José Manuel González-Páramo: Managing risk - the role of the central
bank in a financial crisis
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at Risk Europe 2009, Frankfurt am Main, 4 June 2009.
* * *
1. Introduction1
Ladies and gentlemen,
It is a great pleasure for me to be speaking here at Risk Europe 2009. Over the last few
years this annual conference has succeeded in gathering together the brightest minds in
both academia and financial practice in the area of risk management, offering interesting and
topical discussions and providing valuable insights into future developments in this field. And
I'm sure you will agree with me when I say that the challenges faced by risk managers in the
financial world have rarely been more complex than they are at present. I would like to focus
today on how a central bank can help the risk management community to address these
challenges. I will also highlight the restrictions that I see in central banks' operational leeway.
However, I will not consider the macro-prudential role of a central bank, recognising that this
is a topic large enough to merit a separate discussion.
A few years ago, it would probably have been unusual for a central banker to be giving a
speech at a conference on risk. Today, we know that central banking and risk management
are very much interconnected. First, central banks have played a key role worldwide -
through their operations in financial markets - in alleviating the implications of the dramatic
intensification of banks' liquidity risk since the summer of 2007. It is no exaggeration to say
that central banks have become the best friends of banks' liquidity risk managers. Second,
central banks have learned that their own financial risk management is crucial if they are to
deliver, in a prudent manner, the best possible liquidity support for strained markets and
financial institutions.
While central banks have certainly done a lot, there are no shortage of proposals for other
things that central banks should do. Having the ability to create unlimited purchasing power
at short notice without being constrained by internal liquidity considerations, central banks
have often been regarded as having limitless power to resolve economic crises.
Such discussions concerning the limits on central banks' ability to intervene - and the
dangers if these limits are ignored - are not new. One of the most famous discussions on
this topic is Milton Friedman's presidential address to the American Economic Association in
1968, entitled "The role of monetary policy".2 The address consisted of three main sections:
the first on "What monetary policy cannot do"; the second on "What monetary policy can do";
and finally a third on " How should monetary policy be conducted?"
While opinions on monetary policy have changed a lot since 1968, I would like to follow the
structure of Friedman's address - focusing, however, on central banks' policies for the
management of financial crises.
Central banks have no comparative advantage in credit risk management. To cite just one
example, a study published by the Bank for International Settlements in 2008 on the
management of foreign exchange reserves3 remarks that central banks have traditionally
had a low level of tolerance as regards credit risk, and therefore have limited expertise in
credit risk management. While this is partly explained by the need to hold highly liquid foreign
exchange reserves for intervention purposes, it is also due to the reputational costs
perceived as being associated with a credit event. Even when assessing the credit risk of
financial institutions in their own jurisdiction, for instance their regular counterparties in open
market operations, central banks do not have access to any privileged information available
to banking supervisory authorities - or if they do, they are prevented from using it through the
establishment of Chinese walls. Consequently, central banks should not take on credit risk
unless there are good reasons for doing so in terms of providing necessary liquidity services
or it is required in order to re-establish an effective transmission mechanism for monetary
policy.
Central banks have been made independent in order to fulfil a well-defined mandate. Hence,
they must not take inappropriate decisions which could have a direct and significant impact
on the allocation of public money - for instance taking excessive amounts of credit risk onto
their own balance sheets. Market risks should also be contained, and this can be achieved
through sound risk management. Very substantial risk taking, subsidies and recapitalisation
must be reserved for elected governments. In theory, one could assess central banks' ability
to take financial risk onto their balance sheets by considering the adequacy of their capital
and other financial buffers. However, in practice, one should also take into account the
idiosyncratic features of central banks when compared with private financial institutions, such
as the fact that their ability to issue legal tender also contributes to their resilience by
guaranteeing a future stream of income. Furthermore, however a central bank's risk budget
is set, in specific institutional set-ups the range of measures adopted by a central bank in a
financial crisis could - provided that the independence of the central bank is preserved - be
further extended if a government guaranteed those operations that led to risks exceeding
that budget. These two points mean that a line must be drawn in terms of the financial risk
taken by a central bank. This line is not merely quantitative in nature. It is also determined by
the goals to be achieved by the specific measures adopted by a central bank. While it could
be argued that the government could take the necessary risks associated with the provision
of support in terms of financial stability, the central bank remains responsible for the risks
incurred by measures associated with monetary policy geared towards ensuring price
stability. These two goals may sometimes converge - for example when the impairment of
the transmission mechanism for monetary policy needs to be addressed using measures
which will, at the same time, improve the resilience of the financial system.
When intervening to provide liquidity, a central bank must avoid favouring certain sectors
over others in terms of liquidity support. It must avoid distorting competition or otherwise
hindering the efficient allocation of resources. While the central bank should therefore be
very careful in its market interventions, this is not an argument in favour of inactivity. On the
contrary, when asymmetric information - owing, for example, to a lack of market
transparency or the opacity of certain financial instruments - threatens the functioning of a
particular market segment, there may be grounds for the central bank to intervene. In such
cases, intervention may be what is needed to restore market efficiency.
It follows logically from the points I have just made that the central bank, as the only player
that has no liquidity constraints, can and should help to overcome a liquidity crisis by
injecting additional cash into the system. In doing so, it should use all available instruments,
but should not take on excessive credit risk. Its objective of providing the financial system
with adequate amounts of liquidity needs to be carefully weighed against the need to avoid
central bank losses or the moral hazard of encouraging excessive risk taking by financial
institutions.
Lending against adequate collateral is one of the main ways in which major central banks
can provide liquidity. If such lending is conducted on the basis of a carefully designed
collateral management framework (with eligibility criteria and risk control measures being of
particular importance), central banks can continue to inject considerable amounts of liquidity
into the system without necessarily exposing themselves to additional risk. This is because,
in entering into a repurchase agreement with a counterparty, the central bank is exposed to
counterparty risk, but does not itself take on default risk. It can therefore unilaterally select
the collateral it accepts, imposing haircuts on that collateral which its counterparties are
expected to accept. Haircuts safeguard the value of the collateral pledged to the central bank
by protecting against liquidation risk and market risk, as well as mark-to-market losses owing
to an increase in the credit risk implied by the collateral.
In addition to haircuts, the central bank's capabilities in terms of valuation and credit
assessment are of crucial importance in an environment in which, owing to the market not
functioning properly, central banks act as a backstop for financial activities. In normal times,
market participants establish standards for credit quality and prices to which both buyers and
sellers have an incentive to adhere. In instances when markets break down and investors
disappear, central banks should, to the extent possible, consider stepping in to temporarily
replace the industry as a market-maker of last resort. While the central bank could always
compensate for poor valuation and credit assessment capabilities by means of draconian risk
control measures (e.g. by imposing very large haircuts), this would result in the poor
performance of its policy function of helping to overcome the liquidity crisis.
The central bank's flexibility in terms of its collateral management framework should be used
wisely. In the presence of a liquidity crisis or a credit crunch, financial institutions find it
difficult to fund their assets. Credit lines are reduced or eliminated as other participants,
faced with uncertainty, refuse to take on counterparty risk. Indeed, central banks are the only
market participants that can afford to be counter-cyclical in their behaviour. They continue to
lend as before, being aware that both counterparty and collateral risks have increased. This
"inertia" in central banks' behaviour in the money market was described in W. Bagehot's
"Lombard Street", in which he advised the central bank to continue lending "on what in
ordinary times is reckoned a good security"4. In fact, the ECB has gone beyond "inertia" in
the current crisis in order to mitigate the systemic liquidity risk faced by the financial system
in the wake of Lehman Brothers' failure. It has increased its lending, with financing now
offered at extended maturities of up to one year5, and has even temporarily expanded the list
of collateral accepted in its credit operations.6
As I have said, in a crisis central banks face a trade-off that may prevent them from engaging
in bolder measures, notably as regards the need to contain moral hazard. A constant
concern for central bankers is the issue of how to prevent public resources being directed to
institutions that have engaged in inappropriate risk taking. Were that to happen, not only
would it appear that those institutions were being rewarded for their poor risk management
performance, but other financial institutions would, indirectly, be encouraged to behave in a
similar way in the future. This can be avoided if the central bank pays due attention to its own
risk management practices, making sure that risk taking on its own balance sheet remains
limited and is always well controlled. This approach allows an abstract idea (i.e. the need to
prevent moral hazard) to be translated into a concrete policy constraint (i.e. the control of risk
taking associated with liquidity-enhancing measures).
In conclusion, central banks should aim to provide liquidity in whatever ways they can,
without taking on excessive financial risk. The better the central bank's risk management, the
better the liquidity services the central bank can provide for a given risk budget; or, the other
way round, the less risk it will have to take on for a given set of liquidity services.
4. How central banks can help to overcome the financial crisis
On the basis of the previous considerations, a number of concrete measures can be
regarded as natural responsibilities of central banks in general, and the ECB in particular.
•
The primary objective of the ECB and the Eurosystem is the maintenance of price
stability. Interest rate policies should remain geared towards that primary objective,
with a clear distinction being made between the monetary policy stance and the
management of the banking system's need for liquidity.
•
A central bank can provide liquidity to the banking system as a whole through its
regular open market operations. These can be extended in terms of the maturity of
the lending operations and relaxed in terms of their tender procedures, depending on
the nature, depth and expected duration of a liquidity crisis. Furthermore, financial
institutions have access to standing lending facilities, which are normally provided to
banks at a penalty rate.
•
Collateral policies should at the very least obey the principle of central bank "inertia"
in a crisis - i.e. they should not be tightened. They can even be loosened, provided
that an appropriate risk management framework guards against both financial risk for
the central bank and moral hazard. Again, the precise measures implemented by a
central bank will depend on the nature, depth and expected duration of a liquidity
crisis.
•
Extraordinary liquidity measures can be complemented by non- standard monetary
policy measures, such as the outright purchase of securities. One example of such a
measure is the covered bond portfolio programme announced today. Such purchases
have a longer-lasting impact on the balance sheet of the central bank, making it all
the more important that a carefully designed risk control framework be put in place.
• Furthermore, the central bank can provide emergency liquidity assistance to
individual banks in so far as these are illiquid but not insolvent. This must be done in
close cooperation with supervisory authorities, in order to ensure that informed
decisions are made and public resources are used wisely. Admittedly, the chain
reactions that can be triggered by liquidity problems mean that it is sometimes difficult
to determine whether a financial institution that requires liquidity assistance remains
inherently solvent.
•
On specific occasions some central banks have also played an important role as a
catalyst for private rescue measures (as was the case, for example, in the role played
by the Federal Reserve System in the bailing out of Long-Term Capital Management
in 1998).
5. Central banks' impact on the functioning of the markets
Furthermore, central banks should make an active contribution to improved market
transparency, first and foremost by supporting market initiatives in this regard and thereby
helping to support the identification and analysis of systemic risks.
For instance, securitisation could be made more transparent, leading to the availability of
better, more accurate information on the value of underlying assets - particularly loans.
Improving the infrastructure used by issuers and investors to exchange information on
complex financial products would increase transparency and foster market innovation, while
reducing systemic risk.
Without such initiatives, important market segments could fail to recover from the severe
decline in activity caused by the current crisis. Such markets are important in allowing
financial institutions to secure asset- based funding, expand lending and better distribute
risk. They contribute to the efficiency of the economic system, and so a failure to revive them
would entail considerable social costs.
6. Conclusions
Let me conclude as I started - i.e. by following Milton Friedman in determining what a central
bank both can and cannot do in a financial crisis.
•
Central banks' ability to contribute to the stability of the financial system is based on
their unique capacity to create liquidity without constraints. Consequently, a central
bank can make a substantial contribution to the resolution of a liquidity crisis through
the provision of adequate amounts of liquidity.
•
But there are also things that a central bank cannot and should not contribute to.
Besides the general need for such measures to be fully compatible with monetary
policy, a central bank's ability and willingness to take on financial risk is the deciding
factor when it comes to drawing a red line between what the central bank can and
cannot do. This line is drawn both in terms of the goals that specific measures are
designed to achieve (which should be compatible with the mandate of the central
bank) and in terms of the level of risk taken (which should be compatible with the
ability of the central bank to absorb risk without jeopardising its financial
independence).
•
The idiosyncrasies of certain institutional set-ups have allowed some central banks to
consider extending their remit backed by the issuance of government guarantees.
The need to preserve the independence of the central bank and a clear division of
labour are the overarching considerations in this respect. In any case, the quality of
the central bank's financial risk management is crucial to the services it can deliver
without crossing this red line.
• Finally, a central bank can act as a catalyst in fostering market developments that
improve transparency, improve risk management standards and encourage the
revival of dysfunctional markets.
With these remarks on the role of central banks in a financial crisis, I wanted to explain how I
perceive the role of our institutions: their responsibilities, but also their limitations. Just as
importantly, I wanted to emphasise the importance of risk management considerations - in
line with the theme of this conference - in determining central bank policies in the area of
crisis management. We can add this to the long list of reasons why advances in the field of
risk management, pursued in conferences such as this, will be essential in preventing and -
should it prove necessary - managing financial crises in the future.
Thank you very much for your attention.