Vítor Constâncio: Catching-up strategies after the crisis
Keynote lecture by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the
Conference on European Economic Integration (CEEI) 2010, Vienna, 15 November 2010.
* * *
Distinguished guests, ladies and gentlemen,
It is a great pleasure to be here today to share some thoughts with you on the challenges to
the process of European economic integration in the aftermath of the global turmoil. The
financial crisis has exposed widely-held views on large domestic and external imbalances as
having several shortcomings, which has led to an overall reassessment of the associated
risks.
With regard to the process of European economic integration, the financial crisis has
undermined the staunch belief in a "development model", whereby low income countries in
central, eastern and south-eastern Europe (CESEE) could achieve rapid growth simply by:
(i) engaging in market-oriented reforms; (ii) liberalising trade; (iii) having access to foreign
capital markets via debt flows and foreign direct investment (FDI); and (iv) allowing the entry
of foreign banks. The associated growing imbalances were judged as temporary phenomena
associated with the catching-up process.
I will argue today that this development model should not be abandoned, but refined, as the
push towards market reform has engendered significant benefits. However, the global crisis
has shown that economic convergence in Europe should not be viewed as an automatic
process. In fact, stability-oriented policies and careful risk management should accompany
and support convergence efforts. With this in mind, I will focus on the following three aspects,
which highlight the role of policy in ensuring a sustainable development model:
1. A review of the growth experienced in CESEE countries in order to determine if any
general lessons can be drawn.
2. The role of the foreign banking sector in CESEE countries, which despite having
been beneficial overall for the catching-up process, may have contributed to
increasing domestic imbalances in some countries.
3. The establishment of a new macro-prudential and regulatory framework in the
European Union (EU).
1. The experience of growth in the CESEE region
Before the global financial crisis erupted, the CESEE region was experiencing an economic
boom, with rapid GDP growth that could be attributed to domestic and international factors.
The widespread and enduring process of convergence of living standards and prices towards
euro area levels prompted considerable optimism about the future. Market-oriented reforms
were a key feature of the development model that was followed in almost all EU CESEE
countries from the mid-1990s, spurring productivity gains and access to foreign technology
and capital. However, in most non-EU countries in the region, typically the catching-up
process gained speed only later. There was mounting evidence of a link between these
market reforms and long-term growth.1
However, developments in the region were not homogenous: over time a growing number of
countries showed increasingly visible signs of vulnerability. In particular, over the past
decade several countries recorded a deterioration in their current account deficits and price
competitiveness indicators. To a large extent, these developments were viewed as having
been predicted by economic theory and were thus often downplayed. The explanations
generally advanced to explain these developments were as follows:

capital is expected to flow "downhill" to countries where the rate of return is higher.
From an inter-temporal perspective this appears to be a reasonable argument.
Tapping foreign savings and accumulating external debt allows a country to finance
investment, smooth consumption, import technological know-how and expand the
ability of the export sector to penetrate foreign markets. The trade deficit is
eventually expected to turn into a surplus as exports rise and imports of capital
goods decline, leading to a gradual stabilisation and eventually to a fall in external
debt;

based on economic theory, a country is expected to experience real exchange rate
appreciation during the catching-up phase. This point is typically expressed in terms
of the Balassa-Samuelson effect or equilibrium exchange rate analysis, suggesting
that prices may converge to euro area levels if fundamentals improve. This benign
assessment was also reinforced by pointing to rising export market shares, which
was seen as evidence that overall competitiveness might even have improved.
While these and similar arguments had their appeal, in a sub-set of countries, inflation and
current account imbalances reached such high levels that an orderly self-adjustment
mechanism seemed increasingly unlikely. Nevertheless, access to international capital
markets continued without disruption and the cost of external financing remained low, thus
contributing to rapid credit growth. The risk of economic overheating was also fuelled by low
or, in some cases, negative real interest rates. It was particularly challenging to deal with
these phenomena in countries that had fixed exchange rate regimes, given the lack of an
autonomous monetary policy.
On the eve of the global financial crisis, different countries had accumulated different
degrees of external and internal imbalances. Taken as a whole, most of the CESEE region
was characterised by a sizeable contribution of private consumption to growth and an
increasingly negative contribution of net exports.2 The underlying causes of the shift from the
tradable sector to the domestic sector were rather country-specific. In some cases, it was
related to foreign funding, through bank lending or FDI, while in others, the main underlying
factor was domestic, in the form of rising government spending or a domestic credit boom.
As a result of both external and domestic forces, in some countries the situation appeared
out of control: inflation even surged to double digit levels, wages increased far above gains in
labour productivity and there were remarkable increases in asset prices, notably in housing
markets.
Let me now turn to the global financial crisis, which has made it clear that the risks
associated with growing imbalances such as those described above cannot be neglected. In
fact, after some initial resilience, the CESEE region was affected by the crisis particularly
strongly, even though it was not directly exposed to US markets.
As access to international capital markets was impaired, countries that were most in need of
external financing experienced larger welfare losses. A number of economies in central and
eastern Europe were affected less seriously, but recessionary forces were stronger in the
Baltics and south-eastern Europe, suggesting that it was the countries with the larger
imbalances that were typically most affected. In countries with fixed exchange rates with
limited room for manoeuvre through monetary policy, the adjustment process proved even
more challenging. In the absence of nominal exchange rate flexibility, prices and, in
particular, wages eventually had to be adjusted downward amid rapidly rising unemployment.
Looking back at what has happened since the crisis hit the region, it can be seen that a
considerable stabilisation effort has taken place. National and, in some cases, international
responses prevented the crisis from having a more disruptive impact, as the prevailing
exchange rate regimes were preserved and the banking sector showed considerable
resilience. Indirectly, unlimited liquidity provision by the ECB to banks established in the euro
area helped to secure funding to the region. The policy response to the crisis also varied
significantly depending on the scope for manoeuvre on both the fiscal and monetary front.
Fiscal policies have been tightened in some cases, financial conditions have stabilised and
there are now clear signs of a recovery in economic activity in most countries.
However, the impact of the global crisis and the years of exuberance proved very costly,
leading to a general sharp contraction in national output and a corresponding steep rise in
unemployment. Moreover, the ongoing de-leveraging process, the need to repair household
and corporate balance sheets, tighter bank credit standards, as well as rising long-term
unemployment could all slow the pace of the catching-up process in many CESEE countries
in the coming years. In the most severe cases, the process of unwinding of external
vulnerabilities is still underway.
Although the crisis has not undone the progress achieved on convergence over the past two
decades and past reforms have helped the stabilisation effort, important lessons should be
learned. The good parts of the development model pursued so far should be retained.
Countries in the region should not lose their appetite for structural reform and progress on
enhancing labour market flexibility, improving the business environment and preserving free
access to trade and financial markets. There is still a fundamental need to increase
productivity, promote innovation, as well as raise capital and labour participation. At the
same time, the crisis has clearly revealed that the catching-up process must go hand-in-hand
with macro and financial-oriented policies, while specific challenges remain for countries that
maintain hard pegs, which require adequate support measures.
2. The role of the foreign banking sector in CESEE countries
Let me now turn more specifically to the "parent bank" model in CESEE. At a broader level, it
is still controversial whether international financial integration and foreign banks have an
unambiguously positive effect on economies that are in the process of catching up.3
On the one hand, it is argued that the presence of foreign banks in the region has ensured
the availability of credit to the real economy and improved the efficiency of financial
intermediation process. In addition, the lending activities of foreign banks appear to be more
resilient to local shocks than those of domestic banks.4 It has also been found that the
region's resilience to capital outflows is related to a high level of financial integration and the
presence of foreign banks.5
On the other hand, other observers have argued that financial stress originating in EU parent
banks may have been transmitted to the CESEE region during the early stages of the crisis.6
Some also hold the view that parent banks from western Europe were fuelling local credit
booms and encouraged the use of unhedged foreign currency borrowing.7
As the crisis erupted, region-specific arrangements made CESEE countries more resilient to
the risk of sudden stops in capital inflows: under the umbrella of the International Monetary
Fund, the European Bank for Reconstruction and Development and the EU, the European
Bank Coordination Initiative - also known as the "Vienna Initiative" - enabled a dialogue
between parent banks, home and host supervisors, and relevant governments. This initiative,
in which the ECB participated as an observer, ensured that parent banks kept their exposure
to CESEE countries with large imbalances. Together with a strong commitment on the part of
home governments backing parent banks and thus indirectly the CESEE region, the Vienna
Initiative helped to maintain confidence in the banking sectors across the region. I should like
to take advantage of this occasion to congratulate those of you who were actively involved in
this initiative. In addition, I would like to emphasise the fact that the Vienna Initiative has
become a vehicle for public-private sector coordination, which could serve as a promising
model for overcoming the problems associated with collective action.
However, from a policy perspective, a number of challenges lie ahead. In particular, it is
important to assess the extent to which parent banks may have contributed indirectly to
financial stability risks via lending in foreign currency.8 Lending in foreign currencies to the
non-financial private sector is not an entirely new phenomenon in Europe, and in most
countries of the region such activities account for a significant proportion of the total lending
by banks. In some countries, lending in foreign currencies has led to a substantial build-up of
currency mismatches on private sector balance sheets. The increasing share of foreign
currency in total lending in countries in the CESEE region, in particular euro-denominated
lending, but also loans denominated in Swiss francs and Japanese yen, was accompanied
by a strong expansion in overall credit amid strong inflows of foreign capital attracted by
expectations of dynamic economic convergence.
Let me briefly elaborate on the implications of high dependence on foreign currency lending.
At the turn of 2008-2009, all countries with flexible exchange rate regimes experienced rapid
depreciations of their currencies vis-à-vis the euro. This inflated the local currency value of
foreign currency loans, and thus weighed on private sector balance sheets. However, low
market interest rates on foreign currency loans mitigated, to some extent, the increase in the
debt-servicing burden of borrowers. In an environment of rising interest rates on foreign
currency loans, this could have affected a significant proportion of the private sector and
could have posed a systemic financial stability risk in countries where foreign currency loans
accounted for a large share of total domestic lending. In addition, the major role played by
foreign currency lending has posed some challenges for the conduct of monetary policy. In
particular, the existence of a large stock of loans denominated in foreign currency has
weakened the ability of monetary policy to influence the economy through the interest rate
channel. Furthermore, central banks might have become hesitant to alter their policy stances
in the light of the possible adverse implications for financial stability stemming, for example,
from a downward pressure on the exchange rate.
A number of countries in the region have made attempts to address the risks related to
rapidly expanding foreign currency lending to unhedged borrowers. As standard policies
aimed at decreasing interest rate differentials and developing domestic funding markets
might take too long to achieve this goal, some countries in the region have introduced
different monetary policy, regulatory and administrative measures9 to address the risks
stemming from increased foreign currency lending. Practical experience with these measures
reveals that their effectiveness has been somewhat limited for a variety of reasons. In
particular, persistently wide differentials between interest rates on loans in domestic currency
and those in foreign currency have fostered demand for foreign currency loans, while
shortages of domestic savings denominated in local currency together with intense bank
competition underpinned their supply.10 In fact, as parent bank financing continued to be
mainly denominated in foreign currency, local subsidiaries avoided currency mismatches on
their own balance sheets by lending in foreign currency. In addition, when domestic lending
in foreign currency was made more costly, it was circumvented by cross-border lending.
Recently, authorities in some European countries (e.g. Austria and Hungary) introduced
stricter measures to limit further increase in foreign currency lending to domestic households.
These measures are mostly of an administrative nature and set limits on customer eligibility
to obtain a loan in foreign currency. However, these measures do not preclude domestic
customers in these countries from obtaining foreign currency loans directly from banks
domiciled in other countries.
It appears, therefore, that the issue of foreign currency lending requires a supranational
approach - at least at the EU level. More generally, in order to make the financial system
less prone to crises and ensure long-term sustainable growth, we are setting a broader policy
agenda for the EU as a whole by means of Basel III and the creation of a new
macroprudential supervisor in the EU.
3. Basel III and macro-prudential policy in the EU
During the recent crisis several gaps in the regulatory and supervisory framework for
financial institutions were revealed. It became apparent that the quality and quantity of the
capital base of many financial institutions were insufficient to withstand severe shocks. In
addition, the abundant liquidity that characterised the financial system in the years preceding
the crisis suddenly disappeared, exposing several institutions to liquidity shortages. To avoid
a complete financial meltdown, governments provided an unprecedented amount of financial
support and central banks had to significantly increase their provision of liquidity during the
initial stages of the crisis.
These events led to many different policy responses, resulting in a major overhaul of the
regulatory and supervisory framework. Under the aegis of the G20, a tremendous amount of
work has been done by the Financial Stability Board and the Basel Committee to reform the
regulatory and supervisory framework in order to address the core causes of the crisis. A
major component of this reform was the revision of the Basel II framework with the aim of
strengthening the capital base of banks and introducing stricter liquidity risk requirements
and an absolute leverage ratio.
The revision of micro prudential regulation - Basel III
The recent agreement reached on the Basel III framework and its full endorsement by the
Group of Central Bank Governors and Heads of Supervision is an important piece of work
that delivers on global financial reform and constitutes a cornerstone of the new regulatory
system.
The five main elements of the new framework are as follows.
First, under the new definition of regulatory capital, both the quality and consistency of the
capital base will be improved. This will help to ensure that sufficient high quality capital is
available when it is most needed, namely at times of stress. Particular emphasis will be
placed on the core elements of Tier 1 capital. Tier 2 capital elements will be simplified, and
existing Tier 3 capital will be abolished. Enhanced disclosure requirements will further
improve the transparency of the capital structure of banks. Overall, I am confident that
stricter conditions for what should count as regulatory capital will contribute to restoring
confidence in the ability of banks to weather future periods of stress. This in itself will
substantially reduce the probability of future banking crises, thus improving long-term
economic and social welfare.
Second, the introduction of counter-cyclical capital buffers should protect the banking sector
from periods of excessive credit growth. As witnessed during the crisis, the build-up of
excessive credit levels in an economic upturn is often followed by large losses on this
outstanding credit when economic conditions deteriorate. These losses may in turn have a
destabilising effect on the banking sector. The buffering mechanism consists of two
elements. First, a capital conservation buffer range - equal to 2.5% of risk-weighted assets
and made up of Tier 1 common equity - would be established above the minimum. The
second element, currently under development, consists of the possible extension of the
buffer range up to an additional 2.5% in periods of excessive credit growth (known as a
"counter-cyclical buffer"). An important additional benefit of this measure would be that it
might mitigate the credit cycle.
As a complementary measure to improving the quality and quantity of the capital base, the
third element of the framework consist of the strengthening of the risk coverage of the capital
framework by revising the prudential rules on securitisation and trading book activities, and
by putting forward proposals for the revision of the counterparty credit risk framework. This
would imply higher risk weights and thus result in higher capital requirements for these
activities.
Fourth, the planned introduction of a non-risk based leverage ratio should serve as a credible
supplementary measure to the risk-based requirements to contain the build-up of excessive
leverage and address model risks associated with the risk-based capital framework.
Last, but not least, since it constitutes a building block in the new framework, is the
development of a liquidity risk framework aimed at improving banks' resilience to liquidity
shocks. The liquidity risk framework consists of two main measures: a short-term measure
(Liquidity Coverage Ratio) establishing a minimum level of high quality liquid assets to
withstand severe stress over a one month period and a long-term measure (Net Stable
Funding Ratio) designed to ensure that the maturity structure of assets and liabilities are
better matched, requiring banks to fund long-term assets with more stable types of liability.
Work is underway on the important details and precise calibration of these ratios.
All of these new measures, which will be introduced over the agreed transition period, should
not have any unduly severe implications for the national banking system and will thus
support the nascent economic recovery.
Further work ahead
Although the agreement on Basel III constitutes a robust conceptual framework, much
remains to be done. Aside from the ongoing work concerning the introduction of
countercyclical buffers, more work also needs to be carried out on other important elements of the
framework.
In this respect, the potential implications of the leverage ratio and the liquidity risk framework
still need to be assessed. An observation period has therefore been agreed upon in order to
carefully monitor the potential implications for certain banking sectors, business models and
the real economy. Full use of the observation period should be made to identify any such
implications and to prevent the new measures from having any unintended consequences.
Furthermore, since the leverage ratio is largely based on accounting information, the
accounting standard-setters should strengthen their efforts to eliminate existing accounting
differences. This is essential in order to ensure a level playing field.
Work is also still underway on ensuring the loss-absorbency of all regulatory capital at the
point of non-viability. The Basel Committee has also decided at the level of Governors and
Heads of Supervision that systemically important financial institutions will be required to have
a higher loss absorbency capacity than the other institutions that are subject to Basel III. To
achieve this, banks would be permitted to use new instruments such as "contingent capital"
(coco) or bail-in bonds, which raises some issues. First, on a general level it is necessary to
assess whether these instruments can really provide a feasible funding alternative and foster
a robust investor response. If this is deemed the case, the precise features of these
instruments will need to be determined. Key design features include the event that would
trigger the conversion of the instrument, as well as the conversion price and ratio.
I should like to stress that a strengthened regulatory framework is necessary, but consistent
implementation and application of Basel III at the global level is of the essence to ensure a
level playing field and to avoid regulatory arbitrage causing any disruption in the future. In
this respect, I would like to underline the importance of adhering to the agreed transition
period, which was based on the outcome of the impact assessments and country-specific
considerations. In order not to compromise the economic recovery, any market pressure to
accelerate the implementation of Basel III would be detrimental to the overall objective of the
regulatory reform package.
Potential impact of Basel III
Allow me to say a few words on the potential impact of the Basel III framework on banks. It is
expected that banks engaged in different business activities will be affected differently. The
consensus view among market participants seems to be that the new stricter capital
requirements will have a bigger impact on universal banks, mainly as a result of the limits
imposed on the recognition of minority interest and the application of most regulatory
adjustments to and deductions from common equity Tier 1 capital. As a consequence, banks
that have significant holdings in other financial institutions and insurance companies will most
probably have to adjust to the new rules either by strengthening their capital base or by
revising their business activities. In this context, given the sizeable share of large,
internationally active universal banks in the region, the potential impacts of the new
measures on the financial systems and economies in CESEE have to be carefully explored
and assessed.
The new macro-prudential framework - ESRB
In parallel with the revision of the micro-prudential framework, extensive work is being carried
out at the regional, country and global levels on developing consistent macro-prudential
policy frameworks. The financial crisis has illustrated the importance of having an effective
macro-prudential oversight function to safeguard financial stability by proposing timely policy
responses. Macro-prudential oversight taking a system-wide perspective should complement
micro-prudential supervision, allowing the relevant authorities to assess and address
potential systemic risks.
The European Systemic Risk Board (ESRB) has been entrusted with responsibility for
macro-prudential oversight at the EU level, alongside other initiatives at the national and
international levels in this field. Under the new legislation, the ECB has been entrusted with
providing the ESRB with a Secretariat, as well as logistical, administrative and analytical
support. Similar frameworks were also created in the United States and the United Kingdom
with the close involvement of their respective central banks.
The macro-prudential oversight function of the ESRB is aimed at linking systemic risk
analysis with appropriate policy responses to address potential risks identified as material. It
therefore comprises both an analytical and a policy component. The analytical part focuses
on identifying, measuring and assessing the impact of potentially systemic risks, while the
policy part entails the calibration of policy instruments that could be implemented to address
the identified risks or mitigate their consequences.
More specifically, the first task of the ESRB will be to identify systemic risks. This will require
a broad and deep information basis, aided by a wide range of tools to process the relevant
data. Important ingredients for the analysis include market intelligence, rigorous monitoring of
financial stability indicators and financial market and economic developments at large. It is
important at this initial stage to cast the net as wide as possible to ensure that no risk is
overlooked. This type of analysis could be supported by early warning models and indicators
based on current data on financial or macro variables in order to identify early on where
imbalances may be building up.
Its second task will be to assess the severity of the risks identified and to evaluate the ability
of the financial system to absorb shocks. In this context, macro stress-testing models can be
used to assess the resilience of the financial system, as can contagion and spillover analysis
to evaluate propagation mechanisms and their potential impact on the financial sector or the
real economy.
Finally, the ESRB will use the outcome of the risk assessment for possible risk warnings or
policy recommendations, which will need to be concrete and well targeted.
The ESRB will be in a good position to perform all of these tasks and to address in a timely
fashion potential systemic risks, such as those related to the rapid expansion in foreign
currency lending to unhedged borrowers in the CESEE region. Addressing the problem at
the EU level will allow different measures to be implemented on a consolidated basis, thus
addressing all of the relevant financial sector players active in the region, ensuring that
macro-prudential policy across the EU is consistent and minimising cross-border and
crosssectoral policy circumvention.
In short, the establishment of the ESRB will introduce a new policy function at the EU level
with great potential for enhancing the ability of European and national authorities to
safeguard the stability of the EU financial system as a whole. It is recognised that the design
and implementation of this new EU macro-prudential policy function pose a considerable
challenge. However, with the necessary preparations, which are currently underway in close
cooperation with all involved parties, the ESRB is assured a smooth start in 2011.
Ladies and gentlemen, let me conclude by saying that the crisis has revealed that the
catching-up process in CESEE countries must go hand-in-hand with prudent macro and
financial sector policies, and this lesson also applies to all countries in the EU. The
achievement of high rates of growth cannot be detached from stability-oriented policies and
careful risk management. To this end, policy-makers will be engaged in the task of designing
coherent policy frameworks for some years to come.
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