Lorenzo Bini Smaghi: Monetary policy transmission in a changing
financial system - lessons from the recent past, thoughts about the
future
Speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at the Barclays Global Inflation Conference, New York City, 14 June 2010.
* * *
I wish to thank Luca Benati, José Luis Peydró-Alcalde, Massimo Rostagno, Jens Tapkins and Flemming Würtz for
their contributions to this speech. I remain solely responsible for the opinions contained herein.
Introduction
It is a great pleasure for me to participate in this conference.
Since the crisis erupted, in mid-2007, central banks throughout the world have conducted
their monetary policies using new instruments and techniques. Are these changes
temporary, and linked to the effects of the financial crisis? Or do they mark more lasting
changes in the transmission mechanism of monetary policy? These are important questions
to understand the role of central banks in the current crisis and in the future.
The simple answer is that monetary policy operates through financial markets, markets that
have changed substantially over the last decade. Monetary policy cannot be implemented
without taking these changes into account. However, since central banks have to be
accountable, they need to explain how they reflect these changes in their monetary policy
operations without changing their underlying objective.
I will try to address this issue by dividing my remarks today into three main parts. First, I will
review trend developments in financial intermediation and single out a recurring theme in the
evolution of the financial markets over the last 30 years: the rise of securitisation and
collateralised finance. I will then consider the consequences of this innovation for the
transmission of monetary policy in the post-crisis world. I will start by looking at the money
markets and turn to the wider financial system, including the shadow banking sector. Looking
forward, the main sources of collateralisation will be an issue to consider if the present trend
towards downscaling the creation of private asset-backed securities continues. Public debt
instruments are likely to play an important role. This will lead us to reflect on the role of
central banking at a time of high public debt.
1. The rise of collateral
The financial system has undergone profound changes over the past few decades. Markets
have grown significantly; competition has intensified. These are well-known phenomena. I
would like to focus on the consequence of this, namely that the core of financial
intermediation has moved from depository institutions - commercial banks - to a hybrid
aggregate of institutions and functions, which is broadly referred to as the shadow banking
system. The rise of the shadow banks, their ups and their downs, are inseparably connected
with a key financial innovation of the last 30 years: securitisation.
The emergence of a shadow banking system is not a new phenomenon. What was new over
recent decades was the scale of its activities, which is closely related to the rapid expansion
of securitisation. The securitisation of previously illiquid items in banks' balance sheets gave
perhaps the strongest boost to the financial sector. Securitisation allows traditional banking
assets to be transformed into tradable instruments, thus creating tradable assets. It acts as a
multiplier of negotiable financial claims or, more simply, a multiplier of finance.
Why was securitisation so essential to the expansion of shadow banks? The short answer to
this question is that shadow banking serves as an intermediary for wholesale finance. In this
segment of the financial system, lenders have large - and lumpy - financial resources to
place with intermediaries for short periods of time, with no protection from formal deposit
insurance mechanisms. This lack of formal insurance - since deposits are too large to be
eligible for protection under national laws - calls for an informal or - I should rather say -
market-based system of protection. This is precisely what the securitisation of assets can do:
it can give financial intermediaries enough tradable securities to pledge as collateral for the
large - lumpy - loans that they receive in the wholesale shadow-banking segment of their
activities.
The run-up to the crisis clearly showed that shadow banking and securitisation are not only
interrelated but also that they interact. The shift in banks' funding away from traditional and
stable sources - such as retail deposits - to wholesale funding was as much a by-product of
securitisation as a source of its potentially unlimited expansion. It was a by-product of
securitisation because in order to finance the large increase in their securitisation business
the banking system had to draw on a larger pool of financial resources than retail deposits
could offer. But that shift also caused, independently, an increase in securitisation because
the lending of large sums to shadow banks needed - and needs - marketable collateral. In
its essence, this lending is a large-value deposit which has to be secured by collateral. So,
securitisation received a formidable boost as banks used it to generate the securities which
were required to finance its overall business.
Data confirm this close association between shadow banking, collateral and repo markets. A
large portion of the financing of the shadow banking system takes the form of repurchase
agreements (repos), which work much like deposits. The wholesale lender deposits a large
sum with the shadow bank for a very short term, perhaps overnight. As this callable claim
cannot be covered by formal deposit insurance, it needs to be protected by collateral. So,
technically, the transaction involves the purchase of some securitised assets from the
shadow bank in exchange for cash and a promise by the bank to repurchase the securities at
the stated price at some future date, perhaps on the day thereafter.
Data on activity in the repo market are limited. But we know the volumes are large. The
business model of the hedge fund industry relies on financing their highly-leveraged activities
via the repo market. Repo activity will therefore exceed their already substantial leverage
positions. Moreover, as reflected in the recent analysis of Gorton and Metrick (2009),1
information can also be gleaned from the balance sheets of broker dealers and investment
banks. For example, approximately 80% of the balance sheet of investment banks such as
Lehman Brothers and Bear Stearns in 2007 - that is, before the crisis - was funded by
volatile, short-term instruments. It was this balance sheet structure that, in the end, made
these two banks extraordinarily vulnerable to a sudden withdrawal of liquidity in the
wholesale funding market and which ultimately led to their demise. Note that more than
onethird of this short-term debt was collateralised, that is acquired in the repo market.
To sum up, we have seen the relentless rise of collateralised finance. Any reflections on the
future of the monetary policy transmission mechanism have to start from there.
2. Collateralisation and the money market
The crisis that started in August 2007 has highlighted the key role of collateralised finance in
two ways: first, as a vehicle of distress; second, as a possible instrument of repair.
During the crisis, and notably after the collapse of Lehman, money market spreads in the
euro area surged to unprecedented levels. When I say "money market spreads", I mean the
spreads of unsecured money market rates as well as certain repo rates (over OIS rates).
Indeed, repo rate spreads depend on the quality of the underlying collateral. For example,
single-A private paper repo spreads showed a pattern similar to the spreads of unsecured
money market rates in late 2008 and early 2009. However, triple-A government bond repos
appeared to be relatively unaffected by the worsening crisis, at least in Europe. In addition,
collateral haircuts, which in many cases were very low before the crisis, increased and varied
greatly across asset classes and types of borrowing institution. Of course, money market
spreads were generally wider for transactions with longer maturities and significant parts of
the term money market dried up completely.
Again, we see the power of collateral in today's financial world. The presence or absence of
collateral in money market transactions, and the quality of the collateral used to secure these
transactions determine whether the very first step of the transmission mechanism works. The
collateral influences the scale of market spreads over and above the overnight rate at which
the central bank lends to banks. And money market spreads play an important role in the
smooth transmission of monetary policy to the broad economy.
Early on in the crisis the value of collateral deteriorated so dramatically that even the primary
unsecured form of lending - interbank lending - ceased to function. Precautionary hoarding
of liquidity brought about a complete seizure of many segments of the market for credit. At
the same time, panic sales of assets made market liquidity disappear. Market liquidity is high
when traders can easily find a price, and that price is very close to what every other trader
pays for the same asset at the same time. In early October 2008 the market simply couldn't
find a value for many of those securities that had been so highly priced only a few weeks
before. While available collateral was sharply down-priced, the economy-wide equity capital,
which is largely valued by the market, evaporated in a matter of hours. Equity capital is what
backs up unsecured money market transactions. This partly explains why the unsecured
market seized up alongside the repo market.
While collateralised finance can accelerate a generalised loss of confidence, it provides the
guardians of stability with one more instrument of defence. In late 2008 the ECB increased
its collateralised lending to compensate for the withdrawal of private lending in inter-bank
transactions. To ease banks' liquidity and balance sheet constraints, in particular, we have
broadened the list of assets that we consider eligible as collateral in our refinancing
operations. This has liquified a large fraction of our counterparties' assets, which had
become illiquid in the tense market conditions following the failure of Lehman. This
intervention served to shore up savers' confidence in the viability of the financial sector.
Our enhanced credit support measures were taken to preserve the integrity of the
transmission mechanism of monetary policy at a time when banks showed a tendency to
withdraw in a disorderly way from their intermediation function. A functioning transmission
mechanism is the pre-condition for the central bank to be able to accomplish its mandate of
maintaining price stability in the medium term.
The same policy intention underlies our Securities Markets Programme, which we started on
10 May this year. We intervene in euro area public and private debt securities markets in
order to ensure depth and liquidity in those market segments which have proved
dysfunctional. As government securities are the basis for pricing all private debt instruments,
our action in the sovereign bond markets aims to create the orderly conditions necessary for
lenders to provide a steady flow of credit to the private economy.
Overall, through its enhanced credit support measures, the ECB has replaced ill-functioning
segments of the financial market and acted as an "intermediary" between banks with a
liquidity deficit and banks with a liquidity surplus. At the same time, and with a slightly
longerterm perspective, the measures have contributed to a more stable situation in various
segments of the financial markets during the crisis. For example, easier access to central
bank refinancing meant that banks could refinance their money market activities more easily
if needed. This, in turn, has reduced the risk of lending out liquidity in the money market and
thereby lowered the liquidity risk premia.2
In crisis times, banks the world over learnt what Japanese banks learnt back in the 1990s:
that they could manage their liquidity requirements - perhaps more comfortably and at lower
cost - through central bank intermediation rather than via their traditional money market
activities. Central banks - for their part - have seen that their collateralised lending has
made them key market makers at a time when markets were disappearing.
3. The role of central banks in money markets
In light of all these developments we may well ask whether the new market-making role of
central banks will continue. If central banks intermediate large volumes in normal times, they
may not need to change their operational framework substantially when a liquidity crisis
suddenly hits. Larger intermediation could anchor expectations and make market dynamics
less subject to threshold effects. Does this suggest a new steady state - beyond the
setbacks and progress of the current crisis - in which central banks will become a larger
counterparty to the financial system as a whole?
It is too early to say. Nevertheless, let me share with you some preliminary thoughts on the
future role of central bank intermediation. Let me say up front that central bank
intermediation involves subtle trade-offs. Let me list some of them.
First, the larger the intermediation offered by the central bank, the smaller, ceteris paribus,
the incentives are for banks to reduce liquidity risk (for example, to reduce the maturity
mismatch of assets and liabilities). After all, they can turn to the central bank if they need to.
Of course, while central bank intermediation increases the incentives for banks to take
liquidity risk, it also increases the liquidity insurance available to banks. That is, as long as a
bank does not adjust its balance sheet when the central bank offers more intermediation, its
net liquidity risk exposure may in fact decrease due to the increased liquidity risk insurance
provided by the central bank. But which effect is stronger: the incentive or the insurance
effect?
Second, larger central bank intermediation can crowd out market activities. This might be
perceived as a cost-reducing development by private banks. If the central bank lends larger
volumes in longer-term operations, this might provide a boost to private lending at the same
maturities: some banks might consider offering funds in the term money market only if they
themselves can refinance such activities by participating in longer-term central bank
operations. This may make term money markets more liquid in the end. However, this is not
what the Japanese authorities observed in the first half of this decade.
To sum up, the extent to which the central bank uses collateralised lending to intermediate
between banks has proved helpful in restoring confidence and "real money" financial flows in
the underlying asset markets - the markets in which the collateral is priced. This has
repaired links in the early stages of the transmission channel, the viability of which depends
on those collateral prices. These links would have been brutally and perhaps irrevocably
severed, if private arbitrage had been the only force of market motion, as in normal times.
But increased intermediation has an impact on the liquidity risk exposure of banks, on their
ability to carry out maturity transformation, as well as on the liquidity of specific money
market segments. Whether the impact is positive or negative is hard to say. But moral hazard
- which is the pitfall of any such type of thinking - makes conditions (and behaviours)
change in response to central bank actions. As was the case at the start of the rational
expectations revolution in macroeconomics, a prudent central bank needs to internalise the
private sector's response to its own actions.
4. Collateralised finance and the transmission of monetary policy
The shift of gravity in the financial sector away from traditional commercial banking and
towards shadow banking affects the channels of transmission for monetary policy in different
ways.
In some respects the transmission mechanism is weakened through the loss of control over
some financial aggregates - such as credit formation - and the declining coherence between
credit and money. In a world of shadow banks the money multiplier might become a
will-o'the-wisp which central banks find difficult to use as a steady instrument of policy. The
reserve basis - which in the inverted-pyramid representation of the financial system sustains
the creation of total leverage in the economy - becomes an even thinner support for finance.
As the famous "conundrum" episode has demonstrated, a central bank's intention to impose
limits on credit can be resisted and offset by an endogenous expansion in leverage. While
the base of the pyramid remains narrow, growing leverage can still expand the whole edifice
of finance.
Regulation is an answer to the weakening of central bank controls over the size of finance. It
will be especially important to extend regulatory oversight to those market segments that,
before the crisis, had escaped the attention of regulators. The prime focus of attention here
will be - once again - the shadow banking system. Here, of course, there is an issue of
relative scale. If we want central bank control over leverage to be stronger in the future,
tout
shadow banks need to be part of what we consider "banks" court. In fact, by 2007 the
size of the official and shadow banking systems, measured by the total amount of assets,
had become essentially the same.3
But there is also an issue of quality - or, if you prefer, of composition - of finance. Due to the
increased risk aversion resulting from the financial crisis, collateralised lending is bound to
increase in the future, even in markets where traditionally unsecured lending was the most
important source of finance (e.g., the euro area interbank market). As a consequence, the
demand for securitised assets - of the type that shadow banks have learned to create in the
past - is set to increase further in the future, as institutions demand such types of debt to use
as collateral. To put it in a nutshell, we will continue to need the functions, the financial
products and the expertise that the shadow banks have been offering. But, we need to make
sure that these activities are performed in a non-disruptive way.
The new financial landscape can also reinforce the effectiveness of monetary policy. I
already mentioned that most of the funding of financial institutions - whether banks,
brokerdealers, hedge funds or shadow banks - is short-term. In other words, a key function of the
financial system is maturity transformation. When a central bank takes decisions on the
policy rates, it directly affects the marginal price of leverage for these financial institutions.4
As a result, the behaviour of financial intermediaries - which, by their nature, have high
levels of leverage - can be strongly influenced by even small changes in short-term rates.5 In
other words, short-term interest rates are important in and of themselves, not only because
they influence longer-term rates and other asset prices via expectations of future short-term
rates, but also because they change the liquidity conditions faced by a large portion of
leveraged institutions.
A number of empirical studies have explored this issue. In line with the assumption that lower
short-term interest rates reduce the cost of leverage and thus encourage an expansion of
intra-financial sector transactions, these studies find that money market activity, particularly
in the secured segment, expands when monetary policy is accommodative. For example,
Adrian and Shin (2008) demonstrate that the balance sheets of US broker/dealers expand
when monetary policy is accommodative.6 Similar evidence is provided for the US repo
market by Gorton and Metrick (2009), who found that activity started to increase significantly
from 2001 - that is, at a time when monetary policy in the US was relatively loose following
the bursting of the dot-com bubble.7 Acharya and Schnabl (2010) provide similar evidence
related to the asset-backed commercial paper (ABCP) market.8
In summary, if the process that has been set in motion under the aegis of the G20 has the
potential to place a whole new segment of finance under regulatory scrutiny and oversight,
the new collateral-based finance can give a central bank stronger influence over financial
and macroeconomic conditions more broadly.
5. Monetary policy in a high-debt environment
I mentioned earlier that collateral is likely to play a growing role in the functioning of capital
markets. Demand for collateral is thus likely to increase. But, given the collapse of
securitisation activity during the crisis, we could imagine that the current decline in the
creation of securitised assets might become a permanent feature of the new landscape.
There will be fewer ABSs created out of bank books.
Sovereign debt will certainly be widespread. It will probably replace ABSs in the
collateralisation of secured lending. Unlike in the past, the risk characteristics of this type of
debt instrument will be more graduated than was considered possible only few years ago.
The risk associated with what used to be considered risk-free assets is something new in
financial markets.
What type of risk will be incorporated in the market returns on sovereign debt? For people of
my generation, Sargent and Wallace provided the traditional answer: in a game of chicken
between an irresponsible and institutionally strong fiscal authority on the one hand and a
committed but unrealistic central bank on the other, the former is bound to win. Inflation will
be the outcome. Knowing this, investors will demand high returns on government debt to
offset higher expected inflation. So the game ends before it has even started.
In the new world, the Sargent and Wallace story has lost some of its descriptive and
predictive power. The fiscal authority is confronting a strong player with institutional backing.
And certainly in Europe's Monetary Union, the central bank is as strong and institutionally
established as the fiscal authority. If the fiscal side does not adjust, inflation risk mutates into
liquidity risk. In the most severe cases, if the fiscal adjustment is delayed, liquidity risk turns
into solvency risk As you know, markets have learned to become more discriminating with
regard to fiscal solvency than they have been for decades. Countries with comparatively
better managed public finances will pay lower risk premia, and therefore lower interest rates,
which, in turn, will help them to keep budget deficits and the stocks of national debt under
control. Countries with larger budget deficits and higher stocks of national debt, on the other
hand, will face higher risk premia, and therefore higher interest rates, which, in turn, will
affect their ability to control the dynamics of their public finances.
How will a central bank committed to price stability and endowed with the constitutional
guarantees necessary to enforce a price stability-oriented policy pursue its mandate in a
high-debt / high-risk environment?
Sovereign securities have traditionally been the prime form of collateral for central bank
credit. In the future, given the greater importance of this type of debt instrument in the total
portfolio of the economy - to which I was referring before - this primary role is unlikely to
diminish. So, a central bank will continue to emphasise strongly the maintenance of orderly
market conditions for this type of instrument. The ECB's Securities Markets Programme has
demonstrated how critical it is for a central bank to safeguard the functioning of this segment
of the market.
1. At the same time, we have to recognise that, when executing lending policy, a
central bank functions much like a private financial intermediary. Of course, a central
bank loan creates money, which is not the case for private loans. But the lending
side of the operation is essentially the same. The granting of private credit is
accompanied by restrictions imposed on the borrower which limit its ability to take
risks that might endanger the value of the loan. Likewise, when a central bank
provides credit against collateral, it must follow up with a frequent re-evaluation of
the credit conditions so as to safeguard its funds and make sure its commitment is
not abused. Also, by the very act of declaring an asset eligible for monetary policy
operations, a central bank has to be aware that it might affect its price. This argues
in favor of a graduated system of collateral valuation, in which haircuts reflect the
underlying fair value along a continuous scale, possibly with less threshold
discontinuity than at present. These are issues for further analysis.
2. In any case, while central banks will be called upon to support market functioning in
liquidity crises when the integrity of the transmission mechanism is threatened, they
cannot be asked to rescue insolvent issuers - whether private or public institutions.
In line with this principle, the SMP is meant to repair the integrity of the transmission
mechanism, not to finance public debt.
Conclusions
Let me briefly summarise the thrust of my message. Central banks have provided
exceptional support in exceptional circumstances. Now, they need to apply the Lucas critique
to their own actions. They need to try and work out what the implications of their actions will
be for financial markets in the future. Unless new regulations and a material extension of
oversight to the new world of financial intermediation - which the crisis has exposed - are
applied in earnest, central bank activism risks fuelling moral hazard in the long run.
Provided that financial regulation covers the full breadth and width of financial intermediation,
then the new world will likely be one in which the transmission of monetary policy will be
stronger, not weaker. Risk aversion will call for more collateralisation. The move away from
unsecured to collateralised lending could make overall lending more sensitive to fluctuations
in the value of collateral. As monetary policy influences the terms on which these trades are
made, its effectiveness will increase.
Sovereign debts instruments are likely to continue playing an important role as collateral -
both in private lending and in central bank refinancing operations. Central banks should be
flexible enough to adapt their instruments to changes to the financial environment. But they
have to remain inflexible in their overall strategy. In a changing financial environment the only
way to maintain credibility is to safeguard the ultimate objective, which is price stability.
Thank you for your attention.