BANKING CRISES BANKING CRISES LESSONS FROM THE SWEDISH LESSONS FROM THE SWEDISH

EXPERIENCEEXPERIENCE

Klas Eklund, SEB

Istanbul, June 22, 2001

Financial crisesFinancial 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 crisesFrequent 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 Why are banks important?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

Effects of a banking crisisEffects 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

Factors behind a crisisFactors 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 instabilityMacroeconomic 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 Stability and sound systems go hand in handsystems 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 costsResolution costsFiscal and quasi-fiscal outlays as share of GDP, %.Fiscal and quasi-fiscal outlays as share of GDP, %.

Chile 1981-85Venezuela 1994-95Spain 1977-85

20-401717

Mexico 1994-95Hungary 1987-91Finland 1991-96USA 1980sSweden 1990-93

12-1515-2010-125-74

THE SWEDISH THE SWEDISH CASECASE

The bubble yearsThe 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 burstsThe 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: IndicatorsSweden: Indicators

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

GDP growth 2.3 2.4 1.4 -1.1 -1.4 -2.2 3.3 3.9 1.3 1.8

Current account/GDP

-0.4 -1.8 -3.0 -1.4 -3.5 -2.0 0.4 2.1 2.5 2.8

Domestic creditgrowth

21.9 21.3 15.5 3.3 1.5 -6.0 -3.8 0.7 2.6 6.7

Credit growth toprivate sector

31.3 25.6 16.5 -1.4 1.7 -19 -5.8 -0.7 3.8 15.7

Lending to non-bank public Lending to non-bank public 1970-19971970-1997

0

20

40

60

80

100

120

140

160

Per

cen

t o

f G

DP

Banks’ earnings and losses Banks’ earnings and losses 1990-971990-97

0

1020

30

40

5060

70

80

Mo

vin

g 1

2-m

avera

ge,

Bn

SE

K

Earnings

Credit losses

The eventsThe 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 recipeThe 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 guaranteeThe 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 creditThe guarantee is not directed to a specific creditor”

Important: Political consensus - because of the dangerous situation

Why was the guarantee Why was the guarantee accepted?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 processThe work-out process

• A Bank Support Authority was set up, evaluated all banks:1. Credit portfolios were classified and valued2. Property collateral was valued3. Sensitivity analyses were carried out

• Three solutions identified1. Private solution, owners put up new equity2. Semi-private solution with equity guarantee3. Total restructuring

• The core task: Separate bad loans from good - split bad banks from sound. Create work-out companies

Three main casesThree main cases

Capital ratio

No help

Temporary Temporary helphelp

Close down

The rescueThe 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

ResultsResults

• 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 Why was the rescue successful?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 WHAT HAVE WE LEARNT? LEARNT?

Crises will occur - Crises will occur - but they can be amendedbut 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 liabilities2. Split into good and bad banks3. Do not protect owners or managers

What to do?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?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?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?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 architectureGlobal 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 systemThe 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

ConclusionConclusion

• 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