Jean-Claude Trichet: The great financial crisis - lessons for financial
stability and monetary policy
Introductory remarks by Mr Jean-Claude Trichet, President of the European Central Bank, at
the Colloquium in honour of Mr Lucas Papademos, Vice-President of the European Central
Bank, Frankfurt am Main, 20 May 2010.
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Ladies and gentlemen,
Introduction
The subject of this colloquium - "the great financial crisis"- could be no other since Lucas
Papademos' tenure will be remembered for the immense challenges for financial stability and
monetary policy that have arisen since the trigger of the subprime crisis in 2007.
Lucas played a key role at both the global and European levels in tackling these challenges.
He was among those who were prescient about the considerable build-up of risks in the
years before the crisis. He placed significant efforts in developing and adapting financial
stability analysis to the fundamental and far-reaching changes in the financial system we
have witnessed in the past decade, particularly as a result of increasing financial integration
and innovation. When the crisis unfolded, Lucas was one of the foremost policy-makers in
devising the actions required to stabilise the financial system. He also played a substantial
part in setting the ground for regulatory reform, namely through his participation in the
Financial Stability Forum, later Board, and in several European and Eurosystem fora, a
number of which he chaired himself.
I am therefore delighted that we were able to organise this colloquium with such a set of
distinguished speakers, all of which have their exceptional professional standing deeply
associated with the financial crisis, either as policy-makers, crisis managers, academics or
proponents of regulatory initiatives.
My introductory remarks this afternoon are organised around the title of this colloquium. My
aim is to review policies in the last few years and draw some policy conclusions. I will first
touch upon some of the lessons for financial stability, where Lucas's contribution was
especially important, as responsible for the financial stability function, and then turn to the
experience with monetary policy.
Lessons for financial stability
The financial crisis erupted in August 2007, when off-balance sheet vehicles that had been
set up by banks to manage portfolios of complex structured credit securities ran into funding
liquidity problems. Although initially a liquidity squeeze, concerns about counterparty credit
risks quickly spread as uncertainties intensified about the nature and extent of exposures of
banks to what we now call "toxic assets". And, as we know, these escalating tensions
culminated in the bankruptcy of Lehman Brothers in September 2008, an event which
triggered an unprecedented surge of volatility across mature-economy financial markets and
a broad-based decline of asset prices. With this, an adverse feedback between the condition
of the financial system and real economic performance was unleashed, contributing to a
sharp economic slowdown across the developed economies. Now we are observing renewed
tensions, as the costs of supporting financial sectors, fiscal stimulus and automatic stabilisers
brought the focus to public finances across many countries both within and outside the euro
area.
With hindsight, the financial crisis has reminded us that the seeds of financial instability are
often the same: balance sheet mismatches, high leverage (on or off balance sheets) and
very rapid growth of financial institutions. Essentially all of these elements were at play in one
form or another in this episode. Now what are the lessons for financial stability monitoring
and assessment frameworks as implemented by the responsible authorities?
A first observation I would like to make in this respect is, that we, as other central banks, had
been drawing attention in our semi-annual Financial Stability Review, which Lucas was
overseeing for many years, to the risks that were building up. For at least two years before
the turmoil began, we issued clear warnings about vulnerabilities that were building up on
account of an increasingly aggressive hunt for yield which was underpinning significant
under-pricing of risks across a variety of asset classes, not only credit derivatives. And, I
should also say that, the same warnings were communicated by several other central banks.
A second observation is that in parallel with our financial stability assessments, we also
repeatedly warned euro area governments of the risks of not consolidating fiscal positions in
accordance with the rules of the Stability and Growth Pact.
Although in many respects the crisis that unfolded in 2007 and 2008 can be seen as the
direct result of vulnerabilities and imbalances which had been growing steadily and which
had been identified fairly early-on, they combined in such ways that few would have
anticipated their potential severity for the functioning of the financial system. This
notwithstanding, we and other major central banks reacted swiftly to mitigate the stresses in
the functioning of money and other affected markets.
Against this background, to build a safer financial system it is of paramount importance that
the responsible authorities enhance their financial sector surveillance while at the same time
financial institutions play a decisive role by enhancing their risk management practices. A key
challenge for policy-makers will be to design appropriate responses to enhance the stability of
the financial system - including improving the detection and understanding of risks and
vulnerabilities and translating these into concrete risk warnings and policy recommendations -
without imposing restrictions that would unnecessarily hamper financial innovation and reduce
the efficiency of the system. Many improvements, including the new Basel II Capital Accord,
were already under way when the crisis erupted, and they address several of the
weaknesses that have been identified. However, the ferocity of the financial turmoil and its
fall-out which spread well beyond the financial sector call for more far-reaching reforms in the
area of macro-prudential supervision.
In this context, a key initiative is the proposal for the establishment of a European Systemic
Risk Board (ESRB), which will be supported analytically and logistically by the ECB and for
which Lucas has already initiated a lot of groundwork.
The ESRB will be an independent body responsible for conducting macro-prudential
oversight of the EU's financial system as a whole. Once the legislative process is completed,
the creation of this new European policy function will fill a significant gap in the ability to
detect, assess and ultimately contain the build-up of risks. In particular, the ESRB will be
tasked to collect information relevant for systemic risk from across the EU. This should help
overcome the significant information gaps which have hindered a comprehensive risk
surveillance thus far, for instance with regard to the interlinkages among the major
crossborder financial institutions.
The ESRB should be seen as the component of a global framework of macro-prudential
oversight. This should support its effectiveness by also allowing it to contribute to the
assessment and containment of global risks, which in turn may also contribute to the
mitigation of risks in Europe. The Financial Stability Board, the IMF, as well as national
authorities, are all actively engaged in the development of a comprehensive framework of
macro-prudential supervision, which also takes into account the risks arising from
systemically important financial institutions. The crisis demonstrated that only internationally
coordinated initiatives are truly effective in addressing risks and vulnerabilities in the closely
integrated financial system.
Lessons for monetary policy
With regard to monetary policy, in many respects recent events have served to confirm the
approach adopted by the ECB since the outset of Monetary Union in 1999. Most
fundamentally, the primacy of price stability as the objective of monetary policy has been
confirmed. Indeed, at times of financial stress, the credible maintenance of price stability
becomes even more important. Were the anchoring of inflation expectations to weaken,
financial market tensions would intensify further and corrective measures would prove less
effective. Moreover, our recent experience of financial crisis - with its roots in the evolution of
bank balance sheets, and thus monetary and credit developments - has vindicated in my
view the importance attached by the Governing Council to a close and regular monitoring of
the monetary data.
In the design of the ECB's monetary policy strategy, it was always foreseen that the close
monitoring of monetary developments would provide a framework for policy makers to
consider asset price developments and potential misalignments. Responding to monetary
and credit dynamics as part of a comprehensive assessment of the risks to price stability in
the medium term implies that interest rate decisions will tend to "lean against" accumulating
financial imbalances and asset price misalignments. Recent research provides a vastly
enriched framework for conducting such monitoring in a systematic fashion, and offers a real
possibility that asset price disequilibria and associated financial distress may be identified at
an early enough stage for corrective measures to be taken by the policy authorities. Further
development of this framework promises to support financial and macroeconomic stability,
within an overall strategy focused on achievement of our primary objective: price stability.
Such considerations, in concert with the development of a new framework for
macroprudential oversight, should permit to reduce the frequency, duration and economic impact of
financial crises. These are themes that will be discussed in depth in the course of today's
colloquium. We have to make sure that the global financial system, as well as continental
and national ones, are made much more resilient. Yet, it would be unrealistic to believe that
financial crises can be eliminated. Recent experience has also demonstrated the need for
central banks to be timely and agile in managing financial crises without ever - in any
circumstances - losing their sense of the medium to long-term orientation to price stability.
As regards the ECB, in the face of financial crisis, monetary policy was eased significantly
through conventional means in late 2008 and early 2009, with key interest rates being
reduced significantly.
Moreover, non-standard measures, in the form of the ECB's enhanced credit support were
introduced. These aimed at maintaining an efficient transmission of monetary policy by
supporting market functioning. Such measures were instrumental in the maintenance of price
stability, since, in the face of downside risks to price stability, they ensured that the easing of
the monetary policy stance was transmitted into a broader easing of financing conditions. In
particular, the ECB expanded scope for central bank intermediation of transactions between
banks, thereby offering an alternative to the malfunctioning private inter-bank money market.
At the same time, the measures supported financial stability objectives by containing and
mitigating the systemic consequences of liquidity tensions in the money market.
To conclude, let me say a few words on the recent decisions of the Governing Council taken
on 9 May and announced on 10 May. As I already said publicly, I will sum up in five points
the Governing Council's position.
1. The ECB is fiercely independent and takes all its decisions independently of
governments, social partners and pressure groups of any nature.
2. We are inflexibly attached to price stability, our primary mandate. Our successful
track record since the inception of the euro is remarkable.
3. Our present monetary policy stance is appropriate. Our decisions taken on 9 May
have confirmed it. We are not engaging in any form of "quantitative easing".
4. The "Securities Markets Programme" is designed to ensure an effective functioning
of the monetary policy transmission mechanism by helping to resolve a
malfunctioning of some segments of the euro area debt securities markets.
5. The liquidity provided through this programme is withdrawn in its entirety through
tenders of term deposits.
Conclusion
I would like to end my remarks by acknowledging the outstanding contribution that Lucas has
made to the conduct of monetary policy and the safeguarding of financial stability in these
demanding and historic times, as I have just described. I cannot stress enough the important
role he has played at the ECB, as well as in Europe and globally, to successfully ensure the
sound pursuance of these essential policies, ultimately for the benefit and well-being of the
societies and citizens which we serve. We are all very grateful to Lucas.