The Swedish Banking Crisis

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The Swedish Banking Crisis
1. Background
The Swedish financial institutions remained highly regulated since the Second World War. Two restrictions that the government imposed on commercial banks are a. A lending ceiling used to limit the lending activity of commercial banks so that the credit scale is restricted. High lending interest rate intrigues banks to pursue huge profit by extending credit to an unreasonable scale and lead to adverse selection that push the borrowers to seek for risky high profit activities. b. liquidity ratio requirement. Commercial banks are required to hold more than 50% of their assets in government and mortgage institution bonds to help financing on large government deficits, another policy used to control credit flows and credit scale as part of macro stabilization policy. The banks, however, think of ways to circumvent the regulation. Instead of being a direct lender or borrower, banks open up services in which they act as broker between lender and borrower and cash-flow can go directly from seller to buyer in the housing market. Such an off balance-sheet activity is hard to inspect and control by the central government and it does add to the bank’s potential risk exposure. Rapid development of financial markets: the growth of an active money market in CD and T-bill was stimulated by mounting budget deficits that was financed in the domestic market. In the early 1980s, The development in money market made the old regulations increasingly inefficient and was thought to be destructive on the structure of credit markets. So the stage was set for deregulation. 2. Deregulation

Deregulation is implemented step by step with a series of abolition announcements: a. Liquidity ratio was abolished in 1983.
b. interest ceiling is lifted in spring 1985
c. lending ceiling and lending ceilings for banks and placement requirements for insurance companies went away in November 1985. d. In 1989, abolition of currency regulations opened the door for international transactions

3. Deregulation effect on banks’ lending and risk exposure Deregulation brings a rapid increase of new lending. The rate of increase of new lending from financial institutions, which varied between 11 and 17 percent per year during the first half of the 1980s, jumped to 20 percent in 1986, and increased by 136 percent during 1986-1990. Deregulation also opened up new opportunities for market share competition, with banks and mortgage institutions expanded most rapidly. Finance and insurance companies, on the other hand, which had largely thrived from regulatory arbitrage lost market shares at a rapid pace. These companies, without the ability to receive deposits and issue bonds, had to finance by direct borrowing in banks and further increased banks risk exposure. Meanwhile, Swedish households and businesses, which were suffering from a high domestic lending interest rate, had to borrow in foreign currency at a lower interest rate. Such international transaction are mostly done within banking system and added to a substantial amount of exchange rate risk in a bank’s balance sheet. Deregulation also had an impact on private lending: corporate lending increased considerably fast by 129 percent, while family lending increased by 86 percent. Compared to a rapid jump in family borrowing, corporate borrowing responded with a 2-3 year time lag and exploded in 1988-90. Despite the fact that private lending increased rapidly, deregulation did not have much impact on consumption and investment according to a series of empirical research. However, deregulation has affected financial flows in the way that credits were increasingly channelled via financial institutions rather than directly between firms and households. Moreover, loans were also increasingly used for high-leverage financial investments, which add to a potential banking crisis.

4. Deregulation effect on real estate price:
The Swedish real...
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