Faroese Banks’ Capital Requirements and Lending Practices Under Scrutiny

Differences in Credit Risk-Weighted Assets between Faroese and Danish Banks

A recent analysis has highlighted significant differences in credit risk-weighted assets between Faroese and Danish banks, with substantial implications for their lending practices. The report notes that segments 4 can only be done for credit exposures, while all exposures are included in the total average risk weight.

• Large Danish banks have a larger share of loans to corporates than their Faroese counterparts, which may affect the way they calculate IRB risk weights.
• Risk weights calculated using the IRB approach depend on individual customer circumstances and an institution’s loss history, making them subject to variation over time.

Impairment Charges and Losses

Faroese banks have posted higher losses and impairment charges than Danish SIFIs with IRB authorization 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.

• The report highlights that it is especially on corporate loans that the Faroese banks post higher losses and impairment charges than the Danish SIFIs.

Capital Requirements and Lending

The capital requirements imposed on credit institutions have a significant impact on their lending practices. Higher capital requirements can lead to reduced lending and increased interest rates, as equity is seen as an expensive source of funding compared to debt.

• However, research suggests that this assumption overlooks the fact that an increase in equity makes the institution more resilient to losses on assets.
• In response to higher capital requirements, banks may adjust their strategies by increasing their capital through retained earnings or raising new capital, reducing risk-weighted assets, or decreasing excess capital adequacy.

Excess Capital Adequacy in Faroese Banks

Despite an increase in buffer requirements, there has been no decline in lending in the Faroe Islands in recent years. This is attributed to the economic upswing in the region.

• The report highlights that all four Faroese banks will be able to meet the phased-in buffer requirements and systemic risk buffer of 3% from January 2020.
• The Faroese banks’ primary funding sources are deposits and equity, with a significant portion of bank deposits not covered by the deposit guarantee. This makes them sensitive to risks in the banking system.

SIFI Requirements

Systemically Important Financial Institutions (SIFIs) like those in Denmark face additional requirements to reduce their probability of failure and mitigate negative consequences if they fail.

• These requirements include a SIFI capital buffer requirement, which is designed to enhance the institution’s resilience to economic shocks.
• The report notes that SIFIs have a larger share of loans to corporates than non-SIFIs, which may affect their lending practices.