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The Banking Sector in the Faroe Islands and Denmark: Risks and Implications

Risk Weights and Losses

The banking sector in the Faroe Islands and Denmark is subject to various risks, including those associated with lending. One key aspect is the use of IRB (Internal Ratings-Based) risk weights for corporate exposures. These risk weights are lower than SA (Standardized Approach) risk weights, which could indicate that Faroese banks might experience higher losses and impairment charges if granted IRB permission.

Capital Requirements and Lending

Higher capital requirements can have a significant impact on lending activities in the banking sector. On one hand, stricter capital requirements can reduce lending or increase interest rates due to the expensive nature of equity funding. However, well-capitalized institutions are better equipped to meet markets with a lower required rate of return on debt.

Adjusting to Higher Capital Requirements

Banks can adjust to higher capital requirements in various ways:

  • Retaining earnings: By retaining a portion of their profits, banks can build up their capital reserves.
  • Reducing risk-weighted assets: Banks can reduce their exposure to high-risk assets and focus on lower-risk investments.
  • Reducing excess capital adequacy: If banks have excess capital, they can reduce it by paying dividends or buying back shares.

The effects of these adjustments will depend on the institution’s ability to adapt and the financial/economic situation.

Faroese Banks’ Excess Capital Adequacy

Despite an increase in buffer requirements, there have been no signs of a decline in lending in recent years due to an economic upswing in the Faroe Islands. This suggests that Faroese banks have been able to maintain their lending activities despite higher capital requirements.

SIFI Requirements

Systemically Important Financial Institutions (SIFIs) are subject to additional capital buffer requirements to mitigate potential negative repercussions for the economy if they fail. These requirements aim to ensure stability in the banking sector and prevent potential crises.

Conclusion

While higher capital requirements might be expected to reduce lending, there is no evidence of this occurring in the Faroese banking sector. The excess capital adequacy of Faroese banks remains high, and SIFI requirements are in place to ensure stability in case of a potential failure.