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ECB's Draghi Rules Out Money Printing

Lionel Barber HKSCKPVIamp; Ralph Atkins, Financial Times
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This is an edited transcript of an interview between Mario Draghi, European Central Bank president, and Lionel Barber, Financial Times editor, and Ralph Atkins, Frankfurt bureau chief.

Financial Times: We are now more than four years into the financial crisis. What lessons would you draw so far? What has gone right and what has gone wrong?

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Mario Draghi: We have to distinguish two stages. First was the financial crisis, with its repercussions for the real economy. I think we learnt the lessons that we need a more resilient financial system, a system where we would have less debt and more capital. There has been substantial progress in designing new regulatory policies and some progress in implementing this new design.

The second stage of the crisis is really a combination of, I would say, a challenging political phase, where euro area leaders are reshaping what I called the fiscal “compact,” and a situation where banks and countries face serious funding constraints. These challenging funding conditions are now producing a credit tightening and have certainly increased the downside risks for the euro area economy.

Action is proceeding on two fronts. At last week’s European Union summit you saw a first step towards fiscal rules that are not only more binding, but actually are of a different nature. They would be binding ex ante, which is an entirely new quality, and written into the primary legislations of the member states.

The second line of action is a set of meaningful, significant decisions taken by the ECBlast week. We cut the main interest rate by 25 basis points. We announced two long-term refinancing operations, which for the first time will last three years. We halved the minimum reserve ratio from 2 per cent to 1 percent. We broadened collateral eligibility rules. Finally, the ECB governing council agreed that the ECB would act as an agent for the European Financial Stability Facility (EFSF) .

FT: Will the three-year refinancing operations give banks an incentive to buy “periphery” eurozone bonds?

MD: Not necessarily. Of course banks also have capital difficulties, and these measures don’t necessarily help them on that side. The objective is to ease the funding pressures that banks are experiencing. They will then decide what the best use of these funds is. One aspiration is to have them financing the real economy, especially small and medium sized enterprises (SMEs). What we are observing is that small and medium sized banks are the ones having the biggest funding difficulties, and they are generally the ones who provide most of the financing for the SMEs. And SMEs account for about 70 percent of employment in the euro area’s corporate sector.

FT: Is this Europe’s version of “quantitative easing” ?

MD: Each jurisdiction has not only its own rules, but also its own vocabulary. We call them non-standard measures. They are certainly unprecedented. But the reliance on the banking channel falls squarely in our mandate, which is geared towards price stability in the medium term and bound by the prohibition of monetary financing [central bank funding of governments].

Coming back to what banks are going to do with this money: we don’t know exactly. The important thing was to relax the funding pressures. Banks will decide in total independence what they want to do, depending on what is the best risk/return combination for their businesses. One of the things that they may do is to buy sovereign bonds. But it is just one. And it is obviously not at all an equivalent to the ECB stepping-up bond buying.

FT: Do you expect, in the next six months, another round of bank recapitalizations and, in some cases, nationalization?

MD: Last week, we had the results of the European Banking Authority (EBA) “stress tests” exercise. But ideally, the sequence ought to have been different: We should have had the EFSF in place first. This would have had certainly a positive impact on sovereign bonds, and therefore a positive impact on the capital positions of the banks with sovereign bonds in their balance sheet. So the ideal sequencing would have been to have the recapitalization  of the banks after EFSF had been in place and had been tested.

In fact, it was done the other way round, so the capital needs identified by the EBA exercise reflect stressed bond market conditions. That may exert pressure on banks to achieve better capital ratios by simply deleveraging.

Deleveraging means two things; selling assets and/or reducing lending. In the present business cycle conditions, I think the second option is by far the worst. I understand regulators have recommended to their banks that they shouldn’t go this way, so let’s hope they follow this advice.

FT: Couldn’t somebody just say to the EBA, look, just hold off now, this is completely unhelpful?

MD: I think the press statement by EBA somehow hints at that, because they say that there wouldn’t be another exercise next year.

To be fair to EBA, the shape of the exercise was decided at a time when the biggest economic threat seemed to be the banking system’s lack of credibility. People feared banks’ balance sheets concealed fragilities that in the end would strain the economies. So they started this exercise thinking that, being transparent, and marking-to-market sovereign bonds, would strengthen the credibility of the banking system and reduce risk premia. At the end, it did not work that way because of the sequencing. But I wouldn’t say it’s EBA’s fault.

FT: The big point here though is, at least the world in 2011, has fundamentally changed, if not for the last two years, where a position where equities would be seen as more risky than government bonds is now in reverse….

MD: The big change is that assets which were considered absolutely safe are now viewed as potentially unsafe. We have to ask what can be done to restore confidence. I would say there are at least four answers.

The first, lies with national economic policies, because this crisis and this loss of confidence started from budgets that had got completely out of control.

The second answer is that we have to restore fiscal discipline in the euro area, and this is in a sense what last week’s EU summit started, with the redesign of the fiscal compact.

However, we are in a situation where premia for these risks overshot. When you have this high volatility — like we had after Lehman — you have an increase in the counterparty risk. In the worst case, you can have accidents and even if you don’t have accidents, you have a much reduced economic activity because people become exceedingly risk averse.

So the third answer to this is to have a firewall in place which is fully equipped and operational. And that was meant to be provided by the EFSF.

The fourth answer is to again ask: why are we in this situation. Part of this had to do with fiscal discipline, but the other part was the lack of growth. Countries have to undergo significant structural reforms that would revamp growth.

FT: And the fifth answer is that the idea of introducing private sector involvement (PSI) in eurozone bail-outs was, in retrospect, a mistake?

MD: The ideal sequencing would have been to first have a firewall in place, then do the recapitalization  of the banks, and only afterwards decide whether you need to have PSI. This would have allowed managing stressed sovereign conditions in an orderly way. This was not done. Neither the EFSF was in place, nor were banks recapitalized, before people started suggesting PSI. It was like letting a bank fail without having a proper mechanism for managing this failure, as it had happened with Lehman.

Now, to be fair again, one has to address another side of this. The lack of fiscal discipline by certain countries was perceived by other countries as a breach of the trust that should underlie the euro. And so PSI was a political answer given with a view to regaining the trust of these countries’ citizens.