 Welcome to the ECB podcast bringing you insights into the world of economics and central banking. My name is Michael Steen and in today's episode we're looking at financial stability. The coronavirus pandemic is shaping our economic and financial environment. Massive policy support has lessened the economic impact of the virus but as Europe goes through a second wave of rising infections and lockdowns the prospect of a new economic downturn is again a cause for concern. And one aspect that we'd like to explore a bit more is the functioning of the financial system and financial stability. Our first guest today is John Fell from our financial stability department at ECB. John, welcome to the podcast. Thank you very much Michael. So we're talking about financial stability. At first glance that might seem pretty self-explanatory, essentially a stable financial system that's made up of companies and households, banks, stock exchanges, payment systems, financial markets and so on. But John, could you maybe talk us through a bit what it means and what your definition is and what we expect from a stable financial system? Sure. What I think the first thing to say is that financial stability is often defined with reference to its opposite. So the reason for that is financial instability is easier to observe. Features often include collapses of asset prices, bank failures, runs, credit crunch, higher unemployment. It's more challenging to characterize financial stability. Now I think three necessary elements to ensure financial stability and that they're actually described in a special feature article that myself and Gary Shinazi who was at the IMF at the time published in the June 2005 financial stability review. Okay, we'll put that in the show notes so you will link to it. And we basically characterized three different elements. So the first is financial intermediation between savers and investors is being facilitated. So savers are putting money on deposit in banks and then it comes out the other end as loans. And then the risks are being priced appropriately. The second element is that the management of risk within the financial system. So here I mean for example financial intermediation takes place not only between banks and their non-financial sector customers but also between banks themselves, between financial institutions, between institutions and markets. The condition would be that that management is efficient and effective. And then the third, and I think it's probably the best known that the financial system is capable of absorbing shocks so that financial intermediation is not interrupted. Now that probably sounds a bit abstract. So I'd like to use a metaphor to explain what I mean. So consider a cyclist on a bicycle. Now the cyclist is the real economy and the bicycle is the financial system. And the cyclist wants to get from A to B. And so it's not to complicate matters, let's say we're going over a flat terrain. Now we impose one constraint on the cyclist. The cyclist is not allowed to let her feet touch the ground. So what happens if the cyclist stops pedaling? Well she'll fall off. She'll fall off. So instability. What happens if the chain breaks? It's going to fall off again. Again instability. And then third, suppose the tires on the bicycle are very thin. What happens if the cyclist runs over a nail causing a puncture to warn her both of the tires? Going to fall off again. Again instability. So the concept of financial stability has many dimensions and it's complex to analyse. But those three elements when they come together ensure that you have a stable financial system. So any of these problems on the bike basically can lead to a bigger failure. So a small thing going wrong like a puncture leads to a bigger failure which is the rider falling off the bike. That's right. So we're talking then about balance and the system not being thrown out of balance. Can you tell us about some episodes in history where we've seen that loss of balance in other words when we've seen financial instability? Well I think I mean probably the one that people have been most familiar with before the COVID-19 shock was the global financial crisis in 2008-2009. I think that can be analysed through the lens of the cyclist bicycle metaphor that I've just explained. So first it had its origins in a US housing market boom where easy access to mortgage finance stoked a bubble and then that bubble burst. And that was channel one, the cyclist stopped peddling. Second then within the financial system banks had become overly reliant on short-term unsecured interbank funding and banks had repackaged mortgage loans into securities with higher credit risk than the investors realised. When the housing market bubble burst banks became wary of each other's exposures to the housing market and they stopped lending to each other and the values of mortgage-backed securities collapsed as well. And so that was channel two, the bicycle chain broke. And then third when the losses came it turned out that banks had insufficient buffers, both liquidity and capital to absorb the losses. And the end result was a credit crunch which fed back to the real economy as some borrowers were unable to obtain the credit that they needed. Now that was channel three, the tires were punctured. So in the global financial crisis almost everything that could go wrong did, the cyclist stopped peddling, the bicycle chain broke and the tires were punctured. So if we fast forward to today and we're seeing this economic shock brought on by the coronavirus pandemic which is comparable if not greater magnitude but there's also a lot of differences. I mean this is mainly a health crisis as the global financial crisis as you were just describing had its roots very much in the financial system. We've talked a lot about the pandemic already but in this series of podcasts but in terms of financial stability how has the pandemic affected the financial system? We've seen a lot of sectors have suffered but has it actually thrown the financial system out of this balance? So I mean as you quite rightly said Michael that the shock clearly came from outside the financial system and the initial impact was a substantial across-the-board fall in equity prices and a widening of credit spreads in corporate bond markets. Sectors that are most vulnerable to social distancing so airlines, hospitality, recreation etc were hit particularly hard, banks were also hit disproportionately and as we often see investors wanted their money back when they saw losses in their investment fund accounts and this caused something resembling a run on investment funds and then at the same time firms seeing their cash flows collapsing because they were not earning revenue because of social distancing measures they needed cash to pay their bills that resulted in a dash for cash and all of that fed back into financial markets causing asset prices to fall even further. Now that was in March. The turbulence didn't last very long as policy-making authorities and that included fiscal, monetary and prudential came up with a vigorous response so the conditions did not get out of hand and so the liquidity stresses were addressed and that was also thanks by the way to the range of monetary policy actions that the ECB itself took but we don't think that all the challenges are now resolved as we expect for example non-performing loans to rise and we have concerns at present about the levels of indebtedness in the sovereign and corporate sectors which could grow even further. Now I should say that twice a year the ECB produces a financial stability review and we've actually timed the release of today's podcast with the latest one and it seems that one of the messages from the latest review is that the financial system was in a better position to maintain financial stability this time around. You've already touched on that a bit but can you expand on that a little bit more please John and talk a bit more about the differences that we're seeing this time to last time. Sure okay well I mean I think the first point that is important is that the shock didn't originate within the financial system but we had been warning for some time at the FSOR now this is pre-COVID-19 that there were important sources of risks and vulnerabilities for financial stability and that this would have been in the issue of last November of 2019 and issues before that and we had been highlighting for some time four main risks our sources of risk and those were first search for a yield in financial markets which had compressed risk premium so going back to the cyclist bicycle metaphor that was channel two vulnerability to the to the bicycle chain breaking and that was just to explain that a little bit more that's investors looking for places to get returns and the essentially low interest environment meaning that becomes very difficult. Yes absolutely yes so I mean we've seen for example the currently the fraction of fixed income instruments globally that are paying two percent or less is about 90 percent of all bonds outstanding in the world are paying currently two percent or less so it's very hard to get to get a return above two percent unless you're prepared to take on more risk and of course what that does by taking on additional risk it creates this vulnerability of the bicycle chain breaking. The second risk was low bank profitability and this would be channel three some weaknesses in the tires so the ability of the banking system the banking system had going into COVID-19 very high and comfortable capital ratios but you know the economy is dynamic the banking system needs to be dynamic as well it needs to grow its capital over time and the primary source of growing capital is through profitability and if the banks are unable to earn a decent rate of return on their investment then the ability over time to retain those buffers becomes compromised so that's channel three as I said weaknesses in the tires. A third was debt sustainability concerns and we have been flagging both sovereign and corporate indebtedness as sources of possible risk for financial stability that would be channel one the peddling and then finally the fourth way is we had concerns about resilience of the investment fund sector the shocks that was another weakness in channel three and that we actually saw materialized and in fact in many ways all of the risks that we had identified in the november 2019 financial stability review those vulnerabilities were to some extent unraveled but that said several factors prevented a full blown financial crisis including as I said the very comfortable capital and liquidity buffers of banks entering into the crisis central counterparties or ccps mitigated counterparty risks as well so the tires of the bicycle were thick going into covid 19 and the vigor of preventative policy action also contained the financial system impacts before it got out of control. John thanks very much I don't know if you came on your bike today but if you're going home I wish you a safe trip on it and thanks for for explaining that to us. Thanks a lot Michael. Next we're going to go into a bit more detail on the subject of businesses and our next guest Tamara Shakir who also works in the ECB's financial stability department has been looking into this topic for the financial stability review tomorrow welcome to the ECB podcast. Thank you, glad to be here. Now lockdowns across Europe and also globally have had a huge impact on companies forcing many businesses to simply shut up shock for several weeks or sometimes even months. Which policy measures in particular have helped them stay afloat? There have been a huge range of policy measures that have been implemented in the wake of the pandemic and right across the euro area and they varied across euro area countries some of them have actually been really special as well and represented governments in particular recognising what they were facing early on. So I might start with those. There have been some ones that are pretty classic policies that happen as soon as economic downturns begin around taxes falling and that giving companies more room for manoeuvre but also we've seen the implementation of a lot of special schemes and there's two that I probably draw attention to one for example has been the short-time working schemes of various forms across the euro area which is where governments have supported companies in keeping their employees on the books and helping take some of the wage bill pressure off them and what that's done is it's allowed companies to avoid laying off their staff permanently for what might be a temporary shock and as a result that's helped keep employment going and it should allow us to recover faster but it's also helped a lot of families keep income coming in even if the company they work for is going through a tough time. Okay and those typically mean that so the employee gets told we only need you for say four days instead of five days but the government also helps pay part of the wage. Exactly so the short-time working scheme so for example you might reduce the amount of hours that you ask an employee to work rather than laying them off entirely. So yeah so there's a cut in working hours but you've still got a job but you've still got a job and you've still got income coming through and that helps households and it's also helped companies not have to lay off staff because laying off staff is also expensive especially if later on you then have to try and recruit them and if you had to do that process then the recovery could be even slower when it eventually comes because companies would have to go through that whole process so that's been one area of policy. The other one that we pay a lot of attention to particularly in the financial stability review is that governments have been helping banks to lend to those companies through offering guaranteed loans so that's where a bank at the current time might naturally be a bit reluctant about lending to a company that it doesn't know if it's going to survive after the pandemic or how its business might need to change so the governments have said look we'll take on some of that risk for you and they've offered these guaranteed loans and that's been huge actually so we've seen a lot of the lending that's been happening in recent months has been backed by these government guarantees and there's also been what they call moratoria and loans which has allowed people to take a break from their loan repayments for a while as we go through the pandemic on the basis that eventually they'll be able to recover and return to paying the loan and that's affected by companies and households actually. Do we look at most of these then as quite successful policies? We look at them it was really important yes they've been significant they came into place really quickly so you hopefully have reduced what we call scarring effect so there's been this real concern that what is should be a temporary and temporary may mean one or two years at the rate we're going but a temporary episode of the pandemic doesn't have really long lasting effect of companies that were perfectly viable failing or people losing their jobs and then having to go and find another job in the future. You talked about this scarring idea so in terms of the rise in unemployment what's the assessment there? So we have seen that pickup in unemployment which is tough for the people who've been laid off but it's better than it might have been so if you looked at the size of what's happened the amount of companies that've had to shut their doors effectively as you said during the spring you might have expected a lot more people to have lost their jobs and we haven't seen that. So what I'm hearing is that we've got through this first phase of this crisis quite well really and in terms of if you're putting your financial stability hat on financial stability was more or less being preserved so far right? Yes so to the extent that if you might have worried that banks really would have shut the taps on loans to companies at households right at the point where they needed it that didn't happen and so that's been a real success and on top of that although it's early days we haven't seen banks failing so this whole thing could have made a whole lot worse if on top of everything we'd seen banks having weak balance sheets and coming under real pressure but because of the efforts over the last decade since the last crisis to put resilience into bank's balance sheet to have them build up their capital positions in particular they look pretty ready to withstand a lot of what's to come. Okay so as we look into this sort of second wave we're in a sort of relatively good position but of course I mean you and your colleagues are paid to worry about these things so what are the kinds of things that you'll be looking at in the next few months would you say? So I am a bit worried about a few things hopefully we get the vaccine or some other measure and the pandemic starts to abate even if that happens though we can't take away the fact that there's been a big impact from this pandemic and what we need to see is for example going back to companies which of those look like they have had such a big change in their business model that maybe they can't quite survive or operate the way that they were operating before all this happened and obvious question might be how long will it take before for example restaurants can think about having the same number of people that they used to have on a given evening and if that number falls fairly permanently or for quite a long time then that affects their margins and they have to have some deeper thinking about how they run their business and that would be the same as true for a whole host of businesses that centre around social leisure and interaction and you know if you think this year every single major music concert has been cancelled right every big festival every big thing that's all thinking about what does that look like in the future will I ever be in a crowded nightclub again and the companies running those kind of businesses those kind of businesses they just that they may have survived so far but there could be question marks over whether they do and what that means for those of them that have borrowed money we're going to have to have a look and see what does that mean for those loans and then what in turn are the knock-on effects for banks from that and that in turn will help. Right so they get to the point where they can't pay the loan off anymore and then the bank has to declare that a bad loan and then if there's too many of those for a bank that becomes a problem for the bank. It can do yes I mean when we've looked at it one of the things that gives us real confidence is we think a lot of our banks are in in pretty decent shape so they have the buffers that should be able to take actually quite sizeable losses and that's not an accident that they have those buffers that's been the consequence of a concerted effort by people over the last decade to improve the position of the euro area banking system. Also by ECB banking supervision we should say on the ECB podcast I guess. Exactly and so that means that we go into this in a pretty good position it is a big shock though and so we need to see in what that really looks like we hope that banks themselves also start to make that assessment fairly soon and can start form what we call in a good assessment themselves of what's the expected losses that they might take on their books and they've been doing that already to varying degrees then I think that's something we look at in the financial stability review. You asked about what I'd be worried about in the future the other consequence of course is even for companies and households that make it through they are probably going to be carrying a bigger debt burden and also governments are going to be carrying a bigger debt burden and that's all sort of manageable to a certain extent particularly because financing costs have been really low partly related as well to the ECB but nonetheless those debt positions need to be reckoned with in some form hopefully when the economy recovers that will do a large part of the job but we've got to keep an eye out on our side and one of the things I think we are particularly mindful of is a situation where you've got a group of companies that need to look at their situation you've got banks that have taken on debt in order to help those companies through and they've done a lot of that through the banking system and by offering those loans also we're keeping a careful watch out on the fact that there's this growing interlinkage between the corporate sector the governments and the banks. I mean that's a bit of a reminder of the last crisis with the so-called sovereign bank nexus where countries started getting into trouble because their banks got into trouble because the banks had a lot of debt from those countries. Are we in a different world now or is that also a concern? It's always tempting to say we're in a different world now isn't it? I think there are genuine reasons to think parts of that old sovereign bank nexus shouldn't worry us too much and a lot of that is to do with a combination of both monetary conditions but also actually the action of Europe. So the European recovery program that's been put forward should provide a lot of support to countries that may need it at certain points in time to avoid the kind of single country risk that we saw in the sovereign debt crisis. So you've talked a lot about the support that's being offered is one of the worries also about how that support ends or how quickly it stops? Yes so we have seen governments show a lot of commitment to being there for companies and households at the current time and we've seen some schemes extended but when we look at what's been announced so far a lot of schemes some schemes have actually ended already and a lot of them are due to end over the course of 2021. If the economy is recovering well by the time they end it should all be fine but there is some risk that if all of these policies which are doing a massive amount to underpin everything together all ended at once it's sort of pulling the rug from under people's feet that could weigh either on the recovery so it could mean that companies and families and households have to reckon a little bit with that change in their income and the support they're being offered. A sort of more tail risk event that we might worry about is this sort of an accident of a bit of policy makers in different countries withdrawing things not realizing kind of that they're pulling as much support away from the economy all at once and that and it may be if the economy is economic recovery is more fragile than we realize it could have an even bigger effect and almost take us back a step before we go forward. The other reason to be worried about it is as time goes on it seems very likely that there will be some policy makers in different parts of the system who might find that they don't have as much room to deal with things as they'd like and particularly fiscal room and that might become an issue. So there's all risks of support being taken away too suddenly I guess on the other hand there's kind of also because there's risk everywhere a risk of the support staying in place for too long would you say sir? That is something that as time passes you'd get a bit more worried about and are there probably particularly businesses that are too reliant almost on the support and it becomes harder to tell whether they're really viable if you take away the support. It might not be seen as the best use of public resources if guaranteed loans are being made to companies that don't have a long-term viable business model and that can be hard to see right now because we don't have all the information about where things are going so both banks and governments are making these decisions sort of in good with good intentions about giving everyone a chance but in the long term at some point we'll have to see which businesses need to adjust and how they need to adjust and or if everything returns to the world of 2019. Okay thank you very much Tamara so really a lot to think about there and thanks for joining us on the podcast. Thank you. That brings us to the end of this episode we've seen that in the face of this extreme shock financial stability and the balance within the financial system have been largely preserved funds have continued to flow to those who need them thanks to monetary fiscal and supervisory policy supports and the fact that banks are well prepared. Businesses and households have in general been able to keep their assets avoiding an economic fallout similar to that seen during the great financial crisis. We're linked to the ECB's latest financial stability review in the show notes as well as other related information we'd love to hear your feedback and thoughts for future episodes via social media. You've been listening to the ECB podcast with Michael Steen if you like what you've heard please subscribe and leave us a review until next time thanks for listening