Open Econ Rev (2010) 21:175–182 DOI 10.1007/s11079-009-9151-7 R E S E A R C H A RT I C L E

The 2007–2009 Financial Crisis and the European Central Bank Benoit Mojon

Published online: 15 January 2010 # Springer Science+Business Media, LLC 2010

Keywords Euro . International currencies JEL Classification F33 In this paper I review some aspects of the 2007–2009 financial crisis and whether it questions the foundation of the euro and its central bank, the European Central Bank. This question can in principle be raised for two reasons. First, because the ECB is still a very young institution. This crisis can either be the opportunity to strengthen its legitimacy or weakens its foundations. Second because financial crises have always had a large impact on the functions and mandates of central banks (Aglietta and Mojon 2009). I will first recall that the crisis has not originated in the ECB’s jurisdiction. Then I will review what I see as the main steps taken by the euro area central bank to tame the crisis. Finally I will describe what I see as the challenges ahead at a time when the path out of the crisis remains highly uncertain.

1 The origin of the crisis The central banks mandates have to be pursued whatever the macroeconomic circumstances. Central banks should however prepare for turbulent periods that may arise independently from their own actions, and, perhaps more importantly, avoid laying the seeds of financial and macroeconomic instability. In the case of the 2007–2009

Head, Monetary Policy Research Division, Banque de France. The views expressed in this paper do not reflect the view of the Banque de France or the Eurosystem. B. Mojon (*) Banque de France, 1 rue Vrilliere, 75001 Paris, France e-mail: [email protected]

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crisis, it is obvious that the ECB could do very little to prevent the build up of financial fragility in the US. The ingredients of the crisis can be listed as follows: 1. too rapid expansion of credit to US households, including to households that were unlikely to meet their debt obligation; 2. increasing leverage and exposure of the US banking system to real estate risk through undercapitalised vehicles, which, effectively rolled over short-term debt to invest in mortgage back securities (Acharya and Schnabl 2008); 3. faith that financial innovation always improves market completeness and efficiency (Greenspan 2008); 4. possibly, an overly accommodative monetary policy stance between 2002 and 2004 (Taylor and Williams 2007); 5. possibly, let Lehman file for bankruptcy. On these five ingredients, the ECB may plead guilty only of the third one. ECB economists and policy makers, were, like the vast majority of economists, convinced that financial innovations such as securitisation would imply a “better allocation of resources and risks”. However, it should be stressed that securitisation has not developed in the euro area countries as much as it did in the US and securities backed on credit issued in the euro area have not had a first order role in amplifying the financial crisis. It should also be recalled that when Jean-Claude Trichet repeatedly invited “every body to do their homework”, he made clear that the US should increase their domestic savings.1 So, although the weakness of the US financial system had not been foreseen by the ECB, the dangers of ever rising leverage of the US household sector was clearly perceived as a threat to macroeconomic stability. The ECB could also in principle be blamed for not having foreseen that money markets would suddenly be struck by a crisis of confidence in August 2007. Figure 1 shows counterparty risk premia for short-term liquidity transactions in the US, UK and euro area money markets. These premia, which are the spreads between collateralized and uncollateralized transactions, have simultaneous risen in the three markets. As of today, as stressed by Mervyn King, we cannot be certain that we will go back to equilibria of negligibly low and stable counterparty risk premia that these markets enjoyed before August 2007. But blaming the ECB here would be extremely unfair given that the freeze of money markets is precisely the Black Swan that nobody had foreseen (Taylor and Williams 2007). It would be another matter if the case could be made that the ECB was not prepared for turbulent times. The purpose of the next section is to assess this case.

2 The ECB responses to the crisis The ECB has taken a number of steps to react to the crisis since its first symptoms appeared in August 2007. Giving a full description of these measures goes beyond 1

See the transcript of the monthly press conferences where Jean-Claude Trichet intervened, since November 2003, as the spoke-person for the European Central Bank Governing Council.

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Fig. 1 Spreads for counterparty risk in major money markets

the scope of this paper. I will rather recall three such steps: the distribution of liquidity to the banking sector, de facto replacing the interbank market; the lowering of interest rates; the full allotment 12 months refinancing operations, announced on 7 May 2009. &

Distribution of liquidity to the banking sector

First of all, the fact is that the ECB was the first central bank to react to the 9 August 2007 disruption of the money market. The ECB, on that very day, increased the scale of its main refinancing operations by 95 billion euros. This because it observed a rising spread between the interest rate on interbank transactions and the interest rate on its main refinancing operations. Since then, the ECB has, like the other major central banks, progressively taken a larger role in the money market, de facto acting as an intermediary between banks in excess of liquidity and banks in need of liquidity. This increasing intermediary role has developed in part by moving away from the quiet time management of the money market. The range of collateral admitted to access central bank liquidity was extended. The horizon of the refinancing operations increased through 3 months, 6 months, and eventually 12 months operations. Last but not least, refinancing operations offered a full allotment instead of an auction where largest bidders were sanctioned through higher interest rates. The extensions of the supply of liquidity to a financial system struck by a sudden fear of any counterparty preserved the integrity of the payment system. It avoided that the near state of panic in the interbank market spread to the real economy. Now, comparing these operations with the evolution of the Fed operations reveals that the ECB disposed of all the instruments necessary to secure the financing of banks. In contrast the Fed has successively modified its operations with the introductions of numerous Facilities. The list of such modifications, by order of appearance, is impressive: the TAF, CPFF, PDLF, MMLF, TALF,…, (see the Saint-Louis Fed chronology of the crisis for a detailed explanation of each of these).

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These modifications of the Fed operations were necessary to reach a larger set of financial intermediaries, extend the eligible collateral,… Prior to 2008 the Fed distributed liquidity through 19 primary dealers. It now can lend liquidity to all the 7,000 banks that operate in the US. The anonymity of the access to the discount window has been introduced. &

Lowering interest rates

The traditional monetary instrument, the short-term interest rate, is now near zero through out the OECD. In the euro area, the EONIA (the interbank overnight interest rate) wiggles around 0.35 basis points since June 2009. This is nearly 400 basis points lower than its level in October 2008. The speed and magnitude of this fall in interest rates echoes the sudden collapse of the business cycle and of inflationary pressure. This path of interest rate is very similar to the one that occurred elsewhere in Europe. The one year delay with the first decision to cut interest rate in the US will no doubt raise a lot of comments in the forthcoming studies of the crisis. It reflects however the view, widely held until mid-2008, that the financial crisis would not necessarily spill over from the US to the rest of the world. The emergence of the BRICs (Brasil, Russia, India, and China) could shed some of the slowdown of US domestic demand. And actually, the oil price, which peaked at 147 USD per barrel in July 2008 brought very palatable credence to that view. 2008 has seen the highest level of inflation in the OECD and the euro area since the early 1990’s. This implied very low short-term real interest rate. However, while growth from emerging market helped sustain growth in the OECD, including with very large contributions of US net exports until 2008 Q3,2 the sudden collapse of trade in 2008 Q4 contributed to bring about the most dramatic fall of demand and output of the post war era. The oil price, which collapsed from its July peak to 40 USD per barrel in December is one of the most striking thermometers of the abruptness of the recession. Central banks eager to stabilize inflation had to use all their firepower to counter the deflationary forces mutually reinforced by the financial and the macroeconomic crises. This is what they did, including the ECB, bringing nominal interest rates near zero and real interest well into negative territory. They also started to implement the so called non-conventional measures of monetary policy to add further monetary stimulus to the economy. Among these, the most impressive measure announced by the ECB is the 12 month, full-allotment refinancing operations, which we analyse in the next paragraph. &

The 12 month, full-allotment refinancing operations

On May 7th 2009, the ECB Governing Council announced three refinancing operations with full allotment at fixed rate and 12 months horizon to be held in June, September and December 2009. The first such operation led to the distribution of 442 billion euros to the banking system and a state of excess reserves that, in turn, brought the overnight interest rate to 0.35%, i.e. very close to the interest rate of the deposit facility (see Fig. 2). 2

The net exports contribution to the growth rate of US GDP has been successively 0.6 and 1.2 in 2007 and 2008 after having been −0.5 on average between 2000 and 2005.

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deposit rate minimum bid rate/main refinancing rate overnight interest rate marginal rate of main refinancing operations marginal lending rate 6.0

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Fig. 2 Level of the euro area money market interest rates

The purpose of this extension of maturity is twofold. First, the ECB influences the yield curve very effectively up to 12 month maturities. Second, all banks that can pledge collateral3 can secure their funding for as much as twelve months at a very low interest rate. This further easing of monetary condition should affect most debt issuers in the euro area. As a matter of facts, unlike in the US, most (85%) of non financial corporation debt is still held by banks in the euro area. And of course, euro area households borrow mainly from banks. The provision of liquidity to the banking sector, in very large amounts, limits the uncertainty that bank face with respect to accessing funding. This is appropriate at a time when the money market for short-term financing stopped to function for maturities beyond a few days. It should also limit the cost of funding for bank clients and help the banking system rebuild its capital position.

3 A historical perspective One year after the bankruptcy of Lehman, the climax of the 2007–2009 crisis, we have some perspective on the challenges ahead for central banks. This is all the more important that central banks’ functions have generally been responses to major financial and monetary crises. To recall, central banks’ mandates and functions evolved as responses to the financial and monetary crises that have punctuated the history of modern capitalism: 1867 and the Bank of England, 1907 and the US Federal Reserve, the period of high inflation in the 1970s and the European Central Bank. Central banks have several tasks: they issue currency, act as the bank of banks, are the lenders of last resort and are, in most countries, responsible for banking supervision. These tasks emerged in the 19th and 20th century. Initially, a central 3

The ECB has also enlarged the list of financial assets eligible as collateral to access liquidity.

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bank was a private bank to which the government had granted an issuing right in exchange for a commitment to finance the Treasury. This issuing right was first based on the convertibility of the currency issued by the central bank into precious metals. However, the currency issued by the central bank established itself de facto as the means for settling debts between economic agents, and in particular between commercial banks. It is important to understand that this dual development, i.e. the superiority of the currency issued by the central bank and the move away from the metallic benchmark, was not straightforward. Initially, the debt issued by each bank was considered as a means of payment once the party receiving the debt (like, nowadays, a cheque associated with a bank account) was convinced that the bank inspired sufficient confidence for this debt to be accepted as a means of payment in its future transactions. As central banks were also commercial banks, it was not necessarily in their competitors’ interest to give a higher status to currency issued by the central bank. Besides, in the 19th century, the banking system did, at times, function without a central bank. Between 1716 and 1845, the Scottish financial centre was dominated by two major competing banks, which ended up by co-operating by mutually accepting their issues as means of payment. Similar situations occurred in the United States, Australia, Switzerland and Sweden during part of the 19th century. However, the experience of financial crises has shown that, to ensure the integrity of payments, there is a need to rank monies and to establish a superior currency. The latter must be capable of settling debts between private parties and, during a financial crisis, quenching economic players’ sudden liquidity thirst. The current financial crisis is not different in that respect. The crisis typically follows a phase of optimism during which confidence enables banks (and ad hoc structures that they have set up) to borrow at a lesser cost. For example, real-estate loans to US households are financed by short-term borrowings renewed every three months. As long as confidence lasts, banks, which borrow at a cheaper short-term rate than the rate on their loans to households, make profits. However, if there are any doubts about their credit quality, the cost of their borrowings increases to such an extent that their activity becomes non-profitable. A climate of mistrust leads investors to shift to the most liquid instruments, i.e. those that they know will always be accepted by third parties as payment: government debt securities and the currency issued by the central bank, which, given its function as currency issuer, has an endless liquidity supply capacity. The financial crisis that started in August 2007 is the most severe one since the 1930s. Its scope (in Europe the level of industrial output wiped out ten years of growth within a few quarters) highlights that public policies that aimed at controlling the financial system have failed. Besides, it cannot be ruled out that central banks’ success in containing inflation and reducing cyclical fluctuations since 1995 contributed to creating the illusion of a new era where macroeconomic and financial risks would have disappeared. In fact, investors’ confidence in the 2000s resulted, through lower interest rates, in a steady increase in the level of debt. In the US, households and the banking system increased their leverage. Including, through under-capitalised shadow banks, set up to take advantage of the low level of interest rates. As always, the financial weaknesses built up during the period of confidence became obvious only after the turnaround in the cycle.

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4 Challenges ahead What solutions are the new public policies offering to reduce the risk and the scope of such crises in the future and what will be the role of central banks? First, it seems essential to recognise that financial innovation, when it loosens credit constraints, amplifies the risks of destabilising financial cycles. Contrary to the pre-crisis dominant view that financial intermediaries can always allocate risk efficiently, they seem unable to determine the aggregate credit growth rate that is sustainable in the long term. As the G20 concluded at its last meeting in London in Spring 2009, this inability calls for a strengthening of “macro-prudential” policies. These policies fill the current void between the micro-prudential regulation of banks, which ensures that banks do not take inconsiderate risks, and monetary policy, which aims at stabilising the prices of goods and services. Among the possible solutions being currently discussed, it seems useful to mention three radically different approaches calling into question the current objectives of central banks. The first consists in changing the definition of price stability to include asset prices linked to the currency’s purchasing power, i.e. realestate prices. This approach would have a direct impact on monetary policy by changing its objective. Central banks would have to raise their interest rates during a real-estate bubble, thus leaning against the bubble. The second approach consists in setting up a dynamic capitalisation system for financial intermediaries. Their leverage would decline during a boom phase. This type of policy could also be implemented by central banks in countries where they are responsible for banking supervision. The last approach involves controlling credit through measures that directly impact borrowers, for example through consumer protection laws, in which central banks play no role. Limiting debt to a given share of the borrower’s income, requiring a minimum investment and capping the maturity of loans would limit the potentially de-stabilizing self-reinforcing dynamics between debt and asset prices. While it seems that each one of these three solutions may have prevented the financial crisis of 2007–2008, past experiences call for caution. The endogenous and destabilising nature of financial cycles is a fundamental feature of capitalism. Central banks are able to limit the frequency and scope of financial cycles, but it would be an illusion to believe that they could eliminate them. All in all, it is striking that in the debate on the potential extension of central bank mandates, the ECB has been treated very much like other central banks. Perhaps more importantly, in spite of the crisis severity, the ECB has never been the focus of major criticisms. Early in the crisis, Jean-Claude Trichet, the President of the ECB, has even been granted the Financial Time Man of the Year award. And many commentators have stressed that the euro has been a very effective shield in the crisis. One easily imagine the exchange rate instability that may have amplified the crisis if the euro had not been in place. The crisis raises challenges for central banks in general, no more and no less so for the ECB. However, when we look back at this period of financial and macroeconomic turmoil, it will appear as one of the major tests that strengthened the legitimacy of the still young central bank.

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References Aglietta M, Mojon B (2009) “Central Banking”, Handbook of Banking, Berger A, Molyneux PH, Wilson J (Editeur), to be published by Oxford University Press AcharyaV, Schnabl P (2008) How banks played the leverage “Game”? NYU Stern White Paper. Executive summary of Restoring Financial Stability: How to Repair a Failed System, Chapter 2 Greenspan A (2008) Testimony to congress, 23 October 2008 Taylor J, Williams J (2007) A black swan in the money market, NBER Working paper 13943 Trichet J.-C (2003–2007) Transcript of press conferences on the first Thursday of the Month, www.ecb.int

Further Reading European Central Bank (2004) The Monetary Policy of the ECB, www.ecb.int Goodhart C (1988) The evolution of central banks. The MIT, Cambridge