Financial Stability 2/2001
6 Banks' financial position
6.1 Growth in lending, financial strength and competitive environment
6.2 Banks' profits
6.3 Uncertain outlook
Box:
Breakdown of loan losses and loss provisioning practices
6.1 Growth in lending, financial strength and competitive
environment
Despite high lending growth, financial strength remains satisfactory
Growth in bank lending has been relatively strong for a prolonged period (see
Chart 6.1). Banks have curbed lending growth from the second to the third quarter
2001 and twelve-month growth is now less than 10%.
Chart 6.1
So far, lending growth has not caused an appreciable decline in banks' financial
strength. Lending growth has been higher in small and medium-sized banks, which
have also experienced a reduction in financial strength in contrast to the three
largest banks. Nevertheless, they still comply with capital adequacy requirements
by a good margin. Several of the larger banks have reduced lending growth and
improved core capital ratios the past year to the end of the third quarter 2001
(see Chart 6.2). Some banks have raised new equity. Overall financial strength
in the banking sector at the end of the third quarter 2001 is relatively good.
The core capital ratio was 8.5% and 10.3% for commercial banks and savings banks
respectively. Continued high lending growth in banks will nevertheless require
solid earnings to avoid a reduction in capital adequacy.
Chart 6.2
The competitive situation and interest margins
Banks' lending margins should cover expected losses on loans, costs connected
with lending activities and a competitive servicing of equity. If an increased
volume of lending is to contribute to improving earnings, loan pricing must
be both satisfactory and sound. When competition is intense, there is a risk
that banks' risk premium on lending is too low.
Competition is relatively strong in the Norwegian banking sector. Estimation
of the Herfindahl index8 for the Norwegian loan
market shows that market concentation is low in the retail market (see Chart
6.3). The corporate market is somewhat more concentrated but is still at a fairly
moderate level. Developments in banks' interest margins may also reflect this.
Banks' overall interest margin has declined for several years (see Chart 6.4).
One possible explanation for this is increasing competition. During the first
half of 2001, however, the lending margin has increased somewhat while the deposit
margin has declined. Strong competition and low margins make it difficult for
banks to substantially strengthen underlying earnings through growth in lending.
Chart 6.3 Chart
6.4
8 The Herfindahl index is the
sum of the square of the individual market share of each firm measured as a
percent. Concentration is considered low in markets with a Herfindahl index
under 1000, while markets with an index above 1800 are considered to be concentrated.
6.2 Banks' profits
The three largest banks had approximately the same pre-loss operating profits
in the first three quarters of 2001 as in the corresponding period of 2000 (see
Table 6.1). Pre-loss profits in small and medium-sized banks were weaker than
in the same period last year (see Table 6.2). This reflects both lower net interest
income and a reduction in other operating income as a percentage of average
total assets (ATA).
Table 6.1 Table
6.2
Loan losses in the three largest banks are still low, but showed an upward
trend this year (see Chart 6.6). A substantial portion of the losses was recorded
in the third quarter. Loan losses in the other banks are somewhat higher. The
volume of non-performing loans at the three largest banks is low but has increased
during the first three quarters of 2001. Gross non-performing loans have increased
more in the other banks. The low volume of non-performing loans in the three
largest banks is probably related to the fact that in recent years these banks
have chosen a somewhat different credit strategy and a less expansive lending
policy than the smaller banks. The largest banks can thus have developed a loan
portfolio of higher quality (see Box on loan losses).
On the whole, banks' results are weaker this year than last. Many more banks
have reported profits between 0.5% and 1.5% of ATA this year than last (see
Chart 6.5). More banks have also reported a loss. Pre-tax profits have declined
for small and medium-sized banks compared with last year, partly because banks
recorded a substantial gain on the sale of shares in Fellesdata last year. The
two largest commercial banks won a tax dispute concerning the treatment of preference
capital transferred to the banks at the beginning of the 1990s, and this has
affected the year's results after tax for the three largest banks.
Chart 6.5 Chart
6.6
The three largest Norwegian banks have generally been able to show very good
results for a number of years. This reflects a favourable tax position for a
long period combined with low loan losses. During the first three quarters of
2001, banks' return on equity was more than 16%. If the largest banks' results
are adjusted for a more normal tax level and more normal loan losses, the banks'
return on equity based on the earnings reported for the first three quarters
of 2001would have been between 10% and 11%. This shows that the largest banks,
despite solid results so far this year, will need to improve underlying earnings.
In order to achieve this, banks must reduce costs, find alternative sources
of income and/or charge higher fees on lending and deposit activities.
6.3 Uncertain outlook
Weaker results ahead
A number of factors indicate that banks' results will be weaker in the future.
The negative trend in the stock market may reduce underlying earnings. Due to
increased domestic uncertainty and a downward revision of international growth
forecasts, it is reasonable to expect an increase in non-performing loans and
subsequent loan losses.
Falling share prices may result in lower commission income from customer trading
in shares and fund units through both lower prices on traded volume and lower
traded volume. Due to a decline in share prices, more companies may also choose
to delay plans for share issues, which affects banks by reducing commissions.
Banks' own securities trading is also negatively affected, although the impact
is limited since trading portfolios are relatively small.
Credit risk in banks' loan portfolios is considered to be higher due to increased
uncertainty in the domestic economy, a reduction in international growth forecasts
and a higher debt burden in both the household and enterprise sectors (see Section
3). There is a risk that banks may incur losses on loans in the private customer
market due to an increase in defaults and falling house prices. In the largest
commercial and savings banks, most mortgage loans are collateralised within
80% of the assessed value. Losses on loans to the household sector are still
expected to be fairly low. Enterprises are dependent on continued solid earnings
in order to service debt. Developments so far this year may point more strongly
to weaker earnings in the enterprise sector. Loan loss predictions based on
Norges Bank's credit risk model indicate a slight upward trend (see Chart 6.7).
Defaults in the enterprise sector were on the rise from the second to the third
quarter of this year (see Chart 6.8).
Chart 6.7 Chart
6.8
In the event of a recession, losses will increase and banks' profitability
will be under pressure unless banks succeed in raising the interest margin on
loans. To allow for the possibility of a strong increase in loan losses over
and above expected losses, banks must maintain their financial strength and
preferably improve it somewhat (in some banks). Recorded losses are on the rise.
However, losses are still low and must increase markedly before stability in
the banking sector is eroded.
Life insurance companies and financial stability
Life insurance companies have been hit hard by the decline in share prices
(see Section 2). Several companies were on the verge of losing their buffer
capital and the authorities implemented measures that strengthened the companies'
buffer capital by NOK 6 billion in the short term. Some companies have also
strengthened their equity.
Life insurance companies play a less important role than banks with regard
to financial stability, primarily because these companies do not have the kind
of liquidity risk that banks have. Banks' liabilities consist largely of short-term
deposit accounts (which may be terminated with immediate effect), while life
insurance companies' liabilities are long-term and contractual. Thus, there
is no basis for the kind of rapid withdrawals that can have a negative effect
on banks and cause serious financial instability. The significance of life insurance
companies for financial stability must also be seen in the light of the fact
that the companies' total assets are only one-quarter of banks' total assets
and that they play no role in the payment system.
Therefore, life insurance companies have a more indirect impact on financial
stability. Problems in insurance companies can spill over to banks and securities
markets both directly through current transactions and through a general loss
of confidence in the financial sector. Problems can also spread through financial
groups, although legislation regulating financial groups aims at limiting this
risk.
A number of life insurance companies in Norway are part of financial conglomerates
where bank activities dominate. The risk of spillover effects from the conglomerate's
life insurance operations to banking operations is limited. If the life insurance
company should need fresh capital, one solution might be for other parts of
the conglomerate to supply the capital. This supply of capital is not regarded
to represent a threat to the overall financial strength of these financial conglomerates,
a threat that could have had a negative impact on banking operations. Due to
the recent reduction in life insurance companies' buffer capital, the companies'
equity is more exposed to a new decline in the securities markets. More emphasis
must be placed on contingency plans designed to strengthen the capital base.
Breakdown of loan losses and loss provisioning practices
Loan loss provisions play an important role in revealing the value of assets
in banks' balance sheets. Loan loss provisions are also very important for
both fluctuations in and the degree of cyclicity in banks' earnings and profits
over time.1
1 Refer to Borio, Claudio
and Phillip Lowe, "To provision or not to provision",
BIS Quarterly
Review, September 2001, pp. 36-48.
Norway has a separate regulation that provides guidelines for recording loan
losses.2 Book losses consist primarily
of specified and unspecified loan loss provisions as well as actual losses
(see the diagram below). Specified loan loss provisions are made on
loans that the institution considers to be doubtful, for example when a customer
has defaulted3 on a loan. When the bank
makes a new provision for loan losses, however (2)4,
the timing and amount of the loss are unknown. In the course of one period,
the bank can therefore either increase (3) or decrease (5) an earlier provision
for loss.
Chart
2 Regulation for commercial
banks, savings banks, finance companies and Den norske Industribank AS concerning
assessment of loss on loans, guaranties etc. Laid down by the Banking, Insurance
and Securities Commission on 14 November 1991 pursuant to Act No. 1 of 7 December
1956.
3 A loan is considered in default when
the principal/interest has not been paid when due. The bank shall then evaluate
the necessity of making a provision for loss on the loan. If 90 days have
elapsed since the loan payment fell due and no principal/interest has been
paid, the loan is considered to be in default regardless (and the bank must
evaluate the necessity of making a provision for loss).
4 The figures in ( ) refer to the diagram.
In addition, based on an assessment of the economic outlook, industry analyses
and other factors that are important to the loan portfolio's risk profile,
the bank should make a discretionary provision for unspecified losses.
Depending on the size of the previous unspecified loan loss provision, the
provision will either represent an increase (4) or a decrease (6).
Loan loss provisions at the end of an accounting period (8) are thus equivalent
to the provisions at the beginning of the period (1) plus new and increased
loan loss provisions (2+3+4) minus decreases in previous loan loss provisions
(5+6) and actual losses that have already been covered by loan loss provisions
(7).
Gradually, some loans will move from being doubtful to being actual losses.
The size of the actual loss will then be the difference between the size of
the loan and the value of realised collateral. The bank may have made allowances
for the actual loss by previously making a provision for loss on the loan.
The actual loss (7) will then contribute to reducing the loan loss provision
at the end of the period (8). The alternative is that the bank has not
made a provision for the loan earlier (9). Then, the actual loss has no effect
on the bank's loan loss provisions but increases the recorded loss directly.
Losses or gains in connection with acquired assets will either be recorded
as actual losses on loans (9) or recoveries of loans previously written off
(10). Recorded loan losses (11) thus consist of the "net"increase
in loan loss provisions (2+3+4-5-6) plus "net"actual losses not
previously covered by loan loss provisions (9-10).
The table below shows losses in the eight largest banks during the first
three quarters of 2001. Recorded losses during the period are due in particular
to new specified provisions for losses on loans where provisions have not
previously been made, but banks also increased provisions on existing problem
loans. There were some new actual losses during the period, whereas new unspecified
loan loss provisions were low.
Table 1
Loan loss provisioning practices will vary to some extent at different banks.
This may be reflected in how early losses are recorded as an expense and how
strictly the banks assess predictable losses (for example, with regard to
the valuation of collateral). At the end of the third quarter 2001, specified
loan loss provisions in the eight largest banks accounted for between 31%
and 45% of problem loans (gross non-performing and doubtful loans). Unspecified
loan loss provisions in the same group of banks came to between 0.4% and 1.3%
of gross loans. The variation in provision ratios may be related to the different
risk profiles of banks. This may also be due to differences in banks' use
of discretion and practices when interpreting loan loss provisioning rules.
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