Finland’s 1992 Capital Injection

Buildup

During the 1980s there was a large-scale deregulation of the financial sector as outlined in the chart below. The government allowed banks to lend into areas where they had not lent before and therefore lacked market-specific knowledge. Regulatory decisions were subject to court challenges, and it has been theorized that this, “raised the threshold for introducing stricter supervisory practices” (Nyberg and Vihriälä 1994). In addition, regulators lifted strict limits on deposit and interest rates. More broadly, the supervisory authorities were viewed as relatively weak—“they lacked resources and qualified staff and did not prioritise on-site inspections” (Moe et al. 2004). The savings banks were taking extraordinary risks and were undercapitalized.

During the same period, both household and corporate debt increased significantly. The Finnish, Norwegian, and Swedish “tax systems encouraged borrowing through very generous rules for deducting interest expenses from taxable income” (Moe et al. 2004). Household debt rose from 25% of GDP in 1980 to 45% in 1992, and corporate debt rose from 70% of GDP to nearly 90% of GDP in just a couple of years starting in 1989 (Mayes et al. 2001). Housing prices doubled between 1986 and 1989, and the Finnish stock market tripled between 1985 and 1988 (Mayes et al. 2001). Commercial property prices may have increased even more than residential. This led to the traditional cycle where the increases in property prices lead to higher collateral values which facilitate an increase in bank lending.

Finally, there were two significant international events that affected the Finnish economy in the late ’80s and early ’90s. First, Finland was scheduled to join the European Union in 1995 and use the new Euro currency in 1999 (EU 2019). However, the steps taken to prepare caused a dilemma. Finland could use exchange-rate targeting in the late ’80s and early ’90s and make the transition to the Euro smoother, but the resulting interest rates would be lower than they naturally would have been, and borrowing would outpace growth. Alternatively, they could raise interest rates to dampen the borrowing but lose the exchange rate peg and risk a disruptive transition to the Euro. They chose the former (Mayes et al. 2001).

Second, Finnish exports collapsed with the fall of the Soviet Union (Moe et al. 2004). The Soviet Union had accounted for approximately 15% of the exports of Finland (Mayes et al. 2001). The decrease in exports to the former Soviet Union caused a negative demand shock of approximately 2.5% of GDP to the Finnish economy (Nyberg and Vihriälä 1994).

The Crisis

Finland was not alone in suffering a banking crisis and economic downturn during the early 1990s. Sweden, Norway, and Denmark experienced crises that, although they had distinct causes and effects, were similar in many ways. However, Finland suffered the most with a growth rate of -8% of GDP during the worst of the crisis years and a peak unemployment rate at over 20% (Mayes et al. 2001).

Lending to the public by all Finnish deposit banks more than doubled from FIM214b to FIM491b from 1985 to 1990 (Nyberg and Vihriälä 1994). Throughout the time period, GDP was growing at a similar pace, so this lending represented a consistent 75% of GDP (WBGDP). Then from 1991 to 1995 bank lending fell by more than a third. It would take nine years before bank lending returned to the pre-crisis levels (Moe et al. 2004). This dramatic build-up and then crash of the banking sector can be seen in the following two charts showing the decrease of employment in banking by more than half and, similarly, the closure of more than half of physical bank branches. By 1993, nearly one in five loans were non-performing (Klingebiel 2000).

In mid-January 1992, the Prime Minister organized a working group with the goal of “draw[ing] up a concrete programme to safeguard the banking system” (Kuusterä and Tarkka 2012). The group was chaired by the Governor of the Bank of Finland and included members from the finance ministry and leadership from all of the major banks. The number-one recommendation from the group’s March 16, 1992, report was, “to set aside funds [FIM 5 to FIM 10 billion] that could be used for capital investments to reinforce bank equity” (PMGroup 1992). This suggestion became the capital injection program authorized by parliament in April 1992.

Along with a number of suggested actions that the banks themselves could take—including: reduce operational costs and staff (3.3.1), avoid overcorrecting and limiting lending too much (3.3.2), and do better risk management (3.3.3) (PMGroup 1992)—the working group’s other significant recommendation was that the government complete measures that had begun the previous autumn in establishing a Government Guarantee Fund (Kuusterä and Tarkka 2012). (See Nygaard’s 2020 Finland-Arsenal YPFS case for more details on the Government Guarantee Fund and the asset management company.)

The Finnish Parliament acted quickly on the proposals from the working group’s report. On April 29, 1992, approximately six weeks after the report’s publication, Parliament authorized the Government’s recommended bank capital injection as part of the 1992 Supplementary Budget Proposal. The proposal took the report’s suggested FIM 5 billion to FIM 10 billion (Kuusterä and Tarkka 2012) and authorized up to FIM 8 billion. The budget explained the purpose of the capital injection as follows: “to counteract the deterioration of deposit banks’ solvency, which significantly limits their ability to lend and thus worsens the recession as investment and consumer demand decline” (Budget 1992). An additional purpose was to “help banks avoid [further] emergency support” (Nyberg and Vihriälä 1994).

In June 1992, the Bank of Finland (BoF), which is the country’s central bank, and the Ministry of Finance (MoF) outlined the terms of the capital injections (Vihriälä 1997). The voluntary program was open to all banks (Moe et al. 2004), regardless of their solvency. Banks received the funds in autumn 1992 (Kuusterä and Tarkka 2012) and were permitted to apply twice, the final time in December 1992 (Nyberg and Vihriälä 1994).

The size of the capital injection was determined by the size of the bank, as measured by their risk-weighted assets, balance sheet (Kuusterä and Tarkka 2012), and their off-balance sheet commitments (Vihriälä 1997). The injection was structured as non-cumulative, convertible preferred capital (Moe et al. 2004). The conversion could be executed by the government if interest remained unpaid for three years in a row or if the bank’s solvency ratio fell below the legal minimum (Nyberg and Vihriälä 1994).

The variable interest rate set on the preferred shares was set slightly above market and, “gradually increase[d] in relation to market to incentivise banks to repay.”^FNThe interest rates were calculated as follows: 1992-1997: one-year government debt financial cost of debt 50bp; 1997-2000: one-year government debt financial cost of debt 150bp; 2000-2007: same plus 200bp every year. Bank losses could only eat into the injected capital after the bank’s distributable equity capital and reserve funds had been exhausted (Nyberg and Vihriälä 1994). Banks were permitted to pay back the full sum in installments or all at once (Teemu 1992). However, interest payments had to be made before dividends to other shareholders could be distributed (Report 1993).

The government acknowledged the risk inherent in the bank capital injections. In the Supplementary Budget Proposal, passed in April 1992, the parliament admitted, “The return on an investment may be forfeited to the extent that the bank’s distributable earnings are insufficient to pay the return” (Budget 1992). Of the FIM 8 billion parliament made eligible for the program, FIM 7.9 billion was deployed (Nyberg and Vihriälä 1994). That amount represented 7.1% of Finland’s 1992 GDP (Borio et al. 2010) and 14% of the sectors’ regulation-prescribed capital (Vihriälä 1997). The recipients included 56 cooperative banks and 22 savings banks (Vihriälä 1997), of which FIM 5.0 billion went to five of the largest banks (Borio et al. 2010). None of the preferred shares were ever converted to common (Moe et al. 2004).

As of Jan 1, 1996, FIM 6.6 billion outstanding with banks and FIM 1.427 billion interest accrued (Communication 1996). By Nov 16, 1999, FIM 7.9 billion had been repaid with only FIM 580 million outstanding with Skop Bank (Report 1999). (For the full story on the government’s interventions with Skop Bank, see the YPFS Finland-Arsenal case, Nygaard 2020.)