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Faroese Banks’ Capital Buffers: A Closer Look

A recent analysis has revealed that large Danish banks have a larger share of loans to corporates than their Faroese counterparts, with IRB risk weights significantly lower than those calculated using the SA method. This is because institutions with IRB authorization often have highly diversified portfolios and a loss history justifying low risk weights.

Impairment Charges and Losses

Despite this, the Faroese banks have posted higher losses and impairment charges than their Danish counterparts since 1996, according to Chart 5. This suggests that if given IRB permission, the Faroese banks’ risk weights would not be as low as those of the Danish SIFIs.

Capital Requirements and Lending

Credit institutions fund their lending with a mix of equity and debt, with binding capital requirements introducing minimum criteria for the share of equity funding. However, an increase in equity makes the institution more resilient to losses on assets, reducing the risk of creditors suffering losses.

Adjusting to Higher Capital Requirements

Banks may adjust to higher capital requirements by:

• Increasing their capital through retained earnings or raising new capital
• Reducing their risk-weighted assets
• Reducing excess capital adequacy

Experience with Basel III in Denmark does not suggest that higher capital requirements have reduced lending.

Faroese Banks’ Excess Capital Adequacy

Despite an increase in buffer requirements, there has been no decline in lending in the Faroe Islands, which has seen an economic upswing. The four Faroese banks are expected to meet the phased-in buffer requirements and systemic risk buffer of 3% from January 2020.

Capital Requirements and Excess Capital Adequacy (Q2 2019)

According to Table 4, the Faroese banks’ primary funding sources are:

• Deposits: 45%
• Equity
  • Share of bank deposits not covered by the deposit guarantee: 45%

This makes them sensitive to risks in the banks.

SIFI Requirements

Systemically Important Financial Institutions (SIFIs) like large Danish banks are subject to additional requirements to reduce the probability of failure and limit negative consequences if they fail. These requirements include a SIFI capital buffer requirement, which aims to ensure that SIFIs have sufficient capital to withstand potential losses.

Conclusion

While the Faroese banks may not be as resilient as their Danish counterparts in terms of risk weights, they are expected to meet the phased-in buffer requirements and systemic risk buffer from January 2020. The banks’ primary funding sources are deposits and equity, making them sensitive to risks in the banks.