The risk associated with banks' foreign borrowing.

• Author: Gerdrup, Karsten R.

Since 1995 banks' foreign borrowing has increased sharply, matching the growth recorded in the mid-1980s. Measured in relation to banks' total loans, foreign funding is smaller now than at that time. As was the case in the mid-1980s, the increase in foreign borrowing came in response to strong demand for domestic NOK loans. In principle, the exchange rate risk associated with borrowing is eliminated inasmuch as banks use the foreign currency loans to buy NOK spot and sell the same volume of NOK forward in the foreign exchange market. Foreign borrowing, however, involves higher liquidity risk than funding from other sources. Liquidity risk increases both because foreign borrowers may react collectively towards Norwegian banks to a greater extent than ordinary Norwegian depositors and because of the possibility of liquidity problems in the forward market where the currency is temporarily exchanged for NOK. The increased magnitude of bond issues since 1997 has contributed to extending the maturity of foreign debt, thereby curbing the increase in liquidity risk.(1)

1 Introduction

This article attempts to shed light on developments in banks' foreign borrowing and analyse the associated risk. The risk is primarily related to the possibility that foreign lenders may abruptly reassess their perception of future developments in a country's economy and collectively reduce their exposure to a country's borrowers. An example of this was most recently seen in connection with the Asian crisis. We also saw how ready access to foreign loans contributed to the build-up of imbalances that later triggered a reversal of foreign funding.

It is difficult to evaluate the possibility of forward market failure. There are several types of operators with varying needs in this market and the harmful effects of herd behaviour from a limited group of operators will thus be reduced. It must be assumed, however, that a macroeconomic shock where foreign lenders collectively reassess their Norwegian borrowers will also influence the forward market to some extent.

Banks' foreign funding is of particular interest to. Norges Bank as lender of last resort (LLR). When foreign funding dries up, this represents a type of crisis which, at least in principle, will emerge as a pure liquidity crisis without accompanying solvency problems.

Part 2 of this article describes developments in foreign borrowing. Part 3 discusses the possibility that the foreign sector as a funding source will dry up and the risk of liquidity problems in the forward market, while part 4 presents a summary.

2 Description of foreign funding

Banks' foreign debt

Banks' gross and net foreign debt rose substantially between 1995 and April 2000 (see Charts 1-3). The increase in foreign borrowing must be seen in the light of a combination of sharp lending growth and far lower growth in customer deposits (see Chart 4). Sharp lending growth towards the end of the 1990s was the result of a vigorous cyclical upturn and historically low interest rates up to the first half of 1998. Developments after the first half of 1998 were marked by a steep decline in prices in securities markets, higher interest rates and uncertainty concerning future economic developments. For a while this contributed to slower growth in lending to the general public and higher growth in customer deposits.

[Charts 1-4 OMITTED]

The competition for savings from other investment alternatives, such as securities funds and insurance products with a savings component, increased in this period, making it more difficult for banks to finance strong lending growth on the basis of customer deposits. Money and capital markets in Norway and other countries have been alternative funding sources. One possible reason that banks have largely chosen foreign funding may be that domestic money and capital markets have not been considered sufficiently liquid to cover this funding requirement and higher credit ratings internationally have resulted in favourable foreign funding.(2)

Short-term loans account for a large share of foreign borrowing, with foreign banks placing deposits in Norwegian banks (see Chart 5). Since the second half of 1997, banks have to an increasing extent relied on bonds denominated in foreign currency for long-term financing. This may be related to Standard and Poor's upgrading of Christiania Bank on 21 July 1997. Den norske Bank was given its first rating by Standard and Poor's the same day. However, both banks were upgraded by Moody's as early as 1995.

[Chart 5 OMITTED]

It may also be natural to view developments in banks' foreign debt in connection with other components of the capital account of the balance of payments (see Table 1). In the period 1995-1999, capital outflows from Norway were larger than the current account surplus, primarily as a result of allocations to the Government Petroleum Fund. The central government sector also recorded an outflow in connection with the repayment of government foreign debt. Despite large current account surpluses in the period, capital inflows to private sectors were therefore required.

Table 1 Banks' foreign financing and Norway's external account. In billions of NOK

1996 1997 1998 Current account balance 72.5 56.1 -16.3 Capital outflows 72.5 56.1 -16.3 From Norges Bank 79.9 57.5 -6.0 From `Other sectors' -7.4 -1.5 -10.2 Commercial and savings banks -53.2 -40.3 -13.3 Insurance 5.6 18.3 8.4 Other financial institutions -6.7 -11.3 -2.5 Central government 13.5 11.4 16.6 Local government 1.4 0.8 0.2 Ocean transport -4.6 -2.5 5.0 Petroleum activities -5.9 -5.5 -46.4 Other private and state enterprises 5.2 15.1 -5.0 Undistributed capital transactions and errors and omissions 37.3 11.3 31.0 Accumulated 1999 1996-99 Current account balance 43.5 155.8 Capital outflows 43.5 155.8 From Norges Bank 67.5 198.9 From `Other sectors' -24.0 -43.1 Commercial and savings banks -18.5 -125.3 Insurance 34.1 66.4 Other financial institutions 0.3 -20.2 Central government -7.2 34.2 Local government 0.2 2.6 Ocean transport -3.4 -10 Petroleum activities -1.2 -59.2 Other private and state enterprises -21.7 -6.4 Undistributed capital transactions and errors and omissions -7.9 71.7 Sources: Statistics Norway and Norges Bank

The capital outflow from Norges Bank and the central government sector probably contributed to slightly higher interest rates in Norway than would otherwise have been the case. It is unlikely, however, that this has motivated banks to borrow abroad. Because banks exchange foreign currency for NOK and hedge the...