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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