Save the Banking System, Not the Bank Owners and Managers

Lars Jonung served as chief economic adviser to the Swedish Prime Minister Carl Bildt in 1992-94 when the Swedish solution was implemented, and has been credited with much of the Swedish bank resolution solution’s creation. He shared his thoughts on today's crisis, as compared to what happened in Sweden, in a post at EuroIntelligence (Lessons from Swedish Bank Resolution Policy):

Banks all over the world are in deep trouble. This has created an interest in the successful bank resolution policy adopted in Sweden in the early 1990s. But can the Swedish model of yesterday be applied in other countries today?

When Sweden was hit by a financial crisis in 1991-93, its response comprised a unique combination of seven distinctive features: 1) swift policy action, 2) political unity, 3) a blanket government guarantee of all bank liabilities (including deposits but excluding shareholder capital), 4) an appropriate legal framework based on open-ended government funding, 5) complete information disclosure by banks asking for government support, 6) a differentiated resolution policy by which banks were classified according to their financial strength and treated accordingly, and 7) an overall monetary and fiscal policy that facilitated the bank resolution policy.

Two major banks were taken over by the government. Their assets were split into a good bank and a bad bank, the “toxic” assets of the latter being dealt with by asset-management companies (AMCs) which focused solely on the task of disposing of them. When transferring assets from the banks to the AMCs, cautious market values were applied, thus putting a floor under the valuation of such assets, mostly real estate. This restored demand and liquidity, and thus put a break on falling asset prices.

The Swedish model proved successful. The banking system was kept intact. It continued to function, swiftly emerged from the crisis and remained mainly in private hands. Taxpayers did not lose out in the long run. The net fiscal cost of the bank resolution 15 years after the crisis is close to zero. The policy priority of saving the banks, not the owners of the banks, kept moral hazard at bay.

The bank resolution policy was carried out transparently and openly. The centre-right government under Carl Bildt cooperated with the social democratic opposition, creating public trust in the resolution process.

Today's global crisis is different from the Swedish crisis of the 1990s in important respects. The Swedish financial system was small, with only half a dozen major banks. It was also bank-based, with few major non-bank financial actors, and was less sophisticated and less globalized than the current world financial system.

Still, there are lessons from the Swedish resolution policy that may serve as guiding principles today.

First, the Swedish experience demonstrates that a genuine threat of public receivership or nationalization does galvanize banks into action. With this threat hanging over them, private banks in Sweden made great efforts to solve their problems themselves by asking their owners for capital. The lesson is that no government support should be given to a financial institution with zero or negative equity until its present owners have surrendered their control and ownership.

Banks and their networks of debtors and creditors should be saved – not bank owners and not bank managers. Once this principle is commonly accepted, government rescues will be easier to carry out. Moral hazard will be reined in – today and in the future. Taxpayers will more readily accept the necessary public expenses.

Presently, policy choices are often hampered by a political dislike of public receivership (nationalization) – even if such a step would be economically more efficient and just. The Swedes, however, put ideology and fear of big government aside. Their priority, from the Conservative party to the Social Democrats, was to find a quick, workable solution.

Today, major steps towards pseudo-nationalization have been taken in many countries, creating the worst of all possible worlds: governments are financing bad banks without outright owning them and failed managers and owners are not punished. This creates public distrust in the resolution policy as a whole. Temporary public receivership with a clear exit strategy is a more efficient approach, and less costly to the taxpayers. As any student of finance knows, the value of a bankrupt bank is zero.

Second, the Swedish experience suggests that all banks that are put under public receivership should be split immediately into a good bank and a bad bank, under the control of an independent authority with the goal of terminating the operations of the bad bank in a specified time frame, say within less than 10 years. This avoids Japanese-style "zombie" banks. Alternative solutions include purchase-and-assumption transactions, in which a part of a bank's good assets and matching liabilities are sold to another bank.

The good bank should continue operation and be re-privatized as soon as possible. The bad bank should manage the bad assets taken from the old bank with a view to selling them in due course. This will help recreate a market for such assets.

Third, the Swedish case shows that the bank resolution policy should have an open-ended financial commitment from the government to be credible and efficient. At this stage of the global crisis, it is impossible to estimate exactly the cost of rescuing a financial system in any country. However, the ad hoc measures that have been taken in many countries seem to be an open invitation for struggling banks and institutions to demand more funds. Any attempt to fix a sum for the rescue effort undermines its credibility. It should be made clear that the government is ready to mobilize the resources needed. Fighting a financial crisis is like fighting a war. Losing is simply unthinkable.

Finally, the process of bank resolution should be transparent, based on full disclosure of the steps taken and the valuations of assets made. Openness fosters public trust in the bank resolution policy and in the financial system that will emerge after the crisis. And trust is the basic building block of any banking system.