Mr. Heikenstein discusses the Swedish financial crisis of the early 1990s  (Central Bank Articles and Speeches, 15 Jul 98)
Central bank: riksbank | Type: speech | Date: 1998-07-15

Mr. Heikenstein discusses the Swedish financial crisis of the early 1990s Speech by the Deputy Governor of the Bank of Sweden, Mr. Lars Heikenstein, at a seminar arranged b Swedish embassy held in Seoul, Korea on 15/7/98.Let me begin with a thank you to the organisers of this seminar.

I am honou have the opportunity to share with you some experiences from the Swedish financial crisi early 1990s.

## 1.

IntroductionAn IMF study from 1996 showed that in the past fifteen years, 132 of the Fund' member countries had experienced macroeconomic and/or financial crises.

Today the figure i higher.

Crises are a recurring phenomenon.

In spite of every effort to prevent them, I fea will continue to occur.

We should therefore use the opportunities to learn from each oth order to avoid making the same mistakes and to find the appropriate correctives sooner.Needless to say, there are no single 'best solutions'.

Crisis situations a specific in some respects, not least with regard to their structural and political environm not been specific, they would probably never have occurred because they would have been 'sp in advance.

Having said this, however, there are a number of globally accepted 'truths' a constitutes a good response to crises.Discussions around crisis situations are usually divided into two parts: prevention and crisis management.

In this presentation I will be focusing on the latter.

To the handling of a crisis, it is useful to know which factors generated the problems. narrative will include the events that led up to the crisis in Sweden.

I will also com developments in Asia, with some emphasis on Korea.

Having sketched this background, I wil to the actual handling of crises, explaining why we found certain types of solutions Sweden - leaving it to you to consider whether the same might apply to some extent to your

## 2.

Background

## The macroeconomyFirst, let me say a few words about the macroeconomic background to the cris Sweden.

There are both similarities and differences between Sweden and Asia.

In the foll will touch on some of them.

It should also be remembered that substantial differences a between the Asian countries.One common factor is the fixed exchange rate .

In Sweden this led to high levels of foreign borrowing, particularly in the private sector.

In addition it made it difficult gradual overheating of the economy by applying contractive monetary measures - raising i rates tended to increase capital inflows which, to the extent they were monetised, further to the overheating.Following the deregulation of the domestic financial market, the crisis in Swed also preceded by a rapid expansion of credit ; in the course of five years, private borrowing gr from 85 to 135 % of GDP.

The credit expansion coincided with a protracted boom and a signi proportion of the borrowed money was spent on speculation, both in real estate and in assets, such as equity.

The real estate speculation in Sweden culminated in a bubble th 1990-91.

Shielded by the economic upswing, there had been many misdirected and overly opti investments in various industrial and other projects.In these aspects I find similarities between Sweden in the late 1980s and th countries during the 1990s.

A feature common to Sweden and Korea was, moreover, that domestic financial market was liberalised long before the external capital outflows.

This overheating of the domestic economy could not be adequately balanced by capital outflo investment abroad.But there are also some differences.

Other factors that contributed to Sweden' crisis were a relatively deep international downturn and high interest rates in our part of the world in the wake of German reunion.

On top of this, our fiscal position was more vulnerable , entering the 1990s with a public debt-to-GDP ratio of around 40 per cent.

Sweden's external borrowing ra also high - some 30 per cent of GDP.

Besides reflecting the public budget deficit, this ha an extremely low private savings ratio .

In some years this ratio was actually negative.

The weaknesses made Sweden highly vulnerable to shifts in confidence in our economy.

## The financial sectorThere

were also underlying weaknesses in financial systems.

Let me now turn these.The financial systems had not adapted to the change from a sheltered environment to a deregulated and much more competitive situation.

In the earlier environment, banks had incentive to develop a sophisticated credit culture, involving comprehensive evaluations o projects and collateral. (One important similarity between Sweden and Korea was the overop reliance on collateral and other guarantees, rather than on the viability of the loan p When deregulation was a fact, bank managers saw a chance of gaining market share and incr revenues by taking new risks, but did not clearly see the dangers in a lack of the necessarOne of the major faults in credit decisions in Sweden was that banks le customers, projects and geographical areas of which they did not have sufficient knowledge. major mistake was that banks accepted high-risk concentrations , not just to individual companies but also to economic sectors, primarily real estate, and to geographical areas.

At the crisis, bank loans to real estate, or collateralised by real estate, accounted for more t of all loan losses.A further weakness was the inability of the banks, as well as of the author register the growing prevalence of indirect concentration risks.

For instance, bank demanded loans denominated in foreign currencies .

Interest rates on these loans were lower than o krona loans and as the krona was fixed within a fairly narrow band, there was presumed t exchange risk.

The banks borrowed the foreign currencies abroad and on-lent them to cus avoiding open exchange risk exposures.

However, when the krona was attacked and the f exchange rate subsequently had to be abandoned, banks were doubly affected.

For counterparties, perceiving the banks' weakened position, reduced or withdrew credit lin forced the banks to demand either early repayment from customers or loan conversion into d currency.

This led, in turn, to sharply increased loan losses because, at short notice, bo unable to raise the larger amounts in krona that were needed to repay the foreign curre which the krona's depreciation had made much more expensive.Neither had the supervisory authority , the Bank Inspectorate, adjusted .

It continued its traditional formal supervision, ensuring that reports, permits et cetera were form rather than supervising the actual risks.

The authority was also somewhat complacent about be frank, the Central Bank and the Ministry of Finance should share the blame for thiSweden had not experienced a financial crisis since the 1930s.

Lacking relevant crisis e the authorities did not perceive that the 1980s could pave the way to a new financial decade was, after all, characterised by sustained economic growth, rising bank profits and low loan losses.The financial weaknesses I have described so far are quite similar in Swede Korea.

However, some differences should also be noted:- In Sweden, banks had built up good capital reserves .

Before the onset of the crisis, all th banks fulfilled or surpassed the 8 per cent Basle requirement for capital.

So, alt performing and other impaired loans amounted to 15 per cent of GDP in Sweden (a fi that is rather similar to recent estimates for Korea), the original cost to the go rescuing the banking system amounted to only some 4 per cent of GDP; since t moreover, most of this has in fact been recovered.- Sweden applied restrictive rules to central bank involvement in the banks.

Only liquidity support was provided, inter alia in the form of foreign currency deposits to stem th from the banks and to reduce the risk of a credit crunch.

This did not involve the R any risks because the State guarantee for banks' repayments also applied to us as a l

## 3.

TriggersNow, let me turn to the actual crisis.

It is well known that the event (o triggering a crisis is often different from the crisis' underlying causes.

In the absence factor, countries with substantial underlying problems from time to time have also been abl an acute crisis.

The event triggering a crisis is sometimes rather dramatic, such as the of a politician - as in the Mexican case - or a sudden loss of confidence, e.g. due to th of a disappointingly weak fiscal budget.

Opinions may differ about what were the most im 'triggers' of the acute crises we are discussing today.

Again, I see both differences and between Sweden and the Asian countries.In our case, a policy shift to the low-inflation regime in the rest of Europe, combined with structural changes and a more hostile international environment (with higher interest rat lower growth, as I mentioned before), made the existing situation unsustainable and trig crisis.In the early 1990s the government refrained from accommodating the high costs inflationary pressures that had been building up in the 1980s.

Under similar circumstances the 1970s and 1980s we had devalued several times.

Now there was broad agreement that we s stick to the fixed exchange rate in order to bring inflation down; in this respect, th indeed successful: inflation fell from 8-10 per cent to 2-3 per cent in less than two year of this, however, was that real interest rates shot up.

Structural reforms were also i particularly in the tax system but also in housing and other areas.

One aim of these refo create more market-related incentives for savings and to reduce subsidies.

While these cha long overdue, they now came at the worst possible time from a macroeconomic point of view.In this context, it is relevant to mention the importance of the sequencing of policy changes .

In our case, some things, such as financial deregulation, were achieved during t (although obviously not enough) and supported demand when this was already strong.

Late when the economy was on its way down, tax changes were implemented that encouraged saving. this should be added the mistake I have already mentioned, of not liberalising outward cap at the same time as the domestic credit market is deregulated.The crisis culminated in the fall of 1992, when for a few days repo rates wer to 500 per cent in the vain hope of stemming currency outflows.

Interest rate hikes contractive measures for defending the fixed exchange rate in the midst of European currency turmoil further exacerbated the economic downturn and added to the banks' loan losses.

All i the three years from 1991 to 1993, Sweden's GDP fell by a total of around 6 per cent.

Be financial crisis had even been recognised in the summer of 1992, production had probably fallen by 2-3 per cent.It is my impression that the process in these respects has been quite differen perhaps apart from Thailand.

Growth did not drop much before the crisis.

More important w direct contagion effects , particularly via financial markets.

Other 'triggers' were political , such as uncertainty caused by upcoming elections, and perceived balance of payments problems.

In m respects the process - once it had started - was also more rapid in Asia.

Perhaps markets all - learnt something from previous crises in Europe and Latin America.

They did not see coming but once it started, they reacted more rapidly.

## 4.

Crisis managementI will now turn to the issue of how to resolve a crisis, once it has erup obviously necessary to tackle macro and micro problems in parallel since the two are interlAs I stated earlier, I believe that the origin of the Swedish crisis was macroeconomic, due to policy mistakes in the 1980s and early 1990s, and triggered by the shift to a low inflation regime.

(Although there were also structural weaknesses in th sector).

The solutions were also primarily macroeconomic in kind.

Once the krona peg ha abandoned, demand got a stimulus.

The task confronting policy makers was to restore the cr of economic policy.

This required in our case, given the weak fiscal position, very st measures (some 8 per cent of GDP 1994-98).

But it also called for a consistent monetary However, and this is important to underline in the present context, if the financial probl been managed properly, they could easily have been a drag on the macro economy.

For exampl taking prompt action it seems that we largely avoided a 'credit crunch', which was a possi worried people a lot at the time.

Credit volumes obviously fell, but this could be expla reduction in demand.Briefly, the important components of the solution for the financial sector were as fo1.

The Government, later confirmed by Parliament, issued an unlimited guarantee stating that no depositors or other counterparties to Swedish credit institutions would suffer a This was a fundamental measure in order to restore confidence in the Swedish banks from domestic and from foreign depositors and other counterparties.

The results s themselves rather quickly, e.g., in the form of renewed interbank credit lines wit banks.

Also the Swedish public remained calm and there were no runs on the ba However, the government (Parliament) guarantee and the other measures must also be m known to all interested parties.2.

The mandate to implement the support policies was given to a new agency, the Bank Sup Authority, which was at arm's length from the political sphere but accountable to the Government.

To avoid conflicts of interest, it was found appropriate not to have the Authority in either the Ministry of Finance, the Central Bank or the Financial Sup Authority.3.

A common framework of measures was constructed for support of the banking system. strategy for deciding which banks to reconstruct and which to liquidate was developed and explained to the general public.

The measures were designed to minimise costs f Government and the risk of moral hazard.

Consequently, shareholders were not covere the government guarantee and would lose their equity investments to the same degree Government had to provide support for their banks.

This provided an incentive to the to avoid applying for state support unless it was absolutely necessary, to mini amount of support and to reduce the time-period of receiving support.

We used a simple, but clear and easy-to-explain, method of identifying banks which should be support in order to survive and those which should be liquidated or merged.

Fir write -down the bank's bad loans.

Then you test the bank in a micro- and macroecono model.

If the model indicates that the bank will be adequately profitable agai medium-term future it should be given support to survive.

But if the model indicates bank will never be profitable again the bank will not be of economic benefit to th and should thus be closed or merged in an orderly manner.4.

Strict valuation rules were used from the onset of the crisis.

This was deemed necessary order to restore confidence but the policy was not without risks.

All bank assets marked-to-market even if the market, such as that for real estate, was exceptional This led to higher bank losses and a weaker financial position than if a somewha flexible valuation rule had been adopted.

The Bank Support Authority hired exper valuation of various types of assets to ensure that the banks did not over- or und the value of their assets with the aim to motivate requirements for more support.

In the rules on when to identify a loan as a non-performing loan and how much to wri were made stricter and with less room for the banks' own judgement.5.

The Swedish government did not take any specific measures to rescue or reconstruct t non-financial companies , neither did it instruct the banks on how to use the support th received.

All support was provided via the banks and the state-owned asset manage corporations, leaving them to negotiate the best terms for themselves and their noncustomers.

There was a wave of bankruptcies and restructuring of non-financial comp primarily in the domestic sector due to weak domestic demand.6.

The extensive use of Asset Management Corporations (AMCs) in Sweden has become well known abroad.

AMCs had, in fact, been established in other countries before the S crisis, so this was nothing new.

The special feature in our case is the emphasis on splitting an ailing bank into a good bank and a 'bad part' and transferring the bad assets to the AMC at carefully assessed market values.

Once in the AMC, the assets are regrouped and imp in order to become attractive to potential buyers.

As soon as a reasonable pric obtained, the asset was sold.

This was sometimes a rather time-consuming process but end the results were probably better than if there had been a quick 'fire-sale' of t is my opinion that the use of AMCs is superior to having the bad assets remain problem banks.

The bank staffs are no experts in the field of handling bad assets and obtain the best sales values.

Also, the bank management needs to tackle other probl to work hard on future strategic planning for the bank - they do not have time enoug often very large number of complex decisions to be taken on the bad assets.

## 5.

ConclusionsFinally, can we draw any conclusions for Asia in general and Korea in part from the way the financial crisis was handled in Sweden?First, I think it is important, as I said before, to recognise the impo macroeconomic developments.

Once the fixed exchange rate had been abandoned, Sweden' economy experienced an export-driven upturn.

But it did take a long time for confidenc Swedish economy in general to return - at least another two years.

It is noteworthy that despite the fact that the recovery in growth had started in the summer of 1993.

The expla primarily in the fiscal situation, to which the financial sector and related problems substantial contribution - enlarging the budget deficit by perhaps as much as 6% of GDP at On top of this, the krona was depressed for a long time by the repayment of foreign loans.The financial problems did not have a major impact on economic developments fr 1993 onwards.

Once the important decisions concerning the financial sector had been taken not long before the financial aspect of the crisis had disappeared from the headlines.

An were already recovering in late 1993 - just a year after the peak of the crisis.

This obviously a great achievement and it may be worth briefly stating some of the more im lessons that, in my opinion, can be drawn from this episode of financial crisis management:1.

Confidence needs to be restored rapidly .

This was achieved in Sweden as far as the financia sector was concerned.

If confidence returns fairly soon, the real effects on the eco not be large.

But if, on the other hand, the lack of domestic and/or external confi to persist, this could act as a drag on economic development for a long period.

It experience from other countries that the longer the period with a lack of confid more drastic the measures that will be needed to restore credibility.

Among other restoring confidence involves being transparent about the problems and about the me for dealing with them.

It also means that measures are implemented as stated responsible authorities, without any deviations in timing or application.

Just the that specific industries or other interest groups may be receiving unjustifiably treatment would quickly erode any confidence.2.

Transparency is important .

A severe crisis wipes confidence out - rightly so.

We realise it was up to Sweden to regain it.

To do so, all the cards had to be on the table.

T the losses and the magnitude of the bad loans had to be revealed in their enti valuation had to be prudent.

If you hide losses initially or are overly optimistic i you risk having to apply again to the international investment community or to taxpa additional support.

This, in my view, might jeopardise confidence and legitimacy.

I necessary to have highly transparent and fair 'rules of the game' for government su the financial sector, not least to avoid political bickering.

The responsibility for falls primarily on two parties:

the authorities and the banks.

The authorities transparent about the broad framework for the solution of the crisis and the banks transparent about their losses and other deficiencies, financial position and need f support.3.

Someone must take the losses .

It is important to realise that once the crisis has occurr losses cannot be hidden and must be dealt with in one way or another.

In this Swedish institutions worked well.

Party politics were clearly separated from b realities.

And the politicians did a good job, realising that bygones were bygones, s fair framework to sort the crisis out.

From a political perspective it was importa banks' owners were not rescued.

People at large had to take substantial cuts i standards - at least temporarily.

Letting the 'big guys' go unhurt under these circ would have jeopardised the whole operation.4.

The macroeconomic policy mix for crisis management can differ .

In our case, there was obviously not much room for fiscal stimulation of the economy.

Considering the muchpublic debt, there could be more room in some Asian countries but the potential effects of the financial losses also need to be taken into account.

Monetary pol difficult dual role: it has to strike a balance between stimulating the economy so the burden on the banks and on their borrowers and at the same time ensuring the inflows that are needed to rebuild the depleted foreign currency reserves.5.

On top of this - and perhaps the most important factor - there was political consensus .

The government sought and received backing from the main opposition party.

That party also allowed to appoint Board members of the Bank Support Authority so that it cou continuously informed and influence decisions.

That was important both for pol legitimacy at home and for credibility abroad - investors could be sure that the s had created would be upheld even if there were a change in government.Let me end on a positive note.

Economically, the crisis in Korea and in many other Asian countries should be manageable although it will probably take time before the r clearly visible.

Korea is in far better shape than many other countries, including my own 1990s, given the high rates of potential growth and that the fiscal balances are in reaso However, what actually happens will depend on how the crisis is managed.That is now precisely the question.