A real expert on dealing with financial crises talks about how to deal with this one

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While the econoscribes of the U.S. (me included) were writing Thursday about what the President’s Working Group on Financial Markets had to say about the current financial crisis, a guy who may know more about dealing with financial disaster than anybody in Washington was giving a speech on “kriser i det finansiella systemet” to the Swedish Economics Association in Stockholm.

I’m talking about Stefan Ingves, who is currently Governor of the Bank of Sweden (the country’s central bank) but was more importantly one of the chief engineers of the most successful financial bailout and restructuring of the 20th century. This happened in Sweden in the early 1990s, when Ingves was Under-Secretary and Head of the Financial Markets Department at the Ministry of Finance. What befell Sweden between 1990 and 1993 was a full-fledged depression: Housing prices fell 20-25%, real GDP dropped 6%. But by quickly taking over and recapitalizing insolvent banks, Swedish authorities kept it from becoming a long, dragged-out affair like the Great Depression in the U.S. or Japan’s lost decade in the 1990s.

Anyway, Ingves speech is really long, and it’s surely better in the original Swedish. But there’s some interesting stuff in it:

1) There are lots of parallels between the 1990s Swedish crisis and the current global one. “It is … interesting that the abstruse structures, which led to the current financial turmoil and the bank crisis in the 1990s, were in both cases partly due to so-called regulatory arbitrage. The most recent wave of securitisation of the banks’ credit portfolios was partly propelled by deficiencies in the capital adequacy rules. Through securitisation the banks could easily avoid a lot of expensive capital adequacy.”

2) Despite all the advances and changes in finance, what we’re seeing now is basically an old-fashioned bank run. “Essentially this is a question of the same thing, namely lending at long durations that is funded in short durations. … What is new is that banks around the world have become much more dependent on the securities markets for managing risks and financing themselves.”

3) They’ve heard of John Dillinger in Sweden. “The banks and their account systems are … a vital part of the payment system. So if anyone asks why the banks are special, I could reply in the same way as John Dillinger, designated by the FBI in the 1930s as public enemy number one, when asked why he robbed banks: ‘Because that’s where the money is.’ ”

4) Sometimes we’ve just got to bail banks out. “Seen from society’s point of view, the individual agents’ incentives are not sufficient to take protective measures against crises that affect the financial system as a whole. The shareholders can never lose more capital than they have put in and individual depositors find it difficult to monitor a bank with widespread operations. There are, to use economic terminology, considerable negative externalities. In addition to the consumer protection aspects, this is a decisive motive for having a financial safety net in the form of special regulation, supervision and a deposit guarantee.”

5) Countries need a framework that allows regulators to take quick action on troubled banks, but also prioritizes the interests of the different parties in the financial system. “An essential condition for a well-functioning system is that one can attain a balance between all of the interested parties who come forward when a bank is in distress. The various interests include society’s interest in financial stability and the depositors’ interest in good consumer protection. But there are also the creditors’ interest in good protection and fair treatment, the taxpayers’ and the fee-paying institutions’ interest in the cost of the deposit guarantee system being as low as possible. In addition to this are the owners’ interest in their legal rights and not least society’s interest in the administration of justice functioning in the field of economic crime. All of these interests, and probably more, are entirely legitimate and must of course be taken care of in the legislation. But they must be classified according to their relative significance to society.”

6) Increasingly, bank regulators need to coordinate all these priorities with those of their counterparts in other countries. “[I]t is not sufficient to merely patch up the gaps in the domestic regulatory framework. The real challenges lie in managing cross-border crises.”

Ingves was of the opinion that the current Swedish financial regulatory regime is pretty inadequate on points 5 and 6 (in part because the special legislation that allowed him and others to take such dramatic action in the early 1990s expired in 1996). He said the UK is having to quickly draw up a set of rules and procedures in the wake of the Northern Rock failure, and is doing a pretty good job of it. He didn’t really comment on the U.S., but my sense is that we don’t have a framework up to his standard. In the case of actual domestic bank failures we might, but in dealing with the current amorphous, international “bank run” the Fed is simply frantically trying to keep the big banks and securities firms out of distress without paying much attention to the priorities of anyone else. And Congress and the Administration–which is who’ll eventually get stuck with the setting priorities if priorities are to be set–are, so far at least, not doing much at all.