José Manuel González-Páramo: Liquidity, financial markets and the
economy - the role of central banks
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the Fundación Caixa Galicia, Santiago de Compostela, 16
October 2008.
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1. Introduction
Ladies and Gentlemen,
It is a great pleasure for me to be here in Santiago de Compostela and I would like to thank
the organisers - Cátedra Fundación Caixa Galicia, Universidad de Santiago de Compostela,
and, in particular, Jorge Martínez-Vázquez and Santiago Lago Peñas - for giving me the
opportunity to participate in this Conference and share with you some considerations about
the recent developments in international financial markets and the responses by central
banks, particularly by the ECB.
The degree of integration of international financial markets has significantly accelerated in
recent decades, particularly since the second half of the 1990s. While some researchers
often point out that the current level of international financial integration is not unprecedented
by historical standards, there is no doubt that we live in a world in which advances in
financial and communications technology combined with regulatory and institutional changes
have led to financial markets and institutions becoming more interrelated across borders and
time-zones than ever before.1
Growing financial integration across borders is a potential source of benefits, notably due to
enhanced opportunities for international risk sharing. Indeed, financial globalisation may
provide countries with instruments to hedge against idiosyncratic shocks in order to better
smooth consumption smoothing, thereby yielding significant welfare gains. In addition, larger
integration into the international financial system may contribute to the efficient functioning of
the entire economy by providing additional financing at a reasonable cost to domestic
agents, by facilitating the transfer of technology from abroad and by stimulating the
performance of the domestic financial sector.
However, financial globalisation may also entail some risks. Increased international financial
integration is likely to lead to a larger sensitivity to external spillovers. In addition, financial
globalisation is likely to induce stronger and faster transmission of shocks across countries.
This poses some challenges for policymakers that require: (1) on the one hand, a closer
monitoring of global financial and real developments, and (2) on the other hand, the need for
national authorities to coordinate their responses to shocks with their key partners in the
international economy.
2. The financial turmoil
The episode of financial market turmoil that we have experienced since August 2007
provides a dramatic illustration of how - in a globalised economy - an idiosyncratic shock
can be propagated more rapidly and through a variety of new channels to seemingly distant
countries and markets. Indeed, the turmoil originated in a relatively small segment of the US
economy - the sub-prime segment of the mortgage market - that has no obvious relationship
with the Eurosystem's sphere of interest. Yet, its quick propagation caused an increase in
volatility and a decline in liquidity in a variety of markets all around the world, including the
euro area market for inter-bank unsecured loans, which represents a key component of the
money market and the starting point of the area-wide monetary transmission mechanism.
The decrease in liquidity has been most obvious for the markets directly related to the core of
the current turmoil, namely the market for sub-prime mortgage-backed securities (MBSs).
However, since the start of the turmoil problems of illiquidity have spread further, affecting
other asset-backed securities (ABSs), asset-backed commercial paper (ABCP), and basically
all structured credit instruments. Also the liquidity in the secured non-government repurchase
agreement (repo) markets has been heavily affected, as many banks no longer want to
accept the types of securities mentioned above (MBSs, ABSs at large, and CDOs) as
underlying collateral in repo transactions. Another market segment that has seen a partial (at
times, even severe) deterioration of liquidity conditions is the foreign exchange swap market,
which is very important for banks managing liquidity in different currencies. Occasionally,
poor liquidity conditions have been reported even in markets for securities historically
regarded as very liquid and safe, such as the market for bank covered bonds or government
bonds of some developed economies.
In recent months - in particular following the takeover of Bear Stearns and the collapse of
Lehman Brothers -, the financial market turmoil has intensified again and entered a more
damaging and disruptive phase in which large financial institutions have failed or have had to
be rescued by either their private counterparties or public authorities, while the viability of the
investment banking industry as a whole and of "the originate to distribute business" business
model has been put into question. At the same time, a number of international financial
markets - particularly the markets for equities and commodities - have experienced a
significant increase in volatility. More notably, significant tensions have emerged again in
global money markets, where market liquidity has come under severe strain and term
interest rates have continued to rise.
3. International transmission of liquidity shocks and liquidity spirals
Let me now refer to a couple of elements which have played a central role during the turmoil:
(1) the international transmission of liquidity tensions, and (2) the interaction between market
liquidity and funding liquidity.
Indeed, the events of the past year have illustrated vividly the strength, the complexity and
the rapidity of the transmission of liquidity shocks across countries. At the root of the
international transmission mechanism is the fact that interbank markets are linked across
countries by the funding needs of banks involved in cross-border business on a large
geographical scale and holding assets and liabilities denominated in various currencies.
Changes in liquidity conditions in the interbank markets are therefore correlated at the global
level, and are amplified by the fact that many of the key players are subject to common
shocks.
Another dimension of the ongoing turmoil is the enhanced interaction between market
liquidity and funding liquidity. Under normal market conditions, market illiquidity is typically
short-lived, particularly since it creates profit opportunities for traders who, by providing extra
funding liquidity, support the price discovery process and restore the smooth functioning of
the market. In contrast, at times of severe turbulence the disruption of the mechanisms
channelling liquidity - be it through asset prices or the balance sheet of financial institutions -
may also deeply and protractedly perturb the functioning of markets, ultimately creating risks
for systemic imbalances.
The current episode is an example of this. Even in the interbank markets - traditionally
considered as the deepest and most liquid of all markets - activity has been protractedly
"frozen". This has happened primarily due to uncertainties as to the size and locations of
losses created by the opaque transfer of credit risk brought about by complex securitisation
mechanisms. Such uncertainty has heightened counterparty credit risk concerns,
discouraging banks from lending to each other. Moreover, it has brought to the fore the
increased interaction between market liquidity and funding liquidity of individual institutions.
Indeed, the trend among large global banks has been towards greater reliance on wholesale
market sources of funding as opposed to retail deposits. This has made access to funding
liquidity more dependent on market conditions.
In addition, the range of systemically relevant institutions has become broader. Indeed,
nondeposit taking investment banks and primary dealers play a systemic role in their crucial
broker-dealer function. They perform a key role in maintaining market liquidity in a broad
range of unsecured and secured markets. If they face funding liquidity constraints, market
liquidity will be widely affected, with potential negative repercussions for the banking sector
as a whole in addition to the risks to the individual institutions themselves.
More generally, the experience of some financial institutions in recent months shows that a
protracted adverse liquidity spiral may weaken the balance sheets of institutions and in
extreme cases jeopardise their solvency. This environment poses challenges for central
banks, as addressing funding liquidity shortages may require supporting market liquidity, also
with a view to preventing insolvencies. Of course, this does not mean that central banks
should tackle individual counterparty solvency concerns. This is a clearly a task which falls
outside the reach and responsibilities of central banks, and that governments are better
positioned to fulfil.
The point is rather than in the current "new world" in which market and funding liquidity can
be highly interdependent, liquidity interventions aiming to ease the impaired functioning of
the money market can also alleviate funding liquidity concerns and contribute to prevent that,
in extreme cases, protracted illiquidity develops into lack of solvency. Along these lines, let
me explain how central banks have responded to the challenges arising from market turmoil
using a combination of operational measures and increased international co-operation.2
4. Policy responses
4.1 Central banks
Clearly, the responses have varied across central banks, but in general terms, they have
tried to address the liquidity squeeze in similar ways and have concentrated on the following
fronts:
First, central banks have acted to keep short-term money market rates in line with their policy
rates (or targets) through more active reserve management, thereby flexibly responding to
shifts in the demand for reserves.
Second, central banks have sought to ease pressures in broader funding markets through a
combination of measures, such as an increased supply of longer-term funds, the expansion
of collateral accepted in lending operations, and the widening of the range of counterparties
that may have access to collateralised lending. In some cases, central banks have also
extended lending to non-depository banks and to financial institutions other than banks.
Third, some central banks have also established securities lending facilities to improve the
functioning of interbank repo markets.
Fourth, central banks have increased their co-operative efforts both through enhanced
communication and collective market monitoring, and through co-ordinated actions to provide
both overnight and longer-term funds.
Fifth, some central banks also calibrated their monetary policy stance to take into account
any impact that the unfolding credit market turbulences might have on inflation and real
activity.
Finally, in a fortunately limited number of episodes, central banks have assisted their
domestic governments in providing emergency liquidity assistance to institutions under
stress.
4.1.1. Responses of the Eurosystem
Let me now briefly describe how the Eurosystem has responded through operational
measures to changes in banks' liquidity demand.
Over the last fifteen months, the following three key features of the operational framework
have proven useful in allowing the Eurosystem to address funding constraints indirectly also
in term money and asset markets:
1. access of a broad range of counterparties to central bank liquidity has facilitated the
direct provision of liquidity to a large number of banks in need of it, at a time when
the money market was working imperfectly;
2. acceptance of a broad range of collateral in all classes of lending operations has
facilitated the raising of liquidity via the Eurosystem for banks with reduced access
to the interbank market, at the same time economising through their operations with
the Eurosystem on those few types of assets that have continued to be tradable
throughout the turbulence, such as government bonds. In this respect, the
framework may have also supported the continued functioning of capital markets;
3. the relatively large scale of the open market operations (around one third of total
assets in the Eurosystem balance sheet - or €450 billion) has allowed the
Eurosystem to provide longer term refinancing to banks at a large scale, thereby
temporarily taking over a significantly increased intermediation role, and at the same
time to continue to adequately steer liquidity in the course of the maintenance
period, in line with the aim to keep short term rates close to the policy rate.
Indeed, since the early phase of the ongoing turbulences in August 2007, the Eurosystem
has resorted to a more pro-active liquidity management in order to maintain a proper control
of short-term interest rates. In particular, we have adjusted the distribution of euro liquidity
supplied over the course of the maintenance period, in contrast to normal times, by
frontloading the supply of liquidity at the beginning of the period and reducing it later in the
maintenance period. Furthermore, we have significantly increased the amount of refinancing
provided via longer-term refinancing operations with a view to smoothening conditions in the
term money market. In fact, the outstanding amount of refinancing provided via longer-term
refinancing operations has increased by around €270 billion since 2007. In order to keep the
total amount of outstanding refinancing unchanged, the net amount of liquidity provided via
shorter term refinancing operations has been reduced accordingly.
Following the rescue of Bear Stearns last March the financial market turmoil has entered a
new, more intense phase that has further deteriorated after the collapse of Lehman Brothers
last month. In response to the renewed tensions, the Eurosystem has stepped up its efforts
to support the appropriate functioning of the euro money markets and to alleviate both the
euro and the USD funding needs of euro area banks by:
1. Further enhancing its frontloading euro liquidity policy. For instance, last month the
ECB enlarged the provision of liquidity at its regular weekly main refinancing
operations, well above the amount normally envisaged by the frontloading approach,
with the aim of further strengthening its liquidity intermediation at a time of significant
rigidity in the euro money market. The ECB then reabsorbed the resulting excess of
liquidity on a daily basis through overnight fine-tuning operations, and continued to
rebalance the liquidity conditions towards the end of the reserve maintenance
period.
2. Significantly increasing the average duration of its refinancing operations, notably
with the introduction of six-month maturity operations, the expansion of those with
three-month maturity and the announcement of a series of special six-week
refinancing operations in September 2008 that will be continued until at least beyond
the end of the year.
3. Also by expanding coordinated provision of USD liquidity within the context of the
Term Auction Facility, as will be discussed in the next sub-section.
Besides, in response to the recent intensification of the financial market turmoil, the
Eurosystem took on 8 October the exceptional decision to temporarily change the tender
procedure in our weekly main refinancing operations to fixed rate tender with full allotment
and to reduce the corridor of standing facilities from 200 basis points to 100 basis points
around the interest rate on the main refinancing operation. By providing uncapped access to
euro liquidity (of course, against adequate collateral), the new format of the main refinancing
operations will provide an important contribution to easing liquidity tensions in the euro
money markets.
In addition, in another crucial step, on 8 October the Eurosystem adjusted its monetary policy
stance to address the changing balance of risks to the outlook for medium-term price
stability.
Yesterday, the Eurosystem announced a new set of extraordinary measures to temporarily
expand the list of assets accepted as collateral in the Eurosystem lending operations and to
enhance provision of euro long-term refinancing over the current and next quarters.
However, before discussing more in detail about the changes to the monetary policy stance
and the latest temporary adjustments to the operational framework, I would like to highlight
the role of increased international cooperation in the supply of USD liquidity in international
money markets.
4.1.2 Increased international cooperation
As pointed out before, in addition to domestic operational responses, central banks have
further strengthened their cooperation throughout the turmoil, while preserving differences in
their operational frameworks. They have enhanced their cooperation first by means of
enhanced information sharing and collective monitoring of market developments and later on
through coordinated steps to provide liquidity.
The main example of such coordinated actions among central banks is the by now familiar
US dollar Term Auction Facility, which started in December of last year and in which the ECB
agreed with the US Federal Reserve to grant loans in dollars to euro area banks. These USD
liquidity providing operations have increased over time in terms of size and number of
participants, with up to nine central banks now participating.
As far as the Eurosystem is concerned, the scope of this facility has significantly increased
over time in terms of maturities covered and volumes involved. Last Monday the Governing
Council took a further step with the decision - announced together with Bank of England and
the Swiss National Bank - to conduct operations at 7-, 28- and 84-day maturities at fixed
interest rates and with full allotment. As a result of this decision, euro area counterparties will
be able to borrow as much USD liquidity as they wish against eligible euro-denominated
collateral. The supply of USD is guaranteed by an unlimited temporary reciprocal currency
arrangement between the Federal Reserve and the ECB that will remain in place for as long
as needed. These liquidity-providing operations do not have a direct effect on euro liquidity
conditions, but are conducted to address the availability of US dollar funding for euro area
banks and aim at improving global funding conditions.
It is important to stress that the actions in connection with the TAF marked, to my knowledge,
the first systematic, multilateral and successful central bank co-operation in the money
market field, a market which is central to the implementation of a central bank's monetary
policy. I believe that all of these actions have proved to be effective in easing the tensions at
the short-term end of the global money markets and in maintaining control of short-term
interest rates in the euro area. I am sure that global money and funding markets will continue
to benefit from our very close cooperation. We will carry on working together closely and are
prepared to take appropriate steps as needed to address funding pressures.
4.1.3 Increased financial intermediation
Before discussing the latest monetary policy decision, I would like to point out that as a result
of its enhanced liquidity interventions in euro and USD over the last fifteen months, the
Eurosystem has significantly increased its involvement in financial intermediation in the euro
area. Indeed, the Eurosystem has moved from the situation before the start of the turmoil in
which it provided banks only with as much liquidity as necessary to implement its monetary
policy stance, with the intermediation being performed by the market, to the present condition
in which it effectively intermediates liquidity flows among banks in order to mitigate
dysfunctions of money markets.
The increased intermediation role assumed by the Eurosystem during this period of
turbulence has contributed to the stabilisation of short-term liquidity conditions, as well as to
contain volatility in the very short-term rates (especially in the overnight rate as measured
through the so-called EONIA) and to limit somewhat the volatility in the three-month Euribor,
even if the behaviour of the money market remains extremely tense. Of course, this is not the
ideal solution in a market-oriented economy like the euro area and, indeed, the Eurosystem
looks forward to the reactivation of inter-bank lending and to banks resuming their traditional
intermediation activity. However, as long as money markets remain dysfunctional, the
Eurosystem will continue to provide liquidity as needed in order to ease tensions in the
impaired money markets, with a view to ensuring that access to liquidity of solvent banks is
not disrupted, thereby contributing to safeguarding financial stability.
4.1.4 Monetary policy adjustment
As mentioned earlier, in responding to the financial market turmoil the ECB has consistently
stuck to the principle of a clear separation of tasks between monetary policy and liquidity
policy. Monetary policy must define the appropriate level of the policy rate in order to achieve
and maintain the primary objective of price stability, thereby supporting long-term economic
growth and employment creation. Liquidity policy must aim to keep the very short-term
money market rates in line with the chosen policy rate and to guarantee the smooth
functioning of the market, thereby delivering the desired monetary policy stance and
contributing to preserving financial stability.
In practice, this principle implies that the ECB does not use its key policy rate as an
instrument to mitigate liquidity stress, to prop up the balance sheets of financial institutions or
to support asset price valuations. If agents believed that the ECB was prepared to do so,
investors would probably engage in excessive risk-taking behaviour, thereby sowing the
seeds of future financial crises. More fundamentally, if the ECB was perceived as assigning
higher priority to supporting the financial sector or asset prices than to safeguarding price
stability - its primary statutory objective - inflation expectations could be adversely affected
and even become disanchored.3
Of course, the separation principle does not mean that the ECB should not adjust its
monetary policy at times of financial turbulence, if some adjustment is required by changes in
the balance of medium term risks for price stability. Consistent with this consideration, the
ECB announced on 8 October a 50 basis point reduction in its key policy rate - the interest
rate on the main refinancing operation - in a move coordinated with five other major central
banks. The decision to ease monetary conditions in the euro area (and, more generally, at
the global level) was warranted by the recent moderation in inflationary pressures and
inflationary expectations, partly reflecting weakening economic activity, a marked decline in
the prices of energy and other commodities and increasing downside risks to future
economic growth. Besides, the recent intensification of the financial crisis has affected the
outlook for economic growth and price stability in the euro area, particularly by augmenting
the downside risks to growth, while further diminishing the upside risks to price stability and
bring inflation expectations back to levels consistent with price stability.
The recent coordinated interest rate cut was unprecedented by historical standards and was
very much welcomed as a sign of the strong commitment of the international central banking
community to addressing the macroeconomic implications of the financial market turmoil. At
the same time, the effectiveness of the coordinated monetary policy moves was very much
enhanced by the public's trust in their own central banks' commitment to fulfilling their
respective mandates.
In this respect, the public at large should be confident that the monetary policy in the euro
area will be always consistent with the ECB's mandate of delivering medium term price
stability at home and with the need to maintain expectations firmly anchored at levels
consistent with price stability. This is the best contribution that the ECB can provide in order
to preserve the purchasing power of citizens over the medium term and to support
sustainable growth and employment in the euro area.
4.1.5 New temporary measures to expand the collateral framework and the provision of
liquidity
In the context of recent initiatives undertaken by the EU authorities to restore confidence and
the appropriate functioning of our financial systems, the Governing Council of the ECB
approved last Wednesday a new set of temporary measures designed to enhance the
provision of long-term euro liquidity and to expand the list of collateral accepted in the
Eurosystem monetary policy operations.
These new temporary measures aim to further enhance the provision of liquidity to solvent
banks, while also contributing to restore confidence among market participants in the current
environment in which money markets remain under stress and the traditional channels of
liquidity transmission are impaired. Given the starting position of money markets in the
transmission mechanism of monetary policy, ensuring their smooth and orderly functioning is
a primary objective for central banks.
As part of the new measures, we have decided to strengthen the provision of long-term
refinancing in euro over the rest of the year and the first quarter of 2009. The new measures
include inter alia the switch to a fixed-rate tender with full allotment for longer-term
refinancing operations, consistent with the procedure already in use for the weekly main
refinancing operations. At the same time, the ECB will continue to steer liquidity towards
balanced conditions in a way consistent with the objective of keeping short-term interest
rates close to the key policy rate (the interest rate on the main refinancing operation). In
order to facilitate the steering of liquidity, the ECB will also accept fixed term deposits with a
1-week duration from banks holding more liquidity than needed.
In addition, on an extraordinary basis and for a temporary period (i.e. until the end of 2009),
the list of assets accepted as collateral in our monetary policy operations has been
expanded. As a result of this expansion, banks will be able to post as collateral with the
Eurosystem some categories of assets available within the euro area that were not eligible
before. In addition, we have temporarily lowered the minimum credit rating accepted for
marketable and non-marketable instruments (expect for ABSs), while maintaining the
requirement that assets must be "investment grade".
The temporary expansion of the list of eligible collateral may potentially imply an increase in
the risks taken by the Eurosystem through its refinancing operations. In order to fulfil the
Eurosystem's statutory obligation to ensure that its balance sheet remains adequately
protected against financial risks across time, adequate risk control measures will continue to
be carefully and thoroughly applied to the enlarged collateral set.
4.2 Governments
Governments all over the world have been involved in interventions designed to provide
support to systemically-relevant individual banking institutions.
Initially, interventions were addressed to address isolated cases of stressed institutions and
mainly fell into two categories: (1) the rescue of troubled individual institutions, whose failure
may have given rise to financial instability; and the (2) provision of guarantees covering the
liabilities of individual institutions under stress. In the US, government support in the form of
liability guarantees was extended to non-bank financial institutions - notably, the
government-sponsored mortgage agencies Freddie Mac and Fanny Mae - whose insolvency
may have triggered systemic disruptions worldwide (though the failure of government
guarantees to stabilise the agencies prompted the US government to subsequently take
them over).
Some governments also announced measures to provide relief to struggling homeowners
and made use of traditional fiscal policy tools to stimulate the domestic economies,
particularly in countries where the slowdown in housing markets was more significant.
More recently, the scope and reach of interventions by governments has broadened, with
several countries announcing more general and comprehensive schemes designed to
support the entire domestic financial industries rather than individual institutions. The need to
develop broader plans for public intervention has become more acute with the intensification
of the financial market turmoil and the increasing awareness that the current turmoil has the
potential to jeopardise financial stability and, ultimately, macroeconomic stability in the world
economy.
As part of the more recent and decisive efforts by governments, public recapitalisation of
banks by public authorities, mostly through capital injections in exchange for equity, has
become more extensive, leading to partial and, in some cases, majority or total state
ownership of several banking institutions in various European countries both inside and
outside the EU.
In addition, the provision of guarantees covering deposits or other liabilities has been
extended to the entire domestic banking sectors rather than focus on individual institutions.
In particular, several governments have increased current limits on retail deposit guarantees
and even announced unlimited guarantees in order to prevent generalised bank runs. In
addition, some governments have also extended the guarantees to non-retail deposits and to
bank liabilities other than deposits, particularly bank loans and debt instruments issued by
banks. In order to restart bank lending and restore confidence in money and credit markets,
some countries have announced that guarantees will cover also new liabilities issued by
banks.
In some cases government guarantees have also been extended to holdings with money
market funds, an industry that has been historically a major source of financing for banks. In
addition, US public authorities have approved a large-scale programme to support the
banking sector and the market for asset-backed securities by allowing the Treasury to
acquire (directly or though auctions) distressed mortgage-related assets from banks
(Troubled Asset Relief Programme, TARP). This programme allows for the possibility to
inject capital directly in banks and also to extend the range of distressed assets covered by
the programme. Similar publicly-funded scheme to purchase illiquid securities from banks are
under consideration in some European countries.
Most initiatives by governments have been presented as designed to reassure domestic
savers and investors by systematically addressing problems at national financial institutions.
However, the "national" orientation of such initiatives clearly contrasts with the global nature
of the financial tensions, which by definition requires a common understanding among
governments of the roots of the tensions and concerted actions to address them. The
desirability of concerted actions both for technical and signalling reasons is well illustrated by
the favourable reception that coordinated liquidity injections by central banks have met
among market participants and the public at large.
Increasing awareness that an overly domestic approach to addressing the present tensions
may subtract strength from public interventions, introduce cross-border market distortions
and even be interpreted as signalling a coordination failure, has prompted governments to
publicly state the importance of pursuing a more coordinated approach. In this respect, three
important statements are (1) the Plan of action of the G-7 finance ministers and central bank
governors of 10 October, (2) the ECOFIN Council conclusions of 7 October and (3) the
Declaration on a concerted European action plan of the euro area countries of 12 October.
These documents list common principles in key areas (ensuring appropriate liquidity,
facilitating the funding of banks through various means, providing additional capital resources
to financial institutions, recapitalisation of distressed banks, ensuring appropriate
implementation of accounting rules, and enhancing cooperation among European countries),
while leaving national governments free to design the operational aspects o