Lucas Papademos: Address upon receiving the 2007 "Risk Manager of
the Year" Award of the Global Association of Risk Professionals
Speech by Mr Lucas Papademos, Vice President of the European Central Bank, at the 9th
Annual Risk Management Convention & Exhibition, New York, 26 February 2008.
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I. Introduction
Ladies and Gentlemen,
I would like to thank the Chairman of the Board of Trustees, Mr William Martin, for his kind
words of praise for the European Central Bank (ECB). It is indeed a great pleasure for the
ECB to receive the Risk Manager of the Year Award, which I gladly accept on behalf of the
Governing Council and all my colleagues at the ECB. I am aware that, in receiving this
award, the ECB finds itself in the privileged company of distinguished past recipients who
have made important contributions to academic research and business practice in the area
of risk management. This is the first time that the award has been given to an institution and,
in particular, a central bank. Mr Martin explained why the Board of Trustees decided to
honour the ECB for a number of its achievements. Indeed, given the inevitable uncertainty
characterising our economies and the risks that can affect their performance, central banks
may be seen as institutions whose tasks involve the prevention and management of risks
that can impact on the achievement of their policy objectives. Preventing and managing such
risks involves monitoring, analysis, assessments, decisions and actions that engage the
entire institution: its decision-making bodies, its management and its staff.
Risk management has undergone fundamental changes over the past two decades. In the
financial sector, it has had to deal with the unprecedented increase in the complexity of new
financial instruments, as well as with multiple interactions between the different types of risk
and different markets in the world economy. Responding to the challenge, the techniques
used to analyse and manage risk have reached a level of sophistication that has made risk
management an academic field of study in its own right. Equally importantly, it is now
recognised that risk management plays a central role in the business model of any enterprise
and that risk management expertise is an essential tool for senior managers. With almost
75,000 members in 100 countries, the Global Association of Risk Professionals (GARP) is
undoubtedly the main force in the international community of risk managers. Its activities,
which are aimed at the "advancement of the risk profession through education, training and
the promotion of best practices globally" are making a valuable contribution to improving risk
management across the world. This is especially important because the rapid pace of
innovation and the increasing level of integration among our economies and financial
systems necessitate better risk management - both in terms of systems and practices - in
order to optimise economic performance, that is, achieve higher sustainable growth,
preserve price stability and minimise financial volatility.
From the very beginning, the ECB, as an institution, has placed particular emphasis on risk
management. As a new central bank, established only ten years ago, it has aimed to meet
the highest governance standards in terms of organising its risk management function and
has applied state-of-the-art tools. Moreover, in the context of our task to contribute to
safeguarding the stability of the euro area financial system, we closely monitor and carefully
analyse developments in risk transfer instruments, as well as the implementation of risk
management strategies and methods by financial institutions.
For the remainder of my remarks this morning, I would like to focus on three issues
pertaining to the ECB's role and activities in assessing, preventing and managing the risks
associated with achieving its primary objective of preserving price stability and fulfilling its
responsibility to help safeguarding financial stability. I will do so by reviewing the Bank's risk
assessments, policy decisions and market operations in 2007 and by examining some policy
challenges that we face this year. More specifically, I will first discuss the extent to which the
ECB, other institutions and market participants managed to foresee the eruption of the
financial market turmoil, and if they did not, why not? Second, I will explain the ECB's money
market operations since last August, their rationale and their effects thus far. Finally, I will
address some challenging issues concerning the economic outlook and the financial markets
in the euro area.
II. The financial market turmoil: to what extent did we foresee, or could we have
foreseen, it?
Since the financial market turmoil erupted last summer, the underlying causes, as well as the
factors that have contributed to the propagation and spreading of initial triggers across
markets and countries, have been the subject of extensive debate. And these issues will be
discussed further by other speakers at this convention. What may be of greater interest and
relevance to risk professionals are the answers to the following questions: Did we see it
coming? To what extent did we see it coming? And if the answer is, at least in part, no: Could
we, or should we, have seen it coming? In fact, the ECB, as well as other central banks,
international institutions and some market participants, had identified a number of risks and
vulnerabilities in the financial system well before the financial market tensions erupted in
August last year.
In the four years to the summer of 2007, the exceptionally benign macroeconomic, financial
and monetary conditions and the process of financial globalisation, including a "savings glut",
had contributed to reducing risk aversion and market volatility, had fostered a "search for
yield" and rising leverage, and had resulted in the emergence of imbalances and the possible
underpricing of risk. Thanks to financial innovation, we witnessed an unprecedented growth
in the securitisation of bank loans, in credit risk transfer instruments and in other complex
structured finance products. Consequently, monitoring the distribution and identifying the
concentration of credit risk in the financial system became increasingly difficult. These and
other concerns had been expressed in various documents, speeches and statements back in
2006 and even before, for example, in the ECB's Financial Stability Reviews of June and
December 2006.
In early 2007 the warnings became stronger and more specific. For example, the ECB's
Financial Stability Review of June 2007 had warned (i) that the crisis in the US sub-prime
mortgage market could deepen and spread to other markets; (ii) that financial market liquidity
could vanish abruptly if investor uncertainty and risk aversion were to rise, revealing several
vulnerabilities in the financial system; (iii) that investors may be relying excessively on credit
rating agencies' risk assessment of structured products; and (iv) that it had become
increasingly uncertain whether those who ultimately held the credit risk could manage it
effectively.
But this, of course, is not the whole story. There were a number of other factors and
mechanisms that played a role in the propagation and amplification of the market turmoil
which neither we, nor other institutions, foresaw, at least not fully, notably: (i) the way various
intertwined vulnerabilities would eventually combine; (ii) the speed and intensity with which
tensions in one specific segment of the credit market in one country could spread so
extensively to other markets and countries; (iii) the size of banks' off-balance sheet
exposures to the US sub-prime related structured finance products; (iv) the activities,
features and implications of new financial entities - conduits and other structured investment
vehicles - that have been sponsored by banks and linked to them by liquidity commitments.
Finally, it was impossible to predict the extent to which risks were transferred to market
participants who were ultimately unable to bear them.
Should policy-makers and market participants have been able to foresee these weaknesses
and risk propagation channels in the financial system? Of course, "hindsight is always
twenty-twenty", as a well-known actor once remarked. But can we at least explain why we
did not see them ex ante? There are several reasons. But let me point to two main ones. The
first is that, to some extent, some of these factors were impossible to see. Insufficient
transparency and disclosure on the part of financial institutions, especially as regards their
(on- and off-balance sheet) exposures to complex structured finance products, are partly to
blame and are issues that need to be addressed urgently in order to improve the functioning
and resilience of the financial system. Similarly, inadequate information about the quality of
the assets underlying complex structured finance products led to valuation problems, as did
inappropriate accounting for the illiquid nature of many of these products. In the same vein,
the lack of transparency regarding the models and methodologies and the information used
by credit rating agencies in producing their credit ratings limited the understanding of those
ratings and obscured the true risk characteristics of the complex structured finance products.
The second reason is that some market participants did not care to see. Here I am referring
to the role and effects of distortions in the incentive structures embedded in the business
models of banks and other financial market participants in the originate-and-distribute chain
which have had a bearing on the provision of information about the quality of assets and the
distribution, accumulation and containment of risks in the financial system. Even 2000 years
ago, long before securitisation and credit risk transfer had been invented, Seneca had
identified the problem of inappropriate incentives when he warned that one should "be wary
of the man who urges an action in which he himself incurs no risk". Investors relied too
heavily on credit rating agencies in assessing the value of complex structured finance
instruments and were not fully aware of the true risk structure implied in their positions. The
lack of appropriate incentives led many market participants to ignore the warning lights that
had started flashing well before the summer of 2007 when the turmoil erupted.
III. The ECB's money market operations during the financial market turmoil
As the market tensions spread from the US sub-prime mortgage market through the market
for structured finance products and for asset-backed commercial paper to European money
markets, how did the ECB react? The liquidity squeeze in the interbank money markets that
was observed in early August 2007 was triggered by the larger-than-expected funding
liquidity needs, or perceived needs, of some banks, while at the same time those financial
institutions that had liquidity balances tended to hoard them because of uncertainty about
their future liquidity position and increased counterparty risk. In the face of these information
asymmetries and heightened uncertainty, the normal functioning of the euro money market
was severely impaired. The ECB therefore stepped in and addressed these tensions, initially
by launching a series of overnight fine-tuning operations, and subsequently by taking four
specific measures to ensure that very short term money market rates remained close to the
ECB's policy rate and to contain upward pressures in the longer-term money market.
First, the ECB shifted the time pattern of liquidity provision through its main refinancing
operations in the interbank money market by providing more liquidity at the beginning of the
reserve maintenance period and less towards the end of the period. This "frontloading" led to
more balanced liquidity conditions and helped to keep very short-term rates close to the key
policy rate, without changing the overall amount of liquidity provided. Second, responding to
banks' greater preference for assuring the fulfilment of their liquidity needs on a longer-term
basis, the ECB increased the share of refinancing provided via three-month longer-term
refinancing operations and reduced the share provided via the one-week main refinancing
operations. Again, the total amount of outstanding refinancing remained unchanged;
however, the average maturity was extended. Third, the ECB undertook a number of specific
measures designed to address expected money market tensions around the year-end. And
fourth, to ensure the availability of funding denominated in US dollars, the ECB joined a
concerted action with other central banks, notably the Federal Reserve System in December
2007, the aim of which was to improve global funding conditions.
It may be useful to clarify that the Eurosystem requires adequate collateral from its
counterparties for its credit operations. Adequate collateral in this context has two
dimensions: First, the Eurosystem should be protected from incurring losses in its credit
operations. Second, sufficient collateral should be available to counterparties, so that the
Eurosystem can provide the amount of liquidity deemed necessary for its monetary policy
and payment systems operations. To facilitate this, the Eurosystem accepts a broad range of
assets as collateral, which also reflects the variety of practices that had been applied by the
National Central Banks of the euro area. This collateral framework remained unchanged
during the recent market tensions. The diversity of eligible collateral had a stabilising effect
during the financial market turmoil, allowing counterparties to obtain liquidity from the
Eurosystem against adequate collateral.
Why did the ECB intervene in money markets? The objective was twofold. The interbank
money market plays a crucial role in the transmission of the effects and signals of monetary
policy. If money markets do not function in an orderly manner and very short-term money
market rates deviate significantly from the central bank's policy rate, the effectiveness of
monetary policy is impaired. The ECB therefore had to act swiftly and decisively in order to
steer these rates close to the official ECB interest rates and contain upward pressures on the
longer-term money market, in order to avoid the money market tensions feeding into the
credit market, spreading to other markets and adversely affecting the real economy.
In this context, it is important to emphasise that the ECB conducted these money market
operations without changing the overall monetary policy stance and, needless to say, without
aiming to "bail out" any specific financial institution with a special liquidity need. We have
clearly distinguished between two types of central banking action. On the one hand, the
ECB, like other central banks, takes decisions on the monetary policy stance and the level of
official interest rates. These have a clear medium-term orientation, they are geared towards
preserving price stability and are based on our assessment of the risks to price stability. On
the other hand, the ECB conducts money market operations that provide liquidity to ensure
the orderly functioning of the interbank money market, with a view to fulfilling its task of
safeguarding financial stability and to ensuring that the effects of its interest rate decisions
are transmitted to the financial markets and the real economy effectively.
So, did we accomplish what we wanted to achieve? Very short-term money market rates
have remained very close to the level of the ECB's key policy interest rates, and tensions in
the term money markets have eased gradually for maturities up to three months. Moreover,
banks now seem to be able to satisfy their US dollar liquidity needs, allowing the ECB to
discontinue the US dollar swap arrangement for the time being. However, we clearly have
not yet returned to the status quo ante. Central banks' liquidity operations cannot address the
underlying causes of the money market tension reflecting a lack of confidence among market
participants and uncertainty in other financial markets.
IV. The economic outlook and the adjustment of financial markets
Let me conclude by addressing some policy issues that we are facing this year. The
economic outlook for the euro area is surrounded by an unusually high level of uncertainty
and is subject to several risks. The ECB's latest assessment confirmed that risks to price
stability remain on the upside and that risks to economic growth continue to lie on the
downside. The ongoing process of risk reappraisal and balance sheet adjustment in financial
markets is likely to last for some time, and it is highly uncertain what impact it will have on the
real economy. Indeed, the risks to the outlook for economic growth are linked to and are
interacting with the uncertainty surrounding the ongoing risk reappraisal in financial markets.
Although the impact of the financial market turmoil on the euro area economic activity is
difficult to measure and forecast, the latest available information and analysis suggest that it
is not likely to be sizeable. Real GDP is expected to grow in 2008 at a more moderate pace
than previously projected, but most recent forecasts from international organisations and the
private sector point to GDP growth of between 1.6% and 1.8% in 2008. The upper end of this
range is not far below the euro area's potential rate of growth. The sound fundamentals of
the euro area economy and the absence of major macroeconomic imbalances should help
cushion the adverse effects of the financial market tensions and the deceleration of global
economic growth. Nevertheless, we cannot be complacent, as risks to euro area growth
remain on the downside.
An important and relevant question is whether the ongoing process of de-leveraging and
reintermediation and the impact of the financial market turmoil on banks' balance sheets are
likely to lead to a credit crunch. The evidence so far is reassuring. On the basis of the
available data, there have been no signs of a credit crunch or even indications of a
deceleration in the rate of loan credit growth to the private sector which has remained strong,
in particular the pace of credit expansion to non-financial corporations. It is, of course, true
that we have witnessed a tightening of financing conditions and credit standards in the euro
area. However, the increase in the average real cost of financing has been relatively modest
over the past few months, although credit spreads for parts of the corporate sector have
widened substantially. Moreover, the considerable tightening of credit standards reported by
banks (in the January 2008 bank lending survey for the euro area) has taken place from a
very "loose" level and has not significantly constrained the availability of credit. The available
information suggests that the decline in securitisation activity and the re-intermediation of
offbalance sheet assets onto banks' balance sheets have not affected substantially the supply
of bank loans, and, for the time being, the re-intermediation of non-bank credit has not
artificially distorted upwards the figures for credit growth.
Nevertheless, caution is warranted before reaching any conclusions on the likely effects of
the financial market turmoil on the cost and availability of bank credit. The impact of the
market turmoil on some banks' balance sheets has been considerable and a number of
credit institutions will have to strengthen their capital positions and be more cautious in their
lending policies. Moreover, the time lags in the effects of a change in credit standards by
banks on loan demand imply that it could be some time before their cumulative impact
becomes observable. More data and further analysis are required before a better
assessment can be made of the extent to which the ongoing process of risk reappraisal and
banks' balance sheet adjustment will affect credit growth in the future.
With regard to the prospects for price stability, the short-term inflation outlook is not
satisfactory. The annual inflation rate in the euro area, which was 3.2% in January 2008, is
likely to remain at such an elevated level significantly above 2% in the coming months and
moderate towards 2% very gradually, and more slowly than previously envisaged. The
likelihood that inflation will remain at a high level for a prolonged period underscores the
importance of this temporary but protracted upward pressure on inflation not spilling over to
the medium term. The assessment derived from economic analysis that there are upside
risks to price stability over the medium term is confirmed by the continuing vigorous money
and credit growth.
It is therefore imperative that the risk of second-round effects on wage and price setting
stemming from short-term inflation pressure be avoided. It is also essential that medium and
long-term inflation expectations remain well anchored to price stability. The ECB remains
committed to preventing second-round effects and the materialisation of upside risks to price
stability over the medium term. This commitment will guide the determination of the monetary
policy stance. At the same time, the ECB stands ready to respond flexibly, effectively and in
a timely manner, in order to address potential money market liquidity pressures, so as to
support its monetary policy objective and mitigate the risks to the financial system and the
real economy. If necessary, this will be carried out in close concertation with other major
central banks, as has been done successfully in the past.
The ongoing adjustment of financial markets is likely to last for some time. This could prove
to be challenging and further test the shock-absorption capacity of components of the
financial system. Policy-makers and market participants have already taken significant
measures, and several additional initiatives are under way, to address the identified
weaknesses in the financial system, enhance risk management practices, restore confidence
and strengthen the resilience of the financial system.
V. Concluding remarks
The policy challenges that the ECB and other central banks are facing this year and beyond
require the close monitoring of all developments, as well as comprehensive analysis and
determined action to prevent certain risks from materialising and to effectively manage
others. Fundamentally, however, the performance of our economies and the resilience of our
financial system depend on market participants' decisions, actions and risk management.
The close cooperation of policy-makers and market participants is an essential ingredient for
achieving sustainable economic growth and preserving price stability. To this end, the Global
Association of Risk Professionals has an important role to play, as the expertise and
experience of its members will contribute to further improvements in the field of risk
management. Once again, I should like to thank you, also on behalf of all my colleagues at
the Bank, for awarding the Risk Manager of the Year Award to the ECB.
Thank you very much for your attention.