DNB - Overview of Financial Stability

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Overview ofFinancial Stability

Autumn 2012


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De Nederlandsche Bank

Autumn 2012 , no. 16

Over view ofFinancial Stability


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2012 De Nederlandsche Bank NV

Edition: 400

This document uses data available up to 21 September 2012, unless stated otherwise.Country abbreviations according to ISO norm.

Publication and multiplication for educational and non-commercial purposes is allowed,

with acknowledgement.

Westeinde 1, 1017 ZN Amsterdam PO Box 98, 1000 AB Amsterdam, the NetherlandsTelephone (+31) 20 524 91 11 Telefax (+31) 20 524 25 00Website: www.dnb.nl


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Contents

Foreword 5

1 Overview of financial stability 7

2 Banking Union 13

3 Stronger capital buffers at banks 17

4 Commercial real estate 23

Country abbreviations 28


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5

Overview of Financial Stability

Foreword

DNB monitors financial stability in the Netherlands, expressly considering theinteraction between financial institutions and their environment: other institutions,financial markets and the financial infrastructure. As part of its macroprudentialpolicy, DNB publishes the Overview of Financial Stability (OFS) twice a year.

The OFS outlines risks that impact groups of institutions or entire sectors as wellas the Dutch financial system and could eventually disrupt the economy. DNBdraws up the OFS to raise awareness of these risks among stakeholders financial

institutions, policymakers and the public.

The OFS contains no forecasts, but analyses scenarios. DNB aims to present thebest possible risk analysis of potential future threats based on current knowledge.Where possible, DNB makes proposals for risk-mitigating policies. The analyses andrecommendations in the OFS present institutions and policymakers with insightsinto ways of reducing the effects of shocks in the financial system. This forms thefirst line of defence in safeguarding financial stability.


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1 Overview of financial stability

This chapter describes the main risks to the Netherlands financial stability. The riskmap below presents a graphic summary of these risks. Colours denote groups of riskswith an extremely strong interaction and dotted lines indicate the correlation betweenrisks. The overview of financial stability gives rise to the following priorities and recom-mendations.

The European debt crisis rages on. Problems at banks engender problems in

governments, and vice versa. An effective banking union would break this spi-

ral.

Dutch banks are making good progress towards Basel III compliance. However,

their scope for absorbing setbacks as they advance towards this goal and their

access to the capital market are limited. Moreover, their leverage ratios need

to be improved. This leaves most banks with almost no room to pay dividends.

Market parties must be able to trust the accuracy of commercial real estate

valuations by Dutch banks. Real estate appraisals must therefore be sufficient-

ly up to date and of high quality. Negative factors such as vacancy rates and

falling prices must be allowed for.

Interaction betweengrowth and debt

sustainability

Addiction tolow-interestenvironment

Insufficient

strengthening ofcapital buffers

Risk ofcommercial real

estate losses

Diminishingtrust in financial

institutions

Weakening ofthe Dutch public

finances

Funding risk forbanks

Segmen-tation

within themonetary

union

Risks in thehousingmarket

Further escalation ofEuropean debt crisis

International financialstability risks

Stability risks for theDutch financial system

Slow burningFast burning

Risks for financialinstitutions

Risk oflosses onperipheralexposures


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Debt crisis

The European debt crisis constitutes the greatest and most urgent threat to the

Netherlands financial stability (Chapter 2). Collapsing trust in vulnerable countriesleads to segmentation of financial markets and capital flight. One key element inthe European crisis is the negative interaction between banks and government. To

reverse the downward spiral, the euro countries must improve the structure andgovernance of the currency union; it is essential that the arrangements made tocreate an effective banking union are properly executed. Further escalation of thecrisis could culminate in substantial credit losses for Dutch financial institutionsand sharply rising costs for the Dutch State.

There is a dangerous interplay between the crisis and the gloomy economic outlook

in the euro area. The economy of the euro area has been weak for five years, andcontracted by 0.4% in the past year. Uncertainty about the outcome of the crisis isundermining consumer and producer confidence. While households and govern-ments are seeking to reduce their debts and are cutting their spending, disappointing

growth is frustrating their efforts to restore their balance sheets. Meanwhile, creditrisks for European banks are worsening.

Persistent uncertainty causes capital market volatility and creates the risk of sudden

shocks. Risk premiums on assets that are considered not to be safe have risen whileinterest rate levels in relatively safe countries have fallen. This reflects the prevailingsupply and demand tensions. Since the outbreak of the crisis, investors have becomehighly risk-averse and the quantity of perceived risk-free paper has steadily declined.Trading volumes are depressed. In this environment, any turn in sentiment cantrigger abrupt market corrections. On the one hand, a further deepening of the debtcrisis could cause investors to suddenly shed assets they currently perceive as safe.On the other hand, however, hopeful signs might prompt investors to anticipate

diminishing tensions in the euro area, which would cause price corrections. Theseand other developments could spark unexpected rises in interest rates and falls inmarket values of assets that are currently regarded as safe.

European banks are insufficiently successful in regaining market trust and depend

on cheap central bank funding. The ECB has largely taken over the role of theinterbank market at European level and counters the rising tensions in financialmarkets through low policy rates and relaxed liquidity conditions. Trust in thebanking sector must be restored to break this pattern. To this end, weak banks needto improve their capital position as rapidly as possible, provide transparency onpossible losses and restructure their operations where necessary. Mistrust is fed bythe risk that banks will continue to refinance bad assets on relatively soft conditions

instead of taking losses.

The ECB has announced new policy supporting further government bond pur-

chases subject to strict conditions, in order to ease rising tensions. The new policyhas put a definite stop to the former securities markets programme(SMP), in whichthe ECB intervened in the secondary government bond market through supportbuying, and replaced it with a new outright monetary transactions(OMT) programme,aimed at safeguarding monetary transmission. One major improvement of the OMTcompared to the SMP is that support buying can now only take place if countriescommit and adhere to a macro-economic reform programme. Though necessary,this condition is not sufficient in itself. Interventions must also be justified from a

monetary policy perspective. Moreover, the support buying is limited in principleto paper with a maximum term of three years. The ECBs measures have brokenthe self-reinforcing spiral of rising interest rates in peripheral countries. However,the ECB cannot resolve the crisis. That is a task for the authorities. In imposing


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strict conditions, the OMT introduces the correct incentives to stimulate moves inthis direction.

The Dutch financial system

Partly thanks to the ECBs actions, the acute stress in financial markets that are

important to the Netherlands has eased over the past months. At the end of 2011,stress levels shot up when the funding difficulties of weak European banks translatedinto acute systemic risk. This can be seen in the pattern of the financial stress index,which measures pressure on four markets that are important to the Netherlands

(Chart 1). Since the ECBs interventions in the bank funding market, stress levelshave decreased to a point comparable to one year ago, notably due to falling stressscores for the environment of Dutch banks.

Dutch banks need to improve their shock resilience by further reinforcing their

capital buffers (Chapter 3). Though banks are able retain a large portion of theirprofits, the sectors capital ratio is only rising slowly (Chart 2). One reason is thatmounting credit losses are putting profits under pressure. The risk-weighted coreTier 1 capital ratios currently meet international standards, but the leverage remains

Chart 2 Buffers of the Dutch banking sector

In percentages of risk-weighted assets and total assets, EUR billion (right-hand scale).

14 105

100

95

90

85

80

75

70

12 CT1 ratio

Leverage ratio(inverse ofleverage)

CT1 capital(right-handscale)

10

8

6

4

2

0

08 09 10 11 12

CT1 ratio = core Tier 1 capital / risk-weighted assets (incl. Basel I floor) 100.Leverage ratio = core Tier 1 capital / total assets 100.Core Tier 1 capital in EUR billion (right-hand scale)Source: DNB.

Chart 1 Financial stress index for the Netherlands

1-1-2000 to 28-9-2012.

Long Term Recent developments

10 6

8 5

6 4

4 3

2 2

0 1

-2 0

00 01 02 03 04 05 06 07 08 09 10 11 12 Jan.10

July Jan.11

July Jan.12

July

The stress index consists of sub-indicators for the Dutch bond, equity and currency markets, and several markets that areof specific importance to the Dutch banking sector.Sources: Thomson Datastream, Bloomberg, Euronext and DNB calculations.

First support packagefor Greece

Dotcom crisis

LehmanBankruptcy

LTROs


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high and financiers are keeping a critical eye on the risk weighting. One positiveaspect is that Dutch banks are able to improve their capital ratios by increasing theirequity position in particular.

Capital buffers are particularly important for Dutch banks because of their strong

dependence on market funding. The domestic deposit funding gap the percentage

of loans that banks are unable to fund with received deposits is narrowing slightlythanks to the growth in savings, but remains large (Chart 3a). Dependence on marketfunding makes Dutch banks vulnerable to loss of trust. Banks are reviewing theirfunding profile in the light of the adverse market sentiment. While banks clearlyneed to reduce their dependence on market funding, this can only be achieved inthe long term as it will require major balance sheet adjustments. In the meantime,a strong capital position will help to bolster trust in banks and promote their accessto the funding market. Moreover, capital is also a stable source of funding in itsown right.

To limit the uncertainty for financiers, banks are issuing more covered bonds, thus

tying up a growing share of their balance sheets. This means that banks providecollateral to a select group of covered financiers at the expense of other creditors.Though differences exist between institutions, the tied-up assets of Dutch banksaverage about 14%, which is low from an international perspective. However, Dutchbanks depend more strongly on uncovered market funding. If the trend towardstying up more assets continues, uncovered creditors will become less willing toprovide funding, which may result in rising uncovered funding costs.

Tensions in funding markets are preventing Dutch banks from passing on the his-

torically low risk-free interest rates to debtors. Market parties perceive greater riskssince the onset of the crisis and are demanding appropriate compensation. Thisis visible in the rising CDS spreads (i.e. the price of default protection). In the

Netherlands, where the deposit funding gap is significant, savings interest rates arehigher than elsewhere a sign of strong competition in the savings market. Despitethe recent marginal fall in Dutch savings rates, the difference with other countrieshas generally widened further during the crisis. High borrowing costs mean thatlending interest rates cannot follow the low risk-free interest rates (Chart 3b). Higherlending rates, in turn, constrain the demand for credit.

Chart 3a Deposit funding gap in the Netherlands

EUR billion.

500

450

Depositfundinggap

400

350

300

04 05 06 07 08 09 10 11 12

The year 2012 shows the Q2 2012 figure; all other years are year-end figures.Source: DNB.

Chart 3b Lending rate and funding costs

In percentages, for 1-5 year fixed-rate new loans.

7

6 Mortgageinterest rate

Corporateloans

CDS spreadon top ofrisk-freeinterest rate

Risk-freeinterest rate

5

4

3

2

1

0

03 04 05 06 07 08 09 10 11 12

Pink area constitutes a proxy for funding costs.The swap rate has been used as the risk-free interest rate.The CDS spread is the unweighted average of large Dutch banks.Sources: DNB and Thomson Datastream.


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Though Dutch banks are not scaling down their domestic activities, credit growth

is below the long-term trend (Chart 4). This declining credit growth follows yearsof exuberant lending. Deleveraging is virtually inevitable and is also desirable, par-ticularly for households. The decelerating growth rate cannot be seen separatelyfrom the weak economic recovery and the faltering housing market. In addition,banks have an incentive not to accommodate demand for credit in order to improve

their capital ratios. Any pick-up in credit demand will exacerbate this tension. Theposition of small and medium-sized enterprises (SMEs), which pose a relativelysubstantial credit risk, is less favourable than that of large companies. The pricedifference between small and large credits is widening and the Bank Lending Surveyshows that on balance, credit conditions have tightened more for the SME sectorthan for large corporations. Moreover, unlike their larger counterparts, SMEs havevirtually no direct access to the capital market.

Rising credit losses put buffer build-up under pressure, which is impeding access to

funding. Losses on corporate, commercial real estate and mortgage loans are risingand loan provisioning by banks has multiplied fivefold compared to the pre-crisis

situation. This is depressing any profit that can be added to the equity. Concernsamong financiers about the credit quality of portfolios may make it more difficultto raise both covered and uncovered funding.

The losses on commercial real estate are a source of concern within the loan portfolio

(Chapter 4). The outstanding loans of banks to Dutch real estate parties amount tojust under EUR 80 billion. Losses are growing and the current provisions, totallingclose to 2% of the portfolio, are insufficient to absorb large losses. Alongside directrisks on loans to real estate parties, banks are also exposed to indirect risks as a resultof the situation in this market. One such risk is that real estate is often providedas collateral for other loans. Appraisals of collateralised real estate are often olderthan one year and, in addition, it is sometimes difficult to determine the market

value of properties. In the current environment banks that base their valuations onoutdated or inaccurate appraisals underestimate the risk facing their loan portfolios,particularly in view of the recent decline in values and the high vacancy rates.

Mortgage loan losses are rising, but are still very limited as a percentage of the port-

folio. Due to the falling house prices and high loans, the homes of an estimated 20%of Dutch homeowners are worth less than their outstanding mortgage loans. Since2005, payment arrears have been rising without interruption and are concentratedamong loans that are high relative to the value of the collateral. The number of cases

Chart 4 Credit development in the Netherlands

Ratios in percentages of GDP; Trend deviation = actual trend; Q1 1970 to Q1 2012.

225 20

200 15 Trenddeviation(right-handscale)

Credit/GDPratio: trend

Credit/GDPratio: actual

175 10

150 5

125 0

100 -5

75 -10

50 -15

25 -20

70 75 80 85 90 95 00 05 10

Trend is calculated using an HP filter with =400,000.Sources: IMF, Statistics Netherlands, DNB and own calculations.


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where payment arrears ultimately lead to foreclosure sales is also growing, as are thecredit losses for banks (Chart 5). Expressed as a percentage of the overall portfolio,however, these losses are only eight basis points, which is still very limited.

Dutch mortgage debt is high and debt reduction is vital for financial stability. Dueto tax incentives that encouraged mortgage debt and discouraged repayments,households have become more vulnerable and banks are facing funding problems.The proposed policy changes will partly remove the tax incentive that discouragesmortgage loan repayments and is therefore to be welcomed. Looking to the longterm, it is desirable to eliminate all tax incentives for taking on debt. For financialstability reasons, a gradual introduction is necessary to prevent substantial and

abrupt price adjustments.

Five years of economic crisis have severely undermined public finances as well

as confidence in the economy and financial institutions. Public debt is rising fast,while GDP growth has fallen off. The gloomy economic prospects are depressingconsumer confidence. Trust in the financial sector is also low, as is evident from theresponse in the DNB Household Survey regarding the attitude towards banks, insur-ers and pension funds. Alongside the ongoing stream of bad news, incidents suchas credit losses on complex financial products, the prolonged unit-linked insurancescandal and, more recently, the global LIBOR scandal have further dented trustin the sector. It is important for institutions and policymakers to continue theirefforts to restore trust. This calls for action on several fronts: government, financial

institutions and households must rebuild their buffers and balance sheets; banksmust continue funding profitable investments; and effective European bankingsupervision must be put in place.

Chart 5 Mortgage write-downs

Write-downs as a percentage of total home mortgage lending by Dutch banks (domestic bankingoperations).

0.08%

Total

Extrapolationbased onannual trend

0.06%

0.04%

0.02%

0.00%

03 04 05 06 07 08 09 10 11 12

Relates to mortgages of Dutch households.Source: DNB Monetary statistics.


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2 Banking Union

Unrest has already dominated the currency union for three years. Loss of trust has ledto capital flight and segmentation of financial markets. One crucial element in the debtcrisis is the negative interaction between banks and governments. The combination ofstrict European supervision, European safety nets and the European resolution wouldhelp to break the close intertwining between banks and governments. It is therefore essen-tial that the arrangements to create an effective banking union are properly executed.This will help to rebuild trust in the overall European banking sector and reinforce theinternal market.

In the years preceding the crisis, European economies and financial markets becameincreasingly integrated. However, the responsibility for fiscal policy and bankingsupervision has remained in national hands. At the end of 2011, member statesresponded to the pressures of the crisis by tightening up their mutual agreementsfor preventing public finance imbalances. The agreement reached at the euro areasummit in June 2012 for the creation of a banking union is a logical step forwards,and will also help to strengthen the financial sector in the currency union.

Problems at banks can have severe consequences for a governments debt positionand the countrys financial stability. This became manifest in Ireland in 2010 and inSpain in 2011. The reverse occurred in Greece, Portugal and Italy, where weak public

finances infected the balance sheets of national banks with heavy exposures to thenational public debt. Ultimately, a vicious circle between banks and governmentsserved to deepen the problems in all these countries. As banks in other memberstates also have exposures to these countries, there is a risk of contagion to theentire currency union.

The collapse of trust in the peripheral countries has led to segmentation of finan-cial markets and capital flight. Foreign financiers are reducing their exposures toperipheral countries while residents are transferring their deposits elsewhere. Withsources of foreign finance rapidly drying up, peripheral governments are placingfar more government bonds with the domestic banks. The peripheral banks areabsorbing both their governments financing requirements and the flight of savers

and investors by borrowing more from the national central bank against collateral.

This process results in rising obligations of peripheral central banks to the ECBin the form of the so-called Target2 balances. By contrast, in high-rated countriesclaims of central banks against the ECB are rising: on balance, private banks inthese countries receive more savings and market funding. In normal conditions, dif-ferences between obligations and claims are adjusted through the interbank market,but since the onset of the crisis, a long-term imbalance has arisen due to capitalflight (Chart 6). The capital flight is thus predominantly borne by the euro system,which has largely taken over the role of the European interbank market.

An effective banking union is one way of countering the negative interactionbetween banks and authorities and calling a halt to capital flight. The purpose of abanking union is to set up banking supervision, resolution mechanisms and depositand guarantee funds at European level. The aim is to break the close intercon-


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nectedness of banks with national authorities. To this end, the ESM Fund mustrapidly be empowered to offer direct capital support to institutions in countrieswhere the private or public sector is no longer able to bear this burden. The guidingprinciple should be to minimise the costs for the European taxpayer by windingdown the operations of banks that lack a credible business model and to recoverany losses from risk-bearing financiers. An analysis of the banks balance sheets by

an independent party will offer the reassurance that the European safety net is notsaddled with hidden losses.

In addition, the restoration of trust is promoted by developing and structuringthe various required components of the banking union as effectively as possible.The first component is to entrust European supervision to an independent supra-national supervisor. This removes the incentive among national supervisors andgovernments to postpone painful measures for the national banking sector or topaint too rosy a picture of the actual situation. Efforts are currently under way towork out a model that places the supervision with the ECB. Under the currentproposals, this institution will initially exercise supervision over banks that have

received or applied for aid.

But this must be followed as quickly as possible by moves to place all system-relevant banks or groups of banks under the wing of the ECB. These banks consti-tute the greatest risk to the financial stability in the European member states. Thisdoes not exclusively concern large international banks, but also groups of bankswith a strongly interconnected business model and common exposures. The recentexperiences in Spain show that a group of smaller banks can also pose a threat tofinancial stability.

Ultimately, all European banks must become part of a banking union. This will pre-vent differences in the scope of supervision between countries with highly diverse

banking sectors. Countries such as the Netherlands and France have highly concen-trated sectors with large banks. Spain and Germany, by contrast, have a relativelylarge number of small banks (Chart 7). The day-to-day operational supervision canbe delegated to national level in order to take advantage of each countrys expertise,provided that the European supervisor can enforce decisions and retains ultimateresponsibility.

The second component concerns the creation of a credible European resolutionauthority because even European-wide supervision can never entirely rule out thepossibility of bank failure. The resolution authority must strive for solutions that

Chart 6 Net positions in Target2EUR billion.

1,000

DE / NL /LU / FR

GR / IE /IT / PT /ES

750

500

250

0

-250

-500

-750

-1,000

07 08 09 10 11 12

Source: DNB.


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place the costs with the shareholders of banks and, where necessary, creditors butnot with the European governments. The resolution authority must be equippedwith the necessary instruments for this task. Firstly, it must be able to (temporarilyor permanently) transfer assets or liabilities of a troubled bank to a new private party.This makes it possible to split off healthy parts of a bank or to create a bridging bank.Secondly, it must have powers to transfer the shares of a troubled bank to a newparty or to write these shares off. Thirdly, and finally, it should have the option, asan instrument of last resort, to write off debt instruments or to convert these intocapital shares. To implement these instruments, the various member states will needto amend their national legislation.

The third component consists of the formation of resolution and deposit guaranteefunds, ex-antefinanced by European banks themselves to further limit the financialrisks for European governments. Guarantee and resolution funds at European levelare larger than national funds, which means that larger financial problems can besolved without public aid. The European governments will then only act as a safetynet of last resort.

The coordinated development and introduction of these components is vital toachieve credibility and ensure policy consistency. This prevents supervision frombeing lifted to European level without providing effective means of winding upbanks and setting up European safety nets for extreme cases.

Strict requirements for all European banks, based on harmonised European supervi-sory rules, will help to rebuild trust in the European banking sector and improve theoperation of the internal market. A harmonised supervisory framework for Europeanbanks will create consistency and prevent supervision arbitrage. Supervision andresolution will then be in line with the current situation in which many bankshave already been operating at European level for a considerable time. As a smallopen economy with a relatively large banking industry, the Netherlands stands toparticularly benefit from this development.

14098199

133

286194

255

109

510549 183

129159

202109

177301

49174

132362

74

214

33 38 47

Chart 7 Concentration and size of banking sector

In percentages of GDP, year-end 2011

800

Large banks

Other banks

600

400

200

0

IEother

euro

countries

NL AT ES FI FR BE DE PT GR ITeuro

area

Definition of large banks based on participation in the EBA stress test 2011.Sources: Annual reports, Bankscope, EBA and ECB.


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3 Stronger capital buffers at banks

To retain market confidence and improve shock resilience, it is vital for banks to continuestrengthening their capital position. Issuing new capital is difficult in the current marketenvironment, while reinforcing the capital buffers through an aggressive rundown ofactivities would affect the economy. Retention of profits is therefore the most obviousway for Dutch banks to increase their capital buffers. As a consequence, it is importantthat banks build in a margin to be able to absorb any setbacks. However, this leavesmost banks little scope for dividend payments in the coming years.

Need to strengthen capital buffers

In the run-up to the crisis, the Dutch banking sector was increasingly leveraged andthe equity position of banks decreased relative to their activities. With hindsight,the banks overextended themselves, as became clear when the state had to resort tocapital injections and guarantees. Consequently, supervisors and market parties atboth national and international level are calling upon banks to reduce their leverage.

In the first phase of the crisis, the Dutch banking sector considerably bolstered itscapital position, largely with state aid. Since then, capital buffer strengthening hasslowed down. In 2011, repayments and dividend payments to the state limited thesectors ability to strengthen capital buffers. Banks used roughly a third of their

profit to repay the state aid. A further fifth of the profit was swallowed up by defactoobligatory payments on hybrid capital instruments, which had been issued ona large scale prior to the crisis and could be counted as capital subject to certainconditions. On balance, this left just over a third of the profit to strengthen thecapital buffers (Chart 8).

It is positive that banks actually used the remaining profit to improve their capitalposition. In terms of the risk-weighted capital ratio, the Dutch banking sector is

36%

2%

19%

6%

27%

37%

Chart 8 Profit distribution of Dutch banking sector in 2011

In percentages.

Dividend onordinary shares

Dividend onother Tier 1instruments

Dividend paymentsto the state

Repayment ofstate aid

Retained earnings

Figures based on 80% coverage of Dutch banking sector according to balance sheet total.Adjusted for discretionary remuneration payments from profits.Source: DNB.


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among the European front-runners. The average risk weighting in the Netherlandsis low, however. In terms of the unweighted ratio or inverse leverage internation-ally referred to as the leverage ratio the Dutch banking industry is lagging behindthe international competition (Chart 9). In the run-up to the crisis, leverage wasan important predictor of problems. Market parties are therefore looking with anincreasingly critical eye at the leverage of banks. Moreover, the future Basel III

rules, global harmonised capital and liquidity requirements, will impose limits onthe unweighted capital ratio. To satisfy the stricter supervisory requirements andhigher market expectations regarding their capital position, Dutch banks will needto lower their leverage even further in the coming years.

Lending

When buffers are low and the issuance of capital instruments is unattractive, thereis an incentive to improve the capital ratio by reducing assets. Though there hasbeen little or no scaling down of domestic operations by Dutch banks, lending isgrowing a lot less quickly than before the crisis. Incidentally, this deceleration in

credit growth follows years of exuberant lending and cannot be seen separately fromthe weak economic recovery and the muted demand for loans.

Alongside cyclical changes in credit demand, the tightening of lending conditionsis also having an adverse effect on the growth of commercial lending, particularlyin the Netherlands. The squeeze is affecting the small and medium-sized enterprise(SME) sector more than large corporations. The Bank Lending Survey (Chart 10a)shows that the credit acceptance criteria have been broadly tightened for all com-panies since the outbreak of the crisis. However, while the conditions were relaxedslightly for large corporations in 2011, they remained tight for the SME sector, whichposes a greater credit risk. Moreover, in times of constrained bank lending, it is easierfor larger corporations to raise finance in the capital market than for SMEs. All this

Chart 9 Leverage ratio per country

In percentages of total assets, H1 2012.

7

6

5

4

3

2

1

0

US ES IT BE GB NO AU SE NL DK CH FR DE

Leverage ratio = core Tier 1 capital / total assets 100.Based on a sample of large international banks.Source: Interim financial reports.


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translates into widening spreads between small and large loans (Chart 10b). Higherlending rates, in turn, dampen the demand for credit.

The banks have submitted Basel III migration plans outlining how they expectto comply with the new supervisory requirements and the implications for theirstrategy. In these plans, the banks assume that operational growth will be virtuallyzero in real terms for the coming years. If the capital buffer build-up process falters,banks will be unable to accommodate accelerating demand for credit. This limited

availability of credit could, in turn, jeopardise economic growth.

Falling returns

As it is difficult for banks in the current market environment to issue new capital,while any rundown of operations would put lending under further pressure, profitretention is the most obvious way for Dutch banks to strengthen their capitalbuffers. According to their Basel III migration plans, banks are aiming to addEUR 43 billion to their capital buffers up to 2018, which works out at 70% of theestimated cumulative profits. This must be achieved against the background of anuncertain economic climate in which profits are under pressure.

The sector is evidently aware of the challenges it faces and is no longer counting onthe double-digit returns on equity achieved before the crisis, but on more realisticpercentages of around 8%. This reflects the emergence of a new market situationsince the crisis as well as the adoption of more risk-averse business models. Recentfigures confirm the lower returns. In the past five years, return on equity in theDutch banking sector sank from 14% in 2006 to 6% in 2011 (Chart 11). This declineis partly attributable to the higher capital buffers, which depress the return per unitof equity but which also reduce the risks run by providers of equity.

The return on equity has mainly decreased because, on balance, banks are earningless on their assets. Firstly, their financing costs have increased. Since the onset of

the crisis, market parties perceive greater risks and want to be compensated accord-ingly. Secondly, their income from non-core activities is now lower than before.Prior to the crisis, wholesale banking activities were a particularly lucrative line ofbusiness.

Chart 10a Banks acceptance criteria for corporate

loansIn percentage points (relaxation percentage minus tighteningpercentage). Dotted line is estimate for next quarter.

100 Large

corporations

SME sector

50

0

-50

-100

03 04 05 06 07 08 09 10 11 12

A negative percentage indicates a tightening of the acceptance criteria.Sources: DNB en ECB.

Chart 10b Interest rate differential between small and

large corporate loansInterest rate differential, three-month moving average in percentagepoints.

3,0

2,5 Interest ratedifferential

2,0

1,5

1,0

0,5

0,0

05 06 07 08 09 10 11 12

The graph shows the interest rate on small loans minus the interest rate on largeloans. Large loans have a value of more than EUR 1 million.

Source: DNB.

Relaxation

Tightening


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However, since the crisis these have become much less profitable and have beenpartly divested. Finally, the provisions for loans that are past due have also increased.The crisis is making it more difficult for consumers and companies to service theirdebts. In July 2012, the corporate default rate in the Netherlands hit its highest levelin the past ten years. The implication for banks is a higher percentage of bad loans(Chart 12a). As losses mainly increase during recessions, provisions follow a cyclical

pattern (Chart 12b). Following a brief decrease in 2010, banks once again made largeprovisions in the first half of 2012. Provisions make it possible to absorb actual losses,but also depress profits. In a scenario of weak or even falling growth, the pressureon profits is set to increase.

Thanks to higher interest income and greater operational efficiency, banks haveso far succeeded in limiting the fall in profits. Particularly reductions in operatingexpenses still offer scope for improving profitability. Operating expenses of largebanks currently make up about 60% of income, which is around the Europeanaverage, but the most efficient banks show ratios of some 40%.

Further strengthening of capital buffers

The need for further buffer build-up remains for the Dutch banking sector. Alongsidethe future supervisory requirements, the expectations of market parties are also ofcrucial importance. Due to the large deposit funding gap loans that banks do notfund with savings the Dutch banking sector relies on market funding, while marketparties remain extremely nervous.

Judging from their migration plans, the Dutch banks are able to strengthen theircapital buffers without excessively reducing their lending operations. However, theunderlying lending and profit forecasts are surrounded by uncertainties. Write-downs may rise further if economic growth remains low for a protracted period or if

the debt crisis results in fresh losses. And it is precisely when profits are disappointingthat capital markets are difficult to approach. The opportunities for strengtheningthe capital position by selling off business assets are not endless. And capital bufferreinforcement through the aggressive rundown of operations is damaging for the

Decline inreturn on

risk-weightedassets

Decrease in

leverage

Chart 11: Change in return on equity of Dutch banking sector, 2006 2011

In percentage points of Tier 1 capital (for solvency purposes), 2006 2011.

16

14

12

10

8

6

4

2

0

2006 Changes 2011

Tier I capital (for solvency purposes) was used as the measure of equity. Risk-weighted assets include the Basel I floor.Source: DNB.


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economy as a whole. For this reason, it is important for banks to build in sufficientmargin, so that credible progression towards the higher capital buffer requirementscan be sustained even in times of rising loan losses. The upshot is that in the comingyears most banks will have little or no room to pay out dividends.

Chart 12a Non-performing loans in Dutch banking

sector

On a consolidated basis, in percentages of total outstanding loans.

3.5

3.0

2.5

2.0

1.5

1.0

08

Q4

09

Q2 Q4

10

Q2 Q4

11

Q2 Q4

12

Q2

Non-performing loans include impaired loans and loans that are past due morethan 90 days. Based on a representative group of banks.Source: DNB.

Chart 12b Dutch banking provisions and economic

cycle

Moving four-quarterly sum of provisions as a percentage of averagetotal outstanding loans and year-on-year real GDP growth, inpercentages (right-hand scale).

1.4 4,0

1.2 2,0Real GDPgrowth, y-o-y(right-handscale)

Loanprovisioning

1.0 0,0

0.8 -2,0

0.6 -4,0

0.4 -6,0

0.2 -8,0

0.0 -10,0

08

Q4

09

Q1Q2Q3Q4

10

Q1Q2Q3Q4

11

Q1Q2Q3Q4

12

Q1Q2

Sources: DNB and Statistics Netherlands.


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4 Commercial real estate

The commercial real estate market is under pressure: vacancy rates are steadily rising andprices have now been falling for around four years. Within the portfolios of financialinstitutions, the exposures to this market constitute a specific source of concern. One

potential risk is that losses will rise and delay banks efforts to strengthen capitalbuffers. Market parties must be able to trust the accuracy of Dutch banks valuations ofcommercial real estate. That requires sufficient up-to-date and high-quality appraisals.

Market developments

The market for Dutch commercial real estate is highly cyclical (Chart 13). However,the most recent cycle is coinciding with a structural fall in demand for real estate.The gap between supply of and demand for space is widening steadily, particularlyin the office and industrial segments. According to market data, the office vacancyrate is 14%. Factors that are contributing towards the downward trend are the rise ofonline retailing, more flexible use of office buildings and structurally lower labourforce growth. These developments combine to create a persistent supply surplus.

The failure of supply to adjust sufficiently to contracting demand is reflected in thecurrent price falls. Prices in the Dutch commercial real estate market have alreadybeen falling for some four years. In March of this year, prices were 12% below their

last peak in September 2008. There are large differences between market segments,with prices of offices (-20%) and industrial property (-26%) showing particularlysharp falls (Chart 14). The retail sector initially staged a modest recovery, but hassince flattened out.

Chart 13 Commercial real estate price movements and economic cycle

Year-on-year real estate price changes, in percentages, output gap in percentage of potential GDP.

20

15

Output gap

Commercialreal estate10

5

0

-5

-15

77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 08 09 10 11 12

Output gap is the difference between actual and potential GDP expressed as a percentage of potential GDP.Sources: IPD/ROZ and OECD.


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Risks for financial stability

The situation in the real estate market can lead to risks for the financial stability,particularly due to the exposure of banks. Bank loans to Dutch real estate partiesadd up to the substantial amount of almost EUR 80 billion. At the end of 2011,insurers had lent about EUR 11 billion to the Dutch commercial real estate marketwhile pension funds had outstanding loans of about EUR 20 billion. In addition,Dutch financial institutions also hold investments in foreign real estate, totallingover EUR 80 billion.

Insurers and pension funds are mainly invested in a relatively diversified portfolio,with the added comfort that about 50% of these holdings concern comparativelysafe rented housing. The banks exposures, by contrast, largely consist of loans toreal estate companies, funds and property developers. Some individual real estateloans involve substantial amounts, so that large losses may occur. If an individualbank suffers large losses, the need to increase its provisions will impair its ability tobuild up capital buffers (Chapter 2). This risk adds to the existing uncertainty amongfinanciers and capital providers.

Three circumstances are currently contributing towards this. Firstly, defaults oncommercial real estate could potentially rise further due to the poor market condi-tions. According to a sample survey, about 6% of Dutch credits were designated as

non-performing at the end of 2011. On average, the provisions made for these loansare about a quarter of the loan amount. At that moment, therefore, the total provi-sions for absorbing expected losses were slightly less than 1.5% of the outstandingloans. In the first half of 2012, banks added 0.5% of their exposures to the provisions.

The economic situation and the large supply can create a situation where real estateparties find it more difficult to renew rental contracts or can only do so at a lowerrent. The rental contracts for one-eighth of the properties are due to expire withinone year. About one-quarter of the rental contracts have terms longer than fiveyears (Chart 15). If real estate prices fall, real estate companies run an increasingrisk of sinking into an underwater situation as well as the risk of being unable to

meet their financial obligations to the bank due to disappointing rental income.The bank may then be forced to sell the real estate that secured the loan at lowermarket prices. The average value of real estate loans relative to the collateral value(the LTV ratio) is estimated at 70% to 80%, but rises when property values slide. The

Chart 14 Commercial real estate price movements market segments

Year-on-year change, in percentages.

10

5

Retail

Residential

Offices

Industrial

0

-5

-10

-15

01 02 03 04 05 06 07 08 09 10 11 12

Source: IPD/ROZ.


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60% of the real estate loans mature within three years (Chart 19), there is the riskthat not all real estate parties will be able to roll over their loans. On the other hand,banks have an incentive to roll over loans if this helps prevent their customers fromrunning into payment problems. However, banks that continue to finance weakparties will impair the quality of their real estate portfolios.

Finally, the value of real estate also has a direct impact on the borrowing capacityof companies. In this case, falling prices erode the collateral value for future loansand thus undermine the borrowing capacity of companies that have real estate ontheir balance sheets.

The last circumstance concerns the uncertainty about the quality of real estatevaluations. Market parties must be able to trust the accuracy of the Dutch banksvaluations of commercial real estate. These valuations must therefore be sufficientlyup to date and realistic. The frequency of appraisals at banks is generally lower thanat insurers and pension funds. This difference is partly due to the fact that bankstypically use real estate as collateral for loans and keep it off balance sheet. Within a

broad random sample of the banking portfolios, about half the appraisals are morethan one year old (Chart 18). In the case of 10% of the properties, the last appraisalactually pre-dates 2010.

Furthermore, due to the absence of transparency, lack of liquidity and limited com-parability of properties, it is difficult to make an objective valuation of buildings.It is also hard to establish whether recent appraisals allow sufficiently for the pricefalls in the past years.

More realistic valuations

The current market conditions are prompting large downward fluctuations in real

estate values. At the same time, specific characteristics such as location, vacancy andrent discounts are also exerting a strong influence on current values. Though prop-erty prices remain buoyant at some in-demand locations, the number of distressedproperties is growing. These conditions not only call for increased attention for thevaluation processes but closer scrutiny of valuations of commercial real estate thatis affected by the aforementioned problems.

Chart 17 Loan maturity year

In percentages of total commercial real estate loans.

25

20

15

10

5

0

2012 2013 2014 2015 2016 After 2016 Unknown

Relates to Dutch commercial real estate loans.Source: Estimates based on DNB sample.


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If their real estate collateral has probably declined sharply in value, banks must haveit appraised at least once a year by an independent surveyor. Institutions shouldrequire the surveyor to provide a formal statement confirming his independencetowards the customer, to adhere to adequate professional standards and to providea transparent account of the basic assumptions and methods used in the appraisalreport. It is furthermore desirable for the external auditor to devote extra attention

during the audit to appraisals that affect the balance sheet valuations of financ-ings. Banks may only count real estate collateral in full if, among other things, thevaluation meets certain minimum quality requirements. If these conditions are notsatisfied, the loan in question carries a heavier credit risk weighting for solvencycalculation purposes.

Institutions with materially significant real estate portfolios must give extra atten-tion to the valuation risks in respect of these portfolios in their risk and capitalmanagement procedures. Stress tests tailored specifically to these portfolios are anappropriate instrument for this purpose. In order to carry out these stress tests andto ensure proper group-wide risk management, institutions need to keep centralised,

detailed records of their real estate portfolios. This also makes it easier to report tothe supervisor.

Alongside measures aimed at the supervised institutions, DNB together with theNetherlands Authority for the Financial Markets (AFM) also continues to main-tain an active dialogue with parties that can contribute towards a further increase intransparency in this market (access to data and improved communication) as wellas with parties who play a role in enhancing the quality of valuations and valuationprocesses.

Chart 18 Last appraisal year of collateral at banks

In percentages of total commercial real estate loans.

50

40

30

20

10

0

2008 or earlier 2009 2010 2011 2012 Unknown

Relates to Dutch commercial real estate loans.Source: Estimates based on DNB sample.


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Country abbreviations

AT AustriaAU AustraliaBE BelgiumCH SwitzerlandDE GermanyDK DenmarkES SpainFI Finland

FR FranceGB United KingdomGR GreeceIE IrelandIT ItalyLU LuxembourgNL NetherlandsNO NorwayPT PortugalSE SwedenUS United States


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Documents

DNB - Overview of Financial Stability