Peter Praet: Keynote speech at the Paris Europlace International
Financial Forum
Keynote speech by Mr Peter Praet, Member of the Executive Board of the European Central
Bank, at the Paris Europlace International Financial Forum, Paris, 9 July 2014.
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I would like to thanks Jan Hammermann und Arthur Saint-Guilhem for their contribution in the preparation of this
speech.
Introduction
• Over the past seven years, the financial system has been severely shaken, in
particular one of its major components: the banking system.
• The adjustment process is well-advanced, as witnessed by higher liquidity and
capital buffers; better crisis management institutions.
The finalisation of the ECB comprehensive assessment will be a key milestone in
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the near term.
But this will not be the end of the road: looking ahead, we also need to build a
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financial landscape that is more diversified, more capital market-based for all
segments of financial products. It is with this perspective that the ECB has singled
out securitisation as one priority; but there are others, such as venture capital.
• A note of caution however: the financial system cannot contribute to growth if the
underlying fundamentals are not sound.
Contribution of monetary policy and the ECB in particular
Throughout the crisis, the ECB has deployed a number of instruments, conventional and
unconventional.
Our approach to crisis management and inflation control in pursuit of our objective was
mostly founded on an expansion in size and tenor of temporary credit operations with our
counterparties. This reflected the predominant role of banks in euro area financial
intermediation and, hence, for the financing of the euro area real economy.
In the post Lehman environment (when banks in the euro area suffered the wave of
contagion from the US subprime confidence crisis) and, again, in the face of an escalation in
the debt crisis (when banks in selected countries suffered the consequences of a near-loss
of market access of their sovereigns) our temporary credit operations were adapted so as to
reduce banks' liquidity and roll-over risks. This meant providing banks with unlimited liquidity
at a fixed price and with expanded maturity and against a wider pool of collateral:
• In the aftermath of Lehman's demise, we changed the liquidity allotment system
from one where we fixed the quantity of liquidity lent to banks (being confident that
the market would distribute that quantity widely at a price that reflected our intended
monetary policy stance) to one where we fixed the price of liquidity and let the
market decide over the quantity that is needed to support that price.
• Also, in the aftermath of Lehman's default we extended the term at which liquidity
was lent to banks from three to six months to one year (in June 2009) and we
broadened collateral rules. By allowing banks to liquefy a larger share of their assets
and by stabilising the liquidity horizon of those banks in liquidity deficit, which had
lost access to the money market, we averted a major disruption in the first stages
of the transmission mechanism.
• In the face of the 2011-2012 escalation of the debt crisis (when the confidence
collapse reached two systemic countries) we concentrated on banks' loss of access
to the wholesale market to address a major roll-over risk. We conducted two
threeyear operations (LTROs) that helped banks in a wide part of the euro area to do
funding substitution. A significant share of the increase in Eurosystem credit to
banks in Spain and Italy, for example, was used to reimburse bank securities that
were coming due over the next 12 months and would not have been rolled-over by
the market. Without this relief banks would have had to shed assets on a large scale
(given high leverage), with potentially systemic implications for the euro area
economy as a whole.
• Finally, when a major tail risk emerged in the securities market in mid-2012, as more
and more weight was given in the pricing of market debt to the risk of a euro area
break-up, we announced our decision to conduct Outright Monetary Transactions in
the market for sovereign securities, conditional on the issuer submitting to strict
multilateral surveillance.
In a very difficult environment the ECB succeeded in preserving its credibility, as witnessed
by the anchoring of inflation expectations throughout the crisis.
Over the following 12 months or so, the cumulative effects of this action were able to
eliminate fears of disaster events, remove tail-risk from the market and thereby reduce
fragmentation.
However, with growing evidence since the start of 2013, banks in large parts of the euro area
started to respond to the funding challenges and the need to reinforce their capital structure
by reducing their activities, in particular their loans to the real economy. The funding crisis
had morphed into a trend which could lead to a widespread credit crunch.
Therefore, in May 2013 against the background of subdued monetary and loan dynamics
and very weak economic sentiment, and with the aim to support prospects for a recovery, we
decided to cut our key interest rates further. This, in conjunction with the abundant liquidity
conditions that had been created as a consequence of the 3-year LTROs, helped stabilise
the overnight money market rates around levels close to the lower bound of our monetary
policy corridor - which had been reduced to zero in July 2012.
However, soon thereafter, market expectations about the likely future evolution of monetary
policy worldwide changed abruptly, notably as a consequence of Fed communication about
their intention to end its bond-buying programme. And this change of market sentiment
introduced heightened volatility in the term structure of money markets rates of the euro area
as well, beyond very short maturities. The sharp swings in the term structure that we
observed as a consequence starting in late May threatened to lead to a withdrawal of the
monetary accommodation that we had introduced in early May.
As a response, the Governing Council decided to clarify its policy orientations going forward,
conditional on the outlook for inflation and weak economic activity. Our forward guidance
concerning the future likely evolution of our key interest rates which the Governing Council
started to provide in July 2013 was a strong signal by the Governing Council on its
commitment to fulfil its mandate and anchor market interest rates around levels that were
considered consistent with the underlying macroeconomic conditions in the euro area. The
forward guidance formulation that was adopted in July 2013 - and substantially reconfirmed
subsequently - communicated our assessment of the economic situation, reiterated our
twopillar strategy and the implications on the monetary stance.
It was particularly important to decouple the monetary conditions of the euro area from those
prevailing in other major currency areas, in a context where the monetary policy cycle in the
euro area was different from that in the US and the UK. Overall our guidance succeeded in
securing our accommodative stance and promoting more stable market conditions.
Consistent with our guidance, and with a view to reinforcing its grip on the interest rates in
the private interbank market, in November 2013 we further cut our interest rates and we
reduced the width of the monetary policy corridor to 25 basis points.
In March 2014 we reinforced our guidance by referring to the degree of economic slack and
subdued money and credit creation as conditions for reducing or maintaining rates
unchanged even in the face of a recovering economy.
More recently we have been confronted with a situation of successive downward revisions of
our expected inflation path. To give you an example, in December 2013 Eurosystem staff
projected HICP inflation at 1.1% for 2014. In the most recent projection round of June 2014 -
that is, about six months later - inflation was expected to be only 0.7% in 2014. While
surprises were initially more in headline (as opposed to core) inflation and stressed (as
opposed to non-stressed) countries, very recently the surprises have been more in core
inflation figures, and in non-stressed countries. The reasons are well-known:
• A mixed bag of supply shocks (energy & food; structural reforms in strained
countries) and persistence of underutilised capacity in a wide area of the euro
area...
• ... in a context in which banks' credit - a critical ingredient to a self-sustained
recovery of investment and durable consumption - was withdrawn in many countries
and/or made available to companies and households at interest rates probably only
partially justified by increasing lending risk.
To address risks and implications associated with a prolonged period of low inflation, we
have to ensure that the developments do not become entrenched in inflation expectations.
This is why we further cut our interest rate last month in the context of a broader package of
mutually reinforcing measures aimed at addressing impairments in lending conditions and
the knock-on effects that these impairments are having for the real economy and inflation.
Loan growth is still contracting; lending rates have not declined in line with improvements in
financial markets.
While the lending rates (for stressed countries) reflect credit risk, borrowers' credit risk is in
part endogenous. High lending rates contribute to higher loan delinquencies, which in turn
increase the need for banks to make provisions on past legacy loans by increasing lending
rates; so, ex post, higher delinquencies justify high lending rates, and there is a mutually
reinforcing spiral of high lending rates, high credit risk and poor macroeconomic conditions.
The TLTROs are designed to contribute to breaking this spiral. They are expected to ease
overly tight conditions through several channels.
• The first and most important channel is through a reduction in term funding costs for
banks. Note that the interest rate on the TLTROs will be fixed over the life of each
operation, at the rate on the MROs prevailing at the time of take-up, plus a fixed
spread of 10 basis points. So if a bank does well in its lending performance, it enjoys
very attractive refinancing conditions for up to four years. Funding relief, however,
does not per se guarantee better credit conditions for banks' customers, unless the
supply of loans shifts in parallel and lending mark-ups are kept constant or even
pushed down as banks are encouraged to move down the demand curve for loans
by chasing good credit with lower lending rates. This is why the targeted nature of
the TLTRO is important: by making funding relief conditional on generation of new
lending volumes, the TLTRO will encourage a shift outward in the credit supply
curve. By simply moving along the demand schedule, this outward shift will reduce
the price for lending while increasing new loans. If banks do not manage to exceed
a certain benchmark in terms of net lending, they will not benefit from the additional
allowances that can be earned under the TLTROs. This shows that the TLTROs are
indeed targeted, rather than a broad-based unconditional provision of liquidity as in
the case of the earlier 3-year LTROs.
• Second, and as a side effect, the TLTROs are expected to increase excess liquidity,
which reduces interest rates in the short- to intermediary-term money market.
Remember that banks take into account the money market curve when pricing their
loans as the pricing basis over which they charge additional lending spreads in order
to recover funding and capital costs. By keeping the money market base rate stable
at compressed levels, the TLTROs will reinforce the lowering of the ECB's key
interest rates.
Third, by partially replacing term funding in the form of more expensive bank bonds,
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the TLTROs can create a scarcity of investible assets, which will result in lower
yields and easier market funding conditions even for banks that have not taken part
in the operations. It may also create spillover effects to other segments of the
corporate credit market, as investors in bank bonds will be induced - by a scarcity of
supply - to diversify away from that market and re-invest in other market segments.
The latter mechanism is not dissimilar to the "portfolio balance channel".1
The TLTROs are targeted operations. Indeed, there are positive and negative incentives for
banks to use the funds for lending, rather than for alternative investments. First, due to the
large multiplier that converts the flows of a bank's new net lending to non-financial
corporations and consumers (relative to a specified benchmark) into additional borrowing
allowances under the facility, there is a strong inducement for banks to beat their lending
benchmark and expand lending beyond their pre-announcement plans. Second, banks that
as of April 2016 cannot prove that they have beaten their benchmark will be asked to
reimburse in advance funds that otherwise could be borrowed for a period of up to 4 years.
Through these combined effects, we believe that a widespread use of this facility has the
potential to halt the vicious circle of constrained lending, weak macroeconomic conditions
and elevated loan delinquencies, and re-ignite a positive "credit multiplier" process.
And in fact the combination of monetary policy measures decided last month already led to a
further easing of the monetary policy stance. In particular:
• We have seen a marked downward shift in the whole term-structure of the money
market. For example, in the overnight segment, EONIA fell by 12 bps to 0.03%
between 4 June and 1 July. Over the same period, the 3-month EURIBOR declined
by 10 bps and the 1year 4year OIS forward rate declined by 23 bps.
To gauge the overall easing effect of our measures one may go back a bit more in
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time and look at developments since early May, when the Governing Council
signalled its readiness to act in June. For instance over the period 7 May [the day
before the May GC] and 1 July the 3-month EURIBOR declined by 13 bps and 1y4y
OIS forward rate declined by 36 bps.
Since early May we have also seen some compression of liquidity premia [as for
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example evidenced by a decline in the spread between KfW bonds and German
bund yields with the same residual maturity] and government bond spreads.
The monetary operations to take place over the coming months will add to this
accommodation.
All measures together should support lending to the real economy, support the economic
recovery and - through that avenue - steer inflation rates to levels closer to 2%.
As usual, effects on the real economy will take time as the measures will need to work their
way through the economy.
Monetary policy cannot do it alone... and did not do it alone
Although the policy reactions were often too weak and delayed, they have finally been
decided and implemented in a number of countries: structural adjustment at national level
has proceeded (not sufficiently in all countries). Also institutional reforms at euro area level
have been launched. The Banking Union is a key element. It will not only lead to a more
effective and resilient banking system but also to better private sector risk-sharing across
countries.
The impact on financial markets has been impressive. But let me be clear: the work is not
yet done.
Potential implications that a protracted period of monetary accommodation may have
on financial stability
Finally questions have been raised on the potential implications that a protracted period of
monetary accommodation may have on financial stability.
First of all, not acting forcefully would have had very serious financial stability implications.
Second, looking forward, our monetary policy accommodation is essential to keep medium to
long-term inflation expectations well anchored also for financial stability reasons: a fall of
expected inflation leads to an increase in expected real interest rate which makes debt
sustainability more difficult.
That being said, monetary policy needs to be aware of the potential implications that a
protracted period of monetary accommodation may have for financial stability. There are two
major risks: first, postponement in bank balance sheet repair; and second, bubbles in asset
prices.
The first risk is that cheap funding allows banks to back-load the deleveraging of their
balance sheets and encourage so-called "ever-greening" practices which in turn may prolong
macroeconomic stagnation. After a financial crisis, banks have to undergo a thorough
cleanup. Otherwise, they may continue to roll over legacy loans, thus restricting the resources
available for new lending in support of the real economy - so-called "ever-greening". This
risk is being countered through the ECB's on-going comprehensive assessment of banks'
balance sheets - consisting of the asset quality review and a stress test - which will be
completed roughly in parallel with the launch of the first TLTRO. Thus, banks will not be able
to benefit from funding relief without also repairing their balance sheets where necessary.
Also, macroprudential measures should be used, if needed, to smooth the financial cycle in
specific sectors or jurisdiction.
The design of the measures should also limit to some extent the second risk to financial
stability, the build-up of bubbles. The TLTROs exclude explicitly loans to households for
house purchases. Furthermore, credit developments are always closely monitored when the
assessment from the economic analysis is cross-checked with the signals coming from the
monetary analysis, the two pillars of the ECB's monetary policy strategy. Thus, concerns that
the measure could stoke a housing bubble seem unwarranted. Nonetheless, it is important to
keep in mind the distinction between what monetary policy can and should do, and what is
the domain of macro-prudential policy. Monetary policy has the clear primary objective to
maintain price stability in the euro area over the medium-term. Macro-prudential measures
should be used, if needed, to smooth the financial cycle in specific sectors or jurisdictions.