European Central Bank Archives - The Industry Spread

Monetary policy decisions – European Central Board

July 26, 2019 by Reg Hub Leave a Comment Filed Under: Central Bank Annoucements, Central Bank News Tagged: ECB, European Central Bank, European Central Board, Eurosystem

At today’s meeting the Governing Council of the European Central Bank (ECB) decided that the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will remain unchanged at 0.00%, 0.25% and -0.40% respectively. The Governing Council expects the key ECB interest rates to remain at their present or lower levels at least through the first half of 2020, and in any case for as long as necessary to ensure the continued sustained convergence of inflation to its aim over the medium term.

The Governing Council intends to continue reinvesting, in full, the principal payments from maturing securities purchased under the asset purchase programme for an extended period of time past the date when it starts raising the key ECB interest rates, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.

The Governing Council also underlined the need for a highly accommodative stance of monetary policy for a prolonged period of time, as inflation rates, both realised and projected, have been persistently below levels that are in line with its aim. Accordingly, if the medium-term inflation outlook continues to fall short of its aim, the Governing Council is determined to act, in line with its commitment to symmetry in the inflation aim. It therefore stands ready to adjust all of its instruments, as appropriate, to ensure that inflation moves towards its aim in a sustained manner.

In this context, the Governing Council has tasked the relevant Eurosystem Committees with examining options, including ways to reinforce its forward guidance on policy rates, mitigating measures, such as the design of a tiered system for reserve remuneration, and options for the size and composition of potential new net asset purchases.

The President of the ECB will comment on the considerations underlying these decisions at a press conference starting at 14:30 CET today.

Private sector working group recommends legal action plan for transition from EONIA to €STR

July 24, 2019 by Reg Hub Leave a Comment Filed Under: Central Bank Annoucements, Central Bank News Tagged: ECB, EONIA, Euribor, European Central Bank

Working group proposes €STR plus a fixed spread of 8.5 basis points as the EONIA fallback rate
Working group recommends, whenever feasible and appropriate, no longer entering into new contracts referencing EONIA as from 2 October 2019
In existing contracts referencing EONIA and maturing after December 2021, market participants should replace EONIA as a primary rate as soon as possible or embed robust fallback clauses
For new contracts that still reference EONIA and mature after December 2021, or fall under the EU Benchmarks Regulation (BMR), robust fallback provisions should be included

Today, the private sector working group on euro risk-free rates has published a set of recommendations on the legal action plan for the transition from the euro overnight index average (EONIA) to the euro short-term rate (€STR).

Among other things, the working group recommends the €STR plus a fixed spread of 8.5 basis points as the EONIA fallback rate for all products and purposes. Market participants, whenever feasible and appropriate, should consider avoiding entering into new contracts referencing EONIA, in particular new contracts maturing after 31 December 2021 as EONIA will cease to exist after that date. For existing contracts referencing EONIA and maturing after December 2021, market participants should consider replacing EONIA as a primary rate as soon as possible or embed robust fallback clauses. In those cases where new contracts still reference EONIA and mature after December 2021, or fall within the scope of the EU Benchmarks Regulation (BMR), market participants should include robust fallback provisions.

Additionally, for the purpose of enhancing transparency, while not strictly necessary, new contracts signed before October 2019 should ideally include clarification that the EONIA methodology is expected to change as of 2 October 2019 and that references in contracts to EONIA shall be understood to be references to EONIA as changed, unless otherwise agreed by the parties. Following the public consultation on the legal action plan and the feedback received from the market, the working group is also providing two templates for EONIA discontinuation fallback language for new cash products; market participants may use the wording and tailor it to take into account the terms and conditions for each particular asset class and the legal requirements of each governing law and relevant European jurisdiction.

For media queries, please contact William Lelieveldt, tel.: +49 69 1344 7316.

Notes:

The working group on euro risk-free rates, for which the European Central Bank (ECB) provides the secretariat, is an industry-led group established in 2018 by the ECB, the Financial Services and Markets Authority, the European Securities and Markets Authority and the European Commission. Its main tasks are to identify and recommend alternative risk-free rates and transition paths. On 13 September 2018 the working group recommended the €STR as the new euro risk-free rate. The €STR reflects the wholesale euro unsecured overnight borrowing costs of euro area banks and will be produced by the ECB as of October 2019 at the latest. The working group will now focus on the adoption of the €STR and on further analysis of fallbacks for EURIBOR.

Benoît Cœuré: The rise of services and the transmission of monetary policy

July 22, 2019 by Reg Hub Leave a Comment Filed Under: Central Bank Annoucements, Central Bank News Tagged: CPI inflation, ECB, European Central Bank, Eurosystem, globalisation, HICP

One of the biggest mysteries currently facing central banks around the world is why inflation has failed to pick up more forcefully after years of extraordinary monetary stimulus.¹ This is one of the most fiercely debated topics in macroeconomics, with few definitive answers.

Many explanations have been put forward, including discussions on the appropriate measure of economic slack, the role of inflation expectations and the effects of globalisation and digitalisation.²

One aspect that has received much less attention in the public discussion, however, relates to the impact of the structural transformation of our economies on inflation dynamics and monetary policy transmission.

There are many dimensions to this transformation to which central banks should remain alert, including the impact of ageing and, looking forward, climate change.³ In my remarks this evening, I will focus on another dimension. Across advanced economies, secular forces have shifted economic activity, employment and consumption expenditure away from manufactured goods and towards services.

In my remarks this evening, I will argue that these secular forces are likely to have played, and continue to play, a non-negligible role in explaining the sluggish response of inflation to economic activity and monetary policy in recent years.

I will start by presenting some stylised facts that illustrate the extent of past changes in consumption and production patterns in the euro area, the United States and Japan. I will then explain how these changes, and the shift towards services, are likely to have affected monetary policy transmission on both sides of the Atlantic.

In short, prices in the services sector change much less frequently than in other sectors and are less sensitive to exchange rates. This means that it takes longer for inflation to respond to changes in monetary policy and economic activity than it did a few decades ago.

I will also suggest that the rise of the services sector in our economies has only affected the pace of the response of inflation to shocks, but not the overall effectiveness of monetary policy. In other words, the effects of monetary policy take longer to pass through the economy but they have not become less powerful.

Finally, I will argue that policies that can help raise productivity and competition in the services sector may contribute to reduce the lags with which monetary policy is transmitted to consumer prices.

The rise of the service economy

One of the most striking trends in advanced economies over the past few decades has been the growing importance of the services sector in aggregate economic activity.

Three stylised facts document this rise.⁴

First, from 1970 to 2010, the share of services in total gross value added increased by more than 20 percentage points in the euro area and by about 14 and 16 percentage points in the United States and Japan respectively. You can see this on my first slide.

Second, and unsurprisingly given that many services are labour intensive, there has been an even greater increase in the percentage of the workforce employed in the services sector. You can see this on my next slide. In 2010, the services sector accounted for three-quarters of the jobs in the euro area, while in 1970 this figure was about 45%. The situation in the United States is even more stark. In 2010, the services sector accounted for nearly 85% of jobs.

And, third, over the past 40 years we have seen a significant increase in the consumption of services by households.⁵ You can see this on my next slide. Services in the euro area today account for more than 50% of final consumption, compared with less than 40% in 1980. In the United States, households today spend nearly 70% of their consumption expenditure on services, and in Japan, this figure is 60%.

These developments have been studied widely in the literature.⁶ William Baumol’s famous “cost disease” channel, for example, predicted that lower productivity growth would raise the relative price of services compared with manufacturing, which in turn would affect the sectoral allocation of consumption and labour.⁷

You can see this clearly on my next slide. Across advanced economies, the output price of services relative to manufacturing goods has risen steadily as productivity gains in the manufacturing sector have outpaced productivity gains in the services sector. As a result, households in advanced economies are allocating less and less of their expenditure to goods, which are getting cheaper, and are instead spending more on services, whose relative prices increase with income over time.⁸

Work by David Autor and others, on the other hand, has documented how technological progress and globalisation have caused profound sectoral shifts in employment in the United States.⁹ Their research focused mainly on the flipside of the developments in the services sector – that is, on the stark decline in manufacturing employment.

You can see this on my next slide. Since the 1970s, the manufacturing sector’s share of total jobs in the United States and the euro area has practically halved. Today, only around 15% of workers in the euro area are employed in the manufacturing sector.¹⁰ In the United States, the figure is less than 10%. The research by David Autor and others has sensitised policymakers to the challenges that global trade and automation may bring in terms of inequality and social cohesion.¹¹

Services, inflation and the transmission of monetary policy

A question that has received much less attention in central banking circles, however, is whether and how the rise of the services sector has affected the transmission of monetary policy, and whether it has contributed to the stubbornly weak inflationary pressures that we are observing today.

There are at least two broad and complementary channels through which this may happen.

The first channel relates to a composition effect – that is, to the changing weight of services in the consumption basket. As final consumption expenditures shift, so do the weights used to calculate inflation. You can see this on my next slide. The weight of services in euro area core inflation has increased by around 10 percentage points since the launch of the single currency in 1999.¹² In the United States, services today account for three-quarters of the core CPI basket.

If prices in the services sector differ in terms of level, volatility and persistence compared with other sectors, this can be expected to affect aggregate inflation dynamics.

The second channel relates to a transmission effect – that is, differences in how the economy reacts to monetary impulses from the central bank. If services and manufacturing differ with respect to their nominal and real rigidities, or feature different interest and exchange rate sensitivities, then monetary policy will be transmitted differently through the economy. To put it simply, the investment-saving (IS) curve may have a different slope depending on the weight of services in the economy.

In what follows I will argue that both the composition and transmission effects could help us improve our understanding of recent inflation dynamics across advanced economies.

The composition effect

Idiosyncratic shocks in the services sector account for a larger share of aggregate fluctuations today than they did in the past. Today, an arbitrary increase in service price inflation raises euro area core inflation by nearly 25% more than it did in the mid-1990s. On my next slide you can see that, all else being equal, euro area core inflation would have been around 15 basis points lower in 2018 were it not for the increase in the weight of services in the euro area HICP.

So, consistent with Baumol’s cost disease effect, the shift towards services, whose relative prices increase over time, has tended to lift the level of core inflation.¹³ This is also consistent with the limited support often found in the literature for global factors in driving domestic underlying inflation, and with evidence of a declining pass-through of exchange rate changes to final consumer prices since the 1970s and 80s.¹⁴

Put differently, those products that are most exposed to international competition, that are imported or that have a large import content have gradually become less significant drivers of aggregate inflation outcomes over time. For example, the import content of non-energy industrial goods is close to 20% in the euro area HICP, compared with just 8% for services. I will come back to this in a minute.

The transmission effect

Even more relevant for policymakers, however, is the effect of structural transformation on the persistence of inflation. This can be best illustrated when considering the impact of the second channel I mentioned before, namely the way monetary policy propagates through the economy.

To measure the effects of services deepening on the economy, Eurosystem staff have used a structural model of the euro area to compare how the changes in the structure of the euro area economy between 1970 and 2010 have affected the response of inflation and output to an easing of monetary policy.¹⁵

On my next slide you can see the results. Three observations stand out.

First, today the (simulated) immediate reaction of inflation to an easing of monetary policy is roughly 20% smaller than it was in 1970.¹⁶ You can see this by the blue dashed line being well below the red line for the first year or so.

Second, over a longer horizon, monetary policy affects inflation outcomes more strongly than previously, meaning its effects are distributed more evenly over time.

Third, the real effects of monetary policy – that is, its effects on employment and growth – have changed much less over the past few decades and are, at the margin, even slightly stronger today. You can see this on the right-hand side.

Let me now try to make sense of these three observations.

Services and price rigidities

The key insight for understanding these three effects is the different behaviour of price-setters across economic sectors. In particular, there is a large and growing body of evidence that shows that prices in the services sector are considerably “stickier” than in all other sectors in the economy – that is, they adjust less frequently.¹⁷

Take the micro evidence presented by the Eurosystem’s Inflation Persistence Network. In the euro area, 5.6% of prices in the services sector change each month, compared with 9.2% for non-energy industrial goods and 28% for unprocessed food.¹⁸

Housing services, meanwhile, which account for a quarter of the services weight in the euro area HICP, are among the most rigid prices in the economy. Apartment rents in Germany, for example, remain unchanged for more than four years, on average.¹⁹ Ranking industries by frequency of price changes produces remarkably consistent results across economies, both within and outside the euro area.²⁰

Estimates of sectoral Phillips curves corroborate these findings. For France, for example, estimates show that the frequency of price changes across sectors ranges from a single quarter to almost two years. In virtually all service industries, the frequency of price changes is towards the upper end of this range.²¹

There are at least two factors that may help explain why services prices may react more sluggishly to changes in firms’ external conditions. One is that wages account for around 40% of input costs in services, compared with 20% in the manufacturing sector.²²

Just think of education, health, childcare, restaurants and so forth. Wage rigidity implies that the costs of producing most services are relatively stable over time, resulting in less need for price adjustments.

Another factor relates to competition. Evidence shows that markups in the services sector are higher, on average, than in the manufacturing sector, partly reflecting reduced exposure to foreign competition.²³ Although the share of services in total global trade has increased somewhat since 1970, they still only account for around a fifth of total global exports today.²⁴ Lower competition may allow services firms to adjust their prices less frequently.

The implication is that the rise of the services sector has measurably lowered the median frequency of price changes in the economy and, therefore, the response of inflation to changes in demand and monetary policy in the short term, as you can see on the left-hand side of my slide.

But in the medium term, as more and more firms readjust their prices as economic conditions improve, inflation will respond more forcefully. The model predicts that, after around two and a half years, the cumulative effects of monetary policy on inflation are higher today than in 1970. To sum up, services deepening implies that monetary policy takes more time to be transmitted to inflation, but its effectiveness has not diminished.

This is also true for the impact of monetary policy on growth and employment, as you can see on the right-hand side. In a nutshell, there are two opposing forces at work. On the one side, services are, on average, less interest-rate sensitive – that is, the IS curve is flatter, which in principle makes a service-based economy less responsive to monetary policy.

But because prices are now more rigid on the whole, more of the adjustment in the economy needs to happen through changes in quantities rather than prices. Rigid prices are the reason why monetary policy has real effects in the first place. This latter effect may more than offset the reduced interest rate sensitivity, leading to the picture you can see on the right-hand side.²⁵

The rise of services as a production input

And yet, one may correctly argue that, even when taking into account the transmission effect, underlying inflation in the euro area today remains too low, given how much time has elapsed since we launched our monetary stimulus. Low inflation appears even more of a puzzle when considering the composition effect, which should cause inflation to rise over time, all else being equal.

Of course, a number of factors may currently be at play, many of which we do not yet understand properly, such as firms’ state-contingent pricing decisions.²⁶ Structural transformation is also still ongoing. Consider Spain. The services sector’s share of total employment has increased by more than 8 percentage points, to 78% since the start of 2008 alone. The unwinding of imbalances is often the catalyst for large reallocations of economic activity across sectors, which may further delay the pass-through of policy changes.

But I would argue that part of the puzzle may also relate to structural changes within the services sector, which is itself subject to transformation. I would like to highlight two of these changes.

First, all services are not made equal. Recent research shows that some services industries, mostly those that can be delivered at distance, such as telecommunications and finance, are among the most productive and thriving industries in the economy.²⁷ As a result, a portion of services have been found to feature a falling relative price as income rises, much like manufacturing industries.²⁸

Indeed, on my next slide you can see that the difference between price inflation for services and non-energy goods has been steadily trending downwards over time, reducing overall inflationary pressures in the economy. In other words, the pace with which the relative price of services is increasing over time – Baumol’s cost disease channel – has gradually started to decelerate, at least in the euro area.²⁹

The second structural change relates to the input-output structure of our economies. Services not only account for a much larger share of consumption and employment, they also make up a growing share of intermediate inputs used in the production of both services and manufacturing – a development that some have coined “servicification”.³⁰

You can see this on my next slide for the case of the United States, where reliable long time series data are available. For the manufacturing sector, the proportion of total inputs accounted for by services increased from around 28% in 1970 to 32% in 2010. For the services sector, the increase is even more striking. Intermediate services increased their share of total inputs by 14 percentage points, to 87%, over the same period.

The implication is that sticker services prices spread much more widely through the economy via their effect on firms’ marginal costs.³¹ On my next slide you can see the impact on the transmission of monetary policy. Eurosystem staff have calibrated the same model I mentioned before, but this time for the US economy, also taking into account the change in the input-output structure.

Clearly, the “servicification” of the US economy has contributed to further dampening the impact of monetary policy impulses on inflation in the short term, meaning it takes even longer to see the full effects of monetary easing. Data on input-output structures for the euro area suggest that the effect is likely to be of a similar magnitude on this side of the Atlantic.³²

Again, current inflation outcomes are likely driven by a host of factors. But, all else being equal, it is now easy to see that the increase in wages that we have observed over the past year or so can be expected to take longer to pass through to final consumer prices than it did in the past.

Conclusion

I will leave you with three key takeaways tonight.

The first is that the rise of services in production and consumption over the past few decades has contributed to lift core inflation across advanced economies – making current low inflation appear even more puzzling.

The second key takeaway is that services deepening has had a profound impact on the transmission of monetary policy, also in the euro area. It has lowered the median frequency of price changes in the economy, increasing the lag with which monetary policy is transmitted to consumer price inflation.

The third and final takeaway is that the service sector itself is subject to change. The rise and expansion of “modern” services that can be delivered at distance means that competition and aggregate productivity may increase over time, thereby contributing to reducing price rigidity. Completing the single market for services in Europe, and reducing barriers to trade for services, would support this process and thereby also facilitate a faster transmission of monetary policy.³³

Thank you.

Benoît Cœuré: Exchange of views with members of the High Council of Public Finance

July 22, 2019 by Reg Hub Leave a Comment Filed Under: Central Bank Annoucements, Central Bank News Tagged: ECB, EDIS, EMU, European Central Bank, Eurosystem, HICP, TLTRO-III

Thank you for inviting me to the High Council of Public Finance. It is a pleasure to engage in an informal exchange of views with you on the monetary policy of the European Central Bank (ECB) and more broadly on Economic and Monetary Union (EMU), with a specific focus on issues of relevance to fiscal policy.

Allow me to start by briefly discussing the economic situation of the euro area.

The euro area economic outlook

The euro area economy grew by 0.4%, quarter on quarter, in the first quarter of 2019, following an increase of 0.2% in the fourth quarter of 2018. However, incoming economic data and survey information point to somewhat weaker growth in the second and third quarters of this year. This reflects the ongoing weakness in international trade in an environment of prolonged global uncertainties, which are weighing in particular on the manufacturing sector.

Looking ahead, the euro area expansion will continue to be supported by favourable financing conditions, the mildly expansionary euro area fiscal stance, further employment gains and rising wages, and the ongoing – albeit somewhat slower – growth in global activity. This assessment is broadly reflected in the June 2019 Eurosystem staff macroeconomic projections for the euro area, which foresee annual real GDP increasing by 1.2% in 2019, 1.4% in 2020 and 1.4% in 2021.

The risks surrounding the euro area growth outlook continue to be tilted to the downside, on account of the prolonged presence of uncertainties related to geopolitical factors, the rising threat of protectionism and vulnerabilities in emerging markets.

According to Eurostat’s flash estimate, euro area annual HICP inflation was 1.2% in June 2019, unchanged from May 2019. Based on current futures prices for oil, annual HICP inflation is likely to decline over the coming months. Adjusting for the temporary factors behind the recent volatility, measures of underlying inflation remain generally muted.

Looking further ahead, underlying inflation is expected to increase over the medium term, supported by our monetary policy measures, the ongoing economic expansion and stronger wage growth. This assessment is broadly reflected in the June 2019 Eurosystem staff macroeconomic projections for the euro area, which foresee annual HICP inflation at 1.3% in 2019, 1.4% in 2020 and 1.6% in 2021.

The ECB’s monetary policy and its impact on the euro area economy

The benefits of our monetary policy measures have been sizeable and tangible. Lending rates for euro area firms and households are at historic lows and have converged across the euro area, while growth in bank lending volumes has recovered significantly since the beginning of 2014, thereby supporting investment and job creation.

There are now 10.8 million more people in employment in the euro area than there were in the second quarter of 2013, when the number of people in work fell to its lowest point during the crisis.

However, against the backdrop of a decline in the pace of the euro area expansion and the prolonged presence of uncertainties, the ECB’s Governing Council in June took a number of policy decisions to ensure that inflation remains on a sustained path towards levels that are consistent with our inflation aim – a rate of inflation which is below, but close to, 2% over the medium term.

First, we updated our forward guidance on the key ECB interest rates and now expect them to remain at their present levels at least through the first half of 2020, and in any case for as long as necessary to ensure the continued sustained convergence of inflation consistent with our inflation aim.

Second, the Governing Council reaffirmed its intention to continue reinvesting, in full, the principal payments from maturing securities purchased under the asset purchase programme. This will continue for an extended period of time past the date when we start raising the key ECB interest rates, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.

Third, we decided on the modalities of the new series of quarterly targeted longer-term refinancing operations (TLTRO III) that was announced after our March meeting. We decided that the interest rate will be set at a level that is 10 basis points above the average rate on our main refinancing operations, but for banks whose eligible net lending exceeds a benchmark, the rate applied can be as low as the average deposit facility rate plus 10 basis points. This new series of TLTROs will help preserve favourable bank lending conditions and the smooth transmission of monetary policy.

Looking ahead, the Governing Council is determined to act in case of adverse contingencies and also stands ready to adjust all of its instruments, as appropriate, to ensure that inflation continues to move towards the Governing Council’s inflation aim in a sustained manner.

Completing Economic and Monetary Union

To reap the full benefits from our monetary policy measures, other policy areas must contribute decisively to raising the longer-term growth potential of the euro area and reducing its vulnerabilities.

Sound fiscal and economic policies at the national level are the first line of defence to make the euro area stronger. Economic reform needs to be substantially stepped up in euro area countries to increase resilience, reduce unemployment in a lasting way and boost productivity.

On the fiscal side, Member States often fail to make sufficient use of economic upswings to build fiscal buffers. This leaves those with fragile fiscal positions ill-prepared to face economic downturns.

At the current juncture we expect the aggregate euro area fiscal stance to be mildly expansionary in 2019, which provides welcome support to economic activity at a time when growth has decelerated. However, the aggregate picture masks the suboptimal differentiation across countries. In particular, countries with high levels of debt are, with few exceptions, not building fiscal buffers, thereby risking a repeat of the mistakes of the pre-crisis period. Countries with fiscal space could use some of it to strengthen public investment and increase their growth potential.

The European Fiscal Board has recently issued a report¹ recommending a broadly neutral euro area fiscal stance for 2020, based on the expectation of a gradual pick-up in economic activity as of the second half of 2019. This is also our baseline scenario, but we are aware that it is surrounded by a multitude of downside risks. If those risks were to materialise, additional fiscal support may be needed. To be clear, such support should come from countries that have fiscal space. But while not all countries have the space to spend more, all have the opportunity to spend better.

The euro’s benefits, however, will not fully materialise for as long as the architecture of EMU remains incomplete.

Material progress has been achieved in recent years. The European Stability Mechanism provides an important safeguard and reforms currently under discussion will strengthen its precautionary and crisis resolution toolkit.

Banks directly supervised by the ECB have built up strong capital positions in recent years, with a Common Equity Tier 1 (CET1) ratio of 14.3% in the first quarter of 2019 compared with 11.3% at the end of 2014. They have also substantially reduced their non-performing loan ratio, which stood at 3.7% in the first quarter of 2019 compared to 7.5% in the second quarter of 2015. These are important steps forward as euro area firms rely heavily on bank credit to finance growth and investment.

So what more should be done at the European level?

First, the ability of the financial sector to contribute to economic stabilisation should be strengthened. During the crisis, financial integration in the euro area reversed and it has only gradually recovered over the past few years.

The creditworthiness of banks remains linked to that of national governments. Unlike in the United States, cross-border investment is not a significant buffer against economic shocks. The euro area still lacks genuinely integrated capital markets, which hinders the efficient allocation of European savings, private cross-border risk-sharing to smoothen consumption during idiosyncratic shocks and the use of the euro as an international currency.

Recent legislative steps are commendable but do not measure up to the initial ambition of the capital markets union project. Brexit will further accentuate the need to develop and integrate the EU’s capital markets. A large number of banks and investment firms are in the process of establishing or expanding their euro area presence, possibly resulting in the development of a multi-centric European financial system.

While the landscape may evolve further in the future, in a financial system with a number of increasingly important hubs, as opposed to one dominant hub in London, it will be more important than ever for these hubs to be able to efficiently interact with one another and to avoid differences across Member States providing opportunities for regulatory arbitrage.

Second, the banking union needs to be completed. In particular, a fully fledged European deposit insurance scheme (EDIS) is a key missing element. In this context, the ECB has proposed that EDIS could be accompanied by risk-based contributions by banks linked to their sovereign holdings.

Third, further efforts are needed to deepen fiscal union in the euro area.

European fiscal rules are complex, opaque and plagued with exceptions and exemptions which have accumulated over time. They rely excessively on measures of cyclical positions which are controversial and prone to manipulation². Simpler and more credible and effective rules are needed to ensure that euro area countries safeguard fiscal sustainability and build the necessary buffers to create room for countercyclical stabilisation in economic downturns. Recent proposals to focus the fiscal framework on a debt anchor complemented by an expenditure rule deserve further consideration.³

EMU also needs a central fiscal stabilisation mechanism to enhance countercyclical stabilisation during severe recessions. Past experience shows that the aggregate fiscal stance in the euro area is often suboptimal. During the European debt crisis, for example, it was strongly contractionary, thereby reducing the effectiveness of an expansionary monetary policy stance.

While the euro area budgetary instrument currently under discussion is a welcome step to support convergence, it is not designed to fulfil this stabilisation function. Work on the fiscal architecture of EMU therefore needs to continue to ensure that fiscal policies can play an effective stabilisation role.

Conclusion

Let me conclude.

The euro, which celebrates its 20th anniversary this year, enjoys broad support among European citizens, with three in four people in the euro area in favour of it. Its growing popularity is testimony to the fact that people have trust in the currency and in the ECB’s strong commitment to price stability, which supports investment and job creation.

To preserve this trust, we need to step up our efforts at both national and euro area level to strengthen the architecture of the single currency. Much has been achieved but some of the failings that caused and perpetuated the crisis remain unresolved.

At a time of heightened global uncertainty, completing the euro area’s architecture is also necessary for Europe to be able to achieve its other objectives. Europeans won’t be able to foster cooperation on security and defence, or to speak with one voice on international affairs, or to complete the Single Market if they repeatedly have to tackle economic crises which are largely of their own making. A sound and sustainable euro area will help redirect political capital where it is most needed.

Thank you.

UAB General Financing granted a specialised bank licence

June 27, 2019 by Reg Hub Leave a Comment Filed Under: Central Bank Annoucements, Central Bank News Tagged: Bank of Lithuania, European Central Bank, UAB

Following the assessment and proposal of the Bank of Lithuania, UAB General Financing has been granted a specialised bank licence by the European Central Bank. This is the fourth company to receive a specialised bank licence.

Having secured a specialised bank licence, the company intends to offer banking services: it will accept resident deposits, provide consumer credits and leasing services.

UAB General Financing, established in 2005, is a part of Esco Marginalen AB, a group of companies established in Sweden. The group provides various financial services in Sweden, Estonia, Latvia and Lithuania. Until now, in Lithuania, UAB General Financing has been providing consumer credit and leasing services.

Specialised bank licences were previously granted to the country’s largest credit union Mano unija, which established AB Mano bankas, Revolut Technologies UAB, a global FinTech company providing payment and other services, and European Merchant Bank UAB. Together with the European Central Bank, the Bank of Lithuania is currently assessing four more applications: three of them – for a specialised bank licence, one – for a bank licence.

The main difference between a specialised and a full-range bank is that the former is not authorised to provide investment services. The opportunity to establish a specialised bank was introduced in 2017. The authorisation process lasts for roughly a year.

V. Vasiliauskas: Central bank transparency bolsters market and public confidence

May 24, 2019 by Reg Hub Leave a Comment Filed Under: Central Bank Annoucements, Central Bank News Tagged: Bank of Lithuania, European Central Bank

Open communication with market participants and the general public enhances the transmission of central bank policies and boosts their credibility, says Vitas Vasiliauskas, Chairman of the Board of the Bank of Lithuania, who is currently on an official visit to Kiev (Ukraine).

“Until just a decade ago, central banks were rather secretive institutions, however now transparency is one of their key operating principles. The need for greater openness was prompted by the general understanding that accountability builds public confidence in central banks and their decisions, which bear significant importance for economic growth on a domestic, regional and international level,” said Mr Vasiliauskas. He also stressed that public confidence is one of the key factors ensuring central bank independence, which, in turn, enhances their credibility.

The Chairman of the Board of the Bank of Lithuania has been invited to speak on a panel at “Central Bank Communications: From Mystery to Transparency“, an annual conference organised by the National Bank of Ukraine and the National Bank of Poland. During his visit, he will meet with Jakiv Smolii, Governor of the National Bank of Ukraine, to discuss monetary policy, economic and other relevant issues. Mr Vasiliauskas will also give a presentation on recent developments in central bank communication at the National University of Kyiv-Mohyla Academy.

National University of Kyiv-Mohyla Academy.

As also noted by the European Central Bank, in recent years central bank communication has become one of the key monetary policy instruments that helps steer market expectations and influence market participants’ behaviour, for instance, investment decisions with regard to different asset classes. Central bank communication has gained more prominence in the low interest rate environment, which has prevailed since the 2008‑09 global financial crisis.

Central bank independence calls for their transparency and accountability. Comprehensive explanation of policy decisions through more intensive communication reaches a wider audience, which helps increase awareness of central bank activities and strengthen.

Luis de Guindos: Deepening EMU and the implications for the international role of the euro

May 20, 2019 by Reg Hub Leave a Comment Filed Under: Central Bank Annoucements, Central Bank News Tagged: ECB, European Central Bank, European Central Board

It is a great pleasure to be speaking today at the joint European Commission and ECB conference on financial integration in Europe.

The choice of the international role of the euro as the guiding theme represents a change in focus in the discussions on Economic and Monetary Union (EMU) reforms, from a post-crisis response to a broader agenda.

At the same time, Europe is facing new challenges, not least a return to fragmentation at the global level and the United Kingdom’s departure from the EU, amid heightened political uncertainty.

In this context, I would like to give an overview of where we are in terms of European financial integration and draw lessons for the concrete policy actions that would promote integration.

Where do we stand on financial integration in Europe?

At the ECB, we analyse two dimensions of financial integration: price convergence across the euro area and quantity-based integration via cross-border activities.¹

The great financial crisis caused fragmentation along both of these dimensions. Since then, we have made great progress thanks to measures to reform EMU and the announcement of our Outright Monetary Transactions. These actions, together with a wide range of policy measures taken in the years that followed, put us back on the path towards greater integration.

However, this process has stalled somewhat in the last two years.

On the capital markets side, most of the recent positive developments in terms of financial integration have been driven by an overall reduction in price dispersion, rather than an improvement in holdings of non-domestic assets, or cross-border holdings.

Going beyond the aggregate figures, however, we see that the investment fund sector makes a positive contribution to integration by allowing investors to spread and diversify their asset holdings across countries. In 2017, investment funds held roughly 78% of all their holdings in bonds issued outside their own domicile.² This is important because more cross-border holdings are needed to support consumption smoothing in the face of shocks and to enhance cross-border risk-sharing.

In banking markets the picture is also mixed. In general, we have seen a reduction in the cross-country dispersion of banks’ funding costs and lending rates, pointing to some price-based integration.

In terms of quantity, however, integration is still fairly low as cross-border interbank lending remains stagnant and cross-border retail lending continues to be very limited.

More cross-border lending would be welcome as it could better insulate the domestic banking sectors from regional shocks, thus helping to sustain consumption or investment levels in the face of adverse shocks.

These findings have implications for the EU’s policy agenda.

First, cross-border financial integration still falls short of the potential for cross-border private risk-sharing we would like to see in the euro area. While the United States is an ambitious benchmark in this respect, it is interesting to note that 40% of shocks to GDP growth can be mitigated through diversification via capital markets in the United States. This compares with only 20% of shocks to GDP growth that can be smoothed in the euro area.³

The capital markets union (CMU) agenda therefore needs to be pursued with renewed vigour to foster a deeper integration and development of markets.

Second, the banking union is still not a reality even though two of its three pillars have been put in place. Euro area-based banks have substantially reduced their cross-border claims since the crisis, and about 60% of banks’ total exposures are to their home countries.⁴

This is worrying at a time when the political momentum behind completing the banking union is fading. Importantly, this may lead banks to refocus their activities on their domestic markets as they anticipate that the banking union will remain incomplete, resulting in further fragmentation.

Euro sign in ECB

Renewed risks of fragmentation increase the need for European integration

Pursuing reforms through European projects is even more important in view of a possible return to fragmentation at different levels.

At the global level, a lack of commitment to fully implement internationally agreed standards may hinder international activity. Europe should be taking a leading role here and promoting an integrated and level playing field within its own borders and beyond by implementing the agreed reforms and maintaining a high-quality regulatory framework. This will provide confidence in the health and resilience of our markets and buttress Europe’s credibility as a rule-maker.

From a global perspective, European capital markets are currently too small and too fragmented. The CMU agenda should therefore be geared towards creating the ecosystem needed to develop more vibrant European financial markets and intermediaries that are able to compete internationally. This means both promoting policies that help markets to increase their size and scope, and doing away with the barriers to the cross-border functioning of markets implied by differences in national policy concerning insolvency, taxation and other areas. Promoting a single rulebook in a wide range of areas, including consumer protection, anti-money laundering and accounting rules, is also key to the success of CMU. Regulatory consistency in a broad sense and a level playing field, as opposed to leniency, are crucial to render EU markets attractive.

At the European level, Brexit is an additional challenge which may lead to fragmentation as services could be provided in a more decentralised way. At the same time, EU27 capital markets are still subject to national rules and supervision, making for a patchwork of regimes which prevent the integration of markets and may open the door to regulatory arbitrage. As a response to Brexit, we need to develop truly European capital markets, and this makes progress on the CMU front even more urgent.

As the United Kingdom leaves the EU’s regulatory and supervisory framework and develops a new one of its own, a different relationship between the two jurisdictions will need to be defined. It will need to balance the benefits of continued integration with the UK financial markets with the potential risks to financial stability, consumer and investor protection, and the integrity of the Single Market. This path will not be easy for either side as the lure of the flexible and light-touch regulation of the past can be strong, bringing with it the risk of divergence between EU and UK rules or a potential race to the bottom. And these considerations will also play out as we review the role of equivalence regimes in EU financial legislation.

European responses are the way forward

Turning to policy responses, the way forward is clear: we need to move away from national responses and promote European ones within the CMU and banking union agendas. Let me briefly emphasise five priority areas.

First, we need to complete the banking union’s institutional architecture. In particular, we should ensure that the backstop to the Single Resolution Fund is fully operational, agree on a banking union solution to liquidity needs in resolution and define a clear path towards a European deposit insurance scheme (EDIS). A fully fledged EDIS would facilitate cross-border banking since depositor protection would be independent of a bank’s location, and ensure that an increase in cross-border activity does not reduce the overall resilience of the system. This would provide the institutional framework for the cross-border risk-sharing that Europe needs.

Second, to facilitate cross-border activity and the emergence of pan-European entities, we need to put an end to national ring-fencing. Within the banking union, supervisors should be able to grant cross-border waivers for capital, liquidity and large exposures, provided that prudential safeguards are in place. This would lead to more efficient resource allocation and support the emergence of resilient cross-border banks able to provide credit across borders and to offer investors access to diversified products.⁵ It would also foster cross-border bank penetration, which would support the credit channel of private risk-sharing. Within CMU, a more level playing field would also enhance the capital market channel of risk-sharing.

Third, we need to mobilise the large existing pool of savings in Europe so it can be put to productive uses. Today, households keep 35% of their financial wealth in cash and deposits, around a third in insurance and pension funds, and the rest in shares, funds and bonds. Differences in saving behaviours – through banks or through pension funds – suggest that there is potential for savings to be allocated more efficiently within the banking union and for retail investors to participate more actively in capital markets. Fostering equity investment by addressing the debt-equity bias and improving financial literacy, for instance, would support the development of an equity culture in Europe, which would, in turn, help to finance innovation, growth⁶ and risk-sharing⁷, while also increasing the return on savings for households.

Fourth, we need to continuously review the financial regulatory and supervisory framework to ensure that authorities can monitor and address potential financial stability risks. European firms are relying more heavily on corporate bonds for their financing than they did in the past, and both households and various financial intermediaries are increasingly holding corporate bonds via investment funds. This changing environment might entail new sources of risk as well as different transmission channels of financial instability. Robust prudential standards in the non-bank financial sector therefore need to be upheld, and changes to the financial structure need to be reflected in the supervisory framework to avoid risks developing beyond the watch of supervisors. The macroprudential toolkit will also need to be extended to the non-bank financial sector so that the authorities have the means to address risks at the system level.⁸

Last but not least, we should not shy away from having an open discussion on the need for a European safe asset. If well designed, such a European asset could become the benchmark for investors in EU capital markets, reduce the incentives for capital flight on national bonds within the euro area and contribute to lowering risks on banks’ balance sheets.

Deeper financial integration will strengthen EMU and ultimately enhance the international role of the euro

More developed and integrated banking and capital markets play a complementary role in financing the real economy by providing different sources of financing adapted to various funding needs and stages of firm development. They also help to match borrowers and investors in an efficient way.

Efficient capital and banking markets also contribute to fostering cross-border private risk-sharing via the credit and capital channels, which reduces the need for public risk-sharing and enhances the resilience of EMU.

We therefore need to promote a European approach to financial integration so that we can complete both the banking union and the capital markets union. Achieving developed, integrated EU markets that are open and attractive to international investors would ultimately reinforce the role of the euro on the international stage.⁹

Olli Rehn: Living with populism – reflections on the economy and democracy in Europe

May 16, 2019 by Reg Hub Leave a Comment Filed Under: Central Bank Annoucements, Central Bank News Tagged: Central Bank of Malta, European Central Bank, Eurozone, olli rehn

Accompanying slides of the speech.

Ladies and Gentlemen, Dear Friends,

Let me first wish you a very good Schuman Day – or Europe Day. It is a great pleasure and honour to meet and talk with you today.

It is indeed appropriate that precisely on the Schuman Day 2019 we discuss one of the major political developments in Europe of our time, the rise of political populism. All over Europe we are currently living with populism, which calls for broader reflections on the economy and democracy, and I will discuss these matters today in my talk.

These issues are also of paramount importance for central banking. That’s why I want to warmly thank the Central Bank of Malta for organising this conference and Governor Mario Vella for taking the initiative to create an interdisciplinary European research network to look into the notion of populism in central bank communication. Populism has become a normal part of the democratic process in today’s Europe, and as democratically-minded people we have to recognise the role it plays.

Why does this matter for central banking? Because the central banks, including the ECB and euro area central banks, do not live in a vacuum, but are reflections of the society at large – independent reflections and actors, I should add. In this context, let me refer to Joseph Schumpeter, one of the greatest economists of all time, who wrote: “The condition of the monetary system of a nation is a symptom of all its conditions.”¹

olli rehn

SLIDE 2. Schumpeter’s Triangle

What Schumpeter said about a nation, goes today as well for Europe as a whole, for our Economic and Monetary Union. What happens to our money, is a reflection of the state of our union and its economy, of the society and the democracy. So we have to take a broad view.

1. Let me start by pondering the root causes of populism. Pinpointing a single underlying reason for this development is impossible. However, there seems to be broad agreement that a combination of increased economic insecurity, perceived threats to identity i.e. identity politics, and failures of the political decision-makers to address citizens’ concerns, all these have acted as a key trigger for populist surges in recent years.

Many countries have faced a host of challenges in the decade following the global financial crisis. The euro area was particularly hard hit following the sovereign debt crises in several member states. On top of all economic hardship, a refugee crisis exploded in Europe. Nowhere else were these impacts felt as strongly as here in the Southern Europe.

SLIDE 3. Economic recovery of the Eurozone from 2013 onwards

With the help of a strong policy response by member states and EU institutions, not least the European Central Bank, and by reforming the Eurozone economic governance and institutional set-up, Europe eventually managed to overcome the financial and economic crisis.

However, the institutional response has not yet been completed. More remains to be done to complete the job with the banking union, and the EU fiscal framework needs to be amended to better protect against the highs and lows of the economic cycle, and support economic reforms.

Apart from the economic and financial policies, it is particularly regrettable that the EU has been unable to decide on and implement sufficient measures to address the refugee crisis, which you know only too well here in Malta and more broadly in Southern Europe. This is a policy area where more consequential joint European efforts are critically needed.

2. Populism is a multidimensional phenomenon and difficult to define. There is no single definition of populism. That is probably because the roots of populist parties and their political agendas vary by country. Let’s look at some varieties of definitions of political populism.

SLIDE 4. Timo Soini’s Pro Gradu

On this, the views of the present Finnish foreign minister, Mr. Timo Soini, are particularly worth reading, as he has for long time combined both the theory and practice of populism: he wrote his master’s thesis on populism some 30 years ago², and was a party leader for the True Finns for over 20 years, before leaving the party in 2017 – so he very much practiced what he preached, and indeed preached what he had studied!

Soini wrote in his 1988 thesis that “populism is an ideology of the people, but it requires almost always a charismatic leader and a group of intellectuals to lead it.” He regards the nationalist ideology as the basis of populism and as the common denominator of all populist parties in Europe.

The distinguished historian of theworld economy, Professor Barry Eichengreen comes in fact very close to this definition, having written in his recent book The Populist Temptation as follows: “[populism] involves the reaction of voters against the political establishment, nationalist and racialist sentiment directed against foreigners and minorities, and a yearning for forceful, charismatic leadership”.

In line with Eichengreen and Soini, populism typically focuses on a handful of ideas with anti-elite, authoritarian, and usually nationalist tendencies in appealing to their base of supporters. Both rightly point out that populist movements have been part and parcel of the democratic political landscape for a long time, from the United States to Finland.

3. What about the relationship of populism to economic hardship? Does economic crisis breed populism? One can make an interesting observation that the recent rise of populism is widespread, and not just contained in the countries experiencing the biggest economic difficulties.

The country I know best, Finland, is a case in point. Finland was recently named – for what is worth, I don’t know how much – in the World Happiness Report the “happiest country in the world”, for the second year in a row. In this ranking, all Nordic countries have fared well over the years. I should add that, instead of happiness, we should in my view really speak about life satisfaction in this context. The Report’s results suggest that it is not just high national income, but supportive social systems and institutions that play a big role in creating ‘happy’ societies.

The good performance of Finland and its Scandinavian neighbours in these rankings is largely explained by the so-called Nordic model. This is a system that combines a market economy with highly inclusive social policies – strong safety nets, universal health care and free education.

SLIDE 5. Vote for populist parties over time in advanced democracies

The average share of vote for the populist parties in advanced democracies has substantially grown over the past decades, as seen from this slide: from below 5% in the 1980s to 10-15 % in this millennium, and it has been growing in recent years, as we know.

You may find it then a bit surprising that populist political forces have fared so well in Finland and the other Nordic countries. In the Nordic countries, support for populist parties has ranged between 15-20 percent in recent years. In Finland, the (True) Finns Party has scored between 17-19 percent of the vote in the last three national elections in 2011-19.

So why is it so that even the “happiest people in the world” are so prone to populist temptations? As mentioned, the combination of economic insecurity and threats to national identity appear to trigger populist surges. This is amplified if the political system fails to address citizens’ concerns.

In fact, the economic argument about populism seems to be as much about distribution as aggregate growth – a favourable macro-economic development may mask big differences across different groups.

The distributional impacts of a key driver of today’s changes – especially technological development, such phenomena as artificial intelligence, automatization, digitalisation, robotics – have been widely recognised for some time. Initially, technological development mainly crowded out low-skilled labour. But more recently, with the latest advances in artificial intelligence, it is many medium-skilled jobs that are being threatened, thus placing an even bigger premium on high-skilled jobs and education.

One very relevant and realistic recent book that relate to populism is by Torben Iversen and David Soskice called Democracy and Prosperity – Reinventing Capitalism through a Turbulent Century. They refute the crisis of democracy, and rather call the present state of affairs as a challenge for democracy. As comparative or international political economists, their point of departure is the ongoing economic transformation into a fully-fledged knowledge economy, which is very skill-intensive.

For them, the question is how the majority of the people – or voters – can feel that they have a place, stake and future for their children in the society. The key intervening variable is education. Not primarily as a civilizational project, but rather as a way of maintaining one’ position in the reasonable prosperous middle class, or at least keeping up the aspiration for one’s children. They underline the ‘aspirational vote’ of the middle class.

Iversen and Soskice also counter the argument that states are powerless in the face of international capitalism. For them, location matters, and it is the clusters of industries that drive the economy and the thriving cities that attract people. Again, education and training are critical to keep the people on board. And the democratically elected governments can decide on the policies for competitiveness and on the nature of the welfare state. As political economists Iversen and Soskice coin their argument as follows:

“We suggest that the essence of democracy is not redistribution or equality, as so commonly assumed, but the advancement of middle class interests, and we capture this idea as the “fundamental equality of democracy” (to distinguish it clearly from Piketty’s (2014) “fundamental inequality of capitalism”.³

Likewise, in two recent books, Paul Collier and Raghuram Rajan highlight the role played by the widening geographic divide and the loss of shared identity between the thriving metropolis and the declining provinces.⁴ This is related to technological development. In particular, the rapid evolution of the knowledge economy has significantly boosted specialisation to harness productivity gains. Thus, specialists need to work near other specialists with complementary skills to maximise their productivity – and cities provide an opportune environment for close connections.

For the firms eager to harness economies of scale, cities offer large pools of both workers and customers. As the economies of scale have become more important, many provincial towns find it hard to keep up with the competition. At the same time, increased global competition has led to the demise of traditional manufacturing industries in tcentral banks, including the ECB and euro area central banks, do not live in a vacuum, but are reflections of the society at large – independent reflections and actors, I should add. In this context, let me refer to Joseph Schumpeter, one of the greatest economists of all time, who wrote: “The condition of the monetary system of a nation is a symptom of all its conditionshe advanced economies, many of which have been situated in these provincial towns.

4. The geographic redistribution of growth is also associated with the diminished role of local communities and the decline in different forms of belonging to society. This case is particularly strongly made in Raghu Rajan’s recent book “The Third Pillar”: the three key pillars of society – the state, the market, and the community – need to be in balance for strong, sustainable and inclusive growth and development. If any of the pillars weakens too much relative to the others, the society suffers. According to Rajan, this is exactly what has happened to the community pillar due to the centrifugal pull of global markets and new technologies.

In the populist agenda, localism matters and any actual or perceived transfer of power to a more distant elite is viewed with suspicion. This was clearly a key factor behind the Brexit vote, and many others. The regional reaction to rapid urbanisation has been called “the revenge of the regions”.

Finally, two significant shocks coincided with the rapid changes driven by globalisation and technological development. First, the 2008 global financial crisis, followed by the economic recession; second, the European refugee crisis. These amplified citizens’ fears and frustrations towards the elites and the immigrants, thus further feeding to populist tendencies.

Overall, I see three stages in the development of populism. The first stage is recognition of protest or issues. In the second stage, there are increasing demands for policy change. And in the third stage, there are actions for a regime change – for more illiberal and authoritarian. In many advanced liberal democracies, we are normally in stage two.

5. Since economic policies of populist parties seldom provide real solutions, and the impact of populists on political institutions can be erosive, the liberal democracies need to find ways to contain the rise of populism. Otherwise, we face both fragmentation and un-governability.

SLIDE 6. Vote for the broad political centre in Finland

To illustrate this, in Finland the combined share of votes for the three main centre-left and centre-right parties has declined from a steady 65-70% up until the global financial and economic crisis to below 50 per cent in the most recent elections. At the same time, the share of votes for the largest party has declined from roughly 25 percent to less than 20 percent.

More generally in the advanced liberal democracies, the rise of populism has led to an increased fragmentation of the political system. It has made governing effectively harder, and also made it more difficult to form functioning coalition governments and to carry out structural reforms.

Another notable consequence of the rise in populism is its impact on the policies pursued by the mainstream parties. In some/many cases, the mainstream parties have shifted their policies towards the populists’ agenda in fear of losing many more of their voters.

So what can the liberal democracies do to curb or accommodate populist pressures? In theory, the required policies are simple, but modern societies have shown little capacity to be able to respond in the correct way.

SLIDE 7. Agenda for reform in Europe

First step, reinvigorate economic growth. Second, and equally important, ensure that fruits of growth are widely shared. This includes not only that individuals displaced by technological progress and international competition are assured sufficient social support but also assistance to seek alternative ways to fulfil a meaningful role in society.

As underlined e.g by the IMF, the big changes affecting our economies and labour markets may require a new social contract to provide citizens with a greater sense of security and confidence in the face of imminent changes. This also involves making choices about the division of responsibilities between the community, the market, and the state.

In economic policy, it needs to be asked whether a more even balance between monetary and fiscal policy stances would be desirable in order to sustain the growth momentum. In our view it is important to underline that, in order to reap the full benefits from the ECB’s monetary policy measures, other policy areas should contribute more decisively to raising the growth potential and reducing vulnerabilities. For the longer term, implementation of structural reforms is key for boosting euro area productivity and growth potential. In this way, one would enable a more balanced macroeconomic policy mix. Monetary policy should not be the only active player in town.

FT’s Martin Wolf recently presented a list of issues to be tackled in order to contain a new wave of populism. These include leadership, citizenship, inclusion, economic reform, local communities, public services, and better management of globalisation. It is a long and challenging list and needs to be adapted to country-specific circumstances.

There are fundamental value judgements to be made in this process and it is up to the democratic political system to come up with them. On some controversial issues, we need to be able to take a pragmatic approach. Immigration is a case in point – a balance needs to be found between addressing the demographic headwinds by work-based immigration, while avoiding populist backlashes in the advanced economies.

Ladies and Gentlemen,

6. As we have seen, populism is here to stay and pose a challenge to liberal democracies and the rules-based international system, which has been pivotal in the global economic development and helped to lift a vast number of people from poverty over the last century. Nowhere else are the benefits felt more strongly than in small, open economies like Malta and Finland. The gains of commerce and free trade have been immensely important for both countries’ catching-up process and prosperity.

The values that underpin our economic and political models in advanced liberal democracies are being challenged both politically and socially, from inside and outside. It is a common challenge for all of us to defend the values of liberty and democracy and the rules-based world order. I do hope that we realise the urgency of this effort, especially now as the role of Europe as the standard-bearer for liberal democracy is even more crucial.

In my view, the best and most effective way to defend liberal democracy is simply by finding and enacting such policies that solve practical problems of our citizens – be they related to employment, environment, immigration, climate change, or other things. We certainly need bolder joint efforts to steer our societies towards a more sustainable future.

Many thanks for your attention.

Benoît Cœuré: Exchange of views with members of the French Parliament

May 16, 2019 by Reg Hub Leave a Comment Filed Under: Central Bank Annoucements, Central Bank News Tagged: CET1, EURO, European Central Bank, European Central Board, EuroStat, TLTRO-III

Mr Chairman,

Ladies and gentlemen of the National Assembly,

Thank you for inviting me here today. It is a pleasure to engage in an informal exchange of views with you today on the ECB’s monetary policy, and on policies to raise the economic potential of the euro area.

Allow me to start by briefly discussing the economic situation of the euro area.

The euro area economic outlook

In 2018 the euro area economy grew by 1.9%, compared with 2.4% in the previous year. This moderation in economic growth was mainly due to weaker global trade, as well as some temporary factors at both the domestic and global levels.

While there are signs that some of the idiosyncratic domestic factors dampening growth are fading, global headwinds continue to weigh on euro area growth developments. Moreover, the persistence of uncertainties related to geopolitical factors, the threat of protectionism and vulnerabilities in emerging markets is leaving marks on economic sentiment. As a result, the slower growth momentum has extended into the current year.

At the same time, the euro area economy continues to exhibit a high level of capacity utilisation, and the unemployment rate has continued its downward trend. In March it stood at 7.7%, its lowest level since September 2008. Employment gains and rising wages continue to underpin the resilience of the domestic economy.

Looking ahead, the latest ECB staff projections from March 2019 put euro area annual real GDP growth at 1.1% in 2019, 1.6% in 2020 and 1.5% in 2021. At the same time, the persistence of uncertainties, mainly stemming from the global environment, continues to pose downside risks to the growth outlook.

Looking at inflation developments, euro area annual HICP inflation was 1.7% in April 2019. While measures of underlying inflation remain generally muted, the ongoing economic expansion, with tightening labour markets and rising wages, will support the further build-up of price pressures. The latest ECB staff projections foresee annual euro area headline inflation of 1.2% in 2019, 1.5% in 2020 and 1.6% in 2021.

Benoît Cœuré

The ECB’s monetary policy and its impact on the euro area economy

At its last monetary policy meeting on 10 April, the ECB Governing Council confirmed that an ample degree of monetary accommodation remains necessary to safeguard favourable financing conditions and support the economic expansion. This will ensure that inflation remains on a sustained path towards levels that are consistent with our inflation aim – a rate of inflation which is below, but close to, 2% over the medium term.

We continue to expect the key ECB interest rates to remain at their present levels at least through the end of 2019, and in any case for as long as necessary to ensure the continued sustained convergence of inflation consistent with our inflation aim.

The Governing Council also confirmed its intention to continue reinvesting, in full, the principal payments from maturing securities purchased under the asset purchase programme. This will continue for an extended period of time past the date when we start raising the key ECB interest rates, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.

To preserve favourable bank lending conditions and the smooth transmission of monetary policy, and to support access to financing, in particular for small and medium-sized enterprises, the Governing Council decided in March to launch a new series of quarterly targeted longer-term refinancing operations (TLTRO-III). They will start in September 2019 and end in March 2021.

Significant monetary policy stimulus is thus being provided by our forward guidance on the key ECB interest rates, reinforced by the reinvestments of the sizeable stock of acquired assets and the new series of TLTROs. The Governing Council stands ready to adjust all of its instruments, as appropriate, to ensure that inflation continues to move towards our inflation aim in a sustained manner.

The benefits of our monetary policy measures have been sizeable and tangible. Lending rates for euro area firms and households have declined to historic lows and converged across the region, and growth in bank lending volumes has significantly recovered since the beginning of 2014, thereby supporting investment and job creation.

According to today’s preliminary flash data release provided by Eurostat, there are now 9.2 million more people in employment in the euro area than there were at the end of 2014, just before the ECB announced its expanded asset purchase programme, and 10.8 million more than in the second quarter of 2013, when the number of people in work fell to its lowest point during the crisis.

Completing Economic and Monetary Union

In order to reap the full benefits from our monetary policy measures, other policy areas must contribute decisively to raising the longer-term growth potential of the euro area and reducing its vulnerabilities.

Sound fiscal and economic policies at the national level are the first line of defence to make the euro area stronger.

Economic reform needs to be substantially stepped up in euro area countries to increase resilience, reduce unemployment in a lasting way and boost productivity. The country-specific recommendations that the European Commission will publish next month will lay down the main reform priorities to be implemented.

On the fiscal side, the mildly expansionary euro area fiscal stance and the operation of automatic stabilisers are providing support to economic activity. Countries which have fiscal space should use it in a way that makes their economies stronger and more resilient for the future. At the same time, countries where government debt is high, including France, need to continue rebuilding fiscal buffers. All countries can and should reinforce their efforts to achieve a more growth-friendly composition of public finances.

The euro’s benefits, however, will not fully materialise for as long as the architecture of Economic and Monetary Union (EMU) remains incomplete.

Material progress has been achieved in recent years. The European Stability Mechanism has become established as an important safeguard and the reforms currently being discussed will provide it with new instruments to better protect Member States, keeping in mind the longer-term objective of making it a Community institution accountable to the European Parliament.

The creation of banking union, meanwhile, has considerably strengthened the resilience of the euro area financial sector and, together with the Bank Recovery and Resolution Directive, has created instruments to combat banking crises in a way that is swifter and fairer than in the past. Banks directly supervised by the ECB have built up strong capital positions in recent years, with a Common Equity Tier 1 (CET1) ratio of 14.3% at the end of 2018 compared with 11.3% at the end of 2014, and have substantially reduced non-performing loan ratios. These are important steps forward as euro area firms rely to a very large extent on bank credit to finance growth and investment. Let us also keep in mind that these measures build on the achievements of ten years of financial regulatory reform, which should not be reversed.

So what more should be done at the European level?

First, we need to further strengthen the ability of the financial sector to contribute to economic stabilisation. Increased financial integration is the key competitive advantage the euro area should leverage here. During the crisis, integration in the euro area reversed and it has only gradually recovered over the past years. The creditworthiness of banks remains linked to that of national governments. Cross-border investment is not a significant buffer against economic shocks, as it is across US states. The euro area still lacks genuinely integrated capital markets, which hinders the efficient investment of European savings as well as the use of the euro as an international currency.

Recent legislative steps are commendable but they do not measure up to the initial ambition of the capital markets union project. Brexit will further accentuate the need to develop and integrate the EU’s capital markets to prepare for the likelihood that the City of London will play a more reduced role in the future as a hub of European savings.

Second, we need to ensure that the EU fiscal framework delivers on its main objective: preserving fiscal sustainability while allowing room for automatic fiscal stabilisation. This is essential to help stabilise the euro area in the face of large shocks without having to rely excessively on the ECB’s policies.

Sound national fiscal policies should remain the basis. Simpler and more credible fiscal rules would help ensure that euro area countries build adequate fiscal buffers in good times so that fiscal policy can be used in bad times. The euro area budgetary instrument currently under discussion is a welcome step to support competitiveness and convergence, but it is not designed to fulfil a stabilisation function. In order to play that role, it would therefore have to evolve further in the future.

In the longer term, the creation of a common euro area safe asset, if done in a way that does not undermine incentives for sound national fiscal policies, could have a beneficial impact on the conduct of the ECB’s monetary policy, help strengthen the international role of the euro and contribute to completing EMU.

Conclusions

Let me conclude.

The euro, as it marks its 20th anniversary, enjoys broad support among European citizens, with three in four people in the euro area in favour of the single currency. Its growing popularity is testimony to the fact that people have trust in the currency and in the ECB’s strong commitment to price stability, which supports investment and job creation.

To preserve this trust, and to deliver on the promise we made when the euro was introduced, namely that it would bring prosperity and opportunities, we need to step up our efforts at both national and euro area level to strengthen the architecture of the single currency. Many of the failings that caused and perpetuated the crisis remain unresolved.

Ensuring the political relevance and legitimacy of this process is in the hands of the European Parliament and national parliaments. I very much look forward to today’s discussion.

Thank you.

Luis de Guindos: Challenges for bank profitability

May 7, 2019 by Reg Hub Leave a Comment Filed Under: Central Bank Annoucements, Central Bank News Tagged: EURO, European Central Bank, European Central Board, non performing loans, NPL, risk premia

Introduction

Sustained economic expansion over the past six years and greater banking sector resilience have supported financial stability within the euro area.

But the recent softening of growth prospects heightens risks. The financial stability environment has become more challenging than it was a year ago. The risks that have been with us for some time now – a possible disorderly increase in risk premia, debt sustainability concerns, low bank profitability and imbalances in the non-bank financial sector – are still present. But they are no longer being mitigated by an improving macroeconomic outlook.

Indeed, the deteriorating macro outlook renders some of these risks more acute. In particular, it may reawaken concerns over debt sustainability and worsen the outlook for bank profitability. Debt sustainability concerns could drive up sovereign bond spreads. In turn higher spreads generate losses on bond portfolios and higher market-based funding costs for financial institutions.

Bank profitability tends to go hand-in-hand with economic activity. Slower growth prospects may dent bank profitability through a reduction in lending activity and a possible increase in credit impairments.

Moreover, the ongoing political uncertainties – including trade disputes – and the softer economic momentum may trigger volatility in asset prices. And if a sudden, disorderly increase in risk premia were to materialise, it could further elevate banks’ funding costs.

Against this backdrop, I am going to focus my remarks today on bank profitability. Returning banks to sustainable rates of profitability is a key step towards ensuring that the sector remains resilient, particularly in the face of slowing economic momentum and the potential for market distress.

Euro area banks have certainly improved their profitability in recent years. Their return on equity reached 6% at the end of 2018, up from 3% two years earlier. But their profitability remains below their long-run cost of capital, which most banks estimate to be in the range of 8-10%.¹Low profitability prospects translate into low bank valuations, as observed in price-to-book ratios well below one, hindering the ability to raise capital, where needed.

European bank profitability has been structurally weak since well before unconventional monetary policy measures were introduced. Broadly speaking, the sources of that weakness can be divided into cyclical factors, cost inefficiencies and competitive challenges arising from outside the sector. Before discussing these sources, let me begin by reminding you why bank profitability is important.

Why bank profitability matters

Clearly, bank profitability matters for financial stability. Profits are the first line of defence against losses from credit impairment. Retained earnings are an important source of capital, enabling banks to build strong buffers to absorb additional losses. Those buffers ensure that banks are able to provide financial services to euro area households and businesses, even in the face of adverse developments, thereby smoothing rather than amplifying the impact of negative shocks on the real economy.

Banks with poor structural profitability can face higher funding costs and may be tempted to take on more risk.² Within the euro area, weak banks are more likely than healthy banks to be connected to unprofitable firms.³ This reduces the flow of lending to profitable firms that need funding to invest and grow. The resultant misallocation of capital⁴ towards unproductive businesses weighs on long-run economic growth.⁵

Low bank profitability can also matter for monetary policy by impairing the accumulation of bank capital over time. Thinly capitalised banks stymie the ability of monetary policy to stimulate economic activity in downturns. Their capacity to lower the interest rates they charge their customers and increase the volume of lending to the real economy is constrained.⁶ This limits the effectiveness of an important transmission channel of monetary accommodation in the euro area, which relies on bank lending supporting consumption and investment.

As the crisis showed, dislocations in the banking sector can deepen recessions and seriously impair the smooth transmission of monetary policy across the euro area. That risk remains today. We recently carried out what we call a macroprudential stress test, which assesses this amplification of shocks using a micro-macro model that feeds back individual bank reactions into macroeconomic outcomes. On the basis of the 2018 European-wide stress test data, we estimate that the banks’ behavioural reaction to the adverse scenario exacerbates the fall in GDP by a further 1.6% with respect to the initial shock, which itself further depletes banks’ capital.⁷

Cyclical factors

Given that important link between bank behaviour and the cycle, let me turn to the cyclical factors affecting bank profitability in the euro area.

The economic expansion continued through 2018, although with a sizeable reduction in the pace of growth relative to the previous year. Since the trough, the number of people in employment has increased by over 10 million. While the data since the end of 2018 have been weak – notably in manufacturing and the external sector – the economic fundamentals remain in place to support continued expansion.

The economic expansion and employment growth have supported bank profitability. Loan growth has been robust in recent years, with higher volumes helping to mitigate margin compression.⁸

The stock of non-performing loans (NPLs) has been substantially reduced. Outstanding NPLs fell by €142 billion in 2018 and the aggregate ratio dropped to 3.8% of significant banks’ loans at the end of 2018, from 7% at the end of 2015.

NPLs represent a double drag on bank profitability. First, NPLs have to be recognised and provisioned for, reducing current profitability. Indeed, the major driver of the increase in bank profitability over the past two years has been the smaller flow of new impairments. But even when fully provisioned, NPLs hamper profitability by tying up scarce capital without providing returns, absorbing operational capacity and incurring legal and administrative costs.

While NPL ratios have improved over the course of the expansion, overall revenue growth remains subdued across the banking sector. Aggregate net interest income as a share of equity fell marginally between 2015 and 2018, although it is still higher than in countries such as the United Kingdom that have not had negative policy rates.

Yet a number of euro area banks have successfully delivered robust earnings in recent years. A recent study by the ECB highlighted the differences between this group and the remainder of significant euro area banks.⁹ The median of these best performers managed to lift its return on equity by 3.6 percentage points in 2014-17 relative to 2009-13. By contrast, the median profitability for other significant banks was essentially unchanged.

Between those periods, the best performers managed to keep net interest income growing roughly in line with costs, whereas the other banks generally witnessed cost growth outpacing growth in net interest income. Moreover, the best performers managed to increase net fee and commission income by more than half between 2009 and 2017, relative to the less than 10% growth managed by the remainder.

Developing sustainable revenue streams beyond net interest income – such as fee and commission income – remains vital in order to buttress profitability in the coming years. The low interest rate environment is with us for the foreseeable future and is caused in large part by durable structural factors.¹⁰ The interest rate below which monetary policy is accommodative has fallen in the euro area, as is the case in much of the developed world.¹¹ Even once monetary policy normalises, interest rates are likely to remain below levels that were common in previous decades.

Cost inefficiencies

The second source of low profitability for euro area banks is enduring cost inefficiencies. Cost-to-income ratios remain high in the euro area relative to international peers. The euro area has too many banks, too many branches and too many bankers. The aggregate cost-to-income ratio of euro area banks reached 66% in 2018, up from 62% in 2010, as the dip in revenues was not offset by cost containment. While similar to that of peers in Japan and the United Kingdom, it is above the ratio typical for US banks, and substantially above the ratio of roughly 50% for Nordic banks.

Reducing costs requires grasping the opportunities offered by technology. Banks have been able to make greater reductions in the density of the branch network in countries where the take-up of online banking is higher. The number of branches in the Netherlands and the Baltic states has halved since 2008, but progress in other countries has been much more limited. Technology can also help enhance operational efficiency by improving processes for loan origination and servicing and enable workloads to be shared better across employees in multiple locations.

That requires substantial investment in information technology (IT). The best performing euro area banks I mentioned earlier increased their IT spending by around 60% between 2009 and 2017, whereas the remaining banks increased theirs by just 10%. Such investment is expensive, but has proven worthwhile. The cost-to-income ratio for the median of the best performers fell by 5.5 percentage points, whereas that for the median of the other banks increased by 3.1 percentage points.¹²

The other source of higher costs for euro area banks is the adjustment to a suite of post-crisis regulation. This includes holding greater amounts of high-quality capital and debt instruments that can be “bailed in” should resolution become necessary. It is also more difficult now to increase measured profitability by increasing leverage. And whilst international requirements on loss absorption only apply to the most systemic banks – so-called G-SIBs – and the Basel standards typically apply to internationally active banks, in the euro area such requirements are applied to all banks. Of course, such regulations have been put in place in recognition of the significant public costs borne throughout the banking crisis. And regulation cannot be seen as the main driver of costs – Nordic banks operate under the same regulatory framework and have been able to attain a high rate of profitability.

But one key element in regulation worth noting is the lack of waivers for liquidity and capital in the euro area. As a result, euro area cross-border banking groups potentially face higher costs than interstate banking groups in the United States.

This recourse to ring fencing takes a narrow national perspective. At present, national deposit insurance schemes will be drawn upon should depositors need to be compensated during bank resolution. Hence the desire of national authorities to ensure that each national subsidiary is sufficiently capitalised and has adequate liquidity. Completing banking union, including the introduction of a European deposit insurance scheme and the removal of the remaining national options and discretions, would help ensure that the costs of resolution are equitably shared. Meanwhile, it would enable banks to use liquidity and capital efficiently at the euro area level.

Competition from outside the sector

The final challenge for bank profitability comes from increasing competition from outside the sector, in particular from financial technology companies (fintech) and non-bank financial companies.

Lightly regulated fintech companies have begun to encroach into the realm of payment and settlement systems. More than 60% of incumbents view fintechs as a threat to their income from these activities.¹³ Given the greater desire by consumers for instant payments and the use of mobile payments, investment in IT is vital to secure future revenue streams.

Banks also face increasing competition in the provision of credit. Total assets of non-bank financial intermediaries doubled in the euro area between 2008 and 2017, whereas total banking sector assets remained broadly unchanged. The growth is particularly marked in the investment fund sector. Around 28% of euro area non-financial company debt issuances are held by euro area investment funds, compared with 18% pre-crisis.

The greater provision of market-based credit is welcome, and indeed the capital markets union agenda has been put in place with this aim in mind. But banks will need to carefully consider how to adjust their business models to accommodate this greater degree of competition. It certainly increases the urgency to improve efficiency in credit provision.

Conclusion

Let me conclude.

The structurally low profitability of the euro area banking sector remains a concern for financial stability and for monetary policy.

Return on equity below the cost of capital is unsustainable in the long run. The causes of low profitability are for the most part structural and hence require structural solutions. Successful implementation of long-run profitable business plans is essential.

Consolidation remains necessary.

There are a number of benefits arising from cross-border consolidation. Cross-border holdings of deposits and loans can help bolster economic resilience within the euro area by helping to smooth shocks through income sharing. Such private sector risk-sharing channels play an important role in smoothing shocks in the United States, but currently smooth a much smaller share in the euro area.¹⁴

Moreover, it can provide benefits for the banks themselves. In general, more geographically diversified banks have displayed stronger revenue performance in recent years.¹⁵

But there are a number of national banking sectors that would also benefit from consolidation within national borders, allowing for greater cost synergies and rationalisation of branch networks. Such consolidation would permit small and medium-sized banks to attain sufficient scale to undertake the IT investment necessary to meet the challenges of the digital era.

While both national and cross-border consolidation options are potentially viable, the key consideration for financial stability is that the combined entity should be able to successfully execute the merger, resulting in a bank that can sustain profitability in the long run.

The rise of the service economy

Services, inflation and the transmission of monetary policy

The composition effect

The transmission effect

Services and price rigidities

The rise of services as a production input

Conclusion

The euro area economic outlook

The ECB’s monetary policy and its impact on the euro area economy

Completing Economic and Monetary Union

Conclusion

Where do we stand on financial integration in Europe?

Renewed risks of fragmentation increase the need for European integration

European responses are the way forward

Deeper financial integration will strengthen EMU and ultimately enhance the international role of the euro

The euro area economic outlook

The ECB’s monetary policy and its impact on the euro area economy

Completing Economic and Monetary Union

Conclusions

Introduction

Why bank profitability matters

Cyclical factors

Cost inefficiencies

Competition from outside the sector

Conclusion

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