Banking Regulations in the Faroe Islands: A Review

Risk Weights and Capital Requirements

In the Faroe Islands, banking regulations have been a subject of interest due to the unique characteristics of the local financial system. One key aspect of these regulations is risk weights, which determine the amount of capital that banks must hold against different types of assets.

• IRB vs SA Risk Weights: Internal Ratings-Based (IRB) risk weights are typically lower than Standardized Approach (SA) risk weights. This means that institutions with IRB authorization can have lower capital requirements.
• Impairment Charges and Losses: However, Faroese banks have posted higher losses and impairment charges than Danish SIFIs since 1996. This suggests that their risk weights might not be as low as those of the Danish SIFIs.

Capital Requirements and Lending

The relationship between capital requirements and lending is often a topic of debate in banking regulations. The text argues that binding capital requirements do not necessarily reduce lending, but rather make institutions more resilient to losses on assets.

• Higher Equity Levels: Higher equity levels allow banks to absorb larger losses before creditors are affected, reducing their risk exposure.
• Reducing Risk Exposure: This makes banks more stable and less likely to fail, even in times of economic downturn.

Excess Capital Adequacy in Faroese Banks

Despite an increase in buffer requirements, there have been no signs of a decline in lending in the Faroe Islands. In fact, all banks are expected to meet the phased-in buffer requirements from 2020.

• Deposits and Equity: The Faroese banks’ primary funding sources are deposits and equity, which makes them sensitive to risks in the banking system.
• Meeting Buffer Requirements: The expectation is that all banks will be able to meet the phased-in buffer requirements without a decline in lending.