Mario Draghi: Strengthening financial resilience
Speech by Mr Mario Draghi, President of the European Central Bank, at the 2013
International Monetary Conference, Shanghai, China, 3 June 2013.
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Ladies and Gentlemen,
Introduction
It is a great pleasure to speak to you at this year's International Monetary Conference.
Let me start by congratulating the organisers for devising a programme that precisely
pinpoints the key challenges that policy-makers must address on the path towards a more
resilient financial sector.
The financial sector constitutes the main link between monetary policy and the real economy.
So the challenges associated with financial stress and the prospects for financial reform are
close to the heart of every central banker.
The economic situation in the euro area remains challenging but there are a few signs of a
possible stabilisation, and our baseline scenario continues to be one of a very gradual
recovery starting in the latter part of this year.
The drivers of such a gradual recovery are the highly accommodative monetary policy and
export growth, caused by growing foreign demand. There is an adjustment happening across
the board, with fiscal deficits and external deficits declining. The price of energy is declining
as well and finally there are a number of important wealth effects that can support
consumption and investment. These effects come from the rebound of financial markets that
is benefitting virtually all economic agents, including corporations, banks and households.
Nevertheless, vulnerabilities remain, and I would like to take this opportunity to share my
thoughts on the appropriate policy response to remaining financial and economic
vulnerabilities from a euro area perspective. In doing so, I will focus on the banking system,
which accounts for around two thirds of financial intermediation in the euro area.
When analysing the capacity and willingness of euro area banks to lend, it is useful to
distinguish three factors: their funding situation; their capital position; and their attitude
towards risk.
Each of these factors may, at times, require targeted policy intervention to overcome
obstacles to bank lending. But the types of policy intervention and the domains of policy
responsibility fundamentally differ across these three factors.
In this context, let me outline what I believe are the three major lessons of the crisis.
First, the crisis has reconfirmed both the scope and the limits of what central banks can do to
support the economy.
Central banks play a pivotal role in stabilising funding conditions at times of acute market
turmoil. But they cannot compensate for weaknesses in banks' capital positions. And they
cannot substitute for reforms to boost the growth potential of economies.
Second, in the euro area, the crisis has demonstrated the capacity and unwavering
commitment of the European Central Bank (ECB) to support the economy in its pursuit of
price stability.
We have adopted monetary policy measures that are unprecedented in scale and scope. In
doing so, we have benefitted from the array of different perspectives on the Governing
Council. These different perspectives collectively shape the single monetary policy for all
euro area countries and form a durable basis for our united institutional decisions.
Third, the crisis has shown the need to adjust our monetary policy toolkit to a new reality. A
very important new tool have been the two 3-year LTROs (long-term refinancing operations)
that helped avoid a massive euro area wide credit crunch in early 2012. But the most salient
feature of this new reality is financial fragmentation across euro area countries.
In response, the ECB has adopted Outright Monetary Transactions (OMTs). This policy
initiative was necessary to counteract the threats to price stability; it has been effective in
maintaining price
mitigating fragmentation and especially in fulfilling our mandate of stability.
Let me explain in a little more detail.
Improving banks' funding situation
As the crisis has demonstrated forcefully, a sudden retreat of market liquidity can severely
rattle financial markets.
Unable to refinance their illiquid assets, banks are forced either to explore alternative
sources of funding or to engage in large-scale fire sales to shrink that part of their assets that
remains tradable, although at falling prices.
To avoid socially costly fire sales and in common with most other central banks, the ECB
compensated for the shortfall in private finance by providing solvent banks with additional
central bank liquidity against adequate collateral.
In doing so, the Governing Council followed three avenues.
First, we provided these banks with ample access to central bank liquidity - both by reducing
our main policy rate and by expanding the collateral pool against which we would lend to
euro area banks.
Second, we provided reassurance to market participants that ample access to central bank
liquidity would persist over the relevant planning horizon. Most notably, our two three-year
long-term refinancing operations (LTROs) assured banks that their liquidity needs would be
met over horizons that stretch beyond the usual maturity of central bank credit. In fact, the
LTROs come closer to matching the average maturity of their loan books.
Third, we forcefully confronted financial fragmentation which has weakened the impact of
monetary policy in the very parts of the euro area where it is most needed. Fragmentation
has created divergent borrowing conditions for firms and households with equal
creditworthiness but different country codes.
As our main tool to combat fragmentation, we adopted Outright Monetary Transactions (OMTs).
OMTs allow for targeted intervention in euro area sovereign debt markets - provided the
country concerned commits itself to strict and effective conditionality under an EU/IMF
economic adjustment programme.
A closer look at OMTs
At almost one year from its announcement, the benefits of OMT are visible to everybody:
Spreads in sovereign debt markets have fallen substantially. Since the OMT announcement,
spreads on long-term bonds for Spain, Italy and Ireland have fallen by around 250 to
300 basis points and for Portugal by almost 600 basis points.
Spreads in corporate debt markets have fallen by about 150 to 200 basis points for important
market segments, and made it easier for firms to raise funds in the market. This has been the
case for highly rated large corporations as well as for other corporations.
Banks have been able to re-access the market, for both funding and for raising capital, and
the strong divergence in funding costs across constituencies has receded somewhat.
Deposits have flown back: banks in stressed countries have seen the deposits by the euro
area money-holding sector increasing by about 200 billion euros since August 2012.
Another sign of normalisation, and a very important one for German savers, pension funds
and insurance companies, has been the increase in German government bond yields,
previously suppressed by panic-driven safe-haven flows, which have edged up by around
25 basis points.
And the best summary indicator for fragmentation and related payment flows in the euro
area, the level of Target balances, has shown a decline by 285 billion euros, or 25%, since
the peak last year. Target balances now roughly stand at levels prevailing before the launch
of the two 3-year LTROs in late-2011.
The establishment of OMT has therefore been beneficial to everybody: sovereigns,
corporations, banks as well as individuals, and it has benefitted both periphery and core
countries.
Therefore, I would like to reflect in more detail on this measure. What is its purpose?
OMTs are aimed at eliminating redenomination risk from the markets - the unwarranted
anticipation of euro area breakup.
Redenomination risk undermined our ability to preserve price stability and contravened the
singleness of monetary policy.
The possibility that financial claims may be redeemed in a different unit of account than the
one in which they were denominated at issuance - that is, the euro - was the prime source
of panic that fractured transmission of monetary policy a year ago.
OMTs priced that risk out of market values and act as a deterrent against a resurgence of
fundamentally unjustified redenomination fears. But their role is cast within a robust
framework in which the ECB can fulfil its primary task of ensuring stable prices in steady
financial conditions. And the fiscal authorities can take care of their solvency conditions and
concentrate on structural adjustment.
One concern that has been raised with regard to OMTs is that they may discourage reform at
the national level.
Quite the opposite is true. OMTs can be applied only if governments accept policy
conditionality that leads to reforms. At the same time, it was the requirement of effective
conditionality embedded in OMTs discourages governments and parliaments from requesting
a programme unless strictly necessary.
They can either reform without OMTs and retain economic sovereignty or they can reform
with OMTs but give up some of their economic sovereignty. Either way, they have to
persevere in their reform efforts.
So it is quite misleading to compare OMTs to historical episodes in which governments relied
on central bank support to replace fiscal consolidation.
Another concern made against OMT was that conditionality weakens the independence of
monetary policy. The reality is that OMT's are not tied to political decisions since the
Governing Council retains its full discretion, even after a country has engaged in a
programme. In addition, that same conditionality ensures that the governments remain
solvent, which in turn protects the freedom of action of monetary policy.
A third argument made against OMTs suggests that they would reintroduce excessive
compression of euro area bond yield spreads, as observed prior to the crisis.
This too is inaccurate.
OMTs are designed to keep government bond yields just below 'panic' levels, as previously
defined, not to bring them down to levels that would somehow help government solvency.
As we have seen, the mere existence of OMTs keeps government bond yields from rising
excessively: the market expects that if yields rose too much, governments would apply for
the programme and ECB purchases would bring yields back down. OMTs have therefore had
a self-fulfilling downward effect on yields, just as before, in absence of OMT, there was a
self-fulfilling upward effect with a potentially catastrophic risk for the euro area.
But this downward effect does not mean that spreads are forced to converge. In fact, ECB
intervention under OMTs would not address those parts of sovereign bond yield spreads that
are fundamentally justified.
The implication of a high backstop rate is that governments continue to have the incentives
to raise their primary balance towards stabilising levels and to engage in structural reform.
These are the only two options for them to lower their funding costs well below the backstop
level implied by the OMTs.
For governments and parliaments, the ultimate driver of their actions remains employment. It
is important to recall that always and especially in the present situation, the need for
governments and parliaments to reform does not stem so much from the bond market but
from the dramatic conditions in the labour market. Unfortunately, millions of unemployed
are a much greater driver to reform that the interest rate to be paid on sovereign debt. And
unfortunately, OMTs have almost no effect on the sources of employment creation.
Indeed, while OMTs have eliminated one dimension of financial fragmentation (the risk of
euro breakup), they only have a muted and indirect effect on the other source of
fragmentation - the adverse feedback loop between sovereigns and banks.
A final criticism of OMTs is portraying them as a means of transferring risks from peripheral
to core euro area countries via the ECB balance sheet. Quite the opposite has happened:
the elimination of catastrophic outcomes strongly benefits core countries.
To see this, recall that the tail risks that OMTs seek to address distort financial prices and
quantities in both the core and the periphery. Tail risks generate a glut of liquidity in core
banking systems, as monetary assets are relocated by panicking investors from fragile
countries to safe-havens.
With OMTs, pressure to reform remains on peripheral countries, while re-establishing
confidence in the euro area reduces the flows of money from the periphery to the core
countries like Germany.
So what do the data say? I mentioned already the large decline in overall Target balances,
and it is important to add here that this improvement has materialised also for Germany: the
Target claim of Germany has fallen from a peak of 760 billion euros in the middle of last year
to about 590 billion euros last month. This is a decrease of 170 billion euros or 22%.
This important improvement largely reflects the removal of unwarranted fears of a systemic
collapse of monetary union that was previously priced-in by markets. Today, the euro area is
therefore a more stable and resilient place to invest in than it was a year ago.
And not a single euro of government bonds has been purchased under the OMT programme.
Strengthening banks' risk absorption capacity
Banks' capital position clearly lies outside the remit of central banks. In fact, it is - first and
foremost - the responsibility of shareholders to ensure that their bank is solvent and able to
sustain its core business. And if the private sector is unable or unwilling to provide the capital
necessary to achieve solvency, it is for the fiscal and regulatory authorities to decide whether
and how to act.
Monetary policy cannot substitute for or subsidise either of these policy domains.
But the euro area has achieved significant progress in terms of solvency. Banks have
received fresh capital. Problematic legacy assets have been removed from banks' balance
sheets, notably in countries under financial assistance programmes
More remains to be done. In particular, two policy initiatives should take precedence.
First, we need to create full transparency about the risks on banks' balance sheets. Such
transparency is a pre-condition for the banking sector to return to lasting health. And a
healthy banking sector is a pre-condition to revitalising bank lending.
Second, we must align investors' incentives with those of society. This means that market
participants that stand to benefit from the upside of risky activities should also bear
commensurate losses on the downside.
Europe is making some progress in these areas too.
To strengthen transparency, we are establishing a Single Supervisory Mechanism (SSM),
which tasks the ECB with overseeing major parts of the European banking system. By
placing this responsibility with an independent institution at European level, the Single
Supervisory Mechanism will ultimately allow earlier identification of financial risk.
To strengthen incentives, the institutional architecture is being augmented by rules to
facilitate investor participation in dealing with distressed banks. In particular, harmonised
rules and procedures for bank recovery and resolution are currently being developed at
European level. To ensure a fully consistent and effective application of these rules, their
implementation should be placed within the remit of an independent Single Resolution
Mechanism.
Before the ECB takes over the SSM, it will conduct together with the national supervisory
authorities and with an appropriate involvement of private sector companies, a balance sheet
review of those banks that it takes into the SSM. To this end, the national budgets and where
needed, the ESM will have to provide adequate backstop.
Mitigating macroeconomic risk
The final determinant of banks' capacity and willingness to lend concerns their attitude
towards risk.
Like any central bank, the ECB cannot control microeconomic risk - how banks assess
whether a specific potential borrower will fail to repay a loan.
But the ECB is actively contributing to a reduction in macroeconomic risk: by firmly stabilising
inflation expectations, it provides a nominal anchor for the economy as a whole. This
supports lending and borrowing decisions, and ensures that longer-term investment projects
remain profitable.
But it is the responsibility of national governments to eliminate uncertainty about growth and
the sustainability of public finances.
Without unravelling the progress already achieved, it will be essential to focus consolidation
on the fiscal composition of the budget, reducing those expenditures that make the least
contribution to growth and reducing the tax burden on economic activity. To inspire
confidence, policy-makers must follow-through with their fiscal reform agenda. In fact, little
would be gained from a loosening of fiscal adjustment today if it creates market expectations
that additional tightening will become necessary tomorrow.
In the medium term, we need to ensure that the adjustment is based on increasing the
productivity of our economies.
Only through steadfast pursuit of such structural reforms can the competitiveness of euro
area economies in the global marketplace be restored.
Summary and outlook
Let me summarise.
Strengthening financial resilience requires ambitious policy efforts in various areas. Lending
to the real economy can only be expected to resume if accommodative monetary policy is
accompanied by swift balance sheet repair and determined fiscal and structural reforms.
Within the euro area, recent progress suggests that decision-makers are ready to tackle the
simultaneous tasks of reforming their domestic economies and completing the institutional
architecture at the European level.
The ECB will continue to support macroeconomic performance by ensuring price stability in
the euro area.
In calibrating our policy response to future challenges, the ECB will remain deeply committed
to our monetary policy framework.
That framework is characterised by pursuing unambiguously price stability, firmly preserving
our central bank independence and tailoring our policy instruments to the specific challenges
at hand, while maintaining fixed our price stability objective.
As such, our framework is inspired by successful experiences of other central banks which
have demonstrated the benefits for monetary policy to rely on a sound institutional anchor,
and have earned trust and respect based on their clear commitment to price stability. The
ECB has the same commitment and has the task to implement its monetary policy not in a
single-country but in a multi-country setting.
This different context and the unprecedented threats to financial stability during the crisis
have required new instruments to achieve the same objective of medium-term price stability
for the whole of the euro area. We have consistently delivered on that commitment ever
since the euro was launched. Over these last 13 years, inflation expectations have on
average been at 1.9%.
Thank you for your attention.