Asset encumbrance and its relevance for financial stability

In this article, Reimo Juks analyses how banks in Sweden and other countries encumber assets in order to reduce their funding costs. Part of this pledging may be justified in periods of financial unease, when investors seek safety at the same times as there is a shortage of lowrisk securities. The possibility to encumber assets or pledge collateral thus can make funding less expensive. However, if the encumbering of assets becomes very common it may also contribute to the creation of risks in the financial system. This is because the encumbering of assets has the potential to shift risks to non-secured creditors. If unsecured creditors count on being able to transfer some of this risk to the government, and thus to the taxpayers, there is a possibility that the proportion of encumbered assets in the banking sector will be larger than is socially justified. To counteract this possibility it may be appropriate for the authorities to strengthen market discipline. This can be done, for example, by making the deposit guarantee dependent on the level of encumbrance and by increasing the transparency of the banks' asset encumbrance.

The article is included in this year's third issue of the Sveriges Riksbank Economic Review, which was published on 17 October.