Jens Weidmann: A look at the euro area from a central bank perspective
Keynote speech by Dr Jens Weidmann, President of the Deutsche Bundesbank and Chairman
of the Board of Directors of the Bank for International Settlements, at the Second Finance
Forum Liechtenstein, Vaduz, 23 March 2016.
* * *
1. Introduction
Head of Government Hasler
Your Serene Highness
Esteemed ladies and gentlemen
Thank you very much for inviting me to the Principality of Liechtenstein. I am very glad to be
here with you today.
A reporter at Germany's Süddeutsche Zeitung daily once wrote, with a slight undertone of
sarcasm: "Those who have the joy of spending part of their lives at banking congresses will
frequently be confronted with words ending in '-ation' and '-ing'." The prime examples listed by
the journalist included "regulation", "capitalisation" and "digitalisation".
Rest assured that, at today's event, you, too, will be confronted with a great many words ending
in "-ation" and "-ing", especially since two of the aforementioned words were already
mentioned in the invitation. There's also a good chance that you will hear terms such as
refinancing and implementation, positioning and focusing, standardisation and stabilisation or
even the optimisation of bookkeeping and accounting bandied about today.
Some years ago, the German language critic Bastian Sick complained, in his book Der Dativ
ist dem Genitiv sein Tod - literally, The dative is to the genitive its death - of the "overweening
dominance of words ending in -ation" and "-ing". Admittedly, the literary merits of this
nounheavy style of writing are not truly existent - but at a financial industry conference, that is
probably not what counts. Let me therefore focus on content and not on the linguistic
packaging.
In my remarks today, I would like to take a look at the situation in the euro area.
Liechtenstein borders on the euro area, and not just geographically. There are also close
economic and legal ties with the EU, especially since the Principality is a member of the
European Economic Area and thus part of the internal market. Liechtenstein's banks have
been among the major beneficiaries. And the sharp appreciation of the Swiss franc against the
euro last year weighed not only on Switzerland's industrial sector but also on Liechtenstein's
exporters.
The ECB Governing Council's monetary policy decisions are therefore just as relevant to the
Swiss franc zone as financial market regulation and the institutional stability of European
monetary union.
Before I delve deeper into these topics, I would like to lay out three core talking points.
1. First, European monetary policy has ventured deep into uncharted territory, and there
is a growing risk of it being subjugated to fiscal policy. In what is admittedly currently
a difficult monetary policy environment, risks must not be underestimated, nor should
the capabilities of monetary policy be oversold.
2. Second, in order to stabilise monetary union over the long run, its institutional
framework needs to be reformed. The balance between actions and liability for their
consequences needs to be restored.
3. Third, significant progress has been made in financial market regulation; our banking
system is thus more robust today than before the financial crisis. However, the
regulatory agenda has not yet been fully concluded for the banks and shadow banks
alike.
2. Monetary policy in the euro area
Let me begin with monetary policy.
As you know, at its meeting nearly two weeks ago, the Governing Council of the European
Central Bank (ECB) adopted an even more accommodative monetary policy stance.
The move that gained the most public attention was the renewed cut in the ECB's policy rates.
The main refinancing rate is now at 0%, and the interest rate on deposits with the Eurosystem
was cut further to the current level of -0.40%. But on top of that, the Governing Council also
adopted a rather extensive package of measures:
beginning in June, the Eurosystem will be providing a further set of targeted longer-term
refinancing operations (TLTROs) with which banks can acquire liquidity for a term of four years
at extremely favourable conditions - usually at the 0% main refinancing rate throughout the
entire term. Banks that grant additional loans - except for loans for house purchases - will
even get something back: in the most favourable case, the difference between the main
refinancing rate and the deposit rate in effect at the time of allotment.
In addition, the volume of monthly bond purchases was raised from €60 billion to €80 billion.
The idea here is to also purchase, within this overall volume, non-financial corporate bonds
issued in the euro area. At the same time, the Governing Council stated that it did not intend
to raise its central bank rates for a relatively long period of time. Not even once the asset
purchase programme has already been concluded.
This package of measures was the Governing Council's response to the very subdued price
outlook in the euro area. It may be assumed that, over the forecasting horizon, the inflation
rate will only very gradually approach the norm for price stability; at the end of 2018, inflation
will stand at 1.6%.
In addition, the ECB staff projections show that the gradual economic recovery in the euro area
will continue, but at probably a somewhat weaker pace than had been envisaged as recently
as last December. The sluggish growth of the global economy is also impacting on the euro
area.
Now, a gloomier price outlook need not necessarily translate into a monetary policy response
- especially if price movements have been caused primarily by a sharp drop in oil prices.
For an indication of how the strong fluctuations in energy prices impact on the forecast, one
need only consider that the projection of the inflation rate based on the current oil price, which
is around 20% higher than the price used in the projection, would be in and of itself around 0.2
percentage point higher in 2016.
Core inflation, ie the inflation rate excluding volatile components, such as energy or food prices,
also dropped unexpectedly recently. Despite a projected slight increase over the forecasting
horizon, core inflation, which is used to approximate domestic price pressures, will remain
below the definition of price stability in 2018 as well.
However, I believe it is still too early to say with any degree of certainty whether this decline in
core inflation is temporary or of a permanent nature. That is not the only reason why uncertainty
surrounding inflation projections is currently very pronounced.
Monetary policymakers can also come under particular pressure to take action if a relatively
prolonged period of persistently very low inflation sharply diminishes the longer-run inflation
expectations, as that could be a factor in keeping future inflation rates too low as well. At last
report, market-based longer-run inflation expectations, at a value of 1.4%, were indeed well
short of our definition of price stability.
This finding does not, however, represent evidence of their de-anchoring and thus of the risk
of an excessively low inflation rate taking hold. Indeed, these values could also be the
consequence of the liquidity effects of government bond purchase programmes and negative
inflation risk premiums. This, at least, is what we can gather from a comparison with
surveybased inflation expectations, which at last report fell only a very little or not at all and are
running much closer to the definition of price stability. However, the risk of de-anchoring
naturally increases, the longer economic agents observe an inflation rate which they perceive
as being sustainably below the definition of price stability.
The new forecast picture therefore certainly did present quite a monetary policy challenge and
exposed a need for action to be taken. On this topic, there was agreement within the Governing
Council of the ECB. But taken as a whole, I think the decisions went too far, and the
comprehensive package of measures didn't win me over.
My reservations concerning government bond purchases in the euro area are well known.
Similarly, the latest downturn in the outlook for prices and growth still leaves me unconvinced
of the alleged need to use this instrument, one that I regard purely as an emergency
instrument. For this will ultimately lead to a dangerous commingling of monetary and fiscal
policy. Even after taking note of the latest forecast revisions, I still see a very remote risk of a
deflationary spiral.
It is a fact, however, that the Governing Council of the ECB is striving for an inflation rate of
below, but close to, 2% in the medium term in order to fulfil its mandate of price stability.
One reason why the central banks of the major currency areas generally aim for an inflation
rate of just under 2% is because slightly positive rates of price increase provide a certain safety
margin to the lower bound on interest rates. As we now know, this bound is not exactly at zero,
nor is it significantly below that level. If the inflation target is too low, a central bank's scope for
stimulating the economy using conventional instruments can quickly be exhausted.
Naturally, the target ought not be too high, either, as we all know that inflation is costly. And
not just when inflation rates hit the double digits. Which is precisely the reason why many
central banks across the world now have the mandate to safeguard price stability.
Maybe a comparison with a ship will help to illustrate the situation. A ship ought to have enough
water below its keel at all times in order not to run aground. At the same time, too much water
would prevent the ship from casting its anchor.
It is important to emphasise that our target is a medium-run one. The medium run does not
mean "sometime in the distant future", nor does it mean "as fast as possible and at all costs".
The term "medium run" thus consciously contains a certain degree of vagueness over the
precise time horizon. This gives monetary policy the flexibility it needs to respond appropriately
to a myriad of different types of macroeconomic shock. Monetary policy would surely be unable
to cope with the expectation of always being able to guarantee an inflation rate of just under
2%, for alongside the justified desire to steer inflation back towards the 2% mark, monetary
policy must also keep in mind that there are risks associated with the protracted
low-interestrate policy and the non-standard monetary policy measures. One expression of this is that the
ECB Governing Council is having to fend off increasingly absurd demands - such as showering
the population with "helicopter money".
Ladies and gentlemen
Telling you lots and lots about the risks and side-effects of monetary policy would probably be
akin to "carrying coals to Newcastle". You all know that an ultra-accommodative monetary
policy brings with it long-term risks to the stability of the financial system.
First, because of the mounting risk of financial market bubbles. This is why some euro-area
member states have now also taken what are known as macroprudential measures in order,
for instance, to counteract excesses in real estate markets.
Of course, whenever such financial stability risks are looming, this represents a challenge,
above all, to macroprudential policy. And a stability-oriented central bank should not seek a
trade-off between monetary stability and financial stability; this will soon lead to monetary policy
arbitrariness. However, a monetary policy which is intended to ensure longer-term price
stability cannot completely ignore these risks, for at the end of the day, financial stability risks
generally also threaten price stability - as was clearly shown by the financial crisis.
Second, because profitability in the banking sector can take a hit, the severity of which rises
the longer the period of low interest rates persists and the flatter the yield curve is. As central
bankers, our concern here is naturally not the profits generated by the banks per se; instead,
it is the banks' ability to transmit monetary policy stimuli. And this capability is not independent
of capital adequacy, as the latter plays a major role in shaping banks' ability to cushion shocks.
It is all the more important, then, for banks to gear their operations towards sustainable
profitability. To achieve this, they need to review their business models, get their balance
sheets in order and harness any available scope for consolidation in order to cut costs. Failing
this, they may find it difficult during a protracted phase of low interest rates to retain profits with
a view to further strengthening their capital base.
3. Institutional framework of monetary union
Another risk of the ultra-accommodative monetary policy is that the low interest rates and the
extensive asset purchases will ease the pressure on member states to consolidate and reform.
But that's not all. These bond purchases are increasingly fusing monetary policy and fiscal
policy. For a significant share of sovereign debt, government financing costs have become
decoupled from capital market conditions: since the purchases ultimately increase banks'
surplus liquidity, when all is said and done, governments are obtaining this share of their
funding at the - currently negative - deposit rate.
With regard to the assets purchased by central banks, interest rates are quite simply no longer
being geared to the soundness of a country's public finances, which is a far cry from the
principle of capital market funding. However, bonds held outside central bank balance sheets
are also affected indirectly. On the whole, this undercuts market discipline, the intent of which
is to secure not only compliance with fiscal rules but also sustainable budgets.
The recent waning of the euro-area countries' enthusiasm for consolidation is no surprise. If
the cyclical improvements are factored out of the euro-area countries' budget deficits, adjusted
for interest expenditure, for the past two or three years the relevant primary surpluses have
either been treading water or have even been receding.
The opportunity opened up by the low interest rates to bring down budget deficits particularly
quickly was thus squandered. And this could mean repeating a mistake that was already made
by many member states in the early days of monetary union.
A recent comment in the Italian daily newspaper Corriere della Sera said it all:
"At the beginning of the new millennium, Italy wasted a golden opportunity created by the
narrowing of yield differentials, the notorious spread. The advantage afforded by accession to
the single currency led instead to an expansion of government spending, the productivity of
which was extremely low with respect to investment and jobs. It would not be desirable for this
opportunity to be squandered, either, for that is something we would deeply regret."
This quote, through referring to Italy, is certainly applicable to other countries.
In fact, stricter fiscal rules for the euro-area member states had been agreed in response to
the financial and debt crisis; however, their binding effect has proven to not be as strong as
was promised.
This is due not least to the fact that the European Commission, in its dual role as the guardian
of the Treaties and a political institution, has made compromises time and again at the expense
of fiscal discipline. But in fact the whole point of stricter fiscal rules was to ensure sounder
public finances over the long term. That was the basis for creating the permanent ESM firewall
in return.
As part of the measures to contain the crisis in the euro area, however, risks were then
communitised not only through the euro rescue shield but also through the Eurosystem's
balance sheet.
These measures undoubtedly stabilised monetary union during the crisis. Yet they have also
upset the balance between actions and liability for their consequences. The increase in joint
liability, however, has not gone hand in hand with an increase in joint action. This is a bit like
opening a joint account with your neighbour but not being able to influence your neighbour's
spending. It can work, but that is by no means certain.
This equilibrium needs to be restored in order to stabilise monetary union once and for all. In
the euro area, the principle of independent national responsibility is currently in force. The
Maastricht Treaty, with its "no bail-out" clause, even explicitly ruled out mutual liability among
member states.
However, that does not mean that each country can run up debt at will. On the contrary: sound
public finances are a key prerequisite for a monetary policy based on price stability and for
keeping the euro area stable over the long term. Therefore, additional rules were put in place
to protect the single currency: the debt rules, which were fleshed out in the Stability and Growth
Pact, and the ban on the monetary financing of the public sector, ie the ban on financing
government deficits by printing money.
At the same time, many proposals for institutional reform are aimed at increasing risk-sharing
still further, yet they remain vague when it comes to surrendering sovereign rights to the
European level. That comes as little of a surprise. After all, willingness among member states
to relinquish sovereignty is not particularly pronounced.
As long as member states cling to national decision-making, increased risk-sharing in the
policy fields affected will undermine the stability foundations of the euro area.
Let me give you a specific example. As long as member states can have a major say on the
quality of bank balance sheets, such as through national insolvency legislation, then a
European deposit protection scheme would not only be premature but would also create
incentives to shift risks to the banking system; these would then have to be borne by all.
A European deposit protection scheme, moreover, would be justifiable only if banks were less
dependent on the solvency of their home countries. However, since the banks are currently
holding large quantities of their own countries' sovereign bonds, a European deposit protection
scheme would be tantamount to communitising sovereign debt.
Without the willingness to extensively relinquish sovereign rights, there is only one way to
weatherproof the structure of the euro area: we need to reinforce individual national
responsibility by making the "no bail-out" clause enshrined in the Maastricht Treaty more
credible. After all, the only way this "no bail-out" clause can exert its disciplining effect is if
financial market players also believe it to be in force.
In order to lend credibility to the "no bail-out" rule, sovereign debt restructuring would need to
be possible without jeopardising financial stability. As things now stand, were one euro-area
member state to become insolvent, this would threaten the entire euro-area financial system
owing to the close nexus between sovereigns and banks. Member states, fearing contagion
effects, were therefore willing to provide fiscal assistance to Greece and other euro-area
countries in crisis.
But it's not just the recipient countries that benefit from the ESM firewall, the private creditors
are, too, as, thanks to the ESM loans, they get back all the funds they lent to the crisis
countries, for which they will, in most cases, have collected a sizeable risk premium. Only in
Greece have private creditors taken a voluntary haircut, but that wasn't until 2012, two years
after the first fiscal assistance was granted.
This practice is not compatible with the liability principle propounded by Walter Eucken ("Those
who enjoy the benefits must also bear the costs").
Against this background, the Bundesbank presented a relatively simple proposal a number of
years ago that is designed to prevent private investors being let off the hook at taxpayers'
expense. This idea would require the bond terms and conditions to be changed such that the
paper automatically rolls over by, for instance, three years if a country applies for ESM
assistance.
During this period, it would need to be determined whether the country was only temporarily
illiquid or actually insolvent. Should the latter be the case, private creditors could then be bailed
into the necessary restructuring. This would minimise the risks to taxpayers since the required
volume of assistance loans would be lower from the outset.
Creditor liability, of course, presupposes the creditors' ability to bear the resultant losses.
Ensuring this is, not least, a task for financial market regulation, which brings me to my third
and final topic.
4. Financial market regulation
I have already mentioned two flaws in the existing institutional framework: the weakened
binding effect of the fiscal rules and the lack of credibility afflicting the "no bail-out" rule. A third
flaw - in effect, an Achilles' heel of monetary union - turned out to be the banking system
during the crisis.
Many banks are still suffering from legacy risks in their balance sheets to this very day. Large
volumes of distressed loans have been taking their toll on poorly capitalised and insufficiently
profitable euro-area institutions, in particular. Although the cleansing of balance sheets is
making progress, it will not be completed for the foreseeable future.
Bearing this in mind, it is, moreover, little wonder that euro-area bank lending is still mired in a
slump despite the extremely accommodative monetary policy.
This state of affairs likewise shows that the expansionary monetary policy is reliant on actions
by other agents as well as by policymakers in order for its full effects to materialise. This
explains, for instance, why Japan suffered at least a "lost decade" while the United States
overcame the financial crisis very quickly.
However, significant strides have been made towards a less fragile banking system in the
seven and a half years that have passed since Lehman Brothers collapsed. Misguided
incentives were reduced and institutions' resilience has been strengthened. Important
regulatory measures have been implemented or are currently being finalised. A case in point
is Basel III, which has already increased the quantity and quality of capital being carried on
banks' balance sheets.
In Germany, the average tier 1 capital ratio was languishing at just 9.1% at the beginning of
2008. By mid-2015, though, it stood at 15.6%, while the quality of own funds had improved
perceptibly at the same time.
The revamping of the Basel framework is scheduled for completion before the end of this year.
A further significant tightening of the capital adequacy requirements, in the sense of a "Basel
IV", is not on the agenda, however. I think this is an important message, as the banking system
should not be additionally burdened by unnecessary regulatory uncertainty.
Global systemically important banks (G-SIBs), which are generally regarded as being "too big
to fail", will have to demonstrate their total loss-absorbing capacity (TLAC) going forward. But
the other EU banks, too, will be asked to hold capital instruments which, in a resolution event,
can be converted into liable capital.
Bail-in will take precedence over bail-out in future. It needs to be possible to resolve distressed
banks in an orderly fashion, with the taxpayer only footing the bill as a last resort.
Naturally, this implies higher risks to investors, who also witnessed this first-hand in the past
few months. However, those now calling into question, yet again, the liability of owners and
creditors should also step forward and say who should pay for the losses of a failed bank
instead. This must not be the taxpayer, at any rate, for that would jeopardise the standing of
our free market economic system in society at large.
Ladies and gentlemen
The creation of the Single Supervisory Mechanism (SSM) for banks in Europe has been a
significant step - the most important step, even, since monetary union was launched. The SSM
has remedied an inherent flaw in economic and monetary union, consigning the occasionally
rose-tinted glasses of national supervisors to the history books.
Much has been done, then, to make the banking system more robust. Yet a banking system
can only ever be truly stable if banks' reliance on the solvency of their national sovereigns is
effectively reduced as well.
Too little has been done in this regard thus far. On the contrary: banks in some euro-area
countries have invested heavily in their domestic government bonds in the past few years,
making them even more reliant on the health and wellbeing of their governments' public
finances. Italian banks have pumped nearly all their capital into domestic government bonds,
and the situation is similar in Spain.
The preferential regulatory treatment of sovereign borrowers is one of the primary reasons for
this. Unlike private sector borrowers, governments are not subject to the cap on large
exposures. In addition, virtually no capital is required to be held by banks against government
bonds since such bonds are permitted to be given a zero risk weight. The European
Commission's own think tank has therefore written quite rightly in a recent paper that
"zerorisk weighting of sovereign debt in the EU, as well as the exemption from existing large
exposure requirements, are a source of vulnerability."
I have therefore been advocating, for quite some time, the abolition of the preferential treatment
of sovereign borrowers and welcome the fact that this issue is now also on the agendas of the
relevant regulatory forums.
There has been opposition to this proposal and that's hardly surprising. It ought to be clear that
such rules could only be phased in gradually, as countries would need time to adjust to the
new regime. But it is equally clear that only if banks can deal with a sovereign default will the
restructuring of a highly indebted sovereign's debt emerge as a realistic option.
Financial markets are, by their very nature, crisis-prone as they tend towards exaggerations.
Smart regulation is therefore indispensable.
Appropriate capital adequacy requirements are the best and most important contribution that
financial market regulation can make towards the stability of the banking sector. The better a
bank's capital base, the more readily that bank will be able to withstand losses and a period of
low profitability brought about by the low-interest-rate setting, say. And this is a point where
some people see regulation as an impediment because, in their view, it imposes limits on
banks or creates costs. In this sense, regulation always walks a fine line between too strict and
too lenient.
In addition, care has to be taken to ensure that bank regulation does not lead to undesirable
evasive action on the part of banks. I am thinking here, in particular, of business being shifted
into what is known as the shadow banking sector, the importance of which has grown in the
past few years.
In Europe, especially, this trend is not problematical in and of itself. Given the major importance
of bank lending for corporate finance, enhancing the role of alternative, market-based sources
of funding could well be quite conducive to financial stability - provided, that is, the potential
risks are adequately and consistently regulated.
This is an area where significant progress has been made globally and at the European level
over the past few years. Examples include the regulation of managers of alternative investment
funds or the rules governing securitisation. However, a number of items on the regulatory
agenda still need to be wrapped up.
At the global level, for instance, liquidity rules for investment funds need to be developed in
order to prevent excessive maturity transformation. And, at the European level, it would make
sense, during the process of creating a capital markets union, to regulate credit funds in an
adequate and consistent manner in order to avert risks to financial stability.
Ladies and gentlemen
You might have heard the tale about the client that goes up to a bank teller and says, "Tell me
how much money's in my account - and hurry up, you fool," whereupon the teller goes to the
manager to complain about the cheeky client. The manager then asks him, "How much does
the guy have in his account?" "Three million," the teller replies. The manager then says, "Tell
him how much is in his account - and hurry up, you fool."
Quite apart from the fact that, in times of negative central bank deposit rates, large sums of
customer funds are possibly no longer all that welcome, this anecdote also seems a bit dated
in the light of digitalisation. I mean, who still goes to a bank these days to check the balance
on their account?
The current wave of digitalisation sweeping through the financial sector, in fact, goes far
beyond internet banking, which is now standard operating procedure. It is in the process of
revolutionising the banking industry.
Highly specialised, innovative financial technology enterprises, also known as fintechs,
represent a new group of competitors to traditional bricks-and-mortar banks. Blockchain
technology, originally developed for the virtual currency known as the bitcoin, has a wide
variety of uses for financial services, such as in securities trading.
At the same time, increasing digitalisation is making the financial system ever more reliant on
technical infrastructures. Cyber risks have grown considerably in the past few years.
There's no need to elaborate on this issue here, all the more so as these topics will be
discussed on several occasions in the course of today. It is clear that digitalisation and
cybersecurity are a major challenge not only for banks but also for supervisors.
We should not stifle the innovative power of fintechs, yet we need to keep an eye on potential
risks to financial stability. To quote Felix Hufeld, the head of the German financial supervisor,
"It is not a firm's 'coolness factor' which is decisive, but the type of business it conducts and
the risks it takes in doing so."
Ladies and gentlemen
There is no question that banks are currently facing major challenges. However, I have no
doubt whatsoever that banks will also continue to play a crucial role in the European financial
system going forward. Since the economic structure features a large number of small and
medium-sized enterprises, the financial system will remain primarily bank-based.
5. Conclusion
I would like to conclude with a few remarks.
At the beginning, I quoted a journalist who, at banking conferences, always heard all those
words ending in "-ing" and "-ation." As you will have noted, my speech, too, was teeming with
nouns ending in "-ing" and "-ation"
I started with monetary financing of the public sector, continued with fiscal consolidation and
interest rate differentiation, the disciplining effect of the markets and the restructuring of
sovereign debt, the finalisation of regulation, the "deprivileging" of government bonds, and I
ended with digitalisation.
The Canadian-born economist John Kenneth Galbraith, who passed away nearly ten years
ago, is credited with the caustic remark that "meetings are indispensable when you don't want
to do anything."
With regard to the Finance Forum Liechtenstein, that's most certainly not a view that I would
espouse. Quite the opposite, in fact - exchanging views and refreshing contacts is certainly
doing something, and will ultimately also benefit your firms.
I would therefore like to wish you a rewarding conference and thank you for being such an
attentive audience.