Impact of Financial Crisis on the Banking Sector

May 29 2009

Since late 2008 the financial crisis has rapidly weakened the global economy and has
demonstrated that Finland is not isolated from disturbances in the global financial markets.
Although at first the problem was considered to be one of solidity, affecting only a few
companies, it has turned out to be a more widespread problem requiring state involvement.
According to a recent analysis published by the Financial Supervisory Authority in April
2009, the profitability of the banking sector has materially weakened, but loss-bearing
capacity remains fairly solid.

During 2008 the global financial crisis and economic downturn increased uncertainty and
negatively affected the Finnish economy. Finland is a small, export-driven country and the
sharp decrease in export volumes during the latter half of 2008 and the first quarters of 2009
has already had a major impact on industry. National efforts to maintain domestic demand
alone will not bring Finland out of the woods. This is also evident from the European
Commission's May 4 2009 financial forecast which, despite noting signs of stabilization in
the economy, indicates that the indirect impact of the financial crisis may cause significant
risks to the economy and inflation.

The greatest risks posed to banks by the slowdown of economic growth take the form of
credit risks. So far, the number of loans in default is still relatively small, but it is increasing
and is expected to grow two or threefold. The first signs of this can already be seen in the
number of bankruptcies declared, which is rapidly increasing.

The capital adequacy of Finnish banks has also weakened during the past year, but it is still
satisfactory compared to the situation in many other EU countries. Fortunately, Finnish banks
are facing the current turbulence in a relatively healthy condition - the solvency of all Finnish
banks exceeds the statutory requirement of 8%. Regulation and management of the Finnish
banking sector is much more sophisticated than during the previous financial crisis in the
1990s. The banking sector is marked by a renewed sense of caution. Internal risk procedures -
for example, the criteria for corporate and private lending - have been tightened and
enterprises are closely monitored by banks. Although many European countries have already
been forced to provide state aid to banks, Finnish banks have not yet needed such support.

So far in 2009, Finnish banks have reduced their dividends and announced plans to issue new
shares. The liquidity of the Finnish banks and their ability to pay have remained at good
levels. However, profitability is undermined by the continuing reduced income. Furthermore,
banks' funding costs have risen as a result of the crisis. Credit risk premiums are particularly
high for long-term funding and the price for long-term financing has risen as it is in short
supply and is already exceeding demand. As a result, companies are facing liquidity
problems.

The takeover of the three largest Icelandic banks by the Icelandic government was also
reflected in the Finnish branches of these banks. Kaupthing Bank suspended operations of its
Finnish branch in October 2008 in order to protect depositors' assets. The situation was
resolved by a private sector arrangement with the three major Finnish banks (Nordea Bank
Finland plc, OP-Pohjola Group and Sampo Bank plc), which provided for full repayment of
all deposits with the Kaupthing. The Finnish government provided a state guarantee against
the legal risks incurred by the parties taking part in the arrangement. This approach differs
from the solution adopted in other EU countries, as it provides for a more rapid and
convenient recovery for depositors.

The current crisis has clearly demonstrated the importance of risk management. In this
respect, Finland has been vocal in advocating stress tests for the banking sector at a European
level during the first quarter of 2009 in meetings of European financial ministers. Restoring
mutual trust between banks by developing common criteria for stress tests is seen as the only
route to economic recovery.

Despite measures to manage risk in the banking sector and the fairly optimistic forecast of the
European Commission predicting stabilization in the financial markets, there has been
criticism of the authorities' capability in managing the crisis. Critics have observed that the
authorities have again failed to stop an economic bubble bursting, just as happened with the
IT bubble at the beginning of the 21st century. In addition, this time US consumers are not
helping Finland by increasing growth and the employment situation is unlikely to improve in
the short term. The question is whether, in time, the financial crisis will affect the banking
sector more fundamentally.

In fact, the financial crisis has already had a direct impact on the Nordic banking sector. For
example, Finnish bank Nordea has expanded its business into the Baltic region. The Estonian
economic forecast is rapidly deteriorating and the Nordea banks in Estonia are a part of the
Finnish group. Any further credit losses by banks in this area will naturally have a knock-on
effect for their Finnish parent companies.

However, even though Finnish banks in the Baltic region will have to endure some hardship,
it seems unlikely that their solvency will be threatened as, in principle, they operate under the
same lending criteria as in Finland.

The global financial crisis has affected the Finnish banking sector in another respect by
leading to structural changes regarding monetary financial institutions. When Icelandic
market participants withdrew from the Finnish market, new entrants appeared. There was a
temporary suspension of asset transfers of Icelandic banks and a termination of operations of
some other banks (eg, the Finnish branches of Icelandic bank Landsbanki Islands hf and the
British-owned FCE Bank plc). In addition, the Celeres Korko investment fund of Celeres
Fund Management was closed down in February 2008. However, important new entries by
monetary financial institutions included the Finnish branch of Swedish firm TeliaSonera
Finans AB, which commenced operations in January 2008, and the Helsinki branch of JP
Morgan Europe Limited, which opened for business in July 2008. In 2008 there were also
mergers in the monetary financial institutions sector.

The number of monetary financial institutions has remained stable despite the crisis. At the
end of 2008, there were 390 monetary financial institutions in Finland, of which 357 were
credit institutions. In relation to population, there were 15,000 inhabitants for each credit
institution.

Despite the ongoing economic crisis, the Finnish banking sector seems stable. Even though
risk management strategies have been unable to guard against all risks, there appears to be no
immediate danger to Finnish banks. The solid profitability and capital adequacy buffers have
enabled banking and lending operations to continue as usual.

For further information please contact Kalevi Tervanen at Procopé & Hornborg by
telephone (+358 10 3090 300) or by fax (+358 10 3090 333) or by email
(kalevi.tervanen@procope.fi).

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Kalevi Tervanen
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