A Lesson From Stockholm.(Global Investor)

Byline: Holger Schmieding; Schmieding is chief European economist at Bank of America.

All hurricanes are different, but each shares common traits. The same holds for financial storms. Few advanced economies had been battered as badly, and then dealt with the gusts as successfully, as Sweden during its own banking crisis 16 years ago. Sweden's trouble sounds eerily familiar to even the most casual observer of the current turbulence. Throughout the second half of the 1980s, Sweden enjoyed a credit-fueled economic boom. As house

prices and equity markets soared, Swedes saw more reason to borrow than to save. Financial institutions were eager to lend, and focused more on the seemingly ever-rising value of the collateral pledged to back the loans than on the merits of the projects they were actually financing.

Shortly after the domestic credit and real-estate bubble burst in 1990, a global economic downturn pushed this small, open economy further into a deep recession. Swedish banks, which had been highly profitable and had looked well capitalized in the boom years, suddenly hit the rocks. The stock of troubled bank assets surged to the equivalent of 15 percent of Sweden's annual economic output. If that were to happen today in the United States or the euro zone, nonperforming and impaired loans would have to equal $2.2 trillion or [euro]1.4 trillion, respectively. Fortunately, today's problems still seem to be of a much smaller scale.

To find its way out, the Swedish government initially tried to tackle the problems case by case. When two of the country's seven big banks no longer had the capital required, the government took the first over and guaranteed the second. But when a third major bank ran aground in late 1992, Sweden acted swiftly, decisively and with bipartisan consensus to save the system as a whole. The government guaranteed all liabilities of Swedish banks, cementing the safety of all deposits. If need be, the Swedish taxpayer would honor the claim on the bank. Everybody doing business with a Swedish bank knew that he could not lose out--with one important exception: the government would not guarantee the value of equity stakes in the banks. To sort out the problems of bad debt and depleted bank capital reserves, Sweden established a new and independent Bank Support Authority. The authority offered banks support to shore up their capital base, but with strings attached. The more and the longer any bank needed such support, the greater the equity stake it had to grant to the state. All banks had to write down troubled assets to realistic (that is, low) levels immediately, with a valuation board of experts within the authority ...