Svein Gjedrem: Is the financial system stable?
Speech by Mr Svein Gjedrem, Governor of Norges Bank, at the 2001 Annual Meeting of the
Norwegian Savings Banks Association, Haugesund, 18 October 2001.
Please note that the text may differ slightly from the actual presentation
* * *
Introduction
The role of the financial industry in the economy has become increasingly important over the last
decades. Deregulation and technological advances have increased the industry's opportunities and
scope to channel savings to various projects. Strong competition has induced the industry to make use
of these new opportunities. The range of saving and financial instruments is becoming ever wider.
Systems and financial instruments for managing and controlling risk are becoming more advanced. As
a result, it has become easier for households and enterprises to decouple consumption and
investment from current income. In the second half of the 1990s, in particular, international capital
markets have become more integrated.1 It has been easier for growing economies to finance
investments through a balance-of-payment deficit and foreign capital. At the same time, countries with
high savings can increasingly diversify their investments.
Globalisation places increasing demands on the business sector's ability to adapt. New products and
technology squeeze out old solutions. This creative destruction, as Schumpeter called it, may foster a
more efficient distribution of resources and higher economic growth in the long run. A rapidly changing
environment places considerable demands on the financial industry. The financial prospects for a
project must be assessed in relation to risk. A diversified portfolio of loans and investments limits
expected losses. Losses on one project may be more than offset by gains on another.
Economic growth is cyclical. During an upswing most projects fare better than expected. A deep
recession can lead to heavy losses, insolvency and financial crisis. Banks may address this risk by
building up sufficient buffers during upturns. Often, this is not done in practice. Instead, financial
enterprises tend to place special emphasis on increasing market shares while times are good and
allow their capital ratios to fall.
It is during an upturn that the basis for the downturn is laid. Financial crises are often characterised by
a first phase when optimism predominates, risk assessments weaken and the willingness to borrow
and asset prices increase. When negative news starts to spread, investments fall short of expectations
and the mood shifts, asset prices fall and debt-servicing problems accumulate.
A financial bubble can first be identified with certainty after it has burst. There are a growing number of
examples of this. After the Asian crisis, which started in 1997, and gradually had global spillover
effects, there have been national financial crises in Turkey and Argentina.
During much of the 1990s, the US experienced extensive restructuring and high economic growth. The
gap between the US and the rest of the world widened. Investment expanded sharply, particularly in
the technology sector. This was made possible by dynamic credit and capital markets. Developments
led to a broad expansion in other sectors of the economy and other countries. Restructuring and new
technology may also have increased the long-term growth potential of the US economy. The marked
turnaround that has now come shows that developments went too far. The technology stock bubble
burst. The focus has now shifted towards heavily indebted households and businesses. Banks are
expecting higher losses.
The question may arise as to whether financial crises are an inherent feature of a market-based
financial system. What can the authorities and the financial industry do to reduce the likelihood of
future crises?
I will take a closer look at certain crisis periods that occurred before World War II and government
responses in the form of legislation, regulation and the introduction of a financial safety net. In the
decades prior to 1914, financial crises with a pronounced impact on banks were just as frequent as in
our time.2 During the interwar period, financial crises occurred even more frequently.
In the period of extensive direct regulation of banks up to the 1970s, there was a virtual absence of
banking crises. However, the system was not sustainable and was at the root of many of the problems
that followed. With a succession of crises since the early 1980s, financial stability has again become
an issue, both at home and abroad. Nevertheless, there is fairly broad consensus as to the merits of a
market-based system and free cross-border capital movements. The frequency of financial crises must
be reduced by fostering solid financial enterprises. Risk systems must be improved. Market access to
information on developments in micro and macro performance must be enhanced in order to
strengthen market discipline in the financial industry. Better and uniform standards for accounting and
statistics are important. Financial safety nets may offer greater security to households and small
enterprises, which have difficulty obtaining an adequate overview of the risks in the financial system.
At the same time, however, they must not be so favourable that they encourage irresponsible risk-
taking. Central banks are also faced with the challenge of ensuring financial stability through their
analyses and monetary policy.
Developments from the 1800s to the present
The regulation of financial institutions has undergone considerable changes. In the 1800s and up to
World War I, the regulation of banks and other financial institutions was very limited. Norway was one
of the most liberal countries. Regulation in other countries such as the US and the UK was more
extensive.
In Norway, savings banks were subject to separate legislation, because they were to have a more
social function than commercial banks. There were no guarantee funds, and the law for savings banks
was designed to ensure that they were operated in a manner that safeguarded depositors' funds.
Cross-border capital movements were also subject to little or no regulation in the decades prior to
1914.3 Capital markets were integrated in countries that had adopted the gold standard. There was
solid confidence in the gold standard, and exchange rate risk was regarded as very low. Movement of
capital between countries was often long-term, and tended to be associated with specific projects. As
a small, open economy, Norway was totally dependent on an open, smoothly functioning capital
market. From 1885 to 1913, the fixed investment rate in Norway was on average higher than the
saving ratio.
Although short-term gross capital movements were far from their current levels, they were
nevertheless significant. Monetary policy was restricted by the gold standard. Capital was highly
mobile, and the interest rate had to be set to ensure that the exchange rate remained between the
gold points. As a result, monetary policy could not normally be used to stabilise economic
developments. Countries that suspended the gold standard were penalised with higher interest rates.4
A look at earlier crises
A weak stabilisation policy, relatively ineffective banking legislation combined with a poorly developed
financial industry provided fertile ground for many financial crises.
The Oppland crisis occurred in 1864. It was a backlash of the boom in the latter half of the 1850s,
when a sharp upswing in the timber industry led to widespread speculation.
Growth was also very strong in the early 1870s. At the same time, the boom paved the way for a
period with the most severe banking disasters up to that time. There was considerable overcapacity in
many industries at the time of the turnaround in the international economic situation in 1874. The most
serious crash occurred in Arendal in 1886.
Not long afterwards, in the late 1890s, Kristiania (now Oslo) experienced a financial bubble. A
favourable international economic situation and the building of railways led to a period of prosperity in
the Norwegian economy, particularly in the capital. The money market was highly liquid as a result of
the inflow of gold, and interest rates were relatively low. Growth in banks' deposits and lending
increased in pace with the money supply. Kristiania's population grew and there was an explosive
period of construction, of both dwellings and commercial buildings. Prices for land, building materials
and houses rose dramatically. The crash was triggered in 1899 by a major bankruptcy. The crisis
gradually became more acute for Norwegian banks, particularly commercial banks. It had lasting
consequences for the Norwegian financial industry and the economy. The stock market was virtually at
a standstill until World War I.
The crash compelled Norges Bank, for the first time in its history, to channel crisis liquidity to the
banking industry.
The next financial bubble occurred during World War I. During the first half of the war, in particular,
there was strong growth in the Norwegian economy. This provided the foundation for a boom that is
unparalleled in history. Banks' lending rose sharply. The build-up of risk in the financial system was far
more pronounced than in previous episodes. A strong inflow of gold led to uncontrolled growth in the
money supply and inflation at the beginning of the war. In addition, the constraints implicit in the gold
standard gradually broke down, and the money supply expanded sharply. The banking crisis came in
the wake of a cyclical downturn in the early 1920s and can largely be attributed to the build-up of risk
during the boom period. The bulk of bank losses occurred before the introduction of parity policy.5
The authorities' response
In response to the extensive banking crises in the interwar period, a financial safety net for banks was
introduced in most developed countries. In Norway, guarantee funds were introduced for savings
banks in 1921 and for commercial banks in 1938. There was also a need for separate rules on public
administration of banks. These arrangements helped to dampen the effects of the crises and prevent
new ones.
Commercial banks were subject to separate legislation and supervised by the newly established
Banking and Savings Bank Inspectorate. Supervision of savings banks commenced as early as 1900,
with the establishment of the position of Inspector of Savings Banks. This was probably one reason
why savings banks were not as expansive as commercial banks during World War I. Nor were they as
severely affected by the banking crisis.
A gradual increase in the regulation and supervision of financial enterprises and the introduction of a
financial safety net did not mean that the market-based system was abandoned. However, recessions
and demands for more protectionism led to restrictions on international trade and capital movements.
The result was that domestic investments increasingly had to be financed through domestic savings.
This can be illustrated by looking at the relationship between the saving ratio and the fixed investment
rate for selected countries. A strong correlation indicates a limited degree of openness. Measured in
this way, integration was greater before 1914 than in the interwar period.6 Protectionism had a very
harmful effect on economic developments.
After World War II, international organisations were established to promote economic cooperation and
their objective was increased integration of international trade and fixed investment. However,
crossborder capital movements remained heavily regulated. The same applied to direct regulation of
financial enterprises. Other considerations, than returns and risk, took precedence in connection with
the provision of credit and capital movements.
At the end of the 1970s, direct controls were gradually removed. As a result of the emergence of new
financial instruments, the controls no longer had the same effect. There was a growing realisation that
the existing controls had a negative effect on the allocation of credit and capital, and hence on
longterm economic growth. Cross-border capital movements were gradually liberalised. It was not until the
1990s that capital was able to move between countries as freely as before 1914.
Because of the serious effects of financial crises, the financial industry is subject to many regulations
and to extensive supervision. The industry is by no means deregulated, but the regulations are now
designed to make markets function more securely and more efficiently. Clear requirements have been
established for both capital adequacy and liquidity. Nevertheless, the regulations do not eliminate the
possibility of financial crises.
Are financial crises an inherent feature of today's system?
The transition to a market-based system has increased the scope for financial cycles.7 The cycles may
be amplified by unrestricted cross-border capital flows. Because of the central role of the financial
industry as a credit and capital intermediary, this can also influence macroeconomic developments. At
worst, an upswing in the economy can be amplified through the build-up of financial imbalances, which
may trigger and reinforce a downturn and financial crisis.
Technological innovations that increase productivity in the economy may rapidly lead to general
optimism and a broad economic upturn. Since the 1800s, we have seen waves of optimism and
largescale investment in railways, shipping, hydroelectric power stations and now, most recently,
information technology. Upturns may also be driven, or amplified, by demand-side factors in the
economy.
During an upturn, income growth is high in both the enterprise and the household sector. The value of
property and securities, and thus the collateral for new loans, rises. Financial and other enterprises are
upgraded by credit rating agencies. Banks record low losses and solid results and can increase
lending without weakening capital adequacy. Demand for credit can easily be met by obtaining
financing on favourable terms in both domestic and foreign money and capital markets. As a rule, it is
also easier to raise equity during economic upturns.
Under these circumstances, credit risk may be underestimated and not priced into margins. The
financial industry may share in the generally prevailing optimism, and strong competition may lead to a
contest for market shares. In this way, banks contribute to building up risk in the financial system. The
loans with the highest risk are probably those granted at the peak of the economic cycle. Households
and enterprises often have a relatively high debt burden at such times, and loans are secured by
inflated property and asset prices.
The securities and capital markets are another important source of capital for enterprises. During an
upturn, many enterprises find that capital is "cheap", because the outlook for the future is regarded as
very bright. There is a risk of over-investment.
Optimism may rapidly give way to pessimism if investments fall short of expectations and negative
news starts to spread. As a result, the risk that has accumulated during the upturn period may
materialise. The financial sector may choose to interpret developments as a sign that the risk
associated with new projects has also increased, with the result that this risk may be overestimated. A
drying up of credit and capital may trigger or amplify a crisis.
The costs of financial instability may be very substantial. Therefore, it is necessary to dampen financial
cycles.
The outlook for financial stability
The outlook for the global economy is now weak. The terrorist attacks on the US on 11 September
have increased uncertainty. We have witnessed a bubble in technology shares. From 1998, the price
of technology shares rose substantially more than earnings, and since March 2000, there has been a
sharp correction in prices. Life insurance companies and pension funds, both at home and abroad,
have lost a substantial portion of their buffers due to the decline in share prices. Telecommunications
companies have been through a phase marked by substantial borrowing. Credit rating companies
have downgraded many telelcoms due to high debt levels in relation to future prospects. This has
increased funding costs.
When economic growth slows, problems in enterprises and countries with high debt burdens rise to
the surface. There has been constant unrest in countries like Turkey and Argentina, which are
struggling with high borrowing costs. Japan has not yet recovered from its more than 10-year-long
banking crisis and is vulnerable to new shocks.
Up to this autumn, the effects of the international turnaround on the Norwegian economy were limited.
It now appears clear that Norway will also be affected by the slowdown. A number of Norwegian
enterprises in export industries and the travel industry have felt the effects of growing caution among
households and businesses worldwide. Investment in mainland enterprises will probably also decline.
Domestic credit growth remains high, and since 1993 has been stronger than growth in value added
measured in terms of GDP. Banks in particular have contributed to this.
At times, growth in lending has been markedly higher in savings banks than in commercial banks. At
the end of August, year-on-year growth in lending was 11.7 per cent for savings banks and 9.2 per
cent for commercial banks, when adjusted for portfolio transfers. There seems to be an indication of
growing competition for market shares. Savings banks are also competing increasingly in commercial
banks' traditional business areas. There is a risk of overcapacity.
Credit growth in both the household and enterprise sectors has been strong. At the end of August,
year-on-year growth was 11 and 9.1 per cent respectively. Growth in lending to the enterprise sector
has slowed recently while demand for credit in the household sector has remained stable. Both
households and mainland enterprises have increased their debt burden markedly in recent years.
If credit to the household sector continues to grow through next year, household gross debt is
expected to increase to more than 140 per cent of disposable income by the end of next year. Even
with such high debt, the interest rate will have to rise by more than 3 percentage points for gross
interest expenses to constitute the same burden, measured as a percentage of income8 as before the
banking crisis, when it was around 10 per cent. This illustrates that we have a long way to go before
households are as vulnerable as they were then, but no one wants us to come that far either.
High credit growth has resulted in a falling core capital ratio. However, capital adequacy ratios at many
savings banks remain high.
Bank lending has increased more than deposits, and in the last few years banks have become more
dependent on money and capital markets. Small and medium-sized banks have substantially
increased their borrowing from other credit institutions. Short-term foreign debt has also risen.
Although the decline in stock markets appears to have improved the financing situation in recent
months, other forms of saving are expected to compete strongly with bank deposits.
In general, foreign borrowing is a source of diversification and thus risk reduction, but it can also
spread unrest. By international standards, Norwegian savings banks are small. It can be costly to
change a source of funding if one source should dry up. In the event of considerable financial unrest in
international financial and capital markets, savings banks may be affected. Today, the shocks are
often global.
If the current high credit growth continues, financial stability in Norway will be threatened. We will
become more vulnerable to all kinds of shocks. I have already touched upon the weak outlook for the
global economy. There is also reason to expect considerable structural changes in the business
8
Income here is defined as household disposable income before deduction of gross interest expenses.
sector, for example, when economic resources have to be transferred to the public sector and other
sheltered sectors. Restructuring may take place within established companies, but may also take
place in a far less controlled manner and result in losses for banks and other lenders.
Policy challenges
Like banks and other market participants, the authorities also learn from crises. I will discuss three
areas in which we have learned important lessons.
First, economic policy must be oriented towards stable economic development. An inappropriate
economic policy has been a contributing cause of crises both in Norway and abroad.
Norges Bank has been given an operational target for monetary policy, which means that monetary
policy instruments shall be used with a view to maintaining low and stable inflation. The inflation target
is set at 21⁄2 per cent. Low and stable inflation is probably the best contribution monetary policy can
make to financial stability. This is also supported by empirical studies.9
However, there have been episodes where bubbles have accumulated in the form of sharp increases
in asset prices in the property and financial markets while inflation has been low. Developments in
Japan in the 1980s and in the US in the 1990s may be examples of this. When the bubbles burst, the
result may be an economic downturn. Thus, developments in the financial and property markets may
also fuel more unstable inflation. In principle, it might be appropriate to use the interest rate to counter
this. In practice, however, it is difficult to assess whether developments in prices for property and
financial assets are sustainable.
When Norges Bank concludes that the key rate should be changed, the change will in most cases be
made gradually. If special emphasis is placed on developments in financial or property markets when
the key rate is changed, Norges Bank will provide an assessment of this.
It is Norges Bank's responsibility to present its view on the risks facing the financial system from a
macroeconomic perspective. This is the purpose of Financial Stability, a report published twice a year.
Second, the international financial infrastructure must be strengthened. This also entails increased
international cooperation.
Many financial crises in the 1980s and up to today have occurred in countries where rules and
supervision are relatively ineffective. As a result, the financial sector has become fragile. The capital
strength of financial institutions has been inadequate. Deregulation has occurred before the country's
financial infrastructure is in place. This has fuelled the build-up of financial bubbles. Large fluctuations
in capital movements have often intensified the problems. Elements of this were also present during
the banking crisis in the Nordic countries.
The financial safety net should help prevent financial instability and curb the effects if instability should
arise. This may also prevent the development of imbalances. Deposit guarantees, crisis liquidity
schemes and the assumption that large banks will be rescued by the government may weaken market
discipline. The result may be increased risk-taking.
International organisations have developed international codes and standards for the financial
infrastructure and for the regulation and supervision of the financial sector, which are in line with good
practices.10 These codes and standards should contribute to improving policy and creating more
robust financial systems. They should make it easier for investors and others to keep abreast of
developments, which in turn will increase their ability to assess risks in a country. This will reduce the
risk of herd behaviour and the build-up of substantial imbalances.
The International Monetary Fund plays an important role in international surveillance and crisis
management. They have substantially strengthened their oversight of the financial systems in member
countries. Other international organisations are also intensifying their efforts in the area of financial
stability.
In the Nordic countries, both the supervisory authorities and the central banks have expanded their
cooperation as a result of the integration of the Nordic banking industry. One question that will arise is
whether guarantee funds and other rules and regulations can differ when markets are so closely
integrated.
Next year, an important international milestone will be reached when the Basel Committee on Banking
Supervision presents the new capital adequacy rules. According to plan, the rules will apply from
2005. Basel II has a three-pillar architecture. First, the rules relating to minimum capital requirements
will be further developed. Second, the supervisory authorities will monitor banks more actively. Third,
information disclosure requirements will enhance market discipline. Combined, this will constitute a
coherent system for protecting the financial strength of banks. The regulations will improve the
balance between capital requirements and banks' financial risk. This will also increase the focus on
the development of risk management systems.
Finally, I would like to place particular emphasis on the need for market discipline, which is the third
pillar in the proposed Basel Capital Accord. Financial stability is dependent on the identification,
management and control of risk. This also means that we must factor in risk. This applies to banks in
their internal credit routines, and others with interests in banks - shareholders, lenders, bondholders
and depositors. Market participants must understand that equity, subordinated loan capital and other
claims on banks not covered by deposit guarantees may be lost. The financial industry must therefore
be forward-looking. Buffers must be built up in periods of expansion when losses are low and
profitability is high.
The financial safety net must be reassessed if it is so favourable that banks and market participants
are not encouraged to exercise market discipline. For example, deposit guarantees in Norway cover
larger amounts than in many other countries.
Despite the lessons that both the authorities and the financial industry have learned from financial
crises, such crises may nevertheless occur in the future. Experience indicates that crises are often a
result of inherent processes in the financial system. There is still reason to hope that the authorities
through their policies and formulation of rules and the financial industry through its management of risk
will reduce the frequency of financial crises.
Thank you for your attention.