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The Nordic Banking Crisis from an International Perspective
Speech by Stefan Ingves, Director
Monetary and Exchange Affairs Department
Seminar on Financial Crises
Kredittilsynet
The Banking, Insurance and Securities Commission of Norway
Oslo, September 11, 2002

Ladies and gentlemen, colleagues and friends:

These days, I am invited to talk at many seminars all around the world—but let me say that I am especially honored and pleased to be participating in this one. The Nordic banking crisis is something that has occupied my mind a lot, and I think I can bring to the discussions of this seminar a unique perspective, because I have been an "insider" on both sides, first in the Nordic banking crisis itself and more recently in the international fight against banking crises and the discussions of what to do to prevent them. This is also an anniversary in the sense that I gave a speech about the Swedish banking crisis in this very hotel about 10 years ago.

The organizers of the seminar have asked me to talk about the causes of the crises in the Nordic countries and the similarities and differences to financial crisis in other countries and regions of the world. I will not go into a detailed review of the causes of crises in the Nordic countries, because my presentation will be followed by so many experts on the causes and developments in each Nordic country. Therefore, I will only briefly review the causes of the crisis in order to draw parallels to other banking crises in the world, then focus on the differences between the crises in the Nordic countries and most other banking crises cases, and finally talk about the lessons that we have learned from crisis in the Nordic countries—which is a lot—and what efforts are underway internationally to prevent future banking crisis.

The causes of the Nordic banking crises

Painting with a very broad brush, let me start by saying that the Nordic banking crises had all the ingredients and show the full range of causes that we have observed in banking crises elsewhere around the world. Each banking crisis shows a somewhat different combination of causes but most of the main ingredients are always there, as they were in the Nordic countries in different forms: (i) bad banking, (ii) inadequate market discipline, (iii) weak banking regulation and supervision, and (iv) inadequate macro policies, including having to deal with financial liberalization. Let me mention each of them briefly:

1. Bad banking: poor lending practices, excessive risk taking, poor governance, poor risk management, lack of internal controls, focus on market share rather than profitability, currency and maturity mismatches in the banks themselves, or in their borrowers, etc. Add to this distorted incentives for bank owners, who may not have enough capital at stake, and for bank managers, who carry little personal responsibility for the excessive risks they are taking.

2. Inadequate market discipline. If bank creditors have limited information on a bank's financial condition, they cannot exert discipline on bank owners. This is typically the result of poor transparency and disclosure, poor accounting and auditing practices, especially due to the lack of proper loan and collateral valuation methods and consolidation, which allow overstatement of capital adequacy. Market forces are further impeded by weak frameworks for dealing with problem banks, including weak legal, judicial and institutional frameworks for dealing with failing banks and companies. Expectations of depositor and creditor bailouts may overpower any policy to the contrary.

3. Weak regulatory and supervisory frameworks, including: allowing for concentrated lending, portfolio mismatches, inadequate loan valuation that overstate bank profits and capital, incompetent management, etc. Supervision may also lack authority, and have an insufficient number or skilled staff that may be poorly motivated and compensated.

4. Inadequate macro policies and adverse macroeconomic developments, including: lending booms, possibly stoked by excessive capital inflows or changes in tax rules; real estate and/or equity price bubbles that inflate and burst; slowdown in growth and/or exports, or the loss of export markets; growing excess capacity/falling profitability in real sector; lower overall investment; rising fiscal and/or current account deficits; weakened public debt sustainability; sharp changes in exchange rates and real interest rates; etc. Not all these developments are under authorities' control—but governments must be ready to adapt macro policies that take the conditions of a systemically distressed banking system into account.

Another contributing cause to banking crisis is premature financial liberalization, together with inadequate preparation among bankers and supervisors. The former may not have the needed skills to manage and price risk, and the latter may not be given adequate resources and competencies to monitor the more complex new risks. This can easily create a situation with pure ignorance about the risks involved among relevant parties. Not having a clue about what is going on is sometimes a much more important cause of serious difficulties than the in academia so often discussed moral hazard.

5. The above causes can create contagion, as bank or payment system weaknesses destroy credibility of all banks, and lead to creditor and depositor runs regardless of the soundness of individual banks. Contagion is often triggered by some market, policy or political shock that becomes the "wakeup call" for dealing with problems so far ignored, causing dramatic shifts in expectations and a systemic bank run, which often is accompanied by a run on the currency. The latter holds particularly with increasing capital flows if the country is borrowing heavily abroad.

The differences between crises in the Nordic countries and elsewhere

The causes present in the Nordic countries that I have mentioned can also be found to different degrees in all the banking crisis in other countries. But there are often additional causes and problems in emerging market economies and developing countries that can make the crisis more severe and more difficult to solve. Let me mention some of these additional causes:

1. In these countries bad bank management is likely to be even worse, as bank ownership often is very narrow and banks are run as personal "piggy banks" or pyramid schemes of industrial groups or families. Managers and owners that are neither fit nor proper—to use supervisors' jargon—may be the rule rather that the exception. Connected lending, insider operations and outright fraud may be allowed to go on with little or no impunity. This is often due to political interference on behalf of powerful owners and/or outright corruption; the problems may be concealed in off-shore units and subsidiaries beyond the supervisors' reach. Government-directed lending schemes (both implicit and explicit), including forced investment requirements in government paper, may make banks vulnerable to credit losses and deteriorating government finances. State banks are often run as quasi-fiscal agencies based on political criteria with disregard for commercial principles, which undermines their solvency and the soundness of other better run banks. The clean up cost is often very large measured as a percentage of GDP.

2. Macroeconomic sustainability constraints

It is one thing to have a banking crises in a country with a government with a relatively good credit rating, a capacity to borrow and a functioning domestic bond market. This was the case in the Nordic and in most of the Asian countries. It is quite a different challenge to deal with a systemic banking crisis when political stability, the sustainability of a country's macroeconomic policies or its creditworthiness, both internal and external, are in doubt. These are problems that countries like Turkey, Argentina, and most recently Uruguay, have had to face. These countries, with banking sectors of a size similar or smaller to those in the Nordic countries in relative terms, have all had serious banking crisis aggravated by market concerns about the public sector's capacity to borrow. Such concerns can erode confidence in a banking sector to the point where a blanket government guarantee to protect creditors and depositors becomes meaningless. A run on the banking system has been successfully avoided in Turkey, where much of the government debt is in local currency and the government has made clear its intent of honoring its commitments and where the bank restructuring strategy is similar to the ones used in the Nordic countries.

Argentina presents a totally different picture. Here the combination of a currency board regime and loose fiscal policies forced the government to default on its debt, which rendered the banking system nearly insolvent. Additional measures such as the application by law of different exchange rates to banks' assets and liabilities undermined their financial position further. Under such circumstances no traditional government guarantee could be expected to be credible, and the government was forced to declare a deposit freeze, which further damaged the banking system. It should be stressed that getting out of a freeze in an orderly way is one of the most difficult tasks when it comes to systemic crisis management. The Argentina crisis is not going to be solved until the government is prepared to made some hard decisions about loss sharing. Neighboring Uruguay, where many Argentines used to deposit their funds, suffered immediate contagion from Argentina. Only after lining up sufficient external financing from abroad to give credibility to the financial integrity of its banking system has Uruguay been able to bring its banking system closer to normality.

Compared with the banking crisis in these countries, the crises in the Nordic countries—excruciating as they were for those of us involved at the time—were mild, almost a "piece of cake." However, it must be strongly stressed that the Nordic countries are unusually orderly at the micro level. Hence they represented an almost ideal environment for crisis management and bank resolution. This was the case even in the absence of a systemic resolution framework or a clear regulatory framework for dealing with problem banks—a lot was improvised, but it was done very well because the microeconomic structures were in place (it was relatively easy for the public sector to take over and recapitalize a bank, lend or guarantee funds to a private bank, set up limited liability companies for dealing with problem assets, etc.—transactions that have proven extraordinarily difficult in many other countries). One of the lessons of this is that countries need to think through the type of resolution framework that they would need in times of crisis; pre-planning is invaluable. To produce the hose while the house is burning, is a lot more difficult compared to having prepared the hose in advance, and then just turn on the fire hydrant when the fire starts.

3. Ability of political systems to make decisions in the public interest

A very basic issue for the success of any systemic bank restructuring is the ability to get political decision makers to recognize that there is a problem, that the problem is severe, that it requires quick and resolute actions, and that the problems largely are technical rather than political in nature. How lucky we were in the Nordic countries to have governments able to make tough decisions and leaving most of the implementation to a group of civil servants (statstjansteman) and technical experts. In other countries, vested bank owner and borrower interests sabotage such actions through political interference, corruption and intimidation of courts and officials, etc. Necessary political decisions such as loss sharing and the allocation of public support funds are hard to come by, even in cases where the governments have the financial capacity to provide the resources. It is much easier to do nothing and wish the problems away. Needless to say, burden sharing decisions become exponentially more difficult when public financial resources are severely limited or nonexistent. Lack of legal protection of supervisors often add to the problem.

4. Access to well-trained staff, with personal integrity

This is fundamental. In the Nordic countries we did not have the expertise when the crises struck but we were quickly able to bring in foreign an local experts and train or retrain a new generation of bank and corporate restructurers. In many countries local staff is not available and there may be political limitations on the involvement of foreign experts. Bank and corporate restructuring require a high degree of personal integrity. Deals have to be negotiated opportunely, often on a case-by-case basis, and naturally this opens a potential bonanza for corruption and insider deals. We were fortunate in the Nordic countries to have a tradition of personal honesty and openness, both among government and private sector officials, that does not always exist elsewhere in the world. Instead, governments often are forced to set up complex legal structures with stifling operational guidelines to protect themselves, which impedes and slows down their capacity to efficiently deal with the banking crisis. So the problems many countries have to deal with in confronting banking crisis are huge.

5. Size and economic importance of banking system

The severity of a banking crisis for an economy is dependent on its relative size: clearly a crisis in a banking system with assets equivalent of 200 percent of GDP (as in Korea and Thailand in 1997) is much different from one with assets of some 10 percent of GDP (as in Russia in 1998). Had the Nordic countries had loan stocks of similar relative size as those in the above-mentioned Asian countries, the overall costs of the crises would have been larger, and it would have taken much longer to bring about the corporate restructuring necessary for the system to return to normal profitability. Another issue, of course, is the extent to which the real economy relies on bank financing rather than other financing sources such as stocks and bond markets—although here most countries still mainly rely on bank financing. Here it should be stressed that the lack of a domestic bond market has been a serious drawback in several systemic bank restructuring cases.

International efforts to prevent the occurrence of banking crises

1. A lot of international attention has been devoted to banking crises and how to prevent one or deal with one, once it occurs. Triggered by the Nordic crises and the Mexican crisis of the mid-1990s, the G-10 established a working group to come up with recommendations for how to strengthen national financial systems (this succeeded by an expanded G-22 working group). By mid-1996, the IMF's Managing Director, Mr. Camdessus, predicted that the next major international crisis would have its origin in the banking sector and called for better international banking guidelines; and instructed IMF staff to develop such guidelines. This, of course, was outside IMF's traditional turf and did not move far. But it did trigger the Basel Committee on Banking Supervision to develop the Core Principles for Effective Banking Supervision in 1997, which subsequently have become accepted worldwide as a minimum standard.

2. Then came the Asian banking crises, and subsequent crises elsewhere (Russia, LTCM) that rocked the international financial system. In early 1999, to draw the lessons from these crises and avoid repetition, the Financial Stability Forum (FSF) was created as a consultative body to develop rules and procedures for preventing financial problems and crisis, and effectively dealing with those that may occur. The FSF has supported specialized international bodies to develop standards and codes on most aspects of financial sector activity, and as you know there has been a proliferation of those in the last couple of years. At present, the thorniest issue on the agenda of the international community, including the FSF and the IMF, are issues related to private sector involvement in debt restructuring (PSI) and international bankruptcy procedures for countries or sovereigns—major issues with direct implications for how to manage banking crises, especially in places like Argentina and Ecuador.

3. These international efforts highlighted the need for increased surveillance of national financial sectors, and a better understanding of the two-way linkages between the macro economy and the financial sector. Recognizing that a weak financial sector will undermine macroeconomic stability and that macroeconomic weaknesses will undermine even a seemingly robust financial sector (e.g., Argentina), increased focus on the financial sector has been viewed as essential. Also, international policymakers agree that prevention is the best and cheapest way to deal with potential banking problems. Accordingly, IMF surveillance therefore has been expanded to include the financial sector under the so called Financial Sector Assessment Program (FSAP) which feeds into the IMF's traditional Article IV surveillance process. The FSAP does not focus only on the banking sector but also on the broad financial infrastructure that provides its underpinnings (e.g., accounting, bankruptcy and foreclosure rules, payments systems, etc.) and on other subsectors of importance for financial stability, such as insurance and pension schemes. There is also a race under way to find the "holy grail" of macroprudential indicators and early warning signals that will signal major problems and weaknesses and allow prevention of major financial sector crises. This is an elusive task, which remains highly country specific. Let me say that I am particularly pleased to note that the monitoring of domestic financial stability is placed high on the policy agenda in all the Nordic countries and that you continue to be in the forefront of the work on this subject internationally. The new trend of publishing reports assessing strengths and vulnerabilities of a country's financial sector is one that deserves strong support.

4. Caveats about capital account liberalization

In the 1980s and early 1990s many countries around the world liberalized their foreign exchange regimes and restrictions on international capital movements. This was typically done at the initiative of each country and generally supported by the IMF. In 1997 there was even a move under way to enshrine such liberalization in the IMF's basic law (its Articles of Agreement). However, the Asian crisis changed this, as the downside of free and unfettered capital flows became clearer. The experiences of the crises and subsequent studies have made it clear that for capital account liberalization to be the positive force it is expected to be, it must be supported not only by sustainable macroeconomic policies but also by a robust domestic financial system, which typically requires that it be preceded by major institutional strengthening. And such strengthening takes time to become effectively ingrained—how long it takes has consistently been underestimated by those eager for liberalization. Some strains can be considered the cost of liberalization. Countries therefore need to be made fully aware the preconditions for effective financial liberalization, the dangers if those preconditions are not met, and be alert and prepared to deal with any ensuing strains. This is not at all saying that capital account liberalization is bad, but rather pointing out what is obvious ex-post that one has to be careful of how to go about doing it.

5. Importance of the Nordic crises for the rest of the world and the IMF

The Nordic banking crises of the early 1990s were the first systemic crises in industrialized countries since the 1930s, if the banking problems directly related to the devastation of the second world war are excluded. They had been preceded by the widely studied U.S. Savings and Loan (S&L) crisis, but that crisis was not really a systemic one. Rather, the S&L crisis affected a subsector within an otherwise functioning large financial market. The Nordic banking crises were therefore eye-openers. How could such problems occur in otherwise well organized and managed economies and financial systems? The Nordic countries also showed how to effectively deal with such crisis.

Until that time, the IMF had little experience of banking crisis. In the early 1990s, the organization was busy leading the Western efforts to establish market-based banking systems in Eastern Europe and the former Soviet Union. This included setting up central banks and regulatory and supervisory structures for banking—but also how to deal with problem banks and systemic crises. For the latter, the IMF was principally looking to two sources for experiences: the United States experience for dealing with individual bank problems, and the Nordic experience for dealing with systemic cases. Nothing was written on the Nordic crises at the time, so experts from Sweden and Finland were brought to Washington in the early 1990s, so that IMF staff could "pick their brains" and learn the policy and operational issues of dealing with a banking crisis. So you can all be pleased to know that the IMF's body of best practices for banking crises management, which was developed in the years prior to the Asian crisis, drew heavily on the Nordic experiences. These best practices were put to test in the Asian crisis cases, and we were pleased to find that they did work as expected, with many adaptations, of course, to take into account special features of each country. And as a parenthesis, my own involvement in the Swedish banking crisis was a determining factor for me ending up in the IMF as well, and I am one of the few in the world who continue to make crisis management a way of earning a living.

Finally, let me mention some of the important lessons from the Nordic countries that became part of the policies for dealing with banking crises that were adopted by the IMF. In the mid-1990s, many of them were substantially at odds with the common view of a dominant group of US RTC-inspired financial economists. The principal one is that you cannot rely on the private sector or markets alone to solve systemic banking problems. Similar to the need for a lender of last resort to deal with systemic liquidity shortfalls, there is need for an investor or owner of last resort when all other sources of capital have dried up—and closing down an entire banking system is not a feasible option. There is also a role for a blanket government guarantee to restore confidence and prevent bank runs and a potential "financial meltdown"—with the wholesale destruction of values that such a scenario would imply. This now seems noncontroversial, but it was certainly not so at the outset of the Asian crisis.

The Nordic banking crises taught the world powerful lessons of the need for prominent state involvement in the resolution process: it was the state rather than the private sector that had to lead the systemic restructuring exercise seeking to bring in private sector owners and investors as much as possible. The Nordic crises also showed a role for the state in the protection of asset values of banks, in situations where private asset markets collapse; the use of special asset management companies and loan workout units, that have to be government owned, if no private investors were available—as they seldom are in a systemic crisis. Such bodies can protect values through careful management rather than destroy values through rapid "fire" sales. The Nordic experiences also highlighted the importance of operational restructuring of corporations as the underpinning of bank restructuring—an area in which most other countries have fallen short due to a range of institutional reasons. And I have already mentioned other necessary ingredients such as political decisiveness, functioning institutions, and the availability of expertise and human resources.

We are all pleased to see how well the banking systems of the Nordic countries have recovered and how efficient they have become. We are also pleased to note how much cheaper the aggregate final cost has turned out to be than what was estimated in the darkest midnight hours of the crises in the early 1990s. Now there are even some analysts who claim that the Nordic banking crises, except in Finland, ultimately generated a profit to the governments, especially when the revenue impact of all the efficiency gains are included. Here in Norway, I know that there have been claims by previous bank owners that their banks were inappropriately taken over by the government. But at the time the banks were insolvent and the government was the only entity available to put in the necessary risk capital to keep these banks going. It is therefore appropriate for the government alone to reap any benefits of this action, a conclusion that I also understand the courts have come to.

* * * * *

Let me end by saying that the lessons of the Nordic countries in dealing with their banking crises continue to be extremely valuable to the world. I therefore very much welcome this seminar and the initiative of det Norske Kredittilsynet and hope not only that the discussions will be lively and bring out a number of conclusions, but also that those conclusions will be disseminated in writing to the rest of the world. It is important to remind everyone that efficient crisis management processes lead to excellent end results. Ten years later there is certainly good reason to be content with the outcome! This conclusion is very different from how it felt at the peak of the crisis 10 years ago. Then every day and night was just a matter of survival.

Thank you!




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