MONETARY POLICY INSTRUMENTS OF THE ECB

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1 Roberto Perotti November 17, 2016 Version 1.0 MONETARY POLICY INSTRUMENTS OF THE ECB For a mostly legal description of the ECB monetary policy operations, see here, here and in particular here. Like in the US, the instruments of monetary policy for the ECB are: Reserves Open market operations Standing facilities RESERVES You can find more details here, including a list all Eurozone MFI s (Monetary and Financial Institutions) subject to reserve requirement. These consist of required (or minimum) reserves (remunerated) and excess reserves (not remunerated). Holdings of required reserves are remunerated at the average, over the maintenance period, of the interest rate of the main refinancing operations (see below). Currently the interest rate on reserves is 0. Each institution must hold its minimum reserves on one or more reserve accounts with the NCB (National central Bank) in the Member State in which it is incorporated. This is the latest information on required and excess reserves 1

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3 OPEN MARKET OPERATIONS More details here. OMOs by the ECB are broadly similar to FED s daily OMO, with two key differences: 1) FED: 18 primary dealers; ECB: hundreds of counterparties. Of the 6334 credit institutions in the Euro area as of January 2011, 2267 were eligible for open market operations. 2) FED: accepts government securities and GSE securities; ECB: much wider range of collateral, including private securities (a less important difference is that the FED conducts OMOs through the NY FED, while the ECB conducts them through NCBs) There are four types of open market operation Main refinancing operations Longer-term refinancing operations Fine-tuning operations Structural operations Main Refinancing Operations The main refinancing operations are the most important open market operations conducted by the Eurosystemy. MROs are repos (called by the ECB reverse transactions ), through which ECB provides reserves to banks (through NCBs) in exchange for securities and then reverses the transaction at the expiration. MROs are conducted regularly on a weekly basis. They generally have a maturity of one week. They normally provide the bulk of liquidity to the banking system. Thus, the operational features of the main refinancing operations can be summarised as follows: (a) they are executed regularly each week; (b) they normally have a maturity of 1 week; (c) they are executed in a decentralised manner by the NCBs; (d) all counterparties fulfilling the general eligibility criteria may submit bids for the main refinancing operations; and (e) marketable and non-marketable assets are eligible as underlying assets for the main refinancing 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. From 27 June 2000 the MROs were conducted as variable rate tenders with a minimum bid rate using a multiple rate procedure. Here is the explanation of the terms. 3

4 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. The liquidity is allotted pro rata. Variable rate tender: counterparties bid both the amount of money they wish to transact and the interest rate. They may submit up to 10 bids. In each bid, counterparties must state the amount of money that they are willing to transact with the NCBs and the relevant interest rate. Bids are then listed in descending order of offered interest rates. Bids with the highest interest rate levels are satisfied first, until the total liquidity to be allotted is exhausted. 1 For variable rate tenders, the Eurosystem may apply either single rate or multiple rate auction procedures. In a single rate auction (Dutch auction), the interest rate applied for all satisfied bids is equal to the marginal interest rate (i.e. that at which the total allotment is exhausted). In a multiple rate auction (American auction), the allotment interest rate is equal to the interest rate offered for each individual bid. Starting on 15 October 2008,the MROs were conducted as fixed rate tenders with full allotment. Full allotment procedure. In this case, the ECB allots all the liquidity requested by counterparties, i.e. it accommodates all bids in full. The Governing Council may set a minimum bid rate in order to signal the monetary policy stance Long Term Refinancing Operations (LTROs) LTRO s are repos (liquidity-providing reverse transactions, in the parlance of the ECB) with a longer maturity than MROs. Regular LTROs with a maturity of three months are conducted each month by the Eurosystem. The Eurosystem may also conduct non-regular longer-term operations, with a maturity of more than three months. 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. Hence, in order not to blur the signal arising from the Eurosystem s MROs, LTROs are usually executed in the form of pure variable rate tenders with preannounced allotment volumes. Under exceptional circumstances, the Eurosystem may however execute LTROs through fixed rate tenders and may decide to accommodate all bids in the operations (full allotment procedure). The largest such operations occurred in December 2012 and February 2013, with 36 months LTROs for a total of about 1000bn (see below for these 3-years LTROs). The operational features of the longer-term refinancing operations can be summarised as follows: (a) they are executed regularly each month; (b) they normally have a maturity of 3 months; 1 If, at the lowest interest rate level accepted (i.e. the marginal interest rate), the aggregate amount bid exceeds the remaining amount to be allotted, the remaining amount is allocated pro rata among the bids according to the ratio of the remaining amount to be allotted to the total amount bid at the marginal interest rate. 4

5 (c) they are executed in a decentralised manner by the NCBs; (d) they are executed through variable rate tenders; Fine tuning operations They are aimed at smoothing the effects on interest rates caused by unexpected liquidity fluctuations. Fine-tuning operations are primarily executed as repos (reverse transactions), but may also take the form of foreign exchange swaps or the collection of fixed-term deposits. Fine-tuning operations are normally executed by the Eurosystem through quick tenders or bilateral procedures. The Eurosystem may select a limited number of counterparties to participate in finetuning operations. They are usually very quick tenders: one hour from publication of allotment announcement to announcement of results Structural operations These operations are executed whenever the ECB wishes to adjust the structural position of the Eurosystem vis-à-vis the financial sector (on a regular or non-regular basis). They can be carried out by the Eurosystem through reverse transactions, outright transactions, and the issuance of debt certificates. Structural operations in the form of reverse transactions and the issuance of debt instruments are carried out by the Eurosystem through standard tenders. Structural operations in the form of outright transactions are normally executed through bilateral procedures. STANDING FACILITIES Marginal lending facility Thus is the equivalent of the Fed s discount window The NCBs provide overnight liquidity under the marginal lending facility by means of repurchase agreements or collateralised loans. There is no limit on the amount of liquidity that may be provided under the marginal lending facility, subject to the requirement to provide adequate collateral. The interest rate remunerating the marginal lending facility is announced in advance by the Eurosystem. The interest rate applied to the marginal lending facility is referred to as the marginal lending facility rate. The interest rate on the marginal lending facility normally provides a ceiling for the overnight market interest rate. 5

6 1.3.2 Deposit facility Counterparties may use the deposit facility to make overnight deposits with the Eurosystem through the home NCB, to which a pre-specified interest rate shall be applied. There is no limit on the amount a counterparty may deposit under the deposit facility. The following graph shows the behavior over time, since 2007, of the interest rates on the deposit facility, the marginal lending facility, the MROs (Blue: ECB Deposit facility; Yellow: ECB Marginal lending facility; Red: ECB Main refinancing operations - fixed rate tenders). Note that the interest rate o the deposit facility is now negative, at percent; it became negative for the first time in June 2014, when it was fixed at percent. The interest rate on MROs is 0. 6

7 Reference date Open market operations excl. MonPol portfolios Marginal lending facility Deposit facility Net liquidity effect from Autonomous Factors and MonPol portfolios Current accounts Reserve requirements 30/06/ /06/ /06/ /06/ /11/ Data in billions of euros Source: ECB Historical data on daily liquidity conditions Thus, in normal circumstances there is 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 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. Note also that the use of the deposit facility is much higher in November 2016 than in mid-2014, even though the interest rate on the deposit facility is now negative at percent!. Note also the decline in OMOs, as the new asset purchase programs have replaced in part the OMOs. THE COLLATERAL POLICY OF THE ECB Accepted collateral Eligible market assets 7

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9 Use of acceptable collateral Source: ECB: (In the graph, the term Credit claims indicates bank loans ) You can find a description of the collateral policy of the ECB here. You can find the list of all eligible securities here In May 2015, the list of acceptable collateral for Italy included 1897 securities, with haircuts ranging from 0,5 percent to about 50 percent Differences in the collateral policies of the ECB and the FED 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: 9

10 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).. 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, there is a 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 10

11 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 quasigovernment bonds for open market operations. (ii) ECB and Bank of Japan accept a broad range of both public and private sector claims as collateral. In fact, in the figure above note the very limited use of government bonds as collateral for the ECB Bank loans and ABSs as collateral Note that the ECB accepts both bank loans and private ABSs as collateral. In August 2004 the Governing Council decided to include bank loans as an asset category in the single list. In the euro area, bank-based financing is still bigger than market-based financing. Bank loans therefore often remain the most important asset class on the balance sheets of banks. By accepting bank loans as collateral, the Eurosystem reinforces the principle of granting access to monetary policy and intraday credit operations to a broad range of counterparties. Bank loans have relatively low opportunity costs as collateral because they are rarely traded and counterparties have limited alternative uses for them. The range of eligible debtors is restricted to non-financial corporations and public sector entities. In particular, interbank loans are excluded from eligibility so as to avoid potentially artificial increases in the collateral pool for counterparties. As regards the eligible loan types, undrawn credit lines, current account overdrafts and letters of credit are not eligible. In order for ABSs to be eligible, all cash-flow generating assets backing the ABSs shall be homogenous, i.e. it shall be possible to report them according to one of the existing loan-level templates, which shall be one of the following: (a) residential mortgages; (b) commercial real estate mortgages; (c) loans to small and medium-sized enterprises (SMEs); (d) auto loans; (e) consumer finance loans; (f) leasing receivables; (g) credit card receivables. In August 2004 the Governing Council took the decision to limit the collateral framework to debt instruments and not to accept equities, which were potentially usable in some countries as tier two collateral. The first consideration for making equities ineligible was that the volume of eligible equities was very small. The second consideration was that equities are intrinsically more risky than debt instruments, so eligibility criteria have therefore to be restrictive, and this limits the volume of potentially eligible additional collateral What determines the collateral policies of Central Banks? 11

12 Development of capital markets The central bank s decision on whether to use primarily outright or temporary operations (repos) 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) The lack of a single euro area government bond market was 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 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 crisis, very low at 1:200. In the Eurosystem it was much higher, at 1:10 b) The 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 areawide eligibility framework for bank loans, which was launched at the start of 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 Banking structure 12

13 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. The 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. In principle, the Federal reserve s open market operations are open to all types of financialinstitutionse. 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 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 the 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