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BANKING CRISES
LESSONS FROM THE SWEDISH
EXPERIENCE
Klas Eklund, SEB
Istanbul, June 22, 2001
Financial crises
• Currency crisis
• Foreign debt crisis
• Banking crisis
• The ERM crisis in 1992-93: A typical currency crisis
• American savings and loan problems in 1980s: A
banking crisis
• The Asian crisis 1997-98: A combination of
currency, debt and banking crises that occurred
simultaneously
• Turkey 2001: All three components
Frequent financial crises
• 75% of IMF members have experienced
financial crises in the past 15-20 years
–
–
–
–
–
–
Latin America in the 1980s
American S&L crisis 1980s
The Nordic countries 1980s and 90s
South East Asia 1997-99
Brazil 1999
Turkey 2001
• Resolution costs are higher in developing
and transition economies than in
developed countries
Why are banks
important?
• Banks have a special position. A bank
failure - or rumours - can lead to
systemic risk
• Banks transmit financial problems
through maturity/FX mismatches
• Banks can conceal problems by rolling
over bad loans and secure funding by
paying more
• Banks are less transparent than nonfinancial firms as they can defer a crisis
Effects of a banking crisis
• The real economy is hurt by macroeconomic instability, higher credit costs,
credit squeeze and a less efficient
allocation of savings
• Growth will suffer
• Monetary and fiscal policy may have to
accommodate a weak banking sector
• Other countries are effected by contagion
and/or decline in external demand
Factors behind a crisis
• Macroeconomic volatility
– Lending booms
– Maturity/currency mismatches
– Badly prepared or wrongly sequenced
liberalisation
– Rigid exchange rate regimes
• Micro problems
– Weakness in accounting, disclosure and
legal framework
– Fraud
– Political involvement
– Too many eggs in one lending basket
Macroeconomic instability
• Instability more pronounced in emerging
markets due to less diversified economies,
structural rigidities and less developed markets
• Makes them more exposed and less able to
absorb shocks
• Leads to more volatility in exchange rates,
interest rates and terms of trade
The roots of a banking crisis
often lie in bad policies
Stability and sound
systems go hand in hand
• In a financial crisis, causality between
macroeconomic environment and
financial sector soundness runs in both
directions
– Macroeconomic instability weakens financial
institutions
– An unsound financial sector undermines
macroeconomic performance
• Severe external shocks are easier to
overcome in an environment with sound
financial systems
Resolution costs
Fiscal and quasi-fiscal outlays as share of GDP, %.
Chile 1981-85
Venezuela 1994-95
Spain 1977-85
Mexico 1994-95
Hungary 1987-91
Finland 1991-96
USA 1980s
Sweden 1990-93
20-40
17
17
12-15
15-20
10-12
5-7
4
THE SWEDISH
CASE
The bubble years
• Devaluations in 1981-82: High inflation
and rapid wage increases
• Deregulation of domestic credit in 1985
gave an increase of bank lending due to
pent-up credit demand
• Fixed exchange rate blocked monetary
policy, politics blocked fiscal policy
• Result: Credit expansion, overheating,
rising asset prices, business boom, huge
lending to the real estate sector
The bubble bursts
• In 1990, the boom in real estate ended.
Asset prices fell
• Governmental crisis and tighter policy
• Inflation fell, growth turned negative,
unemployment rose
• Tax reform, higher real rates
• The result: A sharp credit contraction,
increasing bank losses
• Problems exacerbated by ERM crisis 1992
• Capital outflow forced tight monetary policy
with high interest rates
• Forced a change of currency regime; the
fixed rate was abandoned
Sweden: Indicators
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
GDP growth
2.3
Current account -0.4
/GDP
Domestic credit 21.9
growth
Credit growth to 31.3
private sector
2.4
1.4
-1.1
-1.4
-2.2
3.3
3.9
1.3
1.8
-1.8
-3.0
-1.4
-3.5
-2.0
0.4
2.1
2.5
2.8
21.3
15.5
3.3
1.5
-6.0
-3.8
0.7
2.6
6.7
25.6
16.5
-1.4
1.7
-19
-5.8
-0.7
3.8
15.7
Lending to non-bank public
1970-1997
160
Per cent of GDP
140
120
100
80
60
40
20
0
Moving 12-m average, Bn SEK
Banks’ earnings and losses
1990-97
80
70
60
50
40
30
20
10
0
90
9
1
Earnings
Credit losses
93 994
9
1
1
97
9
1
The events
• Summer 1990, a major finance company
suspended payments. A liquidity crisis for
commercial papers issued by finance
companies
• Problems spread to banks; two major
banks needed new capital in 1991
• Currency crisis Aug-Sep 1992 caused sharp
rise of key rates
• Dramatic situation. Loss of credibility in
international markets. The stability of the
system at risk in the autumn 1992
The recipe
1. State depositors’ and credit
guarantee
– political consensus
2. All-encompassing work-out
process
– government-controlled, but
with foreign and private
experts
The state bank guarantee
“The state guarantees that banks and certain
other credit institutions can meet their
commitment on a timely basis.
The purpose is to ensure the stability of the
payments system and to safeguard the
supply of credit
The guarantee is not directed to a specific
creditor”
Important: Political consensus - because
of the dangerous situation
Why was the guarantee
accepted?
• Deep and acute crisis in 1992
• Acute loss of credibility
• Dependence on international
borrowing
• Caused risks of a payments
system breakdown
• Rapid measures were necessary
The work-out process
• A Bank Support Authority was set up,
evaluated all banks:
1. Credit portfolios were classified and valued
2. Property collateral was valued
3. Sensitivity analyses were carried out
• Three solutions identified
1. Private solution, owners put up new equity
2. Semi-private solution with equity guarantee
3. Total restructuring
• The core task: Separate bad loans from
good - split bad banks from sound. Create
work-out companies
Three main cases
Capital ratio
No
help
Temporary
help
Close down
The rescue
• The state support consisted of guarantees,
loans and share capital
• It covered all banks with a Swedish charter.
The banks should be able to meet all their
obligations. The guarantee did not cover
share capital and subordinated debt
• Government worked closely with the Bank
Support Agency, the SEC and the Central
Bank.
• The Central Bank made it clear that its role
was limited to supply liquidity to solvent
banks
Results
• Direct costs around 65 bn SEK (4% of
GDP); private owners raised 13 bn in
new equity
• Currency depreciation plus lower rates
created favourable macro background
• Work-out lasted 4 years
• The economic recovery was swifter than
expected
• Costs have been recovered
• The state guarantee was abolished July
1, 1996
Why was the rescue
successful?
• The rescue action came early, was
comprehensive and fully transparent
• Implemented without delay
• Broad political consensus about the
support program
• No nepotism or protection of vested
interests
• Market pricing of bad debt
• Immediate credibility among foreign
investors and creditors
WHAT HAVE WE
LEARNT?
Crises will occur but they can be amended
• Swift deregulation and credit expansion
can cause bubbles
• After bubbles burst swift measures are
needed
• Bank restructuring, political consensus
important
• The tool-box is there:
1. Thorough evaluation of assets and
liabilities
2. Split into good and bad banks
3. Do not protect owners or managers
What to do?
1. Volatility
–
–
–
–
–
–
improve economic fundamentals
pay attention to price stability
allow foreign-owned banks
hedge against risks
increase the banks’ capital base
more prudence in risk taking
2. Mismatches
– high reserve requirements in normal
times
– long term funding in foreign currency
What to do?
3. Lending booms
–
–
–
–
–
improve internal risk controls
strengthen supervision
diversify lending
look at collateral and cash flow
price products according to risk
4. Government involvement
– enhance transparency
– establish an equal playing field for all banks
– public ownership is no guarantee for sound
banking
What to do?
5. Liberalisation
– introduce tough fit and proper tests
– strengthened supervision must precede
liberalisation
6. The framework
– adopt best international practices
– aim for universal banks
7. Exchange rate regime
– apply a sufficiently flexible regime
– do not defend an unsustainable rate
What to do?
8. Incentives for prudence
– strong capital base
– no general bail-out policy
– equity always at risk
9. Fraud
– too many want a banking license
– fit and proper test cannot sort out all criminals
and others that are unfit
– a banking license is not forever
– a good criminal law is important
– law enforcement is a must
Global financial architecture
• International rules and supervision
– Internationally accepted standards for best
practices in the financial sector (banks, securities,
accounting, auditing, asset valuation, corporate
governance )
– More transparency (fiscal and monetary policy,
foreign currency positions in public and private
sector)
– Private sector participation in the prevention and
resolution of financial crises (the role of investors)
• Apply the rules to more than banks
– Banks are financial supermarkets and complex
conglomerates. Non-banks are also becoming too
big to fail
– The moral hazard danger relates not only to banks
The global currency system
• Banking crises often connected to currency crises
• Three tasks for the currency system
– Liquidity
– Stability
– Sovereignty
• But the existing systems cannot fulfil all tasks:
– Target zones and fixed rates block liquidity
– Floating rates do not give stability
– Currency boards and dollarisation do not allow
sovereignty
• The world will move towards fewer currencies
Conclusion
• Several types of financial crises
• Successful solution needs both macro and micro
policies
• The tool-box for solving banking crises is there:
Corporate finance techniques
• Speed, political consensus and honesty are key words
• More transparent international institutions, common
standards
• Monetary union diminishes the risk of currency crises
in Europe. But no option for Turkey today. Qualifying
for the monetary union is a very long process
• Domestic work-out process is priority #1. Long-term
there will be fewer currencies