Stefan Ingves: Financial crises and financial regulation - thoughts after
five turbulent years
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank and Chairman of the Basel
Committee on Banking Supervision, to the Swedish Economics Association, Stockholm,
13 June 2012.
* * *
Palmstruch and the Bank of the Estates of the Realm
In 1656, Johan Palmstruch founded Sweden's first bank, Stockholms Banco. In 1661, to
facilitate the handling of money, Palmstruch launched the first banknotes. They were initially
successful. But it all ended in a bank failure after Palmstruch became tempted to issue too
many banknotes in relation to the underlying value that was deposited in the bank. In
response to this failure, the Riksdag resolved to form the Bank of the Estates of the Realm in
1668. This bank was later renamed the Riksbank and is today the world's oldest central
bank.
Palmstruch's story illustrates the importance of price stability - and also the risks of financial
instability.
Today, I would like to discuss financial crises and financial regulation from the perspective of
the national economy. I want to explain the value of orderly and well-reasoned financial
regulations for the prevention of financial crises. Banks are not normal companies. For one
thing, banks in crisis can result in very large costs for the entire economy. The public sector
thus has an obligation towards the citizens to attempt to prevent and manage financial crises
to the best of its ability.
I will start by touching on the benefits and risks of a financial system, and how these can be
balanced against each other. I will then go on to describe the global financial crisis and how it
was met. Following this, I will discuss how the global financial crisis turned into a euro crisis,
and the role the banks are playing in this crisis. In the final part of my speech, I will try to
provide some answers as to how society can better avoid crises like this in the future.
The economic balance between benefit and risks in the financial sector
I have elsewhere described the banking system as a motorway junction for the economy. In
the banks, and, more generally, in the financial system, households' and companies' income
and expenditure meet like a flow of traffic coming from all directions. A robust structure is
needed to make this interaction proceed smoothly. When a lot of traffic is moving at high
speed, the structure must also have a clear focus on safety. The higher the speed limit, the
greater the safety margins must be.
Banks are important to the national economy
The Riksbank defines financial stability as the maintenance of the financial system's basic
functions and its resilience to disruptions.
The system converts savers' money into productive investments, ensures that we can pay
each other when we exchange goods and services, and allocates risk among those who are
willing to take risks and those who are not.
The banks are the single most important providers of these basic functions. The banks'
income largely consists of payments by consumers to the banks for their specialisation in
these functions. This income also reflects the fact that the banks borrow over the short term
- for example through our wage accounts - and lend over the longer term - for example
through our mortgages. As it is cheaper to lend over the short term than the long term, the
banks also earn money this way.
In comparison with companies in other sectors, the banks have little equity. To some extent
this is natural, in that the banks' core activity is borrowing money, which is to say taking on
debt. Leverage means that the banks can earn a lot of money by maintaining low
equity/assets ratios. Of course, leverage applies to all companies, but, as we will see, banks
can have particular reason to take greater risks than other companies.
Vulnerability and contagion risks demand special bank regulations
The combination of the banks' central functions and their high indebtedness creates risks.
This is a matter of credit risk - the risk of not getting the money you lent back again - and of
liquidity risk - the risk of being unable to borrow money. The banks are vulnerable due to
their high levels of indebtedness.
Problems at one bank also risk spreading to other banks. This kind of contagion can happen
on both the asset and liability sides of a bank's balance sheet. Deposit and lending surpluses
in different parts of the world are managed on a global interbank market. The banks' assets
thus largely consist of loans to other banks. The banks' liabilities largely consist of loans from
other banks.
The banks are dependent on confidence - illustrated, in its most classic form, by a bank run.
Rumours that a bank is facing problems can lead people to want to take their money out,
which may give the bank problems - even if it had no problems to start with.
So banks have a series of characteristics that distinguish them from normal companies. If a
normal company is unable to meet its payments, it will have to file for bankruptcy. If a bank
defaults on its payments, the consequences for the financial system - and the real economy
- can be enormous.
This means that it is difficult to let banks go bankrupt, at least if these banks are large and
times are troubled. So other disciplinary mechanisms must be found - such as tougher
regulation and thorough supervision. Special legislation covering banks in distress is also
needed.
Of course, bank regulations are primarily a way of allowing the public sector to safeguard the
public interest. But the regulation of banks is also a way of mitigating principal-agent
problems between a bank's management and borrowers on the one hand, and the bank's
owners and lenders on the other. For this second category, it is often difficult or expensive to
monitor the risks on the bank's asset side.
One important aspect of bank regulation is the requirement for the amount of capital the
banks should maintain. As capital adequacy requirements play a central part in the
discussion of financial stability, I would like to examine them in a little more depth.
There is a difference between the private and social benefits and costs of financial
regulation
Demands for bank regulation are not infrequently met with resistance from interested parties
who claim that regulation is too expensive. Not least, this resistance is aimed at higher
requirements for banks' capital adequacy, as the interested parties claim that capital is more
expensive than loans. But in this context, it is important to make a distinction between private
costs and social costs. Higher capital adequacy requirements entail private costs for the
banks. But we public sector participants should primarily be discussing the social
consequences.
One cornerstone of modern financial research is the basic theory that was established by
Modigliani and Miller over 50 years ago.1 This says that the value of a company does not
depend on how that company is funded - under certain assumptions. In principle, the model
shows that the form of funding is only significant if there is a difference between the debts of
companies and those of private individuals. And there is, of course - a limited liability
company is basically a means of protecting its owners from the private consequences of the
company becoming bankrupt. Being able to fund a business operation through borrowing is,
of course, necessary and, in most cases, effective. In efficient markets, lenders' risks are
handled by means of interest rates and contract clauses. The limited liability company is thus
a historically wealth-generating social institution. Nevertheless, the example illustrates that
the higher cost of funding through equity is more a matter of private than social costs.
Another factor that separates the costs for own and borrowed funds is the tax system.
Companies may deduct interest on loans, but pay corporate tax for profits on equity. But this
is just a private economic difference - from the social perspective, the only difference is the
subsidisation of debt-financing in preference to equity.
This specifically applies to banks that may be systemically important - it would be socially
costly to allow them to file for bankruptcy. So the market often expects that the state will save
a bank that is on the ropes, one way or another. These so-called implied guarantees create
even greater differences between social and private costs, and risk leading the banks to take
even greater risks.
Banks are vulnerable, contagious and sometimes systemically important. There are great
differences between private and social cost-benefit calculations. Economic theory and
empirical experience gives us good reason to regulate banks. But the difference between
social and private costs also makes clear that many well-motivated social measures will meet
with resistance from private interests.
The global financial crisis illustrated these risks all too clearly
The global crisis painfully demonstrated the risks of banking activities and financial instability.
Of course, experience from the crisis lies behind the comprehensive agenda of regulations
that has been developed in recent years.
So I thought I would describe the course of the crisis, how authorities met it, and the lessons
we believe we have learned.
The risks were realised during the crisis of 2007-2009
The factor that triggered the global financial crisis was the increasing problems in the
US mortgage sector in 2007. These problems then spread, as many mortgages had been
repackaged into so-called structured products, sometimes to the point of being
unrecognisable. These instruments were held by a number of agents - and the complexity of
the instruments made it difficult to see which agents had major or minor problems. At the
same time, many banks had low equity/assets ratios. When the problems spread in the
financial sector, even relatively limited losses could thus lead to major problems.
The lack of transparency and weak resilience led to an almost-total lack of confidence
between financial institutions in the autumn of 2008. Banks became hesitant to lend to each
other. As the banks largely obtain funding from loans from each other and other financial
institutions, the lack of confidence led to a drying-up of liquidity within both the financial and
real economies.
The crisis was met in a somewhat similar way by the United States, Europe and
Sweden
On the whole, the financial crisis was met in a similar way by all OECD countries. The
automatic stabilisers were put to work in fiscal policy, and many countries launched targeted
fiscal policy stimulation measures to break the fall. The central banks reduced interest rates
to very low levels. Almost all economies also took measures to prevent even deeper
problems in the financial sector.
In the United States, where the crisis originated, the Federal Reserve and other authorities
provided emergency liquidity assistance to the banks and other parts of the financial system.
The Department of the Treasury's TARP (Troubled Assets Relief Program) purchased
problem assets from banks and other financial institutions. The guarantee programme for the
banks' deposits was expanded. In addition, in 2009, a stress test was carried out of the
19 largest US banks as of the spring of 2009. Ten of these banks were deemed to need new
capital, which they also succeeded in raising. It seems likely that this test helped restore
confidence in the equity/assets ratios of the US banking system.
In Europe, the banks are more important for the supply of capital to the real economy than
they are in the United States. So, on our side of the Atlantic, support was channelled via the
banking system to a greater degree. The ECB has increased liquidity, partly by offering loans
with longer maturities. In addition, the ECB has supported the markets for both covered
bonds and government securities and has thereby supported the banking system of the euro
area. It has not been able to prevent European banks from encountering serious problems.
Many smaller banks - and a number of major banks - have been forced to close. These
liquidations have often been carried out with governmental participation and support. The
costs of government capital contributions and guarantees have been comprehensive. These
lie behind a large part of the fiscal policy problems currently being faced by many European
states, a subject I will return to.
The most critical period for Swedish banks was between the autumn of 2008 and the spring
of 2009. The liquidity shortage on the financial markets made it difficult for the banks to
renew their loans. This was joined by the threat posed by the crisis in the Baltic countries and
the Swedish banks' exposures there. The consequences of this were that the value of
Swedish bank securities fell drastically and demand for government securities rose.
In this situation, the Swedish authorities implemented a series of measures:
 The Swedish National Debt Office issued extra treasury bills and, in practice, let the
banks exchange their mortgage bonds for more liquid government securities.
 The government and the Riksdag extended the deposit guarantee and quickly
passed laws enabling support to the banking sector.
 In addition to the repo rate cuts we implemented, the Riksbank provided liquidity in
several ways. We lent money for longer periods, eased the policy for collateral and
introduced more counterparties to supply more liquidity to the banking system. We
created swap lines with the Federal Reserve and ECB to meet the banking system's
need for foreign currency. We also contributed to crisis management in
neighbouring countries by creating swap lines with Iceland, Latvia and Estonia.
Finally, we also extended emergency loans to Carnegie and Kaupthing Sverige.
The Riksbank no doubt considers that Sweden's crisis management was successful. And
other analysts have also shared this assessment - including, for example, Goodhart and
Rochet in their review of the Riksbank's work carried out last year.2 Unlike other central
banks, we have also been able to phase out our crisis measures.
The crisis has cost enormous amounts
The crisis entailed huge costs, both for society as a whole and for the tax-funded public
sector.
Andrew Haldane, Executive Director of Financial Stability at the Bank of England, has shown
that the crisis cost UK taxpayers just over 1 per cent of GDP. The corresponding figure for
the United States is just below 1 per cent, or USD 100 billion.3 Eurostat has calculated the
figure for the EU as a whole at 0.7 per cent, or EUR 90 billion.4
But these figures are only the direct public costs of keeping the financial system more or less
on its feet. The real social costs of the crisis are significantly higher. Financial crises lower
output and the growth path. In addition, a part of the effect is permanent, even if it is difficult
to say how large a part. A historical estimate of the cost of financial crises, calculated as a
present value, is about 60 per cent of GDP. For the global financial crisis, this figure is
considerably higher.5
The banks are playing an important role in the sovereign debt crisis
The banks are also central to the problems that succeeded the global financial crisis, which
is to say the sovereign debt crisis in the euro area. As I mentioned, several governments in
Europe were forced to manage problems in the banking sector, often at great expense.
Those countries with domestic property bubbles were hit particularly hard. But financial
exposures to the United States and the other countries most affected by the crisis impacted
the banking systems of several countries. These stresses led to financial problems in many
European banks and countries, and, eventually, to the current sovereign debt crisis.
The crisis has created a vicious circle between the real, financial and public
economies
The current European sovereign debt crisis has its origins in the period before 2007. In the
absence of a common fiscal policy, budgetary discipline in the euro area should have been
safeguarded by the Stability Pact. But, by 2003, it could already be seen that the
implementation of the Stability Pact was weak. The financial markets also treated the euro
countries as a homogenous block for a long time. Consequently, warning signals in the form
of interest rate differentials between countries were absent.
When the global financial crisis impacted what were often weakly-capitalised banking
systems, and the ability of many countries to support their financial systems became
questioned, the crisis became acute. The crisis has often been described as a vicious circle
between the real, financial and public economies: weak growth in the economy leads to
problems in the banking sector; banking problems generate costs for the state; the public
sector has to implement austerity measures to maintain credibility, and this reduces growth.
This vicious circle also works in the opposite direction: problems in the banking sector spill
over into lending and growth, which weakens public finances and the state's ability to back
up the banking system when necessary.
Incidentally, this pattern of interaction between problems in the financial, real and public
economies recurs throughout history. Reinhart and Rogoff have described how economic
problems and bursting speculation bubbles have led to financial crises and subsequent
sovereign debt crises time and again over the last 800 years.
Developments in the banking system, 2007 and on
So far, the European banks have not regained their credibility in the same way as the
US banks did in 2009 and the Swedish banks did in 1992 and 1993. A great deal of
uncertainty still prevails over which European banks are robust in the long-term.
According to one estimate, the total decline in the value of assets on the European credit
markets amounted to EUR 184 billion by the summer of 2011. The same publication made
the assessment that losses over the years to come could amount to over EUR 200 billion, of
which EUR 125 billion would derive from losses linked to government securities.6 The IMF
has calculated that the effects of the sovereign debt crisis may amount to EUR 300 billion.7
Even so, the European banking sector was reported to have a larger balance sheet total in
2010 than in 2008. This reflects the fact that the problem assets have still not been
addressed.
For long periods, European banks have had problems obtaining funding on the market. This
uncertainty is also reflected in the Riksbank's calculations of the stress index for Europe.
(Figure 1)
State support to the banking sector has been significant. In addition to EUR 90 billion in
direct public expenditure, governments and central banks have paid out the equivalent of
13 per cent of GDP, EUR 1.6 trillion, in emergency liquidity assistance and support for the
banks. The total commitments amount to triple this figure.8
The problems in the banking sector have still not been addressed
The management of the present European banking problems can be contrasted with the way
we handled the Swedish banking crisis twenty years ago. Of course, although we are often
considered to have succeeded well in Sweden in 1992, this was due to a relatively beneficial
political environment, rather than intellectual superiority. Even so, the differences illustrate an
important insight from economics - more specifically, the significance of asymmetric
information.
Like other central banks, the ECB intervened in 2008 to support liquidity by various means,
including offering loans at longer maturities. Unlike in Sweden, these extraordinary loan
facilities continue to be available. Furthermore, the ECB has supported the markets for both
covered bonds and government securities.
In a crisis situation, it is necessary to maintain liquidity among the banks. The Riksbank and
other Swedish authorities did the same in 2008-2010. In 1992, the Swedish government
issued a guarantee for the banks' commitments aimed at preserving confidence in the
Swedish banking sector.
But guaranteeing liquidity is not enough. Confidence in the European banking market is still
low. Few lenders are prepared to lend to European banks on market terms over the longer
term. This is where the theory of asymmetric information comes in. As nobody knows with
certainty which banks will or will not remain solvent over the longer term, cautious investors
will treat all banks as high-risk counterparties - in the same way as the car buyers in
Akerlof's "Market for lemons" treat all used cars as potential wrecks.9
When we, in Sweden, introduced the bank guarantee in 1992, it was to win time while banks
were closed down, divided up and recapitalised with government assistance. The banks that
were left were robust and able to regain the market's confidence. This action reduced
uncertainty and, in the course of time, contributed to keeping government expenditure down.
In Europe, similar measures have only been carried out to a more limited extent. This delay
and lingering uncertainty have contributed to the current sovereign debt crisis. Before these
problems are brought to light and dealt with, it will be hard to see any long-term solution for
the European banking sector.
A new framework - the way forward
At the same time as the crisis has to be managed, those of us interested in financial markets
must think ahead and build a more robust framework. The world doesn't need a new 2008.
Encouragingly enough, we have taken important steps towards creating structures that may
prevent new problems. But there is still a lot of work to do.
The crisis taught us lessons about risks in the financial sector
Obviously, the experience of authorities around the world in the crisis will form the basis of a
new and more secure financial framework. Academic research has also contributed valuable
insights.
It is obvious that risks in the financial sector were underestimated before the global financial
crisis. One underestimation concerned the degree of correlation of risks in individual
institutions. But it could also be argued that we, on the regulatory side, were a little naive
regarding the risk of moral hazard in the governance of banks.
To generalise slightly, it could be said that, before 2008, we felt quite safe when we saw that
the risk in individual institutions looked manageable. Today, we know better. Even an
individually well-diversified bank has assets that could be highly exposed to the same
macroeconomic risk. In addition, as the banks largely act as each other's counterparties, one
bank's problems can easily become another's. If the banks providing loans suddenly no
longer wish to continue lending, the banks that have borrowed money can face problems.
And, if they are not affected before, the other banks will be impacted when one or more
banks rapidly need to sell their assets, pushing down the prices. To this can be added the
vicious circle of negative effects for the real, public and financial economies that I have
already discussed.
To continue these generalisations, it could also be said that previously we usually believed
that market discipline was enough to ensure that business incentives would correspond to
socio-economic efficiency. Following the crisis, we know that this is not the case. Private
economic incentives for decision-makers in the banks can be so strong that market discipline
is not always enough to achieve transparency or effective risk management (to take two
examples). The observation that US subprime loans were often sold with the same credit
rating as Swedish sovereign bonds should be a good enough example of this. The private
benefits - or corporate profits, if you prefer - of debt-financing relative to equity lead to moral
hazard. Risks can be passed on to lenders and taxpayers. The management of the banks
have been rewarded according to return on equity. By using their own risk models, the banks
have been able to keep risk weights low, which has meant that they have not had to maintain
so much equity.
New frameworks are being established on the basis of these insights. Here, I will briefly
explain what Basel III - the new regulatory framework for the banks - entails. I will also
briefly discuss the thinking behind macroprudential policy, which has become something of
an in-word in recent years.
Basel III increases demands on the banks
The most important areas of the global Basel III Accord deal with the quantitative demands
for capital and liquidity being placed on the banks.
The banks are to have sufficient equity...
As financial crises can lead to considerable losses, the Basel Committee maintains that the
banks need substantial resilience.
So capital requirements are being increased in Basel III, above all for Common Equity Tier
1.10 The minimum requirement for the banks' equity is being set at 4.5 per cent of
risk-weighted assets - more than double the requirement under Basel II. A capital
conservation buffer of 2.5 per cent, added to a counter-cyclical buffer, has created a stronger
shock absorber than previously existed. I will return to the counter-cyclical buffer when I
discuss macroprudential policy. The capital adequacy requirement can also be
complemented with a pure gross solvency measure, meaning that equity may not fall below
3 per cent of total assets.
All in all, the banks' capital position will be strengthened considerably compared with
previous regulations, contributing to the boosting of confidence, both in the individual banks
and in the system as a whole.
...and carry out clear measures for liquidity
In the light of the crisis of the autumn of 2008, the Basel Committee has decided, for the first
time, on quantitative requirements for liquidity in the banks. Basel III works with two liquidity
measures - one short-term and one long-term. The short-term measure is based on, in
principle, every bank having sufficient liquid assets to survive for at least 30 days. It is difficult
to consider such a requirement as unreasonable. The long-term measure, in principle, limits
the gap between the maturity of a bank's assets and the maturity of its debts. So this limits
the duration risk of the bank.
In the end, Basel III will be implemented as national legislation
The regulations I have just sketched will eventually enter national legislation. They are to be
fully implemented by 2019, with several sub-targets on the way.
In the EU, Basel III will be implemented through what is referred to as the CRR/CRD IV.11
Those of you who have followed the ongoing negotiations know that both countries and
EU institutions have different views about how implementation should take place in the EU.
An important dividing line has been to what extent countries should be able to stipulate
higher requirements nationally than those formulated in the common EU regulations.
The Basel Committee has been clear that the regulations and the implementation of them
form a minimum standard. As you know, the Riksbank and other authorities in Sweden
believe that there are good reasons for moving more quickly ahead and setting higher
requirements than the minimum regulations in Basel III. Our reasons for this are that the
Swedish banking market has distinctive features that entail risks and that there is no
international framework for managing banks in crisis. Although banks live globally, they die
locally. Ultimately, the Swedish banks are our responsibility.
Macroprudential policy has become a distinct policy area
Responsibility for the national banking systems leads to the final point of my speech:
macroprudential policy. The crisis has taught us that relatively stable institutions do not
necessarily add up to a stable system, for the reasons I have already discussed. There is a
clear need for a system perspective. This is the perspective of macroprudential policy.
The idea behind macroprudential policy is that it should address risks in the financial system
as a whole and thus complement microprudential focus on risks in individual institutions. The
macroprudential policy analysis can be divided into two dimensions: the structural and the
cyclical.
The structural dimension addresses the concentration of risk and interlinking
The structural (or cross-sectional dimension) relates to how the concentration of risk and the
links between different parts of the financial system at any given time affect the risk of a crisis
hitting the system as whole. I have already discussed the links between financial institutions
and the contagion risks these entail.
Existing and newly-invented tools have been proposed and applied to deal with these
structural risks. The former include stricter capital adequacy requirements and limits on
activities and exposures. The newly-invented tools include plans to manage banks in crisis
(so-called recovery and resolution plans), liquidity requirements and special capital adequacy
requirements for institutions that are deemed to be systemically important. Work is underway
within the framework of the Basel Committee to identify globally systemically important banks
which will be subject to stricter capital adequacy requirements. The Swedish authorities'
demand for a higher level of capital adequacy in our major Swedish banks is of course an
example of the same thinking.
The cyclical dimension addresses risk management over time
The cyclical dimension (also referred to as the dynamic dimension or the time dimension)
relates to how risks in the system as a whole can develop over time. The crisis and the
period preceding it clearly illustrate the tendencies towards exaggerated cyclical behaviour
that often characterise the financial markets. The demand for loans usually increases during
periods of strong growth, and the perception of risk often appears to weaken. When the
downturn comes, lending is tightened and many players want to sell their assets at the same
time, which aggravates the downturn in both the financial and the real sectors.
Cyclical risks can also be met using existing tools or tools especially designed for the
purpose. A loan limit has been imposed on lenders in Sweden in the form of a mortgage cap.
Although Finansinspektionen introduced this cap for consumer-protection reasons, the
measure can also be used, at least potentially, for counter-cyclical purposes. Liquidity
requirements also have a cyclical dimension. The Basel III regulations comprise a
counter-cyclical buffer that should be built up in good times when lending is increasing faster
than the trend. When a downturn comes, the authorities can then release the buffer, which
gives the banks a safety margin and can counteract credit tightening.
Macroprudential policy requires organisational development
The advance of macroprudential policy has also led to organizational changes in supervisory
work. In an increasing number of countries, individual authorities, or authorities working in
collaboration, are being given direct responsibility for macroprudential policy. However, the
question of the responsibility for macroprudential policy analysis and tools is not always
simple. Macroprudential policy encompasses clear elements of both supervisory and central
bank activities. I discussed this in my speech here at Nationalekonomiska föreningen a year
ago. Then I made the remark that a separated responsibility for monetary and
macroprudential policy, without any coordination, could result in a game between authorities,
which could lead to an outcome not desired by any of the authorities.
In the United Kingdom, sole responsibility has been given to the central bank. A Financial
Policy Committee is to be set up alongside the existing Monetary Policy Committee. Such a
solution of course means that the coordination between these two almost parallel
committees, although each with a different focus, becomes an important issue.
In the EU, the European Systemic Risk Board (ESRB) has been set up at the ECB in
Frankfurt. Central banks and supervisory authorities are represented on the ESRB, but the
central banks have the majority of the votes when decisions are made.
In Sweden, Finansinspektionen and we at the Riksbank set up the Council for Cooperation
on Macroprudential Policy in January this year. This council will discuss the assessment of
risks in the financial system as a whole and discuss appropriate risk-prevention measures.
The Council will also discuss analyses and the development of tools and methods in the area
of macroprudential policy. The Council is a temporary solution while awaiting a more
permanent distribution of the responsibility for macroprudential policy. At present, the
Financial