In S&P Global Ratings' view, Nordic banks' risk-adjusted capitalization remains robust and a key rating strength. The banks' average S&P Global Ratings' RAC ratio was 12.8% at year-end 2019 compared with 12.0% at year-end 2018, and we project a ratio of 12.5 % on average in 2020.

Key capital assumptions for 2020 include:

• Increased risk-weighted assets (RWAs) due to increased lending to corporates, and muted demand from retail customers.
• Resilient net interest income on the back of volume growth.
• Weaker net fee and commission income and materially higher costs of risk will out pressure on earnings this year.
• We assume banks will pay out dividends for 2019 once allowed by regulators, and we therefore continue to deduct them from our capital measure.

At year-end 2019, all Nordic banks demonstrated RAC ratios above 10%, reflecting strong or very strong capital according to our criteria. Unsurprisingly, the Nordic weighted-average ratio continues to outperform that of the European top-50 largest banks and many other global peers, by a large margin of 2-3 percentage points.

High Capital Levels Contribute To Stability Amid Economic Uncertainty

Although not immune to its effects, we believe Nordic banks are well-prepared to withstand the COVID-19 pandemic, especially elevated loan loss provisions that will have an adverse impact on profitability this year. In particular, their strong capitalization, supported by solid earnings and low-risk operating environment, distinguishes the region from the rest of Europe.

In the Nordics, banks have generally high capital requirements, which might curb lending capacity expansion in times of distress, and we note that Nordic countries' financial authorities have been quick in responding to the economic impact of COVID-19:

• The banking regulators in Denmark, Iceland, Sweden, and Norway have relaxed the countercyclical buffer requirements for domestic lending; thereby freeing up lending capacity. Denmark lowered the buffer to zero (from 1%), as did Iceland (from 2%) and Sweden (from 2.5%), while Norway lowered it to 1% (from 2.5%).
• Finland has not activated a countercyclical buffer, but the Finnish Financial Supervisory Authority lowered banks' capital requirements by decreasing systemic risk buffers.

Furthermore, suspension or postponement of 2019 dividends in line with regulators' recommendations will help form a material cushion against potential losses, and will ensure continued stable lending in the Nordic economies. However, we still expect banks' earnings, asset quality, and in some cases capitalization, will weaken through 2020 and into 2021.

During 2020, we have taken a more conservative stance on overall banking industry risk in Iceland (see "Three Icelandic Banks Downgraded On Weaker Business Prospects And Effect Of COVID-19; Outlooks Stable," published April 24, 2020, on RatingsDirect), and remain more cautious regarding Finland's banking system (see "Seven Finnish Banks Outlooks Revised To Negative On Deepening COVID-19 Downside Risks", published May 19, 2020). Our view of banking markets' relative riskiness is unchanged for Denmark, Sweden, and Norway. We continue to view trends in these three countries as stable (see "COVID-19: Resilient Fundamentals And Assertive Policy Measures Will Buoy Nordic Banking Systems," published June 16, 2020).

Nordic Banks Built Up Further Capital In 2019

At a system level, slightly positive changes in average RAC ratios at year-end 2019 compared with 2018 stem mainly from our changed view of economic risk in Denmark. We now view economic risk in the Danish banking sector as low, and more in line with that of the broader Nordics. Our assessment reflects our view of improved fundamentals, such as reduced private sector leverage to GDP and moderate price developments in the housing market. As a result, the associated S&P Global Ratings' risk weights for Danish exposures in the RAC framework were reduced to levels similar to those of Sweden, Finland, and Norway, resulting in structurally improved RAC ratios for the five Danish banks-- Danske Bank A/S, Nykredit Realkredit A/S, Jyske Bank A/S, DLR Kredit A/S, and Danmarks Skibskredit A/S.

Chart 1

Other Nordic banks that saw more than a one percentage point change in their RAC ratio in either direction in 2019 included the following:

• Arion Bank: RAC ratio decreased mainly due to capital optimization measures such as extraordinary dividends and share buybacks.
• Bank Norwegian AS and Sparbanken Sjuharad AB: Increased due to a strong capital build up.
• Central Bank of Savings Banks Finland PLC: Increased because of capital build up, reduction of operational and market risk, and falling risk weights within retail exposures.
• Eiendomskreditt AS: Increased due to categorization of some commercial real estate exposures within our RAC model.
• Islandsbanki hf: Decreased because of a slight increase in total-adjusted capital, although S&P Global Ratings' RWAs increased at a faster rate, which was mainly due to loan book expansion and increases in market and operational risks.
• Oma Savings Bank PLC: Decreased because of fast loan growth and increases in trading book exposures, which led to higher S&P Global Ratings' RWAs.
• Storebrand Bank ASA: Increased thanks to internal capital generation, in addition to additional issued hybrid instruments.
• Svenska Handelsbanken AB: Increased following capital increase through earnings retention and lower S&P Global Ratings' RWAs, leading to a RAC ratio above 10%.
• Swedish Export Credit Corp.: Increased due to reduced credit risk weights, particularly due to changes in corporate and institutional exposures.

Weaker Economic Recovery Leaves Some Banks Sensitive To Downside Risk

For banking industries that entered this crisis with structurally weak profitability, such as many in Western Europe, one long-term consequence of the pandemic will likely be that interest rates will stay even lower for even longer, tilting earnings prospects to a more negative bias. This could occur even if asset quality deterioration remains contained or short-lived on the back of support measures.

Since the start of the pandemic, we have revised our view on several European banking systems because we believe the damage caused to European economies, household wealth, and various corporates sectors could increase economic risk in the region. Particulary relevant in the Nordics is our negative view of economic risk trend in Finland and Iceland, but also Nordic banks' direct exposure to the U.K. and continental Europe. This could impact our assessment of their RAC ratios if, for example, we were to simultaneously increase the economic risk score in our BICRA for banking sectors with a negative economic risk trend (the U.K., Germany, France, the Netherlands, Belgium, Finland, and Iceland). As demonstrated in the chart below, under this scenario, Finnish and Icelandic banks' RAC ratios would suffer the greatest impact due to increased RWAs in their domestic exposures. However, a few of the larger Nordic banks could see meaningful changes in their RAC ratios due to their material exposures to economies with negative economic risk trends.

Chart 2

We Expect Cost Of Risk Will Rise Through 2021

It is clear that COVID-19-induced turmoil will have a material negative effect on Nordic banks' asset quality and profitability for 2020-2021, and is likely to markedly increase the banks' cost of risk in the medium term from historically low 2019 levels.

However, we expect provisioning needs in 2020 and 2021 will remain lower than those in most European markets. We expect most Nordic economies will show some resilience, supported by the countries' sizable COVID-19 response packages and the region's robust social safety nets (for more information, please see "COVID-19: Resilient Fundamentals And Assertive Policy Measures Will Buoy Nordic Banking Systems," published June 16, 2020).

Chart 3

In our opinion, the most exposed banks are those with corporate- and small and medium enterprise-dominated loan books, and concentrations in the hardest hit sectors such as leisure, transportation including shipping, retail trade, and commodities. Although we generally expect the pandemic will have only a limited effect on retail exposures, at least in the short term, we believe unsecured consumer loans will be sensitive to changes to furlough and medium-term unemployment. This will amplify problems for banks whose earnings are already under pressure.

Chart 4

Provisioning levels for the larger Nordic banks in the first two quarters of 2020 were scattered, in our view. As per the new International Financial Reporting Standards 9 (IFRS9) accounting rules, the banks' provisioning models stem from internal assumptions and banks are allowed to make material judgement calls. Although the IFRS9-models aim to build loan loss reserves for troubled exposures at an earlier stage, they also limit the comparability of banks' asset quality and provisioning. Different assumptions related to macroeconomic scenarios, future stage transfers, and individual assessments complicate banks' comparability in first-half 2020. We believe this opacity will fade, but, in the meantime, remains a challenge.

Still, the cost of risk trend (new loan loss provisions to customer loans) is a better indicator of the potential impact of the COVID-19 pandemic in 2020 than nonperforming asset (NPA) ratios, which have remained quite stable until now. Stable NPA ratios reflect the lagging nature of corporate defaults, material policy measures supporting the real economy, some temporary relaxation in bankruptcy laws, and the high degree of payment holidays offered by banks. We believe these factors temporarily inhibit transfers from Stage 2 to Stage 3 (our definition of NPAs under the IFRS9 accounting standards).

Chart 5

Stable Core Earnings Protect Banks Against COVID-19 Impact

In second-quarter 2020, preliminary economic indicators in the Nordics show gradual normalization of the private sector consumption and, to some extent, a milder drop in economic activity than expected. Than banks' first-half 2020 results could be an indication of earnings development for full year 2020, although the different provisioning strategies might still mask some of the impact. Overall, the large Nordic banks performed better than we expected because the dip in fee and commission income was not as severe as we anticipated. For example, despite the lower consumption affecting card payments, the activity recovered almost to pre-crises level by summer and the banks' mutual fund business continues to be supported by market recovery and continuous asset inflow.

Chart 6

We expect Nordic banks will, in the most part, be able to manage the overall impact of the pandemic. The banks' profitability continues to outperform that of the European peers and should support continued robust capital levels. In 2019, the weighted average return on equity for Nordic banks equaled 10.6% compared with estimated 5.9% for the top-50 European banks. Despite the low interest rate environment, Nordic banks have countered pressure on net interest income with profitable volume growth, and have strengthened their noninterest income, in particular through asset management and their mutual fund and insurance businesses. The strong focus on cost efficiency and continuous investments in digitalization will also help the banks keep costs under control and well below the European average level, which will support profitability despite the expected pressure on revenue over the next two years.

We acknowledge a high degree of uncertainty about the evolution of the coronavirus pandemic. The consensus among health experts is that the pandemic may now be at, or near, its peak in some regions but will remain a threat until a vaccine or effective treatment is widely available, which may not occur until the second half of 2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings).

As the situation evolves, we will update our assumptions and estimates accordingly.

Related Criteria

• Risk-Adjusted Capital Framework Methodology, July 20, 2017
• Banks: Rating Methodology And Assumptions, Nov. 9, 2011
• Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011

Related Research

• Svenska Handelsbanken 'AA-/A-1+' Ratings Affirmed On Strengthened Capitalization Balancing Rising Risks; Outlook Stable, July 22, 2020
• COVID-19: Resilient Fundamentals And Assertive Policy Measures Will Buoy Nordic Banking Systems, June 16, 2020
• Bank Regulatory Buffers Face Their First Usability Test, June 11, 2020
• How COVID-19 Is Affecting Bank Ratings: June 2020 Update, June 11, 2020
• European Banks Count The Cost Of Inefficiency, Oct. 22, 2019
• Risk-Adjusted Capital (RAC) For The Top 50 European Banks: September 2019, Sept. 26, 2019