by Jean-Claude Trichet, President of the ECBdelivered at the Second Conference of the Monetary Stability Foundation,Frankfurt, 3 June 2004.
Ladies and gentlemen,
I am delighted to be here in Frankfurt, speaking to such a broad audience, on a subject that holds great importance for all of us: financial stability and globalisation. At the European Central Bank, we closely monitor financial stability in the euro area. A precondition for successful monetary policy transmission is a sufficiently robust financial system that efficiently allocates financial resources in the economy. We must also keep abreast of financial developments beyond the boundaries of the euro area, as they may have an impact on the stability of the financial system in our part of the world.
Today, I would like to take a step back from daily market movements, and consider the implications for financial stability, and for authorities striving at maintaining it, of ongoing structural changes in the financial system. In particular, I would like to draw your attention to three major trends that have emerged in the last few years. They are the increasing role of financial market activity, the globalisation and cross-border integration of financial markets and, as both a response and a spur to the first two developments, the rapid pace of financial innovation. Given the topic of my speech, I shall emphasise issues relating to the globalisation of the financial system.
A common thread among the three developments I just outlined is that they are unambiguously improving the efficiency of the financial system in allocating capital and sharing risks. However, since they bring new financial stability risks with them, they also demand responses from the authorities.
To organise my remarks, I will begin by discussing the first two developments in financial markets in terms of their implications for financial stability. Then I shall discuss the market response to these implications, emphasising the role played by financial innovation. Last, I will analyse the regulatory responses that have either already been set in motion or that might still be needed.
A. The increasing role of financial market activity and the globalisation of financial markets
As an important, indeed viable, alternative to bank loans in the financing of the economy, the increasing role of financial markets derives from a longer-term trend that has been in place over the past 10 to 20 years in most, if not all, mature economies. The factors that have stimulated the growth of financial markets are manifold. A non-exhaustive list includes advancements in technology, deregulation and the increased demand for hedging products following the breakdown of the Bretton Woods system and the high inflation of the 1970s. Similarly, increasing wealth and demographic changes boosted the demand for voluntary pension saving products. Moreover, in the euro area, the launch of the euro further supported the growth of capital markets in the euro area, mainly through substantially improved market liquidity.
ECB data show that the increase in securities’ importance has been substantial. Deposits, as a share of total financial assets of the euro area households, declined from over 40% to around 30% between 1995 and 2002. Over the same seven year period, the share of households’ financial assets in securities investments, including pension funds, rose from 55% to 63%, with a peak of 66% in 2000. This happened despite the adverse equity market developments in 2001 and 2002. Among different savings vehicles, pension funds and especially mutual funds were the fastest growers, doubling their share from 1995 to 2002.
At the same time that the demand for securities was increasing, firms increasingly made recourse to the capital markets for their external funding needs. As a proportion of the total liabilities of euro area non-financial firms, bank loans’ decreased slightly from 35% to 33% between 1995 and 2002. At the same time, the share of equity increased from 44% to close to 50%. The growth of corporate bond markets has been very robust since the launch of the euro: the share of the euro area non-financial firms’ total liabilities accounted for by corporate bond liabilities increased from 3% to 5% between 1995 and 2002. Nonetheless, corporate bond markets in the euro area are still quite small and the importance of bank loans remains much higher than in the market-based United States.
The second major development over the past two decades is the process of globalisation and integration of financial markets. A regional example of this integration is the developments that have taken place since the introduction of the euro in the euro area. For example, underwriting gross fees in the securities issues by euro area firms fell over the period 1995-2000 to the point that, in 2000, fees for the largest bond transactions were less than one-third of their level five years earlier. This brought underwriting fees in the euro segment to a level comparable to that of the US dollar segment. Similarly, in 1995, 15% of large syndicated loans involved at least one non-domestic euro area arranger, while in 2000 this figure was over three times higher, indicating substantially increased cross-border lending. These and similar other developments have produced a tightly integrated financial area that we expect to grow ever tighter in the future.
Looking beyond the euro area, the globalisation and integration process has greatly benefited the management of liquidity by intermediaries and issuers of securities, as it has permitted rapid movements of capital across borders to places where it can be put to productive uses. The markedly higher levels of capital flows to emerging market economies that we have seen since the 1990s relative to previous decades should be understood in this context. For example, even accounting for the after-effects of the East Asian financial crisis, net capital flows to the major Asian economies stood at around USD 25 billion per year over the 1990s, in comparison to only USD 8.5 billion per year during the 1980s. More importantly, the process of increasing financial market integration has been accompanied by a diversification of investment instruments across emerging market economies that is expected to support a more efficient allocation of capital. This process has been underpinned by a diminished presence of official flows in total net capital flows to major emerging markets, which dropped to average less than a fifth of total net flows per year during the 1990s, from an average of over three-quarters per year in the 1980s.
Together with the increasing importance and tighter cross-border integration of financial markets, new challenges have arisen and financial market volatility has become more important for economic decision making. The direct effects on household sector wealth of the two major developments in financial markets discussed so far are, perhaps, well known, but there are other important implications that may change the nature of the types of risks and vulnerabilities affecting financial stability. First, the rapid increase in banks’ financial market activities has heightened their exposure to market price and liquidity movements. Second, market movements can affect non-bank institutions, like insurance companies and pension funds. With increasingly frequent ties between bank and non-bank institutions through ownership and lending relations, like in bancassurance groups, this means that problems in non-bank financial institutions can now produce financial stability concerns, through the banking system’ exposure to them. Third, by the very nature of financial markets, where claims on future cash-flows are traded in the absence of the large type of physical transaction costs affecting goods markets, their growth is not limited by national boundaries. As a consequence, the growing role played by financial markets is bound to increase the importance of cross-border financial flows. This development, however welcome, brings with it the risk of the transmission of shocks across borders. Contagion risks via money and derivative markets have become a substantial part of the overall risk profile of financial institutions. Contagion can also take place through sudden movements in financial market prices, because of a liquidity dry-up at times of market stress, as was the case during the LTCM crisis in 1998. Similarly, the risk of major global stress events remains in the vivid memory of all of us who experienced it in the mid- and late-1990s following the Mexican, Russian and Asian crises, illustrating the need for an orderly and gradual liberalisation of the capital account. As the global financial system becomes more and more integrated, financial stability risks may indeed be related to the growing complexity of the financing of emerging countries and the related co-ordination problems of smoothly managing crisis periods.
Let me stress, however, that even when faced with the risks I have just mentioned, the benefits associated with financial deepening and the globalisation of financial markets are such that we should not try to stop or hinder these two major developments in financial markets. Rather, we should aim at creating the best conditions for the fruition of such benefits.
B. Market Response through Financial Innovation
Financial markets have responded to the challenges of increasing complexity in several ways, and most importantly by taking advantage of the remarkable pace of financial innovation over recent decades.
In the area of market risk management, the main international banks have responded to the changing environment and the market turmoil of the late-1990s in particular with investments in risk management technologies. They seem to have enhanced their portfolio management and diversification and complemented their Value-at-Risk models through stress testing and attention to liquidity risks. I would think that these advances helped the financial sector to remain resilient during the recent period of financial market turmoil we have just emerged from.
Progress has also occurred in the area of credit risk management. The revision of the Basel Accord - the international benchmark for banks' capital requirements - is strongly supporting the development of banks’ credit risk management tools. In this context, I would like to personally thank Mr. Caruana for his work as chairman of the BCBS. He played an important role in the recent discussions, which have led to agreement on the remaining issues regarding the development of the new capital standards.
In addition, the growing use of new instruments, such as, credit risk transfer instruments (for instance, credit derivatives and collateralised debt obligations) has brought undeniable benefits. These instruments facilitate the spreading of financial risk through the system and allow for more sophisticated management of credit risks.
At the same time, this innovation process has raised concerns over the relative opacity of the market for credit risk transfer instruments. Transparency is essential for the efficient use of these instruments, and information on how risks are transferred or how concentrated the risks are is not yet completely satisfactory, although there is evidence of a general attitude of major banks towards further sharing of information on these instruments.
On the other hand, the market response to the increasing cross-border integration of financial markets and their globalisation has been more problematic. In particular, in the case of emerging market economies, the shift from mainly bank-based to more market-based financial systems and the larger participation to the international arena has widened the set of financial instruments, the number of creditors and the number of debtors. At times of repayment disruptions, these shifts have created what is arguably the most pressing problem at present associated with more internationally integrated financial sectors. Namely, the coordination among creditors and between creditors and debtors in an international context. There, lack of a common jurisdiction makes the creation of a level playing field between debtors and creditors extremely difficult. At present, there is a widespread sense that pure market solutions may not be able to overcome the ensuing agency and contracting problems between private creditors and debtors, sovereign debtors and international financial institutions.
C. Regulatory responses
Let me now turn to the regulatory responses to the issues raised by the market developments.
Starting with the regulation of banks, capital standards must be in line with banks’ view of their activities as more and more active trading on portfolios of risks, rather than as stable borrowing and lending relationships. This is the consequence of securitisation and the use of credit risk transfer instruments.
Hence, instituting highly risk-sensitive capital regulation – setting clear incentives for adequate risk management, avoiding regulatory arbitrage, and ensuring sufficient capital against all risks – is of utmost importance. In this light, the existing Basel I framework is clearly not appropriate any longer. The Basel II framework will introduce a significantly more risk-sensitive approach, building on banks’ internal risk management systems. For the first time, a specific capital charge will also be applied to operational risks.
There is also a need to ensure sufficient capital regulation of other financial institutions. In the European Union, Basel II will also be applied to securities firms and insurance sector capital regulation is being developed as well. However, as capital requirements remain largely insensitive to the asset risk profile of insurance companies, this might induce a shift of credit risk to the insurance sector in order to save on capital requirements for banks.
As I mentioned, in a more market-based financial system, financial stability also depends on the adequacy of information so that markets can impose effective discipline and corporate governance. At the EU level, forthcoming Directives on transparency, market abuse and prospectus all aim to make more precise information about issuers available and to harmonise disclosure requirements across countries. At the global level, an important development is the endeavour of the International Accounting Standards Board and the Federal Accounting Standards Board to improve and harmonise accounting standards on both sides of the Atlantic.
Harmonised and high quality accounting standards also contribute to the integration and efficiency of financial markets. The ECB voiced its concerns on the financial stability implications of a wider and potentially inappropriate application of fair values contained in the IAS 39 standard. The ECB welcomes the acknowledgement of some of these concerns by the IASB, resulting in the recently issued Exposure Draft of proposed amendments to IAS 39.
On corporate governance, careful arrangements can provide a system of checks and balances to make fraud more easily detected. In this vein, in the United States, the Sarbanes-Oxley-Act has been adopted, and in the EU, the Commission has put forward an Action Plan for Company Law and Corporate Governance as well as a proposal for a new Directive on Statutory Audit. The ECB fully supports these initiatives as providing a line of defence against corporate scandals and enhancing the control of management by shareholders.
I would now like to turn to the public response to respond to the increasingly more closely integrated financial system. In the EU, greater regulatory and supervisory convergence across countries is needed to ensure equal competition conditions and reduce the regulatory burden for financial institutions operating in several Member States. The so-called Lamfalussy framework for financial regulation and supervision has been exactly designed to address these issues. The implementation of the framework is expected to deliver more flexible Community legislation and supervisory convergence.
At a broader international level, the experience of crises in several emerging markets has led to a number of new initiatives to improve the prevention and management of such crises. This process is leading the international community to address the risks associated with wider integration of financial markets in the most effective way, although full resolution of these challenges still requires some work.
In relation to crisis prevention, the international community has responded by strengthening existing prevention tools and developing new ones. Let me just highlight three examples: (i) the underpinning of domestic policy-making and strengthening of market discipline through voluntary compliance with internationally agreed standards and codes; (ii) closer IMF surveillance of the financial sector in borrowing countries; and (iii) enhanced transparency both at the level of individual countries and at the IMF. It is of course difficult to assess precisely to what extent these tools have improved countries’ resilience to crises. However, it is at least reassuring that over the last five years – except for negative spillover effects of the Brazilian turbulence in mid-2002 that were mostly limited to the region – there have been no major episodes of contagion from crisis-hit countries to other emerging markets. It is to be hoped that – thanks to the crisis prevention efforts I mentioned – countries are nowadays more resilient and investors differentiate better between countries than before. Currently, the outlook for emerging markets appears to be rather positive, which is due both to the favourable global outlook and strengthened fundamentals in the countries concerned. Over the last few months, however, emerging market bond prices have experienced a diverging performance, and insofar as this development reflects increasing discrimination by investors, it might be deemed benign.
As for crisis resolution, important progress has been achieved, although some issues still remain open. In my view, the overarching issue relates to the appropriate balance between rules and clarity on the one hand and discretion and flexibility on the other. This is still the main question in the debate about the role of official financing, as can be seen in the implementation of the IMF’s access policy. Some countries were granted exceptional access to IMF financing despite the fact that they had not met all the necessary criteria that were set up last year. And it is also still the main question in the discussion on the involvement of the private sector in crisis resolution. Regarding the latter, discussion is still ongoing on how the actions of a large number of private creditors should best be co-ordinated. Without a co-ordination mechanism, all creditors may have an incentive to “rush for the exit”, which could lead to an outcome both disorderly and sub-optimal for all parties involved. In a domestic context, such co-ordination problems are typically addressed through bankruptcy procedures, which, however, do not exist for sovereign states. To solve this problem the IMF had suggested the establishment of a comprehensive legally binding Sovereign Debt Restructuring Mechanism, but this idea has been put aside given the opposition from many emerging market economies and private sector creditors. Another proposal, which has received more support, is based on the use of Collective Action Clauses (CACs) in bond contracts, which set clear rules, including for majority voting, to overcome co-ordination problems and to reach binding agreements on debt restructuring. Over the past year, significant progress has been made towards a more widespread use of such clauses, as several emerging markets issued bonds under New York law with CACs. This progress and the fact that no impact on borrowing costs could be detected is to be welcomed. Of course, so far they have not been tested in practice and it will take some years until the CACs are included in the entire stock of debt.
Finally, another proposal – which I suggested myself at the IMF Annual Meetings in September 2002 – consists in developing a so-called “Code of Good Conduct”. Such a Code would define best practices and guidelines regarding early dialogue, information-sharing and fair treatment. The G20, the G7 encouraged further work on the Code. Presently, the G20 is closely following the process. At present, the official sector confines itself to a catalysing role and leaves the floor to the true stakeholders in the process, i.e. emerging markets and private sector representatives. There are intensive discussions going on between a group of representatives from emerging markets issuers and market participants to agree on the main elements of such a Code. I encourage all partners to be as active as possible in working out what could be a significant new tool to prevent and help solving potential crises.
C. Closing remarks
The issues I have been speaking about today are complex and demanding for both market participants and public authorities. Faced with new developments in the financial markets, namely, their increasingly large role and their integration across borders, both markets and regulators have given a powerful, if possibly yet incomplete, response. Financial innovation has undeniably supported the deepening of financial markets, making them more efficient and enhancing their potential to support growth and distribute risk. Regulators have followed these developments by completing the market response with appropriate regulation. Globalisation of financial markets has so far proven to be a more challenging development, but given its potentially very large benefits, the international community has correctly invested considerable resources in making these benefits come true.
With the market and regulatory responses both appropriately targeted at the challenges associated with the present developments in financial markets, we stand the best chance to benefit from financial markets progress.
 For information: data for 2003 will be released only in September 2004.
 For information: the remaining 5% of household financial assets is accounted for by loans and other receivables.
 For information: they are China, Hong Kong, Taiwan, Singapore, Thailand, Malaysia, Indonesia, and Korea.
 It should be noted, however, that China accounts for most of this trend. Excluding China and Hong Kong’s role as a financial hub, the average net capital flow figures to Asia are USD 11.4 billion per year during the 1990s and USD 7.8 billion per year during the 1980s, respectively.
 This might be the case of other emerging regions, such as Latin America, where recent net capital flow levels are not unprecedented by historical standards (the regional average of USD 28.7 billion per year for the six major economies since 2000 is comparable or lower than that prevailing in the run-up to the debt crises of the 1980s). However, the diversification of investment instruments, including ‘safer’ investment forms such as FDI, is still notable.