José Manuel González-Páramo: The role of information and
communication in central bank policy - the experience of the recent
financial turmoil
Keynote address by Mr José Manuel González-Páramo, Member of the Executive Board of
the European Central Bank, at the SUERF Conference on "Tracking Financial Behavior:
Where do Macro and Micro Meet?", Milan, 3 December 2007.
* * *
Ladies and Gentlemen,1
I am very pleased to be able to speak at this prestigious SUERF conference today. As a
policy-maker at an institution with responsibilities in both the areas of statistics and market
operations, I am particularly pleased to see that much high-quality work is being done to
improve and deepen our understanding of financial activity. The recent turmoil in financial
markets has reminded us of the importance of timely access to accurate and comprehensive
information on financial events as well as of the need to ensure that financial development
and innovation are accompanied by advances in financial statistics.
Let me take the liberty to narrow my intervention from the rather general issues suggested by
the programme to the more specific subject of the role of information and communication in
the recent financial turmoil, particularly for the implementation of monetary policy.
Information asymmetries
When talking about information in the context of the financial turmoil, a key dimension of
interest regards the role of informational asymmetries in the money markets (though I will
often refer to the euro money market, it goes without saying that the issue of information
asymmetries and adverse selection equally applies to money markets in other currency
areas). Indeed, during the current turmoil widespread uncertainty about the distribution of
exposures to sub-prime losses across financial institutions has led to the inability of
distinguishing sound from unsound financial institutions, almost bringing inter-bank trading to
a halt in August.
The disruptions to inter-bank trading were compounded by banks' uncertainty about their
own liquidity needs reflecting various factors: (1) difficulties in tapping market funding
sources (particularly the US dollar-denominated asset-backed commercial paper market), (2)
larger than anticipated recourse by investment funds to committed credit lines, and (3) at
least for some banks, uncertainty about the possible need to take over struggling off-balance
sheet conduits and structured investment funds.
Although the interventions by the ECB have since had a stabilising effect on the euro money
market rate at the very short maturities and, more generally, this market has recovered some
of the lost ground, lack of confidence among commercial banks continues to restrict trading
activity and inflate counterparty risk premia (particularly in the unsecured term money
market).
The persistence of difficulties in the term money market, despite the existence of sufficient
aggregate euro liquidity, points to an important limitation for public policies (and expectations
about such policies) in the current environment, namely that central banks cannot and should
not be expected to solve the more fundamental problems of commercial banks and credit
markets.
Through their liquidity management policies, the ECB and other central banks can certainly
ease some of the liquidity difficulties faced by banks, but they cannot certainly restore the
efficient functioning of the term money market. The current difficulties in this market will
subside only when banks regain confidence in each other and the uncertainty about their
own liquidity needs diminishes. This is likely to occur only when enhanced transparency and
more extensive disclosures are made available to market participants, investors and
regulators by both banks and non-regulated entities, thereby dispelling the current state of
perceived opaqueness and uncertainty.
The market turmoil and available information
Let me now address another key aspect of information during the recent turmoil.
Policymakers normally work under conditions of partial and incomplete information. However,
policy-making becomes significantly more challenging at times of market stress, when
historical regularities cannot be entirely relied upon, while increased volatility blurs the
information content of market variables and other indicators.
In periods of stress, analytical tools that under normal conditions provide valuable inputs into
the information set available for policy decisions may at least to some extent lose their utility.
And although comparisons with previous episodes of turmoil may add historical perspective
and provide benchmarks for policy actions, spells of financial tensions often resemble each
other only to a limited extent. Indeed, when thinking about the dynamics of financial turmoils
and crises, one is tempted to recall the Ana Karenina's opening that "All happy families
resemble one another, but each unhappy family is unhappy in its own way."
Indeed, the current turmoil has been "unhappy" in its own way. From its origin in the relatively
small sub-prime segment of the US market for mortgage loans to its somewhat unusual
dynamics of transmission (for instance, the fact that the current turmoil initially manifested
itself in the difficulty for banks, mainly European, to obtain short-term liquidity in the US dollar
market), a number of factors have set this episode of turmoil apart from previous
experiences.
Thus, during the current turmoil we have been less able to rely on standard analytical tools
and conventional information sets, particularly in the area of liquidity management.
To illustrate this point, let me briefly recall how our liquidity policy normally works. In normal
times, the ECB calculates each week the expected liquidity needs of the banking sector and
publishes an estimate of the "benchmark" amount of liquidity needed. This benchmark is
calculated under the assumption that banks prefer to fulfil their reserve requirements
smoothly by holding, in aggregate terms, the same level of current account holdings with the
central bank on each day of the reserve maintenance period. The ECB then provides an
amount of liquidity close to the "benchmark" in its weekly liquidity operations (the so-called
"main refinancing operations").
This pattern of liquidity provision has functioned well in the past, when it has succeeded in
delivering short-term money market rates close to the target rate corresponding to the
announced monetary policy stance. However, since 9 August when the tensions in financial
markets first spilled over to the short-term euro money market, an increase in precautionary
demand for liquidity and a change in the temporal pattern of liquidity demand within the
reserve maintenance periods have altered the behaviour of banks, temporarily rendering the
assumptions underlying the "benchmark" computations less realistic.
As a result, while maintaining entirely unchanged the structure of its operational framework
(a testimony to the flexibility and resilience of this framework), the ECB has somewhat
departed from the regular patterns of liquidity provision that it normally follows in order to
steer the very short-term money market rates. Thus, in order to satisfy the banking sector's
demand for liquidity buffers on particular days and for fulfilling reserve requirements earlier in
the maintenance period, the ECB has (1) occasionally provided liquidity to the market
through exceptional operations,2 and (2) it has changed the time patterns of liquidity
provision within the reserve maintenance period.
In addition, from the start of the market turmoil the ECB has intensified its communications
with market participants so as to indicate its alertness and readiness to act in order to reduce
the volatility of the very short term interest rates around the target rate and to contribute to
the smooth functioning of the money market. For instance, last Friday we published a press
release pointing out that the ECB's Governing Council has noted that market participants are
concerned about conditions in the euro money market in connection with the upcoming end
of the year; and announcing the decision to lengthen the maturity of the main refinancing
operation settling on 19 December 2007 to two weeks so that it matures on 4 January 2008.
In this refinancing operation, we will aim to satisfy the banking sector's liquidity needs for the
entire two week period, covering both the Christmas holidays and the end of the year.
This example provides a good illustration of the importance that the ECB has attached in
recent months to intervene in money markets through a combination of flexible liquidity
management operations and regular communications.
And, of course, the need to communicate more frequently has also reflected the deviation
from standard liquidity management practices. By extensively communicating about future
refinancing operations and the general orientation of our liquidity policy, we have aimed to
facilitate and accelerate the process of learning by banks about how we intend to implement
monetary policy under the current conditions of market stress.
Challenges for monetary policy implementation under stress
As I will explain below, the current turmoil has also confronted us also with more general
communication challenges, but let me first elaborate on some of the challenges that our
liquidity management policy has faced during the recent turmoil.
In normal times, the soundness of a central bank's operational framework and the
experience of both the central bank and market participants ensure that the implementation
of monetary policy works smoothly. However, as I mentioned earlier, under stress conditions
some of the principles usually guiding the implementation process may function differently. In
this respect, particularly important for a central bank is the case of changes in the
determinants of short-term interest rates.
In normal times, the behaviour of the overnight rate is fairly well understood. In a system with
reserve requirements, the possibility to average reserve holdings over a maintenance period
supports a stabilization of short-term interest rates, because day-to-day fluctuations of
liquidity conditions can be smoothed out over the remainder of the period. Expected liquidity
conditions on the last day of the maintenance period, when averaging is no longer possible,
anchor interest rates of that day, and - via the so called "martingale hypothesis" - also of the
preceding days.
The present turmoil shows, however, that at times of stress, the strength of the martingale
hypothesis may weaken. Interest rates may no longer be necessarily linked to liquidity
conditions on the last day of the maintenance period as banks do no longer regard reserve
holdings across different days of the maintenance period as substitutes.
Implementing monetary policy in these conditions can be challenging for a central bank,
especially since it can not use its regular procedures for estimating the demand for liquidity -
not least in the absence of any relevant empirical references. This is the main reason why
the ECB conducted the very first of its fine-tuning operations during the turmoil (on 9 August)
through a fixed rate tender with pre-announced full allotment. At that point in time, it was
assessed that the market was in a better position than the ECB to judge which amount would
bring interest rates back to the desired level. To some extent, the resulting amount was taken
as guidance for successive allotments carried out in the format of variable-rate tenders,
which were reduced in size, in parallel with a temporary easing of tensions at the shortest
end of the money market term structure.
More generally, at times of market stress, a central bank has to operate in an environment
characterized by an extreme level of unrest, in which interest rates are much more volatile
than usual, and the martingale property loses its power to tie interest rates to the desired
level. In such conditions, central banks can act quickly only if they have access to timely and
accurate information. Indeed, differences in the speed, frequency and magnitude of
interventions by central banks during financial turbulences can be due not only to structural
distinctions in the banking sectors or in the operational frameworks and policy principles of
the central banks, but might more simply reflect differences in information sets.
Let me at this point briefly recall some of the main sources of information of interest for the
Eurosystem in the current turmoil.
Market intelligence. Over the last few months we have extensively used market information
and activated our regular communication channels with the banking and financial industry.
Particularly useful in this context has been the work of the Money Market Contact Group, a
discussion forum on issues related to euro money market gathering representatives of the
central banks of the Eurosystem and of the commercial banks from all over Europe. Since
the outbreak of the financial tensions, this Group has solidly worked to gather and share
information on developments in the euro area money market and has also provided us with
useful feedback on the effect of the ECB's money market operations.
Statistical information. The ECB has also benefited from the wealth of harmonised area-wide
financial, banking and monetary statistics that the Eurosystem has developed over the last
decade as well as from the recently released quarterly integrated accounts. In addition, very
useful information has been collected through surveys (notably, the Bank Lending Survey).
Information exchanges with other central banks. During the current turmoil information has
been extensively shared and discussed within the central banking community on a wide
range of issues, from very technical and operational to more policy-relevant considerations.
Especially at the onset of the tensions, the consultations among the relevant central banks
were very intense and particularly useful to assess the extent of the turmoil accurately and
rapidly.
Information exchanges among European authorities. During a market turbulence like the one
we have recently witnessed, it is crucial to assess in a timely and comprehensive fashion the
implications of the turmoil for the banking and financial industry and, ultimately, for the
economy as a whole. In this context, it is important to ensure that the responsible public
authorities, notably central banks and supervisors, have the adequate procedures and
infrastructure in place to share the relevant information among them. This is necessary for
assessing, determining and calibrating the appropriate policy measures, as those taken by
the Eurosystem to address the market turbulence.
All in all, the turmoil has confirmed a number of strengths in our information-exchange and
statistical arrangements. At the same time, it has revealed some information gaps and
weaknesses that will need to be addressed once we draw the main lessons of the current
turmoil. Indeed, it has been suggested that insufficient information has been the main reason
why problems originating from the relatively small sub-prime segment of the US mortgage
market have had such widespread consequences.3
For instance, the turmoil has revealed information gaps related to the valuation of illiquid
complex structured products or the assessment of the concentrations among various types of
collateral - including sub-prime - within structured finance securities. Besides, the turmoil
has shown that there is a need for credit rating agencies to provide also information on the
liquidity risks associated with structured investment products. In addition, the turmoil has
confirmed that the significant lags in the release of some statistics, for instance those on
integrated accounts, reduce our ability to use them in real time.
Challenges for communication under stress
As I mentioned earlier, implementing monetary policy under stress poses special challenges
for communication. Indeed, following deviations from the standard practices and the setting
in motion of a learning process, central banks must re-establish a "reputational equilibrium"
with their counterparts. In fact, the reason why in normal times the martingale property
delivers interest rates close to the policy rate is to a large extent because market participants
have learned to form, over a long period of time, correct expectations about the central
bank's liquidity policy. And, at the same time, market reactions to its open market operations
are somewhat predictable for the central bank.
However, once the usual pattern of liquidity provision is broken, it is difficult for the market to
converge quickly to a new behavioural equilibrium since an adequate level of confidence and
knowledge needs to be first restored on both sides. Through communication and renewed
predictability in its liquidity policy, a central bank can though succeed in restoring such
equilibrium.
Let me now move to two - less operational - challenges that we have faced in the
communication of our interventions during the present turmoil: (1) the "moral hazard" critique;
and (2) the need to underscore the distinction between liquidity management and monetary
policy.
The moral hazard critique
Some observers have recently criticised recent measures by central banks, including those
taken by the ECB, on the grounds of moral hazard considerations. According to these critics,
by reacting to the financial market tensions, central banks may contribute to "bailing-out"
those who have triggered the tensions through excessive risk taking.
It is true in my view that moral hazard issues need to be taken into account very seriously
when central banks decide on measures to support the financial system in a situation of
market turmoil. Of course, any such support policy, if anticipated, will be taken into account
when banks establish their risk management frameworks for "tail" events.
Still, one cannot generally conclude from this that central banks should not re-act and
support the system in the case of severe tensions. To rigorously analyse moral hazard
issues relating to financial crisis management by central banks, one first needs to distinguish
between different but interrelated types of policy interventions. The reason for this is that the
possible effects on incentives of different measures can be very diverse. However, this
differentiation has often been missed when criticising central bank actions on the grounds of
moral hazard considerations.
Let me distinguish briefly between four possible types of central bank measures:
First, moral hazard issues have been raised in relation to the case in which the central bank
lowers its key policy rate in response to financial turmoil. It has been argued that, if central
banks lower interest rates at a time of market corrections and declining asset prices,
economic agents may believe that the policy-makers are prepared to use monetary policy to
support asset price valuations in order to prevent market downturns. If such belief becomes
widespread, investors are likely to engage in excessive risk-taking behaviour, thereby sowing
the seeds of future financial crises. In addition, if central banks are perceived to assign
higher priority to supporting asset prices than to safeguarding price stability, inflation
expectations may be adversely affected and even become disanchored.
Let me say clearly that I consider a situation in which the central bank would reduce its
interest rate with a view to strengthening asset prices and banks' balance sheets as purely
hypothetical and, in the case of the Eurosystem, simply unthinkable. This is a situation that
would obviously open up issues of moral hazard and that no central bank committed to price
stability would ever contemplate.
This discussion reminds me of a famous article by Alan Blinder, the former Fed
ViceChairman.4 He notes that academic economists are always concerned about the inflationary
bias problem, that is the fear that central bankers may be constantly tempted to engineer
inflation surprises in order to achieve sustained short-term employment gains, without
realising that in the long run they would simply create higher inflation. Blinder reassures
these concerns by observing that "during my brief career as a central banker, I never once
witnessed nor experienced this temptation". Let me then borrow Blinder's words and use
them to reassure the concerns of those who believe that we might be tempted to temporarily
forgo our commitment to price stability out of worries about financial market developments:
this is a temptation that neither I nor my colleagues at the ECB's Governing Council have
ever experienced.
At the same time, a different issue is when financial turbulences develop into a fully-fledged
crisis and eventually affect growth prospects, therefore lowering the level of the short term
interest rate considered to lead to price stability in the medium term. I find it difficult to see
any moral hazard issue arising from this type of central bank action. Losses of individual
banks stemming from imprudent risk management will not be suppressed by such a lowering
of central bank key policy rates. Adjusting the monetary stance as a reaction to
macroeconomic developments, so as to achieve the ultimate goals of monetary policy, can
never be rejected on the basis of moral hazard considerations.
Second, moral hazard issues have been seen in the context of aggregate liquidity injections
through open market operations. I am not entirely sure that I see the moral hazard dimension
in these measures.
In times of money market tensions, inter-bank interest rates may move to levels above the
target rate set by the central banks, if the profile of the liquidity supply by the central bank is
unchanged. Therefore, it is natural for a central bank to re-adjust the profile of liquidity supply
to demand in order to stabilise short term inter-bank rates around their target.
In this regard, let me already hint at a point that I will discuss later, namely the need to
distinguish between monetary policy stance and monetary policy implementation. In other
words, we need to distinguish clearly between: (1) on the one hand, the task of defining and
communicating the target level for short term interest rates, and (2) on the other hand, the
task of achieving this level in the inter-bank market.
Moreover, taking into account the fact that the Eurosystem has not increased the supply of
liquidity, but has only adapted the profile in terms of maturity and timing in the course of a
reserve maintenance period, it becomes clear that the re-alignment of market rates with
central bank target through open market operations cannot contain losses of individual banks
stemming from imprudent risk management. Rather these liquidity policy measures should
be seen as a continuation of the practice in normal times to align liquidity supply with liquidity
demand, the only exception being that, under the current circumstances, it has not been
possible to estimate the latter by means of the regular liquidity analysis.
Third, concerns about moral hazard issues have been raised in the case of a reduction of the
penalty rate associated with the recourse to a central bank borrowing facility, such as the
discount rate or the marginal lending rate. The case there for moral hazard is not entirely
obvious to me at least as long as (1) such a reduction is a measure used to steer short-term
inter-bank rates close to the target level and (2) as long as the rate of the borrowing facility is
in any case close to the target rate - e.g. one percentage point or less - so that a reduction
has no substantial impact on the profit and loss accounts of banks. In this regard, the recent
money market tensions have confirmed the importance for the effective liquidity management
of banks of enjoying unimpeded access to borrowing facilities.
The fourth potential moral hazard issue is a widening of the set of eligible collateral in a
central bank's monetary policy operations. Admittedly, this type of measure could have moral
hazard implications, particularly (1) if the general widening of the collateral set in fact targets
a small number or, say, even a single bank under liquidity stress, which is rich in the specific
type of additional collateral; and (2) if the central bank offers facilities, for instance a standing
borrowing facility, to effectively refinance such collateral. This type of action invites moral
hazard as it may indeed be decisive to establish whether the single bank fails or not, while at
the same time sparing to the banks' management and shareholders the substantial costs
associated with resorting to real emergency liquidity assistance.
Therefore, a widening of the collateral set accepted for monetary policy purposes should
probably only be considered if this measure would substantially help a significant number of
banks and if the set of assets were very narrow. In this case the lack of collateral obviously
seems to be more of a systemic issue, and the central bank should consider taking action.
In this respect, let me underscore two features of our collateral framework that have served
us well in the recent period. First, access to funding is available to a broad set of
counterparties. And second, the Eurosystem - whilst requiring high-quality standards -
accepts a broad range of public and private fixed-income securities, as well as
nonmarketable assets. Hence, sufficiency of collateral has not been an issue for the Eurosystem,
even at the peak of the refinancing needs during the turmoil.
Finally, moral hazard is a potential issue in individual banks' emergency liquidity assistance.
But here, it is up to the central banks and supervisors to ensure that in particular senior
management and equity holders, and possibly debt holders, pay a sufficient price for the
rescue. This issue has been discussed at length in the literature, the bulk of which
convincingly argues that moral hazard issues can be taken into account in a satisfactory way
in the design of the rescue mechanism.
So, to conclude on the moral hazard topic, I would say that, in order to draw meaningful
conclusions, it is important to distinguish between the very different possible types of
financial crisis management measures available to central banks. When assessing and
choosing among these different measures, it is necessary to take into account the
implications for both the central bank and for its counterparties, including the future
incentives of the latter, in order to achieve, overall, the most efficient allocation of resources.
Separation of liquidity management and the monetary policy stance
Finally, a frequent focus of our communication during the turmoil has been the importance of
distinguishing between interventions related to liquidity management and changes in
monetary policy stance.
It is very important for the public to understand that the implementation of technical
measures related to liquidity management during the current turmoil has been completely
separated from any considerations on the monetary policy stance. Contrary to the occasional
public perception, these operations have had no effect on the overall liquidity supply to the
banking sector. Overall, the amount of liquidity provided within the various maintenance
periods since the start of the turmoil has remained unchanged. Instead, the liquidity provision
has been to some extent simply brought forward in time within each period, thereby simply
representing a shift in the time path of liquidity supply within the reserve maintenance period.
Also, it is important to understand that the interest rates at which the fine-tuning operations
and the supplementary longer term refinancing operations were settled contain no
information on the future monetary policy stance, since the ECB acted as a rate taker in
these operations.
The need to understand the difference between technical liquidity provision measures and
changes to the monetary policy stance is particularly important in the current environment,
since the turmoil in money markets has occurred at a time of increasing concerns about
rising inflationary pressures and deteriorating outlook for inflation. In this context,
misunderstandings about the purpose of our liquidity interventions might adversely affect
inflationary expectations.
Conclusion
Let me conclude by emphasising that the recent market developments have stressed the
importance for policy-makers to have access to timely and accurate information on financial
developments, and to set up mechanisms that facilitate the smooth and rapid exchange of
information among market participants, central banks and other authorities. The recent
turmoil has also highlighted the importance of effective communication for central banks, in
order to provide guidance about the principles informing their liquidity management
interventions under market stress conditions, and to dispel undesirable misunderstandings
about the reasons why these interventions are taken.
We are only starting to draw lessons from the recent financial turmoil, but we can pretty sure
that the need to fill information gaps and enhance market transparency will figure prominently
among them. Events like this conference can prove of great help for the purpose of defining
more precisely those gaps and to show the way forward.
Thanks very much for your attention.