Holger Schmieding on the Banking Crisis and Sweden

All hurricanes are different, but each shares common traits. The same holds for financial storms. Few advanced economies had been battered as badly, and then dealt with the gusts as successfully, as Sweden during its own banking crisis 16 years ago. Sweden's trouble sounds eerily familiar to even the most casual observer of the current turbulence. Throughout the second half of the 1980s, Sweden enjoyed a credit-fueled economic boom. As house

prices and equity markets soared, Swedes saw more reason to borrow than to save. Financial institutions were eager to lend, and focused more on the seemingly ever-rising value of the collateral pledged to back the loans than on the merits of the projects they were actually financing.

Shortly after the domestic credit and real-estate bubble burst in 1990, a global economic downturn pushed this small, open economy further into a deep recession. Swedish banks, which had been highly profitable and had looked well capitalized in the boom years, suddenly hit the rocks. The stock of troubled bank assets surged to the equivalent of 15 percent of Sweden's annual economic output. If that were to happen today in the United States or the euro zone, nonperforming and impaired loans would have to equal $2.2 trillion or €1.4 trillion, respectively. Fortunately, today's problems still seem to be of a much smaller scale.

To find its way out, the Swedish government initially tried to tackle the problems case by case. When two of the country's seven big banks no longer had the capital required, the government took the first over and guaranteed the second. But when a third major bank ran aground in late 1992, Sweden acted swiftly, decisively and with bipartisan consensus to save the system as a whole. The government guaranteed all liabilities of Swedish banks, cementing the safety of all deposits. If need be, the Swedish taxpayer would honor the claim on the bank. Everybody doing business with a Swedish bank knew that he could not lose out—with one important exception: the government would not guarantee the value of equity stakes in the banks. To sort out the problems of bad debt and depleted bank capital reserves, Sweden established a new and independent Bank Support Authority. The authority offered banks support to shore up their capital base, but with strings attached. The more and the longer any bank needed such support, the greater the equity stake it had to grant to the state. All banks had to write down troubled assets to realistic (that is, low) levels immediately, with a valuation board of experts within the authority determining the values to be used. Those banks, which the authority then deemed too frail, were de facto taken over by the government to be run down in an orderly fashion or merged with other institutions.

The major institutions that Sweden had nationalized early in the crisis were both split into a good bank with performing assets and a "bad bank" holding the bad ones. The good banks were free to function normally again. The two agencies handling the rotten apples, called "Securum" and "Retriva," were given capital, time and expertise to make the best of what they had, gradually calling in or selling a collection of loan collateral and other assets. Once the government had extended its guarantee and established the Support Authority, the financial turmoil abated. As a result of the blanket guarantee for all deposits and bank liabilities, Sweden suffered no major run on banks. The frozen markets started to thaw immediately as banks were ready to lend to each other again, and were again able to borrow from abroad.

Although it still took years to sort out the debris from the crisis, the financial upheaval ceased to weigh on Sweden's economy almost immediately. Helped by a global upswing and its competitively valued exchange rate, Sweden's economy recovered. The government even got much of its money back within five years, more and faster than expected. Proceeds from selling troubled assets and from running and privatizing the nationalized banks kept the final cost to taxpayers—many of whom benefited handsomely from the boom before—below 2 percent of Sweden's annual gross domestic product.

While small Sweden, with its own traditions and institutions, cannot offer a complete blueprint to solving today's international crisis, it offers some valuable lessons. Once a crisis spreads from individual institutions to the whole financial system, it takes swift and decisive government action to restore trust. If banks can draw on government support that comes in convincing size—but with clear strings attached—fewer banks are forced by their own balance-sheet problems to deny credit to worthy customers. Putting troubled assets into a "bad bank" to recover as much value as possible without undue haste can cut the final costs to taxpayers significantly. In a systemic crisis, the taxpayer may have to put considerable amounts of money on the line, but resolute action can help mitigate the pernicious credit crunch, which can turn a financial crisis into a disastrous and much more costly meltdown. Sweden shows there is hope after the crisis.