Jean-Claude Trichet: The ECB's enhanced credit support
Keynote address by Mr Jean-Claude Trichet, President of the European Central Bank, at the
University of Munich, Munich, 13 July 2009.
* * *
Introduction
Ladies and gentlemen,
It is a pleasure to be in Munich today and speak at this renowned university with its strong
economics faculty. I would like to thank the organisers, Professor Hans-Werner Sinn of
CESifo and Marc Beise, the chief economics editor of Süddeutsche Zeitung, for inviting me
here. I am delighted to have this opportunity to talk about the ECB's policy actions in these
times of exceptional challenges for monetary policy-makers. I also hope to contribute to the
academic debate on monetary policy. An active exchange of views between academic and
policy-making circles is important for both sides.
The Munich seminars have become one of the best-known events of their kind in Europe.
More events of this type are needed. CESifo - with its close links to the University of Munich
- has established one of the most active and widely respected platforms for European policy
debate. It is therefore a great pleasure for me to be here talking about the field in which
European integration has progressed the furthest, namely monetary policy-making.
In the last two years the environment in which we operate has changed very profoundly. We
went through a period of global financial panic, and we are still in demanding and uncharted
territory. I am therefore pleased to report that the policy toolkit of the European Central Bank
- a young institution albeit benefiting from a very solid legacy - has been up to the challenge.
The ECB's actions since the onset of the financial crisis have been bold, and yet firmly
anchored within the medium-term framework of our monetary policy strategy.
We took unprecedented action in August 2007, on day one of the financial turmoil, when few
others had identified the potential for macro financial disruption. We stepped boldly into the
breach when the collapse of a major financial player last autumn caused interbank funding
markets to stop functioning. Moreover, since the crisis began, not one systemically important
financial institution has collapsed in the euro area. This is no small achievement, given the
damage we have observed as a result of such events.
Since October 2008, our key policy rate has been cut from 4.25% to 1%. In addition, and just
as importantly, we have embarked on a policy of fully accommodating banks' liquidity needs.
This bold and necessary step has avoided a situation in which stressed liquidity conditions
spiral into a systemic threat to the stability of our banking system as a whole.
And we have been far from passive in recent months. We have broadened the set of
measures that, collectively, represent the policy toolkit that we call "enhanced credit support".
I will explain in detail why the approach of "enhanced credit support" was developed, what its
main elements are, and how it is working for the euro area economy - not just the banks, but
also for the European businesses and households. I will also explain how the set of
underlying policies can be unwound once the financial crisis eases or if upside risks to price
stability emerge.
But let me first say a few words about our assessment of the current situation in the euro
area. I will take for granted that we share a common understanding of the severity of recent
events. Right now, economic activity is expected to continue declining for the remainder of
this year, but significantly less strongly than it did in the first quarter of 2009. Looking ahead
into next year, following a period of stabilisation, a gradual recovery with positive quarterly
growth rates is expected by mid-2010. This is our working hypothesis at this stage. The
significant policy stimuli in the major economic areas should support growth around the
world, including in the euro area.
Inflation fell into slightly negative territory in June. This outcome was anticipated and mainly
reflects the earlier sharp decline in global oil prices. It is therefore a welcome development,
and one that supports households' real incomes. Looking ahead, we expect prices to remain
dampened over the medium term. We are particularly pleased that all indicators of inflation
expectations over the medium to longer term remain firmly anchored in line with the
Governing Council's aim of keeping inflation rates below, but close to, 2%. Our success in
firmly anchoring inflation expectations is of crucial importance, and I will talk more about this
later on.
Let me also make some general remarks on the principal achievements of the first ten years
of the euro.
I. The euro: performance and institutional foundation
The euro is the most visible symbol of European unification. It is now the shared currency of
16 countries and 329 million people. The number of citizens united by the single currency
already is in the same order of magnitude as the population of the United States of America.
The euro was introduced more than ten years ago - in 11 countries at the time. Ten years is
a short period of time in historical terms, but long enough to take stock of what has been
achieved.
The main achievement can be summarised in a single sentence: the euro is a very stable
currency and all the institutional requirements are in place to preserve its solidity in the
future. This is what defines success in monetary affairs.
Being here in Munich, I would say that the promise that the euro will be "stabil wie die Mark"
has been kept. A glance at the inflation rates makes this clear: the average annual inflation
rate in the euro area in the first eleven years of the euro will be around 2.0%, notwithstanding
the tough challenges of successive oil and commodity shocks we had to cope with. This will
even be slightly lower than the average annual inflation rate in Germany in the 1990s.
Moreover, the priority given to price stability in the euro area has by no means been at the
expense of employment. Between 1999 and 2008, the number of people employed in the
euro area increased by more than 16 million - significantly more than in the US during the
same period. In the preceding period, from 1990 to 1998, the increase in employment was
less than 6 million for the same time span. This can be seen as confirmation that a monetary
policy oriented towards price stability is fully compatible with job creation. This is not to say
that we have not to face up with new challenges since the crisis erupted, and that this is a
time for complacency. But those figures put into perspective what has been achieved since
the start of the euro.
Speaking in Germany, and having been the first governor of the politically independent
Banque de France since 1 January 1994, I will say that we are all aware that assigning an
independent central bank to the pursuit of price stability was both a historical necessity and a
key ingredient in economic success. It is also well-known that the solid tradition of the
Deutsche Bundesbank sprung out of the painful experiences of the more distant German
monetary history in the first half of the 20th century, in particular the German hyperinflation of
the early 1920s, which has left deep scars in the collective memory of both Germany and
Europe. In a sense, the German experience between the two world wars demonstrates how
painful deviations from price stability can be - both in economic and in political terms.
Firm lessons were learned from history in Germany, in particular in the period of the great
inflation of the seventies, where the Bundesbank, and a very small number of independent
central banks like the Swiss National Central Bank, gained a world-wide reputation for their
ability to control inflation. A key ingredient for this success, on top of their independence, was
an explicit monetary policy strategy. In the case of the Bundesbank, this included a
mediumterm policy orientation, the importance attached to monetary developments, and an element
of rule-based behaviour in policy determination.
These lessons of history were shared all over Europe. I was the Governor of the Banque de
France when its independence was granted in January 1994, five years before the euro. As
soon as independence was granted to the 200-year-old institution, we defined price stability
as an inflation rate below 2% over the medium term. Applying the ancient motto of the
Banque de France "La sagesse fixe la fortune", which I could translate as "Wisdom
disciplines
fortune", we also worked out a monetary policy concept based on a two-pillar
strategy, including a monetary pillar. I was particularly proud that average inflation in France
was 1.4% per year over five years from 1994 to 1999, fully in line with the definition of price
stability. It had been an important contribution to the strategy of "competitive disinflation" that
I had advocated for France and the economies participating in the Exchange Rate
Mechanism (ERM I).
With the creation of the euro, that stability culture has been fully "Europeanised", and was
given a legal face in the Maastricht Treaty and an institutional face in the form of the
European Central Bank. What has been achieved in the first ten years of the euro is
substantial, both in economic terms and in institutional terms. Very solid foundations are in
place in order to preserve these achievements, and this gives us confidence for the future.
Let me now turn to the current crisis and the toolkit developed by the ECB in response.
II. Origins and development of the financial crisis
In looking back on the years prior to the eruption of the crisis, we have to acknowledge that
there was a dramatic shift in focus in large parts of the financial sector - away from
facilitating trade and real investment towards unfettered speculation and financial gambling.
Hans-Werner Sinn has called these deviations "Kasino-Kapitalismus". Of course, we all know
that financial liberalisation and financial innovation have made important contributions to the
overall productivity of our economies. The securitisation of loans, for example, had
tremendous potential for the diversification and efficient management of economic risk. But
securitisation was implemented in a precarious way. Banks and non-banks were able not
only to sell loans, but also to place them fully off-balance sheet as soon as they had been
granted. This resulted in weak underwriting standards and a lack of incentives for lenders to
conduct prudent screening of loans.
This is true for the most recent product innovations in the field of securitisation. But it is not
true for a particular financial innovation that is more than 200 years old and was in particular
introduced in Germany under the name "Pfandbrief": covered bonds. I will return to this asset
class of covered bonds later.
The credit boom leading up to the crisis was exacerbated by three multipliers:
•
first, incentives: ill-designed compensation schemes for loan managers and traders
that reinforced the shortening of their time horizons;
•
second, complexity: increasingly complicated and opaque financial instruments that
made it difficult for holders of securities to assess the quality of the underlying
investments; and
•
third, global macroeconomic imbalances: a chronic shortage of savings in some
industrialised economies was made possible by an excess of savings in other parts of
the world.
In mid-2007 the turmoil erupted. This was sudden, but not entirely unexpected. Indeed, as
long ago as January 2007, I myself expressed the views of my fellow central bankers, when I
indicated that markets would need to prepare for a general reassessment and repricing of
risk, which was clearly underestimated at that time.1 Some months later, this repricing
occurred very suddenly, triggering turbulences in the interbank market. The consequences of
this very sharp repricing threw the credit boom into reverse. The asset cycle turned, and
many of the missing links in the financial chain were exposed.
BIS Review 87/2009
The collapse in mid-September of last year of a major financial institution transformed the
financial turmoil into a global financial crisis. Immediately, financial intermediaries restored
liquidity buffers, scaled down their balance sheets and tightened lending conditions. They
dramatically reduced exposure to the risks that they had imprudently accumulated during the
period of financial euphoria. Collectively, they engaged in a large-scale "deleveraging"
process. Banks' intermediation was sharply reduced, and loans to companies were curtailed.
A long-term trend that had brought credit risk spreads on loans extended by international
financial intermediaries to historical lows was suddenly reversed. A credit squeeze ensued
which took a severe toll on the real economy.
III. Key characteristics of the euro area
The ECB has moved pre-emptively and forcefully to counter the adverse consequences of
the financial crisis. At all times the ECB's response has been carefully calibrated to the
structure of the euro area economy.
Allow me to elaborate on this structure, which differs significantly from those in other
advanced economies, notably the United States, which may be the most relevant
comparator.
First, there are profound differences in their financial structures. The differences in the
composition of funding sources for non-financial corporations are striking. Looking at an
average for the last few years, in the euro area bank financing accounted for roughly 70% of
firm's total external financing. In the United States, by contrast, firms rely to a much larger
extent on market-based sources, which make up about 80% of total external financing.
The different financial structures have implications for the appropriate design of the monetary
policy response in the face of a crisis that undermines the stability of the financial system. To
be effective, ECB policy must focus first and foremost - although not exclusively - on the
banking sector.
There are also profound differences in the economic structures of the euro area and the
United States. Let me, for the sake of brevity, single out three characteristics of the euro area
economy that our policies must take into account in order to be effective.
•
First, small and medium-sized enterprises. They play a pivotal role in the euro area
economy and are particularly important for growth and job creation. These
enterprises cannot generally tap credit markets directly. Guaranteeing continued
access to bank credit is vital in order for them to be able to finance their activities.
•
Second, the housing market. In the United States it is at the epicentre of the crisis.
This is not true for the euro area. At the same time, the euro area is indirectly affected
as banks hold toxic assets partly backed by mortgage loans originated in the United
States. Forcefully addressing the toxic asset problem is a precondition for reviving
credit on both sides of the Atlantic. Where necessary, banks should take full
advantage of government measures, particularly as regards recapitalisation.
•
Third is the flexibility of the economy. Wages and prices of goods and services are
slower to change in the euro area than in the United States. In normal times, this
sluggishness has drawbacks as it slows down the adjustment of the economy; in the
current circumstances it offers some protection against very bad outcomes, provided
that the policy frameworks provide a solid anchor for private sector expectations. In
the euro area, the institutional frameworks provide such an anchor through the
medium-term stability orientation of policies, with fiscal policies geared towards
sustainability and a monetary policy geared towards price stability. In this
environment, overly activist policies may risk destabilising expectations, thereby being
counterproductive.
The financial and economic structures I have just described provide the background for our
policies.
IV. The ECB's response to the financial crisis
Let me now turn to the ECB's responses to the financial crisis. Following the intensification of
the financial crisis in September of last year - and against the background of rapidly receding
inflationary pressures - we have taken monetary policy measures that are unprecedented in
terms of their nature, scope and magnitude. These measures fall into two categories: first,
standard measures in the form of interest rate changes; second, what have become known
as "non-standard" measures. The latter, taken together, constitute what I would call the
"toolkit" for the ECB's policy of enhanced credit support.
Interest rates
Let me begin with interest rates, the standard indicators of stance of monetary policy. Some
observers tend to reduce monetary policy to the level of the key policy rate. The lower the
policy rate, the argument goes, the more effective is monetary policy in response to a
downturn. This view is too simplistic. To compare only the levels of policy rates without
consideration for the resulting market rates and other economic variables is to look at just
one part of a far broader canvas.
Let me give you a concrete example. At 1% at the moment, our rate on refinancing
operations is higher than the US federal funds rate target range of 0-0.25%. But owing, in
particular, to the relatively low level of credit and liquidity premia that are observed in our own
money market, this difference in policy rates does not translate into equivalent differences in
money market rates.
In the euro area, six-month and twelve-month euro interbank rates are important
benchmarks. These rates are widely used by banks to grant floating rate loans to households
and companies. These six- and twelve-month rates, denominated in euro, are comparable to
the corresponding rates for contracts in US dollars. This is due not only to the fact that
spreads between secured and unsecured money market rates at comparable maturities are
currently lower than their counterparts in the United States at six-month and twelve-month
maturities, but also to our full allotment concept of supplying liquidity, which is part of an
enhanced credit support. In conclusion, this shows that in the current circumstances,
international comparisons of policy rates, if not done with the appropriate qualifications,
provide limited information about the effective credit conditions in individual markets.
Enhanced credit support
In recent months policy actions have gone well beyond cuts in policy interest rates. They also
include non-standard measures. These measures are not identical across currency areas.
They reflect the specific needs of the respective financial systems and transmission
mechanisms. As you know, Japan has become known for an approach termed "quantitative
easing" which entails, among other things, the expansion of the monetary base through
outright purchases of government bonds. The US Federal Reserve is currently engaged, in
particular, in "credit easing", which makes use of direct lending facilities vis-à-vis market
participants.
The ECB is engaged in policies that I have characterised as "enhanced credit support". Let
me explain this to you now. This approach focuses primarily on banks as they are the main
source of credit in the euro area economy and seeks to provide enhanced support for credit
provision through specific policies. Hence, one can make the following definition: enhanced
credit support constitutes the special and primarily bank-based measures that are
being taken to enhance the flow of credit above and beyond what could be achieved
through policy interest rate reductions alone.
Our measures currently comprise five building blocks.
Liquidity management measures
1. When the very significant stress in interbank markets first manifested itself in August 2007,
the ECB immediately stepped into the breach and accommodated banks' temporarily
elevated liquidity demand, through a fine-tuning operation on a full allotment at policy rate
mode. The demand of liquidity was as high as 95 billion euro.
When, in mid-September 2008, interbank trading came to a virtual halt, the ECB temporarily
generalised this particular model of liquidity provision: since autumn of last year the unlimited
provision of liquidity through "fixed rate tenders with full allotment" has comprised the first
important building block of our policy of enhanced credit support.
Our first and primary concern was to maintain the availability of credit for households and
companies at accessible rates. The new fixed rate full allotment tender procedure was
designed to ensure the effectiveness of monetary policy transmission at a time when
borrowing through interbank transactions had become abnormally elevated for many
financial institutions. Since autumn of last year we have stood ready to remedy any shortage
of liquidity that might occur in our refinancing operations.
2. The second building block of our new liquidity management approach is the list of assets
that we take as collateral. This list was already very long before the crisis. We have enlarged
it further and now accept an even wider range of securities as collateral. Government
securities account for less than half of the nominal value of the securities on the list. The rest
are private securities. By contrast with many other central banks, the ECB already accepted
private paper before the crisis. In this sense, we were fairly well prepared for the crisis, as we
had a relatively "modern" collateral framework. As a consequence, the total value of these
eligible securities is currently €12.2 trillion, equivalent to 130% of the GDP of the euro area.
This very broad range of eligible collateral has considerably eased banks' liquidity constraints
during the crisis.
The first two building blocks offer unlimited refinancing against a very wide range of
collateral. However, they can only reach the financial system because of the very large
number of counterparties that participate in our refinancing operations. Currently, 2,200
credit institutions in the euro area have the opportunity to refinance themselves with us. This
fact demonstrates the scale of our outreach to the financial system in the euro area and its
effectiveness in insuring against a systemic liquidity threat.
3. The third building block concerns the lengthening of the maturities of our refinancing
operations. In a first step, we lengthened the maturities to up to six months. Just over two
weeks ago, we began to provide liquidity for up to one year.
The first such operation, conducted in late June, led to a record amount of €442 billion of
liquidity being supplied to the euro area's banking system. This exceptional outcome
amounts to around 5% of the euro area's GDP and is a sign of banks' enduring demand for
liquidity security. Banks are now able to access such new sources of central bank credit with
longer-term maturities and borrowing costs at historically low levels. Thanks to this facility,
they can resolve the mismatch between the investment side and the funding side of their
balance sheets. This is expected to make their liquidity planning horizon longer and less
uncertain. It will thereby encourage them to provide credit over and above what could be
expected otherwise.
It may take some time, however, for the extra liquidity to be transformed into credit. Just after
the first 12-month funding operation we have seen that some part of the extra liquidity still
remains within the banking system and is even coming back to the central bank and being
deposited with us temporarily. Banks will have to gain experience in using the longer-term
credit that they obtain from their central banks to expand their longer-term assets rather than
increase the availability of short-term liquidity. We remind banks of their responsibility to
continue to lend to firms and households at appropriate rates and in suitable volumes. We all
have to contribute, each of us with our own responsibility, to the continued functioning of our
economy in these very difficult times.
4. The fourth building block is that we are currently providing liquidity in foreign currencies,
particularly in US dollars. This is to avoid any shortages and is arranged via swap lines with
the Federal Reserve. This demonstrates the considerable degree of cooperation among
central banks in order to ease liquidity tensions in the global money markets. In addition, the
Eurosystem has signed agreements with the central banks of several European countries in
order to improve the provision of euro liquidity to their banking sectors.
Covered bond purchases
5. The fifth building block was added in May: outright purchases of covered bonds. This
measure complements the liquidity management measures I have just described. Covered
bonds are debt securities issued by banks, which give them access to funding of a
longerterm nature than the ECB's refinancing operations. Covered bonds thus allow banks to
manage the maturity mismatch between their assets and liabilities.
Why did we decide to engage in purchases of this particular asset class? Several factors
guided our decision.
•
First, as I have stressed, in the euro area measures to support the flow of credit to the
non-financial sector need to operate first and foremost through banks. Covered bonds
were a major source of funds for banks in the euro area before the intensification of
the financial crisis last autumn, when the covered bonds market virtually shut down.
The Governing Council came to the conclusion that the Eurosystem could help to
revive this market, in terms of liquidity, issuance and spreads, by engaging in outright
purchases of covered bonds.
•
Second, covered bonds are different in nature from the various asset-backed
securities that became so popular before turning sour with the financial crisis.
Importantly, covered bonds do not involve the transfer of the credit risk implied by
underlying assets from the issuer to the investor. The credit risk stays with the
originator, preserving the incentives for prudent credit risk evaluation and monitoring.
We could therefore say that covered bonds are incentive compatible while many
asset-backed securities were not, at least not in the way the concept was
implemented before the crisis. I have previously mentioned that covered bonds -
Pfandbriefe - existed in Germany already 200 years ago. Given that the financial
crisis clearly exposed the dire consequences of the imprudent evaluation of credit
risk, the usefulness of more conservative asset classes such as covered bonds,
which have proved to be safe assets over a long time, is obvious.
We are confident that this measure will contribute to support financial markets. The
announcement effect has been encouraging. The purchase programme started last week
and will be conducted gradually, stretching well into next year. We are already seeing a
number of new issuances of covered bonds and a degree of compression in the spreads in
this important segment, which might have an influence also on other financial markets.
V. Monetary and fiscal assignments
This brings me to the last point in my speech. The ECB's enhanced credit support measures
are designed in full respect of the euro area macroeconomic framework. Financial support
measures potentially involving the significant transfer of credit risk from financial institutions
to the taxpayer clearly fall within the realm of fiscal policy. Our decision to conduct outright
purchases of covered bonds is fully consistent with this fundamental principle. While they are
expected to be effective in supporting credit, these purchases do not burden the Eurosystem
with excessive credit risk.
More generally, I have already mentioned that different environments call for different
actions, even if there is agreement among central banks about the ultimate objectives. This
helps to explain why the ECB's enhanced credit support measures, by contrast with the
concepts of "credit easing" and "quantitative easing", do not involve outright purchases of
sovereign debt. On this feature, I would like to make three comments, stressing pragmatism,
principles and preparations for exit.
First, there is a pragmatic explanation. History matters to a prominent degree. In the United
States, for example, in normal times outright purchases and sales of treasury bonds with
short maturities belong to the routine toolkit of monetary policy implementation. Given that
tradition, it may be a natural step, under non-standard circumstances, to adapt this
procedure by significantly expanding the volume of purchases and focusing on governments
bonds with longer maturities.
The Eurosystem comes from a different tradition. For us, "reverse transactions" with banks -
on the basis of repurchase agreements or collateralised loans - are the single most
important - and in many respects exclusive - instrument in open market operations. Given
that tradition, it has been a natural step to extend the maturity of our refinancing operations
and make adjustments to the collateral requirements.
Second, principles need to be stressed very firmly. For reasons known to all of us, the euro
area has a clear separation of responsibilities. The ECB's enhanced credit support fully
respects this separation.
Third, are important. The Governing Council will ensure that the
preparations for exit
measures taken are quickly unwound, and the liquidity provided is absorbed, once the
macroeconomic environment improves. Long-term refinancing operations (like operations
with shorter maturity) provide liquidity over a fixed time horizon and run off in a fully
predictable way. By contrast, the unwinding of outright purchases typically requires an
additional decision, namely whether to hold the securities to maturity - and if not, when to
sell. The route taken by the Eurosystem limits such decisions to our covered bonds
purchases and for the rest relies on built-in mechanisms for the re-absorption of liquidity.
By their nature, fiscal policies lack a similarly strong built-in mechanism when it comes to the
unwinding of stimulus. Discretionary policies need to be invoked to engineer an exit from the
current degree of fiscal expansion. A return to sound, sustainable public finances, thus
strengthening overall macroeconomic stability, must be ensured. Euro area governments
should prepare and communicate ambitious and realistic fiscal exit and consolidation
strategies within the framework of the Stability and Growth Pact.
Conclusions
Let me draw to a close.
I have described to you the profound changes in the environment in which we have operated
over the past two years. These changes have made it unavoidable that we take monetary
policy measures that are unprecedented in nature, scope and magnitude. These measures
fall into two categories: first, standard measures in the form of interest rate changes; and
second, a number of non-standard measures, which together constitute the ECB's policy
toolkit of enhanced credit support. These are special and primarily bank-based actions we
have taken to enhance the flow of credit above and beyond what could be achieved through
interest rate reductions alone.
Let me once again emphasise that we conduct all our policies in full continuity of our mission
which started ten years ago, with foundations that have a much longer history and which are
well anchored in the most stable monetary policy in Europe - the pursuit of price stability.
Moreover, despite the need for the policy innovations to address the particular economic
challenges of our times, all our measures are deliberately designed in a way that they can be
unwound once any upside risks to price stability should emerge.
I have also mentioned the existence of different approaches to crisis management of major
central banks, which are related to differences in the structure of their economies and their
institutional arrangements. Let me reiterate that we are all united in purpose. It is absolutely
essential to ensure that inflation expectations remain firmly anchored in line with price
stability over the medium term.
This will contribute to what is lacking most, namely confidence on the part of households and
companies, and will lay the groundwork for a return to sustainable prosperity.
Right now the scarcest resource we have is confidence in the future. That is why in the
present, very demanding, circumstances all necessary steps should be taken to strengthen
confidence at all levels. This calls for bold yet solidly anchored responses. We must maintain
the appropriate balance between the need to take immediate action commensurate with the
gravity of today's situation, and the equally undeniable o