Longer-term financing in banks

Banks play an important role in the economy. Their task is to convert short-term deposits into long-term loans. In times of crisis, fulfilment of this task is put to the test. A century ago, depositors could lose confidence in the banks and rush to withdraw their savings. However, deposits stabilised when guarantee schemes were established in the 1930s.

Loans to households make up a third of banks’ assets. Residential mortgage loans are long-term loans. At the same time, funding for Norwegian banks has changed. Market funding has assumed a more important role. In recent years, both short-term market funding and funding in foreign currency have grown in Norwegian banks. Banks have increasingly transformed short-term deposits from international money markets into long-term domestic lending. This is the main reason for the strain on liquidity experienced by Norwegian banks when foreign funding came to a halt in 2008. For Norwegian banks, the financial crisis has primarily been a liquidity crisis and not a solvency crisis.

The authorities all over the world are currently reviewing the regulation of banks’ liquidity. The Basel Committee on Banking Supervision presented recommendations on quantitative liquidity requirements in December 2009. The UK, Switzerland and New Zealand have introduced, or are in the process of introducing, stricter rules. Norwegian banks must also expect the regulation of liquidity to be more stringent in the future. It will be more difficult to base housing finance on short-term funding. Issuing covered bonds may be an alternative. The collateral pool for covered bonds may comprise residential mortgages or mortgages for holiday homes with a loan-to-value ratio (LTV) of up to 75 per cent, commercial property mortgages with an LTV of up to 60 per cent or loans to public sector entities with an LTV ratio of up to 100 per cent. These instruments are highly collateralised, carrying lower risk premiums than ordinary bank bonds, and are well suited to pension fund investment and other investments with a long-term horizon.

According to the rules for the issue of covered bonds, the value of the cover pool is required at all times to exceed the value of the covered bonds. Both assets and liabilities are to be recorded at estimated market value. This implies that a mortgage company must add further collateral to the cover pool, for example in the form of government bonds, to replace any shortfall.

An efficient bond market can handle large trading volumes without substantially affecting prices. Such a market requires instruments that are easy to understand and clear regulation. Trading should be transparent. Ideally, there should be multiple independent bidders and askers and trading volumes should be high in primary and secondary markets.

Issues of covered bonds have picked up in Norway since the regulations relating to covered bonds entered into force on 1 June 2007, supported since autumn 2009 by the arrangement for the exchange of government bonds for covered bonds.

To facilitate banks’ access to borrowing from Norges Bank during the period of financial turbulence, collateral requirements for loans were temporarily eased. In October 2009, it was announced that the temporary rules for collateral requirements would be changed. Acceptance of new securities eligible under the temporary rules was discontinued in October. Securities already approved under the temporary rules would be eligible as collateral until maturity, or at the latest until 15 February 2012.

Changes in the so-called bank quota were also announced. Under the current rules, up to 35 per cent of a bank’s borrowing facility can be based on collateral in bonds issued by other Norwegian banks. Debt instruments issued by foreign banks will be included in the bank quota as from 1 December 2010. Securities issued by banks will no longer be eligible as collateral for loans as from 15 February 2012.

Covered bonds will still be eligible as collateral, including, until further notice, bonds to which no credit rating has been assigned and bonds issued by a bank’s own mortgage company. This is expected to contribute to the development of the Norwegian covered bond market.

The housing market – a source of disturbances in the economy

Banks have had strong incentives to extend credit for house purchases. Even during the banking crisis around 1990, Norwegian banks’ losses on residential mortgages were low. This is reflected in the low risk weights for residential mortgages in banks’ risk models. For an individual bank, residential mortgages are low-risk loans. However, market fluctuations, accompanied by shifts in saving behaviour, are nonetheless a source of business cycle fluctuations and substantial losses when banks have to write off loans to firms selling goods and services to households.

With low risk weights for residential mortgages, banks can lend extensively, operating with a substantially reduced equity ratio. As a result, banks are more vulnerable to disturbances in funding markets. Thus, low risk weights for residential mortgages also lead to higher liquidity risk in our banking system.

A high level of tax incentives for house ownership and a large volume of adjustable-rate mortgages contribute to wide fluctuations in activity and prices in the Norwegian housing market. [1] The rise in house prices over the past two decades has also been very strong compared with countries where housing bubbles have burst.

We have been through the longest period of uninterrupted house price inflation. In real terms, house prices in Norway have tripled since the trough in 1992. House prices fell in 2007 and 2008, but have picked up again and have, in nominal terms, surpassed the summer 2007 peak.

Norwegian household debt is high compared with households in other countries. The number of residential mortgages with a high loan-to-value ratio, i.e. above 80 per cent, has also increased.

Periods of sharply rising house prices have historically been followed by periods of declining prices. House prices can fall considerably over only a few years. Loan-to-value ratios will then increase. Mortgage companies should therefore take housing market fluctuations into account when issuing covered bonds.

Conclusion

I think it is fair to say that housing finance in Norway is in its infancy. There is a large proportion of adjustable-rate loans. Fixed-rate loans offered in Norway are less customer-friendly than, for example, in Denmark, where it is less expensive to cancel a fixed-rate mortgage and where there is a secondary market, providing risk diversification. Mortgage companies have a limited role in housing finance. Loan-to-value ratios are in some cases alarmingly high. And last, but not least, banks finance their housing loans by means of short-term asset swaps in foreign markets. This is not a sustainable solution. I hope that this forum can contribute towards the development of a better foundation for housing finance in Norway.

Footnotes

1. See Van den Noord, Paul (2005): “Tax Incentives and House Price Volatility in the Euro Area: Theory and Evidence”, Économie Internationale 101, pp.29-45. This paper shows that house price volatility is higher in countries where tax regimes favour owner-occupied housing. See also IMF (2004): World Economic Outlook, September, p.81, where house price volatility is higher is countries where adjustable-rate mortgages are common.

By Svein Gjedrem

Governor at Central Bank of Norway

Link.

And here’s the charts.