Financial Stability 1/2003
6 Financial institutions
Rammer:
- Credit risk in connection with banks' lending to the corporate sector
- Banking crises in Norway have followed periods of high debt growth
Deterioration of banks’ results
Weak securities markets and increased loan losses contributed to a deterioration
in banks' results in 2002 and the first quarter of 2003 (see Table 6.1). The
losses are still moderate, from a historical perspective, but the trend is
negative. Losses on loans to most business sectors have increased, but the
losses on loans to Finance Credit and some fish-farming companies have been
particularly high. This has resulted in a sharp increase in the share of banks
with weak or negative results in the last two years (see Chart 6.1). In the
first quarter of 2003, 12 banks (8% of banks) recorded negative results, compared
with only 5 banks (3% of banks) in the first quarter of 2002.
Table 6.1 Chart
6.1
Small and/or newly established banks in particular have recorded substantial
losses and weak results. Recorded losses were particularly high in the fourth
quarter of 2002 (see Charts 6.2). These developments have led to higher financing
costs and restructuring in some banks. Nordlandsbanken has been acquired by
DnB. Small savings banks like Enebakk Sparebank and Flora Bremanger Sparebank
have ceased to exist as independent entities.
Chart 6.2
A number of medium-sized banks that take part in the SpareBank 1 cooperation
have recorded substantial losses on loans to Finance Credit. In addition,
losses sustained by SpareBank 1 Gruppen AS have contributed to a decline in
the item ‘Other operating income’ in the banks that own the company.
This has contributed to a sharp reduction in the results of the medium-sized
banks. The exception is Fokus Bank, where results improved in 2002, primarily
as a result of large reversals of previously earmarked loss provisions.
The increase in losses at the three largest banks has largely been concentrated
in the fish-farming industry. In contrast to the small and medium-sized banks,
their loan losses increased in the first quarter of 2003. Other operating
income fell as a result of the negative trend in securities markets. The overall
effect was a marked decline in results (see Chart 6.3).
Chart 6.3
Despite weaker results, the average core capital ratio has remained steady
(see Table 6.1). The core capital ratio in the three largest banks has remained
approximately unchanged. However, there has been a rise in the share of banks
with a core capital ratio of between 10% and 15%, while the share of banks
with higher core capital ratios has declined (see Chart 6.4). The small banks
have accounted for this downward shift.
Table 6.1 Chart
6.4
Credit risk in connection with banks' lending to the corporate sector
Norges Bank has developed an indicator for the credit risk associated with
each bank’s lending to the Norwegian corporate sector. The indicator
is developed by linking corporate data from Norges Bank’s credit risk
model, SEBRA1, and data in the official
banking statistics. The indicator provides insight into how credit risk
varies both over time and across banks. Preliminary analyses suggest that
the indicator is relatively effective in explaining banks’ loan losses
and hence credit risk.
1 For a further account of this model,
see Eklund, T., K. Larsen and E. Bernhardsen: “Model for analysing
credit risk in the enterprise sector”, Economic Bulletin
3/01, Norges Bank.
The data is annual, and the indicator has been calculated for the period
1988-2001. The period is limited by the availability of data. In the SEBRA
model, the annual bankruptcy probability of every limited company in Norway
is calculated from accounts data. The associated database contains information
about the industry code and geographical location of each company. A direct
link cannot be made between these corporate figures and the banking statistics,
however, because the banking statistics do not contain information that
identifies the banks’ individual borrowers. However, the individual
bank reports the distribution of borrowers by county and within each county
according to a two-digit industry code. The estimated bankruptcy probabilities
for individual enterprises are aggregated for each industry group in each
county, so that the aggregation corresponds to the distribution of the banks’
loan portfolios in the banking statistics. An average bankruptcy probability
is estimated each year for the corporate loans of the individual bank. This
is done by weighting the aggregated bankruptcy probabilities from the SEBRA
database with the bank’s lending to each industry code in each county.
The calculation method is based on the assumption that all banks face the
same bankruptcy probability on loans to enterprises in a particular industry
group in a particular county. The indicators do not take account of the
different degrees of diversification in banks’ loan portfolios.
The indicator for credit risk associated with loans to enterprises shows
an appreciable difference between large, medium-sized and small banks (see
Chart 1).2 This must be seen in relation
to the fact that household loans represent a far larger share of small banks’
lending. Experience from the previous banking crisis indicates that loans
to households are far safer than loans to enterprises. As a result, small
banks can withstand a higher average level of risk in connection with corporate
loans than larger banks. It is usually assumed that small banks, in particular,
have more information than large banks about the enterprises to which they
extend loans. Informational advantages of this kind may also allow small
banks to take on somewhat greater risk, as measured here, in connection
with their corporate loans.
Chart 1
2 Banks’ loans to enterprises
are used as weights for the individual banks. The largest banks are DnB,
Nordea Norge, Union Bank of Norway, Fokus Bank and the four largest banks
in the Sparebank 1 alliance. The medium-sized banks are other banks with
total assets of over NOK 1bn.
In the period 1990-1992, during the banking crisis, the average bankruptcy
probability in banks’ loan portfolio was 2.9%. In the years after
the banking crisis, 1994-2001, it fell to 1.5%. The spread among banks was
also far greater during the banking crisis than in the latter half of the
1990s and up to 2001. In 1991, one bank had an average bankruptcy probability
of over 8% in its corporate loan portfolio. In 1999, the highest individual
observation was just 3%, the same as the average during the banking crisis.
Increase in loan losses in most industries
Gross non-perming loans in the corporate sector increased from 0.7% to 1.2%
of gross lending from end-2001 to end-2002. The share of non-performing loans
fell somewhat in the first quarter of 2003 (see Chart 6.5). This may be due
in part to high recorded losses in this quarter. Non-performing loans in the
household sector remained more or less unchanged.
Chart 6.5
A sectoral breakdown of banks’ corporate loans shows that a substantial
portion of banks’ exposure is to enterprises in property management
and services. Loans to these two sectors amounted to 54% of total corporate
loans in 2002 (see Chart 6.6). Banks’ exposure to the property sector
has increased in recent years. Losses on these loans are still relatively
small, but have increased markedly from the negative level in 1997, when general
economic growth was very strong (see Chart 6.7). Banks’ losses on loans
to enterprises providing services amounted to 2.4% of lending to this sector
in 2002, up from -0.2% in 1997. Losses on loans to enterprises in several
other sectors also increased from 2001 to 2002. Developments in fish-farming
have been most negative, but banks’ loans to this sector are small on
average. Losses on loans to manufacturing increased appreciably in 2002.
Chart 6.6 Chart
6.7
What is causing the increase in losses?
There are probably two reasons for the marked increase in recorded losses in
2002. First, the general deterioration in the internationally exposed sector
may contribute to explaining the increase in recorded losses on loans to manufacturing.
Second, debt servicing problems in the business sector normally increase after
a period of high fixed investment, large mergers and acquisitions and a strong
willingness to take on risk (see Chapter 3). To the extent that this investment
has been financed by bank loans, banks are also affected. Factors such as
these can help to explain the increase in recorded losses on loans to enterprises
in commercial services, property management and fish-farming.
The greatest increase in recorded losses has been experienced by some small
banks. This may be because they have sharply increased their business loans,
possibly without taking appropriate account of the associated risk.
International comparison
Developments in banks in other countries provide a yardstick for measuring
developments in Norwegian banks. Table 6.2 shows that developments in banks
in neighbouring countries are very similar to developments in Norwegian banks.6
In general, income from securities markets has dropped and loan losses have
increased. This development reflects the downturn in the global economy. Danish
banks are unusual in the sense that their loan losses declined in 2002. This
may be due to a reversal of the large loan loss provisions made the previous
year. German banks had the highest loan losses in 2002, more than double the
losses for 2000. The result of these developments is a substantial decline
in return on equity in all countries except Denmark. The decline is particularly
dramatic in Germany. Core capital adequacy has nevertheless remained at approximately
the same level in the years 2000-2002.
Table 6.2
6 Different accounting rules and practices
make it difficult to directly compare figures.
The largest banks are well equipped to face a deterioration of the macroeconomic
situation
Norwegian banks have a capital adequacy that on average is well above the statutory
minimum requirements. They therefore have substantial buffer capital. It is
difficult to gauge how much banks can afford to lose before their buffer capital
is depleted. This is because capital adequacy depends on many factors. We
have carried out calculations based on some simplified assumptions in order
to assess banks’ ability to withstand losses over a three-year period.
Our point of departure is the financial statements for 2002 of the eight largest
bank groups. It is assumed that these banks do not raise equity or supplementary
capital, that the size and composition of the balance sheet do not change,
and that the banks do not pay out a dividend.
Our calculations show that if results before losses are equal to those in 2002,
the most financially sound of the eight largest banks will tolerate an average
loss over three years of 2.6 per cent of gross lending (see Chart 6.8). If
the result before losses is zero in the three years, the most financially
sound bank will only tolerate an average loss of 1 per cent of gross lending.
The least financially sound bank will tolerate an average loss over three
years of 1.6% and 0.8% of gross lending, respectively, given these two assumptions
concerning results.
Chart 6.8
The risk of a widespread financial crisis among Norwegian banks can be assessed
by comparing banks’ ability to tolerate losses with the size of their
loan losses in the event of a sharp macroeconomic deterioration, i.e. a stress
test scenario: It is assumed that unemployment is 1 percentage point higher
in 2003 and 2 percentage points higher in 2004 and 2005 than in the baseline
scenario in the March 2003 Inflation Report. Moreover, annual growth in house
prices is set at zero in 2003 and -10% in both 2004 and 2005. With this scenario,
loan losses increase appreciably, and average annual losses amount to about
2.6% of gross lending in 2005 (see Chart 6.9). The rise in losses reflects
increased debt-servicing problems in the household and enterprise sectors
because of higher unemployment and lower earnings, and a fall in the value
of collateral.
Chart 6.9
In the reference scenario, in contrast, average annual loan losses will increase
to over 1 per cent of gross lending in 2005, mainly as a result of somewhat
lower corporate earnings, a slight increase in unemployment and a slower rise
in house prices than before.
These simplified calculations show that the largest bank groups have a reasonably
good ability to withstand future loan losses before their buffer capital is
depleted. If macroeconomic developments are very negative and bank earnings
are low for several years, it will be necessary to improve capital adequacy.
This could be achieved through adaptions in the lending portfolio or through
the addition of new capital.
The situation for life insurance companies
The ability of life insurance companies to withstand losses deteriorated further
in 2002. Buffer capital has fallen steadily from 11.1 per cent of total assets
in 1999 to 3.4 per cent at end-2002. Total results in this sector improved
compared with 2001, largely due to increased financial income. Results were
nevertheless negative.
A decline in value and the sale of shares have brought about a sharp reduction
in life insurance companies’ shareholdings (see Table 6.3). The companies’
exposure to a further decline in the stock market is therefore low. However,
they will not benefit significantly from short-term upswing either. At the
same time, bondholdings classified as “held to maturity” increased
sharply, and at end-2002 accounted for 31 per cent of total assets. Almost
70 per cent of these bonds had maturities after 2005. Problems related to
the decline in stock markets and the consequences for life insurance companies
are discussed in depth in a box in Chapter 2.
Table 6.3
Future developments
Banks’ loan losses will probably continue to increase somewhat in the
period ahead, even though the decline in interest rates will strengthen borrowers’
debt servicing capacity. The increase in losses reflects weak developments
in parts of the internationally exposed sector and that high levels of investment
in some business sectors may lead to increased debt servicing problems. The
banking sector as a whole is expected to be capable of maintaining its financial
strength, however, even in the event of a further deterioration of the macroeconomic
situation. At the same time, a further deterioration in financial strength
may be expected in some small banks that have had expansive lending strategies
and have not taken appropriate account of the associated risk. This may lead
to further restructuring in the banking sector.
Banking crises in Norway have followed periods of
high debt growth1
1 Based on a forthcoming article
by Karsten Gerdrup about Norwegian banking crises.
There have been a number of banking crises in Norway. During the time of
the silver and gold standard prior to 1914, banking crises occurred relatively
frequently and were mainly regional, reflecting the dispersed structure
of the banking industry. Many Norwegian banks experienced liquidity and
solidity problems in 1857 (following the collapse of the US railroad industry),
1864 (Oppland), 1886 (Arendal) and 1899-1905 (Kristiania). Of these, the
1899 banking crisis in Kristiania (now Oslo) was the most serious. Kristiania
was an important financial centre, and credit conditions in the rest of
the country were therefore affected. The crisis was particular to Norway,
following in the wake of the property boom and the subsequent crash in summer
1899.
The next two banking crises, in 1920-28 and 1988-92, were far more severe
than the pre-1914 crises, reflecting the more unstable macroeconomic conditions
in these two periods.
There were particular reasons for each of the three latter crises, but they
also have much in common:
- The years prior to the crises were characterised by a sharp increase
in competition in the credit market.
- Strong growth in banks’ deposits and favourable financing terms
for banks underpinned expansion during all three periods. In the second
half of the 1890s and during World War I, commercial banks expanded sharply
by issuing new (“cheap”) equity capital. Savings banks were
not as expansive. One reason for this may be that savings banks were to
a certain extent subject to supervision and regulation. There was little
regulation of commercial banks until the interwar years. Sharp lending
growth in the 1980s was mainly made possible by foreign funding. In all
three crises, the banks that were most expansive were also the most severely
affected in the subsequent crises.
- Asset markets were an integral part of economic developments and developments
in the banking sector prior to and during the banking crises. Property
prices rose sharply prior to the crashes in 1899 and 1988. Share prices,
particularly in shipping and whaling, rose dramatically during World War
I, then fell sharply afterwards.
- Debt of the general public (municipalities, non-financial institutions
and households) increased more than nominal income in the periods of expansion
preceding the crises (see Chart 1), making the general public more vulnerable
to loss of income or increases in real interest rates. Relative debt growth
was modest in the 1890s and during World War I due to a strong increase
in nominal income. Under the gold standard, however, periods of growth
in nominal income were normally followed by a fall in nominal income.
The debt burden thereby increased when the economy declined. The increase
in nominal income was artificially high during World War I as a result
of a strong inflow of gold and suspension of the exchange of notes for
gold in 1914. These developments were reversed in the 1920s.
Chart 1
History shows that the foundation of a bank crisis is laid during a period
of economic expansion. Strong bank expansion can also in itself amplify
the economic upturn and subsequent downturn. Regulation, supervisory practices
and macroeconomic policy must therefore reflect the fact that risk is built
up in periods of expansion and materialises in periods of decline.