Stefan Ingves: A cure for crises - confidence, confidence and trust
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank, at the Eurofi Forum,
Gothenburg, 29 September 2009.
* * *
It is an honour for me to hold this keynote address at the EuroFi-conference here in
Gothenburg. We have recently witnessed a financial crisis of historic proportions. We may
have seen the worst, but the crisis is not over. The development of the last year gives me an
excuse to address a topic that has followed me for much of my working life: namely financial
crises and trying to sort them out. I could go on and talk about financial crises for hours, but I
promise you that I will stay - at least roughly - within my time limit.
I have been working with the resolution of financial crises for almost two decades. I started
out, here in Sweden, with the banking crisis of the early 1990s. Later, I toured the world as
an IMF employee, assisting in crisis resolution in many different countries, and I came to
know many difficult situations from within. In my present role, the last year has, to a large
extent, been about dealing with the repercussions of the latest financial crisis. One difference
this time is the magnitude and the global reach of the crisis - it is not really just any other
domestic crisis. However, I do believe that financial crises are related creatures - or
monsters if you prefer. On a fundamental level, all crises share causes and cures but they
also have many differences. The cure is made up of two ingredients: 1) regain confidence to
resolve a crisis; and 2) preserve confidence to prevent a crisis from repeating itself. Given
the international dimension of this crisis and the proliferation of cross-border banking, the
cure for this crisis also involves a third component - trust between authorities to enhance
cross-border crisis management. So, the outline of my speech can simply be stated as:
confidence, confidence and trust!
Most financial crises will involve banks because banks are special. Banks are both central to
all economic activity, due to their role in the payment system, and inherently unstable, due to
the maturity mismatch from borrowing short and lending long. To avoid a run, a bank must
maintain the confidence of depositors and market participants. If a bank loses the confidence
of its customers, it faces problems. If confidence for the entire banking sector disappears, a
financial crisis is a fact.
The underlying idea of my cure is quite simple. Confidence is essential to operate a bank.
Consequently, confidence is essential to prevent and resolve financial crises. More precisely,
to resolve a crisis, the cure should restore the public's and the market's confidence in the
banks. This should be done by acknowledging the losses and dealing with the bad assets.
To prevent this crisis from repeating itself, measures should be taken to ensure that
confidence does not dissipate so rapidly again. To this end, liquidity and capital regulation
need to be reformed. The final ingredient in the cure is trust. This ingredient stresses the
importance of trust between national authorities to the efficient management of cross-border
crises.
Regaining confidence in the short run: go get the lemons!
Banks create confidence by telling good and credible stories about the future, stories about
why you will get your money back. Money may make the world go around, but it is good
confidence-building storytelling that spins the money around. When these stories fail to
create confidence, the markets will dry up. This is basically an example of the well-known
lemon problem.
The current problems first surfaced in the US subprime market. The repackaging and sale of
assets backed by subprime loans meant that the crisis, at its outset, had already started to
grab hold of banks internationally. Bankers exposed to subprime assets began to find it
increasingly difficult to tell convincing stories. Banks and market agents became less willing
to trade and to lend to each other. In March 2007, Bear Stearns received emergency lending,
followed by a forced sale. Rating downgrades and more bad news kept arriving and the crisis
started to spread geographically and to affect more markets. Banks experienced serious
funding problems. The ECB and the Fed responded by injecting liquidity on August 9, 2007.
On September 13, Northern Rock received emergency liquidity support from the Bank of
England. Concerns for bank-to-bank contagion due to interconnectedness resulted in a loss
of confidence for the entire banking system. In 2008, bad events continued to unfold. In the
summer of 2008, the US government was forced to rescue Fannie Mae and Freddie Mac.
The relatively slow build-up of the crisis abruptly came to an end when Lehman collapsed on
September 15. Confidence simply disappeared and liquidity evaporated. Several banks got
into severe difficulties: Merrill Lynch, Hypo Real Estate, Bradford & Bingley, Fortis, Dexia and
the Icelandic banks: Landsbanki, Glitnir and Kaupthing, to mention a few. A melt-down of the
financial system was prevented by a massive intervention by central banks and governments
worldwide.
A loss of confidence is the driver of a liquidity crunch, but the lemon problem, as first noted
by George Akerlof in 1970, explains the mechanics of a market breakdown. A lemon is an
asset of bad quality, originally referring to poor quality cars. In short, the lemon problem
arises when sellers know whether or not their asset is a lemon, but potential buyers cannot
tell the difference. The risk of purchasing a lemon will lower the price buyers are willing to
pay for any asset and, because market prices are depressed, owners of non-lemon assets
will be unwilling to put them up for sale.
In normal times, banks can obtain short-term finance by borrowing on the interbank market
and by selling assets. When it became apparent that some assets had turned sour - that
they were lemons - confidence in the strength of individual banks' balance sheets was
eroded. Confidence in the banking sector as a whole was eroded, given the uncertainty over
the extent of the problem - uncertainty over where the bad assets were located and the fear
of possible bank-to-bank contagion. Such uncertainty over the extent and location of lemons,
coupled with a fear of contagion, are normal features of any crisis. However, the opacity of
some of the new financial products and the increased interconnectedness of the financial
system inflated the degree of uncertainty and the fear of contagion, compared to past crises.
The lack of confidence between the banks resulted in the breakdown of interbank markets.
At the same time, previously liquid asset markets completely dried up, due to the lemon
problem. As a consequence, banks found it costly - or even impossible - to obtain liquidity
by selling assets.
Basically, when there are lemons out there, bankers cannot tell convincing
confidencecreating stories about the future. A precondition for the return to normal conditions, that is, to
a situation where banks do not depend on central banks for liquidity, is that confidence is
restored. Central banks have been injecting liquidity for two years now, but still the
underlying problem - the lack of confidence - has not been fully solved. Normality will not
return until the impaired assets are dealt with. Consequently, we convincingly need to go and
get the lemons!
To do that is both messy and costly. A difference to previous crises is the new financial
products that have turned sour. It will be difficult to deal with these opaque and complicated
new breeds of lemon. However, this does not make it less important to get the lemons -
rather the contrary. There are also no shortcuts in dealing with bad assets. The losses must
be recognised. A loss is a loss. The costs involved may make it tempting to sugar-coat the
lemons by letting the bad assets be valued above market value, but this will only postpone
the recovery.
One possible approach to dealing with bad assets is through various forms of asset relief
measures. However, if asset relief is offered, then the pricing must be set at conservative
market values. A transfer value set above the market value is basically a transfer of money
from taxpayers to bank-owners. This could also be costly over time, in terms of increased
moral hazard. In addition, pricing above market prices may destroy the asset market for
years to come and thus add to the costs of the crisis. To restart a market, it is crucial that
investors become confident that the bottom has been reached. This confidence can only be
achieved by the realistic and transparent valuation of assets. Once at the bottom, people will
start to listen to good stories about the future again. Risk appetite will return and market
activity will pick up. In my view, a key part of the successful resolution of the Swedish
banking crisis in the 1990s was that the impaired assets were assigned realistic and
conservative values. Removing the suspicion that bad surprises may linger around the
corner is essential to restarting a market. It is a matter of confidence.
Similarly, the lack of confidence in the banks' balance sheets cannot be improved by creating
opaque accounting rules. The book value of a bank will increase if we assign book values
above market value, but will it restore confidence? Again, to regain confidence, the balance
sheets of banks should reflect realistic values.
Accounting rules should force banks to disclose what their assets are worth and not allow
problems to be hidden. Lack of confidence arises over concerns about a bank's actual
financial situation. If market participants have to recalculate reported valuations, then the
return of confidence will be more difficult to achieve. It is therefore important that accounting
is transparent and internationally harmonised. We should also keep in mind that accounting
rules are not only about preserving financial stability in the short run. Changing the
accounting rules could make communication more uncertain and less transparent.
Another tool for telling stories about the future is stress testing. Stress testing can thus be a
very valuable and effective tool in restoring confidence. However, this requires that the stress
tests are both credible and adequately disclosed. The Fed's stress tests of US banks earlier
this year present a good example of how this tool can be used. We - at the Riksbank - have
been publishing stress tests of individual banks since 2006. With a track record of
reasonable stress tests, the credibility of the methodology and the results has continued to
increase during the crisis.
Building confidence in the long-run: liquidity and capital regulation
The financial crisis of the past two years has been very costly. We must ensure that this
crisis does not repeat itself. Lawmakers, central banks and financial regulators have a
daunting task ahead of them. Regulatory and supervisory reform is needed. I have great
hope that we will take this opportunity to create a safer and sounder financial system. In this
respect, I would like to bring up two important issues for a safer financial system: liquidity and
capital regulation.
Liquidity or, rather, illiquidity has been in the centre of this crisis. Banks will always be
exposed to liquidity risk due to the maturity mismatch, as this is a central feature of banking.
However, in the run up to the crisis, this maturity mismatch increased too much. Banks relied
on the misguided perception that short-term financing would be available from liquid markets.
A key lesson from the crisis is that a liquid market can very quickly become illiquid.
The conclusion is that liquidity must be regulated more firmly. Banks need to hold a buffer of
liquid assets large enough to allow them to weather a liquidity shock. However, the definition
of this liquidity buffer, as well as what type of assets should be viewed as liquid, requires
careful thought. We should keep in mind the lesson that market liquidity can vanish quickly
and be extremely cautious about what securities we consider to be liquid. Furthermore, the
power to dictate the type of assets a bank must hold will have an impact on asset markets.
We must ensure that this power is not misused.
From a central banker's perspective, the content of the liquidity buffer has a bearing on the
central bank's policy on what assets to accept as collateral. In a crisis, it is the central bank's
decision on which securities to accept that defines liquid and illiquid assets - at least in the
local currency. Therefore, the interplay of liquidity regulation and the central banks' collateral
requirements also warrants considerable reflection.
Finally, liquidity regulation will make maturity transformation more costly. We clearly need
more regulation today but, in casting additional regulation, we have to consider the costs.
Too strict regulation would stifle competition, make financial services more expensive and, in
the long run, hamper economic growth. On the other hand, too loose regulation would inspire
speculation with taxpayers' money and also reduce economic growth. Thus, the extent of
financial regulation is - at least partly - a question of society's risk tolerance.
Liquidity buffers will create a cushion. However, the root of a liquidity crunch is a lack of
confidence. A major aim of regulatory reform should thus be to ensure that trust does not
dissipate so rapidly and completely again. In order to do this, we need to increase capital
requirements, both in terms of the quality of capital and the amount of capital. After all,
capital provides protection against bad outcomes. Increasing the quality and amount of
capital will increase the resilience of individual banks. In addition, strengthening the ability of
banks to absorb losses mitigates the risk of contagion - therefore more and better capital will
also strengthen the resilience of the system.
In my view, the important part of capital is loss-absorbing common equity. In addition, other
forms of capital are needed to protect the state. If a bank defaults, capital typically
evaporates very quickly. I have seen many examples of banks that have defaulted because
they did not meet the capital adequacy rules. In my experience, when bank managers say
that they have a problem, they often claim to have - say - 6 per cent regulatory capital,
rather than the required 8 per cent. When the authorities eventually and realistically assess
the assets, capital is often negative and the state has to bail out the bank. Thus, capital
should be of good quality to protect the bank on a going concern basis, but also to protect
the state in the event of a default. As some banks may be too big to fail, as regulators we
should also discuss the possibilities of creating debt instruments which automatically convert
to equity when losses mount above certain trigger points.
Building trust to enhance cross-border crisis management
A financial crisis is costly to resolve. The potential costs are so large that only the nation
state, through its power to tax, can shoulder the costs. This makes the state the only ultimate
and credible guarantor of financial stability.
Today, we have a mismatch between the geographical reach of the only party that can
guarantee financial stability - the state - and the international financial system. The logical
solutions to this geographical mismatch are either to shrink the financial system back to
within national borders or to create an international institution with a right to tax or a system
of burden-sharing, so that confidence in an ultimate guarantor can be established on an
international level.
The first solution would be too costly. Basically, it would imply rolling back decades of
globalisation and financial integration. Consider, for example, the costs of dismantling a large
cross-border bank. It would also mean a serious blow to the European single market. In a
way, I find it puzzling that we are discussing the possibility of a single market for all kinds of
goods and services except for the commodity most suited for free trade: money. A concrete
example of the merits of financial integration is how the arrival of foreign banks resulted in a
rapid development of the banking systems in the Eastern and Central European countries.
The citizens and corporations of these countries benefitted substantially from early access to
advanced financial services.
The second solution - to create an international institution with taxation rights or a system of
ex ante burden sharing - is simply not realistic for the foreseeable future.
Consequently, we are stuck with the geographical mismatch and, as a consequence,
crossborder banks pose a real challenge to crisis management. To accommodate this mismatch,
national authorities must cooperate more effectively. This is the only feasible option. In order
to achieve efficient cooperation, it is vital to build trust between authorities, which explains
my third ingredient.
In the EU, we have the home country principle as a fix for the geographical mismatch. We
have also signed a European Memorandum of Understanding (MoU) aimed at improving
cross-border cooperation.
However, the home country principle does not solve the dilemma of international banks and
national authorities. Tension arises because the home country is responsible for the
supervision of branches but the host country is responsible for the financial stability of the
country. This tension also persists if the foreign bank operates through subsidiaries. Many
cross-border banks centralise different parts of management. There are good economic
reasons for such centralisation. However, the implication is that the home supervisor, as the
consolidating supervisor, has the overall picture, while the host country has the responsibility.
In a crisis, decisions must be taken fast and, typically, based on insufficient and uncertain
information. Access to information is thus crucial for effective crisis management. In the
present crisis, host countries have had difficulties in obtaining timely information from home
country authorities. Considering the importance of information, the frustration of host
countries is understandable. However, let me emphasise that the problem of insufficient
information flows also goes the other way. Home country authorities have also experienced
difficulties in getting accurate information from host authorities. A result of the lack of
cooperation has been suboptimal solutions, the breaking up of banks and a move towards
nationalistic objectives.
Experiences from the crisis prove that it is easy to sign an MoU in good times, but much
more difficult to live up to the spirit of that MoU in bad times.
Financial integration will continue. The question, then, is how do we improve cross-border
crisis management? Part of the problem today is a lack of mutual trust. In bad times, trust is
essential for sharing information. Reaching a joint assessment and making efficient decisions
often require frank and open-hearted discussions. Such discussions will not take place if the
parties do not trust each other. I believe that we must put effort into building trust among
authorities. In this respect, the trust shared among the Governors of the Nordic Central
Banks can provide inspiration.
The Governors of the Nordic countries have built trust for a long time. This building of trust
dates back to the 19th century. Although it is not very widely known, in 1873, Sweden,
Denmark and Norway formed a monetary union based on the gold standard. This union was
eventually dissolved in 1924. However, I believe that one legacy of the union has been that
the Governors of the Nordic Central Banks - adding Iceland and Finland to the group - have
continued to meet regularly since then. This tradition of regular meetings has built trust. It
has taken some time, but today the trust is there.
The Nordic example shows that trust between authorities can be achieved, but that trust
takes time to build - so patience is warranted. At the same time, we need to start getting this
process going immediately. On a European level, I think that the MoU can enhance
crossborder cooperation by increasing harmonisation, regulatory convergence and, not least, by
building trust. Consequently, we should continue to fully implement the MoU. We are working
on this in the Nordic and Baltic countries and are currently establishing a Nordic-Baltic
Voluntary Specific Cooperation Agreement. This may serve as an example and, although it
may take some time, I am confident that we can increase trust in Europe as well.
Conclusion
In my speech, I have talked about confidence and trust. Confidence is essential for a
wellfunctioning financial system. I have touched upon some reforms and actions that I believe
are important to regain and preserve confidence in the banks. I have also talked about how
building trust between authorities is essential to enhance cross-border crisis management.
At the very beginning of my speech, I promised to stay within the time-frame. I should, of
course, in the spirit of my speech, repay your trust by living up to my promise. But, before I
end, I would like to take the chance to stress the need for immediate action. Right now,
nobody doubts the need for and the relevance of reforms. But our memories are short. Good
times also have a tendency to further shorten our memories of financial crises. So we must
take this opportunity to make reforms while the public awareness and the political will are
present. It will be a lot of work, but it will pay off.
Thank you!