Lars Nyberg: Current financial stability issues
Speech by Mr Lars Nyberg, Deputy Governor of Sveriges Riksbank, to the Riksdag Standing
Committee on Finance, Stockholm, 25 November 2003.
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Allow me to begin by thanking you for your invitation to come here and speak about the Riksbank's
work on financial stability. In the same way that the Standing Committee has the opportunity to
regularly question the Riksbank Governor about monetary policy, it is natural that the Committee
should also be able to learn about the Riksbank's stability efforts.
In the aftermath of the banking crisis, the Riksbank began to develop its expertise and analytical
capacity with regard to stability issues. In autumn 1997, the Riksbank published the first report with a
more coherent analysis of financial stability. The Riksbank became the first central bank to present its
view of stability publicly. Other countries were more hesitant about speaking openly about stability in
the financial system. Their opinion was that it would nevertheless be impossible to be open about
these issues in the event a crisis should occur. The Riksbank's attitude, however, was that it is better
to be open. Discussing risks and vulnerabilities at an early stage would enable crises to be avoided.
Moreover, the experiences of transparency in the area of price stability were positive.
Today, some thirty countries have followed suit. Repeated financial crises have made it clear that
there will always be problems to take account of and that authorities can therefore be benefited by a
structured approach to financial stability.
Banks are the focus of our work on financial stability. This is because banks are the institutions that
ensure the functioning of the payment system. Experience shows that if individuals and companies are
unable to make ordinary payments, or if the credit function in society is disrupted, this has highly
adverse effects on the economy. Insurance companies are also important in society, but they are not
system-critical in the same way as banks. I intend to return to the subject of insurance companies later
on as they are undeniably in the spotlight at present.
But banks are not only important for stability; their balance sheets also contain a built-in source of
instability. Banks' funding is generally short term in nature and can quickly disappear, while their
assets have long maturities and cannot be realised as quickly. Should depositors and financiers lose
confidence in a bank, it could face an acute liquidity crisis. Moreover, problems in one bank can
spread to other banks. This can happen because they have liabilities to one another due to loans or
securities trading, or because they participate in the payment system. Contagion effects can also arise
if other economic players suspect that there are connections between the banks. Banks can then
encounter difficulties, even if the original suspicions were entirely unfounded.
As a result of these factors, banks operate within the bounds of a strict regulatory framework and are
subject to public supervision. Finansinspektionen has primary responsibility for prudential supervision
of individual banks. The Riksbank oversees the banking system as a whole and attempts to assess
the risks that could arise in it in both the short and long term. Of course, there is some overlap in the
tasks of both Finansinspektionen and the Riksbank, but it is sometimes fruitful to approach a problem
from somewhat different angles. I am also of the opinion that the cooperation between the authorities
works well.
If a crisis were to actually occur in spite of regulations and supervision - and this can happen as we
know - the Government may need to take action. The Riksbank's task in a crisis is to provide
emergency liquidity assistance (ELA) to the banks that have run into liquidity problems. Allow me to
underscore, however, that it is far from certain that a bank in difficulty will be given ELA. Since all our
experience says that it is easier to provide assistance than not, especially when decisions have to be
made under time constraints, there is reason to carefully consider such a measure - and to be well
prepared. It would be serious if the banks were to feel certain that they would automatically be given
assistance in the event of difficulties. Such thinking could cause them to take unnecessary risks. Were
the crisis to spread to other healthier banks than the bank that requested ELA, perhaps the Riksbank
should concentrate its liquidity injections to these banks in order to rescue the system rather than the
bank itself.
If the problems in a bank are of a more serious nature, whereby its solvency - that is the bank's ability
to meet its long-term obligations - rather than its liquidity is in question, this is more an issue for the
Government than the Riksbank. Even in such cases, there is reason to question whether the bank
really is systemically important before taking measures. In practice, every crisis should entail intensive
cooperation between Finansinspektionen, the Riksbank and the Ministry of Finance. I am keen to
stress how important it is to be well prepared for such cooperation, especially given how quickly crises
can develop in today's financial markets.
Stability in the Swedish financial system
The Riksbank presents an analysis of system stability twice a year. This comprises partly a review of
developments in banks, mainly the four major banking groups, and partly an analysis of the financial
infrastructure. The analysis of the banks discusses how borrowers' indebtedness and their ability to
service this debt has changed and how the banks themselves have acted. The analysis of the financial
infrastructure discusses problems and risks in the rather complicated technical systems that are
currently used to transfer payments, for example RIX, VPC and BGC.
The Financial Stability Report enables the Riksbank to describe the banks' ability to cope with
unexpected disruptions. We can point to conceivable risks and dampen any exaggerated optimism
during an upturn, when everything appears problem-free. Similarly, we can modify the picture during a
downturn and, with the help of thorough analysis, ease concerns about serious loan losses. We can
also call attention to risks and discuss these with the banks. However, the day will never come when
the Riksbank indicates in a Financial Stability Report that the risk of a financial crisis occurring is high.
In such a case, the crisis would materialise immediately, as pricing in the financial markets is based on
expectations of future developments.
Following this background information about the Riksbank's stability efforts, I intend to discuss the
most recent assessment of the Swedish financial system that was published in a Financial Stability
Report yesterday.
As always, the point of departure is the general picture of economic activity. An improvement in activity
usually enhances bank profitability and thereby the resilience of the financial system. I should probably
add here that this applies in the short term, as a prolonged economic upturn can lead to over-optimism
and price imbalances in asset markets, which subsequently affect the banks in the form of loan losses.
At the moment, there is no doubt that the overall economic outlook appears more positive than it did
six months ago, both in Sweden and abroad, even if it is somewhat mixed. Prospects for an
acceleration in growth are favourable for the United States and a number of emerging markets, but
less so in Europe.
The major Swedish banks have now begun to increase profitability for the first time since 2000. This is
partly because the equity market has strengthened again, but also because the banks have cut costs
while their interest income from lending has continued to increase. Banks have thereby improved their
ability to cope with unexpected losses. Loan losses remain low. There has not been any expansion in
credit other than in mortgages to households. The Tier 1 capital of the four major banks has risen over
the past two years and now averages just over seven per cent, which is satisfactory given current
economic conditions. Developments in the coming year are expected to lead to a further increase in
profits and capital adequacy ratios.
Neither are the banks' borrowers - of which half actually reside outside Sweden - expected to cause
the banks any considerable losses in the period ahead if economic activity strengthens in accordance
with the Riksbank's main scenario. The corporate sector, which is the largest borrower group and the
group that previously has caused the banks' biggest loan losses, has reduced its debt burden
somewhat in relation to equity. Companies should also be able to benefit from an improved economic
situation and thereby lower their interest expenditure in relation to income. Property companies have
been feeling the effects of a decline in office prices and rents, but their debt is moderate and their
earnings continue to be well above interest expenditure. We are far from the situation that existed at
the end of the 1980s.
However, households' debt burden has increased throughout the slowdown. The main reasons have
been higher disposable income and low interest rates, which has led to high house prices. Debt in
relation to income is now approaching the levels seen before the crisis at the beginning of the 1990s.
The difference, however, is that interest expenditure makes up a considerably lower percentage of
income than it did then. This makes the high debt levels possible to endure.
There is reason for vigilance regarding growth in household debt, even if households have never
caused the banks' losses that have posed a threat to financial stability. But it is also possible that the
increase in indebtedness is partly an adaptation to a low-inflation economy. The pattern of rising
household borrowing is evident in many industrialised countries that have got the better of inflation in
the past decade. When there is less uncertainty about future inflation and thereby interest rate levels,
lenders are more willing to grant credit and also demand a lower risk premium for this credit. Loans
become cheaper. This makes borrowers more inclined to borrow, also because they are less uncertain
about their future costs. Thus, they can accumulate more debt.
However, households' willingness to borrow tends to boost demand for housing and thereby raise
house prices. This has been observed both in Sweden and other countries. House prices in Sweden
have risen 56 per cent since 1997 at current prices. Also, unlike commercial property prices, they have
not declined during the economic slowdown of recent years. In addition to low financing costs,
increasing disposable income and the low housing supply have also contributed to the price rises.
Does this give us reason to suspect that a speculative bubble is developing in the housing market? I
don't believe so, even if we have glimpsed local tendencies, notably in Stockholm. We don't see any
signs of housing being bought as an investment with a view to leasing it out until prices rise further.
Such indications are evident in a couple of other European countries. As far as we can see, the price
increases in the Swedish housing market appear to be due to fundamental factors and are not being
driven by speculative behaviour. Low interest rates, rising income and limited housing construction
goes a long way towards explaining current price developments.
Lower confidence in insurance companies
Recently, the media have drawn attention to the strained financial situation of life insurance
companies. The crisis in these companies has been placed on a par with the banking crisis at the
beginning of the 1990s, and there is concern that it could have equally serious repercussions for
society. This is not the case. The actions of the life insurance companies do not jeopardise the
financial system's basic functions - to transfer payments, provide credit and manage risk. What could
happen is that those who have saved in these companies choose to transfer their savings elsewhere,
in the event that they can do this. In any case, fewer people will be signing new life insurance policies.
This is bad news for life insurance companies, but has limited significance for financial system
stability.
It is unfortunate that the criticism of the life insurance companies, which is justified, also affects their
products, especially traditional life insurance. Traditional life insurance is an excellent product for
anyone hoping to have a long life. The insurance includes the "risk" of policyholders living a long life,
that is, policyholders ensure that they will receive a predetermined income over life, which is enabled
by evening out the risk in a large insurance portfolio. It is a unique product and a form of saving that
deserves a better fate than that of disappearing because of a confidence crisis. Anyone that doesn't
know exactly when they're going to pass away, and that means most of us, have reason to reflect over
the advantages of life insurance.
In my opinion, the serious consequence of the life insurance companies' problems is that confidence
in the financial system as a whole may have taken a blow. As savers we feel cheated, both by broken
promises about returns that have not been forthcoming and by the greed inherent in some perks and
bonus programmes. Low confidence in financial market institutions tends to subdue capital formation,
which we all lose out on in the long run. Functioning financial markets are a precondition for good
growth.
As regards the life insurance companies, I personally believe that the root of the problem is found in
their mutual construction, which has long been cherished since it means that all profits are given back
to the policyholders. But as the companies have largely been affiliated to non-life insurance
companies or banks, it has been natural for them to charge high fees for various services, such as
sales and asset management. As profits go to policyholders, this is the only way to yield any gains
from the affiliated life insurance companies. This is not a new problem, far from it, but it has come
under the spotlight due to recent events, particularly the sale of asset management companies, where
values that were previously difficult to establish have become evident.
It is especially annoying that the life insurance companies' mutual construction and no-dividend rule
has made policyholders responsible for the entire risk capital. Affiliated non-life insurance companies
or banks have neither been able to nor had reason to contribute equity, in spite of the fact that they
have controlled the life insurance companies in practice. For this reason, the board of
Finansinspektionen has proposed that it should not be possible for the boards of the mutual life
insurance companies to be controlled by affiliated companies. The fact that the mutual corporate
structure is being investigated further as planned is, I believe, also necessary, though overdue.
It should be observed that the Insurance Committee called attention to the problems associated with
mutual life insurance companies in its 1998 report and proposed that profit-making companies be
established to clarify both ownership structure and control. Legislators adopted the Committee's
proposal and a profit-making life insurance company has since been established. In this case,
moreover, the owner was forced to inject new risk capital as a result of the equity market decline.
Another confidence issue stems from the fact that many savers since the bursting of the equity market
bubble naturally feel they were misled by the advice they received from banks, securities brokers,
insurance brokers and life insurance companies. It has happened many times that salespeople at
these institutions have been presented as advisers, which has created the credibility we associate with
neutrality. Unfortunately, the advisers' competence has been rather superficial in some respects,
especially with regard to assessing risk. Although information, particularly from the major banks and
life insurance companies, has become appreciably better, much remains to be done so that savers
with limited knowledge are not led astray. Whether companies' own efforts are sufficient in this respect
is a delicate question. Strict ethical guidelines, drawn up by each company and followed up by
Finansinspektionen, could be a start. In countries like the United States, where families have long
been forced to plan their saving to finance their children's education and their own pensions, it has
become natural to turn to independent investment consultants to discuss how much and in what way
they should save.
A new financial landscape?
Allow me to conclude by taking a look ahead to discuss a number of challenges we may encounter
regarding financial stability. They are all tied to our increasing international dependence. Financial
market integration is beginning to become a reality in several parts of Europe and this has led to
increasing interdependence between these countries' banking systems. A problem in one country can
spread in various ways to the banking systems of other countries. This places new demands on
prudential supervision, oversight and regulations.
In order to create a single market for financial services, the EU is striving to introduce a regulatory
framework that will be common to all financial companies within the Union. This will enable banks to
compete on equal terms, thus allowing the evolution of a single market with only the most competitive
companies.
This is an important initiative. Common regulations are often a precondition for enabling far-reaching
integration. The integration we have seen so far has been very positive for growth, even if it is difficult
to quantify the exact effects. Studies have indicated that increased financial integration in the EU could
boost growth by around half a per cent per year.
The risk, however, is that harmonisation in itself will make regulations more extensive and onerous for
the banks than really desired. In their eagerness to safeguard stability, regulators risk overlooking
efficiency. If regulations are to be harmonised, there is a risk that the strictest rules in the Union will
also be those that prevail, as the reluctance to ease already existing rules is often greater than the
reluctance to tighten rules further. The biggest common denominator is a more natural choice than the
smallest.
Neither can we have the ambition to regulate away all potential problems - for then we will also
regulate away competition and efficiency, just as we did in Sweden up to the mid 1980s. Therefore, it
is not unlikely that we will also witness bubbles in the asset markets in the future, as well as banks that
have over-expanded or that have encountered difficulties for other reasons. We have to be able to
manage such situations without them developing into systemic crises. Our ongoing work on financial
stability is one way of dealing with these issues, not least as regards the financial system's sensitivity
to bubbles. But we also need legislation that can bolster efforts during a crisis, which is something that
is lacking in several countries, including Sweden. However, the Banking Law Committee put forward a
proposal in 2000 for such legislation in Sweden. We have to hope that a Government bill will come
before the need becomes acute!
Although harmonisation of regulations is desirable and opens up new possibilities, it also leads to
problems that need to be dealt with, for example with regard to prudential supervision and crisis
management. I intend to leave it at that as regards supervision, but would like to say a few words
about crisis management.
Managing a domestic banking crisis can be tricky enough, but managing one across national
boundaries is in all probability even more difficult. Let me give you an example. After its most recent
restructuring, Nordea is a Swedish bank with subsidiaries in other Nordic countries. It has market
shares of approximately 40 per cent in Finland, 25 per cent in Denmark, 20 per cent in Sweden and
15 per cent in Norway. The bank wants to change its subsidiaries into branches. This would make
Nordea an entirely Swedish bank with branches that potentially could be systemically important in
other countries. According to current EU legislation, prudential supervision and crisis management
would in principle be an issue for Swedish authorities. But would the Finnish authorities accept that
Sweden takes responsibility for the most important part of the Finnish financial system? And would we
in Sweden be willing to resolve a banking crisis in Finland, with all that it would ask of the Swedish
taxpayers, if Nordea were to run into difficulties? The answers to these questions are not
straightforward. But it is fairly obvious that present EU legislation does not accommodate banks with
systemically important branches. An article in the Riksbank's Financial Stability Report discusses this
particular problem.
The Nordic central banks have a joint working group for discussing cross-border crises, and we have
drawn up a memorandum of understanding for how we are to manage them. The supervisory
authorities have a corresponding group for their purposes. Unfortunately, such cooperation is still
uncommon at European level.
Thus, to sum up, we require harmonised rules for the financial sector in Europe, but it is important to
resist the forces that seek to make them unnecessarily extensive. We also need legislation for crisis
management in Sweden, which we have been waiting a long time for. And we need new regulations in
the EU for managing cross-border banks. These are the main priorities for now.
Thank you.