Lars Heikensten: Risk management and financial stability
Speech by Mr Lars Heikensten, Governor of the Sveriges Riksbank, at the Risk Management Forum,
Stockholm, 17 February 2004.
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Why is the Riksbank interested in risk issues?
Firstly, I should like to thank you for the invitation to come and speak at the Risk Management Forum.
The Riksbank's objectives are not limited to price stability; the Sveriges Riksbank Act also requires
that we promote a safe and efficient payment system. We therefore have a natural interest in
monitoring risks in the financial sector and that these are handled in a responsible, but also efficient,
manner. As you know, this has not always been the case. At the end of the 1980s, risks built up in the
Swedish banking system that were much greater than most people realised. The Riksbank was as
unaware of the situation as others. However, when the crisis was over, we decided that we needed to
improve our knowledge of the risks in the financial system and to closely follow their development.
Later, we began to publish a twice-yearly report on financial stability, which focuses on the
development of risks in the financial system. We were actually pioneers in this work and several
central banks have since followed our example.
Naturally, our endeavour has not been to ensure that the risks are as small as possible in every
aspect. On the contrary, one of the most important tasks with regard to the financial system is to
facilitate risk-taking; to manage and redistribute financial risks. Methods for this have developed at an
incredible rate over the past decade. The new possibilities for risk management have strongly
contributed to increasing the efficiency of the financial sector and thereby the economy as a whole.
However, it is important that the risks are managed carefully and that they are reasonable in relation to
the capital allocated to cover them. They must therefore be clear and transparent to all involved. In this
respect, the financial institutions and society as a whole have no fundamentally difference of interests.
No one wishes to be surprised by risks they knew nothing about.
The Riksbank also works on financial risk issues in many international contexts, in the Basel
Committee, the IMF and on committees within the EU and ECB. As the financial markets to a large
degree operate across national borders, it is often necessary to establish joint regulations and
principles at international level. Throughout, the important issue is to weigh stability concerns against
efficiency aspects, to find regulations that make the risks transparent and limit them in relation to the
available capital. This should also be achieved without excessively encroaching upon the efficiency
and development of the markets.
My overall theme today is how the Riksbank views developments in the risk management field from
the perspective of financial stability and efficiency. However, before I go into this further, I should like
to provide some background to this by reminding you of a time when some risks were managed
inadequately, which led to a serious systemic crisis, namely the
Swedish banking crisis at the beginning of the 1990s.
The banking crisis from a risk management perspective
Taking a narrow view, one could say that the banking crisis was the result of the institutions and
authorities lacking the capacity to assess and manage risks. The banks came from an environment
that had been strictly-regulated for many decades and where their operations were so firmly controlled
and restricted that a cursory awareness of risk management sufficed in day-to-day operations. The
demand for credit was much greater than the supply, which meant that only those with the best credit
ratings were allowed to borrow. When the regulations were gradually phased out during the 1980s, the
banks and other financial institutions lacked the expert knowledge and organisation necessary to
manage the new, increased risks, which were also more difficult to assess. As this curb no longer
existed and the banks instead began to compete for market shares, they took on hasty and in many
cases unhealthy risks. We were not the only country to experience this development. Over the past
fifteen years, many countries around the world have suffered financial crises for similar reasons; as
the result of financial deregulation, which has not been combined with the necessary improvements in
risk management and supervision.
The authorities responsible for the institutions and for financial stability, mainly Finansinspektionen
(the Swedish Financial Supervisory Authority) and the Riksbank, had not built up sufficient
competence regarding the financial risks. Nor did the legislation suffice as a basis for the authorities to
limit imprudent credit-granting. The oversight of the banks and other credit-granting bodies therefore
became formalistic and fragmentary. We were not always looking in the right places.
In defence of the banks' management and the authorities it can be pointed out that risk assessment
was made difficult for many different reasons. Several important factors counteracted a sound financial
development, such as the high inflation rate, misleading tax incentives and central government
subsidies. In addition, there was a lock-in effect in that currency regulation, which was in force until
1989, had kept our capital inside Sweden and contributed to a form of hothouse effect. The banks did
not take these factors into account in their risk assessment, or not to a sufficient degree. They then
suffered the consequences when the government made some decisions that were desirable in
themselves, but which altered conditions drastically. Inflation was pushed down, the tax system was
reformed and subsidies were erased.
Developments in the property market were a central component in the banking crisis, as the banks'
credit-granting meant they were highly exposed to the property sector. Property prices rose at an
unreasonable rate, regardless of how one measures them. They left the basis for normal pricing, i.e.
the net return for the near future and instead reflected pure hopes of what a future buyer of a property
might be prepared to pay. When the property bubble burst, prices plummeted, in some cases by over
60 per cent in around 18 months.
There were several weaknesses in risk management with regard to property loans:
- An incapacity (or unwillingness) to see the price trend as a speculation bubble. Some people
did realise the dangers, but had trouble making themselves heard in the prevailing
atmosphere.
- The emphasis on the loan collateral, i.e. the property itself, at the cost of an assessment of
the borrower's capacity to repay.
- The fact that no one saw the substantial concentration of risk through exposures that were
ultimately dependent on property price trends. It has been calculated that more than 60 per
cent of the banks' loan losses during the crisis can be attributed to property loans.
- The bank's "self-delusion", which consisted of high-risk loans, i.e. loans against collateral of
low priority, being granted by financial companies that were closely linked to the banks. It
was among these companies that the financial crisis began. In other words, there was a lack
of overall group perspective in the risk management.
As the rise and later the fall on the property market played such a central role in the banking crisis, it is
worth a special mention. However, it was not the only risk factor the banks should have managed
better. There were also inadequacies with regard to credit granting. Large loans were made to new
customers, new sectors and new geographical areas. This type of lending strategy is not wrong in
itself, but it requires that the credit-granter has done his homework and is aware of the possible risks.
In some parts of the banking world, they talk about credit-granting according to the church tower
principle, i.e. that loans should be primarily made to customers living and active close by. How this
principle was applied in connection with investments in Atlanta or Brussels is not easy to see.
In addition, the banks contributed to their customers building up a comprehensive credit exposure in
foreign currencies, regardless of whether or not they had matching income in their loan currency. As
the krona exchange rate was high, some borrowers chose to take out loans in foreign currencies that
had a lower nominal interest rate. The risks with this strategy became evident after the krona's rapid
fall of almost 25 per cent in six months, calculated from when the krona was allowed to float in
November 1992. When the banks' borrowers found that their debt amounts had increased by up to
25 per cent, calculated in kronor, many of them were unable to meet their obligations and the banks'
loan losses increased further. These actions by the banks are actually quite remarkable. The
speculation in continued price rises in Sweden was evidently completely contrary to the belief that it
would be possible to maintain a fixed exchange rate in the long term.
With hindsight, I can observe that financial risk awareness in many parts of Sweden was low during
the 1980s. Since then, however, there has been a rapid improvement.
From regulation to a market-based financial sector
The 1980s entailed a transfer from a severely regulated and controlled financial sector in Sweden - as
in many other countries - to a deregulated and market-based sector. Deregulation created better
conditions for the financial sector to provide an efficient contribution to macroeconomic growth, not
least by freer granting of loans and other forms of financing and by managing and distribution of risks.
However, to ensure this could be done without the type of problems that led to the banking crisis, the
banks' risk management had to be improved. Over the past 30 years, developments have been very
rapid with regard to measuring and managing certain risks and enabling the end-customer to choose
risk level. The breakthrough for option assessment in the 1970s and the emergence of the swap
market in the 1980s were followed by the development of credit risk management instruments in the
1990s, such as securitisation and credit risk derivatives. This is a development which is continuing in
important areas, such as market risk and credit risk and related markets. The breakthrough in financial
theories has contributed to this development and made it possible to create instruments for buying and
selling risks.
When writing history, we must not forget IT developments. Without these it would not have been
possible to rapidly calculate and update the values of instruments, model parameters and risks in
individual cases or in portfolios. The emergence and development of markets for risk management
instruments and even institutions' internal risk management would have been delayed.
The combination of new financial instruments and markets has led to better conditions for risk
distribution, where those who are best-equipped and most willing to take on risks can do so, while
those who want lower risk can reduce their exposure. Sometimes, risk distribution is seen as a
zero-sum game, but this is incorrect. A financial agent may take on further risk if this covaries with
other risks in such a way as to reduce the total risk in the agent's portfolio. This example can be
stretched to cover society as a whole, where there were probably people and companies who had not
achieved the risk portfolio that best reflected their willingness and ability to take on risk, but will now be
better able to do so with the new instruments and markets.
My overall assessment is that there is no doubt that this development has contributed to the financial
system's capacity to carry out its fundamental tasks, while its resistance to destabilising shocks has
been reinforced. But has the development of the derivative markets and the often sophisticated
derivative instruments really led to better risk management? I believe it has. Derivatives redistribute
risks to other risk-takers. These risk-takers may, of course, be better-equipped or more
poorly-equipped to manage risks than a bank. If the risk is realised, it may lead to large losses in other
parts of the financial sector, for instance, the insurance companies. However, if the risks are really
diversified to a large number of agents, this should on the whole be positive from a macroeconomic
perspective. One could say that we will all bear a small part of the gain or loss on our future pensions,
but we hopefully avoid financial and macroeconomic costs from banking crises of the type we
experienced in Sweden at the beginning of the 1990s.
Given the significance of risk management for society and for financial stability, it is natural that the
Riksbank should carefully follow developments in this field. During the era of regulations, we were the
authority with the task of monitoring that the banks observed credit policy restrictions in their
operations, but we now have a completely different direction. We closely follow - and sometimes even
try to influence - how risks are managed in the financial sector. Risk management should be governed
primarily by the needs of the customers, markets and intermediaries. It is only necessary for
authorities to intervene with regulation and other means of control where there is a risk of market
failure, i.e. when the interests of the institutions and the markets do not coincide with the interests of
society as a whole - the lenders' short-term market-share philosophy at the end of the 1980s is an
example of this. If means of control are needed, they should be designed as far as possible to lead to
solutions that are compatible with the normal working of the institutions and markets.
Some problems
We can all see that interest in risk management has increased and that considerable resources are
being invested here. The interest applies to both the production of new financial instruments, the
emergence of new markets and the practical measuring and management of various risks. In addition,
awareness is being stretched to cover new types of risk that did not previously receive the attention
they deserved, such as operational risks, interest risks throughout the bank, liquidity risks and legal
risks. This is essentially a positive development, but let me nevertheless conclude by pointing out
some phenomena and situations, which indicate that the new developments have also brought about
problems that need to be discussed and hopefully solved.
The best known example is perhaps the LTCM debacle. The hedge fund suffered a sudden decline in
value, which led to a confidence crisis among customers and it had to be shored up with liquidity
infusions of many billions of dollars from a group of banks. The Federal Reserve even assessed the
situation to be a possible threat to the overall stability of large financial markets. How could this
happen with two Nobel prize-winners responsible for the strategy and risk models, which should
guarantee that they were designed according to the latest research? The weakness lay in the fact that
these models, like all others, were based on a given probability of history repeating itself. However, in
autumn 1998, reality in the form of various simultaneous political and financial events took a different
turn than was usual. It should also be added, for accuracy, that LTCM also suffered because its risk
strategy was not very transparent. Investors were unable to assess to what extent the fall in value was
temporary or permanent and therefore preferred to recall their investment. The main conclusion is
nevertheless evident. Don't rely too heavily on historically-based models.
A further potential problem is that risk models are standardised. The demands from the supervisory
authorities that the models should meet a number of minimum criteria could lead to the management
and assessment of the risks becoming more and more similar. There is a fear of a destabilising
lemming effect, with all financial agents running in the same direction when new data is received. In
addition, there are fears that the standardisation leads to certain categories of borrower experiencing
more difficulty in obtaining loans in future. The possibility of going to a different bank to get a loan
could be reduced if all banks apply largely the same credit assessment system. I believe that these
worries are exaggerated, on the basis of studies made by the Riksbank and others that have indicated
that different banks tend to assess individual customers differently, even when they use similar risk
models. This could be because they have unique knowledge of the customers, or because their
present loan portfolio favours accepting a particular customer. Although I am not excessively worried
on this account, it is important to ensure that international and Swedish regulations do not lead to
unnecessary standardisation.
Operational risks have come to the fore in recent years, partly through a number of events,
September 11, of course, as well as others such as large-scale power failures, IT and
telecommunications breakdowns and the Basel Committee's capital adequacy requirements. The
development of methods to manage operational risks has not come very far. Attempts are currently
being made to rectify this. An increasing number of bank managers - both in Sweden and abroad - are
showing a positive attitude to the focus on operational risk management, as they see these risks as
potentially large ones. From the Riksbank's stability perspective, I can only agree - events affecting
practical operations in the financial system could threaten stability. I therefore consider it important that
the banks continue to build up their risk analysis and their protection against risks in this field.
It is possible to view the development in itself as a risk in that it has created new, potent instruments
and possibilities for speculation. If used incorrectly or carelessly, these instruments could destabilise
the financial system or in other ways lead to inconvenience. It is therefore important that both the
financial agents themselves and the authorities responsible in this field closely follow developments in
both theoretical and practical work and are prepared to take action if they identify risks to stability. Of
course, it is another matter in this context - as in others - that the costs of new methods of control must
be weighed against the risks to be managed.
Regardless of the fact that there are now outstanding issues to be resolved to improve risk
management, my overall conclusion is positive. The development underway with regard to identifying,
measuring and managing risks provides possibilities to improve stability in the banks and other parts
of the financial sector. We still have some way to go, but the work is proceeding and is presently in an
intensive phase in both the financial institutions and the authorities concerned. The Riksbank intends
to continue to play an active role in this work.
Thank you.