Stefan Ingves: The development of a modern financial sector in Sweden
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank, at the Indira Gandhi Institute of
Development Research, Mumbai, 16 November 2006.
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I am honoured and grateful that you have invited me to speak here today. This is an institute of
development research so it is appropriate for me to talk about development in the financial sector. It
has become gradually more acknowledged by academics as well as by practitioners and policymakers
that a well developed financial sector is necessary to a country's overall economic growth and stability.
It also improves the services provided to the individual citizens. A well-functioning financial services
industry facilitates the transformation of savings into productive investments. It assumes, transforms
and distributes risks to those willing and prepared to hold them. It facilitates payments between people
and companies. The financial sector is an instrument to promote the smooth functioning and
sustainable development of the whole economy.
Conversely, experience has clearly shown that a badly-managed or inadequate financial system is
detrimental to the stability and development of society. It may provide inefficient and expensive
services and it may run hidden or explicit losses, which in the end may have to be covered by private
and public money. It may also distort competition.
The conclusion is obvious: Arguments for social and economic development speak in favour of
conducting reforms with the aim of creating a well-functioning financial system. Such a system should
offer a wide variety of financial services. Since providing the necessary financial functions is more
important than the exact set-up of institutions, we should be flexible as to the means to achieve the
desired services.
In practice, most countries' financial systems contain banks, other financial institutions, markets and
exchanges, and payment and settlement systems. I will later elaborate on why the financial system
must be well regulated and supervised, in accordance with modern and globally-acknowledged
practices, for instance those formulated by the Basel Committee for Banking Supervision. Moreover,
the development of a well-functioning financial system depends on a number of external factors, such
as macroeconomic stability, an adequate legal and judicial structure, robust rules for accounting and
auditing, and a financial safety net to deal with problems occurring in the financial institutions and
markets.
In my presentation today I will discuss all of these components and I will base it on my experiences of
transforming the Swedish system from highly regulated and inefficient to a modern one that today
competes successfully on the international scene. The Swedish experience might in some ways also
be relevant for other countries, although one must always take into account the specific domestic
circumstances. The basic conditions underlying a sound financial system are similar for all countries.
I will first give an overview of the regulated system we used to have in Sweden and some of its
objectives and consequences and I will then turn to deregulation and the challenges we faced. The
second half of my presentation deals with the modernization of the banking system, of other segments
of the financial system, and of the underlying regulation and supervision. I will also discuss some of
the most recent developments in financial services and in regulation.
A highly regulated financial system
The Swedish financial system was heavily regulated from the late 1930s to the beginning of the
1980s. The intention was to ensure a stable financial system which could provide cheap financial
services to the consumers and the export industry and, in particular, financing prioritized purposes
such as the fiscal budget deficit and apartment housing construction at low cost. More than half of the
amount available for bank lending was channelled into these prioritized fields. In addition, the pension
funds and the insurance companies were forced to allocate large parts of their funds to similar priority
purposes.
Competition between the banks was curtailed; for instance, the authorities set floors and ceilings for
bank fees and interest rates. Credit expansion was also regulated by the central bank, with the aim of
avoiding excessive credit growth in relation to the overall growth of the economy. There were also
strict liquidity and cash reserve requirements as an instrument of the central bank's monetary policy.
The establishment of new banks was decided by the authorities only if they found that there was a
"need" for the proposed bank. The same type of test was conducted before a Swedish bank could
receive a permit for opening branches within Sweden.
Capital movements and certain current account transactions in and out of Sweden were restricted.
Companies were only allowed to transfer funds abroad in order to finance their overseas investments
if they could prove sound economic reasons for doing so, such as if the investments might eventually
lead to increased exports from Sweden. Companies were allowed to borrow abroad, but only in foreign
currency and there were also requirements from the Riksbank on the minimum maturity of the loan.
Physical persons were only granted a small foreign currency allowance for travel, and had to apply to
the central bank for any additional sums such as for acquiring a house or apartment abroad. Foreign
companies were generally not allowed to issue securities in the Swedish markets.
Foreign banks were not allowed to operate in Sweden and Swedish banks had to obtain permits when
they wanted to establish subsidiaries abroad; branches were not allowed at all.
These restrictions on capital movements had several aims.
One was to ensure a stable Swedish currency, with a fixed exchange rate, insulated from any sudden
capital flows. Originally, and in particular during and immediately after the Second World War the
restrictions supported the rationing of the scarce foreign currency revenues available to the Swedish
economy. The restrictions also ensured orderly conditions on the securities markets: The Riksbank
arranged a queue for the issuance of new securities and monitored the timing and sequencing of
issuance in order to match it with the available liquidity and investor appetite. Another aim of the
restrictions was to make it more difficult to circumvent the domestic restrictions on the credit market
through overseas transactions. Finally, I must admit that there was a degree of protection of the
Swedish financial institutions from foreign competition.
The regulations on the domestic credit market as well as of capital movements resulted in a highly
rigid and underdeveloped Swedish financial sector. However, given the oligopoly situation the sector
was rather profitable. You might conclude that the priority purposes were subsidized at the expense of
the banks' savers.
Regulation, policy mistakes, and their consequences
Starting from the late 1970s it became gradually more obvious that the restrictions did not function as
planned. The financial sector became gradually more inefficient since it could not progress in line with
external developments and it could thus not provide the necessary new financial services to support
the overall economy which was undergoing modernisation. The restrictions were in various ways
circumvented by the institutions themselves and by other market participants. Instead of promoting
financial stability the restrictions led to increasing vulnerabilities, for instance when the share of
lending provided by less regulated entities increased. The restrictions on capital movements meant
that imbalances in the Swedish economy were not always identified as early as they should have
been. In addition, the large Swedish exporting companies learnt how to evade the restrictions on
capital movements which gave them a competitive advantage over smaller competitors also in the
domestic market.
The increasing deficits in the fiscal budget and in the current account made the restrictive system
nonoperative. The government finally decided to abolish them, although in a careful and gradual fashion
to minimise disturbances to the markets and the economy. During a period spanning the late 1970s
and the early 1980s the domestic regulations and the restrictions on capital movements were
gradually scrapped. The credit market restrictions were finally rescinded in 1985 and the capital
movements' restrictions in 1989. This was very late compared to most other European countries.
However, domestic policies were not adjusted to an environment of free capital flows and a free credit
market. The fiscal policy and the tax system induced borrowing and monetary policy could not act as a
brake since it was geared to the fixed exchange rate regime. Consequently, a few years after the
completion of the deregulation, a financial crisis broke out. In today's presentation, I will not go into
detail about the manifold reasons leading to the crisis but instead focus on the aspects relevant to the
financial sector.
First, the earlier strict regulations on lending meant that banks did not really acquire the skills to
evaluate the creditworthiness of customers and loan projects - only those with very high
creditworthiness had had access to the limited amounts available for bank lending to non-prioritised
purposes. The restrictions on lending to other purposes led to a large unsatisfied demand from
potential borrowers. After deregulation, bank lending increased extremely rapidly without banks' credit
managers really having much experience on how to evaluate borrowers' creditworthiness. A similar
weakness applied to the supervisory authority - they had supervisors with good skills to check the
banks' formal compliance with laws and regulations but not to evaluate credit decisions. At the outset,
the central bank took the erroneous view that the loan expansion in the banks could to a large degree
be explained by old loans moving out of the former "grey sector" and into the banks. Since this had
different implications than an extension of new loans, the central bank found that there was no need
for the authorities to worry.
Second, a large share of bank lending went into the real estate and commercial property business.
There was a building boom in Sweden during the 1980s and prices rose rapidly - paving the way for
additional lending. When real estate prices collapsed in the early 1990s the value of the collateral for
many bank loans fell sharply and banks suffered huge credit losses from non-payments.
Third, the industrial sector had also borrowed heavily during the export boom period of the 1980s, but
when the recession occurred in 1990, they had overextended themselves and in many cases were
unable to repay their debts. Many borrowers had their loans denominated in foreign currencies but
earned their main revenues in the domestic currency. Their debt payments increased drastically in the
end of 1992, when the Swedish currency was suddenly and sharply depreciated by some 25 percent.
This led to further loan repayment problems.
Losses for these and other reasons led to a severe and systemic banking crisis in Sweden. The costs
to bank owners and to the general public to re-stabilize the banking system were huge, and in addition
the overall macroeconomic development and welfare of the citizens suffered for several years. As an
example, unemployment soared rapidly from 21⁄2 to some 14 percent. But the crisis is not the main
theme for today's presentation so I will only make a few observations.
not
The crisis was clearly a result of deregulation. However, shortcomings in the deregulation process
did contribute to the crisis. As I mentioned, bank managers and also the supervisory authority were not
prepared for the transition from strictly regulated banks to a situation in which banks were allowed to
assume more risks. Thus they did not recognise, manage and monitor the risks properly, which led to
problems. Another shortcoming was that no authority had taken on the responsibility to oversee the
financial sector as a whole, to promote overall financial stability, which is different from the supervision
of individual institutions and markets. If we had had such an authority, the events and developments
outside the financial sector that eventually undermined its stability might have been detected earlier.
Corrections might have been implemented that could have prevented or at least reduced the impact of
the crisis. Monitoring overall financial stability has now become one of the primary tasks of the central
bank, the Riksbank.
Let me stress this again: The fact that deregulation in some countries, also in South East Asia, was
followed by banking problems does not imply that you should not deregulate. The conclusion is rather
that deregulation must be carefully planned, succeeded by other and more modern types of regulation
and monitoring, and supported by a sound macro economic policy. I will speak more about this in the
following.
The development of the banking sector in Sweden
For many years there has been consolidation in the banking sector in Sweden as well as in other
countries; this development was accelerated by the crisis. Banks merged and larger banks acquired
smaller banks. For instance, the large network of co-operative banks merged into a single bank which
savings
later merged with the bank that emanated from the network of the major banks - forming one
large bank. In this way, several hundred banks became one very large bank.
Is bank consolidation a good or a bad development? The answer is not clear-cut. Sometimes the large
resources in manpower and funds that are available in large banks are needed to develop and
manage the complex activities which are part of modern banking. Large institutions have a better
chance of diversifying their risks by entering into different activities and geographical areas; hence
they become more stable. But on the other hand - if there is a problem in a large bank rather than in a
small bank, this may threaten the overall financial stability and become a problem also for society at
large.
In my view, there is room for large as well as small institutions, which could be specialised in certain
activities and services. Anyway, the composition of the banking sector is generally not for the
authorities to decide by regulation as long as the institutions are safe and sound.
An issue in geographically vast countries with remote villages such as India but also Sweden is how to
ensure that people in remote and small villages also have access to basic financial services. We have
tried to solve this in different ways. Internet and telephone banking improve access for some people
and services. Payment orders may be sent through the ordinary mail. Another method might be to
allow "authorised retail shops" to act as intermediaries for taking deposits and receiving simple loan
applications on behalf of a bank.
In fact, after the consolidation phase we have witnessed a period in which the number of banks and
bank-like institutions in Sweden is increasing. The new ones have mostly been small banks
specialising in certain activities and services, for instance linked to major retail store chains and
benefiting from the cash flow from the stores' customers. We call them "niche banks".
Sweden never had a large share of state-owned banks in its financial system. In the crisis one bank
had to be nationalised during the resolution phase but that bank was rapidly merged with another
bank. Another of the banks which suffered during the crisis was state owned already at the outset but
the shares of this bank were gradually sold to private investors as soon as the bank had recovered its
financial health. The Swedish government remains a shareholder in the bank but holds only 19
percent of its total equity capital. Today, this bank which is named Nordea, is highly profitable and has
formed a large group which has significant market shares in the countries in the Nordic region.
As a government official deeply involved in the banking crisis, I took the decision that although some
banks had to be rescued by public funds, the management of the banks should be left to
professionals, without undue operational interference from the government. The banks should be run
in accordance with market conditions just like any other bank.
This brings me to the trend of the Swedish banks in recent years to open branches and subsidiaries in
other countries, foremost in the Nordic and Baltic region but also elsewhere such as in Germany and
the UK. At the same time foreign banks operate in Sweden - the restriction on foreign banks which I
mentioned earlier was abolished many years ago - and a Danish bank has acquired a significant
market share in Sweden of more than ten percent in some activities. This leads to the question: Which
are the benefits and challenges from cross-border banking?
From a stability view, diversification is a benefit. The bank group can diversify its risks between several
countries and thus protect itself against volatilities in macro economic and other developments among
its customers. Hopefully, if there is an economic downturn in one country or sector, this can be
compensated for by good economic conditions in another country or sector where the bank group
operates.
A cross-border bank may become more profitable because of "economies of scale". Many bank
investments in new products and systems, in particular IT systems, are initially very expensive, but the
cost of adding more customers to the same product or system is marginal. Of course, the bank can
obtain the same benefits by growing domestically, but the major Swedish banks have already reached
so large market shares that further domestic growth is limited.
A bank can also profit if it is more competent than its competitors in some areas, for instance in
offering certain services or if its organisation runs smoother and more efficiently or if it is regarded as
being more reliable or customer-friendly than other banks. For various reasons, Swedish banks have
rapidly gained market shares in other markets. It has proved more difficult for foreign banks to gain
inroads into the Swedish market, with the exception of the Danish bank I mentioned.
The main challenge from cross-border operations comes from the new risks to the bank. It will start
operating in a new legal environment and in a new customer market. If the bank has not prepared
itself carefully, it may run into unexpected problems because it approaches the new situation in an
erroneous way.
A challenge for the cross-border banks as well as the authorities is to monitor the activities on a
consolidated basis for the whole bank group in all countries where it operates. It is important for the
head office and the supervisor to identify early any indication of problems in the entities abroad and to
take the necessary measures. If this does not take place, the problems may grow and threaten the
survival of the bank. In a crisis situation, the bank together with the authorities must decide on the
appropriate course of action. This can lead to difficult questions such as whether a bank branch or
subsidiary abroad should be closed or rescued. The issue is all the more difficult since the host
authorities of the bank branch or subsidiary may have a different view. For them, the bank may have
an important role in the market, whereas the bank group is fairly insignificant in the home country.
Sweden and other EU member states grapple with these issues. Some steps have been taken, for
instance to sign Memoranda of Understanding so that central banks and supervisors in different
countries undertake to inform one another and cooperate in problem bank situations. But talking and
sharing information is not enough to solve the problems. This is, of course, not only an issue for
Europe and I believe that the issue of solving crises in cross-border financial groups should be
discussed more on the global level, such as in the Financial Stability Forum.
Before concluding this part, I wish to say a few words on deposit guarantee systems. This topic is
relevant both for domestic banks and for cross-border banks.
For a long time there was no unanimous view on the benefit of such systems. Those who argued
against them said that depositors might become lazy in their screening of banks and would put their
money only in the banks which offered the highest returns, even if these banks took excessive risks in
their activities. There would be a lack of discipline on the banks from the depositors. Also the bank
owners and managers might venture into excessive risk-taking knowing that the depositors would be
taken care of under a guarantee system. This would be bad for financial stability.
The general view has now shifted and speaks clearly in favour of countries implementing an explicit
deposit guarantee system, inscribed in legislation with all its terms and conditions. Such a system
should focus on the small depositor. A major reason for such systems, apart from the aspect of
protecting the small depositor, is that they greatly facilitate the resolution of problem bank situations
and they may even prevent problems from occurring. In a situation where depositors hear negative
rumours about their bank, guaranteed deposits might make them less inclined to "make a run on the
bank" - to withdraw their cash and thus exacerbate the bank's problems. A further major reason for
introducing explicit guarantee systems is that experience from many banking crises has shown that
the authorities feel obliged to reimburse depositors anyway, for political reasons. This is often done in
an unpredictable and sometimes unfair manner favouring certain segments of the population. The cost
of such implicit deposit protection is often higher than that of explicit guarantees.
A guarantee system makes it easier for the authorities to close problem banks. Where such a system
is lacking, the authorities tend to delay the unpleasant decision of closing a bank since they are afraid
of the negative repercussions on depositors and other counterparties. But such supervisory
forbearance only leads to growing problems and costs. It will always be difficult to close banks, but
with a deposit guarantee at least the issue of the depositors is partly solved.
What I just described fits in with the development in Sweden. When the bank crisis came, we had no
deposit guarantee system but the government found it necessary instead to issue a general
guarantee, sometimes referred to as a blanket guarantee protecting all depositors but also other
counterparts to Swedish banks, with the exception of the shareholders. This guarantee was in fact
much broader, and potentially more expensive, than a limited deposit guarantee. After the crisis,
Sweden has introduced legislation on a system of explicit limited deposit protection. All current
deposits up to a certain amount, approximately 35 000 US dollars, are covered. For this, the banks
pay a yearly premium, currently 0.10 percent on average of the total amount of deposits.
Other parts of the financial sector
In my presentation I have focussed on the banks, but an efficient financial sector must also contain a
broad range of institutions and markets. They can specialize in certain activities and instruments and
improve competition and diversity. They may also reduce the risk concentration on the banking system
which implies that the overall economy will be less gravely hit if there ever is a systemic banking crisis.
Compare for example Thailand in 1997, where the banks played a dominant role and Russia in the
same year where banks played a minor role. Both countries were hit by financial problems but the
overall effects on the economy were much worse in Thailand.
In Sweden many different types of institutions and markets perform specialized roles alongside with
the banks. There are also rapid developments in these in the form of volume growth but also in new or
improved activities and instruments.
The insurance sector which was as restricted in its activities as the banks during the regulation years
has grown strongly in Sweden after deregulation, both for non-life and life insurance products. The
demography of Sweden is such that we have an ageing population. Thus savings for retirement, for
instance in the form of pension schemes, have become increasingly important. Some of the insurance
companies are owned by banks, forming financial conglomerates, but others are independent.
Mortgage banks have always played a strong role in Sweden. Most of them are owned by the major
banks, but a few remain independent. The banks themselves are also allowed to extend mortgage
credits so there is open competition. The market for mortgage loans is highly competitive because the
product is simple and comparable so it is difficult to argue for a higher interest rate.
Credit market companies, leasing companies, factoring companies, and card companies provide
specialised financial services. Some of them are linked to the bank groups while others are
independent. Many of them are quite small.
Equity and bond markets and exchanges for specialised products such as derivatives have grown
tremendously both in volume terms and in terms of offering a wide variety of instruments ever since
the first Treasury bills were issued in Sweden in the early 1980s. Equity and bond financing have
gained in importance relative to lending from banks. This diversification of funding is positive for
financial stability, since the dominating role of the banks in providing loans is reduced. From the
issuers and also the investors' viewpoint the existence of active markets ensures good competition,
leading to efficiency and favourable loan terms.
To sum up, the Swedish financial sector contains many different types of institutions and markets and
competition is strong. This is fine, because our crisis taught us the problems of being overly reliant on
the banking system.
The tendency is that the other institutions take markets shares from the banks, for instance in
providing channels for saving. But since many of those institutions form part of bank groups, the bank
groups' overall share of the financial system is not reduced to the same extent.
Recent developments in the composition and structure of financial services
In addition to the developments in the institutions and markets, we are also witnessing new trends in
financial services. Mutual funds, money market funds, equity funds etcetera are growing rapidly.
Depositors seek higher yields than those offered by bank deposits and they invest in various securities
and asset funds. Banks and other asset managers, including hedge funds, make large profits from this
business. The effects on financial stability are unclear. On the one hand, the growth of the funds
means more liquidity to the equity and securities markets so they can provide more financing of
investments hence reducing the reliance on bank lending. The risks to the banks, particularly credit
risk, will diminish. But on the other hand, the risks will instead be assumed by the institutions and the
general public which invests in these funds. In the event that the value of the funds decreases the
investors will suffer. This may in turn affect their behaviour in the economy, for instance it may reduce
their consumption and also the value of property. We have not yet seen any such situation so the
outcome is unclear, but we should not neglect the risks.
Another form of transferral of risks is taking place in the financial sector. Through the use of new
instruments and structures it has become easier to transfer and redistribute risks. For instance, a bank
may deem that it has too much exposure to one customer or to a sector. It could then divest itself of
this risk through credit risk derivatives or by securitisation. The advantage from a financial stability
view is that the risks become more widely dispersed between the various holders and that the
individual bank can build a well-balanced portfolio. But at the same time a new risk has emanated -
the risk that the new holder of the risk cannot fulfil his obligations. In the event that there is a credit
default, the seller of the derivative to the bank may not have the necessary financial means. Or, there
could be an unclear legal position about the risk transfer agreement. Such events might mean that the
bank would have to suffer a loss although it thought it had protected itself. The conclusion is that the
authorities must force the banks to assess whether the risk buyers have adequate financial and
organisational capabilities and whether the legal arrangements are robust.
As in many other countries, there is a strong tendency in the Swedish financial sector to move from
"bricks and mortar", such as having many branch offices, to providing their services through the
Internet and telephone. About half of all payments of companies and physical persons in Sweden are
made through the Internet and by phone. This has made it possible to increase bank efficiency in
terms of staff numbers and branches. Each Swedish bank branch now services an average of 4,700
persons in the population compared to, for instance, only 1,900 being serviced by the German banks'
branches in Germany. Of course, each country is free to choose its own service level and may prefer a
higher level, although it brings higher costs.
Modern regulation
In my view, Sweden abolished its old-fashioned regulations for good reasons. Using the banks for
directed lending and for other non-commercial purposes may seem handy for the government, but
entails large risks and costs. If you want to subsidize some activities, regions or parts of the population
you should at least do it in a transparent manner, so the costs become explicit in the fiscal budget,
implying an open debate and decision by the Parliament or government. Our regulation was also
erroneous in trying to micro-manage the banks in their own business decisions on lending rates, fees,
liquidity management and so on. Experiences from many countries have clearly shown that the banks
themselves, guided by market forces make better decisions than outside parties. Finally, the
restrictions on the capital flows were wrong because they hid the signals from Swedish and overseas
investors and other actors and also because they led to an unsound protection of the Swedish
financial system and markets. With hindsight it is easy to see these shortcomings but when they were
in force, the regulations represented the flavour of the day.
As I have shown, there are forms of regulation which are harmful and should be terminated. Should
there be any regulation at all? Yes, I think so. Let me explain why by using the example of banks,
which in most countries dominate the financial sector.
Banks offer several unique and valuable services to society. As I noted in the beginning of my
presentation, they receive deposits and transform them into lending. They assume, distribute and
transform various risks. They facilitate payment transactions by the use of accounts in other banks and
payment systems. However, performing these activities makes banks vulnerable, in particular
receiving short-term deposits and transferring them into long-term loans. At worst, banks may fail and
destabilize the whole financial sector and even the whole economy. To avoid such calamities from
happening, society is willing, under certain specified circumstances, to rescue banks from failure by
providing exceptional lending from the central bank or solidity enhancements from the government.
Depositors may be protected by a deposit insurance scheme. But the willingness of the authorities to
assist the banks and their customers must be matched by regulation and monitoring to ensure that the
bank owners and others do not use, or I might say "abuse", the possibility of public support to further
their own purposes.
Hence, there must be some regulation and supervision to make sure that banks behave in ways which
are consistent with the overarching goals of society, such as financial stability and consumer
protection. Regulation must also provide the necessary incentives for banks to act prudently and in fair
competition with other banks and other financial institutions. An adequate level of domestic regulation
is also necessary if you want your banks to do business internationally or if you allow foreign banks to
do business in India. You should welcome foreign institutions