Credit premia also increased for other fixed income instruments, such as conventional mortgage bonds, corporate bonds and loans to emerging markets, from summer 2007, although on a far more moderate scale than for subprime-backed securities. In the last half of July, the turbulence spread to other financial market segments. The risk premium required by investors rose, and equity prices fell sharply. The contagion was due to uncertainty as to the risk subprime-backed financial products represented for the financial system, and to a lack of information about who had invested in such products. Conduits and Structured Investment Vehicles (SIVs) were among the investor groups investing in the financial products based on subprime mortgages. As a rule, these investment companies were wholly or partially owned by banks. They invested in assets with a high rating, such as the senior tranche in subprime-backed securities. These investments were debt-financed, primarily in the short-term money market through asset-backed commercial paper (ABCP). High ratings on these assets gave investment companies favourable funding rates. Due to the turbulence in the subprime market, interest rates for ABCP have risen sharply and maturities have been reduced. The flow of money to investment companies through money markets has dried up. Banks have to a large extent had to finance the investment companies themselves. However, this increases banks’ liquidity requirements. There have been examples of banks that did not have the capacity to finance their investment companies.
Combined with higher interest rates, this may reduce profitability in the commercial property market, increasing banks’ losses. Losses on loans to the property industry accounted for a large share of banks’ loan losses during the banking crisis. Outlook for the banking industry Banks in Norway have experienced extremely favourable developments over the past few years: strong lending growth, minimal loan losses, high returns in securities markets and firm cost control. Despite lower interest margins, banks’ net interest income in NOK is rising as a result of strong lending growth. Measured in relation to total assets, however, net interest income is  6  BIS Review 100/2007  falling. In recent years, this has been offset by a reduction in costs. Today’s high debt growth is not sustainable over time, and it is unlikely that the pressure on interest margins will abate. Given these developments, banks must reduce costs or increase income from other sources if they are to maintain their current profitability. To illustrate the effect of lower lending growth on banks’ income, we have carried out a simple calculation where the interest margin is held constant. If lending growth among banks had only been 3 per cent in 2006, banks’ net interest income and pre-tax results would both have been approximately 6 per cent lower this year. The composition of banks’ income has been fairly stable in the past ten years, even though net interest income has become less important since 2002.