Ben S Bernanke: The European economic and financial situation
Testimony by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal
Reserve System, before the Committee on Government Oversight and Reform, US House of
Representatives, Washington DC, 21 March 2012.
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Thank you, Chairman Issa, Ranking Member Cummings, and other members of the
Committee for inviting me to testify about the economic and financial situation in Europe and
the actions taken by the Federal Reserve in response.
Developments in Europe and their effects on the U.S. Economy
For almost two years, developments in Europe have had an important influence on the tenor
of global financial markets and on the global economy more generally. The combination of
high debts, large deficits, and poor growth prospects in several countries using the euro has
raised concerns about fiscal sustainability and, consequently, led to sharply higher sovereign
borrowing costs - initially for Greece, but subsequently for other euro-area countries as well.
Pessimism about these countries' fiscal and economic situations, in turn, has undermined
confidence in the strength of European financial institutions, increasing the cost and difficulty
those institutions have faced in obtaining funding and reducing their willingness to supply
credit.
The difficulties in the euro area have affected the U.S. economy. The European Union
accounts for roughly one-fifth of U.S. exports of goods and services. Not surprisingly,
U.S. exports to Europe over the past two years have underperformed our exports to the rest
of the world. In addition, weaker demand from Europe has slowed growth in other
economies, which has also lowered foreign demand for our products.
Financial strains in Europe have also shown through to our financial markets. During times
when financial conditions in Europe were at their most turbulent, investors around the world
retreated from riskier assets. In the United States, these pullbacks decreased stock prices,
increased the costs of issuing corporate debt, and reduced consumer and business
confidence. In addition, U.S. financial institutions that were thought to have substantial
exposures to Europe saw their stock prices fall and their credit spreads widen.
In the past few months, financial stresses in Europe have lessened, which has contributed to
an improved tone of financial markets around the world, including in the United States. The
improvement reflects, in part, a number of actions taken by European policymakers. First,
measures taken by the European Central Bank (ECB), including implementing two
longer-term refinancing operations and easing collateral rules and reserve requirements,
have allowed European banks to lock in funding for up to three years, thereby alleviating
concerns about their near-term prospects. With the benefit of this support, European banks
in turn have increased their holdings of sovereign debt, contributing to lower borrowing costs
for some countries.
Second, euro-area leaders, the Greek government, and private-sector holders of Greek debt
are taking steps to put Greece on a more sustainable fiscal path. Its sovereign debt has been
significantly reduced, the Greek authorities are intensifying their efforts to implement fiscal
and structural reforms, and the European Union and International Monetary Fund have
pledged a considerable amount of new funds as part of a second assistance package. The
Greek economy remains in a deep recession, however.
Third and finally, leaders of most of the members of the European Union have approved a
new fiscal compact treaty that strengthens fiscal rules and their enforcement. This treaty
represents a positive step toward resolving the fundamental tension inherent in having a
monetary union without a fiscal union, and thus should help bolster the viability of the
euro-area economy in the longer term.
Although progress has been made, more needs to be done. Full resolution of the crisis will
require a further strengthening of the European banking system; a significant expansion of
financial backstops, or "firewalls," to guard against contagion in sovereign debt markets; and,
critically, continued efforts to increase economic growth and competitiveness and to reduce
external imbalances in the troubled countries.
Actions taken by the Federal Reserve
The Federal Reserve has followed developments in Europe closely, and we are in frequent
contact with key European policymakers. We are particularly focused on protecting
U.S. financial institutions, businesses, and consumers from adverse financial and economic
developments in Europe.
To help calm dollar funding markets and support the flow of credit to U.S. households and
businesses, the Federal Reserve acted in concert with major foreign central banks to
enhance the U.S. dollar swap facilities that were originally put in place during the global
financial crisis and reestablished in May 2010. Use of the reestablished lines was limited until
late last year. However, in late November, the Federal Reserve agreed with the ECB and the
central banks of Canada, Japan, Switzerland, and the United Kingdom to extend the swap
lines through February 2013 and to reduce their pricing, from a spread of 100 basis points
over the overnight index swap rate to 50 basis points.1
The lower cost to the ECB and other foreign central banks enabled them, in turn, to reduce
the cost of the short-term dollar loans they provide to financial institutions in their
jurisdictions. As a result, usage of the swap line increased considerably, peaking at
$109billion in mid-February. The expanded use of the swap lines has helped to ease funding
pressures on European and other foreign banks, lower tensions in U.S. money markets
(in which foreign banks are major participants), alleviate pressures on foreign banks to
reduce their lending in the United States, and boost confidence at a time of considerable
strain in international financial markets. In recent weeks, as market conditions have
improved, usage of the swap lines has fallen back to about $65 billion.
I would add that the swaps are very safe from the perspective of the Federal Reserve and
the U.S. taxpayer. They present no exchange rate or interest rate risk; each drawing has a
short maturity and must be approved by the Federal Reserve; they are collateralized by the
foreign currencies for which dollars are swapped; and our counterparties are the foreign
central banks, not the foreign commercial banks that receive the dollar loans.2
In addition to its actions to reduce pressures in global markets for dollar funding, the Federal
Reserve has collaborated with other agencies - both bilaterally and through the Financial
Stability Oversight Council - to monitor the potential vulnerabilities of U.S. financial
institutions and to work to enhance their resilience in the face of possible shocks to the global
economy. Notably, U.S. financial institutions have very limited direct net credit exposures to
the most vulnerable euro-area countries, and U.S. money market funds also have almost no
exposure to those countries.
U.S. financial institutions do have some gross exposure to potential losses arising from sales
of credit default swap (CDS) protection referencing European sovereign debt. However, for
the large U.S. dealer banks, these sales have been more than offset by purchases of
protection, which would imply that in the event of a sovereign default, U.S. financial
institutions would be net recipients of CDS payouts. These positions still carry some risk in
that some U.S. banks' counterparties might conceivably fail to make good on their
obligations, but such risk is mitigated by the fact that the counterparties to large U.S. dealer
banks for sovereign CDS trades are dispersed, primarily across large financial institutions.
And in the vast majority of cases, these institutions post collateral to each other to help
minimize possible losses.
Although U.S. banks have limited exposure to peripheral European countries, their
exposures to European banks and to the larger, "core" countries of Europe are more
material. Moreover, European holdings represented 35 percent of the assets of prime
U.S. money market funds in February, and these funds remain structurally vulnerable despite
some constructive steps, such as improved liquidity requirements, taken since the recent
financial crisis. U.S. financial firms and money market funds have had time to adjust their
exposures and hedge their risks to some degree as the European situation has evolved, but
the risks of contagion remain a concern for both these institutions and their supervisors and
regulators. In particular, were the situation in Europe to take a severe turn for the worse, the
U.S. financial sector likely would have to contend not only with problems stemming from its
direct European exposures, but also with an array of broader market movements, including
declines in global equity prices, increased credit costs, and reduced availability of funding.
To address these broader risks, we have been working closely with large U.S. financial
institutions. Most recently, on March 13, we released results from our Comprehensive Capital
Analysis and Review (CCAR) - a supervisory assessment by the Federal Reserve of the
capital planning processes and capital adequacy of large, complex bank holding companies.3
As part of this exercise, bank capital positions were evaluated under a hypothetical stress
scenario that involved a deep recession in the United States (with unemployment reaching
13 percent) and a notable decline in activity abroad, combined with sharp decreases in both
domestic and global asset prices. This exercise was designed to capture both the direct and
indirect exposures and vulnerabilities of U.S. financial institutions to the economic and
financial stresses that might arise from a severe crisis in Europe. The results show that a
significant majority of the largest U.S. banks would continue to meet supervisory
expectations for capital adequacy despite large projected losses in an extremely adverse
hypothetical scenario.
Conclusion
The recent reduction in financial stresses in Europe is a welcome development for the United
States, given the important trade and financial linkages connecting our economies. However,
Europe's financial and economic situation remains difficult, and it is critical that the European
leaders follow through on their policy commitments to ensure a lasting stabilization. I believe
that our European counterparts understand the challenges and risks they face and are
committed to take the necessary steps to address those issues.
For our part, the Federal Reserve will continue to monitor the situation closely, work with our
financial institutions and foreign counterparts to enhance the resilience of our financial
system, and be ready to use our tools to help stabilize U.S. markets should the situation
require such action.
Thank you. I would be pleased to respond to your questions.