The Nordic Banking Crises: Pitfalls in Financial Liberalization?


WP/95/61-EA
The Nordic Banking Crises: Pitfalls in Financial
Liberalization? by Burkhard Drees and Ceyla Pazarbasioglu

The banking industries in three Nordic countries, Finland, Norway, and
Sweden, underwent considerable changes in the 1980s. The period was marked
by increased competition in financial services, economic deregulation, the
removal of cross-border restrictions on capital flows, and financial
innovation. After a sharp credit boom, it also proved to be a period of
financial fragility, as lower asset quality and declining profitability
deteriorated banks' balance sheets to the point where governments had to
support some of the largest banks to preserve financial stability.

A financial crisis in the aftermath of financial liberalization does
not necessarily imply that the crisis was caused by the deregulation itself.
The paper notes that the Nordic financial crises, similar to experiences in
other countries, were associated with macroeconomic circumstances, such as
economic downturns, declines in incomes, and depressed asset markets, that
typically follow domestic credit booms. The parallel developments in the
Nordic countries are striking, yet there are at the same time significant
differences in the performance of their financial systems and their
regulatory environments, and in the macroeconomic shocks that impacted on
their economies.

This paper presents a survey of the Nordic banking systems in an
attempt to examine competing hypotheses about the causes of the banking
problems and to provide some policy lessons. A key conclusion of this paper
is that factors in addition to business cycle effects explain the financial
problems that the Nordic countries have experienced. Although the timing of
the deregulation in all three countries coincided with a strongly
expansionary macroeconomic momentum, other contributing factors, such as the
delayed policy responses, the structural characteristics of the financial
systems, and--last but not least--banks' inadequate internal risk management
controls, determined the consequences of the transition from tightly
regulated to more or less competitive financial systems.

Against the background of these enhanced competitive pressures, the
paper concludes from the Nordic experience that a negative shock may put the
stability of the financial system at risk if economic incentives are
distorted by policy measures and by the inherent structure of the financial
sector. In the absence of strengthened prudential banking supervision,
these incentives, coupled with expectations of government intervention in
the event of a crisis and a booming macroeconomic environment, prompted many
Nordic banks to increase their lending and risk taking excessively, leading
to a loss of efficiency in allocating capital. As the distortive tax
incentives that strongly favored debt financing were not corrected,
borrowers responded to the lifting of credit rationing by incurring debt
burdens that, at least ex post, turned out to be unsustainable. Monetary
policy was largely unable to stem the credit expansion, owing to pegged
exchange rate regimes, while fiscal policy was not tightened sufficiently.