European Central Bank

The European Central Bank runs one of the most complex monetary policy regimes in the world. Since the euro area sovereign crisis its operating framework has extended well beyond regular liquidity supply and now includes [i] long-term full-allotment and targeted lending operations, [ii] large-scale asset purchases, [iii] active and comprehensive collateral policies, [iv] flexible forward guidance on policy operations and [v] a contingent facility to intervene in government bond markets in case of sovereign debt crises.

Basics of euro area monetary policy

Multiple fiscal policies and financial systems

The ECB conducts monetary policy for a currency area of 19 countries, which means 19 national fiscal policies and distinct financial systems. Fiscal coordination has been limited and based on non-binding or flexible arrangements. While ECB policy decisions are centralized at the Governing Council, policy implementation is decentralized and involves both the ECB and the national central banks, the “Eurosystem”.

Financial system integrity across national borders relies essentially on Target2, the real-time gross settlement system of the Eurosystem. 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 fund external transactions without liquidity pressure (view post here). There would still be a constraint on external balances, due to their effects on long-term credit risk and spreads charged on national debt. Yet, convertibility risk could only emerge if concerns developed over the scope and durability of Target2.

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 the European Central Bank has historically concentrated its non-conventional monetary policy more on extended bank lending operations than on asset purchases.

Crises that shaped monetary policy

In a speech on 4 May 2017 ECB Executive Board member Peter Praet summarized the sequence of transformational crises as follows:

“In the euro area, the crisis has evolved through three phases.

  • The first phase was triggered by the abrupt liquidity strains…in the immediate aftermaths of the collapse of Lehman Brothers. Banks…suddenly became very uncertain about the underlying health of other banks and stopped lending to each other.
  • The second phase of the crisis came as a…loss of confidence in some sovereigns. It brought on the development of redenomination risk…The sovereign debt crisis…became a two-way interaction through the ‘bank-sovereign’ nexus. Banks remained dependent on fiscal authorities for solvency assistance, and the financial obligations vis-à-vis banks…of some national fiscal authorities…further undermined their credit standing…ultimately leading to entire national banking systems losing market access. This in turn resulted in financial fragmentation and a serious disruption to the monetary transmission mechanism.
  • The third phase of the crisis started in 2014, as it became clear that the incipient recovery was too fragile…The debt crisis had…triggered among ..banks a drawn-out process of deleveraging aimed at shedding…loans to the economy…There was a palpable risk that the disinflationary pressure would de-stabilise long-term inflation expectations and usher in a self-sustained period of deflation.

Extension of bank lending operations

Overview

Prior to 2014, the ECB’s non-standard measures operated mainly via an extension of its operational framework. Liquidity was made available in virtually unlimited amounts at increasingly longer tenors and for a broadening range of collateral:

  • The Eurosystem suppliedunlimited funding to banks against appropriate collateral at a fixed interest rate, a practise that was labelled “fixed rate full allotment policy”. This allotment procedure was essential for removing funding uncertainty for banks when access to interbank and capital markets had become unreliable.
  • The Eurosystemextended 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).
  • Moreover, the Eurosystemextended overtime the range of eligible collateral,  i.e. the scope of marketable securities that it accepted for its refinancing operations (see the section on collateral policies below).

“There is no liquidity issue for the banking sector of the euro area. We can supply unlimited liquidity.”

Jean Claude Trichet, 2011

Long-term repo operations (LTROs)

Non-conventional lending operations focused on the extension of size and maturity of liquidity supply to banks by means of full allotment at fixed rates. Moreover, the maximum maturity of lending was extended to 3 years through so-called long-term repo operations (LTROs). A particular focus of the Eurosystem has been to secure the participation of a broad range of credit institutions in these transactions.  Hence, the LTROs eased funding pressure particularly on banks located in countries that had been battered by the euro area sovereign debt crisis.

However, LTROs are not fully equivalent in impact to central bank asset purchases, because they do not remove economic risk from banks’ balance sheets. 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 difference 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. Indeed, a central bank margin call can set in motion a chain of margin calls across the financial system.
  • Long-term repooperations 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.

“A large portion of the financing provided to eurozone banks through the LTRO was used to buy periphery sovereign debt. This became known as the ‘Sarko trade’ after Nicolas Sarkozy suggested that the LTRO meant that the Italian and Spanish governments could depend on their countries’ banks to buy their bonds.”

Financial Times

Targeted lending operations (TLTROs)

In June 2014 the European Central Bank announced Targeted Long-Term Repo Operations (TLTROs). The main purpose of these operations has been to stimulate bank lending to non-financial corporations, which had been in a mild (2% annualized) recession 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.

In March 2016 the ECB launched four new targeted longer-term refinancing operations (TLTRO II), starting in June 2016, each with a maturity of four years. The interest rate would be be fixed over the life of each operation, at the rate on the Eurosystem’s main refinancing operations prevailing at the time of take-up. For banks whose net lending exceeds a benchmark, the rate would be as low as the interest rate on the ECB deposit facility, which was a negative 40 basis at the time of announcement.

Banks usage of the TLTROs has been large and broadly based. As of 2017, these operations constitute the largest part of Eurosystem lending to financial institutions. They establish a linked between eligible loans reported by banks and these banks’ borrowing limits. According to the ECB “the incentives embedded in the TLTROs helped to stimulate the supply of credit by banks that submitted bids. Banks used the liquidity taken in TLTROs to grant loans, in particular loans to enterprises and consumer credit”.

“What is in…this TLTRO that makes it different?…The underlying spirit is that we want to enhance lending to the non-financial companies in the private sector.”

Mario Draghi, President of the European Central Bank, June 2014

Asset purchases

A last resort

The ECB launched large-scale asset purchase programs later than other central banks. Until 2014 outright securities purchases had been no more than a footnote of the menu of non-conventional policies.  From 2009 to 2012 the Eurosystem operated two covered bond purchase programs. Also, from 2010 to 2012 it bought public and private debt obligations under the “Securities Markets Programme” (SMP). However, total asset purchases under these operations reached just around 2% of euro area GDP.

In the fall of 2014 the ECB began larger asset purchases similar to the quantitative and qualitative easing of the U.S., the UK, and Japan (view post here). In a first step the ECB announced a covered bond purchase program and an asset-backed securities purchase program aiming at a total net balance sheet expansion of at least 4% of euro area GDP per annum over two years.

However, with deflation risks increasing asset purchases had to be topped up. Hence, a Public Sector Purchase Programme (PSPP) was initiated in January 2015 to allow operations at greater volume and speed (view post here and a full manual here). The PSPP would buy bonds issued by euro area central governments, agencies and international or supranational institutions with maturities of between 2 and 30 years.
Thus, by 2015 asset purchases had broadened to encompass asset-backed securities, covered bonds, sovereign bonds and quasi sovereign debt. Pace and size would be open-ended and conditional on inflation expectations. Annual purchases would be 6-7% of euro area GDP.

In March 2016 the governing council decided to expand asset purchases further. In terms of size, monthly purchases would increase from EUR60 billion to EUR80 billion per month, reaching a annual pace of 9% of euro area GDP. In terms of scope, investment-grade euro-denominated bonds issued by non-bank corporations became eligible from June 2016 (corporate sector purchase programme or CSPP). The CSPP intended to strengthen the pass-through of asset purchases to the real economy. The eligibility criteria supported broad access including for smaller issuers.

“We will buy government debt up to the percentage that will allow a proper market price formation.”

Mario Draghi, President of the European Central Bank, January 2015

The effectiveness of asset purchases

ECB purchases are subject to restrictions on market size and issuer quality. These restrictions limit either pace or time horizon of asset purchases (view post here). To mitigate the constraints the issuer and issue share limits for the purchases of securities issued by eligible international organisations and multilateral development banks was raised from 33% to 50% in March 2016. Another limitation of asset purchase effectiveness is that the Eurosystem has not agreed to full loss sharing across national central banks in case of sovereign issuer default.

The ECB’s own research suggests that the asset purchase programme exerted influence on markets and the economy through three channels: asset valuation, signalling effects and the re-anchoring of long-term inflation expectations (view post here).  ECB research estimates the influence of these channels has been considerable and that “compared to a counterfactual scenario without the purchase programme, the peak increase in inflation was around 40 basis points and in output around 1.1 percent.”

In particular, ECB research emphasized that its asset purchase programs significantly compressed term and credit spreads. Unlike previous such programs, the ECB’s large-scale asset purchases did not tackle acute financial distress in particular market segments. Instead, they functioned mainly through the broad compression of risk premia and spill-over to non-targeted assets. (view post here).

Collateral policies

A broad framework

The Eurosystem’s collateral framework has adapted over the past decade to the challenges of the great financial crisis and the euro area sovereign crisis. Importantly, the Eurosystem broadened the range of eligible collateral for its credit operations and modified the rules of haircuts, effectively reducing collateral value relative to market value.

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.”

Since 2008 the ECB has broadened eligible collateral in several steps, 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…Thecredit 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 national central banks 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, the ECB also introduced a new element of automatic pro-cyclicality into its operations, as negative credit shocks could lower security ratings and, thereupon, Eurosystem refinancing conditions for these same securities.

Eurosystem Eligible Collateral (EUR bn)

“The Eurosystem collateral framework has played a key role in the implementation of monetary policy since the euro was launched in 1999. It has also played a pivotal role in stabilising financial markets and institutions during the financial and sovereign debt crisis.”

ECB occasional paper on collateral framework, May 2017

Forward guidance

Late and flexible guidance

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 lower bound, 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, The ECB’s commitment to low rates was based on a qualitative “narrative” citing 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).

“The formulation ‘for an extended period of time’, marks a change in the ECB’s communication of monetary policy. It is a form of forward guidance”

Peter Praet, Member of the ECB Executive Board, 2013

Outright monetary transactions

A key tool that was never used

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 and “severe distortions in the pricing of sovereign debt in some euro area countries”, which had given 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” have never been activated, but served effectively to reduce risk premia and quell fears of a market-driven euro area disintegration.

How the OMTs would work

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 onsovereign 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 limitsare set on the size of Outright Monetary Transactions.
  • The Eurosystem intends to clarify in the legal act concerning Outright Monetary Transactions that itaccepts 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 isstrict 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. “

“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

Mario Draghi at the Global Investment Conference in London
26 July 2012

A footnote

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.

“Whenever the transmission channel of monetary policy is severely impaired conventional monetary policy actions are largely ineffective. Any policy decision therefore needed to take account of the extraordinary situation in money markets.”

Lorenzo Bini Smaghi, Member of the ECB Executive Board, 2009