Stefan Ingves: Coming stronger out of a crisis - lessons from Sweden
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank, at the Brussels Economic
Forum, Brussels, 18 May 2011.
* * *
"If in debt, you are not free." This expression was widely used by Göran Persson, Sweden's
former prime minister, to explain the need for the extensive fiscal consolidation process that
Sweden underwent after the crisis in the 1990s.1 In 1997, a three-year nominal expenditure
ceiling was introduced. This was an important step towards increasing budgetary discipline
and strengthening the long-term perspective of the budget process. In addition, as part of this
fiscal consolidation process, a new fiscal policy framework that included a budget surplus
target of 1 per cent over the business cycle was introduced in the year 2000. With these
instruments in place the debt to GDP ratio fell from 56 per cent in the year 2000 to 35 per
cent today.
Recent developments in many European countries remind us of Göran Persson's words:
small, open economies are vulnerable to crises of confidence when financial markets are in
turmoil. They need to stand on very solid economic foundations and be supported by a
credible and sound fiscal-policy framework. Sweden was lucky enough to be in this position
when the recent crisis struck.
This was indeed fortunate as the crisis had a major impact on the Swedish economy. GDP
fell by more than 5 per cent in 2009 - the largest fall since the 1930s. However, the fact that
Sweden was relatively well equipped to confront the crisis, in combination with other factors,
contributed to a rapid recovery of the Swedish economy. During 2010, GDP increased by
more than 5 per cent. Thus the increase was as large as the decrease had been the year
before. And some of the reasons behind the pronounced decline also explain the rapid
recovery. I will cover this in the first part of the speech.
But Sweden was also lucky that the crisis did not have more severe consequences. As in
many other countries, the crisis exposed vulnerabilities in the regulatory and supervisory
framework for financial stability. The key conclusions we draw are not unique for Sweden
and I will spend the rest of the speech outlining these issues and what we are doing to deal
with them.
Why were both the recession and the recovery more pronounced in Sweden than in
the rest of the world?
Sweden is indeed a small, open economy! Our exports and imports are approximately
50 and 40 per cent of GDP respectively. This is the main reason why the Swedish economy
was hit so badly during the recent international recession, as global trade collapsed. While
exports in the euro area and the United States fell by approximately the same amount as in
Sweden, our higher export share meant a larger impact on the economy. Later this
vulnerability became a boon for Sweden, as the strong upturn in global trade after the crisis
benefited Sweden more than many other countries due to its high export share.
But the recovery was not only led by exports. As I said initially, Sweden was well prepared to
confront the crisis as public finances were strong, unlike much of the euro area and the
United States. In both these regions the budget deficit averaged 2 per cent of GDP in the
10 years leading up to the recent crisis, while Sweden had, on average, a surplus of over
1 per cent; in line with the surplus target I mentioned previously. Strong public finances limit
the need for fiscal restraint during and after a crisis. While in other countries the fiscal
stimulus needed during the crisis was widespread, in Sweden the fiscal stimulus was more
targeted to the labour market and to those sectors that were more strongly hit. In addition to
this, Sweden has had a high level of household saving and a relatively strong increase in
disposable incomes in recent years. This combination has also enabled a high rate of growth
in private consumption during and after the crisis. All these preconditions were weaker in the
United States and the euro area.
Lastly, Sweden does not have the major structural problems that have arisen in the
economies of those countries hit by a "boom-bust" cycle on the housing market - problems
that have been reflected in a substantial weakening of public finances. House prices
recovered after a slight turndown in connection with the crisis and are now at a higher level
than before the crisis began. While we continue to follow developments in the Swedish
housing market, structural factors, such as a low level of construction and traditionally low
levels of credit losses on Swedish mortgages, reduce the likelihood of major price falls in the
near future.
What have we learnt from the crisis?
It would be wrong to focus solely on the factors that explain Sweden's relatively strong
recovery. There were also a number of vulnerabilities in the Swedish institutional set up and
banking system which threatened to increase the severity and length of the downturn.
The major Swedish banks are heavily reliant on international funding and liquidity in these
markets fell sharply following the collapse of Lehman Brothers. To protect the banking
system, the Riksbank provided general liquidity assistance in the form of loans in SEK and
USD at long maturities. This liquidity assistance was substantial: it peaked at around 15 per
cent of GDP and lasted for over two years. Some Swedish banks were also exposed to
significant risks through their operations in the Baltic countries. When the financial crisis hit
Europe, GDP in the Baltic region fell sharply as foreign investors withdrew and demand for
exports fell. And even if the global financial crisis had not arrived when it did, a combination
of lax fiscal policies and rapid growth in wages and lending in the Baltics meant that the
economies were overheating and were not on a sustainable path.
In addition, global financial inter-linkages produced serious negative externalities for Sweden
and many other countries. This was a situation we had not encountered before.
To some extent, the reliance on international funding markets and exposure to the
rapidlyexpanding Baltic region were vulnerabilities that could have been identified before the crisis.
It is now clear that in the past financial regulation and supervision did not function
satisfactorily in Sweden and in many other countries.
Macro-prudential policy is needed
Prior to the crisis, financial regulation focused excessively on individual institutions under the
erroneous assumption that the system would remain stable as long as the individual
institutions were stable. Consequently, processes that create risks on the system-wide level
were ignored. One important lesson from the global crisis is that we need to include more
explicit systemic-risk preventive regulations, or macro-prudential regulation, in the regulatory
framework. The European Systemic Risk Board (ESRB) and the Financial Stability Oversight
Council in the United States are leading the development of formalized macro-prudential
policy arrangements. Many other countries, Sweden included, are thinking seriously about
how to implement and conduct macro-prudential policy in their jurisdictions. Macro-prudential
policy needs to be operational soon, but some difficult hurdles remain to be overcome.
An important challenge for the design of a new regulatory framework will lie in finding an
appropriate balance: on the one hand, the regulations will need to be sufficient to effectively
reduce the risk of financial crisis; on the other hand they should not be so stringent as to
impose unnecessary costs on the financial sector. It is a matter of finding just the right level
of regulation.
Handling the interactions between monetary policy and macro-prudential policy poses further
challenges. During the recent financial crisis, we observed the difficulties of conducting
monetary policy in a non-stable financial environment. Interest rate signals from the central
banks were sometimes dwarfed by contradictory events in the markets. Conversely, financial
stability is dependent on smooth and predictable monetary policy. Thus, policy makers must
always keep in mind that the increased use of regulatory tools will inevitably affect monetary
policy in different ways. Regulations will affect the interest rates that firms and households
meet and this is something that the central bank needs to take into consideration when
setting the policy rate - in much the same way as monetary policy has to take into account
changes in interest-rate spreads due to changes in financial conditions.
A key element in handling the interactions between monetary policy and macro-prudential
policy will be putting an appropriate governance structure in place. How should we structure
the decision-making process in order to take account of the nexus between monetary policy
and financial stability? It seems clear that the central bank should have some role in setting
macro-prudential policy but that precise role may differ depending on the regulatory structure
preferred by different countries. For example, responsibility for macro-prudential policy could
be given to a committee in which a representative from the central bank would sit (like in the
United States) or it could be given to the central bank (like in the UK). And central banks can
adopt different internal governance approaches: some have a separate board for monetary
policy; others also have a separate board for financial stability. Most central banks have the
same board for both, but may have separate Deputy Governors responsible for each of the
two strands.
What matters, as I see it, is that "the buck stops somewhere". There must be a decision at
some high managerial level which balances the interests of monetary policy and financial
stability as well as other central bank responsibilities. The organisation and processes of the
central bank must also be structured so that there are analytical tools and resources
available to help policy makers take a balanced view in their decisions concerning both
monetary and financial stability policy objectives. For instance, there should be
interdepartmental working groups.
It is also important to remember that systemic risks can quickly spread between countries
and reducing the build-up or impact of such risks will require coordinated international
actions. Therefore, international governance arrangements also matter because they
influence how macro-prudential policies interact across national borders. This matters a lot,
not least in the Baltic region. In Europe, the ESRB will play an important role in identifying
European system-wide risks and recommending policy responses, which will help manage
cross-border issues.
Sound crisis resolution systems also needed
Effective macro-prudential policy would provide a line of defence against the build-up of
systemic risks but it is unrealistic to expect it to prevent all serious financial disruptions in the
future. It is therefore important to supplement macro-prudential policy with other measures to
lessen the impact of financial instability when it occurs. This includes special resolution
regimes for financial institutions which alter normal insolvency rules so that priority is given to
reducing the negative externalities created when financial institutions fail. In many countries
these regimes were completely absent or insufficient to deal with the magnitude and nature
of institutions that failed in this crisis.
Despite the lessons from the crisis of the early 1990s, Sweden failed to create permanent
resolution powers and so was unprepared in this respect when the recent crisis hit.2 The lack
of a legal framework meant that the authorities lacked the legal power and useful guidance
on how to deal with failing banks. As a result, the Swedish government quickly passed the
Government Support to Credit Institutions Act in October 2008, which gives the Swedish
National Debt Office powers to intervene if a failing bank poses a serious threat to financial
stability. We were fortunate that we could draw on people with experience from the 1990's
crisis to help draft the legislation so quickly.
However, the increasing globalization of the financial system means that crisis management
is more difficult today than it was at the beginning of the 1990s. As financial institutions and
groups have become more internationally active, they are increasingly difficult to resolve as
authorities from multiple countries must cooperate on tricky issues like burden sharing and
national insolvency / resolution laws can clash.
Fortunately, there is currently a considerable push by international bodies such as the
Financial Stability Board and the European Commission to design resolution tools (such as
bail-in tools) and to develop guidelines or principles for national resolution regimes and for
handling the failure of cross-border financial institutions. This work should help reduce the
cross-border issues by making national resolution regimes more compatible. It is important
that these regimes are well designed and properly implemented as we should not remain in a
situation in which certain financial institutions or banking sectors are reliant on taxpayer
bailouts to survive. Removing (or reducing) the implicit government guarantee for these
institutions reduces the impact and probability of financial crises and avoids an unwanted
transfer of funds from taxpayers to bank creditors. In addition, this will help reduce the
feedback loops between the banking sector and the public sector. These loops arise when risks
in the financial sector are resolved using public funds, weakening the fiscal budget which
can, in turn, increase risks in the financial sector.
The way forward
As I said, these are key lessons for Sweden and the international community more generally
and, as a result, there has been a significant amount of work by authorities and academics
on the issues since the crisis began. The Riksbank is involved in this work through its
engagement in the national and international debates and proposals on possible reforms to
the financial system and through its own work on possible measures. For example, the
Riksbank recently published an inquiry into risks on the Swedish housing market, including
the risks associated with rising house prices and increasing household indebtedness and
possible measures to address these risks.
The new capital adequacy and liquidity rules included in Basel III form a major element of the
international response to the crisis. The new regulations are welcomed by the Riksbank.
Basel III will introduce a counter-cyclical capital buffer which will form a part of the
macroprudential toolkit and entail higher minimum capital requirements which will improve the
ability of authorities to resolve failing banks effectively. Finansinspektionen (Swedish FSA)
recently announced that the major Swedish banks should prepare for their capital
requirements to rise to the levels proposed in Basel III within the next few years, ahead of the
international schedule for implementing Basel III. And I think that we should consider going
further than Basel III in other ways in order to reflect the specific vulnerabilities and risks that
exist in Sweden, for example by introducing liquidity requirements with specific rules for
matching maturities per currency. This also seems to be the Swedish Government's view.
According to the Fiscal Spring Policy Bill of 2011, the government's intention is - while the
transition rules for Basel II still applies - to try different ways of strengthening the capital
adequacy rules for systemically important banks beyond what will be required when Basel III
is implemented.
In addition, the Swedish government recently established a Financial Crisis Committee to
review the current regulatory framework and the handling of the recent crisis. It will also
propose changes that would reduce the likelihood of future financial crises, by using
preventive measures, and allow them to be resolved in an efficient manner. This will be a
wide-ranging review that will consider the issues I have briefly mentioned in this speech, as
well as many other issues. It is an important step towards ensuring that we have the
appropriate institutional set-up in place to handle internal and external threats to financial
stability in the future.
Concluding remarks
The Riksbank was formed in 1668 and in the nearly 350 years since then has seen many
crises of many different shapes and sizes. I have experienced some (but not all!) of them.
And in its time the Riksbank will have seen many different reforms and changes in response
to the various crises. It seems extremely unlikely that we will be able to achieve what has
eluded my predecessors in the Riksbank; namely, introducing changes that will eradicate all
crises from our future. But it is still worth remembering the words of George Santayana, that
"those who cannot remember the past are condemned to repeat it".
Ultimately, in the long-run, we may be condemned to repeat the past, but we can put
structures in place that make the repetition less frequent and less costly. Institutions have a
longer memory than individuals, so an important element of the current reforms to the
regulatory structure and financial system is to create frameworks to ensure that the mistakes
made in the run-up to this crisis are not forgotten and repeated once the key actors in this
crisis are gone. In this context, three factors are key: fiscal sustainability, stable prices and
sound financial stability policies.