O ver view of Financial Stability in the Netherl and s

Transcription

1 10 De Nederlandsche Bank O ver view of Financial Stability in the Netherl and s May 2 010, no. 11

2 10 De Nederlandsche Bank Overview of Financial Stability in the Netherlands May 2010, no. 11

3 2010 De Nederlandsche Bank NV Edition: 525 This document uses information available up to May 20, Reproduction for educational and non-commercial purposes is permitted, provided that the source is acknowledged. Westeinde 1, 1017 zn Amsterdam - Postbus 98, 1000 ab Amsterdam Telephone (+ 31) Telefax (+ 31) Website: www. dnb. nl.

4 Contents Summary and conclusions 4 1 Developments in the international environment 6 Box 1: Government debt in the eurozone 13 2 The real economy in the Netherlands 16 3 Dutch financial institutions 20 Box 2: Correlation between loan quality indicators 22 Box 3: Major changes in European banking sector 27 4 Institutional developments and infrastructure 29 3

5 Summary and conclusions Public finances a new source of concern The nature of the risks to financial stability has changed rapidly in recent months. The general recovery in the markets which took place in the second half of 2009 was knocked off course in the spring of this year by concerns about the ability of national governments to control their public finances. Initially, it was above all the situation in Greece which sparked off unrest in financial markets, but as the spring progressed the negative market sentiment spread like an oil slick to reach other countries on the periphery of the eurozone. The financial sector was also affected by the unrest. When this dynamic began to pose a real threat to general market confidence European governments, the IMF and the ECB joined forces in early May to announce far-reaching measures to protect financial stability. These necessary measures succeeded in restoring calm to the markets. Still, it remains crucial that governments push through necessary and credible reforms in order to put the public finances back on track. This would remove a key obstacle to a restoration of financial stability and economic recovery. The increase in sovereign debt also has consequences for the private sector. The deterioration in the public finances has contributed to the sharp rise of total financing requirement of national governments in the years ahead. This could make it more difficult for non-financial enterprises to access funding. Since the publication of the last Overview of Financial Stability, a start has been made on gradually phasing out the national measures taken to support the financial sector. The temporary interventions by the ECB to boost liquidity will, however, continue for the time being, partly in the light of the recent unrest concerning Greece and the European periphery. In addition, the ECB has embarked on a programme of buying (government) bonds. Despite the continuation of the temporary liquidity-raising facilities, it is important that banks restore their ability to finance their operations via the private markets as quickly as possible. This requires that financial institutions have adequate solvency and liquidity, something which is monitored by DNB through its regular macro-stress tests. Risk of new economic downturn remains The Dutch financial sector has recovered somewhat from the dire situation at the end of Nonetheless, the recent downturn in financial markets serves as a reminder that the markets are still reacting violently to potential problems and that the situation remains fragile. A double-dip recession, with a renewed deterioration of the economic climate, cannot be ruled out, although recent economic trends have been predominantly positive. This could push up credit risk again in the banking sector. If a new downturn were to occur in combination with a further deterioration in the housing market, the banking sector would be exposed to substantial potential losses. In addition, the banking sector is vulnerable to sudden changes in interest rates, which could put pressure on interest income, a key source of revenue. The pensions and insurance industry also continues to face challenges. The insurance sector is seeing a sharp fall in sales of new life insurance policies, while several factors have put severe pressure on the sustainability of the pensions system in the future. It is therefore crucial that the present opportunity to reform the system be grasped. 4

6 A number of initiatives are being developed, aimed at strengthening the international financial system. DNB believes that the most important need, in line with the proposals being developed by the Basel Committee, is to raise the capital and liquidity requirements for the banking industry in order to improve the resilience of the financial system. And it is imperative that a threatened surfeit of potential supplementary measures not divert attention from this priority. Stricter capital and liquidity requirements deserve priority Key reforms are taking place in the financial infrastructure. Among them is the migration away from mutual (OTC) derivatives trading to central counterparties (CCPs). This migration brings benefits and is in principle to be encouraged, though it could also create new vulnerabilities and it is therefore important to ensure the solidity of the central counterparties. In short, the outlook with regard to financial stability is mixed and is subject to market fluctuations. The recent European support package has laid a basis for a cautious recovery in the financial markets, but concerns remain about growing sovereign debt and large budget deficits, especially in combination with the limited liquidity of the markets. Another important stabilising factor involves Europe acting in a strong and united way in implementing support measures and pressing for structural improvements in the public finances of individual member states. Failure to do this to sufficient degree could lead to renewed instability. An economic downturn whereby credit losses increase or there are sharp movements in the yield curve still poses a risk to financial stability. The task facing the authorities is to be alert responding to new and sometimes rapid developments. Against this backdrop, implementing the necessary reforms to the public finances, the capital and liquidity requirements for banks and the Dutch pensions system is vital. Failure to do so will sow the seeds of the next crisis. It is therefore crucial that the reform measures be taken quickly in all cases, particularly since prudent introduction of reforms sometimes requires a long transitional period. Structural reforms of great importance 5

7 1 Developments in the international environment The global economy has picked up gradually over the past year. The recent recovery in world trade has boosted industrial output in many countries, and the stock markets are also recovering. Recently, however, risks of a different nature have materialised, as concerns about public finances dominate the financial markets and in the case of Greece, the markets have lost confidence altogether. When this negative sentiment threatened to spread to other countries, the eurozone members and the ECB implemented drastic measures. Changing risks on financial markets Financial markets recover after low point but problems in Greece spark new unrest. After hitting a low point in March 2009, the financial markets gradually recovered up to the beginning of During this period, risk premiums on bonds fell, share prices rose and the volatility on the financial markets reduced (chart 1). Accessing the capital markets also became easier for some financial institutions. Since the introduction of the Covered Bond Purchasing Programme (CBPP) of the ECB, the European covered bond market has shown some recovery. Although the European market for external securitisations remained largely closed, it too has recently begun showing some activity again (chart 2). From the end of 2009, however, it became increasingly clear that the financial crisis had left deep scars on the public finances of several countries. The first tangible evidence of this was when the biggest state-owned company in Dubai announced a general moratorium on its payments. The turbulence this caused in the markets was however quickly overshadowed by the problems surrounding the public debt of Greece. The Greek authorities announced at the end of 2009 that the budget deficit was much higher than the official estimate published six months earlier. This revised Chart 1 Volatility and risk premiums In basis points Volatility, right-hand scale ittraxx - Europe financials July 06 July 07 July 08 July 09 July 10 Note: volatility refers to the SPX volatility VIX index. Source: Datastream and Markit. 6

8 Chart 2 Issuing of RMBS x EUR billion UK Netherlands other eurozone countries External Internal Ytd Ytd Ytd Notes: Other eurozone countries are: Italy, Spain, Belgium, Greece, Ireland, Portugal, France and Finland. Internal means internal securitisations held on the balance sheet of the bank as collateral; external means securitisations placed with an external party. Ytd 10 is the year up to and including quarter I. Source: Bloomberg, Datastream and own calculations. estimate increased doubts about the sustainability of the public debt and seriously undermined the credibility and reputation of the Greek government. Rating agencies responded by downgrading Greece s credit rating; the effect of this was to drive up the cost of refinancing the high public debt so sharply that the public finances were in danger of becoming unsustainable very quickly (chart 3). The rising interest rates also meant that financial institutions suffered substantial losses in the value of their holdings of Greek government paper. When market confidence in the Greek government plummeted, the IMF and the eurozone countries stepped in with a rescue package totalling EUR 110 billion. DNB welcomes the involvement of the IMF, which has a great deal of the expertise needed to ensure that the support package is accompanied by the necessary economic reforms. Chart 3 Five-year sovereign CDS-spreads In basis points 1,000 Portugal 800 Ireland 600 Greece 400 Spain 200 Netherlands 0 June 08 Dec. 08 June 09 Dec. 09 Germany Source: Datastream. 7

9 Large-scale intervention by eurozone countries, ECB and IMF Fiscal consolidation is key The negative market sentiment surrounding Greece has already led to a more general deterioration in sentiment on the financial markets, driving up risk premiums for other European countries with relatively weak public finances as well, such as Portugal and Spain. Financial institutions with exposure to these countries found themselves confronted by volatile stock prices and waning confidence on the interbank money market. The eurozone countries and the ECB took radical steps in a bid to head off potential threats to the financial stability. A European support mechanism was put in place totalling EUR 500 billion as a safety net for countries that get into difficulties. EUR 60 billion of this was made available directly via the European Commission. The effectiveness of the support package is further increased by the contribution from the IMF, which is likely to put up half the funding contributed by Europe in each rescue operation. In addition, as with the rescue package for Greece, the IMF will be closely involved in the negotiation of reform programmes in the recipient countries. Simultaneously with the announcement of the support package, the ECB decided to inject additional liquidity into the banking system in the coming period, and also to intervene in the European bond markets in order to boost liquidity where necessary. The aim of this programme is to improve the functioning of these markets and thereby ensure the effectiveness of the monetary transmission mechanism. As this Overview of Financial Stability was being completed, most indicators were suggesting that the rescue package had helped to temper the unrest in the markets. However, if the stability of the financial system is to be assured, it is essential that the underlying problems are tackled vigorously. This will require that governments presiding over unbalanced public finances put their budgetary houses in order in a lasting and credible way and improve their countries competitiveness. At the same time, the European institutional framework needs to be strengthened in order to prevent any future recurrence of the present problems. Since the onset of the credit crisis, financial markets have increasingly been assessing the creditworthiness of major banks on the basis of the creditworthiness of the countries where those banks are based. This is evident from the increased correlation between movements in the prices of credit insurance contracts Credit Default Swaps (CDS) issued by governments and by banks (chart 4). Since the start of the crisis, the markets have attached more weight to the possibility of government inter- Chart 4 Correlation between sovereign CDS-spreads and bank CDS-spreads Correlation Until 18 July 2007 (start of liquidity crisis) 18 July 2007 to 15 September 2008 (from liquidity crisis to solvency crisis) After 15 September 2008 (start of systemic crisis) Notes: This is the correlation between sovereign CDS-spreads and the CDS-spreads of one or two major national banks averaged over the period in question. For the period before 18 July 2007, an average is taken of the available figures, which vary from country to country. Source: Bloomberg, Datastream and own calculations. 8

10 Chart 5 Yield curve, US and Europe In percentage points, 10-year minus three-month interest rates US Eurozone Source: Datastream. ventions. In most cases, government support also provides protection to professional creditors, and a reduction in the creditworthiness of a government therefore also has indirect consequences for confidence in the banking system in the country concerned. Expansionary monetary policy brings risks Central banks throughout the world reduced their policy interest rates sharply during the crisis and provided liquidity to the banking sector on generous terms in a bid to prop up the stability of the financial system and therefore of the monetary transmission system. In the eurozone, the ECB did this among other things in the form of 12-month financing operations totalling EUR 634 billion. These measures led to a sharp increase in the spread between short and long-term interest rates (chart 5), enabling banks to boost their interest rate margins and thus improve their financial resilience. On the other hand, current interest rate levels and the large amount of liquidity also bring risks; for example, there is a danger that the expansionary monetary policy could lay the basis for new financial asset bubbles. Low interest rates have bolstered financial system Chart 6 Equity prices Index: 31 Dec = World Emerging markets July 06 July 07 July 08 July 09 July 10 Note: MSCI World and MSCI Emerging Markets. Source: Datastream. 9

11 Chart 7 Domestic lending Year-on-year movements per quarter, in percentages Developed economies Emerging economies Eurozone US UK China Brazil India Russia Source: Datastream - IMF Banking survey. but could lay the basis for new asset bubbles Such a situation could for example arise with European and US investments in emerging markets. Chart 6 shows that share prices worldwide have risen sharply since their low point in March 2009, to levels that are comparable with early Shares of companies in emerging markets have rallied even more strongly and have almost returned to the levels seen before the crisis. Property prices in a number of emerging markets have also risen sharply over the past year, reflecting the substantial growth in lending (chart 7). Some commodity prices have also risen sharply since early However, the recent unrest on the financial markets has caused the prices of many assets to fall again. In addition to the risk of asset bubbles, temporary liquidity measures can also constrain the incentives for banks to raise private funding. Moreover, the low money market interest rates make it attractive to raise short-term funding, thus increasing liquidity risks (see also chapter 3). It is therefore unavoidable that central banks will eventually move to normalise the monetary situation and raise policy rates. For the time being, however, accommodating measures remain necessary in order to stabilise the financial system. Phasing out of temporary crisis measures Gradual unwinding of support measures In the wake of the recovery in the financial markets which set in in March 2009, the authorities have begun unwinding the measures taken to support the financial sector. In January 2010, for example, the premiums for the Dutch bank debt guarantee scheme were raised. DNB endorses the gradual withdrawal of such support measures, in which the use of the facilities is discouraged but the safety net remains intact for some time. No Dutch institution has made use of the scheme since the beginning of this year, while three Dutch financial institutions have paid back part of the government support they received. The temporary measures implemented by the monetary authorities in the eurozone have also been adapted to take account of the changing situation in financial markets. From the start of 2010, the frequency and term of the liquidity operations was 10

12 reduced, giving banks an incentive to begin raising more of their funding from private markets. In May 2010, however, exceptional market circumstances arose once again; severe volatility in the government bond market in Europe combined with a renewed rise in risk premiums in the interbank market threatened the monetary transmission system. This prompted the ECB to reintroduce full allocation of threemonth financing to all banks at a fixed interest rate. In May, the ECB also provided financing to banks with a term of six months. Next to this, the ECB launched a new programme of intervention in dysfunctional markets for debt instruments, such as certain government bonds. The intervention programme was intended to resolve shortcomings in these markets, with the injected liquidity being reabsorbed, so that the programme is not inflationary. Finally, the ECB reopened a temporary swap facility, with liquidity in dollars being exchanged for collateral in euros. Provided the circumstances permit, the temporary measures will be phased out gradually so as to minimise any shocks to the system. There is however still a risk that some banks will refinance longer-term ECB liquidity on a shorter-term basis, thereby increasing liquidity risks. The principles underpinning the monetary policy of the ECB remain unchanged. In due course, the ECB will want to normalise the very loose monetary situation, which could potentially lead to inflation and financial instability. At present, inflation in the eurozone is low, but the inflationary outlook is highly uncertain. On the one hand, a lengthy period of low inflation or even deflation cannot be ruled out, especially in a climate of slow economic recovery and ongoing deleveraging of debt. On the other hand, the exceptionally low interest rates and unconventional liquidity measures could at any time spark off a sharp increase in the inflationary outlook. Research by DNB suggests that, since the crisis, the inflationary expectations of financial actors now react more strongly to economic news. 1 This is reflected in the trend in prices of index-linked bonds and inflation swaps, financial instruments whose value depends on the inflation rate. The large budget deficits also pose a risk to price stability, especially where the deficits are seen as stubborn and doubt is cast on the independence of central banks. Trend in price level highly uncertain High financing requirement in several sectors Financial institutions, governments and businesses will have a very high financing requirement over the next few years. Up to the end of 2010, debt instruments issued by governments, financial institutions and private companies will mature to a value of more than 5,000 billion euros (chart 8). A high proportion of this debt will have to be refinanced in the market. In addition, governments in developed economies will be issuing new debt on a large scale to address the high budget deficits in the years ahead. This will come on top of the refinancing of existing debt as shown in the chart. Much of the deterioration in public finances can be traced directly to lower tax revenues, higher social security spending and stimulus packages in the wake of the financial crisis. This has brought to light the fact that many countries were already in a fragile financial state even before the crisis. Banks will also have a higher than normal need for refinancing in the coming period, because they issued shorter-term debt during the crisis. When the economy picks up further, there will moreover be a growing need for financing of business activities as well. High financing requirement The high overall financing requirement could create problems with lending and in capital markets. If that happens, the sharp rise in budget deficits would then lead not only to concerns about the sustainability of government debt, but could also 1 G. Galati, S. Poelhekke & C. Zhou, Did the crisis affect inflation expectations?, DNB Working Paper No. 222, september ( paper 222_tcm pdf) 11

13 Chard 8 Reducing bond loans per sector worldwide x EUR billion 5,500 5,000 Financial 4,500 institutions 4,000 3,500 Businesses 3,000 2,500 Government 2,000 1,500 Other 1, Notes: The horizontal axis shows the year in which the bond loans mature; the figures are based on the original terms to maturity. Source: Dealogic. Risk of crowding out private investments crowd out private investments and thus impede growth in the private sector, as banks begin investing more in government paper at the expense of new lending to businesses. Crowding out could also occur in capital markets, as higher risk premiums on government paper work through into the corporate bond market; there are for example signs that some investors are increasing their holdings in government bonds at the expense of corporate bonds. On the other hand, an economic recovery and normalisation of the markets could give lead to crowding out as in such a situation investors focus more on securities other than bonds. In the US, the anticipated tightening of liquidity requirements could prompt banks to become major buyers of government bonds in the near term. Even so, some market players foresee a lack of absorption capacity, especially for long government bonds; this would put upward pressure on long-term interest rates. This is currently less of an issue in Europe and Japan. Fragile recovery of the real economy The financial crisis has begun to impact on the real economy in the past year. Unemployment has risen sharply in many countries; the unemployment rate in the eurozone ranges from 6.1% in the Netherlands to 19% in Spain. The number of business failures is also rising, and property prices in many countries have fallen, sometimes steeply. These trends are reflected in the lending portfolios of financial institutions; for example, banks have seen an increase in the number of loans in arrears in the past year, forcing them to make larger provisions. Some sectors are being hit harder than others. One sector which is still suffering badly in many countries is the commercial property market, as falling demand for office and retail space pushes up vacancy rates, in turn depressing commercial real estate prices. In addition, many commercial property loans will have to be refinanced in the coming years; this could cause problems if borrowers are unable to obtain the necessary finance. Future developments in this and other markets depend greatly on what happens to the economy. The recent economic recovery is still fragile; another economic downturn (e.g. due to rising market interest rates) would put markets under renewed pressure and greatly increase the credit risk for banks. 12

14 For DNB it is important to have a clear picture at all times of the ability of Dutch institutions to withstand new shocks in the financial markets or the economy. One of the tools for assessing this is the macro-stress test, in which financial institutions are asked to calculate the impact of a uniform scenario on their balance sheet and solvency. The results of the macro-stress test are then used as part of the ongoing supervision of financial institutions. Supervisory changes Macroeconomic developments in the coming years will be determined partly by measures taken to strengthen the financial system. For example, last December the Basel Committee on Banking Supervision (BCBS) published a number of proposals designed to increase the capital and liquidity buffers of banks. This would increase the resilience of banks worldwide, a key factor for a sustainable economic recovery. However, these changes also come at a price. For example, in the future banks could find themselves confronted with higher financing costs, some of which they will pass on to customers in the form of higher interest rates on loans and lower interest rates on deposits. These increasing costs need not by definition be a negative factor, however: before the crisis the costs of liquidity and the risk costs for balance sheet capital were not adequately reflected in the price of financial products, thus helping to fuel excessive use of debt financing (leverage). Changes in the supervisory regime, for example with regard to liquidity, would also have consequences for the assets held by banks. All in all, the traditional maturity transformation by banks the process whereby banks finance long-term loans with short-term finance and demand deposits could be influenced, and this will have implications for the real economy. How these effects will play out in the longer term is difficult to predict and will depend among other things on the behaviour of banks, the balance of supply and demand on the money and capital markets for example the availability of new liquid paper and the attitude of other financial institutions which could take over part of the maturity transformation function from the banks. The Basel Committee is currently studying the potential consequences of the new measures before they are definitively adopted. In order to limit unwanted macroeconomic effects in the short term, the new requirements will be phased in gradually. Study of consequences of new regulations Box 1: Government debt in the eurozone Against the backdrop of the financial crisis, the public finances of many industrialised nations have deteriorated substantially in recent years as a result of automatic stabilisers, spending on stimulus packages and support measures for the financial sector. While households, businesses and financial institutions have been reducing their level of debt and absorbing losses, the government debt in many countries has been rising sharply: the average ratio of public debt to GDP increased in the OECD countries from 73% in 2007 to 90% in In many countries and especially the Netherlands this has been accompanied by a shift towards shorter terms to maturity for government debt (chart 9). In 2008, the money markets financing of the Dutch state quadrupled, partly due to the short financing of unexpected financing requirements, such as the need to rescue financial institutions. Financing at the short end of the yield curve is cheap, but this is offset by higher interest rate and refinancing risks. The interest rate risks are partially hedged using derivatives, but this still leaves the higher refinancing risk. 13

15 Chart 9 Short-term paper as a fraction of total government paper in issue In percentages, progressive three-month average Germany Eurozone France Netherlands Spain Note: Figures are based on original terms to maturity and are up-to-date up to and including March Source: ECB. Countries which already had high levels of debt that has increased rapidly as a result of the crisis can no longer automatically assume that they have the confidence of investors. This is reflected in negative adjustment of their credit ratings and higher risk premiums on government bonds. As a result, it is sometimes considerably more difficult for these countries to meet their financing needs via the regular channels. Within the eurozone, this applies in particular for certain peripheral countries, especially Greece. If the increased sovereign risks materialise, the Dutch financial sector could be hit both directly and indirectly. The direct impact will be felt via the exposures of Dutch financial institutions to debt in the countries affected, as higher spreads and negative ratings adjustments potentially lead to losses. A sovereign default by a eurozone country could substantially weaken the capital position of Dutch financial institutions. Given the high level of interdependence between the different countries, institutions and financial markets, the indirect effects of a sovereign default could be greater than the direct effects. For example, institutions in the peripheral countries have mutual exposures to government paper from these countries. If the market perceptions of a country deteriorate, this could lead to a concomitant deterioration in the perceptions of other countries in a similar situation. This could be driven for example by the level of public debt, the credibility of government policy or the reliability of government statistics. Moreover, any shocks in a country with a high refinancing requirement could make it more difficult for another country with similar financing patterns and about which there are also negative market perceptions to refinance its own debt in the short term. Potentially, therefore, Dutch institutions could be faced with a domino effect of falling countries. Financial institutions could encounter difficulties in refinancing their debts if the sovereign risk of a country to which they have major exposure increases. The financing costs could increase in parallel with the financing costs of the governments concerned, and it is moreover possible that if a rating falls below a certain level, government paper from those countries will no longer be accepted as 14

16 collateral in private repo transactions. In the event of a sovereign default, CDS contracts which serve as an insurance against default would be activated, potentially mitigating the losses for some institutions but having negative consequences for others. In a scenario in which a sovereign default leads to major uncertainty, the impact on the financial sector could be very considerable. Withdrawal of deposits and loss of trust between banks could have far-reaching consequences for other asset markets, lending and the real economy. In such a scenario, the government has not only become a source of risk, but there is even a risk that the government will have an insufficient financial basis to step in if financial institutions get into difficulties. In conclusion, the high economic interdependence means that a sovereign default by a eurozone country could pose a significant threat to financial stability in the Netherlands. This goes further than just a weakening of the euro. The financial integration in the eurozone offers key advantages from which the Netherlands also benefits, for example through the efficient distribution of resources and risks and the fostering of international trade. On the other hand, that integration means that risks cannot be confined to the country where they originate. The recently launched support plan for governments in the eurozone is therefore not only necessary for the governments in question, but also for the Dutch economy. For the same reason, a credible and sustainable solution for the public finances in the various member states is important for all eurozone countries. 15

17 2 The real economy in the Netherlands Businesses Dutch businesses have seen their profitability fall sharply over the past year (chart 10), as the financial crisis prompted a dramatic decline in domestic and foreign demand for products. On the other hand, the starting position of Dutch businesses on the eve of the crisis was relatively good thanks to a strengthening of their capital position in the preceding years, among other things due to growth in the company deposits held. Businesses vulnerable for new setbacks Naturally, not all companies built up their capital positions to the same degree, as is illustrated by the large number of Dutch business failures. On the other hand, the number of bankruptcies did fall slightly in the second half of 2009, while at the same time both manufacturer confidence and industrial output are rising, partly thanks to improving exports. All these indicators suggest a modest improvement in the business climate, though many businesses remain vulnerable in the present climate to new setbacks; for example, the fragile recovery could be interrupted by a new deterioration of the economy or renewed evaporation of foreign demand for goods. Dutch businesses are also vulnerable to a downturn in business lending. Thus far, lending is still growing and the slowdown in lending growth is due to demand factors. Despite this, the possibility cannot be ruled out that banks will become more cautious in advancing new loans in the future, especially in high-risk sectors. The combination of new capital and liquidity requirements and write-downs on the loan book will put additional pressure on future growth in bank lending, potentially for a considerable period. Since the opportunities to raise funding via the markets could also come under pressure in the coming years due to competition on the bond mar- Chart 10 Earnings growth of Dutch businesses Year-on-year changes, in percentages Profit per unit output Output (GDP growth) Profit (gross operating margin/ mixed income) Source: CBS. 16

18 ket, the likely outcome is a rise in the cost of borrowing. The impact of this is likely to vary from sector to sector, with highly leveraged businesses, in particular, seeing the appeal of their business model fading. Households Unemployment in the Netherlands continued to rise, reaching 6.1% of the labour force in March This increase is however more modest than predicted in earlier macroeconomic forecasts. To some extent this is because companies are first ending their contracts with self-employed workers before shedding salaried staff. Cuts in working hours partly facilitated through part-time unemployment benefit are also helping to avoid redundancies. Finally, employers appear to be reluctant to lay off staff at the moment, fearing an eventual return of a labour market squeeze. The Netherlands Bureau for Economic Policy Analysis (CPB) estimates that these factors together have prevented between 80,000 and 150,000 redundancies. 2 Household income in the Netherlands is under pressure. Partly due to rising unemployment and the falling income of self-employed workers, real disposable income fell by 0.2% over 2009, and is expected to shrink further or grow only slowly over the next two years. New government policy aimed at reducing the budget deficit could squeeze disposable income further through increased taxes and social insurance contributions. The rising unemployment rate and uncertainty about future incomes also have consequences for the Dutch housing market. House prices have fallen further in the past year (chart 11), and the number of homes sold is also declining, though it does appear to have stabilised recently. As well as income uncertainty, uncertainty about the future of the tax-deductibility of mortgage interest is also exacerbating the negative sentiment on the housing market. Any changes to this facility will have to be crafted carefully in order not to disrupt the stability of the housing market, which is essential for the stability of the financial system as a whole. This means that any measures should where possible be introduced gradually. Dutch home sales in the doldrums Chart 11 Housing market trend in prices and sales Year-on-year percentage change and 12-month progressive total x 1,000 (right-hand scale) Movement in prices of existing homes Number of homes sold (right-hand scale) July 04 July 05 July 06 July 07 July 08 July 09 July 10 Source: Kadaster Kwartaalbericht. 2 Centraal Economisch Plan 2010, chapter 5.2, table

19 Chart 12 Loan-to-value ratio of Dutch home purchases In percentages Notes: Loan-to-value ratio = average mortgage amount / average purchase price (excl buying expenses). The mortgage sum registered with the notary may be higher than the loan actually drawn down in order to anticipate future increases. Source: Het Kadaster Kwartaalbericht. Sharp rise in loan-tovalue ratio mortgages There was an increase last year in the average loan-to-value ratio of mortgages taken out by Dutch home-buyers (chart 12). Where mortgages substantially exceed the value of the home, there is a risk that households will be left with a residual debt in the event of a forced sale. This negative equity can also result in losses for the institution which finances the home purchase, if it proves impossible to collect that residual debt. Although it is not necessarily the case that the full mortgage will be drawn down immediately, the increase in the loan-to-value ratio to 118% at the end of 2009 is worrying. Bringing down this ratio would improve the financial resilience of households and reduce the risk to lenders, and could therefore contribute to the stability of the Dutch financial system. On the other hand, the risks for banks and households are currently mitigated by the sharp rise in the number of mortgages taken out under the National Mortgage Guarantee (NHG) scheme in the past year, to 80% in the first quarter of This scheme now guarantees mortgage loans in the Netherlands to a value of EUR 110 billion. The government for its part underwrites the scheme in the event that the guarantee fund (totalling EUR 518 million) should prove inadequate. It thus assumes the risks of households and financial institutions and acts as indirect guarantor for a growing proportion of the Dutch mortgage market. One worrying development in this regard is the rise in the number of NHG claims by banks which are being refused, thus effectively pushing the credit risk back onto the banks. The percentage of rejected claims has been increasing over recent years and reached 41% of the total amount claimed in In most cases, a refusal to pay out is due to incorrect or incomplete documentation. DNB urges institutions falling under its supervision to improve their documentation and records rapidly in order to avoid these unnecessary losses. Public finances Steep increase in budget deficit As in many other countries, the crisis has led to a sharp increase in the public debt in the Netherlands (see also Box 1). Initially this was due mainly to support measures for the financial sector, but in the last year it has been caused by a sharp rise in the budget deficit, which in 2009 amounted to 5.3% of GDP, whereas in 2008 the budget was in surplus. The sharp rise in the deficit is due to a fall in revenues combined with a rise in expenditure. Government revenues fell by EUR 13 billion in 2009 as a result of the economic downturn, whereas government spending rose by 3 Stichting WEW press release, April

20 EUR 21 billion. Most of this was the result of spending plans that were in place before the crisis, though expenditure as a result of the crisis, such as the economic stimulus package, also played a role. The government is deliberately opting not to make spending cuts during a period of economic recession. International experience from earlier crisis periods shows that as long as the sustainability of the debt is not in jeopardy this is a sensible option, since spending cuts can exacerbate the downturn. The government will however have to cut the budget deficit and the public debt. The budgetary advisory body Studiegroep Begrotingsruimte has recommended cuts of EUR 18 billion in the period to 2015, on top of the cuts of EUR 7 billion already planned. Options for radical spending cuts have been put forward by various civil service working groups. Difficult choices will have to be made during the coming government term in order to rebalance the budget. This will demand decisiveness. In addition to the consequences of the credit crisis and recession, demographic trends will also place a heavy burden on the public finances in the coming decades. The combination of growing life expectancy and a falling birth rate puts pressure on the affordability of state pensions. In order to maintain the value of pensions, raising the retirement age to 67 years is now inevitable, and further increases may be necessary as life expectancy grows further. Several other countries have initiated a similar policy. This reform, as well as other structural measures, will demand transitional periods spanning several government terms, and it is therefore vital that decisions on reform are not postponed. Structural reforms essential 19

21 3 Dutch financial institutions The operating climate for Dutch financial institutions has improved in some respects; write-downs on bad loans have for example fallen slightly. Nonetheless, banks, insurers and pension funds remain vulnerable to shocks in the financial markets and a renewed deterioration of the economy. The risks vary from sector to sector. For banks, an increase in short-term interest rates would hit their profitability; by contrast, low long-term interest rates could hold back the recovery of pension funds and life insurers. Banks Bank results improve The results of Dutch banks have improved over the last year. Whereas the sector as a whole posted a considerable loss in 2008, the industry recorded a modest positive operating result of EUR 150 million in The results were buoyed up by interest income, which proved to be a stable source of income for the sector over the past year. Continuing large additions to provisions depressed the results (chart 13), though the amounts did fall slightly in the last quarter of 2009 compared with a year earlier. On the other hand, the number of loans with payment arrears remains as high as ever. The spread between long-term and short-term interest rates the yield curve has increased substantially since Most banks are benefiting from this, because they traditionally raise their own finance on a short-term basis whereas their loans generally have a long term to maturity. A flattening of the yield curve would reduce Chart 13 Net interest income and addition to provisions x EUR billion Net interest 8.0 income Addition to provisions I 06 II III IV I 07 II III IV I 08 II III IV I 09 II III IV I 10* Note: *10 Q1 figures are provisional. Source: DNB. 20

22 the interest rate margins of banks. An increase in long-term interest rates, for example as a result of increased government debt, could also be bad for the banks because it would depress the economic value of interest rate-sensitive assets. Banks use internal models in their risk management systems to estimate the risk of an interest rate shock. The outcomes of these models are largely determined by assumptions about the behaviour of savers and other market players. In the present exceptional climate, however, these assumptions may prove incorrect. For example, problems on the money and capital markets could lead to increased competition for deposits, making banks more likely to pass on an increase in interest rates to savers; this would squeeze interest rate margin and cause the potential loss of income to be greater than expected. but are sensitive to changes in the yield curve The steep yield curve provides an extra incentive for banks to increase the term spreads between assets and liabilities. The average term of bank financing reduced during the crisis due to problems in capital markets. As a result, the refinancing requirement of banks is exceptionally high this year. This means there is a heightened risk of new shocks and that a prudent approach is required to the unwinding of the present monetary policy. On the other hand, the opportunities for raising longer-term finance have improved because the capital markets have recovered somewhat, and Dutch banks have consequently not had to call on government guarantees for their financing needs since December A rise in interest rates would also have consequences for the potential credit losses of banks. Higher interest rates could put households and businesses into payment difficulties, leading to an increase in the number of bad loans. These losses would come on top of the already substantial credit losses resulting from the crisis. The IMF has calculated that banks in the eurozone will collectively have to write off around EUR 185 billion in A fall in economic activity could also spark off a renewed rise in credit losses. At the moment, defaults are highest in the business loans portfolio, though are still well below forecast. The level of payment arrears in the private lending portfolio is lower, though in some cases does exceed the internal bank forecasts (see also Box 2). and economic downturn. Banks are not only exposed to credit risk for businesses and households; the weakened financial position of a number of governments also poses a key risk (see also Box 1). In addition to direct losses in value due to rising risk premiums, the government paper could become less acceptable as collateral for generating liquidity in the market, and capital requirements could increase. On the other hand, the risk premiums on government paper in the majority of developed countries are still substantially lower than those on mortgage bonds, for example. Banks will be faced with new regulations in the coming period. In December 2009, for example, the Basel Committee announced plans to make the banking sector more stable by raising the capital and liquidity buffers. A Quantitative Impact Study (QIS) is currently being carried out to look in detail at the consequences of these new regulations for individual financial institutions. The findings of this study will help determine the calibration of the new capital and liquidity requirements. Introduction of new Basel requirements The capital position of the Dutch banking industry has improved markedly in the last year (chart 15). The Tier-1 ratio of the sector a measure of core capital is higher than the average for major European banks, and provides a good basis for the migration to the new Basel standards. Nonetheless, it is likely that the sector will have to take additional steps. One possible obstacle here is the relatively low operating result of Dutch banks compared with other European countries (chart 16), which means there is little scope to reinforce their balance sheets by retaining profits. Cost reductions will be needed in order to improve this situation. 21

23 Box 2: Correlation between loan quality indicators Revenue from lending is the main source of income for banks. In an economic downturn, the quality of the loan portfolio deteriorates; this leads to losses for the bank. Banks accordingly monitor the quality of the lending portfolio very closely, so that they are able to take any necessary steps in good time. Three key indicators of the quality of a bank s lending portfolio are payment arrears, the bank s assessment of the risk that a borrower will not pay (also referred to as the probability of default (PD)) and the provisions formed. Banks estimate the PD using internal forecasting models. Provisions are intended to accommodate losses if customers are unable to meet their obligations. The intuitive correlation between these credit indicators is that the (forward-looking) PD predicts the payment arrears and that the payment arrears together with the expected proceeds e.g. from the sale of the collateral determine the level of the provisions. Chart 14 Loan quality In percentages Corporate loans Retail loans Weighted average risk of default Weighted average ratio of provisions to exposure I 08 II III IV I 09 II III IV I 08 II III IV I 09 II III IV Weighted average ratio of payment arrears exceeding 90 days to exposure Note: All averages are weighted by exposures. Calculations based on changing composition of banks in connection with availability of data. Source: DNB. Analysis of the trend in these indicators reveals that payment arrears rose on all portfolios during the crisis (chart 14). The average payment arrears in the corporate portfolio rose by over 1% to around 4% in , higher than the PD estimated by the banks. The increase in provisions anticipates the rise in payment arrears and has flattened off considerably since the second quarter of Payment arrears in the retail portfolio remained below 1%, much lower than the estimated PD. requires strengthening of capital and liquidity buffers In order to meet the liquidity requirements, it is also important that Dutch banks have good access to the capital markets. Historically, Dutch financial institutions have made relatively wide use of the markets for securitisations and mortgage bonds. After virtually grinding to a halt during the crisis, these markets have shown some recovery recently. However, the market climate remains fragile. Investor demand for mortgage bonds currently depends on the degree to which newly issued paper meets regulatory and market standards. It is therefore becoming more and more important that banks ensure that new issues meet these standards. 22