Financial Stability 1/2002
2 International developments and securities markets
2.1 The international environment
2.2 Securities markets in Norway
Boxes:
- Implications of the Enron bankruptcy
- Japanese banks increasingly vulnerable
2.1 The international environment
Main picture
Uncertainty in international financial markets has abated since last autumn.
The cyclical turnaround in the world economy has contributed to growing optimism
in financial markets. In recent years, the financial system has been exposed
to various shocks, such as the bursting of the IT bubble in 2000, the synchronized
downturn in the major industrial countries, the 11 September terrorist attacks
on the US, Argentina’s government debt default and the Enron case. The
crises have been dealt with in a satisfactory manner. Soundly capitalised financial
institutions and sharp interest rate cuts in many countries contributed to stabilising
markets.
In Japan, the economic situation represents a considerable source of uncertainty.
Government debt accounts for close to 150% of GDP and is on the rise. Japan’s
sovereign debt has recently been downgraded to AA by Standard & Poor’s,
with a risk of further downgrading. The stock market recovery this year may
indicate renewed optimism regarding the future. Deflation and a steadily rising
portion of non-performing loans suggest continued weak prospects for the Japanese
banking sector and its ability to contribute to restructuring and growth (see
separate box). In the US, household and corporate debt has not been reduced
during the downturn, which means these two sectors are vulnerable to possible
interest rate increases.
Less uncertainty in stock markets
Stock markets recovered rapidly following the sharp fall subsequent to the
events of 11 September. By the end of the year, most markets had advanced back
to the level prevailing prior to 11 September. However, optimism about future
developments has waned somewhat so far this year, which has primarily affected
the US stock market. The US market has fallen by 5% since the beginning of the
year (Chart 2.1). In the same period, the European market declined by 4%. The
Japanese stock market exhibited a sharp decline up to 6 February 2002, but has
subsequently advanced sharply. Tighter rules for short sale contributed to the
advance. Stock prices in Japan are now 8% higher than at the beginning of the
year.
Chart 2.1
The price/earnings ratio (P/E ratio) is an important measure for assessing
share prices. The relatively favourable trend in share prices since 11 September
has taken place in spite of a sharp fall in corporate earnings. As a result,
the P/E ratio for the broad S&P 500 index in the US has advanced since the
second quarter of 2001 and is now at a historical peak (Chart 2.2). However,
analysts estimate that earnings will show renewed growth next year, after falling
since the second quarter of 2001 (Chart 2.3). Uncertainty in the US stock market,
as measured by implied volatility in the options market, has abated and is currently
low compared with the past two years (Chart 2.4).
Chart 2.2 Chart
2.3 Chart 2.4
Reduced credit risk for corporate bonds
The risk of a long-term cyclical downswing following the events of 11 September
generated fears of corporate loan defaults. Credit risk, as measured by the
yield differential between US corporate bonds and government bonds, increased
sharply (Chart 2.5). Growing optimism later in the spring has reduced credit
risk, which is now by and large lower than last spring. The fall in credit risk
has been particularly pronounced for bonds with a low credit rating. Historically,
this has indicated an economic upturn. Normally, an upturn primarily boosts
earnings for highly leveraged companies. Increased earnings make an important
contribution to financial strength and induce investors to bid up bond prices
ahead of the upturn so that yields fall.
Chart 2.5
High debt and weak trends in the telecommunications sector
High debt and lowered expectations as to future growth in this sector have
led to a sharp price fall in telecommunications shares (Chart 2.6). European
telecom operators increased debt considerably in connection with licences for
the 3G mobile network in Europe in 2000. It has proved difficult to reduce the
level of debt. Major operators such as France Télécom and Deutsche
Telekom have net debt of EUR 61 billion and EUR 62 billion, respectively. In
addition, France Télécom has contractual obligations linked for
example to the company’s share prices, which could entail an increase
in debt of EUR 17bn. US telecom operators, such as WorldCom, are also highly
leveraged. Lower production of mobile equipment and weaker prospects have led
to a sharp stock price fall for the large Nordic equipment producers Ericsson
and Nokia.
Chart 2.6
Limited contagion effect from Argentina
In the latter part of autumn 2001, the already deep crisis in Argentina intensified.
In December, the situation became acute. The authorities did not succeed in
renegotiating government debt terms and declared a cessation of debt payment
and abandoned the peso’s fixed link to the US dollar. Fears of this scenario
and a subsequent depreciation of the exchange rate for the peso had prompted
a general capital flight and a sharp reduction in bank deposits, particularly
in pesos, over the summer and autumn (Chart 2.7). To prevent further capital
outflows after the peso had been de-linked from the US dollar, stringent restriction
on foreign exchange trading were introduced. At the same time, the government
imposed tight limitations on bank deposit withdrawals. Since the beginning of
the year, the peso has depreciated by 70% against the US dollar in spite of
extensive central bank interventions. Banks’ balance sheets have deteriorated
markedly as a result of the government requirement that they convert their USD-denominated
assets at a lower rate than their liabilities in USD. Five of the ten largest
banks are foreign-owned, and the parent banks have sustained substantial losses
on their commitments in Argentina. Government regulations have so far prevented
a total collapse of the banking system. The situation is still very serious,
and agreement with the IMF concerning new loans has not been reached.
Chart 2.7
Crises in emerging economies, such as the Asian crisis in 1997 and Russian
crisis in 1998, have often had knock-on effects on other countries via capital
markets. The crisis in Argentina, however, has had relatively limited effects
on capital inflows to other emerging economies. The risk premium on loans to
these countries, as measured by the interest rate differential against US government
bonds, increased after 11 September, but fell throughout the crisis in Argentina
(Chart 2.8). Several factors explain the limited contagion effects from Argentina.
Investors had the opportunity to follow the unfolding of the Argentine crisis
over a long period. As a result, there was ample time to compare developments
in Argentina with developments in other countries, such as the neighbouring
country of Brazil. The absence of surprises may have limited herd behaviour.
In addition, part of the explanation can be found in the EMBI+, which is an
important benchmark index for managers with bond portfolios in emerging economies.
At the beginning of December, Argentina restructured portions of its government
debt, which reduced the volume of marketable government bonds by USD 41bn. Combined
with reduced liquidity of other Argentine securities, this reduced Argentina’s
weight in the EMBI+ from 10.6% to 2.6% in the course of December. In response
to the weighting change, index managers had to increase purchases of debt securities
in other emerging economies and sell Argentine securities. The weighting change
may thus have had a stabilising effect in that the yields on other countries’
bonds were kept down. This may in turn have induced managers with less restrictive
mandates to maintain positions in these securities.
Chart 2.8
Implications of the Enron bankruptcy
The US energy company Enron collapsed in December 2001, and is the biggest
bankruptcy in the US to date. Debt and compensation claims are estimated to
amount to about USD 100bn. The main threat to global financial stability did
not stem from the Enron bankruptcy itself, but from the uncertainty as to
whether corporate accounts provide reliable information.
Over many years, Enron moved assets from its balance sheet to so-called Special
Purpose Entities (SPEs). Large investment banks helped Enron organise SPEs
as partnerships where external investors had smaller holdings, in many cases
thanks to capital lent or guaranteed by Enron. The practice of transferring
assets to SPEs was not generally known to the average investor. The structures
were not transparent because of a complex network of cross-ownership of the
SPEs. A fundamental problem associated with the relationship between Enron
and the SPEs was that they were not independent of Enron as far as either
ownership or business transactions were concerned. It was common to capitalise
the SPEs by injecting Enron shares and furnishing guarantees that equity capital
would exceed a specified minimum level. When Enron shares started to fall,
Enron therefore had to inject more capital into the SPEs. As a result, Enron’s
credit rating was downgraded so that terms linked to Enron’s debt were
activated. The problems were further aggravated by Enron’s hedging transactions
with the SPEs because they did not provide genuine protection as Enron was
in reality its own counterparty. In the end, Enron had to seek bankruptcy
protection.
The Enron case has intensified the focus on US accounting standards, which
are based on detailed rules. Norwegian accounting standards are based on general
accounting principles supplemented by recommendations. Detailed accounting
rules can shift the focus away from the main purpose of accounts, which is
to provide as complete and clear a picture as possible of a company’s
financial position. Even with ownership interests of up to 97%, Enron could
avoid consolidating the SPEs. US accounting rules accept that SPEs are not
consolidated as long as external ownership interests exceed 3%. As a general
rule, companies in Norway are to be consolidated when ownership interests
exceed 50%. Moreover, notification is to be provided concerning companies
where ownership interests reach 20%. In the wake of the Enron collapse, the
US authorities have proposed changes to the accounting rules. Increased transparency
is required with regard to transactions with associated companies and their
employees. Companies also have to describe the most critical accounts items
and state what effect various scenarios would have on the results. The proposal
emphasises in particular that the accounting rules shall not be used to conceal
information from investors. Consolidation is required if external ownership
interests in SPEs are less than 10%.
The question has been raised as to whether the substantial fees paid to the
Enron employees who administered the SPEs and the extensive use of options
programmes may have encouraged illegal behaviour to achieve personal gains.
In addition, the sizeable transactions between Enron and the SPEs may have
provided room for manipulating Enron’s results through internal pricing.
Any illegalities should have been disclosed by the company’s auditors.
A conflict of interests has been invoked as Enron’s auditor, Andersen,
was also one of Enron’s chief advisors and earned more from its consulting
services than from its auditing services. As a result of a lack of confidence
in Andersen after Enron’s bankruptcy, Andersen is now being wound up.
In the wake of the Enron collapse, the question had also been raised as to
whether an audit firm should be permitted to perform other services for the
companies it audits.
In addition, the Enron disaster seems to have induced financial markets to
impose a risk premium on companies with unclear accounts. The world’s
largest company, General Electric, is one of the companies that has noticed
this. Following the sharp fall in its share price in February, corporate management
promised detailed information about all the company’s business activities.
There are other examples of press reports on opaque corporate constructions
that have led to a sharp fall in share prices, which in turn has initiated
a simpler corporate and funding structure.
2.2 Securities markets in Norway
Relatively favourable price performance in the Norwegian stock market
Since last autumn, the Norwegian stock market has performed markedly better
than international stock markets (Chart 2.1).The all share index (OSEBX) has
advanced by 7% since the beginning of the year. The energy index has shown the
strongest gains, rising by 16%, followed by the financial index with a rise
of 13% (Chart 2.9). At the beginning of this year, Norsk Hydro was moved from
the industrial index to the energy index. The energy index, which also includes
Statoil and other energy-related companies, has thus become the predominant
sub-index on the Oslo Stock Exchange. Higher oil prices have pushed up the energy
index and thereby the all share index. Improved economic prospects have not
led to an increase in new share issues. Listed companies issued shares for NOK
2.6bn in the first four months of 2002, compared with NOK 4.0bn in the same
period in 2001. Turnover in the stock market also fell in the first four months
of the year compared with the same period one year earlier.
Chart 2.9
The options market’s assessment of the probability of a fall in the Norwegian
stock market can be derived from put and call options prices.1) The risk-neutral
probability of a price fall of at least 10% over the next four weeks has largely
remained in the 0-10% interval (Chart 2.10). During the period of falling share
prices in the autumn of 1998 and 2001, the probabilities were 20% and 16%, respectively.
Option market assessments appear to be heavily influenced by observed price
falls, but not by the price level.
Chart 2.10
1) See also the box “The market view
of future uncertainty – information from option prices” in Financial
Stability 1/2001 and Working Paper 2002/3, "Estimering
av indikatorer for volatilitet" (Estimation of volatility indicators).
Market risk for Norwegian financial institutions
Norwegian banks have small securities holdings, particularly shareholdings,
compared with other countries. Short maturities on debt securities and some
use of interest rate derivatives for hedging purposes also contribute to low
market risk (Table 2.1). Calculating Value at Risk (VaR) and stress tests are
two methods used to measure market risk. The two methods differ in that VaR
models are based on the premise that recent price movements are representative
of market fluctuations in the immediate future, while stress tests measure the
effect of a pre-defined market shock. Using a simple VaR model, the probability
of price falls of 0.6% and 0.7% for commercial and savings banks’ securities
holdings, respectively, over a 1-2 week period was lower than 1% in mid-May.
By way of comparison, the figures at the end of September 2001 were 1.7% and
2.7%, respectively. A stress test scenario based on a general fall in share
prices of 30% would result in capital losses on commercial and savings banks’
securities holdings of 3% and 4%, respectively, which corresponds to about 0.3%
of total assets. Another scenario based on a 2 percentage point parallel shift
upwards in the yield curve would result in capital losses of around 2% for both
types of banks. VaR and stress test estimates are based on simplifying assumptions
about the composition of banks’ securities portfolios. Hedging transactions
are not taken into account.
Table 2.1
Norwegian insurance companies are exposed to market risk to a far greater extent
than banks because of their substantial holdings of shares and interest-bearing
securities (Table 2.1). This was clearly illustrated during the turbulent period
in financial markets last autumn. In the period following the turbulence, the
proportion of equity holdings increased again but is still markedly lower than
in 2000 when it was higher than 30%. A lower proportions of equity holdings
has led to an increase in the proportion of bond holdings. Life insurance companies’
buffer capital was close to zero on 21 September 2001. Positive stock market
developments and a change in government regulations resulted in an increase
in buffer capital to NOK 18bn at end-2000. However, this level is still lower
than the level prevailing at end-2000 when buffer capital came to NOK 23bn.
Japanese banks increasingly vulnerable
Japanese banks have a high and rising share of non-performing loans, which
accounted for 7.4% of total loans outstanding at 30 September 2001 (Chart
1).1) Loss provisions accounted for 32.5%
of non-perform-ing loans. Regional banks are particularly vulnerable as they
have the highest share of credit to small and medium-sized enterprises, which
are facing more severe problems than export-oriented companies. Banks are
heavily exposed to securities markets. At 30 September 2001, securities accounted
for 20% of total assets. Equity holdings alone account for an estimated 5%
of assets. Several years of losses have resulted in substantial deferred tax
credits, which is an asset item of uncertain value.
Chart 1
1) Non-performing loans in Norwegian
banks accounted for about 9% of total loans outstanding at the height of
the banking crisis in 1992.
The accounting year 2001 ended on 31 March 2002. Preliminary results figures
for the largest banks, published by the supervisory authorities, show higher
loan losses than estimated mid-year, but lower losses on securities. The capital
ratio was around 10.5%. In the last half-year, the supervisory authorities
have conducted a survey of the quality of the largest banks’ loan portfolios,
with particular emphasis on problem loans. Almost half of the commitments
scrutinised were downgraded and close to 30% of the stock of loans outstanding
fell into the category “risk of bankruptcy” or poorer. External
analysts consider the quality of loans outstanding to be even poorer than
indicated by the survey. They are of the view that the banks are impeding
a necessary restructuring of the business sector by keeping large, unprofitable
companies afloat. Developments in bank shares compared with other shares reflect
market pessimism as to the outlook for the banking sector in Japan (Chart
2)
Chart 2
Several reforms aimed at enhancing transparency in the banking sector have
been implemented:
- On 1 April 2002, the unlimited guarantee for time deposits was replaced
by a limited guarantee with a ceiling of JPY 10m (about NOK 650 000) per customer
per bank. This measure was designed to raise depositor awareness of the banks’
financial position. However, this could also make the banks more vulnerable
to a bank run.
- The accounting year 2001 was the first year when Japanese banks were required
to apply market values in calculating the value of their securities. The use
of market values also means that unrealised gains/losses have a direct impact
on results and that the accounts to a larger extent reflect the banks’
true financial position.
- The Japanese tradition of cross-holdings between banks and enterprises results
in poor risk diversification. The banks own over a fourth of the Japanese
stock market. The equity exposure of the largest banks is on average 50% higher
than core capital. One of the main reasons behind the deterioration in financial
strength in the first half of the accounting year 2001 was the fall in share
prices. In order to reduce market risk, a law has been adopted stipulating
that the value of banks’ equity holdings shall not exceed core capital.
Banks have been given a period of 4 years to satisfy this requirement.
The predominant risk factor for banks is a continued unfavourable macroeconomic
environment, resulting in a further deterioration of the loan portfolio. In
addition, banks’ heavy exposure in the securities market makes them
vulnerable to changes in share prices and interest rates. As to their bond
portfolios, the risk is more or less only on the downside because of today’s
very low interest rates.
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