Mr Bäckström looks at the Riksbank and financial system stability and comments on
the LTCM case
Speech by Mr Urban Bäckström, Governor of Sveriges Riksbank, to the Swedish Economics
Association in Stockholm on 25/2/99.
Financial stability is a topical subject in the light of events in the past yeara year that saw
continued financial problems in Asia, the devaluation of the rouble and suspended payments
in Russia, considerable turbulence in western financial markets and financial unrest in Brazil.
What happened last autumn, when it was considered that problems for a single playerthe
hedge fund Long Term Capital Managementmight create grave difficulties for the financial
system in the United States, highlighted risks of a new type. The LTCM case can be seen both
as an extreme example of what could happen in Sweden's financial markets and as a serious
reminder that the continuous development of financial markets is liable to give rise to new
risks. The suspension of payments in Russia and its consequences should likewise lead us to
reflect on the risks in the system.
Today I shall be discussing the problems behind last autumn's events in the U.S. market and
the fact that a systemic crisis was judged to be imminent. First, however, I shall briefly sketch
the background and explain stability's central importance for the Riksbank.
Background
There is nothing new about financial crises. Over the centuries they have repeatedly hit
financial systems in the industrialised world, as well as in less developed countries.
A classic example is the tulipmania in the Netherlands, which ended in 1636 with the collapse
of the market for tulip options. From the tulip crisis it is also clear that derivative instruments
are not a recent innovation in financial markets. The world also saw numerous financial crises
in the nineteenth century. As for the present century, what first comes to mind is the crisis in
the wake of the stock-market crash in New York in 1929, with effects that left their mark on
the global economy in the 1930s. There are various explanations for the Great Depression but
it clearly involved widespread financial turbulence and the failure of many banks. In Sweden,
too, there were serious bank crises in the early 1920s and '30s; on both occasions they were
accompanied by a deep economic depression and serious deflation. The drop in output and the
price level reached two-digit figures before the problems could be overcome.
In recent years the pace of financial market development has been rapid. As a result of
innovations in communications and information technology, with the new instruments and
methods they provide for risk management, the financial system is now more extensive and
globalised than ever before. The system channels savings more effectively to those activities
in the global economy that need them most.
The rapid pace of financial developments and their internationalisation are a logical
consequence of arrangements for the production and international exchange of goods and
services in the world economy. To cope with these arrangements, firms and households have
required new financing facilities. The developments also stem from a deliberate post-war
trend in economic policytrade barriers have been removed and tariffs abolished. There are
no grounds for supposing that the benefits from labour specialisation have been exhausted.
The ongoing globalisation of the production of goods and services, with increased
international trade, calls for continued development and internationalisation of the financial
system.
However, just because the financial system channels savings and spreads risks more
efficiently today, it naturally does not follow that it functions sufficiently well in every
respect. The recurrent financial crises are at least an indication of this. To some extent the
problems may have stemmed from uncertainty about the future price trend in financial
markets. But political errors or faulty risk assessments among market players may also have
played a part.
While the crises in recent years have arisen in different ways, they all demonstrate the
important part that a properly functioning financial system plays for a good real economic
development. There have been some instances where a global increase in financial market
unrest has arisen from a sudden deterioration in the macroeconomic conditions for a particular
country. Last autumn, however, the causal relationships of the events in financial markets in
the industrialised world were the oppositeit was problems in the financial markets that
engendered fears of a serious shock to much of the global economy.
The Riksbank and financial stability
Much work is being done with a view to avoiding financial crises. The Riksbank is one of the
participants in these endeavours. Our efforts have included the development of an intellectual
framework for contributions to improving the stability of Sweden's payment system. In recent
years it has become increasingly clear that the Riksbank has a main function that is probably
just as important as maintaining price stability, namely promoting financial stability.
The financial system has a central function in the economy and performs three main tasks:
firstly, it handles payments; secondly, it channels savings to investments with a good return
for future consumption; and thirdly, it spreads and reduces economic risks in relation to the
players' required returns.
A smooth functioning of all these activities facilitates economic growth in that the production
of goods and services as well as employment are promoted by lower costs and risks. In this
way the financial system contributes to increased prosperity.
In view of the financial sector's central function in the economy, the authorities are
particularly active in monitoring and regulating developments in this sector. In Sweden, the
work for financial stability was accentuated by the serious incidents in the early 1990s. Since
1989 the Riksbank had been required by law to "promote a safe and efficient payment
system". The problems among Swedish banks naturally strengthened the Riksbank's
determination to contribute to the work on stability so that similar events would not occur
again.
As virtually all economic transactions involve some form of payment, one of the financial
system's principal components is the payment system. This is clearly expressed in a statement
in the main report from the Banking Law Committee, to the effect that concern for the
payment system is the primary reason for supervising and controlling financial institutions.
In Sweden it is the Riksbank that provides and is accountable for the central payment system.
This RIX system handles 1,500 interbank payments a day with a total value of SEK 350
billion. While it is often the central bank that is responsible for a country's payment system,
there is nothing to prevent this function being performed by some other player. In countries
where that is the case, the payment system is not a central bank concern. Nonetheless, one
reason for assigning the task to the central bank is the payment system's importance for the
transmission of monetary policy. Another reason is that a central bank is in a unique position
to provide the liquidity that the smooth functioning of the system constantly requires. Players
are liable to need a temporary supply of liquidity in order to smooth the flow of payments with
other participants.
The payment system can be said to consist in turn of two components: the payment
infrastructure and the financial firms, mainly banks, with access to the system. The stability of
the system is dependent on the proper functioning of both these components. The
infrastructure must be constructed so that it does not exacerbate any problems that may arise.
It needs to be capable of handling external shocks without any danger of collapsing.
However, the severe strains that arise from time to time in the payment system tend to be
generated not so much by hang-ups in technical and administrative systems as by problems for
one or several of the participating banks. Problems for one bank quickly spread to the rest of
systemic
the payment system and may generate a risk. This risk arises if problems with credit
or liquidity prevent bank A from completing its payments to bank B, which thereby has
difficulties in paying bank C. Banks B and C are then liable to fail solely because bank A
cannot fulfil its commitments. The risk obviously varies with the size of the payments in
question; the larger these are, the greater is the potential systemic risk.
The occurrence of systemic crisis threatens the whole or parts of the payment system, and if
this ceases to function the entire financial system as well as the real economy will be affected.
The crisis in Sweden in the early 1990s was associated with large systemic risks. Last autumn
the U.S. Federal Reserve perceived considerable systemic risks in the domestic financial
market. In neither of these cases, however, was there a full-blown systemic crisis.
In the event of a systemic crisis, the payment system needs a large supply of credit. As a last
resort the law therefore allows the Riksbank to provide financial support for banks that are
viable but in temporary difficulties. The provision of credit is a very important instrument in
the management of systemic crises.
The Riksbank focuses on the banks, particularly the largest ones, because one of the main
systemic risks stems from problems with the settlement of large-value payments. It is
therefore important that the Riksbank analyses the overall stability of the bank sector in order
to identify banks that may encounter temporary difficulties. In this way, our oversight of the
payment system is extended to include much of the financial system.
The continuous analysis of the financial system by the Riksbank currently focuses on three
aspects:
1. Each institution's efficiency and earning capacity, as this is liable to influence the
institution's risk behaviour.
2. Credit risks, particularly those connected with the payment system, that is, counterparty
and settlement risks. The analysis of these risks is intended to give the Riksbank a general
picture of the whole system and enable the timely detection of any problems in some stage of
the payment process.
3. Systemic risks from factors outside the payment system. Problems may be caused by
uncertainty and a lack of confidence in the financial system. This involves other players
besides the banks. Historically, it is macroeconomic imbalances that have caused confidence
to decline in this way. Examples of such imbalances are highly volatile asset prices,
fluctuations in the rate of price increases and a growing household debt ratio. Macroeconomic
indicators accordingly play an important part not only in the assessment of future inflation but
also in the analysis of payment system stability. Experience has shown that a balanced
macroeconomic policy and stable prices reduce the risk of shocks that threaten financial
stability.
Analyses of these three aspects are presented twice a year in our Financial Market Report.
The Riksbank is accountable for oversight and the Financial Supervisory Authority for
supervision. This means that the Riksbank is primarily concerned with the development of a
system or a market, while the FSA considers the situation in each institution as well as the
system's overall stability. But as the dividing line between these two functions is blurred in
practice, it is important that these two authorities cooperate closely. Such cooperation is
indeed a hallmark of our interaction, from senior management down to divisional staff.
Note, therefore, that while oversight is an important Riksbank function, the direct supervision
of Sweden's financial system is not our concern. Our legislators have assigned the latter role
to the Financial Supervisory Authority, which accordingly has the possibility of directly
pointing to shortcomings in particular institutions.
The Riksbank may nonetheless detect problems at an early stage because they are likely to
leave their mark on the payment system, which is the Riksbank's concern. Our chances of
influencing the course of events then lie in contacting the bank's executives and informing the
Financial Supervisory Authority. Our Financial Market Report can no doubt also play an
important part in exerting a more continuous influence. In the longer run, the Riksbank can
also contribute to stability through international collaboration, as well as by participating in
Sweden in legislative work and the structural adjustment of various systems.
Undervalued credit risks-a recurrent phenomenon
One aspect of the Riksbank's oversight of financial stability in Sweden has been the analysis
of the run-up to the bank crisis here and the possible causes of crises in other parts of the
world.
The causes and course of the various crises have differed in some respects but they do present
many similarities. Many of them were preceded by a period of rapidly rising asset prices and a
strong expansion of credit. This period ended with an abrupt reassessment-a jolt that altered
risk assessments and led to heavy losses for those involved. Signs of economic problems
meant that the supply of credit virtually ceased. It seems that the stronger the credit supply in
the first period, the more serious were the effects in the second phase, with decreased
production and rising unemployment.
Another factor in many cases has been that the country had a fixed, but adjustable, exchange
rate regime that lacked credibility. With such a regime, the central bank seemingly absorbs
exchange risks, which gives private investors an incentive to utilise the interest rate
differential with the rest of the world that characterises a situation where domestic inflation
expectations are higher than in other countries. Loans were therefore obtained in foreign
currency for investment in domestic assets. The maturities of the financing instruments often
differed from those of the investments-the funds were borrowed short and invested long.
When the exchange rate ceased to be perceived as sustainable and the risk of an adjustment
grew, the earlier capital inflows turned into massive outflows. This accentuated the pressure
on the exchange rate and created an acute currency crisis. If the capital inflow had been
channelled through the banking system, the lack of confidence during the acute phase of the
crisis often led to severe repercussions on the financial system.
The course of events of this type is essentially dependent on the supply of credit. The problem
has lain in widespread lending losses and it seems that the banks have repeatedly made much
the same mistakes. This applies to their generosity in financing asset investment by private
players as well as to the willingness of international banks to supply foreign currency to
domestic counterparties. Situations of this type often involve a high concentration of credits
and the credit risk assessments appear to have been rather superficial.
What are the reasons for this? One is probably the difficulty, for banks as well as supervisors,
in assessing the risks in loan portfolios. The management of credit risks is cumbersome and
neither is it easy to obtain a good picture of the players' portfolios. Genuine difficulties in
making assessments are thus one explanation; another is that in certain cases the banks seem
to have hunted with the pack instead of making independent risk assessments.
Undervalued credit risks accordingly seem to be a recurrent theme in these crises. It is
therefore essentially the banks that must construct sounder credit policies in their institutions.
These policies must include the scrutiny of everything from the work of the individual credit
officer up to the more general strategies of the executive management and board of directors.
A great deal of international work has also been done to rectify these problems. Authorities
and financial agents are working together on the formulation and introduction of international
principles-core principles-for the proper functioning of banking systems and supervision.
One aspect of these efforts is the construction of capital adequacy rules that are more suited to
the banking system's present situation-the current rules were formulated in the light of the
financial situation in 1988. Efforts are also being made to achieve a higher degree of
transparency and clearer accountancy.
The recurrent crises in financial markets unmistakably show that the work of reinforcing the
system is a continuous process that must not be neglected. Developments last autumn made it
clear that the work the banks had already initiated to improve risk management did not suffice
to prevent renewed financial turbulence. The pattern of risks differed somewhat from earlier
periods with problems. Instead of the familiar difficulties with the banks' loan portfolios, in
large measure it was a matter of risks that certain highly leveraged players would generate
problems through large positions in the repo market, for example.
A drastic example-LTCM
The problems in the U.S. hedge fund Long Term Capital Management can be seen as a drastic
example of how systemic risks can arise if the banks' counterparty risks and concentration
risks become unduly large. A single player, seemingly far removed from the payment system,
threatened to generate a systemic crisis in the U.S. financial system, with the risks of
contagion that this might involve.
LTCM, which had been operating since 1994, based its strategy on the use of statistical and
mathematical models to identify temporary price differentials between similar financial
market assets. This involved speculating, for example, in narrowing interest rate spreads in the
U.S. bond market. In simple terms, a limited capital input was used to combine forward
purchases of U.S. corporate bonds with forward sales of U.S. federal bonds. The combination
of countervailing positions meant that the outcome would not be affected by the general
development of interest rates. It was only the relative paths of the two asset categories that
mattered-a narrowing interest rate spread would result in a profit.
Similarly, the fund took large countervailing positions between different asset markets as well
as between markets in different geographical regions. To begin with the strategy was notably
successful; high profits were obtained with a low capital input. In 1995 and 1996 the annual
profit was over 40 per cent. This performance and the confidence that the fund management
enjoyed made many banks willing to provide loans or invest in the fund.
In time, however, the financial markets moved in the opposite direction to what LTCM-and
others-had expected. Russia's debt moratorium on 17 August was followed by markedly
increased financial turbulence as investors became more nervous and withdrew from other
markets that could be perceived as risky. A uniform tendency developed, with falling share
prices, widening interest rate spreads, growing unrest and decreased liquidity. There was a
flight to quality of a kind that had not been observed before in the financial markets. Instead
of narrowing, interest rate differentials became markedly wider. The diversity of risks on
which LTCM had relied ceased to provide protection. The market movements were such that,
if anything, it was a source of increased losses.
The rumours of problems in LTCM contributed in turn to even greater turbulence in the
financial markets. In that market prices would be depressed by a winding-up of positions,
investors tried to close positions in those markets where they feared that LTCM was also
involved. It can be mentioned, for example, that Risk Magazine estimated that LTCM's
positions in the interest swap market totalled 5 per cent of the global market, which says
something about the size of the fund's positions. The flood of closures, almost amounting to a
panic, caused a further widening of interest rate spreads.
LTCM's situation deteriorated rapidly; by the end of September the fund had lost almost 90
per cent of its capital in the course of nine months. The U.S. Federal Reserve had initiated a
meeting with some of LTCM's counterparties and on 23 September fourteen banks with
claims on the fund agreed to take over LTCM as a joint venture and try to wind up the
positions in a more orderly manner.
The Federal Reserve's motivation for initiating a solution to the problem was not the sizeable
losses that might have been incurred by many of the banks concerned. Its concern instead was
the financial system in general. If the banks that had provided loans were to close their large
positions spontaneously in a market that was already illiquid and turbulent, other agents who
were not directly involved would be hit. The steep price fall would probably have paralysed
the financial markets for a time and this might have triggered a vicious circle of declining
confidence and further closures-the Fed perceived a large systemic risk. The ultimate
consideration was, of course, the potential hazard for the global economy.
It is difficult to say what might have happened if the Federal Reserve had not acted. The banks
that were involved had a strong interest in achieving a controlled settlement of their
commitments and would probably have acted at some stage. In such a crisis, however, prompt
action is vitally important. The central bank initiative contributed to this.
Lessons
Swedish banks were never directly involved in these problems, though they did feel certain
effects of the developments in U.S. financial markets. Even the Swedish market became less
liquid.
However, the involvement of Swedish banks might have been greater and that is why the
Riksbank needs to analyse the origins of such problems. Our function of promoting a safe and
efficient payment system cannot be performed properly without a good capability for
analysing and understanding the implications of the crises that occur around the world. The
results can lead to conclusions that underpin the stability of Sweden's financial system. The
Riksbank has in fact been working on these matters for a long time; risks of the type that
caused problems last autumn were considered in the Financial Market Report that was
published in November.
In the case of LTCM, the threat of a systemic crisis came from the combination of extensive
counterparty risks and a high risk concentration. Counterparty risks occur when there is
uncertainty about the ability of counterparties to meet their commitments.
One of the problems was the large number of banks that had provided loans to LTCM. This
gave a concentration of risks to a particular counterparty, which had large positions of its own.
Such a concentration can have several causes. The high profits-probably also the reputable
status of executives-no doubt made the fund attractive as a counterparty. Banks were
therefore willing to approve credits in order to establish a relationship with such a profitable
customer as LTCM. At the same time, the fund's reticence about its risk profile made it
difficult for creditors to form an accurate picture of the total risks. The banks were evidently
unaware of the size of the credits that other players had provided, which by itself is
remarkable. Neither did they fully appreciate what the large positions might have for
consequences if the collateral had to be called. In other words, the banks ought not to have
relied to such an extent on the collateral, in the form of securities, they had accepted for their
loans. Lending of this type requires that even the banks obtain a picture of the borrower's total
situation. Had they done so in the case of LTCM, the outcome would certainly have been
different.
The problems last autumn also revealed shortcomings in current risk models and the
management of certain types of risk. The banks must pay more attention to how the models
work in the event of a pronounced change in market conditions. The markets moved to such
an extent that historical estimates of co-variations ceased to apply.
The crisis accordingly offers several lessons:
• In the light of what happened in international financial markets last autumn, all
participants in the financial system must improve their credit policies.
• Relying solely on securities as collateral is not enough; a picture must also be obtained of
the borrower's total commitments.
• The LTCM crisis demonstrates that credit assessments must include a larger element of
readiness for extreme events. Models based on historical events were incapable of
foreseeing the debt moratorium in Russia and the resultant slump in virtually every
market. Neither could they envisage that market liquidity would dry up to such an extent
that the banks would not be able to dispose of their loan collateral without eliciting a very
steep price fall. The banks need to augment their risk models with stress tests-
assessments of the direct and indirect effects that unusual market developments would
have on their current positions.
• Banks must improve their risk management and knowledge of different forms of risk but
so must the supervisory authorities.
• A further question concerns the adequacy of existing laws and regulations. Are there
things we have missed? As I mentioned earlier, intensive efforts are being made to
improve the rules.
Having said all this, we must also recognise that the extensive work that is continuously being
done to strengthen the financial system does not mean that the system will be made
completely immune to crises. The work must focus on mitigating the effects and trying to
ensure that crises which do occur are less extensive and socially costly than those we have
experienced in recent years.
The competent parties must endeavour to find solutions that combine the necessary market
regulation and supervision with the advantages inherent in capital mobility. A completely
regulated market reduces capital flows and generates large fluctuations in market prices,
leading in turn to welfare losses. But neither is a market without any common rules and
supervision an ideal remedy. Operations in financial markets need some degree of supervision
but this must not paralyse the potential for developments that can contribute to higher
prosperity in the global economy.