sou · GVB351 · 2008-01-01 00:00:00 — To , Minister for Local Government and Financial Markets On the government decided to appoint a Special Investigator to head a Commission of Inquiry to investigate issues related to the Riksbanks balance sheet structure, capital structure and its profit allocation. The Special Investigator shall submit proposals for the statutory regulation of the principles for allocating the Riksbanks financial result. Director General was appointed Special Investigator. On 30 2006 Chief Economist , Doctor of Economics , Associate Judge of Appeal and Professor were appointed special advisors. Director and Desk Officer were appointed experts. Bachelor of Science (Econ.) was appointed secretary until 12 January 2007. Since then Chief Economist has been secretary. The Commission of Inquiry herewith submits its report (SOU 2007:51) The Riksbanks financial independence. A special opinion has been delivered by the experts and . THE BASIS OF THE RIKSBANKS FINANCIAL INDEPENDENCEUT...................... COMMISSIONS PROPOSALS REGARDING THE CAPITAL STRUCTURE OF THE RIKSBANKUT ........................ COMMISSIONS PROPOSALS REGARDING THE ASSET MANAGEMENT OF THE RIKSBANKUT ....................... STU TATUTORY PROPOSAL FOR THE COMMISSIONS ALTERNATIVE 1UT ............................................................. STU TATUTORY PROPOSAL FOR THE COMMISSIONS ALTERNATIVE 2UT ............................................................. TERMS OF REFERENCE AND WORK OF THE COMMISSIONUT .................................. TERMS OF REFERENCE OF THE COMMISSIONUT ........................................................................ WTU ORK OF THE COMMISSIONUT ....................................................................................................... CTU URRENT SYSTEMUT....................................................................................................................... EUTU CRITICISM OF THE CURRENT RULESUT ....................................................................................... RIKSBANKS OPERATIONAL ACTIVITIESUT............................................................................... TheU Riksbanks tasksUT ............................................................................................................. TheU Riksbanks governanceUT................................................................................................... RIKSBANKS BALANCE SHEETUT.............................................................................................. AUTONOMY AND FINANCIAL INDEPENDENCE OF THE RIKSBANKUT.................... ITU NDEPENDENT CENTRAL BANKS - BACKGROUND AND MOTIVEUT.................................................... RIKSBANKS INDEPENDENCE RELATES PRIMARILY TO ITS TERMS OF REFERENCE AND points on the need for financial independenceUT ........................................................ is unique about financial independence in a central bank?UT......................................... factors for a financially weak central bankUT........................................................ WTU HAT CREATES FINANCIAL INDEPENDENCE?UT.............................................................................. 3TU .4.1.UT TheU ability to generate revenueUT ............................................................................................. 3TU .4.2.UT TheU Riksbanks current operating costsUT ................................................................................ 3TU .4.3.UT TheU risk of major lossesUT......................................................................................................... in the event of lossesUT....................................................................................... need for current operating costsUT............................................................................... IN THE RIKSBANKS OPERATIONSUT ............................................................................... RTU ISK IN THE PROVISION OF EMERGENCY LIQUIDITY ASSISTANCEUT ................................................ RTU ISK IN THE MANAGEMENT OF THE FOREIGN EXCHANGE RESERVEUT ............................................. 4TU .2.1.UT TheU need for a foreign exchange reserveUT .............................................................................. the foreign exchange reserve carry currency risk or should this risk be neutralised?UT large should the foreign exchange reserve be?UT............................................................. RTU EDUCED CURRENCY IN CIRCULATIONUT ....................................................................................... risk in operational activitiesUT....................................................................................... financial risks in asset management.UT .......................................................................... 4TU .4.4.UT ATU summary of the other risksUT................................................................................................. STRUCTURE IN OTHER CENTRAL BANKSUT.......................................................... NTU ATIONAL CENTRAL BANKS BALANCE SHEETSUT.......................................................................... NTU ATIONAL CENTRAL BANKS OWN CAPITALUT................................................................................ RTU EGULATION OF THE CENTRAL BANKS OWN CAPITAL AND PROFIT ALLOCATIONUT ....................... OF ALTERNATIVE CAPITAL STRUCTURESUT........................................ COST OF MAINTAINING CAPITAL IN THE RIKSBANKUT.............................................................. VTU ARIOUS METHODS OF ENSURING THE RIKSBANKS FINANCIAL INDEPENDENCEUT ........................ losses arising from being the lender of last resort be borne by the Riksbank?UT ......... losses arising from foreign exchange interventions be borne by the Riksbank?UT ....... seigniorage accrue to the Riksbank?UT......................................................................... the Riksbank bear other risks?UT .................................................................................. MTU ANAGING LOSSES - RECAPITALISATION RULE OR CAPITALUT ....................................................... HTU OW SHOULD THE RIKSBANKS ASSETS BE INVESTED?UT............................................................... ATU CCOUNTING ISSUESUT .................................................................................................................. TOTAL CAPITAL NEEDUT .......................................................................................................... COMMISSIONS PROPOSALS FOR CAPITAL STRUCTUREUT....................................... ATU LTERNATIVE 1UT .......................................................................................................................... ATU LTERNATIVE 2UT .......................................................................................................................... RIKSBANKS ASSET MANAGEMENTUT...................................................................................... CONCEPT OF PRIMARY CAPITALUT ........................................................................................... EU TREATY AND THE PROPOSALSUT...................................................................................... OF THE RIKSBANKS BALANCE SHEET IN THE TWO ALTERNATIVESUT ............. ETU FFECTS OF THE EXTRAORDINARY DIVIDEND IN ALTERNATIVE 1UT.............................................. ETU FFECTS ON THE FOREIGN EXCHANGE MARKET OF A CHANGE IN THE MANAGEMENT OF THE FOREIGN EXCHANGE RESERVEUT................................................................................................................. 8TU .2.1.UT TheU need for transitional provisionsUT ................................................................................... borrowing on foreign marketsUT.................................................................................. the foreign exchange reserve on derivative marketsUT............................................. 8TU .2.4.UT SaleTU of the foreign exchange reserveUT................................................................................... INVESTOR IN THE FIXED INCOME MARKETUT ................................................... issues of supply and demand in the fixed income marketUT................................... of interest for the Riksbank as an actor in the fixed income marketUT .................... FOR CENTRAL GOVERNMENT FINANCEUT........................................... RIKSBANK´S TRANSFERS TO CENTRAL GOVERNMENTUT........................................................ STU IZE OF CENTRAL GOVERNMENT DEBTUT...................................................................................... EXCHANGE-RATE EXPOSURE OF CENTRAL GOVERNMENT FINANCEUT.................................... ATU LTERNATIVE 1UT ........................................................................................................................ ATU LTERNATIVE 2UT ........................................................................................................................ ATU SSET MANAGEMENTUT ............................................................................................................... COMMISSION DIRECTIVE (DIR. 2006:50)UT..................................................................... While the Riksbank is a government authority, it is different in many respects to other authorities. This is reflected by it being an authority responsible to Parliament; by its operational activities being governed by the Riksbank Act; and that it is a legal entity in its own right with its own assets. The unique position of the Riksbank is because there are economic and political reasons for the central bank having substantial independence. This independence was strengthened with the comprehensive 1999 Riksbank reform, which led to the Riksbank today having statutory grounds for functional, institutional and personal independence. Functional independence is achieved through the statutory target that the Riksbank has for monetary policy. Institutional independence means a prohibition on giving the Riksbank instructions related to monetary policy issues. Personal independence means that members of have long terms of office; are covered by strict rules of disqualification; and have far-reaching protection against dismissal. In addition, there is a need for financial independence. This means that the Riksbank should be able to fund its operational activities and fulfil its obligations, without requiring financial support from central government. Its financial independence is not currently regulated by law, as are the other forms of independence, and the Commission of Inquirys (henceforth the Commission) terms of reference are to propose legislation that guarantees this financial independence. A separate balance sheet is the basis of the Riksbanks financial independence Currently, the Riksbank has a strong financial independence. This is based on the fact that the Riksbank has its own balance sheet, such that the bank receives revenues that more than cover the banks operating costs. These revenues are founded on the Riksbank holding yield bearing assets, while not needing to pay interest on the most important items on the debit side of its balance sheet, currency in circulation and own capital. This Commission defines currency in circulation and own capital as the Riksbanks cost-free capital. The Commission considers that the Riksbanks financial independence should continue to be based on its balance sheet providing a large enough return. Factors other than current operating costs must also be taken into account for this purpose. The Riksbank may incur costs in the form of losses in its operational activities. The risks identified by the Commission are credit risk arising from its task of providing emergency liquidity assistance, and the risk of losses in its asset management. There are certain other risks, but these are relatively small. The cost-free capital needs to be adequate to cover operating costs even after the Riksbank has suffered such losses. The Riksbank is allowed to act as lender of last resort, providing emergency liquidity assistance () if this is required to protect the stability of the financial system, but only to banks which have liquidity problems and no solvency problems. These credits can give rise to losses. Both the extent and probability of these losses are very difficult to assess. The Riksbank holds most of its assets in the foreign exchange reserve, comprising investments in foreign currency (and gold). The mismatch between the Riksbanks assets in foreign currency and the balance sheets debit side in Swedish krona, generates financial risk, in that fluctuations in the exchange rate of the Swedish krona affect the value of the assets but not the value of the liabilities. The foreign exchange reserve exists because the Riksbank may need to make foreign exchange interventions. The need for a foreign exchange reserve for this purpose is small given the current foreign exchange rate regime with its floating exchange rate. The probability that will, in the foreseeable future, switch to a fixed exchange rate, where foreign exchange interventions would have a greater likelihood, seems remote today. The risk of losses arising from foreign exchange interventions could mainly be associated with interventions carried out over a short period of time prior to entry into the Euro. Foreign exchange interventions can be carried out without the Riksbank holding a large foreign exchange reserve; the reserve that results in todays open currency position given the structure of its balance sheet. Given this, and the limited need for foreign exchange interventions; and the substantial financial risk arising from the open currency position; this Commission believes that the Riksbank should neutralise currency risk in the foreign exchange reserve. This would reduce the Riksbanks need for cost-free capital. As it does not affect capital need, the Commission takes no view on whether neutralisation should be achieved by currency borrowing, positions in derivatives or by reducing the size of the foreign exchange reserve. The Commissions proposals regarding the capital structure of the Riksbank There are different ways of organising a central banks operational activities and the structure of its balance sheet varies from country to country. No clear-cut conclusions can be drawn from the Commissions international comparison as far as is concerned. The cost of maintaining capital in the Riksbank is so low that there is no point in being restrictive about it. At the same time the Riksbank should not have more capital than necessary for its financial independence. It would be a more effective use of capital for central government to undertake to restore a certain level of lost capital, than for the Riksbank to maintain enough capital to cover even the most unlikely losses However, the Commission chooses not to propose a statutory recapitalisation rule, because the cost of maintaining capital in the Riksbank is low, and such a rule could, in principle, be suspect. The Commissions analysis is based on estimating the size of the Riksbanks operating costs and the potential unforeseen costs related to certain risks, and on making an assessment of how much cost-free capital the Riksbank needs in order to cover these costs. This cost-free capital can consist of own capital and of currency in circulation. Currency in circulation gives rise to seigniorage, the earnings that are a consequence of currency in circulation not receiving interest, but can be invested in yield bearing assets. As a basis for revenue, own capital and currency in circulation are equivalent, however they do have somewhat different properties in other regards. These differences can influence how the Riksbanks capital structure is viewed. Thus analysing the similarities and differences has been one of the Commissions main tasks. One of the differences is that currency in circulation is influenced by external factors, outside the Riksbanks control, because its size is determined by the publics demand for banknotes and coins. So currency in circulation can display considerable variation. When the Riksbanks cost-free capital consists of currency in circulation, the risk of reduced demand for cash must be taken into account. This is not the case if the cost-free capital consists of own capital. Currency in circulation is booked as a liability item in the balance sheet. However, the book value of currency in circulation is not comparable to a liability of a corresponding value, as currency in circulation is not interest-bearing. Even if the Riksbanks own capital was completely expended, and the value of the assets was therefore lower than the book value of currency in circulation, i.e. negative own capital, the Riksbank would still have long-term survivability. As long as the value of the discounted cash flows generated by the Riksbanks assets is greater than the discounted value of future costs, the Riksbank has a positive net worth. This net worth can be positive even when own capital is negative. The Commission has also evaluated alternative methods of structuring the Riksbanks balance sheet. For example whether the Riksbank should hold the foreign exchange reserve and whether currency in circulation should make up part of the balance sheet. The international comparison carried out by the Commission shows that there are alternative ways of organising a national central bank (NCB) and its balance sheet. However, the international examples have not resulted in the Commission proposing any changes along these lines. The Commissions analysis of the properties of currency in circulation shows that in most regards it is equivalent to own capital as a source of funding for the Riksbank, but that there are still some problems in relying on it. This has caused the Commission to submit two alternative proposals for capital structure; one in which currency in circulation is utilised as cost-free capital and the other in which only own capital is utilised. The choice between the two alternative proposals is therefore largely a matter of whether currency in circulation can be seen as an adequate alternative to own capital. Alternative 1 means that the Riksbanks right to issue banknotes and coins is used to fund its operational activities. Currency in circulation constitutes a cost-free capital which more than covers the needs identified by the Commission. According to the Commissions calculations the Riksbank needs a cost-free capital of between and 74 billion. Today, currency in circulation is approximately billion. Of course, the basis of this assessment could change were the volume of currency in circulation to change. 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. Despite currency in circulation being sufficient cost-free funding for the Riksbanks operational activities, the Commission believes that it should also be provided with a relatively small amount of own capital. Own capital in its traditional sense 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 technical advantages with such a system. The Commissions proposal is that own capital should be made up of a primary capital, regulated by law, and initially amounting to billion. This proposal would mean that approximately billion could be transferred from the Riksbank to central government. The size of primary capital, which must be adjusted upwards with changes in the consumer price index, will form the basis of calculating profit distribution from the Riksbank. If the primary capital is less than the legally necessary amount, profit distribution may not take place. Otherwise, the entire profit shall be distributed to central government. Alternative 2 has as its basis 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 guarantees the Riksbanks financial independence. This alternative also means that currency in circulation is considered a debt to central government for which the Riksbank pays interest. This interest should correspond to a short-term risk-free interest rate in Swedish krona, e.g. the repo rate. In this alternative the cost of production for banknotes and coins, currently borne by the Riksbank, should be deducted from the interest it pays to central government. Thus the capital need for current costs is lower in this alternative, this is because in alternative 1 there must also be assets providing a return to fund the costs of production for banknotes and coins. In this alternative the Riksbanks total need for cost-free funding must be covered by own capital. This Commission estimates the total capital needs to be – 63 billion. So this capital need is relatively close to the level of own capital that the Riksbank has today (billion). In this alternative the proposal is based on the Riksbank having a level of own capital of billion. With regards profit distribution, the same principle as in alternative 1 should apply, i.e. all profit augmenting own capital above the target level of billion should be distributed. As in alternative 1 this level should be index linked and written up in line with inflation. In this alternative the balance sheet total will be about the same as it is today. If the Riksbank, in accordance with the proposal in alternative 1 distributes about billion to central government, it will need to sell a corresponding value of currency assets. In order for this to have a neutral effect on the exchange rate of the Swedish krona, the distribution will need to take place over a long period of time, or in some other way that will not affect the exchange rate. From a central government finance perspective both proposals are considered equal. The Commissions proposals regarding the asset management of the Riksbank With the neutralised foreign exchange reserve advocated by the Commission, the Riksbank will have different assets to administer than todays foreign currency assets. The Commission does not believe that these assets should be managed in such a way that new financial risks arise, leading to new capital needs. A certain risk tolerance would probably lead to a better return, benefiting central government and, by extension, taxpayers. It is very important for the terms of reference of the Commission (proposing rules and a capital which guarantees the Riksbanks financial independence) that the Riksbank can fulfil its obligations with the capital it has, even in improbable situations. On this basis the Commission believes that the Riksbanks assets should be invested at low risk. So the Commission proposes that the currency risk in the Riksbanks foreign exchange reserve be neutralised. Regardless of how neutralisation is carried out (for example by selling currency assets or using derivative instruments) neutralisation will mean an increased demand for Swedish krona. This must occur gradually if these operations are not to have the same effect of strengthening the Swedish krona as a foreign exchange intervention. The Commission believes that this transition could last several years. The proposed statutory protection for the Riksbanks capital structure can still be introduced before the transition has been carried out. The proposed legislation is not dependent on the full neutralisation of the currency risk.