Having looked at the tools available to the ECB and at its balance sheet, after considering financial market failures due to Fractional Reserve Banking, overlending and VaR, I would like to turn my attention to the actual operation of monetary policy and its transmission into the interbank lending market. Although broader frameworks exist that will be examined in due time, this post takes on a very specific approach, limited to the transmission of monetary policy in the Euro-Zone through the channel system of interest rates.
To this effect, this post is divided in 4 parts. The first part introduces some terminology, particularly regarding interbanking credit indeces. The second part describes the Whitesell 2006 model of the channel system of interest rates, its logic and implications. The third part offers credit market observations. The forth provides a discussion of the appropriateness of the model, which is arguably reinforced by an understanding of the tender procedures used and of the liquidity conditions prevailing in the market. This is a heavily “charted” post. All data is taken from the ECB and is generally, either in € millions or in %.
When discussing these issues it is important to understand their definition and composition well. To this end, it becomes necessary to explain the following concepts, before considering how they interact with one another:
- “Market Rates” refer to the interest rates at which banks borrow from and lend to each other. They have different names depending on the duration (“term”) of the underlying debt contract and the collateral requirements. EONIA is the average overnight rate charged between banks in uncollateralised debt contracts. EURIBOR is the average rate charged between banks in uncollateralised debt contracts with terms as short as 1 week and as long as 12 months ( EURIBOR differs from Euro LIBOR both in the formula applied as well as in the panel of banks it is applied to). EUREPO is the average rate charged between banks in collateralised debt contracts with terms as short as 1 week and as long as 12 months. These averages are calculated using a specific panel of banks.
- “Official Rates” are the rates charged and offered by the ECB as a part of its normal monetary policy operation. Official rates associated with the ECB are the ones corresponding to the MRO, the LTRO, the Marginal Lending Facility and the Deposit facility. A more indepth discussion of these instruments, with links, can be found in a previous post.
- “(Minimum) Average Reserve Requirements” are liabilities that banks must hold in their current account at the ECB in order to be able to operate in the Euro-Zone interbanking market which the central bank facilitates through the TARGET 2 payments system. A more indepth discussion of this tool, with links, can be found in a previous post.
The Theoretical Model
The model of the interbank lending market presented below is a simplified version of the one presented by Whitesell in 2006. Banks lending to each other can reach the end of the business day and have either positive or negative clearing balances. With negative clearing balances the bank will generally approach the central bank to provide liquidity, at a lending rate, to facilitate the clearing of those balances. This has existed for a long time and it sets the maximum overnight interest rate for that interbanking market. However, some central banks (such as the ECB) also provide deposit facilities, so that banks with positive clearing balances can leave the money to the central bank earning a deposit interest, the minimum at which the system is willing to lend. Reserve balances have a two sided cost. Positive reserves earn a low return, lower than if they had been lent. Negative balances cost the banks the highest possible overnight rate.
Therefore, in deciding how much loans to provide and at what rate, a bank in the interbanking market can be modelled as a minimizer of the cost of its reserves, “b”, given a lending rate”rl” and a deposit rate “rd”, provided by the central bank, and expected net settlements described by distribution F(c), where “c” represents unpredicted claims from other banks. In that case, a bank solves the following optimization problem:
If, as “r” increases, (-b) increases, then “b”, the reserves demanded, decreases. Moreover, if all banks target a zero clearing balance, then b=0, so that
If the distribution of unpredictable claims is symmetric around zero, then F(0) = 0.5, in which case,
As a result, and following Keister, Martin and McAndrews (2008), the actual relationship between demand, “b”, and interest rates can be graphically depicted as such:
Figure 1: The Channel System of Interest rates and Reserves
As the graph above shows, the imposition of a maximum or a minimum does not cause the money market to fall apart, but bounds it instead. The graph also shows that in doing so, it actually stops it from falling apart when excess liquidity hits the economy, such as in the case of QE where the interbank lending market rates could fall to zero.
Euro Denominated Credit Markets and Bank Reserves in the Euro-Zone
The binding created by the deposit facility and by the marginal lending facility is apparent in the case of the Euro-zone, where such a system is used by the ECB. The deposit rate and the lending rate provide binding limits to the Euro OverNight Index Avearge (EONIA). As long as the Monetary and Financial Institutions (MFIs) are able to provide accepted collateral, the ECB will be able to set the maximum interest rate at which the interbanking market will lend.
Figure 2: Reserve Requirements & Interest Rates (over time)
For longer maturities, the time variation looks like this:
Figure 3: EURIBOR & EUREPO
However, the theoretical framework presented above might appear to have some inconsistencies. I will consider four issues. First, it is possible to see that across time, the EONIA does not fluctuate around the MRO symmetrically positioned between deposit and the marginal lending facilities. Secondly, in the interest rates/reserve requirements plot (last graph in figure 1) it might appear to show that the direction of the relationship is not the negative one shown in the theoretical graph. Next, the highest values of reserve requirements seem to correspond to two different levels of interest rates. Finally it is obvious that the overnight facilities do not bind the EURIBOR and the EUREPO rates. While these observations are consistent with the model, they are confusing and require an explanation.
Explaining Apparent “Inconsistencies” – Fluctuations of EONIA
Soares and Rodrigues (2011:8-9), provide a very good historical account of the changes in monetary policy variables induced by the financial crisis. In particular they explain how the auction process through which MROs are conducted affects the symmetry of the interest rate channel:
“In September 2008, there was a sharp deterioration of the financial markets following the Lehman Brothers investment bank fallout.(…) The most relevant measure taken by the Eurosystem was to switch all liquidity providing tenders to a procedure of fixed rate tender with full allotment of the amount bid by banks. In this way, banks were able to secure all their funding needs via the ECB. (…) Thus, money market activity, including the overnight segment, diminished. The EONIA moved below the MRO rate and kept systematically closer to the deposit facility rate. Broadly speaking, the measures were effective in limiting the turmoil in funding markets. (…) Given that the fixed rate full allotment procedure of refinancing operations was kept, the excess liquidity and the high recourse to the deposit facility remained.” (emphasis added)
A similar argument is made in Nautz and Offermanns 2006. Clearly the relationship was more symmetric until September 15, 2008, the day of Lehman Brothers’ bankruptcy. The theoretical way to see this is to understand that F(0) can vary. Assuming that F(0) is related to liquidity conditions, then if liquidity conditions improve, if there is more money in circulation in the economy, then the probability of achieving a balanced current account falls. Although the same is true of a shortage in liquidity, the cumulative distributions F(b) are different, so that only an increase in liquidity increases F(0). These probabilistic arguments are more intuitive when seen graphically.
Figure 4: Probability distributions – Skewness
In this sense, the theory described in Whitesell in 2006 and in Keister, Martin and McAndrews (2008) is still consistent with these observations. This insight allows for the generalisations of the effects of tender (auctions) procedures as in the table below:
Table 2: ECB Tenders and their consequences
Explaining Apparent “Inconsistencies” – Direction and Levels of EONIA
The next two apparent inconsistencies fall somewhat in the realm of graphical misinterpretation. What figure 1 shows is that the interest rate corridor set by the central bank binds the market rates and in so doing determines the reserve requirements. However, while figure 1 might appear to imply a negative relationship between interest rates and reserves, such a negative relationship does not exist. What does exist is a fluctuation space for any given market interest rates to relate to bank reserves. Figure one does not represent a path to be followed from high to low rates, but rather the relationship that determines the rate at every point. Low levels of reserves do not necessarily correspond to high levels of interest rate, and vice versa.
The values of both variables are in effect largely set by the ECB and by liquidity shifts. The EONIA is virtually determined by the intererest rate channel in the manner described under the previous subheadings. The current account clearly fluctuates around the monthly average reserve requirements set by the ECB. Given the relative stability of the reserve ratios, the changes in reserve requirements are overwhelmingly explained by changes in the stock of liabilities accepted in the reserve base.
Figure 5: Reserve Base and Components
The ECB’s influence should be apparent from figure 2 and fact that a reduction of the reserve ratio from 2% to 1%, led to the fall in reserve requirements shown at the end of January 2012.
Explaining Apparent “Inconsistencies” – EURIBOR, EUREPO & Term Spreads
The last issue regards the longer term debt contracts and the fact that the channel of deposit and marginal lending facilities does not bind longer term market interest rates. It particular, it is evident that the Marginal lending facility does not bind EURIBOR and the deposit facility does not bind the EUREPO. However this is not an inconsistency, in the sense that the Whitesell 2006 model described above only binds the overnight market. In both cases the curves are usually above the MRO. This positive bias is due to the yield curve/term spread. Without entering in too much detail, the point is that all debt contracts depend on five different things:
- Expected Risk-free rate: This is generally associated with the average yield of the dominant asset (normally sovereign debt) for the relevant maturity. A good proxy for this determinant of the term spread is the Overnight Indexed Swaps (OIS) of that asset. Given its reference point, this captures the effect that sovereign risk has on the credit market.
- Term Premium: The Term Premium is ” the excess yield that investors require to commit to holding a long-term bond instead of a series of shorter-term bonds”. In a sense this measures the amount by which creditors discount future earnings and their preference for present consumption. While it is easy to measure at any given moment, there is a wide range of way to forecast it, be it through surveys, VAR, DSGE or other, none of which are particularly good.
- Liquidity Risk: This captures the risk that a debtor might be hit by a liquidity shock and run out of cash to pay his creditors. While the debtor might not be insolvent his cash shortage will mean he will fail to meet payment deadlines. One measure of liquidity risk suggested by Holmstrom and Tirole (2001) is the covariance between liquidity and asset returns. Supposedly, this allows for a measure of liquidity risk which can predict market returns.
- Counterparty Risk: This is the risk that the debtor will become insolvent and have to declare bankruptcy, thus being unable to repay his creditors. This type of risk is best measured by CDS markets.
- Collateral: Collateral, which is a type of credit insurance, matters because in case of default creditors have a claim on the assets used to support the debt contract.
Generally speaking normal yield curves will be asymptotically positive, with decreasing marginal growth, as shown below:
This explains why the EURIBOR and the EUREPO rates are generally above the EONIA. The implication is that short term debt is less expensive than a longer term alternative, due to liquidity risk, counterparty risk or the term premium. However if the term premium changes to reflect an expectation of falling interest rates, then the yield curve is likely to become inverted:
However, it is possible to see that there are some maturities for which the EUREPO is lower than the EONIA, going so far as to fall below the deposit rate. This can be explained by the last element in the list of determinants of the yield curve. Debt contracts considered in EUREPO are the only ones that are collateralised. As such, even under default, creditors will not necessarily make a loss, in which case, it is possible to credit at lower levels. Given the amount of liquidity that the ECB has been pumping into the economy, it is not surprising to find such low levels of EUREPO.
This post has endeavoured to describe the manner in which the ECB’s monetary policy is transmitted to the credit market. Using Whitesell’s 2006 contributions it has been possible to illustrate the relationships between interest rates and banking reserves. It has also become clear that the auction procedures used to distribute ECB credit have a profound effect on the fluctuation of the interbanking market credit rates. Moreover, for longer maturities it becomes clear that the yield curves are generally positive, although changes in term premia and liquidity provisions by the ECB might have the ability to bring about inverted yield curves.