José Manuel González-Páramo: Sub-prime crisis, liquidity tensions and
central banks - one year on
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the 2nd Spanish Capital Markets Forum, Madrid,
30 September 2008.
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1. Introduction
Ladies and Gentlemen,
It is a great pleasure for me to be here in Madrid at this 2nd Spanish Capital Markets Forum.
Having very good memories of the interesting discussions and presentations at last year's
event, I would like to thank the organisers for inviting me again and providing me with the
opportunity to share with you some views about the financial market turbulences, how we -
as central bankers - have addressed them and some of the lessons learned so far.
2. The financial market turmoil: where do we stand?
Let me briefly recall the situation prevailing in financial markets when this conference took
place last year. At the time, the market turmoil had already broken out and central banks
were already engaged in interventions aiming to minimise the disruptions to money markets
and to preserve the implementation of their desired monetary policy stance.
In my intervention at the time I reported that although the ECB liquidity measures had had a
stabilising effect on the euro money market rates at the shorter end of the term structure and,
more generally, the money market had recovered some of the lost ground, market
participants continued to report limited trading activity and high spreads, particularly in
unsecured inter-bank term markets. Banks seemed to be particularly reluctant to lend money
in the unsecured inter-bank market due to uncertainty about their own funding needs,
especially in USD, and lack of confidence in the soundness of their counterparties.
One year later, the financial market turmoil has not yet come to an end. In fact, over the past
few weeks, it has intensified again. Large financial institutions have failed or had to be taken
over by others, while a number of markets have exhibited increased volatility and reduced
liquidity. In particular, significant tensions persist in global money markets, where market
liquidity is strained and term interest rates are elevated. Meanwhile, volatility has increased
in other global financial markets, particularly for equities and commodities. Central banks
have provided liquidity to help to stabilise conditions in the euro money market and to
mitigate tensions in the US dollar money market and in the FX swap markets. In addition,
public authorities have announced a number of measures and initiatives to address problems
at both stressed markets and troubled individual institutions. Nevertheless, international
money markets remain under stress.
Excessive volatility is, to a large extent, a reflection of the urgent need to harness investors'
"animal spirits" through the appropriate market and institutional framework. A full and rapid
implementation of the Financial Stability Forum recommendations on the strengthening of
supervision, regulation, risk management, and accounting and transparency frameworks is of
maximum importance. At the same time, as pointed out above, several governments have
taken decisive action to address credit concerns and central banks have been coordinating
to address liquidity pressures in funding markets. In this respect, market participants would
be well advised to heed last week's pledge by finance ministries, regulators and central
banks of the largest world economies to take action as needed, individually and collectively,
in order to protect the integrity of the international financial system and facilitate liquid,
smooth functioning markets. More than ever, bringing market participants back into a liquid
and stable marketplace remains our top priority.
3. International transmission of liquidity shocks and liquidity spirals
Let me now refer to a couple of elements which have played a central role during the turmoil:
the international transmission of liquidity tensions and the interaction between market
liquidity and funding liquidity. Indeed, the events of the past year have illustrated vividly the
strength, the complexity and the rapidity of the international transmission of liquidity shocks.
Clearly, underlying the international transmission mechanism is the fact that interbank
markets are linked across countries by the activity and funding needs of banks doing cross
border business on a large geographical scale and holding assets and liabilities denominated
in varying currencies. Liquidity conditions in interbank markets are therefore correlated at the
global level, because many of the key players are subject to common shocks.
Another dimension of the ongoing turmoil is the enhanced interaction between market
liquidity and funding liquidity. Under normal market conditions, market illiquidity is typically
short-lived, in particular since it creates profit opportunities for traders who, by providing extra
funding liquidity, support the price discovery process and restore the smooth functioning of
the market. In contrast, during a severe turbulence the disruption of the mechanisms
channelling liquidity - be it through assets prices or the balance sheet of financial institutions
- may also deeply and lastingly perturb the functioning of markets, ultimately creating risks
for systemic imbalances.
The current episode is an example of this. Even the interbank market, which is considered
the deepest and most liquid of all markets, has been protractedly "frozen". This has
happened primarily due to uncertainties as to the size and locations of losses created by the
opaque transfer of credit risk brought about by complex securitisation mechanisms. Such
uncertainty has heightened counterparty credit risk concerns, discouraging banks from
lending to each other.
Moreover, it has brought to the fore the increased interaction between market liquidity and
funding liquidity of individual institutions. Indeed, the trend among large global banks has
been towards greater reliance on wholesale market sources of funding. Instead of relying on
retail deposits, some banks are increasingly dependent on interbank borrowing, short and
long-term debt, and, as an ultimate line of defence, on the sale of marketable securities. This
has made access to funding liquidity more dependent on market conditions.
In addition, the range of systemically relevant institutions has become broader. Indeed,
nondeposit taking investment banks and primary dealers play a systemic role in their crucial
broker-dealer function. They perform a key role in maintaining market liquidity in a broad
range of unsecured and secured markets. If they face funding liquidity constraints, market
liquidity will be widely affected, with potential negative repercussions for the banking sector
as a whole.
This environment poses challenges for central banks, as addressing funding liquidity
shortages may require supporting market liquidity. Clearly, the nature of the turbulence
matters: concerns for market liquidity itself could in principle be addressed by central bank
actions, whereas central bank liquidity operations would be ill positioned to tackle individual
counterparty solvency concerns.1 Along these lines, let me explain how central banks have
responded to the challenges arising from market turmoil using a combination of operational
measures and increased international co-operation.
4. How central banks responded
Clearly, the responses have varied across central banks, but in general terms, they have
tried to address the liquidity squeeze in similar ways and have concentrated on four fronts:
First, central banks have acted to keep short-term money market rates in line with their policy
rates (or targets) through more active reserve management, thereby flexibly responding to
shifts in the demand for reserves.
Second, central banks have sought to ease pressures in broader funding markets through a
combination of measures, such as an increased supply of longer-term funds, the expansion
of collateral accepted in lending operations, and the widening of the range counterparties
that may have access to collateralised lending. Some central banks also increased securities
lending to improve the functioning of interbank repo markets.
Third, central banks have increased their co-operative efforts both through enhanced
communication and collective market monitoring, and through co-ordinated actions to provide
both overnight and longer-term funds. Finally, some central banks also calibrated their
monetary policy stance to take into account any impact that the unfolding credit market
turbulences might have on inflation and real activity.
4.1. Responses of the Eurosystem
Let me now briefly describe how the Eurosystem has responded through operational
measures to changes in banks' liquidity demand.
Since the very early phase of the ongoing turbulences in August 2007, the Eurosystem has
resorted to a more pro-active liquidity management in order to maintain a proper control of
short-term interest rates. Owing to the built-in flexibility of its operational framework for
monetary policy implementation, the Eurosystem could address the impaired functioning of
the money market through relatively minor, technical adjustments to its normal operations,
while at the same time utilising the full latitude of its liquidity management arrangements.
In particular, we adjusted the distribution of euro liquidity supplied over the course of the
maintenance period, in contrast to normal times, by frontloading the supply of liquidity at the
beginning of the period and reducing it later, so that the total amount of liquidity over an
entire maintenance period remained unchanged. Furthermore, we increased the amount of
refinancing provided via longer-term refinancing operations significantly with a view to
smoothening conditions in the term money market. As a result of these measures, the
average level of EONIA has remained close to the minimum bid rate, though with a higher
volatility than before the start of the turbulences.
Moreover, the lengthening of the maturity profile in the regular repo operations combined
with the following three key features of the operational framework have allowed the
Eurosystem to address funding constraints indirectly also in term money and asset markets:
Firstly, access of a broad range of counterparties to central bank liquidity. This feature has
allowed the Eurosystem to step in and effectively mitigate funding liquidity risk for a broad
range of counterparties on those occasions when short-term interbank markets stopped
functioning properly.
Secondly, acceptance of a broad range of collateral in all classes of lending operations. As a
consequence, sufficiency of collateral has not been a constraint. Moreover, the acceptance
of private-sector collateral has allowed counterparties to economise on the use of central
government bonds - often the only collateral that counterparties could still use in repo
markets - in their operations with the central bank. And it has to some extent eased
refinancing pressures for assets, such as ABSs, that faced a nearly complete withdrawal of
third party investors.
Thirdly, the relatively large scale of the open market operations has allowed the central bank
to temporarily take over a significant intermediation function.
4.2 Increased international cooperation
As pointed out before, in addition to domestic operational responses, central banks have
further strengthened their cooperation throughout the turmoil, first through enhanced
information sharing and collective monitoring of market developments and later on by
coordinated steps to provide liquidity. One example of such coordinated actions among
central banks is the by now familiar US dollar Term Auction Facility, which started in
December of last year and in which the ECB agreed with the US Federal Reserve to grant
loans in dollars to euro area banks. More recently, the scope of this facility has been
expanded with the decision on 18 September to start providing USD funding to European
counterparties also on an overnight basis and to increase the amounts offered in the existing
operations at longer maturities (28- and 84-days). Besides, last Friday (26 September) an
additional one-week operation designed to mitigate USD funding pressures of euro area
banks over the end of the third quarter was announced. And yesterday, in response to
continued strains in short-term funding markets, ten central banks announced further
coordinated actions to expand significantly the capacity to provide US dollar liquidity. As
regards the specific actions in the euro area, the Federal Reserve and the ECB decided to
double their temporary reciprocal currency arrangements (swap lines) from USD 120 billion
to USD 240 billion. This reciprocal swap facility has been authorised through 30 April 2009.
The increased facility will allow expanding the provision of US dollar liquidity in the euro area.
It should be noted that these USD liquidity-providing operations do not have a direct effect on
euro liquidity conditions, but are conducted to facilitate the funding of euro area banks in US
dollars and aim to improve global funding conditions.
It is important to stress that the actions in connection with the TAF marked, to my knowledge,
the first systematic, multilateral and successful central bank co-operation in the money
market field, a market which is central to the implementation of a central bank's monetary
policy. I believe that all of these actions have proved to be effective in easing the tensions at
the short-term end of the global money markets and in maintaining control of short-term
interest rates in the euro area. I am sure that global money and funding markets will continue
to benefit from our very close cooperation. We will carry on working together closely and are
prepared to take appropriate steps as needed to address funding pressures.
5. What central banks have learned: two lessons among others
Going forward, what preliminary lessons can we draw as central bankers from the ongoing
turbulence?
5.1 Lessons for the implementation of monetary policy
In the past, common central bank wisdom was to say that there is no unique way to
implement monetary policy. In Borio's words (2001): "Just as there are a hundred ways to
skin a cat, so there are a hundred ways to implement monetary policy".2
Nonetheless, the currently prolonged dislocation of interbank markets and, more broadly,
asset markets has shown that there are certain key operational features that facilitate the
implementation of monetary policy in such conditions. In order to distribute reserves
effectively when the interbank market is impaired, central banks should be capable of
providing access to collateralised lending operations to a wide set of counterparties against a
broad range of collateral and on a large scale. Whether those features should become part of
the regular operational framework or are introduced on demand in distressed market
conditions, is ultimately the choice of each individual central bank.
As regards the Eurosystem, we believe that our flexible operational framework, including the
collateral component, has served us well until now, and has helped us to weather a number
of tests, including the latest of a prolonged liquidity squeeze in a wide range of unsecured
and secured markets. However, this does not mean that there is no scope for refinement and
further enhancement.
One recent example is the fine-tuning of our risk control framework in the context of our
latest 2008 review of the adequacy of the risk control measures. These reviews are
conducted on bi-annual basis to meet the statutory obligation of the Eurosystem to adjust the
collateral and risk control framework over time so as to ensure that it remains adequately
protected against financial risks across time, while allowing at the same time the effective
implementation of monetary policy. The new risk control measures, which do not change the
general characteristics of the framework and are not expected to impair the ability of banks to
participate in our operations, were communicated by the ECB on 4 September, and will enter
into force on 1 February 2009.
I would like to highlight in particular the decision to require better rating disclosure standards.
To be eligible as collateral for Eurosystem credit operations, asset-backed-securities will
need a rating that must be explained in a publicly available credit rating report, being a
detailed pre-sale or new issue report, which should include inter alia a comprehensive
analysis of structural and legal aspects and a detailed collateral pool assessment. Moreover,
rating agencies - and the Eurosystem believes this is very important - would need to publish
rating reviews of asset backed securities at least on a quarterly basis. By requiring that the
result of the rating assessment as well as the regular surveillance reports are made public,
the Eurosystem can support the functioning of ABS markets more widely through enhanced
transparency, which is a pre-requisite to restore investor confidence.
Other important changes to the risk control include the introduction of a uniform haircut of
12% to asset- backed securities for all residual maturities and all coupon types, as well as a
valuation mark-down of 5% to all asset-backed securities that are theoretically valued by the
Eurosystem. These two measures respond to a careful analysis of the liquidity characteristics
of asset-backed securities, and in particular, of the valuation uncertainties arising when there
are no market prices that could provide a reference for intrinsic value. By introducing both
measures, the Eurosystem can contribute to the restoration of normal conditions in the
functioning of asset backed primary markets.
5.2. Lessons for enhancing the international distribution of liquidity
The current turbulence has also demonstrated that global channels for distributing liquidity
across borders may become seriously impaired. To prepare for that possibility, central banks
should take steps to strengthen their capacity to counter problems in the international
circulation of liquidity. Two recent reports from both the financial industry and the central
banking community have pointed out to the potential advantages of establishing or
maintaining standing currency swap lines,3 which may be quite important in emergency
situations. From a technical point of view, the coordinated distribution of foreign currency to
the domestic bank sector through swap lines is feasible and it is also possible to design it in
such a way that it does not conflict with domestic monetary policy implementation.
Similarly, both reports consider developing and maintaining the ability to accept foreign
currency denominated assets, which is more complicated than maintaining a swap line but
could support the efficient management of collateral by internationally active banks with
multi-currency liquidity demands. To understand this, one should bear in mind that under
normal conditions, cross-border mechanisms among the infrastructures of major markets
allow private banks to move collateral where it is needed. However, in an emergency
situation, standard transfer procedures may simply not be effective or quick enough and
settlement may become a constraining factor.
Easing liquidity pressure for large internationally active banks by broadening the range of
acceptable collateral may contribute to alleviating potential liquidity contagion risks in
payment systems, where the bulk of activity normally comes from the largest players, thus
having a positive influence on financial stability. However, it should be noted that accepting
foreign currency collateral also implies additional legal and financial risks in the conduct of
monetary policy operations. Hence, this is an area where further work is needed.
6. Final remarks
Let me finally offer you some concluding remarks. One year after its start, the financial
market turmoil has not subsided. In fact, it has intensified over the past few weeks, prompting
central banks to step up their efforts to inject liquidity in global money markets in order to
keep short-term money market rates in line with their policy rates and to guarantee the
smooth functioning of money markets, thereby contributing to preserving financial stability.
While the continuation of the market turmoil does not allow us to draw lessons from the
comfortable position of an ex-post assessment, the experience of the past year suggests that
some key features of the ECB's monetary policy framework - particularly, its ability to
provide access to collateralised lending operations to a wide set of counterparties against a
broad range of collateral and on a large scale - have served us well during these times of
stress.
Similarly, increased cooperation among central banks throughout the turmoil, both (1)
through enhanced information sharing and collective monitoring of market developments and
(2) by means of coordinated liquidity injections, have played an effective role in easing
tensions at the short-term end of the global money markets and in instilling confidence in
market participants about the commitment of the world's major central banks to addressing
such tensions.
Volatility though remains at elevated levels. This calls for a full and rapid implementation of
the Financial Stability Forum recommendations on supervision, regulation, risk management,
accounting and transparency. At the same time, several governments have taken decisive
action to address credit concerns and central banks have been coordinating to address
liquidity pressures in funding markets. In this respect, as earlier mentioned, market
participants would be well advised to heed last week's pledge by finance ministries,
regulators and central banks of the largest world economies to take action as needed,
individually and collectively, in order to protect the integrity of the international financial
system and facilitate liquid, smooth functioning markets.
I am convinced that next year this conference will take place in calmer market conditions
than in its two first editions. In the meantime I look forward to today's interesting discussions
and interventions.
Many thanks for your attention.