The European response to the financial crisis
Speech by Gertrude Tumpel-Gugerell, Member of the Executive Board of the ECBBank of New York Mellon Headquarter New York, 16 October 2009
Thank you for for your invitation to speak here today. Carmen Reinhart and Kenneth Rogoff’s new book, This Time is Different, reminds us that financial crises of the kind we are currently in have been happening over and over again for at least eight centuries. As an institution whose origins go back as long as 225 years, this bank hosting this morning’s breakfast meeting will already have experienced – and survived – its fair share of them.
As you are well aware, the collapse of Lehman Brothers last September led to the most severe and synchronised economic downturn the world has experienced since the 1930s. Policy-makers across the globe responded quickly and decisively, taking extraordinary and unprecedented steps to prevent the economic and financial crisis getting even worse.
We face similar challenges on both sides of the Atlantic. But there have been some differences in the policy responses in the US and the euro area. The choice and design of measures are influenced by the institutional features of the central banks, such as their degree of independence. They are also influenced by structural economic and financial characteristics, such as the relative importance of financial markets and commercial banks in the funding of businesses and households.
You will be familiar with the approach taken by US policymakers. So today, I would like to offer you a European perspective. In particular, I will focus on the measures taken in response to the crisis – by the European Central Bank, by European governments, and by supervisors and regulators across Europe. I will also give my first assessment of these measures, acknowledging that this can only be preliminary as the crisis is not yet fully behind us.
The European reponse: monetary policy
Let me start with the policy area in which I of course have been involved the closest: the monetary policy of the European Central Bank.
Between October 2008 and May 2009, the ECB lowered its main policy interest rate, the rate on the main refinancing operations, by 325 basis points. The current rate of 1% is the lowest since the launch of the euro in 1999, which is a reflection of rapidly receding inflationary pressures since the summer of 2008. This is in line with our primary objective at the ECB, to maintain price stability in the euro area in the medium term.
In addition to lowering the policy interest rate, we have taken a number of measures to support the smooth functioning of the euro area interbank market. These measures have supported the flow of credit to households and enterprises in a way that goes above and beyond what could be achieved through rate reductions alone.
Our non-standard measures have come to be known as “enhanced credit support”. They focus primarily on commercial banks, as these are the main source of funding for households and businesses in the euro area. Just as to give you a comparison to the US: in the euro area about 70% of the funding of corporations and households comes from banks; the equivalent share for the US is around 25%. So a well-functioning money market is essential for Europe’s commercial banks and also for the ECB as the transmission of monetary policy to the economy starts here.
Since all of our non-standard measures are still in place at present, let me briefly summarise their five building blocks:
First, the full accommodation of banks’ liquidity requests at fixed interest rates;
Second, the expansion of the list of assets eligible as collateral;
Third, the lengthening of the maturities of our refinancing operations, up to 1 year;
Fourth, the provision of liquidity in foreign currencies, notably the US dollar;
and, finally, outright purchases of euro-denominated covered bonds issued in the euro area.
The covered bond market is traditionally an important source of funding for banks in the euro area. This market segment suffered heavily from the financial crisis. With EUR 60 billion, we have chosen a volume significant enough to support market functioning but not so large as to dominate market developments. Still, compared with bond purchase programmes in some other major countries, the amount spent by the ECB in the context of its covered bond programme is fairly modest. However, this reflects the fact that the primary role of the ECB is to act as a catalyst for this market, not as a market maker.
The outright purchase of covered bonds is the only truly new element in our monetary policy framework. All other non-standard measures have been implemented by using the flexibility of our monetary policy framework. The implementation of our enhanced credit support has been achieved by adjustments in some parameters of the framework.
For example, before the crisis started the ECB already accepted private securities and asset-backed securities as collateral in our refinancing operations, with appropriate risk-control measures in place. Expansion of the list of eligible collateral was simply achieved by lowering the rating threshold from “A-“ to “BBB-“, with the exception of asset-backed securities.
Overall, looking at the effectiveness of our measures of enhanced credit support, we are pleased to see a positive impact on money market conditions and beyond. The large injection of liquidity into the money market led to a decrease in money market interest rates at the very short end, to levels close to the ECB’s deposit rate of 0.25%.
While the measures we have taken have prevented things from getting worse and helped to revive the money market, we know that credit to the economy is not yet back to normal. The annual growth rate of loans from banks to non-financial corporations stood at a mere 0.7% in August. For a large part, this low number reflects low demand as continuing uncertainty in the business outlook are likely to dampen firms’ demand for bank financing.
Supply factors also played some role. But the latest version of our Bank Lending Survey indicates that the pace of tightening in credit standards, reflecting supply-factors such as banks’ access to market financing, was slowing down in the second quarter of 2009.
While credit growth is subdued, the continuing de-leveraging of banks’ balance sheets does not stopped banks from giving credit to households and businesses in the euro area as deleveraging has been mainly driven by shedding external assets rather than domestic assets.
So for how long do we need to maintain our current monetary policy stance? Certainly, the strong intervention of the ECB in the euro area money market cannot be maintained forever. We will phase out these measures once the underlying rationale fades away and the situation returns to normal.
The crisis is not yet over, and the time to exit has not come. But when it comes, we are ready to take the appropriate action. We will act to ensure that the measures taken are phased out in a timely fashion, and that the liquidity provided is absorbed so as to counter effectively any threat to price stability over the medium to longer term.
Of course, this phasing out is not a linear, straightforward process. Many aspects need to be considered, and the ECB has the operational flexibility and institutional independence to implement the desirable course of action in a determined manner whenever the need arises.
Overall, we are well-placed to do so as the feasibility of a timely exit was one of our guiding principles when designing the non-standard measures. Apart from the outright purchases of covered bonds, all measures taken have finite lifetimes and allow for the return of monetary policy to the pre-crisis mode when required.
The European reponse: government policies
Let me now turn to the response of European governments to the financial crisis. This consisted of measures to support the financial system and measures to reduce the effects of the financial crisis on the rest of the economy.
After the collapse of Lehman Brothers in September 2008, most European governments swiftly adopted measures to support the financial system in a coordinated action. These included increasing deposit insurance ceilings, guarantees for bank liabilities and bank recapitalisations. The extent and design of the commitments vary widely between countries, reflecting the specific characteristics of national financial systems and the presence of large and systemically important institutions.
Our assessment of the effectiveness of the support measures is overall positive. The measures were needed for averting a further escalation of the crisis in late 2008. Initial empirical evidence suggests that government support measures have been effective in reducing banks’ default risk. Here it seems that capital injections have been effective as well as debt guarantees and asset purchases. The three-month euro and dollar Libor spreads over market overnight interest rates, a measure of credit risk, have recently fallen to their lowest levels since the collapse of Lehman Brothers.
Besides these measures to support the financial sector, the government response to the crisis also includes the fiscal reaction to reduce the fall-out of the financial crisis on the rest of the economy. This is a combination of the operation of so-called automatic stabilisers (the automatic reduction in tax receipts and the rise in government welfare payments as economic activity declines) and specific discretionary fiscal measures, such as additional public investment, tax relief and subsidies for part-time employment.
The size and timing of the stimulus measures, of course, differed considerably between countries. For the whole euro area, however, the European Commission estimates the stimulus measures to amount to 1 percent of GDP over the years 2009- 2010.
The variety of stimulus measures and their dependence on the expectations and reactions of households and businesses make it difficult to assess precisely how effective they are. But measures such as car scrapping schemes have helped to sustain private consumption and, on the whole, the recent bout of fiscal activism in the euro area seems to be reasonably well co-ordinated, well timed and well targeted. In the euro area, GDP contracted by 0.1 percent in the second quarter of 2009. While still negative, this was better than most had forecasted.
All in all, the government response has been effective and we have welcomed it. But it comes at a cost as well. According to the European Commission’s spring forecast, the euro area deficit is set to increase to 6.5 percent of GDP in 2010 with the debt increasing to 84 percent of GDP, from 69% in 2008.
The fiscal loosening should be only temporary and we need to make sure that it is abandoned as soon as the underlying rationale fades away and the economic environment improves. The governments should ensure that fiscal consolidation does not start later than the economic recovery when private demand can substitute the public demand. Only a part of the fiscal consolidation will occur through the automatic stabilisers and the temporary nature of some fiscal stimulus measures. Additional and more ambitious fiscal adjustment will be needed as well. Fiscal policy can only be a successful macroeconomic tool if it is sustainable in the long term.
The European reponse: regulation
The crisis has reminded us that monetary and fiscal policies are not sufficient to stabilize the economic situation. We also need to ensure the stability of our financial system. For this we need proper regulation and macroprudential supervision of systemic risk. Let me first focus on the first issue.
In discussing monetary and fiscal policy, I have focused on the European response to the crisis. Now as I turn to the regulatory reform, I necessarily will speak about the global response. Many of the issues can only be truly tackled at the global level. Indeed, under the aegis of the Group of Twenty, authorities worldwide have agreed on a common agenda for regulatory reform. Let me briefly recall the progress made thus far and highlight the measures that are of great importance to us. I will focus on three topics on the regulatory reform agenda that in my opinion are key: the need to strengthen the prudential framework for banks; the need to extend the scope of regulation to all systemically important institutions, markets and instruments; and the need to strengthen the oversight of systemically important institutions.
First, the prudential framework: banks will be required to hold more and higher quality capital that is capable of absorbing losses on a going concern basis. Counter-cyclical capital buffers will be built up in good times to be drawn down in times of stress. A leverage ratio will be introduced as a supplementary measure to the Basel II framework to curb excessive balance sheet growth, and a liquidity requirement will be established, obliging banks to hold sufficient high-quality liquid assets. These measures, to be issued by year-end, will significantly increase the ability of financial institutions to withstand shocks and therefore the resilience of the financial system. Let me highlight, however, that these measures will be phased-in as the economy recovers, to ensure they do not hamper the credit flow to the economy.
Second, the scope of regulation: Credit rating agencies will be subject to mandatory registration and oversight, with the aim of making them more transparent and reducing the potential for conflicts of interest related to the rating process. Hedge fund managers will also be subject to registration and disclosure requirements. This sector, which is highly connected with other parts of the financial system, needs to be included in the effort to achieve greater transparency.
In the European Union, legislation on Credit Rating Agencies was approved while work on alternative investment fund managers, including managers of hedge funds, is on its way. Legislative proposals have also been tabled in the US for both sectors.
Moreover, there is a consensus on the need to extend regulation to the over-the-counter derivative markets, which should be subject to greater transparency and reduced counterparty risk. In this context, support on both sides of the Atlantic has been given to the establishment of central counterparties. Authorities at the international level have worked closely together, with the result that central facilities have now been introduced in both the US and Europe to clear a considerable share of credit default swap transactions.
Third, systemically important financial institutions: We need to mitigate the moral hazard of the “too big to fail” financial institutions, while minimising fiscal costs in case of future instances of financial distress and restoring market discipline and correct incentives. Action in this area is crucial. Work needs to be carried out on assessing appropriate tools, such as the introduction of a capital or liquidity surcharge, or the development of specific contingency plans for major cross-border firms – also referred to as “living wills” – that will facilitate an orderly resolution or wind-down of a financial institution in a rapid and cost-effective manner, should that prove necessary.
The second key pillar in ensuring financial stability is related to the concerns of systemic risk and the supervisory architecture, in particular the macro-prudential approach to supervision. Measures are also being taken at the international level, but I would now like to return my focus to the European response.
The European Commission has recently issued its proposal on the establishment of a European Systemic Risk Board (ESRB). The new body will be responsible for macro-prudential oversight in the European Union. It will identify and assess risks to financial stability, and issue risk warnings and policy recommendations. In this respect, the ECB will be assigned to provide the analytical, statistical, administrative and logistical support to the ESRB.
For the success of such macroprudential supervision, three issues are crucial.
First, the ESRB needs to have good cooperation and extensive information exchange with the microprudential European Supervisory Authorities to ensure a proper monitoring and analysis of systemic risk.
Second, effective mechanisms for the monitoring of the recommendations that the ESRB will issue are needed.
And third, the global dimension of macroprudential supervision is key. We need to ensure international coordination and good cooperation with the International Monetary Fund, the Financial Stability Board and other country counterparts that can contribute towards a better assessment and earlier detection of risks that originate from outside the European Union.
Finally, let me say that while institutional setups are needed to safeguard financial stability, trust in the stability of the financial system cannot be achieved solely by regulation alone. Individual financial institutions also need to contribute their share. This concerns, banks’ business models, corporate governance and general values guiding the behaviour of market participants. In this context, let me briefly touch on the issue of business models. Within the euro area, some banks have been able to withstand the financial crisis fairly well while others have been affected a great deal. In general, it appears that “old-fashioned” banks, following the traditional banking model characterised by an originate-and-hold strategy and funding via deposits seem to have weathered the financial storm better than banks that relied on the “originate-to-distribute” model. Many other factors surely also played a role in explaining differences across countries and banks. For example, the amount of capital buffers held by banks and the differences in the sectoral and geographical exposure of banks. Without going further into details, it is obvious there are important questions to be answered about the optimal business models for banking, by supervisors, but also by the banks themselves. 
Let me also say a few words on the importance of self set standards and values that should govern the behaviour of market participants. I cite Avinash Persuad, Professor at Gresham College: “The response to this several hundred years ago was the livery companies, clubs and guilds which amongst other things used ethical standards to restrict market entry.” I agree with him when he concludes that “there is a role for modern day interpretation of livery clubs, using due process to establish higher standards than we can expect the law to provide”.  Here, we particularly need more self set standards in the financial industry on medium term perspectives in compensation schemes, sound principles for risk management, and greater accountability for individual decisions.
So, public regulation and supervision is needed and necessary. But to implement the lessons learnt from the recent crisis we need the market as well to set its own high standards of corporate governance and future practises in financial markets.
Let me conclude. Policymakers around the world agree on the need to provide public support under current circumstances. But we also acknowledge that institutional and macroeconomic differences between countries have caused some diversity in the design of support plans.
In terms of monetary policy, in the euro area the priority has been to repair the functioning of the money market. This reflects the crucial role that commercial banks in the euro area play in funding businesses and households, and the importance of the money market for these banks.
The different measures taken in the euro area and the US may have implications for the timing and speed of the withdrawal of the non-standard measures once that time comes. Here too we might see some differences across the Atlantic, in part because of differences in the US and European business cycles.
Monetary and fiscal policies in the euro area have thus far been very successful in preventing worse developments, and have helped to kick-start economic stabilisation and recovery.
At the same time we need to be more wary of financial stability matters. Here regulatory reform is on the way and greater focus on macroprudential supervision is being implemented. Regulation should set the right incentives for market participants, balancing profit-seeking and risk-taking. International cooperation in this area is vital to set a level playing field for all financial institutions and avoid regulatory arbitrage.
While the efforts made so far have been encouraging, innovative regulation and supervision can only be complementary to standards and rules self set by the financial market. Financial market participants have to aware of their own responsibility and have to draw the right lessons from the crisis for their future practises. Taken together with the public measures, this is to the overall benefit of healthy, stable and trustworthy financial markets.
Thank you for your attention.
 I thank Guido Wolswijk, Katri Mikkonen, Michael Wedow, Fatima Pires, Nico Valckx and Marien Ferdinanduse for their input to the preparation of this speech.
 More information on this can for instance be found in my presentation “Business models in banking: Is there a best practice?”, at the CAREFIN Conference at Bocconi University, Milan, 21 September 2009.
 Avinash Persaud, Finance & Ethics: Two couple steps to easier collaboration, Gresham College, London, 20 January 2005