Lorenzo Bini Smaghi: From boom to bust - towards a new equilibrium in
bank credit
Speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at the Ernst & Young Business School seminar, Milan, 29 January 2010.
* * *
I would like to thank, in particular, L. Cappiello, P. Aberg, G. Wolswijk and D. Marqués Ibañez for their contribution
to the drafting of this speech. The opinions expressed are solely my own.
1. Introduction
There is now a broad consensus that the period leading up to the crisis was characterised by
excessive credit growth. When the bubble burst, it resulted in the most pernicious banking
crisis since the Second World War, accompanied by a severe economic recession.
In order to revert to a more balanced and sustainable management of credit, while
safeguarding the role that credit plays in stimulating growth, new rules, regulations and
incentives for financial market participants are needed. This is what the regulatory authorities
and governments of all major industrial countries and developing countries are working
towards.
This is not the end of the issue, however. Once the objective of establishing a new "steady
state" has been identified, the path towards achieving this objective must be carved out. This
will not be easy. If the adjustment is too swift, it could result in an over-adjustment of credit
flows, i.e. be too restrictive, giving rise to recessionary effects on the real economy. If the
adjustment is too slow, however, it could encourage a return to past behaviour, which led to
excessive risk-taking.
Today I would like to examine the issues relating to the role of the banking sector in
supplying credit flows, in terms of the following three phases: the pre-crisis state of
imbalance, the new long-term steady state, and the period of transition leading up to said
steady state.
2. The banking system during the credit boom years
As with all system-wide banking crises, the recent turmoil was preceded by strong credit
growth, combined with a speculative asset price bubble.1 This is confirmed by various credit
indicators, such as the deviation of the credit-to-GDP ratio from its trend, detrended global
credit growth2, the credit growth gap, and other indicators.3
For example, the global credit-to-GDP ratio gap, an indicator of the risk of speculative
bubbles, had exceeded its threshold in mid-2007. Likewise, the credit growth gap and the
investment-to-GDP ratio had been on a strong upward trend, signalling the turmoil to come.
Looking at the various market segments confirms the excessive ease with which banking
credit had been obtained, for instance, the boom in lending to finance leveraged buyouts
(LBOs).4
Fast credit growth in the period leading up to the crisis took place against a background of
high capital ratios.5 This was likely driven by four main factors. First, a large share of the
credit granted by large banks, in particular, was shifted off-balance sheet via securitisation.
Second, non-banks (financial leasing companies, credit card firms, etc.) also contributed to
the credit flow. Third, the high profitability of banks contributed to the bolstering of their
balance sheets. Finally, most banks, particularly those in the United States, were operating
under the Basel I regime. Increasing risks, therefore, were not fully reflected in minimum
capital requirements.
The flow of credit, apart from being "excessive", was in part also channelled to insufficiently
productive uses. There was excessive leverage in some sectors, which contributed to the
misalignment of underlying asset prices. For example, between 2003 and mid-2007,
corporate loans to construction and real estate activities constituted almost 60% of total flows
of loans to non-financial corporations in the euro area.6 The easy flow of credit to the housing
sector contributed to the overheating of property markets in some countries. When the crisis
set in, the declines in credit were most pronounced in countries such as Spain, Ireland,
Belgium and Greece, which had been experiencing double-digit credit growth rates during
the lead-up to the crisis.
Banking credit developments prior to the crisis were excessive owing to a combination of
three factors: 1) financial innovation; 2) insufficient supervision, and 3) a highly
accommodating monetary policy. Let's take a quick look at these factors.
The significant advances in financial innovation over the last decade fuelled the idea that
asset liquidity had increased and that there was a greater potential for risk diversification.
This idea proved, in part, to be an illusion. When the crisis erupted, the presumed liquidity of
these assets disappeared. Banks' balance sheets were thereby clogged by illiquid assets.
The growing role of infrastructure for clearing and settling OTC trades - non-standardised
and predominantly bilateral - created uncertainty regarding the distribution of exposures
among the various counterparties, fuelling their mutual distrust.
Another factor that helped create the perception of greater liquidity was the increased
funding available from wholesale financial markets. Moreover, the originate-to-distribute
model was adopted not only by large institutions but also by others, such as Northern Rock,
which were not equipped to deal with funding sources considerably more volatile than
traditional sources, such as deposits.
Recourse to wholesale markets contributed to exacerbating credit pro-cyclicality, with more
abundant credit in periods favourable to markets but also greater vulnerability in the case of
tighter markets conditions. This problem is not new. The crisis affecting savings and loan
undertakings in the United States also originated in the differing maturities of bank assets
and liabilities, which gave rise to risky activities in the junk bond and derivatives markets.7
Securitisation played a role in creating cheaper and abundant credit, providing banks with
additional funding sources.8
These developments posed unprecedented and significant challenges for supervisory and
regulatory authorities. Although, in some cases, the growing risks and vulnerabilities were
identified at the aggregate level, there was insufficient information to understand the
interconnections that had been created in the financial system. Furthermore, risk
assessments mainly targeted market participants' behaviour rather than formulating concrete
ways to intervene. This reflected the micro-prudential approach of existing legislation, which
mainly focused on individual financial institutions, without taking account of interconnections.
Let me also briefly mention monetary policy. A wide-ranging discussion is currently under
way about the role that keeping interest rates at low levels for a prolonged period has played
in fostering the supply of bank credit. According to some research, there is no correlation
between the level of interest rates and bank credit, in particular real estate lending.9 Other
recent studies suggest the opposite, providing evidence of several transmission channels.
First, the low level of interest rates may affect valuations, incomes and cash flows, which, in
turn, can modify the way in which banks measure the expected risks associated with
lending.10 Second, low returns on comparable so-called risk-free securities, such as
government bonds, prompt banks, asset managers and insurance companies to take on
more risk and invest in assets offering higher returns, particularly if the performance of
managers is measured on the basis of nominal yields.11 Finally, low interest rates facilitate
leverage.
Overall, although, from an empirical standpoint further analysis is needed, it is difficult to
reject the view that the policy of low interest rates contributed to the steady credit dynamics
in the period preceding the crisis. Certainly, this is a theme that should be studied further in
the economic literature in the next few years.
3. The new steady state
Given that the financial crisis has demonstrated the excesses in credit developments in the
past, it is necessary to identify a new, sustainable equilibrium point. To reach this steady
state, important measures are needed in various areas, many of which are already in
7
Eventually, this required a clean-up programme with an estimated cost of USD 150 billion.
8
See, for example, A. Ashcraft and T. Schuermann.
9
Ben Bernanke, "Monetary Policy and the Housing Bubble", a speech delivered at the Annual Meeting of the
American Economic Association, Atlanta, Georgia, 3 January 2010.
10
T. Adrian and H.S. Shin, "Money, liquidity and monetary policy", American Economic Review, P&P, vol. 99,
No 2, pp. 600-605, 2009; J.B. Taylor, "The financial crisis and the policy responses: an empirical analysis of
what went wrong", National Bureau of Economic Research Working Paper Series, No 14631, 2009.
11
M.K. Brunnermeier, "Asset pricing under asymmetric information - bubbles, crashes, technical analysis and
herding", Oxford, Oxford University Press, 2001; R.G. Rajan, "Has financial development made the world
riskier?", National Bureau of Economic Research Working Paper Series, No 11728, 2005; G. Jiménez,
S. Ongena, J.-L. Peydro and J. Saurina, "Hazardous times for monetary policy: what do 23 million loans say
about the impact of monetary policy on credit risk?", CEPR Discussion Paper, No 6514, 2007; V. Ioannidou,
S. Ongena and J.-L. Peydro, "Monetary policy, risk-taking and pricing: evidence from a quasi-natural
experiment", NBER Summer Institute, 2009; A. Maddaloni and J.-L. Peydro, "Bank risk-taking, securitisation,
supervision and low interest rates: evidence from lending standards", ECB Working Paper Series,
forthcoming.
32 BIS Review 10/2010
process. I will obviously not go into all of them, given the extent of the work in progress, but I
will mention a few initiatives.
First of all, the regulation of the banking system must be reviewed, with new rules
constraining its assets and balance sheet structure. In December 2009, the Basel Committee
on Banking Supervision announced a reform package aiming to strengthen global capital and
liquidity regulations. Capital requirements will be more stringent, thanks to the improved
quality, consistency and transparency of the regulatory capital base. Proposals include a
counter-cyclical capital buffer, and measures to promote provisioning over the cycle and to
mitigate the possible excess cyclicality arising from the minimum capital requirements.12
Measures concerning the role of external ratings and the treatment of securitisation have
also been announced.
Better risk coverage is also needed, which is capable of capturing major on and off-balance
sheet risks and derivative-related exposures. Various proposals have been formulated in this
regard, including: strengthening the capital requirements for counterparty credit risk
exposures arising from derivatives, repos and securities financing activities; a leverage
requirement (capital divided by total exposure) to put a cap on the level of leverage in the
banking sector; and internationally harmonised global liquidity standards, including a liquidity
coverage ratio and a structural ratio (measuring the amount of longer-term stable funding
sources to cover the liquidity needs for funding assets over the period of one year). Finally,
governance of financial institutions must be strengthened, for instance with regard to
remuneration incentives.13
The regulatory community is well aware of the fact that the reform must be introduced in an
ordered manner in order to ensure the resilience of the financial system as a whole, while
also supporting economic growth over the longer term. The proposals are currently the
subject of extensive consultations with the banking system. In addition, an impact study will
be conducted to assess the implications of the various measures. Based on the outcome
thereof, the aim is to arrive, by the end of 2010, at an appropriate calibration for the new
requirements in terms of the level and quality of capital, in order to find a balance between
financial innovation, financial stability and sustainable economic growth. The Basel reform
will be phased in gradually as financial conditions improve and the economic recovery
strengthens, with the aim of implementation by the end of 2012. Appropriate grandfathering
arrangements will be put in place in order to ensure a smooth transition.
A further point highlighted by the crisis is the availability of resolution schemes that allow for
speedy and decisive interventions in the event of bank failures or near-failures, averting
deposit runs and limiting contagion effects on the wider banking system. Several initiatives in
this area are under way both at the European and global levels.14
12
The potential role of capital regulation (Basel II) in amplifying credit cycles is being investigated by a number
of authorities and institutions, including the Basel Committee and the ECB. The consultative document issued
by the Basel Committee on 17 December 2009 already includes proposals on: (i) mitigating the cyclicality of
the minimum requirement; (ii) introducing forward-looking provisioning; (iii) building buffers through capital
conservation; and (iv) mitigating excessive credit growth. The latter would imply the introduction of a
countercyclical buffer requirement, which would come into effect during periods of excessive credit growth. The Basel
Committee's proposal is currently at an early stage of development and a fully-fledged version will be
developed by the Committee in time for its June 2010 meeting.
13
See, for instance, F. Panetta and P. Angelini (coordinators), U. Albertazzi, F. Colomba, W. Cornacchia,
A. Di Cesare, A. Pilati, C. Salleo and G. Santini, "Financial sector pro-cyclicality - lessons from the crisis",
Questioni di Economia e Finanza, No 44, Banca d'Italia, 2009.
14
At the international level, the Basel Committee's Cross-border Bank Resolution Group has published a report
with recommendations to improve the resolution of failing financial institutions that conduct cross-border
activities. At the European level, the European Commission has launched a public consultation on the EU
framework for cross-border crisis management in the banking sector.
As regards derivatives, the aim is to increase transparency and risk management, especially
through the creation of market infrastructures to centralise transaction settlement.
Another area in which more stringent requirements are to be imposed is that of securitisation
and credit derivatives activity.15 During the crisis, there was a strong decrease in
securitisation. For this segment of the market to experience a broad recovery, fundamental
changes towards more transparency, standardisation and simplicity are required. There are
various initiatives, both public and private, targeting this. The ECB is taking measures in
order to gradually align the collateral eligibility criteria and risk control measures with best
market standards and investors' requirements.16
In the context of the regulatory reform, the international community has committed itself to
reducing the moral hazard posed by systemically important financial institutions. A number of
proposals are being discussed with international bodies, in particular the Basel Committee
and the Financial Stability Board. The debate recently gained momentum following the
President of the United States' proposal to adopt the "Volcker rule", which aims to separate
the activities of large financial institutions. An important element of this proposal is that any
financial institution that obtains federally-insured deposits or has access to refinancing from
the Federal Reserve would be prohibited from owning, investing in or sponsoring hedge
funds or private equity firms. Essentially, it aims to separate traditional banking activities from
higher-risk, proprietary trading operations. It also proposes imposing limits on large financial
institutions regarding their market share of liabilities, as a supplement to the existing caps on
the market share of deposits.
These proposals have still not been detailed in depth. Nonetheless, on the basis of what has
been made public, I am of the view that the initiative is heading in the right direction and
represents the first step to ensuring the financial system can effectively support the real
economy and is not weakened by the most volatile market fluctuations. It is, however, not the
final step. Above all, it should not be a substitute for two other lines of action, which, in my
opinion, are essential for a complete reform of the system. The first is that the whole financial
system should be subject to regulation, even if the specific regulations may vary according to
the activities or institutions to which they apply. However, I do not want the separation
between traditional banking activities and high-risk proprietary trading operations to drive the
latter to be undertaken by sectors or institutions that are less vigilant or are outside the
sphere of regulation. My concerns arise from the fact that, while during the first G20 summit
meetings, there was widespread consensus on the necessity of ensuring that no segments of
the financial system are left outside the scope of the regulatory framework, over time, this
resolve has dwindled and attention has mainly been focused on banks. Given the
interconnectedness of markets, it is essential that investment banks, hedge funds and other
institutions are also subject to adequate regulation. In particular, the supervisory authorities
must have adequate information on the activities of these institutions in order to be able to
evaluate vulnerabilities and possible contagion effects. The second line of action relates to
the strengthening of the supervisory authorities, beginning with their independence. Only
institutions independent not only of political authorities but also of market participants can
have the clarity and the power to take measures to reduce the cyclicality of credit and
financial activities. There are, therefore, concerns regarding the developments in the current
debate in the United States, where the most independent institution, namely the Federal
Reserve, is subject to attacks and pressures from various corners, including legislative
initiatives aiming to curtail its powers.
A final concern regarding international cooperation is this: there is no doubt that the "Volker
rule" represents a new topic for discussion and that there is a risk that not all countries will
want to follow this path, out of a wish not to penalise the financial institutions based in their
own countries through the new regulations on separation. As has been the case in the past,
it can be expected that vast financial resources will be employed in an attempt to influence
political decisions and to stand in the way of a proposal of this kind. It would be a shame if
the authorities in major countries put the interests of these institutions ahead of those of the
taxpayers and ahead of global interests.
This brings me to the role that central banks can play in supporting more sustainable credit
flows. Recent work shows that price stability is necessary, but not sufficient to ensure a
homogenous flow of credit to the economy and avoid financial instability. In particular, if
monetary policy concentrates solely on inflation objectives, it might, in some circumstances,
end up being too accommodative of credit cycles and fuel speculative bubbles. Such a risk
tends to become more apparent when interest rates are kept at a very low level for an
extended period of time.
On the other hand, it appears to be a difficult task for a central bank to use one instrument,
such as interest rates, to achieve two objectives at the same time, namely price stability and
financial stability. This is the reason why central banks should also be equipped with
macroprudential instruments, distinct from monetary policy, which can be used in order to avoid the
excessive pro-cyclicality of credit. These instruments should enhance the stability and
resilience of the banking sector over the business cycle, as well as the sustainability of the
balance sheet structures of borrowers. A more efficient allocation of credit should result, thus
helping to avoid the build-up of financial imbalances and contributing to improved economic
performance.
To sum up this part, the new steady state will be characterised by higher capital ratios and
lower leverage in the banking sector, and probably also less recourse by the banking system
to market financing in general, and to securitisation in particular. This will allow for more
stable credit growth, which is less subject to pro-cyclicality, especially that deriving from
supply factors. Credit growth will also be less affected by financial market volatility.17
4. The transition
The transition from the old equilibrium, which was really one of imbalance, to a new, more
sustainable one cannot be instant, as that would involve an excessive adjustment with
potentially recessionary effects. Nor can it take too long as this would risk creating incentives
to return to the unsatisfactory behaviour exhibited prior to the crisis. Defining the transition
phases is possibly the most difficult challenge.
The transition is characterised not only by the lag between decisions relating to new
prudential regulations and their application, of which I spoke earlier, but also by the
extraordinary measures in terms of monetary and financial policy, adopted by governments
and central banks to combat the recession and support the financial system in facing the
systemic crisis.
The major central banks have promptly and forcefully responded to the crisis with a broad
variety of measures. The classical prescription by Walter Bagehot, which describes central
banks as lenders of last resort, has proven to be as valid today as it was 137 years ago when
"Lombard Street" was first published.18 Accommodating the sudden increase in the demand
for liquidity prevented a disorderly de-leveraging process, prevented illiquid but solvent banks
from going bust, and, more broadly, sustained confidence in the economy.
The steps taken by central banks have taken them into, up to now, uncharted territory.
Interest rates have been reduced to very low levels by historical standards, clearing the way
for significantly lower bank interest rates (although with a significant time-lag), thus
supporting credit demand from households and firms. At the same time, non-conventional
measures have been adopted with the aim of bringing abnormally high money market
spreads down and ensuring a proper transmission of the monetary policy impulse.
These exceptional measures have had important effects on macroeconomic and financial
stability, and improved the overall conditions on financial markets.19 In particular, they have
helped to "liquefy" assets that could otherwise have caused the insolvency of many financial
institutions. More generally, they have helped to restore confidence by reducing uncertainty.
In addition, they have prevented contagion effects that can arise in the financial system as a
result of the inter-connectedness between various market participants.
The monetary policy intervention also helped to restore the profitability of banks as the fall in
short-term interest rates steepened the yield curve, to the benefit of the banking system,
which usually funds itself in the short term in order to provide credit for longer terms. This
profitability also helped to support the flow of credit to the economy.
Financial measures have also been adopted, such as increased deposit insurance,
guarantees for bank liabilities, and injections of capital. In addition, fiscal budgets have
supported aggregate demand via automatic stabilisers and expansionary measures.
Over the last few months, leverage has generally fallen, especially among those institutions
that were most highly leveraged.20 The fall reflects, in part, recapitalisation efforts, lower
risktaking as a result of more prudent lending standards, and the shedding of assets and/or
limitation of the growth in balance sheets. It also reflects pressure from the market and
supervisory authorities to control leverage, as well as expectations regarding the possible
22
introduction of a leverage ratio, in addition to risk-based capital requirements.21,
Likewise, capital position ratios of large and complex banking groups in the euro area are
improving. The earnings of these banks have recovered, while the growth of total assets and
of risk-weighted assets has slowed down and capital has increased, both from public and
private sources. These developments were necessary in view of the expected increase in
non-performing loans as a delayed result of the economic crisis.
18
W. Bagehot, "Lombard Street: a description of the money market", Scribner, Armstrong & Co., 1873.
19
With regard to the importance of an accommodative monetary stance at the margin, see, for instance,
T. Adrian and H.S. Shin, "Financial intermediaries and monetary economics", Handbook of Monetary
Economics, forthcoming.
20
It should be noted that this effect only arises when the impact of losses on the capital base is greater than the
reduction in the value of marked-to-market assets on the balance sheet.
21
There are currently three countries that use, or plan to use, a leverage ratio, namely the United States,
Canada and Switzerland. Switzerland has introduced a leverage ratio for its two large, internationally active
banks, which will take effect in 2013.
22
Pressure on banks to reduce leverage has been apparent from discussions in various international fora, such
as the G20, which has called for the introduction of leverage ratios, in addition to risk-based capital ratios, in
order to prevent banks from arbitraging capital requirements.
36 BIS Review 10/2010
With improving conditions in the economy and financial markets, supportive measures by
governments and central banks have progressively less "raison d'être". The withdrawal of
these measures must occur in a timely fashion; being too early or too late could have
unwanted implications for the speed at which the new steady state can be reached. In
particular, too brisk a phasing-out could lead to a dramatic process of de-leveraging,
jeopardising the economic recovery. On the other hand, it is essential to prevent the banking
system from relying on support measures for too long, i.e. becoming "addicted" to them. The
intermediation role of the central banks during the crisis, if drawn out for too long, may
reduce incentives for banks to return to actively operating in the money market. Such a
scenario may also weaken incentives to restructure banks' balance sheets.
Credit flows to households and firms represent an indicator of financing conditions and of the
prospects of a recovery in economic activity. However, they also reflect supply and demand
factors. On the whole, developments in credit appear to have been, up to now, in line with
historical regularities, according to which loans to firms typically lag the economic cycle by a
couple of quarters. In fact, credit flows remained positive, even during the period of the most
severe contraction in economic activity, presumably as a result of the growing use of credit
lines and revolving credit facilities.23 Therefore, lending to firms can be expected to remain
subdued even in the early stages of economic recovery, but it cannot be ruled out that supply
factors will continue to restrict credit for some months.24 The flow of loans to households
began to grow again at the end of last year.
The quarterly survey on bank lending indicates that the degree of tightening adopted by
banks for the granting of credit to firms declined over the last few months of 2009, but remain
positive (see Figure 1). It is interesting to note that among the factors that affect banks'
restrictive intentions, neither the one concerning the liquidity position of the banks
themselves nor the one concerning access to financial markets seems significant any longer.
Both factors now contribute in a positive way to the intentions of banks to grant credit.
Considerations relating to the prospects for economic growth and those linked to specific
sectors of the economy remain restrictive, but the degree of restriction is declining sharply.
The element that marks a growing concern with regard to restrictiveness relates to the capital
of banks. Clearly, the considerations in respect of the need to replenish capital are starting to
exert a strong influence on the decisions of banks to grant new credit.
This dynamic is worrying. It indicates that the banking system is interpreting the new
regulations restrictively for credit. This approach is undesirable and out of line with the
objectives so far followed by the economic policy authorities of supporting the financial
system, not as an end in itself but as an essential function of savings intermediation. The
outcry surrounding the effects that future capital standards and risk management - the
so-called "Basel 3" - will have on credit developments in the short term seems unjustified.
The new rules are specifically intended to ensure a more orderly and sustainable flow of
credit, not a reduction. Moreover, as I said earlier, a gradual process of adaptation to the new
requirements is foreseen.
The new capital requirements may be attained in two different ways, although they have
opposite effects on banking activities: reduction in banking activities, particularly in credit to
firms, on the one hand, and capital increase on the other. The alarm that seems to be
widespread in the banking sector concerning the new rules seems to mask the intention of
adapting to them via a reduced exposure to the real economy, rather than via a capital
increase. This reaction seems to reflect the incentive of managers and shareholders to
favour remuneration on equity and human capital, rather than long-term investment. This is
not in line with the macroeconomic objectives. This is why we insist that the profits made in
these months by the banking sector - which were obtained thanks to the interventions by the
policy authorities to keep the system going, and thus ultimately by the taxpayers - should be
used to increase the capital rather than to reward the banks' managers and shareholders.
This applies not only to banks that have received direct assistance through guarantees and
public capital injections, but also to the indirect benefits obtained as a result of low interest
rates.
5. Conclusion
The pre-crisis period was marked by unsustainable credit policies by the banks and, more
generally, by the financial system. These policies were encouraged by inadequate
supervision and slack prudential regulation, and also by the excessive influence the financial
system had on regulatory mechanisms. This caused the biggest crisis of the post-war period.
We must find a new equilibrium in which the financial system truly supports the real
economy, encouraging a flow of balanced credit. The adjustment may not be immediate and
it needs to follow a gradual path in order to arrive, in due course, at a new point of balance
that allows a restoration of confidence not only among investors but also taxpayers.
Everyone must play his or her part. The regulatory authorities have to agree quickly on the
new system parameters, in consultation with the private sector. Macroeconomic policy must
promote conditions for a gradual adjustment, in line with the objective of sustaining economic
growth and the restoration of a financial market that efficiently performs its primary role as an
intermediary. Market players must understand that the future cannot be a simple return to the
past, to the pre-crisis situation.
If we fail to reach the new equilibrium in due course we will have wasted not only the crisis
but also the resources of taxpayers that have been used to save the system. This can only
backfire on the system.
Figure 1
Changes in credit standards applied to the approval of loans
or credit lines to enterprises
(net percentages of banks contributing to tightening standards)
Notes: The net percentage refers to the difference between the sum of the percentages for "tightened
considerably" and "tightened somewhat" and the sum of the percentages for "eased somewhat" and "eased
considerably". The net percentages for the questions related to the factors are defined as the difference
between the percentage of banks reporting that the given factor contributed to a tightening and to an easing.