Luis de Guindos: International spillovers of monetary policy and
financial stability concerns
Speech by Mr Luis de Guindos, Vice-President of the European Central Bank, at the conference
"The ECB and its watchers XX", Frankfurt am Main, 27 March 2019.
* * *
Introduction
It is a great pleasure for me to speak at this year's ECB Watchers Conference. Given the topic of
this session, I will start by referring to our recent findings on international spillovers of monetary
policy and the related financial stability concerns for the euro area. I will then focus on our
financial stability assessment at the present juncture. In doing so, I will briefly refer to an
analytical tool we have employed to monitor and assess the banking system's resilience.
Globalisation has not only caused inflation and output to become increasingly synchronised
across countries. Equity prices and financing conditions have become more synchronised, too.
Most of this synchronisation stems from (common) global shocks, but the effects of international
spillovers of monetary policy are less obvious.
In my talk today, I will touch upon issues surrounding these international spillovers, and whether
they are of concern for the financial stability of the euro area.
In a globalised and financially integrated world, spillovers from the monetary policy of one country
to other economies are unavoidable.
We can identify at least three international transmission channels:
1. The "aggregate demand" channel, through which monetary policy affects domestic demand
and, thus, the demand for foreign goods.
2. The "exchange rate competitiveness" channel, through which monetary policy affects the
exchange rate, meaning it changes the price of domestic goods relative to foreign goods.
3. The "financial channel", through which monetary policy affects domestic financial conditions.
When there are strong financial connections between countries, these conditions may
change abroad as well.
From these transmission channels, let me focus on the "financial channel" for the remainder of
my talk.
Financial spillovers from US monetary policy to the euro area
Measuring international spillovers is not easy, because global shocks lead to economies moving
1
in a synchronised manner for reasons unrelated to monetary policy.
2
In line with previous evidence , recent ECB research identifies large financial spillovers from US
3
monetary policy to global financial conditions, including euro area financial conditions.
More specifically, over the course of one month, monetary policy tightening by the Federal
4
Reserve System drives up euro area corporate bond spreads just as much as US corporate
bond spreads. It also triggers declines in euro area stock markets of a similar magnitude to the
5
declines in US stock markets.
However, the financial spillovers from ECB monetary policy to US bond spreads, or to foreign
equity markets, are found to be less impactful. This asymmetry in the international impact of US
monetary policy and euro area monetary policy is rooted in the dominant role of the US dollar in
global financial markets.
6
Furthermore, our analysis shows that there are only limited spillovers from the monetary policy
of the Federal Reserve to euro area inflation and output. This suggests that ECB monetary policy
actions are, by and large, able to shield the euro area economy from spillovers from US
monetary policy.
But undoubtedly, there is evidence that US monetary policy is a driver of a "global financial
7
cycle".
In step with such a financial cycle the risks to euro area financial stability can change as well.
Current financial stability concerns in the euro area
As you know, our characterisation of the main risks to euro area financial stability has remained
broadly unchanged over the recent years. We see four main risks: The most prominent risk
stems from the possibility of a disorderly increase of global risk premia. The second risk is
related to renewed debt sustainability concerns, for sovereign debt in particular. The third risk is
that banks' intermediation capacity may be hampered by their continued low profitability. Finally,
we are of the opinion that possible liquidity strains in the investment fund sector constitute a
growing risk. All four risks are intertwined and would have, if they were to materialise, the
potential to be mutually reinforcing.
In 2018, a growing economy and improved banking sector resilience were important positive
factors supporting financial stability. Now, however, the assessment is affected by a weakening
economic growth outlook for the euro area. In the latest ECB staff macroeconomic projections,
expected real GDP growth was revised downwards, and the outlook continues to be viewed as
tilted to the downside on account of persistent uncertainties related to geopolitical factors, the
threat of protectionism and vulnerabilities in emerging markets.
In my view, the deterioration in the growth outlook increases the risk of financial instability
particularly via two main channels. First, low economic growth raises concerns about sovereign
debt sustainability. And second, it further dampens profitability prospects for the banking sector.
A weaker growth trajectory will challenge euro area sovereigns' ongoing deleveraging. Low
growth and elevated public sector debt also leave a number of euro area countries vulnerable to
higher funding costs. Furthermore, threats stemming from rising protectionism around the globe,
and high political uncertainty within Europe, may amplify potential corrections of sovereign bond
risk premia. These risks notwithstanding, market-based indicators of stress in the euro area
sovereign bond markets have remained relatively contained in 2019, and debt sustainability
concerns have remained country-specific. Looking ahead, as growth prospects moderate it is
imperative that fiscal buffers are rebuilt in countries where government debt still is too high.
A prolonged period of low economic growth also poses challenges for euro area banks. Over the
past ten years following the great financial crisis, funding strains and subsequently hampered
bank intermediation capacity related to low bank profitability have figured prominently in our risk
assessments. The low growth and inflation environment will probably exert downward pressure
on the risk-free rate component of bonds across maturities. As a result, profitability stemming
from the maturity transformation business may come under renewed pressure - not least as
retail household deposits tend to be bound at zero. Furthermore, should downside risks to the
economic outlook materialise, higher loan loss provisions may further compress bank
profitability.
Accommodative monetary policy has greatly supported bank profitability in past years. In fact,
conventional and unconventional measures have improved the quality of credit overall, thereby
reducing provisioning needs. Our measures have also increased the demand for loans, which
has more than offset the negative effect of compressed margins. Furthermore, structural factors
are also weighing heavily on euro area banks' profitability.
In an environment where cyclical factors may exert further downward pressure on bank
profitability, banks would need to step up their efforts to overcome structural challenges. Such
measures may include cost reductions - including lower staffing costs and streamlining of
branch networks, enhanced digitalisation - implying initial, one-off large-scale investments,
revenue diversification and the reduction of the stock of non-performing loans in the six countries
where levels are still high.
A number of regulatory and policy measures could help to improve the institutional setting in
which the banking sector operates and facilitate banks' efforts to adjust their business models.
Such measures should include completing the banking union (in particular the establishment of a
European deposit insurance scheme), the subsequent removal of the remaining non-harmonised
national options and discretions, and making progress with the capital markets union. This could
foster further consolidation, including across borders, and address the problem of overcapacity
in the euro area banking system.
Assessing the financial stability of the euro area
Beyond regular monitoring activities, financial stability analysis entails assessing the impact on
the financial system of risks materialising, including risks related to international spillovers. Such
assessments can also help inform the calibration of possible appropriate macroprudential policy
responses.
The stress-testing framework is an important analytical tool to quantitatively assess financial
system vulnerabilities and risks. Stress testing exercises of the banking sector assess the
sector's resilience and how it performs under adverse circumstances, thus providing a measure
of the severity of these risks. Individual bank results provide further information about banks'
potential capital needs. Stress tests can therefore show how the financial system will react when
risks, such as those relating to spillovers, materialise.
In order to enhance its stress-testing capacity, the ECB has invested in an analytical framework
that not only tracks the resilience of the banking sector but also accounts for how it interacts with
8
and feeds back in to the economy as a whole.
This framework complements the EU-wide stress tests conducted under the aegis of the
European Banking Authority (EBA), which are predominantly microprudential in nature.
Our so-called macroprudential stress testing loosens the assumption that banks' balance sheets
are constant. As banks are hit by, say, negative (spillover) effects from the global environment,
they may react by deleveraging their loan books. This type of stress testing also accounts for
what implications banks' reactions would have for the real economy. In other words,
macroprudential stress tests consider the adverse credit supply shock that may lead to an
amplification of the macroeconomic effects of the global shock, which, in turn, could further
damage banks' balance sheets. By modelling the negative feedback loop between the banking
sector and the real economy beyond the first round of shocks, we believe the exercise becomes
more realistic.
A macroprudential stress test of banks directly supervised by the ECB, using the baseline and
adverse scenarios of the recent EBA stress test, confirmed the general resilience of the euro
area banking system. Results, however, point to an additional fall in GDP of 1.6% across the
euro area, on top of the GDP shocks of the adverse scenario over the three-year horizon.
This stress-testing framework can also inform the calibration of macroprudential policies with the
aim of limiting unintended spillovers to other parts of the financial system or the real economy.
In the spirit of pre-emptive macroprudential policy, these exercises can emphasise the need for
the timely build-up of capital buffers, which can then be used to absorb losses when risks
materialise, before they affect growth and employment.
Finally, the stress-testing framework can be used to analyse the spillover effects of the
9
macroprudential policies themselves.
For instance, another finding of the framework is that capital-constrained banks are more likely to
reduce their foreign exposures than their domestic ones. We are particularly concerned about
spillover effects of macroprudential policies within the euro area, because the build-up of a
capital buffer in one country should, to the extent possible, not impair the functioning of financial
intermediation in other euro area countries.
Conclusion
Let me conclude by emphasising that, in a globalised and financially integrated world, the euro
area is not immune to spillovers from other regions, in particular to shocks emanating from the
United States.
But we are convinced that we have the appropriate policy tools to largely shield the euro area
economy and financial system from such spillovers. Monetary policy and macroprudential policy
have different objectives and, therefore, different sets of policy tools.
Cyclical factors, such as compressed interest margins, pose challenges to banks' operating
environment, but the gains have so far greatly offset the losses. In turn, euro area banks need to
address their structural fragilities, which partially explain the very low price-to-book ratios of euro
area banks when compared with their international peers.
References
Avdjiev, S., Bruno, V., Koch, C. and Shin, H. S. (2018), "The dollar exchange rate as a global risk
factor: evidence from investment", BIS Working Papers, No 695.
Bernanke, Ben S. and Gertler, M. (1995), "Inside the Black Box: The Credit Channel of Monetary
Policy Transmission", The Journal of Economic Perspectives, Vol. 9, No 4, pp. 27-48.
Borio, C. and Zhu, H. (2012), "Capital regulation, risk-taking and monetary policy: A missing link in
the transmission mechanism?", Journal of Financial Stability, Vol. 8(4), pp. 236-251.
Bruno, V. and Shin, H. S. (2015a), "Cross-Border Banking and Global Liquidity", Review of
Economic Studies, Vol. 82(2), pp. 535-564.
Bruno, V. and Shin, H. S. (2015b), "Capital flows and the risk-taking channel of monetary policy",
Journal of Monetary Economics, Vol. 71, pp. 119-132.
Ca' Zorzi, M. et al. (2019), "Monetary Policy and its Transmission in a Globalised World", ECB
discussion papers, forthcoming.
Cetorelli, N. and Goldberg, L. (2012), "Banking Globalization and Monetary Transmission", The
Journal of Finance, Vol. 67(5), pp. 1811-1843.
Chen, Q., Lombardi, M., Ross, A. and Zhu, F. (2017), "Global impact of US and euro area
unconventional monetary policies: a comparison", BIS Working Papers, No 610.
Chen, Q., Filardo, A., He, D. and Zhu, F. (2016), "Financial crisis, US unconventional monetary
policy and international spillovers", Journal of International Money and Finance, Vol. 67(C), pp.
62-81.
Curcuru, S. E., De Pooter, M. and Eckerd, G. (2018), "Measuring Monetary Policy Spillovers
between U.S. and German Bond Yields", International Finance Discussion Papers, No 1226,
Board of Governors of the Federal Reserve System.
ECB (2019), "A bird's-eye view of the resilience of the European banking system: results from
the new macroprudential stress test framework", Macroprudential Bulletin, March 2019,
forthcoming.
Ehrmann, M. and Fratzscher, M. (2005), "Equal Size, Equal Role? Interest Rate Interdependence
between the Euro Area and the United States", The Economic Journal, Vol. 115(506), pp. 928-
948.
Farhi, E. and Maggiori, M. (2018), "A Model of the International Monetary System", The Quarterly
Journal of Economics, Vol. 133(1), pp. 295-355.
Forbes, K., Reinhardt, D. and Wieladek, T. (2017), "The spillovers, interactions, and (un)intended
consequences of monetary and regulatory policies", Journal of Monetary Economics, Vol. 85,
pp. 1-22.
Georgiadis, G. (2016), "Determinants of global spillovers from US monetary policy", Journal of
International Money and Finance, Vol. 67(C), pp. 41-61.
Iacoviello, M. and Navarro, G. (2018), "Foreign Effects of Higher U.S. Interest Rates",
International Finance Discussion Papers, No 1227, Board of Governors of the Federal Reserve
System.
Jarociński, M. and Karadi, P. (2018), "Deconstructing monetary policy surprises: the role of
information shocks", Working Paper Series, No 2133, ECB.
Kim, S. (2001), "International transmission of U.S. monetary policy shocks: Evidence from
VAR's", Journal of Monetary Economics, Vol. 48(2), pp. 339-372.
Miranda-Agrippino, S. and Rey, H. (2018), "US Monetary Policy and the Global Financial Cycle",
NBER Working Papers, No 21722.
Neely, C. J. (2015), "Unconventional monetary policy had large international effects", Journal of
Banking & Finance, Vol. 52(C), pp. 101-111.
Rey, H. (2018), "Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy
Independence", NBER Working Papers, No 21162.
Rogers, J., Scotti, C. and Wright, J. (2014), "Evaluating asset-market effects of unconventional
monetary policy: a multi-country review", Economic Policy, Vol. 29(80), pp. 749-799.123456789
results for conventional and unconventional monetary policy are similar. Rogers et al. (2014) and Chen et al.
(2016) provide evidence on large spillovers from the Federal Reserve's unconventional monetary policy to the
euro area.
3
Ca' Zorzi et al. (2019) and Jarociński and Karadi (2018) draw a distinction between monetary policy surprises
(the so-called shocks) and other surprises, such as news effects.
4
Spreads relative to speculative bonds (below BBB rating), averaged over all maturities.
5
Corporate bond spreads increase by about 10 basis points and stock markets decline by about 50 basis points
in response to a monetary policy shock that increases one-year government bond yields by 2 basis points.
6
See Ca' Zorzi et al. (2019).
7
See Miranda-Agrippino and Rey (2018).
8
See ECB (2019), "A bird's-eye view of the resilience of the European banking system: results from the new
macroprudential stress test framework", Macroprudential Bulletin, March 2019, forthcoming.
9
Forbes et al. (2017) describe how macroprudential policies can create spillovers on their own.