the plan would require those firms seeking government assistance to make the taxpayer senior to all shareholders

TO BE NOTED: From the FT:

"Troubled banks must be allowed a way to fail

Thomas Hoenig

Published: May 3 2009 19:01 | Last updated: May 3 2009 19:01

When the financial crisis began to unfold in 2007, US policymakers reacted quickly out of fear that rapidly evolving events would lead to a global economic collapse. In my view, the policy response to this point has been ad hoc, resulting in inequitable outcomes among firms, creditors, and investors. Despite taking a number of actions to stabilise markets and institutions, uncertainty continues and markets remain stressed.

I believe there is an alternative method for addressing this crisis that deals more effectively with the issues we currently face while also considering the long-run consequences of those actions: the implementation of a systematic plan to resolve large, problem financial institutions.

In recent weeks, I have outlined such a resolution framework for dealing with these large, systemically important institutions. Boiled down to its simplest elements, the plan would require those firms seeking government assistance to make the taxpayer senior to all shareholders, with the government determining the circumstances for managers and directors. These firms would be operated by outside individuals with no conflicts involving either the firm or its competitors.

Non-viable institutions would be allowed to fail and be placed into a negotiated conservatorship or a bridge institution, with the bad assets liquidated while the remainder of the firm is operated under new management and re-privatised as soon as is feasible. This plan is similar to what was done in Sweden in the 1990s and in the US with the failure of Continental Illinois in the 1980s.

This plan has many advantages, including that management and shareholders bear the costs for their actions before taxpayer funds are committed. This process also is equitable across all firms; is similar to what is currently done with smaller banks; and provides a definitive process that should reduce market uncertainty. These are important reasons to implement this kind of resolution process.

In contrast to this suggested approach, the current policy raises a host of issues:

● Certain companies have not been allowed to fail and, as a result, the moral hazard problem has substantially worsened. Capitalism is a process of failure and renewal, and a “too big to fail” policy undermines this renewal and makes the financial system and our economy less efficient.

● So-called “too big to fail” firms have been given a competitive advantage and, rather than being held accountable for their actions, they have actually been subsidised in becoming more economically and politically powerful.

● The US government has poured billions of dollars into these firms without a defined resolution process, adding to our national debt. While there will be some repayment, there also will be losses. The longer resolution is postponed, the greater the losses and the larger the debt burden.

● As these institutions are under repair, the Federal Reserve is making loans directly to specific sectors of the economy, causing the Fed to allocate credit and take on a fiscal as well as a monetary policy role. This is reflected in the fact that its balance sheet continues to swell, which may compromise the independence of the Federal Reserve and make it more difficult to contain inflation in the years to come.

● Failing effectively to resolve these non-viable firms has long-term consequences. We have entrenched these even larger, systemically important, “too big to fail” institutions into the economic system, assuring that past mistakes will be repeated.

Certainly, the approach I suggest for resolving these large firms also is not without substantial cost, but it looks to both the short and long run.

A systematic approach would reduce the uncertainty that has paralysed financial markets; the cost is more measurable and therefre manageable; and there will be fewer adverse consequences compared to the path we are on now.

Because we still have far to go in this crisis, there remains time to define a clear process for resolving large institutional failure. Without one, the consequences will involve a series of short-term events and far more uncertainty for the global economy in the long run.

While I agree that central banks must sometimes take actions affecting the short run, they must keep the long run in focus or risk failing their mission.

The writer is president of the Federal Reserve Bank of Kansas City"

So let me be clear: for sixteen months now I have been a Swedish-model advocate who wants to guarantee bank bondholders

TO BE NOTED: Grasping Reality with Both Hands:

"Tim Geithner and the Swedish Model

James Surowiecki:

The Sweden Example: The Balance Sheet: Ryan Avent beats me to the punch by pointing out the most important part of today’s Times’ story on Tim Geithner, namely that in the summer of 2008, after the collapse of Bear Stearns but before the meltdown of Lehman Brothers, Geithner proposed having the government guarantee the debts of all U.S. banks. The plan was shot down as politically untenable, but, as Ryan points out, had it been put into effect, we would most likely not have seen Lehman go under or had to deal with the incredibly negative consequences of that failure. More important, perhaps, by reducing the threat of panicked runs on bank debt (since those debts would have been guaranteed), such a guarantee would also have made it easier for regulators and banks to deal in a transparent fashion with the toxic-asset problem. That’s why the very first step in Sweden’s much-admired solution to its banking crisis in the early nineteen-nineties, was, yes, a guarantee of all bank debt. As one of the regulators involved in that effort put it, the guarantee “was provided in order to restore confidence and to ease the immediate pressure on banks,” by ensuring “the stability of the payment system and to safeguard the supply of credit.”

Given all this, Ryan is perplexed that Yves Smith... dismisses Geithner’s proposal... her conviction that any plan to deal with the banking system has to require bank bondholders to take a major hit. In other words, for Smith, the Swedish solution is not the right one. Nationalizing the banks, and wiping out the shareholders, isn’t enough: you have to impose significant pain on the banks’ debtholders, too. Lots of nationalization advocates believe that a debt guarantee is a bad idea. But one of the things that’s made the debate over nationalization confusing is that many of these same people, while arguing that bank debtholders should take a hit, also say that what the U.S. should do is emulate Sweden.... [T]his doesn’t make any sense. At the heart of the Swedish solution was the guarantee of all bank debt, ensuring that bondholders would not take a hit. And the Swedes, at least, thought that guarantee was essential to making their plan work.... [N]ationalization supporters should be clear: if they want to cram down the debtholders, then they don’t want the U.S. to follow the Swedish model. You cannot “Go Swedish” and “wipe out bond holders” at the same time.

There are nationalization advocates who really do want the U.S. to emulate Sweden, including most notably Paul Krugman, who’s said, “Sweden guaranteed all [bank liabilities]. If forced to say, I would go the Swedish route; but of course we can’t do that unless we’re prepared to put all troubled banks in receivership.” But many supporters of nationalization are just invoking Sweden in order to prove that there’s a historical precedent for successful nationalization, while at the same time arguing that the U.S. should reject a crucial part...

So let me be clear: for sixteen months now I have been a Swedish-model advocate who wants to guarantee bank bondholders. I thought and think it is the best practical road out of this mess."

by ensuring “the stability of the payment system and to safeguard the supply of credit.”

TO BE NOTED: From The New Yorker:

"The Sweden Example

Ryan Avent beats me to the punch by pointing out the most important part of today’s Times’ story on Tim Geithner, namely that in the summer of 2008, after the collapse of Bear Stearns but before the meltdown of Lehman Brothers, Geithner proposed having the government guarantee the debts of all U.S. banks. The plan was shot down as politically untenable, but, as Ryan points out, had it been put into effect, we would most likely not have seen Lehman go under or had to deal with the incredibly negative consequences of that failure. More important, perhaps, by reducing the threat of panicked runs on bank debt (since those debts would have been guaranteed), such a guarantee would also have made it easier for regulators and banks to deal in a transparent fashion with the toxic-asset problem. That’s why the very first step in Sweden’s much-admired solution to its banking crisis in the early nineteen-nineties, was, yes, a guarantee of all bank debt. As one of the regulators involved in that effort put it, the guarantee “was provided in order to restore confidence and to ease the immediate pressure on banks,” by ensuring “the stability of the payment system and to safeguard the supply of credit.”

Given all this, Ryan is perplexed that Yves Smith, in her post today on the Times article, dismisses Geithner’s proposal as just another attempt to give Wall Street a handout. In part, this could be because Smith thinks that, in the absence of a systematic plan to deal with toxic assets (which we don’t know if Geithner had), guaranteeing all bank debt would have allowed banks to engage in more risky behavior, knowing that taxpayers would foot the bill. But I think what’s really driving Smith’s attack on Geithner’s proposal is her conviction that any plan to deal with the banking system has to require bank bondholders to take a major hit. In other words, for Smith, the Swedish solution is not the right one. Nationalizing the banks, and wiping out the shareholders, isn’t enough: you have to impose significant pain on the banks’ debtholders, too.

Lots of nationalization advocates believe that a debt guarantee is a bad idea. But one of the things that’s made the debate over nationalization confusing is that many of these same people, while arguing that bank debtholders should take a hit, also say that what the U.S. should do is emulate Sweden. Henry Blodget, for instance, has argued that that we should follow “a tried and true way of fixing banks: The Swedish Model,” and yet he also insists that we should stop bailing out bank bondholders. And Barry Ritholtz has written that when it comes to dealing with the banks we should “Go Swedish. Wipe out shareholders, bond holders, and all the bad debt and junk paper these firms hold.”

Needless to say, this doesn’t make any sense. At the heart of the Swedish solution was the guarantee of all bank debt, ensuring that bondholders would not take a hit. And the Swedes, at least, thought that guarantee was essential to making their plan work. In the U.S. context, maybe we should follow a different approach, but nationalization supporters should be clear: if they want to cram down the debtholders, then they don’t want the U.S. to follow the Swedish model. You cannot “Go Swedish” and “wipe out bond holders” at the same time.

There are nationalization advocates who really do want the U.S. to emulate Sweden, including most notably Paul Krugman, who’s said, “Sweden guaranteed all [bank liabilities]. If forced to say, I would go the Swedish route; but of course we can’t do that unless we’re prepared to put all troubled banks in receivership.” But many supporters of nationalization are just invoking Sweden in order to prove that there’s a historical precedent for successful nationalization, while at the same time arguing that the U.S. should reject a crucial part of what made that precedent work. So the news that Geithner wanted the U.S. to take a first step on the Swedish path is unlikely to change their view of him. If anything, it’ll just confirm their assumption that he’s not willing to do what’s necessary.

Posted by James Surowiecki"

And:

April 27, 2009

The Fetishization of Boldness

Justin Fox has a nice post laying out a range of possible explanations for the Obama Administration’s decision not to nationalize some of the country’s biggest banks. Sensibly, the very first explanation Fox offers (and one he says he’s finding more plausible) is that the Administration is following its current strategy for dealing with the banks (a mix of regulatory forbearance and government subsidy in the form of debt guarantees and capital injections) because it believes “it’s the proper course of action, because most banks will be able to earn their way out of their problems if given some time and forbearance by regulators.” Oddly, this simple explanation—that Barack Obama, Tim Geithner, and Ben Bernanke have adopted their strategy because they think it has the best chance of getting the economy back on track while taking the least systemic risk, rather than because they’re stupid, or corrupt, or “cognitively captured”—is one you rarely hear floated these days, even though it is, I think, almost certainly true.

At the same time, Fox echoes one of the most common, but least convincing, criticisms of the Administration’s approach in general, and of Tim Geithner in particular, namely that they’re handling the crisis in a “tentative way” and not being bold enough. This critique has become a commonplace—it’s at the heart of Gary Weiss’s piece on Geithner in the new issue of Portfolio, where Geithner is described as “tentative,” “lacking in boldness and imagination,” and lacking “fresh ideas.”

I don’t buy it. Geithner did flub his first big speech, when he gave markets only a tentative sketch of what the Administration’s bank plan would look like. But from a policy perspective, the Administration has not been tentative at all: in fact, it’s been unwavering in its insistence that, given current market and economic conditions, the risks and costs of nationalization outweigh the benefits. And its alternative strategy may be wrong, but that doesn't mean it’s ill-considered, or halfhearted.

It's true that the administration's approach may not be bold in the sense of being radical, but no one believes that boldness is, in itself, a good thing or that the more radical a solution is, the better it must be. (The Bush Administration’s decision to invade Iraq was certainly bold and radical. That didn’t make it any less of a mistake.) More important, the boldness issue is really a red herring. Obama’s critics’ problem with the Administration isn’t really that they think it should act more decisively: it’s that they think the Administration should act differently. In that context, the personal attacks on Geithner for being weak and hesitant (like the persistent references to him as “Timmy,” as if he were somehow a child) are really just rhetorical gambits designed to make the Administration’s strategy seem weak and hesitant as well. The myriad criticisms of Geithner’s style and connections and the Administration’s lack of imagination all really boil down to the same unvarying argument: the government should nationalize the banks. And as long as the Administration refrains from doing this, nothing it does on the banking front—either stylistically or in terms of policy—will satisfy its critics.

Keywords

• Justin Fox;
• Obama administration;
• Tim Geithner;
• Treasury;
• banking crisis;
• banking system

Posted by James Surowiecki"

Berlin's plans include a complete takeover -- by expropriation, if necessary.

TO BE NOTED: From Spiegel Online:

"THE STATE'S SILENT TAKEOVER

Germany's Big Banking Bailout

By Christian Reiermann and Wolfgang Reuter

The German government wants to buy up large segments of the domestic banking sector. In addition to the partial nationalization of many ailing financial institutions, Berlin's plans include a complete takeover -- by expropriation, if necessary.

Josef Ackermann, the CEO of Deutsche Bank, likes to come across as generous. A few days ago in Berlin, he said that he is by no means too proud to take advantage of the government bailout program for banks, and that all he wants is to see it benefit those banks that truly need it. "We are a long way from that," he said.

But the competition is skeptical, especially when the industry leader is having trouble hiding the fact that it lost about €4 billion ($5.2 billion) in 2008. In addition, both competitors and politicians have noted with interest Ackermann's behind-the-scenes involvement in the development of a "bad bank," that is, a sort of government dumping ground for unmarketable, high-risk securities.

DDP

Storm clouds gather over Frankfurt, Germany's banking center.

Industry insiders suspect that Deutsche Bank hopes to shift its own toxic waste into this new entity -- saving face in the process because, after all, everyone else will be doing the same thing.

Ackermann is receiving support for the project from the Association of German Banks, in which Deutsche Bank exerts substantial influence. Last Monday Hugo Bänziger, the chief risk officer at Deutsche Bank, appeared before members of the conservative Christian Democratic Union's (CDU's) finance committee to promote the potential benefits of a "bad bank."

FROM THE MAGAZINE

Find out how you can reprint this DER SPIEGEL article in your publication.

But all of Ackermann's and Bänziger's efforts proved to be in vain. On Friday, a fundamentally different approach to solving the problems of German banks emerged at a meeting of the two members of the coalition government, the CDU and the Social Democratic Party (SPD). Instead of a single, government-run landfill for the banks' toxic securities, the new plan calls for a large number of privately held "bad banks." Contrary to the arrangement Ackermann and his allies comrades-in-arms envisioned, this would see the banks' shareholders being the ones who would primarily vouch for risks in the future rather than the government and taxpayers.

Nevertheless, the government is not abandoning all responsibility. Should the healthy parts of the banks lack equity, the government will provide the necessary funds. This would make it a major shareholder in the German banking sector, turning the federal government into a silent power in the skyscrapers of Frankfurt's banking district.

The bailout program will be costly. The government will have to more than double the €80 billion ($104 billion) capital injection included in its first bank rescue package. Experts at the Finance Ministry anticipate that the stripped-down banks will require up to €200 billion in additional capital.

Making the Bailout More Appealing

It is a development that would have been unthinkable only a few months ago, but is now being surpassed by another of the government's rescue projects, as it discreetly prepares to nationalize the stricken lender Hypo Real Estate.

Both programs may seem disconcerting for a market economy. And yet, in the state of the emergency brought on by the continuing financial crisis, they may be unavoidable.

The German government is more likely to face criticism from economists for considering bailouts for individual companies, like ball-bearing maker Schaeffler-Conti or Airbus. But the bank bailout plan involving many small "bad banks" has received widespread support.

Unlike the Ackermann concept, under the new plan the government would not simply take on the banks' risks. Instead, that would be left up to shareholders. Chancellor Angela Merkel and Finance Minister Peer Steinbrück hope that this approach will generate more support with the public for the government's second bid to use taxpayer's money to rescue the banks.

Most important, the federal government would not be acquiring the worthless parts of a bank, but instead would invest in its promising aspects. This also makes the proposal politically appealing.

After the first bank bailout package, this is the government's second major attempt to stabilize the center of the ongoing economic and financial crisis, the banking world. It is still deeply shaken by the collapse of the US real estate market in 2007, when millions of mortgage loans lost their value. Since then, these toxic assets have crippled banks' ability to do business virtually everywhere in the world.

Because the banks do not know how much of their old risk they can even write off anymore, they prefer not to assume any new risk. The consequences have been fatal. As the banks issue too few loans, companies lack the necessary funds for investment, causing the economy to slow down.

The amounts of money involved are already largely beyond the scope of human imagination. In Germany alone, the biggest 18 banks are carrying a volume of €305 billion ($397 billion) in toxic assets on their balance sheets, less than a quarter of which has already been written off.

Further value adjustments seem unavoidable. The International Monetary Fund (IMF) estimates that worldwide losses could total $2.2 trillion (€1.7 trillion). No one has a formula for how best to recapitalize the banks and get credit flowing again.

RELATED SPIEGEL ONLINE LINKS

• The World from Berlin: 'German Banks Are on the Edge of the Abyss' (01/23/2009)

• The State as Über-Entrepreneur: Berlin Sees No Limits to Economic Intervention (01/21/2009)

• 300 Billion Euros in Toxic Securities: German Banks Face Further Big Losses (01/19/2009)

• Germany's Faltering Bank Bailout Program: The Bottomless Pit (12/23/2008)

Great Britain, for example, is placing its hopes on a government insurance system under which the banks, in return for a fee, could insure themselves against further losses. The new US administration under President Barack Obama is doing what Ackermann would have liked to see happen in Germany: It plans to establish a giant, government-owned "bad back" for toxic loans.

This American deposit fund would spend an additional $2 trillion (€1.54 trillion) to buy high-risk securities from lenders. The hope is that the banks, provided with fresh capital and freed of their toxic assets, could then devote themselves to their actual business: lending money to citizens and companies.

The government in Berlin does not consider either of the two Anglo-Saxon approaches to be suitable. The Germans see the British model as too costly and the American approach as inequitable.

Why should the government buy up billions in worthless securities and take all risk off the hands of those responsible for the crisis in the first place, ask those behind the new bailout plan? They characterize the US and British plans as gifts for shareholders at the expense of taxpayers. For this reason, the German government prefers a different concept, which it hopes to implement within the next four weeks. The plan, conceived by staff at the Finance Ministry, amounts to a radical modification of the German banking industry. Hardly any of the ailing lenders will likely manage without government investment in the future.

There are two possibilities for the disposal of bad loans. Either the securities are depreciated before being deposited into the special funds, or the "bad banks" receive large portions of the remaining equity to offset losses. Either way, the newly streamlined banks will lack capital to conduct their transactions.

Following Sweden's Example

This is where the government comes in. It provides the healthy banks with capital via its Special Fund for Financial Market Stabilization (Soffin). As a result, the government becomes a shareholder in many banks, initially through silent deposits. But if it comes to the aid of publicly traded banks, it soon finds itself forced, as in the case of Commerzbank, to acquire a blocking minority consisting of 25 percent plus one share. This is the only way it can prevent a buyer from simply clearing out the government's money.

The concept makes sense for both the government and taxpayers. The government can hope that its investment will eventually pay off. Once the banking crisis has been weathered, its deposits are returned and it can resell its shares, possibly even at a profit. This, at least, was the Swedes' experience during their banking crisis in the 1990s. German government experts were inspired by the Swedish experiences when developing their own rescue plan.

The establishment of "bad banks" within existing institutions also has a psychological effect, for employees and customers alike. Separating out the bad assets into a "bad bank" has a liberating effect on the healthy part of a bank. From then one, it can operate without the constant threat of further write-offs.

But the removal of their troubled assets also creates new challenges for banks. The risks are not decreased simply because they have been separated from the actual bank. The management of so-called troubled loans requires skills beyond those needed to issue ordinary loans, which merely require routine monitoring.

Hardly anyone is more aware of this than Jan Kvarnström. A Swedish national, Kvarnström headed the Institutional Restructuring Unit, the "bad bank" with which Dresdner Bank overcame its troubles, from 2002 to 2005. The job description of a chief liquidator ranges from tough negotiations with delinquent borrowers to the receivership and subsequent forced sale of the securities. He handles a wide assortment of large and small assets.

DER SPIEGEL

German Banks' Write Downs.

During the course of his career as a liquidator, Kvarnström has sold a bank in Chile, many forms of financial holdings in companies, real estate and a collection of guitars once owned by the Beatles.

"All of this has nothing to do with the normal work of a banker," Kvarnström recalls. For this reason, he says, it makes sense "to concentrate the bad investments, together with the corresponding personnel, in a bad bank."

The drawback of the plan is that the money made available in the bank rescue package, €80 billion ($104 billion) will not be sufficient for government equity capital injections. Soffin's authority to issue credit must be augmented by about €120 billion ($169 billion). This would make it the largest shadow budget in the history of postwar Germany.

Commerzbank, under CEO Martin Blessing, has already received €18 billion ($23.4 billion). The nationalization debate over ailing Hypo Real Estate is already burdening the Soffin budget. The bank needs at least €10 billion ($13 billion) in additional funds.

But that isn't the extent of it, because the government will also be called upon to spend even more money to buy up at least 95 percent of the Munich-based lender. This is the second front in the government rescue concept: The takeover of Hypo Real Estate is intended to prevent a possible bankruptcy from leading to other bank failures, thereby bringing down large segments of the German financial market.

Nationalization and Expropriation

This scenario could materialize, as a result of Hypo Real Estate having gambled away funds for the purchase of long-term government bonds. To be able to afford the transactions, the bank took out short-term loans. As long as the interest rates on those loans were low enough, the business was profitable. But then loan terms deteriorated as a result of the financial market crisis. Since then, the bank has accumulated an uninterrupted series of losses, which could only be offset with a constant stream of new government loan guarantees.

The government believes that it has only one option left to stop the downward spiral: to essentially nationalize Hypo Real Estate. This would allow the lender to take up new loans under the favorable terms of publicly owned financial institutions and turn a profit with most of its transactions. Only then would the previous liquidity injections of more than €90 billion ($117 billion) not be lost.

To minimize conflicts with owners during the takeover, the government will pursue an escalation strategy. Its preferred method would be to acquire the bank with the consent of previous shareholders, through a simple takeover bid.

But the shareholders are not biting, leading government representatives to believe that they are holding out for a better offer. The shareholders know that the government has a strong interest in a takeover, and they want to be handsomely compensated in return, which the government wants to avoid. When the negotiations ended on Friday evening, no results had been achieved.

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As a next step, the government plans to amend the law on stock corporations and strengthen the rights of shareholders' meetings so that refractory minority shareholders can be booted out. It is also unlikely to shy away from expropriation of the lender's shareholders.

A proposed expropriation law to be debated by the cabinet in the coming weeks reveals how serious the government is. The nine paragraphs of draft legislation would define the conditions for the government's compulsory takeover of a company.

Because the German constitution bans nationalization without compensation, the draft legislation also contains compensation rules for the former owners of a nationalized company.

The compulsory nature of these measures has left a sour taste in the mouths of federal government experts. Because the constitution expressly protects private property, the German government hopes never to have to apply its emergency legislation. According to ministry officials, the purpose of the plan is to provide a credible threat of nationalization to encourage shareholders to negotiate. Members of the Grand Coalition already joke that the bank rescue program now apparently follows the logic of the Cold War: "You have to threaten with a nuclear bomb so that you will never have to use it."

Translated from the German by Christopher Sultan"

The GAPS is basically a good-bank/bad-bank structure

TO BE NOTED: From Alphaville:

"Comparing the Swedish timeline Posted by Paul Murphy on Apr 02 10:56.

A considered piece of research out of Goldman Sachs on Thursday reached the brave conclusion that Britain’s Government Asset Protection Scheme will mark the turning point for Britain’s banks.

The GAPS is basically a good-bank/bad-bank structure, according to Goldman’s Aaron Ibbotson. And, so long as the two participants, Lloyds and RBS, make sure the bulk of their bad assets are in the “bad bank” GAPS, both Lloyds and RBS look to be low risk players compared with their European peers.

Indeed, Britain’s experience (ex-Barclays) may yet emulate that of Sweden during the 1990s. Here are two timelines for comparison purposes. Click to view.

Related links:
Bad bank brewing - FT Alphaville
Knowing our banks, knowing yours - FT Alphaville

This entry was posted by Paul Murphy on Thursday, April 2nd, 2009 at 10:56 and is filed under Capital markets. Tagged with barclays, Lloyds, rbs."

they failed to reassure investors that the banking system was genuinely backed by the government and private sector

TO BE NOTED: From The Daily Beast:

"Don't Fear the Swedish Model

by Benjamin Sarlin

March 24, 2009 | 7:23am

Fredrik Sandberg, Scanpix / AP Photo

Bo Lundgren, Sweden’s minister for fiscal and financial affairs, stared down a financial crisis in the 1990s and lived to tell the tale. In a Daily Beast interview, he says the US could learn a thing or two from his famed solution.

In happier times the words "Swedish model," were more likely to be found in a Budweiser ad than a Wall Street Journal op-ed. But with the financial sector in ruins, a debate over whether to follow Sweden's lead and nationalize America's weakest banks has given the phrase an ominous new context.

At one point last month Sweden's plan was approaching consensus opinion, with conservatives like Sen. Lindsey Graham and former Fed Chairman Alan Greenspan finding common ground with liberal economists like Paul Krugman. President Obama countered that the US had many more banks than Sweden and a profoundly different culture. And with the announcement Monday of the administration’s plan to buy up toxic assets using a combination of public and private investment, the dreams of a Swedish solution in America are being put to rest.

"From the market liberal's perspective, don't be afraid of Sweden being a socialist example because in this respect we are not," Lundgren said.

Before today’s news, The Daily Beast called Bo Lundgren, who, as minister for fiscal and financial affairs, conceived and implemented the famed "Swedish model" in the 1990s. Lundgren said the American fears of a Swedish planet are largely misguided.

"I'm a market liberal. My party that I used to lead, the Moderate Party, is the conservative party in Sweden and the parallel to the Republican Party in America," Lundgren said. "When I nationalized the banks, it wasn't because I wanted to: It was crisis management. Their owners had been wiped out, the banks were black holes, they had no equity left, and there was no alternative but to take them over."

He added that foreign observers often confuse Sweden's socialized income distribution and government services with its privatized business environment, leading to inaccurate claims that their government is fundamentally different than other free-market economies. One example of Sweden's privatization chops: The government is refusing to bail out the famed car company Saab this week, as officials say they don't think running an auto manufacturer is within the state's job description.

"From the market liberal's perspective, don't be afraid of Sweden being a socialist example because in this respect we are not," he said. "Governments shouldn't interfere in business life other than to build the legal framework within which our businesses have to work. They should otherwise leave businesses alone and that's what we mainly do."

The Obama administration's initial plans have fallen short, Lundgren said, because they failed to reassure investors that the banking system was genuinely backed by the government and private sector.

"There are similarities [to Sweden's case]," Lundgren said. "There are three things any plan must do—the first is to maintain liquidity, that's taken care of by the Fed. The second thing is to restore confidence, and that hasn’t been done so far and obviously the first proposal to buy toxic assets wasn't enough. And then you need capital injections so banks can keep lending at the levels needed for the economy as a whole."

However, Lundgren said that Obama was correct in observing that a similar nationalization scheme might be more difficult given America's size and preeminent role in world finance compared to Sweden.

"With Japan and Sweden, the crises we had, even if it was a very long process with Japan, they were crises that we had on our own," Lundgren said. "The rest of the world economy managed to be not perfectly good but still reasonably good. This time it's worse; it's a kind of financial tsunami."

According to Lundgren, the question of whether the White House follows Sweden's example or not is less important than the larger goal of soothing investors' current panic over the financial crisis.

"Even if it’s a totally different situation, you have to get the financial system in order and in order to do that you have to get confidence," Lundgren said. "Franklin Roosevelt did it by closing all the banks and reopening the sound ones, we did it with a blanket guarantee to creditors and depositors. And Japan, well, they didn't do anything, to be honest. Now the question is what can be done in the US. You don't need the same techniques, but you need to restore confidence."

Lundgren said he has been most encouraged so far by Geithner's promised "stress tests," which will look at banks' balance sheets to determine if they are healthy enough to receive bailout funds and still function in the depressed economy. Some economists, Krugman included, have suggested that this approach could prove to be a backdoor route to nationalization, as banks that prove insolvent after undergoing a stress test could force the government to take a more hands-on approach. Either way, Lundgren said the tests will at least help Wall Street separate the good banks from the bad, a crucial step toward talking investors down from their current ledge and back into bankrolling the abandoned finance sector. He advised that the tests be done quickly for maximum affect, getting painful discoveries out of the way in one fell swoop.

"If the situation is bad and a lot of banks have bad problems, it’s better to get it out into the open than hiding and waiting, because it then takes longer to manage the crisis," he said. "What you have to do is be very transparent. We started implementing a very straight process of evaluating banks' balance sheets–something Japan didn't do, for instance."

One other step America could take to bolster confidence would be to put a bipartisan sheen on any bailout plan, something Sweden did in the 1990s with a coalition of center-left and center-right parties. Of course, given how recent policy debates have turned out (total Republican votes for the stimulus: three), this may be tougher to achieve in America.

"If you are going to have a financial crisis, please have it after an election," Lundgren advised, noting that last fall's bailout battle was negatively influenced by politicians who were afraid to face voters over the unpopular measure just weeks after their vote. "I don't know how the situation is in the US, but if there could be a bipartisan agreement to handle this, it would be a much better thing, more stable and with less-critical risk."

Benjamin Sarlin is a reporter for The Daily Beast. He previously covered New York City politics for The New York Sun and has worked for talkingpointsmemo.com."

Overall, Sweden’s financial crisis containment and resolution strategy largely avoided mistakes that would skew uninsured investors’ incentives going

TO BE NOTED: From Vox:

"Sweden as a useful model of successful financial crisis resolution

Kent Cherny Emre Ergungor 19 March 2009

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The way Sweden handled its 1990s banking crisis has been offered as a useful case study in resolving systemic banking crises. This column discusses the merits of the Swedish experience relative to ideal resolution strategies.

Governments of the world’s rich nations are clearly in need of positive examples of how to fix broken banking sectors. While we have many such examples from the last century (Caprio, Hunter, Kaufman, and Leipziger 1998), one of the most recent is the Swedish crisis.

In the early 1990s, Sweden’s economy was nearly toppled by a banking sector swollen with bad loans from the preceding decade’s credit bubble. The Swedish government seized ownership of the largest financial institutions and publicly-capitalised asset managers were put in charge of managing the poorly performing banking assets and returning what could be salvaged back into private hands. In this column, we compare the Swedish government’s intervention to four identified principles of effective crisis resolution:

• Transparency of asset losses up-front, and honest communication about the extent of public intervention
• Politically and financially independent receivership
• Maintenance of market discipline
• Restoration of credit flows
• Four principles of effective crisis resolution

A paper published by the Federal Reserve Bank of Cleveland, based on the analysis of evidence from financial crises across the globe, identified four practices common to successful financial crisis resolutions.

Transparency

The most important attribute of successful crisis resolutions has been the transparency of the entire process. Triage and full public disclosure of associated losses clear the uncertainty surrounding financial institutions and make it possible for viable institutions to raise new funds from private investors or from the government if private sources are not available. Failing to acknowledge the true value of assets or the condition of troubled banks early on makes it easy for them to live on as propped-up “zombies” (as happened in Japan during the 1990s or with savings and loans in the US in the 1980s) – healthy on paper but economically insolvent.

Politically and financially independent receivership

Crisis resolutions have been most successful when they were handled by a politically and financially independent agency. Granting independence to those responsible for containing the crisis and restructuring shields decision makers from political pressures, which mount as institutions are closed and assets are liquidated. The decision to close a financial institution or a business must be economic, not political. Financial independence is necessary to give credibility to political independence – if a government agency holds the purse strings, it can dictate policy. Incidentally, a transparent process is essential to the success of the independent agency. Without transparency, investors and taxpayers cannot verify independence.

Maintenance of market discipline

A successful resolution strategy must maintain market discipline, lest it simply set the stage for future crises. Investors who assumed greater risks must be credibly exposed to loss and suffer the consequences of having ignored or failed to detect signs of trouble. Blanket guarantees of uninsured depositors and investors are an example of a policy manoeuvre that might lessen the pain of a crisis in the short run but also distort market discipline going forward.

Restoration of credit flows

Finally, a full crisis resolution must begin to restore credit flows within the economy. For that to happen, the creditworthiness of borrowers must be restored throughout the economy – a difficult task, given that the economic fallout from a crisis (such as rising unemployment) actually erodes credit quality further.

How did these principles work in Sweden?

Sweden’s crisis

Sweden’s crisis followed a massive surge in speculative real estate and consumer debt. In 1991, two of Sweden’s largest banks, Föreningsbanken and Nordbanken, fell below their required capital levels amid rising loan defaults. Afraid of a meltdown, the government guaranteed all of Nordbanken’s liabilities and took ownership of the bank, while arranging a guarantee for Förenings. When a third large bank, Gota, was taken over shortly thereafter, policymakers acted quickly to separate the good from the bad.

Government-held assets that were deemed viable were merged under one name, Nordbanken, and permitted to continue operating. Bad assets were transferred to two asset management companies – Securum for Nordbanken’s assets and Retrieva for Gota’s.

The asset management companies were charged with managing and liquidating the bad assets of these banks and taking on the assets of non-bank companies that were in default. Swedish legislators made sure that the companies were adequately capitalised and granted exemptions from regulatory rules that would have rushed their actions or limited their effectiveness, including a rule that required seized collateral to be liquidated within three years.

Often, the asset management companies became managers of otherwise private, failed companies, performing such tasks as hiring and firing, managing property, and changing operational strategies until their assets could be favourably sold. Their flexibility and financial resources shortened their own existence from an expected duration of 15 years to a few years. Liquidations were completed in 1997, and the companies’ remaining funds (less than half of their original capitalisation, in real dollars) were returned to the Swedish treasury.

Lessons learned

Sweden emerged from its credit market turmoil without the zombie banks and dismal growth that characterised Japan’s “lost decade”. This achievement is at least partly due to Sweden’s crisis containment and resolution strategies.

First, Sweden’s approach was remarkably transparent. The magnitude of losses was established by a Bank Support Authority, which was independent of the Ministry of Finance and the central bank. Good assets were separated from bad assets, and the full extent of the government’s involvement was clearly outlined. Transparency about losses from the outset likely avoided the “zombie” effect and what Douglas Diamond has called “evergreening,” a process whereby undercapitalised banks choose not to address problem loans because doing so would force asset write-downs, possibly prompting technical insolvency.

Sweden also extended considerable political and financial independence to the asset management companies, which allowed them to carry out their task with adequate resources. Doing so served as a public signal that their operations would not be subject to changing political winds. Similarly, Swedish officials’ relaxation of collateral liquidation requirements implied that the dispensation of assets would take place over an extended period of time. Arguments can be made either way about the best time to sell assets – selling early returns assets to private use and avoids investor anxiety about debt overhang, while selling gradually sidesteps a distressed-pricing feedback loop. In any case, asset managers were given flexibility to make their own decisions about the trade-off.

To restore credit flows, Sweden moved quickly to provide incentives to bank owners to inject additional capital into their banks or to inject government capital into banks directly, when necessary. Asset management companies played a key role in restoring the financial health of the non-bank companies they were operating. Some viable corporations were allowed to survive through capital injections, though in return the government acquired a majority of their shares so that taxpayers could profit from any upside. Recapitalised institutions could return to ordinary operation, gradually rebuilding the creditworthiness of the overall economy.

Sweden’s success at maintaining market discipline was perhaps more limited. Ideally, discipline is sustained by not saving undisciplined investors through issuing blanket guarantees and unlimited liquidity. In Sweden’s case, policymakers avoided the liquidity pitfall but ended up guaranteeing bank liabilities before the banks themselves were taken over. Edward Kane and Daniela Klingebiel have suggested an alternative to such incentive-skewing guarantees. They have argued that the optimal response to a systemic banking crisis is to call a bank holiday long enough for examiners to determine which banks are viable, while still giving insured depositors access to their funds. Doing so would insure business as usual for insured depositors without permitting uninsured investors to cash out before they’ve taken their share of unrecoverable losses.

Most of the criticisms that can be levelled at the Swedish crisis resolution are easy to make in hindsight. Overall, Sweden’s financial crisis containment and resolution strategy largely avoided mistakes that would skew uninsured investors’ incentives going forward. Its policies were enacted transparently, insured political independence, and attempted to restore credit flows in the broader economy. The Swedish case illustrates the trade-offs and considerations of market discipline that crisis managers must address if they are to minimise taxpayer losses and speed the return to a rebalanced, growing economy.

Recommended reading

Caprio, Gerard, William Hunter, George Kaufman, and Danny Leipziger, 1998, “Preventing Bank Crises: Lessons from Recent Global Bank Failures”, Federal Reserve Bank of Chicago and the EDI of The World Bank, Washington, D.C.

Diamond, Douglas W. “Should Banks Be Recapitalized?” 2001. Federal Reserve Bank of Richmond, Economic Quarterly, vol. 87, 71–96.

Ergungor, O. Emre. “On the Resolution of Financial Crises: The Swedish Experience,” 2007. Federal Reserve Bank of Cleveland, Policy Discussion Papers, no 21.

Ergungor, O. Emre and James B. Thomson. “Systemic Banking Crises,” 2006. In Research in Finance, edited by Andrew H. Chen. Elsevier.

Kane, Edward J. and Daniela Klingebiel. “Alternatives to Blanket Guarantees for Containing a Systemic Crisis,” 2004. Journal of Financial Stability, September, 31–63"

In response to the new crisis, legislation was rushed through after 16 years of being ignored.

TO BE NOTED: From the FT:

"Self-assembly solution

By Peter Thal Larsen and Chris Giles

Published: March 17 2009 20:30 | Last updated: March 17 2009 20:30

In calmer times, Stockholm would not be an obvious destination for economic policymakers hoping to improve their understanding of the financial system. The capital of a small economy on the fringes of Europe typically spends most of its time responding to events whose origins lie elsewhere.

Yet in the past year growing numbers of eminent visitors have passed through the revolving doors of the imposing black granite block on the Brunkebergstorg that houses the Riksbank, Sweden’s central bank. Their mission: to learn whether Sweden’s response to the crisis that rocked its financial system in 1992 can offer lessons for dealing with the current global meltdown.

Particularly in the US, politicians and commentators express enthusiasm for what has become known as the “Swedish model” for tackling failing banks. It has come to be seen as a template for rapidly sorting out problems through nationalisation and the dumping of toxic assets into “bad banks”. For rightwing commentators, it has become a metaphor for a slide into central planning.

President Barack Obama has hinted that he views a swift, Swedish-style approach as preferable to Japan’s response to its 1990s banking problems, which contributed to a “lost decade” of growth. Tomorrow, Bo Lundgren, the head of Sweden’s debt office who was among those to have worked on clearing up his country’s banking mess, is due in Washington to offer insights to the Congressional Oversight Panel, which supervises the US government’s troubled asset relief programme. Matthew Richardson and Nouriel Roubini, both professors at New York University’s Stern Business School, recently declared: “We are all Swedes now.”

Yet the reality is less simple. Interviews with several figures involved in designing and implementing the Swedish bail-out suggest there are some parallels with the current crisis. However, there are also important differences.

Indeed, one of the first things visitors who ask about the 1992 bail-out are told is disconcerting. “There is nothing Swedish about what people call the Swedish model,” says Stefan Ingves (left), the Riksbank’s governor, in his spartan office. Mr Ingves was a finance ministry official in the early 1990s and headed the Bank Support Authority, the agency Sweden set up to resolve its crisis. “What we did was to put the thing together but we did not invent the wheel – we used the knowledge that we could find wherever we could find it in other parts of the world.”

Visitors also receive reassurance that they are not too late; Sweden grew serious about its crisis only after two years of dithering and individual bank support packages between 1990 and 1992. By that time, Mr Ingves says, “we had done a number of ad hoc cases and realised that since they tended to come back it was hard to get it right the first time”. It was only in mid-1992, when the country nationalised Nordbanken, that Mr Ingves says there “grew a feeling that [the wider banking crisis] could just spiral out of control”.

So officials, thinking about a plan to buy time, devised a system-wide programme that could apply to all banks. In September 1992, the government announced a guarantee for all bank creditors apart from shareholders, along with a wider restructuring.

Mr Ingves says that moment was six months in the planning. Unlike the US with Tarp, the Swedish authorities decided not to put a figure on the size of the guarantee. “If you pick a low number, people say it’s not going to be enough; if you pick a very high number they say, ‘oh, is that the problem?’” the central banker observes.

The Bank Support Authority he would head was authorised to offer support to any bank that requested help, but on strict terms. Any bank seeking support had to submit to a forensic examination of its books – and, if necessary, an injection of government capital. Contrary to the myth that surrounds the Swedish model, the authorities nationalised only two banks: Nordbanken, which was already state-controlled, and Götabanken. Co-operative and savings banks were merged but other private banks ultimately chose to raise private capital.

TIMELINE:

From liberalised banking to rescues and attempts at revival

1985 Sweden liberalises its banking system, abandoning limits on interest rates and credit. Banks embark on a lending spree, particularly in commercial property.

1990 Economic output peaks in the second quarter as the central bank raises interest rates to defend the krona’s peg with the European currency unit.

1992 Problems at Nordbanken, already 80 per cent owned by the state, force the government into a full nationalisation of the bank. In September, Götabanken suspends payments to creditors. Overnight interest rates reach 500 per cent.

On September 24, the finance ministry issues a blanket guarantee of bank liabilities. A Bank Support Authority is to be created.

On November 19, the government abandons its defence of the krona, which falls 30 per cent against the Ecu.

Interest rates fall rapidly and an inflation targeting system is introduced. Götabanken is nationalised in December.

1993 The economy begins to grow again, with output down 6.1 per cent from the peak. In January, the government injects Nordbanken’s bad assets, which include office blocks and hotels across Europe, into a vehicle called Securum.

Götabanken’s good assets and branches are added to Nordbanken and its bad assets managed through Retriva. The fiscal deficit reaches
12 per cent of gross domestic product.

1994 By the summer, all banks have been recapitalised and are healthy again. The economy grows strongly.

1995-2007 Banks expand and merge. Nordbanken combines with Finnish, Danish and Norwegian banks to create a pan-Scandinavian institution called Nordea. Swedish banks lend aggressively in eastern Europe, particularly the formerly communist Baltic states.

2008 Following the collapse of Lehman Brothers in the US, the Swedish government offers to guarantee up to $205bn of its own banks’ debts and sets up a SKr15bn fund to take equity stakes in banks.

Three of Sweden’s four largest banks, including Nordea, which is still 19.9 per cent owned by the government, raise capital.

“It was never the intention of the government and the Bank Support Authority to sort of take over as many banks as possible,” says Mr Ingves. “The issue was to be ready to sort out the mess in the system. To do so we needed a process that made it possible for us to evaluate whether a bank was actually OK, had a small problem or a huge problem.”

Arne Berggren, the finance ministry official responsible for bank restructuring, is blunt about the approach he took. It was clear from the outset that the government would act as a commercial investor, demanding equity stakes in return for capital. “We were a no-bullshit investor – we were very brutal,” he says. The authorities also insisted on control. “You take command. If you put in equity, you have to get into the management of the business, [otherwise] management is focused on saving the skins of the [remaining private] shareholders.”

Dag Detter, who oversaw all of Sweden’s state-owned enterprises in the mid-1990s, says it is crucial that such companies are run with commercial objectives, are insulated from political interference and are transparent in their actions in order to maintain the trust of the public and the markets. “If any of these three principles is ignored, taxpayers will suffer along with the commercial assets in state ownership.”

Once the government had taken control of the two banks, it set about ring-fencing their troubled assets into separate “bad banks”. Central to this decision was the recognition that the management of good and bad loans requires fundamentally different skills. “Bankers want to keep their customers. That’s how you define success,” says Mr Ingves. “If you’re running a ‘bad bank’, success is to get rid of your customers – and that means that you have to have a different mindset when you deal with these issues.”

Private banks were also encouraged to place their bad loans in separate entities. However, in contrast with the recent debate in the US, the authorities never contemplated removing bad assets from those banks. “We refused to buy assets from privately owned banks because it would have been impossible for us to agree on the price and we were never in the business of giving privately held banks subsidies,” says Mr Ingves.

Does this mean the US, UK and other countries that have committed vast sums to insure bad assets, on the books of banks that remain at least partially in private hands, have lost the plot? Mr Ingves is too polite to say but there is no doubt in his mind who will pay: “How you want to define the loss between the public sector and the old shareholders, that’s a value judgment, that’s a political judgment,” he says.

But for all the potential lessons, many factors suggest the Swedish experience is an imperfect guide to navigating the current crisis.

First, Sweden’s banking system was relatively small. When Stockholm issued its guarantee, banks’ total liabilities represented little more than a year’s gross domestic product. As a result, the guarantee was more credible than it would be today, when the banking systems of small countries such as Ireland are many times larger than their economies. “Nobody questioned the credibility of the government of Sweden,” says Gabriel Urwitz, who was chief executive of Götabanken until shortly before it was nationalised. “They issued the guarantee and the rest of the world accepted it.”

Another difference is that Sweden’s banks in 1992 were simpler than today’s large, com plex financial institutions. Bad assets consisted mainly of loans to commercial property developments that defaulted when interest rates rose and the country entered recession. The result was that banks were left with portfolios of hotels and office blocks including the London Ark, a landmark building that greets visitors driving in to central London from Heathrow Airport – but not mortgage-backed securities, derivatives or other complex debt instruments. Even so, it took the authorities six months to complete their examination of the banks’ books.

Third, the bail-out was conducted amid political consensus. When the finance ministry outlined the guarantee in September 1992, it had no legal powers to do so; the necessary legislation was not passed until months later. Support from the main Social Democrat opposition party allowed it to act as if the laws were already in place. This is in contrast with the US, where congressional Republicans caused turmoil in the markets last September when they initially rejected Tarp.

Yet the most important part of Sweden’s banking bail-out may have been the devaluation of the krona, a move that the government had actively resisted. In November 1992, the authorities gave up their defence of the currency, allowing it to float freely. This move, which coincided with an economic upturn in Europe, is likely to have given Sweden a boost by stimulating demand for exports. Whatever the reason, GDP started to grow again in the second quarter of 1993.

Whether the political consensus would have held in the event of a prolonged slump is open to debate. Even the architects of the bail-out cannot be sure what influence their actions had. “Our objective was to minimise the economic cost and bring down the length of the crisis,” says Mr Berggren. “Maybe we were successful. We will never know.”

If the Swedish experience can provide some pointers for today’s stressed-out policymakers, the country’s subsequent approach offers a lesson in what not to do. Having tackled the crisis, the authorities conspicuously failed to put in place longer-term reforms to help avert similar problems in the future. “The regulatory framework we put in place in the early ’90s had sunset clauses. So the sun set and that was it,” says Mr Ingves. “The politicians felt, ‘that won’t happen again’,” says Staffan Viotti, an adviser to Mr Ingves and adjunct professor at the Stockholm School of Economics.

During the recent credit boom, Sweden’s banks embarked on another growth spurt, expanding their lending throughout the Nordic region and particularly in the Baltic states, where Swedish lenders account for a large chunk of the banking system. So when the global financial crisis struck, the Swedish government was once again forced to step in, pledging to guarantee up to $205bn (£146bn, €158bn) of bank borrowings while also setting up an SKr15bn ($1.8bn, £1.3bn, €1.4bn) fund to invest in banks. Three of Sweden’s four largest banks, including Nordea – fashioned in part from the former Nordbanken – have raised fresh capital. In response to the new crisis, legislation was rushed through after 16 years of being ignored.

As they leave the Riksbank for Stockholm’s Arlanda airport, therefore, visiting central bankers and policymakers may ponder that perhaps the most important lesson is the one the Swedes failed to learn themselves.

Copyright The Financial Times Limited 2009"

Policy must be carried out swiftly and openly, aiming at saving banks, not their owners or managers.

TO BE NOTED: From Vox:

"The Swedish model for resolving the banking crisis of 1991-93: Is it useful today?

Lars Jonung 14 March 2009

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Sweden's fix of its banks in the early 1990s is considered a model for today’s policymakers. This column reviews the main features of the Swedish approach and discusses its applicability to today’s banking problems. Policy must be carried out swiftly and openly, aiming at saving banks, not their owners or managers.

The Swedish banking crisis was part of a major financial crisis that hit the Swedish economy in 1991-93. Its origin should be traced to financial liberalisation in the mid-1980s that triggered a rapid lending boom. The pegged exchange rate for the krona prevented monetary policy from mitigating the boom by means of interest rate increases. The boom turned into bust and crisis around 1990, threatening a meltdown of the banking sector. The response of policymakers developed into the Swedish model for bank resolution. It comprises the following seven key features.

The Swedish model for bank resolution

Political unity

A central feature was the political unity across party lines which underlay the bank resolution policy from the very start. The Centre-Right government and the political opposition - the Social Democrats - joined forces and avoided making the banking crisis into a partisan political issue. This unity, initially forged by the determination of the major political parties to defend the pegged exchange rate of the krona, lasted throughout the crisis. Political unity guaranteed the passage through the Swedish parliament, the Riksdag, of measures to support the financial system. It also created policy trust amongst voters.

Blanket guarantee of bank deposits and liabilities

The Swedish government, in cooperation with the opposition, announced in a press release on 24 September 1992 – a critical month when currency pegs in several European countries were successfully attacked – that depositors and other counterparties of Swedish commercial banks were to be fully protected from any future losses on their claims. The guarantee was successful in the sense that foreign confidence in the solvency of the Swedish commercial banks remained intact.

In addition, this measure proved highly beneficial, as it expanded the options for the Riksbank to support commercial banks regardless of their financial position. The government guarantee of bank liabilities gave the Riksbank the option to lend to any commercial bank operating in Sweden, even to those that were on the brink of insolvency.

Swift policy action

Once it was fully understood that a serious financial crisis was in the making, the government, the Riksdag, and the Riksbank responded by taking decisive steps to support the financial system, in particular to help banks in distress. In this way, the confidence of depositors and counterparties in the financial system was strengthened at an early stage of the financial crisis by swift and determined action. Throughout the resolution of the crisis, confidence could then be maintained at a relatively low political cost.

An adequate legal framework based on open-ended funding

In December 1992, the Riksdag, passed legislation by an overwhelming majority to establish a Bank Support Authority, Bankstödsnämnd, as envisaged in the press release of 24 September 1992. The parliament approved open-ended funding for the Bankstödsnämnd, rather than settling for a predetermined fixed budget. This was a deliberate choice in order to avoid the risk that the Bankstödsnämnd would be forced to go back to the Riksdag to ask for additional funding at a later stage. The open-ended funding underpinned the credibility of the bank resolution policy.

The Bankstödsnämnd was set up as an independent agency at arm's length distance from the government, the Riksbank, and the Finansinspektion (the financial supervisory authority) to underline its independence. This construction fostered credibility and trust in its operations. The opposition was given full insight into its activities. The agency was staffed by professionals, and it began operation in the spring of 1993, shortly after being established.

Full information disclosure

Banks that turned to the Bankstödsnämnd with requests for support were obliged to give disclosure of all their financial positions, opening their books completely to scrutiny. This requirement facilitated the resolution policy and made it acceptable in the eyes of the public.

Differentiated resolution policy to maintain the banking system and prevent moral hazard

Banks that turned to the Bankstödsnämnd were dealt with in a way that minimised moral hazard. The policy priority was to save the banks, not the owners of banks or the bank managers. Banks in trouble were first asked to obtain capital from their shareholders. If they were not able to do so, present owners would have to surrender control and ownership before public support was given. Faced with this threat, private banks in Sweden made great efforts to raise capital from their owners. One bank, the SEB, decided to withdraw its request for government support. Banks that were in temporary difficulties could ask for government guarantees.

Out of six major banks, two were not expected to be profitable in the long run. They were taken over by the government with the aim of being re-privatised. 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 set up by the Bankstödsnämnd, which focused solely on the task of disposing of them. When transferring assets from the banks to the asset-management companies, the government applied cautious market values, 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 "good" assets of the two failed banks were transferred to a new bank that eventually emerged as Nordea, now one of the major Nordic banks.

The role of macroeconomic policies in ending the crisis

The bank resolution was facilitated by monetary and fiscal policy. The fall of the pegged exchange rate of the krona on November 19, 1992, following heavy speculative attacks, was an important move towards recovery. Once the krona was floating, it depreciated sharply, encouraging a rapid growth in exports. The ensuing fall in interest rates eased the pressure on the banking system. In July 1996, the crisis legislation and the blanket guarantee were abolished. The government allowed huge budget deficits to build up during the crisis, mainly as a result of the workings of automatic stabilisers, peaking at around 12% of GDP in 1993.

A successful bank resolution

The Swedish bank resolution was successful. Sweden's banking system remained intact. It continued to function with no bank runs and hardly any signs of a credit crunch. It remained largely privately owned and became profitable shortly after the crisis.

In the long run, the net fiscal cost - the 'cost to the taxpayer' - turned out to be very low, close to zero. Figure 1, displaying the net fiscal costs for 39 systemic banking crises in 1970-2007, demonstrates Sweden's favourable ranking with a net fiscal cost of almost zero. The gross fiscal cost for the bank support policy amounted to around 4% of GDP initially.

Figure 1. Net fiscal costs from systemic banking crises, 1970-2007, per cent of GDP.

Source: Jonung (2009).

Can the Swedish model be exported?

Answering this question requires comparing the Swedish crisis of the early 1990s with the present global crisis. On a very general level, the similarities are striking. The two crises are both financial crises driven by identical forces – a boom fuelled by lax monetary policy and negligent financial oversight, later turning into a bust.

On the other hand, there are considerable differences. The Swedish crisis of the early 1990s was primarily a local phenomenon, or – more accurately - a Nordic one, as Finland and Norway also went into crisis at roughly the same time as Sweden. Being a small open economy, Sweden was able to abandon its pegged rate and obtain a significant and lasting depreciation of its currency that contributed to strong recovery. This option is hardly open to an individual country today because the present crisis is global.

The small size of the Swedish financial system in the 1990s facilitated the bank resolution policy. Policy-makers dealt with a limited number of banks - only six major banks - in an overall environment of trust in the banking system. This is in sharp contrast to the current situation in the US, for example, with thousands of banks of different types and many non-bank financial actors, and where public trust in the financial system and its actors (“Wall Street”) is extremely low.

The Swedish bank resolution policy was faced with a financial system that was much less sophisticated and much less globalised than the financial systems of today. There were no structured products, no sophisticated derivatives, hardly any hedge funds, less securitisation, and so on. Indeed, the ongoing crisis has been difficult for the authorities to manage, in part, because some traditional central banking tools – especially in the UK and the US – are not well suited, either legally or architecturally, to provide liquidity for the institutions most in need, including investment banks and insurance companies.

In addition, Sweden has a tradition of substantial public confidence in its domestic institutions, political system, and elected representatives. Such social capital made it easy for the government and opposition to reach swift and stable agreements on policy actions.

Lessons for today

In spite of the differences between Sweden in the early 1990s and the world today, the Swedish experience holds lessons. A policy to support the financial system benefits from political unity and from being carried out swiftly and openly. The aim should be to save banks in distress, not their owners or managers. This minimizes moral hazard. The resolution policy should be implemented within a consistent and all-encompassing strategy, having a legal framework in which the administration of the support is left to experts acting at arm's length from the government, the central bank, and the financial supervisory authority. The support benefits from being financially open-ended to ensure the solvency of the financial system. The support should also be designed in a way that the public perceives as fair and just.

The Swedish case illustrates that the task of government during a financial crisis, or - in popular terms - the task of the taxpayer, is to serve as the capitalist or investor of last resort by recapitalising the financial system, thus dampening the effects of the financial breakdown on the real economy.

The Swedish formula cannot be fully imported by other countries due to institutional differences. Still, its guiding principles are applicable outside Sweden today, most prominently in four areas. First, the Swedish experience demonstrates that the threat of public receivership or nationalisation should be a real one as it forces the private sector to find private solutions. Second, the Swedish record suggests that banks in distress, nationalised as well as in private hands, should be split into a good and a bad bank, in order to get the financial system swiftly working again – more precisely, bad assets should be taken off the balance sheets of banks to prevent them from becoming "zombie" banks. Third, the bank resolution policy credibility is significantly enhanced by an open-ended financial commitment by the government. Fourth and finally, policy action should be swift and decisive to arrest the negative feedback loops arising during a financial crisis.

To sum up, the Swedish model of bank resolution should be used as a general template for countries facing financial crisis, but these countries will need to adapt the details of the implementation to their own circumstances.

Editors’ Note: The views expressed here are those of the author.

References

Jonung, L., (2009) "The Swedish model for resolving the banking crisis of 1991-93. Seven reasons why it was successful." European Economy, Economic papers 360, European Commission, February 2009, Brussels.

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The idea of a good-bad bank solution was actually inspired by the US experience of bank resolution.

The Swedish record looks attractive compared to that of Japan, where the banking system remained in distress for a much longer period than in Sweden."

“What we learnt in Sweden is that you cannot solve financial crises by taking a piecemeal approach,”

TO BE NOTED:From the FT:

"Insight: US is ready for Swedish lesson on banks

By Gillian Tett

Published: March 12 2009 19:13 | Last updated: March 12 2009 19:13

Next week, Bo Lundgren, the head of Sweden’s debt office who played a central role in resolving his country’s banking mess in the early 1990s, will embark on a striking mission.

Washington’s Congressional Oversight Panel has summoned Mr Lundgren and others to explain how they fixed Sweden’s banks – presumably to glean tips on what Washington should do next.

The Nordic gods might well chuckle at this twist in the global financial saga. As recently as last autumn, the phrase turning “Swedish” was tantamount to an insult among most American politicians (and on Wall Street, the joke currently goes, Swedish models used to only attract attention when they were blonde and leggy). But these days, as the economist Nouriel Roubini recently observed, “we are all Swedes now” – at least in the sense of using state funds to fix the banking mess.

Hence Washington’s sudden invitation to Mr Lundgren and his colleagues. Whether the Americans will actually like the message that Mr Lundgren and others wish to impart, though, remains to be seen. For many Scandinavian observers are distinctly critical about what the US is currently doing with its banks. In Washington, politicians are wrapping themselves in knots about words such as “bail-out”. But to the Swedes that misses the point: the really important issue is not whether state money is used, but how it is dispersed. After all, as Mr Lundgren notes, “the word nationalisation can have many meanings” – and not all are very effective.

Sweden’s own crisis bears this out. When its banking woes first erupted, Stockholm (like the US) initially responded with procrastination and denial. Eventually, however, it nationalised two banks, wiping out the shareholders, and placed toxic assets into a special “bad bank”. That cost the government about SKr60bn-Skr70bn (although much of that sum was later recouped through asset disposals). To some extent, many western governments are copying elements of this approach. The UK and US, for example, have partly nationalised banks such as Citi and Royal Bank of Scotland. But, thus far, the UK and US have not ringfenced bad assets, preferring to urge the banks to deal with them while still on their books (supported with complex guarantee and financing schemes.) Anglo-Saxon governments have also refused to wipe out shareholders in banks such as Citi and RBS, for fear of looking too “socialist”.

To the Swedes, though, this seems intellectually muddled. They have a point. After all, American and British politicians are still trying to exert de facto control over banks, by banning bonuses, directing lending patterns (or, at Citi, blocking an order for a corporate jet). “Sweden is less nationalised than people might think,” chuckles Mr Lundgren, who notes that “socialist” Sweden – ironically – never dared “tell the banks how to lend or where to lend, because that is a management decision!”

But the more serious criticism lies with what is not being done. While Stockholm was nationalising two banks in the early 1990s, it also offered a blanket guarantee to any investor holding any Swedish bank liabilities (except for shares or subordinated debt). These days, that measure is not well known outside Sweden. But many Swedish officials and bankers consider that guarantee to have been the most crucial decision of all.

“To restore confidence it is very important to extend a guarantee to bank creditors,” says Mr Lundgren. “Even if you don’t issue a blanket guarantee, there have to be measures that assure creditors that they will not have to take losses, otherwise you just get more uncertainty . . . and it is very hard to get confidence back and to get stability.”

Thus far, that part of the Swedish package has been shunned. The UK and US have introduced schemes to guarantee some new bank debt, for a fee. But outstanding debt is being treated in a variety of ways. At Bear, creditors were saved, at Lehman Brothers, they were wiped out, while at WaMu the fate of covered bonds was initially unclear. Even today the fate of some Northern Rock debt remains contested. No wonder investors are nervous.

The Americans and British seem unlikely to change this situation soon, since they fear that extending a Swedish-style blanket guarantee would cost too much (or look too “socialist”). That is not surprising. Whereas Sweden had just five banks holding easy-to-analyse toxic property loans, the US has hundreds of banks, with complex, opaque products.

But the grim truth is that, if the financial system keeps melting down, then eventually even the unfathomably large cost of a blanket guarantee might look more palatable than other options. And even before that, there is another crucial point: “What we learnt in Sweden is that you cannot solve financial crises by taking a piecemeal approach,” laments Mr Lundgren, who confesses to feeling deeply worried that “there are still [so many] piecemeal approaches being used”.

It is a message that is needed now more than ever – not least with the G20 meeting looming.

gillian.tett@ft.com"

what parts of the banking structure you are going to either guarantee or effectively guarantee

From Bronte Capital:

"Paul Krugman’s false logical step

To my way of thinking Paul Krugman has finally nailed the question as to bank nationalisation that matters. This the money quote:

That said, some decision must be reached on bank liabilities. Sweden guaranteed all of them. If forced to say, I would go the Swedish route; but of course we can’t do that unless we’re prepared to put all troubled banks in receivership. And I’m ready to be persuaded that some debts should not be honored — this is a deeply technical question.

He is absolutely right that this is the critical step in the decision making process is what parts of the banking structure you are going to either guarantee or effectively guarantee. The critical question is not nationalisation.

Sweden could guarantee all banking liabilities because – frankly – their banks were not that deeply insolvent.

We know they were not that deeply insolvent for a few reasons – the best of which is that ex-post the Swedish bailout cost very little (and the Norwegian bailouts were actually profitable for the government).

However it is fairly easy ex-post to tell how insolvent the banking system was. It is not very easy ex-ante to tell. If it were easy then banks that were not at all insolvent (such as Svenska Handelsbank) would not become 20 bagger stocks quite quickly after the crisis. The stock market would not have marked them down so much.

The US Government’s stated position – Bernanke yesterday as well – is that there will be "No More Lehmans". What that means is that there will be no more uncontrolled liquidations of large financial firms.

The only way that the government can say that there will be no more Lehmans is to effectively guarantee large parts of the financial system. That is what the statement “no more Lehmans” means. If you want to make that statement operational you either (a) need to guarantee the banking system or (b) pour money in continuously whenever a bank (Citigroup. AIG or otherwise) threatens to become the next Lehman Brothers.

The state of US policy at the moment is nothing more sophisticated than (b) above – which is whenever an institution threatens to become Lehman the US Government tips in another 30-300 billion. We are still in the world of the ad-hoc guarantee - of the Sunday press release.

The problem with the ad-hoc guarantee is that nobody really thinks that it is a guarantee – and the generalised wholesale run on financial institutions will continue until they are sure. In other words we are effectively guaranteeing the liabilities without getting the policy benefit of that guarantee (which is the restoration of faith in the financial system).

Krugman has nailed the right question. The right question is whether the correct policy is “No More Lehmans”. I am pretty sure it is. I think the revisionist history about how bad the Lehman failure was is simply revisionist crap. I am convinced that at least in some instances the “no more Lehmans” policy will be operationally expensive in some instances and will leave the taxpayer with an enormous hangover*. The alternative is simply to allow big institutions to be pulled apart by the FDIC. Chris Whalen by contrast is convinced the other way – he says the model is easy to determine – just go down to the Southern District of New York and talk to the Lehman Trustee.

There is a reason why the right policy might not be "No More Lehmans". Its about cost. If the cost of making that promise operational was $12 trillion then you probably should just let the financial system burn. Why – because it is so much money the taxpayer could not plausibly absorb it without decades of higher taxes. If the cost is $1 trillion then hey – just suck it up - a fast rebound to the US economy as per Sweden after its crisis is worth more than a trillion dollars. The cost depends on the size of the banking system and the size of the losses relative to GDP. Iceland had to let its system burn because it could not plausibly bail out its banks. The UK banks started with very little capital and with very big balance sheets relative to GDP. They are also problematic. The US banks by contrast started with lots more capital and smaller balance sheets relative to US GDP. The upper-end estimate of losses (Roubini) is $3.4 trillion. If that is the case the upper limits to cost of the "No More Lehmans" policy is less than $3.4 trillion.

My long post has some indication of how you might estimate the costs of making a “No More Lehmans” promise operational. I have a forthcoming post which explains quite carefully what the least cost way of making that promise operational is. (The costs are however potentially very large - and whilst I think substantially less than the Roubini number I can't dismiss the possibility the costs could be large indeed.)

Anyway – if you have made the decision to have “No More Lehmans” then you have made the important decision – you are going the Swedish Route and guranteeing stuff - whether by Friday evening crisis or whether by design. I think America will go the Swedish Route – I am just waiting. The Swedish route is guarantee and selective nationalistion. I have never been afraid of the Nationalisation word – and anyone who buys money center banks now can expect a few of them to be nationalised. I have small positions - which would be larger positions if I knew the rules.

But the second part of Krugman’s paragraph contains a deeply troubling false logical step. He says: “but of course we can’t do that unless we’re prepared to put all troubled banks in receivership”.

To see why this is a false logical step you need a little history. A long time ago most the liabilities of almost all banks were deposits. The government guaranteed the deposits by creating the FDIC – it hence stopped crisis driven bank runs. It increased stability in a crisis. However it also allowed financial firms to take huge risks or even be looted (as per Charles Keating). The solution which was adopted (and let lapse of late) was that banks got the guarantee – but were heavily regulated to protect taxpayer interests. There was no need to nationalise the banks simply because you guaranteed the bulk of their liabilities. There was however a requirement to (a) regulate them, (b) assess their capital and (c) take “prompt” corrective action when that capital was inadequate. Prompt corrective action included confiscation. You did not take over banks because they had runs (the purpose of the FDIC guarantee was to stop runs), you took over banks when they inadequate capital.**

Nowadays a lot of banks have the bulk of their assets funded by things that are not deposits. Indeed at many banks deposits constitute less than half the balance sheet.

The old FDIC guarantee can’t stop runs because the run that happens is wholesale – it happens outside FDIC guarantee limit. If you want to stop bank runs the way that the original FDIC stopped bank runs you need to bite the “Swedish Bullet” – that is you need to effectively guarantee everything.

However just as the creation of the FDIC did not require you to be “prepared to put all troubled banks in receivership” a Swedish guarantee also does not require you to put all troubled banks into receivership.

What the FDIC guarantee required – and what a Swedish Guarantee will require – is you be prepared to (a) regulate banks heavily on an ongoing basis, (b) test the capital of banks, (c) force them to be adequately capitalised (rasing money if they can), and (d) nationalise the banks that cannot raise adequate capital.

When the good times return you probably need walk away from this general guarantee. In other words you have to regulate banks in such a way that they can’t become large enough to destroy the whole economy - so that you reduce the systemic risk at the cost of stifling "financial innovation". That means that the recidivist Citigroup – a bank that seems to blow up every cycle – will never be allowed to become as big and nasty again. It would be a terrible policy outcome if we did not learn from this crisis and did not regulate in such a way that it was less likely to happen again. Willem Buiter's call for "over regulation of banks" looks right to me.

Krugman’s illogic however does not help the debate. There is a need to guarantee all banking assets – and it should be done provided it is affordable. There is no consequent need to nationalise the whole system – though there will be a need to have a process which will result in nationalisation of some institutions – what I call “nationalisation after due process”.

Oh, and the number of losses in the system is not fixed. If the ability to borrow to fund risk assets is not restored then commercial property for instance will fall until its yield becomes attractive to an unlevered buyer. My guess is that is about 15%. As the economy will be in a slump at the same time and rents will also fall that might mean a top to bottom move in commercial property of 80%. If the move is that big then all the banks (good, bad, otherwise) are insolvent. However if the banks had guaranteed funding then (a) they could lend so the slump in the economy would not be so bad and (b) people could borrow to buy commercial property so its price does not need to fall until the yield is 15%. The top to bottom fall might be 35%. The system losses would be smaller.

If we do not guarantee all bank funding then I am afraid that Christopher Whalen will be right - the macroeconomic wave going through the economy will just smash up everything fast.

The longer we wait before biting the Swedish bullet the larger the system losses will be - and hence the higher the cost of biting that bullet. Either do it now or give up saying that there will be "No More Lehmans". If you wait too long everything becomes Lehman.

It took Krugman a long time to realise that the "Swedish Guarantee" is the important question. And it is. Nationalisation (which should happen for some institutions) is only the secondary question.

John Hempton

Some post scripts

*The instances in which I think the “no more Lehmans” policy will be operationally expensive are (obviously) AIG (almost certainly) Fannie and Freddie and speculatively a few others that are properly insolvent. My biggest problem child is Barclays – which is technically a UK institution – but it is too big for the UK to bail out – and which has a lot of its operations in the US. I suspect that the US can – as a technical thing – let Barclays be the next Lehman – saying – hey – its not one of ours! But that is a post for another time.

**This is one of the things that most annoys me about Sheila Bair’s confiscation of Washington Mutual. WaMu had a run. The old role of the FDIC was not to make banks fail when they had runs – it was to stop runs. I would have no objection to confiscation of WaMu if it was demonstrably insolvent. However it was not demonstrably insolvent – and Sheila Bair’s own press release said it was capital adequate when confiscated. It was a very strange interpretation of her role indeed that she should close a bank because it had a run. "

Me:


Don said...

Actually, I realize now that I agree with you. In the last post, I said that we had already agreed to guarantee everything, if we have to. But, from my point of view, the main reason to announce the guarantees is not to have to spend the money, but to stop the panic, which would allow for a more orderly unwinding of these investments, saving money in the long run. So, I was wrong. Even though we have signaled that we have guaranteed everything, an explicit statement, in theory, would help.

Also, since, from my point of view, we've guaranteed foreign bondholders implicitly by our actions with Citi, we might as well make it explicit. It could be huge, but there's really no other good choice.

Don the libertarian Democrat

March 11, 2009 12:52 PM