Selected Issues in the Financial System33
55. This paper discusses key issues in the Norwegian financial sector. The paper first outlines recent financial developments and banking soundness indicators, followed by a discussion of the financial policy framework. An overview of the comparative recovery of the Nordic banking systems following the crisis in the early 1990s is presented along with the broad lessons provided by such experiences. The recovery sets the stage for the current international competitive position of Norwegian banks vis-à-vis other countries. Issues of competitiveness are important in light of rapid structural changes sweeping financial systems across Europe. These changes provide a new opportunity for the Norwegian government to assess its structural policy goals for the financial sector, as discussed in the final section of the paper.
A. Recent Financial Developments 34
56. The weakness in commodity prices that started with the Asian downturn in 1997 contributed to a plunge in oil prices and the depreciation of the krone in 1998. This led to a sharp rise in short-term interest rates in Norway, with long-term rates moving in parallel with rates in other European countries (Figure 1). Short-term rates in Norway have eased somewhat in 1999, but were still above the levels prevailing at the beginning of 1998. Toward the end of 1999, short term rates edged up in part due to uncertainty about consequences of any Y2K computer glitches.
Figure 1.Norway: Interest Rate Developments,1995-1999
Sources: IMF, International Financial Statistics; and WEFA.
57. Equity prices recovered strongly in 1999 on firming commodity prices, recovering most of their sharp 1998 loss—oil and other commodity-related stocks account for a substantial part of the Norwegian stock exchange (Figure 2, bottom panel). Stock price increases represented a gain for life insurance companies since about 30-35 percent of their balance sheet assets consisted of equities, in contrast to less than 2 percent of bank balance sheet assets.
Figure 2.Norway: Asset Prices, 1987-99
Source: National authorities; and Bloomberg.
58. Property prices grew strongly in real terms since their trough in 1992 (Figure 2, top panels). The rise has been particularly strong in urban areas as a result of substantial in- migration. The upward trend in residential housing prices continued into 1999—prices of resale houses rose by 9 percent in the year to the third quarter. The price increases could be attributed to several factors. Supply constraints resulted from tightened regulations on housing starts and the scarcity of approved construction sites, especially in 1999. A steady rise in disposable income, sustained low unemployment, and high household confidence boosted demand. Although real after-tax interest rates rose to about 4 percent following market turbulence in 1998, the increase was expected to be temporary. An easing of monetary conditions and expectations that rates would continue to decline may have also contributed to the buoyant prices. Commercial property prices also grew steadily after the crisis, but turned down slightly in 1999 as business prospects weakened.
59. Credit growth, which had been rapidly rising as the economy enjoyed several years of boom in the mid-1990s, subsided in 1999 (Figure 3). Strong credit growth by private banks had earlier reflected attempts to regain market share from the state banks. There had also been strong lending growth to state-owned oil companies. However, in 1999, total credit from domestic sources to municipalities, non-financial enterprises, and households fell to around 8 percent y-o-y from above 10 percent in early 1998. The largest banks have contributed the most to the recent easing of credit growth. At first, a reduction in the supply of loans for risk management reasons had reduced pressures; then, higher interest rates and slack investment played a role from the demand side. The contraction in business investment was partly oil-related, but also reflected completion of airport-related investment.
Figure 3.Norway: Credit Growth
Source: Norges Bank
60. Household net financial wealth as a percent of disposable income was at a peak level of 54 percent in 1999 (Figure 4), extending the steady rise over the decade from 7 percent in 1990. Net wealth excluding insurance claims also improved, but the level remained negative throughout the period. Only about a quarter of household insurance claims is in the form of saleable life insurance policies, the rest being in collective pension schemes inaccessible to the claimant. Therefore, the negative ratio excluding the mostly illiquid claims represents a liquidity risk to household repayment of debt, of which mortgage loans constitute the largest part. Nonetheless, household interest expenses have fallen from about 11 percent of cash income in 1993 to around 7 percent in 1999, accompanied by a steady decline in non-performing loans. With gross borrowing increasing in line with disposable income, and low unemployment, household credit risk is likely to remain low for the near future.
Figure 4.Norway: Position of the Non-financial Sector
Source: Norges Bank
61. Credit risk has risen in the corporate sector where profitability has been low and investment has declined in some industries (Figure 5). Profitability in the enterprise sector deteriorated in 1998 and 1999 due to high wage growth, increased competition, and lower product prices. The growth in operating revenue declined sharply between 1997 and 1998 and the return on equity fell by over 2 percentage points. Enterprise debt was high and the proportion of long-term debt in high risk enterprises (those with negative earnings and equity shares) relative to total long-term debt had increased. Nonetheless, the number of enterprise bankruptcies has remained relatively unchanged since 1994, while non-performing loans have declined. The equity ratio in the corporate sector had increased to about 38 percent in 1999 from 28 percent in 1990.
Figure 5.Norway: Banking Profitability, 1990-99
Source: Norges Bank
B. Banking Soundness Indicators
62. Banks’ operating profits and return on capital improved in 1999, with increases in net interest income and non-interest income, low loan losses, and a reduction in operating expenses (Figure 5). Interest rate margins, which had risen in mid-1998 as changes in deposit rates lagged increases in lending rates, declined in 1999 to levels above those prevailing in the early 1980s (Figure 6). Favorable developments in other operating income reflect strong returns on securities in the first part of 1999. Securities returns have been incorporated into earnings by accounting changes that required marking the trading portfolio to market. Negative loan losses in 1994-97 reflected the reassessment of loans previously recorded as non-performing. Current loan loss rates below 0.2 percent are expected to rise over time to a normal level of around 0.5-0.6 percent of gross loans.
Figure 6.Norway: Banking Indicators, 1990-99
Source: Norges Bank
63. The core capital ratio has been maintained at about 8 percent in commercial banks for the last several years, despite high credit growth, and has dipped slightly to 103/4 percent in 1999 in savings banks(Figure 7). Incentives to maintain high ratios of core capital have been strengthened in 1998 by a banking commission rule which requires core capital to be a minimum of 7 percent before the expansion of supplementary capital is permitted.35 Total capital adequacy was 11 percent and 12¾ percent in 1999, for commercial and savings banks, respectively. However, strong capital ratios are advisable in Norway to serve as buffers against balance sheet shocks arising from the cyclical volatility of the Norwegian economy.
Figure 7.Norway: Capital Adequacy, 1991-99
Source: Norges Bank
64. Despite the weaker recent performance in the corporate sector, there has been no increase in the stock of non-performing loans (Figure 8). Indeed, non-performing loans of commercial and savings banks have declined steadily from their cyclical peaks in the early 1990s. Non-accrual loans (using a 3-month reclassification period) represent about 80 percent of non-performing loans. The rest comprise loans secured above the nominal value of the loan, for which earnings can be recorded.
Figure 8.Norway: Non-Performing Loans Provisions,1990-99
Source: Norges Bank
65. The stock of loan loss provisions as a percent of gross lending has fallen to about 1½ percent in both banking groups and loan loss reversals have flattened out (Figure 8). Banks raised non-specified provisions in 1998 in response to a pessimistic economic outlook. The banks have not shown any desire to further increase provisions since there had not been any effect from manufacturing weakness and even shipyards have remained solvent. An open question is whether provisions are sufficient to prepare for losses that might occur a few years ahead given the increased credit risk inherent in the corporate sector weakness. Some regional banks in particular will likely have to raise provisions somewhat in the future.
66. The proportion of deposits relative to bank liabilities has been declining, reflecting a portfolio balance shift of household financial assets into mutual funds. As a consequence, banks have had to obtain new funding sources and have responded by seeking greater amounts of long-term foreign funding. In addition, the interest rate differential with abroad widened in the second half of 1998, providing greater incentives to obtain credit from foreign sources. The currency exposure on the liability side has been mostly balanced by foreign- currency denominated assets (Figure 6), reflecting strict exposure limits. The rise in bank earnings from the management of mutual funds will require increased supervisory attention to off-balance sheet items.
67. Banking exposure to risky sectors has been limited. Commercial bank lending to the ship-building industry—currently one of the most troubled industries—is less than 1 percent and savings bank exposure is also low. This can be attributed to the fact that survivors from the severe downturn suffered by the shipping industry in the 1970s have mainly relied on reinvested earnings for funding investment. Bank exposure to other weak sectors is also insignificant—less than 2 percent. Real estate exposure was 10-13 percent in commercial banks and 8-16 percent in savings banks, with larger banks taking a greater share of the market. The performance of these loans has tended to reflect overall economic conditions.
68. The banking supervisory authorities undertook a risk assessment exercise in 1999 to study the possible implications of risky lending by banks. Using a risk classification model from Norges Bank and forecasts from Statistics Norway,BISC examined bank exposure to selected industries. They found that credit growth had been the fastest in the low-risk loan categories until 1998, after which the highest risk category grew the fastest.
69. An important recent prudential regulation has reduced the capacity of banks to take on risks associated with large exposures—defined as a loan to a single borrower that constituted more than 25 percent of own funds for savings banks (10 percent of total lending for commercial banks). A new reporting requirement for large exposures, connected to the EEA agreement, became effective at the beginning of 1998. In conjunction with the reporting rule, banks were not permitted to make new loans that would become large exposures and were given a transition period of 4-5 years in which to bring their existing portfolio in line with the limit. This regulation has already resulted in a spreading of lending risk across several small banks that had previously been individually exposed to one or two corporate clients and has kept at least one small bank solvent after the bankruptcy of a large client.
70. On the basis of the above financial market trends and indicators of banking vulnerability, the overall current health of the financial sector appears to be sound. There have been favorable developments in many indicators, such as household wealth, credit growth, banking profitability, and loan losses. However, the financial institutions and national authorities will need to maintain strong vigilance in responding to some increased risks—such as the higher credit risk associated with the low profitability in certain segments of the corporate sector—and in forestalling the emergence of new risks.
C. The Financial Framework
71. Norway’s Banking, Insurance, and Securities Commission (BISC), was established in 1986 through the merger of pre-existing institutions, as a comprehensive supervisory authority for all banks, insurance companies, securities firms, real estate agents, and accounting and auditing companies. In 1988 its jurisdiction was extended to cover other non- bank financial institutions and financial groups. Supervision of the stock exchange is expected to be transferred to BISC from the Ministry of Finance in 2000.
72. In the wake of the banking crisis, staff and other resources of the BISC were increased significantly—staff size doubled from 71 employees in 1986 to 143 in 1999. This expansion provided more resources for monitoring the financial system, inter alia to permit more frequent on-site examinations of banks and to strengthen supervision of insurance companies and conglomerates.
73. The BISC also tightened reporting and disclosure rules and developed a system of indicators for early warning of potential liquidity and solvency problems. A major focus of on-site examinations is the adequacy of banks’ internal systems for risk assessment and management. In 1996 the BISC established new requirements under which the adequacy of banks’ capital is assessed in relation to the risk of loss in their individual portfolios. Given the large and growing role of diversified conglomerates in the Norwegian financial system, the BISC has sought to base its supervision of the participating institutions increasingly on the comprehensive financial situation of the conglomerates.
74. Building on earlier practices, additional guidelines were established in 1993 for collaboration between the BISC and the Norges Bank in the exchange of information, contacts with financial institutions, development of regulations, economic and financial analysis, and statistical reporting (in cooperation with Statistics Norway). In 1994 the BISC and Norges Bank initiated a program of macroeconomic surveillance, intended to supplement supervision of individual institutions with an assessment of threats to the stability of the sector as a whole. Under this program, the BISC and Norges Bank each report twice a year (in alternating quarters) on economic and financial conditions in the sector, new developments and trends, and scenarios of the future financial strength of supervised institutions.
75. Deposit insurance had been in place for savings banks since the 1920s and for commercial banks since the 1950s. The contributory deposit guarantee funds have gradually rebuilt their balances that had been nearly depleted by the end of the banking crisis, although the commercial bank fund has been only partially paid-up, the rest taking the form of bank guarantees. In contrast to the trend in some other industrial countries, proposals to combine the commercial and savings bank guarantee funds, so as to ensure uniformity of treatment and greater pooling of risk, have not been adopted in Norway. Savings banks had a stronger financial position after the banking crisis and were able to maintain their separate fund. The deposit insurance funds have traditionally played an active role in the financial system—especially for savings banks. In addition to support for troubled banks, fund resources can be used for merger guarantees. The board comprises 5 members elected by the banks and one representative each from Norges Bank and BISC. Under legislation that became effective in January 1997, each guarantee fund insures deposits up to a maximum of NOK 2 million per depositor.
The payment system
76. The authorities have also collaborated to improve the efficiency and security of the payments system. In 1989 the Norges Bank incurred losses in conjunction with its decision to settle the outstanding balances of a small Norwegian commercial bank, Norion Bank, that had been declared insolvent and placed under public administration. Subsequently the Bank clarified that it would carry out final settlements only at the end of the business day, and that it would not settle transactions for other banks under public administration. The banks, Norges Bank, and the BISC cooperated in the following years to establish a new joint clearing and information system and to develop a system for balance checks for transactions prior to settlement. During 1997 the separate payments system maintained by the Postal Savings Bank was integrated into the general interbank settlements system. To further reduce settlement risk, in November 1997 the Norges Bank began the phased introduction of a real-time gross settlements system for large-value transactions.
D. Recovery from the Nordic Financial Crisis: A Comparison
77. The recovery from the banking crisis began earlier in Norway and Denmark (1993) than in Sweden (1994) and in Finland (1996). One important requirement for recovery was to reduce capacity and costs. Finland had the most extensive downsizing of staff and branches (Figure 9), although downsizing prevailed in all of the countries. The number of institutions declined as mergers and acquisitions became common following the banking crisis (Figure 10). Mergers and buyouts were highest in the early 1990s and took on a Nordic- Baltic strategy to access a larger market and obtain a distribution network. The number of savings banks in particular fell sharply, although in Norway this continued a preexisting trend. Norway has had the least concentrated banking system of the Nordic countries in recent years, although concentration has been higher in the Nordic countries than in some major industrial countries (Table 1). In Norway, more merger attempts have failed than in the other countries. Mergers between some of the largest and smallest banks have been denied due to regional and other considerations and public policy reasons. Moreover, savings banks have resisted being dominated by larger banks.
Figure 9.Nordic Countries: Number of Branches and Employees, 1979-1996
Source: OECD Bank Profitability, 1998
Figure 10.Nordic Countries: Number of Banking Institutions, 1979-1996
Source: OECD Bank Profitability, 1998
|Share of die five/ ten largest banks 2/||Number of Institutions|
78. In the 1980s, banks in Nordic countries were most concerned with expanding market share, so lending and deposit rates were set to attract customers. High interest rate spreads in Nordic banks following the banking crisis reflected the credit crunch period when the focus was on increasing profitability to strengthen the banks’ balance sheets (Figure 11). Later, as the economies have recovered and competition has increased, margins have declined. Net interest income as a percent of assets has paralleled this development, but has also displayed a long run trend decline in Norway and Finland (Figure 12). Net non-interest income, while more volatile in some countries, has been steadier in the long run. Operating expenses rose during and following the banking crisis, but have fallen since (Figure 13). As the Nordic economies recovered in the mid-1990s, bank profitability has been restored.
Figure 11.Nordic Countries: Interest Rate Margins, 1986-1999
Source: International Financial Statistics
1/The levels of interest margins are not comparable between countries since the underlying lending and deposit rates are based on different definitions in some cases.
Figure 12.Nordic Countries: Selected Profitability Indicators, 1979-1996
Source: OECD Bank Profitability, 1998
Figure 13.Nordic Countries: Selected Expense Indicators,1979-1996
Source: OECD Bank Profitability, 1998
E. Lessons from the Crisis and Recovery
79. Lessons drawn from the experience of previous banking crises are important for preventing the outbreak of new crises. In this respect, the Nordic banking crisis of the early 1990s has underscored the importance of several factors for maintaining financial system stability.36
Appropriate macro policy
80. Among other economic costs associated with an inability of macroeconomic policy to stabilize sharp economic fluctuations, systemic banking problems can arise from bank losses incurred during deep recessions, made worse by riskier loan portfolios acquired during strong booms. Against the backdrop of deregulation in the 1980s that heightened competition for deposits, banks undertook excessive risk in search of high-yielding assets that could exceed funding costs. Norway, Sweden, and Finland experienced a pronounced boom and bust cycle, exacerbated by accommodative macroeconomic policy. The strong upswings, initiated by favorable terms of trade shocks and reinforced by rapid credit expansion, were not sufficiently counteracted by fiscal policy and monetary policy options were constrained by fixed exchange rate regimes. Overheating increased the collateral values of real property, helping to justify risky lending behavior that increased the vulnerability of banks to economic reversals. Private indebtedness rose to unsustainable heights. Later, tax reforms combined with monetary tightening and lower inflation raised real interest rates sharply, leading to asset price deflation. Domestic demand slumped and bankruptcy rates surged. Losses and repayment problems in the nonfinancial sector and the decline in collateral values quickly translated into banking problems and a banking crisis.
Effective legislation and regulations
81. A framework for financial stability must deter excessive risk-taking through effective legislation and regulations. Sound capital adequacy requirements are needed to strengthen banks’ capacity to bear unanticipated losses and to limit excessive lending growth. Capital adequacy regulations in Norway are more stringent today than they had been when the banking crisis erupted. It is also important to set criteria for the use of subordinated capital as an additional capital buffer. During the banking crisis, subordinated capital was not written down despite the provision of public support to ensure the continuation of banking operations. Under a new Bank Guarantee Act, subordinated capital can be drawn on to a certain extent while the bank is still operating. This also boosts market discipline since banks that take on excessive risk with insufficient capital must pay more for subordinated capital. A prudential framework also needs a consistent set of requirements including accounting, asset valuation, income recognition, risk management, bank governance, and entry and exit. These should follow best international practices.37
82. The framework should include safety nets for financial institutions but designed in a manner to minimize moral hazard. The use of bank capital and subordinated capital as first lines of defense can help reduce moral hazard. As a second line of defense, deposit guarantee schemes funded by the financial institutions can assist in peer monitoring and self-discipline. Industry funded schemes for commercial banks and savings banks were already in operation in Norway during the crisis, but the Act on Guarantee Schemes, which came into effect in 1997, has clarified the limits of the deposit guarantee. A limit of 2 million NOK per depositor, although generous in comparison to many other countries, represents a tightening of earlier statutory rules for savings banks and clarification of the rule for commercial banks in contrast to the practice of covering all deposits during the banking crisis. The guarantee funds have also been provided with support measures to ensure that a member can meet its obligations and continue operations, and if necessary to transfer its activity to another bank. Indeed, capital supplied from the guarantee funds during the banking crisis proved to be a lower cost and more effective means of resolving the crisis than referring solvency issues directly to the government.
83. After exhausting private and industry resources to deal with a crisis, public supportmay be required. The Nordic banking crisis underscored some important conditions for the provision of public support to reduce moral hazard. In Norway, prior to the use of public resources, banks’ share capital was fully written down, management changes were required, and strict criteria for bank operations were applied to promote recovery.38 The situation was dealt with swiftly and with broad political support. One key element of the official line of defense against financial instability is central bank liquidity support. In the event of systemic liquidity problems, the central bank can alter interest rates and supply large volumes of liquidity to the market. Regarding problems at individual institutions, Norges Bank can provide loans at a penalty rate to illiquid but solvent institutions. Norges Bank also has the capacity to provide loans on special terms, but has stressed its reluctance to use this instrument since it would weaken the incentives for banks to preemptively reduce risk or draw upon the resources of the interbank market or guarantee funds to solve their problems. Indeed, Norges Bank loans to banks are almost negligible and collateral requirements apply to all of the standard lending facilities.
Effective supervision of institutions and markets
84. Supervision has been strengthened since the banking crisis. Resources of the BISC have been increased. Greater emphasis has been placed on on-site examinations. Internal control routines have been enhanced. International surveillance cooperation has been strengthened. With the rise of large financial groups, greater attention has been played to monitoring consolidated bank accounts. In addition, the authorities have become more aware of the importance of identifying emerging tensions and possible sources of systemic failure at an early stage through heightened monitoring and simulation of risk.
85. Coordination between central bank and supervisors and regular reporting by the authorities are key elements of effective surveillance. Norges Bank and the BISC cooperate closely in their surveillance work, each producing regular reports with assessments of the financial outlook. In addition to monitoring indicators of financial soundness, these reports also analyze the potential impact of macroeconomic developments on the strength of the financial system. The Norges Bank report, Financial Sector Outlook, is published semi–annually in its Economic Bulletin and also submitted for discussion to the Ministry of Finance, with an indication of whether the financial situation will require the use of instruments not available to Norges Bank.
Robust payment and settlement system
86. Financial difficulties of one bank could be spread to others through the payment and settlement system, especially if banks credit the accounts of their customers before they receive settlement from the payer bank. An example of settlement losses in Norway is described above (e.g. the Norion Bank incident of 1989). Measures that can be taken to reduce settlement risk include (i) settle large interbank transactions on real time gross basis,and (ii) introduce collateral requirements for banks’ loans. A large share of interbank transactions is settled continuously during the day through Norges Bank’s settlement system. The largest interbank payments are settled individually and continuously on a gross basis. Prior to finalizing settlement, the sufficiency of funds is verified in the paying bank’s account at Norges Bank. In addition, the introduction of collateral requirements for bank loans has lowered the risk assumed by Norges Bank. As international transactions become increasingly important, a high-priority task will be to ensure that the settlement systems have secure and effective international links.
F. Structural Changes
87. There have been many forces leading to change in financial systems in the Nordic countries and all of Europe in recent years. Deregulation in European countries since the 1980s has eliminated many controls, such as those on interest rates, credit growth, and access to money markets. Implementation of EU and EEA rules on the right to establish affiliates and cross-border operations has contributed to increased integration and competitiveness in financial markets. Globalization in connection with various free trade agreements has led corporate clients to require more international services. Advances in information technology have accelerated competition by providing low cost access to information and by permitting home delivery of financial services. The rapid aging of the population in conjunction with these developments has led to changing savings patterns: more savers have turned away from traditional bank deposits toward insurance products and securities funds. Consequently, there has been a trend toward hybrid financial institutions that offer both bank and insurance products. Nonbank financial institutions, such as securities firms and finance subsidiaries, have made competitive inroads. All of these forces have increased competition and led to financial sector restructuring and consolidation across Europe, which will likely be hastened as a result of the introduction of the euro. Competition among banks has driven down interest rate margins and required cost reductions, further increasing the need for bank restructuring.
88. In Norway, many of these same forces have resulted in consolidation over the last two decades. The number of commercial banks fell from 24 in 1980 to 14 in 1999 while the number of savings banks fell from 322 to 132 in the same period. There was also a steep drop in the number of general insurance companies.
89. In recent years, there has been significant merger activity, especially between banking and insurance markets. These two services have become dominated by integrated financial groups and conglomerates, with about two-thirds of domestic financial services accounted for by the nine largest conglomerates at end-1998, These institutions had market shares ranging from 40 percent of finance company business to more than 70 percent of banking, investment fund, and life insurance business.
90. Smaller Norwegian financial institutions (most of which are savings banks) have attempted to compete with the conglomerates by forming alliances that enable them to offer a fuller range of financial services. The savings banks (with 40-45 percent market share) have divided into three large cooperative groups. They have more of a regional orientation and are more heavily involved in mortgage lending than the commercial banks. Most of the savings banks are opposed to a recent proposal to convert savings banks into joint stock companies. Incorporation would make the savings banks, and their management, more vulnerable to hostile takeovers. There are also no tax or regulatory advantages since the regimes are the same for commercial and savings banks.
91. Despite this trend in consolidation, the Norwegian financial system is relatively small and competitive. At end-1998 the Norwegian banking system included the Norges Bank (the central bank), 13 commercial banks (one foreign-owned), 133 savings banks, and 6 Norwegian branches of foreign banks. Banking concentration is lower in Norway in comparison to banks in other Nordic countries.
92. Competition from foreign financial institutions has increased in recent years, especially following the EEA Agreement which permits cross-border operations and the establishment of affiliates. The share of loans to the public from foreign banks and affiliates established in Norway have been increasing, although the level is still small.39 Of these, market shares to nonfinancial enterprises have been significantly higher than to households.
G. International Competitive Position
93. Norwegian banks have operated at average efficiency relative to banks in other European countries. Profitability levels in Norway, Denmark, and Sweden are close to the average in Europe, at about 0.9 percent. Finnish banks are among the best, with a profitability ratio of 1.2 percent. Core capital has been in line with other international banks and equity ratios have been high. According to data from the OECD, operating expenses in Norway have been similar to the other Nordic countries, measured both as a percent of average balance sheet assets or as a percent of gross income, as have staff costs as a percent of gross income (Figure 13). Employee costs have been the lowest in Sweden, although Finland has recently closed the gap. On the other hand, data for 1998 provided by the Ministry of Finance shows that operating costs in Norwegian banks were higher than in Denmark, Sweden, and Finland, but lower than in the UK (Figure 14).
Figure 14.Selected Industrial Countries: Banking Profitability, 1998
Source: Ministry of Finance; and other national authorities.
94. There are different indicators for assessing cost efficiency of banks, each with strengths and weaknesses. Using the cost to income ratio as a measure of efficiency can be inaccurate since banks with similar cost to income ratios could have different returns on equity or returns on assets. On the other hand, differences in operating expenses as a percentage of assets can give a distorted picture when used to compare banks with different balance sheet compositions. Higher cost banks may also have higher net interest rates.
95. Indeed, there are differences in the overall structure of the financial system in Norway compared to other Nordic countries. Banks in Norway have had a higher proportion of traditional loans relative to their balance sheet total, with less activity in asset management services (Figure 15). These traditional services are typically more costly (though the trend is toward lower costs), but the returns are more stable than those of other banks whose fortunes vary with financial market developments. However, there is also a greater extent of financing through bank deposits rather than through money markets (Figure 16), implying higher financing margins. In addition, bank operations in other Nordic countries have a greater degree of wholesale orientation than in Norway—accounts are larger, with lower costs but lower margins. Retail-oriented banks in Norway, along with those in Sweden, have had lower personnel costs as a share of income compared to other Nordic banks while Norwegian wholesale-oriented banks have been on par with other Nordic banks. Norwegian banks are also competitive when comparing cost-income ratios to other international banks. Another structural difference is that state housing banks take a large share of Norwegian mortgage lending, compared to the large proportion of mortgages in Danish banks for instance.
Figure 15.Nordic Countries: Selected Bank Assets, 1979-1996
Source; OECD Bank Profitability,1998.
Figure 16.Nordic Countries: Selected Bank Liabilities, 1979-1996
Source; OECD Bank Profitability,1998.
96. Using alternative measures of efficiency, which exclude non-core banking functions, banks in Norway had a higher core spread in the early 1990s, but there has been a significant drop in margins in recent years to levels prevailing elsewhere. Core costs are in line with banks in other countries and there have been favorable cost developments as new technologies allowed banks to handle larger volumes. Swedish banks have been leaders in core transactions. Some large banks in the United States have had high core costs since their focus has been on trading activities.
97. Norwegian financial institutions are small in an international context. At end-1998, the combined trust capital of DnB and Postbanken was only about 43 percent of the trust capital of Handelsbanken, the largest Nordic conglomerate (MeritaNordbanken was a close second), while Christiania Bank represented less than one-quarter of the size. Moreover, there is a substantial gap between the largest European and the largest Nordic institutions—Handelsbanken was ranked 44th in Europe.
98. There has been close cooperation between small banks on information technology and the payments system. Financial innovation and information technology in Norway have been on par with or ahead of the European average. Norwegian banks were ahead of others in electronic banking and other retail activities.
99. The competitive position of Norwegian banks has not been affected much by the introduction of the euro, although in the longer run the impact is expected to be significant. Banks must increasingly be able to provide their customers with excellent payment and financial services in euros. Currently, cross border payments are facilitated by correspondent banking relationships that provide Norwegian banks with access to the TARGET payments system. However, to reduce fees, the banks would prefer to obtain access directly through Norges Bank. In addition to improving the payment system, consolidation in Norway and the other Nordic countries will need to be accelerated to keep pace with developments in euro area countries.
H. Structural Policy
100. This section considers key aspects of the government’s structural policy in the financial sector. An important recent merger bid had been made by the Swedish-Finnish bank MeritaNordbanken for Christiania bank (Kreditkassen). This has given Norway’s government (as the largest shareholder of this second largest Norwegian bank) the opportunity to assess its structural policy goals in the context of international financial trends, especially the trend toward consolidation.
101. Current guidelines for structural policy in the Norwegian financial sector was set out in the Credit Report of 1997. According to the Report, "the chief objective of structural policy is to ensure that Norway has well-functioning and solid financial institutions and that there is strong competition between institutions." Policy should also maintain a satisfactory selection of financial services in all regions.
102. The emphasis on providing a choice of banks to customers in all regions is long–standing. This regional coverage was interpreted as requiring a network of local banks, but these had to be protected from competition by large national commercial banks with headquarters in Oslo or Bergen. The Odelstinget Proposition No. 41 (1986-87) stated that competitiveness required independent competitive entities so that any single company could not have monopoly power. The Proposition restricted the ability of the largest three commercial banks or largest four insurance companies to merge with other banks.
103. At the end of the 1980s, many financial institutions developed income problems and needed to reduce costs as part of their restructuring plans. The National Budget of 1993 therefore stressed that for the sake of reducing over-capacity in the banking industry, structural changes involving mergers could be required. Nonetheless, statements in the National Budget of 1996 and elsewhere found it undesirable that the government should contribute to further centralization and concentration in the financial sector. Regional considerations were important, for example, in the government’s rejection of Den norske Bank’s application to take over BN-Bank in 1998.
104. The government recognizes that cross border competition is intensifying and other types of financial institutions are steadily becoming more important as competitors to banks. The range of new products and services is increasing, while competition from these other sources is keeping prices low. In order to compete in the new environment, financial institutions must reduce costs while developing new products and services. Mergers or buyouts represent one strategy to accomplish this. However, the government views the financial benefits of mergers and buyouts as ambiguous on the basis of available information. It also raises public policy concerns about mergers.
105. Regarding the benefits of mergers, there may be large scale advantages associated with the expansion and management of technological systems involving large investment. Size may facilitate the expansion into new products and services. Economies of scope could be important for distribution of a range of services, combining banking and insurance products, for example. Empirical literature in banking has analyzed the degree of cost-based and revenue-based economies of scale, cost-based and diversification-based economies of scope, and the degree of X-efficiency gained from bank mergers.40 Economies of scale appear to exist up to a size of about 100 billion dollars. The evidence casts doubts on the significance of these benefits beyond that size. However, the most important competitive gain appears to be the improvement in operating efficiency that can arise from the acquisition of a bank by a more efficient one. Also, mergers can help reduce overcapacity and coordinate the closing of branches.
106. Apart from cost-reducing benefits, the trend toward large size might also be motivated by strategic considerations. A large institution may have greater options for buying out other institutions, and increasing future market share and profitability. It may also help reduce vulnerability to hostile takeovers that could threaten the position of current management. However, the costs of merger or buyout and the ensuing integration of distinct corporate cultures can be high. While risks can be diversified, new risks may be taken on without sufficient experience to handle them.
107. Public policy issues arising from bank mergers include an increase in concentration, a reduction in the attention paid to smaller customers, and systemic stability.41 Concentration can provide market power, with potentially detrimental effects on the real economy through higher interest margins. However, the increased competition from foreign sources and other types of financial institutions has led to reduced margins across Europe, counteracting any tendency toward monopoly power from domestic bank mergers. Increases in competition are likely to continue for the medium-term, so that concerns about monopoly power should be mitigated. Recent evidence from the US casts doubt on concerns that small players would have reduced access to banking services since a diminution of attention by large banks have opened up opportunities to other financial service providers. Mergers may, however, increase systemic vulnerabilities since the failure of a large bank may endanger the solvency of other banks in the system. In addition, a large bank may be viewed as "too big to fail." This may require considerable public resources for bailout, especially if it is a large international bank located in a small country. For example, the cost of bailing out the largest Swiss bank has been estimated at 18 percent of Swiss GDP.42 In Norway’s case, the likelihood that greater concentration may take the form of combination with foreign entities raises the specter of losing national control of large banks. The next section considers this issue.
Public Ownership and National Control
108. Government ownership in Norwegian banks is partly a legacy of the Nordic banking crisis. In the initial phase of the crisis, the two industry-funded and operated deposit insurance funds—the Commercial Banks Guarantee Fund and the Savings Bank Guarantee Fund—assisted ailing banks and provided funds to facilitate mergers with stronger banks. However, by the end of 1990, the capital of the deposit insurance funds was virtually exhausted. In March 1991, the government established the Government Bank Insurance Fund to provide loans to the deposit insurance funds, which in turn could provide support to member banks conditional on implementing recovery plans. The mandate of the Government Bank Insurance Fund was extended in November 1991 to allow it to provide distressed banks with core capital. The Government Bank Investment Fund was established in November 1991 to participate on commercial terms along with private investors in bank equity issues. In 1991 it became evident that the positions of the three largest Norwegian banks—Den Norske, Christiania, and Fokus—were worse than previously believed despite earlier capital injections into the latter two. By the end of the year, the government had become the sole owner of Fokus Bank and owned 98 percent of Christiania Bank (CBK). Following capital injections in 1992, the government owned 55 percent of shares Den Norske Bank (DnB), and its ownership share increased to 88 percent in 1993. These three banks accounted for about 85 percent of the total assets of all commercial banks. The government also assumed an ownership claim of 48 percent in the savings bank, Sparebanken NOR in 1993.
109. The primary objective of public support during the banking crisis had been to recapitalize troubled banks and restore them to profitability. Accordingly, official financing had mainly been provided in conjunction with restructuring plans, including loan writeoffs, measures to increase efficiency, and changes in ownership and management. These restructuring efforts in the aftermath of the crisis eventually succeeded in restoring profitability as reflected in sharp dropoffs of loan losses and lower operating costs. Consequently, public ownership in the banks has been reduced. Fokus Bank and Sparebanken NOR were completely privatized in 1995 and 1996 respectively. By early 1999, public ownership interests in DnB and CBK were reduced to about 52 percent and 3 5 percent, respectively. The Budget of 1998 expressed the intention of reducing the government’s share of DnB to 35 percent, but a pending merger with the fully state-owned Postbanken (which will increase the combined public stake to 61 percent) has postponed this action.
110. A policy for government ownership in the banking sector was first formulated in the Revised National Budget of 1992. Government ownership would play two distinct roles in the banking system. First, the Government Bank Insurance Fund was charged with providing an expedient method for safeguarding depositors and the financial system. Second, the Government Bank Investment Fund was assigned the role of managing the long-term state investment on a commercial basis and helping to secure national ownership in Norwegian banks.
111. The Government Report No. 39(1993-94) stated that long-term government ownership would be desirable in the two largest Norwegian commercial banks to ensure that the main decision-making functions associated with bank headquarters remained in Norway. The government’s current ownership interests in the two largest commercial banks are directed by the Government Bank Investment Fund. The guidelines for the operation of the Fund specify that the Fund shall not participate in the daily operations of the banks and the Fund must consider commercial criteria in its evaluations of prospective decisions, except those that relate to national interests wherein the Ministry of Finance must first consider the matter.
112. The level of public ownership, at 1/3 share in the largest commercial banks, permits the government to have negative control of the banks. Pursuant to the Corporation Act, changes in corporate bylaws require a 2/3 majority vote at shareholders’ meetings. Therefore, shareholders voting one third of the company’s capital can prevent changes in the bylaws such as those that specify the location of the headquarters. This negative control can also prevent a reduction of ownership shares through capital stock dilution or merger.
113. The MeritaNordbanken group offered to pay 44 krona per share, 29 percent above the market price, for shares in Christiania Bank. The bid was considered by the government, but it did not accept the offer by the October 29, 1999 deadline. MeritaNordbanken has extended the deadline several times, the latest to January 31, 2000. In December 1999, the government issued a mandate to the Government Bank Investment Fund to consider viable solutions for Den norske Bank and Christiania Bank as institutions, and for the government as owner. The mandate required that alternatives for strategic development be based on business criteria, but considerable weight would need to be given to retaining strong national ownership, and in particular, retaining headquarters in Norway. A majority of the Standing Committee on Financial Affairs of the Storting (the Norwegian parliament) further recommended that the government should combine its ownership interests into one entity and ensure national control by owning at least 1/3 of the shares. The majority also recommended that no sale of the shares of Christiania bank be permitted to foreign entities until a Norwegian solution has been considered.
114. Some of the interest that foreign institutions have been showing in taking over Norwegian institutions may also be connected to ownership rules. According to current rules, private ownership shares can not exceed 10 percent unless the firm is wholly owned. The government is considering increasing the allowable minority share to enhance possibilities for Nordic cooperative agreements and strategic alliances. The Banking Law Commission, set up by the government to consider banking law revisions, suggested raising the limit to 30 percent—just under the 1/3 share that could give negative control by a foreign entity. However, the Ministry of Finance recommends a limit of 25 percent, since the typical lack of full attendance at shareholders’ meetings permits negative control with an ownership share smaller than one third.
115. The policy of maintaining Norwegian ownership in the banking sector has been frequently stressed by the government. The main objective is to ensure that the control of decision making remains in Norway in order to meet national interests encompassing employment, development, and access to a full range of financial services in all regions. In this context, the government and the Norwegian authorities have expressed the following arguments in support of maintaining national ownership.
The Nordic financial market is highly integrated, but banks in other Nordic countries are much larger than banks in Norway for historical reasons. While maintaining a high share price might sometimes be a barrier to corporate takeover, it cannot always deter strategic interest from financial institutions in neighboring countries. Continued government involvement will be required to maintain Norwegian ownership of large banks. Moreover, private owners are viewed as inappropriate for ensuring national ownership since they must constantly reevaluate their ownership interests and the strategic policy of their firm.
Many countries have large financial institutions with national ownership.43 State ownership has been declining in the Norwegian banks, down to levels required to exercise control and thereby ensure that national interests are met.
The financial industry is more integrated into the economy than most other industries. Adverse effects can be huge if access to services is impaired, with repercussions on other sectors leading to real economic losses. In particular, foreign ownership by a large bank could hurt cyclical Norwegian industries (shipping, oil, fish) in a downturn since the large foreign bank would likely cut such marginal operations.
The government does not interfere in the day-to-day decisions of the banks, such as by directing credit to favored industries. In addition, Norway is completely open for foreign banks to establish branches and affiliates. In these respects, market discipline is maintained. Indeed, the present policy focuses on promoting domestic competition and increasing choices available to users of financial services.
116. The government’s recent mandate to find a national solution to the need for further consolidation raises the possibility of a merger between the two largest domestic banks. However, some market participants have given a lukewarm reception to this idea. They point out that a merger between DnB and Christiania banks would produce an institution with monopoly power in the domestic market, but with a small size in the Nordic region. There would not be a significant expansion in the client base in Norway nor abroad and cost reductions would likely occur only through the reduction of staff.
117. The possibility of a continued large public ownership share in the financial sector raises other policy concerns. As earlier noted, large public financial institutions can be viewed as "too big to fail," which increases the likelihood of greater risk-taking. In addition, the possibility of regulatory capture arises. Indeed, the track record of state-owned banks has been poor in many countries. State-owned banks may distort the banking market through access to low-cost capital and fully guaranteed liabilities. They may also be exempted de facto from prudential regulations. However, state-owned banks may operate effectively if they operate according to commercial criteria, conform to the same prudential regulations, and if their quasi-fiscal undertakings are transferred to the budget. In Norway, many of these conditions appear to hold. Moreover, a case could be made that foreign acquisition of the large Norwegian commercial banks could result in a greater degree of asymmetric information, potentially leading to disruption of financial services to some enterprises under certain conditions. However, if loans to small enterprises are profitable, it is not clear why other smaller Norwegian banks would not take over the provision of such services. In the case of loans that do not meet market standards but generate other social benefits, these could be combined with other net lending activities by the government.44 Finally, in the event of a large negative shock hitting Norway, a single nationally owned bank might be at least as impaired as an uncommitted multinational. Clearly, the debate on these issues in Norway, among other countries, has further to run. Irrespective of the final structure of the financial system that emerges, prudential and regulatory policies will need to be shaped in close co–ordination with the policy on financial supervision. This will be the key to ensuring that the financial sector seizes the opportunities and guards against the risks of the specific solution that Norway chooses to follow.
Brown, Scott, 1998, “The Norwegian Banking System—From Crisis to Healthy Competition,” Norway—Selected Issues, IMF Country Report, SM/98/39.
Claessens, S., A.Demirguc-Kunt, and H.Huizinga, 1998, “How does foreign bank entry affect the domestic banking market?” World Bank Policy Research Working Paper.
Dermine, Jean, 1999,“The Economics of Bank Mergers in the European Union: A Review of the Public Policy Issues,” OECD Report, DAFFE/CMF(99)21.
Drees, Burkhard and CeylaPazarbasioglu, 1995, “The Nordic Banking Crises: Pitfalls in Financial Liberalization?”IMF Working Paper 95/61, June(Washington:International Monetary Fund).
———,1998, “The Nordic Banking Crises: Pitfalls in Financial Liberalization?” IMF Occasional Paper 161.
Gjedrem Svein, “Financial Stability—Experiences and Challenges”, Address to the Annual Meeting of the Norwegian Savings Banks association,October1999.
Gronvik, Gunnvald, and CecileRom, 1995, “Structural Changes in Norwegian Financial Markets 1989-1994”, Norges Bank Economic Bulletin, Q3.
Eika, Kari, and TorReistadbakk, 1998, “The Competitive Environment in the Banking Industry—Driving Forces and Trends,” Norges Bank Economic Bulletin, Q4.
Hawkins, John, and PhilipTurner, 1999, “Bank Restructuring in Practice: An Overview,” in Bank Restructuring in Practice, BIS Policy Paper No. 6.
Holvik, Elizabeth, and Dag-IngeFlatraaker, 1997, “Norges Bank’s New Settlement System- NBO”, Norges Bank Economic Bulletin, Q3.
International Monetary Fund, 1998, “Toward a Framework for Financial Stability,” World Economic and Financial Surveys.
Karlsen, Harald, 1994, “The Norwegian Banking Crisis—Rescue Operations in the Period 1988-1993”, Norges Bank Economic Bulletin, Q1.
Karlsen, Harald;SindreWeme, and Inger AnneNordal, 1997, “Financial Institutions in 1996”, Norges Bank Economic Bulletin, Q1.
Kodres, Laura, 1999, “Financial Sector Issues in Germany,”IMF Staff Country Report No. 99/130.
Kredittilsynet, 1996, (the Norwegian Banking, Insurance, and Securities Commission), Annual Report.
———, 1997, Report on Macroeconomic Surveillance Program (mimeo).
Moland, Torstein, 1994, “Economic Policy and Financial Distress,” Norges Bank Economic Bulletin, Q3.
Norges Bank, 1997, “Financial Sector Trends,”Norges Bank Economic Bulletin, Q2.
Ordoobadi, David, 1996, “Recent Developments in the Norwegian Financial System, in IMF Norway Background Paper,”SM/96/17, January, (Washington: International Monetary Fund).
Royal Ministry of Finance and Customs, 1992, Report by the Commission on the Banking Crisis.
Royal Ministry of Finance and Customs, 1999, “On Ownership and Structure of the Financial Market,” Kredittmeldinga 1998.
Prepared by Valerie Cerra.
Much of the information presented in this section and those following reflect discussions with the Banking, Insurance, and Securities Commission (BISC); Norges Bank; the Ministry of Finance; the Norwegian Bankers Association; and several Norwegian private financial institutions.
As an exception, the banking supervisors can approve new subordinated capital for a bank with a Tier 1 capital ratio between 6Y2 and 7 percent, provided that the bank has a low-risk loan portfolio and good risk management system.
Many of these lessons have been underscored by Norges Bank Governor Gjedrem in an October 1999 speech to the Norwegian Savings Banks Association, entitled “Financial Stability—Experience and Challenges”
A detailed treatment of these issues is contained in IMF (1998).
However, Drees and Pazarbasioglu (1998) provide several reasons in support of their assessment that restructuring efforts were more successful in Sweden than in Norway or Finland.
A study by Claessens, Demirguc-Kunt, and Huizinga (1998) suggests that an increase in the foreign share of bank ownership tends to reduce profitability and overhead expenses of domestic banks, so the general effect of foreign bank entry may be positive for bank customers. The number of foreign entrants seems to matter more than their market share, suggesting that local banks respond to the threat of competition.
Much of this evidence is based on the United States, with few complete studies covering Europe. Dermine (1999) elaborates in more detail on the empirical literature.
See Dermine (1999) for an extensive treatment of the public policy issues in Europe concerning bank mergers.
Based on twice the book value as was required in the French bailout of Credit Lyonnais.
For example, the two largest sets of publically-owned banks in Germany controlled 32 percent of non-bank deposits and 29 percent of domestic lending to non-banks as of June 1999. See Kodres (1999) for more details.
For example, net lending by the government recently comprised the Norwegian State Housing Fund (6.3 billion NOK), the State Education Loan Fund (3.1 billion NOK), the Norwegian Regional and Development Fund (100 million NOK), and the State Bank of Agriculture (80 million NOK), which contained some subsidy element.