Market Update: 10 16 08 _The Fed, the Financial Crisis and what you need to know about Norway

What you need to know about the Nordic Banking Crisis

Earlier this week St. Louis Federal Reserve President James Bullard went to great lengths to point out that in the Feds view the best comparison for our financial systems current plight, and the government’s plan to respond to this plight, is the Nordic Banking Crisis of the late 80’s and early 90’s.  This statement was clearly a sign for anyone listening or reporting on the speech that the Feds actions going forward will be modeled on the actions that the Nordic countries used to tackle their problems.  As you see the Treasury and the Fed apply fixes to this problem and you wonder what on earth they are thinking, you should break out this guide to the Nordic Banking Crisis and use it as a beginning point of reference.

Before we look at the solutions I’ll summarize as best I can (and this will be a very brief synopsis) the conditions that set the stage for the Nordic crisis as it unfolded in Norway.  Sweden and Finland faced the same problems and dealt with them in similar but not identical fashion.

What caused it?

The Norwegian banking system was deregulated between 1984 and 1985.  Upon this newly deregulated landscape, banks competed for market share, free from their old restraints.   In many cases bank management teams were not sophisticated enough to even grasp the risks posed by the new environment, much less able to manage those risks.

A low interest rate environment combined with a newly deregulated banking system and a general sense of optimism fueled a huge boom in loans.  Lack of expertise in competitive credit markets on the part of bank management and regulators along with poor loan valuation techniques and a lack of internal controls ultimately would prove fatal in a down economy.

Recession hit the Nordic countries in the late 80’s and at that point the fundamental shortcomings mentioned above were brought into stark focus as the bad loans began piling up.  Bank losses ballooned to roughly 2.8% of Norway’s GDP at the height of the crisis.  US GDP for 2007 in current dollars is roughly $13.8 Trillion.  By comparison 2.80% of our 2007 GDP would equate to losses of $386 Billion.  Earlier this year we passed the $500 Billion mark in worldwide bank losses associated with problem loans and investments.  Many estimates put the final tally between $1 Trillion to $2 Trillion before the bleeding stops.  A $1 Trillion figure would equate to 7.24% of total US GDP…a shocking figure.   Not all losses will be absorbed by US firms but framing the losses in percentage of US GDP I think helps gain perspective.

Small and mid-sized Nordic banks went down first, then the problems began overtaking the big banks.  After the loan problems burned through the industry generated insurance funds the government had to step in to help recapitalize the banks.  Not all banks were deemed salvageable and any banks that sought government help had restrictions attached…here is where things should begin to sound familiar.

A summary of the more important restrictions set forth by Nordic regulators are below:

·         the management and board of directors of the bank were replaced

·         the existing share capital was written down to cover losses to the fullest extent possible

·         the bank's operating costs were reduced and some of its activities downsized

·         measures were taken to restrain growth in the bank's total assets.

(this list provided by Mr. Jarle Bergo’s paper “Crisis Resolution and Financial Stability in Norway”)

At the height of the crisis the Norwegian government owned roughly 60% of the banking sector…a startling figure.  Ultimately the government realized a “reasonable” return on the money lent to those problem banks.   What Norway considers a “reasonable return” in exchange for taking over 60% of the banking industry isn’t mentioned.   

So that is the short story of what caused the crisis.  Next we need to look at how they got out of it since theirs is the model that will guide our efforts.

How did they fix it?

“The most important characteristics of the resolution of the Norwegian crisis can be summarized as follows:

·         The banks' own collective guarantee funds handled the problems in the banking sector before the crisis became systemic.

 

·         No blanket guarantee for the banks' debts was provided by the government.

 

·         No regulatory forbearance.

 

·         No liquidity support to banks whose solvency was in doubt.

 

·         A clear and transparent division of responsibility between the political authorities, the supervisory authority and the central bank was established early on.

 

·         Government support was contingent on strict requirements being met, e.g. existing shareholders accepting a write-down to cover losses to the extent possible.

 

·         No micro-management of the banks.

 

·         Measures taken to prevent supported banks exploiting the situation vis-à-vis non-supported banks.

 

·         No asset management companies or "bad banks". “

 

(The list above was copied in its entirety from “Crisis Resolution and Financial Stability in Norway” by Mr. Jarle Bergo.)

So in summary the government set up a way for banks to draw on taxpayer funds to recapitalize, if it was demonstrated that the bank could remain solvent, and there were significant penalties involved with the government funding in order to provide incentive for the banks to exhaust all other alternatives before approaching the government for a handout.

Finland appears to have had the worst road as they had massive bank failures/mergers as GDP plummeted from positive 5.4% to negative 6.5%.  After Finlands crisis had run its course approximately 60% of their banks were owned by foreigners.  St. Louis Fed President Bullard specifically mentions Seppo Honkapohja’s paper as a reference point for their plan.  I’ve attached Mr. Honkapohja’s paper “The 1990’s Financial Crisis in Nordic Countries” for reference, along with a checklist of causes of the Nordic banking crisis as listed in the attached IMF paper on the subject, and a widely studied paper on the crisis by the Bank of Norway.

I hope you find this roadmap useful as we chart our own course.  Based on St. Louis Fed President Bullard’s comments it appears the Fed is telling us that this is the model they are using for reference.  With this in mind we should all be able to better track the method behind the madness. 

In the near future we’ll take a look at Japans Lost Decade as the Fed is beginning to mention avoiding our own Lost Decade as a primary motivator behind this effort to fix the financial mess.  That will have to wait a bit…right now I need to go sell some bonds.

If you have any questions or if there is anything I can be doing for you please let me know.