Stefan Ingves: The monetary policy landscape in a financial crisis
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank, at the Swedish Economics
Association, Stockholm, 31 March 2009.
* * *
Introduction
"The monetary policy landscape in a financial crisis" is the theme of my speech this time. I
thought for once that I would begin by showing you a picture.
The slide shows an oil painting that was done in 1842 by the English artist William Turner.1 It
is called "Snow Storm - Steam-Boat off a Harbour's Mouth". It is part of the collection at the
Tate Gallery in London.
The only thing you need to know about the painting just now is that Turner used a very
special technique. He built up the picture gradually by painting several thin, semi-transparent
layers on top of each other. He then added somewhat thicker, more pastose sections. As you
can see, this layer-by-layer technique gave his paintings a special lustre and a special
atmosphere. We would probably say that the atmosphere in this painting is dramatic.
Turner's technique can also act as a starting point for a description of the situation today.
Reality is made up of different layers. Every layer that is added or peeled away reveals a
partly new landscape.
We can compare the financial crisis to the snow storm in Turner's painting. In order to paint
the picture of the complete storm we need to begin with a layer that describes the
macroeconomic preconditions, the macroeconomic landscape. Then comes a layer that
describes the financial landscape. This consists of financial players, institutions, markets and
instruments. Over this there is yet another layer that describes the regulatory landscape, that
is the special legislation, regulations and supervisory arrangements that cover the activities
of financial companies.
Somewhere in the middle of the picture, symbolised by the steam boat that is trying to
navigate the right course through the snow storm, we have the Riksbank which is fighting to
both meet the inflation target and safeguard the stability of the payment system. For the
Riksbank, as for steam boats at sea, the room for manoeuvre is determined by the conditions
in the surrounding landscape. We have to understand how the weather, visibility and other
prevailing factors affect our chances of steering the boat in the right direction. This becomes
particularly important when conditions are difficult, when there is a snow storm raging at sea.
This - in a nutshell - is what my speech today will be about. First, however, it may be
interesting to look at how we sailed into the storm.
From fair weather to the perfect storm - what went wrong?
The metaphor of the different layers in Turner's painting can be used to describe the causes
of the current crisis.
Global imbalances were built up
If we are to understand the origins of the crisis, we cannot ignore certain factors in the
macroeconomic landscape. This applies in particular to the major global imbalances that
were built up over a long period of time. In the rapidly-developing economies in the
oilproducing countries and Asia, particularly China, domestic saving reached a level that was
higher than required to fund domestic investments. This led to substantial current account
surpluses. Large amounts of capital were built up which sought an outlet on the global
financial markets. These were used, for example, to buy assets in the West.
At the same time, the economies in the West, especially the USA, experienced an unusually
long, uninterrupted period of favourable conditions with strong growth and low inflation.
Policy largely focused on maintaining these good conditions. It was possible to stimulate
domestic demand at the cost of a gradually increasing current account deficit. The large
capital flows on the financial markets helped to keep interest rates down. With consumer
prices held in check, it was also felt that there was no real reason to conduct a stricter
monetary policy. The result was that significant global imbalances arose - a lasting savings
surplus in some countries and a deficit in others.
Image 2: Current account deficit as
percentage of GDP
12 12
Kina
10 10
Sverige
USA
8 8
6 6
4 4
2 2
0 0
-2 -2
-4 -4
-6 -6
-8 -8
-10 -10
95 98 01 04 07
Källa: IMF
Image 3: Credit spreads* for
corporate bonds in the USA
Basis points
2200
Aaa
2000
Baa
High-yield
1800
1600
1400
1200
1000
800
600
400
200
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
difference between the yield on corporate bonds and the yield on treasury bonds. Source: Reuters Ecowin
*The
The markets priced risk incorrectly
This also laid the foundations for changes in the financial landscape. The good supply of
capital available for investment and the low interest rates for risk-free assets increased the
demand for assets with a higher yield, a "search for yield" arose. However, investors all over
the world, including many major banks, largely ignored the fact that, in the long term, higher
yield can only be achieved by taking greater risks. This contributed to a dramatic increase in
asset prices. The very favourable conditions that prevailed on the global financial markets
meant that the premiums for credit risk were generally extremely low for a long period of
time.
The explosion in asset prices was fuelled by a rapid expansion in credit. Money was lent
more carelessly than previously. Housing bubbles developed in several parts of the world. In
the USA, the development of such bubbles was reinforced by the inadequate regulation of
the mortgage market and a political agenda that aimed to promote house ownership among
people on low incomes.
The search for yield drove investors to borrow more in order to achieve greater leverage in
the investments. Financial innovations also helped to drive this development. A steady flow
of new and increasingly complex instruments were created to satisfy the demand for
investments with a higher yield. Advanced techniques arose for the securitisation of different
forms of credit, including mortgages for less creditworthy borrowers. Many banks around the
world - although this applies to a lesser extent to Swedish banks - thereby changed their
business model. While previously they had specialised in developing long-term customer
relations and in evaluating and monitoring credit risks, the banks now increasingly went over
to repackaging and selling their credit risks as quickly as possible. One might think that the
banks used securitisation to get rid of a large proportion of their credit risks. Unfortunately,
this was largely an illusion. The banks created special intermediaries off their balance sheets
to hold and structure the securitised credits. This made it possible for the banks to increase
leverage both on and off the balance sheet. However, explicit and implicit guarantees from
the banks to these special companies meant in practice that the risks led directly back to the
banks' balance sheets.
The result of all these new instruments and artificial intermediaries was a motley and almost
impenetrable structure. A wide range of asset types with idiosyncrasies in pricing arose. This
also made them more difficult to value. Moreover, the complicated links between the banks
and their special investment vehicles made it difficult to see exactly what the banks'
exposures were. Eventually, no one knew where the risks were. The increasing amount of
credit not only made investors highly indebted in relation to their equity, many banks also did
not really have enough capital in relation to the risks they took.
When economic activity began to decline in the USA and prices fell on the US housing
market, many institutions suffered major losses. Above all, however, a great deal of
uncertainty arose. It proved to be simply impossible to know with any certainty who was
exposed to "toxic assets", that is assets that risked losing value as a result of major credit
losses. The realisation that many institutions could be more in debt than appeared to be the
case on their balance sheets fuelled this uncertainty. The resulting anxiety led to the waning
of trade on a number of financial markets. As the banks have become increasingly
dependent on the financial markets for their funding, many banks now found it difficult to
refinance their operations. In other words, they found it difficult to borrow in order to cover
their lending.
When the US investment bank Lehman Brothers was forced to apply for bankruptcy
protection in September last year, this had major repercussions in many parts of the world.
The global financial crisis escalated and the Swedish banks were also affected to an
increasing extent. When the conditions on the global financial markets deteriorated, there
was a general increase in credit risk premiums. For those borrowers - banks or countries -
that were deemed to entail the highest risks, the premiums increased more than for others. A
process to reduce exposures and debt/equity ratios began among banks and other financial
institutions around the world. The rapid decline in the supply of credit reinforced the downturn
in global economic activity. This in turn accelerated the substantial fall in asset values and
the increase in the bank's credit losses. A vicious circle arose in the global economy in which
the financial turmoil aggravated the weakening of the real economy and vice versa.
The events in the financial sector reflect fundamental failures in the risk management of the
financial players. Securitisation partly removed the banks' incentive to monitor credit risks.
The credit rating institutions largely took over this role. But the models used by the rating
agencies were in many respects inadequate and the credit ratings were interpreted
incorrectly. The correlation between credit risks was underestimated, as were the liquidity
risks. The market thus priced risks incorrectly. This did not mean, however, that all of the
players acted irrationally. Many players were able to make a lot of money in the upturn while
others had to bear the losses in the downturn. The reward systems in many cases thus
encouraged exaggerated risk-taking by promoting short-term profits.
There were thus shortcomings in basic corporate governance. These shortcomings were not
helped by the fact that many institutions had developed into very large and complex
organisations - too large in some cases to be allowed to fail.
Gaps in regulatory frameworks and supervision
These developments of course all took place against the background of the landscape of
regulations and supervisory arrangements that surround the financial system. A general
problem in all forms of financial regulation is that, if the regulations are binding, players
attempt to conduct an increasing proportion of their activities outside the regulated sector.
There were without doubts large gaps in the regulatory frameworks that enabled so-called
regulation arbitrage. Some institutions, for example many investment banks, were not subject
to the same insight or constraints as ordinary banks. Some markets, for example the OTC
market for credit derivatives, were permitted to grow explosively without the authorities
having any real oversight. The capital adequacy frameworks also made it cheaper in many
areas for the banks to expand off their balance sheets. After the event, we can also note that
the regulatory frameworks focused too little on liquidity risks. Many of these gaps in the
frameworks are now being closed. However, the eternal problem is of course that the
markets are always faster at finding new ways of circumventing the regulations than the
authorities are at closing the gaps.
Perhaps a more fundamental problem was that there was too weak a link between financial
supervision and macro factors and other factors that affect the risk of shocks in the financial
system as a whole. There was quite simply too much focus on individual companies and too
little focus on broader development trends. Nor did the supervisory arrangements adequately
reflect the increased internationalisation of the financial sector. In recent decades, the
financial markets have become increasingly interlinked and very large sums change hands
around the world every day. Large, complex banks and other financial institutions now
conduct extensive operations in several countries. At the same time, supervision was mainly
conducted on the basis of national mandates and focused on companies within individual,
national jurisdictions. Supervision thus lacked the oversight required.
Many factors interacted
A number of interacting factors thus lay behind the situation that arose. Global
macroeconomic imbalances, fundamental shortcomings in the risk management of the
financial players and gaps in regulatory frameworks and supervision together formed the
underlying layers in the current financial and economic crisis - a crisis that many observers
regard as the worst since the 1930s. In order to avoid a total breakdown in the financial
system, governments, central banks and other authorities around the world have been forced
to take a range of massive and unusual measures.
Massive and unusual measures on the part of the authorities
So, what have the authorities done? The central banks have lent large sums of money to the
banks at longer maturities and against other forms of collateral than has normally been the
case. This has improved the short-term funding situation for the banks. Several central banks
have also provided emergency liquidity assistance to individual institutions. The Federal
Reserve, the European Central Bank and other central banks have also entered into
agreements to provide loans in their own currencies to other central banks to mitigate the
effects of the crisis in other countries. The central banks have also cut policy rates rapidly
and forcefully, sometimes in coordinated actions, to alleviate the repercussions of the
financial crisis on production, employment and inflation. Governments have offered
guarantees and capital injections to reduce the risk of further bankruptcies in the banking
sector. Deposit guarantee schemes have been extended. Several countries have also
adopted fiscal policy stimulation packages to mitigate the effects on the real economy.
In Sweden too, authorities such as the Riksbank, the National Debt Office and
Finansinspektionen (the Swedish Financial Supervisory Authority) have acted to alleviate the
crisis. As in many other countries, the government has increased the national deposit
guarantee scheme and has extended it to cover all forms of deposits in accounts. The
government has also introduced a guarantee programme, set up a guarantee fund and
decided on capital injections for banks. At the same time, the government is conducting a
more expansionary fiscal policy than previously to mitigate the effects on the real economy.
The Riksbank has implemented a large number of measures to safeguard financial stability
and mitigate the negative effects of the financial crisis. We have changed the collateral
requirements so that the banks can use more types of security as collateral when they
borrow from the Riksbank. We have, for example, begun offering loans with commercial
paper as collateral to facilitate the companies' financing. We have also begun to lend at
longer maturities, with variable interest rates and with smaller supplements. We have
provided special liquidity assistance to Kaupthing and Carnegie. In addition, we have entered
into loan agreements with Iceland, Latvia and Estonia to ease the situation in these
countries. All this has meant that during the second half of 2008 the Riksbank increased its
total lending to the banks by more than SEK 450 billion. I will discuss what this entails in just
a moment.
The Riksbank has also cut the repo rate to the lowest level it has been at since we
introduced an inflation target. How monetary policy can be conducted under the prevailing
conditions is a question that I will discuss in more detail later. The financial crisis has of
course changed these conditions a great deal. But before we get into that, I would like to say
a few words about how monetary policy is supposed to work under normal conditions.
How monetary policy works normally
Normally, monetary policy aims to keep inflation at a low and stable level and to stabilise the
real economy. To achieve this, the Riksbank controls the shortest market rate, that is the
overnight rate which is the interest rate on loans between the banks from one day to the
next. The overnight rate in turn affects the interest rates charged to the general public, and
thereby activity and prices in the economy. We have a system in which we influence the
overnight rate by determining the conditions for the banks borrowing and lending with the
Riksbank so that it is close to our policy rate, the so-called repo rate. The repo rate
expresses the level at which the Riksbank wants the overnight rate to lie.
The way in which the monetary policy conducted has an impact on, for example, the banks'
lending rates, the development of the real economy and inflation is usually called, somewhat
the transmission
loosely, mechanism. This mechanism is often described in terms of three
different channels: the interest rate channel, the credit channel and the exchange rate
channel. These channels are intertwined with each other and the division is mostly for
explanatory reasons.
The interest rate channel can be used to influence the cost of saving and borrowing. A lower
interest rate means that it becomes less expensive for companies to finance investments and
for households to borrow for consumption. Lower interest rates normally also make saving
less attractive.
Interest rate changes also affect the economy through the credit channel. Lower interest
rates generally increase the net present value, that is the value today, of the cash flows that
financial assets are expected to generate in the future. Lower interest rates also increase the
demand for real assets, for example housing. In this way, the prices of both real and financial
assets increase. As these assets are used as collateral for loans, the creditworthiness of
households and companies also increases. This leads banks and other financial institutions
to be less restrictive in their lending and means that they can lend more. This in turn
stimulates investment and consumption and thus increases inflationary pressures in the
economy.
Through the exchange rate channel, monetary policy can influence the value of the currency.
Normally, a reduction of the repo rate leads to a weakening of the krona. This is partly
because Swedish assets appear less attractive than investments in other currencies. A
weaker exchange rate affects inflation directly in that imported goods will become more
expensive. At the same time, domestic goods become cheaper than foreign goods. This
leads to a decline in imports and a rise in exports. Higher demand for domestic goods
contributes to an increase in resource utilisation and inflationary pressures.
Inflation expectations are also important to the way in which companies set prices and to
how wage formation functions, and thereby to the development of inflation. If everyone is
confident that inflation will remain low, the companies do not need to change their prices so
often, and employees do not need to increase their wage demands. This makes it easier for
the Riksbank to achieve the inflation target.
This then is mainly how monetary policy is supposed to work normally. But when the financial
markets are not working normally the transmission mechanism is also affected. The various
channels simply do not work as effectively as they usually do. This also makes the link
between monetary policy and financial stability particularly important.
Monetary policy and financial stability are interlinked
As you know, the Riksbank has more than just a monetary policy mandate. In addition to
maintaining price stability, the Riksbank also has the task of promoting a safe and efficient
payment system. We thus have two main tasks: monetary policy and financial stability.
These tasks are of course interlinked even under normal conditions. Without stability in the
financial system it becomes more difficult to conduct monetary policy, and price stability is
part of an effective payment system. Practically and organisationally, however, these are two
separate fields of work. You could say that we normally use two different toolboxes to
perform these two tasks.
First, we have a monetary policy toolbox, parts of which I have already described. The
monetary policy measures, for example the setting of the repo rate, have a clear objective: to
influence economic activity with the aim of maintaining price stability. This in turn is an
important component of our efforts to achieve stable development in the real economy.
Second, we have a box of tools for promoting stability in the financial system. Financial
stability is a basic prerequisite for a safe and efficient payment system. The Riksbank
normally uses tools other than the repo rate to promote financial stability. Our analyses of the
risks in the financial system that we produce and publish every six months in our "Financial
Stability Report" represent the primary tool in this toolbox. If nothing else, this and other
feedback that we provide to the banks makes them more aware of potential vulnerabilities
and, in the best case, gets them to take preventive measures. This is usually referred to as
"moral suasion". But this toolbox also contains more concrete tools. These include the
possibility to quickly add liquidity to the banking system.
We thus normally approach these two main tasks somewhat differently and we often regard
monetary policy and financial stability as two separate parts of the Riksbank's mission.
Recently, however, it has become increasingly clear just how interlinked these two tasks are.
When the interbank markets have been ineffective and interest rates have to a certain extent
been governed by a lack of confidence, the impact of monetary policy has been weakened.
This has meant that we have needed to use tools from both of the toolboxes during the crisis.
The situation has required the use of some tools that we otherwise use rarely. We have even
had to reinvent some of the tools and refine them as we go along. The measures have
primarily aimed to strengthen financial stability and to maintain the functionality of the
financial markets so that the payment and credit systems work effectively. This is a
prerequisite for the effective functioning of the economy as a whole.
Many measures that are taken with the aim of safeguarding financial stability also have
indirect monetary policy effects. For instance, measures that lead to greater confidence in
the markets contribute to lower interest rates and increased access to credit, thereby
increasing the impact of monetary policy. Similarly, the Riksbank's interest rate reductions
contribute to financial stability by improving the supply of credit. The measures that are
normally taken under the framework of monetary policy or to promote financial stability have
thus begun to complement and mutually reinforce each other. To illustrate what we are doing
today we can use a simple equation that describes the banks' lending rate - that is the rate
charged to households and companies - as the repo rate plus a premium.
Image 4: Monetary policy and financial
stability are interlinked
= +
i i mc (
tlending t t,...)
The size of this premium depends on the bank's demand for compensation for, for example,
credit risks, any differences in periods to maturity and the need to retain sufficient capital to
cover the loans. What we are doing now is partly to control the first term, that is the policy
rate, and partly to attempt to influence the second term, that is the risk premiums that are
today reflected in large credit spreads as a result of the financial turmoil. To do this we must
use tools from both of the toolboxes. It is against this background that we can view the
monetary policy measures of a more or less unconventional nature that are now being taken
in various parts of the world. I will now try to discuss this in a little more detail.
Unconventional monetary policy
As I mentioned earlier, the central banks have reduced policy rates quickly and dramatically
in order to mitigate the effects of the financial crisis. At the end of last year, the US central
bank cut its policy rate target to an interval of 0-0.25 per cent. In early March, the Bank of
England cut its policy rate to 0.5 per cent and is thus also close to zero. Many other central
banks, including the Riksbank, have also reduced their policy rate to all-time low levels.
When the central banks' traditional tools for influencing demand in the economy can no
longer be used - when no further cuts in the policy rate are possible - then other options
have to be found. In both the USA and the UK, as in some other countries, the central banks
have begun to conduct monetary policy using unusual, and in some case untested, methods.
It may be worth pointing out, however, that there may be good reasons for implementing a lot
of what the central banks have done irrespective of whether the policy rate is close to zero or
not. This relates to various measures that aim to improve the functioning of the financial
markets and ease the supply of credit.
One way of trying to illustrate the course of events is to study the central banks' balance
sheets. The exact form of these balance sheets varies from country to country, but they have
a number of common features. For the sake of simplicity, and without claiming to present an
exact picture of reality, allow me to assume a stylised balance sheet. On the asset side there
are foreign and domestic assets and the lending to the banks. On the liabilities side, there
are banknotes and coins, deposits from the banks and equity.
Image 5: Unconventional monetary policy
A stylised balance sheet for a central bank
Assets Liabilities
Foreign assets Banknotes and coins
Domestic assets Bank deposits
Lending Equity
The balance sheet totals of the central banks increased dramatically during the autumn of
last year and have remained at approximately these levels since then. A major part of this
increase was due to the expansion of lending.
Image 6: Central banks' balance sheets
Percentage of GDP
25 25
ECB
BOE
20 20
Federal Reserve
Riksbanken
15 15
10 10
5 5
0 0
jan-07 apr-07 jul-07 okt-07 jan-08 apr-08 jul-08 okt-08 jan-09
Sources: Bureau of Economic Analysis, Eurostat, Office for National Statistics, SCB and the respective central banks
As I have mentioned, during the second half of 2008 the Riksbank increased its lending to
the banks by more than SEK 450 billion. As a result of the increase in lending, the
Riksbank's balance sheet grew during the second half of 2008 from around SEK 200 billion
to around SEK 700 billion, that is it more than tripled. What happened was, put briefly, that
when the interbank and securities markets stopped working normally, the demand from the
banks for loans and for liquidity reserves at the Riksbank increased. It could be said that the
Riksbank acted as an intermediary in the sense that the banking system was able to borrow
at longer maturities in order to invest in a secure and liquid asset in the Riksbank.
Image 7a: The Riksbank's balance sheet
30 June 2008 (before Lehman Brothers)
Assets Liabilities
Gold Banknotes & 108
26coins
Currency reserve 158Fine tuning 0
Lending USD Riksbank
0certificates
0
Lending SEK 4Debt to Fed 0
Other 4Equity 59
Other 25
TOTAL 192TOTAL 192
Image 7b: The Riksbank's balance sheet
31 December 2008 (after Lehman Brothers)
Assets Liabilities
Gold Banknotes & 112
30coins
Currency reserve 200Fine tuning 207
Lending USD Riksbank
196certifikates
49
Lending SEK 262Debt to Fed 189
Other 7Equity 59
Other 84
TOTAL 700TOTAL 700
If we compare the balance sheets at the end of June and the end of December 2008 - that is
before and after Lehman Brothers applied for bankruptcy protection - we can see that
lending in Swedish kronor increased by approximately SEK 260 billion. This is reflected on
the liabilities side by the increase in the Riksbank's fine-tuning facility, where the banks
deposit their surplus liquidity overnight, as well as the increase in Riksbank certificates with a
maturity of one week. The banks have thus increased their reserves at the Riksbank.
The Riksbank has also lent almost SEK 200 billion in US dollars. We have financed this
partly by borrowing against the currency reserve and partly by means of a loan agreement
with the Federal Reserve. The fact that the currency reserve appears to have increased is
primarily due to exchange rate effects.
The liabilities item "Other" includes the Riksbank's net income and the revaluation account.
This item has increased mainly due to exchange rate effects, but also because we have
earned quite a lot of money from these transactions.
Some other central banks, such as the Federal Reserve and the Bank of England, have gone
one step further. Apart from increasing their lending to the banks, they have also bought
various types of domestic financial assets. When a central bank lends money to the banks,
or purchases different types of assets, the banks' access to funding increases. This in turn
increases the so-called monetary base on the balance sheet's liability side, that is the total of
outstanding banknotes and coins and the banks' deposits in the central bank.
A common feature of the measures taken by the central banks is thus that they have inflated
the balance sheets and increased the monetary base. There are, nevertheless, some
differences and different central banks have also described their measures in slightly
different ways. For example, most of the measures taken by the Federal Reserve have
aimed to make it easier for households and companies to get access to credit and to reduce
risk spreads. The strategy has therefore been called credit easing. The Federal Reserve has
thus focused on the asset side and has, for instance, bought different types of domestic,
private financial assets. In this context, what happens to the monetary base on the liability
side of the balance sheet has not been the central issue, although of course everything that
happens on the asset side of a balance sheet is directly reflected on the liability side and vice
versa. Technically speaking, the monetary base has increased in Sweden too because the
Riksbank has increased its lending to the banks. This has not, however, been the main aim
of the lending and is not something that, in the present circumstances, can be expected to
automatically lead to an increase in lending to borrowers outside the banking system. The
Riksbank's lending has, on the other hand, eased trading on the interbank market.
However, increasing the monetary base may sometimes be a deliberate strategy. In such a
case we usually talk about quantitative easing. What we mean by this term is that the central
bank has moved away from monetary policy easing in the form of reductions in the price of
the banks' deposits in the central bank, that is the policy rate, to increasing the quantity of the
bank's deposits - and the monetary base - directly. Opinion is divided on exactly how
quantitative easing works and how it relates to credit easing. Most economists are cautious
about describing the concrete channels. In very simple terms, it is possible to illustrate what
we want to achieve with quantitative easing with the help of a classic quantity equation.
Image 8: Quantity equation
× = ×
M V PY
This well-known equation says that the money supply times the turnover rate for money is
equal to the price level times production. In severe crises, the turnover rate for money, V,
declines. To keep up prices, P, and production, Y, we need to increase the money supply, M.
By buying government securities and thus increasing the supply of money, the central banks
aim to increase the supply of credit and thereby improve liquidity among private players -
and ultimately increase consumption. This presupposes, however, that the banks do not
simply hoard these extra reserves but also actually increase their lending. If the central bank
buys government securities, risk free interest rates at slightly longer maturities may also fall.
It can be said, in simple terms, that the application of quantitative easing entails a focus on
the liability side of the balance sheet, while the state of the asset side becomes less
important even though this is also reflected in the balance sheet. The express purpose of this
shift from price to quanti