91. Developments in world financial markets during 1997 focused renewed attention on the potential fragility of banking systems, related governance issues, and the adequacy of supervisory capacity. This paper provides a summary of the Norwegian authorities’ response to the banking crisis which first struck the country a decade ago, describes the subsequent recovery of the banking system, and assesses possible areas for further modifications of government macroeconomic, regulatory and ownership policies to help promote a healthy banking sector. As the Norwegian banking crisis had many features in common with the problems that later emerged in Finland and Sweden, the discussion includes some references to the experience in these two countries; a more detailed examination of these country experiences is provided in recent staff papers by Drees and Pazarbasioglu (1995 and 1998).

Abstract

91. Developments in world financial markets during 1997 focused renewed attention on the potential fragility of banking systems, related governance issues, and the adequacy of supervisory capacity. This paper provides a summary of the Norwegian authorities’ response to the banking crisis which first struck the country a decade ago, describes the subsequent recovery of the banking system, and assesses possible areas for further modifications of government macroeconomic, regulatory and ownership policies to help promote a healthy banking sector. As the Norwegian banking crisis had many features in common with the problems that later emerged in Finland and Sweden, the discussion includes some references to the experience in these two countries; a more detailed examination of these country experiences is provided in recent staff papers by Drees and Pazarbasioglu (1995 and 1998).

IV. THE NORWEGIAN BANKING SYSTEM–FROM CRISIS TO HEALTHY COMPETITION30

A. Introduction and Summary

91. Developments in world financial markets during 1997 focused renewed attention on the potential fragility of banking systems, related governance issues, and the adequacy of supervisory capacity. This paper provides a summary of the Norwegian authorities’ response to the banking crisis which first struck the country a decade ago, describes the subsequent recovery of the banking system, and assesses possible areas for further modifications of government macroeconomic, regulatory and ownership policies to help promote a healthy banking sector. As the Norwegian banking crisis had many features in common with the problems that later emerged in Finland and Sweden, the discussion includes some references to the experience in these two countries; a more detailed examination of these country experiences is provided in recent staff papers by Drees and Pazarbasioglu (1995 and 1998).

92. The Norwegian financial system has benefitted from timely action and effective coordination among the responsible public agencies during and after the banking crisis. Timely intervention, in ways that minimized moral hazard, helped to contain the costs to society as a whole and enabled the affected banks to resume playing an effective role in financial intermediation early in the subsequent economic recovery. Nevertheless, recent trends in banks’ lending practices, profit margins and capitalization underscore the importance of effective surveillance by the supervisory authorities. In addition, it will be important as the recovery matures to ensure that mechanisms are in place to encourage further efficiency gains; elimination of the government’s remaining ownership stake in Norway’s largest commercial banks could contribute to this objective. Finally, macroeconomic policy has an essential role to play in protecting the stability of the banking system, by helping to avoid an unduly rapid expansion of credit.

B. Snapshot of the Norwegian Financial System at end–1996

93. The Norwegian financial system is relatively small and highly concentrated. At end-1996 the Norwegian banking system comprised the Norges Bank (the central banks), 17 commercial banks (two foreign-owned), 133 savings banks, the postal savings bank, and 3 Norwegian branches of foreign banks; there were also 12 foreign branches of Norwegian banks. Other financial institutions included 38 finance companies, 8 mortgage companies, 10 loan intermediaries, and 9 Norwegian branches of foreign finance and mortgage companies.

94. The two largest commercial banks became almost entirely government-owned during the response to the banking crisis and the government’s ownership stake remains over 50 percent. The third largest commercial bank is the publicly-owned Postal Savings Bank. Collectively these three institutions accounted for 73 percent of commercial bank assets, and 41 percent of the total assets of commercial and savings banks, finance, and mortgage companies, at end-1996.

95. In recent years the Norwegian banking and insurance markets have become dominated by integrated financial groups and conglomerates, with about two-thirds of domestic financial services accounted for by the eight largest conglomerates at end–1996. 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. The BISC cooperates closely with the Norges Bank (see below).

C. The Banking Crisis of 1988-1993

96. The Norwegian banking crisis occurred in two waves, triggered initially by the fall in world oil prices in 1986 and subsequently by snowballing loan losses in the early 1990’s. The effects of the oil price shock on business activity and asset prices led to a sharp increase in corporate bankruptcies and nonperforming loans. While most financial institutions incurred operating losses in 1987–88, initially it appeared that severe problems would be limited mainly to finance companies and a few savings banks. During 1991–93, however, loan losses also drove the country’s largest commercial banks into insolvency.

97. The banking system was particularly vulnerable to macroeconomic shocks in the late 1980’s, as a result of the failure of management practices and the supervisory regime to take into account fully the risks associated with the ongoing process of financial liberalization. At the beginning of the decade, both interest rates and the quantity of bank credit were tightly controlled in Norway, as in other countries in the region. Lending rates were subject to ceilings, which were tied to the central bank base rate and changed infrequently. As interest payments were deductible from both individual and corporate income taxes, after-tax interest rates were negative in real terms even before the acceleration of inflation in the late 1970’s. While there were no explicit restrictions on deposit rates, banks lacked incentives to compete actively for deposits due to the existence of controls on both the total amount and the allocation of credit. During 1981–87 Norwegian banks were frequently subject to individual credit limits, beyond which lending was subject to a steep supplementary reserve requirement. Corporate borrowers had only limited alternatives to bank financing since the equity market was underdeveloped, access to foreign financing was limited by capital controls, and placements on the domestic bond market were subject to a restrictive quota. As a result they were chronic and, often, highly-leveraged borrowers form the banking system. Liquidity ratios further channeled part of banks’ assets to government and housing bonds.

98. Under these circumstances there was substantial excess demand for credit, banks lent mainly to customers with whom they had long-standing relationships, and interest rate spreads were kept at levels that appeared to provide for an adequate level of profits. Consistent with the perception that conservative lending practices limited the risk exposure of the banking system, and also with the authorities’ objective of facilitating lending, commercial banks were subject to a minimum capital/asset ratio of only 6.5 percent and savings banks did not have any statutory capital requirements.31 Actual capital/asset ratios in 1981 to 1985 averaged 7.0 percent for both commercial and large for savings banks.

99. These arrangements became increasingly untenable due to higher rates of inflation in the late 1970’s and early 1980’s. The resulting sharp increases in asset prices provided further impetus to credit demand, which was met to a considerable extent by non-bank financial institutions (such as finance and mortgage companies), funded in part by banks’ off-balance-sheet operations. A growing share of financial intermediation thus fell outside the purview of existing monetary policy and supervisory arrangements.

100. In response, the authorities began to liberalize interest rate, credit, and foreign exchange controls gradually in 1984. However, they did not take full advantage of the scope for active use of interest rate policy to moderate the lending boom: following an initial increase at the time of decontrol, lending rates were fairly stable despite continued strong credit demand, in large part due to a sharp increase in liquidity support from the Norges Bank and the availability of central bank swap lines to hedge lines of credit from foreign commercial banks.

101. The rapid growth of bank credit and, in particular, the spread of asset-based lending in the banking sector posed considerable risks. Assessing loan quality for asset-based lending was a new challenge for managements accustomed to developing long-term business relationships with well-known borrowers. As in many other industrial countries undergoing financial liberalization, the safety net and supervisory regime provided incentives for increased risk-taking.32 A 1976 official report had indicated that it would not be appropriate for banks’ own capital to provide the main buffer against cyclical fluctuations in economic activity, or even disturbances in particular sectors or regions, and that action by the authorities would be warranted in such cases. In this context the authorities were seen as signaling that no bank would be allowed to fail, undermining a potential source of discipline through the behavior of shareholders and creditors. As noted above, capital adequacy requirements were relatively low and, moreover, compliance was facilitated in the 1980’s by an increase in the allowable portion of subordinated debt in banks’ total capital, to 75 percent. Moreover, Norway’s financial supervisory agency, the BISC, lacked the capacity to rely significantly on examinations on-site.

102. Under these circumstances, the Norwegian financial system was highly vulnerable to the negative effects of the 1986 oil price shock on their borrowers. The downturn in economic activity and asset prices in 1986 and 1987 led to widespread nonperforming loans in the real estate, construction, and service sectors. Many finance and mortgage companies, with little capital and a large exposure in these sectors, experienced large operating losses and either went out of business or were restructured. Commercial banks also began to incur losses in 1987, reflecting both their own direct exposure in these sectors and their investments in finance companies, while the earnings of savings banks were greatly reduced (Table 25).

Table 25.

Norway: Bank Profitability, 1980–1997 1/

(In percent of average total assets)

article image
Source: Norges Bank.

Due to changes in definitions, data for 1980-86 are not fully comparable with those for later years.

Data for the 24 largest savings banks until 1992, and the 30 largest savings banks thereafter.

103. One of the first official actions prompted by the spread of loan losses was the issuance in 1987 by the BISC of regulations seeking to promote more uniformity and transparency in the classification and writeoff of assets. Operational intervention began in 1988, with an officially-supported merger of two large savings banks. The 1988 merger was supported both by the Savings Bank Guarantee Fund (SBGF) and through subsidized loans from the Norges Bank (Table 26). The scale of intervention to recapitalize troubled institutions increased in 1989, with further support to the merged savings bank and five other savings institutions, plus drawings on the Commercial Bank Guarantee Fund (CBGF) by two small commercial banks. By late 1989 it appeared that the crisis might be coming to an end, as commercial banks were again becoming profitable. However, continued weakness in mainland economic activity led to a further increase in the scale of loan writeoffs in 1990–91, endangering the solvency of the country’s largest commercial banks and posing requirements for official support far in excess of the remaining resources of the guarantee funds.33

Table 26.

Norway: Financial Intervention in Connection with the Banking Crisis, 1988–1993

(In millions of Norwegian Kroner)

article image
Source: Norges Bank.

Subsidy element of concessional loans and deposits by the Norges Bank. The estimate for 1992 covers the period December 1991–November 1992, and the estimate for 1993 covers the period December 1992–November 1993.

Government Bank Insurance.

Commercial Bank Guarantee Fund.

Savings Bank Guarantee Fund.

Government Bank Investment Fund.

Excluding the NOK 1.0 billion transferred to the SBGF from the budget in 1991.

104. Thus, in 1991 the government found it necessary to supplement the guarantee funds with two new institutions, the Government Bank Insurance Fund (GBIF) and the Government Bank Investment Fund (GBINVF), both financed from budgetary resources. The GBIF was intended to make equity investments in banks in crisis under conditions that would give the government a controlling interest, while the GBINVF was intended to provide subordinated capital to institutions not yet in crisis on the basis of commercial criteria, in order to increase the confidence of private investors. Subsequently it was decided that the GBINVF would exercise responsibility for managing the assets acquired by the GBIF.

105. During the banking crisis the GBIF provided financing, both directly and through transfers to the two guarantee funds, equivalent to 2.2 percent of GDP. Other sources of official financial support (the subsidy element of Norges Bank loans and deposits, direct budgetary transfers to the SBGF, and capital injections into commercial banks by the GBINVF) totaled a further 1.0 percent of GDP. In addition, the two bank-financed guarantee funds made disbursements from their own funds equivalent to 0.9 percent of GDP.34 As a result of official interventions during the crisis, by end-1993 the government had become virtually sole owner of the country’s second- and sixth-largest commercial banks (Christiania Bank & Kreditkassen, and Fokus Bank) and obtained an 87.5 percent stake in the largest commercial bank (Den Norske Bank). Most of the previous private shareholdings in these banks were written down to zero value.

D. Recovery from the Banking Crisis

106. The primary objective of official support operations during the banking crisis was to raise banks’ capital/asset ratios to at least 8 percent and restore them to profitability. Accordingly, in most cases official financing was provided in conjunction with restructuring plans, including loan writeoffs, measures to increase efficiency, and changes in ownership and management.

107. Both commercial and savings banks have succeeded in restoring profitability roughly to pre-crisis levels, as indicated in Table 1. This has been reflected in a sharp drop in loan losses, following large writeoffs during the early 1990’s, and lower operating costs. Underpinning the reduction in operating expenses has been a cut of about one-third in the both number of branches and total employment in the Norwegian banking sector since 1987. In addition, since 1995 commercial banks have benefitted from a reversal of some of the loan loss provisions taken in earlier years.

108. Banks are also far better capitalized than in the early 1980’s, as summarized in Table 27. In 1994–96 the capital/asset ratio averaged about 12 percent for commercial banks and about 14 percent for large savings banks. However, the capital/asset ratios for both sectors have been declining as the recovery matured. The BISC and the Norges Bank have expressed concern that the rapid growth of lending and increases in asset prices may be signaling an increase in the riskiness of banks’ portfolios, which would warrant higher capital/asset ratios for some institutions.

Table 27.

Norway: Bank Capitalization, 1981–1997

(In percent of applicable asset base)

article image
Sources: Norges Bank and OECD.

Commercial bank data are for parent banks. The figures for the consolidated balance sheet of diversified financial conglomerates headed by banks in 1995 and 1996 were 12.6 percent and 10.7 percent, respectively.

Data for the 24 largest savings banks until 1992, and the 30 largest savings banks thereafter. In 1995 and 1996 the remaining savings banks had an average capital/asset ratio of 21.0 percent and 20.8 percent, respectively.

109. During 1995–96 the government re-privatized Fokus Bank and reduced its stake in the two largest commercial banks to just over 50 percent. While it has announced an intention to reduce this stake further to 33 percent in 1998, the government has instructed the Investment Fund to maintain a controlling interest indefinitely in order to secure a substantial element of national ownership of Norwegian commercial banks. This policy is intended primarily to ensure that the focus of these banks is on the financing of Norwegian industry.35

110. In view of its rapid recovery from the banking crisis and a more adequate level of capitalization since 1993, the Norwegian banking sector is rated favorably by agencies such as Moody’s and Standard & Poor. These agencies’ recent reports highlight the gradually declining trend in operating incomes in recent years and the likelihood that competitive pressures will lead to further consolidation in the sector.

E. Supervisory and Other Economic Policy Challenges

111. In the wake of the banking crisis, staff and other resources of the BISC were increased significantly, inter alia to permit more frequent on-site examinations of banks and to strengthen its supervision of insurance companies and conglomerates (see below).36 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.

112. Building on earlier practices, in 1993 additional guidelines were established 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. Recent surveillance reports have explored the risks posed by increased reliance on brokered funds and overseas borrowing to supplement the deposit base, rising loan-to-value ratios for mortgage lending (which has since become a special focus of BISC supervision), loans secured by transferable securities, rapid credit expansion, and declining interest margins, which could undermine the ability of some institutions to maintain adequate capitalization.

113. Since the end of the banking crisis, the contributory deposit guarantee funds have gradually rebuilt their balances. In contrast to the trend in some other industrial countries, proposals to combine the commercial and savings bank funds, so as to ensure uniformity of treatment and greater pooling of risk, have not been adopted in Norway. Under legislation that entered into force in January 1997, each guarantee fund insures deposits up to a maximum of NOK 2 million per depositor (just over US$260,000 at current exchange rates).

114. 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. The Norges Bank will facilitate banks’ liquidity management by offering intraday loans against security, as well as extraordinary loans in excess of collateral as a safety net for priority settlement. The real-time gross settlements system is expected to be in full operation by July 1, 1998.

115. While the new settlements system will bring Norwegian procedures more closely in line with those to be used in the new EU TARGET system, there is not yet any arrangement for providing Norwegian institutions with access to TARGET. The lack of a low-cost settlements capability in Euros could leave Norwegian banks at a significant competitive disadvantage, exacerbating existing pressures on profit margins. It will thus be important for Norwegian banks to obtain the services of a participating foreign institution as an intermediary, in the event that a direct link to TARGET in unavailable.

116. 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 their conglomerate. Smaller 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. Institutions form neighboring countries, which typically have a larger scale of operations, also have a growing presence in the Norwegian market since the entry into effect of the EEA regime for financial services in January 1994.

117. As illustrated by recent developments, financial supervision has an essential role in helping to ensure the safety and stability of the Norwegian banking system, in the face of rapid loan expansion and pressures on profit margins. This can be fully effective only if it is supported by other economic policies. Banks will be more likely to respond to incentives to reduce their costs further and increase efficiency if legal impediments to consolidation within the banking sector are relaxed.37 A more rapid phasing out of the government’s ownership stake in the country’s two largest banks could contribute to this objective, and possibly also improve the likelihood that lending decisions will be based on commercial considerations. In a strong economic upturn it is important that changes in interest rates, in response to market conditions, are a major force equilibrating supply and demand for credit. Ultimately, the response to the risks posed by rapid rates of expansion in domestic credit must lie primarily in the use of macroeconomic policy to avoid overheating of the economy.

REFERENCES

  • Drees, Burkhard and Ceyla Pazarbasioglu, 1995, “The Nordic Banking Crises: Pitfalls in Financial Liberalization?” IMF Working Paper 95/61, June (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Drees, Burkhard and Ceyla Pazarbasioglu, 1998, “The Nordic Banking Crises: Pitfalls in Financial Liberalization?” IMF Occasional Study (forthcoming).

    • Search Google Scholar
    • Export Citation
  • Gronvik, Gunnvald, and Cecile Rom, 1995, “Structural Changes in Norwegian Financial Markets 1989–1994,” Norges Bank Economic Bulletin, Q3.

    • Search Google Scholar
    • Export Citation
  • Holvik, Elizabeth, and Dag-Inge Flatraaker, 1997, “Norges Bank’s New Settlement System-NBO,” Norges Bank Economic Bulletin, Q3.

  • Karlsen, Harald, 1994, “The Norwegian Banking Crisis–Rescue Operations in the Period 1988–1993,” Norges Bank Economic Bulletin, Q1.

    • Search Google Scholar
    • Export Citation
  • Karlsen, Harald; Sindre Weme, and Inger Anne Nordal, 1997, “Financial Institutions in 1996,” Norges Bank Economic Bulletin, Q1.

  • Kreditilsynet, 1996, (the Norwegian Banking, Insurance, and Securities Commission), Annual Report.

  • Kreditilsynet, 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.

  • Norges Bank, 1997, “Introduction of Real-Time Payment Settlement in Norges Bank,” Circular No. 5, (November).

  • Royal Ministry of Finance and Customs, 1992, Report by the Commission on the Banking Crisis.

  • Norwegian Bankers’ Association, 1996–1997, Annual Report.

  • OECD Economic Survey of Norway, 1994, 1995, and 1997.

  • Ordoobadi, David, 1996, Recent Developments in the Norwegian Financial System, in IMF Norway–Background Paper, SM/96/17, January, (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Skanland, Hermod, 1992, “Norway’s Banking Sector and Economy: Current Situation and Outlook,” Norges Bank Economic Bulletin, Q2.

30

Prepared by Scott B. Brown. This paper reflects information drawn from the sources cited in the bibliography and discussions with representatives of the Norges Bank; the Banking, Insurance, and Securities Commission (Kreditilsynet); the Ministry of Finance and Customs; the Bankers’ Association; and the Savings Bank Association.

31

Commercial banks’ minimum capital/asset ratio had been lowered in 1961 from 10 to 8 percent, and again in 1972 from 8 to 6.5 percent. In conjunction with the 1972 reduction, the asset base for the requirement was also narrowed.

32

Prior to the crisis, the formal safety net for the banking system relied on three components: banks’ own capital and two deposit guarantee funds financed by contributions from the banks, the Commercial Bank Guarantee Fund and the Savings Bank Guarantee Fund. In addition, as noted above the Norges Bank became an increasingly important source of liquidity for the system in the 1980’s, facilitating the sharp increase in bank credit.

33

The situation was further complicated in late 1992 by sharp increases in Norwegian interest rates, in the attempt to defend Norway’s fixed exchange rate during the period of turbulence in the European Monetary System.

34

Total official support thus totaled 3.2 percent of GDP, and total financial intervention including the use of the guarantee funds’ own resources was 4.2 percent of GDP. For reference, direct official support during the banking crises of the early 1990’s in Finland and Sweden was equivalent to 10 percent and 4 percent of GDP, respectively, with additional assistance through guarantees of 6 percent and 2 percent of GDP.

35

The government is also owner of the Postal Savings Bank, the third-largest bank in Norway, and a number of small “traditional” state banks, including the Housing Bank and the Industrial and Regional Development Fund.

36

On-site examinations are now held annually for large banks, and on a 5–6 year cycle for smaller banks. The BISC also uses indicators of potential problems, such as a high rate of growth of assets, to trigger more frequent examinations.

37

Such legal impediments include provisions that no investor may acquire more than a 10 percent ownership stake in a financial institution (waived temporarily for the government’s takeover of major commercial banks during the banking crisis); and that a one-third vote of shareholders is sufficient to block a change in corporate statutes (e.g., merger, change in share capital, or relocation of the corporate headquarters).