sou · GVB351 · 2008-01-01 00:00:00 — These estimates can be changed so that the amounts are different without changing the structure of the argument significantly. Proposal of the Commission: The Riksbanks right to issue banknotes and coin should be used to fund its operational activities. Currency in circulation constitutes cost-free capital which more than covers the needs identified by the Commission. Own capital in the traditional sense has the advantage of being generally accepted proof of financial strength. Own capital should therefore be made up of a statutory basic fund of billion. This would mean that approximately billion could be transferred from the Riksbank to central government. The basis of this alternative is that it would be an advantage if the Riksbank had access to a large cost-free capital in the form of currency in circulation, which could be used for funding operational activities. Of course, the basis of this assessment could change were the volume of currency in circulation to change (see 6.3). However, in the opinion of the Commission such a change is a long way off, and will happen in such a way that there will be plenty of time for the political system to react. Besides, there is a significant difference between the current currency in circulation, approximately billion and the cost-free capital required to fund current costs, billion. The currency in circulation can be reduced considerably without affecting the potential to fund the Riksbanks obligations. As a result, if currency in circulation remains as cost-free capital in the Riksbank this should be adequate to fund current costs. However, the risk of losses also needs to be managed. As we discussed before, in strictly economic terms negative capital cannot be proved to be a financial problem for the Riksbank, as long as currency in circulation remains in the Riksbanks balance sheet. In principle own capital is interchangeable with currency in circulation. So it is possible to look at the volume of currency in circulation and see whether it would be sufficient to withstand potential losses caused by risk identified for the Riksbank. However, the Commission believes that there are advantages in having some own capital in the Riksbank. The size of this own capital is debatable. In Chapters 4 and 6 there are indications and a summary of the possible extent of losses. As we discussed before the Commission considers that own capital over and above that necessary should not be maintained by the Riksbank, though from a central government finance perspective the cost of maintaining capital in the Riksbank is small. This indicates that there is no reason to reduce the capital so much that confidence in the Riksbank could be called into question. Own capital in its traditional sense also has the advantage of being a generally accepted proof of financial strength, which can be an advantage internationally as well as with the Swedish public. Furthermore there are certain technical advantages with such a system. Thus the Commission believes that the Riksbank should be provided with a relatively small amount of own capital, and proposes that the level of this own capital be billion. This would allow the Riksbank to pay an extra dividend of approximately billion to central government. In this case the Riksbank would distribute profits which would otherwise lead to its own capital exceeding billion. If own capital was below this level the Riksbank would retain its profits until the level of capital had been restored to billion. The principal of billion should be adjusted for inflation to make it applicable in the long-term. Because the purpose of statutory regulation is to guarantee financial independence there is only reason to restrict the size of own capital. If for some reason the Riksbanks cost- free capital should be deemed insufficient, it would be appropriate for Parliament to allow the Riksbank retain a greater proportion of its profit, so that its own capital became greater than that indicated here. For example, this could be the case if currency in circulation decreased considerably or if losses greater than those considered by this Commission. the change made now the Riksbanks balance sheet total would amount to billion. Proposal of the Commission: The basis of this alternative is that currency in circulation is not suitable as cost-free capital, as it is difficult to explain in a credible fashion that currency in circulation can bear potential losses and thereby guarantee the Riksbanks financial independence. This alternative means that currency in circulation is considered a debt to central government for which the Riksbank pays interest. So the Riksbanks total requirement for cost-free funding must be covered by own capital. Own capital should therefore be made up of a statutory basic fund of billion. The basis of this alternative is that currency in circulation is not suitable as cost-free capital. The reason for this is, as discussed previously, that it is difficult to explain clearly and credibly that currency in circulation can bear potential losses. It is also natural that the right to seigniorage which currency in circulation gives rise to is seen as an asset for central government, not for the Riksbank. It is also an advantage that the financial position of the Riksbank is not affected by the demand for banknotes and coin, and that it is not exposed to risk associated with a sudden drop in this demand. Such an approach means that currency in circulation can be seen as loan capital which central government has contributed to the central bank, and for which it is reasonable for the Riksbank to pay interest. This gives currency in circulation more the character of the liability it is already reported as in the balance sheet. The interest which the Riksbank must pay for currency in circulation should correspond to a short-term risk-free interest rate in Swedish krona. The reason for this is that paying the interest should not mean that the Riksbank would be forced to take risks in its investments in order to be able to pay this interest. It would be suitable for the interest rate to be the shortest-term risk-free interest rate available, i.e. the repo rate. The Riksbank would thereby be determining the interest rate on its own loan, which causes a certain conflict of interest. However, since the Riksbank will be exposed to Swedish interest rate risk in its asset management according to the Commissions proposal, there is already a conflict of interest since the Riksbank would be able to improve its return by utilising its insider knowledge of the setting of interest rates. This is a problem which is discussed in Chapter 8. While the Riksbank has a different interest rate exposure in this alternative, because there is a debt for which the Riksbank pays interest, this does not change the problem fundamentally. The Riksbanks open interest rate position is not reduced in this alternative, but this does not change the need to handle the conflict of interest, especially as the balance sheet total, and thereby the assets, is greater than in alternative 1. At the same time it should be emphasised that the Riksbanks management is primarily focussed on the fight against inflation, and that they are judged on their success in managing this task. The incentive for the Riksbanks management to exploit this conflict of interest should largely be non-existent. they have strong reasons for showing that the conflict of interest is being handled. If currency in circulation is seen as loan capital the Riksbanks total capital need should be covered by its own capital. The summary of the capital need in the previous section indicates a capital need in the order of magnitude of billion, when the cost of banknotes and coin is excepted. The reason that this cost is excepted is that is should be deducted from the interest which the Riksbank otherwise would pay, instead of forming a capital need. In addition, the Riksbank will be liable to pay a portion of its seigniorage to the ESCB if joins the Euro. A deduction should be made for any such payments from the interest the Riksbank pays to central government. However, all other risks have been added, even though they do not occur at the same time. It can be assumed that there are certain diversification effects, so a somewhat lower capital need seems suitable. One benefit of this alternative is that the estimate of the Riksbanks need for own capital is relatively close to the level of own capital that the Riksbank currently has today. At the end of 2006 own capital was about billion. The Riksbank therefore needs neither to make extra payments nor receive capital supplements, which can be seen as benefit. The international comparison which the Commission has carried out also shows that the Riksbanks capitalisation is good when compared with other central banks. This argument means that the Riksbank should have a level of own capital in the order of magnitude if billion. Consequently the Commission considers that billion is an appropriate level of own capital for this alternative. With regard to profit distribution, all profits that raise own capital above the target level of billion should be distributed. Because the purpose of statutory regulation is to guarantee financial independence, the size of own capital should be restricted. If for some reason the Riksbanks cost-free capital should be deemed insufficient, it would be appropriate for Parliament to allow the Riksbank retain a greater proportion of its profit, so that its own capital became greater than that indicated here. This could take place if losses were incurred greater than those considered by the Commission. This level should be index linked and written up in line with inflation. The adjustment for inflation is more important than in alternative 1 because the Riksbanks cost-free capital in this alternative consists solely of own capital. This means that adjustment for inflation here refers to all cost-free capital, while the size of the largest portion of cost-free capital in alternative 1, currency in circulation, is dependent on factors outside the control of Parliament and the Riksbank, so cannot be adjusted for inflation. In this alternative the balance sheet total will be about the same as today, i.e. 7.3.The Riksbanks asset management Proposal of the Commission: The task of asset management is made clear in the Riksbank Act. The Riksbank manages its assets in order to carry out its policy tasks and to generate a return which can fund its operational activities, thereby creating financial independence. In managing its assets the Riksbank shall aim for a good return while taking account of the risk entailed. In managing its assets the Riksbank must also take account of its position as a central bank. shall establish detailed guidelines for asset management. The management of the Riksbanks assets is an important task. However, the current wording of the Riksbank Act gives no unequivocal guidance for asset management. The provisions of the Riksbank Act regarding foreign exchange policy and in terms of monetary policy govern the asset management according to existing law. The lack of general rules for its asset management have probably contributed to the fact that the Riksbank currently invests all funds that do not have a specific purpose (e.g. monetary policy repo transactions and IMF obligations) in the foreign exchange reserve. The Commission has not been tasked with submitting proposals regarding the focus of the Riksbanks asset management. However, when the currency risk in the foreign exchange reserve is neutralised in accordance with the Commissions proposals, a need will arise to indicate more clearly in the Riksbank Act how asset management is to be carried on. The basic purpose of asset management needs to be specified. It is clear that asset management is first and foremost aimed at allowing the Riksbank to fulfil its terms of reference. Its policy tasks must come first. In addition, the return on the Riksbanks assets forms the basis of its financial independence as we have shown. We therefore propose that the basic purpose of asset management set out in the Riksbank Act shall be that the Riksbanks asset holdings are there so that the bank can fulfil its tasks and that they create the conditions for the independent funding of its activities. The Commission has given an account of the deliberations regarding how the Riksbanks assets should be managed in Section 6.4. The opinion of the Commission is that these assets should be managed in such a way to make the financial risk low enough that no cost-free capital need be specifically allocated for risk in asset management. Greater risk tolerance would probably lead to a better return, benefiting central government and, by extension, taxpayers. But the Riksbanks need to be able to meet its obligations with the capital it has, even in the most unlikely situations, means that the Riksbanks assets should be invested taking careful account of the risk this entails. The objective of guaranteeing the Riksbanks financial independence, the Commissions task, does not require the achievement of higher returns in asset management if this is at the price of increased risk. The balance between return and risk is a central strategic decision faced by all asset managers. It is difficult to give more tangible guidance to how to make this balance in the broad formulations that characterise legislation. One example can be taken from the rules related to the First - . This expresses the focus in law as follows: The total level of risk in the investments in the funds shall be low. Fund assets shall, at the selected risk level, be invested so that a long-term high return is can invest a substantial proportion of their assets in equities. For example all four of the buffer funds have approximately 60 percent of their portfolios in equities. Equities are normally seen as a high risk investment. The fact that it is possible for the , despite the legal requirement for low risk, to invest a large proportion of the portfolio in equities, is in part due to the long-term risk perspective and in part due to good risk diversification. The Commission does not consider it possible in legislation to better define the balance between risk and return. In the view of the Commission no specific cost-free capital should be conferred on the Riksbank for risk-taking in its financial management. Instead a system of internal governance and built in control mechanisms must be created. In addition, the suitability of defining the Riksbanks asset management in more detail in legislation, is a subject for discussion. As an independent central bank the Riksbank should have relative freedom to formulate its operational activities, within the framework of the terms of reference given to it by Parliament. As was mentioned previously, the Commission has not been tasked with proposing the statutory regulation of the Riksbanks asset management. In the opinion of the Commission it is sufficient for the legislation to indicate that the Riksbank shall aim for a good return, while taking into account the risk related to asset management. This gives a good basis for a more detailed development of asset management based on as discussed in Section 6.4. One further aspect which must be considered is the Riksbanks special position. Investments must not be made in such a way that the Riksbanks opinion on the economic situation can be deduced. Neither must the Riksbank take undue advantage of its position or knowledge in its asset management. must there even be a suspicion that the Riksbank is using its position or special knowledge to gain financial advantage. 41TP PT Chapter 4, Section 1 of the Act (2000:192) investments may not be made in such a way that third parties can, or believe that they can, predict future Riksbank policy. Naturally, asset management must not obstruct the implementation of policy. Generally, the meaning of this requirement is obvious, but difficult considerations may need to be made. The statute must express the need for the Riksbanks position to be taken into account in its asset management. However, it is not meaningful for the statute to try to specify the content of the requirement in more detail. The relatively open task of asset management means that it is important that it be clear how the asset management guidelines are to be drawn up in detail. should be obliged to draw up guidelines for overall asset management. These guidelines shall be the instrument which in all respects governs how asset management is carried on in the Riksbank. It is therefore of the greatest importance that all relevant perspectives are expressed in these guidelines. The absence of detailed legal regulation of asset management is based on the idea that a system of internally set guidelines can be just as safe but more flexible as an instrument of governance, and thereby effective. The guidelines shall provide comprehensive instructions for asset management. In addition the guidelines shall be drawn up to facilitate external evaluation and governance. The guidelines must thus highlight governance. This means that the internal supervision of the Riksbanks organisation should be dealt with in the guidelines. This includes issues such as the authority of various functions and staff and also reporting to ancillary and senior managers regarding actions taken. It is incumbent on to create an internal system of governance that is efficient as well as easy for third parties to oversee. 7.4.The concept of primary capital Proposal of the Commission: The concept primary capital has a new meaning. Primary capital is increased by amounts being transferred from the reserve fund and contingency fund. According to the Commissions two alternative proposals, the definition of fund assets will change in the Riksbank Act. The present division into a primary capital of million, a reserve fund of million and a contingency fund, is changed so that the Riksbank in alternative 1 has the right to issue banknotes and coin and has a primary capital of at least billion, and in alternative 2 has a primary capital which shall be at least billion. Thus the concept primary capital has a new meaning in that through the new proposed legislation it will be the only form of own capital in the Riksbank. The background to this proposal is that the Commission sees no reason to have three different funds, as the size of total own capital will have been set as a certain amount. In the opinion of the Commission to justify several funds they would need to be treated differently in law. For example the consequences of a fund not achieving the correct size which is the case for a limited company. There is nothing in the Commissions proposals that justifies the minimum amount of own capital held by the Riksbank being divided into The Commission therefore proposes only one form of capital called primary capital. An increase of primary capital from billion to billion in alternative 1 and billion in alternative 2 will be achieved by transferring amounts to primary capital from the reserve fund and contingency fund. 7.5.The EU treaty and the proposals Judgement of the Commission: Both proposals fulfil the requirements of EU law on the financial independence of central banks. One of the reasons for guaranteeing the Riksbanks financial independence has been to fulfil the requirements of Article 108 of the EU treaty which states that the central bank shall be independent. Article 108 is not very specifically formulated, but the interpretations of it expressed in the convergence reports for state that the central bank must have sufficient financial resources to meet its obligations and that Parliaments allocation of the Riksbanks surplus should be regulated by law. The Commission considers that the requirements in the convergence reports are fulfilled in both of the Commissions proposals. Alternative 1 says that part of the Riksbanks own capital, approximately billion, will be paid to central government. This means that the Riksbanks financial strength will be decreased, which could be seen as an erosion of the Riksbanks financial independence. The Commission has clearly shown that the Riksbank can continue to meet its obligations, even with the smaller capital proposed, so we consider it unreasonable to view the reduced own capital as a threat to the Riksbanks financial independence. In certain respects a similar situation arose in in 2003-2004. A number of changes to the Act on were proposed, one of which was related to a significant reduction in own capital. The proposal on the repayment of capital was withdrawn, but a rule was left in place stating that should distribute its entire profit to central government. In its comments on the proposal, the ECB stated that a repayment of the capital at the same time as there was no safeguard for it, would have threatened the independence of was also critical about the modified proposal, in that the entire profit should be paid out, because, among other things, there was no safeguard for the realisable value of the capital. In addition there was criticism that the proposed legislation did not guarantee clearly enough that could perform its ESCB-related tasks. The Commissions proposals deal with the relevant issues in the ECBs criticism. In part the level of own capital is confirmed in law and in part its realisable value is safeguarded by being indexed. The Commissions proposals should therefore not run into the same criticism from the ECB as the Finnish proposal. In addition the Riksbank discharges its ESCB-related tasks with the proposed capital structure, in the first instance outside the 42TP PT Opinion of of 20 January 2004 (/2004/1) Euro, but also in the event of accession. The Commission therefore considers the proposals to meet the requirements of financial independence in the . Another aspect of EU law is that there is a general principle that countries should not diverge from the norm in the EU when making changes to legislation. With regard to the size of capital, the international comparison shows that the Riksbank is well capitalised, and the proposals cannot be deemed to cause divergence in respect of this. To a certain extent the proposal to neutralise the currency risk in the foreign exchange reserve is unconventional. However, the Commission does not consider this to be divergence. As we have already discussed, currency interventions in modern financial markets are to a large extent carried out in derivatives. Because the Riksbank will continue to have a large balance sheet and substantial financial strength, there is no obstacle to it making currency interventions if this was required. The Commission cannot see that the proposal would diverge from the norm in the EU. To summarise, the Commission considers that its proposal fulfils the requirements of EU law on the financial independence of central banks. Overall picture of the Riksbanks balance sheet in the two alternatives Figure 11 contains an illustration of how the Riksbanks balance sheet will look in the two alternatives. The Riksbanks balance sheet in the two alternatives. "Position in SEK assets" This Chapter deals with issues of how the transition from the current balance sheet structure to one of the proposed structures will take place. Firstly there are the consequences of the extraordinary dividend of approximately billion in the Commissions alternative 1. Secondly there are the consequences of the transition from an open currency position in the foreign exchange reserve to a matched one.