Stefan Ingves: Can the authorities manage crises in the financial
system?
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank, at the Swedish Economics
Association, Stockholm, 13 March 2008.
* * *
I'm sure that no one here has failed to notice the fact that there has periodically been turmoil
in the financial markets since last summer. It is scarcely remarkable or unusual that the
financial markets experience upswings and downswings. And there are almost always some
countries in the world experiencing problems in their financial sector. We have become used
to this being a fact of life.
But this time there appears to be much greater nervousness than we have seen in a long
time. Central banks have also followed developments with great interest. For instance, the
ECB, the Federal Reserve and the Bank of England have taken a number of well-publicised
measures. So why all the commotion this time?
Well, this is one of the subjects of my speech today. Financial stability is the Riksbank's other
task in addition to monetary policy. Apart from being a red-hot topic of discussion, it is also
an area to which I have devoted many years of work. Today I want to talk about the
regulations for managing financial institutions in distress and the challenges we face. But let
me first reason a little about financial crises on the basis of the current turbulence and the
crisis Sweden experienced at the beginning of the 1990s.
The problems began in the subprime market
As you all know, the recent credit concern began with problems on the US mortgage market.
This applies in particular to the area offering so-called subprime loans. These are loans to
mortgage customers with lower credit ratings - often households without a documented
credit history and with a lower income than the average household. These loans doubled
between 1996 and 2006, although they still comprise a relatively small part of the US credit
market. The problems began to affect many borrowers back in 2005 in connection with the
rise in interest rates.
When loans were renewed at new, higher interest rates the loan costs for these borrowers
rose substantially. And when property prices fell in many areas, there was no scope to
mortgage the house so householders could borrow their way out of their problems. This was
otherwise a common - albeit dubious - strategy during the years of rising property prices.
Many borrowers could no longer make the interest and mortgage payments on their loans.
This led in turn to substantial credit losses for many mortgage institutions. But the loan
losses did not merely affect the banks and mortgage institutions that had originally issued the
loans. As you all know, the problems came to have a much wider spread.
And the problems spread as the risks were sold on
The reason why the problems spread is the extensive securitisation of mortgages. This
special form of financial engineering has made it possible for lenders to sell credit risk
together with the right to the payment flows from the loans to prospective investors around
the world. What this means, basically, is that a number of loans are combined and put into a
an investment vehicle created especially for this purpose, which is in turn financed by issuing
securities, what are known as mortgage-backed securities. In principle, this is a way of
making illiquid assets liquid.
This has become increasingly common among banks and other credit institutions around the
world. One can say that they have thus increasingly moved away from the traditional role as
monitor of credit risk. Instead they have to a greater degree originated loans, where the
inherent credit risks have immediately been distributed to investors in the financial markets
willing to take risks. Their business strategy has changed from focusing on long-term
customer relations to repackaging and selling. Having said this, securitisation is not
necessarily a bad thing in itself.
What has been new and something of a problem this time has been the way in which the
securitised loans have been repackaged and sold through several stages. They have created
so-called structured credit risk products, which have often included a large portion of
subprime loans. The variety of these has been impressive. Often one product has been
included as a component in another product, which in turn has been repackaged and
included as a component in a new product. One can equate this to Russian dolls: a large one
that contains a smaller one, which in turn contains an even smaller one, and so on. This has
been a means of creating assets that suit investors with differing risk appetites, particularly
assets with a high return and high risk level.
A complicated structure emerged
But there has been substantial variation among the special vehicles used by banks and other
credit institutions for their securitisation. I do not intend to describe in detail all of these
conduits and SIVs and suchlike. But what they have in common is that they invest in
highyield assets and long durations, often structured credit-risk products with a subprime content.
They have been financed, at least partially, by issuing certificates in the fixed income market
for short durations, what are known as asset-backed commercial papers. The special
vehicles have thus to a greater or lesser degree been dependent on the liquidity in the
market for these securities for their financing.
Even if these special vehicles are in principle independent from the banks, it is common that
the banks supply some form of liquidity guarantee. In other words, if a special vehicle for
some reason is unable to issue new certificates when the old ones fall due, the bank
guarantees the ability to pay, wholly or partly. Such guarantees need not only consist of
formal obligations. They may also be of a purely informal nature. This is because the bank
may be disinclined to abandon its special vehicle if only to protect its name and reputation.
Whatever the case, it means that the financing problems that affect the special vehicles can
easily lead back into the bank. What one has regarded as true sale may in reality not always
have been so.
Credit ratings attracted investors but were used wrongly
As you realise, the result has been an extremely complicated structure. Many asset classes
have arisen, each with their own unique conditions and idiosyncrasies in pricing. This has in
turn made it difficult to assess the different products.
Then they can instead obtain help from the credit rating agencies. With the aid of the credit
rating the agencies have issued, investors have been persuaded to invest in the products.
Credit ratings are excellent aids that measure the probability of a failure or an expected loss.
But they do not take into account how the risks covary and are otherwise distributed.
Unfortunately, many investors appear to have disregarded these limitations. In addition, all of
the repackaging, special middlemen and more or less visible guarantees have made it
difficult to gain insight into where the risks are. In particular the geographical spread appears
to have been greater than in earlier episodes of financial turbulence.
Uncertainty increased and liquidity disappeared
When the problems in the subprime market began to show here and there, this caused great
uncertainty. It was quite simply impossible to know who was actually left with the direct or
indirect exposures to the subprime loans. This led to liquidity waning in parts of the interbank
market. It therefore became more difficult and more expensive for the banks to refinance
themselves. When many banks experienced problems, a number of central banks chose to
take measures to increase liquidity in the interbank market.
The unease in the credit markets has continued during the winter and spring. Many large and
established banks have been gradually forced to write down the value of their
subprimerelated assets. This has led to some major financial groups requiring new capital. At the
same time, there has been increased uncertainty over international economic activity. This
has in turn contributed to major fluctuations on the world's stock markets.
Over the past week the unease has increased again. This has contributed to rising interest
rates on the interbank market in, for instance, the United States and the United Kingdom.
With the free capital movement this of course also affects Swedish interbank rates. But
higher interest rates in the interbank market do not by definition mean that the banks will
experience liquidity problems. The Swedish banks have had good liquidity throughout the
entire period of turmoil. They have not been exposed to subprime-related securities to any
great extent. Their solidity was and remains good and their loan losses are at present very
small. Nevertheless, the Swedish banks have not been able to entirely escape the effects of
these events.
There are similarities between today's financial turmoil and the Swedish bank crisis
The current financial turmoil and the Swedish bank crisis actually have a number of common
denominators. Harvard professor Kenneth Rogoff together with Carmen Reinhart of
Maryland University has pointed to a number of similarities between the US mortgage turmoil
and a number of earlier financial crises, including the Swedish bank crisis at the beginning of
the 1990s. Some common denominators for the period prior to the outbreak of the crisis
include a rapid increase in property and share prices, the fact that the current account deficit
was large and growing and that economic growth had declined from an earlier high level.
One important difference is that the exchange rate regime has not played a prominent role in
the US case.
Too low risk premiums and abstruse risks
But it is also possible to find more specific parallels to the Swedish bank crisis. In both cases
lending has increased rapidly at the same time as the banks have underestimated and
therefore not taken sufficient payment for the credit risks. In Sweden this was linked to the
banks - after decades of credit regulation - lacking a developed strategy for managing and
pricing credit risk. When deregulation came in the mid-1980s they were quite simply unused
to loan losses. But such tendencies could also be seen prior to the recent market turmoil. For
a long time, risk premiums for credit risk-related securities were remarkably low. The
uncertainty has led to an increase.
But, there are also other parallels. This includes in particular the arrangements that made the
banks' real risk-taking more abstruse. The banks' formal and informal promises of loans to
special investment vehicles meant that the problems quickly bounced back into the banks'
balance sheets.
In the Swedish bank crisis one can say that the finance companies in some respects played
a corresponding role to the special vehicle. It was the finance companies that primarily
financed the expansion in the construction and property markets. The finance companies
largely financed themselves in the short term by issuing so-called commercial papers in the
fixed income market. When the property market folded, it was a finance company, Nyckeln,
which in September 1990 was the first to throw in the towel when it could not renew its
financing. Other finance companies then followed suit.
Many of the finance companies were owned by the banks. And the banks were tied by both
formal and informal commitments. The losses therefore soon returned to the bank system. In
1991 it became apparent that the banks had substantial problem loans through their
exposures to the property branch both directly and indirectly through the finance companies
they supported. The bank crisis had become a reality. Perhaps you begin to see a pattern
now?
The structures were a side-effect of the desire to avoid regulation
It is also interesting that the abstruse structures, which led to the current financial turmoil and
the bank crisis in the 1990s, were in both cases partly due to so-called regulatory arbitrage.
The most recent wave of securitisation of the banks' credit portfolios was partly propelled by
deficiencies in the capital adequacy rules. Through securitisation the banks could easily
avoid a lot of expensive capital adequacy. Since 2004 a new capital adequacy regime, Basel
II, has applied. This is more finely meshed and does not allow the same possibilities to avoid
capital adequacy through securitisation. However, it has not yet been implemented in all
countries, such as the United States, for instance.
The Swedish finance companies were in their day the result of regulatory arbitrage. Prior to
the abolition of credit regulation in Sweden, the finance companies were often used as a
means for the banks to get round the credit restrictions. This "grey" credit market was once
substantial and an important source of additional income for the banks. Around 25 years ago
I myself wrote quite a lot about this.
Credit insurances existed then as now
One can also observe another similarity, namely the occurrence of so-called credit
insurances. A company that sold credit insurances to the Swedish banks in the 1980s and
1990s was Svenska Kredit. Many banks bought insurances against losses from their loans to
property companies from this company. When the property market crashed, Svenska Kredit
was unable to meet all of its obligations and consequently went bankrupt. This in turn fuelled
the problems for the banks.
There are parallels between the Swedish credit insurance companies of that time and the
current so-called monolines. These are large insurance companies which are specialised in
insuring various types of bond loan. Those who have bought the companies' insurances
have traditionally been municipalities, federal states and other bond issuers with poorer
credit ratings. The insurance has meant that the bond loans have received better credit
ratings and it has been possible to sell them at better rates. In July 2007 the outstanding
volume of bonds insured by monolines amounted to a value of USD 3,300 billion.
In recent years these monolines have increasingly been used to insure securities issues with
a subprime content. This has meant that they have also begun to experience problems. This
risks in turn having repercussions for the securities they have insured and ultimately for
those who have invested in them.
Of course, there are also some essential differences between the most recent financial
turbulence and the Swedish bank crisis. This applies to both the nature and the scope of the
crisis. But, as you will note, there are many and striking similarities in the way people have
acted. Or as Voltaire is supposed to have said "While history may never repeat itself - man
always does!"
Financial crises arise as a result of imbalances in the balance sheet
So why do financial crises arise? The root of most financial crises can quite simply be found
in the imbalance between assets and financing. The simplest way to illustrate this is to look
at a stylised bank's balance sheet. On the asset side there is lending to companies and
households. These are assets that cannot be realised quickly without a substantial discount.
In other words, they are illiquid. The bank's financing on the other hand largely consists of
deposits from the general public and short-term borrowing on the interbank and securities
markets. Their financing is thus very liquid.
In normal circumstances this is not a problem, as we do not expect all depositors and other
lenders to withdraw their money or their financing at the same time. But at the same time this
liquidity transformation makes the bank sensitive to its financiers' confidence in its ability to
meet its obligations. Suspicions that the bank has financial problems could very quickly lead
to a bank run.
There have been many bank runs in the past. Stockholms Banco, which was founded by
Johan Palmstruch in 1656, was hit by a bank run in the 1660s when the depositors lost
confidence in the notes issued by the bank. The bank was taken over by the estates of the
realm, and is the precursor to the Riksbank which was founded in 1668. There were
countless bank runs in the United States at the end of the 1920s and the beginning of the
1930s. Argentina and Indonesia were hit at the end of the 1990s and the beginning of the
2000s. And as recently as September 2007 the British building society Northern Rock
suffered a bank run. I shall return to this shortly.
It is clear that even the most recent financial turmoil is a question of an imbalance between
assets and liabilities, although the assets and liabilities have come to look rather different
than in the fictitious example. Essentially this is a question of the same thing, namely lending
at long durations that is funded in short durations. The awareness of this inherent instability
and the difficulty in seeing where the risks lie meant that there was sometimes too little
liquidity in parts of the money market. What is new is that banks around the world have
become much more dependent on the securities markets for managing risks and financing
themselves. In 2007 we had concrete evidence of how sensitive the banks have become to
liquidity shocks in these markets. Problems in the securities markets have almost never
before returned to the bank systems with such force.
The importance of financial stability
When Northern Rock suffered problems, the British authorities took a number of exceptional
measures. For instance, the Bank of England granted the building society emergency
liquidity assistance. And HM Treasury abandoned the limits of its existing deposit guarantee,
extending them to cover all deposits in Northern Rock without limitation.
The question that many people are probably asking is why so much effort was made for one
individual financial institution. Public measures of this type could hardly be appropriate if it
had been a question of an ordinary engineering company or retail chain that was in financial
straits. It is due to two factors. Firstly, it concerns the special role played by the banks and
the bank system as a whole in the economy. Secondly, it concerns the special contagion
risks in the financial system. In a central bank context, these are usually called systemic
risks.
Banks and other intermediaries in the credit market who receive deposits from the general
public play a central role in the financial system. They contribute, for instance, to facilitating
the mediation of capital by acting as intermediaries between depositors and borrowers.
They also create the conditions for more efficient mediation of payments in the economy.
The banks' deposit accounts are of central importance for the use of payment cards, credit
cards and credit transfers. Many banks also participate in the system for the settlement of
large-value payments supplied by the central bank. The banks and their account systems are
therefore a vital part of the payment system. So if anyone asks why the banks are special, I
could reply in the same way as John Dillinger, designated by the FBI in the 1930s as public
enemy number one, when asked why he robbed banks: "Because that's where the money
is."
At the same time, problems that arise in one bank can easily spread to other banks. This
spread can occur in different ways. Firstly, there can be a direct spread, through the
exposures the banks have to one another in the payment systems and in connection with
foreign exchange and securities trading. Severe chain effects can arise if the customers of a
bank suffering problems have their means of payment tied up in the bank. This makes it
difficult to make payments to other households and companies. It can lead to liquidity
problems that can in turn give rise to loan losses and payment problems for these customers'
banks.
Secondly, the banks are often exposed to the same sorts of risk. This increases the
probability that, for instance, a macroeconomic shock may affect more than one bank. The
spread of problems between banks can thus also arise as an indirect effect, through
expectations that other banks may suffer similar problems to the one first affects, or via more
well-founded suspicions of the banks' exposures to one another.
The contagion risks mean that problems in one bank can easily lead to problems for the
entire bank system. The costs to society of a crisis affecting the entire bank system can be
substantial. It is, of course, difficult to calculate these costs. Some surveys have indicated
that an average production loss resulting from a bank crisis could be around 15-20 per cent
of GDP. According to some calculations, the collapse of the Swedish bank market cost
around 5 per cent of GDP in terms of a loss in output.
Seen from society's point of view, the individual agents' incentives are not sufficient to take
protective measures against crises that affect the financial system as a whole. The
shareholders can never lose more capital than they have put in and individual depositors find
it difficult to monitor a bank with widespread operations. There are, to use economic
terminology, considerable negative externalities. In addition to the consumer protection
aspects, this is a decisive motive for having a financial safety net in the form of special
regulation, supervision and a deposit guarantee. It is also the reason why central banks have
the possibility to provide liquidity support in the form of emergency liquidity assistance. Such
emergency liquidity assistance shall in principle only be granted if the institution in question
has temporary liquidity problems, but is essentially robust and if there are systemic contagion
risks.
It was exactly this risk of domino effects in the rest of the financial system that meant that
Northern Rock, which can hardly be said to be of critical significance to the bank system,
became the object of a number of measures taken by the British authorities. It was probably
similar considerations that motivated the measures taken in Germany to save IKB and
Sachsen Landesbank.
Now one has seen that it was not so easy for the British authorities to manage the problems
in Northern Rock. The existing regulations and arrangements did not prove particularly
effective. Despite the measures taken, they did not manage to avoid a bank run. This has led
to the authorities in Great Britain drawing up, in an impressively short time, proposals for a
number of improvements in the regulatory framework for managing institutions in distress. In
February the British finance minister announced that they had decided to nationalise
Northern Rock, as there was otherwise a risk that the cost to the taxpayers would be too
high.
The regulations for managing institutions in distress are inadequate
As partially responsible for the stability of the financial system, I ask myself, how are things in
Sweden? Do we have the regulatory framework required to manage possible future
problems? Unfortunately, the answer to that question must probably be no, at least at
present.
During the Swedish bank crisis at the beginning of the 1990s a number of extraordinary
measures were taken. These included issuing the bank deposit guarantee. This was a
general declaration that the banks' creditors would be protected. In addition, a special crisis
management authority was established, the Swedish Bank Support Authority. In connection
with this, a number of provisions of a compulsory nature were introduced to prevent the
possibility of the state being placed in a blackmail situation. For instance, an act was
introduced that meant in principle that the Swedish Bank Support Authority could make
decisions in the bank through a state compulsory purchase of the shares if the bank's capital
adequacy fell below two per cent.
But these temporary provisions, like the general bank guarantee, ceased to apply in 1996.
The Bank Support Authority was transformed into the Deposit Guarantee Board, which was
given the task of managing the deposit guarantee and investor protection.
Since then it is in principle only the general regulations for competition and liquidation and
the system for the deposit guarantee that are available for managing institutions with
problems. Unfortunately it is not particularly appropriate - if even possible - to apply the
general competition regulations to banks. The regulations on competition and liquidity are
primarily to protect the interests of the creditors. They are not particularly well-adapted to
take into account society's interest in maintaining the stability of the financial system. The
primary task of a receiver in a bankruptcy is to safeguard the interests of the creditors. He or
she has neither the authority nor can be expected to have the skills required to take the
measures needed to safeguard the stability of the financial system.
Problems which threaten stability require immediate action. Bankruptcies usually take years
to resolve. Some elements of the general bankruptcy procedure, such as freezing balance
sheets, may in some cases be directly harmful if applied to a systemically-important
institution. For example, the banks' central role in the payment system means that one
cannot merely stop payments in one or more of the major banks, as this could have
devastating consequences for the financial system. During the bank crisis no banks were
declared bankrupt.
The lack of specially-adapted regulations for winding up problem institutions with the capacity
to take into account society's need for financial stability was emphasised by the Banking Law
Committee. This was a commission of enquiry appointed in 1995 in the wake of the bank
crisis to look into the needs for modernised legislation for banks. The Committee also
presented a proposal for a new system to manage banks in distress, called public
administration. This proposal has now been under investigation, as it is called, by the
Government Offices since the year 2000.
Custodia was a reminder of the shortcomings
Since then we have received new indications of the shortcomings in the regulations. The
course of events at credit institution Custodia in 2006 indicated worrying difficulties in
managing even a relatively small and insignificant problem institution. We are therefore in no
way better equipped than the United Kingdom to manage problem institutions and this
applies with regard to both small and large institutions.
Fortunately, Custodia was a small company and the problems occurred in a situation where
there was relative calm on the financial markets. The stability of the financial system was
thus definitely never threatened. But it is regrettable that we still have not managed to create
an adequate regulatory framework in this field, more than fifteen years after our own bank
crisis.
In countries where they have slightly more experience of bank failures, such as the United
States and Canada, they have learn that special institutions and arrangements are required
to manage institutions that are experiencing financial problems.
One of the most important lessons is that the authorities must be able to intervene as quickly
as possible when a bank faces problems. There are several reasons for this. The first is to
put pressure on the management and owners of the bank to rectify the situation and
hopefully to prevent the situation deteriorating further. The so-called Savings and Loans
crisis in the United States in the 1980s become more costly when the authorities failed to
take action in time. This meant that in the United States at the beginning of the 1990s they
introduced a system with so-called prompt corrective action. This means that the authorities
quite simply are obliged by law to intervene at certain specified thresholds. In my opinion it is
desirable that Finansinspektionen (the Swedish Financial Supervisory Authority) should also
have a large toolbox of measures that can be taken at an early stage. It should be possible to
intensify these measures gradually as problems worsen. Of course, it is not desirable that the
only possibility is to withdraw the license of an institution whose capital adequacy falls below
the eight per cent level. In Sweden, there is every reason to look more closely into the
obligations and powers of authority of Finansinspektionen.
Another motive for the authorities to act quickly is to be able to quickly pay the deposit
guarantee. To be able to make the necessary preparations for this, the authorities therefore
need to have access to and control over relevant data files at an early stage when an
institution gets into difficulties. This has been a problem in earlier cases of compensation
from the Swedish deposit guarantee.
If the financial system is threatened, the authorities must also be able to temporarily take
control over the bank to maintain vital functions. The banks' central role in the payment
system means that payment defaults by one bank can have substantial domino effects. The
consequences for the rest of the financial system may then be difficult to survey.
With regard to institutions lacking a long-term survival capacity, it is of course important that
they are wound up as quickly and smoothly as possible. There must be several different
alternative methods for winding up banks to make it possible to choose the model that is best
suited and entails the least cost to society. Of course, it would be best if one could get
another bank to take over this institution's activities. But the possibility to carve up the
business and sell it in parts could in some cases prove more profitable. In certain cases a
reconstruction of the bank may be the most appropriate solution.
If it were to take too long to find a buyer, it might be necessary for the state to take over the
bank temporarily. This was what was ultimately necessary in the case of Northern Rock.
There is a risk in similar situations that the state could be exposed to blackmail. To minimise
the costs to taxpayers, it is therefore necessary in my opinion that the state has sufficient
strength to negotiate with existing and presumptive shareholders. For instance, there must
be legal possibilities for the state to redeem the shares at a price corresponding to the value
of the bank if there are no state aid measures. It is also particularly important to avoid
situations where a bank ends up in a no man's land regarding ownership.
An essential condition for a well-functioning system is that one can attain a balance between
all of the interested parties who come forward when a bank is in distress. The various
interests include society's interest in financial stability and the depositors' interest in good
consumer protection. But there are also the creditors' interest in good protection and fair
treatment, the taxpayers' and the fee-paying institutions' interest in the cost of the deposit
guarantee system being as low as possible. In addition to this are the owners' interest in their
legal rights and not least society's interest in the administration of justice functioning in the
field of economic crime.
All of these interests, and probably more, are entirely legitimate and must of course be taken
care of in the legislation. But they must be classified according to their relative significance to
society. Otherwise it will not be possible to distribute the roles between the different
authorities in the best way when managing problem institutions. There is also a risk of
wasting valuable time on managing conflicts between different interested parties instead of
managing the institution's problems. In other words, it is necessary to have a bird's eye view
when drawing up regulations.
The regulations must be formulated to give the state the right tools
I know that the Ministry of Finance is currently working hard on a proposal for public
administration of banks in distress. The design of the deposit guarantee and
Finansinspektionen's powers of authority are also being reviewed. We eagerly await these
proposals. Even if the work is carried out on parallel tracks, it is important that the final result
is coherent. Otherwise it could be difficult to manage a future crisis in the financial system.
It is also important that the proposals are not toothless. Running a bank is not a right, rather
it entails considerable responsibility towards both society as a whole and the customers who
have entrusted their savings to the bank. Bank owners are already protected through the
financial safety net and isolated against risks in a completely different way to those who own
ordinary companies. It would therefore be unfortunate if the result was merely a proposal that
entailed the state taking over the management of a problem insti