José Manuel González-Páramo: Liquidity, funding and solvency - policy
responses and lessons
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the Universidad de Alcalá de Henares, Madrid, 16 January 2009.
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1. Introduction
Ladies and Gentlemen,
It is a great pleasure for me to participate in this Conference of Universidad Alcalá de
Henares, together with so many distinguished speakers, and share with you some
considerations about the responses of the Eurosystem and other public authorities to the
financial market crisis as well as on some of the lessons that we have drawn. I am very
grateful to the organisers - Foro de Economía del Centro de Políticas Públicas UAH and, in
particular, its director Rodrigo Rato - for giving me the opportunity to address you today.
After one year and a half from the start of the turmoil, the international financial system
continues to undergo a period of severe adjustment. The global money and credit markets
are still impaired by the effect of high uncertainty about the solidity of financial and banking
institutions and their ability to withstand the consequences of both the vulnerabilities at the
root of the current crisis (such as the exposures to the US sub-prime mortgage market) and
new shocks stemming from the ongoing slowdown in economic activity. Indeed, the
deterioration in credit supply conditions, together with falling asset prices, exceptionally high
uncertainty and declining confidence, has fed back into economic activity, leading to a severe
worsening of the outlook for economic growth in both developed and emerging countries.
Of particular concern for central banks is the persistence of tensions in global money
markets, where market liquidity has come under severe stress and term interest rate spreads
remain at levels that - though significantly lower than three months ago - are nevertheless
elevated by historical standards. Other important segments of the global financial system,
such as the markets for equities, bonds and commodities, have also entered a period of
considerable turbulence and stress.
In my intervention today, I will focus on what the ECB has done from the beginning of the
financial market turmoil to contribute to the smooth functioning of the euro area money
markets and to mitigate funding shortages of euro area banks.
2. The financial market turmoil and policy responses from the Eurosystem
The turmoil over the last year and a half has hung on our economies like a dark cloud,
prompting central banks and other public authorities to undertake measures that have in
some cases been historically unprecedented in scope and number. As a somewhat
anecdotal illustration to this point, I have recently noticed that a document kept by staff at the
ECB listing the main actions taken by major central banks in response to the turmoil since
September 2008 only, already exceeds thirty pages of concise descriptions of policy
initiatives and specific interventions.
More generally, in order to understand the actions by central banks and other public
authorities in response to the financial turmoil, it is better to position them against the
background of the different moments of the turmoil in which they were taken. Indeed, it is
possible to distinguish three main phases from the turmoil:
1. From its start in August 2007 to the rescue of Bear Stearns in March 2008;
2. From the post-rescue of Bear Stearns to the bankruptcy of Lehman Brothers in
September 2008; and
3. from the bankruptcy of Lehman Brothers to date.
To the risk of oversimplifying, I would say that the first phase of the turmoil was dominated by
concerns about market liquidity and their interaction with funding liquidity at individual
institutions; during the second phase, it became increasingly evident that, as a result of
protracted market and funding illiquidity, adverse liquidity-solvency spirals with the potential
to undermine the viability of specific banking business models were at work; finally, following
the default by Lehman Brothers, widespread concerns about the solvency of banking and
other financial institutions have become predominant. Policy responses have evolved during
the various phases of the turmoil so as to address the increasing difficulties.
2.1 First phase of the financial market turmoil: August 2007-March 2008
During the first phase of the turmoil, the Eurosystem responded to the challenges mostly
through a combination of operational measures in the field of euro liquidity management and
increased communication to the public. This phase also saw the start of significant
international cooperation among central banks to mitigate funding shortages in the global
money markets.
In line with its historical practice and institutional responsibilities, the key objectives pursued
by the Eurosystem's liquidity management during this first phase were two:
1. to steer the overnight money market rate as close as possible to its central policy
rate (the minimum bid rate in the main refinancing operations), so as to implement
the monetary policy stance chosen by the Governing Council; and
2. to ensure the smooth functioning of the money market, also at term maturities, by
facilitating access to liquidity to solvent credit institutions.
In particular, by pursuing the second objective, the Eurosystem aimed to contribute to
reestablishing confidence among market participants and to safeguarding financial stability,
while also supporting the appropriate functioning of the monetary policy transmission
mechanism. Contributing to the stability of the financial system is among the tasks assigned
to the Eurosystem by the Treaty establishing the European Union under Article 105(5).
Ensuring the smooth functioning of the money market is crucial for central banks since the
short-term segments of the money market represent the first step along the mechanism of
transmission of monetary policy impulses, and their impairment may complicate the
signalling and implementation of the desired policy stance.
What did the Eurosystem do in practice? In practice the Eurosystem engaged in more active
liquidity management and adjusted its modalities of liquidity provision to the euro area
banking sector.
As an illustration of more active liquidity management, let me recall our intervention right at
the beginning of the market turmoil. The problems that originated in the exposure of many
financial institutions worldwide to the US sub-prime mortgage market started simmering in
international financial markets in the spring of 2007. In money markets the impact of the
turmoil was initially felt mainly in the longer-dated unsecured inter-bank market and in
nongovernment repurchase agreement (repo) transactions. Tensions eventually spilled over to
the very short-term money markets (i.e. below one-week) in the summer, at first in the US
dollar market, where banks - particularly, the European institutions - encountered difficulties
in raising short-term liquidity, and on 9 August 2007 to the short-term euro money market.
After it became clear that there was the risk of an imminent gridlock in the euro money
market, the ECB released a communication stating its readiness to contribute to orderly
conditions in the euro money market. The ECB then put its money where its mouth is by
providing EUR 95 billion on an overnight basis to the euro area banking sector through a
fine-tuning operation conducted as a fixed rate tender with full allotment.
This operation marked the start of a new phase in which the Eurosystem would make some
adjustments to its liquidity supply practices in two main directions:
1. Under its so-called front-loading policy, it modified the time profile for the provision
of euro liquidity via the weekly refinancing operations within the reserve
maintenance period; and
2. it made adjustments to the modalities of distribution across instruments, particularly
by raising the maturity of its refinancing operations, increasing the frequency of
finetuning operations and occasionally applying different tender specifications to some
operations.
front-loading policy
The was introduced to accommodate a change in the time pattern of
liquidity demand from the banking sector within each reserve maintenance period,
particularly with the emergence of strong precautionary demand in the early weeks of each
period.
Indeed, under normal circumstances, the ECB calibrates its liquidity provision in order to
satisfy the liquidity deficit of the euro area banking sector under the assumption that banks
as a whole prefer to fulfil their reserve requirements smoothly, i.e. by holding - in aggregate
terms - the same level of current account holdings with the central bank on each day of the
reserve maintenance period. As a result, the ECB normally allots at the weekly main
refinancing operations an amount of liquidity that is close to its "benchmark" estimate of the
expected liquidity needs of the banking sector. This practice has functioned well in the past,
when it has normally delivered short-term interest rates close to the target policy rate.
However, at the start of the turmoil, banks became increasingly reluctant to lend to each
other on unsecured terms, both out of concerns about credit risk and out of fears of being
confronted with adverse liquidity shocks and, as a consequence, preferred fulfilling their
reserve requirements relatively early in the maintenance period.
In order to accommodate the increased demand for liquidity buffers by banks and also to
prevent upward pressure on interest rates at the beginning of the reserve maintenance
period, the Eurosystem increased the amount of liquidity supplied in the operations
conducted at the beginning of the period, while later reducing it in the following weeks so as
to keep the average supply of liquidity unchanged.
At the same time, the ECB decided to increase the amount of refinancing provided via
longer-term refinancing operations with a view to smoothening conditions in the term money
market. This decision was accompanied by a reduction in the amounts allotted at the weekly
main refinancing operations in order to keep the total amount of outstanding liquidity
constant.
Just to illustrate the importance of the shift in the maturity composition of the ECB's
refinancing operations, let me quote a few figures. In the summer of 2007, just before the
outbreak of the turmoil, the ECB typically provided about 2/3 of its euro liquidity (around
EUR300 bn) via the main refinancing operations, with the rest (around EUR150 bn) via
operations with a three-month maturity. At the end of the first phase of the turmoil, the
relative importance of the operations was almost inverted (with MROs accounting for roughly
EUR180 bn versus EUR270 bn for the longer-term operations).
As mentioned above, the ECB increased the frequency of operations to respond with greater
occasionally adjusted the tender
sensitivity to shifts in the demand for reserves and also
specification of its operations, particularly on 9 August when - given the large amount of
uncertainty about the severity of market illiquidity - it was deemed more efficient to move
from the standard variable-rate tender without pre-announced allotment to a fixed-rate tender
with full allotment. A key difference between these two tender specifications is that under
fullallotment, the amount of liquidity provided is entirely driven by demand.
Similarly, in order to address concerns about funding shortages over Christmas and the
yearend, on the occasion of the two-week main refinancing operation conducted on 18 December
2007, it was decided to shift from a variable-rate tender to a quasi-fixed rate with
preannounced full allotment.
As mentioned earlier, during this first phase the Eurosystem aimed to keep the overall level
of refinancing provided to the banking sector at levels close to those prevailing just before
the turmoil (roughly around EUR450 bn). This desire to stabilise average liquidity over the
reserve maintenance period reflected the Eurosystem's longstanding policy of providing to
the banking system only the amount of liquidity needed to smoothly fulfil their liquidity deficit
over each maintenance period.
Explaining that the average level of refinancing provided to the market remained constant
was also important to dispel some occasional confusion in press reports about the
implications of the liquidity interventions of the ECB. In particular, press reports occasionally
argued that the ECB had increased the amount of refinancing made available to the euro
area sector based on somewhat impressionistic calculations and comparisons (e.g. by
adding up allotment at overnight operations on different days or by comparing the scale of
the ECB operation with those of central banks operating under completely different
operational frameworks).
These reports were occasionally accompanied by warnings that in responding to the financial
market tensions, the ECB and other major central banks may not be taking "moral hazard"
considerations into account.
The ECB made it clear from the start of the turmoil that it attached large importance to the
issue of the possible effects on future incentives and behaviour of banks of its actions, while
noting that concerns about moral hazard should nevertheless not prevent from providing
appropriate policy responses to the turmoil. More specifically, in the euro area concerns
about sowing the seeds of moral hazard were mitigated by the observation that the ECB had
not made changes to its existing operational framework from the start of the turmoil.
Indeed, although by changing the amounts and time patterns of liquidity provision and the
occasional conduct of extraordinary refinancing operations, the ECB had departed from past
regularities followed in the steering of liquidity conditions, it had not made structural changes
to its existing operational framework that may be rightly or wrongly seen as aiming to provide
relief to any specific financial institutions or sectors bearing substantial losses as a result of
past imprudent risk taking.
Indeed, the ECB's more active management of liquidity conditions was achieved by making
few changes to its traditional way of using instruments and tools that were already part of its
operational arsenal from the start of the turmoil. Moreover, the focus of the ECB's
interventions was to adjust aggregate liquidity conditions so as to continue to deliver the
desired monetary policy stance and to provide support to the money market and banking
sector from a systemic perspective rather than with the purpose of supporting specific
institutions in trouble.
The ability to respond to the challenges posed by the turmoil using the existing toolbox
reflected three key features of the Eurosystem's operational framework: (1) it grants access
to central bank liquidity to a very large range of counterparties; (2) it accepts a rather wide
spectrum of private and public collateral in its refinancing operations and marginal lending
facility; and (3) it conducts open market operations on a relatively large scale, partly
reflecting the level of reserve requirements. Thus, unlike other central banks, from the start of
the turmoil the Eurosystem was in a position to reach a large number of financial institutions
and to mitigate their funding liquidity risks, thereby providing support to the money market as
a whole, without the need to make significant amendments to its framework. The large
spectrum of assets accepted as collateral represented an additional channel through which
the Eurosystem helped to mitigate the refinancing risk of categories of assets for which
secondary market liquidity had basically dried up, since they could be used as collateral in
credit operations of the Eurosystem.
The ECB's liquidity interventions were also accompanied by an intensification of its
communication
policy. A key objective of communication efforts was to reassure market
participants and the public at large about the ECB's full awareness of the severe
deterioration of liquidity conditions in money markets and its preparedness to act in order to
preserve orderly conditions in money markets. In addition, increased communication was
requested by the rather technical nature of issues related to liquidity management and the
relative lack of familiarity of the general public with them, also in order to prevent and
occasionally correct misunderstandings about the scale, modalities and objectives of the
Eurosystem's liquidity operations.
As regards the objectives of such operations, it was important to continuously remind market
participants and the financial press that, under the Eurosystem's institutional set-up (further
reinforced by some changes to the operational framework in 2004), decisions on liquidity
operations are separated from considerations on monetary policy stance. In fact, in the euro
area changes in liquidity conditions are directed to implement the stance of monetary policy
chosen by the General Council, as summarised by the ECB official rates (which are explicitly
communicated to the public through the regular press release on monetary policy decisions),
and under no circumstances can be interpreted as signalling changes in such stance.
From the first day it opened its doors, the ECB has stuck to this principle - the so-called
separation principle - for reasons of accountability, transparency and efficiency in the
implementation of its monetary policy. The need to remind the public of the separation
between monetary policy formulation and implementation became essential in the course of
the first phase of the turmoil against the background of strong inflationary pressures and
rising risks to price stability.
In addition to operational responses on the euro market, the Eurosystem further
cooperation with other central
strengthened its banks, first by means of enhanced
information sharing and collective monitoring of market developments and later on through
coordinated steps to provide liquidity to euro area banks in what was, to my knowledge, the
first systematic and multilateral initiative of central bank co-operation in the money market
field, a market which is central to the implementation of a central bank's monetary policy.
More specifically, in order to address the concerns of euro area banks on the availability of
their funding denominated in US dollars, in December 2007 the ECB agreed with the Federal
Reserve System a currency arrangement (swap line) in connection with their US dollar Term
Auction Facility (TAF). Under this agreement, two operations with a maturity of one-month
amounting to USD 10 billion each were initially conducted, subsequently renewed in January
and expanded in mid March to USD 15 billion each, while announcing that the USD funding
operation would continue for as long as needed.
The TAF operations proved very successful, as they met with strong demand from market
participants and succeeded in mitigating the liquidity shortages in the global term money
markets.
2.2 Second phase of the financial market turmoil: March 2008-September 2008
The start of the second phase of the turmoil was marked by the rescue of Bear Stearns by
JP Morgan with the support of the Federal Reserve. This event provided a clear example of
the potential impact of protracted market illiquidity on funding illiquidity and, ultimately,
solvency for individual financial institutions, whose business activities depended in many
different ways from the viability and strength of the originate-to-distribute banking business
model.
Such concerns related in the first place to large banks reliant on wholesale markets for the
funding of their lending activities. Indeed, many large banks had become increasingly
dependent on interbank borrowing, both unsecured and collateralised, short and long-term
debt, and, as an ultimate line of defence, on the sale of marketable securities rather than on
retail deposits, which made them vulnerable to the persisting of disruptions in financial
markets.
Moreover, there was increasing concern that - as the experience of Bear Stearns had shown
- the range of systemically relevant institutions had become broader, so that not only large
traditional banks but also non-depository financial institutions, such as investment banks and
primary dealers, played a systemic role in maintaining market liquidity in a broad range of
unsecured and secured markets. If such institutions faced funding liquidity constraints,
market liquidity would be widely affected, with potential negative repercussions for the
banking sector and, ultimately, for systemic financial stability.
In the euro area the Eurosystem reacted to the deterioration in money market conditions by
intensifying its provision of euro liquidity to the domestic banking sector and by strengthening
its cooperation with the Fed in order to expand the supply of USD liquidity to the euro area
banks. The focus of the Eurosystem during this phase was to support market liquidity as a
means of mitigating funding liquidity, ultimately contributing to preventing that solvent
institutions became unable to continue operating.
As part of the enhancement of euro liquidity provision, the Eurosystem continued to shift the
maturity composition of its refinancing operations from the weekly maturities to longer-term
maturities. Specifically, it increased the number of 3-month variable-rate tenders and
diversified the maturity structure of its longer-term operations by introducing auctions with a
6-month maturity.
The gradual expansion in the size of longer-term refinancing operations aimed to mitigate
funding risks by providing banks with a stable source of liquidity at term maturities, with a
view also to preventing tensions in term markets from spilling over to the short-term money
markets. Overall, the split between main refinancing and longer-term operations shifted
slightly toward the second category in the course of the second phase of the turmoil. In
addition, the average maturity of the refinancing operations rose as a result of the
introduction of operations with a six-month maturity. By the end of this phase of the turmoil,
the split between the longer-term refinancing operations between the three- and six-month
maturities was EUR250 bn versus EUR50 bn.
In the course of this phase, the scale of the joint initiative among the Fed, the ECB (and the
Swiss National Bank) was substantially expanded. First, in May 2008 it was decided to
almost double the size of the allotment (to USD 28 bn) at the one-month auctions of USD
liquidity, and also decided that the auctions would be regularly conducted with a bi-weekly
frequency. At the end of August, the USD operations were further expanded, with the
addition of operations with three-month duration (with allotments of USD 10 bn each, while
reducing the allotment of the one-month operations to USD 20 bn). As a result of this
expansion, in the summer of 2008, the cooperation between the ECB and the Fed in the
context of the TAF made funding amounting to USD50 bn available to euro area banks on a
regular basis, also at the problematic term maturities.
2.3 Third phase of the financial market turmoil: September 2008 to date
In September 2008 the financial market turmoil entered a more critical phase following the
collapse of Lehman Brothers. In response to the renewed tensions, the Eurosystem stepped
up its efforts to support the appropriate functioning of the euro money markets and to
alleviate both the euro and the USD funding needs of euro area banks. In particular, it took
some exceptional measures aiming to facilitate unlimited access by solvent banks against
adequate collateral to euro and USD liquidity operations. In addition, the ECB adjusted its
monetary policy stance in response to the change in the outlook for medium term price
stability.
A key contribution to easing liquidity tensions in the euro money markets was provided by the
decision on 8 October to temporarily change the tender procedure in the weekly main
refinancing operations to fixed rate tender with full allotment, which - as earlier mentioned -
implies that the allotment at the refinancing operations is fully determined by the level of
demand. This was followed on 15 October by the decision, taken in the context of initiatives
undertaken by the EU authorities, to temporarily extend the fixed-rate tender procedure with
full allotment also to the longer-term refinancing operations.
As a result of these decisions, euro area counterparties can now borrow as much euro
liquidity as they wish both at the weekly and at some key term maturities, against a set of
Other
eligible assets accepted as collateral that has also been temporarily expanded.
measures taken in the last quarter of 2007 included the temporary expansion of the number
of counterparties eligible to participate in fine-tuning operations and the introduction of a
special term (roughly, one-month) refinancing operation.
The decision to temporarily relax the criteria for eligibility as collateral, while continuing to
apply adequate risk control measures, was related to the significantly increased role played
by the ECB in providing liquidity. During the first two phases of the turmoil (and a fortiori
under normal circumstances), the wide range of assets eligible as collateral guarantees that
availability of collateral does not become a constraint for banks' participation at the ECB's
credit operations.
Indeed, historically, there has been a significant degree of over-collateralisation in the euro
area. For instance, in 2007 the average value of eligible collateral posted with the
Eurosystem exceeded EUR1.1 trillion, more than twice the average amount of outstanding
credit at policy operations. However, since the start of the current phase of the turmoil, the
amount of refinancing operations provided by the Eurosystem has significantly increased and
now exceeds EUR800 billion at the euro liquidity operations (and also the size of the
collateralised dollar operations has significantly increased). In addition, the increase in the
average duration of the ECB refinancing operations implies that collateral may remain on
average locked-in for longer periods. Thus, while a significant degree of overcollateralisation
remains, it was regarded appropriate to temporarily expand the collateral set in order to
further facilitate the access to euro liquidity of solvent banks.
Following the collapse of Lehman Brothers, the ECB further strengthened cooperation with
other central banks in order to facilitate the access of euro area banks to liquidity in USD and
Swiss Francs. On 18 September, the ECB announced the expansion of its USD liquidity
operations in collaboration with the Fed by adding operations with an overnight maturity and
increasing the size of the allotment at the existing one-month and three-month operations,
overall more than doubling the overall size of its temporary USD liquidity provision (to USD
110 bn). This was followed by a further expansion to USD 240 billion at the end of
September (with the introduction of a one-week operation).
Finally, on 15 October the ECB announced (together with Bank of England and the Swiss
National Bank) that, in the context of its cooperation with the Fed to provide euro area banks
with USD liquidity, it would conduct operations at the various maturities at fixed interest rates
and with full allotment. On 15 October the Eurosystem also entered into an agreement with
the Swiss National Bank in order to facilitate the provision of liquidity denominated in Swiss
Francs to euro banks. At the same time, in the past few months the Eurosystem has signed
agreements with the central banks of several European countries in order to improve the
provision of euro liquidity to their banking sectors.
the scope of the decisions taken in October 2008 should not be
Overall, underestimated. As
a result of such decisions, euro area banks can now borrow from the ECB as much euro and
USD liquidity as they wish, also at some key term maturities, of course against eligible
eurodenominated collateral. The new set of temporary measures provide an important
contribution to mitigating the funding risks of solvent banks in the euro area, while also
contributing to restore confidence among market participants in the current environment in
which money markets remain under stress and the traditional channels of liquidity
transmission are impaired. While it is too early to assess the impact of such measures, there
is evidence that these operations have had a positive on the term spreads, which have now
moderated from the peaks recorded right after the Lehman Brothers' bankruptcy (though
they still remain at high levels by historical standards).
The more recent measures by the ECB should also be seen in conjunction with the important
initiatives (mostly based on capital injections in exchange for equity and on the provision of
state guarantees) recently taken by national governments of the EU, US and other areas of
the world to support their domestic financial and banking systems.
It is important to notice that, as a result of its enhanced liquidity interventions in euro and
other currencies (notably, in USD) during the present phase of the turmoil, the Eurosystem
has significantly increased its involvement in financial intermediation in the euro area.
Indeed, the Eurosystem has moved from the situation before the start of the turmoil in which
it provided banks only with as much liquidity as necessary to implement its monetary policy
stance, with the intermediation being performed by the market, to the present condition in
which it effectively intermediates liquidity flows among banks in order to mitigate dysfunctions
of money markets.
To illustrate this point, it is useful to distinguish between gross and net liquidity provided by
the Eurosystem. Under normal circumstances, there is no much difference between these
two notions since the recourse to the deposit facility is limited and fine-tuning operations are
not frequent. By contrast, there is at present a significant difference between gross and net
liquidity, with the total level of refinancing provided by the Eurosystem exceeding EUR800
billion, against over EUR300 billion held by banks at the marginal deposit facility.
Taking up a significant intermediation role to guarantee the orderly functioning of our
economy was essential in the wake of the collapse of Lehman Brothers, when an
unprecedented deterioration in the degree of public confidence in the banking sector of most
developed economies seemed to fundamentally undermine their ability to perform its
institutional financial intermediation function. The gravity of the situation required prompt and
extensive actions by central banks and public institutions, also through concerted initiatives.
And as long as money markets remain dysfunctional, it is crucial for the Eurosystem to
continue to provide as much liquidity as needed in order to ease tensions in the impaired
money markets, with a view to ensuring that access to liquidity of solvent banks is not
disrupted, thereby also contributing to safeguarding financial stability. However, this is not
the ideal long-term solution in a market-oriented economy like the euro area. It may
discourage the resumption of normal inter-bank trading activity. It also potentially implies
increased financial risks for the Eurosystem (which are nevertheless taken care of through
adequate risk control measures). All of this explains why the Eurosystem looks forward to the
reactivation of inter-bank lending and to banks resuming their traditional intermediation
activity.
In this context, it was decided on 18 December to restore to 200 basis points the corridor of
standing facility rates around the central policy rate (the rate of the main refinancing
operation) that had been temporarily narrowed by 100 basis points at the height of the
tensions in the global money markets following the collapse of Lehman Brothers, but may be
creating disincentives to inter-bank lending.
Finally, it should be recalled that from the start of the current phase of the market turmoil, the
ECB has significantly adjusted its monetary policy stance in response to changes in the
outlook for price stability in the euro area.
On 8 October, the ECB announced a 50 basis point reduction (to 3.75%) in its key policy rate
- the interest rate on the main refinancing operation - in a move coordinated with five other
major central banks (Bank of Canada, Bank of England, the Federal Reserve, Sveriges
Riksbank and Swiss National Bank). The dec