European Monetary System

package co-ordinated by the Federal Reserve Bank of New York to prevent the

LTCM hedge fund from collapsing is a good example of public intervention

being used to achieve a private solution.

Acting as a "midwife" in brokering a private sector deal is not the

only example of managing crises without injecting public funds. Banking

supervisors have at their disposal a number of tools to intervene at the

national level to limit losses and prevent insolvency when a bank faces

difficulties. These tools include special audits, business restrictions and

various reorganisation measures.

In the euro area, national supervisors and central banks will

continue to be the key actors in the pursuit of market-based solutions to

crises. The Eurosystem, or the Banking Supervision Committee, would become

naturally involved whenever the relevance of the crisis required it.

24. Second, the "taxpayers' money solution". Taxpayers have been

forced to shoulder banks' losses in the past, when public authorities felt

that otherwise the failure of a large portion of a country's banking system

or of a single significant institution would have disrupted financial

stability and caused negative macroeconomic consequences. In such instances

banks have been taken over by the state, or their bad assets have been

transferred to a separate public entity to attract new private investment

in the sound part of the otherwise failed banks. The US savings & loans

crisis of the 1980s, the banking crises in Scandinavia in the early 1990s

and the current banking crises in Japan and some East-Asian countries are

examples of system-wide insolvency problems that have triggered taxpayers'

support. Crйdit Lyonnais and Banco di Napoli are recent examples of public

support to individual insolvency problems.

The introduction of the euro leaves crisis management actions

involving taxpayers' money practically unaffected. The option of injecting

equity or other funds remains available for the Member States, since these

operations are not forbidden by the Treaty. Nevertheless, the European

Commission will be directly involved in scrutinising and authorising such

actions, since any state aid must be compatible with the Community's

competition legislation. This happened, for example, in the cases of Banco

di Napoli and ‚[pic]Crйdit Lyonnais.

The handling of solvency crises is not within the competence of the

national central banks nor that of the ECB, although national central banks

are likely to be consulted, as they have been in the past.

25. Third, the "central bank money solution". This is the lender-of-

last-resort issue that has brought the Eurosystem under vigorous criticism

by distinguished academics and the IMF's Capital Markets Division of the

Research Department. The criticism has been that the alleged absence of a

clear and transparent mechanism to act in an emergency raises doubts in the

markets about the ability of the Eurosystem to handle crisis situations. It

is said that the uncertainty generated by the present arrangements would

entail new risks, including the possibility of investors requiring an

additional risk premium at times of financial market volatility and,

ultimately, of the credibility of EMU being damaged. Two examples of these

concerns deserve an explicit mention. The IMF "Report on Capital Markets",

September 1998, stated that "it is unclear how a bank crisis would be

handled under the current institutional framework …which is not likely to

be sustainable". Similarly, the first report of the CEPR (Centre for

Economic Policy Research) on monitoring the ECB entitled "The ECB: Safe at

Any Speed?" expressly suggested that the Eurosystem lacks crisis management

capacity and is too rigid to pass the A-Class test to keep the vehicle on

the road at the first steep turn in financial market conditions in Europe.

26. My response to this criticism is threefold. To my mind, the

criticism reflects a notion of lender-of-last-resort operations that is

largely outdated; it underestimates the Eurosystem's capacity to act; and,

finally, it represents too mechanistic a view of how a crisis is, and

should be, managed in practice.

27. The notion of a central bank's lender-of-last-resort function

dates back more than 120 years, to the time of Bagehot. This notion refers

to emergency lending to institutions that, although solvent, suffer a rapid

liquidity outflow due to a sudden collapse in depositors' confidence, i.e.

a classic bank run. A bank could be exposed to depositors' panic even if

solvent because of the limited amount of bank liquidity and an information

asymmetry between the depositors and the bank concerning the quality of

bank's assets that do not have a secondary market value.

Nowadays and in our industrial economies, runs may occur mainly in

textbooks. They have little relevance in reality because, since Bagehot,

many antidotes have been adopted: deposit insurance, the regulation of

capital adequacy and large exposures, improved licensing and supervisory

standards all contribute to the preservation of depositors' confidence and

minimise the threat of a contagion from insolvent to solvent institutions.

A less unlikely case is a rapid outflow of uninsured interbank

liabilities. However, since interbank counterparties are much better

informed than depositors, this event would typically require the market to

have a strong suspicion that the bank is actually insolvent. If such a

suspicion were to be unfounded and not generalised, the width and depth of

today's interbank market is such that other institutions would probably

replace (possibly with the encouragement of the public authorities as

described above) those which withdraw their funds. It should be noted, in

this respect, that the emergence of the single euro money market lowers

banks' liquidity risk, because the number of possible sources of funds is

now considerably larger than in the past.

Given all of these contingencies, the probability that a modern bank

is solvent, but illiquid, and at the same time lacks sufficient collateral

to obtain regular central bank funding, is, in my view, quite small. The

textbook case for emergency liquidity assistance to individual solvent

institutions has, as a matter of fact, been a most rare event in industrial

countries over the past decades.

28. What if this rare event were nevertheless to occur and cause a

systemic threat? The clear answer is that the euro area authorities would

have the necessary capacity to act. This is not only my judgement, but also

that of the Eurosystem, whose decision-making bodies have, as you can

imagine, carefully discussed the matter. I am not saying that we are, or

shall be, infallible; no one can claim such a divine quality. I am saying

that there are neither legal-cum-institutional, nor organisational, nor

intellectual impediments to acting when needed. In stating this, I am aware

that central banks may be the only source of immediate and adequate funds

when a crisis requires swift action, while solvency remains an issue and

failure to act could threaten the stability of the financial system.

In these circumstances the various national arrangements would

continue to apply, including those concerning the access of central banks

to supervisors' confidential information. As is well known, such

arrangements differ somewhat from country to country.

29. The criticism I have referred to also underestimates the

Eurosystem's capacity to act. To the extent that there would be an overall

liquidity effect that is relevant for monetary policy or a financial

stability implication for the euro area, the Eurosystem itself would be

actively involved.

The Eurosystem is, of course, well equipped for its two collective

decision-making bodies (the Board and the Council) to take decisions

quickly whenever needed, whether for financial stability or for other

reasons. This readiness is needed for a variety of typical central bank

decisions, such as the execution of concerted interventions or the handling

of payment system problems. Indeed, it has already been put to work during

the changeover weekend and in the first few weeks of this year.

A clear reassurance about the capacity to act when really needed

should be sufficient for the markets. Indeed, it may even be advisable not

to spell out beforehand the procedural and practical details of emergency

actions. As Gerry Corrigan once put it, maintaining "constructive

ambiguity" in these matters may help to reduce the moral hazard associated

with a safety net. I know of no central bank law within which the lender-of-

last-resort function is explicitly defined.

The question of who acts within the Eurosystem should also be

irrelevant for the markets, given that any supervised institution has an

unambiguously identified supervisor and national central bank. As to the

access to supervisory information, the lack of direct access by the

Eurosystem should not be regarded as a specific flaw of the euro area's

institutional framework, as has been frequently argued, since this

situation also exists at the national level wherever a central bank does

not carry out day-to-day supervision.

30. Finally, the criticism reflects an overly mechanistic view of how

a crisis is, and should be, managed in practice. Arguing in favour of fully

disclosed, rule-based policies in order to manage crises successfully and,

hence, maintain market confidence, is almost self-contradictory. Emergency

situations always contain unforeseen events and novel features, and

emergency, by its very nature, is something that allows and even requires a

departure from the rules and procedures adopted for normal times or even in

the previous crisis. Who cares so much about the red light when there is

two metres of snow on the road? As for transparency and accountability,

these two sacrosanct requirements should not be pushed to the point of

being detrimental to the very objective for which a policy instrument is

created. Full explanations of the actions taken and procedures followed may

be appropriate ex post, but unnecessary and undesirable ex ante.

31. So far, I have focused on the provision of emergency liquidity to

a bank. This is not the only case, however, in which central bank money may

have to be created to avoid a systemic crisis. A general liquidity "dry-up"

may reflect, for example, a gridlock in the payment system or a sudden drop

in stock market prices. The actions of the Federal Reserve in response to

the stock market crash of 1987 is an often cited example of a successful

central bank operation used to prevent a dangerous market-wide liquidity

shortfall. This kind of action is close to the monetary policy function and

has been called the "market operations approach" to lending of last resort.

In such cases, liquidity shortfalls could be covered through collateralised

intraday or overnight credit, or auctioning extra liquidity to the market.

The Eurosystem is prepared to handle this kind of market disturbance.

VI. CONCLUSION

32. In my remarks this evening, I have looked at the euro area as one

that has a central bank which does not carry out banking supervision. This

would be normal, because in many countries banking supervision is not a

task of the central bank. What is unique is that the areas of jurisdiction

of monetary policy and of banking supervision do not coincide. This

situation requires, first of all, the establishment of smooth co-operation

between the Eurosystem and the national banking supervisors, as is the case

at the national level where the two functions are separated. The most

prominent reason for this is, of course, the scenario where the provision

of liquidity from the central bank has to be made in a situation that is

generated by problems of interest to the supervisor. But beyond that, I do

not know any country in which the central bank is not very closely

interested in the state of health of the banking system, irrespective of

its supervisory responsibilities.

33. In my view, we should move as rapidly as possible to a model in

which the present division of the geographical and functional jurisdiction

between monetary policy and banking supervision plays no significant role.

I do not mean necessarily a single authority or a single set of prudential

rules. Rather I mean that the system of national supervisors needs to

operate as effectively as a single authority when needed. While the causes

of banking problems are often local or national, the propagation of

problems may be area-wide. The banking industry is much more of a system

than other financial institutions.

34. I am clearly aware that we are far from having a common

supervisory system. But since the euro has just been launched and will

last, we have to look in prospective terms at what needs to be set in

place. There is no expectation, at least to my mind, that the division of

responsibility in the euro area between the central bank and the banking

supervisory functions should be abandoned. Although the Treaty has a

provision that permits the assignment of supervisory tasks to the ECB, I

personally do not rely on the assumption that this clause will be

activated. What I perceive as absolutely necessary, however, is that co-

operation among banking supervisors, which is largely voluntary but which

finds no obstacles in the existing Directives or in the Treaty, will allow

a sort of euro area collective supervisor to emerge that can act as

effectively as if there were a single supervisor. This is desirable in the

first instance to render the supervisory action more effective against the

background of current and future challenges and, second, to assist the

Eurosystem in the performance of its basic tasks.

TABLES

Table 1. Market share of branches and subsidiaries of foreign

credit institutions as % of total domestic assets, 1997

From EEA countries From third countries

TOTAL

Branches Subsidiaries Branches

Subsidiaries

AT 0.7 1.6 0.1 1.0

3.4

BE 9.0 19.2 6.9 1.2

36.3

DE 0.9 1.4 0.7 1.2

4.2

ES 4.8 3.4 1.6 1.9

11.7

FI 7.1 0 0 0

7.1

FR 2.5 NA 2.7 NA

9.8

IR 17.7 27.8 1.2 6.9

53.6

IT 3.6 1.7 1.4 0.1

6.8

NL 2.3 3.0 0.5 1.9

7.7

SE 1.3 0.1 0.1 0.2

1.7

UK 22.5 1.0 23.0 5.6

52.1

Source: ECB report "Possible effects of EMU on the EU banking

systems in the medium to long term" (February 1999).

Table 2. Assets of branches and subsidiaries of domestic credit

institutions in foreign countries

as % of total domestic assets, 1997

In EEA countries In third countries

TOTAL

Branches Subsidiaries Branches

Subsidiaries

AT 2.6 NA 3.7 NA

NA

DE 12.0 7.3 7.8 0.9

27.9

ES 5.5 1.4 2.1 5.9

14.9

FI 5.9 0.3 6.6 0.3

13.1

FR 9.1 6.9 9.4 3.8

29.2

IR 8.3 14.9 1.3 10.1

34.6

IT 7.2 2.7 3.8 1.5

15.2

SE 7.2 NA 5.4 NA

NA

Source: ECB report "Possible effects of EMU on the EU banking

systems in the medium to long term" (February 1999).

Table 3. Concentration: Assets of the five biggest credit

institutions as % of total assets

1985 1990 1997

AT 35.8 34.6 48.3

BE 48.0 48.0 57.0

DE NA 13.9 16.7

ES 38.1 34.9 43.6

FI 51.7 53.5 77.8

FR 46.0 42.5 40.3

IE 47.5 44.2 40.7

IT 20.9 19.1 24.6

NL 69.3 73.4 79.4

SE 60.2 70.02 89.7

UK NA NA 28.0

Source: ECB report "Possible effects of EMU on the EU banking

systems in the medium to long term" (February 1999).

Table 4. Number of branches and subsidiaries of foreign credit

institutions, 1997

From EEA countries From third

countries TOTAL

Branches Subsidiaries Branches

Subsidiaries

AT 6 20 2 11

39

BE 25 16 15 15

71

DE 46 31 31 45

153

ES 33 21 20 6

80

FI 9 0 0 0

9

FR 46 118 43 98

305

IR 18 21 3 7

49

IT 36 4 17 4

61

NL 11 8 11 19

49

SE 14 0 3 1

18

UK 106 18 149 114

387

Source: ECB report "Possible effects of EMU on the EU banking

systems in the medium to long term" (February 1999).

Table 5. Private non-financial enterprises' bonds, credit

institutions' bonds and government bonds outstanding as % of GDP,

1997

Private Credit Government

non-financial institutions' bonds

bonds bonds

AT 2.7 31.1 30.6

BE 10.0 38.3 111.0

DE 0.1 54.6 37.6

ES 2.6 4.5 52.9

FI 3.7 7.1 35.5

IE 0.01 1.6 32.2

IT 1.6 19.4 100.4

NL NA 43.1 53.4

SE 3.6 38.6 46.5

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