Topic 8: Japan and Scandinavian Financial Crises

Question 1

what happened to credit/gdp in 1980s and 90s

Answer 1

rose sharply in 19802 and shrank during part of 90s

Question 2

what happened to asset prices in japan during 1980s and 90s

Answer 2

Land and stock prices rose sharply during the boom. Returns 1980-1990:
Commercial real estate: 600%.
Residential and industrial real estate: 200%.
Stock market: 400%.

Prices dropped sharply during the 1990s. Returns 1990-2000:
Commercial real estate: -85%.
Residential and industrial real estate: -60%.
Stock market: -50%.

Question 3

what happened to asset prices in sweden during 80s and 90s

Answer 3

Land and stock prices rose sharply during the 1980s.
Office prices in central Stockholm: 250% in real terms during 1981-1990.
Stock market: 200% for broad index (AFGX), 350% for real estate companies,
during 1984-1990.

Dropped sharply during the early 1990s.
Close to pre-boom levels by 1993.

Question 4

what were the two forces driving the boom

Answer 4

financial liberalization
macroeconomic policies

Question 5

what was regulation like in sweden pre boom

Answer 5

Credit provision was regulated tightly by the state.
Prudential regulation of banks (standard):
Banks’ capital ≥ fraction of total risk-weighted assets.
8% for corporate loans, 1-4% for mortgages depending on loan-to-value ratio.

Additional regulations:
Banks’ holdings of government and mortgage-backed bonds ≥ fraction of
assets.
Bank lending could not exceed a ceiling.
Excluding residential construction and some forms of business investment.
Ceilings were bank-specific and depended on last year’s lending.
Bank lending rates and deposit rates were capped.
Firms needed special permits to issue bonds.
Limits on international inflows and outflows.

Question 6

what were the costs of regulation in sweden

Answer 6

Lending ceilings → Some positive NPV investments are not undertaken.
Lending ceilings → Banks have no incentives to raise their market share and
design better products.

New institutional arrangements are created to circumvent the regulations.
Money-market instruments and government bonds offer higher rates than
deposits → Pressure to abolish cap on deposit rates.
Non-regulated lenders have an advantage over regulated ones → Pressure to
abolish lending ceilings.

Question 7

what was the financial liberalization in sweden

Answer 7

Deposit-rate caps were abolished in 1978.
Liquidity ratios were abolished in 1983.
Lending ceilings and lending-rate caps were abolished in 1985.
Limits on international flows were abolished in 1989

Question 8

what was the effect on financial liberalization on bank assets and liabilities (sweden)

Answer 8

Annual credit growth rose from 8-13% in 1980-1985 to 16% in 1985-1990.
Bank employment rose by 20% from 1985 to 1990.

Banks became more reliant on wholesale funding.
Deposits (retail funding) decreased from 67% of assets in 1980 to 58% in
1985 and 40% in 1990.
Interbank loans (wholesale funding) rose from 23% of assets in 1980 to 28% in
1985 and 43% in 1990.
An increasing fraction of wholesale funding came from abroad: 44% in 1990

Question 9

what is wholesale funding

Answer 9

funding by other banks

Question 10

what were the incentives to lend post liberalization and implications (sweden)

Answer 10

Banks expanded lending rapidly without sufficient regard for borrower quality.
Employment in banks’ marketing departments rose by 25% from 1985 to 1990.
Employment in internal auditing departments dropped by 22%.

Short-termism: Loans yield interest income in the short term, but default
risk appears in the longer term.
Strong incentives to raise market share.

Over-optimism: Lenders assume that the economy and asset values will
keep growing, and are confident that borrowers will repay.

Question 11

what were the macroeconomic policies in sweden in 1980s

Answer 11

Pegged but adjustable exchange rate.
Inflation (9% between 1970-1980) and occasional devaluations.
Central bank defended the peg by keeping the interest rate high.
One-year rate was 1-2.5% higher than international average.
Spread rose when market expected a devaluation.
Fiscal deficits until 1986.

Question 12

what were the macroeconomic dynamics port-liberalization (sweden)

Answer 12

Increase in credit → Increase in asset prices and other financial accelerator
mechanisms.

Increase in credit → Increase in aggregate demand → Increase in inflation →
Decrease in real rates → Increase in credit.

Increase in inflation → Loss of international competitiveness → Trade deficit.

A flexible exchange rate could cushion some of these effects.
Smaller inflows of foreign capital → Smaller credit expansion

Question 13

regulation in japan pre boom

Answer 13

Credit provision was regulated tightly by the state.
Prudential regulation of banks.
Bank lending rates and deposit rates were capped.
Firms needed special permits to issue bonds.
Limits on international inflows and outflows

Question 14

financial liberalization in japan

Answer 14

Deposit-rate caps were gradually abolished, from 1985 to 1993.
Caps for large deposits were abolished first.
Restrictions on bond issuance were gradually abolished, from 1975 to 1996.
Liberalization for borrowers (bond issuers) was faster than for savers
(depositors).
Limits on international flows were gradually abolished during that period

Question 15

effect of liberalization on bank assets and liabilities in japan

Answer 15

Slow liberalization for savers → Deposits remained a significant source of
banks’ funding.
Faster liberalization for borrowers → Large firms left the banks for the bond
market, and banks had to find other borrowers.
Rise in real estate loans.

Question 16

what happened to real estate loans in japan

Answer 16

increased sharply late 80s

Question 17

macro policies and dynamics in japan

Answer 17

Flexible exchange rate.
High US interest rates in early 1980s → Appreciation of USD relative to JPY.
Plaza Accord, Sep 1985 → Agreement between G5 countries (France,
Germany, Japan, UK, US) to let USD depreciate.
Central banks intervened in currency markets.
JPY appreciated relative to USD by 46% between Sep 1985 and Dec 1986.
Japan’s exports and GDP stopped growing in the first half of 1986.
Japanese authorities undertook policies to stimulate the economy.
Bank of Japan lowered interest rate by 3%.
Government provided large fiscal stimulus.
GDP started growing again in 1987.
Increase in credit → Increase in asset prices and other financial accelerator
mechanisms.

Question 18

similarities in boom between japan and sweden

Answer 18

Financial liberalization generated additional lending.
Japan: Large firms migrated to the bond market. Depositors remained with
banks.
Scandinavia: Pent-up demand by borrowers. Banks met that demand by
borrowing from abroad.

Macroeconomic policies facilitated the credit boom.
Fiscal expansion.
Monetary policies:
Japan: Low interest rate limited the JPY’s appreciation.
Scandinavia: Pegged exchange rate.

Question 19

crisis triggers and macro dynamics in sweden

Answer 19

Crisis triggers:
Increase in European interest rates because of German unification.
German 3-month rate rose from 3.7% in Dec 1987 to 5.6% in Dec 1988 and to
8.5% in Dec 1989.
Fiscal tightening in response to high inflation.
Decrease in tax benefit of deducting interest payments from 50% to 30%.
Real after-tax interest rate rose from -1% in 1989 to 5% in 1991.

Macroeconomic dynamics:
GDP grew by 0.9% in 1990 and -1.1% in 1991.
Investment grew by 0.8% in 1990 and -9.8% in 1991.
Bank lending grew by 15.3% in 1990 and -6.3% in 1991.
Real crisis started before financial crisis.
Stock market fell by 37% from its peak in Aug 1989 to Dec 1990.
Commercial real estate prices fell by 6% in 1990 and 40% in 1991.
Financial accelerator started running in reverse.

Question 20

what happened to finance companies (unregulated lenders) in sweden during crisis

Answer 20

Finance companies were the first to face problems.
They relied on wholesale funding.
Bank loans.
Tradeable investment certificates, typically guaranteed by the banks.

As their credit losses increased, investors did not roll-over the investment
certificates.
Half (three) of the finance companies defaulted in late 1990.
The remaining half had to be supported by the banks.

Question 21

banking crisis in sweden

Answer 21

Two banks needed new capital to meet regulatory requirements in late 1991.
Nordbanken: State owned majority stake pre-crisis. It acquired the bank by
paying 2bn SEK to minority shareholders, and injected 14.2bn of additional
capital (equity) in 1991-1992.
Forsta Sparbanken: Private owners injected new capital and gave an
interest-free loan. State subsidized the loan at a cost of 1bn.

An additional bank needed new capital in early 1992.
Gota: Private owners injected limited new capital, but the bank was insolvent.
State acquired the bank and injected 25.1bn of capital.

State intervention was relatively uncontroversial.
No deposit insurance existed in Sweden.
Emphasis on saving the banks and not their owners

Question 22

swedish currency crisis

Answer 22

Sep 1992:
Uncertainty about semi-pegged exchange rates in European Exchange Rate
Mechanism (ERM).
UK and Italy exited ERM in 16 and 17 Sep, respectively, devaluing their
currencies.
Speculative attacks on SEK → Swedish central bank raised interest rates.
Overnight rate rose to up to 500%.
Fears that banks may not be able to continue borrowing internationally →
State provided debt guarantee for all banks on 24 Sep.

Nov 1992:
Further speculative attacks on SEK → Central bank did not raise interest rate
→ SEK devalued by 9% immediately and by 20% by year-end.

Links from currency crisis to banking crisis:
High interest rates made banking crisis worse.
Devaluation hurt Swedish firms borrowing in foreign currency. Yet, Sweden’s
net international investment position was ≈ 0.

Question 23

swedish debt guarantee

Answer 23

Debt guarantee in Sep 1992 was systemic (concerned all banks).

Goal: Ensure that banks could continue borrowing and avoid runs.

Conditions:
Guarantee available only to solvent banks.
State had to inspect banks.
Banks had to ultimately pay for the costs of the guarantee.

Limited use for the guarantee.
No solvency problems.
Economy started recovering in 1993.

Question 24

what is a bad bank

Answer 24

Nordbanken set up in 1992 a “bad bank”, Securum.
Securum acquired Nordbanken’s bad loans.
One-third of Nordbanken’s assets.
Paid 50bn to acquire loans with face value 67bn.
Capital of 24bn provided by the state.

Question 25

what did securum do

Answer 25

Securum started with 3000 loans to 700 firms.
Liquidation (bankruptcy) was chosen for 70% of the firms.
Securum firms were more likely to be liquidated than other comparable firms.
Most liquidations were completed by 1994.
As a result of the liquidations, Securum owned 1-2% of all commercial real
estate in Sweden.

Remaining firms were reorganized.
Change CEO and board composition.
Swap debt into equity.
Reorganized Securum firms outperformed other comparable firms.
Securum sold its assets (real estate and reorganized firms) gradually.
Most sales took place in 1995-1996, when market had started to recover.
Securum was wound up in 1997.
1997 prices were still 40% below 2000 prices

Question 26

what are the benefits of setting up a bad bank

Answer 26

1 Avoid extend-and-pretend.
Force banks to acknowledge losses on their bad loans.
Banks can otherwise roll-over bad loans to zombie firms.

2 Avoid fire-sales.
Assets are not sold at depressed prices.
Assets can be sold slowly, as economy begins to recover.

3 Exploit economies of scale.
Manage many similar loans.
Coordination between lenders is easier when there is only one lender.

4 Better incentives.
Employees at the bad bank: Acknowledge that loans are bad, and maximize
revenue from managing them.
Employees at the originating banks: Show that they made good loans.

5 Free up bank capital for loans to new firms

Question 27

what is extend and pretend / why would banks want this

Answer 27

Extend-and-pretend allows banks to avoid issuing new equity due to regulation (capital as % of ass goes down so rights issue to keep capital req)
Equity issuance makes old shareholders worse off.
Depositors benefit because deposits become less risky.
New shareholders must break even.
Debt overhang

Question 28

what are the options for dealing with problematic banks

Answer 28

Recapitalization.
By private funds (e.g., Forsta Sparbanken).
By state funds (e.g., Nordbanken and Gota) or a mixture.
Bad loans may be transferred to a bad bank (e.g., Securum and Rectiva).

Resolution.
Bank is typically split into good bank and bad bank.
Good bank:
Assets are good loans and state funds used to acquire the bad loans.
Liabilities are most deposits.
Sold off to another bank.
Bad bank:
Assets are bad loans.
Liabilities are remaining deposits and funding used to acquire the bad loans.
Assets are gradually sold off.

Liquidation.
Bank is shut down and assets are gradually sold of

Question 29

what triggered japan crisis (one small thing)

Answer 29

increase in interest rates in 1989

Question 30

comparison of japan crisis vs sweden (in nature)

Answer 30

took longer for bank crises to appear after asset prices dropped
crisis lasted longer

Question 31

how were banks is 1994-95 resolved in japan

Answer 31

by funds from private banks, BoJ and deposit insurance corp
Solvent banks were increasingly concerned that their contributions in covering
losses of insolvent banks could endanger their solvency.

Question 32

what was jusen crisis

Answer 32

Non-bank financial institutions making housing loans.
Similarities to finance companies in Sweden.
These institutions were resolved.
Funds came from:
Related private banks and other financial institutions.
State: 680bn JPY.
Using taxpayer money generated public resentment.

Question 33

1997 bank failures

Answer 33

Three large banks.
Nippon Credit Bank and Hokkaido Takushoku Bank in Apr 1997.
Tokuyo City Bank in Nov 1997.
NCR was recapitalized using 290bn of private and BoJ funds. HTB and TCB
were resolved.

Two security companies.
Sanyo Securities and Yamaichi Securities in Nov 1997.
Security companies were borrowers in the interbank market.
Their failure caused the interbank market to freeze.

Question 34

japan stabilization measures

Answer 34

Debt guarantee for all banks announced on 26 Nov 1997.
Financial assistance package of 30tn JPY legislated in Feb 1998.
17tn for resolution and 13tn for recapitalization.
Government bonds and government-guaranteed credit lines.
Banks were reluctant to apply for financial assistance to not be singled out.
Applied collectively for total of 1.8tn, paid out on 30 Mar 1998

Question 35

extend and pretend in the japan crises

Answer 35

Prudential regulation of banks’ capital was not enforced vigorously (banks could avoid issuing new equity by overstating capital)

reasons for this -> lack of political will to commit taxpayer to save banks, limited funds meant acknowledging losses could lead to bank failure

Question 36

why is extend and pretend costly for real economy (japan)

Answer 36

zombie firms less productive than healthy firms -> no incentive to issue new equity and invest

zombie firms crowd out healthy firms -> receive subsidized bank loans, can’t loan to other banks, lower profitability of good banks by competing with them in goods and labour markets

Question 37

similarities between japan and scandinavia crisis and clean up

Answer 37

one off measures at early stages of the crisis
more systematic and drastic measures at later stages (debt guarantee, sharp increase in funds made available by state)

Question 38

differences between japan and scandinavian crisis and clean up

Answer 38

japanese crisis took longer to manifest and lasted longer (drastic measures were taken later, extend and pretend was more prevalent)

cost of crisis was 4% of GDP in sweden and 17% in japan