Yves Mersch: Financial stability - quo vadis?
Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the Seminar on
Financial Stability, Central Bank of the Republic of Turkey, Ankara, 21 October 2008.
* * *
Let me start by thanking the Central Bank of Turkey for having provided the
opportunity to present my views on financial stability, likely the most discussed policy
issue these days. I shall not dwell on the description of where financial markets and
economies stand today as this is well known by this audience. Instead, I shall discuss the
evolution of financial stability frameworks in general - and in the EU in particular - and,
profiting from the ongoing financial markets crisis, I shall draw lessons that could guide us in
enhancing the EU framework of financial stability. Noblesse oblige, I will stress the crucial
role played by central banks in that endeavor given the accrued importance of liquidity in
preserving financial stability in the modern world of structured finance. The bottom line is that
we will have to go well beyond implementing changes in accounting rules, in the modus
operandi of rating agencies and in the risk management procedures of financial institutions.
This is hardly a time to herald the joy of central banking! At the time of writing, news of
financial instability and ample central bank-coordinated increases in liquidity fill up our
screens. Lehman Brothers Holdings filed for Chapter 11 bankruptcy protection a seminal
event in the intensification and broadening of financial turmoil. Bank of America purchased
Merrill Lynch for $50bn; in an unprecedented action, the Fed agreed to provide an $85bn
loan to AIG in exchange for an 80 percent stake in the troubled insurer; Fortis was bailed out,
with the Benelux governments agreeing to inject €11.2bn and taking a 49 percent stake in
the group as a result; the U.K. government took over Bradford & Bingley, nationalizing its
loan book and selling its branches and savings operations to Spain's Santander; Iceland's
financial system collapsed; Belgian bank Dexia received a €6.4bn capital injection from
Belgian, French and Luxembourgish governments. Huge public sector interventions were set
in motion in the United Kingdom, France, Germany, Ireland, Denmark, Austria and
Switzerland among others either in form of guaranties, recapitalizations or distressed assets
relief. In the U.S., the Treasury obtained Congressional approval for sweeping powers to
purchase $700bn worth of illiquid U.S. mortgage-related assets created prior to September
17, 2008. In addition, a $50bn U.S. state guarantee became necessary to stop institutional
investors withdrawing funds from U.S. money markets funds. Hedge funds and money
market funds are facing intense redemption pressures and several emerging markets are
experiencing financial difficulties and calls for IMF support are suddenly back on the agenda.
Interest rates have been further cut in several countries and deposit guarantees increased. In
fine, leaders from 15 nations committed to a coordinated effort to bolster financial systems
with rescue packages totaling nearly 1.9tn euros and central banks offered unlimited dollar
funding to banks in short-and medium-term maturities at fixed rates and longer maturities.
Financial stability and liquidity, and the evolution of the supervision paradigm
It is noteworthy that there is neither a widely agreed definition of financial stability nor
of liquidity. Definitions of financial stability and liquidity vary significantly in academic papers
and among policy makers. Definitions are more than amusing conceptual constructs; they
are useful tools to discuss the evolution of financial frameworks and the role of central banks
in financial stability. I suggest as definition of financial stability a dynamic one: I view financial
stability as a range of states in which the financial system facilitates the performance of the
monetary economy, and is able to dissipate financial imbalances originated either
endogenously or as a result of adverse unanticipated events. The key elements of the
definition are that financial stability is best viewed as a process and as such, it is uncertain, it
has intertemporal and evolutionary features. In addition, this process occurs in a monetary
economy, one based on fiat money, where resources and risks are mobilized efficiently.
Finally, the process has self-equilibrating mechanisms that preclude that arising imbalances
trigger a crisis.
"Liquidity is an elusive concept". That is the first sentence of the Banque de France's
February 2008 Financial Stability Review. As with financial stability, I suggest as working
take
definition of liquidity a dynamic one: I view liquidity as the ability of market participants to
risks on each other as they seek to fund asset purchases and meet obligations, both over
normal and stressful environments. As it was the case with the definition of financial stability,
endogeneity
this definition of liquidity stresses its dynamic aspects. The of liquidity indicates
that it is best viewed as the outcome of confidence among market participants on the risk
distribution of the decisions they make, and thus the monetary price they pay or receive.
Liquidity is not an intrinsic, static, feature of financial instruments or markets. This definition
of liquidity is compatible with the evidence that modern financial markets may be subject to
instability due to liquidity rapidly drying up in interbank markets. One should also disentangle
concepts like systemic liquidity, market liquidity and instrument liquidity.
Liquidity and financial stability are therefore intimately linked in a monetary economy.
When central banks were created, partly to protect the economy from recurrent episodes of
financial instability, their monopoly power to issue the generally accepted means of
settlement and their role as bankers' bank made of them the natural guarantors of financial
stability. Central banks in Europe, in contrast to the Fed in the U.S., were not explicitly
mandated to regulate and supervise financial markets; this was viewed as part of their role in
preserving financial stability.
Over time, technological events and the interplay of ideas and experiences modified
the role of central banks in financial stability. The Great Depression brought, like major
crises normally do, a shift toward increased regulation and the introduction in the U.S. of
deposit insurance. In the 1970s, pushed by developments in academia and the limitations of
the functioning of deposit insurance, the pendulum turned back toward a more market
friendly regulation. Administrative restrictions on banking were increasingly replaced by
prudential standards. The main issue at stake was the inherent vulnerability of banks as
transformers of short-term liabilities into long-term illiquid assets, and the moral hazard that
resulted from the safety net put in place to preserve financial stability via deposit insurance
and the lender of last resort. With the advent of big conglomerates and the interrelationships
between banking and insurance, growing concerns about the concentration of supervisory
powers and monetary policy responsibilities started a trend toward removing supervision
from central banks' responsibilities.
The trend toward the elimination of supervision from central banks' role was naturally
accompanied by a trend toward integrated supervision.1 The development of
conglomerates blurred the distinction between financial institutions and markets. In addition,
the liberalization of capital flows fostered mergers and acquisitions and the appearance of
large and complex financial institutions. The experience with the Latin American crisis, and
closer to home, with the Finish and Swedish crises, stressed the importance of enhancing
risk diversification. Structured finance became the response to that need as it allowed
financial institutions to transfer and diversify risk. By pooling together assets such as loans,
mortgages or commercial paper, techniques such as securitization made it possible to
transfer risk, and separate the underlying assets from the original seller. In addition, central
banks' core competence became more structured via monetary policy frameworks with an
explicit mandate for price stability and a high degree of technical independence. Central
banks' involvement in financial stability was justified by the need to preserve the well
functioning of the clearing and settlement payment systems as well as by their role as
ultimate providers of emergency liquidity and participation in crisis management.
Financial innovation has brought new vulnerabilities and is forcing again a change in
the financial stability paradigm toward a greater involvement of central banks. The
reversal of Glass-Steagall in 1999 set off a leverage race outside the banking system, largely
unregulated. As capital markets developed in depth and scope, structured complex products
further blurred the distinction between banks, insurance and security firms. Property and risk
were transferred from the banks' balance sheets to investors, while insurers provided liquidity
lines linking thereby, in an inextricable manner, banks, insurance firms and non-bank
financial institutions. The expansion of banks' funding sources beyond deposits came,
however, at the expense of a more complex assessment of risks. And the spreading of risk
expanded the possible sources of instability in ways not always transparent. As a result, the
sources of financial instability changed once more: financial instability could also result from
market instability (the recent suspensions of short-selling in several countries acknowledge
it), from non-bank financial institutions and from ever larger, private clearing and settlement
systems. Moreover, liquidity itself could become a contagion channel by triggering discreet
changes in asset prices, in the capital base of financial institutions, and thus by feedback
onto banks' funding capacity. As a result, interbank markets have now become a source of
crisis, or even aggravate a crisis, as fundamental uncertainty makes it too costly for banks to
assess counterparty risk. This eventuality, observed in the current crisis, constitutes a clear
example of the endogeneity of liquidity.2 As the role of liquidity and contagion has become
more important, central banks' special role in financial stability has been reinforced.
Regarding financial institutions, their next generation models of risk management will have to
incorporate the non-linearities and discontinuities of modern financial markets.
We may have already moved toward some form of a new international monetary
framework. To conclude this section, I remark that the wide range of coordinated responses
to the crisis that we are witnessing, a characteristic feature of which has been the
predominant role played by central banks, has perhaps sawn the seeds of a global monetary
framework. I think of massive recapitalizations of systemically-large institutions and
crossborder financial firms and the boosting of deposit insurance limits. At monetary policy level
we have witnessed not only concerted action in lowering the policy rate but also narrowing
the policy corridor and through asset swaps, provision of cross-border liquidity in US$ and €
in unlimited amounts as well as a lengthening of the term funding. This coordination has
been accompanied by the enlargement of counterparties either directly or indirectly and we
have also seen a broadening of eligible collateral. This new emerging monetary policy
framework adjusted in emergency times was required by large cross-border and globalized
financial institutions and products. The more flexible and diversified framework of the ECB
has, in this respect, proven its benchmark capacity in times of duress even if itself has been
enhanced since. The world has moved toward a much more significant coordinated role of
central banks in preserving world financial stability. After the times of duress we are living, it
is likely that this de facto framework might evolve toward a more institutionalized set with
some ingredients of a world system of information sharing, with world collateral and world
monetary policy.
From a system of national regulators and supervisors to an EU stability framework
Financial stability frameworks in the EU are largely national. Each country's supervisory
authorities drive their legitimacy from national parliaments, are subject to national
accountability mechanisms, and are financed nationally. Each country's authority is
responsible for the consolidated supervision of financial institutions domiciled in that country
for which it is the home supervisor. Host supervisors are responsible for subsidiaries of
institutions from other countries operating in their territories. National authorities are
organized differently in the EU, e.g., as a single authority, or according to a sectoral model.
Their mandates also differ with some including financial stability, the protection of investors
and creditors, or depositors. Additional tasks such as responsibility over market conduct,
consumer protection and market competition are unified to a larger or smaller extent. Each
national central bank is responsible for ELA to financial institutions domiciled in its territory
with the obligation of informing the ECB. Beyond national banks, the ECB also manages the
overall liquidity of the euro area according to market needs. But the ECB does not have
direct supervisory authority, and many central banks have few prudential supervisory
responsibilities.
An EU umbrella superstructure seeks to facilitate cooperation across national stability
frameworks. Many MOUs have been signed to obtain a regular exchange of information and
cooperation, and some MOUs have been signed to deal with banks of regional systemic
importance. Colleges of supervisors are responsible for monitoring insurance groups and
some banks. Lamfalussy committees have been established to promote financial integration
and make proposals for the coordination of regulation and supervision in the EU. Level 3
committees, for instance, develop guidelines for the functioning of supervisory colleges and
the assessment of financial sector vulnerabilities that are reported to the Financial Stability
Table of ECOFIN. EU regulations are applicable to all EU countries (e.g., CRD, MiFID, and
Solvency II), but countries can choose the form and methods to implement those regulations
nationally. Sometimes national options are numerous: in the CRD more than 100 options
were exercised! The EU Commission has enforcement powers in matters related to the
completion of the common market, and thus on mergers and acquisitions of financial
institutions and injections of state capital. Finally, international organizations and international
standard setters such as the BIS, the IMF, the FSF, IAIS and IOSCO also affect EU
legislation.
The current EU financial stability framework is a rational outcome of a long evolution,
but the current financial crisis, by highlighting its limits, suggests a rethinking is
timely. The attribution of responsibilities at the lowest level that can effectively meet them,
the principle of subsidiarity, has served the EU well. Yet, it is a principle, and as such it
requires that the EU financial stability framework that it has delivered so far evolves in
tandem with financial innovation. But proximity of supervision is also reflecting the
fragmentation of the banking landscape with more than 7.000 banks and only 40 large cross
border banks. The EU financial stability framework should ideally deal with the full spectrum
of risks, including cross-border risks, at a minimum cost to the taxpayer who remains
national. This requires rapid decision-making and quick implementation of remedial actions.
Outside observers assert that the operation of large committees and reliance on consensus
may slow decision-making while financial innovation keeps accelerating; disparate current
national practices hinder integration and competition, as well as increase the regulatory
burden; the complexity of regulations and arrangements risks favoring national interests and
limiting the exchange of information among supervisors. As the current crisis shows, the
outside observer's view might however be clouded by his prejudice.
At political level, decision making in Europe was nimble and decisive at all levels -
Eurogroup, ECOFIN, Euro area Summit, European Union Summit, European Commission
and European Parliament - within a short time frame. They delivered a more powerful and
clearer message in shorter time than other constituencies.
The same goes for the monetary policy level. The decentralized operational modus operandi
of the Eurosystem was no hinderness to swift adjustment. During the last month, the
Governing Council had 13 non physical decision-making gatherings, outside its 2 physical
meetings in Frankfurt, in order to take several dozens of decisions, all implemented since.
Overcentralization is no panacea for optimal decision-making as it might hamper collegial
wisdom and creative thinking. Each EU Member State has to be concerned by the
soundness of financial institutions in other Member States. In this respect, the decision to
could
include a European mandate for national supervisors increase the speed of
decisiontaking, reduce the regulatory burden and favor EU integration.
The main lesson from the current crisis is that EU financial stability benefits from a
commonly shared philosophy. This commonly shared philosophy appears in Europe in the
area of Government intervention. The increased need for cross-border cooperation was
initiated in a first Memorandum of Understanding in 2005 and has been reinforced with a
Memorandum of Understanding signed by all Treasuries, Supervisors and Central Banks
during last summer, to be implemented by the end of the year. A sense of urgency is instilled
in the task of developing a stability framework with an explicit ex-ante, EU-wide, crisis
prevention mechanism that increases confidence among national authorities that necessary
actions will be taken; that information will flow; that there will be adequate representation of
their interests in decision10 making and implementation; and that authorities at all levels (i.e.,
EU, national, institutional) will be accountable for the stability aspects they control. This
Memorandum of Understanding covers crisis prevention, management and resolution.
Importantly, at the national level, stability frameworks should develop institutional
mechanisms that ensure the ex-ante compatibility between microprudential and
financial stability objectives. While there has been significant progress in setting standards
(e.g., via the CRD), there is no agreement yet on a common set of procedures for early
action. For example, there is an array of national triggers for remedial action, different
degrees of discretion in the use of sanctions across countries as well as a wide degree of
central banks' involvement in the supervision of national market liquidity and in the evaluation
of market operators' liquidity risk management. The current crisis has shown that central
banks' role in supervising liquidity management must become proactive and forward looking
so as to be compatible with the dynamic nature of liquidity. In addition, cooperation between
central banks and authorities responsible for microprudential supervision needs to be
enhanced in several EU countries.
The mismatch between responsibilities and accountability in crisis management
should be alleviated. Crisis management remains a national responsibility, but streamlined
in the 2008 Memorandum of Understanding which has set the direction toward more
information sharing and better allocation of responsibilities in case of crisis. However, the
current crisis has shown that rapid, and low cost decision-making is possible. In the case of
existing ELA arrangements, the same misguided outside observer reflects that it will be
necessary to correct the current situation whereby host countries are responsible for ELA for
subsidiaries and branches, but do not have access to supervisory information about
branches, and thus, have no way of assessing the risks involved in the ELA operations they
undertake. As a result, the distinction between liquidity and solvency, and the ensuing impact
on the sharing of the costs of the operation, would remain opaque. Moreover, host country
supervisors would not have the incentive to provide liquidity support because funds could
flow back from a troubled branch to the parent company due to EU ring-fencing prohibitions.
On the other hand, home-country authorities might delay providing information or taking
crisis-management actions to avoid capital losses, reputational effects or political
backlashes. So the home authority would not always have the incentive to keep
smallcountry host authorities informed in an acceptable way. In turn, host country authorities
would seek to retain as much intervention authority as possible. I beg to disagree.
Fact is that the broadening of the operational and instrumental framework of the ECB,
especially concerning eligible collateral and broad institutional access to central bank
liquidity, has created a kind of informal euro area liquidity assistance. Furthermore national
ELA operations need to be flagged by the Governing Council and allow for extensive
information sharing reinforced by bilateral contacts on a "know as you need" basis.
Crossborder institutions benefited from nationally coordinated ELA, not only in the Benelux case of
Fortis, but involved in other cases extensive cooperation between 2 or even 3 countries.
An EU-level crisis resolution framework, especially for systemic banks, is however
pending. Like crisis prevention and management, crisis resolution was fundamentally
national up to this crisis. Differences across countries' approach to financial institutions'
failure vary enormously. Even for banks, there is little harmonization. Some countries have
only a few bank-specific regulations; general commerce bankruptcy laws apply despite the
winding up directive after BCCI. As shown again during the current crisis, banks have a
liquidation value that is well below their value as going concerns. So, recapitalization is less
expensive than liquidation. In the case of a large cross-border banks (LCBB), the problem is
even worse as the focus of bankruptcy law is on the right of creditors in some countries,
protecting debtors in some others.
Yet, the disparate history of legal regimes in the EU suggests that institutional changes will
be slow. Also, despite moves in deposit insurance toward harmonization, notably via the
Deposit Insurance Directive, there are glaring differences across countries regarding the
definition of deposits, co-insurance, risk-based premia, and funding. This situation creates
perverse incentives, uncertainty, and regulatory arbitrage opportunities.
Since the crisis, however, change seems to be faster. The provision of recapitalization funds
and guarantees for bank debt, though nationally implemented, will follow common rules.
Yesterday the Eurosystem agreed on 10 recommendations sent to national Governments
covering pricing modalities, timing, eligibility criteria, etc.. At a cross-border level, as no EU
agreement exists on the financing of insolvent institutions, home country authorities may be
reluctant to spend resources that will benefit host countries, or will be faced with situations in
which they will not be able to save financial institutions because they are "too big to save".
On the other hand, host countries may not be able to restore the bank as a going concern
because the subsidiary may not be viable. An EU-level framework with ex-ante fiscal cost
sharing mechanisms should move national authorities' incentives away from a sole regard for
the costs for the country. The recent approval by ECOFIN of a uniform EU deposit insurance
limit is a step in the right direction.3 Finally, an EU framework would reduce the costs of
dealing with troubled LCBB by making transparent the conditions under which solvency
support to a failing financial institution implies state aid and becomes incompatible with EU
competition rules. The Commission has to this end empowered one Commissioner for rapid
decision-making.
I wish to finish on a hopeful note reminiscent of Schumpeter's celebrated "creative
destruction" concept. Technological developments, by changing economic agents'
constraints, modify their actions and prompt a new equilibrium. Institutional changes also
become necessary to preserve a level playing field given that asymmetric information,
herding behavior, and the notorious difficulties of economic agents to measure the evolution
of risk over time, make financial markets incomplete. Effective institutions should affect
behavior and will, in turn, suggest the need for a new equilibrium. Therefore, the current
crisis, by having sent the financial system way far from an old equilibrium, may end up being
useful in bringing forward necessary changes to the EU financial stability framework. It may
do so by moving discussions from a nearly exclusive focus on what can be delivered under
the existing framework to what a framework of financial stability should deliver.
Thank you for your attention.