Banking Soundness and Monetary Policy
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Comment

Editor(s):
Charles Enoch, and J. Green
Published Date:
September 1997
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Author(s)
ARMANDO M. TETANGCO, JR.

This paper by Stefan Ingves and Goran Lind makes a detailed presentation of how the Swedish authorities dealt with the banking crisis in the early 1990s and provides an excellent account of the issues involved and the restructuring and support strategy that was implemented by the government. The paper can usefully serve as a manual for formulating and executing a bank restructuring program. This is not to say that there is one single approach to restructuring. Judgment and flexibility are clearly important, particularly because conditions vary across countries, and information does not usually become available all at once.

Given this, I would like to highlight the “best practices” underlying the Swedish effort that contributed to a successful bank restructuring. The authors do this toward the end of their paper, and 1 would like to add some points as appropriate, including comparable experience in the Philippines. Then 1 identify aspects of the paper where further elaboration would be helpful in clarifying certain relevant issues.

Overall Strategy

On balance, the strategy used by the Swedish authorities was a comprehensive one, involving both financial and operational restructuring of affected institutions. Financial restructuring focused on improving the balance sheets of troubled banks to improve the flow of income mainly by capital infusion, provision of guarantees, and management of assets. In the case of Sweden, most of the bad assets appear to have been transferred to asset management companies that took care of their disposition. The good assets remained with the banks; these provided the sources of income that would subsequently bring affected institutions back to profitable operations.

At the same time, improvement in internal governance through operational restructuring formed the other important component of the strategy. This was pursued through such measures as changes in management and reduction in the number of staff. It is worth noting that the failure to adopt operational restructuring was a principal reason for the reemergence of financial distress in other countries in the early 1990s.

A parallel of the Swedish approach is the rehabilitation of the two largest government-owned banks in the Philippines during the second half of the 1980s. After being found insolvent, these two banks were rehabilitated by the government and their balance sheets reduced through a write-off of government deposits and other liabilities and the transfer of their nonperforming assets to the national government through the Asset Privatization Trust. The latter was established to provisionally manage and dispose of assets that had been identified for privatization or disposition. In addition, the banks got new management teams; they were prohibited from expanding their branch networks; and significant cost reduction programs were implemented. Moreover, special privileges were withdrawn and they had to compete on a more level playing field with private banks. The rehabilitation program had a successful outcome with the two banks returning to solvency and profitable operations. The bigger of these two banks was subsequently privatized.

Main Principles

The experience of Sweden illustrates how certain principles of restructuring were successfully put to work toward a prompt resolution of the crisis, and the authors effectively list the important lessons to be learned from the crisis. In particular, substantial merit can be found in the following:

  • The authorities’ swift response to the problem helped to restore confidence in the banking system promptly. This was clearly crucial in preventing the crisis from getting bigger. The restoration of confidence was greatly helped by the support of parliament, which formulated a plan that, according to the authors, provided for “unlimited use of public funds to finance support agreements between the government and the banks.”

  • The authorities gave adequate—rather than excessive—support to troubled banks. This minimized the extent of state support while maintaining as much as possible a level playing field for players in the industry, including those that did not require government financial assistance.

  • Their uniform use of careful valuation of loans and other assets helped to achieve equal and fair treatment of beneficiaries. The use of experts specialized in asset valuation in different sectors proved crucial in this step of the process.

  • In addition, the governing principles of the sales process of the asset management companies (AMCs) were well thought out, with their emphasis on transparency and ready access to information by interested parties. Such principles were undoubtedly important in generating a broad political consensus for, and facilitating public acceptance of, the restructuring strategy.

The paper also discusses in some detail the advantages and disadvantages of shifting the bad assets of banks to a separate agency with explicit funding sources. Ultimately, the choice between public, private, or joint management of problem assets should depend on which sector is likely to be more efficient in handling the problem assets. This would depend on the nature, number, and size of such assets. At any rate, the paper makes a compelling case for operating an AMC on strictly commercial criteria, and the need to provide it with an incentive structure that rewards efficiency. These would support the authorities’ efforts to maximize the recovery value of loans and collateral, thus helping maximize the cost effectiveness of the government assistance.

The application of these principles proved to be effective in weathering the banking crisis in Sweden. Of course, countries should adopt policies designed to avoid the occurrence of a crisis, but when something goes wrong, and the authorities need to respond to a systemic bank failure, the principles applied in the Swedish case provide valuable lessons for countries that may find themselves in a similar situation.

Additional Elaboration

Having said this, there are certain aspects of the paper where further elaboration could help to clarify certain points. The first concerns the issue of moral hazard and the effects on solvent borrowers and banks. To be fair, the hammock approach adopted by the Swedish authorities indicates that government support was not extended indiscriminately. Rather the decision to extend or withhold assistance depended on the ultimate viability of the bank. Apparently, bankruptcy was resorted to in certain cases, thus helping to weed out the inefficient banks.

Nevertheless, a history of central bank intervention to shore up troubled institutions can create the perception of future bailouts, in the eyes of both lenders (the banks) and borrowers. As a result, these entities may behave differently because of this expectation, and their future risk-taking behavior can be affected. It would be interesting to know how the Swedish authorities viewed this issue, and whether the approach that was adopted, including the imposition of costs on shareholders of failed or distressed banks, provided sufficient credibility that future inefficiency would be dealt with promptly and not be condoned.

In any case of banking system failure, a question that begs to be asked, and this is my second point, is why the authorities failed to recognize the problem earlier, and why they apparently failed to establish internal measures to minimize the undue concentration of loans to a particular sector. The authors say that, in order to gain market share, banks lowered their credit standards despite their lack of adequate knowledge and procedures for proper credit assessment in a deregulated banking environment. In the Philippines, during the early part of the 1980s, severe difficulties in the banking system were caused by, aside from the significant macroeconomic problems, weaknesses in bank supervision, regulatory forbearance, and political interference in bank lending. Such difficulties had to be addressed by a comprehensive rehabilitation program for the country’s two largest government-owned banks.

Evidently, there were weaknesses in the prudential regulation and supervision of Swedish banks, since the problem of loan losses arising largely from the collapsed property market seems to have gone unnoticed until the losses had become substantial. There do not appear to have been any early warning indicators, and the authorities apparently were unable to control the volatility in the collateral asset portfolio (for example, by requiring loan loss provisions or recapitalization by existing equity holders).

Admittedly, imposing restrictions on real property lending to avoid overexposure has to be balanced against the possibility that such action may be interpreted as an official signal that the banks are carrying excessive risk and may aggravate the problem. This emphasizes the importance of taking action when the potential difficulty is just beginning to develop. It would be interesting to know what the Swedish authorities were aware of prior to the development of the crisis.

The third point concerns the measures that were taken to avoid the recurrence of such problems in the future. The costs of delayed adjustments to the decline in asset prices could have been prevented, or at least minimized, by frequent surveillance of collateral assets and up-to-date market-based measurement of their values. Up-to-date market-based valuation and frequent inspection are clearly important means of minimizing possible losses. These reforms can help the authorities spot problems in bank management and bank portfolios well before insolvency occurs and compel banks to take timely corrective action. In this regard, it is important to assess both lending to a sector like real estate as well as lending for other purposes that is collateralized by real estate.

In drawing policy lessons from the crisis, the authors could have devoted some discussion to the need to correct deficiencies in bank regulation and supervision. It would have been instructive to learn whether corrective measures were instituted to foster strong internal governance by the monetary and supervisory authorities, as these would serve as the first line of defense against banking problems in the future.

A fourth point is that the paper deliberately sets aside the monetary and fiscal implications of the bank restructuring. Considering the importance of this aspect of the program, it would have been useful to address it. The recovery rate for government resources spent on the rescue effort is a creditable 74 percent (SKr 48 billion against SKr 65 billion worth of state support, excluding guarantees). While the paper recognizes that the opportunity cost of state support was not considered, it would be instructive to include some measure of this cost.

The paper notes that the financing of the rescue package came from state (taxpayers’) funds. It would be interesting to know the fiscal implications of the government’s involvement. If the rescue package was financed through the flotation of government securities, it would have been interesting to examine if it had an impact on interest rates. If the rescue package was financed out of existing government resources, it would have been interesting to examine whether it crowded out other government expenditures.

A final point is that the Swedish authorities’ success in “picking winners” through the hammock approach—by distinguishing banks that were inherently viable from those that were inefficient—was facilitated by their ability to gather and analyze information about the banks’ future financial prospects. Furthermore, their intervention was made easier by the fact that the crisis was limited in scope and that the collateral assets had easily ascertainable values, at least relative to other assets. In other countries, the ability of the authorities to obtain the enormous amount of information necessary to make accurate valuations, as well as to assess the data, may be severely restricted. In addition, countries vary a great deal in their legal frameworks, administrative infrastructures, and political constraints.

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