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SPEECH/08/456
Joaquín Almunia
European Commissioner for Economic and Monetary Policy
Situation of the world financial system and its effects on the European economy
European Parliament Plenary Debate
Brussels, 24 September 2008
Many thanks Mr. President,
Ladies and Gentlemen,
The series of events we have witnessed in financial markets during the last year, and in particular during the last few days, are of a magnitude that exceeds anything we have seen in our lifetime. Many believe, and I tend to agree, that this will trigger important changes in the functioning of the international financial system.
Since the outbreak of the crisis in August 2007, disclosed losses have totalled more than 500 billion dollars, a sum equivalent to the GDP of a country like Sweden. And unfortunately the final figure is considered to be larger still.
The acceleration of declared losses in the US during the last few weeks, and the subsequent decline in investor confidence, has pushed several major financial institutions to the brink of collapse. In cases where the fall of one of these institutions would have implied a systemic risk, that is to say, put the entire financial system at risk, emergency rescue operations have been required.
Some of these rescue operations took the form of public interventions, such as those carried out by the US Treasury and the Federal Reserve to avoid the bankruptcy of the world's largest insurance company, AIG, or of the mortgage financiers Fannie Mae and Freddy Mac, that together underwrite half of all mortgages in the United States.
Others took the form of private takeovers, such as the purchase of the investment bank Merrill Lynch by Bank of America.
For others like the case of investment bank Lehman Brothers or almost two dozen US regional banks, bankruptcy was the only option possible. In short, we have witnessed an extraordinary transformation in the US banking landscape.
Consequently we have reached a point where the US financial system is facing a substantial confidence problem. At this juncture, according to the US authorities, a series of bail outs is not the answer anymore. A systemic solution is urgently needed.
In the short term, we all need a response that will restore confidence and stabilise markets.
The US plan announced by Paulson last week is a good initiative. In short, the US Treasury Secretary proposes to set up a Federal fund to remove from the banks balance sheets the illiquid assets – those mortgage linked securities that are at the root of the problems we face. Removing these from the system would help to remove uncertainty and re-focus markets on fundamentals.
However, the details of this proposal need to be properly defined – and quickly – if it is to succeed.
I should say that we are talking about a US plan, adapted for circumstances in the United States, where it should be recalled, the crisis originated and where the financial sector has been most severely affected.
But we all have to analyse why this has happened, we all have to cope with the consequences and react to the present situation.
To do this, we first have to understand how we arrived at this point.
The origins of the turmoil we see today lie in the persisting global imbalances in the world economy which created an environment of high availability of liquidity and poor assessment of risks.
The interconnectedness of global financial markets, the high level of leverage and the use of innovative and complex financial techniques and instruments, which were only poorly understood, caused this risk to spread across the international financial system on an unprecedented scale.
What is clear is that market participants, but also regulators and supervisors were unable to properly understand the risks of this situation and therefore could not prevent the consequences that we see today.
True, in the months leading up to the crisis the IMF, the ECB and the Commission, among others, all warned of these underlying risks. We knew this situation was unsustainable. But what we could not know, and what no-one was able to predict, was how, when and just how violently the crisis would be triggered by rising defaults in the sub-prime mortgage sector.
What we are now seeing is the process of the last few years going into reverse, with the financial system grappling with the consequent need to deleverage. Because of the exceptionally high leverage and the scale of linkages between risks, this process of unwinding is proving particularly painful.
The lack of transparency in the system and the inability of supervisors to piece together an accurate and complete picture of the situation, has led to a dramatic fall in confidence.
The financial sector has been most severely affected, as nervousness among banks has caused liquidity to dry up in the interbank lending market.
Several key credit markets remain disrupted and recently there has been a renewed flight to quality among investors accompanied by widening spreads between benchmark bond yields and yields on relatively risky investments.
Thanks to the swift and coordinated interventions by Central Banks, with a relevant role of the ECB, we have managed to avoid a severe liquidity shortage. Nevertheless, banks remain under pressure. The crisis of confidence has provoked a fall in asset prices, compounding the strain on banks balance sheets. Combined with the situation in the interbank market, banks face difficulties to recapitalize.
The situation we face here in Europe is less acute and Member States do not at this point consider that a US style plan is needed.
Taking a medium term perspective, it is evident that we need a more comprehensive structural response. The latest events in financial markets have made it clear that the current model of regulation and supervision needs to be revamped.
In the short term, we rapidly need to address the weaknesses in the current framework. In this respect, the ECOFIN roadmap of regulatory actions and the recommendations of the Financial Stability Forum contain all the elements necessary.
As you know, these include concrete initiatives on enhanced transparency for investors, markets and regulators; revised capital requirements for banking groups and clarification of the role of credit ratings agencies. Work is progressing and the Commission will soon come forward with proposals on a revision to the Capital Requirements Directive and new legislation on Credit Rating Agencies.
But given the latest developments, it is likely that we will need to explore additional issues that have come to light. We will continue to discuss what else should be done to better ensure financial stability and to correct the reasons lying behind this crisis.
Finally, let me turn to the impact of the financial sector crisis on the economy.
There can be no doubt that events in the financial sector are hurting the real economy. These effects have been compounded by the inflationary pressures of rising oil and commodity prices and the severe housing market corrections in some Member States.
This combination of shocks has impacted directly on economic activity via higher costs and negative wealth effects and indirectly via a sharp erosion of economic confidence. The result has been a break on domestic demand at a time when external demand is fading.
Leading indicators on economic activity point to a marked deceleration in the underlying growth momentum in both the EU and the euro area. Against this background, GDP growth for 2008 was revised down significantly in the European Commission's latest interim forecast to 1.4 % in the EU (and 1.3% in the euro area).
At the same time inflation for this year has been revised up substantially to 3.8% in the EU and 3.6% in the euro area. Inflation could, however, be at a turning point as the impact of past increases in energy and food prices gradually fades in the coming months. This could possibly be reinforced by a further downward correction in oil and other commodity prices, although this remains to be seen.
Overall, the economic situation and outlook remain unusually uncertain. Risks to the growth outlook remain on the downside, while risks to the inflation outlook are on the upside.
Indeed, uncertainties are even higher regarding economic developments in 2009, but we expect growth in both the EU and the euro area to remain relatively weak next year.
How should we respond the economic slowdown? The best answer is to make use of all the policy instruments we have at our disposal.
First, in budgetary policy, we must preserve our commitment to fiscal discipline and the rules of the Stability and Growth Pact while letting the automatic stabilisers play their role. In this regard, the reform of the Pact in 2005 is being very helpful.
Second, a clear commitment to implement structural reforms, as defined in the framework of the Lisbon strategy and the National Reform Programs, would be crucial to boost consumer and investor confidence in the short term and improve the resilience and dynamism of our economies in the longer term. Measures to strengthen competition in retail and energy markets and improve the functioning of labour markets would be particularly valuable at this juncture.
Finally, delivering improvements in financial market regulation and meeting the goals of the Ecofin roadmap is, as I have already stressed, more urgent than ever before. An effective and rapid solution to the difficult challenges we are facing could go a long way to restore confidence quicker than expected and limit the damage to our economies.
In each of these policy areas, our actions will be more efficient and effective if we coordinate them at EU and euro area level. Inevitably, we will need to overcome some resistance by Member States to agree common action. Yet, the consensus we reached during the ECOFIN meeting in Nice last month should be deepened and developed.
European countries face common challenges. We will overcome them most effectively if we work together to find common solutions. In this respect, EMU is a formidable asset and we should exploit the opportunities it provides to strengthen coordination, along the lines we proposed in our EMU@10 report and Communication.
However, events make clear that internal European action is not sufficient to confront global challenges. We need to reinforce common external action in the Financial Stability Forum, Basel Committee and G7, as well as devote more attention to the future role of the IMF. Looking ahead, we need to think about how we can shape the future of our financial systems and global governance. And the role of EU in this regard is vital.
Europe can be a driving force behind reinforcing global coordination and should take a leading role in international debates in this area. And this first requires EU countries to work together and agree on internal solutions.
Ladies and gentlemen, thank you for your attention.
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