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Hearing on the ESRB before the Committee on Economic and Monetary Affairs of the European Parliament

Introductory statement by Jean-Claude Trichet, Chair of the ESRB Brussels, 11 October 2011

Dear Madam Chair,

Dear Honourable Members,

I am delighted to appear before this Committee today in my capacity as Chair of the European Systemic Risk Board (ESRB) to explain to you what the ESRB has done in its first nine months of activity.

Je décrirai dans un premier temps la situation actuelle et l’appel lancé par le Comité européen du risque systémique (CERS) à agir sans délai. Je vous présenterai ensuite les premières recommandations formulées par le CERS, qui seront publiées aujourd’hui même.[1] Ich werde außerdem bestimmte makroprudenzielle Auswirkungen derzeitiger Gesetzesvorschläge aufgreifen, an denen das Parlament als Mitgesetzgeber beteiligt ist. Schließen werde ich meine Ausführungen mit einigen Worten zur laufenden Arbeit des Ausschusses an eher strukturellen, mittelfristigen Themen.[2]

Current situation: ESRB calls for immediate action

Let me start by describing the current situation and the actions that, in our view, need to be taken.

The crisis has reached a systemic dimension. In a press release published after the ESRB General Board meeting of 21 September, we stated the following: “Over the last months, sovereign stress has moved from smaller economies to some of the larger EU countries. Signs of stress are evident in many European government bond markets, while the high volatility in equity markets indicates that tensions have spread across capital markets around the world. The situation has been aggravated by the progressive drying-up of bank term funding markets. The high interconnectedness in the EU financial system has led to a rapidly rising risk of significant contagion. This threatens financial stability in the EU as a whole and adversely impacts the real economy in Europe and beyond.

Over the past three weeks, the situation has continued to be very demanding. The crisis is systemic and must be tackled decisively: national governments and authorities, as well as European institutions, must rise to the challenge and act together swiftly. Further delays are only contributing to aggravate the situation.

In the immediate future, in the view of the European Systemic Risk Board, the measures agreed upon at the meeting of the euro area Heads of State or Government on 21 July must be implemented fully and rapidly. Credible and sustainable fiscal policies and growth-enhancing structural measures must be enacted so as to fully preserve and restore the credibility of sovereign signatures in global markets. Coordination and consistency of communication must be enhanced. I stress once again that it is a matter of urgency that all authorities act in unison, with total commitment to safeguarding financial stability.

Supervisors must coordinate efforts to strengthen bank capital, including having recourse to backstop facilities, and also taking into account the need for a transparent and consistent valuation of sovereign exposures. The possibility for the European Financial Stability Facility (EFSF) to lend to governments in order to recapitalise banks – including, if necessary, in non-programme countries – could be of benefit here.

ESRB publishes recommendations on lending in foreign currencies

Today, the ESRB is publishing its first recommendations – on lending in foreign currencies. Lending in foreign currencies to borrowers that are not protected against exchange rate risk has become common practice in some EU countries. It is a phenomenon that entails significant risks for the financial sector.

Let me elaborate on the three main risks. First, by exposing borrowers, such as households, to foreign exchange risk, this practice ultimately entails higher levels of credit risk, since a devaluation of the domestic currency would increase the value of the principal to be repaid. Second, foreign currency lending, which carries a lower interest rate than loans in domestic currency, may contribute to excessive levels of overall credit growth. Third, liquidity and funding risks are heightened, for instance due to an over-reliance on short-term foreign currency swap markets.

Given the risks to financial stability, the potential for cross-border contagion, and the circumvention of national measures so far, the ESRB decided to adopt policy recommendations. These recommendations focus on policies aimed at addressing risks stemming from new loans extended in foreign currencies tounhedged borrowers.

Overall, the recommendations we put forward today aim to provide a holistic policy response to the concerns stemming from excessive foreign currency lending. They aim to address the roots of the problem, while increasing the overall resilience of the financial sector.

Let me give you a brief overview of what these recommendations are about, without entering too much into the technicalities.

  • First, we recommend that authorities require financial institutions to: (i) provide borrowers with adequate information so as to increase borrowers’ risk awareness; and (ii) improve the creditworthiness of new borrowers.
  • Second, we recommend that authorities monitor whether foreign currency lending is inducing excessive overall credit growth and that they apply measures to counteract such developments.
  • Third, we recommend that authorities require institutions to properly take into account this source of risks in their internal risk management systems and to hold adequate capital for this practice.
  • Fourth, we recommend that authorities closely monitor funding and liquidity risks, and consider imposing limits whenever necessary.

For the relevant authorities, the publication of these recommendations will mark the beginning of the implementation phase; and for the ESRB, it will be the beginning of the monitoring phase. Based on the “act or explain” mechanism, authorities have until 2012 or 2013, depending on the individual recommendation, to act to implement the recommendations. The ESRB will then assess the actions taken – or, in cases of inaction, the explanations provided – and will decide on the appropriate follow-up. As you know, the legislation foresees that the ESRB will report to Parliament in cases where implementation is deemed insufficient. Be sure that it is clear that we will do it punctually.

I should also like to note that, at the same time as addressing vulnerabilities stemming from lending in foreign currency, the ESRB is also working on systemic risks that could originate from banks’ funding in foreign currencies.

In particular, the ESRB is considering the medium-term need for action to reduce vulnerabilities of large EU banks in US dollar funding markets. Preliminary ESRB work has helped to increase authorities’ awareness of potential systemic risks stemming from over-reliance on short-term US dollar funding. Such work points to a need, in the first instance, to further enhance monitoring of US dollar funding mismatches and to strengthen banks’ plans for contingency funding. The ESRB is thus aiming to prevent a future repetition of the tensions experienced in US dollar funding markets in 2008 and 2011, and that have been appeased through the multilateral swap agreements between the major central banks.

ESRB highlights macro-prudential implications of EU legislation

Let me now turn to some legislative proposals on which this Parliament has been working as co-legislator over the last few months.

As a European, I think it is important that the EU is the first to start the process to implement the Basel III Agreement, as approved by the G20. As the first mover, the EU carries naturally a strong responsibility to deliver, beyond any doubt, a full and consistent implementation of the Basel III Agreement.

The extraordinary conditions currently facing the EU highlight the importance of timely and rigorous action to address systemic risk. To this end, the ESRB stresses that national macro-prudential authorities of EU Member States must be able to tighten settings of prudential instruments to levels above those provided for in EU legislation in a timely fashion and based on local economic conditions. Our citizens would not understand if we failed to address serious systemic risks, leading to damage to the economy, just because authorities were prevented from dealing with it appropriately and promptly.

Needless to say, this needs to be done without jeopardising the integrity of the Single Market. This is indeed possible. The use of macro-prudential powers at both European and national levels can, and must, be reconciled with the prevention of violations of the four fundamental freedoms of the EU. The ESRB, given its mandate, can review decisions taken at the national level by the competent macro-prudential institutions, to signal any violation to the Commission and ensure that national authorities take account of possible cross-border spillovers.

With this in mind, we have reviewed, and will continue to review, the draft EU regulations for banking (CRD/CRR), market infrastructure (EMIR) and insurance (Solvency II) from a macro-prudential perspective to ensure that policy-makers have the necessary flexibility to act. And in line with our mandate for macro-prudential oversight in the EU, when appropriate, we will make suggestions to this Parliament, and the other EU legislators, to strengthen the macro-prudential aspects of draft EU regulations.

ESRB’s ongoing work on structural, medium-term issues

Let me now finally say a few words about the ESRB’s ongoing work on more structural, medium-term issues. Against a backdrop of concern about developments in exchange-traded products and high-frequency trading, the ESRB has responded with macro-prudential perspectives to two public consultations initiated by the European Securities and Markets Authority (ESMA) in these areas.

First, on UCITS exchange-traded funds and structured UCITS, the ESRB response – available on the ESRB’s website – is focused on ensuring that lessons from the past on financial innovation are taken on board in a pre-emptive way. Our experience, for example, with complex, asset-backed securities in the run-up to the current crisis has shown that the risks in complex products may be poorly understood; and not just by retailers, but also by institutional and other investors.

Given the opacity and complexity of some of the current UCITS structured products – for example synthetic ETFs – the ESRB suggests looking into the possibility of withdrawing the UCITS label from such structures, as this would help to keep UCITS products simple. And it would also help to protect and maintain trust in the UCITS label should complex products give rise to problems in the future.

Second, on high-frequency trading, the ESRB’s response – also available on our website – acknowledges that financial innovation and technological advances have contributed to the ability of financial markets to provide adequate financial services to the real economy. Nonetheless, experience has also shown that unrestrained financial innovation contains often the threat of systemic risk and that therefore technological significant changes need to be fully understood and monitored carefully.

This calls for further investigation into the potential detrimental impact of high-frequency trading on liquidity and the possible amplifying impact on market shocks. The ESRB suggests possible measures to promote the monitoring and surveillance of algorithmic and high-frequency trading and also proposes further measures of a more pro-active nature – for example, crisis management tools and structural measures – that merit further study.

Let me now conclude this overview of work conducted by the ESRB in the first few months of its existence. I am proud to have had the honour of being the first Chair of the ESRB together with Mervyn King and Andrea Enria – a body which I know is also close to your hearts. I would like to wish the ESRB and my successor, Mario Draghi, all the very best and continuing fruitful interaction with this Committee.

Thank you for your attention.



[1]I will begin by outlining the current situation and the ESRB’s call for immediate action. I will then move on to the ESRB’s first recommendations, which are being made public as I speak.

[2]I will also touch upon certain macro-prudential implications of current legislative proposals on which this Parliament is working as co-legislator. And I will then conclude with a few words about the Board’s ongoing work on more structural, medium-term issues.