Financial Stability 1/2004

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3 Financial institutions

3.1 Developments in banks’ results and financial strength
3.2 Risk outlook for banks
3.3 Other financial institutions

Boxes:
- Loan loss provision rate and loan losses
- A more robust securities settlement system

3.1 Developments in banks’ results and financial strength

The decline in interest rates has contributed to higher growth in the Norwegian economy. The equity market has surged in the past year, and banks’ sales of securities products have climbed. Both developments have boosted banks’ earnings: Pre-tax profits in banks rose from 0.53% of average total assets (ATA) in the first quarter of 2003 to 1.04% of ATA in the first quarter of 2004 (see Chart 3.1 and Tables 2 and 3 in Annex 1).⁸ Results in the first quarter of 2004 were characterised by low loan losses, particularly in the two largest banks.⁹ DnB NOR’s gain on the sale of Elcon Finans and restructuring costs made a positive net contribution to earnings.

Chart 3.1

The decline in interest rates contributed to reducing banks’ net interest income from 1.96% to 1.74% of ATA from the first quarter of 2003 to the first quarter of 2004. This is primarily because banks are gaining less of an accounting advantage from financing some of their lending activities through net interest-free liabilities, including equity. It is also due to a slight decline in banks’ overall interest margin (see Chart 3.2). The fall did not commence before the fourth quarter of 2003. This is because the lower limit of zero for deposit rates became more important than previously, while at the same time the competitive situation did not permit full compensation for this effect through increased lending margins. Information from banks’ quarterly reports indicates that interest margins were still under pressure in the first quarter of 2004.

Chart 3.2

Other operating revenues have increased markedly as a result of capital gains, increased share dividend earnings and higher earnings from commissions on securities sales (see Chart 3.3). Since these are figures for parent banks, increased earnings from insurance companies forming part of financial conglomerates are not included. For example, life insurance revenues in the DnB NOR Group increased by NOK 1bn (0.15% of the group’s ATA) from 2002 to 2003. A strongly improved result from Sparebank 1-Gruppen AS, where insurance accounts for a large share of activities, also contributed to an improved result for the banks that own the group.

Chart 3.3

Banks have become more cost-effective in recent years (see Chart 3.1). According to national accounts figures, the financial industry is among the sectors with the greatest improvement in productivity. Technological changes, sharp competition and consolidation have contributed. This trend is expected to continue.

Sluggish economic growth, the Finance Credit case and the fisheries and fish-farming crisis contributed to relatively high loan losses in 2002 (0.46% of ATA). These factors continued to affect loan losses in 2003, but there was a change for the better from the third quarter onwards. This indicates improved credit quality, which is also reflected in an appreciable fall in gross non-performing loans (see Chart 3.4). The decline in interest rates and increased economic growth contributed. Overall, loan losses dropped to 0.14% of ATA in the first quarter of 2004. Loan losses in the two largest banks were equivalent to 0.11% of ATA. The reduction in recorded losses compared with the same quarter in 2003 is due to reduced losses on both old and new loans, and the fact that unspecified loan loss allocations remained unchanged (see Table 3.1).

Chart 3.4     Table 3.1

There have been no major changes in banks’ financial strength. The Tier 1 capital ratio of the two largest banks fell from 8.4% to 7.8% from the first quarter of 2003 to the first quarter of 2004. The Tier 1 capital ratio of the other commercial banks rose from 10.3% to 10.9%, and in other savings banks from 11.4% to 12.0%. A number of savings banks have strengthened their Tier 1 capital by issuing preferred capital securities, a hybrid instrument that has features in common with both debt and equity capital.

The substantial improvement in the results of Norwegian banks has brought their return on equity up into line with the large Nordic banks (see Table 3.2). The large Nordic banks have long had very low loan losses, and have largely succeeded in maintaining the level of net interest income despite low interest rates (see also Chapter 1.2).

Table 3.2

3.2 Risk outlook for banks

Banks are exposed to a number of types of risk. This section presents an assessment of banks’ credit, market and liquidity risk (see box with definitions). Lending to households, non-financial enterprises and municipalities has accounted for 72%-74% of banks’ total assets in recent years (see Table 3.3), making credit risk the primary source of risk for banks. Market risk is low in banks, as a relatively small share of banks’ assets is invested in securities. Liquidity risk will depend partly on how large a share of long-term lending and other illiquid assets is based on long-term financing. Banks may also have drawing rights etc. on other banks that are not recorded on the balance sheet, but that affect liquidity risk.

Table 3.3

The risks will be assessed separately, but may co-vary and/or influence one another. For example, a sharp fall in the equity market may coincide with weak economic growth and an increased risk of loan losses. Access to funding may be influenced by how funding sources assess banks’ credit risk.

Credit risk associated with loans to the households

Mortgage-backed loans to households (including self-employed persons) increased from 82% to 83% of gross lending to households from the first quarter of 2003 to the first quarter of 2004 (see Table 3.4). In the same period, the share of lending to households increased from 66% to 69%. This means that developments in households’ debt-servicing capacity and house price developments are of increased importance to banks’ credit risk.

Table 3.4

Banks have been willing to meet households’ high demand for loans, possibly because they have considered the risk associated with mortgage-backed loans to be relatively low. Expectations of lower capital requirements for housing loans as a result of new capital requirements (Basel II) point the same way. Developments in banks’ lending rates reflect this situation. Average interest rates on new mortgage-backed loans have dropped as much as Norges Bank’s key rate (see Chart 3.5).¹⁰ Up to the present, the effect on the average interest rate on all mortgage-backed loans, both old and new, and with both fixed and floating rates, has been less. From the end of the third quarter of 2002 to the end of 2003 (most recent figures available), Norges Bank’s interest rate statistics show that the average lending rate for mortgage-backed loans was reduced by 4.1 percentage points. The lack of impact on the average interest rate on all housing loans reflects the fact that a portion of the loans have fixed interest rates and that there is a time lag in the adjustment of interest rates on existing loans.

Chart 3.5

Housing loans with a high loan-to-asset-ratio involve a particular risk for banks. Kredittilsynet’s most recent housing loan survey¹¹ shows that the proportion of loans (by value) with a loan-to-asset-ratio of over 80% has increased markedly (see Table 3.5).

Table 3.5

Partly as a result of low interest rates, households’ interest burden is low (see Section 2.2). The risk of higher losses on loans to households is therefore relatively limited in the short term. As a result of high debt growth, however, households are now more vulnerable to economic disturbances. A sharp rise in interest rates might represent a debt-servicing challenge to some households, and result in increased loan losses for banks that have not allowed for such a development.

Credit risk associated with loans to non-financial enterprises

As a result of low economic growth and reticence about investing in recent years, corporate demand for loans has been low. At the same time, banks have used the decline in interest rates to increase the pricing of risk, with the result that interest rates on loans to many companies have fallen less than Norges Bank’s key rate and housing loan interest rates (see Chart 3.5). However, information from Norges Bank’s regional network does not suggest that banks as a whole have become more restrictive in extending loans to the corporate sector.

Loans to non-financial enterprises accounted for 30 per cent of banks’ gross lending to households, municipalities and non-financial enterprises at the end of the first quarter of 2004 (see Table 3.4). Non-performing loans and losses on loans to the corporate sector increased sharply in 2002, and were high in the first half of 2003 (see Chart 3.4).

Banks have greatest exposure to the property management industry. Loans to this sector amounted to 32 per cent of corporate loans at end-2003 (see Chart 3.6). This share has increased in recent years, in spite of weak developments in parts of the property market (see Section 2.3). Recorded losses on loans to the property industry have not been higher than losses to other industries in recent years, however, and they dropped appreciably in 2003 (see Chart 3.7 and Table 4 in Annex 1).

Chart 3.6     Chart 3.7

The loss picture for other industries was mixed in 2003. Losses on loans to the service sector dropped markedly from 2002 to 2003, while losses in construction increased appreciably. Losses on loans to fish-farming and fisheries increased further in 2003, primarily in the first half of the year. Loans to this industry accounted for just under 3% of banks’ corporate sector loans at end-2003. The potential for new substantial losses is therefore limited.

Banks' capacity to absorb losses

Banks’ capacity to absorb loan losses depends on their results and capital adequacy. We have assessed the capacity of the seven largest banking groups to sustain losses by measuring how large the losses would have to be over a 3-year period before their capital base fell below the minimum requirement. The accounts for 2003 form the starting point, and it is assumed that banks do not raise new equity or supplementary capital, that the size and composition of the balance sheet do not change, and that the banks do not pay a dividend. In the first example, it is assumed that banks have the same results as in 2003 in each of the three subsequent years. In the second example, a result before losses of zero is assumed for these three years.

With the same result before losses as in 2003, the soundest of the seven largest banking groups¹² will sustain an average loss per annum over three years of 3.1% of gross lending (see Chart 3.8). If the pre-tax profit is zero in the three years, this group will sustain an average loss of 1.4 per cent of gross lending. The weakest bank will sustain average losses over three years of 1.7% and 0.8% of gross lending, respectively, given these two assumptions concerning results. The capacity to sustain losses, given a profit of zero before losses, fell on average from 2002 to 2003 (see Chart 3.8). This is because the banking groups’ Tier 2 capital ratio fell somewhat in 2003. On the other hand, somewhat better results before losses in 2003 than in 2002 contributed to an improvement in banks’ capacity to absorb losses, given the assumption that their results for the next three years are the same as in 2003.

Chart 3.8

Banks’ loan losses – baseline scenario and stress tests

Banks’ loss absorption capacity must be assessed against different scenarios for banks’ overall loan losses in the future. The baseline scenario for loan losses is based on the baseline scenario for economic developments in Inflation Report 1/2004.¹³ In this scenario, loan losses decline somewhat in 2004, and increase to about 0.5% of gross lending in 2006, partly as a result of increased interest rates (see Chart 3.9). The largest banking groups will have no problem in handling such a loss level.

Chart 3.9

In order to assess the risk of Norwegian banks’ experiencing solvency problems, we have also considered the capacity to absorb losses in relation to the size of the loan losses in two scenarios where there is a marked deterioration in borrowers’ debt-servicing capacity. In these stress tests, we consider the effects of the following exogenous changes compared with the scenario in Inflation Report 1/2004:

• Three-month money-market rates rise gradually to 7.2%¹⁴ and 10%, respectively, towards the end of 2005, and remain at these levels in 2006.
• House prices remain approximately unchanged in 2004, but fall by 7% and 10%, respectively, in each of the two following years.

A very sharp fall in oil prices, a serious loss of confidence in the Norwegian economy and a marked increase in interest rates in other countries are examples of disturbances which in combination could trigger such scenarios. The stress tests have been applied to the next few years, for technical reasons. The purpose is to analyse the vulnerability of banks when the Norwegian economy and vulnerability of banks’ borrowers are similar to the current situation.

In the stress tests, growth in the Norwegian economy will decline sharply and unemployment will increase. Given our simplifying assumptions, the interest rate level will not be reduced in response to this negative trend. The interest burden of both household and corporate sectors will increase appreciably. A fall in house and commercial property prices will reduce banks’ mortgage values, causing a rise in loss given default.

In the first scenario, loan losses will increase gradually to 1.5% of gross lending in 2006 (see Chart 3.9). The second scenario implies a sharper deterioration in the Norwegian economy and the value of collateral furnished, with the result that loan losses will increase to 2.4% of gross lending in 2006. It takes time before weak economic growth and weakened debt-servicing capacity translate into increased losses. Banks’ loan losses will therefore probably be high also after 2006, even if new negative disturbances do not occur.

With a macroeconomic deterioration such as the first scenario, the 4 banking groups in the weakest financial position would experience problems in satisfying the minimum capital requirement, assuming a profit of zero before losses for 3 years. In the second scenario, and assuming a profit of zero before losses, all 7 banking groups would probably fall below the minimum requirement. With the same profit before losses as in 2003, all the banking groups would satisfy the minimum requirement regarding capital in both scenarios. The result before losses would probably be somewhere between the two scenarios. A pronounced economic deterioration will often lead to weak developments in securities markets, and a high share of non-performing loans will mean lower interest recorded on lending. Under such circumstances, it may also be a challenge to raise new equity or supplementary capital.

Market risk

Banks engage to only a limited extent in securities trading for their own account. They primarily hold interest-bearing securities, because most of them can be used as collateral for intraday loans and fixed-deposit loans from Norges Bank (see Chart 3.10). The low share of securities classified as current assets therefore contributes to low market risk in Norwegian banks, measured at parent bank level. The most important source of market risk for Norwegian banks is connected with ownership of life insurance companies.

Chart 3.10

Liquidity risk

The low interest rate level has contributed to making bank saving less attractive than other kinds of saving. Deposit growth has therefore been low, and deposits from the non-financial sector have continued to fall, as a percentage of lending, since autumn 2002 (see Chart 3.11). The increased difference between lending and deposits has been financed primarily with bonds. Since both customer deposits and bonds can normally be regarded as stable financing, this shift has not affected liquidity risk in banks, viewed as a whole, to any particular degree

Chart 3.11

However, there are considerable differences between banks. From autumn 2002 and through the first half of 2003, many small banks had problems in securing financing on conditions that ensured satisfactory profitability. This is because banks’ creditors have increased their risk and liquidity premiums. A number of banks have reduced their lending growth sharply in order to adapt to this situation. The number of banks with a high liquidity indicator¹⁵ value therefore increased sharply in the first half of 2003 (see Chart 3.12). This applied on average to commercial banks excluding Nordea Bank Norway and Fokus Bank (see Chart 3.13), but also to a number of small savings banks. Funding problems have continued for a number of these banks through the second half of 2003 and up to the present. For many small and medium-sized banks, high lending growth and low deposit growth led to reduced liquidity indicator values from the second to the third quarter of 2003. After this, the volume of bond financing increased, so that a number of these banks again recorded a liquidity indicator value of over 100. DnB and Gjensidige NOR, which have been combined in Chart 3.13 for the whole period, have had an average indicator value of over 100 for several years.

Chart 3.12     Chart 3.13

Because of the increased difference between lending volume and deposits, it has been a challenge for small and medium-sized Norwegian banks to secure long-term funding in the capital markets. This situation has been exacerbated by the decline in interest rates. A number of these banks do not have a rating from international credit rating agencies. This makes it expensive to obtain financing in the international capital markets. Nor do large international financial institutions consider it profitable to assess the creditworthiness of and extend relatively small loans to Norwegian banks. When the German Landesbanks lose their government guarantees on new loans (from 2005), another important source of funding for Norwegian banks may become more expensive. However, there are signs that Nordic banks have increased their activity in relation to small Norwegian banks.

With the exception of DnB NOR, Norwegian banks have lower ratings than the largest Nordic banks (see Table 3.6). This is partly due to difference in bank size. Moody’s upgraded Sparebank 1 SR-Bank in November 2003, and both Danske Bank and Fokus Bank in April this year. Handelsbanken and SEB were upgraded by Moody’s earlier this year.

Table 3.6

Foreign-owned subsidiaries such as Fokus Bank and Nordea Bank Norway have access to financing via their respective parent banks, Danske Bank and Nordea Bank AB. This type of financing has increased substantially in recent years (see Chart 3.14).

Chart 3.14

In order to remedy structural financing problems and meet competition from large Norwegian and Nordic banks, small banks in the Terra Group have planned to establish a mortgage company as soon as the regulations for asset-backed bonds¹⁶ are in place. The company will mainly take over housing loans that are within 60 per cent of market value from banks. In this way the individual bank will release capital and reduce the need for relatively expensive financing from the money and capital markets. The newly established Credit Association for Savings Banks (KfS) will have a somewhat different purpose. By taking up large bond loans in Norwegian and international capital markets, KfS is to be able to mediate long-term loans to small and medium-sized savings banks at more favourable conditions than they could have achieved themselves. In this case, banks’ lending will remain on their balance sheets.

Overall, the liquidity risk for banks is regarded as relatively low and roughly unchanged since Financial Stability 2/2003. With the current low interest rate level, the deposit-to-loan ratio will probably continue to edge down in most banks. Securing long-term financing will be a challenge for small and medium-sized Norwegian-owned banks. The establishment of a mortgage company and KfS may help to reduce or curb liquidity risk for savings banks. The introduction of rules and regulations concerning asset-backed bonds will probably lead to other banks’ rapidly establishing and transferring housing loans to mortgage companies. This would contribute to a reduction of liquidity risk.

Overall assessment of the risk outlook for banks

The low interest rate level and increased economic growth have contributed to strengthening the debt-servicing capacity of borrowers. In the short term, banks’ credit risk associated with households is relatively low, and somewhat reduced since Financial Stability 2/2003. Credit risk associated with loans to the corporate sector varies from one industry to the next, but on the whole it is moderate and somewhat lower than in Financial Stability 2/2003. Banks’ market and liquidity risk is assessed as being approximately unchanged compared with six months ago. Banks' risk picture is therefore somewhat improved in the short term. At the same time, the sharp rise in debt has made households more vulnerable to economic disturbances. A sudden debt consolidation among households would reduce the earnings and debt-servicing capacity of many enterprises. Households’ high debt growth may therefore be paving the way for higher loan losses in the longer term. Greater household vulnerability is thus an uncertainty factor for developments in the economy and in banks

Box:

Loan loss provision rate and loan losses

Banks’ loan losses are ultimately determined by two factors: the size of the loans that borrowers cannot service and the portion of these loans that is lost. The latter depends on banks’ collateral and borrowers’ future debt-servicing capability.

Banks’ problem loans comprise defaulted and doubtful loans. Defaulted loans are loans that have not been serviced within 90 days after the due date. Doubtful loans are loans where no formal default has occurred, but where the banks expect to incur losses. The number of problem loans fell after the banking crisis at the beginning of the 1990s, increased somewhat again in 2002 and was slightly reduced in 2003 (see Chart 1). Specified loan loss provisions are calculated losses on problem loans. In recent years, total calculated losses have accounted for approximately 30 per cent of problem loans, compared with just below 50 per cent in 1993.¹

Chart 1

Loan loss provisions are on average higher for enterprises than for households. The loan loss provision rate for enterprises was 34 per cent at end-2003, compared with about 90 per cent in 1992 during the banking crisis. For the household sector, the loan loss provision rate has remained relatively stable at around 20 per cent.

For enterprises in particular, it is reasonable to expect a positive relationship between the extent of problem loans and banks’ loan loss provision rate. Real estate is often used as loan collateral. Loan default figures are usually high during a downturn. Prices for commercial and residential property will then often fall, resulting in a decline in the value of banks’ collateral.

While loan loss provisions express what banks at any given time expect to lose on problem loans, losses in banks’ profit and loss accounts (recorded losses) express the amount to be charged against the accounts for the period. Recorded losses are mainly determined by loan loss provisions for new problem loans and corrections of loss estimates for previous periods. While losses on new problem loans will always have a positive value, reassessments of previous loss estimates can be both positive and negative. A downward revision of loss estimates on some loans will be regarded in the accounts as income.

Recorded losses for the DnB Group for the years 1989-2003 show the effects of changes in loss estimates (see Chart 2). Losses were highest in the banking crisis years, reaching a peak in 1991, while losses on new problem loans were highest in 1992. Reassessment of loss estimates contributed to increasing recorded losses in the years 1990-1993, but contributed to reducing loan losses in the subsequent period.

Chart 2

Bank losses will increase most sharply if new problem loans and the loan loss provision rate both increase. There is currently a relatively low level of problem loans and the effect on total bank losses of an increase in the loan loss provision rate for these loans will therefore be limited.

3.3 Other financial institutions

Norwegian banks have entered into alliances or become part of financial conglomerates that also include other financial institutions (see Tables 5 and 6 in Annex 1). Developments in other financial institutions may therefore have an impact on the banks. Developments in mortgage companies, finance companies and life insurance companies are assessed below. For many banking groups, the most important developments outside banking are taking place in the life insurance sector.

Mortgage companies

Mortgage companies provide long-term mortgage loans to enterprises, municipalities and to some extent to individuals. Many mortgage companies have specialised in providing loans to commercial property companies. Fokus Kreditt has gained an increasingly prominent role as mortgage provider in the Fokus group. Many mortgage companies are to a large extent financed through loans from their owners, and the share of this type of financing has increased markedly in recent years (see Table 3.7). On the other hand, the share of bond funding has declined.

Table 3.7

For the last twelve months to the end of the first quarter of 2004, mortgage companies’ lending growth was 16%. Profits, net interest income and other operating income for mortgage companies remained approximately unchanged from 2002 to 2003 measured as a percentage of ATA (see Chart 3.15). The low interest rate level, however, contributed to a decline in net interest income in the first quarter of 2004 compared with the same quarter of 2003. Recorded loan losses have been very low for a number of years. As a result of strong lending growth, the Tier 1 capital ratio fell from 10.2% to 9.4% from the first quarter of 2003 to the first quarter of 2004.

Chart 3.15

Finance companies

Finance companies offer short-term loans, factoring and leasing for many different purposes (see Table 3.8). Finance companies are, to a greater extent than mortgage companies, part of financial groups that include banks, but they account for a small portion of these groups’ total assets. Finance companies’ owners are also their most important source of funding. Over the last twelve months to the end of the first quarter of 2004, finance companies’ lending growth was 7%.

Table 3.8

Finance companies’ profits rose from the first quarter of 2003 to the first quarter of 2004 due to increased interest margins and net interest income (see Chart 3.16). This probably reflects less intense price competition in markets in which finance companies operate than in the mortgage market. Recorded loan losses remained approximately unchanged at 0.9% of ATA. The Tier 1 capital ratio increased from 8.9% to 9.2% from the first quarter of 2003 to the first quarter of 2004.

Chart 3.16

Life insurance companies

Life insurance companies’ pre-tax profits before payments to customers improved from 1.2% to 2.5% of ATA from the first quarter of 2003 to the first quarter of 2004. Value-adjusted profits, including changes in the adjustment fund, increased from 1.3% to 4.9% of ATA. The improvement is mainly due to positive developments in both the equity and fixed income markets. Both equity and bond prices have fallen so far in the second quarter of 2004.

Because of earlier reductions in buffer capital, life insurance companies reduced the risk associated with their assets through 2001 and 2002. The equity portfolio was reduced and bonds were redefined from the trade portfolio to investments that are held to maturity. Such bonds are assessed at face value, and their value does not fluctuate in pace with interest rates. Partly due to the rise in equity markets since spring 2003, life insurance companies increased the share of equities and reduced the share of bonds and short-term paper in the trade portfolio up to the first quarter of 2004 (see Table 3.9). The portion of bonds held to maturity has increased further. Life insurance companies’ buffer capital improved from 3.4% to 5.7% of total assets from the first quarter of 2003 to the first quarter of 2004.

Table 3.9

Box:

A more robust securities settlement system

Securities settlement is a system to settle amounts outstanding, in the form of securities or cash, in a securities transaction. This system is regarded as an independent payment system. The central banks of the Group of Ten countries have published guidelines for assessing when a payment system should be considered systemically important.¹ The main focus is on volume. The cash leg of security transactions is, however, typically regarded as systemically important even when volumes are moderate. One important reason for this is that an unpredictable and inefficient securities settlement system can undermine participants’ confidence in the securities market. A number of international recommendations for securities settlement have been drawn up to ensure efficiency and financial stability.² The new Act relating to the Norwegian Securities Depository, which entered into force on 1 January 2003, has brought the Norwegian system more into line with international recommendations. The Norwegian Central Securities Depository (VPS) and Norges Bank have followed up the Act and cooperated on modernising their systems.

In Norway, a joint settlement system is used for equity instruments, bonds and short-term paper, referred to as the securities settlement system (VPO). In addition to Norges Bank, 17 banks and 22 brokers currently participate directly in the VPO. The process from an investor’s decision to trade securities through to final settlement of the trade is called the securities chain. The chart illustrates a trade initiated by a broker on the Oslo Stock Exchange between a buyer (B) and a seller (S), with both the securities and the cash leg of the transaction settled in the VPO.³ nvestors who wish to trade securities on the Oslo Stock Exchange must have an account with a broker and a bank, as indicated at the top of the diagram. A securities transaction is initiated when a broker places a trade order on the Oslo Stock Exchange, either for own account or on behalf of an investor. After the trade has been concluded on the Stock Exchange, the buying and selling brokers must report the trade for settlement in the VPO.

To simplify, we have presented the VPO process in the chart in three stages. In the first stage, banks must earmark funds prior to each settlement. The brokers’ financial positions in the VPO are settled over the banks’ accounts in Norges Bank on the basis of agreements between bank and broker. The next stage in the process is that the VPS clears each participant’s position in the settlement. Amounts outstanding between participants are offset, so that a net position for each security and a net position in NOK are calculated for each participant. Total net cash positions in the VPO averaged around NOK 5bn per day in the first quarter of 2004. Total stock market turnover of equity instruments, bonds and short-term paper averaged more than NOK 20bn per day in the same period. In the final stage of the VPO process, the cash positions are settled in Norges Bank and the VPS enters the transactions in the securities accounts. After the securities settlement is completed, a cash settlement is made between investors, brokers and banks, as shown at the bottom of the chart.⁴

Chart

Under earlier legislation, changes in securities accounts in the VPS were made only once a day. Settlement was therefore only executed once a day (every morning). Under the new Act, rights in the VPS are legally binding as soon as registration is completed. This makes it possible to execute several settlements in the course of the day. The VPS and Norges Bank decided to introduce two settlements a day (early and late morning). Previously, net positions for the following day’s settlement were calculated by the VPS even though it had no information about participants’ financial cover. There was therefore a possibility that the settlement would not be approved in Norges Bank’s balance check the next morning. Even though Norges Bank never had to reject a settlement, delays while brokers obtained more liquidity were not unusual. The delays created uncertainty as to whether and when the settlement would be executed. This problem has now been solved by requiring banks to earmark funds for this purpose. Transactions with inadequate cover are postponed to the next settlement. Thus, settlements are now executed at fixed times of the day. The VPO has thus become more predictable and more in line with international recommendations in this area.

The principle of protecting participants against credit risk by only releasing payment if the securities have been delivered and vice versa is continued in the modernised VPO. All securities trading entails a certain degree of market and liquidity risk, however, depending on whether the seller can deliver securities and the buyer can produce payment on the agreed settlement day. The standard settlement day within the industry is three days after the trading day. The portion of trades that are settled on the agreed day in the VPO has increased from around 80% at the end of the 1990s to the current level of 97%. Today, trades for which cover is lacking in the early morning will be postponed until the late morning settlement, providing another opportunity for settlement on the agreed day. The introduction of a late morning settlement has made it possible to choose settlement on the trading day. One advantage of this is that investors’ exposure to market and liquidity risk is more short-term than in a standard settlement. A disadvantage is that brokers have little time to raise cover for the settlement. Nevertheless, participants in the VPO now have a wider range of choices, and this contributes to increased settlement efficiency.

A securities lending scheme has been linked to the VPO since 1999. The purpose of the scheme is to allow participants that lack securities cover for a settlement to borrow securities so that trades can be settled on the agreed day. So far, only foreign lenders have participated in this scheme. This is because securities lending by Norwegian market participants is taxed in the same way as realisation, making securities lending unattractive. These tax rules were amended with effect from 1 January 2004, providing scope for increased liquidity in the lending scheme.⁵

The new Act relating to the Norwegian Securities Depository provided the basis for a modernisation of the collateralisation system in the VPS. Two-thirds of the securities used by banks as collateral for loans in Norges Bank are collateralised in the VPS. This collateral may now be changed through the day with immediate legal effect. This provides greater flexibility for banks’ borrowing from Norges Bank and reduces the risk of liquidity shortages for the banks.

All in all, the above measures have brought the Norwegian system more into line with international recommendations in terms of both predictability and efficiency.