Financial Stability Review, January 2018
The Governing Board of the Bank of Slovenia discussed the January 2018 Financial Stability Review1.
Since the previous Financial Stability Review of June 2017, there has been no change in risks in the financial sector to a degree that would significantly endanger financial stability. Income risk remains among the most significant risks, and is being maintained by the low interest rate environment and the adaptation of banks’ business models to this environment. The growing maturity mismatch between the banks’ assets and liabilities represents a risk to the stability of their funding, which could increase sharply in the event of shocks in the financial sector and the real sector. The rapid growth in prices on the real estate market demands careful monitoring of the potential increase in excessive risks that could endanger the stability of the banking system and the financial system. The sustained low interest rate environment and rising business optimism are increasing investors’ willingness to take up higher risks. Investors’ quest for higher returns is being reflected in growth in real estate prices, growth in prices of certain financial assets, and the appearance of new financial forms such as virtual currencies, which are attracting new speculative investments. A warning about the latter was issued in the autumn of 2017 by the Financial Stability Board, which emphasised that virtual currencies and cryptocurrencies are not backed by any government institution or central bank, and that stakeholders in virtual currency and token schemes that facilitate purchase, storage or trading in Slovenia are not subject to systemic regulation and supervision. On 18 January 2018 the Bank of Slovenia also published a document entitled Frequently asked questions and answers about virtual currencies on its website, which is helping to raise awareness among potential investors in virtual currencies.
Generating income in the low interest rate environment will remain a challenge for the banks in the future. Profitability has been positive since 2015, and is rising, albeit based on growth in short-term factors. Non-interest income has increased in recent years, generally as a result of one-off developments, and has not succeeded in fully compensating for the decline in net interest income. The decline in operating costs has come to an end after several years. Net releases of impairments and provisions over the first eleven months of last year had a positive impact on the operating result. However, the release of impairments and provisions as a result of the intensive resolution of non-performing claims at banks and the improved economic situation will gradually disappear. Higher credit growth will require the renewed creation of additional impairments and provisions. The most important source of bank income (net interest income) continued to decline in magnitude in 2017. The net interest margin stood at 1.82% in September 2017, its lowest level to date.
Bank income is gradually beginning to strengthen with the revival in lending activity. Growth in net interest income was still negative in November, but the continuing increase in credit activity will contribute to a gradual increase in interest income. At the same time pressure on income is being maintained by the simultaneous maturing of higher-yielding securities issued in the past, which in the current situation banks can only replace with lower-yielding securities. Slovenia government bonds still account for fully 47% of investments in securities, although the figure is down significantly on previous years. The smaller stock of securities in the banks’ portfolio and the decline in average yield are significantly reducing interest income from this segment of assets.
The period of several years of contraction in bank credit activity came to an end at the end of 2016. Growth in corporate loans saw the total aggregate of loans to the non-banking sector begin to increase. Lending strengthened more in the household segment than in the corporate segment in 2017 in terms of both volume and pace. Growth in household loans was highest in the consumer loans segment. The previous decline over several years meant that they nevertheless remained down a fifth on 2008 to 2010. Housing loans increased for the majority of the year at a stable rate of growth of just over 5%. Despite the relatively rapid growth in borrowing at banks, household indebtedness indicators remain favourable, and are still lower than in previous years. According to available data, the banks have remained within the boundaries of the Bank of Slovenia recommendations in the approval of housing loans. The banks maintained their credit standards at the high levels previously attained. From the perspective of the banks, growth in prices on the real estate market is not giving rise to any excessive risk for the moment.
The risk to the banking system could increase in the event of a sharp price reversal in the real estate market, which could bring a deterioration in the coverage of claims by real estate collateral. Credit risk at banks could also increase as a result of the increased supply of long-term loans with exceptionally low interest rates, if the risk premiums fail to reflect the long-term credit risks. Credit protection for consumer loans in its current form of insurance with insurers is being abandoned at certain banks, primarily on account of shorter approval procedures. Instead banks are raising the premiums on interest rates. Whether the higher interest rates adequately reflect the increased credit risk taken up depends on the adequacy of credit risk assessment at the banks.
Generating income from corporate lending is a process with more uncertainties than household lending. The factors that could support this process include increased corporate demand for loans for investment and for current operations, and reduced indebtedness in the rest of the world, particularly at foreign banks. The smaller stock of debt and low interest rates mean that corporates are significantly less burdened by servicing debt from past loans primarily concluded with variable interest rates. The ratio of interest paid to corporate operating surplus declined from 20% in 2009 to 3%, thereby releasing a proportion of corporate income for financing investment. Corporate expectations of more favourable financing conditions at banks with regard to the level of interest rates and collateral requirements also increased. The banks’ efforts to increase return on investments and grow market share in corporate lending cannot be allowed to bring a reduction in credit standards, irrespective of the favourable forecasts of a continuation of the good climate in the coming years.
As a result of the lengthening maturity of fixed-rate loans, the difference between the average repricing periods for banks’ asset and liability interest rates is widening on all types of loan. According to the latest stress tests, the banks are managing interest rate risk well by means of appropriate measures. The lengthening of the average maturity of assets in the context of short funding maturities, particularly on deposits by the non-banking sector, means that the risk to financial stability remains among the most significant risks in the banking system.
Maturity transformation is part of the banks’ regular management of assets and liabilities, but in the current conditions of a rising proportion of long-term investments and extremely short deposit maturity, it is uncertain what the actual stability of sight deposits is. In conditions of normalising interest rates, i.e. a rise, there is an increased likelihood of deposit switching between banks, and thus a need for greater liquidity. The proportion of sight deposits, which is highly above average and still rising, is reducing the stability of bank funding in the event of a rise in interest rates and one-off developments that are less likely.
Households increased their holdings of investment funds in 2017, particularly equity funds and mixed funds, and thus indicated greater willingness to take up risk than in previous years. That their net inflows into mutual funds reached only 10% of the net flow of assets into sight deposits at banks is testimony to the high level of conservativeness.
Despite the growth in borrowing at banks, households maintained a low level of indebtedness, which actually declined in the wake of simultaneous growth in GDP and disposable income. The credit risk of this part of the portfolio at banks remains low. The faster growth in the banks’ exposure to households than in other client segments is further improving the average quality of the portfolio. Credit risk at banks declined in 2017, partly as a result of the active resolution of non-performing claims and the improved economic situation.
Upgradings are increasing in the corporate segment, but there nevertheless remain corporate segments that are still a heavy burden on bank balance sheets. This is particularly the case of claims against firms in bankruptcy, which have declined sharply in absolute terms, but in relative terms represent an increasing proportion of the banks’ remaining non-performing claims. Individual sectors are still notable for being more heavily burdened by non-performing claims, but the balanced development of the economy, both the part based on domestic demand and the part based on export demand, is a sound basis for their further autonomous improvement in all sectors.
Bank liquidity was favourable in 2017. Secondary liquidity strengthened. The change in asset structure, where the proportion accounted for by investments in Slovenian government securities is declining, is reducing the average return on investments in securities. The banks remain strong in capital terms, with a slight decline in the total capital ratio in 2017. Increased lending is increasing the amount of capital requirements. The net profit also brought an increase in regulatory capital in 2017, albeit less than the increase in capital requirements. Ongoing credit growth will also raise risk-weighted assets, and thus the pressure on capital adequacy.
Positive trends are continuing in other segments of the financial system. The volume of business is increasing at leasing companies, particularly in the area of real estate leasing; performance and investment quality are also improving. Under the influence of economic growth, confidence is also increasing in the insurance market, which is being reflected in a gradual increase in gross premium written in all classes of insurance. The capital adequacy of insurance corporations remains at a high level.
Prices on stock exchanges are continuing to rise without major corrections. The majority of global stock indices have already sharply exceeded their highs from the pre-crisis period. The optimism is also being reflected in the domestic capital market, with increased investments in domestic mutual funds by households in particular, and increased investment in foreign bonds by banks, insurance corporations and pension funds.