mr backstrom looks at the riksbank and financial system stability and comments on the ltcm case speech by mr urban backstrom, 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 yeara 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 playerthe hedge fund long term capital managementmight 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

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