Are Banks Being Too Risk Averse?

January 21, 2015

Jan-Peter Olters The Kosovo Banker

Even if pouched in complex, quantitative studies, “risk” remains a complex, multi-dimensional, and highly subjective concept that reflects an analyst’s lack of confidence and sense of uncertainty. In this, financial markets are not different from other sectors in the economy. Decision-making processes—especially if they relate to large-scale investments to be realised over a medium- to long-term horizon—are facilitated by an environment, in which the underlying “risk components” can be objectivised, quantified, and tracked over time. This is where functioning markets play such an important role, aggregating individual risk assessments, perceptions, and resultant actions and “translating” them into (accurate) price signals, which will help to increase the effectiveness of economic decisions made in the economy as a whole. In the financial sector, this price signal is the interest rate. Even though reported figures tend to be averages spanning over a wide range of individually relevant prices (typically reported without accompanying standard deviations), they condense important information from market participants in the private and financial sectors.

To take an example, consumer loans in Kosovo, over a one-year period, dropped by about 100 basis points to 11 per cent at the end of the second quarter in 2014. As such, consumer loans cost about 1½ percentage points more than they do in Montenegro, the only other country in the Western Balkans having adopted the euro as sole legal tender, and 6 percentage points more than in Germany, the eurozone’s benchmark economy. Similar differentials apply to the cost of credits for enterprises. This interest rate differential vis-à-vis any benchmark country—be it Germany or Montenegro—reflects the additional “risk premium” that banks perceive and charge on loans. In the Kosovo-specific context, it comprises essentially three types of perceived extra risks, viz., (i) business climate (difficulties faced with collaterals, contract enforcement, and/or property rights); (ii) business conduct (the high degree of informality, and the lack of financial transparency and/or viable business plans); and (iii) the particular challenge faced by foreign-owned banks in Kosovo that their respective headquarters would group them together with troubled banks elsewhere in Eastern Europe and integrate them in corporate deleveraging strategies out of (perceived) high-risk markets. Faced with this particular set of constraints, the banking sector in Kosovo has, in principle, adapted astonishingly well to the environment, in which it operates—focusing its activities on remaining healthy, liquid, profitable, deposit-based, with portfolios that contain only manageable risks.

Against this backdrop, it is apparent why banks in Kosovo have been conservative in their lending decisions; and this prudence has served the sector and the economy well in recent years (especially if compared to the experiences made in neighbouring countries). At the same time, demands on the banking sector—by the public and polity alike—have been increasing to contribute more to the country’s socio-economic development. For any given financial institution to be open to fostering growth and employment generation, there has to be a business case. Within this tension between “micro-economic” and “macro-economic” objectives, there is an underlying question on banks’ optimal degree of risk-taking.

The inherent costs of a banking sector being too willing to take risks are well-understood and—having just witnessed the aftermath of the Global Financial Crisis—well documented. However, the opposite case, when banks are too risk-averse, has similarly clear macro-economic consequences, posing the risk of asphyxiating an economy’s innovation and growth potential. A corresponding “vicious cycle” would start with weak businesses (without proper financial reporting) and unknown start-ups, which leads to considerable hesitation among banks to lend. As a result, banks require high collaterals and high interest rates for credits with short maturities, which leave the private sector with heightened cash-flow management problems and reduced rates of returns on its investments. Such a situation cements firms’ financial vulnerability, leaving them still weak and unattractive to the banking sector and exposed to the risk of exiting the market altogether.

The overarching consideration is thus the following: if a bank is convinced of the economic potential inherent in a client’s business plan, it will benefit from efforts to align repayment/amortisation obligations with the expected turnover and profit profiles. Evidently, a failed business is in nobody’s interest, but it is an outcome that becomes more likely if the combination of high interest rates and short maturities intersects with an ex ante unexpected deceleration of economic growth (for instance, as a result of a protracted political crisis and the ensuing deterioration in overall business confidence). Banks might not see any space (yet) to lower interest rates beyond current levels. However, extending loan maturities alone might be an important step to reducing default risks for a considerable number of corporate clients.

Evidently, demands to the banking sector for lower interest rates and more favourable conditions to the private sector must not come at the expense of increased vulnerability and fragility to the financial sector—the macro-economic costs would be far too high and detrimental to the development objective motivating said requests. But reflections along these lines invite the question of whether it would not also be in the financial sector’s own economic interest to move towards the edge of, or go slightly beyond, its current comfort zone. Market leaders will see it first: unrealised opportunities are costly not only to the country and its citizens’ socio-economic welfare but also to the bank’s own bottom line.