Finnish banking crisis of 1990s

Following a large credit expansion in the late 1980s, a housing and stock market bubble developed in Finland. Their collapse was accompanied by the significant loss of exports to the former Soviet Union (from 20 % of total exports to virtually zero ). An unprecedented recession followed and a banking crisis in autumn, 1991. The government intervened with takeovers, financial assistance and blanket guarantees to banks.

Crisis
In the second half of the 1980s, securities markets developed rapidly and the abolition of exchange controls allowed the private sector to borrow from and invest abroad freely. This improved the availability of finance from sources other than the banks.

Because equity capital remained heavily taxed relative to debt, the latter continued to be the cheapest form of external finance to companies. Furthermore, households' interest expenses could be deducted from taxable income at a high marginal tax rate, making borrowing very attractive to households. Finally, tax exemption of interest earnings on low-yielding bank deposits constituted a subsidy to banks, boosting their capacity to lend.

Previously, credit rationing had prevented the attainment at the preferred portfolio compositions implied by these borrowing incentives. With the lifting of the regulations such hindrances suddenly no longer existed. Understandably, a large-scale stock adjustment followed. Households as well as businesses started to borrow as never before. In the peak year of 1988, for instance, bank lending grew by no less than 30 per cent.

The Bank of Finland, for its part, did not take timely action to restrain credit expansion through monetary means, apart from some rather strong statements.

Simultaneously with the new freedoms in the credit market, national income was boosted by a significant improvement in the terms of trade between 1986 and 1989; oil prices declined in 1986 while export prices kept on rising. 1n Finland, confidence was further boosted by the relative ease with which the oil shocks in the early 1980s had been overcome with the help of bilateral trade with the Soviet Union.

Demand not only for consumer goods but also for all real and financial assets increased substantially. Stock prices and real estate values soared. In part, new investments expanded the productive capacity of export industries. However, far more money was spent on investment in the closed sectors of the economy: retail trade, recreation and housing.

The record-high rates of credit expansion and other relevant data led the authorities to tighten monetary policy in early 1989. The markka was permitted to appreciate by adjusting the fluctuation range for the currency index. At the same time, expansion of bank lending was penalized by a special reserve requirement imposed on the banks by the Bank of Finland. Short-term market rates increased substantially towards the end of the year.

The markka lending of most banks started to decelerate rapidly. However, some banks in the savings bank sector chose to pay the new penal rates rather than curtail their rapid credit expansion. Furthermore, as markets were free, borrowing in foreign currencies continued to increase at a high rate (partly through bank intermediation). Changes in taxes did not help either. In 1989 housing production alone rose by 20 per cent.

With an unemployment rate of below 4 per cent, the economy was in a state of overheating. This showed up in an acceleration of labour costs, further eroding external competitiveness, which had already been weakening for some time.

Towards the end of 1989, the tighter monetary conditions and high debt levels started to undermine domestic demand. Servicing the newly-raised debts took an increasing share of the cash flow of many enterprises and households. Particularly demand for real estate was quickly affected. Asset values and profits started to decline sharply. Unemployment bottomed out and income prospects weakened. At the same time, export performance deteriorated as market growth decelerated and market shares were lost in response to weakened price competitiveness. 1n 1990, the growth af the economy slowed to zero, reflecting both capacity constraints and weakening demand.

Following a gradual decline over several years, exports to the Soviet Union finally collapsed in 1991. Given the different commodity composition of exports to eastern and western markets and the weak price competitiveness of Finnish manufactures, only a very small proportion of the lost exports could be directly replaced by sales to other markets. The increasingly severe payments problem of that country also implied that at least part of Finnish credits to Russian importers could not be recovered on time.

The resulting decline in incomes further increased the problems of those with relatively high debt-service obligations. As the adjustment of domestic demand to increased indebtedness continued with full force, total demand declined by 6.5 per cent in 1991. The unemployment rate reached 11 per cent by the end of the year.

The confidence in the Finnish economy and in the fixed exchange rate was weakened. Expectations of a devaluation of the markka started to gain strength. In an attempt to bolster confidence in the existing exchange rate, the markka was linked to the ecu in June 1991. That allowed nominal money market rates to decline for a short while, but real rates of interest generally moved higher in 1991. Strong expectations of an imminent devaluation pushed nominal short-term rates substantially higher in the autumn, and in November the markka was devalued by 12.3 per cent.

Both the high and continually rising interest rates and the devaluation reduced the public's capacity to service its debt. By mid-1991 the number of bankruptcies had increased to a monthly average of some 600 from around 200 a year before. While the effect of higher rates worked through gradually, the depreciation of the markka abruptly raised the debt-service burden for firms in the domestic sector, with substantial borrowing in foreign currency.

Combined with plummeting profits and declining household incomes these developments transformed a steadily increasing share of banks' loan portfolios into non-performing assets. Some 1.5 per cent of banks outstanding loans (about 1 per cent of the balance sheet total) had to be booked as credit losses in 1991.

The first bank failure was the Skopbank, a commercial bank acting as a central bank for the savings banks. Skopbank had pursued an aggressive lending policy in the boom years. It was supervised by the Bank of Finland since 1989 and taken over in 1991. BoF has used a total of more than FIM 16 billion to finance the operation.

The contraction of the economy continued. Business failures, primarily in the domestic sector, reached a high of 800 failures a month in the autumn. At the same time, nominal interest rates continued to rise.

The stock of banks' non-performing assets grew rapidly during 1992 from FIM 42 billion at the beginning af the year to no less than FIM 77 billion by the end of the year. Reflecting the structure of lending during the boom, some 40 per cent of the non-performing assets were related to construction, real estate and retail trade. Households accounted for 21 per cent of the total and foreign engagements for 14 per cent. Manufacturing accounted for less than 8 per cent of problem assets, reflecting the increased competitiveness and activity of that sector.

In March 1992, the government decided to provide the banks with a capital injection in order to support the supply of bank credit to customers. At the same time, the capital infusion would, of course, help banks avoid emergency support. It was offered to all banks regardless of their solvency and in relation to their risk-weighted assets. By December 1992, virtually all banks had availed themselves of the facility, receiving, in a11, F1M 7.9 billion in fresh capital.