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In the past few months, financial stresses in Europe have lessened, which has contributed to an improved tone of financial markets around the world, including in the United States. The improvement reflects, in part, a number of actions taken by European policymakers. First, measures taken by the European Central Bank (ECB), including implementing two longer-term refinancing operations and easing collateral rules and reserve requirements, have allowed European banks to lock in funding for up to three years, thereby alleviating concerns about their near-term prospects. With the benefit of this support, European banks in turn have increased their holdings of sovereign debt, contributing to lower borrowing costs for some countries.
Second, euro area leaders, the Greek government, and private-sector holders of Greek debt are taking steps to put Greece on a more sustainable fiscal path. Its sovereign debt has been significantly reduced, the Greek authorities are intensifying their efforts to implement fiscal and structural reforms, and the European Union and International Monetary Fund have pledged a considerable amount of new funds as part of a second assistance package. The Greek economy remains in a deep recession, however.
Third and finally, leaders of most of the members of the European Union have approved a new fiscal compact treaty that strengthens fiscal rules and their enforcement. This treaty represents a positive step toward resolving the fundamental tension inherent in having a monetary union without a fiscal union, and thus should help bolster the viability of the euro-area economy in the longer term.
Although progress has been made, more needs to be done. Full resolution of the crisis will require a further strengthening of the European banking system; a significant expansion of financial backstops, or "firewalls," to guard against contagion in sovereign debt markets; and, critically, continued efforts to increase economic growth and competitiveness and to reduce external imbalances in the troubled countries.
Actions taken by the Federal Reserve
The Federal Reserve has followed developments in Europe closely, and is in frequent contact with key European policymakers. It is particularly focused on protecting US financial institutions, businesses, and consumers from adverse financial and economic developments in Europe.
Although US banks have limited exposure to peripheral European countries, their exposures to European banks and to the larger, "core" countries of Europe are more material. Moreover, European holdings represented 35 per cent of the assets of prime US money market funds in February, and these funds remain structurally vulnerable despite some constructive steps, such as improved liquidity requirements, taken since the recent financial crisis. US financial firms and money market funds have had time to adjust their exposures and hedge their risks to some degree as the European situation has evolved, but the risks of contagion remain a concern for both these institutions and their supervisors and regulators. In particular, were the situation in Europe to take a severe turn for the worse, the US financial sector likely would have to contend not only with problems stemming from its direct European exposures, but also with an array of broader market movements, including declines in global equity prices, increased credit costs, and reduced availability of funding.
Mr Bernanke concluded his testimony by saying: "The recent reduction in financial stresses in Europe is a welcome development for the United States, given the important trade and financial linkages connecting our economies. However, Europe's financial and economic situation remains difficult, and it is critical that the European leaders follow through on their policy commitments to ensure a lasting stabilisation. I believe that our European counterparts understand the challenges and risks they face and are committed to take the necessary steps to address those issues.
"For our part, the Federal Reserve will continue to monitor the situation closely, work with our financial institutions and foreign counterparts to enhance the resilience of our financial system, and be ready to use our tools to help stabilise US markets should the situation require such action."