Jean Claude Trichet: Hearing before the Economic and Monetary Affairs
Committee of the European Parliament
Speech by Mr Jean Claude Trichet, President of the European Central Bank, at a hearing
before the Economic and Monetary Affairs Committee of the European Parliament, Brussels,
11 September 2007.
* * *
Madame la Présidente, Mesdames et Messieurs les membres de la Commission
Economique et Monétaire,
La crise du marché américain des prêts immobiliers subprime et son impact potentiel sur
l'Europe ont suscité beaucoup d'intérêt au cours des dernières semaines. Je souhaiterais
tout d'abord vous fournir de plus amples informations sur les interventions de la BCE en
réaction à la forte volatilité enregistrée sur les marchés financiers. En second lieu,
j'évoquerai brièvement la situation économique et monétaire et reviendrai plus en détail sur
les raisons sous-jacentes à nos récentes décisions de taux. Zum Abschluss möchte ich
einige vorläufige Schlussfolgerungen aus Sicht der Finanzmarktstabilität ziehen.
***
Let me begin by providing you some further information about the recent events in financial
markets and the ECB's interventions. In July and early August, the crisis in the so-called US
sub-prime mortgage market intensified and appetite of global investors for risky assets
declined. Market volatility increased in all asset classes. Stock prices declined and
government bonds benefited from safe-haven investment flows. In this context, several
investment funds holding asset-backed securities suspended withdrawals. A number of
European banks admitted direct or indirect exposures to the US mortgage market. Yet it is
important to remark that the credit losses were not significant enough to materially impact the
soundness of core financial institutions.
Initially, the impact was felt in the US dollar money market, where domestic and international
banks were raising short-term liquidity in order to cope with the liquidity needs of a number of
"special vehicles" or "conduits" that had difficulty to refinance themselves on the commercial
paper market. On Thursday morning 9th of August, the tensions also spread to the euro
money market. These unprecedented circumstances called for commensurate actions.
Therefore, the ECB injected additional liquidity in the money market in order to restore
orderly conditions.
Let me briefly describe our operations in more detail. Our first operation was carried out on 9
August and matured the following day. It was a non-regular overnight operation where the
ECB provided liquidity to banks at a fixed rate of 4.00 percent, which is the level of our key
policy rate. This liquidity was provided through so-called reverse repurchase agreements.
These are transactions whereby the ECB purchases a given amount of eligible assets on the
understanding that these will be repurchased by the counterparty at a given price the
following day. We pre-announced that we would fulfil 100 percent of the bids submitted by
banks. This allowed us to gauge the amount of exceptional liquidity needs in the banking
system as a whole and to contribute to calming down the overnight money market under
these circumstances. As a result of this operation, the calm on the very short-term money
markets was restored for the rest of the day.
During the following three business days, the ECB conducted similar overnight
liquidityproviding operations through variable rate tenders with a minimum bid rate of 4.00 percent.
In the case of variable rate tenders, counterparties are asked to indicate both the desired
amount of money and the interest rate at which they wish to obtain it. The Eurosystem then
satisfies first the bids with the highest interest rates. The use of a variable rate in these
subsequent overnight liquidity-providing operations was in line with our usual practice.
Thanks to these operations, on each day from 9 to 14 August the ECB provided additional
euro liquidity above what is needed by the banking system under normal circumstance. It
rolled over a progressively smaller amount on each day, as the rates and amounts bid by
banks in our tenders became progressively lower.
On 14 August, the first Tuesday following the start of the tensions in the money market, the
ECB resorted to its standard instrument for market operations, namely its one-week main
refinancing operation which is usually allotted on Tuesdays. With a view to ensuring orderly
conditions in the money markets, the ECB allotted significantly larger amounts of liquidity
than it would have under normal circumstances. The same approach was adopted in the
subsequent one-week main refinancing operations on 21 and 28 August and 4 September.
Thanks to this relatively generous allotment, money market rates with maturities up to one
week were brought back to usual levels.
However, tensions remained in money market rates for maturities above one week. In order
to support a normalisation in this money market segment, the ECB decided to implement two
supplementary longer-term refinancing operations, the first decision being taken on 21
August and the second on 6 September, both with the usual maturity of three months.
In preparing and deciding upon the various operations, the Eurosystem remained, as usual,
in close contact with other central banks, including in particular, but not exclusively, the
Federal Reserve, the Bank of Japan, the Bank of England, the Bank of Canada and the
Swiss National Bank. These other central banks also took steps, each within the parameters
of their own operational framework. When comparing the steps taken by the various central
banks, it is important to take account of these differences in operational frameworks.
In any case, it is important to stress that the Eurosystem has shown its capacity to react both
promptly and effectively to these challenges. I am convinced that, given the circumstances,
we did the right thing at the right level at the right time.
Monetary policy stance
Through these liquidity operations, the ECB fulfilled one of its key responsibilities, namely to
ensure an orderly functioning money market. I will now turn to our primary objective, namely
that of delivering price stability over the medium term and be credible in the delivery of price
stability over the medium and long term. I would like to emphasize that our primary mandate
calls for our monetary policy stance to deliver price stability in the medium term. Once the
level of interest rates is decided we have the responsibility to ensure the smooth functioning
of the segment of the money market that we influence. The two responsibilities are clearly
separated and should not be mixed.
On 6 September the Governing Council decided to leave the key ECB interest rates
unchanged. The incoming macroeconomic data confirmed that risks to price stability remain
on the upside over the medium term, as identified by both our economic and monetary
analysis. The incoming macroeconomic data also again confirmed the strong fundamentals
of the euro area economy and support a favourable medium-term outlook for real GDP
growth. Data on activity in the third quarter - from various confidence surveys and
indicatorbased estimates - remain overall favourable. The latest data on unemployment indicate
improving labour market conditions and the global economic activity is expected to remain
robust, as the likely slowdown in the United States is expected to be largely offset by the
continued strong growth in emerging markets. This outlook is also reflected in the September
2007 ECB staff macroeconomic projections for the euro area, which foresee average annual
real GDP growth in a range between 2.2% and 2.8% in 2007, and between 1.8% and 2.8% in
2008.
The monetary analysis confirms the prevailing upside risks to price stability at medium to
longer-term horizons. On the basis of the latest available data, covering the period to the end
of July, the underlying rate of monetary and credit expansion remains strong. This is
reflected in the rapid growth of the broad monetary aggregate, M3 and the strength of MFI
loans to the private sector, which continue to increase at double-digit rates on an annual
basis.
Against this background, our monetary policy stance is still on the accommodative side with,
inter alia, money and credit growth vigorous in the euro area. At the same time, the financial
market volatility and reappraisal of risk of recent weeks have led to an increase in
uncertainty. Given the current high level of uncertainty, the Governing Council has deemed it
appropriate to gather additional information and carefully examine all new data, before
drawing further monetary policy conclusions. Accordingly, the Governing Council will monitor
very closely all developments. On the basis of our assessment, by acting in a firm and timely
manner, we will ensure that risks to price stability over the medium term do not materialise
and that inflation expectations are firmly anchored in line with price stability, which is even
more important in the current context of financial market volatility and increased uncertainty.
In this respect, the Governing Council will continue to pay great attention to future financial
market developments.
Financial stability
I would like to conclude my introductory remarks by drawing some tentative lessons for
financial stability and supervision of this episode.
Let me first qualify how we see the current situation. We are experiencing a market
correction with a significant reappraisal of risk, the possibility of which we had been warning
about for quite some time. I can recall that in my appearances before you and elsewhere, I
had said that we were diagnosing a level of risk appreciation in global financial markets that
was signalling an under-appreciation of risks in general. This was illustrated in particular, but
not exclusively, by the relatively low level of spreads, the low level of risk premia and the low
level of volatility across a wide range of financial markets. In the very first issue of the ECB
Financial Stability Review published in December 2004 we had said that a high level of risk
appetite was encouraging a search for yield among investors across a wide range of markets
and asset classes. This phenomenon went on for several years together with a very
significant degree of innovation and creativity in global financial markets which was
improving financial efficiency but also creating new sources of risk.
As I just said we are now in a correction phase which can, as frequently observed in such
situations, comprehend episodes of hectic behaviour, a high level of market volatility and
elements of over-shooting.
We had seen a distinct possibility that the ongoing deterioration of the creditworthiness of
borrowers in the US sub-prime mortgage market could be a trigger for more broad-based
market correction. We had said this in our Financial Stability Review published as recently as
last June. The most important channel for the propagation of the correction turned out to be
the maturity mismatch and, therefore, the strains placed on the balance sheets of special
purpose vehicles and conduits which had funded medium-term positions in asset backed
securities - where sub-prime mortgages were an important element - with short-term
financing commercial papers. It was the difficulties these vehicles faced in rolling over their
short-term funding which created much of the strains we saw in money markets.
Now, I know that you are particularly interested in the lessons we can draw from the present
episode. As we are not yet at the end of it, I would say that at this stage we must be prudent
in drawing definitive conclusions. That said, I believe there are a number of areas where we
know lessons will have to be drawn by the international community and where orientations
for appropriate improvements can be seen.
First, over the past decade, we have experienced a tremendous increase in the
sophistication of financial instruments. While the positive effect of these innovations has
been to allow market participants to better share risk, some negative aspects have clearly
been highlighted by the ongoing episode. In particular, the degree of complexity of some
products that are designed for the purposes of re-packaging and selling debt instruments has
become overwhelming. Although I would be very hesitant to impose limitations on the
creativity of market participants in their pursuit of innovation and enhanced efficiency of the
financial markets, in my view, instruments and structures that cannot be fully understood
even by those who bear the ultimate responsibility of the level of risk taken by financial
institutions should not be acquired or set up by banks and investors who are lacking
sufficient sophistication in the management of the risks. At the same time, the responsibility
of those originating such new products should not be understated either, as the current
episode has demonstrated that the underlying assumptions in the pricing models for complex
instruments are not always robust to changing financial market conditions. Investment banks
have become very active in this area and a part of the dramatic increase in derivatives
markets and financial leverage that we have witnessed has been favoured by the
underpricing of risk, of which the ECB has repeatedly warned about in the recent past.
Second, much attention has been focused on the role played by rating agencies prior to the
current market correction. It is true that the very small number of large global rating agencies
is a real issue for the present functioning of global finance. Potential conflicts of interest,
where they exist, would have to be dealt with and possible benchmarks for improved
behaviour could be worked out. In any case an important lesson of the current risk re-pricing
is that investors must never take the opinion of rating agencies as a substitute for their own
credit analysis and due diligence.
Third, the current events highlight the importance of further improving financial sector
surveillance activity by financial regulators and the risk management practices of financial
institutions. The new Basel II capital accord, which is currently being implemented, will bring
substantial benefits in this sense. Indeed, Basel II strongly relies on significantly improved
risk management in determining the appropriate capital buffers for banks. Despite these
improvements, the degree of sophistication of financial markets calls for constant investment
in stress-testing practices in order to ensure that banks are aware of the potential losses they
might accrue even in highly unlikely scenarios. The Basel Committee for Banking
Supervision, where the relevant authorities are represented, is playing a very important role
in this field. Another area where progress could and should be made is the area of liquidity.
Appropriate harmonisation of the various national rules and requirements appears to be
particularly opportune in the light of the recent events.
Fourth, we have to continue reflecting on how to deal with all non-regulated entities. The
main channels of propagation of the present turbulences have been the non-regulated
constituency of so-called conduits and special investment vehicles and not the highly
leveraged non-regulated institutions like hedge funds and private equity funds. I would say at
this stage that we should implement rapidly what is already crystallized in international
consensus on hedge funds, namely the recommendations of the Financial Stability Forum.
And we have to improve very substantially our handling of conduits and special vehicles.
Looking forward, some tentative policy implications can be identified from a financial stability
perspective. First, we need to restore confidence as we have a paradox that there is a large
number of high quality assets which investors are currently treating as if they were not
creditworthy. Now, it seems to me that the one important reason why we observe such a lack
of confidence is because we do not have sufficient transparency. This is an area that we
need to look at very carefully, to see which measures should be taken to improve
transparency. Let me remind you that after the Asian crisis we drew that conclusion: the
absence of sufficient transparency had driven a number of investors and market participants
to consider that each particular issuer in Asia was to be treated with great caution and fear,
because they were not sure of the accuracy of the information and data which were
displayed. The international community drew the conclusion that it was necessary to
increase transparency in particular as regards monetary policy, fiscal policy and the level of
reserve assets in these emerging markets. And it worked, in my opinion, pretty efficiently. So
again, it is a lesson that we learnt in the past.
I am now at your disposal for questions.