III Deregulation

Burkhard Drees, and Ceyla Pazarbasioglu
Published Date:
April 1998
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The regulation of the financial markets in the Nordic countries led to significant distortions in the allocation and pricing of credit. However, regulatory protection was not sufficient to isolate segments of the financial system from market forces completely. As one would have expected, market participants in the Nordic countries found ways to circumvent interest rate restrictions as the tensions in the financial systems increased markedly in the early 1980s.

Shortcomings of the Regulated System

Rising inflation—coupled with the reluctance to adjust nominal interest rate ceilings accordingly—made lending rate restrictions more and more binding and thus created ever greater incentives to bypass the regulated sections of the financial system. A parallel market (grey market) developed where lenders and borrowers interacted directly, and thus contributed to disintermediation (see Berg and others, 1993; Commission on the Banking Crisis, 1992; and Koskenkylä, 1994).

Financial institutions, however, were not bypassed entirely; they participated in the unregulated loan market through off-balance-sheet activities, such as guaranteeing and arranging grey market loans, and by channeling part of their lending through nondepository subsidiaries, such as finance companies, that were less regulated. The traditionally close banking relationships started to weaken when borrowers and lenders increasingly turned away from their “house banks” to find funding elsewhere.

It was generally recognized that the grey market did not unambiguously improve the allocation of capital because it created further distortions. By reducing the role of banks in gathering information and making risk assessments as well as in monitoring borrowers, credit flows were increasingly diverted to less information-intensive borrowers, in particular large corporations, to the detriment of bank-dependent borrowers.

Nor did the grey market enhance the quality of monetary policy control. To the contrary, the parallel credit market was seen as undermining the effective conduct of monetary policy, and, as money and capital markets developed, direct monetary policy instruments became less effective. The international trend toward indirect, market-based monetary policy instruments facilitated and accelerated the deregulation of the domestic financial system in the Nordic countries.

Reform Measures

In reaction to the increasing inefficiency of financial intermediation and the rapidly growing unregulated market, the authorities chose to relax most restrictions. In the process, regulators hoped to increase competition and efficiency in the banking industry in anticipation of the development of a European-wide financial market. To that end, bank lending and bank funding were deregulated to allow market forces to gain more influence, and foreign banks were permitted to establish subsidiaries.

The Norwegian Experience

During 1982–83, credit targets in Norway were exceeded owing to the increased circumvention of controls, and it became increasingly clear that credit policy had to be reformed to improve the efficiency of the credit market and the allocation of capital in the economy more generally.11Table 4 presents a chronology of selected reform measures.

Table 4.Norway: Chronology of Selected Liberalization Measures
1980The rates for individual loans were not regulated; rather the average level was regulated through interest rate declarations from the Ministry of Finance.
Foreign borrowing by banks was liberalized. Under the new foreign exchange legislation, foreign currency exposure limits were established on banks; however, because the Norges Bank provided currency swaps, this measure imposed no constraint on banks’ foreign borrowing.
1984Supplementary reserve requirements were removed.
1985Interest rate declarations were removed and interest rate monitoring was introduced.
The bond investment requirement was phased out.
1986Supplementary reserve requirements were reintroduced.
The limits on the commercial and savings bank borrowing facility at the Norges Bank were increased markedly.
Foreign banks were permitted to open subsidiaries.
1987The supplementary reserve requirements were removed.
Perpetual subordinate capital was excluded from the limitations on approved loan capital. The Banking, Insurance, and Securities Commission issued guidelines for assessing nonperforming loans and entering them in accounts.
1989–91Remaining foreign exchange controls were removed.
1990Foreign banks were allowed to operate through branch offices.

As a first step toward liberalizing lending rates, the Norwegian authorities switched in 1980 to interest rate declarations that provided some flexibility in the structure of lending rates because they were applied only to average rates.12 But the effectiveness of these declarations was limited. Banks were partially able to get around the loan rate restrictions by manipulating their balance sheets, requiring borrowers to hold compensating balances, and charging extra fees for some services related to loans. Lending rates were further liberalized in September 1985.

Because they faced supplementary reserve requirements on their regular loans, Norwegian banks had a strong incentive to find other lending channels. In response, they expanded their finance company subsidiaries, which were initially not subject to reserve requirements. In reaction to the rapid expansion of the grey market, the authorities abandoned supplementary reserve requirements in January 1984, marking the end of lending controls in Norway.

With regard to bank funding, new rules concerning the foreign currency exposure of large Norwegian banks took effect in the late 1970s.13 Under the new regulations, a bank’s foreign currency debt in the spot and forward markets could not exceed its foreign currency liabilities. However, as long as currency swaps were available, this restriction imposed no constraints on banks’ foreign borrowing.

In a move to open the financial system to foreign competition, in early 1985 the government granted seven foreign banks permission to establish subsidiaries in Norway. All seven banks were headquartered in countries where Norwegian banks were also allowed to operate through subsidiaries. Foreign banks, however, were permitted neither to open branches in Norway nor to set up nonbank financial institutions.

The Swedish Experience

As government budget deficits widened and the public debt grew, the obligation on banks (through liquidity ratios) to buy government and housing bonds became increasingly distortionary—in effect, a growing share of deposits was transferred to the government in exchange for long-term bonds bearing low interest. As a result, the share of regular bank loans to businesses and households declined, and institutions that were not covered by regulations gained significance.14 The considerable credit flows outside the regulated market challenged banks’ traditional role. In response, banks attempted to bypass the interest rate regulations by establishing their own finance companies, which formed an important part of the informal credit market in Sweden.15 The increased inefficiency of financial intermediation, the globalization of financial markets, and the perception that regulations were increasingly being circumvented led the authorities to initiate financial liberalization in the late 1970s—a process that continued during the 1980s.16Table 5 presents a chronology of selected reform measures.17

Table 5.Sweden: Chronology of Selected Liberalization Measures
1978Ceilings on bank deposit interest rates were abolished.1
1980Ceilings on issuing rates for private sector bonds were lifted. Controls on lending rates for insurance companies were removed.
A tax on bank issues of certificates of deposit was removed.
Foreigners were allowed to hold Swedish shares.
1982Ceilings on new bond issues by private companies were removed.
1983Requirements on banks to hold government and housing bonds to meet liquidity quotas were abolished. Use of liquidity ratios to guide bank lending was discontinued and replaced by recommended growth rates for lending.
1985Ceilings on bank loan rates were lifted.
1986Placement ratios for banks and insurance companies were abolished.
Foreign banks were allowed to establish subsidiaries in Sweden.
1986–88Foreign exchange controls on stock transactions were relaxed.
1988–89Swedish residents were allowed to buy foreign shares.
1989Foreigners were allowed to buy interest-bearing assets denominated in Swedish kronor.
Remaining foreign exchange controls were removed.
1988–91Cash reserve requirements were introduced for finance companies in 1988 and abolished in 1991.
1990Foreign banks were allowed to operate through branch offices and were entitled to participate in the Riksbank’s clearing system on the same terms as Swedish banks.

However, interbank agreements linking deposit rates to the discount rate continued for some years.

However, interbank agreements linking deposit rates to the discount rate continued for some years.

Credit and bond markets were deregulated first, followed by the removal of regulations on international transactions. The system of liquidity ratios for banks was abandoned in 1983, and in 1985 the ceilings on commercial bank lending and the restrictions on lending rates were lifted. By 1989, all remaining foreign exchange restrictions had been abolished. In 1986, foreign banks were allowed to establish subsidiaries in Sweden, and in 1990 they were granted permission to operate branch offices.18 But their share of the banking market remained small; by end-1994, the assets of foreign-owned banks represented only about 2.6 percent of the total assets of commercial banks.

The Finnish Experience

Under the traditional banking regulations in Finland, average lending rates were tightly controlled. Moreover, the lending rate ceilings were unresponsive to market forces and, in particular, could not adjust to banks’ funding costs. However, as higher inflation exerted increasing upward pressure on lending rates, the Bank of Finland allowed a part of the banks’ unregulated funding costs to be reflected in their lending rates starting in 1983. But, in 1986, the restrictions on average lending rates were abolished altogether, paving the way for market forces to dominate the financial system. Table 6 presents a chronology of selected reform measures.19

Table 6.Finland: Chronology of Selected Liberalization Measures
1982Foreign banks were permitted to open subsidiaries.
1984Banks were allowed to lend abroad and to invest in foreign securities.
1986The average bank lending rate was permitted to exceed by 1.75 percentage points the Bank of Finland base rate or by 50 basis points the average deposit rate on markka deposits.
Later that year, regulations on average bank lending rates were abolished.
Long-term foreign borrowing by manufacturing and shipping companies was exempted from exchange control regulations.
1987The Bank of Finland began open market operations in bank CDs in the money market.
HELIBOR money market rates were introduced.
Credit guidelines were discontinued.
Requirements on down payments on housing loans and consumer loans were eliminated.
Restrictions on long-term foreign borrowing by corporations were lifted.
1988Floating rates were allowed on all loans.
Banks were permitted to use long-term market rates as loan reference rates.
1989A supplementary reserve requirement linked to lending growth was introduced.
Remaining regulations on foreign currency lonas were abolished, except for households.
1990Prime rates were allowed as loan reference rates.
1991Cross-border short-term capital movements were liberalized.
Private households were allowed to raise foreign-currency-denominated loans.

Banks remained, however, constrained with respect to their lending rates in another (admittedly less restrictive) way. Finnish bank loans traditionally carried variable interest rates, and virtually all loan rates were tied to the base rate, which was set administratively by the Bank of Finland and tended to be relatively unresponsive to changes in market conditions. To enhance the influence of market forces, after 1985 the Bank of Finland allowed bank loans to be linked to other reference rates.20

Parallel to the liberalization of bank lending, banks’ funding sources were expanded. For instance, the quota restrictions on advances from the central bank at the call money rate were lifted in 1984.21 To give banks an incentive to trade directly with each other on the interbank money market, the Bank of Finland created a spread between its call money credit rate and its call money deposit rate in 1986. Finally, after reserve requirements on certificates of deposits (CDs) were removed in 1987, a domestic money market developed and gave the Bank of Finland the opportunity to conduct open market operations. As in other Nordic countries, the money market provided banks with new funding opportunities that permitted more aggressive lending policies.

In 1991, all foreign exchange controls were eliminated and even households were allowed to have access to foreign funds. Foreign-owned banks have been permitted to open subsidiaries in Finland since 1982.

According to an estimate by the Norges Bank, the amount of grey market loans increased from 1 percent to 10 percent of the domestic credit supply to private sector and municipalities during 1978–83.

In July 1978, the government appointed an Interest Rate Commission to (1) propose fundamental guidelines for interest rate policy, (2) study how best to organize interest rate policy with a view to monetary and credit policy control, and, finally (3) assess how interest rate conditions affect income and wealth in Norway. The study concluded that deregulating the credit market would facilitate monetary management and reduce adverse effects of resource allocation. In January 1980, the Interest Rate Commission presented the results of its analysis, mainly advocating the liberalization of the credit controls and market determination of interest rates.

These rules were introduced in 1978 on a trial basis and were made permanent in 1980.

The grey credit market consisted for the most part of loans of nonbank financial intermediaries and trade credits.

Finance companies owned by banks account for approximately one-third of finance companies’ aggregate balance sheet (Biljer, 1991). At the end of 1988, there were 290 finance companies with a total credit volume of about 10 percent of total credit.

In the credit and currency exchange markets, long-established regulations caused a lack of competitiveness. The increased global financial integration and the rapid development of financial instruments made quantitative regulations inefficient (Dahleim, Lind, and Nedersjo, 1993).

Various aspects of the regulatory framework and the liberalization process are described in Englund (1990); Gottfries, Persson, and Palmer (1989); Gottfries, Nilsson, and Ohlsson (1992); and Jonung (1986).

The first foreign-owned bank branch opened in 1992.

For a detailed account of the deregulation measures, see Abrams (1988).

By the end of 1985, loans with a term of up to one year could be linked to the call money rate. Gradually, other referequantitative regulations inefficientnce rates were permitted, such that by January of 1988 short-term loans could be linked to the new money market rates (the Helsinki interbank offered rates (HELIBOR)), and long-term loans with maturities of more than five years could be tied to the newly introduced three- and five-year reference rates, which were based on the market yield on bonds issued or guaranteed by banks. The proportion of loans tied to the base rate decreased to less than 20 percent in 1996 compared with more than 90 percent in early 1988.

However, in March 1987 quotas were temporarily reintroduced.

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