Risky strategy to rescue banks is sure to disappoint

[EireWarrior]

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Risky strategy to rescue banks is sure to disappoint
Friday, May 1, 2009
SERIOUS MONEY: The Irish plan to assist troubled banks differs in many key respects to the Swedish model, writes CHARLIE FELL .

SWEDEN RARELY attracts attention from economists in the rest of the world, yet history shows that it produced the first European paper banknotes in 1661 and established the world's oldest central bank in 1668.

More than three centuries later and it is this Nordic country to which the world has turned for inspiration amidst the ongoing battle to stabilise the global financial system.

Indeed, our own Government in the face of a severe crisis that has pushed our major banks to the brink has looked to Sweden and the measures it took to resolve its banking crisis of the early 1990s. The Swedes adopted a good-bank/bad-bank strategy that is heralded as a model for success, given that the eventual net fiscal costs were close to zero.

Our own version of the Swedish model, however, has already erupted into considerable controversy. Taxpayers deserve to be made aware of the differences between the respective solutions.

Indeed, the socialisation of losses gives taxpayers the right to know whether the Irish model will return the banking system to health or will it be seen in hindsight as the action of cowardly lions.

The facts reveal that similarities between the two approaches are few. Sweden's financial crisis, just as here, was centred on impaired property-related loans. A speculative bubble in commercial property was fuelled by rapid deregulation in the financial sector during the 1980s that sparked rapid credit growth.

The party came to an end in 1990 due to a sharp and unexpected increase in real interest rates. The Swedish krona was linked to the Ecu (European currency unit, precursor of the euro) and tighter monetary policy in Germany following reunification forced Sweden to raise its already-high domestic interest rates in order to maintain the peg.

Tight monetary policy pushed the Swedish economy into recession. Property prices began to drop while the banking system's level of non-performing loans increased markedly. Commercial and residential property prices dropped 42 and 25 per cent respectively in real terms from 1990 to 1995. Meanwhile, the banks' non-performing loans jumped from just half a per cent of total loans in the late-1980s to 5 per cent in 1992.

The crisis however, took a dramatic turn for the worse following the attack on the exchange-rate mechanism (ERM) in November 1992. Non-performing loans rose to 11 per cent of GDP one year after the krona was floated.

The Swedish government acted forcefully to restore international confidence and established the Bank Support Authority, a politically and financially independent agency that forced the troubled banks to take appropriate write-downs on impaired loans. The write-downs wiped out shareholders at Nordbanken and Gota Bank, precipitating the state to take full ownership of both. That gave it ownership of 22 per cent of all Swedish banking system assets.

The state then elected to divide the banks into two good and bad banks. Senior management was replaced and those who had originated the impaired loans were excluded from their eventual work-out. All told, roughly 70 per cent of the troubled borrowers were liquidated. The plan was completely transparent with the expected losses made available, which ensured public support and political unity from the start.

The Irish plan differs in many important respects to the Swedish model. The taxpayer is being asked to accept all of the downside but little potential upside because it has been maintained that a stock market quotation is somehow necessary to maintain international confidence. Yet the proposed plan appears to have a complete disregard for moral hazard and, thus, hardly inspires confidence.

It would appear that there are no plans in Ireland to replace senior management who get not only to keep their jobs but also the potential upside on their current shareholdings. Furthermore, professional investors who failed to provide effective monitoring and thus capitalised bad lending decisions also get to share in the upside.

The current plan clearly violates a basic capitalist maxim – the idea that risk and reward should be positively related.

It could also be argued that the strategy is simply wishful thinking. Should the write-down of impaired loans come to 25 per cent as was the case in Sweden, current shareholders will be eliminated. Even if the discount is more generous, the major banks will still not be well-capitalised and it is therefore unlikely that the lending channel will be returned to normal functioning.

The economic background today is also vastly different to the Swedish experience. The banking crisis was isolated to the Nordic countries, unlike the global nature of the current situation. Sweden let the krona float following the attack on the ERM and, within 12 months, the currency had devalued by some 30 per cent. The increased competitiveness allowed for an export-led recovery that resulted from buoyant demand in the rest of the world. Neither increased international competitiveness nor strong external demand is applicable to Ireland today.

Comparisons between the Swedish experience and the Ireland of today are simply unrealistic. The cumulative drop in Irish GDP is likely to be at least twice the 6 per cent drop experienced by Sweden and the peak unemployment rate is likely to be several percentage points higher while the global picture unlike the early 1990s offers little relief. The Irish strategy is sure to disappoint.

[Ognir]

Time will tell but the people are goingto suffer one way or another