Jean-Claude Trichet: Today's financial institutions and tomorrow's
monetary order
Keynote speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the
19th Frankfurt European Banking Congress: "After the Crisis", Frankfurt am Main, 20
November 2009.
* * *
Ladies and Gentlemen,
It is always a pleasure to join you at the annual Frankfurt European Banking Congress.
I noted that the organisers have chosen as title: "After the crisis".
I understand that the mood in the financial system is one of relief.
But as of today, it is too early to declare the crisis over.
Recent financial developments have been more benign, it is true. However a significant
volume of official support underlies these developments. Nobody knows this better than
financial institutions and markets themselves.
The total amount of outstanding ECB refinancing is around 60% larger than it was before the
financial market turmoil. This reflects also the need for the ECB to "intermediate" parts of the
money market.
Euro area governments for their part have committed 26% of GDP to supporting the financial
sector. This assistance has come in the form of guarantees, capital injections and asset
support.
The magnitude of support is without precedent, and all participants in financial markets
should be conscious of that. It has been extended on behalf of the general public, and for the
benefit of the overall economy.
Banks are an important part of the economy. The support has been given for their role in the
economy, not for the banks by themselves.
We also have to understand the concern of our democracies as regards compensation and
bonuses. Principles have been agreed upon at the level of the international community. They
were worked out by the Financial Stability Board and approved by the G20. Let us apply
rigorously those principles, under the control of the banking supervisory authorities. The
wrong incentives to embark in absurd risks and dangerous short-term ventures have to be
eliminated.
Challenges to guard against excesses are as old as mankind. I quote Frankfurt's most
famous son:
"Die Hauptsache ist, daß man lerne, sich selbst zu beherrschen. Wollte ich mich ungehindert
gehen lassen, so läge es wohl in mir, mich selbst und meine Umgebung zugrunde zu
richten."
One could translate this as follows. "The most important issue is to learn self-restraint. If I
wanted to lavishly let myself go, I could well destroy myself and my environment."
Goethe made this remark in 1830. I am sure he would have repeated it today.
* * *
Three points appear essential regarding the banking sector.
First, banks need to strengthen their balance sheets. They need to become self-reliant and
be able to stand on their own two feet.
The authorities can - and have - provided considerable temporary support, but in a market
economy we cannot manage the financial sector or provide exceptional support indefinitely.
Banks must rebuild their capital base. There are many ways to do so. The improved capital
markets offer opportunities to raise funds including equity. Profits earned should be used -
as priority - to build capital and reserves, rather than to be paid out as dividends or undue
compensation.
Second, banks should lend, because the magnitude of public support has been provided for
this purpose, and the strengthened balance sheets will allow them to lend. Banks should
strive to maintain their supply of loans. Most recently, in the third quarter of this year, the
annual growth of loans to non-financial corporations continued to decline, while the annual
growth of loans to households remained broadly unchanged.
This pattern of loan dynamics is broadly in line with past regularities around business cycle
turning points. But the latest ECB bank lending survey suggests that, while the peak in the
tightening of banks' credit standards is behind us, credit standards remain considerably
tighter than prior to the turmoil. It will be particularly important that banks intensify their efforts
to expand their supply of loans once loan demand picks up in the recovery.
Third, compensation and bonuses must remain contained. Otherwise, we would take risks
that Goethe already described.
When necessary, banks should take advantage of the available government support to
achieve these goals.
From this perspective, I will interpret the conference theme - "After the crisis" - as an appeal
to look forward and draw lessons for the future from our experience of the past two years.
* * *
I would like to outline now what measures we, as the central bank of the world's
secondlargest economy, have taken in the crisis, and how and why we have designed these
measures.
To illustrate, I would like to draw on a medical analogy, identifying three lessons for how we
should collectively care for the health of the financial system going forward.
First, once a patient falls seriously ill, emergency medication is required. Strong and invasive
painkillers may have to be administered. Contagion must be avoided.
Similarly, a global financial crisis of first magnitude requires prompt and decisive policy
action, possibly of an unprecedented nature.
When this crisis began, the European Central Bank was in the vanguard of the policy
response, taking early and bold action to address financial turmoil. During the crisis, our
exceptional measures - the ECB's "enhanced credit support" - served to prevent a systemic
liquidity crisis, enabled banks to continue functioning and helped to restore confidence.
Second, medical experience tells us that, over time, the continued administration of strong
painkillers can be harmful. They can create dependence - r even addiction - or the
recipients. Such medicine cannot be a permanent solution. It would eventually create new
problems.
By analogy, the exceptional support provided by central banks to the private sector must not
degenerate into long-term dependence of the private sector on such support. For that
reason, the current non-standard monetary policy measures will have to be progressively
phased out. Enhanced credit support is not for eternity. Financial institutions must prepare
themselves for an eventual withdrawal, which, as I have said on behalf of the Governing
Council, will be timely and gradual.
Third, looking forward, we know that "prevention is better than cure". "Preventive medicine"
reduces the risk of future recurrence of the illness.
Recent experience has offered important insights into how public policies and private
incentives can be improved so as to reduce the chances of recurrence. Through preventive
medicine, we must develop a fitter and healthier financial system.
So let me describe in more detail: how we have administered the "central bank medicine" to
the financial system; how we envisage continuing the treatment going forward; and what
lessons we are drawing for the future design of a preventive framework.
Emergency medicine: crisis management and "enhanced credit support"
It is natural to start with the "emergency treatment" that we have provided to the financial
system throughout the financial crisis.
The alertness of the ECB was reflected in its actions from the very moment that financial
tension first emerged. In August 2007 the ECB was the first central bank to respond, acting
within hours. In the ensuing months, we changed the timing and maturity of our liquidity
provision, so as to support the functioning of the money market. In addition, we offered
foreign currency liquidity to our counterparties.
The intensification of the crisis in mid-September 2008 brought soaring credit spreads,
dramatic declines in trading and a spike in volatility. In short, the global financial system
came close to seizing up.
Central banks stepped into the breach, addressing this unprecedented market failure. The
ECB was in the vanguard, acting to contain these tensions through both standard and
nonstandard policy measures
In full consistency with our mandate to maintain price stability, the Governing Council
reduced the ECB's key interest rates rapidly. The current very low level of interest rates is
unprecedented throughout the euro area. Together with our credible anchoring of inflation
expectations, these policy actions have resulted in a considerable easing of nominal and real
monetary conditions in the euro area.
Moreover, we have gone beyond standard interest rate cuts by adopting several
"nonstandard" monetary policy measures.
As I have described in the past, collectively these measures embody our policy of "enhanced
credit support": fixed-rate full allotment; expansion of collateral; lengthening maturities of
operations; liquidity provision in foreign currencies; and financial market support through a
measured but significant covered bonds purchase programme.
This policy has been designed to support the flow of credit over and above what could be
achieved through interest rate cuts alone.
Avoiding dependence and addiction: exit strategies
Emergency treatment and strong medicines are sometimes necessary. But, if their use is
prolonged, they can lead to dependence and even addiction. Eventually, the administration
of painkillers must be stopped if patients are to get back on their own two feet.
This brings me to the exit from our non-standard monetary policy measures. The rationale for
exit from these measures is the inverse of the rationale for their implementation. We have
introduced exceptional measures under exceptional circumstances. These measures will
have to be unwound when the situation normalises and the rationale for the measures fades
away.
The cornerstone of our exit strategy is its link to our primary objective of price stability. Our
actions throughout the crisis have been taken resolutely with this primary objective in mind.
Thus, any non-standard measure whose continuation would pose a threat to the
achievement of price stability must be undone promptly and unequivocally.
As I said on behalf of the Governing Council, looking ahead, not all our liquidity measures will
be needed to the same extent as in the past. Accordingly, we will make sure that the
extraordinary liquidity measures taken are phased out in a timely and gradual fashion and
that the liquidity provided is absorbed in order to counter effectively any threat to price
stability over the medium to longer term. By so doing, we will continue to ensure a firm
anchoring of medium-term inflation expectations. Such anchoring is indispensable to
supporting sustainable growth and employment and contributing to financial stability.
The financial system and individual institutions within it must act now to ensure that a future
removal of central bank support can be managed without painful "withdrawal symptoms".
Preventive care: lessons from the crisis
The overriding objective of someone recovering from a severe illness is not to suffer a
relapse. Unfortunately, there is no way of guaranteeing the avoidance of illness. But
"preventive medicine" is crucial in reducing the risk of recurrence.
We have to develop a new preventive framework to minimise the risk of recurrence. This
framework will have both monetary policy and regulatory dimensions.
"Leaning against the wind" in monetary policy
Recent experience has reopened the debate about whether central banks should use
interest rates to "lean against the wind" of asset price surges.
Prior to the crisis, conventional wisdom was sceptical about such an approach for three main
reasons: asset price misalignments or "bubbles" were seen as difficult to identify in real time;
it was doubted that interest rate increases of a plausible magnitude could contain surging
asset prices once these have achieved a momentum of their own; and third, it has been
argued that any damage to the economy stemming from an asset price correction can be
contained by prompt and aggressive monetary policy easing.
With these considerations in mind, a "wait-and-see" approach was seen as preferable when
addressing asset price surges.
Having spoken on these issues in the past, I do not wish to enter into a detailed discussion of
these arguments today. I only want to emphasise that recent experience has demonstrated
the limitations of a wait-and-see approach. Unprecedented policy action in response to the
financial crisis could not prevent a sharp fall in economic activity, with all the consequences
for the labour market, public finances and the society as a whole.
Moreover, a wait-and-see approach risks creating moral hazard. What is required is a more
symmetric approach: one that leans against the emergence of asset price booms as well as
dealing with the consequences of asset price busts. By encouraging more responsible
behaviour on the part of investors, such an approach should make such cycles of boom-bust
less likely.
But substantial practical questions remain. Clearly, central banks should not target, nor react
mechanically to, asset prices. Judgement is necessary in addressing asset price dynamics
within an overall framework geared to price stability.
At the ECB, our monetary policy strategy - with its medium-term orientation and focus on
monetary and credit developments - offers such a framework. It ensures that we consider
the implications for price developments at longer horizons of financial imbalances and asset
price misalignments, which may cumulate slowly.
Therefore, while vindication is a strong word, we feel encouraged as regards our monetary
policy strategy, whose underlying analysis we continuously deepen.
Concluding remarks
Let me mention that a number of institutional reforms to the supervisory framework within the
European Union are currently being finalised. We welcome the new macro-prudential
aspects of this framework. They will take concrete form in the creation of the European
Systemic Risk Board. The ECB and the EU national central banks stand ready to provide the
risk board with their full support.
The Systemic Risk Board will endeavour to provide early warnings and issue
recommendations that will help to prevent a renewed build-up of excessive risk in the
financial system as a whole. Such warnings would have been useful in the past: they
represent a crucial part of the preventive framework for the future.
While financial liberalisation, deregulation and innovation all have the potential to make our
economies more productive and more resilient, the financial sector must not forget that it is to
serve the real economy, not the other way around.
This, above all, requires a change in mentality within the financial industry itself.
Specifically, the financial industry has to increase transparency, strengthen its management
of liquidity and risk, and make its business models more robust. As I mentioned, while
maintaining the flow of finance to the real economy, financial institutions must continue to
strengthen their balance sheets, by improving their capital and funding positions.
The future will no doubt bring further challenges. As concerns the authorities, we will
continue to be alert and vigilant, as in the past. And our 330 million fellow citizens in the euro
area will surely not tolerate a relapse into excessive risk-taking at the taxpayer's expense.
Therefore, the financial sector has to secure its future in a responsible and sustainable way.
Thank you very much for your attention.