Peter Praet: The European Central Bank and its role as lender of last
resort during the crisis
Speech by Mr Peter Praet, Member of the Executive Board of the European Central Bank, at
"The Lender of Last Resort: An International Perspective", a conference sponsored by the
Committee on Capital Markets Regulation, Washington DC, 10 February 2016.
* * *
Accompanying charts can be found at the end of the speech or on the European Central Bank's website.
I am grateful for the assistance of F. Hammermann, S. Holton and J. Hutchinson.
Introduction
Ladies and gentlemen,
Since tensions emerged in the interbank market in August 2007, central banks have been at
the forefront - and centre - of the response to the financial crisis. Such prominence is
directly linked to their ability to create liquidity for the entire financial system as well as
solvent individual banks experiencing funding difficulties and to a central bank's function as
lender of last resort (LOLR). This distinctive role was first identified more than two centuries
ago by Henry Thornton (1802) and elaborated on 70 years later by Walter Bagehot (1873).
According to their dictum, central banks should lend freely to solvent but illiquid firms against
good collateral, at a high rate of interest (Tucker, 2014). While much has changed in the
intervening period, these overarching principles have influenced central banks ever since.
In responding to the worst financial crisis in a century, the European Central Bank faced two
challenges which we tried to address with two different approaches to our LOLR function.
First, we had to deal with a system-wide liquidity shock of unprecedented magnitude which, if
left unattended, would have developed into a liquidity crunch and, later, a disorderly
contraction of the stock of broad money and nominal income. We addressed this formidable
stress by resorting to what I will term the "monetary approach" to LOLR. In this way, we
sought to deter a contraction in the stock of bank-created money and to compensate for a
decline in its velocity of circulation, which could otherwise have provoked a more severe fall
in spending, employment and prices than what was observed in reality.
Second, and in parallel, we kept intervening in support of particularly acute idiosyncratic
liquidity strains faced by individual solvent credit institutions (or groups thereof) under the
"credit approach" to LOLR, which is embedded in the Eurosystem's emergency liquidity
assistance (ELA) - a responsibility of the national central banks.
In my remarks today, I would like to provide a brief overview of the ECB's standard liquidity
provision framework before discussing our policy response to the crisis and the rationale
behind our decisions.
Monetary policy operations and the lender of last resort function in the pre-crisis
years
In the euro area, the vast majority of firms and households meet their financing needs via
direct bank intermediation, reflecting the fact that market financing and securitisation are less
developed than in other major jurisdictions. As a result, the euro area banking system lies at
the heart of the conduct of our monetary policy. In the pre-crisis period the ECB's conduct of
monetary policy was founded on temporary credit operations in the form of repurchase
agreements, or repos, with over 1,500 eligible monetary financial institutions (MFIs).
When implementing monetary policy via repos, the ECB's Governing Council decides on two
parameters. First, the desired degree of monetary stimulus, as reflected in the short-term
interest rate that is charged under the main refinancing operations (MROs) and, second, the
expected aggregate demand for liquidity in the market. By calibrating the amount of liquidity
to be auctioned in the MROs so that it was just enough to meet the system's expected
demand for cash balances at the intended main refinancing rate (MRO rate), the ECB could
steer the market rate for overnight liquidity close to the MRO rate during the pre-crisis period.
Indeed, in that era, our prime overnight market rate, the euro overnight index average
(EONIA), was fluctuating closely around the MRO rate.
The MRO is complemented by the two standing facilities which form the monetary policy
corridor. The corridor's floor is the deposit facility, where banks can place overnight their
reserves in excess of reserve requirements and other liquidity needs and earn interest at a
(pre-set) rate lower than the MRO rate. The corridor's ceiling is the marginal lending facility,
where banks can receive overnight liquidity at an interest rate (also pre-set) above the MRO
rate. This marginal lending facility has a dual function: it acts as a "built-in" lender of last
resort for shortfalls in overnight liquidity. But, at the same time, its role in the overall policy
framework is broader, as it serves as the backstop for fluctuations in overnight money market
conditions. It is because of this latter function in the settings of the stance that the
responsibility for marginal lending is shared, as a Eurosystem facility, among all national
central banks (NCBs) of the euro area and the ECB.
Euro area credit institutions can receive central bank credit not only through Eurosystem
monetary policy operations but, exceptionally, also through ELA. Cases in point are banks
which have run out of collateral considered as eligible under our monetary policy framework
or whose counterparty status has been suspended on the grounds of prudence. Technically,
emergency liquidity assistance is activated when a Eurosystem national central bank
provides central bank money and/or any other assistance that may lead to an increase in
central bank money to a financial institution or a group of financial institutions outside
monetary policy operations. Unlike the marginal lending facility, liquidity provision via ELA is
at the discretion of the providing NCB and this is why I refer to ELA as embedding the credit
approach to LOLR. The main responsibility for the provision of ELA lies at the national level,
i.e. with the NCBs concerned. This means that any costs and risks arising from the provision
of ELA are incurred by the relevant NCBs. Nevertheless, in order to ensure that ELA
operations do not interfere with the single monetary policy, the ECB's Governing Council
may object to or restrict the provision of ELA, in line with the Statute of the European System
of Central Banks and of the European Central Bank and the NCB concerned and the
institutions receiving ELA are subject to a special information-sharing framework.
Furthermore, ELA provision is monitored for compliance with the prohibition on monetary
financing which applies to the Eurosystem - and, in fact, to all the central banks of EU
Member States - and is laid down in the Treaty. More specifically, the Treaty stipulations
pertaining to the prohibition of monetary financing ban any ELA transactions akin to an
overdraft facility or any other type of credit facility for a Member State, and any financing of
the public sector's obligations vis-à-vis third parties, or any cases in which, through ELA, the
central bank de facto takes over a state task. Moreover, ELA provision is prohibited for
insolvent institutions and institutions for which insolvency proceedings have been initiated
according to national laws.
In the context of this institutional set-up with many safeguards, the provision of ELA has a
broader scope than monetary policy operations. First, ELA is not limited to monetary policy
counterparties, but is available to a broader set of credit institutions, provided they are
solvent. The wider focus takes into account the fact that financial institutions outside the
narrow realm of our eligible counterparties can run into temporary liquidity shortages that
could challenge financial stability. Second, the set of assets accepted as collateral for ELA
purposes is wider than the one required for Eurosystem monetary policy operations.
Therefore, the cost of liquidity drawn under ELA is also higher than the marginal lending rate.
The ECB's response to the crisis
As the crisis unfolded, our approach to the LOLR function evolved in parallel. Three main
phases can be identified.
The first and second phases of the crisis: system-wide liquidity strains
The first and early phase was the immediate post-Lehman Brothers liquidity crisis. Not unlike
in other advanced economies, the financial trauma that followed the demise of one of the
largest global investment banks created anxiety about the magnitude of European banks'
exposure to subprime products of uncertain quality. This prompted a sudden stop in the
availability of money market funding for many credit institutions in the euro area and a
systemic rush to cash. As interbank markets seized up, the strains were diffused with
virtually no region or sector being spared.
The second phase of the crisis came as a consequence of a much more targeted and
disruptive loss of confidence: the sovereign debt crisis. This was special to Europe; it brought
on the development of redenomination risk and thereby threatened the integrity of our
currency. Banks' exposures to selected governments came under intense market scrutiny
and entire national banking systems lost access to wholesale funding.
Note that during both the first and the second phase, banks faced an urgent need to replace
a source of market funding that had suddenly become unavailable - primarily an impaired
access to money market borrowing in the post-Lehman phase and the impossibility to roll
over maturing bank bonds during the debt crisis. In both episodes, however, the original
source of stress was investors' distrust in the quality of banks' exposures - to the private and
the public sectors. Our role was the same in both phases, namely to create new reserves, on
demand, for cash-stripped banks with viable business models, and thus to help these banks
go through an emergency liability substitution operation without being forced to make
largescale fire sales of assets that would lead to insolvency.
Concretely, for the Eurosystem this meant abandoning its conventional framework for
liquidity provision. We discontinued the practice to auction a pre-set quantity of liquidity and
moved instead to an unlimited allotment of funds at a fixed rate. The tenors of our
longerterm refinancing operations were extended from the pre-crisis standard of three months to
six months in 2008 and to three years in 2011. We also expanded the universe of eligible
collateral.
In essence, we adopted a genuinely classical approach to our LOLR responsibilities.
This approach can be described by using the classical equation of exchange: B*m*V = P*Y.
This simple equation states that base money (B) times the money multiplier (m) times broad
money velocity (V) - or the turnover rate of the broad money supply - is always equal to
nominal income, i.e. the price level (P) times real output (Y). The central bank is concerned
with preserving price stability and supporting the economy, but it can do so only very
indirectly and imprecisely by controlling base money, i.e. the sum of currency and bank
reserves. Therefore, in keeping with the monetary approach to LOLR, base money should be
expanded sufficiently aggressively with two intermediate objectives and one ultimate
objective in mind. The intermediate objectives are: compensate for the fall in the money
multiplier - and the decline in broad money velocity. The ultimate objective is to prevent the
possibility of a collapse in broad money leading to a downward adjustment in nominal
income.
Why do the money multiplier and broad money velocity tend to fall during confidence crises?
The money multiplier is a complex function of the public's preferred ratio of currency holdings
to deposits and of banks' desired ratio of reserves to deposits. Increases in uncertainty
during times of crisis can impact on the behaviour of banks and the money-holding sector,
leading to changes in these ratios, as banks prefer to hold larger reserves with the central
bank as perceptions of counterparty risk increase, and - in the most severe episodes
featuring bank runs - the public may try to convert bank deposits into currency. All of this
alters the association between base money and broad money and increases the quantity of
base money that the system demands in order to hold a given amount of broad money.
Turning to velocity, crisis-induced uncertainty can also lead to a decrease in velocity as
people prefer to hoard broad money as a precautionary measure to prepare for difficult days
and reduce spending. Because velocity has a tendency to fall in tandem with the multiplier, in
episodes of financial dislocation the central bank has one more reason to increase base
money in order to keep nominal income from falling.
This is in essence what we did over the first two phases of the crisis. During this period
(2008-12), the volume of base money was endogenously determined by banks' demand for
it, which was accommodated fully by the Eurosystem, the only restriction being availability of
eligible collateral. This can be seen by comparing Chart 1 and Chart 2. As the multiplier
started to fall early on, the money base expanded strongly and this cushioned pressures on
M3 which could have accentuated its trend deceleration (Chart 1). Even more evidently, as
the debt crisis reached its climax in mid-2012, and banks started to pay down the bonds
which the market was refusing to roll over using newly borrowed Eurosystem funds, the
sharp expansion in base money permitted banks to keep the broad money stock from falling.
Chart 2 shows a disaggregation of broad money growth by counterparts: in other words, it
documents the items on banks' balance sheets which account for and offset the expansion of
M3. It is clear that, starting in 2012, the possibility offered to banks to redeem maturing
bonds with base money and thus pay them off with newly created deposits (dark green bars)
provided critical support for M3 expansion.
The extraordinary injection of fresh liquidity into the system had a profound impact on the
Eurosystem's balance sheet. With hindsight, it proved very successful in building a firewall
against financial contagion and a further decimation of value. Banks could refinance
themselves in the aggregate, preserving a level of intermediation which could bridge the
economy through a sharp contraction and avoid a more severe degradation of confidence
and macroeconomic stability.1
The third phase: addressing a new round of deleveraging
However, as the macroeconomic contraction morphed into a prolonged slump, banks in large
parts of the euro area finally started to engage in a drawn-out process of downsizing their
exposures and de-risking their operations. In those countries most severely hit by the debt
crisis, the risk-adjusted returns on loans had declined to the point where banks had a strong
incentive to redeem loans and deleverage. The crisis had evolved into its third stage: a stage
characterised by a chronic malfunctioning of bank-based transmission, growing signs of a
credit crunch and a rising risk that the dearth of credit and finance for households and firms
would feed back into consumption and investment, thereby magnifying the chance that the
economy might be trapped in a deflationary spiral.
As banks were actively deleveraging, their funding conditions were normalising too, and
liquidity ratios were being restored. In fact, as the debt runs of 2011 and early 2012 faded,
banks were eager to accelerate reimbursement of central bank credit as the pressure to
refinance a leaner balance sheet had diminished and they viewed less dependency on
official borrowing as a way to project a positive image of financial health to their investor
base. Along this process of retrenchment, borrowing conditions were being tightened at
precisely the time when the economy needed support.
Under these conditions, the ECB had to resort to a different strategy, one which would shift
focus from banks' liabilities to banks' assets. Inducing banks to arrest and reverse asset
redemptions and keep credit flowing to the real economy became our policy priority. We
introduced three new instruments: a series of targeted longer-term refinancing operations
(TLTROs), a negative interest rate policy, and an asset purchase programme which included
both private and public sector securities. The TLTROs are a sequence of eight refinancing
operations offering banks long-term refinancing (of up to four years) on the condition that
they use the funds to expand lending. Indeed, banks have responded to the targeting
incentives embedded in the new facility by reducing lending rates and increasing their loan
supply. The asset purchase programme, together with a negative rate on excess reserves,
quickens the pace at which banks and other lenders are resuming providing credit to the
economy at more favourable conditions. Lower term spreads on public sector securities
encourage a shift in the composition of banks' portfolios towards other types of exposure with
a higher risk-adjusted return, which primarily includes loans. The negative interest rate on
reserves discourages liquidity hoarding and speeds up the process of asset reallocation.
With the start of the third phase of the crisis, the monetary approach to LOLR had reached its
limits. Importing LOLR elements into the conduct of monetary policy had been a critical and
far-sighted decision in a phase when the primary purpose was assisting banks in an orderly
exercise of liability substitution. But when our priorities shifted towards the need to re-engage
banks in active credit intermediation, those elements lost traction. The non-discretionary,
passive generation of liquidity which is characteristic of systemic LOLR operations had to be
replaced by a more active strategy of control over the size and composition of our balance
sheet.
The credit approach
Throughout this whole period, in each of its three phases, the credit approach to LOLR has
remained in place. National central banks have continued to assist banks that are unable to
take part in standard Eurosystem monetary policy operations by exercising their LOLR
function under ELA. But the credit approach to LOLR that is embedded in ELA has not
remained static over the crisis period.
During the early phase of the crisis, ELA support was limited to individual banks. Its original
construction, which foresees that funds be provided on a discretionary basis - not
automatically - and be conditional on the Governing Council's judgement that ELA extension
does not interfere with the determination of the monetary policy stance, was preserved.
Discretion and conditionality on the Eurosystem's non-objection are safeguards against
moral hazard.
But as the crisis intensified, and a number of euro area countries became the target of debt
runs and exhausted their fiscal capacity, entire national banking sectors were deprived of the
natural port of call which in other circumstances would have acted as a provider of solvency
support: their national fiscal authority. Very often, these countries had to have recourse to
multilateral financial assistance programmes which - while replacing the local fiscal authority
as the ultimate source of capital support - placed banks under an enhanced regime of
supervisory scrutiny and imposed various forms of regulatory conditionality.
This situation led to two types of innovation in the governance of ELA interventions: first, the
duration of assistance lengthened; second, the scope of assistance broadened from
individual institutions to entire banking systems. For example, in Greece last year the
combined lending of the ECB and the Bank of Greece to Greek banks reached 71% of the
country's GDP. Most of this liquidity was provided via banks' recourse to ELA.
This evolution was proportional to the severity of the circumstances and has proven to be
effective.
In the case of Greece, provision of ELA was certainly necessary in order to ensure the
functioning of the Greek banking system and the continuation of lending to businesses and
households. A discontinuation of ELA would have thrown all Greek banks into default and
would have forced the country to leave the currency union, a decision the Eurosystem could
not have taken without violating the Treaty. ELA provision was proportional as it was
disciplined and justified by rules. We granted ELA for as long as the Governing Council
judged that prospects were favourable for a positive outcome to the negotiations between the
government of Greece and the European institutions. Its expansion was suspended when it
appeared that these conditions were no longer confirmed (Draghi, 2015).
Institutional challenges
The incomplete institutional construct of the euro area, especially the lack of an integrated
banking system, has at times severely complicated the management of the crisis.
Fortunately, a great deal of progress has been made in this area in recent years, but it is
imperative that the banking union be completed, as well as the integration of the euro area
banking sector.
With the Single Supervisory Mechanism (SSM) now fully operational, we have a system of
supervision that is less liable to capture or forbearance. And the Bank Recovery and
Resolution Directive (BRRD) provides a harmonised and predictable framework for private
sector risk-sharing across the EU.
Financial stability considerations are a key driver behind the new regulatory landscape.
Indeed, there are many instances where the framework acknowledges the need to strive for
exceptional solutions in order to achieve the overall goal of preserving the stability of the
entire financial system, which is a precondition - from the ECB's perspective - for
accomplishing its primary objective of price stability. For example, there is a financial stability
exception from the general rule that a bank which needs extraordinary public financial
support is deemed to be failing or likely to fail and thus has to be either resolved or
liquidated. The EU resolution framework explicitly clarifies that the need for emergency
liquidity assistance from a central bank, per se, does not necessarily trigger the resolution of
a bank, and it acknowledges the role of central banks in providing liquidity to the financial
system in times of stress.2
Euro area governments are also on the way to establishing a European public backstop for
the Single Resolution Mechanism. But significant further steps are still required to complete
banking union, including the establishment of a common deposit guarantee scheme.
A complete banking union would have beneficial macroeconomic effects, but it would also
have positive implications for the central bank's function as lender of last resort.
Conclusion
Please allow me to conclude.
The severity and nature of the financial crisis resulted in an extraordinary response by central
banks; one which was very much in the spirit of Thornton and Bagehot.
In a complex and incomplete institutional environment, the Eurosystem has been able to
adapt its set of interventions by using all the flexibility allowed by our instruments in a
principled way to address both systemic and idiosyncratic liquidity problems. We will continue
to do so. And we will be supported to a greater extent than in the past by a more complete
and consistent institutional framework.
References
Bagehot, W., Lombard Street: a description of the money market, London: H. S. King, 1873.
Draghi, M., Speech at the Università Cattolica del Sacro Cuore, Milan, 5 November 2015.
Thornton, H., An enquiry into the nature and effects of the paper credit of Great Britain
(1802).
Tucker, P., "The lender of last resort and modern central banking: principles and
reconstruction", contribution to Re-thinking the lender of last resort, BIS Papers, No 79, 2014.