Monday, 12 January 2015

Norwegian Banks: Increased Lending and Weaker Balance Sheets

One of the single biggest economic risks facing most societies are weak bank balance sheets. This risk arises from two main sources. Firstly, banks have an explicit guarantee from the central bank to receive financial help when they run into liquidity problems. Banks receive this aid primarily through loans granted by the central bank and the central bank buying government securities owned by the banks. This is how the central bank acts as "a lender of last resort" and it makes banks act considerably less prudent than they would have without (moral hazard). Secondly, banks are not only allowed to create money out of thin air, but also allowed to finance their operations with the very deposits (money) they create when issuing loans to customers. These two sources combined results in banks operating with an extraordinary level of gearing compared to non-bank companies. 

Any government interested in achieving the coveted goal of "financial stability" must seek to correct the current flaws in the banking system if it wants to achieve this goal. If it doesn't, any talk of achieving financial stability should be considered nothing more than paying lip service to the issue. 

According to the latest data published by Statistics Norway, Norwegian banks continue to operate with very fragile balance sheets. The chart below, showing funding sources in percent of total assets, illustrates only too well the inherent risk in banks' balance sheets. Note how equity (7.1% of the total as of November) makes up by far the smallest funding source for the banks while the very deposits banks are supposed to keep safe on behalf of customers makes up the single largest source of funding (46.8% as of November). 

Source: Statistics Norway. Period covered: November 2009 to November 2014.
The table below highlights additional weaknesses related to solidity and liquidity and how the current ratios compare to the averages since May 2009 (data not published prior to this). 

As deposits owned by customers and financial institutions are a liability for banks, it's alarming that banks currently only hold a minuscule 1.9% of cash against them. Adding certificates and bonds to cash, which banks can sell to the central bank in exchange for cash during financial turmoil, the ratio increases to 20.8%. This ratio has deteriorated during the last few years and is as of November the lowest ever reported based on data since May 2009. 

Equally alarming is that equity (assets minus liabilities) for banks overall makes up only 10.7% of total deposits. Though this ratio has steadily improved since May 2009 when it was 7.8%, it remains exceedingly low. To put this in perspective: if all bank assets and liabilities were liquidated and settled at book value, Norwegian banks would be able to pay back only 10.7% of all deposits. 

Though bank equity in percent of total assets has improved since 2009, it remains extremely low. Worse yet, it has gotten worse during the last couple of months and currently stands at 7.1%. That certain "risk-weighted" ratios may argue that Norwegian banks are relatively solid should be dismissed without further ado based on the extremely low equity to total asset ratio. Any company or bank operating with a gearing of almost 14.2 times (1/7.1%) should be viewed as a very risky venture indeed. 

But instead of requiring banks to become substantially more financially solid, the much-favoured easy money policies continue in Norway. Bank lending to customers increased 7.6% on last year in November, the highest year on year growth reported based on data since May 2009. 

Norges Bank, the country's central bank, is doing what it can to make these easy money policies possible. Last month it lowered the key policy rate 25 basis points to 1.25%, the lowest ever based on data since 1991. Interest rates on mortgages and other loans follow suit as usual, making a range of projects seem profitable and keeping mortgages more affordable than otherwise would be the case. The easy money policies will likely continue to be pushed as far as possible and until reality comes homes to roost and the whole house of cards collapses once again as it always must in the end.