Svein Gjedrem: Risk and growth in the financial industry
Speech by Mr Svein Gjedrem, Governor of the Central Bank of Norway, at the Annual meeting of the
Norwegian Savings Banks' Association, Bergen, 27 October 2005.
The speech does not contain assessments of the economic situation or the monetary stance. Please note that the text below
may differ slightly from the actual presentation.
The charts in pdf-format can be found on the Central Bank of Norway's website.
References can be found on the Central Bank of Norway's website.
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1. Introduction
Over the past decades, debt and financial assets have risen sharply worldwide. The financial system
serving lenders and borrowers has also expanded. The number of participants in these markets has
soared, some new operators have appeared and a broad range of instruments has emerged. Growth
in financial markets provides the basis for more efficient use and distribution of capital and for
improved risk management. Developments in the financial industry have thus contributed to stronger
and more stable economic global growth over the past decades.
New instruments have increased banks' possibilities of managing risk, among other things credit risk
associated with lending. In many countries, growth in household borrowing has been high for several
years. In Norway, mortgage loans account for an increasing share of banks' balance sheets.
I will now discuss different aspects of this.
2. Developments in the financial sector
Scale and size of the various markets
Financial markets have expanded strongly in many countries, partly as a result of extensive
deregulation in the financial sector in the 1970s and 1980s. Technological advances reduced the
effect of regulation and have, together with institutional changes, made it possible for market
participants to respond in improved and more efficient ways. Credit institutions' total assets have
increased sharply over the past few years in all countries in the comparison.
Banks' total assets, as a share of GDP, are not particularly high in Norway compared with other
countries, even though banks are the main lenders to Norwegian households and enterprises. This
may be because Norwegian banks extend few loans to the public sector and to foreign borrowers
compared with banks in other countries, and because Norwegian enterprises borrow from foreign
credit institutions more than enterprises in other countries.
Banks' total assets have increased while the number of employees and person-hours has declined.
Productivity growth has been strong.
Direct mediation of assets and liabilities through the securities market has also increased.
Nevertheless, bonds and notes do not account for more than about 7 per cent of domestic debt. This
share has remained fairly stable in recent years. Private enterprises borrow less in the domestic bond
market than enterprises in other countries. Particularly in the US, lending through these markets is well
established.
The financial system in Norway is largely dominated by banks. Banks have a total market share of
over 50 per cent, while mortgage companies and finance companies have a combined share of
14 per cent.
Growth in financial markets makes it easier to channel savings surpluses to customers with sound
investment plans. It also makes it easier to diversify risk. Both enhance the economy's growth
potential. At the same time, a larger financial sector may increase the consequences of financial
instability for the real economy.
As a result of globalisation, debt and financial assets are now more widely distributed across
countries. Home bias has declined. This has reduced the risk in the financial system and improved the
relationship between risk and return. The Government Petroleum Fund has contributed to a sharp
decline in home bias in Norway. In recent years, Norwegian life insurance companies have also
invested more of their capital abroad.
Tendency towards larger entities and increased concentration
National consolidation
In the past few years, domestic mergers and acquisitions have been a central feature of the European
banking industry. Concentration, which can for example be measured by the size of the five largest
credit institutions, varies considerably across countries. However, concentration generally appears to
be higher in small countries than in large ones. It is not particularly high in Norway, and is lower than
in Denmark, Finland and Sweden.
Developments in the number of credit institutions are another measure of market consolidation. The
total number of credit institutions in the euro area has been sharply reduced over the past eight years.
The number has declined from 29 institutions per million inhabitants in 1997 to 21 in 2004.
The high level of concentration in small countries may be an indication that there are economies of
scale in the financial industry. In large countries, even banks with small market shares can achieve
economies of scale. Large credit institutions offering a range of services can also achieve economies
of scope by selling several types of product to the same customer.
Norway has more banks per capita than the euro area, and the number of banks has remained fairly
stable over the past few years. One reason may be that bank alliances have allowed smaller banks to
benefit from economies of scale and scope. This occurs in part through integrated technology and
product development solutions, and the sharing of knowledge and expertise. In addition, the number
of foreign operators in Norway has increased.
Concentration in the banking industry also results in a concentration of risk. At the same time, larger
entities may manage risk better than smaller entities.
Cross-border activity
In countries with a high level of concentration, more consolidation may weaken competition.
Particularly in small countries, it has been necessary for banks to establish activities in other countries
in order to achieve economies of scale. In the Nordic countries, Nordic financial conglomerates have
emerged in recent years, and the largest banks now define the entire Nordic region as their domestic
market. The Nordic region is very advanced in the development of cross-border solutions.
Foreign bank branches and subsidiaries have more than doubled their market share in the Norwegian
banking market since 1999. The share is considerably higher than in Sweden and Denmark, although
the proportion of foreign institutions has also increased markedly in these countries. The sharp rise in
Finland is due to Nordea's becoming a Swedish rather than a Finnish bank in 2004.
Cross-border activity contributes to increased competition, a wider range of options for operators and
the sharing of expertise. With banks from several geographical markets, the financial system is also
less vulnerable to cyclical developments in any one country.
Growth in new, less well-known markets makes risk assessment more demanding. A consequence of
cross-border institutions may also be that turbulence in financial markets in one country more easily
spills over to other countries. Moreover, a crisis may be more complicated to resolve in an
internationally active institution than in a national institution.
Conglomerates
The trend in financial markets is moving towards large financial conglomerates and alliances. In
addition to traditional banking services, these conglomerates also offer other financial services. Large
banking and financial groups in Norway have substantial market shares in several sectors. Compared
with other Nordic banking conglomerates, Norwegian banking conglomerates earn a larger share of
their revenues from services outside the bank itself.
Banks that grow into other sectors will face challenges relating to risk management, product
knowledge and customer relations. Banks' exposure to reputation risk also changes since problems in
another, non-banking part of the conglomerate may influence and damage the bank's reputation. In
terms of financial stability, it may nonetheless be an advantage that bank conglomerates spread their
revenue base. This is particularly true if earnings from new activities do not fluctuate in step with
earnings from traditional banking activities. However, this is not entirely certain since most sources of
bank revenues failed during the banking crisis at the beginning of the 1990s.
Risk diversification through the securities market
Credit that is channelled directly through the securities market diversifies risk and thereby eases the
burden on the banking system. Developments in the securities market have made it easier for banks
to vary their financing. In addition, the emergence of a number of new credit sources and new
instruments has made it possible for banks to engage in risk trading. Therefore, it has also become
easier for banks to diversify risk.
The structure of the financial system varies considerably across countries. This is illustrated by the
different ways enterprises finance their activities. Norwegian enterprises have a fairly low level of
borrowing in the bond and short-term paper market, representing as little as 8 per cent of total
financing.
Different financing structures mean that the risk associated with extending credit and providing other
financial services varies across countries. It is an advantage for enterprises and other operators in the
financial market to have several financing sources to draw on. If problems arise in parts of the financial
system, operators can find alternative sources of credit. A larger bond market would enhance financial
stability. This is also the case in Norway.
New investment and risk management instruments
Structural changes and strong growth over the past decades have led to more perfect financial
markets. This has made the markets more efficient and improved the distribution of resources and risk
between operators, sectors and regions, and over time. There is rapid growth in product development
in financial markets, and trading in instruments for the transfer of credit risk is rising. Greater focus on
risk management by banks and other operators generates demand for these products. The
emergence of new instruments is being driven forward by intensified competition, technological
developments and new, more risk-based capital adequacy requirements.
In many countries, there has been a tendency towards separating those who provide loans and who
assess and price the risk, from those who take over the loans and bear the risk. Through
securitisation, banks can sell entire loan portfolios to special purpose vehicles that issue bonds that
are collateralised by these loans. It is the buyers of these bonds that bear the risk. Such special
purpose vehicles are not subject to capital adequacy requirements or supervision. Asset-backed
bonds are a similar instrument where bond holders have collateral in loans that banks have
transferred to a mortgage company. Mortgage companies are subject to supervision and capital
adequacy requirements. Efforts are being made to allow these instruments in Norway. Use of these
instruments will probably strengthen the bond market and thereby improve the diversification and
management of risk.
In recent years, we have seen the development of new instruments that make it possible to sell the
credit risk associated with a loan while the actual loan remains on the balance sheet. This makes it
easier to diversify and manage risk. A credit default swap is a type of credit insurance contract linked
to one or more loans. The purchaser of the contract is guaranteed payment if the loan defaults. The
contract issuer must pay.
Collateralised debt obligations, or CDOs, are another popular instrument. Simplified, this is often a
corporate loan that has been transferred from a bank and split into tranches with varying risk profiles.
Debt instruments are issued for the various tranches. If the loan defaults, the first losses will be
incurred by the lowest tranche (which has the highest risk). The bank that has transferred the loan
often holds this tranche. The tranche that incurs losses last will thus be very secure. The return in the
various tranches will naturally be related to risk. In this way, it is possible to create many different
combinations of risk and return and tailor them to individual investors. Synthetic CDOs involve credit
default swaps rather than loans. This makes it even easier to achieve the combination of risk and
return the investor is seeking.
In the global market, banks are net buyers of risk protection, whereas insurance companies are net
sellers. Nevertheless, the majority of transactions are between banks and not between banks and
insurance companies.
In terms of financial stability, there are both advantages and disadvantages to these new instruments.
Among other things, they allow the transfer of risk to market participants that are willing to bear it.
Such participants are often specialised and well equipped to bear the risk. If the credit risk is spread to
market participants outside the banking sector, banks' risk exposure is reduced.
Disadvantages arise if there is a concentration rather than a diversification of risk on the buyer side. If
individual market participants take on too much risk, their counterparties (such as banks) may be
exposed to losses. There is always a risk that buyers lack sufficient knowledge of new products.
Another problem has been that the new markets' infrastructure has not kept pace with turnover so that
operational risk in the system has increased.
Risk management implies that investors take into account how risk and return are correlated for
different investments. Normally, such assessments are based on correlations under normal
circumstances, and the challenge lies in dealing with a completely different correlation during a crisis.
New instruments can make such risk management more demanding. There may be poor liquidity in
these markets and this can increase price fluctuations during a crisis and spread turbulence from one
market to another.
In general, the new instruments for risk management and diversification have probably contributed to
stronger and more stable economic growth. As a result, economies have become more efficient. Thus
far, it also appears that improved opportunities for risk management have resulted in more stable
developments. The consequences of considerable financial turbulence, as for example when the IT
bubble burst in 2000, have become less severe than earlier. Norway is lagging behind international
developments in this area, together with a number of other European countries.
3. Developments in the household sector and house prices
In recent years, considerable attention has been focused on higher house prices and strong growth in
household debt in many countries, including Norway. The International Monetary Fund (IMF), for
example, has expressed concern that house prices may be too high in relation to fundamentals in
some countries. A sharp fall in house prices or other financial assets can trigger turbulence in financial
markets.
Norges Bank's analyses show that high house prices may explain most of the growth in household
debt. Sales of new dwellings have also made a positive contribution. The contribution from interest
rate changes was high in 2003 and 2004, but has diminished recently. Lower unemployment in 2004
and increased house sales have pushed up debt growth.
Higher house prices affect debt for a long period. Changes in the loan-to-asset value ratio of a
dwelling is closely related to turnover and only a small share of the housing stock is for sale at any
given time. Even if house prices stabilise following a sharp rise, there will be a long period during
which houses change hands at a higher price level than the last time they were sold.
What influences developments in the housing market?
Norges Bank's calculations show that high wage income has pushed up house prices. The
contribution from interest rate changes has also been high in the past two years but has diminished
somewhat recently. Interest rate changes have a strong and rapid impact.
From 2004, housing starts were substantially as a result of high house prices, low interest rates and a
favourable economic outlook. In Oslo in particular, housing starts have been high. A higher supply of
dwellings will reduce pressures in the housing market.
When we increase the interest rate, we expect house prices to rise at a slower pace. Norges Bank
increased the interest rate by 1⁄4 percentage point last summer. Before this increase, banks' mortgage
rates fell, even though Norges Bank's sight deposit rate remained unchanged. Stiff competition for
mortgage loans and lower capital requirements for mortgage loans when the Basel II Accord comes
into force may have contributed to this.
In recent years, nominal long-term interest rates have fallen more than inflation. The real interest rate
has declined. This may not only be an expression of economic conditions, but may also reflect a lower
normal level for real interest rates. A lower normal real interest rate level will result in higher
equilibrium prices for all capital goods, including houses, because the present value of future returns
increases.
Norges Bank's estimates, which are based on the assumption that interest rates in Norway will
increase gradually,1 show that the rise in house prices will slow until 2008 and then stabilise. As the
chart illustrates, there is considerable uncertainty associated with such estimates and we may also
experience that prices fall.
Household wealth
In recent years, higher house prices have resulted in increased housing wealth. There is considerable
uncertainty associated with estimates for housing wealth, but a conservative estimate indicates that
housing wealth is 11 per cent higher than household financial assets and more than 40 per cent higher
than household debt.
Household gross financial assets have also increased more than debt in recent years (measured in
NOK). This financial buffer reduces some of the concern related to debt growth. Nonetheless,
developments in saving are uncertain. Credit market statistics may indicate that saving has declined
considerably and is now fairly low after adjusting for the fact that owners are ploughing huge profits
back into their companies as equity capital. The national accounts present a picture of higher saving.
Total debt is unevenly distributed
Developments in assets and debt are, naturally, unevenly distributed among different groups of
households. Compared with the 1980s, the debt burden has increased in low- and middle-income
households (deciles 1-6), often younger households in the start-up phase. This partly reflects changes
in the tax system. Before the tax reform in 1992, extensive borrowing was very profitable for
individuals with high income.
In order to shed further light on the distribution of debt and assets between households, Norges Bank
now analyses data for households included in the income and wealth survey published by Statistics
Norway (2003). The data cover 17,000 households, of which 14,000 have debt. The chart on the left
presents the relationship between gross income and debt for households with debt. The households
with the highest debt and income have been excluded. For approximately 1,400 households, debt is
higher than three times their income. For the entire population, this figure would be scarcely 200,000
households.
Income is the first line of defence against debt-servicing problems. The next line of defence is financial
assets. The chart on the right shows the relationship between debt and financial assets for the same
households. Many of the households have very limited financial assets. Households with less than
NOK 19,000 in financial assets account for a total of NOK 198 billion in debt. This represents a quarter
of the households.
Consequences of developments in household debt
The household interest burden, i.e. interest expenses after tax in relation to the sum of interest
expenses and disposable income, is low despite strong growth in debt. The interest burden will
increase, however, when the interest rate reaches a more normal level.
Only 14 per cent of household loans are fixed-rate loans. This is low in relation to other countries and
makes households vulnerable to an interest rate increase that is higher than expected.
Losses were low on loans to the household sector compared with loans to the enterprise sector during
the banking crisis at the end of the 1980s and beginning of the 1990s. Despite high real interest rates
and a decline in income, households were largely able to service their debt. High interest expenses
and a decline in income, however, led to a reduction in household consumption. This led subsequently
to lower turnover in the enterprise sector and weakened profitability and debt-servicing capacity. In
this way, households contributed to an increase in banks' losses on loans to the enterprise sector. The
higher the household debt burden is, the stronger the spillover effect can be from households to
enterprises.
4. The stability of the financial system
Given the current picture, a sharp increase in bank losses is not likely in the near future. This is also
the assessment of the IMF, which recently evaluated the Norwegian financial system. The IMF
concluded that the Norwegian financial system is solid and well managed, and that short-term
vulnerabilities are low. Even with a strong negative shock to the economy, losses are expected to be
far lower than during the banking crisis. This is probably because of the increase in the share of loans
to households, for which losses are normally not very high, and because enterprises are now in a far
stronger financial position than they were at the end of the 1980s and beginning of the 1990s.
Long periods of strong growth in debt, asset prices and investment may be a source of subsequent
instability and problems in the financial system. We have observed this phenomenon both in Norway
and in other countries. When optimism turns to pessimism, the financial system can come under
pressure. However, it is not possible to determine with any certainty the value of debt, asset prices
and investment that may constitute an unacceptable risk in this context.
The pace of growth in household borrowing cannot be sustained over time. It would probably be wise
for both borrowers and lenders to acknowledge that the root of subsequent problems, and demanding
corrections, is often to be found during such periods.
Thank you for your attention.