The IMFs stress testing of the Norwegian financial sector.

• Author: Hagen, Jan

Following a thorough examination of the Norwegian financial system, the IMF concluded in summer 2005 that the system is sound and well managed. (2) Shorter-term vulnerabilities are low. This conclusion is based partly on the results of stress tests of the financial system that were performed by the IMF in cooperation with Norges Bank and Kredittlisynet (The Financial Supervisory Authority of Norway). In this article we provide a more detailed description of these stress tests. We also discuss stress tests and their use more generally.

1. Introduction

   The International Monetary Fund (IMF) monitors the economic policy of member countries and promotes dialogue among the countries on the national and global consequences of their economic policy. Exchange rate policy, monetary policy and fiscal policy have long held a central place in the IMF's surveillance work. However, the series of banking and financial crises in the 1990s, in both developing and industrialised countries, prompted the IMF to pay increasing attention to issues relating to financial markets and the state of the countries' financial sectors.

   The financial crises of the 1990s showed that unstable financial markets could lead to substantial economic costs. Great importance was once again attached to financial stability, as it had been in the interwar years. Financial stability was moved up on the agenda in international organisations such as the IMF, the World Bank and the ECB. The increased weight attached to financial stability formed the background to the establishment of the Financial Stability Forum, in which central banks and supervisory authorities participate. Financial stability was also in focus on the national level, among central banks, supervisory authorities and ministries of finance.

   In the IMF's work to prevent financial market instability through surveillance of the economic policy of member countries, special emphasis was placed on the situation in the financial sector. In addition, the IMF, in collaboration with the World Bank, established a Financial Sector Assessment Programme (FSAP) in 1999. Most IMF member countries have had an FSAP assessment of their financial sectors, including the Nordic countries: Iceland and Finland in 2001, Sweden in 2002 and Norway in 2005. Denmark's assessment will be completed in 2006. No FSAP has yet been carried out for countries like China and the US.

   The purpose of an FSAP is to assess the strengths and weaknesses of member country financial sectors and to assess the challenges facing their financial systems. The IMF's primary focus is on the financial system as a whole, and not on individual institutions. All aspects of the financial system are assessed: markets, financial institutions and financial infrastructure (including payment and settlement systems). The most important sources of risk associated with the macroeconomic situation and the financial situation of households and enterprises are assessed. The resilience of financial institutions to any macroeconomic shocks is of central importance to financial stability, and stress tests play a key part in these assessments. Important structural aspects of the financial system are examined, and great emphasis is placed on an assessment of institutional factors, including responsibilities, cooperation and the framework for oversight of financial stability, regulation and supervision of the financial sector, crisis management and a safety net for the financial sector. Measures that in the view of the IMF will contribute to strengthening the financial system are recommended to the authorities.

   Norway's FSAP assessment was carried out during autumn 2004 and spring 2005. Meetings were held with Norwegian authorities (the Ministry of Finance, Norges Bank and Kredittilsynet) and a number of financial institutions and trade organisations. An important part of an FSAP consists of evaluating the country's compliance with international standards for supervision and regulation of various parts of the financial sector. In Norway's case, supervision and regulation of banks, insurance and payment systems were examined. The IMF's assessment is summarised in an FSSA (Financial System Stability Assessment), which also covers Norway's compliance with these international standards. The report was published in June 2005. In addition, Financial Action Task Force (FATF) conducted an examination in January 2005 of Norway's observance of recommendations for combating money-laundering and the funding of terrorism.

   The assessments of Norway were generally positive. It was concluded that "Norway's financial system appears sound, well managed and competitive and shorter-term vulnerabilities appear low overall". Recommendations were provided in various areas associated with stability, structural issues and institutional conditions (see box).

   Main recommendations following the IMF FSAP assessment of Norway (1) Key short-term stability-related issues: * Continue carefully monitoring the evolution of household debt and the housing market; and examine whether banks have concentrations of exposures to more vulnerable sub-groups of household borrowers. * Given the reduced risk weighting of mortgages under Basel II, carefully consider whether additional capital requirements should be required for banks under "Pillar 2". * Continue to carefully monitor the risk of spillovers, in extreme events, resulting from the two-tier payments arrangements, and examine the scope for increasing the use of collateral in interbank market exposures. * In the securities settlement system (VPO), ensure that measures are taken to reduce market and liquidity risk in the event of a key bank failing to settle. In addition, in the retail payments system, examine the scope for shifting more payments from NICS Retail (Norwegian Interbank Clearing System) to Norges Bank's real time gross settlement system (NBO), and/or introducing more settlement cycles in NICS Retail during the day. * Continue working with other Nordic authorities on the evolving framework for cross-border crisis management and coordination of last resort lending; and domestically, ensure appropriately coordinated contingency plans in the unlikely event of a major problem at the largest, partly state-owned bank. * Formalise more regular high-level meetings between Kredittilsynet, Ministry of Finance and Norges Bank on financial stability issues, and consider establishing a formal tripartite financial stability Memorandum of Understanding on respective roles and responsibilities. Key structural and longer-term issues * Reexamine key aspects of the deposit guarantee arrangements, including whether and how to achieve greater international comparability in coverage levels. * Examine whether the clearing of medium and smaller interbank payments in NICS SWIFT net could be phased out. * Review the continued desirability of state ownership in DnB NOR. In the interim, consider further entrenching commercial autonomy and accountability for the bank through clearly specifying--in law, regulation or at least in a public policy statement--the principles that will be followed with respect to the government's relationship with DnB NOR. Refinements to supervisory arrangements and other technical recommendations * Increase the level of powers delegated to Kredittilsynet in respect of licensing and similar authorisations, and for issuing prudential regulations and supervisory decisions; strengthen and make more explicit some aspects of the regulations relating to, e.g., connected lending, treatment of insiders and enforcement measures; and complete the development of risk management guidelines for various other types of risk. * Formalise and publish supervisory requirements and standards for payments and securities settlement systems, and formalise monitoring, in Norges Bank's Payment System Department, of NBO's compliance with standards. * Further strengthen Norges Bank's risk management arrangements in relation to the collateral it accepts from banks. (1) The recommendations are published on page 6 of IMF (2005). 2. Stress tests

   It is usual to conduct stress tests in connection with an FSAP. The financial crises of the last few decades have shown bow important it is to be aware of the financial system's vulnerability to different types of economic disturbances, or shocks. A stress test is a method that has been developed to identify this vulnerability. Its purpose is to estimate the effect on the result and solidity of a portfolio (for example one or more financial institutions) of extreme--but not implausible--economic shocks. Stress tests were originally developed to gauge market risk, i.e. changes in the value of a portfolio as a result of major changes in market prices for securities or in exchange rates. They were gradually developed to identify all types of risk in a portfolio. Today stress tests are used both in individual financial institutions and, as in FSAPs, to measure the vulnerability of the financial sector as a whole.

   Stress tests are also increasingly used in the authorities' oversight of financial institutions. The supervisory authorities impose increasingly stringent requirements on financial instutions to conduct quantitative tests of the risk associated with their activities. The new Basel rules on banks' capital adequacy emphasises the use of stress tests to identify their vulnerability to various extreme events (see box).

   Stress tests may be designed to examine the isolated effect of an unexpected, major change in a single economic variable, or the effect of an economic shock scenario where account is also taken of the second-round effects of the original shock on the economy. Both types of tests were carried out in connection with the FSAP.

   Basel II and stress testing Basel II, which is expected to apply from 1 January 2007, introduces the use of stress testing in banks (some of the rules will not apply until 1...