Axel A Weber: Financial market stability
Speech by Professor Axel A Weber, President of the Deutsche Bundesbank, at the London
School of Economics, London, 6 June 2008.
* * *
1 Introduction
Financial markets perform an indispensable task for economic well-being. They provide the
services and products by which the intertemporal allocation of savings and investments is
accomplished. As such, financial market stability is a precondition for macroeconomic
stability and economic growth.
An efficient allocation of funds presupposes that the necessary flow of information between
borrowers and lenders is sufficiently stable to overcome the inherent information
asymmetries between both parties. Risks to financial stability, on the other hand, imply also
risks to the real economy and to overall economic stability.
It should come as no surprise then, that central banks in their strive for macroeconomic
stability always had a keen eye on developments in financial markets and an interest in
preserving financial stability. And the abundance of published financial stability reports over
the recent past is indicating that the respective resources invested by central banks have
been increased visibly over the past couple of years. It would have not needed the most
recent financial market turbulences that started last summer to drive home that point.
However, the events since last August have made clear for even distant observers that
central banks have a natural interest and responsibility to safeguard developments on
financial markets.
AAA, ABCP, ABS, CDO, CDS, SPV, SIV - until just under a year ago, these abbreviations
could only be found in the financial press, if at all. This has radically changed in the past ten
months or so. What was previously only of little interest to outsiders has thus moved into the
limelight of public attention, within a very short time period. Much the same can be said of the
regular weekly recurring refinancing operations of the Eurosystem central banks, through
which the commercial banking sector is supplied with central bank money. While interest rate
decisions often receive public attention, such money market operations have so far been
regarded largely as a purely technical matter and have very rarely been covered by the
financial press. In the meantime, however, the public interest in our operational framework
has made clear that monetary policy involves more than just tweaking the interest rate.
In my following remarks I would like to touch upon some issues in the context of financial
markets and monetary policy. At first, I would like to explain the meaning and importance of
financial stability for central banks. Then I will briefly describe the causes of the recent
turmoil on financial markets and some of the lessons learnt. Thirdly, I would like to say
something in more detail about the liquidity operations we have been engaged in.
Finally, I would like to take up a more general aspect in discussing the potential role of
financial market trends for changes in the monetary transmission process.
2 The term "financial stability" and the role of the central bank
The term "financial stability" describes a financial system's ability to efficiently allocate
financial resources, reliably assess and tackle risks, and securely settle payments and
securities transactions. A stable financial system generally fulfils these functions also in
stress situations. Financial stability therefore also means resilience to shocks.
The term "financial stability" describes the functioning of the financial system as a whole, not
the skills of individual market participants. Or to put it bluntly: From a financial stability point
of view, the fates of individual institutions are of interest only if they could negatively affect
the system as a whole. Stable financial systems reduce uncertainty and thus develop
positive external effects on the real economy, thereby contributing to greater economic
prosperity. However, the reverse is also true: Instability in the financial system or even
financial crises can have negative external effects and thus cause high economic costs.
Contributing to financial stability is therefore part of a central bank's core area of
responsibility, in order to ensure price stability and avert negative repercussions of the
financial system on the real economy.
However, an emphasis on central banks' (joint) responsibility for financial stability must not
lead to false conclusions: Government measures should generally function only as a
subordinate security net when trying to ensure financial stability. The primary and essential
task is to underline and strengthen the responsibility of market participants not only for
themselves but also indirectly for the system as a whole.
After these more general thoughts, I will now come to some brief remarks on the dominating
topic of the past few months: the subprime crisis and its effect.
3 Subprime crisis: cocktail of causes and lessons learnt
What are the causes of the most recent tensions on financial markets? Here, I am extremely
sceptical about monocausal explanations. Instead, I believe that a cocktail of various
ingredients triggered the shock waves for the financial system.
A cocktail - whose individual ingredients would have been some cause for concern,
however, digested more or less smoothly by financial markets, but whose dynamic
interaction when mixed proved to be a severe and ongoing stress test for the international
financial system. The three main ingredients of this recipe are lending standards which have
become more lax and less risk-oriented, especially in the real estate sector in the United
States, weaknesses in credit risk transfer, especially in the originate-and-distribute model,
and overly optimistic assessments of structured securities.
Lax lending standards
The notion of obtaining a real estate loan with almost no capital and with only a poor or no
credit rating at all, is quite strange. In some countries, such mortgage loans, however,
became a major feature of the real estate market in the two to three years preceding its
peak.
Weaknesses in credit risk transfer
The almost oblivious-to-risk approach of lending to debtors with a low credit rating was
fuelled by two factors, previous house price increases and innovative financial instruments
which permitted the credit risk to be passed on from the bank to yield-seeking non-bank
investors. By securitising and tranching, it appeared for a while to be possible to convert
unstable individual loans to almost fail-safe securities. Some observers called this "financial
chemistry". In the corresponding passage in its last Annual Report, the German Council of
Economic Experts wrote of transforming "vin de pays into a cru", a bit like trying to make silk
purses out of sows' ears.
Not to be misunderstood: In principle, the possibility of transferring credit risks increases the
flexibility of financial market players and is an element of modern risk management.
However, the disruptions of the previous few months have highlighted major weaknesses in
this process. It has become clear that the tradability and fairly broad dispersion of credit
risks, in particular, can actually improve the resilience of the financial system only if a high
quality standard is maintained at all levels of the transfer process and no new concentrations
of risk arise. When transferring credit risks, one must always bear in mind that the transferred
risks themselves do not vanish into thin air - they are merely elsewhere and the danger
remains that they could resurface, possibly even in concentrated form. It was precisely such
new concentrations of risk that led to the distress in the past few months threatening the
existence of a number of financial institutions which were not themselves active players in
the area of real estate lending.
Overly optimistic assessment of structured securities
The previous ten months have shown dramatically the limited value of even professional
ratings. The assumption held by many around 12 months ago that structured securities
backed by mortgages provided a premium over government bonds at a similar (low) level of
risk has since proven to be a gross misperception.
The effects of the US subprime crisis meant, that for a period, a general crisis of confidence
spread among financial market participants. This crisis of confidence also restricted the
distribution of liquidity on the interbank money market, and still continues to do so.
In a nutshell: New and complex instruments to transfer credit risks in combination with large
banks engaging in an "originate and distribute" business model have amplified the
consequences of the undeniable credit excesses in the US mortgage market. These new
instruments exhibited several weaknesses that seriously hampered the efficient flow of
information between originators and investors. In the end, the new instruments of credit risk
transfer "distributed fear instead of risks" (Borio 2008). Already stated by Walter Bagehot in
his classical treatment "Lombard Street" in 1873, "credit means that a certain confidence is
given, and a certain trust reposed". Thus, it was not surprising that, in the end, the
turbulences on a special segment of the US mortgage market had the power to develop into
a general turmoil on credit markets and into a crisis of confidence between the still most
important intermediaries on current financial markets, i.e. banks.
A lot of effort by national and international institutions is currently put into the identification of
lessons learnt and necessary reforms. In an international context, most notably, the analysis
and reform proposals by the Financial Stability Forum deserve close attention. They are an
important step forward to make the international financial system more resilient. Most of the
reform proposals focuses on supervisory, accounting, and risk management issues. This
focus is certainly justified, but as it is somewhat separated form the core business of central
banks, I do not want to elaborate on them in greater detail.
In my following remarks I will try to sketch out in somewhat more detail issues that are more
central to monetary policy. In doing so, I will try not only to focus on the recent developments,
but also stress some more general aspects of the issues involved. To be more concrete, I will
discuss Eurosystem liquidity operations in the face of tensions on interbank markets. Here I
will for comparative reasons also refer to the latest steps by the Bank of England. Finally, I
would like to elaborate somewhat on the more general implications of financial market
developments on the monetary transmission mechanism to make clear that it is not only in
times of stress when financial markets are of interest or the core business of monetary
policy.
4 Current money market distortions and measures against it
4.1 The need of a well-functioning money market
Since August 2007 financial market turbulences have had a strong impact on the money
market - not only in the euro area but in nearly all important currency areas in the world. Due
to a rapid loss in confidence among banks the distribution of central bank money on the
interbank money market was distorted massively. Two cumulative effects were at work: On
the one side, banks' willingness to lend decreased sharply due to increased counterparty
risks. On the other side, banks' demand for short-term financing went up significantly due to
involuntary re-intermediation of former off-balance-sheet activities (SPVs, conduits) and a
higher liquidity preference due to the mounted uncertainty about future liquidity needs. The
resulting increase in the spread between money market rates and central bank interest rates
complicates monetary policy: The determination of the appropriate level of the central bank
rates is aggravated and the signalling function of these rates becomes more limited.
To counteract distortions in the money market, central banks all over the world took a wide
range of different measures. Some central banks reacted earlier, some central banks later,
some central banks had to change their operational framework more strongly, others less so.
While the Eurosystem reacted promptly but left its toolbox of monetary policy instruments
nearly unchanged, the Bank of England (BoE) stayed calm in the first turbulent phase, but
implemented some more extensive changes in its conduct of monetary policy after having
recognised that money market tensions were more enduring and more severe than
previously expected.
4.2 The operational framework of the Eurosystem (and the Bank of England)
Since the outbreak of the financial market turbulences the conduct of Eurosystem's
refinancing operations has changed only slightly - but not dramatically. All modifications
happened within the existing operational framework and without any change in Eurosystem's
key interest rates. Promptly after the financial market turmoil in August 2007 the Eurosystem
sharply increased its temporary liquidity provision to the banking sector. It announced
liquidity providing fine-tuning operations with favourable conditions and the banks took the
additional money readily. This quickly increased confidence of market participants and
brought the overnight rate roughly back to the minimum bid rate for main refinancing
operations. Since then, liquidity providing fine-tuning operations became largely
unnecessary.
However, despite a fostered liquidity provision at the beginning of the maintenance period,
no additional liquidity has been provided on average because the Eurosystem withdraw the
additional liquidity again at the end of the maintenance period with liquidity absorbing
finetuning operations. The resulting "front-loading" of the reserve requirements helped the banks
in their liquidity management. The same objective was achieved by the conduct of a
twoweek main refinancing operation for the last two weeks of December. This measure was also
designed to increase banks' planning reliability especially around the turn of the year.
Furthermore, the Eurosystem participated in a co-ordinated action of five important central
banks, together with the Bank of Canada, the BoE, the Federal Reserve, and the Swiss
National Bank in mid-December. Namely the Eurosystem took part in the newly implemented
Term Auction Facility of the Fed.
Already at the end of August 2007 the ECB Governing Council decided to introduce
supplementary long-term refinancing operations. The maturity of these operations was three
months (as for the regular longer-term refinancing operations). At the beginning of April
2008, for the first time, a supplementary longer-term tender with six-month maturity was
conducted. The announced six-months tender being allotted on 9 July will for the first time
provide liquidity beyond the turn of the year.
Despite these measures, however, especially unsecured longer-term money market rates
continued to entail significant default-risk and liquidity-risk premiums.
As I said, money market tensions emerged in all industrial countries and created a challenge
for the respective central banks. Whilst the Eurosystem kept its operational framework
largely unchanged, let me just for comparative purposes describe the decisions taken by the
Bank of England in adjusting its operational framework.
During the financial turmoil, the BoE announced that it allows banks to hold more
remunerated reserves and that it will provide the additional funds to do so. Normally the BoE
tolerates an on-average under- or overshooting of banks' remunerated reserve holdings of
±1% around banks' own reserve targets. For the maintenance period starting in September
2007 it widened the range to ±37.5%, and shortly later to ±60%, to increase the flexibility of
the banks. Meanwhile, since last October, the range has been reduced again to ±30%.1
Within the above mentioned co-ordinated action of five central banks the BoE gave notice in
mid-December 2007 that it has expanded the amount of reserves offered at the 3-month
maturity longer-term repo open market operations (OMO) on 18 December and 15 January
and, more importantly, that it has widened the range of collateral accepted for these
additional funds.
Again within another co-ordinated action of the five central banks, the BoE announced on 11
March 2008 a continuation of its expanded 3-month OMO against the wider range of
collateral.
On 21 April 2008 the BoE introduced a special liquidity scheme to swap high quality
mortgage-backed and other securities for UK Treasury Bills - which are provided to the bank
by the UK treasury for this purpose - for a given period of time. The purpose was to
temporarily exchange illiquid assets of high quality against very liquid securities thereby
stimulating the secured inter-bank money market. It is worth to note that the asset swaps
exist for a period of one year with the opportunity of a renewal of up to three years.
The developments in the operational frameworks of the Eurosystem and the Bank of England
indicate a certain convergence in responding to the liquidity tensions. The same is true if one
takes the actions of other important central banks into account. Most notably, all relevant
central banks have responded by undertaking exceptional fine-tuning operations and by
lengthening the average maturity of their refinancing operations. Central banks with a more
restrictive pool of eligible collateral and/or counterparties before the current turmoil have
broadened the range of accepted securities and counterparties. This is especially true for the
Bank of England and the Federal Reserve.
4.3 (Financial stability) implications of the operational measures
Although it is always difficult to draw conclusions from a cross-border comparison - even
more as we are right in the middle of a broad refurbishment of the causes and consequence
of the current financial market turmoil - I try to derive some conclusions:
From today's perspective it was the right decision of the Eurosystem to act promptly and to
inject additional funds temporarily into the money market. Confidence was re-established
quite fast and at the end of the reserve maintenance period there was no on-average
increase in central bank money.
In this respect, the communication policy of the central bank is very important. Policy makers
have to stress the separation between liquidity operations and general changes of the
monetary policy stance. To avoid "ex-post insurance of risky behaviour" - and to avoid
negative implications for price stability, too - it is predominantly important to make clear that
changes in the monetary policy stance are justified only when there is a risk to the primary
mandate of the central bank, i.e. price stability. I will come back to the current stance of
monetary policy in the Eurosystem, but let me first devote some further remarks on the
refinancing framework.
Central bank's flexibility is important in order to suffocate upcoming money market tensions.
A quick response to money market distortions will be supported by having a broad toolbox of
monetary policy instruments. In times of distorted money markets, a broad access to central
bank money undoubtedly helps banks to control their central bank liquidity. Both from an
implementation perspective as well as from a monetary policy perspective it is generally
desirable that all banks have access to central bank money. This broad access to central
bank money is even more important in the current environment. In normal times, however,
usually only a subset of banks will actually use the direct access to central bank money on a
regular basis.
One of the main differences between the Eurosystem and the BoE frameworks concerns the
range of accepted collateral. The Eurosystem did not and does not only accept government
bonds as eligible collateral but also highly rated private issuances and even bank loans to
the private sector with a good credit quality (according to Eurosystem Credit Assessment
Framework; ECAF). It is exactly this feature of our framework, that provided us with a high
degree of flexibility and allowed us to conduct our operations without changing the toolbox.
In general, it is quite difficult to assess whether a narrow or a broad range of collateral is
preferable. All in all, however, at least for me the advantages of a broader range of collateral
outbalance the potential disadvantages. In turbulent times a broad range of collateral helps
to grant additional funds to the banks without being restricted by their available high liquidity
range of securities. In this respect, a broad range may help to safeguard financial stability.
However, it is occasionally pointed out that the acceptance of private assets could create
adverse incentive problems aggravating counterparty risks of the central bank.
Counterparties have recently brought forward more than before less liquid collateral to the
Eurosystem, in particular asset-backed securities (ABS), for which primary and secondary
markets have basically dried up. The annual average share of ABS pledged as collateral
increased to 16 percent in 2007, up from 12 percent in 2006 and 6 percent in 2004. This
development may be promoted by the fact that, in terms of volume, nearly 60 percent of the
European securitisation market is eligible for Eurosystem collateral purposes. As a measure
of risk control the Eurosystem generally refers to market prices and deducts a haircut from
that value. If a market price is stale or not available, the Eurosystem calculates a theoretical
price itself. Therefore, the submitted collateral is at any time valuated with up-to-date prices.
If the (daily) valuated collateral falls below a certain level, the Eurosystem makes a so-called
margin call, requiring additional collateral from the counterparty. From a risk management
perspective, time-varying haircuts may also mitigate, among other adequate measures,
counterparty risks of the central bank. This instrument is also in use by the BoE for
evaluating collateral. It requires central banks' ability to assess the recoverability of the
collateral appropriately. For this purpose the Eurosystem continuously monitors the quality of
its collateral very carefully.
We should keep in mind, however, that in light of the financial tensions central bank repo
transactions as such can only mitigate some funding tensions for banks. They do not
address the fundamental cause of the problems, that is an overhang of illiquid assets on
banks balance sheets due to former credit excesses.
5 The current monetary policy stance in the Eurosystem
For setting the Eurosystem monetary policy stance, however, the outlook on price stability is
the magnetic needle of the Governing Council. It is only the possible repercussions of stress
in financial markets on real economic developments and on the outlook for inflation that is of
interest for monetary policy in that regard. Against this background the fallout of the financial
market tensions - but also the effects of higher commodity prices - will be a more moderate,
but still resilient, global growth.
The euro area remains on solid fundamentals with regard to real economic growth. This view
is underlined by the Eurosystem staff projections published yesterday. And also the outlook
on Germany as laid out in the Bundesbank forecast published today supports this
assessment. While we will see a moderation in growth rates over the coming quarters, both
in the euro area and also in Germany, already at the turn of the year we will have reached
the through. Moreover, the moderation in growth rates in the quarters ahead have to be seen
against the positive developments in Q1. Looking through the volatile quarterly figures, it is
evident that the current cycle is resilient and robust.
At the same time, current inflation rates as well as the medium-term outlook on consumer
prices leaves us in a state of heightened alertness. Even under the optimistic assumption
that recent dynamics in commodity prices diminishes over the projection horizon and that
there will be no broad-based second-round effects, monthly HICP inflation rates will stay
above our definition of price stability far into 2009. And the risks to this outlook are clearly on
the upside.
Given our focus on price stability, the Governing Council has sent a clear signal to markets
and to the broader public yesterday, which seems to have been well-understood, that such
an outlook on inflation is not acceptable for a stability-oriented monetary policy. The
message of yesterday's Governing Council meeting also strongly underlines the already
mentioned principle to keep distinct liquidity operations and interest rate setting in the
conduct of Eurosystem monetary policy.
6 MTM and financial developments
The relationship between monetary policy and financial markets, however, is by no means
one that is only of interest for policy makers in the face of a crisis. Developments on financial
markets have the potential to modify core economic relationships and, thus, are of utmost
interest for monetary policy. Let me therefore move away somewhat from the recent stress
episode to discuss another more structural issue.
The recent decade has seen remarkable financial development, leading to many new
financial products, more competition, a tremendous increase of securitization activities,
disintermediation, and a consolidation process in the banking sector. This alters the range of
activities of financial market participants and it possibly also changes their reaction to
monetary policy. In the following, I will briefly discuss how financial innovations could have
modified the interest rate channel and the bank lending channel of monetary policy
transmission
6.1 Interest rate channel
Increased competition in banking together with an enhanced availability of alternative capital
market-based instruments for financial investment has likely amplified and/or sped-up the
effects of monetary policy changes on bank interest rates (and, ceteris paribus, on output
and inflation): Increased competition between banks, but also between banks and different
other financial market segments led to a closer relationship between market and bank
interest rates. Consolidation in the banking system has also potentially accelerated the
transmission of monetary policy shocks to bank lending rates as well as to other financial
variables if (fewer and) larger banks use improved arbitrage opportunities between different
market segments. The deepening of financial markets has likely fostered the role of
expectations and thereby increased the speed at which changes in short-term interest rates
are transmitted to other financial variables and to the real economy.
In sum, the existing literature points to a faster interest rate pass-through caused by deeper,
more complete and more competitive financial markets. This is also confirmed by the
respective empirical literature.2
6.2 Impacts on credit channel
The credit channel consists of several sub-channels, with the bank lending and the balance
sheet channel being the most prominent ones. The bank lending channel concentrates on
the effects of monetary policy on bank loan supply via changes in the banks' funding
possibilities. The balance sheet channel looks at the effects on the overall supply of funds via
changes in the borrowers' balance sheets (esp. value of collateral). The bank lending
channel is generally expected to have lost importance due to the financial development of
the recent years: Banks' flexibility to react to an interest rate hike has increased, and the
dependency on bank loan supply has declined. With a higher flexibility on the banks' side,
caused, e.g., by increased securitization or an improved risk management, banks have
become able to better isolate their loan customers from monetary policy impulses. In
consequence, European banks can nowadays react more flexibly to changes in market
conditions than before.
Empirical studies (e.g. Altunbas, Gambacorta and Marques (2007) point in this direction and
suggest that asset securitization may have reduced the importance of the bank lending
channel for monetary policy transmission. Further, it allows banks to transfer parts of their
credit risk to other market participants such as institutional investors. Thus, those banks that
use securitization more intensively are better sheltered against monetary policy.
In a similar vein, with the increasing use of derivative instruments lending policies of banks
might also have become less vulnerable to macroeconomic shocks - such as an unexpected
monetary policy tightening. In addition, derivative instruments potentially facilitate banks to
raise non-reservable sources of funds, for instance, by improving a bank's liquidity. Drawing
on US data, the empirical results of Purnanandam (2007) show that the lending volumes of
those banks that use derivatives are not sensitive to a Federal funds rate shock. On the other
hand, those banks that do not use derivatives (even the very large one) significantly cut their
lending volume when the Fed tightens the monetary policy. This suggests that derivatives
help banks to shield themselves (at least partially) from a monetary policy shock. However,
credit protection through credit derivatives may also be associated with an increase in bank
credit supply, as has been found for other innovations like securitizations as well. Drawing on
US micro data Hirtle (2007) finds that greater use of credit derivatives is associated with
greater supply of bank credit for large term loans.
Further, huge amounts of loan-backed instruments have been acquired by entities known as
conduits/SIVs which, while not appearing in banks' balance sheets, benefit from large
contingent credit lines granted by banks that set them up. The turbulences starting in the
second half of 2007 have just illustrated that, as structural investment vehicles draw on their
credit lines, bank balance sheets may greatly inflate in times of stress (ECB, November
2007).
Moreover, financial development has not just broadened banks' possibilities to react to
monetary policy and thereby reduce the effect of loan supply - it has also broadened
borrowers' financing opportunities, reducing their dependency on bank loans. The additional
funding opportunities entail a larger share of market-based (instead of bank-based) products;
due to the fact that these are more standardized and less idiosyncratic, collateral may play a
more important role now. Therefore, the importance of the balance sheet channel which
relies on the effects of monetary policy on the supply of funds via wealth and collateral
effects may gain importance due to financial development.
Whether the credit channel as a whole loses or gains importance due to financial
development is an open issue, both theoretically and empirically.
Since a good knowledge of the monetary transmission process, that is of the key variables
and the lags involved, is key for monetary policy, it is necessary for central banks to closely
monitor the developments in the financial markets because they have the potential to
seriously affect the monetary transmission process. Factoring-in the influence of financial
market developments underlines the fact that monetary policy has to be based on a broad
range of different indicators in order not to run the risk of missing important information.
7 Conclusion
I have tried to illustrate some aspects of the relationship between monetary policy and
financial markets. Developments on financial markets have repercussions on our operational
and refinancing framework. In addition, they have the potential to alter the impact of interest
rate measures on the rest of the economy. It goes without saying that without financial
stability the task of monetary policy becomes more complicated.
In that regard we should remember that in safeguarding price stability monetary policy
supports financial stability. Thus, considering the influence of financial market developments
on monetary policy does not lead to a change of the well-respected fundamental goals of a
stability-oriented monetary policy.
Literature
Altunbas, Y., L. Gambacorta and D. Marqués (2007), "Securitisation and the Bank Lending
Channel", ECB conference on "The Implications of Changes in Banking and Financing on the
Monetary Policy Transmission Mechanism", 29-30 November, Frankfurt.
Bondt, G. de (2005), "Interest Rate Pass-through: Empirical Results for the Euro Area",
German Economic
Review, Vol. 6, No. 1, pp. 37-78.
Bondt, G. de, B. Mojon and Natacha Valla (2005), "Term Structure and the Sluggishness of
Retail Bank Interest Rat