BANKING CRISES LESSONS FROM THE SWEDISH EXPERIENCE

1. BANKING CRISES LESSONS FROM THE SWEDISH EXPERIENCE Klas Eklund, SEB Istanbul, June 22, 2001

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. Resolution costsFiscal and quasi-fiscal outlays as share of GDP, %.

10. THE SWEDISH CASE

11. 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

12. 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

13. Sweden: Indicators

14. Lending to non-bank public 1970-1997

15. Banks’ earnings and losses 1990-97

16. 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

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

18. 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

19. 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

20. 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

21. Three main cases Capital ratio No help Temporary help Close down

22. 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

23. 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

24. 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

25. WHAT HAVE WE LEARNT?

26. 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 liabilities2. Split into good and bad banks3. Do not protect owners or managers

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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