The decline in credit to the private sector was accompanied by an increasing reluctance on the part of the euro area private sector to invest in financial assets; it severely hampered banks’ access to financing via the secured money market, due to an increase in haircuts and a deterioration of the available collateral. While market-based funding was becoming ever scarcer for banks in the euro area (as investors were growing increasingly nervous about the escalation of the sovereign crisis), banks were also facing regulatory and market pressures to strengthen their capital position. In short, back in December 2011, even though there was significant cross-country heterogeneity, the overall picture was rather gloomy. There were clear signs that supply-side factors were making banks less willing to lend to the non-financial private sector, and that banks may have entered a vicious circle which could compromise their ability to supply credit to the economy, both in the short and the long run. The additional negative impact on banks’ balance sheets of rapidly declining sovereign bond prices made the situation even worse. Banks typically have three ways to adjust to pressures on their funding and capital positions: they can sell assets, raise capital or reduce lending. Let’s look at each of these options in turn. In an environment of extreme uncertainty and high risk aversion, risky assets can only be disposed of at very low prices, possibly considerably below their book value.
It can and should take on an international dimension. Through facilitating the inward investment of foreign savings, the source of funding for much needed domestic investments can be tremendously enlarged. This would also enhance the overall efficiency in the international allocation of funds, to economies that can provide a higher return commensurate with the risks involved. An economy with capital controls should therefore plan for the eventual internationalisation of the bond market, even though the associated financial liberalisation process can be quite a risky one. But risks are to be managed and not avoided, and the benefits of open markets far outweigh the costs in terms of financial instability. I can confirm this, even with the unpleasant experience of the financial turmoil of 1998. Free and open markets impose a valuable discipline on policy makers that is to be welcomed in the long-term interest of the people they serve. Fifth, and turning to the actual bond market development issues, there is a need to adopt a comprehensive approach. We should address the demand and supply sides, the environment in which they interact to discover the prices for the debt instruments, including market making arrangements and the determination of benchmarks, and the market infrastructure, including payment, clearing and settlement systems. Focusing on these issues individually, and this is the sixth point, there is usually strong latent demand for debt instruments, particularly in economies with a high savings rate.