hermann remsperger : financial stability issues – a view from the bundesbank 1 speech by professor dr hermann remsperger, member of the executive board of the deutsche bundesbank, at the china society for finance & banking, beijing, 7 november 2007. * i * * introduction ladies and gentlemen, first of all, i would like to thank the “ china society for finance and banking ” for giving me the opportunity to hold a speech on “ financial stability issues ” in beijing today. i have to admit that i talked about a very similar subject in brussels at the end of june. 2 four months separate these two speeches. and, what is more, in the intervening period there has been turmoil in the financial markets that has captured our attention. of course, i do not want to pretend that i foresaw this turbulence. nevertheless, i cannot resist the temptation to quote a few lines from my brussels speech here in beijing as an introduction to my talk today : “ i believe there is a certain risk in the fact that not enough consideration is being given to the time when this period of market calm comes to an end. ( … ) i still see risks in the kind of things that are happening in the financial markets. these risks are not only of a cyclical nature. in some cases they are closely linked to structural changes occurring in the financial sector. ” despite all these warnings, at the time i said that the financial system was in robust shape overall. this assessment was based mainly on the resilience shown by financial institutions in the financial markets ’ spring turbulence in 2006 and 2007. now we are in the autumn of 2007. and we have every reason to look to the “ hot ” financial summer of this year. before i enlarge on this subject, let me explain briefly what i mean by financial stability. at the bundesbank, we define it as the ability of the financial system to perform its key functions efficiently, namely the allocation of capital and risks and the settlement of payments and securities transactions. these functions must also be fulfilled smoothly in stress situations and during periods of structural adjustment. as central bankers, we are interested in financial stability because a stable financial system is a precondition for the effective transmission of monetary policy decisions into the real economy. disturbances in the financial system, including speculative bubbles, can delay or impair the transmission process. today, i will look at financial stability in the light of the recent turbulence. i would like to share my

alone to take any promising measures to prevent the recurrence of such developments. at present, a whole range of international bodies are inquiring into various aspects of the turmoil. in my view, the financial stability forum is a “ natural choice ” for discussing the recent events. the bundesbank also contributes to the work of the forum. recently, the forum set up a working group that is to examine the underlying causes of the recent financial market turmoil and make appropriate recommendations. of course, other bodies, such the committee on the global financial system and the international committees of supervisors ( for example, the basel committee on banking supervision, iosco ) are currently working on this issue. in my view, at least two weaknesses in the current system should be discussed in all these fora : liquidity risks and a lack of transparency. i will now first talk about liquidity and then discuss transparency issues. liquidity issues this summer, it became more than obvious that liquidity is essential for the functioning of the financial system and thus key for financial stability. in my view, we should make a distinction between three different types of liquidity : market liquidity, which is generally defined as an asset's ability to be easily bought and sold without causing a significant movement in its price, funding liquidity – in other words, the access to markets for funding – and monetary liquidity provided by central banks. let me start with some remarks on monetary liquidity. many observers see a link between years of ample monetary liquidity and what is known as search for yield. david dodge, governor of the bank of canada, argues that the increase in securitisation implied an easing of credit conditions. the securitisation probably led to the creation of loans that would not otherwise have been made. monetary policy may thus have been less restrictive than thought. but this effect, and here i also agree with david dodge, should not be overestimated since inflation rates remained contained. what i would like to stress, nevertheless, is that central banks need to take account of the link between monetary and market liquidity. in particular, we must be aware that a change in monetary liquidity can result in a more than proportional effect on market liquidity. let me add that during the turbulence central banks had a very difficult task : ensuring the functioning of the money market without creating moral hazard. the ecb initially responded to the disruptions in the money markets by providing overnight liquidity and additional liquidity with a