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The European Central Bank is due again Thursday to offer cheap loans to eurozone banks on the condition that they pass on the funds to eurozone firms. It’s one of a number of measures the ECB has enacted since the start of the crisis in 2007 to get the region’s economy back on its feet.
One of the mainstays of the ECB’s crisis response has been that it meets banks’ full funding needs with regular loans at a fixed interest rate. The ECB started this policy, known as ‘fixed rate full allotment,’ in October 2008, amid the turmoil of the Lehman Brothers bankruptcy. The ECB has kept this weekly policy for almost seven years (it briefly reverted to variable rates on three-month loans from March to May 2010).
This means that as long as a lender can present appropriate collateral at the ECB window, the central bank will provide it with all the cash it needs at a single, fixed interest rate.
But is it time to scrap this staple of crisis fighting?
A professor in Frankfurt thinks so: Falko Fecht, a professor of financial economics at the Frankfurt School of Finance and Management and a Deutsche Bundesbank Research Professor, argues that the ECB’s liquidity provisioning policy has the undesired side effect of keeping banks afloat that really shouldn’t still be in the market.
“Fixed-rate full allotment…contributes to the lengthening of the crisis,” said Mr. Fecht in a phone interview with The Wall Street Journal. “I think what we need is a market consolidation in the banking sector, some of the undercapitalized banks that are unable to survive without ECB financing, need to leave the market one way or the other.”
So what did ECB operations look like in what Germans like to call “former times”? Thanks to a charmingly dated video on the ECB website (yes, that’s Jean-Claude Trichet, Lucas Papademos, and Juergen Stark) one can learn how this was once done back in the good old days.
In short, banks placed bids on funds, with the interest rate that we now know as the ‘main refinancing rate’ serving as the floor for rate bids. Banks that placed a higher bid were given the first access to funds, which were also capped.
It’s still pretty likely that this variable rate tender will remain in the history books for a while longer. The central bank is clearly in full-on policy accommodation mode, having recently launched QE in March and with ECB President Mario Draghi even suggesting at the last press conference that QE could be stretched out if need be.
Mr. Fecht doesn’t think bringing back some market discipline to policy operations would undermine the idea of an accommodative policy stance, which he admits is appropriate. “It’s not necessarily a tightening of policy conditions,” he said, though it would up the pressure on banks who might need to exit the market so that the financial system can work “properly” again. To offset the destabilizing effect of the move somewhat, Mr. Fecht says the ECB could also be sure to provide enough liquidity that matches the calculated liquidity needs of banks. It could also lower its overnight emergency lending rate. The latter move would help banks unable to borrow at the regular weekly loan.
Full article on Wall Street Journal