7 June 2010

Minister of State and Finance,
Secretaries of State,
Chairman of the Board of Auditors of Banco de Portugal,
Members of the Advisory Board of Banco de Portugal,
Vice-President of the European Central Bank,
Dear colleagues, Members of the Board of Directors of Banco de Portugal,
Ladies and Gentlemen,

I am truly grateful for the Government’s trust in me, expressed through the invitation to become Governor of Banco de Portugal, the central bank of the Portuguese Republic and member of the European System of Central Banks and the Eurosystem.

This independent and much respected Portuguese institution has long served the country and it is a great honour for me to become its Governor. Today, the Bank’s main concern is the maintenance of stability – that of prices and of the national financial system, through its capacity as supervisor of credit institutions, financial companies and payment institutions, and as a member of the National Council of Financial Supervisors.

I am all the more honoured by this appointment since it has come at a particularly demanding time for both the country and the institution itself. We are currently facing challenges which the international financial crisis is posing for central banks in general, and for the European System of Central Banks and Banco de Portugal in particular.

The international financial crisis that broke out in August 2007 was to become the severest crisis of the last 75 years and has recently taken on a particularly virulent form in the euro area, where it brought about a sudden disruption in the balance and in the principles established just two months ago. The Portuguese economy and its banking system then bore the brunt. There are lessons to be drawn from the way events have unfolded, though it is too early to foresee just how extensive the fallout will be.

The international crisis has highlighted many things. Firstly, it is that a successful price stability policy is crucial for sustained economic growth, but it does not alone ensure financial stability; secondly, it has demonstrated that financial instability may lead to severe macroeconomic imbalances, and it is for this reason that financial stability must be the second major objective of a central bank; thirdly, it has shown that financial stability requires a range of macro-prudential instruments that take into account the fact that systemic effects cannot be detected by prudential supervision of each financial intermediary as a separate entity; and finally, it has illustrated how safeguarding the stability of a financial system in a context of globalisation and cross-border financial integration requires concerted international action by supervisory authorities in the countries involved, and this covers defining prudential rules, monitoring compliance by financial institutions, and solving the problems that emerge.

We stand therefore in the midst of an international financial crisis which has underlined and strengthened the role played by central banks in creating the conditions essential to underpin sustained development: price stability and financial stability. These conditions are indeed necessary but they are not sufficient: their impact on sustained development hinges on other economic policies, budgetary and structural among them, and on their consistent articulation with monetary and financial stability policies.

In short, the international financial crisis has reminded us how important central bank functions are for the fostering of sustained development.

Firstly, it is the task of central banks – and in our case the Eurosystem – to ensure the price stability necessary for guaranteeing the real value of income and savings, for minimising financing costs, with the variations of risk premia in mind, and for setting the compass to optimal resource allocation.

Since their establishment, the ECB and the Eurosystem, which includes Banco de Portugal, have fulfilled their mandate, which has been to ensure that the annual average inflation rate holds firm below 2%.

For Member States which, like Portugal, adopted the euro after a long period of much higher inflation, integration within a monetary area enjoying price stability has been instrumental in improving financing conditions for corporations and households, in terms of both price and volume. This has brought in its wake the capacity to take on more debt.

The economic and social players, however, were in general quicker to take up the benefits of participation in the euro than they were to respect the rules on wage and price formation consistent with price stability. On the back of this has come an economy slacker on competitiveness and with an added drawback – the emergence of new players with wage cost advantages. A start has indeed been made on addressing this problem, but a solution for the Portuguese economy has yet to be found.

Restoring competitiveness in the tradable goods sector is indispensable for ensuring sustainable economic growth and job creation. This means that price stability, which is a prerequisite for deconstructing the uncertainty of savers and investors, also requires economic agents (corporations and households) to come more quickly to an understanding of the need for curbs on the wage and price formation process; in parallel, it requires greater reliance on the increase in value added per unit of output, either by raising productivity or by rapidly transforming the tradable goods productive sectors and racking up efficiency in non-tradable sectors.

The current account balance deteriorated as a result of a specific combination: on the one hand, easier access to financing and greater exposure to debt among economic agents; and on the other, faltering competitiveness. The result was an economy with higher external public and private indebtedness.

On top of this, there was another factor: the structural shortfall in domestic savings, where the situation has in fact worsened, as a result of the fact that the public accounts have leeched with the impact of the international financial crisis and of the budgetary measures introduced to stem the crisis and shore up economic recovery.

The great challenge now facing the euro area in general and the Portuguese economy in particular is the combination of deteriorating external financing requirements in some of the area’s Member States, above all those posting a structural shortage of domestic savings, with financial markets more focused on and concerned with the sustainability of mounting indebtedness – especially, though not exclusively, for public agents – as well as tighter conditions for external financing.

It is urgent to make it clear to external financing agents that the country’s indebtedness is sustainable. This requires gradual but determined adjustment of external financing requirements to the severe restrictions now being faced, and as the trust that financial agents have in the country ebbs away, so will these restrictions be tightened.  A guarantee needs to be flagged to the markets, and this necessarily involves a more solid bedrock of domestic savings, both private and public, and an economy showing improved competitiveness. The cornerstones of sustained growth in the Portuguese economy are consistent and credible public deficit cuts, increased private savings and buoyant exports.

It therefore follows that the great advantages of price stability and participation in the euro area, so quickly taken on board by economic agents, must perforce be matched by an adjustment in the behaviour of wage formation and income distribution. The pace of this adjustment, in the current international crisis, must be decisively and credibly ratcheted up, since otherwise Portuguese economic recovery will be jeopardised.

Secondly, as I mentioned at the start, the present international financial crisis has shown that financial stability is a prerequisite for price stability, with central banks responsible for monitoring the stability and efficiency of the financial system, which is the cornerstone of a modern economy. An efficient and stable financial system is a necessary condition for fostering domestic savings and ensuring they are channelled into financing economic agents and rationalising investment. The credibility and efficiency of the financial system are two key features in proper financing for corporate and household requirements, ensuring volumes and maturities that mesh with the nature of the investments; they are also key features in promoting the optimal allocation of resources and thereby the returns on savings.

And so it is that the international financial crisis has drawn our attention again to the fact that financial system stability has an impact on other sectors. It is a public good that cannot be left to self-regulation by financial institutions; nor does it simply happen as a result of supervision that focuses on individual institutions as separate entities.

In economies where financing comes chiefly via credit operations through the banking system, two of the factors that enhance the capacity to attract and channel savings are a pro-active approach and quality from the financial system supervisor. This is particularly important for those agents that do not have access to capital markets or international financing, such as small and medium-sized companies and it is all the more relevant in economies like the Portuguese, where the banking system plays a fundamental role, not only in funding investment but also in attracting external savings that make up for the structural deficit in domestic savings.

As I mentioned earlier, the stability of the Portuguese financial system is the second main objective of Banco de Portugal. The issue can be broken down into various tiers: micro-prudential, macro-prudential and European supervision, along with participation in the provision of new prudential rules.

With regard to the first level – micro-prudential supervision – I need only say that the Portuguese financial system is sound. It was not directly exposed to the so-called sub-prime crisis and it took advantage of an initiative stemming from Banco de Portugal to increase its own funds to what is, in international terms, a very acceptable cushion. Be that as it may, there is room for improvement in the accuracy and the quality of the supervision applied to each and every institution in the system.

First and foremost, therefore, the supervision of financial institutions must be reinforced and carried through as an ongoing process, using teams already set up on site in some institutions, with the broadening of this practice to the main institutions in the financial system. This will make it possible to acquire a more direct and profound knowledge of the supervised entity and of its risk profile. Close ongoing supervision analyses the nature of business lines and the risks in various financial products; it covers the process of identifying, assessing and managing the different types of risk (among them credit, market, liquidity, interest rate, exchange rate and operational risk); and it provides an appraisal of the organisation and management model. A thorough assessment of all the implications for the institution has to be made, in particular as regards the taking on of risk, complex vehicles, and securitisation and re-securitisation transactions, the aim being to ensure that such risks are correctly reflected in the institutions’ balance sheets and adequately covered by own funds. Finally, it is necessary to check whether the institution’s remuneration schemes do not hamper its very sustainability.

Secondly, micro-prudential supervision has to apply the principle of systematic doubt, so that it can, among other things, carry out a role that is counter-cyclical. The fact that a financial institution is coming in with good performance does not mean that permanent oversight of that institution can be dispensed with: a constant check is needed on the soundness of its fundamentals, its future risks and the way these are recorded on its balance sheet.

Thirdly, it is important to take into account that the more thorough the internal auditing, control and compliance mechanisms of each institution, the better the quality and reliability of micro-prudential supervision; and the same is true the more adequate the governance model of the supervised financial institution, both from the perspective of risk assessment, acceptance and monitoring, and also that of its accountability; and the same is also true, as recent experience bears witness, the more competent and responsible the external audit. The micro-prudential supervision carried out by Banco de Portugal must include a clear definition of the competences and responsibilities of the various control levels of financial institutions.

Finally, the confidence of savers and investors in the banking system must be bolstered, through clear characterisation of the financial products on offer, including withdrawal conditions, the risks involved and the method used to calculate return. The current international financial crisis has shown that the information supplied to savers or investors has not always been complete or suitable to their level of financial literacy; moreover, investors sometimes select a financial product and either ignore the risk involved, or assume that the risk is covered by insurance mechanisms that do not in fact exist.

With regard to the second level of supervision – systemic or macro-prudential – it should be noted, as I mentioned earlier, that developments are occurring in this area all round the globe. The international crisis that began in 2007 brought an awareness that the decision-making processes in financial institutions do not take into account the externalities that result from their actions; therefore, supervision must assess the resilience of the system, i.e. its capacity to absorb such externalities while keeping on an even keel. Thus, for instance, in August 2007, there were default and volatility rates, risk premia and asset ratings which, if considered in isolation in specific financial institutions, would make it impossible to anticipate subsequent developments, as a self-amplifying chain reaction took hold. In this context, where Portugal is concerned, the work undertaken by the National Council of Financial Supervisors must continue and be further developed.

As for the third level – European and international supervision – it is necessary to bear in mind that systemic risk has a cross-border nature and that, as a consequence, it requires a concerted response at both European and international levels. This has already given rise to an array of institutional innovations and proposals for new prudential rules. Banco de Portugal has addressed these developments, which are part of a process under way that must continue to be carefully monitored, with the sustained credibility of domestic financial institutions hinging on it.

The cumulative effect of the proposals under discussion must be duly examined, with consideration, among other things, of the role of banks in financial intermediation, and therefore the overall impact on the economy.

What must be ensured is a level playing field, taking into account the specific nature of business models and the nature of associated risks. On the one hand, there must be the guarantee that the increase in banking intermediation costs is in line with the nature and the assessment of the risks to be covered and, on the other, that the emergence of non-regulated financial intermediation is not being encouraged, giving rise to a new systemic problem. It needs to be understood that supervision may involve costs, but it produces a public good.

Finally, as regards the reformulation of prudential regulations, Banco de Portugal will continue to monitor the existing legal framework, building on the information gathered in the exercise of both micro- and macro-prudential supervision, ensuring in particular that the scope of supervision covers all banking institutions and products and that the prudential treatment involved is commensurate with the associated risks, and a level playing field guaranteed.

This means that in the coming years Banco de Portugal will have to face major challenges in the field of prudential supervision, not only at a domestic and European level, but also more generally at an international level. Therefore, Banco de Portugal will continue to acquire the skills and the organisation models required to guarantee timely, effective and independent micro-prudential supervision (while questioning preconceived ideas where necessary); it will continue with its ongoing assessment of systemic risks; and it will continue to play an active part in domestic macro-prudential supervisory mechanisms. At the same time, its capacity to dissect and discuss the new prudential supervisory rules and models must be further enhanced, in order to maximise its influence in the various European fora in which the Bank participates.

Banco de Portugal not only watches over the stability of the financial system, but also over the smooth operation of payment systems. This is an important component of the transaction costs borne by economic agents, and is particularly relevant in an open economy like the Portuguese. In fact, it is impossible to conceive today of a modern economy without electronic payment systems, and the Portuguese system is widely acknowledged as excellent.

In this field, Banco de Portugal and the institutions participating in Portuguese payment systems are currently facing a number of challenges that require special attention.

Firstly, there are the effects of the transposition of the Payment Services Directive – in particular greater competition in the provision of payment services – and this has given rise to new areas which have brought increased responsibility for Banco de Portugal.

Secondly, there is the implementation of the Single Euro Payments Area (SEPA), with public authorities specifically urged by the ECOFIN Council to prove that they fully intend to push the migration process forward by drawing up integrated and coordinated national plans for the full migration of domestic public administrations to SEPA rules, products and services.

Thirdly, there is the launch of the TARGET2 Securities platform, which will significantly change the role of the national central banks of the Eurosystem in the area of post-trade settlement services for securities transactions, bringing about European harmonisation unprecedented in this type of markets.

Finally, I would like to mention the implementation of new payment processors, the new payment technologies (such as the Internet and mobile phones) and increasing innovation in the retail payments market, particularly with the development of the e-Payments Framework. This will require a considerable increase in the role played by Banco de Portugal in payment systems oversight, especially regarding the risk control mechanisms in these systems and the production of relevant statistical information.

Minister of State and Finance,
Secretaries of State,
Chairman of the Board of Auditors of Banco de Portugal,
Members of the Advisory Board of Banco de Portugal,
Vice-President of the European Central Bank,
Ladies and Gentlemen,

In short, Banco de Portugal is now facing a number of challenges that will test the capacity of both its Board of Directors and staff, but I firmly believe that these challenges will continue to be successfully met.

My belief is based on three factors: the culture of Banco de Portugal and the levels of excellence and reputation achieved within the Eurosystem; the work carried out by Professor Vítor Constâncio and the other members of the Board of Directors in addressing current challenges; and, last but not least, the quality and commitment that have always been displayed by the staff of the Bank.

Firstly, Banco de Portugal is an institution with unparalleled reputation and credibility. These two features have proved to be invaluable at times when the country was confronted with change and even turbulence. For over 160 years, Banco de Portugal has never failed to make a decisive contribution to the country’s stability and prosperity.

Secondly, Professor Vítor Constâncio’s further enhancement of prudential supervision is either already in place or in the pipeline. I would like to take this opportunity to congratulate our outgoing Governor and current Vice-President of the European Central Bank, wishing him every success in his new post. Professor Constâncio, it is really an honour for our country that you have taken on this important position at the ECB.

Finally and no less important for that, I would like to mention the quality and commitment of the Bank’s staff. All organisations must adapt to the challenges around them, by acquiring new skills and reshaping work organisation matrices. Throughout its history, Banco de Portugal has more than proved its capacity to respond effectively to challenges. Its adaptation to the demanding criteria for participation in the Eurosystem was particularly noteworthy. In the space of a few years, there were many departments in Banco de Portugal deemed to be among those with the best quality and reputation in the Eurosystem – from support areas, such as IT, and traditional activities, such as treasury and issue, to more specialised departments, such as economic research, markets and statistics, which are directly involved in monetary policy definition, implementation, monitoring and analysis. This is what leads me to believe that Banco de Portugal will once again prove that it is an agile and responsive institution, living up to its commitments, enjoying prestige both at home and internationally and attracting the most talented professionals. Both I and fellow members of the Board of Directors count on the dedication of all staff to achieve this aim.

As a final note, I would like to stress that it is a pleasure to chair a Board comprising members with the highest moral and professional standards, as is the case of the current members of the Board of Directors of Banco de Portugal.

Carlos da Silva Costa

Lisbon, 7 June 2010