Financial Stability 2/2003
1 International developments and Norwegian securities markets
1.1 The global picture
1.2 Continued large financial imbalances in the US
1.3 International banking industry
1.4 International securities markets
1.5 Securities markets in Norway
Boxes:
- Global house prices and credit growth
- Market-based indicators of banks' financial position
Global developments influence the Norwegian financial sector through several
channels, via both the real economy and financial markets. Developments in
the global economy have an impact on growth, the krone exchange rate and interest
rates in Norway. This in turn has an influence on Norwegian enterprises and
households, and thereby banks’ lending portfolios. Norwegian securities
markets are influenced by developments in international securities markets.
Banks are influenced by developments in securities markets through changes
in income derived from trading on their own behalf or on behalf of customers.
Developments in securities markets and in the international banking industry
also affect Norwegian banks’ funding costs.
1.1 The global picture
This summer and autumn, international financial markets have been characterised
by increased confidence in an economic upswing. Since the trough was reached
in March 2003, equity prices have climbed some 25-35% in the largest markets
(see Chart 1.1). The increase in bond yields in recent months (see Chart 1.2)
reflects confidence in higher growth, but the immediate effect of the fall
in prices is a loss of wealth for bond owners. Macroeconomic indicators in
a number of countries show a more positive trend than has been the case for
a long time, and corporate results have generally improved. Both sovereign
states and individual enterprises are therefore considered to be less risky
borrowers now than was the case only a short time ago. This positive trend,
however, is vulnerable to a swift correction of financial imbalances. There
is uncertainty associated with a sharp rise in debt and house prices in many
countries and to movements in bond prices. The greatest uncertainty, however,
is associated with the large current account deficit in the US and possible
consequences for global economic developments and the financial system if
the value of the dollar should abruptly depreciate further.
Chart 1.1 Chart
1.2
1.2 Continued large financial imbalances in the US
The US is expected to record a current account deficit equivalent to about
5% of GDP this year. With the exception of three quarters in 1991-1992, the
US has had a continuous deficit over the past 21 years. In 2002, the country
had a net foreign debt corresponding to 25% of GDP.
Asian countries’ purchases of US securities are now to an increasing
extent financing the US current account deficit (see Chart 1.3). While until
recently the current account deficit was due to low private saving, it is
now a rapidly rising budget deficit that is the main factor. Foreign investors
are now primarily buying government securities, while earlier they bought
private securities. It is particularly central banks in countries with a large
trade surplus and, in part, high capital inflows that are building up large
foreign exchange reserves through interventions. The purchases are being made
either to counter an appreciation of a floating currency or as a result of
a fixed exchange rate regime. China, Taiwan, Japan, South Korea and India
increased their foreign exchange reserves by a total of USD 444bn between
January 2002 and end-September this year. Most of the reserves are denominated
in dollars.
Chart 1.3
The US dollar has depreciated (see Chart 1.4), which is contributing to reducing
the US current account deficit. If purchases of US government securities decline,
it will be more difficult to finance the budget deficit, possibly resulting
in a rise in long-term interest rates in the US. In recent years, economic
growth in the US has been sustained by private consumption, fuelled by rising
house prices, low interest rates and tax cuts. As a result of the fall in
long-term interest rates, households have undertaken extensive refinancing
of their home mortgages and, at the same time, increased the loan-to-asset
value ratio (see Chart 1.5). Gross housing wealth is accounting for a steadily
higher share of total household wealth. Following a long period of high debt
growth and low saving, household consumption in the US is not very robust
to a fall in the housing market or an increase in interest rates.
Chart 1.4 Chart
1.5
1.3 International banking industry
Improved results for banks in Europe and the US
For several years, subdued economic activity and large losses on loans and
other claims on the telecom sector have contributed to low profitability and
substantial loan loss provisions in large parts of the European banking industry.
In mid-2003, however, many banks’ financial statements showed improved
results and a decline in loan loss provisions. This also applies to a number
of banks in the Nordic countries. These have the largest potential spillover
effect on the Norwegian financial industry through subsidiaries, branches
and other activities focused on Norway. The European banking industry is vulnerable
to weaker-than-projected cyclical developments. This autumn, the risk premium
on bonds issued by financial institutions in the euro area has increased relative
to the corporate sector as a whole (see Chart 1.6).
Chart 1.6
Banks in the US have shown substantially improved results. Pre-tax profits
increased by 11% in the second quarter of 2003 compared with the same period
one year earlier, and the default rate has fallen markedly (see Chart 1.7).
US banks have fared well through the period of falling stock markets, and
have recorded considerable earnings on their securities positions over the
past year.
Chart 1.7
New measures to strengthen Japanese banks
In general, Japanese banks have low equity capital and large portfolios of
non-performing loans, even though the latter has declined somewhat (see Table
1.1). Deflation has increased enterprises’ debt burden in real terms,
but low interest rates mean that a number of enterprises can service their
loans despite weak earnings. As a result of bank’s exposed positions,
their capacity to extend new loans to the large number of small and medium-sized
enterprises is limited.
Table 1.1
The authorities are now supporting measures whereby banks’ lending portfolios
are being sold to companies that issue securities based on these lending portfolios.
The objective is both to promote a better securities market for financing
enterprises and to strengthen banks’ balance sheets. The central bank
has announced that it will be able to purchase such securities for up to JPY
1000bn (about NOK 63bn). Since autumn 2002, the central bank has also made
substantial equity purchases from banks in order to reduce their exposure
to the stock market.
More than half of the core capital in the largest banks consists of deferred
tax assets, which cannot function as a buffer against losses in the short
term. The IMF has estimated that a 20% drop in the stock market or a 3 percentage
point higher write-off of loan losses will result in the loss of all equity
capital, except tax credits, in the largest banks. In May 2003, the Japanese
government injected new capital into one of the country’s largest banks
after the rules on the recording of tax credits were tightened. Private ownership
was maintained.
Global house prices and credit growth
The housing market is of considerable importance to financial stability.
Dwellings normally account for the largest wealth component for households.
A rise in house prices may lead to an increase in households’ home
mortgages, both because it is more expensive to buy a dwelling and because
they borrow more in connection with refinancing. In many countries banks
are the most important source of financing for house purchases. Mortgages
are usually provided with the dwelling serving as collateral. Banks are
therefore vulnerable to a decline in house prices. Banks also have exposures
to the construction sector. A fall in house prices may result in lower construction
activity, excess capacity and weaker results in the industry. This will
increase banks’ credit risk.
For a long time, statistics on house prices have not been readily available
or very comparable. As a result of an increased focus on financial stability
in recent years, a number of countries have initiated projects in order
to compile and publish statistics on the housing market.1
1 For example, the
German central bank has recently published national house price indices
for the first time, cf. article in the central bank’s
Monthly
report for September 2003.
Chart 1 shows changes in indexed nominal house prices in selected countries
since 1995. In the UK and Norway, house prices have risen sharply. In the
last three years, however, the rate of increase has been far stronger in
the UK than in Norway. The US index is somewhat flatter, but has nevertheless
risen by more than 50% since 1995. Germany and Japan have experienced the
opposite, with stable or falling house prices throughout the period.
Chart 1
Countries that record a sharp rise in house prices also have high growth
in total domestic credit (see Chart 2). Among the countries examined here,
only Germany and Japan have recorded low or negative credit growth. The
positive relationship between the rise in house prices and credit growth
also applies to earlier observation dates. Norway is an example of a country
where credit growth remains high even after house prices level off. In the
period from 2000 to 2003, the 12-month rise in house prices fell from 17%
to about 2%, while the 12-month growth in credit remained more stable at
about 9-12%. One reason for continued high credit growth is the preceding
period of sharp increases in house prices, which often results in an increase
in the loan-to-asset value ratio in connection with a change in ownership.
In addition, housing turnover has remained buoyant. This is discussed further
in section 2.2.
Chart 2
1.4 International securities markets
Rally in stock markets
Equity prices have risen substantially since this spring in the US, Europe
and Japan (see Chart 1.1), although they have fallen again recently in Japan.
The broad-based rise primarily reflects an improved economic outlook, partly
as a result of record-low interest rates in many countries. Very low interest
rates have also resulted in lower returns on alternative investments. The
gains in stock markets improve financial institutions’ balance sheets
and enterprises’ access to new funding and potential growth. Following
a lengthy decline in equity prices and improved corporate earnings, the valuation
of equities is now more normal. In the US market, the P/E ratio is back to
the level prevailing in 1997 (see Chart 1.8).
Chart 1.8
Increased investor confidence in US enterprises?
Since spring 2003, investors have required a steadily lower excess return
in relation to safe government bonds in order to buy bonds issued by US enterprises
(see Chart 1.9). There may be several explanations for this. First, investors’
risk aversion may be lower. Second, investors may adapt to new information
more quickly than credit rating agencies. When there are more optimistic expectations
concerning economic developments, the market may for a period consider some
borrowers to be less risky than implied by their credit rating. As a result,
the yield spread for a given credit rating may narrow during an economic upturn,
even though investors’ risk aversion and borrowers’ credit ratings
are unchanged. Third, it is conceivable that in a market with very low interest
rates, investors do not behave entirely rationally and purchase more risky
bonds in order to achieve a higher return.
Chart 1.9
Improved conditions for emerging economies
Both low interest rates in industrial countries and lower risk aversion may
have led to a lower risk premium required by investors to invest in emerging
economies (see Chart 1.10). Several countries have succeeded in issuing bonds
containing clauses that make it easier to achieve a coordination of creditors
in the event of any debt restructuring. Issuers have not had to pay extra
premiums to have these clauses included.
Chart 1.10
Since the moratorium on government debt in 1998, Russia has experienced a very
swift economic upturn. Equity prices for Russian companies have almost doubled
since the beginning of the year. In October, the country’s debt was
upgraded to investment grade. Since many investors in government securities
apply this credit rating as a minimum requirement in order to invest, Russia
may see a further improvement in its funding possibilities in the period ahead.
At the end of October, the head of Russia’s largest oil company was
arrested, charged with corruption and tax evasion. The Russian authorities
seized 44% of the shares in the company. The event contributed to an increase
in the risk premium on Russian debt.
1.5 Securities markets in Norway
Rise in prices and lower credit risk premiums
Historically low interest rates and a rally in international stock markets
have contributed to a sharp rise in prices in the Norwegian stock market since
the previous report (see Chart 1.11). Over the past six months, the Norwegian
stock market has risen considerably more than international stock markets.
In earlier periods of substantial price movements the effects have also been
greater in the Norwegian market than in other countries.
Chart 1.11
The bank index showed weaker developments than other sub-indices this summer,
but has since risen rapidly. The rise partly reflects investors’ favourable
response to third-quarter results in many banks as well as the Norwegian Competition
Authority’s decision to approve the merger between DnB and Gjensidige
NOR on certain conditions. Other market indicators also show that investors
consider banks’ financial position to be favourable (see box on p. 16
for a discussion of the indicators). The risk premium on bonds issued by Norwegian
banks has been declining in recent months (see Chart 1.12). Developments in
the probability of default based on market data for Norwegian commercial and
savings banks show the same picture (see Chart 1.13). The probability of default
among the weakest banks has been falling over the past two years, while the
median bank has exhibited stable developments. The volatility of Norwegian
bank shares has been sharply reduced since the spring (see Chart 1.14).
Chart 1.12 Chart
1.13 Chart
1.14
High turnover in several markets
In the first three quarters of 2003, turnover in both equity and bond markets
was higher than in the same period last year. The volume of bonds traded on
the Oslo Stock Exchange was 27% above the level in the same period in 2002.
In particular, turnover has been high in the government bond market. High
demand for long-term fixed income instruments as a result of the fall in short-term
interest rates through the spring and summer contributed to this.
The rise in prices and higher turnover in the stock market have resulted in
increased activity in the derivatives market. Permission for insurance companies
and mutual funds to use derivatives has probably also been a factor. Turnover
in exchange-traded option contracts has been increasing since May 2003, and
in September this year the number of open positions in the option market was
at its highest level since March 2001.
Fluctuations in the foreign exchange market in recent years have resulted in
higher demand from enterprises for long-term currency hedging products, such
as options, futures and currency swaps. Prices for such derivatives have fallen
somewhat, but there are wide price differences between the various products
and between customers.
Fall in issuance of private bonds
The issuance of private bonds has fallen in the first three quarters of 2003
compared with the same period last year. Both commercial banks and private
non-financial enterprises have reduced their issuance of bonds in the Norwegian
market. Savings banks, however, have increased their borrowing by 38% in the
period, and so far this year have been the largest issuer in the Norwegian
market. Savings banks and commercial banks have issued two thirds and half,
respectively, of their bond debt in Norway. Increased issurance of government
bonds contributed to a total issue volume in the Norwegian bond market that
was 14% higher in the first three quarters of 2003 than in the same period
last year.
In the stock market, the issue volume was lower in 2003 than in 2002 up to
the end of the third quarter, but picked up in October. The conversion of
debt to equity in companies with debt problems accounts for a considerable
portion of the share issues.
Higher new purchases in mutual funds
Net new purchases of units in Norwegian-registered mutual funds were relatively
high in September, at NOK 1.8bn, after showing negative figures in July and
August. Equity funds pushed down this figure despite low money market rates
and a rising stock market. During the third quarter, there has nevertheless
been a pronounced increase in net new purchases in equity funds.
Market-based indicators of banks’ financial
position
Securities markets can provide useful and current information on banks’
financial position. Indicators based on market data reflect market participants’
expectations concerning future developments, and they may be updated often.
Market indicators of banks’ financial position may be based on market
data both for banks directly and for enterprises in banks’ credit
portfolios.
The spread between the yield on bonds issued by banks and the yield
on government bonds (risk-free interest rate) is an indicator of
banks’ financial position. When investors' view is that a bank’s
financial position has deteriorated, they will require increased compensation
for buying the bond, and the yield spread widens. The downside risk will
probably be better reflected in the bond market than in other markets as
bond owners do not have access to potential gains as a result of increased
risk-taking in banks. The yield spread may, however, contain a liquidity
premium. Changes in the yield spread may therefore reflect changes in liquidity
instead of a change in the assessment of the bank’s financial position.
It is difficult to quantify this liquidity premium.
New information is often incorporated more swiftly in the equity market
than in the bond market. This is because turnover and the turnover rate
are normally higher in the equity market. Data on banks’ share
prices have for a long time been used as an indicator of risk in
banks. One problem associated with this indicator is that the share price
should reflect the discounted value of all future earnings, so that the
share price can vary considerably even if the credit risk does not change.
An alternative indicator is the return on portfolios of bank shares.
A study of Swedish bank shares prior to, during and after the banking crisis
in Sweden in 1990-1992, found a significant difference in the cumulative
return between shares in banks that received government support during the
banking crisis and banks that managed without government support.1
The difference was significant up to three years prior to the crisis. Similar
results have been found in studies conducted, for example, in the US.
1 Blåvarg
and Persson (2003): “The use of Market Indicators in Financial Stability
Analysis”,
Penning och Valutapolitik 2/03, Sveriges Riksbank.
Volatility in the return on bank shares may provide valuable
information on risk in banks. Since shares in a bank may be looked upon
as claims on the bank’s assets, volatility in the equity return may
provide information on investors’ assessment of the risk associated
with the bank’s assets. Increased risk on the asset side will result
in increased volatility in the equity return. Studies of the banking crises
in the Nordic countries show that up to ten years prior to the crisis one
observed significantly higher volatility in the equity return in crisis-hit
banks compared with banks that avoided a crisis.
Implied volatility from equity options can also be used
as a risk indicator. Implied volatility is the market’s estimate for
the volatility of a share in the period up to the option’s expiry
date. Increased uncertainty about the share’s price movement will
be reflected in higher implied volatility. Options with different exercise
prices but the same maturity can provide further information about this
uncertainty. Different implied volatilities for different exercise prices
can provide a picture of the direction of the uncertainty concerning the
share’s price movements.2
2 Syrdal (2002):
“A study of implied risk-neutral density functions in the Norwegian
option market”,
Working Paper 13/02, Norges Bank.
Option theory can provide information on the risk in banks in other ways
as well. The share capital of a bank may be looked upon as a call option
on the bank’s assets. The option provides payment to shareholders
if the market value of the bank’s assets is higher than the bank’s
liabilities on the option’s expiry date.3
Since one can observe the value of liabilities, as well as the market value
and volatility of the share capital, it is possible with the help of option
pricing models to derive the assets’ market value and volatility.
These variables are an indication of expected changes in the value of assets
and the uncertainty associated with this change in value. Against this background,
it is possible to estimate the probability that the bank will default
on its obligations.4
3 Merton (1974):
“On the pricing of Corporate Debt: The Risk Structure of Interest
Rates”,
Journal of Finance, Vol. 29, No. 2.
4 See box in
Financial Stability
2/2002 for a further discussion of this method.