Some lessons from the global financial turmoil

Going more into depth, let me describe how the Eurosystem responded with its operational measures to banks’ changed liquidity demand.

In line with other affected central banks, the Eurosystem resorted to a more pro-active liquidity management to maintain a proper control of short-term interest rates. However, owing to the built-in flexibility of its operational framework for monetary policy implementation, the Eurosystem could address the impaired functioning of the money market through relatively minor, technical adjustments to its normal operations, while at the same time utilising the full latitude of its operational framework.

In particular, it adjusted the distribution of liquidity supplied over the course of the maintenance period, in contrast to normal times, by frontloading the supply of liquidity at the beginning of the period and reducing it later, so that the total amount of liquidity over an entire maintenance period remained unchanged.

Furthermore, the amount of refinancing provided via longer-term refinancing operations (LTROs) increased significantly with a view to smooth conditions in the term money market. Since April, the Eurosystem has further diversified the LTRO maturity structure by also offering LTROs with a 6 month maturity. The amount of refinancing provided via the one-week main refinancing operations (MROs) was reduced correspondingly, so that the total amount of outstanding refinancing has remained unchanged. This measure was welcomed by market participants, although the amount of outstanding 6-month LTROs (currently €50 billion) is admittedly relatively small to account for all the demand for term refinancing in the money market. As a result of these measures, the average level of EONIA has remained close to the minimum bid rate, though with a higher volatility than before the start of the turbulences.

Moreover, in addition to the main aim of controlling very short term rates, three features of the operational framework in combination with a lengthening of the maturity profile in the regular repo operations have allowed the Eurosystem to address funding constraints indirectly also in term money and asset markets:

Firstly, access of a broad range of counterparties to central bank liquidity, not only at the marginal lending facility but also at the regular temporary open market operations. Counterparty eligibility criteria are defined in general terms so that a wide range of institutions, small saving banks and co-operative banks can access central bank liquidity directly. This feature of the operational framework has helped during the turbulences, as it allowed the Eurosystem to step in and effectively mitigate funding liquidity risk for a broad range of counterparties when short-term interbank markets stopped functioning properly.

Secondly, acceptance of a broad range of collateral not only in the marginal lending facility and intraday credit operations, but also in temporary open market operations. As a consequence, sufficiency of collateral has not been a constraint, facilitating access for a broad range of counterparties to central bank money. Moreover, the collateral framework has allowed counterparties to economise on the use of central government bonds with the central bank, which has been often the only collateral counterparties could still use in repo markets. And it has to some extent eased refinancing pressures for assets, such as ABSs, that faced a nearly complete withdrawal of third party investors, since they can be brought forward as collateral in credit operations of the Eurosystem. This includes also ABSs that counterparties have originated themselves and retained on their balance sheet. The Eurosystem accepts only ABSs based on a true sale and that are bankruptcy remote from the originator. These requirements should in principle ensure a delinkage of the issuer from the originator.

Thirdly, the Eurosystem provides the bulk of its refinancing via temporary open market operations. Consequently they are of a large scale, and allow the central bank to temporarily take over a significant part of the intermediation function of markets if needed.

As pointed out before, in addition to domestic operational responses, central banks have strengthened their cooperation as the turbulence developed, first through enhanced information sharing and collective monitoring of market developments and later on by coordinated steps to provide liquidity. One example of joint actions between central banks during this period is the by now familiar US dollar Term Auction Facility, which started in December of last year, in which the ECB agreed with the US Federal Reserve to grant loans in dollars to euro area banks with a maturity of one month against collateral eligible for Eurosystem credit operations. As you know, Eurosystem loans were financed through a currency arrangement (swap line) with the Federal Reserve, and granted at a fixed rate equal to the marginal rate of the simultaneous Federal Reserve tenders. The first two operations, for an amount of USD 10 billion each, were settled in December 2007 and renewed in January 2008. Similar operations were also carried out by the Swiss National Bank. These liquidity-providing operations did not have a direct effect on euro liquidity conditions, but were conducted to address the funding of euro area banks in US dollars and aimed at improving global funding conditions.

Since these coordinated actions, the G-10 central banks have continued to work closely together and to consult regularly on liquidity pressures in funding markets. Owing to continued pressures observed in the money market, the ECB, as well as the Swiss National Bank, resumed in March 2008 the US dollar liquidity providing operations in connection with the Federal Reserve Term Auction Facility, every second week for as long as needed, and for an increased amount of USD 15 billion each. This amount was further increased to USD 25 billion each on 2 May 2008, and in August the Eurosystem agreed to extend the maturity of a fraction of the TAF operations to 84 days.

It is important to stress that the action in connection with the TAF marked, to my knowledge, the first systematic and multilateral central bank co-operation in the money market field, a market which is central to the implementation of a central bank’s monetary policy. In my view, the TAF operations have been successful, as they were well received by market participants’ high demand, and succeeded to address the liquidity challenges in the global term money markets.

One interesting remark around the participation in the TAF is why banks would prefer to participate in the European USD auctions instead of obtaining the USD directly from the Fed via their TAF auctions. There are several possible explanations to this. First, and rather obvious, some European banks have no direct access to the Fed and its TAF auctions. Second, the European central banks participating in the TAF have different lists of eligible collateral which for some banks have made the access to USD easier. Third, European auctions for US dollars provide a better timing for European banks.

In the past common central bank wisdom was to say that there is no unique way to implement monetary policy. The currently prolonged dislocation of interbank markets and asset markets more broadly has though shown that there are certain key operational features that facilitate the implementation of monetary policy in such conditions. In order to distribute reserves effectively when the interbank market is impaired, central banks should be capable of providing access to collateralised lending operations to a broad set of counterparties against a broad range of collateral and on a large scale. Whether those features should become part of the regular operational framework or are introduced on demand in distressed market conditions, is ultimately the choice of each individual central bank.

The recent developments have provided also central banks with a wealth of information that has highlighted a number of weaknesses in the financial system, namely in the areas of transparency, valuation, risk management practices, and market functioning. The lessons learned affect also the way central banks mitigate risks in monetary policy operations.

As regards the Eurosystem, we are of the belief that our flexible operational framework, including the collateral component, has served us well until now, and has helped us to weather a number of tests, including the latest of a prolonged liquidity squeeze in a wide range of unsecured and secured markets. However, this does not mean that there is no scope for refinement and further enhancement.

One very recent example is the fine-tuning of our risk control framework in the context of our bi-annual review of the adequacy of the risk control measures. The Eurosystem needs to make sure that the collateral and risk control framework are monitored and adjusted over time to ensure that an adequate level of risk tolerance is met. This ensures that the Eurosystem remains adequately protected against financial risks across time, which is an obligation for the Eurosystem enshrined in its statutes.

The results of previous reviews of the risk control framework were reflected in the 2004 and 2006 editions of the General Documentation. In February 2004, different liquidity categories were introduced to better reflect the risks associated with different eligible asset classes. In 2006, specific eligibility criteria regarding asset-backed securities were established that excluded instruments such as synthetic CDOs and cash CDOs containing other synthetic tranches of ABSs.

The 2008 biennial review introduced an additional set of risk control measures aiming at ensuring that the collateral continues to meet the Eurosystem’s risk tolerance level, while allowing at the same time the effective implementation of monetary policy. The new risk control measures, communicated by the ECB on 4 September and entering into force on 1 February 2009 reflect, inter alia, improvements in the methodological framework, the assessment of market and liquidity risk characteristics of eligible assets, the actual use of eligible assets by counterparties and new developments in financial instruments.

I would like to highlight in particular the decision to require better rating disclosure standards. To be eligible as collateral for Eurosystem credit operations, asset-backed-securities will need a rating that must be explained in a publicly available credit rating report, being a detailed pre-sale or new issue report, which should include inter alia a comprehensive analysis of structural and legal aspects and a detailed collateral pool assessment. Moreover, rating agencies – and the Eurosystem believes this is very important – would need to publish rating reviews of asset backed securities at least on a quarterly basis.

The Eurosystem has witnessed in recent times a deterioration in the disclosure standards of rating agencies for some of the ABS that are eligible for its credit operations. The new measure requires enhanced disclosure standards in order to be able to perform eligibility assessments that take into account inter alia the assessment and analysis conducted by rating agencies. Of particular importance for the Eurosystem is that the performance of ABS transactions is monitored on a regular basis. By requiring that the result of the rating assessment as well as the regular surveillance reports are made public, the Eurosystem can support the functioning of ABS markets more widely through enhanced transparency, which is a pre-requisite to restore investor confidence.

Other important changes to the risk control include the introduction of a uniform haircut of 12% to asset- backed securities for all residual maturities and all coupon types, as well as a valuation mark-down of 5% to all asset-backed securities that are theoretically valued by the Eurosystem. On the one hand, the introduction of an uniform 12% haircut responds to a careful analysis of the liquidity characteristics of asset-backed securities, which provided evidence that an upwards adjustment of haircuts for asset-backed securities with short maturities was advisable. The observation of the significant draw-downs in some ABS prices experienced over the last year, even in quite short periods of time, has reinforced this view. On the other hand, the application of a 5% valuation markdown to theoretically valued asset backed securities reflects recent experience showing that the valuation of asset-backed securities can be subject to significant uncertainties especially when there are no market prices that could provide a reference for intrinsic value. By introducing both measures, which have been motivated entirely by the desire to maintain an adequate level of risk tolerance, the Eurosystem can contribute to the restoration of normal conditions in the functioning of asset backed primary markets.

The current turbulence has also demonstrated that global channels for distributing liquidity across borders may become seriously impaired. To prepare for that possibility, central banks should take steps to strengthen their capacity to counter problems in the international distribution of liquidity. It is interesting for me to see the high degree of consensus about future measures, comparing the seven recommendations for the central bank community from your Final Report of the IIF Committee on Market Best Practises, with those seven of the Committee on the Global Financial System’s report on Central bank operations in response to the financial turmoil. Both reports point out to the need of establishing or maintaining standing currency swap lines. From a technical point of view, the coordinated distribution of foreign currency to the domestic bank sector through swap lines is a feasible solution, presenting some potential advantages, including rapid implementation, expeditious settlement and immediate access to the liquidity by banks, and could be very important in emergency situations. Moreover, such swap lines could provide flexibility in choosing the best way for redistribution of foreign currency funds. Also, the implementation can – and must ‑ be designed in such a way that it does not conflict with domestic monetary policy implementation.

Both reports also consider developing and maintaining the ability to accept foreign currency denominated assets, which is more complicated than maintaining a swap line but could support the efficient management of collateral of internationally active banks with multi-currency liquidity demands. To understand this, it needs to be borne in mind that settlement –a step that goes largely unnoticed, but is of critical importance– can become a constraining factor. When collateral is available in the market where the central bank granting credit is located, the basic step of delivery takes a few seconds. However, in the global financial market major banks with large international portfolios may need liquidity in one country or currency, and hold eligible collateral in another currency and in another country. Cross-border mechanisms are in place between the infrastructures of major markets and allow banks to move collateral where needed. These mechanisms normally meet the market needs, since in routine situations there is no particular “urgency” to deliver collateral.

However, in an emergency situation, things may be very different. Liquidity needs may arise suddenly and within a short time, and standard transfer procedures may simply not be effective or quick enough, or recourse to troubled or volatile markets may be overly costly for the collateral borrower. With its collateral stuck in one country and being unable to deliver it to the relevant central bank, a global bank may have to make costly choices to find a solution to its liquidity strains. And the situation may get possibly worse if, for example, the liquidity is needed in a market located to the west of the one where the collateral-holder is located. In some cases, time-zone differences may reduce to less than two or three hours the time available for a transfer.

Easing liquidity pressure for large internationally active banks by broadening the range of acceptable collateral may contribute to alleviating potential liquidity contagion risks in payment systems, where the bulk of activity normally comes from the largest players, thus having a positive influence on financial stability. However, it should be noted that accepting foreign currency collateral also implies additional legal and financial risks in the conduct of monetary policy operations. Hence, this is an area where further work is needed.

A third possibility, which the central banks of the G-10 countries are studying through their Committee of Payment and Settlement Systems, is to explore ways to ease the frictions in the existing models for cross-border transfer of collateral. Here various questions are on the table: for instance,

As part of their work to further deepen their understanding of the mechanism of transmission of shocks, central banks are also doing extensive work on the interdependencies between market infrastructure and market participants.

Financial markets rely and depend on increasingly complex infrastructures. Payment systems, central securities depositories, central counterparties and their participants are interconnected by a complex network of technical, operational and financial relations ^[3]. Not only markets rely on infrastructures but, in turn, modern infrastructures also increasingly depend on well functioning, orderly and efficient markets.

Most of these interdependencies were introduced to reduce undue exposure to risks, and contribute to the safer and more efficient environment that we enjoy today compared to the past. Still, when international markets, clearing and settlement systems and participants are strictly interconnected, the potential for spreading contagion across the globe via this network of relations should not be underestimated.

In our ever-changing environment, understanding shocks transmission mechanisms and engaging in a positive dialogue with infrastructures operators and market participants are two tasks of central bankers that are time-consuming, resource-absorbing and on-going.

Perhaps not that visible, but rewarding indeed. For instance, the increasing attention being devoted to the field of operational risk and business continuity has made the financial system resilient to a number of otherwise potentially disrupting threats. Let me give you a practical example: during the turmoil although some clearing and settlement systems were individually challenged by unusual transactions volumes, the system as a whole coped well thanks to effective capacity-planning, appropriate risk management, and stress testing activities undertaken well before, not at the time, of the outbreak of the tensions.