Comparing Swedish And American Governement Policies

Published Date: 02 Nov 2017

1 Introduction

There is hardly any dispute that the current U.S-led financial crisis can be characterised as a â€˜once-in-a-generationâ€™ economic crunch. Although the critical stages of the crisis have passed, the concern among politicians and the general public is that the recession may linger indefinitely. In times like these, politicians and policy makers have all the reason to dust off their history books to study historical and international records of financial crises. Despite there has not been a real change in paradigm of how the financial markets operate there are still many lessons to be learnt from studying how past governments have handled their own crises.

The era that has been quoted most frequently is perhaps the Great Depression of the 1930â€™s, given its reputation of being the most devastating economic crisis in modern history. The banking crisis in the 1990â€™s that plagued the Japanese economy for a whole decade is likewise getting considerable attention among interested observers for its parallels with the current US crisis. And similarly the crisis that occurred in Sweden during the 1990â€™s likewise has many apparent similarities.

This dissertation in European Business Studies takes the character of a study comparing U.S. government policies during the 2007-2009 Subprime Mortgage Crisis with that of the Swedish governmentâ€™s policies in the 1990â€™s banking crisis. Given the recent nature and severity, the Swedish crisis is of considerable relevance to the current state of affairs, as at the time of writing essentially most of the U.S banking system is still insolvent- a recent case in point being the CIT-group.

The Swedish authorities were greatly criticised, much like their American counterparts are today, for their imprudent deregulation efforts before the crisis, resulting in the inflation and bursting of the real estate bubble and the consequent liquidity problems in the banking sector. However, they were equally commended for their swift financial sector reforms that were introduced shortly thereafter which proved highly significant in the context of both instilling confidence and restoring economic stability in the financial sector at the time. These reforms bestowed essentially unlimited legal and economic power to the government to nationalise banks in order to liquidate those banks that were not survivable and to reconstruct others by whatever means that were available. Through these [interventionist] measures the Swedish banking system was kept solvent; it continued to function and emerged from the crisis without taxpayers losing out in the long run.

Tracing through the reactions of the American Government and central bank to its own crisis, it is unclear whether lessons have been learned from the Swedish crisis. So far many of the implemented policies have proven to be politically unpopular. On an ad-hoc basis banks have been pseudo-nationalised, arguing that the Swedish approach is not applicable to the US situation. Clearly, the question of what type of bank rescue plan to adopt is a difficult one and the policies implemented depend on the economic problems faced, the government in power and a number of other factors. The planned dissertation will thoroughly analyse these factors in conjunction with the US and Swedish situations and answer the question: What does the market response to the Swedish policy measures indicate about the effectiveness of such an approach and are there any lessons/conclusions to be drawn in light of the US situation?

Methodology

To analyse all aspects of the American and Swedish banking crisis would be unfeasible given the guidelines and limitations of this study. Moreover, as the full effects of the aftermath to the U.S crisis is still unfolding any study that includes long-term consequences could be prone to error. However, as most economists would agree on, the main concern amidst a critical crisis event is to secure the short-term functioning of the financial sector. Therefore, specific focus of this study is on the short-term effects of decisions by the respective Governments to inject capital into troubled banks by either bailouts or by part or complete nationalisation. The comparative framework for this analysis centres on the situations of the Swedish banks Nordbanken (nowadays Nordea) and Sparbanken. These have been specifically chosen to commensurate the US cases of Lehman Brothers and Fannie Mae.

In other words, the case method provides the methodological basis for this dissertation. However, finding a single means of evaluating the success of the various policy measures in each presented case, with respect to restoring the stability of the financial sector and the real economy, is unfeasible. There is no economic manual that provides a clear-cut method by which the success of the authoritiesâ€™ implemented policies can be measured. Therefore, without a standard measure by which this type of analysis can be made, a multifaceted approach to the problem must be applied.

In the first section focus is on qualitative research. Researched information includes, among others, banks historical and financial records (e.g. cash liquidity, pertinent ratio), information and background regarding policy measures (e.g. ruling political party/coalition, public opinion) and economical background (e.g. employment, inflation, income, tax, GDP). These resources have been found from a variety of academic and sources. Such sources include, among others, the Federal Reserve, Swedish National Bank, Swedish National Audit Office, Quarterly Bulletin from the Bank of England, Harvard International Review and National Bureau of Economic Research. Due to the subjectâ€™s current nature it has been necessary to consult a number of additional news sources such as the Economist, New York Times, the Guardian and even economic conferences (e.g. by the Institute of International and European Affaires) found through websites such as YouTube.com.

Furthermore, to allow for a more quantifiable analysis of each presented case, financial indexes are used to determine the short-term market response to the policy measures put in place by the respective governments. As such, it requires the necessary assumption that the Efficient Market Hypothesis holds true, arguing that financial markets rationally reflect all information in the economic environment at every point in time (Arnold, 2008:563). Information in this respect comprises the governments communicated actions and signals picked up by the market. Thus, the following market indexes are used:

TED-Spread is measured in basis points and calculated as the differential between the three-month U.S Treasury bill rate and the three month London Interbank Offered rate (LIBOR), which represents the rate at which banks typically lend to each other. The spread thus shows the extra return an investor requires in order to lend to another bank rather than buying a government issued T/Bill. The T/Bill can be broken down into two components that both relate to the expected average policy rate during maturity of the loan *OIS(

The first consists of the spread between the LIBOR and OIS. As the Libor is unsecured, investors risk losing their investments. Apart from this there is a risk that investors may need the money they have invested before the loan matures. The spread between the LIBOR and the OIS can therefore be seen as the risk/premium that compensates the investor for these risks.

The Second component is the difference between the Treasury bills and the OIS. Typically both these interest rates are considered risk free which means that investors will buy these securities at a higher price than the LIBOR. At volatile times when the market is characterised by uncertainty investors will want high quality collateral and thus the demand and price for government securities will increase and consequently the spread between the

The first element consists of the spread between the Libor and the OIS . As the

Libor is unsecured, there is a risk that investors will lose their investments. There is also

a risk that investors will need the money they have invested before the loan matures.

The spread between the Libor and the OIS therefore compensates the investors for

these credit and liquidity risks.

The second component in the TE D spread is the spread between the OIS and Treasury

bills. Normally, both of these interest rates are considered to be risk free. The difference

between them is usually primarily due to supply and demand and the flight-toquality.

In periods of uncertainty investors want high-quality collateral which increases

the demand for, and thus the price of, government securities. Consequently, this also

increases the difference between the expected monetary policy interest rate and the

interest rate for Treasury bills. One example of this is that the interest rate for US

Treasury bills was negative during the most acute phase of the financial crisis in 2008.

As both the Libor-OIS and the OIS -T-bill spreads tend to increase during periods of

uncertainty, the TE D spread constitutes an informative measure of the degree of

financial stress.

In other words when there is a confidence crisis in the financial system banks are not willing to risk lending to other banks since they do not trust their counterparts are on sound financial ground to repay the loan, either because their credit rating by institutions such as Standard & Poor (S&P) is low or because there is a high degree of uncertainty as to whether the rating is correct. Thus the banks are more likely to

TED Spread. This statistic, measured in basis points, is calculated as the

difference between 3-month US Treasury bills (T-bills) and the 3-month

Eurodollars contract as represented by the 3-month US dollar London Interbank

Offered Rate (LIBOR). Coxe (2008, p. 26) notes:

" ï‚¼ the TED spread measures risk within the global banking system.

Eurodollars are the primary instrument of inter-bank lending -

unregulated and uninsured dollars. Therefore, the spread over T-bills

reflects bankers' pricing of the risk in short-term loans to each other. It

always spikes in advance of a financial crisis. It always falls when the

crisis is past ï‚¼ [the TED spread] has kept its 100% [forecasting]

accuracy through all financial crises since 1974."

Stated in other words, when there is a crisis of confidence in the financial system,

bankers are less willing to lend to each other since they do not trust that their

counterparties are on sound financial footing. Hence, when they lend to other

banks in the Eurodollar market, they will demand a higher interest rate than

normal. If one considers that lending to the US government through the purchase

of US T-bills is risk-free (that is, the US government would never default), then

the difference in yield demanded by the bank lender of another bank vis-Ã -vis the

US government becomes a telling indicator of financial sector risk in the

economy. Therefore, the TED Spread should decline if the actions of authorities

are successful in re-instilling confidence in the financial sector. In this study, the

TED Spread is used to examine this very sentiment in the money markets, in the

wake of key interventionist decisions made by US authorities.

â€¢ Japanese Yen 3-Month Tokyo Interbank Offered Rate (TIBOR). TIBOR represents

rates at which banks lend one another funds in the short-term, Japanese money

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market (Japan Bankers Association, 2009). Similar to the TED Spread, TIBOR

provides information on the confidence and risk present in the financial system -

the higher the TIBOR, the higher the risk. In this study, the TIBOR is used to

measure sentiment in money markets with respect to key interventionist decisions

made by Japanese authorities.

â€¢ Prices of financial sector stocks. According to an empirical study by Hong et al.

(2002, p. 16), the performance of US financial stocks is highly statistically

significant in its ability to predict the direction of the overall market, "with a two

standard deviation shock in its returns resulting in a movement of [overall] market

returns that is 74% of market volatility." Such market leadership by the financial

sector is apparent by a period of up to two months (Hong et al., 2002, p.16).

Therefore, if one accepts that the actions of the authorities have a significant

impact on the direction of financial sector equities and the stock market as a

whole, then examining price reactions of financial stocks may provide insight on

both the success of the authorities' implemented measures and the well-being of

the entire economy. Financial sector equity price indices used in this study

include the Nikkei Bank Index for Japanese financials and the Keefe, Bruyette, &

Woods (KBW) Bank Index for US financials. In addition, where possible, moves

in the share prices of the individual case financial companies have also been

examined.

â€¢ Prices of the overall stock market. To gauge reaction in the overall stock market

and, by extension, the respective economies as a whole, the Nikkei 225 Index and

the Standard & Poor's 500 Index have been utilized in conjunction with the

Japanese and US stock markets, respectively.

In conjunction with the qualitative analysis that describe in detail the prevailing circumstances in the financial sector and the background to the various policy measures a discussion and conclusion is made in the final part.

Obviously, researching all aspects of the Japanese banking crisis, Big Bang, and the US

financial crisis is infeasible given the guidelines for this study. Therefore, specific focus

on the decisions of Japanese authorities to either inject public capital (via bailout,

nationalization) into troubled banks and financial institutions or let them fail - and then

comparing selected situations to commensurate US cases - will be given priority.

Specifically, the cases of Yamaichi Securities and Long-Term Credit Bank of Japan will

be examined against the US situations of Lehman Brothers and Fannie Mae.

Accordingly, the case method provides the structural foundation for this thesis. Attention

will focus on the background and responses of the respective Japanese and US authorities

in each of the four situations. However, measuring whether the authorities' actions are

succeeding with respect to buttressing the health of the financial sector and the economy

at large presents a significant challenge. With no single parameter able to perfectly

gauge the effectiveness of the policy actions, a multi-pronged approach has been

implemented.

Emphasis will be placed on qualitative observations in this study. Aspects of the

qualitative include, but are not limited to, firms' historical background, the prevailing

political and economic environment, details regarding the authorities' policy responses,

and resultant consequences on the financial sector and economy at large. With respect to

the Japanese cases, a mix of academic and news sources have been utilized. Such

sources include, but are not limited to, literature from the National Bureau of Economic

Research, Harvard International Review, Euromoney, Japan Times, and the Far Eastern

Economic Review. Due to the very current nature of the US subprime mortgage crisis,

articles from the financial press are prominent in the corresponding analysis. Sources

here include, but are not limited to, literature from The New York Times, The Guardian,

CFA Institute Magazine, and the Federal Reserve Bank of St. Louis.

Second, to bolster the qualitative analysis and also provide a more quantifiable angle on

each case and the relative immediate success of the implemented policy measures, short-

term movements of selected financial market indices comprise an important part of this

study. Financial markets are acutely attuned to economic conditions and move

accordingly in real-time. As such, when material information is disseminated into the public domain, market reaction is reflected in prices; this line of thinking is consistent

with the efficient market hypothesis (Fama, 1991, p. 1575), a fundamental financial

concept.

Choo, Page 9

Information concerning public authorities' actions in the financial sector constitutes

material information and, without a doubt, in both the Japanese and US crises, authorities

have made consequential decisions. Markets have moved in response and such market

reaction - when analyzed in conjunction with prevailing qualitative factors - provides

information regarding the success of the authorities' efforts. In this vein, one-week

market movements in the following financial market indices have been used in the

analysis of the case discussions:

â€¢ TED Spread. This statistic, measured in basis points, is calculated as the