Sweden's Minister of Finance explains the Swedish Stability Fund and Stability Fee.
The Swedish Stability Fee and the Stability Fund have attracted considerable international attention and both initiatives have been the subject of much international debate. The path chosen by the Swedish government provides for an easily implementable solution to some endemic problems in the finance sector by ensuring that it contributes to the costs of financial stability. In this short essay, we briefly describe the Swedish government’s motivations behind the introduction of the Stability Fee and the Stability Fund. Thereafter, we discuss how the two fit into the ongoing debate on financial regulation.
Support Measures Should Not Aim at Saving the Owners
The banking sector plays a crucial role in any economy; it allocates both capital and risks, and it acts as a payment intermediary. All three of these factors are indispensable for our modern economies. As a result, governments may have no choice but to rescue key players which have become too important to fail within that system. Anticipation of this ‘last resort support’ may induce large institutions to take on too much risk in the knowledge that they are likely to be saved from failing. The government consequently faces two interrelated problems; first, it needs to mitigate moral hazard which leads to excessive risk taking and, second, it must ensure the availability of sufficient resources while safeguarding the interest of the taxpayer in case of an intervention. The Stability Fee and the Stability Fund aim at navigating both of these problems.
The Act on State Support to Credit Institutions provides the Swedish government with a broad mandate to deal with situations that might cause serious disturbances to the Swedish financial system. Examples of measures are guarantees, support in connection with acquisitions and capital injections. Support is only provided subject to a contract between the National Debt Office and the recipient of support, conditions that are put in place to ensure that losses are borne by shareholders and junior debt holders in the first instance. This key principle, which likewise came under international scrutiny during the Swedish financial crisis that occurred during the 1990s, allows the government to deal with moral hazard issues. Owners of financial institutions may not be saved by the taxpayer. Neither should management. Moreover, support should be made on non-concessionary terms to maintain a level playing field.
In cases where parties fail to reach an agreement, conditions can be considered by a special Appeals Board. Ultimately, the National Debt Office has the legal power, under pre-defined circumstances, to redeem all outstanding shares in an institution if it is of extraordinary importance that the government takes control of it.
The Swedish Stability Fund
The Swedish government has set up a Stability Fund whose purpose it is to finance support measures for credit institutions. The Fund will be fed through a Stability Fee which is paid by credit institutions (see below), and is therefore financed ex ante. Reimbursement fees for support measures, e.g. government guarantees, will also be channelled into the Stability Fund. The Swedish government has initially allocated SEK 15 billion (approximately EUR 1.5 billion) from the central government budget to the Fund. The National Debt Office is responsible for managing the Fund and places the Fund’s capital in an interest bearing account. As this will lower the government’s borrowing needs, it is considered a more efficient administration of the means than a fund that invests in assets. This is equivalent to investing in government bonds which, in a crisis, are the most liquid asset.
The Stability Fund’s targeted size of 2.5 per cent of GDP on average is based on experience from earlier domestic and international financial crises. The short-term need of financing support measures may nevertheless exceed the size of the Fund. The National Debt Office therefore has the right to grant the Stability Fund unlimited credit.
By construction, the build-up or use of the Stability Fund affects the central government’s borrowing needs but has no direct impact on the standard measures of central government’s spending. This is of great importance, as the Swedish central government is obliged to comply with a pre-determined limit on fiscal expenditures. The Stability Fund, then, is not pro-cyclical as it will not affect central government spending. This is of particular relevance with respect to economic downturns. In contrast to ex post funding mechanisms, the Stability Fund will not place an additional burden on the financial sector following a crisis when the sector is weak.
The Stability Fee
The basic idea with the Stability Fee is to make credit institutions pay a fee in proportion to the risk they pose to financial stability. In ensuring public acceptance for the measures that the government must take, it is key that the banking sector pays for its own rescue and that taxpayers’ money does not constitute a first line of defence. This approach is also reflected by the Swedish government’s key principle not to use taxpayer money to bail-out shareholders and to replace management. Complementing this principle the fee allows to better align the incentives of the banks with those of the society within which they operate.
All banks and other credit institutions incorporated in Sweden that may receive support are obliged to pay the Stability Fee. The fee is triggered by the company’s legal form and not some threshold size. The argument for including small institutions is that financial stability is a public good and that the benefits cannot be restricted to large institutions. Swedish banks will pay for their branches in foreign countries, but not for their subsidiaries in those countries. Foreign banks do not pay for their Swedish branches, though their subsidiaries are subject to the fee.
The fee, which amounts to 0.036 per cent per year, is levied on parts of the institutions' liabilities according to an approved balance sheet. The basis for calculating the fee are all liabilities excluding (i) equity capital, (ii) junior debt securities that are included in the capital base, (iii) group-internal debt transactions between companies that pay the Stability Fee, and (iv) debt that has been issued under a guarantee program. Hence, institutions do not pay a fee for risk-bearing capital or for liabilities for which they already pay another fee. That risk-bearing capital is excluded reinforces the signal that owners will not be rescued and it punishes banks that are more dependent on borrowing in the market.
The Stability Fee first application will be based on the balance sheets for the financial year 2009. However, in order not to interfere with the recapitalisation of the financial sector, only a reduced fee (50 per cent) will be charged on the 2009 and 2010 balance sheets.
The Stability Fee can be viewed as being based on a crude measure of systemic risk since the size of the balance sheet, everything else being equal, is positively correlated to the impact of a failure and the magnitude of the contagion effects. The Swedish government intends to improve the design of the Stability Fee and is currently analysing how this can be done. Our personal beliefs are that two issues will be at the centre of this analysis. The first issue is how to allow for risk differentiation, i.e. how to let banks pay more for risk with a systemic impact? Here, remuneration might, among others factors, have to be considered. The second issue is whether the deposit guarantee scheme can be merged with the Stability Fund and, if so, how this should be done. Naturally, the ongoing reform of financial regulation has to be taken into account.
The International Perspective
Much of the international debate has focused on a few interrelated issues; how to make the financial sector contribute to the cost of financial stability, how to reduce moral hazard and the ‘too big to fail’ problem, and how to reduce pro-cyclicality in the regulatory framework. The combination of a Stability Fund and a Stability Fee provides a part of the answer on each issue, yet there is a need for complementary regulation and action, both from the governments and from the industry itself.
On the issue of how to make the financial sector contribute, the debate has narrowed the alternatives down to some form of stability fee, and a tax on financial transactions. Both the IMF and the European Commissions seem to favour a stability fee and the issue is on the G20 agenda. The US, UK, Germany, France and some other countries have proposed similar fees on their financial sectors. Compared to a transaction tax, the stability fee has a number of obvious advantages: it addresses risk; it does not hurt liquidity in the financial markets; it can mitigate the ‘too big to fail’ problem by capturing an institution’s contribution to systemic risk; and, most importantly, it does not require global participation.
Letting the financial sector finance a national stability fund is a first step to a more sustainable financing system that reduces the strain on the government’s budget from potential future financial crises. Revenue from the fee must be used to reduce the level of public debt if it is to increase the manoeuvrability in the future. This also happens to be the best way to make the fund highly liquid.
Of equal importance to these considerations is the political dimension. Taxpayers should perceive the fee as aiming at undoing the unfairness of owners and management pocketing the full gains of good times while leaving taxpayers to pay when the sector’s bets turn sour. This legitimises eventual government support and increases the government’s ability to ensure financial stability. Having said this, we recognise the need in some countries with large deficits caused by the financial crisis to use their revenue to close the deficits. Any international agreement must therefore be flexible enough to reflect these needs.
Using the revenue from the stability fee for lowering the sovereign debt is viewed in some quarters as increasing moral hazard. We don’t share this view. Moral hazard arises when shareholders and subordinated debt holders, and eventually managers, act under the expectation that they will be rescued at the expense of the taxpayer. Such expectations are best kept at bay through credible commitments not to bail out shareholders or other risk-bearing parties, and to fire management in the event of a takeover. Government guarantees and any capital injections must be made on non-concessionary terms. Incorporating such a commitment in a global agreement is a key element in strengthening credibility and providing for time-consistent government policies.
The driving forces behind the ‘too big to fail’ problem are economies of scale and scope and an unmotivated funding subsidy reliant on implicit government guarantees. A risk-differentiated stability fee that takes systemic importance, systemic risk and contagion effects (interconnectedness) into account is one way of countering economies of scale and scope as well as low funding costs. The financial sector must be made to internalise externalities that otherwise lead to private profits and impose costs on society.
The issue of pro-cyclicality is addressed through ex ante financing and a reduction of public debt, which eliminates crowding-out effects on public consumption and the necessity of further burdening the financial sector ex post. Ex ante financing is also fairer than ex post financing in the sense that it makes all eligible institutions contribute, including those that will default, instead of restricting payments to surviving institutions.
Though the advantages of a Stability Fee are many, it does need to be bolstered by complementary measures, such as a credible resolution framework that keeps moral hazard at bay, as has been discussed. Increased capital requirements and other measures to make financial institutions more robust are also needed. In addition, proactive action by the industry is warranted, e.g. an increased use of contingent capital. Such complementary measures lower the probability of requiring future support measures, but they can never fully eliminate the potential need for government intervention.
In reality, the only thing that can be said for certain about the finance sector is that there will be new crises in the future whose shape and form nobody can predict. The best a responsible government can do is to create institutions that facilitate crisis management. Instead of being viewed as substitutes, the Stability Fee and other measures should be viewed as complements. Instead of talking of “replacing”, we should speak of a “proper balance” and avoid a regulatory cycle where periods of excessive regulation are followed by periods of laissez faire. Based on this view, we in the Swedish government firmly believe that the world would benefit substantially from an international agreement on some form of stability fee that incorporated stringent principles for a resolution framework.
Anders Borg, Minister of Finance, Sweden and Björn Segendorf, Ph.D, Special Adviser