Strategic tasks of central banks: focus on the ECB

When we look at the doings of a central bank, the focus in the various media is on expectations of interest rates set by the institution or on its arsenal of technical measures to operate in the interbank market:

• conventional tender offers to refinance banks - for example, the ECB main refinancing operations (MRO); •

• today, in times of liquidity crisis the extraordinary refinancing operations of the ECB called LTRO for long term refinancing operations

We also look at its strategy of purchasing securities: government securities to help finance public deficits (direct monetization like the FED or BOE, sterilized purchases of government bonds by the ECB to control growth of money supply); other securities to facilitate the refinancing of banks in the medium and long term (purchase program of covered bonds by the ECB for example) or to stabilize the housing market, purchases of MBS by the Fed or the BOE for example)

Beyond these traditional measures (securing refinancing conditions, allocation of liquidity to banks, purchases of governments and non-government bonds), in the context of systemic risks that we live we want here to examine more specifically what should be the strategic tasks of a central bank

PREVIOUSLY, IT IS IMPORTANT TO REMEMBER THE CONTEXT OF NEW IMPLEMENTATION OF MONETARY POLICY

Since the beginning of the financial crisis in 2007, two major lessons can be learnt

 1/ We finally lived with the idea that central bank credibility was enhanced and that the consequences had been a sharp reduction in the variability of the business cycle: growth, inflation, interest rates. All things serve to stabilize the expectations of economic agents and thus create conditions for sustainable growth In fact, there were only illusions as transfer on the variability of asset prices with excess liquidity and repeated crises caused by the bursting of bubbles in asset prices. We will therefore hold this and the need to redefine certain objectives of central banks

 2/ Since the crisis began in 2007, it was necessary for central bankers at first: to respond to the interbank liquidity crisis, and substitute to the financial market in a situation of distress and of course limit the impact of financial crisis on the economy ... This substitution feature to the interbank market by the ECB (and despite the official orthodox and "conservative" speech) unfortunately must continue to be exercised until the crisis of confidence lost in intensity (we will therefore monitor the financial crisis indicators)

FIRST STRATEGIC FOCUS: RETHINKING AND REDEFINING THE OBJECTIVES OF THE CENTRAL BANK

1/ This is to review and evolve the inflation traditional target concerning prices for goods and services

Need to add new goals (credit, asset prices) and the fact that Central Banks have only monitored inflation in goods and services has led since the late 1990s to accommodating monetary policy and therefore rates very low rates over a long period with consequences that we know: bubbles in asset prices, excessive debt (this is particularly true for countries from the south of the Euro zone, today in liquidity and / or solvency crisis)

We know that asking to central banks to stabilize or guide asset prices can generate a number of problems: moral hazard that disempowers the investor in his choices; price distortions of certain assets. The role of the central bank must then be double

• counter during certain periods of destabilizing dynamics of asset prices change in markets: forced asset sales related to accounting constraints, and prudential regulations (See the recent history of the markets in summer 2007, fall 2008 , summer 2011 ...)

• on the other hand, monitor the excess liquidity bubble generators and disconnection between the growth of the real economy and the evolution of financial asset prices

Therefore it is not easy to ask the central bank to be able to "fight" against overvaluation or undervaluation of financial assets. The central bank in fact is not omniscient but has a huge advantage over investors, traders and other market participants: it is first in principle insensitive to the mark-to-market (valuation) of assets it holds and then when proven loss, there is no need to recapitalize it as a bank or insurer. This is what drives many politicians, economists and business leaders to demand that the ECB takes some of the losses today on Greek assets held, tomorrow why not on other assets. We will see in a future paper in this series on central banks that things are still a bit more complex in terms of the externalization of losses by the central bank and especially its macroeconomic consequences

2/ In addition to the redefinition and extension of the price targets, it should be set at the ECB an exchange rate target

It should not be excluded that in certain circumstances, an exchange rate target can be substituted for the objective of price stability. This may be the acceptance of a strong devaluation of the euro against the dollar in particular and against European currencies (except Swiss franc, the Swiss economy in need of a less "stronger" currency and the SNB has staked his credibility by defending a floor of 1.20 on the Euro / Swiss Franc)

But this assumes that the statutes of the Central Bank can evolve without necessarily calling into question the entire independence vis-à-vis the political power

Such a policy should be implemented vigorously in period of deflationary doubts (we see therefore that the whole point is to overweight inflation target or exchange rate target following the macroeconomic environment) and allow a number of guidelines economic policy will not be neutral for the investor:

• For example, an inflationary stimulus if needed and creating an environment of negative real interest rates and dropping the rates of indebtedness

• Or, maintaining a competitive cost by the depreciation of the currency (we still have to work to the re-industrialization of some countries in the Euro zone to enable them to find an export capacity)

SECOND STRATEGIC FOCUS: STRENGTHENING THE POSITION OF THE NATIONAL CENTRAL BANKS IN THE EUROSYSTEM AND THE POSITION OF THE ECB ON THE INTERNATIONAL FINANCIAL NETWORK

The objectives here are to increase the influence and effectiveness in the definition of monetary policy and strengthen the operational positioning in markets

To do this, it is necessary to remedy the shortcomings of international monetary cooperation. That is to imagine two types of indicators

1/ Establishing a measure of money supply growth at the "global" scale so that individual decisions of central banks leading to a global excess liquidity does not disrupt the effectiveness of the monetary policy of other central banks

2/ There is no international organization that does not protest when the exchange rate policies of countries are clearly non-cooperative (China, United States, United Kingdom ...). For example, the Fed quantitative easing have created liquidity that will certainly finance the U.S. debt but will also invest in emerging assets (currencies, bonds and equity) and commodities; this organized depreciation of the dollar and appreciation of emerging currencies led Asian central banks to create its own liquidity by issuing the national currency to be sold against the dollar (emerging competitive forces). However this behavior of emerging tends to diminish with the development of a growth model based more on domestic consumption and less on export competitiveness.

We return in any case to the need for an exchange rate target in Europe because this vicious circle of liquidity creation by the Fed and central banks in Asia between 2009 and until mid-2011 led to a monetary dumping to the detriment of the euro. The euro then played the role of adjustment variable via an appreciation beyond what the economy of the Euro zone can bear. We must be able to have a strong influence in particular in France and Europe in general to set stable exchange rates while being adjustable.

THIRD STRATEGIC FOCUS: MAJOR PLAYER IN THE FINANCIAL STABILITY

The clear objective is to prevent systemic risk

1/ Need to conduct a real macroeconomic supervision of economic policies of countries and establish indicators of systemic risks linked to these macroeconomic risks. Central banks must be able to play a major role in the management of stress tests applied to the banking sector with the establishment of very unfavorable simultaneous scenarios in terms of macroeconomic risks.

• Scenario of sharp drop in GDP
• Scenario of default rate of borrowers
• Scenario with an adverse evolution of the yield curve, thus flattening or inversion of the curve. Although this risk is marginal today because short rates will not rise before very long in the OECD countries, this risk has never been seriously stressed by the actors of the banking system.
• Scenario of violent reversal of financial asset prices and real estate
• Scenarios with confused and non-cooperative movements in exchange rates

The major objective is to make the link between systemic macroeconomic risk and systemic banking risk..

Mory Doré

2/ But ensuring financial stability requires that the central bank use several types of instruments beyond the setting of interest rates

 Assets purchases (to change the interest rate on long-term loans for example, or the price of some financial assets), that is qualitative or quantitative easing with stronger constraint than what has been practiced since 2009: framework for these actions in terms of growth of money supply, thus implementing what is called a partial sterilization of money creation
 Use of reserve requirements (we come back to this in initiative 4)
 Monitoring of certain ratios and banks’ balance sheets limits (capital ratio, levels of interest-rate and liquidity gaps to frame the risk of transformation)

This is therefore to advocate an integration of functions of central banks and regulators of the banking system. Notice that in France for example in terms of regulation / legislation, a bank deals with multiple contacts. Discerned

• The Basel Committee and respect for different pillars (solvency, risk governance, communication on the general policy of risk management)
• The supervisory, supervisory authority of the French banking sector
• The European Banking Authority, creation of the EU, whose mission is to contribute to the stability and effectiveness in the short, medium and long term of the European financial system by a level of regulation and supervision satisfactory enough, efficient and coherent
• Advisory Committee on Legislation and Regulation Financial (CCLRF) which replaced the famous Committee on Banking and Financial Regulation

Standards and regulations issued by these institutions are listed in various texts and documents

• European Directives
• Monetary and Financial Code
• Regulations of the former CRBF and decrees of the Ministry of Economy under the CPA authority

For example there are "sacred" texts in the banking industry. One thinks of Article L511-41 of the Monetary and Financial Code and Regulation 97-02 of 21 February 1997 the former CRBF. They define precisely the establishment of an internal control in credit institutions. Not to mention the so called contention with the rules of conduct ("best practices" among Anglo-Saxon), the CPA instructions and various reportings to regulatory and accounting (Financial reportings said FINREP and common reportings called COREP ) The observer might wonder how is it that with this multiplication of institutions and regulations, banking crises of the magnitude that we know today may occur

 First, and we have often talked about it, the rules are consistently late and they grows stronger only with the pressure of crises. This is what we call skillfully pro-cyclicality. For example, the Bale 3 future regulatory environment that will make (or rather makes already) the cost of liquidity and capital more expensive takes place in an inappropriate macroeconomic context: non-existent economic growth in Europe, increasing competition between public and private issuers in the capital markets; upcoming rebalancing of international capital flows with a progressive disappearance of excess savings in emerging countries. It is not when growth is low and capital is scarce and expensive that prudential rules should be tightened (there are better ways to discipline the banks - we will return). That was when growth was strong and that liquidity and capital were abundant and cheap that it had to be done

 Second, and in this sense we speak of a strategic focus, the recent history of the banking crisis has shown a lack of integration of functions of central banks in regulating the banking system

3/ To be a major player in financial stability, we need central banks to define ’ intelligent ’ devices for risk management of banks’ balance sheets (interest rate risk and liquidity). Today, most major central banks would be unable to raise interest rates and tighten their monetary policies if economic conditions require. We are certainly far today but we should not refrain from raising this type of problem and ask what would be the ability of some national banking systems to withstand such shocks.

It is therefore necessary to establish new ratios in Bale 3 by ensuring that they combine minimal profitability of banks (maintaining a profitable business transformation during steep curve as now), ability to finance the economy in tolerable economic conditions and stabilizing the financial system (comfortable level of solvency for banks and access to liquidity)

 LCR (for Liquidity Coverage Ratio) is a ratio of short-term that requires banks to hold a stock of safe haven assets, readily marketable under stressed net cash flows of one month. This ratio can be defined as a stress test on liquidity horizon of 30 days. The LCR requires banks to establish a reserve of liquid assets. We should be very vigilant regarding the perimeter of the so called liquid assets (major discussions at the moment) so as not to create risks of asset overvaluation and excessive concentration of the same types of securities in bank balance sheets. We know too that when everyone does the same thing at the same time without asking too many questions, it often ends badly (some call it mimicry and herd behavior)

 The NSFR (for Net Stable Funding Ratio) is a long-term ratio requiring banks to finance with stable resources a significant part of their assets in a crisis over a year. Be careful though with the introduction of this ratio (actual setting for 2019 ...!) Not to kill any transformation activity of banks and one of the most stable sources of profitability (GNP to net banking income related to the processing margin - the difference between the yield on loans indexed to long benchmark rates and the cost of borrowed resources often linked to short rates)

FOURTH STRATEGIC FOCUS : HELPING IN THE GOOD FUNCTIONING OF THE ECONOMY

It’s not like some French politicians make it understand with electoral outbidding to have finance as the primary enemy. When we govern a country or we aspire to govern a country, one must hold a responsible and consistent debate on the economy. I’m probably naive and have not any experience in politics but I have a basic understanding of economic and financial mechanisms. Therefore, it does not make sense to transform finance into a scapegoat, especially when one wants to lead a country that refinances 2/3 of its public debt on international capital markets What we expect from policy makers is that they reaffirm the historic opportunity we have to redefine the true financial industry
 one that would allow to finance the economy at the lowest cost for households and businesses
 one that helps ensure that the excess savings are recycled in the most productive way
 one that allows economic agents to cover in optimal liquidity conditions their financial risks (interest rate, credit, foreign exchange, equity ...)

To return to the missions of the Central Bank, recognize that it must contribute to the functioning of the economy and must create the conditions for a healthy and sustainable growth (without excess money creation out of nothing as some major OECD central banks are doing today with lack of serenity). The objectives are clearly stated: protection of private savings, financing of the economy at the lowest cost, competitive pricing and customer servicee

1/ This must be based on the strong performance of financial management of banks and therefore assumes that the central bank can create the conditions for this stability. Among the rules of conduct and principles to be adopted which may appear to often contradictory

• ensure that regulatory changes in banking do not lead to a contraction of credit supply.
• ensure that these regulatory changes do not lead to excessive risk-taking to restore the return on equity (which makes inevitable higher capital requirements and limit the leverage of banks)

Indeed, central banks should be aware of the following problem : increased risk taking by financial intermediaries if they keep the same requirement of return on equity as before (systematic selection of the most risky assets within asset classes involving the same consumption of capital). Without doubt it is necessary that central bankers get involved in the debate on the redefinition of the objectives of profitability of bank capital by taking better account of the reality of the potential growth of economies

Therefore the priority of central banks: avoid banks to continue to take increasingly important risks and not necessarily the right risks to help fund the economy at least cost, but bad risks who seek against all odds to maintain a disproportionately high shareholder returns.

2/ To create these stable conditions, it is essential that central banks implement the following measures

 Remember from Bale three techniques of calculations that weigh heavily in consumption capital the market risks ... we must be able to accept useful speculation and to distinguish between market activities socially and economically useful and those which are not. Rather than returning to a brutal and inefficient separation between retail banking and corporate and investment banking
 Use, as does, among others, China in managing its monetary policy, flexible instruments: calibration of the reserve requirement ratio of banks; systematic establishment of loan to value ratios (ratio proportioned to the amount of credit value of the property purchased and why not its prospects for valuation)
 Protection of citizens’ savings by implementing a generalized system of insurance to all resources (thus avoiding the race for deposits and panic that penalize the normal refinancing of banks)

So why not imagine a finally effective taxation of market activities unnecessarily risky (not that difficult to define) and especially to ensure that the tax credit is used to finance just the cost of insurance of various sources of banks refinancing. This is a simple way to restore confidence: the banks focus on economically useful activities and they are able to refinance themselves in different secured and guaranteed forms (customer deposits, market resources), in other words they borrow and lend normally

Anyway, as shown in this paper, a central bank has many missions to complete and many roles to play. We should then stop claiming all day to the central bank to buy back the debts of insolvent states close to bankruptcy or takes its losses on the more toxic debt and to put in place LTRO every two months to flood the market liquidity. It certainly makes the equity markets and other risky assets rise expressed in so doing, and that relieves pressure in the short term but it solves nothing and worse the conditions are created for new asset bubbles and thus new financial crises. I am presently preparing a paper on these issues that the news always puts forward for many months with the balance of power between the ECB on the one hand and the rest of the world on the other (investors, politicians in the south of the Euro Zone, France included, economists ...)