yves mersch : european lessons to be drawn from the crisis to improve global financial stability speech by mr yves mersch, governor of the central bank of luxembourg, at the 54th congress of the international association of lawyers ( union internationale des avocat, uia ), istanbul, 31 october 2010. * * * excellences, ladies and gentlemen, three years after the first turbulences occurred on the interbank markets, it is apparent that they marked the beginning of the most severe crisis since the end of world war ii. as the crisis is not yet over, we still lack the perspective of setting up a comprehensive list of lessons from the crisis. nonetheless, i thank the international association of lawyers for inviting me to share my views on this issue. in my speech, i will highlight the causes of the financial crisis, the political responses, and the likely consequences. in particular i will make clear, that policy responses cannot be applied globally but need to take into account the structure and special features of an economic area. as a member of the governing council of the european central bank ( ecb ) i will elaborate on the european experiences and challenges and the role of monetary policy in particular. however, what i will say should not be interpreted in the context of the future monetary policy decision of the governing council next thursday. you might recall that my colleagues and i are in our purdah period. causes of the crisis let me start with an overview of the causes of the financial crisis, giving examples of market and government failures, referring to an excellent analysis by guillermo de la dehesa, chairman of the centre for economic policy research ( bold mine ) : “ the first failure appeared when the u. s. government tried to encourage wider homeownership by households, allowing every american family to be entitled to mortgage loans, regardless of their income level or their ability to pay, thus creating a problem of “ adverse selection ”. [ … ] the second failure occurred in the originated and securitized subprime mortgages market, both in terms of government regulation and supervision. on the one hand, the majority of mortgages were not originated by the banks but by agents and brokers working on commission, who were not regulated and who were only required to obtain an administrative local state permit to sell financial products. therefore, their main objective was to sell a mortgage to a family and charge a commission without much effort to verify whether the mortgage holder could pay it. [ … ] the third major failure

but, we have to be conscious that in some cases and without public interventions, as in germany and the uk, a few banks would have been in serious trouble. at a recent conference at banque de france, professor h. rey of london business school assigns the contagion from relatively small losses in the u. s. sub - prime market of a magnitude of usd 200 billion into a global financial turmoil to three major market dysfunctionalities : 1 ) the first one is due to the originate and distribute model ; 2 ) the second one can be explained by a process referred to as the cds vicious circle ; and the third one 3 ) is attributed to mark to market asset valuation. in fact, one of the core lessons of the current financial turbulences is the failure of the “ originate - and distribute ” business model. until the sub - prime crisis, a number of experts argued that securitization had contributed to a stabilizing effect on the global financial system through diminishing the degree of risk on the banking sector by sharing it more widely. theoretically, this will be the case. but, excessive recourse to securitization in reality may create a lot of uncertainty and increase the opaqueness of the financial market. indeed, several financial institutions were unable to give us their real exposure to the sub - prime market. in addition, the still heterogeneous disclosure across firms raises doubts on the realism of the valuation provided by the industry. many have to confess that they did not understand the complexity of various financial products they use. in addition, the impact of the us mortgage defaults has spread to other asset classes and across the global financial system. investors did not know which parties were exposed and how big their exposures were! uncertainty got settled and gave rise to both more market volatility as we have seen in recent months and to a sharp increase of investors ’ risk aversion ( see chart 2 ). • since december 2007, attention has been drawn to insurance companies and their monoline financial guaranty activities. the monoline insurers became the next potential victim of both sub - prime crisis and financial market turmoil. until the recent turbulences, monoline insurers were very successful at avoiding losses and their business model exhibited a very high operating leverage with a fairly low capital base and reserve positions compared to the amount of insured risk. this common practice was allowed in the past, but has become a major source of concern at present