José Manuel González-Páramo: Financial market failures and public
policies - a central banker's perspective on the global financial crisis
Closing remarks by Mr José Manuel González-Páramo, Member of the Executive Board of
the European Central Bank, at the XVI Meeting of Public Economics, Granada, 6 February
2009.
* * *
Introduction1
Ladies and Gentlemen,
It is a great pleasure for me to participate in the XVI Meeting of Public Economics here in
Granada, and to be able to share with you some analyses and reflections on the current
financial crisis and the role of public policies in responding to it.
The subject of my speech today deserves some explanation. We are currently experiencing
one of the deepest and most complex crises witnessed by the world in many decades. At the
root of the crisis, we find the combined effect of a number of market failures as well as
regulatory failures that explain how the turmoil stemming from a relatively small segment of
the US mortgage market has translated into a global crisis posing a number of challenges for
our economies and societies. The notions of market and regulatory failures are at the heart
of the Public Economics field.
The current crisis also represents an extraordinary example of how stabilising the
international and domestic financial systems and invigorating them in the medium-term
required and will continue to demand cooperation among different public policies, ranging
from macroeconomic to liquidity-related, regulatory and supervisory policies.
I will structure my intervention in four parts. I will devote the first part to analysing the
underlying causes that have contributed to the crisis. Later, I will broadly describe the policy
responses given by the major players in the global economy from four different angles:
liquidity policy, monetary policy, fiscal policy and regulatory reform. In the third section, I will
discuss in depth the actions undertaken by central banks - with especial focus on the
policies deployed by the ECB and the Eurosystem - and their rationale, as well as some of
the challenges ahead. Finally, in the last part, I would like to make some considerations on
the potential new environment for policy makers, and in particular for central banks, that may
be a key legacy of the current crisis.
Section 1. Market failures in the financial system
Highlights of the crisis
The start of the financial crisis was triggered in the summer of 2007 by the realisation that the
risks associated with the US market for sub-prime mortgages were not properly reflected in
the price of related instruments, particularly mortgage-backed securities. A market-wide
reassessment of financial risk led to sharp increases in premia and spreads across all
segments of the credit market. The rapidly falling market values of credit instruments hit both
the net worth and the profitability of the banking system.
Tensions in the markets for credit instruments spread to the money markets in early August
2007, giving rise to concerns about systemic disruptions. Indeed, inter-bank trading came
almost to a halt on 9 August as a result of the combination of: (1) exceptionally high
uncertainty about potential direct exposures of banks to "toxic" assets; and (2) increased
demand for liquidity to honour credit lines committed to so-called conduits (i.e.
banksponsored off-balance sheet investment vehicles).
Lack of transparency about the extent of exposures compounded uncertainty, preventing
market participants from distinguishing good banks from bad banks, leading to a decline in
trading in a real-life version of Akerlof's "lemon market". In addition, conduits had become
over time increasingly reliant on the issuance of short-term paper for the funding of their
securitisation activities. However, with the outbreak of the turmoil, they became unable to
roll-over short-term financing in the asset backed commercial paper market amidst great
uncertainty about asset valuations. Against this background, money market interest rates
and spreads rose sharply, while liquidity dried up, prompting central banks to intervene
through large-scale liquidity injections.2
As the year 2007 went on, the fall in US housing prices accelerated against the backdrop of
the rising number of foreclosures and the slowdown of the US economy. This led to an
increase in the number of defaults in mortgages, not only for sub-prime mortgages but also
for the prime segment of the markets. Thus, an increasing number of securities linked to
mortgages turned out to be much riskier than previously thought.
All major central banks around the globe continued to address market disruptions through
significant liquidity injections. However, the losses in several important markets for financial
assets continued to mount and in March 2008, the Fed had to engineer the rescue of Bear
Stearns, then the fifth largest U.S. investment bank, by JP Morgan and grant direct access to
its financing to the other main investment banks for the first time since the Great Depression.
The financial turmoil deepened in the weeks following the collapse of the Lehman Brothers in
mid-September 2008, more than a year after the onset of the crisis, eventually developing
into a full-blown crisis with adverse spillovers into real activity. Within two weeks from the
bankruptcy of Lehman Brothers, mounting losses from the sub-prime mortgage markets led
to both the US largest insurance company (AIG) and largest savings and loan institution
(Washington Mutual) being seized by the government. Widespread concerns about the
solvency of financial institutions ensued and spread to Europe, where government
assistance was needed to avert the collapse of several institutions.
Underlying causes
It goes without saying that, determining the appropriate policy responses to the crisis
requires a thorough understanding of its underlying causes. For this purpose, it is important
to distinguish the macroeconomic factors from those of a microeconomic nature.
As for the macroeconomic factors, the roots of the current crisis may go as far back as the
late 1990s, when global imbalances in current account positions and capital flows across
major economies, particularly in the US, started to build up. At the time, several emerging
economies enhanced fiscal discipline and recorded a collapse in investment, which
contributed, alongside other factors, to substantial surpluses in savings-investment and
current account balances. In the industrialised countries, corporate investment fell after the
collapse of the IT bubble in 2001. Meanwhile, in the US private saving was falling, while
domestic demand was expanding. Excess savings in the world outside the US - the so-
called "savings glut" - together with accommodative global monetary conditions led to ample
liquidity in the world financial markets and low interest rates across the maturity spectrum.
micro
Turning to more factors, financial innovation allowed the repackaging of mortgages -
traditionally, illiquid assets originated and held by local banks - into higher-yielding complex
securities with triple-A rating. Mortgage backed securities or more complex products based
on those securities were in high demand by banks and investors around the world who were
"searching for yield" in an environment characterised by low interest rates. The situation
endured, as sustained appetite of foreign investors for debt securities issued by the US
government and government-sponsored agencies as well as by the corporate sector allowed
the country to smoothly finance its current account deficit.
The "search for yield" fostered the demand for more complex forms of securitisation, which
led to the creation of instruments that entailed risks that were difficult to assess and price. No
active secondary market existed for many of the new instruments, and the associated opacity
of the credit risk distribution made it difficult to keep track of the exposures.
A key question is why investors did not look more closely into the risks associated with the
securities purchased, thereby playing a disciplining role in the securitisation process. The
answer leads us to an important microeconomic factor behind the current crisis: the
existence of agency problems associated with the implementation of the "originate and
distribute" model. This model - that became prevalent among large banks over the past
twenty years - was designed to deliver a more efficient allocation and distribution of risks in
the economy.
However, because of information asymmetries and frictions, the "originate and distribute"
model in practice gave rise to inefficient outcomes and distorted the behaviour of the various
parties involved in the securitisation process: investors, rating agencies, intermediaries, and
originators.3 The main reason for this is that the goals of the parties involved differed, and in
some instances may even have been in conflict. Besides, the different categories did not fully
internalise the consequences of their individual actions in the overall process, and therefore
did not have the right incentives to share information efficiently.
investors
In particular, became over-reliant on the ratings provided by the rating agencies
and often did not properly conduct their due diligence. The fact that regulators gave ratings a
prominent role in the risk assessment framework might have indirectly affected investors'
incentives. Investors often ignored the fact that rating agencies' risk measures offer only a
partial account of the risks embedded in the securities, as they focus primarily on the
expected loss and do not take into account the tail of the loss distribution. In addition, they do
not take liquidity risks into account.
Moreover, rating agencies were themselves subject to potential conflicts of interest that may
have diminished their incentives to undertake timely downgrades of structured products and
provide adequate information to investors regarding the analysis underlying the rating
decision. In fact, because ratings are paid for by issuers, rating agencies may have
incentives to expand coverage to products whose risk assessment is difficult and, potentially
unreliable, in order to maximise their revenues. Besides, agencies may also provide
commercial advice to the issuers of those securities that are then requested to rate.
originators of
As regards loans, their incentives to screen and monitor borrowers may have
been reduced under the "originate and distribute" model, once they sold the originated assets
to intermediaries that subsequently took care of repackaging them into securities. Instead,
the loan originators may have concentrated on expanding volumes of loans originated to
boost their profits. The diminished incentive to screen and monitor borrowers implies that
investors may have ultimately acquired assets of relatively lower quality and performance.
This is compounded by the fact that the intermediaries, who purchased assets and bundled
them into pools prior to securitising them, focused on maximising revenues stemming from
the servicing fees charged to investors, without necessarily delivering the risk/return balance
desired by investors.
More in general, remuneration schemes based on rewarding short-term profits tended to
predominate throughout the financial system, often to the detriment of the longer-term health
of the financial institution. For example, compensation structures at the top management
level are based on the comparison of latest results vis-à-vis those of their peers and thus
tend to encourage short-termism and risk-taking by managers keen on avoiding
underperformance. The pressure to deliver quick profits makes it more difficult for risk
management departments, that are often viewed as "party spoilers", to curb excessive risk
taking in their financial institutions. The job of risk managers is also complicated by the fact
that certain risks are hard to quantify and measure (for example, tail risks) and that
commonly agreed valuation models are missing for more complex securities.
These factors magnified the more general "pro-cyclical" tendencies of financial systems,
which also stemmed from a host of other factors, such as accounting standards (e.g.
markto-market accounting) and the dependence of collateral values and leverage ratios on asset
prices.
These structural incentive problems have not been fully taken into account by regulators and
supervisors. The Basel I framework that was prevalent at the time of the turmoil's outbreak
(and still is) underestimated banks' exposures by not capturing the bulk of the risks related to
off-balance-sheet vehicles as well as liquidity and reputational risks.
Supervisors and regulators should also have paid more attention to the challenge of
regulatory arbitrage. In fact, some financial innovation processes were triggered - among
other considerations - in order to circumvent the existing regulation, particularly on capital
requirements. This aspect is even more pressing in the current environment, with large and
complex financial institutions operating across borders, under different national regulatory
and supervisory regimes. As I will mention below, an improved and closer cooperation and
information sharing among central banks, regulators and supervisors at both national and
international levels seems, therefore, essential.
To sum up, we have seen that the causes of the current crisis can be traced back to
macroeconomic imbalances incentive problems regulatory
and, at the micro level, to and that
and supervisory deficiencies have also played a role. Nonetheless, the crisis has once again
shown the importance of system-wide externalities in propagating and exacerbating the
crisis. Problems of individual banks may have wide and serious implications for both the
financial system itself and the economy as a whole. Overall, banks must ultimately respond
to losses on risky assets by raising new capital. New equity, however, may be difficult to be
issued in sufficient amount in the short run. As a consequence, banks' first responses have
been both asset "fire sales" and the scaling back of their lending activity.
These two effects affect the banking system widely. Widespread liquidation of assets in the
current market conditions pushes prices down. Through mark-to-market accounting,
declining asset prices lead to unwarranted contagion to other banks with similar assets.
Those banks may be forced to adjust their positions by selling assets themselves, thus
leading to further asset price declines. Similarly, when deciding to cut lending, banks may not
internalise the repercussions of their decisions on the real economy in terms of foregone
profitable investment opportunities, output and employment.
2. Policy responses
Let me now turn to the public policy responses to the crisis, with a special emphasis on the
common elements
of the responses of the major players in the global economy.
Liquidity policies
Central banks have established the first line of policy defence against the adverse dynamics
massive provision of
set in motion by the financial crisis, particularly through the liquidity.
Although the specific responses have varied across central banks, since 9 August 2007 the
common objective of these institutions has been to address the global liquidity squeeze,
particularly in order to mitigate as much as possible the risk that protracted liquidity
shortages turned into solvency problems.
Central bank liquidity policies have not been limited to the shortest end of the money market
rates, but have in some cases also sought to ease pressures in term funding markets. This
has been pursued through an increased supply of longer-term funds. Access to central bank
funding has also been facilitated by enlarging the list of collateral eligible for the central bank
lending operations and by widening the range of counterparties with access to these
operations. In some countries, central banks have also extended lending to non-depositary
banks and to non-bank financial institutions. Additionally, some central banks have
established securities lending facilities to improve the functioning of their interbank repo
markets.
An important characteristic of the global liquidity policy response to the financial crisis has
been the strengthened cooperation among central banks. Cooperation has taken place first
through enhanced information sharing and collective monitoring of market developments,
and later on by taking coordinate steps to ease liquidity tensions in the global money
markets.
The first initiative in this direction was the agreement in December 2007 between the ECB
and the US Federal Reserve to grant loans in US dollars to euro area counterparties in
connection with the Fed's Term Auction Facility (TAF). The US dollar-denominated loans to
euro area banks were financed through a currency arrangement (swap line) between the two
central banks.
The US dollar liquidity-providing bilateral agreements between the Fed and the ECB (as well
as between the Fed and a growing number of central banks4) under the TAF programme -
that has become a symbol of the determination of the central banking community to address
global liquidity tensions - has been significantly expanded over time in terms of scale. In
addition, the Eurosystem has signed agreements with the central banks of several European
countries in order to improve the provision of euro liquidity to their banking sectors.
Finally, in a fortunately limited number of cases, central banks have assisted their domestic
governments in providing emergency liquidity assistance to institutions under stress.
Monetary policies
Let me now quickly review the common elements of the measures taken by central banks
from the perspective of monetary policy. The distinction between (1) liquidity management
and (2) monetary policy is very important in the case of the ECB, since its strategy clearly
separates the role of monetary policy in determining the optimal interest rate level required to
maintain price stability from the role of its operational framework in ensuring that interest rate
decisions are transmitted to the financial markets and the real economy in an effective
manner.
Although at different paces, reflecting differences in domestic macroeconomic conditions and
specific monetary policy objectives, from the start of the crisis the major central banks around
the world have also adjusted their respective monetary policy stances to reflect the
diminished risks for price stability. By doing so, these institutions have clearly signalled the
strong commitment of the international central banking community to anchor inflation
expectations and addressing the macroeconomic background and the implications of the
financial crisis.
Fiscal policies
On the fiscal side, governments around the world have announced a number of initiatives in
order to tackle the effects of the financial crisis. The nature of the fiscal measures has
evolved with the development of the financial crisis and its propagation to the real economy.
Government interventions initially focused on addressing problems at single institutions,
rescues
mainly through and provisions of guarantees. Some governments also announced
measures to provide relief to struggling homeowners, and attempted to stimulate domestic
economies, particularly in those countries where the slowdown in housing markets was more
significant.
Next, as the financial turmoil intensified and the need to support the entire financial system
became clearer, the fiscal response in Europe and in the US evolved into more
comprehensive plans designed to support entire domestic financial industries rather than
individual institutions. Such plans typically comprised capital injections in exchange for equity
and the more systematic provision of state guarantees. Finally, stimulus packages aimed at
fostering aggregate demand have also been announced, as the adverse effects of the crisis
have worked through the real economy.
In parallel to the increase in the scope of fiscal measures, there has also been a rise in the
degree of international policy coordination, reflecting the global nature and amplitude of the
current crisis. The G-7 and G-20 summits have represented major steps for policy
coordination at the global level, while at the EU level international cooperation has been
shaped by the exceptional procedures from the European Commission to coordinate and
accelerate national rescue plans, as well as by the European Economic Recovery Plan. This
plan provides a common framework for the efforts made by Member States and by the EU,
with a view to ensuring consistency and maximising their effectiveness, always in
accordance with and within the framework of the Stability and Growth Pact.
In addition, other types of fiscal measures are currently at work. As the economic crisis has
deepened, a significant contribution to the fiscal adjustment may come from the so-called
automatic stabilisers. These are programmes linked to social security and unemployment
benefits, which are generally more comprehensive in Europe than in the US. As they act
immediately and are proportionate to the depth of the business cycle, automatic stabilisers
can be more timely and targeted than discretionary policies, and do not suffer from political
economy risks that can undermine the effectiveness of the discretionary measures.
The volume of public resources made available or committed by governments has no
precedent. In this context, fiscal authorities should not forget that sustainability of the public
finances is a pre-condition for the effectiveness of the extraordinary measures. Some of the
fiscal stimulus packages that have been adopted recently in Europe have raised some
concerns, as some of them have been adopted in countries where the fiscal situation already
calls for particular prudence regarding its sustainability. Governments around the world, but
especially in countries where the presence of automatic stabilisers is significantly important,
should take the prospective burden of such stabilisers into account when designing their
overall fiscal plans.
Regulatory reforms
Regarding regulatory reforms, the competent authorities at both the European and the global
level have been actively involved in the development of measures aimed at restoring market
confidence and enhancing the stability of the financial system.
At the European level, policy action has been guided by the ECOFIN Roadmap which
identified four priority areas: (1) enhancing transparency, (2) improving valuation standards,
(3) reinforcing prudential rules and risk management, and (4) improving market functioning.
These priorities have been mirrored at the international level by the Financial Stability Forum
in its proposal of April 2008 (consisting of a set of 67 recommendations), subsequently
endorsed by the G7 ministers and central bank governors). To recall, the Financial Stability
Forum brings together central banks, banking supervisors and finance ministries from the
largest world economies. The Forum also involves international institutions such as the
International Monetary Fund and the Bank for International Settlements. In recognition of the
global dimension of the current financial crisis, the G20 Finance Ministers and central bank
Governors' acknowledged in their November meeting last year, the need to expand the FSF
membership to include also key emerging market economies. This is expected to contribute
to further enhancing the FSF's ability to coordinate global efforts towards a more resilient
financial system.
Section 3. What did central banks do? Why did they do it?
Central banks have acted on three different fronts to tackle the crisis, namely liquidity
management, monetary policy and financial stability. Over the next few minutes I would like
to share with you some reflections on the policy actions that central banks in general - and
the ECB in particular - have undertaken and on the challenges that we are likely to face in
each of these three areas.
Liquidity policy
Before discussing liquidity management interventions, it is useful to recall that the ECB's
measures to provide support to money markets have been based on the fundamental
principle of the separation between monetary policy decisions and their implementation.
This principle is important in order to reduce the risk that economic agents may mistakenly
interpret volatility in short-term money market rates, triggered by temporary and
unpredictable fluctuations in liquidity conditions, as containing information on the desired
monetary policy stance (which is instead given by the rate applied to the main refinancing
operations). The separation principle has proved to be particularly effective during the
financial market turmoil and at times of high volatility in the short-term money market rates.
(i) Addressing liquidity risk through increased intermediation
Let me now try to explain in somewhat greater detail the rationale behind the operational
measures of the Eurosystem during the financial market turmoil.
From the start of the turmoil until the collapse of Lehman Brothers in mid-September 2008,
the ECB engaged in active liquidity management by adjusting the temporal and quantitative
distribution of its liquidity provision within the maintenance period.5 Besides, from October
2007, the Eurosystem has engaged in increasing international cooperation to ease tensions
in global money markets, particularly by facilitating the access of euro area banks to US
dollar liquidity.
Through the adjustments to its euro operations, the ECB responded to the perceived change
in the pattern of banks' demand for liquidity over the maintenance period, in particular
responding to the increasing evidence that interest rates were no longer necessarily linked to
liquidity conditions on the last day of the maintenance period (as postulated by the so-called
"martingale hypothesis"). Indeed, unlike in normal times, banks seemed to no longer regard
reserve holdings on different days of the maintenance period as substitutes. By contrast,
there was evidence of the emergence of precautionary demand for liquidity early in the
maintenance period.
As mentioned earlier, the shift in the time pattern for liquidity demand was related not only to
the fact that counterparties were reluctant to lend to each other on unsecured terms, but also
to their fear of being confronted with unexpected liquidity shocks. As a consequence, banks
seemed to prefer reducing their so-called "liquidity gaps", also by fulfilling their reserve
requirements relatively early in the maintenance period.
The rise in precautionary demand implied a pricing of liquidity that was inconsistent with the
martingale hypothesis, which prompted the ECB to bringing its supply of liquidity forward in
the maintenance period - i.e. to " frontload" - in order to achieve the same level of short term
interest rates as before. Concretely, the ECB accommodated banks' preference for the
frontloading of reserves by systematically allotting more than the so-called "benchmark" amount
in its weekly main refinancing operations. The allotments above the benchmark were
reduced in the course of the maintenance period so that the average supply of liquidity over
the entire maintenance period remained unchanged.6
In the same vein, the ECB increased the amount of refinancing provided via longer-term
refinancing operations, with a view to reduce the liquidity gaps of the banking system and to
smooth conditions in the term money market. It correspondingly reduced the amounts
allotted at the weekly main refinancing operations so that the total amount of outstanding
liquidity supply remained unchanged.
Indeed, during the early phases of the turmoil, the Eurosystem aimed at keeping the overall
level of euro refinancing provided to the banking sector at levels close to those prevailing just
before the turmoil, in line with its longstanding policy of providing the banking system only
with the amount of liquidity needed to smoothly fulfil its aggregate liquidity deficit over each
maintenance period. The Eurosystem's intermediation role in support of the affected
segments of the euro money market was therefore mainly achieved by adjusting the
modalities of the liquidity supply operations.
Following the collapse of Lehman Brothers in September last year, the financial market
turmoil entered a more intense and disruptive phase, in which the money market became to
a large extent dysfunctional. In response to the deterioration of market conditions, the
Eurosystem stepped up its temporary intermediation activity to ensure that the dysfunctions
of the money market did not drive solvent banks out of business. Out of the various
measures implemented, perhaps the most important was the switch to fixed-rate tender
procedures with full allotment in all refinancing operations - not only euro credit operations
with maturities of 1 week up to 6 months, but also the ECB's US dollar operations with
maturities from 1 week to 3 months - against a temporarily enlarged set of collateral.
In practice, these measures imply that the ECB's counterparties - which represent a very
large number of euro area credit institutions - can now borrow as much euro and US dollar
liquidity as they wish, both at the weekly and at some key term maturities, against a larger
than usual set of eligible assets. As a result, the amount of euro refinancing provided by the
Eurosystem in collateralised dollar operations in euro and US dollar is currently close to EUR
900 billion.
Overall, the ECB's liquidity measures during the more recent phase of the turmoil have
focussed on addressing liquidity shortfalls in the interbank market, but have not (and could
not) address the problem of heightened counterparty credit-risk aversion. The situation in the
euro money market is still far from normal, being still significantly affected by elevated level
of risk aversion and information asymmetry.
(ii) Reactivating the money market
The Eurosystem has moved from the situation before the start of the turmoil, in which it did
not provide more refinancing to the banking system than was needed to satisfy the
aggregate liquidity needs arising from autonomous factors and reserve requirements, to the
present situation in which it effectively intermediates liquidity flows among individual banks.
Therefore, the clearing of intra-bank liquidity flows has to a large extent moved from the
dysfunctional money market to the Eurosystem's balance sheet. Reflecting the increased
role played in financial intermediation, the Eurosystem's consolidated balance sheet (weekly
financial statement) has increased by around 60% since the start of the turmoil.7
Taking up a significant intermediation role to guarantee the orderly functioning of our
economy was certainly essential in the wake of the collapse of Lehman Brothers, when an
unprecedented deterioration in the degree of public confidence in the banking sectors of
most developed economies seemed to undermine in a fundamental manner the ability of
banks to perform their institutional financial intermediation function. It should not be forgotten
that, while the euro area financial landscape has significantly changed in recent decades as
a result of a number of structural developments (including the introduction of the euro), it is
still predominantly "bank-based". As a result, dysfunctions of the banking system have a
relatively larger potential to cause disruptions to the economy in the euro area than in other
regions of the world.
Of course, taking up an extensive intermediation role is not acceptable in the long-term for a
market-oriented economy like the euro area. The increased intermediation role of the
Eurosystem is only a temporary answer to the dysfunction of money markets and is now
without potential disadvantages, including disincentives for banks to resume normal trading
activity and also potentially increased financial risks for the Eurosystem (which are
nevertheless mitigated through adequate risk control measures).
Thus, while the Eurosystem is determined to continue supporting the banking system
through its enhanced liquidity policy for as long as needed, it also looks forward to the
reactivation of inter-bank lending and to banks resuming their traditional intermediation
activity. Indeed, an exit strategy from the exceptional temporary measures undertaken in
support of the banking sector will be considered in conjunction with the progressive restoring
of normal conditions in money markets.
In the meantime, banks must show willingness to re-establish credit li