The financial crisis: challenges and responses
Speech by Lorenzo Bini Smaghi, Member of the Executive Board of the ECB
Associazione Pianificatori Bancari
Florence, 16 October 2009
Ladies and Gentlemen,
I would like to thank the organisers of this event for their invitation and for giving me an opportunity to make some comments on the financial crisis.
1) Main developments of the recent financial crisis
Let me begin with the causes of the turmoil: in the four years leading up to the summer of 2007, macro-financial conditions were very favourable – on the surface, that is. The world economy was growing strongly; inflation was low; liquidity in capital markets was abundant; the financial sector was providing remarkable returns; profitability was high; asset prices were rising, and implied volatilities in equity markets, bond markets, credit markets and foreign exchange markets all very low by historical standards; and finally, risk premia were extraordinarily small.
Against this seemingly favourable economic background, innovation was rapidly taking place in financial markets. One prominent example is securitisation: banks repackaged loans, in particular, mortgage loans and sold them on, thereby freeing up capital for new lending. This was widely perceived as a positive development, as it enabled a better and wider distribution of risk. This perception is likely to have encouraged risk-taking not only inside but also outside the financial sector. With abundant liquidity available, some banks’ business lines became heavily dependent on securitisation and on funding from the unsecured money markets.
Yet, there was one blemish on this overall benign economic picture, which was, however, disregarded by many economists: significant imbalances were building up at various levels in the global economy and the global financial system. Among these imbalances were exuberant real estate prices and an ebullient securitisation business which facilitated huge credit growth. Another important imbalance consisted of one group of countries – Japan, China, Germany, the oil-exporting countries – saving too much, while others – the US, Spain, eastern Europe – were borrowing to finance consumption and investment (e.g. related to residential and commercial construction). These developments were unsustainable and would only need a spark to cause turmoil in the financial markets and the world economy.
In the end, the US mortgage market provided that spark. Rising delinquencies and foreclosures revealed the exuberance in the housing market, and brought the sub-prime business to a sudden halt. Securitisation markets froze, banks had to bring assets from special purpose vehicles back onto their balance sheets, and confidence in the financial markets started to crumble. The crisis rapidly spread through the financial sector and spilled over to other industrialised and emerging market economies. Central banks became the first line of defence, responding to the emerging crisis by injecting liquidity into the financial system. When the liquidity crisis became a solvency crisis that threatened the stability of the financial system, governments initially resorted to traditional measures to rescue individual institutions: liquidity lines were granted to insolvent institutions which in many cases were then sold and merged with a partner presumed to be stronger.
Despite these measures, the financial system stood on the brink of disaster in autumn 2008 after the collapse of Lehman Brothers on 15 September. Its failure sent a shock wave through the global financial system, largely due to its importance as a counterparty in the credit derivatives market. The crisis was not confined to the United States; it spread to countries that had initially escaped its worst effects. Losses on exposures to Lehman Brothers showed up in the balance sheets of banks around the globe. While risk aversion and mistrust between financial players led to the drying-up of funding markets, concern over the solvency of financial institutions now severely affected the confidence of depositors.
The rapidly worsening crisis also spread beyond financial institutions. Conditions in interbank markets and other short-term funding markets deteriorated sharply. Credit risk spreads rose to new highs, and equity prices fell sharply. And financial markets in emerging market economies came under pressure as a flight to safety reversed capital flows.
Governments around the globe were forced to act swiftly to avert the partial or complete failure of their financial systems. In the EU, after an emergency summit in Paris in October 2008, governments implemented coordinated support measures to alleviate strains on their banking systems. These measures supplemented the extensive liquidity support that has been provided by the ECB since the summer of 2007 and involved guarantees for bank liabilities, including higher deposit insurance coverage. In addition, governments recapitalised financial institutions. In some cases, they even became majority owners or diluted the equity owned by shareholders. Countries also adopted measures to shield institutions from losses on their assets, by ring-fencing, offering state guarantees, and by swapping and transferring so-called toxic assets from banks’ balance sheets.
These measures averted an escalation of the crisis and prevented a meltdown of financial systems. To be sure, government support measures helped to reduce market perceptions of banks’ default risk, as reflected by patterns in CDS spreads, for example. However, for some time, the elevated levels of interbank money market spreads and banks’ CDS spreads, as well as the depressed level of bank stock prices reflected sustained pessimistic investor sentiment towards the banking sector. Yet, the positive developments in these indicators on both sides of the Atlantic since March 2009 have indicated a cautious return of confidence in the market – a confidence reinforced by a broad-based improvement in banks’ profitability, mainly because of strong net interest revenues and a rebound in trading revenues in the second quarter of the year.
While these developments are certainly reassuring, it would be too early to call the crisis over. We need to see whether the different sources of income remain strong in the second half of the year, as competition is set to increase and financial markets are still only showing a relatively weak recovery. In addition, at least in the euro area, there is evidence that the credit quality of banks’ loan books has deteriorated on account of intensifying financial distress in the household and corporate sectors. Banks could be gradually getting over the valuation losses they have suffered on their securities holdings; however, the rapid increase in loan loss provisions suggests that a renewed wave of write-downs on euro area banks’ assets may be imminent, with ensuing capital reductions.
So the outlook for the financial sector remains uncertain and depends greatly on the macroeconomic recovery. Lately, the pace of contraction in the euro area has come to a halt, although economic developments across countries vary considerably. Looking ahead, we expect a gradual recovery, with positive growth rates in 2010. These expected positive developments may improve to some extent the resilience of household and corporate balance sheets. However, the historically strong depth of the recession, the eventual fading-out of government support, along with a highly uncertain economic outlook implies continued strong risks to financial stability stemming from the macroeconomic environment. In this context, adverse interactions between macroeconomic and financial factors may reinforce each other and then may determine further write-downs. Although banks have so far been able, roughly speaking, to match write-downs with capital increases, the struggle to raise capital and decrease leverage may hamper the granting of credit to the real economy, further increasing the stress felt by households and firms.
2) Lessons to draw from the crisis and action by public authorities
The weaknesses in the regulation and supervision of financial markets exposed by the financial crisis – and the need to remedy them – have become a focus of international debate. An awareness that the global dimension of the crisis needed international coordination has triggered action at the level of the Group of Twenty, whose leaders have agreed on a regulatory and supervisory reform agenda.
More specifically, the financial crisis has highlighted the need to reform the current policy approach in respect of three fundamental aspects. First, regulation and supervision should improve substantially in order to avoid, among other things, distorted incentives arising in the financial markets, even if it means taking a more intrusive approach to regulating financial institutions. Second, the regulatory framework should be extended to all components of financial markets that may pose risks to financial stability. Third, supervision should have a system-wide approach, recognising that financial institutions operate in a complex environment with many inter-linkages among them.
I will now elaborate on each of these issues and on what has been done to address them and, in my view, what should still be done.
The defining of policies and the technical preparations have progressed steadily at global level. Now we need to keep up the momentum for the remaining work and also when implementing the measures agreed at EU and national level.
First, the incentives of market participants have to be aligned with the risks they take. Indeed, the incentive structure is at the root of the boom and bust cycles that we have been experiencing. Financial innovation, flawed appreciation of risks and compensation practices that did not relate to risks and long-term performance all contributed to this phenomenon. Banks must improve their risk management procedures and review their compensation practices. The authorities must provide a regulatory framework that supports the goal of getting the right incentives in place. This has consequences in particular for the design of the prudential framework for banks, for the supervisory review of banks’ risk management procedures, and for rules on compensation and pay.
In terms of the prudential framework, the capital base of banks needs to be strengthened and rules must be introduced to ensure that they are sufficiently capitalised and remain liquid at all times. A lot of technical work is already under way, notably under the auspices of the Basel Committee. A first step in the right direction in this regard is the improvements to the Basel II framework that the Committee published in July. The revised rules include stricter treatment of securitisation exposures and off-balance vehicles, and significantly higher capital charges for the trading book. In addition, the Basel Committee is developing a proposal to strengthen the quality, consistency and transparency of bank capital. Work is also under way to introduce countercyclical capital buffers, to define a simple measure of leverage to supplement capital requirements, and to develop standards for liquidity risk for cross-border banks. These proposals are expected to be finalised by the year-end.
It can be argued that significant progress has been made at global level which now needs to be properly finalised. It is also important that the improvements to the prudential framework are implemented swiftly once the economy starts to pick up. I would like to stress the importance of getting the timing of the implementation right. This is particularly true for the introduction of a higher level of capital and countercyclical capital buffers, for which we need to ensure that the functioning of financial markets and the recovery of the economy are not endangered by hasty action.
In addition to enhancements to the prudential framework, banks need to improve their internal risk management procedures, with appropriate supervision. The improvements to the Basel II framework that I just mentioned also include supervisory guidance to address the flaws in the risk management practices of banks that were revealed by the financial crisis. In this regard, a raising of standards is planned in respect of firm-wide governance and risk management, off-balance sheet exposures and securitisation, the management of risk concentrations, and incentives for the management of risks and returns over the long term. Banks and supervisors should implement these improvements immediately.
Finally, the excessively short-term view also has to be curbed by establishing a closer link between bankers’ pay and risk and performance. The Principles for Sound Compensation Practices were published on 2 April 2009 by the Financial Stability Forum which was re-established as the Financial Stability Board on the same date. Their implementation is currently taking place worldwide with the support of the Basel Committee and the International Organization of Securities Commissions (IOSCO). At the request of the G20 Finance Ministers and Governors, the Financial Stability Board also produced implementation standards for the principles. These standards were endorsed by the G20 leaders in Pittsburgh in September.
In the EU, important provisions on bankers’ remuneration were included in the draft amendment to the Capital Requirements Directive that the European Commission made in July. The draft states that remuneration practices should promote prudent risk management and long-term profitability targets, and also discourage excessive risk-taking. It also gives the banking supervisors the authority to penalise banks if they do not comply with the requirements. The supervisor’s sanctions in such a situation range from imposing a change in the remuneration structure or demanding that additional funds be held through to levying fines and penalties.
The developments in the areas of risk management and compensation are welcome. Enhanced corporate governance, strengthened transparency and credible enforcement mechanisms will have a positive bearing on financial stability. Therefore we support the principles and the implementation standards of the Financial Stability Board on compensation and call for their prompt implementation. I would like to stress here that international consistency is essential to maintain a level playing field, in terms of both the content and timing of the measures. Otherwise, we risk not only a transfer of talents or even of financial institutions between jurisdictions, but we also risk losing some momentum in the implementation by local legislators.
The second important issue on the reform agenda of the Group of Twenty leaders concerns the extension of the scope of regulation to cover all systemically important financial markets, institutions and instruments that were previously unregulated. These include OTC derivatives, hedge funds and credit rating agencies. Activities in these areas are typically international in nature, and entail a risk of regulatory arbitrage and evasion, if not handled in a globally consistent way.
We have to acknowledge, with satisfaction, the swift progress that has been made in enhancing the scope of regulation. For example, an EU regulation on credit rating agencies aiming to increase transparency and reduce potential conflicts of interest was approved by the European Parliament and EU Council in April this year; the US administration proposed corresponding legislation in July. In a similar vein, legislative proposals on the oversight of private pools of capital, notably including hedge funds, have been tabled on both sides of the Atlantic.
I am well aware that there are detailed discussions ongoing about hedge fund regulation in Europe. I take this occasion to repeat the ECB’s call for globally coordinated and consistent hedge fund regulation. Given that concrete proposals on this issue already exist both in the European Union and the United States, I think that there is a need and an opportunity to continue the dialogue between the jurisdictions in order to achieve an internationally coordinated response and to maintain a level playing field.
Third, efforts are under way to build up a regulatory and supervisory framework with a macro-prudential orientation. The financial crisis has demonstrated the importance of a close interplay between macro and micro-prudential supervision to safeguard financial stability, as the latter cannot by itself fully assess the systemic risks present in the financial markets.
In Europe, the Commission has recently proposed the establishment of a European Systemic Risk Board (ESRB) to conduct macro-prudential oversight of the financial system in order to prevent or mitigate systemic risks and to avoid episodes of widespread financial distress. The ESRB will identify potential risks to financial stability, issue warnings where risks appear significant and issue policy recommendations for appropriate action to mitigate and contain the identified risks.
In the fulfilment of its tasks, the ESRB will be assisted by an Advisory Technical Committee, which will allow a pooling of the expertise and detailed knowledge of financial markets provided by national central banks and supervisory authorities. It will also be crucial to set up efficient arrangements between the ESRB and the new European Supervisory Authorities for the mutual cooperation and exchange of information, as foreseen in the Commission’s legislative proposals.
3) A global response to the financial crisis
The global dimension of the financial crisis triggered a response at international level that shows some novel features.
As I mentioned earlier, the Group of Twenty leaders took a leadership role in autumn 2008 by defining the reform agenda for regulatory and supervisory policies. In an unprecedented way, the G20 agreed on a broad series of measures to be followed up by national authorities and international standard setters. At the Pittsburgh Summit last month the same group of leaders continued to stress the importance of global coordination and designated the G20 as the premier forum for international coordination.
Second, to give more impetus to the process, and to deepen understanding of global inter-linkages in financial markets, a central role was attributed to the Financial Stability Forum, which I mentioned earlier on. The FSB now has a stronger institutional basis and an expanded membership, including the rest of the G20, Spain and the European Commission. The Basel Committee also adjusted its membership in June 2009 to include the G20 countries, Hong Kong and Singapore.
The leadership role taken on by the G20 in reforming the regulatory framework, and the enlarged compositions of the FSB and the Basel Committee will add momentum to the proper and timely implementation of the reforms, also in major emerging countries. At the same time, they will agree on the coordination of efforts at international level.
At the moment, the financial system is in transition; predicting the future is not easy. The global banking system is just re-emerging from a financial crisis which has wiped out value on a large scale and seriously damaged its credibility. Meanwhile, regulatory initiatives will fundamentally change banking structures and financial products in the near future.
The financial crisis may have caused a temporary halt in the global integration of the banking sector. This is because the banks may have had to concentrate on their main markets and repair their balance sheets. In addition, some national stabilisation plans include measures to support creditors, such as small and medium-sized enterprises or households that are purely and typically domestic. However, once the economy recovers and markets return to normal, I expect that the long-term factors that have promoted financial integration in the past will re-emerge.
In contrast, I expect the ongoing regulatory reforms to have a more permanent effect. In the future, banks should hold higher levels of capital – of higher quality – and more liquid assets. They will improve their internal risk management processes and pay more attention to maturity mismatches. Finally, banks’ balance sheets will become more transparent in respect of their activities in the capital markets.
The financial crisis represents a valuable opportunity for the international community to pursue regulatory reform. Right now, the political momentum to change things for the better is strong, but it might fade quickly along with the first signs of economic recovery. So, quick implementation of the agreed measures is essential to the future stability of financial markets.
I also expect that banks will have to rethink some of their funding strategies. In the past, some business lines depended to a large part on securitisation and the unsecured money market. Both of these funding sources basically dried up during the crisis, and it is uncertain how well they will recover. Hence, banks are likely to be forced to find alternative funding sources. Since the beginning of the crisis, many banks have already been partially compensating for the shortage of liquidity on the money market by actively increasing their deposit basis. While it’s desirable for the banks to work in this way, they should also consider moving their business away from activities that are particularly dependent on the availability of short-term funding.
Another important aspect in the medium term is the exit from the government support measures, including budgetary and financial policies. Clearly articulated exit strategies are important, as they facilitate the orderly and gradual unwinding of the support measures.
Another important issue is the timing of the exit. It will need to carefully balance the risks of a premature exit against those of a tardy exit. The latter may run the risk of distorting competition, of encouraging the moral hazard inherent in downside protection mechanisms, and of posing risks to public finances.
At the same time, there are also risks associated with a premature exit. In particular, the sustainability of the global and euro area economic recovery and the strengthening of financial stability still depend on the continuation of the existing support measures.
Ladies and Gentlemen,
Let me now conclude.
The financial markets have been in turmoil for over two years now; they have been severely put to the test. The troubles in the financial sector spread to the real economy towards the end of 2008, leading to a particularly sharp recession by historical standards on both sides of the Atlantic. In recent months, there have been increasing signs of stabilisation in economic activity in the euro area, suggesting that the period of acute contraction is over and that a period of stabilisation and very gradual recovery will follow. The generally positive and better-than-expected developments in the financial markets recently have likewise contributed to the favourable outlook for financial stability. However, many weak spots and risks to financial stability remain; coupled with the high level of uncertainty, they suggest that the financial sector and the economy as a whole remain vulnerable.
But the financial crisis should also be seen as an opportunity to undertake regulatory reform. It also gives banks a chance to overhaul their risk management practices and verify that the procedures they adopt take full account of the complexities of the financial markets. At the political level, the G20 agreement on the regulatory agenda is unprecedented both in terms of its scope and its geographical reach. Now we need to make sure that the agreed measures are swiftly implemented at regional, national and industry levels. It’s a train that’s on the move – and we shouldn’t miss it.