Julius Probst

julius.probst@ekh.lu.se
Phd student, Lund University

Banking and
financial history

Mats Larsson
Gabriel Sderberg
Mikael Wendschlag
Tom Petersson
sa Malmstrm-Rognes

An account of the Swedish twin crisis of the early 1990s:

1. Introduction

Financial crises have been as old as the modern payment system. Neal (2015) has a detailed
account on how deposit banking was invented in Italy during the Renaissance. Bond markets
and stock markets came into existence in the pre-industrial period, first in the Netherlands and
then in Great Britain. With the evolution of modern financial markets speculative finance was
born as well. Kindleberger (2001) has a detailed account of the history of financial panics.
The South Sea Bubble is an example of a stock market bubble that developed in Great Britain
as early as 1720. Reinhart and Rogoff (2008) have assembled a dataset of all financial crises
that occurred around the world in between 1800 and 2010. While emerging markets seem to
be more prone to such events, maybe because institutional failures are more common, their
impressive dataset shows that developed economies are by no extent invulnerable. The global
financial crisis of 2008 is obviously the latest reminder of this truism. While one can
distinguish between banking crises, stock market crashes, currency crises, and sovereign debt
crises, for example, Reinhart and Rogoff (2008) show that financial crises commonly entail
more than one factor. As such, Kaminsky and Reinhart (1999) have coined the term twin
crisis to refer to a simultaneous crisis in banking and currency. The Swedish experience of the
early 1990s fits very well into this classification. Financial deregulation in the early 1980s led
to a domestic credit boom and substantial appreciation in the price of real estate. The
subsequent economic slowdown of the economy combined with a substantial decline in
housing prices put pressure on the banking system. Private investors were also holding a non-
trivial amount of debt in foreign currency. The crisis was resolved with a public bailout of the
financial system. Furthermore, the Riksbank had to abandon the currency peg since it was
unable to defend the value of the Swedish krona against speculators who were betting against
it in the foreign exchange market (Englund, 2015). In what follows, I will discuss the
involvement of the banking sector in the Swedish financial crisis. While the financial sector
was extremely involved in the buildup and the acute phase of the crisis, it is possible that the
economic downturn could have been avoided with better macroeconomic policy.

2. Financial deregulation and asset price inflation

An underappreciated fact of modern macroeconomic theory is that many financial crises are
very often preceded by domestic credit booms and substantial runups in the price of one or
several asset classes (Turner, 2015). Swedens financial system was swiftly deregulated in the
mid-1980s. Interest rate ceilings were lifted and liquidity ratios for banks were abolished. The
deregulations led to an increase in lending from financial institutions to the private non-
financial sector (Englund, 2015). Total bank lending increased by a factor of 2.5 in between
1985 and 1990. In retrospect it is clear that the private sector took on substantial foreign
currency risk as by 1990 about 40% of the bank loans outstanding were denominated in
foreign currency, up from less than 20% in 1986. Swedish household debt was already at an
extremely high level in the mid-1980s in an international comparison, but increased even
further by the end of the decade. The debt to disposable income ratio increased from 99% in
1985 to 131% in 1988. It seems that most of the debt increase supported higher valuations of
a slowly growing stock of real estate as well as higher stock prices (Englund, 2015).
House prices in real terms increased by about 30% in Sweden as a whole in between 1980
and 1990. The increase was obviously not uniformly distributed across the country. The large
agglomerations of Stockholm, Gothenburg and Malm saw the largest rise in prices.
Apartments in Stockholm and Gothenburg almost doubled in prices in real terms during that
time period. Interestingly, by 1991 house prices in Stockholm and Gothenburg were almost
twice as high as in 1957, but were not out of the ordinary compared to 1991. Very high
inflation rates in the early 1980s eroded house prices in real terms for a few years while the
subsequent lending boom led to a much faster appreciation of real estate than increases in the
CPI in the end of the 1980s. The high valuations achieved in 1991 came to an abrupt end with
the financial crisis and the economic downturn. Moreover, these high real estate prices were
not reached again in real terms until about 2000. However, it is also very apparent that the
real estate boom of the late 1980s is totally dwarfed by the appreciations Sweden has
experienced over the last two decades, especially in the large agglomerations. Turner (2015)
explains how modern macroeconomics does not appreciate the fact that banks can create
purchasing power out of thin air by creating credit. Real estate and land has become
increasingly more desirable in large metropolitan areas over the last decades because
agglomeration effects have become stronger. The interaction between elastically supplied
credit and inelastically supplied housing can create dangerous credit booms and asset price
bubbles. That is because credit growth can support higher valuations of asset prices, which in
turn can serve as collateral for further credit expansion, thus creating a financial cycle until
the inevitable downturn when asset prices collapse and the private sector has to deleverage
(Turner, 2015).

3. The macroeconomic background

Sweden experienced more than a decade of higher inflation than many other advanced
economies in the 1970s with an average inflation rate of about 9% in between 1970 and 1980.
Consequently, the Swedish krona continuously appreciated in real terms, interrupted only by
occasional devaluations of which there were six in between 1973 and 1982. The exchange
rate peg aginst a basket of currencies was supposed to discipline domestic macroeconomic
policy (Englund, 2015). The sixth devaluation in 1982 was by as much as 16%. However, the
Swedish krona continued to appreciate in real terms in the three years thereafter by about 8%
because of higher domestic inflation rates than abroad. In line with the Fisher equation,
Swedish interest rates were also consistently higher than the international average by as much
as 1% to 2.5%. The real after-tax ex post interest rate was negative throughout the 1970s and
even for most of the 1980s. Negative borrowing costs thus lasted for more than a decade and
contributed to the runup in asset prices, particularly real estate (Englund, 2015).
The economy performed well until the fall of 1989 and there were very little indicators of a
coming financial crisis, rising leverage and booming asset prices being the exception. The
stock market reached a peak in August 1989 at a level that was 42% higher than just at the
beginning of the year. The unemployment rate reached an all-time-low of 1.4% and consumer
prices cointinued to rise more rapidly than in other countries, thus leading to a higher real
exchange rate. There were thus signs that the economy was overheating in 1989. The interest
rate gap to Germany remained around 5% and the fixed exchange rate increasingly lacked
credibility (Englund, 2015).
In 1990, the economy was hit by a number of international shocks. German unification and
the downfall of the Soviet Union led to a rise in international interest rates and triggered
unrest in currency markets. German short-term interest rates rose from 3.7% in December
1987 to 8.5% in December 1989. Furthermore, Swedish fiscal policy started to change
towards combatting inflation by increasing the VAT and by pursuing a more contractionary
policy stance. The Riksbank decided to peg the Swedish krona in May 1991 to the European
Currency Unit (ECU) in an attempt to maintain credibility (Englund, 2015). Milton Friedman
(1953) already pointed out that flexible exchange rates are more likely to lead to a better
macroeconomic outcome because of downward wage rigidities and price stickiness in general
in the economy. In response to an external shock, changes in the exchange rate can quickly
bring the necessary adjustment in order to bring back the economy to equilibrium whereas
with a fixed exchange rate it is often output and employment than prices that tend to decline.
A fixed exchange rate combined with capital mobility also implies that monetary policy is
imported from abroad, the so-called trilemma (Obstfeld et al., 2005).
The Swedish financial crisis coincided with the with the European ERM-crisis (exchange rate
mechanism). During the 1980s, a number of European countries started to enter a system of
pegged exchange rates in preparation for the euro as a common currency. However, the
system was extremely vulnerable to attacks. Several countries like Sweden had to devalue
their currency multiple times vis--vis the Deutsche Mark because of differentials in domestic
economic conditions, such as higher inflation rates. Speculators like George Soros, the man
who is known for breaking the Bank of England, could put downward pressure on
individual currencies within the system by betting agianst the currency in foreign exchange
markets. Countries would then have the choice to deplete their international reserves and hike
interest rates in order to defend the peg, which would come at the expanse of tighter domestic
financial conditions, or abandoning the fixed exchange rate and leaving the ERM-system
altogether. In November 1991, the Finish markka was devalued, which also led to increasing
pressure on the Swedish krona. The Swedish Riksbank was forced to temporarily increase its
interest rate to 17.5% to defend the currency peg. After a period of stability there was again
increasing turmoil in the currency markers in the summer of 1992. In September, coinciding
with the day of the Gota default, one of Swedens main commercial banks, the Riksbank was
forced to hike interest rates 75%. A week later, both Italy and the UK left the ERM-system
whereas the Riksbank hiked the overnight rate to 500% in a desperate attempt to defend the
krona. However, the relief only proved to be temporary amidst renewed speculation in
November. On November 19th, the krona was left to float and depreciated immediately by
close to 9% the following day and by 20% by the turn of the year (Englund, 2015).
There is no doubt that the macroeconomic regime must share a big part of the blame for the
Swedish financial crisis of the early 1990s. Defending the fixed exchange rate at all cost for
more than a year with various interest rate hikes came at the cost of extremely tight domestic
financial conditions by increasing debt burdens and causing credit losses and it surely
contributed to the decline in asset prices. The economic slowdown actually preceded the
banking crisis. There is thus a case to be made that tight monetary conditions caused or at
least exacerbated the financial crisis.
The counterargument that defending the fixed exchange rate was necessary because of large
private sector liabilities in foreign currency does not hold up to much scrutiny. While it is true
that the liberalization of capital markets led to a drastic increase in foreign denominated loans
in the runup to the crisis, one should note that foreign denominated liabilities and assets rose
roughly in tandem, meaning that the consolidated private sector balance sheet was not too
heavily exposed. Obviously, the distribution of assets and liabilities between different private
actors matters a great deal. However, the devaluation of the Swedish krona in November 1992
shows that concerns about foreign denominated debt were overblown. The devaluation
provided the necessary monetary accomodation and easing of financial conditions that would
pull the country out of recession within a few months after the abandoning of the currency
peg.

4. The banking crisis

The real estate and stock market bubble of the late 1980s combined with the swift
liberalization of capital markets also led to an erosion of lending standards. Research has
found a significant positive correlation between the rate of credit expansion after 1985 and
credit losses during the same time period for individual banks. This indicates that some banks
were increasingly willing to take on additional credit risk during the boom years, a common
feature that is widely shared during boom periods both across time and space (Englund,
2015). The economy started to deteriorate at the same time as housing prices and stock prices
started to fall in the beginning of the 1990s with causality surely being bidirectional. The
Swedish economy was hit by a series of international shocks during the ERM crisis, which
led to poorer economic conditions at home. At the same time, asset valuations increasingly
looked out of synchronization with economic fundamentals and were only supported by high
levels of private debt. The economic downturn and the decline in asset prices thus went hand
in hand, which led to increasing losses in the loan market as economic conditions
deteriorated. In the fall of 1991, several Swedish banks started to face solvency problems as a
result of credit losses. As Frsta Sparbanken and Nordbanken needed new capital to fulfill
their capital requirements, the government started to issue emeregency loans to the former
and increased its share in the latter since Nordbanken was a state-owned bank (Englund,
2015). In September of the following year, Gota Bank faced a minor bank run as more than
5% of its deposits were withdrawn within a week. As a result, the bank was acquired by the
state-owned Nordbanken. The unrest in international currency markets started to spillover
into the Swedish banking system in 1992 as many banks were heavily reliant on international
capital markets with more than 40% of their lending in foreign currency. As the banking crisis
became more acute and more and more banks were facing funding problems, the government
announced a blanket guarantee for all obligations of the entire banking system (Englund,
2015).
It is quite clear that the Swedish banking crisis was partly the result of poor macroeconomic
management. The lending boom and the deterioration of lending standards could have been
detected by regulatory authorities. But even with the bursting of the bubble, the more serious
damage could have been prevented if it was not for a rapid tightening of financial conditions
as the Riksbank desperately tried to defend the currency peg. It is thus the associated
economic slowdown that ultimately led to the failing of more loans and brought the
commercial banking system to the brink of collapse.

5. The creation of a bad bank

In the spring of 1992, the state-owned Nordbanken decided to create an entity called
Securum, which would be its own bad bank. Securum was a separate institution handling all
distressed loans and assets. Later on during the crisis, Securum became directly owned by the
state and completely independent of Nordbanken. It was well capitalized from the start with
an equity value of 24 billion SEK, which was supposed to give the institution the financial
strength for a long life if deemed necessary. The goal of Securum was to take over assets
from distressed financial institutions in order to strengthen their balance sheets. Furthermore,
this operation was also supposed to prevent fire sales, which would only exacerbate financial
distress in times of crisis (Englund, 2015). The liquidation of assets under management took
several years. Most of the sales were done in 1995 and 1996 when the economy and the real
estate market had already begun to recover. By 1997, Securum was already resolved. The
entire liquidation process thus only took a few years. In retrospect, more money could have
been made if the liquidation process had been spread out over a longer time period, thus
profiting from higher prices later on. Nevertheless, the operation was quite successful because
it allowed the financial sector to gain strength and recapitalize during the financial crisis since
banks in distress were able to unload their assets of poor quality onto the bad bank.
Furthermore, the tax payers bill was limited due to the fact that sales were somewhat spread
out over time when prices already started to recover (Englund, 2015).

6. The resolution of the crisis

Government debt as a percentage of GDP almost doubled in between 1990 and 1995,
increasing from 40% to 75%. However, only a fraction of the increase can be attributed to the
bailout of the financial sector, a little more than 2% by some estimates (Englund, 2015).
Instead, the biggest harm came from the macroeconomic damage of the economic slowdown.
The recession led to a significant increase in the unemployment rate from about 2% in the late
1980s to almost 10% in the middle of the 1990s. Elevated unemployment levels persisted for
many years as a result of so-called hysteresis effects (Blanchard and Summers, 1986). This
led in combination with large shortfalls in GDP to severe increases in the government budget
deficit, which can explain the main part of the increase in public debt.
The economic recovery started once the Riksbank finally decided to abandon the peg of
Swedish krona. The rapid devaluation of the currency and lower domestic interest rates led to
an easing of monetary and financial conditions in the economy. The currency peg effectively
acted as a straightjacket since it did not allow the Riksbank to pursue policy goals that were in
accordance with domestic macroeconomic stability. A free floating currency regime, on the
other hand, gave the Central Bank full autonomy to pursue domestic nominal stability.
Consequently, the Riksbank decided to adopt a 2% inflation target in the middle of the 1990s
after quitting the ERM.

7. Lessons to learn and conclusion

The Swedish financial crisis was in a way very stereotypical. Kindlebergers (2001) detailed
account of financial panics during history shows that there is very often a common thread that
runs through many financial crises across time and space. Reinhart and Rogoffs (2008)
analysis as well as the data by Schularick and Taylor (2012) show that periods of extreme
financial instability are often preceded by prolonged periods of rapid credit boom as well as a
built-up in leverage ratios by the private sector. There are, in my opinion, several key lessons
to be learnt from the Swedish financial crises:

Rapid deregulation of the financial sector can lead to imprudent behavior by key
market participants. In the Swedish case, the deregulation of financial markets led to
a credit boom as well as a large increase in private sector borrowing, thus increasing
leverage ratios throughout the economy. The interaction of credit, which can be
supplied elastically by financial firms, and location-specific real estate that is
supplied inelastically, at least in the short to medium run, can lead to large increases
in housing prices, thus creating cyclical behavior. Other asset classes, such as stocks
and bonds, can be experience similar patterns. Policy makers should be aware of
these fianancial cycles and monitor credit booms and asset price inflation. Stricter
lending conditions in boom periods and better housing policies could go a long way
in mitigating some of the aforementioned problems.
Macroeconomic stabilization policies have a very important role to play. In Sweden,
the currency peg of the Swedish krona was the key mechanism that led to an
economic downturn, thus exacerbating the fall in asset prices during the bust and
creating a vicious cycle between falling asset prices and poor macroeconomic
performance. Conversely, the abandonment of the currency peg and the
implementation of a more stimulative monetary policy created much easier financial
conditions and led to a quick economic recovery. Comparing the experience of the
Swedish twin crisis in the 1990s with the performance of the Swedish economy after
the global financial crisis of 2008, for example, shows how monetary autonomy and
the stance of monetary policy matters a great deal for macroeconomic outcomes.
Large falls in asset prices might only have a marginal impact on the real economy if
monetary and fiscal policy makers react quickly enough, the Black Monday in the
U.S. being a good example. The poor macroeconomic performance in the early 1990s
can thus mainly be attributed to contractionary monetary and fiscal policy. In that
sense, the collapse of asset prices and distress in the financial sector were not so
much a cause rather than a symptom even though there is no doubt that they
exacerbated the recession.
The big macroeconomic cost does not stem from the bailout of the financial sector,
which in the case of the Swedish experience in the 1990s only accounted for a small
fraction of the increase in the public debt to GDP ratio in the years after the crisis.
Most of the cost was a result of large and persistent increases in the unemployment
rate as well as with the substantial shortfall in GDP growth and the associated
increases in government deficits.
The creation of a bad bank in times of severe financial distress can be helpful for the
repairment of the financial system. Financial firms can repair their balance sheets by
 unloading distressed assets onto the bad bank, which might make the banks in
question less willing to engage in behavior like credit rationing that could prevent a
successful economic recovery. Furthermore, bailing out the financial system in times
of crises, if executed poorly, often comes at a huge cost for the taxpayer. Taking
equity stakes in failing financial instituions, spreading out the sale of distressed
financial assets by the bad bank over a long time period, are two policies that can
save tax payers money.

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