Gertrude Tumpel-Gugerell: Payments and monetary and financial
stability
Opening remarks by Ms Gertrude Tumpel-Gugerell, Member of the Executive Board of the
European Central Bank, at a joint European Central Bank/Bank of England conference on
"Payments and Monetary and Financial Stability", Frankfurt am Main, 12-13 November 2007.
* * *
Ladies and gentlemen,
It is a pleasure to welcome you to this conference and I am grateful that I can do so also in
the name of the Bank of England. The idea of the joint conference was born at one of our
regular bilateral meetings and it is wonderful to see the idea come to fruition.
You may wonder why we have put payments first, and monetary and financial stability
second. This is not only because payments are at the root of a functioning (or not
functioning) financial system; payments also require a thorough understanding of the
economics of banking, money, financial markets, industrial organisation, and regulation. The
diversity of theoretical and policy issues in this field is also reflected in the conference that I
have the pleasure of opening this morning.
Historical overview
Considering the historical evolution of interbank settlement arrangements and central
banking functions may help to understand why central banks evolved as the natural
candidates for taking the responsibility for financial and monetary stability.1 Indeed, I would
argue that the reason lies in the key role central banks played in payment systems. In a
world with many banks, it is inefficient for every agent in the economy to have an account
with each and every bank. One solution is for each bank in the economy to have an account
with all the other banks and to net obligations bilaterally with them. In a world with many
banks, this will tend to result in an inefficiently large number of interbank accounts. A more
efficient solution is for a hierarchy of banks to develop, with banks at the bottom of the
hierarchy having accounts with correspondent banks in its upper tier, which in turn have
accounts with banks at the apex of the hierarchy. These banks at the top of the hierarchy
were naturally and literally "central" banks. Indeed, there is plenty of historical evidence that
hierarchical structures evolved naturally in a free-banking environment without the need for
the state to superimpose and/or guarantee a "settlement institution" at the apex of the
hierarchy. One example is in fact the Bank of England.
The status of a central bank at the top of the hierarchy derived also from the fact that it was
perceived to be "safe" - that is, an institution with a large capital base, holding high-quality
assets. Such a central bank would also need to be concerned about its own soundness. This
led the central bank to be careful about to whom it should provide settlement accounts and to
monitor these banks. In addition, it also had to weigh carefully the advantages of providing
lender-of-last-resort assistance to the banking system to avoid a drop in its revenue stream
against the risk of lending to an insolvent institution and making a loss that could decrease its
capital base and threaten its reputation as the supplier of the ultimate settlement asset.
Similarly, central banks had a natural interest in ensuring the ability of the banking sector as
a whole to meet the public's demand for liquidity. The reason for this is that if it allowed a
solvent commercial bank to fail as a result of a bank run, it would only aggravate the situation
and this could ultimately result in a more general run on the banking system and ultimately
on itself. As a result, financial stability became a concern for central banks. Moreover, for the
central bank as the provider of the ultimate settlement asset, it was also important to
maintain monetary stability. In particular, if the central bank printed more and more of its
banknotes without a corresponding increase in the demand for them, the notes would fall in
value relative to those of other banks. Eventually, central bank money would no longer be
seen as "safe" and this would undermine the confidence in and acceptability of the
settlement asset.
This brief historical overview demonstrates that the development of the core functions of
central banks - monetary and financial stability - has been closely linked to their role in the
provision of the ultimate settlement asset in the payment system. It is therefore important for
central banks to have a thorough understanding of how these links work. Let me share some
thoughts with you in this regard.
Payment systems, monetary policy and central bank actions in the recent financial
market developments
Central banks provide liquidity for different purposes.2 To achieve their primary objective of
price stability, monetary authorities supply base money to the economy. By matching the
demand for base money with the supply that they control, central banks steer short-term
interbank interest rates, which, via the transmission mechanism of monetary policy, have an
impact on the price level.
Another objective of central banks is to ensure the smooth functioning of the payment
system. Central banks provide intraday liquidity to bridge the timing mismatch between
banks' incoming and outgoing payments during the day. This not only facilitates intraday
liquidity management of banks, but also makes payment gridlocks less likely and therefore
contributes to financial stability.
Payment systems clearly matter for monetary policy. Monetary policy implementation today
means steering short-term interest rates. If you are the treasurer of a bank and plan for the
end-of-day settlement of your accounts, uncertainty about whether expected incoming
payments will actually be received is obviously a major issue. It does not make an immediate
difference if expected incoming payments are at risk for payment system reasons, or
because the payments may not have been initiated. In both cases, the treasurer will need to
look for alternative funding, and if there are no internal buffers, will turn to the interbank
market for overnight funds. There, the treasurer will be ready to pay a premium and will thus
bid up rates. If uncertainty about incoming payments generally increases and affects all
banks, be it for payment system or other reasons, banks will all tend to enter the interbank
market on the buy side and will bid up the overnight rate accordingly. This is a monetary
policy issue and will imply the need for the central bank to inject excess reserves into the
system to bring interest rates down again. While payment system disruption may hence
potentially have an impact on monetary policy, central banks have found ways of
safeguarding price stability, while at the same time ensuring the smooth functioning of the
payment system. This is achieved by drawing a clear line between providing intraday liquidity
for payment system purposes and providing credit for monetary policy implementation.
Let me therefore turn briefly to these two types of liquidity provision by central banks. Central
banks need to define the conditions under which they provide these two types of liquidity. In
particular, they need to decide on the fee/interest they wish to charge and on the level and
type of collateral they consider appropriate. Allow me to discuss briefly both features.
Central banks typically provide intraday liquidity on more generous terms than overnight
credit. Why? To answer this question, consider the following alternatives: imagine that
central banks would only ask for interest when credit spans a weekend, then we would have
intra-week credit. Or, more extremely, imagine that interest would be charged only for credit
spanning the year-end. Or why don't central banks require banks to settle every hour, such
that every end of hour would be what today is an end of day, with credit bridging every end of
hour being charged at the monetary policy interest rate.
I think that the reason why central banks choose a full day as the demarcation line reflects in
particular three considerations.
First, economic projects have rarely, if ever, a lifetime of less than a day, so there is no need
to impose positive interest rates at the appropriate policy level intraday from a transmission
mechanism perspective. However, there may be projects with a lifetime of days or certainly
months and weeks, such that lowering the frequency of settlement points to, say, annually
would clearly create an artificial and harmful annual economic cycle and affect price stability.
Second, increasing the frequency of points in time when banks need to settle, say to hourly,
would increase liquidity management costs of banks considerably. Because this is not
needed from a monetary policy perspective, this would mean a waste of economic
resources.
Finally, central banks probably want to control the ability of banks over time to settle their
accounts, and also banks are probably more comfortable to see that other banks settle their
accounts with the central bank on a regular basis, as proof of their soundness.
To sum up, the daily cut-off separating free central bank credit and credit against a monetary
policy-related interest rate is a reasonable convention, reflecting monetary policy
transmission mechanism issues, convenience of banks' liquidity management, and credit risk
management considerations. It allows central banks to safeguard price stability, while at the
same time ensuring the smooth functioning of the payment system.
Turning to collateralisation, it is important to note that in the past, central banks often set
ceilings for intraday and overnight credit to banks. In contrast, today, many central banks,
including the Eurosystem, tend to provide unlimited access to both types of credit, but with
the need to provide eligible collateral. This reflects first that unlimited liquidity facilities
provide banks with a buffer against liquidity shocks and thereby contribute to financial
stability. Second, it however also reflects the need for sound credit risk management by the
central bank, which argues against unsecured lending, in particular at overnight and longer
maturities.
This framework - of unlimited access to intraday and overnight central bank credit against
eligible collateral - implies that collateral availability becomes the ultimate liquidity issue for
banks. As long as banks have sufficient eligible collateral for overnight or intraday credit, they
have a buffer against liquidity shocks. Once a liquidity shock exceeds the eligible collateral, a
major liquidity issue arises, and the bank may fail to fulfil its payment obligations, with all the
serious consequences that this has for the bank itself and, via knock-on effects, potentially
for the entire financial system.
This is what makes collateral availability so important today as a contribution by central
banks to financial stability - again, both intraday, i.e. for payment purposes, and for overnight
credit.
Let me now turn briefly to the recent financial market developments, which involved, as you
know, partially a shortage of credit, but eventually also a significant drying-up of liquidity. It
was not a failure of the payment system, as all payment systems worked smoothly.
Nevertheless, let me say a few words here.
The recent developments were triggered by a perception of higher credit risk originating from
a perceived deterioration of the credit quality of assets held both by banks and by special
investment vehicles, with which banks were associated either through liquidity commitments
or reputation issues. The situation deteriorated when liquidity buffers of banks were put
under stress by the need to meet their liquidity commitments and to take on their balance
sheet assets which had become illiquid. Then, banks also became unwilling to provide
unsecured lending to other banks, in particular at longer maturities, because of uncertainty
whether they would themselves obtain liquidity if needed. Once this stage was reached, the
deterioration of liquidity conditions became self-reinforcing, and turned out to be painfully
durable, as can be seen for instance from the still exceptional three-month EURIBOR spread
relative to three-month repo rates.
What could central banks do about this? First, they provided extra liquidity through open
market operations. This not only contributed to bringing down short-term interbank rates to
target levels again, fulfilling monetary policy implementation purposes, but may also have
contributed to supporting the willingness of banks to lend.
Second, accepting that availability of central bank eligible collateral is the ultimate line of
defence against illiquidity for banks, many central banks widened the set of eligible collateral.
For instance, the central banks of Canada and Australia took such actions, and also the US
Fed clarified that it would accept certain instruments in its discount window.
The Eurosystem was not forced to take such measures, since its collateral framework
already foresees the acceptance of a very wide set of collateral. The Eurosystem framework
specifies that this very wide range of collateral is accepted for all types of Eurosystem credit
operations: intraday operations and monetary policy-related operations, the latter including
both access to standing facilities and open market operations. The wide and unified set of
collateral supports both the smoothness and systemic stability of intraday and overnight
liquidity management of banks.
Payment systems and financial stability
The global financial system has been going through a phase of major structural change,
which may have several implications for payment systems and financial stability.3
First, we have witnessed the creation of new financial instruments and products to address
market and credit risk, and in principle to enhance liquidity of financial assets. At the same
time, the size of the financial sector in relation to the real economy has significantly grown.
This suggests that the stability of the financial system has become more important for the
real economy. Moreover, there has been a growing symbiosis between markets and
intermediaries. While intermediaries and markets have often been seen as alternative forms
of arranging financial relationships, they are increasingly complementary. Indeed,
intermediaries such as banks have become increasingly reliant on markets as a source of
income and for their risk management, through their hedging operations. Markets in turn
have become increasingly dependent on intermediaries for the provision of market-making
services and of funding liquidity. This structural change may have some implications for
payment systems and market infrastructures, especially in periods of financial distress. One
important implication is that more than ever before, the smooth functioning of the financial
system is dependent on the assumption that the option to trade can be exercised even under
stressed market conditions. This is a natural consequence of the development of markets
and instruments which are actively traded or that are held in the expectation that, should the
need arise, they could be traded. Moreover, the new financial environment appears to be
more reliant on the immediate availability of funding liquidity. Funding liquidity is critical for
the orderly execution of trades and it can become scarce at times of distress, precisely when
it is most needed, as market participants cut credit lines and/or raise margin requirements to
protect themselves against counterparty risks. In conclusion, the stability of the financial
system is also dependent on the assumption of ample market liquidity and, most critically, of
the smooth functioning of the payment systems and market infrastructures.
Second, the complexity of the financial system has greatly increased. This complexity applies
not only to individual financial instruments, but also to the financial system as a whole. Its
various segments have become more closely interconnected and the linkages across them
more opaque. A new configuration of players in the financial system has led to a blurring of
distinctions between different types of intermediaries, to greater consolidation, and to a rapid
growth of new financial players and services. Payment, clearing and settlement systems
naturally evolve in response to such financial market developments. As the number of new
financial products is growing and existing markets are rapidly expanding, the infrastructure
needs to be in the position to handle such developments. A good example is the evolution of
clearing and settlement arrangements for OTC derivatives. It took a while for the
infrastructure to adjust to the tremendous growth in OTC derivatives. Eventually, with support
from central banks, the most pressing shortcomings began being addressed. Today, there is
a far higher degree of automation, new technical processes have been introduced, and
innovative services are available. The infrastructure for the OTC derivatives markets will
undoubtedly continue to evolve. Whatever path the evolution takes, as the market
infrastructure moves further in the direction of centralised processing of trades and
posttrade events, several issues will assume greater importance. First, providers of essential
post-trade services for OTC derivatives should provide open access to their services and
should aim to achieve convenient and efficient connectivity with other systems. Moreover,
central banks and supervisors will need to consider whether certain existing standards for
securities settlement systems, central counterparties or systemically important payment
systems should be applied to providers of clearing and settlement services for OTC
derivatives.
Including new players in stress-testing the system is challenging and requires cooperation
and timely transparency. Many of these new players are non-banks. It is therefore important
to look at the role of non-banks in payment and settlement systems. Payment, clearing and
settlement services have traditionally been offered by banks and non-banks alike. The
coexistence of banks and non-banks raises some important regulatory questions. In fact, while
there is a trend towards common regulatory standards, banks would typically argue that they
are subject to prudential supervision and that there is no need for further regulation. In
contrast, non-banks would argue that common regulatory standards should apply to all
relevant service providers in order to ensure a competitive level playing-field. In the end, the
question is whether the approach to regulation should be based on functions or institutions.
Finally, the globalisation of finance has resulted in the expansion of cross-border financial
linkages. An implication of globalisation is that financial distress is more likely to have
farreaching cross-border effects. This is a natural consequence of the tighter cross-border
linkages that have formed. Such effects are almost guaranteed if distress were to involve one
of the global players that operate across so many countries and underpin the smooth
performance of so many markets. In fact, over 30 years ago, even the failure of a small bank
active in FX transactions was sufficient to have significant cross-border ramifications - so
significant as to act as a catalyst for the establishment of the Basel Committee on Banking
Supervision. The knock-on effects of distress at one of the current large global players would
presumably be much bigger.
Conclusions
Let me briefly conclude, ladies and gentlemen. Central banking and payment systems are
inextricably linked. Central banks all around the world are involved in payment systems and
market infrastructures in many different ways owing to their roles and responsibilities in
relation to monetary policy and financial stability. Indeed, payment systems disruptions would
not only affect financial stability, but may potentially also have an impact on monetary policy
implementation. Central banks have found ways of safeguarding price stability, while at the
same time ensuring the smooth functioning of the payment system, by drawing a clear line
between providing intraday liquidity for payment system purposes and providing credit for
monetary policy implementation. Moreover, the sufficient availability of collateral is important
today as a contribution of central banks to financial stability.
The roles of central banks in the field of payment systems are changing in a number of ways
as a result of progressing globalisation, increasing complexity, and the emergence of new
players and services:
•
The approach of central banks to analysing financial stability is changing. A
comprehensive view of the key sources of risk and vulnerabilities facing the
payment systems and market infrastructures cannot be formed without taking due
account of developments at the global level, such as the emergence of cross-border
payment systems and offshore centres. Issues and questions relating to the location
of payment systems and market infrastructures are also gaining in importance for
central banks.
•
Central banks have started interacting and cooperating with new interlocutors and
partners outside the banking area. Many new players and providers in the field of
payment, clearing and settlement services are indeed non-banks with which central
banks traditionally had little - if any - direct interaction.
•
Central banks are increasingly concerned with the division of responsibilities and the
allocation of risks between infrastructure providers and their clients. The
responsibility for the safety of a payment, clearing or settlement system rests largely
with the system operator. However, to the extent that participants in the system can
take action to reduce risks that may have a bearing on the system as a whole, they
should be given incentives to do so. For example, the margining systems of central
counterparties should give incentives to participants to trade prudently.
•
Central banks are increasingly involved in cross-border cooperation and information
exchange with other central banks and authorities contributing to financial stability in
order to obtain a comprehensive picture of risks and vulnerabilities and to identify
appropriate and effective mitigating policy actions.
•
Central banks have been intensifying their efforts to produce consistent regulatory
and oversight standards on a cross-border basis. The Core Principles for
Systemically Important Payment Systems and the CPSS-IOSCO Recommendations
for Securities Settlement Systems and Central Counterparties have been important
steps in this direction. Against this background, some further work needs to be done
on the harmonisation of the oversight framework for securities clearing and
settlement in the European Union. The continuous absence of such a harmonised
oversight framework generates a number of undesirable effects. However, after the
recent ECOFIN decision, I am very optimistic that we will soon see the finalisation
and adoption of the ESCB-CESR recommendations for securities clearing and
settlement.
•
The relevance of collateral for liquidity issues has been clearly recognised by central
banks. During the past ten years, central banks have - especially in the context of
the Committee on Payment and Settlement Systems and other Basel committees -
focused jointly their attention on the use of collateral in financial transactions,
including the cross-border use of collateral.4 Cooperation in this respect is very
useful and, especially for emergency situations, I would think that central banks -by
enabling the cross-border use of collateral - could make a positive contribution to
financial stability.
Ladies and gentlemen, let me now close my introductory remarks by once again welcoming
you all and by thanking all of those who have been involved in preparing this conference, in
particular Daniela Russo and Mark Manning.