Maintaining Financial Stability
in an Open Economy:
Sweden in the Global Crisis and Beyond
Ralph C. Bryant
Dale W. Henderson
Torbjörn Becker
November 21, 2011
Sweden is highly open to the rest of the world, dependent on
extensive cross-border transactions in goods, services, and
financial assets and liabilities.
• The openness for goods and services has substantially
increased during recent decades.
• The financial dimensions of openness have increased still
more rapidly.
• Swedish financial institutions and markets are now
pervasively linked to the rest of the global financial system.
Two key characteristics of the Swedish financial system:
- Swedish financial institutions rely heavily on borrowing and
lending across the Swedish border, with many of the
transactions and the resulting balance-sheet items
denominated in foreign currencies.
- The financial institutions depend significantly on wholesale
market funding, arranged at shorter maturities, to finance their
lending at longer maturities.
- The combination of these characteristics can be potentially
hazardous in periods of global financial stress.
- Such vulnerabilities did suddenly surface in the fall of 2008.
Swedish Emergency Financial Policies During the Global Crisis
The report discusses the entire broad range of collective-support
activities taken by Swedish authorities during the 2008-2010 crisis
period:
•
•
•
•
•
emergency liquidity lending in dollars
emergency liquidity lending in kronor
emergency market support and extension of government guarantees
modification in government deposit guarantees
facilitating the orderly recapitalization or resolution of institutions coping with
possible insolvency
• in general the catalyzing of cooperative behavior to manage the crisis.
• the crisis-period Riksbank decisions for the setting of the official policy interest
rate, the instrument of traditional monetary policy.
All things considered,
the Swedish crisis actions seem to us
 commendably prompt,
 typically appropriate, and
 augur well for the management of
potential future crises.
Some Questions about Crisis Decisions Taken
with the Traditional Instrument of Monetary Policy
 Could the Riksbank have adopted a more accommodating
posture for forward guidance about the repo rate during the
crisis period?
 Could the repo rate have fallen all the way to zero? Might
more flexibility about the “zero lower bound” have been
feasible and helpful?
 Could forward guidance have constructively given greater
emphasis to uncertainty? Might there be a marginally
different approach to the fan charts and their uncertainty
bands?
Figure 24. February 2009
Figure 25. April 2009
Figure 26. July 2009
Figure 19.
Fan Charts Monetary Policy Report October 2008
Could forward guidance have constructively given
greater emphasis to uncertainty? Might there be a
marginally different approach to the fan charts and
their uncertainty bands?
- All central banks struggling with the issue
- Uncertainty in severe crises is especially great.
- Example of how the conventional uncertainty bands were very
wide of the mark in the crisis.
Modifications or Refinements to Procedures
for Handling Uncertainty
- Move away from the calculation of uncertainty bands dependent only on
historical forecast errors. Experiment with a temporary abandonment of the
customary procedures, introducing elements of discretionary judgment and
contemporaneous conditions?
- Prepare uncertainty bands not only for the main scenario but also for the
alternative scenarios?
- a temporary shortening of the time horizon over which forecast levels and
uncertainty bands are to be presented.?
- consider abandoning – temporarily, and perhaps even permanently – the
presentation of bands that are symmetric about a forecast path?
- consider an enhancement of the textual discussion of uncertainties in
Monetary Policy Reports and Updates.
Exiting from Crisis Conditions in 2010-2011
- Recent period has been characterized by a debate within the Riksbank about
the most appropriate stance and communication techniques for forward
guidance for the repo rate.
- What explains the differences in analytical approach between the majority and
minority views?
-
The current differences of view between the Board majority and Board
minority about the substance of forward guidance are a first-order issue.
-
Might it be helpful to give the public a more explicit discussion of the
differences in analytical approach between the different views? Tailor that
discussion to handling of uncertainty in communication of forward
guidance?
-
The Global Crisis and the
Debate About Financial Policies
• View that monetary policy ought to put higher
priority on financial stability taken more seriously.
• New urgency for improving prudential policies.
• Recognition that monetary policy and prudential
policies related so probably better if coordinated.
• Increased focus on allocation of responsibilities for
financial policies – among agencies in a country
and among international institutions.
Monetary Policy and Financial Stability
• Before
• First, the Fed cannot reliably identify bubbles in asset prices.
Second, even if it could identify bubbles, monetary policy is far too
blunt a tool for effective use against them. (Bernanke 2002)
• If prices of houses or other assets are partly driven by factors that
are hard to explain and that are believed to give rise to inefficient
allocations and risks of large fluctuations in real economic activity
and inflation, such events will, in one way or another, find their way
into our thinking about monetary policy. (Ingves September 2007)
• After
• The diverse tools of financial regulation and supervision, … should
be, I believe, the first line of defense against the threat of financial
instability. However, …the possibility that monetary policy could be
used directly to support financial stability goals, at least on the
margin, should not be ruled out. (Bernanke October 2011)
Monetary Policy and Financial Stability
• Conditions for using monetary policy to fight bubbles (Kohn 2006)
– Must be able to identify bubbles with reasonable accuracy and
at an early stage to avoid taking actions that unnecessarily harm
the economy.
– Must be a good chance of damping speculative activity with
policy-rate increases that do not take too heavy a toll on the
rest of the economy.
– Costs of ending the bubble early must be less than the costs of
waiting to take action until after the crash.
• These conditions enunciated before the global crisis. The
conviction that all three must hold appears to have softened.
• Growing sentiment that, in a highly uncertain world, the conditions
might be satisfied more often than previously thought.
Prudential Policy Instruments
Illustration of Possible Layering of Capital Requirements
Type of
Requirement
Reason for Imposition
Percent of
Assets
Structural
Capital too low (moral hazard)
7.0
Cross-sectional
Foreign-affiliate loans exceed 25%
2.0
Cyclical
Cost of and need for capital
2.5
SIFI
Size & connectedness externalities
2.5
Maximum requirement
14.0
Maturity Mismatchs: General
• “… Riksbank’s stress tests indicate that the banks …are taking
larger liquidity risks than many other European banks.” FSR
2011:1
• View echoed by IMF staff in their Financial Sector Stability
Assessment for Sweden (July 2011)
• It is noteworthy that neither report stresses maturity
mismatches in foreign currency.
• According to Finansinspectionen’s liquidity reporting
regulations) “All amounts shall be…reported separately in SEK,
EUR, USD and other currencies”. (FFFS 2011:37, Section 5)
• Large short-term uncovered dollar borrowing makes Sweden
vulnerable to liquidity squeeze in dollars. Rough estimate is SEK
450 billion , 14% of GDP, by big four bank. (Nyberg 2011)
Foreign Currency Mismatch: Solution One
• Require banks to reduce maturity mismatch in foreign currency.
• Basel III minimum regulatory standard for Liquidity Coverage
Ratio (LCR) regardless of currency
stock of high quality liquid assets regardless of currency
≥ 100%
net cash outflow over a 30−day time period regardless of currency
• Basel III framework includes not as minimum regulatory
standard but as a monitoring tool a LCR by significant currency.
For the dollar
stock of high quality liquid assets in dollars
≥ no standard.
net cash outflow over a 30−day time period in dollars
• Sweden free to set its own standard
Foreign Currency Mismatch: Solution 2
• Have Riksbank hold significant amount of dollar
reserves and act as lender of last resort in dollars
• When is this solution efficient?
– If dollar liquidity needs of banks uncorrelated,
Riksbank reserves can be low since only a few banks
will need to borrow at any given time.
– But if dollar liquidity needs of banks very correlated,
as they often have been, much less to gain.
– Might be cheaper because Riksbank (via SNDO) can
borrow at a relatively low rate.
Foreign Currency Mismatch: Comparison
• What are the costs and who should pay them?
– Difference between rate for long-term dollar borrowing
and short rate for liquid dollar investment.
– Banks pay a fee for a credit line in dollars at the Riksbank
related to their short-term liabilities
• Difficulties with either solution
– Level of liquidity ratio?
– Amount of fee and relationship of credit line with Riksbank
to short-term liabilities?
Coordination in Principle
• Two instruments: interest rate, capital requirement.
• Three goals inflation  t, output y t , and credit growth f tf t
asterisks indicate desired values. (Instrument scarcity)
Lt    t   t *    y  y t  y t *    f
2
2
 ft 
ft *
2
• Centralization - A single measure of loss (loss function)
– Single policymaker controls both instruments.
• Coordination – Two policymakers behave like one
– Each controls one instrument but both consider effects
of their instruments on all three goal variables
– Advantages: efficient, specialized knowledge
– Disadvantages: accountability problematic
Coordination in Principle
• Decentralization – Divide loss function up and have
policymakers consider only effects on parts they have been
given when choosing their instruments.
L m ,t    t   t *    y
2
L p ,t   f

 yt
ft  ft *
 yt * 
2
2
– Advantages: accountability and specialized knowledge
– Disadvantage: inefficient
• Degree of inefficiency depends on effects of each on the
other’s goal
• Different loss functions not so plausible.
• Differences in model or information
Coordination in Practice
iFinancial Stability Council?
Ministry of
Finance
National
Debt Office
Finansinspektionen
Riksbank
Is It Broke?
• Memorandum of Understanding 2009 sets out the
responsibilities of a “consultation group” of same four
agencies but
– no formal rules for making sure advice considered
– no way of confirming what happened at meetings.
• Apparent efficiency gains from merging Riksbank and FI
• However, looks as though headed for continuation of
something like current division of responsibilities
• Set up a “Financial Stability Council” with same agencies
but changes to remedy shortcomings
– Comply or explain
– Minutes made public with a lag.
Need for Better Models of Financial Behavior
• Models of the transmission of monetary policy through
the financial system more inadequate than realized before
crisis.
• Few models of effects of macroprudential policies
including their possible time variation.
• Now intensification of research efforts to improve the
modeling of financial behavior, including at the Riksbank.
• Efforts include integrating research on financial behavior
into the larger, general-equilibrium models underpinning
all types of macroeconomic and prudential policy actions.