FINANCIAL STABILITY • 2010 • STABILITYFINANCIAL FINANCIAL STABILITY Special issue • 2010 Contents

Preface ...... 1

Summary ...... 2

Financial stability • 2010 Published 20 Dec 2010 Operating environment ...... 6 (Special issue, published annually)

Banking and insurance sector ...... 18 Editor-in-Chief Erkki Liikanen

Financial market infrastructure ...... 32 Steering Group Päivi Heikkinen Jouni Timonen Financial system policy ...... 38 Jukka Vauhkonen Kimmo Virolainen

Appendix. Authors Infrastructure critical to Eeva Alho Hanna Putkuri Jyrki Haajanen Pertti Pylkkönen the Finnish financial market ...... 54 Päivi Heikkinen Kirsi Ripatti Timo Iivarinen Eero Savolainen Karlo Kauko Heli Snellman Risto Koponen Katja Taipalus Helinä Laakkonen Jouni Timonen Marko Myller Hanna Westman Tuomas Nummelin Jarmo Pesola Erja Pullinen Jukka Vauhkonen

Technical assistants (texts, charts, tables) Nina Björklund Jonna Elonen-Kulmala

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

Subcriptions Email: [email protected]

Printed Multiprint Oy, Vantaa 2010

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

ISSN-L 1796-539X (print) ISSN 1796-5578 (online)

Bank of Finland PO BOX 160 FI-00101 HELSINKI Phone: National 010 8311, International +358 10 8311 Fax: +358 9 174 872 www.bof.fi

The cover picture depicts the national motif on the Greek 1 euro coin: Athenian owl. Preface

Soundly functioning financial and 2010 and again at the end of the year. payment systems are essential to the The financial sector’s risk-bearing ability entire national economy. A stable financial has been improved by applying both system is capable of operating beyond state and banking sector’s own measures, reproach, of handling its basic tasks, such but there are large differences in the Sas the undisturbed transmission of development between various countries finance and payments, pricing of financial and banking groups. instruments and efficient distribution of The Finnish economy experienced a risk. Furthermore, the risk-bearing sharp downturn last year, mainly as a capacity of the financial market agents consequence of the disturbances on the and public confidence in financial institu- international markets. However, the tions and the financial markets must be Finnish financial system withstood the sufficient to endure even large disruptions crisis well and was able to prevent a bad in the operating environment. downward spiral from taking hold. The One of the tasks of the Bank of robustness of Finnish financial institutions Finland is to promote the stability, has the effect of reducing the contagion reliability and efficiency of the Finnish of economic problems from indebted financial system and to participate in its countries, to Finland’s financial system. development. The Bank’s efforts are This is vital to Finland, as Finland is not integrated with the objectives of the immune to international economic and European System of Central Banks and financial system disturbances. also require close cooperation with The Financial Stability Report is other authorities. intended for all financial market agents, The Bank of Finland’s task is to other authorities and the public to evaluate the stability of the financial provide information and promote system, as a whole. The Bank evaluates discussion on relevant topics. This serves the most significant potential threats to the purpose of ensuring that these parties stability in the operating environment can take financial market conditions and of financial institutions and financial stability outlook into account in their system, the state of the principal operations. borrower sectors, the risk-bearing The Bank of Finland has published capacity of financial market partici- its assessment of financial stability since pants and the reliability and efficiency 1998. Information presented in this of the underlying payment and report is based on data available on 15 settlement systems. November 2010. The international financial system’s recovery from the world-wide economic HHelsinki,elsinki, 3 December 2010 and financial crisis will take its own time. The weakening of national economies due to the recession was a phenomenon experienced around the world. A lack of confidence in the most Pentti Hakkarainen, highly indebted European countries’ Member of the Bank of Finland Board ability to service their debts shook the Deputy Governor of the Bank of financial markets first in the spring of Finland

Financial stability • 2010 1 Summary

The shrinkage in taxation revenue, expan- 2010 to record levels, to an estimated 109 sionary fiscal measures and bank support percent. On top of which, the relative using public funds all following on the number of households that became deeply heels of the global financial crisis and its indebted in relation to income grew subsequent recession have rapidly considerably during the first decade of the Tweakened many countries’ financial 2000s. However though, with interest position around the world. A lack of rates remaining low, the household debt confidence in the most highly indebted servicing burden has been small in European countries’ ability to service their historical terms. debts came to a head in the spring of The growth in the level of indebted- 2010 and again at the end of the year. ness is not expected to pose an immediate Prolongation or further tightening of the threat to financial stability in Finland; debt crisis remains a threat to the recovery although it can be seen as having an accel- of the European economy and to the erating effect on rising housing prices in world economy overall as well as to Finland. The spike in housing prices, financial system stability. The world experienced in the spring of 2010 was a economy is still on fragile footing. warning signal of how asset prices have a The bulk of Finnish banks’ and other tendency to be susceptible to forceful financial institutions’ claims on the most fluctuations and exaggeration. The latest indebted European countries are relatively economic crisis has also shown the small, which reduces the risks that there massive risks associated with an uncon- would be direct contagion of these trolled rise in asset prices. countries’ problems to the Finnish On the whole, the payment and financial system. Finnish banks have settlement systems have functioned fairly survived the financial and economic crises reliably over the last year. Internationalisa- relatively unscathed and their profitability tion of the Finnish financial market’s infra- and capital adequacy have remained structure has made the country’s payment strong. Bearing the depth of the recession and settlement systems part of the pan- in mind, if the Finnish economy grows as European financial market infrastructure. forecast, loan losses to the banks caused Payments are in the process of becoming by the recession would appear to remain transmitted via a pan-European clearing fairly small. house, and securities exchanges and market However, the Finnish economy is places as much as central counterparty highly export-driven, meaning that the clearing and custody services are all either disturbances in the international financial part of an international enterprise or are system and the difficulties in financial handled abroad. This development is a intermediation are reflected more than natural progression from integration, average in Finland’s economic growth. which is expected to bring economies of The average Finnish households’ level scale and scope. At the same time, above of indebtedness illustrated by the all, the authorities seek to ensure that the household sector’s borrowing stock in functions essential to the domestic financial relation to disposable income increased in markets are secured, in such a way that

2 Financial stability • 2010 consumers’ needs in terms of quality, of global financial crises, which hit efficiency, availability and price are all met. export-dependent economies like Finland Loss of both operating potential and the hardest. the power of influence over domestic In the effort of strengthening the markets present the major potential threat resilience of the financial system and to Finnish financial infrastructure. The further improving financial regulation, the regulatory changes underway are a very Bank of Finland wishes to emphasise the important pre-emptive measure against the following aspects: materialisation of this threat. For exercise 1) The sovereign debt crisis has of the power of influence, a common highlighted how a lack of confidence in national understanding of future develop- the management of public finances can ments in infrastructure is necessary. shake the stability of the financial system. The major risks to financial stability in Maintaining the sustainability of public Finland in 2011 are: finances and a moderate level of indebted- 1) Escalation of the sovereign debt ness in the Finnish economy also serves crisis depresses international financial the interests of national financial stability. markets, which is reflected in tighter 2) There are structural elements present availability of financing and funding to in Finnish housing markets that increase Finnish actors, too. price fluctuations and, hence, expose the 2) The sovereign debt crisis takes financial system and the economy to global recovery to a standstill, slowing disruptions. In Finland, an exceptionally consumption, investments and export large proportion of mortgage rates are tied demand and weakening the operating to short-term market rates. Households environment of financial companies. must measure the amount of housing loan 3) Ongoing growth in the indebted- against their debt-servicing ability and ness of Finnish households will make prepare for the risks related to the interest households increasingly vulnerable to rate option chosen. rising interest rates and undesired 3) Authorities currently do not possess economic surprises. adequate measures for intervening in Following the teachings from the exaggerated rises in asset prices or financial crisis, measures to tighten excessive growth in lending and indebted- financial regulation considerably have ness. Central banks should in future have been introduced. The major new a central role in putting into use measures regulatory change so far, the Basel III whose effect is in calming excessive reform prepared by the Basel Committee lending and indebtedness, ie so called on Banking Supervision, was adopted in macroprudential policies. November 2010. The Basel III reform will 4) At the global level, systemically raise banks’ resilience to institution-spe- important financial institutions must be cific as well as macroeconomic shocks. subjected to tighter financial regulation and The global reforms of financial supervision than other financial undertak- regulation are largely in line with Finnish ings. In the future, no financial institution interests. They serve to reduce the threat should be considered too big to fail.

Summary Financial stability • 2010 3 Box 1.

Stability map representation of the financial stability situation

This Box discusses developments overheating in financial markets, slightly worse than normal in the key indicators underlying whereas rapid deterioration of outlook. The impending collapse stability in the Finnish financial the macroeconomic situation of GDP in 2009 was not yet in system over the years 2008–2010, may cause financial system stress sight. In 2009, however, forecasts in light of Chart A.1 In the chart, for example in the form of loan rapidly turned very gloomy. the external point values represent losses. The upper point of the Despite the highly dramatic a weaker macroeconomic outlook, chart illustrates the macroeco- effects of the crisis, it looks as if higher risks and higher stress. nomic situation in Finland. The it will not be as drawn out as The point values are based score for the macroeconomic previously thought. In 2010, on their underlying variables, dimension is derived from the forecasts of economic growth for with its conceptual centre point Bank of Finland’s GDP growth the present and following year (origo) and the outer edge repre- forecasts for the present and have returned to normal levels, senting the two extremes of each following year.2 so to speak, hovering around time series. The grey zone Being an export-driven 2.5%. It should, however, be portrays the two middle quarters country, Finland is sensitive to borne in mind that the of the time series, ie the area disruptions in the global uncertainty surrounding which the value of the variable economy. Still, with all its drama, forecasts of economic growth hits 50% of the time. the effects of the financial crisis remains higher than normal. Of the indicators of the on economic growth in Finland Moreover, bridging the stability situation, the macro have been difficult to predict. In production gap caused by the economy is of crucial importance 2008, the macroeconomic downturn presents a major to the financial system, as strong projections for that and the challenge, the signs of recovery economic growth could fuel following year only pointed to a notwithstanding.3 Several studies4 have dem- 1 For details of the indicators and 2 In contrast to other dimensions, the onstrated that over-indebtedness technical design of the chart, see dimension of the macroeconomic Kaukoranta, I (2010) Rahoitusmarkkinoi- situation is forward-looking. The scores and overheating housing markets den vakauden visualisointi (Visualisation for the other dimensions of the chart are may predict future financial of financial stability). BoF Online 8/2010. experience-based. market crises. Hence, the two Chart A. right-hand side points of the Financial stability map for Finland chart illustrate mounting threats to stability: developments in real Macroeconomy housing prices and private sector indebtedness. Both figures are Banks’ Housing calculated as deviations from the sustainability prices long-term trend.

3 For details of the macroeconomic situation in Finland, see the section Operating environment (p. 10) and the special issue of the Bank of Finland Risk premia Indebtedness Bulletin, Economic Outlook 2/2010. 4 December 2008 December 2009 December 2010 Eg Borio, C. – Drehmann, M. (2009) Towards an operational framework for Sources: Merrill Lynch, NASDAQ OMX Helsinki, banks, financial stability. BIS Working Papers No 284. Statistics Finland and Bank of Finland.

4 Financial stability • 2010 Developments in housing The two left-hand side what is understood to be the market prices in Finland have points of the chart denote actual normal level.9 displayed a strong positive trend stress in financial markets. Risk Overall, the financial crisis since the meltdown in the 1990s. premia reflect the availability of was reflected in a steep increase Housing prices are high funding. The underlying measure in risk premia on corporate compared to long-term averages, is represented by the interest rate loans in 2008, whereas the solid but in the absence of signs of an spread between companies with Finnish banking sector did not actual strong deviation from the credit rating AAA and credit suffer any exceptional stress trend it is difficult to identify the rating BBB. during the crisis. By contrast, the point at which the price level Following the emergence of crisis had a strong effect on the starts to present a threat to the financial crisis, the availabil- macroeconomic situation in financial stability. The chart ity of funding deteriorated Finland, causing extreme illustrating financial stability rapidly, which was reflected in a changes in GDP growth. shows that the risks associated steep increase in the risk premia However, the macroeconomic with developments in housing charged from companies. In situation seems already to have prices have increased slightly response to the recovery of entered the path to recovery, since 2009, although the obser- international capital markets although remaining sensitive to vations from all three years of in 2009, risk premia were the uncertainty surrounding comparison fall within the restored to more moderate global economic developments. so-called normal range.5 levels, having dropped In the domestic By contrast, the second further in 2010, although still environment, private sector measure of threats to financial remaining higher than in indebtedness currently forms the stability, ie private sector indebt- pre-crisis years.7 biggest threat to financial edness, has been higher than The upper left-hand side stability. The growing debt normal over the whole period point of the chart illustrates burden increases the vulnerabil- under review, 2008–2010. The banks’ sustainability, which is ity of the private sector and the level of household indebtedness measured by the Bank of economy especially in the has risen continually ever since Finland’s stress index for the context of interest rate changes the late 1990s. Similarly, banking sector. 8 The Finnish or other economic disruptions. corporate indebtedness has also banking sector has suffered only In addition to the domestic been steadily growing, but at a minor damage in the highly operating environment, the more moderate pace. The threat challenging environment situation in global financial posed by private sector indebted- witnessed over the past few markets also has a bearing on ness to financial stability was years. Finnish banks suffered financial stability in Finland. higher than ever before in 2009, most badly under the financial Furthermore, regulatory and having decreased only crisis in 2009, but even then the supervisory changes also bring marginally in 2010.6 stress level in Finnish banks was challenges to the financial sector. only slightly more elevated than

5 See the section Operating environment (pp. 13–14) for a more detailed discussion 7 For details of the availability of funding of price developments in Finnish housing to Finnish companies, see the section markets. Operating environment (pp. 14–17). 6 For details of household and corporate 8 The stress index is calculated on bank 9 For details of the sustainability of indebtedness, see the section Operating share prices, interbank deposits, profita- Finnish banks, see the section Banking environment (pp. 11–12 and 14). bility, regulatory capital and loan losses. and insurance sector (pp. 18–29).

Summary Financial stability • 2010 5 Operating environment

Uneven global economic growth presents course of the year, the main concern in challenges to financial market stability. the financial markets has been the In Europe, exposure to disruptions is sovereign debt problems of Greece, increased by the debt problems of certain Portugal, Spain and Ireland that have countries. Growing government debt escalated rapidly. The uncertainty is a threat to global economic stability. concerns the governments’ debt- In Finland, households’ vulnerability to servicing capacity and the increased an increase in unemployment or higher exposures of their financial sectors. interest rates has grown with the rise in Even though the growth outlook their debt burden. Non-financial for the world economy in the next few corporations’ availability of financing has years has remained cautiously positive, improved, but uncertainty in the financial growth is expected to be significantly market may rapidly shorten the supply of slower than in the pre-recession period financing. of strong economic expansion. Exit from stimulus measures and the tighter lending standards of the engines of Economic growth uneven in current economic growth, eg China, the major economic regions will contribute to slower growth. In the first half of 2010, many Growth will nevertheless continue to be economies experienced stronger-than- focused on the emerging economies. expected growth, which was partly due Indebted countries face the risk of to sizeable economic support measures. slower-than-expected growth, which The phase of rapid expansion turned may weaken their debt-servicing ability. out to be fairly short in some countries, Concerns about the repayment targets eg the United States and Japan. In the turning out to be overly ambitious have been reflected in the risk premia of the Chart 1. countries considered vulnerable (Chart 1). The increase in government GIIPS countries’ general government debt and interest rates on debt entails the risk that the failure of 10-year government bonds 1. Spain 2. Ireland 3. Italy 4. Greece 5. Portugal governments to service their debts Left-hand scale would cause financial market Right-hand scalle instability, followed by contagion to the Debt-to-GDP ratio, % % 160 4 16 banking sector. The scale of the Irish 140 14 banking crisis proved to be unbearable 120 3 12 2 100 10 for public finances, which caused 5 80 1 8 resurgence in market uncertainty after 60 6 the disruptions in spring. 40 4 20 2 The impact of low interest rates 0 0 2005 2006 2007 2008 2009 2010f 2011f not only stabilising f = forecast Sources: European Commission, Eurostat and Reuters. In an environment of relaxed monetary policy, interest rates in developed

6 Financial stability • 2010 Chart 2. economies have remained extremely low. Low interest rates have been Corporate bonds reflected in the channelling of 1. Euro area, new issues (left-hand scale) investments to instruments with a 2. United States, new issues (left-hand scale) 3. Euro area, AAA–BBB (right-hand scale) higher yield. Demand and issuance of 4. United States, AAA–BBB (right-hand scale) USD bn Yield spread corporate bonds, for example, has been 150 600 record high in 2009 and 2010. The 125 3 500 improved economic outlook and strong 100 400 2 demand have contributed to shrinking 75 300 50 200 the risk premia on corporate bonds 4 (Chart 2). The search for yield is due to 25 100 0 0 investors’ yield targets which are still at 1 –25 –100 pre-crisis levels. If protracted, this type 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 of search for yield can endanger the Sources: BIS and Merrill Lynch. fair pricing of risks and, at worst, give rise to a pre-crisis phenomenon in which, in an environment of low Chart 3. interest rates, investors searched for Foreign banks’ claims on BRIC countries yield for example in high-risk 1. Brazil 2. Russia securitised instruments. 3. India 4. China EUR bn An environment of low interest 400 350 1 rates creates also other types of threats. 300 4 Countries in which the impact of the 250 international recession remained minor 200 3 150 or short-term are already now 2 100 experiencing rapid growth. Capital in 50 search for yield is thus channelled to 0 countries with rapid growth, which 1995 1997 1999 2001 2003 2005 2007 2009 BRIC countries = Brazil, Russia, India and China. boosts their exchange rates and stock Source: BIS. market valuation. There is a real risk of overheating. Valuation risks in the property market also grow. Ample liquidity and an increase in prices time, share prices have risen sharply and valuations in these markets as a and the external value of the currency result of debt leverage increases fears has strengthened in these countries. about low-yield investments and future Countries have sought to restrain the loan losses. Foreign investments in inflow of capital by protectionist emerging economies, eg BRIC measures as a change in foreign countries,1 have increased robustly in investors’ risk-bearing capacity easily recent years (Chart 3). At the same turns the direction of investment flows, which could increase price volatility in 1 BRIC countries are Brazil, Russia, India, and China. emerging markets.

Operating environment Financial stability • 2010 7 Macroeconomic situation their government bonds and the rapid uncertain rise and volatility in credit derivatives According to the VIX index2 which is prices suggest a lack of confidence in considered a gauge of market the ability of these governments to nervousness (Chart 4), the markets are service their debt. no longer as explosive as they were Uncertainty has a negative impact when the financial crisis escalated. on the real economy as, for example, it Despite this, uncertainty increased dampens financial institutions’ again, triggered by the debt crisis in propensity to lend, postpones summer 2010, and has been reflected in companies’ investment decisions and eg strong investment flows to reduces household consumption. instruments considered safe havens Uncertainty over macroeconomic devel- (eg. gold and US and German sovereign opments can be described by examining debt) and stronger-than-normal the standard deviation of forecasts on volatility of prices in various asset macroeconomic indicators (eg GDP and classes. industrial production) (Chart 4). The Instead of general nervousness, bigger the disagreement between the measured by the VIX index, uncertainty survey respondents on the development has recently creasingly focused on of the real economy, the higher the European countries with a debt uncertainty levels. problem: the higher risk premia on Uncertainty over US macroeco- nomic fundamentals increased as the

2 VIX index is calculated using the implied volatility financial crisis escalated in 2008, of the Standard & Poor’s 500 index. It shows whereas in Europe, the crisis affected investors’ expectations of 30-day volatility. the macroeconomic expectations with a Chart 4. six-month lag compared to the United States. The debt crisis in summer 2010 also increased uncertainty over macr- Uncertainty in the real economy and stock markets oeconomic developments, and this 1. VIX index (right-hand scale) 2. Standard deviation of survey-based forecasts on continued to be reflected in the US macroeconomic indicators* (left-hand scale) 3. Standard deviation of survey-based forecast on euro area deviation of euro area forecasts in macroeconomic indicators* (left-hand scale) autumn 2010. IndexI Index 5 100 2 3 Sovereign exposures strain 4 80 banks’ funding 3 60 As a result of the massive stimulus 1 2 40 measures and support of the banking

1 20 sector, many European countries have witnessed a rapid increase in general 0 0 2006 2007 2008 2009 2010 government debt. Governments and *GDP and Industrial Production Index. Source: Bloomberg. central banks have now taken the first steps in exiting from the support

8 Financial stability • 2010 measures as banks’ shock-absorption Banks’ funding position differs from capacity has strengthened, due to the previous years as the securitisation improvement in financial performance market is not fully functioning. and the easing of funding. Rapid action European banks’ financial by the authorities, eg the decision to performance has improved over the establish a European Financial Stabili- year. Developments in loan losses have sation Mechanism and the creation of a been more positive than expected and European Financial Stability Facility, there has been a decrease in credit risk, and the Europe-wide stress testing particularly in that arising from lending exercise, contributed to reducing to small companies. While the recovery market uncertainty. Government debt is still fragile, macroeconomic shocks nevertheless still poses a significant risk may cause an upturn in unemployment, to the global banking system. payment defaults and banks’ loan loss Due to the close linkage in the provisions. Income and costs are international financial system, the debt weighing on net interest income. In an problems of individual European environment of expected sluggish countries pose a threat also to other economic growth, lending growth is European countries. Fears concerning subdued and banks’ funding costs are counterparty risk will trigger a rapid strained by a competition for deposits cross-border spreading of the debt and an increase in the cost of problems if banks have large claims on borrowing. the countries with the largest debt. The Money market conditions and contagion risk would also be reflected banks’ liquidity have improved slightly in the interest rates of countries with a since spring, but the situation has not high credit rating and also in the returned to normal. The fact that funding of banks operating in Finland governments’ financial risks become (Box 2 discusses the impact of government debt and the investment Chart 5. risks of Finnish financial institutions). A growing supply of bonds in the Maturities of government and bank debt securities in Europe capital markets is competing for in the next few years* 1. Government 2. Banks investment flows which may, in the next EUR bn 1,400 few years, crowd out banks’ funding 1,200 and raise the cost of funding in all 1,000 sectors. Over the next few years, 800 government borrowing will coincide 600 1 with the massive refinancing needs of 2 400 other sectors (Chart 5). Banks’ 200 refunding needs are partly directed to 0 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 the capital markets as banks seek to *Situation at 29 October 2010. decrease financial risks by extending Source: Bloomberg. the average maturity of debt financing.

Operating environment Financial stability • 2010 9 Chart 6.

European governments’ and banks’ risk premia in Europe Financing reshaped by changes in financial regulation 1. 20 May 2010 2. 27 November 2010 3. MSS 20 May 2010 4. MSS 27 November 2010 Basis points Changes in financial regulation will

GR reshape financial companies’ operating 800 environment in the years to come. GR IE 600 Tightening regulation will affect the PT share of traditional bank lending and Governments 400 ES PT IE market financing, and shift the focus IT ES 200 ITT FR BE towards market-based financing if the FRF BE NL ATA DE ATAT 0 NLN DED future tighter banking regulations 0 200 400 600 800 1,000 1,200 Banks decrease banks’ willingness to lend. MSS = Minimum sum of squares (linear model). This would reshape the European Source: Bloomberrg. financial system more towards the US financial system in which market financing traditionally plays a large banks’ funding problems is reflected in role. Tighter banking regulation entails banks’ risk premia particularly in the the danger of the creation of a new countries that are struggling with a large shadow banking system and of general government deficit (Chart 6). financing and risks being channelled The weak parts of the banking past traditional supervision. system are a risk to the entire European financial system even though euro area Finnish economy recovers slowly banks are financially sound on average. with the global economy There are indications of mixed develop- The Finnish economy is recovering ments in the soundness of banks as the from a deep recession. The recovery same group of banks is affected by was delayed because Finnish exports many of the profitability, income have traditionally focused on capital formation and funding problems. If the goods. Domestic demand has been solving of structural problems in the supported by household consumption banking system is delayed, there is the demand and housing investment. The threat of increasing indebtedness, due housing market has been boosted by to governments’ support commitments. exceptionally low interest rates and If a number of European banks remain government action to support housing dependent on public support, it will production. slow the markets’ return to normal Relative to the significant changes in operation and distort competition. output growth, employment in Finland Measures that were initially intended remained stronger than expected. The to be temporary have become Finnish economy is not expected to grow long-term. There are clear adverse at a particularly strong pace in the near effects on the international financial future as global economic growth slows. system, which will increase its vulnera- Although growth in Finland is expected bility to crises. to run at just a good 2½ per cent per

10 Financial stability • 2010 annum in the immediate years ahead,3 the of heavily indebted households relative drop in output caused by the recession to their income have increased in the will be closed slowly. current decade. At the end of 2008, for 9% of households (16% of indebted Household debt continued to grow households) the amount of debt was despite the recession Finnish consumer confidence in the Chart 7. economy has strengthened in 2010 and Household indebtedness and interest expenditure was very strong in the autumn.4 1. Stock of loans (left-hand scale) 2. Interest expenditure (right-hand scale) Confidence has been boosted by the 3. Interest expenditure, scenario 1 (right-hand scale) improved outlook for the Finnish 4. Interest expenditure, scenario 2 (right-hand scale) 5. Interest expenditure, scenario 3 (right-hand scale) economy and employment. Households’ 120 % of disposable income % of disposable income 12 confidence in their own finances has 100 10 1 also improved and returned to its 2 80 8 long-term average. 60 6 The indicator of Finnish 5 40 4 households’ average indebtedness, ie the 4 3 ratio of households’ loan stock and 20 2 0 0 annual disposable income, will in 2010 * ** ** rise record high, to around 109% 1985 1990 1995 2000 2005 2010 *Estimate in 2010. **Three interest rate scenarios for 2011–2012. (Chart 7). The debt ratio has continued In the scenarios, the 3-month Euribor rises in 2011 and 2/3 of the rise is passed on to the average interest rate on the stock of loans in 2011 and 1/3 in 2012. to rise since the late 1990s, and Finland Stock of loans and disposable income remain at 2010-levels. Scenario 1: 3-month Euribor rises 0.6 percentage points to 1.4% is in the middle range by European (market expectations on 2 November). Scenario 2: 3-month Euribor rises 2.2 percentage points to 3.0% comparison.5 (average level in 1999–2010). Scenario 3: 3-month Euribor rises 4.2 percentage points to 5.0% (peak in 1999–2010). The largest debts and highest debt Sources: Statistics Finland and Bank of Finland calculations. ratios are concentrated on a fairly small number of households. About 40% of Chart 8. households have no debt, and over half of households have a debt ratio below Distribution of households and debt based on household debt ratio* 100%, ie these households’ debts are 1. Proportion of all households lower than annual disposable income 2. Proportion of total household debt 50 % (Chart 8).6 The number and importance 40

3 1 For more details, see Economic Outlook 2/2010, 30 the special issue of the Bank of Finland Bulletin. 4 Statistics Finland’s consumer confidence indicator 20 (October 2010). 2 5 See also Box 3 “Household debt” by Risto Herrala 10 in Economic Outlook 2/2010, the special issue of the Bank of Finland Bulletin. The examined debt ratio 0 does not include households’ estimated share in No debt Over 0% Over 100% Over 200% Over 300% Over 400% Over 500% housing company debt. and and and and and maximum maximum maximum maximum maximum 6 The figures are based on the latest data by Statistics 100% 200% 300% 400% 500% Finland on household debt; the data on household *Horizontal scale: debt, % of disposable income in 2008. debt refers to 2009 and the data on debt ratios refers Sources: Statistics Finland and Bank of Finland calculations. to 2008.

Operating environment Financial stability • 2010 11 over three times as high as their annual Finnish households have continued disposable income. These households to accumulate debt, despite the deep account for as much as 46% of total recession of the Finnish economy. MFI household debt. In 2002, the share of lending to households has grown at an households similarly highly-indebted annual rate of just under 6% in 2010 was 4% (8% of indebted), and they (Chart 9). Demand for credit has been accounted for 26% of the household sustained by low interest rates and the stock of debt. continued good employment situation considering the recession, which has Chart 9. boosted housing prices. Risks associated with indebtedness are linked Households’ MFI loans 1. Euribor-tied loans from deposit banks (left-hand scale) to the development of these same 2. Prime rate-tied loans from deposit banks (left-hand scale) factors. Thus far households’ debt- 3. Loans with fixed and other rates, from deposit banks (left-hand scale) 4. Loans from other MFIs (left-hand scale) servicing ability has remained good, 5. Annual change in loan stock (right-hand scale) and the amount of impairment losses EUR bn % 120 18 recognised on household loans has 100 4 15 remained minor. The proportion of 3 80 12 2 household sector loan losses of the 60 9 stock of loans remained fairly small 1 40 5 6 also during recession in the early 1990s 20 3 (Chart 10).

0 0 2003 2004 2005 2006 2007 2008 2009 2010 Growing debt burden underlines Source: Bank of Finland. the importance of interest rate risk The majority of bank loans to Chart 10. households are variable-interest-rate (Chart 9), and hence changes in market Loan losses, unemployment rate and average interest rate on rates are quickly passed to the interest the stock of loans 1. Loan losses on household lending*, % of households’ stock of loans rates on household loans. In (left-hand scale) 2. Unemployment rate (right-hand scale) 2009–2010, the average interest rate on 3. Average interest rate on households’ stock of loans (right-hand scale) the stock of loans to households was % % 1.0 20 below 3% and the interest burden has

0.8 16 remained very low by historical standards (Chart 7). At the same time, 0.6 12 2 growth in indebtedness has however 0.4 8 increased the sensitivity of the debt- 3 0.2 4 servicing burden to a rise in interest 1 rates. 0 0 1990 1995 2000 2005 A sensitivity calculation (Chart 7) *Loan losses incurred by domestic financial and insurance corporations according to National Accounts figures. illustrates how a rise in interest rates in Sources: Statistics Finland and Bank of Finland. 2011 would affect households’ interest expenses relative to income in 2011 and

12 Financial stability • 2010 2012.7 According to market expecta- 2010: housing prices in the whole tions, short-term interest rates will rise country were 7.8% higher than a year moderately in 2011, which would keep earlier, but only 0.4% higher than in the interest rate burden low (Scenario the previous quarter. The decline in the 1). History has however shown that number of housing transactions also households should be prepared for a point to a cooling down of the housing considerably higher level of interest market in the summer and early rates and bigger interest rate expenses autumn. (Scenario 2 and Scenario 3). A Prices in the housing market can significant increase in the interest be assessed by comparing long-term burden would decrease household developments in housing prices and consumption and possibly increase the rents or housing prices and wage and debt-servicing problems. salary earnings.8 Both indicators were in the third quarter of 2010 higher than Fall in employment decreases risks the long-term average, but clearly lower to income than during the 1989 peak in prices During the recession, employment in (Chart 11). Following the dip at the Finland has held up better than turn of 2008, the ratios have risen close expected, partly due to companies’ use to pre-crisis levels, but developments in of layoffs. The unemployment rate rose, but it remained notably lower than in 8 The ratio of housing prices and rents is the P/E ratio the early 1990s (Chart 10). In 2010, of the housing market; it shows the development of the valuation of dwellings relative to the benefits of unemployment has started to decline, owning a dwelling: either the rental income, or rent that the holder of owner-occupied housing avoids which reduces the risks to household paying. The ratio of housing prices and wage and income. The recovery of the economy salary earnings reflects developments in the affordability of housing. continues to be surrounded by uncertainty and it will take years before Chart 11. employment returns to pre-recession levels. Relative prices of housing 1. Housing prices relative to rents 2. Average relative to rents over the review period Cooling of the housing market positive 3. Housing prices relative to wage and salary earnings 4. Average relative to wage and salary earnings over the review period in terms of price risks Index, Q1 1981 = 100 225 The decline in housing prices that 1 200 started in mid-2008 was short-lived; 175 3 lasting only three quarters of a year. 150 2 The prices returned to their early-2008 125 4 levels in autumn 2009, and they rose at 100 a rapid pace until mid-2010. Housing 75 prices levelled off in the third quarter of 50 1981 1986 1991 1996 2001 2006

7 The calculation does not account for differences in Sources: Statistics Finland and Bank of Finland calculations. repayment methods and reference rates, possible changes in payment schedules, or other discretionary factors.

Operating environment Financial stability • 2010 13 autumn 2010 show positive signs of financial position of the household levelling off. sector, and households’ debt-servicing The rapid rise in housing prices in ability is expected to remain good. early 2010 was a warning sign of the Households’ vulnerability to economic tendency of asset prices to fluctuate disruptions, eg a strong increase in strongly and overreact. The biggest unemployment or a considerable rise in threat in the housing market is a vicious interest rates, has however increased circle in housing prices, followed by a due to the growth in the debt burden. drastic collapse, in which the Households should prepare for the risks authorities do not have the powers to by ensuring that the size of the debt and intervene (see chapter Financial system debt-servicing expenses are reasonable policy). relative to their income and collateral, Financial Supervisory Authority by calculating the effect of an interest (FIN-FSA) has drawn attention to large rate rise on debt-servicing expenses or housing loans and emphasised that in the loan repayment period and by order to reduce the risk associated with keeping a sufficient financial buffer a decline in housing prices the size of against a rise in interest rates or the loan should be reasonable, taking unexpected expenses. into account the purchase price of the house. FIN-FSA has encouraged banks Non-financial corporations to put emphasis on an adequate self- have survived the recession financing share for customers and to be better than expected cautious about personal customer Finnish non-financial corporations housing loans with loan-to-value (LTV) seem to emerge better from the excep- ratios exceeding 90%.9 According to tionally deep recession that followed information available to FIN-FSA, 28% the financial crisis than from the of the new housing loans granted by recession in the early 1990s. Stimulus Finnish banks had in May 2010 a LTV measures by several governments and ratio exceeding 90%.10 Other available the replenishment of the international data show that the use of LTV ratios corporate sectors’ inventories that were exceeding 85% has increased since depleted during the crisis have recently 2007.11 boosted exports and non-financial cor- porations’ order books. Finnish non- Overall assessment of households’ risks financial corporation confidence In light of economic forecasts, there are indicators thus started to rise rapidly in no indications of major changes in the 2009. The focus of the recovery in demand has however varied between 9 FIN-FSA Supervision release 20/2010. sectors. At best, order books are thinner 10 FIN-FSA (2010) Valvottavien taloudellinen tila ja than before the crisis. riskit 2/2010 (Financial position and risks of supervised entities 2/2010, in Finnish only). In response to domestic stimulus 11 Federation of Finnish Financial Services (spring measures, housing investment has 2010) Saving, borrowing and payment methods in Finland. resumed growth in 2010. In contrast,

14 Financial stability • 2010 Chart 12. the industrial sector’s order books are thinner than normal and the amount of Non-financial corporations’ problems in acquiring external spare production capacity is relatively financing 1. Micro companies 2. Small companies large. The recovery in industrial 3. Medium companies 4. Large companies Problems, % of companies confidence indicators thus seems to 40 have come to a halt, at levels close to the long-term average. Service sector 30 1 companies’ sales have been growing 20 and growth is expected to continue.12 2 The corporate sector’s debt ratio 10 was relatively low when the recession 3 4 0 hit. Average corporate profitability has 2007 2008 2009 2010 remained good for a number of years, Source: Survey on Business Finances (BoF, EK, MEE). and sluggish investment activity dampened the growth in debt. Solvency of the SME sector was also good on in 2010 (Chart 12).14 Demand for average at the onset of the crisis. Half corporate sector funding has been of the SMEs are practically debt-free.13 dampened by companies’ moderate Finnish non-financial corporations’ investment plans. As a result of the availability of financing deteriorated sluggish demand for corporate sector suddenly at the onset of the financial funding, banks’ stock of corporate crisis as international investors loans has grown at a slow pace. withdrew from small markets and The easing of banks’ own funding financial institutions focused on inter- has improved the availability of mediating financing to their domestic corporate loans and alleviated the customers. As foreign financing dried credit terms. Banks’ margins on up, large non-financial corporations corporate loans have narrowed, but sought to ensure financing by increasing they are clearly wider than pre-crisis. borrowing, both from domestic banks The risk premia on corporate loans and employee pension companies. acquired from the capital markets have The pickup in the capital markets also decreased, and they are also in early 2009 facilitated large non- currently bigger than pre-crisis. financial corporations’ access to Banks’ loan losses on corporate financing from the capital markets and lending seem to remain considerably at the same time boosted smaller non- smaller than expected. Corporate bank- financial corporations’ domestic ruptcies increased significantly in 2009, financing. This is also reflected in the but since then their number has been improved access to corporate funding declining substantially. Non-financial corporations’ probability of bankruptcy 12 Confederation of Finnish Industries EK (November 2010) Business outlook indicator. 14 Confederation of Finnish Industries, Ministry of 13 Federation of Finnish Enterprises (autumn 2010) Employment and the Economy, and Bank of Finland Pk-yritysbarometri (SME confidence indicator, in (2010) Yritysten rahoituskysely (Business financing Finnish only). survey, in Finnish only).

Operating environment Financial stability • 2010 15 Chart 13. size, and Finnish non-financial corpora-

Listed non-financial companies’ Expected Default Frequency tions are also in future forced to resort (EDF) to banks as their source of working 1. Median 2. 90th percentile 3. Average capital and investment financing. % 9 8 Domestic stock market as 7 6 a funding channel 5 Robust capital markets are one of the 4 2 3 pillars of corporate financing. They will 2 be needed in future as investment 1 3 1 activity restarts and banking regulation 0 2000 2002 2004 2006 2008 2010 probably tightens the terms of bank Source: Moody’s KMV. financing. The securities market infra- structure lays the foundation to the operation of the capital markets. also decreased in 2010, close to The directive on markets in pre-crisis level (Chart 13). In contrast, financial instruments (MiFID) opened non-financial corporations’ payment share trading for a new type of difficulties and payment defaults are competition as a large number of new still rising, particularly the payment pan-European marketplaces were defaults of smaller companies. established. Technological advances The majority of Finnish non-finan- have in practice removed all the barriers cial corporations’ bank loans are varia- to the cross-country integration of ble-interest-rate. Interest rates on infrastructure.15 Integration continues corporate loans have in recent years to be affected by future regulation and been lower than in Europe on average. the Eurosystem’s TARGET2-Securities The rise in short-term market rates project.16 rapidly increased Finnish non-financial In the Finnish financial system, corporations’ financing costs. Similarly, international integration has in recent an increase in banks’ funding costs is years been everyday life. From the likely to be reflected in a future rise in technical point of view, the location of the costs of corporate loans. Tighter an infrastructure is of minor banking regulation is also likely to importance to investors and securities affect the price and availability of issuers. Investors want to trade on corporate loans. The reform of banking specific securities and minimize the regulation may have a larger-than-aver- costs of trading, whereas the issuer is age impact on Finnish non-financial interested in the cost-effective and corporations as banks are their main source of financing. Finnish non-finan- 15 See chapter Financial market infrastructure. cial corporations’ possibilities to raise 16 The TARGET2-Securities project creates a single technical infrastructure which enables CSDs to settle financing directly from the capital securities transactions in central bank money and conduct both securities and cash settlements on a markets are limited, due to their small single technical platform.

16 Financial stability • 2010 reliable management of book entries, channel of funding for domestic corporate actions and transmission of companies, market participants should information. know how to take advantage of the In stock exchange and central European infrastructure and safeguard securities depositories’ operations, fixed the functionalities that are of national costs account for a large portion of importance and the possibilities to total costs. Economies of scale can be influence also in the new environment. gained to some extent by merging Domestic interest groups share the several marketplaces and settlement concern over maintaining the competi- infrastructures. The harmonization of tiveness of the Finnish capital markets. EU regulations also supports this development. Competition between trading places is also reflected in the operations of the Helsinki Exchange. A significant proportion of trading in listed shares has moved to alternative trading facilities, particularly that of the more liquid shares. Listing activity is slowly restarting globally. The impact of the financial crisis was particularly strong in 2009 as listing activity collapsed compared to 2008: 12 companies listed on the Nasdaq-OMX Nordic exchange, and only 2 companies on the Helsinki exchange.17 Subdued listing activity is likely to be partly explained by the decline in investments in an environment of weak economic growth in recent years. On the other hand, the low level of interest rates has kept the price of borrowed money relatively inexpensive compared to share issuance. As the economy picks up, the increase in financing needs (eg investments) and the rise in interest rates will boost the attractiveness of other forms of financing. To ensure that the capital markets are a functioning

17 Nasdaq-OMX.

Operating environment Financial stability • 2010 17 Banking and insurance sector

The low level of interest rates has reduced risks. Several of these risks materialised banks’ net interest income, but loan loss during the crisis, though with varying experience has not been as bad as timing and effects on profitability. Banks projected. Losses on household loans, in met with refinancing difficulties, suffered particular, have been low. Although credit investment losses, a decline in net institutions’ claims on the most indebted interest income and higher loan losses. euro area countries are rather limited, The above risks will be discussed later in contagion risks to the Finnish economy this section. Here, we will focus on the and financial system through indirect past and projected future development channels are a cause for concern. Finnish of banking sector profitability. banks have good credit ratings and are, hence, able to raise funding in the market. Developments in fee income and loan The solvency of insurance companies has losses turned positive improved quickly, but considerable The decline in the performance of the investment risks remain. Finnish banking sector2 slowed consider- ably in the course of 2010. Total Profitability of banking operating profits for January–September Banks have faced a highly challenging amounted to EUR 724 million (Chart international operating environment 14), which was roughly EUR 30 million over the past few years because of the less than in the corresponding period in global financial crisis, the deep the year before. Although the result was recession of the real economy following close to that of the previous year, it had in its wake and the subsequent changed considerably in structure. The sovereign debt crisis. result was depressed by a reduction in The risks related to banking can be both net interest income and net income divided into liquidity risk,1 market risk, from trading and investments. This was, credit risk, contagion risk and other however, offset by lower loan losses and higher net fee income compared with the 1 See the Box on page 37. Chart 14. year before. Net interest income declined further Factors underlying the changes in Finnish banking performance as the fall in market rates that had EUR m 1,200 started towards the end of 2008 was 99 –281 1,000 210 fully passed on to banks’ lending rates to

800 755 –59 724 customers. The decline was mostly

600 related to the record contraction of the deposit margin, which even turned 400 negative at times. This narrowing of the 200

0 Operating Impair- Other Net interest Expenses Operating 2 Banking operations of the Aktia group, Evli Bank profits ments income income profits group, the banking operations and investment services 1–9/2009 1–9/2010 of OP-Pohjola group, local cooperative banks, savings Source: Banks’ interim reports. banks, the Ålandsbanken group and the banking operations of the Nordea and Danske Bank groups in Finland.

18 Financial stability • 2010 margin is partly related to the fierce on equity for Finnish banking has competition for deposits, but is also an hovered around 0.5% ever since spring ‘automatic’ consequence of the fact that 2009. In terms of profitability, Nordic rates on transaction accounts, which financial groups have drawn level with were very low to begin with, could not Finnish financial groups in the course of fall at the same pace as market rates 2010. The profitability of US banks has without turning negative. fluctuated much more than that of Net interest income was also Finnish and Nordic banks. This is partly depressed by a reduction in lending explained by the relative importance of margins. Margins on housing loans investment banking, which is much narrowed in the course of 2010, while higher in the United States than in growth in the margins on corporate Finland and the Nordic countries. The loans came to a standstill. Growth in performance of investment banks is lending and deposit volumes was also more sensitive to cyclical fluctuations clearly more sluggish than in pre-crisis than that of traditional banking. years, when banks showed record levels The capital adequacy of the of profitability. banking sector remains strong. The The loss of net interest income was amount of regulatory capital held by partly offset by the favourable develop- banks is well above regulatory require- ment of net fee income, particularly secu- ments, and the capital is of good rities-related fee income, which increased quality. At the end of September 2010, strongly in response to the share price rise the capital adequacy ratio for the that stimulated trading activity and banking sector stood at 14.5%, on increased managed assets. Also fee average. The amount of regulatory income from payments and lending grew. capital held by banks amounted to Banks’ expenses remained EUR 21.4 billion, exceeding minimum unchanged. This was hardly surprising, capital requirements by EUR 9.6 billion. considering that expenses are practically Chart 15. the only income statement item the size Banks’ operating profits relative to balance sheet assets* of which banks are able to determine 1. Finnish banking themselves, whereas other items are 2. Nordic financial groups 3. US banks much more dependent on the operating 4. European banks % environment and competition. In the 2,0 challenging operating environment 1,5 1 prevailing over the past few years, banks 1,0 2 have sought cost savings by closely 0,5 4 reviewing their expense structures, 0,0 3 having gained substantial savings –0,5 through efficiency measures. –1,0 –1,5 International comparisons bear 2007 2008 2009 2010 witness to the stable performance of *Based on a sample of major banks. Finnish banks (Chart 15). Total return Source: Bank of Finland calculations.

Banking and insurance sector Financial stability • 2010 19 The Tier 1 capital adequacy ratio will fall short of the exceptional peak averaged 13.7%. The median of the Tier witnessed in 2009–2010. 1 ratio for the entire banking sector was, As in previous years, banks’ at 21.4%, considerably above the expenses are expected to develop average, reflecting the strong capital moderately, whereas loan losses are adequacy ratios and high number of projected to decline considerably. large local banks. In addition, the Together with the increase in net regulatory capital in the banking sector interest income, this will restore banks’ is mostly made up of common equity, results to a higher growth path. the importance of which is emphasised Generally speaking, the brighter in the Basel III regulatory reform. results prospects means that banks will again have the means for seeking Banks’ results improving in 2011 growth opportunities and market Banks’ operating profits are expected to shares after having focused on securing remain unchanged in 2010 but start to their results during the acute phase of increase in 2011 and continue to grow the crisis. Signs of dawning competition in 2012. The decline in net interest for market shares especially in housing income came to a halt in the second loans and fixed-term deposits have been half of 2010, when short-term market visible for some time. rates turned up. Quotations of interest These projected developments in the rate futures signal that markets expect banking sector are surrounded by uncer- interest rates to continue to rise over tainties particularly related to the macr- the next few years. Notwithstanding oeconomic development. In the event of this, market rates are expected to worse-than-expected economic develop- remain rather low compared to the ments, banks’ profitability would be level witnessed over the past decade. reduced through a number of channels. In response to the rise in market Developments in net interest rates net interest income for banks will income depend both on the growth in improve. The deposit margin will lending and deposit volumes and on broaden as the increase in deposit rates, future interest rate margins. If economic especially on transaction accounts, lags growth is slower and market rates are behind the rise in market rates. lower than predicted, the overall margin However, banks’ competition for between lending and deposit rates will market shares is projected to reduce be smaller than expected. This will mean lending margins somewhat. The overall net interest income will be lower than margin is expected to broaden slightly expected as a result of narrower margins but to remain much below the average and smaller lending volumes. In for the first decade of the 2000s. conditions of weak economic Other income is projected to show development, asset prices will also mixed development: while net fee decline, which is reflected in lower fee income will post steady growth, net income from investments and income from trading and investments impairment losses on investments.

20 Financial stability • 2010 Subdued economic growth means higher lending and deposits in the Finnish loan losses. According to the results of banking sector (Chart 16). With the the stress test exercise conducted by the outburst of the crisis, this balance started Financial Supervisory Authority to shift towards the deposits as deposits (FIN-FSA) in spring 2010, banks would were growing at a higher rate than show a slight profit also under a lending. The ratio has now stabilised at scenario of ‘severe global recession’.3 slightly under EUR 40 billion. The competition for deposits New liquidity regulations heighten focuses on fixed-term deposit and the need for long-term funding investment accounts. Still, transaction The amount of central bank financing accounts, which account for roughly held by credit institutions operating in 60% of public deposits, are most Finland started to grow in spring 2008. important for the banks’ financing and In June 2008, the amount of long-term profitability. Their low rate of interest operations recognised in the Bank of and stable development make them Finland’s balance sheet increased to excellent credit material. A pronounced close to EUR 4 billion as credit institu- rise in the rates on transaction accounts tions turned to the central bank for would reduce net interest income, while large amounts of financing with an shifts of funds to competing instruments agreed maturity of one year at the rate would increase the excess of lending. of 1%, which was considered attractive Developments in banks’ liquidity under the current market situation.4 in the euro area have been mixed. Solid These volumes have fallen since then, banks have been able to raise sufficient and at the maturity of the above funding in the market at competitive transaction in summer 2010, the rates, whereas struggling banks have amount of funding started to decline had to pay a high price for market substantially. At the end of November, Chart 16. banks’ credit related to monetary policy operations with the Bank of Finland Financial deficit of banks operating in Finland only amounted to EUR 90 million. 1. Financial deficit (=lending-deposits) (left-hand scale) 2. Lending (right-hand scale) Hence, the Finnish banking sector is not 3. Deposits (right-hand scale) EUR bn dependent on central bank financing. 50 EUR bn 200 Banks’ need for market funding 40 160 depends on the gap between public 2 30 120 lending and deposits. During the years 3 leading up to the financial crisis, the 20 80 stock of lending expanded substantially, 1 10 40 resulting in a negative balance between 0 0 2005 2006 2007 2008 2009 2010 3 See FIN-FSA press release of 23 July 2010. Includes public lending and deposits of deposit banks operating in Finland (excl. their foreign branches) and mortgage banks. 4 See Välimäki, T. (2010) Rahapolitiikan Source: Bank of Finland. toimeenpano finanssikriisin aikana. Euro & talous 3/2010 (in Finnish).

Banking and insurance sector Financial stability • 2010 21 funding, or have been refused this new bad news may have an adverse funding altogether. Banks operating in effect on Finnish banks’ prospects for Finland have been successful in obtaining raising market funding. For example, long-term financing in the market. escalation of the sovereign debt The new liquidity regulations problems of individual countries may underway are designed to reduce banks’ have repercussions on Finnish banks as dependence on short-term market discussed in Box 2 below. funding. The liquidity coverage ratio means that banks are required to build Stronger credit risk outlook, with up larger liquidity buffers, whereas the some uncertainty still remaining requirement of permanent funding Finnish deposit banking groups’ increases the proportion of longer-term domestic and overseas lending permanent financing. Banks are required amounted to a total of EUR 196 billion to raise a considerable amount of new at the end of September 2010, which is long-term funding in a challenging roughly 3% more than in the year environment marked by governments before. More than half of the lending seeking substantial amounts of funding volume (EUR 100 billion) was related to cover their deficits. to domestic households and less than Some of the Finnish banks’ major one-third (EUR 62 billion) to domestic international debt securities issues have companies and housing corporations. been effected in the form of covered By industry, the property and manufac- bonds through mortgage banks. The new turing industries had the highest loan Mortgage Bank Act that entered into volume (altogether EUR 33 billion). force in August 2010 extended the right Lending overseas represented about 15 of issuance to deposit banks and credit %.5 The breakdown of the lending organisations, with the first covered bond stock shows that banks’ credit risks are issue by a commercial bank taking place above all related to the financial in November 2010, when Nordea Bank situation of the domestic debtor sectors. Finland issued a covered bond in the In the banks’ credit portfolios, the amount of EUR 2 billion. weight of households has increased in The financial crisis highlighted the relation to companies, while the importance of liquidity management. proportion of housing loans has risen in The Finnish banks responded to the relation to other household loans. crisis by strengthening their liquidity Banks’ impairment losses on loans buffers. Recent developments have been and other receivables increased markedly positive overall. Also long-term market in response to the global financial crisis funding at competitive prices is and the economic downturn following in available to banks of good repute. This its wake. In 2009, the net impairment paves the way for the regulatory losses of domestic banking groups changes underway. Nevertheless, the amounted to more than EUR 800 situation in international financial 5 For more details on the risks related to financial markets remains vulnerable, in that any institutions’ foreign claims, see Box 2.

22 Financial stability • 2010 Chart 17. million, but this was less than 0.5% of Domestic banks* net impairment losses on loans and other the average stock of lending. receivables and pending bankruptcies Examined by domestic sector or 1. Commercial banks (left-hand scale) 2. Cooperative banks (left-hand scale) industry, loans to manufacturing 3. Savings banks (left-hand scale) 4. All banks (left-hand scale) companies have generated the highest 5. Bankruptcies filed (right-hand scale) EUR bn, at 2009 prices No. 1,000 losses. Losses on household loans have 5 7.5 remained small, with the major risk in 4 6.0 household loans being related to 3 3 4.5 unsecured consumer credits, which only 2 5 1 2 3.0 account for a minor proportion of the 1 1.5 credit portfolio. 4 Considering the deep downturn of 0 0 the Finnish economy, materialisation of –1 –1.5 1990 1995 2000 2005 2010 credit risk has been limited. Loan losses 1–6 *Parent companies of deposit banks, incl. their Finnish and foreign have remained lower than expected, branches. Commercial banks refer to all parent banks in limited liability form. above all because of the low level of Sources: Statistics Finland and Bank of Finland calculations. interest rates, higher than expected levels Chart 18. of employment and short duration of the Domestic banking groups' impairment losses on loans and economic downturn. Both loan losses other receivables, quarterly data 1. Net impairment losses and pending bankruptcies will remain 2. Gross impairment losses much lower than during the banking 3. Impairment losses, reversals and recoveries EUR m crisis of the early 1990s. 400 At quarterly level, banks’ net 300 impairment losses were largest for July– 200 2 1 September 2009. While in gross terms 100 new loan losses remained at the same 0 level still in the early part of 2010, net 3 –100 loan losses nevertheless declined in –200 response to higher loan loss reversals 1–3/ 4–6/ 7–9/ 10–12/ 1–3/ 4–6/ 7–9/ 2009 2009 2009 2009 2010 2010 2010 and recoveries (Chart 18). In January– * Incl. branches of foreign credit institutions with deposit bank September 2010, net loan losses were operations in Finland. Source: Financial Supervisory Authority. more than one-third lower than during the first three quarters of 2009. The positive outlook also appears Banks’ problem loans have from the sectoral breakdown. In the declined in amount in response to the case of households, the amount of non- onset of economic recovery. The performing assets was 4% and in the amount of non-performing assets, ie case of companies and housing corpo- loans due for more than 90 days, was rations 8% lower at the end of around 9% smaller in September 2010 September 2010 compared with the compared with the year before (Chart year before. For both sectors, problem 19). Similarly, the amount of loans due loans accounted for roughly 0.6% of for 30–90 days has been reduced. the lending stock.

Banking and insurance sector Financial stability • 2010 23 Chart 19.

Finnish banking groups' non-performing assets and net the debt servicing ability of the impairment losses on loans and other receivables domestic debtor sectors is expected to 1. Non-performing assets 2. Net impairment losses, 12-month moving total remain good overall, while impairment EUR bn 7 losses are expected to decline compared with the situation in 2009. 6 1 5 Under the prevailing economic 4 cycle, credit risks do not pose a threat 3 to the stability of the domestic banking 2 sector. Over the next few years, the 1 2 future amount of impairment losses 0 –1 will, however, be one of the main 1996 1998 2000 2002 2004 2006 2008 2010 factors of uncertainty underlying the * Incl. branches of foreign credit institutions with deposit bank operations in Finland. profitability of the banks operating in Source: Financial Supervisory Authority and Bank of Finland calculations. Finland. In terms of credit risk, the major threat scenario is represented by According to Statistics Finland, the a much worse-than-expected number of new bankruptcies filed over development of the global economy the period January–September 2010 and, therewith, the Finnish economy. was 15% lower than in the correspond- ing period a year earlier. In August Contagion risks 2010, the Finnish business and credit Banks have substantial mutual receivables information company, Suomen Asia- the loan loss risks of which are associated kastieto, projected that the bankrupt- with both the size of the receivables and cies over the next 12 months will entail the debt servicing ability of the debtor. receivables in the amount of roughly During the financial crisis, mutual trust EUR 580 million. Total debts of between the banks eroded globally, and in companies declared bankrupt during this environment of distrust, banks the past 24 months amounted to started to give precedence to central around EUR 1.3 billion. banks as counterparties. Consequently, an Economic recovery is still increasing proportion of banks’ assets surrounded by some uncertainty, and were deposited with central banks, while payment difficulties remain clearly an increasing proportion of funding was more common in the case of both raised from central banks. The situation companies and households than before has to some extent been restored, which the recession. In the quarterly reports probably reflects regained trust between for January–September 2010, banks the banks and normalisation of perceived projected that their net impairment counterparty risk. losses on loans would, in the short The restoration of trust in the term, remain higher than before the banking industry is reflected in a financial crisis, but believed that a turn narrower interest rate spread between for the better had taken place. In light banks’ securitised and unsecuritised of the projected economic development, loans. For euro-denominated loans with a

24 Financial stability • 2010 maturity of three months, the spread was, sheets of domestic deposit banks at most, over 1.5 percentage points increased by more than 55% from June during the peak of the financial crisis. In 2009 to June 2010. According to Bank of autumn 2010, it had narrowed down to Finland’s statistics, foreign claims based around 0.3 percentage points. Loan avail- on derivatives have increased substan- ability in interbank markets has also tially after the turn of the year, but the improved. figure also includes other than interbank As the situation of Finnish banks is contracts. good by international comparison, foreign banks are likely to present the Market risks major contagion risk to the domestic Fluctuations in euro area long-term banking sector. Finnish banks’ claims interest rates calculated on German on foreign banks decreased slightly government bond reached their peak in during the first three quarters of 2010. winter 2008–2009, while a more Large-scale materialisation of moderate increase in interest rate contagion risk would probably be related volatility was witnessed in June 2010. to a new wave of the financial crisis Volatility has also picked up in spilling over to Finland via the interbank European share markets, but the market and, especially, the global situation is not nearly as bad as in the economic development. Such a new wave latter half of 2008. In the derivatives could arise for example from the market, the implicit volatility of the euro escalation of the sovereign debt crisis. At to dollar exchange rate was strongest the end of September 2010, claims of towards the end of 2008, strengthening credit institutions operating in Finland on again temporarily in early summer 2010, Greece, Ireland, Portugal, Italy and Spain but having receded since then. amounted to EUR 4.9 billion, only part According to the press release of of which was bank-related claims. This the Financial Supervisory Authority (22 amount is clearly lower than the banks’ September 2010), the amounts of capital buffers, which currently exceed capital to be held by banks to support EUR 9 billion. Most of the interbank market risk increased strongly towards claims relate to Nordic banks, which the end of 2009, whereas changes in have fairly good credit ratings by interna- capital requirements have been minor tional comparison. in 2010. The securities and foreign Large counterparty risks may exchange positions of the banks emerge rapidly in the interbank OTC operating in Finland are relatively derivatives markets, as changes in the moderate overall. Banking groups show value of securities, exchange rates and an appreciable dispersion with respect other potential underlying assets cause to the changes in the level of capital sudden fluctuations in the prices of held to support market risk. Most of derivatives. According to Statistics the capital charge for market risk is Finland, the amount of derivative related to the position risk on interest contracts entered as assets in the balance rate instruments.

Banking and insurance sector Financial stability • 2010 25 Chart 20.

Stress index for the Finnish banking sector of share markets and banks’ balance sheet values (Chart 21). According to 9 the indicator, banks experienced the

6 worst situation in 2009, after which the

3 situation started to improve and is

0 * already almost normal. Bank share prices have risen and price fluctuations –3 have moderated, which has had a –6 1988 90 92 94 96 98 2000 02 04 06 08 10 positive effect on the value of the index. *forecast 2010/Q3. Sources: NASDAQ OMX Helsinki, banks, Stastistics Finland and Bank of Finland. Stronger solvency for insurance companies Chart 21. Finnish insurance companies, similarly Finnish banks’ distance to default indicator as Finnish banks, have faced a very 1 January 1988 – 15 November 2010 Distance to default demanding operating environment over 7 the past few years. The deep economic 6 downturn, low level of interest rates and 5 4 highly volatile investment markets have 3 presented major challenges for both the 2 underwriting and investment operations 1 of insurance companies. The steep fall in 0 asset prices resulted in a temporary 1988 90 92 94 96 98 2000 02 04 06 08 10 Sources: NASDAQ OMX Helsinki, banks and Bank of Finland. relaxation of the solvency requirements for employee pension companies at the end of 20087 to avoid forced sales of the Banks’ risks in light of indicators companies’ share holdings and the The banks’ stress situation may be adverse effects such sales would have on described using an index developed on share prices. Equities carry less weight in the basis of the variables of bank share the asset portfolios of life and non-life prices, interbank deposits, banks’ prof- insurance companies, and, hence, their itability, equity and loan losses (Chart solvency regulations were not changed 20).6 A higher index value represents a during the financial crisis. higher risk. The index shows that the Following the recovery of banks’ situation deteriorated fairly investment markets since spring 2009, rapidly over the years 2008–2009, but the solvency of insurance companies was not nearly as critical as in the early has strengthened. Rising share prices years of the 1990s. An indicator of the probability of 7 The provisions on the funding of old-age pensions and the solvency margin for private-sector employee default may be computed on the basis pension providers were temporarily changed, in that part of the provision for pooled claims was subjected to equivalent treatment with the solvency margin, the 6 The methods are discussed in the special issue of the required minimum amount of which is independent of Bank of Finland Bulletin, Financial Stability 2006, pp. the pension provider’s asset allocation. The Temporary 44–46. Act will remain in force until the end of 2012.

26 Financial stability • 2010 Box 2.

Government debt problems and financial stability

Less-indebted countries cannot international financial system, a indebtedness and the vulnerabil- afford to be lulled into believing crisis spreads as a contagion ity of banks’ funding, there is the that they are safe from the debt directly through impairment of risk of a negative spiral emerging crisis storming Europe. Stability government bond investments, between governments and banks problems, even in an individual through herd and panic with real economic impacts country, shake the international behaviour in the markets, or (Chart A). financial markets and threaten to counterparty concerns in the The deep recession and undermine other countries’ money market. As a result of support given to the banking economies, too. In the integrated slow economic growth, public system have increased govern-

Chart A. Destructive dynamics of the government debt crisis and investments of Finnish financial institutions in debt securities of European governments and credit institutions

Major financial crisis

1. Crashes government tax 5. Losses and lack of capital revenues and increases buffers restrict lending expenditure 4. Increased financing costs weaken banks’ funding

2. Government bond yields rise Severe government Impaired bank indebtedness funding 3. Government borrowing crowds out banks’ funding

Distrust in governments’ Lack of confidence spreads repayment capacity to banks in other countries Increased probability and Market value losses on extent of government support Market value losses, government debt investment financial markets freeze

Stock of foreign debt security investments of major Finnish investor sectors in September 2010, EUR bn

Investments in European government debt securities Investments in debt securities of European credit institutions Credit Employment Insurance Investment Credit Employment Insurance Investment institutions pension providers institutions funds institutions pension providers institutions funds Debt Debt securities, 2.7 15.4 4.5 5.8 securities, 12.7 6.2 5.7 9.1 total total Largest Germany 1.3 Germany 5.4 Germany 1.2 Sweden 1.5 Largest Denmark 2.4 United 1.0 Sweden 2.1 Sweden 3.4 country Sweden 0.4 Italy 3.0 France 1.0 Germany 1.0 country Kingdom positions Nether- 0.3 France 2.0 Nether- 0.5 Italy 1.0 positions France 2.1 Sweden 1.0 United 0.7 United 1.1 lands lands Kingdom Kingdom Sweden 1.9 France 0.9 France 0.6 Denmark 0.9 GIIPS Total 0.1 4.9 1.0 1.6 GIIPS Total 1.4 1.1 0.3 1.0 positions Greece 0 0.6 0.2 0.2 positions Greece 0 0 0 – Portugal 0 0.3 0 0 Portugal 0.2 0.2 0 0 Spain 0 0.4 0.2 0.3 Spain 0.6 0.3 0.1 0.2 Ireland 0 0.6 0.2 0.1 Ireland 0.2 0.3 0.1 0.4 Italy 0 3.0 0.4 1.0 Italy 0.4 0.3 0.1 0.4 28.4 33.7

Source: Bank of Finland

Banking and insurance sector Financial stability • 2010 27 ments’ indebtedness. Higher billion (Chart A, table) of debt The market value of yields are required from bonds securities issued by European insurance companies’ foreign issued by governments struggling (excl. Finnish) governments and portfolio investments totalled with economic difficulties as a credit institutions, a small EUR 23.9 billion, over half of compensation for their higher proportion of the total stock of which consisted of debt perceived repayment risk. The investments and assets of securities. Insurance companies rise in government bond yields is financial institutions.1 A majority GIIPS government exposure shown throughout the economy of the foreign portfolio assets of amounted to a billion euro. The as higher interest rates, which employment pension providers, majority of fixed-income also affects banks’ funding. In insurance companies as well as investments were in low-return addition, financial difficulties credit investments was European. government bonds, with German give rise to concerns about the A good fifth of the investments and French government bonds as capability of governments to of Finnish investment funds was the most important investments. support domestic banks, if made in securities whose issuers Finnish credit institutions needed. The weaker the state of are based outside the EU. held a total of EUR 2.7 billion in a country’s banking system, the Employment pension debt securities issued by higher the probability of a need providers’ foreign government European general government for public support, which further debt holdings were almost entities. The probability of the undermines government exclusively from Europe. They debt crisis spreading through financial position and creditwor- held a total of EUR 15.4 billion market risks to Finnish credit thiness. of European government debt institutions is low. The The concerns of market securities. About a third of the investments of Finnish credit participants are related, in government debt, EUR 4.9 institutions in debt securities addition to the most indebted billion, were government bonds issued by credit institutions in countries, to banks with large issued by countries with the GIIPS countries exceeded their direct exposures to indebted biggest debt problems, Greece, investments in the government countries or banks operating in Portugal, Ireland, Spain and Italy debt of the same countries, but them. Increased counterparty risk (so-called GIIPS countries). the risks are minor relative to the is priced immediately in the Another third of the bond port- entire investment portfolio. markets, and yields on bonds folio consisted of investments in The market value of issued by banks exposed to debt German government bonds. The investments by Finnish crisis countries also rise in other proportion of Italy was EUR 3 investment funds in Europe countries. Changes in market billion. (excl. Finland) totalled EUR 34.9 values cause investment losses to In 2010, employment billion, half of which being those holding government and pension providers have reduced invested in debt securities. bank bonds. their investments in foreign Finnish investment funds held a The market risks of Finnish credit institutions, and since the total of EUR 9.1 billion in debt financial institutions related to escalation of the debt crisis in securities issued by European debt security investments in the the spring, also in government credit institutions and EUR 5.8 most indebted European debt securities. billion of debt securities issued countries are moderate. by European governments. The According to September 2010 risk of a decrease in the value of 1 The figures only include investments in statistics, Finnish financial insti- debt securities. They exclude investments the security assets of investment in equities, investment fund units and tutions held a total of EUR 62 other investment instruments. funds is borne by the unit holder.

28 Financial stability • 2010 and falling risk premia especially in the this, insurance companies’ total results market for corporate loans has after recognition of changes in market bolstered insurance companies’ profita- values improved considerably. In 2009, bility and solvency that deteriorated the aggregate total result for life during the financial crises. The solvency insurance companies exceeded EUR 1 of employee pension companies has billion, while that for employee pension also been supported by the relaxed companies amounted to EUR 5.5 billion. solvency requirements introduced under The results improvement was above all the Temporary Act. The favourable related to the strong rise in share prices development of investment markets witnessed in 2009 and 2010. The total continued in 2010, except in the market result for non-life insurance companies for government bonds (see the section amounted to a little over EUR 2 billion. on Operating environment). The smaller results improvement of Following the economic recession, non-life insurers was related to their growth in premiums written by lower portfolio share of equities. insurance companies dampened in 2009. Following the financial crisis, the With the economic recovery, premiums solvency ratios for insurance companies written have turned up during 2010. declined considerably. Solvency has Rising share prices have restored policy- been boosted by the rise in asset values holders’ interest in unit-linked life and is currently good on average (Chart policies. Their proportion of the life 22). In September 2010, solvency insurance portfolio is steadily growing, margins exceeded regulatory minimum as the popularity of policies tied to the levels manifold (Table 1).9 interest rate assumption has been fading. Currently, unit-linked policies account 9 Until the end of 2012, the required minimum for a good third of the life companies’ amount of solvency margins for employee pension companies represents 2% of the technical provisions insurance savings, which amount to a laying the basis for calculation of the solvency limit. little over EUR 32 billion. Growth in unit-linked policies has Chart 22. been strongest in capitalisation Life insurers’ solvency capital agreements,8 but premiums written on 1. Equity (left-hand scale) 2. Capital loans (left-hand scale) personal unit-linked life policies have also 3. Solvency margin (left-hand scale) increased strongly. The investment risks 4. Solvency, % (right-hand scale) EUR bn % related to unit-linked life policies are borne 8 24 by the customers, which eases the solvency 6 18 position of life insurance companies. 4 3 Insurance companies’ investments 4 12 generated a high income in 2009, with 2 results remaining fairly positive though 2 6 January–September 2010. In response to 1 0 0 2003 2004 2005 2006 2007 2008 2009 2010 8 June Capitalisation agreements are lump-sum, fixed-term Source: Financial Supervisory Authority. unit-linked policies without insured risk.

Banking and insurance sector Financial stability • 2010 29 Rise in asset values lowered the risks in associated with personal pension the insurance sector policies are generally low in Finland as The risks related to the insurance the insurance contracts are mostly made business are divided into two main for a fixed term. By contrast, higher life categories: underwriting risks and expectancy may mean that payment of market risks. The risks related to the disability or sickness benefits under non-life insurance business include the non-life policies will extend beyond the risk that premiums written are not term calculated at the time of pricing sufficient to meet claims expenditure or the insurance contract. that technical provisions are not Life insurance companies sufficient to cover the damages arising determine the rate of guaranteed under insurance contracts. interest applied to the insurance The life insurance underwriting contract for the entire contractual risks include interruption and surrender period. Hence, a fall in market rates risks and the risk related to higher life during the validity of the contract may expectancy of the beneficiaries. While require replenishment of technical interruption and surrender risks rarely provisions. Currently, insurance present major risks to the life insurance contracts based on the guaranteed rate business, higher life expectancy may do of interest account for a little over 60% so. However, the longevity risks of life insurance policies, which means

Table 1.

Solvency of life, pension and non-life insurers 9/2010 12/2009 12/2008 12/2007 12/2006 Life insurers Equity, EUR m 2,598 2,252 1,475 2,127 2,088 Solvency margin, EUR m 5,331 4,237 2,665 4,096 4,727 Solvency capital, EUR m 5,503 4,407 2,864 4,274 4,893 Solvency margin, % of minimum amount 488.4 382.4 242.9 358.8 423.2 Solvency capital, % of technical provisions 21.8 18.0 11.7 16.5 19.2 Employee pension insurers Equity, EUR m 338 334 325 311 295 Solvency margin, EUR m 17,634 14681 8,952 17,663 17,107 Solvency margin, % of minimum amount 1,336.4 1,164.5 767 289.7 338.1 Solvency margin, % of technical provisions 26.7 23.3 15.3 29.9 31.3 Non-life insurers Equity, EUR m 1,776 1,737 1,387 1,686 1,465 Solvency margin, EUR m 2,646 2,208 1,760 2,244 2,064 Solvency capital, EUR m 4,864 4,381 3,784 4,184 3,814 Solvency margin, % of minimum amount 427.4 360.6 288.5 374.8 353.9 Solvency capital, % of technical provisions 60.8 58.1 51.8 59.4 56.2 Solvency capital of premiums earned over 12 months 157.3 143.9 126.9 145.7 132.0

Source: Financial Supervisory Authority.

30 Financial stability • 2010 that the discount rate risk is relatively suffered by counterparties to derivative high. or reinsurance contracts. In the fixed Market and credit risks related to income portfolios of insurance the investment business are the major companies, the proportion of corporate underwriting risks facing insurance debt instruments has been increasing. companies. Investment risks vary con- The profitability of insurance siderably by type of company, reflecting companies has improved, and credit differences in asset allocation. Interest risks in the insurance sector have not rate risks are highest for non-life taken on alarming proportions. companies, with fixed income holdings The liquidity and refinancing risks accounting for nearly 70% of their of insurance companies are much lower total investments. Similarly, interest rate than for banks. The Finnish insurance risk is also the key investment risk for sector is highly concentrated, which life insurance companies. Equity risks means that problems of a large life or are clearly higher for pension non-life company may rapidly spill over companies than for other insurance to the banking sector, for example companies. At the end of September through ownership structures. 2010, equities accounted for 36% of the risk-based asset allocation of pension companies. In the context of insurance companies, credit risk refers to losses arising from reductions in the credit rating of, or bankruptcies suffered by, issuers of debt securities held by the insurance company, or reductions in the credit rating of, or bankruptcies

Banking and insurance sector Financial stability • 2010 31 Financial market infrastructure

The financial market’s infrastructure new institutions enter the market. Mul- refers to the payment and settlement tinational institutions are also able to systems, through which all the financial save with the possibility to use the same market transactions are concretely carried systems and resources on several out. In effect, this means that the infra- markets. Integration can also facilitate structure is the backbone of the economy, services for smaller markets, and often whose reliable and efficient functioning is at a rapid or timely rate, that would not essential for both the financial system and necessarily be possible otherwise. society at large. Any possible disruptions Conversely, systems integration also can also be discerned at the public’s level brings the need for compromise and very quickly. One of the functions of a adjustment to solutions that may be no central bank is to ensure that the payment more than satisfactory to all the partici- and settlement systems do not allow or pants. This may initially bring about a contribute to financial market crises. A drop in service levels, as routines effective number of regulatory projects, initiated in at the national level are surrendered. As response to the financial crisis, also concern integration is intensified, more attention infrastructure, and their aim is prevent must be paid to equal treatment of the crises from arising. Regulation is mainly participants and to the standard and done at European level as the financial quality of services provided; thereby markets infrastructure is widely integrated. bringing out the benefits of integration over a longer period. Integration should not lead to a Highlighting the advantages of draining of Finland’s extensive integration competence in payment and settlement Efficiency has been sought through systems from the country. The disap- integration of payment and settlement pearance of such competences would systems. Economies of scale can be make the creation of new innovations achieved in systems that handle large and market development more difficult volumes, in terms of numbers of trans- and could easily lead to a turndown in actions. This is reflected in smaller the entire market. This would also transaction costs. Less attention is paid mean a reduced ability to take advantage to other advantages of integration or of international infrastructures. possible negative effects. In principle, In addition to the integration integration should lead to taking process, the outsourcing of services and advantage of the best characteristics of processes has an effect on how the infra- different markets. However, the markets structure functions. When outsourcing, are not perfect, which means that the service providers must ensure that as smaller markets often just have to adapt services are outsourced to subcontractors, and carry the related costs. or as the physical distance to the service Integration often brings lower provider grows, no problems are discern- service prices and an increasingly able by the customer. Overall responsibil- competitive operating environment, as ity vis-a-vis the customer remains with

32 Financial stability • 2010 the service provider, regardless of where links between CCPs is at an acceptable the service production takes place. standard. The Bank of Finland takes part Outsourcing and centralisation are in all the oversight activities regarding challenges that the Finnish authorities are central counterparty clearance in the also faced with and serve to underline the Finnish market. importance of international cooperation. The reduction in volume brought about by the CCP can be seen in the Settlement systems trying to income of the Finnish CSD. In a find their bearings changing market, it remains in Adoption of central counterparty everybody’s interest that Finland has an clearing (CCP) in Finland just over a operational, efficient and customer-ori- year ago changed market habits.1 The ented central securities depository. introduction of CCP onto the market Finland’s CSD is a part of the has gone relatively well. Surprisingly Euroclear group. Still at the beginning many settlement counterparties have of the year, Euroclear Finland looked to applied for direct membership of the taking advantage of the IT systems of CCP. With the netting that results from Ireland and Great Britain. This plan has the use of central counterparty clearing, now been given up and the hunt has the number of transactions settled on the returned to finding a more cost-effective Finnish Central Securities Depository solution from an amalgamation of the (CSD Euroclear Finland) has declined. Finnish and Swedish systems. The Where the majority of transactions were Chart 23. settled according to the delivery vs. payment principle (DVP), these days it is Structure of Finnish securities market infrastructure applied only to netted transactions. Against expectations, adoption of the Customerrs CCP has reduced the settlement rate. Currently the situation is better than it Securities intermediaries was in the first half of the year. Trrading Regardless, market players need to find Stock Exchanges (NASDDAQ OMX) and a means for improving the situation still other marketpplaces Clearingg further. Central counterparty clearing is systems CCP European multilateral clearing provided to the Finnish market by facility (EMCFF) Settlement European Multilateral Clearing Facility Finnish Centrral N.V. (EMCF) from the Netherlands. Securities Depository (CSD) Euroclear Finland Plans to start up two new CCPs have been postponed. Operations can be started up once the risk management of Securities issuerrs

1 Myller, M. (2009) Keskusvastapuoliselvitys alkaa Helsingin pörssissä: Mikä muuttuu? BoF Online 12/2009. (BoF Online expository studies: Central Counterparty Clearing starts up in the Helsinki Stock Source: Bank of Finland. Exchange: What will change?), available in Finnish.

Financial market infrastructure Financial stability • 2010 33 intention has been to harmonise the system. There are several alternatives operating practices and services in these available and are distinguishable from two markets. The process must also each other by their cost effects. The take into account that there are changes ongoing amendment of the Securities in the pipeline that affect the whole of Markets Act may support an effective Europe. operating model. The changes that are The Eurosystem’s TARGET2- currently due to be undertaken need to Securities is creating a pan-European be examined as a whole, as they will clearing facility for securities. The have an effect on the competitiveness of project has already progressed to the Finnish markets over the long term. mid-way and, according to current plans; migration to the system will be Disturbances in customer payments completed by 2014. Preparations have On the whole, the payment and progressed in a very open manner and settlement systems have functioned every possibility has been offered, for reliably over the last year. However, in those who wish to, to express their recent months (and in October 2010 in opinions and influence the project as it particular), there have been several dis- advances. The T2S acquisition’s key turbances in the retail payment systems, decisions on pricing, its governance and which have affected the customers of contractual relationships should all be the banks concerned through delays in made in the near future. Once the processing so-called recurrent transfers pricing is clarified, it will be time for such as pension and salary payments. the domestic participants to select the The disturbances are not the result of book-entry securities account model merely one cause, rather they are due to that should be applied in the T2S technical problems experienced in Chart 24. individual banks or the entire system. Reported disturbances and reasons for occurrence, 2008–2010 (For more specific details on the reasons 1. 2010 2. 2009 3. 2008 behind any disturbances, see Chart 24,

25 No.; latest observation date 15 November 2010 in the Financial Supervisory Authority’s 1 2 report on the disturbances 2008–2010.) 20 Since implementation of the 3 15 Payment Services Act,2 recurrent transfers

10 have been settled at night using the domestic PMJ Interbank retail payments 5 system. This has resulted in payments 0 Systems Appli- Commu- External Data- Hardware Human Process External Other being made to customers’ accounts in the fault cation nication attack base failure error error disturbance fault disturbance error early hours of the morning, a little later Examples of disturbances Systems fault: faulty batch processing or other technical systems error. than previously. Any disturbances that External attack: phishing or malware invasion. occur, affecting the night time settlement, Database error: database capacity used up. Process error: activities in violation of instructions. can delay payments still further. Intro- External disturbance: power cut or water damage. Source: Financial Supervisory Authority. 2 Payment services Act valid from 1 May 2010.

34 Financial stability • 2010 duction of the Single European Payments than planned. For this reason, the Area3 (SEPA) has meant that domestic European Commission is preparing a recurrent transfers are being cleared and Regulation, defining a binding end date settled in the STEP2 system, maintained for the migration process. by EBA Clearing.4 All the parties The Regulation needs to succeed in concerned are committed to improving speeding up the migration process their operations, so that the systems throughout Europe, so that the expected would be free of the kind of disturbances benefits of SEPA can be fully achieved. and delays that have been experienced Development work on SEPA has required recently. From Finland’s point of view, significant investments from non financial STEP2 is a systemically critical retail corporations and banks alike. There is a payment system and its oversight is one potential risk that the harmonisation of of the Bank of Finland’s priorities. There retail payments is not fully achieved, is a particular emphasis on international which would mean, among other things, cooperation. The Bank of Finland takes extra costs arising from the running of an active role in the oversight parallel payment systems. This risk partic- cooperation with the lead overseer, the ularly concerns the Finns, who are at the European Central Bank. Thus it can forefront of the migration. Ultimately, the ensure the opportunity to exert influence cost of ineffective payment system is and receive adequate information for filtered down to the system users, example on the performance of systems consumers and companies. crucial to Finland, as well as on the In Finland, all developments on systems’ operational reliability, risk other payment systems have been, in management and future developments. effect, on hold for some years while preparing for the Europe-wide system. Speed needed for SEPA migration Elsewhere in the world, there have been Transition to the Single Euro Payments developments for example in real-time Area is well under way in Finland in payment systems as well as in mobile and terms of credit transfers, when the Internet payments. Speeding up migration majority of companies have updated to SEPA as much as the introduction of their banking and related software to new, service providing, payment institu- be compatible with SEPA. Also the tions to the market are, from this point public sector’s transition to the new of view, in the Finnish end-users’ interest. service helps promote efficient migration. However, adoption of SEPA Liquidity positions reveal market in Europe in general has been slower confidence Liquidity is a measure of the reserves a 3 For more details on the Single Euro Payments Area, see for example the website of the Federation of bank has available to secure its Finnish Financial Services at www.fkl.fi. payment flows. In order to manage 4 The European banks’ interbank clearing house for their liquidity, it is commonplace for euro payments, see www.ebaclearing.eu. It is planned that transition to the system will have mainly been banks to rely on loans between completed during 2010 and will be finalised by October 2011, at the latest. themselves, on the interbank market.

Financial market infrastructure Financial stability • 2010 35 Chart 25. Pankki system and minimum balances Collateral posted by participants with the Bank of Finland fluctuated since the beginning of the and average monthly usage of collateral crisis period more than they normally 1. Total collateral 2. Limit 3. Credit via open market operations would, but despite that, banks still have 24 EUR bn plenty of unused limits (Charts 25 and 20 26). There were considerable amounts 1 16 of unused collateral, which means that

12 the participants would have had the 3 8 possibility of increasing their limits still 2 further (Chart 25). Apparently, the 4 counterparties want to secure their 0 2007 2008 2009 2010 extra liquidity by having it in the Source: Bank of Finland. central bank accounts to ensure the Chart 26. success of their transfers also in such cases where some other counterparty Participants’ minimum balances and intraday credit limits, total in the TARGET2- Suomen Pankki system, would have problems or where not all 1 Jan 2007–15 Nov 2010 payments would arrive on time. 1. Minimum balance 2. Limit 3. RTGS-accounts* 4. Minimum reserve requirement As an alternative to the money 40 EUR m markets, banks can invest any excess

30 liquidity as central banks’ overnight 3 deposits. The fluctuation in these 20 overnight deposits explains a large part 10 4 of the fluctuations in central bank 0 1 account balances, for example in June 2 –10 2010 (Chart 26). Because of the uncer- –20 2007 2008 2009 2010 tainties prevailing in the markets and *Incl. minimum reserve deposits plus over-night deposits and credit. the drying up of liquidity, the Source: Bank of Finland. Eurosystem used its monetary policy operations to lend banks, against collateral, the funds they need, at a From the early stages of the financial fixed interest rate, since October 2008. crisis, these markets petered out, as Since then, the banking sector has been banks were no longer willing to lend overly liquid. The majority of extra each other funds. Meanwhile, banks had money is returned to the central bank even more liquidity than normal in their as overnight deposits. After 1 July TARGET2-Suomen Pankki accounts. 2010, the value of overnight deposits The participants’ liquidity is made seems to have evened off, at least for up of the funds they hold in their the moment. The amount of liquidity in central bank accounts and in collateral- the central bank remains plentiful, ised limits, which enable them to access which is an indication of the continuing intraday credits. The value of transac- uncertainty and the excessive amount tions made in the TARGET2-Suomen of liquidity in the markets.

36 Financial stability • 2010 Box 3.

Liquidity analysis as a prudential tool

Taken as whole, the participants each other for overnight credit Oversight is evolving to be to the TARGET2-Suomen Pankki (Chart B). When this information more quantitative, and the aim is system have managed their is combined with actual liquidity to identify emerging problems as liquidity well. There are, usage, an indicator of a quickly as possible. A tool is however, differences in liquidity participant that may be running needed to analyse payment management by different partici- into problems is obtained. If the system data, and the payment pants. Some may actively manage interest rate paid by a participant system simulator, developed at the amount of their liquidity and were to increase simultaneously the Bank of Finland, provides an use intraday central bank credit, with an enlargement of the black excellent tool for this purpose. while others may hold large area in Chart A, this could refer to The Bank of Finland’s simulator deposits on their central bank distrust and problems. Such an has also laid the basis for the accounts, as are considered immediately observable change in simulator used in the Eurosys- absolutely sufficient for a smooth behaviour could serve as a guide tem’s analytical work, modelling execution of payments. The low for a closer supervisory scrutiny the operation of the TARGET2 level of liquidity may also point of the participant involved. system in different situations. to a participant’s problems in meeting its obligations. In the Chart A. enclosed chart (Chart A), which illustrates actual liquidity Liquidity usage by TARGET2 -Suomen Pankki participants management by various partici- 0–30% 30–50% 50–70% 70–90% >90% Proportion of participants, % pants, black indicates that some 100 participants have drawn down 90 80 almost all their available 70 liquidity, whereas green shows 60 the proportion of participants 50 40 who have used a maximum of 30 30% of their liquidity. 20 10 In a normal situation, banks 0 2006 2007 2008 2009 2010 even out their liquidity fluctua- Source: Bank of Finland calculations. tions in interbank money markets. If a counterparty has to pay a Chart B. higher interest rate than others for Spread between minimum and maximum interest rate paid the overnight credit extended by by participants for overnight credit % the counterparties among 5

themselves, it may be a sign of a 4 lack of confidence in that particular counterparty. As such 3 details are not reported, Bank of 2 Finland experts have been 1 developing a method that, on the basis of payment system data, 0 2006 2007 2008 2009 2010 enables assessment of interest *50 % of observations concentrated on the dark area. rates paid by the participants to Source: Bank of Finland calculations.

Financial market infrastructure Financial stability • 2010 37 Financial system policy

International reform of financial regulation frequency of financial crises in the period advances at full speed. The new capital and from the beginning of the 1940s to the liquidity standards for banks, Basel III, beginning of the 1970s (Chart 27). were approved in November 2010. Why is financial regulation relaxed Financial regulation needs to be tightened at regular intervals when regulation in order to reduce the threat of financial would seem to be capable of reducing crises. Looking ahead, authorities should the likelihood of financial crises? First, in have stronger mandates and tools to boom periods it is typically argued that constrain excessive credit growth and accu- an excessively regulated financial system mulation of debt. Central banks should is unable to achieve effective financial have a central role to play in this macro- intermediation, and thereby acts as a prudential policy. In order to reduce moral constraint on economic growth. Second, hazard, no financial institution should be financial system participants have too big to fail in the future. always been able to circumvent the rules imposed, which has eroded regulation Financial regulation to undergo over time. Regulatory arbitrage may considerable tightening even lead to worse distortions than those In general, financial regulation has been that regulation had originally sought to tightened after the biggest financial eliminate. Third, political pressures to crises. A good example of this is the relax regulation may become excessively Glass-Steagall Act, which entered into strong in good economic conditions. force in the United States in 1933, and However, in order to prevent financial which established a separation between crises from occurring, regulation should deposit and investment banking be tightened on a permanent basis. functions. Financial regulation was otherwise tight after the Second World The international financial system War. Tight regulation probably provides has become increasingly vulnerable at least a partial explanation for the low to risks

Chart 27. Governments’ implicit promises to rescue financial institutions perceived as being Proportion of countries with banking crises, 1900–2008 (weighted by their share of world income) too big to fail have increased banks’ risk appetite (moral hazard). The too big to 45 % of countries The great depression of the 1930s fail problem has become too big a 40 The banking crises of Japan, the 35 emerging markets, the Nordic problem. It must be ensured that large Countries and the United States 30 World War I financial institutions can also fail without 25 The panic The first risk to financial stability and without 20 of 1907 global 15 financial taxpayers needing to bear the costs for crisis of 10 the 21st the bailout of financial institutions in the 5 century 0 future (see section ‘The too big to fail

1900 1903 1906 1909 1912 1915 1918 1921 1924 1927 1930 1933 1936 1939 1942 1945 1948 1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 problem needs to be mitigated’). Source: Reinhart-Rogoff (2008) Banking Crises: An Equal Opportunity Systemic risk has increased in the Menace. NBER Working Paper 13901. last few decades, reaching totally new

38 Financial stability • 2010 dimensions. The interconnectedness of objectives of the ongoing financial financial institutions has become more reform. Furthermore, exceptionally rapid widespread and complex, which has growth in private sector indebtedness increased the risk of contagion. increases systemic risk, as shown by the Moreover, uncertainty about the real latest financial crisis (see section values and risks of complex financial ‘ Macroprudential supervision to be instruments and about counterparties’ reinforced’). credit standards has increased, which, in crisis situations, may lead to a collapse Ambitious objectives set for in confidence between market partici- regulatory reforms pants. Enhancing transparency is Financial regulation is being updated in undoubtedly one of the most important several areas (Table 2).

Table 2. Summary of regulatory initiatives and their primary objectives Mitigate Reduce systemic risk Curb risk- Improve Ensure that Objective the too big Reduce Increase Flatten out taking and crisis taxpayers to fail intercon- transparency credit cycle increase resilience are not problem nectedness long-term called on to of financial approaches pay the costs Regulatory initiative institutions Basel III Capital adequacy improved •• Leverage capped ••• Quantitative liquidity requirements introduced ••• Countercyclical capital buffer requirement introduced •• Additional requirements imposed on systemically important financial •• institutions Regulation extended beyond traditional banking Trading in financial derivatives regulated •• Hedge and private equity funds regulated ••• Credit rating agencies regulated and their supervision reinforced •• A new crisis management framework to help deal with failing banks •• • Tax on the financial sector • Financial institutions’ compensation schemes revisited • Financial institutions required to improve their risk management •• practices Source: Bank of Finland.

Financial system policy Financial stability • 2010 39 Capital adequacy regulation for banks Third, the risk coverage of the to be tightened capital framework will be strengthened. The new capital requirements for banks, In particular, there will be a substantial the Basel III framework, were approved increase in capital requirements for by the G20 Seoul summit in November market risks. The treatment of 2010. securitised financial instruments in the The reform will tighten the quality capital adequacy framework will also requirements for banks’ regulatory be tightened. capital. In the future, banks’ holdings of Fourth, bank leverage will be higher-quality common equity, such as capped. A new requirement in the form share capital, must account for at least of a leverage ratio defines the minimum 4.5% of their risk-weighted assets, level for the ratio between banks’ instead of the current requirement of 2%. regulatory capital and their non-risk- Second, the minimum requirement weighted assets. The leverage ratio for regulatory capital relative to risk- requirement acts as a backstop for weighted assets will be increased. In situations where risk-based capital addition to the current 8% minimum requirements are artificially low. Such a capital requirement, a new capital con- situation is most likely to emerge in a servation buffer of 2.5% will be strong boom, where risks are widely imposed on banks. The updated underestimated. Consequently, the minimum requirements will be phased leverage ratio could at best act as a in gradually, starting from 2013, and regulatory instrument to cool down the banks are expected to comply with overheating of the financial system. them by 2019 (Chart 28). Fifth, new quantitative liquidity standards seek to improve banks’ ability Chart 28. to withstand liquidity crises. The Liquidity Coverage Ratio (LCR) requires banks to hold in their balance sheets a Banks’ minimum regulatory capital according to Basel II and Basel III rules in the transition years 2013–2019 sufficient amount of assets that can be 1. Common equity converted into cash, quickly and at low 2. Tier 1 capital 3. Tier 2 capital cost. The Net Stable Funding Ratio 4. Capital conservation buffer (NSFR), in turn, seeks to constrain banks’ % risk-weighted assets 12 too quickly expanding accumulation of Basel III 10 short-term debt, which could lead to Basel II 4 8 excessive lending and to an unsustainably 3 6 rapid elevation of asset prices. 2 4 Sixth, a requirement of countercy- 1 2 clical capital buffers will be imposed on

0 banks. The primary aim of these buffers 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 is to protect national banking systems Source: Basel Committee on Banking Supervision. against the consequences of excessive aggregate credit growth. Countercyclical

40 Financial stability • 2010 capital buffers can also contribute to costs to taxpayers. The creation of a curbing lending and thereby flattening harmonised crisis resolution framework out the credit cycle. Accordingly, in for the EU is a prerequisite for a addition to the fixed capital conservation successful crisis management of large buffer of 2.5%, national authorities are cross-border banks. allowed to impose a discretionary Authorities need to have adequate capital buffer requirement not exceeding tools and powers to take the necessary 2.5% on banks, when aggregate credit steps for winding up, reorganising or growth in the country concerned reaches closing down banks encountering exceptionally high levels. The imposition serious problems with the adequacy of of the capital buffer requirement should their capital positions. be based on the ratio determined by the The official crisis management Basel Committee on Banking framework planned by the Commission Supervision: the private sector’s stock of breaks down into three classes of credit, divided by nominal GDP, relative measures. The first category comprises to this ratio’s trend. Applied in a strictly preparatory and preventative measures, mechanical manner, the countercyclical including reinforced supervisory action, capital buffer would, according to this asset transferability within (banking) ratio, have been set at its highest level groups, recovery and resolution plans in Finland between 1991–1993 and (‘living wills’) and various possibilities from 2005 onwards (Chart 29). to intervene in banks’ excessive The Basel Committee on Banking risk-taking by, for example, restricting Supervision is also considering, for lending or prohibiting entirely a bank’s example, the imposition of capital business activities. surcharges and potential other additional The second class of measures loss-absorbency requirements on large, concerns the powers to intervene early. so-called systemically important banks. They would significantly increase the

New crisis management tools to help Chart 29. deal with failing banks Performance of countercyclical capital buffer in Finland In October 2010, the European 1. Debt-to-GDP ratio relative to trend (left-hand scale) Commission published a communication 2. Countercyclical capital buffer (right-hand scale) concerning an EU framework for crisis 40 % 4 management in the financial sector. The communication outlines the principles 20 2 2 on the basis of which the Commission 0 0 will prepare its actual draft directive in spring 2011. The Commission’s objective –20 –2 1 is clear: going forward, it must be –40 –4 possible to allow all financial institutions 1979 81 83 85 87 89 91 93 95 97 99 2001 03 05 07 2009 to fail or to reorganise their operations Sources: Statistics Finland and Bank of Finland calculations. without risk to financial stability or

Financial system policy Financial stability • 2010 41 authorities’ chances of interveing in a banks, in other words the deposit bank’s activities prior to the bank’s insurance and the implicit government running into too big problems. For guarantees of debt financing by systemi- example, the relevant supervisory cally important banks, benefit both authority could replace the bank’s banks’ shareholders and management. management, take over the bank for a One aim of bank taxes is to tax this limited period or require the implemen- indirect public support received by banks. tation of recovery plans. Alternative tax models are, for As regards the third category, ie example, the Financial Transaction Tax crisis resolution measures, their primary (FTT) and the Financial Activities Tax aim would be the liquidation of a bank’s (FAT), which is suggested to be levied on operations under ordinary insolvency bank profits or remuneration. The FTT proceedings. Should this not be feasible applies to transactions between and if financial stability were to be companies. The drawback of this tax is threatened, the bank could be split up that it distorts companies’ business and its assets sold or transferred to decisions, which could have a constrain- special ‘temporary bridge banks’. As a ing impact on economic growth. There is last resort, debt write-down and also evidence that the FTT would bring conversion of debt to equity are also more volatility to the financial markets, under consideration. This option could raise funding costs and increase the use mainly be taken into account in the case of financial innovations with the of large multinational institutions. purpose of tax evasion.1 The Commission has proposed the The FAT on bank profits or com- establishment of national resolution pensation is a tax comparable to funds as a new crisis management value-added tax. As such a tax is not measure. The operation of such funds influenced by the sources of profits or would be funded by ex ante contribu- remuneration, it will not distort tions from banks. The assets collected financial market structures to the same for such funds could be drawn down in extent as the FTT. A potential tax connection with crisis resolution should be implemented on a uniform measures, but, in order to avoid moral basis in different countries, in order to hazard problems, not drawn down for avoid competitive distortions. the provision of direct support to failing banks. The establishment of resolution Macroprudential supervision to funds would give an assurance that the be reinforced crisis management framework is a There were a number of reasons behind credible tool in practice, too. the financial crisis, but one of the most significant was the imperfect supervision Tax on the financial sector of systemic risks that threaten the stability Besides contributions to resolution funds, taxes on banks are also under considera- 1 See eg IMF (2010) A fair and substantial contribution by the financial sector: final report for tion. The safety net offered by society to the G20, p. 19–21.

42 Financial stability • 2010 of the financial system as a whole. the financial system as a whole by Financial supervision has been based on identifying risk concentrations and supervising individual institutions, with weak points in the financial system, and inadequate attention being given to the 2) achieving more stable economic financial system as a whole. The key task activity, for example, by flattening out of macroprudential super vision is to credit cycles. identify systemic risks threatening A number of tools are needed to financial stability and to ensure that risk implement the objectives of macropru- concentrations and interactions between dential policy. The countercyclical different institutions and markets are capital buffers included in the Basel III understood and possible problems are regulatory reform (Chart 30) constitute addressed before it is too late. the most important tool to ensure the The new supervisory system for adequacy of banks’ capital positions financial markets, which is due to go live during periods of economic downturn in Europe at the beginning of 2011, will (see section ‘Capital adequacy be composed of two parts. The European regulation for banks to be tightened’). Systemic Risk Board (ESRB), which is to The accumulation of such buffers may operate in connection with the European also help reduce the procyclicality of Central Bank, will be responsible for excessive bank lending, as higher monitoring and analysing the build-up of capital requirements make the provision systemic risks and issuing recommenda- of credit more costly and thereby tions and warnings concerning macropru- constrain borrowing. Conversely, when dential stability. Similarly, the European the economy enters a downturn, capital Supervisory Authorities2 will reinforce the buffers can be released, thereby halting supervision of large financial conglomer- a further slowdown in lending. ates and securities markets. The new EU Other means to influence banks’ supervisory organisations were created in excessive risk-taking or provision of response to the need to monitor the Chart 30. financial system as a whole and to deliver Minimum common equity and capital buffers a more effective supervision of cross-bor- 1. Countercyclical capital buffer der financial activities. At national level, 2. Capital conservation buffer 3. Minimum common equity preparations are in progress to support the EU supervisory systems and develop Accumulation of countercyclical capital buffer corresponding national structures. Release of countercyclical capital buffer 2 1 Macroprudential tools taking shape

Macroprudential policy has two general 3 objectives: 1) improving the stability of

Economic recovery: Economic downturn: 2 European Supervisory Authorities will be made up of risk-weighted capital risk-weighted capital three supervisory authorities: the European Banking requirements fall requirements rise Authority (EBA), the European Securities and Markets Sources: Basel Committee on Banking Supervision and Authority (ESMA) and the European Insurance and European Central Bank. Occupational Pensions Authority (EIOPA).

Financial system policy Financial stability • 2010 43 credit include the limitation of the debt- important step towards more effective to-equity ratio by means of the new macroprudential supervision. The ESRB leverage ratio requirement, the will be a key institution at European level tightening of collateral requirements for to promote macroprudential stability, and collateralised credit, the imposition of its work will be supported by national specific capital requirements on certain central banks and supervisors. types of credit and the build-up of larger The national organisation of mac- provisions for loan losses in an economic roprudential supervision has largely been boom (‘dynamic provisioning’). left for consideration by the member Many of the planned macropruden- states themselves. This enables the tial tools are indirect in nature, affecting setting up of a supervisory system that banks’ excessive lending or risk-taking best suits each country’s requirements. with a lag. Authorities need additional Several EU countries have tools that, whenever needed, enable legislation in place that imposes a prompt intervention in the operations of general obligation to monitor financial systemically important banks before markets on the central bank, but these banks endanger the financial without granting the central bank stability. In addition to actual crisis powers to address the problems management measures, the Commis- detected. This is also the case in sion’s framework for crisis management Finland. The Act on the Bank of in the financial sector includes a number Finland defines the role of the central of preventative measures and powers for bank in the supervision of financial early intervention, which could also be markets in highly general terms. The made use of (where applicable) in mac- Bank of Finland is responsible for con- roprudential supervision. For example, tributing to the reliability and efficiency the possibility to restrict lending by sys- of the payment system and overall temically important institutions or financial system and participating in prohibit activities that include excessive their development.3 No particular risk-taking would provide authorities powers or tools for the discharge of with means to prevent the emergence of these duties have been provided for. In risk concentrations. However, such a the future, a similar problem will relate large-scale intervention in the activities to the implementation of recommenda- of an institution would be an extreme tions and warnings that may be issued measure and could only be taken on by the European Systemic Risk Board. condition that the institution’s activities Finnish authorities are committed pose a clear threat to financial stability. to taking account of ESRB recommenda- tions in their work, but the implementa- Questions of competence in macro- tion of many such recommendations as prudential supervision need to be binding upon financial market partici- resolved at national level pants may prove impossible within the The establishment of the European

Systemic Risk Board (ESRB) is an 3 Act on the Bank of Finland, Section 3.

44 Financial stability • 2010 scope of current mandates. For example, to this belief, tax payers will bail out Finnish authorities currently have no systemically important financial right to require that banks restrict their companies and their creditors in the provision of credit by appealing to event of a crisis. In the light of the overall financial stability, economic recent financial crisis, the belief proved overheating or ESRB recommendations. right: of the largest financial companies Macroprudential supervision can be that had drifted into problems, only the organised domestically in a variety of Lehman Brothers investment bank was ways. An effective way of organising allowed to fail in autumn 2008. This macroprudential supervision is to decision on Lehman Brothers almost concentrate the necessary tools and led to a collapse of the entire interna- powers on one institution. The tional financial system, after which, institution could be a particular single practically speaking, public authorities authority or possibly a ‘macroprudential have bailed out all important financial committee’, formed by several companies that had run into serious authorities. A committee structure would liquidity or solvency problems. have the advantage of enabling the par- It is likely that the too big to fail ticipation of all relevant authorities in problem has worsened further still macroprudential decision-making. The following the financial crisis. The establishment of a joint committee world’s largest banks have become even would also make it easier to concentrate bigger. For example, the share of the the relevant powers on a single point of largest 10 global banks in the aggregate supervision. However, the activities of a assets of the largest 1,000 global banks committee exercising such extensive was 14% in 1999, 19% in 2007 and powers should meet the requirements of 26% after the financial crisis in 2009.4 openness and transparency. The too big to fail problem is par- Ambitious objectives have been set ticularly serious in Europe, as the on macroprudential supervision. The banking systems are highly concen- achievement of these objectives requires trated in most European countries. A effective tools and sufficiently extensive few large banks dominate national official powers. Authorities need to markets in most European countries have a possibility to address problems (Chart 31). in a timely fashion, and if problems are The too big to fail problem impairs to occur, the system must also be able the stability of the financial system and to resolve them effectively. the effective allocation of finance, in a number of ways. First, financial The too big to fail problem needs to companies perceived as being too big to be mitigated fail distort competition. They can Prior to the financial crisis of obtain debt financing at artificially low 2007–2009, markets already believed that many large financial companies 4 Goldstein – Veron (2010) Too big to fail: the transatlantic debate, Peterson Institute for had become ‘too big to fail’. According International Economics. Memorandum, p. 3.

Financial system policy Financial stability • 2010 45 Chart 31. via big leverage were undoubtedly the Credit institutions’ balance sheets in different countries: proportion of the five largest institutions ex ante and ex post most important of them. financial crisis The too big to fail problem could 1. 2006 2. 2009 perhaps be accepted as a side-effect of the % 100 12 financial system if very large banks were 80 significantly more cost effective than

60 small ones, in other words, if considerable economies of scale or economies of scope 40 were attached to their banking activities. 20 However, empirical studies hardly 5 0 provide evidence of such efficiency gains. e n e UK EU27 Spain Italy Looking ahead, in order to reduce Estonia Greec Swede FrancIrelandAustria BelgiumFinlandPortugal Denmark Germany Netherlands Euro area16 the huge macroeconomic costs of a Source: European Central Bank. financial crisis, it must be possible for even large banks to fail, without jeopard- cost, as creditors need not, in earnest, ising financial stability and tax payers’ be afraid of losing their investments. money. This is targeted by the European Such artificially cheap financing Commission’s plan for new crisis encourages financial companies to resolution mechanisms (see section ‘New expand and incur debt excessively. crisis management tools to help deal with Second, these companies have failing banks’). A failure does not need to inadequate incentives in place for entail closing down of a bank’s all managing their risks, as they can always operations. For example, payment rely on governments’ implicit promises services provided by a large bank cannot to rescue them in the case of an be suspended for a longer period of time, emergency. Prior to the financial crisis, without causing major costs to society. it was thought that large financial Even so, there must be the possibility to companies would be safer than small separate vital operations and the healthy ones because of their better chances of parts of a non-viable bank from its spreading risks. The financial crisis unhealthy parts so that, in the first place, showed that this was wishful thinking: the bank shareholders and creditors other in reality, many of the largest financial than depositors covered by deposit companies wasted their risk diversifica- insurance are called on to pay the costs tion edge on bolder risk-taking. arising from the reorganisation.6 Going forward, uncontrolled risk-taking by financial companies that 5 See eg Amel et al. (2004) Consolidation and efficiency in the banking sector: a review of the have become even bigger may also give international evidence. Journal of Banking and rise to the build-up of financial crises like Finance 28. 6 In its report Reducing the moral hazard posed by the one we have seen quite recently. systemically important financial institutions, the Although there were several reasons for Financial Stability Board puts forward detailed rec- ommendations for changes needed in official the latest financial crisis, the risks taken supervisory tools and cooperation arrangements, in order to enable an orderly failure of systemically by large and complex financial companies important banks at global level.

46 Financial stability • 2010 Capital surcharges need to be imposed raise more capital at a time when they on systemically important banks started to make losses and deplete their Revision of the crisis resolution capital resources. The low level of bank framework concerning failing banks capitalisation was probably due to the contributes to alleviating the too big to rapid reduction in investors’ risk fail problem and improving the prereq- appetite and the fact that acquisition of uisites for market discipline. In any case, new share capital by banks with weak crisis prevention will be less costly for capital positions would have benefited society than remedying the consequences the banks’ creditors more than their old of a crisis. Financial regulation should shareholders (‘a debt overhang thus encourage financial companies to problem’). reduce systemic risks caused by them. Recently, much attention has been Any upcoming regulation concerning devoted to a proposal that could ease systemically important financial institu- bank capitalisation in the event of a tions should be tighter than that applied crisis. According to the proposal, at to other financial institutions. Currently, normal times, banks would be required this is not the case. For example, the to issue ‘contingent capital’, ie debt existing Basel II capital adequacy instruments that would be converted frame work has favoured large banks, into bank equity in a crisis situation. The because the advanced risk measurement relevant authorities could decide when methods they are allowed to apply in and on which terms such conversion their minimum capital calculations have would take place. Alternatively, the generated lower than average capital materialisation of the terms and requirements. In the future, any capital conditions of the capital instruments requirements imposed on large banks would trigger the conversion.8 should be tighter than those on small Contingent capital could prove a ones, since the systemic risks caused by new useful tool for capitalising crisis- large banks are bigger. The Commission of ridden banks and strengthening market Experts appointed by the Swiss authorities, discipline. A working group commis- for example, proposes that minimum sioned by the Swiss authorities suggests capital and capital buffer requirements that, of the 19% minimum capital imposed on systemically important Swiss requirement proposed for the country’s banks should be substantially higher than systemically important banks, even 9 those imposed on other banks.7 percentage points could be composed of contingent capital. Contingent capital: a device to allevi- However, the introduction of ate the too big to fail problem contingent capital may also entail The financial crisis was exacerbated by adverse effects. There may be the banks’ inability and unwillingness to

8 Contingent capital according to the former 7 See http://www.sif.admin.ch/ alternative is called ‘bail-in capital’ and that according dokumentation/00514/00519/00592/index. to the latter alternative ‘contingent convertible html?lang=en. capital’, ie ‘CoCo’.

Financial system policy Financial stability • 2010 47 danger that conversion of debt for bank employees, depositors, instruments in the event of a crisis borrowers and investors, but, via exacerbates the crisis further still. This banking crises, causes major adverse problem will be of particular concern if externalities to other parts of society. For investors who have bought these example, environmental policy has relied instruments are other banks. Conversion on emissions taxes to reduce the exter- of a single bank’s contingent capital nalities of pollution. In principle, similar instruments may also generate fears of taxes could also be used in an effort to conversion of corresponding instruments reduce the externalities of banking. issued by other banks, thereby leading to However, in the real world, which a collapse in the valuations of such is full of uncertainty and imperfect instruments. Nor is it clear whether information, regulation and direct there would be enough demand outside limitations are more reliable channels for the banking sector for financial exerting influence on bank incentives. instruments with contingency features.9 The mechanisms through which bank Despite these open questions, contingent taxes influence are uncertain. Bank taxes capital is a tool worth considering for would possibly need to be very high in the mitigation of the too big to fail order to have a significant guiding problem. impact on bank operations. Another advantage of capital Bank levies and taxes non-optimal requirements in relation to bank taxes means to reduce banks’ risk-taking is that capital buffers directly reduce incentives the risk of failure of a single financial Bank levies and taxes have recently institution. By contrast, bank taxes, attracted much attention (see also collected and established as a fund, section ‘Tax on the financial sector’). mean only an ex-post sharing of costs The European Council determined at its from financial crises between financial June 2010 summit that EU member institutions and tax payers.10 Because states should introduce systems for of the enormous costs involved in levies and taxes on financial institu- financial crises, crisis prevention should tions, in order to ensure the financial be the primary objective of financial sector’s participation in fair burden- system policy. Even if bank levies and sharing in upcoming financial crises taxes were not to prove effective means and to set incentives for financial insti- for reducing the risk of financial crises, tutions to contain systemic risks. they could still have an important role In the light of economic theory, to play in the financing of a bank bank taxes could constitute an effective resolution regime, planned within the means for reducing the adverse external- EU (see above). ities of banking. Banking brings benefits 10 IMF (2010) A fair and substantial contribution by 9 For potential problems related to the introduction the financial sector: final report for the G-20, Annex of contingent capital instruments, see eg the article: 3, provides a more detailed comparison of bank taxes Goodhart (2010) Are CoCos from Cloud and capital requirements as means to reduce the Cuckoo-Land?, www.voxeu.org. externalities generated by financial institutions.

48 Financial stability • 2010 Restrictions on banking business still Attitudes taken towards the under consideration restriction of bank operations have In Anglo-Saxon countries in particular, been more moderate in Europe than in arguments have been put forward to the Anglo-Saxon countries. Banks are of effect that the financial regulatory great importance for the financial reforms now under way are not adequate systems of European countries. Limiting to solve the too big to fail problem: the the scale of bank operations is the most only solution would be to radically limit rigorous tool for constraining risks the size, structure or business operations related to banking. It is also unclear to of financial companies that have become which extent the limitation of certain too big. Proposals brought forward in bank operations can reduce the overall these discussions include maximum limits risks attached to banks and the on the size of bank balance sheets and financial system. Such restrictions can market shares in various business areas, be either ineffective, because banks are the splitting up of large banks and the able to increase risk-taking in their separation of deposit and investment other business operations if they wish banking functions.11 to do so, or quasi-effective if risk-taking The financial regulatory reform shifts away from the banking sector. A agenda adopted in the United States in primary concern would be to reduce July 2010, the Dodd-Frank Wall Street banks’ general incentives for risk- Reform and Consumer Protection Act, taking, using the tools discussed above. imposes some restrictions on bank size and business operations. Banks are, for Special issues related to financial example, prohibited from conducting market infrastructure proprietary trading, with certain In the area of market infrastructure, exceptions. Banks’ investments in hedge there are significant European and and private equity funds are also national regulatory initiatives in restricted. Deposit banks and other sys- progress, of which the most important temically important financial institu- ones concern the Single Euro Payments tions are prohibited from participation Area (SEPA), central securities deposito- in mergers as a consequence of which ries, central counterparties and trading the total consolidated liabilities of the in financial derivatives. resulting company would be in excess Progress in SEPA has been slow, of 10% of the aggregate consolidated although it would bring benefits for liabilities of all financial companies.12 Europe as a whole. Finland has been determined to promote the single 11 Options to restrict bank operations are discussed eg in a report issued by the Independent Commission payments area, but asynchronous devel- on Banking, set up by the UK Chancellor of the Exchequer (‘The Vickers Report’), http://bankingcom- opments across Europe pose a threat to mission.independent.gov.uk/bankingcommission/. the efficiency of our markets. It is 12 For the key contents of the Dodd-Frank Act, see eg therefore important to have a legislative Davis-Polk (2010) Summary of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Passed deadline in place for SEPA implementa- by the House of Representatives on June 30, 2010. Davis-Polk, Washington DC, July. tion.

Financial system policy Financial stability • 2010 49 Preparations are currently under continue to have adequate chances of way to create EU legislation that would exercising supervision and exerting remove the remaining legal barriers to influence with respect to all participants securities markets integration. The most relevant for their own markets. At important legislative initiatives in the national level, another important aspect securities field concern central counter- is to establish effective cooperation parties and central securities deposito- among all competent authorities. ries. Their uniform regulatory As integration advances, care must framework provides the legal basis for a be taken to safeguard operational level playing-field and cross-border conditions for domestic capital markets. provision of services. Such regulation In 2009, the Bank of Finland published also seeks to strengthen the capital minimum requirements for the use of adequacy of market participants, which foreign infrastructures in the Finnish promotes financial stability. Although, in markets. According to these require- practice, infrastructures have functioned ments, financial market infrastructure smoothly during the crisis, their closer should 1) comply with the requirements regulation will underpin other regulatory set by the authorities, 2) secure business measures concerning financial markets. continuity and efficient crisis Central counterparty clearing is management and 3) ensure the encouraged, because it would bring reliability, efficiency and functionality greater efficiency to liquidity usage and of national markets.13 Integration facilitate the management of counter- must also benefit end-users: payers, party risks. A further aim is to route payees and investors alike. Current financial derivatives, which posed providers of services in the Finnish problems during the crisis, through markets meet official requirements centralised clearing parties in the future. quite well. Legislation needs to ensure that central The central securities depository counterparties themselves will not active in Finland has been planning become problematic risk concentrations. technical integration and functional A new supervisory authority, the harmonisation with the central European Securities and Markets securities depository operating in Authority (ESMA), has been created for Sweden. The project can be supported securities infrastructures. This authority provided that the resulting central will have a key role to play in the securities depository will meet the creation of specific EU legislation and above minimum requirements and the the supervision of securities market solution will enable the further participants. ESMA will reinforce the development of securities markets. This supervision of global market partici- integration process must make use of pants and promote uniform regulation. the best functionalities of both markets. Nevertheless, for the sake of It should benefit market participants supervisory efficiency, it must be 13 Bank of Finland Bulletin: Financial Stability, ascertained that national authorities Special issue 2009.

50 Financial stability • 2010 and end-customers, while simultane- for indirect holding would lead to an ously promoting potential future expansion in the grey economy. migration to a Europe-wide securities The integration of the Finnish clearing and settlement infrastructure. financial market infrastructure into The best outcome will be achieved if other European structures continues to local decision-making powers and equal deepen. Operational conditions for the opportunities to access information and domestic markets need to be exert influence are safeguarded for both ascertained, regardless of whether a Finnish and Swedish parties. domestic or a foreign infrastructure is In the European context, the used. There must be a common national Finnish securities markets present pecu- view of how this will be guaranteed. As liarities in that our legislation requires regards payments, this type of ‘direct holding’ of securities from discussion takes place within the Finnish citizens. Elsewhere in Europe, context of the Payments Forum.16 The ‘indirect holding’ is the typical model of future development of the securities holding securities.14 The indirect markets could be fostered by a similar holding model would entail undeniable forum, which would have an economic benefits, as put forward in adequately broad and high-level repre- the Ministry of Finance Rapporteur’s sentation from all groups important for report.15 A working group reporting to capital markets, such as infrastructure the Ministry of Finance is currently suppliers, banks, investors, issuers, revising Finnish securities markets companies and authorities. The forum legislation. The revision includes a would offer a framework for discussion proposal for permitting indirect holding and common policies in respect of of securities for Finnish investors, too, issues important for the domestic alongside with direct holding. Indirect capital markets. holding should be rendered possible for the purpose of safeguarding the efficiency, competitiveness and development of the Finnish securities markets. Even so, authorities’ adequate access to information must be secured to avoid the possibility that permission

14 Under the direct holding regime, each investor’s securities are held in the investor’s own book-entry account. In the indirect holding option, several investors’ securities are held in one book-entry account (‘an omnibus account’) and the custodian keeps record of each investor’s holdings in the omnibus account. 15 The economic impact of an expansion of multi-tiered custody and nominee registration of securities. Rapporteur’s report. Ministry of Finance 32/2010, http://www.vm.fi/vm/fi/04_julkaisut_ja_ 16 Bank of Finland’s Payments Forum, http://www. asiakirjat/01_julkaisut/07_rahoitusmarkkinat/201006 bof.fi/en/rahoitusmarkkinat/km_yhteistyo/ 02Arvopa/name.jsp. maksufoorumi.htm.

Financial system policy Financial stability • 2010 51 Box 4.

Long-term impact of regulatory reforms probably positive in Finland The macroeconomic impact of tions would need to increase their become more expensive, the the extensive banking regulatory capital levels. By contrast, in growth rate of GDP would reform (Basel III) has been current state, the banking sector decelerate by 0.2 percentage point evaluated in several studies. The would not meet the future in the first year and by 0.1 key factors can be broken down liquidity requirements.3 It was percentage point in the second into the two following: assumed that all banking groups year. If the change were to occur 1) Since equity funding is would need to increase their gradually and was anticipated, the considered expensive, tighter liquid investments by about a slowdown in GDP growth would capital adequacy requirements third in order to meet the require- spread more evenly over several will increase bank lending rates, ments. years. The following calculations reduce investment and decelerate The impact of the regulatory are built on the assumption that economic growth in normal times. reform on the price of lending GDP would fall permanently by This was emphasised by the was calculated using a model that 0.3 percentage point. Institute of International Finance was also applied in the Basel The Basel Committee in its report from June 2010.1 Committee assessment. The need assessment finds that the capital 2) Tighter capital adequacy for two banks to increase their adequacy requirements have no requirements will reduce the capital and an increase in liquid impact on the severity of banking probability of banking crises and assets in all banks were incorpo- crises – only on their frequency. the associated recessions. The rated in the calculation framework. If, after a crisis, output returns to results of an assessment commis- The calculation formula assumed the pre-crisis trend trajectory, the sioned by the Basel Committee that the banks’ required return on cumulative output loss in a on Banking Supervision suggest equity would remain the same as typical crisis would be about that these benefits are the main in the past on average. The spread 20% of annual GDP. factor in estimating the long-term between market interest rates and The planned liquidity impact of the regulatory reform.2 bank lending rates would widen requirements would reduce the Rough calculations have by about 0.25 percentage point, annual probability of a new been conducted at the Bank of which is practically completely banking crisis by approximately Finland, in which similar methods attributable to liquidity require- half a percentage point if banks were applied on the Finnish ments. The change would occur are as strongly capitalised as in economy. The calculations were within about four years. Finland.4 based on the assumption that the The impact of more The Finnish economy is structures of the economy and the expensive bank credit on the among one of the most vulnerable banking sector would remain economy was calculated using a to cyclical fluctuations in Europe. relatively unchanged from the dynamic stochastic general Measured by a simple indicator, present situation. equilibrium (DSGE) model that the intensity of cyclical fluctua- Most of the Finnish banks has been presented in the Bank of tions in Finland has been about are already sufficiently capitalised. Finland discussion paper 5/2010. double that in the current euro Only two of the five banking As a result of more expensive area.5 If this is a structural groups included in the calcula- credit, GDP would remain about 0.3% lower than otherwise for 4 See the Basel Committee assessment 1 Interim Report on the Cumulative (Table 3). several years, at worst. If bank Impact on the Global Economy of the 5 Proposed Changes in the Banking credit were unexpectedly to In the review period the average absolute Regulatory Framework. value of the deviation from trend of the logarithm of real GDP (H-P filter) was 0.021 2 BIS (August 2010) An assessment of the for Finland and 0.009 for the benchmark long-term economic impact of stronger 3 Financial Supervisory Authority’s group. The quarterly data covered the period capital and liquidity requirements. supervision release 21/2010. from early 1985 to mid-2010.

52 Financial stability • 2010 feature, in a few years a domestic assessment, the regulatory reform The calculations could not banking crisis would cause would reduce the probability of take all of the channels through output losses in the amount of new crises in the euro area by as which the economy is affected 40% of one year’s GDP. This much as 3.5 percentage points into account. For instance, the means that a half a per cent per year. This would increase the smoothening of business cycles reduction in the probability of a expected value of Finland’s GDP mitigates investment risks, which new crisis would raise the by 1.1% if the current crisis is to in turn accelerates growth. expected value of output by 0.2 be considered typical. If a bank’s capital adequacy percentage point. Aggregating the impact of improves, there is more capital to The Bank of Canada the lower incidence of domestic cover business risk. Return on assessment of the implications of and foreign crises, and subtracting equity becomes more stable, in the regulatory reform6 comes to from this figure the loss caused by which case a sensible investor is the conclusion that the lower more expensive investment funding, ready to subscribe to the bank incidence of foreign financial Finland’s average output is about shares, even in an environment of crises – mostly those in the United one per cent higher than without lower return expectations. In States – would affect the expected the regulatory reform. Compared addition, a bank with an value of future GDP twice as with foreign analyses, the impact improved capital adequacy is much as a more robust domestic is stronger due to the cyclical more creditworthy and is likely to banking sector would. Finland’s sensitivity of the Finnish economy. obtain loans on more favourable export industry also suffers from At the same time, economic cycles terms. It can therefore be assumed banking crises in its main market would become smoother as the that the calculation overestimates areas, since they easily cause crises became fewer. the impact of the regulatory recessions of various degrees and These kinds of calculations reform on bank lending rates and indirectly dampen the demand for should be treated with caution, investments in normal times. almost all goods. The regulatory and the end result is only a rough Tighter regulation can lead reform reduces the probability of estimate, at best. The applied to increased financial intermedia- new crises in the Nordic countries statistical correlations have been tion outside banks’ balance sheets, and elsewhere, and both of these valid in the past, but they can which can have substantial macr- factors must be taken into change. The impact of capital oeconomic implications. In the account separately. adequacy and liquidity on the calculations, Nordic banks’ If GDP is believed to return occurrence of banking crises is Finnish subsidiaries were regarded to its former growth trajectory not a straightforward question as separate banks. The treatment and follow its previous dynamics, that can be answered absolutely. of groups as single units could the Finnish economy will have The relevance of banks’ capital have yielded different results. recovered from the crisis that adequacy in preventing crises The calculations presented began in 2007 by early 2014. The depends on many features in a above only considered a financial crisis would generate an given economy, and there are long-term period and did not deal output loss in Finland, which hardly any studies on this field. It with a potentially difficult would amount to about 31% of is also difficult to analyse the transition period. If banks adapt the 2011 trend value of GDP. In impact of crises on GDP. The to the new regulations rapidly by the light of the Basel Committee calculations used assumed a reducing lending substantially, the permanent negative effect from negative impact from the

6 Strengthening International Capital and higher cost of funding on GDP, transition on output is larger than Liquidity Standards: A Macroeconomic contrary to what the applied mac- estimated above. Impact Assessment for Canada. August 2010. roeconomic model would project.

Financial system policy Financial stability • 2010 53 Appendix

Infrastructure critical to the Finnish financial market

System Description Oversight responsi- Assessment bility TARGET2 Eurosystem technically ECB (lead overseer), In 2009, the ECB Governing Council approved the first centralised RTGS-system based Eurosystem. comprehensive assessment of system design and implementation on a single shared platform. in accordance with the Core Principles. The system’s continuity planning has been assessed as fulfilling the set requirements. Operations have been reliable. TARGET2 - Bank of Finland TARGET2 Bank of Finland A risk assessment of the system was undertaken in 2009. Suomen Pankki component system. oversight; adherence Operations have been reliable. -system to common principles with other Euro- system TARGET2 participants. CLS A significant settlement system US Federal Reserve System operations cover 17 currencies and have expanded to for foreign exchange trans- (lead overseer), ECB include settlement of OTC credit derivatives traded outside the actions that enables PvP settle- (overseer of settle- stock exchange. Self-assessment of CLS in 2007 established that ment to eliminate settlement ment in euro), G10. the system fulfils the Core Principles. Operations have been risk. In operation since 2002. mainly reliable. Heightened importance in the management of risks relating to foreign exchange transactions during the financial market turmoil. EBA Euro1 EBA Clearing’s transfer system ECB (lead overseer), Assessed in 2001 as being in accordance with the Core Principles. for euro-denominated large- Eurosystem. Found to be a systemically important large-value payment value payments. system. An assessment of the system’s continuity planning performed in 2009. Overall, the system fulfilled the require- ments. A comprehensive oversight assessment undertaken in the course of 2010. Operations have been reliable; no significant disruptions. EURO1 started to provide settlement services as a TARGET2 ancillary system in June 2010. POPS Banks’ online system for Bank of Finland Assessed in 2004 as being in accordance with the Core Principles express transfers. Domestic oversight. and fulfilling the requirements. An assessment of the system’s large-value payment system. continuity planning performed in 2009. No flaws identified. Operations have been reliable. Number of payments is declining. EBA STEP2 Pan-European automated ECB (lead overseer), Considered a prominently important retail payment system. clearing house (PEACH) for Eurosystem. Operations have been relatively reliable. In the future, a euro-denominated bulk systemically important retail payment system for Finland. The payments. Bank of Finland takes an active part in cooperative oversight with the ECB and EBA. PMJ Domestic retail payment Bank of Finland Assessed in 2004 as being in accordance with the Core Principles transfer system; operates as an oversight. and fulfilling the requirements. Critical system for domestic retail ancillary system to TARGET2. payments. An assessment of the system’s continuity planning was performed in 2009. Some disruptions of night-time clearing in 2010, causing delays in recurrent payments. Transfer of pay- ments towards EBA STEP2 in response to introduction of SEPA. ACH Finland A clearing house set up by some Bank of Finland System oversight in progress. An assessment of the system’s Finnish banks. Operations oversight. continuity planning performed in 2009. Oversight assessment to started in March 2009. be completed in 2010. Operations have been reliable. European Provider of central counter- An oversight group Monitored and assessed jointly by national oversight and super- Multilateral party clearing services to the coordinated by the visory authorities. The Bank of Finland participates in this Clearing Facility, Nordic stock exchanges of Dutch authorities. group. EMCF NASDAQ OMX. Euroclear A Central Securities Bank of Finland Operations have been reliable. The settlement system for debt Finlandin Depository operating settle- oversight. securities (Ramses) and its collateral management services have (former APK) ment systems for stock and been assessed based on the Eurosystem user standards; system systems money market instruments. fulfilled requirements in 2009. Comprehensive assessment based on ESCB-CESR recommendations jointly with FIN-FSA is due to begin. Euroclear SA Program of the Euroclear An oversight group This is a highly challenging project. Oversight of the Group’s systems Group for harmonisation of coordinated by the central securities depositories will remain in the hands of the services of the group’s Belgian authorities. national authorities. The Bank of Finland participates in the central securities depositories. group of national oversight and supervisory authorities responsible for monitoring and assessing the Euroclear Group and its projects. Consolidation of the systems of the Finnish and Swedish central securities depositories have been examined. Information networks SWIFT Most significant provider of Oversight group SWIFT is a critical provider of services for financial market messaging services to the headed by the central infrastructure. Its operations have been mainly reliable. In its financial markets; an entity bank of Belgium (see self-assessment of 2008, SWIFT has stated that it meets the managed by its members NBB Financial Stability oversight requirements. SWIFT has strengthened operational Review, 2010, p. 99) reliability by establishing a new service centre in Europe. Pankkiverkko 3 Domestic closed interbank Bank of Finland Subject to oversight monitoring. Operations have been reliable. network used by for example oversight. PMJ and POPS. ATM networks Networks significant for the Bank of Finland Subject to oversight monitoring to ensure acquisition of data supply of cash to individual oversight. and secure preparedness for crisis management. members of the public.

54 Financial stability • 2010 Organisation of the Bank of Finland 1 November 2010

PARLIAMENTARY SUPERVISORY COUNCIL

SeppoTimo Kääriäinen, Kalli, Chairman, Chairman, Antti Antti Kalliomäki, Kalliomäki, Vice Vice Chairman, Chairman Pekka, Pekka Ravi, Ravi, LiisaTanja Jaakonsaari, Karpela, Martti Tanja Karpela,Korhonen, Martti Mika Korhonen, Lintilä, MarjaMika Tiura, Lintilä, Jutta Marja Urpilainen, Tiura, Ben Ben Zyskowicz Zyskowicz

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, currency supply services, investments of financial assets, domestic economic policy, financial administration and administration. membership of the Governing Council procurement, risk control, and General Council of the ECB. Chairman of the 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 Currency report. and Administration report. Arno Lindgren, Secretary to the Board DEPARTMENTS Monetary Policy • Economic Development and Analysis Institute for Economies Research and Research • Forecasting in Transition (BOFIT) Tuomas Saarenheimo • Information Services

Financial Stability • Macroprudential Analysis Statistics • Information and Statistics • Oversight of Market • Balance of Payments Management Kimmo Virolainen Infrastructure • Financial Statistics

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

Currency • Regional Offi ces • Currency Operation • Currency Technology Mauri Lehtinen Kuopio, Oulu, Division Division Tampere, Vantaa

General Secretariat Communications Strategy and Senior Secretarial Antti Suvanto European and International Affairs Organisation Staff Legal Affairs

Administration • Financial Administration and • Personnel Information Technology Pirkko Pohjoisaho-Aarti Procurement • Risk Control Security and • In-House Services Property Management • Language and Publication Services

Internal Audit Erkki Kurikka

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

A complete list of publications is available on the Bank of Finland website (www.bof.fi > Publications).

The Bank of Finland has introduced a free electronic subscription service on its website, through which it is possible to order the Bank’s publications in electronic form. Subscribers are sent an email alert whenever the publications subscribed to are newly released. Publications can be subscribed to at www.bof.fi > Publications > Order and subscribe to electrionic publications and reports.

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 FINANCIAL STABILITY • 2010 • STABILITYFINANCIAL