Hermann Remsperger: Current financial stability issues from a European
viewpoint
Speech by Professor Dr Hermann Remsperger, Member of the Executive Board of the
Deutsche Bundesbank, at the representative office of the Federal State of Hesse at the
European Union, Brussels, 27 June 2007.
My thanks are due to Ms Susanne Korbmacher for her kind assistance in preparing this talk.
* * *
Ladies and gentlemen
I have chosen to give this lecture the title "Current financial stability issues from a European
viewpoint" for the simple reason that it allows me to elaborate on a whole bundle of burning
questions concerning financial stability. Needless to say, these issues are highly complex in
their nature.
I Summary
In order to make matters more understandable I used last Sunday to go through my speech
again and completely rework it. I shall begin at the end - that is to say, by focusing on the six
comments that I had originally intended to use in my final summary.
1. Despite some risks in the financial markets - particularly in the credit markets - I
consider the international financial system to be remarkably robust, not least on
account of the very good performance and ample capitalisation of systemically
important banks
2. With the arrival of new financial market instruments for credit risk transfer and
thanks to the growing influence of unregulated financial investors, credit risks are
not necessarily located in the kind of places where they would have traditionally
been expected. This not only makes it more difficult for market participants to
manage risk. The task of assessing stability risks relating to the international
financial system is also made more difficult for the official agencies responsible.
3. When evaluating the stability situation in future, it will be even more important than
in the past to combine a proper examination and assessment of new instruments
with an analysis of the behaviour of new market participants. This would appear to
be the best way to deal with the fact that the financial system is not only expanding
but also becoming increasingly complex.
4. The transparency of the distribution of risks across the financial system has tended
to decrease, thus presenting the official agencies with the question of how it might
be possible to increase this transparency again. Much of the recent discussion on
hedge funds has revolved around this point.
5. The remarkable initiative by London-based hedge-fund managers to consider
introducing improved, and possibly also binding, sectoral standards is an indication
of the real potential that exists for agreement between official agencies and market
players on the urgent need for greater transparency.
6. The fact that financial markets are becoming more complex is partly explained by
their growing geographical integration. At the same time, the emergence of closer
links between European banks raises the question of how banking supervision
should be structured. Bearing in mind the political and legal conditions that apply in
Europe, the "cooperation model", as it is called, offers a good framework for further
developing the kind of convergence that is needed in supervisory practice.
If you were to ask me how I arrived at this six-point conclusion, the simple answer would
have to be that I started with a definition.
II Monetary and financial stability
We view a financial system as being stable when it is able to efficiently perform its key
functions of allocating capital and risks as well as settling payments and securities
transactions, and can do so in stress situations and during periods of structural adjustment.
There are three aspects that deserve particular emphasis in this connection.
1. Disturbances in core functions of the financial system generally come at an
economic cost, in the form of loss of growth and, in some circumstances, direct
fiscal aid to help prop up financial institutions. This is something to be avoided.
2. In the event of a shock there may be a sudden and dramatic rise in the liquidity
needs of individual financial market participants. In integrated financial markets,
such shortages of liquidity can be passed on quickly and, especially if they reach
systemically important market participants, can have a negative impact on the
financial system as a whole. Once again, this is something that is best avoided.
3. Last but not least, it must be emphasised that price stability and financial stability go
hand in hand. Disruptions in the financial system can delay or otherwise impair the
transmission of monetary policy impulses to the real economy. It follows that central
banks have a special interest in maintaining a stable financial system.
III Current stability situation
Against this backdrop, most central banks have, in recent years, extended and refined their
financial stability analysis. The main focus here is on risks, that is to say not the likeliest of
events but possible unfavourable developments that may arise.
If you were to ask me about the current situation concerning risks for the international
financial system, I would start by pointing out that for about two years macroeconomic
developments have surpassed expectations. The global economy is forging ahead on its
expansionary course, with an increasingly more balanced regional growth pattern. This has
improved the outlook for a gradual reduction of financial imbalances - with the US current
account deficit serving as one of the crystallisation points.
The USA seems as if it is enjoying a soft landing while European countries are experiencing
larger growth than expected. In the emerging market economies, especially in Asia, there is
no end in sight to the ongoing boom.
However, this situation should not lead us to view things through rose-tinted spectacles.
Macroeconomic risks continue to exist. Contrary to my own expectations it is quite possible
that the US economy will cool down even more. Over and above this, a disorderly dissolution
of financial imbalances in the global economy still cannot be ruled out altogether. Should the
downturn in residential construction in the USA spill over into other sectors, this could lead to
a reversal in the credit cycle as well as to pessimism in the financial markets, which in turn
would test the resilience of market participants.
Certainly, the large and complex international financial institutions that are based in Europe
and the USA, in other words, those which are systemically important for the international
financial system, are in a fairly robust state. The favourable cyclical background and the
propitious capital market environment play a major role in this connection. In the fiscal year
2006, the large international financial institutions posted record results. They were able to
record an average year-on-year earnings growth of around 30%. Volatile income sources
such as proprietary trading are proving particularly productive while the need for risk
provisioning is modest. The positive yield trend seems to be continuing in the current year.
Owing to their extremely good performance, ample capitalisation and the continuous
improvement in their management of risks, the resilience of these financial intermediaries,
that is, their ability to absorb external shocks, is to be considered strong.
There will, of course, be cyclical risks in the medium term, and these will mostly be in the
form of the turn-around in the credit (quality) cycle, which has already been expected for
some time. We are observing quite high and/or rising levels of debt in households in the USA
as well as in a number of European countries. This is compounded by the heavy
indebtedness of some non-listed enterprises. A deterioration in macro-financial conditions
could place a strain on them and therefore their creditors as well. At the same time, in a
depressed environment the increasingly homogeneous focus of large financial institutions
could have the effect of reinforcing unfavourable financial market developments
In the international financial markets pricing and risk assessment are being determined
largely by positive macroeconomic expectations. This said, in some parts of the credit
markets there are signs of overheating. In the market for risky syndicated loans, for example,
providers of capital have considerably eased their conditions. In the case of financing for
leveraged buyouts (LBOs), there has been a further rise in the leverage. The trend towards
more relaxed loan terms and conditions is continuing, owing to the favourable economic
environment and strong competition.
The easing of credit standards witnessed in recent years has for some time left its mark on
the US mortgage market in the form of rising default rates among debtors with poorer credit
ratings. A large part of the credit risk arising from subprime mortgages is to be found in
securitised and structured form at institutional investors. These include hedge funds. News
reports over the past few days have made this patently clear. It is my view , however, that in
terms of the market as a whole such relatively minor distortions do not yet constitute a
systemic risk. Nevertheless, they do raise the fundamental question of how these securitised
credit risks should be assessed.
A phase of fundamental re-assessment in the markets and therefore also in the corporate
credit markets would present risk managers with special challenges. This would typically
involve changes in the correlation between financial market prices and burdens on market
liquidity.
The rapid recovery that followed this year's spring turbulences and the as yet limited impact
of the crisis in the sub-prime mortgage business in the USA would appear to have bolstered
the confidence of market participants. Even before this, the somewhat more turbulent
financial market episodes experienced in the springs of 2005 and 2006 proved to be very
short-lived. Bearing all of this in mind, I believe there is a certain risk in the fact that not
enough consideration is being given to the time when this period of market calm comes to an
end.
On balance, however, I would say that the international financial system is now in a robust
state. I rest this assessment mainly on the resilience exhibited by the financial institutions as
I still see risks in the kind of things that are happening in the financial markets. These risks
are not only of a cyclical nature. In some cases they are closely linked to structural changes
occurring in the financial sector.
IV Structural change in the financial system
In the light of these conclusions I would now like to talk in greater detail about two structural
trends which are relevant to the question of stability in the international financial system. The
first of these is the trend towards new financial instruments, especially in the credit markets.
The second is the growing importance of new financial market participants or categories of
investor.
Innovative financial instruments and new categories of investor have resulted in even greater
differentiation in the financial markets. In terms of efficiency this is definitely a positive
development, as it enables a better allocation of capital and financial risks. This should have
the effect of enhancing the financial system's ability to absorb shocks.
At the same time, however, it is possible that investors with volatile investment habits and
financial instruments with an inherent leverage effect will generate risks. Please note that I
am only saying this is a possibility.
We cannot tell for sure whether such structural changes will in fact improve or worsen the
stability of the financial system. This said, ladies and gentlemen, we surely all agree on one
point and that is that these developments present market participants, financial supervisors
and policy-makers with some major challenges.
1 New financial instruments
Although I myself come from the banking business, the financial markets' capacity for
change never ceases to amaze me. The credit markets are the most recent example of this.
For a long time, the lending business was an exchange merely between lenders and
borrowers, what we now refer to as "buy and hold".
Since then, a large market with many new instruments has evolved around this bread and
butter business. Loans can now be sold on the secondary market. Loans can also be
bundled and tranched to be treated as structured products. And, finally, a debtor's credit risk
can be traded via derivatives completely separately from a credit relationship.
With all of these possibilities, a new business model has been born. The maxim is "originate
and distribute". Of course, the basics of lending are still being carried out as before.
However, instead of keeping loans in own books, the loans, or at least the isolated credit
risks, are often quickly passed on to investors.
These new forms of credit markets are growing dramatically, whereby the structural trend
has been boosted significantly by the global economic situation - strong economic growth
coupled with low interest rates.
The outstanding volume of credit default swaps, the backbone of most credit derivatives,
doubled in both 2005 and 2006, according to BIS statistics. In December 2006, the nominal
volume amounted to USD 29 trillion. The incentive to achieve balance sheet relief by insuring
against default risk has long since become less important than the incentive to trade or to
design new financial products.
By appropriate structuring, even a portfolio which includes loans to borrowers with a less
than perfect credit rating can produce investment securities with an AAA rating. Despite
having the same rating classification, these instruments are riskier than the best government
bonds and have a much higher coupon. The interest rate premium makes these instruments
attractive to institutional investors geared to rating-based investment criteria. However,
market participants express doubt as to whether the legal risks can be evaluated
appropriately. The arranging banks currently earn a large proportion of their commission from
their structuring business.
At the same time, the banks that originally granted the loans create new scope for granting
loans by passing on their loans. The option of selling on loans plays a significant role in
lending - especially for debt-financed acquisitions. Exercising all due caution, this suggests
that the large demand for structured products increases primary lending.
With the new instruments, credit risks are not just being reallocated but additional risks are
also being created. For example, operational risks arise if the expansion of the market's
technical infrastructure lags behind the development of business volume. Up until the start of
last year, trade confirmations for credit default swaps were often written weeks after the
transaction had been concluded.
For me, the most important factor here is the simple realisation that it is precisely in the new
credit markets that two types of financial investor play an important role: private equity funds
and hedge funds. I can imagine what you are thinking, and you are right: these are not "new"
financial market participants per se. I personally had many a dealing with hedge funds long
before my time at the Bundesbank. But the significance that they have now achieved for
financial markets has reached new heights owing to the capital constantly accruing to these
funds and increasingly, too, from regulated institutional investors such as insurance
companies and pension funds. I therefore see them as "new" players on the international
financial stage.
In some credit market segments, for example, hedge funds now generate more than half of
turnover volume. At the same time, loans for debt-financed acquisitions conducted by private
equity funds promote the international large exposure business. In short, the dynamics of the
credit markets and the new financial instruments are closely connected with the growth in
hedge funds and private equity funds.
2 Hedge funds
The speed with which hedge funds1 have developed shows that the volume of assets
managed by them has tripled over the past six years from almost USD 500 billion to just over
USD 1,500 billion. At the same time, the number of funds - with a high degree of fluctuation
- more than doubled from almost 4,000 to approximately 9,500.
Of course, the term "hedge funds" refers to a very heterogeneous group with a wide range of
market strategies. However, all hedge funds have one thing in common, the use of high
financial leverage, which they also apply by means of short selling or derivatives. The
volumes of capital shifted by hedge funds therefore far exceed their reported assets. We
closely observe hedge funds from a financial stability perspective for two reasons.
Firstly, hedge funds are borrowers from and counterparties to systemically important financial
institutions. Should a series of unfavourable developments arise, extensive business
relationships with a risk-seeking group of investors could have a negative effect on
systemically important financial institutions and therefore, in a worst-case scenario, on the
functioning of the entire financial system. Intense competition for lucrative (prime brokerage)
business with hedge funds can result in large concessions being granted to this important
group of customers, for example, in collateral.
Secondly, hedge funds can both trigger and intensify disruptions to financial markets. Not
only the characteristic high leverage of these funds but also the increasing investment in
illiquid and complex instruments give observers food for thought. This is all the more true
considering relaxed margin requirements during unfavourable market developments can give
rise to margin calls with corresponding pressure to backtrack. In such a situation, tension can
build up in the market and market liquidity can decrease considerably or even dry up
completely.
However, I would also like to stress that precisely hedge funds, as long as their positions
allow, often identify such situations as good business opportunities, go against the trend and
consequently stabilise the market. A range of market participants with different positions has
a stabilising effect on the market. In other words, market liquidity is enhanced by the
heterogeneity of market participants.
However, this conclusion does not change my opinion that hedge funds need to become
more transparent. Without transparency how can investors and counterparties correctly
assess the risk profile of a fund and make sound investment decisions?
I therefore believe that it was right to include the topic of hedge funds on the agenda of the
German G7/G8 presidency and to ask the Financial Stability Forum (FSF) for a statement.
We in the FSF were unanimous in making a series of recommendations based on market
discipline and indirect regulation of the already regulated hedge fund counterparties. These
met with approval at the G8 summit in Heiligendamm. The recommendations ask all
participants, that is investors, counterparties, supervisors and hedge funds, to work actively
towards increasing transparency and risk awareness.
The hedge fund sector is called upon to review and enhance existing sound practice
benchmarks, especially with regard to risk management, assessment and disclosure
practice.
I therefore welcome the fact that more than a dozen large hedge funds, which are all
managed in London, have launched a remarkable initiative. Under the leadership of Sir
Andrew Large, the group plans to develop improved sectoral standards based on the various
recommendations and best practices that already exist. These home-grown sectoral
standards are to abide by the principle of "comply or explain". These standards are to cover
assessment, disclosure and risk management and thereby the exact same areas identified
by the FSF.
Of course, only time will tell if the group's project will bring us closer to a code of conduct with
mandatory disclosure requirements which is on the to-do list of the G7/G8 presidency. I for
one am taking this initiative seriously and see it as a good step in the right direction.
The FSF's recommendation to investors and counterparties is to actively obtain the
information required so that market discipline has a chance to come into effect. This
particularly concerns information on the risk profile.
The FSF's other three recommendations are addressed to financial supervisors. They should
take an indirect approach to ensuring that systemically important financial intermediaries
firstly strengthen their counterparty risk management practices and secondly prepare
themselves for a sudden erosion of market liquidity. Thirdly, financial supervisors should also
explore the extent to which systematically collecting data from systemically important
intermediaries on their consolidated counterparty risks vis-à-vis hedge funds would be an
effective complement to existing supervisory efforts. It should also be considered whether
international cooperation between supervisory authorities should be strengthened.
I believe that the important factor now is for all parties to ensure that no time is lost in putting
these recommendations into practice, especially as the macroeconomic and financial setting
is not likely to remain as favourable as it is at the moment.
At this interim point, ladies and gentlemen, let me take a moment to recount a personal
experience. In all of the discussions about new financial instruments and new market
players, I have discovered that the Anglo-Saxon perspective is often quite different from that
of continental Europe. Whilst the emphasis here is on risk, in the UK it is the stability of the
financial system through innovations in the field of financial instruments and financial
intermediaries that is promoted. I believe that both perspectives are justified.
And I am also of the opinion that both of these perspectives - that is, opportunities and risks
- also play a role in the evaluation of financial integration but here I am jumping forward to
another section of my speech.
The integration of financial markets and the banking systems are causing the structure of the
financial system to change. Financial markets will become broader and deeper if market
players look beyond national borders more and more and find a larger selection of financial
instruments, greater turnover and higher liquidity. This indicates that an integrated financial
system is more capable of absorbing shocks and that it is more resilient.
However, it should also be noted that disruptions in a highly integrated system can spread at
a much faster pace over market segments, market players and countries, meaning that it is
much easier for an unfavourable self-perpetuating momentum to develop, which is likely to
be much stronger than in a fragmented financial system.
V Integration of European financial markets
Europe is making headway towards a single market for financial services. This single
financial market is a cornerstone of European economic and monetary union - and let's not
forget that this is not just a monetary union but also an economic one. Tighter integration of
further sub-markets would be desirable in order to take maximum advantage of the economic
benefits which a shared currency has to offer.
1 Financial integration
Monetary union was followed virtually overnight by integration in the unsecured money
market, which in turn led to uniform market interest rates applying to all euro-area countries.
Since EMU began, other segments of the financial market in Europe have become
increasingly interlinked. The closer a financial market segment has been tied to monetary
policy and the larger the volume of business, the faster integration has occurred.
Bond markets belong to the category of particularly well-integrated markets. In the case of
government bonds, most interest rates have been brought into line.
The remaining interest rate differentials reflect differences in the degree of credit risk in
individual countries as well as in the liquidity of specific instruments.
With regard to banking services, business with major corporate customers has likewise
become very well integrated. To take the example of syndicated loans, there has been an
increase in the proportion of financing that is arranged by a foreign bank, from the
perspective of the borrower.
Integration is least developed in retail banking. Some experts complain about "fragmentation"
in the retail banking business. My advice would be to take a more relaxed view.
Of course, the regulatory framework for convergence has to be right, and the FSAP along
with its follow-up and the Lamfalussy procedure certainly have a helpful role to play here. But
the market participants will definitely themselves find the right speed and identify the
appropriate areas for action and the methods to be used. This applies in even greater
measure to retail banking, where national traditions set natural limits to the degree and
speed of integration. Integration cannot be achieved with force.
However, it is not just the financial markets that are integrating. The big banks and banking
groups are following suit and becoming more and more European. Starting in 2001, the
ESCB's Banking Supervision Committee has examined this process every two years (the
most recent data relating to year-end 2005).They have been doing this on the basis of the
cross-border activities of 46 European banking groups at the last count. Their latest survey
clearly confirms the trend towards Europeanisation that had already been observed.
The European banking groups have grown considerably, mainly as a result of mergers, with
30% of the groups of institutions under review having assets of more than €500 billion.
The foreign presence of these groups is on the increase, both in terms of the number of EU
countries where they have a foreign affiliate and in terms of their share of external assets.
These average 38% of the consolidated group assets, 14 percentage points higher than the
figure for 2003! Big differences exist between individual countries, with the share of external
assets ranging from 16% in the case of Greece to 65% for Italy. The value for a total of eight
countries is equal to or above the average.
In the EU15 countries, the aggregated market share of the banking groups under review
stands at an average of 20%. Meanwhile, at 56%, the figure for new EU member countries is
more than half of the total.
What we see here is a pronounced degree of Europeanisation at the level of the larger
banking groups. I am sure there is little need for me to emphasise that this development is
directly connected with the question of what kind of structure is best suited for banking
supervisory purposes in Europe.
2 Implications for financial supervision
This question is anything but easy to answer.2 This is because the large financial
intermediaries active across Europe operate alongside a much larger number of nationally or
even locally focused institutions. Also, the EU member states each have their own individual
legal systems.
A European supervisory system must therefore take account of the financial reality of an
increasingly integrated financial system as well as the political reality of national legal and
administrative systems. Moreover, and I would like to place particular emphasis on this, the
supervisory structure should also be competitively neutral. This means that a "level playing
field" must be established not only between domestic institutions and their foreign
competitors but also between nationally and internationally focused institutions. This is
definitely no easy feat.
The EU has, however, developed a system which, in my opinion, has met these
requirements. While the supervision of institutions is the responsibility of member states, a
cooperation model between home and host supervisors applies for internationally active
institutions. It is envisaged that the consolidated supervisor as defined in the Banking
Directive will carry out supplementary supervision of an institution through the supervisory
authorities of the bank's country of domicile in cooperation with the supervisory authorities of
the host countries.
The nature and scope of this cooperation are defined in the "home/host guidelines" of the
level 3 committee CEBS. This expert committee was established under the Lamfalussy
framework and is designed to provide for a convergent application of European banking
supervisory legislation among other things.
The "home/host guidelines" also describe the "supervisory colleges" in which the participating
supervisory authorities responsible for a bank organise themselves. This facilitates the
exchange of information and the coordination of supervision.
A whole range of measures such as exchanges of staff, joint training sessions or the option,
currently being developed, of a mediation procedure in cases of dispute between supervisory
authorities serve to increase cooperation and convergence in supervisory practice.
This cooperation model provides the best solution under the present political and legal
conditions. The necessary and desired improvement in supervisory cooperation and
convergence should be further developed within this framework.
But I know that this approach is criticised by some for not going far enough. Large European
banks have been requesting a concentration of supervisory functions for some time. At the
beginning of June, the IMF strongly criticised the existing arrangements for the supervision of
institutions and crisis management in its concluding statement to Article IV consultation with
the euro-area. Not only did they lag behind the market but they even prevented further
integration.
In my opinion, however, the IMF's criticism of the European supervisory model can be
qualified by the fact that, among other things, there are no appropriate legal and political
provisions to enable the solution suggested by the IMF for large internationally operating
financial institutions to be applied.
Most important is that a single supervision and bankruptcy law be established in all member
states. Even then the question would remain as to whether a supervisory system which de
facto is in two parts is consistent with the idea of the single market and the goal of a level
playing field.
The IMF also criticised the sluggish progress in the preparations for the management of any
financial crises in internationally active financial institutions.
Without doubt, the question of adequate crisis management in the financial sector is
extremely important for financial stability. The aim of supervisory authorities and central
banks is to avoid systemic consequences in the event of an incident.
In my opinion, two things are important, when preparing for a crisis: First, what market
participants expect from the crisis management system and, second, the flexibility necessary
to make the best of the individual circumstances of a critical situation.
The expectation that the central bank and the taxpayer will make funds available in a crisis
situation reduces the financial institutions' own sense of responsibility. Such expectations
could even lead to a careless attitude towards risk and would therefore be counterproductive.
Owing to this moral hazard phenomenon, I believe advance detailed arrangements are not
helpful.
The institutional system in the EU for crisis management has been expanded over the past
few years and has been tested in several crisis simulations.3 It addresses the expectation
problems and offers the necessary flexibility.
At an EU level, two memoranda of understanding currently exist for cooperation in a crisis
situation. The older one (2003) was agreed between supervisory bodies and central banks;
the second (2005) includes the finance ministries. These agreements cover the principles
and procedures for the exchange of information and assessments in crisis situations. Then
there is the information exchange between the supervisory authorities already
institutionalised in the "supervisory colleges".
Independent of this, the Eurosystem has arrangements and procedures in place for the
effective performance of its functions in crisis situations as well as for the provision of
emergency liquidity assistance by the national central banks.
With this institutional framework, Europe is, in my opinion, well prepared for a situation which
could threaten the stability of the financial system. Some participants in the discussion on
crisis management envisage further, more extensive agreements.
However, I see the danger that flexibility in financial crisis situations will be limited if such
further, more ex