sou · GVB351 · 2008-01-01 00:00:00 — This is in addition to the capital in the revaluation account. entire profit from the issuing department is paid to central government, and this is regulated by law. The size of the banking operations own capital is not regulated. Profit allocation is regulated by law in that it is stipulated that 25 percent of the profit from banking operations shall be paid to central government, unless the parties agree on another distribution. Currently the distribution is 50 percent. own capital is regulated by law and has not changed since 1955. Should the bank make a loss, own capital must be built up again by a share of profits being allocated to own capital until it has built up to CDN 30 million. All of the banks profit goes to the Canadian central government. It should also be noted that the bank's minimal own funds are based on the banks current balance sheet structure largely guaranteeing a profit every year. On the debit side is almost only currency in circulation - a non-interest bearing debt. The asset side consists almost completely of Canadian government bonds – a risk-free but interest-bearing asset. of 's own capital is not regulated by law or in any other way. In a somewhat simplified and abridged form the law states that the government has the right to determine how much of the notional surplus income that must be paid to central government and how much should go back as reserves in the balance sheet. Notional surplus income is defined as the years realised revenues reduced by the accumulated unrealised losses. The difference between the actual and budgeted operating income is added (the budget is set by the government for five years at a time in a funding agreement). As the size of the allocation is determined the government must take account of the banks capital need, the opinion of the banks , and other relevant circumstances. Consideration of alternative capital structures 6.1.The cost of maintaining capital in the Riksbank Judgement of the Commission: The cost of maintaining capital in the Riksbank is so low that there is no point in being highly restrictive about it. Nevertheless, the Riksbank should not have more capital than necessary for its financial independence. In the discussion carried out by the Commission so far, there has been an implicit assumption that the Riksbank should not have more capital than is necessary. In the directives this is formulated as there is no reason for the Riksbank to be overcapitalised. The Commissions discussion about the risks to which the Riksbank is exposed has shown that it is difficult to determine the probability of the risks materialising and the size of potential that losses. This means that it is difficult to establish an exact amount for the amount of capital required. So there are grounds for looking at the cost of maintaining capital in the Riksbank. The Commission needs to balance ensuring that in all circumstances the Riksbank will have adequate capital to fund its current costs against not maintaining capital in the Riksbank which could represent an unnecessary cost (or risk) for central government. The extent to which capital in the Riksbank represents a cost to central government is debatable. One way of looking at this is to see what would happen if a certain amount of capital was paid by the Riksbank to central government. An equivalent amount of central government debt could be repaid and central government interest costs would be reduced. If the Riksbank can administer its asset base to achieve a return that exceeds the interest costs of the Debt Office for central government debt, there would be no direct cost for maintaining capital. A higher expected return can be achieved by accepting some level of risk, but there is also a risk that the return will be lower. Whether it is reasonable for the Riksbank to take a higher financial risk in order to achieve higher expected returns is discussed in Section 6.5. To make a relevant comparison of the cost of maintaining capital we should look at what the cost would be if the Riksbank took the same risk as that taken by the Debt Office in its debt administration. This would be the same as the Riksbank maintaining an asset portfolio entirely matched with the central government debt. In this case the cost consists entirely of the transaction expenses of maintaining a portfolio of Swedish government securities or the equivalent interest rate positions. It would not be meaningful to estimate these transaction expenses in more detail. Firstly, they depend on how the Debt Office funding costs are matched, for example whether this is done using securities trading and if so what intensity of transactions would be required. Secondly, they depend on how large the volumes would need to be, because many costs are fixed and the economies of scale are large. However, it is clear that the transaction expenses for this sort of administration are low. order of magnitude, a portfolio of billion with a transaction expense of one basis point would result in a cost of million. The transaction expense may very well be higher or lower but they do not constitute large amounts. One proviso for the discussion thus far has been that central government finances are good, just as they are today. The current size of the Riksbanks own capital amounts to about 5 percent of the central government debt. Although this is not a large proportion of the borrowing, the size of the borrowing requirement can affect the cost of borrowing. Such a situation with central government finance under pressure arose in the middle of the 1990s. In such a situation, the cost for central government of maintaining capital in the Riksbank could become significantly greater. So there could be a cost of maintaining capital in the Riksbank in a situation where the borrowing opportunities are more limited, or borrowing more expensive, due to increased government borrowing. While this situation seems remote now, it is still worth taking into consideration. In addition to this there are national objectives for central government budget expenditure, public sector savings and the consolidated gross debt of the public sector resulting from the convergence criteria of Euro participation. Currently these do not suggest any reason for reducing borrowing by decreasing the Riksbanks own capital but this could change given other circumstances. Another way of looking at the situation is from a political perspective. In most cases central government chooses not to transfer capital to particular sectors of central government unless there are special grounds to do this. It would be possible to fund many operations by providing them with capital to administer and letting them live off the returns. But normally Parliament decides on annual funding of the operation through appropriation. This means that the preparation of the central government budget allows an annual review of funding requirements and, through various governance mechanisms, ensures that the central government operations are governed in accordance with political objectives. In those cases where central government allocates funds for administration the operations often have a reason to create a reserve pending losses or an increase in costs. are a good example. Another is fund for paying out money from the deposit guarantee. However, this example is linked to the advance collection of premiums to cover specific obligations, and these premiums are kept separate from the treasury in order to emphasise the existence of a latent obligation. So no real comparison can be made with the operational activities of the Riksbank. In the judgement of the Commission, the cost of maintaining capital in the Riksbank is so low that there is no reason to be very restrictive in allowing the Riksbank to maintain capital. At the same time there is a cost, and capital should not be provided over and above what is considered necessary with regard to the Riksbanks earnings requirements and ability to handle losses within realistic probability levels. Various methods of ensuring the Riksbanks financial independence The Commission has stated that there are different methods of handling potential losses by the Riksbank. One is to give the bank a cost-free capital large enough to cover probable losses. The other is a recapitalisation rule which would mean that central government would provide capital if losses become too large. The difference between these two alternatives is developed in Section 6.3. However, there are also other ways of handling losses. These consist of variations on the responsibility for the risk of losses being removed from the Riksbank in such a way that the economic risk of losses is borne directly by the central government budget rather than the Riksbank. The conditions and suitability of such alternatives are discussed in the following for each of the significant risks discussed in Chapter 6. Should losses arising from being the lender of last resort be borne by the Riksbank? Judgement of the Commission: In light of the current division of roles between central government and the Riksbank, and current practice in emergency liquidity assistance management, the Riksbank should be prepared to bear losses and should have cost-free funding in order to manage this. In Section 4.1 we discussed the Riksbanks role as a lender of last resort, the probability of losses resulting from this and the size of losses which could arise. This discussion established that the probability of losses is low, mainly because the Riksbank may only give emergency liquidity assistance if a bank is having liquidity problems and that these are not caused by a lack of solvency. At the same time, the likelihood of short time frame in which decisions about emergency liquidity assistance need to be taken, and the difficulty in assessing a banks solvency, mean that there is a risk that emergency liquidity assistance is provided to a bank which later also proves to have solvency problems. One reason that the Riksbank should not bear these losses is the division of roles in the event of a crisis in the financial system. In line with this, the Riksbank is responsible for liquidity assistance to solvent banks, while any financial support to banks which have solvency problems comes from the central government budget, and accordingly must be decided on by Parliament. If emergency liquidity assistance provided by the Riksbank proves to have been given to a bank with solvency problems, this means that the Riksbank really should not have provided the assistance in the first place, and assistance should have provided from the central government budget (on condition that it was needed to protect the stability of the financial system). Consequently it would not be unreasonable if losses incurred by the Riksbank in such a situation were reimbursed by central government. On the other hand, it does seem unreasonable that the Riksbank does not bear the economic consequences of decisions that can be seen as wrong and central government is presented with a fait accompli. It is also the case that the Riksbank would have less incentive to take decisions which would reduce costs for central government. This concerns both the inclination to take decisions about emergency liquidity assistance, and the extent to which the risk of losses is limited by risk reducing measures once emergency liquidity assistance has been granted. With regard to the inclination to take positive decisions on granting emergency liquidity assistance the Commission considers it unlikely that this incentive effect would be significant. It is clear that the Riksbank may not provide emergency liquidity assistance to banks with solvency problems and it will be very clear afterwards if this has been the case. In such cases the Riksbanks decision-makers will be subjected to distinct criticism, and it would appear improbable that the question of who bears the losses would influence these decision-makers other than marginally in this situation. This assessment is reinforced by the fact that the Riksbanks management does not have any financial motives to differentiate between money belonging to the bank and that belonging to central government. The circumstances are somewhat different in relation to risk reducing measures, predominantly the type of collateral which the Riksbank requires in order to grant emergency liquidity assistance. There is a large risk that the securities that a bank in a crisis can provide as collateral will not suffice. The Riksbank may need to accept more unusual collateral, for example loan portfolios. To be able to accept this type of collateral, practical and legal preparations must be in place. In this case the Riksbank must prepare itself thoroughly for a highly unlikely event, which is not necessarily an obvious priority. It therefore appears more likely that whoever bears any losses can affect the extent to which the Riksbank invests in this sort of preparedness. Possibly the division of roles between central government and the Riksbank (that central government is responsible for support to banks with solvency problems and the Riksbank for pure liquidity assistance) may also be clarified in the future. If the proposals related to the public administration of banks in distressTPF FPT, submitted by the and currently being drafted by the Government Offices, are introduced, this division of roles will in all likelihood be even clearer. The issue of division of roles between central government and the central bank is also one being discussed in relation to the supervision of the banking system in EU home and host member states. However, in the view of the Commission, there is currently no reason to advocate a situation in which losses from emergency liquidity assistance are immediately taken on by central government. It is more suitable for the Riksbank to bear the losses, managing them with a capital buffer which protects its financial independence. 40TP PT Public administration of banks in distress, SOU 2000:66. Should losses arising from foreign exchange interventions be borne by the Riksbank? Judgement of the Commission: Because there is only a limited need for a large foreign exchange reserve, and because its financial risks should be neutralised, there is currently no reason to propose a change of responsibilities regarding the losses related to foreign exchange interventions. The Riksbank should continue to be liable for these. As discussed in Chapter 4, the Riksbank generally only needs to intervene in the foreign exchange market if the foreign exchange policy objective is a fixed exchange rate. If there is a floating exchange rate, reasons for intervention are limited while if interventions are made in spite of this, the risk of losses should also be limited. Because it is the government and not the Riksbank that determines the exchange rate regime, even if the Riksbank determines the actual fixing rate, there would be a certain logic if losses due to currency interventions, which would be more likely to arise in defending a fixed exchange rate, were borne by central government. One argument that reinforces this logic is that it is predominantly the government that can create the conditions for a stable fixed exchange rate. Fiscal policy is one of the most important means for achieving this, and that lies in the hands of Parliament and the government. The Riksbank risks being forced to defend a fixed exchange rate which it has opportunity to influence, and bear losses due to a mismanaged economic policy. It should also be noted that the international comparison shows two countries which actually do manage their foreign exchange reserve in this way – and the . There, the foreign exchange reserve is kept separate from the central bank and its results do not affect the central banks balance sheet. On the other hand, the central banks do participate in the administration of the foreign exchange reserve. At the same time it should be noted that one of the requirements of membership in the ESCB is that it is the task of the countrys central bank to hold and manage the member states official foreign exchange reserve. Even if, in the view of the Commission, there is reason to consider moving the foreign exchange reserve out of the Riksbanks balance sheet and instead report it on central governments balance sheet, this would cause both legal and administrative problems. At the same time, as was stated in Chapter 4, the necessity for a substantial foreign exchange reserve to make currency interventions is debatable. It is also unlikely that a fixed exchange rate will be introduced in the foreseeable future. As the need for a capital buffer for this purpose is relatively low, the Commission does not consider such a change justified. Should seigniorage accrue to the Riksbank? Judgement of the Commission: The currency in circulation provides a significant earning capacity through its role as cost-free capital. At the same time the currency in circulation is not capital entirely equivalent to other capital. It should therefore be possible to remove currency in circulation from the Riksbanks balance sheet in order to provide central government with the return it generates directly, as is the case in the . Another way of achieving about the same thing is viewing currency in circulation as loan capital, on which the Riksbank pays interest to central government. The Commission takes no view on whether seigniorage should go to the Riksbank or central government, it submits two alternative proposals which handle this issue in different ways. As we discussed in Chapter 4 there is a risk of a future decrease in currency in circulation which would limit the volume of assets that create the Riksbanks earnings. However, this risk is small, in part because there is a substantial between the size of the currency in circulation and the Riksbank´s need to cover its operating costs in the long-term, and, as discussed in Chapter 4, in part because any decrease in the currency in circulation should happen relatively slowly. So in most cases there would be time for Parliament to adapt to an erosion of this earning capacity. One alternative to having the currency in circulation included in the Riksbanks balance sheet as it is today, would be to separate the item banknotes and coin and consider this as belonging to central government. One advantage of this would be that it would be more transparent to central government what return currency in circulation was actually providing. It is already difficult to explain that the currency in circulation can be considered equivalent to own capital while at the same time it is reported in the same way as a liability in the balance sheet. It is also possible that greater risk could be taken in asset management, achieving a higher expected return than would be appropriate for the Riksbank. One of the countries in the comparison, the , has a currency in circulation which is separated from the central bank, which demonstrates that it is fully possible to do it that way. There the central bank has two balance sheets, one for currency in circulation and the other for banking operations. The disadvantage of separation is that the cost-free capital which exists today in the form of currency in circulation, will not be utilised to guarantee long-term cover for the Riksbanks operating costs. Because of this other cost-free capital would be needed to generate long-term earnings, which would give the Riksbank a greater need for own capital than would otherwise be the case. This solution would also have a number of practical consequences, above all because there is a correlation between the volume of currency in circulation and the bank´s accounts with the Riksbank. The banks continuously deposit and withdraw banknotes and coin from the Riksbank and these transactions are made through the banks accounts. Another consequence would be a greater total capital tie-up in the Riksbank. An obvious alternative would be to consider currency in circulation as loan capital. In taking the view that currency in circulation is loan capital, provided by central government, the Riksbank should pay interest to central government for this form of This would achieve an equivalent economic effect to a separation of the balance sheet. Currency in circulation is also accounted for as a liability item in the current balance sheet. The Commission has weighed up the alternatives and finds that there are advantages and disadvantages in having currency in circulation belong to the Riksbank, giving it the right to seigniorage. The Commission therefore takes no view on this issue, but makes one proposal where the currency in circulation remains on the Riksbanks balance sheet and one where seigniorage should accrues to central government through the mechanism of the Riksbank paying interest to central government for this form of borrowing. This is developed further in one of the Commissions two alternative proposals, see also Section 7. Should the Riksbank bear other risks? Judgement of the Commission: The scope of other risks is limited so there are no grounds to consider transferring the responsibility for potential losses for the Riksbank. By its very nature operational risk is difficult to deflect from the Riksbank because, to a great extent, it cannot be specified. Some operational risk is insurable, but not to the extent that this is worth taking into account in the circumstances. It is difficult to see the need for the gold reserve. However, as discussed in Chapter 4 this cannot be sold immediately. If it is sold in accordance with the international agreements in place, it will reduce in size and the risk associated with it will decrease. Taking into account the significant financial risk it entails, lifting it out of the Riksbanks balance sheet could be considered. However, the Commission chooses not to propose this as it is of no great importance to the Commissions findings. Besides, the gold requires special management for which the Riksbank has the expertise and experience, and the sale of gold is managed in discussions and agreements between central banks, to which other organisations are not necessarily given access. IMF obligations are a result of its choice to participate in the international relationship constituted by the IMF. This is more a political commitment than a financial one, even if it does have financial consequences. There has been a discussion between the government and the Riksbank about how Swedish participation in the IMF should be managed and governed. The Commission sees no reason to go into this matter in detail as the risks entailed in these obligations are relatively small. In the view of the Commission there are no grounds to propose changes either to the responsibility for or the division of the financial consequences of IMF obligations. 6.3.Managing losses - recapitalisation rule or capital Judgement of the Commission: Instead of the Riksbank maintaining capital to cover losses, even unlikely ones, central government could undertake to replace a certain level of capital if such a situation did arise. However, a statutory recapitalisation rule is unnecessary as the cost of maintaining capital in the Riksbank is low and such a rule could lead to issues of principle. There are different ways of managing losses for an organisation. The most obvious alternative for the Commission was for the Riksbank to have adequate cost-free capital to bear its losses in the same way as has been the case up to now. One alternative is that an undertaking be drawn up requiring central government to replace a certain level of capital if the Riksbank suffered losses.