BANKING CRISES LESSONS FROM THE SWEDISH EXPERIENCE

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BANKING CRISES LESSONS FROM THE SWEDISH
EXPERIENCE

• Klas Eklund, SEB
• Istanbul, June 22, 2001

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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

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Frequent financial crises

• 75 of IMF members have experienced financial
  crises in the past 15-20 years
• Latin America in the 1980s
• American SL 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

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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 non-financial
  firms as they can defer a crisis

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Effects of a banking crisis

• The real economy is hurt by macro-economic
  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

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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

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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
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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

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Resolution costsFiscal and quasi-fiscal outlays
as share of GDP, .
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THE SWEDISH CASE
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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

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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

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Sweden Indicators
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Lending to non-bank public 1970-1997
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Banks earnings and losses 1990-97
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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

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The recipe

• 1. State depositors and credit guarantee
• political consensus
• 2. All-encompassing work-out process
• government-controlled, but with foreign and
  private experts

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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
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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

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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

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Three main cases
Capital ratio
No help
Temporary help
Close down
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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

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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

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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

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WHAT HAVE WE LEARNT?
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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 there1. Thorough evaluation of
  assets and liabilities2. Split into good
  and bad banks3. Do not protect owners or managers

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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

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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

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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

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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

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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

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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

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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