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FEDERAL RESERVE BANK OF CLEVELAND pd papers NUMBER 21 By O. Emre Ergungor POLICY DISCUSSION PAPER On the Resolution of Financial Crises: The Swedish Experience JUNE 2007 POLICY DISCUSSION PAPERS FEDERAL RESERVE BANK OF CLEVELAND On the Resolution of Financial Crises: The Swedish Experience O. Emre Ergungor is an economist at the Federal Reserve Bank of Cleveland. By O. Emre Ergungor Sweden was one of the Scandinavian countries experiencing a severe ﬁnancial crisis In the late 1980s and early 1990s. I review the policy choices and external factors that pushed the country’s ﬁnancial system over the edge and then examine the steps the government took to make its resolution of the crisis one of the most successful in the past 30 years. Materials may be reprinted, provided that the source is credited. Please send copies of reprinted materials to the editor. POLICY DISCUSSION PAPERS Policy Discussion Papers are published by the Research Department of the Federal Reserve Bank of Cleveland.To receive copies or to be placed on the mailing list, e-mail your request to firstname.lastname@example.org or fax it to 216-579-3050. Please send your questions comments, and suggestions to us at email@example.com. Policy Discussion Papers are available on the Cleveland Fed’s site on the World Wide Web: www.clevelandfed.org/Research. Views stated in Policy Discussion Papers are those of the authors and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. ISSN 1528-4344 FEDERAL RESERVE BANK OF CLEVELAND Introduction In the late 1980s and early 1990s, the Scandinavian countries underwent their most severe ﬁnancial crisis of the postwar period. While such crises are not rare, what sets these countries apart is their freedom from the institutional weaknesses that dogged lessdeveloped countries in the 1970s and emerging-market economies in the 1990s (slow bankruptcy procedures, lax law enforcement, regulators who lacked the power to close banks, and so forth).This makes the Scandinavian nations an interesting laboratory for examining how crises develop and are ultimately resolved. In this Policy Discussion Paper, I focus on the experience of Sweden, ﬁrst reviewing the policy choices and external factors that pushed this country’s ﬁnancial system over the edge, and then discussing what steps the government took to make its crisis resolution process one of the most successful of the past 30 years. The paper emphasizes the resolution process rather than the way in which the ﬁnancial crisis unfolded, because any number of events can lead to crises, but the general principles for resolving crises successfully are universal. The Road to Crisis In the mid-1970s, Sweden was a small, open economy, whose growth depended heavily on exports. Its economic policies were inﬂuenced by the core tenet of its political system: The government’s primary focus should be keeping unemployment low and promoting economic equality.At the same time, its policies had to be aligned with the central bank’s commitment to keeping the exchange rate ﬁxed relative to a basket of Sweden’s trading partners’ currencies (details later), all within the context of a closed-capital-account environment. How did these constraints affect the economy? The success of the export-based growth model is conditional on keeping the tradable goods industries competitive in global markets; this means that production costs cannot grow faster than competitors’ as long as the exchange rate is ﬁxed.Yet in the 1970s, wage inﬂation grew out of control.The seeds of inﬂation had been sown in the 1960s and early 1970s, when policymakers thought they faced only a temporary slowdown in productivity growth and in the development of Sweden’s primary export industries (such as forestry products and ship building), but in reality, the slowdown had resulted from tougher foreign competition. Although the natural rate of employment was rising, the government would not back off from the unsustainable policy of full employment to which it had committed itself. Instead, it decided to overcome economic weakness by increasing its expenditures on welfare programs (Bosworth and Lawrence, 1987), a further sign that the government thought the decline in productivity growth was temporary. Workers in export industries who lost their jobs were retrained and found employment in the white-collar service sector or 1 POLICY DISCUSSION PAPERS NUMBER 21, JUNE 2007 the public sector.The ensuing growth of public-sector employment was remarkable:The sector’s share of total employment grew from 20 percent in 1965 to 30 percent in 1975 and 38 percent in 1985.1 In hindsight, this policy seems to have been a costly alternative to higher unemployment. As budget deﬁcits grew, the holes were plugged by foreign borrowing and higher income taxes (the marginal income tax rate on full-time workers earning the average hourly wage increased from 35 percent in the second half of the 1960s to 65 percent in 1. This growth is due, in part, to the entry of women into the labor force and their taking of jobs in the public sector. So, in addition to the switch from the private to public sector jobs, the public sector also grew internally. 1976). The disincentive to invest created by higher income taxes probably cost Sweden dearly in future private-sector job creation. And the exchange rate risk the government assumed by borrowing in international markets came back to haunt it in later years, when rising labor costs and deﬁcits necessitated large devaluations.2 The growth in public-sector and white-collar employment also had an unintended consequence: It strengthened the unions that represented these workers, which, given the circumstances, played a signiﬁcant role in breaking the link between wage growth and productivity growth.The Social Democrats who ran Sweden from 1932 to 1976 had a very close relationship with the country’s most powerful union of blue-collar workers, the Landsorganisationen (Weaver, 1987). Both sides understood that their interest lay in keeping export industries competitive by holding wage growth in check. The three white-collar unions, which also participated in the negotiation process, were too small to dictate wage policy. As public and white-collar employment grew and these workers gained bargaining power, the unions began to compete with each other for new members. But public-sector and white-collar workers had no incentive to reduce their wage demands so that export industries could remain competitive, so unions forsook the centrally determined wages and made side deals with employers for higher wages (Flanagan, 1987). Soon thereafter, the link between wage growth and productivity growth broke down. In addition, Sweden’s generous unemployment beneﬁts may have put the unions in a heads-we-win-tails-the-government-loses situation. The unions won if they could negotiate higher wages for their members, and if companies failed, their members were still covered by government insurance (Calmfors, 1987). The Stage Is Set High inﬂation made the ﬁxed-exchange-rate policy untenable, so the krona was devalued several times. Foreseeing the unsustainability of the ﬁxed exchange rate, the unions demanded higher wages in anticipation of the krona’s decreased purchasing power. When consumer price inﬂation hit 15 percent in 1980, the government decided to break the inﬂationary spiral (i.e., inﬂation expectations) and promote economic growth through a series of ﬁnancial reforms, made at intervals throughout the 1980s.The reforms have three major components that are relevant to our discussion. 2 2. This is similar to the Southeast Asia crises, in which growing ﬁscal deﬁcits rendered the ﬁxed-exchange rate regime increasingly unworkable—and made devaluation imminent. FEDERAL RESERVE BANK OF CLEVELAND First, Sweden lifted restrictions on borrowing in the 1982–85 period. Until then, the government had tried to control the quantity and price of credit, favoring major exporting companies over smaller enterprises (such as those in property development and real estate management) and households. As might be expected, a gray market developed to circumvent these measures (Tranøy, 1999).3 Over time, the Riksbank (and the administration) concluded that these interest rate and credit ceilings were unsustainable and restricted growth; consequently, the credit market was fully liberalized in 1985. Not sur- 3. In a “gray” credit market, noninstitutional lenders and borrowers interact directly, using banks as brokers. prisingly, the formerly credit-constrained Swedish companies and households ran to their lenders, and a credit boom followed. After the capital account was opened in late 1980s, these companies gained further freedom to borrow in international markets. Second, a series of devaluations in 1981 and 1982 had temporarily revitalized Sweden’s export industries. However, inﬂation remained out of control despite many ill-advised attempts to restrain wage inﬂation through labor negotiations and price and rent freezes. When those attempts failed, the government gradually lifted restrictions on foreign capital ﬂows between 1986 and 1989 as a commitment to a nonaccomodation policy, thereby abdicating its discretion over domestic monetary policy to more-credible foreign central banks.The krona was still anchored to a basket of currencies, primarily the German mark, based mostly on their trade weights. However, the weight of the U.S. dollar in the basket was double what it would have been if it had been based solely on the size of its trade with Sweden. With the decline in the dollar relative to the mark during the 1980s, this weight gave an advantage on Swedish exports to Germany (Bosworth and Lawrence, 1987b). Third, the government made a commitment to stop borrowing in international markets and borrow only domestically in kronas. Foreign borrowing had been seen as a way for the government to keep real krona borrowing rates low by staying out of the domestic money market and thus avoiding the crowding out of private ﬁrms (Bosworth and Lawrence, 1987b). An unintended consequence of this policy, however, was that banks borrowed in foreign markets and lent to the government in kronas. In essence, this policy transferred foreign exchange risk from the government to the banks. Unfortunately, these ﬁnancial reforms were not enough to overcome rigidities in the Swedish political system and labor markets (Weaver, 1987). With full-employment targets and the associated incentives to workers and unions still in place, the economy’s devaluation-induced competitiveness proved to be temporary. Although inﬂation cooled initially, it never came down to the levels of Sweden’s trading partners. Consequently, maintaining the currency peg required high domestic real interest rates. The peg must have seemed credible to the many Swedish companies that borrowed heavily in foreign currencies to escape high domestic real interest rates. In addition to banks’ borrowing abroad and lending in the domestic market, the real economy also took on large exposure to exchange rate risk.Before the crisis,more than 50 percent of all corporate debt was foreigncurrency denominated (Drees and Pazarbasioglu, 1998). 3 POLICY DISCUSSION PAPERS NUMBER 21, JUNE 2007 Borrowing cheap abroad and lending at higher rates domestically helped banks ﬁnance a consumer lending surge.Also, foreign bank entry was allowed in 1986, one year after interest rate liberalization, so locals may have wanted to move ﬁrst in a growing credit market. It is possible that in a new ﬁnancial environment, bankers did not fully understand the risks they were taking. A statement from the then-Riksbank-Vice-President Lars Heikensten (head of the Riksbank from 2003 to 2006) supports this view: When deregulation was a fact, bank managers saw a chance of gaining market share and increasing revenues by taking new risks, but did not clearly see the dangers in a lack of the necessary expertise. As often happens in such cases, the real estate market experienced a speculative boom parallel to the rapid growth in credit (Ergungor and Thomson, 2006). As ﬁgure 1 shows, home prices more than doubled between 1981 and 1991.4 Heikensten referred to this sharp increase in home prices as a “speculative bubble.” The impact of credit growth on household ﬁnances is apparent in ﬁgure 2. Despite the rising cost of credit, Swedish households’ outstanding debt increased rapidly after 1986. The Dominos Fall The shock that pushed Sweden’s teetering economy over the brink of crisis came from German uniﬁcation in 1990, when the mark weakened against the U.S. dollar and Germany’s real interest rates jumped as a result of high uniﬁcation costs.The ﬁxed exchange rate obliged Sweden to import the higher German real interest rates, pushing its own alFIGURE 1 HOUSING PRICE-RENT RATIO IN SWEDEN Index (1981=100) by assessed value and period Ratio 240 1.6 1.5 220 Home prices 1.4 200 1.3 180 Price/rent (right axis) 1.2 160 1.1 Rents 140 1.0 120 0.9 100 0.8 1981 1983 1985 1987 1989 Note: The shaded bar marks the recession. Sources: Statistics Sweden; and the Riksbank. 4 1991 1993 1995 4. The price-rent ratio is conceptually similar to the price-earnings ratio for stocks. However, in ﬁgure 1, the rent index that I use does not reﬂect the estimated rental income stream of the homes included in the price data. It is also worth noting that rents are tightly controlled in Sweden, which further reduces their usefulness as a measure of market fundamentals. Therefore, the ratio is only for illustrative purposes. FEDERAL RESERVE BANK OF CLEVELAND ready-high domestic rates even higher. The currency basket’s tilt in favor of the U.S. dollar, which formerly had given Swedish exporters a competitive edge, came back to haunt them when the krona became overvalued. An attempt to ﬁx the country’s ﬁscal imbalances dealt a ﬁnal blow to its weakened economy:A change in tax policy in the late 1980s abolished the tax-deductible status of interest paid on consumer debt, effectively increasing households’ interest burden. It is hard to maintain speculative asset price growth when the credit feeding it becomes costlier. From 1990 to 1995, residential real estate prices dropped 25 percent and commercial real estate prices dropped 42 percent (inﬂation-adjusted rates). Banks’ nonperforming loans mushroomed from 0.2 percent–0.5 percent of total loans in the 1980s to 5 percent in 1992. Then came George Soros’s infamous 1992 attack on the European exchange-rate mechanism (ERM). After the krona was ﬂoated, domestic banks’ losses increased signiﬁcantly.5 Nonperforming loans hit 11 percent of GDP in 1993. The institutions that suffered most (especially among the large banks) were those funded by foreign funds. The ﬁrst victims of the economic downturn were two of Sweden’s six largest banks, Första Sparbanken and Nordbanken.6 After they announced in the fall of 1991 that they could no longer meet the regulatory capital requirements (8 percent of assets), the state eventually guaranteed all their existing liabilities, took full ownership of Nordbanken, and 5. Once the ﬁxed exchange rate was abandoned, the krona immediately dropped by 11.5 percent against the reference basket of currencies. A year later, the decline exceeded 30 percent. 6. I borrow this description of events from Calomiris, Klingebiel, and Laeven (2004) and Bergstrom, Englund, and Thorell (2003). helped Första Sparbanken with a loan guaranty to the owners.Within a year, a third major institution, Gota Bank, became undercapitalized. When its largest owner refused to provide additional funds, the state guaranteed all its liabilities to prevent a meltdown; Gota declared bankruptcy the same month. Once again, the state took ownership of the bank. FIGURE 2 DEBT LOAD OF SWEDISH HOUSEHOLDS Percent 1.4 Percent 14 Debt/income 12 1.3 10 Interest expenditure to disposable income (right axis) 1.2 1.1 8 6 4 1 2 Real after-tax lending rate (right axis) 0.9 0 –2 0.8 –4 0.7 –6 0.6 –8 1980 1984 1988 1992 1996 Note: The shaded bar marks the recession. Sources: Statistics Sweden; and the Riksbank. 5 POLICY DISCUSSION PAPERS NUMBER 21, JUNE 2007 After acquiring Nordbanken, the state owned 22 percent of all banking-system assets. As a resolution strategy, it elected to divide each bank into two separate entities, one with its good assets, the other with its bad ones.The entities holding the good assets continued to operate under their old names and were later merged under the name Nordbanken. The bad assets were transferred to two asset management companies (AMCs): Securum for Nordbanken’s assets and Retrieva for Gota’s.7 The Recovery In creating the AMCs, the legislature gave them a high degree of independence from political and regulatory constraints. The state never explicitly assumed the role of an active owner; however, the chairman of Securum’s board resigned when he could not 7. Part of the reason for rehabilitating an existing insolvent bank by stripping away its bad assets stems is a desire to protect (or at least salvage) the value of the bank’s relationships, particularly its lending relationships (see Diamond, 2001). agree with the Ministry of Finance about compensating the AMC’s leading staff, so the state seems to have had some say, at least on compensation-related issues. Still, the AMCs, which were adequately overcapitalized in relation to the expected costs and losses during their expected life-time, held their own purse strings. Securum alone was capitalized with SEK24 billion, an amount equal to Sweden’s defense budget. This deliberate overcapitalization enabled the AMCs to carry out their salvage operations autonomously; they did not have to request funding from the legislature, which might have tried to inﬂuence their decisions. The AMCs were also free of many regulations and activity restrictions that applied to banks, even though managing the loan portfolio, collecting payments, and possessing collateral in case of bankruptcy might be considered banking activities. The AMCs needed broad leeway because they had to be more than banks.They injected equity into troubled borrowers to maintain and restore their values as well as revive the real economy. In many instances, this meant that they had to take over defaulting companies.They became responsible for running those companies, much as a private owner would (including hiring and ﬁring management, rehabilitating neglected property, acquiring supplementary property, changing the focus of companies’ operations, and so on) until liquidation. A second area in which they were exempt from bank regulation was the timing of collateral liquidations. Swedish banks were required to dispose of any collateral within three years.8 Because the AMCs’ portfolio was so large, policymakers worried that selling all the problem assets within a short period would put too much pressure on market prices.To ease those concerns, the AMCs emphasized from the very beginning that cleaning up the bad assets would take a long time, more than a decade if necessary (Bergstrom, Englund, and Thorell, 2003). In the end, the resolution occurred much more quickly than initially anticipated, thanks to the rapid growth of the Swedish economy, which paralleled the global economic boom of the 1990s. Liquidations were completed by 1997 at a smaller cost to the taxpayers than was anticipated. Securum returned to the state nearly SEK14 billion ($1.8 billion in 1997 6 8. During the crisis, the Swedish banks were also exempted from the three-year rule. FEDERAL RESERVE BANK OF CLEVELAND dollars) of its SEK24 billion ($4.5 billion in 1997 dollars) initial capital—admittedly, in depreciated kronas.9 That being said, the cost of the crisis to Sweden was not limited to the capital spent by the AMCs.There have been signiﬁcant income and output losses as- 9. Constant dollars are calculated using the GDP deﬂator. sociated with the crisis. In the early 1970s, Sweden had one of the highest income levels in Europe; today, its lead has all but disappeared. Cerra and Saxena (2005) found that the crisis caused a permanent decline in output that can explain the entire fall in Sweden’s relative income. So, even well-managed ﬁnancial crises don’t really have happy endings. Lessons of 20/20 Hindsight How much of Sweden’s success in crisis resolution can be credited to its wise policies and how much to a strong global economic expansion in the years after the crisis? Did sensible policies pay off, or did the rising tide lift all boats? I suspect it was a bit of both. As evidence for the rising-tide hypothesis, foreign demand for Swedish goods and services (measured by exports) rose from 0.89 percent of GDP in 1990 to 1.2 percent of GDP in 1995. Unfortunately, there is no evidence that quantiﬁes each factor’s contribution. Still, we can evaluate the resolution strategy in light of previous crises and those that followed. Ergungor and Thomson (2006) point out a number of traits that successful resolution strategies have in common. I focus here on four: First, the process must be transparent; expected losses must be recognized early on to preserve the market’s conﬁdence in the process. Second, crisis resolution is best handled by a politically and ﬁnancially independent agency. An independent structure is desirable because it shields decision makers from political pressures, which mount as banks are closed and borrowers are pushed into liquidation.The decision to close a bank or a business must be an economic—not a political—one. Financial independence is necessary to give credibility to political independence: If a government agency holds the purse strings, it can dictate policy. Financial independence is also important because it allows rapid response when funding needs emerge suddenly (as when new losses are discovered in a ﬁnancial institution) and waiting for the legislature to appropriate funds is impractical.10 A case in point is the Resolution Trust Corporation (RTC), which was founded in 1989 to handle the U.S. savings and loan crisis. With no internal source of funding, it relied on Congressional appropriations, which made long-term planning difﬁcult. Between March 31, 1992, and December 17, 1993, the RTC had to reduce its crisis-resolution activity for lack of funds (Spade and Thomas, 1998; also see Kane, 1990). The third trait of a successful resolution strategy is the maintenance of market discipline.Without it, the stage is set for future crises. For example, extending blanket guaran- 10. As a comparison, in its ﬁnancial crisis, Finland decided on a ﬁxed and limited amount of funds for bank resolution, and when this amount proved inadequate later, a new Parliamentary decision had to be requested and taken at a signiﬁcant cost to the credibility of the resolution process. tees during a crisis weakens the market discipline exerted by uninsured creditors in the postcrisis period. Uninsured depositors and nondeposit creditors have strong incentives 7 POLICY DISCUSSION PAPERS NUMBER 21, JUNE 2007 to monitor and discipline ﬁnancial institutions by raising their cost of funding when their risk increases. At some point, as the probability of default increases, uninsured claimants will threaten to liquidate their claims. If market discipline is to be effective, these investors must be credibly exposed to loss; that is, they must suffer the consequences of ignoring or failing to detect signs of trouble. An explicit blanket guarantee of all the liabilities of problem institutions in the throes of a crisis reduces the credibility of claims that de facto guarantees will not be extended in future bank failures. Similar incentive problems arise when regulators and policymakers respond to the crisis by bailing out banks’ creditors through a policy of capital forbearance and unlimited liquidity support. Although bailouts tend to alleviate pressures on the ﬁnancial system, forbearance and unlimited liquidity support allow uninsured investors to take their money out of the bank, shielding them from loss and reducing their incentive to monitor in the future. In essence, capital forbearance and unlimited liquidity support provide an implicit blanket guarantee and serve as a taxpayer-funded rescue package for sophisticated investors who purposely took on risk and were compensated for bearing it. The fourth—and ﬁnal—requirement for successful crisis resolution is a plan to jumpstart credit ﬂows in the ﬁnancial system by repairing the damaged creditworthiness of the real economy. Even if banks can be completely restored to health through recapitalization, borrowers may be in no position to repay any new loan they may get. This was the case in the United States during the Great Depression. The Reconstruction Finance Corporation (RFC) was founded in 1932 to handle banking crises. Noticing that loan growth was very slow, in 1934 Congress authorized the RFC to make loans to business and industry.The RFC invited local bankers, who would have superior knowledge about borrowers, to participate in the lending. The banks’ response was unenthusiastic. Jesse Jones, head of the RFC under President Franklin D. Roosevelt, reported (Jones and Angly, 1951): At one time I sent a letter to every one of the 14,000 banks in the United States asking their cooperation in making loans to business. Only 1 percent acknowledged receipt of our letter.That seems hardly credible, because more than half of the banks had been directly assisted by the RFC and all had been indirectly assisted; but it is human to forget. The RFC was disappointed by the lack of participation and criticized the banks for it. Jones even admits doing some arm twisting to induce bankers to lend, even when denying the loan might have been the right decision.When they refused to participate despite such pressure, the RFC made the loans itself. In hindsight, Jones admitted that these were loans that “no one would have expected a careful banker to make” because businesses’ balance sheets had been severely damaged by the long recession and lack of funding. 8 FEDERAL RESERVE BANK OF CLEVELAND How does Sweden’s experience relate to these four traits of successful crisis resolution?. With respect to transparency, Sweden did particularly well in terms of recognizing the magnitude of the losses, assigning realistic values to seized collateral, and giving markets a clear picture of how the crisis was being managed (Ingves and Lind, 1996; Bäckström, 1997).The Swedes also get high marks on the second trait, the independence of the resolution agencies they created. As Klingebiel (2000) notes, the success of asset management companies depends greatly on the type of asset that must be disposed of, professional management, political independence, a skilled resource base, appropriate funding, adequate bankruptcy and foreclosure laws, good information and management systems, and transparency in operations and processes. In every category, Sweden is a success story. As to the third trait, resolution policies that maintain market discipline, Sweden, to its credit, refused to go down the path of forbearance and unlimited liquidity support. However, by guaranteeing all bank liabilities, Sweden is likely to have reduced incentives to monitor bank risk on the part of uninsured creditors, who would have anticipated implicit insurance. Such a guarantee, intended to calm markets at the onset of a crisis, has been governments’ typical response to crisis situations around the globe. However, being typical does not make it the only alternative. Kane and Klingebiel (2004) argue that the best response would be a bank holiday long enough to allow bank examiners to determine the extent of the damage, while also giving insured depositors access to their funds.This response would solve the problem of market discipline because uninsured depositors could not move out and would be forced to take a haircut if losses were large. It would also save taxpayers money because banks that were not viable would not receive liquidity support during the holiday and good money would not be thrown after bad to keep a nonviable institution operating. The Swedish experience also demonstrated the fourth trait of a successful resolution, as the asset management companies showed clearly their ability to repair the creditworthiness of the economy. They moved quickly, making equity injections to revitalize borrowers who were damaged but still viable, and acquiring a majority of their shares in most cases. The ones that were deemed beyond repair were liquidated, and their collateral was seized. The efﬁciency of Sweden’s legal infrastructure was a critical factor in the country’s speedy resolution process (Klingebiel, 2000).There was some criticism that the AMCs were trigger-happy in initiating liquidations and too quick to dispose of the assets (mentioned in Bergstrom, Englund, and Thorell, 2003). If the AMCs had waited a few years, the quick-disposition argument goes, the government might have recovered a larger share of its losses by selling the assets at higher prices during the recovery. The main weakness of such criticism is that the market may never recover if a large inventory of assets is sitting on the sidelines, ready to be dumped onto buyers when prices go up. 9 POLICY DISCUSSION PAPERS NUMBER 21, JUNE 2007 Whether or not the AMCs were too quick in initiating liquidations is debatable, but there seems to be no conclusive evidence either way. Still, there may be room for criticism (again, in hindsight) of the methods used to rescue viable ﬁrms. One alternative to injecting equity and assuming ownership of ﬁrms is provided by Mexico’s response to the 1994 Tequila Crisis. After some failed attempts to revive the economy after the onset of crisis, the Mexican government started the Punto Final program in December 1998, targeting mortgage holders, agribusiness, and smalland medium-sized enterprises.The program offered debtors a subsidy of up to 60 percent of a loan’s book value if they began to repay it.The cost of the subsidy was shared by the banks and the government. Moreover, the government promised to increase its share of the subsidy by one peso for every three pesos in new loans that the bank made. This program incorporated some very intelligent incentives. First, borrowers could get a chunk of their debt erased only if they started to repay it. Because a borrower who is not hopeful about his business’s prospects is unlikely to throw more money at it, this subsidy mechanism reveals which borrowers expect to do well in the future, solving the adverse-selection problem. Second, the program gave banks an incentive to provide new credit:They could reduce the amount they had to charge off as a part of the subsidy deal by making new loans. Third, the program got more bang for the buck by targeting small enterprises, the businesses that depend most heavily on banks for funding and are least likely to have government connections.11 I am not suggesting that this strategy would have been more successful in Sweden than the AMCs’ quick-liquidation approach, only that—in hindsight—one can see alternatives to (or steps that might precede) taking possession of a troubled company. Conclusion We have analyzed the resolution of the ﬁnancial crisis that hit Sweden during the 1990s in terms of four traits that are essential to a successful crisis resolution in a developed economy: transparency, independence, the maintenance of market discipline, and the restoration of credit ﬂows. Transparency is necessary to gain credibility in the market. Independence of the agencies charged with resolving the crisis protects the resolution process from political pressures, prevents politically connected forbearance, and guarantees that taxpayers’ money is used to save viable banks and borrowers, not the wellconnected ones. Policies that preserve market discipline are critical for reducing the likelihood and severity of future crises. Finally, it may be necessary to rehabilitate the real sector because the ﬁnancial sector’s troubles may cause a credit crunch that damages healthy ﬁrms. Without healthy borrowers, bank restructurings will fail to restart credit ﬂows.The keys to successful rehabilitation are to use incentives that separate viable from nonviable borrowers and to dispose of seized collateral as quickly as possible. 10 11. Although it incorporated the right incentives, the program was impaired by Mexican supervisors’ lack of enforcement authority, an inefﬁcient bankruptcy system, and the presence of politically connected lending (Calomiris, Klingebiel, and Laeven, 2004). One would hope that these problems would be less prevalent in a developed economy. FEDERAL RESERVE BANK OF CLEVELAND References Bäckström, Urban, 1997. “What Lessons Can Be Learned from Recent Financial Crises? The Swedish Experience, “Maintaining Financial Stability in a Global Economy (Federal Reserve Bank of Kansas City, Jackson Hole,Wyo..). Bergström, Clas, Peter Englund, and Per Thorell, 2003. “Securum and the Way out of the Swedish Banking Crisis” (SNS—Center for Business and Policy Studies, Stockholm), translated by Timothy Chamberlain. Bosworth, Barry P., and Robert Z. Lawrence, 1987a. “Adjusting to Slower Economic Growth,” in Barry P. Bosworth and Alice M. Rivlin, eds., The Swedish Economy (Brookings Institution,Washington, D.C.). Bosworth, Barry P., and Robert Z. Lawrence, 1987b.“Economic Goals and the Policy Mix,” in Barry P. Bosworth and Alice M. Rivlin, eds.: The Swedish Economy (Brookings Institution,Washington, D.C.). Calmfors, Lars, 1987. “Comment on Robert J. Flanagan, ‘Efﬁciency and Equality in Swedish Labor Markets,‘“ in Barry P. Bosworth and Alice M. Rivlin, eds., The Swedish Economy (The Brookings Institution,Washington, D.C.). Calomiris, Charles W., Daniela Klingebiel, and Luc Laeven, 2004. “A Taxonomy of Financial Crisis Resolution Mechanisms: Cross-country Experience,”The World Bank Policy Research Working Paper Series, No. 3379 (Washington, D.C.). Cerra, Valerie, and Sweta C. Saxena, 2005. “Eurosclerosis or Financial Collapse: Why Did Swedish Incomes Fall Behind?” IMF working paper 05/29 Diamond, Douglas W., 2001. “Should Banks Be Recapitalized?” Federal Reserve Bank of Richmond, Economic Quarterly 87, 71–96. Drees, Burkhard, and Ceyla Pazarbasioglu, 1998.“The Nordic Banking Crisis: Pitfalls in Financial Liberalization,” Occasional Paper, No. 161 (International Monetary Fund,Washington, D.C.). Ergungor, O. Emre, and James B. Thomson, 2006.“Systemic Banking Crises,” in Andrew H. Chen, ed.: Research in Finance (Elsevier). Flanagan, Robert J., 1987. “Efﬁciency and Equality in Swedish labor Markets,” in Barry P. Bosworth, and Alice M. Rivlin, eds.: The Swedish Economy (The Brookings Institution, Washington, D.C.). 11 POLICY DISCUSSION PAPERS NUMBER 21, JUNE 2007 Ingves, Stefan, and Göran Lind, 1996. “The Management of the Bank Crisis—in Retrospect,” Sweriges Riksbank, Quarterly Review 1, 5–18. Jones, Jesse H., and Edward Angly, 1951. Fifty Billion Dollars: My Thirteen Years with the RFC (1932–1945) (The Macmillan Company, New York, NY). Kane, Edward J., 1990.“Principal-Agent Problems in S&L Salvage,“ Journal of Finance 45, 755–64. Kane, Edward J., and Daniela Klingebiel, 2004. “Alternatives to Blanket Guarantees for Containing a Systemic Crisis,” Journal of Financial Stability, September, 31–63. Klingebiel, Daniela, 2000.“The Use of Asset Management Companies in the Resolution of Banking Crises: Cross-country Experiences, “ The World Bank, Policy Research Working Paper Series: 2284 (Washington, D.C.). Spade, Mike, and Edward D.Thomas, 1998.“Evolution of the RTC’s Resolution Practices,“ in William R. Ostermiller, ed.: Managing the Crisis: The FDIC and RTC Experience (FDIC, Washington, DC). Tranøy, Bent Sofus, 1999.“The Swedish Financial Sector 1985–1992: Policy-Assisted Boom, Bust, and Crash,” ECPR Joint Sessions Workshop, No. 16: Success and Failure in Governance (Mannheim, Germany). Weaver, R. Kent, 1987.“Political Foundations of Swedish Economic Policy,” in Barry P. Bosworth, and Alice M. Rivlin, eds., The Swedish Economy (The Brookings Institution, Washington, D.C.). 12 pd papers Presorted Standard FEDERAL RESERVE BANK OF CLEVELAND RESEARCH DEPARTMENT P.O. BOX 6387 U.S. Postage Paid Cleveland, OH Permit no. 385 CLEVELAND, OHIO 44101 Return Service Requested: Please send corrected mailing label to the Federal Reserve Bank of Cleveland, Research Department, P.O. Box 6387, Cleveland, Ohio 44101.