Jean-Claude Trichet: Enhancing the EU arrangements for financial
stability
Keynote address by Mr Jean-Claude Trichet, President of the European Central Bank, at the
session "European Financial Supervision, Crisis Management on Financial Markets",
European Parliament, Brussels, 23 January 2008.
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Mesdames et Messieurs les membres du Parlement Européen et des parlements nationaux,
Je me réjouis d'apparaître devant vous aujourd'hui et de pouvoir m'exprimer sur la
surveillance prudentielle et la gestion des crises financières. Je commencerai mon
intervention par rappeler les principaux aspects du cadre institutionnel de l'Union
Européenne pour garantir la stabilité du système financier. Je présenterai ensuite les
évolutions récentes dans ce domaine qui doivent être prises en compte lors de l'élaboration
des arrangements de stabilité financière. Ausgehend von diesen Überlegungen werde ich
über die Hauptelemente sprechen, die meiner Meinung nach für die Verbesserung dieser
Regelungen wichtig sind. Schließen werde ich mit einigen Beobachtungen zu den
Auswirkungen der Finanzmarktturbulenzen auf den EU-Rahmen zur Sicherung der
Finanzstabilität.
1. The EU framework for safeguarding financial stability
Let me start by recalling the main components of any framework for safeguarding financial
stability. At the national level, a financial stability framework is based on three main
components: crisis prevention, crisis management and crisis resolution.
The first component, crisis prevention, is ensured by the exercise of supervisory and central
banking functions. Supervisory functions regard the surveillance of the safety and soundness
of individual financial institutions. Central banking functions include the financial stability
assessment aiming at identifying sources of risks and vulnerabilities and their potential effect
on the financial system, as well as the oversight of payment and securities settlement
systems.
The second component relates to crisis management. It may be defined as the set of tools
that public authorities may deploy when and if a disturbance occurs in the financial system.
Supervisors may, for instance, take measures regarding the management of a financial
institution, require additional capital from shareholders, or impose reorganisation measures.
Central banks may take actions aiming at restoring normal liquidity conditions in money
markets or at ensuring the smooth operation of market infrastructures.
Finally, the third component, namely crisis resolution, relates to the arrangements aiming at
an orderly handling of a financial institution facing solvency problems and the protection of
the rights of creditors, notably depositors. In this case, treasuries have also an important role
to play if and when the injection of public money is required.
There is evidently a close interrelation between these three components of the financial
stability framework. For instance, the effectiveness of crisis management and resolution
largely depends on the existence of an efficient supervisory and central banking framework
able to identify and react at an early stage to potential threats to financial stability.
Conversely, the effectiveness of supervisory action depends also on the existence of
appropriate arrangements to support an orderly exit from the market by insolvent institutions.
Indeed, the fact that institutions could exit the market if they are affected severely by a crisis
provides a powerful incentive for them to optimise risk management and draw up proper
business plans. At the EU level, a key element is the cross-border dimension which
characterises all three components of the financial stability framework. This dimension calls
for a smooth and efficient cross-border interplay within and among the set of authorities
involved in crisis prevention, management and resolution. In this respect, as a general
observation, I would only say that the existence of the Eurosystem provides an extremely
strong and effective decision making in the area of central banking, while the Level 3
Committees are expected to develop their own cooperative network in the field of
supervision.
2. Key developments in the European financial system
Against this background, let me point out that the European financial system has
experienced fundamental developments in the past years, which have a particular bearing on
the EU financial stability arrangements. I would like to highlight three of them.
First, the overall progress in European financial integration. The ECB's analysis, conveyed
through our annual report "Financial Integration in Europe" demonstrates that financial
integration has advanced significantly since the introduction of the euro at the level of
financial markets, market infrastructures and financial institutions. Progress has however
differed considerably across market segments. The euro area money market has been
strongly integrated since the introduction of the single currency, supported by the integrated
market infrastructure for large-value payments. As to the wholesale banking segment, there
are clear indications of strong progress in financial integration as well. For example, the
share of securities issued in other euro area countries and held by monetary financial
institutions has strongly increased in the last ten years. By contrast, retail banking markets
have remained fragmented.
Second, the growing prominence of EU banking groups with significant cross-border
activities. EU banks with significant cross-border activity hold a sizeable and rising share of
total EU banking assets. Although the number of EU banking groups with significant
crossborder activities increased only slightly between 2001 and 2005, their consolidated assets
grew by 54% and their share in the overall consolidated EU banking assets increased from
around 54% to 68%.
Third, the high pace of financial innovation which resulted in the rapid growth of new types of
financial instruments for transferring risk and of structured credit markets. In turn, this
fostered the activities of non-bank intermediaries, many of which are highly leveraged and,
mostly, non-regulated. These developments have facilitated the transfer and redistribution of
risks across the financial system, thus increasing its efficiency and potentially its resilience to
shocks. At the same time, as recent events have shown, the growing complexity of financial
instruments and the opacity of exposures of financial institutions can give rise to increased
uncertainty regarding the degree of risk involved, the ultimate bearer of the risk, and the
extent of potential losses. As we presently see in periods of turbulence, this complexity and
opacity may prompt a further propagation of initial shocks and a more generalised contagion.
3. Enhancing the EU financial stability arrangements
The structural developments in the European financial system, which I have just outlined,
entail challenges to the EU financial stability framework. In a nutshell, given the increasing
interlinkages between markets, market infrastructures and institutions in the EU financial
system, potential disturbances have EU-wide effects. Therefore, the EU financial stability
framework should be able to detect effectively risks to the stability of the EU financial system
as a whole and to handle efficiently any crisis with a cross-border dimension.
As you are well aware, there are a number of policy initiatives at the EU level, both
predating and following the financial market turbulence, in order to refine and reinforce over the
medium-term the ability of existing arrangements to cope with such challenges. These
initiatives include the strengthening of the financial crisis management arrangements, in line
with the strategic roadmap adopted by the ECOFIN in October last year, and the
enhancement of the Lamfalussy framework for regulation and supervision, as agreed by the
ECOFIN Council last December. In April we will discuss these policy initiatives in order to
assess their adequacy and consider possible further progress.
In this context, I would like to emphasise a few elements which I regard as important in the
process of enhancing the EU financial stability arrangements.
First, concerning the general objectives of this process, I would argue that, while the primary
objective of the EU financial stability framework should evidently be to safeguard effectively
financial stability, it should also contribute to removing the remaining obstacles to financial
integration. This mainly requires identifying and reducing to a minimum the existing
divergences in national laws and also in supervisory requirements and practices, which still
hinder the effective functioning of the single financial market. Whereas since the inception of
the Lamfalussy framework there has been good progress in regulatory and supervisory
convergence in the EU, further measures are necessary on (i) the harmonisation of
regulatory requirements at the EU level, also through the elimination of the so-called
"goldplating", namely the addition by Member States of unnecessary national layers to EU
regulation, and (ii) the consistent implementation of the supervisory requirements, agreed by
Level 3 Committees, and the development of streamlined and coherent supervisory
processes by national supervisors, with the support of Level 3 Committees.
Second, the improvement of the financial stability arrangements should build on the existing
largely national responsibilities for financial stability, thus focusing on reinforcing the EU
mechanisms for cross-border co-ordination and co-operation between the responsible
authorities. In this respect, the Lamfalussy framework provides the appropriate institutional
setting. One of its key advantages is the combination of a decentralised set-up of
responsibilities for financial stability with the co-ordination mechanisms provided by the Level
3 Committees. A decentralised approach allows drawing on the advantages of geographical
proximity and of the established experience and knowledge of local authorities. However, in
order to be effective, this approach requires the significant reinforcement of the role and
operating mechanisms of Level 3 Committees so as to achieve the required high level of
cross-border convergence, co-operation and information-sharing among national supervisory
authorities.
Third, concerning the crisis prevention leg of the EU financial stability framework, it is crucial
to ensure a smooth interplay between central banks and banking supervisors in order to
ensure that potential threats to EU systemic stability are detected at an early stage and dealt
with in a prompt and co-ordinated manner. Appropriate sharing of information and
assessments between central banks and supervisors is needed to detect and evaluate
potential risks to EU systemic stability. To that end, a closer link between the financial
stability assessment of central banks and the supervision of major cross-border banking
groups undertaken by the colleges of supervisors would be helpful.
It is also important to ensure an effective coordination of policy actions between central
banks and supervisory authorities in case a systemic threat is identified.
Against this background, the Eurosystem strongly supports the ECOFIN conclusions adopted
in October 2007, whereby the Council invites the Commission to assess possible
clarifications in the legal framework for the exchange of information between supervisors and
central banks.
Fourth, in order to ensure effective crisis management and resolution at the EU level, it is
crucial that all responsible authorities maintain a high degree of preparedness to handle the
complexity of a cross-border crisis situation, while preserving the necessary flexibility of
action. Every crisis situation is unique and the arrangements for crisis management and
resolution cannot anticipate the full range of causes, propagation channels and outcomes of
financial disturbances. Moreover, setting out ex-ante detailed arrangements on how to deal
with and resolve crises can unduly constrain the flexibility of action of supervisors, central
banks and also treasuries in a stress situation. Instead, the emphasis should be on
enhancing preparedness. This may be achieved, among other things, through stress-testing
exercises aiming at verifying the resilience of the financial system under stress conditions
and through financial crisis simulation exercises aiming at assessing the effectiveness of
existing arrangements. In this respect, the periodic conduct of simulation exercises at the EU
level is a positive aspect. Also the Eurosystem devotes particular efforts to this area. It has
conducted already two simulations which tested the effectiveness of its own arrangements
and plans to conduct others in the future.
Finally, I should emphasise that the EU arrangements should also take into account the
global dimension of financial stability. I do not need to dwell much on this aspect, since the
financial market turbulence provides a vivid reminder of how a disturbance in a particular
market segment can propagate across many markets and countries.
This entails that the EU arrangements should also include mechanisms which support the
co-operation between authorities from the EU and from third-countries in addressing
common concerns.
In this respect central banks can claim a long-standing tradition of effective co-operation on a
global basis. This has been illustrated recently by the joint initiatives of various central banks
to address tensions in the money market.
4. Conclusions
Let me conclude with the possible lessons from the present significant financial market
correction for the EU financial stability arrangements.
Careful reflection is taking place at the European and global level with regard to the
identification of the main determinants of the present market correction as well as the policy
lessons which will have to be drawn by public authorities with regard to the measures
necessary to avoid the recurrence of such major turbulent episodes in the future.
First, although it is too early to draw definitive conclusions in this respect taking into account
the fact that the present market correction is particularly complex, multidimensional, and
ongoing, it seems to me that we know already a number of areas where it is certain that we
will have to engineer significant improvements.
- There will be very important lessons to be drawn by credit institutions in terms of
their risk management systems. The experience of the turmoil has highlighted that
some categories of risks have been underestimated by banks including liquidity risk
relating to liquidity commitments to conduits and SIVs, concentration risk in
structured products and reputational risk associated with sponsoring special
purpose vehicles. The current regulatory framework based on Basel II might need
some refinement to take these aspects into account.
- There will also be lessons to be drawn in terms of the structure of incentives in all
stages of the securitisation process and the "originate to distribute" model. All the
relevant players - including originators of loans, arrangers of securitised products,
rating agencies, conduits and SIVs, and final investors - should have the right
incentives to undertake a proper assessment and monitoring of risks.
- Regarding the role of public authorities, let me mention three aspects. First, it is
important to permanently identify the various risks at stake in the global financial
system. And from that standpoint I have to say that Central Banks had diagnosed a
significant underpricing of risks in a large array of markets and have been public on
that. It remains complex and difficult to identify the triggering event of a market
correction and the nature and scale of propagation channels. This reinforces the
notion that the main objectives of a financial stability framework should be to
promote to the maximum possible extent sound risk management practices, to
strengthen the resilience and shock absorption capacity of financial institutions and
to have efficient crisis management arrangements in place.
Second, the experience of the turmoil emphasises the importance of a smooth and effective
interplay in terms of cooperation and information exchange among supervisory authorities
and between them and central banks in the detection of threats to the stability of financial
system, the assessment of the unfolding of a stress situation and the decision on possible
policy action to counter potential negative impacts. I will say that the present experience fully
confirms the position taken a long time ago by the Eurosystem according to which a close
institutional link between central banks and banking surveillance authorities is extremely
important.
Third, I trust that in all circumstances, but even more particularly in demanding times of
significant market correction and turbulences, it is the responsibility of the Central Bank to
solidly anchor inflation expectations to avoid additional volatility in already highly volatile
markets. Also important is for the Central Bank to ensure an orderly functioning of the money
markets at the level of interest rates required for anchoring the inflation expectations. It is
what the ECB has been doing since the beginning of the turbulences, namely since the
beginning of August last year.
I thank you for your attention.