Gertrude Tumpel-Gugerell: Monetary policy challenges in light of the
current financial market developments
Speech by Ms Gertrude Tumpel-Gugerell, Member of the Executive Board of the European
Central Bank, at Alpbach Talks, Vienna, 15 June 2009.
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Introduction
Ten years ago, on 1 January 1999, the euro was introduced as the common currency of 11
Member States of the European Union. Today, the euro is used by around 330 million
citizens in 16 countries and it has established itself as a stable currency, accepted in
financial markets worldwide. Looking at the inflation performance over the first decade of
Monetary Union with inflation averaging slightly more than 2% during this period, the ECB
has fulfilled its mandate under the Maastricht Treaty, which is to maintain price stability for
the euro area as a whole.
Nonetheless, undoubtfully, we are currently facing the biggest challenge so far: The world is
hit by a severe economic and financial downturn, the deepest since the beginning of the
Great Depression in 1929. It poses grave challenges to the financial industry and central
bank community, as well as to supervisory and regulatory authorities and national
governments and to the citizens at large.
The key challenges arising from the current financial market turbulence
Since August 2007 the global financial markets have experienced extensive corrective
realignments. The repercussions of the turbulence were initially visible in the financial market
in the form of dramatic increases in risk premia and increased volatility in interest rate
movements.
The outbreak of the financial market turbulence was not entirely unexpected, however. Both
the ECB and other institutions had warned of macroeconomic imbalances and systematic
undervaluation of risks in the years leading up to the crisis.
Those years were characterised by an extended period of low interest rates, low inflation and
sustained economic growth, both globally and within the euro area. At the same time,
liquidity was abundant and default risks were considered by many to be very low. This
environment strengthened investors' risk appetite. In particular, with financial market
participants expecting this environment to continue for quite some time, risks were
systematically underestimated and the search for ever higher yields intensified. As a result,
commercial banks readily granted credit for house purchases to households that otherwise
could not have afforded it, and without adequately assessing their creditworthiness or credit
default risk. At the same time, in an attempt to achieve higher yields, a number of innovative
and increasingly complex financial products were offered, particularly in the United States.
One prominent example of this was the bundling of mortgages in new and highly complex
financial products and their resale as new securities to third parties via global financial
markets.
It eventually became evident that this practice was viable only as long as house prices in the
United States continued to increase. When the many years of increases in house prices
came to an end and house prices started to fall, problems soon emerged, including in the
euro area, as banks here were among the buyers of these securities. Investors suddenly
began to doubt the quality of their assets. This led to a sharp correction in prices on the
financial markets, accompanied by a withdrawal of funds from the markets, leading to
corresponding liquidity shortages for banks, particularly in the money market.
Response to the crisis
From the very beginning of the crisis, the ECB has acted in a decisive manner. It has taken a
number of measures unprecedented in nature, scope and timing. The ECB has provided
large amounts of liquidity support to banks. By making changes to its operational framework,
the ECB made sure that all solvent banks would have sufficient access to funding. When the
crisis intensified in September last year, we introduced a number of new measures. Most
importantly, we provided banks with unlimited access to liquidity at fixed rates for up to six
months. The ECB also expanded its list of assets eligible for use as collateral in the
Eurosystem's credit operations. Moreover, we recently announced further measures, namely
to provide longer term refinancing up to one year and to purchase covered bonds of up to
EUR 60 bn.
As a result of these new measures, the size of the Eurosystem's balance sheet has
expanded by a substantial EUR 600 billion and now stands at 16% of GDP, compared with
10% in mid-2007. The measures taken by the ECB have eased banks' balance sheet
constraints and thereby certainly helped to avoid a sudden collapse in the supply of credit
and the emergence of a systemic crisis.
Moreover, in line with the substantial weakening of global demand and economic activity,
inflationary pressures and risks have been diminishing. As a result, the ECB's policy rates
have been cut by 3.25 percentage points since the intensification of the crisis last October.
These rate reductions, together with the liquidity management measures, have had a
significant impact on money market interest rates. Since last October overnight money
market rates have fallen even more steeply than the ECB's policy rates. Money market rates
in the euro area have now reached very low levels by international standards. Lower money
market rates have also led to lower interest rates for private households and firms, although
the decline in money market rates has so far been greater than the decline in interest rates
on credit for households and firms.
The fiscal authorities in the euro area have also demonstrated their capacity to react rapidly
to exceptional circumstances. In a coordinated effort, the national governments of the euro
area have provided support to the banking system, most notably through recapitalisation and
guarantees for liabilities and assets. The funds provided under the package announced to
stabilise the financial sector through these types of measure amount to 23% of the euro
area's GDP. The overall fiscal stimulus - through discretionary policy measures and the
effect of automatic stabilisers - amounts to 3.6 percentage points of GDP for 2009 and 2010.
Overall, during the ongoing financial market turbulence, the euro area and the EU as a whole
have proved their capacity to act decisively and promptly under difficult circumstances.
Lessons from the crisis
The current financial crisis has pointed to a number of weaknesses that need to be
addressed if we are to avoid a similar crisis in the future. Some weaknesses are rooted in the
current design of the international financial system. This is particularly true with regard to the
lack of transparency and accountability within the financial system. In this respect, much
relies on financial players themselves taking responsibility for evaluating risk more effectively
and increasing transparency as regards risk. In addition, various initiatives at national,
European and international level aim, in particular, to improve the robustness of the financial
system
I would like to highlight three areas where I think change is necessary: there needs to be an
increase in transparency, a dampening of pro-cyclicality and an improvement in institutional
design in the field of financial supervision and regulation.
First, we need to undergo global regulatory and supervisory repair. The Basel Committee
has already set some milestones in this regard including the publication of the principles for
sound liquidity risk management and supervision and its current work on strengthening the
Basel II capital framework. Work is also underway concerning the development of measures
to mitigate pro-cyclicality stemming from the regulatory frameworks, namely by building
buffers in good times that can be withdrawn in less benign conditions. In this context, let me
recall that the G20 Leaders approved the recommendations by the FSB to address
procyclicality, which are to be implemented by the end of this year. To this aim, the Basel
Committee is developing proposals for countercyclical buffers and ways to promote
provisioning over the cycle, with the aim to come up with concrete proposals by year-end.
Second, regulatory gaps need to be closed. In that respect, the G20 Leaders endorsed last
April the extension of the regulatory net to all systemically important institutions, markets and
instruments. These include systemically important hedge funds, credit rating agencies and
Over-The-Counter (OTC) derivatives markets. With the aim of preventing regulatory
arbitrage, the IMF together with the FSB, have been requested to develop, by autumn,
guidelines to assess systemic importance.
And third, macro-prudential supervision has to be strengthened. This includes in particular
the global monitoring of systemic stability and the supervision of systemically important
cross-border institutions, while properly addressing interlinkages among themselves, with
other financial and non-financial institutions and markets. In this context, I fully support the
broadened mandate and stronger institutional basis given to the Financial Stability Board
(FSB). The G20 Leaders called on the re-established FSB to develop macro-prudential tools,
together with the Bank for International Settlements (BIS), to identify and take account of
macro-prudential risks across the financial system and limit the build up of systemic risk for
regulated entities. Moreover, the envisaged cooperation between the IMF and the FSB for
the conduct of Early Warning Exercises will be crucial for the success of the global
monitoring of systemic risks.
At the European level, the proposal of the De Larosière group to establish a European
Systemic Risk Council should substantially improve the assessment of risks to financial
stability at the EU level. In order for the new Council to perform its tasks in an optimal
manner - in my view - three requirements must be fulfilled. First, the ECB must have timely
access to the relevant information, including information concerning individual institutions.
Second, risk warnings from the new Council should be translated into effective policy action.
And third, for the new Council to be independent and effective in its decision-making, it is
essential that it have a solid institutional and legal basis.
I also think the current crisis holds some lessons for monetary policy. The crisis has shown
us that a stable financial system is a prerequisite for price stability. Monetary policy-makers
should try to mitigate the risk of the build-up of financial bubbles by being aware of the
effects their policy decisions can have on the financial system. Therefore, one could argue
that asset prices should play a greater role in monetary policy considerations. As the build-up
of an asset price bubble might have severe economic consequences in the longer term,
central banks should try to deal with the bubble pre-emptively.
Nonetheless, the interrelation of financial stability goes beyond the pure consideration of
asset prices. Analysing developments in borrowing and lending, particularly loans to the
private sector, is helpful in extracting the relevant signals from monetary developments on
potential financial imbalances. Consideration of these aspects must become more extensive
and systematic in the future.
Strengthening the ECB's role in financial supervision should contribute to ensuring that
proper consideration is given to the possible build-up of financial imbalances when making
monetary policy decisions. The current crisis has clearly demonstrated that risks to financial
stability are accompanied by risks to price stability. Central banks must give even greater
consideration to these risks in their analyses.
The benefits of the euro in the current crisis
As mentioned, the current crisis represents the greatest challenge for the euro so far. 2009
will be a very difficult year. According to the most recent macroeconomic projections by ECB
staff, published in June of this year, the euro area economy is expected to contract by
between 4.1% and 5.1% in 2009. This means, among other things, fewer jobs, higher
unemployment, less investment and less exports.
That said, we should not forget how Europe would look today without the euro. In addition to
the financial market turbulence, the problems in the financial sector and the economic
downturn, we would be facing potentially large fluctuations between Europe's national
currencies. In fact, the currencies of some of the countries outside the euro area have
experienced considerable fluctuations during the current crisis. This is an additional source of
uncertainty for these countries. Therefore, the turmoil has confirmed one clear advantage of
the euro, namely that, in stormy seas, it is better to be aboard a large ship than a small boat.
This seems to be also reflected in the fact that many central and eastern European countries
have expressed the wish to join the euro area as quickly as possible. This is no surprise,
given that many countries have already made progress towards adopting the euro.
Nevertheless, all countries must first fulfil all of the relevant criteria before joining the euro
area.
Still, I would like to emphasise that the euro area is not a closed shop. Five new countries
have joined since the start of Monetary Union in January 1999, with Slovakia becoming the
newest member of the euro area in January of this year. The door is open to all those that
meet the clearly stated and predefined criteria for membership of the Economic and
Monetary Union.
Conclusion
Joseph Schumpeter coined the expression of the creative destruction to bring about
entrepreneurial innovation and progress. Schumpeter certainly did not have in mind an
economic and financial crisis of the severity and extent we are experiencing today. But
having the concept of Schumpeter in mind, the current crisis also created a window of
opportunity for change and reform. This window, however, will not remain open forever.
Therefore, we have to act now in bringing forward the necessary reforms in the international
financial system to strengthen the supervisory architecture. The ECB stands ready to take up
its part on macroprudential supervision.