Transcript of Governor Philip R Lane's interview with Daan Ballegeer, Het Financieele Dagblad

In several euro area countries populist parties claim their country would be better off without the euro. Lega in Italy for example, sees the currency union as a straightjacket that limits Italy’s self-rule.

Governor Lane: What we have now is a lot of synchronisation across Europe in terms of cyclical factors but income levels differ and monetary policy cannot solve convergence problems: what makes some countries rich and some countries poorer. In the US there are differences across regions and States, and monetary policy is not intended to solve that problem. It is important to recognise what is the role of monetary policy versus the role of other policies. The ECB can deliver its job but its job is not to solve every problem in the European Union.

Let’s consider the counter argument, if the Euro had never come into existence I don’t think that a Europe of 19 extra currencies would necessarily be in a more dynamic situation.

The proposal of the European Commission for sovereign bond-backed securities (SBBS) received a lukewarm reception in countries like Germany and the Netherlands. You led the working group that came up with these SBBS. Are you disappointed?

Governor Lane: Our role as the ESRB was to propose a realistic mechanism to solve the detrimental entanglement of the financial health of banks and the countries they reside in. The idea of SBBS has good potential. With anything that is new and untested there are still a lot of questions. In the end, the European Parliament and the Member States must decide. Let’s see how this goes.

The Netherlands and Germany are said to be against SBBS because Italian banks can still consider the Italian debt on their balances as not carrying any risk. This weighs on the success of SBBS, as Italian banks will still prefer buying the higher yielding Italian sovereign debt.

That is a consideration. But there are several ways in which financial institutions are limited in these kinds of investments. Even within the current legislation, supervisors would have concerns if they see a bank taking excessive risk in its sovereign portfolio. There are also the financial markets. If investors observe banks that are taking excessive risk - no matter what the regulation says - that bank will be penalised.’

Why not just impose concentration limits, where the exposure of a bank to sovereign debt is limited?

Governor Lane: If regulation reinforces the incentives for banks to diversify or take less risk, that will raise the demand for the senior tranche of the SBBS. So clearly there’s an interplay between that and the markets.

The currency union remains a work in progress. There is for example no system in place for budgetary transfers, something academics consider crucial for a sustainable currency area.

Textbook economics says that under normal conditions it is enough for governments to run a sound cyclical fiscal policy. This means running surpluses in the good years and allowing deficits in the bad years. In that case, you would not need fiscal transfers.

However, if there is a severe shock to an economy, it can be advantageous to have fiscal risk sharing. There is a lot of working going on as to whether this is something Europe wants to sign up to. It is a genuine debate but it’s not about whether the euro area needs it or not, it’s a question of what would optimize European performance. Ultimately of course, any risk sharing requires a political agreement.

One of the themes is that the euro area is unique, there is no parallel, so while we can learn lessons from federal systems like Germany and the USA, there are limits because what we have in Europe is 19 sovereigns, each able to issue debt on the market. They are not constrained like US States or Länder in Germany. We really need to think about how Europe works, rather than trying to lift the designs from elsewhere.

Starting off with risk sharing is easier when all participants face similar risks. But some economies are more vulnerable for shocks than others. Why would the more stable euro area countries want to participate in such a scheme?

Governor Lane: Any realistic risk sharing scheme should be set up to avoid permanent or predictable transfers. This could mean that countries with a higher cyclical risk would have to pay more into the common fund than others.

The IMF pointed towards high debt burdens in its recent report, spurred by central banks that have made it cheap for governments to increase their debt.

The IMF is speaking to a global audience that is not customised for the euro area. In the last several years government debt has, by and large, stabilised and fiscal deficits have come down a lot. The post crisis period from 2010 onwards has been a period of austerity in Europe so you can have a situation where the debt problem is not being helped by a low GDP growth rate. If you look at Ireland for example, the fiscal ratio has declined, partly because of austerity and partly because of the recovery. It may be that there is a misinterpretation of what’s happening.

The OECD has warned that central banks are hampering creative destruction by keeping zombie companies alive through their low interest rates. How worried are you about that?

Governor Lane: The zombie company problem is one reason why the ECB, through its supervisory mechanism, is pushing that non-performing loans need to be cleaned up. It is a problem and now that we have a good economic environment in Europe, it would be a mistake not to crystallise any non-performing loans.

A very large proportion of European banking assets are now inside banks directly supervised by the ECB so they have a lot of influence. The wider non-performing loan strategy involves countries improving their insolvency systems, their core properties.

I’m a supporter of the Single Supervisory Mechanism because it means that the decisions are the same area-wide with a level playing field. Decisions are taken because they are economically necessary rather than being subject to political considerations of individual countries. Banks can find a lot of reassurance that the same framework operates across Europe while the application is bank specific.

The consensus among analysts after the ECB decision on June 14th was that Mario Draghi succeeded in giving both the hawks and doves something to cherish. The first group got the end of the bond-buying program by the end of this year, the second one a postponement of the first rate hike until after the summer of 2019. What is your take?

Governor Lane: It is important to emphasise that this was a unanimous decision. When inflation is below target, as it is now, the distinction between hawks and doves loses its meaning because when inflation remains below target it means an accommodative monetary strategy remains necessary. Also, the usual objection to easy money – that it creates risk to financial stability – is now contained. Since the financial crisis, we have extra policy tools. Last week the French raised their counter-cyclical capital buffer. More and more countries are introducing loan-to-value and loan-to-income ratios in the mortgage market. One typical risk factor, which you might claim to be ‘hawkish’, is now managed through these other instruments. That allows monetary policy to focus more directly on hitting the inflation target. It’s hard to disagree with the analysis, inflation is recovering but we are still far below target and continued policy is needed.

Larry Summers argued recently that the neutral rate of interest has declined substantially over the past decades. This limits the room central banks have to stimulate the economy by cutting rates. He argued that therefore the ECB should accept a higher inflation target to stimulate the economy. Do you agree?

Governor Lane: I would not see what he says as a criticism, it is a factual observation that there has been a trend decline in the real interest rate. The fundamental challenge is about being proactive. The interest rate is not our only available tool. We have shown over the past few years that we can engage in forward guidance, push the deposit rate below zero, and do asset purchase programs. So the answer is not necessarily to say that we need a high inflation target but when there is a need for active monetary expansion you use the tools available. For monetary policy the basic answer is not fundamentally to do with the targets but to be proactive to avoid undershoots.

Critics of the ECB see asset price inflation as the main result of the accommodative monetary policy, while ‘real’ inflation has remained subdued.

Governor Lane: We do think that inflation is moving. In fact, it is currently close to target, with an HICP of 1,9% in May. So we are increasingly confident that our policy is working. It is true that we are seeing side effects, but much of the asset price inflation is temporary in nature. As the accommodation gets reversed, so will asset prices. If you are buying a house on the basis of the current level of interest rates, then you should realize that interest rates will not remain low forever. That effect is temporary and should go into reverse as rates normalise. We now have more policy instruments to tackle these side effects.’

Through its monetary policy, the ECB is pushing banks to take more risks by keeping the interest rate margin low. At the same time, in its role as supervisor, the central bank prohibits banks from taking risks in their investments. A paradox?

Governor Lane: Through tougher capital and liquidity regulations and risk-based supervision, the credit decisions of banks are now more heavily regulated. Banks need sufficient capital to absorb losses on bad loans, and also stable sources of funding to contain liquidity risks. With banks constrained, this means that new credit is also being provided by non-bank lenders, so a lot of effort is going into looking at non-banking intermediation. A lot of it is now ‘out of the shadows’ compared to years ago. A lot of these vehicles are also interconnected to the banking system, by the way. It is a balancing act.

According to the Financial Stability Board (FSB), shadow banking activities have risen from $32.500 bn in 2010 to $45.200 bn in 2016. Hedge funds, money market funds and open-ended fixed-come funds do not fall under the same strict regulation as banks. How dangerous is this evolution for the financial stability?

Governor Lane: The financial crisis left me with the strong conviction that there is excessive reliance on the banking system in Europe. So non-bank credit through bond funds for example is desirable, even though we realize that this can create new types of financial stability risks. That remains a continual risk factor, what would happen if there is an exit from these funds. However, that has to be put in context that they do diversify these risks, and that these risks are not concentrated in a particular institution. If many people lose a little money from a bond fund it is quite different from a bank getting into existential trouble. We need to recognise that as long as the core banking system has enough capital and enough liquidity and is being prudentially supervised, that buys a lot of protection.