Liquidity management More capital is important for the solidity of the banking sector. However, we must not forget that the turbulence first translated into a liquidity crisis, as was the case for the UK bank Northern Rock in autumn 2007 when depositors rushed to withdraw their savings. For Norwegian banks, the crisis has essentially been a liquidity crisis. Norwegian banks were affected because they became dependent on market funding. The financial crisis has revealed that substantial short-term money market funding is risky. When it comes from foreign markets, the risk of funding shortfalls increases. In the mid-1980s, Norwegian banks also borrowed heavily in foreign markets. In spring 1986 – following a sharp fall in oil prices – confidence in the Norwegian economy plummeted, and liquidity flowed out of the country as was the case in autumn last year. The funding source that is considered to be the most stable, deposits, has become less important over time. It is our assessment that the funding of Norwegian banks is a structural problem. When the financial crisis is behind us, we expect banks to give increased weight to deposits and long-term loans as funding sources. BIS Review 131/2009  13  The maturity of banks’ market funding should be longer than it was before the financial turbulence. During the financial crisis, investors were reluctant to provide long-term funding and required high risk premiums. Prospects for banks in general have now improved and risk premiums have declined. Strengthening of banks’ equity capital is helping to reduce the risk facing bondholders.

The interlinkages between financial institutions amplify risk in the financial system. In our assessments, it is important to be aware of any build-up of systemic risk. Residential mortgages provide a good illustration of the difference between the individual risk for a bank and systemic risk. Even during the 1990s banking crisis, Norwegian banks’ losses on residential mortgages were low. Today’s low risk weights for residential mortgages provide strong incentives for banks to extend these mortgage loans. However, housing market fluctuations, which go hand in hand with shifts in saving behaviour, are nonetheless a source of business cycle fluctuations and substantial losses when banks have to write off loans to firms selling goods and services to households. 8  BIS Review 131/2009  The Norwegian housing market is vulnerable. Both a high level of tax incentives for house ownership and a large volume of adjustable-rate mortgages contribute to wide fluctuations in activity and prices. 8 The rise in house prices in the past two decades has also been very strong compared with countries where housing bubbles have burst. To finance strong growth in residential mortgages, banks have to rely to a great extent on borrowing, thereby increasing their vulnerability to a liquidity squeeze. Thus, low risk weights for residential mortgages also lead to higher liquidity risk in the banking system as a whole. It is important to be aware of the similarities between developments in the Norwegian housing market and bank lending and developments in the countries most severely affected by the crisis.