Lars Nyberg: The crisis, the Riksbank and monetary policy
Speech by Mr Lars Nyberg, Deputy Governor of the Sveriges Riksbank, at the
Bankmarknadsdagen, Stockholm, 28 November 2008.
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Introduction
The financial system is an important part of our social structure. The payment system and
the supply of credit are central to all economic activities. When the general public's
confidence in the financial system is shaken and when the participants in the system no
longer trust one another, then something serious has happened in our society. This means
that all those involved, both in the private and public sectors, must have a discussion on how
this situation arose and what we can do to avoid it happening again.
The financial turbulence, which began in summer 2007 with problems in the US mortgage
market, has during the autumn become an acute crisis. Also during the autumn we in
Sweden have gone from largely watching the crisis from the sidelines, to being very much
involved.
Today I will give my views on how this could happen and on what has occurred during the
autumn. Last spring there were many indications that conditions in the financial markets were
gradually improving. I shall also reflect on the methods used by central banks and
governments around the world to try to manage the problems and to safeguard financial
stability. It would take too long in this context to analyse what conclusions should be drawn
for the future, and it is probably too early to do so yet, but I shall nevertheless share my
impressions this far. In conclusion, I shall discuss how monetary policy can complement the
more acute financial measures taken, and alleviate the effects of the financial crisis on the
real economy.
Acute financial crisis...
The turn for the worse can be clearly dated to the middle of September when US investment
bank Lehman Brothers was forced to file for bankruptcy protection. Money market
participants had not expected such a prominent bank to default. When the bank nevertheless
defaulted, fears grew that more participants risked the same fate. This was when the
confidence crisis broke out in earnest. No one dared to lend money to anyone else because
of fears that the other party could become insolvent and the money that had been lent would
disappear. Investors preferred to put their money in government securities. One result was
that interbank lending around the world more or less ceased. The difficulties the banks had
experienced earlier with financing at longer maturities were intensified. The banks' borrowing
costs increased further and companies outside of the financial sector also experienced
financing difficulties.
At the same time, the large US commercial paper market suffered substantial disruptions.
This market is an important source of financing, both for financial companies and ordinary
industrial companies. The industrial companies tried to make use of their promised loan
facilities with the banks, but the banks were not able to lend money as usual. This resulted in
a credit gridlock, which severely limited the access to loans. The problems spread from the
United States to Europe and the European credit system also essentially ceased functioning.
This meant that the Swedish banks and the Swedish financial system also suffered
problems.
...followed by countermeasures and stabilisation
In this situation governments, central banks and other authorities were forced to intervene to
avoid a collapse in the global financial system. Without these measures the financial markets
would most probably have ceased functioning - things were so serious. The measures have
taken different forms in different countries, but two main types can be identified. The first is
that the banks have been offered risk capital or other guarantees so that they can survive the
crisis. The aim is to avoid more defaults like Lehman Brothers occurring when the financial
market is so vulnerable. Those who lend money to a bank should be able to feel certain that
the bank will still be there when it is time to repay the loan. The second type of measure is
that the central banks have continuously supplied the banks with the short and medium-term
loans they have not been able to obtain in the usual way on the market.
Although it is not yet possible to know whether the measures will succeed in full, my
assessment is that they have been sufficient to counteract the most acute problems. The
measures create a basis for restoring confidence among the general public and between
participants in the financial markets. If one tries, one can see some signs of normalisation in
the form of falling interbank rates and improved liquidity in the form of higher turnover on
some markets. But progress is slow. I consider it rather surprising that market functioning
has not normalised to a greater degree, despite the extensive and forceful measures taken
by central banks and governments. It is possible that the authorities have not succeeded in
communicating the fundamental message that all who lend money to a bank will get their
money back.
A remaining problem is that, as a result of the crisis, the market is requiring that the banks
reduce their risks in relation to equity capital. The banks are therefore selling financial assets,
which squeezes the price in the entire world market. This is why the banks want to reduce
their balance sheets by cutting back on lending. The process will continue until the banks
have reduced their balance sheets sufficiently or acquired new risk capital.
The Riksbank will contribute liquidity as long as is necessary
The Swedish interbank market functioned satisfactorily up to mid-September, although the
cost of the banks' international borrowing rose, of course. But the confidence crisis that
followed in the wake of Lehman filing for bankruptcy protection also affected the Swedish
financial system. To counteract the effects of the financial crisis, the Riksbank has supplied
the market with loans in kronor and US dollars in a similar manner to what other central
banks have done in their currency areas. The loan facilities have allowed a different class of
collateral than usual. The maturities have been longer than those the market has been able
to offer and longer than the Riksbank normally provides. In total, the Riksbank has increased
its lending by more than SEK 400 billion. We will continue to provide the market with liquidity
as long and as far as it is needed.
During the autumn the Riksbank has received signals from Swedish industrial and trade
companies that they have been unable to find satisfactory credit. Quite simply, they have not
been able to borrow on the market or from the banks in the same way as usual. This problem
originates outside of Sweden and has arisen despite the Swedish banks being financially
strong. As a preventive measure, the Riksbank established a new, temporary, credit facility
on 29 October. The aim is to improve the opportunities for companies to borrow money.
Companies can organise their financing through this facility by issuing and selling
commercial paper to the banks. The banks can in turn use commercial paper as collateral for
loans from the Riksbank. The purpose is thus to make it easier for companies to borrow in
that the banks are given better scope for financing. It is primarily large companies that issue
commercial paper, but smaller companies should also benefit as the banks' increased scope
for borrowing from the Riksbank means their total lending capacity will be less strained. So
far, however, the banks have chosen to use only a small part of the credit facilities offered by
the Riksbank. It remains to be seen whether this is because the companies have
nevertheless succeeded in borrowing elsewhere or whether they consider the bank loans to
be too expensive. Despite the fact that some companies are experiencing problems with
borrowing, bank lending in Sweden is continuing to rise. However, this should not
automatically be interpreted to mean that the supply of credit is functioning well in every
aspect. The international credit markets are still largely closed to Swedish companies and
they cannot borrow from foreign banks to the same extent as before.
The Riksbank has also granted special liquidity assistance during the autumn to Kaupthing
Bank Sverige AB and Carnegie Investment Bank AB. The liquidity assistance was offered in
the form of loans against collateral and at a higher interest rate than on normal loans. The
market turbulence and the great uncertainty that prevailed were reasons for granting liquidity
assistance to safeguard financial stability, even though these institutions were relatively
minor participants in the Swedish financial market. Confidence in the Swedish financial
system could have been seriously damaged if a failure like the one at Lehman Brothers had
been allowed to occur. The Riksbank's assessment was that the two banks were
experiencing temporary liquidity problems, but that their solvency was not threatened.
Finansinspektionen later revoked Carnegie's licence to conduct banking activities owing to
serious deficiencies in the company's risk management and violation of the law concerning
asset management. The decision to revoke the licence thus had nothing to do with
Carnegie's liquidity problems or with the Riksbank's loan. Carnegie is now owned by the
Swedish National Debt Office and the Riksbank's liquidity assistance has been repaid.
The Riksdag (the Swedish parliament) has also introduced a new act concerning support to
credit institutions, which will give the government the opportunity to take the necessary
measures to strengthen stability in the financial system. For instance, a government
guarantee programme has been presented to support the banks' and mortgage institutions'
medium-term funding, and a stability fund has been established to manage potential future
solvency problems in Swedish institutions.
The current situation
Despite the crisis in the global financial markets and the increasingly gloomy economic
prospects, the assessment is that the Swedish banks still have good resilience to facing the
situation that has arisen and future developments.1 The losses arising from the international
crisis have so far been limited, not least in an international perspective, and the Swedish
banks have good financial strength. In addition, most of the banks' borrowers have a good
ability to pay their loans. To summarise, the Riksbank's assessment is therefore that the
stability in the Swedish financial system is satisfactory. But it is important to emphasise that
the measures taken by the Riksbank and other authorities are currently a necessary
condition for this to be the case.
Improved regulatory framework
The measures the Riksbank has taken after 15 September, and which I have just described,
concern stabilising the functioning of the market and ensuring financial stability in the short
and medium term. In the longer term, however, other types of measure are required to make
the financial system function as it should, both in Sweden and abroad.
The crisis has clearly shown that the regulatory framework and financial supervision need to
be improved. But it is not necessarily the case that a larger number of more complicated
regulations are needed to make the financial sector function efficiently in society. One must
carefully consider how the regulations should be changed.
I believe that on an overall level it is mainly a question of developing and modifying the
regulations that are already in place rather than introducing further regulations. The talk of a
new financial order should, in my opinion, be taken with a pinch of salt. But one must try to
assess in what areas there are clear market failures and how society should best act to
remedy these. The usefulness of new regulations must also outweigh the costs.
Unfortunately, the existing regulations are designed so that they have in some respects
encouraged rather than limited risk taking in the current crisis. Speedy and short-term
changes in regulations should not be allowed to prevail. But experience unfortunately shows
that political eagerness to quickly furnish new regulations often prevents a more in-depth
analysis of the problems.
Which areas of the international regulatory framework are in most urgent need of review?
Essentially, of course, the problem is that the risk taking was too great in relation to equity
capital. Both the trend towards increased securitisation and a focus among financial
institutions on short-term activities have contributed to an increase in risk taking. It is of
course important to eliminate any loopholes in the capital adequacy rules, and the capital
adequacy requirements in both banks and other financial institutions will probably need to be
tightened once we have come through the financial crisis.
It is undeniable that the liquidity risks have been underestimated and a review of the banks'
management of these risks will be necessary. It is also evident that increased insight is
necessary, both into the banks' balance sheets and into certain markets and instruments.
Some products that have been common outside of Sweden have had such complicated
structures that they have been difficult to understand and to valuate. It is also evident that the
reputations of the credit rating agencies have become tarnished, but how much of this can be
remedied through regulation is not so clear.
In addition, the trading, clearing and settlement of certain derivatives has been carried out in
such a way that insight has been poor and counterparty risks have been substantial. There is
thus reason for the authorities to press for the development of the underlying infrastructure
of, for instance, OTC-traded derivatives.
Many ideas regarding what needs to be done to reduce the risk of future crises will probably
be put forward over the coming six months. Let us hope that the wise and well-reasoned
proposals will be the ones that are implemented.
Crisis management
I would also like to touch briefly on some crisis management issues. Good preparedness and
good preparations are the be-all and end-all of crisis management. Both in Sweden and
other EU countries, and in particular in the United States, it has been necessary on this
occasion to improvise measures to a great extent in the management of the financial crisis.
This is of course not exactly desirable. Experiences of earlier crises point to improvised
measures often coming too late and costing more than ought to have been necessary.
It is as yet too early to say what the outcome of the measures taken now will be, but there
are nevertheless some bright spots. It has recently become slightly easier for the banks to
issue at longer maturities both in Sweden and other parts of Europe. In the United States,
too, the issue volumes in the commercial paper market have increased. The Swedish
mortgage spreads have also declined. We can thus see positive effects of the measures
taken, although there appears to be a long way to go before the crisis has run its course.
However, looking ahead to future crises - and I do not believe that we can entirely avoid
crises occurring in the future - it is desirable that we acquire a better preparedness. If there
is one thing we have learned from this crisis it is that we need to have in place regulatory
frameworks for managing banks in distress. Such regulations should include several different
aspects, everything from a deposit guarantee system to insolvency procedures for banks.
Above all, the crisis has pointed to the need for cross-border cooperation. We have seen
examples of this in Europe. This type of cooperation on crisis management should begin in
"peace time". Contacts that have been cultivated already and a common parlance may be
decisive factors in determining how efficiently a crisis in a cross-border institution is handled.
It is also important to hold joint crisis exercises, using different scenarios.
We can also observe that the Memorandums of Understanding in the field of financial crisis
management, which have been drawn up between authorities in Europe in recent years have
proved to be too vague. In future, therefore, we need to have more concrete and binding
arrangements. One complicated and important question is how the costs should be
distributed when a crisis spreads to several countries.
Differences in regulation and supervision also complicate the crisis management. Greater
harmonisation is in actual fact an important condition for both crisis management and crisis
prevention work. As a result of the crisis, the EU has begun to look into how its framework for
supervision can be improved. My view is that after the crisis it is both essential and possible
to take a step towards better joint supervision in Europe. But although the supervision issue
is important, the systems for deposit guarantees and crisis management must be designed to
function when needed, not merely within individual countries, but also between countries.
This has not always been the case during the current crisis.
Monetary policy and the build-up of risks
Does monetary policy have a role to play in preventing a financial crisis? This has long been
a controversial issue, where economists have held differing opinions. However, the financial
crisis has undoubtedly given us experiences we should make use of.
The predominant view has probably been that one should not use the interest rate to try to
counteract a credit boom that is expressed in rapid price increases on houses or financial
assets. This view is based on the fact that it is difficult or almost impossible for a central bank
to determine whether a credit boom has its base in the real economy or whether it is due to
unrealistic expectations of continuing price increases. Instead of trying to deliberately burst
the bubble, one should use monetary policy to counteract the negative effects that may result
if it bursts.
The disadvantage of this reasoning is that the negative effects when the bubble bursts may
be fairly substantial - which to a large degree is illustrated by the current financial crisis. It is
also difficult to deny that the long period of low interest rates in the world prior to the crisis
may have contributed to an unreasonably high build-up of credit. With hindsight, this view
does not appear so controversial.
Does this mean that monetary policy can and should be used to prevent financial crises? I
believe that monetary policy can be a complement to other measures when overly large risks
appear to be building up in the financial sector, but that the main responsibility must lie with
other methods of regulating the relationship between capital and risks. The emphasis here is
on regulatory frameworks and supervision. Putting all of the responsibility on monetary policy
would probably mean such high interest rates that they would have seriously negative
repercussions for the real economy. Moreover, the argument remains that it is difficult to
determine when a credit boom changes from being beneficial for growth to becoming a risk
that can trigger a financial crisis.
I nevertheless think that the crisis has taught us that when we conduct monetary policy we
must also follow a number of variables that are linked to the build-up of risk in the financial
markets, primarily credit growth in different sectors of the economy. The fact that monetary
policy alone cannot prevent financial crises does not mean that we can only look at an
inflation target and otherwise disregard what a long period of low interest rates may entail
with regard to risks in the financial system. This is also the view the Riksbank has expressed
in recent years, occasionally, one must say under strong criticism from both academics and
various other parties in society.
Monetary policy can alleviate the consequences of the financial crisis
The financial crisis has meant that the focus normally placed on monetary policy has been
transferred to the measures taken to safeguard financial stability. Monetary policy cannot be
used to resolve acute problems in the financial markets. This requires a different type of
measure, as I have already described. What role can monetary policy then play in the current
situation? How has the Riksbank formulated monetary policy during the autumn to counteract
the negative events?
On 8 October the Riksbank took part in a joint action with other central banks to alleviate the
consequences of the financial crisis. The Riksbank, together with the Bank of England, the
ECB and the Federal Reserve, announced cuts in their monetary policy rates. The
advantage with this type of coordinated action is that it reinforces confidence and increases
the chances of the rate cut having positive effects. The Riksbank cut the repo rate by 0.50
percentage points in this action.
At our most recent ordinary monetary policy meeting on 22 October the decision was to cut
the repo rate by a further 0.50 percentage points, to 3.75 per cent. The Riksbank adjusted its
forecast for the repo rate path downwards, compared with that presented at the beginning of
September. The members of the Executive Board were unanimous regarding both the repo
rate cut and the new interest rate path. Together with the joint central bank action on 8
October, the Riksbank thus cut the repo rate by a total of one percentage point in the space
of two weeks. Other central banks have also substantially cut their policy rates. For example,
the Bank of England has cut its bank rate from 5 per cent to 3 per cent since the beginning of
September.
The reason for the repo rate cuts was to alleviate the effects of the financial crisis on the real
economy, while ensuring that inflation stabilised around the target of two per cent. Although
monetary policy cannot be used to resolve the financial problems, it can help to dampen the
negative effects on the real economy, without jeopardising the inflation target.
The Riksbank's assessment is that the financial crisis aggravates the ongoing economic
downturn resulting in weaker growth, a deterioration in the labour market and lower inflation.
The repo rate therefore needs to be cut by a relatively large amount during a short period of
time. In addition to the cuts already made, the assessment at the most recent meeting was
that the repo rate needs to be cut by a further 0.50 percentage points, to 3.25 per cent, over
the coming six months.
The repo rate is currently less effective than normal as a tool for influencing the economy.
The repo rate cuts in October did not lead to an immediate fall in interbank rates. The
confidence crisis in the financial system has meant that the normal link between market rates
and the repo rate has been broken. Although market rates also declined, there remains an
unusually large gap between the repo rate and mortgage rates in particular. The gap
between the 3-month lending rate to households and the repo rate has been around 100
basis points in less turbulent periods than that we are experiencing now. At present the gap
is around 200 basis points. This is a lot in an historical perspective. Although some mortgage
rates have declined slightly following the repo rate cuts, the gap remains. Mortgage rates are
to a great extent governed by the banks' possibilities to borrow abroad. The effect of this is
that interest costs for households with mortgages fall less than one might have expected. As
a result of the financial crisis, the stimulating effect of a repo rate cut is thus less than it
would have been otherwise.
I would like to emphasise that there is unusually great uncertainty surrounding the
assessments and forecasts at present and that it is thus more difficult to judge the effects of
our monetary policy. The outcome data and indicators the Riksbank has received since the
monetary policy meeting in September clearly pointed to a severe deterioration in economic
activity, both in Sweden and abroad. Compared with the assessment made in September,
the Riksbank revised down its forecast for international growth by almost one percentage
point. Growth in 2009 was assumed at the monetary policy meeting held on 22 October to be
close to zero in the United States, the euro area and Sweden. There are also signs that the
economies in Asia are slowing down. In China, growth has fallen during the first half of the
year and is expected to continue to fall. Economic activity in Japan has also slowed down
and the most recent GDP figures show that the economy is now in a recession.
Inflation is still high at present, but the forecast for inflation was adjusted downwards for the
entire forecast period in the Monetary Policy Report published in October. Our assessment
was that inflation will fall quickly over the coming year and then rise slightly, reaching the
target of 2 per cent in 2011. The slowdown in economic activity will in all likelihood have a
dampening effect on domestic price pressures. Another factor that contributes significantly to
the changed view of inflation prospects is the fall in commodity prices. It is mainly increases
in energy and food prices that have earlier pushed up inflation in Sweden far above the
target. During the fourth quarter of last year commodity prices began to rise. The inflation
rate will fall if there are no price increases or if the increases are lower than last year. To
summarise, there are several factors pointing to a decline in the inflation rate. The Executive
Board's assessment at its most recent meeting in October was therefore that a repo rate cut
was not incompatible with the price stability target. It was possible to use monetary policy to
alleviate the negative effects of the crisis on the real economy without any risk of neglecting
the inflation target.
What has happened since the most recent monetary policy meeting? The picture of a drastic
slowdown in economic activity has been reinforced, both in Sweden and abroad. New
statistics confirm the picture of an economic downturn and falling inflationary pressures. With
regard to Sweden, a record-low level in the purchasing managers index points to a continued
slowdown in economic activity. The purchasing managers' index for the manufacturing sector
fell in October, for the fifth month in a row. Households' confidence in the economic situation,
as reported in the National Institute of Economic Research's economic tendency survey,
plummeted in October to the lowest level since the beginning of 1993. Confidence did not
change substantially in November, but remained at a historically low level. The confidence
indicator for the manufacturing industry fell further in November and is well below the
average. A large number of redundancies have been notified by Swedish companies in both
October and November. Inflation fell in October, which was entirely in line with the
Riksbank's most recent forecast, and there are also signs of lower inflation expectations. At
the same time, the krona has been weaker than in our most recent forecast, which in all
likelihood will somewhat weaken the forces pushing down inflation. The indicators and
outcome data that have been received regarding international growth point to a sombre
development. The GDP figures for the United States indicate negative growth during the third
quarter and a weak beginning to the fourth quarter. The confidence indicators are pointing
downwards, the retail trade is weak and orders are falling. The euro area is in a recession as
growth was negative during both the second and third quarters. Since the monetary policy
meeting on 22 October, growth prospects have deteriorated considerably, both in Sweden
and abroad.
Concluding remarks
During the autumn, the Riksbank has taken measures, together with governments and other
central banks, to counteract the confidence crisis that arose in the financial markets in
connection with Lehman Brothers filing for bankruptcy. The measures have been taken
different forms. The Riksbank has taken part in these measures through both general
liquidity support to the Swedish banking sector and special support to Carnegie and
Kaupthing Bank, but also through cooperation with other central banks. The Riksbank will
continue to contribute liquidity as long as is necessary.
Although the most acute problems in the global financial markets have been counteracted, I
consider it slightly surprising that the markets have not normalised to a greater extent than
they have. Although the interbank rates have fallen, they are still at a high level in historical
terms. The measures implemented by central banks and governments have nevertheless
been both extensive and forceful. An important part of the counter-measures implemented by
governments and central banks around the world during the autumn has been to ensure that
no systemically-important bank is allowed to fail.
The financial crisis has meant that the focus has been moved from monetary policy to the
efforts made to safeguard financial stability. This is entirely natural. Monetary policy is not an
effective tool in preventing financial crisis or in resolving a crisis that has broken out. It has
had some impact on financial stability in that the Riksbank's repo rate cuts have helped to
push down market rates. However, the large gap remaining between the repo rate and
market rates shows that monetary policy cannot resolve the financial crisis. But I would
nevertheless like to emphasise that monetary policy fulfils an important complementary
function in alleviating the effects of the financial crisis on the real economy.
As I described earlier, the stimulating effect of the Riksbank cutting the repo rate has been
weakened as the normal link between the short-term market rates and the repo rate has
been broken. This situation should gradually change as conditions in the financial markets
normalise. When the inflation rate falls again, there will be good opportunities for monetary
policy to dampen the economic downturn without jeopardising the Riksbank's inflation target.
Thank you!