Christian Noyer: World financial crisis - public and private strategies to
overcome the crisis
Speech by Mr Christian Noyer, Governor of the Bank of France, at Paris-Europlace, Dubai,
22 January 2009.
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Ladies and Gentlemen,
It is a great pleasure for me to be here and share some thoughts on the financial crisis and
on solutions that may be found to overcome the situation. It is too early to draw definitive
lessons from recent events in financial markets. It is however vital to start reflecting on the
experience of the last few months. Even more in periods of tension than in normal times,
action and reflection should reinforce one another. It is at the very moment of managing the
crisis that we lay the foundations for the future financial system.
Having said that, I propose to discuss with you two main topics:
•
The nature of the financial crisis
•
The policies implemented to address it both from a public and a private sector
perspective.
The nature of the crisis
The crisis first emerged as a liquidity crisis. The first symptoms appeared at the beginning of
August 2007 when serious disruptions surfaced on the inter-bank market in the Western
world. More than a year later, tensions on money markets are still with us. Recent months
have witnessed abnormal levels of spreads, a shortening of maturities, and the contraction,
or even closure, of some market segments. Through spill-over, these tensions are also
affecting non-financial corporations and, more broadly the financing of the economy. They
also have spilled over to emerging market economies, which had until the autumn 2008
remained largely unaffected.
The crisis also emerged as a crisis of securitisation. Securitisation is an old and successful
technique used to refinance a range of loans. What was new about it is that it got used
extensively in highly unstable financial structures. These were financing short-term illiquid
and complex assets whose value proved to be uncertain and contingent upon models. The
instability of such structures was largely masked. Indeed, cheap money allowed easy
refinancing of poor quality debt and of assets with uncertain value. Also, favourable ratings
and credit enhancements artificially boosted the quality of loans underlying structured
products. The rise in defaults on such loans, first on subprime mortgages, triggered a chain
of reactions whose consequences are still unfolding now. Credit protections proved illusory.
Liquidity dried up much more quickly than it had appeared. Rating agencies massively,
suddenly and sharply downgraded products which until then were deemed of the highest
quality.
The demise of the "new" securitisation chain highlights two fundamental realities. The first
one is that far from being spread across the whole system, credit risk was implicitly or
explicitly concentrated in the hands of specific institutions, foremost among which were the
major investment banks. Hence the successive waves of depreciations of structured
products, imposed by accounting rules, with these depreciations in turn fuelling doubts about
counterparty risks and solvency, liquidity constraints and further falls in asset prices. The
second reality is that recent financial innovation served mainly to increase leverage in the
system. Signs of this are many. Banks' balance sheets became overstretched. Off-balance
sheet vehicles without any equity proliferated. Monoline insurers guaranteed volumes of
structured products way beyond what their equity position could bear. As you know, leverage
works both ways. It amplifies gains as well as losses. Amplified gains took the form of the US
property boom. Amplified losses are with us now. The whole deleveraging process still
underway has meant, since its start, that financial institutions unable to raise capital had to
suffer very considerable depreciations on some products, which in some instance wiped out
their net worth, bringing them to failure.
Against this background, what about French banks? Of course, they are not immune to the
crisis. Direct or indirect exposures to toxic assets implied that they too had to record
writedowns; sometimes substantial ones. The liquidity shortage is also hurting and the prolonged
market disruptions have raised their refinancing costs. That said, our banks are sound and
robust and still exhibit high solvency ratios, above minimum prudential requirements. Overall,
they remain profitable. This is so not least because they benefit from regular sources of
income. They are universal banks; and as such much less vulnerable to funding market
conditions. Sound and revolving sources of profits are a vital asset at the current juncture. In
this context, French banks can play an active role in the ongoing restructuring of the
international financial sector. All in all, beyond sometimes serious tensions and incidents,
French banks are now reaping the benefits of the major advances in productivity and
innovation they have made over the last two decades.
Public policy during the crisis both from a public and a private sector perspective
Past months have seen a marked change in public policy. Having been in a first phase
geared exclusively to providing liquidity to financial intermediaries, public intervention is since
last Fall also aiming to support banks' financing and own funds. This is a significant shift.
Needless to say, restoring liquidity remains a pressing priority. Inter-bank markets have
shown gradual signs of improvements. Yet, there is still some way to go. To this end, central
banks have mobilised considerable ammunition. A process underway for over a year has
culminated in the central banks having adjusted their operational frameworks in various
areas. The maturity and currency of their facilities have been expanded. The range of eligible
counterparties has been broadened. The tender procedures have been modified with a view
to ensure unlimited amounts of central bank money. The list of collateral for refinancing has
been widened. As for the Eurosystem, they have been providing liquidity at a fixed rate for
unlimited amount. Enhanced international coordination between monetary authorities is
ensuring that their actions are part of a consistent overall strategy. These measures are
highly exceptional with indeed unprecedented monetary easing leading key policy rates to
historically low levels and the adoption, in certain cases, of unorthodox monetary policy
actions. As such, they should greatly contribute to restoring confidence and a smooth
functioning of money markets.
Governments have moved aggressively to support banks' solvency and resilience. Since the
Paris Declaration by euro area member-countries, Europe, under the leadership of France
until year end, has been acting according to what I consider a sound and consistent action
plan. I won't enter into the details. Just bear in mind the three following elements. First,
authorities are extending guarantees to banks' refinancing so that they can, in turn, properly
finance the economy. Second, significant reforms of accounting rules are now being
implemented. Basically, these reforms allow banks to transfer instruments previously marked
to market to portfolios where that will no longer be the case. They also provide for greater
flexibility in methods used to value assets whose market has shut down. Third, and lastly,
governments have confirmed their willingness, when warranted, to step in and support
banks' capital.
What about France's actions? Government and Parliament very quickly put meat on the
bones of the European principles. A new bill has been passed, which provides for two things.
First, it sets up a EUR 320 billion funding vehicle to guarantee banks' medium-term
refinancing (i.e. up to five years). This vehicle is strictly supervised by the French
Government and the Banque de France. The guarantee is granted for a fee, so that the
beneficiaries pay costs corresponding to normal market conditions and also with a view to
protect taxpayers' interests. Second, the law also creates a state-owned company
empowered with EUR 21 billion and entitled to subscribe to banks' subordinated debt issues
or preferred shares. As you know, six banks have issued subordinated debt and the
Government subscribed to these issues for EUR 10.5 billion. Such support boosted their
capital position and as a result ensure these banks to keep up their lending to the economy.
Did the French banks really need such a boost to their solvency and capital? Setting aside
the Belgo-French bank DEXIA, the answer is "not really". DEXIA was very specific: because
of its large exposure to US monoline risks, public recapitalisation was absolutely necessary.
By contrast, all the other French banks have sufficient own funds, be it in terms of prudential
requirements or in comparison with their peers from other developed countries. Public
recapitalisation is not aimed at making up for faults or weaknesses. Rather, it is to anticipate
potential problems. Circumstances are indeed exceptional; even the soundest and most
profitable banks cannot take it for granted that they will be able to tap markets to meet their
funding and capital needs. As long as such uncertainty pervades and markets continue to
fail, it is the public authorities' duty to protect the credit system and safeguard the financing of
the economy.
The private sector strategies to overcome the crisis cover several aspects. First, I
would like to mention the initiative to create a compensation scheme with a central
counterparty for credit default swaps (CDS). This initiative from the private sector is strongly
encouraged by public authorities given its importance for financial stability. Regarding
institutions themselves, different proposals are on the table which relate to their business
model and risk profile, to governance and risk management schemes and to disclosure and
communication policy.
In terms of risks profile, two main models are intensely discussed. Under the first one,
universal banks that benefit from diversified sources of profits were better off during the
crisis. By contrast, specialised financial institutions, especially those heavily engaged in
investments activities, suffered significant losses. I have already mentioned the case of
French banks. In the same vein, the interest of Deutsche Bank for Postbank in Germany
stems from the same logic: to diversify sources of funding and of profitability.
Conversely, the other model under scrutiny focuses on selected core businesses precisely to
reduce diversification in markets for which in-house knowledge and capacity may have
proved insufficient relative to the risks involved. The move towards this more focused model
is contributing to the deleveraging process that is deeply needed in some institutions. The
case of Citibank which is on the verge of selling Salomon Smith Barney illustrates this trend.
As far as governance and risk management are concerned, major improvements are
needed, and I think, are on their way. It is certainly true that regulation needs adjustments
and that a more macro-financial angle is requested in order to avoid, for example,
procyclicality.
However, the first responsibility lies with financial institutions themselves that did not develop
enough scrutiny in risks analysis, were too much focused on short terms profits, did not
integrate the cost of risks premium and liquidity, and in some circumstances, did not fully
understand the likely financial consequences of their behaviour.
Therefore, strong improvement is needed in terms of risk management and governance at
the highest level of financial institutions.
In terms of disclosure and communication policy, the crisis showed the importance of
transparency. Financial institutions made a lot of efforts in this respect in recent months.
They should continue to do so. Authorities will monitor progress on that matter.
Public and private strategic improvements will help overcome the financial crisis. Beyond
that, there is a growing consensus around the need for a fundamental review of the
foundations of financial regulation. Heads of States of the G20 have mandated changes in
that matter and set principles to that purpose. The crisis has also rekindled concerns about
the structure of supervision.
As you know, at the French President's instigation, huge efforts are made to think about what
has been termed a "new Bretton Woods". Beyond these ambitious words, I do believe it to be
useful to take a fresh look at the existing financial regulation. As a contribution to this debate,
I would like to make two final sets of remarks. One has to do with the fluctuations of financial
systems. The other concerns financial supervision.
Financial systems that operate in the context of a developed market economy are, by nature,
subject to cyclical forces. Some are a consequence of the business cycle. Credit activity is
an obvious example, as credit demand is heavily influenced by economic activity. Others are
from within financial systems. For instance, financial institutions' equity position moves in line
with asset prices especially in a fair value world where fluctuations result in capital gains or
losses.
The challenge for the authorities is to assess whether and to what extent regulations
reinforce these dynamics and impact the entire financial system. With these questions in
mind, work is being undertaken to examine the impact of prudential standards. It is also on
this basis that the accounting adjustments that I mentioned earlier have been made. The
need to develop a "macro-prudential" policy is now under debate. The general principle is
straightforward: it consists in ensuring that supervision manages to limit risks for the stability
not only of a particular institution, but also of the entire financial system. Its implementation,
however, is complex. For the moment, we are only at a preliminary stage, contemplating
which tools a macro-prudential policy could be based on, and how these tools could be used.
As regards supervision, this crisis has shown the merits of having the banking supervisor
close to the central bank. The point is not to claim there is an optimal supervisory structure
that fits any country's circumstances. Rather, it is to note that a system such as the one we
have in France has proved very useful in allowing for an in-depth knowledge of the banking
sector and the various financial institutions. It also allowed for very swift and timely
exchanges of information, and, as a result, allowed us at the central bank to quickly pass
sensitive judgments, not least on the usefulness of injecting liquidity.
Let me conclude by stressing what may seem obvious. We are going through very
challenging times, in some respect even unprecedented times. In this context, policy making
is also about confidence building and financial education.
Thank you very much Ladies and Gentlemen.