Financial markets and the monetary policy strategy of the ECB
Vitor Gaspar, Director General, DG-Research
Dinner speech at the ECB conference on:
"The Operational Framework of the Eurosystem and Financial Markets"
Frankfurt, 5 May 2000
1. Introduction
During the course of the first day of this conference, we have had the opportunity to witness numerous papers examining the operational framework for monetary policy and the monetary policy strategy of the Eurosystem. I may be biased, but I take from the discussions that both are comprehensive and flexible enough to deal with changes that may arise. Looking back at the first year, both the operational framework and strategy have performed remarkably well. Much lies in the future, and from the program of the conference, tomorrow's presentations will focus on the impact of the framework on money and bond markets. In this speech, I will review some of the salient features of the ECB's operational framework in the context of the ECB's overall objective of price stability. I will then outline some of the major recent developments in financial markets. I will argue that the introduction of the single currency has directly had a major impact on money markets, but that the integration of other financial markets will be an ongoing process. I further propose that the introduction of the single currency accelerated this process. I will then turn to the impact of these changes in financial markets and institutions on the transmission of monetary policy. The speech will conclude with a brief discussion of the way the ECB's monetary policy strategy and framework are able to meet the challenge of this transformation.
I believe that all in this room are convinced that the positive network externalities achieved through an integrated and deep financial market are among the potential benefits of the process of economic and monetary unification in Europe. We are also aware, however, that financial market integration does not take place overnight, and that its full benefits can only materialise at the end of a gradual process of adjustment. The ECB ensured the speedy integration of money markets, namely through the implementation of measures to ensure the full linkage of the payment and settlement systems across European countries. Concerning the other segments of financial markets, market integration may have been stimulated indirectly through a reduction in uncertainty associated with monetary policy itself.
In October 1998, the ECB formally announced its stability-oriented strategy. The interface of the strategy with financial markets is provided by the operational framework, that is the set of instruments, and procedures, through which the Eurosystem itself intervenes in the market to achieve its objective.
Three broad requirements have been taken into account in the design of the operational framework: goal efficiency, signalling capability, market compatibility. In accordance with the principle of goal efficiency, the framework aims to ensure the achievement of its objective of price stability. That is done through the control of money market rates (and, indirectly through the influence of the term structure of interest rates). The function of signalling is performed mainly by the interaction between the interest rate on the main refinancing operations and the corridor between the rates applied on the two standing facilities. Fixed rate tenders and variable rate tenders are part of the tool kit of the ECB, as described in the general documentation. The fixed rate auction mechanism for repo allocations has played an important role in this respect. At the start of the monetary union it was preferred to the variable given that it conveys a purer signal of the level of short term rates deemed appropriate by the central bank, thereby providing clearer guidance. Finally, the framework is in line with the principles of a market economy, in order to favour the efficient allocation of financial resources. The reserve requirement system and its averaging mechanism provide an incentive to credit institutions to optimise their liquidity flows during the monthly computation period, based on their expectations of future market conditions and their attitude towards risk.
As already said, financial market integration was to be expected but its timing was uncertain. It is therefore very pleasing to witness already, after little more than one year, signs of progress in that direction. In spite of the many challenges faced by the ECB at the beginning of 1999, the transition to the single currency has been quite smooth and successful. I will therefore take pride in summarising here the positive signals that we already observe in various segments of European financial markets.
Structural changes in financial markets are relevant for monetary policy, because of their impact on the transmission mechanism. The stability-oriented strategy, however, has been devised exactly with the aim to provide the Governing Council with a framework appropriate to cope with uncertainty and structural change, including an evolving financial system.
2. Recent developments in financial markets
The introduction of the euro dominated money markets. Until the end of 1998 the various money markets of the euro area exhibited significant distinctive features. Almost immediately after the introduction of the euro on January 1 1999, they integrated swiftly and smoothly. Today, there is a single euro area wide money market. However, looking closely at the various market segments, small differences in the degree of integration have received considerable attention. The segment that is most integrated is the unsecured deposit market, while the repo market, in which participants exchange short-term liquidity against collateral, is relatively less integrated, which most argue is due to differences in banks balance sheet structure, legal and institutional aspects, and to cross-border settlement of collateral.
Nevertheless, the overall increase in efficiency and depth of the money market is reflected in a narrowing of bid-ask spreads and an increase in volumes, in particular at the very short end namely the overnight deposit market. For unsecured transactions, I can report some information from the Italian market, where spreads narrowed, on average, to about half during the past year (from 3 basis points in 1998 to 1.5 basis points in 1999; data are from the "Mercato Interbancario di Depositi", a screen based market for interbank deposits.). We were also pleased to observe that the narrowing of spreads overall was accompanied by a convergence towards the previously lowest spreads. At this stage, differences in overnight interest rate spreads largely reflect differences in the credit worthiness of banks and are no longer determined by the country where the transaction happens to take place.
Contract sizes also rose sharply. Traders in Germany and France, for example, report that contracts in national currencies were replaced, one for one, with euro contracts, thus multiplying (respectively by 2 and 6) the previous value of transactions. It is clear that these developments have eased the transition to a single monetary policy and enhanced its efficiency right from the outset.
The integration and development of other financial markets, while accelerating, will take more time. Just as TARGET was instrumental in the rapid integration of money markets, the absence of integration of security settlement systems for bonds and stocks has slowed integration. However, I am pleased to see that the depth and liquidity of markets has increased virtually across the board. Consider for example the commercial paper market. In general, commercial paper serves as an alternative to bank credit lines in firms' liquidity management. While the figures that are available are often incomplete and in some instances not fully comparable across countries, they show that in all countries, with the notable exception of the Netherlands, commercial paper issuances are rapidly increasing, although from an extremely low base. In the Netherlands, commercial paper has traditionally been an important financing tool of the corporate sector and here the market has stabilised at its high level. As is often the case, there is a caveat: This increase may somewhat overstate the shift from bank-based finance to market based finance: Commercial paper issues at present are largely bought by banks and held to maturity, which may also explain the relatively illiquid secondary markets for commercial paper.
Of course, the integration of financial markets in the euro area started well before Stage 3 of the Economic and Monetary Union. This is maybe best illustrated by the convergence of interest rates in government bond markets. Yield differentials among the euro area government bonds converged markedly since 1996 and this convergence further accelerated after the May 1998 pre-announcement of the irrevocable fixing of the euro parities. Since then, they have only rarely exceeded 30 basis points, whereas in the past spreads well in excess of 100 basis points have been common. This convergence was accompanied by a noticeable reduction in volatility. For most countries the elimination of currency related risk premia has resulted in a marked reduction in government funding costs. This was further enhanced by the prospect of a relative scarcity of government bonds, as a result of the 'Stability and Growth Pact' and the related decrease in overall supply.
Following the introduction of the euro, the European corporate bond market grew significantly and has begun to integrate. Interestingly, private issuers' activity became more important than that of sovereign issuers, which had traditionally led European bond markets. In the context of increased competition among issuers, substantial efforts were made to try to improve liquidity conditions and, thereby, the attractiveness of individual issues for a larger investor base.
The role of the new single currency was of some importance in this context. The introduction of the euro has provided corporate issuers with a much larger investor base. While in some respects the forces for change and increased competition are common to both the government and the corporate bond segments, their starting point was rather different: whereas the national government bond markets were rather developed already prior to EMU, European corporate bond markets were largely underdeveloped. All in all, the impact of EMU in the euro area bond market was reflected in a substantial increase in the total issuance of euro-denominated bonds, which grew by more than 30 percent. Aside from the larger home currency investor base due to the euro mentioned above, two further mutually reinforcing factors can be identified as underlying this development: One, increased financing needs may have arisen due to the intensive process of consolidation underway in the European corporate sector, partly as a consequence of EMU. Second, stronger competition in the European financial sector prompted banks to use their balance sheet more efficiently, in order to increase their return on equity. As a consequence, banks are increasingly facilitating direct access by corporations to the capital markets.
The most significant changes in this area may very well take place for smaller and less well-established firms. The issuance of corporate bonds of firms with a rating below A grew disproportionately during the past year. This raises the possibility that bonds over the medium term may increasingly become an alternative source of financing for smaller and less well-established firms. Nevertheless, at the present time the overall magnitudes are still extremely small. In this context, let me stress that market participants view the fact that relatively few euro area corporations have a credit rating as an important impediment to further rapid growth of the euro area bond market. Hence, in comparison with the US, the euro area corporate bond market is still lacking in liquidity and market completeness. To be concrete about the relative magnitudes, the European corporate bond market, as measured by the market value of outstanding issues, stands at an estimated EUR 300 billion versus EUR 2200 billion in the US.
Overall I think you will agree that the introduction of the single currency has a direct major impact in the money market and has increased depth and liquidity almost everywhere else. In order for all financial markets to fully integrate across the euro area, the remaining impediments will need to be removed. This will take time, but I am looking forward to further integration.
3. Banking and implications for the transmission of monetary policy
What are the implications for banks and monetary policy transmission of these developments? As central banker and policy maker, it is of primary importance to understand the answer to this question, as changes in financial markets may shape the impact of our policy on the economy.
The trend away from banks towards markets, the "disintermediation" process, I have just described, has significant implications for banks. Clearly, in spite of this trend, banks will remain major providers of financial services to households and firms in the euro area. At the end of 1999, bank loans to firms still were eight times as large as the total market value of corporate debt securities. As a matter of comparison, the US corporate debt securities constitute more than half of the borrowing by the corporate sector. This highlights the persistent difference between the European "bank-based" system of finance and the Anglo-Saxon "market based" system.
Most market participants and academics argue that competition in the banking sector has significantly increased during the past 20 years for a number of additional reasons. The important factors include the ongoing process of deregulation (e.g. the 2nd Banking Directive), financial and technological innovation (I only mention Internet Banking) and the introduction of the euro itself. The more competitive environment is, inter alia, reflected in the convergence of retail interest rates and margins across the euro area. In response, the banking system is undergoing dramatic structural change. Hardly a day passes without the announcement of a bank merger of two or more European banks. Consequently, by any measure, concentration in Europe has significantly increased during the past two years. In some countries, including in France, Italy and Spain, the market share of the five largest institutions has reached more than 50 percent of the total. This share is even higher in some of the smaller economies of the euro area.
All of these factors, combined with the developments in financial markets, which I outlined in the previous section, may have important consequences for the transmission of monetary policy. I will only give five main arguments:
First, the pressure on interest rate margins and the reduction in the ability to cross-subsidise across time and services suggests that banks set their deposit rates and credit rates more in line with market conditions. Hence, changes in the interest rate instrument of the ECB monetary policy should be transmitted more rapidly to the non-financial private sector of the euro area as the ability of banks to insulate their customers from changes in money market rates will decrease.
Second, rationalisation of banking activity could reduce the availability of the bank credit to small businesses that some observers consider a relatively unprofitable banking activity, as it requires significant resources to be devoted to monitoring and sufficient knowledge of local markets which may be lost in a merger. The structural change may also undermine long-standing bank firm relationships, which have in the past have overcome the asymmetric information problems between entrepreneurs and suppliers of funds. Although this issue has been given a lot of attention in the academic literature, no consensus has been reached on the importance of this question for growth. It could be the case that the restructuring of the banking sector will result in some banks specialising in small business lending. What may matter most for monetary policy is the question of whether and how the structural transformation will affect the prevalence of credit constraints to small business and whether this change will be significant from a macroeconomic viewpoint.
Third, with regards to the asset side of banks, the increase in competition from market based finance available to firms will impact upon the transmission mechanism directly. As an increasing share of firms will be able to issue debt on markets instead of using bank credit, I would expect to see that bank credit interest rates are set more in line with market conditions. Clearly, firms, which are in a position to issue debt directly on the market, are less dependent on banks. For these firms that are able to diversify their sources of finance, the market interest rate should become a more important factor of their borrowing decisions.
Fourth, problem loans of euro area banks, e.g. loans that experience payment delays or are otherwise non-performing, have reached new heights recently in a number of countries. The reasons for this increase may be manifold, but it is likely that the tougher operating environment has played an important role. For example, if the financially sounder customers finance themselves in capital markets, banks may have expanded their lending to worse credit risks. Combined with the reduction in interest rate margins, this would suggest that banks have little choice but to expand into other, "non-traditional" activities (e.g. underwriting or other fee-based services) in order to maintain profitability. Increased risk awareness and meticulousness in the monitoring of risks on the part of banks and supervisors will hence be required.
Finally, the maturity and interest rate structure of bank balance sheets matter. In banking systems with a greater proportion of long-term fixed rate assets and liabilities, monetary policy shocks will be propagated much more slowly than in banking systems with largely short-term variable rate assets and liabilities. So far, the differences among member countries in this area, which reflect different inflation histories, as well as "traditions" and "tastes," have only converged to a very limited extent. Hence, asymmetries in the transmission of monetary policy will remain for a number of years to come. In any event, the eventual convergence would be expected towards longer-term, fixed rate instruments, as this is usually observed in low inflation environments. This may, over the medium term, reduce the speed of the transmission of monetary policy. Nevertheless, households in euro area are increasingly offered a wider range of possibilities to schedule the flows of payments on the mortgage date according to their own preference.
All in all, I would submit that we have fairly good reasons to expect that disintermediation and the restructuring of the European banking sector will result in a banking system that neutrally transmits changes in money market interest rates to their customers in an increasingly direct way. That is, as banks are less likely to be willing to buffer the impact of interest rate changes on the income of the non-financial sector, the impact of market interest rates on the interest payments/income across non-financial debtors and borrowers should increase.
Finally, allow me some brief remarks on the potential consequences of the growing importance of equities in household portfolios for monetary policy. Stock markets are growing essentially under the strength of two fundamental trends, which, incidentally, have little to do with EMU. First, the ageing of the population combined with some uncertainty surrounding the sustainability of public social security systems has resulted in a relative increase in the importance of private savings for retirement. Many households and especially younger families are investing an increasing share of their savings in long term assets such as stocks. Second, the increased access of smaller and less well-established corporations to equity finance related to the creation of several stock markets, specialising in "start ups", has increased the choices of small investors. Even if the capitalisation of these markets is still small, it is expanding rapidly. Looking across the Atlantic, NASDAQ shows that they may have the potential to attract a significant share of the invested funds.
And third, the recent announcement of Euronext, a merger of the Paris, Amsterdam and Brussels stock exchanges, each specialising a certain market segment, and the finalisation of the merger negotiations between the Frankfurt and London stock exchanges, announced this week, suggest a quicker pace of the consolidation process of European stock exchanges. This consolidation is expected to further enhance the attractiveness of stocks as investments through a deepening of markets, accompanied by further reductions in transaction costs.
These developments may have an impact on the importance of wealth effects in monetary policy transmission. As you know, these effects have traditionally been much smaller in Europe than in the U.S. However, as more and more wealth is invested in securities, these effects may gain in importance.
4. Conclusions
The structural changes under way in European financial markets are welcomed.
The stability-oriented strategy represents the response of the ECB to this challenge and to the particularly uncertain environment which the single monetary policy was expected to face right from the inception of the EMU, including the transformation of the financial sector. These special circumstances have discouraged the adoption of monetary targeting - in spite of its highly successful application in Germany for 25 years - or inflation forecast targeting - notwithstanding that it is very much á la mode at this particular point in time. Both these strategies rely on the prevalence of a relatively stable environment characterised, in the first case, by a stable demand for money and predictable velocity, in the second, by an absence of structural breaks to behavioural relationships of the macroeconomic model on which the policy forecast is based. Neither could be taken for granted by the ECB.
The concept underlying the stability-oriented strategy represents both a structure for the internal filtering and processing of information and a scheme for external communication with financial markets and the public at large. This consistency of the frameworks used for internal and external communication is the central feature that ensures the overall transparency of the decision making process, another crucial element to reduce the sources of uncertainty faced by financial markets.
The ECB strategy has sometimes been criticised along this aspect and I have already had a chance to reaffirm my belief in the high degree of transparency achieved through our model of communication to the public. Let me simply emphasise here once again that our critics have failed to pay attention to the virtues of the timing of our model. The ECB's reading of current economic and financial developments is summarised and explained by the President immediately after the first Governing Council of each month is adjourned. Moreover, the President and the Vice-President are available for extensive questioning, transcripts of which are made available on the ECB Web site. This model of communication "in real time" fosters the quick transmission of monetary policy signals, avoiding, at the same time, situations in which market participants are left to second guess the precise reasoning behind a policy move until the publication of the minutes of the meeting at some future date.
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Goal efficiency, signalling capability and market compatibility of the monetary policy framework, together with a transparent monetary policy strategy, all contribute to the integration and deepening of European financial markets. I wish to conclude, however, emphasising that the success of the overall project of European monetary unification ultimately hinges on the ability of the Eurosystem to preserve price stability in the medium term. Historical experience demonstrates that price stability prospects increase the attractiveness of domestic financial markets because, on average, they bring about higher ex post returns in real terms and low risk. In turn, an attractive market tends to become more liquid, thus originating a virtuous spiral of increasing attractiveness and liquidity.
The ECB's pre-commitment to the Treaty's price stability requirement has been reaffirmed at the moment of the announcement of the stability-oriented strategy. A clear, numerical definition of price stability has been given in order to provide an anchor to markets' expectations and to underline the Eurosystem's full assumption of responsibility on medium term inflation. The dynamics of bond prices in the first year of the EMU appear to confirm that this message of stability has been clearly understood and that there is full trust in the ECB's anti-inflationary resolve. The integration of European financial markets is going to progress for some time to come and I am looking forward to tomorrow's presentation in this area.
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