Mario Draghi: The current crisis and beyond
Remarks by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial
Stability Forum, at the Federal Reserve Bank of Kansas City Symposium, Jackson Hole,
22 August 2008.
* * *
More than a year into the most challenging financial crisis of our times we now face a
complex and interlocking combination of rising inflation, declining growth, tightening credit
conditions, and widespread liquidity tensions pervading the world financial services industry.
Authorities are using a range of tools at their disposal to address these challenges. But this
crisis has shown, together with the lack of private sector discipline and weaknesses in the
regulatory framework, some novel interrelations that call for action on all these fronts
concurrently, and this further complicates our tasks.
And yet, as we develop responses to these challenges, we also need to step back and
consider how we have arrived at where we are. At a very general level it is now becoming
apparent that the transformation undergone by the financial services industry in the last few
years has not been fully appreciated in its implications for monetary and regulatory policy
making. As was well said by Adrian and Shin in the paper presented this morning, this has
been the first post-securitization crisis. Low interest rates and volatility have boosted the size
of both regulated and unregulated financial institutions' balance sheets and their leverage
during a long period of time. But of course not all of them were able to withstand a sudden
change in financial conditions amplified by the accumulated leverage. Market participants
failed to soundly manage, measure and disclose risks, with ignorance, greed or hubris
playing their customary roles. But that is where, with the benefit of hindsight, regulators
should have stepped in responding to the externalities imposed on the financial system by
weak financial institutions, the agency problems that foster excessive risk-taking by financial
firms and investors, and the collective action problems in such areas as investment in risk
management capacity and infrastructure, in market infrastructures, in the maintenance of
market liquidity and, above all, transparency.
Still more broadly, reviewing our experience of the past two or three decades, one is struck
by the repeated tendency of the financial system to build up risk and leverage over a series
of years, then turn and shed risk rapidly and indiscriminately. While the assets and agents
involved and the triggering mechanisms differ from one cycle to the next, the cycles have
tended to produce significant deadweight costs and distortions in the real economy, both
during the upswing and during the subsequent retrenchment, and this is especially significant
the more the financial system is leveraged. While we cannot and would not want to eliminate
the bouts of optimism and pessimism that are part of human nature, we must address some
of the pro-cyclical implications of our own policy making.
The conviction of the FSF, called a year ago by the G7 to draft the first report in response to
the crisis, is that, due in part to a perverse set of incentives, leverage had reached a level
that was both excessive for the risk management capacity of many institutions, and
misperceived in its real entity. Therefore, improving the incentives in the system so that
risks are appropriately managed and risk control frameworks keep pace with financial
innovation; improving the resilience of the system to shocks, whatever their source; and
introducing frameworks for dampening the cyclicality of risk-taking, have become the
cornerstones of our work plan.
Our aim should be to produce a system more immune to the perverse incentives that we
have seen, where leverage is lower, and where the sources of leverage and their associated
risks are better identified and addressed. Regulatory and supervisory changes will need to
go hand-in-hand with enhanced transparency about risk exposures and valuations
throughout the system.
Let me start with actions to improve incentives. Under the umbrella of the FSF, and in a
collaborative effort of national and international regulatory and supervisory authorities, we
urged prompt implementation of Basel II, which will align capital requirements more closely to
banks' risks (and I will have more to say about this in a moment). We also recommended
strengthening Basel II with respect to capital charges for credit risk in the trading book, for
resecuritised assets, and liquidity lines for off-balance-sheet vehicles. We encouraged the
Basel Committee to strengthen liquidity management practices and buffers. We have called
on financial institutions to align compensation better with long-term, firm-wide profitability,
and recommended a range of measures to discipline the practices of credit rating agencies
and to reduce regulatory reliance on ratings so that investors engage in proper due diligence
rather than relying exclusively on ratings.
We also set out several recommendations to enhance transparency and valuation practices.
We outlined "leading practices" for disclosures by financial firms, and urged financial
institutions to use these as part of their financial reports starting in mid-year 2008. The
International Accounting Standards Board, in response to a proposal by the FSF, has
initiated a process to develop improved guidance on the valuation of illiquid instruments and
related disclosures. We have also called on accounting standards setters to overhaul
standards for asset de-recognition and consolidation of off-balance sheet vehicles. And we
recommended that securities market regulators address incentives problems in the
securitisation chain and work to expand information for investors on securitisation products
and their underlying assets. These measures should improve the ability of investors and
others to track the risks taken by financial institutions, and thereby increase the effectiveness
of market discipline.
The progress already achieved testifies to the importance we as financial authorities attach
to a stronger framework of regulation. Not only has a consensus been built internationally
and cross-sectorally on what is needed, but the process of policy development and
implementation is moving forward in coordinated and consistent fashion - and faster than we
ever experienced in the past. To illustrate:
•
Supervisors proposed in July new capital requirements for credit exposures in
banks' and securities firms' trading books and will set out later this year adjustments
to capital requirements for "re-securitisations" and short-term liquidity facilities.
•
In May, the Basel Committee issued revised guidance on liquidity risk management
that materially raises standards for sound liquidity risk management and
measurement - including requiring banks to maintain a robust cushion of
unencumbered, high quality liquid assets as a safeguard against protracted periods
of liquidity stress.
•
IOSCO and the SEC has set out fundamental changes to its requirements on credit
rating agencies to address the quality of ratings, as well as proposals concerning
how ratings are used in regulatory guidelines.
•
Regarding transparency, over this summer, the larger banks have been using our
recommended disclosures to provide expanded information on their risk exposures
and valuations.
•
And the IASB is making good progress on new guidance and revised standards for
valuations and off-balance sheet entities, which we expect to see in the next few
months.
There are many other initiatives underway, alongside complementary efforts in the private
sector. We welcome the recommendations, along with accountabilities, that have been set
out by the Institute of International Finance (the IIF), the Counterparty Risk Management
Policy Group, and the American and European Securitization Forums.
The key challenge for us as authorities will be to remain engaged in seeing these and other
reforms through, particularly given the short-term challenges we face. Regulatory changes
will need to be phased in over time to avoid adding to the adjustment challenges the system
faces now. But there should be no stretching of timetables for enhancing disclosures,
including of off-balance sheet positions, as this is essential to repairing market confidence.
Even if we do succeed in rectifying the incentive problems that have tended to generate
excesses, our financial system will not be spared risk management failures, shocks and
disruptions in the future. This calls for strengthening the system's resilience, in terms of both
a better financial infrastructure and stronger shock absorbers in financial institutions.
At the level of the infrastructure, a resilient system is one that is able to withstand the effects
of the failure of a large financial institution. By reducing the centrality of any one institution to
the system's stability, stronger infrastructure should also contribute to reducing moral hazard.
A critical priority in this area is to address weaknesses in the operational infrastructure of
over-the-counter derivatives markets, and the work undertaken by the NY Fed to this extent
should be commended by all the jurisdictions. It is also imperative that we strengthen
national and cross-border crisis resolution frameworks so that we can allow weakened
financial institutions, including large ones, to fail without putting the remainder of the system
at risk. In addition to national reform efforts in a number of countries, work is underway in the
FSF and the Basel Committee to strengthen cross-border cooperation and contingency
planning among authorities in responding to crisis.
At the level of individual institutions, improving resilience means ensuring that capital and
liquidity buffers are large enough to enable firms to resist external shocks - without
mandating buffers at a level that impedes efficiency and encourages regulatory arbitrage.
The issue is quite complex, because both the actual and the appropriate size of a buffer shift
over time depending on the market and systemic environment. With regard to capital buffers,
it is not yet clear how required, desired and actual capital levels will evolve over a full cycle
under Basel II, but a framework is now in place for tracking and assessing this.
Regulatory minima are one of several inputs into firms' capital decisions. Banks have made
significant efforts to raise new capital to meet anticipated needs relative to regulatory minima
as well as to respond to the need to reassure markets. Banks clearly see a benefit to
maintaining capital significantly above regulatory minima, and markets (including rating
agencies) reward them for healthy capital levels.
One reason, among others, that banks maintain this margin is underlying uncertainty over
risk exposures, valuations and earnings prospects. When as at present this uncertainty
increases, the margin required by the market also rises. To a degree, this is unavoidable. But
to reduce the tendency that market reaction lead banks to raise capital (or reduce exposures)
to possibly inefficient levels in a systemic crisis, we need a more robust ex ante framework of
transparency about risk exposures, along with provisions, margins and reserves for valuation
uncertainty, than we have at present.
The appropriate size for liquidity buffers is even harder to mandate, or to predict, than for
capital buffers, given the unpredictable nature of shocks to market and funding liquidity, and
the understandable reluctance of monetary authorities to create perfect certainty about when
and how they will provide emergency liquidity. But, as with capital, greater ex ante
transparency about banks' liquidity risk management frameworks, cushions and supporting
arrangements should help reassure investors and counterparties and reduce the risk of
sudden drains on liquidity, as well as the uncertainty that, over the past year, has led to wide
and volatile liquidity premia in interbank funding markets.
As we consider how to strengthen buffers, more thought needs to be given to how to
promote higher buffers above the regulatory minimum in good times, and more flexibility for
the system to make use of these buffers when they are comfortably above regulatory
minima. Both the banks themselves and their counterparties should be more confident about
the banks' ability to draw on such buffers in bad times. Banks will only be willing to do this if
they do not fear they will be punished by the market - which brings us back to the
importance of transparency improvements. If banks can credibly assure markets and their
regulators that risks to their asset values and earnings prospects are being soundly managed
and contained, then they may be able to survive a temporary decline in capital levels, while
still above their regulatory minimum, during cyclical downturns.
Authorities will be closely monitoring banking conditions to inform decision on the best timing
for introducing tighter capital requirements. We will not unduly burden financial institutions
during the adjustment phase, but also not miss the opportunity of the next calm phase in
financial markets to strengthen the structure of the financial system. Pacing regulatory
changes, but firmly committing to them, will contribute to reducing the potential for cyclicality
in the system to be deepened by regulatory capital requirements.
There is no shortage of ideas around for how the capital regime might be modified to
dampen potential pro-cyclicality. Some have suggested that a regime that adjusts regulatory
minima with the cycle could help reinforce the message that buffers need to be built up in
good times and are there to be used when a rainy day arrives. To a degree, this is already
possible under the second pillar of Basel II. However, too much divergence in national
implementation of pillar 2 would raise issues of transparency and consistency in international
regulatory arrangements and should therefore be constrained. To be credible, a discretionary
system would need to be limited in its scope, fully transparent, and broadly consistent across
countries; ad hoc, uncoordinated reductions in required minima could be viewed as
forbearance and could give the wrong signal about authorities' judgement as to the overall
strength of the system.
It may also be possible to give more attention to the mix of capital instruments supporting
banks' risk exposures. There may be scope to enhance the quality of capital during strong
economic conditions. A complementary policy aimed at strengthening buffers could look at
mechanisms to automatically increase bank equity levels in bad times, such as reverse
convertible debentures proposed by Flannery or the insurance scheme proposed by
Kashyap, Rajan and Stein. Although many issues of security design would need to be
addressed for these instruments to effectively discipline banks, generate adequate investor
demand, and to be reliably collected on when bad states occur, these mechanisms could
potentially reduce the bad-signal problems associated both with discretionary changes in
minima and with capital-raising efforts by the banks themselves. A necessary complement
would be a disclosure framework for risk exposures and valuations that prevents the market
taking conversion events or the resort to insurance as a trigger for a broader downgrade of
the system's future prospects.
Strengthened capital and liquidity buffers and improved incentives to assess and manage
risk should all help reduce the pro-cyclicality of the financial system, and, in the new
configuration of the financial services industry more than ever, help monetary policy to attain
its traditional objectives. But should monetary policy itself embody in its objective function the
health of the financial system?
As Chairman Bernanke and others have noted, we cannot afford to ignore the health of
financial markets when setting monetary policy. It would be difficult to disagree with this
statement, and we should try to make it operational considering however that its application
may have different degrees of intensity. We should certainly use the monetary and credit
aggregates that give the best projections of financial conditions for a given structure of the
financial services industry. But how to go beyond that is a matter of considerable complexity.
Though I share the importance of the policy goal, it should be clear that how to define the
objective function is not only analytically difficult, but it would also pose serious institutional
challenges. For a central bank whose primary mandate is to preserve price stability alone,
introducing financial stability as an additional objective could introduce a trade-off where
none exists today. Indeed, at times of extraordinary volatility and dramatic risk re-pricing,
maintaining price stability could be the best contribution that monetary policy could give to
the return to financial stability. The same remains true during peaceful times, when
prolonged periods of double digit growth in several credit aggregates should call for action to
protect future price stability even if in absence of an immediate danger. Second, I can only
point at the difficulty of having a framework that is as clear and measurable as the one we
have today for our monetary policies. But where I see the greatest difficulty is in the amount
of information that would be needed in order to run a monetary policy having financial
stability among its objectives. In other words, we would have to know about both the
regulated and the unregulated parts of the financial services industry as much as we know
about inflation and output. Of course this would also be the area where, were we to move in
this direction, the benefits from enhanced transparency and interactions with regulatory
policy would be greatest.
In conclusion, the next few years are likely to be ones of low risk-taking and progressively
low leverage, as financial institutions and households repair their balance sheets and as
internal and external macroeconomic imbalances are resolved. These adjustments will not
be painless, and ensuring that they take place in an orderly manner will pose substantial
challenges for policymakers: Preserve price stability while supporting growth, and continue
injecting liquidity as needed by an industry that is still far from having resolved its problems,
at a time of strong inflationary pressures and tightening credit conditions.
In such a situation, monetary policy cannot be the only, or even the main tool for reflating the
economy and the financial system. Fiscal policy will have a key role to play, in its various
configurations. But equally important would be to recreate an environment where banks
during this current transitional period were both able and willing to use their buffers to lend,
and capital markets were able and willing to fulfil their functions. For this to happen, the
uncertainties about risk exposures and asset valuations, about developments in the real
economy, about the strength of financial, corporate and household balance sheets need to
be adequately addressed. This implies a central role for improved transparency as well as
action by the private sector to repair balance sheets and strengthen the functioning of
markets.