Financial Stability 2/2003

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3 Financial institutions

3.1 Developments in banks' results and financial strength
3.2 Risk outlook for banks
3.3 Other financial institutions

Boxes:
- Merger of DnB and Gjensidige NOR - effect on financial stability?
- Nordic agreement on the handling of financial crises
- Inclusion of the Norwegian krone in CLS
- Economic shocks, monetary policy and financial stability

3.1 Developments in banks’ results and financial strength

Banks’ results have deteriorated in recent years. In the first three quarters of 2003, pre-tax profits were just over 0.7% of average total assets (ATA) (see Chart 3.1). Although many banks have improved their results compared with the same period last year, lower profits for commercial banks due to higher loan losses resulted in a slight decline in results for banks as a whole. From the second to the third quarter of 2003, banks’ loan losses fell, however, and results improved.

Chart 3.1

Banks’ net interest income has fallen somewhat since 2002 (se Chart 3.1). With an increasing volume of non-performing loans, the share of loans that do not provide interest income has increased (see Chart 3.2). In addition, the sharp decline in interest rates since December 2002 has reduced the accounting advantage of interest-free equity capital. This is primarily important to banks with a high equity ratio.

Chart 3.2

The interest margin has considerable impact on net interest income. Available interest rate statistics show that the interest margin has fallen slightly in the first half of 2003 compared with the same period last year (see Chart 3.3), resulting in a negative contribution to net interest income. Information in quarterly reports from the major banks indicates that the interest margin will show a further decrease when the statistics for the third quarter are included, as the banks had then reached a minimum level for interest rates on some deposits. The relationship between interest margin and net interest income is not clear-cut, however. The deposit margin has fallen sharply over the past year, while the lending margin has increased. Since the volume of banks’ loans is larger than the volume of deposits, the positive effect of an increase in the lending margin is greater than the negative effect of a reduction in the deposit margin. The lending margin has increased partly because a large number of banks have increased their risk pricing of high-risk corporate loans, and partly because it has taken time for the full effect of Norges Bank’s interest rate reductions to feed through to banks’ lending rates. The first effect will probably be sustained for some time, while the second effect is temporary. The lending margin is therefore likely to fall somewhat in the period ahead, thus contributing to reducing the interest margin and net interest income.

Chart 3.3

The upswing in securities markets in the second and third quarters of 2003 has reversed the negative developments in banks’ income from securities that were recorded in the first quarter. On balance, securities income in the first three quarters of 2003 increased compared with the same period last year. Developments in both equity and bond markets (see Chapter 1) contributed to a rise in capital gains. These developments had an effect at both parent company level (see Chart 3.4) and at group level via ownership in life insurance companies (see section 3.2).

Chart 3.4

Reduced costs in relation to ATA have in isolation contributed to an improvement in results in recent years (see Chart 3.1). Cost reductions have been driven by technological changes and competition in the Norwegian and Nordic bank markets. Both Danske Bank and Svenska Handelsbanken have, for example, recorded better returns on equity than the largest Norwegian banks since 2001 (see Table 3.1).

Table 3.1

Banks’ loan losses were just under 0.5% of ATA in the first three quarters of 2003, almost double the figure from the same period last year. This increase may be due to an abrupt reduction in credit quality for some exposures through 2002. Both the number of gross non-performing loans in the corporate sector (see Chart 3.2) and new specified loss provisions have increased (see Table 3.2). There has also been a marked increase in new recorded losses.

Developments in the fisheries and aquaculture industries have been particularly weak. DnB, Nordea Bank Norge and some medium-sized banks have incurred substantial losses on loans to these industries. In addition, loss provisions related to business loans in service industries and manufacturing have continued to edge up for a number of large banks compared with last year. Although credit risk in relation to loans to commercial property companies was considered to have increased in the last Financial Stability report, losses on these loans have not increased. One reason for this is probably this year’s decline in interest rates. Some small banks have experienced high loan losses as a result of sluggish developments in parts of the business sector and as a result of a combination of strong growth in the past and inadequate risk management. Savings banks that have concentrated their activities on households have, however, recorded low loan losses.

Table 3.2

In spite of a deterioration in banks’ overall results in the first three quarters of 2003 compared with the same period last year, the vast majority of banks have maintained a Tier 1 capital ratio well above the statutory 4% minimum. At the end of the third quarter, the Tier 1 capital ratio for the three largest banks was on average just below 8.5% (see Chart 3.5), while the figure for other commercial banks was 9.6% and for savings banks 11.3%. There has, on average, only been a slight reduction in Tier 1 capital ratio since the end of the third quarter of 2002. The Tier 1 capital ratio has fallen for small banks in particular, but is still substantially higher than for larger banks. A number of savings banks have strengthened their Tier 1 capital ratio by issuing preferred capital securities, a hybrid instrument that has features in common with both debt and equity capital. Market-based indicators of banks’ financial position have shown positive developments since the May Financial Stability report (see Chapter 1).

Chart 3.5

3.2 Risk outlook for banks

Banks are exposed to a number of types of risk. This section presents an assessment of banks’ credit, market, liquidity and counterparty risk. Loans to the public (households, non-financial enterprises and municipalities) accounted for about 70% of banks’ total assets at the end of the third quarter 2003 (see Table 3.3), making credit risk the primary source of risk for banks. Market risk is low in banks, as a relatively small share of banks’ assets is invested in securities. Liquidity risk will partly depend on the share of long-term loans and other illiquid assets that is based on long-term financing. Banks may also have drawing rights etc that are not recorded on the balance sheet, but that have an impact on liquidity risk. Counterparty risk includes exposures that are balance-sheet or off-balance-sheet items.

Table 3.3

Credit risk associated with loans to the household sector

Loans to households account for two-thirds of gross loans to the public, and can therefore be a potential source of considerable credit risk to Norwegian banks (see Table 3.4). This risk is nonetheless limited for two reasons. First, the vast majority of loans are mortgage-backed loans. Unless house prices fall sharply, losses due to default will be limited. Second, for households, debt is usually backed by all their personal wealth and income, and banks can therefore recover a large share of the non-performing loans over time. This also means that recorded losses on loans to households have been very small in spite of the fact that these loans have comprised about a third of the volume of non-performing loans.

Table 3.4

The risk of losses on loans to households in the period ahead will partly depend on the loan-to-asset-value ratio and developments in house prices. Loans with a high loan-to-asset-ratio in particular involve a risk for banks. The Banking, Securities and Insurance Commission’s annual mortgage survey in March⁶ showed that the share of loans (in value) with a loan-to-asset-value ratio above 80% has declined slightly since 2002 (see Table 3.5). Despite this, the share of loans with a high loan to asset value ratio accounts for a third of the portfolio. The share of loans with a loan to asset value ratio of more than 100% fell slightly from 2002 to 2003, following a marked increase in 2001 and 2002. At the same time, there has been an increase in the number of loans with a loan to asset value ratio of above 100% without additional collateral.

Table 3.5

In the short term, the decline in interest rates in 2003 has made it easier for households to service their debt and reduced the likelihood of a fall in house prices. This lowers the risk of higher losses on loans to households in the short term. If the sharp increase in loans to households continues (see Chart 3.6), debt servicing problems may increase in the longer term. Many banks have for some time focused on households as a strategic priority area because loans to households are regarded as less risky than loans to non-financial enterprises. The introduction of new capital adequacy regulations (Basel II), scheduled for 2007, will entail reduced capital requirements for housing loans. Competition in the banking market will probably result in reduced margins in connection with housing loans due to lower costs. This may further stimulate household debt.

Chart 3.6

Credit risk associated with loans to non-financial enterprises

Loans to non-financial enterprises accounted for 32% of banks’ gross lending to the public. This sector normally makes the strongest contribution to loan losses. The marked increase in defaults in the corporate sector in the past two years is reflected in an increase in loan losses. One reason for this is that collateral for corporate loans is usually far less secure than for household loans. The value of loan collateral in the corporate sector will often be closely linked to profitability in the individual enterprise and the individual industry. In private limited companies, the owners also have limited liability, preventing a bank from transferring a company’s liabilities to the owners.

Banks are exposed to developments in many different sectors. Banks’ exposure is greatest in the property management sector. For DnB, Gjensidige NOR and Nordea Bank combined, loans to this sector accounted for 30% of corporate loans at the end of the third quarter of 2003 (see Chart 3.7)⁷ , an increase of 3 percentage points since the end of 2001. Figures up to the end of 2002 also show that the banking sector overall has increased its exposure to the property management sector. At the same time, some of banks’ largest single loans are extended to property companies. The outlook for the commercial property sector therefore has a considerable influence on banks’ future earnings. So far this year, the three largest banks’ loan losses in this sector have been below the average for corporate loans (see Chart 3.8). The credit risk associated with loans to parts of the property industry, however, is still considered to be relatively high (see Chapter 2).

Chart 3.7     Chart 3.8

Service industries accounted for almost 18% of corporate lending in the three largest banks at the end of the third quarter of 2003. Losses on loans to this sector have increased markedly in recent years. On the other hand, the three largest banks have to some extent reduced the share of loans to this sector.

Loans to manufacturing accounted for 10% of the three largest banks’ corporate loans. Losses on loans to manufacturing have been higher than the average for the business sector in recent years. Manufacturing enterprises are heavily exposed to competition from foreign companies. Future profitability and debt servicing capacity in manufacturing enterprises will therefore partly depend on developments in the global economy and the krone exchange rate.

Loans to the primary industries, including aquaculture and fisheries, accounted for just under 7% of the three largest banks’ corporate loans at the end of the third quarter. Financial problems in the aquaculture and fisheries industries have accounted for a substantial share of the loan losses in DnB, Nordea Bank Norge and some small and medium-sized banks. Banks’ overall lending to this sector is on a relatively small scale. The potential for losses is therefore limited.

Overall, credit risk associated with loans to sectors other than the property management sector is considered moderate and lower in relation to the previous Financial Stability report (see Chapter 2). The share of banks’ total loans to these sectors has been reduced in recent years.

Market risk

Since banks have invested a relatively small share of their assets in securities classified as trading book, their market risk is low (see Chart 3.9). For banks, this securities portfolio mainly comprises bonds. These securities are not used in active trading to any extent, and are largely used as collateral for loans from Norges Bank. In addition to assets on the balance sheet, derivative contracts will determine banks’ market risk. In spite of substantial changes in interest rates and foreign exchange rates, and in equity and bond prices in recent years, changes in other operating income have been relatively modest (see Chart 3.4). The most important source of market risk for Norwegian banks is connected with ownership of life insurance companies, see discussion below.⁸

Chart 3.9

Liquidity risk

Because banks’ lending is long term, while their own financing is largely short term, they are exposed to liquidity risk. The certificate and interbank markets can be associated with high risk because shifting market conditions and changes in risk assessments can rapidly increase refinancing costs. Even though customer deposits can be withdrawn at short notice, they are regarded as a stable source of financing, in particular because of the deposit guarantee of NOK 2m per depositor per bank.

The deposit-to-loan ratio (deposits from the non-financial sector as a percentage of lending) has fallen since the end of 2002 (see Chart 3.10). The drop in interest rate levels has probably contributed to these developments in that bank savings have become less attractive compared with other forms of saving. The lower deposit-to-loan ratio has on average been financed by higher bond debt. Certificate debt has fallen measured as a percentage of gross lending. The fall in the deposit-to-loan ratio has thus only affected liquidity risk to a limited extent.

Chart 3.10

Banks’ funding structures vary widely. Liquidity risk can be assessed by comparing banks’ stable financing with their illiquid assets (see Chart 3.11). A value of 100 indicates that banks have balanced illiquid assets with stable sources of funding. A reduction in this ratio indicates higher liquidity risk. Possible drawing facilities available to banks are not taken into account.

Chart 3.11

The number of banks with a value on the liquidity indicator of over 100 increased sharply in autumn 2002 and in the first quarter of 2003. These developments were amplified in the second quarter. The liquidity indicator has subsequently been reduced for a large number of banks, however, and primarily for the group classified as other savings banks (see Chart 3.12). These banks have maintained solid lending growth even though the growth in deposits from the non-financial sector has been low or negative from the second to the third quarter of 2003. For the category other commercial banks, however, the liquidity indicator has been rising sharply since autumn 2002. For a number of commercial banks, more costly financing may have been an important reason for the sharp fall in their lending growth and its increasingly negative trend since autumn 2002. Increased focus on monitoring and risk pricing of banks by their creditors since autumn 2002 have contributed to this. In addition, small banks have had to pay a higher premium as a result of creditors’ increasing emphasis on the size of the borrower. Some commercial banks have offered high interest rates on deposits in order to attract deposits as other types of financing have fallen due. The deposit guarantee has made it attractive for depositors to deposit their money in banks regarded by other actors as risky. The liquidity indicator for the two largest banks has also increased in 2003 from an already high level. The liquidity indicator for Nordea Bank Norge and Fokus Bank as a group has been sharply reduced in recent years.

Chart 3.12

The relationship between the level of the liquidity indicator and actual liquidity risk is not clear cut. Financing using short maturity instruments may still be long-term in character. Interbank financing from a foreign parent company may, for example, be regarded as far more stable than other types of interbank financing. Nordea Bank Norges and Fokus Bank have as a group considerably increased their short-term foreign debt over the past 2-3 years (see Chart 3.12). The liquidity risk in these banks cannot be assessed without including the financial strength and liquidity of the Nordea group and Danske Bank. These are both solid financial conglomerates with a Moody’s rating for financial strength that is at least as good as ratings for Norwegian banks (see Table 3.6). The marked fall in the liquidity indicator overall for Nordea Bank Norges and Fokus Bank in the past few years does not therefore necessarily indicate higher liquidity risk. Liquidity risk in Norwegian branches of foreign banks is solely dependent on the liquidity risk in the foreign banks. This applies to, for example, Skandinaviska Enskilda Banken AB and Svenska Handelsbanken AB, which are two of the six largest banks in Norway in terms of total assets.

Table 3.6

For banks that are not closely allied with or part of a foreign financial group, short-term foreign financing may involve a liquidity risk that is particularly high. Foreign creditors may have a lower threshold than Norwegian creditors for withdrawing financing if uncertainty about Norwegian banks’ financial strength increases. The fall in the share of foreign financing this year for the category other commercial banks, and to some extent other savings banks, has therefore in isolation contributed to lower liquidity risk for these two groups (see Chart 3.13). The share of short-term financing from abroad has traditionally been larger for the two largest banks than for smaller banks, ranging between 15 and 20% of gross loans since the end of 1997.

Chart 3.13

Overall, the liquidity risk for banks is regarded as relatively low and somewhat lower compared with the May report. On the positive side, short-term foreign debt has fallen in all categories of bank. The risk picture is very mixed, however. Liquidity risk has probably been reduced in the category other commercial banks and in the two largest banks, while it may have risen in the category other savings banks. There is considerable uncertainty with regard to liquidity risk in the period ahead. With the current low interest rate level, the deposit-to-loan ratio will probably continue to edge down in most banks. Liquidity risk will depend on how banks adjust to these developments. For some banks, relatively costly financing will probably continue to limit lending growth. When the rules concerning asset-backed bonds is introduced, banks may find it attractive to transfer loans to mortgage companies, which may reduce banks’ liquidity risk.

Counterparty risk

Norges Bank is making a survey in collaboration with the Banking, Insurance and Securities Commission of Norwegian banks’ counterparty exposures. The survey shows the level of exposure of the nine largest Norwegian banks to their fifteen largest counterparties. The exposures are in the form of derivatives, securities, unsecured deposits, loans, guarantees and foreign exchange transactions for which settlement has not been confirmed. One of the aims of the survey is to assess the liquidity and credit risk associated with banks’ unsecured, short-term exposures. It also provides a basis for assessing the risk of direct contagion of liquidity or solidity problems between the banks included in the survey. It has been decided to conduct a survey at the end of the first quarter every year from now on.

The largest exposures for the banks in the survey, by a clear margin, are exposures in connection with foreign exchange settlement transactions (see Chart 3.14). Most of these exposures are to foreign financial institutions with a high rating or large Norwegian banks (see Chart 3.15). The size of the exposures nonetheless indicates that banks’ risk in connection with foreign exchange settlement can be considerable. Banks’ exposure to foreign exchange settlement risk will, however, be reduced significantly as a result of the inclusion of the krone in the international currency settlement system CLS on 8 September 2003 (see separate box).

Chart 3.14     Chart 3.15

A bank’s capacity to bear losses will depend on its Tier 1 capital ratio. Chart 3.16 shows what the effect on banks’ Tier 1 capital ratios would have been if the largest, second largest or third largest counterparty in isolation had failed to honour their obligations. At the time of the last measurement, one bank would have failed to meet the statutory requirement of a 4% Tier 1 capital ratio if the largest counterparty had defaulted. Six other banks would have had a Tier 1 capital ratio of between 4 and 7%.

Chart 3.16

Overall, the survey shows that few of the exposures are so large that they would result in serious solvency problems for banks should a large counterparty be unable to settle. A relatively limited share of the exposures are to large Norwegian banks (see Chart 3.16). This indicates that the risk of spreading liquidity and solvency problems from one Norwegian bank to others is also limited, particularly after the krone was included in the CLS.

Overall assessment of the risk outlook for banks

Credit risk associated with households is relatively low and reduced in the short term. Credit risk associated with segments of the property industry is relatively high and unchanged, while credit risk associated with loans to other industries as a whole is moderate and somewhat lower than in the May Financial Stability report. Other risks – market risk, liquidity risk and counterparty risk – are considered to be somewhat lower or unchanged since May. On balance, the risk outlook for banks has therefore improved somewhat since the last Financial Stability report. High household debt growth increases households’ vulnerability to negative financial disturbances. If high debt growth in the household sector continues, it may over time give rise to higher loan losses.

3.3 Other financial institutions

Norwegian banks are an integral part of alliances or financial groups that also comprise other types of financial institution (see Tables 3 and 4 in the Annex). Developments in other financial institutions may therefore have an impact on banks. Developments in mortgage companies, finance companies and life insurance companies are assessed below. The most important developments for many banking groups are those in the life insurance sector.

Mortgage companies

Mortgage companies provide long-term mortgage loans to enterprises, municipalities and to some extent to individuals. Many mortgage companies have specialised in providing loans to commercial property companies. The value of property and the financial position of property companies therefore have a considerable influence on mortgage companies’ credit risk. The bond market is an important source of financing, but many mortgage companies are also financed by loans from their owners (see Table 3.7).

Table 3.7

Mortgage companies will probably become more important in the Norwegian financial industry when the regulations concerning asset-backed securities are introduced. It will then be possible to transfer some of the banks’ loans to mortgage companies and finance them by issuing bonds.⁹ The scope of this practice will depend on the attractiveness of the regulations. Fokus Bank (Fokus Kreditt), Gjensidige NOR (Sparebankenes Kredittselskap) og Nordea Bank Norge (Norgeskreditt) are examples of banks that own mortgage companies. Eiendomskreditt is owned by the Terra Group and Kommunalbanken is owned by the government and KLP. For the last twelve months to the end of the third quarter 2003, mortgage companies’ credit growth was 18 percent. Twelve-month growth has been rising for more than a year.

Mortgage companies’ profits improved somewhat in the first nine months of 2003 compared with the same period of 2002 (see Chart 3.17). Pre-tax profits amounted to a little more than 0.5% of ATA this year. Net interest income was approximately unchanged compared with the same period last year, but other non-interest income rose as a result of capital gains on securities. Loan losses have doubled, but from a low level. Loan losses amounted to 0.2% of ATA in the first three quarters of 2003. The core capital ratio averaged 10% at the end of the third quarter of 2003.

Chart 3.17

Finance companies

Finance companies offer short-term loans, factoring and leasing for many different purposes (see Table 3.8). Finance companies are, to a greater extent than mortgage companies, part of financial groups that include banks, but they account for a small portion of these groups’ total assets. The finance companies’ owners are also their most important source of financing. For the last twelve months to the end of the third quarter 2003, finance companies’ credit growth was 8%.

Table 3.8

Finance companies’ pre-tax profits amounted to a little more than 1.9% of ATA in the first three quarters of 2003 (see Chart 3.18). Profits have remained at the same level as last year despite a sharp increase in loan losses, which amounted to a mere 1% of ATA in the first three quarters of 2003. Finance companies’ losses are on average considerably higher than those incurred by banks and mortgage companies. This is because collateral is not always required and the risk is generally higher. Relatively high losses are offset by high net interest income, which rose, compared to 2002, to 4.6% of ATA. At the end of the third quarter of 2003, the core capital ratio declined, compared with 2002, to 8.3%.

Chart 3.18

Life insurance companies

Life insurance companies have strengthened their earnings in 2003, primarily reflecting positive developments in securities markets. This has also improved banking groups’ returns on equity stakes in these companies. This is the case for both DnB (Vital) and Gjensidige NOR (Sparebankforsikring). Similarly, the loss on shareholdings in Sparebank 1 Gruppen AS this year has been lower than in 2002 for banks participating in the Sparebank-1 alliance.

Life insurance companies’ buffer capital¹⁰ has increased sharply as a result of higher earnings and amounted to 4.3% of total assets at the end of the third quarter 2003. By comparison, buffer capital was 2.0% of total assets at the end of the third quarter of 2002.

Life insurance companies have reduced market risk since 2000, due to a substantial reduction in the share of assets invested in equities and an increase in the share invested in bonds that are held to maturity. This trend has continued for the last year (see Table 3.9). Sensitivity to interest rate changes has therefore become lower. On the other hand, the possibilities of benefiting from an upturn in the equities market have deteriorated.

Table 3.9