Henrik Braconier, Chief Economist at FI, spoke on risks related to low interest rates at SNS/SHOF’s Finance Panel: Corporate Finance in a Low Interest Rate Environment.
Thanks for the opportunity to participate in the SNS/SHOF Finance Panel on Corporate Finance in a Low Interest Environment.
As we are all aware, we have a prolonged period of falling and low interest rates behind us. On top of this, expectations about future rates are also more subdued than any of us has ever experienced. This development has impacted our economies and raised concerns about financial stability, primarily through rising leverage and increasing risk-taking. While this risk build-up has many dimensions, today I would like to talk about two specific but interrelated issues. The first is the build-up of leverage and risk in the Swedish commercial real estate (CRE) sector. The second is the consequences of the increase in market-based funding within the Swedish corporate sector on stability. And, being a regulator, you will have to excuse me for focusing on the stability aspects of these phenomena.
We all know that lower rates have incentivized corporates to take on more debt. This is by all means a global phenomenon, highlighted just this week in the IMF's Global Financial Stability Report. In Sweden, non-financial firms have increased their debt levels rapidly, from less than 55% of GDP in 2005 to almost 85% in 2019. The rise has been especially sharp since 2015 when interest rates fell to almost zero.
This debt build-up has been particularly pronounced in the CRE sector, where debt has roughly doubled since 2015. Finansinspektionen (FI) has therefore focused in recent years on identifying and addressing vulnerabilities related to the CRE sector.
There are multiple reasons for why developments in the CRE sector are crucial for financial stability. Firstly, CRE is a debt-intensive sector and makes up almost 45% of the total debt of non-financial firms. This makes the sector sensitive to low rates and search-for-yield behaviour. Secondly, CRE is a cyclical sector. Thirdly, problems in the CRE sector often mutate into financial crises and severe economic downturns as, for example, Sweden experienced in the early 1990s. The reason for this is that the real estate sector is strongly interlinked with the banking system.
One indication that risks associated with CRE are rising is that, since the financial crisis, debt has risen faster than (fast-growing) incomes, and, as a result, debt-to-income levels are at an all-time high. While supportive policies so far have cushioned falls in rents, there is clearly a risk that the COVID-19 crisis eventually will drag down rental incomes, pushing debt-to-income further upwards. If funding costs were to rise substantially, this could exacerbate problems in the sector, as interest sensitivity is high.
Our stress tests have also illustrated that the banks have substantial credit risks related to CRE, and their financial cushions in terms of capital requirements have not risen as risks have mounted. Therefore, we decided earlier this year to add an additional Pillar 2 capital requirement for CRE exposures.
Let me now go over to another dimension of how risks are evolving in the low-interest environment and focus on the composition of corporate debt rather than its size. Or, to be more specific, the relative importance of bank loans and market-based financing through bonds.
Credit in Sweden, along with the rest of Europe, has traditionally been (and still is) to a large extent a bank-based business. Still, market-based finance has grown in importance, and the share of corporate debt funded by bank loans has fallen from around 75% to 60% over a period of 15 years.
The growing importance of market-based finance reflects the emergence of a number of trends, including:
-Lower interest rates, which have made it more attractive to invest in corporate bonds than, for example, covered bonds, and
-Tighter banking regulations after the financial crisis to improve banks' insufficient resilience, which has increased the banks' lending costs relative to market-based financing.
So, what does the rising share of market finance in corporate funding imply for financial stability? One viewpoint is the twin-engine approach, which implies that it is better to have two equal-sized funding channels if one of them fails. Specifically, we want the market-based engine to be sufficiently strong and resilient to land the plane even if the banking engine stops working.
How resilient is the market-based engine? Research on the U.S. credit market by Becker and Ivashina (2014) shows that the supply of market-based finance to corporates indeed held up better than bank lending during periods of crisis. Market-based finance also held up better than bank lending to corporates in the euro zone during both the 2008 financial crisis and the 2011 debt crisis. In fact, market-based finance proved sufficiently resilient to maintain positive credit growth despite shrinking bank credit through these troubled times. While it is wrong to suggest that the euro zone landing was in any way smooth, the market-based engine helped to avoid a fatal crash.
What about the Swedish market? In a recently published analysis, my colleagues Mathias Skrutkowski and Madeleine Fredelius worked with Bo Becker and Pontus Angewald Westesson from the Stockholm School of Economics to analyse the corporate credit cycle in Sweden. In contrast to what we have seen in the euro zone, the credit supply from both banks and capital markets fell after the financial crisis. In this case, the market-based engine didn't compensate when bank lending fell. Similar patterns seem to prevail also in other small non-euro zone countries (Switzerland, Czechia, Denmark and Norway).
Micro-level data confirms that the share of financing in Swedish krona from banks to Swedish corporates remained stable during the crisis. However, the share of financing in foreign currency coming from banks demonstrates a procyclical pattern similar to those observed for euro zone corporates, falling below trend in 2008 as well as in 2011. This suggests that it was easier during these periods for Swedish corporates to access capital-market funding in foreign currencies – typically achieved through, for example, emitting EUR-denominated bonds on capital markets in the euro zone – than to obtain foreign currency bank loans.
Anecdotal evidence from the outbreak of the COVID-19 pandemic this spring confirms that the weaknesses in the Swedish market-based engine persist. Emissions in the primary market for corporate bonds fell sharply in March and April 2020 – particularly in the commercial paper segment – whereas credit supply to corporates from the banking sector held up better and more than made up for the shrinking market finance.
So, what lessons can we draw about financial stability from this?
Firstly, improving the resilience of the banking sector since the financial crisis seems to have paid off. Swedish banks have so far been able to increase their credit supply during this crisis, supported by FI's lifting of the countercyclical buffer requirement and additional measures from the Government and the Riksbank.
Secondly, market-based finance needs to become more resilient, too. This may to some extent reflect a need to develop better crisis management tools in this area. For example, the IMF has found evidence that jurisdictions with swing pricing seem to have experienced less pressure on redemptions during the COVID-19 crisis.
Thirdly, Swedish bond markets need to become more resilient. There is no quick fix for this, but better transparency, more liquidity in the market, and a more stable investor base are all likely components of a more resilient market.
Becker, B., and Ivashina, V. (2014). Cyclicality of Credit Supply: Firm Level Evidence. Journal of Monetary Economics, 62, 76–93.
Becker, B., and Ivashina, V. (2018). Financial Repression in the European Sovereign Debt Crisis. Review of Finance, 22(1), 83–115.
Becker, B., Fredelius, M., Skrutkowski, M., and P. Angvald Westesson (2020). Kan obligationsmarknaden dämpa kreditcykeln?, FI Analysis 23, Finansinspektionen. An English summary is available at fi.se.
IMF (2020), Global Financial Stability Report.