The Riksbank and financial stability Much work is being done with a view to avoiding financial crises. The Riksbank is one of the participants in these endeavours. Our efforts have included the development of an intellectual framework for contributions to improving the stability of Sweden’s payment system. In recent years it has become increasingly clear that the Riksbank has a main function that is probably just as important as maintaining price stability, namely promoting financial stability. The financial system has a central function in the economy and performs three main tasks: firstly, it handles payments; secondly, it channels savings to investments with a good return for future consumption; and thirdly, it spreads and reduces economic risks in relation to the players’ required returns. A smooth functioning of all these activities facilitates economic growth in that the production of goods and services as well as employment are promoted by lower costs and risks. In this way the financial system contributes to increased prosperity. In view of the financial sector’s central function in the economy, the authorities are particularly active in monitoring and regulating developments in this sector. In Sweden, the work for financial stability was accentuated by the serious incidents in the early 1990s. Since 1989 the Riksbank had been required by law to “promote a safe and efficient payment system”. The problems among Swedish banks naturally strengthened the Riksbank’s determination to contribute to the work on stability so that similar events would not occur again.
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  5  BIS Review 23/1999  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.