Chapter

II Banking Regulation and Its Impact on the Structure of the Financial System

Author(s):
Burkhard Drees, and Ceyla Pazarbasioglu
Published Date:
April 1998
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In the early 1980s, the banking systems in Finland, Norway, and Sweden were heavily regulated. The regulations, which shaped the structure of their financial systems, were motivated largely by the same principles and objectives in the three countries. Besides securing the stability of the banking system, they were designed to maintain low and stable interest rates and—particularly in Norway and Sweden—to channel subsidized credit to specific priority sectors, such as housing and government. As a result, the Nordic countries in the late 1970s and early 1980s were characterized by widespread credit rationing. The chronic excess demand for credit fostered close and long-term relationships between borrowers and their banks and allowed banks to be highly selective in choosing relatively safer credit risks. At the same time, bank profitability was largely ensured by restrictions on competition from other domestic and foreign financial institutions.

In this section, we review the key banking regulations, in particular interest rate ceilings, quantitative lending regulations, and foreign exchange controls, that were in effect in the three Nordic countries prior to deregulation. We also discuss how these regulations may have affected the structure of the banking systems (Table 1).

Table 1.Banking Regulations and Their Impact on the Financial System
RegulationsEffects
Interest rate regulationsLimited price competition.
Lending rates were controlled and were tied to money market and/or central bank base rate (changed infrequently).
Deposit rates were linked to the base rate in Finland, but not in Norway and Sweden.Led to competitive advantage of banks vis-à-vis other financial institutions in Finland, as only banks were allowed to issue tax-exempt deposits.
Quantitative restrictions Reserve requirements Funding quotas from central bank Direct credit ceilingsPromoted extensive branch networks.
Liquidity ratios (bond investment obligations)Shifted portfolio composition of banks in favor of government and housing bonds rather than loans to private sector.
Controls on capital flowsPrevented banks from resorting to foreign funding.
Prudential regulations
No strict enforcement of capital adequacy requirements.Banks held low equity capital.
No regulations on cross ownership between financial and nonfinancial institutions.Led to holdings of direct equity stakes in nonfinancial companies by banks.
Other
Foreign banks were not allowed to establish subsidiaries.Prevented competition by foreign banks.

Interest Rate Regulations

As justification for a policy of low interest rates, it was widely argued that investment in housing and long-term capital were particularly sensitive to the level of interest rates, while consumer loans (which received a low priority) were thought to be largely insensitive to interest rates. It was feared that higher interest rates would crowd out investments that were considered more socially desirable.

Lending rate regulations in the early 1980s were similar in the three countries. In Norway, such regulations had been briefly removed in the late 1970s, but in 1980 so-called interest rate declarations that set upper limits on average bank lending rates were introduced. Initially, these limits were meant to be changed by the central bank (Norges Bank) more or less in step with money market and bond rates. In practice, however, lending rates were adjusted only infrequently.3 Explicit limits on average lending rates were also imposed in Finland and Sweden. These limits were tied to the central bank base rate, which was changed infrequently, because such decisions were heavily politicized. In all three countries, particularly in Finland and Norway, lending rates lagged behind money market rates.

Because rates on individual loans were not directly regulated, banks retained—at least in principle—the ability to charge different rates on individual loans. Nevertheless, loan rates did not primarily reflect the perceived credit risk of the borrower, but instead depended largely on the closeness of the borrower’s relationship with the bank. (See Commission on the Banking Crisis, 1992; Jonung, 1986; and Nyberg, 1994.) In effect, artificially low interest rates—reinforced by a generous tax treatment of interest payments that implied sharply negative after-tax real interest rates for household borrowers—exacerbated strong excess demand for credit.4 As a result, a close banking relationship was in many cases essential for obtaining loans.5

Although explicit restrictions on deposit interest rates had already been lifted in Norway and Sweden by the late 1970s, deposit rates remained low and inflexible, apparently because of limited bank competition. Banks lacked incentives and opportunities to expand their lending and thus did not need to aggressively increase their funding through active liability management.

In contrast, Finnish deposit rates remained tightly controlled and closely linked to the central bank base rate until the early 1990s. Banks were allowed to issue household deposits with interest payments that were exempt from income tax, yet at the same time interest on deposits was tax exempt only on deposits that offered specific terms that were set by the authorities.6 By requiring that all banks pay the same low interest rate on tax-exempt deposits, the tax rules encouraged banks to form a cartel-like arrangement, which severely reduced competition for private funds. The tax preference of deposit interest provided deposit banks with a competitive advantage by lowering their funding costs and may explain the relatively small role that other institutions, such as finance companies, played in the Finnish financial sector.

Lending rate regulations (together with deposit rate controls in Finland) meant that bank profitability was relatively stable in the Nordic countries because price competition—at least on the lending side—was ruled out. Moreover, low interest rate ceilings created “favorable selection” in the credit applicant pool by implicitly limiting the share of risky borrowers. As a result of lending rate ceilings, bank lending was directed at the safest investments, and there was little need for banks to provide for credit losses and no immediate need to build strong management systems.

Quantitative Lending Restrictions

As restrictions on bank lending rates were eased during the early 1980s, the authorities resorted to controlling the volume of lending primarily through reserve requirements and liquidity ratios (i.e., bond investment obligations). In some instances, credit ceilings were also imposed. Restrictions on bank lending were supplemented with funding quotas from the central bank and controls on short-term capital flows, which prevented banks from resorting to foreign funding to finance their lending growth. Such quotas on lending prevented expansionary market-share strategies in practice, and, as a result, the close banking relationships were cemented further.

To restrict bank lending, the authorities imposed a supplementary reserve requirement on Norwegian banks mandating that lending in excess of bank-specific credit ceilings had to be deposited in non-interest-bearing accounts at Norges Bank. This requirement, which was in effect from 1981 to 1983, was high enough to restrict bank lending.7 Norwegian state-owned banks were subject to direct government control through so-called credit budgets, which, as part of the national budget, provided guidelines for the supply of credit.

Bond investment obligations, implemented as liquidity ratios, that required banks and other financial institutions to invest part of their assets in priority housing bonds and government bonds, were applied in Norway, but played a greater role in Sweden. By shifting the portfolio composition of banks in favor of government and housing bonds, these obligations limited loans to the private sector. Even though the yield on government bonds was often below market levels, private banks—as well as life insurance and pension funds—were required to invest in such bonds. The Bank of Sweden also relied on moral suasion and on quantitative ceilings on loans to control the volume of credit.

In Finland, the central bank controlled the volume of bank loans by assigning each commercial bank a quota for central bank advances. Because banks relied heavily on the central bank for their marginal funding, the quotas had a noticeable effect on the volume of bank lending.8 Similar quotas on central bank funding were in effect in Norway and Sweden.

Many borrowers were constrained in their ability to obtain credit from banks as well as other sources. Even the amount of private bond issues and their terms—in particular their initial yields—were tightly controlled in all three countries. Specifically, in Norway, nonfinancial corporations were granted only small quotas for bond issues.

Borrowers also faced foreign exchange controls that were designed to insulate the domestic financial system and prevent international capital flows from undermining the effectiveness of domestic restrictions and regulations. The controls largely prohibited foreign short-term bank funding, although long-term borrowing by corporations was less restricted in the three Nordic countries. In contrast to Norway and Sweden, where foreign banks were not permitted to establish subsidiaries before 1984 and 1986, Finland allowed foreign banks to enter its financial system in 1982.

Impact of Regulations on Financial System Structure

Together with universal banking rules, the regulations led to the development of financial systems that were dominated by the banking sector and where money and credit markets remained insignificant. In 1980, three main types of deposit-taking institutions existed in the Nordic countries: commercial banks, savings banks, and, except in Norway, cooperative banks. These institutions together accounted for about 43 percent, 55 percent, and 86 percent of loans by the financial sector in Norway, Sweden, and Finland, respectively (Table 2). The post office banks, which also accept deposits, participated marginally in lending activities in Norway and Sweden, but constituted about 14 percent of lending in Finland.

Table 2.Structure and Market Share of the Banking Institutions
Finland1Norway2Sweden3
198019851990199519801985199019951980198519901995
Commercial banks
Loan market share494961702630303037383232
Deposit market share454964644747454262646692
Number of institutions1371072429222014141213
Number of branches8809591,0377295657026024881,4791,4241,3452,239
Number of employees (in thousands)151827201418171520242539
Savings banks
Loan market share161625417232327141582
Deposit market share2321185454544463229258
Number of institutions2752541504032219214213316411910490
Number of branches9891,0769842111,2001,2281,1941,0681,2851,2491,124349
Number of employees (in thousands)1011101101515131215154
Cooperative banks
Loan market share23221427331
Deposit market share19181827678
Number of institutions372370359300121212
Number of branches822852800667380389373
Number of employees (in thousands)8999334
Source: Organization for Economic Cooperation and Development, Bank Profitability, various issues.

For Finland, loan and deposit market data cover commercial banks, savings banks, foreign banks, cooperative banks, and post office banks. Data for 1990 and 1995 include the post office banks classified under commercial banks. Data for 1995 also reflect the change in the composition of the savings banks, some of which were taken over by commercial and cooperative banks.

For Norway, loan market data cover commercial banks, savings banks, postal system banks, state banks, and mortgage, finance, and insurance companies. Deposit market consists of commercial banks, savings banks, and postal system banks.

For Sweden, loan market data cover commercial banks, savings banks, foreign banks, cooperative banks, postal system banks, mortgage institutions, credit institutions, finance companies, and insurance companies. Deposit market consists of commercial banks, savings banks, cooperative banks, and postal system banks. For commercial banks, 1995 data include cooperative banks, which were merged into a single commercial bank in 1992, and the largest savings bank, which became a commercial bank in 1993.

Source: Organization for Economic Cooperation and Development, Bank Profitability, various issues.

For Finland, loan and deposit market data cover commercial banks, savings banks, foreign banks, cooperative banks, and post office banks. Data for 1990 and 1995 include the post office banks classified under commercial banks. Data for 1995 also reflect the change in the composition of the savings banks, some of which were taken over by commercial and cooperative banks.

For Norway, loan market data cover commercial banks, savings banks, postal system banks, state banks, and mortgage, finance, and insurance companies. Deposit market consists of commercial banks, savings banks, and postal system banks.

For Sweden, loan market data cover commercial banks, savings banks, foreign banks, cooperative banks, postal system banks, mortgage institutions, credit institutions, finance companies, and insurance companies. Deposit market consists of commercial banks, savings banks, cooperative banks, and postal system banks. For commercial banks, 1995 data include cooperative banks, which were merged into a single commercial bank in 1992, and the largest savings bank, which became a commercial bank in 1993.

In addition to these depository institutions, loans were originated by state banks (40 percent) and by mortgage finance and insurance companies (17 percent) in Norway.9 In Sweden, mortgage and credit institutions and finance companies accounted for about 42 percent of lending, and insurance companies for about 12 percent.

The banking sectors were dominated by a few large commercial banks that offered a wide range of financial services and also played a considerable role in the nonfinancial sector because of the predominance of debt financing and the banks’ direct equity stakes in nonfinancial companies. At the same time, the markets for banking services were de facto segmented: commercial banks focused on the corporate sector, while savings and cooperative banks concentrated on households and small businesses.

As part of banks’ liability management, deposits played a pivotal role as a funding source. Given that price competition was eliminated in Finland (where deposit rates were still regulated) and remained weak in Norway and Sweden despite liberalized deposit rates, banks competed for market share by building extensive branch networks.10 Particularly in Finland and Norway, banking regulation appears to have supported cost structures that would not have been viable in a deregulated environment. International comparisons suggest that Swedish banks record the lowest costs (total operating expenses as a percentage of balance-sheet total) among European banks, while Finnish and Norwegian banks have very high costs (Table 3). The ratio of Finnish and Swedish banks’ net interest income to balance-sheet total has been among the lowest in Europe, reflecting relatively narrow financial intermediation margins.

Table 3.Bank Profitability: International Comparisons, 1980–84(In percent of balance sheet total; average)
Net Interest Income (Intermediation margin)Net Noninterest Income (Overall gross margin)Net Banking IncomeTotal Operating ExpensesPre-Tax Profit
Belgium1.650.321.981.430.28
Denmark3.131.095.332.801.48
Finland2.521.654.163.420.30
France2.500.462.962.010.37
Germany2.250.510.571.690.63
Italy2.911.094.002.570.62
Netherlands2.170.712.881.840.39
Norway3.630.934.563.170.83
Portugal2.041.073.121.870.47
Spain3.900.674.573.060.69
Sweden2.240.783.021.740.29
Switzerland1.251.082.331.330.62
United Kingdom3.101.424.533.180.88
Mean2.560.993.552.320.60

In general, the sheltered banking environment, which was characterized by credit rationing and the absence of price competition, fostered a business mentality and banking strategies aimed at long-term relationships with clients. It also allowed decentralized credit decision making (often at the branch level) and lax credit risk management and encouraged cross-subsidization between various banking services. Profitability was largely ensured—although low in Finland and Sweden compared with other European banks (Table 3)—and most measures of bank profitability remained quite stable.

See Cottarelli and Kourelis (1994) for an analysis of the relationship between financial structure and the stickiness of bank lending rates in a cross section of countries.

Using a disequilibrium model of credit supply and demand, Pazarbaşioğlu (1997) finds evidence of excess demand for credit in Finland.

When information is asymmetric, a close long-term banking relationship may also arise because it lowers loan costs. Banks’ functions of gathering information and monitoring borrowers are in general discharged more efficiently as part of a long-term banking relationship with borrowers. See Stiglitz (1993).

Corporate deposits were not regulated.

The Bank of Finland imposed supplementary reserve requirements in the late 1980s, after financial deregulation, to curb the credit expansion.

Deposits from the Bank of Finland at commercial banks were equivalent to about 10 percent of deposits from the public in the early 1980s.

The state banks are specialized banks financed through the budget to provide loans at preferential rates and other subsidies to favored sectors. See International Monetary Fund (1996) for more information on the market structure and evolution of the Norwegian financial system.

There were no branching regulations for domestic banks.

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