Jean-Claude Trichet: Intellectual challenges to financial stability analysis
in the era of macroprudential oversight
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, for the panel
discussion on "Global imbalances and financial stability" at the Eurofi G20 High Level
Seminar, Paris, 18 February 2011.
Comments on the article published in the Banque de France Financial Stability Review Nr. 15, February 2011.
* * *
1. To focus the Banque de France Financial Stability Review on "Global imbalances
and financial stability" is extremely timely. After some partial reduction induced by
the crisis global imbalances have started to widen again. This poses challenges for
international monetary cooperation and exchange rate relationships. Moreover, a
further surge in private capital flows to emerging economies could lead to an
acceleration of reserve accumulation and to the re-emergence of the pattern of
imbalances that contributed to the factors causing the crisis. The potential
disorderly unravelling of these imbalances remains one of the main risks to
the European and global financial systems over the medium term.
2. Therefore we need to continue thinking about how we can make the international
monetary system more resilient to such imbalances and policy structures more
flexible in addressing them more effectively than the case in the past. In this regard I
welcome the focus of the French G20 Presidency on the process of mutual
assessment of its members' macroeconomic and structural policies.
3. I decided to focus my remarks today on a related but more specific topic. My starting
point is that we have recently entered a new era of financial stability policies,
the era of macroprudential oversight. Both the European Union and the United
States of America have established new bodies whose task it is to identify early
emerging systemic financial risks and to consider policy measures that could
mitigate them. These are the European Systemic Risk Board and the Financial
Stability Oversight Council, respectively.
4. One pre-condition for matching the expectations to this new era is that the
competent authorities possess a comprehensive and reliable analytical apparatus
for identifying systemic risks and for assessing the effectiveness and efficiency of
policies that could contain them. In my contribution today I would like to highlight
four challenges that I see in advancing such an analytical apparatus and point in
some directions one could go in meeting these challenges.
5. The first challenge relates to the basic functioning of financial systems. Whereas
important parts of - let me say - the "DNA" of financial systems is known, the crisis
has shown that there remain significant difficulties (1) in grasping the benefits and
risks of some major "mutations", namely important financial innovations and new
business models, and (2) in predicting how the overall "body" reacts to specific
stresses.
6. More specifically, I would argue that our analytical apparatus would still have to
make progress in characterising the role of non-bank financial intermediaries. For
example, the "explosion" of the industry of highly leveraged financial institutions from
around 100 billion US dollars of capital under management in 1990 to 3 trillion
dollars in 2007 implies that this industry is likely to generally have important
systemic implications, even though the present crisis was not caused by failures of
large hedge funds. Many hedge funds are highly sophisticated, but this does not
imply that in the aggregate they always act in the stabilising contrarian way
perceived by some observers. Recent research about the "dot.com" bubble episode
7. The second intellectual challenge for such an analytical apparatus relates to when
and how a financial system migrates from tranquility to a severe crisis. It
appears to me that in economics we have some way to go in understanding the
triggers, speed and abruptness of such migrations. See, for example, the sudden
eruption of systemic instability in August 2007 and its dramatic worsening in
September 2008, as reflected in a new indicator of systemic stress developed by
ECB staff displayed in chart 1 of my article. In physics, however, "phase transitions"
are the subject of ample research since a long time. For example, Jean-Philippe
Bouchaud from the Ecole Polytechnique here in Paris has shown how fundamental
research in physics on "crackling noise" and "self-organised criticality" can be
applied to transitions to financial crises. This helps, for example, to understand the
initial persistence and subsequent abrupt breakdown of financial bubbles. While this
type of approach closely matches a number of important empirical patterns in asset
prices, for example, it does not assume very high levels of rationality of economic
agents, a strong tendency towards equilibrium situations or universal efficiency of
financial markets. This observation might be insightful, if we compare it with the
standard models that are nowadays used in economics.
8. The third challenge concerns how financial instability interacts with the
macroeconomy. In my article, in chart 2, I have illustrated how drastically major
forecasting institutions missed the start of the "Great Recession", the "free fall" of
economic activity in late 2008 and in 2009. A tremendous challenge is therefore to
improve macroeconomic forecasting models, so that they give us also faster and
more accurate characterisations of such situations over the relevant policy making
time horizon. Two directions in which we probably have to go in order to make
progress are to generally integrate more realistic characterisations of financial
systems in macroeconomic models and to capture the relevant nonlinearities that
are so typical for the unfolding of financial crises.
9. Fourth and last, we need to make further progress in the regulation of systemic
risk, as opposed to only regulating individual risks. To be fair, Basel III goes some
way in this direction. It generally increases the quantity and quality of capital and
liquidity buffers. And the conservation of capital against excessive distributions will
be complemented with a counter-cyclical element. Moreover, major international
initiatives are under way to further reduce the probability and impact of failures of
systemically important financial institutions (the so-called SIFIs), including the
development of effective resolution regimes and recovery planning. One area where
our analytical apparatus supporting macroprudential policies could make further
progress is in terms of the assessment of early regulatory responses to credit
bubbles. Some moderately sized Asian emerging countries, for example, have made
some interesting experiences with the tightening of loan-to-value ratios or
debt-toincome limits when property markets started to boom. We would benefit from more
work about the effectiveness of these instruments in large industrial countries and
as fully counter-cyclical tools, which would mean to also relax them in downturns.
10. Europe has pushed ahead with establishing the European Systemic Risk Board,
which started to work last month. The ESRB will monitor systemic financial risks to
the EU, including the ones emerging from global imbalances. When necessary, it
will issue risk warnings and/or policy recommendations. One of its strengths is the
ESRB's broad membership, bringing around the table the right institutions and
expertise. In this way, all relevant issues can be tackled in a coordinated way and its
recommendations carry due weight.
11. Let me now conclude. The agenda we have to meet in the era of macroprudential
oversight is tall. We need to advance our analytical and policy apparatus along the
four types of challenges I just discussed. This will require, inter alia, enriching the
way of thinking in economics and finance. New approaches should be
considered that do not necessarily rely on the notions of equilibrium and universal
rationality and efficiency. Going beyond the latter concepts may benefit from
inspiration of approaches used in other fields, such as notably the natural
sciences. This would not only help us advancing the foundations of national and
regional supervisory policies but also the foundations of global macroeconomic
policy coordination.