Stefan Ingves: The crisis in the Baltic - the Riksbank's measures,
assessments and lessons learned
Speech by Mr Stefan Ingves, Governor of the Sveriges Riskbank, to the Riksdag Committee
on Finance, Stockholm, 2 February 2010.
* * *
The crisis in the Baltic - the Riksbank's measures, assessments and lessons learned
It is not possible to provide a comprehensive reply to all of the questions discussed in
connection with the crisis in the Baltic in the space of 15 minutes. I shall therefore give a brief
summary of the assessments made by the Riksbank during the course of the crisis and
something about the measures we have taken. In conclusion, I shall say a few words about
the lessons that can be learned.
Before I discuss the role of the Riksbank, I would like to point out that the responsibility for
developments in the Baltic countries primarily lies with their own governments with regard to
economic policy, and with the banks, which have a responsibility for understanding
developments in the economy and taking sustainable, long-term action.
People often seem to forget in the general debate that we are talking about three different
countries here. Financial market participants also tend to see the Baltic countries as a unit,
which makes it difficult to manage the crises in these countries. Of course there are many
similarities between the countries, for instance, their economic expansion and decline.
However, there are also important differences.
Swedish banks' commitments in the Baltic
The Swedish banks' total lending to the Baltic countries currently amounts to around SEK
400 billion. There are mainly two Swedish banks that have had a large presence in this
region; SEB and Swedbank. These banks, their subsidiaries and branches dominate the
markets in the Baltic and comprise 80 per cent of the Estonian market, 55 per cent of the
Lithuanian market and 60 per cent of the Latvian market. Around 16 per cent of Swedbank's
total lending is to the Baltic countries. The corresponding figure for SEB is 13 per cent and
the figure for Nordea is 3 per cent. Swedbank's loan losses for the three first quarters of
2009 total SEK 19 billion, and 60 per cent of this stems from the Baltic countries. SEB's loan
losses total SEK 9 billion, with 75 per cent stemming from the Baltic region. According to the
Riksbank's own estimates, the three banks' total loan losses in the Baltic region will be
SEK 27 billion for the whole year 2009, and roughly the same in 2010, with around
80 per cent, or SEK 50 billion, falling to the lot of Swedbank and SEB. This figure of
SEK 50 billion should be regarded in the light of the two bank groups' total primary capital,
which is SEK 185 billion, or the capital held in their Baltic subsidiaries which amounts to
SEK 27 billion. It will be necessary for the parent banks to continue transferring capital to
their subsidiaries to maintain their creditworthiness. Assuming that developments in
Swedbank's and SEB's other markets continue to be relatively good, however, the bank
groups should be able to cover most of the losses from the Baltic region with the earnings
from the remainder of their operations. Swedbank and SEB have subsidiaries in the Baltic
countries, while Nordea has a branch. According to EU regulations, the authorities in the
country where subsidiaries are located have responsibility for their supervision, while the
home country authorities have the responsibility for branches and for the bank group as a
whole.
Around 80 per cent, equivalent to SEK 320 billion, of the Swedish banks' lending to the Baltic
countries is in euro. These euro are lent almost exclusively in the international loan markets
by the parent bank in Sweden.
The Baltic economies developed rapidly after these countries gained their independence,
although there have been some setbacks. This development was supported by extensive
inflows of capital from abroad, particularly after EU membership in 2004. Much of the money
came from neighbouring countries such as Finland and Sweden. The average standard of
living for the populations in the Baltic countries increased rapidly from 41 per cent of the EU
average in the year 2000 to 62 per cent in the year 2008.
Domestic and to an even greater degree foreign banks (which had better access to liquidity
from their parent banks) increased their lending at a rapid rate and demand was further
boosted by rather lenient fiscal policy in Latvia and Lithuania, although not in Estonia.
However, the rapid growth led to the economies overheating. As early as 2007, for instance,
the rate of wage increase was 20-30 per cent a year, bank lending to the corporate sector
increased by 30-50 per cent and lending to the private sector by 50-70 per cent. The deficit
in the current account was 25 per cent of GDP, although that in Lithuania was slightly lower.
Foreign analysts, such as the IMF, came to the conclusion that this development was not
sustainable in the long run.
The course of the crisis
As a result of the large imbalances in the Baltic economies, developments would sooner or
later have led to an economic crisis regardless of the external circumstances. Now the global
financial crisis acted as the trigger. Investors no longer wished to take on as much risk and
as the Baltic region was considered risky, with a risk of their currencies devaluating, capital
was withdrawn from the region. Governments and banks, both local and foreign-owned,
experienced difficulties in finding funding. The outflow led to an acute currency crisis in
Latvia.
The downswing in the economies was very rapid and severe, as a number of factors
combined:
•
The countries' competitiveness had been undermined by the large wage increases,
at the same time as the strong demand in the domestic markets had led to a waning
interest in production for export.
•
"Bubbles" of overproduction and high prices, primarily in the property sector, led to a
more or less complete stop in construction.
•
The global crisis meant that demand for the countries' export goods declined.
• The global crisis led to foreign investors being neither willing nor able to inject
capital to the Baltic countries. At the same time, foreign depositors made large
withdrawals from the banks.
The crisis led to GDP in the Baltic countries falling by up to 20 per cent during 2009 alone,
and budget deficits soared, as did the outflow of currency, which put pressure on the foreign
currency reserves. Real wages fell, unemployment rose, property prices collapsed and the
number of borrowers experiencing problems repaying their loans increased rapidly. However,
the outcomes in the different countries differed somewhat from one another.
How has the Riksbank assessed developments in the Baltic countries and what action
has it taken?
As many of the major Swedish banks have such large commitments in these countries, the
Riksbank has long been closely following developments in the region. This forms a natural
part of our work in the financial stability field, which also encompasses other countries where
the Swedish banks have a significant presence. We analyse statistics and other information
from these countries and we discuss developments with management and employees at
their central banks, governments and financial supervisory authorities. We also follow the
reports on these countries from other sources such as the IMF, the EU/ECB and market
data. Representatives of the Riksbank have accompanied the IMF on several of their visits to
the Baltic countries and have taken part in the discussions with governments and public
authorities there. The purpose of this participation, which has been at the invitation of the
countries concerned and of the IMF on each individual occasion, has been to acquire
up-todate knowledge of the situation in the country and of the negotiations, so that the Riksbank
could, if necessary, provide financial support at very short notice.
The Riksbank's Financial Stability Report, which is published twice a year, sounded a
warning as early as 2005 regarding economic developments in the Baltic region and the tone
has gradually sharpened in the reports published since then. The Financial Stability Report
also publishes the results of stress tests, in which the banks' resilience is tested in the light of
improbable but nevertheless possible scenarios. Examples of some of the scenarios tested
include the effects on the banks of various crisis situations in the Baltic region. Back in 2006
we made the first stress test based on a possible worse development in the Baltic region and
noted that if this were to occur, the banks' resilience would deteriorate and their scope to
manage other negative shocks would be reduced.
The Riksbank's Deputy Governor Lars Nyberg informed the board of Finansinspektionen (the
Swedish financial supervisory authority) of his fears regarding developments in the Baltic.
Mr. Nyberg raised the issue in Finansinspektionen, in the summer of 2008, that the capital
adequacy requirement for Swedish-owned banks with operations in the Baltic region should
be raised to compensate for the higher risk. However, the board concluded that bank groups'
capital already exceeded the legal minimums on a consolidated, group-wide, basis and thus
the parent bank could transfer part of its excess capital to a subsidiary in the Baltic countries,
if necessary. Hence, no further measures were required.
The Riksbank has regularly informed the Swedish banks of our assessment of risk in the
Baltic countries. We have also required that the banks send us supplementary information so
we can analyse the potential risks in greater detail. In addition, together with
Finansinspektionen we have visited the banks' subsidiaries and branches in the Baltic
countries to study in detail, for instance, their loan management.
The Riksbank has for several years now carried out regular crisis management exercises
regarding financial crises. In 2007 a crisis management exercise was held together with all of
the Nordic and Baltic countries, where the scenario involved a crisis in a cross-border Nordic
bank. The purpose was to get the countries to cooperate in analysing and solving problems
and to clarify the distribution of roles and responsibilities.
When the crisis moved into an acute phase in Latvia in December 2008 and large amounts
of capital left the country, a loan agreement was signed at very short notice with the
Riksbank and Danmarks Nationalbank on the one side and the Latvian central bank on the
other side. The agreement totalled EUR 500 million, around SEK 5 billion. The main purpose
of the agreement was to support Latvia's foreign currency reserve up to the point when the
first payments from the IMF and EU became available. One condition was that Latvia should
sign an agreement with the IMF, as the Riksbank neither can nor should become involved in
assessing whether or not the country is making the necessary economic adjustments. The
Riksbank's assessment was that if Latvia had not received extensive financial support from
abroad at this stage it could have led to uncontrolled exchange rate depreciation and very
large currency outflows.
In February 2009 the Riksbank offered an arrangement to the Estonian central bank for
short-term currency support. This arrangement was never used. Its purpose was to give the
central bank the possibility to provide emergency liquidity support in the event of an acute
crisis in local currency to the Swedish subsidiaries. It thus had a different purpose than the
agreement with Latvia. Given Estonia's own currency board arrangement, it would not
otherwise have been possible for them to provide support other than on a very small scale
and the Swedish authorities would have been forced to take full responsibility for a liquidity
injection. This agreement is a good example of the allocation of responsibility between
countries with interwoven financial systems.
The legal base for the Riksbank's loan arrangements with Latvia and Estonia is described in
the Sveriges Riksbank Act, which enables loans to be granted for monetary policy purposes
and currency policy purposes. An acute crisis in these countries would probably have such
repercussions in Sweden that it would be difficult for the Riksbank to conduct efficient
monetary policy, and the exchange rate would probably be weakened to an extent which
would be detrimental to Sweden's economic development.
The Riksbank has strengthened its own foreign currency reserve through extensive
borrowing abroad to have sufficient resources to be able to act effectively in a crisis. The size
of the foreign currency reserve prior to the borrowing was not adequate to meet the demand
for support measures that arose. When access to foreign markets disappeared after the
Lehman collapse in the autumn of 2008, demand for foreign currency from the Riksbank
increased sharply.
Why has the Riksbank acted in the way it has?
When foreign market participants assess the situation and risks for Sweden and Swedish
financial institutions, they also take into account to a large degree what is happening in the
other Nordic countries and in the Baltic countries. The global financial crisis has affected
financial stability in Sweden, although financial institutions here have coped better than those
in many other countries. At the end of 2008 and the beginning of 2009 there was
considerable international uncertainty and the market was particularly sensitive to
consequences for Swedish banks resulting from the crisis in the Baltic. There was thus good
reason for the Riksbank to take measures to stabilise the situation among the major Swedish
banks in accordance with its task "to promote a safe and efficient payment system".
As the problems of the Swedish banks concerned mainly lay in the Baltic region, there was
even greater justification for aiming the measures at strengthening these countries and
thereby the banks there. The costs of these measures would probably be much lower if the
problem could be dealt with at source rather than waiting until it had spread to the parent
banks in Sweden, for instance through a dead stop in the liquidity supply from international
markets. When the Riksbank made an assessment of the resources required to manage a
widespread Swedish bank crisis, we took into account the fact that the Swedish banks'
balance sheets nowadays amount in total to 3.7 times Sweden's GDP (which can be
compared to 1.2 times GDP during the bank crisis in the 1990s).
There is a debate regarding the fixed exchange rates in the Baltic countries. The Riksbank
has no reason to question the Latvian government's wish to retain its fixed exchange rate.
The main argument for our stance is that the Latvians themselves wish to maintain a fixed
exchange rate to be able to ultimately apply to adopt the euro. They are prepared to make
far-reaching sacrifices in the form of wage reductions, budget cutbacks and the ensuing
unemployment, to attain the cost reductions that will restore competitiveness. I consider that
the possibilities for the Latvian government to obtain popular support for such painful
measures would be greatly undermined if other countries were to force an unwanted solution
on Latvia. Nor is devaluation an easy path to take. There are considerable risks that it will not
be possible to control the magnitude of the exchange rate changes and that there may be
large distortion of the economy.
I also want to refute the argument that the Riksbank is supporting fixed exchange rates in
these countries because the Swedish banks would suffer large losses in the event of
devaluation. Devaluation or not, economic restraint is required over a long period of time to
restore balance to the economies. This implies that the banks' loan losses will be around the
same size in both alternative scenarios, but will probably have a slightly different distribution
over time.
What has the Riksbank learned?
As I have described, the Riksbank had detected at a relatively early stage that the Swedish
banks' lending in the Baltic region was not sustainable and that it would lead to significant
risks. Admittedly, the severity of the risks did gradually become clearer as time went. We
took a number of measures, although they were all of a "soft" nature, such as discussions
with the banks, with the authorities in the Baltic countries and with Finansinspektionen.
However, it became clear that these measures did not have the intended effect. This is not a
unique phenomenon; experiences from many countries show that it is very difficult for the
authorities to require constraint from the banks as long as their profitability remains good and
loan losses are low. A complicating factor was that the authorities in the Baltic countries did
not see the impending risks, but expressly encouraged the Swedish banks to maintain a high
level of lending. The Riksbank lacks sharp, legally-binding instruments for dealing with the
banks in these situations. Prior to autumn 2008 there was also no Swedish framework for
crisis management, and there are still significant shortcomings in the public management of
individual banks in distress, which became clear in the case of Custodia. The Riksbank is
currently analysing what further tools that might prove necessary.
The Riksbank is also considering how our messages regarding risks to financial stability can
be made clearer. Perhaps they must be based on a clearer interpretation of our mandate in
the Sveriges Riksbank Act which currently states that we shall "promote stability in the
payment system". Perhaps we need to use more formal measures to a greater extent, such
as expressing our recommendations in letters to the parties concerned. Regardless of the
importance of clarity, it is always a sensitive issue to determine at what point the Riksbank
can issue warnings regarding weaknesses in the financial system. This is of course even
more difficult when it refers to another country. The Riksbank therefore also works through
non-public contacts with other authorities in Sweden and abroad, with international
organisations and with the Swedish banks. It is important to achieve consensus on the
problems and possible measures. Of course, it is also very important to make our views
public to put pressure on those concerned and to inform a broader public. - The Riksbank's
basic outlook is that we shall be as open and clear as possible.
One lesson learned from both the global crisis and that in the Baltic countries is that the
regulation and supervision of the financial sector must be strengthened. This entails, for
instance, more and better capital in the banks, stricter requirements regarding the banks'
liquidity and risk management in general, as well as stricter supervision of large,
crossborder bank groups. The Riksbank works actively in various international forums such as the
EU/ECB, the BIS and the IMF to be able to detect at an early stage weaknesses that could
lead to financial crises and to meet threats to stability. We support in various ways the
endeavours to strengthen and harmonise international regulations and supervision work in
different countries.
Concluding remarks
The economic downturn in all three Baltic countries is a deep one. There are some
indications that the recession may have bottomed out or is at least close to it. The trade and
current account balances have improved, which is mainly due to domestic constraint, but to
some extent also to improvements in exports. The pressure on the currencies has declined.
It is easier for the countries' governments to fund their budget deficits. Although those deficits
are still high, they appear to be held in check, at least temporarily, through drastic fiscal
stabilisation measures. The IMF's and the EU's loan programmes for Latvia are still in
operation. With regard to Estonia, efforts are being focused on clarifying the conditions for a
possible adoption of the euro as early as the turn of the year. All three countries have
recently succeeded in acquiring loans on the international markets.
But at the same time as we note these positive signs, we must be aware of the continued
crises in the economies, with high and rising unemployment, and a heavy fall in GDP,
consumption and investment. On the financial side, we can see that the number of borrowers
who are unable to repay their loans is increasing rapidly. Both foreign and domestic banks
must make corresponding provisions for losses, which has made an impact on, for instance,
Swedbank's and SEB's interim reports.
As consumption demand will be weak for many years, the way out of the crisis must be
through investment and exports. This is only possible if competitiveness improves through
further reductions in real wages. Moreover, demand from abroad must increase from the low
levels experienced during the crisis.
Finally, I would like to stress for the sake of clarity that the Riksbank, and thus the Swedish
taxpayers, has not lost any money on the transactions with the Baltic countries. Those who
have suffered financial losses are the banks' shareholders, who have been forced to
compensate for the losses with new capital. But there is also another loss - in addition to the
economic contraction which the citizens of the Baltic countries currently suffer from - that is
more important, and this concerns the Swedish economy as a whole. When banks make
losses abroad they do not have the same possibilities to provide loans in Sweden, and thus
our country may have poorer economic development. The Riksbank has done all it can to
prevent such a negative development.