Jean-Claude Trichet: Key lessons from the crisis
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the "Annual
conference 2009", organised by the Asociación de Mercados Financieros, Madrid,
23 November 2009.
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Ladies and Gentlemen,
First of all let me thank the Asociación de Mercados Financieros for inviting me to its Annual
conference. It is a special honour for me to speak directly to so many active participants in
Spain's financial sector and beyond. Your association provides an important platform for
market participants to reflect and address the challenges and opportunities for the sector in a
rapidly changing environment.
The financial industry is a key part of the service sector, the infrastructure that makes
businesses efficient and a source of value for the economy.
We all have been witnessing the formidable change and progress of the Spanish economy
since its accession to the European Community in 1986. Today, and despite the crisis, the
Spanish economy is close to the highest standard of economic and social progress available
worldwide. The 1990s and the early years of this century have inspired perceptions that a
renewed siglo de oro had started.
But the crisis has not spared this country. Spain's unemployment rate is once again edging
above euro area averages, with impacts on private consumption and capacity utilisation.
Looking forward, Spain's convergence to a balanced growth pattern will require a more
balanced progression of income components. Consumption needs to be less dependent on
perceived wealth gains, and investment to be more diversified, well beyond the construction
sector. This will make participation rates more sustained.
For what concerns the Spanish financial sector, it has long been a source of strength and
national pride for this country. In many respects, Spain can be a leading example for global
financial reform. I will say more on this later in my talk. Spain's financial system has proved
resilient to the shock in the early stage of the crisis. Supported by prudent regulation and
supervision, the banking system in this country has built dynamic provisioning cushions
during good times. And the traditional role of banking, founded on long-term relationships
with customers, has largely been preserved. Looking forward, this is an important asset.
But a solid future calls for some areas of adjustment in the way the financial industry
behaves. The exceptional support of public policies will, at some point, have to be withdrawn.
Private sector confidence in the future will need to replace policy intervention as the main
spur of growth.
The Asociación de Mercados Financieros and its members are an important link in the chain
through which confidence will build and transmit to your customers. The obvious prescription
for a sustainable return to stability is for many of you to simply look back at your past of
prudent and sound management.
Today, I will mainly focus on what we have done at the ECB to deal with the crisis and to
support the euro area economy and its banking sector. In particular, I would like to explain
the policy that the ECB has adopted to support credit flows in the current environment. This
policy has provided a tangible support to households' disposable incomes and firms' credit
conditions in all member countries. The people of Spain - a country where a large share of
the outstanding mortgages have adjustable rates - have benefited from this policy
considerably.
I will draw some key lessons for the stability, resilience and health of the financial system, the
global economy and the individual economies more specifically.
Structural reforms in Spain - as in other euro area countries - cannot be avoided or
postponed. But in facing these challenges, Spain can build on its past of consistent progress
and success since its entry into the European Union, on a young and well-educated labour
force and on solid institutions.
I. The ECB's response to the crisis
As you all know, the start of the turbulences began on 9 August 2007. The interactions of
very bad risk management and wrong incentives in the financial industry, excessive
complexity in financial products and underlying global imbalances were responsible for the
previous credit boom and the ensuing bust. The asset cycle turned, and many of the missing
links in the financial chain were exposed.
Then, the collapse of a major financial player mid-September 2008 transformed a large-scale
crisis of confidence into a global financial panic. Financial intermediaries scrambled to
restore liquidity buffers, shed risk and tightened lending conditions. Collectively, they
engaged in a large-scale process of "deleveraging". Credit spreads surged and trading
activity in a large number of markets collapsed.
In these unprecedented circumstances, the ECB's primary mission was to preserve price
stability, in line with our definition - below 2% but close to 2% - and therefore contribute to
financial stability. As the inflationary pressures seen over the summer of 2008 receded, we
swiftly reduced our policy interest rate in a tight series of steps down to 1%. This interest rate
level has not been experienced in the countries of the euro area at any time in recent history.
In parallel, we had to tackle the paralysis of inter-bank transactions in the money market. As
you know, the flow of credit is primarily channelled by banks in the euro area. A complete
breakdown in the funding relationships that constitute the money market would have derailed
the bank lending channel altogether. The interruption of the bank lending channel would
have made our policy action ineffective. It could have turned the financial crisis into a
profound depression.
This is what motivated the second tier of our approach to crisis management: what we refer
to as our policy of "enhanced credit support". These "non-standard" measures started in
October 2008 and were designed to ensure that our monetary policy intentions were
transmitted to the broader economy, despite the problems in the financial sector. The aim
has been to enable banks to continue their lending to households and firms.
What have we done specifically? Since October 2008 we have been supplying liquidity in
unlimited amounts at the policy rate to the banks demanding refinancing. At the same time,
we expanded the list of eligible assets to allow banks to refinance with us a larger share of
their balance sheet. This made it possible for many banks to protect their loan and securities
portfolios from forced liquidation. Otherwise they could have triggered an avalanche of fire
sales in the open market. The interruption of loan contracts would have taken a high toll on
the real economy.
We also wanted to support banks in maintaining longer-term credit commitments. Therefore,
we have provided liquidity for longer periods. In June this year, we conducted the first
operation for one year. We allotted more than €440 billion in this operation. In the second
operation, in late September, we supplied banks with €75 billion, and a third operation of one
year is scheduled for December.
The crisis also exposed the severity of currency mismatches in banks' balance. To help
alleviate those problems, we have provided liquidity in foreign currencies, most notably in US
dollars, backed by a swap facility with the Federal Reserve System. Thanks to our policy,
banks could count on an ongoing access to foreign currency balances.
These measures can all be seen as an expansion of our regular open market operations with
banks. In consonance with this tradition, our non-standard policy was first and foremost
aimed at expanding that form of credit in volume and maturity. In July this year, we started to
purchase securities outright as a vehicle for introducing further credit support. We intervened
directly in the longer-maturity segments of financial markets by buying covered bonds issued
by banks. When presenting this decision, I stressed that we were very much in the continuity
of our open market operations, because we still had in front of us both the signature of the
commercial bank issuing the bonds and the underlying asset itself.
Let me focus more closely on covered bonds for a moment, as they are important for the
euro area - and for Spain.
Covered bonds are an attractive source of funding for banks because they have long-term
maturities. They help control and rebalance the maturity mismatch between assets and
liabilities in banks' balance sheets.
But they are attractive instruments of finance for investors as well. Unlike asset-backed
securities, covered bonds do not involve a transfer of credit risk from the issuer to the
investor. Credit risk stays with the originator, preserving the incentives for prudent evaluation
and monitoring.
From the point of view of the Eurosystem, this was a very important attribute, on top of the
fact that covered bonds are akin to our traditional repurchase operations.
Since the announcement in May there has been a wave of new issuances. As Spanish banks
have traditionally been significant issuers of this type of securities, developments in Spain
are representative.
The issuance volume of Spanish banks between the time of the announcement and the end
of October has reached 16 billion euro. It is now around 20% of the total euro area issuance.
Spreads have declined in tandem. In Spain they are now more than 100 basis points lower
than the level they reached at their peak. Liquidity has returned to the market, with tangible
reductions in bid-ask spreads in secondary transactions.
We interpret these developments as a confirmation that our purchase programme, although
measured in size, has been effective in bringing new life to an important segment of the
European financial market. Overall, we are very satisfied with the effectiveness of this
programme.
II. Lessons: present and future
What lessons can we draw from the financial crisis that has occupied all of us for more the
last two years?
The crisis has exposed the fundamental fragility of the international financial system. No
segment of the market or category of players has been spared.
Therefore, we have to re-consider all aspects of finance as a precondition to reform.
Macroeconomic policies in some areas have also shown deficiencies, in particular when they
lacked a medium-term orientation towards sustainability.
Looking ahead, we need to refine and broaden their oversight of the nexus between financial
markets and the macro-economy. Financial risks and the increasing potential for these risks
to become contagious and escalate to systemic proportions need to be better identified.
At the level of national economies, efforts should be reinforced by measures to strengthen
the structural engines of their economic systems. Far from putting off the agenda for
structural reforms, the crisis has made them more urgent.
I want to share with you my thoughts on reform along each of these three dimensions: the
financial sphere, global governance, and the structural set-up of local economies.
Financial reform
The ultimate goal of financial reform is clear: the financial sector will have to return to its role
of providing the best possible service to the real economy. The fundamental role of financial
markets is the intermediation of funds between savers and investors.
During the recent past, this function has been expanded by increasing possibilities for
diversification: diversification of risks for savers; diversification of funding sources for
investors. For a long time, the demand for hedging against economic risk among
entrepreneurs has grown in tandem with the growing supply of new and innovative financial
techniques. But at some point supply outgrew demand. Financial innovation ceased to
facilitate trade and real investment opportunities and started to become self-sustaining. This
weakened incentives to conduct prudent screening and a thorough monitoring of loan quality.
Credit became plentiful and market liquidity expanded at a pace that could ultimately no
longer be justified.
Looking ahead, three steps will be required to a more resilient system.
•
First, the tendency for finance to become pro-cyclical even at a system-wide level
needs to be strongly mitigated. The quality and quantity of bank capital and their
liquidity buffers have to be improved in good times to provide a sufficient buffer for
bank equity when the cycle turns. The cyclicality of market economies is inevitable.
But the financial system should not be allowed to amplify swings.
•
Second, the transparency of the financial structures needs to be enhanced.
Informed decisions by market agents are a key element of market economies. Lack
of transparency of financial products masked abuse and led to disaster. Looking into
the future, all institutions, instruments and markets of any relevance for systemic
stability need to enhance risk disclosure.
•
Third, once more, incentives need to be aligned. Market participants - traders, loan
managers, risk committees and boards of directors - were given strong economic
incentives to focus on short-term profits. Long-term value creation was not a
concern in the pre-crisis world. Collectively, this has resulted in excessive risk
taking. A reform of the executive compensation schemes and practices is an
essential part of our effort to secure financial stability.
At the financial level, reform in Europe will follow a two-pronged approach. First, it will be
centred around the European System of Financial Supervisors. The establishment of this
System will permit better coordination among national authorities responsible for financial
regulation. If one lesson can be learnt from the crisis, it is that the reach of financial
supervision and regulation needs to be extended to better monitor those financial institutions,
including highly leveraged, which can arbitrage across national borders and across oversight
jurisdictions.
The European Systemic Risk Board (ESRB) will be the other dimension of the European
approach to financial reform. This new body will provide early-warnings and issue
recommendations that will help to prevent a renewed build-up of excessive risk in the
financial system as a whole. The crisis has displayed the phase transition that risk can
undergo almost overnight: a mutation from localised liquidity risk to a generalised solvency
threat attacking the whole system of financial interconnections. The ESRB will have to
oversee the likelihood and measure the severity of these reactions and instant transmissions.
The ECB and the National Central Banks in the EU will fully contribute to this new
institutional framework.
Global governance
The underlying approach to reforms should be holistic. The global proportions of the crisis
call for a rethinking of the links between financial behaviour and macroeconomic policies, as
they interact in a global scene.
The G 20 has made a quantum leap in creating the new premier global economic group. The
aspect that impresses me most about this group is the virtually universal consensus on
global economic issues. There is a broad consensus at the level of the G 20 on the diagnosis
of the crisis. There is a broad consensus on the appropriate response to the crisis. And there
is a broad consensus on the direction of financial sector reform, along with the main ideas
that I described a moment ago.
There is agreement that macroeconomic policies at the domestic level need to be consistent
with the objective of global financial and economic stability. Medium-term and long-term
sustainability in domestic macroeconomic policies will have to prevail. A renewed
mediumterm perspective should guide macro-economic policies from now on. Like financial
regulation, policies should not amplify economic fluctuations.
Structural reform
As I said, structural reform is ultimately the responsibility of individual economies. The crisis
has reduced some of the imbalances almost automatically. In the euro area, economies with
wide current account imbalances - including Spain - have suffered relatively more than
others. As a consequence, output and employment losses in these countries are acting as
potent stabilisers to re-absorb long-standing gaps between domestic savings and domestic
investment. As Miguel Fernández-Ordóñez has said, some structural weaknesses have been
revealed even more clearly and call for appropriate reforms.
Spain was on a pattern of growth in the run-up to the crisis that was not sustainable. Before
the decline, the housing market had seen an important boom fuelled by expected future
higher earnings, an important inflow of migrants and low financing costs. The buoyancy of
aggregate demand, in turn, supported a wage-setting environment that did not correspond to
the underlying gains in productivity.
In the future, changes in labour market institutions to make wages adjust to productivity are
essential to repairing past cumulative misalignments. There is a need for moderation in wage
claims to regain competitiveness. This window of opportunity cannot be missed in those
countries where substantial increases of production costs have been one of the causes for
widening imbalances in current accounts, and Spain is one of them. In this country, the
burden of the crisis has fallen disproportionately on temporary workers. Compensation for
those employed on a permanent basis has seen only minor adjustments. Looking into the
future, wage flexibility will need to be made more widespread.
At the same time the main asset for growth and development in our societies is human
capital. Incentives need to be shaped to maintain and develop knowledge by each individual
and - collectively - by companies and institutions. This includes training and investment into
the workforce, supported by well-designed employment contracts. Reforms in services, can
further support the recovery and contain price increases once private expenditure recovers.
In the end, these reforms, by increasing productivity and competitiveness help rebalance the
external accounts on a permanent basis and reduce the reliance on external financing.
Needless to say, the complexity of the international financial crisis and the synchronised
weakening of the real economy have put banks in a complex and exceptional position. In the
short-term, with the economic slump and the high levels of unemployment, non-performing
loans will be on the rise. And pressure on banks' balance sheets will keep increasing. The
business model will have to adapt to the new competitive reality and the international
conditions. This may translate into stricter cost management and the use of new
technologies. One of the most important tasks will be to embark on a profound restructuring
of a number of medium-sized institutions. Restructuring processes ought to aim at tighter
synergies and economies of scale. The effort that needed is formidable, but Spain has
witnessed numerous processes of this type in the past, which have resulted in highly
successful business models.
III. On the way to normal times
As you know, in its last meeting the Governing Council of the ECB has judged the present
level of our policy rates as appropriate. As regards our non standard measures, as the
situation returns to more normal times, the focus on the medium term calls for a gradual and
timely phasing out of these measures.
A number of measures - think of our refinancing operations - will phase out naturally by
design. As of today, it is still premature to declare the financial crisis over. But when the
appropriate time comes, there should be no concern about the ECB's determination and
ability to exit. As I said on behalf of the Governing Council, looking ahead, not all our liquidity
measures will be needed to the same extent as in the past. Accordingly, we will make sure
that the extraordinary liquidity measures taken are phased out in a timely and gradual
fashion and that the liquidity provided is absorbed in order to counter effectively any threat to
price stability over the medium to longer term. By so doing, we will continue to ensure a firm
anchoring of medium-term inflation expectations. Such anchoring is indispensable to
supporting sustainable growth and employment and contributing to financial stability.
On the institutional side, the Governing Council has the unfettered capability to decide and
institute appropriate policies whenever circumstances warrant.
Fiscal authorities, too, need an exit strategy. Their response was instrumental in avoiding a
collapse of the financial system. It helped to halt the sharp decline in economic activity and
build general confidence. But that response also entailed significant fiscal costs. Only the
additional fiscal burden that is associated with the workings of automatic stabilisers will
reverse by design once economic conditions improve. Discretionary interventions will need
discretionary action to unwind. In any case, the additional fiscal costs that governments have
shouldered will be carried forward in terms of higher debt for years to come. This is why
there is an increasingly pressing need for ambitious and realistic fiscal exit strategies and for
fiscal consolidation. Some countries are in a relatively favourable position because their past
management was wise and prudent, while others are already very close to losing credibility.
Spain - where fiscal consolidation had progressed more than elsewhere - will have to make
sure that it keeps its fiscal credibility in the years to come in strictly meeting the requirements
of the Stability and Growth Pact.
A clear plan for a medium-term fiscal correction becomes even more pressing for rapidly
ageing societies like ours, as an increasing numbers of pensioners will mean mounting
claims on public transfers.
IV. Conclusion
More than one year after the dramatic deepening of the financial crisis in September 2008,
we can spot a number of signs of economic stabilisation in the euro area. We have halted the
freefall in economic activity that we witnessed over a period lasting more than six months
after the intensification of the crisis in mid-September 2008.
But the crisis has debilitated the real economy. As I said, the crisis has proved so deep
because it has deprived our citizens of confidence. Every business activity is by its very
nature an act of trust, an expression of confidence. As regards bankers, by granting loans
more actively to entrepreneurs they can contribute to transmitting and inspiring confidence to
the economy at large.
Being part of the euro area and the European Union will help in this process.
For what concerns the ECB and the entire Eurosystem team, with Banco de España as a
very active member of the team, our 330 million fellow citizens in the euro area ask that we
continue to deliver price stability over the medium term, in line with our definition - less than
2% but close to 2%. Our determination to anchor solidly inflation expectations has served us
well since the introduction of the euro, including in the recent period of crisis, by helping to
avoid the materialisation of the risk of deflation.
The euro area can count on us to continue to be a solid anchor of stability and confidence in
these challenging times.
Thank you for your attention.