European money and finance forum

Speech by Fabrizio Saccomanni, Vice President for Risk Management: Seminar on Ensuring Financial Stability – Global and European Perspectives
Central Bank of Malta, 27-28 March 2003

Financial stability is a pre-requisite for the optimal allocation of resources. Consumer and investment decisions are misguided by the distorted asset prices, which characteristically precede a financial crisis.  The ability of the financial sector to attract savings and channel them to the productive economy is eroded during a period of financial instability. Inevitably, this leads to output losses, the size and duration of which can eventually have an impact on the ability of traditional economic policy instruments to reverse the crisis.

Ensuring financial stability in an enlarged European Union (EU) – the subject of this highly topical SUERF seminar – is an issue that can be addressed at two distinct levels.  At the level of the EU, it means that individual member states, both “old” and “new”, must endeavour to ensure that their banking and financial systems are sound, efficient, competitive and well regulated, consistent with the objective of full financial integration in Europe.  These are challenging tasks, but at least they are sufficiently clear in terms of their policy implications. But in the context of globalisation, ensuring financing stability is a task that must be addressed also at the level of the international monetary and financial system.  Here the policy implications are much less clear since, with the process of globalisation the very nature of the “system” has been undergoing major changes in its institutional foundations and in its “rules of the game”.  Despite these difficulties I will try to address the seminar topic from both viewpoints.

I will briefly review the recent evolution of the international monetary and financial system in the context of globalisation and examine current trends in international capital flows. Secondly, I will survey the process of reform in the banking and financial sectors in the prospective new member countries of the EU and will identify potential risks to financial stability.  Finally, I will raise some outstanding analytical and policy issues that will have to be tackled in the form of international economic cooperation in order to achieve lasting conditions of monetary and financial stability.

Recent evolution of the international monetary and financial system

The gradual establishment of conditions of financial globalisation in the 1980’s has coincided with the intensification of episodes of instability, with significant international repercussions. These episodes have been associated with large unidirectional movements in the price of assets, such as real estate, bonds, shares, currencies, followed by sharp reversals leading to significant disruptions in the orderly functioning of financial markets, the bankruptcy of intermediaries or, in some cases, to the suspension of the debt servicing obligations of major sovereign borrowers.  Contrary to popular belief, these episodes have not occurred only in emerging or transition countries, but have involved also mature economies, like Japan, or affected efficient markets like the New York Stock Exchange, NASDAQ or the international bond market. Currency misalignments have not been concentrated in Latin America or South East Asia, but have at one time or another affected the three key currencies of the world monetary system: the dollar, the euro and the yen.

Although the triggering factors for the outburst of crises have been closely connected with specific imbalances in individual countries or markets, the alternation of situations of excessive credit expansion with phases of sudden credit contraction, typical of such crises, has been increasingly linked to “systemic” shortcomings of global financial markets.  These include the tendency by global players to underestimate and therefore to “underprice” the risk of financial operations and the tendency to overestimate the degree of liquidity of markets; moreover, competitive pressures lead to “herd behaviour” of intermediaries which may result in phenomena of financial contagion.  In turn, the tendency of markets to generate “boom and bust” cycles has been associated with the monetary policy stances adopted by the major key currency countries (i.e. the US, the Euro zone and Japan) whose influences have been amplified and propagated by financial intermediaries, thus influencing the direction of international capital flows (Saccomanni, 2002).

Under these circumstances, financial flows to emerging markets have shown considerable volatility, as clearly visible in Figure 1. These developments are well known, and I would like to highlight just a few aspects which may be relevant for the issue under discussion in this Seminar.

A first aspect is that since the Asian-Russian crisis of 1997-98, there has been a drastic decline of private financial flows to emerging markets, signalling a generalised phenomenon of risk aversion, in particular as regards banking flows. This is quite different from the situation prevailing after the Mexican crisis of 1994, when private flows to emerging countries recorded only a temporary decline and resumed a strong growing pattern in 1995 96. Such risk aversion attitude towards emerging markets is all the more significant in the present circumstances of abundant liquidity in international capital markets and historically low interest rates in major industrial countries.

A second notable aspect is that since 1999 even the more stable component of capital flows, foreign direct investment (FDI), has shown a moderately declining pattern. This development is probably a consequence of the way in which the debt crisis has been managed in Argentina: the disregard of investors’ rights and the vicissitudes of the negotiations on debt restructuring have increased the long-term risk perception of investors and contributed to a sharp decline in foreign direct investments in Argentina. In 2001 the FDI flows in Argentina declined to almost a quarter of the amount in 2000 (from $11.2 billion in 2000 to $3.2 billion in 2001).

Although the experience has differed at the region level, the issue of capital flows volatility is a concern for all regions of emerging markets. Political and economic turbulence in Latin America, accompanied by weak equity market performance and increased bond spreads, led to a sharp decline (by half) of total net capital flows of that region over the past year (in all its components). In emerging Asia, a significant economic performance has attracted larger capital in flows.  However, if one deducts FDI to China, which account for about 85 per cent of the total, very little new direct investment flows have gone to the rest of the region.

In transition countries, macroeconomic stability and reform progress have attracted private investment, including a growing proportion of portfolio flows which are more prone to volatility. Among transition economies, accession countries received 60 per cent of FDI flows to the region, as they are considered an attractive risk in view of the institutional linkages with the EU and the prospect of continuing strong economic performances in the context of the convergence process.

Even among accession countries, a significant episode of FDI volatility has been recorded. In Hungary, after a decade of significant foreign direct investment inflows (an average of 4.5 per cent of GDP over the 1991-2001 period), the absence of new privatization deals, combined with the protracted exclusion of foreign investors from large public sector investments in infrastructure and lack of transparency in public procurement practices led to a drastic drop in FDI to 1 per cent of GDP in 2002.

The conclusion I would like to draw from these considerations is that volatility of financial flows to emerging markets is likely to stay, at least for the foreseeable future, and will continue to affect, albeit in differing degrees, all components of international capital movements.

Financial sector developments and challenges in the new EU member countries

In this Section, I would like to review the status of financial sector reform in the new EU members, the potential sources of instability and the remaining policy agenda after accession. Many of the issues raised here affect in particular the transition economies among the accession countries, as Malta and Cyprus have fairly advanced financial sectors. Some of the challenges, however, are common to all EU members, both new and old.

Overview of financial sector reform and development

The accession countries have made remarkable progress in transforming their financial sectors in the 1990’s. There have been significant achievements in the privatisation and restructuring of state banks in most of these countries; there has been exit by failing institutions and entry and development of new domestic and foreign banks; there has been improvement in the legal, supervisory and regulatory framework, which has supported enhanced competition in the provision of banking services.

Despite this significant progress, the financial sector still lags behind as regards the scale and scope of their provision of financial services. Financial systems have developed more as ‘bank-based’ systems than as ‘market-based’ systems, with the banking sector being the major provider of financial services. Nonetheless, the size of the banking sector is still generally small both in relative and in absolute terms compared to the current EU member countries. The ratio of banking assets to GDP ranges between 32 per cent (Lithuania) and 130 per cent (Czech Republic) as compared to 240 per cent of the Euro area.  Only in Malta and Cyprus this ratio stands at about 230 and 250 per cent of GDP, comparable to the Euro area average.

The banking sector in the region is characterised by a high degree of foreign ownership (71 per cent of assets on average in accession countries of Central and Eastern Europe, ranging from 16 per cent in Slovenia to about 98 per cent in Estonia). This is a significant difference with the Euro area banking sector, where, for historical and cultural factors, foreign ownership accounts for only 20% of assets on average. Foreign ownership has the advantage of bringing in needed capital, know-how and best practices in banking and corporate governance; over the past decade it introduced competition in state controlled sectors and significantly strengthened the banking system against spill-over of crises in other emerging markets.

However, foreign-ownership has not been necessarily conducive to a more active role in lending to the real economy.  The degree of bank intermediation in all accession countries has in fact contracted since restructuring and privatisation took place, albeit to a different extent among countries, and only in very recent years it has risen again.  The low level of bank intermediation is explained primarily by the prudent behaviour of banks vis-à-vis clients lacking the appropriate risk-return profile; however, the lack of long-term funding, poor credit skills and weak enforcement of the legal framework for creditor protection also played a role. Moreover, the large presence of foreign banks has not reduced the relatively high proportion of non-performing loans (ranging from 1.5 per cent in Estonia to 24 per cent of total loans in Slovakia).  

The range of financial services provided by the banking sector in accession countries (except for Cyprus where banks provide the full range of financial services) is also very limited compared to that of developed market economies. The degree of availability and terms of mortgage finance and other consumer finance (credit card, electronic banking, etc.) make these services accessible only to a very small fraction of the population. Leasing, a suitable financing tool for small and medium-sized enterprises (SMEs), has not really taken off in some countries (e.g. Bulgaria and Romania), and in others it is available only on a short-term basis.

Furthermore, even in the most advanced countries of the region, banking efficiency remains lower than that in the EU countries despite some progress.  A significant indicator is the spread between lending and deposit rates which at the end of 2001, ranged from 4.1 per cent in the Czech Republic to 17 per cent in Romania, as compared to an average of 3.3 per cent for the Euro-area. Only in Malta and Hungary banking efficiency has improved considerably and the lending deposits spreads are below the Euro area average (2.0 and 2.9 per cent respectively).

The relative underdevelopment of the banking sector in accession countries is not compensated for by a strong non-bank financial sector or by thriving capital markets. If anything, the degree of underdevelopment of capital markets and non-bank financial institutions is greater than that of the banking system. Stock markets exist in all the accession countries and so does the relevant legal and regulatory framework to support them. However their growth has not been comparable to the growth experienced by their respective economies, in some cases they have actually shrunk in recent years. Moreover they are dominated mainly by large companies and do not manage to offer a meaningful opportunity for allocation of savings, nor provide a reliable source of finance for local companies or an exit route for foreign investors. The dominance of foreign investor constitutes an element of volatility as they are highly exposed to global market sentiment. Domestic players are few, both institutional and individual.  Reform of the pension systems in these countries has only recently started and pension funds are generally reluctant to take risks, having been scarred by poor performing stock investments in the first half of the 1990s.  Because of the thinness of these markets, the best firms opt to be listed abroad rather than domestically.  Moreover the legal and regulatory environment still needs to be further developed in order to lower barriers to both entry and exit.

Potential sources of financial sector instability

From the short overview of financial sector development in accession countries it is possible to conclude that the goal of becoming EU members has accelerated the reform process of the financial sector in these countries in an unprecedented way. However, additional challenges may arise as a result of the process of financial integration in the EU.

A first potential risk to financial stability in accession countries relates to the size and volatility of capital flows which is expected to increase, with the prospect of total liberalisation of capital account and the eventual adoption of the single currency in the context of EMU membership.  Large capital flows may have a negative effect on the financial sector of accession countries, especially on the banking sector which is the major channel for their intermediation (Buiter and Taci, 2003).  Capital inflows into the banking sector may fuel rapid credit expansion, with banks being increasingly exposed to credit and foreign exchange risks and to maturity mismatches in foreign currencies.  Heavy inflows can also lead to excessive real exchange rate appreciation, potentially eroding competitiveness and resulting in deterioration in performance of some of the banks' clients, with possible negative repercussions on debt repayments, thus more bad loans in the banks’ balance sheet.  More generally, rapid growth of assets strains banks’ capacity to assess risk adequately.

The perceived sustainability of policies in the prospect of the EU/EMU accession, may also affect the composition of capital inflows. In particular, speculation on interest rate convergence as well as on improved economic conditions and currency appreciation may attract an increasing flow of short-term and portfolio capital.  For at least a year now, the accession countries have been the subject of ‘convergence plays’ by external portfolio investors and domestic borrowers, especially local banks.   Short-term inflows driven by speculative considerations can be quickly reversed once the arbitrage opportunity ceases to exist. With a build-up of cross-border and foreign currency transactions, sudden and large reversals of capital flows or large currency movements can have damaging consequences on the health of individual financial institutions. Moreover, shifts in sentiment, leverage, and liquidity problems can multiply and transmit shocks throughout the financial system. The re-emergence of twin fiscal and current account deficits in some accession countries (as in the Slovak Republic and in Hungary) points to the risk of a sudden reversal in investor confidence.  Local banks with hard currency liabilities and local currency assets will be highly vulnerable to a sudden depreciation of the exchange rate due to reversal of capital flows.

The increased integration of financial markets after accession also intensifies the risk of contagion through financial channels.  In a more financially integrated market, events in other EU countries may have a destabilising impact on countries with relatively underdeveloped banking and financial systems.  Given the relative low level of intermediation in the accession countries as well as the limited range of financial services currently provided by the financial sector, the integration in the EU markets will be inevitably associated with a further expansion of bank’s balance sheets and loan portfolios.  The EU accession will increase the competition not only within the banking sector but also through the pressure of increased provision of services from non-bank financial institutions;  this may induce banks to take excessive risks and expand further in the new activities and markets in an attempt to survive in a more competitive and complex market place.  These market segments, such as retail loans, SME lending and financial derivatives, are, however, particularly prone to problems of asymmetric information rendering the risk assessment from banks more difficult.  Indeed, higher risk-taking behaviour by financial institutions in EU accession countries,  has already been recorded as blue chip corporate clients are increasingly borrowing directly from international markets.

The agenda for financial stability

In view of the potential increase in the threats to financial stability, the new EU members face the challenge to continue to strengthen their financial systems.  Conceptually, the agenda to achieve this objective is relatively simple.  At the level of individual intermediaries the key issue is to strengthen and improve the ability to identify and effectively manage risks incurred in their activity: credit, interest, foreign exchange and operational risks.  The presence of foreign intermediaries can be of help in this respect, but the rapid pace of financial innovation in fully integrated capital markets poses a challenge to every market participant to continuously reassess the adequacy of its own capital and risk management techniques.

At the level of financial authorities, the top priority is to strengthen prudential supervision techniques and procedures in order to prevent the emergence of crisis situations or to manage them in such a way as to forestall systemic repercussions.  There again, the presence of foreign intermediaries may appear to facilitate the tasks of the local authorities.  But, in fact, it requires increased cooperation with the home country authorities and does not lessen the risk of repercussions on the domestically owned banks, should a foreign-owned bank become insolvent.

From a structural point of view, it is also important that the authorities promote the development of a deep and mature non-bank financial sector.  The level of development and the structure of the financial sector are important sources of strength in the presence of more intense competitive pressures and more volatile cross border capital flows. By providing risk-sharing opportunities and a range of instruments to manage financial risks, a deep and mature financial market can play an important role in safeguarding financial stability.  Well-developed capital markets can also help to fill the funding gap and dampen the destructive impact of a banking crisis on the real economy.  At the same time, effective legal and institutional arrangements must be strengthened with a focus on improving the implementation of the legal framework, especially as regards effective bankruptcy laws and procedures of recovery of collateral.  Further improvement in corporate governance, in both financial and enterprise sectors, is essential for ensuring financial sector soundness.

Securing financial stability: the systemic implications

The analysis conducted so far points to the need for strengthening banking and financial sectors in the accession countries as a prerequisite for financial stability. In my view this is a necessary condition, but may not be a sufficient one, not only for the accession countries, but in general terms.  As indicated in Section 2, in the present configuration of the international monetary and financial system, with freely floating exchange rates and full capital mobility, there is the risk that situations of financial instability may materialise even in countries with sound financial systems in connection with excessive credit expansion induced by international capital flows. This could result in significant departures from equilibrium levels of crucial variables like the exchange rate, the money supply, the price-earning ratio on stocks, or property prices.  In turn, in such circumstances the likelihood of overshootings and bandwagons increases, with the risk of generating a speculative bubble.  Moreover, the capacity of financial markets to exert discipline on intermediaries and borrowers has been generally inadequate and the “disciplinary” actions imparted have often turned out to be “too much, too late”.

In these circumstances financial instability could have systemic implications, in the sense that might result in the illiquidity of markets, in the interruption of normal financing and borrowing operations and in the bankruptcy of a large number of intermediaries.

If having a sound and well managed financial system is no guarantee for financial stability, then what are the policy options available to the monetary and financial authorities of individual countries to counter at an early stage emerging financial imbalances?  Until recently the answer to this question coming from both academic economists and policy-makers was rather disappointing, for a variety of reasons. A broad consensus supported the thesis that monetary policy cannot be used to pursue financial stability as it is already assigned to pursue price stability: if you have two objectives, you need two instruments. This view has received strong support by such an authority in the field as Alan Greenspan (2002), who has recently reiterated the arguments against the recourse to interest rate hikes to counter the formation of bubbles. Rather – Greenspan maintains – monetary policy should be used promptly and aggressively to limit the deflationary impact of the bursting of the bubble, after it has occurred.

If an instrument, other than monetary policy, is required to pursue financial stability, it is widely recognised that the instruments available to the regulatory authorities of financial markets are not really suitable to cope with the situations of systemic instability such as those generated by excessive credit creation.  Typically these authorities are equipped to deal with the instability of individual market participants, be they banks or other financial intermediaries, and their primary concern is to ensure that market participants have a capital base adequate with respect to the risks they incur and that their operations are transparent. The approach followed by supervisory authorities is, in other words, “microprudential” while the problem they have to deal with is of a “macroprudential” nature.

In these circumstances, one would have to conclude that there is not much that the authorities can do to prevent systemic financial instability or the emergence of bubbles. To take such a resigned attitude, however, could be seriously counterproductive as it might convince citizens and their elected representatives that the only way to cope with financial instability is to introduce restrictions to capital movements or to “throw sand in the wheels” of international financial markets. Protectionism is not a viable strategy to deal with international financial instability, as it would distort the flow of international trade and investment with negative repercussions for growth and employment on a global scale. Fortunately, the importance of devising a policy framework that would allow the normal operation of global financial markets while promoting conditions of financial stability is being increasingly recognised, mostly within the central banking community.

A first call for a thorough re-examination of the issues raised for monetary authorities by financial instability came from Andrew Crockett with his seminal paper for the 22nd SUERF Colloquium (Crockett, 2000), in which he identified two areas for further research and analysis: one, how to deal with the systemic risks associated with the financial cycle; two, the relationship between monetary and financial stability. This latter question, Crockett advised, should be explored with a “critical but open mind”. Not surprisingly, Crockett’s suggestion has been heeded primarily within the BIS, where a number of very stimulating papers have been produced by Claudio Borio and his associates. In a first paper (Borio and Lowe, 2002), empirical evidence is presented that it is possible to identify ex ante financial imbalances and that sustained credit growth, combined with large upward movements in asset prices, increases the probability of an episode of financial instability.  The paper also argues that while low inflation promotes financial stability, it also increases the likelihood that excess demand pressures show up first in credit aggregates and asset prices rather than in goods and services prices.  In subsequent papers (Borio, 2002 and Borio, English and Filardo, 2002) the policy implications of these empirical findings are analysed. As regards the framework for monetary policy, it is argued that no change would be required in the objectives of monetary policy, but in the way they are pursued: basically, greater weight should be given “to signs of the build up of financial imbalances in deciding when and how far to tighten policy”.  As regards the framework for financial supervision and regulation, it is argued that a macro-prudential approach would be required in which the main concern would be “the disruption of economic life…brought about by generalised financial distress” rather than “the pursuit of narrowly interpreted depositor protection objectives”.  In practice, the macro-prudential approach would rely to a large extent on the cooperation among central banks and supervisory authorities.

Similar conclusions are reached by Tommaso Padoa-Schioppa (2002) of the ECB in a recent paper in which he looks for the “the land in between” monetary policy and prudential supervision; he discovers that that land indeed does exist and that in it there are instruments that can be used to pursue financial stability at the system’s level: management of the payments system, emergency liquidity support, crisis management coordination, public and private comments (sometimes defined by market participants as “oral interventions”).  As these instruments are available to central banks or to supervisory authorities or to both, it follows that their efficient use depends crucially on the coordination of interventions by the authorities involved.

I have briefly summarised these analytical contributions simply to underline the point that the pursuit of financial stability requires indeed going beyond the purely structural reforms necessary to strengthen the foundations of the banking and financial sectors.  No doubt further analytical work would be required to identify the appropriate policy stance to tackle at an early stage emerging threats to financial stability.  I would venture, however, to make a few general comments of a preliminary nature.

Irrespective of the precise content of the strategy, it is quite likely that a certain degree of policy activism would be required on the part of monetary and financial authorities.  In a regime of global finance, there are no “automatic pilot” devices in the framework for monetary and exchange rate policies or in the prudential regulatory system to which one can safely relinquish the responsibility of ensuring financial stability.  Nor is it advisable to adopt a policy of benign neglect and rely on market discipline. Policy activism does not necessarily mean to adopt new measures or to change policy at every sign of turbulence; it means to be ready to broadcast appropriate policy signals whenever there appear to be evidence of unsustainable trends in relevant financial variables such as credit aggregates, asset prices, exchange rates.  The “signal” should make clear to market participants that the authorities consider current trends as unsustainable and likely to lead to severe financial imbalances.  The nature of the signal may be appropriately differentiated in light of circumstances: it may take the form of an oral warning, or might involve monetary policy measures, exchange market interventions, tax or regulatory changes.

It may be argued that such policy activism may be in itself destabilising and give rise to greater market volatility.  Moreover, if the activism included a pre-emptive monetary tightening by the central bank, without clear evidence of an inflationary threat, this may be criticised as damaging to the economy and the legitimate interests of, say, private investors in the stock market.  These arguments are understandable, but are not really convincing. Any policy action is bound to change financial market expectations and the evaluation of risks and return by intermediaries and investors.  The volatility in financial markets that normally accompanies policy changes reflects precisely the adjustment process carried out by the market as intermediaries re-arrange their positions in light of the new expectations about risks and return on their investment.  In this process, inevitably, some people gain and some people lose.  But what important is that the volatility implies an enhanced perception of risk by market participants, which may be the crucial ingredient for deflating a potential financial bubble.  Indeed bubbles are generated when markets lose the perception of a two-way risk; it is one way markets that generate overshootings, bandwagons and bubbles.

Thus, in my view, the key question is not if policy activism is justifiable or not; the key question is whether a potential financial imbalance can be safely identified at an early stage.  Here again, I would tend to discount the usual arguments that monetary authorities are not endowed with perfect foresight, that they should not presume to know better than the collective wisdom of millions of market participants, etc..  What is required in this case is not the crystal ball, but a considerate judgement on the sustainability of economic trends that are relevant for financial stability.  I believe that economic theory, empirical analysis of historical data, careful monitoring of market dynamics and plain common sense are in most cases quite sufficient for passing such a judgement.  In fact, the experience gained in the management of unsustainable trends in exchange rates shows that when the authorities have been explicit in advocating a reversal of the trend and have supported their words with consistent policy actions, the market sentiment has generally turned around, in many cases quite rapidly.

In a regime of globalisation, however, it may be difficult for the monetary authorities of any individual country, large or small, to have all the information needed to assess the impact on financial conditions of international capital flows and of the operation of global financial markets.  It is only in the fora of international consultation and cooperation that the full picture of the trends and the vulnerabilities of the international financial system can be seen.  Indeed, also at the international level, there is a need for reconsidering how best to implement a macro-prudential approach to financial instability, bringing together the expertise of national finance ministries, central banks and supervisory agencies. Steps in this direction have been made in the EU with the reform of the architecture of financial supervision advocated by the Lamfalussy Committee report; on a broader international scale, the creation of the Financial Stability Forum has allowed the development of important synergies of analysis and in the policy debate.  Still, more formal and explicit procedures could be devised to link the review of macroeconomic policies, with the analysis of financial market trends and of financial vulnerabilities.  A more central role could be envisaged in these procedures for international institutions like the IMF and the BIS, who have accumulated an invaluable expertise in the identification of unsustainable financial trends.  To call for strengthened international cooperation in this tense moment for international relations may sound naïve and unrealistic, but the fact remains that international financial stability is a public good that can only be produced by international institutions.

In conclusion, securing financial stability in a globalised international economy is going to be quite challenging for national monetary authorities and for the institutions of international cooperation.

As a former central banker, I think the chances of success will depend crucially on the role that central banking will be allowed to play in this difficult game.  To confine central banks in the role of guardians of price stability, without fully using their expertise in dealing with banking systems and financial markets would be a serious misallocation of resources.  At the same time central bankers should not be overcautious and refrain from giving stability-oriented policy signals to the markets for fear of criticism. As a great American central banker, William McChesney Martin, famously said: “the central banker is the guy that takes away the punch bowl when the party gets going”.  And I cannot forget that Guido Carli, Governor of the Bank of Italy when I joined it in  the mid 1960’s, had wanted in his office a large painting of Saint Sebastian, looking calm and determined, despite being pierced by several painful arrows.  The painting is still there.