Jean-Claude Trichet: Remarks on the financial turmoil
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the British
Bankers Association's Annual Reception, European Parliament, Brussels, 8 December 2008.
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Ladies and Gentlemen,
Let me begin by thanking MEP Purvis and Ms Knight for the opportunity to address such a
distinguished audience and to share my remarks on the financial market turmoil. I need not
emphasize to this audience just how extraordinary and challenging current times are; but I
would like to emphasize that the response of central banks and governments to address
these challenges have been equally extraordinary.
In my intervention today I will focus on the decisive and resolute actions taken by public
authorities to support the functioning of the financial system in the wake of the very difficult
developments following the intensification of the financial crisis that occurred mid-September,
I will also take the opportunity of speaking before you, to stress the important role that the
financial industry has to play in this respect.
Indeed, the failure of Lehman Brothers in September triggered an unprecedented
deterioration in the degree of confidence in the banking sector which ran the risk of
undermining its fundamental function of financial intermediation. In Europe, this was reflected
in record increases in overnight interest rates, especially for US dollar funding, and a marked
decline in traded volumes, in both interbank and swap markets. Some banks were even
"locked out" of the money market completely. In addition, strong declines in banks' share
prices and large increases in banks' CDS spreads were observed. These developments
required a prompt and extensive set of actions to be coordinated across countries and public
institutions.
With hindsight and drawing on my personal experience in those very intense coordination
efforts, I can say that the overall response by governments and central banks was effective
in preventing further deterioration in market conditions. With particular reference to the
experience in the EU, in addition to the long-established cooperation among central banks,
the coordinated approach for government measures to support the banking sector should be
highlighted. The agreement by the Heads of State of the euro area Member States on 12
October, subsequently endorsed in the European Union summit were key events in
endorsing an action plan at the highest political level. These summits were very important
milestones because they demonstrated the high degree of commitment and responsibility of
public authorities to act decisively and in a unified manner to preserve confidence and proper
financing conditions for the economy.
I should also underline the very effective coordination which prevailed between governments
and central banks in the definition of these measures.
Let me now focus on the measures taken by public authorities aimed at facilitating the
funding activity of banks and their recapitalisation. I will then turn to key challenges going
forward that need to be addressed to prevent the reoccurrence of such financial market
turbulences in the future.
The funding conditions of banks
Since the onset of the financial turmoil, increased uncertainty, reflected particularly in
counterparty risk, has led banks to hoard liquidity. This has resulted in a significant decline of
trading in the interbank money markets. However, the dramatic deterioration of confidence
that emerged in mid-September led public authorities to take a wide array of measures to
support the funding activity of banks. Central banks intensified their actions in the interbank
money market which were complemented by specific government measures to improve
market functioning over longer term maturities.
First, the Eurosystem and other central banks substantially stepped up their efforts to ensure
access to central bank liquidity by solvent banks. Let me recall the main measures in this
respect.
On 8 and 15 October 2008, the Eurosystem took in particular the decision to adopt
temporarily a fixed-rate tender procedure with full allotment in all refinancing operations, that
is operations with maturities of 1 week up to 6 months. These measures increased the
intermediation role of the Eurosystem and were aimed at reducing banks' funding costs
which had soared as parts of the money market became dysfunctional. At the same time,
longer-term operations are conducted more frequently and at more diversified maturities.
These exceptional measures ensure that banks have access to refinancing at longer-term
maturities, the market for which has been particularly affected by the turmoil.
Since December 2007, the ECB has participated in unprecedented joint operations with the
US Fed and several other central banks to improve US dollar funding conditions by providing
US dollar refinancing to its own counterparties against euros or collateral eligible for euro
open market operations. In October 2008, the ECB started conducting its US dollar
operations as fixed-rate tenders with full allotment and increased the range of maturities. In
addition, it entered into a swap agreement with the Swiss National Bank to facilitate the
distribution of Swiss franc liquidity to euro area banks.
Coupled with the sizeable enlargement of the list of assets eligible as collateral, which will
remain in place until the end of 2009, these measures have substantially reduced the funding
strains of banks. However, significant challenges remain as money market activity continues
to be abnormally limited.
Second, governments in a concerted and coordinated manner granted guarantees on new
issuances of bank debt.
The aim of this measure is to address funding problems of liquidity constrained but solvent
banks. The granting of government guarantees on bank debt should facilitate the distribution
of liquidity in interbank money markets, particularly by reducing globally the uncertainty on
counterparty risk and by increasing the volume of tradable collateral in the private interbank
market.
The Eurosystem contributed to this endeavour by proposing a set of recommendations on
the appropriate framework for the granting of government guarantees. These included
recommendations on overarching objectives as well as on parameters of the pricing system.
From our perspective, such a framework should aim at: solving the funding problems of
solvent but liquidity constrained banks; preserving the level-playing field among financial
institutions, avoiding market distortions; and ensuring consistency with the management of
liquidity by the Eurosystem and with its operational framework, so as not to impair the
implementation of the single monetary policy.
Banks have recently begun to make use of this funding opportunity. The current outstanding
volume of government guaranteed unsecured bank bonds in Europe amounts to €24 billion,
of which €15 billion have so far been issued by the UK banks. More banks have already
indicated their intentions to issue similar bonds this year. The issuances have been
considerably oversubscribed and spreads of these government guaranteed bonds are lower
than for secured bonds from the same country with a comparable maturity. Thus this initiative
is effectively representing a viable and less costly source of funding.
The recapitalisation of banks
Government measures in this context should mainly be designed to strengthen the capital
position of fundamentally sound banks, with the aim of improving the functioning and stability
of the banking system and fostering an adequate flow of credit to the economy.
Member States have committed to providing banks with additional capital resources, by
acquiring equity in the form of ordinary shares, preferred shares or other hybrid instruments
such as subordinated debt.
Also in regard to these measures, the Eurosystem has contributed with a set of
recommendations on the main features and pricing of different forms of capitalisation
instruments. These recommendations are without prejudice to guidance from the European
Commission aimed at avoiding distortions in competition in accordance with State aid rules
of the Treaty.
In this context, the Eurosystem considers that any recapitalisation should take into
consideration the specific market situation of each institution, distinguishing in particular
between fundamentally sound and distressed banks. Furthermore, it is important to ensure
that the temporary nature of government measures is preserved and that capital raising by
private investors is not discouraged.
The level of commitment of public authorities in restoring confidence and the flow of credit to
the economy is very high. This is also reflected in the figures: EUR 1,800 billion in
government guarantees and EUR 280 billion in recapitalisation schemes have been agreed
thus far.
Overall, I believe that the actions taken by central banks and national governments provide
an exceptional response to address the challenges stemming from the recent significant
deterioration in market confidence and provide a new environment aiming at reactivating the
intermediation role of banks. At the same time, success ultimately depends on the banking
sector making appropriate and prudent use of these measures and contributing to restoring
normal market conditions. In this context, reactivating the interbank market and ensuring the
proper financing of the economy is of paramount importance. Taking advantage of speaking
before such a distinguished audience, I call on banks to live up to their responsibility in this
regard.
Key challenges to be addressed
Let me now shortly focus on some key challenges that need to be addressed in order to
prevent that such a crisis occurs again in the future.
At the current juncture, priority has been given to comprehensively formulate policy
responses to address the challenges raised by the financial market turbulence and to
effectively and timely implement the agreed measures. As you are aware a number of
reforms have been put forward at the European and international level notably by the
ECOFIN Council and the Financial Stability Forum (FSF), and have recently been reflected in
the declaration of the G20 summit. I will mention three issues, which I believe are especially
important in a longer-term perspective: first, mitigating procyclicality; second, correcting
incentives towards short-termism and third, enhancing transparency by improving the
availability of data important from a financial stability perspective.
First, there is a need to mitigate procyclical effects stemming from the current regulatory
framework. A number of potential sources need to be investigated, including capital
requirements, valuation and leverage, banks' compensation schemes and provisioning
regimes. In this context, I welcome the work to be carried out under the auspices of the FSF.
Second, markets have excessively rewarded short-term profits at the expense of lower
longterm performance or plain losses. The excessive focus on the short-term has resulted in a
significant underestimation of low probability but high risks and in the increase of risk-taking
behaviour. In this context, there is a need to create an incentive framework that adequately
assesses and rewards performance over the medium to longer term.
Third, the availability of aggregate information regarding the main risks to the financial
system needs to be significantly enhanced. Information should be available concerning
institutions, instruments and markets that are currently unregulated but whose risks raise
financial stability concerns given their potential systemic impact. In this context, one example
is the need for increased transparency in the OTC derivatives markets. In particular, I
welcome the initiative to establish a central counterparty clearing for the CDS market.
Conclusion
To conclude, national governments and central banks have taken decisive and concerted
measures to address the challenges posed by the current conditions in the financial markets.
In addition we have put forward reforms aimed at avoiding the reoccurrence of a similar crisis
in the future. However, measures taken by public authorities can only go so far.
The banking sector needs to also do its part by committing to reactivating the interbank
market, resuming their intermediation role and implementing the necessary reforms aimed at
strengthening the resilience of the financial system in the long term. The Governing Council
of the ECB looks forward to witnessing your action in this regard and will continue to support
your efforts.
Thank you for your attention.