Mario Draghi: How to restore financial stability
Lecture by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial
Stability Forum, at the 5th Bundesbank Lecture, Berlin-Brandenburgische Akademie der
Wissenschaften, Berlin, 16 September 2008.
* * *
As this crisis hits its first anniversary, it has evolved into an even more complex combination
of rising inflation, declining growth, tightening credit conditions, and widespread liquidity
tensions pervading the global financial industry. Banks have raised a significant amount of
capital to partly offset writedowns and credit losses. But they are now moving into a phase
where credit losses in the banking book will begin to rise. And banks are entering this phase
with weakened balance sheets. Alongside a rise in credit related losses, the outlook for bank
profitability is poor.
The aggregate amount of capital in the system is great enough, under reasonable scenarios,
to prevent the system as a whole from falling below regulatory thresholds. But the distribution
of that capital obviously matters. And, for larger banks, the capital levels demanded by the
market have gone up in response to the greater uncertainty and reduced transparency about
their balance sheets.
We estimate that banks are likely to need to raise at least once again the amount of capital
raised since the crisis began. There are various reasons why some banks will be struggling
to reach those levels. That is especially the case for the banks that ran the debt-financed,
highly leveraged and maturity mismatched business model that provided steady fee income
over the last several years. Now their profitability looks impaired, and their desired
deleveraging is likely to be happening through a reduction of new lending. Capital increases are
especially difficult in a situation of deteriorating stock markets where falling equity prices
nullify the still significant efforts undertaken to delever banks' balance sheets. This has
spurred increasing recourse to hybrid capital instruments, but these may raise in the future
concerns about the quality of the capital raised. Let me finally observe that the situation of
the banks in the Euro area is so far better than the one we are witnessing in the US and in
other jurisdictions.
As the crisis unfolds policies are taking a variety of shapes that can be grouped within two
broad categories: emergency and structural responses. Until now, the first remained typically
national since each crisis was unique to the financial structure of the country and so were the
remedies. However, if the crisis were to become systemic - and the past weekend has
shown just how sudden and dramatic the turn of events can be - I believe that an
internationally coordinated effort will be necessary.
On the other hand, it was immediately clear that the structural response that would lay out
the foundations for a more resilient financial system in the years to come could not be other
than internationally coordinated. It is primarily to this effort that the Financial Stability Forum
(FSF) has been called to respond by the G7. The FSF - brought into being by Hans
Tietmeyer in 1999 - brings together national financial authorities (central banks, supervisory
agencies, and finance ministers) from large international financial centres as well as bodies
such as standard setters and international financial institutions, giving it a unique capacity to
give impetus to and facilitate coordination among these bodies.
Our conviction is that misaligned incentives in several areas of the financial services industry
weakened lending and underwriting standards, particularly but not exclusively in the United
States. At a more general level, innovation and complexity outstripped banks' capacity to
manage key risks - including funding and liquidity risks, concentration risks, reputational
risks, legal risks and warehousing risks. Investor due diligence was poor and reliance on
credit ratings unquestioning. Institutions accumulated a level of leverage that was both
misperceived and excessive. The initial spark set off by the U.S. subprime downturn fed on
these much broader weaknesses, causing the dramatic loss in confidence and liquidity in
financial markets that we have seen. This explains why initial losses that might have been
insignificant are having such meaningful consequences on the real economy in both Europe
and the U.S.
The financial system that will emerge from this crisis will be one that operates with less debt
and more capital, should be immune to the set of perverse incentives that are at the root of
the crisis, and should be such that the risks are better assessed and identified. In the end,
while avoiding over-regulation that would stifle innovation, the reform process will re-draw the
balance between market discipline and regulation.
The FSF report, which was endorsed by the G7 ministers and central bank governors in April
this year and has been made public, draws on an extensive body of work by national
authorities and the main international supervisory, regulatory, and central bank bodies. A key
strength of this report is that it contains recommendations that have been agreed by those
that have the authority and commitment to implement. Another key strength is that it aims at
correcting the identified weaknesses while preserving a level playing field across countries. A
well-defined process is in place for following up on implementation, comprising who does
what and by when, and how progress is to be monitored and reported. A comprehensive
follow-up report will be presented to the G7 next month.
Our recommendations were in the following key areas:
•
Strengthening the prudential framework for banks, including with regard to capital,
liquidity, risk management and market infrastructure;
•
Strengthening the framework for transparency and valuation;
•
Changing the role and uses of credit ratings; and
•
Enhancing the authorities' responsiveness to risks and our co-operation in dealing
with weak banks.
Progress in taking forward implementation of these recommendations has been remarkable.
To name a few examples:
•
Supervisors proposed in July new capital requirements for credit exposures in
banks' and securities firms' trading books and will set out later this year adjustments
to capital requirements for "re-securitisations" and the short-term liquidity facilities
that funded off-balance sheet conduits.
•
In May, the Basel Committee issued revised guidance on liquidity risk management
that materially raises standards for sound liquidity risk management and
measurement - including requiring banks to maintain a robust cushion of
unencumbered, high quality liquid assets as a safeguard against protracted periods
of liquidity stress.
•
Over summer, IOSCO and the SEC set out fundamental changes to their
requirements on credit rating agencies to address the quality of ratings, to expand
the information they provide, as well as proposals concerning how ratings are used
in regulatory guidelines.
•
Regarding transparency, the larger banks have implemented our recommended
disclosures to provide expanded information on their risk exposures and valuations
of problem assets, on and off the balance sheet.
•
And the IASB is making good progress on new guidance and revised standards for
fair valuations when markets are illiquid, and for consolidation of off-balance sheet
entities, which we expect to see in the next few months.
On the private sector front we welcome the recommendations that have been set out by the
Institute of International Finance (the IIF), the Counterparty Risk Management Policy Group
III, and the American and European Securitization Forums. The industry's involvement in
drawing lessons from events has heightened the understanding of market participants of the
need to redraw the balance between unfettered markets and regulation.
Some of the regulatory changes that I have discussed will need to be phased in over time to
avoid adding to the adjustment challenges the system faces now. However, there should be
no uncertainty about the authorities' determination to implement the program of actions that
has been internationally agreed. And there should be no stretching of timetables for
enhancing disclosures, including of off-balance sheet positions, as this is essential to
repairing market confidence.
No financial system will be free from crisis whatever the rules of the game. The fundamental
task for authorities is therefore to enhance the resilience of the financial system to shocks
and disruptions whatever their source, with a view to minimising the knock-on effects
elsewhere.
At the level of the financial system as a whole, a critical element is the infrastructure of
payment and settlement systems, and the body of contract documentation and market
practices that underpin financial activity. A resilient infrastructure is one that is capable of
withstanding the effects of the failure of a large financial institution. As we speak this
objective is being tested by reality. By reducing the centrality of any one institution to the
system's stability, a stronger infrastructure also contributes to reducing moral hazard. A
critical priority in this area is to address weaknesses in the operational infrastructure of
overthe-counter derivatives markets. The work undertaken by the NY Fed to this end should be
commended by all the jurisdictions. The objective of this work is to move the OTC derivatives
markets on to a platform where trades can be captured and settled in an orderly way.
It is also imperative that we strengthen national and cross-border crisis resolution
frameworks so that we can allow weakened financial institutions, including large ones that
operate across borders, to be wound down in an orderly manner. This is an area where the
mismatch between what we need to have in place, and what is in place, is large. In addition
to important national reform efforts in a number of countries, work is underway in the FSF
and the Basel Committee to strengthen cross-border cooperation and contingency planning
among authorities in responding to crisis.
At the level of individual institutions, improving resilience means ensuring that capital and
liquidity buffers are large enough to enable firms to resist external shocks - without
mandating buffers at a level that impedes efficiency and encourages regulatory arbitrage.
The issue is quite complex because both the actual and the appropriate size of a buffer shifts
over time depending on the market and systemic environment. Both the markets and
regulatory authorities affect the level of capital and liquidity buffers institutions maintain.
A key issue, which is particularly relevant in the current period of adjustment, is the ability of
banks to use capital levels above the regulatory minimum during adverse conditions. What
we have seen is that higher cushions above the regulatory minimum become a new de facto
market requirement. Indeed, banks' efforts to raise new capital in the past year have been
not just to meet regulatory minima but also to respond to the need to reassure markets. This
is, at least in part, because of festering uncertainty over risk exposures, valuations and
earnings prospects. Some of this uncertainty is inevitable - for example, terminal values for
securities backed by US housing loans cannot be determined as long as the US market
continues to fall. But it is clear that we need a much more robust ex ante framework of
transparency to reduce the tendency that market reaction lead banks to raise capital (or
reduce exposures) to possibly inefficient levels in a systemic crisis. If banks can credibly
assure markets that risks to their asset values and earnings prospects are being soundly
managed and contained, then they may be able to survive a temporary decline in capital
levels when needed, while still remaining above their regulatory minimum.
As the above illustrates, the recent turmoil has raised fundamental questions about the
nature of procyclicality, its impact on financial stability, and the feasibility of policies to
address it. This brings me to two areas that I believe merit further attention on the part of
policymakers going forward:
•
First, is there a role for the official sector to address procyclicality as a source of
financial instability?
•
And second, should monetary policy embody in its objective function the health of
the financial system?
Reviewing our experience of the past two or three decades, one is struck by the repeated
tendency of financial systems to build up risk and leverage in good times, then shed it rapidly
when conditions change. While the assets and agents involved and the triggering
mechanisms differ from one cycle to the next, the cycles have tended to produce significant
deadweight costs and distortions in the real economy, both during the upswing and during
the subsequent retrenchment. This is especially significant the more the financial system is
leveraged, as we have seen in the past year. While we cannot and would not want to
eliminate the bouts of optimism and pessimism that are part of human nature, we must
address some of the pro-cyclical implications of our own policy making.
We decided not to address procyclicality per se in our April report (although some of the
recommendations touch on it) because of the urgency of making concrete recommendations
in other areas. But now it is time for us to return to this topic. As in the areas that I described
earlier, the goal will be to strengthen the resilience of the system without hindering the
process of market discipline and innovation that are essential to the financial sector's
contribution to economic growth.
There is no shortage of ideas around for which aspect of procyclicality is most relevant for
financial stability, and for the range of policy options that could help dampen procyclicality.
Some of the areas that we in the FSF have decided to look at include:
• capital
The regime: the Basel II framework ties required capital more directly to the
perceived riskiness of an asset, which is likely to increase during downturns and fall
during expansions. This is not new, but because Basel II itself is new there is more
we need to know on the mechanics - it is not clear yet, in particular, how required,
desired and actual capital levels will evolve over a full cycle under Basel II (although
a framework is now in place for tracking and assessing this). As we consider how to
strengthen the regime, more thought needs to be given to how to promote higher
buffers above the regulatory minimum in good times, which can then be dipped into
more flexibly during cyclical downturns. To a degree, this is already possible in a
discretionary way, although too much divergence in national implementation of
Basel II would raise issues of transparency and consistency in international
regulatory arrangements and should therefore be constrained. Ad hoc,
uncoordinated reductions in required minima could be viewed as forbearance and
could give the wrong signal about authorities' judgement as to the overall strength of
the system. How we can best dampen procyclicality in bank capital is an inquiry we
are now engaging internationally and in the European context in a coordinated
fashion.
•
A related issue is sound loan-loss provisioning: these are useful tools to counter the
effects of procyclicality, especially on new lending. However, our banking systems
came into this crisis with historically low levels of provisions. To a degree, this can
be attributed to the benign recent default environment. But it also reflects new
accounting principles and prudential rules, the effects of which we need to assess in
the light of experience. Our aim must be to create scope to promote more
throughthe-cycle provisioning techniques that place institutions in a position to absorb
losses rather than curtail credit during a downturn.
•
Compensation issues - these have been much in the public eye recently: do
bonusbased pay systems, for both traders and senior and top management of financial
firms, reward short-term risk taking with little penalty for the longer-term risks taken
to achieve profits? What are the elements of a sound compensation scheme? On
this issue, the interests of regulators and shareholders broadly align but banks face
a collective action problem. If there is a role for regulators and supervisors in this
area, is it ex ante (to adjust risk taking incentives), and/or ex post (to adjust capital
to the risks taken)?
•
Valuation and leverage: the interplay between these has become more important
over time for a number of reasons, including more marketable assets (especially
credit) that need to be marked to market, more market-based collateralized funding,
more leveraged position-taking. But here too there is more we need to know about
the mechanics involved. What effects have valuation practices and leverage had on
the cyclicality of the financial system? Acting through which channels? Is there a
possible or desirable course of action for the official sector?
-
Coming to the issue of monetary policy and financial stability If the market turbulence tells
us anything, it is that the pace of financial innovation in recent years, the volume of
transaction in certain markets, the amount of embedded leverage in the system, and the
global nature of finance, have transformed the functioning of the international financial
system. These transformations were not fully appreciated in their implications for monetary
policy making.
Central banks are inherently concerned with the health of the financial system. Because of
the critical role it performs - that of allocating capital and risk to the economy - a
wellfunctioning financial sector is key for the achievement of primary macroeconomic objectives,
such as stable prices and sustained growth; for central banks, it is also fundamental for the
effective transmission of monetary policy decisions to the real economy. Contributing to the
health of the financial system is, in a sense, encoded in the genes of central banks: one of
the historical reasons for establishing a central bank was indeed to reinforce financial stability
by having an institution that could act as a lender of last resort.
The policy followed by the European Central Bank since the start of the turmoil is very much
in line with this historical role. The ECB has not remained passive. It has used the tools at his
disposal, in particular its liquidity operations, to support the smooth functioning of the money
market in periods of acute stress. Its operational framework has proved to be robust and
flexible to effectively respond to the challenge posed by the drying-up of market liquidity.
However - and this is a crucial aspect of the ECB policy - we have operated under the
principle of strict separation between the liquidity provision policy and the stance of monetary
policy. Monetary policy, the setting of the level of interest rates by the ECB, has been
directed at fulfilling its primary goal: maintaining price stability. This principle is crucial.
Charging monetary policy with additional objectives, such as a direct responsibility for
financial stability, would risk blurring responsibilities, increasing moral hazard and creating a
trade-off where there is none. I fully agree with the remark often made by Otmar Issing that
there is no lasting trade-off between price stability and financial stability.1 Even if, as he
acknowledges, some short-term conflicts may occasionally arise, this can be easily
accommodated by a monetary policy strategy that focuses on an appropriate medium term
horizon, as the one chosen by the ECB. Over such horizons, price stability and financial
stability are mutually reinforcing, rather than alternative, goals. We should not forget that
some of the most damaging and prolonged periods of financial distress (such as the Great
Depression, the Japanese experience in the 90's and many of the currency crises in
emerging markets in the past century) have been associated with - and sometimes
aggravated by - the inability to control the inflation process.
Relying on a clear separation of roles and a correct assignment of instruments to objectives
is particularly important at the current juncture, as we face inflationary pressures combined
with weaker economic activity and financial turbulence. It is precisely in these difficult
situations that the benefits of a sound monetary framework become apparent. Only by
ensuring a return to price stability in a reasonable time frame we will be able to control
inflation expectations, reduce uncertainty and risk premia, sustain longer-term financing and
purchasing power and thus reinforce the prospects for real activity and financial stability. The
risk that a prolonged period of high inflation may destabilize expectations and become
entrenched in wage and price setting requires a resolute stance in monetary policy. It is
essential that other economic actors too adopt a responsible behaviour. It is also quite
obvious that should current financial instability aggravate and threaten to lead to a
deflationary situation, monetary policy would have to take this into account.
While the role of monetary policy in the current circumstances should be clear, it is
nevertheless wise, also in this field, to draw lessons from the recent experience. An
important one, which relates to the topic of procyclicality I just mentioned, is on the role that
unusually easy global credit conditions over many years had in the build up of the current
turmoil.
There is a clear asymmetry between the two phases of boom-bust cycles. While the effects
of the bust phase are very visible, the building-up of imbalances in the boom phase is not
easily detected. This is because there are of course many other factors - not necessarily
related to imbalances - that contribute to changes in asset prices and balance sheet
positions, and not all booms end up in busts. Central banks are thus easily forced into a
situation where they may need to intervene after the crash, injecting liquidity to avoid a
financial crisis, or even at times loosening monetary policy to avoid deflation, but remain
passive during the previous phase. The problem however is that a monetary policy that limits
itself to such a passive role - the so called "mop up after" policy - may increase moral
hazard and plant the seeds for further and more acute imbalances in the future.
The key challenge is therefore to understand whether monetary policy can or should be more
proactive and "lean against the wind" also in periods of growing financial imbalances in a
preemptive manner, even in the absence of immediate threats to price stability. This is an open
issue on which opinions diverge. I will limit myself to the following observations.
First, risk premia in equity, housing, government bonds and corporate debt markets had
reached over the past ten years - with different timing - a historical minimum. They had
consistently declined since the mid-eighties. There are structural reasons behind this trend:
the deepening and broadening of global financial markets; and more stable policy regimes, in
particular for monetary policy, leading to lower macroeconomic volatility - and therefore risk
- in the last two decades (a phenomenon also known as the Great Moderation).2 But there
have also been transient, and thus less comforting, factors at work: lower volatility in the
economy may have been due to "good luck", i.e. a historically unprecedented decline in the
vigour of exogenous shocks. This may have generated a false perception of safety. Most
importantly from the point of view of monetary authorities, protracted low interest rates at the
global level may have favoured an excessive appetite for risk, reinforcing the flawed
incentives in risk management that have played a pivotal role in the recent turmoil. Indeed,
the existence of a "risk taking" channel - an impact of monetary policy on either risk
perception or risk tolerance - appears to have some ground in both theoretical arguments
and empirical research.3 Again, all this is not new. From a historical perspective,
accomodative monetary policy has been found to be a key factor in many cycles that ended
up in crises.4 The underestimation of risk is particularly worrying when it involves the housing
markets, as participants are likely to be on average less informed and less protected against
changing conditions than is the case in other markets. Protracted low interest rates
associated with asset price booms - especially in housing - very low risk premia and
buoyant credit growth should ring a bell to policy makers.
Second, the thorough analysis of intermediaries' balance sheets and monetary and credit
developments, which the Bundesbank has championed and is now an essential part of the
ECB strategy, is crucial in this field. Besides supporting the assessment on the outlook for
price stability, this analysis could be an indispensable ingredient of a monetary policy aiming
at a higher symmetry of response to boom-bust cycles, reducing procyclicality and moral
hazard in the financial sector. Monetary analysis may be all the more important in situations
of potential financial distress when it is necessary to lengthen the horizon of policy, but it is
very hard to do so by means of forecasts given the complexities involved. This may be even
more true if we allow for the possibility put forward by some observers, that when monetary
policy is highly credible, excessive liquidity expansions may find their way first in fuelling
asset price and credit booms, rather than in creating inflationary pressures.5 The analysis of
credit and money has also permitted us to form a balanced opinion on the effects the
financial turmoil. While we do see a slowdown in credit growth in the euro area, this appears
to be in line with the regular impact of slower economic activity and tighter policy conditions.
Up to now, we have seen no signs of additional effects coming from financial tensions, and
so far the capital position of banks overall in the euro area remains sound. Of course, if the
crisis were to become systemic, counterparty risks could always spread all over the world.
Third, I do not think that central banks possess a superior knowledge, relative to the private
sector, to be able to judge whether a deviation from fundamentals is occurring in the pricing
of any individual asset. Having said that, central banks - with their strong technical skills,
independent judgement and system-wide, longer-term perspective - are perhaps better
placed to assess systemic risks emerging from financial markets. This can prompt informed
communication to the financial system and to the wider public and, at times, also monetary
policy action. As it is the case in general when confronting low-probability but high-cost
events, it may be optimal to choose to err on the side of caution if this helps to reduce the
likelihood of future crises.6
Fourth, as recently recognized by Adrian and Shin among others, in a market based financial
system, banking and capital developments have become inseparable.7 Through the impact it
has on capital market conditions, monetary policy may have become more important in
influencing the size of financial intermediary balance sheets. In this respect it could play an
important role in dampening fluctuations that may lead to potential disorderly unwinding of
3
See, among others, G. Jimenez, S. Ongena, J.L. Peydrò, and J. Saurina (2008), "Hazardous times for
monetary policy: what twenty-three million bank loans say about the effects of monetary policy on credit
risktaking?", CEPR discussion paper No. 6514.
4
C. W. Calomiris (2008), "The subprime turmoil: what's old, what's new, and what's next", paper presented at
Federal Reserve Bank of Kansas City's symposium, Jackson Hole, August 2008; Bordo, M. (2007), "The crisis
of 2007: the same old story, only the players have changed", paper presented at the Federal Reserve Bank of
Chicago and International Monetary Fund conference "Globalization and systemic risk"; Chicago.
5
Borio, C. and P. Lowe (2002), Asset prices, financial and monetary stability: exploring the nexus", BIS working
papers, No. 114.
6
Bordo, M. and O. Jeanne (2002), "Monetary policy and asset prices: does "benign neglect" make sense?"
International Finance, 5(2).
7
Adrian, T. and H. S. Shin (2008), "Financial intermediaries, financial stability and monetary policy", paper
presented at Federal Reserve Bank of Kansas City's symposium, Jackson Hole, August 2008.
BIS Review 112/2008
leverage. Given the interlinkages existing in the global system, today this is true not only in
the Anglo-Saxon systems, but also in the more bank-oriented European context.
Therefore, while monetary policy should continue to focus on delivering price stability, it
should aim at a greater symmetry throughout the cycle and cannot afford to neglect the
modifications and innovations affecting the structure of the financial system.
We should not, however, underestimate the enormous informational challenge we have to
confront. We need to improve our analyses and tools to be able to better assess the risks of
a systemic crisis, quantify the effects that our actions may have to mitigate those risks and
develop a deeper understanding of the two-way linkages between the financial and real
sectors. In this respect, a closer interaction between macroeconomic and macroprudential
analyses is essential. This requires stronger cooperation and information sharing among
authorities both domestically and cross-border. Moreover, greater transparency and
improved disclosure practices in the private sector are necessary to be able to fully assess
the conditions of the financial system and formulate the appropriate monetary policy. In this
sense, monetary policy and policies to achieve financial stability are closely linked.
The crisis we are facing is one of the most severe and complex of our times. The challenges
will be substantial: restore price stability that would support growth, and ensure that the
needed adjustments in bank and households balance sheets and in internal and external
macroeconomic imbalances take place in an orderly manner. This will require action on the
monetary, fiscal, and regulatory front. It will also require decisive action by the private sector
to repair balance sheets, strengthen corporate governance, and improve the functioning of
markets.
History has repeatedly shown that needed reforms are ignored until a crisis forces action,
and that the will to reform quickly dissipates after the crisis has passed. This crisis is no
different, and this is an opportunity to strengthen the structure of the financial services
industry.