11/17/2021 | Press release | Distributed by Public on 11/17/2021 10:44
Thank you very much for giving me the opportunity to speak on this occasion. The topic of this conference comes just at the right time. Ultimately, financial stability means nothing less than a functioning financial system. This, in turn, is the basis for sound fiscal and monetary policy. The Corona pandemic has clearly shown how closely these policy areas interact, and how they support each other:
First, extensive fiscal and monetary policy responses to the Corona pandemic have cushioned its impact on the real economy, thereby - indirectly - protecting the financial system. This has supported financial stability.
Second, vulnerabilities in the financial system with regard to adverse shocks continue to build up. As we are leaving the phase of acute crisis management behind, this reinforces the need to take preventive action in order to mitigate future risks to financial stability.
Third, structural change arising from climate change, demographic change, and digitalization requires a resilient financial sector. Ensuring financial sector resilience should be a policy priority - precisely because it ensures that fiscal and monetary policy can play their respective roles in dealing with the challenges that lie ahead.
Let me explain these points in more detail, drawing on the experience of Germany and Europe with responses to the crisis.
The Corona pandemic is a truly global shock that hit rather unexpectedly. Overall, the coronavirus pandemic had a stronger impact on economies worldwide than the global financial crisis. Ex ante insurance in the private sector was hardly available. In the initial phase of the pandemic, many firms in the real economy reported severe liquidity problems, in particular those in sectors affected by containment and lockdown measures.
Governments around the world responded resolutely and swiftly to stabilize the economy. Fiscal measures such as loan guarantees, direct transfer payments, or tax relief measures supported the liquidity and solvency of businesses and households. Monetary policy ensured favourable financing conditions for banks and financial markets. Supervisors used flexibility within the regulatory framework to temporarily relax balance sheet constraints and allow the banks to continue lending to the real economy. The financial sector entered the pandemic with stronger balance sheets, also thanks to financial sector reforms of the past decade. This alone, however, would have been insufficient to fully absorb the shock of the pandemic. Taken together, policy responses to the crisis provided ex post insurance against the Covid-shock. Policy coordination has worked well - both across policy areas and across countries.
In Europe, the size, uptake, and structure of fiscal measures differs across countries. In May 2020 the European System Risk Board (ESRB) has issued a recommendation to collect information on Covid-related fiscal measures and to monitor the financial stability implications. [1] Generally, the announced size of programmes significantly exceeds the amount being taken up, and there has been some heterogeneity in terms of the measures used across countries.
Work done by the ESRB shows that COVID-related fiscal measures have contributed to supporting financial stability.[2] The financial system has continued to provide funding to the real economy, and bank losses have been contained during the pandemic. Yet, the longer the crisis lasts and the weaker the economic recovery will be, losses to the non-financial sector could spill over to financial sector balance sheets. The report thus identifies three policy priorities:
In Germany, guaranteed loans, federal subsidies, and short-time allowances were the most important fiscal measures. Many firms made use of more than one measure at the same time, such as bridge loans and direct transfers. As the economy recovers from the pandemic, many of these measures are scheduled to be phased out and firms report less need for fiscal support.
Bank capital remained largely unaffected as policy measures have contained credit losses. While GDP declined by 5% in Germany in 2020, banks did not report significant losses. Broad-based corporate insolvencies could have resulted in large-scale losses for banks and triggered a pro-cyclical amplification of the shock through the financial system. This has not happened. Bank capitalisation relative to risk-weighted assets even increased slightly. The increase in the Tier 1 capital ratio partly reflects that many new loans were covered by government guarantees and that some supervisory constraints had been relaxed.
As the global economy recovers from the pandemic, vulnerabilities with regard to future shocks need to be monitored. Debt levels in the private and in the public sector have increased, which weakens resilience against adverse future developments. In Germany, the structure of credit portfolios of banks had shifted to firms with relatively higher credit risk as compared to the overall pool of borrowers. As debt levels have tended to increase, future credit risks might increase as well.
Despite the brighter outlook, risks to the macrofinancial environment remain. A more persistent rise in inflation that is currently expected could lead to increasing risk premia and interest rates.[3] This could trigger corrections in financial markets and expose vulnerabilities in the financial system. The ongoing low interest rate environment provides incentives to search for yield, and it encourages risk-taking. For Germany, the early warning indicator calculated by the Bundesbanksignals increased financial stability risks. The increase in this indicators is driven primarily by an increase in the credit-to-GDP gap and increased house prices. The upswing of the financial cycle has thus hardly been affected by the pandemic.[4]
Given the exceptional policy support during the pandemic, the impact of future macro risks on the financial system could be underestimated. In Germany, the correlation between credit risk and GDP growth has been around 30-55%, depending on the sector considered, over the past years. This correlation has fallen significantly during the pandemic. Also, the correlation between corporate insolvencies and GDP growth has been much weaker in the past two recessions than up until the early 2000s. Based on this experience, market participants may adapt their expectations and assume that future recessions will have similarly benign effects.
Looking ahead, structural change is likely to pick up speed. Climate change, the digital transformation, and demographic change pose challenges for the real economy and the financial sector. Some of these trends have been accelerated by the pandemic.
Dealing with these future challenges requires a resilient financial sector. A resilient and stable financial system ensures that monetary, fiscal and macroprudential policy can focus on their respective mandates e.g. price stability. To enable the financial sector to fulfil its macroeconomic functions, it must be in a position to tackle future challenges:[5]
Going forward, I see the following policy priorities:
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