margins. under basel ii, risk weights on lending are required to reflect differences in risk to a greater extent. risk weights for mortgages, for example, have been sharply reduced. this will lead to a considerable reduction in capital adequacy requirements for norwegian banks. the new rules were introduced in norway in 2007, but it is likely that many banks began to adjust to the effects even before the rules were introduced. this has resulted in a fall in banks ’ interest margins. banks ’ lending margins on new mortgages are estimated at - 0. 05 percentage point at the beginning of october. as mentioned above, the money market rate is clearly higher than the key policy rate as a result of the problems in the interbank market. with normal interest rate formation in money markets, given our key policy rate, lending margins would have been ½ percentage point. norges bank ’ s estimates show how low lending margins on fully secured mortgages could fall when banks have a required return on the equity underlying the mortgages of 15 per cent. lending margins are determined by expected loan losses, the loan ’ s administrative costs, the share of the loan financed by the bank ’ s equity capital, and the required return on equity. in the estimates, it is assumed that expected loan losses and administrative costs will be 0. 3 per cent of the lending volume. the method banks choose to calculate capital adequacy will affect the share of lending that is financed by equity capital. under basel i, the lending margin on fully secured mortgages is estimated to be 0. 9 percentage point. using the standardised approach under basel ii, banks will be able to operate with a lending margin on fully secured mortgages of 0. 8 percentage point. banks using the internal rating - based advanced approach under basel ii, will be able to make the largest reduction in their lending margins. as an illustration, we have assumed that the share of equity capital is 1. 5 per cent. the lending margin on fully secured mortgages could then be 0. 5 percentage point. in conclusion, we should be able to say that the decline in lending margins has probably come to an end. it will come as no surprise if lending margins rise somewhat ahead. it is now likely that a number of banks are not achieving a satisfactory return on new loans. banks may have compensated for this by having low deposit rates. however, as mentioned above, there has been a marked rise in borrowing costs. even if some of the increase should be

. the mezzanine tranches are sold to another special purpose vehicle, which repackages them and issues cdos split into tranches. a third special purpose investment vehicle invests in the senior tranches and obtains its financing by issuing asset - backed commercial paper. the commercial paper is bought by a money market fund, which in turn has received its capital from savers. banks can be involved in all stages of the chain. a bank may have an ownership share in and / or provide credit lines to both the lender and several other types of special purpose vehicles. if problems arise in one of more of the intermediaries, the responsibility easily falls on the bank. us and european banks have also invested in securities issued by special purpose vehicles. an important part of the process is the packaging of mortgages by special purpose vehicles. the senior tranches have a high rating. the subprime mortgage market has thus gained access to funding from insurance companies and other financial institutions that would not otherwise have invested in this market, and credit risk associated with these mortgages has been spread to international financial markets. rising defaults on subprime mortgages resulted in a sharp rise in the yield spread between securities backed by this type of loan and us government bonds. the turmoil quickly spread to other financial market segments. uncertainty arose in banks that were directly or indirectly exposed to losses on loans to subprime borrowers. banks ’ oversight of their own potential losses was poor. it was also unclear to what extent special purpose vehicles would draw on credit lines. a number of takeover companies, known as private equity companies, had difficulty obtaining financing in bond markets for their leveraged buy - outs. as a result, banks that had guaranteed temporary funding for these companies were left holding these loans for longer than originally planned. for both these reasons, banks did not know how much their balance sheets would grow. this created uncertainty as to their own liquidity requirements. banks were also uncertain about the size of potential losses in other banks. information was not available to indicate which banks were exposed to losses in the us subprime market. in addition, it was difficult to pin down the actual risk associated with subprime - related securities. banks became highly reluctant to lend to each other, resulting in a marked increase in risk premia in financial markets. several funds began to lose money on securities that were linked to the us housing market. as a result, customers wanted to redeem their investments. the funds