“The ECB cannot and should not turn a blind eye to risks to financial stability.”
“Maintaining financial stability is about two things: First, it is about preventing the build-up of bubbles; second, it is about making the system more resilient,” said ECB Executive Board Member and Vice-Chair of the ECB’s Supervisory Board, Sabine Lautenschläger, today in a speech. It’s not often that central bankers are allowed to use the B-word in public, except when denying that bubbles exist, or when denying that they can be identified if they do exist.
“Prices of several asset classes are influenced by the central bank’s policies,” she said. And these policies of the ECB include:
- A negative interest rate policy (NIRP), with the ECB’s deposit rate a negative -0.4%;
- An asset purchase program (QE) where the ECB buys government bonds, corporate bonds, asset backed securities, and covered bonds.
These policies have driven yields of many government bonds and some corporate bonds into the negative. The ECB’s balance sheet has swollen with assets. Borrowing for some companies has become essentially free. Asset prices have surged, including the prices of homes, stocks, bonds, commercial real estate, etc.
Even at the riskiest end, junk bond yields dropped to a ludicrously low 2.1% by October 30 last year (ICE BofAML Euro High Yield Index Effective Yield). When bond yields fall, bond prices rise; hence the concern about a bubble. These policies have triggered the most dizzyingly absurd corporate bond bubble ever.
But this bubble is losing some of its hot air. The average junk-bond yield has since surged to 3.7% now – which is still ludicrously low and has a long way to go before it’s properly deflated.
“So there are some risks,” she said:
- “There are risks that bubbles might be building up”
- “There are risks that assets might be mispriced”
- “Market participants might become too lenient when assessing the real value of assets”
- Market participants “might overly rely on readily available liquidity and become too lazy to prepare for different, less convenient times.”
And these “risks” – or rather already blooming conditions – have been the result of the ECB’s monetary policy. “So, this is a case where monetary policy might affect financial stability,” she said.
“Financial stability” doesn’t just concern the banking sector, she said, but also the “shadow banking sector,” which comprised all assets not held by banks, insurance companies, or central counter parties. This shadow banking sector is “big,” Lautenschläger said. “It accounts for 40% of the EU financial system.”
And “the ECB cannot and should not turn a blind eye to risks to financial stability.” Here are some keys points:
“Financial stability and price stability are functionally connected. They are linked in good times – and they are linked in bad times.”
“As we saw during the last crisis, financial instability can block the channels through which monetary policy influences prices. Thus, it can limit the ability of central banks to do their job. Without financial stability, it becomes quite hard to ensure price stability.”
“Financial stability, or rather the lack of it, can affect monetary policy.”
“Monetary policy can affect financial stability” [by creating the above-mentioned risks and bubbles].
She referenced the “extraordinarily accommodative monetary policy” and “unconventional tools” that the ECB has used. And while they did whatever they were supposed to do, there are “potential costs, too.”
- “The tools may have changed the incentives of banks, businesses and even governments.”
- “Low interest rates and abundant liquidity may encourage investors to take excessive risks.”
- “Bond purchases by the central bank can reduce liquidity in the relevant markets or distort prices.”
- “The more bonds we buy, and the longer we go on buying, the greater the risk that prices will be distorted.”
Financial stability is hard to describe, Lautenschläger said, “but you know when you no longer see it.”
Our experts think of financial stability as a condition in which the financial system, including financial intermediaries, markets and market infrastructures, is capable of withstanding shocks and the unraveling of financial imbalances. Only a resilient financial system is able to support the real economy during a potential shock.
To identify risks to financial stability, the ECB is looking at “incoming data” and is “talking to those who shape” the markets. And “we analyze asset prices.”
The findings are reported in the ECB’s Financial Stability Review. The most recent edition pointed out four key risks, she said:
- “Market sentiment might suddenly change.” This could “force prices in asset markets to adjust and set off a downturn in the real economy.”
- Banks still face structural challenges. “If financial or economic conditions deteriorate before the structural challenges are addressed, banks may lose their ability to finance the economy.”
- “Public and private debt may not be sustainable. Households, firms, and governments are highly indebted in a number of countries.”
- “Liquidity in the non-bank sector,” which is “highly interconnected with the banking sector.” Non-banks are also “interconnected among themselves: their portfolios tend to be similar, making them more vulnerable.”
How can the ECB communicate these risks without throwing markets into a panic? This is “always a challenge,” she said.
We know that the words of a central bank can be powerful. They can affect markets in either direction. Such communication is a challenge we cannot shy away from as it can encourage market participants to behave more prudently.
And it might also improve market discipline: by sharing our views on relevant risks, we create greater transparency about vulnerabilities in the financial sector.
So she did – another top-level central banker of one of the big central banks communicating ever so gingerly that the era of free money is ending, and that this era has caused all kinds of problems, including bubbles, that now need to be dealt with.