Jean-Claude Trichet: Risk and monetary policy
Lunch remarks by Mr Jean-Claude Trichet, President of the European Central Bank, at the
Stanford Institute for Economic Policy Research (SIEPR) Economic Summit, Stanford
University, Stanford, 12 March 2010.
* * *
Ladies and gentlemen,
It is a pleasure to be in California today. I am delighted to have been invited by the Stanford
Institute for Economic Policy Research to address the Economic Summit. Stanford University
and the area that surrounds this spectacular bay are renowned across the world for a highly
productive blend of scientific innovation and entrepreneurial business.
Financial innovation is part of scientific progress. It is an engine of growth and prosperity.
Yet, the key question, which I would like to highlight in my remarks today, is to what extent
financial innovation serves the real economy and to what extent it only serves itself. At some
point in our recent past, finance lost contact with its raison d'être. It ceased to be a source of
services for the real economy and developed a life of its own. Finance became
selfreferential. I will briefly review the driving forces that led to this situation and the profound
crisis that followed.
Financial crises have been a recurrent feature of human history. Let me take you back over
two millennia in Europe to see how the great historian Tacitus described the financial crisis
that hit the Roman Empire in the year 33 AD. In the Annales, he wrote:
"The destruction of private wealth precipitated the fall of rank and reputation. At last, the
emperor interposed his aid by distributing throughout the banks a hundred million sesterces,
and allowing freedom to borrow without interest for three years, provided the borrower gave
security to the State in land to double the amount. Credit was thus restored, and gradually
private lenders were found."1
Replace "emperor" with "governments and central banks", "sesterces" with "dollars" or "euro",
"security" with "collateral": this two thousand year old quotation could sound surprisingly
familiar.
Yet, even though two thousand years have passed, with many financial debacles in between,
I think it is fair to say that we entered the current crisis less than ideally prepared.
First, we had to improvise with an economic interpretation of the causes that led to those
unprecedented market disruptions. The dramatic fall in confidence revealed a source of risk
that macroeconomists had not modelled carefully and that had not even been considered
relevant by most theorists of finance. Now, the concept of "systemic risk" is almost common
knowledge.
Second, we had thought that the financial system would act as a shock absorber. Portfolio
theory had demonstrated that the dispersion of individual risks would attenuate aggregate
risk. But the mispricing of risk multiplied exposures, and the assumption of similar risks by
market participants increased the potential for contagion. In the event, we learned that
dispersion does not necessarily mean effective diversification.
Third, as central bankers we had to design intervention strategies that had not been studied
in recent times. The extraordinary liquidity measures that central banks took at the height of
the crisis on both sides of the Atlantic had been expelled from the economics textbooks.
Modern monetary economics had suggested that unlimited arbitrage in financial markets
would make such measures irrelevant and unnecessary.2 In the event, amid conditions of
extreme uncertainty, private arbitrage was unavailable. As in ancient Rome, public credit
became vital because private finance had - at least temporarily - disappeared.
What are some of the long-term lessons we can draw from the current crisis?
Just as we have had to re-evaluate our understanding of the nature of risk of market
disruptions and the potential responses in terms of implementation of monetary policy, so we
must re-evaluate our understanding of the role of financial markets in our economies and our
societies. The lack of a framework for monitoring and addressing systemic risk in the run-up
to the crisis is part of the motivation for financial reform and improved market regulation. But
we must also consider fundamental questions about the relative importance and limits of the
pure financial "game" in markets, the potential abuse of market power, and, more generally,
the role of the financial sector in the economy.
Financial reform needs to go beyond the banking sector on which so much attention has
been focused. We also have to look very closely at non-bank financial institutions and at the
set-up and functioning of financial markets. Leverage cycles, for example, have been a
constant source of instability for centuries. If left to their own devices, their ultimate outcome
has regularly been financial disruption, wealth destruction and economic hardship for our
people.
Let me start by elaborating first on risk before and after the crisis and then turn to monetary
policy. I want to share with you the European Central Bank's approach to dealing with the
balancing act, in which we have sought a combination of bold action as regards
nonstandard measures, while entirely preserving our clear focus on medium and long term price
stability.
Risk before and after the crisis
Risk is inherent in economic activities because economic pay-offs are uncertain. Even the
prototype model of finance - the competitive economy studied by Gérard Debreu and Ken
Arrow - is subject to stochastic shocks. Therefore, economic returns are risky, because they
are not known with precision ex ante.
But the type of risk that we faced in the crisis was of a different nature. It was not triggered by
stochastic variation in the real economy - by shocks to "endowments, technologies and
tastes" as theory would predict. At source, it was financial risk. The financial structures that
we thought were in place to assess, absorb and neutralise risk were either dysfunctional, or
worked - perversely - to magnify volatility. This is how financial risk was created, transmitted
to the real economy and eventually became systemic.
Key factors in creating this risk were opaque financial structures, particularly vulnerability to
contagion and domino effects, and pro-cyclicality in financial markets.
The lack of transparency in many financial instruments meant that market participants did not
know who was exposed to what kind of risk. In this state of incomplete knowledge, some
market players could exploit - for their own, private benefit - information that was not
generally available.
Pro-cyclicality acts as a formidable accelerator of financial trends. Demand for finance
increases and declines in tandem with the cycle. But the supply of finance does not simply
accommodate demand: it often amplifies the cycle.
Where does pro-cyclicality stem from? To my mind, distorted incentives and herd behaviour
are key explanatory factors.
The role of distortions in economic incentives is probably better known as it had traditionally
been widely appreciated even within neo-classical modelling.3 By comparison, herd
behaviour as a driver of pro-cyclical patterns in financial markets still needs a thorough
explanation.
It is difficult to rationalise herd behaviour. There are two possible explanations. One is that a
market player's own evaluation, pay or external reputation depends on its performance
relative to the rest of the market. This is reminiscent of Keynes' famous beauty contest
analogy. To be successful in this contest you don't need to make your own assessment of
the candidates; all you need to do is figure out who the other participants think is most
beautiful. Applied to financial markets this means that individual participants do not form their
own opinion, but follow the general mood prevailing among financial market participants. One
could call this a dereliction of responsibility. Everybody seeks to ride on the wave created by
generalised sentiment, hoping to step out before the general sentiment turns.
The second explanation is that global markets are in fact less atomistic than we think.
Indeed, despite globalisation, increasing market concentration was already a long-term trend
before the crisis. Derivatives activity in the U.S. banking system, for example, is dominated
by a small group of large financial institutions. Five large commercial banks represent 97% of
total notional amounts and 88% of net exposure.4 And, of course, the market for credit
ratings is famously dominated by three signatures, which act as standard-setters for an
enormous volume of financial transactions.
Imitative strategies and market concentration make financial trends overly dependent on
idiosyncratic decisions and market sentiment. What is clear is that while the end result - herd
behaviour - seems to be individually rational, it is socially wasteful.
Herd behaviour favoured the build-up of leverage. Leverage cycles have been a constant of
many of the financial crises of the past. But the financial players that contributed to the boom
before the crisis were able to use previously unavailable ammunition. In the run-up to the
crisis, we saw the emergence and fast development of a new set of complex financial
instruments such as ABSs, RMBSs and CDOs as well as hedging instruments like CDS.
These were invented as instruments to repackage, disseminate and hedge risks. As they
became available, they were viewed as filling a gap in an incomplete market structure. In
fact, credit derivatives turned into potent vehicles for pure financial market participants to
leverage their views.
The distinction between arbitrage and directional positioning is critical here. Arbitrage is an
essential market force. By eliminating differences in risk-adjusted returns, arbitrage promotes
price discovery and fosters market dynamics. Directional positioning or "pure speculation" does
not necessarily eliminate existing discrepancies between risk-adjusted financial prices: it might
amplify or even create price gaps. It does so by acting on expectations of future price changes.
Unlike in the case of arbitrage, these price gaps are notional - indeed, speculative - and might
be large only because they are not suitably discounted for risk.
The state of "meta-stability" of financial markets is one in which large-scale positioning has
become a leading force of market dynamics.
Indeed, system-wide conditions of overexposure and illiquidity placed the markets in a state
of meta-stability, i.e. potentially unstable, ultimately triggering systemic risk. An economy in a
state of meta-stability is prone to shocks that are seemingly innocuous but can reveal facts
that were either unknown or little appreciated before. This new knowledge can trigger the
crisis.5
Monetary policy in times of crisis
And then the crisis came. Immediate action was needed to fend off systemic risk.
Governments and central banks around the word were united in purpose. With their actions,
central banks broke new ground which monetary theorists will be studying for years to come.
The modern theory of central banking had a narrow focus on interest rates. Even in a crisis
situation - in conditions of collapsing confidence and very low interest rates - monetary
theory assumes that a central bank will always be in a position to influence inflation and
demand by steering expectations of the future path of its interest-rate instrument in the
future. These theoretical prescriptions are based on the assumption of perfect market
arbitrage.
Intertemporal arbitrage is indeed what makes monetary policy effective in normal times. It
ensures that the return on a long-term security is equalised with the return on a strategy of
holding a very short-term security - paying the policy rate - and rolling it over until the end of
the policy commitment.
In this crisis, however, market arbitrage was simply unavailable. The disappearance of
market arbitrage was a challenge for monetary policy. But by no means did it imply policy
ineffectiveness. It called for central banks to engage in non-standard measures and play an
intermediation role that the market was unwilling or unable to perform. The ECB fulfilled its
role of market-maker in particular by providing liquidity to banks without limit, for "as long as
was needed", to restore normal market functioning.
Note here a difference between the ECB and the Federal Reserve. Even in normal times the
ECB conducts monetary policy through loans, rather than via direct purchases and sales of
securities. Unlike Fed discount-window lending, however, our loans are untargeted. They are
an instrument for the routine provision of monetary policy liquidity, rather than part of
selective assistance to distressed banks. It is a system centred on overnight and term credit
to banks.
So our system was tailor-made to be used as an instrument to resist a banking crisis. In the
event, it was flexible enough to be activated - with only limited adjustments - in emergency
conditions. The need to tackle the collapse of private arbitrage motivated two features of our
enhanced credit support: first, the full, unlimited accommodation of banks' demands for
central bank credit at our policy interest rate contributed to repair the collapse of interbank
lending; second, the extension of central bank credit provision to longer maturities, up to one
year, was a substitute for market intertemporal trading.
Our actions would not have been effective if they had not been enshrined in our
mediumterm monetary policy framework. Our definition of price stability steered expectations in a
sufficiently firm manner. So the ECB can dispense with making promises about the future
path of the monetary policy stance. The ECB's approach to steering market expectations is
based on comparing inflation outcomes and projections with our quantitative definition of
price stability. This can be done without making statements about the policy instrument in the
future. Each month we provide the market with a comprehensive assessment of the risks to
price stability over the medium term. This allows market participants to form expectations
about the future course of monetary policy, conditional on our real-time assessment of the
state of the economy. In this sense, the ECB is predictable, and this minimises the volatility
of expectations in normal times.
Our quantitative definition of price stability and our medium-term orientation significantly
reduce the likelihood of either deflation scares or inflation scares. The firm anchoring of
inflation expectations - throughout a time of crisis - meant that we could maintain the rate on
our refinancing operations at positive levels without having any materialisation of a
deflationary risk or inflationary expectations.
The phasing-out process
I mentioned that we chose to expand our credit to banks. When executing lending policy, a
central bank functions much like a private financial intermediary. Private credit extension is
accompanied by restrictions on the borrower to limit its ability to take risks and to protect the
value of the loan. If a central bank provides credit support, the analogy suggests that it must
follow up with a continuous re-evaluation of the credit conditions to safeguard its funds and
make sure its commitment is not abused. It also has to make sure that it does not subsidise
certain economic activities nor permanently suppress the private interbank market.
Overall conditions in the markets for capital have improved greatly from the autumn 2008
paralysis. The functioning of money markets is now comparable with the conditions that
prevailed in the third quarter of 2007. Money market spreads are close to levels that are
reasonable to view as normal after the equilibrium re-pricing of risk that was needed and is
likely to have taken place since then. Term lending has resumed on a satisfactory scale. The
funding ability of banks is not a restraining factor for lending, as it was the case for some time
after October 2008. Since the second half of last year, it appears to support bank profitability.
Corporate and bond spreads have also declined steadily across the quality spectrum.
Currently, these considerations are what motivate and guide a gradual phasing-out process.
We started to phase out our enhanced credit-support measures in December 2009, in an
environment of improving financial market conditions and emerging signs of recovery. On
4 March we came to the conclusion that the current pace of phasing-out is appropriate.
With the resumption of longer-term loans in the private market, we have started to adapt the
conditions of our longer-term credit to banks. The first step was to announce a
discontinuation of one-year and six-month longer-term refinancing operations. One-year
refinancing now pays an interest rate indexed to the average rate that will be applied in our
weekly main refinancing operations over its 12-month life. The pricing will be the same in our
upcoming and last 6-month refinancing operation.
This underscores the fact that our long-term refinancing operations are designed to assist
banks in their control and management of liquidity risk. They are not an instrument of
commitment to a future policy path.
We will return to a competitive tender procedure for three-month operations in the second
quarter of 2010. At the same time, we have made it clear that we will continue to conduct our
weekly main refinancing operations and one-month operations as fixed-rate tenders with full
allotment for as long as needed and, in any case, until 12 October 2010.
While we monitor the conditions for a gradual phasing-out very attentively, we are convinced
that a delayed exit from extraordinary liquidity support would distort market behaviour and
misallocate credit.
We do not wish to breed dependency. Banks might become dependent on today's very
favourable access to central bank refinancing to such an extent that their incentives to repair
their balance sheets remain weak. Moreover, permanent extraordinary liquidity measures
provide undifferentiated support to all banks, whether in liquidity deficit or in liquidity surplus.
This opens the door to opportunistic bidding behaviour and to a sort of arbitrage across
assets that is unproductive.
What is our end point? We view the pre-crisis operational framework as a very natural
reference point for the phasing-out process. Of course, we are reviewing carefully the
potential lessons of the financial crisis for the design of our operational framework. It seems
to me, however, that in this respect the ECB has relatively little reason to change
fundamentally what has served our monetary policy well, both in normal and crisis times.
The speed and path of the phasing-out of non-standard measures will depend on
developments in financial markets and the economy. The current situation of ample liquidity
in euro area money markets guarantees a continued positive impact on financing conditions.
As regards the monetary policy stance itself, it will be designed as always to deliver price
stability, in the medium and long term, in line with our definition.
Crisis prevention
Governments and central banks have been focused on financial reform since October 2008.
The new financial architecture will build on the assumption that a re-pricing of risk around its
fundamental value is needed. Price discovery within the market in pursuit of a fundamental
equilibrium in risk pricing - one that can be sustained by long-term trends - is likely to take
time and experience some further oscillations.
A question that remains is: Where will this process end?
As aggregate - undiversifiable - risk diminishes, this will be reflected in lower premia that
financial markets pay for risk-taking. We know that the commitment by central banks to keep
inflation low and stable, communicate clearly about their price stability objectives, and then
act on those objectives, has all contributed to a long-term reduction in macroeconomic risk.
The fraction of the reduction in risk compensation related to having a stable macroeconomic
framework is a steady acquisition of modern societies.
Instead, the complement to that fraction - that which is due to excessive financial
sophistication, abnormal risk tolerance and shortcomings in risk management - should be
gone for ever.
That is why my conjecture is that risk premia in a number of markets will continue to be
reduced - but they are unlikely to reach the compressed levels that we saw prior to the crisis.
Normalcy will probably be reached at a permanently higher level of risk compensation in a
number of markets.
In order to build an effective system of crisis prevention, we will all need to take on board this
simple fact: compensation for risk will need to be appropriate. We shall prevent "pure"
speculative activities from becoming the dominant force on the markets. And we shall build
financial infrastructures with sufficient buffers to make them bulwarks against instability and
resist shocks.
Let me mention some striking facts about the power of such buffers. There is a widespread
perception that banking crises in times when money was convertible into gold had
apocalyptic consequences for bank depositors. This is not true. The estimated average loss
on assets born by depositors in banks that were closed down as a consequence of financial
crises was minuscule. Taking a yearly average between 1865 and 1920, it was six cents for
every one hundred dollars of deposits. This time-frame covers five of the most severe
episodes of financial panic in recorded history, most notably the 1907 crisis.6
Do you know why the losses were so small? Because banks were well capitalised and bank
equity cushioned depositors - and the economy more broadly - against losses in the event
of a bank failure. According to a study, the average capital-asset ratio fell from a high of 60%
in 1880 to a low of 20% at the turn of the century. Then, after the crash of 1929, it rose to
about 30% in the 1930s and 1940s.7 It is now much lower, as you know.
Making sure that banks are well-capitalised is the foremost life jacket of our system.
Lifesupport in the form of liquidity assistance cannot act as a surrogate for appropriate
management practices inside the banking system.
The European Systemic Risk Board (ESRB), which will be hosted by the ECB, will assume a
novel role in crisis prevention at the level of the 27 economies of the European Union as a
whole. The ESRB will have the aim of identifying emerging systemic risk, and, if necessary,
publishing early warnings as well as making recommendations to the competent authorities.
The ECB is also fully involved in G20 reform efforts. International cooperation is absolutely
vital given the interconnectivity between financial markets. A return to pre-crisis business
practices would be fatal. Financial market participants need to restore trust. But this alone
will not be sufficient. We absolutely require intelligent regulation that will prevent
self-destruction.
It seems to me that we are all - industrial countries as well as emerging economies - very
much united in purpose: correct distorted incentives, improve very significantly the resilience
of the financial system, and counteract pro-cyclical mechanisms and behaviours. We are
also convinced on both sides of the Atlantic - and here in Stanford, I would say also on both
sides of the Pacific Ocean - that the success of the enlarged governance of global finance
and the global economy through the G20, the Financial Stability Board and the cooperative
activities of the Central Banks, is key for the stability and the prosperity of the present unified
global economy.
Concluding remarks
At the height of the crisis - when irrational exuberance had turned into excessive pessimism -
I repeatedly stated that regaining confidence was of the essence. Since then, confidence in the
short term has been restored, not least because of bold and courageous policy actions around
the globe. Going forward, we need to strengthen longer-term confidence, and this requires
policy frameworks that will help to prevent a future crisis.
I started with Tacitus' example of bold policy action. I would like to end with Cicero's fides.
There was a famous controversy between Julius Caesar and Cicero 80 years before the
crisis described by Tacitus. Rome, at that time, was struggling with a debt overhang. Caesar
proposed partly to remit the debt. Cicero strongly opposed such action. He argued that debt
forgiveness would shake the foundations of the Roman Republic and destroy one of its most
Fides
important values: fides. is trust, confidence, good faith.8
In modern terms, Cicero was hinting at the moral hazard that can - but need not - be
created by intervention in a crisis. The "lender of last resort" responsibility of central banks -
that Walter Bagehot advocated 1800 years after Cicero and Tacitus - should always be a
dual responsibility. It should be crisis management and future crisis prevention at the same
time. When these go hand in hand, the result is confidence in the medium and long term
(fides) which, ultimately, helps getting out of the short term crisis as well as contributes
significantly to long-term growth and prosperity.
Thank you very much for your attention.