Of course, determined efforts are required on the part of EU governments to reach a consensus on improvements in governance – particularly on the rules governing budgetary policy in the monetary union – and on the provision of bail-out funds. While the discussion and decision process surrounding these matters are often regarded as a weakness in the governance structure, it must also be recognised that the changes involved represent significant levels of assistance to programme countries and also touch directly on issues related to sovereignty. It is perhaps ironic that current problems are in part a side effect of the success of the monetary union, and the benefits it brought about. More precisely the crisis has also been triggered by the misuse of the benefits of monetary integration. The new currency reduced the cost of borrowing in several countries, as credit spreads narrowed and exchange rate risk on intra-euro area borrowing was eliminated.1 The reduced cost of financing public as well as private debt was reflected in higher government debt and private sector leverage. In the wake of risk repricing by the financial markets, there is now the strong tendency for market operators to unwind their holdings of public and private sector debt. This can be seen in Chart 1, which shows as an example the ensuing reduction in the leverage of monetary and financial institutions. The deleveraging process could set the stage for a deterioration in economic conditions. However it also serves to correct past excesses.
It is therefore essential that, while staying abreast of innovations in the financial world and taking on the changes that are required to stay competitive and improve efficiency, the domestic banking sector must also continue to build upon the strengths of the traditional model. By contrast, the financial turmoil of recent years has had a negative effect across many countries, particularly on financial institutions that rely on wholesale funding sources. In response to the rapid drying up of the interbank markets and with liquidity abruptly disappearing in many key financial markets in the euro area, the Eurosystem has for the past three years been implementing a broad programme of enhanced credit support. In particular, the Eurosystem has been providing liquidity on a fixed rate and full allotment basis and has also extended the maturity of its re-financing operations. These non-standard measures have been instrumental in avoiding a credit crunch and supporting financial stability. These measures are designed to ensure an effective transmission of monetary policy – to maintain the flow of credit to the real economy, avoiding liquidity problems and supporting growth in productive activity. However, there may be instances where the availability of these funding sources may induce some credit institutions to embark on alternative business models where access to central bank funding becomes the primary source of funding. I would like to make it very clear that the Central Bank of Malta is not prepared to support such ventures. When the conditions are favourable a higher leverage ratio increases the return on capital.