• The interaction between monetary policy and financial stability in the euro area

    Keynote speech by Mario Draghi, President of the ECB, at the First Conference on Financial Stability organised by the Banco de España and Centro de Estudios Monetarios y Financieros, Madrid, 24 May 2017

    Introduction

    Price stability and financial stability are inherently interlinked. They tend to be mutually reinforcing, and in the long run each is a necessary, albeit insufficient, condition for the other. As the crisis showed, periods of heightened financial turbulence can impair the transmission mechanism of monetary policy. Similarly, the failure of price stability – periods of deflation or hyperinflation – has also been accompanied in the past by periods of financial instability.

    These interactions have been visible in the euro area during the crisis. The combined effects of the financial and sovereign debt crises resulted in a protracted period of low growth and low inflation. The severity of the recession in turn contributed to episodes of financial turbulence. By 2014, it had left its mark in the form of a very challenging situation both for price stability and financial stability in the euro area. Accordingly, the policy response has involved decisive action aimed at both policy domains.

    The ECB has taken a series of unconventional measures to enhance the transmission of monetary policy and secure its mandate. Important changes have also been made to the policy framework for financial stability in the euro area. Together, these actions have been instrumental in stimulating and sustaining the economic recovery while limiting the possible side-effects of unconventional policies. They have enabled a longer period of low interest rates unmarked by any significant negative side-effects on financial stability.

    Policy responses to the crisis

    The crisis in the euro area has been characterised to a large extent by feedback loops between the financial and real sides of the economy. In the early phases of the crisis, we witnessed a severe disruption in the transmission of monetary policy in parts of the euro area as the interbank market fragmented along national lines. Later, as the economy deteriorated, a number of national banking sectors saw a sharp increase in non-performing loans and, in some, the macroeconomic situation created a strong incentive to deleverage by reducing lending.

    The ECB took a number of measures to respond to financial fragmentation within the euro area. But by the start of 2014, the provision of bank credit to the real economy had dried up, shrinking at an annual pace of 1.7% in the first quarter. The euro area found itself in a vicious circle: as credit tightened, the economy worsened and risk perceptions rose, causing credit to tighten still more. The economic outlook at the time was marked by the risk of a further recession and potentially even deflation – a combination that would likely have resulted in worse outcomes for financial stability.

    So in 2014 and thereafter, the ECB took further decisive action to counteract these forces and comply with its price stability mandate. We introduced a number of unconventional measures including negative deposit facility rates, targeted longer-term refinancing operations (TLTROs) and an expanded asset purchase programme. These measures – known as our “credit easing” package – were aimed at combating the impairment of the transmission mechanism caused by bank deleveraging, and thereby ensuring the even transmission of our policy decisions across all euro area countries and along the yield curve.

    But at the same time as these measures were being deployed, two important regulatory changes took place which had profound implications for financial stability. The more resilient financial system in turn bolsters the ability of monetary policy to achieve its price stability objective.
    First, in 2014 the Single Supervisory Mechanism (SSM) Regulation came into force, under which the ECB became responsible for the direct supervision of significant credit institutions in the euro area. This has helped produce a more resilient financial system than in 2014, with higher capital ratios and lower leverage. Indeed, one of the first steps of European banking supervision was to perform a “health check”, namely a Comprehensive Assessment of bank balance sheets. The announcement alone of the Comprehensive Assessment encouraged banks to frontload their deleveraging and strengthen their balance sheets, by over €200 billion in advance of the outcome.

    The second important regulatory change was the SSM Regulation conferring macroprudential powers and responsibilities upon the ECB. Macroprudential measures are now a shared responsibility between national authorities – which have the power to implement them – and the ECB, which has the power to tighten the measures set out in the EU legal texts (i.e. in the Capital Requirements Directive IV and the Capital Requirements Regulation).

    The ECB can therefore counter any inaction bias if national authorities do not take adequate and prompt actions to implement macroprudential measures. It can lead analysis of cross-border effects, helping to avoid cross-border arbitrage and spillovers via large and interconnected banks. And it can promote a common basis for analysis, the sharing of information and the adoption of best practices, contributing to the consistency and coordination of macroprudential policies across the SSM area.[1]

    This new policy framework supports both the implementation of our monetary policy and helps build resilience in the financial system. Financial and business cycles can potentially be de-synchronised, meaning financial imbalances can grow in an environment characterised by relatively muted inflation. And in such an environment, the use of monetary policy to counteract financial imbalances may not be optimal, since it may result in substantial deviations of aggregate output and inflation from their desirable levels. In this situation, macroprudential policy, addressing financial imbalances, can complement the long-run objective of monetary policy.[2]

    The unconventional monetary policy measures and the improvements to the regulatory architecture have put the euro area banking system in a stronger position to transmit the ECB’s credit impulse to firms and households across the monetary union and to ensure sufficient financing to sustain the recovery – which is exactly what we have seen. In the first quarter of 2017, annual loan growth to euro area households stood at 2.6% and non-financial corporations at 1.6%, up from respective troughs of -0.6% in the second quarter of 2014 and -3.6% in the third quarter of 2013. Bank lending rates for both firms and households have dropped by around 110 basis points over the past three years and are now at historical lows.
    As a result, the euro area is now witnessing an increasingly solid recovery driven largely by a virtuous circle of employment and consumption, although underlying inflation pressures remain subdued. The convergence of credit conditions across countries has also contributed to the upswing becoming more broad-based across sectors and countries. Euro area GDP growth is currently 1.7%, and surveys point to continued resilience in the coming quarters.[3]

    Challenges for financial stability in the current environment

    With the resilient recovery underway, the tone of the debate in Europe surrounding financial stability has shifted. Some have expressed concerns that monetary policy measures are having unwanted side effects on financial stability. This is not a new subject for academics or central bankers: monetary policy always has side effects. But the use of unconventional measures by central banks has generated greater awareness of the issue.
    Of course, the monetary policy measures taken in recent years can have positive side effects on financial stability. Lower interest rates across the curve reduce the debt-servicing costs of households and businesses. Furthermore, by sustaining the recovery and the consequent lower unemployment, monetary policy bolsters the earnings of households and businesses, reducing the likelihood of default, which in turn supports bank profitability.[4] Banks also benefit from capital gains on assets held, and from a short-term reduction in overall funding costs. Finally, banks accessing the Eurosystem funding via the TLTRO-II can borrow at rates as low as the deposit facility rate, provided that they exhibit strong performance in loan origination.

    Yet the current environment also suggests that close monitoring is necessary in the following three areas: the effect on risk-taking in bank lending, the impact on bank profitability andthe impact on institutional investors.

    The so-called risk-taking channel of monetary policy transmission is where changes in interest rates may also affect banks’ incentives to bear risks.[5] In particular, low interest rates may lead to a search for higher yields, encouraging banks to soften their credit standards, thereby increasing both the volume and average riskiness of supplied loans.[6] If credit growth and additional risk-taking became excessive, this could lead to a build-up of imbalances and endanger the stability of the financial system.

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