Jean-Claude Trichet: Restoring confidence in the global financial system
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the annual
meeting of the Research Institute of Japan, Tokyo, 17 April 2009.
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Ladies and Gentlemen,
I am honoured to be invited to address the Naigai Josei Chousa Kai.
Today I would like to share with you my views on the roots of the current financial crisis, and
the policy responses which aim to address it and to inspire a new sense of direction. The
G-20, at its meeting a fortnight ago, sent a strong signal of reform that can provide the basis
for a more resilient and stable global economy, in the period to come. Swift implementation
of this important agenda will be key.
I will explain the ECB's response to the financial crisis. I will also note, en passant, how our
policy compares with those of other major central banks. In my view, differences in crisis
management approaches between major central banks reflect differences in economic
structures rather than conflicting views on fundamental principles. The ECB's guiding
principles are very simple and very clear. In the medium term, the ECB's policy is geared
towards preserving price stability in line with our objective and in so doing, creating the
conditions for enduring financial stability. This policy is essential to revive a resource that has
become much too scarce over recent months: confidence in the future.
Financial excesses - at the root of the financial crisis
In the last ten years finance has seen a dramatic shift of focus away from facilitating trade
and real investment to unfettered speculation and financial gambling. The assumption and
hedging of genuine economic risk - the risk that companies face when engaged in product
and process innovation - gradually ceased to be the main concern of international finance.
Over time, the creation and assumption of financial risk became the core activity of the
financial industry. This is the risk posed by arbitrage and deliberate exposure to asset price
changes. It reached a point where it seemed that the financial system no longer existed
primarily to hedge existing economic risks, but, increasingly, to create and propagate new
risks on its own.
In the past two decades financial innovation and liberalisation have made important
contributions to the overall productivity of our economies. But, as the demand for finance
increased throughout the 1990s, intermediaries had growing incentives to develop innovative
funding techniques. The securitisation of assets, for example - the transformation of bilateral
loans into tradable credit instruments - had tremendous ability to facilitate the diversification
and efficient management of risk. As such, it was a powerful and useful tool.
But securitisation also meant that banks and non-banks were able to sell loans - or place
them off-balance sheet - immediately after they had been extended. This alchemy enabled
lenders to expand the volume of their operations and conserve on capital. Fatally, the same
mechanism weakened lenders' incentives for prudent screening and constant monitoring.
The resulting decline in underwriting standards and lending oversight was one of the main
reasons for the excessive credit growth.
The credit boom was exacerbated by three factors. First, ill-designed compensation schemes
for loan managers reinforced the shortening of lenders' horizons. In the eyes of many loan
managers, the short-run gains from an expansion of credit outweighed the need to consider
the potential losses that their institutions could incur over the longer term.
Second, the complex structures of securitised products made it difficult for holders to assess
the quality of the underlying investments. This perpetuated the boom, as it took time for
investors to discover and assess the underlying risks.
Third, international macroeconomic imbalances reflected a chronic shortage of savings in
some of the world's advanced economies, made possible by a glut of savings in other parts
of the world. These imbalances resulted from unbalanced international macroeconomic
policies pursuing an inconsistent set of goals. These imbalances also contributed to the
augmentation of global liquidity, further fuelling credit and debt accumulation. In the period
before the start of the crisis, the oil and commodity price boom further fuelled the
international savings glut and aggravated major imbalances.
The global response to the financial crisis
The interplay of the forces and the facilitating factors that I have described so far went into
reverse in the middle of 2007. This reversal was sudden, but not unexpected. When the
asset cycle turned, and many of the missing links in the financial chain were finally exposed,
investors lost confidence. After years of high profits and exceptional risk tolerance, markets
became extremely discriminating with regard to financial risks. Funding costs for borrowers
increased. The spreads on the debt of financial companies - seen as being clogged with
assets of dubious value - widened considerably. Uncertainty over the extent of credit
writeoffs and the future earnings capacity of financial institutions took a heavy toll on the valuation
of many revered names.
Central banks around the globe had to spring into action in the summer of 2007 when there
were signs of what appeared at the time to be a liquidity crisis. You might remember that the
ECB was the first central bank to embark on exceptional decisions as early as 9 August
2007. The collapse of a major, highly interconnected financial player in mid-September 2008
eventually turned a very large-scale financial market's correction into a financial panic.
Throughout the difficult months that followed, central banks and governments around the
globe took unprecedented and bold steps. These steps were aimed at restoring financial
market functioning and the flow of credit, and at ensuring that our banks have the capital and
the liquidity necessary to discharge their critical function even in an acute economic
downturn.
Before going into detail, allow me to say that the crisis has brought out the best in terms of
international cooperation. Leading central banks around the globe, including the Bank of
Japan and the ECB, have cooperated intimately to alleviate financing strains in interbank
markets. Governor Shirakawa and I had numerous useful exchanges of views on the
sidelines of our regular meetings at the G-7, G-20 levels and, more importantly, in the
occasion of the global economy meeting of central bank governors which takes place every
two months in Basel. In the language of game theory, one could say that major central banks
are closely cooperating to deliver the best possible outcome for the global economy.
Similarly, the outcome of the G-20 meeting a fortnight ago has confirmed that governments
can agree on a future course for policy that is based on unity of purpose and shared
principles of action. Decisive and immediate action is still required. In my view, progress on
three fronts will be critical to restore confidence. Two are geared to the medium term; one is
geared to the short term.
First, we need a quantum leap in the breadth and authority of international financial
supervision and regulation. Any viable and effective solution will necessarily require
broadening the focus and overcoming the fragmentation of domestic oversight
arrangements. Second, lasting confidence can only be restored if the commitment to
nearterm fiscal and monetary stimulus is backed by an equally strong and credible commitment to
fiscal sustainability and price stability. The importance of this point cannot be overstated.
Third, governments need to swiftly implement the far-reaching set of measures, designed to
support the financial system. With fellow governors, Governor Shirakawa has convincingly
argued that resolute action to put commercial banks in a healthy situation was absolutely
indispensable in the experience of Japan at the beginning of the millennium. In the absence
of such action, there is a risk that fiscal stimulus packages will simply trickle away, leaving us
burdened with the full load of outsized fiscal liabilities and with no prospect of a sustained
economic recovery.
How far has Europe advanced on these issues? With regard to financial supervision and
regulation, the European Union is currently preparing important decisions along the lines
recommended by the De Larosière report. Among other things, this report proposes a new
system for macro-prudential supervision in which the General Council of the ECB would play
an important role. There was certainly no lack of warnings - from many quarters - before the
crisis. But no mechanism or institution existed to ensure that admonitions were followed by
decisive and swift action. The new European system would assign the task of pre-emptive
analysis and grant the necessary authority to put risk mitigation measures into practice.
With regard to the appropriate balance between near-term stimulus and medium-term
stability, the euro area clearly benefits from its medium-term stability-oriented framework. It is
an invaluable anchor for private sector expectations, regarding both fiscal sustainability and
price stability. Having proved its value in times of crisis, this framework has emerged even
stronger than before. With regard to the overall support to the financial sector, I have been
deeply impressed by the action plan drawn up by euro area governments and the European
Commission within a short period of time. This action plan and its swift implementation has
confounded the sceptics who had questioned the ability of euro area governments to act in a
timely fashion in the event of a major economic crisis. Nevertheless, more action is urgently
needed to entirely resolve the toxic asset problem.
The ECB's response to the financial crisis
Let me now turn in more detail to the ECB's management of the financial crisis. When the
first signs of liquidity hoarding by banks appeared in August 2007, the ECB took several
measures to protect against a disorderly correction in credit. Banks were not only concerned
volume horizon
about the of liquidity that they could secure at present, but also about the at
which liquidity was expected to remain available to them. So the first thing we did was to
provide banks with an insurance against future liquidity shortfalls. We lengthened the liquidity
horizon for banks by expanding the share of refinancing that was granted at maturities longer
than two weeks. This "insurance scheme" encouraged banks to maintain those lending
relations with their clients that are central to Europe's financial architecture. At the same
time, it helped bolster public confidence that banks would remain solvent.
The financial panic that developed in mid-September 2008 marked a dramatic turning point.
Interbank trading in the euro area and elsewhere came to a virtual halt. As cash-rich banks
were unwilling or unable to lend to cash-deficient institutions, the ECB had to substitute for
the missing interbank trading. We started to provide credit well above the levels that banks
had absorbed to fulfil their reserve requirements in normal times.
Since October, against a background of a drastic deterioration in global conditions, falling
commodity prices and rapidly receding inflationary pressures, the ECB has stepped up its
crisis resolution measures in an extraordinary effort to protect the functioning of our financial
system and the stability of our economies.
Again, our primary concern was to preserve the availability of credit for households and
companies at accessible rates. Under our new "fixed-rate full allotment" tender procedure,
banks have been granted access to essentially unlimited liquidity at our policy interest rate.
To fully appreciate what this means, one should note that in normal times we auction a given
amount of central bank credit and let competition among bidders determine the interest rate
at which that credit will become available to the banking system as a whole. But, as the
demand for liquidity by individual institutions has expended abnormally and markets have
ceased to perform their allocative function, we have turned that practice around. We now
determine the lending rate and we stand ready to fill any shortage of liquidity that might occur
at that interest rate. We currently surrogate the market in both its allocative and price
discovery functions.
We have also considerably lengthened the list of eligible assets that banks can pledge as
collateral, so as to ease banks' balance sheet constraints and facilitate the liquefaction of
bank assets for which markets could find no price. The intention was to encourage banks to
extend new credit or continue rolling over maturing loans.
Traditionally, the number of counterparties that are eligible to take part in our refinancing
operations - both ordinary and long-term - has been the largest among the major central
banks that are most directly comparable to the Eurosystem. This structural feature of our
operational framework has been instrumental in the first stages of the crisis in ensuring that
all relevant intermediaries could be granted easy access to liquidity. The recent changes to
our operational framework have expanded the number further. Between July 2007 and
March 2009, counterparties have increased from 1676 to 2136.
We have granted unlimited access to central bank credit at a decreasing cost. Our key policy
rate has been reduced by 300 basis points since the exacerbation of the crisis in the autumn
of last year. As I speak, the Eurosystem provides refinancing to all commercial banks that
present eligible collateral at a rate of 1.25%. Sound and creditworthy banks can secure
overnight credit at an interest rate that is significantly lower, today 0.8%, something never
seen before in the entire post-war history of European monetary affairs. Being able to borrow
at such low costs, banks can grant credit to other banks and to non-bank borrowers at
conditions that are very favourable by historical and international standards. For example,
the 6-month and 12-month euro interbank offered rate - benchmarks that euro area banks
widely use to reset floating-rate loans to households and firms - have reached levels that are
lower than the corresponding rates for contracts denominated in dollar and British pounds.
This underscores that in current circumstances international comparisons of policy rates
alone do not provide all the pertinent information about the effective credit conditions
prevailing in single markets.
Our measures to support credit have resulted in a sharp expansion of the Eurosystem's
balance sheet. As banks' usage of central bank credit soared at the height of the crisis late
last year, the value of our operations grew quickly. Between June 2007 and March 2009 the
size of our balance sheet increased by close to €600 billion. Since the end of September
2008 the growth in the overall size of our operations has been 40%. These measures have
likely prevented the whole credit market from seizing up. Since then, the volume has
declined somewhat, as banks have been more conservative in bidding for central bank credit
and strains in the money market have eased to a certain extent.
The ECB has so far concentrated its non-standard measures on commercial banks'
refinancing, mainly because of the nature of the euro area financial structures. As compared
to the United States, which have primarily a market-based financial system, the euro area is
very largely bank-centred. Accordingly, in a euro area context, guaranteeing firms and
households steady access to credit largely means preserving the functioning of the banking
system. In our economy, banks play such a dominant role that non-standard measures need
to be implemented - first and foremost - through the intervention and with the active
participation of banks. This is why I have sometimes referred to our non-standard measures
as those of enhanced credit support. They aim at supporting banks in providing credit to
firms and households on an ongoing basis.
This goes a long way towards explaining events in the past. As regards the possible further
additional non-standard measures, I have been very clear. On behalf of the Governing
Council, during my last press conference in Frankfurt: We will decide in our next monetary
policy decision Governing Council meeting on 7 May. And it is on 7 May that I will make
public the decision of the Governing Council. At this stage, as a porte-parole of the
Governing Council, I think it is important not to create or encourage expectations. Be sure
that what we will decide will fully take into account the financing structure of the euro area
economy and will be fully in line with our medium term strategy.
When taking all our decisions, we are inspired by our remit to provide a solid nominal anchor
for the economic system. As you know, the ECB's quantitative definition of price stability is a
key element of its monetary policy strategy. We define price stability as a year-on-year
increase in consumer prices of below 2% over the medium term. In 2003 the ECB's
Governing Council clarified that, within its definition, it aims to keep the inflation rate close to
2% over the medium term. This clarification was aimed at confirming the robust anchor for
long-term inflation expectations that the ECB had provided since the setting up of the euro.
In the first ten years since the introduction of the euro, the ECB's quantitative definition of
price stability has proved to be an invaluable asset, guarding against undesirably high
inflation and against deflation. Long-term inflation expectations in the euro area, whether
based on surveys or extracted from financial indicators, have been and continue to be firmly
anchored at levels consistent with our definition of price stability.
Conclusions
More than ever, in the present very demanding circumstances, confidence is key. The global
economy was hit in mid-September 2008 by an unprecedented sudden loss of confidence. It
was perhaps the first time in economic history that a single adverse event was able, in just a
few days, to have a simultaneous adverse effect on all private economic agents in every
economy, industrialised and emerging. We are in uncharted waters, and the risk of the
sudden emergence of economic and financial phenomena and unprecedented behaviour on
the part of economic agents remains.
Public authorities, executive branches, and central banks must do all they can to restore,
preserve and foster confidence among households and corporations in order to pave the way
for sustainable prosperity. This calls for a measured response to changing conditions. We
must maintain the appropriate balance between the need to take immediate action that is
commensurate with the gravity of today's situation, and the equally essential obligation to
return to a path that is sustainable in the medium to long term. Confidence today relies
equally upon the audacity of our immediate decision and upon the soundness and credibility
of our exit strategies. Any ambiguity in our medium term policy direction would delay the
return of sustainable prosperity, because they would undermine confidence, which is the
most precious ingredient in the present circumstances. We will continue serve our 329 million
fellow citizens as a solid anchor of stability and confidence.