sou · GVB351 · 2008-01-01 00:00:00 — the Riksbank to have such a weak financial position that confidence in it was threatened, the political system would have every reason to attempt to restore confidence by ensuring that its finances were strengthened, otherwise suspicions might be raised that the political system was wavering in its support of the independence of the Riksbank. The Riksbank was given its independent position by the Parliament, and this position should remain, as long as the political system is at heart positive towards fighting inflation in the long-term. And, if it is not, then Parliament can, within the limitations of the , change the terms of reference of the Riksbank by changing the law. 3.4.What creates financial independence? We have already argued that one of the primary conditions for financial independence, which was also a starting point for this Commission, is that the political system cannot remove funds from the Riksbank too easily. This can be achieved by setting out in law the size of the Riksbanks own capital and how profit distribution is to be undertaken. Ensuring that the Riksbank has sufficient cost-free capital to finance its current costs and cover unexpected losses will be developed in more detail in the following sections. 17TP PT This was pointed out by from the Japanese national central bank in a speech on 1 . (2003): Challenges for monetary policy in . The ability to generate revenue Judgement of the Commission: The Riksbanks earning capacity is based on it having cost-free capital which can be invested in assets that provide a return. This cost-free capital can consist of own capital and of currency in circulation. Under the current arrangement, the Riksbanks earning capacity is based on it having assets that can generate a return. Essentially these assets consist of financial assets. As shown in Chapter 2, they largely consist at present of the foreign exchange reserve, i.e. interest-bearing securities in foreign currency and gold. Today the size of the foreign exchange reserve is to a large extent a result of the size of currency in circulation and own capital. It is debatable whether the Riksbank currently has the legal right to invest in assets other than currency assets. There would be scope to invest in other assets were the Riksbank given the express right, in the Riksbank Act, to make an independent evaluation of how large the foreign exchange reserve should be. This would involve other risks and other return opportunities. The liabilities side of the Riksbanks balance sheet mainly consists of currency in circulation and own capital. Neither the liability item constituted by currency in circulation, nor the own capital, cost interest or otherwise have any yield requirement. Both can be seen as contributions made by central government, without the need for anything in return financially than payment of the Riksbanks surplus to central government. the Riksbanks earning capacity consists of being able to invest cost- free capital in assets that generate a return. The magnitude of that earning capacity depends on the size of the cost-free capital and the expected return on the assets. One specific factor which can affect the Riksbanks earning capacity is that currency in circulation is determined by the publics demand for cash. This demand is difficult for the Riksbank to influence, and, as there is a risk that the use of cash will decrease as a result of an increased use of credit cards and other electronic payment methods, there is a risk that the earning capacity of the Riksbank may be weakened in this respect. This is discussed in more detail in Chapter 4. The Riksbanks current operating costs Judgement of the Commission: The Riksbanks current operating costs of about million, and the costs of banknotes and coin of million, are a good starting point for calculating the capital need. One condition for the Riksbank to fulfil its terms of reference is the ability to finance its current operating costs. The current operating costs for 2006 were million. This includes a cost for banknotes and coin of million. Otherwise they consist largely of personnel costs and administrative costs such as IT, office and property administration. The calculations made by the Commission of expected operating costs are based on this level of operating costs, approximately million, with the cost of banknotes and coin excluded. The reason for this is that the Commission does not see it as its task to assess whether this is a reasonable level of costs, i.e. the Commission makes no judgement as to whether the Riksbank is carrying on its activities in an efficient or not. In addition, a major change to the Riksbanks terms of reference and operations could cause the cost level to change. However, the Commission does not consider the changes discussed to be significant enough to adjust the current operating costs. However, the operating costs will have to be adjusted over time with an expected level of inflation of 2 percent, in order to take account of a general increase in prices. The cost of banknotes and coin refers to the cost of purchasing new banknotes and coin. These costs are extraordinary in that they vary greatly over time, depending on the various denominations and the need to replace banknotes and coin. Figure 3 shows how these costs have varied with time over the last 20 years. The cost of banknotes and coin for the Riksbank 1987 -2007 in current prices. The solid line shows the average for the entire period. The average cost for the entire reported period is million annually. The Riksbank has reduced the average cost level recently, above all by purchasing banknotes and coin instead of producing them itself. It is therefore reasonable to proceed from a somewhat lower level than this average for the Commissions calculations. The Commission has chosen to proceed from a level of million. In the calculations this cost should also be adjusted upwards with an expected rate of inflation of 2 percent. The risk of major losses Judgement of the Commission: In addition to a funding requirement for current costs, the Riksbank runs a certain risk of unexpected major costs in the form of losses in its operations. Such risk is found in asset management and any emergency liquidity assistance. In addition to current operating costs the Riksbank runs some risk of unexpected major costs, i.e. There is a parallel here with commercial banks, which are typically exposed to different types of risk for which it is important to have efficient risk management procedures and an ability to handle potential major losses by having an own capital buffer. The risks to which the Riksbank is exposed are, to a certain extent, similar in character to those risks faced by commercial banks. In contrast to those banks, whose risk taking is part of a profit making business operation, the Riksbanks risks are mainly associated with its tasks. We will only present the fundamental risks in the Riksbanks operation here. The size of these risks and how they can be influenced by the structure of the Riksbanks balance sheet will be developed in Chapter 4. The significant risks identified by the Commission are the following: Financial risks in asset management. When investing in financial assets there is always a risk that the assets will not provide the expected return and that they may even fall in value causing losses. Because the financial assets are currently mainly foreign interest-bearing securities, the Riksbanks financial risk is primarily in foreign exchange and interest rate risk. Of course were the Riksbank to invest in other assets other financial risks could arise. Credit risk in emergency liquidity assistance provision. tasked with providing emergency liquidity assistance, primarily to banksTPF FPT if this is needed to protect the stability of the payment system. These credits are only given for liquidity support purposes, i.e. not to protect a bank that is going bankrupt. This should mean that the credit risk for the Riksbank is limited. However, because emergency liquidity assistance is typically provided at short notice and on the basis of inadequate information, there is still some risk of misjudgement which can result in some credit risk. 18TP PT The law confers upon the Riksbank the potential to provide emergency liquidity assistance to all firms under the supervision of (and also some foreign banks). However, the Riksbank itself considers that it is primarily banks that are eligible as they are central to the stability of the financial system in the main. Independence in the event of losses Judgement of the Commission: The Riksbanks cost-free funding must cover both operating costs and potential losses. Alternatively, central government can provide a guarantee or other pledge so that the cost-free capital will be restored if losses arise. The Commission has chosen to make a distinction between current operating costs and losses, despite them being, in both cases, costs. The reason for this is that the current operating costs arise continuously and should be fairly stable in size, while losses usually have a very low probability. However, they can be large. In practice, however, there is no clear boundary between a current operating cost and a loss in terms of the effect on financial independence, the breakdown is only made for elucidatory reasons. The current operating costs should be covered by the expected return from assets being greater than the cost by some . With regard to the risk of losses for the Riksbank, these have the character of highly unlikely events, the costs of which can be large in relation to current earnings should they occur. It is natural for firms facing the risk of major losses to have some degree of own capital against which losses can be set. It is realistic to suppose that the Riksbanks own capital is a buffer that can bear losses. However, as discussed above, it is not necessary for a central bank to have positive own capital. In principle the item on the liability side of the balance sheet made up by currency in circulation can act as a buffer capital, because it has an earning capacity in the same way that own capital does. The natural point of departure when assessing how large a capital buffer needs to be is the probability of a loss arising, how large the loss would be in this case and how bad it would be if the losses were greater than originally estimated. It is desirable to be able to quantify these factors in order to really be able to calculate the capital need. However, the Commission does not consider it possible to estimate either the probability of losses or the potential size of loss with enough precision for it to be meaningful to attempt more sophisticated calculations. Based on this, the Commission takes a primarily qualitative approach. An alternatively way of managing the risk of losses is to ensure that an owner (or someone else for that matter) replaces losses through some form of guarantee if they should arise. To achieve the desired level of protection for its independence the Riksbank would need a guarantee against losses to take the form of a statutory recapitalisation regulation, a pledge from Parliament for a capital infusion or other statutory guarantee. The conditions and suitability of such a regulation are discussed in more detail in Chapter 6. Capital need for current operating costs Judgement of the Commission: The capital need to fund current operating costs is billion. In addition to this is the capital need for the cost of banknotes and coin of billion. In the previous section we discussed the fact that the Riksbank had an earning capacity because of its access to investable cost-free capital, and that this earning capacity must be able to cover current costs if financial independence was to be achieved. In addition there are certain risks that could lead to greater expenditure or a reduction in earnings. So the first step is to assess how much cost-free capital the Riksbank needs in order to cover its current costs. In addition to this basic capital need, further cost-free capital may be needed to cover losses, or to compensate for the reduction in the cost-free capital that a reduction in the currency in circulation would cause (see Chapter 4) In its estimate of the capital need for current costs the Commission, as discussed in Section 3.4.2, is using as a starting point an expected operating cost level of millions. In addition to this is the expected cost level for banknotes and coin of million. It is assumed that the Riksbanks costs will rise from this level at the rate of inflation, which is expected to be the 2 percent target inflation rate. the capital to be invested in completely risk-free assets, i.e. short-term fixed-income instruments issued by the Swedish central government, they would provide a return in line with the long-term level of Swedish short-term rates. Of course it is difficult to accurately estimate how high this level will be. In the past the Riksbank has stated that an interest rate level neutral in terms of monetary policy would be around 4 percent. This is equivalent to a long-term real interest rate of 2 percent, if inflation is assumed to be at the target inflation rate of 2 percent. From a long-term perspective, real interest rates have been at this level in , although at times they have been considerably higher and at times lower.TPF FPT To be conservative in our calculations, a somewhat lower long-run short- term rate such as 1.5 percent should be used. We have therefore selected an average yield band of between 3.5 and 4 percent, i.e. a 1.5 to 2 percent real interest rate plus 2 percent inflation. The capital need for operating costs excluding banknotes and coin can be calculated using the formula million/(0.035-0.02) or (0.04-0.02) = billion. The capital need for the costs of banknotes and coins can correspondingly be calculated as billion. This calculation is very sensitive to changes in the expected return. Small changes to the long-term return will cause a large divergence in the calculated capital need. Changes to the long-term assumed cost level will also cause a relatively high sensitivity. An illustration of the sensitivity of the capital need if the expected return changes or if the Riksbanks costs change is contained in Figure 4. 19TP PT See the Riksbanks Inflation Report 2000/1 for a discussion of the long-term levels of Swedish real interest rates. The capital need of the Riksbank assuming different levels of long-term return, and whether the cost of banknotes and coin are included or not. Inflation is assumed to be 2 percent in the long-term. Capital need incl. cost of banknotes and coins Capital need excl. cost of banknotes and coins 2,3,3,4,4,5,5,6,6,7,7,8, In the figure, the dashed vertical line shows the two interest rate levels assumed in the Commissions calculations above, corresponding to a long-term return of 3.5 and 4 percent nominally and 1.5 and 2 percent in real terms. The figure shows that at low levels of interest, the Riksbank's capital need approaches infinity. Another way to express this is that if real interest rates are not positive in the long time horizon assumed in this calculation (theoretically an infinite time horizon), the Riksbanks capital need will be infinite. This is a reasonable assumption. Table 2 shows real interest rates between 1960 -1999 for a number of countries and the G10 group of large industrialised countriesTPF FPT. 20TP PT The G10 is a cooperative association for the national central banks of the , , , the , , , , , , and . Short-term real interest rates in industrialised countries 1960-1999 This compilation shows that real interest rates were actually low, even negative, for relatively long periods, above all in the 1970s. However, this was in periods when interest rates were not being set primarily to influence inflation (discussed in Section 3.1). High inflation meant an increased demand for banknotes so that the yield bearing assets also had a high rate of growth. In addition there was no developed financial market in which the development of interest rates mirrored a market assessment of the price of money. Figure 5 illustrates the development of short-term rates, inflation and real interest rates in in the last 75 years. Short-term rate, level of inflation and real interest rate level 1930 – 2006. Rolling five year average of the real interest rate. Real interest rate, five years' rolling window -6,00 Sources: Frennberg and , Reuters Ecowin The figure shows that during periods when the real interest rate has been negative for long periods, this has been because inflation has shot up at the same time as the interest rate level has not been adjusted for it. It is highly unlikely that we could experience anything similar given the present focus of monetary policy. If there is an inflationary spurt the Riksbank must adjust the interest rate level upwards in line with it. It is hard to imagine how negative real interest rates could occur, apart from temporarily, in such conditions. In the model discussed here the one scenario that could threaten the Riksbanks earnings is deflation, where the deflation was persistent despite the Riksbank reducing the repo rate to very low levels or even to zero. Developments in over the past 15 years are the closest example to a similar situation in modern times (see Figure 6). Short-term risk-free rate, inflation and real interest rates in over the past 15 years. Short-term real interest rate Source: Reuters EcoWin The figure shows that the central bank has kept interest rates very low, occasionally at 0 percent and that deflation has sometimes occurred, above all at the beginning of the 2000s. Because the central bank cannot reduce interest rates below zero, there is a positive real interest rate when there is deflation. The average real interest rate during the period 1993 – 2006 was 0.47 percent. With a real interest rate equivalent to the 0.5 percent experienced by , the Riksbanks capital need in the calculation above would be billion. However, the Commission does not consider this assumption to be useful. As was mentioned above, the calculated formula is based on an infinite time horizon. Although has experienced deflation for almost 15 years, its circumstances are very extraordinary. Without going into these in detail we can say that it would be difficult for a small, open economy such as , with open capital markets, to end up in a similar situation. Above all there would be exchange rate adjustment, something that, for various reasons, was not possible in . For a more long-term level of real interest rates the Commission considers that the level of 1.5 – 2 percent (3.5-4.0 percent in nominal return), used as a basis for the Commissions calculations, is a conservative assumption. Table 2 above shows that real interest rates were higher than this during the 1980s and 1990s in all countries except , and that they were at least as high as this on average throughout the period 1960 – 1999 for all countries, despite the inclusion of the period of negative real interest rates in the 1970s. What really drives the real interest rate is arguable. The real interest rate is the compensation investors want for refraining from using a sum of money today. There is no accurate, empirical way of determining what the long-term real interest rate should be. As a rule of thumb the real interest rate in the long-term should not deviate too much from real growth in the economy. the past century production has grown by 2-3 percent annually. A further reason for choosing a nominal interest rate level of 3.5-4.0 percent is that a low return will only lead to a slow, gradual erosion of the capital. Only at a nominal return of 1.4 percent (calculated on a capital of billion) will annual revenues not cover the current costs, i.e. a loss will arise. Only if Swedish short-term rates were below 3.5 percent in the long-tem would a long-term erosion of the Riksbanks earning capacity occur. But this would occur so slowly that it would be very likely that the political system would take this into consideration. For example the Riksbank could retain a larger share of its profits, and in that way build up its capital more rapidly. It must also be emphasised that the underlying assumption in this discussion is that the investment is made in short-term risk-free interest-bearing securities. The aim of this is to make clear what the return is on a completely risk-free investment. If the Riksbank takes some risk in its investments the expected returns also increase, but so does the financial risk. This trade-off is discussed in more detail in Chapter 6. The calculation of capital need is also sensitive to the level of the Riksbanks costs, though not to the same extent as the long-term return level. If the Riksbanks costs should increase or decrease by 20 percent, from a level of million (excluding the cost of banknotes and coin), its capital need would change from to 51 and 34 billion respectively. These variations seem large, but still manageable. In summary the capital need for the Riksbanks operating costs, excluding banknotes and coins, are calculated to be billion. The capital need for the costs of banknotes and coins can be calculated as billion. The range is due to the calculation being carried out using an expected return of 3.5 or 4 percent. Risk in the Riksbanks operations This Chapter discusses the various types of risk that may lead to the Riksbank requiring cost-free capital greater than that needed for its returns to cover the current operating costs. For each type of risk, its cause, probability and the extent of its likely financial consequences in terms of capital need are discussed. However, it should be emphasised that we are dealing with risks that are highly improbable, with consequences that are very difficult to assess. Because of this, the Commission is not presenting exact probability calculations or estimates of the extent of potential losses. Instead we will present a qualitative argument with calculations to indicate approximate capital need to protect against risks. 4.1.Risk in the provision of emergency liquidity assistance Judgement of the Commission: The Riksbank can provide emergency liquidity assistance if this is required to protect the stability of the financial system, but only to banks which have liquidity problems, not those with solvency problems. These credits can give rise to losses. Both the size and probability of these losses are very difficult to assess. However, a capital need of billion is judged adequate for this. As part of its task to encourage a reliable and effective payment system the Riksbank has been given the ability to provide emergency liquidity assistance to banks and other financial firmsTPF FPT if this is required in order to protect the stability of the financial system. The Riksbank can also issue guarantees with the same aim. This task is regulated in Chapter 6, Section 8 of the Riksbank Act. The need for emergency liquidity assistance, provided with the aim of supporting liquidity, is related to the pivotal importance of the banks to the payment system and the fact that banks are quite vulnerable to liquidity problems. A suspension of payment by one bank may lead to a knock-on effect for other banks and may lead to them also having payment problems. The entire payment system may stop working in such a situation. Taking into consideration the importance of the payment system for the economy in general, it is very important that this can be avoided. Through its central role in the payment system as the provider of the system, and with its ability to produce legal tender in Swedish krona, the Riksbank is the natural body to provide liquid capital in an emergency situation, i.e.