Jean-Claude Trichet: The financial turbulence - where do we stand?
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the
Economic Club of New York, New York, 14 October 2008.
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Introduction
Ladies and Gentlemen,
It is a great honor and a pleasure for me to be invited to speak at the Economic Club of New
York in these very challenging times for banking supervisors and central bankers.
The changing nature of the turbulence over recent months, together with the new
developments over the past few weeks, have meant that the turmoil is an enormous
challenge for the financial system at large, as well as for policy makers and regulators
around the globe. Since August 2007 central bankers have been busy managing increasing
volatility and risks in financial markets. The primary goal of a central banker and certainly of
the ECB is to maintain price stability over the medium term and be credible in delivering price
stability, which is a necessary condition for financial stability, if not a sufficient condition. To
achieve this, we not only have to define the monetary policy stance and set policy rates, but
we also have to implement our monetary policy. This is done by conducting open market
operations with the aim of steering short-term interest rates on the interbank money market -
and in particular the overnight rate - close to our main policy rate, i.e. the minimum bid rate
in the main refinancing operations of the Eurosystem. In doing so we steer the shortest end
of the yield curve, which is the starting point of the transmission process of monetary policy,
ultimately reaching the real economy in order to achieve price stability.
I would like to commence by describing how the ECB has implemented monetary policy
during the financial market turbulence, which started in August last year. In this context, I
shall describe how the Eurosystem took action through its liquidity provision to the euro
money market in order to ease tensions. I shall then turn to the coordinated action taken by
central banks, and how important it was for them to address effectively tensions in global
financial markets.
In the second part of my intervention, I will discuss the measures put in place by the
international financial community to restore market functioning and to ensure that the
weaknesses highlighted by the current market correction do not recur in the future. In this
regard, I will cover the progress made on the implementation of the priority recommendations
of the Financial Stability Forum (FSF), as well as policy areas in which work is currently
underway, including risk management of financial institutions, procyclicality and cooperation
between central banks, supervisors and regulators. I will conclude with the most recent
"action plan" that was adopted by the G7 in Washington and on the "concerted European
action plan of the euro area countries", which was just agreed last Sunday in Paris.
1. The responses of central banks to the financial turmoil
Over the past four weeks - in particular following the collapse of Lehman Brothers - credit
risk concerns have intensified and have led to additional disruptions in the functioning of
money markets, not only in the United States, but also in the euro area and Europe in
general.
Central banks are taking all the necessary steps to stop the downward spiral, and recent
actions have once again demonstrated their determination in this respect.
In both "normal" and "turbulent" times, the primary objective of the Eurosystem's open market
operations is to keep the shorter rates, in particular, the overnight rate, as close as possible
to the minimum bid rate. However, during the recent period of turbulence, open market
operations have also aimed at ensuring the continued access of solvent banks to liquidity,
notably by contributing to easing the impaired functioning of the money market. The
Eurosystem intends to continue to follow this approach as long as necessary.
From the first day of the financial market turbulence on 9 August 2007, in an environment of
increased liquidity risk and in response to banks' changed liquidity demand pattern, the ECB
has achieved these objectives through making technical changes to the way in which it
supplies liquidity in normal times, while also utilising the full latitude of its framework for
monetary policy implementation.
First, the Eurosystem has adjusted the distribution of liquidity supplied over the course of the
reserve maintenance period by frontloading, relative to normal times, the supply of liquidity at
the beginning of the maintenance period and reducing it later. In this way, the total supply of
liquidity over the entire maintenance period remained unchanged and, at the same time, the
changed pattern in banks' liquidity demand was satisfied without putting pressure on
shortterm interest rates. In addition, 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.
Second, the Eurosystem has supplied liquidity to the banking system by using open market
procedures, which were very rarely, if at all, used before the start of the turbulence.
1. The use of fine-tuning operations has been much more frequent than in "normal
times" because of the volatility in banks' liquidity demand and the difficulty of
producing a reliable ex-ante estimate of the overall liquidity conditions. In particular,
I would like to mention that the ECB made recourse to these operations repeatedly
in August 2007 and again in September this year to provide overnight liquidity in
addition to the liquidity provided at its weekly main refinancing operations. In
addition, as already mentioned, in the past two weeks, overnight fine tuning
operations have been used regularly to re-absorb the excess liquidity provided to
the euro money market.
2. The Eurosystem has very significantly increased the average maturity of its lending
to euro area banks. The outstanding amount of refinancing provided via longer-term
refinancing operations has increased by around €270 billion since 2007. The latest
measure in this respect consists of a series of special term refinancing operations
with a maturity of six weeks, which were launched in September 2008 and will be
continued until at least beyond the end of the year. Consequently, and in order to
keep the total amount of outstanding refinancing unchanged, the amount of liquidity
provided via the one-week main refinancing operations has been reduced
correspondingly.
3. On 8 October, due to intensified tensions in the financial market, the ECB took the
absolutely exceptional decision to adopt a fixed rate tender procedure with full
allotment for all its weekly main refinancing operations as long as market conditions
dictate.
Third, in October 2008 the ECB reduced the corridor of the standing facilities around the
interest rate on the main refinancing operations was reduced from 200 basis points to 100
basis points.
These measures, which reflect the increasing intermediation role assumed by the
Eurosystem during this period of turbulence, have contributed to the stabilisation of
conditions in the euro money market, to containing the volatility in the very short-term rates,
especially in the overnight rate as measured through the so-called EONIA, and to limiting
somewhat the volatility in the three-month Euribor, even if the behaviour of the money market
remained extremely tense, as was also the case in New York.
Cooperation between central banks in the field of monetary policy
It is important to recall that as the financial market turbulence developed , central banks
strengthened the already remarkable levels of cooperation, first, through enhanced
information exchange and collective monitoring of market developments and, later on,
through coordinated steps to provide liquidity. Since December 2007, the ECB, in
cooperation with the US Federal Reserve System and the Swiss National Bank, has been
conducting term auction facilities - so-called TAF operations - in which it provides USD
liquidity on behalf of the US Fed to euro area banks against ECB eligible collateral. These
operations do not have a direct impact on euro liquidity conditions and are aimed at
improving global funding conditions.
In this respect I would like to stress that to my knowledge this was the first joint action of that
kind ever taken by central banks to relieve pressures in the short term funding markets.
Yesterday at 8 a.m. Central European Time and 2 a.m. in New York, the ECB announced,
together with the Bank of England and the Swiss National Bank, that - thanks to a swap
agreement with the Federal Reserve System - we will conduct tenders of US dollars funding
at 7-day, 28-day and 84-day maturities at fixed interest rates for full allotment. Counterparties
in these operations will be able to borrow any amount they wish against the appropriate
collateral in each jurisdiction. This is a "world premiere" in exceptionally confident
cooperation between central banks.
Another exceptional "first" at global level was the coordinated reduction in policy rates by the
same amount of 50 basis points, which was decided by a large number of central banks from
the G10 countries. It was justified by the fact that the intensification of the financial crisis had
further diminished the upside risks to price stability and that central banks were considered to
have regained control of inflation expectations.
The role of the Eurosystem operational framework during the financial market
turbulence
The current financial market turbulence has certainly provided the biggest challenge to the
operational framework of the Eurosystem since its inception more than ten years ago. The
recent experience has so far proved that some of the structural features of our framework
have had an important role in stabilising short-term money market rates, signalling the
monetary policy stance and contributing to financial stability.
More precisely, the Eurosystem's operational framework is characterised, first, by a large
number of counterparties eligible for refinancing operations and marginal lending facility. This
facilitates the direct provision of liquidity to a large number of banks in need of it, at a time
when the money market is working imperfectly.
Second, the Eurosystem accepts a wide range of collateral eligible for its refinancing
operations. This 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.
Third, the large size of its refinancing 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, and at the same time to continue to adequately
steer liquidity in the course of the maintenance period.
2. Implications for central banks, financial regulators and supervisors
At the level of the international community, we have adopted a methodology for responding
to the present turmoil and working out what lessons can be drawn from the crisis: the FSF,
created after the Asian crisis, coordinates global efforts towards creating a more resilient
financial system. By April 2008, the FSF had reached consensus on a set of 67 policy
recommendations aimed at addressing the vulnerabilities identified in the global financial
system. Some of these recommendations concern structural changes and thus can only be
implemented over the medium term. However, a number of priority areas calling for
immediate action were identified and the relevant recommendations are already being
implemented by the competent authorities and the industry. In this respect, a major priority
area involves the disclosure of financial institutions' structured finance-related exposures and
their valuation practices. Many large global banks have already applied the methodology set
out in the FSF report to their holdings of complex and illiquid instruments in their mid-year
financial reports. By doing so, they have demonstrated the willingness of the private sector to
contribute to strengthening market confidence by increasing transparency. I strongly support
this development and believe that the example set by these banks should be followed by a
wider range of institutions.
Furthermore, guidance on transparency has been provided and is being further developed by
the Basel Committee on Banking Supervision and public sector initiatives, such as the
European and the American Securitisation Fora. In the same vein, the International
Accounting Standards Board is intensifying its work to enhance the accounting and
disclosure standards for off-balance sheet entities and to develop guidance for valuation in
illiquid markets. The ECB is monitoring developments in this area, and I believe that
providing clear guidance on this issue is pivotal to improving the confidence in and the
comparability of banks' financial statements.
Finally, another area where good progress has been made under the impulse of the FSF
concerns the role of credit rating agencies, which is being clarified thanks to new regulation
by the SEC and the revision of the IOSCO Code of Conduct. At the same time, in Europe,
the European Commission will engage in regulatory initiatives for the credit rating agencies'
authorisation and supervision.
Let me now focus on three issues which I believe are especially important in the current
context and for which transatlantic cooperation between central banks and financial
regulators is warranted, namely risk management, procyclicality and financial stability
arrangements.
With regard to risk management, it has become clear that the current situation in the financial
markets originated for the large part in excessive risk-taking and leverage by financial
institutions. A key explanation for this behaviour lies in banks' risk management systems,
which did not appropriately price risks, resulting in the creation of capital and liquidity buffers
that (in many cases) proved insufficient to insulate them from the dislocation in the financial
markets. Furthermore, liquidity risk did not receive enough attention in banks' overall risk
management.
Strengthening risk management techniques and procedures is key in the current context.
Public authorities have a clear role in this respect, and the Basel Committee on Banking
Supervision is a major player in this field at the global level. I fully endorse the work done by
the Basel Committee to review banks' risk management practices, as well as the Guidance
on Sound Liquidity Risk Management and Supervision, which was recently published and
constitutes a benchmark for the practices of financial institutions.
The European Central Bank, as the ultimate provider of liquidity in the euro area, has a
particular interest in issues relating to liquidity risk management. Against this background,
our work on liquidity stress testing and contingency funding plans has highlighted the
importance of both banking supervisors and central banks having access to the results of
liquidity stress tests carried out by banks so that they can better assess the potential
systemic impact of a liquidity shock. The ECB supports the idea of organising common
liquidity stress tests, for which participating banks would use their own stress tests based on
a joint scenario.
Furthermore, the contingency funding plans of large banks should be shared not only with
banking supervisors but also with central banks, as also recommended by the FSF.
Having said that, I would like to stress that financial institutions are ultimately responsible for
ensuring that all relevant risks, including liquidity risk, are properly integrated into their overall
risk management. In this vein, the full and timely implementation of the principles and best
practice recommendations developed by both the public authorities and the industry, as well
as a regular assessment of this implementation process, are of utmost importance.
The second issue that I would like mention is that of procyclicality, and in particular the
extent to which the current regulatory framework could encourage the procyclical behaviour
of financial institutions. This is a complex issue as procyclicality depends on many factors.
Although the way in which financial institutions manage their risk is regarded by many as the
main determinant of procyclicality, other elements such as capital requirements, accounting
standards or banks' compensation schemes can act as contributing factors. In terms of policy
action in this field, in the short term, regulators are determined to avoid measures aimed at
tightening capital requirements, as these could impinge on the financial standing of banks
and negatively impact the supply of credit and, in turn, the whole economy. At the same time,
the contributing factors to procyclicality must be looked at from a longer-term perspective.
Finally, I would like to address the importance of cross-border cooperation between
central banks, supervisors and regulators in the current context. Indeed, the significant
impact of the crisis in the US sub-prime market on other parts of the world highlights the
importance of improving cooperation between national authorities, both for preventing and for
resolving shocks. On the crisis prevention side, it has now been agreed that there is a need
to reinforce multilateral surveillance at the global level. To this end, the FSF and the IMF will
intensify their cooperation with a view to enhancing the assessment of financial stability risks
on a global scale as well as to coordinating possible policy responses. This endeavour
should be mirrored at the national and the regional level by heightening the level of
cooperation and exchange of information between central banks and supervisory authorities
to establish an overall better monitoring and assessment of the risks to the financial system.
On the crisis management side, the ECB focuses on central bank operations and on
crossborder arrangements between financial authorities. With regard to central bank operations, I
would underline that we need to ensure that central banks' operational frameworks are
flexible enough to deal with extraordinary situations. In this respect, the Eurosystem's
framework is very flexible. In terms of cross-border arrangements between financial
authorities, I would stress the urgent need for enhancing cross-border arrangements
between banking supervisors for dealing with weak banks. In fact, the global nature of
financial markets and the increasing interlinkages between markets and institutions mean
that the systemic impact of a financial crisis can only be properly assessed if supervisory
authorities share information on the risk exposures of large institutions and on the impact of
shocks in their jurisdiction. In addition, supervisory cooperation should be intensified on a
cross-sector basis. Indeed, all financial sectors are impacted by market developments as the
boundaries between financial activities are becoming increasingly blurred. More broadly, all
competent financial authorities, central banks, supervisors and ministries of finance should
strengthen their coordination mechanisms for managing a crisis impacting cross-border
financial institutions. In Europe, an important step has been taken in this direction with the
Memorandum of Understanding signed by the financial authorities of all EU Member States
in June 2008, which established common principles, procedures and terminology to be used
by all parties involved in a cross-border crisis.
Conclusion
We are experiencing a very challenging and demanding episode of the market correction
which started more than a year ago and was due to a significant underassessment and
underpricing of risks in global finance. This fostered extremely high risk-taking behaviour,
excessive leverage and a widespread use of toxic, obscure and abnormally sophisticated
financial instruments. In this regard, global finance was potentially unstable before the start
of the turbulence and this was mentioned publicly, particularly in 2006 and the first part of
2007, by a number of speakers, including myself. The sub-prime mortgage crisis has
therefore played the role of a trigger but there was a good deal of explosive around.
My experience of previous crises is that it is extremely important to analyse situations very
carefully and lucidly and never to underestimate its gravity. Since 9 August 2007, we at the
ECB realised that we were facing a very serious situation and drew all the lessons for such
events not to be repeated.
The same experiences lead me to think that crisis management is essential and that it
requires a lucid diagnosis as well as the ability to act not only wisely and decisively but also
in a quick fashion whenever and wherever it is necessary.
These are times where quick decisions are indispensable because the adverse
consequences of a delayed - albeit right - decision may be considerable. Central banks, on
both sides of the Atlantic, have in my opinion been lucid in their judgement of the situation,
bold in their decisions and quick to take these audacious actions. Let me only mention
yesterday's decision to provide broad access to liquidity and funding in dollars.
We are doing - and will continue to do - everything that is necessary to supply the requisite
liquidity while preserving the solid anchoring of inflation expectations. However, we cannot,
and should not, assume the role of executive branches. It is time for all of us to take action -
private sector as well as public authorities - at the global level.
From this standpoint, I am impressed by the concision of the Plan of Action that I signed,
together with Ben Bernanke, Ministers and Governors of the G7 in Washington last Friday.
This unusually concise five point plan shows that this is time for immediate action and not for
eloquent rhetoric.
It is such action, called for at the level of the international community three days ago in
Washington by the G7, the IMFC and the G20, that the Europeans considered indispensable,
particularly in the euro area last Sunday, with the adoption of a concerted European action
plan.
This plan has six dimensions: ensuring appropriate liquidity; facilitating the funding of banks
through various means (guarantee, insurance or similar arrangements for new medium-term
- up to five years - bank senior debt issuance); providing additional capital resources to
financial institutions; recapitalisation of distressed banks; ensuring appropriate
implementation of accounting rules; and enhancing cooperation among European countries.
The very day after the meeting, namely yesterday, a large number of euro area countries
displayed their implementation of the Eurogroup commitments at the level of the Heads of
State and Government.
I will not hide the fact that I am impressed by the degree of responsibility and decisiveness
that was demonstrated last Sunday and this week in the euro area. I am impressed by the
will of the countries that share the single currency not only to work together, but also very
closely with the United Kingdom and all EU Member States. And I see that the new decisions
taken in the United States are further reinforcing this very impressive implementation of the
plan that has been approved by the international community.
This is no time for complacency. Central banks will remain solid anchors of stability and
confidence. Public authorities must be alert, decisive and effective at a global level: this is not
a problem of the industrialised countries alone; this is a global issue that has to be addressed
with the full participation of the emerging countries. At the same time, private financial
institutions and market participants must behave wisely, prudently and with a solid sense of
responsibility. It is time to keep our composure.
I thank you for your attention.