Jean-Claude Trichet, President of the European Central Bank

European Central Bank President Jean Claude Trichet said on Monday that it was still premature to declare the global financial crisis over, while he provided reassurance that the ECB was well prepared to unwind its unconventional measures in a gradual and timely manner. Meanwhile, Trichet's former boss at the French Treasury, Dominique Strauss-Kahn, IMF Managing Director, also speaking on Monday, said  it is still too early for a general exit from accommodative fiscal, monetary, and financial sector policies. Such exit should instead await a sustained recovery in private demand, as well as entrenched financial stability. The former French finance minister also said that the old growth model under which households in the United States and elsewhere propelled the global economy with their voracious appetite for consumption, is dead - - or at least on its last legs.

"We have halted the freefall in economic activity that we witnessed over a period lasting more than six months after the intensification of the crisis in mid-September 2008,"Trichet said at a Financial Markets Association (Asociación de Mercados Financieros) convention in Madrid. "But the crisis has debilitated the economy."

"As of today, it is still premature to declare the financial crisis over," he said. "But when the appropriate time comes, there should be no concern about the ECB's determination and ability to exit."

"We will make sure that the extraordinary liquidity measures taken are phased out in a timely and gradual fashion and that the liquidity provided is absorbed in order to counter effectively any threat to price stability over the medium to longer term," Trichet assured.

"By so doing, we will continue to ensure a firm anchoring of medium-term inflation expectations."

The ultimate goal of financial reform is clear: the financial sector will have to return to its role of providing the best possible service to the real economy. The fundamental role of financial markets is the intermediation of funds between savers and investors.

During the recent past, Trichet said this function has been expanded by increasing possibilities for diversification: diversification of risks for savers; diversification of funding sources for investors. For a long time, the demand for hedging against economic risk among entrepreneurs has grown in tandem with the growing supply of new and innovative financial techniques. But at some point supply outgrew demand. Financial innovation ceased to facilitate trade and real investment opportunities and started to become self-sustaining. This weakened incentives to conduct prudent screening and a thorough monitoring of loan quality. Credit became plentiful and market liquidity expanded at a pace that could ultimately no longer be justified.

Looking ahead, the ECB president said three steps will be required to a more resilient system:

• First, the tendency for finance to become pro-cyclical even at a system-wide level needs to be strongly mitigated. The quality and quantity of bank capital and their liquidity buffers have to be improved in good times to provide a sufficient buffer for bank equity when the cycle turns. The cyclicality of market economies is inevitable. But the financial system should not be allowed to amplify swings.
• Second, the transparency of the financial structures needs to be enhanced. Informed decisions by market agents are a key element of market economies. Lack of transparency of financial products masked abuse and led to disaster. Looking into the future, all institutions, instruments and markets of any relevance for systemic stability need to enhance risk disclosure.
• Third, once more, incentives need to be aligned. Market participants – traders, loan managers, risk committees and boards of directors – were given strong economic incentives to focus on short-term profits. Long-term value creation was not a concern in the pre-crisis world. Collectively, this has resulted in excessive risk taking. A reform of the executive compensation schemes and practices is an essential part of our effort to secure financial stability.

Last Friday, Lorenzo Bini Smaghi an ECB executive board member, said history showed that the late implementation of “exit strategies” could cause future crises.

Also on Friday, the ECB set tougher standards for asset-backed securities used as collateral for liquidity provided to Eurozone banks. From March, securities will only be eligible if they have a AAA/Aaa rating from two ratings agencies, rather than just one agency as previously.

Jean-Claude Trichet said at a European banking congress in Frankfurt:  "The financial system and individual institutions within it must act now to ensure that a future removal of central bank support can be managed without painful withdrawal symptoms."

In September, the ECB announced it would stop providing loans of three-month dollar liquidity, and its next step is widely expected to be an announcement that an offer of unlimited one-year euro liquidity planned for December will be the last.

In June this year, the ECB conducted the first operation for one year, when it allotted more than €440 billion in this operation. In the second operation, in late September, it supplied banks with €75 billion.

Strauss-Kahn

The global economy remains very much in a holding pattern—stable, and getting better, but still highly vulnerable, IMF Managing Director Dominique Strauss-Kahn said in London on Monday.

Speaking at the annual conference of the CBI (Confederation of British Industry), Strauss-Kahn said the major advanced country areas in particular remain fragile, still dependent on policy support. Financial conditions have improved, but are far from normal.

“Signs show confidence returning, but banking systems in many advanced economies remain undercapitalized, weighed down by leaden legacy assets and, increasingly, non-performing loans,” Strauss-Kahn told the conference of UK private sector employers. “On the household side, weak financial positions and high unemployment will damp down on consumption for some time. And large public deficits add to vulnerabilities.”

Strauss-Kahn said it is still too early for a general exit from accommodative fiscal, monetary, and financial sector policies. Such exit should instead await a sustained recovery in private demand, as well as entrenched financial stability.

“Exit too soon, and you kill the recovery. Exit too late, and you sow the seeds for the next crisis,” he said. “We recommend erring on the side of caution, as exiting too early is costlier than exiting too late.”

As the pace of recovery differs among countries, so must exit strategies differ, Strauss-Kahn stressed. Plans for fiscal consolidation should be the top priority, especially in advanced economies.

A related challenge to exit strategies is managing capital flows to emerging markets. “In many countries, appreciation should be the key policy response. Other tools include lower interest rates, reserves accumulation, tighter fiscal policy, and financial sector prudential measures. Capital controls can be part of the package of measures,” Strauss-Kahn said. “But we should recognize that all tools have their limitations. We should be pragmatic,” he added.

Old growth model is dead

Turning to the sources of future growth, Strauss-Kahn said the old model under which households in the United States and elsewhere propelled the global economy with their voracious appetite for consumption, is dead - - or at least on its last legs.

“If we are to have sustained global growth, somebody else needs to step into the breach. The leading candidates are the surplus countries,”Strauss-Kahn said, noting that China and other emerging Asian economies are shifting from exports toward domestic demand, aided by expansionary fiscal policy.

“But they have some way to go,”he stated. “This shift would be helped by stronger social security systems and higher spending on health and education, as well as reforms to boost access to credit. An appreciation of China’s exchange rate, along with some other Asian currencies, will also need to be part of the package.”

Noting that the financial sector in the advanced economies brought down the whole global economy, Strauss-Kahn called for progress on reforms to make the financial sector a safer, more stable place, without discouraging financial innovation.

Better application of rules

“In addition to better rules, we need better application of rules—and that means beefing up supervision and supervisory capacity,” Strauss-Kahn said. “The new regulatory system must do a better job of avoiding capture and complacency. This is another lesson from the crisis. We also need to address risk management in the financial sector, and break the link between risky behavior and compensation.”

On addressing risk management in the financial sector, he added that it was essential to break the link between risky behavior and compensation. “In this context, we have been asked by the G-20 to look into financial sector taxes. There are a number of ways to think about this, and we will look at it from various angles and consider all proposals,” he said.