ECB Monetary Policy Tools – A brief review

Central Banks (CBs) have at their disposal an large range of weaponry they can use to (try to) tame the economy. Given the geographical focus of this blog I will consider only the European Central Bank (ECB) and the monetary policy tools at its disposal. The table below summarises the discussion that follows and builds upon the ECB’s own summary.

Current Account and the TARGET2 system of Transactions

All credit institutions (MFIs, Investment Banks and Financial Vehicle Corporations) operating within the Euro-zone must have an account with the National Central Bank (NCB) under which jurisdiction it is registered. They deposit their reserves in these accounts and perform their transactions through them.

All the transactions from one account to another (ie: from one bank to another) are “settled one by one on a continuous basis in central bank money” through the “Trans-European Automated Real-time Gross settlement Express Transfer system” (TARGET2).  It is a necessary device, without which the Euro-zone would not be able to operate. If a French bank lends money to a Greek bank, if a German bank buys Greek sovereign debt, if the ECB lends money to a Spanish bank, if in Portugal I buy something through ebay from someone in Finland, or if Italian parents send money to their daughter doing an ERASMUS in Belgium, TARGET2 is used. Sinn, Buiter and Withaker wrote at length on this issue in 2011, although they all focused on the relationships between NCBs. The original insight to follow their discussion is that the ECB’s balance sheet is the sum total of all the balance sheets of the Central Banks of the EMU countries. So when a bank registered in Portugal borrows from the ECB, it approaches the Bank of Portugal and bids for the funds there. However, the balance sheet of Bank of Portugal is shared with the rest of the EMU countries, so even if it does not have sufficient own resources to channel to the banking sector, it does not matter. In effect it is only a branch of the ECB, which can channel funds from other National Central Banks to cover the needs of the Portuguese sector. This is not a loan. It’s as if I transferred money from one of my accounts I used to purchase goods in one country to one that used to purchase goods in another.

Reserve Requirements

Average (Minimum) Reserve Requirements are determined by ECB whose monthly average reserve requirements are the result of its chosen reserve ratios. The way (minimum) reserve requirements are calculated in set out in Regulation (EC) No. 2818/98. Articles 3.1 and 3.2 set out the list of acceptable and unacceptable liabilities for the reserve base:

• Accepted: Bank deposits, debt securities issued and money market paper
• Excluded: Liabilities to other credit institutions subject to the Eurosystem’s minimum reserve requirements, the ECB and euro area national central banks

According to the ECB, Reserve Requirements “contribute to creating or enlarging a structural liquidity shortage. This may be helpful in improving the ability of the Eurosystem to operate efficiently as a supplier of liquidity“. As noted in the definitions above, reserves at the ECB are taken from the market operator’s liabilities. Deposits, debt securities issued and money market paper are liabilities of the credit institutions to their depositors, debt creditors and shareholders. However, once these liabilities are deposited at the ECB, they become assets of the commercial banks and a liability of the ECB. Here’s how it work’s:

• Assume you have a job and earn €10,000. On your balance sheet you credit the “Cash Holdings” account in assets as well as the relevant one in Net wealth/Equity.
• When you deposit those €10,000 at a BNP Paribas Desk (for example), you continue to have assets worth €10,000. On your balance sheet you debit your “cash account” and credit your “Deposits”, which are a claim on the bank. BNP Paribas however has an asset, the cash worth €10,000 but also a liability, the €10,000 it owes you.
• To banks, deposits are not earned assets. Because BNP Paribas is a bank operating in the Euro-Zone, your €10,000 are part of its deposits, which means they are a part of the Reserve base. When BNP Paribas deposits the €10,000 in its current account at the ECB, it decreases its liabilities, but also its assets, because it no longer has the cash.

As I show in another post, this means that BNP Paribas has less assets and so can lend less. Therefore, Reserve Requirements are liquidity absorbing. They limit the amount of liquidity in the economy in order to guarantee the influence of the ECB in managing liquidity.

Simultaneously, Reserve holdings also have a somewhat liquidity creation role. They pay out an interest to the depositing banks, proportional to the MRO. This is described in article 8.1 of the previously mentioned regulation, as the Remuneration Rate. This does not include excess reserves.

In parallel, if an entity fails to meet the reserve requirements of the ECB, they are also liable to pay a Penalty Rate for deficiencies (current account holdings below the minimum reserve requirement).

Reverse Transactions

Reverse transactions refer to repurchase agreements (REPOs). In this type of transaction is a bank puts forward some collateral (generally government bonds), which the ECB purchases for a certain price on the agreement that the bank will repurchase it again tomorrow for the same price plus the Marginal Lending Facility interest rate. It is a form of collateralised debt contract virtually equivalent to a loan, where the agreed interest rate is the difference between the price at which the ECB buys it and the price at which it sells it.

Tenders

Tenders are the procedures used to determine interest rates and liquidity provided. In the context of Central Bank operations, “Tenders” is a synonym for “Auctions”. There are 3 different relevant dimensions on which to consider the tenders.

First, there’s the issue of the format of the Auction. In the specific case of the ECB there are 2 alternatives. It can use fixed rate (Dutch Auction), where “the ECB specifies the interest rate in advance and participating counterparties bid the amount of money they want to transact at the fixed interest rate”. It can also use variable rate (American Auction), where “counterparties bid the amounts of money and the interest rates at which they want to enter into transactions with the national central banks” and where “bids with the highest interest rate levels are satisfied first and subsequently bids successively lower interest rates are accepted until the total liquidity to be allotted is exhausted”.

Secondly, there’s an issue with tender allotment. The tender can be completed with full allotment, where every bid is satisfied, no matter how much liquidity is demanded by banks. Alternatively,  “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 bid at the marginal interest rate.”

Third, there’s the issue of the timing of the settlement of the transaction. The ECB’s operations can be settled at a standard pace (MRO, LTRO), where “a maximum of 23 hours elapses from the announcement of the tender to the certification of the allotment result (where the time between the submission deadline and the announcement of the allotment result is approximately 2 hours)”. “Quick tenders[, on the other hand]are normally executed within 90 minutes of the announcement of the tender, with certification taking place immediately after the announcement of the allotment result. ”

ECB TOOLS

Deposit and Marginal Lending Facilities

The ECB possess a Marginal Lending Facility and a Deposit Facility, which provide a maximum and a minimum, respectively, for the European overnight interbanking market to determine the EONIA rate. If at the end of the day, a bank has a negative clearing balance with its central bank, the NCB will lend it the money at the Marginal Lending Facility rate. If on the other hand, a bank has a positive clearing balance with its central bank, then the ECB will pay it the deposit facility’s interest rate. Therefore there is no reason for any bank to accept paying a higher rate than the Marginal Lending Facility’s or for any bank to charge any less than the Deposit facility. The access to these facilities is available to all registered institutions (MFIs, Investment Funds and Financial Vehicle Corporations) on the usual conditions and with recourse to eligible assets. Therefore, while the Marginal Lending Facility is a liquidity providing tool, the Deposit Facility is a liquidity absorbing one. Note that the operation of the Marginal Lending Facility is automatic. As the ECB puts it,

“At the end of each business day, counterparties’ debit positions on their settlement account with thenational central banks are automatically considered to be a request for recourse to the marginal lending facility.”

MRO and LTRO – Main Refinancing Operations & Long Term Refinancing Operation

These instruments are relatively similar. Both are liquidity providing operations. Nonetheless, they have some crucial substantial differences. While the above Facilities of the ECB help determine the overnight rate, the MRO and the LTRO have weekly and three month maturities. Moreover, whereas the facilities are in permanent operation, the refinancing operation tools happen once a week or once a month. It is a similar REPO, but with a maturity of one week and have specific tender procedures associated with themselves, implying they are not necessarily available to all those who need them and who can offer the appropriate collateral.

At the moment this post is being written, MRO tenders were fixed rate, full allotment, while the LTROs were conducted through variable tenders allocated pro-rata.

Finally, whereas MROs are the considered as the main tools of monetary policy used to steer the economy, LTROs are not and their use is more infrequent.

Fine Tuning and Structural Operations

According to the ECB, “Fine-tuning operations aim to manage the liquidity situation in the market and to steer interest rates, in particular in order to smooth the effects on interest rates caused by unexpected liquidity fluctuations in the market. Fine-tuning operations may be conducted on the last day of a reserve maintenance period to counter liquidity imbalances which may have accumulated since the allotment of the last main refinancing operation.”

Strutural Operations, on the other hand, are “aimed at adjusting the structural position of the Eurosystem vis-à-vis the financial sector”. This means that the ECB will use this type of operations to ensure the sustainability of its accounts and that its assets and liabilities are distributed in a satisfactory manner, whatever that might be.

The main tools of Fine-tuning operations are fixed term deposits and forex swaps. Structural Operations on the other hand make use of outright purchases and sales, as would be expected of operations aimed at balance sheet management, and of issuance of ECB debt certificates.

In parallel, if an entity fails to meet the reserve requirements of the ECB, they are also liable to pay a penalty rate for deficiencies.