José Manuel González-Páramo: Some lessons from the global financial
turmoil
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the IIF Conference on "Global Financial Turmoil: Next Steps for
the Industry", London, 9 September 2008.
* * *
1. Introduction
Ladies and Gentlemen,
It is a great pleasure for me to be here in London at the IIF Conference. I would like to thank
the Institute of International Finance for inviting me and providing me with the opportunity to
share with you some views about the financial market turbulences, how we - as central
bankers - have addressed them and some of the lessons learned so far.
2. International transmission of liquidity shocks
Although the turbulences are still present and their consequences, or even their origins, have
not been fully analysed or identified yet, the rapid transmission of liquidity shocks at the
international level stands out for further reflection. Clearly, underlying the international
transmission mechanism is the fact that interbank markets are linked across countries by the
activity and funding needs of banks doing cross-border business on a large geographical
scale and holding assets and liabilities denominated in varying currencies. Liquidity
conditions in interbank markets are therefore correlated at the global level, because many of
the key players are subject to common shocks, and this probably is a key factor explaining
similar liquidity conditions across money markets.
At the risk of pointing out the obvious, let me stress that liquidity shocks are not exclusive to
stress situations. Under normal conditions, however, market illiquidity is typically short-lived
in particular since it creates profit opportunities for traders who, by providing extra funding
liquidity, support the price discovery process and bring the market to functioning again. In
contrast, during a severe turbulence the disruption of the mechanisms channelling liquidity -
be it through assets prices or the balance sheet of financial institutions - may also profoundly
and lastingly perturb the functioning of markets, ultimately creating risks for systemic
imbalances. The current episode is an example of this. Even the interbank market, which is
considered the deepest and most liquid of all markets, has been "frozen" long-lastingly. This
has happened not primarily due to a lack of liquidity, but because of uncertainties as to the
size and locations of losses created by the opaque transfer of credit risk brought about by
complex securitisation mechanisms.
Such uncertainty has heightened counterparty credit risk concerns and prevented banks from
lending to each other. Moreover, it has brought to the fore the increased interaction between
market liquidity and funding liquidity. By market liquidity I mean the ability to trade an asset
quickly and at low costs with little impact on its price, whereas by funding liquidity I refer to
the ease for economic units, in this case especially banks, to meet payment obligations with
internal or external funds as they fall due.
The trend among large banks, especially among the major global banks, has been towards
greater reliance on wholesale market sources of funding. Instead of relying on retail deposits,
banks are increasingly dependent on interbank borrowing, both unsecured and collateralised,
short and long-term debt, and, as an ultimate line of defence, on the sale of marketable
securities. This has made access to liquidity more dependent on market conditions.
Moreover, the range of systemically relevant institutions has become broader. In the
literature on "traditional" banking crises, the focus has been on the systemic implications of a
deposit run. However, non-deposit taking investment banks and primary dealers play a
systemic role in their crucial broker-dealer function, too. They perform a key role in
maintaining market liquidity in a broad range of unsecured and secured markets. If they face
funding liquidity constraints, market liquidity will be widely affected, with potential negative
repercussions for the banking sector.
The interaction between market liquidity and funding liquidity is best illustrated by a concrete
example: should the market liquidity of a particular asset be low, it will also be more difficult
to use it as collateral to raise funds, for instance in the repo market. The flip side of the coin
is that difficulties in raising funds by large market makers then may in turn further reduce
market liquidity. Thus, severe events or shocks, such as a credit crunch negatively affecting
market liquidity may trigger a negative feedback process between market liquidity and
funding liquidity. Indeed, during the turbulences, market liquidity first declined for a number of
assets closely related to the market for sub-prime mortgage backed securities - the core of
the recent turbulence. It then went on to affect all kinds of structured finance products,
including re-pricing of plain-vanilla ABS and RMBS securities. Problems in the ABS market
spilled over to the market for asset-backed commercial papers. The re-pricing of securitised
instruments and loss of confidence in turn negatively affected liquidity in the secured
nongovernment repurchase agreement markets as many banks no longer wanted to accept
securitised products as collateral. Only government bonds remained fairly liquid, although
some price differentiation across countries has been seen due to differences in public
finances. It became obvious that the deteriorating market liquidity had a negative impact on
funding liquidity: the originate-and-distribute banking business model took a hit due to an
almost complete dry-up of the securitisation market.
This environment poses challenges for central banks, as addressing funding liquidity
shortages may require assisting market liquidity. Clearly, the nature of the turbulence
matters: concerns for market liquidity itself could in principle be addressed by central bank
actions, whereas central bank liquidity operations would be ill positioned to tackle individual
counterparty solvency concerns.1 Along these lines, let me explain how we as central banks
responded to changing needs with operational measures and increased international
cooperation.
3. Central bank responses
Let me sketch with a broad brush the various actions the major central banks have
implemented in the course of the turbulences. Clearly, the responses varied across central
banks, reflecting differences in the extent to which markets have been hit by the turbulences,
and differences in the design of their operational frameworks. But in general terms, central
banks tried to address the liquidity squeeze in similar ways, acting on four fronts:
First, central banks acted to keep short-term money market rates in line with their policy rates
(or targets) through more active reserve management, reassuring banks of their orderly
access to overnight funds. They increased the frequency of operations to respond with
greater sensitivity to shifts in the demand for reserves.
Second, central banks sought to ease pressures in broader funding markets through a
combination of measures:
•
They increased the supply of longer-term funds via discretionary operations to
accommodate the demand for term funds.
•
Most of the central banks expanded to varying degrees the collateral accepted in
collateralised lending operations, and included in some cases securitised assets that
have been particularly affected by the liquidity squeeze.
•
Moreover, they widened and improved the access of counterparties to collateralised
lending from the central bank, to facilitate the distribution of central bank funds and
increased the scale of those operations.
•
Some central banks increased securities lending to improve the functioning of
interbank repo markets.
Third, central banks increased their co-operative efforts both through enhanced
communication and collective market monitoring, and through co-ordinated actions to provide
longer-term funds. Finally, some central banks also calibrated their monetary policy stance to
take into account any impact the unfolding credit market turbulences might have on inflation
and real activity.
3.1. Responses of the Eurosystem
Going more into depth, let me describe how the Eurosystem responded with its operational
measures to banks' changed liquidity demand.
In line with other affected central banks, the Eurosystem resorted to a more pro-active
liquidity management to maintain a proper control of short-term interest rates. However,
owing to the built-in flexibility of its operational framework for monetary policy
implementation, the Eurosystem could address the impaired functioning of the money market
through relatively minor, technical adjustments to its normal operations, while at the same
time utilising the full latitude of its operational framework.
In particular, it adjusted the distribution of liquidity supplied over the course of the
maintenance period, in contrast to normal times, by frontloading the supply of liquidity at the
beginning of the period and reducing it later, so that the total amount of liquidity over an
entire maintenance period remained unchanged.
Furthermore, the amount of refinancing provided via longer-term refinancing operations
(LTROs) increased significantly with a view to smooth conditions in the term money market.
Since April, the Eurosystem has further diversified the LTRO maturity structure by also
offering LTROs with a 6 month maturity. The amount of refinancing provided via the
oneweek main refinancing operations (MROs) was reduced correspondingly, so that the total
amount of outstanding refinancing has remained unchanged. This measure was welcomed
by market participants, although the amount of outstanding 6-month LTROs (currently €50
billion) is admittedly relatively small to account for all the demand for term refinancing in the
money market. As a result of these measures, the average level of EONIA has remained
close to the minimum bid rate, though with a higher volatility than before the start of the
turbulences.
Moreover, in addition to the main aim of controlling very short term rates, three features of
the operational framework in combination with a lengthening of the maturity profile in the
regular repo operations have allowed the Eurosystem to address funding constraints
indirectly also in term money and asset markets:
Firstly, access of a broad range of counterparties to central bank liquidity, not only at the
marginal lending facility but also at the regular temporary open market operations.
Counterparty eligibility criteria are defined in general terms so that a wide range of
institutions, small saving banks and co-operative banks can access central bank liquidity
directly. This feature of the operational framework has helped during the turbulences, as it
allowed the Eurosystem to step in and effectively mitigate funding liquidity risk for a broad
range of counterparties when short-term interbank markets stopped functioning properly.
Secondly, acceptance of a broad range of collateral not only in the marginal lending facility
and intraday credit operations, but also in temporary open market operations. As a
consequence, sufficiency of collateral has not been a constraint, facilitating access for a
broad range of counterparties to central bank money. Moreover, the collateral framework has
allowed counterparties to economise on the use of central government bonds with the central
bank, which has been often the only collateral counterparties could still use in repo markets.
And it has to some extent eased refinancing pressures for assets, such as ABSs, that faced
a nearly complete withdrawal of third party investors, since they can be brought forward as
collateral in credit operations of the Eurosystem. This includes also ABSs that counterparties
have originated themselves and retained on their balance sheet. The Eurosystem accepts
only ABSs based on a true sale and that are bankruptcy remote from the originator. These
requirements should in principle ensure a delinkage of the issuer from the originator.
Thirdly, the Eurosystem provides the bulk of its refinancing via temporary open market
operations. Consequently they are of a large scale, and allow the central bank to temporarily
take over a significant part of the intermediation function of markets if needed.
3.2 Increased international cooperation
As pointed out before, in addition to domestic operational responses, central banks have
strengthened their cooperation as the turbulence developed, first through enhanced
information sharing and collective monitoring of market developments and later on by
coordinated steps to provide liquidity. One example of joint actions between central banks
during this period is the by now familiar US dollar Term Auction Facility, which started in
December of last year, in which the ECB agreed with the US Federal Reserve to grant loans
in dollars to euro area banks with a maturity of one month against collateral eligible for
Eurosystem credit operations. As you know, Eurosystem loans were financed through a
currency arrangement (swap line) with the Federal Reserve, and granted at a fixed rate
equal to the marginal rate of the simultaneous Federal Reserve tenders. The first two
operations, for an amount of USD 10 billion each, were settled in December 2007 and
renewed in January 2008. Similar operations were also carried out by the Swiss National
Bank. These liquidity-providing operations did not have a direct effect on euro liquidity
conditions, but were conducted to address the funding of euro area banks in US dollars and
aimed at improving global funding conditions.
Since these coordinated actions, the G-10 central banks have continued to work closely
together and to consult regularly on liquidity pressures in funding markets. Owing to
continued pressures observed in the money market, the ECB, as well as the Swiss National
Bank, resumed in March 2008 the US dollar liquidity providing operations in connection with
the Federal Reserve Term Auction Facility, every second week for as long as needed, and
for an increased amount of USD 15 billion each. This amount was further increased to USD
25 billion each on 2 May 2008, and in August the Eurosystem agreed to extend the maturity
of a fraction of the TAF operations to 84 days.
It is important to stress that the action in connection with the TAF marked, to my knowledge,
the first systematic and multilateral central bank co-operation in the money market field, a
market which is central to the implementation of a central bank's monetary policy. In my
view, the TAF operations have been successful, as they were well received by market
participants' high demand, and succeeded to address the liquidity challenges in the global
term money markets.
One interesting remark around the participation in the TAF is why banks would prefer to
participate in the European USD auctions instead of obtaining the USD directly from the Fed
via their TAF auctions. There are several possible explanations to this. First, and rather
obvious, some European banks have no direct access to the Fed and its TAF auctions.
Second, the European central banks participating in the TAF have different lists of eligible
collateral which for some banks have made the access to USD easier. Third, European
auctions for US dollars provide a better timing for European banks.
4. Lessons for central banks
Going forward, what preliminary lessons can we draw as central bankers from the ongoing
turbulence?
4.1 Lessons for the implementation of monetary policy
In the past common central bank wisdom was to say that there is no unique way to
implement monetary policy. The currently prolonged dislocation of interbank markets and
asset markets more broadly has though shown that there are certain key operational features
that facilitate the implementation of monetary policy in such conditions. In order to distribute
reserves effectively when the interbank market is impaired, central banks should be capable
of providing access to collateralised lending operations to a broad set of counterparties
against a broad range of collateral and on a large scale. Whether those features should
become part of the regular operational framework or are introduced on demand in distressed
market conditions, is ultimately the choice of each individual central bank.
The recent developments have provided also central banks with a wealth of information that
has highlighted a number of weaknesses in the financial system, namely in the areas of
transparency, valuation, risk management practices, and market functioning. The lessons
learned affect also the way central banks mitigate risks in monetary policy operations.
As regards the Eurosystem, we are of the belief that our flexible operational framework,
including the collateral component, has served us well until now, and has helped us to
weather a number of tests, including the latest of a prolonged liquidity squeeze in a wide
range of unsecured and secured markets. However, this does not mean that there is no
scope for refinement and further enhancement.
One very recent example is the fine-tuning of our risk control framework in the context of our
bi-annual review of the adequacy of the risk control measures. The Eurosystem needs to
make sure that the collateral and risk control framework are monitored and adjusted over
time to ensure that an adequate level of risk tolerance is met. This ensures that the
Eurosystem remains adequately protected against financial risks across time, which is an
obligation for the Eurosystem enshrined in its statutes.
The results of previous reviews of the risk control framework were reflected in the 2004 and
2006 editions of the General Documentation. In February 2004, different liquidity categories
were introduced to better reflect the risks associated with different eligible asset classes. In
2006, specific eligibility criteria regarding asset-backed securities were established that
excluded instruments such as synthetic CDOs and cash CDOs containing other synthetic
tranches of ABSs.
The 2008 biennial review introduced an additional set of risk control measures aiming at
ensuring that the collateral continues to meet the Eurosystem's risk tolerance level, while
allowing at the same time the effective implementation of monetary policy. The new risk
control measures, communicated by the ECB on 4 September and entering into force on 1
February 2009 reflect, inter alia, improvements in the methodological framework, the
assessment of market and liquidity risk characteristics of eligible assets, the actual use of
eligible assets by counterparties and new developments in financial instruments.
I would like to highlight in particular the decision to require better rating disclosure standards.
To be eligible as collateral for Eurosystem credit operations, asset-backed-securities will
need a rating that must be explained in a publicly available credit rating report, being a
detailed pre-sale or new issue report, which should include inter alia a comprehensive
analysis of structural and legal aspects and a detailed collateral pool assessment. Moreover,
rating agencies - and the Eurosystem believes this is very important - would need to publish
rating reviews of asset backed securities at least on a quarterly basis.
The Eurosystem has witnessed in recent times a deterioration in the disclosure standards of
rating agencies for some of the ABS that are eligible for its credit operations. The new
measure requires enhanced disclosure standards in order to be able to perform eligibility
assessments that take into account inter alia the assessment and analysis conducted by
rating agencies. Of particular importance for the Eurosystem is that the performance of ABS
transactions is monitored on a regular basis. By requiring that the result of the rating
assessment as well as the regular surveillance reports are made public, the Eurosystem can
support the functioning of ABS markets more widely through enhanced transparency, which
is a pre-requisite to restore investor confidence.
Other important changes to the risk control include the introduction of a uniform haircut of
12% to asset-backed securities for all residual maturities and all coupon types, as well as a
valuation mark-down of 5% to all asset-backed securities that are theoretically valued by the
Eurosystem. On the one hand, the introduction of an uniform 12% haircut responds to a
careful analysis of the liquidity characteristics of asset-backed securities, which provided
evidence that an upwards adjustment of haircuts for asset-backed securities with short
maturities was advisable. The observation of the significant draw-downs in some ABS prices
experienced over the last year, even in quite short periods of time, has reinforced this view.
On the other hand, the application of a 5% valuation markdown to theoretically valued asset
backed securities reflects recent experience showing that the valuation of asset-backed
securities can be subject to significant uncertainties especially when there are no market
prices that could provide a reference for intrinsic value. By introducing both measures, which
have been motivated entirely by the desire to maintain an adequate level of risk tolerance,
the Eurosystem can contribute to the restoration of normal conditions in the functioning of
asset backed primary markets.
4.2. Measures to enhance the international distribution of liquidity
The current turbulence has also demonstrated that global channels for distributing liquidity
across borders may become seriously impaired. To prepare for that possibility, central banks
should take steps to strengthen their capacity to counter problems in the international
distribution of liquidity. It is interesting for me to see the high degree of consensus about
future measures, comparing the seven recommendations for the central bank community
from your Final Report of the IIF Committee on Market Best Practises, with those seven of
the Committee on the Global Financial System's report on Central bank operations in
response to the financial turmoil. Both reports point out to the need of establishing or
maintaining standing currency swap lines. From a technical point of view, the coordinated
distribution of foreign currency to the domestic bank sector through swap lines is a feasible
solution, presenting some potential advantages, including rapid implementation, expeditious
settlement and immediate access to the liquidity by banks, and could be very important in
emergency situations. Moreover, such swap lines could provide flexibility in choosing the
best way for redistribution of foreign currency funds. Also, the implementation can - and
must be designed in such a way that it does not conflict with domestic monetary policy
implementation.
Both reports also consider developing and maintaining the ability to accept foreign currency
denominated assets, which is more complicated than maintaining a swap line but could
support the efficient management of collateral of internationally active banks with
multicurrency liquidity demands. To understand this, it needs to be borne in mind that settlement
- a step that goes largely unnoticed, but is of critical importance - can become a
constraining factor. When collateral is available in the market where the central bank granting
credit is located, the basic step of delivery takes a few seconds. However, in the global
financial market major banks with large international portfolios may need liquidity in one
country or currency, and hold eligible collateral in another currency and in another country.
Cross-border mechanisms are in place between the infrastructures of major markets and
allow banks to move collateral where needed. These mechanisms normally meet the market
needs, since in routine situations there is no particular "urgency" to deliver collateral.
However, in an emergency situation, things may be very different. Liquidity needs may arise
suddenly and within a short time, and standard transfer procedures may simply not be
effective or quick enough, or recourse to troubled or volatile markets may be overly costly for
the collateral borrower. With its collateral stuck in one country and being unable to deliver it
to the relevant central bank, a global bank may have to make costly choices to find a solution
to its liquidity strains. And the situation may get possibly worse if, for example, the liquidity is
needed in a market located to the west of the one where the collateral-holder is located. In
some cases, time-zone differences may reduce to less than two or three hours the time
available for a transfer.
Easing liquidity pressure for large internationally active banks by broadening the range of
acceptable collateral may contribute to alleviating potential liquidity contagion risks in
payment systems, where the bulk of activity normally comes from the largest players, thus
having a positive influence on financial stability. However, it should be noted that accepting
foreign currency collateral also implies additional legal and financial risks in the conduct of
monetary policy operations. Hence, this is an area where further work is needed.
A third possibility, which the central banks of the G-10 countries are studying through their
Committee of Payment and Settlement Systems, is to explore ways to ease the frictions in
the existing models for cross-border transfer of collateral. Here various questions are on the
table: for instance,
• how to increase flexibility in central banks' and infrastructures' availability to counter
for time-zone frictions, or
•
how to support - through stricter central banks co-operation - the settlement
process of foreign liquidity transactions.
4.3. Deeper understanding of interdependencies between market infrastructure
and market participants
As part of their work to further deepen their understanding of the mechanism of transmission
of shocks, central banks are also doing extensive work on the interdependencies between
market infrastructure and market participants.
Financial markets rely and depend on increasingly complex infrastructures. Payment
systems, central securities depositories, central counterparties and their participants are
interconnected by a complex network of technical, operational and financial relations.2 Not
only markets rely on infrastructures but, in turn, modern infrastructures also increasingly
depend on well functioning, orderly and efficient markets.
Most of these interdependencies were introduced to reduce undue exposure to risks, and
contribute to the safer and more efficient environment that we enjoy today compared to the
past. Still, when international markets, clearing and settlement systems and participants are
strictly interconnected, the potential for spreading contagion across the globe via this network
of relations should not be underestimated.
In our ever-changing environment, understanding shocks transmission mechanisms and
engaging in a positive dialogue with infrastructures operators and market participants are two
tasks of central bankers that are time-consuming, resource-absorbing and on-going.
Perhaps not that visible, but rewarding indeed. For instance, the increasing attention being
devoted to the field of operational risk and business continuity has made the financial system
resilient to a number of otherwise potentially disrupting threats. Let me give you a practical
example: during the turmoil although some clearing and settlement systems were individually
challenged by unusual transactions volumes, the system as a whole coped well thanks to
effective capacity-planning, appropriate risk management, and stress testing activities
undertaken well before, not at the time, of the outbreak of the tensions.
5. Lessons for regulators and market participants
Both public and private fora have made significant efforts to identify weaknesses in the
financial sector and develop measures to restore its smooth functioning. Against this
background, I would like to mention the recommendations of the Financial Stability Forum's
(FSF) report on Enhancing Market and Institutional Resilience as they represent a main
reference point at the global level for measures aimed at addressing the weaknesses
revealed by the turmoil in the financial markets.
The short-term measures put forward by the FSF and endorsed by the G7 in April this year
were set up as immediate priorities and thus had a time horizon of 100 days for their
implementation. These comprised: (i) the full disclosure of credit institutions' risk exposures
in their mid-year reporting, using the leading disclosure practices set out in the FSF's report;
(ii) immediate action by the International Accounting Standards Board (IASB) to improve
accounting and disclosure standards for off-balance sheet items and to enhance guidance on
fair value accounting in times of stress; (iii) the enhancement of risk management practices
of financial institutions, including stress testing and strengthening capital positions, when
needed; (iv) the revision of liquidity risk management guidelines by the Basel Committee on
Banking Supervision; and (v) the revision of the code of conduct for rating agencies by the
IOSCO.
While a more thorough review of the progress in the implementation of these
recommendations is due for the G7 meeting in October, the preliminary assessment has
been encouraging. Financial institutions have made progress in improving their financial
reporting, following leading market practices and the so called "FSF template" providing for
more meaningful quantitative and qualitative disclosures. Furthermore, guidance in this area
has been prepared and is currently being further developed by both public fora - such as the
Basel Committee on Banking Supervision at international level and the Committee of
European Banking Supervisors (CEBS) in the EU - and private sector initiatives, including
the recommendations of the European and the American Securitisation Fora, aiming at
standardising disclosure practices and at enhancing the accessibility, usability and
comparability of information. To conclude my reference to the major initiatives in the area of
valuation and transparency, the IASB is accelerating its work to enhance accounting and
disclosure standards of off-balance sheet entities and to develop guidance for valuation in
illiquid markets.
In the same vein. progress has been observed in the area of liquidity management and the
enhancement of the tools for the oversight of rating agencies. In the field of liquidity
management, the Basel Committee and the CEBS have issued consultation papers on
banks' liquidity risk management and supervision. As regards rating agencies, the IOSCO
published the revised code of conduct and the European Commission is considering
regulatory initiatives for their authorisation and supervision.
From the above, it becomes evident that a lot of work is under way aimed at restoring market
functioning, which is backed by high level political momentum (G7 and G10 as well as the
ECOFIN at EU level). Regarding immediate priorities, I am of the view, as I already
mentioned, that significant progress has been achieved. Now the focus is increasingly
shifting towards effective and congruent implementation, which is the ultimate objective
against which the success of the reforms would be assessed. To this end, international and
EU committees have to play a critical role while political momentum needs to be preserved.
At the same time, policy work is under way on other important areas which have been
characterised as medium-term priorities. Let me make a reference to the following topics that
I see as of critical importance also from a central banking perspective: (i) strengthening
prudential oversight of capital and risk management; (ii) strengthening the authorities'
responsiveness to risks; and (iii) developing robust arrangements for dealing with stress in
the financial system.
Effective and timely implementation of the new Basel II framework and the revision of the
detected shortcomings thereof, are expected to realign the flawed regulatory incentives in
certain areas, and thus contribute to enhancing systemic resilience. To this end, assessing
the potential procyclical impact of Basel II should be among the primary interests of
supervisory authorities and central banks.
Now, let me highlight the importance of improving cooperation and the exchange of
information between supervisory authorities and central banks on financial stability issues.
The recent fin