Axel A Weber: Financial markets and the central bank
Keynote speech by Professor Axel A Weber, President of the Deutsche Bundesbank, at the
SUERF Colloquium "New trends in asset management: exploring the implications", Munich,
12 June 2008.
* * *
1 Introduction
Ladies and gentlemen
In recent years, we have seen far-reaching structural changes in global financial markets.
Financial innovation has manifested itself in various ways, the most prominent being the
growing importance of new and complex financial instruments, the increasing significance of
new business models, especially in the realm of securitisation and disintermediation, and
intensifying competition, partly owing to the consolidation process in the banking sector,
partly owing to the rising importance of relatively new, largely unregulated players, such as
hedge funds, private equity firms, conduits and SIVs.
These remarkable financial developments are bound to alter the range of activities financial
market participants pursue. But are they also changing financial markets' reaction to
monetary policy?
The starting point for answering this question is easy to find: the monetary policy
transmission process. This term describes the long, variable and uncertain process by which
a change in a central bank's official interest rate impacts first on financial markets and is
ultimately transmitted to the economy in general and the price level in particular. As a
significant part of this monetary policy transmission process takes place in financial markets,
it goes without saying that the recent trends in global financial markets are of special interest
to central bankers - and it would not have needed the recent financial market turmoil to drive
home that point.
Against this backdrop, I will focus my remarks today on the following three issues. First, have
the recent structural changes in the global financial system altered the transmission process
of monetary policy - and, if so, do these changes make a central banker's life more - or less
- difficult? Second, how can central banks help avoid disturbances in the financial system?
This is a crucial question because financial stability is a precondition for the effective
transmission of monetary policy decisions to the real economy. Third, how does financial
integration affect monetary policy transmission? Specifically, what is the current state of
affairs in the euro area?
2 Financial markets and monetary policy transmission
I shall start with the most general question. To what extent have the recent financial market
trends changed the way monetary policy affects the economy and its price level? This is a
crucial issue. Without a fair knowledge of the monetary transmission process, its key
variables and the lags involved, central banks will face a tough job when deciding on official
interest rates. For this reason, the Eurosystem closely monitors structural developments in
financial markets. We also try to detect how financial innovations could have modified the
way changes in short-term interest rates are transmitted to other financial variables, output
and inflation.
Without wanting to go into too much detail, it is essential to point out that, when it comes to
the impact the recent financial trends have on monetary policy transmission, several
countervailing effects are in play. These countervailing effects are best captured when
unravelling monetary policy transmission into its different channels, that is by considering
individually the different ways in which a change in central bank interest rates affects
economic variables - at least in the short term.
Let me focus on the channels and arguments that are the most prominent in the euro area.
To begin with, there is the interest rate channel. According to the existing literature, the
development of deeper, more complete and more competitive financial markets seems to
have strengthened the pass-through from central bank interest rates to market interest rates.
This can be put down to two factors: Consolidation in the banking system, implying the
emergence of (fewer and) larger banks and thus improved arbitrage opportunities between
different financial markets, and an enhanced availability of alternative capital market-based
instruments for debt financing.
It is indeed likely that the increased competition between banks, as well as between bank
loans and different financial market products, has led to a closer relationship between market
and bank interest rates. Consequently, the deepening of financial markets should have
amplified and/or speeded-up the effects of monetary policy on bank interest rates (and, other
things being equal, on other financial variables, output and inflation).
Financial developments over the past decade should also have strengthened the balance
sheet channel. Basically, the idea is that, in an economy with highly developed mortgage
markets and a proliferation of mark-to-market accounting rules, changes in the value of
collateral and wealth have a greater impact on the economy. In such an environment,
borrowers' balance sheets tend to fluctuate more, which leads to a higher volatility in the
amount of funds banks are willing to lend to households and firms. Obviously, greater
changes in the supply of credit will translate into greater changes in consumption and
investment, thereby strengthening monetary policy transmission.
At the same time, a third prominent monetary policy transmission channel, the bank lending
channel, is generally supposed to have become less important. Comparable with the balance
sheet channel, the bank lending channel emphasises that monetary policy can influence
aggregate demand not only through interest rates, but also through its impact on the supply
of bank loans. Whereas the balance sheet channel focuses on the availability and value of
collateral necessary for borrowing operations, the bank lending channel refers to changes in
the banks' and borrowers' funding possibilities.
Usually, two reasons are put forward why the balance sheet channel has weakened of late.
Banks have become more flexible because of the growing use of securitisation and
improvements in risk management. Consequently, banks can respond more flexibly to
changes in financial market conditions and will therefore not pass through each and every
change in the central bank's official short-term interest rate. Hence, other things being equal,
the effect of monetary policy on the overall loan supply has decreased. Moreover, financial
development has not only broadened banks' options in terms of responding to interest rate
changes; it has also broadened borrowers' financing opportunities, reducing their
dependency on bank loans.
To put all the arguments in a nutshell, monetary policy seems, on balance, to have gained
influence on financial market prices and the real economy in the short run. This is confirmed
by the existing theoretical and empirical literature, which, by the way, delves much more
deeply into the intricacies of the various transmission channels than I am able to do today. In
any case, it should be borne in mind that the evidence is still tentative. As financial
development is an ongoing phenomenon, it should therefore be considered valid only at the
current juncture. Nonetheless, the bottom line is that, in the face of greater competition
among financial intermediaries, financial innovation and financial globalisation, monetary
policy remains a powerful tool for delivering price stability.
In this context, however, it is of the essence that the monetary policy strategy utilises a
broad-based approach in order to guarantee a robust assessment of the developments in the
economy and on financial markets.
3 Financial stability
3.1 Financial stability analysis
Let me now turn to financial stability. A widely accepted definition of financial stability is the
ability of the financial system to perform its key functions efficiently, namely, the allocation of
capital and risks and the settlement of payments and securities transactions. These functions
must be fulfilled smoothly not only in normal times, but also during periods of structural
adjustment and stress.
For obvious reasons, supporting financial stability is an important objective for central banks
- and has always been so. First, as noted above, monetary policy is largely transmitted
through financial market operations. Hence, the effect that monetary policy has on the real
economy depends crucially on the smooth functioning of financial intermediaries and
financial markets. It is at this point that financial stability analysis and monetary policy
analysis are most closely interlinked.
Second and more generally, major macroeconomic objectives, especially price stability and
sustainable output growth, are jeopardised if the financial system suffers from instability. This
is underlined by the generally high macroeconomic costs of financial crises. In addition, this
aspect has gained importance since financial turbulences seem to have become more
frequent in past decades owing to accelerated growth in financial transactions and the
greater complexity of new financial instruments.
Third, financial stability is closely linked to a central bank's interest in the prudent design and
management of the payment and settlement systems which process its currency. The
Eurosystem, for instance, has the statutory task of promoting the smooth operation of
payment and settlement systems.
Against this background, referring to financial stability analysis as a new trend among central
bankers would be something of a misnomer. Indeed, financial stability analysis is anything
but a passing fashion. It has, in fact, been a field of research of its own right since the
mid1990s. This is reflected in the wide dissemination of Financial Stability Reports, which are
now produced in more than 50 countries worldwide.
Nonetheless, it is fair to say that financial stability analysis is still, to a large extent, work in
progress. To illustrate my point, let me outline briefly the kind of challenges central banks
face. To begin with, financial stability is not easily measured. This is hardly surprising as, in
contrast to monetary policy analysis, there is no single indicator (such as inflation) to
observe. Similarly, initiatives to create some sort of an all-encompassing financial stability
index have failed to convince so far. Instead, the concept of financial stability involves
various financial intermediaries, financial market segments and infrastructure, for which a
whole host of different quantitative and qualitative indicators exist. As a consequence,
determining the degree of financial stability remains a highly complex task.
At this point, the natural suggestion from an academic outsider would be to construct a
theoretical model. Such a simplified representation of reality would help the academic to
single out the most relevant indicators and to define the interrelationships between financial
market and economic variables. However, model-based financial stability analysis is still in its
infancy. Three issues are particularly striking.
The feedback effects between financial system behaviour and the real economy are difficult
to model, especially in episodes of stress. Currently, most macroeconomic models treat key
financial system interactions and feedback effects only in a rudimentary manner. Therefore,
the "true" costs in terms of real GDP that are associated with systemic risk in financial
markets are difficult to determine. This is a significant limitation, given that feedback effects
play a crucial role in assessing a financial system's vulnerability to contagion and
systemwide stress.
Another principal reason why episodes of stress are difficult to model lies in the fact that
financial instability is inherently non-linear. As one consequence of this non-linearity, risk
factors typically are not normally distributed. Instead, their distribution is characterised by fat
tails, implying that extreme values are observed more frequently than what would be
predicted under the assumption of normality. Modelling non-linearities greatly complicates
research, but it is indispensable, given the central focus of financial stability analysis on
default, contagion and spillover effects.
A further challenge faced by financial stability analysts is a lack of relevant data. First of all,
historical time series on episodes of stress are rare, luckily. But that makes it even more
difficult to understand financial markets' behaviour in the fat tail of risk distributions.
Moreover, and more generally, some of the data needed for financial stability analysis still
require development. With the exception of market prices and regulatory information, only a
limited set of data is on hand in a timely, comparable and satisfactory manner. Think, for
instance, of financial intermediaries' financial reporting and the little information available on
credit risk transfer. Therefore, methods have to be found for handling the shifting demand for
data in an environment in which financial markets are constantly undergoing change.
To sum up, feedback effects, non-linearities and the handling of a limited set of data are
prime examples of the numerous challenges encountered by financial stability analysts in
designing financial stability models. As a consequence, it comes as no surprise that a
standard analytical model of financial stability has not yet been developped. At present,
modelling is often scattered with respect to risk categories, financial market segments and
structural or regulatory issues.
Mind you, there is no reason to play down the progress achieved so far, on the contrary.
Financial stability analysis is becoming more and more sophisticated, as is borne witness by
the increasing number of related working papers and conferences.
As for the recent financial market turmoil - the trigger for the recent financial market
turbulence, the speed at which it spread across global financial markets and its persistence
were not foreseen, but that does not conflict with my statement. Far from it - financial
stability analysis does not aim for clairvoyance. Instead, it is most likely that financial crises
will continue to emerge in spite of perceptible progress in financial stability analysis. But the
crucial point is that their impact can be alleviated by warnings, moral suasion and - if
necessary - adjustments to the institutional and regulatory framework. For this reason,
further improvement in the framework for financial stability analysis is a very high priority for
central banks.
3.2 Dealing with episodes of financial instability
There is yet another reason why central banks need to keep well-informed on financial
market developments. The turmoil that has been affecting global financial markets since
summer last year has been a further example of central banks not only taking a
predominantly passive role in analysing and commenting on financial stability, but also of
playing an active part as well. Indeed, the role of central banks in crisis management dates
back to the 19th century and was reflected in the views of Thornton and Bagehot. Both noted
that a central bank should - under specific conditions - provide liquidity to the banking
system as a lender of last resort.
And that is exactly what happened when the crisis in the US subprime market triggered a
rapid loss of confidence among financial intermediaries on a global scale. As a result of it,
uncollateralised interbank lending has been muted - the reasons for which are twofold. On
the one hand, banks' willingness to lend has fallen sharply due to mounting counterparty
risks. On the other, the uncertainty banks face with respect to their own longer-term liquidity
planning has increased considerably. To alleviate ongoing tensions in interbank money
markets, central banks from all over the world have acted as liquidity providers of last resort
to the banking system.
As for the Eurosystem, we have so far stood the test in this challenging environment. Owing
to the broad design of our liquidity operations toolbox, the Eurosystem's operational
framework has had to change only slightly since the outbreak of the financial market
turbulence. What is more, the Eurosystem succeeded fairly quickly in reestablishing
confidence in the functioning of the Euro money market by promptly injecting additional funds
on a temporary basis. We shall continue to provide liquidity flexibly - which seems warranted
given the ongoing tensions in the Euro money market, including, and especially, in the
longer-term sector.
Although there have recently been some identifiable signs of easing in several financial
market segments, it is still too early to give the all-clear. Specifically, the still elevated level of
money market spreads underlines the fact that there is no room for complacency.
In this context, I would like to stress two points. In the Eurosystem, we have strictly
separated our management of aggregate liquidity conditions from the determination of our
monetary policy stance. Hence, when deciding on interest rates, the primary objective of the
Governing Council has been (and will continue to be) price stability. Against the background
of the continuing and persistently strong upside risks to price stability, the Governing Council
is in a state of heightened alertness and in readiness to act. Moreover, our strict separation
makes clear that the Eurosystem does not intentionally and directly offer some sort of ex post
insurance to financial market participants who have engaged in excessive risk-taking. This is
intended to limit moral hazard to a large extent.
Apart from this, it seems appropriate to point out that, in a free market economy, central
banks' liquidity support must always be confined to a transitional period. In other words, in
the medium run, central bank interventions cannot substitute the need for financial
intermediaries to regain confidence gradually. At the top of the list of requirements, I would
like to see financial intermediaries trying to enhance their transparency regarding credit and
market risk exposures and also, if necessary, raising capital and adjusting business models.
Furthermore, it is essential that financial intermediaries convince investors that the financial
system as a whole is capable of managing risks adequately in a setting of continuously
changing financial market trends.
Finally, taking a step back from crisis management, the recent financial market turmoil has
underscored the need for crisis prevention to be strengthened. This is exactly what is taking
place at the moment. National, European and international forums and organisations are
currently putting a lot of effort into identifying the lessons to be learned. There are various
initiatives under way, but it is particularly important that the recommendations made by the
Financial Stability Forum are implemented rapidly and effectively. The implementation of
these recommendations, including those on disclosure standards and risk management, will
be a major step forward in enhancing the resilience of the international financial system.
4 Financial integration in the euro area
If I were governor of a central bank whose currency area coincided with the boundaries of its
financial markets, I could end my speech here with a brief summary. However, as governor
of a central bank that is an integral part of the Eurosystem, there is yet another topic to
cover: financial integration. It is generally accepted that, in a currency union, well-integrated
financial markets facilitate the implementation of the single monetary policy. There are three
aspects worth mentioning.
First, a currency union should work more smoothly, the more integrated the national financial
markets are. Indeed, financial integration can help individual EMU member states to absorb
country-specific shocks more easily. The reason for this is that the more diversified the
sources of national income and the easier it is to borrow abroad, the less consumption and
investment need to follow fluctuations in national output. Hence, national consumption and
investment levels can be insulated from domestic macroeconomic shocks via cross-border
risk sharing.
Second, financial integration strengthens the stability of the euro area financial system - and
of the macro economy in general. Basically, in a well-integrated financial system, risks tend
to be more diversified on a cross-border scale which should lead to financial intermediaries,
markets and infrastructure becoming more resilient to idiosyncratic shocks. Having said that,
integrated financial markets arguably broaden the scope for spillover effects across borders
- as manifested by the recent US subprime crisis.
Third, I have already stated that the Eurosystem's tasks include the smooth operation of
payment and settlement systems - which is closely linked to the progress of financial
integration. There is an abundance of evidence that the launch of the euro was a major
catalyst for financial integration in the euro area.
In general, financial integration is most advanced in those market segments which are the
closest to the single monetary policy. This is particularly visible in the unsecured money
market, which was almost perfectly integrated right at the start of EMU, as measured by the
low cross-country standard deviation of the average overnight lending rates among euro area
countries. Moreover, the euro has significantly reduced home bias in the euro area bond and
equity markets, albeit to varying degrees. Principally, financial integration has progressed
most in government bond markets and is least advanced in equity markets. Having said that,
the percentage of cross-border holdings of bonds and equities in the euro area has grown
over the past ten years. In addition, bond market yields and share prices are increasingly
being driven by common euro area factors, although local factors continue to play a role.
These developments have been supported by the elimination of currency risk within the euro
area, the higher demand from a larger pool of investors, and - as far as bonds issued by
smaller member states and companies are concerned - the reduction of liquidity premiums in
domestic-currency debt. In essence, however, these developments reflect the high degree of
substitutability among bonds and equities issued by various governments and corporations
across the euro area.
Let me also highlight the fact that the recent financial market turbulence has not undone the
process of financial integration in the euro area. True, euro area sovereign spreads vis-à-vis
the German benchmark have increased substantially. Moreover, cross-border country and
cross-sector dispersions in euro area equity returns have risen since the second half of 2007.
Both examples indicate that national factors in market dynamics and asset pricing have
regained importance in a time of financial market tensions. But the scale on which this has
happened is still small in comparison with the major developments of the past ten years.
As already noted, financial integration in the euro area has not proceeded at the same pace
across all sectors and markets. Integration of the retail banking markets, for instance, has
remained limited, reflecting the persistence of legal, institutional and cultural differences. This
shows that financial integration in the euro area is dependent not only on how close a market
segment is to monetary policy, but also on how far the relevant market infrastructures have
become integrated. A case in point is the high degree of integration of the large-value
payment systems in the euro area. They have made possible the integration of euro area
money markets. TARGET2, offered by the Eurosystem, is a further step forward in that
direction. Other efforts to reduce infrastructure barriers are under way. One of the most
significant initiatives in this regard is the Eurosystem's TARGET2-Securities project which
will provide a pan-European securities settlement platform. These innovations demonstrate
that the Eurosystem attaches great importance to promoting financial integration in the euro
area.
5 Concluding remarks
Ladies and gentlemen, this has been a wide-ranging overview of the changing relationship
between central banks and financial markets. I hope it has given you some flavour of the
importance that financial stability, financial market developments and financial integration
have for monetary policy implementation. Financial markets have always been a field of vital
interest to the Eurosystem, but certainly, the recent financial market turmoil has been a
further spur to our efforts in coping with periods of financial stress, conducting financial
market research, and supporting the integration of the euro area financial markets.
First and foremost, however, the Eurosystem contributes to safeguarding financial stability by
maintaining price stability in the euro area in the medium term.
Thank you for your attention.