urban backstrom : financial cycles speech by mr urban backstrom, governor of sveriges riksbank, at the philadelphia fed policy forum on crises, contagion and coordination : issues for policymakers in the global economy, philadelphia, 22 november 2002. * * * first i want to express my thanks to the organizers for inviting me to this very interesting conference. let me especially thank tony santomero for everything he has done in his previous capacity in inspiring and assisting us at the riksbank over the years as an academic adviser. i wish you, tony, every success as president for the philadelphia fed and as an important policy maker here in the u. s. i think one can say that central bankers around the world have never before had such a central and well respected position as they have had during the past decade. their task seemed to be well defined and the job to deliver price stability has worked rather well. much of the mystique that typically surrounded central banks has gradually disappeared. openness and transparency have become the key words of the day. moreover, research concerning monetary policy has made good progress during the past decade. the world of central banking has indeed undergone positive changes. however, it would be most dangerous for us, central bankers, to just sit down and relax in the belief that all the important problems in the field of monetary policy have been resolved and need no further consideration. one aspect that indeed needs further thinking is the issue of financial cycles and how they could be mitigated and whether monetary policy should play a role in doing so. let me say a few words about this. before i became involved in central banking i was state secretary in sweden ’ s ministry of finance in the early 1990s and dealt, among other things, with the management of our nation ’ s banking crisis. being in the middle of a crisis like that was indeed a frightening experience. financial crises would seem to evolve from excessive optimism. that is, credit expansion ( domestic or foreign ), which feeds into asset prices, lowers the cost of capital, stimulates investment and subsequently leads to an economic boom. eventually, the investments are found not to be sustainable in that they do not generate profits. the whole structure may ultimately collapse, the economy moving from boom to bust, often followed by banking or currency crises or a combination of the two. the most severe bubbles have historically been those that involve rapid credit expansion in the banking system. economic history books are full of examples of this process. also

operations. there may also be difficult political considerations that have to be taken. for example, a minority government may need to seek support from other parties to use budgetary resources, a support that may be hard to get or at least take some time. however, this is not to be taken as an argument for governments to use the central bank as a provider of support because it does not want to use budgetary resources. the central bank should be independent and control its own resources. the conclusion of this is that ela operations should have the role in the general crisis management infrastructure of dealing with quickly emerging problems. where problems arise gradually, other measures available to supervisory authorities and governments are more likely to be used. ela should be seen as a means for handling acute problems, so that the authorities gain time to decide whether other crisis management measures are needed, such as restructuring of troubled institutions. if private sector support can be organised, such as in the case of ltcm, that is of course to be preferred. if the view is accepted that ela should function as a “ bridge ” measure to prevent acute crises from occurring, it is very important that the support is given in a way that minimises the credit risk for the central bank, in order to avoid moral hazard effects. the central bank must have a well - considered exit strategy for its lending operations. the most obvious way to do this is to lend against collateral. in most cases where a need for support occurs, collateral that is normally accepted by the central bank will probably not be available. the central bank may in these cases be required to accept lower quality collateral. it should in these cases apply a larger haircut on the collateral than is used for normal collateral. another part of a proper exit strategy is that financial support should not be given to shareholders or other holders of risk capital. 2. internal procedures for ela in the previous section, two main points were suggested : ( 1 ) that ela is a measure that predominantly should be used for problems that arise without warning ; and ( 2 ) that ela should only be provided if there is a risk that a systemic problem would occur if the central bank did not act. these two features bring about requirements for the way central banks should organise the ela function internally. the possible need for speedy assistance necessitates that a central bank must have internal procedures for managing requests for liquidity support and doing so very rapidly. to accomplish this, central banks need to have a