The ECB now runs one of the most complex monetary policy regimes. Beyond regular liquidity supply, its operating framework features long-term full-allotment refinancing operations, generous collateral acceptance, and a commitment to conditional open-ended interventions in sovereign markets. Subsequently, it has adopted or expanded forward guidance, targeted lending and large-scale outright asset purchases.
The below is an extended update of the ECB section of the page Central Bank Policies in the Systemic Risk section of this site.
It is based on a number of posts, with the links given below.
1. Historic and structural specifics of the ECB approach
1.1. National fiscal policies and financial systems
The ECB conducts monetary policy for a currency area with 19 national fiscal policies and financial systems. Fiscal coordination relies on non-binding or flexible arrangements. Financial system integration relies essentially on Target2, the real-time gross settlement system of the Eurosystem (collective of ECB and national central banks) . Target 2 allows central banks to redress reserve losses that result from balance of payment deficits. Put differently, if a national central bank experiences reserve losses through external deficits, Target2 loans via the ECB secure the funding of external transactions without liquidity pressure (view post here). There would still be a constraint on external balances, in form of long-term solvency and credit spreads charged on national debt. Yet, convertibility risk would only emerge if concerns developed over the scope and durability of Target2.
1.2. A bank-based financial system
Compared with the U.S. the euro area’s monetary policy transmission and credit supply depend more on bank lending than on market-based financing. At the end of 2012 loans granted by financial institutions accounted for 49% of total liabilities of the euro area non-financial sector, whereas securities, including quoted shares, constituted only around 35% of its financing sources. This goes a long way in explaining why from 2008 to 2013 the European Central Bank concentrated its non-conventional monetary policy on direct support for the banking system, rather than on asset purchases.
1.3. The separation principle (and its dissolution)
Historically, the ECB kept a dividing line between monetary policy decisions and their implementation through monetary policy operations. Hence, before 2014 the ECB officially declared its non-standard measures to be a complement to interest rate cuts, not a substitute or an extension. The idea was that the transmission of the monetary policy stance, as expressed by the Governing Council’s interest rate decisions, would depend on functioning banking systems and money markets. Thus, when financial turmoil impaired these markets, the ECB introduced non-standard measures ” in order to keep the transmission mechanism fully operational”.
Importantly, the Eurosystem’s operational framework allowed separating the level of the refinancing rate (conventional monetary policy) from the volume of gross lending to the banking system (nowadays mainly the domain of non-conventional policy). The key instrument for this separation was the deposit facility, which remunerates excess reserves (deposits over and above mandatory reserves) at a pre-set marginal deposit rate. Hence, in the wake of the 2007-2012 financial crises and fragmentation of money markets the Eurosystem drastically expanded its lending to commercial banks above actual aggregate liquidity needs. However, neither did the balance sheet expansion ease credit conditions directly nor did the ECB lose control of short-term interest rates. Cash-rich banks would simply park excess funds at the deposit facility (view post here).With the introduction of a negative deposit facility interest rate in June 2014 this separation dissolved. Since late 2014 the ECB has effectively signaled its policy stance through a conditional balance sheet target and other modalities of asset purchases.
2. Extension of ECB bank lending operations
Prior to 2014, the ECB’s “non-standard measures” operated mainly via an extension of its operational framework in the following important ways:
The Eurosystem supplied unlimited funding to banks against appropriate collateral at a fixed interest rate, a practise that was labelled “fixed rate full allotment policy”.
The Eurosystem extended the range of eligible collateral, i.e. the scope of marketable securities that it accepted for its refinancing operations (see below).
The Eurosystem extended the maximum maturity of its lending operations from 3 months prior to the Lehman bankruptcy to up to 3 years at the height of the euro area sovereign crisis.
Finally in 2014 the ECB introduced targeted long-term refinancing operations to encourage bank lending (see below and view post here).
There has been some debate as to effectiveness of the initial phase of ECB non-conventional monetary policy that was focused on bank lending operations. An ECB Working Paper by Fahr et al (May 2011) suggests that changes in the ECB refinancing operations, i.e. full allotment for fixed tenders and long-term repo operations (LTROs), reduced the spread between a 10-year government bond yield and a 3-month rate by 75bps.
2.2. Long-term repo operation
While non-conventional policy in the U.S.focused on quantitative easing, in the euro area it concentrated on the extension of size and maturity of liquidity supply to banks by means of full allotment at fixed rates. The maximum maturity reached 3 years for so-called long-term repo operations (LTROs). However, even LTROs are not fully equivalent in impact to central bank asset purchases. That is because asset purchases remove economic risk from banks’ balance sheets. By contrast, the LTRO is a repo transaction where the Eurosystem takes on collateral temporarily in order to back its loans. The economic risk of the assets remains with the bank. This has important practical consequences:
- Repo operations are subject to variation margin call risk. If credit markets sell off collateral value may drop below threshold levels. The ECB normally requires the pledging bank to stump cash or more assets, using daily marking to market. A central bank margin call can set in motion a chain of margin calls across the financial system.
- Long-term repo operations cannot break the link between government and bank funding problems. Thus, in the euro area most non-conventional funding went to banks in distressed peripheral countries and their asset base remained highly correlated with the performance of domestic sovereign bonds.
2.3. Collateral policies
In official ECB language “all credit operations of the Eurosystem are based on adequate collateral…Collateral adequacy implies that the Eurosystem is to a large extent protected from losses in its credit operations…The Eurosystem accepts a broad range of assets as collateral…This feature of the Eurosystem’s collateral framework, together with the fact that access is granted to a large pool of counterparties…has allowed the Eurosystem to provide the necessary liquidity to address the impaired functioning of the money market during the financial crisis, without counterparties encountering widespread collateral constraints.”
The broadening of eligible collateral has come in several steps since 2008, of which two were of particular importance:
- “In October 2008 the Governing Council decided to expand the list of eligible collateral on a temporary basis…The credit threshold…was lowered from “A-” to “BBB-”, with the exception of asset-backed securities… the Eurosystem has also accepted debt instruments issued by credit institutions…which are not listed on a regulated market, but traded on certain non-regulated markets”
- “Since February 2012 euro area NCBs have been allowed, as a temporary solution…to accept as collateral…additional performing credit claims that satisfy specific eligibility criteria [called the ACC framework]. The responsibility entailed by the acceptance of such credit claims is borne by the NCB authorizing their use. In addition, [in] June 2012 the eligibility criteria for certain types of asset-backed security (ABS) were broadened….”
The ECB published in July 2010, a schedule of graduated valuation haircuts to the assets rated in the BBB+ to BBB – range, which replaced the flat haircut add-on which was, until then, uniformly applied to such assets. The new haircuts were aimed at striking a balance between collateral adequacy and sufficiency. However, they also introduced a new element of automatic pro-cyclicality into ECB operations, as negative credit shocks could lower security ratings and, thereupon, Eurosystem refinancing conditions for these same securities.
2.3. Targeted long-term repurchase operations (TLTROs)
In June 2014 the European Central Bank announced Targeted Long-Term Repo Operations (TLTROs), to be initiated in September 2014. The main purpose of these operations has been to stimulate bank lending to non-financial corporations, which had been in a mild (2% annualized) contraction prior to the announcement. The TLTROs would offer conditional cheap funding to banks in large size and for maturities of up to four years on condition of the banks expanding their loan books (view post here). This would provide an incentive for new lending, particularly in the euro area periphery, but there has been considerably uncertainty as the TLTRO’s significance for area wide credit supply.
3. Outright Monetary Transactions
In August 2012 the European Central Bank announced Outright Monetary Transactions (OMT), a facility for intervention in the secondary market for government securities, subject to specific conditions. The OMT were introduced in response to the increasing fragmentation of capital markets across the euro area, which had led to a complete drying-up of certain financial market segments and gave rise to “euro area breakup” fears. As a consequence, monetary policy signals had no longer been transmitted properly to the real sector.
These “Outright Monetary Transactions” were never invoked, but served to quell fears of a liquidity-driven euro area disintegration.
According to ECB governing council statement on 6 September 2012, “OMTs address severe distortions in government bond markets that originate from… unfounded fears on the part of investors of the reversibility of the euro. Hence, under appropriate conditions, we will have a fully effective backstop to avoid destructive scenarios… Outright Monetary Transactions…will be conducted within the following framework:
- Transactions will be focused on the shorter part of the yield curve, and in particular on sovereign bonds with a maturity of between one and three years…. The liquidity created through Outright Monetary Transactions will be fully sterilised.
- No ex ante quantitative limits are set on the size of Outright Monetary Transactions.
- The Eurosystem intends to clarify in the legal act concerning Outright Monetary Transactions that it accepts the same (pari passu) treatment as private or other creditors with respect to bonds issued by euro area countries and purchased by the Eurosystem through Outright Monetary Transactions, in accordance with the terms of such bonds.
- A necessary condition for OMTs is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism program. Such programs can take the form of a full EFSF/ESM macroeconomic adjustment program or a precautionary program (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The Governing Council will consider OMT to the extent that they are warranted from a monetary policy perspective as long as program conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment or precautionary program…Outright Monetary Transactions will be considered for future cases of EFSF/ESM macroeconomic adjustment programs or precautionary programs as specified above. They may also be considered for Member States currently under a macroeconomic adjustment program when they will be regaining bond market access.
- Following a thorough assessment, the Governing Council will decide on the start, continuation and suspension of Outright Monetary Transactions in full discretion and acting in accordance with its monetary policy mandate. “
4. Forward guidance
Unlike the Federal Reserve, the ECB remained long reluctant to make any form of “pre-commitment” to future interest rate decisions. However, on 4 July 2013, with its policy rates close to the zero boundary, continued poor economic growth, and an unwanted increase in longer-dated yields, the Governing Council launched its own version of forward guidance. The declared intent has been to communicate the Governing Council’s reaction function and its assessment of the economy, rather than making an unconditional pre-commitment to a specific interest rate level (view post here).Like elsewhere in the world, forward guidance initially served to add monetary stimulus and to contain interest rate volatility. Unlike in the U.S. or the UK, however, the condition for low policy rates has not been expressed in quantitative trajectories with a labor market focus, but rather on a qualitative “narrative” of a broad range of macroeconomic developments that support a subdued medium-term inflation outlook. Thereby guidance has been more flexible in respect to conditions and horizon (view post here).
5. Asset purchases
Until 2014 outright securities purchases had been no more than a footnote of ECB non-conventional policy. In 2009-12 the Eurosystem ran two covered bond purchase operates and from 2010 to 2012 it conducted interventions in debt markets under the “Securities Markets Programme” (SMP), with total purchases just exceeding 2% of euro area GDP.However, from the fall of 2014 the ECB began to phase in larger asset purchase programs that would make its policies more similar to the quantitative and qualitative easing measures of the U.S., the UK, and Japan (view post here). In a first step the ECB announced purchases of asset-backed securities and covered bonds for a total net balance sheet expansion of at least 8% of euro area GDP over two years.Yet with deflation risks increasing, asset purchases had to be topped up greatly through a government bond purchase program in January 2015, to allow operations at greater volume and speed (view post here). On the whole, the ECB unveiled a 2015/16 asset purchase program that would encompass operations ABS, covered bonds, sovereign bonds and quasi sovereign debt. The envisaged annualized pace of balance sheet expansion was set at around 6% of GDP. Pace and size would be open-ended and conditional on inflation expectations. Purchases would be subject to restrictions on market size and issuer quality. The Eurosystem has avoided, however, full loss sharing in case of sovereign issuer default.