Play misty to me! Basil Venitis asserts that I play a confidence game with you! A confidence game is defined as an attempt to defraud a person or group by gaining their confidence. The victim is known as the mark, the trickster is called a confidence man, and any accomplices are known as shills. Confidence men exploit human characteristics such as greed, vanity, honesty, compassion, credulity, and naivete. The common factor is that the mark relies on the good faith of the confidence man.
My mission is to instill confidence in you about the economy while simultaneously instilling confidence in you about the abilities of ECB itself. Central bankers are almost always publically bullish and hardly ever publically bearish about the economy. The economy always looks good, if not great. If there are some problems, don't worry, ECB will come to the rescue with truckloads of money, lower interest rates, and easy credit. If things were to get worse, which they won't, ECB would be able to respond with monetary weapons of mass stimulation.
Systemic risk can be defined as the risk that financial instability becomes so widespread that it impairs the functioning of a financial system to the point where economic growth and welfare suffer materially. The crisis that we have experienced over the last three years is an overwhelming case of the materialisation of systemic risk. Whereas many of the risks that played a role in the crisis were identified by central banks and official international financial institutions, not enough attention was paid to the ways in which these risks could combine and reinforce each other so as to lead to a severe systemic crisis.
The European Central Bank(ECB) thus welcomes the agreement to create the European Systemic Risk Board(ESRB), a body designed precisely to deal with risks that develop and interact in a way that can endanger the financial system as a whole. The ESRB will start its operation in January next year. The core of the ECB's policy support will be undertaken by a new unit to be established, the ESRB Secretariat. This new unit will be closely connected with the ECB, the Directorate General Financial Stability and other business areas. But at the same time, the Secretariat will have its own status and operate under the guidance of the ESRB. ESRB, together with its governance and sub-structures, is a body of its own.
The ESRB is complementary to other institutions. It does not replace the functions of any existing institution, be it a supervisory organisation or a central bank. The task of macroprudential oversight of the EU financial system is a new one, and the ESRB will have to interact very fruitfully with other competent authorities in the area of financial supervision and regulation. To this effect it is part of the European System of Financial Supervision(ESFS), together with the new ESAs and the national supervisory authorities.
The orientation of the ESRB's policy actions is also new in terms of early warnings and recommendations to contain systemic risk. Systemic risk analysis and macroprudential policy have to consider all elements of the financial system and how they interact with each other and with the economy as a whole.
This is an important point about the scope of the new body, which I could not stress more. One lesson from our experience of the crisis is that there should not be any "pockets" of financial systems that are not considered and understood for their implications for financial stability. Another lesson is that we have to understand better how regulatory instruments act at the level of the system as a whole, beyond their effectiveness at the level of the individual intermediary or market.
For the ESRB to be effective, the quality of the analytical input – an area to which this conference intends to make a contribution – and the clarity and specificity of the strategy to issue and follow up on warnings and recommendations will be essential.
Accordingly, we at the ECB, in collaboration with other future ESRB member institutions, are working intensively on further developing the conceptual and analytical underpinnings for macroprudential policies. Several analytical approaches for the identification, prioritisation and warning about systemic risks are available. We have systemic risk indicators and early warning models, macro-stress testing approaches and contagion or spillover models. We are continuously trying to improve them and keep them at the frontier of research knowledge.
But we also need to be conscious that the economic models we – and other policy authorities – have at our disposal do not necessarily capture all the relevant dimensions of systemic risk. The research community can make a significant contribution to rectifying this. Existing approaches should not only be improved gradually, but also some fundamental gaps should be filled.
Let me give you three examples. First, many standard macroeconomic models do not have well developed financial sectors and are mostly linear in nature. Therefore, they cannot easily capture widespread financial instability. As a consequence, they were not able to predict the drastic downward revision of growth figures we experienced during the crisis.
Second, a greater understanding is needed of how financial regulations act at the aggregate level, both in containing systemic risk and in affecting the growth potential of economies. This would allow a more precise "calibration" of policy recommendations that would have to been made in the ESRB context, for example.
Third, the systemic importance of non-bank financial intermediaries is not explored as well as systemic banking risk. But we do need to include the roles of large and complex insurance corporations or highly leveraged financial players and their interactions with banks in our overall judgements about relevant system-wide interactions. For example, the impact of a large pool of "hyperliquid funds" that can shift allocation in global markets in real time is not yet fully understood, and it would be valuable to see it captured in financial models.
Venitis points out other financial institutions, such as AIG, Bear Stearns and Merill Lynch, invested in the same products and made the same mistakes as Lehman Brothers. When the government saw banking chaos headed its way, it decided to sacrifice one institution in order to get the Senate to pass the planned banking rescue package. Uncle Sam took Lehman Brothers' head, put it under water, and then watched the bubbles. Today, banks are in better shape than they were two years ago. Their balance sheets are cleaned up, and they carry less risk. Not because of finance reform, but out of fear.
Venitis asserts the Fourthreichian bank stress tests are a hoax! Fourth Reich(EU) wasted an opportunity by not pushing harder criteria and by leaving important crisis scenarios out of the tests, such as Eurokleptocracy, gigaregulation, Antitrust Armageddon, gigataxation, especially VAT, a real estate crash, the collapse of certain markets, and total defaults of PIGS. The hoodwinking test did not bring any real insights. The whitewashed test criteria prevented what could have been an opportunity to really clean up the banking sector. Stress tests were never expected to show massive capital shortfalls, as banks have also already raised about 300 billion euros since the start of the crisis, which includes about 170 billion euros of government support to 34 banks.
Venitis notes one scenario used in the fake stress test was a drop in the value of Fourthreichian government bonds. The test assumed a 23% drop in troubled Greek bonds relative to their levels at the end of 2009. Five-year German government bonds, on the other hand, dropped just 4% in the scenario. The writedowns, only done on paper, were based on the securities that are already listed in the banks' account books in which all securities that are meant for sale must be listed at their market values. But most government bonds are held in the bank book, meaning they are not intended for sale but will be kept until they mature. Bonds held in the bank book were not included in the test.
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