Successfully Resolving Financial Crises: Cleveland Fed Notes Lessons from Sweden

As policymakers worldwide focus on resolving the current financial crisis, they might look to Sweden as a useful model for effective financial crisis resolution, according to a study released today by the Federal Reserve Bank of Cleveland.

Bank researchers O. Emre Ergungor and Kent Cherny identify four practices that are common to successful financial resolutions and note that Sweden's financial crisis in the early 1990s provides good insights into these practices:

  1. Transparency – Full disclosure of losses associated with financial institutions clears the uncertainty surrounding the institutions and makes it possible for the viable institutions to raise new funds.
  2. Political and financial independence – Decisions must be made apart from political pressures. Financial independence gives credibility to political independence: If a government agency holds the purse strings, it can dictate policy and can also impede the process if emergency funding is needed.
  3. Maintenance of market discipline – An incentive framework must remain; in other words, investors must suffer the consequences of having ignored or failed to detect signs of trouble. As past historical examples demonstrate, the stability of financial markets after crises largely depends on the incentive framework that is left in place.
  4. Restoration of credit flows – The credit worthiness of borrowers must be restored – a difficult task, given that the economic fallout from a crisis (such as rising unemployment) actually erodes credit quality further.

In Sweden – considered one of the relatively successful efforts to resolve a financial crisis in the past 30 years – policies were enacted transparently and with political independence, and attempts were made to restore credit flows in the broader economy.

Sweden’s success at maintaining market discipline was perhaps more limited. Policymakers guaranteed bank liabilities before the banks themselves were taken over. Investor disincentives to closely monitor financial institutions in the future may still exist as a result.

In conclusion, Ergungor and Cherny note that the Swedish case illustrates the trade-offs and considerations of market discipline that crisis managers must contend with if they are to minimize taxpayer losses and speed the return to a rebalanced, growing economy.

To read the Commentary,Effective Practices in Crisis Resolution and the Case of Sweden, follow this link: http://www.clevelandfed.org/research/commentary/2009/0209.cfm

For more information on Sweden’s financial crisis resolution, see On the Resolution of Financial Crises: The Swedish Experience.

For further reading on financial crisis management, see Central Banks and Crisis Management and Systemic Banking Crises.

For more information on the Federal Reserve Bank of Cleveland, visit www.clevelandfed.org.