Finnish economists recall when their banking system collapsed in the early 1990s, writes Derek Scallyin Helsinki

PUSHING OPEN the heavy wooden door of the Bank of Finland, a hulking Russian-German architectural landmark in downtown Helsinki, it's hard to imagine that these austere halls once echoed with the sound of economic panic.

Yet, in 1991, Finland was hit by a crisis that shook the foundations of its banking system and forced a state takeover of the leading savings bank. By far the most severe of a wave of Nordic banking crises, the Bank of Finland's rescue plan cost the taxpayer some 8 per cent of GDP and left a legacy of thousands of bankruptcies.

Finnish experts say that there was no classic recipe for their banking crisis. It boiled down to a mixture of bad luck, bad policies and bad banking.

Today's Ireland is very different from the Finland of 1991, yet warning bells begin to sound when veterans of the Finnish crisis recount their experiences - like their description of the Finnish credit bubble of the late 1980s, inflated by a new era of easy money where, as one analyst puts it, "euphoria supplanted risk analysis".

"There was no proper understanding of risk management in Finnish banks then," said Pertti Pylkkönen, senior economist at the financial stability division of the Bank of Finland. "I'm sure Irish banks have much more modern supervisory systems now, don't they?"

To believe the financial experts of the time, the Finnish banking crisis came from nowhere. The country had enjoyed a decade of steady economic growth thanks to strong exports to western Europe and lucrative bilateral trade agreements with the Soviet Union, exchanging expensive Finnish goods for relatively cheap Soviet oil.

Adding to the sense of prosperity was a liberalisation of the banking sector in the late 1980s that contributed to a rapid increase in lending. A culture of debt, where previously none had existed, contributed to a steep rise in property prices.

Then, in June 1991, Bank of Finland forecasts showed that the GDP would drop 6 per cent. Trade with the disintegrating Soviet Union had collapsed, as had exports to western neighbours badly hit by recession.

"The government didn't believe the figures I gave them. They said: 'It can't be that bad'," Pylkkönen said. "The banks were very slow to react too, they didn't realise for months how deep the crisis actually was."

The fuse for the crisis had been lit in the late 1980s with a poorly designed and badly executed deregulation of financial markets. A liberalisation of domestic credit and foreign exchange transactions drove domestic credit demand as well as price and income expectation. Lawmakers though didn't create any means of steering the resulting expansionary effect, nor did they increase bank supervision.

High taxes on equity capital meant that debt was a more attractive financing option for companies. The private sector invested heavily in foreign currencies, reassured by the apparent security of a fixed exchange rate regime and a "hard" Finnish markka.

However the collapse of exports changed all that and forced a currency depreciation in 1991. At the same time, banks tightened up the loose regulations which had contributed to the lending boom and which had driven the housing price bubble. The result was a 25 per cent drop in lending and a halving of asset prices.

Bank losses soared, so too did the cost of using the depreciated markka to service foreign debts - at the time comprising 15 per cent of total debt.

From 1991-93, Finland's real GDP declined by 12 per cent, the jobless rate soared from less than 4 per cent to almost 20 per cent, stock prices dropped by two-thirds and hundreds of companies went bankrupt.

With a growing number of banks facing solvency and liquidity problems, the Bank of Finland was forced to take over the Skopbank, which acted as a central bank to Finland's savings banks. After injecting about 8 per cent of GNP into the banking sector to guarantee liquidity, ownership of Skopbank was transferred to a special "guarantee fund" outside the Bank of Finland.

"We completely changed the bank supervisory laws and the banking sector afterwards had nothing to do with the old one," says Pentti Forsman, economist in the Bank of Finland's monetary policy and research division.

"Today we have the most efficient banking sector in Europe, but the downside is that many small- and medium-sized companies went under."

Later on, the IMF highlighted banks' poor lending practices and poor risk management as key ingredients in the crisis.

"Add to this distorted incentives for bank owners, who may not have [had] enough capital at stake, and for bank managers who [carried] little personal responsibility for the excessive risks they were taking," says Stefan Ingves, director of the IMF's monetary and exchange affairs department in 2002.

Ask Bank of Finland economists about the risks Ireland might be facing now and they point to the gap between economic expectations and economic reality.

"As in Finland, there is a danger of arrogance. That you have done very well, people in general have done very well and expect it to continue, but eventually things have to go down," Pylkkönen says. "The problem arises when this [expectation] gap becomes apparent. I see a 99 per cent probability you already have a crisis in Ireland."

Ireland's greatest insurance policy against a banking crisis is membership of the euro zone, whereas Finland was master of its own economic destiny and currency in 1991. Ireland can draw on the support of the European Central Bank in Frankfurt, which has a whole department charged with preventing such crises.

Jaakko Kiander of the Labour Institute for Economic Research in Helsinki warns against a false sense of security.

"The Irish economy is extremely open, much more than Finland used to be, and Ireland could easily face a big external shock if US and European economies slide deeper into recession, hurting Irish exports," Kiander says.

Talking about the economic pressures Ireland faces today will not cause a banking crisis any more than talking about a fire drill will cause a fire. On the other hand, Kiander warns that not talking about possible economic pressures for fear of a psychological snowball effect only panders to an inherent weakness of the financial industry.

"The financial industry is always short-sighted and always in denial," he says. "They always think they're very clever and have good risk-assessment, but they always repeat old behaviour patterns."