Tue, Feb 24, 2009 page9

• What defines a good ‘bad bank’?

  With proper management and an eye to pragmatism, ‘bad banks’ can recover losses and turn a distressed industry around

  • By Leif Pagrotsky
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  The idea of a “bad bank” appears to be growing more popular by the day in countries where toxic assets have paralyzed lending. The Swedish bank cleanup in the early 1990s is often cited as an example of how successful this idea can be. But the lessons that are sometimes derived from Sweden’s experience are based on misunderstandings of what we actually did, and of how our system worked.

  The initiative to set up a “bad bank” in Sweden was taken not by politicians but by the management of Nordbanken. Following years of mismanagement and reckless lending, the bank was the first big victim of the commercial property market’s decline in 1990.

  Nordbanken had become fully state-owned and new management was put in place to restore the bank to viability. But it soon turned out that the managers had little time to spend on Nordbanken’s core banking business because they had to focus disproportionately on handling an enormous variety of assets. Every quarter brought new write-offs that ruined efforts to rebuild the bank’s reputation and its employees’ morale.

  The radical solution was to separate all the assets that were alien to the bank’s core business, mainly real estate companies, but also firms in the manufacturing, construction and service industries.

  The “bad bank” that was established for this purpose, Securum, needed an enormous injection of capital from the owner, the Swedish government. But Securum was then able to recruit skilled staff members who could maximize the assets’ value when markets recovered — and to be in a financial position to await that recovery. The rest of Nordbanken, now known as Nordea, proceeded to become the largest bank in Scandinavia.

  In contrast to today’s situation, the bad assets were usually entire companies, not complex securities. But, as with today’s toxic assets, there was no market, and rapid disinvestment would have triggered fire-sale prices, depressing all asset values in the economy and resulting in more bank failures.

  Furthermore, the point was not to help private banks get rid of their troubled assets. When most other Swedish banks followed Nordbanken’s example and established their own bad banks, they did so without state participation. But this was possible only because the Swedish government already owned all the assets, thereby circumventing the hopelessly difficult issue of pricing them.

  With a private owner, huge public subsidies would have been politically unacceptable. The assets would have to be priced at far above their market value, with taxpayers subsidizing the previous, failed owners, or the private bank would not have been helped at all. A government-sponsored bad bank for private assets is thus a very bad idea.

  In 1994, when I became state secretary for financial affairs in Sweden’s Ministry of Finance, recovery appeared to be on the horizon following the abolition of the fixed exchange rate, the ensuing sharp depreciation of the Krona and lower interest rates. The new government implemented an effective and very big program to close a budget deficit of roughly 12 percent of GDP.

  Gradually, confidence grew and financial markets began to function again. As opportunities appeared, we began to re-privatize assets, and within a few years Securum was closed. With hindsight, I believe we sold its assets too quickly. Taxpayers could have recovered more of their losses if we had been more patient because prices continued to rise for a long time. But the stigma of socialism was stronger than the instinct to make a profit.

  The following lessons of Sweden’s experience seem relevant today: A bad bank can be an effective instrument in the recovery of losses and the revival of banks.

  Although Sweden’s experience concerned shares in companies used as collateral for credit rather than bonds or similar financial instruments, this situation will likely arise in many countries today as the crisis continues, more companies go bankrupt and banks recall their collateral and take possession of shares in indebted companies.

  Government subsidies for private bad banks, or public bad banks to clean up private banks’ toxic assets, are a bad way for taxpayers to transfer money to troubled banks compared with normal capital injections. All subsidies should be transparent; public/private bad banks are not.

  It is vital to staff bad banks with professional and experienced managers who are untainted by previous scandals. Here, Sweden’s experience is encouraging. It was easier than we expected to recruit good people for Securum because working in the public interest for this pioneering state-owned bad bank was perceived as a unique challenge.

  Maximizing taxpayers’ economic interests, not ideology or political considerations, must be the guiding principle. The public should be in no doubt about this, for their trust is essential.

  Leif Pagrotsky, a Social Democratic member of the Swedish parliament, was minister for industry and trade and minister for education under former prime minister Goran Persson. In 1994, he was state secretary for financial affairs.COPYRIGHT: PROJECT SYNDICATE
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