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Swiss monetary policy in the current crisis and beyond.

Decisive action by the Swiss National Bank (SNB) since the outbreak of the crisis has supported financial stability and economic activity. A distinct monetary framework that directly targets the three-month interbank market rate (the Swiss franc Libor) has also helped support domestic credit conditions by limiting the rise in money market spreads compared to other currency areas since the onset of financial market turbulence. With the deepening of the crisis and growing deflationary pressures, the SNB turned to unconventional measures to provide further stimulus, including exchange rate interventions. The sizeable lending activity of Swiss banks in foreign currencies raises the demand for liquidity in foreign currency at times of crisis. It must be ensured that this demand can be met, for example by continued co-operation with other central banks on swap arrangements. Carry trade in Swiss francs has followed the global financial market cycle and has influenced recent exchange rate developments which played a determining role in monetary policy when it was constrained by interest rates reaching zero.

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The current crisis has put the monetary policy strategy and instruments of central banks to a test. The Swiss National Bank (SNB) is no exception. The SNB's primary goal is to ensure price stability, while taking into account the business cycle (Box 2.1). Its first challenge at the outset of the crisis was to maintain financial stability through restoring the proper functioning of money markets. As the financial crisis spread to the real economy and economic recession became a major concern, the SNB started lowering interest rates aggressively until overnight rates reached zero. Unconventional monetary policy measures were then employed. An exit strategy consistent with the price stability objective will move to the top of the policy agenda once the economic recovery takes hold.
Box 2.1. Main goals and responsibilities of the Swiss National Bank
(SNB)

The SNB primary goal is to ensure price stability, while taking due
account of cyclical developments of the economy. The SNB equates it
with a rise in the national consumer price index of less than 2%
per annum. The SNB has a statutory mandate to participate in
international monetary co-operation. Its tasks also include
securing the supply of sufficient money market and currency
liquidity as well as overseeing systemically important payment and
securities settlement systems. To contribute to financial market
stability, the SNB analyses sources of risk in the financial
system. In doing so, it co-operates with the Swiss Financial Market
Supervisory Authority. It also has a mandate to inject liquidity in
the domestic financial system when this is necessary to prevent
systemic crises. Its lender of last resort function is however not
regulated so as to limit the resulting moral hazard of market
participants.


This chapter is divided into two sections. The first assesses how effective the SNB has been in maintaining financial stability and supporting growth since the outset of the crisis, in particular through its original targeting of the interbank market rate. It also analyzes how monetary policy has responded to the new challenge of deflationary pressures through unconventional measures and how the SNB could improve these measures while preparing for the exit strategy. The second section is devoted to the international role of the Swiss franc and the strong foreign currency exposure of the financial sector.

The SNB has effectively supported financial stability and economic activity

The SNB acted decisively from the outset of the financial crisis

The outbreak of the crisis is usually dated to the beginning of August 2007 when the loss of confidence in structured finance products led banks to become reluctant to lend to each other on the interbank market at maturities longer than a few days. On 9 August, the SNB together with the European Central Bank (ECB) was the first central bank to react by initiating a phase of more frequent and larger liquidity provision at repo auctions and to lengthen their maturity. From November 2007, following dollar liquidity shortages among European banks, the Federal Reserve (Fed), the ECB, and the SNB engaged in a concerted action by introducing swap lines between the Fed on the one hand and the ECB and the SNB on the other hand. On 17 December, the SNB conducted a repurchase auction in foreign currency for the first time.

Interbank market turbulences peaked in autumn 2008 after Lehman Brothers failed. On 16 October, the SNB announced an emergency agreement with UBS to transfer up to USD 60 billion of its illiquid assets to a separate entity, mostly funded by the SNB in the form of a loan (Chapter 3). As was the case with other central banks, the SNB increasingly became the primary supplier of liquidity to the financial system. The increased demand for Swiss francs by foreign banks put considerable strains on the Swiss franc interbank market and made it increasingly difficult for the SNB to steer the three-month Libor (see below). To address this issue, a new foreign exchange swap facility was established on 20 October. Through this facility, the SNB provides the ECB with Swiss francs in exchange for Euros. Similar agreements have been put in operation with the National Bank of Poland and the Central Bank of Hungary.

In autumn 2008 the SNB reacted to the strongly worsening state of the economy by rapidly lowering its interest target range for the Libor from 2.25%-3.25% on October 8 to 0-1% on 11 December in four steps (see Figure 2.1).

[FIGURE 2.1 OMITTED]

The SNB's main policy instrument to steer the Libor are weekly repo transactions (see Box 2.2). The one-week repo rates dropped to 0.1% on 21 November, leaving little room for a further reduction in the weekly rate. Nonetheless, the Swiss franc Libor dropped from 1.3% to 0.45% between 21 November and 12 March 2009. The SNB introduced several extraordinary measures that may have contributed to the further lowering of Libor rates. It extended the maturity of its repo transactions and conducted auctions at terms of up to one year, using a fixed rate and full allotment procedure. Second, it communicated to market participants its intention to bring Libor rates down further and thereby tried to affect market expectations. Finally, to counter the strong demand for Swiss francs and ease upward pressure on the money market rates, the SNB concluded, swap agreements with the European Central Bank, the National Bank of Poland, and the Central Bank of Hungary, as mentioned previously. With the deepening of recession, the SNB warned about risks of deflation. Ultimately, it resorted to unconventional measures (see below).
Box 2.2. Monetary policy strategy implementation

The SNB undertakes quarterly economic and monetary assessments at
which it reviews its monetary policy. If circumstances so require,
it also adjusts the Libor target range in between these quarterly
assessments as it did several times in 2008 following the
intensification of the crisis. It publishes a quarterly forecast of
consumer price inflation for a period of three years. It serves as
the main indicator for the interest rate decision. The forecast is
based on a scenario for global economic developments and on the
assumption that the policy rate will remain constant over the
forecasting period.

The SNB implements its monetary policy by fixing a target range for
the three-month Libor, a reference rate for unsecured lending in
the interbank market. It is a trimmed mean of the rates charged by
twelve leading banks and is published daily by the British Bankers'
Association. As a rule, this range extends over one percentage
point, and the SNB generally aims to keep the Libor in the middle
of the range. The need for some degree to respond to temporary
high-frequency shocks (e.g. to the exchange rate) without having to
announce a change in monetary policy motivated the choice of this
operational target. In normal times the SNB steers the three-month
LIBOR through repurchase operations with maturities from I day to
several weeks (Jordan and Kugler, 2004).


The direct targeting of the Libor has helped keeping interbank rates relatively low

Interbank markets have played a significant role in transmitting falling prices for structured financial products to deteriorating liquidity conditions, generating concerns about a credit crunch in many OECD countries. The magnitude of the stress within interbank markets during the current crisis can be measured by the spread between the three-month Libor rate and three-month overnight indexed swap (OIS) rate. This spread gives an indication of the premium market participants expect to earn on interbank loans (the Libor rate) over expected average risk-free overnight interest rates (OIS rate) over the same period.2 Compared with the euro, the British pound, and the US dollar, the Swiss franc spread has remained relatively low from the onset of international financial market turbulence in July 2007 to April 2009 (Figure 2.2). Of the currencies compared, only Swedish Krona spreads have stayed at a comparable level to Swiss spreads.

[FIGURE 2.2 OMITTED]

Differences in the spread between the three-month Libor and OIS rates across countries could, in principle, be the result of differences in perceptions of insolvency risk among the banks dealing in each interbank market. Such perceptions can be measured with the credit default swap rates (CDS). (3) CDS rates of the banks included in each panel used to measure interbank rates in each currency have moved very closely together since the outset of the financial crisis. (4) Hence, the cross-country variation in Libor-OIS spreads cannot be explained by differences in perceptions of solvency risk between the banks dealing in each interbank market represented in Figure 2.2.

The differences in the spreads may have been influenced by monetary policy, via its impact on liquidity risk. In the case of Switzerland, the direct targeting of the Libor may have reduced the fluctuations in the Libor and reduced uncertainty about future availability and cost of interbank funding, lowering the premia risk-averse participants require. (5) In particular, since the targeting of the Libor rate represents a commitment on behalf of the central bank to lean against market forces in the interbank market when, for example, liquidity in the market dries up (which would drive the Libor rate up), banks may be induced to hoard less liquidity and be more willing to lend it on in the interbank market, as lending banks concerns about their own and counterparties' future liquidity is reduced by this commitment. Table 2.1 presents a measure of volatility of interbank interest rates for a country sample from 1 August 2007 to 14 September 2008. (6) The evidence in the table suggests that countries with low volatility in the Libor (Sweden, Switzerland)--and hence, lower uncertainty--experienced lower spreads in the interbank market, as shown in Figure 2.2. In the case of Switzerland, it is likely that the targeting of the Libor rate helped keep its volatility low.

The Libor plays a central role for the refinancing of major banks and companies, and serves as reference for the rates of credit and derivatives contracts, including in the retail mortgage market. (7) Thus, reduced uncertainty about current and future three month funding costs may have had knock-on effects on domestic credit markets, making banks less reluctant to lend.

In early 2009 the economic situation and outlook worsened further and deflationary risks increased sharply. Against this background, the SNB narrowed the three-month Libor target to 0-0.75% at its assessment of 12 March 2009 and stated it would "use all means at its disposal" to lower it to 0.25%. With short-term interest rates almost at zero, the SNB announced three unconventional monetary policy measures to achieve further relaxation in monetary conditions. The further extension of longer-term repurchase transactions with banks, the purchase of private Swiss franc bonds and the purchase of foreign currency against the Swiss franc.

The long-term repo operations target the liquidity shortage in the banking system and are aimed at reducing longer-term interbank lending rates, which are important for credit transmission. Following the announcement, the three-month Libor rate dropped from 45 to 40 basis points reflecting the fact that expected risk-free overnight rates were already close to 0 over the same period.

The purchase of private bonds targets at the reduction of specific credit risk premia in capital markets. In contrast to long-term repo operations that are aimed at a general easing of longer term interest rates, independently of the risks of underlying assets, the purchase of private sector bonds affects credit risk spreads of specific assets. However, the effectiveness of these measures depends on the degree of substitutability of demand between the different types of bonds (with a high degree of substitutability reducing effectiveness) as well as the importance of the targeted capital markets in corporate financing. Purchases of government bonds would represent an alternative, but such measures could only affect term, not risk, premia. As can be seen from Figure 2.3, corporate and government debt markets have less depth than in other countries. The SNB also intervened in the market for bonds covered by mortgages. The covered bonds market is slightly larger than the corporate bond market but still rather small, accounting for about of 8.9% GDP.8 The limited depth of debt markets may limit the provision of additional stimuli. In the case of corporate bond markets it might also aggravate the problem of allocative distortions of a central bank's purchase of privately issued securities.

[FIGURE 2.3 OMITTED]

The unsterilized purchase of foreign exchange was introduced to prevent an appreciation of the Swiss franc against the Euro and to limit the deflationary pressures from falling prices, in domestic currency terms, of imported goods and services, as well as from a severe downturn in exports. The SNB has emphasized that its foreign exchange interventions were not aimed at a competitive devaluation. Indeed, in the context of a global recession, such a devaluation could have a particularly undesirable adverse effect on activity in other countries. Moreover, the interventions in the foreign exchange market were aimed at fulfilling the price stability objective so did not signal a change in the monetary policy framework. The effectiveness of this policy in preventing deflation may also be limited if trading partners are themselves subject to deflation risk. Given the limitations to foreign exchange interventions and the limited depth of the Swiss franc bond market, the SNB may consider alternative measures to alleviate deflation risk.

The appropriate timing for the exit strategy will be crucial

The extraordinary measures undertaken by the SNB throughout the crisis are reflected in a massive increase in the SNB's balance sheet. The balance sheet and the monetary base doubled in size between September 2008 and June 2009. The increase is mainly a consequence of the tenfold increase in reserve holdings in addition to about 15% growth of currency in circulation. With growth rates of 40% and 35% over the same period, Switzerland's narrow money aggregates M1 and M2 have also increased considerably (Figure 2.4). The broad money aggregate M3 has however expanded slowly, so far, although the SNB noted in its assessment from September 2009 that growth accelerated. (9)

[FIGURE 2.4 OMITTED]

As financial conditions improve, excessive risk aversion may abate and banks may become more willing to use their excess reserve holdings to increase lending, leading to a marked increase in broader money. To the extent that this could fuel inflationary pressure once the economy recovers, the SNB needs to be able to withdraw liquidity, which raises the question of an appropriate exit strategy. On the other hand, a premature tightening would jeopardise economic recovery. In this respect, a number of issues need to be addressed, such as the right sequencing, timing and speed, and availability of tools for the phasing out of the unconventional monetary policy. Also, given the unprecedented nature of the size and the scope of the exit, it is important that the SNB effectively communicates its exit strategy.

The SNB states that the exit must occur when "tensions in money and capital markets recede" and when "the advent of a sustained recovery led to increased medium-term inflationary risks" (Jordan, 2009b). The determination of inflationary risks is complicated given the unconventional measures in place, and it is not clear what a "normal" mode of operation of money and credit markets should look like after this crisis. Money market spreads might have become too depressed before the crisis in August 2007 and they might now be above their appropriate level, the long-term equilibrium is hard to determine (IMF, 2008a). The fight sequence of an exit strategy raises the issue of when to unwind unconventional monetary policy accommodation and raise policy rates again (Bini Smaghi, 2009).

Part of the exit will be achieved in a nearly autonomous manner. In particular, many of liquidity-providing programmes are expected to run their course over time, as improving financial conditions lead to less use of those programs and the previously built positions mature. Indeed, provided that the pace of economic recovery is expected to be slow, the SNB can take time for the exit to complete: premature withdrawal of liquidity is even riskier. However, to the extent that the economic recovery turns out to be quicker than expected and/or when the recovery is judged to be firmly established, more active exit may become warranted that would require some deliberate actions on the part of the SNB.

The international role of the large Swiss banks and of the Swiss franc influence policy-making

Carry-trade has been a major driver of exchange rates development of the Swiss franc

The prolonged depreciation of the Swiss franc until the outbreak of financial market turbulence in September 2007 has been mainly attributed to the build up of "carry trade" positions in Swiss franc, the funding currency (Box 2.3). The depreciation is likely to have contributed to Switzerland strong export-led growth in this period (see the 2007 Economic Survey). (10) Following the outbreak of the crisis, the abrupt unwinding of these positions resulted in a high demand for Swiss francs, leading to a sharp appreciation. (11)
Box 2.3. What explains carry trade?

Carry trades are a leveraged form of investment and refers to an
investor borrowing in a low-interest-rate currency (the "funding"
currency) and lending the resulting amount in the
high-interest-rate currency (the "target" currency). For such a
strategy to be profitable, deviations from the Uncovered Parity
Condition (UIP) are necessary. According to the UIP condition the
difference between interest rates reflects the rate at which
investors expect the target currency to depreciate against the
funding currency. On average the overall returns from the funds
lent in the target currency are equal to the returns from lending
in a funding currency. While evidence confirms that the UIP holds
in the medium run, in the short run exchange rates seem to move in
the opposite direction (which is the so-called "forward discount
premium puzzle"), thus creating scope for short run profits,
although these positions imply high risk.

Positions taken while "carry trade" is built up will tend to
depreciate the funding currency. This depreciation tends to make
carry trade profitable for some time if interest rates do not
change. Hence, there is a risk that a carry-trade feeds on itself,
creating a speculative bubble. This is particularly the case if the
depreciation has a limited impact on inflation, and hence on policy
rates set by the Central Bank.


The Japanese yen and the Swiss franc have been cited as the main funding currencies. Japan has had the lowest interest rates in the world since the adoption of the zero interest policy in 1998. Switzerland also had very low interest rate constantly below 1% between March 2003 and March 2006 (Figure 2.5). Australia, Hungary and Poland, which have been widely cited as target currencies for carry trade, have been maintaining considerably higher interest rates.

[FIGURE 2.5 OMITTED]

While direct evidence on the extent of carry trade is not available, indirect evidence is provided by the opposite developments in the effective nominal exchange rates of funding and target currencies (Figure 2.6). After the financial crisis emerged in August 2007, the Japanese Yen and the Swiss franc started appreciating. These movements suggest that carry trade positions accumulated before the crisis were progressively unwound.

[FIGURE 2.6 OMITTED]

As mentioned, the strong appreciation contributed to risk of deflation. Moreover, banks which had lent in Swiss francs outside Switzerland required liquidity in Swiss francs, putting upward pressure on the interest rates in the Swiss franc interbank market. (12) Both the foreign exchange market intervention, and the swap agreements which provided Swiss franc liquidity via various foreign central banks, eased this pressure.

Monetary policy needs to take account of the build-up of financial market imbalances

One of the debates arising from the global financial crisis is whether monetary policy needs to lean more strongly against the credit cycle in upswing periods in order to avoid the build-up of financial market imbalances, even if inflationary pressures are not apparent (e.g. White, 2009). There is considerable evidence that Phillips-curves flattened in pre-crisis years, in part owing to the increased credibility of inflation objectives (see e.g. Pain et al., 2006). As a result of flatter Phillips curves, the impact of low policy rates in periods of expansion of lending and economic activity may not make itself manifest in consumer price inflation forecasts which guide monetary policy, but through other imbalances, such as asset bubbles. In Switzerland, for example during the economic expansion that preceded the crisis, ex-ante real policy rates peaked below 2%. (13) While low interest rates did not generate strong growth of lending domestically, they appear to have contributed to carry trade.

Monetary policy at all times takes into account the impact of exchange rate movements on inflation over the inflation forecast horizon. However, in the build-up phase of carry trade, monetary policy was not constrained to resort to exchange rate policy, particularly so since price stability was not threatened over the forecast period, giving some room for the mutually reinforcing build-up of carry trade positions and the depreciation of the Swiss franc. By contrast, in the wind-down phase, monetary policy was more constrained in its instruments and exchange rate interventions had to be utilized to counteract deflationary pressures. Maintaining a symmetric policy response with respect to upward and downward pressures on the exchange rate is important in order to prevent the risk of strengthening the self-propagating behaviour of carry trade. Otherwise, speculators could expect that their losses in the wind-down phase would be limited if they anticipated that the central bank only intervenes to limit currency appreciation. Such expectations could eventually fuel a new speculative bubble of carry trade positions.

The SNB elaborates its inflation forecast with a portfolio of econometric models and indicators, which incorporates credit and money supply growth. Nonetheless, further investigation could be useful as to whether monetary policy should help prevent strong credit growth from contributing to financial market imbalances even when such credit growth does not appear to lead to inflationary pressures over the forecast horizon. Indeed, a number of episodes of strong expansion of lending and economic activity which were followed by severe financial crises and recessions were not accompanied by rising inflation (White, 2009). The SNB should further examine whether its current policy framework already takes sufficient account of the potential costs of asset imbalances. It has been argued that it may be difficult for monetary policy to mitigate such imbalances as bubbles in asset prices are difficult to identify. Moreover if leaning against asset market booms were to become an additional objective of monetary policy, the inflation rate deemed consistent with price stability could be undershot during such a boom. On the other hand, a policy of leaning against excessive asset market booms could be based on a broad assessment of developments in lending volumes as well as asset prices, relative to historic trends, so may not require identification of specific asset price bubbles. Undershooting of inflation targets may carry little risk in periods of credit expansion as they are typically characterised by vigorous expansion of economic activity (see White, 2009, and references therein, for a discussion of these arguments).

The foreign currency exposure of Swiss banks requires appropriate instruments to preserve the SNB's role of lender of last resort

Owing to the maturity mismatch that characterises bank balance sheets, with assets having more long-term maturities, any bank is potentially vulnerable to a run by its creditors, generating a liquidity crisis. Perceptions that such a crisis may occur can make banks more vulnerable. Hence central banks have assumed the role of lender of last resort. However, their capability to supply liquidity in foreign currency is limited.

Bank exposure to foreign currencies, especially US Dollar, is large

More than half of Swiss banks' assets are denominated in foreign currency, mostly in US dollar (Chapter 3). A drying-up of the foreign currency market could challenge the capability of the SNB to provide enough liquidity. This point is reinforced by the large size of the Swiss banking sector relative to the size of the economy. The net position towards banks in US dollars increased dramatically since 2002, peaking in mid-2007 (Figure 2.7). The funding via customers and money market instruments was by far too low to offset the gap between assets and liabilities in US dollar. This gap may be understood as measuring the extent to which big Swiss banks potentially had to rely on foreign exchange swaps (BIS Quarterly March 2009).

[FIGURE 2.7 OMITTED]

Risk of these exposures emanated from the potential inability to roll-over the foreign exchange swaps, which tend to be short-term. To honour their swap arrangements, banks were forced to sell US dollar assets prematurely. With a declining and increasingly illiquid market for these assets, their sale became increasingly difficult and was associated with high losses. As the crisis intensified, US banks worried about their counterparties' financial soundness and were uncertain about their own liquidity needs. This made the banks increasingly reluctant to provide US dollars via foreign exchange swaps. (14) The problem was particular severe for those European banks which do not have direct access to the Federal Reserve's auction facilities. (15)

The disruption in foreign money markets required the SNB to step in

To address the difficulties in the foreign exchange market the Fed and the SNB concluded a US dollar-Swiss franc swap agreement. The Fed engaged in a similar agreement with the ECB and other central banks. The agreement initial maximum limit for the provision of US dollar was lifted in mid-October 2008. The SNB provided US dollars obtained through the swap agreement to its counter-parties in repo operations. All counterparties (including foreign banks) providing the collateral according to the general SNB rules had access to this facility.

The scale of the foreign currency liquidity provision in Switzerland through dollar repurchase operations offered to commercial banks was relatively large in the early phase of financial market turbulence, reaching 6.5% of GDP in October 2008, but dropping subsequently (Figure 2.8).(16) However, these figures do not include the loan of USD 26.6 billion (about 5% of GDP) provided by the SNB to a fund ("StabFund") set up to purchase toxic assets from UBS. Thus, the stock of foreign currency support would reach about 5% of GDP at the end of the first quarter 2009, among the highest of the countries compared in Figure 2.8.

[FIGURE 2.8 OMITTED]

The relatively fast reduction in foreign currency provision through dollar repurchase operations may indicate that Swiss banks were no longer in large need of such funds or were able to mobilize funds in different ways. The two large banks (UBS, and Credit Suisse, CS), which conduct most of the foreign operations of Swiss banks, have access to the liquidity lines of the US Fed, as they are both primary dealers. In fact, according to the BIS (March 2009), US dollar liabilities booked by European banks' offices (including borrowing from the Federal Reserve) increased during the crisis and various European banks channelled funds via inter-office transfers to their parent companies. Indeed, supply of foreign currency was more important for other banks, which do not have the privileged access to the Fed's facilities. On average 14 banks (including foreign banks with access to the SNB's facilities) participated in the auctions until mid-October 2008 (which marked the peak in outstanding US dollars provided by the SNB).The appreciation of the Swiss franc may also have helped Swiss banks to acquire US dollar liquidity. However, the provision of foreign currency liquidity by foreign central banks remains conditional on their monetary policy objectives, and the pattern of Swiss franc appreciation at times of crisis cannot be taken for granted (Chapter 3).

The SNB role as a lender of last resort may be challenged

In the long run, the large exposure of domestic banks to assets and liabilities in foreign currency could again be associated with a disruption of liquidity in foreign currency. Central banks have traditionally resorted to three ways of providing foreign currency to commercial banks: the provision of its foreign currency reserves, the direct borrowing of foreign exchange in the market and the exchange of national currency against foreign currency directly with foreign central banks.

The first option would require that the SNB could ensure a high enough reserve level to provide foreign reserves when needed. Given the extraordinary extent of foreign assets it is however impossible to cover the entire stock. The second option, the direct borrowing in the market, may not ease currency pressures (as the central bank would demand foreign currency).

The third option, the swap between central banks, is the most attractive because of its low chance of interfering negatively with the foreign exchange market. Another reason which makes swap agreements preferable is the signal they provide to markets. The mechanism demonstrates the willingness of policy makers to act promptly (BIS 2008). Consequently, a co-operation of the SNB with other central banks on swaps arrangements to provide liquidity in foreign currency should be continued as needed. This should help avoid liquidity issues in foreign currency. However, it may generate moral hazard in the banks' management of foreign currency liquidity. In view of the extraordinary size of the foreign activities of the two big Swiss banks, effective regulation of liquidity risks is particularly important for Switzerland (Chapter 3).
Box 2.4. Recommendations on monetary policy

* As the economy recovers the SNB should withdraw excess liquidity
in order not to jeopardize price stability over the medium term. At
the same time, it must not act too soon, for otherwise the recovery
could be put at risk. The strategy with respect to the withdrawal
of excess liquidity must be clearly communicated.

* The SNB should further examine whether its current policy
framework already takes sufficient account of the potential costs
of asset imbalances.


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Notes

(1.) Salvatore Dell'Erba, Simone Meier, Pascal Towbin and Sebastian Weber contributed research and drafting to Chapter 2.

(2.) Libor rates are the benchmark used for interest rates that banks charge to each other on unsecured loans in major currencies worldwide. They are calculated by the British Bankers' Association (BBA) as an average rate from quotes contributed by a panel of banks that varies across currencies. OIS contracts are agreements between two counterparties to exchange at maturity the difference between an agreed fixed rate (the OIS rate) and the average of the overnight interest rates over the period. OIS rates therefore provide a measure of expected future overnight rates that approximate risk free interest rates.

(3.) See e.g. Michaud and Upper (2008), CDSs are bilateral insurance contracts against credit risks. The protection buyer pays a fixed fee (premium) expressed in basis points. If a certain pre-specified "credit or default event" occurs, the protection seller covers the occurred losses. The CDS rate for a specific bank should reflect the credit risk premia that a lender would demand for a loan given to this specific bank.

(4.) Similar changes in CDS rates for various currencies are in fact not too surprising since the banks that participate in the various Libor panels are similar.

(5.) Other policy settings, such as the strictness of collateral requirements in monetary operations, may also play a role.

(6.) For each period with an unchanged policy rate a separate mean of the OIS swap rate and the LIBOR is computed. The mean is defined as the average of the corresponding daily interest rate during the period. The volatility is calculated as the standard deviation with respect to this varying mean.

(7.) See SNB (1999), IMF (2008a) and Jordan, Ranaldo and Soderlind (2009).

(8.) Sorg (2009), estimates the overall size of the covered bond market to 47.5 billion CHF at the end of 2007.

(9.) In the euro area, by contrast, the relationship between the various monetary aggregates has remained stable.

(10.) The increase in the current account surplus within this period is mainly attributable to an increase of net exports in service and net investment income, while the goods trade surplus has remained stable around at 1.5% of GDE For a detailed analysis of the Swiss current account surplus, see e.g. Jarret and Letremy (2008).

(11.) Other explanations consistent with the depreciating trend are the substantial sale of gold by the SNB started in 2005, and the diminished role of the Swiss franc as a reserve currency after the inception of the Euro (see IMF, 2008a).

(12.) Swiss banks have rather low exposure to these markets (SNB, Monthly Bulletin on Banking Statistics, April 2009). Most lending has been done by other European banks often using the Swiss franc as a funding currency.

(13.) Assuming inflation expectations around 1%, consistent with the definition of price stability and long-term historic inflation performance.

(14.) Even though many transactions are done via clearing houses or with the provision of collateral a significant part of FX swaps is done in an uncollateralized way (see BIS, Quarterly Review Sept. 2008). Hence, counter-party risk does still play an important role.

(15.) The problem was heightened by the difference in the time zones. European banks were asking for US dollar liquidity in early office times in the US, when US banks were still unsure about their own liquidity needs and therefore unwilling to engage in trades. This made the rollover of US dollar liabilities increasingly costly since markets did not provide sufficient liquidity at normal conditions.

(16.) The data for the foreign currency provision comes from the respective central banks. In the case of the ECB the outstanding foreign currency provision is constructed by cumulating the allotments taking account of the different maturity horizons. This includes both the US dollar and the Swiss franc swaps. For other countries the newly introduced items in the balance sheets were used: for Sweden "Claims on resident in foreign currency", for Canada "Loans and receivables--Securities purchased under resale agreement", for Japan "US dollar funds-supplying operations against pooled collateral" and for Denmark "Other Lending--Banks in Currency". For the SNB the item "claims form USD repo transactions" was used.
Table 2.1. Libor volatilities

                                                              United
                                  Swedish   Swiss   British   States
                           Euro   korona    franc    pound    dollar

Libor 3 month volatility   0.18    0.11     0.05     0.21      0.18

Source: Bloomberg, British Bankers Association, own calculations.
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Title Annotation:Chapter 2
Publication:OECD Economic Surveys - Switzerland
Date:Dec 1, 2009
Words:6372
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