Monday, 17 January 2011

Banking crises morphing into sovereign debt crises...

What we younger ones have come to realize during this episode of financial turmoil and what seasoned market observers have realized long ago is that banking crises tend to morph into sovereign crises. The cases of Ireland and Iceland serve as good examples of that. 

What I find of particular interest is the mechanism through which one crisis morphs into another. Over-simplistically it works a bit like this; in order to prevent banks from going bankrupt and risking a serious destabilization not only of the financial but of the whole social edifice, governments run deficits and in order to finance them they take on more debt. The magnitude of the increase in sovereign debt that this process will bring depends on how big and how troubled is the said country’s financial sector.

source: OECD

source: OECD

In the graph above we can see that all countries whose banking sector got some form of bailout or support package (along with other programs to get the economy back on its feet), had their government debt increase substantially. I cannot recall a large bailout package for Spain (just a small amount of funds injected into the cajas) but I very well be wrong, so I am glad to accept any corrections.

Everybody knows what happened in Ireland where the banking crisis evolved into a full-blown sovereign crisis. For USA and the UK the jitters at the beginning of the crisis have dissipated (I will not get into whether problems there have been resolved or not) and local banking sector are experiencing a relative calmness. But what is the reason for this? Is it the fact that the UK and the USA are larger countries and still enjoy the relative trust of investors? The fact that if needed they can print money? The fact that their government took extraordinary steps to prevent the crisis from escalating, showing willingness to take all actions necessary? Is it that markets focus on the weaker links of the chain first? Or is it something entirely different…?
In the early 90s there was a banking crisis in Sweden that did not result in a sovereign crisis, with the crisis in the banking sector being resolved in a pretty satisfactory way.  

The crisis in Sweden set off among important geopolitical and economic developments and a global downturn. After deregulation in the banking sector took place in the mid 80s, there was a credit boom that helped fuel a housing bubble. House prices took off at an increased rate, proving once more that a credit boom is essential for a housing bubble to form.

source: Statistiska Centralbyran  

Efforts to tidy up the state budget brought on the removal of interest payments from tax-exempt status something that raised interest rate cost for households. Other external sector developments caused a significant rise in interest rates and along with the aforementioned change in interest payments tax treatment were the triggers that set off the crisis. To prevent a few large banks to go under the Swedish government took over some of them (nationalized them) and provided loan guarantees to others. Two bad banks were formed and all the” bad assets” were moved there. As a result of the bailouts the Swedish government became the owner of 22% of total assets of the sector. Most info about the crisis timeline and going-ons is taken from the paper in the parenthesis (On the Resolution of Financial Crises: The Swedish Experience, Emre Ergungor, Federal Reserve Bank of Cleveland, Policy Discussion Paper, number 21, June 2007)

What the Swedish government did to fight the crisis was not that different from what the Irish government did. Total Government debt more than doubled after the measures for bailing out the banking sector. Nonetheless, the banking crisis did not escalate into a sovereign debt crisis. What was the differentiating factor in the Swedish case?

The way the Swedish government tackled the banking crisis was methodical and effective, since it attacked the problem head on. But we have to add that certain factors back then were far more favorable for the problem to be solved than they currently are for Ireland.

The size of the banking sector back then was much smaller, thus easier to rescue. This played a crucial role to the success of the bailout. In 1996 total assets of the banking sector accounted for 100% of GDP when the ratio for Ireland dwarfs this number (probably around 600%). Even for Sweden today this particular ratio stands at 220%. 

source: Statistiska Centralbyran
The global economic environment at the time was not that strained as it is today and the global negative effect of the downturn was minimal compared to the present one.

There wasn’t a global financial crisis going on that had shaken the foundations of the global financial system and undermined mass psychology hence affecting trust in the financial sector and virtually every aspect of the economic life. There is one now though. The problem was confined in Sweden and neighboring Norway (at least this is what I think) putting contagion (essentially) out of the picture. Moreover, the global financial system was not as interconnected. This assisted in keeping risk aversion relatively at check. Maybe at the time a sovereign default of a “developed” economy must have seemed pretty distant as a possibility.  

source: Statistiska Centralbyran

All these factors helped the Swedish government in solving the problem during the peak of the crisis as well as in the coming years. The easiest way to control unfavorable government debt dynamics and banking sector problems is to grow out of your problem. The milder recession in Sweden back then helped in that respect and the country did just that.  Austerity in Ireland is bound to make matters worse, because of the recession it will probably bring along and the high unemployment rate that is already there(I certainly hope that this won’t be the case and that Ireland will register strong growth these next years).

source: OECD, Statistiska Centralbyran

As we can read at the FED paper cited above (On the Resolution of Financial Crises: The Swedish Experience, Emre Ergungor, Federal Reserve Bank of Cleveland, Policy Discussion Paper, number 21, June 2007) the bad banks set up by the Swedish authorities recovered SEK14 billions out of the SEK24 billions that they were initially capitalized with. We still have to wait and see what the recovery ratio will be for the Irish bad bank. I somehow have some reservations whether the recovery ratio will be that high, but I could and really hope to be proved awfully wrong. 

I think that it is now obvious that the crisis that Sweden faced in the 90s was very different not in the nature of the crisis itself (it certainly was a banking crisis) but in the economic background prevailing at the time of the crisis, something that is already proving to be an important factor. Not all crises are the same, actually not two crises are the same, each and every one is different, hence sweeping comparisons are not correct in my view…


  1. Great post! Undoubtedly the economic environment was very different back then but policy independence is a key factor. Do you think the whole euro scheme is viable? Large imbalances between countries, different "diseases" that require different measures.

  2. thank you, I'm glad you liked it...well, they surely won't let it go without putting up a fight...but, I think that imbalances will always exist in federal states, there are imbalances between the US states, but there labour mobility is greater and people think of themselves as a nation...this is not the case in the EU....if the Europeans want to become a single state they all have to make sacrifices and I don't think that they seem willing to do so...but before great changes there is always friction, so maybe this is just part of the process...