The Importance of Credit and Capital in the Norwegian Banking System During Crisis
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View metadata, citation and similar papers at core.ac.uk brought to you by CORE provided by NORA - Norwegian Open Research Archives The importance of credit and capital in the Norwegian banking system during crisis- A comparative study of the Norwegian banking crisis and the recent financial crisis Rasmus Grue Schøning Thesis for the degree Master of Economic Theory and Econometrics University of Oslo January 2011 P a g e ii | ” For the second time in seven years, the bursting of a major-asset bubble has inflicted great damage on world financial markets. In both cases, the equity bubble in 2000 and the credit bubble in 2007, central banks were asleep at the switch. The lack of monetary discipline has become a hallmark of unfettered globalization. Central banks have failed to provide a stable underpinning to world financial markets and to an increasingly asset-dependent global economy.” - Stephen Roach, Morgan Stanley “A bank is a place where they lend you an umbrella in fair weather and ask for it back when it begins to rain.” – Robert Frost P a g e | iii Preface The research for this thesis was done over the course of 2010 and it was written between August and December of that same year. The decision to write about the two most recent crises in the Norwegian banking industry was first and foremost inspired by a strong personal interest in the recent financial crisis. I find the economic organization of banks and how their operation affects the rest of the economy fascinating. In addition to five years of economic studies, much of the relevant technical background came from the course ECON 4335 The Economics of Banking. I would therefore like to thank Jon Vislie, Bent Vale and Asbjørn Rødseth for providing me with the necessary tools in advance to deal with the sometimes complex workings of the banking industry. For providing corrections and for pointing me in the right direction prior to and during the writing process, I would also like to thank my supervisor Tore Nilssen. I appreciated his product oriented view of the master’s thesis. He also pushed the process forward by setting sometimes ambitious deadlines, supplying me with relevant reading material, and helping me to get in touch with Norges Bank. I would like to thank Bjørn Bakke and Bjørne Dyre Syversten from Norges Bank for reading a draft and agreeing to see me halfway through the writing process. We had a very constructive meeting and they provided me with a wide array of material to improve upon the empirical parts of my thesis. I would like to thank Ida Karlsson and Morten Schøning as non-economists for reading my final draft and giving feedback about spelling mistakes as well as where I fail to make common sense. Finally, I would like to give a special thank you (and a bit of an apology) to my friends and family for showing patience and keeping me sane during my growing social isolation this semester. P a g e iv | Summary My thesis investigates the two most recent crises affecting the Norwegian banking system, namely the Norwegian banking crisis from 1988 to 1993 and the recent financial crisis reaching Norwegian markets in 2008. Although the financial crisis was a global phenomenon and originated from the US mortgage market, my main focus will be on the Norwegian system and how it was affected by the spillovers from international markets. Chapters 2 and 3 provide a presentation of the two crises and chapter 4 compares them in some key respects. Even though every banking crisis has some unique characteristics, there also exist several fundamental similarities. Banks, through their organization, are exposed to external shocks affecting market risks, the capitalization of firms and consumers, and aggregate investment. The main task of a commercial bank is to act as a financial intermediary, transforming deposits from customers and funding by outside investors into loans and further investments. Profits are generated from earning a higher interest or return on the loans and investments than what is demanded by depositors and investors. An unregulated, profit maximizing bank will try to expand its activity as much as possible in proportion to its own capital. Loans are often long-term and considered less liquid than deposits. This maturity- mismatch between investments and funding is an important source of risk to a bank since the premature liquidation of assets is likely to drive down their prices. Falling asset prices can cause a bank to become illiquid and eventually insolvent. Being liquid means that the bank at all times possesses legal tender to service transactions, like withdrawals, while solvency means that the value of the bank’s assets exceeds the value of the bank’s liabilities excluding own capital. When a bank is suffering from decreasing asset values due to for example an increasing number of defaults on its loans, solvency is upheld by the share of a banks capital that can be written down as compensation, for example stocks, but obviously not deposits. Prior to both crises, banks kept only small levels of capital relative to their operations. Investments were largely funded by relatively cheap short-term debt which can be difficult to refinance in a recession. While such a strategy is capable of boosting earnings during periods of strong economic growth, it will also increase risk exposure and thus likely contribute to larger financial problems during a recession. In other words, a short-term profit maximizing strategy will increase the impact of fluctuations in the business-cycle on the banking system and the real economy, and can be referred to as pro-cyclical banking. P a g e | v Chapter 5 I introduces a model by Holmström and Tirole from 1997 which shows how moral hazard creates a need for intermediaries in the financial system. Banks can monitor investments through repeated transactions with their borrowers and can make the arrangement efficient by exploiting economies of scale. The monitoring alleviates the moral hazard problem. Individual investors are assumed to find monitoring to be too expensive to undertake themselves. Banks can therefore profit on financing a market share of firms considered too risky or opaque by individual, uninformed investors. Within this framework, the authors illustrate how the volume of credit and capital in the system affect investment, financial intermediaries and regular firms. Since the model was designed in the time period between the two crises in question and was partly inspired by the Norwegian banking crisis, I will test its explanatory powers on recent events. My thesis will, in the light of the two banking crises, examine how pro-cyclical banking affects the availability of credit in the market and how this in turn affects firms dependent on debt financing from banks. I will also look at how the business cycle affects banks’ lending behavior and their approach to risk. By looking at the two most recent crises to the Norwegian banking system, I will point to similarities and differences. Unregulated banks are under pressure to offer its investors and shareholders with a competitive rate of return. If the whole system gravitates towards maximizing short-term profits at potentially high future risk of default, then the banking system is in a bad equilibrium in the sense that longevity and a stable credit supply is undermined. There has been clear progress in the way Norwegian banks operate since the Norwegian banking crisis. Improved regulation and higher capital levels have rendered the banking system more robust against external shocks. Still government intervention to restore system liquidity was required during the recent crisis. Internationally, there has also been an increased use of financial innovation, with the effect of banks moving risky assets off their balance sheets, enabling them become highly leveraged despite regulation. I therefore feel that a thesis questioning certain fundamental, possibly destabilizing aspects of banking is very relevant in light of the recent financial crisis. P a g e vi | P a g e | vii Table of contents 1. Introduction 1 1. 2. The Norwegian banking crisis 1988-1993 3 2. 2.1 Quantitative loan restrictions and credit rationing 3 2.2 Financial deregulation, credit expansion and price bubbles 3 2.3 From boom to bust 6 2.4 Government intervention 8 3. 3. The subprime financial crisis 2007 10 3.1 Securitization and risk taking 10 3.2 Crisis and credit crunch 12 3.3 The Norwegian experience 15 3.4 The Terra scandal of 2007 20 3.5 Government intervention 21 3.6 Developments in international banking regulation 22 4. A tentative comparison of the two crises and the road ahead 24 5. The model 28 5.1 The microeconomics of banking 28 5.2 Assumptions and prerequisites 29 5.3 Direct finance 30 5.4 Indirect finance 32 P a g e viii | 5.5 Equilibrium in the credit market 35 5.6 Important results 37 5.7 Relevance for the Norwegian banking crisis 38 5.8 Applicability to the financial crisis 39 6. Analysis 41 6.1 The fragility of banking 41 6.2 The availability of credit and consequences for small firms 42 6.3 Bank failures 44 6.4 Liquidity 45 6.5 Capital requirements 46 6.6 Credit rationing and banks’ approach to monitoring 48 6.7 Model shortcomings 49 7. Theoretical extensions 53 7.1 Securitization 53 7.2 Certification 54 7.3 Manager’s incentives 56 8. Conclusion 59 Appendix: A short introduction to banks, concepts and securities 64 References 69 P a g e | ix List of graphs 1. Norwegian real estate prices deflated by CPI (1979-2001) 5 2.