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Faroese Banks’ Capital Requirements: A Closer Look

In a move aimed at bolstering financial stability, the Faroese banking system has been subject to increased capital requirements in recent years. According to data from the Danish Financial Supervisory Authority (DFSA), the country’s four banks have seen their minimum common equity capital requirement rise to 8% of risk exposures.

Lending and Capital Requirements

While some might assume that these higher capital requirements would lead to a decline in lending, the experience so far suggests otherwise. Despite an increase in buffer requirements, the Faroese banks have not reduced their lending activities. In fact, the country has seen an economic upswing in recent years.

Funding Sources and Risk Sensitivity

The Faroese banks’ primary funding sources are deposits and equity, with a significant portion of bank deposits not covered by the deposit guarantee scheme. This suggests that they may be more sensitive to risks in the banking system.

Capital Adequacy Ratios

According to Table 4, which provides an overview of the capital buffer requirements and excess capital adequacy of the four Faroese banks as of Q2 2019:

• BankNordik, Betri Banki, Norðoya Sparikassi, and Suðuroyar Sparikassi all have excess capital adequacy ratios above 3%.
• This suggests that they are well-capitalized to absorb potential losses.

IRB Risk Weights

The IRB risk weights for corporate exposures in Faroese banks are significantly higher than those of Danish SIFIs, according to Chart 5. This is an indication that the Faroese banks’ risk weights would not be as low as those of the Danish SIFIs if they were given IRB permission.

Capital Requirements and Lending

The capital requirements introduced by Basel III aim to ensure that credit institutions maintain a minimum level of equity funding to absorb potential losses. Critics argue that these higher capital requirements will lead to reduced lending and increased borrowing rates, as equity is seen as an expensive source of funding compared to debt.

However, empirical evidence suggests that well-capitalized banks are more resilient to losses on assets, which can reduce the risk of creditors suffering losses. This could lead to lower interest rates on bank debt and a lower required rate of return on equity.

Ways Banks May Adjust

In practice, banks may adjust to higher capital requirements in various ways, including:

• Increasing their capital through retained earnings or raising new capital
• Reducing their risk-weighted assets by decreasing lending or changing their asset mix
• Reducing excess capital adequacy

SIFI Requirements

Systemically Important Financial Institutions (SIFIs) are subject to additional requirements to reduce the probability of failure and limit the negative consequences in case of failure. These requirements include a SIFI capital buffer requirement, which is designed to ensure that SIFIs have sufficient capital to absorb potential losses.

Conclusion

In conclusion, while higher capital requirements may seem like a burden on credit institutions, they are an essential part of maintaining financial stability. By increasing their capital adequacy ratios, banks can reduce the risk of creditors suffering losses and maintain lending activities. The experience of Faroese banks suggests that these higher capital requirements have not led to reduced lending, and instead, the country has seen an economic upswing in recent years.