Miguel Fernández Ordóñez: Mechanisms to prevent and manage banking
crises in the future
Speech by Mr Miguel Fernández Ordóñez, Governor of the Bank of Spain, at the
presentation of the report entitled "Mecanismos de prevención y gestión de futures crisis
bancarias", Fundación de Estudios Financieros, Madrid, 1 December 2011.
* * *
The crisis still with us has seen the adoption of a broad package of financial measures at the
global, European and national levels. The global response has had political backing at the
highest level of the G-20. In the implementation of this response, a key role has been played
by the Financial Stability Board (FSB), which has coordinated the work of numerous
international institutions and committees. In Europe, in addition to the implementation of
these global agreements on the continent, other worthwhile initiatives have been adopted.
These include most notably changes in the supranational supervisory architecture. Finally,
with regard to Spain, both the Banco de España and the Finance Ministry have contributed
long and hard to implementing these global and European initiatives. But, to highlight a
singular facet of the Spanish response, I should like to mention the restructuring of our
financial system.
I shall spare you my assessment of the numerous and substantial changes stemming from
various fora that have marked progress in recent years. The authors of the book give a good
account of this and, were I to repeat what they say, they might not be read. And it is precisely
my role here today to encourage people to read them. I would therefore prefer to share some
broad reflections with you, having experienced this crisis from my vantage points on the FSB,
the ECB Governing Council and at the Banco de España. Further, given the key juncture at
which we stand, I shall add further remarks as to what we must do in Spain to emerge from a
crisis in which, after four years, we remain immersed.
My first suggestion is that we cease to refer to the "crisis" in the singular and start talking
about "crises" in the plural. This is because the far-reaching shock the Spanish economy and
its banking system have undergone has not been caused by a single crisis but by the
extraordinary overlapping of three economic/financial crises. Spain had never experienced
such an occurrence in its history, a fact which should be borne in mind when deciding on the
best exit therapies. The impact of the first of the three crises, the so-called international
financial crisis, came about in a context in which the banking system was reasonably
wellsupervised and focused on the traditional retail business. But, as was noted at the time,
neither the economy nor its credit institutions would prove immune to its consequences, in
particular to the global recession and to the seizing-up of the regularly used external funding
mechanisms. The second crisis is a typically Spanish crisis, associated with excesses in the
real estate sector, private-sector debt and deteriorating competitiveness, a crisis which in
principle seemed to be a familiar bugbear. However, this time the imbalances emerged within
a monetary union, which has invalidated many of the instruments used in the past to
overcome apparently similar crises. The third crisis is in the euro area, the clearest but not
the only sign of which has been the sovereign debt crisis, which has affected Spain with
particular force. The upshot of the overall impact of these three crises is an extraordinarily
complex scenario with multiple and unprecedented interactions, which means we must avoid
intellectual laziness and seek innovative solutions to manage an exit from the situation. This
is because many of the solutions used in the past are not only no longer available or useless,
but - given the side-effects - may even prove harmful.
I shall now try to draw your attention to the responses that crises prompt. As is well known,
crises, which entail so many personal tragedies, may ultimately have beneficial effects in the
countries they affect if the response to them is the correct one. My first observation is that
any crisis usually generates not only one response but three types of response. The first
reaction leads to the design and adoption of measures whose aim is to prevent a similar
crisis recurring. The second response to the crisis drives us to equip ourselves with new
tools that mitigate the effects of future crises, because experience tells us that, even
assuming that all the preventive measures conceivable today are adopted, it will never be
possible to do away once and for all with economic crises. The third response to a crisis
does not involve preventing or adopting tools to manage future crises, but looking for the
right way to manage the current crisis from which, need I remind you, we have not yet
emerged.
I make this distinction between the three types of response that an economic crisis always
elicits so that my following remarks may be better understood. Firstly, I think that most of the
huge efforts deployed to date at the global and European level in response to the crisis have
focused on avoiding or mitigating future crises. Yet much less time and imagination has been
used in designing and agreeing on measures to emerge from where we are. I am certain that
we are now much better prepared to prevent the recurrence of a crisis such as the present
one, but the problem is that we still do not know how to exit from it. Moreover, there is a
second reason for stressing the difference between the three types of response, which is that
both the measures seeking to prevent the recurrence of a similar crisis, and those seeking to
increase the future resilience of the financial system are usually of little use in resolving the
problems that affect economies and financial systems in the short term, that is to say now.
The authorities naturally wish to "sell" the decisions they are adopting. But nobody should
think that the immediate application of the measures aimed at preventing future crises or
mitigating their intensity will suffice to resolve our short-term problems.
If we analyse the matters addressed on the FSB or European Commission's agendas, we
will see that, until relatively recently, most progress has been centred on preventing the
repetition of a crisis such as the current one, which has affected the entire financial system.
And in the case of a fresh crisis arising, the aim has been for the financial system - for banks
and for the authorities - to have resolution mechanisms that mitigate its adverse effects. With
sole regard to the management of future crises, although major efforts have been made to
move towards more effective crisis-resolution arrangements, most of the prescriptions
admittedly require time to be effectively set in place, meaning that they cannot be used to
manage the current crisis.
Returning to the management of the euro area sovereign debt crisis, much progress has
clearly been made in the reform of European governance. Indeed, henceforth instruments
will be available that make the recurrence of a crisis such as the present one highly unlikely,
and undoubtedly this work is very useful and very important going forward. Had these
instruments been available to us from the outset of the Monetary Union, the current crisis in
the euro area would surely not have broken, since the levels of cross-country divergence in
terms of competitiveness, excessive debt or budget deficits that we are trying to redress
would not have been reached. But all this progress has a very limited impact on our most
immediate problem, which is to manage the crisis in which we are immersed. And what I
wish to stress here is that this task requires very different tools from those needed to prevent
this type of divergence recurring in the future. 18 months on from the outbreak of the
sovereign debt crisis, we have robust mechanisms to prevent and sanction future
imbalances, mechanisms that may be reinforced further if the improvements proposed by the
ECB or some of the suggestions by the German government are finally heeded. But we have
still not managed to activate the right mechanisms to halt the current market dynamic.
Another example of reasonable approaches in respect of financial regulation - but which
may prove insufficient to emerge from the current crisis - is the handling of moral hazard, the
perverse incentive which induces agents to pursue inappropriate and risky behaviour
because they assume they are not going to pay for the consequences. It is known that banks
and countries behave imprudently when they think that they will be bailed out, that others will
bear the consequences of their conduct. There is broad consensus that both in the regulation
of banking business and in that of sovereign debt, elements are needed to reduce moral
hazard to a minimum, and sufficient deterrents must be in place so that banks and countries
have an interest in acting correctly. Indeed, a large part of our work for the future, and in
particular the change in resolution arrangements, is geared to preventing such irresponsible
behaviour.
However, as things currently stand, the strategy of punishing with bankruptcy those who
have "done wrong" or "lent badly" may have undesirable and far-reaching side-effects both in
the banking sector and as regards sovereign debt. The disorderly bankruptcy of an institution
might have very adverse repercussions for the national or indeed European banking system
as a whole. Default by a Monetary Union member country might cause a most considerable
knock-on effect on other sovereign risks. It is not reasonable to ignore these externalities
when calibrating the true scale of this "moral" consideration.
The recent years of crisis have offered us two patent examples of the adverse consequences
of applying a "moral" view to the solution of problems at an inappropriate time, i.e. not before
they occur - which would have its logic - but during the crisis. One example was when the
authority of a European country suggested letting a bank go bankrupt for having made
management mistakes. Wisely, it quickly changed its mind, showing that wisdom does not
mean never committing errors but rather recognising such errors in time. The consequences
of the other example of the mishandling of moral hazard were worse. I refer here to the initial
reaction to the euro area sovereign debt crisis. As we have often repeated at the European
Central Bank, the negative consequences of openly admitting the possibility of sovereign
debt default by one of the euro area countries, and even of demanding default as a
centrepiece of any bail-out programme, were perhaps not taken sufficiently into account. And
these factors have no doubt contributed significantly to the crisis attaining its current scale.
But let us be clear: avoiding the costs associated with the potential bankruptcy of or default
by banks and countries is perfectly compatible with laying down rigorous conditionality
criteria when extending aid to resolve crises. Averting bankruptcies in specific cases does
not mean going "soft" on banks or countries which took on too many risks or incurred
excessive debt. Countries or credit institutions should be helped only in exchange for strict
conditions. And not only for moral reasons (never helping those who do not help
themselves), but essentially because to be able to stand on one's own two feet it is
necessary to enact far-reaching restructuring and reforms. The experience of the IMF is most
illustrative as regards the importance of demanding strict conditionality criteria so that aid
programmes may be successful.
Another fairly common mistake is to believe that crisis-management solutions should always
and everywhere be the same. Before applying uniform measures, it should be borne in mind
that countries may differ in respect of their problems, their legislation and their institutional
structure. Likewise, learning from the past may prove of limited use when it comes to
teaching us how to act in the face of a crisis such as the present one. As I have illustrated
when talking about the Spanish case, the current crises may generate a very different
pathology from those in the past, which means new solutions tailored to the present-day
problems must be sought.
In this respect, a consistent and internationally coordinated response to the crisis must be
made compatible with a reasonable adaptation to the specific circumstances of each country.
For example, it is one thing handling a bank crisis in a country where the major systemic
institutions have been seriously affected and where, therefore, a rapid response is called for,
providing all the public aid needed to avoid the harmful consequences that a bank failure
might have on the banking sector and on the economy as a whole. It is quite different in
another country where the problems are confined to small institutions, where the ultimate aim
should not be their survival in order to avoid a serious interruption in the flow of credit, but
rather their removal as soon as possible at as little cost as possible.
Indeed, some of the biggest developed economies witnessed, at the onset of the financial
crisis, how several of their leading banks were collapsing. This was because, in addition to
the sudden downturn in the value of their assets, they saw the short-term funding channels
on which they relied so heavily disappear. Given this scenario, the logical and no doubt
inevitable reaction was to swiftly inject huge amounts of public money. Yet in Spain's case,
there was overall excess capacity in the sector and the problems were at a group of small or
medium-sized institutions with a reasonably long-term financing structure. All told, the
advisability of earmarking public funds to these institutions immediately was much less
evident. On one hand, it is not surprising that ailing institutions should apply for public aid, if
possible without conditions. But the mission of the authorities is to look out for the general
interest, setting conditions for this aid that ensure the adjustment and restructuring of the
sector and the creation of new, stronger and better managed institutions, of a sufficient size
to gain access to wholesale funding, thus enabling them to channel funds appropriately to
the economy as a whole.
Conversely, it is not surprising that those institutions in a better position should call for the
swift winding up of the institutions facing problems. Yet as one of the articles in the book
being presented today clearly explains, bank-resolution processes can entail enormous costs
for taxpayers, which must be set against the unquestionable benefits of shortening
restructuring time. Moreover, insofar as these costs may affect sovereign risk, the cure might
prove worse than the illness.
But let us talk about the present, about what we should do now. Evidently, not only have we
not exited the crisis, but the information reaching us shows that the crisis may worsen in the
coming months. Exit will depend on what the reaction is on the domestic, European and
global fronts. At present, the key to our future lies in the capacity of the European institutions,
the European Council, the Eurogroup and the ECB, and the national governments, to act in
unison, each in its own area of responsibility, with a single, shared objective: to halt the
dangerous current market dynamic. In the absence of joint action, any piecemeal and
uncoordinated progress on any of those fronts will be worth little. European progress is
absolutely vital so that the adjustment drive in the national economies should not prove
sterile. Headway in these adjustments is likewise vital for preparing the terrain on which the
European institutions must progress.
So as not to overstay my welcome, and given that next week several meetings involving
these European institutions are to be held, I propose that we assume that these meetings will
eventually see the adoption of the decisions needed to turn the markets around.
This assumption about what the European institutions will do allows me to conclude my
address by talking exclusively about our national problems. What must Spain do to emerge
from the crisis? As I said at the outset, the conjunction of three economic crises, and in
particular the worsening of the sovereign debt crisis, mean that precise economic policy
implementation is extremely difficult at present, although the diagnosis as to what must be
done is relatively simple and widely known.
At present, what is most important is to promptly pursue an ambitious reform of our labour
market institutions, while continuing to make headway on two key fronts: budgetary
consolidation and financial system restructuring. In the past two years significant steps have
been taken in both these areas, but to achieve fully satisfactory results, perseverance with
the path of reform is needed.
Starting with the reform of the labour market institutions, certain measures have been taken
recently. But the truth is that, since the outset of democracy, Spain has not been capable of
making any meaningful progress in this area, whereas most European countries have used
the past three decades to reform their labour systems, in order to achieve higher levels of
flexibility and job protection, i.e. greater "flexicurity". During this time, the Spanish economy
has been radically modernised in many other areas, through the adoption of regulatory
frameworks and measures comparable to those of the most advanced economies, such as
the removal of barriers to trade, the liberalisation of certain sectors, privatisations, etc.
However, our labour market, which is characterised by the very high levels of unemployment
generated during crises and also by its inability to reduce unemployment rates during
upturns, has retained the same institutional structure with no substantial changes for
30 years. The cost for workers of this resistance to reform has been insecurity both for the
unemployed and for those who have jobs but fear losing them. The insensitivity of wage
growth to the cyclical situation and to productivity generates numerous perverse effects. First
and foremost, the adjustment to shocks is borne entirely by employment. But also wage
growth in some sectors or firms may be lower than it would have been if more flexible labour
institutions had allowed productivity gains at the firm level. This is what one observes when
the situation of Spanish workers is compared with that of workers in those European
countries that have the highest levels of flexicurity.
For all these reasons, as I have so often said, Spain's labour institutions must be reformed in
order to lay the foundations for employment creation and for reducing unemployment from its
very high current level to one similar to those of other European countries. All I can add
today is that a gradual process is no longer sufficient. The seriousness of the situation
requires the adoption forthwith of a reform that draws our labour market closer to the levels
of job flexibility and security prevailing in most European countries.
Reform of our labour institutions is very necessary for many reasons. First, to put an end to
the personal and family drama that unemployment entails. But also to help reduce the budget
deficit. Indeed a more efficient labour market, that gave us unemployment rates similar to
those of other countries, would permit the costs of unemployment - which in Spain amount to
around 4% of GDP - to be reduced, and would increase government receipts from income
and consumption taxes without tax rates having to be raised. A reduction in unemployment
and an increase in employment are also very important for the banking system. First,
because high rates of unemployment eventually lead to higher default rates. Second,
because a reduction in unemployment is essential to reverse a trend that is having very
serious effects on banks, namely the fall in solvent demand for credit. That said, at present,
owing to the worsening of the sovereign crisis, supply-side factors are also contributing to the
decrease in lending to households and firms which, as usual in this type of situation, affects
small and medium-sized firms disproportionately.
However, as I have repeatedly said, labour reform, accompanied by liberalisation processes
to foster a more competitive environment, is the only way within the context of monetary
union of achieving an internal devaluation within a relatively short space of time. This reform
will not have immediate effects, but that only makes it all the more pressing. Without this
reform, the recovery in competitiveness could only be achieved through an extremely slow
and very painful, with unacceptable suffering for many Spaniards and negative
consequences beyond the purely economic ones.
Turning to budgetary policy, lowering the deficit is absolutely necessary given the stance of
the markets, whose distrust of the sovereign debt of the euro area countries has been
increasing in recent weeks. Admittedly, tough decisions have already been taken in Spain,
such as the reform of pensions, which have served to reduce the deficit not only in the short
run, but also in the medium and long term. However, there is still a long way to go merely to
comply in 2012 with the 4.4% budget deficit commitment, whatever the final figure for 2011.
Finally, some very significant progress has been made in Spain in recent years in financial
restructuring. The banking system has written off bad debts (equivalent to more than 10% of
GDP in the last three-and-a-half years), the average size of banks has increased, capacity
has been reduced and a process is under way to transform the savings bank sector, which
will help these institutions to meet the new prudential regulation requirements and strengthen
their ability to fund themselves on the markets. Yet, as I said in September when presenting
the results of the recapitalisation required by the royal decree law passed early this year, the
restructuring process cannot be considered to have been completed. In fact, insofar as the
economic forecasts for 2012 have in recent weeks been revised drastically downwards and
funding problems on wholesale markets have worsened for all European banks, the pressure
on our credit institutions has intensified and therefore the need for adjustment and financial
restructuring not only remains but has actually increased.
During economic upturns the major danger is complacency, which leads one to think that
reforms are not necessary because everything (growth, employment, government revenues)
is going well. During crises however, the great danger is reform fatigue, tiring of reforms that
have no visible effects in the short term.
For this reason, we must not only press ahead with financial restructuring, but must also be
open to the possibility of taking further action when this is considered necessary. That said,
irrespective of the instruments that may soon be adopted, both the objective and the main
criteria that have been followed in recent years should, in my opinion, be maintained. The
objective is clear and leaves little room for discussion: to have solid institutions that are able
to contribute effectively to the financing of households and businesses. And it would also be
useful to preserve the main criteria used hitherto in the financial restructuring. Specifically, I
am referring to the anticipation of problems, minimisation of the use of public funds, reducing
capacity, the conditionality of assistance, the emphasis on downsizing balance sheets and
the promotion of transparency.
First it is very important to anticipate problems. The primary obligation of a banking
supervisor is to ensure at all times that the credit institutions operating are solvent and viable.
However, good supervisors should not limit themselves to analysing the present, but should
also anticipate possible scenarios of non-viability that might arise in the future and attempt to
reduce problems to a minimum before they emerge. When the crisis broke, the 45 Spanish
savings banks then existing were all solvent and viable. However, taking into account the
new economic and financial environment stemming from the crisis, it was possible to foresee
that while some of them were very well-managed and unquestionably sound, many others,
within a matter of years or months, might eventually be non-viable. That is why it was urgent
to change the legislation on restructuring, which had been designed to resolve isolated,
nonsystemic crises and which, in particular, was not appropriate for managing the restructuring
of savings banks. Moreover, the legislation then in force involved the use of tools that had
been very useful for resolving crises in the past, but that were banned by the Monetary
Union. Consequently it was important to create instruments such as the FROB to enable
preventive action to be taken, before the situation worsened and required a wholesale
winding up of institutions. Apart from the costs of winding up, there was a risk, especially at a
time of global banking crisis, that contagion might spread throughout the Spanish financial
system.
When examining the possible formulae for financial restructuring, the authorities ruled out
some that definitely might have speeded up the process of restructuring the banks. They did
so on the basis of prudence, since a sudden sharp deterioration in public finances in the
midst of the crisis could, as it did elsewhere in Europe, have meant that the rescue of the
banking system brought the country to the brink of bankruptcy and an eventual bail-out. The
containment of public spending matters not only from a medium-term perspective; given the
current vulnerability of sovereign debt on the markets, its short-term effects must also be
considered.
It is also essential to maintain the criterion of demanding conditionality when designing public
assistance, so that this is only received by institutions that adjust their capacity and manage
to improve their efficiency, which is easier to do when their size is increased. At the same
time, any strategy that encourages banks to seek private solutions requires more time than
one of wholesale public intervention. But this system of incentives, which has required an
enormous amount of work not only by the supervisory authorities at the Banco de España
but also by many savings bank managers, has meant that most institutions have voluntarily
undertaken integration and restructuring process. That has not only served to reduce the
contribution of the Spanish taxpayer, but also to increase banks' size and reduce their
capacity, thus giving rise to a banking system that is somewhat better prepared to withstand
the crisis than the one we had when it started, although all the institutions still have much to
do in the way of improving their efficiency.
It is also important to emphasise that the key to every restructuring is to clean up balance
sheets. Some of the criticisms that you may have heard during the savings bank
restructuring process have been that it was unfair to require savings banks first to write down
their assets and then to recapitalise too. With the benefit of hindsight, I do not think that
anybody would now consider that we should have started in any other way than by requiring
assets be written down, and then at a later stage, requiring recapitalisation. Balance sheet
restatement is not just "one" possible formula for restructuring, but rather a vital ingredient of
all restructuring processes.
Finally, I understand but do not share the view of those who see a danger in forcing
institutions to increase transparency in the midst of a crisis. I am convinced that, in the
present situation of general distrust in the markets, suspicion is always much worse than
reality, however problematic that may be. Admittedly, despite increased transparency, doubts
persist as to the extent to which our banks have cleaned up their balance sheets. And
although write-downs have been very intense, unsatisfactory economic performance might
make further efforts along these lines necessary in future.
Be that as it may, let me conclude by reiterating that such is the speed of change in the
economic environment in Spain, Europe and the world in recent months, and even in the last
few weeks, that it would be a grave error to establish rigid criteria that rule out the possibility
of incorporating fresh financial restructuring tools, if changing circumstances mean that they
are required in order to achieve the final goal. That can be none other than to have a set of
solid credit institutions ready to effectively meet the solvent demand of Spanish households
and firms for funds.
Thank you very much.