José Manuel González-Páramo: The response of the Eurosystem to the
financial crisis
Keynote speech by Mr José Manuel González-Páramo, Member of the Executive Board of
the European Central Bank, at the European Parliament's Special Committee on the
Financial, Economic and Social Crisis (CRIS), Brussels, 10 November 2009.
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Introduction
I am happy to have the opportunity to speak in front of the European Parliament's Special
Committee on the Financial, Economic and Social Crisis on the Eurosystem's various
measures to address the crisis.
The financial crisis created great uncertainty and presented a number of challenges from the
policy-making perspective. It is generally recognised that from the start of the tensions, the
Eurosystem's response to the crisis has been effective. Indeed, when widespread tensions
severely impaired the functioning of the money market in early August 2007, the Eurosystem
rapidly reacted by injecting €95 billion into the banking sector in an overnight operation,
followed by various additional liquidity injecting operations. When the crisis intensified again
in September 2008, the Eurosystem swiftly reacted by announcing further exceptional
measures to enhance the provision of liquidity to banks. Similarly, the rapid and pronounced
cuts in interest rates after October 2008 represented a timely response to contain the
spreading of the turmoil from the financial sector to the real economy, with significant risks to
the outlook for price stability.
In my speech today, I will first review the main steps taken by the Eurosystem in response to
the crisis. Next I will elaborate on the effects that these non-standard measures had on the
Eurosystem's balance sheet and on the provision of liquidity to the financial sector. Finally, I
will report on our current thinking about the phasing out of some of these measures.
The Eurosystem's monetary policy response
Central banks around the world reacted to the financial crisis by both cutting policy interest
rates and engaging in so-called "non-standard" measures of monetary policy. These are
called "non-standard" because they go beyond changes in the interest rate, which represents
the traditional tool with which central banks steer monetary conditions in the economy.
Between October 2008 and May 2009, the Eurosystem's key policy rate - the interest rate on
the main refinancing operations - was lowered by a cumulative 325 basis points. The speed
and extent of the monetary loosening experienced over this period are without precedent
since the Eurosystem took responsibility for the conduct of monetary policy in the euro area.
This is of course a rather short period, just over a decade. However, changes in interest rate
of this magnitude remain exceptional even if we look at the much longer historical experience
of the Deutsche Bundesbank and other major central banks in Europe.
The unconventional policy taken, for which we also coined the term "enhanced credit
support", consisted of four main types of measures:
1. Full allotment and increased maturity of the Eurosystem's refinancing operations.
Already in 2007, the number and allotment volumes of 3 month operations were
increased, compared to the weekly main refinancing operations. In April 2008, we
conducted for the first time 6 month operations. In October 2008, the Eurosystem
switched in all its refinancing operations to the so-called "fixed rate with full allotment"
modality, thereby fully accommodating private banks' demand for central bank
liquidity at the central policy rate. In addition, in May 2009, an announcement was
made to conduct three 12-month operations at fixed rate with full allotment. The first
such operation was allotted in June 2009 with an amount of €442 billion. The third
12month operation will be allotted in December 2009.
2. Provision of liquidity in foreign currencies. In December 2007, the Eurosystem started
to provide US dollar against our standard euro collateral set. In October 2008, the
Eurosystem expanded the provision of liquidity in selected foreign currencies, by
offering in principle full allotment. In addition, we started to provide our counterparties
with Swiss franc denominated liquidity. The provision of foreign currency was
refinanced through FX swap agreements between the major central banks. Again,
this appears to be unprecedented in central banking history and illustrates the very
effective co-operation between major central banks over the past two years as well as
the willingness to enter new modes of liquidity support to banks.
3. The expansion of the list of assets eligible as collateral. The Eurosystem expanded in
October 2008 its already broad list of eligible collateral, against which counterparties
are able to obtain liquidity in central bank refinancing operations. Ample availability of
collateral is important in a financial crisis, as counterparties can only obtain liquidity in
refinancing operations to the extent that they hold eligible collateral. It may be noted
that other central banks widened the eligible collateral set much earlier during the
turmoil. This however did not reflect a lack of pro-activeness of the Eurosystem, but
the fact that it had always accepted a broad range of collateral. The steps taken by
other central banks during the first year of the financial crisis can therefore be
considered as convergence of collateral sets in the direction of the Eurosystem's
framework.
4. Outright purchases of covered bonds. The covered bond market, which has
historically been an important source of funding for banks in large parts of the euro
area, had suffered from the financial crisis, both in terms of primary and secondary
market activity. The total sum allocated to the purchase programme - €60 billion,
representing about 5% of the outstanding eligible covered bonds - is deemed
sufficient to significantly support activity in this important market, ensuring that the
ECB acts as a catalyst for re-activating this market rather than as a market maker of
last resort. During the first four months, the Eurosystem bought over €20 billion worth
of covered bonds, with the total of up to €60 billion being targeted for June 2010.
Compared with measures taken by other central banks, the measures implemented by the
Eurosystem were specifically targeted at the banking sector. The reason for concentrating on
the banking sector stems from structural features of the euro area's economy, particularly the
fact that its financial system is predominantly bank-based. Indeed, bank loans account for a
much larger share of financing to households and firms in the euro area than in the United
Kingdom or in the United States, where non-bank financial institutions and capital markets
provide important alternative sources of funds. For instance in 2007, the ratio of bank lending
to the private sector relative to GDP amounted in the euro area to about 1.5, compared with
a ratio of 2/3 in the United States. At the same time, the ratio of outstanding debt securities
issued by the euro area private sector relative to GDP was just over 3/4 in the euro area,
while it was above 1.5 in the United States.
Accordingly, the set of measures implemented by the Eurosystem - our enhanced credit
support programme - were designed with the objective of providing support to the banking
sector by: (a) helping the functioning of the money market, (b) easing funding conditions for
banks, and (c) improving market liquidity in segments of the private debt securities market
(specifically, the market for covered bonds) that represent an important source of funding for
euro area banks. Through these measures, the ECB aimed to mitigate the risk of systemic
illiquidity in the euro area banking sector and to guarantee a steady flow of banking credit to
euro area households and firms.
Impact of measures implemented by the ECB
Let me start with the impact of our measures on the Eurosystem balance sheet.
As in the case of other central banks, the size and complexity of the Eurosystem balance
sheet has significantly increased. In June 2007, just before the start of the crisis, total assets
of the Eurosystem amounted to around 10% of area-wide GDP (€913 billion). By January
2009, the size of the balance sheet had almost doubled, reaching 19% of GDP (€1,763
billion). Subsequent improvements in money market conditions have led to a reduction in the
amount of total assets, but they remain at a higher level (16% of GDP, or €1,454 billion) than
in the pre-crisis period.
The expansion of the Eurosystem balance sheet was driven both by changes in the so-called
autonomous factors, as well as by the introduction of non-standard measures. On the liability
side, banknotes and government deposits have steadily increased during the past two years:
banknotes changed from around €600 billion at the beginning of 2007 to €768 billion at the
end of October 2009, while government deposits over the same time period went from
around €50 billion to €140 billion.
On the asset side, three factors may be distinguished, reflecting the non-standard measures.
First, the banking system as a whole tended to demand more euro liquidity through
refinancing operations with full allotment than actually needed to fulfil reserve requirements
and liquidity needs from autonomous factors, and hence deposited the excess amounts back
into the deposit facility of the Eurosystem. Second, the composition of the Eurosystem
balance sheet is affected by the covered bond purchase programme, whereby the purchases
mainly imply a substitution effect, as they are likely to lead over time to a corresponding
reduction of Eurosystem refinancing operations. The importance of these two factors for the
overall expansion of the Eurosystem balance sheet can be measured very simply in the form
of the recourse to the deposit facility. The daily recourse to the deposit facility peaked on 3
July 2009 with €316 billion, reflecting the high demand in the first 12 month long-term
refinancing operation (LTRO) in June 2009. Recourse to the deposit facility stood at €106
billion on average during the last maintenance period ending on 13 October 2009. The third
factor lengthening the balance sheet was the provision of liquidity in foreign currency, either
via collateralised lending or via swaps.
Let me also mention briefly the impact of the change of allotment procedure and increase of
maturity on our open market operations volume. The outstanding amount of long-term
refinancing operations, i.e. operations with a maturity of between 1 and 6 months, increased
from €150 billion in June 2007 to over €600 billion at the end of 2008. Over the same period
the total amount of outstanding refinancing operations has almost doubled, peaking at €850
billion on 2 January 2009, and currently standing at €672 billion. The January 2009 figure
represented more than 9% of euro area GDP. The 12 month operations conducted in June
2009 was with its €442 billion euro the largest single refinancing operations ever conducted
by a central bank. It attracted a widespread participation of counterparties, namely 1,100
financial institutions, which may also have been a historical record.
Turning to the impact of our measures on financial markets and the real economy at large,
there are some clear signs that the measures are having positive effects. In particular, the
spreads between unsecured term interest rates and overnight interest rate swaps in the
money market have declined significantly since last autumn and are now back at levels last
seen before the bankruptcy of Lehman Brothers. Related to that, and in conjunction with
policy rate cuts, interest rates on loans to households and firms have declined substantially.
At the same time, recent data indicates that growth in aggregate lending has not turned
around. Although there have been signs that the slowdown in lending to households has
come to a halt, the growth rate of loans to non-financial corporations has continued to
moderate. Seen in context, the recent developments in loans to firms appear to be broadly in
line with past regularities in bank lending behaviour, particularly at turning-points in the
business cycle. Indeed, loans to firms tend to lag GDP growth by about three quarters. This
may be related to the fact that non-financial corporations usually see their cash flows
improve early in an economic upturn and thus tend to finance working capital and fixed
investment with internal funds first, and only later with external financing. In addition, when
macroeconomic conditions are weak, the dynamics of bank loans are affected by
demandside factors. Having said this, it is important to closely monitor developments in credit in
order to assess to what extent supply-side constraints may play a role in limiting credit
availability.
Recent data suggests that the global economic slowdown may be bottoming out, and the
freefall in economic activity has come to an end. Concomitant positive signs are the
improvements in the funding situation of banks, the continued decline in lending rates and
increasing indications of a turning point in bank lending conditions. However, uncertainty still
remains high and the economic data remain volatile. In addition, we should acknowledge that
the future, the evolution of lending will, most likely, depend more than in past episodes, on
adjustments taking place within the banking sector.
Preparation for phasing-out from non-standard measures
Although the financial crisis is not yet over, we have carefully and thoroughly developed the
set of principles and contingent courses of action that will govern the progressive exit from
the set of non-standard measures currently in place. The ECB's monetary policy continues to
provide substantial support to the availability of liquidity and the recovery of the euro area
economy. Looking ahead, as conditions in the financial markets normalise further, not all our
liquidity measures will be needed to the same extent as in the past. Accordingly, the
Governing Council will make sure that the extraordinary liquidity measures taken are phased
out in a timely and gradual fashion, and that the liquidity is absorbed in order to counter
effectively any threat to price stability over the medium to longer term.
In so doing, the stance of monetary policy could be normalised through the change of key
policy rates as well as through the gradual withdrawal of our enhanced credit support
measures, or through a combination of both. The precise sequencing will depend on the
circumstances prevailing at the time.
With regard to the non-standard measures, it is useful to distinguish again between the four
different types of measures.
First, for the non-standard refinancing operations, there is an obvious built-in mechanism that
facilitates their removal, as the operations mature at pre-specified dates and can then be
replaced by conventional refinancing operations, if needed.
Second, as with non-standard euro refinancing operations, the provision of foreign currency
liquidity does not need to be renewed when it is considered that it is no longer warranted. In
this context, let me remind you that the exit from this specific measure has already started:
owing to lack of demand, we have already discontinued foreign currency-providing
operations with longer maturities.
Third, it has been made clear that the widening of the collateral framework is temporary.
More precisely, its remaining into effect is linked to the conduct of the 12 month LTRO in
December 2009. Hence, the widening of the collateral framework will be naturally phased out
in December 2010, unless otherwise decided.
Finally, in relation to the covered bond portfolio, there is no particular need to dispose of the
purchased bonds at any future moment in time, as it does not interfere with monetary policy
implementation. We could therefore decide to hold the portfolio until maturity and let it
gradually shrink over time as a result of redemptions. Alternatively, the portfolio could be
disposed of in a gradual way that would make it possible to avoid market distortions. In any
case, the alternative options can be considered again once the entire portfolio has been
established.
Regardless of the specific modalities adopted for the exit strategy, let me stress again that
the key principles to phase out existing measures should in any case be timeliness and
gradualism. Indeed, the stance of monetary policy should be normalised and the
nonstandard measures withdrawn in parallel with the gradual improvement in economic and
financial conditions.
Let me also stress that there are no technical obstacles to the implementation of our exit
strategy. In any case, we have the instruments to allow us to actively withdraw liquidity.
Longer-term liquidity-absorbing operations could be envisaged in a scenario where it is clear
that the need to absorb persists for a certain period of time, and where a significant
tightening in monetary policy is needed. In this case, long-term liquidity absorption could be
used to quickly restore a deficit situation along with an increase in interest rates.
In this context, let me mention that, when assessing whether or not the non-conventional
liquidity measures have achieved their objectives, we need to be aware that such measures
have been introduced for systemic purposes and not to address problems at individual
institutions, which fall within the sphere of competence of national governments. Therefore,
concerns about the costs or difficulties faced by individual institutions, once the exceptional
provision of liquidity is discontinued, should not act as a constraint on the timely
implementation of an exit strategy from non-conventional monetary policy.
A final point must be made: the specific operational steps of an exit should not be interpreted
as signalling imminent changes to key policy rates. The exit strategy will take place in an
orderly fashion with a well-designed and clearly communicated exit framework. The
longterm success of non-standard measures is conditional upon achieving both an appropriate
stimulus to the economy in the short-term in conjunction with keeping long-term private
sector inflation expectations firmly anchored.
Conclusion
The financial crisis has presented exceptional challenges to central banks to support the
functioning of money markets and the funding liquidity of banks, to stabilise economic activity
and to preserve price stability. The ECB responded swiftly to these challenges by engaging
in non-standard monetary policy and aggressively cutting policy interest rates.
While the current economic environment continues to pose challenges, we have a strategy
that will govern the progressive exit from the set of non-conventional measures currently in
place. Our preparations for a gradual exit from these measures, however, do not suggest
that fundamental change in policy is imminent. Rather, the development, communication and
eventual timely implementation of a well-designed exit strategy are vital in terms of the
preservation of the macroeconomic and financial stability gains derived from the
nonconventional measures.