Transcript

José Viñals, Financial Counsellor and Director of the Monetary and Capital Markets department
Robert Sheehy and Jan Brockmeijer, Deputy Directors
Peter Dattels, Chief of the Global Markets Monitoring and Analysis Division
William Murray, Chief of Media Relations, External Relations Department
September 21, 2011

Mr. Murray: Good day. This is our briefing on the latest Global Financial Stability Report. Joining me today is Jose Viñals, Financial Counsellor and Director of the Monetary and Capital Markets Department which produces this report. With Jose is Jan Brockmeijer, Deputy Director; Robert Sheehy, Deputy Director; and Peter Dattels, Assistant Director of the Monetary and Capital Markets Department. Jose will have some brief opening remarks and after that we will take your questions.

Mr. Viñals: Thank you very much. Since our previous report financial stability risks have increased substantially, reversing the progress that had been made over the previous three years, so we are back in the danger zone. As we have moved into a new political phase of the crisis, several shocks have recently buffeted the global financial system, including unequivocal signs of a broader global economic slowdown, French market turbulence in the Euro Area and the credit downgrade in the United States. This has thrown us into a crisis of confidence, which is being driven by three main factors: Weak growth, weak balance sheets and weak politics.

First, weaker growth prospects and larger downside risks to growth have prompted investors to reassess the sustainability of the economic recovery, which appears increasingly fragile. You had the opportunity to hear about that yesterday at the WEO launch.

Second, the reduced pace of economic activity and incomplete policy actions have stalled progress in balance sheet repair. This has led to increased concerns about the financial health of sovereigns in advanced economies, of banks in Europe, and of households in the United States.

Let me elaborate a little bit more on the issue of balance sheets. In Europe, sovereign risks have spilled over to the region's banking system and this has put funding strains on banks, of many banks operating in the Euro Area, and, hence, this has depressed their market capitalization. We have quantified the size of these spillovers on banks in the European Union since the outbreak of the sovereign debt crisis in 2010. During this period, banks have had to withstand an increase in credit risk coming from high-spread Euro Area sovereigns that we estimate amounts to about 200 billion euros. If we include exposures to banks in Euro Area countries, the total estimated spillover increases to 300 billion euros.

This analysis helps explain current levels of market strain, but it does not measure the capital needs of banks, which would require a full assessment of bank balance sheets and income positions. Still, because of increased market pressures, banks may be forced to speed up deleveraging, curtail credit to the real economy, and thus worsen the economic drag. Clearly, this is something that must be avoided.

In the United States, there have been concerns and much debate about the longer-term sustainability of US government debt. These concerns, if left unaddressed, could potentially reignite sovereign risks and could have serious adverse consequences on the domestic and the global economy. At the same time, US households are still repairing their balance sheets, a process that has affected economic growth, house prices, and US bank balance sheets.

The third factor driving the confidence crisis is weak politics. Policymakers on both sides of the Atlantic have not yet commanded broad enough political support for the needed policy actions, so markets have begun to question their resolve.

There is another important issue facing policymakers nowadays. Incomplete balance sheet repair in advanced economies, coupled with a prolonged period of low interest rates, can pose financial stability risks for both advanced and emerging markets. Low policy rates are necessary to support economic activity under current conditions. They can also buy time to repair public and private balance sheets. But if time is not well used and these repairs remain incomplete, low rates can pose risks to longer-term financial stability by encouraging the build-up of excess pockets of leverage by diverting credit creation to the more opaque shadow banking system and by pushing capital flows toward emerging markets in excessive amounts.

I turn now to the policy part. What can and should policymakers do? In general, I think that policymakers need to switch gears, shift the focus from treating just symptoms of the crisis to dealing once and for all with its underlying causes. In advanced economies, the most important thing is to decisively and expeditiously resolve the current crisis of confidence. The biggest problems, rising sovereign risk, weak banks and the spillovers between them, can only be tackled through swift and comprehensive balance sheet repairs.

Public balance sheets in the United States, in Europe, and in Japan need to be bolstered through credible medium-term fiscal consolidation strategies. This is absolutely essential.

In addition, overstretched US households' balance sheets might benefit from a more ambitious program of mortgage modification involving principal write-downs. Banks in the European Union need to cope with the spillovers from riskier sovereigns. At the same time, they also need to have sufficient muscle to support the economic recovery through lending.

While significant progress has been made recently, banks need to build adequate capital buffers. Some banks may need to do very little, but others, especially those who are very reliant on wholesale funding and exposed to riskier public debt, may need more capital. Private sources of capital should be tapped first, but in those cases where this is not possible or not sufficient, injections of public funds may be necessary for viable banks, and weak banks need to be restructured or resolved.

How about emerging markets? Emerging economies need to balance current risks to avoid future crises. Given the experience of past credit growth, with rapid credit growth in many emerging markets, often in the context of strong capital inflows, policymakers need to avoid a further build-up of financial imbalances where credit growth remains elevated even if capital flows have abated somewhat recently.

In addition to sound macroeconomic policies, macroprudential policies and capital flow measures can also play a supportive role in addressing these concerns. At the same time, emerging markets face a potential global shock that could lead to a reversal of capital flows and a drop in economic growth. Our analysis shows that the impact on emerging market banks could be substantial and, thus, warrants a further build-up of capital buffers in the banking system.

Let me conclude. The lack of sufficiently decisive policy action to finally address the legacy of the financial crisis has led to the present crisis of confidence. This has thrown us back into the danger zone and poses a major threat to the global economy. Yet we believe that while the path to sustained recovery has considerably narrowed, it has not disappeared. It is still possible, thus, to make the right decisions that will help restore global financial stability and sustain the recovery, but for this we need to act now; we need to act boldly; and we need to act in a globally coordinated manner. There is a way. Now we need the political will. We will be happy to handle any questions that you have, together with my colleagues.

QUESTION: In your report you refer to the difficulty—I think you were referring mainly to the United States but you referred to Europe as well—of small and medium-sized enterprises accessing cash, even through the banks, because they have not got the same access to capital markets as the big corporates. I am particularly interested in the United Kingdom, where we do have a problem with small- and medium-sized enterprises. I just wondered if you could address how they may get more access to bank finance.

Mr. Viñals: Small and medium-sized enterprises are very important because they contribute to a very significant share of job creation in most economies. These enterprises, unlike the larger firms that can access capital markets directly, have access to credit through banks. So, it is fundamental for the small and medium-sized enterprises, if they’re going to have the credit that they need to keep going and to continue creating jobs, that banks have sufficient strength so as to be able to get funding on good terms, and then pass this funding on to the small and medium-sized enterprises through credit given abundantly and at good conditions. So that would be something that is very important.

Another thing is that securitization was very much broken down as a result of the crisis, because we had a lot of bad, unsafe securitization. But securitization, the safer type, is something that can be very useful to provide credit to households and small and medium-sized enterprises. This is why it is fundamental to continue making efforts to revive safer securitization in order to support this process of credit flowing to small and medium-sized enterprises.

In the United Kingdom, in particular, I think it is fundamental that the process of financial restructuring that is ongoing in a couple of banks, and you know which ones I am talking about, is successfully completed, and also that the new regulatory measures that the authorities take basically reach their target. That target is to enhance the solidity of the banking system in the United Kingdom, which is important not just for small and medium-sized enterprises but also for the functioning of the whole economy.

Mr. Dattels: Let me just add to that that during the period of balance sheet repair, particularly in the UK, there were targets set for lending. In my discussions with the British banks, I think that did help in drawing attention to the SME sector and helped assure that credit was flowing to that segment. Of course, such targets need to be under continuous review. And as banks progress to the phase of becoming stronger and better able to deal with their balance sheet issues, then lending targets should be lifted. But I think during that transition period that was a useful set of policy measures.

QUESTION: My question is about monetary policy and financial stability in emerging markets and advanced economies. The Fed is about to announce new monetary easing here and I wonder what would be the impact in the financial stability exercise of this action. Also, I would like to know if some emerging markets have deployed macro-prudential measures to deal with this credit growth risk. I wonder if there is a role here for monetary policy as well in these countries, like Brazil.

Mr. Viñals: On the first part of your question, I will not speculate on what the Fed is going to decide today. Let us see what they decide first, and then we can assess the consequences. On the issue of credit growth in emerging markets, it is true that in many cases credit has been growing much faster than the growth of nominal GDP. This is something that, in a number of cases, is good because it contributes to their financial deepening. These are countries that have relatively small shares of the financial sector relative to the size of the economy. But if you do this very fast, then quite soon you are also going to have higher nonperforming loans. In fact, this is something that we look at in our report.

So, I would say that when you have a country where credit is expanding very fast, where asset prices are also growing very fast, and where you have current accounts turning into deficits, there may be a need to think whether the overall macroeconomic policy, not just monetary policy, is the appropriate one. In many cases, monetary policy has to pull interest rates up because fiscal policy is not doing as much as it should. So, I think that you have to have a balanced policy mix both on the monetary and fiscal side, and you have to use as a complement macroprudential measures in order to target better those pockets of financial instability that may be building up in the system.

QUESTION: First, in your perspective, how big is the chance for Germany to give further support to other cash-strapped euro economies? Secondly, is it possible for China and other BRIC countries to give more support to the euro economy, including EFSF? What are the pros and cons?

Mr. Viñals: As you know, in Europe, there is the process of ratification going on to validate the decisions that were reached by the Euro Area Summit of 21st of July. We think these are very important decisions, the ones that were reached there. Germany is going to hold a discussion in parliament before the end of the month. So, we very much hope that not only in Germany but also in the rest of the countries concerned, that they can agree to ratify these enhancements in the EFSF and that this can be made a reality as soon as possible. We think that is of the essence.

In terms of China, of course, China plays a very important role in the world economy. I think that one of the key contributions that China can make—and there are a number of contributions that we could discuss—, but one very important one is, together with the advanced economies, to contribute to global rebalancing. I think that would be, among others, a very important contribution that China could make. Of course, that would have to be in tandem with advanced countries doing their part of the rebalancing, too.

QUESTION - Earlier this year the European Banking Authority (EBA) did a stress test of euro banks and found that most of them were, by and large, adequately capitalized. From what you are saying, from what you seem to be saying, you do not agree with that. Can you confirm that that is the case and, if so, where did the EBA go wrong?

Mr. Viñals: We are not passing judgment on the EBA. What the EBA did was a regulatory test that was published in July; and it was performed even before that. Since then, things have changed. As I said in my opening remarks, we are not estimating the amount of capital that is needed in European Union banks, and this is something that will vary very much according to different countries and also among banks in the same country. What we are saying is that there is a significant spillover of sovereign risk into banks and this is something that is creating market strains.

So, at this time, where sovereign risk is very important, what we have is a two-handed approach. First, you have to deal with the source of sovereign risk at its heart, and that means pursuing credible medium-term fiscal consolidation policies that will reduce the source of sovereign risk and that would do a lot to relieve the pressure on banks. That is absolutely essential.

But, because this is something that is likely to take time and markets may not be convinced overnight, you need to have a complementary approach, which is to make sure that all banks in the European Union have adequate capital buffers. This is something which supervisors will need to look at very carefully and then decide what is the size of capital buffers that the banks must have in order to get funding in attractive or in appropriate conditions, so under reasonable conditions.

What we have now in the European Union is that there are many banks whose Tier 1 capital levels are not as high as markets are demanding, because the bar that markets apply to give you funding in appropriate conditions has risen. So, you have to do a little bit more. If I am not mistaken, even in the EBA stress test, it was said that not just the banks that failed to pass the stress tests, but also other banks, which have come sufficiently close to it, should also put in place measures to enhance their capital levels. So, this is where we come out.

QUESTION: You mentioned in the report the difficult political dynamics and the consequences—talking about Italy—and the consequences of these over market uncertainty. Would you please elaborate on that? Would you please explain what exactly you mean with "difficult political dynamics"? I am asking because this is an important issue, on the basis of which Standards and Poor's have decided our recent downgrading.

Mr. Viñals: I think that it is fundamental, but not just in Italy but in many of the countries that have come under market pressure, to do whatever it takes and to show a united political front in addressing the fiscal responsibilities of the country and of convincing markets that there is no problem.

As regards sovereign risk, we are seeing a degree of overshooting. That does not mean there are no real issues underlying. You may exacerbate the problem, but it is there. So, it is fundamental that any uncertainties in the political discussions are minimized and that the right measures are taken. We think that the Italian authorities have been taking now measures that are very important to reassure markets on the fiscal front. We think that this is essential and this is very important. Of course, the uncertainty that happened a few months ago did not help and this is in the public domain.

So, the constructive message is: if there is a problem, let us unite in order to solve the problem so as to convince the markets of the solidity of the public finances. That would be very good for the financing and rollover of your public debt, but also it would be very good for your banks because they would have a lower amount of sovereign credit risk in their balance sheets if you manage to shrink sovereign credit risk through appropriate fiscal actions.

QUESTION: You mentioned the need for some European banks to strengthen their balance sheets, preferably with the private funds but possibly with public funds. Would it in the end imply nationalization of banks?

Mr. Viñals: Well, I think that tapping the private markets is absolutely essential. This is something that can be done in addition to other actions that banks can take. Banks can use return earnings; they can use some of their internally-generated reserves in order to build up capital buffers; and banks need also, if that is not enough, to tap private markets, and this is happening in a number of European countries now. Let me just mention what has taken place in terms of the restructuring and capitalization of the cajas in Spain. They are tapping private markets successfully so far, those which have gone out to raise money in the markets.

Now, for those banks where it is not enough to give them adequate capital buffers in the view of the national supervisor, you need to do something. The worst thing that you can have are banks which cannot get funding at appropriate terms and have to deleverage by curtailing credit. That is something you want to avoid. So, in those cases you have to use, as a complement to the private funding, public injections of capital, which should be introduced under certain conditions because you do not want the public sector to be there for a long time. You want the public sector to be there for as long as it is required, but no longer, because you want to have a private and vibrant banking system. So, this would be something to be contemplated.

In those cases, where the national authorities have deep pockets—fiscal pockets—and fiscal room for maneuver to contribute to their banks by injecting public capital, so be it. In those cases where this is needed and cannot happen, then you have an ultimate backstop in the Euro Area, which is the European Financial Stability Facility, which, after the very important decisions of the July 21st Euro Summit, can be used to help banks, to recapitalize banks, even if you are not under a joint EU-IMF program. It is the ultimate backstop, but it is available.

QUESTION: My question is about Greece. What impact will have an exit of Greece from the Eurozone? Are you supporting the aspect which says that the Greek debt needs a broader restructuring?

Mr. Viñals: I do not want to speculate on things like the one you mentioned at the beginning, of a potential exit for Greece, because this is not the scenario with which we are working. I think that in the Euro Area you have had the recent, very strong statements by political leaders, like Angela Merkel and President Sarkozy, basically saying that they are ready to do whatever it takes in order to preserve the integrity of the Euro Area, which I think is not just very important for Europe but also for the world.

Again, this is not a scenario that I want to contemplate, nor the one with which we are working. On the contrary, what we are doing is to work very closely with the Greek authorities and with our European partners from the European Union, the European Commission and the European Central Bank, working together with the Greek authorities to make sure that Greece remains on a good path and that it overcomes its present difficulties, which are important but can be overcome. But for that it is fundamental that there is a combination of several factors: Strong implementation of the measures agreed in the program on the fiscal side, but also to restart growth through structural reforms, coupled with a successful debt exchange operation, like the one which is under way nowadays. This, plus official financing, we think are the key ingredients for what we want to achieve. But the cornerstone of this is the full implementation by the Greek authorities of the measures that are in the program now.

QUESTION: I am interested in your analysis on page 23 here regarding insurers in Europe. It look like from what you are saying here that spillovers would basically wipe out the common equity of the four big ones potentially and I am wondering what is your sense of the sort of systemic exposure outside the banks. Has exposure to sovereigns either through derivative contracts, CDS, other things, accumulated in some way that you regard as systemically important? If so, where?

Second, even though you are not planning for this scenario, what sort of contingency emergency planning is being done to prepare for disorderly default in Greece?

Mr. Viñals: Again, I think that this is not a scenario that we are contemplating at all. At all. Let me be very clear on that. At the same time, I think that what I said before applies. It is very important that the EFSF, which has been enhanced in terms of its flexibility, its effective lending capacity, has the ability to use this flexibility as soon as possible. I think this is going to be very important in all cases.

Mr. Dattels: Just on the insurers, one very important factor is that this potential impact is shared with policyholders so you need to disentangle what potential losses are borne by policyholders. In terms of the overall impact on insurers, there has been a stress test done by the EIOPA that was looking at the impact of insurers that have some 1.3 trillion euros of holdings of sovereign debt in total, which represents about 21 percent of their assets, and that in particular it looked at the 300 billion exposure to the periphery, which would also include exposures to Italy and Spain.

They found overall that the impact was quite reasonably manageable except potentially in a few cases where the size of those exposures, particularly on country insurers' exposure, such as in Italy, are fairly sizable. However, insurers also have a big advantage compared to banks and that is that they have very long-term funding and they are not subject to strains on the funding side to the extent that banks are. Therefore, the overall view is that it is reasonably manageable within the framework.

In terms of the broader impact, the concern is obviously that the sovereign risk spills over to other markets and obviously we are seeing a substantial amount of pressure on bank equities, which have fallen substantially. Essentially European bank equities have fallen some 40 percent. The loss is substantial in terms of the impact on market capitalization, somewhere on the order of 400 billion. So, it is a substantial impact. That goes to make the connection between what Jose said about the impact of sovereign stress and the impact on financial markets. So, that is why we think that it is an extremely important issue to stabilize the situation and take appropriate action.

QUESTION: I wonder if you could just elaborate a little on what you mean by 200 billion euros of capital—of spillovers not being a proxy for capital charge. I just wondered if you could help us to understand terms like that, expressions, and the capital effects. Also, because these assets have and still are being zero-weighted formally for capital purposes, I wonder if you could just elaborate on how you view that. I think your colleague, Carlo Cottarelli, said yesterday that there is now no such thing as a risk-free investment. Does that mean there should be in the future no such thing as zero-weighted assets for capital purposes?

Mr. Viñals: Let me just clarify this 200 billion, because it is important. This 200 billion euros is our estimate of the higher credit risk which has been imported by European banks, European Union banks, as a result of the higher sovereign credit risk in a number of European countries, which are the risky ones, namely the three program countries, plus Belgium, Italy, and Spain, which also have relatively high spreads. Of course, these countries are very different from one other in terms of their economic and financial fundamentals, and these latter countries are also very different from the three program countries.

So, this 200 billion, this increase in credit risk in bank portfolios, this is a potential loss for banks if the credit risk materializes. How do you translate that into a capital figure? I would say that this is difficult because you would have to have a full-fledged analysis of many other things going on in the assets and liabilities sides of the balance sheets of banks in order to come up with this answer.

In particular, some of this increase in credit risk may have been already recognized in the trading books of banks. Some of it may have been recognized as available for sale and some of it may have been provisioned for. But it is very unclear what the extent of this recognition is, because there is not enough transparency in the way in which banks treat sovereign risk. You remember the call from the International Accounting Standards Board, basically saying that we need more consistency and that we need more clarity on how banks price sovereign risk and how they account for it. That is I think very important.

On the issue of zero-risk weights, let me just say the following. According to Basel II, you have zero-risk weights only on certain type of sovereigns. These are the highest-rated sovereigns, but you always have the capacity if you use internal models to assign a higher risk weight to sovereign debt that you think has become riskier. This is something that banks could do and probably banks are not doing, but we do not have enough information to know exactly what is happening.

I think that this is something that supervisors may want to look at in order to make sure that the current practice, which is applying zero-risk weight on a lot of this debt, is replaced by these internal models which put nonzero-risk weights when the risk is now evident while before it was not. So, I think this is very important.

QUESTION: (Inaudible)

Mr. Viñals: Basel III, which is now going to replace Basel II, is a universal standard. This is something that all banks should take into consideration, that there is no longer a risk-free rate, and the supervisors should have a conversation with the banks on that, a serious one. Of course, in those areas where the sovereign risk that you have in the bank portfolios has become larger, this conversation is even more important. But it does not apply only to the European Union.

QUESTION: Banks have said that costs for creditors are going up too much already in terms of needing to raise capital, and that additional capital buffers would raise those costs too much and slow growth. Can you respond to that? In talking with European banking authorities during the putting together of the GFSR, how confident are you that they are receptive and will heed the recapitalization call? Finally, how best to raise capital, specifically. I know you said public and private funds. But, exactly how? Are we talking about contingent capital, etc?

Mr. Viñals: On the last part, I think you need to have capital loss absorbency and I think this is something best raised through common equity. This is what should be the main component of capital: common equity. There may be other things also that have very high loss absorbing capacity and that count toward equity, and we have now the Basel III regulation, which is accounting for that. But I think that common equity is most important.

In terms of the costs of regulation on banks; yes, banks have said that the regulatory reform process may end up imposing too high a cost on banks and that this is something that may take a toll on lending and on the real economy. You know that there is a very sharp contrast between the results of the studies that have been elaborated by the industry and the results of the studies that have been elaborated by the official sector. Very, very different.

So, given that we have participated, together with the BIS (Bank of International Settlements), the Financial Stability Board and the Basel Committee on Banking Supervision, and with all the members of the international community, central banks and supervisors, in assessing the impact of these measures, I will stand by what we are saying, which is that the impact is likely to be very, very moderate, and that if you do not raise these regulatory standards, you are going to have much worse consequences. If banks do not have sufficient capital and are not perceived as sufficiently safe, then they are going to have big trouble in raising funding in good conditions. They are going to curtail credit and that is going to have a very important negative impact on the economy. So, we think that this is the right way of thinking about it.

You asked another question, which is how confident are we that the European authorities are receptive to the message that banks have to have adequate capital buffers. I think that if you look at what European authorities have been saying, I think that we are in the same boat. I think that we consider it very important, together with action to address the fiscal problem, to also have adequate buffers for banks. I do not expect big discrepancies there.

QUESTION: You mentioned a couple of times that this is also now a political crisis and Europe has to act faster. Is this not a little bit too easy? What about the other side of the problem, the banks? Why didn’t they themselves so far start to strengthen their capital buffers? Is this kind of a dysfunction in the private sector or what is going on on the other side?

Mr. Viñals: At the end, this is a joint venture between the banks and the public sector. I think that banks need to do their share and sometimes they may have an analysis that is based on their own standing. I think that the authorities have to take also a macroprudential vision, they have to look at the system as a whole. I think that by talking during the supervisory process and the regulatory process there are a lot of interesting ideas that can come out.

I think that there are a number of actions that need to be undertaken in order to strengthen the position of banks. One is to have banks have adequate capital buffers, and this is something that in the end banks need to do and, if not, they should be told to do it if in the view of the authorities they are not doing enough.

But there are also other important things that are in the hands of the authorities, which is that there are a number of banking sectors in Europe that need to be restructured and a number of institutions that need to be resolved. That is something that requires public policy. This is happening in a number of countries. It is a process that needs to happen also more broadly in order to have a vibrant financial sector for the future. We will overcome this crisis and then we need to have a banking sector that is vibrant and that can support a long period of growth, as we would like.

Mr. Murray: That is a good message to stop on. I would like to thank José Viñals, Jan Brockmeijer, Robert Sheehy, Peter Dattels, and all of you for joining us today. Thank you.