Jean-Claude Trichet: What can central banks do in a financial crisis?
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, on the
occasion of the Susan Bies Lecture, Kellogg Distinguished Lecture Series, Evanston, Illinois,
27 April 2010.
* * *
Introduction
The global economy is now recovering - albeit in a gradual manner - from the deepest
recession experienced since the end of the Second World War. The recession was triggered
by a financial crisis, to which the policy response has been both innovative in nature and
unprecedented in magnitude. While these measures have proved remarkably successful in
stabilising the financial system, the broader repercussions of the crisis continue to shape the
outlook for prices, public finances and the economy as a whole.
The events of the past three years have provided a salutary reminder of the macroeconomic
importance of linkages between the financial sector and the real economy. It has become
commonplace to observe that models of the economy that neglected financial and monetary
factors have been found wanting.1 Policy-makers, practitioners, and the research community
have embarked on a quest to improve their understanding of these linkages and develop
more robust frameworks for managing systemic risk and macroeconomic dynamics.
At the outset of this quest, it is worth remembering the words of the eighteenth-century
Anglo-Irish philosopher, Edmund Burke: "Those who don't know history are destined to
repeat it".
For this financial crisis is hardly a unique event. On the contrary, the evolution of
the global economy over many centuries has been punctuated by financial crises. In recent
decades, such crises came to be seen as the preserve of emerging markets. But mature
economies too have been subject to periodic asset price booms and asset price busts.
Should we thus view financial crises as unavoidable? Are our efforts to prevent them futile?
Or can we hope to reduce their frequency, severity and impact on the broader economy?
These are the questions that I will discuss here today. More precisely, I will offer some
thoughts on how we can refine the macroeconomic policy framework so as to prevent crises
and make crisis management more robust.
These are challenging questions. I do not pretend that I can offer complete answers today. In
central banks, finance ministries and international institutions, we are collectively seeking
new and better policy responses. Taking inspiration from Burke, I will draw on my experience
as a policy-maker over the past three decades to tease out some lessons from history about
the required policy framework. After all, history offers our only empirical guide.
A large part of my professional career has involved dealing with episodes of financial
disruption.
As President of the Paris Club in the mid-1980s, I was closely involved in the resolution of
the sovereign debt crisis that had struck a large number of countries in Latin America, Africa
and the Middle East. More than 50 countries defaulted. Even if advanced economies were
not touched directly, their financial systems were deeply implicated. And the impact on entire
continents in the emerging world - economically, and by way of consequence in social and
human terms - was profound.
At the French Treasury and then as Governor of the Banque de France, I also witnessed first
hand the exchange rate crises of the European Monetary System in 1992-93. A succession
of emerging market crises followed later in the decade: the "tequila crisis" in Mexico in 1994;
the Asian crisis from 1997; and the Russian crisis of 1998. Each of these rocked global
financial markets and created new challenges for monetary and financial policy.
Here in the United States, the collapse of LTCM in 1998 and the bursting of the "dot-com
bubble" at the turn of the century were episodes of significant financial disruption, with an
impact that reverberated across the Atlantic. And, as President of the European Central Bank
since 2003, I have been very closely involved in the global response to the current crisis, in
concert with colleagues at the Fed and other leading central banks.
In short, my professional life has been one of dealing frequently with financial crisis. What
have I learned from this experience? And what are the implications from these lessons for
the refinement of policy design?
In anticipation of my answer to these questions, allow me to give an initial flavour of my
response, which will be organised around two themes.
First, I will argue that financial crises share some commonalities. In particular, crises are
associated with the emergence of euphoria and complacency in financial markets, typically
supported by rapid credit growth and a growing belief that new concepts like financial
innovation or technological advances have rendered old limits on economic performance
obsolete. The existence of such commonalities in the anatomy of financial crisis gives rise to
a number of hopes. They suggest that it is possible to develop warnings of nascent crises at
an early stage. They imply that policy-makers could design and implement policies that
contain or avoid such crises.
Yet these hopes should not give rise to complacency, still less to the belief that by tweaking
our policy framework we can condemn financial crises to the past.
While sharing commonalities, each financial crisis is also unique: what triggers the crisis,
how it is propagated through the financial system, and which sectors are most affected are
specific to each episode. Such considerations bring me to the second theme of my remarks:
the need for a flexible and innovative approach to crisis management. Policy-makers need to
be constantly alert, aware that financial turmoil is likely to emerge in a way that they did not
anticipate. As a result, they must be prepared to act decisively to contain financial disruption
of a form for which they were not ideally prepared. At the same time, these inevitably
somewhat discretionary actions need to be embedded within a credible, rules-based and
medium term-oriented framework, which ensures that the immediate needs of crisis
management do not place at risk future price stability, future macroeconomic stability and
future financial stability.
Marrying an exploitation of commonalities with a respect for specificities is the key to
managing financial crises. Allow me now to develop further these two themes.
Exploiting commonalities: a more robust policy framework
All financial crises are unique, but they also share a number of commonalities.2
For example, many crises exhibit a common evolution. The starting-point is typically
structural change to the real economy - the unexpectedly rapid take off of emerging
economies in the 1980s; the emergence of a new technology; the opening-up of new
markets; or the implementation of comprehensive fiscal and regulatory reform. While the sign
of the impact of such changes on economic performance is well understood, the magnitude
and timing of the impact is highly uncertain. Such uncertainty is perhaps best characterised
as Knightian: given the novelty and magnitude of the change, uncertainty cannot easily be
boiled down to a calculus of probabilities.3
Entrepreneurs and investors seek to exploit the new opportunities created by the improved
environment. Households seek to raise consumption in anticipation of higher future incomes
and wealth. Such efforts rely on the financial sector: finance provides the necessary bridge
between opportunities and expectations today, and higher productivity, output and incomes
tomorrow.4
How do financial intermediaries manage these inter-temporal flows in such an uncertain
environment? The challenge of doing so is compounded by changes to the financial sector
itself. Technological advances or regulatory changes in the real economy are also likely to
have direct implications for banks and financial markets. Financial innovation abounds in
such a situation. Financial regulators are faced with new instruments and processes to
police.
In this context, financial market participants face both a favourable macroeconomic
environment - stronger economic growth and relatively benign price developments - and
many new, and apparently profitable, opportunities at the firm level. The question arises of
whether such circumstances prompt them to lapse into euphoria: to take on more risk; to
expand balance sheets more rapidly; to increase leverage; and to bid up asset prices.5
Of course, the underlying shock to fundamentals is in many cases favourable and offers the
prospect of greater prosperity. But the danger exists that financial imbalances may emerge in
such a situation. Such imbalances both increase the vulnerability of the financial sector and
the broader economy to future economic shocks and may create unsustainable positions in
financial institutions that will eventually unravel of their own accord.
In principle, economic fundamentals impose a limit on such euphoria and imbalances,
thereby introducing self-equilibrating forces for the economy. But assessing such
fundamentals is notoriously difficult - for policy-makers and the private sector alike - all the
more so because the evolution of fundamentals themselves can be influenced by the
pervasive euphoric state of financial markets.
In this context, levels of leverage, liquidity or asset prices completely outside historical norms
can be justified on the basis of a four-word refrain, recently used by Carmen Reinhart and
Ken Rogoff for the title of their book: "this time is different".6
But, as Reinhart and Rogoff demonstrate, experience over several centuries reveals that the
self-sustaining booms induced by this sequence of events are ultimately unsustainable. They
culminate in financial crash, with severe consequences for both the financial sector and the
stability of the real economy. This time is not so different after all.
3
See: F.H. Knight (1921), Risk, uncertainty and profit, Houghton Mifflin Company.
4
For an application of this framework in the context of emerging markets, see: R.I. McKinnon and H. Pill (1997),
"Credible economic liberalizations and overborrowing" American Economic Review 87(2), pp. 189-193.
5
Literature on the so-called "risk-taking channel" of monetary policy transmission provides a deeper insight into
such behaviour; see (inter alia): C.E.V. Borio and H. Zhu (2008), "Capital regulation, risk-taking and monetary
policy: A missing link in the transmission mechanism?" BIS working paper No 268; Y. Altumbas,
L. Gambacorta and D. Marques (2010), "Bank risk taking and monetary policy" ECB Working Paper No 1166;
G. Jiménez, S. Ongena, J-L. Peydro and J. Saurina Salas (2010), "Credit supply: Identifying balance sheet
channels with loan applications and granted loans" CEPR discussion paper No 7655; and A. Maddaloni and
J-L. Peydró (2009), "Bank risk-taking, securitisation, supervision and low interest rates: Evidence from lending
standards" ECB Working Paper, forthcoming.
6
See: C.M. Reinhart and K.S. Rogoff (2009), This time is different: Eight centuries of financial folly, Princeton
University Press.
BIS Review 57/2010
How well does this pattern of behaviour map into recent events? The onset of financial
turmoil in 2007 and its intensification in 2008 were marked by specific events in the money
markets, to which I will return. As is typical, the trigger and propagation of the current crisis
were specific. Nonetheless, a number of commonalities identified by the academic literature
on financial crises are clearly discernible.
Globalisation - in particular, the integration of the large emerging markets into the global
economy - represents a significant, positive real shock, both to those economies and to the
rest of the world. The impact on economic performance is beneficial, but of much-debated
magnitude. As a result, from the turn of the century, we witnessed the incidence of a positive
shock to economic fundamentals with uncertain implications, typical of those that initiate a
boom-bust financial cycle.
Financial innovation was also key. The rapid growth of securitisation techniques, as the
banking sector increasingly adopted an "originate-to-distribute" business model, had important
implications for the economic outlook. Advocates of securitisation saw it resulting in both a
better distribution of credit and liquidity risk and easier and cheaper bank access to funding.
Such benefits justified the higher levels of leverage and liquidity observed from the middle of
the decade. Both financial market participants and the regulatory authorities were swayed by
these arguments, at least to some extent, and were therefore willing to tolerate much greater
leverage than had been seen in the past.
Yet, with the benefit of hindsight, it is now clear that the value of these financial innovations
was more apparent than real. What were portrayed as increases in equilibrium leverage
ratios were, in fact, an accumulation of financial imbalances. Credit and liquidity risk transfer
was a chimera: in many cases, these risks ultimately resided on bank balance sheets,
arguably in a more toxic form than previously.
But at the peak of the credit boom, such concerns were forgotten. Enjoying abundant
liquidity, the volume of capital chasing limited investment opportunities led to an aggressive
"search for yield". The demand for risky financial assets surged, feeding the securitisation
frenzy. Credit growth accelerated well into double digits. And spreads and yields were
depressed to very low levels, consistent with an under-pricing of credit and liquidity risks.
Ultimately, this accumulation of imbalances proved unsustainable. The growing losses on US
sub-prime mortgage instruments triggered an evaporation of confidence in banks' solvency,
causing the interbank money markets to freeze. The specifics of this triggering event and the
course of its subsequent propagation proved hard to predict in real time. But, with the
considerable benefit of hindsight, one can easily identify warning signals of the subsequent
financial distress in the data for 2006-07. And at that time, central bank communication
pointed to excessive monetary and credit growth, an under-pricing of risk and an excessive
narrowing of spreads as causes for concern.
Similar traits can be recognised in previous crises.
The high-tech bubble of the second half of the 1990s was rooted in the belief that a
technological revolution based on the "new economy" had opened new vistas of economic
opportunity. It spawned novel financing techniques via the explosion of venture capital and
private equity. Expectations again ran ahead of reality, as the speculative excesses in
"dot-com" investments ultimately led to the collapse of equity prices at the turn of the century.
Emerging market crises display similar characteristics. The commodity boom in the 1970s
and the miracle of the "Asian tigers" in the 1990s spawned the belief that emerging
economies could make an extraordinary development leap. Newly liberalised markets for
international capital, supported by financial innovations (such as syndicated loan markets or
emerging market mutual funds) fuelled the ensuing economic boom. But the euphoria of the
embryonic economic miracle eventually proved ill-founded, leading to financial crisis and a
sharp reversal of capital flows.
A comprehensive review of every episode of financial crisis lies well beyond the scope of this
lecture. Nevertheless, this brief overview already illustrates the commonalities shared across
crises in different locations and at different times.
Such commonalities offer hope that policy-makers can detect, at an early stage, a nascent
financial crisis. On the basis of inductive logic, we can exploit historical regularities to help
predict the future. Being able to identify financial tensions would allow appropriate policy
actions to be taken in a timely manner.
Of course, the existence of commonalities in the historical experience does not amount to
rigorous statistical proof that such relationships can be identified in the data and exploited for
policy purposes. It has proved difficult to construct a robust economic indicator that provides
a reliable signal of growing financial excesses.
In part, this reflects some of the processes that I have mentioned, which are integral to the
boom-bust cycles themselves. Continuous and often rapid financial innovation can alter the
character and relevance of existing monetary and financial statistics. And in an increasingly
interconnected world, financial and economic imbalances more and more assume a global
dimension.
These caveats notwithstanding, research conducted at the ECB and elsewhere points to a
link between boom-bust financial cycles and the evolution of broad measures of money and
credit.7
For example, the ratio of global credit to global GDP offers an indication of nascent financial
stress. The departure of this ratio from its historical trend offers a signal of emerging financial
imbalances and asset price misalignment. Of course, the indicator is imperfect: one needs to
define the appropriate credit measure, agree how to aggregate to a global indicator, decide
how to estimate the trend and identify an appropriate threshold of distress.
Nevertheless, even the simple portrayal in Figure 1 corroborates the intuition behind my
assertion that early warning indicators of financial distress can be meaningful.8 As shown in
the chart, credit developments lead financial distress: the positive "credit gap" that emerged
during the 1980s precedes the US savings and loans crisis; that observed in the second half
of the 1990s precedes the collapse of the dot-com bubble; and growing credit excesses are
apparent from 2005, before the onset of the current crisis.
Considerations of this type support the ECB's emphasis on monetary analysis, including a
regular assessment of credit developments, as a central aspect of the framework for
preparing monetary policy decisions. More specifically, we have always foreseen that a close
monitoring of monetary and credit developments constitutes an important element in
identifying asset price misalignments that may threaten price and macroeconomic stability.
The ECB continues actively to conduct research along these lines, in the context of its
continuing enhancement of monetary analysis.9
Figure 1
Global excess credit
At times, the ECB's decision to pay close attention to monetary and financial developments
in formulating monetary policy has been controversial. The canonical model of monetary
policy neglected the role of monetary aggregates and of their counterparts, emphasising the
output gap as the main indicator of inflationary pressures.10
Recent events have forced a re-evaluation of such models in the research community. It
seems to me that the ECB's approach has been vindicated by the financial crisis. The
importance of monitoring money and credit developments is becoming more recognised in
both the academic literature and the policy debate. Indeed, leading academics have argued
in favour of defining and monitoring new monetary indicators to detect the build-up of
leverage within the financial sector.11
Of course, recognising the importance of monetary analysis is not a panacea. It is only the
starting-point of a difficult process that requires an ongoing monitoring and understanding of
financial innovation and continuous attempts to sharpen and deepen our understanding of
financial developments. Nor should monetary analysis, or the detection of the build-up of
financial imbalances, be seen as an end in itself. Monetary analysis is only useful insofar as
it improves policy decisions and furthers the achievement of the ECB's ultimate objective.
The primary objective of the ECB is the maintenance of price stability in the euro area. From
the outset, we have emphasised the need to adopt a medium-term orientation in pursuit of
this objective, acknowledging the long and variable lags in the transmission of monetary
policy, which make "fine-tuning" of price developments in the face of the inevitable economic
shocks both impossible and potentially counterproductive.12
Adopting such a medium-term orientation allows a degree of flexibility to monetary
policymakers. There are many paths of policy interest rates that are consistent with maintaining
price stability over the medium term. In choosing among these various paths, policy-makers
may seek policy settings that contain the emergence of financial imbalances, so as to impart
greater stability to the economy as a whole.
Analysis of monetary and credit developments may offer insight into the slow accumulation of
financial imbalances and thus identify a growing threat to macroeconomic stability in general,
and price stability in particular, over the longer term. Given such signals, central banks can
respond in a commensurate and timely manner.
Responding to money and credit developments in this way implies "leaning against" financial
imbalances and asset price misalignments. Even if such an approach creates some inflation
volatility in the shorter run, it better serves price and macroeconomic stability at longer
horizons.
While conducting monetary policy in this way helps to provide an environment of price and
macroeconomic stability that is conducive to financial stability, alone it will not suffice.
Responsibility for the maintenance of financial stability should largely fall on the shoulders of
regulators and supervisors. Along this dimension, the crisis has highlighted the distinction
between risks facing individual financial institutions and risks to systemic financial stability.
Let me elaborate on this point, which I see as crucial.
Managing risk is, of course, an indispensable aspect of financial intermediation. Banks have
to remunerate depositors and must constantly search for investment opportunities, offering
rates of return that are higher than the cost of funding. Financial economics tells us that,
ultimately, increasing risk is the only way to earn higher returns. So, almost by definition,
financial intermediation would not be possible without risk-taking.
Problems arise in two cases. The first case involves financial intermediaries choosing a
combination of risk and returns that is not efficient from their individual perspective. This can
happen when financial players' incentives are aligned against prudent practices. These
problems should be tackled by an appropriate micro-supervisory framework. Indeed, until
recently, the main focus of financial supervision was on ensuring the soundness of individual
financial institutions.
Supervision at the micro level is a very challenging task. It is vastly complicated by the
uncertainties and innovations that characterise the historical experience. In the interests of
brevity, I will not dwell on these challenges here, but in coming to an overall assessment they
should not be neglected.
Problems can also arise in a second case, in which the choice of risk and returns may be
appropriate at the individual bank level. Individual banks, however, may not take into account
the impact of their decisions on the rest of the financial system.
For example, individual banks may be rationally willing to hold the risky tranche of a
mortgage-backed security for a fee that appears to be in line with prevailing market rates.
The banking system as a whole may, however, fail to appreciate in full the various
dimensions of risk for that security. More specifically, it may fail to appreciate that
widespread holdings of assets exposed to a common risk can generate catastrophic
consequences for the system as a whole. When the value of those assets starts falling, a fire
sale can be ignited as each bank attempts to guard against further reductions in value, but
no bank is on the other side of the market.
Such considerations are magnified in the context of the uncertainties and innovations that
characterise the build-up to financial crisis. In such a situation, individual institutions and
regulators may not be fully aware of all interconnections and correlations associated with
new financial instruments and business models.
The risk of systemic instability, and its potential costs for the economy, has long been
recognised in both the academic literature and in policy circles. This is reflected, for example,
in the fact that many central banks have been producing regular financial stability reports,
which try to identify and analyse these risks. The crisis, however, has heightened the need to
deepen this analysis and, moreover, to take appropriate policy actions to address these risks
and prevent them from imposing severe losses on the real economy. Against this
background, the need for additional tools and policies, which fall under the broad heading of
macro-prudential policy, has been widely recognised.
In the case of Europe, this has led to a decision by the European Council to create a new
independent body responsible for the conduct of macro-prudential oversight: the European
Systemic Risk Board (ESRB). The main task of the ESRB will be to identify and assess risks
to the stability of the European Union's financial system and issue risk warnings when the
risks appear to be significant. When appropriate, the ESRB could complement its risk
warnings with policy recommendations for remedial action.
In pursuing this task, the ESRB will also have to rely heavily on the commonalities that we
have identified in our experience of financial crises. It is these commonalities that provide the
basis for identifying risks at an early enough stage that remedial policies can be introduced.
By exploiting the common features of the lead-up to previous financial crises, policy-makers
can identify nascent financial distress. By refining the existing policy regime on both
monetary and prudential dimensions, policy-makers can exploit such information to reduce
the frequency and severity of financial crises, and thereby their impact on macroeconomic
and price stability.
Respecting specificities: effective crisis management
Yet even if a refined policy framework promises to be more effective in diffusing nascent
financial distress, it would be naive to rule out altogether the possibility of future crises. What
can policy-makers do once a crisis erupts? What have we learnt from experience about how
financial crises should be managed?
Financial crises typically induce a large and sudden fall in aggregate demand, owing to
negative wealth effects, a collapse of confidence or, more generally, both. While these
shocks are difficult to quantify in real time, conceptually they are similar to the shocks
addressed by monetary policy on a continuing basis. To simplify, downward pressure on
price developments associated with a fall of economic activity can be countered using
standard interest rate policy, reducing official rates so as to spur spending and bolster
confidence. Such measures serve the maintenance of price stability.
The timing of the interest rate response is crucially important. Financial crises can strike
suddenly. By implication, the response to the crisis should be commensurably swift and
decisive. This requires a stance of permanent alertness, to identify promptly new threats to
price stability, including those arising from the crisis itself.
The current crisis, however, has demonstrated that deeper market failures may occur in the
financial sector, such that standard interest rate changes alone may prove insufficient to
restore economic and price stability. Introducing measures to address these market failures
naturally requires that the failures themselves are correctly identified and well understood. It is
on this dimension that the specificities associated with each financial crisis can play a key role.
To illustrate, it is helpful to recall how the current crisis was triggered and propagated. The
money markets played a crucial role in this respect. Until mid-2007, money markets were
viewed as quiescent and well-behaved - not as candidates for the outbreak of financial
turmoil.13 But, through the re-pricing and re-rating of sub-prime-related credit risk transfer
instruments, the money markets came to play a central role.
To be more concrete, the difficulties experienced by a small number of investment funds in
June 2007, owing to the non-performance of US sub-prime mortgage securities, led rating
agencies to downgrade a large number of asset-backed instruments. The immediate
consequence of these downgrades was a deterioration in the quality of the balance sheets of
banks holding those securities, as their price fell and capital losses were incurred.
As the number of large and complex financial institutions severely affected by the re-pricing
of asset-backed securities was recognised, this financial shock was propagated to the
broader financial market and real economy. The ensuing rounds of write-downs and a lack of
transparency regarding exposures to these toxic instruments created an atmosphere of
anxiety and suspicion. The root cause of this information problem was this generalised
uncertainty regarding counterparty risk, which, at some point, made it impossible for lenders
to distinguish between healthy and distressed institutions.
These informational problems became manifest in a freezing of the money market.
Figure 2
illustrates the unprecedented extent of the turbulence using a common measure of liquidity
and counterparty risk.
Figure 2
Interbank market spreads
More precisely, the spread between the cost of unsecured short-term funding from other
financial intermediaries - in the euro area, the so-called EURIBOR rate - and the interest
rate on the equivalent index swap rates, which had been negligible around the middle of the
decade, suddenly rose to record levels.
These events were especially worrying because they threatened to disrupt the transmission
of monetary policy to the real economy. To the extent that firms and households borrow at
interest rates indexed to unsecured interbank rates, the emergence of a large and variable
spread between policy rates and these market rates implied a potential loss of control of
central banks over financing conditions.
Given heightened concerns about counterparty risk - which intensified dramatically after the
failure of Lehman - cash-rich banks proved unwilling to lend to banks needing liquidity.14 As
a result, the money market came close to a total freeze. The ensuing decline in banks' ability
to raise funds led to a tightening of credit conditions facing enterprises and households.
There was a clear and present danger that the resulting tightening of financial conditions
would lead to augment the risk of a deflationary spiral, to trigger additional credit losses and
a vicious downward cycle of financial and real distress.
To avert this danger, central banks introduced a variety of non-standard measures to permit
their reduction of policy interest rates to be fully transmitted. In the case of the ECB, the
Governing Council acted swiftly to address these risks through our policy of enhanced credit
support.15
Since banks play a central role in the intermediation of credit in the euro area, we have
largely directed our efforts at banks rather than intervening to influence activity and spreads
in specific financial markets. To satisfy the higher liquidity needs of banks, we decided to
allocate liquidity on a full allotment basis at fixed rates. We also lengthened the maturity of
our operations up to one year, to give banks a more medium-term perspective in their
liquidity planning. This measure greatly attenuated the maturity mismatch between assets
and liabilities in banks' books, which would otherwise have further deterred bank lending. At
the same time, we expanded the list of assets that we accept as collateral in our operations.
By expanding the list of eligible collateral, we ensured that banks could refinance that large
proportion of their assets that had become less liquid in the crisis. In addition, we provided
liquidity in foreign currencies to banks by means of swap arrangements with the Federal
Reserve and other central banks. Finally, we decided to purchase of €60 billion of covered
bank bonds in order to revive this market segment, which is important in Europe.
The fact that our operational framework was very flexible from the start has been a
considerable asset. Unconventional measures did not require modifications to the same
extent as elsewhere and this flexibility enabled us to react very quickly.
As a result of these measures, the adjustment of retail bank interest rates in response to
reductions in policy rates appears to have