The financial crisis and the role of central banks: The experience of the ECB

Keynote address by Jean-Claude Trichet, President of the ECBat the international symposium marking the 50th anniversary of Bank Al-Maghrib.Marrakech, 29 May 2009

Dear Governor Jouahri,

Dear Governors,

Ladies and gentlemen,

It is an honour and a great pleasure for me to be a speaker at this celebration marking the 50th anniversary of the Bank Al-Maghrib. I would like to congratulate Governor Jouahri on this occasion, and wish him and the staff of the central bank all the best for the future.

The Eurosystem has a well-established framework for dialogue with the Bank Al-Maghrib, the Euro-Mediterranean Seminar. This forum regularly brings together the governors of Eurosystem central banks with those of the “Barcelona Process: Union for the Mediterranean”. The Euro-Mediterranean Seminar has, since its first meeting in 2004 in Naples, strengthened our dialogue by addressing various topics relevant to central banks around the Mediterranean. The Bank Al-Maghrib and Governor Jouahri have contributed to this fruitful exchange of views and will no doubt do so at the next meeting in March 2010 in Cyprus. In addition, the Bank Al-Maghrib has close bilateral relations with some of the central banks in the Eurosystem and in particular with the Banque de France on various aspects of technical assistance.

We are living in a very challenging time. Morocco, like all countries worldwide, has been hit by the global crisis. The business cycles of Morocco and the EU are largely synchronised and the existence of various economic transmission channels such as trade, tourism, and remittances, explain why both the European and Moroccan economies are going through a challenging period in the present global context.

My speech today will focus on the global financial crisis and its roots, on the ECB’s response to the crisis and on the role of emerging market economies in the world economy.

Let me start by briefly highlighting the origins and evolution of the current crisis. Imagine a neutral observer who looked at the financial sector about a decade ago and then didn’t look at it again until the eve of the current financial crisis. He would have found a completely different financial industry, one which over the past decade has undergone a dramatic shift of focus. He would have discovered a financial system that had moved away from its traditional role of supporting trade and real investment. He would have found a financial system in which speculation and financial gambling had run rife. He would have encountered a system transformed – a system no longer managing genuine economic risks but one actually creating and assuming financial risks – risks resulting from arbitrage and intentional exposure to asset price changes.

That same observer would have realised that financial liberalisation and innovation had made our economies more productive. The securitisation of assets, for example, had great potential to diversify economic risks and to manage them efficiently. But it also meant that financial institutions were able to sell loans or take them off the balance sheet, which weakened lenders’ incentives to conduct prudent screening and constant monitoring of credit risk. So underwriting standards and lending oversight declined, and contributed to the excessive credit growth in the second half of the 1990s.

In sum, the observer would have concluded that the factors that fuelled the credit and asset price boom of the past decade also created the conditions for a bust.

In mid-2007 we started to see the backlash. The start of the financial turmoil was sudden but not unexpected. The financial system as it worked over the past decade – with its flawed incentives and its overly complex products and with global imbalances as its macroeconomic backdrop – was no longer sustainable. The asset cycle turned, the weaknesses were exposed and investors suddenly lost confidence. After years of exceptional risk appetite and high profits, the pendulum swung in the opposite direction, as markets became extremely sensitive to financial risk.

In September last year, the crisis escalated sharply. In particular, a major financial player collapsed, which was directly involved in about 30 large payment and settlement systems worldwide and had a balance sheet of USD 600 billion. Its failure turned a large-scale crisis of confidence into a global financial panic. Financial intermediaries restored liquidity buffers, tried to economise on capital and to scale down their balance sheets. They sold assets and tightened lending conditions. Banks and other financial institutions drastically reduced their exposure to the risks that they had imprudently accumulated during the phase of financial euphoria. Financial intermediation and loans to companies were curtailed in the wake of a forceful process of “deleveraging”.

This was the point when important spillovers of the financial crisis set in. We saw the almost immediate spillover from the financial sector to the real economy. The credit squeeze and loss of confidence started to take a toll on the real economy, and a negative feedback loop developed between the financial sector and the real economy, and has since become a major feature of economic and financial developments. Almost simultaneously, the crisis that originated in the advanced economies spilled over to the emerging market economies. Since the fourth quarter of 2008, virtually all economies – both those of the industrialised countries and the emerging markets – have faced synchronised business cycles. Since half a year, we are facing a highly synchronised global economic downturn.

Turning to the ECB’s response to the crisis, let me first insist that none of my remarks should be interpreted in terms of the future course of monetary policy. I stick rigorously to what I have said during my last press conference. We are indeed in the one-week “purdah period” before the next meeting of the Governing Council.

Since the start of the financial turmoil, central banks around the globe face unprecedented challenges. We at the ECB and other central banks have reacted swiftly, flexibly and decisively. The ECB took the lead with some exceptional decisions as early as 9 August 2007. We have, since then, modified our operational framework and used an exceptional set of non-standard policy tools. These tools, combined with the bold action taken by euro area governments over recent months, have played an essential role in preventing a collapse of the financial system and in bolstering confidence.

I would like to emphasise that despite this upheaval and our exceptional measures, our objective remains unchanged: to preserve price stability over the medium term, and that’s what guides our policy. In so doing, we support the conditions for financial and economic stability. The crisis has not changed this objective.

Today we are celebrating the 50th anniversary of Bank Al-Maghrib. This is also an occasion to reflect on the role of the Mediterranean region, and on the role of emerging market economies in general in the global economy.

The growing importance of these economies, including those in this area, has profound implications for the euro area and the rest of the world. I would like to share my thoughts with you on this phenomenon.

To conclude, I would like to call your attention to the following points.

To start with, we are, for the first time, putting to the test the soundness and resilience of the globalised economy, which has become increasingly integrated over the past fifteen years. We now have to draw, systematically and without complacency, the lessons of the global crisis that we are fighting against.

Secondly, we have a duty. Our duty is to considerably reinforce the resilience of the global financial system and the soundness of the real global economy. We should not allow that, a few years from now, a new crisis would emerge that would be similar to the current one. That would be unforgivable.

Thirdly, the international community has engaged in drawing all lessons from the crisis. We agree on the method, on the role of the G20, on the role of the Financial Stability Board, and on the role of international financial institutions, in particular the crucial role of the International Monetary Fund, and also of the Bank for International Settlements, which during the past years has shown remarkable lucidity in its analysis. As regards the global financial sector, we agree on the broad orientations to follow: to reduce procyclicality, to fight short-termism, and to impose transparency.

Fourthly, we are still today in a very difficult and very unpredictable environment. We permanently need to remain alert, and there is no place for complacency. I would have two main messages in that regard. As concerns direct government support to the financial sector, today’s priority is “rapidity of execution.” Decisions that have already been taken should be implemented swiftly. This holds true, in particular, for recapitalisation, as currently only 55% of funds earmarked for recapitalisation have been used in the euro area. In crisis times, rapid implementation is crucial. As concerns global governance, I insist on the absolute necessity to reinforce macroeconomic policy surveillance of systematically important countries and economies. The IMF has to play a fundamental role in such monitoring, coupled with responsible and active peer surveillance.

Finally, central banks have a fundamental role in ensuring monetary and financial stability from a long-term perspective. Morocco knows that it can count on the crucial contribution of Bank Al-Maghrib, whose fiftieth anniversary we are celebrating today. The world economy can count on central banks to continue to act as anchors of stability, which are more needed than ever. The European Central Bank, for its part, will continue to be an anchor of stability and confidence. And I am pleased to note the recent proposals by the European Commission, in line with the recommendations of the de Larosière report, to establish a European Systemic Risk Council under the auspices of the ECB.

Thank you for your attention.