IV Response to Deregulation

Burkhard Drees, and Ceyla Pazarbasioglu
Published Date:
April 1998
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Banks, just like other enterprises, develop their business practices and behavior on the basis of the prevailing regulatory environment, as the preceding section illustrated. Financial deregulation, which was accomplished within a few years in the Nordic countries, was a major shock to the system and posed new challenges for borrowers and lenders alike to adapt to the new environment. Indeed, the financial systems in the Nordic countries responded quickly. As in other countries that underwent financial liberalization, the most striking development was the significant rise in bank lending and risk taking (see Sundararajan and Baliño, 1991, and Bisat, Johnston, and Sundararajan, 1992). This section analyzes the incentives that led borrowers and lenders to expand credit and banks to alter their loan portfolios and funding.

Borrowers’ Response

Because the ability of some businesses and of households to obtain credit had been constrained, a substantial stock-adjustment response in private credit was to be expected after liberalization (see Hubbard, 1991; and Minsky, 1977). Demand for credit was, however, also fueled by robust economic growth at the time of liberalization. Bank lending surged in all three countries. In Norway, the ratio of bank loans to nominal GDP increased to 65 percent in 1988 from 40 percent in 1984 (Figure 1). The surge in lending in Finland and Sweden took place somewhat later, reflecting in part differences in the timing of financial liberalization and in macroeconomic conditions. In Finland, the ratio of bank loans to nominal GDP increased to 98 percent in 1990 from 55 percent in 1984, while it increased in Sweden to 58 percent from 41 percent.22 The effect of pent-up credit demand pressure was visible in all three countries, and liberalization resulted in a credit-financed surge in capital formation and consumption (Figure 2) (see Lehmussaari, 1990). In all three countries, the current account balance deteriorated and was largely negative following the liberalization (Figure 3).

Figure 1.Ratio of Bank Loans to GDP

(In percent)

Source: International Monetary Fund, International Financial Statistics database.

Figure 2.GDP, Gross Fixed Capital Formation, and Private Consumption

(In real terms; percentage change)

Source: International Monetary Fund, International Financial Statistics database.

Figure 3.Ratio of the Current Account Balance to GDP

(In percent)

Source: International Monetary Fund, World Economic Outlook database.

Household Sector

The reaction of households to financial deregulation was similar in the three Nordic countries: households began to borrow aggressively and reduced their savings sharply (Figure 4). Net household saving as a percentage of disposable income declined in Norway from less than 5 percent in 1984 to –2.5 percent in 1985. The decline in the household saving ratios in the other two countries was more gradual: in Finland, it fell from 5.7 percent to –1.6 percent between 1980 and 1988 and, in Sweden, from about 6.5 percent to –3.4 percent between 1980 and 1987. Most of the household borrowing was channeled into purchases of consumer durables and real estate. In all three countries, household indebtedness (defined as the ratio of household debt to net disposable income) reached record levels between 1989 and 1991. In Finland, this ratio increased to about 90 percent in 1990 from 45 percent in 1980, and in Norway, to 175 percent in 1989 from about 90 percent in 1980.

Figure 4.Household Savings and Real After-Tax Lending Rates

Sources: Organization for Economic Cooperation and Development Database; and national authorities.

Note: Household savings as a percentage of disposable household income.

In addition to an inevitable jump in credit owing to the stock-adjustment effect in the wake of the abolishment of credit controls, several other factors contributed to the incentives to borrow and the resulting drop in household savings. First and foremost, in all three countries, high marginal tax rates and full tax deductibility of interest payments meant that real after-tax interest rates were excessively low and sometimes even negative (Figure 4). Because of the generous tax deductibility of interest expenses for both mortgages and consumer loans in an environment of relatively high inflation, households readily exploited their freer access to credit after financial liberalization. Higher asset and collateral values also facilitated borrowing. The initial surge in credit contributed to a jump in asset prices, in particular real estate prices. Expecting that the sharp asset price appreciation would continue along the prevailing trend, many borrowers were willing to incur heavy debt burdens despite relatively high interest rates because they perceived considerable upside potential and limited downside risk. Moreover, low and declining unemployment combined with strong growth in disposable income (in particular in Finland where economic growth in the late 1980s was strongest among the three countries) fueled the propensity to borrow. In hindsight, it is clear that most borrowers did not anticipate the possibility of a surge in after-tax real interest rates on their variable-rate loans. Interest rate volatility picked up markedly in the early 1990s when monetary policy was tightened and the tax deductibility of interest payments was reduced.

Corporate Sector

The indebtedness of the corporate sectors in the three Nordic countries also grew rapidly after deregulation. Traditionally, corporations had been highly dependent on borrowing from financial institutions and, as in other countries with universal banking systems, relied heavily on debt financing. In 1980, the debt-equity ratios were about 3, 4, and 5.5, in Norway, Finland, and Sweden, respectively, compared with less than 0.2 in the United Kingdom and 0.25 in the United States (see Schuijer, 1992). A significant increase in private investment took place in the Nordic countries following deregulation, with the majority of activity occurring in residential and non-residential construction, real estate, and services sectors.23

The lifting of foreign exchange restrictions opened up new opportunities for debtors to borrow from banks at what they perceived to be low interest rates in foreign currency. The surge in foreign currency borrowing was particularly strong in Finland, where in the late 1980s about half of the corporate borrowing was denominated in foreign currency (see Brunila and Takala, 1993). Given the large interest rate differentials vis-à-vis other European interest rates and the perception of a firm commitment to fixed exchange rates, a “convergence play” based on the belief that exchange rate parities were unlikely to change provided a strong incentive to borrow in foreign currencies even for corporate borrowers in the sheltered domestic sectors (see Goldstein and others, 1993).

Lenders’ Response

Financial liberalization profoundly changed the competitive environment of financial institutions. In particular, the lifting of lending and deposit rate restrictions and credit ceilings opened the door to more competition. Whereas prior to deregulation obtaining a loan was often conditional on a close banking relationship and—as a result—a sizable segment of potential borrowers had difficulty obtaining credit, banks could use interest rates as strategic variables after the financial deregulation. The shift to more price competition weakened traditionally close banking relationships and impaired banks’ ability to assess credit risks and monitor borrowers. It also facilitated the entry of banks and nonbank financial institutions into new segments of the credit market. Banks increased the role of fee income in order to lessen the dependence on interest income as traditional banking became less profitable (see Schuijer, 1992).

Heightened competitive pressures created considerable uncertainty about the new banking environment. In particular, the dense branch networks and sizable bank capacity that had been built up to compete for customers were becoming less viable. To secure their positions in the deregulated environment, many banks felt compelled to expand their lending aggressively by accommodating the surging loan demand, in particular to the real estate sector, which was thought to provide the best collateral. The higher risk taking was also supported by incentives that stemmed in part from banks’ thin capitalization and from moral hazard resulting from explicit or implicit full deposit insurance coverage and the expectation that no bank would be allowed to fail in a financial crisis.24

Changes in Market Shares of Different Financial Institutions

In Norway, during 1980–90 the share of state-owned banks in the loan market declined from about 40 percent to 18 percent. Reflecting, in particular, increased circumvention of regulations by private financial institutions, the market share of private banks rose from about 43 percent to 52 percent, and the share of private nonbank financial institutions almost doubled, from 17 percent to 30 percent. Similarly, in Sweden the credit market share of nonbank financial institutions increased from about 30 percent to 45 percent during 1985–90. The Swedish banking system as a whole experienced a decline in loan market share from 55 percent to about 40 percent (Table 2).

In Finland, savings banks as a group gained loan market share (16 percent in 1985 to about 25 percent in 1990) from other banking institutions (Table 2).25 Because large corporations had well-established relationships with commercial banks and increasingly borrowed directly on financial markets, savings banks had to focus on more risky corporate borrowers, including small and medium-sized businesses that had previously been more or less neglected by the large commercial banks. Particularly rapid was the credit growth by Skopbank, the central institution of the savings banks, which increased its loans by 50 percent in 1987 and maintained high growth rates in 1988 and 1989.26

Changes in Loan Portfolios

Increasingly aggressive bank lending policies were accompanied by a noticeable increase in risk taking, as banks shifted their loan portfolios toward more cyclical sectors, such as real estate, construction, and services and toward loans denominated in foreign currency.

Most commercial banks in Finland (Skopbank in particular) had built up heavily concentrated loan exposures, mostly to connected nonfinancial corporations. Before1991, there were no regulations that limited exposure to individual borrowers. Although exposure limits were in effect in Sweden, some Swedish banks attempted to circumvent them by lending to property developers indirectly through finance companies (see Bank Support Authority, 1993).

After foreign exchange restrictions had been gradually lifted, lending to domestic firms in foreign currency increased in all three countries, but particularly rapidly in Finland. Finnish commercial banks increased the share of foreign currency loans from about 22 percent of their total loan portfolio in 1986 to almost 43 percent in 1991. Even savings banks, which in 1986 had almost no loans denominated in foreign currency on their balance sheets, by 1990 were lending 12 percent of their loans to the public in foreign currency.

Funding of Credit Expansion

At the same time as bank lending opportunities expanded, banks’ capabilities to fund the rapid credit expansion improved significantly. Evidence from other countries suggests that, in the aftermath of financial liberalization, the volume of loans grows significantly faster than the volume of bank deposits (see Bisat, Johnston, and Sundararajan, 1992; and Cottarelli, Ferri, and Generale, 1995). The same phenomenon took place in the Nordic countries (Figure 5). Traditionally the Nordic banks financed their assets almost exclusively through bank deposits, whereas after financial liberalization some banks resorted increasingly to other funding sources, such as borrowing in the domestic and international interbank markets. In 1983, the Norwegian loan-to-deposit ratio was 0.9 for commercial banks and 0.8 for savings banks. By 1987, the loan-to-deposit ratios had risen to 1.5 and 1.2, respectively. Bank lending as a percentage of total assets expanded in Sweden by about 10 percentage points between 1985 and 1990, whereas the share of deposits shrank by about the same amount. In Finland, the ratio of bank loans to deposits, which had been rather stable in the past, rose from 1.3 in 1985 to 1.8 in 1990.

Figure 5.Deposits and Loans

(In billions of national currency)

Sources: International Monetary Fund, International Financial Statistics database; and national authorities.

To finance their asset growth, some banks depended increasingly on the money market and on foreign funding, which tend to be much more volatile than retail deposits. The shift also meant higher funding costs. In Norway, for example, the interbank rate, which reflected borrowing costs in the money market, was more than 5 percentage points above the average deposit rate during most of the 1980s. Since bank deposits as a percentage of total assets declined and the share of money market funding increased, banks’ funding costs rose sharply (see Commission on the Banking Crisis, 1992). In Norway, the lending boom was also partially fueled by liquidity support to the financial institutions by the central bank.

Pricing Policies

In theory, higher equilibrium real interest rates should be associated with more efficient investment, higher returns on capital, and higher savings and growth. However, very high real interest rates may also be associated with adverse selection and with the channeling of funds into riskier projects. They may also reflect a lack of credibility, country risk premiums, or banking system fragility (see Calvo, 1988; and Persson and Tabellini, 1990). Furthermore, following interest rate liberalization, the relative influence of domestic versus external factors in determining nominal interest rates depends on the degree of rigidity of lending rates and the openness of the capital account (see Cottarelli and Kourelis, 1994). If capital flows are unrestricted, the domestic interest rates will be largely determined by external factors through the uncovered interest parity relationship.

In all three Nordic countries, real lending rates rose before the liberalization of interest rates, reflecting the declining trend in inflation (Figure 6). After the abolition of lending rate restrictions, real lending rates declined to levels in line with international rates. However, it is puzzling that the rates on new lending remained below the money market rate until the late 1980s in Norway and below the yield on public issues in Finland. This suggests that banks did not raise lending rates to appropriate levels, which would have compensated them sufficiently for the risks associated with the rapid expansion of lending and for the increased cost of funding from money markets rather than deposits. What is more, the surge in interest rates coincided with a tightening of the tax treatment of interest payments and a decline in inflation that, as a result, raised after-tax real lending rates substantially (Figure 4).

Figure 6.Lending Rates

(In percent)

Sources: International Monetary Fund, International Financial Statistics database; and national authorities.

1 Calculated as lending rate minus three-year ahead average inflation.

The net interest income—the intermediation margin—of Finnish and Norwegian banks declined during the liberalization period (1985–90) compared with the preliberalization period (1980–85) (Tables 7 and 8). This decline was particularly evident for Norwegian commercial banks and the Finnish savings banks. It can be explained by four main phenomena: increased competition between financial institutions, the growing dependence on more expensive money market funding rather than deposits, an increase in nonaccrual loans,27 and the reduction in credit commissions. (See Berg and others, 1993; and Berg, Forsund, and Jansen, 1992).

Table 7.Finland: Bank Profitability(In percent of average total assets)
Commercial banks
Net interest income2.
Operating expenses3.593.383.162.882.862.802.592.582.812.642.614.024.354.543.963.32
Loan loss provisions0.
Profits before taxes0.710.970.990.700.801.090.820.901.090.460.38–0.73–1.93–1.76–1.12–0.55
Cooperative banks
Net interest margins3.713.733.663.503.343.363.
Operating expenses4.524.494.664.504.494.
Loan loss provisions0.
Profits before taxes0.670.710.770.690.640.750.670.730.960.600.780.760.03–1.65–1.17–0.02
Savings banks
Net interest income3.573.573.833.503.
Operating expenses4.
Loan loss provisions0.
Profits before taxes0.590.660.690.530.400.600.640.720.760.450.56–0.41–9.29–4.94–2.050.41
Sources: Organization for Economic Cooperation and Development, Bank Profitability (1996); and Bank of Finland.
Sources: Organization for Economic Cooperation and Development, Bank Profitability (1996); and Bank of Finland.
Table 8.Norway: Bank Profitability(In percent of average total assets)
Commercial banks
Net interest income3.
Operating expenses3.553.473.273.313.273.112.902.922.682.642.623.152.482.382.572.76
Loan loss provisions0.
Profits before taxes0.850.990.811.181.170.920.95–0.04–0.130.04–1.17–4.29–1.250.581.212.00
Savings banks
Net interest income3.924.524.604.644.443.873.704.033.624.143.853.794.344.734.143.91
Operating expenses2.973.183.323.473.473.383.
Loan loss provision0.
Profits before taxes1.031.562.121.351.230.860.940.63–0.04–0.30–0.77–
Sources: Organization for Economic Cooperation and Development, Bank Profitability (1996); and Norges Bank.
Sources: Organization for Economic Cooperation and Development, Bank Profitability (1996); and Norges Bank.

The decline in the interest rate spreads at the time of the credit boom also suggests more intense competition among financial institutions.28 The net interest income of cooperatives and savings banks increased in Sweden during the deregulation period reflecting the reallocation of bank portfolios from government bonds to private sector loans (Table 9) (see Dahleim, Goran, and Nedersjo, 1993; and Lind and Nerdersjo, 1994). In contrast, Finnish banks’ intermediation margins were among the lowest of European banks (Table 10).

Table 9.Sweden: Bank Profitability(In percent of average total assets)
Commercial banks
Net interest income2.102.151.992.272.211.992.612.492.442.
Operating expenses2.
Loan loss provisions0.050.110.350.280.390.230.340.
Profits before taxes1.071.130.911.381.121.111.851.291.451.220.68–0.50–2.31–1.220.981.33
Cooperative banks
Net interest income2.723.153.333.693.704.084.504.504.694.843.873.94
Operating expenses2.
Loan loss provision0.
Profits before taxes0.560.981.121.351.101.101.561.211.471.571.06–1.03
Savings banks
Net interest income2.643.093.223.603.593.944.
Operating expenses2.412.382.542.633.193.704.004.023.953.924.397.239.336.124.424.61
Loan loss provision0.
Profits before taxes0.751.191.201.391.181.261.601.141.341.211.04–1.79–2.821.541.741.58
Sources: Organization for Economic Cooperation and Development, Bank Profitability (1996); and Sveriges Riksbank.
Sources: Organization for Economic Cooperation and Development, Bank Profitability (1996); and Sveriges Riksbank.
Table 10.Bank Profitability: International Comparisons, 1985–89(In percent of balance sheet total; average)
Net Interest Income (Intermediation margin)Net Noninterest Income (Overall gross margin)Net Banking IncomeTotal Operating ExpensesPre-Tax Profit
United Kingdom3.031.744.763.100.81

Overall, the vulnerability of banks to credit losses increased in all three countries because no additional operating profits were being generated during the lending boom to compensate for the greater lending risks. Unlike most other European countries, the banking systems in the three Nordic countries all recorded below-average pre-tax profits during the postliberalization period (Table 10).

Incentives for Increased Risk Taking

A central question about the Nordic banking experience in the late 1980s is, what was the banks’ economic motivation and their underlying incentives for the sharp increase in bank lending, and more important, in risk taking? Several factors appear to have contributed to the banks’ behavior. These include moral hazard incentives stemming from implicit state policies that no bank will fail; reduced bank franchise values owing to lower economic rents and cost rigidities in the banking industry after liberalization; and insufficient adjustment of internal control incentives and business practices to the new environment (see Guttentag and Herring, 1986). Moreover, banks seem to have underestimated the increased risks attributable to changed bank-customer relationships and risks involved in asset-based lending.

Banks entered the 1980s poorly capitalized in terms of book or market value. The insufficient cushion against loan losses made banks vulnerable to adverse economic shocks and gave them a strong incentive for risk taking to maximize the option value of deposit insurance.29

In Finland and Norway, the book-value ratio of shareholder equity to total assets of all banks ranged from 2 percent to 2½ percent. The financial strength of the Norwegian banking industry was further weakened because banks were allowed to count subordinated debt as equity capital. By 1990, the subordinated debt of Norwegian commercial banks represented about three-quarters of their equity capital. The Swedish banks also had low capital ratios, in the range of 3½–4½ percent; however, the banks had accumulated substantial loan loss reserves, which were tax deductible.

In principle, leverage-related and risk-related costs (such as bankruptcy costs) may restrain banks’ incentive to take risks, as can regulatory costs that potentially change with the riskiness of a bank’s portfolio and capitalization (see Shrieves and Dahl, 1992). Taken together, however, the reduced regulatory costs that were associated with deregulation and the low equity ratios provided a strong incentive for banks to accommodate the surge in credit demand and to bear more risk.

The trend toward riskier lending could also have resulted from the diminished franchise values of deposit banks as a consequence of deregulation and increased competition.30 Before the mid-1980s, banks in Finland, Norway, and Sweden operated in highly regulated markets that tended to thwart competition and allow banks to earn considerable economic rents (excess profits) from providing financial services. But instead of the rents benefiting shareholders, banks appear to have used them to boost the scale of their operations.31 This was particularly apparent in Finland and Norway, where an extensive branch network, high operating costs, and low profits prevailed. In principle, deregulation reduces future bank profitability and thus tends to lower rents in the banking industry. Given the rigid cost structure and reduced scope for discretionary expenditures, bank managers in Finland, Norway, and Sweden, like shareholders, had to take on increased risk to get higher returns after financial liberalization.

Fearing that they could lose ground in the vigorous competition touched off by liberalization, many banks, in particular some large ones, pursued aggressive lending policies as a preemptive response and were prepared to accept higher risk. In this context, the aggressive lending behavior of the Finnish savings banks following a loss of market share in the early 1980s may not be surprising in hindsight. They probably faced the biggest scope for risk taking on account of their ownership structure—they can be characterized as managerially controlled banks without shareholders to monitor behavior. Moreover, savings banks shared their credit risks through a system of mutual loan insurance. Given that individual institutions accordingly did not bear the entire default risk, this system potentially created a strong incentive to grant risky loans. To what extent the scope for risk taking was actually used, however, depended on bank management, as illustrated by the Finnish cooperative banks. Although cooperative banks shared many structural characteristics of savings banks, including mutual loan insurance, they pursued more cautious lending policies.

Beyond changing incentives, financial liberalization also altered traditional banking relations, with adverse implications for banks’ ability to monitor the creditworthiness of customers. Before deregulation, close relationships existed between banks and their borrowers owing to credit rationing. After market forces became dominant in the credit market, transaction-based banking gained more importance relative to relationship banking. In that connection, banks appear to have underestimated the increased risk of the larger pools of borrowers to whom they were lending. Moreover, banks’ internal credit policies and control mechanisms appear to have been inadequate for the task of assessing credit risks and of monitoring debtors in the newly deregulated environment. In Finnish and Swedish commercial banks, complicated cross shareholdings with nonfinancial corporations provided ample opportunity for connected lending, and credit exposures often exceeded prudent limits.32 Although significant interest rate risks were shifted to the borrower because most loans carried variable interest rates, banks did not adequately anticipate the possibility that a surge in interest rates could turn a borrower’s interest rate risk into the bank’s credit risk, as demonstrated in Finland and Sweden in the early 1990s when monetary conditions were sharply tightened.

The experience in the Nordic countries also illustrates the potential pitfalls of asset-based lending. Banks appear to have misjudged the initial upward pressure on asset prices as a sustained trend justified by favorable fundamentals. With the steady and often spectacular increases in prices, banks were prepared in some cases to provide almost 100 percent financing for asset purchases, requiring only that the asset serve as collateral. Some borrowers had inadequate equity stakes leaving the banks vulnerable to an economic downturn and asset price deflation.33

Policymakers’ Response

The response by policymakers was inadequate for three reasons. The authorities failed to see the need to tighten prudential bank regulation in areas such as real estate and foreign currency lending; the favorable tax treatment of interest payments was not reformed until well after the credit boom; and monetary conditions were not tightened sufficiently and in a timely manner.

It is now widely recognized that economic deregulation needs to be supplemented by a strengthening of prudential regulations (see Bisat, Johnston, and Sundararajan, 1992; Sundararajan and Baliño, 1991; and White, 1991). But in the Nordic countries little emphasis was placed at the time of deregulation on strengthening and adapting prudential safety-and-soundness regulations to the new competitive environment, in particular in the areas of real estate and foreign currency lending. Even after deregulation, the bank supervisory offices in the Nordic countries continued to focus primarily on the banks’ compliance with regulation and did not review in depth the banks’ lending practices and risk-management policies. Furthermore, at the height of the credit expansion by banks, the banking supervisory offices in Norway and Sweden were merged with the insurance supervisory bodies and devoted special attention to developing capital markets and less attention to monitoring the banking system. In Finland and Norway, routine on-site inspections—rather than being increased—were sharply reduced as a result of the explicit move toward document-based supervision. In Finland, direct supervision and on-site inspections of savings and cooperative banks remained the sole responsibility of their own supervisory bodies.

With high marginal tax rates, the tax deductibility of interest expenses meant that the real cost of borrowing for households was low during most of the 1980s; the real costs of purchasing a home were in fact markedly negative. Yet, mainly for political reasons, the authorities did not correct these incentives at the time of deregulation; instead, tax reforms were delayed until 1988 in Norway (when marginal tax rates were lowered) and 1990–91 in Finland and Sweden (when marginal tax rates were lowered and the deductibility of interest payments was curtailed).34

Despite the sharp growth in lending and the surge in private indebtedness, monetary conditions were not immediately tightened. Norges Bank sharply increased central bank credit to banks, from 3 percent to 23 percent of the private credit extended by banks in 1986, following the 10 percent devaluation of the Norwegian krone that was triggered by a decline in oil prices.35 The increase in the banks’ borrowing facility was a deliberate measure to offset an anticipated decline in foreign borrowing (which never materialized). In Finland, the exchange rate peg initially constrained the monetary policy response, but in early 1989 the markka was revalued by 4 percent and a special reserve requirement was imposed to slow the growth in bank lending. Yet some banks, in particular savings banks, chose to pay the penalty rates instead of curtailing their lending growth (see Nyberg and Vihriälä, 1994).

The figures for Sweden do not include housing loans from mortgage banks—most of which are subsidiaries of the major banks. In Finland and Norway, housing loans were typically provided directly by the deposit banks.

In all three Nordic countries, the government promoted construction activity through various subsidies.

In contrast with Finland and Norway, Sweden had no explicit deposit insurance scheme. In September 1992, the Swedish government announced that it would guarantee that all bank commitments be met on a timely basis and that no depositors, creditors, or other parties would suffer any losses (Sveriges Riksbank, 1992).

See Koskenkylä and Vesala (1994), Koskenkylä (1994), and Solttila and Vihriälä (1994) for an analysis of balance-sheet growth.

Skopbank was the first bank subsequently to encounter financial difficulties.

Nonaccrual loans are potential bad loans that have not yet been entered as losses, but are instead debited to the banks’ earnings.

See Cottarelli, Ferri, and Generale (1995) on the experience of Italy and other European countries.

The incentive for bank risk taking tends to rise as the relative share of equity financing declines. See, for example, Furlong and Keeley (1989). In Finland, deposit insurance funds have been in existence for savings and cooperative banks since the 1930s and for commercial banks since the 1960s; deposit insurance was made mandatory in 1969. Insurance coverage is unlimited. The insurance funds are operated by their member banks and charge a flat-rate premium. Their resources, however, proved inadequate for the banking crisis.

A related hypothesis on the impact of liberalization on bank risk taking focuses on the erosion of rents accruing to shareholders. This argument has been applied to U.S. bank performance by Keeley (1990) and Fries (1993). For a discussion of this hypothesis in the context of the Nordic countries, see Llewellyn (1992).

Economic rents accruing to shareholders can be measured by the ratio of the market value to the book value of their assets (Tobin’s q ratio). See Keeley (1990) and Fries (1993) for an application to the banking industry. The basic premise behind this measure is that the capitalized value of any excess profits is reflected in the market value but not the book value of bank assets. For selected banks in Finland, Norway, and, Sweden, Tobin’s q ratios were not significantly higher than 1 before financial liberalization, which points to the absence of excess profits accruing to shareholders.

The Finnish Deposit Bank Act of 1991 introduced exposure limits.

High leverage itself may also have contributed to an adverse selection problem among borrowers (see Stiglitz, 1993).

The Swedish tax reform lowered to 30 percent the share of interest expenses that could be deducted from the taxable income of households (Bank Support Authority, 1993). In Finland, the deductibility was reduced in steps between 1990 and 1993.

At the end of 1987, central bank financing accounted for 28 percent of the commercial banks’ total assets and 14 percent of savings banks’ total assets.

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