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11 April 2012

Benoît Coeuré: Financing the economy of the euro area – the European Central Bank’s role


Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank, gave a speech at the Association Française des Tresoriers d’Entreprises, focusing on the LTRO operations of the ECB.

Launch of new non-standard measures and their impact

Faced with this critical situation, the Eurosystem adopted a two-pronged strategy. First, it offered ample liquidity at very long maturity to prevent funding issues from igniting a potentially destructive deleveraging process. Second, it widened the eligible collateral to facilitate access to the liquidity and the provision of credit to SMEs. Specifically, on 8 December 2011, the ECB announced the following initiatives.

  • First, the ECB said it would launch two longer-term refinancing operations (LTROs) with a maturity of 36 months. The LTROs were to be conducted as fixed-rate tender procedures with full allotment, with the interest rate fixed at the average rate of the main refinancing operations over the life of the respective operation. To increase the flexibility of the operations and to cater for different liquidity needs, counterparties were offered the option to repay after one year any part of the allotted amounts.
  • Second, the ECB decided to increase collateral availability by allowing national central banks, among other things, to accept as collateral additional performing credit claims (i.e. bank loans) that satisfy specific eligibility criteria.

The Governing Council’s view is that banks were facing significant funding problems and that, by removing impediments to their ability to finance the real economy, the three-year LTROs helped to avoid a dangerous credit crunch in the euro area. The large injection of liquidity via the three-year LTROs had an immediate impact on many market segments. By reducing concerns over the liquidity situation faced by banks and by cutting banking sector systemic risk (which is reflected, for instance, in a sharp decline in EU bank CDS premia), the LTROs contributed to reopening funding markets.

Euro area banks’ issuance of medium- and long-term debt picked up in the first two months of 2012, compared with the subdued levels in the second half of 2011. In this period, euro area banks issued about €50 billion in senior unsecured debt, which is about as much as was issued in the entire second half of 2011. Banks also issued €35 billion in covered bonds. While term debt issuance was mostly concentrated in some AAA euro area countries in the early phase of market reopening, the issuer base broadened thereafter. In particular, February saw the issuance of senior unsecured debt by some large banks from Italy and Spain, as well as some increased covered bond issuance by large banks and new issuance by “second-tier” lenders from these countries.

Challenges ahead

A side effect of the three-year LTROs is that the banking system in the euro area is now in a situation of abundant excess liquidity. “Excess liquidity” (defined as the difference between outstanding open market operations and the liquidity needs from autonomous factors and reserve requirements) currently stands at around €800 billion and is expected to remain at roughly this level at least until the end of January 2013, when banks will be able to exercise the option of early repayment on the first three-year LTRO. The leeway for a reduction in outstanding refinancing operations before that date currently amounts to around €100 billion, and the scale on which banks will exercise early repayment options is difficult to anticipate at the current juncture. As a consequence, the balance sheet of the Eurosystem has grown to €3 trillion. This large increase is a symptom of malfunctioning money markets, and reflects the fact that the Eurosystem has replaced much interbank activity. When the situation stabilises and money markets go back to functioning normally, the balance sheet of the Eurosystem will also go back to its normal size. To this respect, the Eurosystem is often compared with other major central banks. Such comparisons however disregard the initial size of balance sheets, as the Eurosystem holds a large volume of assets that have nothing to do with monetary policy. In early March, the ratio of monetary policy instruments to regional GDP was 15 per cent for the Eurosystem, 19 per cent for the Federal Reserve System and 21 per cent for the Bank of England.

This large amount of excess liquidity has drawn criticism of two different kinds. Some observers have argued that since banks are re-depositing with the ECB large amounts of liquidity, the injected liquidity is not circulating within the system and therefore the ECB’s actions will be ineffective in preventing deflationary pressures. Others, however, have warned that since these large amounts of excess reserves may remain in the system for a relatively long time, if they are not appropriately absorbed they will hamper the ECB’s ability to keep inflationary pressures in check.

The first criticism  reflects a fundamental misunderstanding of the functioning of the operational framework of the ECB. By an accounting identity, any amount of liquidity injected in excess of the liquidity needs of the banking system will be necessarily re-absorbed via the deposit facility. The increase in the deposit facility does not provide any information whatsoever about how banks use the funds borrowed from the central bank.

Let me turn now to the second criticism – namely that excess liquidity will generate inflation. It is important to recall, first, that the three-year LTROs have helped avoid a disorderly deleveraging which may have led to deflation. Let’s analyse now the arguments behind the fear that the LTROs may have, however, increased the upside risks to price stability. Central bank reserves represent one of the many assets in the balance sheet of a bank. Up to a certain amount, banks’ demand for central bank reserves is completely inelastic. Beyond this amount, however, the decision to hold excess reserves responds to risk-return considerations as for any other asset: if a bank decides to hold a certain amount of excess reserves, it is because their risk-adjusted return dominates that of other assets.

There is a third concern which I would like to touch upon, and which I consider to be a serious one: the risk of moral hazard behaviour triggered by the non-standard measures. The large liquidity injections have avoided so far a disorderly deleveraging of the banking sector in the euro area as well as a dangerous credit crunch, but they have not removed the underlying causes of the turmoil. If governments and banks would stop or slow down their consolidation efforts and structural reforms, this would undermine the positive effects of the liquidity operations.

The large amount of liquidity now present in the system is a consequence of these actions. It represents the symptoms of a malfunctioning interbank market, which, if left untreated, could have led to a credit squeeze. The ECB’s ability to maintain price stability remains intact: we will have the possibility to adjust the interest rates and, if necessary, we have at our disposal a range of tools to actively absorb the excess liquidity.

The ECB has addressed the immediate symptoms, but monetary policy cannot cure the underlying causes. The situation in financial markets has reached a turning point but recent market developments have highlighted that it remains fragile. All the relevant players must act responsibly by taking the necessary steps. Banks need to meet capital adequacy objectives, improve their funding profile, and start lending again. Governments must build on the steps already taken to restore sound fiscal positions and support long-term growth. At the ECB we will continue to monitor further developments closely. We will do whatever it takes to fulfil our mandate of delivering price stability over the medium term for the 330 million people of the euro area.

Full speech



© BIS - Bank for International Settlements


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