Financial Stability 2/2000

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6 Credit risk

Norges Bank: Financial stability 2/2000

6.1 General credit developments
6.2 Credit risk in the household sector
6.3 Credit risk in the enterprise sector

6.1 General credit developments

Growth in mainland credit from domestic and foreign sources picked up during the first half of 2000 (see Chart 6.1). At the end of June, annual growth was 9.6%, which is considerably higher than nominal mainland GDP growth, and reflects a higher debt burden for domestic market participants on the whole. Domestic sources, especially banks, have largely contributed to this development. Growth in credit from domestic sources (C2) has increased steadily since mid-1999 and was 12.2% at end-September 2000 (see Chart 6.2). This is higher than the peak level in March 1998, when annual growth was 10.8%. Banks' lending growth was 13.9% at end-September. During the first half of 2000, credit in foreign currency from domestic sources showed a particularly sharp increase.

Non-financial enterprises, which accounted for about 37% of total domestic credit to the private non-financial sector and municipalities (C3) at end-September 2000, have recorded high growth in new credit in recent years. After a sharp increase at the beginning of 1998, growth contracted somewhat in 1999 (see Chart 6.3). During the first half of 2000, growth in credit to non-financial enterprises edged up again. Households, which accounted for about 55% of total domestic credit to the private non-financial sector and municipalities at end-September, have increased the amount of new credit appreciably the last year. At end-September, credit growth (C2) to non-financial enterprises and households was 14.7% and 11.1%, respectively.

Chart 6.1      Chart 6.2      Chart 6.3

6.2 Credit risk in the household sector

Financial institutions' credit risk associated with lending to the household sector will depend on the ability (and willingness) to pay and the value of collateral, of which dwellings are the most important.

Resale home prices have risen more or less continuously since 1993 (see Chart 6.4), giving banks a buffer against a decline in house prices for earlier loans. The Banking, Insurance and Securities Commission's housing loan survey for loans extended this year shows that about 25% of banks' lending (value) had a loan-to-asset value ratio of more than 80%, about the same as in 1999. The share increased in commercial banks and declined in savings banks (see Chart 6.5). Nevertheless, the level in savings banks is definitely highest. Furthermore, additional collateral for loans with a loan-to-asset value ratio of more than 100% is much less common in savings banks (about 17% of the value of loans) than in commercial banks (49% of the value of loans).

Recent figures from various sources indicate that the rise in resale home prices is slowing. According to figures from ECON Centre for Economic Analysis and the Norwegian Association of Real Estate Agents, resale home prices fell by about 3% from the second to the third quarter this year. Prices of OBOS dwellings declined from May to October, with the exception of a price rise from August to September. The year-on-year rise was 12% in the third quarter. A number of developments point to continued slowing of the rise in resale home prices in the future: i) interest rate developments⁷⁾ (see Chart 6.8), ii) high housing investment this year and next, which will gradually provide a number of new homes, and iii) weaker growth in disposable income, partly because some of the increase in welfare is being taken out as leisure time rather as a further rise in income.

Chart 6.4      Chart 6.5

Lower net lending than for several years

Growth in credit to households has been high and rising during the past year. Household debt rose by NOK 75 billion from end-June 1999 to end-June 2000. At the same time, investment in financial assets has levelled off. Four-quarter investment in financial assets has been between NOK 70 billion and NOK 80 billion since 1997. As a result, net lending is at the lowest level since 1990 (see Chart 6.6). In addition to net lending, households' net financial wealth is determined by changes in the value of financial instruments. A rise in the value of securities and insurance claims has increased households' net financial wealth during much of the 1990s and so far this year. At the end of the second quarter of 2000, households had net financial wealth of nearly 66% of their disposable income.

Although households as a group have large net financial wealth, the ability to pay loan principal and interest with current income will nevertheless be decisive for the majority of households. The reason for this, among other things, is that insurance claims, which for the most part are illiquid, account for 35% of gross financial wealth, and that nearly 16% of gross financial wealth consists of directly owned shares and bonds that are probably owned by a limited portion of the population.

Chart 6.6

Debt burden increases

Households' debt burden (loan debt as a percentage of disposable income) started to increase during the second half of 1999, after having been about 118% for several years. The debt burden is expected to rise to more than 125% towards the end of 2000 (see Chart 6.7). This trend is due to rapid and increasing growth in debt and lower growth in disposable income. The rapid growth in debt may be seen in the light of a strong increase in resale home prices and housing wealth throughout 1999 and expectations of high growth this year. Interest rate developments and a slower rise in resale home prices and housing wealth may contribute to weaker growth in households' loan debt in the future. It is assumed that, on average, households' loan debt will increase in line with disposable income during the next three years. The estimates are shrouded in uncertainty. A continued sharp rise in resale home prices may result in stronger growth in debt than assumed.

Higher interest rates in the course of this year and expectations of additional interest rate increases next year contribute to increasing the interest burden (see Chart 6.8). The interest burden is defined as households' gross interest expenses (after tax) as a percentage of cash income (disposable income before deduction of interest expenses). Assumptions concerning a decline in interest rates from the end of next year will help reduce the interest burden.

Chart 6.7      Chart 6.8

Some smaller groups may be vulnerable

Although households' debt and interest burden on average is fairly low, some groups may nevertheless have problems servicing their debt. When households are classified according to the pre-tax interest burden, we see from Chart 6.9 that households with an interest burden over 20% accounted for 24% of total debt in the household sector in 1998, an increase from barely 18% in 1997. This corresponds to more than NOK 200 billion, based on households' total debt at the end of the second quarter 2000. The increase is primarily due to interest rate increases in 1998. In 1997, about 5% of households had an interest burden over 20%, while the share rose to around 7% in 1998.

The extent to which households with a pre-tax interest burden of over 20% represent a risk of loss for banks will also depend on other household characteristics, such as income level and value of gross financial assets. Charts 6.10 and 6.11 show the distribution of debt by households' income after tax in households with a fairly high interest burden. The lower the household income, the more difficult it will normally be to bear a high interest burden. The charts show that households with an annual income under NOK 220,000 account for more than 20% of debt in households with an interest burden above 20%, or about NOK 40 billion. Households with an interest burden over 30% and annual income under NOK 90,000 are not included, since this is a very complex group which on average has positive net financial wealth.

The impression of households' financial vulnerability does not change when gross financial assets (bank deposits, shares in securities funds, shares, bonds, etc.) are taken into consideration.⁸⁾ Net debt in households with a 20%-30% interest burden is on average more than 2.8 times greater than income after tax. For households with a higher interest burden, the ratio is more than 5.5. The data do not provide scope for assessing the value of dwellings or other tangible assets that are of importance to households' debt-servicing capacity.

Chart 6.9      Chart 6.10      Chart 6.11

Continued low credit risk associated with households

Households' debt burden is increasing markedly for the first time in several years. In addition, household net lending is very low. This may indicate a change in household financial behaviour. If this trend continues, households' financial vulnerability will increase. Assumptions about economic developments indicate, however, that banks' loan losses related to households will also be low in the future, even though some smaller groups of households are vulnerable. The debt burden is considerably lower than at the end of the 1980s.

6.3 Credit risk in the enterprise sector

High debt burden in the enterprise sector

So far this year, investment in the enterprise sector has increased more than projected six months ago. Investment growth is now projected to be slightly positive this year. It is likely that interest rate increases so far this year and assumptions concerning higher interest rates the next two years will gradually contribute to curbing investment growth. As a result, the projected decline in investment this year has been pushed forward to 2001 and 2002.

The enterprise sector has recorded high debt growth for many years. In 1997 and 1998, annual growth was around 20%. In 1999, the growth rate fell to about 13%, which must still be seen as a relatively high rate of growth. Growth in enterprise debt is projected at around 11% this year, a fairly sharp upward adjustment of the 7% projection in the last Financial Stability report. The reason for the upward revision is the expected increase in enterprise investment this year. Debt growth is expected to taper off from 2001.

Enterprises' debt burden, ie the ratio between interest-bearing debt and cash surplus less interest expenses, rose steeply in 1997 and 1998 due to sharp growth in debt and weak results in enterprises, especially in 1998 (see Chart 6.12). As a result of more moderate growth in debt and better results, the debt burden stabilised in 1999. Assumptions of higher growth in debt than in cash surplus the next three years will lead to an increase in the debt burden.

The interest burden in the enterprise sector, ie interest expenses as a percentage of cash surplus, has risen from less than 20% in 1997 to nearly 30% in 1999 (see Chart 6.13). According to our calculations, the interest burden will rise moderately this year and somewhat more in 2001, when it will reach about 36%. This is due to the assumption of higher interest rates in this period, combined with relatively high debt growth relative to enterprise earnings. After this, the interest burden is expected to decrease towards the end of 2003.

Chart 6.12      chart 6.13

Positive earnings trend in 1999

The above analysis is based on macro figures. Norges Bank also has access to financial statements⁹⁾ and other information about nearly all Norwegian public limited companies for the period 1988 to 1999. This makes it possible to analyse developments in enterprises in more detail.

Interest rate increases and weaker demand in the economy had a negative impact on enterprises' earnings in 1998. A low rise in prices for imports in the first three quarters of 1999¹⁰⁾ and increased growth in total demand during the second half of the year contributed to improved earnings that year (see Chart 6.14).

Enterprises' average equity ratio, ie equity as a percentage of total assets, has increased every year since 1988, with the exception of 1991, and was 30% at the end of 1999. The increase is partly due to the fact that enterprises on the whole have financed a relatively high portion of investment through retained earnings and new issues. The median enterprise's equity ratio has also increased since the early part of the 1990s, but showed a negative trend in 1999. The median enterprise's equity ratio has been considerably lower than the average equity ratio for the entire period, because the former is not affected by large enterprises that boost the average.

Financial institutions' loss prospects depend largely on the amount of debt in the weakest enterprises. It is therefore important to monitor developments in these enterprises carefully. After an increase in 1998, the share of debt in weak enterprises declined sharply in 1999 (see Chart 6.15). At the end of the year it was 21%, the lowest level in the entire period from 1988 to 1999. The positive trend in 1999 was primarily due to improved earnings. The moderate enterprises' share of total debt increased considerably in 1999, while the strong enterprises' share of total debt showed a marginal increase.

The share of debt in enterprises at risk, ie enterprises where bankruptcy or the winding up of operations is likely, also dropped in 1999, and was 5.8% at year-end. By way of comparison, this type of enterprise accounted for nearly 20% of enterprises' total debt in 1991. Chart 6.16 shows that debt in these enterprises declined sharply in 1999. After climbing from NOK 26 billion in 1996 to NOK 37 billion in 1998, debt was reduced to NOK 25 billion in 1999. ¹¹⁾ In the crisis years at the beginning of the 1990s, debt in the weakest enterprises was more than 60 billion 1999-NOK. Small enterprises account for the majority of high-risk debt.

The share of debt in enterprises that have been weak the last two years and in weak, newly established enterprises also declined in 1999 (see Chart 6.17). This indicates that credit risk declined. However, this category of weak enterprises still accounts for a fairly large share of weak enterprises' total debt.

Looking at the risk classification of enterprises the year before they raised new debt gives an indication of banks' lending policy. Chart 6.18 shows that the share of new debt in enterprises that were classified as weak the year before raising debt declined marginally in 1998 and 1999, an indication that banks have become somewhat more cautious about granting loans to weak enterprises.

Developments in a selection of listed Norwegian companies show that there were more companies with weak earnings in the first half of 2000 than in 1999. In addition, there were fewer companies with an equity ratio of over 20%.

Chart 6.14      Chart 6.15      Chart 6.16      Chart 6.17

Developments in selected industries

Some industries are traditionally more vulnerable to debt-servicing problems and bankruptcy than others. This is particularly true for industries that are highly sensitive to cyclical fluctuations that can rapidly affect enterprises' profitability and the value of their assets.

The industry with most debt at the end of 1999 was the property management sector, with NOK 107 billion (see Table 6.1). Weak enterprises accounted for about NOK 22 billion of this debt. A large share of banks' loan losses during the banking crisis was associated with enterprises in the property management sector. Loans to the property management industry are especially vulnerable to a downturn or a drop in prices in the property market. This is because borrowers' earnings and the value of financial institutions' collateral are related to one and the same market. A large part of financial institutions' lending and collateral is still associated with the property market. Therefore, it is important to follow developments closely.

Mining and manufacturing is another industry with high debt. Table 6.1 shows that weak enterprises had a lower share of debt in 1999 than the previous year. Weak enterprises accounted for about 14% of debt, or more than NOK 12 billion, at the end of 1999. Norwegian enterprises' competitive strength has declined in relation to many foreign competitors in recent years due in part to high price and cost inflation. The fact that parts of this industry are highly exposed to competition may contribute to problems for a number of enterprises.

Enterprises in the shipping and pipeline transport sector had NOK 75 billion in aggregate debt at the end of 1999, of which NOK 18.5 billion was attributable to weak enterprises. A relatively large number of enterprises in this industry did not file their 1999 financial statements on time.¹²⁾ It is possible that a number of these enterprises were weak. The shipping and pipeline transport industry is dominated by enterprises that are largely financed by foreign sources. Therefore, it is natural to assume that this industry does not affect Norwegian financial institutions' credit risk as significantly as the figures in Table 6.1 indicate.

Developments in the retail trade sector were somewhat weaker than in other selected industries from 1994 to 1998 (see Chart 6.19). However, as in the other industries, debt in weak retail enterprises also declined considerably in 1999.

The hotel and restaurant sector has traditionally been a cyclically sensitive industry, with high risk exposure. At end-1999, this industry had the highest risk exposure, in relative terms, since weak enterprises accounted for nearly 28% of total debt. Nevertheless, this represented an improvement compared with the previous year. Weak enterprises' share of debt also declined in the construction sector. Both of these industries accounted for a relatively small share of aggregate debt in the enterprise sector.

Chart 6.18      Chart 6.19      Table 6.1

Commercial property

In the past few years, average office rent in the major cities has been fairly stable, except in the largest cities (see Chart 6.20). The last few years' rise in rent for new buildings in the centre of Oslo levelled off in 2000. Rentals for centrally located, prestigious and high standard buildings continue to climb, however. Rent has also risen somewhat in Bergen and Trondheim in 1999 and so far in 2000, in contrast with other cities where prices have been stable.

OPAK expects commercial rental prices to increase somewhat in Trondheim and Bergen, but to remain stable in the Oslo area and in other major cities. A number of development projects are under way in Oslo, but few of them will be completed this year. This helps to keep prices high since demand for commercial buildings in central locations is high.

Chart 6.20

Few payment notations and a low default rate

Enterprises in the hotel and restaurant sector have had the most payment notations so far this year. Enterprises in the property management sector have seldom failed to meet payment obligations so far this year. Only about 5% of the enterprises in this industry have had one or more payment notations (see Table 6.2). Enterprises in the shipping and pipeline transport sector have also had few payment notations.

The increase in enterprises' debt burden during the latter half of the 1990s and an interest rate that is somewhat higher than a couple of years ago has not had a significant effect on loan defaults so far. New non-performing loans did increase slightly in the first quarter of 2000, but total loan defaults are still very low (see Chart 6.21).

The number of bankruptcies in enterprises has increased somewhat so far this year. During the year's first three quarters, 2,650 bankruptcy proceedings were instituted, an increase of 11% compared with the same period in 1999. Unincorporated enterprises accounted for nearly half the bankruptcies. Primarily small companies accounted for the remainder. More than 6,000 individuals were employed in enterprises that went bankrupt in the first three quarters of 2000, while total turnover was about NOK 6 billion.

Chart 6.21      Table 6.2

Future prospects

Enterprises' debt has increased sharply the last two years, and total debt in relation to earnings is approaching the levels seen in the late 1980s. A heavy debt burden makes enterprises especially vulnerable to a cyclical turnaround.

On the other hand, analyses of enterprises' financial statements show that the negative trend in enterprises' operations in 1998 was reversed in 1999. Earnings improved and the size of debt in weak enterprises declined. In addition, enterprises' equity ratio rose during the 1990s, making them better equipped to cope with a cyclical turnaround.

Banks have provided a major share of the credit supply. The majority of banks' lending growth relates to strong enterprises, however, so that the quality of banks' total loan portfolio has improved. Our assessment is that credit risk in the enterprise sector as a whole was somewhat lower at the end of 1999 than one year earlier. Future developments in credit risk will depend largely on cyclical trends.

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