SPEECH
SVERIGES RIKSBANK
DATE:
23 May 2023
SE-103 37 Stockholm
SPEAKER: (Brunkebergstorg 11)
Governor Erik Thedéen
VENUE:
Swedish Economic Association, Stockholm
Tel +46 8 787 00 00
Fax +46 8 21 05 31
registratorn@riksbank.se
www.riksbank.se
The links between monetary policy,
financial stability and fiscal policy1
I shall begin by thanking you for the invitation to come here. I have been looking
forward to speaking to the Swedish Economic Association, as it is an opportunity
for me to discuss a subject in more depth. Today, however, I intend to mix some
current topics - high inflation and risks in the financial system - with a more
fundamental discussion of the links between monetary policy, financial stability and
fiscal policy. Finally, I will also say something about how I view the monetary
policy tools.
My main messages
For some time now, inflation has been far too high both in Sweden and abroad. It
is important that inflation quickly falls back to the 2 per cent target. We need low
and stable inflation to secure confidence in the inflation target and good
economic development. Our most recent assessment is that inflation will be close to
the target next year, but it is of course difficult to be sure, and new information
about developments will - as always - be decisive for monetary policy going
forward.
There has been turmoil on the financial markets during the spring. Banks in both
the United States and Switzerland have suffered major problems, forcing
authorities to make far-reaching interventions to avoid a financial crisis. Once again, we
have seen confirmation of how dependent we are on the functioning of financial
institutions, and how financial problems in one part of the world can easily spread
to other parts. As a consequence, global standards for financial regulation are
likely to require a number of changes.
Monetary policy and measures to promote financial stability are interdependent.
If the financial system is not stable, price stability is threatened and without
monetary stability, financial stability is threatened. When inflation is high at the same
time as there are risks in the financial system - which in Sweden is mainly due to
the large private debts of households and companies - this can increase the risk
of "financial dominance", that is, that consideration of risks in the financial system
limits the possibilities for monetary policy to combat inflation and that the
credibility of the inflation target is thereby undermined. I do not consider financial
dominance to be a problem at present, but one cannot rule out the possibility of
such a situation arising at some point in the future. We therefore need to
continuously monitor developments and take measures to prevent this from happening.
The Riksbank is responsible for inflation being stable, while responsibility for
financial stability is shared between Finansinspektionen (the Swedish Financial
Supervisory Authority), the Riksbank, the Swedish National Debt Office and the
Ministry of Finance. The responsibility for macroprudential policy lies with
Finansinspektionen. One of its aims is to limit financial imbalances, but monetary policy
also has effects on financial imbalances.
While macroprudential tools are particularly effective when one knows where
risks in the financial system are building up, such as an excessive build-up of
private debt. However, when interest rates are low for a long time, it can be difficult
to know where in the system the main risks lie. In some situations it may
therefore be reasonable to use the policy rate as a complement to macroprudential
policy, as the policy rate has a broad impact on financial markets.
There is an ongoing discussion in both academia and the central banking world
about the extent to which monetary policy should counteract the build-up of risks
in the financial system. This is an interesting and important discussion that I am
following, but I do not want to belong to any particular camp in this discussion.
However, it seems reasonable to also use monetary policy in certain situations
when major risks build up in the financial system. A necessary condition here, of
course, is that the credibility of the inflation target is not affected and that this
happens when other policies to safeguard financial stability do not fully succeed in
limiting the risks. This is thus an exceptional case; in most situations, the
preventive work to safeguard financial stability falls to policy areas other than monetary
policy.
Monetary policy and fiscal policy are also interdependent. Stable public finances
are necessary for price stability and to avoid fiscal dominance, that is, a situation
where fiscal policy "dominates" monetary policy in the sense that it is fiscal policy
that determines inflation. The risk of this in Sweden is currently small, partly
because we have a fiscal policy framework designed to keep government debt at
manageable levels.
Fiscal policy also affects the Riksbank's ability to achieve the inflation target in the
shorter term. If fiscal policy is expansionary when inflation is too low, and
contractionary when inflation is too high, it can help the Riksbank achieve the inflation
target more easily. There may also be periods when the fiscal policy conducted
makes it more difficult to achieve the inflation target. A tight fiscal policy may
have contributed to the Riksbank's problems in bringing up inflation in the
aftermath of the global financial crisis.
The Riksbank's independence is important for maintaining confidence in the
inflation target. But this does not prevent us from exchanging information on issues
relevant to monetary policy and its target fulfilment with, for instance the Riksdag
Committee on Finance and the Ministry of Finance. This could, for example,
involve how we view resource utilisation in Sweden and abroad. How savings and
consumption develop and why. Which shocks to the macroeconomy are
permanent or temporary, or how the effects of major shocks to the economy should be
analysed, such as during the pandemic.
The policy rate should be the main tool of monetary policy and asset purchases
should be made with caution. Such purchases are particularly effective to
counteract financial crises. Asset purchases in the form of government bonds may be
justified in time when monetary policy needs to become more expansionary, but the
threshold for extensive bond purchases to safeguard the inflation target should be
high.
Asset purchases can have negative side effects, which should be closely
monitored. For example, markets may start to perform less well or private actors
whose securities are bought by the central bank may become accustomed to the
fact that there is always some form of government support when making bad
deals. Moreover, the economic consequences of large asset purchases are still
unclear. We therefore need more analysis and knowledge of the effects. Having said
that, I would still like to emphasise that asset purchases should remain part of our
toolbox.
High inflation
It cannot have escaped anyone's attention that inflation is currently very high. The
shift from the previous low inflation rate was rapid and took us and other
forecasters by surprise. High inflation has multiple and global causes. Pent-up demand
and a rapid shift from services to goods made it difficult to adjust supply in the
short term. This, combined with fiscal and monetary stimulus, pushed up prices.
The rapid economic recovery after the pandemic pushed up the prices of raw
materials, inputs and transport at a time when production had not yet recovered.
Russia's invasion of Ukraine drove up the prices of energy, cereals and other
agricultural products. Energy prices then spread to the prices of transport and other
inputs.
One question to ask is whether we will return to the environment of low inflation
and low interest rates that characterised the economy before the pandemic. Our
assessment is that inflation will fall back rapidly in 2023 and that it will be around
2 per cent next year, see Figure 1. Long-term inflation expectations as measured
in surveys are just above 2 per cent, which supports our assessment, see Figure 2.
However, there is considerable uncertainty and unforeseen events always occur.
Nor do we know whether several years of high inflation has affected companies'
pricing behaviour. Moreover, there is the risk that the deteriorating geopolitical
situation may have a fundamental impact on economic conditions for a long time
to come.
Globalisation, with increased trade and mobility between different countries, has
been one reason why we have had favourable economic development, including
low and stable interest rates and low inflation.2 If conflicts in the world were to
result in globalisation slowing down, this would probably have negative
consequences for both Sweden and the global economy. If trade decreases and the
mobility of labour and capital deteriorates, the conditions for economic growth will
also deteriorate. Greater protectionism means slower development in, for
example, information and communication technology, a sector that has been a strong
driving force behind the pressure for change and productivity improvements in
various parts of the economy. Several of the factors that have dampened price
pressures in recent decades thus risk becoming less important in the future.
Risks increasing in the financial system
Despite the global financial crisis 2007-2010 and the pandemic 2020-2022, GDP
has grown significantly in recent decades. Higher incomes and wealth have also
led to the financial sector becoming a larger and more important part of the
economy. Furthermore, rapid technological developments combined with globalisation
have paved the way for new players and services within the framework of what is
commonly referred to as FinTech. While this is essentially positive, it has also
exposed the financial system to new risks, while many more traditional risks remain.
The bank collapses in the United States and Switzerland are concrete examples of
this.
Bank collapses in the USA and Switzerland
The bank collapses in the United States and Switzerland in March created
uncertainty in the global financial markets. To understand these developments, it is
important to analyse the underlying problems. They are largely well known.
However, there are also a number of new elements that may exacerbate the
wellknown problems and that need to be analysed further. We want to avoid
problems in the banking sector in one area spreading to other parts of the financial
system or to other countries. At the same time, it must be possible to wind down
banks with serious problems in an orderly manner.
It is important to learn from crises. What we have now seen means that I think we
will have to change some regulations. The financial regulatory framework is
governed to a very large extent by global standards, so that is where the analysis
must begin. Any future agreements reached at global level will also clearly affect
the rules in the EU and thus in Sweden.
Let me first focus on the more familiar problems and then return to what I see as
new ones. In a sense, you can probably talk about the financial sector before and
after the Silicon Valley Bank crash. I think it can be a watershed in the way we
think about the design of some financial regulation.
Banks are important
Banks are of fundamental importance to the national economy; without them,
households and businesses would struggle to make payments. Virtually all
payments today depend on various services provided by banks. Without banks,
households and firms would also find it difficult to borrow and manage their
financial risks. Traditional theory often talks about the three key functions of banks:
first, to intermediate payments; second, to allocate credit in the economy,
thereby transforming liquid deposits into illiquid loans; and third, to facilitate risk
management by households and firms. A well-functioning banking system is
therefore a key driver of economic growth.
Since the liberalisation of the financial markets in the 1980s, the financial sector
has also become more efficient and this has contributed to increasing welfare in
many countries, not least in Sweden. At the same time, the risks have increased as
the financial sector has grown.3 The unease we have seen during the spring
emphasises what I noted earlier, that monetary policy and financial stability are
interdependent. I will return to monetary policy shortly, but given the developments
during the spring, it is natural to start with the bank problems we have seen and
what they mean.
Banking involves risks
What happened in the United States and Switzerland in March shows once again
that banks' activities pose risks to the whole economy. This is nothing new. The
risk of bank runs is well known. Such events have occurred many times in history.
They are also well explained in the scientific literature.4 The basic problem is that
banks have an inherent instability.
As a depositor, I want to know that I can always withdraw the SEK 1,000 I
deposited. This is because most of us use these deposits to make our payments and we
need to know that the nominal amount cannot fall and that the money is
immediately available. This distinguishes bank deposits from, for example, shares in
mutual funds. The latter can also be immediately available, but mutual fund shares
vary in value depending on how the value of the assets varies. However, bank
deposits are both liquid and nominally fixed.
For the bank, this means that funding is volatile. At the same time, much of the
bank's assets are locked up for the long term, i.e. illiquid. Those of us who borrow
from the bank want to know that we can repay the loan according to an
instalment plan and cannot be called upon to repay it at any time.
So we should be able to request our deposits at any time, but the bank cannot
request the return of its money - your loan - other than as planned. The bank thus
offers liquidity to households and firms by providing liquid deposits and illiquid
loans. This creates a liquidity mismatch for the bank.
A further problem here is that the bank's assets can be difficult for an outsider to
evaluate. As a result, a bank's financial situation depends to a very large extent on
the trust its customers have in it. A bank builds trust by having plenty of equity,
good earnings, low loan losses and good liquidity. And not least important: a
sound culture where risk management is central.
Confidence is essential for a bank, but it can also disappear quickly. If this
happens, there is a great risk that depositors and other financiers will want to
withdraw their money quickly. The risk is that the depositors who arrive first can
withdraw their money while those who arrive later are left without, as the bank's
liquid assets are then exhausted. This is precisely the reason why bank runs can
occur. It can also lead to other financiers quickly withdrawing their funding.
If the bank is bad, it should obviously be wound up. The problem is that it is
difficult to tell whether or not a bank is bad, so there can be a run on good banks as
well. Experience also shows that even bad banks should be wound up in an
orderly fashion. There are several reasons for this. One reason is what I just
mentioned: banks are highly dependent on trust and are difficult to evaluate.
Therefore, problems in one bank can easily undermine confidence in other banks. So
the contagion risks are significant. In addition, a standard bankruptcy procedure is
rarely a good solution for banks, as banks are central to payments and the first
step in a bankruptcy procedure is usually to suspend payments.
Whether or not a bank is viable, it can be subject to bank runs. I do not want to
judge the viability of the banks in question, but it is clear that some banks in the
United States and one bank in Switzerland experienced a run. Customers lost
confidence and wanted to withdraw their money immediately. There was uncertainty
about whether the banks would be able to survive. This uncertainty can bring
down a bank, whether it is justified or unjustified. On 9 March, depositors at
Silicon Valley Bank withdrew more than $40 billion in one day.5 This represented 19
per cent of its total assets, or 23 per cent of its deposits. In addition, the bank
itself expected withdrawals to be around $100 billion the next day. No bank can
handle such a bank run without help. This is nothing new.
Banks need to be regulated
Precisely because banks are so important to the economy and at the same time so
genuinely unstable, they must be subject to extensive regulation and supervision.
Following the global financial crisis of 2007-2010, when several banks ran into
problems, global standards for banks were tightened, including through Basel III
and the FSB's resolution framework. My assessment is that the problems we saw
in March this year did not spread quite as much as they would have done if Ba-
sel III had not been introduced. The banks now have more capital and more
liquidity and are therefore better equipped to withstand various forms of shock.6
However, it should be noted that Basel III is not yet fully implemented.7 Negotiations
are currently under way on how the final parts of Basel III will be introduced in the
EU and some of the proposals entail less strict rules than those set out in the Basel
standards. I would like to take this opportunity to emphasise the importance of
full, timely and consistent implementation of all Basel standards in all countries,
including the EU. Although the events of March did not hit the EU particularly
hard, we need to learn lessons from what has happened in other parts of the
world. This is important to ensure that the risks do not materialise in our part of
the world as well.
So what is new in the current situation and how do the existing global standards
for bank regulation compare with this background? First of all, I would like to
emphasise that I am not primarily talking about the situation or the regulations in
Sweden, but more about the global standards, as it is these that are now being
questioned. But - and this is important - they are the basis for the regulations in
the EU and thus also in Sweden. I would also like to stress that it is too early to
draw definitive conclusions from the disruptions we have seen. Several authorities
and global organisations are in the process of analysing the events and I do not
want to anticipate these analyses or their conclusions. It will also probably take
several years to agree on how the global standards should be amended.
Nevertheless, today I would like to highlight three issues that I believe will characterise
the global regulatory debate going forward and I will give my preliminary views on
them. These are the deposit guarantee, the resolution framework and the
requirements on banks. These issues are also highly relevant in Sweden.
The deposit guarantee needs to be reviewed
Let me start with perhaps the most important, difficult and relevant part, the
deposit guarantee. Does it fulfil its function today or does it need adjusting?
The vast majority of countries have some form of deposit guarantee, which
usually covers the entire deposit up to a certain amount. In Sweden, it applies to the
full amount, up to SEK 1 050 000 per depositor and bank. The idea is that savers
should feel secure even if the bank runs into problems. This will reduce the risk of
bank runs, which is important for promoting financial stability. From an economic
perspective, there is a trade-off here. We want to reduce the risk of bank runs
through a deposit guarantee. But we also want to avoid banks taking too much
risk. An important task for the creditors of a company is to influence the company
to avoid excessive risk-taking. This applies to all companies. The problem with the
deposit guarantee is that if it applies to all depositors - and by extension all
creditors - it increases the likelihood of the bank taking excessive risks, what is usually
called moral hazard.
It is therefore necessary to find the right balance between guaranteeing deposits
to avoid a bank run on the one hand, and ensuring that creditors give the bank
incentives to avoid excessive risks on the other hand. Some smaller Swedish banks
fund themselves almost exclusively through guaranteed deposits. This means that
in practice there are few creditors who can influence the bank in a risk-reducing
direction, and this increases the likelihood that these banks will take major risks.
The consequence will also be that these banks can charge higher interest rates
and thus also offer higher interest rates to small savers who in turn feel protected
by the deposit guarantee. In so far as this occurs, it can be interpreted as meaning
that the deposit guarantee scheme in practice subsidises risky lending, which
would be unfortunate. The picture is, however, complicated by the fact that
smaller banks contribute positively by increasing competition in the banking
market. Larger banks may also be too large for the authorities to let them fail, which is
also a problem. There are difficult considerations to make here.
Experiences from the United States
When the bank run on the US Silicon Valley Bank began, only about 6 per cent of
its deposits were guaranteed by the US deposit guarantee scheme. The rest were
unsecured deposits, primarily because they were for larger amounts. This is an
example of the fact that deposits in many banks today do not only come from small
savers. Many of them, including the Swedish ones, finance themselves to a large
extent in the financial markets. Some of the market funding takes the form of
direct deposits from financial actors and is not covered by any deposit guarantee
and it is normally very volatile. Another part is funding is through the bank issuing
securities with a specific maturity. These are therefore not immediately available
and thus not exposed to the same risk as the deposit, but on the other hand give
rise to a refinancing risk.
The run on Silicon Valley Bank also highlighted that contagion effects can be large
even when relatively smaller banks get into trouble. Silicon Valley Bank was the
20th largest bank in the United States.8 Although the bank was large by Swedish
standards - about 70 per cent of Swedbank's size - it was small in the US market. I
see the importance of small and medium-sized banks as a clear lesson from the
crisis. As an authority with a financial stability mandate, we cannot ignore such
banks. Even if the problems occur in relatively quiet periods, they can have
unwanted spillover effects. When the problems became acute in Silicon Valley Bank,
the concern spread quickly to other similar banks. The reason was probably that
they had similar business models, risk profiles and so on. This led to a loss of
confidence in these banks, too. The contagion risks became obvious. One lesson is
that we should not only look at the size of individual banks, but also whether
certain groups of banks are similar and thus exposed to similar risks. This means that
even smaller banks as a group can become important for financial stability.9
Well, the Silicon Valley Bank run resulted in the US authorities deciding to
guarantee all deposits in the two worst affected banks. They felt they had to do this to
prevent the problems from spreading.
The bank run in the United States also happened very fast. Technological
developments allow depositors to move their deposits with a few keystrokes, to other
banks, to money market funds or to crypto-assets. Social media also makes the
information spread faster than before. All this raises the very fundamental question
of whether the deposit guarantee scheme actually fulfils its purpose of providing
security to depositors, reducing the risk of bank runs and, on the other hand,
reducing the problems of moral hazard. These are difficult trade-offs and need to be
carefully analysed.
Ways forward?
So how should we proceed now? I note that when large price changes occur in the
stock market, for example, so-called "circuit breakers" are introduced, i.e. trading
is shut down for a short time to allow traders the opportunity to reassess the
situation. I am not convinced that this approach can be applied to banks, but perhaps
it would work if a larger proportion of deposits were fixed in time so that
depositors do not have the right to withdraw them until at maturity. A larger interest
rate difference between regular deposit accounts and accounts with a fixed
maturity might lead more depositors to choose the latter option. Former Bank of
England Governor Mervyn King recently launched a more drastic idea, that a bank
must hold more assets that can be used as collateral in the central bank than it
has liabilities (including deposits) that can suddenly flow outwards.10 In this way,
central banks could always intervene and have sufficient access to liquid funds.
Admati et al. note in a response that the consequence of this would be that the
authorities also supported bad banks, which would reinforce moral hazard
problems and lead to banks that should be wound up not being wound up.11 There is a
risk that we would then have so-called Zombie banks, and this would have
negative effects on growth and efficiency. In any case, I believe that the instability of
deposits is an issue that legislators and regulators around the world need to
analyse more closely.
The resolution framework also needs to be reviewed
The second question concerns the resolution framework. This was introduced
after the global financial crisis and the explicit purpose is to make it possible to
resolve a systemically important bank in an orderly manner. The idea is that losses
should be borne primarily by shareholders and secondarily by bondholders. Public
funds should not need to be used. Allowing bondholders to bear potential losses
also reduces the problems of moral hazard. So if you can use an effective
resolution framework as intended, you reduce the problems created by the deposit
guarantee.
The problems at Credit Suisse in March led to the takeover of the bank by UBS on
the initiative of the authorities, with the help of a public guarantee and without
using the resolution framework. In addition, the value of certain bonds - so-called
AT1 instruments - was written down without shareholders having to bear all the
losses first. This is the first time ever that a government has been forced to
intervene in a bank defined as globally systemically important to avoid its failure. The
measure taken by the Swiss authorities seems appropriate, but the fact that they
chose not to use the resolution framework raises the question of whether the
global standards for this framework need to be modified in some way. The
handling of the AT1 instruments issued by Credit Suisse also raises the question of
what role these instruments should play both in a bank failure and more generally
in the capital adequacy framework.
The resolution of banks in distress is a central part of the regulatory reform that
came into place after the global financial crisis. But could it be that the framework
is perceived as so complicated that it does not seem useful once the crisis occurs?
Here there is every reason to have a continued global discussion about the
present framework and how we can keep the benefits while making it more flexible
and practical. Perhaps the recent proposals of the European Commission could
contribute.12 One aim is to make it easier for authorities to use the resolution tool
for smaller banks as well. Among other things, the proposal means that the
authorities should be able to actively use the funds in the deposit guarantee funds
to facilitate the resolution. However, this proposal needs to be analysed in greater
detail.
The requirements on banks need to be strengthened
The third question concerns the requirements we should impose on banks. There
are several lessons here. Some may seem detailed, but they have a major impact
on the banks' operations and the risks they take. Let me focus on three of these
lessons.
One lesson from the Silicon Valley Bank run is that deposits are not always as
sticky as many people assumed. This is important for the liquidity rules banks
must follow. After the 2008 financial crisis, the Basel Committee developed new
global standards for this. As part of the Basel III agreement, countries were
required to introduce two liquidity measures, the LCR and the NSFR. The LCR
framework makes assumptions about how different types of liabilities flow out of a
bank and how stable different forms of funding are. Deposits are normally
assumed to be sticky. The question now arises whether the outflows assumed in the
LCR framework are reasonable, given the outflows we saw in this case. I think we
need to assume that deposits, especially unsecured deposits, are more unstable
than we previously thought. The Basel Committee may therefore need to review
the standards for the LCR and the NSFR.
Another lesson is that Silicon Valley Bank did not take sufficient account of its
interest rate risks. Here I would like to emphasise the importance of all banks -
including in Sweden - having a good margin for the risks that interest rate changes
can entail. 30 years of low interest rates have contributed to increasing the risks in
the financial system. Households and businesses in many countries have large
debts while prices of homes, commercial properties and financial assets are high.
The sharp and rapid rise in global interest rates experienced over the past year
has brought interest rate risks into sharper focus. Current global standards require
supervisors to take interest rate risk into account as part of the supervisory
process, known as Pillar 2. The consequence is that these risks are managed very
differently in different countries, and potentially even between different banks.
Finansinspektionen has a well-developed model for estimating these risks for the
Swedish banks, but, as I said, the rules vary from country to country. In my view,
there is reason to harmonise some of these rules.
A third lesson is that accounting rules play an important role. When
macroeconomic variables change significantly, the difference between the valuation of
assets at fair value and at amortised cost can be large. Silicon Valley Bank had
invested heavily in US long-term bonds. Since they intended to hold them to
maturity, they were able to book them at amortised cost. As interest rates rose and
the bonds fell in price, a problem arose. When the bank had to sell the bonds due
to the bank run, it realised a large loss, adding to the problem.
This raises an important question about how different assets should be booked.
Admittedly, the reason for the bank's problem is that interest rates rose so
quickly, but if the bank had been forced to book them at market value, the
problems would have been discovered earlier. All this may seem technical, but it has a
major impact on banks' capital adequacy, as the starting point for all capital
adequacy regulations is the accounting values. I don't have a clear view of what needs
to be done here, but when assets that have been booked at amortised cost have
to be sold quickly at a large loss, it can affect the viability of the bank and,
ultimately, financial stability, and therefore it is a problem.
Global rules are important for Sweden
I would also like to take this opportunity to emphasise the complexity and
interdependence of the global financial system. Banks are exposed to many risks that
can be difficult to both understand and monitor. Banks in most countries are also
dependent on other banks and other financial institutions. Many of these are
located in other countries and are therefore supervised in those countries. If
problems arise, they spread faster today and to more actors than they did 30 years
ago. We saw this clearly in March. The concern created by the banking problems
in the United States, which initially concerned a bank smaller than the major
Swedish banks, caused many international investors to become alarmed and wonder
which bank in the world could be next in line. Although many of the problems
with which Credit Suisse struggled were not new, uncertainty in the financial
markets led to an acute loss of confidence in the bank. This proved devastating for the
bank and forced the Swiss authorities to act. My conclusion is that it is important
for all countries to promote global regulation. Swedish financial stability also
depends to a large extent on sufficiently strict regulations in other countries. We are
all dependent on