José Manuel González-Páramo: The euro money and financial markets -
where do we stand?
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the Spanish Capital Markets Forum, Madrid, 24 October 2007.
* * *
I am very grateful to the organisers for inviting me to address such a distinguished audience
on the occasion of this interesting forum on Spanish Capital Markets. In my intervention I will
focus on the developments of the euro area money and financial markets into which the
Spanish capital markets are highly integrated.
Outbreak of the turmoil1
As you are well aware, in July and early August a series of events led to an intensification of
the tensions in the US sub-prime mortgage market and a sharp decline in the degree of risk
appetite of global investors. Market volatility increased across almost all financial asset
classes. Stock prices declined as investors sold equities and moved funds into safe-haven
investment assets, such as government bonds. In this context, several investment funds
holding asset-backed securities suspended withdrawals from their clients. At the same time,
a number of European banks made public their direct or indirect exposures to the US
mortgage market, particularly to its sub-prime component.
In the money markets the impact of the turmoil was initially felt mainly in the longer-dated
unsecured inter-bank market and in non-government repurchase agreement (repo)
transactions: trading in these two segments became increasingly thin. These frictions
eventually spilled over to the very short-term money markets (i.e. below one-week), at first in
the US dollar market where banks - particularly, the European ones - encountered
difficulties in raising short-term liquidity.
Early in the morning of Thursday 9 August, the tensions spread to the short-term euro money
market and also to other money markets such as those related to the British pound and the
Swiss franc. The tensions were also felt in the foreign exchange swap market, which is very
important for banks managing liquidity in different currencies.
Interventions of the ECB
After it became clear that there was the risk of an imminent gridlock in the euro money
market, the ECB released a communication stating its readiness to contribute to orderly
conditions in the euro money market. Subsequently, the ECB conducted a first fine-tuning
operation with an overnight maturity to inject liquidity. The operation was conducted as a
fixed rate tender at 4.00% and the full bid amount of EUR 95 billion was allotted. This
operation was followed by similar fine tuning operations on the following 3 days, which were
however conducted as variable rate tenders and with declining allotment amounts.
These fine-tuning operations together with the following abundant weekly refinancing
operation (EUR 73.5 billion above the benchmark) succeeded in stabilising the very short-
term interest rates.2 The subsequent regular weekly operations in this reserve maintenance
period aimed at gradually reabsorbing banks' accumulated reserve surpluses by the end of
the maintenance period on 11 September.
In the following reserve maintenance period the ECB followed a broadly similar approach,
allotting significant excess liquidity at the beginning of the maintenance period, which was
then gradually re-absorbed over the following weeks.
However, as the activity in the term money market - in particular, unsecured lending -
remained limited, the ECB satisfied some demand by banks for diversified funding by
conducting two supplementary three-month refinancing operations for EUR 40 billion and
EUR 75 billion, respectively. These operations aimed at indirectly supporting the
normalisation in the functioning of the euro money market. Nevertheless, liquidity in the term
money markets continued to be limited.
All in all, it should be emphasised that over the entire two months following the outbreak of
tensions, the ECB did not provide more liquidity than in earlier maintenance periods, in which
the demand by banks was mainly driven by reserve requirements. What was different was
the pattern of liquidity provision (with significant frontloading of the liquidity needs) and its
maturity composition, with much larger weight for 3-month refinancing operations relative to
1-week refinancing operations.
On 8 October, before the start of the current reserve maintenance period, we issued a
communication stating that the ECB continues to closely monitor liquidity conditions and
aims at further reducing the volatility of very short term rates around the MRO minimum bid
rate. For this purpose, we have decided to reinforce our policy of allocating more liquidity
than the benchmark amount in our weekly operations to accommodate the demand of
counterparties to fulfil reserve requirements early within the maintenance period. In the
refinancing operation on 9 October, which was the first of the current period, we allotted EUR
40 billion above the benchmark amount. In the following weekly operation on 16 October, the
allotment exceeded the benchmark amount by EUR 18 billion, and in yesterday's tender we
allotted more than EUR 14 billion above the benchmark amount. Indeed, the difference
between the allotted and the benchmark amount is envisaged to decline gradually in the
course of the maintenance period, taking into account the prevailing market conditions. And
the ECB still aims at balanced liquidity conditions at the end of the maintenance period.
Besides, the ECB intends to steer liquidity towards more balanced conditions also during the
maintenance period, in a way which is consistent with the objective to keep very short term
rates close to the minimum bid rate. We have also stated our commitment to keep this policy
in place for as long as needed.
Before turning to the current situation in the market, let me stress a very important point.
Through the liquidity operations just discussed, the ECB has contributed to the orderly
functioning of the money market, which is one of its key responsibilities. It is worth
emphasising, however, that the ECB's primary mandate calls for its monetary policy to
deliver price stability. The two responsibilities are clearly distinct and should not be mixed.
This is our concept. Only when kept separate, the fulfilment of both duties can reinforce each
other.
Current situation
Let me now turn to the main issues that characterise the nature and dimension of the current
tensions in some segments of the financial markets.
Although the ECB interventions have had a stabilising effect on the euro money market rates
at the shorter end of the term structure and, more generally, the money market has
recovered some of the lost ground, market participants continue to report limited trading
activity, particularly in unsecured inter-bank term markets. Compared to the situation prior to
the emerging of tensions, unsecured deposit rates beyond one month are in some cases
(notably, three months) still significantly higher and turnover remains lower, despite some
improvement during the past few weeks. This situation reflects two main factors.
•
First, some banks' daily funding needs, especially in USD, have significantly
increased at various points in time in the recent past. In addition, they have become
more uncertain, since the credit lines that they had offered to various financial
entities as back-up facilities have been largely utilised or appeared likely to be
utilised. This is due to the fact that these entities have faced difficulties in tapping
their usual market funding sources, in particular the US dollar-denominated
assetbacked commercial paper market.
•
Second, a number of financial institutions are still reluctant to lend money in the
inter-bank market, particularly on an uncollateralized basis, because of uncertainty
about the soundness of their counterparties. This reflects a problem of confidence
and trust among banks, even in the presence of abundant liquidity in the banking
system. Lack of confidence among banks leads to a sustained reduction in
interbank activity.
As regards the funding markets most affected by the turmoil, anecdotal evidence and
bilateral contacts with market participants indicate some recent improvements:
•
In the FX swap market, the degree of market depth and liquidity has improved with
turnover increasing again, while spreads have narrowed, particularly for short term
periods up to one week. However, it seems that turnover may not yet have reverted
to pre-crisis levels for periods beyond one week.
•
In the Asset Backed Euro Commercial Paper (ABECP) market, the amount of paper
maturing (currently about EUR 6.4 billion per day) is now in line with the amount
issued (currently EUR 6.6 billion per day). In addition, there has been a recovery in
the original maturities of ABECP; after falling from above 50 days in early August to
below 25 days in mid September 2007, original maturities have recently returned to
levels close to 45 days.
•
The outstanding amount in the US Asset Backed Commercial Paper (ABCP) market
has decreased from a peak of almost USD 1.2 trillion at the end of July to a current
level of around USD 0.9 trillion, although the pace of decline has stabilised. The
patterns in the US have been similar to those of the ABECP: shortening of roll-over
maturities, issuance smaller than maturing amount and banks buying their own
paper. The 3-month rates on highly rated US ABCPs, which rose up to 50 bps over
LIBOR in August, have declined to pre-turmoil levels just below LIBOR.
Preliminary lessons to be drawn
Recent events have revealed some weaknesses in the organisation and functioning of the
financial system, in particular regarding the market for complex structured products and the
liquidity in this market under stressed conditions. Let me point out three key weaknesses:
•
First, the ability of investors to assess the extent of concentrations among various
types of collateral - including sub-prime - within the structured finance securities
has clearly been shown to be less than adequate. Indeed, conducting adequate due
diligence regarding the nature of underlying investment exposures cannot be
replaced by decision-making based almost exclusively on ratings.
•
Second, market participants were not sufficiently alert to the possibility that liquidity
could dry up in structured finance markets, even though secondary market liquidity
in the various structured finance markets has been traditionally thin. As you know,
there are several reasons for this, inter alia: the specificity of these instruments,
which are often tailor-made; the "buy-and-hold" strategies followed by a large
number of investors (including, pension funds, insurers, and banks); and the limited
comparability of mark-to-model valuations, stemming from the complexity of these
instruments.
•
Third, the Asset Backed Commercial Paper (ABCP) structures had intrinsic liquidity
risk because they invested the proceeds of short term liabilities into longer maturity
structured finance assets. In some cases, certain types of ABCP structures such as
Structured Investment Vehicles (SIVs) faced increased pressure resulting from an
inability to roll-over. This came both from investor anxiety concerning the underlying
collateral and the inability to value adequately the collateral as they were forced to
sell assets. There are indications that the liquidity strains associated to these
structures are not yet over.
Three key weaknesses of credit markets
Whilst it is too early to make a definitive assessment, certain supervisory and regulatory
issues can already be identified as warranting further attention or action. Initiatives are
already underway at the international and EU level to address these various issues, but for
our exchange of views here today I would like to focus on three key issues: transparency,
valuation of complex structured products, and liquidity risk management practices, including
liquidity risk stress-testing.
•
First, transparency for markets, investors and regulators. Adequate
transparency is a necessary basis for an efficient functioning of financial markets.
Recent experience has shown how perceived opaqueness or uncertainty regarding
the underlying exposures, in particular of financial institutions, has translated into a
loss of confidence with a resulting disruption in the interbank market. There have
been recently many calls for enhanced market transparency both from banks (e.g.
enhanced disclosure of banks' liquidity lines to conduits) and non-regulated entities
(e.g. voluntary disclosure of portfolio holdings in order to assess where the US
subprime risk lies, and the development of guidelines for the consistent disclosure of
methodologies used to value portfolio holdings). In this context I would like to note
that improvements are expected from the implementation of the Basel II framework,
namely of the Pillar III requirements, in particular regarding disclosure of risk
positions for banks; with regard to the non-regulated entities, a recent industry
initiative (dated 10 September) from the European Securitisation Forum and the
Securities Industry and Financial Markets Association (SIFMA) calling for additional
disclosures in the structured product market should be mentioned and welcomed.
•
Second, valuation of illiquid complex structured products. Given present market
conditions and the uncertainty concerning the underlying quality of the assets, there
are currently no quotes or market prices for many structured finance products.
However, year-end financial statements including valuations of structured finance
products will have to be prepared soon. The room for discretion under existing
accounting rules and the use of marking-to-model valuations (in the absence of
market prices), may result in very different valuations for similar assets. This lack of
comparability and consistency in the valuation of similar assets should be addressed
in order to restore confidence in this market.
•
Third, liquidity risk management, in particular liquidity risk stress-testing and
contingency funding plans. The complexity of structured finance products requires
banks to have in place commensurately sophisticated risk management systems.
Recent events have shown that significant efforts remain to be done in this respect.
Furthermore, carrying out liquidity risk stress-testing and having in place adequate
contingency funding plans are particularly important given their ability to significantly
improve the preparedness of banks to deal with liquidity events.
Finally, there are other areas of relevance for the recent financial market developments that
deserve further study, such as the role of credit rating agencies. However, I have already
exceeded the number of issues than can be conveniently addressed in ten minutes.
Let me conclude by noting that the recent market developments have not only revealed
weaknesses and challenges to be addressed, but also the strength of some of the
institutional arrangements in place. As a member of the ECB's Executive Board, I take
especial pride in the flexibility and effectiveness that the Eurosystem's operational framework
has exhibited in managing liquidity in the euro money market under stress conditions. But
this is an issue that I leave for the next occasion in which I will have the pleasure to meet
again this audience.
Thanks very much for your attention.