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IMF Working Paper Summaries (WP/95/1 - WP/95/61)
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Summary of WP/95/61: “The Nordic Banking Crises: Pitfalls in Financial Liberalization?”

Author(s):
International Monetary Fund
Published Date:
August 1995
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The banking industries in three Nordic countries, Finland, Norway, and Sweden, underwent considerable changes in the 1980s, The period was marked by increased competition in financial services, economic deregulation, the removal of cross-border restrictions on capital flows, and financial innovation. After a sharp credit boom, it also proved to be a period of financial fragility, as lower asset quality and declining profitability deteriorated banks’ balance sheets to the point where governments had to support some of the largest banks to preserve financial stability.

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

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

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

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