vitor constancio : the governance of financial stability in the euro area speech by mr vitor constancio, vice - president of the european central bank, at the “ ecb and its watchers xiii ” conference, frankfurt am main, 10 june 2011. * * * introduction ladies and gentlemen, it is a pleasure to take part in this thirteenth edition of the ecb and its watchers conference. i would like to use my intervention today to reflect on how the economic and financial crisis should alter policymakers ’ conception of the governance of financial stability in the euro area. prior to the crisis, financial stability was often viewed in a rather abstract manner, as a condition that flowed from other well - defined pre - conditions – for example, low inflation – or as a concept that could only be addressed after the fact – for example, once bubbles had burst. however, the crisis revealed that financial stability warrants much more prominent attention : first, it became clear that financial stability depends on a much broader range of sources than was previously acknowledged, from both macroeconomic imbalances in the real economy and imbalances in the financial sector. second, it was revealed that the channels through which financial instability could spread are various and complex, with negative consequences for both the financial and real sectors, thus requiring ex ante and not only ex post policy responses. these two findings militate in favour of a more comprehensive policy framework for governing financial stability in europe, which should comprise in my view the following. first, the full implementation of the economic governance reform, which is presently under discussion. it is unquestionable that a sound and credible framework of economic governance is fundamental for financial stability, as, for example, public debt developments have demonstrated. second, a strengthening of financial supervision in the euro area. this should be understood as an essential component for the overall effectiveness economic governance alongside the strengthening of the fiscal pillar, the surveillance of macro - economic imbalances, co - ordination of economic policies, and the european stability mechanism. i will organise my remarks today as follows. i will begin by examining how the crisis unveiled the shortcomings of economic governance in what regards in particular the channels through which financial instability can propagate in the euro area. i will then propose what should be, in my view, the five key components of financial stability governance, highlighting in particular the necessary euro area dimension of such governance. economic governance and financial stability the crisis provided some important lessons for economic governance

this year, it is difficult to assess its effectiveness comprehensively. however, it could be instructive to review ex ante the robustness of the analytical toolbox assigned to the esrb, and consider ex post whether such a toolbox would have enhanced policymakers understanding of systemic risk prior to the crisis. before doing so, i should make clear that the purpose of the esrb is not to predict crises. the academic literature on early warning signal models, developed over the years, suggests that, for a number of reasons, the scope for error in predicting crises is substantial. either the eruption of a crisis is missed or a period is wrongly identified by the start of a crisis. for this reason, the esrb ’ s analytical toolbox is based on early warning models and indicators designed to identify emerging vulnerabilities or imbalances that could lead to financial instability. these models aim to perform three functions in particular. first, to identify the variables which are associated with financial instability. to this end, an index of aggregate macro - financial imbalances, or of institution - specific vulnerabilities, is tested against variables such as credit growth, property price changes, private sector leverage and current account deficits, to discover which variables predict that index. measures of bank leverage, balance sheet growth and maturity mismatches may also be used in order to gauge the extent to which the financial sector is driving developments. second, to assess the relative importance of different risks for financial stability. this is done using “ adverse scenarios ” that are designed and macro stress - tested to establish the potential severity of different types of risk and the overall resilience of the financial system to severe shocks. such models, including top - down stress test of individual institutions, allow risks to be assessed more broadly and at a higher frequency than is possible with bottom - up exercises run by financial institutions, thus enhancing the “ real time ” information on systemic risk available to policymakers. third, to assess the financial channels through which risk can be propagated, thereby factoring - in potential second - round effects. the use of contagion and spillover models allows, for example, the assessment of the impact on the financial system of the failure of a particular financial institution or of turbulence in a particular sovereign debt market. bis central bankers ’ speeches we could consider how this framework would have functioned if applied retrospectively. for example, the monitoring of the credit - to - gdp ratio as an early warning