Technical Articles

International Journal of Government Auditing – January 2012


The Role of SAIs in Maintaining Financial Stability

Since it is in the public interest to have stable and resilient financial systems, governments around the world are committed to maintaining financial stability. Supervising a country’s financial system and promoting financial stability are often within the realm of central bank operations. Many countries also have separate authorities to supervise individual financial market participants. According to a report by the INTOSAI Global Financial Task Force: Challenges to SAIs, the role of SAIs in maintaining financial stability is to evaluate the appropriateness of the supervisory structure for financial markets, even if the work of central banks may fall outside the audit mandate of some SAIs.

In 2011 the Swedish National Audit Office (NAO) audited the supervision of Swedish banking operations in the Baltic region before the worldwide 2008–2009 global financial crisis.[1] The Swedish NAO studied how the Swedish Central Bank and Swedish Financial Supervisory Authority, the two entities charged with oversight responsibilities for banking operations, assessed and reported the risks that arose in the Swedish banking system from 2005–2007, a time when commercial banking operations expanded rapidly in the Baltic countries. The results of this audit identified important findings related to the government’s responsibility to maintain financial stability and provide, therefore, an example of the role that an SAI can play in maintaining financial stability by evaluating the supervisory structures for financial markets.

The Swedish NAO’s audit resulted in the following key observations and recommendations:

The Baltic Expansion Implied an Increased Risk in the Banking Sector

The Swedish banks increased their risks by rapidly expanding into the Baltic region during a time of uncontrolled growth in the region’s economies. Signs of a high risk level included extreme credit expansion, rapidly rising home prices, lending in foreign currency, and rising labor costs with fixed exchange rates. All in all, the risks increased to the point that they materialized during the financial crisis.

The Authorities Underestimated the Risks

Although concerns became more substantial as imbalances grew, the risks were considered to be manageable during the entire 2005–2007 period, in part because of the banks’ good capital adequacy. The authorities underestimated the credit risks but, most importantly, they misjudged the liquidity risks, especially those regarding the banks’ foreign financing. However, this mistake was shared by almost all other central banks, supervisory authorities, academics, and the investor community across the world.

The Authorities’ Mandates Need to Be Revised and Clarified

The Swedish Central Bank and Swedish Financial Supervisory Authority have different tools and analysis functions. The former oversees the financial system as a whole, while the latter focuses on individual institutions and can apply sanctions if a financial institution falls short in areas such as capital adequacy or risk management. The mandates of these authorities need to be revised and clarified, and tools to safeguard financial stability in a broad sense need to be developed. Furthermore, a macroprudential policy—an expressly legislative mandate to manage risks in the financial system as a whole—does not exist. The Central Bank and Financial Supervisory Authority should determine how a regulation framework for such a macroprudential policy should be developed and who ought to be responsible for it.

Supervision of Banks with Operations in Several Countries Was Inadequate

The Baltic authorities felt that they had few tools and could not control the development of their own credit markets. They could only apply a strict legal framework on local banks, and the branches of foreign banks—such as Sweden’s—could not be included in modified rules. After the crisis, a new structure and several new regulations were created within the European Union to handle, among others, issues regarding cross-border banks. This should improve conditions so that the issues that branches of foreign banks experienced in the Baltic region will be easier to manage in the future.

The Communication by the Two Authorities Was Inadequate

The audit identified a gap between the Central Bank’s view of its communication of the risks in the Baltic region and other participants. Representatives from the Central Bank believed that they had sent out a stronger message regarding the risks than what the recipients perceived. The fact that the Central Bank discussed the risks in the Baltic region in its biannual reports on financial stability seems to have had little effect on the banks’ actions. Establishing a public arena with regular hearings on financial stability in the Swedish Parliament would force both the Central Bank and Financial Supervisory Authority to take a clear stand on the risks and communicate them to a broader audience.

A Need for Better Coordination

Coordination between the two authorities and between them and the government needs to be strengthened. Sweden’s institutional structure demands significant coordination between its Central Bank and Financial Supervisory Authority, on the one hand, and between these authorities and the Ministry of Finance on the other. The audit demonstrated a good climate of cooperation between the Central Bank and Financial Supervisory Authority, aided by personal contacts between members of staff in both entities. However, it is important to have operations and methods for collaboration that go beyond personal contacts. Furthermore, although the two entities had had an agreement on methods for collaboration since 2003, the collaboration had not been evaluated. The Central Bank and Financial Supervisory Authority should continue their close cooperation to maintain financial stability and report to the Parliament or government on how the cooperation has been carried out during the year. A decision should be made as to whether this cooperation should be evaluated internally or externally.

The Stress Tests Were Not Tough Enough

Overly cautious assumptions were made in the stress tests of the financial institutions’ resilience to adverse economic outcomes. The stress tests that the Swedish Central Bank carried out were based on either assumptions of a geographically isolated downturn in the Baltic economies or a normal business cycle slow-down. A more plausible test would have assumed that the Baltic countries were having problems at the same time the rest of the world was facing an economic downturn. By using cautious assumptions in stress tests, the banks’ strength was overrated and the risks to financial stability were underrated. The Central Bank should clarify what stress tests aim to measure and ensure that stress test assumptions reflect realistic risks. Future stress tests could assume downturns of different magnitudes in the economy, which would provide more information on the banks’ strength.

The Government Has No Tools for Limiting Its Implicit Guarantee to the Financial Sector

The government has an implicit responsibility to support the banking system when crises emerge. The Icelandic example shows that the guarantee can be unreasonably costly when the banking sector grows very quickly in proportion to the rest of the country’s economy. Today, the Swedish government has no tools to limit the size of the banking sector and, thus, its implicit guarantee. Since the Swedish banks had a dominant role in the Baltic payments systems, the Swedish government also assumed an implicit responsibility for these and, thereby, for the countries’ economic stability. The development shows that the Swedish government can have an indirect responsibility for other countries’ economies when Swedish banks achieve a dominant role in a foreign credit market. The government should examine whether risks in the banking sector and the implicit state guarantee can be limited. The government should make sure that it is regularly informed of all risks involved—not only those regarding the banks’ capital adequacy, but also those that the banks’ operations in other countries entail.

Conclusion

The global financial crisis highlighted the importance of the stability in and an efficient regulation of financial markets. Governments’ implicit guarantees to the financial market imply that vast sums of taxpayers’ money are at stake. The Swedish NAO’s audit pointed to several challenges in the institutional setup for the work with financial stability in Sweden prior to the crisis. The fact that the responsibility for financial stability is divided between several independent authorities and the government requires effective cooperation and coordination between these entities. The audit also identified problems in assessing systemic risks and an ineffective regulatory system for cross-border banks. To promote financial stability, the audit recommended that a regulation framework for a so-called macroprudential policy should be developed and that the Parliament should examine the possibility of regularly organizing public hearings on financial stability. These audit results underscore the important role SAIs have in promoting financial stability by evaluating the effectiveness of the supervisory structure for financial markets.

For additional information, contact the author at thomas.hagberg@riksrevisionen.se.

[1]Maintaining Financial Stability in Sweden—Experiences from the Swedish banks’ expansion in the Baltics (RiR 2011:9). An English translation of the audit can be downloaded in full from the Swedish NAO’s website (www.riksrevisionen.se/en/Start/2011_9).