Financial Stability 1/2000

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7 The situation in the financial industry and the balance of risks ahead

Norges Bank: Financial stability 1/2000

7.1 Competitive environment and structural changes
7.2 Profit trends and financial strength
7.3 Future developments in banks' results and financial strength

7.1 Competitive environment and structural changes

The competitive situation in the financial industry is of considerable importance to banks' earnings, which in the long term have a decisive influence on their financial strength. Robust banks with financial strength to cope with disturbances are important for financial stability. A decline in profitability, for example as a result of intensified competition, may compel banks to introduce measures in order to reduce costs and/or increase revenues. The possibility that some banks will choose to increase their risk exposure in order to boost earnings cannot be excluded. This also increases the risk of losses and instability. On the other hand, competition may make banks more efficient and enable them to benefit from changes, which over time may enhance their earnings and robustness.

Stronger competition in the financial industry

For several years, driving forces such as deregulation, liberalisation, globalisation, technological advances and changes in customer behaviour have contributed to intensifying competition in the financial industry and changing the relative position of financial institutions and securities markets.
    Changes in the interest margin indicate that competition in lending and deposit markets has increased. The interest margin generally fell throughout the 1990s (see Chart 7.1), with the exception of 1998 when it rose as a result of an increase in interest rates. The interest margin declined from 3.34 to 3.18% from the third to fourth quarter of 1999. A further indication of intensified competition is the narrowing of differences between the interest margins of the various banks. The fall in the interest margin must also be seen in connection with cyclical developments as well as a shift away from cross-subsidisation of various segments of banks' operations. The positive trend in enterprises since 1993 has probably contributed to reducing banks' risk premium on loans, which has contributed to lower lending margins.
    Many operators compete in the Norwegian banking and financial markets. Competition from foreign banks, particularly the largest Nordic banking groups, has increased and must be expected to increase further in the period ahead. Furthermore, banks are experiencing stronger competition from securities markets and institutional investors, particularly for household savings.¹³
   Intensified competition is one of the reasons why all the largest Norwegian banks have decided to offer a broad range of financial services by establishing financial conglomerates or entering into alliances. Banks have thereby gained several sources of income, which can contribute to stabilising revenues. When banks' activities are expanded, their risk exposure also changes.
   In addition to the entry of new financial service providers and the entry into new markets by existing operators, changes have taken place on the demand side. Demographic changes imply a shift towards increased demand for long-term saving products. Customers have also become more price-conscious and aware of returns, and it is easier to compare products. New technology has been important for improving customers' access to information, and is generally the strongest driving force behind changes in the banking and financial industry. The Internet, in particular, will influence banks' operations in the period ahead.

Chart 7.1

¹³The consequences of these developments are discussed in Section 5 and in Section 7.5

Internet intensifies competition

The Internet is intensifying competition in the banking and financial industry, partly because it is easier for customers to compare prices and terms and partly because it is simpler for new operators to penetrate the market. The Internet may also change the relative positions of existing market participants.
   Almost all Norwegian banks have established some form of Internet banking. So far, the services being offered on the Internet are relatively simple: loan applications, bill payments and transfers between own accounts, overviews of movements on own accounts and other information. Some banks also offer trading in shares and fund units on the Internet. The product range and user-friendliness are expected to increase in the period ahead.
   Norway and the other Nordic countries rank at the top globally in terms of the percentage of the population that has access to the Internet. Many Norwegian banks therefore see an opportunity to serve a substantial share of customers via the Internet.
   The cost of handling a transaction over the Internet has been estimated at a tenth of the cost of a transaction through a traditional bank branch.¹⁴ The potential for a reduction in banks' variable costs is therefore considerable. However, substantial IT investments are required to keep pace with technological market developments. In isolation, this may contribute to increasing banks' fixed costs. Norwegian banks generally have smaller customer bases on which to distribute fixed costs than large foreign competitors. They will probably not be able to reduce total costs without a substantial reduction in the costs of more traditional distribution. Norwegian banks are thus facing a challenge with regard to a further scaling back of the physical distribution network. Bank branches are not likely to be eliminated, but the shift towards an increased focus on advisory services and sales will continue. At the same time, some products, such as loans and credit to small and medium-sized enterprises, will demand physical presence in the market.
   Financial institutions are facing considerable challenges in that they must adapt to new technology, intensified competition and globalisation. Substantial investments will probably be required to keep them competitive. Both management and employees will probably have to devote considerable attention to these aspects. The choice of solutions that prove to be inappropriate may weaken banks' competitive position, profitability and financial strength. This may also have negative implications for financial stability.
   The Internet implies not only risk elements, but also opportunities for traditional banks. For example, banks may have the opportunity to be key operators in trading on the Internet. They have large customer bases and strong brand names, and will be able to offer payment transmission services, advertising space and links on their home pages. There are a number of examples of banks, particularly internationally, that have entered into cooperation with Internet or telecommunication companies for the development of Internet banking and marketplaces on the Internet. This is probably just the beginning of a trend towards increased cooperation across industry boundaries.

¹⁴ECB (1999): "The Effects of Technology on the EU Banking Systems"

7.2 Profit trends and financial strength

Positive profit trend in 1999...

Commercial and savings banks' profit as a share of average total assets (ATA) improved from 1998 to 1999 (see Charts 7.2 and 7.3). The improvement primarily reflects positive trends in securities markets, which resulted in a substantial increase in capital gains. Profit trends in financial groups have approximately shadowed general developments in banks. Profits in mortgage companies and life insurance companies also improved in 1999. The improvement in mortgage companies' profits largely reflects high net interest income, while the improvement in life insurance companies' profits is ascribable to higher premium income and income from financial assets as well as a reduction in costs. Finance companies' ordinary operating profit was reduced as a share of ATA between 1998 and 1999. The negative trend primarily reflects a substantial increase in operating expenses and loan losses.
   Financial institutions' loan losses have remained at a low and stable level in recent years (see Chart 7.4). However, there was a slight rise in recorded losses in savings banks, mortgage companies and finance companies between 1998 and 1999. The reduction in commercial banks' loan losses is primarily ascribable to extraordinary factors in 1998. When this is disregarded, loan losses also showed a rise in commercial banks. It was primarily the enterprise sector that contributed to the increase in losses. The level of banks' total loan losses remains very low.

Chart 7.2      Chart 7.3      Chart 7.4

...but slightly weaker results in the first quarter of 2000

The operating profit of banks, mortgage companies and finance companies was slightly weaker in the first quarter of 2000 than in 1999, despite a reduction in operating expenses. The deterioration is primarily due to lower net interest income and reduced capital gains on securities. Commercial banks' ordinary operating profit declined from 1.19 to 1.09% of ATA in the period, while savings banks' operating profit was reduced from 1.60 to 1.42% of ATA.

...and little improvement in banks' underlying earnings in the 1990s

Despite the reduction in banks' operating expenses and the low/negative level of loan losses the last five years, banks' underlying earnings have not improved in this period (see Charts 7.2 and 7.3). One of the reasons for this is the reduction in interest margins (see Section 7.1).

Continued satisfactory capital adequacy ratio

With the exception of finance companies, there were relatively small changes in financial institutions' capital adequacy ratios between 1998 and 1999 (see Table 7.1). Part of the reduction in finance companies' capital adequacy ratio was due to a transfer of enterprise sector loans to this group in 1999, which increased the basis of measurement. All main groups of financial institutions satisfied the minimum capital adequacy requirement by a good margin at the end of 1999. Financial groups had a slightly higher capital adequacy ratio than commercial banks' parent companies.
   The capital adequacy ratio in most of the largest banks showed an improvement in 1999. At the end of the year, the core capital ratio in the eight largest banks was between 7 and 11%. Some smaller banks had a relatively low core capital ratio combined with high lending growth in 1999.
   The core capital ratio in banks and mortgage companies was reduced in the first quarter of 2000 (see Table 7.1). The reduction partly reflected an increase in the basis of measurement and changes in capital adequacy rules (goodwill is now to be deducted when calculating the core capital ratio compared with earlier when calculating net capital). Finance companies' core capital ratio remained approximately unchanged through the first quarter.

Table 7.1

Risk classification confirms positive trends in 1999

In connection with its surveillance of the financial sector, Norges Bank has developed a system for risk classification of banks based on accounting data. In the system, each institution is assessed on the basis of financial strength, earnings and the quality of its loan portfolio. Institutions are divided into 18 risk categories, where category 1 reflects the highest risk and category 18 the lowest risk. In this report, however, we only use three risk categories: high, medium and low risk. The risk model is described further in Box 7.1.
   Chart 7.5 shows the risk profile of banks at the end of 1998 and 1999. The bars show the percentage of institutions within each risk category. At the end of 1999, 96% of banks were classified in the low-risk group, compared with 92% one year earlier. There were no banks in the high-risk categories at the end of 1998 and 1999.
   Chart 7.6 shows the risk profile of banks according to the risk-weighted basis of measurement¹⁵. Banks classified in the lowest risk category accounted for 98% of the total risk-weighted volume in the banking sector at the end of 1999, compared with only 47% the previous year. The sharp improvement in the risk profile is related to the reclassification of several of the largest banks from medium to low risk.

Box 7.1      Chart 7.5      Chart 7.6

¹⁵The risk-weighted basis of measurement is the sum of the weighted items on and off the balance sheet in accordance with prevailing capital adequacy rules.

7.3 Future developments in banks' results and financial strength

In order to illustrate the consequences that different trends may have for banks' earnings and financial strength, different scenarios are drawn up for internal purposes concerning developments in the coming three-year period. Trends in lending growth, interest margin, costs and loan losses are of greatest importance to developments in banks' earnings and financial strength. Other key factors are changes in other revenues, the share of deposits and choice of funding sources. A brief description of these calculations is provided below.
   It is assumed that lending growth will be slightly lower in the years ahead than in recent years. This is primarily based on expectations of lower business investment. Expectations of a continued rise in house prices and housing investment imply that households will to a greater extent maintain their demand for credit.
   As pointed out earlier, banks must expect stronger competition for traditional deposit and lending activities in the period ahead. An important effect of this is that banks' deposit-to-loan ratio will probably continue to fall in the period ahead. This will result in a greater need for finance from other sources. A substantial share of this funding requirement is expected to be covered by loans raised abroad. Against this background, it is assumed that the deposit margin will decline. The lending margin is assumed to edge up because banks will have to charge more to compensate for a higher risk of loan losses. It is assumed, however, that the total interest margin will be reduced.
   The need for investments in new technology is expected to result in higher fixed costs for banks and a reduction in variable costs. Banks' focus on cost reductions is assumed to yield results in the form of a relatively low rise in nominal costs.
    As a result of reduced reversals of loss provisions and expectations of higher losses associated with the enterprise sector (see Section 6), it is assumed that banks' recorded losses will gradually rise to a more normal level.
   Banks have express objectives of increasing earnings from areas other than deposit and lending activities. It is therefore assumed that growth in commissions and fees will be slightly higher than growth in total assets. Gains on foreign exchange and securities are expected to remain at the level recorded by banks in recent years.
   On the basis of these assumptions, earnings in banks will deteriorate slightly and reduce the return on equity, implying that owners' required return on equity will probably not be fully satisfied in the next three to four years. Banks are expected to respond to this by introducing measures in order to improve profitability and thereby the return on equity. Such measures are expected to have a positive impact on the position of banks and financial stability. There is, however, a possibility that some operators will attempt to boost earnings by increasing their risk, for example by entering market segments for which they have no natural competitive advantage. This may have a negative influence on banks' financial strength and hence financial stability.
   Despite a slight deterioration in banks' results, financial strength is expected to be maintained. This is related to the assumption of relatively moderate growth in banks' loans and thus limited growth in the basis of measurement for the capital adequacy ratio. Overall, the situation in banks over the next few years appears to be satisfactory.

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