sou · GVB351 · 2008-01-01 00:00:00 — This would mean that the Riksbank need not maintain capital to the same extent as would otherwise have been necessary. the Riksbank to suffer major losses central government would contribute capital to allow the Riksbank adequate capital to continue to fund its operating costs. The advantage would be a more efficient use of capital. At the same time the costs of maintaining capital in the Riksbank are low, see the discussion in Section 6.1. and above an efficient use of capital by central government there is another important advantage with a recapitalisation rule. As the Commissions discussion above has shown, it is difficult to accurately assess the magnitude of losses that the Riksbank risks suffering. Because of this, it is also difficult to assess the Riksbanks capital need. A recapitalisation rule would mean that central government would replace capital in the Riksbank, irrespective of the size of the loss and its causes. So no assessment of the size of possible losses need be carried out, which also reduces the impact of the Riksbank making significantly greater losses than were considered when determining any capital buffer. One result would also be that a recapitalisation rule would mean that the conditions for making the rules governing the Riksbanks capitalisation sustainable in the long-term would be better. Should vulnerability increase over time for the Riksbank, due to the introduction of a fixed exchange rate or the reduction in volume of currency in circulation for example, a recapitalisation rule would not need to be changed in the same way as a fixed capital buffer might. There are also some disadvantages related to issues of principle with a recapitalisation rule. One is that a recapitalisation rule would bind future parliaments to contribute funds. This could be seen as a conflict with the principle that Parliament decides on central government expenditure, which is normally set within the framework of the annual central government budget. At the same time, it is not unusual for central governments to be bound by financial undertakings. One example is the liability to pay damages, to which central government can be bound by law. One way to reduce the formal problems and issues of principle of a recapitalisation rule, is to make it more flexible. This could be the Riksbank being required to apply for a capital infusion from Parliament. The Commission has not been able to find an example of a national central bank which enjoys an unconditional pledge on future recapitalisation from its parliaments. To summarise the Commission believes that, while a recapitalisation rule would have appealing characteristics, there are three conditions that still seem central to it not proposing such a rule. The first is that the risk of losses for the Riksbank is not considered to be great enough to create a large capital need to cover losses. The second is that the cost for central government of maintaining capital in the Riksbank is not large. The third are the issues of principle that it could generate. 6.4.How should the Riksbanks assets be invested? Judgement of the Commission: With a neutralised foreign exchange reserve, the Riksbank will have different assets to administer than todays foreign currency assets. These assets should be administered in such a way that the financial risk is so low that no cost-free capital need be specifically allocated for risk-taking in asset management. A certain risk tolerance would probably lead to a better return, benefiting central government and, by extension, taxpayers. With the Riksbanks need to be able to meet its obligations with the capital it has, even in the most unlikely situations, the Riksbanks assets should be invested taking careful account of the risk this entails. The objective of guaranteeing the Riksbanks financial independence, which is the Commissions task, does not require the achievement of higher returns in asset management if this is at the price of increased risk. The Commission believes that the Riksbanks currency risk should be neutralised. While the Commission takes no view on how this neutralisation should be achieved (see Chapter 8 for a discussion of this) this does mean that there is potential for investments other than the current ones. This raises the question of how the assets should be invested. It is generally recognised that asset managers must attempt to adapt the asset portfolio so that its yield is as good as possible on the basis of their liabilities and risk preference. This is usually called (). The Commission has not carried out a detailed analysis which could have provided a more specific focus for the Riksbanks asset management. One reason for this is that the Commission has not seen it as its task to guide the focus of asset management in detail. This should be seen as a task for the Riksbank itself, and it would be appropriate for this to be governed in detail by the legislator. However, there may be a need to provide some guidance, above all where it is relevant to the size of the cost-free capital the Riksbank needs. The following section should be seen as a general discussion of these issues, which can form the basis of the essential focus of the Riksbanks asset management. However, the Riksbank needs to carry out an in-depth analysis before a more detailed focus for asset management can be determined. If, using , we were only concerned with the Riksbanks undertaking to fund current operating costs, a matching position would be theoretically best achieved by the Riksbank investing in a convertible promissory note with an infinite maturity. The yield from such a bond would cover the operating costs and it would be unimportant if there were fluctuations in interest rates or inflation that changed the market value of the bond. However, such bonds do not exist. The fact that the Riksbank may need to realise investments, if, for example, there are losses, or if the volume of currency in circulation decreases, also means that the Riksbank cannot just look for a return from its investments. Variations in the market value of assets must also be taken into account. It is also a fact that modern risk management methods are based on market values, which is why the Commission takes an approach in which the Riksbanks assets are marked to market. This also corresponds with the accounting policies applied by the Riksbank. In the view of the Commission, the basis for this should be a low risk tolerance in the Riksbanks asset management. The reason for this is that the Riksbank has been given its independence and an opportunity to fund its current operational activities with separate capital with the purpose of, independently and without any other considerations, being able to use monetary policy to control inflation. This unique delegation of political power means that the Riksbank is restricted to carrying out such tasks considered compatible with its long-term independence. From this perspective it seems inappropriate for the Riksbank to act as a general asset manager, using a not insignificant measure of risk tolerance in its approach in attempting to maximise its return for its owner, central government. The Riksbank should, in order to protect its financial independence, have different risk preferences to most other asset managers. This means that the Riksbank should ensure that the probability of losses is minimised, so that financial independence is not threatened. This is different compared to many other asset managers which can often be less risk averse in order to achieve a higher expected return. The Riksbank should have a high aversion to risk in its asset management not only because of its need for independence but also because the risk of losses is difficult to quantify. There is a small but tangible risk that losses could be greater than those indicators presented in the inquiry. Another way to express this is that when, in financial risk management, a risk is expressed in the form of a capital sum that can be lost, there is still a risk that the outcome will be worse than that indicated by this capital sum (a tail outcome). Value-at-risk is one such measurement we have discussed, and our assessment of possible losses can also be seen as a similar estimate. Should the Riksbank incur losses, it is unlikely that this will occur in a market situation in which the return on high risk financial assets is also low (which in risk management jargon is referred to as the correlation between risks approaches one in times of crisis). The problems of tail outcomes apply not only to risks related to the Riksbanks activities. If the Riksbank takes financial risk, there is always the risk that the outcome will be worse than that estimated in the risk management models, i.e. losses are greater than those reflected in the VaR approach. To a certain extent there are newer and more sophisticated risk management models, better at estimating the probability and magnitude of extreme events. But even using such methods there is always the risk of a highly improbable event actually happening, or that the data used in the model does not reflect reality. This risk is difficult to manage for an organisation such as the Riksbank, which should have low risk preferences to guarantee its financial independence. One example comes from the financial risk management used by financial actors. They often use the price volatility of financial assets from the past year, past hundred days etc., as variables in their models. Volatility varies a great deal over time, and when it suddenly increases, the financial actors experience many more pass-throughs in their models than expected, i.e. losses were greater than the VaR value for more days than that indicated by the probability distribution of the model. Financial actors often use short time series because this is suitable for day-to-day risk management, and they supplement this with various types of stress test to estimate the more extreme and long-term loss risks. For a long-term asset manager with low risk tolerance, there is no reason to use short time series. On the other hand there are seldom time series as long as could be desired and there is always a serious risk that the data upon which the models are based do not reflect the future. The actual probability of a tail outcome may consequently be much greater than that estimated in the models, but this probability is not observable. There are also reasons not directly connected with the risk of losses with too great a purely financial impact. If the Riksbank takes greater risk in its asset management and makes losses that, while significant, do not threaten its financial position, there may be other consequences. Experience shows that losses in asset management are often seen as a failure and lead to criticism, even when this is a result of conscious risk tolerance. It may appear unnecessary for the Riksbank to expose itself to such a risk. This also risks leading to management focusing on this type of issue instead of carrying out their primary responsibilities. All in all there are a number of different difficulties and uncertainties related to risk assessment both with regard to the Riksbanks activity-related risks and with regard to any financial risk that the Riksbank could take, that mean that there are grounds to view the Riksbanks financial risk-taking restrictively. In the view of the Commission, this should mean that the Riksbank is not provided with cost-free capital in order to take financial risk. Taking into account the range of different types of financial instrument in Swedish krona, a low risk in these circumstances probably means investment in Swedish interest-bearing securities, at least for the largest section of the portfolio. As we discussed in the introduction, there are no grounds for the Commission to put forward a detailed proposal for how the Riksbank should position itself in its asset management. In the view of the Commission, what is important for the capital structure of the Riksbank is that it not be allocated cost-free capital in order to take financial risk. This probably assumes a low risk tolerance in its asset management. However, there is a particular problem in that the Riksbank determines the shortest-term interest rate, the repo rate, which has a major significance for the development of the entire interest rate curve. With regard to the Riksbanks role in this respect it would appear out of the question for the Riksbank to actively administer fixed-income instruments in Swedish krona. Even if interest rate administration is separated internally, the Riksbank would have difficulty in being able to avoid suspicions that the interest rate administration gained an advantage from the information about the setting of interest rates in any trade. Because of that, the Riksbank should have a passive administration of Swedish fixed- income instruments, in which its position in the market is fully transparent and It would be easiest if the Riksbank did not even buy government securities, and instead invested directly in the Debt Office at interest rates corresponding to the applicable rates, and if the position of the interest rate curve (duration) in the Riksbanks asset portfolio was stable and predetermined. However, according to EU rules central banks may not directly fund central government. They only have the right to buy interest-bearing securities on the secondary market, i.e. neither give direct loans nor participate in issues of government bonds. This forces the Riksbank to trade in existing securities in the market. The Commission does not indicate where the Riksbank should position itself on the interest rate curve in terms of duration. If the Riksbank were to be short on the fixed income market it is not certain that the supply of short-term government securities would be sufficient were the Riksbank to get rid of a large part of the foreign exchange reserve. With a duration closer to the duration of the total central government debt, such a clear shortfall between supply and demand will not arise. On the other hand, there will be a general demand for Swedish government securities. In the light of the currently diminishing supply of government securities, this is something to be taken into account. This is discussed in more detail in Chapter 8 on transitional issues. At the same time as there are good arguments for low risk in asset management, it must be noted that this does not provide a particularly good return on capital for taxpayers. There is an argument that it would be reasonable if central government worked towards a better return on the relevant funds, and allowed some risk tolerance on the part of the Riksbank with the aim of increasing the expected return. In the opinion of the Commission, asset management with a higher risk tolerance would entail the Riksbank being provided with cost-free capital which could bear some losses in its asset management. The basis of this approach is that high risk assets, for example equities, give a higher expected return, especially in the long-term, and it would be a shame not to make possible a better return for taxpayers when a relatively large amount of capital must be invested somewhere anyway. However, the Commission considers that advocating more offensive asset management would not be consistent with the terms of reference and objectives of the Commission - proposing a capital structure which guarantees the Riksbanks financial independence. On the other hand, an assessment of how the taxpayers money would best be administered could lead to the Riksbank needing to take more risk in its asset management than has been discussed here. Thus we can see that the aim of financial independence and the aim of generating a good return for taxpayers are in conflict with each other. For the Commission, which is mainly concerned with creating the conditions for financial independence, it is hard to judge how this conflict of aims should be evaluated. In the view of the Commission, the protection of financial independence should lead to the Riksbank being very restrictive in its risk taking; risks should not be taken unless they are necessary to fulfil the banks terms of reference. In the opinion of the Commission, financial independence is best promoted by a low risk asset management. In view of this, the Commission is not proposing that the Riksbank should carry on a more offensive asset management and be allocated cost-free capital for this, although in the longer term this could increase revenue for taxpayers. Judgement of the Commission: With a neutralised foreign exchange reserve and low risk asset management, accounting issues are of importance to the profit allocation and capital structure of the Riksbank, and therefore do not affect the structure of the proposals. Up to now the Commission has not dealt closely with accounting issues because the analysis is clearer if specific accounting rules are ignored. This is particularly true when these rules are not useful in explaining what happens economically when financial assets develop over time. Accounting in the Riksbank is governed by the ECBs rules for central banks within the ECBS and in some respects is specific. Because the Commissions clarification of and proposals related to the capital structure of the Riksbank are broad in so far as only the more significant factors and risks are being discussed, the accounting rules are not of critical importance to the findings of the Commission. However, a couple of factors are worth touching on. The first concerns profit for the year and how this is allocated. Profit for the year is not an unequivocal concept. In addition to a surplus of current income, generated by interest income from bond coupons etc, over costs, the Riksbanks profit consists of both realised and unrealised value change in the securities it holds. According to the accounting rules, realised profits must be included in the profit and loss account, while unrealised profits must be transferred to the revaluation account. the investments in Swedish krona, the surpluses and deficits which could arise in the revaluation accounts would be significantly smaller than they are today. It seems improbable that if the Commissions proposals are implemented that any more significant revaluation accounts of a similar size to todays will be built up. Gold constitutes an exception. At present the gold reserve contains a substantial surplus, booked in a revaluation account. The market value of this gold, according to the annual report, was approximately billion, at the same time as the surplus in the gold revaluation account was the equivalent of billion. For most loss risks identified by the Commission, any losses are reported as a cost and therefore recognised in own capital. However, losses in the gold reserve resulting from value decreases will primarily lead to the revaluation account being written down. Only if losses are greater than the billion in the account are the losses recognised in own capital. This means that that part of the loss risk for gold losses that will need to be recognised in reported own capital is less than the billion discussed in Chapter 4. The remaining loss risk, after any losses have been booked in the revaluation account, can amount to about billion. In the Commissions analysis, profit for the year has not been used as a concept. This can be seen as synonymous with net income. This clarifies that it is the income obtained by the Riksbank which is referred to. As mentioned above, net income contains interest income and realised exchange profit from its portfolio of securities. On the other hand, it does not include unrealised profit, which go straight into the revaluation account, and can be viewed as an accounting provision. In light of this the Commission believes that accounting issues have no major significance for the proposals it is making. 6.6.The total capital need Table 5 is a summary giving an estimate of the Riksbanks capital need. The Commissions assessment of the Riksbanks capital need Reason for capital need Covering the cost of banknotes and Losses from emergency liquidity Losses in the management of the Total capital need, including Total capital need, excluding In the table, the capital need has been totalled for the various types of risk. It could be argued that it is improbable that the losses materialise at the same time, and so it is doubtful whether the capital need should be totalled, at least with regard to the risks. At the same time the estimates are tentative and it is hard to see that diversification effects would better differentiate the total capital need. Nevertheless, as all types of loss should not happen at the same time, the capital need in the table is in the upper region of what could be seen as necessary. The Commissions proposals for capital structure Proposal of the Commission: The Riksbanks capital structure and profit allocation shall be regulated by law. Two alternative proposals are being given. The choice between them is largely a matter of whether currency in circulation is seen as an adequate alternative to own capital. We have shown that there are many different arguments affecting the structure of the Riksbanks balance sheet. These arguments have been presented and discussed in previous chapters. In many respects the deliberations that need to be made mean looking at how to balance the advantages and disadvantages. These advantages and disadvantages consist of such difficult factors as the risk of improbable events, how large losses could be in that case, and how confidence in the Riksbank could be affected. In light of this the Commission has decided not to propose one possible suitable balance sheet structure. Instead we are proposing two different balance sheet structures, both based on different perspectives on currency in circulation. In the first alternative, currency in circulation can be considered an adequate alternative to own capital. This means that the Riksbank can continue to use this large amount of capital to secure the funding of its operational activities. Because currency in circulation is greater than that needed by the Riksbank to cover its costs, some of the Riksbanks own capital can be released and repaid to central government. The size of currency in circulation even means that there is a between the access to cost-free capital and the capital need which the Commission has identified for the Riksbank. The disadvantages of this proposal are mainly that the Riksbank would be vulnerable if there were a rapid reduction in the amount of currency in circulation and that the Riksbank could be put in the situation of needing to explain that it had negative own capital. The basis of the second alternative is that currency in circulation cannot be seen as cost- free capital for the Riksbank. In order to make it transparent that the currency in circulation is loan capital the Riksbank should pay interest to central government for this capital. In return the Riksbank must have substantial own capital. This alternative solves the problems caused by a rapid decrease in the volume of currency in circulation. The Riksbank would have a purer, clearer balance sheet with own capital used to fund current operations and potential losses. The disadvantages are that the proposal binds more capital in the Riksbank and that the Riksbank would be more vulnerable in the case of losses larger than those estimated by the Commission. As we showed in Chapters 4 and 6, in estimating actual amounts the Commission has only been able to give a rough indication of how great the risk of losses would be for the Riksbank. The figures used in the various alternatives are therefore the result of relatively discretionary estimates.