The European Central Bank and the policy of enhanced credit support
Speech by José Manuel González-Páramo, Member of the Executive Board of the ECB, Conference organised by Cámara de Comercio de Málaga and University of Málaga, Málaga, 18 June 2010
I. Introduction 
It is a great pleasure for me to have the opportunity to speak in front of such a distinguished audience. Last time I came to Málaga was at the end of 2008. At the time, I gave a speech as part of a series of conferences dedicated to the issue of “Public economics at times of difficulties”. My intervention focused on the measures taken by the ECB during the financial and economic crisis, which had at the time experienced an acute intensification following the failure of Lehman Brothers.
After one year and a half, I am back to Málaga and I am afraid that, also this time, the subject of my intervention relates to measures taken by the ECB to address the effects of the crisis. And, alas, also this time I am talking against the background of an intensification of the financial crisis.
I have to confess that I would have very much preferred being able to dedicate my intervention today to a more boring subject than the crisis. Indeed, I look forward to a near future in which we will be able to discuss about this crisis as an event from the past, from which to draw lessons in a position of more comfortable and distant detachment.
In the meantime, I would like to thank the organisers – particularly Mr Gumersindo Ruiz from Cámara de Comercio de Málaga and Professor José Sánchez Maldonado from University of Málaga – for giving me the opportunity to explain what the ECB has done and continues to do to address the disrupting effect of this prolonged crisis.
I will dedicate the first part of my address to the main features of the Enhanced Credit Support policy of the ECB and its effects. In the second part of my intervention, I will describe some of the main initiatives that are being taken to enhance the stability of the financial sector
II. Brief overview of the measures adopted during the crisis
For almost three years by now, the world economy has been confronted with severe financial market tensions. In response to these developments, governments and central banks around the world have taken prompt and resolute action.
Notably, during these difficult times, the ECB has confirmed its capacity to react rapidly to exceptional circumstances. In order to support the functioning of financial market segments that are of relevance for the transmission of monetary impulses to the real economy and ultimately prices, the ECB has taken a number of extraordinary measures.
In particular, following the collapse of Lehman Brothers in September 2008, which led to the financial turmoil developing into a full-blown financial and economic crisis, the ECB reduced its main refinancing rate by 325 basis points, to one per cent. These reductions took place between October 2008 and May 2009, i.e. within a period of only seven months. These rapid, yet steady-handed, moves were remarkable and unique in the ECB’s history in terms of magnitude and rapidity. Most importantly, the decisions to cut rates were taken in a context of subdued inflationary pressures and significantly diminished upside risks to price stability due to the weakened economic outlook in the wake of the financial crisis.
Nevertheless, the market disruptions became so severe that the transmission of the reduced ECB interest rates to money market and bank lending rates could not be expected to take place without further actions. Thus, the ECB took a number of non-standard monetary policy measures, i.e. the Enhanced Credit Support policy and, as of late, the Securities Markets Programme, which will be described in more detail in the next section. All these measures have had a positive impact on markets, while remaining fully aligned with the ECB’s mandate to maintain price stability over the medium term for the euro area as a whole.
Likewise, governments have taken extraordinary measures to counter the crisis, notably by undertaking initiatives aiming to bolster banking sectors and by proving discretionary fiscal policy stimulus to support aggregate demand. In addition, automatic stabilizers – i.e. reduced tax revenues due to lower economic activity in parallel with increased transfers due to higher unemployment – were allowed to work in full.
The latest forecasts from European Commission, published in early May 2010, show that between 2008 and 2010 the general government deficit for the euro area as a whole increased from 2.0% of GDP to 6.6% of GDP. Almost all the increase took place in 2009. Recently announced additional consolidation measures – which are welcome – are likely to bring the deficit this year slightly down to 6 ¼ % of GDP, in line with last year’s public deficit.
Given the exceptional economic and financial circumstances faced at the time, coordinated fiscal action was necessary to cope with the adverse impact of the crisis on the economy in the short run. However, the dynamics of public finances, particularly the soaring debt levels, in the euro area and other adversely affected economies entails significant risks over the medium term.
For the euro area, the Commision’s forecasts show a general government debt of almost 85% of GDP this year. This is roughly 15 percentage points above the level seen for 2008. And, although the annual deficits are expected to decline as from 2011 onwards, the debt to GDP ratio will continue to grow for quite some time. Increasing concerns regarding fiscal sustainability in some euro area countries is exactly the background to the serious problems recently experienced by some government bond markets in Europe.
In addition to the fiscal policy response, governments worldwide adopted a series of measures aiming to alleviate the strains on the banking systems and thus to avert an escalation of the crisis and prevent a meltdown of the financial system.
In October 2009, governments around the world stepped in and adopted a series of unprecedented and extraordinary measures, which would have been unimaginable only few months before. The measures aimed to alleviate the strains on the banking systems and thus to avert an escalation of the crisis, which may have ultimately led to the meltdown of the financial system.
A wide range of measures were taken. For example, many countries increased the coverage of their deposit insurance schemes and moved away from co-insurance. Governments guaranteed newly issued bank bonds or announced blanket guarantees for all bank liabilities. Capital was injected, in some cases to such an extent that governments actually became the majority shareholders of the banks. Governments ring-fenced, swapped and transferred toxic assets, extended non-recourse loans and replaced investors in illiquid markets.
Governments pursued these measures partly through ad-hoc measures, but increasingly by implementing explicit schemes, with the US Troubled Assets Relief Program being the largest (USD 700 billion) and most prominent. In Europe, an emergency summit held in Paris in October 2008, paved the way for a concerted and coordinated European action plan. The euro area countries agreed to harmonise the provision of retail deposit insurance, issue government guarantees for bank debt securities, make funds available for bank recapitalisations and provide asset relief measures.
The total commitment of resources (i.e. the sum of the commitments under national schemes) plus the actual amounts spent outside national schemes amounts for the euro area as a whole to 27% of GDP. However, considerable variations exist across countries and the amounts that have actually been used under the schemes are significantly lower than the committed values.
III. Enhanced credit support
Liquidity management in normal times
Before explaining how the measures taken by the ECB in response to the financial crisis have influenced the economy, let me briefly describe some basic features of the interaction between the Eurosystem (i.e. the ECB and the national central banks of the euro area countries) and banks in normal times.
Under normal circumstances, there is a structural deficit of central bank liquidity in the euro area economy, meaning that banks always need liquidity from central banks. This relates to the demand for banknotes and coins in the economy but also to the fact that banks are required to keep a certain amount of reserves in their current accounts with the central bank. The Eurosystem supplies liquidity in the form of loans to banks against collateral through its refinancing operations. These operations take place at least once a week, but not on a daily basis.
As I mentioned, banks are also required to hold a certain level of reserves in their current accounts with the central bank. These requirements only have to be fulfilled on average during each maintenance period (which is approximately one month). Therefore, each bank can use the current account as a buffer to absorb day to day swings in its liquidity needs. To fulfil its reserve requirement, a bank having too little liquidity early in the maintenance period can bid more aggressively in our operations during the remainder of the maintenance period, or, in normal times, borrow at relatively low extra cost in the interbank market. As banks can always deposit in our standing deposit facility and, conversely, borrow (against collateral) in the marginal lending facility, interest rates on these facilities form the floor and ceiling for very short term money market interest rates.
In normal times, the ECB can quite precisely steer the interest rates in the short end of the money market by offering sufficient liquidity and setting the minimum bid rate in the credit operations with its counterparties. This sets the marginal funding cost for banks. This is a crucial, first link through which our policy interest rates are transmitted to and thereby influence the economy. Money market rates are reference rates for many of the banks’ lending and deposit offers to customers. Hence, they directly influence decisions taken by actors in the real economy.
For monetary policy to be effective, not only money markets, but also well-functioning securities markets are indispensable. Normally, financial markets transmit the impulse given by the change in our policy rates along the maturity spectrum, since term rates reflect current and expected future short-term policy rates as well as risk premia. Thus, also the cost of longer-term funding for households, firms, and governments is affected. The resulting financing conditions affect economic activity and, in the end, prices.
In this respect, the functioning of the market for government bonds is a very important part of the transmission mechanism, among other reasons because government bond yields are often used as a reference rate when a bank prices a loan for a customer, or when a company issues a bond. Normally, sovereign financing conditions provide a floor for the funding conditions of the private sector of the same country.
Interest rates on government bonds always include add-ons to compensate for liquidity risk and credit risk, but normally these are not so big and do not vary so much that they completely block the signal from the ECB policy rates. Now, let me turn to the actual events and our response to the financial tensions.
Liquidity management during the crisis
The global financial crisis that erupted in the summer of 2007 has been characterized by unprecedented and persistent rises in the spreads of various money market rates relative to (almost) risk-free overnight index swap rates. In particular, spreads on unsecured term interbank loans, like the Euribor spreads, have been affected. But even spreads on collateralised money market transactions went up in most transactions, except those involving assets of the highest quality as collateral. This created funding liquidity shortages for the institutions that relied on the money market to meet their funding needs.
The underlying reasons for these developments are complex. The one major trigger was the subprime mortgage crisis in the U.S. After U.S. house prices reverted their long upward trend in 2006, and the rate of U.S. subprime mortgage defaults turned up, tensions in the market for complex structured credit products rapidly spread to other market segments, including the money market, which is particularly relevant for monetary policy implementation.
The inherent asymmetric information on the potential solvency of banks with an exposure to U.S. subprime related securities induced a general reluctance to lend out funds, pushing money market rates increasingly upwards. In particular, term money market rates were affected as banks preferred to lend out funds, if at all, overnight, rather than for a longer period in order to protect themselves against adverse selection and to ensure that they could use the funds at short notice in case of a liquidity shock.  When this process - combined with a general liquidity hoarding for precautionary reasons - accelerated, some parts of the money markets broke down. Under these conditions, liquidity and solvency problems became intertwined as also solvent banks, unable to meet their liquidity needs, faced the risk of default.
As a result, the regular transmission of monetary policy got impaired. In the euro area, banks play a key role in channelling credit to the economy. This means that if huge risk premia are charged on bank-to-bank lending and banks stop trading with each other, reductions in the monetary policy rate cannot pass through. The repercussions on the cost and the availability of credit to households and firms can be significant and can threaten price stability.
This observation and the key role played by the lack of liquidity in the development and propagation of the crisis warranted central bank interventions. To offset the unavailability of funding in the interbank market, to limit the risk of contagion due to illiquidity and to restore confidence, the ECB undertook a number of non-standard bank based measures – what we have called our Enhanced Credit Support measures . Let me now turn to the different phases of the crisis in detail.
First phase of the crisis: The tensions between Summer 2007 and Autumn 2008
Already in the year before the default of Lehman Brothers, we increased the frequency of the refinancing operations with a three-month maturity. In addition, we introduced, for the first time ever, refinancing operations with up to six-month maturity and we supplied reserves to banks relatively early rather than linearly over the maintenance period. However, it is important to note that, before the collapse of Lehman Brothers, we did not increase the amount of liquidity lent to the banking system, which remained at about EUR 460 billion. The increased amounts of liquidity supply early in the maintenance period were compensated by reduced amounts later in the period and the increased amount in longer term refinancing operations was compensated by reduced amounts in the weekly main refinancing operations. The share of liquidity lent for a period longer than one week was increased from about 30% to about 60% of total.
Looking back, these measures were in fact not very significant and we relied mostly on the structural features of our operational framework to absorb the money market shocks coming from the financial crisis. These structural features are three-fold and imply that the Eurosystem offers a very broad range of refinancing opportunities.
First, refinancing operations are very large, making up around 50% of the asset side on our balance sheet.
Second, essentially all euro area credit institutions can participate in these operations.
Third, we accept a very wide range of assets as eligible collateral in these operations.
At this stage of the financial market turmoil central banks around the globe amended their operational frameworks with a view to incorporating the same three main features.
Still, there is one non-standard measure introduced before the collapse of Lehman which was particularly outstanding on a historical scale, notably in terms of technical and political ability of the major central banks to collaborate to address the financial tensions. I am referring to the introduction of US dollar liquidity providing operations by central banks, including the Eurosystem. In these operations we obtained, by means of FX-swaps, US-dollar liquidity from the US Federal Reserve, which was in turn lent out to our counterparties against euro denominated collateral. These operations aimed to stem significant tensions in the FX-swap market, which had made it very difficult for banks outside the US to refinance their (large) net holdings of US-dollar denominated assets.
Second phase of the crisis: from Autumn 2008 to the Spring 2010
After the collapse of Lehman Brothers in September 2008, however, there was a need for more significant measures to safeguard the transmission mechanism of monetary policy. To start with, on 15 October we adopted a fixed rate tender procedure with full allotment at the policy rate in all the refinancing operations. As a result, banks could borrow, at our main policy rate, as much liquidity from the Eurosystem as they could collateralise. At the same time, the ECB extended the already broad list of assets eligible as collateral at the refinancing operations.
In addition, we stepped up the provision of US dollar refinancing, by offering unlimited allotment against euro eligible collateral and at a penalty rate of 100 basis points above the OIS rate applied by the US Fed in refinancing operations with similar maturities. We also increased the maturity spectrum of US dollar operations offered (up to three-months) and also introduced Swiss Franc liquidity providing operations.
During the last months of 2008 and the first months of 2009 the money market crisis propagated to the “real” economy and to other segments of the financial market. As a result, we reduced our policy rate from 4.25% in September 2008 to 1.00% in May 2009. In the early summer 2009, we also took further enhanced credit support measures in order to strengthen the structural liquidity provision of the banking system and the functioning of the related segments of the capital markets.
In particular, in order to revive the euro area covered bonds markets, which had suffered significantly despite the low credit risk involved in covered bond investments, we started purchasing euro-denominated covered bonds in June 2009. Covered bonds are long-term debt securities that are issued by banks to refinance loans to the public and private sectors, often in connection with real estate transactions. The covered bond market represents a major source of funding for banks in large parts of the euro area. We expect to achieve the announced target amount for the purchases of EUR 60 billion by the end of June 2010.
Moreover, in addition to the six-month non-standard operations already in place, we decided to carry out three fixed rate refinancing operations with an unprecedented twelve-month maturity in the second half of 2009.
All these measures were tailored to the specific financial structure of the euro area where banks are the primary source of credit to the economy, unlike in the US economy in which the bulk of corporate finance is market-based. One implication of the application of all these measures was that the Governing Council allowed the very short term money market rate, the EONIA (European Overnight Index Average), to drift down to a level close to the deposit rate.
The ECB’s Enhanced Credit Support policy
Before describing our latest interventions, let me summarise the main elements on which the ECB’s Enhanced Credit Support lies:
First, the Eurosystem provided unlimited central bank liquidity to euro area banks at a fixed rate (i.e. the main refinancing rate) and against adequate collateral in all refinancing operations. The primary aim was to support the short-term funding of banks in order to alleviate the potential negative impact of liquidity risk on the availability of credit to households and companies across the euro area economy;
Second, the list of assets accepted for use as collateral was extended. This measure enhanced banks’ access to liquidity during the crisis. In particular, it allowed many banks to refinance a larger share of their balance sheet with the Eurosystem;
Third, the Eurosystem provided liquidity for longer periods, up to one year. These longer-term refinancing operations (LTROs) reduced the refinancing requirements of banks in the short term;
Fourth, in order to address euro area banks’ needs to fund their US dollar assets, the Eurosystem provided liquidity in foreign currencies, most notably in US dollars. In addition, the ECB agreed with the central banks of several European countries outside the euro area to improve the provision of euro liquidity to their banking sectors;
Finally, in order to support the long-term refinancing operations of the financial sector, in May 2009 the ECB initiated a measured, but significant, programme to purchase euro-denominated covered bonds issued in the euro area. The total sum allocated to the programme (€60 billion) represents about 2.5% of the total outstanding amount of covered bonds at the end of 2008 . This sum may appear relatively small but it has revitalised this particular market segment.
The current phase of the crisis: The phasing-out in late 2009 and early 2010 and the renewed tensions
While the non-standard measures were necessary to counter the crisis, keeping them for too long would entail danger of significantly distorting money market participants’ perceptions of actual liquidity risk and their related behaviour. Therefore, they were designed so that they could be easily phased out (in some cases automatically) whenever they are no longer needed.
By the end of 2009, the observed improvements in euro area financial market conditions led us to start a gradual phasing-out of the Enhanced Credit Support policy. The open market operations denominated in Swiss francs and US dollars were discontinued at the end of January 2010. As demand in our longer-term refinancing operations steadily declined, we decided to discontinue also our six- and twelve-month operations in euro. Moreover, we decided to return to variable rate tenders in the three-month euro operations in April. By contrast, all the remaining refinancing operations continued to be carried out as fixed rate tender procedures.
In early May 2010, the phasing-out process was suspended by the emergence of renewed financial market tensions, affecting the yield-spreads among euro area public and private debt instruments. In particular, the surge in quoted spreads observed on 6 and 7 May was very significant – some spreads doubled during these days – and undermined conditions for a smooth transmission of monetary policy. Indeed, the associated decline in some asset prices could set in motion financial market dynamics similar to those observed after the collapse of Lehman: a vicious circle of stop-loss driven “fire-sales”, contagion to other assets, market illiquidity, increasing margin calls, etc.
In this regard, while we did not observe significant increases in money market spreads, real time market intelligence, which was subsequently confirmed by increased participation in our refinancing operations, suggested that the tensions in the securities markets had already reached the money market on 7 May.
Against these very exceptional developments, which came as a surprise to us - both in terms of timing and extent - we introduced the Securities Market Programme (SMP) on 10 May, following intense preparation within few days. Under this programme we can intervene in public and private securities markets to ensure depth and liquidity in dysfunctional market segments. Like all other non-standard measures that we have taken, the Securities Markets Programme is of a temporary nature.
The decision to implement the SMP took into account the additional commitments taken by some euro area governments to accelerate fiscal consolidation and ensure the sustainability of their public finances. In line with Treaty-requirements, the SMP aims to address the malfunctioning of the securities markets and to restore an appropriate monetary policy transmission mechanism.
Let me underline that the SMP does not affect the monetary policy stance, because we absorb the related liquidity provision by means of instruments other than the deposit facility. This “sterilisation” implies that the SMP does not have any effect on current or future liquidity conditions and thereby on the level of short-term interest rates. It also underscores the fact that the SMP must not be confused with the “quantitative easing” policies adopted by other central banks. Within such policies, large scale purchases of government bonds are used as a tool to reach preset, and very large, targets for excess overnight deposits with the central banks. The Eurosystem has never had such targets.
At the same time, in order to pro-actively prevent contagion to the money market, we re-introduced some of our non-standard refinancing operations. In particular, we have temporarily re-introduced the fixed rate full allotment procedure in the three-month longer term refinancing operations, so far until September 2010. We have carried out one additional six-month longer term refinancing operations. And we have re-introduced liquidity providing USD operations in cooperation with the US Fed and other central banks.
IV. Has the ECS worked?
Evidence from market and economic indicators and of surveys
As earlier mentioned, all the measures taken by the ECB during the period of severe financial market tensions have been fully in line with the pursuit of our price stability mandate. The non-standard measures have been necessary to avoid that severe market disruptions rendered monetary policy ineffective, and to achieve effects on the economy beyond what could have been achieved by low policy rates alone. Indeed, the Eurosystem’s exceptional policy measures proved their effectiveness throughout 2009 and continued to do so in early 2010.
The measures seem to have bolstered our credibility in maintaining price stability. Inflation expectations have remained solidly anchored in line with our aim of keeping annual HICP inflation below but close to two per cent in the medium term. Long term HICP inflations forecasts for the euro area stand at 1.9 per cent both in the latest survey by Consensus Economics and the ECB’s Survey of Professional Forecasters. 
In spite of market disruptions, the lowering of the ECB policy interest rates has, with some lags, spilled over to interest rates on bank lending and deposits, roughly in line with what could be expected, based on historical experience.  Thus, our measures seem to have contributed to the maintenance of this important part of the transmission mechanism and, thereby, to continued favourable financing conditions for the real economy.
In particular, the ECB’s non-standard measures have supported the flow of credit to the economy through both demand factors, given the very low level of interest rates, and supply factors, given favourable funding conditions in the banking sector. Unlimited provision of central bank liquidity to banks at a fixed rate exerted significant downward pressure on money market rates and bank lending rates. Consequently, interest rates on short-term loans declined steadily. Likewise, overall financial market volatility decreased substantially.
The development of loans to the non-financial private sector has, nevertheless, been weak since the crisis erupted. While the annual growth rate of loans to households became positive again late last year, loans to non-financial corporations have shown negative annual growth since September last year and what we can say at best is that this negative rate seems to have stabilised in recent months. However, so far the developments in growth of loans to the non-financial private sector remain consistent with historical regularities.
Surveys show that non-financial corporations, and especially small and medium-sized firms, have faced increasing difficulties in obtaining loans, at least until late last year (which is when the latest survey was conducted). This is more of a problem for the smaller firms, as large firms have access to securities markets, where conditions have improved substantially.
Firms’ difficulties in obtaining loans seem to stem more from banks’ credit risk considerations regarding their customers than from lack of liquidity or market access on the part of banks themselves. Our Bank Lending Surveys (the latest one is from April this year) show that since around the middle of last year, access to markeet funding and banks’ liquidity positions have on balance contributed to an easing of credit standards. So, also in this respect, our measures have worked.
Finally, as regards the Securities Markets Programme and the reintroduction of some of the other non-standard measures on 10 May, available evidence suggest that the SMP has helped to reduce and stabilise spreads with respect to German government securities. As such, the programme has had a positive impact on markets.
Evidence from recent research
A more formal assessment of the impact of our enhanced credit support is of course a very complex exercise that will take some more time. However, a few indications, supported by recent research, can be given already now.
To begin with, there is some evidence that our measures caused a long-lasting reduction of liquidity risk premia in Euribor rates.  In this context, it is remarkable that the three- and six-month Euribor spreads declined by around 150 basis points between October 2008 and May 2010.
Our measures may have improved liquidity in money markets through various channels. First, with the start of the crisis the demand for term funding increased as banks tried to replace less and less certain short-term liabilities with longer-term ones. The additional provision of longer-term funding via our refinancing operations, which satisfied some of the unsatisfied demand for term funding, has somewhat reduced the upward pressure on term spreads.
Second, also with the start of the crisis the supply of term funding decreased as lending banks were uncertain about their own fund raising opportunities in the future. To remain flexible, they preferred to lend out funds only at very short maturities. Our full allotment policy in the refinancing operations and in addition the expanded list of Eurosystem eligible collateral gave reassurance to these banks that they could easily raise funds at any time from us. This made them less reluctant to offer term funds to other banks, taking some upward pressure on term spreads away from money markets. 
In addition, by offering unlimited funding for a broad maturity spectrum to a large number of banks, we have helped to avoid that banks be forced to sell assets at fire-sale prices, or at ill-suited moments. And by extending the list of eligible collateral, we have offered euro area credit institutions the possibility to refinance good quality assets, the prices and liquidity of which had nevertheless fallen during the crisis. With these measures, we have contributed to improve asset and funding liquidity and thus to lower money market spreads. 
Finally, through the measurable effect on money market spreads, our measures had also positive effects on the wider economy, including loans and monetary aggregates – as some empirical evidence suggests.  Thus, our measures improved the functioning of the monetary policy transmission mechanism, which allowed to ensure a pass through of lower rates and spreads to the real economy.
V. Enhancing the banking sector stability: The way forward
Going forward, the contribution of the banking sector to the financing of the economy will depend on some key factors. I would like to single out four of them.
Credibility and timing of exit from fiscal stimuli
First, a crucial factor is the credibility and timing of exit from fiscal stimuli. Market concerns about sovereign credit risk among the industrialised economies have progressively intensified over recent months. They opened up a number of hazardous contagion channels and adverse feed-back loops between financial systems and public finances, in particular in the euro area. The ways in which persistently large fiscal imbalances can pose risks for financial stability are manifold, with some of them propagating through real economy channels and others through financial markets and institutions.
Beginning with some of the most important real economy channels, it is well known that the public sector financing needs created by sizeable fiscal deficits often crowd out private sector financing. This usually occurs through the upward pressure that additional government financing requirements places on medium- and long-term real interest rates. Aggregate euro area long-term real interest rates indeed rose in recent weeks to levels not seen in at least a year. This suggests that the relevance of this risk and the likelihood of it impinging on the nascent economic recovery and the sizeable funding roll-over requirements of large and complex banking groups were beginning to rise.
Looking further ahead, deteriorated public sector balance sheets can create risks for longer-term economic growth by raising precautionary savings to shoulder the risk of future fiscal correction, thereby lowering future investment and productivity growth. The inevitable fiscal contraction can also impinge on the prospects for financial sector profitability and soundness.
As to the principal financial propagation channels, if government indebtedness reaches a level that is sufficiently high to trigger a loss of confidence in fiscal sustainability, investors will require additional risk premia to compensate for having to bear greater sovereign credit risk. The resulting rise in risk premia can be passed through to the funding costs of banks and more broadly of the private sector, especially if doubt is cast over the ability of the public sector to counter adverse disturbances to non-financial and financial sectors.
This risk became increasingly evident in the euro area over the past six months in the strengthening of correlations between sovereign and bank CDS spreads in those countries facing the greatest fiscal challenges. Ultimately, as witnessed in early May, the pass-through of higher sovereign credit risk premia to private securities prices can trigger extreme risk aversion, portfolio reallocations into safer assets and a drying-up of market liquidity. Some investors also took on short positions across a range of securities markets, lured by perceptions that asset prices had entered into a downward spiral.
The contagion channels currently at work underline the urgency of significant fiscal consolidation efforts over the medium term. This will also require that governments ensure timely exits from financial sector support. The legacy for the period ahead is the considerable curtailment of the room for fiscal policy manoeuvring in the future, should another episode of systemic risk materialise.
Implementation of support packages in the financial sector
Let me now turn to the second key factor on which the stability of the banking sector will depend, namely the implementation of support packages in the financial sector.
The implementation of the financial support measures have averted the collapse of fundamentally sound banks. But in the long term the support measures can generate unnecessary distortions of competition between financial institutions or give rise to forms of moral, including the possibility of excessive risk taking. Therefore, from the onset it has been clear that the financial support measures would have a temporary nature and Member States have to review their general schemes at least every six months. This review needs to be reported to the European Commission.
Given the adverse long term effects of the support measures and the fact that at the end of 2009 some concrete signs of stabilisation of the banking sector were witnessed, the ECOFIN Council agreed to design a coordinated and transparent strategy for the phasing-out of the different support schemes. A coordinated approach is essential in order to avoid negative cross-border spillover effects. It was decided to start the exit from government support through the phasing-out from government guarantees. The reason for starting the exit with government guarantees is that the unwinding of government guarantee schemes would generate incentives for the exit of sound banks and give other banks incentives to address their weaknesses.
On the basis of a proposal made by the European Commission in collaboration with the ECB, in May this year the ECOFIN agreed to change the criteria for assessing the application of state aid rules to government guarantees to be issued after 30 June 2010. Let me briefly highlight the two main changes.
Firstly, the pricing conditions will change. Evidence shows that the cost of guarantee fees is, in relative terms, considerably below the current cost of funding via unsecured debt. This is particularly the case for banks with a lower estimated creditworthiness. Therefore as per 1 July 2010, the pricing of the guarantee fees will be increased, commensurate with the credit rating of the issuing banks.
The second change is the introduction of quantitative thresholds that will trigger a bank’s obligation to submit a viability plan.
I am of the view that the combination of tighter pricing conditions, commensurate with the rating of the bank concerned, and the need to present a viability plan under certain conditions seems to provide banks with the right incentives to either gradually exit guarantee schemes or address their structural weaknesses. Having said this, I realize that the recent re-intensification of the crisis associated with sovereign debt risks may raise questions on whether the timing is right to introduce the phasing-out of financial support measures. However, given the objective of the measures to also induce certain banks to submit viability plans and possibly to restructure themselves, the goal of phasing-out should be pursued as soon as possible, even more so in light of the current external environment. Guarantees create sizeable contingent liabilities for governments and therefore their reduction/removal should, in principle, alleviate pressures on sovereign funding costs of countries with severe fiscal problems.
Financial sector reform in the medium- to long-term
I will now turn to the third key factor on which the stability of the banking sector will depend, namely the financial sector reforms. The financial sector reforms aim at addressing the weaknesses identified during the crises. Among other things, the financial crisis clearly revealed that the capital base of financial institutions proved to be insufficient to cover unexpected losses arising in times of stress, and that excessive leverage was built up. Another major weakness that became apparent was that the size and interconnectedness of financial institutions poses risks to the stability of the financial system on a global scale.
In order to address these issues, in autumn 2008 the G20 Leaders agreed on a reform agenda for a thorough review of the regulation and supervision of financial institutions. Currently, the Financial Stability Board (FSB) together with the Basel Committee on Banking Supervision (BCBS) is working on designing a comprehensive set of measures. These measures include an upgrade of the capital framework, the introduction of a regulatory framework for systemically important financial institutions, broadening the scope of regulation to encompass credit rating agencies and hedge funds, and enhancing the principles for sound compensation practices.
The G20 has set a tight timeframe for the reform; by the end of this year the work needs to be finished. It is therefore important that the regulatory reform stays high on the agenda and the work stays apace.
Let me highlight three issues which are of particular importance.
First , I would like to stress the importance of the reform package prepared by the Basel Committee as a cornerstone of the financial regulatory reform. It aims at improving the quality, consistency and transparency of capital for credit institutions as well as developing a framework for liquidity risk.
These proposals should improve the quality of capital, especially the so-called Tier-1 capital, which is of utmost importance for loss-absorption on a going concern basis.
Furthermore a non-risk-based leverage ratio will be introduced as a supplementary measure to the Basel II risk control framework. This should curb excessive balance sheet growth.
In order to mitigate the inherent pro-cyclical nature of financial activities, the Basel proposals contain capital buffers and forward-looking provisioning.
Finally, the proposals also contain a global minimum liquidity risk requirements enabling credit institutions to withstand a short-term liquidity stress and ensure longer-term stability.
The objective of this reform package is to enable financial institutions to better withstand the adverse effects of unexpected economic shocks. In order to assess the cumulative impact of the reform, both on financial institutions and on the real economy, the FSB and the BCBS are carrying out both a “top-down” and a “bottom-up” assessment of the capital and liquidity measures. The bottom-up quantitative impact assessment aims to measure how much the minimum capital requirements will increase due to the reform proposals. The main objective of the top-down assessment is to assist decision-makers in properly calibrating the measures for capital and liquidity and thus to strike the right balance between enhancing banking stability and maintaining the stable provision of credit to the economy.
The results of these analyses will be available in June/July. As the results of these assessments are not yet available, it is premature to take a position on the desirable calibration of the individual measures. I am of the view however, that from a conceptual point of view these measures are warranted, but that the precise calibration is largely dependent on the outcome of a careful assessment of their cumulative impact.
A second important issue I would like to touch upon concerns systemically important financial institutions (SIFIs). The financial crisis has demonstrated the need to subject systemically financial institutions to regulatory and supervisory requirements that are commensurate to the risks they pose to the financial system and the real economy. One of the issues currently under debate is the introduction of additional prudential measures, for instance through capital surcharges or contingent capital instruments, liquidity surcharges, more intrusive supervision, and/or the introduction of bank levies.
The ECB supports the initiatives aimed at exploring the feasibility of these additional measures. As regards the evaluation of these measures, they should be framed within a comprehensive comparative analysis investigating the interaction between the proposals and their overall cumulative effects. When assessing the merits of these measures, full account should be taken of the effects of the overhaul of the prudential framework represented by the Basel Committee’s reform package.
A third issue which I would like to highlight is the importance of achieving a single set of high-quality global and independent accounting standards by June 2011, as requested by the G20 Leaders. Among other things, high-quality and convergent accounting standards provide the foundation for a sound and consistent regulatory framework.
Against this background, the recent developments seem to put a question mark not only over the envisaged June 2011 deadline for convergence. In May, the Financial Accounting Standards Board (FASB) issued a proposal on financial instruments, which – if finally adopted – would widen rather than narrow the gap between IFRS and US GAAP. Under the US approach, more financial instruments would have to be “marked-to-market”, which in turn may lead to pro-cyclical effects. Such an outcome would clearly be undesirable from a financial stability perspective, and it would be in direct contradiction to the aforementioned G20 call for convergence.
The importance of pursuing structural reforms
Before concluding my intervention, let me also underline that it will be much easier for our banks to thrive in a sound and growing economy. Thus, in the longer run, structural reforms underpinning sustainable growth in the euro area will also be crucial support to banking sector resilience. The ECB has consistently advocated such reforms. In product markets, policies that enhance competition and innovation are needed. In labour markets, moderate wage-setting, effective incentives to work and increased flexibility are key requirements. Such reforms will also facilitate the necessary fiscal consolidation in euro area countries.
Throughout the crisis, the ECB has shown its ability to act swiftly and decisively, fully in line with its objective to maintain price stability over the medium term. All non-standard measures have been taken in this vein. They have contributed to preserving orderly conditions in the financial markets, although tensions remain. They have helped to maintain the correct functioning of the monetary transmission mechanism, thereby facilitating the transmission of low policy interest rates to financial conditions in the wider economy, thereby supporting the recovery and dispelling any deflation fears. As a result, inflation expectations remain well anchored in line with our aim of keeping inflation rates below but close to two per cent.
Even though the non-standard measures have served the economy well, we are fully aware that keeping them for longer than necessary would entail risks that should be avoided. Hence, their temporary nature and our willingness and ability to phase them out when they are no longer needed.
Meanwhile, it is crucial to continue making progress in the implementation of the regulatory reform agenda of the financial sector. The current crisis has clearly exposed weaknesses of the current regulatory and supervisory framework of the financial sector. It is crucial to address these weaknesses and to set the financial sector on sounder foundations that allow it to withstand the inevitable shocks that will occur in the future. The ability of the financial sector to contribute to the well-functioning of the economy in the long term will very much depend on how much progress is made today on implementing the necessary reforms.
I am grateful to Paola Donati, Cécile Meys and Hans Petter Wilse for contributions to this speech.
See Eisenschmidt J. and J. Tapking (2009) “Liquidity Risk Premia in Unsecured Interbank Money Markets”, ECB Working Paper n. 1025 and Heider F., Hoerova M., and C. Holthausen (2009), “Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk”, ECB Working Paper n. 1126.
Enhanced Credit Support measures have been defined as “bank based measures to enhance the flow of credit above and beyond what could be achieved through policy interest rate reductions alone”.
 According to data from the European Covered Bond Council.
SPF for Q2, long term refers to 2014, Consensus Economics for May, long term refers to 2016-2020. Eurozone Barometer for May shows a long term forecast of 2.1 per cent, referring to 2014, but based on very few observations. Market based indicators of inflation expectations dipped during the worst quarters of the crisis, but have been relatively stable since last summer.
See article in the ECB Monthly Bulletin August 2009: Recent developments in the retail bank interest rate pass-through in the euro area. Since then, bank interest rates have decreased slightly, while our main policy rate has not changed.
See P. Donati (2010), “Monetary policy effectiveness in times of crisis: Evidence from the euro area money market”, ECB Working Paper, forthcoming.
See Eisenschmidt J. and J. Tapking (2009), “Liquidity Risk Premia in Unsecured Interbank Money Markets”, ECB Working Paper n. 1025.
See Brunnermeier M. K. and L. H. Pedersen (2009), Market Liquidity and Funding Liquidity, Review of Financial Studies, 22(6), 2201-2238..
See M. Lenza, H. Pill and L. Reichlin (2010), “Monetary policy in exceptional times” CEPR discussion paper No 7669
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