Gertrude Tumpel-Gugerell: Central banks, liquidity and a changing
financial market infrastructure
Speech by Ms Gertrude Tumpel-Gugerell, Member of the Executive Board of the European
Central Bank, at the Joint Bank of France/European Central Bank conference on "Liquidity in
interdependent transfer systems", Paris, 9-10 June 2008.
* * *
1. Introduction
Ladies and gentlemen,
I am very pleased to welcome you to this conference and I am grateful that I can do so also
in the name of the Banque de France.
Last week we celebrated the 10th anniversary of the ECB and the Eurosystem. Building on
the expertise and reputation of the national central banks of the euro area, the ECB has
developed well and we are very proud that the Eurosystem as a team has delivered what we
were supposed to: we have achieved our main objective of price stability in the euro area
and - more closely linked to this conference - the smooth operation of payment systems.
Given the fast pace of financial markets today, I often feel that the ECB has been around for
ages. When I look around this beautiful Galerie Dorée, however, I feel that the ECB is still a
very young institution. What I find reassuring is the fact that the euro represents a tangible,
perhaps the most tangible, realisation of something that is even older than our conference
venue: the idea of Europe. Please allow me to quote Jean Monnet: "Lorsqu'une idée
correspond à la nécessité de l'époque, elle cesse d'appartenir aux hommes qui l'ont inventée
et elle est plus forte que ceux qui en ont la charge." (When an idea meets the needs of the
time, it ceases to belong to its creators and becomes more powerful than those responsible
for it.)
The well-being of Europe is closely linked to its economic prosperity. Economic well-being, in
turn, depends crucially on a functioning financial system. I would like to take the opportunity
of opening this conference to reflect on the more long-term trends in the financial sector with
a special focus on liquidity in the context of market infrastructures. I will derive challenges
from these trends that I think are particularly relevant for transfer systems. Finally, I will point
out where I see the necessary and adequate responses of the private and public sector to
these challenges, in particular the Eurosystem's contribution to an efficient and safe
infrastructure.
2. Different perspectives of liquidity
Let me begin with a short reflection on liquidity. If we lived in a world with perfect and
complete markets as envisaged by Arrow and Debreu, liquidity problems would not exist.
Everybody would be able to make fully contingent arrangements to insure against
unanticipated short-term needs for funds. Well, the recent financial turmoil has painfully
reminded us that financial markets do not match the theoretical ideal world of the
"ArrowDebreu" model.
What do we then mean when we speak of liquidity? In general, we can distinguish between
at least three types of liquidity1:
•
First, monetary or macroeconomic liquidity refers to a generally accepted medium of
exchange. Such liquidity comprises central bank money and more broadly defined
monetary aggregates.
•
Second, market liquidity means the ability to trade an asset quickly and at low costs
with little impact on its price.2
•
A third concept is funding liquidity, which means the ease of firms, households or
banks to meet their respective payment obligations with internal or external funds as
they fall due.
All these concepts are - of course - closely interrelated. Deviations from expected
developments in any of these areas can cause severe disruptions. This is the essence of
liquidity risk. In the context of transfer systems, which are the focus of my speech today,
liquidity risk is defined as the risk that a counterparty or a participant in a payment or
settlement system will not settle an obligation at its full value when due.3 For example, the
operational failure of a major institution in a real-time gross settlement (RTGS) system can
turn it into a "liquidity sink". This would have a negative external effect on the liquidity
positions of other banks. Liquidity risks could thus turn into a systemic risk when disruptions
would spread across the financial system.4
Overall, liquidity risk is a crucial feature of the financial sector in general and market
infrastructure in particular. This is ably illustrated by an interesting special issue of the
Banque de France's Financial Stability Report that focuses on liquidity.5
3. Trends in the financial sector
Let me take a step back now and look at some long-term trends in the financial sector that
have had an impact on liquidity management and market infrastructures.6
First, the financial sector has experienced a tremendous amount of technological and
financial innovations. For example, real-time gross settlement systems with electronic
bookentries have become state-of-the-art. Such RTGS systems reduce credit risk exposure in
settlement, whilst increasing the demand for intraday liquidity and collateral. Financial
innovation has also triggered a significant rise in the number of derivatives and the
associated trading volume, not least on over-the-counter derivatives markets.
Second, financial globalisation has become manifest in the amount of cross-border financial
flows and cross-border banking, but it goes much further. The increased global integration
has strengthened the natural tendency towards concentrated provision of infrastructural
services, a tendency that is further accentuated in the context of the European single market.
This third trend of increased concentration has not been limited to market infrastructures
themselves. The emergence of key global players in banking has also led to increased
internalisation of payment flows in correspondent banks. Correspondent banks perform
payment and custody services for other banks and have in some cases reached a similar
size to some national payment systems. Thus, correspondent banking begins to blur the
distinction between intermediaries and infrastructure providers. Speaking of concentration, I
would also like to mention networks of interoperable systems. They can be seen as
intermediate steps towards concentration or as alternatives.
All these developments have contributed to lower financing costs, new investment and
business opportunities, and general welfare gains for all citizens. At the same time, these
trends have increased the relevance of market infrastructures and pose considerable
challenges for liquidity managers and central bankers, at all their time horizons.
I want to stress here that market infrastructures have shown a considerable degree of
resilience and functioned well during the recent months. This is a great achievement that
should not be taken for granted. However, some of the trends that I have mentioned have
also played a prominent role during the recent financial turmoil. Thus, there is no reason to
be complacent.
4. Challenges resulting from these trends
I see three challenges, especially from the perspective of market infrastructures, resulting
from these trends. These are: growing interdependencies; the potential emergence of a
global monopoly; and the need for well-functioning financial and political structures at the
supranational level.
Let me first focus on increased interdependencies created by financial globalisation in
conjunction with the other trends that I have just mentioned. The significant benefits of
financial globalisation come at the cost of a more complex global financial system.
Previously, settlement flows, operational processes and risk management procedures could
be considered largely from a national or even more a system-, institution- or market-specific
perspective. Today, the various transfer systems, financial institutions and markets have
become highly interdependent. This can be positive when the associated network effects
improve the safety and efficiency of payment and settlement processes. However, it can also
be negative when it allows an easier and quicker transmission of shocks and financial
disruptions, sometimes in indirect, complex ways. The financial turmoil has once again
highlighted how negative developments in one market segment can abruptly spill over to
other, seemingly unrelated, segments of the financial sector and across borders. One cause
of the severity of the turbulence is that financial institutions had not sufficiently foreseen that
liquidity can dry up in certain markets very quickly. Negative effects can be exacerbated if
banks do not have access to sufficient collateral. The interdependencies of payment and
settlement systems are very well described by a recently released Committee on Payment
and Settlement Systems (CPSS) report that I will refer to again when discussing the
appropriate responses.7
A second challenge arises from the potential emergence of a global monopoly. Economies of
scale and network effects are prominent in fixed-cost-dominated infrastructure services. This
has given rise to the rather utopian idea of a single integrated market infrastructure covering
the whole world as the end-game of the process of financial globalisation and concentration.
At the same time, a global monopoly might lead to a single point of failure and other
economic costs associated with monopolies (such as the abuse of market power and a lack
of innovation). However, it is not obvious that the alternative to a monopoly - that is,
networks of interoperable systems - is superior. For example, are a small number of
interoperable systems really less risky than a single system?
A third challenge that I would like to highlight today concerns the difficulties in establishing a
well-functioning financial and political structure at the supranational level. This challenge
reflects the general change of perspective on the financial sector. Over long periods, mature
and often efficient financial structures had emerged on a national level, protected by - to a
large extent appropriate - regulation, supervision and oversight. National financial
communities had developed a certain degree of trust, transparency and cooperation. Today,
the perspective has changed from the national to the international level. However, we
frequently face a geographical and legal separation between the entities in charge of the
oversight of the system, relevant banking supervisors and the entity providing liquidity to the
system. An important thing that the financial turmoil has demonstrated is that national
degrees of trust, transparency and cooperation have not yet been replicated on an
international, global level. This includes the existence of appropriate supervisory structures.
Overall, we face the challenge to create the same seamlessly functioning financial system
and market infrastructures on a supranational level that we have already today at national
levels.
5. Adequate responses to these challenges
It is very important to find adequate responses to these challenges. This duty - for the sake
of economic prosperity - falls to all of us, the private sector as well as public authorities.
Let me begin with some responsibilities of the private sector because, I believe, we should
rely on market solutions as much as possible. Financial market participants need to take into
account the increased interdependencies. As clearly described in the CPSS report, they
need to adopt a holistic approach to risk management, in particular as banks have
increasingly relied on wholesale and secured funding. And they need to focus on liquidity and
operational risk. I have the impression that the private sector is aware of this challenge and is
preparing the necessary response, as evident from the initiatives of the Institute of
International Finance, for example. Various committees, both at the international and the EU
level, are assisting the private sector in its work. Now, it is necessary to not lose momentum
and to implement the proposed holistic approach to risk management. This means that
systems and institutions need to look beyond their own operations and direct exposures to
understand the broad range of disruptions that might affect them. This is most important for
infrastructure and service providers as well as for financial institutions that have a critical role
in the global infrastructure.
The trend towards concentration represents the second, more long-term challenge that I
have mentioned. I think that it makes a lot of sense to complement the European Monetary
Union with harmonised and efficient market infrastructures in certain areas. However, I do
not expect the utopian idea of a single, globally integrated infrastructure to become reality.
Technological and financial innovation provides limits to concentration. New ideas, the
exploitation of market niches and regulatory changes that promote competition will allow
platforms to continue to have competitive advantages in some specialised areas. It is crucial
that these platforms will be transparent, provide open access to potential users and enable
interoperability with other platforms in order to reap the full benefits of financial globalisation.
But as interoperability requires competitors to cooperate, I am aware that achieving
sustainable and efficient solutions is not always easy.
Finally, let me mention one particular point. As recently recommended by the Financial
Stability Forum8, market participants should make further efforts to ensure that the
settlement, legal and operational infrastructure underlying over-the-counter derivatives
markets is sound. I know that also the CPSS closely monitors developments in this area.
Let me now turn to the responsibilities of public authorities . Just like the market, they need to
take into account the increased interdependencies, concentration and required international
perspective. Being a central banker, I think it is my task to focus on the various roles of a
central bank as a liquidity provider, service provider, catalyst and overseer.
The relevance of collateral for liquidity issues has been clearly recognised by central banks.
During the past ten years, central banks have - especially in the context of the CPSS and
other Basel committees - focused jointly their attention on the use of collateral in financial
transactions, including the cross-border use of collateral.9 Cooperation in this respect is very
useful and, especially for emergency situations, I would think that central banks - by
enabling the cross-border use of collateral - could make a positive contribution to financial
stability.
As a service provider, the Eurosystem has demonstrated with the successful launch of the
large-value payment system TARGET2 that it can deliver state-of-the-art infrastructure.
TARGET2 is the biggest RTGS (real-time gross settlement) system and settles more than
350,000 transactions worth around €2.5 trillion every day. We in the Eurosystem have also
worked a lot together with market participants on two other building blocks of a single
European market infrastructure: TARGET2-Securities (T2S), a single settlement platform for
securities, and CCBM2, a harmonised solution for collateral management within the
Eurosystem. In today's world, the availability of collateral has become the binding constraint
for intraday liquidity management. Hence, it is extremely important to be able to move
collateral quickly and safely across financial systems, borders and currencies. TARGET2,
T2S and CCBM2 are three complementary and mutually beneficial services of the
Eurosystem for this purpose. In a recent ECB survey, banks have reported minimum annual
savings of €53 million in liquidity and collateral management alone from T2S. Based on the
figures from market participants, the very conservatively estimated benefits of T2S for direct
users of T2S are at least €145 million per year in the baseline scenario. For the European
economy as a whole, we can anticipate dynamic benefits from T2S exceeding one billion
euro per year.10 In addition, TARGET2 and T2S make use of counterparty risk-free central
bank money for settlement, a feature that has become even more beneficial in light of the
financial turmoil.
The Eurosystem has acted as a catalyst for another building block for an integrated
European market infrastructure, the Single Euro Payments Area (SEPA). The same holds
true for the interoperability of existing systems. As specialised infrastructures are likely to
remain, the relevance of interoperability between different systems stays at the top of the
agenda.
Oversight is the third role of central banks in payment and settlement systems. In general,
market infrastructures have performed well during the financial turmoil, owing largely to
effective capacity planning by service providers enabling them to handle recent peaks in
volatility and trading. Overseers have to continue to monitor the safety and efficiency of
individual payment and settlement "critical" infrastructure, as well as the safety of the
financial system as a whole.
To achieve this, the increased interdependence requires an international perspective to
oversight. Overseers need to cooperate and to show a certain degree of convergence in
order to avoid regulatory arbitrage and a "race to the bottom" of regulatory standards. I think
that we have some scope for improvement on this dimension.
Increased interdependence also calls for a second dimension of cooperation, namely
between oversight of market infrastructures and banking supervision. For example,
correspondent banks appear to provide substantial non-collateralised intraday credits to their
clients. Traditional capital requirements, however, do not focus on the intraday liquidity
aspects and on possible exposures during the day. Hence, it is crucial to ensure an adequate
surveillance of these intraday risk exposures and the evolution of liquidity and collateral
management at both system level and bank level. Recent work at the Bank for International
Settlements and within the Eurosystem demonstrates that public authorities have recognised
this necessity and started to address it.
The ECB is strongly supportive of the various initiatives at the EU and global level and will
contribute to the pertinent work. I firmly believe that the international cooperation among
public authorities will continue to foster financial integration, development and stability.
6. Conclusion
Let me now briefly conclude. The financial turmoil has once again demonstrated that liquidity
should not be taken for granted. I have highlighted a number of more long-term financial
sector trends that have had an impact on liquidity management and market infrastructures.
Altogether, they result in new challenges from increased interdependencies, consolidation
and the required international perspective on seamlessly functioning financial markets. The
private sector and public authorities, both in their own responsibilities and in joint efforts,
need to continue to address these challenges.
We have made considerable progress in our understanding of the relevant issues and the
necessary policy conclusions, as evident from the various initiatives that I mentioned.
Financial market infrastructure is in evolution; its improvement remains an ongoing
challenge. This conference hosts a number of papers and panel sessions that serve as
further examples of how we are improving our understanding of liquidity and interdependent
transfer systems. I am looking forward to interesting insights and stimulating discussions that
will no doubt be inspired by the outstanding surroundings here in the Galerie Dorée.