Financial Stability 2/2001

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5 Liquidity risk

Box:
Counterparty exposure

Little risk of liquidity problems in the short term,…

A bank is liquid if it succeeds in meeting its commitments as they fall due. Banks accept short-term deposits and provide long-term loans (see Chart 5.1). This makes them particularly vulnerable to liquidity problems. In practice, a large portion of banks' financing has a longer expected residual maturity than the fixed period or contracts indicate. Customer deposits, in particular, are normally a stable source of financing, among other things because they are backed by guarantee schemes. Liquidity problems may arise in connection with unexpected liquidity shocks. Major changes in the payment pattern or payment problems experienced by large financial counterparties or others may lead to liquidity problems.

Chart 5.1

Banks normally have no problems with liquidity under normal market conditions and where there is no uncertainty regarding their financial soundness. Situations may arise in which market liquidity deteriorates sharply. On 11 September this year, there was considerable uncertainty concerning dollar liquidity for a short period, and the interest rate on dollar loans was high for some banks. However, the market stabilised rapidly, and caused no major problems for Norwegian banks.

…but money market financing from abroad is increasing

Banks' lending growth has been strong for several years. As customer deposits have not increased as much as lending, the need to obtain financing from money and capital markets has also increased (see Chart 5.2). From end-1995 to September, the difference between lending to households, municipalities and non-financial enterprises and customer deposits rose from NOK 74 to NOK 319 billion. A falling deposit-to-loan ratio may reflect the fact that bank deposits are meeting strong competition from other types of saving, such as securities funds and various insurance products. It may also to some degree reflect the fact that the deposit-to-loan ratio, as we measure it, does not take fully into account that customers save more than previously in indexed bonds, which are a source of long-term financing for banks.

Chart 5.2

The sharp increase in banks' financing requirements in recent years could scarcely have been met by domestic money and capital markets without a marked increase in interest rates. Domestic non-banking sectors have recorded a large outflow of capital which has not been offset by a corresponding inflow of foreign capital. In this situation, banks have found it profitable to obtain foreign capital to finance the sharp increase in lending. From end-1995 to September, 2001 gross foreign debt increased from NOK 49 billion to a little more than NOK 319 billion (see Chart 5.3). This has made banks more diversified with regard to financing, but at the same time makes it easier for turbulence from abroad to spill over to Norwegian banks. The uncertainty in the global economy has increased the risk of problems in obtaining refinancing from abroad.

Chart 5.3

Financing in money and capital markets has largely shadowed the cost differential in recent years (see Chart 5.4). In the past six months, there has been an increase in bond yields relative to money market rates. It appears that the three largest banks may have adapted to this tendency by increasing their share of short-term financing.

Chart 5.4

In the second and third quarters this year, the three largest banks increased their short-term foreign debt markedly at the expense of their domestic short-term debt. During the same period, liquid assets increased somewhat, but less than short-term debt (see Chart 5.5). Liquidity risk may therefore have increased somewhat in the past six months, but from a relatively low level. The three largest banks have relatively good buffers in the form of liquid assets. However, it must be added that the value of securities, and hence the basis for new financing, may drop sharply in the event of turbulence.

Chart 5.5

In the past six months, small and medium-sized banks have increased their long-term financing, reduced their short-term foreign debt somewhat and slightly increased their domestic money market financing. In isolation, this has led to a reduction in liquidity risk. However, the liquid assets are small in relation to money market financing, so liquidity risk is probably not smaller than for the three largest banks. The low level of liquid assets may be due to the fact that small and medium-sized banks base themselves more on agreements for drawing rights in other banks or interbank deposits when extra liquidity is needed. In times of turbulence and uncertainty regarding the financial soundness of banks, drawing rights may be uncertain, and it may be difficult to raise loans in the interbank market. Although small and medium-sized banks still have relatively little money market financing from abroad, there may still be a high level of risk associated with this financing because these banks may not be very well known in international markets. Moreover, their rating is relatively low compared with major Nordic and other foreign banks.

Chart 5.6

Factors influencing liquidity risk in the future

In Report no. 6 from the Banking Law Commission (NOU 2001: 23 Activities of financial undertakings) it is proposed that banks' liquidity requirements should be qualitative as a general rule, and that liquidity management and maturity reporting requirements should be set out for both balance sheet and off-balance sheet items. Increased use of stress tests is also recommended. These proposals should induce banks to focus on liquidity risk, and contribute to revealing vulnerable financial structures in institutions in which this risk exists. The Commission also proposes giving financial undertakings the right to issue asset-backed bonds and to securitise parts of the loan portfolio. Such a change could improve the funding situation of banks and reduce liquidity risk. In addition, it could contribute to the development of the Norwegian securities and capital market, so that large Norwegian enterprises could to a greater extent obtain financing directly in the capital market.

The proposed new Basle rules may lead to higher capital requirements for interbank deposits for Norwegian banks, if banks' ratings form the basis for the rules. This may make long-term financing more profitable than short-term financing.

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