tests and scenario analysis provide the intellectual backbone for financial stability reports. stress testing, in particular, has come a long way in recent years. the hkma ’ s requirements on stress testing by banks have been in place for some time. our supervisory policy manual module on stress testing, issued in early 2003, requires banks to have in place a stress - testing programme and to integrate stress testing into their risk management processes. for our own internal purposes we also conduct stress tests by applying a range of shocks to the supervisory data that is reported to us. these shocks take into account various adverse movements in banks ’ liquidity, interest rate and market risk positions. however, the techniques of stress testing are rapidly evolving and are becoming increasingly more sophisticated. the first generation of stress tests simply took a variable and subjected it to a shock. it was basically just a matter of saying " let ’ s see what happens to capital if npl ’ s go to 20 percent. " this type of crude stress test is quite helpful for a sense of how solid the system ’ s capital buffer might be, but it doesn ’ t allow you to take into account second and third round effects. if npls have risen to 20 percent of total assets, then there are likely to be a lot of other things happening in the economy at the same time, all of which could have additional implications for banks ’ financial soundness. as a result, stress testing is moving increasingly in the direction of scenario analysis. this involves economists constructing scenarios for the outlook on gdp, interest rates etc. and tracing through these changes in terms of their impact on the key measures of banking system soundness including profitability and capital adequacy. this approach involves some quite advanced economic modelling techniques and is still in its early days. however, the recent revamp of the bank of england ’ s financial stability report that i mentioned earlier was designed to give a larger role to this type of analysis. a final issue that i ’ d like to discuss is that macro prudential analysis cannot stop with the banking system or at the borders of a particular jurisdiction. in the past it might have been reasonable to think that systemic risk was something that began and ended with the banking system. as long as the banking system was – or at least appeared to be – sound, as central bankers we did not need to worry too much about what happened elsewhere in the financial system or the condition of the corporate sector or the structure of household balance sheets. but this is no

has been followed by slowdown in house prices. growth in household debt has been higher than growth in disposable income for several years now. the household debt burden ( household debt as a percentage of disposable income ) has increased to a historically high level and is expected to rise further. however, the household interest burden ( interest expenses after tax as a percentage of disposable income plus interest expenses ) is still low as a result of the low interest rate level. the interest burden is expected to increase to fairly high levels in pace with a normalisation of the interest rate. still, on the whole, households ’ financial position is strong. the rise in the policy rate so far has not been fully reflected in banks ’ lending rates. intensified competition, especially for mortgages, has dampened increases. banks ’ interest margin has declined during the last decade. falling interest margins have, however, partly been compensated by high lending growth, and banks have so far succeeded in maintaining good results. pre - tax profits as a percentage of total assets have been solid. norwegian banks are solid. due to high growth in lending, capital adequacy ratios for banks as a whole declined slightly in 2005. nevertheless, capital adequacy ratios are still high. under basel ii, capital requirements for credit risk are to be calculated using either the standardised approach or more risk - sensitive internal ratings based ( irb ) approaches. the five largest norwegian banks have applied to kredittilsynet to use the foundation internal ratings based ( fibr ) approach for credit risk. under basel ii, the required level of capital for banks in norway will be reduced. the main reason is that mortgages constitute a substantial part of banks ’ total assets. these loans are considered low risk under basel ii. the reduction in the required level of capital may be substantial for the banks using irb approaches for credit risk, though transitional arrangements provide for a gradual reduction. with solid results in banks, a good financial situation for borrowers and a well functioning financial infrastructure, there appears to be little risk of a crisis in norway ’ s financial system in the next few years. however, the long period of strong debt growth and asset price inflation may be a source of subsequent instability in the economy and in banks ’ losses and results. during an upturn such as the current one, it is therefore important to show vigilance and provide a cushion for weaker cyclical conditions and higher interest rates. within