Yannis Stournaras: Financial stability and growth - the role of central
banks and the pre-requisites for sustainable growth in Europe
Keynote speech by Mr Yannis Stournaras, Governor of the Bank of Greece, at the
33rd International Financial Law Conference "Financial stability and growth: the role of
central banks and the pre-requisites for sustainable growth in Europe", co-presented by the
IBA Banking Law Committee and IBA Securities Law Committee and supported by the IBA
European Regional Forum, Athens, 20 May 2016.
* * *
Ladies and gentlemen,
It is a great pleasure to be with you today and to have the opportunity to share with you some
thoughts on financial stability in Europe.
Systemic financial stability is a critical condition for achieving our common goals of prosperity
and sustainable growth. At the outbreak of the international financial crisis in 2008, central
banks and regulatory mechanisms lacked a well-tried toolbox for containing systemic
instability and for preventing its build-up. With the measures taken and mechanisms
established in subsequent years, that picture has changed substantially, as market
participants, regulators, supervisors, macroprudential authorities and others quickly dealt
with the challenges. Not only have we seen the transformation of banking supervision
through the creation of the European Banking Union with its three pillars, the Single
Supervisory Mechanism, the Single Resolution Mechanism and the still-to-be-implemented
common deposit guarantee scheme, but we have also seen increased recognition of the
importance of systemic stability and the role that macro-prudential policies can play in
fostering it. Traditional banking supervision is more focused on individual institutions and the
prevention or management of isolated instances of bank failures. Macro-prudential
regulation, by contrast, focuses on the system as a whole and largely seeks to prevent
systemic instability and to limit the consequence of systemic distress for the macro economy.
But if financial stability is crucial for growth, the crisis has also taught us that growth is crucial
for financial stability. Sluggish growth in the euro area, in spite of unprecedented monetary
policy loosening, has weakened European banks, not least through the rise in NPLs, thus
hampering their ability to finance the real economy.
In order to explore these ideas, I initially examine this new role for central banks and the
tools that have been - indeed, are still being - developed in an attempt to strengthen the
resilience of the financial system. Developments in the EU regulatory framework in this area
are discussed. I then outline some of the challenges ahead and, finally, provide some
thoughts on euro area growth.
A. Central banks and macro-prudential policy
The challenges facing EU financial sectors in recent years have significantly increased the
responsibilities of central banks in the area of crisis prevention. Mandates have been
amended to explicitly refer to financial stability as a core central bank task. Thus central
banks are charged with limiting system-wide distress and, ultimately, avoiding its negative
consequences for the real economy.
In the past, it was not thought necessary to separate monetary policy from the task of
providing financial stability. It was thought that price stability in the market for goods and
services would be sufficient to ensure financial stability in asset markets. Experience has
dispelled such beliefs and has shown that the business cycle and the financial cycle are not
necessarily synchronized; long periods of disconnect between the two cycles can
materialize. In particular, the financial cycle tends to have larger amplitude and lower
frequency than the normal business cycle.
Macro-prudential policy bridges the gap between the traditional micro-prudential supervision
of individual banks and monetary policy. Its objectives are, first, to enhance the resilience of
financial institutions and the entire financial system, and, second, to smooth the financial
cycle. In this regard, macro-prudential policy allows monetary policy to focus on maintaining
price stability, while micro-prudential supervision focuses on individual institutions. In this
way, macro-prudential policy enhances the institutional separation that is one of the
principles of the architecture of the euro area.
Whilst separation is important, the usefulness of coordinating policies should not be forgotten
- whether that be coordination of specific policies across different countries (as happened in
the wake of the failure of Lehman Brothers with the simultaneous cuts in policy rates) or
coordination of policies within one jurisdiction. Respect for the independence of the various
authorities involved in securing financial stability should not imply separation and a lack of
coordination.
B. The macro-prudential toolbox and developments in the EU financial regulatory
framework
If macro-prudential policy is to effectively curb the financial cycle, it is essential to have tools
that deal with the credit-real estate (or whatever other asset) relationship. There are two
ways to deal with this relationship. The first is by imposing restrictions on credit institutions -
for example, through capital-based measures. The second is by limiting the degree to which
households and non-financial corporations take on leverage.
With regard to credit institutions, the Capital Requirements Regulation (CRR) and Directive
(CRD IV) play a prominent role in setting the prudential standards in the EU. Implementation
is ongoing and expected to be completed by 2019. From January 2016, the countercyclical
capital buffer (CCB), the systemic risk buffer (SRB) and the other systemically important
institutions (OSII) buffer, three important macro-prudential tools, have been operational.
However, given the need to diversify the available tools beyond regulations based on capital,
tools based on liquidity, leverage and funding sources are also being introduced.
With regard to the borrower's side, instruments such as the loan-to-value (LTV),
loan-toincome (LTI) and debt-service-to-income (DSTI) limits are considered to be among the most
effective macro-prudential instruments in curtailing excessive credit growth and the build-up
of unsustainable debt positions. In order to effectively moderate the financial cycle, a
timevarying dimension is crucial in the design of the various ratios. For example, the
loan-tovalue ratio should be lowered during the expansionary phase of a financial cycle and raised
during the contractionary phase, while respecting the mandate of financial stability and
avoiding the build-up of systemic risk. Otherwise, there is a risk of pro-cyclicality since
leverage constraints decline as asset prices rise.
It is imperative, however, that the macro-prudential toolbox be further enhanced with
innovative tools beyond those outlined above. Cyclical systemic risk can arise not only as a
result of excessive credit expansion (an issue that can be addressed with the countercyclical
capital buffer along with limits on borrowing) but also because of inadequate channeling of
credit that keeps the real economy under-financed for extended periods. A lesson drawn
from the crisis is that we have focused on rather narrow areas of financial activity.
Nowadays, it is important that we focus on the risks that might have been missed such as the
interlinkages between sectors, and thus explore how the financial system can influence, and
be influenced, by the wider economy. In the euro area, there is evidence of limited financing
of the real economy, with the consequence that euro-area investment has not recovered to
pre-2008 levels despite ECB policies directly aimed at increasing the lending of the banking
sector.
C. Challenges ahead and the way forward
Challenges, of course, remain. Let me point to some that are more relevant for
macroprudential supervision and systemic stability.
1. A first challenge relates to the issue of the increased burden of complying with the
new regulatory framework and assessing its cumulative impact. I am not referring to
additional capital adequacy requirements but rather to the plethora of new measures being
applied by more than one institution. In the pursuit of making banks more robust, liquid,
responsible and transparent, huge progress in regulating and supervision their operations
has been achieved. However, there has been no estimate of the cumulative impact of these
regulations. I welcome and look forward to the report on the impact of capital requirements
on the economy; however, the impact of other regulations should also be examined.
We need to keep in mind the principle of proportionality, a general principle of EU law. As
new regulations accumulate, they can come with costs as well as with benefits. Policymakers
need to be watchful that, in attempting to limit externalities, they do not inadvertently create
new externalities. The financial sector ultimately exists to serve the real economy. It is very
likely that there are trade-offs between ensuring financial stability and imposing such a
burden on the financial sector that it ceases to be able to do its job, namely to intermediate
between surplus and deficit units in any economy in order to encourage long-term investment
and growth. Thus we have to develop methods to judge the appropriateness of indicators
and tools. Since many of the regulations have been applied over the last few years, that is, in
a period of acute financial stress, I expect that in the coming years there will be a need to
reassess those regulations and perhaps conduct some fine-tuning. Similar arguments apply
to the national options and discretion in the new regulatory framework.
2. Closely related to the previous challenge is the degree to which regulatory
developments should be front-loaded. The regulations themselves often have long phase-in
periods such that new versions of the regulations are developed before the previous versions
have been fully implemented. Supervisors have tended to compensate for the long phase-in
periods by front-loading all prudential requirements, a situation that sometimes can be
considered excessively harsh. Of course the long phase-in periods are often a reaction to the
expected impact of the regulation on bank behaviour and, in particular, on the lending to the
real economy. Some middle road has to be found.
3. A third challenge is the need to reduce reliance on models. Recently conducted
stress-tests, a core macro-prudential tool, followed a "single-model-fits-all" methodology,
which left very little room for idiosyncratic and specific national characteristics. Moreover,
according to some analysts, there is a risk that stress tests are becoming less effective as a
tool. Instead, they may increasingly be seen as being conducted simply to calm financial
markets. Ideally, stress tests should be implemented in benign times in accordance with an
old wisdom attributed to John F. Kennedy, that "the time to repair the roof is when the sun is
shining". In crisis times, there is the risk that crucial inputs such as macroeconomic variables
are under or over-estimated and that adverse scenarios become unrealistic - either too
benign or too severe. In consequence, outcomes become ambiguous and difficult to
interpret. Additionally, the potential pro-cyclical effects of stress tests should be explored.
Stress tests should not only place emphasis on solvency, but they should explore the impact
of the assumed shock on bank liquidity, the implications of applying the bail-in tool, the funds
needed to meet any demand on deposit guarantee funds, etc. We should focus on
harmonizing processes, while models should be enriched with constrained judgement as is
standard practice in macroeconomic forecasting.
4. Fourth, there is a need to widen the scope of regulation. Systemic fragility may arise
from sources other than the traditional banking sector. A crucial challenge ahead is related to
recent disintermediation and the development of "shadow" banking as an alternative means
of financial intermediation. The need for macro-prudential regulation of certain financial
activities becomes clear if we consider that banks and non-banks are closely tied through
market-based intermediation activities. These include a broad array of services related to
securitization transactions, securities financing transactions, repos, collateral management
and derivatives. The consequences of poorly-monitored risks in this area are unknown and
the risk of a new crisis could be lurking, while spill-over effects are difficult to assess.
Moreover, the more policymakers are effective in using macro-prudential tools to constrain
excessive credit growth in the banking sector, the more likely it becomes that there will be
excessive adjustments in the non-bank sector through leakages. Fortunately, "shadow
banking" is high on the agenda of the relevant fora and there is a clear need to extend the
regulatory toolkit.
5. A fifth challenge, the role of the central bank as a lender of last resort to the banking
system, needs to be addressed in the light of the mandate to preserve financial stability. The
lender of last resort function is a crucial macro-prudential tool for managing financial distress.
The principle developed by Thornton and Bagehot is well-known. Central banks should lend
freely to solvent but illiquid banks against good collateral at a high rate of interest. How is this
tried and tested principle to be made operational in today's environment with much larger
bank balance sheets and fewer liquid assets? In the past, government bonds were
automatically considered good collateral. Today, central banks accept a wider pool of
collateral. By what criteria should collateral be judged? We know that liquidity problems can
become solvency problems if liquidity is denied or not provided generously enough. Thus the
seemingly simple principle developed by Thornton and Bagehot can be open to various
interpretations. There is a need, I think, to revisit the question. Mervyn King's pawnbroker
concept (2016) provides some new ideas on the issue.
The ultimate aim in meeting these challenges is to make finance in Europe more resilient and
to enhance and safeguard financial stability. The role of supervisors of the financial system is
to enhance harmonization while respecting proportionality. They should safeguard a
levelplaying field among all participants and protect depositors while striking the right balance
between "strictness" and "fairness". Their mandate is to set clear boundaries within which
financial intermediation can prosper while financial stability is maintained.
D. Beyond policies towards the financial sector
As I stated at the outset of my presentation, financial stability is not only crucial for growth;
growth is also crucial for financial stability. So let me close with a few remarks on growth in
the euro area and the completeness of Economic and Monetary Union (EMU).
Despite the progress made in the past few years, EMU remains incomplete. Divergence
across the euro area is significant and the crisis has further highlighted existing shortcomings
and important differences that need to be bridged. To this end, Europe should build upon
other proposals outlined in the Five Presidents' Report (2015). As argued in that report, EMU
will not be complete until the appropriate mechanisms to share fiscal sovereignty are in
place. Monetary unions have to develop mechanisms for risk sharing. Mark Carney (2015)
recently highlighted the stylized fact that, whatever happens to asset prices, debt endures.
Reducing debt levels is difficult and he notes that it is unlikely that high debt in one sector or
region can be reduced without at least temporarily increasing it in another. Fiscal integration
can help in this respect. Allow me to remind you of Keynes's view about the Bretton Woods
System - it needed, he believed, to provide mechanisms to promote symmetric adjustment
within the fixed exchange rate area so that there would not be a bias towards deficient
demand across the system. A more-fiscally-integrated monetary union would help address
the problems of asymmetric adjustment and the deflationary bias of our monetary union.
Sustainable economic growth can contribute to financial stability. Failure to maintain
sustainable growth has been the biggest threat to the long-term stability of the EU since the
onset of the 2007 crisis. An appropriate balance between managing risk and enabling
investment needs to be struck. In this connection, it is crucial that the regulatory framework
does not impede, but provides a suitable environment, for sustainable growth.
Ladies and gentlemen, ultimately, a sustainable recovery will need to be underpinned by
higher investment. Yet, in the euro area we presently face a significant investment gap. The
financial system and its stability have a crucial role to play in closing this gap. Central
bankers and supervisory authorities bear an enormous responsibility in shaping a system
that can deliver prosperity to the citizens of Europe. We have made important progress in
securing the financial stability needed to deliver such prosperity, but we have not yet
completed the job. As the ancient Greek mathematician, Archimedes, once said, "Give me a
place to stand and I will move the earth, but first I need a place to stand, a foundation." The
completion of our financial-stability edifice will provide the necessary foundation for the
citizens of Europe.
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