Speech
Building the Financial System of the 21st
Century
Speech by Luis de Guindos, Vice-President of the ECB, at the 20th
annual symposium on "Building the financial system of the 21st
century: an agenda for Europe and the United States" organised by
the Program on International Financial Systems and Harvard Law
School (by videoconference)
Frankfurt am Main, 19 May 2022
It is with great pleasure that I am taking part in this symposium once again. It is hard to believe how
much has happened since we last met two years ago.
In my remarks back then, I touched upon the enhanced resilience of the banking sector following the
design and implementation of the Basel III regulatory framework - a long process that was set in
motion in the aftermath of the global financial crisis.
Since that crisis, and the ensuing sovereign debt crisis, the euro area has been hit by two unrelated
but sequential global shocks: first, the pandemic and then the massive surge in energy prices
exacerbated by the Russian invasion of Ukraine, which has so far affected Europe more than other
parts of the world. To use some jargon, these were "low probability" events. But they materialised in
rapid succession with a large impact on inflation at global level.
So it is not easy to be a central banker right now. In the euro area, we moved from having to deal with
stubbornly low inflation levels for almost a decade to the highest inflation figures since the creation of
the euro, while also having to contend with extraordinary uncertainty surrounding inflation dynamics.
Today, I will give a brief overview of the current economic situation in the euro area, and then share
our assessment of the current risks to the overall stability of the financial system.
Economic outlook
Just as we were getting the pandemic and its economic implications under control, geo-political
tensions in Europe erupted. Russia's war against Ukraine has cast a dark shadow over our continent
and is likely to trigger a slowdown in growth and higher inflation in the near-term.
After the largest contraction on record in 2020, the euro area economy transitioned to a firm path of
recovery in 2021. However, rising inflationary pressures that had been building up since the latter half
of last year and renewed pandemic-related restrictions look likely to have slowed the momentum of the
recovery in 2022. The Russian invasion of Ukraine exacerbated these pressures on account of large
rises in commodity and energy prices. The war has also created new bottlenecks on top of the supply
chain disruptions resulting from recent restrictions in Asia.
Following a steady rise in the course of 2021, inflation reached a record high of 7.4% in March 2022,
remaining at this level in April. Price increases will most likely remain high over the coming months,
mainly because of the rise in energy costs but also due to higher food prices and renewed supply
chain disruptions.
Medium-term inflation expectations remain anchored, close to our 2% target. That said, we are closely
monitoring for second-round effects, notably wage-setting behaviour. We need to prevent the scenario
where the high inflation that we currently see becomes entrenched in expectations.
We are faced with an exceptional degree of uncertainty regarding the outlook for economic activity and
inflation. So we need to move gradually and cautiously as we normalise our monetary policy. At our
April meeting, the ECB's Governing Council judged that the incoming data reinforced our expectation
that net asset purchases under the asset purchase programme should be concluded in the third
quarter. I would expect this to happen earlier in the third quarter rather than later. A first interest rate
hike could take place some time after that, depending on our evolving assessment of the outlook. Our
June staff projections will put us in a better position to appraise where the euro area economy is
heading. We need to observe the impact that shifts in financing conditions and the erosion of
purchasing power are having on activity and inflation dynamics.
For the past two years, the combination of fiscal and monetary policy has been crucial in helping the
euro area to navigate the pandemic. This combination remains critical today. Monetary policy has to
ensure that inflation stabilises at 2% over the medium-term while fiscal measures need to be very
selective, targeted and temporary - also in part because fiscal space is now more limited than it was in
2020 and 2021.
Despite the current uncertainty, financial markets have, so far, remained relatively calm. If stress
conditions arise, we will deploy flexibility to ensure that monetary policy is transmitted smoothly across
the euro area, as we did to good effect during the height of the pandemic.
Financial stability
The macroeconomic forces I have just discussed, amplified by the economic fallout from the
RussiaUkraine war, also have implications for the financial stability outlook. The improved economic
conditions throughout 2021 helped to reduce near-term risks to financial stability. But medium-term
vulnerabilities continued to build up in the latter half of last year. The pandemic left a legacy of
significantly higher levels of indebtedness across sectors, signs of overvaluation in some financial and
property markets, and increased risk-taking by non-bank financial institutions.
Since the Russian invasion, financial stability concerns have centred on the economic and inflationary
impacts of the current macro-financial environment through higher commodity and energy prices, trade
disruptions and weaker confidence. Let me touch upon some components of the euro area financial
system in turn.
The banking sector is facing new headwinds from the war. Higher energy and commodity prices,
combined with potential energy supply disruptions, could lead to rising credit risks in the corporate
sector, especially in energy intensive sectors. This has already led analysts to cut bank profitability
forecasts for 2022, due to increased provisioning expectations.
An upward shift in interest rate expectations may affect banks' financial positions in two different ways.
On the one hand, bank earnings are expected to benefit from higher rates in the short-term; on the
other, their net worth is vulnerable to rate increases in the medium-term. The economic value of banks
with a high share of fixed-rate assets may drop as assets lose more value than liabilities. That said,
overall interest rate risk exposures are moderate, on aggregate, and banks have actively managed
them to prepare for increasing interest rates.
The slowdown in growth and tightening financing conditions could also lead to renewed challenges for
sovereign debt sustainability, particularly in more highly indebted countries. These risks appear
manageable in the short-term. But a sustained rise in interest rates, or more subdued growth, could
contribute to a reassessment of sovereign risk by market participants and to higher fragmentation risks
in sovereign bond markets.
To the extent that increased sovereign vulnerabilities coincide with fragilities in the corporate and
banking sectors, risks materialising in any of these sectors may lead to the re-emergence of adverse
feedback loops between sovereigns, banks and corporates.
The uncertain outlook could also have an adverse impact on the euro area non-bank financial
sector. Duration risk has recently started to materialise, and valuation losses may further increase in
an environment of rising interest rates. Some non-bank financial institutions have large exposures to
firms with higher credit risk, or firms in energy-intensive industries that are more vulnerable to risks
from rising commodity prices.
Turning to financial markets, corrections we saw after the Russian invasion of Ukraine have
remained largely orderly. But high volatility in some commodity prices has triggered liquidity stress in
related derivatives markets. An increase in initial margin requirements has greatly increased firms'
liquidity needs, making it more difficult for some firms to hedge. This recent episode raises the
question of whether margining practices, including those between the clearing member and their
clients, may be too procyclical. Financial markets remain vulnerable to further corrections that could
potentially be triggered by an escalation of the war, or a faster-than-expected pace of monetary policy
normalisation.
Conclusion
Let me conclude.
Sound financial regulation and greater resilience have helped the European financial system navigate
both the pandemic and the economic fallout stemming from the Russia-Ukraine war.
Yet sizeable challenges remain. To address financial stability risks, we need to implement targeted
macroprudential policy instruments. At the same time, amid global inflationary pressures and risks to
growth, we are walking on a narrow path as we strive to deliver on our price stability mandate. But rest
assured, we remain fully committed to stabilising inflation at our 2% target over the medium-term.