Lars Nyberg: The financial crisis
Speech by Mr Lars Nyberg, Deputy Governor of the Sveriges Riksbank, at HQ Bank, 15
October 2008.
* * *
Over the past year my colleagues on the Executive Board and I have spoken on several
occasions about the financial turbulence currently affecting the entire global economy. We
have had reason to return to the topic because the turbulence is constantly taking new twists
and turns. The turmoil has intensified during the autumn and once again we have reason to
reflect on what is happening and what will happen. That is also what I intend to do in my
speech here today.
I would also like to take this opportunity to speak about the role of the Riksbank and other
authorities in relation to this situation and about what needs to happen to calm the unrest.
However, I would like to begin with a brief glance at the past.
Run-up to the crisis
The financial turmoil began over a year ago with the notorious subprime crisis. For a long
time, US financial institutions had engaged in aggressive lending to borrowers with weak
credit histories, after which the loans were repackaged and sold to investors all over the
world. When the credit losses on these loans became unexpectedly large, it was clear that
those who had invested had grossly underestimated the risks.
The subprime problem was primarily a US problem, but since the loans had been sold to
others outside the United States the turmoil had a global effect right from the start. Since no
one really knew where the losses would turn up, a situation quickly arose in which banks and
other financial institutions became cautious about lending money to each other. They began
to hoard liquidity to meet their own obligations and to deal with any speculations that they
were affected by the subprime problems. As a result the conditions for interbank lending
deteriorated, causing market interest rates to soar.
In this situation several central banks chose to act by injecting liquidity into the interbank
market. This intervention achieved the desired effect in part, but did not eliminate the mutual
distrust among banks. Northern Rock, one of the first casualties of the crisis, became well
aware of this situation in September last year when it could no longer find private financing. It
turned instead to the Bank of England - and as we all know, the story ended when, following
a complicated process, the British government nationalised Northern Rock.
The turbulence deepens
Now the turmoil was not just related to the US subprime market. More and more assets and
markets became affected when even borrowers with better credit ratings were hit. Nor were
the problems just a matter of inadequate creditworthiness of US borrowers any more, as the
ability of European borrowers to pay now came into question.
During the spring the turmoil reaped its most startling victim so far. Bear Stearns, the fifth
largest investment bank in the US, was forced to suspend payments after being unable to
arrange short-term financing. It hardly needs to be said that Bear Stearns was heavily
exposed to the subprime market.
Conditions on the credit markets temporarily eased after Bear Stearns. Although tensions
continued, the market began to slowly return to more normal conditions and credit risk
premiums decreased sharply for a while. Confidence seemed to be returning to the financial
markets.
However, the turmoil gained renewed strength during the late summer when Lehman
Brothers was forced to apply for bankruptcy protection. Since then a number of banks in
Europe and the United States have experienced severe problems. Banks and financial
institutions that were forced into being sold or nationalised include heavyweights such as
Fortis in Belgium, Merrill Lynch and AIG in the United States, and Hypo Real Estate in
Germany. The financial crisis had progressed from being a subprime crisis in the United
States into a global confidence and liquidity crisis.
Where can we find the explanations?
In light of current events, the obvious question is how do we explain the situation? What we
see is largely the result of an extended period of vast expansion of credit and growth of the
financial industry's assets, which with hindsight has proven to be unsustainable. This
development was made possible because for some time economic conditions in both the US
and the rest of the world were extremely favourable, with low interest rates, low and stable
inflation, and robust growth. The low interest rates resulted in increased indebtedness and
willingness to invest, which in turn contributed to rising asset prices, especially in the
property markets. Rising asset prices allowed further indebtedness, which once again fuelled
asset prices.
Parallel to this trend, financial market participants engaged in increasingly aggressive
strategies in the search for yield. Banks and mortgage institutions eased credit terms in order
to gain market shares. High-risk loans were packaged in complex structured products that
were perceived as more secure investments than they actually were.
At the foundation, the art of financial engineering that underpins the development of these
products is undoubtedly positive, making it possible to convert illiquid loans into liquid
securities and enabling investors to trade in credit risk without having to handle individual
loans. However, it is essential that the products can be purchased and sold on a market
where investors are offered clear and continuous pricing information. However, this was not
the case. The variety of instruments became so immense and their complexity so great that
few people - if anyone - were capable of assessing these markets.
One driving force behind the development was the large US investment banks, which in
many cases were the creators of the new products and which were also highly leveraged and
invested in these and other risky instruments. However, everything did not remain within the
United States; large volumes of risky loans were packaged and sold in various forms all over
the world. Investors showed a strong desire to buy and drove up the prices of many financial
assets to levels that did not at all reflect actual risk.
In brief, mispricing, imbalances and complicated structures evolved over a long period of
time and when the US subprime borrowers were unable to repay their loans to a greater
extent than expected, the ball was set in motion.
As I said initially, concerns about the US mortgage market soon expanded into a general
distrustfulness of the overall condition of the global financial system. The issue today is less
about the original US problems, but rather about a general confidence crisis and how banks
around the world will manage in the future. Just as in the United States, the global financial
markets have long been characterised by favourable macroeconomic conditions and
aggressive growth strategies among financial institutions. As business activity now declines,
concern about the European banks is expanding from previously mainly involving losses due
to exposure in US markets, to dealing more with the credit quality of their own loan portfolios.
As a result of this uncertainty, participants who usually are active in the credit markets are
withdrawing, causing disrupted pricing along with a drastic decrease in liquidity. When the
markets deteriorate or cease to function in this way, individual financial institutions are also
hit hard, especially the banks. We have seen the consequences of these developments now
during the autumn, causing central banks and governments to take powerful measures to
avoid a full-scale systemic crisis.
Although most banks have satisfactory solvency levels today, the turmoil has developed into
a serious liquidity crisis, based on distrust of the banks' ability to survive in the future. The
entire problem can actually be summarised in a single word; confidence. Currently there is a
lack of confidence in the financial sector as a whole.
So what needs to happen to restore confidence? Before I attempt to answer that question, I
thought I would say a few words about the situation in the Swedish financial system and
about the role of the Riksbank and other Swedish authorities.
The situation in the Swedish financial system
Even if the situation has worsened in recent weeks it is important to remember that the
Swedish financial system is far from the epicentre of the crisis. According to
Finansinspektionen (The Swedish Financial Supervisory Authority) - and according to our
own assessment - the Swedish banks continue to have strong balance sheets. Their capital
situation is strong, credit losses are low and profitability has reached historic highs. The
Swedish banks have been relatively conservative in their lending, and have not been
exposed to any great extent to the worst-hit markets or institutions.
However, although we are not the source of the turmoil, it now has a considerable impact
even on the Swedish financial system. Several parts of the credit market are not working as
well as usual. For example, due to uncertainty among investors we have seen a sharp
increase in demand for Swedish government securities and a corresponding decrease in
demand for mortgage bonds. As we know, this development caused the Swedish National
Debt Office to auction extra treasury bills and use the money to buy mortgage bonds.
The uncertainty has also had an impact on those markets where the banks borrow money,
as it has become more difficult to borrow over longer time periods, and on the international
markets. Even if the major Swedish banks are lending to each other, international investors
are less willing to invest, which has reduced the supply of loans and driven up the banks'
cost of borrowing. However, I would like to point out that higher borrowing costs do not mean
that the banks have problems (in the sense that their financial situation is threatened). It is
true that the Icelandic bank Kaupthing's Swedish subsidiary did suffer from an acute liquidity
need due to developments on Iceland and was forced to turn to the Riksbank. However, the
major Swedish banks do not have - nor have they had - any of the liquidity problems that
Kaupthing and banks in other countries have had.
Nevertheless, there is a significant risk that the credit supply to Swedish companies and
households could worsen considerably if the problems on the credit markets take hold and
persist. Not only would the effects of such a credit squeeze be unfortunate for companies
and households - they would harm the entire economy. It is in part against the background
of this risk that we should view the Riksbank's liquidity support measures over the past few
weeks. It is also one of the reasons for The Riksbank's most recent decision to cut the repo
rate by 0.5 percentage points.
Role of Swedish authorities
One of the main duties of the Riksbank is to promote a safe and efficient payment system.
More specifically, this means that the Riksbank continually analyses risks and threats to the
stability of the Swedish financial system. The purpose of the analysis is to discover any
changes and vulnerabilities that could lead to a serious crisis. In the event that a crisis should
occur, certain tools are at our disposal to handle the situation. Over the past few weeks you
have seen several examples of how we can assist the banking system in various ways with
liquidity-supporting measures when the situation so requires.
The Riksbank is not the only authority that is responsible for ensuring financial stability.
Finansinspektionen also plays an important role as a regulatory authority. In the current crisis
the National Debt Office has also helped to improve liquidity conditions in the financial
system by auctioning extra treasury bills. Ultimately, the Government and the Riksdag also
have a responsibility for financial stability if it becomes apparent that the initiatives of the
authorities are unable to bring a crisis under control.
These days the Riksbank is working very closely with other authorities to monitor
developments and discuss how to handle the situation. Like other Swedish authorities, we
are also in frequent contact with our foreign colleagues and with market participants.
As I mentioned previously, the Riksbank has helped where we could to improve liquidity and
market conditions. But what have we actually done?
What has the Riksbank done?
First of all, we have taken several general measures aimed at all of the Riksbank's
counterparties. The purpose of the measures is to solve two problems with the Swedish
banks: inadequate access to long-term financing in Swedish krona and a limited ability to
gain access to US dollars.
The lack of long-term financing is due to the lack of mutual trust among the banks during the
crisis, which have had a negative impact on the interbank lending markets. One
consequence is that the banks have been forced to borrow for shorter terms. Even if it has
been possible to get financing, liquidity management have become much more difficult for
the banks and risks also have increased. To enable the banks to restore the situation to
more normal conditions, the Riksbank has offered financing at longer terms than what the
markets can currently provide by lending Swedish krona with maturities of three and six
months.
The lending is designed so that we provide liquidity in the form of somewhat longer loans and
absorb the same quantity of short term liquidity. Combined with the fact that lending takes
place at market rates, this means that banks receive help with their strained financing
situation at the same time that the measures do not have any direct effects on monetary
policy. This is a very important point. The Riksbank is quite simply helping the banks replace
their short-term financing with longer-term financing. In a broader sense, the Riksbank is
assuming the role of market maker in the money market and by doing so ensuring its
functioning.
The other problem is that a general shortage of financing opportunities in US dollars has
arisen. Since the Swedish banks are not counterparties with the US central bank, they
cannot be certain that they will receive any of the injections of liquidity that the Federal
Reserve makes. That is why the Riksbank have offered their counterparties large loans in US
dollars.
Together with the measures that the National Debt Office have taken, the Riksbank's lending
of both Swedish krona and US dollars contribute to a general strengthening of liquidity
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.
Second of all the Riksbank has - as I just mentioned - also provided special liquidity
assistance to Kaupthing Bank Sweden. This loan is against collateral and with an interest
rate that is above normal lending costs. Even if this measure is aimed at an individual bank, it
should also be viewed as an initiative to safeguard financial stability and to maintain
confidence in Sweden's entire credit and payment system. The decision is based on the
assessment that although the bank is solvent, it is unable to perform its obligations without
liquidity assistance. What happens next with Kaupthing Sweden is mainly a question for the
bank's owner, the Icelandic state.
The liquidity support to Kaupthing differs in many regards from the Riksbank's other
measures. In this case the support is aimed at an individual institution and not at money
market participants in general. In Kaupthing's case the point was to enable the bank to obtain
any funding whatsoever and thereby continue to exist. An important similarity with the other
measure, however, is that the liquidity that was injected via Kaupthing into the system also
comes back to the Riksbank in the form of deposits from the bank(s) that have excess
liquidity. In this way this measure does not have any direct monetary policy effects either.
The common denominator for everything the Riksbank has done to date is that all measures
are aimed at strengthening liquidity conditions within the Swedish financial system. Unlike
many other countries, thus far it has not been necessary for the Swedish authorities to
provide the banks with any form of capital support from the government. This point is also
important. However, it remains to be seen whether the Riksbank and other authorities have
done enough. How the situation develops in the future is essentially a question of what
happens outside of Sweden. Nevertheless, the Swedish authorities are prepared to take
those measures that are necessary to ensure financial stability. For the Riksbank, this means
that we will continue to provide the banks with the liquidity required for the financial system to
function.
Let me now proceed to discuss paths out of the crisis.
Paths out of the crisis
We are now in the middle of the most serious financial turmoil that the world has seen in a
very long time. It is difficult to anticipate how the situation will develop in the future, which
means that it is also difficult to talk about paths out of the crisis. However, let me share a few
general thoughts.
In the short term
Large imbalances have been built up in the global financial system over a long period of
time. The risks that banks and other financial institutions have assumed have quite simply
become too high in relation to the risk-bearing capital. Therefore the risk level must be
reduced and capital must be injected. This adaptation process is in full swing and
writedowns have been taken globally for a value of USD 637 billion. Lower asset values must be
met with lower indebtedness, either by disposing of assets or by increasing equity. This
process is also in full swing. Including the measures taken by the US government yesterday,
capital injections of about USD 611 billion have been made so far, but additional capital will
be needed as further write-downs will be made.
To put it succinctly, what is needed is that many financial institutions all over the world must
shrink or disappear. This process will be both time-consuming and painful. Iceland is the
current example of how just painful and spectacular the process can be. But the fact
remains: only when the banks' balance sheets have stabilised and the markets have made
certain that solvency levels are satisfactory will the situation normalise. Only then will
confidence return to the financial markets, and only then will liquidity also return.
Central banks and other authorities need to accept their part of the responsibility while these
processes are in progress. The task of the central bank is to provide the financial system with
liquidity when needed. As we know, this has also taken place to a large extent. However,
there are limitations to what the central banks can do. Other measures must be taken for
banks with inadequate solvency. For these purposes a functioning order to handle banks in
insolvency is needed. Where taxpayer money is involved, the process must be carried out on
condition that the socioeconomic costs are minimised and that the owners of the financial
institutions that are taken under public administration must carry their own losses.
The coordinated crisis package that the Euro countries launched earlier this week contains
the essentials and largely offers the desirable components for such a package. After the
Lehman Brothers bankruptcy it became clear to financial market participants that even the
largest financial enterprises could fall. This insight caused the freezing of the markets that
has now lasted for almost a month. Promises by leading nations that this will not be allowed
to happen again will hopefully help to thaw the financial markets. It is both welcome and
desirable that the government support measures are accompanied by tough
counterdemands on the banks.
The Swedish government has announced that it intends to carry out a nationally adapted
version of this crisis package in Sweden. It is hoped that Swedish banks will not have to
make use of the opportunity for government guarantees or capital injections, since the terms
will probably be rather tough. However, we do not know the details of the proposal at this
time.
However, what we do know is that the Government has decided to expand the deposit
guarantee. This is an important measure to strengthen confidence in the Swedish banking
system. At the same time it is important to add that measures of this type must be
complemented in the long term with mechanisms that facilitate a sustainable financing of the
system; in other words, those institutions that are covered by the guarantee must also carry
its costs.
In the somewhat longer term
In a longer perspective there is reason to consider which structural changes are needed to
prevent similar situations from arising again. An intense discussion is currently underway
about the need for changed regulations and stricter supervision of the financial markets and
institutions. The Riksbank has discussed these issues in various contexts for some time.
For example, the rules for management and supervision of liquidity risks need to be
developed and improved. The financial sector needs greater transparency so that customers
and investors can gain a better overview of the companies' commitments. For Sweden it is
also important to create a functioning regulatory framework to handle banks in insolvency.
And just for the sake of clarity, let me add that this view is in no way related to any such
situation being present in Sweden. This is something that the Riksbank has advocated for a
long time.
In light of what happened in the United States we should also consider regulation of
institutions that do not take deposits from the public. Such institutions are often the subject to
weaker supervision and regulation, which has been justified because they are not as
important for financial stability. But as the developments in the US investment banks clearly
illustrate, even such institutions can substantially shake up the financial system.
Given the global scope of the crisis it is important to coordinate both short-term and
longterm measures among countries. If nations try to find separate solutions in this type of
situation, the costs for handling the turmoil could become even greater than what they
otherwise would have been, even for individual countries. Therefore, in all of the issues
mentioned here, much can be won through international coordination and harmonisation.
Yet another example of an issue that requires international coordination is how to organise
supervision and crisis management within the EU. Today several banks engage in significant
operations in several EU countries, while the responsibility for supervision and crisis
management is still national. Under such circumstances there is a risk that coordination
problems and conflicts of interest could arise between countries, which obviously does not
benefit financial stability. Cooperation within the EU offers a unique opportunity to discuss
and agree on how to handle these problems.
However, dealing with all of these problems is not just a matter of changes in regulation and
supervision. If I may once again take the US as an example, the problems there show that
the incidence of financial crises can also have a clear political dimension. One important
reason for the lending boom was that the country's political leaders had long pressured the
mortgage lending institutions to increase lending to low income groups. Institutions such as
Fannie Mae and Freddie Mac were quite simply forced to base their operations on political
objectives rather than on sound credit risk policies. The fact that unfortunate political
decisions such as these, as well as inadequate regulation, can help to create a crisis is an
important lesson to keep in mind when we eventually close the books on this crisis.
I am aware that my wish list is long and requires extensive reform work. However, the course
of events over the past year has clearly underscored the need to quickly deal with these
issues.
Meanwhile, it is important to make clear that we must not become overly zealous about
regulation. In times such as these it is easy for opportunism to gain the upper hand, resulting
in measures that do more harm than good. The Riksbank supports the EU commission's
motto of "better regulation" and that all regulation changes must be preceded by objective
and extensive impact assessments and cost-benefit analyses.
Concluding remarks
Let me now summarise.
The financial turmoil that began in the United States over one year ago has now spread
around the world with full force. Strong distrust currently prevails in the markets, which in one
way or another essentially afflicts all financial institutions. For Swedish banks this trend is
mainly expressed by the fact that they are forced to borrow on much shorter terms than usual
and at higher rates. In brief, although we are not responsible for the current situation we are
certainly feeling its repercussions.
Both the Riksbank and Finansinspektionen still hold the opinion that the major Swedish
banks have strong capital buffers, robust earnings and low loan losses. Consequently,
conditions are good for handling the current uncertainties as well as for dealing with
unexpected future losses in the economic downturn we see ahead of us.
Thank you!