Svein Gjedrem: The financial crisis - the path ahead
Speech by Mr Svein Gjedrem, Governor of Norges Bank (Central Bank of Norway), at the
annual meeting of the Norwegian Savings Banks Association, Oslo, 22 October 2009.
The text below may differ slightly from the actual presentation. This lecture does not contain assessments of the
economic situation or current interest rate setting.
* * *
The past two years have been turbulent for banks, their customers and the authorities. The
turbulence began to affect Norway in earnest last autumn. Norway has experienced banking
crises before, and there is much to be learned from the management of these past crises.
One who experienced his fair share of crises was Nicolai Rygg, another central bank
governor from this part of Norway and the son of a local shoemaker. The name stems from
the Rygg farm in Randaberg. In 1923, Handelsbanken, the fifth largest bank in Norway, was
on the brink of collapse.1 At that time, government interventions were to a greater extent kept
out of the public eye and the bank received government support in secret. However, the
Government had approved the allocation without informing the Storting. As a result, Prime
Minister Abraham Berge and six government ministers were impeached. In his testimony,
Rygg stated:
"Through both of these years, 1921 and 1922, ceaseless efforts had been made week after
week to resolve a wretched situation. There was a constant stream of worries, one thing after
another, one disheartening report after another, and minor setbacks were followed by major
setbacks. It was reminiscent of an operating theatre. The task was onerous not only because
of its proportions, but also because of the oppressive weight of the anxiety that accompanied
it."2
"The greatest risk lay in the fact that this anxiety had now become pervasive. The very
foundations of confidence, the nation's confidence in its own credit institutions had been
shaken ... The most important objective was therefore to prevent an avalanche, seek to
contain the damage, hang on and hold back. That was the dominant thought, to prevent total
collapse, for the danger of this was indeed present... and the general atmosphere of
nervousness manifested itself in the most peculiar ways. In the blind panic that ensued,
unreasonable attacks were made on institutions that were more than deserving of their
depositors' confidence."3
There may have been a similar feeling in many countries last autumn that the "oppressive
weight of anxiety had become pervasive".
The recent financial crisis started with problems in the US subprime market. It was difficult to
foresee that problems in a small segment of one market could have such dramatic
consequences for financial markets the world over. But the financial system had changed.
BIS Review 131/2009
Today we can see that the crisis was amplified by the surprise at how closely financial
markets are interconnected.4 Losses on high-risk US subprime mortgages triggered general
distrust in the financial system. Financial institutions began to doubt their counterparties.
They did not know whether counterparties held sufficient capital to cover any losses. Even
worse, they were uncertain whether counterparties' counterparties would be strong enough
to withstand losses. So they stopped lending to each other. In the interwar period, as
described by Rygg, depositors were responsible for the flight of funding. This time, that role
was taken by banks' lenders. Confidence had evaporated.
Many banks worldwide had to take losses. The liquidity crisis turned into a solvency crisis.
Banks in Norway have also noted that borrowers have experienced problems servicing their
loans. However the increase in non-performing loans has been modest compared with the
banking crisis at the beginning of the 1990s.
Output in Norway fell through two successive quarters and although unemployment picked
up last autumn, it is still lower than in previous downturns. Norwegian banks felt the impact of
the turnaround in the economy, but government measures have prevented the liquidity crisis
from becoming a crisis in the real economy. Norwegian banks primarily experienced a
liquidity crisis and not a solvency crisis. The Icelandic bank Glitnir's Norwegian subsidiary
received a short-term loan from the Norwegian Banks' Guarantee Fund. But there has never
been any risk that distressed banks would overstretch our fund-based guarantee scheme.
Lessons from the crisis - the work ahead
The global financial crisis has revealed weaknesses in the financial system.
The Basel Committee on Banking Supervision and the EU are working on proposals for
revising the regulatory framework and introducing new regulations. Banks will be required to
build up larger capital and liquidity buffers and to strengthen the quality of bank capital. The
proposals also aim to reduce the procyclicality of bank behaviour. Banks should build up
buffers in good times that can be drawn on in periods of stress. The authorities will focus in
particular on methods of regulating systemically important banks.
Bank capital
Banks play a key role in ensuring that depositors' savings are managed securely, in
extending credit and providing payment services. Banks are commercial enterprises, but they
are also similar to public utilities.5 Banks differ from other firms in that they fund their
activities through deposits from customers who do not know the extent of risk taken by
banks. Since a collapse in the banking system would have very severe consequences, the
authorities have a strong interest in ensuring that banks operate in a responsible manner.
Banks are therefore subject to stricter regulation than other companies and are supervised
by the authorities.
In principle, banks diversify risk by extending many small loans to firms, local government
and households. In isolation, this implies that banks can operate with far lower equity capital
than other companies. When times are good, banks will have the incentive to deplete their
capital base and take higher risk in order to "put equity capital to work".
Banks are therefore required to hold capital in proportion to their risk-taking, the so-called
minimum Tier 1 capital requirement. Tier 1 capital is composed of equity capital and other
capital that can be used to absorb losses on a going-concern basis. Risk-weighted assets,
i.e. the calculation basis for the Tier 1 capital requirement, must reflect the risk the bank
exposes itself to. A bank's exposures are therefore assigned different risk weights.
Experience shows that banks' losses on residential mortgage loans, which are highly
collateralised, are lower than on corporate loans. Risk weights are therefore lower for
residential mortgage loans than for corporate loans.
The financial crisis has revealed shortcomings in the definition of the minimum Tier 1 capital
requirement and changes will be made in both the numerator and the denominator.
The quality of Tier 1 capital will be subject to stricter requirements. Risk weights for some
exposures will be higher, with improved risk coverage for trading book and off-balance sheet
exposures. The minimum Tier 1 capital ratio may also be changed.
There is no simple answer to the question of the correct capital level for a bank. In order to
quantify risk, banks have developed risk models. Risk can be calculated using advanced
methods, but the figures on which the calculation is based too often reflect the current
economic situation. The possibility that the situation can change abruptly is not sufficiently
taken into account. It became evident during the financial crisis that risk measured
beforehand in a model can differ substantially from the actual outcome observed.
Due to risk model uncertainty, many investors prefer to take account of a bank's ratio of
equity capital to total assets. The Basel Committee has proposed the introduction of such a
simple, non-risk based measure, i.e. a maximum leverage ratio requirement (minimum equity
ratio requirement). A minimum equity ratio requirement also limits the number of times banks
can leverage their equity. With a minimum equity ratio of 5 per cent, for example, equity can
be leveraged 20 times.
Today, capital requirements for residential mortgage loans in particular are very low. The risk
models employed by Nordic banks seem to apply risk weights for residential mortgage loans
that are as low as between 7 and 15 per cent. Banks seeking to "put equity capital to work"
are under very strong pressure to increase leverage. A risk weight of for example 10 per cent
for residential mortgage loans with a minimum Tier 1 capital requirement of 4 per cent would
mean that NOK 1 in equity capital could be behind as much as NOK 250 in residential
mortgage loans. Introducing a leverage ratio requirement could have the effect of curbing
banks' debt financing and risk-taking.
Banks in Canada are subject to both a strict national capital adequacy requirement and a
maximum leverage ratio. Banks are required to maintain a minimum Tier 1 capital ratio of 7
per cent. The leverage ratio is defined individually for each bank. In principle, the leverage
ratio should not be greater than 20.6 Canadian banks have weathered the financial crisis
well, also because of the less pronounced role played by market funding.7
At the end of the 1800s, the equity ratio for banks in Norway was about 12 per cent. Over the
years, this ratio has gradually decreased, falling to its lowest level during the banking crisis at
the end of the 1980s. Government bank rescue measures and recapitalisation brought the
ratio up to 8 per cent. Equity capital has not fully kept pace with growth in lending since then
and the equity ratio has declined to 6 per cent. Today, the ratio is even lower than it was
following the bank crises in the 1800s and the beginning of the 1900s.
For a number of Norwegian banks, the ratio of equity capital to total assets is lower than 5
per cent.
Strengthen the quality of capital
Under the current rules, up to 50 per cent of a bank's Tier 1 capital can consist of hybrid
instruments, which are a combination of debt and equity. The remainder must comprise
common equity only. Perpetual capital securities and other hybrid instruments cannot be
used as easily as equity capital to absorb losses on a going concern or at liquidation. The
possibility of limiting Tier 1 capital to common equity is now being considered.
Hybrid instruments make up a large share of Tier 1 capital in many European banks and
many banks must strengthen the quality of capital. There is therefore a risk that political
processes will prevent any significant increase in the minimum Tier 1 capital requirement.
The Norwegian authorities have been restrictive in their approval of hybrid instruments. The
Financial Supervisory Authority of Norway - with strong support from the Ministry of Finance
during the last 20 years - has ensured that banks have been required to fully consolidate all
assets when calculating capital requirements. Since established practice in Norway is
already strict, the new rules may not in themselves affect banks to any great extent.
Capital and macroprudential supervision
A lesson learned from the financial crisis is that regulation of financial institutions should seek
to limit risk not only in each bank, but also in the financial system as a whole. Banks' growth
strategies seldom take into account that one bank's behaviour can affect other banks and the
financial system. The interlinkages between financial institutions amplify risk in the financial
system. In our assessments, it is important to be aware of any build-up of systemic risk.
Residential mortgages provide a good illustration of the difference between the individual risk
for a bank and systemic risk. Even during the 1990s banking crisis, Norwegian banks' losses
on residential mortgages were low. Today's low risk weights for residential mortgages
provide strong incentives for banks to extend these mortgage loans. However, housing
market fluctuations, which go hand in hand with shifts in saving behaviour, are nonetheless a
source of business cycle fluctuations and substantial losses when banks have to write off
loans to firms selling goods and services to households.
The Norwegian housing market is vulnerable. Both a high level of tax incentives for house
ownership and a large volume of adjustable-rate mortgages contribute to wide fluctuations in
activity and prices.8 The rise in house prices in the past two decades has also been very
strong compared with countries where housing bubbles have burst.
To finance strong growth in residential mortgages, banks have to rely to a great extent on
borrowing, thereby increasing their vulnerability to a liquidity squeeze. Thus, low risk weights
for residential mortgages also lead to higher liquidity risk in the banking system as a whole.
It is important to be aware of the similarities between developments in the Norwegian
housing market and bank lending and developments in the countries most severely affected
by the crisis. In Norway, the lead-up was similar with rising house prices, accelerating credit
and consumption growth and lower saving. Interest rate setting managed to stabilise
developments somewhat. Economic policy was perhaps more successful in Norway and the
government had larger buffers. But the soft landing in the Norwegian economy so far is also
attributable to a good measure of luck, not least as oil prices rapidly rebounded after falling
from USD150 per barrel to 35.
Stricter requirements for systemically important banks
The bankruptcy of the US investment bank Lehman Brothers rapidly led to a general crisis of
confidence in the financial system. Central banks and government authorities implemented
extensive measures to mitigate the impact of the crisis.
At a meeting in Washington on 10 October 2008, the G7 countries stated that they would
protect their systemically important institutions.9 This was a decisive measure.
But the social and economic costs have been considerable, particularly reflected in the
dramatic fall in output and employment in most advanced economies. Moreover, government
support for banks has been costly in many countries.
The crisis has shown that regulation of systemically important banks should be considerably
more stringent. This can be achieved by introducing overall higher capital requirements or
seeking to restrict growth in these institutions by imposing stricter requirements than for other
banks. In Switzerland, it has been decided that the capital adequacy requirement for the
country's two large banks in good times will be twice the international minimum requirement.
To prevent a procyclical impact, this target will apply as of 2013.10
In Norway and other countries, all banks are subject to the same capital adequacy
requirements, but the large banks have generally chosen to leverage their capital further than
other banks. This is not advisable.
The UK government intends to propose a plan that would require large banks to elaborate a
plan for orderly unwinding, often referred to as "living wills", stating which parts of a bank's
operations will be sold if a distressed bank is compelled to raise fresh capital.11 The
authorities will then be able to split up or wind down banks quickly, whatever their size or
complexity.
But an additional economic cost is incurred when governments rescue banks. This may have
adverse effects on bank behaviour. In the field, this is referred to as measures that increase
the risk of moral hazard.
I can provide an example. A creditor may for example assume that big banks are in practice
"insured" by the authorities, which will also be reflected in rating agencies' assessments.
Banks considered systemically important receive a higher rating.
As a result, funding costs for these banks are lower, allowing them to increase leverage and
expand even further.
Reducing the procyclicality of bank behaviour
Both international studies and Norges Bank studies indicate that the current capital adequacy
rules, Basel II, amplify the procyclical effects arising from bank behaviour.12 During an
expansion, bank earnings are high. Ample supply of capital leads to high credit growth. In a
downturn, loan losses increase and erode the banks' capital. Banks respond by tightening
lending. Bank behaviour therefore amplifies fluctuations in economic activity.
An analysis by Norges Bank sheds light on the procyclical effects of the Basel II capital
requirements. The analysis is based on a path where the Norwegian economy is exposed to
a severe disturbance. During a downturn, the debt-servicing capacity of borrowers declines
and the value of bank collateral falls. The risk of bank losses increases. This leads to an
upward adjustment of the risk weights used to calculate the minimum capital requirement
under Basel II. The minimum capital requirement increases. The shorter the data series
applied by banks in their risk models are, the more the capital requirements fluctuate with
business cycles. The effects may be considerable. Higher capital requirements for banks in a
downturn will amplify the downturn. In an upturn, the effect will be the opposite.
If banks apply a time series that is longer than 20 years, which includes at least one
pronounced economic downturn, the effect on the minimum capital requirement during a
downturn under Basel II will not be as strong as when the banks use short series. Risk
weights calculated on short series that do not include downturns are thus of little value.
There are also other approaches to reducing the procyclicality of bank behaviour.
In Spain, banks have had to provision for potential losses through the cycle. They were
required to provision using non-tax deductible amounts for future losses at the time the loan
was extended. Such dynamic provisioning has probably functioned effectively also because
this system did not require that the supervisory authorities or the banks themselves had to
decide that capital should be increased.
Nordic cooperation
Equal competition considerations require that banking rules are practiced as evenly as
possible across countries.
For Norway, there are limits to how effectively regulations specific to Norway will be because
we are part of the Nordic banking market. The Nordic region, however, is a well-suited region
for an active use of regulatory measures. Nordic banks engage in cross-border operations.
At the same time, they have little activity outside of the Nordic region. Nor are foreign banks
from other regions large in this region. The conditions are therefore in place for effective
cooperation in the area of banking regulation and crisis management between the political
authorities, supervisory authorities and central banks.
In the growth period from 2004 to 2008, foreign banks expanded rapidly in the Nordic market,
but during and after the crisis they curbed their activity. I am afraid it can be said that they
have amplified fluctuations in Norwegian markets. However, we assume the decline in their
market share over the past year is attributable to their being harder hit by the international
crisis than Norwegian banks.
Liquidity management
More capital is important for the solidity of the banking sector. However, we must not forget
that the turbulence first translated into a liquidity crisis, as was the case for the UK bank
Northern Rock in autumn 2007 when depositors rushed to withdraw their savings.
For Norwegian banks, the crisis has essentially been a liquidity crisis. Norwegian banks were
affected because they became dependent on market funding. The financial crisis has
revealed that substantial short-term money market funding is risky. When it comes from
foreign markets, the risk of funding shortfalls increases. In the mid-1980s, Norwegian banks
also borrowed heavily in foreign markets. In spring 1986 - following a sharp fall in oil prices -
confidence in the Norwegian economy plummeted, and liquidity flowed out of the country as
was the case in autumn last year.
The funding source that is considered to be the most stable, deposits, has become less
important over time. It is our assessment that the funding of Norwegian banks is a structural
problem. When the financial crisis is behind us, we expect banks to give increased weight to
deposits and long-term loans as funding sources.
The maturity of banks' market funding should be longer than it was before the financial
turbulence. During the financial crisis, investors were reluctant to provide long-term funding
and required high risk premiums. Prospects for banks in general have now improved and risk
premiums have declined. Strengthening of banks' equity capital is helping to reduce the risk
facing bondholders. Bond premiums are nevertheless likely to remain clearly higher than
prior to the financial crisis. Investors cannot be certain that government will cover bond
investors' losses when banks' capital evaporates during the next banking crisis, c.f. the
planned UK proposal to impose a "living will" on the large institutions.
A favourable source of funding for banks is covered bonds, referred to as OMF in Norway.
These debt instruments are secured by sound collateral backed by residential mortgages,
public loans or commercial property loans. The risk premium on these loans is therefore
lower than on ordinary bank bonds. The covered bond market was also heavily impacted by
the financial crisis. Activity in the secondary market has been low, and investors showed little
interest in new issues. The swap arrangement introduced by the Norwegian authorities
eased the situation for banks. The market has recently improved.
Covered bonds have a long tradition in other countries' housing markets. As manager of the
Government Pension Fund - Global, Norges Bank has taken initiative to strengthen the
European covered bond market. Together with several other large investors and support
from a number of central banks, the "Covered Bond Investor Council" was established. One
of the main aims of the Council is to improve liquidity in the covered bond market, through for
example more transparent and standardised borrowing terms.
The Norwegian covered bond market is new and small compared with that of other countries.
Covered bonds are well suited for pension portfolios and other assets with a long time
horizon. Further ahead, there should therefore be good possibilities for Norwegian banks to
procure long-term funding. Since residential mortgages usually feature a long maturity,
bonds should also have a long maturity. Before the financial crisis, mortgage-backed covered
bonds were normally issued with a maturity of five to ten years in European countries.13
But this source of funding also has its limitations. The larger the share of borrowing that has
first claim on banks' assets is, the higher the risk becomes for other lenders and for
depositors with savings above the guaranteed amount. The risk for the Norwegian Banks'
Guarantee Fund may increase if covered bonds become too dominant.
The Basel rules require capital for banks' assets, but do not stipulate how the assets are to
be financed or their liquidity. It is now being considered whether common requirements
should be introduced as to the amount of liquid assets a bank must hold to survive a stress
situation over a period of for example 30 days without drawing on loans in the central bank.
In addition, there will be funding stability requirements.14 The Basel Committee is expected to
make concrete proposals in the course of the year.
One of the first countries that introduced stricter requirements is the UK, where banks are
required to apply a stress situation with a duration of three months.15
Assets that would qualify as sufficiently liquid should be easily sold in the market - also in
stress situations. The financial crisis showed that many assets held by banks for liquidity
purposes were not particularly liquid. In the UK, the authorities will only accept that banks'
liquidity buffers include government bonds of high quality and deposits in the central bank.
Norges Bank's macroprudential supervision - use of stress tests
Through recent decades, financial stability analyses have become increasingly important in
many central banks. An important element in the analysis is to assess the vulnerability of the
financial system to macroeconomic disturbances. Stress tests are commonly used in this
exercise. Norges Bank uses stress tests to assess the consequences for Norwegian banks
of several risks having a negative impact simultaneously. We will develop this tool further
and take account of the experiences of other countries. We will seek to be transparent about
the assumptions and results.
Asset prices, credit and monetary policy
There is a division of roles in economic policy. Fiscal policy, through growth in public
spending, influences the real krone exchange rate and the size of the international exposed
business sector in the long term. Monetary policy steers inflation in the medium and long
term and can in addition contribute to smoothing fluctuations in output and employment.
House prices in Norway have risen sharply and probably excessively.
We must take account of developments in equity prices and property prices when projecting
inflation and output. Norges Bank's interest rate setting does not rely solely on one simple
rule. Instead, we seek to take account of all factors that influence inflation and output in the
medium term, and the key policy rate is set on the basis of an overall assessment. Asset
prices such as house prices, the exchange rate and credit growth therefore have a bearing
on Norges Bank's interest rate setting. A written formulation of Norges Bank's monetary
policy reaction function would be fairly comprehensive and include all the variables that are
considered.
However, a reaction function must not be confused with the monetary policy target - our
target function. The fact that we give weight to variables such as the exchange rate, house
prices and credit growth in interest rate setting does not imply that there are specific target
for these variables. The operational target for monetary policy is annual consumer price
inflation of close to 2.5 per cent over time.
Interest rate setting in a small, open economy can be particularly challenging in periods of
strong credit growth and a wide interest rate differential against other countries. A tightening
of monetary policy in Norway specifically aimed at curbing property prices and credit growth
can result in a rising krone exchange rate, a weaker labour market and excessively low
inflation.
Should we seek to avert bubbles in the housing market even when medium-term inflation
prospects are moderate? On this point, it is our judgement that a distinction must be made
between giving greater weight to credit growth and house price inflation in the reaction
function and defining house price inflation as an independent monetary policy objective.
Socalled "leaning against the wind" would not require adjustments to Norges Bank's approach,
bearing in mind that our reaction function already gives weight to asset price movements and
credit growth.16 Should central banks also set explicit targets for asset prices? In our
judgment the answer is no, but we should probably apply a fairly long horizon for achieving
the target so that we seek to take account of any imbalances that might disturb activity and
inflation further ahead.
Household behaviour in the housing market is a considerable economy policy challenge.
This is primarily because demand for housing and housing loans is heavily subsidised by the
tax system and loan supply is marked by the near-absence of an equity capital requirement
for providing housing loans.
Exit strategies
In line with other countries, the Norwegian authorities implement extensive measures to
improve banks' access to liquidity and longer term funding after the Lehman Brothers failure.
This contributed to improved funding conditions for Norwegian banks. As the situation in
financial markets returns to normal, the measures will be wound down.
Recently, we have seen an improvement in money and credit markets. We have therefore
started reducing the use of unconventional measures.
In recent months, liquidity has not been supplied through currency swap lines or liquidity in
foreign currency. Loans at long maturities have not been provided since February - several
of the loans have now matured.
As markets are now returning to normal, liquidity supply will be adjusted so that money
market rates reflect the key policy rate. We want the banks to redistribute liquidity in the
interbank market.
The underlying structural liquidity in the banking system, i.e. liquidity excluding Norges
Bank's liquidity provision, has been negative in recent years. Structural liquidity is influenced
by ingoing and outgoing payments via the government's account in Norges Bank and is
projected to increase ahead, primarily because the government can partly finance increased
lending to state banks, payments from the Government Bond Fund and the State Finance
Fund and share subscriptions by drawing on their large deposits in Norges Bank. The
banking system's demand for central bank loans will then decrease considerably.
The swap arrangement involving covered bonds in exchange for government securities has
made a considerable contribution to securing banks' long-term funding. This spring we saw
that the covered bond market started to reopen. The minimum price in the swap arrangement
is thus adjusted to the interest rate forming in the market. The arrangement will be phased
out in the course of autumn.
Norges Bank temporarily eased its collateral requirements to facilitate banks' access to
borrowing in the central bank. Banks' borrowing needs are falling, and a good supply of
highquality collateral, particularly Treasury notes, has increased markedly.
We are of the view that the conditions are now appropriate for reversing these temporary
changes. We will also tighten the collateral requirements. Today the planned changes have
been circulated for comment. The acceptance of new securities eligible as collateral under
the temporary rules is now discontinued. Securities that were already accepted as collateral
under the temporary rules can normally be used as collateral until they mature or up to no
later than 15 February 2012 when the last long-term fixed-rate loan in Norges Bank has
matured.
We have also announced a change in the so-called bank quota. Under today's rules, 35 per
cent of a bank's borrowing facility in Norges Bank can be based on collateral in bonds issued
by other Norwegian banks. It is a disadvantage that the provider of the collateral and the
collateral are from the same sector. At the same time, it is a competitive disadvantage for
Norwegian banks when their issues are covered by the quota, while this is not the case for
issues by for example Swedish and Danish banks. Therefore, from 1 December 2010 we will
include foreign bank issues in the bank quota without increasing the percentage rate of 35.
From 15 February 2012, we will discontinue access to using bank issues as collateral for
loans.
Covered bonds will still be eligible as collateral, also when the bonds are issued by a bank's
own mortgage company. We assume that this will also contribute to developing the
Norwegian covered bond market.
Conclusion
Allow me to conclude.
Developments in recent months indicate that the financial crisis in Norway will not develop
into a real economic crisis. We have not experienced a bank solvency crisis as was the case
20 years ago. Unless the Norwegian economy is exposed to new major shocks, we expect
the bankruptcy rate for Norwegian enterprises to stabilise or to be at about the same level
recorded in the moderate downturn at the beginning of this decade.
Nevertheless, the crisis has revealed weaknesses in the regulatory framework for banks,
also in Norway.
It is our hope and belief that international cooperation will set the stage for an improved
regulatory framework and systems. For us in Norway, it is important that the Nordic countries
can stand together.
Thank you for your attention.