The ECB’s Swedish plan

Last week I mentioned that Spanish bank security and debt holders were in for a shock stemming from certain sections of the new Spanish banking MoU:

The restructuring plans of viable banks requiring public support will detail the actions to minimise the cost on taxpayers. Banks receiving State aid will contribute to the cost of restructuring as much as possible with their own resources. Actions include the sale of participations and non-core assets, run off of non-core activities, bans on dividend payments, bans on the discretionary remuneration of hybrid capital instruments and bans on non-organic growth. Banks and their shareholders will take losses before State aid measures are grantedand ensure loss absorption of equity and hybrid capital instruments to the full extent possible.

As I noted, a big political issue for Spain is that under the not-so-watchful eye of the government Spanish banks have been converting deposit holders into equity holders and there is now a good chance that billions of Euros in Spanish citizen’s assets were about to be eaten up as the first stages of a banking bailout.

Overnight we saw more on the same topic, but this time an about face from the ECB:

The European Central Bank, in a sharp turnaround, advocated imposing losses on holders of senior bonds issued by the most severely damaged Spanish savings banks—though finance ministers have for now rejected the approach, according to people familiar with discussions.

The ECB’s new position was made clear by its president, Mario Draghi, at a meeting of euro-zone finance ministers discussing a rescue for Spain’s struggling local lenders in Brussels the evening of July 9.

It marks a contrast from the position the central bank adopted during the 2010 bailout of Irish banks—which, like Spain’s, were victims of a property meltdown—when it prevailed in its insistence that senior bondholders in bailed-out banks shouldn’t suffer losses.

I’m not completely sure why, after years of demanding the opposite , the ECB has suddenly changed its mind. Perhaps this is more screw turning by the central bank or perhaps recognition that the emergency mechanism simply aren’t going to be large enough to do the job. Either way, you’ve got to imagine that the Irish must be scratching their heads after Irish taxpayers were forced to wear the burden of unsecured creditors of Irish banks. I’m sure we’ll hear more on that point in the coming months.

Interestingly, what I also realised while reading the MoU was how it seemed to be taking on many characteristics of the Swedish banking resolution process of the 1990s. For those who may not know about that event here is a short summation.

Back in the late 80s Sweden went through a boom-bust cycle after its recently deregulated banking system went on a lending frenzy. Like all good frenzies it ended horribly with the public holding large debts against assets that were falling in value. At the time the Swedish government was also running a currency peg which made the issue worse because in order to maintain the peg the government had to run very tight monetary policy. This was completely the opposite of what was required and accelerated the deleveraging process to a point of crisis. Swedish industrial production collapsed, employment rose sharply and eventually, under speculative attack, the government gave up the currency peg but not before the country entered a period of debt deflation that caused the banking system to fail.

I’m probably not doing the historic record complete justice in that short paragraph, but the major points were that out of control banks mixed with a poor policy responses led to an economic crisis.  Sounds familiar doesn’t it ?

Eventually, after much fumbling and politicking, the Swedish government was forced into finding a resolution for the banking system and, as I said above, you may well notice some similarities to last week’s document:

Banks that turned to the Bankstödsnämnd were dealt with in a way that minimised the moral hazard problem. In short, the aim was to save the banks – not the owners of the banks. By forcing owners of banks to absorb losses, public acceptance of the bank resolution was fostered. In this way, taxpayers were likely to feel that the policy was fair and just.

The general strategy was to divide the banks into three categories, depending on whether the statutory capital adequacy ratio would be breached and, if so, whether this breach was temporary: The first category included those banks that might deteriorate towards the capital adequacy limit, but would subsequently be able to achieve enhanced solvency on their own; the second category covered those that may fall below the limit for a time, but would eventually recover; and the third category was for those that were beyond hope. Each of these three categories was treated differently by the Bankstödsnämnd.

Category 1. The Bankstödsnämnd encouraged these institutions to find private sector solutions and to avoid public involvement as far as possible.13 Shareholders were requested to inject additional capital where such an option was feasible. To facilitate this process, the Bankstödsnämnd was prepared to grant a temporary “capital adequacy” guarantee. Only one bank, Handelsbanken, turned out not to need an injection of capital. Another bank, Skandinaviska Enskilda Banken, chose to reinforce its capital base through a share issue aimed at its current shareholders, without having to apply for any public guarantees.

Category 2. This category covered a bank with short-term problems, but with a good prospect of future profits that could be expected to restore solvency. In such cases, where private solutions may not be available, the Bankstödsnämnd was prepared to deploy more extensive support, including capital contributions or loans, in addition to the guarantee mentioned in category 1. Föreningsbanken was dealt with under this category, receiving a guarantee that the State would contribute share capital in case the capital adequacy ratio fell below 9 per cent. This guarantee proved not to be needed.

Category 3. This category embraced banks that were not expected to become profitable; their equity would gradually erode and ultimately become negative. This category required active State involvement, ultimately in the form of orderly liquidation of the ailing institution. However, if a more favourable result could be achieved with other methods, the Bankstödsnämnd was entitled to apply those as well, for instance by selling bad assets and consolidating the remainder of the bank, either on its own or through a merger with other banks. Such an approach was adopted in the case of two major insolvent banks, Nordbanken and Gotabanken.

Two bank asset management corporations (AMCs), Securum for Nordbanken and Retriva for Gotabanken, were set up to manage the bad debt (non-performing loans) of these two financial institutions as part of the resolution policy – as had been the case in other countries. A novel approach was adopted which involved splitting the assets of an ailing bank into “good” and “bad” assets, and then transferring the “bad” assets to the asset management corporation, principally to Securum. In addition, when assets were placed under the administration of Securum and Retriva, they were assigned low market values in the due diligence process, effectively setting a floor for asset values. Because market participants did not expect prices to fall below this level, trading was maintained.

That looks quite similar to sections 14 through 21 of last week’s draft MoU.

There are obviously quite a few components missing, most importantly a blanket guarantee of bank deposits and liabilities and an open ended funding commitment, but I think there are enough similarities to pose the question.

Is the Eurozone, and more explicitly the ECB, suddenly running the Swedish playbook ?

Swedish Banking Resolution

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  1. Hmmmm, with the ECB proposal, and this I’m not sure it will go anywhere given where we are in the crisis, and just who will be willing to buy the debt? I don’t know, but since 2008 I think the market as a whole might be looking at this differently. No matter what the EU as a whole does I think with the circular EU funding, Libor, MF Global etc. a lot of trust has been lost. Rather than stabilising I think the crisis is getting worse.

    I like the analysis however.

    Hope I’m wrong, but looking ahead at the EU debt schedule in an environment of no growth I struggle to see a solution.

  2. There does seem rather a lot that is ‘beyond hope’ this time however. Just putting a value on that might put the final nail in.

  3. I believe someone at the ECB has done the maths and realised there isn’t enough money in the EFSF and ESM to cover senior bondholders.