Lars Heikensten: The Riksbank's work on financial stability
Speech by Mr Lars Heikensten, Governor of the Sveriges Riksbank, at Göteborgs University,
Göteborg, 25 November 2003.
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First a word of thanks for the invitation to address you today. I feel privileged to be speaking at a Felix
Neubergh lecture.
In autumn 1992 a decision at very short notice was required of Sweden's government and parliament:
should they choose to support Swedish banks without really knowing how large the support might
have to be, or risk a financial crisis with unforeseeable consequences for the Swedish economy? All
the Swedish banks had incurred large loan losses. And regardless of how much a particular bank had
lost, the international credit market had little confidence in the Swedish banking system. The banks
faced severe financing problems that might ultimately have led to their failure and could have made it
difficult in the shorter run for Swedish companies to cover their funding requirements.
The decision was the only reasonable alternative - to rescue the Swedish banks. The government
issued a general guarantee for the banks' liabilities and set up an authority, Bankstödsnämnden,
specifically to cope with the banks that were in serious difficulties. The government, explicitly
supported by the opposition, acted just as vigorously and promptly as the situation required. But this
did entail making a decision - on the basis of insufficient information about the causes and depth of the
crisis - that could have burdened the government budget with at least a hundred billion kronor. That is
an experience we do not wish to repeat.
Sweden recovered from the crisis on that occasion and in many instances our way of resolving it has
served as a model for other countries. The crisis also focused attention on the work for financial
stability. With the growing complexity of payment systems and the financial sector's expansion,
financial stability has become an increasingly important issue for the Riksbank, as it has for other
central banks around the world.
A review
The bank crisis spawned a certain amount of self-criticism, not least in the Riksbank. In practice, the
Bank had not backed up its function of promoting a safe and efficient payment system with any
systematic analytical work. The problems that arose had taken the Riksbank, along with many others,
by surprise. So we started to build up knowledge and an analytical capability in the field of stability.
The work was initiated on a modest scale with just a handful of staff. It had a narrow focus on the early
detection of weaknesses in the banking system that might lead to another bank crisis.
The Riksbank also decided to publish a report that would discuss the situation for bank sector stability.
Internal reports had been produced earlier. In autumn 1997 the Riksbank accordingly presented its
first more cohesive public analysis of financial stability. The new report was intended to signal the
importance the Riksbank attached to work on stability and it also helped to focus and develop the
internal efforts. The experience of work on the Inflation Report had been encouraging, so it seemed
natural to build up the work on and communication about issues to do with stability in the same way.
By launching the Financial Stability Report or, as it was called initially, the Financial Market Report, the
Riksbank was the first central bank to issue a public account of its appraisal of financial system
stability. Its example has been followed to date by about thirty other countries. Recurrent financial
crises have made it clear that there will always be problems which the authorities are obliged to
address in some way and it may therefore be of some assistance to have a clear, structured
presentation of the approach to financial stability. This has led the International Monetary Fund, for
example, to pay growing attention to these issues. Since 1999 the IMF and the World Bank are
engaged in joint evaluations of national financial systems in what is called a Financial Sector
Assessment Program. Matters to do with stability are also on the agenda almost every time I meet my
colleagues from other countries.
Principles for financial system oversight
First I should perhaps reiterate what we mean by the financial system. It is the system that provides
payment services, converts savings into financial resources for investment and consumption, and
contributes facilities for managing risk. In other words, the financial system performs a number of
important social functions. If any of these functions were to be disrupted, the social costs could be very
high.
The damage inflicted by a disruption would probably be particularly great if it involved a vital
component of the payment system. This is readily understood when one considers the enormous flow
of payments. In Sweden, for instance, the payment system has a daily turnover of around SEK 500
billion, which means that the equivalent of our annual gross domestic product has to be handled in
less than a week. Studies show, moreover, that in the past fifteen years there have been more than a
dozen crises which cost the countries concerned at least 10 per cent of their GDP.
So there are good reasons for state supervision of the financial system. The Riksbank has a function
here in that the Riksdag (Sweden's parliament) has made us accountable for promoting a safe and
efficient payment system. A major ground for making us responsible for efficiency and stability is that,
along with the banks, the Riksbank is a central player in the payment system and provides means of
payments. The banks distribute notes and coins, keep transaction accounts linked to giro systems and
operate credit card systems. The Riksbank in turn provides accounts in the payment system, RIX, that
is available for large-value interbank payments.
The work on financial stability is undertaken in three main ways. One concerns the rules and
regulations that set the bounds for the operations of financial companies. Another is the continuous
surveillance of the system that is performed by Finansinspektionen (Sweden's Financial Supervisory
Authority) as well as by the Riksbank. Thirdly, the state needs to be able to manage any crises that
nevertheless occur. The work on stability calls for highly developed cooperation between the Finance
Ministry, Finansinspektionen and the Riksbank.
The laws governing financial operations are enacted by the Riksdag, with the finance ministry as an
important agent. More detailed regulations are issued by Finansinspektionen, which also monitors
their observance. The Riksbank's contribution to the work on rules and regulations consists in the first
place of submitting opinions; in addition, the Bank participates in international efforts to develop the
regulatory framework.
The role of the Riksbank in surveillance work is central and focuses on the functioning of the financial
system as a whole and the risks that may arise. The identification of risks in the system as a whole
means, moreover, that the individual institutions and the financial infrastructure have to be scrutinised.
It is primarily Finansinspektionen but to some extent also the Riksbank that need to keep a continuous
eye on the individual banks. Due to the central functions of the banks, a crisis in the banking system
might swiftly have serious consequences for the payment system as well as for the supply of credit.
But it is not just the significance of the banks in the payment system and as a source of credit that
warrants their supervision. As The Economist wrote last spring, banks are "the most hazardous
economic institutions known to man". That may sound rather drastic but there is some truth to it. It is
not that bankers are a tribe of irresponsible gamblers but that their much-needed function in the
economy requires them to act in certain ways. Banking is essentially a matter of taking risks. A bank's
funds (its deposits or its loans from other banks) are liable to disappear at short notice, while realising
assets takes longer.
Moreover, problems in one bank are liable to spread to other banks. This systemic risk exists because
the banks have liabilities with each other in the form of loans or securities transactions and because
they participate in the payment system. The similarity of their operations also means that problems
elsewhere may hit the banks as a group. Contagious effects may occur, moreover, simply because
people suspect that the banks are inter-connected.
To a growing extent, oversight of system stability calls for oversight of the financial infrastructure in the
sense of the systems that are needed to effect payments and to trade in and deliver financial products.
Bankgirocentralen is a case in point. If these systems function properly, there will be less risk of
problems either spreading between the participants and from the financial markets, or arising because
the system as such is disrupted.
The third aspect of surveillance work - crisis management - has to do with the possibility that the state
needs to act to prevent a crisis from jeopardising system stability. In order to manage a crisis, the state
must be able to judge what the consequences will be if a distressed institution were to fail and, if these
consequences are likely to be serious, what measures can be taken to mitigate them. The solution in
some cases may be to contribute to an orderly closure, while in others it may be to provide financial
support. An example of the latter is the general bank guarantee the state provided during Sweden's
bank crisis.
In certain cases it may be up to the Riksbank to provide assistance with liquidity. If a bank's problems
were to be so serious that stability is threatened - and the bank is considered to be viable in the longer
run - the Riksbank can grant credit on special terms and act as what is usually known as the lender of
last resort.
The continuous surveillance and crisis management are closely connected with each other. Oversight
is essential for the Riksbank's ability to judge whether or not a crisis constitutes a threat to financial
stability. Without a continuous analysis of the banks, it would be difficult to determine whether and how
any support should be provided in a crisis.
The work on oversight and crisis management
The Riksbank presents its analysis of system stability every six months in the Financial Stability
Report. The Report basically aims to provide a picture of the Swedish banks' ability to stand up to any
disruptions. The purpose is to identify conceivable risks and present a sound analysis that influences
the market's participants. The task of the Riksbank can perhaps be described as to keep cool and
restrain undue optimism when there seem to be no problems in an upward phase, and to fill in the
picture, if necessary, in a downward phase to allay concern about serious loan losses.
The analysis concentrates on the four major Swedish banks because their size makes it likely that
they are relevant for system stability. The failure of one of these banks might jeopardise stability,
though this is by no means certain.
The durability of the banks is dependent on a number of factors. The Riksbank analyses the main
categories of borrower, developments in the bank groups and the financial infrastructure.
Borrowers are analysed in terms of the corporate and household sectors in general, with particular
reference to levels of debt and the future ability to pay. The real-estate sector is considered separately
because the companies here account for as much as one-third of the banks' corporate lending. The
prices of commercial properties and private housing are also analysed because they reflect the value
of the collateral that is pledged for loans from banks and mortgage institutions. In that Swedish banks
are expanding their operations in the other Nordic countries and the Baltic region, developments in
those countries are becoming increasingly important for them. Borrowers abroad now account for
approximately half of the banks' total loan stock. The analysis of borrowers has therefore been
extended abroad.
The major bank groups are analysed in various respects. Profitability trends illustrate the ability of the
banks to build up reserves for unexpected losses. Moreover, there is always the strategic risk that a
bank with weak profitability will be tempted to try out new, bold lines of business in order to generate a
higher return on equity.
The analysis of the banks' credit portfolios can provide an indication of how loan losses are likely to
develop in the coming year or two. Another aspect of the analysis is the banks' liabilities. Traditional
banking involves accepting deposits and using the funds for making loans. People's growing
propensity to save in other instruments than bank accounts has forced the banks to finance the growth
of credit by borrowing in the capital market. The structure of bank funding provides an indication of the
risks in bank liquidity. Monitoring this is perhaps the most difficult part in that the liquidity situation is
liable to change very rapidly.
If problems in one bank group spread to other players in the system via the banks' mutual
commitments, the payment system may be affected immediately. The Riksbank therefore keeps an
eye on interbank exposures.
Oversight of the infrastructure concentrates on the systems that are vital for the functioning of the
financial market in Sweden. Besides RIX, the system for large-value payments provided by the
Riksbank, these are primarily the central securities register (VPC), the Stockholm Stock Exchange and
the clearing system for retail payments (Bakgirocentralen or BGC).
The Riksbank has also chosen to work on practical matters to do with risk management. These issues
are invariably complex. Financial crises can arise at very short notice, not least on account of the
massive payment flows and because banks tend to have a large element of short-term funding. The
ongoing integration may have made things even more difficult.
The Riksbank has therefore built up an internal crisis organisation and clearly documented who does
what in the event of a crisis, including those who are to be contacted and put in the picture, how the
press is to be informed, and the legal consequences of various measures. Another important element
in the work on readiness is regular crisis exercises.
Crisis management has also come to feature prominently in Sweden's international profile. This has to
do with our experiences as well as our basic stand on the importance of transparency. The Riksbank
is leading Nordic and European working groups in this field. One of the articles in the latest Financial
Stability Report that was published yesterday deals with the role of the Riksbank as lender of last
resort. It discusses the principles that determine the situations in which the Riksbank can consider
providing support for distressed banks and the terms for the support. Many other countries are
reluctant to talk about these matters openly for fear that banks will be tempted to take greater risks.
The Riksbank, on the other hand, sees openness as a means of deterring greater risk-taking. Clear
game rules mean that the banks know more about what to expect.
Future stability work
Much has been done with the Riksbank's work on stability in the past seven years but it is not hard to
pick out fields where there is room for improvement. The analysis of borrowers abroad will be
enhanced. The Riksbank needs to acquire a better understanding of how the banks manage their
liquidity, select sources of funding and the effects of this on their durability. The analysis of stability
also needs to be supplemented with methods for stress tests, that is, ways of analysing the sensitivity
of bank durability.
To obtain further inspiration for the work of improving the analysis, the Riksbank has commissioned an
external evaluation of the work on financial stability. This evaluation is in the hands of a trio
representing the international research frontier, the central bank world and the Swedish bank sector.
They will be bringing their individual perspectives to bear in a joint effort to evaluate the quality and
focus of the work we have built up. We intend to publish their report and then issue invitations to a
broad discussion on our work's future direction.
In conclusion I would like to say something - without prejudicing the trio's findings - about the issues
that I believe will have growing importance in the future. A natural starting-point for such a discussion
is to identify forces that will be driving future financial developments. Three of the main forces are:
- growing cross-border integration in Europe,
- more advanced risk management by the banks, and
- more and more of a focus on aspects of efficiency.
Consequences of European integration
It is perhaps the increased international dependence that affects us most clearly. While the banking
systems in Europe are still largely national, integrated systems have started to appear in certain
regions. This trend seems to have come furthest in the Nordic-Baltic region but there are grounds for
expecting greater integration elsewhere, too. As a result, national banking systems will become
increasingly interdependent.
This has a number of dimensions for the Riksbank's work on stability. One component of our work
consists in promoting integration by influencing the construction of rule systems. We do so out of a
conviction that integration as such favours economic growth.
The current rule systems were not designed for an integrated European bank market that transcends
national borders. Moreover, the common legislation takes integration into account to only a limited
extent. In order to achieve an inner market for financial services, the EU is striving to produce as
uniform a set of rules as possible for financial companies throughout the Union. Banks can then
compete on equal terms and give rise to a common market with the most competitive enterprises.
The Riksbank supports this admirable ambition. But it is also important to avoid conceivable pitfalls
that may hamper this development. One danger is that the rule system becomes excessively detailed,
that harmonisation starts from the strictest existing system instead of proceeding from an entirely open
discussion.
Integration also affects the regular supervision and oversight. The current principle is home-country
supervision. In other words, a bank's legal country of domicile is responsible for the supervision of the
bank's branch offices; a banking subsidiary, on the other hand, is supervised by the country in which
the subsidiary is legally domiciled. But it is still the legal country of domicile of the parent bank that is
responsible for supervision of the bank group as a whole.
This solution ought to work as long as the foreign operations of the banks are fairly modest. But what
will happen when the banks' foreign branches become systemically important? How much
responsibility are the home countries willing to take for financial stability in the countries where foreign
branches are located? And are the authorities in the latter countries prepared to relinquish the
responsibility for an essential part of their financial system to the home country of the parent bank?
These are not just abstract issues, as can be seen from the fact that Nordea, domiciled in Sweden, is
now the largest bank in Finland and that Swedish banks own the major part of the banking systems in
the Baltic states.
Thus, it seems that the supervision of international bank groups could lead to problems of coordination
and duplication. On the whole, there appears to be no lack of incentives to supervise cross-border
banking operations. The problem is rather that in certain cases the rule system prevents the most
active countries for exercising supervision, so that this is liable to fall between two stools. On the other
hand, an excessively generous right to supervise can lead to the burden of supervision being unduly
heavy for individual banks. That could hamper integration as well as efficiency.
Formalising crisis management is more difficult than other parts of the work on stability. Discussing
crisis management can be perceived as sensitive and troublesome because to some extent it
concerns the state's willingness to assist the financial sector with liquidity. The dividing line between
whether or not this should be discussed openly often runs between countries that have experienced a
financial crisis and those that have not. Those which have lived through a crisis are generally in favour
of a transparent process. A clear-cut arrangement for the management of crises can be difficult to
construct in advance.
It is hard to tell at present how these problems should be resolved. In principle there are two
conceivable approaches. One involves continued cooperation on agreements, joint principles and
regulatory frameworks. The other is to have more supranational management. It is probably a
combination of the two that will be needed. The important thing today, however, is that a debate on
these complex issues gets under way before we find ourselves in a situation where it is necessary
instead to deal with them in an emergency.
More advanced risk management
Another factor that will probably affect future work on the supervision and oversight of stability is the
banks' increased possibilities of managing risks.
The assessment of risks is one of banking's traditional functions. Things have changed markedly in
this respect since the mid 1990s. Technical progress and new financial theories have led to a
refinement of the methods for and possibilities of measuring credit risks. This has been accompanied
by facilities for trading risks with additional financial instruments in increasingly international markets.
All this has enhanced the ability of the banks to manage risks.
Banks in general - not just the largest international groups - have invested in new systems for risk
management. The trend, which began earlier, has been accelerated by the new capital adequacy
rules, Basel II, that have just been produced.
All the major banks in Sweden are working actively on these issues, partly because they are expected
to result in a smaller capital requirement. For the Riksbank, it is of course not a decreased capital
requirement as such that is relevant so much as the fact that the new rules make better allowance for
the actual risk in different credits. Finansinspektionen has a central role here in ensuring that financial
companies honour not just the letter but the spirit of the Basel rules. This in turn should lead to a more
adequate pricing of risk and thereby a more efficient financial system.
A problem that is being discussed in connection with recent methods for risk management and Basel II
is the possibility of this development accentuating cyclical fluctuations in the economy. In that the
basic idea behind Basel II is for the size of a bank's capital to be dictated by the credit risk in its
lending, it is possible that bank capital requirements and thereby the cost of credit will co-vary with the
business cycle. The increased credit risk associated with an economic slowdown means that the
banks need more capital. This, it is feared, might lead to a contraction of credit in downturns and an
expansion in upward phases and thereby make cyclical fluctuations more pronounced.
There are some grounds for this criticism. Experience of business cycles has taught us that the large
credit risks tend to be taken as the business cycle approaches a peak. However, the solution to such
problems does not lie in opposing the new risk management techniques or Basel II. They will help to
promote financial stability. But there is a need for the banks to find ways of handling any effects that
arise from an accentuation of cyclical fluctuations. It is important for economic development that credit
and venture capital are available even when business activity is cyclically low - and perhaps somewhat
less so when activity is peaking.
Besides influencing how the banks handle their capital, the more advanced methods for risk
management have led to the creation of new financial instruments. Two examples are securitisation
and credit derivatives. This enables the banks to divest themselves of the credit risk in their loans by
hedging in the credit derivatives market or by simply selling the risk through securitisation of the loans.
The credit risks in the economy can then be spread over more agents. That is fundamentally
favourable for financial stability and market efficiency.
At the same time, the authorities must follow developments closely in order to understand where these
credit risks end up. Their departure from the bank sector does not mean that they disappear from the
economy; they turn up instead in a different form somewhere else, for instance in insurance
companies or mutual funds.
Do the new risk management facilities also mean that banking operations will take a different
direction? Will banks try to slim their large illiquid balance sheets by selling off loans or securitising
assets? And will that mean that they can no longer be described as the most hazardous economic
institutions known to man?
This development has come further in the United States, where market financing is considerably more
important than in Sweden or the rest of Europe. So what would a similar trend, where the current
predominantly relation-based lending is replaced by market funding, imply for the cyclical supply of
credit in Sweden?
Stronger focus on aspects of efficiency
A third driving-force that most clearly affects the financial system is the stronger focus on aspects of
efficiency. Permit me to touch on this briefly.
Improvements to the financial infrastructure in recent years have made this safer and more robust in
various ways. For example, the settlement routines used by both BGC and VPC are considerably
more secure that before. Every component of the infrastructure now has better solutions for continuity,
which means that operations can be ensured even in connection with more extreme events.
Now that the most serious shortcomings have been rectified, the focus has shifted to enhancing
efficiency in the given framework for safety. Considerable social gains are to be had by making the
infrastructure more efficient. This applies to the central settlement systems and perhaps even more to
the different payment instruments. Increased automation and a greater use of electronic payments
instead of paper-based instruments and cash can generate large savings for society in general.
Although they may amount to just a single krona or even less per transaction, the savings add up to a
large amount because of all the payments that are required in a modern economy.
Economies and greater efficiency have featured prominently in the banks' activities in recent years.
For the authorities it is always important to consider the conditions for competition and balance them
against the forces for efficiency, such as economies of scale. It is also important to monitor
developments to ensure that levels of risk do not rise again. Moreover, the Riksbank has been and is a
major player in the payment system. We must also scrutinise this activity continuously to ensure that
our approach does not impair economic efficiency in general.
From what I have said about the future work it is hopefully clear that the financial markets are
changing rapidly and present a development that is exciting in many ways. The Riksbank will continue
to be a central player in this work. Talking about such issues feels natural at a university. Perhaps I
have even succeeded in inspiring some of you to become involved in questions such as these and
contribute to future developments. Thank you.