Spring 2015

Overview of Financial Stability

Overview of Financial Stability

De Nederlandsche Bank Overview of Financial Stability

Spring 2015 © 2015 De Nederlandsche Bank n.v.

Edition: 750

This document uses information available up to 27 march 2015, unless stated otherwise. Country abbreviations according to ISO norm.

Publication and multiplication for educational and non-commercial purposes is allowed, with acknowledgements.

Westeinde 1, 1017 ZN Amsterdam – PO Box 98, 1000 AB Amsterdam, the Netherlands Telephone +31 20 524 91 11 – Telefax +31 20 524 25 00 Website: www.dnb nl Overview of Financial Stability

Contents

Introduction 5

1. Overview of Financial Stability 6

2. Low interest environment 16

3. Ending too-big-to-fail? 23

4. Incentive effects: the role of governance and variable remuneration 30

Annex 1: Macroprudential indicators 38

Annex 2: Review of DNB actions based on the OFS 40

Overview of Financial Stability

Introduction

DNB monitors financial stability in the Netherlands, paying explicit attention to the interaction 5 between financial institutions and their environment: other institutions, financial markets and the financial infrastructure. As part of this task, DNB publishes the Overview of Financial Stability (OFS) twice a year.

The OFS outlines risks that affect groups of institutions or entire sectors within the Dutch financial system, and that could eventually disrupt the economy. DNB prepares the OFS to raise awareness among stakeholders — financial institutions, policymakers and the general public. The first chapter summarises the principal risks to financial stability in the Netherlands. The following three thematic chapters analyse relevant topics in more detail.

The OFS does not provide forecasts, but instead analyses scenarios. DNB aims to present the best possible risk assessment of potential future threats to the financial system based on current knowledge. Where possible, DNB proposes risk-mitigating policies. The assessments and recommendations made in the OFS present institutions and policymakers with an understanding of how to reduce both the risk and impact of shocks in the financial system.

1 Overview of Financial Stability

6 Priorities and recommendations

▪ The budding economic recovery in the euro area is surrounded by downward risks to financial stability. The developments in Greece have put the European debt crisis in the limelight again, and geopolitical tensions have increased. The current exceptionally accommodative monetary policy is aimed at bringing inflation back to the price stability target and underpinning economic recovery. This policy, however, also has side effects. It leads to increased risk appetite among investors and a search for yield in the financial markets, which aids the formation of bubbles. In addition, despite the very loose liquidity conditions provided by central banks, some financial markets are less liquid than before the crisis, which may amplify the impact of a downward price correction. ▪ The low level of interest rates is affecting the buffers of financial institutions, especially those of insurance companies and pension funds. The situation at life insurance providers gives cause for worry as their recovery options are limited. Low interest rates are fuelling the current concerns about the sustainability of their business models. DNB expects the sector to adjust to fundamental changes in the market and prepare for the situation in which their solvency may inadvertently prove to be inadequate. As the sector is shrinking, life insurers will also need to reduce costs. ▪ In response to the financial crisis, supervisory authorities and governments have developed policies that both reduce the likelihood and the impact of failure of systemic banks. In order to enhance the effectiveness of these policies, it will be necessary to make additional demands on the level and composition of the bail-in capacity. To curb contagion risks, bail-in securities must be subordinated to operating liabilities and the investments that banks make in these securities should preferably be limited. ▪ In the run-up to the crisis, governance at financial institutions was insufficiently effective to manage risks, and variable remuneration induced excessive risk taking. Since the crisis, supervision of governance, conduct and culture has been tightened, and remuneration policies have been developed that aim to curb the incentive to take excessive risks. It is important that the financial sector continues to implement these adjustments. The culture at financial institutions should be changed accordingly, so that management and staff internalise the purpose of the policies and changes are solidly anchored. Overview of Financial Stability

Figure 1 - Risk map 7

Structurally International risks low growth and to financial stability Geopolitical European Interest rate risk low interest rates unrest debt crisis and search for yield with unfavourable prospects for life insurers

Low profits and insucient Bank capital Stability risks funding risk strenghtening to the Dutch by banks financial system

Misconduct Cyber risk due to threats perverse incentives

Losses on Risks for real estate financial institutions and corporate loans

fast burning slow burning

The risk map provides a schematic overview of the key risks threatening financial stability. The size of the circle reflects the magnitude of the risk, and its colour depicts whether the risk is increasing (red), decreasing (green) or constant (grey).

International environment

The budding economic recovery in the euro area continues to be surrounded by downward risks to financial stability. The developments in Greece have put the European debt crisis in the limelight again. Geopolitical tensions have increased, e.g. in Ukraine and the Middle East.

The relative calm in the financial markets is not an adequate reflection of the prevailing risks. The exceptionally accommodative monetary policy is providing for apparent calm in the financial markets (see Chart 1). From time to time, slumbering vulnerabilities re-surface and lead to volatility in some markets. US treasury bonds for instance showed exceptional volatility on 15 October 2014, when the yield on 10-year treasury bonds fell by nearly 0.4 percentage points in a matter of minutes. Several currencies recently came under heavy pressure. The decision by the Swiss central bank on 15 January to abandon its currency peg to the euro caused the Swiss franc to appreciate substantially. Some foreign financial institutions were taken by surprise by the move and incurred losses. 8 Chart 1 - Financial stress is low Stress-index based on indicators of equity, bond and currency markets relevant to the Netherlands and a health index of financial institutions.

4

Bankruptcy Lehman 3 Brothers

2 First support package for Greece

Dotcomcrisis ‘whatever it takes’

1 Expansion of purchasing programme

0

-1 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

Source: DNB.

The situation in Greece continues to give cause for concern. As long as no sustainable solution is found for Greece, the country will continue to demand a great deal of attention. As long as deposits continue to flow out of the country, the already fragile liquidity position of Greek banks will continue to weaken, which may translate into solvency problems. An unforeseen bankruptcy of the government would also seriously disrupt the Greek economy. The effects of such an event on other euro area countries are uncertain. It is important for Greece to continue implementing economic reforms and adhere to the agreed programme, both for the stability of the country itself and that of the currency union. The experiences gained in other countries with adjustment programmes (e.g. Ireland and Spain), illustrate that implementing structural reforms can in due course foster economic recovery based on sound foundations.

In light of the resurging European debt crisis, it is favourable that the European financial system has become more robust with the launch of European banking supervision. Under the Single Supervisory Mechanism (SSM) the ECB took up supervision of the largest European banks in early November 2014. The successful completion of the Comprehensive Assessment (CA) at the end of October 2014 was a milestone that marked the start of European banking supervision. In the CA, problems on balance sheets were identified and repaired by means of balance sheet evaluation and stress tests. In anticipation of the CA, a large number of banks had already Overview of Financial Stability

taken measures to strengthen their balance sheets. Partly owing to this, the CA brought 9 relatively few problems to light. Capital deficiencies totalling EUR 25 billion were identified at 25 of the 130 participating banks. These banks were then given between six and nine months to address their deficiencies. The seven Dutch banks that were examined – ING Bank, Rabobank, ABN AMRO, SNS Bank, BNG Bank, NWB Bank and RBS N.V.) – all remained well above the minimum requirements.

Against the backdrop of low inflation and slow economic recovery in 2014, the ECB in January decided to ease monetary conditions further. With large-scale liquidity injections, the ECB aims to bring inflation back to the price stability target, through lower borrowing rates and a lower euro exchange rate. To this end, the ECB extended the existing purchasing programme for covered bonds and asset-backed securities to bonds issued by euro area governments and European institutions (including the EFSF and EIB). The combined monthly purchases of public and private sector securities will amount to EUR 60 billion, lifting the level of the total purchasing programme to over EUR 1,100 billion. Assuming that the current purchasing rate will be continued within the existing programmes, an estimated total of EUR 45 billion of Dutch government bonds will be bought up, or around 15% of the outstanding Dutch bonds with maturities of between two and 30 years.

Chart 2 - Growing market for European high-yield bonds, amid falling yields Issuing volumes (EUR billion). Yield (%).

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40 10

0 0 05 06 07 08 09 10 11 12 13 14

Issuing volume Yield (right axis) Source: Dealogic DCM, Thomson Reuters Datastream.

10 Prolonged very accommodative monetary policy is not without negative side-effects, however. The current loose monetary policy is aimed at facilitating risk taking in the real economy, but it also leads to increased financial risk taking. This is partly due to the fact that the ample liquidity conditions have created the illusion of calm and permanent liquidity, which is reflected in increased risk appetite and a search for yield in the financial markets. Due to purchases of bonds, term and risk premiums will fall, which induces investors to look for higher returns in longer term and higher-risk securities. The declining premiums and the growing market for higher risk and less liquid products, such as European high-yield bonds (Chart 2), illustrate this trend. If economic developments are not in line with financial developments, there will be no economic foundation for higher financial valuations. This increases the likelihood of bubble formation. There are indications that some prices are deviating from economic fundamentals. This for instance applies to the high-yield corporate bonds segment, where spreads are historically low, despite growing debt ratios. Equity prices also took a sharp flight in some markets including the United States and Germany (Chart 3).

Despite ample liquidity conditions, the risk of a sudden reversal in market sentiment remains. Disappointing macro-economic data, further rising geopolitical tensions, an interest rate hike by the Fed, or a resurgence of the European debt crisis may all cause sentiment to turn. If risks

Chart 3 - Sharp value rises in some markets; price/earnings ratios almost at pre-crisis level in the United States

Share prices (index, 1 Jan. 2006=100) Price/earnings ratios

225 30

150 20

75 10

0 0 06 07 08 09 10 11 12 13 14 15 06 07 08 09 10 11 12 13 14 15

Netherlands United States Germany Euro area Euro area (DE, ES, FR, IT, NL) Source: Datastream, Bloomberg United States and in-house calculations. Overview of Financial Stability

are not priced in adequately and prices deviate from economic fundamentals, the impact of a 11 turnaround in market sentiment is potentially large.

A downward price correction in financial markets may be amplified by a lack of liquidity in the secondary markets. Despite the extremely accommodative liquidity conditions provided by central banks, there are various signals that some financial markets are less liquid than they were before the crisis. This applies for instance to the uncovered interbank market, which has come to a virtual standstill since 2008, but also to the corporate bond market. Despite the substantial growth displayed by this market since the crisis, and bid-ask spreads narrowing to pre-crisis levels, various underlying indicators actually point towards declining liquidity. Trading activity in the secondary market for investment grade corporate bonds in the euro area has dropped steadily and the average size of transactions declined by over 15% between 2007 and 2013. This is partly due to the fact that banks have reduced their market making activities: their share in the corporate bond market is declining (Chart 4). The reduction in these activities is related to new regulations discouraging trading activities by banks. A side-effect of this, however, is that it is becoming increasingly difficult and expensive for market players to settle large positions. This may cause large price swings in times of stress, amplifying downward price

Chart 4 - European banks have reduced their holdings of corporate bonds, while the market is growing Outstanding bonds and dealer stocks (EUR billion). Market share of European banks (%).

1200 60

800 40

400 20

0 0 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Outstanding bonds Dealer stocks Market share of European banks (right axis) Source: ECB, Eurostat. 12 corrections in the financial markets. Whether market liquidity may indeed be upheld often only becomes clear during periods of increased market stress.

A prolonged period of low interest rates also affects the resilience of financial institutions and the financial system. Prolonged low interest rates may harm the profitability and the buffers of financial institutions. As insurance companies have few recovery options, the low level of interest rates is exacerbating concerns about their viability (see Chapter 2). Lower solvency or profitability may also lead to financial institutions taking increasing risk (search for yield).

Financial stability in the Netherlands

The Dutch economy is recovering gradually, with the housing market climbing out of the trough (see Chart 5). Relative to their 2013 low, house prices have gained a total of 3.9%. The number of residential property sales has also increased sharply. The housing market recovery is being underpinned by low interest rates that increase buyers’ borrowing capacity and depress the costs of living. Despite the budding recovery, the housing market is still dealing with past vulnerabilities. For instance, in 2014, over a quarter of mortgages was still under water. In addition to this, at over 95% of GDP, total household mortgage debt in the Netherlands is still among the highest in the world.

Chart 5 - Dutch housing market gradually climbing out of the trough Residential property prices (Index, Jan. 2008 = 100). Transactions (in thousands, based on 12-month sum).

110 220

100 190

90 160

80 130

70 100 2008 2009 2010 2011 2012 2013 2014 2015

House prices Transactions (right axis) Source: Statistics Netherlands (CBS). Overview of Financial Stability

Due to the high level of mortgage debt, Dutch banks are vulnerable to housing market 13 developments, although these vulnerabilities have declined in the past few years. Despite sharp price corrections (Chart 5), big credit losses have not occurred (OFS Spring 2014). The effect that the housing market has on banks is primarily conveyed through the financing channel. Due to the high level of mortgage debt, banks were always strongly dependent on market financing and foreign deposits. The part of domestic lending that is not financed by domestic deposits, but by market funding or foreign deposits (known as the deposit funding gap), has clearly shrunk these past few years (Chart 6). Initially the decline was primarily attributable to the housing market grinding to a halt. New loans to households decreased as a consequence, while domestic deposits kept growing. In the past two years, the increase in voluntary repayments has contributed towards lowering domestic mortgage debt, partly owing to the temporary raising of the gift tax allowance for owner-occupied homes. In addition, pension funds and other institutional investors have become more active in the mortgage market, thus reducing the share of mortgage debt held by banks. Ongoing recovery of the economy and the housing market will be accompanied by a further pick-up in demand for mortgage loans. If banks facilitate this demand, the deposit funding gap may widen again. This risk is, however, small in our projections, also due to tax requirements relating to mortgage repayments.

Chart 6 - Deposit funding gap has narrowed and is expected to narrow further As a percentage of GDP.

90 Projections

60

30

0 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Source: DNB calculations. 14 Macroprudential policy measures

DNB may deploy several macro-prudential instruments in order to manage financial stability risks. Based on the risk description in the Overview of Financial Stability and an assessment of the financial cycle, DNB decides twice a year whether it should activate or adjust the macro- prudential instruments that it directly controls. This decision is aligned with other policymakers in the Netherlands Financial Stability Committee (FSC). Here DNB also contributes to policy positions with respect to the instruments it does not control, such as the loan-to-value (LTV) limit. Table 1 depicts the current use of macro-prudential instruments.

Table 1: Current use of the main macro-prudential instruments

Instrument Status Comment

Capital buffer requirements Gradual phasing-in until 2019 Applicable to Rabobank, ING, ABN AMRO for systemic banks (all 3%) and SNS (1%)

Countercyclical capital buffer Decision on level from 2016 No reason to activate this at the moment (CCB) onwards

LTV limit Phased reduction to 100% in FSC is working on advice about LTV policy 2018 after 2018

From next year onwards, DNB will take a decision on the level of the countercyclical capital buffer (CCB) every three months. This additional capital buffer may be activated during periods of excessive credit growth, which have often been an indicator of a looming financial crisis. In order to be able to decide whether or not the CCB should be activated, a detailed picture of the financial cycle is needed. To this end, the degree to which lending as a proportion of GDP exceeds the historical trend is analysed (Chart 7). Other indicators, such as property prices and the level of lending, are also considered. At present, there would be no reason to activate the additional buffer requirement: lending in the Netherlands is at a very modest level, and other indicators of cyclical risks are not pointing towards excessive lending either (see Annex 1). Overview of Financial Stability

Chart 7 - Credit expansion in the Netherlands is below trend 15 Total lending to Dutch businesses and households as a percentage of GDP

300 30

250 20

200 10

150 0

100 -10

50 -20

0 -30 1970 1975 1980 1985 1990 1995 2000 2005 2010

Credit/GDP ratio Trend Deviation from trend (right axis) Source: BIS, CBS and DNB calculations.

In 2014 DNB examined in detail the risk weights that Dutch banks attach to mortgage lending and decided not to increase them. These risk weights are low from an international perspective. However, based on its analysis, DNB has concluded that neither the current credit risks inherent in the mortgage portfolio, nor the current phase of the financial cycle give cause to increase the risk weights. In an international context, a minimum floor for risk weights is, however, being discussed, also with respect to mortgage loans. 2­ Low interest environment

16 A prolonged period of low interest rates affects the resilience of Dutch financial institutions, insurance companies and pension funds in particular. Problems occurring in the life insurance sector may, under exceptional circumstances, threaten financial stability. The life insurance sector is severely impacted by low interest rates, its recovery options are limited and it has considerable interdependencies with the economy. Low interest rates are also impacting pension funds, yet they have more recovery options. The impact on banks is more limited, but the low interest rate environment may over time erode profitability if it is accompanied by shrinking margins.

Bond yields are historically low and continued to fall in the past months (see Chart 8), partly due to low growth and inflation expectations. At the end of March 2015, Dutch government bonds with maturities up to five years recorded negative yields. The monetary policy measures taken by the ECB (see Chapter 1) are expected to depress the low market rates even more and flatten the yield curve. This policy stance is intended to bring inflation back into line with the target for price stability and to underpin economic recovery in the euro area. Yet a prolonged period of low interest rates cannot be excluded. Prolonged low interest rates have profound consequences for profitability and the buffers of Dutch financial institutions.

Chart 8 - Bond yields have steadily dropped 10-year yields (%).

5

4

3

2

1

0 2007 2008 2009 2010 2011 2012 2013 2014 2015

Netherlands Germany Japan Source: Thomson Reuters. Overview of Financial Stability

Impact on financial institutions 17

Pension funds and insurance companies The impact of low interest rates is most significant for life insurers and pension funds. Liabilities to policy holders often have a long term to maturity. As a result, their market value rises rapidly when interest rates fall. On the assets side, pension funds and insurers make investments, which often have shorter maturities and show less significant value increases when interest rates decline. Consequently, falling interest rates lead to net losses, which show up immediately if assets and liabilities on the balance sheet are measured based on market value. The actual impact on own funds depends on the degree to which insurers and pension funds have hedged this downward interest rate risk.

The European stress test for insurance companies, executed in 2014, has provided an understanding of the interest rate sensitivity of this sector and confirms the large impact of a scenario of prolonged low interest rates. The stress test assesses insurance companies based on provisional Solvency II rules that are due to come into effect in 2016. These rules require insurance companies to measure the assets and liabilities on their balance sheets based on market value. The Dutch insurance companies taking part in the test were hit hard in the low interest rate scenario; own funds were cut by 10% on average. Dutch life insurers have a relatively large number of long-term insurance liabilities. Although the adverse interest rate scenario used in the test was assumed to be hypothetical, it has already materialised: the yield curve has already

Chart 9 - Current interest rates already lower than in the stress test Interest rates (in % according to years of maturity).

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0.0 0 5 10 15 20 25 30 35 40 45 50

Insurers stress test low interest scenario Market rates (2015Q1 swap curve) Source: DNB and EIOPA. 18 dropped below the level assumed in the scenario (Chart 9). Partly in the light of the stress test, DNB has notified the sector about its concerns with respect to the sustainability of its business models. It has asked insurers to develop strategic scenarios that anticipate on the growing uncertainty surrounding their solvency positions. In these scenarios, the traditional market situation and the current business models should not be taken for granted.

The effect of low interest rates on pension funds and insurers only shows up partly in their financial reports, owing to the use of the ultimate forward rate (UFR). Under the UFR method, liabilities with maturities over 20 years are valued based on a yield curve that converges towards a predefined level. The UFR is used since in the absence of sufficiently liquid markets, the perceived market interest rates are considered to be less dependable from a certain maturity onwards. The UFR also contributes to the stability of the solvency calculation. The discrepancy between the UFR curve and the observed long-term interest rates has increased steadily over the past few years, however. An ongoing discrepancy may lead to excessively high expectations among pension fund members, unrealistic promises to policy holders and distorted incentives at institutions. This would occur, for instance, if insurers take their distorted solvency ratios as a basis for determining dividend policies, or if pension funds make payouts that are unsustainable based on the market value of their balance sheets. If an insurance company finds itself in a situation that necessitates transfer of the portfolio, the acquiring party will not want to pay more than the market value. In short, it is important for institutions to remain aware of the discrepancy between the UFR and the market yield curve, which has increased around the sixty-year point to roughly 160 basis points in the first quarter of 2015, from around 75 basis points in 2013 (see Chart 10).

Chart 10 - Dierence between UFR and market rates is growing Interest rates (in % according to years of maturity).

4 Dierence

75 bp (2013 Q4)

2013 Q4

2 160 bp (2015 Q1)

2015 Q1

0 5 10 15 20 25 30 35 40 45 50 55 60

Market rates (swap curve) UFR of pension funds Source: DNB. Overview of Financial Stability

Banks 19 To a lesser extent, the low level of interest rates also affects the large banks in the Netherlands. They depend on interest income; in 2013 net interest income accounted for three quarters of their total income. What matters is not so much the falling and flattening yield curve in itself, but rather the question in which direction the banks’ borrowing and lending margins will develop relative to the yield curve in the new environment. There are various factors that cause the level of interest rates that consumers receive on their savings to adapt slowly. Savings are a stable source of funding for banks and they are important for complying with the supervisory regulations with respect to liquidity. Competition for savers is quite intense in the Dutch savings market and banks foster their relations with savers by paying them interest rates above the level of the actual yield curve.

On the lending side, margins can come under pressure if competition in the Dutch loan markets increases. Since the crisis, competition has waned as a result of restrictions imposed by the European Commission on banks receiving state support. At the same time the interest margin in the Netherlands in 2013 was twenty per cent above the European average, which may prompt new entrants to the market. Relevant in this respect is the rapidly growing activity of life insurance companies in the mortgage market, who saw their exposure growing to over EUR 50 billion in 2014 from EUR 25 billion in 2009. This trend is expected to continue. In the longer term, the ongoing integration of the European financial markets as a result of the banking and capital market union will fuel competition even more. After withdrawing from the Dutch market at the start of the crisis, a number of foreign players recently resumed their activities in the Netherlands.

A DNB stress test suggests that adverse scenarios with further flattening yield curves, weakening economic growth, and narrowing lending margins may in time have a substantial influence on the profitability of the large banks (Chart 11). This stress test assumes a scenario in which annual GDP growth in the Netherlands dips to 0.2% on average over a four-year horizon, and mild deflation of -0.3% on average. This would go hand in hand with a flattening yield curve with 10-year interest rates falling below 0.1%. The trend of bank lending rates has been estimated based on their historic relations with the yield curve, with margins on mortgage loans in particular narrowing further. The falling mortgage interest rates would, however, prevent house prices from declining again. In addition, unemployment would only rise modestly to 8.9% in this scenario, meaning that there would be no large credit losses. Net interest revenue on new loans would, however, take a sharp fall, which over time would detrimentally affect the banks’ profitability.

All in all, in a stress scenario of this kind profitability would not be depressed to such an extent that bank buffers would be eroded as the banks would be able to cushion low profitability for several years. Consequently, the direct effects for financial stability seem to be limited. Profit retention, however, is an important source for further buffer strengthening. Unless banks increase their capital base by means of share issues, buffer strengthening would slow down or lending would come under pressure in these circumstances. 20 Chart 11 - Unfavourable low interest rate scenario would depress large banks’ profitability Scenario, interest rate in (%). Impact (in EUR billion).

6 30 stress scenario

4 20

2 10

0 0 11 12 13 14 15 16 17 18 14 15 16 17 18

Mortgage interest rates Net interest income Corporate loan rates Estimated profits Long-term interest rates Short-term interest rates Source: DNB.

Impact on financial stability

Financial stability will come under threat if the low level of interest rates affects groups of institutions or entire sectors. The situation in the insurance industry gives cause for particular concern. Life insurers have fewer recovery options at their disposal than pension funds. They have often issued nominal yield guarantees (OFS Autumn 2012) that are impossible to adjust and will even increase in real terms in a low inflation environment. In addition, the profitability of life insurance companies is already under pressure due to fading demand for life insurance products.

Large insurance companies, and large groups of insurers in particular, may be systemically important due to their complexity or interdependencies with the economy, meaning that possible bankruptcies will entail contagion risks. For instance, insurance companies are large investors and the bond markets are heavily dependent on the insurance industry. European life insurers hold some 15% of European bank and corporate bonds with maturities over one year, and almost 20% of government bonds. The fact that in the European stress test the low level of interest rates has a significant impact on a large proportion of European insurance companies Overview of Financial Stability

gives cause for concern. Additionally, in the Netherlands, households build up wealth with 21 insurance companies (by means of savings and unit-linked mortgage loans) for about one third of mortgage debt. Solvency problems at individual institutions may also lead to negative confidence effects and liquidity risks if policy holders buy off contracts, or if the administration of group pension contracts is transferred to other insurance companies.

Compared with insurers, pension funds have relatively many recovery options in a low-interest scenario. Their business models are under less pressure as they receive new contribution payments every year. The guarantees given by pension funds are also less rigid: they can decide to abandon inflation indexation, take recourse to cutting pension entitlements, or even review the future pension contract (in consultation with the social partners). In addition, since 2015 new supervision rules have applied to pension funds, which cushion the effect of shocks as they allow pension funds to curtail entitlements at a later stage and to spread curtailments over time. The downside of this is that more risks will have to be borne by pension scheme members.

The combination of low interest rates and lagging solvency or profitability may induce financial institutions to take more risk in an effort to strengthen their positions (Search for yield, OFS Autumn 2014). This applies not only to insurance companies, but also to pension funds and banks. With the implementation of the new supervision rules, pension funds are granted a one-time adjustment of their risk profiles, which increases the risk of search for yield. This year, DNB launched a thematic examination into search for yield. This examination aims to prevent financial institutions from taking excessive risks in their efforts to strengthen their solvency positions and boost returns.

Policy conclusions

The low interest environment is forcing institutions to reconsider their business models, which for life insurers are already under pressure as a consequence of the changing market conditions. DNB expects life insurers to prepare their business models for the future, so that they can continue to comply with their long-term obligations to policyholders. In view of the fact that the sector is shrinking, it is important for insurance companies to keep their costs under control. A recent thematic examination held by DNB has revealed that insurers still do not have a sufficiently clear understanding of their future costs. This year, DNB will launch a new thematic examination in order to improve insight into future costs. Together with ECB supervision, DNB is also examining the profitability and sustainability of bank business models. The ECB expects the banks to exercise caution in paying out dividend if their earnings are not sufficiently large to safeguard migration to the future solvency requirements under Basel III.

The stress test shows that amid the current level of interest rates, solvency is weak at some insurance companies, particularly based on the new Solvency II supervision rules. It is also important for insurance companies to be aware of the discrepancy between their statutory solvency positions based on the UFR, and the (less favourable) underlying position based on 22 market valuation. They will have to take this into account when formulating their capital plans and dividend policies, in order to prevent their solvency positions from eroding. In anticipation of its final implementation, DNB is already using Solvency II as an important yardstick in assessing whether dividend payments are warranted.

In 2015, a European stress test will be performed among pension funds, including some Dutch funds, in order to take stock of the pension sector’s resilience. This means that the interest rate sensitivity of pension funds will be assessed as has been done for insurance companies. Overview of Financial Stability

3 Ending too-big-to-fail?

The failure of large, interconnected, complex banks may shake the foundations 23 of the financial system. Supervisory authorities and governments have therefore developed dedicated policies for systemically important banks, with which they aim to limit the likelihood of bank failure and its impact on financial stability. The policy framework has been firmly established, but it has not yet been completed. For instance, the authorities still have to establish the level and the composition of the bail-in requirement, with which shareholders and creditors may bear a bank’s losses during resolution. Where necessary, regulators will also address the systemic risks of institutions outside the banking sector.

An important lesson learned from the crisis is that some banks are so big and interwoven with the economy that it would be too expensive or too complicated to allow them to fail. As a result, governments were frequently left with no other option but to keep large, complex banks afloat during the crisis. The Dutch government also had to provide relatively large amounts of support to the banking sector by way of guarantees, liquidity support and capital injections.

Impact on financial stability

Large, complex banks needed to be rescued in order to protect the real economy and the financial system, but this also entailed huge costs for governments. In some countries governments ran into trouble due to the financial support that they provided. In addition, government bail-outs also lead to perverse incentives. Large banks for instance profit from a funding advantage as investors assume that the government will bail them out if the bank threatens to fail. This implicit safety net causes systemic banks to emerge, and increases the likelihood of problems at such systemic banks, as investors have little incentive to monitor and discipline them.

Policies implemented

In order to mitigate risks for governments and limit perverse incentives, the Financial Stability Board (FSB) in 2011 developed a policy framework for global systemically important banks. The framework has two objectives (figure 2). The first of these is limiting the likelihood of failure. To this end, global systemically important banks are now subjected to more intensive supervision, and they are required to maintain higher buffers. Depending on the degree of systemic importance, buffers should be between 1% and 3.5% of risk-weighted assets. The Netherlands has a large and concentrated banking sector with a small number of large banks providing the lion’s share of services to the real economy. Therefore, DNB imposes the systemic buffer requirement on all Dutch systemically important banks, i.e. ING, Rabobank, ABN AMRO and SNS (see Table 1). 24 Figure 2: FSB-framework for systemically important banks

Make systemic banks resolvable and limit perverse incentives

Reduce the Reduce the likelihood of bank failure impact of bank failure

Pillar 1: Pillar 2: Pillar 3: Pillar 4: Intensify Increase Improve Improve supervision capital bu ers resolvability infrastructure

Set of instruments and measures incuding bail-in

The higher buffer requirements and intensified supervision aim to reduce, but not to eliminate the possibility of bank failure. Problems at banks can never be fully excluded. Policies are therefore also aimed at curbing the impact of possible defaults by ensuring orderly resolution of banks and limiting the risk of contagion. The financial markets infrastructure is being improved in order to prevent problems occurring at individual institutions from spreading to the financial system. In addition, dedicated authorities have been made responsible for what is known as the resolution process. DNB has been appointed as the authority responsible for resolution in the Netherlands, and resolution at European level has been put in the hands of the Single Resolution Mechanism (SRM). These authorities are developing resolution plans (sometimes called ‘living wills’), which determine how key economic functions will be upheld if banks are threatening to fail. This concerns activities that are of crucial importance to the economy such as lending and payment services.

Bail-in is an important new instrument. The purpose of the bail-in tool is to ensure that private creditors rather than governments bear the losses of failing banks. Under European bail-in rules, shareholders and holders of other capital instruments will always be held accountable for any losses. Subsequently, other subordinated creditors will also be called upon, followed by regular creditors. Deposits made by consumers and small companies have a preferred status and are even excluded from bail-in to the extent that they are covered by the deposit guarantee scheme. In addition, the resolution authority can, under strict conditions, exclude certain groups of creditors from bail-in. In these circumstances, the European resolution fund financed by the sector may be called upon, provided that an amount equivalent to at least 8 per cent of the balance sheet of an institution has already been written off or converted into equity. The fund may contribute up to 5% of the balance sheet. In principle, public funding will not be considered until all this has been done. Based on experiences from the crisis, it is very unusual that losses at banks surpass 13% of the balance sheet.

Orderly resolution requires banks to hold bail-in capital, i.e. liabilities that are still available for bail-in after depletion of regular capital. Hence, the banks’ loss absorption capacity should Overview of Financial Stability

surpass their capital requirements. To this end, policymakers at European and global level are 25 working on establishing a bail-in requirement on top of the capital requirements. The European minimum requirement for own funds and eligible liabilities (MREL) should be established this year, with the level depending on the systemic importance of a bank. The global total loss absorbing capacity (TLAC) standard will also be determined this year, and will for now only apply to global systemically important banks, such as ING.

Are these policies effective?

The question is whether the policies implemented have been effective yet. If bail-in is made credible, systemic banks will lose their funding advantage provided by the implicit government safety net. The size of this advantage therefore serves as a yardstick for the effectiveness of the policy: the smaller the advantage, the more effective the policy is. One way of testing this is by looking at credit ratings. In 2014, implicit government support led to higher ratings for large Dutch banks by an average of 2.3 notches (which is known as ‘rating uplift’). As a result, these banks profit from lower funding costs as a higher credit rating implies a smaller probability of default, thanks to which investors demand lower risk premiums. Chart 12 (left panel) illustrates this difference for the large Dutch banks.

Chart 12 - Banks are profiting from implicit government safety net Historic probability of default linked to credit ratings Weighted average credit ratings of the largest banks (1-year horizon) for Dutch large banks. per country.

2.0% Aa1

Aa3

1.5% A2

1.0% Baa1

Baa3 0.5% Ba2 2012 2014 2012 2014 2012 2014 2012 2014 2012 2014 2012 2014

0.0% 2008 2009 2010 2011 2012 2013 2014 NL DE FR IT ES GB

Probability of default without implicit Rating uplift thanks to expected government support government support Credit rating without implicit government support Probability of default with government support Implicit government support Source: Moody’s. 26 The trend of rating uplifts through time is an indicator for the effectiveness of the adopted bail- in policy. Chart 12 (right panel) shows that except in Spain, rating uplifts have hardly diminished. This is an indication that investors are still hardly taking account of the possibility of losing their money if their bank fails. Another indication is that the uplift increases according to the strength of the financial positions of governments.

The fact that systemic banks are still benefiting from an implicit government safety net is also reflected in the development of the value of the funding advantage. This can be estimated by expressing the rating uplift in basis points rather than notches. The value of the funding advantage has declined sharply over the past few years, which is primarily attributable to the improved market sentiment, also prompted by the accommodative monetary policy and the search for yield. This led to a drop in risk premiums across the board, and a commensurate drop in the value of the financing advantage. Compared with the improved market sentiment, the reduction of the uplift had a limited impact on the value of the funding advantage (Chart 13).

Chart 13 - Reduced rating uplift hardly a ects the value of the funding advantage Trend of rating uplift of Dutch large banks translated into basis points.

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0 Funding Lower average risk Lower rating uplift Downgrade Funding advantage 2012 premium 2014 2014 relative to 2012 advantage 2014

Source: Moody’s, Dialogic and in-house calculations. Risk premiums have been calculated by linking up ratings to the average risk premiums per rating of European bank debt in 2014 and 2012. For a more detailed explanation of the methodology used, see Knot & Van Voorden, 2013 and Autumn 2013 OFS. Overview of Financial Stability

Most large European banks benefit in particular from a funding advantage on their regular 27 debt (senior unsecured debt). One explanation for this is that it is not easy to pass losses on to holders of regular debt, as they have the same position in the creditor hierarchy as for instance derivatives and wholesale deposits. Writing down such operating liabilities can be difficult in practice due to loss of confidence, contagion risks and the likelihood of claims. A higher probability of losses due to the removal of the government safety net has, on the other hand, already been incorporated in credit ratings of subordinated debt. Since the crisis, this type of debt has no longer benefited from an uplift at the majority of European banks. This has induced lower credit ratings, with investors demanding higher risk premia, all other things being equal.

In order to increase the credibility of bail-in of regular bonds, banks may separate bail-inable debt from operating liabilities. This may be done by applying bail-in at the level of the holding company rather than at the level of the operating company. As the holding company does not have operating liabilities, holders of regular debt may bear losses without affecting operating liabilities. Resolution authorities in the United States, the United Kingdom and Switzerland have endorsed this approach, which has supported the credibility of bail-in in these countries. The difference between risk premiums on regular bonds of British holding companies and operating companies of banks recently increased sharply (Chart 14). In addition, holding companies have a lower rating uplift on their regular debt than operating companies of banks. At the end of 2013, rating agency Moody’s even completely removed the implicit government support from its ratings of US holding companies, and Standard & Poor’s recently lowered the uplift for British and Swiss holding companies.

Chart 14 : Bail-in increasingly priced-in at holding level Risk premium expressed in basis points.

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0 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Jan-15 Feb-15 Mar-15

Regular debt of holding companies of banks Regular debt of operating companies of banks Source: Bloomberg, British bank index of Barclays, RBS and HSBC. 28 Applying bail-in at holding level increases its effectiveness, but this demands a drastic change of the corporate structure for banks with holding companies with operational activities. An alternative would be to fulfil the bail-in requirement entirely with instruments that are contractually subordinated to operating liabilities. Such subordination prevents contagion risks through operating liabilities and decreases the risk premium on the relatively large proportion of regular debt.

The credibility of bail-in also grows if holders of bank debt are relatively well able to bear losses. As banks operate with substantial leverage and are very systemically important, it would not be advisable to have them cushion each other’s losses during a banking crisis, as this would create the risk of banks contaminating each other further. Currently an estimated 20% of Dutch subordinated bank debt is held by other banks (Chart 15).

Chart 15: Subordinated debt holdings Proportion per sector.

6% 3%

32% 18%

20%

21%

Investment funds Banks

Households Insurers Source: DNB Securities Holdings Statistics, Pension funds Other (roughly 60% coverage).

Policy conclusions

The development of policies to mitigate the systemic risk of bank failure is at an advanced stage, but has not yet been completed. This year, the FSB and the SRM should determine the level of global and European bail-in requirements, and which instruments should be used to match these requirements. It would be advisable to instruct European banks to hold at least 8% of their balance sheet in the form of bail-inable instruments, as banks are not allowed to take recourse to the European resolution fund until shareholders and creditors have borne losses adding up to 8% of the balance sheet. In addition to the policies having to be completed, Overview of Financial Stability

it will take some time before they have been fully implemented, as resolution plans may heavily 29 impact the banks’ corporate structure. It will also take time to build up a layer of bail-inable debt instruments. In short, it will take some years yet for the policies to be fully completed and fully effective.

Credibility of bail-in policies will benefit from a clear definition of which debt securities are subject to bail-in. As long as this is not clear, resolution will remain a complex operation and systemically important banks will continue to profit from implicit government support. Pricing of debt securities will also be easier for investors if it is clear to them from beforehand whether their loans will bear losses if the bank runs into trouble. This year DNB and the European resolution authority will draw up the resolution plans for Dutch banks. It would be preferable for Dutch banks to hold bail-inable instruments that are subordinated to operating liabilities, either contractually or structurally through a holding company. Based on a bail-in requirement of 8% consisting of core capital and subordinated bail-in debt, the large Dutch banks will be required to replace EUR 40 billion of their regular debt, i.e. an estimated 6% of their total market funding and almost 3% of their balance sheet.

For financial stability it is important that investors will be able to bear bail-in losses without further contagion to the financial system or other complications. This requires rules that discourage banks to invest excessively in each other’s bail-inable debt, e.g. by imposing limits on the size of such exposure as a percentage of own funds. In addition, it would not benefit the resolvability of banks if losses end up with non-professional investors, as they are often unable to assess bail-in risks adequately. This particularly applies to complex hybrid debt instruments (known as cocos), whereby investors lose their total investment or a part of it if a bank’s solvency position falls below a certain threshold value. These instruments are very complex as they all carry different characteristics and threshold values. Non-professional investors often lack the knowledge to assess the attached risks, which leads to increased risk of misselling of these products. Consequently the AFM believes that financial intermediaries should be extremely cautious about selling hybrid instruments to consumers.

To date, policies mitigating systemic risks of failures have been primarily focused on banks1. Yet other market players, such as insurance companies and central counterparties can also be considered too-big-to-fail. Central counterparties are important chains in the financial system, partly due to the obligatory central settlement of derivatives contracts2. Problems occurring at groups of insurers may spread to the real economy (see Chapter 2). DNB is currently asking insurance companies to develop recovery plans should solvency unexpectedly prove to be insufficient. The next step that needs to be taken in an international context is to develop resolution plans for systemically important insurance companies and central counterparties. International policymakers are examining how the systemic risks of failing institutions in other sectors (e.g. central counterparties for derivatives) may best be mitigated.

1 https://www.afm.nl/nl-nl/professionals/nieuws/2015/mrt/cocos-particuliere-beleggers. 2 See the Autumn 2014 Overview of Financial Stability. 4 Incentive effects: the role of governance and variable remuneration

30 In the run-up to the crisis, governance at a large number of financial institutions was not sufficiently effective in controlling risks. Variable remuneration encouraged excessive risk-taking. Since the crisis, DNB has sharply tightened its supervision on governance, conduct and culture at financial institutions. In addition, national and international remuneration policies have been developed to curb perverse incentives and to increase the ‘skin in the game’ of the individuals concerned. The ultimate goal of governance and remuneration policies is to create a corporate culture in which risk-conscious conduct goes without saying. In this light, it is important that the financial sector cultivates and anchors the initiated cultural changes.

Like any other enterprise, financial institutions operate for profit, which stimulates them to remain competitive and innovative. Profit-taking also has a flip side, however. Too much emphasis on achieving return may induce excessive risk-taking (see autumn 2014 OFS). The degree to which these incentives filter through into an organisation is strongly influenced by its governance and corporate culture.

Governance of financial institutions should ensure controlled operations and prevent excessive risk-taking. Governance is a complex notion and comprises risk management, remuneration and corporate structure among other factors. It also involves the role and responsibilities of management and supervisory boards, senior management, internal risk committees and internal audit departments. Financial institutions with effective governance in place are able to identify, analyse and manage risks adequately and at an early stage. Remuneration policies are an important component of governance as they create incentives that influence employee conduct.

Impact on financial stability

The crisis has shown that governance was deficient at many financial institutions. Several studies have highlighted the relationship between the effectiveness of governance and bank failure.3 The European Banking Authority (EBA) and the Bank for International Settlements (BIS) found that banks often had ineffective governance preceding the crisis. For instance, based on a survey held among supervisors and banks, the EBA concluded that the structure of banks was often so complex that effective governance could not be achieved. In addition to this, executive and supervisory boards often lacked the knowledge to manage risks adequately. And finally, risk management and internal controls at banks failed at adequate risk mitigation.

3 Aebi, V et al. (2012). Risk management, corporate governance and bank performance in the crisis. Journal of banking and finance; Ellul, A. & Yerramilli, V. (2012). Stronger risk controls, lower risk: evidence from US bank holding companies. Journal of finance; Beltratti, A. & Stulz, R.M. (2009). Why did some banks perform better during the credit crisis? A cross-country study of the impact of governance and regulation. NBER Working Paper, No. 15180, July. Overview of Financial Stability

Although ineffective governance at financial institutions was not the direct cause of the crisis, 31 it is one of the fundamental underlying factors.4

The consequences of ineffective governance are not only reflected in the control of financial risks, but also in increasing losses due to misconduct. An example of misconduct is selling financial products that are not in the customer’s best interest. Misconduct often entails deliberate ignoring of legislation, governance, or ethical norms by employees of financial institutions. Based on interviews with employees of financial institutions in London, Luyendijk (2015) concluded that such practices are wide-spread in the financial sector. This is to a large extent explained by the system of perverse incentives prevailing in the financial sector, which induces conduct aimed at achieving short-term profits, with downward risks being shifted to other parties. Luyendijk also found that internal controls at financial institutions fail to provide sufficient counterbalance to such perverse incentives.

Misconduct may eventually result in high costs if financial institutions are held responsible for such practices or the damages inflicted by them. In the past five years, the total worldwide costs related to fines, settlements and claims for damages as a consequence of misconduct ran up to some EUR 160 billion, about EUR 45 billion of which was incurred by large European banks (7% of their own funds). Analysts predict that European banks will be held liable for at least another EUR 50 billion in additional costs in the near future (chart 16). This risk is also present in the Netherlands. Rabobank was for instance forced to make a EUR 774 million settlement for its involvement in the manipulation of Libor. Various parties are also claiming for damages relating to past activities such as the sale of interest derivatives to SMEs and particular investment products to consumers (profiteering policies). Misconduct poses a risk to the financial sector not only because of possible high losses, but also due to the resulting breach of confidence in the financial sector.

Variable remuneration may have both positive and negative effects on financial stability. Positive effects may occur if variable remuneration induces staff to improve their performance.5 Besides that, the costs incurred by financial institutions related to variable remuneration may move in tandem with fluctuating economic conditions. Yet an in-depth study initiated by the IMF, analysing the existing literature and in-house empirical research, highlights the flip side of variable remuneration: badly thought-out variable remuneration schemes induce

4 EBA (2011). Guidelines on internal governance; BIS (2010). Principles for enhancing corporate governance; G30 (2012). Toward effective governance of financial institutions; The de Larosíère Group (2009). A review of corporate governance in UK banks and other financial industry entities; Luyendijk, J. (2015). Dit kan niet waar zijn. 5 Lazear, E., P. (2000). Performance Pay and Productivity. American Economic Review; Ariely, D., Gneezy, U., Loewenstein, G. & Mazar, N. (2005). Large stakes and big mistakes. Working paper series // Federal reserve of Boston; Bowles, S. & Reyes, S.P. (2009). Economic incentives and social preferences: a preference-based Lucas critique of public policy. CESifo working paper; Pink, D. (2009). Drive, the surprising truth about what motivates us. 32 Chart 16 - Further increase in costs related to misconduct expected Costs of misconduct for large European banks (in EUR billion).

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Source: Credit Suisse, annual reports banks, EBA, FT and in-house calculations. The provisions made by the banks are based on 2013 year-end and mid-2014 figures.

excessive risk-taking.6 Efing et al.7 conclude that in the run-up to the crisis, the advantages of higher variable remuneration did not weigh up against the disadvantages. Their empirical research shows a negative relationship between the level of variable remuneration and the Sharpe ratio, a benchmark for risk-adjusted return. The survey included 1.2 million German, Swiss and Austrian bank employees working in investment banking and treasury. As both the employment terms and the activities performed by investment banking and treasury staff have a strong international character, it is fair to say that this conclusion also applies to the Netherlands.

In the current low yield environment, effective governance including balanced payment policies is even more important. Due to the current combination of low interest rates and ample liquidity, the search for yield is ongoing. Ineffective governance and adverse remuneration incentives may further induce undesirable risk-seeking behaviour and bring on financial stability risks.

6 IMF (2014). Global financial stability review; Bebchuck, L.A. & Spamann, H. (2009). Regulating bankers’ pay. Harvard Law school. 7 Efing, M., Hau, H., Kampkötter, P. & Steinbrecher, J. (2014). Bankers’ bonuses and performance sensitivity. Journal of international economics. Overview of Financial Stability

Policies implemented 33

Before the crisis it was not so much that governance rules in themselves were inadequate, but rather the implementation of these rules and of their underlying intention.8 The cases of misconduct that have come to light since the crisis also point in this direction. This is why since 2011 DNB has not only exercised strict supervision on the governance of financial institutions, but has also scrutinised the conduct of executive and non-executive directors, and other senior management. DNB’s examinations of financial institutions have shown that improvements have been made to governance these past few years. Financial institutions have also made a start on achieving cultural change, aimed in particular at risk control. Nevertheless, incidents are still occurring. This illustrates that the actual anchoring of a cultural change – and really making governance effective – will demand perseverance in the years ahead, and that a considerable effort must still be made in this respect.

Management and supervisory boards set an example and are conveyors of culture; to a large extent they determine corporate policies. In view of their influence, it is crucially important that executive and non-executive directors are aware of the incentives and risks inherent to their policies. Since 2011, DNB has been assessing managers more explicitly on their knowledge, skills and conduct in order to test their understanding of risks and their ability to take measures to control these risks. Since 1 July 2012 the suitability requirement has also applied to supervisory board members. In addition, DNB uses behaviour and culture examinations to assess whether the dynamics and decision making processes at the top of institutions contribute towards early detection and adequate management of risks.

The past years have also seen fundamental international changes to remuneration policies. These policies are aimed at preventing incentives that induce excessive risk-taking. In the Netherlands, this has also been included in the Financial Supervision Act (Wet op het financieel toezicht – Wft) and the related Regulation on Sound Remuneration Policies (Regeling beheerst beloningsbeleid – RBB). Both translate principles from international standards and regulations to the day-to-day reality in the Netherlands.

The most important common performance criterion in the new rules states that variable remuneration may only be paid out if justified by both the financial and the solvency position of the company. In addition, individual performance criteria directly influencing behaviour must include both financial and non-financial elements, and propagate adequate management of risks rather than risk-taking. The EBA has specified this further: criteria such as risk-adjusted return on capital (RAROC) and customer satisfaction are to be preferred over criteria such as return on equity and profits.9 In line with these developments, a ban on commissions was

8 EBA (2011). Guidelines on internal governance; G30 (2012). Toward effective governance of financial institutions; The de Larosíère Group (2009). A review of corporate governance in UK banks and other financial industry entities. 9 EBA (2010). Guidelines on remuneration policies and practices. 34 imposed in the Netherlands, thus uncoupling the fees earned by financial advisers from the amount of financial products or services sold. Commission-based sales were known to induce excessive lending.

Internationally, additional requirements are being imposed on a small group of staff that have a material influence on a bank’s risk profile, known as identified staff. These requirements should increase ‘the skin in the game’ of these staff members. At least 40% of remuneration should be linked to long-term targets as risks often take a long time to manifest themselves. If risks indeed surface, the intended variable remuneration will be reduced. Variable remuneration of identified staff is also subject to clawback arrangements: if staff members are demonstrably responsible for negative results, variable remuneration can be reclaimed. Legislation also demands that at least 50% of variable remuneration should be paid out in a combination of shares and debt paper; the exact ratio between the two has not been specified. Remuneration in the form of debt paper is to be preferred. This is because equities and especially options have a large profit potential, while extreme losses will have to be borne by other stakeholders. In the case of debt paper, potential profits and losses are balanced more evenly, which dampens the incentive to excessive risk-taking.

Chart 17 - Variable remuneration is highest for identified sta; variable remuneration to identified sta is paid out primarily in cash and shares Proportion of variable remuneration earned by Pay-out form of variable remuneration of identified employees of Dutch large banks in 2013. sta in 2013.

1 1 13%

37% 33%

16%

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0 0 Total work force Identified sta (16,000 FTEs) (800 FTEs)

Cash Shares, delayed Variable remuneration Cash, delayed Other Fixed remuneration Shares Other, delayed

Source: DNB. Overview of Financial Stability

It is too early to determine the effectiveness of the new remuneration policies. For instance, 35 the Regulation on Sound Remuneration Policies was tightened as recently as 2014 and detailed data on variable remuneration is as yet scarce. The information that is available gives an impression of the trend. In 2013 variable remuneration for employees of Dutch large banks was relatively low (chart 17), which is partly due to the complete scrapping of variable remuneration from the collective labour agreements at a number of large banks. Identified staff often fall outside the scope of the collective labour agreement. With the introduction of the Act on Renumeration Policies of Financial Undertakings (Wet beloningsbeleid financiële ondernemingen), which limits the proportion of variable remuneration in principle to 20%, the variable remuneration of identified staff will be further reduced. In conformity with the regulations, variable remuneration of identified staff was either postponed or almost entirely paid out in cash. Variable remuneration of managing directors of large Dutch banks and insurance companies has fallen sharply, partly as a result of societal pressure and the Act on the limitation of liability of DNB and AFM and introducing a ban on bonuses for firms receiving state support (Wet bonusverbod staatsgesteunde ondernemingen) (chart 18).

Chart 18 – Variable remuneration component of executive board members of large banks and insurance companies has decreased sharply

Average remuneration of executive board members (index, 2008=100).

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Variable remuneration Fixed remuneration Source: AMA partners, platform DirectorInsight. 36 As many Dutch pension funds are customers of non-domestic financial institutions, it is important for them be aware of the risks emanating from the remuneration policies pursued by these firms. The remuneration policies of non-domestic financial institutions vary strongly. The variable remuneration component for senior management in Belgium is comparable to that in the Netherlands, but senior management in the United Kingdom, Switzerland and Germany receive a larger component of variable remuneration (chart 19). The recently introduced CRD IV regulations cap variable remuneration in the European Union at 100% (or 200% in exceptional cases) of fixed remuneration. This will also reduce the variable component of total remuneration in the United Kingdom and Germany in the future.

Chart 19 – Variable remuneration component of executive board members at large foreign banks and insurers Average remuneration of executive board members (index, 2013=100)

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Policy conclusions

Since the crisis, incentive effects in the financial sector and the role that governance plays in this respect have received a great deal of justified attention. It should be borne in mind that there is an essential difference between financial and non-financial enterprises. As financial institutions operate with relatively low own funds, shareholders, senior management or staff may profit disproportionately from taking risks, since extreme losses are borne by other stakeholders. A large proportion of the new supervisory policies is therefore targeted at increasing ‘skin in the game’ and improving risk awareness among the relevant parties, so as to attribute a more significant role to the long-term perspective and the interests of society. Overview of Financial Stability

Progress has been made in various areas: solvency requirements for shareholders have been 37 tightened and bail-in of creditors has been introduced (see Chapter 3). More stringent policies targeted at senior management and staff actually influencing the company’s risk profile are part of this approach.

As far as remuneration policies are concerned, it should be borne in mind that not only the level, but also the attached conditions and the pay-out form of variable remuneration is crucial to the degree of ‘skin in the game’ and hence the conduct of staff. Pay-outs in the form of debt paper are consistent with this approach and require that further changes are made to the remuneration policies of financial institutions. The EBA is currently developing guidelines that will further support the relevant regulations on this point. Variable remuneration may also contribute to cost flexibility. However, this demands that financial institutions retain remuneration if they are not sufficiently solvent, or if the relevant staff members do not live up to their performance criteria, which has not always been the case in the past. ECB supervision will address this issue.

The tightened governance and remuneration policies will now have to be fleshed out in practical terms. This demands a great deal of effort, not only from the sector itself, but also from the supervisory authorities. More than before, the financial sector should take primary responsibility for modifying the incentive effects of internal policies and achieving controlled risk behaviour. Needless to say, it should implement the existing governance and remuneration regulations. However, another crucial factor is that the risk culture is sufficiently transformed. A reformed risk culture will help ensure that also the intention underlying the rules is internalised and suitably embedded in day-to-day operations. DNB is monitoring this process and has found that the sector has made a start on cultural change, although the most visible adjustments so far seem to have been primarily made as a result of societal pressure and regulatory requirements. Further cultural change is therefore necessary. As keepers of an ethical corporate culture, management and supervisory boards play a crucial role in this respect. Annex 1: Macroprudential indicators

38 Most recent Trend after 1998 observation Min Max Average Period under review Credit conditions Trend deviation credit/GDP ratio 1 -19.6 -19.6 18.5 1.4 1998Q1-2014Q4 Growth in household lending (y-o-y) -0.9 -1.3 17.1 7.2 1998Q1-2014Q4 Growth in non-financial companies lending (y-o-y) 0.1 -7.8 16.8 4.8 1998Q1-2014Q4 Growth in house prices (y-o-y) 2.3 -9.9 20.0 3.9 1998Jan-2015Feb Growth in commercial property prices (y-o-y) -1.2 -7.8 9.2 1.4 1999Q4-2014Q4 Loan-to-value ratio first-time buyers 2 92.2 92.2 101.6 97.6 1999-2014Q1 Loan-to-income ratio first-time buyers 3 4.4 4.0 4.9 4.5 1999-2014Q1 Long-term interest rates (bp) 4 41.6 41.6 566.6 370.0 1998Jan-2015Feb BBB-AAA risk premium (bp) 5 60.0 53.0 509.0 156.6 2001Jan-2015Feb

Bank solvency Leverage ratio CRD IV, fully loaded 6 3.3 3.3 3.5 3.4 2014Q1-2014Q4 Tier 1-capital/balance sheet total of the banking sector (up to 2013 Q4) 5.0 3.0 5.0 3.9 1998Q1-2013Q4 CET1-ratio of banks CRD IV, based on transition rules 14.3 12.9 14.3 13.5 2014Q1-2014Q4 Tier 1-ratio of banks based on CRD III (up to 2013 Q4) 7 12.5 8.2 12.8 10.0 1998Q1-2013Q4

Bank liquidity Loan-to-deposit ratio 8 163.6 157.1 198.2 179.3 1998Q4-2014Q4 Proportion of market funding with maturities < 1 year 30.3 16.6 38.3 29.6 2003Aug-2015Jan Money market rate offered-middle rate spread (bp) 9 10.7 1.2 186.0 23.2 1999Jan-2015Feb Risk premium on senior unsecured bank bonds (bp) 10 48.4 12.6 321.5 86.3 1999Jan-2015Feb

Systemic importance Size of bank balance sheets as a percentage of GDP 385.8 306.5 562.5 421.3 1998Q1-2014Q4 Share of G5-banks in balance sheet total of the banking sector 11 84.8 79.9 90.3 87.1 1998Q1-2014Q4 Rating uplift of systemically important banks (in steps) 12 2.2 2.2 2.3 2.3 2012-2015

Concentration of exposures of Dutch banks13 Netherlands Abroad 2014Q4 Total of debt securities and loans 49.3 50.7 Central bank 0.4 0.5 Governments 4.3 7.0 Credit institutions 1.3 13.9 Other financial institutions 2.7 5.9 Non-financial institutions 12.8 14.9 Of which: Small and medium-sized enterprises 2.0 3.9 Of which: Commercial property 3.4 1.9 Households 27.8 8.5 Of which: Mortgage loans 26.5 7.4 Of which: Consumer credit 0.8 0.5

Sources: CBS, BIS, IPD, Thomson Reuters Datastream, Bloomberg, Moody’s, DNB. Figures are in (%) unless otherwise indicated. Bp = basis points. Overview of Financial Stability

1 The difference between 1. The ratio of lending to the non-financial private sector (households and non- 39 financial corporations) to the Gross Domestic Product of the Netherlands and 2. The long-term trend for that ratio as calculated in ESRB (2014), Occasional Paper No. 5: Operationalising the countercyclical capital buffer: indicator selection, threshold identification and calibration options. 2 Approximation based on data for individual loans. First-time buyers are defined as individuals aged below 30 when taking out a mortgage loan. 3 Calculated on the basis of the most recent definition of the leverage ratio as agreed by the Basel Committee in January 2014. 4 Calculated on the basis of the methods from CRD III due to the availability of a longer data set. 5 The difference between yields on Dutch ten-year government bonds and prevailing inflation rates. 6 The difference between yields on international BAA-rated corporate bonds and AAA-rated corporate bonds. 7 The difference between three-month EURIBOR and the three-month EONIA swap index. 8 Investments in the most important domestic sectors and international investments, as a percentage of the Dutch banking sector’s total investments. 9 The five largest Dutch banks’ total assets, as a percentage of the Dutch banking sector’s total assets. 10 The yield differential between European senior unsecured bank bonds and five-year swap rates. 11 The five largest Dutch banks’ assets (ABN AMRO, ING, Rabobank, SNS Bank and BNG), as a percentage of the Dutch banking sector’s total assets. 12 The difference between credit ratings including and excluding government support, based on Moody’s methodology. This is an average of ABN AMRO, ING, Rabobank and SNS Bank, weighted by balance sheet total. 13 The share of Dutch and foreign counter sectors in the exposure of all Dutch banks, based on reported consolidated figures for supervision purposes. Annex 2: Review of DNB actions based on the OFS

40 In the past years, DNB has identified macro-level risks in its OFS and has made recommendations for mitigating these risks. These recommendations are primarily aimed at financial institutions and national and international policymakers. In addition to influencing policy-making, DNB also contributes towards mitigating and managing of macro-level risks based on its own mandate. This can be done by means of two channels: firstly by including macro-risks in microprudential supervision on individual institutions (macro-micro link); and secondly by using the macro- prudential instruments that have been at DNB’s disposal since early 2014 (see also Chapter 1 of this OFS).10

This edition of the OFS includes a retrospective overview of the main macro-level risks and the corresponding recommendations and relevant actions taken by DNB since 2011. DNB attaches great value to being transparent on the actions taken in order to mitigate the identified macro-level risks. This is consistent with our own 2014 Supervisory Strategy document,11 government proposals prompted by two reports issued by the Netherlands Scientific Council for Government Policy (WRR) in 201412 and recommendations made by the Netherlands Court of Audit in 201113 to publish actions and results achieved by supervision where possible. As the development of risks also depends on external factors beyond DNB’s sphere of influence, there does not necessarily have to be a causal relationship between the status of risks and the actions taken by DNB.

The first column of Table 1 lists the main macro-level risks and the corresponding recommendations depicted in the OFS between 2011 and 2014. Column 2 reflects the status of the risks compared to their first inclusion in the OFS. The third column lists the specific actions that DNB has taken.

10 DNB issued with macro-prudential instruments (DNBulletin, 2013), Progress made in macro-prudential policy (DNBulletin, 2014). 11 Supervisory Strategy 2014-2018. 12 Cabinet response to WWR reports ‘Supervising public interests’ and ‘From diptych to triangles’ (2014). 13 DNB’s Supervision on the stability of banks (report published by the Netherlands Court of Audit in 2011). Overview of Financial Stability

Table 1: Response to main macro-level risks and recommendations 41

Main risks and recommendations Status of risk since No. (citation in OFS in brackets) first citation in OFS Specific DNB actions

Banks 1 Insufficient strengthening of capital Reduced Supervise accelerated convergence - Banks are required to reinforce their solvency towards Basel III capital requirements. positions (autumn 2011 to autumn 2013)

2 Funding risk for banks Reduced Supervision of accelerated convergence - Caution warranted with respect to covered see also Chapter 1 towards Basel III liquidity requirements funding (autumn 2011 and spring 2013) and additional liquidity requirements - Banks must reduce their dependence on imposed. market funding (spring 2012)

3 Losses on commercial real estate Reduced Asset Quality Review (AQR) on - Real estate must be valued more realistically commercial real estate completed and (autumn 2012) stress test performed. - AQR and stress tests (autumn 2012)

4 Upward interest rate shock Modest change Examination into quality of interest rate - Risk of interest rate shock requires adequate risk management. risk management (spring 2013)

5 Ineffective bail-in Reduced, Involved in fleshing out of European - Embedding of bail-in in European legislation see also Chapter 3 resolution legislation and establishment is required (autumn 2013) of National Resolution Authority (NRA) at DNB. Insurance companies 6 Sustainability of business models of life insurers Increased, Based on examinations, - Life insurers are required to reduce costs; see also Chapter 2 recommendations have been made to consolidation may help in achieving this the sector about cost reduction and (autumn 2011 to spring 2014) enhancing earnings capacity. - Insurers must pursue sustainable business models (spring 2014)

7 Unit-linked insurance (‘profiteering policies’) Modest change Conveyed the importance of finding - If duty of care has been neglected, insurance solutions. companies must make an effort to redress the situation (autumn 2011)

8 Return guarantees Modest change, Monitor that guarantees are valued - Insurance companies must exercise caution see also Chapter 2 accurately and convey that caution when issuing new return guarantees is required in issuing new return (spring 2013) guarantees. 42 Table 1: Response to main macro-level risks and recommendations (continue)

Pension funds 9 Sustainability of the pension system Modest change, Policy advice with respect to new - Pension funds must reinforce their buffers see also Chapter 2 Financial Assessment Framework (FTK), (autumn 2011) position paper for National Pension - Pensionable age must be increased dialogue and advice to the Social and (spring 2012) Economic Council (SER).

System-wide 10 Risks related to the housing market Diminished, Policy advice on lowering of LTV limit - Lowering of loan-to-value (LTV) limit see also Chapter 1 and curbing of tax-induced debt (autumn 2011 to spring 2013) accumulation - Curb tax-induced borrowing (autumn 2011 and autumn 2012)

11 Cyber threats Modest change Examination into measures for - Financial institutions must increase their increasing the resilience of financial resilience (autumn 2013 and autumn 2014) institutions against cyber crime.

12 Vulnerability of derivatives positions Modest change Supervision on compliance with EMIR- - Enhanced solidity of central counterparties requirements, and focus points for (CCPs) (spring 2014) implementation published. - Reduce the impact of failure of CCP (spring 2014) - Reduce pro-cyclical elements (spring 2014)

13 Search for yield and bubble formation Increased, Examination of and instruction towards - Institutions are required to set more realistic see also Chapter 1 prudence at financial institutions. return targets (autumn 2014)

Overview of Financial Stability

Detailed information Table 1 43

1. Dutch banks have improved their solvency position these past few yearsd.14 DNB monitored the accelerated preparation for compliance with Basel III solvency requirements, which have been in force since January 2014. DNB also formulated additional capital buffer requirements for systemic banks: 3% for Rabobank, ING Bank and ABN AMRO, and 1% for SNS Bank. These buffers may be built up gradually between 2016 and 2019.15 2. At the end of 2014 Dutch banks already complied with the Basel III liquidity requirements: the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR), which have respectively been in force since January 2015 and will come into force in January 2018. Banks supervised by DNB accelerated preparation for compliance with the Basel III requirements, and imposed additional liquidity requirements where necessary, based on the individual institutions’ liquidity risks. The banks’ domestic deposit funding gap has gradually narrowed to less than EUR 400 billion at the end of 2014, from around EUR 500 billion at the end of 2008. This means that banks have become less dependent on market funding (see also Chapter 1 of this OFS). 3. Dutch banks have enhanced their resilience in order to cushion drops in the value of commercial real estate. DNB performed an Asset Quality Review (AQR) and stress tests at systemically relevant banks in 2013. Balance sheets have been scrutinised with particular attention for risks relating to real estate. This has led to more realistic valuations, higher provisions and projections of expected losses for each institution. 4. The ongoing low interest environment carries the risk of an unexpected upward interest rate shock. In 2013 DNB examined interest rate risks at banks, including the scenario of an upward interest rate shock in its stress tests. Dutch banks have been made aware of the importance of adequate interest rate risk management. 5. Bail-in has officially been incorporated in the European Bank Recovery and Resolution Directive (BRRD) and the Single Resolution Mechanism (SRM) Regulation. The bail-in instrument will come into full force from January 2016. One aspect of this is that banks must have sufficient loss absorbing capacity at the moment of resolution, in order for bail-in to be possible (see also Chapter 3 of this OFS). DNB is involved in the development of European and national resolution legislation. In addition, DNB was appointed National Resolution Authority (NRA) in January 2015.16 6. The ongoing low interest environment and the declining demand for individual life insurance have put the sustainability of the business models of life insurance companies under pressure (see also Chapter 2 of this OFS). In 2014, DNB examined the long-term viability of the Dutch insurance sector. The results of the examination – that life insurers must improve their earnings generating capacity, and reduce their costs – have been shared with the sector.17

14 Banks are keeping up with increasingly stringent Basel III requirements (DNBulletin, 2014). 15 Additional buffer requirement enhances resilience of Dutch systemic banks (DNBulletin, 2014). 16 New steps towards enabling a controlled approach of bank failure (DNBulletin, 2015). 17 Long-term viability of insurance companies examined (DNBulletin, 2014). 44 7. Insurers may have neglected their duty of care in issuing insurance policies and effecting unit-linked insurance policies. DNB is monitoring the development of the unit-linked insurance policy issue and is discussing this with the insurance sector, the AFM and the Ministry of Finance. 8. Less ambitious return guarantees are now being issued for newly produced insurance policies and group insurance contracts. However, this does not solve the problem of the risks attached to existing portfolios (see also Chapter 2 of this OFS). DNB has examined the outstanding guarantees, monitors that these guarantees are valued accurately in the technical provisions, and has made clear that caution is warranted in issuing new return guarantees. 9. The ageing population and the prolonged low interest environment have eroded the sustainability of the pension system (see also Chapter 2 of this OFS). The pensionable age is being increased in stages. In addition, a new financial assessment framework (nFTK) came into effect in January 2015, on which DNB issued advice.18 The nFTK among other things provides for higher buffers and absorption of shocks such as interest rate drops. The government started up the National Pension Dialogue in order to modernise the pension system. DNB is contributing to this dialogue and issuing advice to the SER.19 10. In 2012, the Dutch government introduced legislation mitigating the vulnerability of households to house price falls and the risk of mortgage losses. Firstly, the maximum rate at which interest payments are tax deductible is gradually reduced. Secondly, mortgage interest payments can now only be offset against tax if annuity-based repayments are made. Thirdly, the LTV limit is being reduced to 100% in 2018 from 106% in 2013 (see also Chapter 1 of this OFS). DNB has recommended reduction of the maximum allowed LTV ratio and curbing of tax-induced debt accumulation.20 11. Institutions are taking additional measures to counter cyber attacks, but the risk remains as financial institutions are by nature dependent on information technology and the manifestations of cyber threats are constantly changing.21 DNB examined which measures banks could take against cyber threats. In addition, we are monitoring the banking sector’s periodic risk analyses in order to test measures and evaluate whether the quality of tests may be improved. 12. New legislation is directed towards increased collateral requirements and central settlement of derivatives contracts. This has been endorsed in the European Market Infrastructure Regulation (EMIR). DNB and the AMF jointly supervise that Dutch CCPs and other financial institutions comply with their EMIR requirements. In this respect, DNB examined the impact of EMIR and published points for attention for institutions in the implementation of EMIR based on the outcome of its examination.22

18 Towards a more shock-resilient, stable and balanced pension (DNBulletin, 2014). 19 DNB Position Paper in support of the national pension dialogue (2015). 20 Economy to benefit from fewer tax incentives to save and borrow (DNBulletin, 2015). 21 Systemic risks arising from cyber threats (DNBulletin, 2015). 22 EMIR points for attention (Open Book on Supervision, 2014). Overview of Financial Stability

13. The ECB’s public sector purchasing programme will contribute to a prolonged period of low 45 interest rates, and may consequently exacerbate the search for yield (see also Chapter 1 of this OFS). DNB is examining the search for yield and is promoting prudence at financial institutions via microprudential supervision.

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