Erkki Liikanen: The European experience - the foundation for the
promotion of securities markets in Finland
Speech by Mr Erkki Liikanen, Governor of the Bank of Finland, at a seminar entitled
"Lessons of the financial crisis", Helsinki, 10 June 2011.
* * *
The European experience
Ladies and gentlemen,
In Europe, the first signs of the latest financial crisis emerged in the money market. The
spreads between collateralized and uncollateralized market rates started to increase rapidly.
We witnessed the development of elevated financial market stress that turned out to be
unprecedented in modern financial history. Liquidity was suddenly becoming a scarce and
costly asset. These developments were particularly disturbing to central banks as the
damaged transmission mechanism of monetary policy ruptured the steady relationship
between policy and lending rates.
It was not only the pricing of the liquidity risk that had been ignored over the years preceding
the crisis. Banks started to feel uncomfortable with the exposures they had been used to
taking on with each other. Suddenly it was not enough to rely on close business relationships
and trust.
Once banks started to hoard liquidity, it was not only an indication of scarce liquidity, but a
sign of an even more fundamental problem. Counterparty risks had risen to a new level.
Increases in counterparty risk were fuelled by falling asset prices - as banks saw how their
own balance sheets started to deteriorate, they became worried about other banks' balance
sheets being affected even more.
Also unprecedented in financial history was the speed with which counterparty risk was
shifted from one country to another. The global lack of trust between banks had a major
negative impact on international trade. Inventories in firms were cut to a minimum and
investment plans were frozen at a record pace. Consumers increased their precautionary
savings. All this caused a sharp global downturn, or a Great Recession as it is now called. In
many countries this was comparable to the great depression of the 1930s.
Policy makers reacted promptly and massively to the crisis in all areas. A strong fiscal
stimulus was supported globally. TTT, Timely, targeted and temporary was the often-used
phrase. Monetary policy reacted aggressively in all advanced economies. Interest rates were
lowered at a record pace and liquidity was pumped into to the banking systems.
As the first signs of the banking crises started to materialize, actions taken were
miscellaneous, depending on the symptoms. But there was one common source of risk that
had a global impact. It was related to the mortgage markets in the US. Housing loans had
been originated without sufficient documentation or with overly optimistic underwriting
assumptions. Then these housing loans were sold off in complex derivative securities
globally. Credit rating agencies had given them high ratings. Suddenly financial institutions
had highly risky positions in their balance sheets due to either a lack of diversification or to
excessive leverage ratios. This risk taking was high enough to wipe out all big investment
banks in the US and to cause bank failures and serious deleveraging needs in Europe.
Often these failures had an insidious reason behind them. The transparency of the banks'
balance sheets had been weakened by the off-balance arrangements. This was a further
reason for increased counterparty risk. Regulators and supervisors had allowed financial
institutions to shift a considerable part of their activities to special purpose entities. This often
happened with generous credit lines from the parent financial institutions.
When liquidity became scarce and asset prices started to fall, those credit lines turned out to
be a big burden for banks' capital. Failures of the off balance sheet institutions and the
resulting losses to the parent companies were the origin of serious deleveraging needs that
put a burden on banks, especially in Europe, to this day.
Banks' problems, first country by country, and after Lehman, globally, forced governments to
promise - implicitly or explicitly - blanket guarantees to safeguard financial institutions. For
some countries and financial institutions this was a blessing, but for other countries it turned
out to be a fatal kiss. During the years leading to financial crisis some countries had made a
choice to centre their growth strategies around financial services. UK, Iceland, Ireland and to
come extent even Sweden were examples.
The strategy worsened the downturn and increased the banks' need to deleverage further.
New capital was also needed. What was not recognized were the consequences of financial
crises in the situation when the size of the banking sector was huge compared to the GDP.
Iceland and Ireland were leading examples, In Ireland and Iceland this strategy was also the
main cause of the government debt crises that immediately followed.
There was also another route that ended in problems to banking. In Greece and Portugal
government deficits turned out to be unsustainable. This was the outcome of slumping
competitiveness and slow growth. It also became evident that the banking sector in any
country is highly dependent on the sovereign market of the home country.
The outcome was unfortunate and highly costly. In Greece, Ireland and Portugal banks have
lost their access to interbank markets. They have become dependent on the central bank's
liquidity provision.
Eurosystem has provided liquidity at various stages of the crises, in different ways, and at
various maturities. These were known as non-standard measures. The response of the
central banks around the world can be characterized similarly.
Within the euro area the maturities of lending operations were extended from three months
up to one year and fixed rate full allotment auctions were introduced. Non-standard
measures were introduced aimed at restoring a more normal functioning of the transmission
mechanism and an environment where the standard measures could operate effectively.
One of the lessons from the crisis is that the terms and conditions of how collateral is priced
are vital to modern financial markets. The importance of collateral policies of the central
banks may not have been sufficiently appreciated from the financial stability perspective. In
times of an economic boom banks feel they are very liquid as asset prices increase and
emission of new credit flourishes.
When financial markets were encouraged to expand, many decisions were guided by
efficiency considerations. Liquidity pools and acceptance of various assets and asset classes
as collateral to central bank credit made it very easy for banks to rely on central bank
financing or short term market financing in general.
The Eurosystem can extend credit only against adequate collateral. Before the crisis, the
Eurosystem accepted a wider set of assets as collateral than most of its peer institutions did.
Furthermore, some of the collateral eligibility criteria were expended during the financial
market crises. Once the still ongoing series of crisis becomes economic history, we should
rethink our collateral policy.
One possibility, suggested by our in-house analysis, is to make a clearer separation between
the assets that are eligible for monetary policy operations and the assets that are eligible for
operations addressing banks' specific liquidity needs. For example, the Eurosystem could
limit the set of collateral eligible to Main Refinancing Operations - the weekly operations by
which the monetary policy stance is signalled - to the assets eligible for the most liquid
private repo markets. Through this, the monetary policy operations would more directly affect
the market rates relevant for monetary policy transmission, instead of impacting rates that
carry significant liquidity and credit risk premia compared to the market repo rates. The
central bank would clearly be the rate setter with its policy operations.
Less liquid assets could continue to be eligible for marginal lending, being used to cover
banks' temporary liquidity needs, and possibly also for longer term and other structural
liquidity providing operations, if the banking sector's liquidity deficit, i.e. banks' structural
need for central bank reserves, remains wide. Contrary to the policy operation, the
Eurosystem normally acts as a rate taker in longer term operations. Hence, the lower liquidity
of the collateral eligible in these operations would be priced by the market demand.
Using this kind of segregation of collateral, between the different functions that can be
assigned to various operations, the Eurosystem would not only assist its control over the risk
free short term interest rates, but this idea could also be used to facilitate the monetary policy
implementation once the Basel III liquidity regulation becomes effective. For example, the
assets eligible for Main Refinancing Operations could equal the set of debt instruments
meeting the Basel III Level 1 criteria.
Greater focus on financial stability and macroprudential oversight1
The latter part of my presentation is related to the conduct of macroprudential policies.
One of the key lessons of the latest global financial crisis is that central banks - and other
authorities - need to pay much more attention to financial stability and macroprudential
oversight. New institutions in which central banks play a key role have already been created
to identify the emerging systemic risks and to take actions to mitigate these risks. Examples
of such institutions include the European Systemic Risk Board (ESRB) in the EU, the
Financial Policy Committee (FPC) within the Bank of England and the Financial Stability
Oversight Council (FSOC) in the United States.
There is a plethora of open and difficult issues concerning how macroprudential policy should
be conducted and which policy instruments are the most efficient in reducing systemic risks.
Today, I will set most of these difficult questions aside and concentrate on an issue that has
not yet received as much attention as it deserves. How should national macroprudential
policies be coordinated so that the combination of these policies would be efficient at the
regional or global level?
The recent financial crisis painfully showed how quickly and forcefully financial crises can
spread over national borders in a world of integrated financial markets and systems.
Because of the ever-deepening financial integration, financial cycles are likely to be highly
correlated across countries also in the future.
In such a world, a successful national macroprudential policy entails positive externalities, as
a reduction of financial risks in one country contributes to financial stability in other countries.
Conversely, a national inaction entails negative externalities, as financial problems are more
likely to spread to other countries in the absence of decisive national policy measures.
I argue that in the absence of strong international coordination, national policymakers are
likely to fail to internalize these positive externalities. This would lead to a combination of
passive national macroprudential policies that are dangerously weak in preventing future
global financial crises.
Let me elaborate further.
Consider a strong upturn of an international financial cycle, during which asset prices grow at
a fast pace, leverage increases excessively and the pricing of risk declines simultaneously in
many countries with interconnected financial markets. This scenario resembles, of course,
the developments in the years preceding the latest global financial crisis. To prevent these
risks materialising into a systemic global financial crisis, national authorities should tighten
their macroprudential policy and possibly other economic policies.
Now, consider the decision-making problem of a macroprudential authority or body in an
individual country. This authority may find it difficult to tighten the national macroprudential
policy for two reasons.
First, there is a well known problem of "taking the punch bowl away in the middle of the
party". This political economy constraint is likely to be even stronger than when interest rates
are increased to contain inflation: there is at least some constituency that dislikes inflation,
but none that dislikes the intoxicating feeling of getting richer2.
Second, as I mentioned earlier, a country which is tightening its macroprudential policy in
isolation would internalise only part of the financial stability benefits of macroprudential
tightening while bearing all the perceived costs in terms of the reduced competitiveness of
the national financial industry. This may lead to a first-mover disadvantage problem, where
no country is willing to be the first to tighten its macroprudential policy unless it knows that
other countries are committed to doing the same.
Unless properly addressed, these disincentives to pursue active national macroprudential
policies may lead to a bad equilibrium, where global macroprudential policies become overly
passive. This implies that the identification of effective macroprudential instruments - which
in itself is a formidable task - does not guarantee that these instruments are used efficiently
either at the national or global level.
What can we do to avoid this bad equilibrium? I have three suggestions.
First, to decrease the extensive political pressure not to take action, we should try to develop
and improve the rules-based macroprudential policy instruments as much as possible. These
instruments, such as the dynamic loan loss provisions used in Spain and the capital
conservation buffer of the Basel III framework, act at best as automatic stabilisers that do not
require continuous discretionary policy decisions. The countercyclical capital buffer
requirement included in the Basel III framework also includes a rules-based element, as
national authorities are advised to use an indicator developed by the Basel Committee as a
benchmark in their national buffer decisions.
Economists in the Bank of Finland have done some preliminary analysis on the feasibility of
rules-based loan-to-value requirements3. I urge the research community to intensify its efforts
to develop simple and robust rules-based macroprudential tools.
Second, national macroprudential authorities need strong enough mandates, independence
and legitimacy to make their discretionary macroprudential policy decisions. Efficient
macroprudential actions will be highly unpopular. The costs of these actions are immediate
whereas their benefits become visible only in the years to come. The weaker the
macroprudential authorities, the more likely they are to bow under the political pressure and
not intervene in the developing systemic risks.
Third, to reduce the first-mover disadvantage problem, we need a strong international
coordination of national macroprudential policies. In the EU, the European Systemic Risk
Board should take this coordinating role.
Without doubt, this is a difficult task. The ESRB has to strike the right balance between
directing its recommendations on macroprudential policies to individual authorities and
making collective recommendations to a larger group of authorities. Individual
recommendations may be more effective in alleviating the first-mover coordination problem
but may, at worst, be regarded by national authorities as a critique that they have failed to do
their job properly. In such a case, their response may be defensive rather than constructive.
Collective recommendations, in turn, would largely remove the stigma related to individually
targeted recommendations but be less effective in reducing the problem of first-mover
disadvantage.
Finding a workable solution to this trade-off will be one the ESRB ́s key challenges in the
coming years.
I thank you for your attention.