lorenzo bini smaghi : risk management in central banking speech by mr lorenzo bini smaghi, member of the executive board of the european central bank, at the international risk management conference 2011, free university of amsterdam, amsterdam, 15 june 2011. * * * introduction1 it is a pleasure for me to speak at this international risk management conference 2011, and particularly to contribute to this workshop on financial stability. in my remarks today, i would like to elaborate on two interrelated issues, namely financial stability and the risk management function in central banking. i plan to structure my talk in two parts. first, i will discuss the role of central banks as liquidity providers and lenders of last resort, seeking to preserve financial stability as a necessary, albeit insufficient, condition for achieving their primary objective of price stability. this role will in turn explain why central banks, including of course the eurosystem and the ecb, have expanded their balance sheets during the crisis. second, i will elaborate on risk management in central banks, explaining how this differs from risk management practices in private financial firms. in doing so, i will also talk about the risk management framework of the ecb and the eurosystem and how this contributes to the ecb ’ s policy goals, among other things, by ensuring the institution ’ s financial protection. my objective is to provide a better understanding of the specificities of central banking activities in the supply of liquidity to the financial sector. i will also clarify why certain comments that have been made recently about central banks – in particular the ecb – becoming “ bad banks ”, as a result of their actions during the financial crisis, are fundamentally flawed. 1. central bank as lender of last resort the financial crisis has reminded us how, after a negative liquidity shock, financial firms may be forced to liquidate assets that they hold in stock in order to preserve a cash buffer. this naturally puts downward pressure on the market value of those assets. and when asset values decrease, other financial firms which hold that type of asset in their portfolios may be forced to sell as well to protect their balance sheet and in particular their desired capital ratio. downward spirals can therefore ensue, which may seriously imperil the financial stability of the entire system. if risks become systemic, investors collectively try to escape them by scrambling for an “ outside asset ”. when situations arise in which all counterparties appear to be at great risk, the only safe

aggregate demand and supply becoming more aligned and lower energy prices in recent months being passed on to other parts of the economy. labour costs are increasingly contributing to domestic inflation, while the latest data indicate that the 1 / 4 bis - central bankers'speeches contribution of profits fell for the first time since early 2022. most measures of longerterm inflation expectations currently stand at around 2 %, but the increase in some indicators needs to be closely monitored. the september ecb staff macroeconomic projections see average inflation at 5. 6 % in 2023, 3. 2 % in 2024 and 2. 1 % in 2025. compared with the june eurosystem staff projections, this is an upward revision for 2023 and 2024 – which mainly reflects a higher projected path for energy prices – and a downward revision for 2025. ecb staff have revised down slightly the projected path for inflation excluding energy and food, to an average of 5. 1 % in 2023, 2. 9 % in 2024 and 2. 2 % in 2025. this is on account of tighter financing conditions – which also reflect the restrictive impact of our monetary policy tightening – and a weaker economic outlook. the ecb's monetary policy response in summary, while inflation continues to decline, it is still expected to remain too high for too long. the ecb is determined to ensure that inflation returns to our 2 % medium - term target in a timely manner. in order to reinforce progress towards this target, we decided to raise the three key ecb interest rates by 25 basis points at the september meeting of the governing council. this decision was informed by the three legs of our reaction function : first, the inflation outlook in light of the incoming economic and financial data ; second, the dynamics of underlying inflation ; and third, the strength of monetary policy transmission. having raised interest rates by a total of 450 basis points since july 2022, we consider that the key ecb interest rates have now reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to our target. our reaction function will continue to serve as the framework for future decisions, and we will continue to follow a data - dependent approach to determining the appropriate level and duration of a restrictive monetary policy stance. uncertainty regarding the transmission of monetary policy as part of this data - dependent approach, we continually assess how monetary policy is transmitted to financing conditions, the real economy and, ultimately, to inflation. in