MONETARY POLICY BEFORE AND AFTER THE CRISIS

Roberto Perotti December 2013

THE ECB Monetary base - currency (banknotes and coins) in circulation - the reserves (required and excess) held by counterparties with the Eurosystem - recourse by credit institutions to the Eurosystem’s deposit facility. These items are liabilities on the Eurosystem’s balance sheet. Instruments 1. Reserves 1.a Required reserves (remunerated) 1.b Excess reserves (not remunerated) 2. Open Market Operations 2.a Main Refinancing Operations MROs are liquidity-providing operations that are conducted regularly on a weekly basis. They generally have a maturity of one week. Repos, through which ECB provides reserves to banks (through NCBs) in exchange for securities and then reverses the transaction two weeks later Steer interest rates, manage the liquidity situation in the market, and signal the stance of monetary policy through the main refinancing rate set by the Governing Council. They also normally provide the bulk of liquidity to the banking system.

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MROs are executed in a decentralised manner by the NCBs. Collateralized. The ECB accepts both government bonds and private securities. It applies a haircut and then requires the haircut-adjusted market value to be maintained over time by applying variation margins (“marking-to-market). All counterparties fulfilling general eligibility criteria may participate in these operations. Of the 6334 credit institutions in the Euyro area as of January 2011, 2267 were eligible for open market operations. MROs are executed through standard tenders, in accordance with a pre-announced schedule, which is completed within a period of 24 hours from the announcement. Fixed rate tender: the ECB specifies the amount of liquidity it intends to provide and the interest rate in advance, and participating counterparties bid the amount of money they wish to transact at the fixed interest rate. Pro rata allotment to the participating banks, depending on the ratio between total bids and total allotment. Variable rate tender: counterparties bid both the amount of money they wish to transact and the interest rate. They may submit multiple bids with different interest rate levels. The Governing Council may set a minimum bid rate in order to signal the monetary policy stance. The bids with the highest interest rates are satisfied first. At the lowest accepted rate, the “marginal rate of allotment”, bids are satisfied pro rata. From 27 June 2000 the MROs were conducted as variable rate tenders with a minimum bid rate using a multiple rate procedure. Full allotment procedure. Starting on 15 October 2008,the MROs were conducted as fixed rate tenders with full allotment. In exceptional circumstances, the ECB may decide to allot all the liquidity requested by counterparties, i.e. to accommodate all bids in full. This full allotment procedure was introduced during the period of acute financial market tensions which began in 2007. To mitigate the adverse effects of dysfunctional money markets on the liquidity situation of solvent banks Broadly similar to FED’s daily OMO, with some differences: 1) FED: done through NY FED; ECB: thorugh NCBs 2) FED: 18 primary dealers; ECB: hundreds of counterparties 3) FED: accepts government securities and GSE securities; ECB: much wider range of collateral, including private securities 2.b Long Term Refinancing Operations MRO: weekly. Also regular LTRO’s with 3-months maturity.

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To provide longer-term liquidity to the banking system. In order not to influence money market rates at more than one point along the maturity spectrum, the LTROs have been designed to ensure that the Eurosystem acts as a “rate taker”. In order not to blur the signal arising from the Eurosystem’s MROs, LTROs are normally executed in the form of pure variable rate tenders with preannounced allotment volumes. Under exceptional circumstances, the Eurosystem may also execute LTROs through fixed rate tenders and may decide to accommodate all bids in the operations (full allotment procedure). The largest such operations o occurred in December 2012 and February 2013, with 36 months LTROs for a total of about €1000bn. 2.c Fine tuning operations On ad hoc basis. Normally executed by NCBs Usually reverse transactions (repos) , but also foreign exchange swaps or collection of fixed rate deposits. Usually very quick tenders: one hour from publication of allotment announcement to announcement of results 2.d Structural operations Executed at the initiative of the ECB to adjust the structural liquidity position of the Eurosystem vis-à-vis the financial sector, i.e. the amount of liquidity in the market over the longer term. Can be conducted using reverse transactions, outright operations or the issuance of ECB debt certificates 3. Standing facilities 3.a Marginal lending facility Analog of FED’s primary credit facility (discount window) 3.b Deposit facility. To limit volatility of key money market interest rates

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Overnight maturity and available to counterparties on their own initiative. Collateralized Interest rate on the marginal lending facility normally substantially higher than the corresponding money market rate, and MRO rate; interest rate on the deposit facility normally substantially lower than the money market rate and MRO rate=> credit institutions normally only use the standing facilities in the absence of alternatives. Since no limits on access to these facilities(except for the collateral requirements of the marginal lending facility),the rate on the marginal lending facility and the rate on the deposit facility normally provide a ceiling and a floor, respectively, for the overnight rate in the money market. By setting the rates on the standing facilities, the Governing Council effectively determines the corridor within which the overnight money market rate, like euro overnight index average (EONIA), can fluctuate Normally EONIA within this corridor, and very close to MRO rate. This behaviour changed in October 2008,when the Eurosystem adopted nonstandard measures to counter the negative effects of the intensification of the financial crisis (see below). Thus, in normal circumstances little incentive for banks to use standing facilities, as the interest rates applied to them are normally unfavourable when compared with market rates. In fact, their use largely remained below €1 billion before the onset of the financial turmoil in August 2007. The use of the standing facilities increased abruptly during the financial crisis as a number of banks preferred to keep more central bank reserves than required and to deposit the additional reserves in the deposit facility instead of lending them out to other banks. The reasons for this included uncertainty and perceived counterparty risk. Under the full allotment procedure introduced by the Eurosystem inOctober 2008, the total amount of liquidity provided by the Eurosystem is the sum of the amounts of liquidity requested by individual banks. As the overall amounts requested by banks were higher than the liquidity needs of the banking system during this period, the excess liquidity was deposited in the deposit facility. The Euro Interbank Offered Rate (Euribor) is a daily reference rate based on the averaged interest rates at which Eurozone banks offer to lend unsecured funds to other banks in the euro wholesale money market (or interbank market). A representative panel of banks (currently 44 banks) provide daily quotes of the rate, rounded to three decimal places, that each panel bank believes one prime

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bank is quoting to another prime bank for interbank term deposits within the Euro zone, for maturity ranging from one week to one year. Every Panel Bank is required to directly input its data no later than 10:45 a.m The Euribor is similar to the Libor used in the US and the UK. The other widely used reference rate in the euro-zone is Eonia, also published by the European Banking Federation, which is the daily average of overnight rates for unsecured interbank lending in the euro-zone, i.e. like the federal funds rate in the US. The banks contributing to Eonia are the same as the Panel Banks contributing to Euribor

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In general, the steering of short-term interest rates is the main objective of the operational framework. The Eurosystem does not, however, specify a particular operational target. Nonetheless, considerable attention has been paid to EONIA, the unsecured overnight interest rate charged by banks in the EONIA panel. In response to the crisis, the corridor between standing facilities was ± 100 basis points either side of the rate applied in MROs. Then it was narrowed, and it is now at 75 basis points The development of the ECB’s official interest rates, as well as of two important money market rates, namely EONIA and three-month EURIBOR, is shown in Chart 4. It is clear that the introduction of the full allotment procedure and in particular the allotment of the first 12-month LTRO at the end of June 2009 caused the emergence of a significant liquidity surplus in the euro area banking system, resulting in overnight rates and 3-month rates drifting below the ECB’s MRO rate for an extended period of time. Only in October 2010, when excess liquidity had significantly declined, did the three-month EURIBOR rise back above the MRO rate. In the course of 2011 this has also occasionally been the case for EONIA. However, the rise in excess liquidity in the second half of 2011 again put downward pressure on money market rates. In particular, following the allotment of the first 36-month LTRO’s operation, EONIA was pushed back to about 10 basis points above the deposit facility rate, with three-month EURIBOR also embarking on a downward trend.

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Open market operations can also classified along different lines 1. Reverse transactions Reverse transactions refer to operations where the Eurosystem buys or sells eligible assets under repurchase agreements or conducts credit operations against eligible assets as collateral. Reverse transactions are used for MROs and LTROs, and also for FTOs and structural operations. Where reverse transactions take the form of a repurchase agreement, the difference between the purchase price and the repurchase price corresponds to the interest due on the amount of money borrowed or lent over the maturity of the operation. 2. Outright transactions The Eurosystem buys or sells eligible assets outright on the market. 3. Foreign exchange swaps Foreign exchange swaps executed for monetary policy purposes consist of simultaneous spot and forward transactions in euro against a foreign currency. They can be used for fine-tuning purposes, mainly aimed at managing the liquidity situation in the market and steering interest rates. 4. Collection of fixed-term deposits The Eurosystem may invite counterparties to place remunerated fixed-term deposits with the NCB 5. Issuance of ECB debt certificates The ECB may issue debt certificates with the aim of adjusting the structural position of the Eurosystem vis-à-vis the financial sector so as to create (or enlarge) a liquidity shortage in the market.

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The balance sheet of the ECB

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On the assets side, three main liquidity-providing items: “Refinancing to credit institutions”: outstanding amount of liquidity-providing open market operations. Always include MROs and LTROs. Any liquidity-providing FTOs and structural operations are also included under this item. “Marginal lending facility”: overnight credit provided by the central bank “Net foreign assets”: assets in foreign currency owned by the central bank, net of any central bank liabilities denominated in foreign currency. On the liabilities side, five main items: “Credit institutions’ holdings on current accounts” (also known as “reserves”): balances held by credit institutions with the central bank in order to meet settlement obligations from interbank transactions (excess reserves) and to fulfill reserve requirements (required reserves). “Deposit facility”: the total overnight recourse to this standing facility. “Banknotes in circulation” : value of the banknotes put into circulation by the central bank at the request of credit institutions. This is usually the largest item on the liabilities side. “Government deposits”: current account balances held by national treasuries with NCBs. “Other factors (net)” is a balancing item encompassing the remaining items on the balance sheet. The net amount of liquidity supplied by the central bank is the sum of two elements. 1) the “autonomous factors” (the sum of “banknotes in circulation” plus “government deposits” minus “net foreign assets” plus “other factors (net)”,which is the net effect of the remaining balance sheet items affecting money market liquidity). 2) credit institutions’ reserves (“credit institutions’ holdings on current accounts”). The sum of the autonomous factors plus the reserves equals the supply of liquidity through monetary policy operations (the sum of “refinancing to credit institutions” plus “marginal lending facility” minus “deposit facility”). The logic of the balance sheet of the ECB from a liquidity perspective

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General principle: other things being equal, any increase in the net provision of liquidity through net open market operations and outright purchases necessarily has to show up on the liability side of the balance sheet in the form of higher current accounts, deposit facility recourse or fixed-term deposits. Autonomous liquidity factors are items of the central bank balance sheet which are unrelated to the implementation of monetary policy, at least in the short term. Liquidity providing autonomous factors: 1) Net foreign assets 2) Domestic assets Acquisition by the central bank of such assets through implies the transfer of central bank liquidity to the banking sector. Liquidity absorbing autonomous factors 1) Banknotes in circulation

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Banknotes in circulation absorb the banking system’s liquidity because they have to be obtained from the central bank: the bank that receives the banknotes sees its reserves at the ECB reduced correspondingly. 2) Government deposits. 3) Other liquidity absorbing net autonomous factors Liquidity providing monetary policy factors 1) Open market operations: normally, MROs and LTROs. During the crisis, also CBPP and SMP. The bulk of the liquidity up to September 2008 was provided through the MROs, reflecting the key role played by this monetary policy instrument. Following the introduction of a fixed rate full allotment procedure from October 2008 onwards for all refinancing operations, the weight of the refinancing operations shifted towards LTROs. Additional liquidity was provided through other operations, notably the covered bond purchase programme (CBPP) and the Securities Markets Programme (SMP). 2) Fine-tuning operations can be used at any point to provide additional liquidity for a specified term. 3) Marginal lending facility (overnight, and very small). Liquidity absorbing monetary policy factors 1) Counterparties can keep central bank liquidity on their current accounts (reserve requirement and excess reserves). Required reserves have a liquidity-absorbing effect which is similar in size to the effect of all the autonomous factors together. 2) Deposit facility, remunerated at the deposit facility rate. Standing facilities (lending and deposit) normally have only a marginal impact on the banking system’s liquidity. Owing to the liquidity surplus of the banking sector in the context of credit operations at fixed rate with full allotment, banks have made larger recourse to the deposit facility than in normal times. 3) Counterparties can tender their liquidity in liquidity-absorbing fine-tuning operations.

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Relationship between deposit facility and refinancing operations We can define daily excess liquidity as the sum of the deposit facility (DF) and excess reserves. Recall that excess reserves are not remunerated, while the deposit facility is remunerated at the deposit facility rate. Thus, the daily average of excess reserves tends to be low. As a result, the excess liquidity is reflected above all in the recourse to the deposit facility. Recourse to the deposit facility reached a relative peak in May 2010, at the height of the Greek sovereign debt crisis, when some banks that had lost access to the market increased their reliance on Eurosystem refinancing operations and generated a liquidity surplus in the system. In the first half of 2010, before the maturity of the first 12-month LTRO, most funds (about 60%) were deposited by the same banks that had borrowed from the Eurosystem, mainly through longer term operations. This evidence confirms that at least some of the funds were borrowed for precautionary reasons. After the maturity of the first 12-month LTRO, the above relationship between the deposit facility and Eurosystem borrowing changed. For the following year (until July 2011) less than 30% of funds were deposited by counterparties with an outstanding refinancing. This appears to suggest that especially during the most difficult times of the debt crisis such demand was increasingly driven by the need to substitute market financing with central bank financing. Again, the two 36-month LTROs somewhat changed this picture; in February and March 2012 counterparties that borrowed funds from the Eurosystem increased their share of the deposit facility from 25% to more than 40% of the total.

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Measures taken by the ECB during and after the crisis The non-standard measures taken by the Eurosystem have been targeted mainly at the banking sector, owing to its important role in the transmission of monetary policy and the financing of the economy in the euro area (in comparison with, for instance, the situation in the United States). 1. ENHANCED CREDIT SUPPORT The collapse of the US financial institution Lehman Brothers on 15 September 2008 had caused a “seizing up” of the money markets. The ECB’s Enhanced Credit Support is a set of non-standard measures to support financing conditions and the flow of credit beyond what could be achieved through reductions in key ECB interest rates alone. Extension of the maturity of liquidity provision After the collapse of Lehman Brothers, the maximum maturity of the LTROs was temporarily extended to twelve months. Reduced uncertainty and a longer liquidity planning horizon was expected to encourage banks to continue providing credit to the economy. Fixed rate full allotment A fixed rate full allotment tender procedure was also adopted for all refinancing operations during the financial crisis. Thus, contrary to normal practice, eligible euro area financial institutions had unlimited access to central bank liquidity at the main refinancing rate, subject to adequate collateral. Currency swap agreements The Eurosystem also temporarily provided liquidity in foreign currencies during the financial crisis, most notably in US dollars, at various maturities. It used reciprocal currency arrangements with the Federal Reserve System to provide funding in US dollars against Eurosystem eligible collateral at various maturities at fixed interest rates with full allotment. This measure supported banks which otherwise faced a massive shortfall in US dollar funding during the period of financial crisis. Collateral requirements The list of eligible collateral accepted in Eurosystem refinancing operations was temporarily extended during the financial crisis, and this allowed banks to use a larger range and proportion of their assets to obtain central bank liquidity. The ability to refinance illiquid assets through the central bank provides an effective remedy to liquidity shortages caused by a sudden halt in interbank lending. This includes, for instance, asset-backed securities, which became illiquid (The temporary expansion relates to bank bonds traded on accepted non-regulated markets; subordinated debt instruments when protected by an acceptable guarantee; securities with a credit rating threshold lowered from A- to BBB-, except for ABSs; and foreign-exchange denominated collateral. In total, as a result of the measures, the increase in collateral amounted to €870 billion at the end of 2008, representing 8% of total eligible marketable collateral, while it accounted for approximately 3% of total collateral used. Under the Basel II regulatory framework, the standard risk weight on banks’ sovereign debt holdings is 0% for both domestic and foreign issuers, provided that the sovereign has a credit rating of AA- or

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higher. Debt of lower-rated domestic and foreign sovereigns attracts a higher risk weight (20% for A-rated entities, 50% for BBB-rated entities, 100% for B- to BB-rated entities), with the domestic regulator having the discretion to impose lower risk weights on domestic sovereign debt. In recent months, banks from severely affected countries (Greece, Ireland and Portugal) have increased their use of Eurosystem liquidity and made greater use of domestic government bonds or government-guaranteed bank bonds to collateralise this funding. This was permitted by a modification of the rules on collateral acceptance by the Eurosystem, which suspended the application of the minimum credit rating threshold for securities issued or guaranteed by governments of countries that had obtained international financial support and adopted a fiscal consolidation plan approved by the European Commission and the IMF. Additional non-standard measures were announced in December 2011. The ECB temporarily expand the list of collateral eligible for Eurosystem operations, as some banks’ access to refinancing operations may be restricted by a lack of eligible collateral. The temporary expansion of the list of eligible collateral announced on 8 December 2011 consisted of two elements. (i) The Governing Council decided to reduce the rating threshold for certain types of eligible asset-backed securities. (ii) A larger proportion of loans which are not securitised (i.e. credit claims) will be accepted as collateral for Eurosystem operations. In particular, each NCB may, as a temporary solution, authorise their use. This measure was taken to facilitate a more uniform transmission of the single monetary policy across the euro area. The responsibility entailed in accepting these “additional performing credit claims” (ACCs) will be borne by the NCB authorising their use. Outright operations: Covered bond purchase programme Within the scope of this programme, the Eurosystem purchased euro-denominated covered bonds issued in the euro area at a value of €60 billion over the period between May 2009 and June 2010. The covered bonds market had virtually dried up in terms of liquidity, issuance and spreads. The aim of the covered bond purchase programme was to revive the covered bond market, which is a very important financial market in Europe and a primary source of financing for banks. As a result of these non-standard measures, the relation between the main refinancing rate and money market rates temporarily changed. Whereas in normal circumstances the EONIA rate closely follows movements in the main refinancing rate, the high demand from banks for central bank liquidity in refinancing operations with full allotment has resulted in the deposit rate playing a greater role in steering the EONIA. In other words, as we have seen, the EONIA fell to its lower bound, the deposit rate. . 2. SECURITIES MARKETS PROGRAMME The Securities Markets Programme was introduced in response to tensions in some segments of the financial market, in particular in the euro area sovereign bond markets, in May 2010. large increases in the spreads between the yields on ten-year bonds of some euro area governments and the German Bund yield.

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Under the programme, Eurosystem interventions can be carried out in the euro area public and private debt securities markets to ensure depth and liquidity in dysfunctional market segments and to restore the proper functioning of the monetary policy transmission mechanism. In line with the provisions of the Treaty on the Functioning of the European Union, Eurosystem purchases of government bonds are strictly limited to secondary markets (to fulfill the “no bail out clause” of the ECB statute) . To ensure that liquidity conditions are not affected, all purchases are fully neutralised through liquidity-absorbing operations. In order to sterilise the liquidity impact of these interventions, the Governing Council decided that specific operations would be conducted to re-absorb the liquidity injected through the SMP on a weekly basis. The absorbing operations are usually conducted on a Tuesday as a collection of fixed term deposits with one-week maturity in a variable rate tender with the rate applied in main refinancing operations as the maximum bid rate. The amount to be absorbed is equal to the book value of the SMP portfolio at theend of the week preceding the SMP-absorbing fine-tuning operation. (look at the lines “SMP” and “Absorbing LTOs” in the next table) However, I personally do not think this is what we call technically a “sterilization”. It does not reduce one asset by the amount that another asset on the balance sheet of the ECB had increased. It is “sterilization” only in the much looser sense that the ECB absorbs liquidity (according to its own definition) by essentially converting excess reserves into fixed term, interest paying deposits. The SMP was used to buy Portuguese and Greek debt in May 2010 and Spanish and Italian debt in August 2011. At end-November 2011 it had a total amount of €200bn. When Greece defaulted to private creditors in 2012, the ECB insisted on having seniority status on its holdings of Greek debt, so that it did not bear any loss.

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3. 36-MONTHS LTROS Furthermore, as part of a wider set of measures to support bank lending, the ECB announced on 8 December 2011 two LTROs of 36-months maturity, with an option of repayment after one year. The first 36-month operation was allotted on 21 December 2011 and replaced the 12-month operation of 26 October 2011, while the second 36-month operation was allotted on 29 February 2012. The two 36-month operations allotted €489 billion to 523 bidders and €530 billion to 800 bidders, respectively. Full allotment => the balance sheet of the ECB has become essentially endogenous because liquidity provision is largely demand-determined.

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4. OMT PROGRAMME

In the textbook “bad expectational equilibrium” case, a country suffering from temporary illiquidity might be forced to default because each would-be lender fears that the others will no longer lend to the country; as a consequence, this expectation becomes self-fulfilling and the country cannot roll over its debt any longer (see e.g. Calvo 1988).

The textbook solution to such a problem is an announcement that the Central Bank stands ready to purchase an unlimited amount of government debt. In theory, such an announcement by itself should eliminate the bad expectational equilibrium, without any actual need of intervention by the Central Bank. On September 6, 2012, the ECB announced the “Outright Monetary Transactions” program: it stands ready to purchase and sterilize unspecified but potentially unlimited amounts of government debt on the secondary market, with maturity up to three years, provided a country were subject to the conditionality of an EFSF/ESM program.

As made clear by the ECB in response to several questions, OMT holdings by the ECB will not have seniority status. However, there is a subtle issue here. The ECB stated that “it accepts the same (pari passu) treatment as private or other creditors… in accordance with the terms of such bonds”. Contrary to what most commentators think, even the holdings of Greek bonds by the ECB, acquired under the (much smaller) OMT predecessor, the Security Market Program, did not have inherently senior status: “The SMP seniority only activated when Greece switched the ECB’s holdings into special securities protected from restructuring [….] That means the ECB could, if hell-bent on avoiding losses through a restructuring, stay legally ‘pari passu’ but effectively senior anyway “ (Cotterill 2012). As further noted by David Nowakowski of RGE Monitor: “The ECB can promise to be pari passu, until a default threatens and it can then pressure Euritania to let it swap into local or international bonds without CACs that receive special treatment, exactly as it did with Greece. They could still argue, though not in good faith, that those bonds are not senior to anyone, they just got lucky again to get such a great offer. The ECB has tremendous leverage on countries whose banking systems depend on it for funding, so it can call the shots.”

In any case, it is widely believed by market participants that the OMT announcement has had a considerable impact on the spreads of peripheral countries’ debt. But there are two good reasons why markets might overstate the importance of the OMT program. On the ”demand” side, activation of the program requires activation of an ESM program; this was designed to obviate the moral hazard problems of government debt purchases by the ECB.1 But governments are extremely reluctant to enter an ESM program, which would be perceived as a signal of political failure.

On the “supply” side, it is well known that the German Bundesbank opposed the creation of the program. Because it is hard to imagine the Eurozone implementing a large program against the opposition of the Bundesbank, it is of fundamental importance to try and understand the German position. This position has been widely criticized in Europe because it makes little sense in light of the textbook model. To make sense of it, one must ask what could happen off-equilibrium – always a possibility in the real world. Also, one has to bear in mind that this program was mostly designed to preempt problems with Spain and Italy, whose combined stock of government debt approximates

1 These moral hazard problems were in stark evidence in the summer of 2011 when, just a few days after the ECB announced the purchase of substantial amounts of peripheral debt under the SMP, the Italian government reneged on many budget measures it had previously agreed with the ECB itself.

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€3,000bn. What could happen if the ECB did have to intervene, buying hundreds of billions worth of this debt? One could envisage at least three problems from a German point of view.

First, in the real world nobody knows for sure if a country is just illiquid or insolvent. A default by one or more countries could result in large losses by the ECB. Even disregarding legal technicalities – which seem to require that national government immediately recapitalize the ECB if it has negative equity - how large a loss could the ECB sustain? Buiter (2012) estimate about €4,000bn, equal to the present discounted value of all future seigniorage; Reis (2012) estimates €200bn, obtained with the same method but taking into account a trend increase in velocity, the incentives of the Central Bank to inflate and the ensuing increase in velocity, and the currently low interest rates, that imply a very low inflation tax.

Beyond mere economics, the key relevant question is: what is the maximum ECB loss that is politically sustainable in Germany? For historical and cultural reasons, the answer would have to be: very small. In this sense, a large OMT intervention would indeed be risky from the point of view of Germany.

Second, is the commitment to total sterilization credible, and would the sterilization be effective anyway? It is frequently asserted that OMT purchases would be different from QE, because the latter is not sterilized. Yet the difference appears to be based largely on semantics. The ECB has not stated how it would sterilize the purchases; a common interpretation is that it would sell equal quantities of government debt of healthy countries. But it is easy to see that this might not work; the Eurosystem currently holds about €590bn of government securities; although the ECB does not release the country breakdown, it is likely that most of this amount consists of debt of problem countries. A large OMT operation on Spanish and Italian debt could not be sterilized this way. More likely, the ECB would “sterilize” by offering banks to convert their free reserves into 1-week deposits with a minimal remuneration, as it did with the Securities Markets Program launched in May 2010. However, these deposits are part of the monetary base, and banks would probably regard these very short term deposits and free reserves as almost perfect substitutes. 2

Third, what happens if, after some time, a country is no longer deemed in compliance with the ESM program conditions? Realistically, can the stock of debt accumulated by the ECB be liquidated? Also, since monitoring compliance is entrusted mainly to the Commission, the fear that the process might be influenced by political considerations (as it has frequently happened in the past regarding compliance with the Maastricht Treaty and the SGP) is not unfounded. In fact, as we have seen Spain has just been granted an extra two years to reach its fiscal targets.

The Eurozone loop between sovereign debt and financial sector risks

2 Because of the large MROs and LTROs there is excess liquidity in the system, and this is largely a nominal issue. But in more normal times sterilization would require increasing the interest rate in absorbing operations or issuing longer term debt certificates.

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Source: CGFS (2011)

In the EZ, there is a tight loop between sovereign debt and financial sector risks, something that we do not observe in the US. The Figure above illustrates the high correlation between CDS premia of banks and sovereign debt in the EZ, and the much smaller correlation in the US.

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In fact, European banks hold a much higher share of their sovereign debt than US banks, which hold almost no government debt at all (see following Table)

The Table below shows the evolution between 2007 and 2011 of the share of different holding sectors in the total holdings of government securities issued by the main euro area countries as well as the United States and the United Kingdom. Comparing 2011 to 2007, some important changes are evident. First of all, holdings of government debt by non-residents have diminished in proportion for all the countries in trouble (Greece, Ireland, Portugal, Spain and to a lesser extent Italy), have remained more or less stable for France and the Netherlands and have increased for Germany. Conversely, the share of domestic banks in total holdings of domestic sovereign debt has increased significantly between 2007 and 2011 in all countries whose bonds have been shun by non-residents (Greece, Ireland, Portugal, Spain and Italy)

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This creates a two way interdependence. 1) From banks to sovereign. The most immediate way in which pressure on the banking system can spill over to sovereigns is through the perceived cost of bank rescue. Acharya et al. (2011) present evidence that the announcements of bailouts in Western Europe coincided with a generalised “shift” of credit risk from banks onto sovereign, evident in the contemporaneous decrease in banks CDS and increase in sovereign CDS. Moreover, they also find both banks and sovereign CDS to increase in the post-bailout period, 2) From sovereign to banks. Government bonds were appealing to banks because they can be easily used as collateral (both on the interbank markets in normal times and for central banks emergency lending in troubled times) and because the Basel regulatory framework allowed for the zero-risk weighting of bonds issued by euro area governments. Increases in sovereign risk may affect banks through their direct holdings of sovereign debt. Losses on sovereign portfolios weaken banks’ balance sheets and increase their riskiness, with adverse effects on the cost and availability of funding. The extent of the impact depends on whether the securities are carried on the balance sheet at market value (that is, held in the trading, available-for-sale or fair value option books) or at amortised cost (assets in the held-to-maturity banking book). In the first case, a fall in the value of sovereign bonds has direct and immediate effects on banks’ profit and loss statements, and on their equity and leverage. In the second case, accounting principles imply that losses are recorded only when the securities are impaired (eg when a sovereign restructuring or default becomes likely);

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nonetheless, these exposures may affect bank funding conditions prior to this occurring, to the extent that investors become concerned about the solidity of the bank. Across EU countries, most of the exposure (85% on average) is held in the banking book, somewhat limiting the immediate impact on banks of changes in the market price of sovereign bonds. Holdings of domestic government bonds as a percentage of bank capital tend to be larger in countries with high public debt. Among the countries severely affected by the sovereign crisis, banks’ holdings are largest in Greece and small in Ireland.

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Sovereign securities are used extensively by banks as collateral to secure wholesale funding from central banks, private repo markets and issuance of covered bonds, and to back over the- counter (OTC) derivative positions. Increases in sovereign risk reduce the availability or eligibility of collateral, and hence banks’ funding capacity, through several mechanisms. 1) When the price of a sovereign bond falls, the value of the collateral pool for institutions holding that asset automatically shrinks. 2) If the asset was already posted in specific transactions, mark to market valuation of collateral could trigger a margin call. 3) A downgrade could even exclude a government’s bonds from the pool of collateral eligible for specific operations or accepted by specific investors 4) The haircuts applied to sovereign securities could increase Provision of central bank liquidity (such as through open market operations) is typically conducted through repurchase agreements or secured transactions. In the Eurosystem’s refinancing operations, 20% of transactions are secured by government bonds. This share likely reflects the fact that a wide range of collateral instruments are eligible with the central bank and that banks tend to use sovereign bonds in private repos, where only very liquid collateral is accepted. In the United Kingdom and Japan, 60-80% of open market and standing facility operations are collateralised by government bonds. Private repo markets are a significant source of funding for banks. In the euro area, the amount of outstanding repos in June 2010 was equivalent to 75% of GDP, with 80% collateralised by government bonds. The private repo market is very sensitive to changes in the perceived riskiness of the collateral. Only 1½% of transactions were collateralised by Greek, Irish and Portuguese government bonds during the six months to December 2010, less than half the share in 2008 and 2009. This reflected sharp falls in the use of Greek and Irish collateral.

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The effect of the 3-years LTRO on the loop between sovereign and financial sectopr risk The main motivation for the LTROs was to furnish liquidity to banks. Many commentators have argued that the operation failed, because all the new liquidity came back to the ECB in the form of higher bank deposits or reserves. This is obviously incorrect, because from a purely accounting viewpoint this had to happen. Nevertheless, for the purposes of this discussion the operation did have a large, unintended consequence.

Total LTROs and shares of Spanish and Italian banks

Spain Italy LTRO

Sep-11 12.2 15.4 379 Oct-11 10.9 16.1 396 Nov-11 13.2 17.4 392 Dec-11 12.1 22.8 704 Jan-12 22.9 22.2 677 Feb-12 23.4 21.5 652 Mar-12 28.9 24.5 1091 Apr-12 28.8 24.6 1092 May-12 29.7 25.3 1062 Jun-12 29.6 25.0 1080 Jul-12 30.9 25.1 1075 Aug-12 31.3 25.3 1078 Sep-12 31.1 25.7 1059 Oct-12 30.2 25.8 1058

Source: Bruegel database of Eurosystem lending operations developed in Pisani-Ferry and Wolff (2012)

The banks receiving the liquidity were largely southern European banks: during 2012

Spanish and Italian banks accounted for more than 55 percent of all outstanding LTRO lending, up from about 30 percent in November 2011 (see Table above); in contrast, the countries depositing the funds at the ECB appear to have been mostly Northern European banks. In fact, in the first months of 2012 a clear pattern can be detected: the Spanish and Italian sovereign debt held by Spanish and Italian financial institutions increased considerably (see Table and Figure below) , with a corresponding decline in the shares of this debt held by foreigners. Thus, Southern European banks appear to have used the LTRO funds to make a simple carry trade with their own sovereign bonds.

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Holdings of own sovereign debt by Spanish and Italian OMFIs and other financial institutions

Spain Italy

OMFI

Other financial

Total OMFI Other

financial Total

2011_1 26.1 15.1 41.2 14.9 18.9 33.8 2011_2 26.9 15.7 42.6 15.5 18.4 33.9 2011_3 24.8 16.4 41.2 16.9 18.6 35.4 2011_4 28.1 16.9 45.1 16.5 18.1 34.6 2012_1 34.9 16.2 51.1 20.0 18.6 38.6 2012_2 34.3 17.6 51.9 21.4 19.1 40.4 2012_3 32.9 17.2 50.2 21.4 20.5 41.9 2012_4 32.6 15.9 48.5 21.5 21.0 42.5

OMFI: Monetary Financial Institutions excluding Central Bank Source: Bruegel database of sovereign bond holdings developed in Merler and Pisani-Ferry

(2012) Thus, the unintended consequence of LTRO was to make sovereign debt holdings even

more fragmented along national lines, making the loop between sovereign and banking sector risk even tighter.

The increased demand for government securities has probably contributed to the decline of the spread between Italy and Spain on one hand and Germany on the other. But there is less evidence that LTRO funds found their way to small and medium enterprises (see Table below)

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The difference in collateral policies of the FED and the ECB Prior to the financial crisis that began in 2007, the Eurosystem and the Federal Reserve System had very different operational frameworks for the implementation of monetary policy, in particular regarding the type of securities that were eligible as collateral for obtaining credit from the central bank. Eurosystem: 1) Accepted a very broad range of collateral in its main open market operations, 2) Allowed a broad range of banks to participate. 3) Open market operations were of large size 4) No differentiation in the interest rate charged in the auctions depending on the type of collateral. Federal Reserve: 1) Accepted only government and quasi-government securities as collateral in its temporary operations 2) Narrow group of less than 20 counterparties. 3) Temporary operations were of a small size, 4) charged different interest rates in the auctions depending on the type of collateral in order to minimise any impact of its operations on asset prices. Following the start of the financial market turmoil, it became clear that central banks needed to provide banks with funds against less liquid collateral in order to prevent a systemic crisis. Federal Reserve expanded their operations significantly. In particular, FED started to accept asset-backed securities issued by the private sector as collateral. The ECB’s had already for many years accepted asset-backed securities as collateral in its liquidity-providing operations, was flexible enough to accommodate banks’ additional demand for liquidity with relatively few adjustments. By the spring of 2009, the Federal Reserve had adopted such a large range of new facilities that the amount of liquidity provision – measured by four criteria: the size of the operations, the type of collateral, the range of eligible counterparties and the interest rate – was equivalent or arguably more ‘accommodative’ than the Eurosystem’s. However, this turned out to be a temporary phenomenon, as many of the Federal Reserve’s programmes began to automatically unwind as market conditions started to improve during the summer and autumn of 2009 and the provision of liquidity decreased quite markedly (until, of course, the Fed started the QE policy)..

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The principal objective of ensuring a high degree of protection against financial loss through the use of collateral could be achieved in two ways: (i) by only accepting assets with a very low credit, market and liquidity risk, e.g. government bonds; (ii) by accepting a wider range of collateral, with varying degrees of credit, market and liquidity risk, but applying sufficiently high valuation “haircuts” In private interbank repo markets, strong tendency to opt for the former approach, with the vast majority of collateral consisting of government bonds; repo markets in non-government bond collateral are still negligible in most developed countries, with the exception of US agency bonds. In 2008, 83.6% of the outstanding €4.6 trillion private repo transactions in Europe are collateralised by government bonds. Similarly, in the US, prior to the crisis, the percentage of central government bond collateral in the total outstanding repo transactions was also high, at approximately 81%. Among central banks, however, there is much more variation. (i) Federal Reserve, Bank of England Bank of Canada: accept only central government or quasi-government bonds for open market operations. (ii) ECB and Bank of Japan accept a broad range of both public and private sector claims as collateral,

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What determines the collateral policies of Central Banks 1. Development of capital markets The central bank’s decision on whether to use primarily outright or temporary operations depends on whether capital markets are deep enough in relation to the liquidity that needs to be provided to the banking sector. The central bank can operate a monetary outright portfolio on a permanent basis without creating market distortions only if capital markets are deep enough. a) Lack of a single euro area government bond market were one of the reasons why the Eurosystem did not establish an outright portfolio earmarked for monetary policy purposes until the launch of its Covered Bond Purchase Programme in July 2009. Thus, the ECB operated mostly with very large temporary operations, amounting to €466 billion (38% of its balance sheet in July 2007) before the onset of the turmoil. This had an impact on the collateral policy of the Eurosystem: in general, the larger the volume of central bank temporary operations relative to the size of the domestic government bond market, the greater the need to expand the eligibility of collateral to private sector securities or non-marketable assets. In the FED, the ratio of temporary operations to the size of the domestic government bond market was, before the current crisis, very low at 1:200. In the Eurosystem it was much higher, at 1:10 2) Eurozone financial system is a more traditional bank-based financial system, with relatively undeveloped private sector bond markets. The funding of residential mortgages in the euro area was and still is predominantly done through retail deposits. Retail deposits accounted for approximately 60% of €6.1 trillion of outstanding residential mortgage balances in the EU 27 in 2007, with only 27% funded through mortgage-related securities, with the remainder funded through unsecured borrowing. The corporate bond market in the euro area was also relatively underdeveloped as companies have traditionally obtained financing from banks or by using retained profits rather than the capital markets. The prominent role of loans in the Eurosystem and the limited scale of securitisation of loans to small and medium sized enterprises was one of the reasons why the Eurosystem developed a euro area-wide eligibility framework for bank loans, which was launched at the start of 2007.

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(Some have argued that by accepting corporate loans as collateral, the Eurosystem may be hampering the development of SME loan securitisation. But it seems more likely that other factors are more important in impeding the market, in particular 1) the lack of homogeneity of the SME loan market 2) the lack of balance sheet data over the cycle 3) Banks would most likely wish to securitise the lower credit quality loans; given that the Eurosystem minimum credit threshold is rather high at single A- (BBB during the financial turmoil) banks would probably wish to retain these higher quality loans on their balance sheet). In contrast, thanks to the ample supply of US Treasury debt (and associated well-developed government securities markets), the FED has faced relatively few constraints concerning the design of its operational framework. Before the crisis the Federal Reserve had a very large outright asset portfolio, amounting to approximately 91% of its balanced sheet, and composed mostly of US Treasuries. Temporary operations amounted to only USD 23 billion or 3% of its balance sheet in July 2007. 2. Banking structure A second important aspect of the central bank’s environment that affects the design of the collateral framework is the choice of counterparties. The wider the range of counterparties, the more diverse the types of collateral asset held on their balance sheets are likely to be => the CB needs to accept a broader range of collateral. ECB: always placed a strong emphasis on ensuring that a broad range of counterparties can access central bank operations for two reasons. The Eurosystem allows all credit institutions subject to minimum reserve requirements to participate in the MROs, provided they are deemed financially sound by national supervisors and meet some basic operational requirements. Those requirements do not require active participation in private repo markets, as the Eurosystem operates temporary operations that are particularly designed for monetary policy purposes. Currently, this means that about 1,700 institutions are eligible to participate in regular open market operations (i.e. around 30% of all credit institutions). FED: distinguishes between depository institutions (banks) that have access to primary credit (discount window) lending, and counterparties that are eligible for its open market operations. All 7,000 depository institutions that have a reserve account with the Federal Reserve and an adequate supervisory rating have access to the discount window against a very broad range of collateral.

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In principle, the Federal reserve’s open market operations are open to all types of financial institutions in principle. However, given the narrow role of temporary operations the FED has traditionally relied on a small group of primary dealers (currently 18) for this purpose. 3. Central bank balance sheet size and composition For precautionary reasons, banks prefer to hold much more than the amount of collateral which they strictly need for the credit operations. It is well known that banks prefer to hold substantial buffers of unused collateral in case other forms of short-term market or retail funding disappear during market turbulence. Ceteris paribus, the smaller the size of the outright portfolio (and the greater size of the temporary operations), the greater should be the size of the collateral pool to avoid the risks of shortages of collateral (in normal times and especially in times of crisis) and the bidding up of prices of the eligible bonds. If the government bond market is not sufficiently large, then the central bank needs to extend eligibility to a broader range of assets. This has been the case for the Eurosystem, which, in the absence of an outright portfolio for monetary policy purposes, has had to operate with very large temporary operations, amounting to €466 billion, or 38% of its balance sheet, as of July 2007.

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Responses to the crisis by the ECB As described earlier, the Eurosystem’s operational and collateral framework prior to the crisis had a certain degree of inherent flexibility due to the need to cope with less developed capital markets. This meant that, despite the absence of a centralised fiscal authority, the Eurosystem did not initially have to adjust its framework to prevent an immediate meltdown of the financial system. There are three elements to this flexibility, as set out below. a) Firstly, a wide range of institutions, small savings banks and co-operative banks, as well as investment banks with a limited deposit base, can access central bank liquidity directly. This feature allowed the Eurosystem to mitigate the funding liquidity risks more directly for a broader range of counterparties when short-term interbank markets stopped functioning properly. b) The fact that the Eurosystem accepts a wide range of collateral in all types of credit operations meant that collateral has not been a constraint, at the aggregate level or at the level of individual counterparties. They have economised, in particular, on the use of central government bonds, which has often been almost the only collateral counterparties could still use in interbank repo markets. By the end of 2008, €193 billion of central government bonds (equivalent to only 9% of total collateral which stood at €2.1 trillion) were pledged as collateral for Eurosystem credit operations => only 4% of the €4.1 trillion stock of government bonds was being tied up in Eurosystem credit operations At the same time, banks have increasingly brought forward less liquid collateral for which primary and secondary markets have nearly entirely dried up. The annual average share of asset-backed securities (ABSs) pledged as collateral with the Eurosystem rose to 28% during 2008 (or €521 billion), up from 11% in 2006 and only 6% in 2004. c) Because the Eurosystem provides the bulk of its refinancing via temporary open market operations, these operations have also been large in scale relative to outstanding volumes in a number of market segments. For example, the size of temporary operations was more than €800 billion by the end of 2008, which was larger than the entire euro corporate bond market or equivalent to almost 50% of the entire outstanding European ABS market. The scale of the Eurosystem’s operations has allowed for a large portion of these assets to be financed through the central bank. These three features, in combination with a lengthening of the maturity profile in the regular repo operations, allowed the Eurosystem to provide liquidity assistance not only to banks but also indirectly to asset markets => Eurosystem did not need to make many changes to its operational framework during the first year of the turmoil. This was most apparent in the ABS market. It is largely due to the Eurosystem’s collateral framework that euro-denominated securitisation issuance did not come to a halt, even though the

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vast majority of transactions were retained on banks’ balance sheets to be used in central bank credit operations. While issuance of “private label” MBSs in the US declined significantly from USD 580.8 billion in 2007 to only USD 39.9 billion in 2008, in the euro area issuance actually increased from €212.2 billion in the first three quarters of 2007 to €278.2 billion in the same period of 2008. The Eurosystem allows counterparties use ABSs that they have originated themselves and retained on their balance sheet (so-called “own use”) and counterparties have made active use of this possibility. The ability to use ABSs as collateral with the Eurosystem has helped counterparties to hedge the asset refinancing risk of those instruments and possibly prevented fire sales even before the switch to fied-rate full allotment tender procedures. However, as long as the Eurosystem applied variable rate tenders in its temporary operations, this did not imply that the Eurosystem refinanced the ABSs on one-to one basis. Eurosystem NCBs generally operate so-called “pooling systems” which allow counterparties to predeposit more collateral than they actually need. Indeed, these precautionary collateral buffers increased significantly during the turmoil, resulting in a large degree of over-collateralisation in the system.3

3 A “pooling” collateral system creates a pledge (or security interest) over a commercial bank’s securities in favour of the central bank but, unlike a repo transaction, leaves ownership of the assets with the commercial banks. The pooling/pledge method of collateralisation is highly flexible as all assets in the bank’s collateral pool are treated as fungible, and unlike the “repo” method it enables commercial banks to pledge more assets than they need to cover their borrowing. In repos, it is necessary to

specify exactly which securities are being used as collateral for a loan from the central bank and “overcollateralisation” can be more complicated to organise.

Even during the period of fixed-rate full allotments, when banks were given the opportunity to refinance all eligible collateral, including ABSs, levels of overcollateralisation still remained very high, at around 50%. There were several reasons for the very high level of overcollateralisation. First, the opportunity cost of keeping the collateral, such as ABSs, at the central bank are extremely low or even zero (i.e. there are no alternative uses: the assets would otherwise have been idle on the banks’ balance sheets). Second, banks prefer to have high precautionary buffers so that it is very quick and easy to increase borrowing levels in the event of abrupt changes in liquidity needs (e.g. due to negative publicity about the bank’s credit standing).

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Lehman Brothers led the Eurosystem temporarily to modify its operational framework quite significantly. There were two main changes. a) First, starting in mid-October 2008, the Eurosystem took the unprecedented step of applying a fixed-rate full allotment tender procedure in all refinancing operations, both MROs and LTROs => through this measure, the Eurosystem in effect took over the intermediation function of money markets: It removed the uncertainty for banks about their ability to finance themselves over a horizon of up to one year (and later three years) . b ) To facilitate the full allotment policy and further increase the already very broad range of eligible assets on banks’ balance sheets, the Eurosystem decided temporarily to expand the list of collateral until the end of 2009. (The temporary expansion relates to bank bonds traded on accepted non-regulated markets; subordinated debt instruments when protected by an acceptable guarantee; securities with a credit rating threshold lowered from A- to BBB-, except for ABSs; and foreign-exchange denominated collateral. In total, as a result of the measures, the increase in collateral amounted to €870 billion at the end of 2008, representing 8% of total eligible marketable collateral, while it accounted for approximately 3% of total collateral used. As we know, in 2011 there were further changes to the collateral rules.

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References Useful tools to understand the Fed’s balance sheet and its monetary policy tools: http://www.federalreserve.gov/monetarypolicy/bst_fedsbalancesheet.htm http://www.newyorkfed.org/markets/Forms_of_Fed_Lending.pdf http://www.newyorkfed.org/markets/index.html Adrian, T., C. R. Burke, and J. J. McAndrews (2009): “The Federal Reserve’s Primary Dealer Credit

Facility”, FRBNY Current Issues in Economics and Finance, August 2009 Adrian, T., K. Kimbrough, and D. Marchioni (2011): “The Federal Reserve’s Commercial Paper

Funding Facility”, Federal Reserve Bank of New York Economic Policy Review, May, pp. 25-39

Cecchetti, S. (2009): “Crisis and responses: The Federal Reserve in the early stages of the

financial crisis”, Journal of Economic Perspectives, Winter 2009, pp. 51-75 Cecchetti, S. and P. Disyatat (2010): “Central bank tools and liquidity shortages” , FRBNY Economic

Policy Review, August 2010, pp. 29-42 Cecchetti, S. aand K. Schoenhotz(2011): Money, Banking and Financial Markets, 3rd Edition, McGraw

Hill, chapters 16 and 17 Cheun, S. et al.: (2009): “The collateral frameworks of the Eurosystem, the Federal Reserve System,

and the Bank of England and the financial turmoil”, ECB working paper series, No 107, December 2009

Committee on the Global Financial System (2011): The impact of the sovereign credit risk on bank

funding conditions”, Bank for International Settlements, CGFS Papers No. 43, July 2011, European Central Bank (2011): The monetary policy of the ECB,

http://www.ecb.int/pub/pdf/other/monetarypolicy2011en.pdf Eser, F. et al.: (2012): “The use of the Eurosystem’s monetary policy instruments and operational

framework since 2009”, , ECB working paper series, No 135, December 2012 Fleming, M. J., W. B. Hrung, and F. M. Keane (2009): “The Terms Securities Lending Facility: origin,

design, and effects”, FRBNY Current Issues in Economics and Finance, February 2009, Merler, S. and Pisany-Ferry, J. (2012): “Hazardous tango: sovereign bank interdependence and

financial stability in the euro area”, Banque de France, Financial Stability Review, No 16, August 2012

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Perotti, R. (2013): “The sovereign debt crisis in Europe: lessons from the past, questions for the future”, presented at the Academic Consultants Meeting of the FED, Washington, DC, May 6 2013

Pisany-Ferry, J. (2012): “The Euro crisis and the new impossible trinity”, Bruegel Policy Contribution

2012/01, January 2012 Pisani-Ferry, J. and G. Wolff (2012): "Propping up Europe?" , Bruegel Policy Contribution 2012/07,

April 2012 Thornton, D. (2009): “What the Libor-OIS spread says”, Federal Reserve Bank of St. Louis Economic

Synopses, No. 24 Trigari, Antonella (2012): “Tools for monetary policy”, classnotes

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