The fi­nan­cial cri­sis and its aftermath

The Pak Banker - - OPINION - Mario Draghi

THE euro area has been through a cri­sis of al­most un­prece­dented drama and sever­ity. Like the Great De­pres­sion of the 1930s, this will most likely pro­vide rich ma­te­rial for eco­nomic his­to­ri­ans for decades to come. It will be stud­ied and an­a­lysed, its causes and con­se­quences de­bated and re­vised. So it is in­ter­est­ing for us to imag­ine, when the dust has set­tled, where the var­i­ous ac­counts of the euro area debt cri­sis will lo­cate its turn­ing point. Some his­to­ri­ans may lo­cate it in in­di­vid­ual pol­icy mea­sures taken dur­ing the cri­sis; oth­ers may place it in a fu­ture that we have not yet reached. In my view, the turn­ing point has passed, and it came in the sum­mer of 2012. What changed at that point was that cri­sis man­age­ment shifted to­wards the de­vel­op­ment and ex­e­cu­tion of a con­sis­tent re­cov­ery strat­egy. It is this strat­egy that I am go­ing to out­line in my re­marks to­day.

First, I will de­scribe the ini­tial de­vel­op­ment of the cri­sis, il­lus­trat­ing how pol­icy choices made un­der the pres­sure of events and that were com­mend­able by them­selves, but that were se­quenced in the wrong or­der, made deal­ing with the con­se­quences of the debt over­hang more dif­fi­cult. This in­ter­acted with fea­tures of the euro area's in­sti­tu­tional struc­ture to post­pone the re­cov­ery.

There­after, I will de­scribe how the right se­quence of steps af­ter June 2012, when the bank­ing union project was first agreed, has put the euro area back on a tra­jec­tory to­wards re­cov­ery. The first step was 're­boot­ing' the fi­nan­cial sys­tem, which is a nec­es­sary con­di­tion of a sus­tained re­cov­ery, not least be­cause it helps mon­e­tary pol­icy to man­age ag­gre­gate de­mand. But it is not a suf­fi­cient con­di­tion: poli­cies of struc­tural re­form that lift the level of po­ten­tial growth are an equally im­por­tant part of the re­cov­ery strat­egy.

In de­scrib­ing this strat­egy, I am not only talk­ing about the past, but also about the present and the fu­ture. The cri­sis is not over. To be suc­cess­ful, the re­cov­ery strat­egy is be­ing, and must con­tinue to be, ex­e­cuted with com­mit­ment and per­se­ver­ance.

The early phase of the cri­sis fol­lowed roughly the same pat­tern across ad­vanced economies. Most had been through a long pe­riod of ex­ces­sive debt ac­cu­mu­la­tion, with pri­vate debt lev­els in sev­eral ju­ris­dic­tions reach­ing his­tor­i­cal highs. In some coun­tries this fu­elled over-in­vest­ment in un­pro­duc­tive sec­tors, in­clud­ing real es­tate, which is the sec­tor as­so­ci­ated with most of the se­vere fi­nan­cial crises in his­tory. The mir­ror im­age of this de­vel­op­ment was a credit bub­ble in the bank­ing sec­tor, as banks fi­nanced both hous­ing sup­ply, i.e. loans to real es­tate de­vel­op­ers, and hous­ing de­mand - that is, mort­gages.

When the cri­sis broke out, this debt build-up quickly be­came a debt over­hang. Many ad­vanced economies en­tered a pro­longed pe­riod of delever­ag­ing as firms, house­holds and banks at­tempted to re­duce their debt lev­els. For firms, this meant less in­vest­ment. For house­holds, less con­sump­tion. And for banks, less credit. More­over, the col­lapse of Lehman Broth­ers sent shock­waves through the global fi­nan­cial sys­tem leading to an un­prece­dented rise in un­cer­tainty and risk aver­sion. This led to a fur­ther re­trench­ment in in­vest­ment, trade and hir­ing and a glob­alised "Great Re­ces­sion". Govern­ment bud­gets went deep into deficit to off­set this mas­sive shock to nom­i­nal spend­ing.

These events were not only shared across ma­jor economies, but they were also largely con­sis­tent with his­tor­i­cal ex­pe­ri­ence. There have been sev­eral episodes in eco­nomic his­tory of large build-ups fol­lowed by pe­ri­ods of debt delever­ag­ing. Se­ri­ous fi­nan­cial crises tend to be fol­lowed by slow eco­nomic re­cov­er­ies.

Nev­er­the­less, by mid-2010, most ad­vanced economies were show­ing signs of re­turn­ing to growth, al­beit at a slow pace. At this point, how­ever, the tra­jec­tory of the euro area de­parted from oth­ers. While the re­cov­ery gained ground in the US in par­tic­u­lar, the euro area en­tered into a sec­ond re­ces­sion that lasted un­til the sec­ond quar­ter of 2013. Why did this di­ver­gence hap­pen?

For two rea­sons that were spe­cific to the euro area. First, the se­quenc­ing of pol­icy re­sponses af­ter the first bail-out for Greece ag­gra­vated con­cerns about bank and sov­er­eign debt sus­tain­abil­ity. Sec­ond, these con­cerns in­ter­acted with an in­com­plete in­sti­tu­tional frame­work in a self-re­in­forc­ing way.

In ad­dress­ing the sit­u­a­tion in mid-2010 - and with the ben­e­fit of hind­sight - one could have le­git­i­mately ex­pected the fol­low­ing se­quence of ac­tions. First, agree on a solid back­stop for deal­ing with sov­er­eign and bank­ing sec­tor prob­lems. There­after, con­duct a stress test and re­cap­i­talise banks where nec­es­sary. Then, with banks in a stronger po­si­tion to ab­sorb losses and a sov­er­eign back­stop in place, con­struct a con­sis­tent frame­work for deal­ing with sov­er­eigns with ex­ces­sive debt. Fi­nally, ap­ply that frame­work to coun­tries that were deemed to need it. For ex­am­ple, this se­quence from back­stop to stress test to re­cap­i­tal­i­sa­tion was ap­plied in the US, once the lessons from the Lehman Broth­ers shock had been drawn, and it ac­cel­er­ated the clean-up of the coun­try's bank­ing sys­tem.

How­ever, in 2010 and 2011 it was al­most the re­verse se­quence that took place in the euro area. The Deauville agree­ment on pri­vate sec­tor in­volve­ment in Oc­to­ber 2010 and the Greek debt re­struc­tur­ing in July 2011 were an­nounced while an ef­fec­tive back­stop for sol­vent gov­ern­ments was still be­ing con­structed. And the ini­tial stress test­ing of banks in 2011 and the cap­i­tal rais­ing ex­er­cise in Oc­to­ber that year were con­ducted with­out any clear back­stop for sol­vent banks. The ef­fect was to cause many banks and some gov­ern­ments to come un­com­fort­ably close to los­ing mar­ket ac­cess, or to lose it al­to­gether. As a con­se­quence, in­stead of act­ing as a shock ab­sorber, both banks and gov­ern­ments be­gan to act pro-cycli­cally.

This sit­u­a­tion then in­ter­acted neg­a­tively with two fea­tures of the euro area's in­sti­tu­tional struc­ture. The first was the euro area's in­com­plete fi­nan­cial in­te­gra­tion. While prices had con­verged in many as­set classes prior to the cri­sis, it turned out that the euro area had not in fact cre­ated the con­di­tions for deep cross-coun­try fi­nan­cial in­te­gra­tion. In­te­gra­tion was largely based on short­term in­ter­bank debt, rather than on eq­uity or di­rect cross-bor­der lend­ing to firms and house­holds, and un­der stress it quickly un­rav­elled. In­deed, the build-up of fi­nan­cial im­bal­ances in the euro area pe­riph­ery had in part been fi­nanced by short-term lend­ing from banks in the core. Those banks then quickly re­versed their ex­po­sures in what amounted to a "sud­den stop", anal­o­gous to crises ex­pe­ri­enced by emerg­ing economies. This con­trib­uted to the frag­men­ta­tion of the euro area bank­ing sec­tor and econ­omy along na­tional lines, a phe­nom­e­non which had not been vis­i­ble in the early stages of the cri­sis.

The sec­ond fea­ture was the euro area's fis­cal frame­work, which was not strictly en­forced. That frame­work was ex­plic­itly de­signed to en­sure fis­cal re­spon­si­bil­ity, with two re­sult­ing ben­e­fits. First, if strictly ap­plied, it would cre­ate fis­cal space ex ante for gov­ern­ments to ab­sorb ex­cep­tional shocks, such as the one ex­pe­ri­enced world­wide. And sec­ond, by an­chor­ing con­fi­dence in the medium-term sound­ness of pub­lic fi­nances, it would al­low gov­ern­ments to run those coun­ter­cycli­cal poli­cies while re­tain­ing mar­ket ac­cess. In such a sit­u­a­tion, there is no need for fis­cal riskshar­ing or a fis­cal back­stop.

Yet, as the fis­cal frame­work was not strictly en­forced, the two ben­e­fits were re­versed: a num­ber of gov­ern­ments ei­ther did not have the fis­cal space to ab­sorb the shock they faced in the early stage of the cri­sis (con­sider Bel­gium or Italy); or they were un­able to main­tain the trust of the mar­ket while do­ing so (con­sider Por­tu­gal or Ire­land). Fis­cal pol­icy in these coun­tries there­fore had to switch from pro­vid­ing a counter-cycli­cal buf­fer to con­vinc­ing in­vestors of debt sus­tain­abil­ity.

Un­der these cir­cum­stances, it was un­avoid­able that fis­cal con­sol­i­da­tion was front-loaded. But it also meant that fis­cal pol­icy changed from be­ing a tail­wind to a head­wind, and added to the drag com­ing from delever­ag­ing across the pri­vate sec­tor. In par­tic­u­lar, as the bank­ing sec­tor had not yet been cleaned up and strength­ened, lower growth pro­duced a fur­ther de­te­ri­o­ra­tion in bal­ance sheets and added to pro-cycli­cal­ity.

In man­ag­ing the cri­sis, Euro­pean pol­i­cy­mak­ers faced an un­prece­dented set of cir­cum­stances. They were mak­ing de­ci­sions in real time in the face of po­lit­i­cal and in­sti­tu­tional con­straints. So the aim of my com­ments is not to crit­i­cise. Rather, it is to high­light the fact that the se­quenc­ing and con­sis­tency of pol­icy de­ci­sions mat­ter. Pol­i­cy­mak­ers dealt with the im­me­di­ate sit­u­a­tion with­out si­mul­ta­ne­ously ad­dress­ing all its con­se­quences. It was only when this be­gan to change in June 2012 that we re­turned to the path of re­cov­ery.

What hap­pened at this time was that Euro­pean pol­i­cy­mak­ers ac­knowl­edged the need to com­plete the euro area's in­sti­tu­tional ar­chi­tec­ture, the ini­tial stage of which was set­ting up the bank­ing union. And in do­ing so, they ini­ti­ated what I be­lieve was the nec­es­sary first step of a con­sis­tent strat­egy for a sus­tained re­cov­ery.

The bank­ing union had to be the first step of a longer se­quence, for two rea­sons. First, be­cause it was nec­es­sary to con­sol­i­date the sin­gle cur­rency. Sec­ond, be­cause it pro­vided an op­por­tu­nity to "re­boot" the euro area bank­ing sys­tem, which in turn is a pre-con­di­tion for the re­cov­ery.

Money, it has to be re­mem­bered, is a li­a­bil­ity of the bank­ing sys­tem. Ban­knotes rep­re­sent only a frac­tion of the money we use daily. The bulk of money is de­posits, which are a li­a­bil­ity of commercial banks. So for there to be a truly sin­gle money among sov­er­eign coun­tries, there has to be fun­gi­bil­ity of de­posits across borders.

Yet, this fun­gi­bil­ity came un­der threat dur­ing the cri­sis. It was threat­ened ini­tially by the frag­men­ta­tion of fi­nan­cial mar­kets in the euro area, and then ex­ac­er­bated by the emer­gence of re­de­nom­i­na­tion risk in fi­nan­cial prices. Those un­founded fears of re­de­nom­i­na­tion put price sta­bil­ity at risk, which the ECB had to al­le­vi­ate through the cre­ation of its Out­right Mon­e­tary Trans­ac­tions ( OMT) pro­gramme. Our ac­tions un­der­lined the ir­re­versibil­ity of the sin­gle cur­rency and were de­ci­sive in restor­ing con­fi­dence.

But the un­der­ly­ing driv­ers of frag­men­ta­tion still re­mained, es­pe­cially the emer­gence of credit risk pre­mia at the na­tional level that mir­rored the per­ceived credit risk of sov­er­eigns, in par­tic­u­lar af­ter the Greek debt re­struc­tur­ing. This link be­tween sov­er­eign and bank risk re­flected, first and fore­most, the per­cep­tion that the ul­ti­mate guar­an­tor of de­posits in the bank­ing sys­tem is the state. Hence, where per­cep­tions of sov­er­eign cred­it­wor­thi­ness di­verged, so did con­fi­dence in their re­spec­tive bank­ing sys­tems.

In essence, what these de­vel­op­ments were high­light­ing was that we did not have a truly sin­gle bank­ing sys­tem in the euro area; we had a jux­ta­po­si­tionof na­tional bank­ing sys­tems, which is why they frag­mented so eas­ily. To en­sure that the sin­gle cur­rency truly is sin­gle, there­fore, the only real­is­tic op­tion was to bring to­gether those na­tional sys­tems into one sin­gle sys­tem, so that the fun­gi­bil­ity of de­posits was re-es­tab­lished. This is where the bank­ing union comes in.

Bank­ing union means three things: it means a sin­gle su­per­vi­sory frame­work that min­imises equally the risk that a euro area bank takes ex­ces­sive risk and runs into fail­ure. It means a sin­gle res­o­lu­tion frame­work, so that if a bank does still fail, it can be re­solved in the same way, with limited use of tax­payer money, ir­re­spec­tive of where the bank is lo­cated or the fis­cal strength of its govern­ment. And it means a sys­tem of de­posit pro­tec­tion that pro­vides de­pos­i­tors with equal con­fi­dence that their de­posits are skafe, re­gard­less of ju­ris­dic­tion.

We are now well ad­vanced in the process of uni­fy­ing the bank­ing sys­tem in this way. The Sin­gle Su­per­vi­sory Mech­a­nism (SSM) will be­gin op­er­at­ing in Novem­ber. A deal was reached last week on a Sin­gle Res­o­lu­tion Mech­a­nism and Sin­gle Res­o­lu­tion Fund. And a har­monised ap­proach to the level and fund­ing of de­posit guar­an­tee schemes across the euro area has been agreed, as a first step to­wards a sin­gle de­posit guar­an­tee scheme. De­posits of in­di­vid­u­als and small- and medium-sized en­ter­prises (SMEs) will also have se­nior­ity in any fu­ture bank res­o­lu­tions. To­gether, this goes a long way to­wards cre­at­ing a gen­uine bank­ing union, al­though some im­por­tant de­tails, such as the back­stop for Euro­pean res­o­lu­tion fi­nanc­ing, still need to be clar­i­fied.

By re­in­forc­ing the sin­gle­ness of money, the bank­ing union pro­vides the con­di­tions for a last­ing rein­te­gra­tion of the sin­gle fi­nan­cial mar­ket. It is there­fore a pre-req­ui­site for the re­cov­ery. It does not, how­ever, by it­self gen­er­ate a re­cov­ery, nor does it put banks in a po­si­tion to prop­erly sup­port that re­cov­ery. This brings me to the sec­ond step in the se­quence of events re­quired to achieve that goal: the role of the SSM in clean­ing up the bank­ing sys­tem.

Prior to the cri­sis, euro area banks had en­tered a rapid pe­riod of bal­ance sheet ex­pan­sion. From the start of that ex­pan­sion in 2005 to its peak in 2012, banks as­sets in­creased by more than 60 per­cent­age points of GDP. This was as­so­ci­ated with the de­vel­op­ment of un­sus­tain­able bank busi­ness mod­els. Banks re­lied too much on debt to fi­nance their lend­ing, and that debt de­pended too much on whole­sale mar­ket fund­ing and too lit­tle on de­posits.

This model was only able to de­velop be­cause of the per­cep­tion of an im­plicit state guar­an­tee for bank debt - a per­cep­tion that re­in­forced the link be­tween sov­er­eign and bank risks that I de­scribed above. The de­te­ri­o­ra­tion of sov­er­eign credit, on the one hand, and the clar­i­fi­ca­tion of the rules re­gard­ing bail-in of bank debt, on the other, have both helped to bring to an end a fund­ing model that was nei­ther de­sir­able nor sus­tain­able.

The euro area bank­ing sys­tem is there­fore now un­der­go­ing a process of re­struc­tur­ing and delever­ag­ing. As this is a nec­es­sary cor­rec­tion, it is not a process that pol­i­cy­mak­ers should seek to pre­vent. How­ever, it is a process that needs to be prop­erly man­aged.

Delever­ag­ing can es­sen­tially take two forms: a "good" form and a "bad" form. The "good" type is where banks quickly carve out non-per­form­ing or non-core as­sets and raise eq­uity, al­low­ing them to restart lend­ing to new, cred­it­wor­thy clients. The "bad" type is where they sell good as­sets and hold on to non-per­form­ing as­sets in the hope that their value re­cov­ers. This tends to cre­ate so-called "zom­bie banks" and leads to a pro­longed pe­riod of low credit growth. And this can be even more dam­ag­ing if, due to fears about coun­ter­party credit and liq­uid­ity hoard­ing, liq­uid­ity dries up and banks have to sell as­sets at dis­tressed prices. Such an in­ter­ac­tion of mar­ket risk and fund­ing risk can cause a sys­temic cri­sis, with an out­right credit crunch as the con­se­quence.

His­tor­i­cal prece­dents sug­gest that - all other things be­ing equal - a quick, "good" delever­ag­ing tends to bring about an ear­lier re­cov­ery.

In the euro area we have largely avoided the worst form of delever­ag­ing, thanks to ECB in­ter­ven­tions to pro­vide liq­uid­ity to banks at key mo­ments of the cri­sis, no­tably our move to un­lim­ited liq­uid­ity pro­vi­sion in 2008 and our two longer-term re­fi­nanc­ing op­er­a­tions (LTROs) in late 2011 and early 2012. In this en­vi­ron­ment banks have made progress in delever­ag­ing and re­struc­tur­ing. How­ever, as late as last year there was still un­cer­tainty as to the true ex­tent and qual­ity of this delever­ag­ing. This was shown by per­sis­tent in­vestor doubts about bank as­set val­u­a­tions, and low credit growth for the real econ­omy. It was in this con­text that the cre­ation of the SSM be­came crit­i­cal.

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