Monetary policy and financial stability in the time of Covid-19 - Comment & Profiles -

The chairman of the board of the Bank of Lithuania discusses the stability of the EU financial system through Covid-19 and beyond.

Vitas Vasiliaskas

Vitas Vasiliaskas

Despite the turmoil unleashed by the Covid-19 pandemic, the global financial system has got through the immediate shock, preventing a health crisis from becoming a systemic financial crisis. 

This resilience is, in part, due to the international regulatory reforms implemented over the past decade. In Europe, banks entered 2020 in much better shape compared to the beginning of the global financial crisis. They improved asset quality, strengthened capital positions and increased liquidity buffers. For instance, the common equity Tier 1 (CET1) ratio in the EU banking sector — a key indicator of financial soundness — rose from 9% in 2009 to nearly 15% in the fourth quarter of 2019, well above Basel III regulatory requirements. 

In July 2020, the European Central Bank (ECB) published the aggregate results of its vulnerability analysis of banks directly supervised within the Single Supervisory Mechanism. Even under the adverse scenario presented in the exercise, the weighted average CET1 ratio remains large enough, and banks can generally continue their role of lending to the economy. The results show just how important it was that banks strengthened their capital positions as a consequence of the regulatory reforms implemented following the 2008 crash. In the area of banking supervision, we did not waste the previous crisis. 

The ECB’s monetary response 

The bold and timely response to the Covid-19 shock by the EU’s monetary and fiscal authorities has been perhaps more important still. The global financial crisis and the European sovereign debt crisis have taught the bloc some hard-learned lessons. In the euro area, monetary policy is a supranational competence, while fiscal policy is conducted on a national level. Previously, asymmetric degrees of integration in these policy areas would often prevent the delivery of a coherent aggregate policy mix. This time, fiscal and monetary policies have been aligned, reinforcing each other. 

The ECB has further loosened its already highly accommodative policy stance. Governments have introduced new fiscal support measures while letting automatic stabilisers do the rest of the work. The Pandemic Emergency Purchase Programme (PEPP), launched in March, has been a key part of the ECB’s response. In June, the governing council scaled up the €750bn envelope for the PEPP to a total of €1.35tn — about 12% of euro area gross domestic product (GDP). 

The PEPP has a dual role. First, extra asset purchases ensure that medium-term price stability — our primary mandate — is protected. But there is a second element to the PEPP, in that it permits purchases to be conducted in a flexible manner. This allows the programme to restore monetary policy transmission and perform the market stabilisation function. The PEPP proved successful in this role during the first months after its launch, and the ECB made full use of the flexibility embedded in the PEPP by frontloading asset purchases and directing them to those market segments where they were most needed. 

As a result, the ECB has stabilised financial markets in an effective manner. Crucially, the ECB also acted to facilitate access to euro liquidity outside the euro area to counter potential market dysfunction. For instance, the Eurosystem has set up new precautionary swap line agreements with the Croatian and Bulgarian central banks. We have also established new bilateral repo agreements with the central banks of Albania, Hungary, Romania and Serbia. This is in addition to the launch of EUREP — a repo facility not limited to a particular counterparty, but available to a broader range of central banks. 

The Eurosystem’s swap and repo agreements help the ECB prevent forced asset sales by the receiving central banks, containing the risk of financial instability in the euro area and the neighbouring regions. In other words, these are arrangements of mutual benefit. 

Going forward, the ECB’s governing council stands ready to adjust its instruments or develop new ones to ensure robust convergence of inflation towards our medium-term aim. This includes the possibility of increasing the size of our asset purchase programmes and adjusting their composition. 

In view of high uncertainty regarding the course of the pandemic, monetary support by central banks — as well as fiscal support by governments — will remain vital in the foreseeable future. Policy cliff-edge — premature withdrawal of support measures — would certainly hamper the already fragile recovery and could have a negative effect on financial stability. We should not rush the time of this landing. 

Limits to euro-area monetary accommodation 

This is why the recent European-level decision on the recovery instrument Next Generation EU is so important — it checks all the necessary boxes. The programme will support national structural reforms and public investment. And it will provide macroeconomically significant fiscal transfers to the more vulnerable European economies, largely on the basis of grants, rather than credit. This will help prevent premature fiscal tightening in Europe beyond the end of 2020. 

Member states should not miss this unique opportunity to move towards a more digital, greener and more sustainable future — as foreseen by the recovery instrument. There is no more time for ‘pork barrel’ spending. We must use this crisis to raise the long-term productivity of our economies and to adapt them to the post‑Covid-19 world. From a long-term perspective, the recovery fund can lay the groundwork for a permanent solution. A centralised fiscal instrument with a substantial common debt-issuing capacity would greatly contribute to the resilience of the monetary union and create a genuine euro-area safe asset. 

The importance of macroprudential policy

The Covid-19 shock has also highlighted the vital role that macroprudential policy can play in both preventing and cushioning a downturn. 

Let me go back, once again, to the lessons of the global financial crisis. It showed us that microprudential regulation and supervision alone are not enough to safeguard the financial system. It became evident that boom-and-bust cycles in asset prices required additional instruments.

The crisis was, therefore, a catalyst for the rise of macroprudential policies — including in Lithuania, which was hit particularly hard by the boom-and-bust cycle. Today, Lithuania features one of the most comprehensive sets of macroprudential policy measures in the EU.

Before 2020, critics would say that our macroprudential set-up was perhaps too wide-ranging and excessive. But this crisis showed, I believe, that our policy stance is the right one. Crucially, it helped prevent a deterioration of lending standards and the build-up of systemic risk in the run up to the Covid-19 shock. For instance, the stock of loans to households and house prices were growing in line with GDP and household income.

As a result, our financial system entered the current downturn on a strong footing. And, when the time came, we implemented counter-cyclical macroprudential policy decisions in line with the intended functioning of the framework. On the back of these measures, Lithuania’s financial sector was able to withstand the Covid-19 shock and support the robust performance of the economy.

Overall, I strongly believe that an alignment of different policy areas is desirable. I wonder whether there is a lesson to be learned from this experience: perhaps we can apply it in the future, when this crisis is over, and start thinking in the frame of a better-balanced policy mix. Another valuable lesson is that the proactive use of the macroprudential mandate can help both prepare for the upcoming shocks and deliver a stronger counter-cyclical response — as has been the case in Lithuania. 

Going forward, policy-makers should not be afraid to step into terra incognita and consider new ways of calibrating macroprudential tools in a crisis. In the future, when faced with a shock, it may be possible to relax borrower-based measures to stimulate lending to the real economy by lowering the loan-to-value requirements or applying exemptions to debt-service-to-income limitations. Overall, it is my conviction that there is still plenty we can discover in terms of the deployment possibilities of macroprudential policy. 

Vitas Vasiliauskas, is chairman of the board of the Bank of Lithuania. Adapted from the speech “Monetary policy and financial stability in the time of COVID-19”, October 2020.

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