Lars Nyberg: Are the risks growing in the banking system?
Speech given by Mr Lars Nyberg, Deputy Governor of the Sveriges Riksbank, at an analyst meeting at
Enskilda Securities, held in Stockholm, on 14 June 2000.
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I would like to thank you for inviting me to today's analyst meeting and giving me the opportunity to
discuss financial stability issues with such a qualified audience.
I would like to start by briefly explaining the Riksbank's analysis of financial stability. In addition to
the inflation target, the Riksbank has another primary task, namely that of being responsible for
financial stability. These two important functions are closely linked. A stable financial system is
important for price stability since financial imbalances can threaten the inflation target. Likewise, an
inflation target policy contributes to stability in the financial system, as it has a levelling effect on
cyclical fluctuations.
The Riksbank's analysis of financial stability can be interesting for analysts of bank and property
shares, since we closely monitor the banking sector and property market within the scope of this
analysis. Our perspective is somewhat different, however, since we are mainly interested in risks
which can threaten the stability of the financial system and which often appear to be relatively
improbable, while stock analysts attempt to assess the most likely developments in the market.
However, the information about the markets is largely the same and analysts also need to consider the
risks in the companies which they are covering.
After this introduction, I will then go on to discuss the strong credit expansion in Sweden and the
measures that a central bank can take if it assesses that this development constitutes a potential threat
to financial stability. I will conclude by looking at international developments, since the development
in Sweden is by no means unique.
The Riksbank and financial stability
The comprehensive changes that have taken place in the financial sector and the financial crises that
have occurred in various parts of the world have meant that the work on securing financial stability
has become increasingly prioritised. Those countries which have undergone severe banking crises in
modern times are now leading the way in terms of the work on financial stability. For example,
Sweden was the first country in the world to regularly and openly publish special stability reports
analysing the situation of the financial system. We would say that the initiative was received with
mixed feelings by other central banks, some of which were concerned that these kinds of reports
would cause problems rather than preventing them. However, the attitude of the Riksbank has been
that it is through open and honest communication with the financial players that we can observe and
remedy potential problems at an early stage. Despite some initial scepticism, several countries have
now followed the Riksbank's example. Norway and the UK now publish stability reports and
Denmark also recently issued its first stability report. Since the financial markets operate across
national borders, the Riksbank works together closely with foreign central banks on these issues. For
example, the Riksbank participates in several ECB committees related to stability issues and takes an
active part in the ongoing work to reform the capital adequacy regulations.
It is also stipulated in law that one of the primary functions of the Riksbank is to promote a stable and
efficient payment system. In order to fulfil this task, the Riksbank must closely follow developments
in those financial institutions that are of central importance to the payment system, i.e. primarily the
four major banks, which are each sufficiently large to cause problems for financial stability if they fail.
The analysis focuses on three main areas. The first area concerns general developments in the banking
sector - how the competitiveness and long-term profitability of the banks are developing. The second
area examines credit risks related to the banks' lending to households and non-financial companies.
The third area that is analysed is counterparty and settlement risks that arise in connection with the
banks' trading and taking positions in the financial markets. The analysis is undertaken on an ongoing
basis and is presented in the Financial Stability Report, which is issued twice a year.
I will mainly focus on the analysis of the banks' credit risks associated with lending to households and
companies. This is a subject that has attracted growing attention as lending, especially to the
household sector, has risen significantly. A certain increase in lending is normal in an economic
upswing, when companies need to borrow in order to invest, while households borrow, for example, in
order to meet rising house prices. In an economic boom, loan losses are also generally low, while they
tend to be higher during a recession.
The increased level of indebtedness has also come under discussion. The question has been raised of
whether households and companies today borrow to such an extent that this could lead to problems in
the banking sector when the economic cycle turns downward. History shows us that the factor which
has triggered banking crises in modern times has often been extensive loan losses caused by changes
in the macroeconomic environment. This was also the case during the Swedish banking crisis at the
beginning of the 1990s.
Is the growth in credit worrying?
So what is the situation at present? Figures for April show that total lending to the general public is up
7.3% compared with April 1999. The main growth is in household lending, which has risen by 8.8%,
while corporate lending has increased by 4.1%.1 A perspective on these figures can be obtained if we
consider them in relation to GDP. This gives a measure of whether lending is growing at a faster rate
than the economy as a whole, which provides us with an indication of whether imbalances are being
built up.
Corporate lending in relation to GDP has remained relatively constant over the last four years, and is
currently far below the levels which prevailed at the end of the 1980s. The financial statements
presented by companies are also currently strong, which suggests good solvency. In this context, I
would also like to point out that those companies within the "new economy" that are currently very
much in the news and which show weak profitability finance themselves primarily via the risk capital
market and not via bank loans. This means that a possible downturn in this part of the corporate sector
should only have limited direct effects on the banks.
In terms of household lending, the situation is rather different. Lending to households has risen
relatively strongly over the last two years and currently amounts to over 40% of GDP. It is therefore
approaching the levels we saw at the end of the 1980s. However, it should be stressed that households'
interest expenses are currently lower due to the low interest rates. This rise in lending is also reflected
in the household debt ratio, i.e. debts in relation to disposable income, which has risen and which now
amounts to 104%.
Households are borrowing to an increasing extent, at the same time as their economic situation has
improved as a result of rising disposable incomes and falling unemployment. Households have
traditionally borrowed mostly for housing, and the current increase in this type of lending is perhaps
not so surprising in view of the fact that housing prices in metropolitan areas have risen relatively
significantly. What is more remarkable is that lending for other purposes is increasing at a higher rate.
It is difficult to see from the statistics exactly how the borrowed money is used, but lending both from
banks and finance companies is now growing at a faster rate than lending from mortgage institutions.
This has given rise to apprehensions that households are borrowing for consumption or in order to
invest in shares, which could lead to rapid increased risks. In order to gain a better understanding of
whether or not this is the case, the Financial Supervisory Authority has recently commenced an
examination of the banks' lending to the household sector.
There are several reasons why property prices play a central role in any discussion of financial
stability. In addition to the fact, as I mentioned earlier, that the credit demand among households is
largely governed by the demand for and price level of property, property can also be used as collateral
for loans. Another reason for monitoring the property sector is that a large part of the banks' lending is
to property companies. These companies also accounted for a large part of the loan losses during the
banking crisis in the early 1990s.
Property prices have risen recently, and in particular the prices of residential property in metropolitan
regions. In contrast to the 1980s, we do not see the same broad price increase across the whole of
Sweden, as was the case then. Likewise, the causes of the rising prices appear to be low interest rates,
a high rate of new occupancies and low construction activity rather than speculation. This indicates
that there are currently no major risks of a fall in residential property prices. However, there is every
cause to observe developments carefully. New construction always takes place with a considerable
time lag and experience shows that many projects are not ready and do not come onto the market until
after a turning point has occurred, at which point things can quickly deteriorate.
With regard to commercial property, the development has been more moderate. Again, it is mainly in
the metropolitan areas that prices have risen due to high demand. The level of new construction
continues to be low and most premises today are already leased before building commences.
One way of analysing the extent to which speculative tendencies are inherent in property prices is to
place the direct yield in relation to risk-free interest.2 At the end of the 1980s, the risk-free interest rate
was considerably higher than the direct yield on properties, which suggests that people bought
properties on the expectation of future price rises and/or significant rent increases. Today, the situation
is different. Direct yield levels appear reasonable in relation to risk-free interest. With regard to
apartment buildings in Stockholm, the direct yield is lower than the risk-free interest, but at the same
time prices are affected by the fact that most property deals are made in connection with converting
apartment buildings to tenant-owned apartments. For these types of transactions, direct yield cannot be
used as a measure since the tenant-owners association does not have a required return comparable to
that for an owner of a rental property.
The financial statements presented by property companies are also considerably stronger today than
what they were ten years ago. The risks associated with lending to this sector by the banks appear to
be considerably lower than then. Among listed property companies, it seems as though many consider
that the level of indebtedness has become too low, considering the extensive interest in buying back
shares within the sector. At the same time as buying back shares can lead to a higher return on equity,
there is reason for companies and their credit granters to observe the risks associated with higher
indebtedness. Above all, the companies can become extremely sensitive to changes in interest rates.
An overall assessment of the credit situation in Sweden thus suggests that there is greater cause to be
pleased that lending is growing as an integral part of the current economic upturn than to worry about
the risks which may accumulate. However, an integral part of the Riksbank's role is to remind about
changes that can occur both rapidly and unexpectedly.
What is the situation in other countries?
Getting back to the credit expansion in the household sector, the development we see in Sweden today
is not unique. The American economy has been the subject of much recent discussion. A growing
number of voices have warned that the risks have been built up into something of a financial bubble.
The apprehensions derive from highly inflated asset values, low saving and increased indebtedness,
i.e. in principle, a similar situation to the one we currently have in Sweden. Total lending by American
banks increased in March by 10.1% compared with March 1999 and lending in relation to GDP is
currently at a historically high level. The lending statistics show that the primary increase is in lending
for housing, due to rising property prices. At the same time as lending is increasing, saving is
declining. Over the last five years, saving as a proportion of disposable income has fallen by nearly 5
percentage points and amounted to a low 2% during the last quarter of 1999. Sweden has shown a
similar development. During the last five years, the saving ratio has fallen by over 9 percentage points
and is currently at 2%. There are thus several signs of a development that is worrying from the view of
financial stability. The rising debt ratio has without a doubt made households more vulnerable.
However, as in Sweden, employment and households' financial assets have increased, which favours
the households' ability to pay.
Another example is the Netherlands which, like Sweden, is normally characterised as a small, open
economy. Even there, worrying signals similar to those in the Swedish and American economies can
be perceived. The improved economic activity has led to falling unemployment and rising asset prices.
During the last two years, total lending has risen at an annual rate of around 15%. In the Netherlands
too, a large part of this rise in lending can be explained by rising prices, especially house prices. Dutch
house prices rose on average 15.8% during 1999. As a comparison, it can be mentioned that Swedish
house prices rose by approximately 8% during the same period (prices for tenant-owned apartments
rose to a considerably higher extent, however). In the Netherlands, household indebtedness in relation
to GDP has traditionally been low, but has risen dramatically in recent years and today amounts to
almost 45% of GDP.
If we compare the developments in Sweden, the USA and the Netherlands, we see Dutch property
prices have risen considerably faster than Swedish and American prices both in real and nominal
terms. In this context, the development in Sweden appears to be less sensational.
What can the Riksbank do if the build-up of risk increases?
An increasing level of indebtedness in the economy, combined with rising asset prices, involves
greater vulnerability to changes in the macroeconomic environment, i.e. growing risks. The obvious
question then, is what the authorities can do to prevent such a build-up of risk. The Riksbank discusses
a number of possible measures in its latest Financial Stability Report. Firstly, the Riksbank tries to
influence developments by communicating our views on what is happening publicly and in the form of
a dialogue with the banks. The Financial Stability Report plays a central role in this context. The
Riksbank can in certain situations provide a more comprehensive picture of the risks than the
individual market players, as the latter attaches greater importance to evaluating developments in their
own portfolios.
If the Riksbank believes that an unhealthy build-up of risk is occurring and our assessment has not had
the intended influence on the individual market players, there are other measures that the Riksbank can
take. In extreme cases, quantitative regulations may be introduced, such as raised required capital
adequacy ratios or a reserve requirement. Nor can an increase in the repo rate be ruled out if financial
stability is threatened. However, these are more far-reaching measures and would only be used if the
build-up of risk was assessed to constitute an acute problem. The assessment of the situation made by
the Riksbank and other authorities will always be marred by a large measure of uncertainty, as it is
extremely difficult to evaluate how serious the build-up of risk actually is. If drastic measures are to be
taken, the assessment must be based on a strong foundation.
The development we can see today is, as I mentioned earlier, far from requiring any intervention. The
Riksbank's assessment is that if the macroeconomic situation should worsen, it will lead to problems
for individual households in meeting their payment obligations, but will hardly comprise a serious risk
for banks in general and therefore not threaten financial stability either. In this context it is important
to mention that the household sector normally accounts for a small percentage of loan losses, even
during the banking crises. There is thus no reason in the current situation for the Riksbank to resort to
special measures to intervene against the build-up of debt currently occurring in the household sector.
When discussing the banks' loan losses, I have alluded to the risk that households and companies will
not be able to pay their loans. Loan losses can also arise when the banks cannot meet the obligations
among themselves. These risks are usually called counterparty and settlement risks. This type of risk
arises in the banks' trading and taking positions in the financial markets. As the major Swedish banks
have extensive commitments to one another and also to foreign banks, problems in one bank can
rapidly spread to the others and cause problems throughout the entire financial system. Such a problem
need not be due to a bank being insolvent; it may be based on, for example, a failing computer system
or similar. The Riksbank has on several occasions pointed out that these individual exposures are a
growing problem from the point of view of stability. To overcome this problem, the Riksbank has
begun a review of the regulations, together with the Swedish Financial Supervisory Authority.
Conclusion
In the current situation there are great expectations that the future will bring economic growth and
good times. "The new economy" with a low inflation rate and high levels of employment and growth
has gradually crossed the Atlantic to reach us. In such times of strong confidence in the future,
consumption and indebtedness increase, while saving declines. We have seen this happen many times
before. If the expectations are fulfilled, there is no problem. However, if the expectations race ahead of
economic developments, asset prices and indebtedness can develop in a way that causes imbalances. If
there is an economic downturn, households may find difficulty in meeting their payment obligations,
which will lead to a rapid increase in saving, falling asset prices and a decline in demand. This is also
something we have seen in other contexts.
While this development could give cause for concern, it is important not to paint an excessively
negative picture. As the Riksbank has pointed out earlier, a decline in the macroeconomic situation
would probably lead to problems for individual households, but would hardly cause sufficient loan
losses to threaten the banks' stability.
However, there is every reason to be vigilant with regard to continued developments, particularly from
a price stability perspective. Continued rising asset prices and credit expansion could risk leading to
overheating and thus rising inflation. An increase in the repo rate would in this case contribute both to
counteracting incipient inflation tendencies and to reducing the risk of financial imbalances, through a
dampening effect on demand for credit and on asset prices.