Stefan Ingves: Monetary policy and financial stability in a globalised
world
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank and Chairman of the Basel
Committee on Banking Supervision, at the Stockholm School of Economics, organised by the
Swedish Economic Association, Stockholm, 28 May 2014.
* * *
Thank you for inviting me. This meeting at the Swedish Economics Association is one of
relatively few occasions during the year when I have the opportunity to discuss rather more
academic questions that I personally find interesting, but which there may not always be time
to consider. At present, however, I am struggling in my day-to-day work with a number of
issues where better research support is needed, so today I would like to raise both very
concrete issues that are currently on the economic policy agenda, and more theoretical
questions about the shaping of the policy.
There is an overall theme in what I intend to say today, and that is "cooperation". I will talk
about cooperation between different authorities and policy areas in Sweden as well as
cooperation at an international level. One reason why I have chosen to put a certain focus on
cooperation is that I perceive that it has become increasingly difficult, or at least more
complicated, to conduct a completely independent policy - partly because of the boundaries
between the different policy areas having become less clear, and partly because of individual
countries being affected perhaps more than ever by international events.
The need for increased cooperation between different policy areas and between countries
may make the tasks of central banks around the world more complicated, but it is important
that this does not paralyse us. Rapid and concrete measures are required to make the
financial system more robust.
The crisis in the early 1990s was a trigger in several respects
Let me start my discussion with a very abridged and selective look back at the past
twentytwenty-five years. At the beginning of the 1990s, Sweden suffered a crisis, or rather a
number of linked crises. This entailed a financial and property crisis that rocked the entire
Swedish banking system and required government intervention. It also entailed a currency
crisis, or rather a crisis for the stabilisation policy regime of the time, where the anchor was
the fixed exchange rate. In addition, there was a sovereign debt crisis, with dramatically
rising budget deficits and an increasing government debt. All of this is not dissimilar to what a
number of other countries have experienced in recent years.
One result of this development was that we were forced to let the krona float and in January
1993 we changed over to the inflation-targeting regime that we have now. Another result was
that we began designing the framework for a long-run sustainable fiscal policy that has
served us so well. One consequence of the fiscal and property crisis was that we began to
build up an apparatus to help us monitor and maintain financial stability. For instance, the
Riksbank's analysis of the financial sector became more structured and systematised, and
from 1997 we began to present our analysis in the form of Financial Stability Reports. This
financial stability work was, however, far from fully-developed when a new financial crisis
broke out just over six years ago, this time on a global scale. For instance, we still lacked a
system for crisis management. We also failed to prevent a too rapid credit boom in the Baltic
region, at the same time as Swedish banks proved to have liquidity problems when the dollar
market froze.
As the new crisis was deeper and affected a much larger number of countries than the crisis
at the beginning of the 1990s, it also acted as a stronger and more worldwide signal that
major efforts were needed to avoid financial imbalances causing problems in the economy as
a whole. The most concrete expression of this opinion was the emergence of the policy area
that came to be known as macroprudential policy, which aims to take the overall view of the
financial system as a whole that was lacking prior to the crisis.
In this context, it is worth pointing out that in Sweden the boundary between macroprudential
policy and supervision of individual banks, microprudential policy, is not particularly distinct
because of the market structure we have, with four dominant major banks. If the stability of
one of these banks is threatened, it also entails a threat to the stability of the financial system
as a whole. To this extent, one can say that we in Sweden have actually been dealing with
macroprudential analysis for quite a long time. But this does not mean that there has been a
ready-developed, fully-functioning framework for macroprudential policy. On the contrary, it is
only fairly recently that the allocation of responsibility for macroprudential policy was made
clear, and the framework that includes the Financial Stability Council, which had its second
meeting a couple of days ago, was established.
"Learning by doing" in macroprudential policy - as when inflation targeting was
introduced
The situation with regard to macroprudential policy today is in many ways like the situation
when the inflation-targeting policy was introduced just over twenty years ago - a new type of
policy is to be launched without really knowing how successful it will be. When we introduced
the inflation-targeting policy in Sweden in 1993, there was not much guidance. Some
countries, such as New Zealand, Canada and the United Kingdom, had introduced such a
policy before us, but they in turn had not really had time to gain much experience. It was
quite simply difficult to know how to conduct the new policy, where the interest rate should be
used to steer inflation towards a quantified target - and to know how well it would succeed.
The situation today is thus similar, with countries around the world contemplating how best to
conduct macroprudential policy. In some areas, particularly in some emerging markets, they
already have some experience of what could be described as macroprudential policy.
However, the results have been somewhat mixed and it is unclear what lessons can be
learned. The research on macroprudential policy has now begun in earnest, but it is still quite
new and has not yet generated any very clear conclusions on which to base a policy. It is
probably unavoidable, therefore, that practical policy-making in coming years will consist to a
great extent of "learning by doing" - with the emphasis on both "learning" and "doing".
Stabilisation of the financial cycle
One of the two main tasks of macroprudential policy is to counteract the build-up of financial
imbalances in the economy. This task can be described as macroprudential policy trying to
stabilise something I here choose to call the financial cycle. The academic literature on this
subject contains other similar concepts such as "credit cycle" and "leverage cycle."1 What this
means in simple terms is that the volume of loans, indebtedness, asset prices and attitude to
risk in the economy vary over time in a way that is not necessarily linked to the economic
cycle. One usually calls this the cyclical dimension, or time series dimension, of
macroprudential policy.
The second task of macroprudential policy is to manage structural risks, or cross-section
risks, which could for instance mean that close links between different parts of the financial
system at any given time will affect the risk of a crisis affecting the system as a whole. Here, I
will primarily focus on the cyclical dimension of macroprudential policy. However, it is not so
easy to draw any clear boundary between structural and cyclical problems on the financial
markets, just as in other areas, such as the labour market.
In Figure 1, the red line represents the normal cyclical fluctuations in the economy, the
business cycle. The second curve in the figure represents the financial cycle. As I noted, the
economic cycle and the financial cycle need not coincide, but can develop differently. Often,
the financial cycle is assumed to have a lower frequency, fluctuate more slowly, than the
business cycle, as illustrated in the figure.2
Links between the financial cycle and the business cycle can create problems
A situation where both cycles definitely coincide is when the financial cycle shows a rapid
downturn, as at the end of the figure. This was what happened in many countries during the
financial crisis, and in Sweden during the crisis at the beginning of the 1990s. Exactly how
the problems will take shape can vary, but it is almost always a question of some sector
having become "over-leveraged", which sooner or later leads to problems. Here I will assume
that it is household indebtedness that is the main problem.
At some stage, it becomes evident that the credit boom and the increased indebtedness
have been based on too optimistic expectations and calculations. A lot more people will want
to sell rather than buy the asset that formed the basis for the credit expansion and its price
therefore falls. Let us assume that, as with the most recent crisis, it mainly concerns housing.
The banks become cautious and reduce their lending, as the value of the collateral declines.
Households' assets have now fallen in value substantially, but the size of the loans remains
unchanged. To attain a better balance between assets and debts, households reduce their
consumption and begin to save. In addition to the fact that the credit supply declines as a
result of the banks becoming more cautious, the demand for loans also declines. This
adjustment in households' balance sheets gives a fall in demand, which in practice has often
proved fairly prolonged.3 This process often leads to a substantial weakening in public
finances, too, partly because of the rapid decline in economic activity and partly because the
banking system may in a worst case scenario require support.
This development means that the business cycle and the financial cycle take a simultaneous
downturn, as in Figure 1. However, the main reason is that the financial cycle has "gone off
the rails" - first through a rapid expansion in credit and debt, and then through a sudden
contraction when conditions and expectations have changed. If one had been able to prevent
or mitigate the upturn, the economic downturn would not have been so deep. Stabilising the
financial cycle is therefore an important part of the general stabilisation policy. There is fairly
good empirical support for this description. The more households and companies borrow
during an economic upturn, the greater the risk appears to be that the upturn will be followed
by a deep recession and a slow recovery.4 The cost to society when financial imbalances are
to be corrected is often very substantial. The cost of the global financial crisis has been
estimated at between 1 and 3.5 times the total production of goods and services in the whole
world during one year.5
One argument put forward after the financial crisis is that it is mainly macroprudential policy
that is responsible for stabilising the financial cycle, while monetary policy shall focus on
stabilising the economic cycle and inflation. Personally, I am very doubtful as to whether one
can make such a division. My doubts are based on both theoretical arguments and
assessments of what one can physically achieve with different policy instruments. I will now
take up some theoretical arguments, after which I will make the discussion more concrete by
giving some examples.
Given the links: How can responsibility be divided between monetary policy and
macroprudential policy?
From a strictly theoretical perspective, one may argue that coordination of macroprudential
policy and monetary policy is always at least as good as not coordinating them. The following
reasoning is a means of showing why this is so.6
Let us assume that monetary policy and macroprudential policy can be conducted either
coordinated or separately. When both types of policy are coordinated, let us call this
alternative A, the interest rate r and macroprudential policy tool c are set at the same time to
minimise
∑
E - ∗) + - ∗) + - ∗ ],
[( ( 
where  is a discounting factor, the first term in the square bracket represents stabilising
inflation, the second represents stabilising resource utilisation or the real economy, and the
third represents stabilising the financial cycle. The interest rate and the macroprudential
policy tool are thus set together so that a weighted sum of the economic cycle, inflation's
deviation from target and the financial cycle in the coming period will be as small as
possible.7
The second possibility, alternative B, is that monetary policy and macroprudential policy are
conducted entirely separately. The interest rate r is set to minimise fluctuations in the
economic cycle and inflation
E ∑ - ∗) + - ∗)] ,
[( (
while c is set to stabilise the financial cycle
∑
E - ∗ ].

[
A theoretical result is that coordination, that is, alternative A, is in general preferable to
separating the two types of policy. The reason is that alternative B is a special case of A. A
policy-maker who can choose both r and c to stabilise both economic activity and inflation as
well as the financial cycle (or two policy-makers who can fully coordinate their decisions on r
and c) always has the possibility to separate the decisions, that is, to go from A to B.
A should therefore not reasonably be able to lead to a poorer result than B.
This does not necessarily mean that coordination is always a good idea in practice. It may be
the case that, in reality, there are costs linked to coordination that can be reduced or avoided
if one separates the decisions on monetary policy and macroprudential policy. For instance,
it may be more difficult to evaluate and forecast economic policy if different instruments are
used at the same time to try to attain different targets.8
A related argument in favour of separating both types of policy concerns the risks of a
decline in confidence in monetary policy. Let us assume that alternative A means that it is the
central bank that accounts for both monetary policy and macroprudential policy (instead of
the central bank and the financial supervisory authority coordinating them). If the central
bank fails to stabilise the financial cycle, some argue that this could also jeopardise
confidence in the bank's ability to attain its traditional price stability target.9 It is therefore
better that another authority than the central bank should have responsibility for stabilising
the financial cycle.
That coordination is in theory preferable does not say anything about how great the benefits
may be in practice. To illustrate the quantitative links between monetary policy and
macroprudential policy, we need the help of macroeconomic models based on data for the
specific country. Such models are currently being developed within several central banks.
We at the Riksbank has also used one such model to better understand the interplay
between the two policy areas - mainly because macroprudential policy could have effects on
economic activity that monetary policy may need to take into account.10 The conclusion from
this exercise so far is that there are no easy answers and that the benefits of coordination
may vary, depending on which shocks are driving the economy and making the authorities
take action.
How have the roles been allocated in reality?
So how have different countries in reality chosen to organise monetary policy and
macroprudential policy? As usual, it is difficult to draw straight lines between theory and
reality. One country that comes fairly close to model A with regard to coordination is the
United Kingdom, where the Bank of England has been given responsibility for
macroprudential policy. The decisions on monetary policy and macroprudential policy are
taken by two different committees in the bank, the Monetary Policy Committee and the
Financial Policy Committee, which is more in line with model B, but there is nevertheless an
explicit aim to coordinate, for instance, in the way the committees are composed.11
In Sweden we have chosen a solution that in institutional terms is closer to B, in the sense
that Finansinspektionen has been given the main responsibility for macroprudential policy
tools. Now, I do not believe that the differences in the practical solutions chosen in different
countries should be exaggerated. An important part of the process regarding
macroprudential policy in Sweden is a close cooperation between Finansinspektionen, the
Government, the Riksbank and the Swedish National Debt Office, with regard to the analysis
of current issues. These four are also represented on the Financial Stability Council, which
meets regularly to discuss issues of financial stability and how financial imbalances can be
counteracted.
I believe that it is much more important that there is actually someone who is responsible for
the macroprudential policy tools and prepared to take action, than that this is perfectly
coordinated with monetary policy. My hope is that the discussions in the Financial Stability
Council will lead to the decision that need to be made actually being made - and being made
in time. This will probably at times involve decisions that are politically uncomfortable, and
have direct consequences for people's wallets. This makes considerable demands with
regard to integrity and independence - not just in the formal sense - of those who are to
make the decisions.
Does monetary policy need to help?
There is an intensive international discussion on whether monetary policy can be separated
completely from the stabilisation of the financial cycle, or whether it may in certain situations
need to provide support to macroprudential policy when it comes to counteracting the
buildup of financial imbalances.12
One argument in favour of monetary policy needing to provide support to macroprudential
policy is that there will probably always be incentives to try to circumvent macroprudential
policy measures, as it may be profitable for the party that succeeds, in much the same way
that there are always incentives to avoid paying taxes. We do not yet know how successful
the systems for macroprudential policy now being implemented around the world will be.
However, we do know that changes in policy rates are significantly more difficult to
circumvent.13 It may therefore be necessary to use the policy rate in certain situations,
despite a side-effect being that some areas of the economy that do not need a higher interest
rate will also be affected. Failure to take macroprudential policy measures, or measures that
are too weak, will put more pressure on monetary policy in this respect.
One circumstance that may also play some role in the effectiveness of macroprudential
policy is that it may be the case that macroprudential policy measures are perceived as more
dramatic, not least for the banks, and as a larger intervention than an increase in the policy
rate. The pressure not to act may thus be particularly strong in the field of macroprudential
policy, and it may be fairly difficult to resist, particularly if the financial supervisor does not
have a high degree of statutory independence. This could lead to an "inaction bias" - that
one waits so long before taking measures that it is already too late by the time they are
implemented.14 Hopefully, these are problems that will decline as macroprudential policy
becomes more established and perceived as less dramatic - roughly in the same way as
inflation-targeting gradually became more established and accepted.
A further reason why macroprudential policy may need support is that monetary policy could
in itself contribute to the problem. If monetary policy is very expansionary over a long period
of time, this could contribute to distorted expectations of how high interest rates will be in the
future and how the housing market will develop, and lead to an increase in risk taking in the
economy.15 This could set in motion forces that macroprudential policy may find difficult to
counteract on its own.
What I consider to be particularly important to bear in mind from all this is that there is
currently a fairly lively discussion internationally among academics and experts, both on the
need to coordinate macroprudential policy and monetary policy and on the question of
whether monetary policy may need to be used in certain situations to counteract financial
imbalances - even when macroprudential policy is in place. For some reason, one does not
see much of this discussion in the Swedish debate. Here it seems rather that there is an
assumption from the start that macroprudential policy and monetary policy are not related in
any critical way and can be conducted more or less independently of one another without
problem. But internationally, this is seen as far from obvious.
12
See, for example, Bayoumi, et al. (2014), Blanchard, Dell'Ariccia and Mauro (2013), Carney (2013), Smets
(2013) and Stein (2013, 2014) for discussions of this.
13
This is an argument that I myself and others at the Riksbank have highlighted on various occasion, see for
instance, Ingves (2010).
14
For a discussion of "inaction bias" in macroprudential policy, see Chapter 9 in ESRB (2014).
15
For instance, Summers (2014) writes: "[A] strategy that relies on interest rates significantly below growth rates
for long periods of time virtually guarantees the emergence of substantial bubbles and dangerous build-ups in
leverage. The idea that regulation can allow the growth benefits of easy credit to come without the costs is a
chimera. It is precisely the increases in asset values and increased ability to borrow that stimulate the
economy that are the proper concern of prudential regulation." The hypothesis that there is a risk-taking
channel for monetary policy is not undisputed, but it has become increasingly accepted and the empirical
support for it is increasing (see, for instance, Altunbas et al., 2014 and Gungor and Sierra, 2014, for a couple
of recent contributions).
Let us be more concrete - some simple calculations
So far, I have spoken about monetary policy and macroprudential policy in theoretical terms.
Let me now go on to talk about them in more concrete terms with regard to resolute
decisions.
An obvious problem we need to deal with immediately is the high and increasing
indebtedness in the Swedish household sector. On aggregate, household debt currently
amounts to 174 per cent of their total income.16 However, this figure is based on all
households, regardless of whether or not they have any loans. If we only include households
that actually have loans, the figure is higher, 263 per cent, which is shown by data from the
eight largest banks in Sweden gathered by the Riksbank. The same data show that the figure
has risen to 313 per cent, if we only include households with mortgages. These figures give
cause for concern, and should not just be allowed to continue growing; we will unfortunately
need to deal with this situation in the foreseeable future. The debt ratio has almost doubled in
twenty years and this is not a sustainable development. There is a risk that overly optimistic
expectations of low interest rates for a long time to come have contributed to increased
indebtedness. And a rapid growth in debt, together with optimistic expectations, is a pattern
that has often preceded financial crises. Even without a crisis, a large debt overhang will
hamper economic developments when conditions change.
If one wants to influence the incentives for households to take on debt, how effective might
the potential measures be? And how do measures in the new field of macroprudential policy
compare with other possible measures? Here we are still to a large extent on uncharted
ground. But even if we cannot base our decisions on extensive theoretical and empirical
research, we can at least gain a rough idea of the potential effects to be expected, by using
some simple calculations. I would like to emphasise that the figures I will mention refer to
partial and statistical calculations that are based on a number of simplifying assumptions and
that they must therefore be taken with a pinch of salt. At the same time, the calculations
illustrate the conditions for taking practical decisions.
Ordinary households in Luleå, Upplands Väsby and central Stockholm
Let us look at some "typical households", ordinary Swedish households consisting of two
adults and two children. Let us say that one of them comes from the municipality of Upplands
Väsby outside Stockholm and one from the city of Luleå in Norrbotten. After a quick look at
the statistics, we can conclude that an average household of this type in Upplands Väsby
has a total income of around SEK 44,000 a month after tax and a first mortgage of around
SEK 1.75 million. A corresponding household in Luleå can be assumed to have a total
income of approximately SEK 39,000 a month and a mortgage of approximately
SEK 1.1 million. I am here talking about two average households without extremely high
incomes or loans. The debt ratio, that is, the loan in relation to disposable income, is in this
case 331 per cent for the family from Upplands Väsby and 235 per cent for the family in
Luleå.17. For the family in Upplands Väsby this is just above the average in the country for
households with mortgages, while the family in Luleå is well below average.
At the same time, we know that it is not unusual for households to have debt ratios of
600 per cent, for example in central Stockholm. Let us therefore include one of these
households in our comparison. For a similar family with two children in central Stockholm,
with a total income after tax of almost SEK 55,000 per month, a loan of almost SEK 4 million
entails a debt ratio of around 600 per cent.
How could various measures be expected to influence expenditure - in terms of direct loan
costs, such as interest, and other loan-related cash flows, such as amortisation payments -
for these households?
We can assume for the sake of simplicity that the interest rate on the mortgage loan is
initially 4 per cent for all households. We also assume that our households have a variable
interest rate, that they do not amortise their loans at all and that they have no savings.
Capital buffers have limited effects on wallets
One of the more accepted macroprudential policy tools is the so-called countercyclical capital
buffers, which are being introduced as a result of the new Basel regulatory framework. This
means that it will be possible to make an extra capital adequacy demand of the banks in
good (read: overheated) times that can be reduced again in less good times. Say that the
banks are now subjected to countercyclical capital buffers and increase their capital
adequacy ratio by a total of 2.5 percentage points. Say also that the banks pass on all of the
cost for the increased capital adequacy requirement to their mortgage customers. An
increase in the capital buffer of 2.5 per cent could then, under slightly simplifying
assumptions, be translated into an increase in the banks' lending rate of around
0.2 percentage points at most.18 Higher capital adequacy thus reduces the risk taken by
shareholders and other financiers and should thus lead to a reduction in the banks' yield
requirements and borrowing costs. The increase in lending rates could therefore also be
lower.
For the family in Upplands Väsby, this means that interest expenditure increases by SEK 204
per month after tax. For the family in Luleå, with a slightly smaller mortgage, the increase is
SEK 128 per month after tax. For the family in Stockholm with the larger mortgage, interest
expenditure increase by SEK 461 per month after tax. Expressed as a percentage of
disposable income, the countercyclical capital buffers entail higher loans costs for our
households corresponding to 0.3-0.8 per cent of their disposable incomes.
These relatively marginal effects on the wallet will probably not influence the incentives for
debt in our standard households to any great degree. To influence households' indebtedness
the capital adequacy requirements made of the banks would need to be raised much more
than is now being suggested. On the other hand, the increased capital adequacy
requirement means that the banks' resilience is strengthened, which is desirable in itself and
an important purpose of the regulation.
Elimination of tax relief would have greater effect
If one wants to influence the incentives, there are other measures that could be much more
effective. Kuttner and Shim (2013) have made a panel study covering 57 countries and
stretching across more than three decades, which investigates the effect on debt and
housing prices of various tools. According to their study, the tools that appear to have the
most obvious effect on debt include the elimination of tax relief on interest payments and the
introduction of a mortgage cap.
Let us try to estimate what effects these measures would have on our standard households
here. Say that the tax relief for mortgages was abolished. Changes to the tax relief are
nothing new - at the end of the 1980s, the tax regulations were changed so that tax relief
was almost halved for certain groups of households.
For the family in Luleå, with loans worth SEK 1.1 million, the loan costs would rise, if they did
not adapt their level of indebtedness, by around SEK 1,100 per month, or almost 3 per cent
of their disposable income. And for the family in Upplands Väsby, the abolition of the tax
relief would increase their loan costs by SEK 1,750, or around 4 per cent of their disposable
income. For our more heavily-indebted family in Stockholm, loan costs would rise by almost
SEK 4,000 per month, or just over 7 per cent of their disposable income.
The increased loan cost that the abolition of the tax relief entails in this example corresponds
to roughly the increased loan cost that would arise if the mortgage rate instead rose by
1.7 percentage points.19
We can thus see that abolishing the tax relief would have much greater effect on households'
loan expenditure than raising the capital adequacy requirement for banks by the amount
currently being discussed. If one wants to influence household indebtedness, changes in the
tax relief would have greater potential to directly affect households' incentives.
Uncertain what effect the mortgage cap has
There is also some support for the mortgage cap having an effect on the loan appetite from
the preliminary evaluation made by Finansinspektionen after the introduction of its mortgage
cap in October 2010.20 The mortgage cap is not a cap in the total sense, but it means that a
person who wants to borrow a large amount must take a larger share of unsecured loans,
which usually have a higher interest rate than first loans and moreover have to be amortised
at a faster rate. Of course, not all households are affected by changes in the mortgage cap.
Say that the mortgage cap is reduced from 85 to 75 per cent. And say that the standard
households are affected by this and must therefore take on a larger share of unsecured
loans at an interest rate of 6 per cent and moreover pay off the unsecured loan over
10 years. This would entail increased interest expenditure corresponding to between 0.4 and
1 per cent of disposable income, and amortisation corresponding to between 2.8 and
7 percent of disposable income. The total increase in expenditure in this example thus
corresponds to between 3.2 and 8 per cent of disposable income. This is comparable with
how much household expenditure would increase if the mortgage rate instead increased by
just over 1.9 percentage points.
Amortisation as a form of saving
Many of you will know that regulations of this type have often been circumvented in various
ways. One way for the banks to make the mortgage cap less binding for their customers and
enable them to take on more loans, for instance, is not to require amortisation on first loans.
When it comes to amortisation culture, we in Sweden differ quite substantially from what
seems to be common in many other countries. In Sweden, around 40 per cent do not
amortise at all. Of those who do, a good 40 per cent do it in such a way that it will take
50 years or more before they are free of debt.
Let us imagine that our households - which we assumed did not amortise at all to begin with -
are forced to amortise their loans over a period of 50 years. If the households began to
amortise in this way, it would on the one hand initially mean increased expenditure for the
h