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Western EuropeMarch 1 2017

Could tax and regulatory reform derail Sweden's strong showing?

Sweden’s banks have survived the recent low interest rate environment and remain profitable. But a payroll tax on financial institutions and ongoing regulatory uncertainty threaten to take their toll. Stefanie Linhardt outlines the likely headwinds.
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Riksdag

Challenged by negative interest rates since February 2015, Sweden’s banks have kept their pricing discipline and, despite strong competition, embraced co-operation to remain profitable. Average return on equity (ROE) ratios are higher than in most western European countries. But with interest rates likely to remain low, planned taxation of the financial sector and an increasing financial impact from regulations, the country's business environment looks set to get more challenging.

Since January 2017, Swedish banks have no longer been able to deduct interest on subordinated debt from their tax bills. Prime minister Stefan Löfven’s government is also planning to levy a payroll tax on the financial sector from 2018. Current proposals are for a 15% tax, which is expected to cost the country’s four largest banks, Nordea, SEB, Svenska Handelsbanken and Swedbank, about Skr2.781bn ($3.12bn) in 2018 (see table).

“There is a view across parties that the financial system in Sweden is undertaxed; rather, the tax environment is very beneficial today,” says minister of financial markets and consumer affairs Per Bolund. “The discussion now is about the appropriate framework and methodology [to tax banks]. The proposal is out on general hearing, to get the views from the affected parties before we can make a general statement of what direction we will move in.”

Payroll tax concerns

While immediate reactions to a payroll tax are unlikely, according to senior bankers across institutions, it could have an impact on future decisions. “The proposal hits not only banks, it hits a lot of companies that engage in financial activities,” says Jan Erik Back, SEB's chief financial officer. “The corporate community has woken up to that fact and a lot of people are protesting against it. The proposal has been ill-constructed.”

Should the move go ahead as planned, the business case for innovation such as further automation and digitalisation would receive a further boost, he adds.

“It would be remarkable to tax employment – very short-sighted,” says Casper von Koskull, president and group chief executive of Nordea, Sweden’s largest bank. “It would have an indirect impact on visions by us and others to accelerate advancements into robotics and other technologies.”

SEB has factored in the additional costs on payroll from 2018, says Mr Back, although a tax on employment would make operating out of its Copenhagen business much cheaper – “not to speak of the Baltics, where we already have a hub”.

Mr Bolund says the decision has been made and a bank tax will be introduced in Sweden, adding that many EU countries have a financial transaction tax, which Sweden does not have.

Impact on Swedish banks

Changing requirements

The Swedish banking system accounts for a large part of the country’s economy, although Swedish bank exposures to the Nordic and Baltic countries individually are more systemic for these countries than they are for Sweden. Still, for this reason, the country’s financial stability authority (FSA), Finansinspektionen, also applies stricter capital requirements to Sweden’s banks than is necessary under international regulation.

“We have a large banking system and it is very concentrated in Sweden’s four largest banks,” says Karin Lundberg, deputy executive director banking at Finansinspektionen. “That is why it is important to have higher capital requirements on the four systemically important banks. That is something we want to be allowed to continue to do.”

Sweden’s banks' capital requirements comprise minimum requirements of 8%, a 2.5% capital conservation buffer, a 1.5% countercyclical capital buffer, and 25% risk floor on Swedish mortgages (see article on regulation to counteract risk from household debt), as well as other bank-specific add-ons plus systemic risk buffers for the four largest banks of 3%, and 2% on pillar two. This puts core equity Tier 1 capital requirements at an average of 19.1% for the big four banks, and total capital requirements at 24.45%.

Sweden’s banks are highly capitalised, at an average of 26.7% across the systemic banks, but Mr Koskull says it is time to shift the focus towards governance and away from today’s “overreliance on capital”.

“If you look at all the things that have been put into place to make the financial system stronger – capital, the resolution regimes, better governance – we have come a long way,” he says. “Now, shareholders and creditors need to take a lot more responsibility. If your governance is bad, it doesn't matter how much capital you have.”

Not all about capital

Although Sweden's regulator swiftly implemented international regulations, a review of Basel III could require further changes, according to Moody’s. The credit rating agency warns that despite Sweden’s banks' high capitalisation, likely alterations to risk weightings under the review could lead to requirements to include higher risk weights. Moody’s suggests the FSA might require the banks to increase their probability of default estimates within their internal ratings-based models, while a need for higher risk weights on assets would lead to banks having to hold more capital to maintain their capital ratios.

According to SEB’s Mr Back, the Swedish regulator has taken a “sensible stance in the Basel IV discussions”, seeking to “protect the risk-based view of the balance sheet” rather than moving to standardised risk weights. “It is good that they stand up for it,” he says. “We [banks] don’t always fight with the regulators as often portrayed.”

“We believe we have achieved a good model, which is risk-based, with capital add-ons for macro-prudential risks, while a large part of the total capital requirements is in the form of buffers that could actually be used if we were in a financial crisis, and we try to be as transparent as possible when it comes to pillar two capital,” says the FSA’s Ms Lundberg. “We will try to uphold those principles, even if we get new regulatory requirements. In practice we can achieve these principles in many different ways.”

Should the Basel Committee on Banking Supervision’s efforts to harmonise risk weights come into force, the Swedish regulator could consider lowering some of its risk-weighted requirements, which are high by international standards, credit rating agency Fitch suggests.

“We have had 10 years of doom and gloom and banker bashing. Now the negative tone has to change because it impacts confidence, which is the only driver of economic activity and growth,” says Nordea’s Mr von Koskull. “We are living in a geopolitical environment with a lot of populism, a lot of fear and anger, and in that environment we are giving the wrong impression of all the things the banking sector together with the regulators has achieved. It is time to change the tone, to stop and calibrate.”

Raising capital

But capital requirements are clearly still at the fore of banks’ minds. Johan Häger, partner at law firm Roschier, notes that financial institutions’ most quoted query is whether to issue more equity or hybrid capital to improve the core capital base. “Ideally, you want to avoid diluting your shareholders through a rights issue, so we are instead considering write-downs of the principal amount for the Tier 1 transactions,” he says.

When it comes to Sweden’s smaller banks, there is a strong reliance on deposits. At Skandiabanken, the country’s seventh largest by assets, only 35% of the funding based is non-deposit, according to chief executive Johanna Cerwall. “We are very conservative in that respect. Our mortgage customers are providing us with a lot of the deposits,” she says. “Our non-deposit funding is only in Swedish krona.”

Roschier’s Mr Häger says targeting deposits can be an attractive and straightforward way for smaller banks to get “quite a lot of funding at an attractive price”, despite negative interest rates of 0.5% since February 2016. Banks are now also returning to securitisations to raise capital, which can be cheaper than competing for deposits. These transactions are now done with special purpose vehicles (SPVs) located onshore rather than in frequently used Jersey.

Sweden’s FSA is currently analysing risks in the new securitisation transactions as well as regulatory requirements to do with SPVs. “It shows that securitisations are very much back on the table today,” says Mr Häger.

As well as traditional securitisations, synthetic ones to offload risk have also been reintroduced in Sweden in the past year. In August 2016, Nordea sold a €8.4bn securitised portfolio of corporate and small and medium-sized enterprise (SME) loans, improving the bank’s common Tier 1 equity ratio by about 40 basis points. No other Swedish bank has so far followed suit but Roschier has “had discussions with other banks and participants in the market” about this method.

Strong ROEs

At an average ROE of 15% across the four largest banks, profit retention could be seen as the easiest way to bulk up capitalisation. But the comparably high returns are a trademark for Swedish banks, which pride themselves in paying healthy dividends to shareholders.

But how are Swedish banks keeping these profit levels at ultra-low interest rates, which have been negative since February 2015? According to Fitch, Sweden’s banks follow a “strong loan and deposit pricing discipline”, which – supported by cheap wholesale funding – kept net interest margins resilient in 2016.

“We are not changing the bank dramatically to counteract negative rates,” says SEB’s Mr Back. “We have expanded our mortgage footprint and have repriced them along with the market. We have done the same with loans to SMEs and mid-caps and worked on margins there.” SEB sees its bancassurance business as an area for further growth and seeks to reinforce its traditionally strong position with corporate clients.

Another area of profit generation across institutions is Sweden’s very buoyant mortgage market.

Swedish banks also have low cost-to-income ratios (CIRs), despite following different models. Handelsbanken, a traditional retail bank, which puts the emphasis on branches, for example, reported an ROE of 15.14% and CIR of 33% on its Swedish branches in 2016.

“It is one of the myths in the industry that a large branch network is expensive,” says Anders Bouvin, Handelsbanken president and group chief executive. “Our branches aren't a cost, they are income. It allows our head office to be smaller and our hierarchy to be flat.”

Despite competition within the Swedish market, banks are also co-operating to keep the cost base low – for example, in fintech. Some 11 banks joined together in 2003 to work on a common electronic identification system. The so-called BankID works as an underlying identification system for banks’ mobile banking applications, and is also used by other companies, authorities and the public.

Banks also share Bankomat-branded cashpoints, a joint venture launched in 2010 between Danske Bank, Handelsbanken, Nordea, SEB, Swedbank and Sparbankerna, which removed the need to operate and service separate machines.

Meanwhile, Skandiabanken has not had a branch network since it opened in 1994, operating purely digitally and offering a “totally transparent mortgage-lending model”, according to Ms Cerwall. “With us, the customer does not have to negotiate their interest rate like with many other banks. We calculate the rate depending on the amount of savings and loan to value you have in accordance to our rules.”

All change ahead?

While the negative rate environment in Sweden is not expected to change this year, Fitch expects to see some gradual improvement in lending margins in 2017 in both mortgage lending and corporate portfolios, “as the additional cost from stricter rules around risk-weight calculations introduced last year is gradually passed onto borrowers”.

But with US president Donald Trump talking about ending international co-operation on financial market regulation, the future is uncertain. With key regulation such as the US Dodd-Frank Act in the firing line, questions have been raised over what impact this could have on the regulatory environment for banks in Europe.

“Even if we were to get a level playing field in Europe, there is the debate of what the Americans are going to do,” says SEB’s Mr Back. “What is going to happen to Basel IV, to Dodd-Frank? Of course, if the Americans back out of a lot of these regulations, Europe will need to think again, too.”

Faced with prospective deregulatory moves from the US, European politicians and regulators are seeking to keep a strong hand.

“We have just gotten out of the last financial crisis and remember the dramatic effects it has had,” says Mr Bolund. “I am concerned that memories seem to be so short and that we don’t see the need for regulation that gives us a stable financial sector on a global scale. I would have imagined that is something we could agree on. I hope there will be a response also from within the US when it comes to these issues.”

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Read more about:  Regulations , Western Europe , Sweden