2 • 2013 Financial stability Contents

Bank of Finland’s Financial Stability Report...... 3

Summary...... 4

Operating environment...... 7

Banking and insurance sector...... 21

Financial market infrastructure...... 33

Financial system policy...... 42 Bank of Finland Bulletin 2 • 2013 Vol. 87 Appendix...... 54 Published 20 June 2013 The Bank of Finland Bulletin is published Pertti Pylkkönen – Eero Savolainen five times a year. The situation of SME finance in Finland...... 55 Editor-in-Chief Jukka Vauhkonen – Hanna Westman Erkki Liikanen Finland must be prepared to impose systemic capital requirements on banks...... 65 Steering Group Päivi Heikkinen Heli Snellman – Eero Tölö Hanna Putkuri Katja Taipalus Payment transfers measure the pulse of the financial markets...... 77 Jouni Timonen Jukka Vauhkonen Kimmo Virolainen

Authors Jyrki Haajanen Marko Myller Timo Iivarinen Hanna Putkuri Esa Jokivuolle Pertti Pylkkönen Kari Kemppainen Eero Savolainen Risto Koponen Mervi Toivanen Jenni Koskinen Jukka Vauhkonen Kimmo Koskinen Hanna Westman Helinä Laakkonen

Technical assistants (texts, charts, tables) Nina Björklund Jere Virtanen

Translated and edited by the Bank of Finland Language and Publication Services

Subcriptions Email: [email protected]

Printed Edita Prima Oy, Helsinki 2013

The contents of the Bulletin may be freely quoted, but due acknowledgement is requested.

ISSN 0784-6509 (print) ISSN 1456-5870 (online)

Bank of Finland PO BOX 160 FI-00101 HELSINKI Phone: National 010 8311 International +358 10 8311 Cover picture depicts the national motif on the German 2 euro coin: Fax: +358 9 174 872 featuring the eagle, the traditional symbol of German sovereignty. www.bof.fi Bank of Finland’s Financial Stability Report

A soundly functioning financial system potential macroprudential risks and is essential for ensuring balanced their sources within the financial system development of the entire economy. A and the operating environment of the stable financial system is capable of financial institutions, the risk-bearing operating reliably and efficiently, of capacity of the domestic banking and handling its basic tasks, such as the insurance sectors, the reliability and transmission of finance and payments, efficiency of payment and settlement pricing of financial instruments and systems critical to Finland and as well distribution of risk. Furthermore, the as the measures necessary for risk-bearing capacity and operational preventing risks and strengthening the preparedness of the financial market financial system. participants and infrastructure must be This issue of the Bank of Finland sufficient to endure even larger Bulletin, publishing the Bank’s Financial disruptions in the operating Stability Report, is intended for all environment. financial market participants, other One of the tasks of the Bank of authorities and the public to provide Finland is to promote the stability of information and promote discussion on the payment system and overall financial stability. The objective is, financial system, to contribute to partly, to ensure that these parties take maintaining their reliability and financial stability conditions and efficiency and to participate in their outlook into account in their development. The Bank’s efforts are operations. In addition to the financial integrated with the objectives of the stability assessment, the publication European System of Central Banks and contains three other articles which also require close cooperation with cover some key special themes from the domestic and foreign authorities and perspective of financial stability and the market participants. development of the financial system. The Bank’s task is to evaluate the The Bank of Finland publishes its stability of the financial system and any assessment of financial stability twice a collective risks that may threaten it – year. Information presented in this so-called systemic risks – as a whole. report is based on data available on 17 The Bank particularly assesses any May 2013.

Bank of Finland’s Financial Stability Report Bank of Finland Bulletin 2 • 2013 3 Summary

The financial markets have stabilised on average. Low interest rates however owing to strengthening of financial institu- weaken investment income. tions’ risk-bearing capacity and public The most important source of funding­ confidence. Despite the signs of recovery in for banks operating in Finland is based on Tthe market, the economic outlook for the deposits. However banks are also highly euro area is weak. Because of which, dependent on market funding from abroad. concerns about many governments’ debt In addition to banks, central and local resilience have not disappeared. Economic governments’ dependency on international growth is necessary for the recovery of the financing sources is considerable. This financial system from the crisis of the last means Finnish susceptibility to disruptions few years. in international financial markets. The The interest rates on corporate and concentration­­­ of the banking sector adds to housing loans have been reduced to histori- the vulnerability of the Finnish financial cally low levels in Finland. This in itself sector and related contagion risks. The tends to increase the volume of loans. banking sector is closely linked to those of Households’ indebtedness has continued to the other Nordic countries and this is an rise and housing loans are subject to variable important factor to pay attention to in rates. All this weakens households’ ability to financial stability analysis. adjust to interest hikes or unexpected, In comparison with other EU countries negative economic events. The debt burden and macro level assessments of business and higher-than-average housing prices over financing, Finland’s corporation financing is the long term have increased the entire in a good position also when it comes to economy’s cyclical sensitivity in Finland. small and medium-sized businesses. Finland’s The financial situation of the banking­ financially sound banking system has been sector in Finland continues to be sound. capable of maintaining their lending­ capacity, However, the prerequisites for bank profit­ even in times of an economic downturn. ability are weakening, as the largest source of According to recent surveys, however, acces- income, net interest income, has shrunk under sibility to financing has weakened­ and their pressure from low interest rates. Large banks terms have tightened. This means diversifi­ have been capable of taking advantage of the cation of corporations’ financing sources is diverse operations and have achieved good highly desirable. profits by, for example, through their invest-­ The financial sector finds itself under ment activities. Smaller banks’ opportunities considerable pressure which has the effect of for compensating through such activities have altering the financial institutions’ operating been limited. Weak development in the real environment. In line with the lessons learnt economy adds to banks’ vulnerability through from the crisis, regulations are being the increase in credit risk. strongly amended. For well capitalised and Because of the signs of recovery in the liquid banks these amendments will cause market, life and non-life insurance companies less change and cost than for weaker banks. have seen an increase in their performance­ In any case, banks adjust their business and solvency. The solvency levels of employee models to changes in the operating environ­ pension companies have also remained good ment, as low interest rates, and the resulting

4 Bank of Finland Bulletin 2 • 2013 Summary negative effect on earnings as well as the Based on the financial stability muted economic development pose analysis, the Bank of Finland recommends challenges to current business models. In order the following measures: to ensure their viability banks are likely to 1) Finland should consider additional change the pricing of loans and deposits, regulations concerning systemically increase­ their cost effectiveness as well as head important banks, in line with the approach towards giving up some of their operations. taken in other Nordic countries. Regulations Stable financial markets require reliable concerning banks should be harmonised and effective payment and settlement systems internationally and particularly in the in a changing operating environment. The integrated Nordic banking market. strong internationalisation of the systems and 2) Finland has to ensure means of strive for economies of scale also continue­ in intervening in the excessive housing loan Finland. Structural changes to the payment growth, in order that the risks associated and settlement systems and more efficient with increasing asset prices can be reduced, working practices should not come at the when necessary. Based on international expense of reliability and service levels. experience, legally binding loan-to-value The banking union that is being ratios are an efficient way of dampening drawn up in Europe is comprised of the excessive growth of housing loans. single supervisory mechanism and a joint 3) Bank liabilities must be extensively framework for bank recovery and resolution­ used in the future as solutions for banks’ in addition to harmonised deposit guarantee recovery and crisis resolution. It would be systems. These aim at repairing the important that the bail-in procedure is European financial architecture’s central directed at sufficiently broad part of banks’ weakness, in other words that financial liabilities. institutions’ operate across borders but their 4) The prerequisites for diversification­ of supervision is national and crisis resolution corporate financing sources must be looked measures are inadequate. As Finland’s into with care. Possible market failures and financial markets are completely linked to gaps in the financing of small and medium- European markets, the development of this sized companies in particular should be project is in Finland’s interest. patched up although at the macro-level the The financial crisis has made itself seen situation in Finland is stronger than elsewhere in tough terms, in that negative trends are in the euro area. It would create an possible­­ in the financial systems and that opportunity for bank financing for those dealing with them requires the actions of companies who fall outside market financing. appropriate authorities and effective macro­ prudential tools. Finland, too, must ensure Helsinki, 21 May 2013 that the authorities tool kit contains the powers and means needed to intervene. Finland’s economy and households are vulnerable­ to housing market risks and in a concentrated­ Pentti Hakkarainen banking system the effects of the crisis would Deputy Governor, be serious for the entire economy. Bank of Finland

Summary Bank of Finland Bulletin 2 • 2013 5 Box 1. Debt accumulation and macroeconomic developments the biggest risk factors for the Finnish financial system

The state of the Finnish financial Finland based on the forecast in recent years. Relative housing system is illustrated by the GDP growth. Weakening prices continue to be higher than ‘financial stability map’ presented economic activity may put a strain in the long term on average, with in the ‘cobweb chart’ below, on the financial system, for the deviation staying within the which reviews the trends in example, by increasing loan losses. upper range of normal variation. relevant key indicators over the Expectations concerning growth The biggest domestic risk is past two years. In the chart, the in the real economy have declined related to debt accumulation, further the pentagon is from the steadily over the past two years. measured as the trend deviation origin, the gloomier the macroe- On the basis of the latest forecast, of the ratio of private-sector debt conomic outlook, the weaker the macroeconomic risks have become to GDP. The level of indebtedness banking sector’s risk-bearing higher than normal. has remained nearly the same capacity and the higher the The angles on the right side throughout the review period systemic risks. The grey zone of the map illustrate threats to and is quite considerable. portrays the two middle quarters financial stability piling up in the The two angles on the left of of the indicator’s previous Finnish housing and credit the map depict disruptions in values.1 markets. Housing prices relative to financial intermediation as well as The upper angle of the wage and salary earnings are used the banking sector’s state and risk- financial stability map illustrates as an indicator for the level of bearing capacity. Risk premia the macroeconomic situation in housing valuation. The long- reflect the availability and price of sustained uncertainty about the international market funding and 1 For details on the indicators and the evolution of the real economy has are measured by yield spreads technical design of the chart, see Kaukoranta, I. (2010) Rahoitusmarkki- also been reflected in the housing between AAA and BBB-rated noiden vakauden visualisointi (‘Visualising market, which is visible in the corporate bonds. Owing to market financial stability’), BoF Online 8/2010 (in Finnish only). levelling off of housing price trends disruptions, risk premia increased significantly in summer 2012, but Chart. have subsequently returned to Financial stability map for Finland their normal level. Macroeconomy According to the stress index constructed on the basis of banks’ share prices and profit & Banks’ Housing loss account and balance sheet current prices data, the risk-bearing capacity of viability the Finnish banking sector is on a sound footing, improving slightly during the review period.2

 2 Risk premia Indebtedness For details on the macroeconomy, financial intermediation, debt accumula- June 2011 June 2012 May 2013 tion and housing prices, see the chapter The outer values reect higher risks. ‘Operating environment’ and for the state Sources: NASDAQ OMX Helsinki, banks, of the Finnish banking sector, see the Statistics Finland and Bank of Finland. chapter ‘Banking and insurance sector’, both in this Bulletin.

6 Bank of Finland Bulletin 2 • 2013 Summary Operating environment

The international operating environment government finances amid growing is polarised. Financial markets have unemployment and contracting exports. stabilised, in part, which has been According to the Bank of Finland’s reflected in Europe as an easing of forecast released in March 2013, the funding for governments and banks and a EU20 countries will see their economies narrowing of risk premia. This has not, contract in 2013, with GDP reaching its however, been visible in the real economy; pre-crisis level only in 2015.1 The deteri­ instead, the gloomier economic outlook oration of the real economy in Europe has continued to erode the profitability of will also have a negative impact on the banking and intermediation of finance to Finnish economy, reducing future room the private sector. Weaker-than-expected for manoeuvre in government finances. performance in the real economy, a The dismal macroeconomic potential re-escalation of the debt crisis prospects have also been reflected in the and the low level of interest rates are key profitability of the European banking near-term risks for Finland, too. In sector. Growing unemployment and a Finland, non-financial corporations’ higher number of bankruptcies have access to finance is deteriorating and increased loan losses and non-perform- margins on small loans, in particular, have ing assets in crisis countries, in widened. Household debt accumulation particular. The low level of interest rates has persisted, which contributes to has also made it difficult to accumulate increasing the susceptibility of the interest income. In 2012, large economy as a whole to cyclical fluctua- European banks’ return on equity tions. Public-sector debt is also growing, (ROE) was very low. However, in the with a high dependence on international last twelve months, the risk-bearing sources of funding. 1 Bank of Finland Bulletin 1/2013.

In the first half of 2013, the partial Chart 1. stabilisation of the financial markets has been reflected in an improving CDS spreads on European government bonds market situation, growing risk appetite 1. Finland 2. Ireland 3. Italy and narrowing risk premia. This has 4. Portugal 5. Spain Percentage points provided easier access to funds for 16 banks and governments (Chart 1). During the debt crisis, Finland has been 12 one of the strong countries in terms of credit ratings and its financial system 8 has remained stable despite a difficult 4 4 operating environment. 5 3 2 1 Even so, the recovery of the 0 markets has not shown in the real 2008 2009 2010 2011 2012 2013 economy. Weak economic growth has Source: Bloomberg. cast gloom over the outlook for

Operating environment Bank of Finland Bulletin 2 • 2013 7 capacity of the European banking government bonds have not been system has improved, in response to the translated into marked increases in banks’ strengthening of their capital bank lending to non-financial corpora- positions. tions, because the debt crisis has had a Although the polarisation between downward impact on banks’ credit European peripheral and hard-core supply (Box 2). According to the latest countries has diminished to some extent euro area bank lending survey, however, in view of the availability and price of pressures for tightening the terms and financing, it still hampers bank funding. conditions for corporate loans in the On the one hand, the weakest European euro area have slightly abated (Chart banks are still dependent on central 2).2 This has been due, in particular, to bank refinancing. On the other hand, banks’ easier access to market funding the partial normalisation of financial and better liquidity. Despite an market functioning has encouraged improvement in the situation, the terms stronger banks to repay credits and conditions of bank funding for obtained from the Eurosystem. Until non-financial corporations are tighter now, euro area banks have repaid a than in recent years, and interest rate total of approximately EUR 280 billion, differentials between crisis countries ie just under 30%, of the amounts and other euro area countries have not borrowed in the ECB’s three-year narrowed. Wide margins and stricter longer-term refinancing operations. loan terms and conditions, especially in Nevertheless, easier access to corporate loans in crisis countries, funding and narrower CDS spreads on reflect higher risks and increasing loan losses. Demand for corporate loans is Chart 2. also weak owing to the paucity of investments and mergers and acquisi- Changes in new corporate loans and credit standards in the euro area tions. Loans are mainly used only for 1. Tightening of credit standards, SMEs, forecast for the following debt restructuring. In Finland, however, three months (left-hand scale) 2. Annual rate of growth* in the corporate loans of up to EUR 1 funding access has so far been better million (right-hand scale) than average.3 Net percentage % 60 45 The banks’ operating environment is changing fundamentally from the 40 30 years preceding the debt crisis, which makes it necessary for banks to adjust 20 15 their business models. More stringent 1 capital adequacy and liquidity require- 0 0 2 ments, regulation concerning bank

–20 –15 structures, low interest rates and 2005 2007 2009 2011 2013 2 European Central Bank (April 2013) Bank Lending * Calculated from the 12-month moving average of new corporate loans. Survey. Sources: European Central Bank and Bank of Finland calculations. 3 For more details on corporate finance, see the article by Pertti Pylkkönen and Eero Savolainen in this Bulletin.

8 Bank of Finland Bulletin 2 • 2013 Operating environment subdued economic activity pose a functioning of European financial challenge to the banks’ current markets would also contribute solutions as regards acquisition of negatively to funding for the Finnish financing, service provision and government and banking sector, since a business areas. To maintain and notable part of the funding is raised improve profitability probably means from international financial markets. enhancing cost efficiency and reducing Accordingly, from the viewpoint of balance sheets as well as abandoning stable developments in Europe, it is non-core activities and capital-intensive important to carry out the promised operations. At the same time, the banks’ adjustment measures and to ensure the capital positions are strengthened. implementation of actions aimed at reforming the structures of the banking Weaker-than-expected economic activity system. Restoring the viability of poses a challenge also to Finland weaker banks, balance sheet restructur- In spite of the stabilisation of the ing and winding up banks in poor situation, the prevailing market shape are also of utmost importance for sentiment is still vulnerable to bad re-building confidence. news, of which the uncertainty during According to the Bank of Finland’s the conclusion of the Cypriot support baseline forecast, the growth outlook package is a telling example. Positive for the Finnish economy is basically developments are overshadowed by the weak.4 Growth prospects are depressed, important challenges faced by in particular, by export performance, governments and the banking sector as which lags clearly behind world trade well as the negative feedback loop dynamics. Moreover, growth in capital between sovereigns and banks. investment and private consumption is Governments should prevent further predicted to be slow. debt accumulation and carry out the Weaker-than-expected developments agreed savings measures. Meanwhile, in the European real economy pose an their ability to support the failing important threat for Finland. A negative banking sector is limited. Doubts about shock to the economy would pass either party’s debt-servicing ability through to Finland via foreign trade, and could trigger a new negative spiral. fading exports would have an adverse A renewed escalation of the debt impact on the economy. This would cause crisis would mean weakening unemployment to increase faster than confidence towards European forecast, and a strong contraction in governments, deeper polarisation in the domestic consumer demand would financial markets and increasing costs impair the operating environment of for funding. In the worst-case scenario, domestic non-financial corporations, foreign investors’ withdrawal from reducing credit demand (Chart 3). At the Europe would have a negative impact same time, a stronger-than-foreseen on the overall availability and price of funding. A serious disruption in the 4 Bank of Finland Bulletin 5/2012.

Operating environment Bank of Finland Bulletin 2 • 2013 9 Chart 3.

Interaction between the macroeconomy and the banking sector

Bank balance sheet Macroeconomic Borrower balance sheet constraints slowdown constraints Growing unemployment Economic slowdown and lower asset quality and falls in asset prices lead to loan losses lead to lower collateral values

Capital constraints and Borrowers weakening ability to lend deleverage

Too risky to lend Unwilling to borrow

Adverse macro feedback Less demand for Less credit supply bank loans Tightening of Too costly credit standards to borrow

Less funding for investment

Sources: IMF and Bank of Finland.

deteri­oration in the position of domestic performance than anticipated. However, borrowers would translate into higher low interest rates, in combination with loan losses, waning profitability and abundant liquidity in the banking system reduced credit supply in the domestic and the economy, may give rise to banking sector. The negative spiral would overheating pressures on asset prices. be replenished by lower investment, Recently, in fact, capital has been which would have a detrimental effect on allocated to higher-yielding and riskier the conditions for economic growth. In investments, such as the stock market. addition, growing problems in the public Moreover, yields on certain corporate sector could, in turn, weaken Finland’s bonds and on government bonds credibility in the eyes of international perceived as being safe investments have investors, thereby increasing the govern- fallen to very low levels. But uncon- ment’s financing costs. trolled growth in risk-taking and abrupt corrections in interest rates and CDS Low interest rates entail new risks spreads may expose the stability of the Restoring the smooth operation of the financial sector to pernicious conse- financial markets, implementing quences in the future. corrective measures and prevailing low More positive economic interest rates underpin the economy and performance than anticipated would create conditions for better economic facilitate the management of the debt

10 Bank of Finland Bulletin 2 • 2013 Operating environment crisis, but is not totally void of risks. As 2013. Several companies have, in fact, the countries are initially in very adjusted their operations via rigorous different situations, economic growth spending cuts. This has maintained would be distributed unevenly. Particu- profitability, but worsened the larly countries experiencing rapid employment situation and possibly the growth would face the challenge of future earnings potential, too. curbing expanding debt accumulation In spite of deteriorating economic and increasing risk-taking. The danger trends, bankruptcies filed in the in the banking sector is that non-viable corporate sector as a whole have not banks are shored up over extended increased, but rather, in the first quarter periods of time. of 2013, the number of bankruptcies remained at the previous year’s level.5 Corporate profitability Nor has the Expected Default falling into decline Frequency of Finnish listed non-finan- The weakening cyclical outlook and cial corporations changed materially ongoing uncertainty in the financial (Chart 4). markets have also shaken the operating Corporate payment defaults have, environment of Finnish non-financial however, been on the increase, which – corporations in many ways. Investments in conjunction with weak economic are cautious, which is reflected in growth – may presage more loan losses subdued demand for long-term debt, for banks. There are signs of relaxation among other factors. The volume of in corporate payment discipline, loans granted by banks to non-financial 5 corporations has already remained Statistics Finland (2013) Bankruptcies. unchanged for almost one year. In addition, direct lending by pension Chart 4. insurance companies to non-financial corporations has contracted. Expected Default Frequency (EDF) of listed non-nancial corporations in Finland Corporate net sales have grown 1. Median slowly or even declined mildly in 2. 90th percentile several sectors. Simultaneously, business 3. Average % profitability is deteriorating and 10 corporate indebtedness is beginning to 8 grow. Still, despite stalling growth and weakening exports, the situation for 6 2 Finnish non-financial corporations has 4 so far remained reasonably good, but the situation is becoming more difficult 2 3 1 in terms of profitability and finance. 0 For example, the aggregate profita- 2000 2002 2004 2006 2008 2010 2012 bility of listed non-financial corpora- Source: Moody’s KMV. tions dropped off in the first quarter of

Operating environment Bank of Finland Bulletin 2 • 2013 11 Chart 5. involving extended times of payment of bills. This hampers cash management at Average interest rates on MFI corporate loans and small and medium-sized enterprises annual growth rate in Finland (SMEs), in particular, and increases 1. Average interest rate on corporate loan stock* (left-hand scale) 2. Average interest rate on new corporate loans* (left-hand scale) demand for working capital in a 3. Corporate loans, annual growth rate (right-hand scale) situation where access to finance is % % 10 30 tightening. The downcast situation in the 8 20 corporate sector is also mirrored by 6 10 corporate confidence indicators, which 1 3 4 0 are considerably lower than their 2 average long-term levels.6 Manufactur- 2 –10 ers’ order books are emptier than

0 –20 normal, and output expectations are 2004 2006 2008 2010 2012 cautious. Although manufacturing * Also includes housing corporations. Source: Bank of Finland. expectations concerning business and economic conditions have improved slightly in spring 2013, the cyclical situation in industry was still distinctly weaker than in the EU countries on Chart 6. average, according to comparative data from March. Finnish corporate sector’s interest-bearing debt structure The long-sustained uncertainty in 1. Loans from MFIs 5. Loans from other 2. Overseas loans public-sector entities the economy can also be seen in the fact (excl. direct investment) 6. Short-term debt securities that the annual number of new business 3. Loans from OFIs 7. Long-term debt securities 4. Loans from employee 8. Debt relative to GDP start-ups has already declined since pension companies (right-hand scale) 2010, while the number of businesses EUR billion % of annual GDP 140 70 closed down has increased.7 6 8 120 45 60 3 100 7 50 Bank lending margins going up and 80 40 availability tightening

60 2 30 The availability of bank funding for 40 1 20 non-financial corporations has 20 10 remained relatively good in Finland. 0 0 Even so, clear signs of difficulty in 2007 2008 2009 2010 2011 2012 accessing finance are discernible. Sources: Statistics Finland and Bank of Finland. Changes in banking regulation and the bank tax that entered into force at the

6 Confederation of Finnish Industries (EK, 2013) Confidence indicators. 7 Statistics Finland (2013) Enterprise openings and closures.

12 Bank of Finland Bulletin 2 • 2013 Operating environment beginning of the year have modified involving higher risks are assigned banks’ business models, and this has greater risk weights in the banks’ contributed to tightening the availabil- capital adequacy calculations, which ity of finance for non-financial corpora- increases borrowing costs for smaller tions. In the short term, regulatory enterprises. Regulation of small loans reforms may increase costs for banks, has been eased in so far as the bank’s but the regulatory changes are aimed at overall exposure to the enterprise promoting financial stability and remains below EUR 1.5 million and the preventing such widespread fallout for enterprise’s net sales are at most EUR the economy in the future as 50 million.10 experienced in previous financial crises. Financial market uncertainties and Interest rates on banks’ new regulatory changes have been reflected corporate loans are mainly tied to in the financing sources of Finnish non- short-term reference rates in Finland. financial corporations (Chart 6). Growth Despite falling market interest rates, the in the stock of loans granted by banks to fall in average interest rates on new non-financial corporations has already corporate loans has come to a halt, as been sluggish since summer 2012. banks have widened their lending Drawdowns of small corporate loans of margins (Chart 5). Growth in lending up to EUR 1 million have declined to margins has primarily focused on loans their lowest level since the onset of the granted to SMEs. Interest rate margins financial crisis. Larger companies, in on small corporate loans of up to EUR turn, have ensured their long-term 1 million have increased considerably financing needs by issuance of bonds. compared with larger loans.8 Like European corporate finance Debt accumulation by SMEs has markets, non-financial corporations in not increased to any significant extent.9 Finland have also sought to diversify Most SMEs are, however, vulnerable to their sources of funding. However, for weakening cyclical conditions, for Finnish non-financial corporations, the example, with regard to financing. With process of changing their financing demand petering out, smaller structures towards a more market- enterprises’ financing buffers are based approach is retarded by the rapidly depleted, causing their payment thinness of the domestic capital defaults and the resultant loan losses to markets, and SMEs, for example, barely increase. Consequently, lending to have the chance to accessing market- SMEs is typically assessed as including based funding. Another limitation for higher risks than lending to large bond issuance in international financial companies. Credits classified as markets by Finnish non-financial corporations is that few of them have 8 The availability and price of finance for SMEs is discussed in more detail in the article on SME finance credit ratings. in Finland in this Bulletin. 9 Federation of Finnish Enterprises, Finnvera (a specialised financing company owned by the State of 10 For more details on corporate finance, see the Finland) and the Ministry of Employment and the article by Pertti Pylkkönen and Eero Savolainen in Economy. PK-yritysbarometri (SME survey). this Bulletin.

Operating environment Bank of Finland Bulletin 2 • 2013 13 Chart 7. Household indebtedness increases the vulnerability of the economy

Household indebtedness and interest burden in Finland The global financial and debt crisis has led to more international attention 1. Housing-related loans*, % of disposable income (left-hand scale) 2. Other loans, % of disposable income (left-hand scale) being focused on risks that may be 3. Total loans, % of GDP (left-hand scale) caused or intensified by excessive 4. Total interest expenditure, % of disposable income (right-hand scale) lending and an unsustainable rise in % % 140 14 asset prices. Excessive lending for house 120 12 purchase and unbalanced movements in 2 100 10 the housing market, in particular, have 1 80 8 proved to be one of the main sources of 3 11 60 6 systemic risks in many countries. 40 4 Specifically exposed to these risks are 4 20 2 countries where the household sector is 0 0 heavily indebted, housing loans are 1986 1991 1996 2001 2006 2011 large in terms of the loan-to-value * Housing loans and households’ estimated share of housing corporation 12 loans. (LTV) ratio and bank balance sheets Sources: Statistics Finland and Bank of Finland calculations. include significant risk concentrations related to housing loans.13 In Finland, household indebtedness has increased considerably in the last 15 years, relative to both the size of the Chart 8. economy and the level of household income. At the end of 2012, household debt in loans amounted to a good EUR Households and their debt by debt ratio* in Finland 123 billion, which was approximately 1. Share of households (left-hand scale) 2. Share of total household debt (left-hand scale) 63% of GDP in the same year and 3. Average debt per household (right-hand scale) about 119% of annual household % EUR, thousands income available for consumption or 50 300 saving (Chart 7). 40 240 About 59% of Finnish households 3 30 180 have debts. Each tenth household (17% of indebted households) have debts 20 120 more than three times their disposable 2 10 60 monetary income (Chart 8). These 1 0 0 11 Systemic risks related to lending for house purchase 0% Over 0% Over 100% Over 200% Over 300% Over 400% Over 500% and measures to prevent them are discussed in more (no debt) and up to and up to and up to and up to and up to 100% 200% 300% 400% 500% detail in the chapter concerning financial system policy. * Horizontal axis: household debt, % of disposable monetary income in 2011. 12 The loan-to-value (LTV) ratio refers to the ratio of Sources: Statistics Finland and Bank of Finland calculations. a housing loan to the value of the residential property to be acquired by the loan and used as collateral for the loan. 13 Eg. European Central Bank (December 2012) Financial Stability Review, p. 38–39.

14 Bank of Finland Bulletin 2 • 2013 Operating environment households’ aggregate debt accounted economic growth began to erode labour for nearly half (48%) of total demand. In spring 2013, consumers’ household debt. Ten years ago, equally views of their own finances and expec- heavily indebted households with tations about Finland’s economic and respect to their incomes represented 4% employment prospects were more of all households (8% of indebted pessimistic than over the long term on households), accounting for a good average. quarter (26%) of total household debt. Higher indebtedness makes it more An ever larger share of household difficult for households to adapt to debt consists of loans granted for house negative economic surprises and other or leisure-time home purchase or changes in circumstances. This adds to renovation. Growth has been particu- the susceptibility of household larly strong in loans taken out by consumption and the whole economy household-owned housing corpora- to cyclical fluctuations and may more tions, which are included in the easily trigger large-scale debt-servicing household sector’s liabilities in the problems. financial accounts within the national accounts framework. These trends have New housing loans growing bigger significantly added to households’ In Finland, a significant share of new aggregate debt burden, and housing housing loans drawn down by first-time market developments have become home buyers in recent years have been increasingly important for Finnish considerably large relative to the value monetary financial institutions (MFIs) of the residential property acquired by and the economy as a whole. the loan. Sample surveys conducted in Risks related to household indebt- 2010 and 201214 revealed that, in more edness and debt-driven rise in housing than one in two purchases of first-time prices are in Finland linked with macro- housing, the LTV ratio for the new economic factors. These factors have so housing loan was higher than the 90% far maintained household credit LTV threshold recommended by the demand and debt-servicing ability. Financial Supervisory Authority Heavily indebted households in view of (FIN-FSA) (Chart 9). their incomes are, however, vulnerable The small amount of self-financing to rising interest rates, unemployment required by banks from house buyers and falling asset prices. As the bulk of and longer repayment periods in the household loans are linked to variable last 15 years may have contributed to rates, low Euribor rates in recent years increasing demand for housing loans have kept households’ interest payment that are large in view of household burden historically small. Favourable income and mortgage collateral. The employment performance following the average size of new housing loans has downturn in 2009 reduced risks to household incomes. However, in the 14 Sample surveys of personal customers’ housing loans conducted by the Finnish Financial Supervisory latter half of 2012, decelerating Authority in November 2010 and in May 2012.

Operating environment Bank of Finland Bulletin 2 • 2013 15 Chart 9. grown substantially in the last ten years.15 Meanwhile, the average Loan-to-value (LTV) ratio* of rst-time mortgages in outstanding amount of housing loan of Finland households with housing debt has 1. 2010 2. 2012 doubled from well over EUR 44,000 in % of number 2002 to a good EUR 89,000.16 60

50 1 2 Housing price developments 40 have stabilised 30 In the first quarter of 2013, real 20 housing prices, deflated by the 10 consumer price index, were on average

0 at the same level as a year earlier. With LTV ratio LTV ratio over 90% and LTV ratio regard to rents and wage and salary up to 90%** less than 100% at least 100% *Amount of loan, % property value. **FIN-FSA recommendation. earnings, housing prices have slightly Source: Sample surveys conducted by FIN-FSA in November 2010 and declined in the last twelve months May 2012. (Chart 10). Relative housing prices are, however, higher than in the long term on average.17 The rate of growth in the housing loan stock has gradually slowed in the Chart 10. last twelve months. In March 2013, the annual rate of growth in housing loans Relative housing prices in Finland granted by MFIs to Finnish households 1. In relation to rents was 5.0%, compared with 6.5% a year 2. Average* 3. In relation to wage and salary earnings earlier. Decelerating growth in the 4. Average* housing loan stock and recent Index, 1981/Q1 = 100 250 moderation in housing prices can be regarded as a favourable trend for 200 preventing potential excesses in the credit and housing markets, especially 150 1 2 in a situation where interest rates on 3 4 100 new housing loans are still historically low. 50 1981 1986 1991 1996 2001 2006 2011 15 Federation of Finnish Financial Services (2013) * Average of the review period. Säästäminen, luotonkäyttö ja maksutavat (‘Saving, Sources: Statistics Finland and Bank of Finland calculations. borrowing and paying’). 16 Statistics Finland’s statistics on indebtedness. 17 See also Lauri Kajanoja (2012) Asuntojen hinnat, kotitalouksien velka ja makrotalouden vakaus Suomessa. (‘Housing prices, household debt and macroeconomic stability in Finland’) BoF Online 2/2012.

16 Bank of Finland Bulletin 2 • 2013 Operating environment Public-sector indebtedness Chart 11. on the increase

Finnish GDP contracted mildly (–0.2%) Finnish government debt and debt maturities 2013–2017 in 2012. With economic growth being 1. Debt held by non-residents (left-hand scale) flat, the general government financial 2. Debt held by Finnish residents (left-hand scale) 3. Maturing debt (left-hand scale) balance remained in deficit for the 4. Government debt (right-hand scale) fourth year in succession. The EUR billion % of GDP 90 50 combined deficit of the general 2 75 45 government, ie the central government, 4 60 40 the local government and social security 1 funds, accounted for 2.3% of GDP in 45 35 2012. Last year, combined central and 30 30 15 25 local government debt increased by 3 EUR 10 billion, to EUR 103 billion, 0 20 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 which is 53% of GDP. Public-sector Sources: Statistics Finland and State Treasury. debt is estimated to continue growing in the immediate years ahead. Central government debt increased by a good EUR 4 billion in 2012, staying at approximately EUR 84 billion at the end of the year, which According to the 2013 Budget, the accounted for well over 43% of GDP. government’s gross borrowing require- The Finnish government’s net ments will remain at the level of the borrowing is based on long-term bonds, previous year, and EUR 18.5 billion and the amount of outstanding worth of new debt will be issued this short-term treasury bills has even year. By the end of May 2013, EUR 7.5 declined in the last two to three years. billion of the gross borrowing require- The average maturity of government ments were already fulfilled, ie 40% of debt has extended by a good one year the whole year’s borrowing require- in the last four years, being 5.8 years in ments. March 2013. The role of foreign investors in the Thanks to the best possible ratings, Finnish government bond market has government bond issues have been become strongly highlighted. At the end successfully launched. Interest rates on of 2012, non-resident investors held new debt have been at record low about 87% of Finnish government debt levels, and interest expenditure has (Chart 11). In view of the government’s remained small. The effective interest upcoming debt issues, it is key that rate on government debt was 2.1% at large international investors’ confidence the end of 2012. This interest rate has towards the Finnish economy and debt- decreased by 0.5 of a percentage point servicing ability remains in place. In a in the last two to three years. crisis situation, dependence on foreign

Operating environment Bank of Finland Bulletin 2 • 2013 17 Chart 12. debt, standing at well over EUR 12 Finnish local government* loan stock by lender billion at the end of 2012, which 1. Deposit banks 2. Other credit institutions accounted for 6.4% of GDP. The 3. Central government 4. Employee pension companies 5. Other financial deficit of the local government EUR billion was a good EUR 2 billion, ie slightly 12 5 4 more than 1% of GDP. The deficit 10 3 nearly doubled on the previous year. 8 Local government debt accumulation is 6 2 predicted to continue growing, with the 4 financial deficit relative to GDP 2 widening slightly at the same time. 1 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 The bulk of new local government * Also includes federations of municipalities. debt is currently obtained via Munici- Source: Statistics Finland. pality Finance, owned by the municipal- ities, the state and Keva, the local government pensions institution. Municipality Finance mainly taps the sources of funding could significantly international financial markets for impair the public sector’s access to financing, on nearly as advantageous finance or raise its price, which would terms and conditions as the Finnish also augment financing costs in the government. Lending by deposit banks private sector. to the local government began to As in the case of the central contract marginally in 2012. The local government, the financial balance of the government also borrows from pension local government also deteriorated in insurance companies, for example. In 2012. Local government debt increased addition, some largest cities have issued slightly faster than central government bonds (Chart 12).

18 Bank of Finland Bulletin 2 • 2013 Operating environment Box 2. The credit supply in the euro area

Since the beginning of the sharp contraction in banks’ financial crises exacerbate financial crisis the euro area’s credit supply, ie a credit crunch. cyclical downturns. Thus, banks’ operating environment As banks play an important determining the magnitude of has changed drastically. The role in mediating funds from changes in lending is of vital banks are confronted with sectors with surplus to those with importance as investments pressures such as declining profit- capital shortfall, changes in the ultimately support the economic ability, tighter capital require- credit supply conditions affect growth and output. In order to ments, disruption in banks’ firms’ capacity to obtain funding. constrain detrimental effects to access to funding and the This effect can be especially large the real economy several actions sovereign debt crisis (Chart A). in the euro area where debt such as bank recapitalizations The shocks influence banks’ markets are relatively small and a and non-standard monetary capital and liquidity positions large part of corporates’ external policy measures have been taken. and trigger banks to modify their financing is provided by banks, Looking at the development business models and balance especially so in the case of small of euro area monetary financial sheets by increasing core capital, and medium sized enterprises institutions’ (MFIs) lending to the adjusting the security portfolio (SMEs). Also, Bernanke and non-financial corporate sector and reducing the risk-weighted Bordo and Haubrich1 show that the annual growth rate has been assets. In the worst case scenario negative since June 2012, 1 Bernanke, B.S. (1983) Nonmonetary the ability of banks to provide Effects of the Financial Crisis in the standing at –2.4 percentage Propagation of the Great Depression. The credit to the non-financial private American Economic Review 73, 257–276. points in March 2013. The sector is negatively affected, Bordo, M.D. – Haubrich, J.G. (2010) contraction has been especially Credit crises, money and contractions: An evoking the idea of an excessively historical view. Journal of Monetary pronounced in the case of new Economics 57, 1–18.

Chart A. Pressures on euro area banks

Macroeconomic and nancial market conditions

Economic conditions Bank funding conditions New regulatory weaken deteriorate Sovereign crisis requirements

Asset pressure Funding pressure Impact on protability Capital pressure

Difculties to roll over Need to increase solvency Bank Asset quality and funding; competition on Increasing impairment losses rations in difcult market protability weaken deposits environment

Capital & liability measures... or...reduction in balance sheet

Cutback in credit supply

Sources: IMF and Bank of Finland.

Operating environment Bank of Finland Bulletin 2 • 2013 19 bank loans less than EUR 1 interest rate margins and restric- particularly strong for smaller million for which the downward tions on loan size. and more liquidity-constrained trend started already in 2008 Puri et al., Aiyar as well as German banks, while in Great 3 (Chart B). This seems worrisome Cihak and Brooks have also Britain foreign subsidiaries and from the viewpoint of SMEs as indicated that bank-specific branches reacted more to the they can be assumed to take factors influence the credit shock on external funding than relatively small loans. supply, as poorly-capitalized and UK-owned banks. Furthermore, Disentangling the impact of less-liquid banks decrease their it has been shown that the euro supply from demand is difficult lending more substantially than area banks’ loan supply responds as both contribute to loan their better-capitalized and negatively to a weakened growth. However, academic well-funded competitors. Banks soundness of banks, measured evidence regarding the latest that encountered either a capital with capital ratio or deposit to financial crisis suggests that the or funding shock during the crisis loans ratio. A cutback of the loan supply-side effects have rejected substantially more loan supply is also likely to have a dominated the demand factors. applications and reduced their negative impact on real economic After having controlled for domestic lending more than the activity in the euro area. demand factors Hempell and non-affected banks. In the case of Finally, using partial Kok Sörensen2 show that the the capital shock the results are adjustment model and supply side constraints by euro information on banks’ target area banks affect bank lending 3 Aiyar, S. (2011) How did the crisis in capital ratios, Maurin and international funding markets affect bank activity in the euro area 4 lending? Balance sheet evidence from the Toivanen examine how euro especially during the financial United Kingdom. Bank of England area banks’ capital targets impact Working Paper 424. Puri, M. – Rocholl, J. crisis. Banks have curtailed – Steffen, S. (2011) Global retail lending in on lending during the financial lending by applying both higher the aftermath of the US financial crises: Distinguishing between supply and crisis in 2005–2011. In the case demand effects. Journal of Financial of a capital shortfall a bank seeks 2 Hempell, H.S. – Kok Sörensen, C. (2010) Economics 100, 556–578. Cihak, M. – The Impact of supply constraints on bank Brooks, P.K. (2009) From subprime loans to close the capital gap in order lending in the Euro area. ECB Working to subprime growth? Evidence for the to reach its internal capital target, Paper 1262. Euro area. IMF Working Paper 69. influenced both by the regulatory Chart B. requirements and the bank’s MFIs’ lending to non-nancial corporations internal decision on capital (12-month moving average of the annual growth rate) buffers. Research shows that the 1. Loans up to EUR 1 million adjustment towards the targets 2. Loans over EUR 1 million exerts a negative impact on credit % 30 growth. In addition, there is also evidence on the pecking order, 20 2 with the impact being more 10 sizeable on security holdings than 1 0 on loans.

–10

–20 2005 2006 2007 2008 2009 2010 2011 2012 2013 4 Maurin, L. – Toivanen. M. (2012) Risk, capital buffer and bank lending: A 12-month moving average is calculated from the annual growth rate granular approach to the adjustment of of new loans. euro area banks. ECB Working Paper Sources: ECB and Bank of Finland calculations. 1499.

20 Bank of Finland Bulletin 2 • 2013 Operating environment Banking and insurance sector

The profitability of the Finnish banking opments in net interest income. sector improved in 2012 despite the Meanwhile, the possibilities for smaller difficult operating environment, but there banks to generate income from other are large differences across banks. Capital activities than basic banking were adequacy of the banking sector has limited, which was reflected as weaker remained solid. Availability of necessary income developments by such banks. market-based funding for the banking The largest income item for the sector has remained good and its price has banking sector, net interest income, remained affordable. However, sluggish contracted due to the low market economic growth and the low level of interest rates. The overall margin, or the interest rates pose a challenge to banks’ differential between the loan and profitability over the next few years. deposit interest rates, which has a Bleak economic prospects increase the major impact on the net interest uncertainty related to banks’ credit risks. income, decreased throughout 2012 as Based on stress tests, the risk-bearing loan interest rates declined more than capacity of the banking sector is sufficient deposit interest rates. The average to withstand even a considerable overall margin of 1.52 percentage weakening in profitability. The low level points was 0.2 percentage points lower of interest rates poses a challenge to than a year ago. insurance companies’ investment activities Banks reacted to the decrease in and undermines their profitability and the overall margin by such measures as solvency. increasing the interest rate margins on new loans. For example, the imputed Profitability of the banking interest rate margin on new housing sector has improved, differences shown across banks Chart 13. The profitability of the Finnish banking sector improved in 2012 (Chart 13). Factors underlying changes in Finnish banking The aggregated operating profit of the performance EUR m banking sector increased mainly on the 3,000 381 –63 –83 2,562 back of positive developments in net 2,302 10 2,500 income from trading and investment 137 –122 2,000 activities. Net income from insurance activities also improved on last year. In 1,500 contrast, the core income items of basic 1,000 banking activities, namely net interest 500 income and net fees and commissions, 0 showed a decrease. Operating Net income Net income Other Net interest Expenses Net Operating pro t from trading from income income impairment pro t There were considerable 2011 and investment insurance losses 2012 activities activities differences in banks’ profitability. The diverse income structure of the largest Source: Financial Supervisory Authority. banks partly offsets the sluggish devel-

Banking and insurance sector Bank of Finland Bulletin 2 • 2013 21 loans has risen constantly since spring The amount of net fees and 2011. The average margin has doubled commissions remained unchanged. from those troughs, to stand at 1.54 While investment-related fees percentage points in March 2013. contracted, the commissions on However, the impact of higher margins payment transmission and lending is reflected in the average interest rates increased. on the entire loan stock after a consid- The number of personnel within erable delay reflecting the renewal of banking groups operating in Finland the loan stock. decreased by 3% in 2012,2 but the From the perspective of trading administrative expenses (including and investment activities, the operating personnel expenses) remained environment was favourable in 2012. unchanged. Total expenses showed a Net income from these activities grew moderate increase of 2% on the 36% on the previous year. Trading and previous year. investment activities were highly Banks’ net impairment losses on concentrated on the three largest loans increased by EUR 105 million in banking groups, which accounted for 2012. Impairments totalled EUR 355 95% of the net income from these million (less than 0.15% of banks’ activities.1 stock of loans and guarantees). The profitability of the Finnish 1 In 2012, the three largest banking groups (Nordea banking sector improved as measured Bank Finland, OP-Pohjola Group and Danske Bank) accounted for 93% of the aggregated operating profit by the return on equity, already for the and balance sheet of the Finnish banking sector. third consecutive year (Chart 14). In 2012, the return on equity amounted to Chart 14. 8.5%. Profitability can be considered satisfactory in the least, taking into Protability and capital adequacy of Finnish deposit banks account the exceptionally difficult 1. Return on equity (ROE)* operating environment of the past few 2. Capital adequacy ratio 3. Common Equity Tier 1 ratio (CET1) years with the low interest rate level 4. Equity ratio (equity to balance sheet ratio) undermining the net interest income % 20 and the sluggish economic activity 2 16 decreasing the demand for banking 3 services. 12 1 Outlook 8 4 The operating environment is expected 4 to remain challenging in the next few 0 years. Macroeconomic forecasts point 2006 2007 2008 2009 2010 2011 2012 to slow economic growth both in * Returns in 2006–2007 are affected by certain reorganisation measures in the banking sector. Source: Financial Supervisory Authority. 2 Federation of Finnish Financial Services. Pankkikon- sernien henkilöstö ja konttorit (Personnel and branch offices of banking groups).

22 Bank of Finland Bulletin 2 • 2013 Banking and insurance sector Finland and in Finland’s most At the end of 2012, the capital important export markets. Interest rate ratio derived from the highest-quality expectations based on market own funds, the Common Equity Tier 1,4 information suggest that market interest stood at 15.5%. The proportion of rates rise slightly but remain at much these funds out of all own funds suppressed levels. Protracted low decreased somewhat. Nevertheless, the interest rates constitute a key risk for proportion of high-quality own funds the profitability of basic banking remained high relative to all own funds. activities. The loss buffer of the banking sector The net interest income is expected exceeding the regulatory capital to begin to grow gradually once the requirement for own funds stood at higher interest rate margins on new EUR 10.4 billion, compared to EUR 9.1 loans start to have a stronger impact on billion a year earlier. the average interest rates on the loan The risk-weighted capital ratios stock. This is already the case in are complemented by capital adequacy corporate loans, which typically have measures based on non-risk weighted shorter maturities than housing loans assets, such as the equity ratio.5 The and whose interest rates are also more protracted decrease in the equity ratio readily revisable. of the Finnish banking sector came to a The risk-bearing capacity of the halt in 2012 when the aggregated Finnish banking sector has been balance sheet for the sector contracted. assessed over recent years in many Nevertheless, the equity ratio of the stress tests. Based on the tests, the loss Finnish banking sector as measured by buffers of the banking sector would this indicator continues to be weaker withstand even a considerable deterio- than in EU member states on average. ration in profitability under difficult This partly reflects internal arrange- operating circumstances. ments within Nordic banking groups which have expanded the banking Capital adequacy remains good sector’s balance sheet in Finland. The capital adequacy ratio for the banking sector at end-2012 stood at Funding and liquidity 17.0%, compared to 14.2% a year Deposits continue to be the most earlier. While the own funds of the important source of funding for the banking sector decreased 6%, the risk- banking sector. In 2012, deposits grew weighted assets and consequently also faster than loans, and the ratio of loans the regulatory capital requirements to deposits continued to shrink. In decreased considerably more.3 Furthermore, increased use of subordi- 4 CET1 is the capital ratio for unrestricted primary own funds, consisting of equity capital and retained nated loans counted as own funds earnings. 5 In this context, equity ratio refers to the ratio of improved the capital ratios. equity to the balance sheet total. This ratio differs from the definition of minimum equity ratio under 3 This was affected by Nordea Group’s internal Basel III regulations for example in terms of the guarantee arrangements. treatment of derivatives.

Banking and insurance sector Bank of Finland Bulletin 2 • 2013 23 Chart 15. credit ratings. In particular, the risk premia on covered bonds and certifi- Funding gap of Finnish banking sector cates of deposit have been small. Risk 1. Loans to the public 2. Deposits from the public 3. Funding gap premia on senior bonds have contracted EUR bn year-on-year even more than the above- 200 1 mentioned securities. 160 At the end of 2012, the stock of 2 120 bonds issued by banks stood at EUR 44.5 bn. Certificates of deposit and other 80 market-based funding amounted to EUR 3 40 36.1 billion. The amount of short-term debt securities decreased in 2012. 0 2007 2008 2009 2010 2011 2012 2013 The banking sector held more cash

The counterparties of loans to the public and deposits from the public are and debt securities eligible for others than nancial institutions. Source: Bank of Finland. refinancing with central banks as well as cash assets. Apparently banks were preparing for the requirements of future liquidity regulations by increasing their 2012, the ratio stood at 135%, which liquidity buffers. largely corresponds to the EU average. The proportion of central bank Covered bonds liquidity in Finnish banks’ funding is The significance of covered bonds as a minor. The amount of central bank source of funding for banks has been funding obtained by the Bank of highlighted during the crisis. The availa- Finland’s counterparties has remained bility of funding obtained with covered practically unchanged since spring 2012 bonds has been good and the price has at EUR 3.6 billion. been affordable for Finnish issuers. The Finnish banking sector is char- Hence, the stock of covered bonds has acterised by a dependence on market- grown rapidly in recent years in Finland. based funding mainly from abroad. At the end of 2011, the stock of covered Banks must cover the difference bonds was almost EUR 25.2 billion between loans and deposits vis-à-vis the (Chart 16). This accounted for 56% of public, or the funding gap, with market- banks’ long-term debt securities. based funding. The funding gap has Due to the growth in covered stood at about EUR 45 billion (Chart bonds, an increased proportion of 15). banks’ assets is encumbered as Thanks to the stable market collateral for the assets of a single conditions, banks were able to issue debtor group.6 However, the debt securities with both short and long encumbrance of banking sector’s assets maturities. The demand for safe-haven investments has also facilitated the 6 Covered bonds are also addressed in the Bank of Finland’s Financial Stability Report for 2012, Bank of funding of banks in countries with high Finland Bulletin 2/2012.

24 Bank of Finland Bulletin 2 • 2013 Banking and insurance sector Chart 16. due to covered bonds is slightly lower in Finland than in the EU on average.7 Finnish banks’ covered bonds In comparison to Finland, the signifi- 1. Stock 2. Issued cance of covered bonds is clearly higher EUR bn 28 particularly in Denmark but also in 1 other Nordic countries. 24 In Finland, slightly more than 40% 20 of housing loans are encumbered as 16 12 collateral for covered bonds. Hence, the 2 lack of available collateral would not 8 prevent an increase in the amount of 4 0 covered bonds outstanding, but in order 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013* to maintain a diverse financial * 2013 to end-April and January-April issue. Sources: Bank of Finland, European Covered Bonds Council and structure, banks should also issue non- Bloomberg. collateralised debt securities. In the event of the issuer’s insolvency, the position of the holders of this type of senior and junior bonds becomes corre- by increased use of cheaper collateral- spondingly weaker as an increasing ised market funding. Pressures are proportion of the issuer’s assets is used mounting on increasing margins as collateral for covered bonds. The particularly on loans that involve high required return on non-collateralised risk and therefore bind a lot of capital. bonds may rise very high if the In order to meet the requirement proportion of covered bonds in the of stable funding, banks must obtain issuers’ balance sheet is considered too more long-term funding. This increases high by the investors. Some countries the demand and price of long-term have adopted binding regulations on funding relative to short-term funding. the maximum amount of covered The increasing price of long-term bonds. funding emphasises the significance of covered bonds as a less costly source of Changes in business models funding than non-collateralised loans. Basel III regulations require banks more The risk premia on senior bonds own funds relative to their risk- increase due to the risk related to weighted assets than previously. In private sector involvement. addition, banks are required to have The increasing pressures on higher liquidity buffers and longer term margins on long-term lending funding. Therefore banks have sought contribute to an increase in the use of to improve their profitability among sources of funding other than banks. other things by increasing their loan Part of corporate credit risk has already margins, containing cost increases and shifted from banks’ balance sheets to investors as banks have arranged bond 7 Based on European Covered Bond Fact Book and Bank of Finland calculations. issues in lieu of granting loans.

Banking and insurance sector Bank of Finland Bulletin 2 • 2013 25 The future liquidity coverage ratio very risky loans should be clearly more requirement obliges banks to hold a expensive than presently. However, higher amount than previously in high- banks’ pricing reflects, in addition to quality liquid assets, such as the interest margin, also other income government bonds, to secure their derived from the customer relationship. short-term liquidity. Hence, liquidity The risk weights of assets tend to buffers become larger than previously decrease when a bank migrates from the but they also have higher quality and standard loan-risk calculation method to therefore lower returns. an internal ratings based approach in its The regulation changes above have capital adequacy calculation. The an unavoidable impact on banks’ adoption of advanced internal methods business models. A bank may reduce may reduce risk weights further. For lending, or allocate it to objects example, the risk-weighted assets of requiring less capital or entirely out of large Nordic banks have decreased their balance sheets. In addition, banks considerably following these measures. are streamlining their operations and re-pricing banking services. Business Signs of increase in credit risks models may have even significant In Finland, the number of bankruptcies differences across banks. and banks’ non-performing loans8, Banks have begun to focus more which can be used as leading indicators on the management of their risk- for future credit risks, have remained at weighted assets. Lending decisions the same level in recent years where highlight the amount of own capital they rose following the recession of tied. According to credit pricing models, 2009 (Chart 17). The materialisation of credit risks is linked to developments in Chart 17. the domestic and international operating environment. In light of the Bankruptcies, non-performing assets and net impairment losses in Finland foreseen economic development of the 1. Corporate bankruptcies €led, 12-month moving total (left-hand scale) next few years, credit risks involve high 2. Banks’ non-performing assets (right-hand scale) uncertainty. The bleak economic 3. Banks’ net impairment losses, 12-month moving total (right-hand scale) prospects increase the probability of Number, 1,000 EUR bn 7 7 credit losses, but at the same time the 6 6 low level of interest rates continues to 5 5 support households’ and companies’ 4 4 3 3 debt-servicing capability. 1 2 2 At the end of 2012, lending and 1 2 1 guarantees at home and abroad by 3 0 0 banks operating in Finland amounted –1 –1 to about EUR 244 billion. About 45% 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Sources: Statistics Finland, Financial Supervisory Authority and Bank of Finland calculations. 8 Assets fallen due and unpaid at least for 90 days after the maturity date, including guarantee receivables and zero-interest assets outside the group.

26 Bank of Finland Bulletin 2 • 2013 Banking and insurance sector Chart 18. of this was granted to domestic households and 27% to domestic non- Finnish banks’ net impairment losses by sector financial corporations and housing 1. 2008 2. 2009 3. 2010 4. 2011 5. 2012 corporations. Looking at different EUR m industries, loans (incl. guarantees) were 500 2 400 concentrated on manufacturing and 3 real estate companies (incl. housing 300 9 45 corporations). Hence, the credit risks 200 1 of banks operating in Finland are 100 highly dependent on the debt-servicing 0 capacity and collateral of industrial companies and households, ie closely –100 Companies Households Other Foreign Collectively and housing domestic sectors assessed* linked to developments in the exports corporations sectors and housing markets. * Other than individually assessed impairment losses, total for all sectors. At the end of 2012, the stock of Source: Financial Supervisory Authority. loans and guarantees stood at about EUR 10 billion (4%) higher than a year earlier. A majority of the growth million) were higher than the total net stemmed from loans granted to impairment losses, since banks recorded households, the real estate industry and net recoveries of about 24 million on abroad. The stock of loans granted to collectively assessed impairment losses, other domestic business activities that is, other impairment losses than remained at last year’s level. Lending to those allocated to individual contracts. domestic manufacturing companies The growth in collectively assessed contracted by EUR 1 billion (8%) from net impairment losses was due to losses the end of 2011. incurred on loans granted to domestic non-financial corporations and abroad Net impairment losses increased (Chart 18). The most losses were In 2012, Finnish banks’10 net recorded on corporate loans, but the impairment losses on loans and other amount remained clearly lower than in assets amounted to about EUR 331 2008 and 2009. million, about a third more than in the previous year. Relative to the stock of Non-performing loans loans and guarantees, net impairment almost unchanged losses remained very low, under 0.15%. At the end of February 2013, Finnish Net impairment losses on assets banks’ non-performing loans stood at individually assessed (about EUR 385 about EUR 1.3 billion. The amount was about 5% lower than a year earlier but 9 FIN-FSA statistics on lending by Finnish deposit roughly the same magnitude as in recent bank group and amalgamations and branches of foreign credit institutions engaging in deposit banking years on average. The proportion of non- in Finland. performing loans in the stock of loans 10 Excluding Finnish branches of foreign credit insti- tutions. and guarantees remained at a good 0.5%.

Banking and insurance sector Bank of Finland Bulletin 2 • 2013 27 Chart 19. industries, the highest proportion of Finnish banks’ non-performing assets in respect of non-performing loans were in the households and certain industries sawmill industry. 1. Accommodation and food service 2. Construction Non-performing assets related to 3. Manufacturing 4. Households 5. Wholesale and retail trade 6. Transportation and storage household loans increased in 2012 by 7. Information and communication 8. Real estate activities about 7%, but their proportion in the % of the lending and guarantee stock of the relevant sector or industry 3.0 total stock of loans to households remained low at about 0.6%. The use 2.5 of flexible loan servicing options related 2.0 1 to loan payback has increased slightly 1.5 6 11 2 during the past year. 1.0 4 5 3 0.5 Systemic risks 8 7 0.0 The ongoing crisis has shown how fast 2009 2010 2011 2012 and widely systemic risks emerging and Sources: Financial Supervisory Authority and Bank of Finland calculations. intensifying in the financial system may spread from a financial institution and country to another. Systemic risks refer Chart 20. to risks resulting from interdependen- Stress index for the Finnish banking sector cies in the operating environment and

12 between banks, to which banks are exposed simultaneously and which, if 9 they materialise, may affect the entire 6 financial system and economy. 3 According to a stress index 0  calculated for the Finnish banking

–3 sector, the ability of the banking sector

–6 to withstand systemic risks improved 1988 90 92 94 96 98 2000 02 04 06 08 10 12 during 2012 and early 2013 (Chart 20). * Estimate 2013/Q1. Sources: NASDAQ OMX Helsinki, banks, Statistics Finland and The stress index has been derived from Bank of Finland. information on bank equity prices, interbank deposits, banks’ profitability, equity and credit losses. The higher the Looking at different industries, the stress index score, the higher is the proportion of non-performing loans perceived stress level of the banking remained the highest in the cyclical system. industries of accommodation and food After 2011, the risk-bearing service and construction (Chart 19). capacity of the Finnish banking sector However, these industries account for a according to the stress index has very small proportion of banks’ stock improved mainly on the back of of loans and guarantees, fewer than 2% 11 Federation of Finnish Financial Services (2013) in total. Among the manufacturing sub- Banking Barometer I/2013.

28 Bank of Finland Bulletin 2 • 2013 Banking and insurance sector Chart 21. favourable performance of banking stock prices and stable developments in Finnish banks’ distance to default indicator interbank deposits and certificates of 1 January – 31 March 2013 deposit. Distance to default The general state of the Finnish 7 banking sector can also be described by 6 an indicator (distances to default) 5 estimating bank insolvency calculated 4 on the basis of bank equity prices and 3 balance sheets. According to this 2 indicator, the state of the Finnish 1 banking sector began to improve in 0 summer 2012. In spring 2013, the state 1988 90 92 94 96 98 2000 02 04 06 08 10 12 of the banking sector in light of this Sources: NASDAQ OMX Helsinki, banks and Bank of Finland. indicator was slightly better than in the review period on average (Chart 21).

Contagion risks 274 billion of foreign assets.13 The The Finnish banking sector has certain proportion of foreign asset in the distinguishing characteristics which balance sheet of the entire credit make it vulnerable to the impacts of institution sector is a rough indicator of negative shocks from abroad. The the vulnerability of credit institutions to banking sector is dependent on market foreign contagion risks. In Finland, the funding obtained principally from proportion is relatively high, almost abroad. In addition, the banking sector half of the balance sheet. A majority of is highly concentrated, and two of the these assets are in other Nordic three large banks are foreign-owned. countries and Great Britain, which is a These foreign-owned banks – and major marketplace. Excluding therefore the entire banking sector – are derivatives and intra-group items, the vulnerable to potential difficulties in proportion of foreign assets is clearly their foreign parent banks. Hence, lower, less than a third. financial stability analysis on the Finnish credit institutions’ Finnish banking sector must pay government bond assets are concen- attention to other Nordic banking trated in countries with high credit groups in addition to the domestic ratings. Direct linkages to countries in banks.12 the core of the euro area debt crisis are At the end of 2012, Finnish credit minor overall. Furthermore, the amount institutions held a total of about EUR of payment transfers with banks

13 Bank of Finland’s balance of payment statistics. The figures include direct investments, securities-based 12 The special characteristics of the Finnish banking investments (equities, bonds and money-market sector are also addressed in the article by Jukka paper), other investments (including loans and Vauhkonen and Hanna Westman in this Bulletin. deposits) and derivatives.

Banking and insurance sector Bank of Finland Bulletin 2 • 2013 29 operating in the debt crisis countries interest rates have the largest impact on has been small, and the value of life insurance companies’ activities. payments has decreased considerably New life insurance products offered by during the crisis. However, problems them are primarily unit-linked. The could be channelled through other solvency margin of life insurance countries in the payment chains.14 companies increased in 2012 by about EUR 1.3 billion to EUR 5.7 billion. Insurance companies’ Their solvency position, or solvency solvency improved margin relative to the statutory Despite the uncertain operating minimum solvency margin, was over environment, the results and capital five-fold. Also the risk-based solvency adequacy of Finnish insurance position improved (Chart 22). companies improved in 2012. Thanks Solid results also supported to the solid investment returns towards non-life insurance companies’ solvency the end of the year, insurance margin growth and risk-bearing companies’ solvency margin increased. capacity, which had been reduced in This supported their solvency, which is 2011 due to a deterioration in the at a good level on average.15 claims ratio. The risk-based solvency Changes in the operating margin also improved somewhat. environment and the low level of The average returns of employment pension companies’ 14 Finnish banks’ payment traffic with foreign banks investment activities at fair values is discussed in more detail in the article “Payment transfers measure the pulse of the financial markets” increased in 2012 due to the equity in this Bulletin. 15 Financial Supervisory Authority (2013) Financial price rally towards the end of 2012 and position and risks of supervised entities 1/2013. the favourable development of the fixed

Chart 22. income markets. The average return on capital employed in investment Finnish life insurers’ solvency capital activities for the entire year was 8.2%.

1. Capital and reserves (left-hand scale) The amount of solvency margin 2. Subordinated loans (left-hand scale) improved materially on the back of 3. Solvency margin (left-hand scale) 4. Solvency, % (right-hand scale) solid investment returns, and EUR bn % employment pension insurance 10 25 companies’ solvency improved to stand 8 20 on average at a high level. The 4 3 6 15 proportion of equity investments increased and fixed-income allocation 4 10 2 in corporate bonds increased. The 2 5 companies’ average risk-based solvency 1 0 0 position remained unchanged. 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Financial Supervisory Authority.

30 Bank of Finland Bulletin 2 • 2013 Banking and insurance sector Low level of interest rates shown in higher annual variation of undermines the returns of insurance companies’ investment activities investment returns. The investments of insurance Year 2012 was a bipolar one from the companies is characterised by a high perspective of insurance companies’ fixed-income weighting. At the end of investment activities. ECB’s activities at 2012, almost 70% of non-life insurance the end of the summer pacified the companies’ investments were allocated operating environment of the financial in different fixed-income investments. markets, and the returns of investment As regards life insurance companies, the activities for the entire year were good corresponding proportion of fixed- despite the economic uncertainties. At income was a good 60%. The relative the end of 2012, Finnish insurance proportions of the different asset classes companies’ combined investments remained relatively stable in 2012. amounted to EUR 187 billion, with Equities accounted on average for employment pension insurance about a fifth of the investments, and for companies and other employment life insurance companies, the insurance companies accounting for proportion was slightly higher than for 80%, life insurance companies for 13% non-life insurance companies. Within and non-life insurance companies for the asset classes, allocations may vary 7%. The investments were just barely significantly; for example the weight of smaller than Finland’s GDP. Although domestic equities in the equity portfolio investments are made increasingly may vary considerably. beyond domestic and euro area borders, Fixed-income investments insurance institutions are still the most generated a solid return in 2012 due to important domestic investor group. the decline of long-term interest rates The allocations of the investment and reduction in risk premia. However, assets of domestic insurance institutions the return potential of fixed-income is show material variations. Pension insti- limited going forward, and therefore tutions’ investment allocation is signifi- most pension institutions have allocated cantly influenced by the fact that public an increasing proportion of their sector pension institutions, the State investments in the equity markets. Pension Fund and KEVA (local The rise in equity prices has also government pension institution) are contributed to the increase in the equity so-called buffer funds whose investment weight. activities are not subject to similar A key macro risk for the solvency requirements as private sector investment activities of insurance pension companies, pension funds or companies is a weaker-than-expected foundations. Indeed, equity investments development of the real economy and a have a clearly higher weight in the protracted low level of interest rates. A public-sector pension institution’s protracted low level of interest rates investment allocations compared to could contribute to the fragility of the other pension institutions, which is entire financial system, if investors’

Banking and insurance sector Bank of Finland Bulletin 2 • 2013 31 return-seeking behaviour would potential of the investment markets has increase in an unfavourable manner decreased, which creates pressures to than return requirements would not change employment pension companies’ adapt to the long-term economic cycles. investment policies to a riskier direction At present, almost half of Finnish life with return requirements remaining insurance companies’ technical reserves unchanged. The equity weight in the consists of unit-linked insurance assets. portfolios has increased somewhat on The growth of these products reduces average, and employment pension the exposure of life insurance companies’ risk-based solvency has companies to the risks posed by the remained unchanged. If equity risk was protracted low level of interest rates to to increase, employment pension both their profitability and solvency. companies’ risk-based solvency would The return requirement of the become increasingly exposed to sudden funded technical reserves of price changes in the equity markets. employment pension insurance The Finnish insurance markets are companies is 3%. If the return potential characterised by heavy concentration. of fixed-income investments weakens, it In both pension, life and non-life will be challenging to reach the required insurance, the combined market share guaranteed returns with fixed-income of the three largest companies as investments as the old fixed-income measured by premiums written is about investments with good returns mature. 80%. Another special characteristic of Hence, employment pension insurance the Finnish insurance market is the high companies have increased their equity proportion of statutory insurance in the investments, and in fixed-income markets. The employment pension investments, the focus has shifted to system as well as statutory accident and corporate bonds. traffic insurance account for about two Employment pension companies’ thirds of the total premiums written of solvency margins have increased, the entire insurance industry. The solvency has improved, and their risk- statutory status contributes to the bearing capacity can be considered stability of income developments and relatively good. However, the return profitability of the insurance sector.

32 Bank of Finland Bulletin 2 • 2013 Banking and insurance sector Financial market infrastructure

Operations of the financial market infra- changes. Short-sighted pursuit of profits structure – ie payment and settlement may lead to a situation where market systems – have been mainly reliable. Even participants are unwilling to invest in though the transfer of retail payments payment and settlement systems continues to experience frequent important for Finnish companies and disruptions, the disruptions have not consumers. Large market participants posed a threat to payment transmission as have access to international infrastruc- a whole. The biggest threats to the tures, but many smaller operators functioning and development of payment knock on doors in vain because of their and settlement systems relate to the imple- insufficient business volumes and mentation and consequences of change. earnings potential. These market partic- Changes in the securities markets, in ipants have only two options: they can particular, have an impact on all the either shut down operations or become market participants. a customer of a larger entity, ie an indirect participant. Their options are Financial integration and competition, however rather limited if they have to as well as the opportunities provided purchase a basic service, for example and the large investments necessitated participation in securities clearing and by technology require adjustment and a settlement from a larger competitor. strategic approach from market partici- The Finnish financial markets already pants operating in Finland. The have a very high degree of concentra- solutions are restricted by heavy cost tion. A continued concentration trend pressures. Operations are enhanced in market structures may lead to a usually by splitting up processes. In this situation in which service providers case, there is a risk that cost minimisa- choose their customers, and not vice tion in individual parts of the process versa. These types of markets have a transfer the risks and cost pressures to low degree of competition. the following stages of the process. The immediate years ahead are Also, cost minimisation in these later crucial as Euroclear Finland, the stages increases the propensity to Finnish central securities depository disruptions, and none of the partici- (CSD), is investing in a new system and pants controls the entire process or joining the European platform takes responsibility for its operation. TARGET2-Securities (T2S). The project IT systems also require investments in will succeed and generate benefits for maintenance to ensure that companies domestic securities markets only if all are not trapped by outdated technology. the participants – both the CSD and its Disruptions in retail payment systems current and potential customers – see have been largely due to this kind of the strategic dimension of the project. enhancement of operational efficiency Moreover, the Finnish securities to extreme. markets must become deeper and more Another, longer-term risk relates to competitive to support the intermedia- the way market participants adjust to tion of finance, particularly to non-

Financial market infrastructure Bank of Finland Bulletin 2 • 2013 33 financial corporations.1 Without incidents. Possible incidents and service payment, clearing and settlement interruptions in card payments have an systems that function smoothly, it is immediate impact on consumers’ impossible to develop the markets. The everyday life, and if they are protracted, development of securities markets also they will hamper the conduct of daily requires the support of financial market business in the entire society. It is thus regulators and supervisors. justifiable to say that card payments are a critical function for the economy. The Retail payment systems reliable and smooth processing of card Banks operating in Finland have payments must be ensured with clarified the governance of domestic adequate continuity arrangements. payments in Finland and looked into The structure of the card payments the risks involved in the payment infrastructure has changed in recent process, as required by the Bank of years. Both the issuance of payment Finland in its oversight assessment of cards and the acquirer services have the special features of the Finnish become bank-specific, and various types payment system. Banks must also in of service providers have been created future analyse the incidents identified in between the merchants and the bank, payment transfers and find solutions to and processes are being increasingly the incidents. Banks are also required to outsourced. The reliability of payments have functioning continuity arrange- depends on the cooperation between all ments in the event that the normal these participants. The key entities in payment system is not available. the card payments process, ie card The actual payment system, issuers and acquirers, have to ensure STEP2, has functioned reliably. Errors that the interfaces of the areas of and delays in payment transfers have responsibility, service level agreements, been caused by the internal processes of communication responsibilities, and Finnish banks. Disruptions in the risk management of the entire payments process of individual banks will value chain have been arranged. however have a major impact also on Efficient risk management requires also other banks’ customers if the bank that cooperation with the commercial sector is suffering from the incident is unable and its service providers. to execute the payments. Minimisation The Finnish payments market is of the incidents is therefore crucial. The increasingly interconnected with the incidents also have to be communicated international infrastructure. In 2012, appropriately. the Danish-Norwegian company Nets Card payments have already for a acquired Luottokunta, a leading card number of years been the most common payment company in Finland, and the form of retail payment in Finland, and two organisations are in the process of they have not experienced any major being merged. The rationale behind the merger is to achieve economies of scale. 1 See the section ‘Operating environment’. The new Nets can select from the two

34 Bank of Finland Bulletin 2 • 2013 Financial market infrastructure companies most efficient systems and for the safety of the interfaces of procedures. The level of service in the traditional banks and new service domestic markets, the maintaining of providers facilitate also the launch and staff competence, as well as business development of activities by new service continuity in disruptions must be providers and promote pan-European ensured. competition, for the benefit of service Online shopping is growing users. rapidly. Currently credit cards (CNP, In the development of payment Card-Not-Present payments) account services, their availability for all user for the majority of internet payments. groups must be ensured. As many as half of the card fraud incidents are CNP fraud. In 2010, CNP T2S fraud in the EU increased to EUR 648 TARGET2-Securities (T2S) is the million.2 securities settlement platform provided EU area central banks and banking by euro area central banks. The supervisors have published, via the new majority of EU area CSDs – incl. forum SecuRe Pay, recommendations Euroclear Finland – are committed to it. for improving the security of internet Migration to T2S will take place in payments.3 Other authorities and waves, in 2015–2017. Finland will join market participants were consulted T2S in February 2017. during the drafting of the recommenda- The T2S platform’s potential tions. The recommendations should be benefits, both for Finland and the entire introduced by 1 February 2015. The EU financial markets, include cost Bank of Finland and the Financial savings generated by economies of Supervisory Authority will incorporate scale, savings in counterparty collateral the recommendations to their current and liquidity, and increased competition principles of oversight and banking between CSDs and their participants. supervision. All the benefits of T2S however will not The next item on SecuRe Pay’s be realised immediately, but only over agenda is the recommendations for time. payment account access services The current technical standards provided by third party service and market practices of securities providers. The recommendations are settlement differ quite considerably currently in the preparatory stage, and between the EU countries. The T2S their purpose is to promote the security platform requires extensive harmonisa- of services and customers’ confidence in tion in this respect. The harmonisation new services. Harmonised requirements of standards and practices benefits, in particular, CSDs’ participants that have 2 http://www.ecb.int/pub/pdf/other/cardfrau- dreport201207en.pdf?7947b6a0a8fb5122e203cd252 cross-border activities because they no 0ffe70b. 3 Detailed information on the recommendation by the longer have to maintain differing coun- European Forum on the Security of Retail Payments try-specific systems and practices. (SecuRe Pay) is available at http://www.ecb.int/press/ pr/date/2013/html/pr130131_1.en.html. Harmonisation will promote the

Financial market infrastructure Bank of Finland Bulletin 2 • 2013 35 functioning of the markets in the entire allowing indirect ownership, which EU, increase competition and fulfils the would require changes in Finnish objective of the internal market. legislation. The allowing of indirect For the Finnish markets, migration ownership, together with current direct to T2S and the harmonisation of related ownership, would bring Finnish functions entail significant changes to practices closer to the market model current standards and practices. The used in the majority of European introduction of the T2S platform is one countries. of the main reason why the Finnish The successful implementation of CSD is updating its systems and the changes introduces by the T2S operations. Part of the harmonisation is platform and the full utilisation of these technical, for example a move to the changes require commitment by all the messaging standard ISO 20022, as parties and that adequate resources are extensively as possible. A major change allocated to the work involved (Chart in market practices will be the change 23). Moreover, smooth cooperation in systems’ opening hours, as for between the various market partici- example a so-called night-time cycle is pants is a prerequisite for creating the introduced in securities settlement. It most efficient systems and services for means that the liquidity that is needed the entire financial markets. This poses for settlement has to be imported into particular challenges for hearing the the system already on the evening views of the markets. To achieve trans- preceding the settlement. parency and a sufficiently broad view, it The full implementation of harmo- is however necessary to launch written nisation involves also the issue of consultations, at least on the issues essential for the entire market.

Chart 23. Finnish securities markets infrastructure faces historical changes Securities settlement in the new T2S platform

Market participants The reform of the European operating environment requires changes in the infrastructure of the Finnish securities Custodians markets. For the settlement systems, the key drivers for change are the introduc- CSD A CSD B CSD C CSD X tion of the European T2S platform, the Target2- European regulation of central Securities securities depositories’ activities, and Integrated settlement process Common securities clearing (domestic and cross-border) and settlement system used by all the introduction of international, central securities depositories (CSDs) harmonised standards. At the same Source: European Central Bank. time, under the pressures caused by the external forces for change, there is an ongoing extensive debate in Finland on

36 Bank of Finland Bulletin 2 • 2013 Financial market infrastructure the tools for deepening the capital The project schedule is very tight. In markets and diversifying financial inter- addition to the support from the parent mediation. Change is always both a company, support from the market possibility and a threat. The immediate participants is a key prerequisite for a years ahead will show whether this successful completion of the project. All phase of development can be utilised market participants should therefore for the benefit of the Finnish financial quite soon increase their preparedness markets. to implement the changes ahead and The elements of a major change in manage the related risks. the operating environment have already In the Nordic units of the been evident for quite some time. Partly Euroclear Group, ie in Finland and due to the financial crisis, international Sweden, business operations have been investment banks’ interest in peripheral streamlined by outsourcing IT countries has decreased, which has been production. Even though an reflected in the Finnish securities outsourcing partner is responsible for markets infrastructure, for example as operating the service, the responsibility delays in transactions. The new pricing for the outsourced functions and hence models for clearing and settlement and the functioning and availability of the the future European CSD regulation infrastructure service still lies with should improve the situation over time. Euroclear. Therefore an adequate The settlement systems of Euroclear number of staff from the customer Finland have operated reliably, without organisation must be allocated to the significant disruptions. control and development of operations. The Finnish central securities Euroclear Finland’s basis of depository, Euroclear Finland, is in a earnings has remained good overall. key position when the Finnish markets Examples of the ongoing development migrate to the T2S platform. The of the company’s service concept are the company published recently its first studies published in 2012 on the user guide for market participants (T2S utilisation of the book-entry system in Planning Guide - Roadmap), and an the custody of new instrument classes.4 extensive IT system investment The company seeks to improve the programme which will run until the attractiveness of its services also from T2S migration phase, with the aim of the perspective of issuers. The company migration to T2S at the beginning of is still considering concrete steps to 2017. The investment decision is also a improve its services. Customer satisfac- positive signal of the viability and tion in the Finnish CSD clientele has future importance of the Finnish infra- been mainly good. structure. The T2S project has caused resource pressures on Euroclear Finland 4 For further details https://www.euroclear.com/fi/ as it is the most extensive development uutiset/uutisarkisto/suomi/esiselvitys.html?ev=event2 and https://www.euroclear.com/fi/uutiset/uutisarkisto/ project in the history of the company. suomi/ao-jarjestelman-hyodyt.html?ev=event2.

Financial market infrastructure Bank of Finland Bulletin 2 • 2013 37 The scope of regulation the cross-border provision of services. will be extended Only then can host countries be The work to extend EU legislation to confident that the risk management of the entire securities trading chain systemically important systems is continues. Securities trading as well as adequate. the operations of central counterparties The EU regulation of financial are already subject to EU-level services has moved to multi-level regulation, and the proposal for a regulation where the principle regulation on central securities deposi- regulations are adopted as Level 1 tories is currently being discussed by regulations, and they are specified with EU Member States. At its best, EU level lower level – but nevertheless binding regulation promotes legal certainty, – Level 2 EU regulation. In both the supports the economic stability of the stages of regulatory preparations, the participants and increases competition. industry has an opportunity, through Competition, in turn, increases mergers public consultations, to influence the between market participants, as a result contents of future regulation. Finnish of which all countries may not have a market participants should pay national CSD in future. This sufficient attention also to the development is already taking place in preparation of lower level regulation. the area of payment systems and central Regulation consisting of two levels counterparties. It is therefore essential increases also the authorities’ respon­ to ensure that all the key authorities sibilities and workload, but it is have a sufficient degree of influence in necessary for achieving regulation that is efficient.

38 Bank of Finland Bulletin 2 • 2013 Financial market infrastructure Box 3.

Payments Council supports the development of services

Migration to the Single Euro TARGET system, and the risk interest groups were invited to Payments Area (SEPA) in Finland management of the banks’ join the group. The first extensive has made steady progress and is payment systems was updated to SEPA forum was held in 2009, in on schedule. The primary respon- fulfil the oversight requirements connection with the Bank of sibility for this change has rested in force at that time. Finland’s Payments Forum. The with the banks, but the project At the turn of the century, joint forums have taken place would not have made such good the European Parliament, the annually. In spring 2013, the progress without constructive European Commission and the joint seminar was held for the cooperation with the customer European Central Bank opened fifth and last time. sectors in the SEPA forum and its up a debate on a Single Euro The work of the SEPA core group. Although migration Payments Area (SEPA). forum and its core group will be to the Single Euro Payments Area Development work now focused terminated upon the completion is taking place on schedule, ie at on the entire payments area that of the SEPA migration at the end the end of January 2014, work to was in the process of integration. of January 2014, ie when the enhance payment services in the The possibilities of participants national direct debit scheme will Single Euro Payments Area operating in Finland to exercise end. The domestic credit transfer continues. In order to ensure the influence in this new was replaced by the SEPA credit reliability and efficiency of environment required common transfer already in 2011. payments also in the future, views and considerable effort. To The development of extensive national cooperation is draw up these common views, payments however does not end also necessary. The Bank of the Bank of Finland launched the here, instead EU-wide Finland is preparing the estab- Payments Forum. The first development will continue. The lishment of a Payments Council, seminar of the Payments Forum European Commission is which will create a basis for this was held in spring 2007. As prep- currently preparing new work and acts as a national arations for SEPA moved ahead, payments legislation. The counterparty to the EU-level a national SEPA forum was Directive on Payment Services is body, ie the SEPA Council. established a couple of years currently being reviewed. The Cooperation between the later, at the initiative of the Commission is also drafting Bank of Finland and the Finnish Federation of Finnish Financial regulations based on its Green banking sector has a long Services, with the aim of Paper on retail payments tradition. In 1995, the Bank of supporting the implementation of published in spring 2012 and the Finland established the Payment the SEPA migration, particularly input received. The initiatives Systems Steering Group to ensure in the corporate sector. The core support the objective stated in that the Finnish payment systems group of the SEPA forum was the European Commission’s fulfil the requirements of the given the task of resolving the report ‘Single Market Act II’, Economic and Monetary Union. concrete issues, to ensure the published in October 2012, to The Bank of Finland’s real-time SEPA migration. facilitate e-commerce and online gross settlement system The core group commenced services and hence improve (BoF-RTGS) was connected to its activities in early 2009, and customers’ choice and user the EU-wide RTGS system, ie the 40 key members of various friendliness.

Financial market infrastructure Bank of Finland Bulletin 2 • 2013 39 The ‘Single Market Act II’ (VAT automatically payed to the for cooperation between all the includes another objective which tax authorities at the same time user groups, service providers is closely linked to payments: the as the invoice is paid to the and authorities in the promotion of e-invoicing. The payee). The report mentions also development of retail payments. objective is to reduce costs and other development initiatives Some EU countries, for delays in payments. The Commis- related to taxation and reporting example the United Kingdom, the sion’s aim is to issue legislation to authorities; some of the Netherlands and Denmark, have on e-invoicing also. proposals have already been already, for some time, had Also in Finland, there are presented at the Payments national cooperative bodies for several ongoing initiatives related Forums. service providers, users and the to payments. The ICT 2015 The promotion of interna- relevant authorities. Even though working group established by the tional and national initiatives the structure of these bodies and Cabinet Committee on Economic requires extensive cooperation their operating procedures differ, Policy published in January its between payment service they have a common key final report ‘21 paths to a Fric- providers, users and authorities. objective of making payments as tionless Finland’. Participation in EU-level effective as possible for the entire The working group proposes a development is the best way of society. Bodies similar to the 10-year growth programme influencing the developments in SEPA forum or its core group based on ICT. The programme payments. National cooperation, have been established in most of includes several payments-related in turn, is important for defining the countries to complete the development projects that have the joint objectives and for imple- SEPA migration. Their work, too, been created for example in the menting the changes, to ensure will probably continue in new RTE programme1 of Aalto the reliability and efficiency of development projects after the University. Of the ICT working payments also in future. completion of SEPA migration. group’s proposals, the concrete, The Bank of Finland The Bank of Finland payments-related proposals are surveyed in spring 2013 the continues the preparations for on the automation of the views of the various interest the establishment of the accounting processes of SMEs groups in the payments sector on Payments Council, in cooperation and a move to real time VAT the continuation of cooperation. with the interest groups. Plans to The idea to establish a Payments establish a Payments Council

1 Real Time Economy Competence Center Council gained wide support. were announced at the Payments operates at Aalto University School of The Payments Council was seen Forum held on 7 May 2013. Business. See http://biz.aalto.fi/fi/research/ projects/rte/. as a way of creating a framework

40 Bank of Finland Bulletin 2 • 2013 Financial market infrastructure Box 4.

Central counterparties – a new type of concentration risk

A central counterparty (CCP) is an into new types of concentrations systems. A situation involving a entity that interposes itself and sources of systemic risk that systemic crisis and the almost between the counterparties to the are ‘too-big-to-fail’ or ‘too-inter- simultaneous failure of several contracts traded, becoming the connected-to-fail’ because of counterparties poses a significant buyer to every seller and the seller their global activities and because challenge on the operations of a to every buyer and carries, on their counterparties are the central counterparty. behalf of the counterparties, the largest global banks. In retrospect, central coun- risk related to the counterparties’ The notionally amount of terparties’ operations have been ability to fulfil their obligations, OTC derivatives contracts is relatively successful, despite some for example deliver money or globally significant. In December failures of local central counter- securities. As a result of global 2012, the notional amount parties. The consequences of these regulation, OTC derivatives will outstanding was approximately failures have been only local but gradually become subject to USD 632,600 billion.1 The they have nevertheless led to the central counterparty clearing. This majority, ie 77%, were interest closing of markets, for example. improves the transparency of rate derivatives. Part of the In the world of global central derivatives markets and decreases volume is already now subject to counterparties, the magnitude of counterparty risk. The use of a central counterparty clearing, and the potential problems is quite central counterparty also simplifies part of it will gradually become different. Although risk and enhances the processes subject to the same requirement. management is at the core of compared to bilateral clearing This will further concentrate the central counterparties’ operations, between several clearing parties. risks on the central counterparties. there is no reason to underesti- The reform will result in an A central counterparty is the mate the existence of new types increase in standardisation. In centre of the financial market of central counterparty risks. No future, tailor-made hedging network where particularly the infrastructure can be assumed to instruments are not necessarily large global banks’ derivative function perfectly and without available anymore as the higher positions are concentrated. A disruptions in the long term. capital and collateral require- blow to this network will come The EU is currently ments encourage the use of stand- primarily from the counterparties, preparing regulations on the ardised derivatives. Moreover, for ie a bank that faces liquidation. A resolution and recovery of credit example collateral and reporting key part of central counterparties’ institutions. In a crisis situation, requirements will increase the operations is to provide a risk the orderly winding up of banks costs to derivatives users. This management mechanism that will help also central counterpar- might result in a shortage of high- gradually stops and subdues this ties. Taking into consideration the quality collateral. blow. If this fails, the central coun- key importance of infrastructure, The use of central counter- terparty may, due to its intercon- it would be reasonable to create party clearing does not actually nectedness, spread the problems crisis management and recovery eliminate counterparty risk; to the other counterparties and arrangements also for critical instead it changes its form. The the payment and settlement infrastructures, to safeguard the question has also risen whether continuity of important functions 1 BIS (2012) Semiannual OTC derivatives central counterparties are turning statistics. also in exceptional circumstances.

Financial market infrastructure Bank of Finland Bulletin 2 • 2013 41 Financial system policy

Finland needs tools for macroprudential Requirements Directive and Regulation policy. Among other things, a cap on and the Recovery and Resolution housing loans should be implemented in Directive for banks. Among other things, accordance with the proposal by the the CRD harmonises the capital require- working group lead by Minister ments regulation for European financial Tanskanen. Finland must also prepare for institutions and considerably tightens the additional regulation on systemically capital adequacy and liquidity require- important banks, since the consequences ments for banks. It also provides of banking crises could be severe in the national authorities an opportunity to concentrated Finnish banking system. In use selected macro-prudential tools to harmonising the authorities’ crisis ward off national systemic risks.1 resolution powers and tools as well as in The Recovery and Resolution building the banking union, it must be Directive will harmonise the crisis ensured that, going forward, shareholders resolution legislation and tools of the and creditors bear the costs of bank EU countries. Regulation potentially restructurings and wind-downs. restricting bank structures would also facilitate banks’ crisis resolution (Box The European financial system 5). At the same time, the European continues to operate imperfectly in the banking union being prepared seeks to wake of the global economic and fix the problematic structure of the financial crisis. Recovery of the European financial architecture where functioning of the financial system financial institutions operate across requires determined efforts on three borders but the responsibility for their fronts: resolute reform of the banking supervision and crisis management has system, regulation of financial institu- been primarily national. tions and European institutions must

continue (Chart 24). 1 The European Central Bank will also have a limited right to influence the use of national macro-prudential The key reforms in European tools under the Capital Requirements Directive. The financial regulation, to be implemented new powers are related to the ECB’s position as part of the common supervision mechanism for the in 2014 and 2015, are the Capital European banking union.

Chart 24.

Strengthening of stability and improvement of functioning of the European nancial system

Institutional repair: Banking sector repair Regulatory repair banking union

– Strengthening of banks’ balance sheets – Capital Requirements Directive and Regulation – Single supervision mechanism – Increase of transparency – Directive on the recovery and resolution – Single crisis resolution mechanism – Unwinding of overcapacity of credit institutions – Harmonised deposit guarantee scheme – Strengthening of macro prudential supervision – Harmonisation of institutional supervision

Sources: Andrea Enria (2013) and Bank of Finland.

42 Bank of Finland Bulletin 2 • 2013 Financial system policy The ongoing international these goals (Chart 25).2 The ESRB tightening of financial regulation is also recommends that the national macro- in line with Finland’s interests. As a prudential authorities should be able to cyclically sensitive economy, Finland use either directly one of the tools of suffers from international financial macro-prudential policy to meet each crises more than many other countries. interim goal or that they should at least It is important for Finland to promote have the right to provide recommenda- such international regulation which tions on the use of the tools to other reduces the likelihood of financial and authorities. economic crises and their spreading to The Finnish financial system has Finland. structural vulnerabilities whose containment requires macro-prudential Finland needs tools for tools. First, the Finnish economy and macro-prudential policy households are very vulnerable to risks The European Systemic Risk Board in the housing markets. Second, the (ESRB) is about to give a recommenda- consequences of crisis emerging in the tion to the macro-prudential authorities concentrated Finnish banking system of the EU member states on the inter- could be very severe for the entire mediate goals for national macro- economy. prudential policy (macro-prudential supervision) and the tools to achieve 2 In 2012, the ESRB gave a recommendation on the goals and institutional arrangements for national macro stability policy.

Chart 25.

Interim and nal goals of macro-prudential policy

Interim goals

Prevention of bank runs Reduction of systemic Strengthening the Containing excessive on retail and wholesale Prevention of emergence risks caused by resilience of lending and deposits, safeguading of excessively large systemically important nancial market indebtedness liquidity of the markets risk exposures nancial institutions infrastructure

Final goals

Financial systems’ Strengthening of riskbearing procyclicality reduced capacity of the nancial system

Sources: Bank of Finland and Committee on the Global Financial System (CGFS).

Financial system policy Bank of Finland Bulletin 2 • 2013 43 Finland needs capability collateral. The proposal by Tanskanen’s to implement loan cap working group has aroused a lot of The Finnish financial system and discussion about the potential economy are vulnerable to disruptions advantages and disadvantages of the in the housing markets for many loan cap. reasons: 1) Houses constitute a very The implementation or lowering of large proportion of the wealth of the loan cap might cushion the Finnish households and housing loans fluctuation in housing lending and of the lending by Finnish banks. 2) house prices and strengthen the crisis Indebtedness of the household sector resilience of the financial system has increased, which can be expected to through many different impact channels continue. 3) New housing loans are (Chart 26). Based on international large relative to the value of the homes experiences, the introduction of a loan purchased. 4) The linkage of housing cap may for example slow down the loans to market interest rates exposes growth and fluctuation of housing households to a high degree of interest lending, dampen the rise and rise expec- rate risk. 5) The supply of homes in the tations of house prices, contain Helsinki metropolitan area is quite speculative house purchasing, reduce inelastic. banks’ credit losses on housing lending, Also in light of Finland’s own decrease household indebtedness and economic history, strong overheating in improve banks’ lending practices.3 housing lending and the housing The loan cap is a particularly markets, and the subsequent collapse of effective tool if it is introduced already house prices could be a major threat to when the housing markets are the Finnish economy. In the severe beginning to show signs of overheating. Finnish economic crises of the 1930s In order that the timely use of the loan and 1990s, there was both rapid credit cap would be possible, the legislative expansion and a collapse of the housing preconditions for its use should be and real-estate markets. In spite of these created already during so-called normal experiences, Finnish authorities at times. A loan cap would be a particu- present largely lack tools to contain the larly necessary tool in a context where expansion of housing lending when a new generation of borrowers is deemed excessive. potentially beginning to harbour a A working group lead by Minister fallacy of permanently very low level of Antti Tanskanen proposed in autumn market interest rates. 2012 that the Financial Supervisory Authority be provided the right to set a binding ‘loan cap’ for new housing

loans when necessary, ie a possibility to 3 International experiences on the use of a loan cap are discussed in more detail for example in the article limit the maximum size of new housing Vauhkonen, J. and Putkuri, H. (2013). Lamauttaako loans relative to the value of the home vai vakauttaako lainakatto Suomen asuntomarkkinat? (Will the loan cap paralyse or stabilise the Finnish financed with the loan and used as its housing markets?) Finnish Economic Papers, 1/2013.

44 Bank of Finland Bulletin 2 • 2013 Financial system policy Chart 26.

Impacts of tightening of loan cap regulations

Loan cap regulations Credit cycle dampens are arbitraged Demand for loans decreases New loans become more expensive Supply of loans decreases

Lowering of loan cap Growth of housing lending slows down Price and risk expectations

Credit losses Banks improve decrease risk management

Crisis resilience of banks and entire ‚nancial system improves

Possible reactions by banks Possible market reactions Source: CGFS (2012).

Finland must create capabilities to set importance of certain banks.4 To systemic requirements for banks safeguard the sustainable stability of The EU’s Capital Requirements the financial system, there must be a Directive will give national authorities a capability to impose the additional discretionary possibility to set capital requirements allowed in the additional capital requirements for Directive. some or all banks in the country due to Nordic banking groups have banks’ systemic importance or a significant subsidiary and branch vulnerable structure of the banking activities in Finland. Uniform sector. The amount of these extra assets regulatory environment in Finland and of the highest quality could be even 5% other Nordic countries – particularly of the bank’s risk-weighted assets at the Sweden, Denmark and Norway– is maximum. therefore important. Major cross-coun- In Finland, the macroeconomic try differences in regulation may damages of potential banking crises encourage financial institutions to take could be very extensive due to the large advantage of regulatory arbitrage, size of the banking system, its consider- whose consequences for Finland could able concentration (Chart 27), the banks’ strong national and Nordic 4 These risks are discussed more closely in article ‘Finland must be prepared to impose systemic capital connectedness and the systemic requirements on banks’ in this Bulletin.

Financial system policy Bank of Finland Bulletin 2 • 2013 45 Chart 27. severe banking crises without causing similar costs to taxpayers as presently. Degree of concentration of the banking sector in EU countries The Commission’s plan contains 1. Proportion of ve largest credit institutions of aggregated two phases. First, a Crisis Resolution credit institutions’ balance sheet in 2011 Directive tailored for banks is % 100 implemented. Thereafter – partly simul- 1 taneously – a European-wide banking 80 union is built, which centralises the 60 supervision of banking and the key

40 elements for crisis management. Preparation of the Crisis Resolution 20 Directive is in the final stretch, and the 0 Commission’s proposal is expected as EE NL FI PL DK CZ CY LT SE HU IE FR ES IT AT DE The gures for the EU countries also include subsidiaries and branches soon as during June 2013. The new of foreign banks operating in the country. regulations would enter into force as of Source: European Central Bank. the beginning of 2015. The content of the Directive can be divided into three areas: crisis prevention, early interven- tion by authorities, and the restructuring of problem banks. All of the areas are be adverse and difficult to predict. important, but clearly the most Internationally comparable regulation important provisions deal with bank also sustains the trust of market partici- restructuring. pants in Finnish financial institutions. So far, banks’ problems have been In setting additional requirements, addressed on the basis of regulations on the impacts of other regulation and general business activities. However, financial architecture initiatives being normal liquidation and bankruptcy prepared – such as the Crisis Resolution legislation is not well suited for the and Recovery Directive for banks, resolution of bank problems. Therefore, regulation potentially intervening in it has often been cheaper for the society bank structures and the EU’s banking to provide public support for problem union – on systemic risks, financial banks than to let them go bankrupt. intermediation and banks’ incentives, The new Directive will change the should also be taken into account. situation. In the future, the operations of even large banks can be run down New tools for bank crisis without causing comparable costs to management in Europe taxpayers as presently. The European Commission has the The most significant changes objective to create an entirely new crisis concern creditor involvement and management system for banks. The new possibility to continue banking system would solidify the capability of activities with critical importance to the financial markets to cope with even financial stability. Currently, based on

46 Bank of Finland Bulletin 2 • 2013 Financial system policy Chart 28. present legislation, creditor involvement materialises only when the entire bank Responsibilities in bank supervision and crisis goes bankrupt. management

Creditor involvement is key Future state Cutting the value of debt or converting Bank likely to fail debt into equity (bail-in) is an Supervisory authority Crisis resolution authority important crisis resolution tool for authorities when a bank in crisis is being restructured. Creditor Supervisory authority Liquidation and bankruptcy involvement takes place in the new procedure Bank is insolvent system through the bail-in procedure. Present state The activities of a problem bank can be reorganised so that the healthy parts Source: Bank of Finland. and those with importance to financial stability are separated from the rest. The problem parts can be transferred to an asset management company whose the Crisis Resolution Directive will be operation is gradually run down. applied at an earlier stage, that is, The costs of the process are borne already when the bank is likely to fall in addition to the owners by the (Chart 28). The new system provides creditors of the bank, exactly as would the authorities with clearly better possi- have been the case in a bankruptcy. The bilities than present to take effective order of preference in terms of the costs restructuring efforts. of the restructuring must be the same as Successful crisis resolution process in a bankruptcy. Restructuring through a requires that the creditors participate in crisis resolution procedure may not put covering the losses. The largest creditors in a weaker position than the proportion of the costs of the process bankruptcy procedure. This condition is will remain borne by the creditors, likely to be met relatively easily, since the exactly as in a normal bankruptcy. overall costs of a bankruptcy procedure Therefore it is important that the bail-in often rise quite high. procedure achieving private sector The crisis resolution process can be involvement is implemented concur- considered an effective method to rently with the rest of the crisis handle the problems of both large and resolution system. small banks. Another significant reform is also the initiation of the crisis Ensuring the prerequisites of crisis resolution procedure even before the resolution is important bank is ripe for bankruptcy so to speak. The Commission’s Crisis Resolution Under present legislation, the Directive clearly improves the possibili- bankruptcy procedure is not initiated ties of the authorities to handle the until the bank is insolvent. In contrast, problems of even large banks in a

Financial system policy Bank of Finland Bulletin 2 • 2013 47 controlled manner. However, the which order the reduction of debt Directive proposal emphasises rather values or the conversion of debt into strongly the measures taken during the equity capital is carried out. crisis resolution procedure. Several A high-level working group lead by the reforms have been made recently to Governor of the Bank of Finland, Erkki strengthen banks’ capital adequacy, and Liikanen, which has considered a banks’ capacity to withstand losses has reform of the structures of the EU improved. Despite the reforms, banks banking sector, has proposed the imple- will remain vulnerable to large sudden mentation of specific designated bail-in losses going forward. instruments in addition to a general In order that the reduction of debt bail-in tool to be used as extensively as values or the conversion of debt into possible. These designated instruments equity is possible, the bank must have a would have a weaker seniority status sufficient quantity of such debt than the bank’s so-called senior debt. In instruments in their balance sheet that addition, banks would not be entitled can be used for that purpose. Therefore to hold these instruments, which would it is important that the bail-in enable a reduction of their value or procedure can be targeted to a suffi- conversion into equity capital without ciently large part of the bank’s immediate contagion effects more liabilities. For the investors, it is also widely in the entire banking sector. important to be sure about how an in

48 Bank of Finland Bulletin 2 • 2013 Financial system policy Box 5. Regulation intervening in bank structures supports financial stability

The debate on structural reforms impact assessment on the the agenda of the international of banking began in the aftermath proposal this spring and is likely regulation community. The of the financial crisis first in the to come forward with a changes were addressed in United States. Paul Volcker, legislative proposal based on the meetings of both the Bank for former chairman of the board of proposal in September 2013.1 International Settlements and the governors of the Federal Reserve, Around the turn of 2013, International Monetary Fund.2 proposed that banking groups the French and German The main objective of the should be banned from trading in governments each gave their structural reforms is to seek to securities for their own account. proposals on how bank activities decrease the probability of the This so-called Volcker Rule, in these countries is intended to too-big-to-fail problem ie that a which was adopted in summer be restricted, going forward. Both systemically important bank 2010 as part of the financial proposals included separating would fail in an uncontrollable market reform (so-called proprietary trading into a manner and to facilitate the Dodd-Frank Act), also restricts separate subsidiary within the winding-down of the bank once investments in hedge and private banking group. However, it has entered unsurpassable diffi- equity funds by banking groups. market-making activity would be culties. The same goal is also Even before the implemen- allowed for deposit banks. sought by setting tighter capital tation of the Volcker Rule, the In Great Britain, the requirements than present for activities of US deposit banks government gave a legislative systemically important banks and within banking groups were proposal in February 2013 on by ensuring that the authorities restricted. Some of these restric- restrictions applying to banking have the necessary tools for crisis tions are still valid, although the structures. Hence, the proposal of management and by tightening Glass–Steagall Act separating September 2011 by an independent­ the supervision of systemically investment and commercial commission lead by John Vickers important banks. However, the banking was repealed to a large on separating retail banking by a structural reforms would extent at the end of the 1990s. ring-fence is about to materialise. complement these regulation Discussion on regulation In accordance with the proposal of initiatives particularly in the initiatives intervening in bank a parliamentary committee, the following ways: structures has gained momentum ring fence will be electrified, which 1) Separation of activities in Europe, too. A high-level means that the authorities will be would simplify the structures of working group established by the given the right to require full large and complex banks and European Commission and lead separation of activities on different reduce the inter-linkages and by Governor Liikanen proposed sides of the ring fence, if it is contagion channels between the in October 2012 that proprietary revealed that a bank has tried to deposit bank and the trading trading, market making and circumvent the ring fence. unit. Critical functions for the certain exposures to the shadow During spring 2013, the society, such as the payment banking system should be structural changes surfaced on 2 separated from commercial Gambacorta – van Rixtel (2013) Structural bank regulation initiatives: banking to a separate trading 1 The Commission discusses the components approaches and implications. BIS research of the impact assessment and remaining report 412. Vinals et al (2013) Act local but unit within the banking group. open questions in its stability report think global: Can the Volcker, Vickers, and The Commission is making an published in April 2013 (European Financial Liikanen structural measures create a safer Stability and Integration Report 2012). financial system? IMF research report 13/4.

Financial system policy Bank of Finland Bulletin 2 • 2013 49 Table. Comparison of regulatory initiatives proposing structural changes to banks

United States France Germany EU (High level United Kingdom (Volcker) Expert Group) (Vickers) Ban on or separation of Ban on banking Separation Separation Separation Separation some business functions groups within banking within banking within banking within banking groups (ban on groups groups groups (full high frequency separation can trading) be required by authorities)

Activities permitted to deposit banks (banking group*) • Proprietary trading No No No No No • Exposures to the Holdings in Exposures to Exposures to Exposures to No shadow banking sector hedge funds and money market hedge funds and hedge funds and exposures to funds not leveraged institu- structured private equity permitted tions not investment restricted permitted vehicles (SIV) not permitted • Market making Yes Yes (authorities Yes (authorities No No have mandate to have mandate to impose restric- impose restric- tions) tions) • Securities underwriting Yes Yes Yes Yes No • Risk management of Yes Yes Yes Customer- Retail bank customers driven, using customers and simple products small and with tight risk medium-sized limits companies, within the framework of tight risk limits • High frequency trading Yes No No Yes Yes

Activities permitted to trading entities­ • Deposits covered by No No No No Deposits from deposit guarantee retail customers schemes and small and medium-sized companies not permitted • Payment system service No No No No No Geographic restrictions No No No No Bank isolated by ring-fence cannot operate outside the EEA N.B. *In the United States (Volcker) column, the description concerns banking groups, not deposit banks within banking groups.

50 Bank of Finland Bulletin 2 • 2013 Financial system policy system, would be better Creditors are expected to become instead of stabilising them.4 For safeguarded from potential more motivated to monitor example, it may be that the restric- outcomes of risk-taking by the banks’ operation when the threat tions on bank structures will force trading unit. This would facilitate of a controlled winding-down of deposit banks to focus increasingly the use of resolution tools when a bank and the materialisation of on housing and real-estate lending, the bank winds up in difficulties. investor responsibility becomes which will increase their exposure 2) If the risk of a given more credible. Simplification of to the impacts of the consequences banking activity is difficult to banks’ structures also helps of a price bubble. The more measure and the risk profile of this investors understand and assess market-driven funding structure of activity may change rapidly, the operation of the bank. the trading unit will increase its capital requirements are not a Effective market discipline has a vulnerability. sufficient tool to contain excessive primarily positive impact on In the planned structural risk taking.3 When it is required incentives in the banking sector reforms in the planning phase that only a deposit bank may fund and it therefore reduces the need this danger has been accounted its activities with deposits subject to tighten regulation. for by requiring that the deposit to the deposit guarantee, and the 4) The separation of bank and the trading unit meet use of resolution tools is activities would facilitate the the capital and liquidity require- facilitated, the implicit government application of corporate ments separately. In the legislative guarantee (assumption of public governance rules. The structural proposals made in Great Britain, support in a problem situation) is reforms are also expected to France and Germany as well has expected to decrease significantly support the objective of regulation in the report by the high-level due to the structural reforms. on governance; long-termism can expert group, other recommenda- When the downward impact of the be increased by reducing the tions were also made to support implicit government guarantee on blending of two different the structural reform.5 One the funding costs of the trading management cultures – the deposit should also recall that many unit is reduced, the incentives for bank’s culture based on long-term other regulation initiatives being excessive risk taking and growth customer relations and the trading prepared would improve the weaken. The structural reforms unit’s culture based on short-term operability of the separated units. also affect the bank’s possibilities transaction-based results. For example, the objective of the to grow too large from the 5) When the linkages of the macro stability tools is to contain society’s perspective. For example, banking group with the so-called the emergence of price bubbles Boot and Ratnowski have demon- shadow banking system are threatening the deposit bank. At strated that banks may allocate separated in the trading unit, the the same time, the systemic risks too many resources on trading and proposals on structural reform of trading activities are sought to too little resources on traditional will support the ongoing reform be contained for example by banking based on close customer seeking to reduce the linkages encouraging market participants relationships in the absence of any between traditional banking and to adopt the use of central coun- restrictions. shadow banking. terparties in their derivatives 3) Decrease in the implicit The appropriateness of the trading (see Box 4). government guarantee also structural reforms has also been increases market discipline. called to question. One of the 4 Goodhart (2012) The Vickers Report: an concerns is that the separation of 3 Blinder (2012) It’s Broke, Let’s Fix It: Assessment. Law and Financial Markets Rethinking Financial Regulation. Boot and the activities would endanger the Review 6:1. 5 Ratnovski (2012) Banking and trading. stability of the financial markets Financial Market Report 2/2012, See IMF Working Paper 12/238. www.bof.fi.

Financial system policy Bank of Finland Bulletin 2 • 2013 51 Box 6.

Researchers criticise banks’ risk-based capital requirements

The debate on development of models of risk measurement and capital requirements.7 It is capital requirements for banks has the calibration of these models. defined as the ratio of equity to continued actively even after the Important risk factors may be the sum of on- and off-balance Basel III agreement. This is only overlooked for example in the sheet items. natural, since the Basel standards context of protracted favourable The minimum requirement are a framework to be specified macroeconomic developments.4 for banks’ leverage ratio may and developed as necessary. Second, banks seek to develop also pose problems. Firstly, an The discussion has flagged such new financial instruments, incentive may be created for the problems of risk measurement, to which the regulator is willing banks to increase risk taking in which have an impact on the deter- to accept lower risk weights than order to meet the return require- mination of the risk weights of the actual risk involved. An ments for the increased equity banks’ assets in the Basel example of this are the problems capital. However, this is not regulations. Research suggests that related to securitised loans.5 obvious since the return banks’ risk-weighted capital Banks may also be incentivised to requirement for equity should adequacy ratios (so called Tier 1 use too low internal risk ratings.6 also decrease due to the lower capital ratios) would not have been Third, other factors than pure leverage.8 Banks may also adapt able to predict the problem banks risk measurement may also have to the situation by spreading during the crisis particularly well. an impact on the formation of risks more evenly amongst In contrast, these banks would the rules on risk weights, such as themselves.9 Furthermore, banks’ have been identified better on the political perspectives. incentive to develop risk basis of the non-risk-weighted The Basel III regulations measurement may weaken as leverage ratio.1 The leverage ratio have sought to address these capital requirements are no also seems to correlate better with concerns by setting a leverage longer determined solely on the other indicators of bank strength ratio requirement for banks, basis of the measured risks. In an than the Tier 1 ratio.2 complementing the risk-based ideal situation, the risk-based The capital adequacy of capital requirements also have banks appears better than the the benefit of possibly containing reality if the risk weights are too too risky lending more effectively low.3 This may happen at least 4 Se eg the following: Gennaioli, N. – than a rougher capital Shleifer, A. – Vishny, R. (2012) Neglected for three reasons. First, there is a risks financial innovation, and financial lot of uncertainty related to the fragility. Journal of Financial Economics 104, 452–468. Caballero, R. J. – Kurlat, P. (2009) The ’Surprising’ Origin and Nature 1 Haldane, A. (2012) The Dog and the of Financial Crises: A Macroeconomic 7 The EU’s Capital Requirements Frisbee. Federal Reserve Bank of Kansas Policy Proposal. Federal Reserve Bank of Regulation (CRR) provides that the City’s 36th economic policy symposium. Kansas City. Jackson Hole Symposium on capital ratio is adopted in the EU at the Jackson Hole. Financial Stability and Macroeconomic earliest in 2018 if the experiences gathered 2 Hoenig, T. (2013) Basel III Capital: A Policy. during the review period show benefits in Well-Intended Illusion. International 5 Acharya, V. V. – Schnabl, P. – Suarez, G. setting the requirement. Association of Deposit Insurers 2013 (2013) Securitization without Risk 8 Se eg Admati, A. – Hellwig, M. (2013) Research Conference. Basel. Transfer. Forthcoming in Journal of The Bankers’ New Clothes. Princeton. 3 Acharya, V. V. – Engle III, R. F. – Pierret, Financial Economics. 9 Kiema, I. – Jokivuolle, E. (2011) D. (2013) Testing Macroprudential Stress 6 Blum, J. M. (2008) Why ’Basel II’ may Leverage ratio requirement, credit Tests: The Risk of Regulatory Risk Weights. need a leverage ratio restriction? Journal allocation and bank stability. Bank of CEPR Discussion Paper No. 9431. of Banking and Finance 32:8, 1699–1707. Finland Discussion Paper 10/2011.

52 Bank of Finland Bulletin 2 • 2013 Financial system policy requirement based on the regulations is too low.12 For crisis, was a more precise leverage ratio.10 example, the leverage ratio measurement of risks through However, the experiences required by the markets from US models. There might also be a from the financial crisis highlight banks before the establishment of need for adjustment in banks’ the difficulties in risk the central bank and the deposit operational targets, which in measurement and banks’ guarantee system was more than recent years have been based on incentives to seek to minimise the 10%.13 Also the proposals on maximising the risk-adjusted risk weights used in risk-based bank structures in the EU and return on equity by function and capital requirements. Therefore, Great Britain include recommen- possibly even at a transaction optimal risk-based capital dations on strengthening the level. On the other hand, the requirements need to be comple- capital buffers determined crisis showed that the return was mented by a rougher capital without a risk weighting.14 often maximised by economizing requirement that is insensitive to A leverage ratio requirement on equity, which lead to measurement errors. Their effec- much higher than the present increased systemic risk in the tiveness can be strengthened Basel III level would entail a entire banking system. when banks publish enough major paradigm shift in banks’ The common objective of information on their risks.11 capital regulation, whose aim, as the regulation reforms after the However, some experts reflected in the Basel II regulation financial crisis is the reduction of consider that the 3% minimum implemented just before the systemic risk to an acceptable requirement for the leverage ratio level so that regulation supports included in the Basel III 12 See eg. Admati, A. – Hellwig, M. (2013) the preconditions for sustainable and Haldane, A. (2012). economic growth. The continuing 10 Jokivuolle. E. – Kiema, I. – Vesala, T. 13 Berger, A. N. – Herring, R. J. – Szegö, (2013) Why do we need counter-cyclical G. P. (1995) The role of capital in discussion on the optimal capital capital requirements? Forthcoming in financial institutions. Journal of Banking requirements from the society’s Journal of Financial Services Research. and Finance 19: 393–430. 11 Vauhkonen, J. (2012) The impact of 14 Liikanen, E. (2012) High-Level Expert perspective must be considered Pillar 3 disclosure requirements on bank Group on reforming the structure of the against this background. safety. Journal of Financial Services EU banking sector. Final Report. Brussels Research 41:37–49. (2.10.2012).

Financial system policy Bank of Finland Bulletin 2 • 2013 53 Appendix

Infrastructure critical to the Finnish financial market

System Description Oversight Assessment responsibility TARGET2 Eurosystem’s technically ECB (lead overseer), The system fulfils the oversight requirements for centralised RTGS-system Eurosystem systemically important payment systems (SIPS). based on a single shared Operations have been reliable. platform. TARGET2- TARGET2 functions under Bank of Finland Operations have been reliable. In addition to Suomen the responsibility of the Bank oversight; adherence Finnish banks, several Nordic banks settle payments Pankki system of Finland. to common principles via the system. with other Eurosystem TARGET2 partici- pants. CLS A significant international US Federal Reserve No problems have been reported in the operation of settlement system for foreign (lead overseer), ECB the system. exchange transactions. (overseer of settlement in euro). EBA EURO1 EBA Clearing’s transfer system ECB (lead overseer), Fulfils the oversight requirements mainly; for euro-denominated Eurosystem. operations have been reliable. large-value payments. POPS Banks’ online system for Bank of Finland. Assessed as fulfilling the oversight requirements. No express transfers. Domestic changes have been made to the system, and large-value payment system. operations have been mainly reliable. EBA STEP2 Pan-European automated ECB (lead overseer), A critical system for Finnish retail payments; fulfils clearing house (PE-ACH) for Eurosystem. the oversight requirements. The oversight assessment euro-denominated retail of the special features used in Finnish payment traffic payments. was completed in autumn 2012. PMJ Domestic retail payment Bank of Finland. Fulfils the oversight requirements; operations have transfer system; operates as an been mainly reliable. Number of payments has ancillary system to declined, as domestic credit transfers are nowadays TARGET2. processed by STEP2. The technical life of the TARGET2 interface runs until end-2013. ACH Finland Clearing house set up by some Bank of Finland. Assessed as fulfilling the oversight requirements; Finnish banks. Operations operations have been mainly reliable. started in March 2009. European Provider of central counter- An oversight group Central counterparty reduces the counterparty risk Multilateral party clearing services to the headed by the Dutch of securities trades, and by netting the transactions Clearing Nordic stock exchanges of authorities. of the counterparties, it reduces the liquidity needs Facility NASDAQ OMX. of the system. Operations have been reliable. (EMCF) Euroclear Central securities depository Bank of Finland Operations have been reliable. The activities of Finland’s operating settlement systems oversight. Euroclear Finland are currently being developed to (former APK) for stock and money market correspond with the requirements of the operating systems. instruments. environment. Assessment of the settlement system for stock market instruments, based on ESCB-CESR recommendations, jointly with FIN-FSA is currently underway. Euroclear SA Parent company of the A cooperative Cooperation covers joint functions of the Group Euroclear Group central oversight group entities. In 2012, the focus was on the central securities depositories, coordinated by the securities depositories’ T2S project risks and providing common services to Belgian authorities. protection against cyber threats. the Group entities. Information networks SWIFT Most significant provider of Oversight group SWIFT is a critical provider of services for financial messaging services to the headed by the central market infrastructure. Its operations have been financial markets; an entity bank of Belgium. reliable. Fulfils the high-level oversight expecta- managed by its members. tions. Pankkiverkko 3 Domestic closed interbank Bank of Finland. Subject to oversight monitoring. Operations have network used by for example been reliable. PMJ and POPS. ATM networks Networks critical for the Bank of Finland Subject to oversight monitoring to ensure supply of cash to individual acquisition of data and secure preparedness for members of the public. crisis management. Operations of the ATM network have been mainly reliable.

54 Bank of Finland Bulletin 2 • 2013 Appendix Pertti Pylkkönen – Eero Savolainen The situation of SME finance in Finland 29.4.2013

The financing situation of Finnish small United States.1 The banks’ share in and medium-sized enterprises has corporate finance has been edging remained fairly robust compared to other moderately downwards in Europe, as EU countries. However, access to finance larger firms have increased their bond and financing terms and conditions are issuances in response to rising demand deteriorating, which has already been on corporate bonds. Growth in securi- reflected in increased margins on smaller ties-based corporate finance also corporate loans in particular. contributes to supporting availability of finance for SMEs, since the transition of Pertti Pylkkönen Economist A healthy financial system is crucial to larger firms increasingly into market- Financial Stability stable economic developments. based funding creates room for SMEs’ and Statistics Impairment of the financial system access to bank financing. contributes to undermining economic SMEs play a significant role in the Agrowth potential. The international economy, particularly in Europe financial crisis has deteriorated creating new jobs. enterprises’ access to finance especially There were about 23 million SMEs in the countries under strain, but the in Europe in 2011. SMEs employed repercussions of the crisis have also more than two-thirds of all employees.2 been reflected in other countries, such According to the European Commission, as Finland, particularly in tighter SMEs have created over 80% of all new financing conditions of small and jobs in Europe in recent years. Eero Savolainen medium-sized enterprises (SMEs). In Finland, the number of SMEs Economist Financial Stability The crisis has affected the increased in the 2000s prior to the and Statistics operating conditions of the SME sector financial crisis substantially faster than primarily via the real economy and in other European countries. Thereafter lower demand. The financing the pace of growth has levelled off to conditions of Finnish firms also deterio- levels prevailing in the other European rated rapidly at the onset of the crisis, countries. Despite the increase, the but the situation calmed down with the share of SMEs is still slightly smaller in stabilisation of banks’ funding. Hence, the Finnish economy than in the EU27 in European comparisons, access to countries on average. Particularly the finance and financing costs of firms, relative share of micro firms of less including SMEs, have remained excep- than 10 employees is smaller in Finland tionally stable in Finland. than in its European peers. This is As in Europe as a whole, corporate partly explained by the less important finance in Finland is mostly bank-based. In Europe more than 70% of the 1 Cour-Thimann – Winkler (2013) The ECB’s Non- Standard Monetary Policy Measures. The Role of external financing of the non-financial Institutional Factors and Financial Structure. Working corporate sector is provided by banks, Paper Series No 1528. ECB. 2 European Union (2012) Enterprise and Industry. compared to less than 20% eg in the SBA Fact Sheet 2012.

The situation of SME finance in Finland Bank of Finland Bulletin 2 • 2013 55 Chart 1. past ten years.4 This notwithstanding, Finnish SMEs’ role as an employer is SMEs’ access to bank loans* in EU27 still among the smallest in Europe. In 1. 2009 2. 2011 2011 Finnish SMEs employed about % 90 870,000 persons, ie 61.7% of the 80 1 70 workforce. 2 60 50 Financing situation of SMEs 40 partly deteriorated in Finland 30 20 Access to finance and financing terms 10 and conditions of SMEs have deterio- 0 FI LV SE PL AT DE SK BE CZ MT LTCY BG DK RO LU EU IT EE FR NL HU ESUK ELIEPTSI rated considerably in several countries *Percentage of successful loan applications. over the past years. As in Finland, SME Sources: European Central Bank and the European Commission. finance in Europe is also largely bank-based. Due to banks’ increased funding constraints and higher costs of funding, SMEs’ access to finance has role of services sector firms in the deteriorated in almost all EU countries Finnish economy. (Chart 1). At the same time, loan The structure of the Finnish SME margins have increased, while other sector differs from the EU27 also in credit terms and conditions have that respect that the importance of tightened. technology- and knowledge-intensive Despite some slight deterioration, firms in this sector is above average in the availability of bank loans for SMEs Finland. Finnish SMEs’ share in the has remained the best in Finland of all total value added of the corporate euro area countries, and rejection rates sector has already increased to close to of SMEs’ bank loan applications have the EU27 average. The share in been relatively low. However, the employment is below the EU average. slowdown in international trade and The importance of SMEs to the Finnish economic growth as well as uncertainty economy is consistent with a study about the economic outlook are also carried out in the United States. reflecting in Finnish SMEs’ activities, According to this study the higher the access to finance and the needs for debt position of a firm in the value added financing. With weaker demand, chain is, the smaller is its relative share willingness to invest has waned and as an employer.3 SMEs’ incentives to grow have In Finland, SMEs have created declined.5 more than 90% of all new jobs in the 4 Federation of Finnish Enterprises, Finnvera and Ministry of Employment and the Economy (1/2013) 3 Antrás – Chor – Fally – Hiibeery (2012) Measuring PK-yritysbarometri (SME barometer). The Upstreamness of Production and Trade Flows. 5 Federation of Finnish Enterprises, Finnvera and The American Economic Review. Vol. 102, Issue 3. Ministry of Employment and the Economy (1/2013) May. PK-yritysbarometri (SME barometer).

56 Bank of Finland Bulletin 2 • 2013 The situation of SME finance in Finland The demand for SME finance in SME loan margins on the increase in Finland Finland is concentrated on the needs to finance working capital. Attitudes The interest rate margins on new towards expansion investment are corporate loans began to grow in cautious, which is reflected in subdued Finland in summer 2011 (Chart 2). demand for long-term financing. Despite monthly fluctuations in loans According to the most recent SME of over EUR 1 million, which is typical barometer of the Federation of Finnish for large loans, the average margin on Enterprises, the relative share of SMEs these loans remained relatively stable. using debt financing has increased The margins on smaller loans increased slightly. The number of SMEs using much more. The margins were the external financing has in turn remained highest for the smallest loans of up to stable for a long time, at slightly over EUR 50,000. Nevertheless, corporate 50%. loans of up to EUR 1 million are still The sources of SME finance are more advantageous in Finland than in relatively scarce in Finland. According Europe on average. The interest rates to the spring 2013 SME barometer, on these loans have stabilised in Finland 80% of firms considering of seeking in the past few years to levels prevailing new finance resort to bank funding. The in EMU countries with the highest corporate financing possibilities of the credit ratings and to substantially lower specialised financing company Finnvera have been strengthened, which has Chart 2. bolstered the company’s role in the funding of SMEs. However, Finnvera’s Average margins on new corporate loans granted resources for SME funding are limited by Finnish MFIs, by loan size and insufficient at present for the 1. New drawdowns of up to EUR 50,000 2. New drawdowns of up to EUR 250,000 company to extensively replace the 3. New drawdowns of over EUR 50,000 and up to EUR 250,000 4. New drawdowns of over EUR 250,00 and up to EUR 1 million banking sector as a financier of SMEs. 5. New drawdowns of over EUR 1 million An unlikely – yet potential – threat Percentage points 3.5 is that banks’ increasing funding 1 constraints could significantly reduce 3.0 2 3 their ability to finance firms. This threat 2.5 4 was concretely experienced in Finland 2.0 5 in early 2009, following the stagnation 1.5 in global banking after the collapse of 1.0 Lehman Brothers. From the perspective 0.5 of corporate finance, the occurrence of 2010 2011 2012 2013 a similar situation could require uncon- Excluding account and repo agreements. ventional measures, which should be Source: Bank of Finland calculations. taken into account.

The situation of SME finance in Finland Bank of Finland Bulletin 2 • 2013 57 Chart 3. Venture capital investment in Finland

Average interest rates on new corporate loans of up to A rise in funding costs in relative terms EUR 1 million with an initial rate xation of up to 1 year has increased SMEs’ interest in venture 1. GIIPS countries* 2. Euro area capital and private equity investors. 3. Finland 4. Countries with high credit rating** 5. 3-month Euribor Although venture capital investment6 in % 7 Finland has only averaged EUR 6 150–200 million per annum in the past 5 1 10 years, this funding type plays a vital 4 2 role in the financing of start-up and 3 3 early-stage businesses. 2 4 In Finland, early-stage businesses 1 that have obtained venture capital grow 0 5 2004 2006 2008 2010 2012 faster than firms without venture

* Greece, Ireland, Italy, Portugal and Spain. capital investors. According to a study ** Germany, France, the Netherlands, Belgium, Austria and Finland. conducted at Aalto University on the Source: European Central Bank and Bank of Finland calculations. impact of venture capital and buyout investment in Finland,7 venture capital/ private equity-funded firms experience markedly faster growth in sales and added value than those not backed by levels than in the crisis countries such investments. The number of (Chart 3). employees has also grown faster in Interest rate statistics show that VC/PE-financed firms than in other the smaller the loan, the higher the benchmark companies. interest rate generally is. Hence, SMEs Venture capital investment typically pay higher interest rates on supports innovation in growing loans than large firms. This is not early-stage businesses, and the study surprising in itself. Banks usually have shows that VC/PE-financed firms were less information on small than large granted double the amount of patents firms, so that they add a risk premium on average than other early-stage firms. reflecting information shortage to the Intangible assets also increased in price of SME credit. Loans to small VC/PE-financed firms and contracted in firms also cause relatively higher benchmark companies. Expenditure on administrative costs to banks than research and development was higher in loans to larger firms, and banks’ venture-backed companies than in non-lending income from SMEs is smaller than the respective income from 6 Venture capital investment includes here seed capital, start-up capital, early-growth stage and later- large enterprises. In addition, the actual growth stage capital funding. 7 Tomi Alén (2012) Venture Capital- ja buyout-sijoi- business risk is high especially for tusten vaikuttavuus Suomessa (The Impact of Venture start-up businesses, so that these loans Capital and Buyout Investment in Finland). Aalto University. Department of Industrial Engineering and tie up banks’ own funds more. Management.

58 Bank of Finland Bulletin 2 • 2013 The situation of SME finance in Finland Chart 4. other firms at the year of investment, but did not grow faster thereafter. Venture capital investment in selected countries in 2011 The funding possibilities of venture % of GDP Sweden capital firms differ in Europe by Denmark UK country. Venture capital investment Finland Ireland relative to the size of the economy has France Austria decreased with the financial crisis to The Netherlands Germany approximately a half compared with EU27 Belgium Spain the pre-crisis years. Investment in EU Portugal Italy was 0.14% of GDP in 2006, compared Greece to 0.07% of GDP in 2011 (Chart 4). 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 Venture capital investment has Sources: EVCA and Eurostat. always been minimal in the crisis countries, even despite the relatively large number of micro and small enterprises in these countries. With the advancement of the crisis, venture current year, the government will capital investors have almost introduce three-year tax incentives for completely withdrawn from crisis private business angels. Finnvera will countries’ markets. In Spain, investment withdraw from direct venture capital was still close to EU average prior to investment for early-stage enterprises, the crisis, but has dried up to minimum but through the Finnish Funding in the past few years. One of the Agency for Technology and Innovation reasons for the scarcity of investment in (Tekes), assets will be channelled to crisis countries is the major role of the funds investing in such businesses. In banking sector in venture capital addition, the government-owned investment: the markets have Finnish Industry Investment will contracted substantially when banks establish a new fund (FoF Growth II) have had to withdraw from these that aims also to attract private capital investments. investors. These measures can be Despite the low level of venture regarded as a step in the right direction, capital investment in Finland, calcula- as from the perspective of the efficiency tions by the European Private Equity of financing early-stage companies it and Venture Capital Association would be more useful for the public (EVCA) and the Eurostat show that sector to focus on picking the right SMEs’ access to this finance in Finland system instead of picking the winners.8 is among the best in the EU. The Finnish government’s spring decisions relating to capital investment basically support capital investment activity, even though the government is pulling out of 8 Kerr – Nanda (2010) Entrepreneurial Finance and direct capital investing. During the Public Policy. VoxEU 27. April.

The situation of SME finance in Finland Bank of Finland Bulletin 2 • 2013 59 SMEs access to finance than access to finance (Chart 5). The deteriorating responses deviate markedly from According to surveys on the funding of average euro area results. SMEs in SMEs, the situation of Finnish SMEs almost all other countries report weak has been among the best in Europe with demand as their most dominant respect to the availability and terms of concern. Problems relating to access to financing, but there are increasing signs finance are perceived as being almost as of deterioration in the access to finance. pressing. Access to finance has deterio- This is best evidenced by the euro area rated significantly especially in crisis Bank Lending Survey (BLS), but other countries dominated by small unofficial information on the availabil- enterprises, which has hampered SMEs’ ity of funding also points to a operating conditions. tightening in SMEs’ access to finance. The survey suggests that Finnish According to the ECB survey on SMEs’ indebtedness has not grown. SMEs’ access to finance,9 Finnish SMEs According to the latest survey published consider tight competition as their most in April 2013, indebtedness has pressing problem. Increased production remained unchanged or even decreased and other costs and weak demand are for almost 70% of Finnish SMEs. Debt also perceived as a greater problem levels have increased for only about slightly over 10% of SMEs during the 9 ECB (April 2013) Survey on the access to finance of small and medium-sized enterprises in the euro area. past six months (from October 2012 to March 2013). Nearly half of SMEs have financed Chart 5. their operations with internal funds. As for financing needs, the use of trade The most pressing problems faced by Finnish SMEs credits has increased. The use of leasing, 1. 1–6/2011 2. 7–12/2011 3. 1–6/2012 4. 7–12/2012 factoring and other similar forms of % 30 financing has also increased to some 1 2 3 extent. Growth in the demand for bank 25 4 credit has still been sluggish. 20 More than half of SMEs have debt 15 financing from various financial institu- 10 tions. Funding is very strongly based on

5 financing via banking groups. Besides

0 credit, leasing-typed funding is also generally raised from banks or financial Other Cost of Finding Accessnance to corporations owned by banks. Regulation customers Competition production Availabilityskilled ofstaff Financing possibilities of the specialised Source: ECB survey on the access to nance of small and medium-sized enterprises in the auro area. financing company Finnvera have been expanded, and the company is playing an increasingly important role as a financier of growth-oriented SMEs in

60 Bank of Finland Bulletin 2 • 2013 The situation of SME finance in Finland particular. Consequently, a larger Impact of changes in the capital adequacy framework on SME number of SMEs are planning to seek lending eased in EU funding from Finnvera. Interest rate margins on credit and The objective of the Basel III capital other costs are on the increase. Banks adequacy framework is to mitigate the have also tightened their collateral probability and impact of financial requirements. In addition, the ECB’s crises. Effective regulation helps in survey on SMEs’ access to finance maintaining stability, thereby lending reveals that SMEs have pointed to a support to economic growth. Stable lower willingness or possibilities of conditions are pivotal to SMEs, as they banks to grant new credit over the past can rarely rely on comprehensive safety year. nets. Smaller firms are also typically SMEs that have applied for bank dependent on external finance, financing have still received almost the especially bank funding, which full amount of their application, so that emphasises the importance of financial there has been no significant change in stability. Therefore, regulatory changes this respect over the past year. have a relatively greater impact on Rejections of SMEs’ loan applications corporate finance in countries have increased marginally. In the most dependent on bank financing, such as recent survey the rejection rate was Finland, than in countries more reliant 11%, compared to 5% in the previous on securities-based financing. survey round. SMEs’ expectations The regulatory changes will regarding their access to bank loans in require banks to hold capital of a the period ahead have also deteriorated higher quality than before, more slightly. suitable for absorbing losses. The effects According to SBA Fact Sheet of the new regulatory framework do Finland 2012 published by the not particularly fall on SMEs. Rather, European Commission, Finland has the the impact on SME finance comes from most SME-friendly environment in the the general requirement to improve EU, and the Commission considers banks’ capital adequacy. Finland as a benchmark in this respect. Capital adequacy can be improved SME finance is highly bank-centred in via increasing capital, reducing risk all European countries. From this weights applied to assets and decreasing perspective it can be discerned that, in the amount of assets. Increasing capital terms of various access to finance causes additional costs for banks, so Changes to bank indicators, Finland’s scores for SMEs that this is usually not the primary regulation will affect are among the best of the EU countries option for banks to raise their capital corporate finance in – according to the Commission, the adequacy ratios. Increasing capital also Finland. best. reduces the return on equity significant for investors, unless profitability increases accordingly. Decreasing assets is not an attractive alternative either,

The situation of SME finance in Finland Bank of Finland Bulletin 2 • 2013 61 since under normal circumstances exposures to an individual SME (excl. banks seek to avoid losing their exposures secured by mortgages) do not market shares, as it may be difficult to exceed EUR 1 million. Otherwise, an reclaim them. Therefore, an attractive unrated firm will be assigned a risk Banks can reduce method for banks to improve capital weight of 100%, while a rated firm has risk-weighted assets adequacy is to reduce their risk- a risk weight of 20–150%. by shifting the focus weighted assets. The Basel III framework will be of lending from There are two methods for introduced at EU level with the Capital corporate loans to calculating risk-weighted assets: Under Requirements Regulation (CRR) and mortgages. the standardised approach (SA), banks the Capital Requirements Directive classify their exposures according to (CRD IV). At the preparatory stage of various asset classes and use, as the regulatory package, banks and the applicable, ratings assigned by external SME sector highlighted the adverse credit rating institutions to determine impact of the new framework on SME the risk weights of these asset classes; lending. At the European Parliament’s under the internal ratings based (IRB) initiative a supporting factor was approach, banks determine the introduced in the regulatory package, minimum capital for credit risk on the which neutralises the impact of the basis of parameters derived from their forthcoming capital conservation buffer own internal models.10 on banks’ exposures to SMEs.11 This Transition from SA to IRB usually relief is granted on the condition that a reduces risk weights. Another method corporate customer’s turnover is EUR to reduce risk-weighted assets is to 50 million at most and the bank’s total replace high-risk assets that tie up a exposures to the company do not considerable amount of capital with exceed EUR 1.5 million. assets that have a low risk weight. This The impact of the supporting can be done eg by shifting the focus of factor is significant. The supporting new lending from SME funding to factor, together with the risk weight of mortgage lending. 75% applicable to retail exposures, The current capital adequacy reduce smaller banks’ risk-weighted framework includes a supporting factor assets related to the smallest firms by for the risk weights of small corporate 43%. The impact is heightened by the customers. Under the SA, exposures to fact that the supporting factor is SMEs can be treated as retail exposures permanent and will also be applied with a risk weight of 75% in capital under the IRB. adequacy calculations. This reduction The ECB considered the supporting in risk weights is granted on the factor as an important policy tool that condition that the bank has a well- may help SMEs in their access to bank diversified credit portfolio and its total

11 The supporting factor corresponds to the ratio 10 Such parameters include the probability of default between the current ratio (8%) and the new one (PD), the loss given default (LGD) and the exposure at inclusive the capital conservation buffer (10.5%) and default (EAD). amounts to 0.7619 (= 8% / 10.5%).

62 Bank of Finland Bulletin 2 • 2013 The situation of SME finance in Finland finance.12 By contrast, financial therefore further reduce the attractive- supervisors took a rather reserved stance ness of SME loans for banks. on the supporting factor. Supervisors considered that easing SMEs’ access to SMEs’ financing conditions finance to secure economic growth and should be improved employment is a commendable objective SMEs are important to the economy, in itself, but the selected method does especially given their fundamental role not comply with risk-based capital in creating employment. In addition, adequacy supervision. It is also uncertain SMEs are highly dependent on banks in whether the funds ‘saved’ will be terms of funding. Sharp deterioration in channelled to SME financing or to other SMEs’ access to bank finance would purposes. For this reason supervisors have significant economical repercus- should regularly monitor the amount of sions especially via weaker employment reductions in credit institutions’ capital and lower economic activity. requirements and developments in the In connection with regulatory stock of lending to SMEs. changes for banks, attention has been Basel III introduces for the first paid on the impact of the changes on SMEs play a time quantitative requirements on SMEs’ access to finance and financing significant role in banks relating to financial risk. The terms and conditions. Regulatory job creation. liquidity coverage ratio (LCR) requires changes will raise the costs of bank Therefore, their banks to maintain larger reserves of funding, but the effects of these changes financing liquid assets than before as a buffer on SMEs have been eased in the EU. conditions should against short-term liquidity stress. The most important regulatory change be improved. This requirement cannot be affecting SMEs would have been the fulfilled with bonds of other banks, capital conservation buffer, but the which will increase the demand for impact was neutralised with the loans of governments and firms with supporting factor. Regulatory changes high credit ratings. This will contribute will encourage banks to optimise risk- to easing robust large enterprises’ access weighted assets, with the focus of to finance. The impact on SMEs can be funding on targets with low risk opposite, since a larger liquidity buffer weights. This may reduce lending to ties up more assets, leaving less room firms with the highest risks. for SME funding. EU comparisons show that The fixed-term bank tax to be Finland’s position in terms of SME introduced in Finland is determined on finance is relatively good, but there is the basis of a bank’s risk-weighted nevertheless room for development. assets. The tax will increase banks’ SMEs’ access to finance is deteriorating, incentives to reduce assets with high however, and the costs of borrowing are risk weights. The bank tax can growing at a brisk pace particularly for smaller firms. Other borrowing-related 12 Benoît Coeuré, Member of the Executive Board of costs have also increased and collateral the ECB (2013) SME financing, market innovation and regulation. Speech on 11 April 2013. requirements have tightened.

The situation of SME finance in Finland Bank of Finland Bulletin 2 • 2013 63 A more robust banking system is able to sustain lending under economic downturns better than before, which is important especially for SMEs dependent on bank financing. Diversifi- cation of funding sources would be welcome for the functioning and stability of financial markets. It would be possible to increase domestic investors’ share in funding of Finnish businesses. This could be done eg by the establishment of domestic bond markets. This would create room for bank financing of small enterprises that have no access to market-based funding. If financing conditions were to deteriorate significantly from the present, it is justified that the government supports SMEs’ access to finance.

Keywords: SME finance, bank regulation

64 Bank of Finland Bulletin 2 • 2013 The situation of SME finance in Finland Jukka Vauhkonen – Hanna Westman

Finland must be prepared to impose systemic capital requirements on banks

2.5.2013

The structure of the Finnish banking The new minimum capital require- system is vulnerable, due to the banking ments are however not necessarily system’s growing size, high degree of sufficient to safeguard the stability of concentration, strong national and Nordic the banking system in all countries. interconnectedness, and the systemic Measures stronger than the minimum importance of some banking groups. requirements may be necessary particu- Finnish authorities must be prepared to larly in countries in which the national impose either on all banks or some banks banking market is dominated by large, additional capital requirements allowed domestic systemically important banks Jukka Vauhkonen under the EU’s Capital Requirements Economist (D-SIBs) or in which the banking Financial Stability Directive (CRD). system has a high degree of concentra- and Statistics tion and is very large relative to the size One of the key reasons for and of the economy. amplifiers of the global financial crisis The EU’s Capital Requirements which started in 2007 was banks’ Directive will grant national authorities capital adequacy which, in retrospect, the right to impose additional capital Owas too weak. Capital adequacy requirements on D-SIBs. In addition, regulations encouraged banks to authorities may impose on the entire excessive risk-taking and allowed them banking sector or some of the banks, to hold on their balance sheets very for macroprudential reasons – eg the small amounts of highest-quality own large size of the banking sector or for Hanna Westman Economist funds relative to risks to cover losses other similar grounds – an additional Financial Stability (see Box 6). Banks’ insufficient capital systemic risk buffer requirement. and Statistics adequacy weakened confidence in the This article assesses whether these banking system and forced a number of national discretionary measures should countries to use a considerable amount be introduced also in Finland. The of public funds to rescue the banking article also examines the plans of the system and to ensure the availability of Norwegian, Swedish and Dutch important banking services. authorities to tighten capital adequacy As a result of the financial crisis, regulations. As the largest Nordic global measures have been taken to banking groups have subsidiary or strengthen the capital adequacy branch operations in several Nordic regulations for banks. The new Capital countries, including Finland, Finnish Requirements Directive (CRD) and authorities should pay close attention Regulation (CRR) for banks, which are to the plans of the Nordic countries to scheduled to be published by the end of tighten the capital regulations on banks. June 2013, will require, among other things, that EU banks hold more and Systemic risks caused by higher-quality capital. In addition, an systemically important banks additional loss absorbency requirement Systemically important banks are banks will be imposed on global systemically whose failure, protracted bankruptcy important banks (G-SIBs). proceedings or other major distress

Finland must be prepared to impose systemic capital requirements on banks Bank of Finland Bulletin 2 • 2013 65 could seriously damage the other parts In terms of financial stability, the of the banking and financial system and systemic importance of a bank may also hence the economy as a whole.1 The have an adverse indirect impact on the greater the systemic importance of a behaviour of bank management, share- bank, the more difficult it is to holders and financiers. An assumption substitute the services it provides, the that the financiers of systemically more difficult and expensive it is to important banks will be bailed out with solve its problems and the easier its public funds (implicit or explicit public problems spread to the other parts of guarantee) will lower banks’ funding the banking system. costs and weaken market discipline. In a crisis situation, systemically Artificially inexpensive funding may important banks have often been bailed encourage banks to excessively increase The use of public out with public funds because they have their balance sheets, risk-taking and funds to bail out been deemed as ‘too-big-to-fail’. The indebtedness, as was witnessed during banks has use of public funds to bail out banks the recent financial crisis. significantly has significantly increased the The importance of implicit public increased the government debt burden and strength- guarantees can be assessed by using government debt ened the links between sovereigns and credit ratings granted to banks based burden and distressed banks in several countries. on various criteria. Credit rating strengthened the The increased exposure to banking agencies issue to the largest banks two links between sector risks has in some countries differing credit ratings: the one is based sovereigns and hampered government borrowing. on the assumption of public (or intra- distressed banks in Events in recent years have also banking group) support in a problem several countries. shown that in a number of countries, situation (support rating), and the other the largest banks have grown to the assumes that a bank must stand alone extent that, relative to general in a problem situation (stand-alone government resources, they are ‘too-big- rating) (Chart 1). The higher a bank’s to-save’. This is a particularly support rating, the lower the price of its significant problem in Europe where market funding. banks operate in cross-border markets A comparison shows that the but the primary responsibility for implicit public guarantee granted to banking supervision and crisis European large banks is still significant resolution still lies with the national (Chart 1).2 The expectations concerning authorities. The objective of the bank bailouts in euro area crisis banking union which is currently in the countries have largely materialised. process of being established is to reduce this disparity (see the section ‘Financial 2 In some countries, the difference between the system policy’). support and stand-alone rating may have decreased recently due to the weakening of public finances and the deterioration of the government’s assumed ability to support banks with public funds. The difference 1 Also other financial institutions than banks can be between the credit ratings has shrunk also in countries systemically important. This article examines only the where authorities have been granted strong tools for regulation of systemically important banks and the the orderly restructuring or winding up of a bank, as systemic risks caused by these banks. eg in Denmark.

66 Bank of Finland Bulletin 2 • 2013 Finland must be prepared to impose systemic capital requirements on banks The vulnerability of economies Chart 1. in banking crises Moodys’s credit ratings for selected Nordic and The new global minimum capital European banks requirements for banks may be insuffi- 1. Stand-alone rating cient in countries in which the banking 2. Difference between supported and stand-alone rating Crisis country sector has a high degree of concentra- Nordic banks Large international banks banks Aaa Aa1 tion and globalisation and is large Aa2 Aa3 relative to the size of the economy. The A1 A2 large size of the banking sector typically A3 Baa1 Baa2 1 increases output losses and costs to Baa3 2 Ba1 taxpayers caused by a banking crisis. A Ba2 Ba3 banking sector’s high degree of concen- B1 B2 B3 tration, in turn, increases the risk of Caa1 Caa2 contagion, particularly via interbank Caa3 Ca lending. Banks’ extensive cross-border C activities hamper crisis resolution as SEB UBS Nordea BBVA SydbankBarclays Unicredit resolution involves several parties and SwedbankJyske Bank Caixabank Pohjola Pankki BNP Paribas Handelsbanken Danske Bank CreditCommerzbank Agricole 3 DeutscheSociété Bank Générale Banco Com. Port. differing national legislations. Banco Santander Bank Monte of Ireland DeiNational Paschi Bank of Greece Some European countries, for For Pohjola Bank and Credit Agricole, the assumption of intra-banking group support is reected in difference between the supported and stand-alone rating. example Switzerland, the United Source: Moody’s Investor Services (data as at 9 April 2013). Kingdom and Sweden, will impose on some of their banks, mainly for structural (macroprudential) reasons, Chart 2. tighter capital requirements than the regulations issued by the Basel Committee on Banking Supervision and Banking sector size and degree of concentration in various European countries the EU’s minimum requirements. In 1. Banking sector size to GDP in June 2012 (left-hand scale) these three countries, the relative size of 2. Share of the ve largest credit institutions in total assets of the banking sector is among the largest credit institutions in 2012 (right-hand scale) % % in Europe (Chart 2). In the other 1,000 100 2 Nordic countries, the banking sector is 1 800 80 also relatively large, as is the situation in the countries that have suffered from 600 60 the banking crisis in recent years, ie 400 40 Spain, Ireland and Cyprus. 200 20 In terms of the size of the banking sector, Finland is close to the European 0 0 LU ML CY IE GB CH NL SE ES AT D KRFR FI DE PL BE GR IT SI LT EE CZB GHU OLISLPL average, but in terms of the degree of The gures for EU countries include foreign subsidiaries and branches operating in a country. The size of the Luxembourg banking sector to 3 The crisis resolution of banks operating in several GDP is 1,770% countries will be facilitated with the entry into force Sources: European Central Bank and the Swiss National Bank. of the Recovery and Resolution Directive which will harmonise the resolution tools of EU countries (see the section ‘Financial system policy’).

Finland must be prepared to impose systemic capital requirements on banks Bank of Finland Bulletin 2 • 2013 67 concentration (Chart 2) and foreign Directive)4. The Capital Requirements ownership, Finland ranks among the Directive defines the minimum capital top European countries. requirements for banks and it applies to all European banks, also those that are Regulations on the identification systemically important. The Directive of and capital requirements for will enter into force on 1 January 2014 systemically important banks at the earliest. will be tightened Moreover, EU legislation will set A key element of the ongoing global on G-SIBs a mandatory additional loss overhaul of capital regulation for banks absorbency requirement (G-SII is the Basel III framework issued by the requirement).5 The Basel Committee on Basel Committee on Banking Banking Supervision has defined Supervision in December 2010. The indicators for measuring the global Basel III rules will be implemented in systemic importance of individual Europe through the Capital Require- banks and for defining the size of the ments Directive and Regulation additional loss absorbency requirement (hereinafter: Capital Requirements for a bank. The indicators reflect the bank’s size, complexity of business and jurisdictional structure, extent of cross- Chart 3. jurisdictional activity, interconnected- ness, and the substitutability of certain G-SIBs and their G-SII capital buffer requirement banking services provided by the bank.

% The Financial Stability Board (FSB) Bucket 5 identifies the G-SIBs based on criteria set by the Basel Committee on Banking Bucket 4 Supervision. The list published in Bucket 3 November 2012 includes 28 banks on which an additional loss absorbency Bucket 2 requirement of 1 to 2.5% would be Bucket 1 imposed if the regulations were already

0 1 2 3 4 in force (Chart 3). Banks are required

Bucket 5 (Empty) to meet these requirements by using the Bucket 4 Citigroup, Deutsche Bank, HSBC ja JP Morgan Chase Bucket 3 Barclays ja BNP Paribas highest-quality capital, ie common Bucket 2 Bank of America, Bank of New York Mellon, Credit Suisse, Goldman Sachs, Mitsubishi UFJ FG, Morgan Stanley, Royal Bank of Scotland ja UBS equity Tier 1 (‘core capital’). Of the Bucket 1 Bank of China, BBVA, Groupe BPCE, Group Crédit Agricole, ING Bank, Mizuho FG, Nordea, Santander, Société Générale, Standard Chartered, State Street, Sumitomo Mitsui FG, Nordic banking groups, only Nordea Unicredit Group and Wells Fargo Group is currently listed as a G-SIB. The list of banks and their allocation to buckets is updated annually. In addition to the mandatory Banks are required to meet the G-SII requirement by using common equity Tier 1. The requirement will be phased in starting from 2016, additional loss absorbency requirement initially for those banks identi ed as G-SIBs in November 2014. 4 Source: Financial Stability Board (November 2012). Capital Requirements Directive / Capital Require- ments Regulation (CRD IV/CRR). 5 Instead of the international term ‘Global Systemi- cally Important Bank (G-SIB), EU legislation uses a more extensive concept, ‘Global Systemically Important Institution’ (G-SII).

68 Bank of Finland Bulletin 2 • 2013 Finland must be prepared to impose systemic capital requirements on banks to be imposed on G-SIBs, the Capital The capital requirements and Requirements Directive will grant to systemic risk buffer requirements based the national authorities of EU Member on global or domestic systemic States two discretionary additional importance will not be cumulative, capital requirements to prevent systemic instead only the highest will be applied risks caused by D-SIBs. Each Member (Chart 4). As a result, the additional State may impose on its entire financial capital requirements set for a bank sector or part of it a systemic risk buffer based on its systemic importance or requirement for the prevention of structural reasons may, under EU long-term structural or macropruden- legislation, be a maximum of 5% tial risks. These risks may include, for relative to risk weighted assets. example, systemic risks caused by the banking sector’s large size or high Capital requirements for degree of concentration. The maximum systemically important banks in Norway, Sweden and Denmark size of the systemic risk buffer requirement is, as a rule, 5% but in The EU’s Capital Requirements exceptional circumstances it can be Directive will grant Member States a even bigger.6 considerable amount of discretion in In addition, from 2016 onwards, setting the capital requirements for Member States may set for D-SIBs a 7 national surcharge of up to 2%. The Chart 4. possible criteria for assessing the systemic importance of a bank in a New capital requirements for banks relative to risk-weighted assets, based on the EU’s Capital Requirements Directive and domestic context are: the bank’s size, Capital Requirements Regulation importance for the EU or for the Additional capital buffer requirement 0–2%* imposed by the supervisory authority national financial system, importance of Pillar 2 for covering other bankspecic risk requirement cross-border activities and interconnect- 0–5% Additional core Tier 1 capital edness with the other parts of the Highest: G-SII, O-SII, requirement: SIBs and structural risks systemic risk buffer financial system.8 The Directive requires 0–2.5%* Supplementary discretionary core Tier1 the European Banking Authority (EBA) Variable counter- capital buffer requirement in case of cyclical capital buffer to issue by 1 January 2015 more requirement excessive lending 2.5% Fixed capital Supplementary core Tier 1 capital buffer detailed guidelines on the identification conservation for covering losses buffer requirements criteria for D-SIBs. 2% Tier 2 capital 6 1.5% EU-level approval and reporting procedures for Other Tier 1 capital setting the systemic risk buffer depend on the size of 4.5% Minimum capital requirement ** the buffer and the date of setting the buffer during the transitional period for the implementation of the Core Tier 1 capital Directive. By approval of the European Commission, Member States can set a systemic risk buffer requirement of above 5%. See European Commission *Initial upper limit (levels can be higher). (2013) CRD IV/CRR – Frequently Asked Questions, **Of the minimum capital requirement of 8%, a minimum of 4.5% must be 21 March 2013. core Tier 1 capital, a maximum of 1.5% other Tier 1 capital, and a maximum 7 So-called O-SII requirement (Other Systemically of 2% Tier 2 capital. Important Institutions, O-SII). Source: European Commission. 8 The assessment criteria are based on the recommen- dation published by the Basel Committee on Banking Supervision in October 2012.

Finland must be prepared to impose systemic capital requirements on banks Bank of Finland Bulletin 2 • 2013 69 systemically important banks. For met with core Tier 1 capital, by the end Finland, it is particularly important to of 2019. The committee also proposes monitor the capital adequacy that banks should be required to hold a regulations and other rules and crisis management buffer of 5%. This regulations the other Nordic countries requirement should be met with core start to apply. Tier 1 capital, other Tier 1 capital (eg In Sweden, authorities responsible hybrid capital) or Tier 2 capital (eg for financial stability have assessed that subordinated loans). The crisis the Swedish banking sector’s large size, management buffer would be converted degree of concentration, extent of cross- to common equity Tier 1 if the bank’s border activities, and dependency on solvency breached the critical limit and funding in foreign currencies create the bank was subject to restructuring. risks that require the tightening of The committee proposes that the capital requirements for systemically systemic importance of a bank be important banks.9 According to the assessed using at least the following initial plan of the Swedish authorities, three indicators: a bank’s total assets the minimum requirement for core Tier relative to GDP, share of loans to the 1 capital should have amounted to a public, and share of deposits from the minimum of 10% of risk-weighted public. A bank is defined as systemically assets as of 1 January 2013. important if its total assets amount to The plan was however postponed, over 10% of GDP or its share of the due to the delay in the EU’s capital loan or deposit stock is over 5%. The adequacy reform. The Swedish fulfilment of just one of the criteria is authorities are however keeping to the sufficient for the bank to be designated core capital requirement of 12% which as a SIFI. Based on the indicators, there will take effect on 1 January 2015. The would have been at least six systemic­ requirement is 5 percentage points ally important banks in the Danish higher than the minimum requirement banking sector at the time of the for core Tier 1 capital (incl. the fixed Committee made its assessment. capital conservation buffer In Norway, a legislative proposal requirement) to be set in the Capital on new capital requirements for credit Requirements Directive. institutions and investment firms was In Denmark, a high-level put forward in March 2013.11 As a committee has proposed an additional member state of the European capital requirement of 1–3.5% of risk Economic Area, Norway will use the weighted assets for Danish SIFIs.10 The law to incorporate the EU’s Capital additional capital requirement must be Requirements into national legislation. Norway will introduce in stages the 9 The Riksbank (2011) New capital requirements for systemic risk buffer of 3% allowed Swedish banks. Press release, 25 November 2011. 10 The Danish Ministry of Business and Growth (2013) SIFI-Committee recommends additional 11 The Norwegian Ministry of Finance (2013) New requirements for the largest Danish banks. News 14 legislation on capital requirements for credit institu- March 2013. tions. Press release, 22 March 2013.

70 Bank of Finland Bulletin 2 • 2013 Finland must be prepared to impose systemic capital requirements on banks under the EU’s Capital Requirements Chart 5. Directive. In addition to the systemic Core capital requirements set and planned for risk buffer requirement that will apply systemically important banks in various countries to all banks, a surcharge of 2% will be % set for systemically important banks. 20

The other Nordic countries, as 16 well as some European countries, will thus impose on systemically important 12 banks capital requirements that are 8 tighter than the EU’s minimum require- 4 ments (Chart 5). The requirements on 0 core capital to be imposed by the other All banks G-SII Switzerland United Sweden Denmark Norway Kingdom Nordic countries are tighter than for Basel III/EU (CRDIV/CRR) example in Switzerland and the United Sources: Basel Committee on Banking Supervision, European Commission, Kingdom. Switzerland and the United and legislative proposals in various countries. Kingdom are however planning to set for their systemically important banks higher total capital requirements than the other Nordic countries (Chart 6). A Chart 6. bank may fulfil part of this requirement with debt securities that it has issued Total capital requirements set and planned for and that can convert to share capital, if systemically important banks in various countries necessary. % 20 Finnish banks’ systemic 16 importance and the Finnish economy’s vulnerability in 12 banking crises 8 Finnish authorities should assess 4 whether the minimum capital require- 0 ments for banks, under the EU’s Capital All banksG-SII SwitzerlandUnited Sweden Denmark Norway Kingdom Requirements Directive, are adequate to Basel III/EU (CRDIV/CRR) safeguard the stability of the Finnish Sources: Basel Committee on Banking Supervision, European Commission, banking system, or whether Finnish and legislative proposals in various countries. authorities, too, should impose on some banks or the entire banking sector, additional capital requirements allowed under the Directive and described above. In several European countries, extensive studies, official assessments and academic analyses have been conducted in recent years on the social

Finland must be prepared to impose systemic capital requirements on banks Bank of Finland Bulletin 2 • 2013 71 benefits and costs of tighter capital relatively large size (Chart 2), the adequacy requirements for banks.12 Finnish banking sector is strongly inter- These studies assess for example the connected, both at the national and optimal level of banks’ capital adequacy cross-border level. Based on commonly requirements, from the perspective of used indicators it would also seem clear financial stability. The assessments that at least the three largest Finnish compare, in particular, the social banking groups could be assessed as benefits of a decrease in banking crises being a D-SIB. and the social costs of a possible The indicator of a bank’s size, ie increase in the cost of bank funding. the balance sheet-to-GDP ratio, enables The majority of the The majority of the assessments the assessment of whether large banks European indicate that capital adequacy require- are ‘too-big-to-save’ relative to the assessments ments should be significantly higher strength of public finances. Nordea indicate that the than the minimum requirements to be Bank Finland Group’s ratio, based on capital adequacy introduced. figures for 2011, was over 200%, ie requirements Finnish authorities have not significantly higher than the ratio of the should be conducted any extensive assessment of other banks (Chart 7). The high ratio is significantly higher the optimal level of capital adequacy partly explained by the fact that than the future requirements for Finnish banks.13 The Nordea has concentrated its capital minimum systemic importance of Finnish banks markets activities serving the entire requirements. and the need to tighten their capital Nordea Group into Finland. The ratio requirements can however be assessed based on figures for 2012 has declined based on international recommenda- to 176%14 but it is still relatively high. tions and the criteria included in the The substitutability of the key forthcoming Capital Requirements banking services provided by a bank Directive, as well as indicators used by can be measures eg with the bank’s other countries in their assessments. market share in loans to the private Based on commonly used sector and deposits from the private indicators, the Finnish economy may sector. Based on the proposal by the suffer from banking crises more than Danish SIFI-Committee and the criteria some other economies. In addition to its examined above, a Danish bank is high degree of concentration and designated a SIFI if its share of loans to

12 See eg. The Independent Commission on Banking the public and deposit from the public Final Report (September 2011) and The Riksbank is higher than 5%. Based on these (2011) Appropriate capital ratio in major Swedish banks – an economic analysis. criteria, OP-Pohjola Group, Nordea 13 In November, a Ministry of Finance working group led by Minister Antti Tanskanen submitted its Bank Finland and Danske Bank Plc proposal for the organisation of macroprudential would be designated as systemically supervision and the macroprudential tools needed by the Finnish authorities. The working group did not important banks in Finland (Chart 8). If assess the need to impose on Finnish banks additional capital requirements, because at the time of the final report, there was still uncertainty as to the contents of 14 Nordea Bank Finland’s balance sheet decreased by the Directive (relating to the O-SII buffer and the 14% in 2012. This was due in particular, to a decrease systemic risk buffer). In its final report, the working in the balance sheet values of derivatives contracts on group noted that the question will be discussed when the back of increased use of central counterparty the related legislation is prepared. clearing.

72 Bank of Finland Bulletin 2 • 2013 Finland must be prepared to impose systemic capital requirements on banks Chart 7. a minimum 5% market share in housing loans were used as criteria for systemic importance, also Aktia Group Banks’ total assets relative to GDB could be deemed as systemically 1. 2012 2. 2011 3. 2010 4. 2009 important. % Nordea 1 Bank 2 Finnish banks are strongly inter- Finland 3 Group 4 connected with other domestic banks OP-Pohjola Group and, due to ownership arrangements, Danske also with large Nordic banking Bank Plc 15 groups. Studies by the Bank of Aktia Group Finland show that the internal Bank of contagion risks in the Finnish banking Åland system are significant. Assessments of 0 50 100 150 200 250 the systemic importance of Nordea Sources: Banks’ nancial statements and Statistics Finland. Bank Finland and Danske Bank Plc in particular, must take into consideration their direct Nordic interconnectedness. The complexity of a bank is often measured by the share of securities Chart 8. trading and investment activities of the bank’s total income or balance sheet total. In 2012, trading and investment Banks’ market share of loans and deposits in Finland, 31 December 2012 activities accounted for more than 40% 1. Loans to the public 2. Deposits from the public of Nordea Bank Finland’s total income. 3. Housing loans to households* % As for the other banks, the share was 40 2 3 significantly smaller (Chart 9), but in 1 the case of Bank of Åland, trading and 30 investment activities accounted for 20 nearly one fifth of total income. A business model which combines 10 core banking and insurance business increases the complexity of a financial 0 OP-Pohjola Nordea Bank Danske Bank Aktia Bank Bank of conglomerate and hence its systemic Group Finland Group Plc Plc Åland importance. In Finland, OP-Pohjola * Households include non-pro t institutions serving households. Group and Aktia are examples of this Source: Federation of Finnish Financial Services. type of a business model. On the basis of the selected indicators examined above and a more comprehensive analysis, the Finnish

15 Nordea Bank Finland and Danske Bank Plc are the most significant subsidiaries operating in Finland and Handelsbanken is the most significant branch.

Finland must be prepared to impose systemic capital requirements on banks Bank of Finland Bulletin 2 • 2013 73 Chart 9. Mechanism (SSM).16 Of the Finnish banking groups, Nordea Bank Finland, Distribution of banking sector income in 2012 OP-Pohjola Group and Danske Bank 1. Net interest income Plc fulfil these criteria. 2. Net fee income 3. Net income from trading and investment activities 4. Net income from non-life and life insurance The structural vulnerability 5. Other income of the Finnish banking system % 100 argues for the tightening of 5 4 capital requirements 80 3 The other Nordic countries are signifi- 60 cantly tightening the capital require- 2 40 ments for banks. Also in Finland, 1 national legislation should enable the 20 setting of additional capital require- 0 Nordea Bank Bank of Danske Bank OP-Pohjola Aktia Bank ments either for all Finnish banks or Finland Group Åland Plc Group Plc some of them. Source: Financial Supervisory Authority. The structure of the Finnish banking system is vulnerable. The size of the banking system, the high degree of concentration, the strong intercon- nectedness between banks, and the systemic importance of some of the banking sector seems to be divided into banks, argue for the tightening of three groups, based on systemic capital requirements above the EU-level importance. The first group comprises minimum requirements. Differences in Nordea Bank Finland, which is systemi- banks’ capital requirements in various cally important based on a number of Nordic countries may encourage banks criteria. The second group consists of to transfer their activities and risks to OP-Pohjola Group and Danske Bank countries with the most relaxed Plc, which are relatively large in size regulations. The consequences of this and significant in terms of the key regulatory arbitrage could be difficult market shares. The third group to anticipate and adverse in terms of comprises the other banks, the systemic the stability of the Finnish financial importance of which seems to be clearly system. smaller than that of the abovemen- Assessments of the need for tighter tioned banks. regulations should take into considera- Assessments of the systemic importance of a bank should also take 16 A bank will fall under the direct supervision of the Supervisory Board operating within the ECB if 1) the into consideration the criteria for total value of its assets exceeds EUR 30 billion; 2) the ratio of its total assets over GDP exceeds 20% and selecting the large banks that will fall the total value of its assets is above EUR 5 billion; or under the scope of the European if 3) it receives direct public financial assistance from the European Financial Stability Facility (EFSF) or the Banking Union’s Single Supervisory European Stability Mechanism (ESM).

74 Bank of Finland Bulletin 2 • 2013 Finland must be prepared to impose systemic capital requirements on banks tion eg the benefits achieved from the more effective than capital adequacy banks’ large size as well as the scope requirements in eg reducing banks’ and extent of cross-jurisdictional trading risks because these risks are business activities. Large banking difficult to measure and the risk profiles groups that provide diverse services and can be adjusted rapidly. operate in several countries are able to The appropriateness of regulation provide demanding banking services that will affect the structure of Finnish required by large customers. Large banks should be assessed taking into banks are also more able to diversify consideration the global progress in risks than the smaller banks. Banking regulation. An assessment of the impact also seems to include economies of that the other regulatory and financial scale, at least to certain extent. architecture initiatives being prepared Assessments of the need for regulation (eg the Recovery and Resolution should compare these factors and the Directive on banks and the EU’s social costs of additional regulation to Banking Union) will have on the the social benefits of regulation. systemic risks caused by systemically Assessments should also take into important banks and the mitigation of consideration that proposals have been these risks must also be made. made to reduce risks caused by the complexity of banks by regulation that Key words: Nordic banks, capital will affect the structure of banks adequacy requirements, systemic risks, (Chart 5).17 Direct restrictions can be systemic importance, implicit public guarantee 17 Final report by the High-level Expert Group on reforming the structure of the EU banking sector (2 October 2012). See http://ec.europa.eu/ internal_ market/bank/docs/high-level_expert_group/report_ en.pdf.

Finland must be prepared to impose systemic capital requirements on banks Bank of Finland Bulletin 2 • 2013 75

Heli Snellman – Eero Tölö Payment transfers measure the pulse of the financial markets

6 May 2013

The euro led to the integration of the central banks of all euro area countries, money markets, enabling banks to flexibly the European Central Bank and the obtain liquidity from each other across central banks of Denmark, Lithuania, borders. During the crisis, however, Latvia, Poland, Romania and Bulgaria, interbank money markets have faded. together with their respective user Cross-border payments between Finnish communities are participating in and debt-crisis country banks have TARGET2. The TARGET2 system diminished. plays a pivotal role in the euro area, as Besides balance sheet data, payment it processes the payment transfers Heli Snellman Economist transactions provide an interesting related to euro area monetary policy Financial Markets channel for monitoring activity in the operations, among others. The and Statistics money markets and in the broader settlement of about 80 ancillary economy, too. Changes in the volumes systems1 also takes place in TARGET2. and values of payment transactions Problems in TARGET2 would rapidly between the parties involved are rapidly lead to problems in other systems, even visible and may give early signs of on a global scale. In addition, many changing patterns in behaviour. Payment large international banks are partici- transfers are actually a kind of measure of pants in several different systems all the pulse of the markets – if unforeseen over the world, meaning that the changes occur in the pulse, the causes for problems of these banks could such volatility deserve closer scrutiny. translate, for example, into simultane- Eero Tölö Research Economist ous payment delays in a number of Monetary Policy For a stable functioning of the systems. The troubles of a single bank and Research economy, it is important that various could then be reflected promptly in economic agents receive their payments many other banks, hampering their in time and may rely on the transmis- operations. Fsion of payments. Money that keeps the The TARGET2 system is made up wheels of the society turning flows of legally separate component systems. through payment systems: bills, wages The TARGET2 component of the Bank and salaries, and pensions need to be of Finland, TARGET2-Suomen Pankki, paid as agreed. Payments between the has about twenty participants, central bank and its counterparties including Finnish and Nordic banks. related to monetary policy operations The Bank of Finland has the possibility are also settled in payment systems. In of monitoring payments in its own addition, interbank money market component system, and this transactions are executed in payment information together with balance sheet systems, as banks lend money to each data may be used in support of other, thus smoothing market liquidity financial stability analysis, for instance. among themselves. The payment traffic can be TARGET2 is a system maintained examined as an integrated whole or it by the Eurosystem for processing 1 Ancillary systems include many other payment large-value payments in euro. The systems and securities settlement systems.

Payment transfers measure the pulse of the financial markets Bank of Finland Bulletin 2 • 2013 77 can be broken down into certain types The crisis has reduced payment transfers with banks of payment, such as payments by the in crisis countries central bank, internal liquidity transfers of banking groups, settlements of Cross-border payments received and ancillary systems, customer payments sent by the participants in the and interbank transactions. Of TARGET2 component of the Bank of interbank transactions, in turn, Finland, TARGET2-Suomen Pankki, payments qualifying for overnight loans have displayed a fairly similar pattern can be followed and used for reviewing, over the years; therefore, this article for example, changes in interest rates mainly focuses on payments received. and differentials in interest rates that Overall, the value of cross-border various banks must pay for overnight payments received by TARGET2- loans. A lower-than-average interest Suomen Pankki participants has varied rate points to strong confidence quite a lot during the last few years between banks and a higher rate, (Chart 1). In value terms, the bulk of conversely, to weaker confidence. The these payments have been interbank number of counterparties and lending transactions. Since summer 2011, volumes may also reflect changes in nearly all payments received have confidence. By illustrating payment originated from countries other than flows, we can quickly obtain those at the centre of the debt crisis information on the pulse of the money (Greece, Cyprus, Ireland, Portugal, Italy markets, ie how money circulates in the and Spain). money markets. It is interesting to analyse volatility in payment transfers vis-à-vis debt-crisis Chart 1. country counterparties during the various stages of the crisis. Next, we Daily average of cross-border payments received will examine payments received from by TARGET2-Suomen Pankki participants, the debt-crisis countries, ie the area on a monthly basis between the blue and yellow lines in 1. Payments from abroad 2. Payments from countries other than GIIPS or Cyprus Chart 1. Of the debt-crisis countries, EUR million Spain has sent the highest number of 22,000 1 payments in value terms to Finland. 19,500 These transactions fluctuated fairly strongly in 2008 (Chart 2). Payments 17,000 from Spain decreased after mid-2011, 14,500 coming to an almost complete standstill 2 12,000 in summer 2012. The payment traffic has not recovered since then. Payments 9,500 2008 2009 2010 2011 2012 2013 from Italy also came to a virtual halt in the latter half of 2011. Payments from Source: Bank of Finland. Ireland diminished considerably as early as late September 2010 and do

78 Bank of Finland Bulletin 2 • 2013 Payment transfers measure the pulse of the financial markets Chart 2. not appear to have regained much momentum since then. In general, there Daily average of payments received was a very subdued flow of payments by TARGET2-Suomen Pankki participants from the debt-crisis countries in 2012. from debt-crisis countries, on a monthly basis

Only a limited amount of payments 1. Italy 2. Spain 3. Ireland from Portugal, Greece and Cyprus have 4. Portugal 5. Greece 6. Cyprus EUR million come to Finland throughout the review 1,400 period. 1,200

Cross-border payments sent from 1,000

Finland have developed in almost the 800 same way as cross-border payments 600 2 received to Finland. Throughout the 400 3 4 5 1 review period, Spain has been the 200 6 destination for the highest number of 0 transactions in value terms, with the 2008 2009 2010 2011 2012 2013 values of payment transfers being Source: Bank of Finland. volatile in 2008. Payments to Ireland virtually ended during the second half of 2010. There has not been much bonds is a kind of insurance that traffic in payments to Greece, Cyprus enables the investor to recover his and Portugal in the review period and, claims on the respective country’s debt overall, payments to the debt-crisis even in the event of the country’s countries have declined sharply since default. 2011. Although, taken as a whole, CDS spreads on government bonds payments with countries at the centre for the debt-crisis countries increased of the debt crisis have been at low generally at the initial stage of the levels, changes in individual banks’ financial crisis in autumn 2008. In late payments may act as a rapidly 2009, the CDS spread on Greek responding indicator that measures the sovereign debt began to divert from the scale of the problems and exposure to trend following disclosure of the contagion. country’s statistical irregularities, but developments moderated subsequently, The sovereign-bank link as a result of the support package is visible in the payment traffic granted in May 2010. In summer 2011, Payment transfers can also be compared confidence towards Greece weakened with other data indicating the scale of again, provoking a surge in the CDS the crisis. Countries’ credit default swap spread. Meanwhile, the difficulties also (CDS) spreads can be considered as one spilled over to Spain and Italy, raising indicator of the crisis. CDSs are credit the price for credit protection in respect derivative contracts used by investors to of their government bonds. The summer hedge their claims against credit risks. of 2012 saw a renewed heightening of For example, a CDS on government distrust, but CDS spreads for many

Payment transfers measure the pulse of the financial markets Bank of Finland Bulletin 2 • 2013 79 Chart 3. Chart 5. country’s credit risk premium as measured by the CDS spread has risen CDS spreads on 5-year government bonds for debt-crisis countries high enough. As can be judged from Payments between Italian and Finnish TARGET2 component system, CDS spread on 5-year Italian 1. Spain 2. Italy 3. Ireland Charts 4–6, in respect of Spain, Italy 4. Portugal 5. Cyprus 6. Greece (right-hand scale) government bonds and Ireland, this threshold has been Basis points Basis points 1. CDS spread on Italian government bond (left-hand scale) 2,000 5,000 exceeded when the premium has been 2. Payments to Finland (right-hand scale) 3. Payments from Finland (right-hand scale) 6 in the region of 400–500 basis points. 1,600 4,000 Basis points EUR million Payment transactions with other 750 1,200 1,200 3,000 debt-crisis countries (Greece, Cyprus 5 3 800 2,000 and Portugal) also appear to behave in 500 800 1 4 a similar fashion relative to the 400 1,000 1 countries’ CDS spreads. 2 2 3 250 400 0 0 The green points in Charts 4–6 2008 2009 2010 2011 2012 2013 illustrate daily payments received from Sources: Bloomberg and Reuters. the debt-crisis countries to Finland, 0 0 2008 2009 2010 2011 2012 2013 while the yellow points depict daily Sources: Bank of Finland and Bloomberg. payments sent from Finland. The value Chart 4. for both appears on the right-hand scale. The lower the points, the smaller Payments between Spanish and Finnish TARGET2 the sum total of daily payments Chart 6. component system, CDS spread on 5-year received and sent. The line indicates Spanish government bonds each country’s CDS spread on the 1. CDS spread on Spanish government bond (left-hand scale) 2. Payments to Finland (right-hand scale) left-hand scale. The CDS spreads have Payments between Irish and Finnish TARGET2 3. Payments from Finland (right-hand scale) component system, CDS spread on 5-year Irish first risen sharply and then declined, Basis points EUR million government bonds 750 2,700 but payment transfers have not 1. CDS spread on Irish government bond (lef-hand scale) rebounded. When the CDS spread 2. Payments to Finland (right-hand scale) 1 trends upward over a long period of 3. Payments from Finland (right-hand scale) 500 1,800 Basis points EUR million time, exceeding a certain threshold (in 1,250 1,500

this case about 400–500 basis points), 2 1 1,000 1,200 250 900 the payment traffic stops almost 2 3 3 entirely. It also remains subdued, 750 900

0 0 despite a subsequent fall in the CDS 500 600 2008 2009 2010 2011 2012 2013 spread. Only for Italy can a recovery in Sources: Bank of Finland and Bloomberg. payments received be seen, in response 250 300

to the country’s CDS spread falling 0 0 2008 2009 2010 2011 2012 2013 back to the range of 200 to 300 basis points. This is not reflected equally Sources: Bank of Finland and Bloomberg. debt-crisis countries have fallen consid- strongly in payments sent (Chart 5). erably since then (Chart 3). The sovereign-bank link appears to During this debt crisis, the value of be significant. Payments of TARGET2- payment transactions would appear to Suomen Pankki participants with coun- collapse as soon as the counterparty terparty banks in the debt-crisis

80 Bank of Finland Bulletin 2 • 2013 Payment transfers measure the pulse of the financial markets Chart 5. country’s credit risk premium as countries would seem to have come to measured by the CDS spread has risen an almost complete standstill in the high enough. As can be judged from latter half of 2011. This may be an Payments between Italian and Finnish TARGET2 Charts 4–6, in respect of Spain, Italy indication of an overall lack of component system, CDS spread on 5-year Italian government bonds and Ireland, this threshold has been confidence towards certain countries 1. CDS spread on Italian government bond (left-hand scale) exceeded when the premium has been and their banks. Banks’ credit 2. Payments to Finland (right-hand scale) 3. Payments from Finland (right-hand scale) in the region of 400–500 basis points. worthiness is strongly interconnected Basis points EUR million Payment transactions with other with their respective home countries’ 750 1,200 debt-crisis countries (Greece, Cyprus credit ratings, because of banks’ 3 and Portugal) also appear to behave in dependency on home-country support 500 800 a similar fashion relative to the in the event of their heading towards 1 countries’ CDS spreads. problems. On the other hand, recently, 2 The green points in Charts 4–6 banks have not necessarily needed to 250 400 illustrate daily payments received from borrow money from each other, as the debt-crisis countries to Finland, central banks have granted long-term, 0 0 2008 2009 2010 2011 2012 2013 while the yellow points depict daily even three-year refinancing to banks Sources: Bank of Finland and Bloomberg. payments sent from Finland. The value against collateral. Chart 4. for both appears on the right-hand scale. The lower the points, the smaller Interbank overnight loans Payments between Spanish and Finnish TARGET2 the sum total of daily payments contracted during the crisis Chart 6. component system, CDS spread on 5-year received and sent. The line indicates Payment system data also include the Spanish government bonds each country’s CDS spread on the settlement of payments related to loans 1. CDS spread on Spanish government bond (left-hand scale) 2. Payments to Finland (right-hand scale) left-hand scale. The CDS spreads have granted by banks to each other. These Payments between Irish and Finnish TARGET2 3. Payments from Finland (right-hand scale) component system, CDS spread on 5-year Irish first risen sharply and then declined, transactions cannot be directly distin- Basis points EUR million government bonds 750 2,700 but payment transfers have not guished from other interbank payment 1. CDS spread on Irish government bond (lef-hand scale) rebounded. When the CDS spread traffic, and the parties involved do not 2. Payments to Finland (right-hand scale) 1 trends upward over a long period of report these data to any register in a 3. Payments from Finland (right-hand scale) 500 1,800 Basis points EUR million time, exceeding a certain threshold (in comprehensive manner. However, we 1,250 1,500 this case about 400–500 basis points), have sought to trace overnight loans 2 1 1,000 1,200 250 900 the payment traffic stops almost granted by banks to each other using 2 3 3 entirely. It also remains subdued, the Furfine algorithm.2 The algorithm 750 900

0 0 despite a subsequent fall in the CDS identifies cases where Bank A pays x 500 600 2008 2009 2010 2011 2012 2013 spread. Only for Italy can a recovery in monetary units to Bank B on a certain Sources: Bank of Finland and Bloomberg. payments received be seen, in response day and Bank B repays the x monetary 250 300 to the country’s CDS spread falling units + interest to Bank A on the 0 0 2008 2009 2010 2011 2012 2013 back to the range of 200 to 300 basis following day. points. This is not reflected equally Overnight loans traced from the Sources: Bank of Finland and Bloomberg. strongly in payments sent (Chart 5). TARGET2-Suomen Pankki data have The sovereign-bank link appears to been visualised using the Bank of be significant. Payments of TARGET2- 2 The original algorithm is described in the article: Suomen Pankki participants with coun- Furfine (1999) The Microstructure of the Federal Funds Market. Financial Markets, Institutions & terparty banks in the debt-crisis Instruments, 8: 24–44.

Payment transfers measure the pulse of the financial markets Bank of Finland Bulletin 2 • 2013 81 Finland’s BoF-PSS2 simulator3 network overnight loans granted by TARGET2- tool (Chart 7). The arrows point from Suomen Pankki participants to each lenders’ central bank to borrowers’ other. The size of the circle is central bank, with the thickness of the comparable to the aggregate value of line being comparable to the aggregate borrowing and lending. During the lending value. Loans granted by partici- period 1 July 2008 to 31 December pants in TARGET2-Suomen Pankki to 2012, the algorithm finds the highest other countries are marked in red number in value terms of cross-border colour and loans from other countries overnight loan transactions for to TARGET2-Suomen Pankki partici- TARGET2-Suomen Pankki participants pants in blue. The arrow curving back with German, Dutch and French to Finland indicates the value of TARGET2 component system partici- pants. 3 The Bank of Finland’s BoF-PSS2 simulator enables Overnight lending volumes payment system operators and overseers to explore what would happen if a certain scenario affecting the contracted discernibly in 2012, payment system materialised. In addition, the network tool of the simulator enables a highly detailed visuali- especially after the interest rate paid by sation of data by transaction type, by participant or with an accuracy of fractions of a second. This allows central banks on overnight deposits was a thorough analysis of data for oversight purposes, lowered to zero in July 2012. There has among other things. The BoF-PSS2 simulator is freely available for research purposes. also been a reduction in the number of counterparties. The algorithm does not recognise overnight lending to Spain, Chart 7. Greece, Ireland, Cyprus or Portugal after 2011. This, in turn, provides an Overnight loans traced by the algorithm, indication of weakening confidence 1 July 2008 to 31 December 2012 between banks, which has led to the fading of interbank money markets. On LU LV NL PL the other hand, long-term refinancing LT granted by the central bank has reduced PT the need of banks in certain countries IT to borrow from abroad. TARGET2- SK Suomen Pankki participants have IE granted credit to each other at a

FI AT relatively low price throughout the

GR review period, but some individual countries have received credit on even BE cheaper terms, on average. FR CY Conclusion The cross-border payment traffic of

ES DE participants in TARGET2-Suomen EE DK Pankki has varied to some degree during the crisis. Payments with banks

82 Bank of Finland Bulletin 2 • 2013 Payment transfers measure the pulse of the financial markets in countries at the centre of the debt terparty would cause problems for a crisis have been at low levels, with the third party closely linked with Finland, value of payment transactions and the problems could thus spill over contracting substantially during the to participants in Finland. crisis. This not only points to Analysing payment flows helps weakening economic activity, but also understand interbank connections and to declining interbank transactions and the volumes and values of different fading money markets. types of payment transactions and their Based on this analysis, the counterparties. Such exploration problems of the debt crisis countries contributes to supporting financial would not appear to feed directly to the stability analysis and, in respect of Finnish banking sector, due to an individual participants, acts as an overall small amount of direct indicator measuring the scale of the payments received and sent with banks problems and exposure to contagion. It in the debt-crisis countries. Given that is important to monitor payment trans- transactions qualifying for overnight actions, since their evolution may reveal loans granted to the debt-crisis changes in system participants’ countries were barely identified in the behaviour. As these changes can be seen data after 2011, there would not appear with a lag of one day, access to data is to have been any resultant direct considerably faster than in the case of exposure to credit risk. Problems could, bank balance sheet data. however, be transmitted via other countries participating in the payment Keywords: Payment transfers, chain or through a domino effect. In TARGET2-Suomen Pankki, debt crisis, such a scenario, a crisis country coun- CDS, overnight loans

Payment transfers measure the pulse of the financial markets Bank of Finland Bulletin 2 • 2013 83 Organisation of the Bank of Finland

1 February 2013

PARLIAMENTARY SUPERVISORY COUNCIL

Ben Zyskowicz, Chairman, Pirkko Ruohonen-Lerner, Vice Chairman, Jouni Backman, Timo Kalli, Mari Kiviniemi, Marjo Matikainen-Kallström, Lea Mäkipää, Petteri Orpo, Pia Viitanen

Anton Mäkelä, Secretary to the Parliamentary Supervisory Council

BOARD Erkki Liikanen Pentti Hakkarainen Seppo Honkapohja Governor Deputy Governor Member of the Board

Monetary policy preparation Financial stability issues, Research, and implementation, domestic currency supply services, financial investments of financial assets, economic policy, membership of the administration and procurement, administration. Governing Council and General risk control, Chairman of the Council of the ECB. Board of the Financial Supervisory Authority.

Member of the Board Member of the Board Member of the Board to whom the Heads of the General to whom the Heads of to whom the Heads of ­ ­Secretariat, Banking Operations, Financial Stability and ­Statistics, Monetary Policy and Research, and Internal Audit report. and Cash Department report. and Administration report.

Mika Pösö, Secretary to the Board

DEPARTMENTS Monetary Policy • Forecasting Institute for Economies Research and Research • International and Monetary in Transition Tuomas Saarenheimo Economy (BOFIT)

Financial Stability • Macroprudential Analysis Division Statistics • Statistical Systems and Statistics • Macroprudential Policy Division • Balance of Payments Management Kimmo Virolainen • Oversight of Market Infrastructure • Financial Statistics

Banking Operations • Market operations • Investments • Payment and Harri Lahdenperä Settlement Division

Cash Department • Currency • Infrastucture and • Security Mauri Lehtinen Systems

General Secretariat Communications • Information Senior Secretarial Staff Mika Pösö European and International Affairs Management Strategy and Legal Affairs Organisation

Administration • Financial Administration and • Personnel Information Pirkko Pohjoisaho-Aarti Procurement • Risk Control Technology • Language and Publication Services • In-House Services Internal Audit Pertti Ukkonen

The Financial Supervisory Authority, headed by Anneli Tuominen, operates in association with the Bank of Finland.

 Publications

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Back copies of older printed publications still in stock can be ordered from the Bank of Finland (www.bof.fi > Publications > Orders and subscriptions, printed ­publications). Suomen Pankki Bank of Finland PO Box 160 FI-00101 HELSINKI FINLAND BANK BANK BULLETIN 2 • 2013 OF FINLAND