José Manuel González-Páramo: The financial market crisis, uncertainty
and policy responses
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the IE Business School Annual Alumni Conference, Madrid,
21 November 2008.
* * *
1. Introduction
Ladies and Gentlemen,
It is a great pleasure for me to participate in the Annual Alumni Conference of the IE
Business School and share with you some considerations about the impact of uncertainty on
international financial markets and the responses by central banks, particularly by the ECB,
and by governments from all over the world.
One of the most relevant features of the current turmoil has been the role of uncertainty both
within the financial sector and toward the financial sector. Indeed, the events over the last
fifteen months have shown that, despite regulatory advances and technological progress in
the financial sector, a number of weaknesses in key areas related to transparency, such as
valuation practices and disclosure standards, are at the root of the financial market turmoil
and have had major repercussions for the smooth functioning of key markets and institutions.
In my intervention today I will briefly recall the dynamics of the financial market turmoil. I will
then highlight the role of uncertainty during the turmoil and the way central banks and other
authorities have responded to the challenges posed by the developments in the financial
system. Finally, I will make some concluding remarks.
2. The financial market turmoil
As we all know, in August 2007 the global financial system entered a period of considerable
turbulence that started with a liquidity squeeze triggered by rising delinquencies in the US
sub-prime mortgages, and led to significant disruptions in various segments of the financial
markets.
More than one year later, the global financial system is still undergoing a correction process,
and money and credit markets are suffering from lack of confidence on the precise impact of
the turmoil on the robustness of financial institutions and their ability to weather the current
shocks.
More generally, most segments of the global financial system continue to function under
stress. While much progress has been made in the efforts to identify and value the
exposures to complex securities that have been in the epicentre of the turbulence in the
markets, uncertainty still remains about the losses that will ultimately be suffered by investors
and financial institutions across the globe.
Many financial institutions are under very high pressure to clean their portfolios and to
strengthen their capital base, reinforcing the rapid de-leveraging process already underway.
In addition, in the months following the takeover of Bear Stearns and the collapse of Lehman
Brothers, the financial market turmoil intensified again and underwent a more damaging and
disruptive phase in which large financial institutions failed or had to be rescued by either their
private counterparties or public authorities, while the viability of the investment banking
industry as a whole and of "the originate to distribute business" business model was put into
question.
At the same time, a number of international financial markets - particularly the markets for
equities in developed and emerging economies, currencies as well as commodities and other
industrial raw materials - have experienced a significant increase in volatility. Of particular
concern for central banks has been the re-emergence of significant tensions in global money
markets, where market liquidity has come under severe strain and term interest rates remain
at elevated levels.
Before talking about what central banks and other public authorities have done to address
the challenges posed by the financial market turmoil, let me take a step back and elaborate
on the role of uncertainty in the current turmoil.
3. The role of uncertainty
One of the most relevant features of the current turmoil has been the enormous increase in
general uncertainty related to the financial sector and the heightened degree of what
economists call "asymmetric information" in credit markets (for instance, the fact that
borrowers have more or better information than lenders about the potential returns and risks
associated with the project for which they demand financing).
In the current context, uncertainty mainly relates to imperfect information in relation to credit
valuations. Uncertainty generally increased during the summer of 2007, because market
participants realised that the current practices used for valuations - often based almost
solely on ratings - were no longer valid. With liquidity strains characterising certain market
segments, it became impossible for financial firms to properly value a range of financial
assets and off-balance sheet exposures using the existing standards on valuation and
accounting.
As a result of widespread uncertainty about credit valuations, market participants found it
difficult to model the expected occurrence of defaults, which led to wider credit spreads.
Another typical effect of increased uncertainty was the flight-to-quality phenomenon in favour
of government bonds as well as cash and bank deposits.
In addition, lack of transparency throughout the securitisation process (the process by which
credit claims are engineered into complex structured products) made it difficult for market
participants to identify where the risks were accumulating in the financial system and to
assess the possible losses from these exposures. Not surprisingly, efforts by public
authorities at the international, European and national level (notably, the Financial Stability
Forum report) to identify measures aiming at restoring confidence and enhancing the
resilience of the financial system, have stressed the need to address weaknesses in
valuation practices and to enhance market transparency.
During the current turmoil, uncertainty about the size and location of losses created by the
opaque transfer of credit risk brought about by complex securitisation mechanisms has
aggravated the adverse selection problem typical of credit markets, rendering it increasingly
difficult for market players to distinguish between solvent and insolvent borrowers (an
application of the so-called "market for lemons" problem). Such uncertainty has heightened
counterparty credit risk concerns, inducing banks to demand high risk premia of their
creditors, while discouraging them from lending to each other.
Thus, increased uncertainty has led to the protracted "freezing" of the interbank lending
market. This has translated into funding liquidity problems for individual banks, i.e. difficulties
in funding their business activities. As the degree of funding liquidity of banks, especially
large banking groups, depends on the liquidity of the credit and securities markets they rely
on for their external financing, funding liquidity and market liquidity are in practice
interrelated. Indeed, some economists have developed models in which market and funding
liquidity reinforce each other, leading to the emergence of "liquidity spirals" that may account
for some of the declines in the liquidity of markets and individual institutions observed from
the start of the crisis.
Protracted market illiquidity can also have potential negative repercussions for the banking
sector and the economy as a whole. In fact, under normal market conditions, market
illiquidity is typically short-lived, particularly since it creates profit opportunities for traders
who, by providing extra funding liquidity, support the price discovery process and restore the
smooth functioning of the market. In contrast, during a severe turbulence the disruption of the
mechanisms channelling liquidity - be it through assets prices or the balance sheet of
financial institutions - may also deeply and lastingly weaken the balance sheets of financial
institutions and undermine their solvency, ultimately creating systemic risks for financial
stability.
4. Policy responses from the Eurosystem and other central banks
The general increase in uncertainty has affected the work of central banks via its impact on
monetary policy formulation, implementation and transmission.
Let me give you three examples of how uncertainty affects the conduct and implementation
of monetary policy in the euro area.
•
The intensification and broadening of the financial market turmoil has led to an
extraordinarily high degree of uncertainty surrounding the outlook for economic
growth and medium terms price stability in the euro area, which poses challenges
for the formulation of monetary policy.
•
As a result of increased uncertainty and the changing environment, the ECB cannot
longer rely on some of the liquidity management tools and procedures that had
previously served it well in order to implement in the money market the monetary
policy stance decided by the Governing Council.
•
Besides, increased counterparty credit risk and developments in the financial
system have impaired the functioning of the money market, which represents the
first step of the monetary policy transmission mechanism.
Along these lines, let me explain how central banks have responded to the challenges arising
from market turmoil using a combination of operational measures and increased international
co-operation.
Main challenges to central banks
In general, public policy responses to the financial market turmoil and the ensuing problems
for the banking systems have focused on addressing three key sources of concern: market
liquidity, funding and solvency.
As earlier mentioned, these three dimensions of the turmoil are not entirely disjointed.
Indeed, the current turmoil has brought to the fore the enhanced interaction between market
liquidity and funding liquidity of individual institutions, partly reflecting the trend among large
global banks towards greater reliance on wholesale market sources for funding as opposed
to retail deposits. In addition, the experience of some financial institutions in recent months
has shown that protracted illiquidity may weaken the balance sheets of institutions and in
extreme cases put their solvency at risk.
Against this background, central bank interventions have aimed to address funding liquidity
shortages by supporting market liquidity. In doing so, they have contributed to preventing
insolvencies. Of course, this does not mean that central banks have targeted individual
counterparty solvency concerns, which is of course a task which falls within the reach and
responsibilities of governments rather than central banks.
Policy responses from central banks
The responses have varied across central banks depending on the conditions of domestic
money and credit markets as well as on their specific institutional frameworks. However, in
general, the responses from central banks have mostly consisted of the following categories
of interventions:
• Active liquidity management: central banks have acted to keep short-term money
market rates in line with their policy rates (or targets) through more active reserve
management, thereby flexibly responding to shifts in the demand for reserves.
•
Enhanced liquidity provision: central banks have sought to ease pressures in
broader funding markets through a combination of measures, such as an increased
supply of longer-term funds, the expansion of collateral accepted in lending
operations, and the widening of the range of counterparties that may have access to
collateralised lending. In some cases, central banks have also extended lending to
non-depository banks and to financial institutions other than banks.
•
Support to market trading activity: some central banks established securities lending
facilities to improve the functioning of interbank repo markets.
•
Increased cooperation: central banks have increased their co-operative efforts both
through enhanced communication and collective market monitoring, and through
coordinated actions to provide both overnight and longer-term funds.
• Emergency liquidity assistance: in a fortunately limited number of episodes, central
banks have assisted their domestic governments in providing emergency liquidity
assistance to institutions under stress.
In addition, several central banks - including the ECB - have also adjusted their monetary
policy stance to take into account the impact of the financial market turbulences on inflation
and real activity.
In particular, in response to changes in the outlook price stability in the euro area, the ECB
announced on 8 October a 50 basis point reduction (to 3.75%) in its key policy rate - the
interest rate on the main refinancing operation - in a move coordinated with five other major
central banks. A further reduction by 50 basis points (to 3.25%) was decided on 6 November
against the background of a further alleviation of risks to price stability at policy-relevant
horizons at a time when weakening demand and the intensification and broadening of the
market turmoil implies the materialising of some downward risks for economic growth.
Responses of the Eurosystem
Having briefly mentioned the adjustment to the euro area monetary policy stance, let me now
discuss how the Eurosystem has responded through operational measures to the challenges
stemming from the financial market turmoil.
As a starting point, it is worth recalling three key features of the Eurosystem's operational
framework that have played a role in shaping the response to the turmoil in the euro area.
The Eurosystem: (1) grants access to central bank liquidity to a very large range of
counterparties; (2) accepts a rather wide spectrum of private and public collateral in all
classes of lending operations; and (3) conducts open market operations on a relatively large
scale.
These features of the operational framework have allowed the Eurosystem to resort to a
more pro-active liquidity management in order to achieve two objectives:
1. to keep the very short-term money market rates in line with the chosen policy rate,
thereby delivering the desired monetary policy stance, and
2. to ensure the smooth functioning of the market, thereby contributing to preserving
financial stability.
In particular, since the outbreak of the turmoil in August 2007 the Eurosystem has adjusted
the distribution of euro liquidity supplied over the course of the maintenance period by
frontloading the supply of liquidity at the beginning of the period and reducing it later in the
maintenance period. Furthermore, it significantly increased the amount of refinancing
provided via longer-term refinancing operations with a view to smoothening conditions in the
term money market. In order to keep the total amount of outstanding refinancing unchanged,
the net amount of liquidity provided via shorter term refinancing operations has been reduced
accordingly.
Following the rescue of Bear Stearns last March the financial market turmoil entered a new,
more intense phase that further deteriorated with the collapse of Lehman Brothers in mid
September. In response to the renewed tensions, the Eurosystem stepped up its efforts to
support the appropriate functioning of the euro money markets and to alleviate both the euro
and the USD funding needs of euro area banks by:
1. further enhancing the policy of frontloading liquidity at its weekly main refinancing
operations,
2. significantly increasing the average duration of its refinancing operations, and
3. also by expanding coordinated provision of USD liquidity within the context of the
Term Auction Facility, as will be discussed in the next sub-section.
In order to contribute to easing liquidity tensions in the euro money markets, the Eurosystem
took on 8 October the exceptional decision to: (a) temporarily change the tender procedure in
its weekly main refinancing operations to fixed rate tender with full allotment so as to
provided uncapped access to euro liquidity (of course, against adequate collateral), while (b)
reducing the corridor of standing facilities (from 200 basis points to 100 basis points) around
the interest rate on the main refinancing operation.
More recently, in the context of the latest initiatives undertaken by the EU authorities to
restore confidence and the appropriate functioning of our financial systems, on 15 October
the ECB approved a new set of temporary measures designed to further enhance the
provision of long-term euro liquidity until the end of the year and over the next quarter and to
expand the list of collateral accepted in the Eurosystem monetary policy operations until the
end of next year.
In particular, as part of the measures designed to enhance the provision of long-term euro
liquidity, the fixed-rate tender procedure with full allotment has also been temporarily
extended to longer-term refinancing operations, implying that euro area counterparties can
now borrow as much euro liquidity as they wish (against eligible collateral) also at some key
term maturities, against an expanded set of eligible assets accepted as collateral.
The new set of temporary measures aim to further enhance the access to euro liquidity to
solvent banks, while also contributing to restore confidence among market participants in the
current environment in which money markets remain under stress and the traditional
channels of liquidity transmission are impaired.
Increased international cooperation
In addition to domestic operational responses, central banks have further strengthened their
cooperation throughout the turmoil. They have enhanced their cooperation first by means of
enhanced information sharing and collective monitoring of market developments and later on
through coordinated steps to provide liquidity.
The main example of such coordinated actions among central banks is the US dollar Term
Auction Facility, which started in December of last year and in which the ECB agreed with
the US Federal Reserve to grant loans in dollars to euro area banks. These USD liquidity
providing operations have increased over time in terms of size and number of participants
(and now involve thirteen central banks, from both developed and emerging economies, in
addition to the ECB).
As far as the Eurosystem is concerned, the scope of this facility has significantly increased
over time in terms of maturities covered and volumes involved. On 15 October the Governing
Council took a further step with the decision - announced together with Bank of England and
the Swiss National Bank - to conduct operations at various maturities at fixed interest rates
and with full allotment. As a result of this decision, euro area counterparties will be able to
borrow as much USD liquidity as they wish, also at some term maturities, against eligible
euro-denominated collateral, with the supply of USD guaranteed by an unlimited temporary
reciprocal currency arrangement between the Federal Reserve and the ECB that will remain
in place for as long as needed.
On 15 October the Eurosystem also entered into an agreement with the Swiss National Bank
in order to facilitate the provision of liquidity denominated in Swiss Francs to euro banks.
At the same time, in the past few weeks the Eurosystem has signed agreements with the
central banks of several European countries in order to improve the provision of euro liquidity
to their banking sectors.
Increased financial intermediation
Before discussing the latest coordinated initiatives, I would like to point out that, as a result of
its enhanced liquidity interventions in euro and other currencies (notably, in USD) during the
turmoil, the Eurosystem has significantly increased its involvement in financial intermediation
in the euro area. We are now effectively intermediating liquidity flows among banks in order
to mitigate the dysfunctions of money markets.
Of course, this is not the ideal long-term solution in a market-oriented economy like the euro
area and it also potentially implies increased financial risks for the Eurosystem (which are
nevertheless taken care of through adequate risk control measures). However, as long as
money markets remain dysfunctional, the Eurosystem will continue to provide liquidity as
needed in order to ease tensions in the impaired money markets, with a view to ensuring that
access to liquidity of solvent banks is not disrupted, thereby contributing to safeguarding
financial stability. At the same time, we very much look forward to the reactivation of
interbank lending and to banks resuming their traditional intermediation activity.
5. Recent coordinated initiatives
Let me briefly refer to the recent coordinated initiatives of international and European
governments and central banks.
During the early phases most of the current turmoil government interventions focused on
addressing problems at single institutions, mainly through rescues and the provision of
guarantees covering the liabilities of individual institutions under stress. More recently,
increasing awareness that the current turmoil has the potential to jeopardise systemic
financial stability has prompted governments to announce more general and comprehensive
schemes (mostly based on capital injections in exchange for equity and on the provision of
state guarantees) that are designed to support their entire financial systems rather than
individual institutions.
The more recent initiatives have not only been comprehensive but also "coordinated",
reflecting the increasingly consensual view that the "global" nature of the financial tensions
requires a common understanding among governments of the roots of the tensions and
concerted actions to address them. The framework for such concerted actions is defined by
the common principles in key areas (ensuring appropriate liquidity, facilitating the funding of
banks through various means, providing additional capital resources to financial institutions,
recapitalisation of distressed banks, ensuring appropriate implementation of accounting
rules, and enhancing cooperation among European countries), laid in the recent public
commitments by the G7, Ecofin and governments of the euro area.
In this respect, three important commitments are: (1) the Plan of action of the G-7 finance
ministers and central bank governors of 10 October, (2) the ECOFIN Council conclusions of
7 October and (3) the Declaration on a concerted European action plan of the euro area
countries on 12 October. These documents list common principles in key areas (ensuring
appropriate liquidity, facilitating the funding of banks through various means, providing
additional capital resources to financial institutions, recapitalisation of distressed banks,
ensuring appropriate implementation of accounting rules, and enhancing cooperation among
European countries), while leaving national governments free to design the operational
aspects of such interventions according to the specific characteristics of their domestic
financial industries.
In particular, these public commitments establish some core principles on how to address
liquidity, funding and solvency problems that should contribute to define a common and more
effective approach to overcoming the present turmoil. This common approach has started
materialising through the announcements by various euro area governments of co-ordinated
action plans that comply with the general principles agreed in euro area and international
fora.
The importance of cooperation mechanisms and information sharing was also underlined by
the European Council on 15 and 16 October with the creation of a "financial stability cell"
aiming to improve crisis management in the EU and the decision to establish regular
meetings of national regulators.
The importance of broad international cooperation to address the challenges faced by the
world economy has been renovated in the Statement released after the G-20 Summit on
Financial Markets and the World Economy of 16 November. The Statement indicates
principles for the reform of the international financial systems and the improvement of the
global financial architecture as well as policy responses to the global slowdown in economic
activity.
Strengthening market transparency, improving disclosure and accountability are indicated
among the core principles for reform of financial markets, with the Statement also including a
specific action plan listing both immediate and medium-term actions in these areas.
In general, the principles for reform indicated by the G-20 are in many respects consistent
with those previously stated in the public commitments of other international fora.
Nevertheless, as has been stressed by commentators, their restatement by the G-20, a
group of countries including both the major developed economies and the largest emerging
economies, is a confirmation of both the global nature of the financial crisis and the equally
global determination to overcome it.
Indeed, all of the public commitments so far together with the plans already adopted by many
countries clearly show the strong determination of the international community to preserve
the stability of our financial and economic sectors and improve the functioning of the
international financial systems.
Of course, it is too early to tell the effect of the latest initiatives by public authorities, but there
are some positive signs. The coordinated measures taken in recent weeks by governments
and central banks worldwide seem to have had a favourable impact on financial markets as
the premia on banks' CDS contracts have fallen sharply, money market rates have fallen
very significantly, spreads have narrowed and volumes traded on money markets seem to
have increased somewhat while some (still smaller than usual in aggregate) term money
market transactions have taken place. Despite these improvements, the situation remains far
from normal.
6. Final remarks
Uncertainty is at the root of the financial market turmoil that we are currently experiencing.
Such uncertainty translated into a severe under-appreciation of the risks associated with
certain classes of financial instruments and institutions. More recently, with the intensification
and broadening of the market turmoil, uncertainty has further increased and developed into a
pervasive phenomenon affecting a wide range of markets, assets and financial sectors.
Systemic uncertainty may potentially undermine the foundations of our financial systems,
which are in turn essential for the orderly functioning of our economies. This is why many of
the policy recommendations from a wide range of fora and organisations aim at addressing
the causes of uncertainty by implementing steps leading to a sound transparency framework
based on improved disclosure, high-quality accounting standards and solid valuation
practices.
In the meantime, public authorities are taking a number of systematic and comprehensive
measures designed to address the ongoing financial turmoil. These measures, in
combination with the enhanced liquidity provisions by central banks, should restore
confidence and contribute to re-establishing an environment in which governments,
regulators and supervisors can implement the urgent reforms that are needed in order to
anchor the global financial system to sound foundations.
It is of essence that private institutions live up to their responsibilities. In particular, by doing
their part to restore orderly conditions in the money markets and by resuming in earnest their
intermediation function, the private banking community should help to ensure that the
liquidity measures taken by central banks and the initiatives taken by governments in terms
of bank recapitalization and debt guarantees lead to the desired results.
Many thanks for your attention.