There was an international trend towards the deregulation of many industries from the 1970s to the 1990s. In Britain and America, these changes were associated, excessively by both their friends and foes alike, with Thatcher and Reagan. In any case, the liberalization of commercial life, and finance specifically, was far from unique to these countries. The Nordic countries also saw a drive towards deregulation in finance. In Sweden for example, various controls were removed which allowed for the creation of a credit bubble, the reversal of which drove the financial system into a severe crisis. Nonetheless, what did not reverse were the reforms undertaken that facilitated, if not caused, the crisis in the first place.

Credit

            In the 1970s, Sweden’s economy was overheating. Inflation was around or above 10% for much of the decade and wage growth was very strong. The government generally ran budget deficits during these years. So far, nothing too unusual for this period. However, these conditions were manifest to a somewhat larger degree in Sweden than elsewhere in the developed world. This led to the depreciation of the Swedish krona against other currencies, occurring over six devaluations between 1973 and 1982. After a point, these periodic devaluations became very predictable and this meant that interest rates were usually higher in Sweden than the international average.

           Still, inflation and favorable tax treatment of interest payments made real ‘after-tax’ interest rates low, indeed often as low as negative 9% in the mid-to-late 1970s. Offered on terms as favorable as this, demand for credit had been high. However, banks could not increase interest rates or the size of their loan portfolios in response to this demand, which could have made the price of credit more sensible. This was because the pricing and supply of credit was controlled by strict regulation. The effect was that, though very cheap, credit was rationed. Certain borrowings, namely those of governments and mortgage institutions, were favored and thus prioritized over other debts. 

            This changed with financial deregulation in the 1980s, largely brought about between 1983 and 1985. In a series of actions, caps on interest rates and other controls on lending, such as ceilings on bank lending activity, were removed. Before this moment, banks were also required to hold 50% of their assets in government bonds or mortgage securities. This requirement was scrapped. In the early 1980s, the real after-tax interest rate on five-year loans rose sharply from deeply negative levels to around 0% by 1985 but credit at these still-favorable rates was no longer rationed, so the increase in rates did not actually cause lending to shrink.

            On the contrary, still-low interest rates and the removal of controls on lending caused the availability of credit to grow. Lending increased 136% in nominal terms, or 73% in real terms, between 1986 and 1990. Bank loans as a percentage of GDP rose from 40% in 1985 to 60% in 1990. This ratio had been oscillating between 40% and 45% for almost all of the prior two decades. Some of this incremental lending was done with capital sourced from abroad since the growth in loans exceeded the increase in local deposits at Swedish banks. Real interest rates were also falling once again in the mid-1980s so that real after-tax interest rates stood between negative 1% and negative 4% for the second half of the decade.

            The nature of bank lending activity also changed. In the days of strictly rationed credit, banks could pick only the best loans. Now, to keep market share, a bank needed to make riskier loans since lending was increasing so much. However, many banks lacked good capabilities in analyzing and pricing credit. Also, non-bank finance companies that filled a void left by the regulations in an earlier era had to migrate to making still riskier loans. The Riksbank, Sweden’s central bank, did increase banks’ non-interest-bearing cash reserve requirements from 1% to 3%, perhaps reacting to this dilemma. However, this was the extent of the new restrictions; overall, the changes seen in the 1980s were largely liberating for banks.

Property

            The new lending financed corporate operations and households alike. The looser credit may have helped drive the principal stock market index in Sweden, the affärsvärldens generalindex, 118% higher between 1985 and 1988 alone. The peak wouldn’t even come until 1989 after many more strong months. Further, a lot of the new credit found its way into investments in real estate.

            Real estate, and especially prized commercial properties, were at the epicenter of the boom. In real terms, residential real estate prices in Sweden rose about 30-40% between 1986 and 1990. Also in real terms, commercial real estate in Stockholm rose over 70% in the same period. In nominal terms over the slightly longer period of 1985 to 1991, housing prices had doubled. Showing that looser bank credit could at least have been a plausible factor in driving this, loan-to-value ratios on new mortgages on owner-occupied properties rose from 75% during the early stages of the boom to 90% in 1988. More risk appetite by banks and lower down-payments on new homes could have caused prices to rise.

            Commercial real estate saw even more appreciation. Between 1980 and 1990, non-residential real estate in prime locations of Stockholm increased 900%. True, some of this happened just before financial deregulation got underway and so this may have reflected, at least partially, a lagged effect of an earlier 1972 deregulation of commercial rents. Still, prices continued to rise sharply during the mid-to-late 1980s. Rents did not rise nearly so much so yields on real estate investments fell from 10% in 1980 to 7% in 1985 and 4% in 1990.

           Nonetheless, investors were not deterred. The rate of investment in real estate stood 88% higher in the three years 1988-90 as compared to 1983-85. The economy was booming as the decade came to a close. Swedish unemployment hit a record low of just 1.4% in 1989. The stock market was up 42% between January and August 1989 alone.

‘The Mushroom’ (or Svampen) in Stureplan, a square in central Stockholm, 1989 (Source: Wikimedia)

Interest Rates

            The summer of 1989 was in many respects the peak of the boom. The real estate market began to cool later that year. The stock market turned and the share index was down 37% by the end of 1990 as compared to its August 1989 peak. The sectors of the economy just discussed fared even a bit worse than this already dismal average. Bank shares were down 41% and the share prices of real estate companies had fallen 52% by the end of 1990. In a deeper sign of trouble, at least one non-bank finance company was having trouble rolling over its debts before the end of 1990. This one, Nyckeln, had heavy exposure to real estate.

            Volatility in foreign exchange and interest rates would bring about the next stage of the saga. During the early 1990s, European countries generally linked their currencies to the deutschemark. This had been desirable in these years of progressing European integration and a continued focus on vanquishing inflation, something the Germans did particularly well.

           However, Germany was not a great model for other European countries to follow. Germany was in peculiar economic circumstances because of German reunification. Its central bank, the Bundesbank, was raising interest rates as part of the integration of East Germany into the country, a critical move after the government there decided to convert East German marks at a 1:1 rate into deutschemarks. The Bundesbank’s move caused other European countries to raise interest rates since European currencies were linked to the German mark by means of the European Exchange Rate Mechanism.

‘500% Interest Panic and Speculation in Swedish Devaluation’, Source: Sveriges Riksbank

           At this point, Swedish interest rates had already been rising in 1991. In 1992, the Riksbank still had to raise interest rates aggressively, taking the overnight rate from 12% in July to 16% in August. During the Exchange Rate Mechanism crisis of September 1992, though Britain and Italy were the more notable victims, Sweden’s Riksbank was also forced to raise interest rates. The overnight rate in Sweden rose to 500% (not a typo) for a few days in order to defend the currency’s value as the crisis peaked. As elsewhere, the government was desperate. Perhaps even more so than others because if Sweden was forced to leave the Exchange Rate Mechanism, as Britain and Italy were, it could have been catastrophic for those Swedish banks with foreign currency debts.

           While interest rates fell from this temporary yet extraordinary level, inflation was also falling. The tax deductibility of interest costs was also reduced with a tax reform measure. The effect of all this was to increase real after-tax interest rates from negative 2% to positive 4%. This discouraged new borrowing, sending the credit expansion firmly into reverse. Prices for stocks and real estate fell; house prices began to fall in 1992 and were down 25% by the end of 1993.

Banking Crisis

            This story would not end without a banking crisis. Amidst falling real estate prices, and a generally worsening economy, the ex-post credit quality of bank loans, especially those in speculative areas like construction, was deteriorating rapidly. Loan losses increased from 0.3% of loans to 7.0% between 1989 and 1992. Lending conditions, once loose, tightened. The average loan-to-value ratio on residential mortgages fell from a peak of 90% back to 75% in 1991.

           The economy more generally was being buffeted by job losses, especially in the construction and property sectors. Unemployment rose to 10% from its earlier record low of under 2%. Consumer credit, which had been based on the equity value of borrowers’ homes, was being withdrawn and businesses sold off inventories. Bank lending decreased 21% between 1990 and 1993.

           Bad loans caused banks to run losses overall and bank capital was thus being depleted by these losses. Swedish banks were required to maintain an 8% capital ratio, essentially a cushion that protects a banks’ creditors, like depositors, from losses sustained by a bank. However, cumulatively between 1990 and 1993, losses amounted to 17% of lending. This threatened virtually all banks and this was just an average. The cumulative losses were higher for some banks, specifically 21% for Nordbanken and 37% for Gota.

Response

            The Swedish government played a large role in resolving the problems at the banks. Government assistance was given on a bank-by-bank basis early on; this essentially meant a focus on two problematic banks, Nordbanken and Första Sparbanken, as it was at these banks where problems became serious first. Nordbanken issued 5.1 billion kronor in new shares in December 1991, 4.1 billion being taken by the government, in order to recapitalize it. This institution was already majority-owned by the government going into the crisis years. Meanwhile, Första Sparbanken was a savings bank owned by a foundation. The government guaranteed a 3.8 billion kronor loan to the foundation for the latter to inject more equity capital into the bank.

            These two banks required continued assistance as time went on. Nordbanken would be totally nationalized in 1992 and a further 10 billion kronor invested. Första Sparbanken later received a fresh 3.5 billion kronor in capital beyond the 3.8 billion kronor already provided.

            This was not the extent of the trouble though. A third bank, Gota, failed on September 9, 1992. The government intervened to guarantee all of its liabilities, not just some or all of its local deposits but all debts, whether local or foreign. In exchange, the government received full equity ownership of the company after its existing owners were unwilling or unable to provide more capital.

            This guarantee of bank liabilities was extended to all banks two weeks later and was to remain in place until stability was restored to the financial system. This marks the moment in the banking crisis when the government had decided that it needed to act on the financial sector as a whole, one whose assets were worth 100% of Sweden’s GDP at the time. The most immediate goals included preventing a situation where foreign creditors of Swedish banks cut off their access to the short-term capital that funded their asset portfolios. If this were to happen, it would be a quick run on the bank and may have led to large fire sales of bank assets at depressed prices, only making matters worse.

            The Swedish government established a new authority to resolve the banking issues, the Bankstödsnämnd. The Bankstödsnämnd was given unlimited resources by the parliament. Losses at the banks were estimated based on current depressed prices to arrive at a conservative read of the situation. From here, two ‘bad banks’ were formed to acquire the riskier assets of troubled banks. Securum was set up for Nordbanken late in 1992. It took over 20% of Nordbanken’s portfolio for 50 billion kronor of which 24 billion kronor was funded by an investment made by the Swedish government and the rest through a loan provided by Nordbanken itself. Retriva, established for Gota in 1994, paid 16 billion kronor for Gota’s bad assets, comprising an extraordinary 45% of that bank’s loans.

            These ‘bad banks’ separated risky assets from bank liabilities. Securum and Retriva weren’t even banks at all but essentially asset management companies that could afford to hold these impaired assets for longer, preventing fire sales that could further depress asset prices. Their distressed asset holdings were gradually liquidated, often by listing real estate companies on the Stockholm Stock Exchange. Firms controlled by Securum and Retriva were also listed or sold to new owners.

           Overall, the nationalization of Nordbanken and Gota was the most expensive part of the government’s endeavor to save the banking system. Ultimately, after the formation of Securum and Retriva, the remaining balance sheets of these two banks were merged into a new ‘good’ bank, Nordea. Meanwhile, Första Sparbanken was merged with ten regional banks to form Sparbanken Sverige, later Swedbank.

Legacy

            Deleveraging was a characteristic of the recession and gradual recovery. In the aftermath of the Swedish banking crisis, household debt and corporate debt fell. However, government debt rose as deficits reached 11% of GDP in 1993. The banking interventions had cost the taxpayers 66.4 billion kronor, or just over 4.0% of GDP. However, this amount was gross of subsequent recoveries. The liquidation of assets reduced the net cost to 1.5% by 1997 and more-or-less zero by 2012.

            The crisis did not reverse, or even stall for any meaningful period of time, the liberal reforms undertaken in this era. During the crisis, the krona was allowed to float freely against other currencies, preventing a repeat of the fiasco with the Exchange Rate Mechanism. Sweden liberalized its economy as additional industries were opened up to more competition. The sustainability of the public finances was maintained by pension and welfare reforms. Sweden’s economy began to improve again in the spring of 1993.

            As for the banks, starting from mid-1994, loan losses, on an industry-wide basis, could once more be absorbed by bank profitability (before accounting for losses), rather than by capital depletion. Put simply, banks were getting healthier again and they returned firmly to profitability by 1995. The next year, after a review of 114 banks, the government ended its blanket guarantee of bank liabilities.

Lesson

            The liberalization of Sweden’s financial system may have been needed and desirable. After all, the movement in this direction did not reverse course even with the banking crisis of the early 1990s. However, the pace of change was more abrupt in the Nordic countries than elsewhere. Indeed, the crisis in Sweden was not totally unique but was mirrored by near-simultaneous panics in Norway and Finland. Still, the Nordic countries were the only developed nations to face major financial crises in that period generally known for its emerging market crises. The reforms were crucial to the story. Financial systems are by nature more fragile than most industries. Thus, rapid reforms, however justified, had negative consequences as markets organized around a past regime had to migrate to a new environment.

More from the Tontine Coffee-House

           Read about the Sveriges Riksbank, the central bank of Sweden and Dag Hammarskjöld, its earlier Chairman and later the the second Secretary-General of the United Nations. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts. 

Further Reading

1.      Englund, Peter. “The Swedish banking crisis: Roots and consequences.” Oxford Review of Economic Policy, vol. 15, no. 3, 1999, pp. 80–97.

2.      McNamara, Christian, et al. “Restructuring and forgiveness in financial crises C: The Swedish Banking Crisis of 1990-1994.” Yale Program on Financial Stability Case Study, July 2015.

3.      Tresor-Economics: Lessons for Today from Sweden’s Crisis in the 1990s, 105th ed., September 2012.

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