Mario Draghi: Combating the global financial crisis - the role of
international cooperation
Text of the HKMA Distinguished Lecture by Mr Mario Draghi, Governor of the Bank of Italy
and Chairman of the Financial Stability Forum, Hong Kong, 16 December 2008.
* * *
Introduction
It is an honour and a pleasure to be giving this HKMA distinguished lecture. I thank Joseph
Yam for his kind invitation. I also thank Joseph and his colleagues at the HKMA for hosting
the FSF Asia-Pacific Regional Meeting that has just concluded.
The crisis afflicting the global financial system has now reached a critical stage. On the one
hand the combined responses of governments, central banks, regulatory authorities and the
private sector have created a base of stability, admittedly still fragile, for the world financial
system. On the other hand, the sharp slowdown in global growth will necessarily translate
into credit losses that will have a further impact on the banking industry. To mitigate the
recession and break this vicious circle a further round of responses - including fiscal,
monetary and regulatory policies - is proving necessary.
Shortcomings in assessment ahead of the crisis
One striking aspect of the crisis is precisely how its unfolding has continued to catch both
policy makers and private sector players by surprise. It started with defaults in a marginal
segment of the financial services industry, then quickly spread to virtually all assets. From
being a US-only event, it has become global, and in fact it is forcing and accelerating the
redressing of world macro imbalances that have been with us for 15 years. The current
recession is the result.
None of these steps had been anticipated in a timely way by the relevant actors. And when I
say "in a timely way" I mean with enough lead-time to permit action that could have affected
the outcomes. Policies that were reactive, and sometimes even very effective, but never
proactive, seem to have been the rule. This is of course not the approach to policy-making
that we try to employ when it comes to controlling inflation or meeting other objectives of
macroeconomic policy. One reason for this asymmetry is that our knowledge of all the
interactions within the financial services industry in a global world was quite superficial at the
beginning of the crisis.
The private sector has not done any better. The immediate outcome of the private sector's
own shortcomings in assessment has been the sudden death of many businesses and a
generalized credit contraction. Our collective understanding of these processes has certainly
deepened during the last year but we do not yet have a conscious and fully-fledged view of
how the financial sector will look in the years to come. Much of the effort has gone so far into
initiatives to address the short-term and medium-weaknesses in the system, but now we may
be approaching the time when it will be appropriate to start thinking about reconstruction. To
do so, however, we first have to see when and how reality eluded our or the market's
perceptions ahead of the crisis.
First, the underlying reason why problems in US subprime loans led to the current
broadbased macrofinancial crisis was the global nature of exposures to increasing risk aversion
and deleveraging. Risk is now priced and traded at the global level. Over the years preceding
the crisis, the overall price of risk fell significantly, and risky, illiquid positions were
accumulated in many different national and international markets. When problems emerged
in the specific category of US subprime, this started a process which ultimately led to a
repricing of risk across all asset classes. As Tim Geithner noted when he delivered this
lecture two years ago, this pattern is not a new one: in times of financial crisis, when
investors cut risk-taking, they cut it everywhere, and the differing fundamentals of individual
markets become irrelevant.
Second, many saw risks and leverage increasing, but an optimistic view that overestimated
the true degree of risk dispersion and diversification in credit markets had become the
conventional wisdom. In particular, even when it became apparent that credit standards had
deteriorated, neither capital markets, nor bankers, nor regulators perceived the extent to
which the risk exposures generated by securitisation stayed on bank balance sheets. Also
we collectively overestimated the ability of the system to absorb, rather than amplify,
pressure for de-risking and deleveraging. On another front, it was only once the crisis was
underway that the world seems to have discovered the risks inherent in business models that
relied excessively on wholesale funding markets, both for specific institutions and for the
system. And, given that these risks were misunderstood at the domestic level, all the more
so was this the case at the international level, where firms, investors and regulators were
farther from the markets where these bad risks were originated.
One way to explain this collective blindness is to review those market developments that, in
the years leading to the crisis, made both the regulators' and market's knowledge suddenly
obsolete, while increasing the opacity of the financial system as a whole. Let me give you a
few examples.
•
For the first time in recent years securitization was applied to lower quality
mortgages. Monitoring by capital markets of this lower quality was made difficult by
the fact that the probability of default did not factor in i) the probability of a drop in
real estate prices in the US at the national level, which had not occurred since the
Great Depression, ii) the effects of changes in lending standards on probabilities of
default in these markets, or iii) the cross correlation across defaults and between
defaults and the rest of the economy.
• Second, especially after 2004, the massive amount of issuance of collateralized
obligations by a few players increased both the market power of these players over
the credit rating agencies and their dependence on this source of revenue.
•
Third, the SEC's relaxation in 2004 of pre-existing limits on leverage for investment
banks vastly increased the complexity of their risk management. For some time
neither banks nor regulators seemed to have fully perceived how this decision would
radically change the industry.
• Finally, the rapid growth of the CDS market, which in ten years went from zero to 44
trillion dollars in notional amounts, created an entirely new definition of counterparty
risk that was much more difficult to assess, evaluate and collateralize.
With the benefit of hindsight one may be tempted to say that regulators should have probed
more deeply, for example, into the risk characteristics of triple-A rated super senior CDO
tranches, and should have realised that the risk of a very sharp fall in the credit quality and
market value of such instrument was much greater than that of a triple-A rated bond. And,
since it is the responsibility of supervisors to be especially attentive to tail risks and extreme
events, they should have required banks to make appropriate capital charges against these
instruments. This might have been the right thing to do but, as the previous discussion has
shown, the knowledge leading to that type of behaviour simply was not there.
There are many lessons that one should draw from the current crisis but one especially
stands out for its general and all-encompassing character. In the future we will all be much
more alert to the systemic implications of both market developments and of our own
decisions, and this will have profound implications in many different ways. For one thing,
financial innovation will not simply be welcomed for its narrow, specific benefits, as has been
the case in the past, but it will be carefully scrutinized for its potential systemic risks. This
may well dampen the growth of the financial service industry, while enhancing its survival in
the long term. Furthermore, it is no longer true that the threat to let a financial institution fail is
the most effective weapon against moral hazard. When implications of defaults are systemic,
and in a global world this is the case much more often than in the past, this threat is not
credible to say the least. And with this goes our reliance on the financial system's incentive to
credibly regulate itself, unless we can find other mitigants of moral hazard that are immune to
systemic implications. Finally, we as regulators have to take a closer look at ourselves, with a
view to eliminating everything that contributes to our segmented perception of events in the
financial system.
Response to the crisis
A financial crisis - an event in which the financial system fails at its core tasks, including
allocating savings, financing investment, pricing assets, and transferring risk - poses difficult
challenges to policy in terms of assessment and the calibration of responses. These tasks
are difficult at the domestic level, and still more complex at the global level.
A critical set of challenges relate to information gaps. We have made progress in recent
years in developing analytical tools and metrics for assessing risks ahead of a crisis.
Unfortunately, almost by definition, a crisis involves events and processes that are
unexpected. And once problems emerge, their dimensions and implications are impossible to
gauge quickly. At the international level, assessment is more challenging still. Cross-border
exposures are difficult to assess, and it is especially difficult to anticipate confidence effects,
which are often the primary means of cross-border contagion.
Also, determining how to calibrate the response is a classic case of decision-making under
limited information and uncertainty. There is no way to know either ex ante or ex post
whether one made the right choice. A too hasty response in some countries may increase
moral hazard in others. But, when we have reached the stage where a forceful response is
needed, a delay by some countries in joining the others will dilute the impact of this response
and delay prompt resolution.
In summary our own vastly imperfect knowledge and its segmented nature would have made
a faster and more effective crisis response unlikely, since we were just learning what to do
while the crisis unfolded. Under the circumstances, I think governments and central banks
have been remarkably flexible and open-minded in developing and implementing creative
responses to the conditions that we have faced.
We can identify four distinct areas where authorities have needed to act: funding liquidity
pressures in interbank markets; solvency risks facing systemically important institutions;
medium- and long-term measures to strengthen the system; and the slowdown in the
macroeconomy. Each has featured a number of critical information gaps that have had to be
overcome, and each has presented its own challenges in terms of international coordination.
Liquidity pressures were the primary focus of policymakers in the early stages of the crisis,
starting in August 2007, and have remained a concern ever since. Central banks understood
at an early stage that they needed to act, and act quickly, given the sudden and rapid rise in
the market's demand for liquid funds, an asset for which they are ultimately the only source
of supply. Central banks initially focused on their own markets, but given cross-border
confidence effects as well as the need for foreign currency liquidity in many markets, they
rapidly developed a number of channels of cooperation, including coordinated policy
announcements and foreign currency swap lines.
After the collapse of Lehman in September, the systemic nature of the crisis has manifested
itself with unprecedented force. In financial markets, we have observed a rapid shift from
liquidity to credit risks, from a prevalent recourse to the market and central banks to massive
governments' intervention. Responses have included varying combinations of deposit
guarantees, debt guarantees, capital injections, and asset purchases. While these have
varied with local conditions, the need for coordination is well understood, and work to make
these responses consistent is well underway.
What have been the lessons of the experiences of recent months in dealing with the liquidity
and solvency problems that have buffeted financial systems? For one thing, we have learned
that in this new global risk environment the speed of developments has increased
dramatically and correspondingly reduced the time that authorities have for an effective
response. This has further increased our reliance on preventative measures ahead of a
crisis.
Second, we have learned that the international aspects of crisis response have become
many times more important than before. The transmission of shocks across borders now
happens through more diverse channels than even a few years ago. Given the many
international externalities involved in the measures that might be taken by national
authorities, the mechanisms for coordinating crisis response need to be in place well in
advance. Plans need to be formulated and potential consequences must be thought through.
Resolution procedures and bankruptcy arrangements also need to be harmonised better
across markets.
Strengthening the system
From the start of the current crisis, it has been clear that short-term measures to address
liquidity and solvency have had to be complemented by actions to strengthen the system in
the longer term. Just as there are critical externalities in short-term response measures that
call for international coordination, these longer term actions have needed to address the
cross-border effects of regulatory policies in order to assure the maintenance of a level
playing field.
The work to strengthen global systemic resilience is proceeding with a degree of international
cooperation and at a speed that would have been unthinkable only one year ago. In
developing these initiatives, there has been a broad underlying consensus among authorities
that the goal should be to create a financial system that is less leveraged, better capitalised,
and more transparent, and that features stronger incentives for all participants in the system.
The FSF has proven to be an effective vehicle for coordinating these actions at the
international level. Thanks to our broad sectoral membership, which encompasses finance
ministries, central banks, top regulators, international institutions, international
standardsetting bodies, and expert groupings, we are able to keep one another apprised of the risks
facing different sectors and of our respective work programs. Importantly, our membership
includes most of the key actors responsible for implementing the actions that we
recommend. The willingness of our members to exchange information and views, and to alter
and accelerate work programs, has been truly remarkable. However, the crisis has also
pointed up the need for us to expand our membership geographically, particularly with
respect to the larger emerging economies. This is an issue that we are working on very
seriously and on which we expect to make progress soon.
A first set of initiatives taken by the FSF has focused on reducing information gaps: in terms
of the raw data available to authorities and the market; in terms of the mechanisms, such as
credit ratings, through which this information is compiled and used by the market; and in
terms of the analytical work we do in the official sector to assess risks and vulnerabilities in
the system. Improved international accounting and disclosure practices should help markets
and authorities understand risks and exposures better. Accounting standard setters have
been taking important steps to address weaknesses in such areas as the valuation of illiquid
securities and the treatment of off-balance sheet vehicles. Securities regulators have taken a
number of actions intended to improve the role of credit ratings in the system, to clarify their
appropriate use by investors and regulators, and to address concerns about conflicts of
interest in the ratings process.
Closer collaboration between the IMF and FSF is one way that we in the global community
hope to improve our ability to stay on top of risks in the future.
A second set of initiatives has focused on prudential regulation and oversight. I believe
strengthened capital and liquidity frameworks will be seen as a central achievement of the
work to enhance systemic resilience. More capital will be required against trading and
securitisation risks, and more intense oversight will be applied on liquidity risk management
by banks. These improvements will be phased in carefully, so as not to exacerbate situations
that are still fragile. Given the importance of preserving a level playing field, this work has
necessarily been coordinated internationally.
Third, the FSF has initiated different work streams directed at reducing procyclicality in the
financial system, i.e. the tendency of the financial system to accumulate excessive risk and
leverage in good times and to shed risks excessively in a downturn. Efforts are also
underway to improve the incentives created by compensation systems in financial firms.
Fourth, supervisors have agreed to cooperate more closely in overseeing internationally
active banks, through such vehicles as supervisory colleges.
Finally, going forward, it will be crucial to review the perimeter of regulation, in order to
reduce gaps and inconsistencies in regulatory regimes and to address potential systemic
issues that are present in sectors currently not regulated.
New challenges for macroeconomic policies
While this structural response is clearly an essential part of the cure, as it helps to renew
confidence in the markets, it is also clear that many of the measures we are taking or
discussing will only have an impact over the medium term. This is in the very nature of a
structural response, which is foremost concentrated on the regulatory framework.
Today the immediate challenge we face is to avoid a situation where the recessive forces
deepen and combine with the impairment of financial markets in creating a vicious spiral.
Over the last few months, the outlook has quickly shifted from slowdown to recession, from
supply to demand shock, and from inflation to deflation risks.
This new situation requires not only further and bolder actions, but also to step up the level of
cooperation and common understanding between policy makers both at the national level
and internationally. Let me briefly review the main challenges confronting the conduct of
macroeconomic policies looking forward.
Monetary policies
Monetary policies in response to the drying up of global liquidity have been extremely
responsive and fully cooperative. On October 8, coordination in the monetary field reached
new heights, with the simultaneous reduction of interest rates in eight major central banks.
Since then official interest rates have been reduced in rapid and successive waves across
the globe, responding to the deterioration of the economic outlook and the rapid receding of
inflation. Today the margins for further action are rapidly shrinking particularly in the US and
Japan where policy rates are close to their zero lower bound.
Rapidly falling inflation expectations and, in some areas, deflation risks, together with the
impossibility of lowering rates below zero, pose the most challenging test for the
effectiveness of monetary policies. We know that the inability to maintain sufficiently low real
interest rates has aggravated crises in the past. At the start of the Great Depression, for
example, short term real interest rates actually increased in the US (up to more than 10 per
cent!) until 1933, because of the rapid fall in inflation. In the Japan of the "lost decade" short
term real interest rates remained relatively high until 1995. Such developments have been
often pointed to as key factors driving these economies into prolonged depression.
The list of monetary policy instruments available to central banks to reflate the economy
when official rates are close to or at zero is fairly wide. It includes:
• a "quantitative easing" policy, i.e. expanding the money base beyond what is strictly
needed to keep the official rates at zero, in order to reduce liquidity risks and provide
incentives for financial intermediaries to expand their credit (elements of this policy,
amply used in Japan until recently, are visible in the exceptional actions of many
central banks today);
• measures to reduce longer term interest rates, through direct purchase of long term
government securities and/or carefully designed communication to influence market
expectations (Bank of Japan and the Fed in 2002-03); and
•
the purchase of a wide range of private assets from securities to equity (as our
guest, the HKMA, experienced during the Asian crisis ten years ago).
As effective these unconventional monetary policy instruments may be in boosting the
economy when price stability is at stake, we have to be aware of their limits and of their
broader implications.
First, the effects of many such policies are not well-known: the conduct of monetary policy is
bound to be surrounded by much more uncertainty than is normally the case. It is for
example unclear how far longer term rates, and in particular the risk premia embedded in
those rates, can be brought down by liquidity injections in a situation of widespread
uncertainty about economic prospects. Well designed communication by central banks may
be crucial in this respect.
Second, and most importantly, we should always keep in mind that the responsiveness of the
economy depends to a large extent on the health of financial intermediaries, in the absence
of which even powerful liquidity injections are not greatly effective.
Third, there is a risk of introducing distortions in financial prices, and this calls for particular
care in designing the measures.
Fourth, unconventional measures may have a more direct redistributive impact on specific
sectors of the economy or categories in society than normal monetary policy actions. This
implies a high degree of common understanding and cooperation between fiscal and
monetary authorities, as part of a clear definition of respective responsibilities and fields of
action.
Fiscal policies
As the effectiveness of action in the monetary field becomes less certain, fiscal stimulus
becomes more necessary. When financial markets are not working properly and credit
constraints are widespread, private spending is more sensitive to current disposable income,
and the impact of a fiscal stimulus is therefore greater.
To maximize their effectiveness, fiscal actions should not affect the longer term sustainability
of public finances, in order to avoid the expectations of higher future taxes; moreover, the
stimulus has to be directed where its impact is strongest and fastest.
In the current circumstances, the size and quality of international coordination is crucial.
Uncoordinated moves create spillovers and relative price or exchange rate movements that
can greatly reduce the incentives to implement a fiscal stimulus at the individual country
level. On the contrary, with coordinated action taken globally, an individual country's
measures will be more significant with the joint benefit of an increase in foreign demand. The
quantitative effects of the spillovers can be quite substantial. Recent simulations conducted
at the Bank of Italy find that a coordinated fiscal action at the European level could increase
by some 30 per cent the impact of the same measure taken in Italy alone.1 The results
reported by the IMF in its latest World Economic Outlook are also quite telling in this
respect.2
Moreover, in the case of concerted action, country level risk premia may remain more stable
than otherwise.
But coordination does not imply that every country has to do the same. Starting conditions
need to be taken into account. Countries that are net creditors vis-à-vis the rest of the world
and with sound public finances, in Asia and Europe, obviously have the possibility to take a
frontline position. By doing so they would not only reduce the consequences of the crises for
their own economies but also help to contain the weakening of net debtors' economies and
currencies. Moreover, bolstering internal demand in these countries goes in the direction of
reducing the large global imbalances accumulated so far and thus may help to set the
foundations for a more sustainable growth looking forward.
In other countries, where public finances and/or net external positions are less sound, the
margins for action are obviously more limited. This does not mean that they are nil. But it
implies that medium term growth-enhancing and debt-reducing policies become more crucial.
For example, compensating actions may be taken to bolster pension reforms, in order to
lighten the burden coming from an aging population and increase participation rates; or to
implement deep restructuring measures in the public sector to enhance the efficiency and
quality of public spending. If taken with determination, such actions can create room for
maneuver in these countries so that they can alleviate the effects of the crisis and improve
growth prospects.
As fiscal measures are being taken in many countries to counteract the economic
contraction, the need to ensure that individual actions come to form a coherent approach is
more pressing. In Europe, the European Commission has proposed a plan, currently under
discussion, for a concerted action of fiscal authorities, that is very much in line with the
principles I have just outlined. In the context of the European single market this is an
absolute necessity. But I think that great benefits could derive from adopting a similar
approach at the global level.
Conclusion
The main theme of this conversation is that at the origin of the crisis we find a variety of
market developments spurred by financial innovation that were not understood neither by the
market actors, banks, and capital markets, nor by regulators. The future challenge lies in
producing an environment that is innovation friendly but where knowledge of market
participants is adequate. This objective is certainly not realistic for all sorts of financial
innovation, for some of the products we discussed, a model taking into account and pricing
all risks simply doesn't exist. In other cases the limits to how much financial innovation will be
accepted or allowed may come from the unwillingness of the relevant private sector players
to provide all the necessary information. Whatever the case it is likely that the future financial
system will have more prudential oversight and more standardisation than in the past.
This crisis, as painful as it is, provides all of us with valuable experience that we at the FSF
and more generally the supervisory community are building on in designing the future
financial system. However the crisis has been remarkable in raising the awareness of all
authorities about the need to cooperate and coordinate their actions domestically and
internationally. Let us hope that the present momentum will stay even when the situation will
improve, as I am confident it will.