Lucas Papademos: The financial market turmoil, the European economy,
and the role of the European Central Bank
Speech by Mr Lucas Papademos, Vice-President of the European Central Bank, at an event
organised by The European Institute, New York, 27 September 2007.
* * *
Ladies and Gentlemen,
I. Introduction
The European Institute in the United States has a long tradition of "fostering transatlantic
dialogue". Through a variety of activities, including the publication of its "European Affairs"
journal, it succeeds in providing a thorough analysis of and in stimulating a constructive
debate on issues pertaining to the European Union and on key aspects of transatlantic
cooperation. I like to thank you for the invitation to address some issues of relevance to the
economies and public policies on both sides of the Atlantic.
The recent financial market turmoil confirmed how closely integrated our economies have
become and, in particular, how events that have a direct impact on financial markets in the
United States can have immediate and significant repercussions on European financial
markets, which in turn can have feedback effects on American markets. The financial market
tensions also underscored the importance of information exchange and cooperation between
central banks and other relevant authorities across the Atlantic - cooperation which can
reinforce the effectiveness of the policies pursued.
In my remarks I would like to share with you some thoughts on two topics:
•
The recent financial market turbulence and its potential impact on the European
economy; and
• The role of the European Central Bank in preserving price stability, safeguarding
financial stability and fostering economic growth in the euro area.
The ECB and other major central banks have been very much in the news in recent weeks
as a result of their money market interventions during the financial market turmoil. Moreover,
over the past few months the monetary policy decisions of central banks have been
occasionally at the centre of public debate triggered by concerns that interest rate increases
might adversely affect economic activity, as well as by more general considerations
regarding their policy mandates.
It is said that it is the job of central banks in the economy "to take away the punchbowl just as
the party gets going." Looking at the developments in financial markets over the past two
months, it looks like the party in some market segments was a rather exuberant affair,
characterised by quite a few excesses! And some market participants are feeling the
consequences, having woken up with a severe hangover! Which begs a question: what,
then, is our role in such a situation? This is precisely one of the issues that I would like to
discuss.
II. The financial market turmoil
In early August, before tensions emerged in financial markets, the ECB's diagnosis of the
economic situation in the euro area was that the economic environment was positive with
conditions in place - both external and internal - for economic activity to continue to expand
at a sustained rate, close to potential growth. It was noted, however, that there were
downside risks to this favourable outlook for economic growth which included "the possibility
of potential abrupt shifts in global financial market sentiment leading to a repricing of risks".
The month of August was characterised by a substantial increase in financial market volatility
and a reappraisal of risk. The financial market turbulence was triggered by a series of events
which intensified tensions in the US subprime mortgage market. This resulted in an
adjustment of investors' attitudes towards risk - a diminished appetite for risky assets - and
led to an increase in uncertainty about financial market conditions and prospects. Market
volatility rose sharply in almost all asset classes. Stock markets tumbled, as investors sold
equities and moved funds into safe-haven investments, like government bonds. Several
investment funds holding asset-backed securities - with subprime mortgage elements -
suspended withdrawals. At roughly the same time, a number of European banks made public
their direct and indirect exposures to the US subprime mortgage market. These exposures
were sometimes sizeable but were not sufficiently significant to materially impact the
soundness of core financial institutions. In addition, several banks, especially in Europe,
were subject to rumours about severe losses stemming from exposures to mortgage-backed
securities.
What were the factors and the channels that contributed to the propagation of shocks and
tensions from one market on one side of the Atlantic to several markets on both sides? The
tensions fundamentally reflected increased uncertainty and a loss of confidence in the
valuations of structured credit instruments, where the underlying assets are US subprime
mortgages. This loss of confidence caused disruption in the asset-backed commercial paper
(ABCP) market where "conduits" and structured investment vehicles (SIVs) were borrowing
to fund their holdings of asset-backed securities. These financial "conduits" and SIVs faced
difficulties to refinance themselves, that is, to roll over maturing ABCP because of concerns
about their credit quality. The tensions in the ABCP markets - both in US dollar and euro -
spread to the interbank money market on both sides of the Atlantic, as banks began hoarding
liquidity to fund their commitments to provide liquidity and credit to these conduits and to put
the underlying assets on their balance sheets. Moreover, banks curtailed their lending to
other banks because of uncertainty surrounding potential exposures of their counterparties.
These developments drove up interest rates for the very short term funds to levels
significantly above the ECB's policy rates.
The actions of the European Central Bank
In this situation of heightened tension and a severe impairment of the functioning of the euro
money market, the ECB stepped in and provided overnight liquidity to the interbank money
markets in a series of fine-tuning operations. These took the form of reverse repurchase
agreement, whereby the ECB lends funds to commercial banks against eligible collateral
which are repurchased the next day, at the agreed price, by the counterparty. Initially, the
ECB provided such funds at the policy interest rate of 4.00% without limit. Throughout the
month of August, the ECB conducted a number of additional fine-tuning operations. It also
provided liquidity through its weekly main refinancing operations and two supplementary
longer-term refinancing operations with a maturity of 3 months.
The aim of these operations was to ensure orderly conditions in the interbank money
markets, to reduce short-term interest rate volatility and to contain the risk that tensions in
the financial markets would propagate through the banking system. The ECB conducted the
money market operations without changing the overall stance of monetary policy and,
needless to say, without aiming to "bail out" any specific financial institution with a special
liquidity need. I emphasise this point because there has been a certain degree of confusion
about this. It is important to make a clear distinction between two types of key central
banking actions. On the one hand, central banks take decisions on monetary policy and
official interest rates and these have a clear medium-term orientation geared towards the
preservation of price stability and they rest on the macroeconomic assessment of the risks to
price stability. On the other hand, central banks may conduct money market operations that
provide liquidity to ensure the orderly functioning of the interbank money market. Put simply,
monetary policy decisions are about the level of official interest rates, whereas certain central
bank operations in the money market aim at the reduction of short-term interest rate volatility
around a given level of official interest rates, for the purpose of safeguarding financial
stability.
I should also emphasise that throughout this episode and the related money market
operations, the ECB and the Eurosystem have been in close contact with other central banks
in the world, notably the Federal Reserve System. While each monetary authority took
decisions to attain its own objectives and in line with its own assessment and operational
framework, it is unquestionable that this liquidity squeeze which had manifestly global
dimensions called for a response with commensurately global cooperation.
Did the actions of the ECB and other central banks accomplish what had been intended? For
the European side, I can state that the ECB's liquidity-providing operations clearly had a
stabilising effect on euro money market rates at the shortest end, and overall, the money
markets have recovered somewhat. However, market liquidity remains thin and activity
limited in the unsecured inter-bank market, and spreads comparably higher. There are two
main reasons for this: first, banks' liquidity needs, especially in US dollar, have risen,
because the credit lines extended to the various "conduits" and other financial entities have
been largely used. Second, a number of banks are still reluctant to lend to each other,
particularly on an uncollateralised basis, in view of perceived counterparty risk. This attitude
contributed to reduced interbank activity - and this in spite of the availability of abundant
liquidity in the banking system as a whole.
Lessons to be learnt
In the light of these developments we, as policy-makers, need to find answers to two
questions: What have been the sources and reasons of what we have witnessed? And what
are the lessons to be learnt so as to try to avoid any repetition? It is still too early to make a
definitive assessment of the combination of factors that explain what happened - and is still
happening - in credit markets and of the consequences of the market liquidity squeeze.
However, recent developments have revealed several vulnerabilities in credit markets and
allow us to reach some tentative conclusions. I should note that a number of these
vulnerabilities and risks had been previously identified by the ECB, in its Financial Stability
Review as well as by other central banks and international financial institutions. Some other
vulnerabilities or structural weaknesses became visible during the recent developments.
These vulnerabilities relate to features of new financial instruments and markets, new market
participants, new business models of credit origination and risk transfer and incentive
structures that can affect the behaviour of market participants. In particular, I would like to
stress four vulnerabilities that have been exposed and that stem from: (i) the lack of
transparency in the broader credit markets, (ii) the valuation of structured credit products
which are not traded frequently, (iii) the role of credit rating agencies, and (iv)
specialpurpose investment vehicles that are highly leveraged.
First, the lack of transparency in credit markets. In recent years, the market of credit risk
transfer has facilitated a widespread sharing of credit risk across the financial markets which
in general should enhance their efficiency and stability. Nevertheless, the market turbulence
confirmed previously expressed concerns about the risks stemming from the lack of
transparency as to where credit risks ultimately reside in the financial system, that is,
whether they have been acquired by market participants that can manage them properly and
how imperfect knowledge of the distribution and concentration of risks can affect participants'
behaviour and the liquidity of markets.
Second, structured credit products whose valuations are model-determined. Even if risks are
well dispersed across the system, in a crisis situation, a suspicion that some financial
institutions could have exposures, event modest, to such assets for which no market value
can be computed, can significantly impair the functioning of the market.
Third, the activity of rating agencies has recently come under particular scrutiny. The issues
related to the very small number of rating agencies, the possible conflicts of interest and the
lack of benchmarks clearly need to be addressed in order to provide optimal conditions for
the efficient functioning of the complex and sophisticated global financial markets. What
should be clear, however, from the current episode is that financial institutions should not rely
exclusively on credit ratings for their risk assessments.
Fourth, special-purpose investment vehicles that are highly leveraged. The financial market
turmoil has highlighted the vulnerabilities created by such, off-balance sheet, investment
vehicles, namely that such vehicles have proven, in the context of mark-to-market accounting
of asset pools, to be prone to liquidity mismatches between their assets and liabilities. These
mismatches caused contingent credit (and liquidity) lines to be drawn on banks and resulted
in the increased demand for liquidity by banks in the (interbank) money market.
These four issues are only some of the lessons to be learnt from this episode of financial
market turmoil; there are others, pertaining, for example, to the liquidity risk management of
banks. We need to carefully assess all factors of relevance to the recent financial market
developments, and should not be rushed into conclusions without a thorough and
comprehensive analysis.
Possible impact on the European financial system
What is the likely overall impact of the recent financial market developments on the
European financial institutions? Some institutions have experienced losses from their
holdings of asset-backed securities, in particular as a result of both direct and indirect
exposures to US sub-prime mortgage securities. Moreover, a number of banks have faced
liquidity pressures as credit lines to special-purpose investment vehicles had to be activated
to meet commitments to provide liquidity support and as a result of increased uncertainty
about counterparty risk. Nevertheless, on the whole, exposures to the US sub-prime
mortgage market manageable given the capital buffers. After several years of strong profit
growth, including strong profitability in the first half of 2007, and with capital bases in excess
of regulatory requirements, the shock-absorbing capacity of the euro area financial system -
especially the core financial institutions - has been enhanced. Although the profitability of
some European financial institutions is likely to be adversely affected to varying degrees by
the recent strains in financial markets, the euro area banking system on the whole should
have no major problems in absorbing the impact of recent disturbances.
Looking forward, the most likely scenario is that financial market conditions will normalise
progressively over a period of time - which could be protracted depending, among other
factors, on the progress made in restoring confidence in the valuation of credit instruments
and the creditworthiness of counterparties. However, it cannot be excluded that some
lowprobability, but plausible and challenging, scenarios for financial stability could be triggered
by adverse market disturbances or "credit events" which would further affect global market
liquidity conditions. A potential further deterioration in credit quality could lead banks to
tighten their lending standards and a less benign scenario could emerge involving a more
significant re-pricing of risk and de-leveraging.
Concluding this assessment of some of the underlying causes and the likely consequences
of the financial market turmoil, I want to stress the following: The recent market liquidity
squeeze originated from a surge in default rates by a subset of borrowers with particularly
weak credit histories and economic fundamentals. In other market segments and economic
sectors, the fundamentals are broadly strong. In order to contain financial market volatility, it
is crucial, at the current juncture, that unanticipated shocks and investor concerns do not
lead to unwarranted contagion to markets and sectors where the fundamentals are sound.
III. The outlook for the European economy
Against the background of this assessment of financial market developments, how do we see
the outlook for the European economy? To what extent does the recent episode influence
real economic activity in the euro area? The overall potential impact on the real economy of
increased financial market volatility and the repricing of risk is difficult to gauge. So far, the
effects of the market turbulence on the euro area economy have not been significant, despite
some tightening of financing conditions. Clearly, the potential effect will depend on future
financial market developments. The longer credit market tensions persist, the greater will be
their impact on the economy. The most likely scenario - that financial market conditions
progressively normalise over a period of time - implies that the effects of the financial market
turbulence on bank intermediation and the cost of capital are likely to be contained.
Therefore, even if lending standards are somewhat tighter than before and risk premia and
the cost of capital increase by a modest amount, their impact on economic activity can be
expected to be moderate.
More generally, looking ahead over the policy-relevant medium-term horizon, we should
assess the likely effects of all relevant factors - economic, financial and monetary - on the
European economy's prospects. The good news is that the fundamentals of the euro area
economy remain strong and global economic activity is expected to remain robust. The
expected slowdown of the US economy is likely to be largely offset by strong growth in
emerging markets. In particular, the fast pace of expansion of economic activity in emerging
Asia is expected to contribute to more 50% of the projected rate of growth of global
aggregate demand outside the euro area. It will, therefore, continue to provide support to
European exports and investment. Moreover, domestic consumption growth should rise
gradually over time, as employment conditions are expected to improve further and in line
with real disposable income developments.
All in all, the strong economic fundamentals, the expected global robust economic growth in
the remaining part of this year and in 2008, and our current assessment of the likely future
financial market developments imply that average euro area real GDP growth in 2007 and in
2008 will be negatively affected only slightly by the recent financial market turmoil and euro
area economic activity will continue to expand at sustained rates, in line with potential
growth. The Eurosystem staff projections published earlier this month foresee average
annual real GDP growth in a range between 2.2% and 2.8% in 2007, and between 1.8% and
2.8% in 2008, the same range projected last June. I would like to emphasise, however, that
there is considerable uncertainty surrounding the central, or most likely, scenario for future
growth and that there are several downside risks. These relate mainly to a potentially
broader impact from the ongoing reappraisal of risk in financial markets, global imbalances,
protectionist pressures, and further rises in oil and commodity prices.
How about the outlook for and the risks to price stability? The medium-term outlook for price
stability remains subject to upside risks. These risks relate to further increases in oil prices
and prices for agricultural products, stronger than expected wage developments, and a
possible increase in the pricing power in some sectors, and the continued vigour of the
underlying monetary and credit expansion, despite some stabilisation in the growth of bank
credit to the private sector.
The current assessment, and confirmation of the previous one, that upside risks to price
stability remain has implications for the stance of monetary policy. It implies that on the basis
of the expected favourable medium-term outlook for real GDP growth, the monetary policy
stance is still on the accommodative side and that the ECB should act in a timely and
effective manner to ensure that risks to price stability over the medium term do not
materialise. At the same time, given the increase in uncertainty surrounding the economic
outlook, it is prudent and appropriate to wait and gather additional information before drawing
any firm conclusions for monetary policy. I should note that the uncertainty we face is not
only related to the likelihood of some specific risks materialising that could affect the financial
and product markets, but it also pertains to the ongoing process of adjustment of the
attitudes toward risk of financial institutions and other market participants, which could have
a bearing on financing conditions. So, we will monitor very closely all developments and
continue to pay great attention to financial markets in the coming period. Having said that, I
would like to stress that the ECB's monetary policy is firmly geared towards its primary
objective of preserving price stability. And especially during a period of increased uncertainty
and market volatility, it is important that inflation expectations remain firmly anchored to price
stability.
IV. The role of the European Central Bank
Having presented these reflections concerning the financial market turmoil, the current
macroeconomic outlook and our monetary policy stance, allow me to conclude by touching
upon some broader considerations regarding the role and policies of central banks and, in
particular, of the European Central Bank. In this context, it is worth recalling that the ECB's
objective, tasks and responsibilities are clearly laid down in the EU Treaty. The primary
objective of the ECB - and the Eurosystem as a whole - is to maintain price stability.
Furthermore, the ECB is to support the general economic policies of the Union, aiming
among other goals at sustainable economic growth, provided that this is possible without
prejudice to the objective of price stability. There is, therefore, a clear hierarchy of objectives,
and for good reason, as I will explain. The ECB and the Eurosystem are also called upon to
"contribute to the smooth conduct of policies pursued by the competent authorities relating to
prudential supervision of credit institutions and the stability of the financial system" (Article
105 of the EU Treaty). The objectives of price stability and financial stability are interrelated
and mutually reinforcing, in that both serve to create conditions which are a prerequisite for
economic growth and prosperity.
Why should the preservation of price stability be the primary, overriding objective of
monetary policy? Both theory and history provide strong arguments and evidence to support
this assignment. First, monetary policy, with the available instruments at its disposal, can
control effectively the price level over the medium and longer run. Second, by contrast,
monetary policy cannot influence the level or rate of growth of aggregate output in a
permanent manner (or to any significant extent). Third, although in the short term a change in
the monetary policy stance could affect economic activity under certain circumstances, such
effects are uncertain, cannot be systematically exploited to stabilise the business cycle and
there is a risk that a countercyclical monetary policy could be counterproductive and
jeopardise the attainment of the price stability goal. Most importantly, by establishing an
environment of price stability, a central bank contributes in a fundamental, though indirect
way, to sustainable economic growth, since in such an environment reduced inflation
uncertainty, inflation expectations anchored to price stability and low levels of long-term
interest rates foster sustainable growth. For all these reasons, the mandates of most central
banks in the advanced economies give primacy to the price stability objective. It is interesting
to note that a major central bank that has a dual mandate has emphasised in its
communication some of the messages that I have stressed here, namely that price stability is
a necessary precondition for growth. It is, therefore, appropriate not to ignore the conclusions
of theory and the lessons of past experience when discussing the objectives of monetary
policy.
I explained earlier at length the ECB's monetary policy stance in order to fulfil its objective of
preserving price stability. How does the ECB perform its financial stability tasks? First, by
monitoring and assessing the outlook for financial stability, and notably by identifying the
main sources of risk and vulnerabilities across the three components of the financial system:
markets, institutions and infrastructures. To that end, the ECB produces a twice-yearly
Financial Stability Review which aims to promote awareness in the financial industry and the
public at large of financial stability issues, and, in this way, to play a role in the prevention of
financial crises. The second strand of activities with which the ECB and the Eurosystem seek
to safeguard financial stability is by providing liquidity to financial markets or institutions in
emergency situations, with a view to preventing the propagation of shocks across markets
and institutions that might transform a single incident into a wide-spread crisis with systemic
repercussions, as I explained earlier.
For a central bank to attain its primary objective and perform its tasks effectively, a number of
conditions - institutional, operational, and analytical - must be in place. An essential
condition for the effective performance of the central bank's functions is its independence,
meaning that it can take decisions on the appropriate policy to achieve its objectives without
being subject to any pressure or interference by the government and any other political
authorities. There are strong theoretical arguments why the central bank should be
independent. But the most convincing reason, which has led many governments to
depoliticise monetary policy and grant independence to the central bank, is past experience
and the empirical evidence.
Europe's "monetary constitution" enshrines the independence of the ECB and the national
central banks in the EU Treaty. But this is not only a case where the law has been made the
"guardian of economic wisdom", it also reflects the will of the peoples of Europe, and the
value which they attach to price stability. Recent public opinion surveys demonstrate that
more than seven out of ten Europeans think that the ECB should be free from influence of
politicians in order to pursue its task to preserve price stability. If we, therefore, publicly
reiterate the Treaty provisions about central bank independence, we are also lending a voice
to this overwhelming majority of European citizens who support our well-established and
tried-and-tested institutional framework.
Thank you very much for your attention.