Indeed, the solvency levels of institutions were not impaired by the faster credit growth because of the increase in Tier 1 and Tier 2 capital. The solvency of institutions was strengthened by the statistical fund, which has grown uninterruptedly since it was created in July 2000. The improvement in earnings and ROE was, as mentioned above, due partly to the high growth in the business volumes of Spanish institutions and especially to lending to mortgage borrowers and to construction and property development firms. In particular, the growth of credit to property developers in 2003 was notable, and was not attributable to just a small number of institutions. It should be taken into account that this lending is markedly cyclical and that in past recessions it has shown high default rates. Moreover, the strong credit growth is an additional cause for concern, basically for two reasons. First, because Spanish household indebtedness is already higher than the euro area average. And second, because the growth of credit extended by institutions is not being accompanied by a commensurate increase in deposits. This produces a greater need for recourse to international financial markets, which may raise the average cost of bank liabilities and hinder profitability gains. BIS Review 39/2004  7  It is therefore not enough to have a strong profit and loss account; instituions must also look particularly hard at the sustainability of their current business model based on strong growth in lending volume, and at the possible alternatives to this model.
These changes include most notably the increasing degree of internationalisation of institutions; the ongoing emergence of more sophisticated and complex new products; the increase in risk transfer processes and, finally, the growing importance of a whole set of risks that not long ago were difficult to quantify. Financial institutions have to respond to these challenges by improving their services to consumers and to society and simultaneously intensifying their efforts in two areas requiring a wide range of actions. First, they have to step up the efforts made to date in designing and implementing robust risk management systems firmly based on corporate governance best practices. In recent years, institutions have become fully aware of their importance and have made considerable headway in this direction, supported by improvements in calculation methods, available technical capabilities and databases, among others. At the same time, they must not neglect the need to invest in human capital, an essential factor in banking. But these investments in technical and human resources - and this is an additional challenge - must not involve any let-up in the pursuit of greater efficiency, which is the key competitive factor in a world of increasingly integrated markets. Financial institutions must therefore redouble their efforts to enhance their capabilities in relation to risk identification and the quantification of committed exposures. They need to design their strategies for managing risk, as well as their capital and liquidity, bearing in mind that economic and financial conditions vary over the cycle.