For starters, I would like to congratulate the Finnish Economic Association, which from the start of the year combines under one roof the activities of the Finnish Economic Association and the Finnish Society for Economic Research. My wish for the Association is for an active future and great success in its important task.
A little less than two years ago at a meeting of the Economic Association held at the Bank of Finland, I spoke about the principles of monetary policy and some topical issues of that time. Since then, much has happened.
At the time, that is, in my presentation in spring 2007 I said: “Monetary policy needs to pay attention to credit and money variables not only in the assessment of the potential inflationary impact of aggregate demand, but also because changes in indebtedness affect the stability of the financial markets and the whole economy. For one thing, the stability of the banking sector is a necessary prerequisite for the pursuance of successful monetary policy. For another, corporate and house-hold indebtedness affects the susceptibility to disturbances of the whole economy. The higher the indebtedness of the economy, the faster aggregate demand reacts to different negative distur-bances, such as fluctuations in economic outlook.”
I doubt that anyone could have foreseen that this threat would began to materialise already in the summer of 2008. Back in August 2007, there was an abrupt turn in one segment of the US housing loan system, the market for subprime loans, which triggered liquidity problems across the fi-nancial sector. Soon huge credit and currency losses and consequent capital adequacy problems surfaced along with the liquidity problems.
We are now witnessing a ‘deleveraging process’, whose impacts on the real economy can be seen everywhere. Growth of aggregate demand in the world economy has come to a halt as economic agents en masse try to repair their balance sheets at the same time.
Throughout last year and even in January of this year, growth forecasts for 2009 have been revised downwards. According to recent forecasts, the GDPs of developed countries will contract substantially this year. World trade will also shrink, and this will notably slow the growth of emerging economies that rely on export-driven growth strategies. The idea that emerging Asian economies could offset the decline in US demand in the world economy is not being realised. This was the rationale for the so-called soft landing and decoupling scenarios of recent years.
Confidence indicators are at historical lows. Not only have growth forecasts been revised substantially downwards; the associated uncertainty still exceeds the usual levels.
Due to the abrupt slowing of growth, inflation has receded quickly. In particular, following the sharp rise of recent years, the prices of raw materials have dropped just as sharply. In some countries the halt in price increases has brought fears of deflation.
The financial crisis has highlighted the extent to which national financial systems are intertwined and how interdependent are the different economies.
How is it that the world’s financial markets are so highly sensitive to a change in the economic outlook? The underlying cause is a protracted and oversized accumulation of debt and an underestimation of risks. The structure finally broke where it was most vulnerable, in the US housing finance system.
Many US financial market innovations in the last few years have been in the area of housing finance. One of these, the originate-and-distribute model of securitisation, which was also employed in the financing of subprime housing, functioned smoothly as long as housing prices kept on rising. However, when the price rise stopped in 2006, the problems began to surface. And when housing prices went into decline in 2007, the system collapsed.
Subprime loans had a structural defect. After two amortisation-free and low-interest years, the interest rate would be set at levels as high as Libor+6 percentage points. Because prices began to decline at the same time, many borrowers whose ability to repay had always been doubtful had to walk out of their homes. Fire sales worsened the downward spiral in the housing markets.
On the other hand, US indebtedness was enabled and fuelled by expanding investment flows from the Asian surplus economies. These countries amassed huge stocks of investment assets and exported relatively cheap capital to the United States, which only acerbated the imbalances in the world economy. The expansion of the financial crisis to the global scale illustrates how dependent on US investment vehicles the international financial system has been in recent years.
Central banks’ monetary policy and the financial crisis
The core functions of a central bank can be summarised as four areas:
- monetary policy: preparation and implementation
- banking operations: monetary policy operations, settlement of large payments and portfolio management
- financial oversight: stability analysis, potential emergency funding)
- currency supply: availability of banknotes and coins and control of their quality and authenticity.
The crisis has brought changes to all of these areas. I will concentrate on the first three, although the crisis has also been felt in connection with currency supply.
Changes are taking place in how we think about monetary policy and how its implementation is organised. Some of the changes are exceptional solutions for crisis situations, but the present crisis will also have a permanent impact on the operation of central banks.
Under normal circumstances, the central bank’s primary focus is on monetary policy aimed at price stability. Now I believe the financial crisis is also impacting our thinking about monetary policy strategy, both in the central banks and in academia.
The one and half decades or so preceding the crisis were a time of growing support for direct inflation targeting. The often-prevailing notion was that monetary policy was simply interest rate policy and that a sufficient aim of interest rate policy was to hit inflation forecasts that were consistent with the price stability objective. In this context, quantitative magnitudes such as money and credit stocks played a secondary - if any - role.
The European Central Bank has not strictly adhered to a strategy of direct inflation targeting; instead, it has always conducted its monetary policy on the basis of a ‘two pillar’ system. In this framework, inflation forecasts are in ‘economic analysis’ pillar and growth of the money stock is in the ‘monetary analysis’ pillar. In past years, this two-pillar framework at times aroused heated criticism and was considered old-fashioned and theoretically opaque.
One cannot exclude the possibility that at some point the present problems will be ascribed to overly lax monetary policy in the pre-crisis years. Neither is it far-fetched to conclude that it would have been better if central banks around the world had paid more attention to controlling the growth of money and credit stocks.
Now that it has become clear how crucial credit expansion and liquidity are for the emergence of the present problems and for the conduct of monetary policy in the crisis, I suspect that monetary policy will be viewed from a broader perspective than before.
Policy interest rates have now sunk to historic lows, as current business conditions would demand. In the United States, monetary policy has even faced the zero-interest-rate constraint. The Fed’s target level for the interbank overnight rate (Federal Funds Rate) has been cut to the range of zero to 0.25%. It is impossible to go much lower since the zero rate on cash holdings constitutes a type of floor for policy rates.
Previous experiences with bottom-level interest rate policy are mainly those of Japan in the 1990s and in the United States in the 1930s. These two episodes show that lowering policy rates to zero may not be enough to get you out of a credit crunch and deflation.
How can monetary policy be eased further when the traditional interest rate measures are exhausted? Japan already has a long experience with ‘quantitative easing’. The Federal Reserve has now resorted to roughly similar measures. The balance sheet total of the Federal Reserve system has tripled, from USD 800 bn to USD 2400 bn, as the Fed has extended its lending to new participants and introduced entirely new means of lending - finance facilities - which enable it to provide loans to the private sector.
Discussion about zero interest rates and quantitative easing has also emerged elsewhere. However, the situation in Europe, at least for the time being, is different. There is less chance of deflation here.
This should be taken into account in discussing how low ECB policy rates can go. At the same time, it should be borne in mind that the ECB's price stability objective means keeping inflation close to, but below, two percent in the medium term. Zero inflation - not to mention falling prices – is not within the scope of this objective. Even expectations of deflation would be detrimental for total demand and for the real-estate markets.
Besides price stability, central banks also strive to ensure the stability of the financial system, a task that is highlighted in times of crisis. At times, emergency funding may also be needed.
In normal times, an important way to ensure financial stability is to succeed in controlling the value of money. Sufficiently calm monetary conditions both contain inflation and prevent credit bubbles that could jeopardize stability. The other side of the coin is that pursuance of sound monetary policy is much easier if financial markets function in a reliable and stable manner.
Under normal circumstances, financial market stability is a concern of regulation and supervision, with central banks mainly monitoring conditions and maintaining crisis management capabilities. However, a stabile situation may be disrupted and, as witnessed recently, the central banks may end up on the front lines, confronting issues such as whether and under what conditions emergency funding can be provided to problem-ridden banks.
However, if regulation, competition and market transparency (the information base) are not up to par, even a good monetary policy environment cannot guarantee financial stability. It has even been claimed that an era of stability leads to a reduction in risk-awareness and the underestimating of risks, which only worsen and lead up to the next crisis.
This ‘disaster myopia hypothesis’ was enunciated by Hyman Minsky already in the 1960s and has recently attracted renewed interest. If the hypothesis is true, then no regulatory- supervisory system can withstand good times and the resultant liberalisation pressures, and so crises will inevitably recur from time to time.
The central bank in acting as emergency financier faces some well known risks. Excessive reliance on liquidity support from the central bank may, at worst, induce banks and other market participants to pay insufficient attention to liquidity or even solvency. On the other hand, denial of emergency funding may have consequences such as we witnessed last autumn in the liquidation of Lehman Brothers. The dilemma is a tough one; but there is no way around it. Many central banks have recently faced it - fortunately not the Bank of Finland.
The upshot is that proper performance of the central bank’s task of ensuring stability requires a good system of regulation and supervision that prevents the ‘moral hazard’ problem of excessive risk-taking due to the existence of a safety net.
The crisis has laid a firmer foundation for international consensus on supervision issues. One step in that direction was the euro countries’ summit in Paris in October, where the countries made a commitment to secure the continuity of systemically important financial institutions and correspondingly promised to strengthen the structures of financial supervision. I will return to the pros-pects for supervision in more detail at the end of my presentation.
Changes in implementation mechanisms of central bank policy
The third key task of a central bank - as bankers’ bank - has also been highlighted in the current crisis. As liquidity in the financial system dried up, banks set out to secure their own payment capacity, which led to a freezing-up of the interbank market. This gave the central banks an even more important role, beyond securing overall liquidity of the banking system: mediating liquidity between banks.
Before the financial crisis, central banks' banking operations were considered to be basic technical services provided in the shadow of monetary policy. Now the situation has changed completely, as the crisis has forced us to pay close attention for example to the auction procedures of monetary policy operations and the central bank’s collateral policy and collateral management. Suddenly these functions assume a very central and changing role on the stage of monetary policy.
Within the Eurosystem, acting as bankers’ bank is a task of the national central banks. Although ECB market operations are decided on a centralised basis, they are implemented on a decentral-ised basis by the national central banks, including the Bank of Finland. The reception and management of collateral for lending is also a job for the national central banks. Hence the financial crisis has spotlighted the role of national central banks within the Eurosystem.
In contrast, in the US, the Fed decides on operations on a centralised basis, but the New York Federal Reserve Bank operates alone in the markets. This division of tasks remains unchanged. In other respects, however, the Federal Reserve has, since August 2007, made more changes in its operations than in its entire previous history. The number of counterparties has increased significantly, collateral procedures have been substantially revamped, etc. In the past, the Fed's market operations were restricted to short-term government paper, and private sector paper was approved as collateral only at the discount window, which provided funding solely for extraordinary and temporary payment difficulties.
The ECB’s operational framework, on the other hand and for historical reasons, from the onset included a large number of counterparties, and the pool of securities and bank loans approved as collateral for refinancing operations was extensive already before the financial crisis. Therefore it has been possible to respond even to pronounced changes in the operating environment of the euro area, primarily by adjusting existing operating procedures and resetting framework parameters.
However, a lot has also happened in the euro area. After all, the financial crisis has been the historically most significant test of the operational framework of monetary policy.
The financial crisis has proceeded in a gradual manner. Initial symptoms of problems in the financial markets surfaced in some sectors already in early 2007, but operation of the money market - the actual home base of the central bank - was not badly disrupted until August 2007. This first stage, labelled a disruption or turbulence, was characterised by a persistent lack of money market liquidity.
Two changes were made already in the early stage.
First, together with the US Federal Reserve, the ECB decided to offer collateralised dollar-denominated refinancing to euro area banks acting as its counterparties.
The reason for such joint operations was the decoupling of the euro interest rates on the dollar from the interest rates in the later-operating US money markets. The widening of the interest rate spread was largely due to a dearth of trust between banks on opposite sides of the Atlantic Ocean, and the central bank cooperation was aimed at securing a frictionless flow of dollar liquidity across the Atlantic.
Secondly, the demand for longer-maturity central bank money – beyond the normal one-week period - increased sharply at the outset of the financial turbulence. Therefore the Eurosystem substantially extended the average maturity of central bank refinancing. Prior to the turbulence, the regular one-week basic refinancing operations accounted for about two-thirds of total refinancing, and the longer-term operations covered a third.
After the financial disruption in late summer of 2007, the Eurosystem began to increase the size and variety of longer-term refinancing operations. Soon the proportions were reversed: only a third was for one-week maturity and the remaining two-thirds were for the longer maturities of 1–6 months.
In September 2008, the financial disturbance turned into a full-fledged crisis in the wake of the Lehman Brothers bankruptcy. Concern about a significant expansion of credit risk paralysed money markets around the world. It was especially at this stage that the problems of the US money markets swiftly spread around the world.
Activity in the interbank money markets virtually came to halt, and conditions in the financial markets worsened materially. Risk premia in the interbank money markets, which were already at high levels, jumped to new highs - in the euro area and elsewhere in the world. Uncertainty about the future state of the financial markets and the economy increased sharply.
Uncertainty as to how much money would be auctioned off induced banks to notably raise their bid rates in a race to obtain liquidity from the central bank. The situation became unsustainable from the central bank’s perspective when the average accepted bids exceeded the policy rate set by the Governing Council by nearly 75 basis points at worst. In other words, at that point the price of central bank money was almost three normal rate hikes above the target level.
At the same time, Euribors in the interbank markets began to have a life of their own, decoupled from the ECB policy rate. The danger was that the ECB would lose its grip on actual conditions in the money markets: the transmission mechanism of monetary policy had been seriously weakened.
At that stage, two major changes were made in the ECB’s basic refinancing system, the first relating to the liquidity auction mechanism and the second to collateral policy.
Previously, the ECB announced the minimum price of auctioned liquidity and at the same time controlled the amount of liquidity distributed. An individual bank would not obtain the liquidity it wanted if its bids were below the marginal auction rate. If it bid at the marginal rate, it obtained only a part of the requested amount. The marginal rate itself was determined by the bids and the ECB’s target level of liquidity.
At the start of October, the Governing Council revised the system by introducing fixed-price auctions. Here, the banks’ quantity-bids are accepted in full if they have enough eligible collateral to cover them. In these ‘volume tenders’, the central bank announces the price of liquidity, at which the supply is perfectly elastic. The banks inform the central bank of the amounts of liquidity they are willing to borrow at the given price.
The move to volume tenders immediately eliminated the gap that had developed between the effective rate and the policy rate and, in a technical sense, the operability of the first link of the monetary policy transmission mechanism was restored. It took much longer before the Euribors - even the shortest ones - converged again to the policy rates. In recent weeks, the situation in this regard has become more normal, and one could probably say that the ECB and Eurosystem have regained their usual grip on the level of money market prices. This has also contributed to a rapid decline in market rates.
However, the uncertainty facing the banks and the heterogeneity of the banking sector continue to impact the markets. Whereas banks previously trusted in being able to borrow short-term finance from the markets whenever necessary, they are now holding large excess reserves – liquidity buff-ers - in their central bank accounts.
The massive amounts of excess reserves were instrumental in the Governing Council’s decision to narrow the interest rate corridor from two to one percentage point in connection with the introduction of volume tenders. If a bank made an overnight deposit in the central bank of money bor-rowed from the central bank, it incurred a cost of half a percentage point - half of the previous cost.
Last week, the two-percentage-point corridor was restored, so that now if a bank deposits such borrowed money in the central bank, it earns interest at one percentage point less than the policy rate. Correspondingly, banks pay one percentage point over the policy rate for overnight loans from the marginal lending facility. The purpose of restoring the original interest rate corridor is to give banks the incentive to once again even out liquidity among themselves on market terms.
Collateral policy was another area of significant change in the policy implementation mechanism. In October 2008, the Governing Council revised the collateral policy of the Eurosystem so as to ensure that banks’ liquidity supply would not dry up because of a shortage of assets for use as collateral. The importance of this action in the context of a financial crisis should be obvious.
The collateral pool was expanded by adding certain dollar, pound sterling and yen-denominated marketable debt securities and by lowering the rating threshold of eligible instruments from A- to BBB-.
I noted earlier the differences between collateral policies of the Eurosystem versus other major central banks. Because the treaty establishing the Eurosystem prohibits the favouring of government debt, private debt instruments - including not only securities but also certain bank loans meeting specific criteria - comprised an important segment of collateral accepted by the ECB already in the years before the crisis.
This is an important factor in the modesty of the changes that have been made in ECB collateral policy even in the midst of financial crisis. In contrast, many central banks have been forced to make fundamental revisions in the principles of collateral policy as the crisis has deepened.
In formulating collateral policy, central banks must always weigh the safeguarding of financial stability against the ballooning risks of their credit operations. The choice is neither easy nor straightforward.
In light of experience gained so far, the operational framework of Eurosystem monetary policy has proven flexible and functional. It has enabled the effective maintenance of market liquidity. With the changes made last autumn, it has also improved the transmission of the Governing Council’s monetary policy actions into market interest rates.
The central bank’s policy measures taken during the worst phase of the financial crisis have solidi-fied the critical role of the Eurosystem in the context of financial market disruptions. Strong, financially sound banks are able to readily utilise the Eurosystem as a source of liquidity even when the interbank money markets are frozen.
The model of centralised decision-making and decentralised implementation has worked well in the euro area. The role of national central banks in putting together the system’s liquidity management toolbox has been underlined by their close relationships with counterparty banks.
The model of centralised decision-making and decentralised implementation can also be credited at least partly for the ECB’s ability to react rapidly in the early stage of the crisis in August 2007 as well as for the Eurosystem's ability to revise its liquidity management practices throughout the crisis.
In this respect, the Bank of Finland has not stayed on the sidelines. Thanks to our own analytical work and previous experiences, we have been actively involved in adjusting the interest rate steering system.
Cooperation between central banks during the crisis
Due to the global nature of the crisis, its management has required joint efforts by major central banks, such as the ECB and those of the UK, Japan, Switzerland and the US, to secure liquidity in the international money markets and to alleviate the impacts of the financial crisis on the real economy.
The dialogue between economists in different central banks and decision-makers, which is active even under normal circumstances, has intensified in the course of the crisis, and the exchange of ideas has been supplemented by unprecedented joint interventions in the money markets.
It was pointed out above that the Eurosystem and many foreign central banks have offered dollar liquidity in their open market operations in cooperation with the Federal Reserve.
In addition to the dollar refinancing operations, the Eurosystem has provided its counterparties with Swiss francs. All of these operations are proof of central banks’ desire and ability to act in money markets in the common interest when the situation requires it.
As the most visible evidence of exceptionally close cooperation between central banks, one could mention the coordinated 50 basis-point rate cut of last October. Central bank policy rates in the developed countries have been rapidly eased to historical lows.
In addition to multilateral operations between major central banks, the large central banks (particularly the ECB) have supported smaller currency areas by granting swap limits to their central banks, allowing the smaller central banks to calm their money markets.
Will financial supervision change because of the crisis?
While the financial crisis has resulted in crisis management operations on an unprecedented scale, it has also spurred discussion about reform of the supervision-regulation systems. The institutional structure of financial supervision has previously been reformed following experiences of financial crisis. Crises help to get over the institutional frictions often related to supervisory reform. Changes are also partly driven by development trends in the markets. Supervisory reforms are now on everybody’s agenda.
Supervision is surely being reinforced and its scope extended in many ways due to the crisis. A commitment to that effect was made also at the political level in the G20 summit in Washington last November.
One common area of development, particularly in Europe, is the internationalisation of supervision. Financial supervision in the EU is currently based on three basic pillars: responsibility of the national supervisory authority, the principle of home state control, and cooperation and coordination arrangements between supervisory authorities.
The number of financial institutions operating in several countries has increased in recent years in the EU area. For example, by the end of 2007, there were 45 European banking groups with significant activities outside the home state. These banking groups operating in many countries account for two-thirds of the EU's banking markets.
Banking groups try to centralise their key businesses, such as funding, wholesale market and trading operations, as well as the management of market risk and partly also credit risk. As a result, not just branches but also subsidiaries are often managed in a highly integrated manner.
These changes in the financial sector have added to the pressure to reform the EU’s financial supervision structures. When a bank is systemically relevant in more than one country, the solution has been to improve cooperation between the supervisor in the head office country (home supervisor) and the supervisor in the country of location of the branch or subsidiary (host supervisor) by establishing ‘colleges of supervisors’.
Progress has been made in this respect, which is important to Finland, and a corresponding legal basis is being established at the EU level.
The ongoing financial crisis has also revealed problems in the institutional structure of the EU’s current supervisory system. There is a chance that in a crisis, efforts will be made to protect the interests of national interest groups even when crisis management concerning financial institutions operating in many countries would require a systemic perspective and seamless cooperation between authorities.
An important question going forward is how to organise supervision at the level of the EU or euro area of large international banks operating in several countries. When the number of countries involved is large and the bank is systemically relevant also to the entire EU area, a college of supervisors is no longer a satisfactory way to arrange supervision. A group chaired by Jacques de Larosiere, former managing director of the IMF, is preparing a proposal on the issue.
In many areas of the EU’s internal market policy, supervision solutions have been designed so that the national supervisor independently deals with nationally relevant issues and then the supervisors together form a supervisory structure that is responsible on a centralised basis for issues or companies with broader influence in the internal market. Examples can be found for instance in the areas of pharmaceuticals or competition - and why not also in chemicals. Another model is the European System of Central Banks.
Financial supervision is a highly diverse and multifaceted issue. Nonetheless, one should be openminded about finding a solution for supervision at the level of the EU or euro area also in this field. Experiences with the present financial crisis now offer an opportunity to implement reforms.
One alternative at hand is that the supervision of large banks operating in many euro area countries be established in connection with the ECB. With respect to supervision of the banking sector, this reform could be effected without revising the Treaty. Therefore it would be a pragmatic way to move on. However, this would require that the division of tasks between supervisors at the European and national levels be clearly defined. In addition, a solution has to be found for how monetary policy and financial supervision can be conducted in the new structures separately and independently enough, while also ensuring proper exchange of information and interaction. To be sure, there are other issues that have to be explored, all with an open mind.
In addition to the internationalisation of supervision, another key reform area is increasing the coverage and uniformity of supervision across sectors. In a G20 statement, commitment was made to regulate or supervise all financial market products and agents. Previously, US investment banks for example operated outside the scope of banking supervision. The fading of sector borders and interlinking of risks has added to the pressure to reorganise and combine the networks of sector-specific supervision and regulation authorities.
In this respect, Finland is on top of market developments. The new financial and insurance supervision authority, the Financial Supervisory Authority (FIN-FSA), commenced operations on 1 January 2009. The FIN-FSA, generally speaking, took over the tasks of the previous Financial Supervision Authority and Insurance Supervision Authority. The Financial Supervisory Authority is independent in its decision-making but operates in connection with the Bank of Finland. The solution has aroused much interest elsewhere.
The advantage of the Finnish model, besides uniformity of supervision, is that it supports coordination and information flows precisely at the interface where it is most needed, between the supervisory authority and the central bank, which may have to consider the need for emergency funding.
In this presentation, I have focused on a review of the impacts of the financial crisis and the challenges posed by it from the perspective of the central bank. Monetary and fiscal policies have their division of responsibilities and central banks have their independence, which they are deter-mined to hold on to.
Nonetheless, it is clear that economic policy can effectively alleviate the negative impacts of a financial crisis only by means of joint efforts among the various policy segments. Central banks consider measures taken by governments to ensure and reinforce banks’ capital adequacy to be crucial. It is good that proposals to that effect have also been made in Finland. Reinforcement of banks’ capital also promotes the objectives of monetary policy and supports the efforts of central banks to ensure the continuous functionality of the financial sector.