Lucas Papademos: Financial market excesses and corrections - a
central banker's perspective
Speech by Mr Lucas Papademos, Vice-President of the European Central Bank, at the
International Research Forum on Monetary Policy, jointly organised by the Board of
Governors of the Federal Reserve System, the Center for German and European Studies at
Georgetown University, the Centre for Financial Studies at Frankfurt University and the
European Central Bank, Frankfurt am Main, 26 June 2008.
* * *
Ladies and Gentlemen,
I. Introduction
It is a great pleasure for me to address you on the occasion of this fifth conference of the
International Research Forum on Monetary Policy. The goal of the Forum is to foster a
transatlantic dialogue, based on rigorous theoretical and empirical research, on issues of
relevance to monetary policy in the United States and the euro area, but also from a global
perspective. And certainly the topics on the conference programme are of global relevance to
monetary policy-makers and concern issues that continue to pose challenges for central
banks.
The financial market turbulence over the past 10 months has highlighted the global and
pressing relevance of several policy issues. And it has posed significant challenges for
central banks: challenges for the conduct of monetary policy, the management of liquidity in
the money markets and the performance of tasks pertaining to their responsibility to help
safeguard financial stability. The ongoing process of risk reappraisal and balance sheet
adjustment has led to extensive analysis and discussion of a number of pertinent matters:
the underlying causes and (proximate) triggers of the market turmoil, the mechanisms
responsible for the propagation and amplification of shocks across markets, institutions and
borders, the identified weaknesses in the capacity of financial institutions and investors to
appropriately assess and adequately manage risks, and, finally, necessary actions of market
participants and authorities to address the consequences of the ongoing financial market
correction and to strengthen the resilience of the financial system.
In my remarks, I will concentrate on three themes:
•
The first pertains to the underlying causes of the turmoil and, in particular, some key
factors and processes that contributed to the emergence and persistence of
financial market excesses and asset price bubbles and can also help explain the
timing and abruptness of the market correction.
• second
The concerns the special role of certain asset markets, notably the housing
and credit markets, in driving the dynamics of boom-and-bust.
• third
The focuses on the role of central bank policies and tasks in containing the risk
of financial market imbalances and in mitigating their potential consequences on the
financial system and the economy.
II. The emergence and persistence of asset price bubbles and financial
imbalances
So what key factors and processes contribute to the emergence of asset price bubbles and
their persistence over a fairly long period before they abruptly unwind? There is no
consensus among economists about the answer to this question. And, indeed, some have
argued that they are meaningless because in their view asset price bubbles do not really
exist! Some economists had claimed that even the most famous bubbles in history - e.g. the
Dutch Tulip Mania from 1634 to 1637, the French Mississippi Bubble in 1719-20, the South
Sea Bubble in the United Kingdom in 1720 and, more recently, - the worldwide new
economy boom in the late 1990s (the "dot.com-bubble") - should not be considered as such
because they can be explained by rational expectations justified by fundamental factors
related to future returns on the respective underlying assets. Which in one case were tulip
bulbs!1
This view may have some merits given the hypotheses on which it rests. But, there is little
doubt in my mind that we occasionally observe behavioural patterns in financial markets,
which although they may be perfectly "rational" or justified from an individual investor's
perspective, they nevertheless lead to large, increasing and unjustifiable deviations of asset
prices from their fundamental values.
Indeed, an insight into special or psychological factors that can affect stock market valuation
can be highlighted by the following simple story: Once an investor approached his
stockbroker for advice on which stock to buy and was told to purchase a penny stock that
was valued at just 50 cents a share. "This one is really going to move", the broker said, and
the persuaded investor instructed his broker to buy him 5000 shares. The following day, the
stock was valued at 1 euro and, seeing this, the investor called the broker and told him to
buy another 10,000 shares. The next day the investor saw that the price of the stock had
jumped up to 3 euro. Excited and satisfied with the huge profit he had made in just two days,
the investor called his broker: "Sell all my shares", he instructed. "To whom?" the broker
replied. "You were the only one buying that stock!"
This humorous story is instructive because it highlights two features of asset markets that
seem to contribute to the emergence of bubble-like phenomena and the build-up of financial
imbalances. The first is the fact that asset markets involve the trade of expectations, or more
precisely, the trade of instruments whose prices depend on expectations about the future
and which are fundamentally uncertain and susceptible to potentially large swings. The
second feature is the fact that asset prices are influenced by positive feedback mechanisms.
These feedbacks effects can amplify initial revisions in expectations and thereby generate
market outcomes that might induce investors to adjust their expectations even further,
leading to a feedback loop between expectations and outcomes.2
Let me mention one important feedback mechanism that seems to have played a crucial role
in the run-up to the current events. It appears that the present financial market turmoil has
partly been driven by a certain pro-cyclicality in risk assessments, especially by what
appears - ex post - to be an unjustified pro-cyclicality in the assessment of liquidity risk.
The increasing volume of securitisation of mortgage loans caused securitised mortgages to
become increasingly liquid assets over the years. Investors in these assets with
longmaturities apparently considered them sufficiently liquid that they could afford to finance their
holdings with very short-term financing instruments. Given the market conditions prevailing
for some time (over the period 2003-2007), such a strategy seemed justified: in case of
insufficient funding, investors could (reasonably) expect to be able to quickly sell some of the
mortgage-backed securities in a rather liquid market. But what would happen if funding
liquidity would dry up for some reason?
Some - possibly even many - investors were aware of the possibility of future liquidity
problems and occasionally even expressed their surprise about the ease with which it was
possible to fund mortgage-backed securities via short-term credit. Nevertheless, most
investors continued doing what they had been doing for some time, underestimating the
associated (liquidity) risk and they even expanded the volume and range of their risky but
profitable activities. Why did this happen? Why did investors underestimate the liquidity risks
and fail to act promptly upon their sceptical views? The answers to these questions are
relevant for our understanding of why the "party lasted for so long" and why some party (that
is, market) participants kept on dancing until the very end, until the music finally stopped
playing.
A number of reasons can help explain the observed behaviour. The first is associated with
the difficulty of speculating against a strongly rising market that is driving prices above
estimates of fundamental values. You may recall that John Maynard Keynes once cautioned
against such a strategy by warning that "The market can stay irrational longer than you can
stay solvent."
One explanation for this is that speculating against the market requires a
critical mass of investors that will act in synchronised or coordinated manner and will be able
to push prices back towards fundamental values. This may not be easy when markets are
deep and liquid as they tend to be during upswings. The "coordination problem" may
therefore substantially delay arbitrage.3 Indeed, it might be rational for each individual
investor to aim at riding the bubble (just) until the moment before it bursts, and this can
explain the apparent contradiction between what investors do and what they believe to be
fundamentally justified.4
A second reason why speculation against a rising market may be limited is that there are few
incentives to do so. Payoff-structures and compensation schemes tend to encourage
riskloving attitudes. Compensation contracts that fail to incorporate sufficient
"historydependence" can similarly lead to risk-loving behaviour: a fund manager whose bonus
depends on his or her annual performance is likely to prefer a volatile environment which
may be characterised by a sequence of bonanza years followed by a year or two of crisis
and doom, rather than a more stable environment.
A third possible explanation, which is "rational" from an individual investor's point of view, is
that if taking investment positions against the market eventually fails to be profitable, it will
carry the stigma of an unsuccessful investment manager, while being wrong with the crowd
is likely to be considered to be just bad luck.
But the music will eventually stop playing. And it will stop playing when the orchestra realises
that market value is totally out of tune with any reasonable expectations of future returns. As
perceptions and attitudes gradually change, seemingly minor events can produce large
changes in valuations. In August 2007, the difficulties emerged when it was recognised that
some of the assets - initially those backed by sub-prime mortgages - turned out to be more
risky investments than previously thought. This meant that structured investment vehicles
(SIVs), hedge funds and other investors suffered losses in relation to the value of these
securities. This in turn caused the liquidity providers to these investors to reassess the value
and risk of the collateral offered against their funding and to demand higher margins. The
resulting funding problems forced investors in mortgage-backed and other related securities
to deleverage. With many investors trying to do the same thing at the same time, the
downward pressure on prices intensified, resulting in extensive losses, even higher margin
requirements and further forced sales until the market for funding and for mortgage-backed
securities largely dried up.
The recent episode has shown how and why fundamentally unjustified asset price booms or
excesses can occur and persist for some time. There are many lessons to be learned. Some
of these are new and relate to the features and functioning in practice of the "originate-to-
distribute" (OTD) model and the securitisation process. Other lessons, however, are not new
and should be relearned as they had been forgotten, including the role of excessive credit
expansion and high leverage in driving the rising phase of a boom-and-bust asset price cycle
and accounting for the steepness of the fall during the downturn phase. One policy-relevant
question which should be addressed is whether some asset markets are likely to be more
vulnerable to valuation swings and are more likely to have significant adverse implications for
the stability of the financial system and the economy. I will now turn to this question.
III. The role of housing and credit markets
Are there particular markets that are more prone to boom-and-bust cycles and, in the event
of a sharp correction, are likely to have more pronounced effects on financial and economic
stability? And if so, which ones? The speculative element that could result in a mispricing of
risk implies that financial market excesses are likely to have their origin in markets with
longlived assets with uncertain returns such as the housing markets or the equity markets, and
possibly also the market for private bonds with long maturities. Moreover, asset markets that
lack effective short-selling instruments, which allow investors to address overvaluations,
should also be more prone to bubble-like price deviations from fundamental values.5
What are the facts? In advanced economies, stock and house price booms seem to occur
rather frequently and with approximately the same frequency. Among the observed housing
booms, every second one is likely to be followed by a house price bust. In equity markets, a
crash follows a stock market boom only in 1 out of 6 cases. Thus, boom-and-bust cycles in
housing markets occur much more frequently than in equity markets. Moreover, house price
boom-bust cycles are historically associated with correspondingly larger inflation and output
gap movements than stock price booms and busts.6
The association of house price cycles and macroeconomic volatility is not necessarily
obvious a priori. We might expect housing boom-bust cycles to have a less pronounced
impact on aggregate output than equity cycles. The available evidence in many countries
indeed suggests that consumption is less sensitive to housing wealth than financial wealth.7]
This probably reflects the fact that financial wealth in many countries can be mobilised more
easily for consumption than housing wealth (e.g. by selling some of the assets).
Over time, however, the effect of housing wealth on consumption seems to have increased.
In the euro area, since the (early) 1990s the effect of a change in housing wealth on
consumption has become significant in terms of size and statistically, with the marginal
propensity to consume out of housing wealth estimated at around 2 cents in response to a 1
euro increase in housing wealth. While the estimated magnitude in the euro area of the
impact is rather small, the sheer size of the housing market and wealth implies that a 10%
permanent decrease in house prices in the euro area as a whole would decrease
consumption by approximately 1%. In the United States the marginal propensity to consume
out of housing wealth is estimated to be considerably larger, roughly twice to three times as
large as in the euro area.8
But there is another important reason why house price cycles have had a pronounced effect
on the economy. Historically a number of housing market busts have been associated with
crises in the banking sector, as banks traditionally have held the largest part of the mortgage
loans on their balance sheets. An increase in delinquency rates, triggered by house price
declines and a coinciding economic slump reduce the capital buffers of banks with adverse
effects on credit expansion and the intermediation process. The greater vulnerability of the
banking sector to sharp housing market corrections explains why these events have had a
bigger impact on output than stock market crashes.9
Turning to the recent experience, it would have reasonably been expected that increasing
financial integration and the rapid growth of the loan securitisation and of the market for
credit risk transfer instruments would have allowed banks to substantially reduce their
exposure to mortgage loans and protect themselves from the effects of a sharp housing
market decline. And, there is no doubt that these financial innovations did facilitate the
spreading and redistribution of credit risks across institutions, sectors and countries.
At the same time, the functioning in practice of the OTD mode of intermediation was
characterised by a number of weaknesses. Let me briefly point to a few of them:
•
First, the increased leverage that was supported by the rapid growth in securitisation
was accompanied by an erosion of credit standards reflecting weak incentives and
competitive pressures.
•
Second, the complexity of structured finance products and the imperfect information
about the risk characteristics of the underlying assets made difficult the proper
assessment and management of associated risks.
•
Third, as a result, financial institutions and other investors relied excessively on the
ratings of complex structured credit products by credit rating agencies (CRA). And,
as it turned out, the models and methodologies used by CRAs had shortcomings,
and inadequate information was provided about the methodologies employed and
the characteristics of the ratings of structured finance products.
•
Fourth, financial institutions established off-balance-sheet conduits and structured
investment vehicles (SIVs) which held the long-term complex structured finance
products and financed them by issuing short-term maturity instruments (which
backed these long-term and not very liquid products). This maturity mismatch
between assets and liabilities was accompanied by explicit or implicit liquidity or
credit commitments of the sponsoring banks to provide financial support in the event
of funding difficulties. Overall, as a consequence of the effects of various factors and
practices, including poor internal controls on the management of on- and off-balance
sheet risks, a number of banks underestimated not only default risks but also
concentration and liquidity risks.
As a result of these shortcomings, the sharp rise in delinquencies on US subprime
mortgages triggered a significant and widespread adjustment in the balance sheets of many
financial institutions which had direct and indirect exposures to mortgage debt on and mainly
off their balance sheet. So, effectively the securitisation process did not sufficiently insulate
bank balance sheets from the adverse impact of sharp corrections in the housing market. In
a few extreme cases, the shareholders of some institutions and the public at large suddenly
realised, looking at the balance sheet, that "on the left side, nothing was right, and on the
right side, nothing was left".
Having said that, however, I would not conclude that the recent experience suggests that the
OTD model and the securitisation process have failed and should be abandoned. These
financial innovations entail important benefits. Looking ahead, the actions and initiatives by
market participants and policy-makers should aim at addressing the identified weaknesses,
by improving incentive structures, risk management practices and transparency, so that the
OTD model can function effectively and contribute to an efficient and stabilising sharing of
risk and help contain the intensity of boom-and-bust asset price cycles.
IV. The role of central bank policies
Let me now turn to some pertinent policy issues for central banks. What is the role of
monetary policy, and more generally of central bank policies and tasks, in preventing or
containing the risk of financial market imbalances - of asset price bubbles - that can
threaten the stability of the financial system and entail serious risks to aggregate output
volatility and medium to long-term price stability? And what is the role of central bank policies
in mitigating the potential consequences of a sharp market correction on the financial system
and the economy?
Over the past 10 months, central bank actions have provided answers to the second
question. The ECB has pursued a clear strategy that aims at ensuring the orderly functioning
of money markets and mitigating financial stability risks through the effective management of
liquidity in the interbank money markets and without changing the stance of monetary policy.
The level of policy rates has been determined by the overriding objective of preserving
medium-term price stability, while money market operations have kept the very short-term
market rates close to the key policy rate and have alleviated pressures in the term money
market. Looking forward, the envisaged actions by public authorities and the private sector,
in line with the proposals of the Financial Stability Forum and the ECOFIN Council policy
roadmap, aim at addressing the consequences of the turmoil by restoring confidence and
strengthening the resilience of the financial system. And very good progress is being made in
implementing the envisaged actions.
But the answer to the first question I posed is also essential, for we can all agree that, in
principle and in general, prevention is better than cure. The issue has been recently debated
again and policy-makers and academic economists have expressed different views. So can
and should monetary policy prevent - or at least contain - asset price bubbles? My answer
to this question consists of five points.
•
First, the overriding objective of monetary policy is - and should remain - the
preservation of the stability of the general price level, as measured by the CPI
(HICP), and monetary policy has the instruments to achieve this objective over the
medium and longer term.
•
Second, monetary policy cannot effectively control asset prices, which are relative
prices that are fundamentally determined by real factors, including expectations of
future real rates of return incorporating risk premia.
•
Nevertheless, and this is the third point, there can be significant links between asset
price developments and consumer price developments over the longer term, while
monetary and credit conditions can influence asset price dynamics in various ways.
For this reason, a careful monitoring of asset price developments and a thorough
assessment of asset price prospects and risks can provide useful input to the
assessment of the risks to medium-term price stability.
•
Fourth, the empirical evidence from many countries and various periods, including
the recent experience, has shown that excessive credit expansion and high leverage
can be key drivers of unsustainable asset price developments, through various
channels, including their effects on funding liquidity risk, risk premia and market
liquidity. Consequently, the monitoring and analysis of monetary and credit
aggregates can provide useful early warning signals about the build-up of asset
price bubbles and their potential longer-term implications for the functioning of the
financial system, macroeconomic volatility, and price stability.
•
Therefore, and this is my fifth point, there may be circumstances when the
assessment of the potential impact of asset price dynamics - past and projected -
on price stability may imply that monetary policy should try to "lean against the wind"
in order to mitigate medium to longer-term risks to price stability and the economy.
Having said that, I should add that defining a monetary policy stance that aims to "lean
against the wind" in a manner that is consistent with the preservation of price stability may
not be straightforward. And the effectiveness of such a policy is likely to depend on the
effects of other factors that influence asset prices and consumer price developments. Time
does not permit to elaborate on these complex issues. But let me note that the monetary
policy strategy of the ECB provides an appropriate and comprehensive framework for the
analysis of the links between money and credit expansion, asset price dynamics and price
stability risks that can provide a solid basis for decision-taking and external communication.
More generally, addressing the broader issue of how to minimise the risk of financial bubbles
occurring requires the involvement of the private sector itself, financial market regulators and
supervisors of financial institutions. Monetary policy could, under certain circumstances, play
a role in containing this risk, but it is certainly not the main instrument to help deal with the
emergence, persistence or unwinding of financial imbalances. Not least against the
background of the market turmoil, we can ask the question: Is there anything else that central
banks could - or should - do to minimise the likelihood of significant financial market volatility
and to strengthen the capacity of the financial system to absorb their consequences? The
answer to this question involves various functions and potential actions of central banks, but I
would like to stress the contribution which central banks can make by enhancing their
monitoring of financial stability, by further developing the pertinent methodologies and
models and improving the availability of the relevant data.
This is, of course, no easy task. Contagion effects and likely non-linearities in both the
buildup of imbalances and their transmission across the financial system and to the real economy
make the modelling of financial stability risks very complex. Moreover, assessing and
estimating the likelihood of typically low probability events - the famous "black swans" - is
exceedingly challenging.
There is no time now to discuss these matters in detail. Allow me, however, to make three
pertinent remarks in this context: First, all of the financial stability indicators that are currently
being developed (by the IMF, central banks and in research institutions) - be they indicators
based on securities prices (such as credit spreads, distances-to default, volatilities implied by
options prices), or "rule of thumb" thresholds derived from longer-term historical averages,
fundamental equilibrium considerations, or from cross-country comparisons - certainly
contain important information, but they are also subject to important inherent limitations.
Therefore, it is necessary to appropriately combine the information contained in various
indicators and avoid excessive reliance on single indicators.10
Second, in order to create an internally consistent framework, or model, for analysing
imbalances and monitoring financial stability, it is also necessary to identify linkages and
channels of contagion within the financial sector - across markets, institutions and
infrastructures - and between the financial and non-financial sectors. Such complexity poses
a formidable modelling challenge. Even if models might never be able to predict a financial
crisis, and its precise timing, we can nevertheless seek to develop models for assessing
vulnerabilities.
Third, a promising way of gauging the ability of the financial system to cope with
disturbances is stress-testing, which is increasingly used at a macro level for assessing
mainly the stability of banking systems. Important advances have been made in developing
stress-testing techniques, and central banks have played a catalytic role in this progress.11
However, also with regard to stress-testing techniques, we are faced with important
limitations, related to unpredictable non-linearities or unexpected links that may surface
during periods of stress. Until the existing limitations have been adequately addressed, our
financial stability assessment will need to use an eclectic approach, building on a wide range
of data sources, indicators and models.
Looking forward, I see the need to make further progress on at least three fronts, concerning
(i) the availability of data, (ii) the development of models and (iii) the understanding of
linkages. Regarding data, more and better data on quantity indicators - such as liquidity,
leverage, market positioning, etc. - would help in shedding light not only on the indicator
properties of securities prices, but also on the vulnerabilities prevailing within financial
markets. In addition, micro balance sheet data, especially on distribution of exposures, can
be helpful when seeking to identify the relevance of linkages both between real and financial
sectors and within the financial system itself.12 As financial institutions further strengthen
their practices, data availability in this area may improve over time.
With regard to models, we need dynamic general equilibrium modelling frameworks capable
of measuring (possibly non-linear) interactions between the financial and non-financial
sectors of the economy and the links to monetary policy instruments. This would allow for a
more accurate assessment of the likely impact of adverse disturbances, and the further
development macroeconomic stress-testing techniques is clearly are a promising avenue to
pursue in this respect.
Finally, regarding linkages, further work would be desirable on the modelling of real-financial
interaction, and on interactions within the financial system itself, including payment systems
and interbank markets. This would help to better understand the likely impact of correcting
imbalances on financial institutions, markets and infrastructures, and to capture possible
second-round effects of financial crises.
V. Concluding remarks
Let me conclude on a note of appreciation and optimism: significant progress has been made
in recent years in understanding how financial imbalances emerge, why they persist, and
how they may be avoided, also, and especially, thanks to the dedicated effort and fruitful
work of researchers in academia and policy-making institutions. But of course, many
conceptual and methodological challenges lie ahead. As you witnessed, some of the
explanations given and conclusions drawn were tentative, for the fact is that we do not know
enough to provide a complete and accurate diagnosis of all the problems and definite policy
prescriptions. Therefore, there is plenty of scope for economists to further contribute towards
the deepening of our understanding of these phenomena and to the development of tools
which can help to quantify their effects and identify the appropriate policy responses. After
all, anticipating the consequences of financial innovation for the functioning of the financial
system is a process of continuous learning and discovery. New products are likely to be
invented, and some of these may give rise to new and unexpected risks. Unfortunately, we
often learn about the risks only after they have materialised. It is, therefore, likely that as
markets will continue to develop and innovate and as long as investors' "animal spirits" are
not harnessed by an appropriate market and institutional framework that can foster prudence
and discipline, the bubbles and financial imbalances will reappear in our economies. And so
will the need for further analysis on our research agenda. This is a clear example of the truth
of the observation (made by 19th century English author Mark Pattison) that often "in
research the horizon recedes as we advance".
There is no shortage of challenges ahead!
Thank you very much for your attention.
References
Adalid, Ramon and Carsten Detken (2007), "Liquidity Shocks and Asset Price Boom/Bust
Cycles", ECB Working Paper No. 732.
Adam, Klaus, Albert Marcet and Juan Pablo Nicolini (2008), "Stock Market Volatility and
Learning", ECB Working Paper No. 862.
Abreu, Dilip and Markus K. Brunnermeier (2002), "Synchronization risk and delayed
arbitrage", Journal of Financial Economics, Vol. 66(2-3), pp. 341-360.
Econometrica,
Abreu, Dilip and Markus K. Brunnermeier (2003), "Bubbles and Crashes", Vol.
71(1), pp. 173-204.
Allen, Franklin and Douglas Gale (2000), "Bubbles and Crises", The Economic Journal,
Vol. 110(460): pp. 236255.
Basel Committee for Banking Supervision (2006), "Studies on credit risk concentration",
Working Paper No. 15, November.
Basel Committee for Banking Supervision (2008), "Liquidity Risk: Management and
Supervisory Challenges", February.
Bordo, Michael D. and Olivier Jeanne (2002), "Monetary Policy and Asset Prices: Does
'Benign Neglect' Make Sense?", International Finance, Vol. 5(2), pp. 139-164.
Borio, Claudio and Philip Lowe (2002), "Asset Prices, Financial and Monetary Stability:
Exploring the Nexus", BIS Working Paper 114.
Case, Karl E., John M. Quigley and Robert J. Shiller (2005), "Comparing Wealth Effects: The
Stock Market vs. the Housing Market", Advances in Macroeconomics Vol. 5(1), pp. 1-34.
Detken, Carsten and Frank Smets (2004), "Asset price booms and monetary policy", in Horst
Siebert (ed.), Macroeconomic Policies in the World Economy, Springer, Berlin.
ECB (2007), "Financial Stability Review", Box 9 "Understanding Financial Market Liquidity",
June 2007.
Goodhart, Charles and Boris Hofmann (2008), "House Prices, Money, Credit and the
Macroeconomy", ECB Working Paper No. 888.
Journal of Economic
Garber, Peter M. (1990), "Famous First Bubbles", Perspectives, Vol.
4(2), Spring, pp. 35-54.
Garber, Peter M. (2001), "Famous First Bubbles: The Fundamentals of Early Manias", The
MIT Press, Cambridge (MA)
Helbling, Thomas and Marco Terrones (2003), "When Bubbles Burst", World Economic
Outlook April, 2003: Chapter II. International Monetary Fund, Washington, D.C.
Herring, Richard a