Bank Nationalization, Swedish Style

“Nationalization” has become a very nasty word. Last Friday, for example, Senate Banking Committee Chairman Christopher Dodd, mentioned that a period of nationalization might be necessary, at least temporarily. Bank stocks roiled. Within minutes of Dodd’s remark, stocks of Bank of America, Citigroup and Wells Fargo plunged 25 percent.

So what’s the deal with nationalization? Why is it such a jarring term? Could it work as a palliative for banks stuffed with toxic assets and whose loan to asset ratios are anemic? The two most recent examples of bank nationalization deal with Sweden and Japan. This post looks at the Swedish experience.

Sweden fell into a severe financial crisis in the late 1980s and early 1990s. Myriad factors came together to cause Sweden’s mess, including the government’s lifting of a restriction on borrowing in the early-mid 1980s, several currency devaluations to boost exports and a mismanaged effort by the government to borrow only in local markets in Swedish kronas, which ended up putting more risk on banks than the government, according to recent survey of the Swedish experience by the Cleveland District of the U.S. Federal Reserve.

To be sure, Sweden’s economy differs significantly than America’s since it has a target employment, broad social programs and high taxes. These factors plus the financial changes Stockholm sought in the 1980s seriously weakened the financial system. A tipping point came in 1990 when the disintegrating Soviet Union allowed German reunification. The German mark weakened and interest rates shot up, impacting faltering Swedish banks.

Forsta Sparbanken and Nordbanken, two of Swedens six largest banks, announced that they couldn’t meet regulatory capital requirements. The government swooped in with a nationalization plan and bought Nordbanken and helped Forsta Sparbanken with loan guarantees. Another bank, Gota Bank, foundered after failing to get loan guarantees so the government bought it, too. In a brief period, the government ended up owning 22 percent of all the country’s banking assets.

As a remedy, the government set up a familiar “”bad” bank arrangement. An asset management company (AMC) called Securum handled the bad assets of Nordbanken and another AMC named Retrieva took over bad loans from Gota. The AMCs operated independently and were free of many routine bank regulations. They injected equity into troubled borrowers and at times took over defaulting companies and ran them.

Supplementing the AMC rescue effort was a policy that required Swedish banks to unload collateral within three years instead of immediately. This tactic was designed to take pressure off short-term prices and reinforce the idea that recovery would take a decade or more.

As luck would have it, Sweden’s economy bounced back rather quickly and liquidations were finished by 1997 at a much cheaper cost than anticipated. On the down side, Sweden lost its leading position in European income levels

What worked? The Cleveland Fed makes these points:

• Transparency. Anticipated losses were recognized and revealed early on.
• Political independence. The AMCs or “bad” banks were free of politics and could shut down banks for economic reasons only.
• Market discipline. Uninsured depositors have strong incentives to enforce discipline by raising their cost of funding when they are forced to swallow more risk. This can be undone if the government promises unlimited liquidity. Sweden sidestepped the problem by refusing unlimited liquidity but guaranteeing bank liabilities.
• The credit-worthiness of the real economy must be repaired. Banks may get fixed, but unless credit truly starts flowing the exercise is self-defeating.

President Barack Obama has mentioned that Sweden offers a hopeful example of financial rescue but he also noted the big differences in the relative size of the two economies and the fact that the Swedish government plays a much bigger role in the economy. True enough, but Sweden offers a better example than Japan, which moved slowly with its recovery plans and lost an entire decade for it.