sou · GVB351 · 2008-01-01 00:00:00 — provide emergency liquidity assistance. This is a task that central banks have long held, and one that most central banks are considered to hold.TPF FPT 21TP PT Emergency liquidity assistance can be provided to financial firms other than banks, but as in practice it is primarily banks that come into consideration, the issue will be discussed in terms of banks. 22TP PT For a detailed description of the Riksbanks role as a lender of last resort, see the article The Riksbanks role as Lender of Last Resort in the Riksbank´s Financial Stability Report 2003/2. The Riksbank Act is formulated so that the Riksbank may provide credit risk on special terms with the aim of supporting liquidity to banks and certain other financial firms in exceptional circumstances. The aim of the condition exceptional circumstances is that the Riksbank may only grant emergency liquidity assistance if this is required to protect the stability of the financial system. That emergency liquidity assistance must only be granted with the aim of supporting liquidity shows that the Riksbank may only grant credit to banks with liquidity problems not banks with solvency problems, i.e. banks that have made substantial losses and whose own capital therefore risks being consumed. The reason that the Riksbank should not give liquidity support to banks with solvency problems is justified by arguments of economic theory (moral hazard) and also based on a more constitutional perspective. The argument related to moral hazard goes that banks that can expect financial support may be inclined to take greater risks than if they could not expect any support. The possibility of emergency liquidity assistance threatens to lead to increased risk-taking in the banking sector. Limiting support to cases of liquidity and not solvency also limits the threat of increased risk taking. The constitutional argument is that financial support to a bank with solvency problems risks leading to continuing and persistent losses for central government, thus de facto central government expenditure. Such expenditure must be decided on by Parliament within the framework of the central government budget, and not by a public authority decision. Access to financial support over and above the central government budget also has the same moral hazard issue as does emergency liquidity assistance, and should therefore be limited as far as possible. This allocation of roles between the Riksbank and the political system was maintained throughout the banking crisis at the beginning of the 1990s. Central government was responsible for support to banks with solvency problems using support measures targeted at individual banks and through the general government guarantee, while the Riksbank made decisions regarding emergency liquidity assistance. Credit risk arises when the Riksbank grants credit. However, because the Riksbank may only grant credit to banks with liquidity problems this credit risk is limited. Only if the bank cannot repay the loan, not even in the longer term, and the collateral taken by the Riksbank for the credit proves insufficient, does a credit loss arise for the Riksbank. Consequently, this happens only in the case of solvency problems and not in the case of pure liquidity problems. This means that the risk of credit losses is extremely limited. The problem is, however, that it is difficult at the time to decide whether a bank only has liquidity problems or if there are solvency problems as well. The threat of liquidity problems generally arises in periods of general disquiet in the market and most often in conjunction with the banks normal lenders questioning its credit worthiness and therefore withdrawing finance. In such a situation, it is difficult for the Riksbank to make a qualified assessment of the banks credit worthiness, especially because the need for emergency liquidity assistance often arises at very short notice and a decision must be taken by the Riksbank within a few days or, in the worst case scenario, within a few hours. Because of this the risk is always there that the Riksbank, after all, will grant emergency liquidity assistance to banks which afterwards prove to have solvency problems rather than pure liquidity problems. Accordingly, the Riksbank may take credit risks that could lead to losses, despite the credit only being granted in circumstances where the problem can be considered to be purely one of liquidity. The Riksbank Act also specifies that credit is granted on special terms, i.e. credit is different to that granted within the framework of the Riksbanks ordinary activities related to monetary policy market operations or credit granted within the framework of participation in the system. Because banks can borrow from the Riksbank at the lending rate (normally 75 points above the repo rate) applicable within the framework of practical monetary policy, as long as they provide satisfactory collateral, it is mainly banks that do not have sufficient collateral to provide that need emergency liquidity assistance. In practice the special terms mean that emergency liquidity assistance can be granted against collateral weaker than would normally be acceptable to the Riksbank, or without collateral at all. It is also possible for emergency liquidity assistance to be granted on special terms representing a lower interest rate than that indicated by the monetary policy framework. This took place during the defence of the krona in , when Swedish banks obtained emergency liquidity assistance at a subsidised interest rate in order to minimise the impact of the 500 percent key interest rate. In a monetary policy regime with a floating exchange rate and target inflation rate it is difficult to see any reason for granting emergency liquidity assistance at a subsidised interest rate. The collateral normally accepted by the Riksbank is government bonds and other fixed- income instruments with high credit worthiness. In most cases these securities are also eligible for refinancing on the market, which implies that only when this type of security is no longer available will emergency liquidity assistance by needed by a bank. Even if because of this the Riksbank cannot obtain normal collateral for its lending, there is the possibility of obtaining other collateral, which per se is not as credit worthy. However, the Riksbank can compensate for this by requiring a greater haircut in order to compensate for the risk that the collateral loses value in relation to the lending date. However, the Riksbank can compensate for this by requiring a greater haircut in order to compensate for the risk that the collateral loses value in relation to the lending date. By doing this the Riksbank can limit its risk of loss to a certain extent. It is very difficult to estimate both the size and probability of losses which the Riksbank could suffer in conjunction with the provision of emergency liquidity assistance. In assessing the risk of loss it is relevant to discuss how large an exposure the Riksbank should have to a bank, and also the proportion of this exposure that risks being lost if the bank suspends payments. With regard to the latter issue it is unlikely that the Riksbank would lose a large proportion of the loan. This is partly because the Riksbank is able to obtain collateral for the loan, and partly because it is in the first instance large, well- diversified banks which need emergency liquidity assistance where the exposure is very large. The latter is because this is the nature of the very large banks in , and also because were emergency liquidity assistance granted to smaller banks the exposure would be small. There is experience of bank bankruptcies in , but statistics from the show that recovery from bank bankruptcies is often high. A study of over 1,500 bank bankruptcies in the between 1984 – 2002 showed that the average degree of recovery was 79 percent.TPF FPT It is reasonable to expect that the degree of recovery is greater for large banks. For the 38 banks considered large (more than billion in assets) the degree of recovery was 87 percent. These banks were still small in relation to the large Swedish banks which have average assets of over billion. Against this background is seems improbable that the Riksbank would lose more than 10 percent of its exposure if a bank defaulted on a large amount of emergency liquidity assistance. Exposure is difficult to assess. Each of the major banks balance sheet totals is between and 2,500 billion. Even a loss of financing making up a small portion of the balance sheet leads to a need for financing amounting to tens or hundreds of billions. However, the major banks manage their liquidity risk actively to avoid being exposed to a situation in which lenders no longer wish to finance the bank. They issue securities in order to avoid short-tem financing and try to match incoming and outgoing cash flows. An exception is deposits, which the banks consider relatively stable, even though they are contractually accessible at short notice. This assessment is based in part on a large proportion being underwritten by the deposit guarantee and that the account holders do not therefore need to withdraw their funds even if the banks solvency is in question, and in part based on experience from the banking crisis. Even before the general bank guarantee was given, there were few savers who withdrew their funds despite the financial position of the banks being openly questioned. Their liquidity management means that the banks should not suddenly experience extremely large liquidity needs. It is not possible to say exactly how large the exposures can be, but it seems improbable that the Riksbank would have to finance hundreds of billions of krona at very short notice. If the Riksbank were to lend billion and had a risk of loss of 10 percent this would mean a capital need of billion. Bearing in mind that the probability of the Riksbank providing emergency liquidity assistance to banks with solvency problems is so small, and there is still potential for obtaining collateral, the Committee believes that there are no grounds to imagine final losses greater than approximately billion. It is also possible to make comparisons with central government support for the banking sector in the 1990s banking crisis, even if this was support provided by central government and not the Riksbank. The total support provided at that time, with the exception of the general bank guarantee, has been calculated as approximately billion and the short-term cost of that support is estimated to be approximately billion.TPF FPT The fact that this support was provided to banks with significant solvency problems should be taken into account, as should the fact that this support was not given in the form of normal credit but as share capital or variations on this. In addition, this support has not proved to be a cost in the long-term because the increase in value of central governments share holdings in the relevant banks has been great. 23TP PT Resolution Costs and the Business Cycle, , FDIC Working Paper 2004-01, 2004. 24TP PT Jennergren, P. & , B., (1997), with Them (report to Parliaments Auditors). It is difficult to draw any far-reaching parallels from these values. However, the Commissions judgement is that the risk of loss of billion discussed above does not seem too low, considering that we are talking about providing credit to banks that should not have solvency problems and where there is a potential for collateral. In this context is should also be emphasised that the Riksbank did not incur any losses during the banking crisis and that the established division of responsibilities between central government and the Riksbank, under which central government provides support for solvency problems and the Riksbank for liquidity problems, was maintained throughout the crisis. Risk in the management of the foreign exchange reserve The Riksbanks assets consist mainly of the foreign exchange reserve, i.e. investments in interest-bearing securities in foreign currency and gold. The financial risk facing the Riksbank is associated with these assets. The risk associated with these financial assets can be divided into interest rate risk, i.e. the risk that the general interest rate levels change and mean that the securities fall in value, and currency risk, which is the risk that the foreign currencies in which the securities are denominated, change in value in relation to the Swedish krona. The risk in the foreign exchange reserve results in a relatively large variation in yield for the Riksbank from year to year (see Figure 7). The Riksbank has a relatively stable net interest income and stable costs but the net income from financial transactions varies greatly. It is under this income item that value changes in assets are reported. It is above all exchange rate fluctuations that give rise to the large variation. Profit and loss account items for the Riksbank 1997-2006 Net result of financial transactions This year's income Risk in the foreign exchange reserve is measured by the Riksbank using the prevalent measure of risk, Value-at-RiskTPF FPT. This measure shows how much the Riksbank risks losing with a specific probability over a particular time period. The probability level used here is 1 percent. Calculated for an annual time horizon the VaR value is approximately billion, i.e. given the current composition of the foreign exchange reserve, the Riksbank risks losing billion or more with a 1 percent probability over one year. This indicates that currently the foreign exchange reserve entails a significant financial risk for the Riksbank and whether this is justified is debatable. As stated in Chapter 4, due to the current application of the Riksbank Act, the size of the foreign exchange reserve is a result of the size of the liabilities side of the Riksbanks balance sheet, not the result of an assessment of how large a foreign exchange reserve the Riksbank needs based on an analysis of foreign exchange policy requirements. Thus, there is good reason to discuss certain basic issues related to the foreign exchange reserve. The first is what, on the whole, is needed from a foreign exchange reserve. The second is whether there are grounds to eliminate currency risk in the foreign exchange reserve. This could be achieved by matching the foreign exchange reserve in such a way that it was financed by borrowing in foreign currency or by hedging the currency risk on derivative markets. 25TP PT Value-at-Risk is a measure which, based on earlier price movements in financial assets, calculates how much an asset manager risks losing in SEK, with a given probability level. One of the advantages of VaR is that it calculates a risk value in the form of an amount, which means that it can be used to compare risk between different types of asset in an investment portfolio, for example fixed-income instruments and own capital. third issue is how large should the foreign exchange reserve be. These issues are discussed below. The need for a foreign exchange reserve Judgement of the Commission: The need for a foreign exchange reserve appears to be limited given the present foreign exchange rate regime with a floating exchange rate. The fundamental purpose of a foreign exchange reserve is to give a central bank the possibility of acting on the foreign exchange market to influence the national exchange rate. By selling foreign currency and buying the domestic currency on the market, the central bank can try to reinforce the exchange rate, or to weaken it by acting in the opposite way. The need to act on the foreign exchange market exists primarily if foreign exchange policy has the objective of a fixed exchange rate. At present the monetary policy objective of the Riksbank is a target inflation rate. The exchange rate regime is not determined by the Riksbank but by the government. The government has decided that the Swedish krona should float and so there is no exchange rate target. While the exchange rate does affect monetary policy by influencing inflationary pressure in the economy, it is only one of many economic factors which have such an effect. So the exchange rate does not have a unique role in the Riksbanks monetary policy. The Riksbank has intervened on the foreign exchange market on a few occasions after the switch to a floating exchange rate in 1992. The last time was in 2001 when the Swedish krona weakened relatively sharply and currency interventions were made to counteract this decline. At the time the intervention was seen as a supplement to the normal focus of monetary policy, which is to determine short-term rates. The analytical basis of the Riksbanks monetary policy, carried out to achieve a target inflation rate with a floating exchange rate, does not identify a need to intervene on the foreign exchange market to affect the exchange rate. There can be grounds to intervene in the foreign exchange market, mainly to signal the direction of monetary policyTPF FPT. Nevertheless, the Riksbank should not need to intervene in the foreign exchange market to the extent that it risks major losses. So it does not appear that a foreign exchange reserve can be justified when a floating exchange rate is being operated. However, a foreign exchange reserve may be required in readiness for a switch to a fixed exchange rate. Today a fixed exchange rate appears remote from a Swedish viewpoint. There is a broad political consensus that a monetary policy directed towards inflation targeting with a floating exchange rate has been an effective component of economic policy over the past decade. Swedish monetary policy has received good marks in several international assessments, the latest in an evaluation carried out by researchers on behalf of the 26TP PT Heikensten,T L. & , A. (2002), TheH Riksbanks foreign exchange interventions - preparation, decision and communication, 2002/1 inflation rates with floating exchange rates are being used by an increasing number of central banks throughout the world, while at the same time the wisdom of using a fixed exchange rate as a monetary policy regime is being increasingly questioned. It is still mainly used in emerging countries and developing economies. is the only established industrialised economy which applies a fixed exchange rate (if one accepts that countries participating in a currency union or smaller countries which use another countrys currency cannot be considered to have a fixed exchange rate). In view of this it appears improbable that will switch to a fixed exchange rate in the foreseeable future. is part of the second stage of the EMU but not the third stage. One of the criteria for participation in the third stage is that the national currency must have been stable against the Euro for a certain amount of time before accession to the currency union. If possible this stability is created through participation in the exchange rate policy cooperation, in which a national currency must not deviate outside a set band around the Euro. Participation in this cooperation means that the target for the exchange rate is fixed, and that consequently there is no need to make currency interventions. However, in all probability accession into would occur when a political decision on participation in the Euro had already been taken, this means that the time period for cooperation should be relatively short. Similarly, it should be relatively unlikely that the exchange rate is put to the test during this period in such a way that it would be necessary to intervene extensively in the foreign exchange market. In the event of Euro membership the ECB requires the central bank to maintain a foreign exchange reserve. However, this does not mean that a foreign exchange reserve is necessary as long as is outside the Euro, it is fully possible to invest in currency assets prior to membership. But it should be noted that membership of System of Central Banks (ESCB), means that as a member of this organisation has undertaken to have sufficient financial resources to be able to discharge ESCB-related tasks. As an example Articles 29 and 30.4 of its statutes state that a member must be prepared to contribute capital and transfer currency assets to the ECB, and in Article 33 the member undertakes to contribute in the event of losses by the ECB. The extent of this is not set. To summarise, the need for a large foreign exchange reserve appears remote for the Riksbank. However, our analysis of this has not been so comprehensive that it can be completely dismissed. The purpose of the discussion in this section has been to give some perspective of the risk associated with the foreign exchange reserve. 27TP PT Giavazzi, F. & Mishkin, F. (2006), An Evaluation of Swedish Monetary Policy between 1995 and 2005, 2006/07:RFR1. Should the foreign exchange reserve carry currency risk or should this risk be neutralised? Judgement of the Commission: The Riksbank should neutralise currency risk in its management of the foreign exchange reserve by matching current currency risk. Matching can be achieved through currency lending or positions in derivatives, but this choice does not affect the capital need. As we demonstrated in the previous section the current foreign exchange reserve entails a significant foreign exchange rate risk for the Riksbank, so there are grounds to discuss both the size of the foreign exchange reserve and the financial risk it entails. Because the need for currency intervention seems relatively limited with a floating exchange rate, the following discussion is founded on circumstances arising from a fixed exchange rate. The Commissions international comparison shows that certain countries choose to have a matched currency position in the foreign exchange reserve, i.e. the currency risk in the foreign exchange reserve has been neutralised. This applies to for example, one of the few industrialised countries that use a fixed exchange rate policy and therefore have an need for a foreign exchange reserve. Matching can be achieved by financing the foreign exchange reserve with borrowing in the same currency as the reserve consists of. Alternatively, the currency risk can be hedged through positions in the derivative market. The Danish central bank applies a combination of these two methods. Neutralising currency risk does not affect the potential to make currency interventions. On the other hand it does affect the central banks income. When the currency position is open, as it is for the Riksbank today, movement in the exchange rate of the Swedish krona means that the income varies from year to year (as shown in Chapter 4). If the currency risk is neutralised, income is only affected by the interest rate risk that exists in the reserve. Todays large variation in income is a drawback, it introduces risk into the Riksbanks balance sheet, risk that must be managed with capital or in other ways. However, it is also important to evaluate what the effects are when the Riksbank actually does make currency interventions. So long as the interventions are successful no substantial negative effect on income should occur. In this case the Riksbank succeeds in influencing the exchange rate getting it close to the target exchange rate so the variation should not be significant. Instead the relevant question is what happens if interventions fail and the exchange rate must be floated. If, as today, the currency position is open, a failed intervention will have the same effect as that arising during the defence of the krona in 1992. When the Riksbank, with the objective of defending the value of the Swedish krona, sells foreign currency and buys large volumes of Swedish krona the result is that the open currency position decreases.