Barbro Wickman-Parak: The financial crisis from a central bank
perspective
Speech by Ms Barbro Wickman-Parak, Deputy Governor of the Sveriges Riksbank, at the
Swedish Bankers' Association annual meeting, Stockholm, 12 November 2008.
* * *
Introduction
In normal times, reporting about the Riksbank is dominated by what we do, or do not do, with
interest rates. The focus is usually on one of the Riksbank's two main tasks: maintaining
price stability. Less attention is paid to the other main task, safeguarding financial stability;
health is silent, as the Swedes say. For obvious reasons, financial stability has been given
more prominence recently.
We have now lived with turmoil in the international financial markets for rather more than a
year and over the past two months have seen it lead to a large-scale global crisis of
confidence. The origin of the current crisis, as well as of our Swedish banking crisis in the
early 1990s, can be found in reckless lending practices related to property. As we now know,
it began when American financial institutions lent money to borrowers with weak credit
histories. Whereas the Swedish banking crisis remained altogether Swedish, the American
crisis has spread like wildfire and reminded us of just how globally connected the financial
markets are. The high-risk sub-prime loans were sold on to a large extent by bundling them
together with low-risk loans in what are known as structured credit products. The use of
these complex products grew rapidly and had a wide geographical distribution. Investors
found it difficult to conduct their own risk assessments and largely relied on the
classifications of credit-rating agencies.
When the losses on sub-prime loans became unexpectedly large, genuine uncertainty arose
about the value of the structured products and where losses associated with them would
occur. Banks and other financial institutions became cautious about lending money to one
another. They began to hoard liquidity to meet their own obligations and to avoid losses on
loans to counterparties about whose status they felt uncertain in the wake of the general
crisis. The cost for bank borrowing on the interbank market rose, causing other market
interest rates to climb.
The financial turmoil spread to Europe and resulted in a general aversion to invest in
mortgage securities. Banks and mortgage institutions found it increasingly difficult to obtain
funds on the securities markets.
Escalating crisis after Lehman Brothers collapsed
When the Lehman Brothers investment bank filed for bankruptcy protection, a full-scale
confidence crisis erupted. A major financial player was left to its fate and there was rapidly
growing concern that other institutions would follow suit. Credit flows dried up almost
completely and investors essentially dared to invest only in government bonds. Companies
had already experienced a tightening of credit terms; opportunities for loan financing now
essentially disappeared.
In this phase of the crisis, around mid September this year, the effects on the Swedish
financial system became clear. When banks' access to liquidity dried up on every market,
this hit all banks, including those that are financially strong, like the Swedish banks. Many
central banks around the world had been taking measures for some time to strengthen
liquidity in banking systems but the Riksbank had not needed to act. The interbank market
and other short-term markets had worked, though interest rates had climbed sharply. When
the crisis had a more tangible impact on Sweden, the Riksbank also implemented a series of
interventions. Meanwhile, central banks in the rest of the world continued with their
interventions and governments approved crisis packages to guarantee financial stability.
Against the backdrop of this summary of events in the financial sector over the past year,
today I will speak about the effects of this financial crisis on the Riksbank's work of
maintaining a safe and effective payments system. But first I would like to briefly describe
how we carry out this work under normal circumstances. I will also conclude with a comment
on the crisis' effects on monetary policy.
Work with financial stability under normal circumstances
The task of maintaining a safe and effective payments system includes the role of the
Riksbank as the banks' bank. This task includes maintaining the RIX payment system for
payments in Swedish kronor. Participants in the system may borrow during the day and
overnight to cover temporary deficits.
The task also includes continuous oversight of the financial system. For some time the
Riksbank has had a well-designed analytical apparatus for early detection of changes and
vulnerabilities that could develop into a serious systemic crisis. Above all, its purpose is the
timely detection of vulnerabilities in banks that are of central importance for the payments
system, which requires knowledge of the status of the various institutions and how the
market functions. This in turn presumes continuous follow-up, where frequent contacts with
financial market participants play an important role. These established contacts are essential
in a crisis situation, both to determine the type of measure that is needed and to ensure
timely implementation.
Ten years ago we began to publish stability reports twice a year. These reports provide a
basic analysis of financial stability with an emphasis on the four major banks. The report
leads up to a comprehensive stability assessment, highlighting the various risks to stability.
Financial stability and implementation of monetary policy
Monetary policy and financial stability have a fundamental relationship in the payments
system. Through its repo rate decisions and by determining the conditions for the banks'
deposits in and borrowing from the RIX system, in practice the Riksbank determines the
overnight rate, that is, the interest rate on overnight interbank loans. Through the steering
system, the Riksbank aims to keep this shortest market rate close to the repo rate. The
overnight rate in turn affects the interest rates offered to the general public, and thereby
economic activity and prices. The repo rate, which is set on the basis of monetary policy
considerations, indicates the level at which the Riksbank wants the overnight rate to lie.
Interest rates with a slightly longer duration are determined in the financial markets and
usually display a fairly stable relationship to the existing repo rate and expectations of its
future level. During periods of financial turmoil and crisis, however, various risk premiums
rise and this may disconnect the short-term market interest rates from their normal
relationship to the repo rate. That weakens the impact of monetary policy
Financial stability in terms of a functioning payments system and financial markets is thus
essential for the Riksbank to conduct an efficient monetary policy.
As can be seen, for a long time the Riksbank has been working intensively on issues relating
to financial stability. This assiduous effort, which hardly attracts any attention under normal
circumstances, provides a good foundation for crisis management. And this brings me to an
account of all the measures taken over the past two months.
Poorly functioning markets require special measures
The crisis we are currently experiencing did not originate in the Swedish financial system.
But the global financial turmoil has been imported to Sweden and has had repercussions on
the Swedish financial system. As I already mentioned, these consequences became clear
when the crisis escalated in the aftermath of the Lehman Brothers bankruptcy filing.
Several components of the fixed-interest market have not been working as well as usual. The
uncertainty there is evident, for example, in the banks' difficulties with borrowing at longer
maturities and in investors' preference for safe government paper over what they perceive as
more risky securities such as mortgage bonds. Even the short-term interest rate on the
interbank market has risen sharply as a result of mutual distrust between banks, causing
them to avoid lending to each other.
As a result, the banks' borrowing costs rise, access to loans decreases, and companies and
households pay more for loans. At times, moreover, trading on certain segments of the
fixedincome market has ceased completely. When such disruptions occur, the Riksbank has
considered that special measures are required to restore the functioning of the markets so
that the supply of credit is not jeopardised and the financial markets, and therefore monetary
policy, can work more normally.
The first sign: a shortage of treasury bills ...
The very first, very concrete sign of the financial crisis in Sweden was an acute shortage of
treasury bills. The high demand for safe investments, especially in the United States, caused
interest rates on American treasury bills to fall almost to zero. Even foreign investors then
turned to European countries, including Sweden, to get treasury bills that gave a higher yield.
The Swedish National Debt Office decided to implement additional issues of treasury bills.
The funds from these extra issues are being used for reversed repo transactions with
mortgage bonds (purchase of mortgage bonds with agreements to resell them within a
specific period of time). Mortgage bonds that were difficult to sell could be converted into a
liquid asset, which meant that the measure simultaneously helped the situation on the
mortgage bond market.
About the same time, the Riksbank also made it easier for banks to borrow from the Bank by
accepting additional types of securities as loan collateral. Covered mortgage bonds issued
by an institution with close links to the counterparty could now be used as collateral to a
greater extent than in the past. This measure is also helping the situation for mortgage
bonds.
... a shortage of dollars the second
The next problem to address was a general shortage of financing opportunities in US dollars.
Since the Swedish banks are not counterparties to the US Federal Reserve (Fed), they
cannot be sure of benefitting from the Fed's liquidity injections. In late September, mutual
currency arrangements with the Fed were established by the Riksbank and several other
central banks. With these swap facilities the Riksbank can borrow US dollars against
Swedish kronor. The Riksbank then offered its counterparties large loans denominated in US
dollars. The loans are granted against collateral at an interest rate determined by auction,
though no lower than a minimum rate related to the expected policy rate in the United States.
General measures to promote liquidity
Since the beginning of October the Riksbank has been implementing measures to support
SEK liquidity, aimed at securing bank funding, facilitating the supply of credit and improving
the functioning of the financial markets.
The lack of trust between banks has complicated their long-term funding, including financing
that only extends a few months into the future. The banks have therefore been forced to
borrow in the market for shorter and shorter terms. Even though financing could be found, it
has become much more difficult for the banks to manage liquidity and the risks also
increased. In an effort to enable the banks to restore more normal conditions, the Riksbank
has provided three- and six-month SEK loans so that funding is available at longer maturities
than what the markets can currently provide and longer than what the Riksbank would
normally offer. These loans will continue for as long as the need exists.
The Riksbank is thus offering the banks an opportunity to replace short-term financing with
the longer-term funding which the market normally provides. These measures are clearly
aimed at improving the functioning of the fixed-income market. However, they should also
help to ensure that short-term market interest rates revert to a more normal relationship with
the repo rate, thereby strengthening the impact of monetary policy.
Two institutions receive special liquidity assistance
The Riksbank can also provide liquidity to individual institutions if extenuating circumstances
are present. Such assistance has been given to Kaupthing Bank Sweden and Carnegie
Investment Bank. These loans are against collateral and carry an interest rate that is higher
than normal borrowing costs (penal rate). Both the Riksbank and Finansinspektionen
(Swedish Financial Supervisory Authority) consider the banks to be solvent. The Riksbank
provided the liquidity assistance to Kaupthing because it wanted to prevent the crisis that has
afflicted the Icelandic banking system from spreading to the Swedish financial system.
Common to both instances of liquidity assistance is that they occur in a situation in which the
entire global financial system is characterised by great uncertainty. Against this background
the Riksbank has deemed it necessary to provide support to these institutions, which under
normal circumstances would not receive it. In the current situation, suspension of payments
by these financial institutions would pose a risk of serious disruption to the rest of the
financial system and therefore lead to an undermining of confidence in the payments system.
It is these assessments, not concerns about individual institutions, that motivated the
Riksbank in granting the assistance for which the banks in question applied. With respect to
Carnegie, a few days ago its operations were taken over by the Swedish National Debt
Office, which granted a loan that replaces the liquidity assistance previously granted by the
Riksbank.
Financing assistance for companies
Another problem begging for a solution is the financing situation of non-financial companies.
As the financial crisis escalated, the credit supply to these companies has also become more
troublesome, which could have strong repercussions on economic activity. To alleviate these
problems, the Riksbank has temporarily offered banks the opportunity to borrow at three
months against collateral comprising more commercial papers than usual. In practice this
means that non-financial companies may obtain funds by issuing and selling certificates to
the banks, which in turn use them as collateral for loans from the Riksbank. This credit facility
is also available through an auction, where the minimum rate is the current repo rate plus a
premium. Since it is mainly large companies that issue certificates, it is they that will benefit
directly from the advantages of these facilities. But since banks can increase their liquidity by
using the certificates to borrow from the Riksbank, there is less risk of them cutting back on
loans to small and medium-sized enterprises that are directly dependent on bank financing.
The way ahead?
When the dust after the crisis has settled, we face a major task. We must carefully analyse
the crisis and determine the areas in which supervision, regulations, etc. need to be
tightened up and in which areas the problems are best solved by players from the finance
industry. Crises create space and acceptance for necessary reforms. At the same time,
extreme situations such as this always generate demands for extreme measures. Careful
deliberation is therefore important before implementing new regulations. It is all too easy to
go too far and implement regulations that are too far-reaching and extensive. Such
regulations could control and conserve market structures for a long time to come or involve
major costs that reduce efficiency.
This crisis will need follow-up care. In conclusion let me briefly focus on a few issues that will
probably need to be discussed carefully, both in Sweden and on an international level.
One lesson that can be drawn already is the need to develop and improve the rules for
supervision and management of liquidity risks. More stringent demands for transparency in
the financial sector will provide customers and investors with better opportunities to assess
the risks associated with companies.
Similarly, transparency in the structured credit instruments should be improved so that their
associated risks can be assessed. More effective trading with these products is also
important; the financial infrastructure needs to be strengthened. This discussion and any
resultant changes in regulations should aim to ensure that this part of the credit market can
work efficiently once again.
Developments in the American investment banks in particular have made us aware that even
financial companies that do not accept deposits from the general public, and which therefore
are subject to weaker supervision and regulation, may have a crucial impact on financial
stability. We should therefore consider how to design regulations and supervision of financial
companies that do not accept deposits from the general public.
Due to the global scope of the crisis, countries must coordinate measures to solve it.
Separate national solutions could result in higher crisis management costs than would
otherwise be the case. In all of these areas where supervision and regulation need to be
improved, they must be coordinated and harmonised internationally.
The international component is particularly apparent in that the majority of banks today
conduct a considerable amount of business in several EU countries. At the same time, the
responsibility for supervision and crisis management remains at the national level. This
entails obvious risks of coordination problems and conflicts of interest between countries,
which naturally do not promote financial stability. It is therefore necessary that organisations
for supervision and crisis management be coordinated within the EU.
Lower repo rate in the wake of the crisis
The escalating crisis intensifies the downswing in the Swedish economy, which was already
apparent. As can be seen in the Monetary Policy Report from 23 October, our growth
forecast for next year has been revised sharply downward to the prospect of zero growth. To
alleviate the real economic effects of the financial crisis, over a short period the repo rate
was cut by one percentage point to the current level of 3.75 per cent. Our forecast for the
repo rate shows that in the future it may need to be lowered by an additional half percentage
point over the course of the next six months.
We can do this without jeopardising the inflation target. It is mainly rising commodity prices in
the global market, such as the price of oil and food, that have driven inflation upwards. Now
that the price trend for these commodities has broken and turned downwards, the rate of
inflation will drop rapidly. At the same time, domestic inflationary pressure will be eased by
the weaker economic trend. We are in a situation in which there is hardly any conflict
between inflation and real economic considerations in monetary policy. Our decision to lower
the interest rate is guided by normal monetary policy considerations - in other words,
"business as usual".
When we lowered the interest rate we also noted that the effect of the lower rate would
probably be smaller than usual. This is because the confidence crisis in the financial system
has led to high risk premiums whereby short-term market interest rates were disconnected
from their normal relationship to the repo rate, as I described earlier. The reduction we
implemented on 8 October did not lead to an immediate drop in interbank rates.
Consequently the mortgage institutions' borrowing costs did not drop either, neither did
interest rates for loans to end customers. This clearly illustrates how the impact of monetary
policy is dependent on financial stability.
Some closing thoughts
The Riksbank has worked on two levels during the current crisis. Interest rates were cut to
alleviate the effects of the financial crisis on the real economy. In addition, measures have
been taken on an ongoing basis to improve the functioning of the financial markets and to
support financial stability.
The interest rate decisions have been based on essentially the same type of considerations
as those on which monetary policy is usually based. The idea is to avoid unnecessarily large
fluctuations in output and resource utilisation at the same time as inflation approaches the
target within a reasonable time horizon.
The Riksbank's other measures, such as lending denominated in both Swedish krona and
US dollars, have resulted in a general functional improvement, primarily in the Swedish credit
markets, thereby also creating conditions for the markets to return to more normal conditions
and allowing financial stability to be maintained - which in turn is a requirement for
conducting an effective monetary policy.
During the current crisis the Riksbank cooperates closely with other regulatory authorities to
handle situations that arise to achieve the best possible outcome. The Riksbank's frequent
contacts with Finansinspektionen, the Swedish National Debt Office and the Government
Offices play an important role in crisis management. Like other regulatory authorities, the
Riksbank also has frequent contacts with its foreign colleagues.
Central banks around the world are also working to improve the functioning of the financial
markets. In addition, governments in the United States and the EU have adopted bailout
packages to support the financial system. In Sweden, the government launched a guarantee
programme and a regulatory framework that improves the ability to handle banks in crisis in
an orderly manner. Having such regulatory frameworks in place is extremely important.
It is still too early to say how soon all the measures that have been taken will have an effect
and result in a return to more normal conditions in the financial market. Even if the
Riksbank's assessment is that the most acute phase of the crisis may subside over the next
few months, it will probably take time before conditions return to normal. Confidence must be
restored on several levels and that takes time.