Jean-Claude Trichet: A paradigm change for the global financial system
Remarks by Mr Jean-Claude Trichet, President of the European Central Bank, at the
International Colloquium "Nouveau Monde, Nouveau Capitalisme" roundtable, Paris,
9 January 2009.
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Ladies and gentlemen,
The current crisis stands out because it is affecting the heart of the global financial system.
Its root cause was a widespread undervaluation of risk in the global financial system,
especially in the most advanced economies. This included an underestimation of the quantity
of risk financial institutions took upon themselves and an underpricing of the unit of risk. Risk
was underpriced because, among other things, financial market participants largely
extrapolated ongoing trends and the very low levels of volatility in financial markets and in
the real economies going forward.
A number of policy-makers indicated at the time that these trends and low volatility could not
be taken for granted. As chairman of the Global Economy Meetings of central bank
governors in Basel, I myself reported my colleagues' sentiments on this matter. We also said
publicly, long before the difficult time we are going through today, that the private sector had
to prepare for a market correction, because such a correction was inevitable. The aim of our
urging was to try to ensure that the correction itself would be as orderly as possible. Yet, one
of the main reasons for the lack of preparation had its basis in the widely held view that
regulation should not stifle financial innovation and that markets knew best and could - for
the most part - regulate themselves adequately.
The turmoil has shown how complacent and misleading this attitude was. When the turmoil
set in, many financial institutions realised that their risk management systems were not as
reliable and robust as they had believed them to be and, indeed, should have been. Most
importantly at the time, market liquidity, that is the ability of financial markets to express
appropriate prices at all times, which had wrongly been taken for granted, evaporated in
large segments of the financial markets.
Investment-banking business models typically featured high-leverage, marking-to-market
accounting, large maturity mismatches and relatively limited liquidity and capital reserves.
This model was efficient as long as markets kept booming and functioned properly, but left
those banks with little or no shock-absorption capacity. We have seen the result: investment
banking, as we knew it, has disappeared before our eyes, and all banking institutions have
come under severe pressure.
The financial authorities - both in Europe and in other parts of the world - reacted promptly.
Central banks, including prominently - and from the very start of the turmoil - the ECB,
provided short-term liquidity support to prevent contagion. A number of the central banks'
actions were coordinated internationally. Regulators gave priority to comprehensive policy
responses, addressing the more fundamental weaknesses. Coordinated guidelines were put
forward at the European and international level by the Financial Stability Forum, the
Eurogroup and the European Council, in particular, and were reflected in the declaration of
the G20 summit. This bears witness to the importance of measures to be applied consistently
in all countries. A global financial system requires a globally coordinated response, and the
official sector has been providing just such a response.
Looking ahead, we should correct the substantial flaws in the financial system that have now
become evident. Of course, we should not throw the baby out with the bath water by
discarding the market economy setup that underlies the system. It is the only setup that has
proved able over time and globally to deliver sustained prosperity, and it has no equal in
overall efficiency. But our basic aim should be to improve very significantly the resilience of
the financial system: the fragility that has become apparent since August 2007 and more
acute since mid-September last year is not acceptable. We have to draw lessons from the
present situation without any complacency.
To be specific in terms of avenues for reform, I would like to highlight three areas where
change is particularly needed: 1) short-termism, 2) pro-cyclicality and 3) transparency. I
believe that shortcomings in these areas were instrumental in creating the conditions for this
crisis and amplifying its severity.
1. First, among financial market participants (traders, managers, risk committees and
boards of directors alike) for a long time there has been an excessive focus on
short-term profits to the detriment of longer-term business performance. This has
resulted in excessive risk-taking and, particularly, an underestimation of low
probability risks stemming from excessive leverage and concentration. We now
need to create more balanced and forward-looking incentive frameworks for
management compensation and more effective internal risk measurement and
control systems that take into account not only near-term profitability but also
sustainability and durable financial strength. This is an area where improvement will
depend crucially on private decisions, in addition to public action.
2. Second, we need to re-examine all aspects of the current regulatory framework to
ensure it does not contribute to the intrinsic cyclicality of banking. A number of
potential sources of pro-cyclicality need to be investigated, including fair value
accounting and leverage, capital requirements and provisioning regimes. Looking
forward, new mechanisms should be devised to ensure that banks accumulate
resources in good times to cushion the shock when the cycle turns. Measures could
include requiring banks to hold additional capital and liquidity buffers and introducing
dynamic provisioning systems that require banks to build up a general reserve that
can be drawn on in downturns. Market economies inevitably entail cyclical swings; it
is up to regulatory and supervisory bodies to ensure that their regulations and
actions do not amplify those swings.
Third,
3. in recent decades transparency has not matched the increasing level of
sophistication and complexity of financial instruments, creating significant gaps in
investor information and financial education. These need to be filled with enhanced
risk disclosure at all levels, particularly in institutions and markets that are currently
unregulated but can - as recent experience has shown - exert a relevant systemic
impact. Financial regulation should be reviewed to better reflect the role of highly
leveraged institutions in particular - namely private equity, hedge funds and special
purpose vehicles - and of derivatives markets in general, including, but not
exclusively, credit derivatives. Regarding the latter, I welcome in particular the
initiative to improve the infrastructure of over-the-counter markets by establishing
central counterparty clearing for the CDS market.
Let me conclude.
In the current, very demanding situation, the swiftness and the magnitude of the decisions
taken by central banks as regards the supply of liquidity and the decisive actions taken by
governments and parliaments as regards recapitalisation in the financial sector and the
provision of guarantees have proved effective in avoiding a meltdown of global finance. But it
would be a mistake to underestimate the structural fragility of the present state of global
finance and, consequently, of the global economy.
This is the heart of the matter: we need a paradigm change in the global economy. The
previous paradigm was based on the concept of relatively short-term financial market
equilibrium. What we need is a new paradigm. A paradigm based upon the following three
fundamental notions. First, the notion of medium and long-term sustainability, which will
require us to be much more resolute in distinguishing between the stable equilibria on the
one hand and the unstable equilibria on the other hand, which should not be accepted.
Second, the notion of resilience to shocks, taking into account the fact that whatever the level
of sustainability of a particular financial situation, we can never eliminate the occurrence of
unpredictable shocks. These shocks can come not only from the economic and financial
sphere - the present stress test is a very powerful example - but also from the geopolitical
sphere, or they can be triggered by natural catastrophes. Resilience is therefore essential; it
is a necessary complement to sustainability. The third notion is holism: the present global
financial system depends on the appropriate handling of a very large number of factors:
prudential practices, accounting rules, audit quality, liquidity management, risk management
and credit assessment, to mention but a few. This holistic approach must also comprehend a
fundamental factor, namely the long-term sustainability and resilience of public macro
policies - whether in particular fiscal or structural - and the associated progressive but
resolute elimination of those large domestic and external imbalances that are one of the
major causes of global economic and financial instability.
Such a paradigm change, including the three notions of medium and long-term sustainability,
resilience and a holistic approach of the global financial system, is now absolutely essential
to correct the fragility of the market economy which we are presently experiencing.
Thank you for your attention.