IV Response to Deregulation

Burkhard Drees; Ceyla Pazarbasioglu

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Author: Mr. Burkhard Drees and Ceyla Pazarbasioglu¹

¹ 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Language:: English

Keywords:: OP; bank; lending; deregulation; savings bank; rate; funding cost; lending growth; bank management; bank Profitability; intermediation margin; Bank credit; Credit; Commercial banks; Loans; Loan loss provisions

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Abstract

Banks, just like other enterprises, develop their business practices and behavior on the basis of the prevailing regulatory environment, as the preceding section illustrated. Financial deregulation, which was accomplished within a few years in the Nordic countries, was a major shock to the system and posed new challenges for borrowers and lenders alike to adapt to the new environment. Indeed, the financial systems in the Nordic countries responded quickly. As in other countries that underwent financial liberalization, the most striking development was the significant rise in bank lending and risk taking (see Sundararajan and Baliño, 1991, and Bisat, Johnston, and Sundararajan, 1992). This section analyzes the incentives that led borrowers and lenders to expand credit and banks to alter their loan portfolios and funding.

Borrowers’ Response

Because the ability of some businesses and of households to obtain credit had been constrained, a substantial stock-adjustment response in private credit was to be expected after liberalization (see Hubbard, 1991; and Minsky, 1977). Demand for credit was, however, also fueled by robust economic growth at the time of liberalization. Bank lending surged in all three countries. In Norway, the ratio of bank loans to nominal GDP increased to 65 percent in 1988 from 40 percent in 1984 (Figure 1). The surge in lending in Finland and Sweden took place somewhat later, reflecting in part differences in the timing of financial liberalization and in macroeconomic conditions. In Finland, the ratio of bank loans to nominal GDP increased to 98 percent in 1990 from 55 percent in 1984, while it increased in Sweden to 58 percent from 41 percent.²² The effect of pent-up credit demand pressure was visible in all three countries, and liberalization resulted in a credit-financed surge in capital formation and consumption (Figure 2) (see Lehmussaari, 1990). In all three countries, the current account balance deteriorated and was largely negative following the liberalization (Figure 3).

Household Sector

The reaction of households to financial deregulation was similar in the three Nordic countries: households began to borrow aggressively and reduced their savings sharply (Figure 4). Net household saving as a percentage of disposable income declined in Norway from less than 5 percent in 1984 to –2.5 percent in 1985. The decline in the household saving ratios in the other two countries was more gradual: in Finland, it fell from 5.7 percent to –1.6 percent between 1980 and 1988 and, in Sweden, from about 6.5 percent to –3.4 percent between 1980 and 1987. Most of the household borrowing was channeled into purchases of consumer durables and real estate. In all three countries, household indebtedness (defined as the ratio of household debt to net disposable income) reached record levels between 1989 and 1991. In Finland, this ratio increased to about 90 percent in 1990 from 45 percent in 1980, and in Norway, to 175 percent in 1989 from about 90 percent in 1980.

In addition to an inevitable jump in credit owing to the stock-adjustment effect in the wake of the abolishment of credit controls, several other factors contributed to the incentives to borrow and the resulting drop in household savings. First and foremost, in all three countries, high marginal tax rates and full tax deductibility of interest payments meant that real after-tax interest rates were excessively low and sometimes even negative (Figure 4). Because of the generous tax deductibility of interest expenses for both mortgages and consumer loans in an environment of relatively high inflation, households readily exploited their freer access to credit after financial liberalization. Higher asset and collateral values also facilitated borrowing. The initial surge in credit contributed to a jump in asset prices, in particular real estate prices. Expecting that the sharp asset price appreciation would continue along the prevailing trend, many borrowers were willing to incur heavy debt burdens despite relatively high interest rates because they perceived considerable upside potential and limited downside risk. Moreover, low and declining unemployment combined with strong growth in disposable income (in particular in Finland where economic growth in the late 1980s was strongest among the three countries) fueled the propensity to borrow. In hindsight, it is clear that most borrowers did not anticipate the possibility of a surge in after-tax real interest rates on their variable-rate loans. Interest rate volatility picked up markedly in the early 1990s when monetary policy was tightened and the tax deductibility of interest payments was reduced.

Corporate Sector

The indebtedness of the corporate sectors in the three Nordic countries also grew rapidly after deregulation. Traditionally, corporations had been highly dependent on borrowing from financial institutions and, as in other countries with universal banking systems, relied heavily on debt financing. In 1980, the debt-equity ratios were about 3, 4, and 5.5, in Norway, Finland, and Sweden, respectively, compared with less than 0.2 in the United Kingdom and 0.25 in the United States (see Schuijer, 1992). A significant increase in private investment took place in the Nordic countries following deregulation, with the majority of activity occurring in residential and non-residential construction, real estate, and services sectors.²³

The lifting of foreign exchange restrictions opened up new opportunities for debtors to borrow from banks at what they perceived to be low interest rates in foreign currency. The surge in foreign currency borrowing was particularly strong in Finland, where in the late 1980s about half of the corporate borrowing was denominated in foreign currency (see Brunila and Takala, 1993). Given the large interest rate differentials vis-à-vis other European interest rates and the perception of a firm commitment to fixed exchange rates, a “convergence play” based on the belief that exchange rate parities were unlikely to change provided a strong incentive to borrow in foreign currencies even for corporate borrowers in the sheltered domestic sectors (see Goldstein and others, 1993).

Lenders’ Response

Financial liberalization profoundly changed the competitive environment of financial institutions. In particular, the lifting of lending and deposit rate restrictions and credit ceilings opened the door to more competition. Whereas prior to deregulation obtaining a loan was often conditional on a close banking relationship and—as a result—a sizable segment of potential borrowers had difficulty obtaining credit, banks could use interest rates as strategic variables after the financial deregulation. The shift to more price competition weakened traditionally close banking relationships and impaired banks’ ability to assess credit risks and monitor borrowers. It also facilitated the entry of banks and nonbank financial institutions into new segments of the credit market. Banks increased the role of fee income in order to lessen the dependence on interest income as traditional banking became less profitable (see Schuijer, 1992).

Heightened competitive pressures created considerable uncertainty about the new banking environment. In particular, the dense branch networks and sizable bank capacity that had been built up to compete for customers were becoming less viable. To secure their positions in the deregulated environment, many banks felt compelled to expand their lending aggressively by accommodating the surging loan demand, in particular to the real estate sector, which was thought to provide the best collateral. The higher risk taking was also supported by incentives that stemmed in part from banks’ thin capitalization and from moral hazard resulting from explicit or implicit full deposit insurance coverage and the expectation that no bank would be allowed to fail in a financial crisis.²⁴

Changes in Market Shares of Different Financial Institutions

In Norway, during 1980–90 the share of state-owned banks in the loan market declined from about 40 percent to 18 percent. Reflecting, in particular, increased circumvention of regulations by private financial institutions, the market share of private banks rose from about 43 percent to 52 percent, and the share of private nonbank financial institutions almost doubled, from 17 percent to 30 percent. Similarly, in Sweden the credit market share of nonbank financial institutions increased from about 30 percent to 45 percent during 1985–90. The Swedish banking system as a whole experienced a decline in loan market share from 55 percent to about 40 percent (Table 2).

In Finland, savings banks as a group gained loan market share (16 percent in 1985 to about 25 percent in 1990) from other banking institutions (Table 2).²⁵ Because large corporations had well-established relationships with commercial banks and increasingly borrowed directly on financial markets, savings banks had to focus on more risky corporate borrowers, including small and medium-sized businesses that had previously been more or less neglected by the large commercial banks. Particularly rapid was the credit growth by Skopbank, the central institution of the savings banks, which increased its loans by 50 percent in 1987 and maintained high growth rates in 1988 and 1989.²⁶

Changes in Loan Portfolios

Increasingly aggressive bank lending policies were accompanied by a noticeable increase in risk taking, as banks shifted their loan portfolios toward more cyclical sectors, such as real estate, construction, and services and toward loans denominated in foreign currency.

Most commercial banks in Finland (Skopbank in particular) had built up heavily concentrated loan exposures, mostly to connected nonfinancial corporations. Before1991, there were no regulations that limited exposure to individual borrowers. Although exposure limits were in effect in Sweden, some Swedish banks attempted to circumvent them by lending to property developers indirectly through finance companies (see Bank Support Authority, 1993).

After foreign exchange restrictions had been gradually lifted, lending to domestic firms in foreign currency increased in all three countries, but particularly rapidly in Finland. Finnish commercial banks increased the share of foreign currency loans from about 22 percent of their total loan portfolio in 1986 to almost 43 percent in 1991. Even savings banks, which in 1986 had almost no loans denominated in foreign currency on their balance sheets, by 1990 were lending 12 percent of their loans to the public in foreign currency.

Funding of Credit Expansion

At the same time as bank lending opportunities expanded, banks’ capabilities to fund the rapid credit expansion improved significantly. Evidence from other countries suggests that, in the aftermath of financial liberalization, the volume of loans grows significantly faster than the volume of bank deposits (see Bisat, Johnston, and Sundararajan, 1992; and Cottarelli, Ferri, and Generale, 1995). The same phenomenon took place in the Nordic countries (Figure 5). Traditionally the Nordic banks financed their assets almost exclusively through bank deposits, whereas after financial liberalization some banks resorted increasingly to other funding sources, such as borrowing in the domestic and international interbank markets. In 1983, the Norwegian loan-to-deposit ratio was 0.9 for commercial banks and 0.8 for savings banks. By 1987, the loan-to-deposit ratios had risen to 1.5 and 1.2, respectively. Bank lending as a percentage of total assets expanded in Sweden by about 10 percentage points between 1985 and 1990, whereas the share of deposits shrank by about the same amount. In Finland, the ratio of bank loans to deposits, which had been rather stable in the past, rose from 1.3 in 1985 to 1.8 in 1990.

To finance their asset growth, some banks depended increasingly on the money market and on foreign funding, which tend to be much more volatile than retail deposits. The shift also meant higher funding costs. In Norway, for example, the interbank rate, which reflected borrowing costs in the money market, was more than 5 percentage points above the average deposit rate during most of the 1980s. Since bank deposits as a percentage of total assets declined and the share of money market funding increased, banks’ funding costs rose sharply (see Commission on the Banking Crisis, 1992). In Norway, the lending boom was also partially fueled by liquidity support to the financial institutions by the central bank.

Pricing Policies

In theory, higher equilibrium real interest rates should be associated with more efficient investment, higher returns on capital, and higher savings and growth. However, very high real interest rates may also be associated with adverse selection and with the channeling of funds into riskier projects. They may also reflect a lack of credibility, country risk premiums, or banking system fragility (see Calvo, 1988; and Persson and Tabellini, 1990). Furthermore, following interest rate liberalization, the relative influence of domestic versus external factors in determining nominal interest rates depends on the degree of rigidity of lending rates and the openness of the capital account (see Cottarelli and Kourelis, 1994). If capital flows are unrestricted, the domestic interest rates will be largely determined by external factors through the uncovered interest parity relationship.

In all three Nordic countries, real lending rates rose before the liberalization of interest rates, reflecting the declining trend in inflation (Figure 6). After the abolition of lending rate restrictions, real lending rates declined to levels in line with international rates. However, it is puzzling that the rates on new lending remained below the money market rate until the late 1980s in Norway and below the yield on public issues in Finland. This suggests that banks did not raise lending rates to appropriate levels, which would have compensated them sufficiently for the risks associated with the rapid expansion of lending and for the increased cost of funding from money markets rather than deposits. What is more, the surge in interest rates coincided with a tightening of the tax treatment of interest payments and a decline in inflation that, as a result, raised after-tax real lending rates substantially (Figure 4).

The net interest income—the intermediation margin—of Finnish and Norwegian banks declined during the liberalization period (1985–90) compared with the preliberalization period (1980–85) (Tables 7 and 8). This decline was particularly evident for Norwegian commercial banks and the Finnish savings banks. It can be explained by four main phenomena: increased competition between financial institutions, the growing dependence on more expensive money market funding rather than deposits, an increase in nonaccrual loans,²⁷ and the reduction in credit commissions. (See Berg and others, 1993; and Berg, Forsund, and Jansen, 1992).

Table 7.

Finland: Bank Profitability