In my post about the Japanese bank collapse I showed how insolvent banks could remain liquid and hence operating for decades provided that they had (a) sufficient deposit funding and (b) low enough interest rates. [Please read the Japan post before you read this one.]
Given that the Japan situation required sufficient deposit funding I argued the Japanese deflation model was not a good model for how the
As I wrote this post I realised that I did not know enough about the Scandinavian collapse generally to write a useful post. But I know plenty about the Norwegian collapse.
This is helped by the Norwegian Central Bank (Norges Bank) who have published a long English language description of the Norwegian banking debacle and its aftermath. You will find it online here – and it is free. This is the single most useful document I have ever read on decoding that sort of banking disaster – and anyone that claims to speak knowledgeably about this sort of banking collapse who has not read it should probably be ignored for spouting theory rather than data. (Ideology abounds amongst the pundits – ignore it.)
The Norwegian case is held up by many pundits (including Krugman and myself) as the best model for how government and central banks should behave in a financial debacle. For reasons that will become clear in this post I am not sure that is always the case.
- It had a recently deregulated financial system where new forms of lending and new processes of credit approval were rapidly introduced
- It had a current account deficit
- It had a fixed exchange rate and
- It had a fairly recent adverse terms-of-trade change (namely a big fall in the oil price).
Of these – in my view – and probably in Norges Bank’s view – the most important factors were the fixed exchange rate and current account deficit.
Financial institutions and current account deficits
Financial institutions intermediate current account deficits. Joe Sixpack is hardly borrowed a couple of hundred thousand for his mortgage by going to the global financial market. Instead he goes to a local bank and the local bank raises the money in global markets either by issuing debt in its own name or by securitisation, covered bonds or some other route. This is true everywhere that there are current account deficits. When there are sustained current account deficits banks on average lend more than they take in deposits.
If there is a run on a fixed currency – meaning people want to take money out of that currency – that in effect becomes a run on the wholesale funded banks.
Further, in the early 1990s there were several countries that had fixed exchange rates in anticipation of European monetary union. In some of those countries (especially the current account deficit countries) the exchange rates were too high – and were vulnerable to speculative attack. By far the most famous speculative attack was against the
The Scandinavian countries were likewise subject to speculative attack. The Norwegian attack was the most severe because the current account was getting massively worse. [
It is worth making an aside here. When the banks actually run out of money they can’t lend. Asset prices depend critically on the ability to borrow against them (and that includes the price of current mortgages in the secondary market). When the banks can’t lend asset prices can fall to very low – indeed insanely low levels. At the height of the crisis some 2 bedroom apartments walking distance from the centre of
Now at this point it is worth noting that the banks are illiquid and point-in-time insolvent. When property prices had fallen to such (absurdly) low levels the entire market was upside-down and if you were to liquidate the banks they would be grotesquely insolvent.
All this ended very rapidly. The government guaranteed bank liquidity – and wound up with ownership. The mechanism by which they nationalised the banks is beyond the scope of this post. Most importantly they floated the Kroner – and the currency driven run on the banks ended almost overnight. Certainly the crisis had seriously abated within three months.
When the run ended the banks were again liquid – so they could again lend. Property prices rapidly rose returning to something that looked more normal (if not expensive by global standards) and the banks were solvent. This was a strange crisis because if the underlying assets were priced rationally the banks were solvent always – they were just illiquid.
There is a proof of this assertion. Paul Krugman suggests in the NYT that the Scandinavian bank bail-out cost a lot of money. But the Norwegian government actually made a profit on the bank bail out. The loans wound up not-very bad and the Norwegian government wound up owning most of the banking sector which they again privatised.
What does this mean in the
It is regularly asserted that the Norwegian model is the superior model for dealing with banking crises. The economy bounced back very fast (and isn’t that the goal?). The government didn’t wind up insolvent. Indeed all was indeed well.
But this misses the point.
What does this mean generally?
For investors there is a simple lesson: be careful of fixed exchange rates and current account deficits. I have already pointed to
But dear readers, you will have to wait for that one…