Vítor Constâncio: Reinforcing financial stability in the euro area
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the Official
Monetary and Financial Institutions Forum (OMFIF) City Lecture, London, 8 May 2015.
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Ladies and Gentlemen,
Thank you for inviting me to speak about the elements needed to reinforce financial stability
in the euro area. In what follows, I will start by recalling the benefits of current monetary
policy for financial stability. I will then turn to those risks for financial stability that should be
addressed by supervision and macroprudential policy. While recent regulatory efforts have
made the banking sector more resilient, I see a need to expand the set of macroprudential
instruments that focus on the non-bank financial sector. In my intervention today, I will
therefore outline the associated elements which, in my view, are still incomplete for
safeguarding financial stability.
The interplay of monetary policy and macroprudential policy
Low nominal growth has been the underlying factor of the main risks for financial stability in
the euro area. The financial crisis, the slow recovery and the low inflation rate, particularly in
the euro area, have created an environment of low interest rates in financial markets, which
has been further accentuated by a necessarily accommodative monetary policy. The policy
pursued by central banks has been essential to stabilise our economies and to dispel the risk
of possible deflationary episodes or of a prolonged "low-flation" regime. In particular, a
possible further reduction in inflation expectations would have had a direct effect on real
interest rates leading to an unwarranted tightening of financial conditions with an
unfavourable impact on inflation and economic growth.
It has to be recognised that a prolonged period of low interest rates contributes to "search for
yield" and possible rich asset valuations which may generate financial stability concerns. This
environment however, is the result of weak economic conditions and low inflation, the related
market players' decisions, and the central bank's response to these conditions. Low medium
and long-term interest rates are not just caused by monetary policy. As the last few days
have shown, market players' decisions may overwhelm central bank policies. Furthermore, in
the last decades, there has been a global trend for lower real interest rates which is related
to secular stagnation resulting from a continuous deceleration of total productivity growth and
an increase in planned savings. Monetary policy short-term rates are low because of these
developments, not the other way around. At the same time, monetary policy needs to remain
accommodative in order to normalise inflation levels close to our objective, thus leading to
higher interest rates.
Consequently, the ECB monetary policy measures that have been taken since summer last
year, including most recently the expanded asset purchase programme (EAPP), not only
contribute to maintaining price stability but are also beneficial for financial stability.
Specifically, I expect the current monetary policy stance to strengthen aggregate demand in
the euro area on the back of lower real interest rates and improved confidence. Higher actual
and expected inflation closer to our price stability objective also help alleviate the real debt
burdens of households, firms and governments, which otherwise could have been subject to
adverse debt dynamics. Credit worthiness of firms and households should improve on
account of higher net worth induced by asset price increases. Moreover, as bank funding
cost should continue to decline, I expect to see a further easing of credit standards on loans
to enterprises as was already noticeable in the latest ECB Bank Lending Survey.
Our policy is indeed working according to plan. Conditions in a host of asset markets, from
equities to bonds or foreign exchange, have reacted in the expected way through the
portfolio rebalancing transmission channel of monetary policy. In the euro area, equity prices
have gone up by 13% since January. Corporate bond yields came down by 49 basis points
since June last year and the most recent (March) data on bank lending rates shows that
rates decreased by 70 basis points, with respect to last year. This last point shows that our
policies are also improving the credit channel, which is confirmed by the fact that credit (bank
loans) to the private sector reached a turning point, as shown by net positive monthly flows in
the last three months. More expansionary financial conditions are supporting the recovery as
well as the increase of inflation expectations. In fact, the 5y/5y ahead swap rate went up from
1.6% in January to 1.8% at present.
No policy intervention is without side effects. Indeed, as I mentioned already, a very
accommodative monetary policy stance geared towards maintaining price stability in the
presence of already generously priced asset markets may also lead to potential risks for the
stability of the financial system. Nevertheless, monetary policy must be focused on inflation
and/or growth according to the different central bank mandates and therefore, such risks
need to be addressed by policy instruments dedicated to ensuring resilience while curbing
cyclical excesses - that is, supervision and macroprudential policy.
In the current situation, we see that risks stemming from excessive risk-taking or any
misaligned asset prices are contained in the euro area. This assessment is supported by
continued moderate private sector credit expansion and leverage. However, we have
certainly noticed that equity prices have continued to rise - albeit from previously low levels -
and that sovereign bond yields are historically low. Moreover, ECB estimates suggest that
corporate bond risk premia are moving towards levels seen before the financial crisis. In
addition, co-movements in financial markets have increased since summer 2014.
These developments justify the need for close monitoring with a particular focus on asset
markets but also on banks, insurers and pension funds as well as the less-regulated
nonbank financial sector and the non-financial private sector.
As financial and business cycles are not always aligned across countries and sectors in the
euro area, area-wide monetary policy needs to be complemented by more targeted
macroprudential policy. Unlike monetary policy that influences the euro area across the
board, macroprudential policy instruments can be applied in a granular manner, addressing
risks at the country, sector and institutional level. Macroprudential policy therefore provides
the most appropriate instruments for mitigating financial stability risks, thereby supporting the
price-stability oriented monetary policy.
In that respect, concerns about the stability of the banking system have been addressed over
recent years, through efforts to put a comprehensive regulatory framework in place and
notably the set-up of banking supervision at the European level with the establishment of the
Single Supervisory Mechanism (SSM). The regulatory framework for banks is at this stage
largely in place. But a few important elements such as leverage ratio, the Net Stable Funding
Ratio (NSFR) and Total Loss Absorbing Capacity (TLAC), which should be finalised in order
to complete our framework for banks, are outstanding. In addition, macroprudential tools for
the banking sector are also available but should be extended to also encompass LTV
(Loanto-Value) and DTI ratios (Debt-to-Income), the leverage ratio, limits to specific large
exposures to shadow banks and to maturity transformation.
Given the achievements in the regulatory framework for banks and the changing landscape
in the euro area financial system, our attention naturally shifts to the more opaque and less
regulated parts of the financial system. Let me next turn to what is needed beyond the
banking system.
The need for macroprudential tools beyond banks
So far, the regulatory reform has largely focused on the banking sector with the effect of
activities and assets in other sectors growing faster than in the banking sector. Growth of the
non-bank financial sector in the euro area has gathered pace in recent years, following the
global financial crisis, accompanied by a shift to market-based funding. The expansion of the
non-money market investment funds sector has been the main source of growth of the
shadow banking sector.
Using the Financial Stability Board's (FSB) broad definition of shadow banking, assets of
non-bank financial entities in the euro area have more than doubled over the past decade, to
reach EUR 23.5 trillion by December 2014. Since 2009, non-bank entities have increased
their share in total assets of the financial sector from 33% to 37%, while, in parallel, credit
institutions have seen their share of intermediation shrink from 55% to 49% of the
approximately EUR 60 trillion of total assets in the euro area financial system.
This strong growth and increasing role of non-bank entities in the euro area financial system,
warrants closer scrutiny of their structural and cyclical developments, including risks to
financial stability.
Non-bank entities are increasingly important providers of credit to the real economy. On the
positive side, they represent a second source of funding for the real economy in addition to
banks, and help diversify the funding base of financial and non-financial corporates. This will
be particularly important in times of deleveraging in the banking sector. However, the
growing role of non-bank entities in the euro area implies that the systemic relevance of
these entities is also on the rise. Non-banks can also exert costs on the wider financial
system and can, just as easily as banks, become excessively risky and too-big-to-fail. What
this requires is enhanced monitoring, a broader regulatory perimeter, strengthened
supervision and the development of a more comprehensive macroprudential toolkit.
At the current juncture, two factors in particular warrant attention. First, there is a growing
concern over the potentially destabilising role of non-bank entities in sharp price adjustments
in asset markets. Solvency concerns are muted due to a high share of equity, for instance in
the investment funds sector, while key vulnerabilities result from liquidity transformation and
the procyclical provision of liquidity to financial markets. Second, the use of leverage
embedded in derivatives positions as well as securities lending and financing transactions
has become widespread, potentially adding to liquidity spirals in a stress scenario. Any
largescale portfolio rebalancing among investment funds could therefore result in significant
swings in asset prices and market liquidity, possibly increasing funding costs for key euro
area sectors.
The investment fund sector provides a case in point: while the ECB believes that the sector
is overall adequately regulated in the EU from an investor protection point of view, i.e., by the
UCITS and Alternative Investment Fund Managers Directives, concerns have risen over the
past few years that this sector in particular, could be part of future systemic events. These
are now worldwide concerns expressed by the IMF or the FSB.
One of the main vulnerabilities stemming from the investment fund sector relates to the
socalled liquidity spirals. These may be triggered if funds are confronted with strong
redemptions or increased margin requirements, as these could result in forced selling into
markets with low liquidity. With these liquidity conditions, initial asset price adjustments would
be amplified, triggering further redemptions and margin calls, thereby fuelling such negative
liquidity spirals. The market impact of large-scale outflows could be aggravated by strategic
complementarities among fund investors, in particular, resulting from first mover advantages
and asset managers being forced to adjust portfolios in a timely manner. Market impact of
investment funds is potentially strong, in particular for the euro area secondary bond
markets, as investment funds hold a substantial and growing proportion of the debt securities
of euro area banks, governments and non-financial corporates.
Liquidity and maturity transformation outside the regulated perimeter have been further
spreading risks across institutions and countries during the global crisis. While regulatory
reforms have addressed the most apparent problems, new players and business models
which require close monitoring are likely to emerge.
The growing size and the associated risks arising from non-bank entities and activities call
for efforts to strengthen the supervisory framework for this sector. Entities and activities
outside the regulatory perimeter will require enhanced oversight and supervision. The
following three points are particularly relevant to achieve this.
First, we need more information, and we need to develop a monitoring framework for the rest
of the financial system. Second, we need to create and develop macroprudential tools for
both entities and activities in the non-bank sector. And finally, we need to strengthen our
regulatory and institutional base in Europe to ensure the efficient application of
macroprudential measures.
Let me expand on each of these three points.
A monitoring framework beyond banking
A prerequisite for an efficient application of macroprudential tools beyond banking is the
need to have sufficient knowledge and information about the entities and activities in this
space.
While very few sectors in the euro area involved in financial intermediation remain truly
unregulated, monitoring of non-bank entities at the euro area level remains largely
fragmented due to data limitations. The recent collection by the ECB of balance sheet items
of investment funds and the Financial Vehicle Corporation (FVCs) classification exercise has
provided detailed data and enabled a better surveillance of the euro area non-bank financial
sector. However, granular statistics are still not available for more than 50% of the sector's
assets. Following the recent ESA 2010 reclassification, some limited information is available
on size, asset composition, and geographic distribution of this "residual".
Limited balance sheet statistics would provide some weight to the assumption that most of
the residual entities are Special Financing Institutions (SFIs) or holding companies which
would not be included in the FSB concept of shadow banking.
Coverage of the investment funds sector is much more comprehensive, where the ECB has
collected statistics on the types of funds, and their asset and liability decomposition. Still, the
ability of the authorities to monitor and map specific risks in the euro area remains limited.
Gaps remain with respect to synthetic leverage created by derivatives as well as securities
lending and financing transactions in the shadow banking sector. Targeted data collection
projects have been initiated to fill these gaps, including derivatives reporting under EMIR and
further reporting requirements of securities transactions under MiFID.
Another angle to address risks in the non-bank sector is to shed further light on and monitor
certain activities that give rise to stability concerns, notably in the derivatives, repo and
securities financing markets. Risks in these markets may also be created by entities
domiciled in jurisdictions outside the euro area, which may otherwise escape the monitoring
perimeter.
Macroprudential tools for non-bank entities
The importance of market-based finance and in particular of asset managers and the new
vulnerabilities they may create, lead me to strongly share the view recently voiced by a
number of prominent supervisors that we need to push ahead to develop a toolkit of policy
measures. Most importantly, the FSB has started looking into the financial stability risks
associated with asset management activities, as well as longer-term structural financial
stability issues that may arise.
This is not to say that the asset management sector is unregulated. In fact, we have a very
successful investment fund regulation in Europe. However, this regulation is largely tailored
to protect investors rather than to contain risks for financial stability. We need to turn some of
the instruments already available to managers of investment funds into macroprudential
tools.
Specifically, additional liquidity requirements, guided stress tests, minimum and time-varying
load, and redemption fees should be part of the macroprudential toolbox. Well defined limits
to leverage, especially synthetic leverage built-up with derivatives, should also be introduced.
In general, it is necessary to intensify the oversight of systemically important non-bank
institutions as is the case in the U.S.A. We need to curtail risks from these systemic players
and raise their resilience through the financial cycle. A first step in this direction is the work
done by the FSB that develops a common methodology to identify systemically significant
non-bank and non-insurers. The FSB is currently also working on the systemic risks in the
asset management industry.
Other measures concern activities or instruments used in the market-based financial sector.
In particular, I have in mind minimum and countercyclical haircuts for Securities Financing
Transactions (SFT). Countercyclical haircuts would limit volatility and leverage in financial
markets more effectively than the minimum haircut requirements recently recommended by
the FSB. Another important FSB workstream focuses on re-hypothecation and re-use of
securities in the repo market. These create chains of inside liquidity that enhance the "illusion
of liquidity", which tend to disappear in times of stress.
Further work to understand the effects of these tools and how best to apply them in practice
is encouraged.
A new regulatory and institutional base in Europe
I have listed a number of tools that would help safeguard financial stability in the euro area.
However, the legal and institutional base would need to be changed in order to implement
the policies required to address the risks from non-banks. This is particularly true in the
context of the implementation of the Capital Markets Union, because it implies the creation of
a single rulebook for capital markets oversight and the clear definition of the mechanisms at
the European level. These would need to be adjusted in order to ensure the harmonised
application of such a rulebook in the whole single market. I presume that an enhanced role
for ESMA will have to be considered.
In this context, it is paramount that authorities, through the development of a macroprudential
framework, have the tools to deal with the build-up of systemic risks at their disposal. We
also need to establish the legal base to place systemically important non-banks within the
perimeter of enhanced supervision in Europe. In the United States, non-bank Systemically
Important Financial Institutions (SIFIs) (designated by the U.S. Financial Stability Oversight
Council) are placed under enhanced prudential supervision by the Federal Reserve Board of
Governors. This step has already been implemented for some institutions while non-bank
SIFI designation is being studied for some large asset managers. I believe it is important that
competent authorities in Europe are equipped with similar powers.
Conclusion
Let me conclude.
Our current monetary policy setting is beneficial not only for euro area price stability but also
for financial stability. At the same time, we are aware that a build-up of risks in the financial
system can arise in a situation of protracted low interest rates and abundant liquidity. Such
risks should be addressed by macroprudential policy in a targeted manner at country and
sector level.
It is essential to ensure that our financial system is well capitalised, liquid and resilient, in
dealing with the challenges to financial stability and avoiding future financial crises. This
holds particularly for Europe with its heterogeneous financial system. We are currently
experiencing a significant shift away from bank-intermediated finance and this process will
continue in the future. A broadened toolkit is therefore required. We need the ability to take
decisive and intrusive macroprudential policy decisions and a framework that is sufficiently
broad to capture all relevant systemic institutions and activities. This becomes even more
critical when monetary policy needs to be accommodative, as I expect will be the case for the
foreseeable future in the euro area.
Thank you for your attention.