Response to solvency crisis: Swedish versus Japanese model

When faced with a financial system that has more debt than the borrowers are capable of repaying, policymakers face two choices:  the Swedish model under which losses are recognized today or the Japanese model under which losses are recognized as banks have the earnings capacity to absorb them.

Both of these choices reflect what the policymaker thinks about preserving bank capital.

As Matt Stoller observed in his Salon article,

“We can either have a rational resolution to the foreclosure crisis or we can preserve the capital structure of the banks,” said Silvers in October, 2010. “We can’t do both.”

The Swedish model, which was successfully used by FDR in the 1930s and Sweden in the 1990s, is for the banks to write-down the debts today.  Under this model, bank capital is there to absorb losses.  It assumes that with the combination of deposit guarantees and access to central bank funding, banks can continue to operate even if they have negative book capital.

Under the Swedish model, banks have an unlimited capacity to absorb the losses on the excesses in the financial system.

The Japanese model, which has been unsuccessfully tried in Japan for the last 2+ decades, is for banks to write-down the debts as the banks generate earnings to absorb the losses.  Under this model, bank capital is there not to absorb losses, but as a ruse to convince market participants that insolvent banks are really solvent.

Under the Japanese model, banks have limited capacity to absorb the losses on the excesses in the financial system.  This capacity is limited to earnings.

There are at least two sources of drag on bank earnings that slowdown the absorption of losses.

• Bonuses.  It is difficult to pretend the banks are solvent and not pay bonuses to bankers.

• Zero Interest Rate Policies.  Over the course of several years, zero interest rate policies compress banks' net interest margins.  With margin compression, comes earnings compression.  With less earnings, comes even less capacity to absorb losses.

Unlike the Swedish model, policymakers do not have to permanently stay with the choice of the Japanese model.  If they see that it is not working, they can adopt the Swedish model instead.