Lucas Papademos: Strengthening macro-prudential supervision in
Europe
Speech by Mr Lucas Papademos, Vice President of the European Central Bank, at the
conference on "After The Storm: The Future Face of Europe's Financial System", organised
by Bruegel, National Bank of Belgium and the International Monetary Fund, Brussels,
24 March 2009.
* * *
I. Introduction
This conference has provided an excellent forum for an enriching and stimulating debate on
"The Future Face of Europe's Financial System", a subject which is both topical and highly
policy relevant. In my remarks, I will focus on two issues:
•
First, what are the key lessons of the ongoing financial crisis for EU financial
supervisory policy;
•
Second, what are the objectives and responsibilities of macro-prudential
supervision, and what are the instruments and institutional requirements for the
effective performance of macro-prudential tasks.
II. The lessons of the crisis for financial supervisory policy
A first lesson of the financial crisis is that it has been a consequence of factors and
processes that have affected both the overall macro-financial environment as well as the
behaviour of individual institutions and the functioning of specific market segments. It was the
joint influence of both macro and micro factors that resulted in market excesses and the
emergence of systemic risks of unprecedented magnitude and complexity.
At a macroeconomic level, large and persisting global imbalances, rapid credit expansion
over a protracted period of time, in a benign environment of low inflation and high growth,
fostered a huge increase in leverage, a significant underpricing of risk and a consequent
divergence of asset prices from fundamental values. At a micro-economic level, financial
innovations, notably the securitisation process, although in principle should have helped to
better diversify and distribute risk, were implemented in a manner that fostered improper
incentives and resulted in the loosening bank lending standards, the creation of complex and
opaque products whose real value and embedded risk was difficult to assess, and the
establishment of off-balance sheet investment vehicles that led to the concentration of (credit
and market) risk and maturity mismatches that contributed to the severity and duration of the
crisis.
A second lesson of the crisis is that the nature and magnitude of the systemic risk in the
financial sector is not related only to the potential illiquidity or insolvency of large banks or
other big regulated financial institutions, but it also depends on the degree of
"interdependence" or "interconnectedness" between financial institutions and between
markets. This "interconnectedness" reflects a variety of direct and indirect linkages in the
financial system and it involves institutions and markets that are regulated as well as those
that are not subject to sufficient, or any, regulatory oversight. This second category includes
not only hedge funds but also off-balance sheet financial entities, such as structured
investment vehicles, as well as the securitisation market, and the market for credit default
swaps (CDS). In this respect, two points are relevant for the design of the regulatory policies.
First, the size of some of the non-bank financial institutions and the overall magnitude of the
activities of the "non-bank, non regulated sector" have become significant and can pose
systemic risks. Second, and as a consequence of the first, the "interconnectedness" of all
institutions and markets implies that it is the "collective" behaviour of all that determines
endogenously systemic risk and its potential impact on the real economy.
A third lesson is that the increasing financial integration in Europe and globally has important
implications for the cross-border distribution and propagation of systemic risk and the
appropriate institutional setting for the prevention and management of a crisis. More
specifically, the regulatory framework and the supervisory arrangements in Europe must be
broadly compatible with those in other large economic areas, notably the United States and
vice versa. And within the EU, the growing presence and significance of cross-border
financial institutions (the largest 43 cross-border banking groups in the EU accounted for 76
% of total EU bank assets at the end of 20071 requires the strengthening of the
panEuropean character of supervision.
A fourth and final lesson that I want to stress is that effective crisis prevention and
management call for close cooperation and efficient information exchange between the
supervisory authorities in various jurisdictions as well as between the central banks, whose
tasks include the safeguarding of financial system stability, and the supervisors of individual
institutions. The effectiveness of such cooperation, which is relevant both within countries,
and across borders, crucially hinges on the exchange of relevant information in a timely
manner.
What broad conclusions can we draw from these lessons, and more generally from the
recent experience, for supervisory policy? Although the severity of the ensuing problems has
differed across institutions and countries, overall the crisis revealed that micro-prudential
supervision in many cases proved inadequate to identify, in a timely manner, the nature and
size of accumulating risks and to impose appropriate remedial action. Moreover, although the
build-up of financial imbalances, the underpricing of risk and the rise in the degree of
leverage in the financial system had been identified as sources of potential instability by
international institutions and central banks, including the ECB, their warning signals, which
had become progressively louder over time, did not trigger appropriate responses either by
market participants or by the authorities responsible for the oversight of individual financial
institutions or specific market segments.
There is, therefore, a manifest need to strengthen both the macro-prudential and
microprudential supervision of the financial system and to do so in a way that achieves valuable
synergies and has a mutually reinforcing impact on the stability of the financial system. In
particular, the role of macro-financial factors, of the interconnectedness of markets and
institutions and of cross-border financial integration in determining the size, nature and
propagation of systemic risk calls for the strengthening of macro-prudential supervision in
Europe and globally. This should help prevent the recurrence of similar episodes of market
excesses and corrections in the future, with disruptive effects on the real economy, and it
should help ensure that the financial system is dynamically stable and resilient to shocks.
III. The framework for macro-prudential supervision in the EU
What are the implications of the lessons of the crisis of these broader policy conclusions for
the appropriate design and the effective functioning of the EU supervisory framework? I will
address this question by taking as a "frame of reference" the pertinent recommendations of
the Report of the de Larosière Group that was broadly welcomed by the European
Commission. The Report is a comprehensive and valuable contribution that deals with a wide
range of issues concerning financial regulation, supervision and global cooperation. I will
focus on the envisaged framework for macro-prudential supervision, as outlined in the two
recommendations, 16 and 19, both because of the importance of establishing such a
framework - since it does not yet exist and is urgently needed - and because of the central
role that the ECB and the European System of Central Banks are proposed to play.
The Report recommends that a new body - called the European Systemic Risk Council
(ESRC) - should be set up, to be chaired by the ECB President, and which should function
under the auspices and with the logistical support of the ECB. The new body should pool and
analyse all information, relevant for financial stability, pertaining to macro-economic
conditions and to macro-prudential developments in all the financial sectors. The general
task of this body will be to "form judgements and make recommendations on
macroprudential policy, issue risk warnings, compare observations on macro-economic and
prudential developments and give directions on these issues". Let me elaborate on two sets
of issues: (1) the functions of the macro-prudential framework; and (2) a number of
necessary conditions pertaining to instruments, institutional requirements and procedures for
the effective performance of macro-prudential policies.
The main functions of the macro-prudential framework include:
•
the identification and assessment of risks and vulnerabilities in the EU financial
system (including all markets, institutions and infrastructures);
•
the issuance of risk warnings; and
•
the adoption of related recommendations on macro-prudential policies.
These functions could be complemented by other relevant tasks:
•
the definition of specific macro-prudential reporting requirements for financial
institutions to fill significant information gaps;
• an advisory role on EU regulatory measures that are relevant for macro-prudential
supervision. This role could also include the identification of possible regulatory
gaps stemming from financial innovation that could pose systemic risks.
The performance of these tasks requires the support of appropriate analysis and a
comprehensive information base. The interconnectedness of financial institutions and
markets within the EU but also globally implies that the monitoring and assessment of
potential systemic risks should be based on a broad set of relevant macro-economic and
macro-financial data and indicators, as well as information provided by micro-prudential
supervisors and information obtained from market intelligence. The development of the
appropriate structure and the procedures for bringing together all types of pertinent
information, also in a manner that ensures strict confidentiality in the use of micro data, will
represent a major challenge, which will require analytical sophistication, market knowledge
and supervisory expertise. Moreover, the monitoring of risk exposures across institutions,
markets and borders will have to rely on the close cooperation with the relevant supervisory
authorities (banking, insurance and securities supervisors) within the EU and globally.
The analysis necessary for carrying out the macro-prudential tasks can partly be based on
the economic and monetary analyses undertaken by central banks for the formulation of
monetary policy. But it will have to be complemented with the further development and use of
models for macro-stress testing and of financial stability indicators. These analytical tools can
help monitor, and assess the implications for systemic stability, of risk exposures across
institutions and markets, for instance, the common credit exposures of interconnected
financial institutions to other firms, sectors or regions; or the market risk exposures through
holdings of securities or common positioning of interconnected institutions in relevant
markets (i.e. potentially leading to so-called "crowded trades").
Macro-prudential analysis and supervision focus, by definition, on the monitoring and
assessment of systemic risk in the whole financial sector. This risk, which can emerge both
during the upswing and the downswing of an economic and financial cycle, reflects the
effects of macroeconomic forces and the collective behaviour of institutions and other market
participants. Central banks, whose primary objective is the preservation of price stability -a
necessary though not sufficient condition for the stability of the financial system- and which
maintain close links with the money and financial markets in order to perform their monetary
policy tasks, are well suited to be the authorities mainly responsible for macro-prudential
supervision. In the EU, the ECB and the European System of Central Banks stand ready to
carry out the analytical and statistical work necessary so that the new EU body responsible
for macro-prudential supervision can perform its functions effectively. At the same time, the
involvement and cooperation of supervisory authorities is also essential. In addition to the
proposed participation of the chairpersons of CEBS, CEIOPS and CESR, as well as one
representative of the European Commission, the heads of national supervisors could be
invited to join the national central bank governors as required by the subjects being
discussed.
Appropriate links should also be established between the ESCB and the proposed European
System of Financial Supervision. These links should contribute, inter alia, to effective
information-sharing as well as to providing an additional channel through which the "output"
of the deliberations of the new EU macro-prudential supervisory body will be communicated
to the micro-prudential supervisors and help trigger appropriate policy measures. This could
include changes to capital requirements and liquidity buffers in order to respond to identified
emerging systemic risk. And this observation brings me to my last two points.
The de Larosière Group emphasised that once a macro-prudential risk warning has been
issued "it must be clear to everyone who should act and according to which timetable". It is
therefore essential that a suitable mechanism is in place to ensure that the required
supervisory or regulatory actions are implemented in an effective and timely manner.
No reflection on the appropriate macro-prudential framework for Europe would be complete
without due consideration of its international dimension. This global financial crisis has
underscored the importance of concerted policy responses globally. The early identification
and assessment of risks and vulnerabilities, the issuance of risk warnings, and the adoption
of the related macro-prudential policies should be key responsibilities in a reformed global
framework for financial oversight, in which the IMF and the FSF should play a key role, but all
relevant parties, including the new EU macro-prudential supervisory body, should be closely
involved. Our European framework should fit in, and be compatible with the global approach
to be adopted.
IV. Conclusion
In conclusion, let me emphasise that the establishment of the proposed EU body responsible
for macro-prudential supervision, the effective performance of its tasks, the efficient
translation of its risk assessments and macro-prudential policy recommendations into
appropriate policy measures will require addressing a number of legal, institutional and
organisational issues. One such issue is the institutional relationship and fruitful collaboration
between the European Systemic Risk Council and the envisaged European System of
Financial Supervision. We should all contribute to addressing these issues in a constructive
and timely manner, for the strengthening of macro-prudential supervision in Europe is an
important and urgent policy objective.
Thank you very much for your attention.