Nicholas C Garganas: Recent financial market developments and
implications for the euro area and the world economy
Keynote speech by Mr Nicholas C Garganas, Governor of the Bank of Greece, at the
Meeting of the International Chamber of Commerce (ICC) Commission on Banking
Technique and Practice, Athens, 16 April 2008.
* * *
It is a pleasure indeed to welcome you to Athens for this meeting of the International
Chamber of Commerce Commission. This meeting is taking place at a time of turmoil in
global financial markets and a significant downturn in global economic growth. I am delighted
to have this opportunity to offer some remarks about the present situation and the challenges
ahead.
We are living in the era of the great globalization and the ICC has been an invaluable voice
championing the benefits - including enhanced economic growth, prosperity, and job
creation - of increased economic and financial integration. While globalization brings
important benefits it also, sometimes, brings heightened risks and uncertainties, as recent
financial market developments vividly illustrate.
The last nine months have been a very challenging period for both policy makers and market
participants. During this period, we have witnessed a major reappraisal of risk and a
considerable, and still ongoing, turmoil in key financial markets. We have also seen -
especially in the US and, to a lesser extent, in the euro area and the rest of the world -
downward revisions of growth prospects amid increased risks and uncertainties. In order to
be able to ensure that the full benefits of globalization are shared by our citizens, it is
necessary to be able to manage the risks and uncertainties associated with globalization. My
remarks today, will deal with the origins of the ongoing financial markets turmoil, the policy
responses to this turmoil, mainly by the major central banks, and prospects and policy
challenges for the euro area and the global economy in the light of this turmoil.
Greece will, therefore, not be the focus of my remarks this morning. Let me just note that
Greek banks generally have a relatively comfortable capital base and strong profitability, their
exposure to U.S. sub-prime mortgage loans has been negligible, while the impact of the
international financial market turmoil on the Greek banks has so far been indirect and rather
contained. However, the financial market turmoil is far from over and there are still risks
ahead of us. For this reason, the Bank of Greece has urged financial institutions to be
especially prudent in their portfolio management.
Origins of the current financial market turmoil
Although the financial market turmoil was triggered by problems in the sub-prime loans of the
U.S. mortgage market, the origins of this turmoil can be traced to earlier developments. In
the four-year period to mid-2007, the world economy had been characterized by
exceptionally benign macroeconomic and financial conditions, as indicated by strong growth
and low levels of inflation and (long-term) interest rates. Such conditions of "low volatility"
fostered a "search for yield", a rise in leverage to increase returns further, and an
underpricing of risk in some key asset markets. These developments were supported by - and, in
turn, they encouraged - further financial innovation, as evidenced by the rapid growth in
securitization of bank loans, in credit risk transfer instruments and in other complex
structured finance products.
Rapid financial innovation over the last 30 years has undoubtedly benefited the world
economy by allowing a deepening of capital markets, easier access to credit by households
and enterprises, and a more effective utilization of resources. However, especially in recent
years, financial innovation has also been associated with structural weaknesses and
complacency in risk management. For instance, the low transparency of these complex
products may have made it easier for investors to underestimate the risks they take on. In
addition, with prudential regulation sometimes lagging behind financial innovation, some
institutions may not have been sufficiently transparent about their exposures to complex
structured finance products, on and off their balance sheets. Moreover, as such products
were often difficult to value owing to inadequate information about the underlying assets,
investors often relied too heavily on credit rating agencies. However, the methodology used
by the credit rating agencies was not transparent, failing to identify the risk characteristics of
the complex structured finance products, including their illiquidity. It is also well known that it
was the distorted incentives in the "originate-and-distribute" business model of financial
institutions that led to a decline in credit standards, the root cause of the "sub-prime"
problem. More generally, the extent of leverage taken on by banks, bond insurers, hedge
funds, and other financial institutions was probably not adequately appreciated, nor were the
risks of a disorderly unwinding.
Eventually something was bound to happen that would trigger a widespread reappraisal of
risk, resulting in re-intermediation and de-leveraging. This turned out to be the escalating
losses on US sub-prime loans, which showed up in certain hedge funds and structured
investment vehicles (SIVs) in the US and in Europe in mid-2007. Subsequently, the market
tensions spread through the market for structured finance products and asset-backed
commercial paper to the key interbank money markets in Europe and the US, the core of the
international financial system.
Central bank policy reaction
Since last August, the major central banks - including the ECB, the Bank of England and the
U.S. Fed - have responded to the liquidity squeeze in the interbank money markets by
expanding the scale and scope of their routine operations. They have injected extra liquidity,
lengthened the maturity of their lending facilities, and (in the case of the Fed) expanded the
list of counterparties and widened the range of acceptable collateral in their operations.
These actions have contributed to a significant improvement in money market conditions
since late December in the euro area, the UK and the US.
Nevertheless, there remains much uncertainty in the market about the liquidity and capital
adequacy positions of financial institutions, which has implied the need for continued central
bank operations. Some large financial institutions - notably in the U.S. and in non-euro-area
Europe - have already acknowledged large losses in their balance sheets over the past few
months, necessitating capital injections (e.g., by Citibank and UBS) or acquisitions by other,
financially strong institutions (e.g., that of Bear Stearns by JPMorgan Chase). Financial
institutions have generally attempted to acknowledge their losses and appropriately value
their balance sheets but there are difficulties in properly valuing some complex financial
assets, not least because markets have often ceased to operate properly for such assets.
There is thus a risk of potential future losses, which has maintained a climate of uncertainty
and contributed to the weak performance of financial institutions in the equity markets. The
IMF has recently estimated that total potential losses of the financial sector could amount to
almost US$1 trillion, of which only about one quarter has so far been acknowledged and
written down.
As regards the ECB, I should stress - in my capacity as a member of ECB's Governing
Council of the ECB - that the market operations since last August have not been intended to
change, nor have they changed, the overall monetary policy stance in the euro area, which is
set by the decisions on interest rates. (As you may recall, the ECB policy rates have
remained unchanged since June 2007.) Rather, the money market operations are intended
to safeguard financial stability and ensure, through the orderly functioning of the interbank
money market, that the Governing Council's interest rate decisions are transmitted to the
financial markets and the real economy.
The economic outlook and policy challenges
The economic outlook for the euro area is surrounded by an unusual degree of uncertainty.
The financial market turmoil is likely to last for some time and its impact on the real economy
is difficult to assess at this time. Much depends on how far banks might tighten their lending
terms in response to losses and the unwelcome transfer onto the balance sheet of
offbalance sheet items. For the time being, there is little evidence that the financial market
turmoil has influenced the dynamics of credit aggregates in the euro area.1 Meanwhile, the
cost of funding for firms and households appears to have edged upwards, albeit only slightly,
in the euro area in recent months.
The latest available information, therefore, suggests that the impact of the financial market
turmoil on euro area economic activity is not likely to be sizable. The sound fundamentals of
the euro area economy and the absence of major macroeconomic imbalances should help
cushion the effects of the financial market tensions. Nevertheless, caution is warranted. The
impact on some banks' balance sheets has been considerable and a number of financial
institutions may have to strengthen their capital positions and be more cautious in their
lending policies.
According to the March 2008 projections of the ECB staff, real GDP in the euro area will rise
in a range of 1.3% to 2.1% in 2008, representing a deceleration from 2.6% in 2007.
Meanwhile, the short-term outlook for inflation is not satisfactory. Inflation reached 3.5% in
March, reflecting mainly the rapid rise in oil and other commodity prices, and is likely to
remain at elevated levels above 2% in the coming months and moderate toward 2% very
gradually.
Globally, the economic expansion is loosing speed in the face of the financial crisis. Outside
of the euro area, growth in the advanced economies of Western Europe is decelerating. The
U.S. economy is likely to experience a more serious slowdown, with minimal - if not negative
- growth in the first two quarters of 2008, followed by a gradual recovery thereafter. The
emerging and developing economies, led by China and India, have so far been less affected
by financial market developments, although activity is beginning to slow in some countries. In
the light of the financial market turmoil, the balance of risks to the short term global outlook
remains tilted to the downside.
At the same time, inflation has increased around the world, boosted by the continuing
buoyancy of food and energy prices. In this environment, the greatest contribution that
central banks can make is the firm anchoring of medium to longer term inflation expectations.
Looking ahead, a key challenge - especially in the U.S. where most of the financial sector
losses are concentrated - will be to ensure that systemically-important financial institutions
expeditiously repair their balance sheets, by raising equity and medium-term funds, in order
to boost confidence and avoid a contraction of credit. This will help avert a spiral of declining
asset values, balance sheet losses, reduced lending and damage to the real economy.
Policy makers will need to address systemic vulnerabilities in ways that minimize moral
hazard and fiscal costs. Meanwhile work is being done, in international institutions and fora -
such the IMF and the Financial Stability Forum - to analyze the causes of the financial
market turmoil and propose policy directions to strengthen financial resilience.
In sum, the present financial market turmoil contains lessons for both market participants and
policy makers. Risks and uncertainties are an inherent part of economic progress. Indeed, as
the great economist Joseph Schumpeter, wrote in the first half of the twentieth century, risks
and uncertainties are basic to the process of what he called "creative destruction" through
which innovations and economic progress are made. By learning to better manage these
risks and uncertainties we can ensure that we will be able to realize the full benefits of
globalization, that is, enhance prosperity for all our citizens.
Let me conclude by saying that the ICC has provided a valuable forum for the exchange of
ideas on the benefits and challenges of globalization. This meeting is taking place at a
particularly challenging time for global financial markets. I very much hope that the
surroundings in Athens will provide inspiration for an especially successful meeting.
Ladies and gentlemen, thank you for your attention.