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The opacity as regards markets, financial instruments and real situations of financial institutions is a recipe for catastrophe, Trichet said. The trend towards short-termism and the profound asymmetry in the response which is given to booms and busts are particularly adverse from a financial stability stand point, he continued.
The purpose of the financial system “is to write, manage and trade claims on future cash flows for the rest of the economy, a purpose that increasingly fell victim to a game for fees, very short-term apparent profits, and arbitraging regulation”, Trichet criticized. The “shadow banking system” rested on a poorly understood system of credence (provided by rating agencies) and the (false) perception that the only way for asset prices was upward.
The ECB President called to augment transparency as the best insurance policy against irrational herd behaviour and unjustified contagion in times of stress, and to reduce pro-cyclicality.
“The paradox is that a number of rules, regulations, procedures and the behaviour of authorities very often contribute to augmenting the amplitude of the fluctuations”, he said referring to the set of prudential rules for banks and insurance companies, and to accounting rules. “We find elements of pro-cyclicality in the attitude of the authorities that can, paradoxically, apply more rigorously their rules and regulations in times of difficulty while they were nonchalant during the previous boom episodes.”
The trigger for the turmoil was a myriad of problems, the ECB President explained. Three broad factors led to the deterioration of confidence, Trichet said. These include the abundance of liquidity, an increasingly interwoven and complex financial system, and some financial agents’ incentives that were aligned against prudent practices, Trichet explained and called on supervisors and regulators to take a careful assessment of the incentive structure underlying financial intermediation.
Referring to the initiatives undertaken by the ECOFIN and in the